Tutorials 3-4 REVIEW OF KEY CONCEPTS

A.

1. The operating cycle (or rather cash cycle) is the time it takes for a company to expend cash
for the acquisition of goods and services, sell those goods and services, and collect the
corresponding cash associated with the sale (so the time “from cash to cash”).

2. Revenue is the gross increase in owners’ equity due to the increase in assets received in
exchange for goods or services delivered to the customer.

3. Expenses are the decreases in owners’ equity that result from the transfer of assets to the
customer through a sales transaction.

4. Income is the excess revenue that remains after associated expenses are deducted.

Income provides a bench mark by which operating performance for a period of time may be
evaluated.

B.

Accountants recognize two basic methods of measuring income: the accrual basis and the cash basis.
The basic difference between the two methods lies with the timing associated with a transaction’s
effect on the financial statements.

1. The accrual basis of accounting is supported by two basic principles: revenue recognition and
matching principle. The accrual basis is considered conceptually superior to the cash basis
because it includes a more complete accounting for an entity’s value-producing activities.

a. Revenue is recognized and recorded in the financial statements when it has been
both earned and realized. This means revenue is recorded when the goods or
services have been delivered to the customer, and cash, or a near cash asset,
have been received in exchange.

b. Expenses are recorded in the same period as the related revenue is recognized.
For example, the cost of inventory sold should be recorded as an expanse in the
same period that the associated sales of inventory was recorded.

2. The cash basis of accounting recognizes a transaction’s impact on the financial statements
when the cash is either received or disbursed. The cash basis focuses on the entity’s ability to
generate cash from current operations.

3. Expenses associated with the particular time period are broken into two classifications:
product costs and period cost.

a. Product costs are costs associated with revenue and are charged to expense in
the same period the corresponding revenue is recognized.
Inventory is a good example of a product cost.

b. Period costs are costs associated with passage of time instead of association with
revenue. An example of a period cost would be administrative salaries for a
production concern, or rent on the administrative offices.

4. Cost recovery is process by which past expenditures for assets are recovered in the period,
or periods, that the assets contributed to cash inflows or the reduction of cash outflows. This

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 recovery process is integral to the whole concept of matching expenses with revenues in the
period the revenues are recognized. Examples would include recognition as expense a
portion of prepaid rent, depreciation expense, and prepaid advertising.

5. Assets are acquired to contribute to production of revenue or the reduction of cost

associated with revenue production. The acquisition costs of assets are "stored" on the
balance sheet until they are transferred to the income statement and recorded as expired
costs, or expenses in the appropriate period.

C.

The income statement is a report of all revenues and expenses of an entity that correspond to a
particular time period. The remainder after expenses are matched against revenue recognized during
the period is income. This income is considered a measure of performance for the entity during the
period and becomes an addition to retained earnings on the balance sheet.

D.

The statement of cash flows represents an effort to bridge the differences between accrual
accounting's focus on changes in net assets and the need to analyze changes in an entity's
cash over the period. The major purpose for the statement is to report the cash receipts
and cash payments of an entity for the period. The statement of cashflows is separated into three
activities: operating, investing and financing.

1. Operating activities involve activities associated with the sale and purchase or production of
goods or services as well as collections from customers, payment to suppliers or employees,
and payment of operating expenses such as rent, taxes, and interest.

2. Investing activities are activities associated with the purchase and sale of long-term assets
such as property, plant and equipment, and making and collecting loans to others as
investments.

3. Financing activities include incurring and repaying debt obligation to the business, the sale
and repurchase of equity shares in the business, and the payment of dividends.

E.

Retained income, as an element of owners equity on the balance sheet, is generally

increased through profitable operations and decreased as the result of unprofitable
operations and/or the distribution of dividends to the shareholders. Changes in retained
income are detailed in the statement of retained income.

1. Cash dividends represent distributions of assets to the shareholders and are charged against
retained carnings. Cash dividends are not considered expenses of the period and are paid out
of after-tax income.

2. Dividend transactions normally involve three dates:

a. The date of declaration is the date the board of directors authorizes a dividend to be
paid. On this date a legal liability to pay the dividend is incurred.
b. The date of record is the ownership cut-off date to be eligible for payment of
dividend.

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 c. The payment date is the date cash is distributed to shareholders on the date of
record.

3. A dividend liability is accrued on the balance sheet if the. period ends after the date of
declaration and before the payment date.

4. Retained incotne is a cumulative balance that represents a general claim against assets of the
entity. There is no relationship between the balance in retained income and the cash account
since retained income may have been "invested" in other forms of assets owned by the firm.

5. The statement of retained income details the changes in retained income that have occurred
during the period. This change is normally due to the addition of profits and the deduction of
dividends distributed to the shareholders during the period.

Tutorials 3-4 QUESTIONS AND EXERCISES

I. True or False – decide which of the following statements is true and which is false

1. The income statement presents the results of operations at a particular

point in time.
2. For revenue to be recognized it must be either earned or realized.
3. The accrual basis of accounting is a better measure than the cash basis for
relating accomplishments to efforts.
4. The statement of cash flows is an effort to show how management
acquired and spent cash during the course of the period.
5. Dividends are considered an expense of the period and are deducted in the
determination of net income.
6. Cash dividends are distributions of assets that reduce a portion of the
ownership claim.
7. Retained earnings represent a cash reserve available to management in the
case of emergency.
8. Sales and sales revenues are synonyms for revenue.
9. Many governmental units use the cash basis of accounting instead of the
accrual basis.
10. Depreciation expense is an example of the expiration of a portion of an
asset's value for book purposes.
11. Prepaid expenses are classified as current liabilities that are waiting to
expire.
12. Matching is a basic principle of accrual accounting that dictates recording
expenses in the period that the related revenues are recognized.
13 The accountants measurements of income are the major means for
evaluating a business entity's performance.

