Question 1: What is the correct order in which financial reports must be created? Answer 1: The income statement is created first, then the owners' equity statement, and finally the balance sheet. This is because each of these statements has information in them that is required for the next statement to be prepared. The result of the income statement net income is an element of the owners' equity statement. It is listed after the beginning owners' investment and owners' capital, and it is added to (if positive) or subtracted from (if negative) to arrive at the increase or decrease in owners' equity. The owners' capital is the result of the statement of owners' equity and is an element of the balance sheet. It is listed as the first entry under owners' equity and is added to the liabilities of the business to arrive at the period ending owners' equity on the balance sheet. Question 2: What information appears in the income statement, and what is the purpose of the income statement? Answer 2: The income statement includes all the income earned (revenue) by the business for the accounting period and all of the expenses related to generating that income. The purpose of the income statement is to determine the business' net income for the accounting period being reported. 1
Question 3: What is the purpose of the statement of cash flows, and what activities are reported in that statement? Answer 3: The statement of cash flows reports the inflows (or sources) and outflows (or uses) of cash for a specific period of time, usually monthly and annually. There are three types of cash flow activities that are reported in the statement of cash flows. The first part of the statement of cash flows reports cash flows from operations. Typically, this is cash flow from transactions that result from purchasing materials and selling products, both of which affect net income. The second part of the statement of cash flows reports cash flow from investing activities. These transactions include the buying or selling of fixed assets, which are usually longer term assets such as buildings and manufacturing or office equipment. The third part of the statement of cash flows reports cash flows from financing activities. These transactions affect the equity and debt of the business. Such transactions include issuing stock or retiring stock and issuing bonds or retiring bonds. The following is an example of a statement of cash flows: 2
Question 4: What information appears in the statement of owners' equity, and what is the purpose of this statement? Answer 4: The information that appears in the statement of owner's equity is the accounting period beginning capital investment by the owners, plus the net income generated by the business during the accounting period, minus any withdrawals by the owners during the accounting period. The purpose of the statement of owners' equity is to determine any increase or decrease in owners' equity that occurred during the accounting period and 3
calculate the ending owner s capital for inclusion on the balance sheet. Question 5: What information appears in the balance sheet, and what is the purpose of the balance sheet? Answer 5: The information that appears on a balance sheet is the listing of all asset accounts, liability accounts, and owners' equity with their balance as of the end of the accounting period. The total assets must equal the total of liabilities and owners' equity. The standard form of the balance sheet is two sided like the accounting equation, with assets on the left side and liabilities and owners' equity on the right side. The purpose of the balance sheet (like the accounting equation) is to ensure that the ledger accounts are in balance. 4
Question 6: How does a horizontal analysis differ from a vertical analysis of financial statements? Answer 6: Both the horizontal and vertical analysis are percentage analyses of items in a financial statement. The horizontal analysis is a percentage comparison of increases and decreases in related items in a comparative financial statement. The comparative financial statement contains more than one year of results and compares one year to the other. The vertical analysis is a percentage comparison of the totals within a single statement. While the statement can contain more than one year, the analysis is of each year s components on the financial statement. Question 7: How are return on investment, return on equity, net margin, and asset turnover ratios calculated and used? Answer 7: Return on Investment (ROI) = (Net Income / Total Assets) This ratio tells you how earnings are generated from sales and how sales are generated from assets. Management s objective is to improve ROI year after year. 5
Return on Equity = (Net Income / Stockholders Equity) This ratio tells you the profitability of the business in relation to the amount invested by stockholders. Improvement in this ratio year after year is important to management because investors look at this when making a decision to buy a company s common stock, which in turn helps maintain the stock market value of the company. Net Margin = (Net Income / Net Sales) This ratio tells you the amount of sales dollars left after all expenses are subtracted. This information is used when comparing one company to another in the same industry. Management wants this to remain constant or improve year over year. Net margin time s asset turnover equals return on investment (ROI). Turnover of Assets = (Net Sales / Total Assets) This information is used when comparing one company to another in the same industry. Management wants this to remain constant or improve year over year. Question 8: What is an example of a journal entry error and its correction procedure? Answer 8: The following are three examples of a journal entry error and its correction procedure: If the journal entry is incorrect but not posted, draw a line through the error and insert the correct title or amount. If the journal entry is correct but posted incorrectly, draw a line through the error and post correctly. If the journal entry is incorrect and posted, journalize and post a correcting entry. In the first two examples, the accountant making the correction would initial the correction to verify who made it. In the third example, suppose an entry to journalize and post the purchase of office equipment on account was incorrectly journalized and posted as a debit to supplies and a credit to accounts payable. A correcting entry would be made by debiting office equipment and crediting supplies. A note would be included in the journal explaining the correction. Question 9: How would I determine whether an entry to a journal was posted in error? 6
Answer 9: An example of a journal entry error would be made by posting $625.00 as $526.00, $265.00, or $26.50. When these types of errors are made and no other error has occurred, the difference between the two trial balance totals, debits and credits, can be evenly divided by 9. This will tell you the type of error that has occurred. You would then know what to look for, and by reviewing all the entries you could determine which entry was posted incorrectly. Question 10: What is an example of accounting for closing adjusting entries? Answer 10: The following are examples of accounting for closing adjusting entries of inventory shrinkage, office supplies used, insurance expense, and accrued salaries not paid: Inventory shrinkage is a reduction (credit) to inventories, an asset on the balance sheet, an increase (debit) to cost of goods sold, and an expense on the income statement. Office supplies used is a reduction (credit) to office supplies, an asset on the balance sheet, an increase (debit) to office supplies expense, and an expense on the income statement. Insurance expense for the month is a reduction (credit) to prepaid insurance, an asset on the balance sheet, an increase (debit) to insurance expense, and an expense on the income statement. Accrued salaries not paid are an increase (credit) to salaries payable, a liability of the balance sheet, an increase (debit) to salaries expense, and an expense on the income statement. 7