ACTG 201—Final Exam Study Guide

ACTG 201—Final Exam Study Guide


Chapter 1

Describe the three primary forms of business organization and list advantages and disadvantages of each. 

sole proprietorship, partnership, or corporation

sole proprietorship
It is simple to set up and gives you control over the business.
If you choose a sole proprietorship or partnership, you generally receive more favorable tax treatment than a corporation.
Proprietors are personally liable for all debts and legal obligations of the business

partnership
Partnerships often are formed because one individual does not have enough economic resources to initiate or expand the business. Sometimes partners bring unique skills or resources to the partnership.
If you choose a sole proprietorship or partnership, you generally receive more favorable tax treatment than a corporation.
Partners are personally liable for all debts and legal obligations of the business

corporation
It is easier for corporations to raise funds.
are taxes and legal liability


Identify the users of accounting information. How do they use this information?

Internal Users

Internal users of accounting information are managers who plan, organize, and run a business. These include marketing managers, production supervisors, finance directors, and company officers.

External Users

There are several types of external users of accounting information. Investors (owners) use accounting information to make decisions to buy, hold, or sell stock. Creditors such as suppliers and bankers use accounting information to evaluate the risks of selling on credit or lending money.

Explain the three types of business activity.

FINANCING ACTIVITIES

It takes money to make money. The two primary sources of outside funds for corporations are borrowing money (debt financing) and issuing (selling) shares of stock in exchange for cash (equity financing).

INVESTING ACTIVITIES

Once the company has raised cash through financing activities, it uses that cash in investing activities. Investing activities involve the purchase of the resources a company needs in order to operate. 

OPERATING ACTIVITIES

We call amounts earned on the sale of these products revenues. Revenue is the increase in assets or decrease in liabilities resulting from the sale of goods or the performance of services in the normal course of business.

Describe the content and purpose of each of the financial statements.

1. INCOME STATEMENT

Define assets, liabilities, and stockholders’ equity, and state the basic accounting equation. 

2. RETAINED EARNINGS STATEMENT

Retained earnings is the net income retained in the corporation.

3. BALANCE SHEET

The balance sheet reports assets and claims to assets at a specific point in time. Claims to assets are subdivided into two categories: claims of creditors and claims of owners. As noted earlier, claims of creditors are called liabilities. The owners' claim to assets is called stockholders' equity.

4. STATEMENT OF CASH FLOWS

The primary purpose of a statement of cash flows is to provide financial information about the cash receipts and cash payments of a business for a specific period of time. To help investors, creditors, and others in their analysis of a company's cash position, the statement of cash flows reports the cash effects of a company's operating, investing, and financing activities. 

Describe the components that supplement the financial statements in an annual report.

1. Management Discussion and Analysis

The management discussion and analysis (MD&A) section presents management's views on the company's ability to pay near-term obligations, its ability to fund operations and expansion, and its results of operations. 

2. Notes to the Financial Statements

Explanatory notes and supporting schedules accompany every set of financial statements and are an integral part of the statements. The notes to the financial statements clarify the financial statements and provide additional detail.

3. Auditor's Report

An auditor's report is prepared by an independent outside auditor. It states the auditor's opinion as to the fairness of the presentation of the financial position and results of operations and their conformance with generally accepted accounting principles.


Chapter 2

Identify sections of a classified balance sheet. Explain the differences between current and long-term assets and liabilities. Identify accounts that fit into each section.

1. CURRENT ASSETS

Current assets are assets that a company expects to convert to cash or use up within one year or its operating cycle, whichever is longer.

2. LONG-TERM INVESTMENTS

Long-term investments are generally (1) investments in stocks and bonds of other corporations that are held for more than one year, (2) long-term assets such as land or buildings that a company is not currently using in its operating activities, and (3) long-term notes receivable.

3. PROPERTY, PLANT, AND EQUIPMENT

Property, plant, and equipment are assets with relatively long useful lives that are currently used in operating the business. This category includes land, buildings, equipment, delivery vehicles, and furniture.

4. INTANGIBLE ASSETS

Many companies have assets that do not have physical substance and yet often are very valuable. We call these assets intangible assets. One common intangible is goodwill.

5. CURRENT LIABILITIES

In the liabilities and stockholders' equity section of the balance sheet, the first grouping is current liabilities. Current liabilities are obligations that the company is to pay within the next year or operating cycle, whichever is longer.

