CHAPTER 18 – Understanding Financial Information and ...



CHAPTER 12 – UNDERSTANDING FINANCIAL INFORMATION

AND ACCOUNTING

ANSWERS

LEARNING THE LANGUAGE

|1. Annual report |13. Account receivable |25. Ledger |

|2. Generally accepted accounting principles |14. Gross margin (gross profit) |26. Certified Management |

|(GAAP) | |Accountant (CMA) |

|3. Governmental accounting standards board |15. Financial accounting |27. Bookkeeping |

|(GASB) | | |

|4 Journal |16. Balance sheet |28. Income statement |

|5. Owner’s equity |17. Private accountant |29. Depreciation |

|6. Trial balance |18. Accounting |30. Statement of cash flows |

|7. Liquidity |19 Revenue |31. Operating expenses |

|8. Independent audit |20. Auditing |32. Ratio analysis |

|9. Managerial accounting |21. Financial statement |33. Gross sales |

|10. Double entry bookkeeping |22. Cost of goods sold (cost of |34 Sarbanes-Oxley Act |

| |goods manufactured) | |

|11 Certified Public Accountant |23. Public accountant |35. Financial Accounting Standards Board |

|(CPA) | |(FASB) |

|12. Assets |24. Liabilities |36. Net sales |

ASSESSMENT CHECK

Learning Goal 1

The Importance of Accounting Information

1. Financial transactions can include specifics like buying and selling goods and services, acquiring insurance, paying employees, and using supplies.

2. Two purposes of accounting are:

a. to help managers evaluate the financial condition and operating performance of the firm.

b. to report financial information to people outside the firm such as owners, creditors, suppliers, employees, investors, and the government.

3. Users of accounting information include:

a. government.

b. suppliers.

c. stockholders.

d. managers of the firm.

e. creditors.

Learning Goal 2

Areas of Accounting

4. The five key areas of accounting are:

a. Managerial accounting.

b. Financial accounting.

c. Auditing.

d. Tax accounting.

e. Government and not-for-profit accounting.

5. Managerial accounting is concerned with:

a. measuring and reporting costs of production, marketing, and other functions.

b. preparing budgets(planning).

c. checking whether or not units are staying within their budgets (controlling).

d. designing strategies to minimize taxes.

6. Financial accounting differs from managerial accounting because the information and analyses are for people outside the organization, while managerial accounting is used to provide information and analysis to managers within the organization. Financial accountants have the responsibility of preparing the annual report.

7. Private accountants are employees who work for a single firm, government agency or nonprofit organization. A public accountant can be hired to help businesses with payroll, taxes and other projects but are not employees of the company.

8. The independent Financial Accounting Standards Board defines what are generally accepted accounting principles that accountants must follow. If financial reports are prepared

“in accordance with GAAP,” users know the information is reported according to standards agreed on by accounting professionals.

9. Internal audits are to ensure that proper accounting procedures and financial reporting are being carried on within the company. Public accountants will conduct independent audits of accounting records. Financial auditors examine the financial health of an organization and additionally look into operational efficiencies and effectiveness.

10. A tax accountant is responsible for:

a. preparing tax returns.

b. developing tax strategies to save the company money.

11. The primary users of government accounting information are citizens, special interest groups, legislative bodies, and creditors. These users want to ensure that government is fulfilling its obligations and making the proper use of taxpayers’ money.

Accounting Tools

12. Bookkeepers record business transactions. Accountants classify and summarize financial data according to formalized practices.

13. The journal is where transactions are kept for each day, week, or month.

14. A ledger is a specialized accounting book in which information from accounting journals is accumulated into specific categories and posted so managers can find all the information about one account in the same place. The journal does not provide information about different accounts, but is a log of transactions as they occur.

15. The Sarbanes-Oxley Act requires higher standards of accounting practices and of auditing firms as a result of accounting scandals in the last decade.

Learning Goal 3

The Six – Step Accounting Cycle

16. The accounting cycle is a six-step procedure that results in the preparation and analysis of the major financial statements. It involves the work of both the bookkeeper and the accountant.

17. The steps in the accounting cycle are:

a. Analyze and categorizing documents.

b. Putting information into journals.

c. Post that information into ledgers.

d. Prepare a trial balance.

e. Prepare financial statements: income statement, balance sheet, and statement of cash flows.

f. Analyze financial statements.

Learning Goal 4

Financial Statements

18. a. Balance sheets report the firm’s financial condition on a specific date.

b. Income statements summarizes revenues, cost of goods, and expenses, for a specific period of time, and highlights the total profit or loss the firm experienced during that period.

c. The Statement of cash flows provides a summary of money coming into and out of the firm that tracks a company’s cash receipts and cash payments.

