Acct 2010 Mizzou Runyan - Test 1 - Chapter 3 Terms

Asset

A cost expected to help generate additional revenue in the future.

What determines if a cost if identified as an asset on the balance sheet vs. an expense on the income statement?

A cost that generates "future" revenues is listed as an asset on the balance sheet. A cost that generated "past" revenues is listed as an expense on the income statement.

Expense

A cost that helped a business generate revenue in the past.

statement of retained earnings

A financial statement that reports the change in a corporation's retained earnings account from the beginning of a period to the end; the account is increased by net income and decreased by a reported net loss and/or any dividends declared.

statement of cash flows

A listing of all cash inflows (sources) and cash outflows (uses) during a specific period of time categorized as operating activities, investing activities, and financing activities.

Current Assets = $161,000 Current Liabilities = $57,000 What is the Current Ratio?

Answer: 2.82 to 1.00 How to calculate: $161,000/$57,000

Other than through operations, how does a company derive net assets?

Beyond operations (as reflected by the retained earnings balance), a business accumulates net assets by receiving contributions from investors who become owners through the acquisition of capital stock.

Example of an Income Statement

Davidson Groceries Income Statement for Year Ended December 31, 2014 Revenues Sales of groceries $1,400,000 Expenses Cost of goods sold $900,000 Salary $120,000 Rent $20,000 Advertising $30,000 Insurance $15,000 Other $25,000 Total Expenses $1,110,000 Operating Income $290,000 Other gains and losses Gain on sale of truck $5000 Loss on sale of land ($15,000) Income before income taxes $280,000 Income Tax Expense . $50,000 Net Income $230,000

gross profit

Difference between sales and cost of goods sold; also called gross margin or markup.

markup

Difference between sales price and cost of goods sold on an item of inventory; also called gross profit or gross margin.

gross margin

Difference between sales price and cost of goods sold; also called gross profit or markup.

current ratio

Formula measuring an organization's liquidity (the ability to pay debts as they come due); calculated by dividing current assets by current liabilities.

net assets

assets - liabilities

Loss

decrease in net assets of an organization

contributed capital

mounts invested in a corporation by individuals or groups in order to attain ownership interests; balance indicates the amount of the corporation's net assets that came directly from the owners.

Purpose of a balance sheet

to report a company's assets and liabilities at a particular point in time. The format is quite simple. All assets are listed first—usually in order of liquidity—followed by all liabilities.

Why is advertising expense, rent expense, payroll expense (for example), listed together at the top of the income statement?

They are all related to generating revenue for the business.

List the financial statement reports (in order) that are prepared annually and/or quarterly by companies for shareholders, etc.

1. Income Stmt 2. Stmt of Retained Earnings 3. Balance Sheet 4. Stmt of Cash Flows

What are the three categories of the Statement of Cash Flows?

1. Operating activities 2. Investing activities 3. Financing activities

balance sheet

A listing of all asset, liability, and stockholders' equity accounts at a specific point in time; also called statement of financial position.

income statement

A listing of all revenues earned and expenses incurred during a specific period of time as well as all gains and losses; also called statement of operations or statement of earnings.

common stock

A type of capital stock that is issued by every corporation; it provides rights to the owner that are specified by the laws of the state in which the organization is incorporated.

accounting equation

Assets = liabilities + stockholders' equity. The equation balances because all assets must have a source: a liability, a contribution from an owner (contributed capital), or from operations (retained earnings).

Key Takeaway Section 3.2

Conservatism is an often misunderstood term in financial reporting. Despite a reputation to the contrary, financial accounting is not radically conservative. However, when two reporting options are equally likely, the one that makes the company look best is avoided. The portrait that results is less likely to be overly optimistic. In this way, decision makers are protected. Their chance of incurring losses is reduced. For example, expenses refer to costs that helped generate revenue in the past while assets reflect costs that provide future economic benefits. If the timing of these benefits cannot be ascertained, the cost should be recognized as an expense. This assignment reduces both reported income and total assets. The resulting net income figure (revenues and gains less expenses and losses) is useful in evaluating the financial health and prospects of a company but no single figure should be the sole source of information for a decision maker. Dividend distributions are not included in this computation of net income because they reflect a sharing of profits with owners and not a cost incurred to generate revenue.

Current Ratio

Current Assets/Current Liabilities

Why are dividend payments not included as expenses of a corporation on its income statement?

Dividends are not expenses and, therefore, are omitted in preparing an income state- ment. Such distributions obviously reduce the amount of net assets owned or controlled by a company. However, they are not related in any way to generating revenues. A dividend is a reward paid by a corporation (through the decision of its board of directors) to the owners of its capital stock. A dividend is a sharing of profits and not a cost incurred to create revenue.

