External Financial Reporting Decisions

Question 1

What is the objective of financial reporting?

Answer 1

The objective of financial reporting is to provide financial information about the entity that is useful for decision-making.

Question 2

What are direct and indirect users of financial information?

Answer 2

Direct users are those who are directly affected by the results of a company. Direct users include investors and potential investors, employees, management, suppliers, and creditors. Direct users are individuals who stand to lose money financially if the company has financial problems. Indirect users are those people or groups who represent direct users. They include financial analysts and advisors, stock markets, and regulatory bodies.

Question 3

What are internal and external users of financial information?

Answer 3

Internal users make decisions within the firm whereas external users make decisions from outside of the firm about whether or not to begin a relationship with the firm, continue a relationship with the firm, or change their relationship to the firm.

Question 4

What are the five financial statements used under US GAAP?

Answer 4

Balance Sheet (also called the Statement of Financial Position). Income Statement. Statement of Cash Flows. Statement of Comprehensive Income. Statement of Changes in Stockholders’ Equity.

Question 5

What is the purpose of the balance sheet?

Answer 5

The balance sheet, also called a statement of financial position, provides information about an entity’s assets, liabilities, and owners’ equity at a point in time (usually the end of a reporting period). The statement shows the entity’s resource structure, ”the major classes and amounts of assets, ”and its financing structure, ”the major classes and amounts of liabilities and equity.

Question 6

What are permanent accounts?

Answer 6

Permanent accounts are not closed out at the end of each accounting period but rather their balances are cumulative. They keep on accumulating transactions and changing with each transaction, year after year.

Question 7

What are assets, liabilities, and equity?

Answer 7

Assets are probable future economic benefits that have been obtained or are controlled by an entity as a result of past transactions or events. Liabilities are probable future sacrifices of economic benefits due to present obligations of an entity to transfer assets or provide services in the future, resulting from past transactions or events. Equity is net assets, or the residual (remaining) interest in the assets of an entity after deducting its liabilities from its assets. For a business entity, equity is the ownership interest.

Question 8

What are current and noncurrent assets?

Answer 8

Current assets are assets that will be converted into cash or sold or consumed within 12 months or within one operating cycle if the operating cycle is longer than 12 months. Noncurrent assets are assets that will not be converted into cash within one year or during the operating cycle if the operating cycle is longer than one year.

Question 9

What are fixed assets (property, plant, and equipment)?

Answer 9

Property, plant, and equipment (PP& E) are tangible assets that are used in operations and will be used past the end of the current period. When the fixed assets are purchased they are recorded at their cost, including costs such as installation costs needed to bring the asset to usable condition. The cost is then expensed over the life of the asset through depreciation.

Question 10

What are intangible assets?

Answer 10

Intangible assets are assets that do not have a physical substance but provide benefit to the firm over a period of time. Intangible assets may be either purchased or developed internally. However, because an asset comes about only as a result of a prior transaction, internally-generated intangible assets are not recorded on the balance sheet.

Question 11

What are current liabilities?

Answer 11

Current liabilities are obligations that will be settled through the use of current assets or by the creation of other current liabilities.

Question 12

What are noncurrent liabilities?

Answer 12

Noncurrent liabilities are liabilities that will not be settled within one year or the operating cycle if the operating cycle is longer than one year.

Question 13

What is equity?

Answer 13

Equity is the remaining balance of assets after the subtraction of all liabilities. Equity is the portion of the company’s assets owned by and owed to the owners. If the company were to be liquidated, equity represents the amount that would theoretically be distributable to the owners.

Question 14

What are the six categories of equity?

Answer 14

Capital stock, the par or stated value of the shares issued. Additional paid-in capital, or the excess of amounts contributed by owners from the sale of shares over and above the par or stated value of the shares issued. Retained earnings, or profits of the company that have not been distributed as dividends. Accumulated other comprehensive income items, or specific items that are not included in the income statement but are included in equity and do adjust the balance of equity, even though they do not flow to equity by means of the income statement as retained earnings do. Treasury stock, or the amount of shares repurchased (a contra-equity account that reduces equity on the balance sheet). Noncontrolling interest (minority interest), or a portion of the equity of subsidiaries that the reporting entity owns but does not own wholly.

