Chapter 1: Financial Statements and Decision Making

Question 1

What is the role of creditors in a company’s financial structure?

Answer 1

Creditors lend money to a company and make money by charging interest on the loans.

Question 2

Who are the internal decision makers in a company, and what information do they need?

Answer 2

Internal decision makers, often called managers, need information about the company’s business activities to control and improve operating, investing, and financing activities.

Question 3

Who are the external decision makers in a company, and what information do they need?

Answer 3

External decision makers, such as shareholders and creditors, need information about the company’s business activities to assess its ability to pay back debts with interest and pay dividends

Question 4

Why do all businesses need an accounting system?

Answer 4

All businesses need an accounting system to collect and process financial information about their business activities and report that information to decision makers.

Question 5

What are the 3 examples of Le-Nature’s business activities mentioned in the text?

Answer 5

Le-Nature’s business activities include

• Financing activities (borrowing or paying back money, receiving funds from shareholders),
• Investing activities (buying or selling assets like buildings and equipment),
• Operating activities (day-to-day processes of purchasing raw materials, manufacturing, delivering products, collecting cash, and paying suppliers).

Question 6

What is the term used for developing accounting information for internal decision makers?

Answer 6

Developing accounting information for internal decision makers is called managerial or management accounting.

Question 7

What is Financial Accounting?

Answer 7

Financial Accounting is a branch of accounting that involves the preparation, analysis, and reporting of a company’s financial transactions and performance to external decision makers, such as shareholders, creditors, and regulatory authorities.

It aims to provide a comprehensive and accurate view of a company’s financial health through the creation of financial statements and disclosures.

Question 8

Exibit 1.1: The Accounting System and Decision Makers

Answer 8

Question 9

What are the three key areas to focus on in Chapter 1 of your financial accounting textbook?

Answer 9

In Chapter 1, focus on the following three key areas:

Content: Learn the categories of items (elements) reported on each of the four financial statements.

Structure: Understand the equation that shows how the elements within each statement are organized and related.

Use: Discover how the information in the financial statements is valuable to shareholders and creditors in making their investment and lending decisions

Question 10

What are the four primary kinds of financial statements prepared by organizations?

Answer 10

The four primary kinds of financial statements are:

Statement of Financial Position (Balance Sheet)

Statement of Earnings (Income Statement)

Statement of Changes in Equity

Statement of Cash Flows

Question 11

What is reported on a statement of financial position (balance sheet)?

Answer 11

A statement of financial position reports an organization’s economic resources (assets) and sources of financing (liabilities and equity).

Question 12

What is reported on a statement of earnings (income statement)?

Answer 12

A statement of earnings reports an organization’s ability to generate revenue by selling goods or services, deducting the cost of acquiring and selling those goods or services (expenses)

Question 13

What information is typically included in a statement of changes in equity?

Answer 13

A statement of changes in equity typically includes details about contributions from or distributions to shareholders and the reinvestment of earnings for future growth

Question 14

What does a statement of cash flows provide information about?

Answer 14

A statement of cash flows provides information about an organization’s ability to generate cash and how that cash was used during a specific period.

Question 15

When are the four basic financial statements typically prepared by companies like Le-Nature’s, and for what time spans can they be applied?

Answer 15

The four basic financial statements can be prepared at any point in time and can apply to various time spans, such as one year, one quarter, or one month.

Le-Nature’s, like most companies, prepares financial statements for external users at the end of each quarter (quarterly reports) and at the end of the year (annual reports).

Question 16

What is the purpose of the Statement of Financial Position (Balance Sheet)?

Answer 16

The purpose of the Statement of Financial Position (Balance Sheet) is to report the financial position of an accounting entity at a specific point in time, providing information about the amounts of assets, liabilities, and shareholders’ equity held by the organization.

Question 17

What are the four significant items identified in the heading of the Statement of Financial Position?

Answer 17

The heading of the Statement of Financial Position includes the following four significant items:

Name of the accounting entity (e.g., Le-Nature’s Inc.)

Title otf the statemen (e.g., Statement of Financial Position)

Specific date of the statement (e.g., At December 31, 2020)

Unit of measure (e.g., millions of U.S. dollars)

Question 18

What is an accounting entity?

Answer 18

An accounting entity is the organization for which financial data are collected and reported.