II. Multiple choice - For the following multiple choice questions, select the best answer.

1. During 20x1 revenues of $400,000 were generated. Expenses totaling $374,000

were recognized during 20x1 as well. As a result of these transactions retained
income will:
a. Decrease $26,000
b. Not be affected
c. Increase $26,000
d. Decrease $400,000

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2. Henke Cap Sales had ending retained income of $147,000 on December 31, 20x3.
Profits were $68,000 and distributions of $27,200 were made to shareholders as
dividends. What was the balance in retained income on January 1, 20x3 ?
a. $187,800
b. $ 79,000
c. $106,200
d. $174,200

3. On December 13, 20x6 Thurmon Optical sold $10,000 worth of eyeglasses

costing $6,000 to a customer on account. The delivery was to be made by
Thurmon's delivery truck on January 3, 20x7. How much revenue should
Thurmon recognize on December 31?
a. $10,000
b. $ 4,000
c. $ 6,000
d. $ -0-

4. Which of the following is an example of an unexpired cost?

a. Rent expense
b. Depreciation expense
c. Unearned rent revenue
d. Prepaid expenses

5. Mim's Group had sales of $144,000, cash collections from sales of $123,000, cash
payments for expenses totaling $106,000 and recognized expenses of $112,000.
Net income would be:
Cash Accrual
a. $11,000 $32,000
b. $32,000 $17,000
c. $17,000 $38,000
d. $17,000 $32,000

6. Weinrich Co. had 112,000 shares of common stock outstanding through 20x4.
Sales totaled $740,000 and expenses amounted to $484,640. What was Weinrich's
earnings per share?
a. $6.61
b. $2.28
c. $4.33
d. $2.25

7. Which of the following would be considered a cash flow from operating

activities?
a. Purchase of store equipment for cash
b. Loan from the bank
c. Cash payments to suppliers
d. Cash proceeds from the initial investment

8. Which of the following is true?

a. Assets = Liabilities + Paid-in capital - Revenue + Expenses
b. Liabilities + Paid-in capital = Revenues - Expenses + Assets
c. Liabilities + Paid-in capital + Revenue - Expenses = Assets

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 d. Assets = Liabilities - Paid-in capital + Revenue - Expenses

9. Scheffer Clothing Ltd. purchased inventory on February 1 20x2 for cash. The
merchandise was sold to a major company on March 15 20x2. Credit terms are
thirty days and the customer is expected to pay by the last day of the credit period.
What is the length, in days, of the operating cycle?
a. 60 days
b. 73 days
c. 57 days
d. 28 days

10. Jazzy Jeff's Music Store sold merchandise costing $100,000 on account for a sale
price of $160,000. What was the effect of this transaction on the following:
Assets Retained income
a. Decrease Increase
b. Increase Increase
c. No effect Increase

11. On March 1, the first day in business for your company, $36,000 rent was paid to
cover the next 36 months. It is now December 31 and you need to recognize rent
expense for the period. What is rent expense for the first year?
a. -0-
b. $36,000
c. $10,000
d. $ 9,000

III. Completion - Fill in the necessary word(s) or phrase(s) to complete the following
statements.

1. ________________ are decreases in owners’ equity that arise because goods or

services are delivered to customers.
2. The time spans established for accounting purposes that are less than a year are
called ________________ periods.
3. ________________ is the excess of revenue over expenses.
4. The ________________ basis of accounting relies on the principle of
________________ expenses with revenues in the period the revenue is recognized
and the principle of recognizing revenue when it is ________________ and
________________ .
5. ________________ is the systematic allocation of the value of a tangible asset to
expense each period over the useful life of the asset.
6. The statement of cash flows reports ________________ and ________________ of
an entity for a period.
7. ________________ are distributions of assets to the shareholders that reduce
retained earnings.
8. The original acquisition cost of the inventory that was sold to the customers during
the reporting period is called ________________ .
9. When a company establishes a year for accounting purposes that ends on some date
other than December 31, it is called a ________________ .
10. ________________ are gross increases in owners’ equity arising from increases in
assets received in exchange for delivery of goods and services to customers.

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 11. The ________________ basis of accounting recognizes the impact of transactions on
the financial statements only when cash is received and disbursed.
12. ________________ are costs linked with revenues and are charged as expenses
when the related revenue is recognized.
13. Items identified directly as expenses of the time period in which they are incurred
are termed ________________ costs.

IV. Exercises and problems

1. Fill in the blanks for each of the following independent situations.

Beginning Ending
Total Total Paid-in Retained Retained
Assets Liab. Capital Income Revenue Expenses Dividend Income
100 ? 30 -0- 125 85 -0- ?
? 40 50 30 ? 70 10 50
775 250 ? ? 675 600 25 425
680 384 76 185 983 935 ? 220
? 109 44 156 323 ? 4 164

2. During 20x6 Midnight Express generated revenues of $485,000 and incurred expense
for rent of $200,000, depreciation expense of $100,000, other operating expenses of
$96,000. In addition, they issued an additional $100,000 in new common stock to
help finance additional equipment purchases of $210,000. The difference was
expected to be funded with a debt issue. The beginning balance in Retained Income
was $602,000 and dividends of $40,000 were declared and paid during the period.

Prepare, in good form, a combined statement of income and retained earnings for
December 31, 20x6.