Guided Readings for Financial Accounting, Lesson 4.1 – Mastery Level

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“How Does an Organization Accumulate and Organize the Information Necessary to Create Financial Statements?” The following set of guided readings cards were created to accompany Chapter Four of the updated third edition of Financial Accounting (Version 3.1) authored by Hoyle, Skender, and Kratz and published by FlatWorld.

Copyright 2022 by Joe Hoyle

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Watch the opening video for Chapter Four of the textbook: Introduction to Chapter Four. This video covers the gathering of information to describe changes in account balances that result from transactions. In this chapter, we identify the accounts affected and whether those balances go up or down. We record each change using an ancient but effective system known as double-entry bookkeeping.

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SUGGESTION: Read the first section of Chapter Four (“The Essential Role of Transaction Analysis”). This section introduces (a) transactions—events that have a financial effect on an organization—and (b) transaction analysis—the determination of the accounts that are affected by a particular transaction. This opening section focuses on three transactions (purchase of inventory on credit, salary paid to workers, and money borrowed on a loan) to demonstrate how an accountant identifies and measures each change in an account balance.

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Read each of the ten transactions listed in Table 4.1. Are any of these events unusual or weird? Probably not. They seem normal. For each one, consider what account balances will change? By how much will they change and will they go up or down? See how many you can figure out for yourself. A central goal of this chapter is to help you analyze transactions. Table 4.1 is a good place to start.

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(4Q1) – In financial accounting, what is an account?

(4A1) – An account is an individual balance that a financial accounting system maintains for reporting purposes. For example, the cash balance is recorded as a separate account as is land, rent expense, dividend distributions, sales revenue, and the like. An account reflects the balance for each asset, each liability, each expense, and so on. The accountant has access to these accounts and can look at them whenever individual monetary figures are needed for reporting purposes.

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(4Q2) – How many accounts does a company maintain for reporting purposes?

(4A2) – A small company might record balances for only a few dozen accounts. A large company will likely have hundreds of accounts if not thousands. The number of accounts is affected by the complexity and size of the business. A bigger company normally has more individual types of assets, liabilities, revenues, expenses, and the like.

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(4Q3) – What is a transaction?

(4A3) – A transaction is an event that has a financial effect on an organization. It always changes two or more account balances. For example, a company buys a piece of equipment using cash. That is a transaction. Equipment goes up while cash goes down. Financial accounting records the change that a transaction has on specific account balances. This recording process is the foundation of financial accounting.

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SUGGESTION: Work the first Test Yourself question in Section 4.1 of Chapter Four (“Each of the following events …”). This question is designed to make sure you can identify a transaction. Three of these answers are transactions but one is not. Which one does not qualify? Determine your answer first and then read the explanation.

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(4Q4) – A company buys inventory for $19,000 that it hopes to sell to its customers. This merchandise was bought on credit with payment to be made later. For the company, what account balances are affected by this transaction?

(4A4) – Inventory increases by $19,000 and accounts payable also goes up by $19,000. “Accounts payable” is an account used to record liabilities that result from a purchase (unless a legal note is signed and then the account is labeled a “note payable”). Any debt incurred from acquiring inventory, supplies, and the like is most frequently recorded as an accounts payable.

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(4Q5) – Ace Company owns a computer that breaks. The computer is taken to a technician who spends several hours fixing it. When the computer is picked up by an Ace Company official, the technician is paid $970 in cash for the work done. For Ace Company, what accounts are affected by this transaction and did they go up or down?

(4A5) – The information here shows that the amount was paid immediately. Ace Company did not need to record a debt for this amount prior to payment. Thus, repair expense goes up by $970 and cash goes down by $970. When an expense is incurred, the accountant must always determine whether a liability was recorded in the accounting system. Here, the payment was made immediately so no recorded liability is needed.

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(4Q6) – Base Company owns a computer that breaks. The computer is taken to a technician who spends several hours fixing it. When the computer is picked up by a Base Company official, the technician indicates that the charge for this work is $980. Base records that transaction even though the company does not make the cash payment for several weeks. For Base Company, what accounts are affected by these two transactions (the repair and the later payment) and did the accounts go up or down?

(4A6) – The information states that Base Company recorded the repair immediately. Thus, when the work is done, repair expense goes up $980 and repair payable also goes up $980. Several weeks later, payment is made. The repair payable goes down $980 to remove the liability. Cash also goes down $980. This recording should seem logical.

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(4Q7) – Case Company owns a computer that breaks. The computer is taken to a technician who fixes it. When the computer is picked up by a company official, the technician indicates that the charge for this work is $990. Case will wait for a week or two before making the payment. Because Case plans to make the payment quickly, company officials decide to delay the recording until payment is made. It is easier that way. For Case Company, what accounts are affected by these two events and did the accounts go up or down?

(4A7) – Because Case expects to make a quick payment, nothing was recorded when the work was done. That is fine as long as the company does not plan to make financial statements during the interim time. No expense or liability was recorded initially so when payment is made, repair expense goes up $990 and cash goes down by the same amount. The liability is not removed because it was never recorded.

