Financial Reporting mechanics(Reading 23)

Exercise Problems:

1.In accrual accounting, if an adjusting entry results in the reduction of an asset and the recording of an expense, the originating entry recorded was most likely a(n):

A. Prepaid expense.

B. Accrued expense.

C. Deferred revenue.

Ans: A.

The adjusting entry to record the expiry of a prepaid expense is the reduction of an asset (the prepaid) and the recognition of the expense.

For example, to record insurance expense:

Insurance expense                               100

Prepaid insurance expense                  100

B is incorrect. Accrued expense is an accounting expense recognized in the books before it is paid for. It is a liability, and is usually current. For example, at the end of the month, a company will accrue its salary expense before actually paying the employees. The entry is:

Salary expense       100

Salary payable           100

C is incorrect. Deferred revenue is advance payment or unearned revenue, recorded on the recipient’s balance sheet as a liability, until the services have been rendered or products have been delivered. For example, if a firm gets advance payment before deliver the good, it needs to make the following entry:

Cash                                   100

Deterred revenue              100

2.  The segment of an accounting system that reports business transaction by account is the:

A. Trial balance.

B. General ledger.

C. Financial statements.

Ans: B.

The general ledger contains all the journal entries that are posted to the general journal and other specialized journals, except that the general ledger sorts the data by account where the general journal and the specialized journal records the transactions by date. The general ledger is considered the core of an accounting system.

A is incorrect. A trial balance is prepared at the end of an accounting period prior to the financial statements. A trial balance reports only ending balances (and not transactions) for each account. Adjusting entries are then made, if required, and then an adjusted trial balance can be prepared, for as many cycles as are necessary.

C is incorrect. Financial statements are prepared from an adjusted trial balance and provide a picture of the firm’s financial status. However, the financial statements do not report business transactions by account; they are much to summarized for that.

3. At the start of the year, a company’s capital contributed by owners and retained earnings accounts had balances of $10,000 and $6,000, respectively. During the year, the following events took place:

The end of year owners’ equity is closest to:

A. $19,400.

B. $19,900.

C. $20,400.

Ans: C.

5. A company fails to record accrued wages for a reporting period. What effect will this error have on the company’s financial statement?

A. Assets and liabilities are understated.

B. Assets and owners’ equity are overstated.

C. Liabilities are understated and owners’ equity is overstated.

Ans: C.

Accrued wages should be recorded as a liability (wages payable). Failing to record a liability for accrued wages will understate wage expense, which leads to an overstatement of net income. Since net income is overstated, retained earnings and owners’ equity are both overstated. Assets are unaffected.

6. The least likely reason that a security analyst needs to understand the accounting process is to:

A. prevent earnings manipulation by management.

B. make adjustments to reflect items not reported in the financial statements.

C. aid in the assessment of management’s judgment in accruals and valuations.

Ans: A.

Understanding the accounting process may assist an analyst in identifying earnings manipulation, but it will not prevent the manipulation of earnings by management. It is important for analysts to understand the accounting process so they can make adjustments for items not reported and to aid in the assessment of management’s judgment of accruals and valuations.

7. What is the most likely effect on the accounting equation when a company purchases office equipment with cash?

A. Assets increase, and liabilities increase.

B. There is no effect on the accounting equation.

C. Assets decrease, and owners’ equity decreases.

Ans: B.

There would be no effect on the accounting equation because the company has exchanged one asset for another. Cash has decreased, and office equipment, a capital asset, has increased.

8. Which of the following statements is most accurate?

A. Accrued revenue arises when a company receives cash prior to earning the revenue.

B. A valuation adjustment for an asset converts its historical cost to its depreciated value.

C. Accrued expenses arise when a company incurs expenses that have not yet been paid as of the end of the accounting period.

Ans: C.

The principle of accrual accounting requires that revenue is recorded when the firm earns it and expenses are recorded as the firm incurs them, regardless of whether cash has actually been paid.

Accrued expense—the firm owes cash for expenses it has incurred. Expense increase and a liability for accrued expenses increases as well. The liability decreases when the firm pays cash to satisfy it.

A is incorrect. Accrued revenue arises when a company receives cash before it provides a good or service to customers.

B is incorrect. A valuation adjustment for an asset converts its historical cost to current market value.