Question 15

What is liquidity?

Answer 15

Liquidity refers to the time expected to elapse until an asset is converted into cash or until a liability needs to be paid. The greater a company’s liquidity is, the lower its risk of failure.

Question 16

What is solvency?

Answer 16

Solvency refers to the company’s ability to pay its obligations when they are due. A company with a high level of long-term debt relative to its assets has lower solvency than a company with a lower level of long-term debt.

Question 17

What is financial flexibility?

Answer 17

Financial flexibility is the ability of a business to take actions to alter the amounts and timing of its cash flows that enable the business to respond to unexpected needs and take advantage of opportunities.

Question 18

What is risk?

Answer 18

Risk refers to the unpredictability of future events, transactions and circumstances that can affect the company’s cash flows and financial results.

Question 19

What is the income statement?

Answer 19

The income statement reports on the success of a company’s operations during a given period of time. The income statement provides users with information to help them predict the amounts, timing, and uncertainty of (prospects for) future cash flows.

Question 20

What are temporary accounts?

Answer 20

The accounts that are used to record revenues, expenses, gains and losses are temporary accounts. They are closed to a permanent account (retained earnings on the balance sheet) at the end of each period (fiscal year). Thus at the beginning of each fiscal year, the balances in the income statement accounts are zero.

Question 21

What is revenue?

Answer 21

Revenue represents inflows or other enhancements to assets or settlements of liabilities as a result of delivering goods or providing services that are the entity’s main or central operations. Revenues are usually recognized when the earnings process (the provision of goods or services to the customer) is complete and an exchange has taken place. The exchange does not need to include cash but may include a promise to pay in the future (a receivable).

Question 22

What are expenses?

Answer 22

Expenses are outflows or other using-up of assets or the incurrence of liabilities as a result of delivering goods or providing services that are the entity’s main or central operations.

Question 23

What are gains?

Answer 23

Gains are increases in equity as a result of transactions that are not part of the company’s main or central operations and that do not result from revenues or investments by the owners of the entity.

Question 24

What are losses?

Answer 24

Losses are decreases in equity as a result of transactions that are not part of the company’s main or central operations and that do not result from expenses or distributions made to owners of the entity.

Question 25

What are the criteria for classification as extraordinary items?

Answer 25

Unusual nature. The event or transaction should be highly abnormal and be clearly unrelated to the ordinary and typical activities of the company. Infrequency of occurrence. The event or transaction should be something the company does not reasonably expect to recur in the foreseeable future.

Question 26

What is comprehensive income?

Answer 26

Comprehensive income is the total change in equity that results from all sources other than distributions to owners and investments by owners. It is a little closer to being an economic measure of income than net income is.

Question 27

What is the primary purpose of the statement of cash flows?

Answer 27

The primary purpose of the statement of cash flows is to provide information regarding receipts and uses of cash for the company during a period of time.

Question 28

What are the three main categories of activities in the statement of cash flows?

Answer 28

Operating activities: cash inflows and outflows that result from the company’s main business activities and central operations. Investing activities: activities that the company undertakes to generate a future profit, or return, from investments. Financing activities: activities that a company undertakes to raise capital to finance the business.

Question 29

What are the specific items classified as operating activities?

Answer 29

Cash received from customers and paid to suppliers in the course of the company’s primary business activity. Interest paid on bonds and other debt (loans, leases, and mortgages). Interest received and dividends received from debt and equity investments. Cash paid to the government for taxes and cash received back from the government as tax refunds, except as noted below under Cash Flows from Financing Activities. Cash flows from the purchase, sale and maturity of trading securities usually will be classified as operating activities, not investing activities.

Question 30

What are the specific items classified as investing activities?

