ANSWERS TO QUESTIONS

Financial Accounting, 8ce, Libby, Libby, Hodge, Kanaan, Sterling © 2023 McGraw-Hill Limited. All rights reserved.1-1 Chapter 1 Financial Statements and Business Decisions

Revised: August 5, 2022

ANSWERS TO QUESTIONS

• Accounting is a system that collects and processes (analyzes, measures, and records)

financial information about an organization and reports that information to decision makers.

• Financial accounting involves preparation of the basic financial statements and related

disclosures for external decision makers. Reporting is generally on a quarterly and annual basis. Managerial accounting involves the preparation of detailed plans, budgets, forecasts, and performance reports for internal decision makers. Reporting is on an ongoing basis.

• Financial reports are used by both internal and external groups and individuals. The

internal users are the various managers of the entity, e.g. marketing, credit, and purchasing. The external groups include the owners, investors, creditors, governmental agencies, other interested parties, and the public at large.

• Investors purchase all or part of a business and hope to gain by receiving part of what the

company earns and/or by selling their share of the company in the future at a higher price than they paid. Creditors lend money to a company for a specific length of time and hope to gain by charging interest on the loan.

• An accounting entity is the organization for which financial data are to be collected. Typical

accounting entities are a business, a church, a governmental unit, a university, and other nonprofit organizations such as a hospital. A business is defined and treated as a separate entity because the owners, creditors, investors, and other interested parties need to evaluate its performance and its potential separately from other entities and from its owners.

• Name of Statement Alternative Title
• Statement of earnings Income statement
• Statement of financial position Balance sheet
• Statement of cash flows Cash flow statement

• The heading of each of the four required financial statements should include the following:

(a) Name of the entity (b) Title of the statement (c) Specific date or the period of time it covers (d) Unit of measure

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• (a) The purpose of the statement of earnings is to present information about the

revenues, expenses, and the net earnings of the entity for a specified period of time, in order to help assess its financial performance during that period.(b) The purpose of the statement of financial position is to report the financial position of an entity at a given date, that is, to report information about the assets, obligations, and shareholders’ equity of the entity as at a specific date.(c) The statement of changes in equity reports the way that net earnings, the distribution of net earnings (dividends), and other changes to shareholders’ equity affected the company’s financial position during the accounting period. The focus in this chapter is on retained earnings. Net earnings for the year increases the balance of retained earnings whereas the declaration of dividends to the shareholders decreases retained earnings.(d) The purpose of the statement of cash flows is to present information about the flow of cash into the entity (sources), the flow of cash out of the entity (uses), and the net increase or decrease in cash during the period.

• The statement of earnings and the statement of cash flows are dated “For the Year Ended

December 31” because they report the inflows and outflows of resources during a period of time. In contrast, the statement of financial position is dated “At December 31” because it represents the resources, obligations, and shareholders’ equity as at a specific date, December 31.

• Assets are important to investors and creditors because assets provide a basis for judging

whether sufficient resources are available to operate the company. Liabilities are important to creditors and investors because the company must be able to generate sufficient cash from operations or seek further borrowing to meet the payments required by debt agreements. If a business does not pay its creditors, the law may give the creditors the right to force the sale of assets sufficient to meet the creditors’ claims.

• Net earnings is the excess of total revenues over total expenses. Net loss is the excess of

total expenses over total revenues.

• The accounting equation for the statement of earnings is Revenues – Expenses = Net

earnings. Revenues result from the sale of goods and services to customers, regardless of the timing of collection of cash from customers. Expenses represent the monetary value of resources the entity used up, or consumed, to earn revenues during the period. Net earnings is simply the excess of revenues over expenses.

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13. The accounting equation for the statement of financial position is:

Assets = Liabilities + Shareholders’ Equity

Assets are the probable (expected) future economic benefits owned by the entity as a result of past transactions. They are the resources owned by the business at a given point in time such as cash, accounts receivable, merchandise inventory, machinery, buildings, land, and patents. Liabilities are probable (expected) debts or obligations of the entity as a result of past transactions that will be discharged with assets (usually cash) or services in the future. They are the obligations of the entity such as accounts payable and notes payable. Shareholders’ equity is financing provided by owners of the business and by the net earnings generated from the operations of the business. It is the claim of the owners to the assets of the business after the creditors’ claims have been satisfied. Shareholders’ equity may be thought of as the residual interest because it represents assets minus liabilities.

14. The accounting equation for retained earnings is:

Beginning retained earnings + Net earnings – Dividends = Ending retained earnings

The equation begins with beginning-of-the-year retained earnings, i.e., the prior year’s ending retained earnings reported on the statement of financial position. The current year's net earnings reported on the statement of earnings is added to this amount and the dividends declared during the current year are subtracted from this amount. The ending retained earnings amount is reported on the end-of-period statement of financial position.

15. The accounting equation for the statement of cash flows is:

Cash flows from operating activities +/– Cash flows from investing activities +/– Cash flows from financing activities = Change in cash for the period.

The net cash flows for the period represent the increase or decrease in cash that occurred during the period. Cash flows from operating activities are cash flows directly related to earning income (normal business activity including interest paid and income taxes paid).Cash flows from investing activities comprise cash flows that are directly related to the acquisition or sale of productive assets used by the company, such as plant and equipment.Cash flows from financing activities consist of cash flows that are directly related to the financing of the enterprise, such as issuing shares to investors.

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