Topic 2: Financial Statements (Balance Sheets)

Question 1

What is the Accounting Equation?

Answer 1

Assets - Liabilities = Equity

Question 2

What is the definition of an Asset?

Answer 2

Something that is owned and used by the business

Examples: Stock, Buildings, Debtors (Accounts receivable)

Question 3

What is the definition of a Liability?

Answer 3

A debt that the business owes to external parties

Examples: Loans, Mortgage and Creditors (Accounts Payable)

Question 4

What is the definition of Equity?

Answer 4

Owners financial interest in the business.

* Owner’s worth at the start of the accounting period is called Capital.

Question 5

What are the only two things owners do in relation to business transactions during the year?

Answer 5

1. Take money/stock out of the business (Drawings)

2. Inject money/stock into the business (Additional Capital)

Question 6

Why is profit recorded under the statement of Changes in Equity?

Answer 6

Profit goes to the owner/s of the business

Question 7

What are Current Assets?

Answer 7

Assets that the business owns and uses that can be turned into cash within a 12 month period.

Question 8

What are Non-Current Assets?

Answer 8

Assets that the business owns and uses, and plan to retain for a period of longer than 12 months.

Question 9

What are Current Liabilities?

Answer 9

Debts the business expects to pay back within 12 months.

Question 10

What are Non-Current Liabilities?

Answer 10

Debts that the business will not be able to pay off in the current accounting period and will have for longer than 12 months.

Question 11

What is the definition of the Return on Equity Ratio and what does the ‘*’ represent?

Answer 11

Measures the rate of return that is made from the owner’s investment in the business. (expressed as %)
‘*’ - Average Owners Equity (Opening Value + Closing Value)/2

Question 12

What is the acceptable range for the Return on Equity Ratio?

Answer 12

The higher the result the better.

*Needs to be compared to past performances and the industry average.

Question 13

What is the definition of the Working Capital Ratio?

Answer 13

Measures the business ability to repay its short-term debts within 12 months.
* Result : 1 (2 dp)

Question 14

What is the acceptable range for the Working Capital Ratio? What happens below and above the acceptable range?

Answer 14

Between 1 - 2
Below 1: business does not have enough assets to cover debts within 12 months. (Bad)
Above 2: business can easily cover its debts, too much idle cash

Question 15

What is the definition of the Quick Ratio?

Answer 15

Measures the business ability to repay its immediate term debts within 90 days.
*Result : 1 (2 dp)

Question 16

What is liquidity?

Answer 16

The business ability to repay debts and have money to operate the business on a day to day basis.

• Working Capital and Quick Ratios measure liquidity.
• If Industry Average is given, then WCR & QR should aim to reach the industry average result.

Question 17

What is the recording procedure for doubtful debts and accumulated depreciation values in a Balance Sheet?

Answer 17

First column is used

• Doubtful Debts MUST be directly beneath Debtors
• Accumulated Depreciation values MUST be directly beneath item

Question 18

What are the three ways assets can be valued in?

Answer 18

1. Historical Cost**
2. Replacement Value
3. Market Value

Question 19

What is the historical cost?

Answer 19

The original/actual price a firm pays for an asset plus any additional costs for installations and modifications.

• Repairs is not included.
• Objective Value - backed by proof
• Only used in NON-CURRENT Assets

Question 20

What is the replacement value?

Answer 20

Subjective Value

*Always gonna change

Question 21

What is the Market Value?

Answer 21

Current price asset will fetch in the market place.

*Subjective Value (estimated)

Question 22

Why do accountants prefer to use Historical Cost when recording assets in Balance sheets?

Answer 22

• Backed by clear and verifiable evidence (receipt/invoice)
• Does not change with time
• Easier and Faster to use (no time spend on estimations)

Question 23

What is vertical Analysis?

Answer 23

Analysing items from the same statement from ONE particular year

Question 24

What is Horizontal Analysis?

Answer 24

Comparing and Analysing reports over TWO years.

Question 25

What is trend Analysis?

Answer 25

Comparing and Analysing reports over at least THREE years.

Question 26

What is the definition of the Prudence Assumption?

Answer 26

Prudence is using care and caution in the valuation of assets and the measuring of profit.
Example: Allowance Doubtful Debts

Question 27

What are some advantages of the Prudence Assumption?

Answer 27

• More cautious value of assets

- Allows for more conservative decision making

Question 28

What are the disadvantages of the Prudence Assumption?

Answer 28

• Based on subjective values (estimations)
• Time consuming with research and calculations in statements
• Being too cautious can affect decision making

Question 29

Why is Accumulated Depreciation not an example of Prudence?

Answer 29

Deprecation of an asset is necessary as the asset is used and the value of the asset must to be reduced.

Question 30

What is the definition of Duality?

Answer 30

Duality is every transaction has a two-sided effect on the accounting equation to maintain the balance of the accounting equation. (A - L = E)

Question 31

Why is analysis and interpretation of financial information important?

Answer 31

To help form trends and patterns, which helps us make better decisions.

Question 32

Define a Balance Sheet:

Answer 32

A general Purpose report that summarises the financial position of a firm on a particular day.