6. LONG-TERM LIABILITIES

Long-term liabilities (long-term debt) are obligations that a company expects to pay after one year. Liabilities in this category include bonds payable, mortgages payable, long-term notes payable, lease liabilities, and pension liabilities. 

7. STOCKHOLDERS' EQUITY

Stockholders' equity consists of two parts: common stock and retained earnings. Companies record as common stock the investments of assets into the business by the stockholders. They record as retained earnings the income retained for use in the business.

What is measured by profitability ratios? Compute EPS and discuss how it is used to measure profitability.

Profitability ratiosProfitability ratiosMeasures of the operating success of a company for a given period of time., such as earnings per share, measure the operating success of a company for a given period of time.

Earnings per Share

Earnings per share (EPS) measures the net income earned on each share of common stock.

What is the relationship between a retained earnings statement and a statement of stockholders’ equity?

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Which contains the most information?

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Define liquidity and solvency. Identify and compute ratios for analyzing a firm’s liquidity and solvency.

Liquidity

Liquidity the ability to pay obligations expected to become due within the next year or operating cycle. You would look closely at the relationship of its current assets to current liabilities.

CURRENT RATIO

One liquidity ratio is the current ratio, computed as current assets divided by current liabilities.

Solvency

Solvency the ability to pay interest as it comes due and to repay the balance of a debt due at its maturity. Solvency ratios measure the ability of the company to survive over a long period of time.

DEBT TO ASSETS RATIO

The debt to assets ratio is one measure of solvency. It is calculated by dividing total liabilities (both current and long-term) by total assets. 

WORKING CAPITAL

One measure of liquidity is working capital, which is the difference between the amounts of current assets and current liabilities

How are these ratios interpreted?

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Use the statement of cash flows to evaluate solvency. Compute free cash flow and describe what it measures.

USING THE STATEMENT OF CASH FLOWS

In the statement of cash flows, net cash provided by operating activities is intended to indicate the cash-generating capability of the company. Analysts have noted, however, that net cash provided by operating activities fails to take into account that a company must invest in new property, plant, and equipment (capital expenditures) just to maintain its current level of operations. 

What are generally accepted accounting principles? Name the U.S. and international standard-setting bodies that establish these principles.

U.S. companies get guidance from a set of accounting standards that have authoritative support, referred to as generally accepted accounting principles (GAAP).

The Financial Accounting Standards Board (FASB) is the primary accounting standard-setting body in the United States. 

The International Accounting Standards Board (IASB) issues standards called International Financial Reporting Standards (IFRS), which have been adopted by many countries outside of the United States.

Define and explain the significance of relevance, faithful representation, comparability, and consistency.

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Define and explain assumptions and principles that are used in financial reporting. 

ASSUMPTIONS IN FINANCIAL REPORTING

To develop accounting standards, the FASB relies on some key assumptions, as shown in Illustration 2-19. These include assumptions about the monetary unit, economic entity, periodicity, and going concern.

PRINCIPLES IN FINANCIAL REPORTING
Measurement Principles

GAAP generally uses one of two measurement principles, the historical cost principle or the fair value principle. Selection of which principle to follow generally relates to trade-offs between relevance and faithful representation.
HISTORICAL COST PRINCIPLE

The historical cost principle (or cost principle) dictates that companies record assets at their cost. This is true not only at the time the asset is purchased but also over the time the asset is held.

The fair value principle indicates that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability). Fair value information may be more useful than historical cost for certain types of assets and liabilities. 

Define and explain cost constraint.

COST CONSTRAINT

Providing information is costly. In deciding whether companies should be required to provide a certain type of information, accounting standard-setters consider the cost constraint. It weighs the cost that companies will incur to provide the information against the benefit that financial statement users will gain from having the information available. 

Chapter 3

What is the basic accounting equation? How do business transactions effect the basic accounting equation?

Assets = Liabilities + Stockholders' Equity

The accounting equation must always balance. Each transaction has a dual (double-sided) effect on the equation. 

What is an account and how does it help in the recording process?

An account is an individual accounting record of increases and decreases in a specific asset, liability, stockholders' equity, revenue, or expense item.

Define debit and credit and explain how they are used to record business transactions.

DEBITS AND CREDITS

The term debit indicates the left side of an account, and credit indicates the right side. They are commonly abbreviated as Dr. for debit and Cr. for credit. 

