Fundamentals Of Financial Accounting Chapter 1

Chapter 1

Business Decisions and Financial Accounting

ANSWERS TO QUESTIONS

1. Accounting is a system of analyzing, recording, and summarizing the results of a

business’s activities and then reporting them to decision makers.

2. An advantage of operating as a sole proprietorship, rather than a corporation, is that

it is easy to establish. Another advantage is that income from a sole proprietorship

is taxed only once in the hands of the individual proprietor (income from a

corporation is taxed in the corporation and then again in the hands of the individual

proprietor). A disadvantage of operating as a sole proprietorship, rather than a

corporation, is that the individual proprietor can be held responsible for the debts of

the business.

3. Financial accounting focuses on preparing and using the financial statements that

are made available to owners and external users such as customers, creditors, and

potential investors who are interested in reading them. Managerial accounting

focuses on other accounting reports that are not released to the general public, but

instead are prepared and used by employees, supervisors, and managers who run

the company.

4. Financial reports are used by both internal and external groups and individuals. The

internal groups are comprised of the various managers of the business. The

external groups include investors, creditors, governmental agencies, other

interested parties, and the public at large.

5. The business itself, not the individual stockholders who own the business, is viewed

as owning the assets and owing the liabilities on its balance sheet. A business’s

balance sheet includes the assets, liabilities, and stockholders’ equity of only that

business and not the personal assets, liabilities, and equity of the stockholders.

The financial statements of a company show the results of the business activities of

only that company.

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6. (a) Operating – These activities are directly related to earning profits. They include

buying supplies, making products, serving customers, cleaning the premises,

advertising, renting a building, repairing equipment, and obtaining insurance

coverage.

(b) Investing – These activities involve buying and selling productive resources with

long lives (such as buildings, land, equipment, and tools), purchasing investments,

and lending to others.

(c) Financing – Any borrowing from banks, repaying bank loans, receiving

contributions from stockholders, or paying dividends to stockholders are considered

financing activities.

7. The heading of each of the four primary financial statements should include the

following:

(a) Name of the business

(b) Name of the statement

(c) Date of the statement, or the period of time

8. (a) The purpose of the balance sheet is to report the financial position (assets,

liabilities and stockholders’ equity) of a business at a point in time.

(b) The purpose of the income statement is to present information about the

revenues, expenses, and net income of a business for a specified period of time.

(c) The statement of retained earnings reports the way that net income and the

distribution of dividends affected the financial position of the company during the

period.

(d) The purpose of the statement of cash flows is to summarize how a business’s

operating, investing, and financing activities caused its cash balance to change

over a particular period of time.

9. The income statement, statement of retained earnings, and statement of cash flows

would be dated “For the Year Ended December 31, 2012,” because they report the

inflows and outflows of resources during a period of time. In contrast, the balance

sheet would be dated “At December 31, 2012,” because it represents the assets,

liabilities and stockholders’ equity at a specific date.

10. Net income is the excess of total revenues over total expenses. A net loss occurs if

total expenses exceed total revenues.

11. The accounting equation for the balance sheet is: Assets = Liabilities +

Stockholders’ Equity. Assets are the economic resources controlled by the

company. Liabilities are amounts owed by the business. Stockholders’ equity is

the owners’ claims to the business. It includes amounts contributed to the business

(by investors through purchasing the company’s stock) and the amounts earned

and accumulated through profitable business operations.

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12. The equation for the income statement is Revenues – Expenses = Net Income.

Revenues are increases in a company’s resources, arising primarily from its

operating activities. Expenses are decreases in a company’s resources, arising

primarily from its operating activities. Net Income is equal to revenues minus

expenses. (If expenses are greater than revenues, the company has a Net Loss.)

13. The equation for the statement of retained earnings is: Beginning Retained

Earnings + Net Income – Dividends = Ending Retained Earnings. It begins with

beginning-of-the-year retained earnings which is the prior year’s ending retained

earnings reported on the prior year’s balance sheet. The current year’s net income

reported on the income statement is added and the current year’s dividends are

subtracted from this amount. The ending retained earnings amount is reported on

the end-of-year balance sheet.

14. The equation for the statement of cash flows is: Cash flows from operating activities

+ Cash flows from investing activities + Cash flows from financing activities =

Change in cash for the period. Change in cash for the period + Beginning cash

balance = Ending cash balance. The net cash flows for the period represent the

increase or decrease in cash that occurred during the period. Cash flows from

operating activities are cash flows directly related to earning income (normal

business activity). Cash flows from investing activities include cash flows that are

related to the acquisition or sale of the company’s long-term assets. Cash flows

from financing activities are directly related to the financing of the company.

15. Currently, the Financial Accounting Standards Board (FASB) is given the primary

responsibility for setting the detailed rules that become Generally Accepted

Accounting Principles (GAAP) in the United States. (Internationally, the International

Accounting Standards Board (IASB) has the responsibility for setting accounting

rules known as International Financial Reporting Standards (IFRS).)

16. The main goal of accounting rules is to ensure that companies produce useful

financial information for present and potential investors, lenders, and other creditors

in making decisions in their capacity as capital providers. Financial information

must show relevance and faithful representation, as well as be comparable,

verifiable, timely, and understandable.