9. At the start of a month, a retailer paid $5,000 in cash for different types of candies. He sold candies costing $2,000 for $3,000 during the month. The most likely effect of these transactions on the retailer’s accounting equation for the month is that assets will:

A. be unchanged.

B. increase by $1,000.

C. decrease by $2,000.

Ans: B.

Buying $5,000 of candies will decrease cash by $5,000 and increase inventory by $5,000. Selling $2,000 of candies for $3,000 will decrease inventory by $2,000, and increase either cash (if cash collected in the same accounting period) or accounts receivable (if sold on credit) by $3,000. The combined effect is an increase of $1,000 in assets.

10. Which of the following statements best describes a trial balance? A trial balance is a document or computer file that:

A. shows all business transactions by account.

B. lists account balances at a particular point in time.

C. contains business transactions recorded in the order in which they occur.

Ans. B.

A trial balance is a document that lists account balances at a particular point in time.

At the end of the accounting period, an initial trial balance is prepared that shows the balances in each account. If any adjusting entries are needed, they will be recorded and reflected in an adjusted trial balance.

A is incorrect. Journal entries show all business transactions by account.

C is incorrect. A listing of all the journal entries in order of their dates is called the general journal.

11. Under IFRS, which of the following financial statement elements most accurately represents inflows of economic resources to a company?

A. Assets.

B. Equity.

C. Revenues.

Ans: C.

The financial statement elements under International Financial Reporting Standards (IFRS) are: Assets, Liabilities, Owners’ Equity, Revenue, and Expenses. Revenues are inflows of economic resources.

A is incorrect. Assets are the firm’s economic resources.

C is incorrect. Equity is the owners’ residual claim of a firm’s resources, which is the amount by which assets exceed liabilities.

12. The following information is available for a company:

In 2010, the company most likely:

A. paid a dividend of $1,000

B. paid a dividend of $5,000

C. did not pay a dividend because they incurred a loss.

Ans: B.

Retained earnings = opening RE + net income – dividends

2010 Retained Earnings = 17,000 = 25,000 - 3,000 - Dividends

Dividends = 5,000

A. Asset.

B. Revenue.

C. Net income.

Ans: C.

Net income is not an element of the financial statements, but the net result of revenues less expenses. The elements are: assets, liabilities, owners’ equity, revenue and expenses.

14. The following information is from a company’s 2008 financial statements ($millions):

In 2008 the company declared and paid cash dividends of $5 million and recorded depreciation expense in the amount of $25 million. The company’s 2008 cash flow from operations ($ millions) is closest to:

A. 25.

B. 30.

C. 35.

Ans: C.

Operating activities:

  NI

+depreciation and other noncash expenses

-gain on sales of long-term assets & investments

+decrease in current asset (- increase in current assets)

+increase in current liabilities (+ decrease in current liabilities)

+increase in deferred tax liabilities (-decrease in DTL)

=CFO

The change in retained earnings is $20 and dividends are paid from retained earnings. 2008 net income equals the change in retained earnings plus any dividends paid during 2008. Depreciation expense is added to net income and the changes in balance sheet accounts are also considered to determine cash flow from operations.

$20 + 5 (dividends) + 25 (depreciation) – 5 (increase in receivables) – 3 (increase in inventory) – 7 (decrease in payables) = $35 million.

15. A company receives a payment of $10,000 on 1 December, for rent on a property for December and January. On receipt, they correctly record it as cash and unearned revenue. If at 31 December, their year-end, they failed to make an adjusting entry related to this payment, ignoring taxes, what is the effect on the financial statements for the year?

A. Assets are overstated by $5,000 and Liabilities are overstated by $5,000

B. Assets are overstated by $5,000 and Owner’s equity is overstated by $5,000

C. Liabilities are overstated by $5,000 and Owners’ equity is understated by $5,000

Ans: C.

The company should have made an adjusting entry to reduce the Unearned revenue account (a liability) by $5,000 and increase Revenue, (and hence net income and retained earnings) by $5,000.

Unearned revenue   5,000

    Revenue                   5,000

As the company failed to make the adjusting entry the liabilities are overstated and owners’ equity is understated.

16. An analyst gathers the following information from a company’s accounting records (all figures in thousands):

The analyst’s estimate of net income ($ thousands) for 2008 is closest to:

A. 650.

B. 850.

C. 1,050.

Ans: C.

