Subject 2. Financial Statement Elements and Accounts

An account is a label used for recording and reporting a quantity of almost anything. It is the:

  • Means by which management keeps track of the effects of transactions.
  • Basic storage unit for accounting data.

A chart of accounts is a list of all accounts tracked by a single accounting system, and should be designed to capture financial information to make good financial decisions. Each account in the Anglo-Saxon chart is classified into one of the five categories: Assets, Liabilities, Equity, Income, and Expenses.

Assets

Assets are economic resources controlled by a company that are expected to benefit future operations.

  • An asset is usually listed on the balance sheet.
  • It has a normal or usual balance of debit (i.e., asset account amounts appear on the left side of a ledger).

It is important to understand that in an accounting sense an asset is not the same as ownership. In accounting, ownership is described by the term "equity."

Types of Assets

  • Current assets are cash and other assets expected to be converted into cash, sold, or consumed either in one year or in the operating cycle, whichever is longer. Current assets are presented in the balance sheet in order of liquidity. The five major items found in the current asset section are: cash, marketable securities, accounts receivables, inventories and prepaid expenses.
  • Long-term investments are often referred to simply as investments. They are to be held for many years, and are not acquired with the intention of disposing of them in the near future.
  • Property, plants, and equipment are properties of a durable nature used in the regular operations of a business. With the exception of land, most assets are either depreciable (such as a building) or consumable. The accumulated depreciation account is a contra-asset account used to total the depreciation expense to date on the asset.
  • Intangible assets lack physical substance and usually have a high degree of uncertainty concerning their future benefits. They include patents, copyrights, franchises, goodwill, trademarks, trade names, secret processes, and organization costs. Generally, all of these intangibles are written off (amortized) as an expense over 5 to 40 years.

Liabilities

Liabilities are the financial obligations that the company must fulfill in the future. They are typically fulfilled by cash payment. They represent the source of financing provided to a company by its creditors.

Types of Liabilities

  • Current liabilities are obligations that are reasonably expected to be liquidated either through the use of current assets or the creation of other current liabilities within one year or within the operating cycle, whichever is longer. They are not reported in any consistent order. A typical order is: notes payable, accounts payable, accrued items (e.g., accrued warranty costs, compensation, and benefits), income taxes payable, current maturities of long-term debt, etc.
  • Long-term liabilities are obligations that are not reasonably expected to be liquidated within the normal operating cycle but instead at some date beyond that time. Bonds payable, notes payable, deferred income taxes, lease obligations, and pension obligations are the most common long-term liabilities.

Owners' Equity

Equity represents the source of financing provided to the company by the owners.

Owners' Equity = Contributed Capital + Retained Earnings

Owner's equity is the owners' investments and the total earnings retained from the commencement of the company.

  • Contributed capital is the amount invested in the business by the owners.
  • Retained earnings are the company's undistributed earnings: accumulated earnings since inception less any losses, dividends, or transfers to contributed capital.

Revenue

Income (often referred to as "revenue") for a company is generated by delivering or producing goods, rendering services, or other activities that constitute the company's ongoing major or central operations. Not all cash receipts are revenues; for example, cash received through a loan is not revenue.

Expenses

Expenses are outflows from delivering or producing goods, rendering services, or carrying out other activities that constitute an entity's ongoing major or central operations. An expense represents an event in which an asset is used up or a liability is incurred. Not all cash payments are expenses; for example, cash dividends paid to stockholders are not expenses.

Practice Question 1

What are short-term obligations that arise from credit extended by suppliers for the purchase of goods and services?

A. Accrued liabilities
B. Accounts payable
C. Deferred credits
Correct Answer: B

Accounts payable are short-term obligations due to credit extended by suppliers for the purchase of goods and services.

Practice Question 2

Which of the following is (are) not included in current assets?

I. Accounts receivable
II. Accrued wages
III. Cash
IV. Inventories
Correct Answer: II only

Practice Question 3

What type of account is accumulated depreciation?

A. Asset
B. Liability
C. Contra-asset
Correct Answer: C

Although accumulated depreciation appears in the assets section of the balance sheet, it is a contra-asset account with a credit balance.

Practice Question 4

Which of the following is not true about net income?

