ACC FINAL EXAM REVIEW.docx

Chapter 1: 1. What are the three different forms of business organizations? What are the advantages and the disadvantages to each of these forms? Sole Proprietorship: A business with one single owner. Very often the business is owned and operated by the same person. Despite the close relationship between the owner and the business, the affairs of the two must be kept separate. (aka: economic entity concept- the assumption that a single identifiable unit must be accounted for in all situations) Canada Revenue Agency does not recognize the distinction between an individuals person and business affairs. That is, a sole proprietorship is not a taxable entity; any income earned by the business is taxed on the tax return of the individual. Partnership A business owned by two or more people. Although a partnership may involve just two owners, some have thousands of partners. Public accounting firms, law firms, and other service companies are often organized as partnerships. Like a sole proprietorship, a partnership is not a taxable entity, the individual partners pay taxes on their proportionate shares if the income of the business. Corporation An entity organized under the laws of a particular province or the federal government. Each of the provinces is empowered to regulate the creation and operation of businesses organized as corporations in it. To start a corporation you must file articles, and get them approved. Once approved you begin to issue shares. (Shares are traded on organized stock exchanges) One advantage to a corporation is that it makes it possible to raise large amounts of money in a relatively brief period of time. Sometimes corporations issue bond or debenture. (Bond- a certification that represents a corporation’s promise to repay a certain amount of money and interest in the future). The ease of transfer of ownership in a corporation is another advantage of this form of ownership. If you hold shared in a corporation whos shares are actively traded and you decide to sell, you simple call your broker and put in an order to sell. Another distinct advantage is the limited liability of the shareholder. A shareholder is generally only liable for the amount of money they contributed to the company. On the other hand, both proprietors and partners can be held personally liable for the debts of the business. 2. Define the three business activities of a company and provide examples of each of these activities. Financing Activities (Raising money to start the business): All businesses start with financing. Simply put, money is needed to start a business. The discussion of financing activities brings up two important accounting terms; liabilities and capital stock. A liability is an obligation of a business; it can take many different forms (examples: notes payable, accounts payable, bonds payable, taxes payable). Capital stock is the term used to indicate the dollar amount of shares sold to the public. Example: CN obtains financing from debt and shares. Investing Activities (buying assets): There is a natural progression in a business or other type of organization from financing activities to investing activities. That is, if operating activities are insufficient to permit all desired investing, then funds must be obtained from creditors and shareholders. As asset, is a future economic benefit to an organization. Money spent on certain assets is classified as investing. For example purchases of land, buildings, and equipment would appear in financial statements as investments in properties. Operating Activities (Generating revenues- and income via sales): Once funds are obtained from financing activities and investments are made in productive assets, a business is ready to being operations. The name from the sale of products and services is revenue. It is the inflow of assets resulting from the same of products and services. The revenue represents the dollar amount of sales of products and services for a specific period of time. Revenue only represents one aspect of operating activities, however, costs must be incurred to operate a business. These are referred to as expenses. An expense is the outflow of assets resulting from the sale of goods and services. 3. What is the purpose of financial accounting? There are two types of accounting: management account and financial accounting. Management accounting deals with the branch of account concerned with providing management with information to facilitate planning and control. Financial accounting is the branch of accounting concerned with the preparation of financial statements for outsider use. Financial accounting is important for shareholders and potential shareholders, bondholders, bankers, and other creditors, government agencies and other external users to have an outlook of how the company is doing. Note: technically shareholders are insiders, because they own shares in the business. In most corporations, however, it is not practical for shareholders to be involved in the daily affairs of the business. Thus they are better categorized as external users. 4. Who are the primary users of accounting information? The primary users of the accounting information are the internal users- the management of a company. The management of a company is in a position to obtain financial information in a way that best suits its needs. There are also the external users. It is important for shareholders and potential shareholders, bondholders, bankers, and other creditors, government agencies and other external users to have an outlook of how the company is doing. 