Suggested Answers to Discussion Questions

SUGGESTED ANSWERS TO DISCUSSION QUESTIONS 1. Although it has no obligation to issue financial statements to creditors or investors, Baker Construction still should maintain an accounting system. For a start, the company probably has numerous reporting obligations other than financial statements. These include income tax returns, payroll tax returns, (including workers' compensation insurance) and payroll data, which must be reported to individual employees. Even though the company is not required by law to issue financial statements, Tom Baker should find such statements useful in managing the business and also in arranging financing should the business ever need additional capital. In addition, an accounting system provides managers and employees with a wealth of information vital to daily business operations. For example, the system keeps track of the amounts due from customers and amounts payable to employees, tax authorities, and suppliers. It also provides information about the company's cash position and the performance of different departments within the organization. Another important use of an accounting system is establishing the accountability of specific employees for the assets and operations under their direct control. 2. Assets are located on the left side of the balance sheet equation; an increase in an asset account is recorded by an entry on the left (or debit) side of the account. Liabilities and owners’ equity are located on the right side of the balance sheet equation; an increase in a liability account or an owners' equity account is recorded by an entry on the right (or credit) side of the account. 3. Asset accounts: a. Increases are recorded by debits b. Decreases are recorded by credits Liability and owners’ equity accounts: a. Increases are recorded b y credits b. Decreases are recorded b y debits 4. No, the term debit means an entry on the left-hand side of an account; the term credit simply means an entry on the right-hand side of an account. Consequently, the term debit means increase when applied to an asset account, but it signifies a decrease when applied to a liability or owners’ equity account. The term credit means decrease when applied to an asset account, but it signifies an increase when applied to a liability or owners’ equity account. 5. The double-entry system requires that equal dollar amounts of debit and credit entries be made for every business transaction recorded. Q1-5 6. Operating profitably causes an increase in owners’ equity. Usually, this increase in equity is accompanied by an increase in total assets. However, the increase in equity might be offset in part or in whole by a decrease in total liabilities. 7. No, net income does not represent an amount of cash. The entire amount of cash owned by a business appears on the asset side of the balance sheet and is entitled Cash. Net income is an increase in owners’ equity and implies nothing about the form in which the company's assets are held. 8. Revenue represents the price of goods sold and of services rendered to customers during the period. It is an increase in owners’ equity accompanied either by an increase in assets or a reduction in liabilities. Not every receipt of cash represents the earning of revenue. The borrowing of money from a bank causes cash to be received but does not increase the owners’ equity and does not represent revenue. Collection of an account receivable is merely the exchange of one asset (the receivable) for another asset (cash) and does not constitute revenue. 9. The term expenses means the cost of the goods and services used up or consumed in the process of obtaining revenue. Expenses cause a decrease in owners’ equity. To determine the net income for a given accounting period, it is necessary that all expenses of that period be deducted from the revenue earned in that period. In deciding whether a given transaction represents an expense of the current period, two questions are pertinent: (1) Was the alleged expense incurred primarily to generate revenue during the current period? (2) Does the item in question reduce the owners’ equity? Not all cash payments represent expenses. Examples of cash payments that are not expenses include purchase of an asset such as a building or supplies, payment of an existing liability, and dividends. Q6-9 10. Revenue is considered realized at the time that services are rendered to customers or goods sold are delivered to customers. The realization principle answers the question of when revenue should be recognized in accounting records. 11. The matching principle indicates that expenses should be recognized in the period (or periods) that the expenditure helps to produce revenue. 12. Revenue increases owners’ equity; therefore revenue is recorded by a credit. Expenses decrease owners’ equity; therefore expenses are recorded by debits . 13. The trial balance provides proof that the ledger is in balance. A trial balance does not, however, prove that transactions have been analyzed and recorded in the proper accounts and/or for the proper amounts. Furthermore, if a transaction were completely omitted from the ledger, the error would not be disclosed by the trial balance. 14. A dividend is a distribution of assets (usually cash) by a corporation to its stockholders. Dividends reduce both assets and owners’ equity (specifically, the Retained Earnings account). Dividends are not an expense deducted from revenue in the computation of net income. Rather than being reported in the income statement as a component of net income, dividends are reported in the statement of retained earnings as a component of the Retained Earnings balance reported in the balance sheet. 15. Some of the more analytical functions performed by accountants include determining the information needs of decision makers, designing information systems, evaluating organizational efficiency, interpreting financial information, auditing financial records, forecasting future operations, and tax planning. Q10-15