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LEARNING OUTCOMES

After completing this chapter, you will be able to do the following:

● explain the relationship of financial statement elements and accounts, and classify accounts into the financial statement elements;

● explain the accounting equation in its basic and expanded forms;

● describe the process of recording business transactions using an accounting system based on the accounting equation;

● describe the need for accruals and other adjustments in preparing financial statements;

● describe the relationships among the income statement, balance sheet, statement of cash flows, and statement of owners' equity;

● describe the flow of information in an accounting system;

● describe the use of the results of the accounting process in security analysis.

SUMMARY OVERVIEW

● Business activities can be classified into three groups: operating activities, investing activities, and financing activities.

● Companies classify transactions into common accounts that are components of the five financial statement elements: assets, liabilities, equity, revenue, and expense.

● The core of the accounting process is the basic accounting equation: Assets = Liabilities + Owners' equity.

● The expanded accounting equation is Assets = Liabilities + Contributed capital + Beginning retained earnings + Revenue – Expenses – Dividends.

● Business transactions are recorded in an accounting system that is based on the basic and expanded accounting equations.

● The accounting system tracks and summarizes data used to create financial statements: the balance sheet, income statement, statement of cash flows, and statement of owners' equity. The statement of retained earnings is a component of the statement of owners' equity.

● Accruals are a necessary part of the accounting process and are designed to allocate activity to the proper period for financial reporting purposes.

● The results of the accounting process are financial reports that are used by managers, investors, creditors, analysts, and others in making business decisions.

● An analyst uses the financial statements to make judgments on the financial health of a company.

● Company management can manipulate financial statements, and a perceptive analyst can use his or her understanding of financial statements to detect misrepresentations.

PROBLEMS

1. Which of the following items would most likely be classified as an operating activity?

A. Issuance of debt.

B. Acquisition of a competitor.

C. Sale of automobiles by an automobile dealer.

2. Which of the following items would most likely be classified as a financing activity?

A. Issuance of debt.

B. Payment of income taxes.

C. Investments in the stock of a supplier.

3. Which of the following elements represents an economic resource?

A. Asset.

B. Liability.

C. Owners' equity.

4. Which of the following elements represents a residual claim?

A. Asset.

B. Liability.

C. Owners' equity.

5. An analyst has projected that a company will have assets of 2,000 at year-end and liabilities of 1,200. The analyst's projection of total owners' equity should be closest to:

A. 800.

B. 2,000.

C. 3,200.

6. An analyst has collected the following information regarding a company in advance of its year-end earnings announcement (in millions):

The analyst's estimate of ending retained earnings (in millions) should be closest to:

A. $1,300.

B. $1,500.

C. $1,700.

7. An analyst has compiled the following information regarding Rubsam, Inc.

There have been no distributions to owners. The analyst's most likely estimate of total assets at year-end should be closest to:

A. 2,100.

B. 2,300.

C. 2,800.

8. A group of individuals formed a new company with an investment of $500,000. The most likely effect of this transaction on the company's accounting equation at the time of the formation is an increase in cash and:

A. an increase in revenue.

B. an increase in liabilities.

C. an increase in contributed capital.

9. HVG, LLC paid $12,000 of cash to a real estate company upon signing a lease on 31 December 2005. The payment represents a $4,000 security deposit and $4,000 of rent for each of January 2006 and February 2006. Assuming that the correct accounting is to reflect both January and February rent as prepaid, the most likely effect on HVG's accounting equation in December 2005 is:

A. no net change in assets.

B. a decrease in assets of $8,000.

C. a decrease in assets of $12,000.

10. TRR Enterprises sold products to customers on 30 June 2006 for a total price of 10,000. The terms of the sale are that payment is due in 30 days. The cost of the products was 8,000. The most likely net change in TRR's total assets on 30 June 2006 related to this transaction is:

A. 0.

B. 2,000.

C. 10,000.

11. On 30 April 2006, Pinto Products received a cash payment of $30,000 as a deposit on production of a custom machine to be delivered in August 2006. This transaction would most likely result in which of the following on 30 April 2006?

A. No effect on liabilities.

B. A decrease in assets of $30,000.

C. An increase in liabilities of $30,000.

12. Squires & Johnson, Ltd., recorded 250,000 of depreciation expense in December 2005. The most likely effect on the company's accounting equation is:

A. no effect on assets.

B. a decrease in assets of 250,000.

C. an increase in liabilities of 250,000.

13. An analyst who is interested in assessing a company's financial position is most likely to focus on which financial statement?

A. Balance sheet.

B. Income statement.

C. Statement of cash flows.

14. The statement of cash flows presents the flows into which three groups of business activities?

A. Operating, Nonoperating, and Financing.

B. Operating, Investing, and Financing.

C. Operating, Nonoperating, and Investing.

15. Which of the following statements about cash received prior to the recognition of revenue in the financial statements is most accurate? The cash is recorded as:

A. deferred revenue, an asset.

B. accrued revenue, a liability.

C. deferred revenue, a liability.

16. When, at the end of an accounting period, a revenue has been recognized in the financial statements but no billing has occurred and no cash has been received, the accrual is to:

A. unbilled (accrued) revenue, an asset.

B. deferred revenue, an asset.

C. unbilled (accrued) revenue, a liability.

17. When, at the end of an accounting period, cash has been paid with respect to an expense, the business should then record:

A. an accrued expense, an asset.

B. a prepaid expense, an asset.

C. an accrued expense, a liability.

18. When, at the end of an accounting period, cash has not been paid with respect to an expense that has been incurred, the business should then record:

A. an accrued expense, an asset.

B. a prepaid expense, an asset.

C. an accrued expense, a liability.

19. The collection of all business transactions sorted by account in an accounting system is referred to as:

A. a trial balance.

B. a general ledger.

C. a general journal.

20. If a company reported fictitious revenue, it could try to cover up its fraud by:

A. decreasing assets.

B. increasing liabilities.

C. creating a fictitious asset.