5. What is the purpose of each of the financial statements? How are the financial statements interrelated? The Balance Sheet (sometimes called the statement of financial position): is the financial statement that summarizes the assets, liabilities, and owners’ equity of a company. It is a “snapshot” of the business at a certain date. A balance sheet can be prepared on any day of the year, although it is most commonly prepared on the last day of a month, quarter, or year. The balance sheet must always balance. Some main items that will appear on the balance sheet: Cash and cash equivalents: includes cash on hand as well as cash in various bank accounts Accounts receivable: arises from selling services to customers and allowing them to pay later Material and supplies: refers to products that the company uses in its operations Properties: includes buildings, land, machinery, and transportation equipment that are all needed to conduct rail services Accounts payable and accrued charges: arise from buying supplies and other materials and being allowed to pay later. Retained earning: amount of income earned less dividends accumulated over life of the company The Income Statement: or statement of earnings summarizes the revenues and expenses of a company for a period of time. Unlike the balance sheet, an income statement is a flow statement. That is, it summarizes the flow of revenue and expenses for the year. The three largest items on the income statement are revenues, operating expenses, and income tax expense. The Statement of Retained Earnings: retained earnings represents the accumulated earnings of a corporation less the amount paid in dividends to shareholders. Dividends are distributions of the net income, or profits of a business to its shareholders. Not all companies pay dividends. A statement of retained earnings explains the change in retained earnings during the period. Revenues minus expenses, or net income, are an increase in retained earnings, and dividends are a decrease in the balance. Dividends are not an expense and thus are not a component of net income, as are expenses. Instead, they are a distribution of the income of the business to its shareholders. Shareholders’ equity consists of two parts: capital stock and retained earnings. In lieu of a separate statement of retained earnings, many corporations prepare a comprehensive statement to explain the changes both in the various capital stock accounts and in retained earnings during the period. 6. What is the accounting equation and how is it connected to the financial statements? The accounting equation is: ASSETS = LIABILITIES + SHAREHOLDERS’ EQUITY The left side of the equation represents the assets of the company, or those items that are valuable economic resources and that will provide future benefit to the company. The right side is who provided, or has claim to those assets. The term shareholder’s equity is used to refer to the owners’ equity (owners equity is the owner’s claims on the assets of an entity) of a corporation. Shareholders’ equity is the mathematical difference between a corporation’s assets and its obligations or liabilities. That is, after the amounts owed to bondholders, banks, suppliers, and other creditors are subtracted from the assets, the amount remaining is the shareholders’ equity, the amount of interest or claim that the owners have on the assets of the business. Note: the fourth major financial statement is the statement of cash flows. The relationship between the accounting equation and the balance sheet: ASSETS = LIABILITIES + SH. EQUITY (economic resources (creditors’ claims to (Owners’ claims example: cash, accounts the assets. to the assets. receivable, inventory) examples: accounts examples: payable, long-term debt) capital stock, retained earnings) 7. You are deciding whether to invest in a company shares. Which financial statement would you want to see, and which areas would you be most interested in? All of them. The balance sheet will show the relative size of the assets and liabilities, and the shareholders’ equity section should state how many shares have been sold (outstanding shares) and how many more are available (authorizes but not yet issued). The income statement’s revenues, operating income, and net income are important, not only for the most current year but also for previous years to determine trends. The statement of retained earnings will report whether dividends were paid, and, if so, the amount. 8. What are the assumptions that underlie the financial statements and why are they important? Name all the assumptions and principles and define them. The assumptions are: economic entity concept, cost principal, going concern, monetary unit, and time period. These assumptions are better explained in the next few questions. 9. Define the cost principle. Give an example of when the cost principle has been violated. Define the going concern assumption. What other principle is interrelated with the going concern assumption? The cost principle requires that accountants record assets at the cost paid to acquire them and continue to show this amount on all balance sheets until the company disposes of them. Why not show an asset such as land at market value? The subjectivity inherent in determining market values supports the practice of carrying assets at their historical cost. The cost of an asset is verifiable by an independent observer and is much more objective than market value. Note: Historical cost refers to the original cost of an asset. The going concern assumption is the assumption that an entity is not in the process of liquidation and that it will continue indefinitely. The going concern assumption justifies the use of historical cost. 10. Define the monetary unit assumption. Give an example of when it has been violated. The monetary unit assumption states that the a monetary unit must be used. A monetary unit is the yardstick used to measure amounts in financial statements, the dollar. The reason for using the dollar as the monetary unit is that it is the recognized medium of exchange. It provides a convenient measure for the position and earnings of the business. As a measure, however, the dollar, like the currencies of all other countries, is subject to instability. We are we are all well aware that a dollar will not buy as much today as it did 10 years ago. 11. Define the time period assumption. How is this assumption connected to accrual accounting? Under the time period assumption, accountants assume that it is possible to prepare an income statement that accurately reflects net income or earning for a specific time period. It is somewhat artificial to measure the earnings of a business for a period of time indicated on a calendar, whether it be a month, a quarter, or a year. Of course the most accurate point in time to measure the earnings of a business would be at the end of its life. Accountants prepare periodic statements, however, because the users of the statements demand information about the entity on a regular basis. 12. What are generally accepted accounting principles? Generally accepted accounting principles are the various methods, rules, practices, and other procedures that have evolved over time in response to the need to regulate the preparation of financial statements. 