Financial Statement Preparation Flashcards

Question 1

What is the main purpose of preparing financial statements?

Accepted Answer

Financial statements summarize a business's financial activity and position so that users can make decisions. They communicate how much the business earned, what it owns and owes, and how cash moved during a period. Users include owners, managers, lenders, investors, and regulators, who rely on them to judge performance and risk.

Question 2

Which four primary statements make up a complete set of financial statements?

Accepted Answer

A complete set usually includes the income statement, balance sheet, statement of cash flows, and statement of changes in equity. Each answers a different question: how the business performed, what it owns and owes, where cash went, and how owners' interest changed.

Question 3

What does the accounting equation state, and why does it matter?

Accepted Answer

The accounting equation states that assets equal liabilities plus owners' equity. It matters because every transaction must keep both sides balanced, which acts as a check on recording. For example, buying equipment with cash raises one asset and lowers another, so the totals still match.

Question 4

What is the matching principle in accrual accounting?

Accepted Answer

The matching principle states that expenses should be recorded in the same period as the revenues they helped produce. Under accrual accounting, a cost is recognized when incurred rather than when paid. For example, wages earned by staff in December belong to December's income statement even if payday falls in January.

Question 5

What is the difference between cash basis and accrual basis accounting?

Accepted Answer

Cash basis accounting records revenue when cash is received and expenses when cash is paid. Accrual basis accounting records revenue when it is earned and expenses when they are incurred, regardless of cash timing. Formal statements under widely used standards generally require accrual accounting, because it reflects economic activity more completely.

Question 6

What does the historical cost principle require for recording assets?

Accepted Answer

The historical cost principle requires assets to be recorded at the amount originally paid to acquire them, not at their current market value. The recorded amount generally stays the same over time, which makes figures objective and verifiable. Depreciation and impairment adjust these amounts later, but the starting point remains the original cost.

Question 7

What is the business entity assumption in financial reporting?

Accepted Answer

The business entity assumption treats a business as separate from its owners and from any other organization. Personal assets, debts, and spending of the owner are not recorded in the business's statements. This separation lets users see exactly what the business earned, owns, and owes.

Question 8

What is the going concern assumption, and how does it affect statements?

Accepted Answer

The going concern assumption presumes that a business will continue operating long enough to use its assets and meet its obligations. Under this assumption, assets such as equipment are recorded and depreciated over their useful lives rather than valued at liquidation prices.

Question 9

How does double-entry bookkeeping record each business transaction?

Accepted Answer

Double-entry bookkeeping records every transaction in at least two accounts, with total debits always equal to total credits. Debits increase asset and expense accounts and decrease liability, equity, and revenue accounts, while credits do the opposite. For a cash sale, cash is debited and sales revenue is credited.

Question 10

What is a normal balance, and how do you determine it for an account?

Accepted Answer

A normal balance is the side, debit or credit, on which an account usually increases. Asset and expense accounts have debit normal balances, while liability, equity, and revenue accounts have credit normal balances. A liability account showing an unexpected debit balance usually signals a posting error.

Question 11

What is the purpose of a source document in the recording process?

Accepted Answer

A source document is evidence that a transaction occurred, such as an invoice, receipt, bank statement, or check. It provides the date, amount, parties, and description needed to record the entry accurately. Keeping source documents also supports audits and allows anyone reviewing the books to trace each recorded amount back to its origin.

Question 12

What is a journal entry, and what information must it include?

Accepted Answer

A journal entry is the first formal record of a transaction, kept in chronological order in the general journal. It must include the date, the accounts affected, the debit and credit amounts, and a brief explanation. Each entry should have equal debits and credits so that the books remain in balance.

Question 13

What is the difference between posting and journalizing?

Accepted Answer

Journalizing is the act of recording each transaction as a journal entry in chronological order. Posting is the later step of transferring those debit and credit amounts to the appropriate accounts in the general ledger. Posting groups each account's activity together, so a single account's balance can be read directly from its ledger page.

Question 14

What is a chart of accounts, and why do businesses use one?

Accepted Answer

A chart of accounts is an organized list of every account a business uses, each with a unique number and name. It is grouped by category, usually assets, liabilities, equity, revenue, and expenses, which makes it easy to find where a transaction belongs.

Question 15

What is the trial balance, and what does it confirm?

Accepted Answer

A trial balance is a list of every ledger account with its debit or credit balance at a specific point in time. It confirms that total debits equal total credits, which catches many posting and arithmetic errors. It does not prove every entry is correct, since offsetting errors can still leave the totals balanced.

Question 16

Which common errors does a trial balance fail to detect?