19. The difference between the financial statements can be summarized this way:

The balance sheet details what the company owns and owes on a certain day.

The income statement indicates what a firm sells its products for and what its selling costs are over a specific period of time.

The statement of cash flows highlights the difference between cash coming in and cash going out of a business.

20. The fundamental accounting equation is: Assets = Liabilities + Owner's equity

21. Things that can be considered assets include productive, tangible items such as equipment, buildings, land, furniture, fixtures, and motor vehicles that help generate income, as well as intangibles of value such as patents or copyrights.

22. Assets on a balance sheet are listed in order of their liquidity, which refers to how fast an asset can be converted into cash.

23 a. Current assets are items that can or will be converted into cash within one year. Current assets include cash, accounts receivable, and inventory.

b. Fixed assets are long-term assets that are relatively permanent such as land buildings and equipment. They are often referred to as property, plant and equipment on a balance sheet.

c. Intangible assets are long-term assets that have no physical form but have value. Examples include patents, trademarks, copyrights, and goodwill.

24. Liabilities are what the business owes to others. Current liabilities are payments due in one year or less; long-term liabilities are payments not due for one year or longer.

25. a. Accounts payable is money owed to others for merchandise and/or services purchased on

credit but yet not paid. If you have a bill you haven’t paid, you have an account payable.

b. Notes payable are short-term or long-term loans that have a promise for future payment.

c. Bonds payable are money loaned to the firm that it must pay back.

26. The value of things you own, assets, minus the amount of money you owe others, liabilities, is called equity. The value of what stockholders own in a firm minus liabilities is called stockholder’s, or owner’s equity.

27. The income statement:

a. summarizes all of the resources, called revenue, that have come into the firm from operating activities, money resources used, expenses incurred, and resources left after covering expenses.

b. reports the firm’s financial operations over a particular period of time, usually a year, a quarter of a year or a month.

28. The formula for developing an income statement is:

Revenue

- Cost of Goods Sold

Gross Margin

-Operating Expenses

Net Income before Taxes

-Taxes

= Net income (or loss)

29. a. Revenue is the value of what is received for goods sold, services rendered, and other financial sources. Most revenue comes from sales, but there could be other sources of revenue such as rents received, money paid to the firm for use of its patents, interest earned, and so forth.

b. Gross sales are the total of all sales the firm completed. Net sales refer to sales minus returns, discounts, and allowances.

30. The cost of goods sold includes:

a. The purchase price.

b. Plus any freight charges paid to transport goods.

c. Plus any costs associated with storing the goods.

31. Most retailers don’t have a cost for raw materials, since this cost is included in the price retailers have paid for the product. So their main concern is purchase price and storage.

32. Two categories of expenses are selling and general expenses. Selling expenses are related to the marketing and distribution of the firm’s goods or services, such as salaries for salespeople, advertising and supplies. General expenses are administrative expenses of the firm, such as office salaries, depreciation, insurance and rent.

33. Cash flow is the amount of money coming in and going out of the firm.

34. The three major activities for which cash receipts and disbursements are reported on a statement of cash flows include:

a. Operations – cash transactions associated with running the business.

b. Investments – cash used in or provided by the firm’s investment activities.

c. Financing – cash raised from new debt or new equity capital, or cash used to pay expenses, debts or dividends.

Learning Goal 5

Analyzing Financial Statements: Ratio Analysis

35. Firms provide key insights into how a firm compares to other firms in the same industry in the key areas of:

a. liquidity c. profitability

b. debt d. business activity

36. Liquidity ratios measure the company’s ability to pay its short-term debts. Short-term debts are expected to be repaid within one year and are of importance to the firm’s creditors who expect to be paid on time.

37. Two key liquidity ratios are:

a. current ratio.

b. quick ratio.

38. Current ratio = Current assets

Current liabilities

39. Acid test ratio = Cash + marketable securities + receivables

Current liabilities

40. The acid test ratio can help answer these questions:

a. What if sales drop off and we can’t sell our inventory?

b. Can we still pay our short term debt?

41. Leverage ratios measure the degree to which a firm relies on borrowed funds in its operations.

52 Debt to equity ratio = Total liabilities

Owner’s equity

This ratio measures the degree to which the company is financed by borrowed funds that must be repaid.

43. A debt to equity ratio of above 100% would show that a firm actually has more debt than equity. It’s always important to compare ratios to other firms in the same industry because debt financing is more acceptable in some industries.

44. Profitability ratios measure how effectively the firm is using its various resources to achieve profits.

45. Three profitability ratios are:

a. Earnings per share.

b. Return on sales.

c. Return on equity.

46. Earnings per share = Net Income

Number of Common shares outstanding

47. A larger number for EPS means that the company either has high net income after taxes or it does not have much outstanding stock.