13. What are the five categories in the financial statements? What are the characteristics or attributes of each of these five categories? Why is an understanding of each of these categories and their characteristics important when creating the financial statements? Chapter 2: 1. What is the objective of financial reporting? The objective of financial reporting is to communicate information to permit users of the information to make informal decision. In other words, to help users reach their decisions in an informed manner. Financial reporting objective: 1) The primary objective: provide information for decision making 2) Supporting objective: Assist with the prediction of cash receipts to investors and creditors 3) Supporting objective: Reflect the management; s stewardship of resources and claims to resources Investors and creditors are ultimately interested in their own prospective cash receipts from dividends or interest and the proceeds from sales, redemption, or maturity of securities or loans. Because these cash flows 2. What makes accounting information useful? List the qualitative characteristics that underlie all financial statements. Define each of the qualitative characteristics. Understandability: the quality of accounting information that makes it comprehensible to those willing to spend the necessary time. Relevance: the capacity of information to make a difference in a decision. Reliability: the quality that makes accounting information dependable in representing the events that it purports to represent. Reliability has four basic characteristics: 1) Verifiability: information is verifiable when we can make sure that it is free from error 2) Representational faithfulness: information is representationally faithful when it corresponds to an actual event. 3) Neutrality: Information is neutral when it is not slanted to portray a company’s position in a better or worse light than the actual circumstances would dictate 4) Conservatism: Information that is uncertain should be presented so that assets and revenues are not overstated while liabilities are not understated. Care is needed here to avoid the creation of bias as a result of being conservative. Comparability: for accounting information the quality that allows a user to analyse two or more companies and look for similarities and differences. Consistency: For accounting information, the quality that allows a user to compare two or more accounting periods for a single company. Materiality: The magnitude of an accounting information omission or misstatement that will effect the judgement of someone relying on the information. Benefit versus Cost constraint: The benefits of accounting information should exceed the costs of providing the information. Such a judgement is a challenge for standard setters and accountants because of the wide variety of users. QUALITY QUESTION Understandability Can the information be used by those willing to learn to use it properly? Relevance Would the information be useful in deciding whether or not to lend money to Russell? Reliability: VerifiabilityCan the information be verified? Is the information free from error? Representational Is there agreement between the information and the events represented? Faithfulness Neutrality Is the information slanted in any way to present that company more favourably than is warranted? Comparability Are the methods used in in assigning amounts to assets the same as those used by other companies? Conservatism If there is any uncertainty about any of the amounts assigned to items on the balance sheet, are they recognized using the least optimistic estimate? Consistency Are the methods used in assigning amounts to assets the same as those used in prior years Materiality Will a specific error in any way affect the judgement of someone relying on the financial statements? Benefits exceed costs Is the company using the differential reporting provisions in its accounting reports? 3. What is depreciation? Depreciation (amortization) is the process of allocating the cost of a long term tangible asset, such as a building or equipment, over it’s useful life. 4. What is materiality and why is it important for the financial statements? Materiality is the magnitude of an accounting information omission or misstatement that will effect the judgement of someone relying on the information. It is important for the financial statement because it is really the issue of whether the error made is large enough to effect the judgement of someone relying of the information. For example: a company pays cash for two separate purchases, one for a $5 pencil, and the other for a $50 000 computer. Theoretically, each expenditure results in the acquisition of an asset that should be depreciated over its useful lifetime. However, what if the company decides to account the $5 pencil as an expense instead. Will this error affect the judgement of someone relying on the financial statements? Because such a slight error will not affect any decisions, minor expenditures of this nature are considered immaterial and are accounted for as an expense of the period. The threshold for determining materiality will vary from one company to the next, depending to a large extent on the size of the company. Many companies establish policies that any expenditure under a certain dollar amount should be accounted for as an expense. Finally, in some instances the amount of a transaction may be immaterial by company standards but may still be considered significant by financial users. For example, a transaction involving either illegal or unethical behanviour by a company officer would be of concern, regardless of the dollar amounts involved. 5. What is the benefit versus cost constraint? How may this affect how a company records transactions? The benefits of accounting information should exceed the costs of providing the information. Such a judgement is a challenge for standard setters and accountants because of the wide variety of users. 