Understanding the Balance Sheet and Statement of Owners Equity
Chapter 3
Understanding the Balance Sheet and Statement of Owners’ Equity
P3-1.
Choice C is correct.
The basic accounting equation is:
Assets = Claims
Claims are of two basic types: those held by the firm’s owners (shareholders’ equity) and those held by nonowners (debt or liabilities). Therefore, A, B, and D are all versions of the basic accounting equation whereas C is not correct. Option holders are potential owners or shareholders and certainly do not represent the debt claims of nonowners. Note, however, that debt can be viewed differently from liabilities make D a possible incorrect answer.
P3-2.
Choice B is correct.
The balance sheet is a snapshot of the firm’s financial position at a given point in time. Information contained in additional financial statements, including the prior balance sheet, would be needed to capture the change in the firm’s position during the period.
P3-3.
Choice A is correct.
It describes the report form of the balance sheet.
B is incorrect as it describes the account form of the balance sheet.
C is incorrect because the balance sheet always describes both the assets and claims, irrespective of the format in which it is provided.
D is incorrect because the form in which the balance sheet is presented does not affect the level of detail that must be disclosed.
P3-4.
Choice B is correct.
U.S. GAAP defines assets as “probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.”
A is incorrect. Cash is a current asset. B is correct. Costs of operating in the current period do not provide future benefits as they do not create something that will be used to operate in future periods. Outlays such as these are classified as period costs and are reported on the income statement as expenses. When costs incurred are expected to benefit future periods, they are classified as assets rather than period costs. C is incorrect. Accounts receivable, which is another example of a current asset, represents future cash receipts from customers. D is incorrect. Prepaid expenses do not cover operating costs in the current period. They are payment in the current or previous period(s) for expenses to be incurred in future periods. The firm has yet to receive the full benefit to be derived from these payments. Therefore, they are recorded as assets.
P3-5.
- As specified in the articles of incorporation, XYZ’s number of authorized shares is one million shares.
- Its issued shares are 200,000 + 350,000 + 150,000 = 700,000 shares.
- Because it bought back 100,000 shares, its outstanding shares are 600,000 shares.
P3-6.
Choice D is correct.
Noncurrent assets are resources that are not expected to be consumed or converted to cash within the year or operating cycle, whichever is longer. They are available for use over periods greater than one year. Therefore, A, B, and C are all noncurrent assets whereas D is a current asset. An equity investment, however, may be considered current if it is classified as a trading security.
P3-7.
Choice C is correct.
Like current assets, current liabilities are those which are expected to come due within one year or one operating cycle. Therefore, A, B, and D are all examples of current liabilities whereas C is not.
Claims arising from a debt contract include principal payments and interest payments. Normally, principal payments are classified as noncurrent (long-term) liabilities. Only the current portion of principal, which is due next period, is classified as a current liability. Interest payable, which is expected to come due within one year, is also a current liability.
P3-8.
The key characteristic that defines owners’ equity under U.S. GAAP is the nature of the claim (i.e., residual interest), not the possession of voting rights. As the security-holders are entitled to the same dividend payments as common stockholders and residual assets in case of bankruptcy, it should be classified as owners’ equity.
P3-9.
Owners’ equity:
Common stock (663,000 shares at $1 par value) $663,000
Plus: Paid-in capital 3,200,000
Plus: Retained earnings 5,134,000
Less: Treasury stock 2,315,000
Owners’ equity $6,682,000
P3-10.
Choice D is correct.
Every company must incorporate an estimate of uncollectable accounts into its measure of accounts receivable, which is reported on its balance sheet. If a company fails to do so, then it will overstate the actual amount of payment that one should expect it to receive from customers for previous sales. Along with the contra-asset account (i.e., allowance for doubtful accounts), the company must record a corresponding expense for the expected amount of “bad debt.” Otherwise, income is overstated. Finally, if accounts receivable is overstated then total assets will also be overstated. Therefore, all of the statements are true.
P 3-11.
Choice C is correct.
A positive figure on a company’s balance sheet for retained earnings indicates that, since inception, the company has earned more income than it has paid out to its shareholders. Some companies that have an accumulated deficit (i.e., negative retained earnings) may never have achieved a positive net income. Others may have achieved a positive income for some periods (and could have paid out dividends), but subsequently sustained losses that eliminated the retained earnings.
It is important to note that a positive figure for retained earnings on the balance sheet is not at all indicative of a company’s liquidity. Retained earnings do not constitute cash or other reserves on hand. Also, a company may pay out a substantial dividend to its shareholders and still retain a significant amount of its net income as retained earnings. Finally, a company’s retained earnings balance does not inform the analyst as to whether the firm is majority-owned by another publicly traded firm.
P3-12.
Many analysts regard book value per share as a dubious indicator of the underlying value of a firm’s assets. Some assets, for example land, that were acquired in the past remain on the books at historical cost (which is typically too low). Second, depreciation of applicable assets does not necessarily correspond to the change in value of such assets. In many cases, equipment that has been depreciated to zero book value continues to function perfectly and possess value to the firm.
Most liabilities are also reported at historical cost. If interest rates have risen or fallen dramatically since long-term debt was issued, then its market value will depart from book value. Alternatively, if a firm’s creditworthiness has changed then the market value of its liabilities need not approximate their book value.
P3-13.
Year-end retained earnings equals $4,500,000. By definition, retained earnings represent the accumulated earnings by the firm that have not been distributed to shareholders. In this case, the firm earned $5 million and distributed $500,000 to shareholders. The initial capital of $50 million received from investors is included in the firm’s total equity but is not classified as retained earnings. The firm’s cash flow does not enter the computation of retained earnings.
P3-14.
Choice A is correct.
The decision to use a relatively higher estimate for bad debt expense reduces reported income and net assets. These differences render Company A’s balance sheet and income statement more conservative.
P3-15
Choice B is correct.
In general, marketable securities are reported at fair market value.
P3-16.
Choice B is correct.
Accounts receivable will be overstated and Inventory will be understated.