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Chapter one solutions

Solutions To Discussion Questions

Chapter 1 Solutions

  1. Generally accepted accounting principles (GAAP) are a set of principles and assumptions that guide the preparation of financial statements, and that have gained wide-spread acceptance among users and practitioners.
  2. The revenue recognition principle assumes that revenue is earned by the entity at the time when a service is provided or when a sale is made, not necessarily when cash is received.
  3. The matching concept states that revenue is recognized in the time period when goods and services are provided and that the assets of the entity that have been used up during the time period (expenses) must be matched with the asset inflows (revenues) during the same period.
  4. Accounting information should be comparable, verifiable, timely and understandable. Accounting information should only be disclosed if it is material – that is, of sufficient size or importance to influence the judgement of a reasonably knowledgeable user. Accounting information should also be disclosed in such a manner that the benefits of doing so outweigh the costs.
  5. An asset is anything of value that is owned by the entity. Assets are economic resources controlled by an entity. They have some future value to the entity, usually for generating revenue.
  6. A liability is an obligation to pay an asset or to provide services or goods in the future. Until the obligations are paid, creditors have claims against the assets of the entity. Equity represents the amount of assets owing to the owners of the entity. The total assets of an entity belong either to the shareholders or to the creditors.
  7. The exchange of assets or obligations by a business entity, expressed in monetary terms like dollars, is called a financial transaction. The exchange of cash for land or a building is an example of such a transaction.
  8. The three forms of business organization are corporations, sole proprietorships, and partnerships.
  9. A business entity is a unit of accountability that exists independently from other units. A set of accounting records is kept for each unit or entity. its owners. This concept is important because it keeps separate all the various activities in which the owner is involved; lumping all the activities together would not yield useful information for keeping track of the financial performance each financial unit.
  10. Financial statements evaluate the performance of an entity and measure its progress. Financial information is collected, then summarized and reported in the financial statements (balance sheet, income statement, statement of cash flows, and statement of changes in equity).
  11. The date line on the income statement, statement of changes in equity, and statement of cash flows represents a period of time. The income statement details the revenues and expenses that occurred over a given period of time. The statement of changes in equity shows how equity changed over a given period of time. The statement of cash flows shows
    how the balance in cash changed over a given period of time. The date line on the balance sheet is a point in time because each account listed on the balance sheet identifies the account balance on a specific date.
  12. The purpose of the income statement is to communicate the inflow of assets, in the form of revenues, and the outflow or consumption of assets, in the form of expenses, over a period of time. Total inflows greater than total outflows creates net income or profit, which is reported on the Income statement and in retained earnings in the equity section of the
    balance sheet. The purpose of the balance sheet is to communicate what the entity owns (its assets), what the entity owes (its liabilities), and the difference between assets and liabilities (its equity) at a point in time.
    If revenue is recorded on the income statement, there is usually a corresponding increase in assets on the balance sheet. Similarly, if expenses are recorded on the income statement, there is generally a decrease in assets or increase of liabilities on the balance sheet.
  13. Revenue is an increase in an entity’s assets or a decrease in liabilities in return for services performed or goods sold, expressed in monetary units like dollars. An expense is an asset belonging to the entity that is used up or obligations incurred in selling goods or performing services.
  14. Net income is the difference between revenues and expenses. It communicates whether the activities of the entity are being conducted profitably. Thus it is one measure of the success of the entity. Net income is one of the criteria used to determine the amount of dividends to be declared.
  15. The statement of changes in equity shows why share capital and retained earnings have changed over a specified period of time – for instance, when shares are issued or net income is earned. The statement of cash flows explains to the users of the financial statements the entity’s sources (inflows) and the uses (outflows) of cash over a specified period of time.
  16. Financial statements are prepared at regular intervals to keep a number of interested groups informed about the financial performance of an entity. The timing is determined in response to the needs of management in running the entity or of outside parties, such as bankers to aid in granting loans to the entity, shareholders, or others interested in evaluating the progress of the entity. They are generally used as a means to inform investing and lending decisions.

  1. A year-end is the last day of the fiscal year of the entity. The income statement, statement of cash flows, and statement of changes in equity reflect financial translations for the year up to this date. The balance sheet reflects the financial position of the entity at the yearend date. Interim financial statements may be prepared more frequently, say quarterly or monthly; these are prepared for each entity only if required by certain users, usually shareholders of large corporations with many shareholders. Year-end financial statements must be prepared for all entities.
  2. A fiscal year refers to a 12-month accounting period and that may not coincide with the calendar year. A company whose fiscal year-end coincides with the calendar year has a December 31 year-end.