It must be precisely defined.

On the statement of financial position, the accounting entity itself, not the business owners, is viewed as owning the resources it uses and being responsible for its debts.

Question 19

What does the heading of the Statement of Financial Position indicate?

Answer 19

The heading of the Statement of Financial Position indicates the time dimension of the report, providing a financial snapshot at a specific point in time (e.g., December 31, 2020).

Question 20

How is financial information typically reported in terms of currency?

Answer 20

Financial information is normally reported in the currency of the country in which the company is located (e.g., Canadian companies report in Canadian dollars, U.S. companies in U.S. dollars).

Question 21

What are the three major captions on the Statement of Financial Position?

Answer 21

The three major captions on the Statement of Financial Position are assets, liabilities, and shareholders’ equity.

They represent key categories of financial information.

Question 22

What is The Basic Accounting Equation?

Answer 22

Question 23

What does the basic accounting equation show regarding a company’s financial position?

Answer 23

The basic accounting equation shows that a company’s financial position is a reflection of the economic resources it owns (assets) and the sources of financing for those resources, which are represented by liabilities and shareholders’ equity.

Question 24

What are assets in financial accounting?

Answer 24

Assets are economic resources controlled by an entity as a result of past business events.

They are expected to provide future benefits to the firm.

Question 25

What are the four common items listed as assets on a company’s Statement of Financial Position?

Answer 25

The four common items listed as assets are:

Property, Plant, and Equipment (used to manufacture products)

Inventories (goods or materials held for production and sale)

Accounts Receivable (promises to pay received when selling goods or services on credit)

Cash (liquid assets)

Question 26

How did Le-Nature’s acquire the economic resources needed for manufacturing and selling beverages?

Answer 26

Le-Nature’s first needed cash to acquire land, build factories, and install production machinery (property, plant, and equipment).

Then, it purchased ingredients and produced beverages, resulting in the balance assigned to inventories

Question 27

What happens when Le-Nature’s sells beverages on credit to grocery stores and others?

Answer 27

When Le-Nature’s sells beverages on credit, it receives promises to pay called accounts receivable, which are collected in cash at a later time

Question 28

How are assets initially measured on the Statement of Financial Position?

Answer 28

Assets on the Statement of Financial Position are initially measured at the total cost incurred to acquire them, not their current market values.

Question 29

What do liabilities represent on the Statement of Financial Position?

Answer 29

Liabilities represent the amount of financing provided by creditors and are the company’s debts or obligations

Question 30

What are the two items listed under the category of Liabilities on Le-Nature’s Statement of Financial Position?

Answer 30

The two items are:

Accounts Payable (arising from purchases of goods or services on credit from suppliers)

Notes Payable to Banks (resulting from cash borrowings based on formal written debt contracts with banks)

Question 31

What does shareholders’ equity indicate on the Statement of Financial Position?

Answer 31

Shareholders’ equity indicates the amount of financing provided by owners of the business and reinvested earnings.

It consists of contributed capital (investment of cash and other assets by shareholders) and retained earnings (profits reinvested in the business and not distributed as dividends).

Question 32

How is total shareholders’ equity calculated?

Answer 32

Total shareholders’ equity is the sum of the contributed capital and the retained earnings.

Question 33

Why are assets important on the Statement of Financial Position?

Answer 33

Assets are important on the Statement of Financial Position because they have the potential to produce cash, which is crucial for judging whether a company has sufficient resources to continue operating its business.

Additionally, assets could be sold for cash if the company goes out of business, making them essential for assessing financial stability

Question 34

Why are liabilities important to creditors and shareholders on the Statement of Financial Position?

Answer 34

Liabilities are important to creditors and shareholders because they help determine if the company will have enough cash to pay its debts.

Creditors need to assess the company’s ability to repay its debts, and existing creditors’ claims against the company’s assets are relevant.

Legal ownership of assets often remains with creditors to secure debt repayment, and if the company fails to pay its creditors, they may force the sale of assets to meet their claims

Question 35

What issue may arise when selling company assets to cover debts, and why does this happen?

Answer 35

In some situations, the sale of assets may not cover all of the company’s debts, resulting in creditors taking a loss.

This happens because the assets were originally acquired with the intent of using them to generate future cash for the company in its normal operations.