Key Takeaway Section 3.1

Financial information is gathered about an organization, but the resulting figures must then be structured in some usable fashion that can be conveyed to interested decision makers. Financial statements serve this purpose. A typical set of financial statements is made up of an income statement, statement of retained earnings, balance sheet, statement of cash flows, and explana- tory notes. The income statement reports revenues from the sale of goods and services as well as expenses such as rent and advertising. Gains and losses that arise from incidental activities are also included on the income statement but separately so that the income generated from primary operations is apparent. Cost of goods sold is an expense that reflects the cost of all inventory items acquired by customers. Income tax expense is reported at the bottom of the income statement because it is actually a government assessment rather than a true expense.

Financing activities on the statement of cash flows

Financing activities is unrelated to daily business operations but, here, the transactions relate to either a liability or a stockholders' equity balance. Borrowing money from a bank meets these criteria as does dis- tributing a dividend to shareholders. Issuing stock to new owners for cash is another financing activity as is payment of a noncurrent liability.

working capital

Formula measuring an organization's liquidity (the ability to pay debts as they come due); calculated by subtracting current liabilities from current assets.

What else (other than revenues and expenses) are reported on an income statement?

Gains and Losses

Gross Profit Percentage

Gross Profit/Net Sales

Investing activities on the statement of cash flow

Investing activities report cash flows created by events that (1) are separate from the central or daily operations of the business and (2) involve an asset. Thus, the amount of cash collected when either equipment or land is sold is reported within this section.

What is the most important number on an income statement?

Most people focus on net income, but should look at all part of the statement, including revenues.

As required by GAAP what other items are required on the financial statements?

Name of the Company Name of the Financial Statement Reporting Period

Does a company receive money when its shares are sold each day on the New York Stock Exchange, NASDAQ (National Association of Securities Dealers Automated Quotations), or other stock exchanges?

No, purchases and sales on stock markets normally occur between two investors and not directly with the company. Only the initial issuance of the ownership shares to a stockholder creates the inflow of assets reported by a capital stock or contributed capital account.

Operating activities on the statement of cash flow

Operating activities relate to receipts and disbursements that arose in connection with the central activity of the organization.

On a statement of cash flows, what is the difference in an operating activity, an investing activity, and a financing activity?

Operating activities relate to receipts and disbursements that arose in connection with the central activity of the organization. Investing activities report cash flows created by events that (1) are separate from the central or daily operations of the business and (2) involve an asset. Thus, the amount of cash collected when either equipment or land is sold is reported within this section. Financing activities is unrelated to daily business operations but, here, the transactions relate to either a liability or a stockholders' equity balance. Borrowing money from a bank meets these criteria as does dis- tributing a dividend to shareholders. Issuing stock to new owners for cash is another financing activity as is payment of a noncurrent liability.

capital stock

Ownership (equity) shares of stock in a corporation that are issued to raise monetary financing for capital expenditures and operations.

practice of conservatism

Preference of accountants to avoid making an organization look overly good; when faced with multiple reporting options that are equally likely, the worst possible outcome is reported to help protect the decision maker from information that is too optimistic.

What are the two main components of an income statement?

Revenues Earned and Expenses Incurred

Key Takeaway Section 3.4

The balance sheet is the only one of the four financial statements that is created for a specific point in time. It reports the company's assets as well as the source of those assets: liabilities, capital stock, and retained earnings. Assets and liabilities are divided between current and non- current. This classification system permits the reporting company's working capital and current ratio to be computed for analysis purposes. The statement of cash flows explains how the cash balance changed during the year. All cash transactions are classified as falling within operating activities (daily activities), investing activities (nonoperating activities that affect an asset), or financing activities (nonoperating activities that affect either a liability or a stockholders' equity account).

On January 1, Year One, the Green River Company was started when owners contributed $100,000 cash to start operations. During the first year, the company earned a reported net income of $23,000 and paid a $2,000 dividend. During the second year, the company earned another $31,000 and paid a $5,000 dividend. What is reported on the company's balance sheet as the total retained earnings at the end of Year Two? a. $47,000 b. $54,000 c. $147,000 d. $154,000

The correct answer is choice a: $47,000 Explanation: As noted earlier, retained earnings are a measure of a company's growth in net assets because of its operations. The amount of retained earnings is accumulated since the beginning of opera- tions. At the end of the first year, Green River reported a retained earnings balance of $21,000. This amount will carry forward into the second year and will be combined with current year oper- ations. In the second year, Green River earned $31,000 and paid out $5,000 in dividends. As a result, net assets rose by $26,000. This amount is added to the already existing $21,000 from the previous year for a total balance in retained earnings of $47,000.