Solutions To Problems

PROBLEM 1–2

  1. The percentage of assets financed by equity is 40% calculated as (5,200/13,000) × 100. Although part 2 of this question did not require that the percentage of assets financed by debt be calculated, it is 60% calculated as 100% − 40%.

PROBLEM 1–3

PROBLEM 1–5

Solutions To Exercises

EXERCISE 1–1
a. Partnership
b. International Financial Reporting Standards
c. Ethics
d. Financial accounting
e. Managerial accounting
f. Separate legal entity
g. Limited liability
h. Unlimited liability

EXERCISE 1–2
a. Violation Cost principle
b. Violation: Business entity principle
c. Violation: Business entity principle
d. Violation: Revenue recognition principle
e. Correct: Materiality principle
f. Correct: Monetary unit principle
g. Correct: Matching principle
h. Violation: Consistency principle
i. Violation: Full disclosure principle and possibly going concern principle if the company is no longer viable

EXERCISE 1–3
a. 30,000
b. 9,000
c. 95,000
d. In a, debt financing = (20,000/50,000) × 100=40%. In b, debt financing = (9,000/10,000) × 100=90%. In c, debt financing = (15,000/95,000) × 100 = 15.79% (rounded to two decimal places). Therefore, the greatest percentage of debt financing is reflected in b.
e. In a, equity financing = 100 − 40 = 60%. In b, equity financing = 100 − 90 = 10%. In c, equity financing = 100 − 15.79 = 84.21%. Therefore, the greatest percentage of equity financing is reflected in c.

EXERCISE 1–5
a. ASSETS = LIABILITIES + EQUITY
Equity at Jan. 1 = $10,000 ($50,000 − 40,000)
Equity at Dec. 31 = $20,000 ($40,000 − 20,000)
The increase in equity during the year was $10,000 ($20,000 ending equity − 10,000 beginning equity). Given that during the year no share capital was issued and no dividends were declared, $10,000 is the amount of net income earned during 2015.

b. ASSETS = LIABILITIES + EQUITY
Equity at Jan. 1 = $10,000 ($50,000 − 40,000)
Equity at Dec. 31 = $20,000 ($40,000 − 20,000)
The increase in equity during the year was $10,000 ($20,000 ending equity − 10,000 beginning equity). Given that during the year no share capital was issued and $5,000 of dividends were declared, $15,000 is the amount of net income earned during 2015 [calculated as net income − $5,000 dividends = $10,000 increase in equity; net income = 10,000 + 5,000 or 15,000].

c. ASSETS = LIABILITIES + EQUITY
Equity at Jan. 1 = $10,000 ($50,000 − 40,000)
Equity at Dec. 31 = $20,000 ($40,000 − 20,000)
The increase in equity during the year was $10,000 ($20,000 ending equity − 10,000 beginning equity). Given that during the year $12,000 of share capital was issued and no dividends were declared, a net loss of $2,000 was realized for 2015 (calculated as net income + $12,000 share capital issued = $10,000 increase in equity; net income = $10,000 − $12,000; net income is therefore a negative $2,000 which represents a net loss).

d. ASSETS = LIABILITIES + EQUITY
Equity at Jan. 1 = $10,000 ($50,000 − 40,000)
Equity at Dec. 31 = $20,000 ($40,000 − 20,000)
The increase in equity during the year was $10,000 ($20,000 ending equity − 10,000 beginning equity). Given that during the year $8,000 of share capital was issued and $12,000 of dividends were declared, $14,000 is the amount of net income earned during 2015 (calculated as net income + $8,000 share capital issued − $12,000 dividends = $10,000 increase in equity; net income = $10,000 − $8,000 + $12,000; net income = $14,000).

The $2,000 amount for shares issued was calculated using A = L + E or, using the accounts in the order given in the alphabetized information; 4,000 + 1,000 + 8,000 = 5,000 − 1,500 − 2,500 − 1,000 + 20,000 + Share Capital − 9,000; 13,000 = 11,000 + Share Capital; 13,000 − 11,000 = 2,000 Share Capital.
Alternatively, you could have inserted all the values from the alphabetized information into the financial statements and then solved for the unknown Share Capital amount. There is often more than one approach to solving math related questions.

EXERCISE 1–10

EXERCISE 1–14

EXERCISE 1–16

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