48. Return on sales = Net Income

Net Sales

This ratio is an indicator of the company’s ability to generate income from sales. It’s important to compare this number to the industry average.

49. Return on equity = Net Income

Total Owner’s Equity

Return on equity shows how much was earned for each dollar invested by owners. It shows how well a company manages the money invested in the company.

50. Activity ratios measure how well a company converts its resources to profits.

51. Inventory turnover = Cost of Goods Sold

Average Inventory

The inventory turnover ratio measures the speed of inventory moving through the firm and its conversion into sales. Inventory sitting by idly in a business costs money.

52. a. A lower than average inventory turnover ratio often indicates obsolete merchandise on hand or poor buying practices.

b. A higher than average ratio may signal lost sales because of inadequate stock. An acceptable turnover ratio is generally determined on an industry-by-industry basis.

CRITICAL THINKING EXERCISES

Learning Goals 1, 2

1. a. Financial accounting g. Certified public accountant (CPA)

b. Public accountant h. Managerial accounting

c. Certified management accountant (CMA) i. Independent audit

d. Tax accountant j. Annual report

e. Private accountant f. Auditing

Learning Goal 3

2. a. Record in journals d. Analyze source documents

b. Take a trial balance e. Post to ledgers

c. Analyze financial statements f. Prepare financial statements

Learning Goal 4

3. a 1. Balance sheet 11. Balance sheet

2. Balance sheet 12. Balance sheet

3. Balance sheet 13. Balance sheet

4. Income statement 14. Income statement

5. Income statement 15. Income statement

6. Balance sheet 16. Income statement

7. Income statement 17. Income statement

8. Income statement 18. Income statement

9. Balance sheet 19. Balance sheet

10. Income statement 20. Income statement

b. 1. Cash

2. Accounts receivable

3. Inventories

4.

BALANCE SHEET

SUN-2-SHADE

Year ending December 31, 200 _

Assets

Current assets

Cash $ 18,000

Investments 45,000

Accounts receivable 110,000

Inventory 62,000

Total current assets $235,000

Property, plant and equipment

(Less accumulated depreciation) 200,000

Total Assets $435,000

Liabilities and Stockholder's equity

Liabilities

Current liabilities

Accounts payable $25,000

Notes payable (current) 15,000

Accrued taxes 40,000

Total current liabilities $80,000

Long-term Debt 60,000

Total liabilities $140,000

Stockholder's equity

Common stock $130,000

Retained earnings 165,000

Total stockholders equity $295,000

Total liabilities and stockholder's equity $435,000

5.

SUN-2-SHADE, INC.

INCOME STATEMENT

Year ending December 31, 200 _

Revenues

Net sales $600,000

Rental revenue 3,000

Total revenues $603,000

Cost of goods sold 313,000

Gross profit $290,000

Operating Expenses

Wages and salaries $125,000

Rent 35,000

Advertising 28,000

Depreciation 4,000

Utilities 12,000

Supplies 3,700

Total Operating Expenses $207,700

Net Income Before Taxes $ 82,300

Less Income Taxes 23,044

Net Income After Taxes $ 59,256

7. Everyone's answer will vary, obviously. The things to look at include your wages for the next two weeks, and any other income you will be receiving within the next two weeks (not including that $10 your friend owes you unless you know they're going to pay you!), and any expenses that will be due within the next two weeks, such as car payments, insurance, rent, groceries, utility bills, cell phone bills, credit card payments, tuition, books, and so on.

Learning Goal 5

6. A. a. Current ratio: $235,000 = 2.9

$80,000

b. Acid-test ratio: $173,000 = 2.16

$80,000

c. It seems that Sun-2-Shade is financially sound from the liquidity perspective, as their ratios are above the benchmark of the 2:1 ratio.

B. a. Debt/Owner's equity ratio: $140,000 = .47

$295,000

b. Sun-2-Shade seems to be in very good shape, and could actually afford to take on slightly more debt, according to the industry average.

C. a. Earnings per share: $59,256 = $1.98 share

30,000

b. Return on sales: $59,256 = 10% approximately

$600,000

c. Return on equity: $59,256 = 20.1%

$295,000

D. a. Inventory turnover: 313,000 = 4.47 times

70,000

b. Sun-2-Shade’s turnover is high, compared to the industry average. This could indicate that they are running the risk of lost sales from inadequate stock.

PRACTICE TEST

MULTIPLE CHOICE TRUE-FALSE

1. d 1. T

2. c 2. T

3. b 3. F

4. d 4. F

5. c 5. T

6. a 6. T

7. c 7. F

8. d 8. T

9. b 9. F

10. c 10. F

11. c 11. F

12. c 12. T

13. d 13. T

14. d 14. T

15. a 15. T

16. b

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