COMMERCE 1AA3 Study Guide - Quiz Guide: Cash Flow Statement, Retained Earnings, Financial StatementExam
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Question 1: Three of your friends, already finished university, recently purchased a
McDonald’s franchise in downtown Toronto. Unfortunately, there was an ice storm last week
and one of their customers slipped and fell as he entered the restaurant, breaking his hip. This
customer is now suing your friends for $500,000. Should your friends recognize the $500,000
as a liability? Provide a well-reasoned explanation, referencing the 3 liability recognition criteria
in your response.
Three criteria for liability as follows:
(1) Present obligation of an enterprise. – this criterion is met – the franchise has not yet made a
payment to the customer.
(2) Obligation arises from past events. – this criterion is met – the customer already slipped and fell.
(3) Settlement of obligation to result in outflow of future economic resources – this criterion is met –
based on limited information in case, we are unable to estimate the amount of the liability;
however, it is likely that a future outflow will occur.
All three criteria must be met to record a liability. As these three criteria are met, a liability must be
recorded. Note recognition is different from measurement. These three criteria deal with recognition
question, not measurement consideration.
Question 2: List and define the four different ways to measure an asset (i.e. one of these is “net
realizable value”). Next, explain these four terms in the context of a soft drink machine, used at
your friend’s Subway franchise.
(1) Net realizable value – the amount of money that an existing asset could be sold for today. (the
amount of $ somebody would be willing to pay for used coke machine)
(2) Replacement cost – the amount of money required to replace an existing asset today. (the amount
of $ to buy a brand new coke machine)
(3) Present value of future cash flows – the amount of future cash flows to be received from the use
of an asset in generating revenues, discounted to current value today. (the amount of $ to be
received from selling pop from the machine for the useful life of the machine, less the cost of the
syrup and water to produce)
(4) Historical cost – the amount of money that an asset originally cost, whether this was yesterday or
forty years ago. (the amount of $ spent to purchase the coke machine when restaurant was first
Question 3: In what order are financial statements generally prepared? Briefly
comment/describe why they are prepared in this order.
The income statement needs to be prepared first as the net income figure is part of the calculation of
ending retained earnings on the Statement of Retained Earnings. Once the Statement of Retained
Earnings has been prepared this figure is then inserted in the Balance Sheet in the Shareholders' Equity
section. Once these three financial statements have been prepared, the cash flow statement can be
prepared (using information from the first three financial statements).
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