I. A company can have a cash shortage and still have net income.
II. Net income is an asset.
III. Net income is the result of revenues exceeding expenses.
IV. Net income represents an increase in owners' equity.
V. Net income has no direct relationship to assets.
Correct Answer: II

Net income is not an asset. It is an increase in owners' equity and does not consist of cash or any other specific assets. Net income is the excess of revenue earned over the related expenses for a given period.

Practice Question 5

Owners' equity is affected by the ______.

A. payment of dividends
B. purchase of an asset, or collection of accounts receivable
C. payment of a liability
Correct Answer: A

The collection of accounts receivable does not affect stockholders' equity. It decreases an asset account (accounts receivable) and increases an asset account (cash).

The purchase of an asset does not affect stockholders' equity. It decreases an asset account (cash) and increases an asset account (such as equipment).

The payment of a liability does not affect stockholders' equity. It decreases an asset account (cash) and decreases a liability account (such as accounts payable).

Stockholders' equity is affected by the payment of dividends because it decreases an asset account (cash) and decreases a stockholders' equity account (retained earnings).

Practice Question 6

True or False? Retained earnings represent the amount that is invested in the business by the stockholders.
Correct Answer: False

Contributed capital represents the amount that is invested in the business by the stockholders. Retained earnings represent equity of the stockholders arising from earnings of the business that are retained for use in the business. Contributed capital and retained earnings are both components of stockholders' equity.

Practice Question 7

A chart of accounts lists account numbers and their corresponding names and is used to help identify accounts in the ______.

A. journal
B. trial balance
C. ledger
Correct Answer: C

Although all accounts appearing in the financial statements appear in the chart of accounts, the chart of accounts lists all accounts in the ledger. Accounts are grouped according to their type (asset, liability, equity, revenue, expense) and each is given a unique number. The chart of accounts can be referred to when classifying transactions and used to locate each account within the ledger.

Practice Question 8

The dividends account appears ______.

I. in the stockholders' equity section of the balance sheet
II. on the statement of owners' equity
III. on the income statement as an expense
Correct Answer: II only

The dividends account does not appear in the stockholders' equity section of the balance sheet. The payment of dividends does not affect net income because it is not an expense. The dividends account, therefore, does not appear in the income statement. It appears on the statement of owners' equity as a deduction from the beginning balance of the retained earnings account.

Practice Question 9

If there are four operating cycles within one year for a company, which time frame should be used to categorize current assets?

A. One quarter
B. One year
C. Either one quarter or one year
Correct Answer: B

Current assets are cash and other assets expected to be converted into cash, sold, or consumed either in one year or in the operating cycle, whichever is longer.

Practice Question 10

If a company's operating cycle lasts for two years, which time frame should be used to categorize current assets?

A. One year
B. Either one year or two years
C. Two years
Correct Answer: C

Current assets are cash and other assets expected to be converted into cash, sold, or consumed either in one year or in the operating cycle, whichever is longer.

Practice Question 11

The essential characteristics of an asset are:

I. The enterprise can obtain the benefit and can limit others' access to it.
II. Its value is known with certainty.
III. It has probable future economic benefits.
IV. It is a result of past transactions or events.

A. I, III and IV
B. II, III and IV
C. I, II and III
Correct Answer: A

By definition, assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

Practice Question 12

Which one of the following is an example of "other revenues and gains" in a multiple income statement for a manufacturing company?

I. Dividend revenue
II. Rental revenue

A. I only
B. II only
C. I and II
Correct Answer: C

Special gains and losses that are infrequent or unusual, but not both, are normally reported in the non-operating section of a multi-step income statement. These items generally break down into two main subsections: other revenues and gains, and other expenses and losses (e.g., interest on bonds and notes).

Practice Question 13

Which of the following best describes the relationship between revenue and retained earnings?

A. Revenue increases net income, which in turn increases retained earnings.
B. Revenue represents a cash receipt; retained earnings is an element of stockholders' equity.
C. Revenue represents the price of goods sold or services rendered; retained earnings represents cash available for paying dividends.
Correct Answer: A

Practice Question 14

Which of the following is least likely to be classified as a financial statement element? Assume U.S. GAAP.

A. Assets
B. Net income
C. Revenue
Correct Answer: B

Net income is not an element of the financial statements, but the net result of revenues less expenses. The elements are: assets, liabilities, owners' equity, revenue, and expenses.