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Chapter 1—Review Questions

1. In broad terms, what is the purpose of accounting?

In the broadest terms, accounting is “the art of interpreting, measuring, and describing economic activ-

ity.” 1 Accounting differs from economics, though, in that economics sometimes concerns itself with general, subjective measures of well-being, such as whether all people or people in general are “better-off” and where the notion of positive measure may includie that “psychic satisfaction” has increased. Accounting, on the other hand, limits itself to financial measures that admit objective valuation and limits its focus to clearly-delineated economic entities such as a specific business entity. Thus, accounting would value an asset at historical purchase price and value its benefit as the amount of revenue from sales of goods or services which that asset produces druing a specific time interval, or accounting period.

In sum, the underlying purpose of accounting is to provide financial information about an economic entity.

2. Why is knowledge of accounting terms and concepts useful to persons other than profiessional accountants?

Professional accountants use specialized knowledge and skills to prepare accounting reports, which summarize, describe, and interpret economic activities of a firm. Examples of these reports are financial statements, such as the balance sheet and the income statement; other examples are managerial accounting reports, such as reports of efficiency and profitability by product line or by department. In both of these cases, though accountants used their specialized skills to create these reports, once created they are useful to other types of professionals, such as managers, investors, credit managers of potential lenders, and government officials concerned with economic activity. An analogy of this situation is the automobile: though engineers with specialized skills such as calculus and mechanics design cars and laborers with strength and dexterity manufacture cars, the completed product

is useful to manuy people, not just those with specialized knowledge.

To use accounting reports, though, one must understand the meaning of the terms and values contained in the report. Thus, for investors, managers, potential lenders, and governmental officials to properly use accounting reports, they need a knowledge of accounting terms and concepts. In summary, the information contained in accounting reports is useful to many people other than professional accountants. Professional accountants use specialized knowledge to prepare the reports. The information contained in the reports is expressed in terms of specialized terms and concepts. Understand- ing the information contained in the reports requires understanding the terms and concepts by which the information is expressed. Thus, for accounting reports to be useful to professionals other than accountants, these non-accountant professionals must understand the terms and concepts by which the information is ex- pressed. As understanding comes through knowledge, knowledge of accounting terms and concepts is useful to persons other than professional accountants in order that they may understand and thus use accounting reports.

3. What is meant by the term “business transaction”?

A business transaction is a completed action composed of an exchange between parties and which has

a definite value in monetary terms. Examples are a machine part sold for a certain, definite price; or, a

definite number of hours of labor provided at a stated rate of so many dollars per hour. Examples which are not business transactions is a stated plan to purchase some thing in the future, but where no binding agreement exists. Contingent events which may affect the future success of a firm, such as the possible death of a key executive, is also not a transaction both because it is contingent and because it has no exact dollar amount. In summary, transactions are completed exchanges of value that possess definite, stated monetary worth in some stated monetary unit, such as pounds, euros, dollars, or yen.

4. What are financial statements and how do they relate to the accounting system?

Financial statements are concise reports that summarize in 2-3 pages the operating results and financial position of a company. The Balance Sheet summarizes a company’s amounts and kinds of assets, liabilities, and owner’s equity as of a specific date. The Income Statement summarizes revenue, expenses, and net income


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over a specific period of time. Financial statements are related to the accounting system by their summarizing large numbers of transactions and account balances, which are themselves described and maintained by the accounting system.

5. Explain briefly why each of the following groups is interested in the financial statements of a business: (a)

creditors; (b) potential investors; (c) labor unions.


Creditors base decisions on types and amounts of credit to extend based on risk of default. Financial statements convey the vinancial health of an entity, which determines the future ability of a business to repay debts.


Potential investors need to evaluate the worthiness of a business as an investment. This requires knowing whether sales and profits are trending up or down, as well as knowing the amounts and ratios of various asset accounts to liability accounts. This information is conveyed in financial statements.


Labor unions are interested in increasing their members compensation and job security. As both are related to profitability and revenue, especially to trends in these results, labor unions are interested in financial statements for their conveying information about these results.

6. The following questions relate to the term “generally accepted accounting principles”:

(a) What type of accounting reports should be prepared in conformity with these principles?:

Among the types of accounting reports prepared are: financial statements, tax returns, managerial data, reports to regulatory agencies, and other special-purpose reports that may be requested by lenders or investors. Only financial statements—the end-result of financial accounting—need be prepared in accordance with GAAP. Although tax returns and reulatory filings are generally prepared under guidelines broadly similar to GAAP, the princples under which they are prepared are determined by the authorities that require them and they should be prepared in accordance with these principles. Reports to specific users, such as lenders and managers, are part of managerial accounting and should be prepared to be most useful to these users, not necessarily according to GAAP.

(b) Why is it important for these principles to be widely recognized?:

Generally accepted accounting principles need to be widely recognized so that they are widely applied. Wide application creates conformity in financial accounting across companies and across accountants. This conformity in preparing accounting information allows financial statements prepared by different accountants and regarding different entities to be broadly comparable.

(c) Where do these principles come from?

Some GAAP principles are specific prnouncements of the FASB. Others have arisen as professional conventions from their widespread use and adaption. Of note, GAAP principles are formalized in the private sector, not as promulgated government regulation.

(d) List two examples of generally accepted acounting principles that relate to the valuation of assets:

The cost principle requires that assets be valued at an objective, definite monetary amount; generally, this is taken as meaning the historical purchase price, not assessed or current value. Using assessed value rather than historical cost would involve estimation and thus would violate the cost principle. The going-concern assumption prevents assets from being valued at replacement cost in times of high inflation. The going-concern principle states that assets are purchased to be used in the business’ operations, not for investment purposes. Hence, their value as an asset only derives from profitable operations, not from gains in intrinsic value.