External parties may not value these assets as having the same potential to produce cash as the company did, making it difficult for creditors to sell the assets for the full amount of the debt

Question 36

Why is shareholders’ equity (net worth) important to creditors?

Answer 36

Shareholders’ equity is important to creditors because, legally, creditors’ claims for repayment of obligations must be settled before those of the shareholders.

If the company goes out of business and its assets are sold, the proceeds must first be used to pay back creditors before shareholders receive any money.

Shareholders provide resources for the company with no promise of future repayment and are entitled to what remains only after creditors’ claims have been settled.

Creditors view shareholders’ equity as a protective cushion.

Question 37

What are some formatting conventions for assets and liabilities on the Statement of Financial Position?

Answer 37

Assets may be listed in either increasing or decreasing order of their convertibility to cash.

Liabilities may be listed in either increasing or decreasing order of maturity (due date).

Most financial statements include the monetary unit sign (e.g., S for Canada)
beside the first amount in a group of items (e.g., cash).

A single underline is often placed below the last item in a group before a total or subtotal (e.g., Other assets).

A double underline is placed below group totals (e.g., Total assets).

These conventions are followed in all four basic financial statements.

Question 38

What does the statement of earnings report?

Answer 38

The statement of earnings reports a business’s primary measure of performance, which is revenues minus expenses during the accounting period

Question 39

What technical terms do accountants prefer to use for the measure of performance reported on the statement of earnings?

Answer 39

Accountants prefer to use the technical terms “net income” or “net earnings” to describe the measure of performance reported on the statement of earnings

Question 40

What information does the heading of the statement of earnings include?

Answer 40

The heading of the statement of earnings includes the name of the entity, the title of the statement, and the unit of measure used.

Question 41

How does the statement of earnings differ from the statement of financial position in terms of time coverage?

Answer 41

Unlike the statement of financial position, which reports financial information as of a specific date, the statement of earnings reports information for a specified period, such as “for the year ended December 31, 2020.”

Question 42

What is the accounting term for the time period covered by the financial statements, such as the statement of earnings?

Answer 42

The time period covered by the financial statements, like the statement of earnings, is called an accounting period.

Question 43

Equation for Statement of Earnings

Answer 43

Question 44

Exibit 1.3: Statement of Earnings

Answer 44

Question 45

What do companies earn revenues from?

Answer 45

Companies earn revenues from the sale of goods or services to customers.

Question 46

How are revenues typically recognized?

Answer 46

Revenues are normally recognized for goods or services that have been delivered to a customer, whether or not the customer has paid for them.

Question 47

What is an account receivable?

Answer 47

An account receivable is a promise of future payment received by a business when goods or services are delivered but payment is to be collected at a later date

Question 48

How does a business recognize revenue for a specific accounting period?

Answer 48

A business recognizes revenue for a specific accounting period by totaling cash and credit sales made during that period.

Question 49

What term is commonly used in financial statements to describe the source of revenue, and how does Le-Nature’s categorize it?

Answer 49

Various terms are used to describe different sources of revenue (e.g., provision of services, sale of goods, rental of property).

Le-Nature’s categorizes its revenue as “sales revenue” on its statement of earnings.

Question 50

What do expenses represent on the Statement of Earnings?

Answer 50

Expenses represent the monetary value of resources used or consumed by the entity to earn revenues during a specific period.

Question 51

What are the four items listed as expenses on Le-Nature’s statement of earnings?

Answer 51

Cost of Sales (total cost of goods manufactured and sold)

Selling, General, and Administrative Expenses (including salaries, marketing, promotion, and depreciation)

Interest Expense (finance cost related to borrowed funds)

Income Tax Expense (corporate income tax based on earnings before income taxes)

Question 52

What is the most significant expense for manufacturing and merchandising companies, and what term do they commonly use to describe it?

Answer 52

The most significant expense for these companies is the “cost of sales” or “cost of goods sold,” which represents the total cost of goods manufactured and sold to customers.

Question 53

What does “Selling, General, and Administrative Expenses” include?

Answer 53

Selling, General, and Administrative Expenses include items such as salaries, marketing, promotion, and depreciation related to manufacturing and storage.

Question 54

Why does Le-Nature’s have an “Income Tax Expense,” and how is it calculated?

