AFM101 Chapter Notes - Chapter 3: Cash Flow Statement, Deferred Income, Accounts Payable

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Chapter 3
ANSWERS TO QUESTIONS
1. A typical business operating cycle for a small gift store would be as follows:
inventory is purchased, cash is paid to suppliers, the product is sold on credit, or
cash. The cash is then collected from the customers if they bought on credit.
2. The Periodicity assumption means that the financial condition and performance of a
business can be reported periodically, usually every month, quarter, or year, even
though the life of the business is much longer.
3. Profit = Revenues + Gains – Expenses – Losses
Each element is defined as follows:
Revenues -- increases in assets or settlements of liabilities from ongoing
operations.
Gains -- increases in assets or settlements of liabilities from peripheral
transactions.
Expenses -- decreases in assets or increases in liabilities from ongoing operations.
Losses -- decreases in assets or increases in liabilities from peripheral
transactions.
4. Both revenues and gains are inflows of net assets. However, revenues occur in the
normal course of operations, whereas gains occur from transactions peripheral to
the central activities of the company. An example is selling land at a price above
cost (at a gain) for companies not in the business of selling land.
Both expenses and losses are outflows of net assets. However, expenses occur in the
normal course of operations, whereas losses occur from transactions peripheral to
the central activities of the company. An example is a loss suffered from fire
damage.
5. Accrual accounting requires recording revenues when earned and recording
expenses when incurred, regardless of the timing of cash receipts or payments.
Cash basis accounting means recording revenues when cash is received and
expenses when cash is paid.
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6. The five criteria that must be met for revenue to be recognized under the accrual
basis of accounting are: (1) The entity has transferred to the buyer the significant
risks and rewards of ownership of the goods, (2) the entity retains neither
continuing managerial involvement to the degree usually associated with ownership
nor effective control over the goods sold, (3) the amount of revenue can be
measured reliably, (4) it is probable that the economic benefits associated with the
transaction will flow to the entity and (5) the costs incurred or expected to be
incurred in respect of the transaction can be measured reliably.
7. The matching process requires that expenses be recorded in the period during
which the related revenue is recognized. For example, the cost of inventory sold
during a period is recorded in the same period as the sale, not when the goods are
produced and held for sale.
8. Profit is added to retained earnings and is part of shareholders’ equity. It is
calculated as revenues minus expenses. Because revenue increases profit it also
increases shareholders’ equity. Expenses decrease profit and shareholders’ equity.
9. Revenues increase shareholders’ equity and expenses decrease shareholders’
equity. To increase shareholders’ equity, a shareholders’ equity account must be
credited; to decrease shareholders’ equity, a shareholders’ equity account must be
debited. Therefore revenues are recorded as credits and expenses as debits.
10. Item Increase Decrease
Revenues Credit Debit
Expenses Debit Credit
Gains Credit Debit
Losses Debit Credit
11. Item Debit Credit
Revenues Decrease Increase
Expenses Increase Decrease
Gains Decrease Increase
Losses Increase Decrease
12.
Item
Operating, Investing,
or Financing Direction
Cash paid to suppliers Operating
Sale of goods on account* None None
Cash received from customers Operating +
Purchase of investments Investing
Cash paid for interest Operating
Issuance of shares for cash Financing +
* This transaction did not involves an exchange of cash.
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13. The total asset turnover ratio is calculated as Sales  Average total assets. The asset
turnover ratio measures the sales generated per dollar of assets. A high ratio
suggests that the company is managing its assets (resources used to generate
revenues) efficiently.
14. Return on assets = Profit / Average Total Assets
ROA measures how much the firm earned for each dollar of investment. It is the
broadest measure of profitability and management effectiveness, independent of
financing strategy. ROA allows investors to compare management’s investment
performance against alternative investment options.
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