The Winston Corporation has prepared an annual report for the past year that includes a complete set of financial statements. Which of the following is not likely to be included? a. Statement of changes in liabilities b. Balance sheet. Income statement. d. Statement of cash flows

The correct answer is choice a: Statement of changes in liabilities. Explanation: The balance sheet reports assets and liabilities at the end of the year. The income statement shows the revenues and expenses incurred during the year. The statement of retained earnings explains the change in the reported retained earnings figure for the year. The statement of cash flows indicates how the organization gained cash during this period and how it was used. There is no statement of changes in liabilities, although information about liabilities is available on the balance sheet.

In a set of financial statements, a company reports an account balance of $19,000 labeled as "prepaid insurance." Which of the following is not true in connection with this account? a. The account appears on the company's income statement.b. The money was paid in the past but will provide benefit in the future. c. The account is an asset.d. The cost is expected to help generate future revenue.

The correct answer is choice a: The account appears on the company's income statement. Explanation: The account title implies a benefit to the company in the future. A payment has been made for insurance coverage on assets such as buildings and equipment over the next few months or years. Because the benefits are yet to be derived, this cost cannot be reported on the income statement; rather, it must be reported as an asset on the balance sheet.

Which of the following is not an example of the effect of the practice of conservatism? A company has revenue, but the revenue is not reported because of some uncertainty. A company has a liability, but the liability is not reported because of some uncertainty. A company has an asset, but the asset is not reported because of some uncertainty. A company has a cost that is reported as an expense because of an uncertainty about the future benefit.

The correct answer is choice b: A company has a liability, but the liability is not reported because of some uncertainty. Explanation: The practice of conservatism holds that when outcomes are equally likely, the option that makes the reporting entity look worse should be reported. Delaying the revenue in A and the asset in C are both examples of conservative reporting. Recognizing an expense in D rather than an asset also reduces reported income and total assets. However, delaying the reporting of the liability in B improves the way the company's financial position appears. Reporting fewer debts makes the company look better.

Which of the following statements is true? a. Rent payable appears on a company's income statement.b. Capital stock appears on a company's balance sheet.c. Gain on the sale of equipment appears on a company's balance sheet. d. Accounts receivable appears on a company's income statement.

The correct answer is choice b: Capital stock appears on a company's balance sheet. Explanation: Assets and liabilities such as accounts receivable and rent payable are shown on a company's balance sheet at a particular point in time. Revenues, expenses, gains, and losses are shown on an income statement for a specified period of time. Capital stock, a measure of the amount of net assets put into the business by its owners, is reported within stockholders' equity on the balance sheet.

In reviewing a statement of cash flows, which one of the following statements is not true? a. Cash paid for rent is reported as an operating activity.b. Cash contributed to the business by an owner is an investing activity. c. Cash paid on a long-term note payable is a financing activity.d. Cash received from the sale of inventory is an operating activity.

The correct answer is choice b: Cash contributed to the business by an owner is an investing activity. Explanation:Cash transactions such as the payment of rent or the sale of inventory that are incurred as part of daily operations are included within operating activities. Events that do not take place as part of daily operations are either investing or financing activities. Investing activities are carried out in connection with an asset such as a building or land. Financing activities impact either a liability (such as a note payable) or a stockholders' equity account (such as contributed capital).

The Bartolini Company has recently issued a set of financial statements. The company owns several restaurants that serve coffee and donuts. Each of the following balances appears in the company's financial statements. Which was not included in the company's reported income statement? a. Loss from fire in warehouse—$4,000 b. Rent expense—$13,000c. Cash—$9,000d. Gain on sale of refrigerator—$1,000

The correct answer is choice c: Cash—$9,000. Explanation:Revenues, expenses, gains, and losses all appear in a company's income statement. Cash is an asset, and assets are shown on the balance sheet.

A company has the following reported balances at the end of the current year: rev- enues—$100,000, rent expense—$40,000, dividends paid—$12,000, loss on sale of truck—$2,000, salary expense—$19,000, gain on sale of land—$9,000, and prepaid insur- ance—$8,000. What should be reported by this company as its net income for the year? a. $28,000 b. $36,000 c. $40,000 d. $48,000

The correct answer is choice d: $48,000. Explanation: Net income is made up of revenues ($100,000) less expenses ($40,000 plus $19,000, or $59,000) plus gains ($9,000) less losses ($2,000), or $48,000. Dividends paid is not an expense, and prepaid insurance is an asset.

The London Corporation has just produced a set of financial statements at the end of its fifth year of operations. On its balance sheet, it shows assets of $700,000 and liabilities of $200,000. The retained earnings balance within stockholders' equity is $100,000. Net income for the cur- rent year was reported as $90,000 with dividends of $50,000 distributed to the company's owners. Which of the following statements is not true? The company's net assets at the end of the fifth year was $500,000. The current year change in the retained earnings balance is an increase of $40,000. The $50,000 dividends represent distributions made to the owners and subsequently reduce the net assets held by the organization. The $700,000 in assets represents the cumulative earnings of the company since it began operations.