Answer 54

Le-Nature’s, as a corporation, must pay income tax to the government based on its earnings before income taxes.

In 2020, the income tax expense is approximately 42.8 percent of its earnings before income taxes.

Question 55

How does accounting handle the recognition of expenses in relation to the timing of cash payments?

Answer 55

Accounting recognizes all expenses incurred during a specific accounting period, regardless of the timing of the cash payment.

For example, if a company incurs an expense in December 2020 but pays for it in mid-January 2021, the expense is recognized for the accounting period ending on December 31, 2020, because the expense was related to generating revenue during that period

Question 56

What is net earnings, and how is it calculated?

Answer 56

Net earnings (also called the “bottom line”) is the excess of total revenues over total expenses incurred to generate revenue during a specific period.

It is calculated by subtracting total expenses from total revenues.

Question 57

What does it mean when total expenses exceed total revenues, and how is it typically noted?

Answer 57

When total expenses exceed total revenues, a loss is reported. Losses are typically noted by parentheses around the reported figure

Question 58

What does it mean when revenues and expenses are equal for a specific period?

Answer 58

When revenues and expenses are equal for a specific period, the business has operated at breakeven, meaning it neither made a profit nor incurred a loss during that period.

Question 59

What important tip should you keep in mind regarding specific account names in accounting?

Answer 59

Do not try to memorize the names of specific accounts, as they can differ somewhat while still being compliant with International Financial Reporting Standards (IFRS)

Question 60

Why does the amount of net earnings typically not equal the net cash generated by operations?

Answer 60

Net earnings are not necessarily the same as cash collections from customers, and expenses are not necessarily the same as cash payments to suppliers.

Therefore, the amount of net earnings usually does not equal the net cash generated by operations, which is reported on the statement of cash flows discussed later in the chapter.

Question 61

Why do investors and creditors closely monitor a firm’s net earnings, and how do they use this information?

Answer 61

Investors and creditors closely monitor a firm’s net earnings because they reflect the firm’s ability to sell goods and services for more than the cost to produce and deliver them. Investors buy the company’s shares when they believe that net earnings will improve, leading to a higher share price.

Lenders rely on future earnings to provide the resources to repay loans.

Additionally, details of the statement, such as changes in pricing, marketing expenses, and other factors, help investors and creditors estimate the company’s future net earnings based on past information.

Question 62

What does the statement of changes in equity report?

Answer 62

The statement of changes in equity reports all changes to shareholders’ equity during the accounting period

Question 63

What does the heading of the statement of changes in equity include?

Answer 63

The heading includes the name of the entity, the title of the statement, and the unit of measure used

Question 64

How long of a period does the statement of changes in equity typically cover?

Answer 64

Similar to the statement of earnings, the statement of changes in equity covers a specific period, such as one year.

Question 65

What kind of information does the statement of changes in equity report?

Answer 65

This statement reports how net earnings, the distribution of dividends, and other changes to shareholders’ equity affected the company’s financial position during the accounting period.

Question 66

Exibit 1.4: Statement of changes in Equity

Answer 66

Question 67

What is reported in the contributed capital section of the statement of changes in equity?

Answer 67

The contributed capital section reports any changes in contributed capital, such as the issuance or repurchase of common shares.

Question 68

How does the retained earnings column on the statement of changes in equity reflect changes in financial position?

Answer 68

The retained earnings column reports how net earnings achieved during the year increase the balance of retained earnings, while the declaration of dividends to shareholders decreases retained earnings.

Question 69

Equation for Statement of Changes in Equity

Answer 69

Question 70

What does the statement of changes in equity begin with, and how does it list changes in balances?

Answer 70

The statement of changes in equity begins with the balances of contributed capital and retained earnings at the beginning of the accounting period.

It lists increases and decreases and reports the resulting ending balances.

Question 71

How is the net earnings reported on the statement of earnings reflected in the statement of changes in equity?

Answer 71

The net earnings reported on the statement of earnings for the current year is added to the beginning balance of retained earnings in the statement of changes in equity.

Question 72

How are dividends declared during the year reflected in the statement of changes in equity?

Answer 72

Dividends declared during the year are subtracted from the combined balance of net earnings and the beginning balance of retained earnings in the statement of changes in equity.

Question 73

What does the ending retained earnings amount in the statement of changes in equity indicate?

