Accounting note 1

University Degree Business and Administrative studies

CHAPTER 2

2-1 The operating cycle depends on the nature of the company. It is the time it takes the company to use cash to acquire goods and services, to sell those goods and services to customers, and to collect cash from the sales.

2-2 A fiscal year is the year used for financial reporting. It may be the same as a calendar year, but often it is not. Many companies elect to begin and end a fiscal year at the low point in their annual business activity.

2-3 The cash basis fails to match accomplishments with efforts. In particular, the cash basis fails to match revenues and expenses properly. Inventory may be bought and paid for in one period, sold in the second with the collection from customers in a third period. Accrual accounting matches revenue and cost of goods sold in the second period, although the cash outlay was in the first and the collection was in the third.

2-4 Expenses are reductions in stockholders' equity; thus they may be accurately described as negative stockholders' equity accounts.

2-5 The two tests of revenue recognition are earning and realization.

2-6 Revenue recognition is delayed when a company sells a magazine subscription because revenue is not recognized until it is earned by delivery of the magazines. Revenue recognition is also delayed if collection of the account receivable is not reasonably certain, which may happen with speculative land sales.

2-7 In theory, all expenses are goods and services that were first purchased as assets and that have now been utilized (used up) in the conduct of operations.

2-8 Managers acquire assets (goods and services) that are then either used instantaneously or at a later time. When the assets are used, they become expenses.

2-9 The balance sheet is a financial picture of a company at one point in time, like a snapshot. In contrast, an income statement shows activity over a period of time. It shows the series of events that take a company from one “snapshot” (balance sheet) to another, just as a moving picture shows movement from one position to the next.

2-10 Synonyms for the income statement are statement of earnings, statement of operations, and profit and loss (P&L) statement. A major reason to learn accounting is to be able to read real financial statements. Such statements contain a variety of terms that may differ from the one first leaned in an introductory accounting course. To be able to read and interpret the financial statements, users need to understand the terminology used, including synonyms used for the major accounting terms.

2-11 Managers are often optimistic and feel that things are bound to get better, so they do not like to report bad news. In addition, they may have bonuses or possible future promotions that depend on the financial reports, so they want the reports to be as good as possible. Finally, financial reports are often the “scorecard” for business success, and competitive managers want to report a high score.

2-12 Cash dividends are not necessary in the conduct of revenue-producing operations. Therefore, they are not expenses but are distributions of assets to owners. These distributions are made possible because of profitable operations, but are not part of the profitable operations.

2-13 Retained earnings is a stockholders' equity account (a residual claim against assets) not an asset account.

2-14 The statement of retained earnings is often only one column in a more comprehensive statement of stockholders’ equity. Although authorities require companies to show the changes in only the retained earnings account, most companies have elected to also include the changes in other stockholders’ equity accounts.

2-15 No. An accounting entity can be a part of an organization, such as a division or department. It can also be an entire economy, such as national income accounting for the U. S. or another country.

2-16 Materiality means that items that are not large enough to influence users’ decisions can be omitted from the financial statements. Thus, you do not find pencils or paper clips listed among a company’s assets. Cost-benefit means, for example, that if the cost of measuring an item is greater than the value from knowing it, it can be omitted. Thus, the cost of operating a division may not include any of the company president’s salary, even though the president spends time overseeing the division’s activities. It would simply be too expensive for the president to account for each minute spent on each different activity he undertakes.

2-17 Reliable data require convincing evidence that can be verified by independent auditors. Accountants must make sure that data reported in the financial statements can be measured with enough accuracy to be useful to users of the statements.

2-18 No. There is one financial ratio, earnings per share (EPS), that is presented on the income statement.

2-19 A high P-E ratio means that investors expect future earnings to exceed current earnings. This is likely to be true for fast growing companies.

2-20 Two dividend ratios are:

Dividend-yield ratio − The amount of dividends paid per dollar invested in a stock at the current market price.

Dividend-payout ratio − The percentage of a company's earnings that is paid out in dividends.

2-21 No. A high payout ratio may be a bad sign. Companies with a high dividend-payout ratio tend to be slow-growing companies. They return a larger percentage of their income to shareholders because they do not have profitable investments for which to use the money.

2-22 It is better to produce relevant approximations to "truth" than precisely verifiable measurements of useless data.

2-23 No. Timing is important because users of financial statements want to judge performance over a particular period of time and want an accurate assessment of status at a particular point in time. Measures of periodic performance and status are not possible if expenses are not recorded in the same time period in which their related revenues appear.

2-24 The fundamental approach that should be taken by the FASB is to concentrate on how measurements and disclosures can improve the communication of economic phenomena. Accounting should not be used to achieve political or social agendas.

2-25 Some types of costs are collecting, processing, and auditing incurred by the preparer. The preparer may also face disclosure costs in terms of a loss of competitive advantage. Once information is produced, analysts and users may need to be educated to understand it.

2-26 A year is a long time to wait for new information about a company’s performance. Preparing full financial statements is time consuming and costly. Quarterly financial disclosures are less complete than annual ones, but they represent a balanced answer to how often and how complete information should be. Within companies many financial items are reported daily, weekly, or monthly depending on the needs of management. In different countries the tradition and the identity of investors have lead to different customs. The United States relies on public ownership of companies and needs a system to keep large numbers of investors adequately informed. In countries where more of the ownership is closely held and more of the liabilities are bank financed, there is less need for frequent public disclosure.

2-27 The real choice is not between the cash basis and the accrual basis. We can have either one, but they provide very different information. The accrual-basis income statement is a better measure of overall performance over an accounting period. The cash-basis income statement provides better information about the risks of running out of cash. In the end, our choice between the two would depend on the question we are trying to answer.