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SUGGESTION: Notice in these three previous questions, an expense was incurred. In the first case, it was paid immediately and recorded. In the second case, it was going to be paid later so both the liability and the eventual payment were recorded. In the third case, for convenience, nothing was recorded until the amount was paid. Then, the expense and the cash reduction were recorded. The liability was never recorded just to save time and energy. Although the reporting on the financial statements should always be the same, the process used by companies to gather and adjust financial information can vary.

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(4Q8) – Dance Company owns a computer that breaks. The computer is taken to a technician who fixes it. The computer is picked up on December 27, Year One. The technician indicates that the charge for this work is $940. Because Dance plans to wait only a few weeks before making payment, company officials decide to make no recording until that time. On December 31, Year One, financial statements are to be prepared and payment has not yet been made. What should Dance do then?

(4A8) – When financial statements are to be prepared, any events that have not yet been included must be recorded. On December 31, Year One, Dance’s repair expense is increased by $940 and repair payable is also increased by $940. Some companies believe that it is simpler to wait until (a) payment is made or (b) financial statements are prepared before recording a small event like this repair work. When financial statements are prepared, the accountant must ensure that the proper effect has been recorded for each account.

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SUGGESTION: Work the third Test Yourself question in Section 4.1 of Chapter Four (“The Abraham Company rents a…”) and the One Step Further question. In both cases, you are told exactly what the company has done. You now have to determine whether the resulting balances are presented fairly or need to be adjusted before financial statements can be made.

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(4Q9) – The East Company plans to build a new warehouse and goes to its bank and signs a note to borrow $1.3 million in cash for the project. For the East Company, what accounts are affected by this transaction and do they go up or down? Assume that no work has started.

(4A9) – The company borrows money from the bank by signing a note. Cash goes up $1.3 million and note payable also goes up $1.3 million. Assets are increased but so are the liabilities.

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SUGGESTION: Read the second section of Chapter Four (“Understanding the Effects Caused by Common Transactions”). This section analyzes the effect of several common business transactions: sale of inventory, payment of a liability, acquisition of an asset, capital contribution by an owner, collection of an account receivable, and payment of rent in advance. These are all basic business events. Make certain that you understand each financial effect.

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(4Q10) – On Monday, Easy Company sells a service for $13,000 on account (the amount will be collected from the customer on a later date). All work is done immediately and the transaction recorded. On Friday, the customer pays the first $4,000 of this amount. These are normal events. For Easy Company, what account balances are affected?

(4A10) – On Monday, the accounts receivable balance is increased by $13,000 and sales revenue (or just “sales”) is increased by $13,000. On Friday, cash goes up $4,000 and accounts receivable goes down by $4,000. That should seem logical. Notice that revenue is reported on Monday when the earning process is completed (the company has satisfied its performance obligation) even though cash is not collected until later. No revenue is recorded on Friday because that would be double-counting the amount.

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(4Q11) – On Monday, Foster Company sells a piece of inventory for $13,000 in cash. The inventory had been bought by Foster a few weeks earlier for $8,000. For Foster Company, what account balances are affected by this sale?

(4A11) – Two events are recorded here. First, the accountant records the effect of the sale. Cash is increased by $13,000. Sales revenue is also recorded as an increase of $13,000. Second, the customer takes the inventory. Inventory is reduced by $8,000. Cost of goods sold (an expense) is increased by $8,000. This expense reflects the removal of the inventory. A sale of inventory includes these two separate events. The sale occurs. The inventory is removed.

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Note in the previous question and answer that the inventory removal was recorded immediately when the inventory was sold. That is known as a perpetual inventory system. Later in the textbook, we will look at a simpler alternative system known as a periodic inventory system. To avoid confusion, only a perpetual inventory system is used in these beginning chapters.

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(4Q12) – A company makes a sale of a service on account on Monday. The work is completed on that day and recorded by the company. The customer pays $5,000 in cash to the company on Thursday. In recording a transaction such as the collection on Thursday, how many accounts must be affected?

(4A12) – In this example, cash is increased on Thursday by $5,000 and accounts receivable is decreased by $5,000. Revenue is not recorded here because it was previously recorded on Monday. Revenue is recorded when the performance obligation (what the company is required to do) is satisfied. Here, that is Monday. One transaction might affect many accounts but it must always change at least two because every effect must have a cause. The cash increase caused the accounts receivable to decrease.

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(4Q13) – In financial accounting, what is an accrual?

(413A) – An accrual is a balance that grows gradually over time. Interest on a bank loan is an accrual because it grows gradually over time. Rent on a building is an accrual for the same reason. From an accounting perspective, the question is whether the financial effects are recorded daily or maybe at wider intervals for convenience.

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(4Q14) – On Monday, an employee does work for a company and earns $500 that will eventually be paid. At the end of the day on Monday, what account changes are recorded by the company?

(4A14) – This is an accrual that might continue to grow over time until paid (if more work is done). An accountant can record this transaction in one of two ways. (1) On Monday, the company can increase salary expense $500 and increase salary payable $500. When paid, salary payable decreases $500 and cash decreases $500. (2) The company can do nothing on Monday. When payment is made, salary expense is increased and cash is decreased by $500. Either way works unless statements are produced in the interim.