Answer 73

The ending retained earnings amount in the statement of changes in equity is the same as that reported in the statement of financial position.

This indicates the relationship between the statement of earnings and the statement of financial position.

Question 74

Why do creditors like Wells Fargo closely monitor a firm’s retained earnings?

Answer 74

Creditors such as Wells Fargo closely monitor a firm’s retained earnings because the firm’s policy on dividend payments to its shareholders affects its ability to repay its debts.

Every dollar paid to shareholders as a dividend is not available for repaying debt.

Question 75

How do investors use retained earnings to assess a company’s financial health?

Answer 75

Investors examine retained earnings to determine whether the company is reinvesting a sufficient portion of net earnings to support future growth.

Retained earnings represent an important source of financing and indicate the company’s commitment to reinvesting in its future.

Question 76

How does net earnings from the statement of earnings impact the statement of changes in equity?

Answer 76

Net earnings from the statement of earnings result in an increase in ending retained earnings on the statement of changes in equity

Question 77

What is the relationship between ending retained earnings from the statement of changes in equity and the statement of financial position?

Answer 77

Ending retained earnings from the statement of changes in equity is one of the components of shareholders’ equity on the statement of financial position.

Question 78

How does the statement of earnings relate to the statement of changes in equity and the statement of cash flows?

Answer 78

The statement of earnings explains, through the statement of changes in equity, how the operations of the company changed its financial position during the year.

The statement of cash flows explains how the operating, investing, and financing activities of the company affected the cash balance on the statement of financial position during the year.

Question 79

Exibit 1.5: Relationships between Financial Statements

Answer 79

Question 80

What are the three primary categories of cash flows presented in the statement of cash flows for a typical business?

Answer 80

The statement of cash flows divides cash inflows (receipts) and outflows (payments) into three primary categories.

Cash flows from:

• Operating activities
• Investing activities
• Financing activities

Question 81

Exibit 1.6: Statement of Cashflows

Answer 81

Question 82

Why does the statement of cash flows exist?

Answer 82

The statement of cash flows exists because reported revenues may not equal cash collected, and reported expenses may not equal cash paid.

Question 83

What does the statement of cash flows report?

Answer 83

The statement of cash flows reports inflows and outflows of cash.

Question 84

How is the change in cash from the end of the last period to the end of the current period described?

Answer 84

The change in cash is described by the statement of cash flows equation, which explains the causes of this change on the statement of financial position.

Question 85

Equation for Statement of Cashflows

Answer 85

Question 86

What are cash flows from operating activities (CFO) related to?

Answer 86

Cash flows from operating activities are directly related to generating earnings, such as cash collected from customers and cash paid to employees and suppliers.

Question 87

What do cash flows from investing activities (CFI) include?

Answer 87

Cash flows from investing activities include cash flows related to the acquisition or sale of the company’s property, plant, equipment, and investments.

Question 88

What are cash flows from financing activities (CFF) directly related to?

Answer 88

Cash flows from financing activities are directly related to the financing of the company itself, involving receipts and payments of cash from/to investors and creditors (except for suppliers).

Question 89

Why is the statement of cash flows considered useful for predicting future cash flows?

Answer 89

The statement of cash flows is useful for predicting future cash flows that may be available for payment of debt to creditors and dividends to investors.

It provides insights into a company’s ability to generate cash from operations and meet its cash needs.

Question 90

Why are notes to financial statements considered important?

Answer 90

Notes to financial statements are essential because they provide supplemental information about a company’s financial condition, and without them, the financial statements cannot be fully understood.

Question 91

What does the statement “The accompanying notes are an integral part of these financial statements” signify?

Answer 91

This statement indicates that notes to the financial statements are crucial for gaining a complete understanding of the company’s financial health, much like nutritional content labels on pre-packaged food

Question 92

What are the three basic types of notes typically found in financial statements?

Answer 92

The three basic types of notes in financial statements are:

Descriptions of the accounting rules applied in the company’s statements.

Additional details about specific lines on the financial statements.

Additional financial disclosures about items not listed on the statements themselves.

Question 93

Why is understanding the content of note disclosures critical when analyzing financial statements?

Answer 93

Understanding note disclosures is critical because they provide essential context and additional information that can significantly impact the interpretation of a company’s financial statements.