6. What is a classified balance sheet and why is it important? Why do companies produce classified balance sheets? The balance sheet is the financial statement that summarizes the assets, liabilities, and owners’ equity at a specific point in time. The operating cycle is the period of time between the purchase of inventory and the collection of any receivable from the sale of the inventory. The operating cycle depends to a large extent on the nature of a company’s business. For a retailer, it encompasses the period of time from the investment of cash in inventory to the collection of any account receivable from sale of the product. The operating cycle for a manufacturer is expanded to include the period of time required to convert raw materials into finished products. A classified balance sheet is helpful in evaluating the liquidity of a business. Working capital, the difference between current assets and current liabilities, indicated the buffer if protection for creditors. The current ratio, current assets divided by current liabilities, provides the reader with a relative measure of liquidity. 7. Define current assets. Define noncurrent assets. Define current liabilities and long-term liabilities. What is shareholders equity? Current assets: will be realized in cash or sold or consumed during the operating cycle or within one year if the cycle is shorter than one year. Because most business have numerous operating cycles within a year, the cut off for classification as a current asset is usually one year. Cash, accounts receivable, inventory, and prepaid expenses are all example of current assets. Non-current assets: any assets that do not meet the definition of a current asset are classified as long-term or non-current assets. Three common categories of long-term assets are: investments, property, plant and equipment, and intangibles. Note: Intangible assets lack physical substance. Examples, trademarks, copyrights, franchisee rights, and patents. Current liability: is an obligation that will be satisfied within the operating cycle or within one year if the operating cycle is less than one year. Many liabilities are satisfied by making a cash payment. However, some obligations are settled by rendering a service. Non-current liabilities: Any obligation that will not be pair or otherwise satisfied within the next year or the operating cycle, which ever is longer, is classified as a long-term liability or long-term debt. Examples are, bonds payable, or notes payable. Shareholders equity: shareholders’ equity represents the owners’ claims on the assets of the business. These claims arise from two sources: contributed capital and earned capital. Contributed capital appears on the balance sheet as capital stock and earned capital takes the form of retained earnings. Capital Stock: indicated the owners’ investment in the business Retained Earnings: represents the accumulated earnings, or net income of the business since its inception less all dividends paid during that time. Most companies have a single class of capital stock called common stock. This is the most basic form of ownership in the business. All other claims against the company, such as those of creditors and preferred shareholders, take priority. Preferred shareholders are a form of capital stock that, as the name implies, carries with it certain preferences. For example, the company must pay dividends to preferred shareholders before common shareholders. 8. What is the purpose of the income statement? Is the income statement for a point in time or a period of time? What is the single step income statement? The income statement is used to summarize the results of operations of an entity for a period of time. AT a minimum, all companies prepare income statements once a year. Companies must report to security commissions prepare financial statements, including an income statement, every three months. Monthly income statements are usually prepared for internal use by management. Single step income statement: an income statement in which all expenses are added together and subtracted from all revenues. 9. What is the purpose of the statement of retained earnings? What is included on the statement of retained earnings? The purpose of a statement of shareholders’ equity is to explain the changes in the components of owners’ equity during the period. Retained earnings and capital stock are the two primary components of shareholders’ equity If there are no changes during the period in a company’s capital stock, it may choose to present a statement of retained earnings instead of shareholders’ equity. The statement of retained earnings provides a link between the income statement and the balance sheet. It explains the changes in retained earnings during the period a, of which net income (loss) is an important component. 10. What is the purpose of the cash flow? What are the three activities that we will see on the cash flow statement? The statement of cash flows classifies cash inflows and outflows as originating from three activities, operating, investing and financing. Operating activities are related to the primary purpose of a business. Investing activities are those generally involved with the acquisition and sale of non-current assets. Financing activities are related to the acquisition ad repayment of capital that ultimately funds the operations of a business. For example, borrowing or the issuance of shares. Notes: Ratio Review Working Capital = Current Assets(BalanceSheet)−CurrentLiabilities(BalanceSheet) Current Assets(BalanceSheet) Current Ratio = Current Liabilities(Balance sheet) Net Income(IncomeStatement) Profit Margin = Sales∨Revenue(IncomeStatement) Chapter 3 1. What is the difference between an event and a transaction? Which one is recorded on the financial statements and which is not? Many different types of economic events affect an entity during the year. A sale is made to a customer. Inventory is purchased from a supplier. A loan is taken out at the bank. A fire destroys a warehouse. A new contract is signed with the union. In short, an event is a happening of consequence to an entity. An event however, is any event that is recognized in a set of financial statements. 2. What is an external vs an internal event? When is an event a transaction? An external event involves interaction between the entity and its environment. For example, the payment of wages to an employee is an external event, as is the hiring of a new sales manager. An internal event occurs entirely within the entity. The use of a piece of equipment is an internal event. What is necessary to recognize an event in the records? Does the a