Answer 30

Purchasing and selling property, plant and equipment (fixed assets). Making and collecting loans to other parties. Acquiring and disposing of available-for-sale or held-to-maturity securities (equities and debt instruments). In addition, as mentioned above, cash flows from the purchase, sale and maturity of trading securities may be classified as investing activities if the securities are not being held for sale in the near term.

Question 31

What are the specific items classified as financing activities?

Answer 31

Issuance of stock. Treasury stock transactions. Paying dividends (note that dividends paid are financing activities, but dividends received are operating activities). Issuing debt (bonds). Obtaining a loan and repaying the principal of the loan. Repayment of principal on other debt obligations, including repayment of the principal portion of capital lease payments for fixed assets. (The interest portion of payments on capital leases and loans is classified as cash flows from operating activities.) Normally, cash flows from taxes paid and tax refunds received are classified as operating activities. However, certain cash flows relating to income tax expense associated with share-based compensation are classified as financing activities.

Question 32

What is the direct method for preparing the statement of cash flows?

Answer 32

The direct method shows each item that affected cash flow, such as cash collected from customers. Each item is calculated by starting with the relevant item on the income statement and adjusting it using the balances in the relevant balance sheet account(s) at the beginning of the period and at the end of the period covered by the income statement. Each individual line on the income statement is also adjusted to remove the effect of noncash transactions and non-operating activity transactions.

Question 33

What is the indirect method for preparing the statement of cash flows?

Answer 33

Under the indirect method, all adjustments are made to the net income figure from the income statement. The adjustments that are made will be the same as they are for the direct method: adjustments for changes in balance sheet accounts and the elimination of noncash and non-operating activity transactions.

Question 34

What are the four adjustments to net income using the indirect method of preparing the statement of cash flows?

Answer 34

Net income is adjusted for four types of items: Eliminate noncash income and expense items such as depreciation that are included in the income statement. Eliminate investing and financing activity events whose results are included in the income statement, for example gains and losses on the income statement. Include the effect of any operating activities that were not included in net income but did have a cash effect and exclude (eliminate) the effect of any events that are included in net income but did not have a cash effect. Cash flows from the purchase, sale and maturity of trading securities will usually be classified as operating activities, not investing activities. If those cash flows are to be classified as operating activities on the SCF, those cash flows will need to be included as an adjustment to reconcile net income to net cash from operating activities.

Question 35

What are the rules for adjusting net income for changes in assets and liabilities?

Answer 35

Assets: The amount of an increase in an asset should be deducted from net income. The amount of a decrease in an asset should be added to net income. Liabilities: The amount of an increase in a liability should be added to net income. The amount of a decrease in a liability should be deducted from net income.

Question 36

Summarize the steps for preparing the operating activities section under the indirect method.

Answer 36

Add all depreciation and amortization expense back to net income. Add all non-operating losses on the income statement back to net income. Subtract all non-operating gains on the income statement from net income. Add and subtract the changes in balance sheet accounts that are related to operating activities , “ net accounts receivable, accounts payable, inventory, other payables and receivables, bond discount or premium, and other assets and liabilities. If purchases, sales and maturities of trading securities are being classified as operating activities, subtract cash used to purchase trading securities and add cash received for trading securities that were sold or that matured. In addition to the above adjustments, the cash amounts for income taxes paid and interest paid need to be disclosed in a supplemental schedule.

Question 37

What are examples of noncash investing and financing transactions?

Answer 37

Debt converted to equity. Borrowing money to purchase a fixed asset when the lender pays the loan proceeds directly to the seller of the asset to make sure the loan proceeds are used as intended. Buying or selling fixed assets for something other than cash (for example, stock). Obtaining a building or other item by gift. Exchanging noncash assets or liabilities for other noncash assets or liabilities.

Question 38

What is the statement of changes in stockholders’ equity?

Answer 38

The statement of changes in stockholders’ equity reports the changes in each stockholders’ equity account and in total stockholders’ equity during the year and reconciles the beginning balance in each account with the ending balance. Since stockholders’ equity accounts are permanent accounts that keep on accumulating their balances from year to year, information about the sources of changes in the separate accounts is required to make the financial statements sufficiently informative.