Total assets = liabilities + owner’s equity.

Owner’s equity = $5,250– 2,200= 3,050.

Owners equity = contributed capital + ending retained earnings.

Ending retained earnings = 3,050– 1,400= 1,650.

Ending retained earnings = beginning retained earnings + net income – dividends.

1,650= 800 + net income – 200;

Net income = $1,050

17. The following is available about the company:

Total liabilities at the end of the year are closest to:

A.    $472,000

B.     $482,000

C.     $487,000

Ans: B.

Assets = liabilities + equity

$800,000=liabilities + $318,000

Liabilities = $482,000

18. Under U.S.GAAP, differences between accrued revenue and expenses and cash flows result in the creation of assets and liabilities. Would each of the following revenue events result in the creation of an asset or a liability when the event originally occurs?

Ans: B.

Revenue recognized before the cash is received will result in the creation of an accounts receivables, an asset, whereas when the cash is received before the revenue is recognized a liability, unearned revenue, is created.

19. An accounting document that records transactions in the order in which they occurs is best described as a:

A. Trial balance.

B. General ledger.

C. General journal.

.

Ans: C.

The general journal records transaction in the order in which they occur (chronological order) and is therefore sorted by date.

A is incorrect. A trial balance is prepared at the end of an accounting period prior to the financial statements. A trial balance reports only ending balances (and not transactions) for each account. Adjusting entries are then made, if required, and then an adjusted trial balance can be prepared, for as many cycles as are necessary.

B is incorrect. The general ledger contains all the journal entries that are posted to the general journal and other specialized journals, except that the general ledger sorts the data by account where the general journal and the specialized journal records the transactions by date. The general ledger is considered the core of an accounting system.

20. An entry made to record an accrual, such as bad debt expense, that is not yet reflected in the accounting system is best described as a(n):

A. ledger entry.

B. adjusting entry.

C. trial balance entry.

Ans: B.

Adjusting entries are a type of journal entries typically made at the end of the accounting period to record items such as accruals that are not yet reflected the accounting system.

A is incorrect. Journal entries record every transaction, showing which accounts are changed and by what amount. A listing of all the journal entries in order of their dates is called the general journal.

C is incorrect. At the end of the accounting period, an initial trial balance is prepared that shows the balances in each account. If any adjusting entries are needed, they will be recorded and reflected in an adjusted trial balance.

21. What is the effect on the accounting equation when a company’s Board of Directors declares a cash dividend?

A. Assets decrease and owners’ equity decreases.

B. Liabilities increase and owners’ equity decreases.

C. There is no effect on the accounting equation until the dividend is paid.

Ans: B.

The company would create (increase) a liability for dividends payable and deduct the same amount from its retained earnings, thus decreasing owners’ equity.

22. Which of the following items is best described as a listing of all the journal entries in order of their dates?

A. Trial ledger.

B. General ledger.

C. General journal.

Ans: C.

The listing of all the journal entries in order of their dates is called the general journal.

A is incorrect. “Trial ledger” is not part of an accounting system.

B is incorrect. The general ledger sorts the entries in the general journal by account.

23. When the Bao Company filed its corporate tax returns for the first quarter of the current year, it owned a total of $6.7 million in corporate taxes. Bao paid $4.4 million of the tax bill, but still owes $2.3 million. It also received $478,000 in the second quarter as a down payment towards $942,000 in custom-built products to be delivered in the third quarter. Its financial accounts for the second quarter most likely show the $2.3 million and the $478,000 as:

Ans: A.

The $478,000 is unearned revenue, a liability. The $2.3 million owned to the government but not yet paid is income tax payable, also a liability. Deferred tax accounts arise from temporary difference between tax reporting and financial reporting.

24. On January 31, Bao Inc. borrowed funds to purchase capital equipment for its business operations. On the same day, it also recorded the cost of salaries incurred to January 31, which will be paid on February 6. When these two transactions are recorded on January 31, the financial statement item that will increase the most is:

A. assets.

B. expenses.

C. liabilities.

Ans: C.

Borrowing funds to purchases capital equipment will result in an increase in assets (equipment) and in liabilities (debt). The accrual of the salaries that are owned, but not paid, as of month-end will increase expenses and increase liabilities (accrued salary expense). Therefore, these two transactions taken together will result in the greatest increase in liabilities.