What are the basic steps in the recording process?

Each transaction must affect two or more accounts to keep the basic accounting equation in balance. In other words, for each transaction, debits must equal credits. The equality of debits and credits provides the basis for the double-entry accounting system.

What is a journal? How does it help in the recording process?

THE JOURNAL

Transactions are initially recorded in chronological order in a journal before they are transferred to the accounts.

What is a ledger? How does it help in the recording process?

THE LEDGER

The entire group of accounts maintained by a company is referred to collectively as the ledger. The ledger provides the balance in each of the accounts as well as keeps track of changes in these balances.

What is the purpose of posting and how does it help in the recording process?

POSTING
The procedure of transferring journal entry amounts to ledger accounts is called posting. This phase of the recording process accumulates the effects of journalized transactions in the individual accounts. 

What is the purpose of a trial balance? If the debits equal the credits in the trial balance, will the financial statements be error-free? Why or why not?

A trial balance lists accounts and their balances at a given time. A company usually prepares a trial balance at the end of an accounting period. The accounts are listed in the order in which they appear in the ledger. Debit balances are listed in the left column and credit balances in the right column. The totals of the two columns must be equal.

Define cash activities as operating, investing, or financing and give one example of each.

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Chapter 4

What is the revenue recognition principle? 

THE REVENUE RECOGNITION PRINCIPLE

When a company agrees to perform a service or sell a product to a customer, it has a performance obligation. The revenue recognition principle requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. 

What is the expense recognition principle?

THE EXPENSE RECOGNITION PRINCIPLE

In recognizing expenses, a simple rule is followed: “Let the expenses follow the revenues.” Thus, expense recognition is tied to revenue recognition. The critical issue in expense recognition is determining when the expense makes its contribution to revenue. This may or may not be the same period in which the expense is paid. If Conrad does not pay the salary incurred on June 30 until July, it would report salaries and wages payable on its June 30 balance sheet.

What are the differences in the cash basis and the accrual basis of accounting? Which is required by
GAAP? Why?

Accrual-basis accounting means that transactions that change a company's financial statements are recorded in the periods in which the events occur, even if cash was not exchanged.

cash-basis accounting, companies record revenue at the time they receive cash. They record an expense at the time they pay out cash.

Cash-basis accounting is not in accordance with generally accepted accounting principles (GAAP).

Why are adjusting entries needed? What are the major types of adjusting entries?

THE NEED FOR ADJUSTING ENTRIES

In order for revenues to be recorded in the period in which the performance obligations are satisfied and for expenses to be recognized in the period in which they are incurred, companies make adjusting entries. Adjusting entries ensure that the revenue recognition and expense recognition principles are followed.

Identify types of prepayments and discuss the adjusting entry for each. What happens if the adjusting entry is not made?

PREPAID EXPENSES

Companies record payments of expenses that will benefit more than one accounting period as assets. These prepaid expenses or prepayments are expenses paid in cash before they are used or consumed. When expenses are prepaid, an asset account is increased (debited) to show the service or benefit that the company will receive in the future.

Identify types of accruals and discuss the adjusting entry for each. What happens if the adjusting entry is not made?

ACCRUED REVENUES

Revenues for services performed but not yet recorded at the statement date are accrued revenues. Accrued revenues may accumulate (accrue) with the passing of time, as in the case of interest revenue. These are unrecorded because the earning of interest does not involve daily transactions.

Describe the nature and purpose of the adjusted trial balance.

After a company has journalized and posted all adjusting entries, it prepares another trial balance from the ledger accounts. This trial balance is called an adjusted trial balance. It shows the balances of all accounts, including those adjusted, at the end of the accounting period. The purpose of an adjusted trial balance is to prove the equality of the total debit balances and the total credit balances in the ledger after all adjustments. Because the accounts contain all data needed for financial statements, the adjusted trial balance is the primary basis for the preparation of financial statements.

Discuss the purpose of closing entries.

At the end of the accounting period, companies transfer the temporary account balances to the permanent stockholders' equity account—Retained Earnings—through the preparation of closing entries. Closing entries transfer net income (or net loss) and dividends to Retained Earnings, so the balance in Retained Earnings agrees with the retained earnings statement.

List the required steps in the accounting cycle. Discuss quality of earnings issues.