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Note that accruals can be recorded as they happen but that can be a lot of work and provide no real benefit. Or, nothing can be recorded until payment is finally made or collected. If the accountant is careful, that can be easier. However, in this second case, if financial statements are made before payment, the financial effects up to that date have to be added.

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SUGGESTION: Work the second Test Yourself question in Section 4.2 of Chapter Four (“Sara Francis is the accountant …”) and the One Step Further question. They deal with the various ways that a company can record an accrued expense—one that grows gradually as time passes. Notice in each case that three of the answers are true. Which of the available answers cannot possibly be true? Make sure to read the explanations carefully.

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(4Q15) – On Monday, an employee does work for a company and will eventually be paid $500. On Wednesday, before payment is made, the company comes to the end of its fiscal year and stops to prepare financial statements. Assume salary expense was increased by $500 on Monday as was salary payable. What should the accountant do on Wednesday prior to producing financial statements?

(4A15) – Because both the expense and payable were increased on Monday, nothing further needs to be recorded or changed on Wednesday in order to prepare financial statements. Both balances are already presented fairly so that financial statements can be prepared.

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(4Q16) – On Monday, an employee does work for a company and will eventually be paid $500. On Wednesday, before payment is made, the company comes to the end of its fiscal year and stops to prepare financial statements. Assume that nothing was recorded on Monday when the transaction took place because the accounting system was programmed that way. What should the accountant do on Wednesday in order to prepare the financial statements?

(4A16) – The company has chosen not to record such events as they occur. Instead, the company normally waits until payment is made to record the effect. Here, financial statements are to be prepared before payment is made. The financial effect has been left off the records for convenience but must now be included so that the financial statements are presented fairly. On Wednesday, salary expense is increased by $500 and salary payable is also increased by $500.

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(4Q17) – The Guest Company buys three acres of land on which it plans to build a new retail outlet. The land has a cost of $1,000,000. The company makes a $40,000 down payment in cash and signs a five-year note for the remaining balance. What accounts are affected by this transaction and do they go up or down?

(4A17) – Guest will increase its land account by $1 million. At the same time, cash goes down by $40,000 while the note payable balance increases by $960,000. The increases and decreases simply mirror the actual effects of the purchase. By practicing with these transactions, the process will become easier for you fairly quickly.

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(4Q18) – An investor pays $43,000 in cash to acquire 400 shares of the capital stock of a new corporation. For the corporation, what account balances are affected by this transaction?

(4A18) – For the corporation, cash goes up $43,000 and capital stock (or contributed capital) also goes up $43,000. The capital stock account measures the amount of assets provided by the owners when they acquired ownership shares directly from the corporation (rather than from another investor on a stock exchange). The capital stock balance is reported in the stockholders’ equity section of the balance sheet to inform decision makers of the source of that amount of the company’s net assets.

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SUGGESTION: As we go through these transactions, start a list. Write down each event that is described and how it is reported. Without too much time and trouble, you can create a complete list for yourself for study purposes.

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SUGGESTION: Work the third Test Yourself question in Section 4.2 of Chapter Four (“The Hamilton Company issues capital stock…”). In this question, a mistake in recording is made. You are supposed to assess the effect of that mistake. Which account balances are now incorrectly reported?

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(4Q19) – The House Company signs a contract to rent a building for $2,000 per month. On July 1, the company pays $4,000 to rent the building for the following two months. How does the accountant record this payment?

(4A19) – Prepaid rent (an asset because the company has acquired a future economic benefit—the company obtains the use of the building for the next two months) is increased by $4,000 and cash is decreased by $4,000. Each time you practice one of these, your knowledge increases. It might be only a bit but that bit will grow gradually until you can read an entire set of financial statements.

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(4Q20) – On May 1, a company signs a contract to rent a building for $2,000 per month starting then. On July 1, the company pays $4,000 for the rent on that building for the previous two months. The company has been recording the financial effect of this rental as the amount accrues over time. How does the accountant record the actual payment that has just been made? Read the question carefully and think about what it is telling you.

(4A20) – During the previous two months, the company has increased rent expense by $4,000 and also increased rent payable by $4,000. According to the information, the rent expense has been reported appropriately. On July 1, the liability balance is paid in full. The company should decrease rent payable by $4,000 and also decrease cash by the same $4,000 amount.

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(4Q21) – On May 1, a company signs a contract to rent a building for $2,000 per month starting then. On July 1, the company pays $4,000 for rent on the building for the previous two months. The company has NOT been recording the financial effect of this rental as the amount accrues. Nothing at all has yet been recorded. The company finds that to be an easier process. How does the accountant now record the payment?

(4A21) – Neither the expense nor the liability has been recorded during the previous two months as the cost was incurred. The company decided to wait about recording the amount until payment was made (or financial statements were prepared). The company should now increase rent expense by $4,000. No liability has been recorded so there is no liability to remove. Instead, cash is decreased by $4,000. It is always important to see what the company has recorded so you can address that directly.