The correct answer is choice d: The $700,000 in assets represents the cumulative earnings of the company since it began operations. Explanation: An asset is defined as something an organization has which helps generate revenue in the future. Net assets is the difference between an organization's assets and its liabilities (what is owed). One way an organization creates net assets is through profitable operations, which is reported as retained earnings. The company's net assets at the end of the fifth year was $500,000 ($700,000 - $200,000). One component of net assets, or equity, is the retained earnings. In the fifth year of operations, the retained earnings balance would have increased by $40,000 ($90,000 income less $50,000 dividends). As previously discussed, the $50,000 in dividends represent distributions made to the owners that reduce the net assets held by the organization. The $700,000 in assets do not represent earnings by the company as there are multiple sources of assets which we will discuss in the next section.

The London Corporation has just produced a set of financial statements at the end of its fifth year of operations. On its balance sheet, it shows assets of $700,000 and liabilities of $200,000. The retained earnings balance within stockholders' equity is $100,000. Net income for the cur- rent year was reported as $90,000 with dividends of $50,000 distributed to the company's owners. Which of the following statements is true? The company's net income for the previous four years can be determined from this information. The company's dividend payments for the previous four years can be determined from this information. The company's retained earnings balance at the beginning of its fifth year was $10,000. Total income less dividends paid during the previous four years was $60,000.

The correct answer is choice d: Total income less dividends paid during the previous four years was $60,000. Explanation: Retained earnings at the end of the fifth year was reported as $100,000. Of that, $40,000 is the growth in net assets during the current year from net income ($90,000) less dividends ($50,000). Retained earnings at the beginning of the year must have been $60,000 ($100,000 total less $40,000 increase). That represents the growth in net assets in all prior years from net income less dividends. The exact amount of income during this earlier period or the total dividends can- not be derived, only the net figure.

A company has the following reported balances at the end of the current year: revenues - $100,000, rent expense - $40,000, dividends paid - $12,000, loss on sale of truck - $2,000, salary expense -$19,000, gain on sale of land - $9,000, and prepaid insurance - $8,000. Which two balances will not appear on the income statement? a. Gain on sale of land and loss on sale of truck b. Gain on sale of land and dividendsc. Loss on sale of truck and dividendsd. Prepaid insurance and dividends

The correct answer is choice d: prepaid insurance and dividends. Explanation: An income statement reports revenues, expenses, gains, and losses. Prepaid insurance is an asset which will be reported on the balance sheet. Additionally, dividends will not appear on the income statement as they are not an expense. They are a reduction in net assets and will be reported elsewhere.

Why is income tax expense listed last, by itself, on the bottom of the income statement and not with the other expenses?

The income tax figure is segregated in this manner because it is not an expense in a traditional sense. Income taxes do not create revenues.

Key Takeaway Section 3.3

The source of a company's net assets (assets minus liabilities) is of interest to outside decision makers. The reported retained earnings figure indicates the amount of these net assets that came from the operations of the company. This growth in size was internally generated. The reported retained earnings balance is all the net income earned since operations began less all dividend distributions. Net assets can also be derived from contributions made by parties seek- ing to become owners. The capital stock (or contributed capital) balance measures this source of net assets. There is no reported impact unless these assets go directly from the owners to the company. Hence, exchanges between investors using a stock exchange do not affect a busi- ness's net assets or its financial reporting.

net income

This balance reflects the growth in an organization's net assets during the period resulting from all revenues, expenses, gains, and losses. Reflects the profitability for the period.

accounting equation #2 (if stockholder's equity is broken down)

assets = liabilities + capital stock + retained earnings

accounting equation #3

assets = the total source of those assets

Gain

increase in net assets of an organization

what are two other names for retained earnings

reinvested earnings accumulated earnings

On January 1, Year One, the Green River Company was started when owners contributed $100,000 cash to start operations. During the first year, the company earned a reported net income of $23,000 and paid a $2,000 dividend. During the second year, the company earned another $31,000 and paid a $5,000 dividend. What is reported on the company's balance sheet as the total retained earnings at the end of Year One? a. $121,000 b. $25,000 c. $21,000 d. $23,000

the correct answer is choice c: $21,000. Explanation: Retained earnings are a measure of a company's growth in net assets because of its operations. During the year, Green River made a total profit of $23,000 and paid dividends of $2,000. As a result, net assets rose by $21,000 ($23,000 less $2,000). This balance is reported as retained earnings. The remaining increase in net assets invested by the owners is known as contributed capital (or capital stock), which is a separately reported figure to be discussed later in the chap- ter.

retained earnings

the total amount of all net income earned by a business since it first began operations, less all dividends paid to stockholders during that same period of time. Retained earnings is a measure of the profits left in a business throughout its existence to create growth. Total net income since organization began operations Less: total of all dividends paid to owners Retained earnings balance