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Discuss the differences between net income and cash provided by operating activities. How do cash-basis and accrual-basis accounting apply?

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Chapter 5

What are the differences between a service enterprise and a merchandising company?

merchandising companies because they buy and sell merchandise rather than perform services as their primary source of revenue. Merchandising companies that purchase and sell directly to consumers are called retailers. Merchandising companies that sell to retailers are known as wholesalers.

The primary source of revenue for merchandising companies is the sale of merchandise, often referred to simply as sales revenue or sales. A merchandising company has two categories of expenses: cost of goods sold and operating expenses.

Give a detailed explanation of the recording of purchases under a perpetual inventory system. Use hypothetical figures to illustrate the perpetual inventory system.

Perpetual System

In a perpetual inventory system, companies maintain detailed records of the cost of each inventory purchase and sale. These records continuously—perpetually—show the inventory that should be on hand for every item. 

How are sales revenues recorded under a perpetual inventory system?

Under a perpetual inventory system, a company determines the cost of goods sold each time a sale occurs. 

What are the differences between a single-step and a multiple-step income statement?

SINGLE-STEP INCOME STATEMENT

Companies widely use two forms of the income statement. One is the single-step income statement. The statement is so named because only one step, subtracting total expenses from total revenues, is required in determining net income (or net loss).

MULTIPLE-STEP INCOME STATEMENT

A second form of the income statement is the multiple-step income statement. The multiple-step income statement is often considered more useful because it highlights the components of net income.

Show how to calculate cost of goods sold under a periodic inventory system.

Determining cost of goods sold is different when a periodic inventory system is used rather than a perpetual system. As you have seen, a company using a perpetual system makes an entry to record cost of goods sold and to reduce inventory each time a sale is made. A company using a periodic system does not determine cost of goods sold until the end of the period. At the end of the period, the company performs a count to determine the ending balance of inventory. It then calculates cost of goods sold by subtracting ending inventory from the goods available for sale.

Periodic System

In a periodic inventory system, companies do not keep detailed inventory records of the goods on hand throughout the period. They determine the cost of goods sold only at the end of the accounting period—that is, periodically. At that point, the company takes a physical inventory count to determine the cost of goods on hand.

Explain how the gross profit rate and the profit margin ratio are computed. What does each represent?

GROSS PROFIT RATE

A company's gross profit may be expressed as a percentage by dividing the amount of gross profit by net sales. This is referred to as the gross profit rate. 

PROFIT MARGIN

The profit margin measures the percentage of each dollar of sales that results in net income. We compute this ratio by dividing net income by net sales (revenue) for the period.

How can each be improved?

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How is the quality of earnings ratio calculated? What does this ratio mean if it is significantly less than 1?

Analysts sometimes employ the quality of earnings ratio. It is calculated as net cash provided by operating activities divided by net income. In general, a measure significantly less than 1 suggests that a company may be using more aggressive accounting techniques in order to accelerate income recognition (record income in earlier periods). A measure significantly greater than 1 suggests that a company is using conservative accounting techniques, which cause it to delay the recognition of income.

What is a key difference between a perpetual inventory system and a periodic inventory system?

Another difference between the two approaches is that the perpetual system directly adjusts the Inventory account for any transaction that affects inventory (such as freight costs, purchase returns, and purchase discounts). The periodic system does not do this. Instead, it creates different accounts for purchases, freight costs, purchase returns, and purchase discounts.

Chapter 6

Why do companies need to determine inventory quantities at the end of the accounting period? Explain the steps in determining inventory quantities. Discuss issues involved in determining the ownership of goods. How do the shipping terms (FOB shipping point and FOB destination) affect ownership of goods? Define consigned goods and discuss related ownership issues.

Explain the basis of accounting for inventories and apply the inventory cost flow methods— FIFO, LIFO, and average–cost—under a periodic inventory system. Discuss the differences between the physical movement of goods and cost flow assumptions.

Discuss the effects on the income statement and balance sheet and tax effects of each of the inventory cost flow assumptions—FIFO, LIFO, and average-cost.

What is the lower-of-cost-or-market (LCM) basis of accounting for inventories? Describe the application of LCM.

What is the inventory turnover ratio? How is it computed? How is it used by external users and management?

What is the LIFO reserve? Explain its importance for comparing results of different companies.

