Ch 2

Assets are recorded at historical costs even though current market values might, arguably, be more relevant to financial statement readers. Describe the reasoning behind historical cost usage.

Historical costs are used by accountants because they are less subjective and, therefore, more reliable than using market values. Market values can be biased for two reasons: first, we may not be able to measure them accurately (consider our inability to accurately measure the market value of a production facility, for example), and second, managers may intervene in the reporting process to intentionally bias the results in order to achieve a particular objective (i.e. enhancing the stock price). The use of historical costs in accounting records does not negate the importance of market values. For example, a firm offering to pledge land as collateral for a loan will be expected to use the market value of that land rather than its historic cost. The same would be true if a corporation were considering the sale of the land. Finally, we shall see that certain assets are reported at market value in the balance sheet; securities that are available to be sold provide an example.

Identify three intangible assets that are likely to be excluded from the balance sheet because they cannot be reliably measured.

An intangible asset is an asset that we cannot touch. To be included on the balance sheet, it has to meet the tests of an asset (e.g., we own it, and it will provide future benefits). In addition, recognized intangible assets are always acquired in a transaction with an independent party. Internally generated intangible assets, however, are not recorded on the balance sheet. Some examples are goodwill, patents and trademarks, contractual agreements like royalties, leases, and franchise agreements. All of the intangible assets, though not recorded if internally generated, are recorded if purchased, as in an acquisition of another company, for example.

What does the term current denote when referring to assets?

Current means that the asset will be liquidated (converted to cash) within the next year (or the operating cycle if longer than 1 year).

On December 31, 2018, Miller Company had $700,000 in total assets and owed $220,000 to credi-tors. If this corporation's common stock totaled $300,000, what amount of retained earnings is reported on its December 31, 2018, balance sheet?

$700,000 Assets - $220,000 Liabilities = $480,000 Stockholders' equity $480,000 Stockholders' equity - $300,000 Common stock = $180,000 Retained earnings

What does the concept of liquidity refer to? Explain

Liquidity generally refers to cash. That is, how much cash do we have, how much cash is being generated, and how much cash can we raise quickly. Liquidity is essential to the survival of the business. After all, we can only pay our loans with cash, and our employees will only accept cash for their wages. Some assets are more liquid than others in the sense that they can be converted more easily to cash. Money market accounts and accounts receivable, which can be sold, provide examples. Inventories are considered more liquid than plant assets. We will address liquidity issues more formally in Chapters 4 and 9.

GAAP is based on the concept of accrual accounting. Define and describe accrual accounting

Accrual accounting entails the recognition of revenue under the revenue recognition principle (record revenues when goods or services are transferred to the customer), and the recognition of expenses when net assets decrease from the process of earning revenue or supporting the company's operations. The recognition of revenues or the expenses does not require that cash be received or disbursed. For example, the recognition of revenues on sale can lead to an account receivable, and wage expense can be accrued using a wages payable (accrued) liability account.

The balance sheet consists of assets, liabilities, and equity. Define each category and provide two examples of accounts reported within each category.

An asset is something that we own that is expected to provide future benefits. A liability is a current obligation that will require a future sacrifice. Equity is the difference between assets and liabilities. It represents the claims of the company's owners to its income and assets. The following are some examples of each:

What are the two essential characteristics of an asset?

An asset must be "owned" and it must provide "future benefits." Owning means we have title to the asset (some leased assets are also recorded on the balance sheet as we will discuss in Chapter 10). Future benefits can mean the future inflows of cash. Or, it could relate to some other benefit, such as the reduction of expenditures, an increase in another asset, or the reduction of a liability.

Company assets that are excluded from the company financial statements a. are presumably reflected in the company's stock price. b. include all of the company's intangible assets. c. are known as intangible assets. d. include investments in other companies.

a

Which of the following is true about accrual accounting? a. Accrual accounting requires that expenses always be recognized when cash is paid out. b. Accrual accounting is required under GAAP. c. Accrual accounting recognizes revenue only when cash is received. d. Recognition of a prepaid asset (e.g., prepaid rent) is not an example of accrual accounting

b

If an asset declines in value, which of the following must be true? a. A liability also declines. b. Equity also declines. c. Either a liability or equity also declines or another asset increases in value. d. Neither a nor b can occur.

c

Which of the following conditions must exist for an item to be recorded as an asset? a. Item is not owned or controlled by the company. b. Future benefits from the item cannot be reliably measured. c. Item must be a tangible asset. d. Item must be expected to yield future benefits

d

Which of the following options accurately identifies the effects a cash sale of an iPhone has on Apple's accounts? a. Accounts receivable increases, sales revenue increases, cost of goods sold increases, and inventory decreases. b. Cash increases, sales revenue increases, cost of goods sold decreases, and inventory decreases. c. Accounts receivable increases, sales revenue increases, cost of goods sold decreases, and inventory decreases. d. Cash increases, sales revenue increases, cost of goods sold increases, and inventory decreases

d

How does the quick ratio differ from the current ratio?

Both the current ratio and quick ratio are measures of a firm's ability to pay its obligations as they come due; measures of a firm's liquidity. The current ratio is computed by dividing the firm's current assets by its current liabilities. Current ratios that exceed 1.0 are deemed to represent a strong current liquidity position. The quick ratio is an even more conservative measure of a firm's liquidity as it excludes inventory from the calculation. The quick ratio is computed by dividing the firm's sum of cash and cash equivalents, marketable securities and accounts receivable by its current liabilities.

Define net working capital. Explain how increasing the amount of trade credit can reduce the net working capital for a company.

Net working capital = Current assets - Current liabilities. Increasing the amount of trade credit (e.g., accounts payable to suppliers) increases current liabilities and reduces net working capital. As trade credit increases, we are using someone else's cash rather than our own. As a business grows, its net working capital grows, as the growth of inventories and receivables are generally greater than that of accounts payable and accrued liabilities. Net working capital is an asset category that must be financed just like fixed assets.

Two important concepts that guide income statement reporting are the revenue recognition principle and the expense recognition principle. Define and explain each of these two guiding principles.

The revenue recognition principle requires that revenues be recognized when earned. Revenues are earned when the product has been delivered to the buyer and is usually signified by a formal transfer of title. A good test of whether revenue has been earned is whether the rights, risks and obligations of ownership have been transferred to the buyer. If a service is involved, revenues are not earned until the service has been provided. The expense recognition principle prescribes that expenses be recognized when assets are diminished (or liabilities increased) as a result of earning revenue or carrying out the company's operations. When these two principles are followed, income can be properly measured in a given accounting reporting period.

What is the statement of stockholders' equity? What information is conveyed in that statement?

The statement of stockholders' equity provides information relating to all events that impact stockholders' equity during the period. It contains information relating to stock sales and repurchases, net income, dividends, and the use of stock for other purposes including occasional acquisition of assets. This statement, also referred to as the statement of owners' equity, also includes the effects of some transactions that are not captured in the determination of net income. These items are included in what is called "other comprehensive income." One example of such an item is the loss or gain on the translation of the assets and liabilities of foreign owned subsidiaries into United States currency.

What three conditions must be satisfied to require reporting of a liability on the balance sheet?

The three conditions necessary to recognize a liability are: 1. The liability reflects a probable future sacrifice on the part of the organization. 2. The amount of the obligation is known or can be reasonably estimated. 3. The transaction that caused the obligation has occurred.