7. Distinguish between accounting and bookkeeping:

Bookkeeping means the recording of transactions, the record-making phase of accounting. It is more routine and rote. Accounting proper refers to the analysis and critical-thinking parts of the financial mea- surements which form the whole of the accounting field. While recording transactions (bookkeeping) is part of accounting as a field, the specific job-title “accountant” includes subjects such as the design of the ac- counting system as a whole, analyzing transactions, and interpreting accounting reports. Bookkeeping does not include these subjects.


8. What is the principle function of certified public accountants? What other services are commonly rendered by CPA firms? The principle function of CPAs is auditing. Other servies commonly rendered by CPA firms are income- tax services, management advisory services, and small business servies.

9. Private accounting includes a number of subfields or specialized phases, of which cost accounting is one. Name four other specialized phases of private accounting:

Besides cost accounting, other specialized phases of private accounting are: design of accounting systems, financial forecasting, internal auditing, and management accounting.

10. Is the FASB a government agency? What is its principle function?

The FASB is a private-sector organization. It is a non-profit organization, supported by the accounting profession, that conducts research into accounting problems. It also issues Statements of Financial Acounting Standards, which represent statements of GAAP. (Besides these statements, many things comprise GAAP, including long-standing and widespread professional conventions.)

11. One primary objective of every business is to operate profitably. What other primary objective must be

met for a business to survive? Explain. Profitability is the conditon of a company’s revenue exceeding its expenses, so its net income is positive. Revenue is composed of cash as well as non-cash items. Thus, a companycould be profitable but see its cash assets decline in that period. Without cash, a business cannot pay its debts as they fall due, no matter how great its non-cash assets are. This condition of having sufficient cash on hand to pay debts as they fall due is known as solvency. Profitability and solvency are the two primary objectives of every business.

12. Not all the significant happenings in the life of a business can be expressed in monetary terms and

entered in the accounting records. Identify two or more significant events affecting a business that could not be satifactorily measured and entered in its accounting records. The death of a key executive, the openig of a competitor adjacent or across the street from a retail business, and the development of a disruptive technology that renders a business’ equipment or processes obsolete are all such examples. These three events share the characteristics of being forward-reaching in their effects; contingent on factors that cannot be precisely measured, partly due to their future and conditional nature; and, that their financial effect on a business cannot be described in terms a business transaction with objectively-determined, monetarily-precise amounts. Rather, they all presage possible future outcomes that may or may not occur and which, if negative, may likely be seen in effect as slowly-declining revenue and net income over years or decades. Or, the outcomes may be positive; or, the effects rapid.

13. Information available from the accounting records provides a basis for making many business decisions.

List five examples of business decisions requiring the use of accounting information:

i) Whether a change in operating processes resulted in increased net income;


Whether sales increased after a new marketing campaign;


Whether all locations contribute equally to profitability;


Whether a purchase is better made by cash or by debt;


Whether delinquent accounts are increasing.


What are the objectives of a company’s system of internal control?

The primary objective of a system of internal control is to assure a company’s management that the accounting information it receives is accurate and reliable. The constituent objectives are that the organiza- tion protects its resources against waste, fraud, and inefficiency; that the accounting and operating data is accurate and reliable; that company policies are complied with; and that the level of performance is properly evaluated across all levels and divisions of the company. In sum, the system of internal control is intended to assure that the entire business operates according to plan.

15. Define assets; list 5 examples:

Assets are economic resources that are owned by the business and which are expected to benefit future operations and production. Cash, land, buildings, equpment, supplies, and accounts receivable are all assets.


16. Define liabilities; list 5 examples:

Liabilities are debts owed by the business. Accounts Payable, Unearned Revenue, Notes Payable, Salaries Payable, and Accrued Interest Payable are all liabilities.

17. Ray Company was offered £300,000 cash for the land and buildings occupired by the business. These

assets had been acquired five years ago for a price of £200,000. Ray Company refused the offer, but is inclined to increase the land and buildings to a total valuation of £300,000 in the balance sheet in order to show more accurately “how much the building is worth”. Do you agree? Explain.

Assets are properly carried on ledger accounts and, hence, financial statements, at historical cost, also called “book value”. This is known as the “cost principle”, a generally-accepted accounting principle. The

rationale for the cost principle is that assets are purchased for use in given business considered as a going- concer; this rationale is also known as the “going-concern assumption”. Now, the measure of “what a business

is worth” is the residual value of assets net of liabilities, which difference is called “Owner’s Equity”.

The worth of a business, from an accounting viewpoint, is its ability to generate net income. In the case of Ray Company, the land and building are owned for the purpose of utilization in the business line of operations and this value is already reflected in Owner’s Equity. Assuming that Ray Company is not in the business of holding real property for appreciation, the greater value reflected by the offer is immaterial to “what the business is worth,” as it fails the objectivity principle and is not based on an actual transaction. It does, however, reflect a non-GAAP estimate of the business’ possible liquidation value.

18. Explain briefly the concept of the business entity:

A business entity is a discrete, clearly-delineated organization that can be regarded as a single thing,

a discrete object. Examples are a single proprietorship, partnership, or corporation. Something that is not

a business entity would be an amalgam of volunteers, without a legal charter, even if they jointly paid for equipment and keep a “kitty”.


State the accounting equation in two alternate forms:


Assets = Liabilites + Owner s Equity


Owner s Equity = Assets Liabilities


The owner’s equity in a business arises from what two sources?

Investments of capital and net income from profitable operation.