17. An ethical dilemma is a situation where following one moral principle would result in

violating another. Three steps that should be considered when evaluating ethical

dilemmas are:

(a) Identify who will benefit from the situation (often, the manager or employee) and

how others will be harmed (other employees, the company’s reputation, owners,

creditors, and the public in general).

(b) Identify the alternative courses of action.

(c) Choose the alternative that is the most ethical – that which you would be proud

to have reported in the news media. Often, there is no one right answer and hard

choices will need to be made. Following strong ethical practices is a key part of

ensuring good financial reporting by businesses of all sizes.

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18. Accounting frauds and cases involving academic dishonesty are similar in many

respects. Both involve deceiving others in an attempt to influence their actions or

decisions, often resulting in temporary personal gain for the deceiver. For example,

when an accounting fraud is committed, financial statement users may be misled

into making decisions they wouldn’t have made had the fraud not occurred (e.g.,

creditors might loan money to the company, investors might invest in the company,

or stockholders might reward top managers with big bonuses). When academic

dishonesty is committed, instructors might assign a higher grade than is warranted

by the student’s individual contribution. Another similarity is that, as a consequence

of the deception, innocent bystanders may be adversely affected by fraud and

academic dishonesty. Fraud may require the company to charge higher prices to

customers to cover costs incurred as a result of the fraud. Academic dishonesty

may lead to stricter grading standards, with significant deductions taken for

inadequate documentation of sources referenced. A final similarity is that if fraud

and academic dishonesty are ultimately uncovered, both are likely to lead to

adverse long-term consequences for the perpetrator. Fraudsters may be fined,

imprisoned, and encounter an abrupt end to their careers. Students who cheat may

be penalized through lower course grades or expulsion, and might find it impossible

to obtain academic references for employment applications.

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Authors’ Recommended Solution Time

(Time in minutes)

Mini-exercises Exercises Problems

Skills

Development

Cases*

Continuing Case

No. Time No. Time No. Time No. Time No. Time

1 3 1 10 CP1-1 45 1 20 1 45

2 12 2 10 CP1-2 10 2 20

3 12 3 15 CP1-3 60 3 30

4 6 4 25 CP1-4 5 4 30

5 4 5 25 PA1-1 45 5 20

6 6 6 10 PA1-2 10 6 30

7 6 7 15 PA1-3 50 7 45

8 4 8 10 PA1-4 5

9 4 9 20 PB1-1 45

10 3 10 10 PB1-2 10

11 3 11 3 PB1-3 50

12 6 12 3 PB1-4 5

13 5

14 5

15 4

16 12

* Due to the nature of cases, it is very difficult to estimate the amount of time students will need to

complete them. As with any open-ended project, it is possible for students to devote a large amount of

time to these assignments. While students often benefit from the extra effort, we find that some become

frustrated by the perceived difficulty of the task. You can reduce student frustration and anxiety by

making your expectations clear, and by offering suggestions (about how to research topics or what

companies to select). The skills developed by these cases are indicated below.

Case Financial Analysis Research Ethical

Reasoning

Critical

Thinking Technology Writing Teamwork

1 x

2 x

3 x x x x x

4 x x x

5 x x x

6 x x x

7 x x

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ANSWERS TO MINI-EXERCISES

M1-1

Abbreviation Full Designation

(1) CPA Certified Public Accountant

(2) GAAP Generally Accepted Accounting Principles

(3) FASB Financial Accounting Standards Board

(4) SEC Securities and Exchange Commission

(5) IFRS International Financial Reporting Standards

M1-2

Term or Abbreviation Definition

I

F

D

E

A

C

J

G

B

L

K

H

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

(9)

(10)

(11)

(12)

SEC

Investing activities

Private company

Corporation

Accounting

Partnership

FASB

Financing activities

Unit of measure

GAAP

Public company

Operating activities

A. A system that collects and processes financial

information about an organization and reports that

information to decision makers.

B. Measurement of information about a business in the

monetary unit (dollars or other national currency).

C. An unincorporated business owned by two or more

persons.

D. A company that sells shares of its stock privately and is

not required to release its financial statements to the

public.

E. An incorporated business that issues shares of stock

as evidence of ownership.

F. Buying and selling productive resources with long lives.

G. Transactions with lenders (borrowing and repaying

cash) and stockholders (selling company stock and

paying dividends).

H. Activities directly related to running the business to

earn profit.

I. Securities and Exchange Commission.

J. Financial Accounting Standards Board.

K. A company that has its stock bought and sold by

investors on established stock exchanges .

L. Generally accepted accounting principles.

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M1-3

Term Definition

F

I

C

A

B

H

D

G

E

J

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

(9)

(10)

Relevance

Faithful Representation

Comparability

Separate Entity

Assets

Liabilities

Stockholders’ Equity

Revenues

Expenses

Unit of Measure

A. The financial reports of a business are assumed to

include the results of only that business’s activities.

B. The resources owned by a business.

C. Financial information that can be compared across

businesses because similar accounting methods have

been applied.

D. The total amounts invested and reinvested in the

business by its owners.

E. The costs of business necessary to earn revenues.

F. A feature of financial information that allows it to

influence a decision.

G. Earned by selling goods or services to customers.

H. The amounts owed by the business.

I. Financial information that depicts the economic

substance of business activities.

J. The assumption that states that results of business

activities should be reported in an appropriate monetary

unit.

M1-4