Chapter 7

What are the three factors of the fraud triangle that contribute to fraudulent activity by employees?

Identify the six principles of internal control. Give examples of each principle. Discuss the limitations of
internal control.

List six internal controls over cash receipts. Explain the application of each.

List six internal controls over cash disbursements. Explain the application of each.


List the steps in preparing a bank reconciliation. Prepare a bank reconciliation. Prepare the journal entries that result from a bank reconciliation.

In which financial statement(s) is cash reported? Discuss restricted cash and negative cash balances.

Discuss the five basic principles of cash management.

What are the primary elements of a cash budget and what types of items would one find in each of the
elements? Be specific in your answer.
Chapter 8

Define receivables. What are the different types of receivables? Why is it necessary to have them in different categories?

Explain how accounts receivable are recognized in the accounts. How are accounts receivable valued on the balance sheet?

What are the two methods used to account for bad debts? Which method is required by GAAP if bad debts are material? How is bad debt estimated when using the allowance method? Prepare journal entries for each method. How is an aging schedule prepared? How is it used?

What is a promissory note? What is the formula for computing interest on notes receivable? Discuss the three issues involved in accounting for notes receivable. Prepare journal entries for note transactions.

Describe the entries to record the disposition of notes receivable. Prepare the journal entries for a dishonored note, assuming the payee expects to eventually collect the note.

Explain the statement presentation of receivables.

Describe the principles of sound accounts receivable management. What are the five steps in managing
accounts receivable?

Identify and compute ratios to analyze a company’s receivables. Explain what the ratios measure and
what they tell users of financial statements.

What methods are used to accelerate the receipt of cash from receivables? Why do companies pay fees
for this service? Prepare the journal entry for credit card sales.
Chapter 9

Why are plant assets listed at historical cost? What costs are included in the cost of plant assets?

What is depreciation?

Compute periodic depreciation using the straight-line method assuming a cost of $10,000, zero salvage
value, and a 5-year useful life. Contrast its expense pattern with that of an accelerated method.

When and how do you revise depreciation? Explain the difference between revenue expenditures and
capital expenditures.

What are the ways in which plant assets can be disposed? Explain how to account for the disposal of
plant assets.

Describe methods for analyzing a company’s use of plant assets.

What are intangible assets and how are they reported?

How are long-lived assets reported on the balance sheet?
Chapter 10

Explain to someone who knows very little about accounting what a current liability is and illustrate by identifying major types of current liabilities.

Describe the accounting for an interest-bearing note at its inception, at year-end, and at maturity.


How do you account for unearned revenues?

Why are bonds issued? What are the different types of bonds a corporation or governmental agency can
issue?

Describe the entries for the issuance of bonds issued at a discount.

What entries are necessary when bonds are redeemed?

In what sections of the statement of cash flows would a financial statement user obtain information
related to the cash inflows and outflows related to debt transactions?

Define contingencies and discuss the accounting treatment for contingencies. How do leases affect the
balance sheet?

Which method of amortization results in a constant amount of amortization and interest expense per
period?

Which method of amortization results in a constant percentage rate of interest?

What two components make up each payment on a long-term notes payable?
Chapter 11

Identify the major characteristics of a corporation and classify the characteristic as being advantageous or detrimental to a business.

Describe the accounting treatment for the issuance of stock.

Describe what treasury stock is. State why corporations buy back their own stock, and explain the
accounting for the purchase of treasury stock.

Describe how preferred stock is different from common stock.

Describe what is to be done when declaring a dividend and to prepare the entries for cash dividends and
stock dividends.

How do net income, net loss, and dividends affect retained earnings?

State the items listed in the stockholders’ equity section of the balance sheet.

Use the ratios discussed in this chapter—dividend payout ratio and return on common stockholders’
equity—to evaluate a corporation’s dividend and earnings performance from a stockholder’s perspective.

What kind of account is Common Stock Dividend Distributable and where is it reported on the financial
statements?

Chapter 13

What is sustainable income?

What are irregular items on the income statement? How are irregular items presented on the income
statement?

What is comprehensive income?

What is horizontal analysis and how is it used?

What is vertical analysis and how is it used?

Identify the liquidity, solvency, and profitability ratios introduced throughout the text. Describe how the
ratios are used in analyzing a firm’s liquidity, solvency, and profitability.

Discuss three factors that affect quality of earnings.