2-28 The stock price should drop by the amount of the dividend per share. Just before the dividend the stock is worth whatever it will be worth after the dividend plus the amount of the dividend. The chapter does not address details of exactly when rights to a dividend are created, when they accompany the sale of a share, or when they are retained by the seller. These issues are covered in the owners’ equity chapter (Chapter 10).

2-29 Many would say that it does not matter because the security markets are efficient and the P-E ratios reflect the expected growth rates of future earnings for each firm. High-growth firms have high P-E ratios and low-growth firms have lower ones. Others would sort into two groups. Each group believes the market tends to systematically misvalue firms, but they disagree on the nature of the market’s “error.” Value investors believe that the market undervalues good low-growth, low P-E firms and therefore buys them. Growth investors believe that the market undervalues good high-growth, high P-E firms and therefore buys them. Empirically, we can find periods of time when value investors have had better results from their investments than growth investors and vice versa. The bottom line is that investing based on P-E ratios alone is never a good idea, although they are an important descriptor of what the market perceptions of a company are at a moment in time.

2-30 (10 min.)

2-31 (5-10 min.)

The dealer is confused. As used by accountants, revenue is a gross amount earned from sales to customers. For example, sales and revenues are synonyms. Revenue is not "the bottom line" in accountants' minds. "The bottom line" is net income, that is, revenue minus all expenses.

Of course, many people use "bottom line" in a nontechnical sense to mean the important or significant result, the result that really matters. For example, "the bottom line is not how much you earn but how much you keep."

2-32 (15-20 min.)

The theme of this solution is that retained earnings is not a pot of cash awaiting distribution to stockholders.

1. Cash $1,000 Paid-in capital $1,000

2. Cash $ 200 Paid-in capital $1,000

Inventory 800

Total $1,000

Note in both Requirements 1 and 2 that the ownership equity is fundamentally a claim against the total assets (in the aggregate). For example, none of the shareholders have a specific claim on cash, and none have a specific claim on inventory. Instead, they all have an undivided claim against (or interest in) all of the assets.

3. Cash $1,150 Paid-in capital $1,000

Retained earnings 150

Total $1,150

Retained earnings is part of stockholders' equity. Even though Cash and Retained earnings have increased by identical amounts compared to number 1, the retained earnings is fundamentally a general claim against total assets (just as paid-in capital is a general claim). Retained earnings is the net rise in ownership claim attributable to profitable operations. However, the assets themselves should not be confused with the claims against the assets.

2-32 (continued)

4. Cash $ 50 Paid-in capital $1,000

($1,150 – $300 – $800) Retained earnings 150

Inventory 300

Equipment 800

Total $1,150 Total $1,150

The same explanation applies here as in Requirement 3. However, Transaction 4 should clarify the lack of a specific link between retained earnings (and paid-in capital) and any particular assets. The ownership claims are general, not specific.

5. Cash $ 50 Account payable $ 500

Inventory Paid-in capital 1,000

($300 + $500) 800 Retained earnings 150

Equipment 800

Total $1,650 Total $1,650

The meaning of retained earnings was explained above. Purchases on "open account" usually create a general liability; that is, the trade creditors usually hold only general claims against the total assets, not specific claims against particular assets (such as mortgages on buildings). In sum, both the creditors and the owners hold general claims against the assets. Of course, if the corporation is liquidated (all assets converted to cash to be distributed to claimants), the creditors' general claims must be satisfied before the owners get one dollar. Thus, the stockholders are said to have a residual claim or residual interest.

2-33 (15-25 min.)

See Exhibit 2-33 on the following page.

2-34 (15-20 min.)

1. First calculate stockholders’ equity from the asset and liability amounts given.

Assets – Liabilities = Stockholders' equity

Dec. 31: $124,000 – $55,000 = $69,000

Jan. 1: 110,000 – 50,000 = 60,000

Change: $ 14,000 – $ 5,000 = $ 9,000

Note that the $14,000 asset increase, less the $5,000 liability increase yields the increase in stockholders equity of $9,000.

2. We can use knowledge of what changes stockholders’ equity to “deduce” the amount of net income. Net income increases stockholders' equity and dividends decrease stockholders' equity.

Beginning stockholders’ equity + net income – dividends = ending stockholders' equity

$60,000 + net income – $5,000 = $69,000

net income = $69,000 + $5,000 – $60,000

= $14,000

3. Sales – Cost of goods sold – Operating expenses = Net income

$354,000 – Cost of goods sold – $ 14,000 = $200,000

– Cost of goods sold = $ 14,000 + $200,000 – $354,000

Cost of goods sold = $140,000

EXHIBIT 2–33 (Amounts are in thousands of dollars.)

TREMAIN COMPANY

Assets = Liabilities + Stockholders' Equity _

Prepaid Sup- Unexpired Unexpired

Cash + Rent + plies + Advertising + Training _ = + Retained Earnings

a1. – 12 + 12 =

a2. – 2 = – 2 (increase rent expense)

b1. – 3 + 3 =

b2. – 3 = – 3 (increase supplies expense)

c1. – 4 + 4 =

c2. – 4 = – 4 (increase advertising expense)

d1. – 9 + 9 =

d2. _ _ _ _ – 9 = – 9 (increase training expense)

The steps shown capture the essence of what is happening. The problem is not explicit that all of the supplies are used during the month, so some students may omit b2. Similarly, some students may argue that c2 and d2 are not clear from the problem, the advertisement and training might occur more than ...