Accepted Answer

A trial balance does not detect errors that keep total debits equal to total credits. Examples include omitting a complete transaction, reversing a debit and a credit, or posting both sides to the wrong accounts. These errors remain hidden until a reviewer checks source documents or compares account balances with expected results.

Question 17

What is the basic structure of a multistep income statement?

Accepted Answer

A multistep income statement begins with net sales, subtracts cost of goods sold to reach gross profit, then subtracts operating expenses to reach operating income. Other income and expenses, such as interest and taxes, are applied next to arrive at net income.

Question 18

How is gross profit calculated, and what does it show?

Accepted Answer

Gross profit equals net sales minus cost of goods sold. It shows how much remains from sales after paying the direct costs of producing or buying the goods sold. A rising gross profit margin, meaning gross profit as a share of sales, can indicate better pricing or lower production costs.

Question 19

What is the difference between current assets and noncurrent assets?

Accepted Answer

Current assets are expected to be converted to cash or used up within one year or the normal operating cycle, whichever is longer. Examples include cash, accounts receivable, and inventory. Noncurrent assets, such as property, plant, and equipment, are held for longer than that period and support operations over multiple years.

Question 20

What makes a liability current rather than long term?

Accepted Answer

A liability is current if it is expected to be settled within one year or the normal operating cycle, whichever is longer. Accounts payable, accrued wages, and the portion of long term debt due within the next year are common examples. Liabilities due later are classified as long term.

Question 21

What is working capital, and how is it calculated?

Accepted Answer

Working capital is current assets minus current liabilities. It measures a business's short term financial cushion, showing whether it has enough liquid resources to cover obligations due within the coming year. Positive working capital generally suggests short term liquidity, although the amount must be judged alongside the nature of the assets.

Question 22

How does retained earnings link the income statement to the balance sheet?

Accepted Answer

Retained earnings is the cumulative net income kept in the business after dividends are paid. Each period's net income from the income statement increases retained earnings, while dividends decrease it. The ending balance appears in the equity section of the balance sheet.

Question 23

Why might two companies with the same net income have different balance sheets?

Accepted Answer

Net income measures performance over a period, while the balance sheet shows financial position at one date. Companies with equal net income can still hold very different assets, debts, or equity, depending on how they financed operations and invested in resources.

Question 24

What does the current ratio measure, and how is it computed?

Accepted Answer

The current ratio measures short term liquidity by dividing current assets by current liabilities. A ratio above one means current assets exceed current liabilities, though acceptable levels vary by industry. For example, current assets of 300,000 dollars and current liabilities of 150,000 dollars give a ratio of two.

Question 25

Why are adjusting entries needed before preparing financial statements?

Accepted Answer

Adjusting entries update account balances so revenues and expenses appear in the period they were earned or incurred, and assets and liabilities reflect their true amounts at period end. Routine transactions rarely capture everything that happened by the closing date. Without adjustments, statements would understate or overstate profit and misstate financial position.

Question 26

What is the difference between an accrual adjustment and a deferral adjustment?

Accepted Answer

An accrual adjustment records revenue earned or expenses incurred before cash changes hands, such as wages owed to employees at period end. A deferral adjustment moves cash received or paid into the correct period, such as unearned revenue recognized as services are delivered. Both ensure income is recognized in the period it belongs.

Question 27

How does depreciation affect the balance sheet and the income statement?

Accepted Answer

Depreciation allocates the cost of a long lived asset, such as equipment, across its useful life. On the income statement it appears as an expense, reducing net income for each period. On the balance sheet, accumulated depreciation is subtracted from the asset's original cost, lowering its carrying amount over time.

Question 28

What is an allowance for doubtful accounts, and why is it recorded?

Accepted Answer

An allowance for doubtful accounts is a contra asset account that estimates the portion of accounts receivable the business does not expect to collect. It is recorded with a bad debt expense in the same period as the related credit sales, following the matching principle.

Question 29

What does a closing entry do at the end of an accounting period?

Accepted Answer

A closing entry transfers the balances of temporary accounts, meaning revenues, expenses, and dividends or withdrawals, to retained earnings or owner's capital. This resets those accounts to zero so the next period starts fresh. Only permanent accounts, such as assets, liabilities, and equity, carry balances forward into the new period.

Question 30

What is an adjusted trial balance, and how is it used?

Accepted Answer

An adjusted trial balance lists all ledger account balances after the adjusting entries have been posted. It checks again that total debits equal total credits, since adjustments themselves must be balanced. Its figures are the direct source for preparing the income statement, statement of changes in equity, and balance sheet.

Question 31

Why is an accrued wage expense recorded with a credit to a liability?

Accepted Answer

Employees have earned wages that have not yet been paid at period end, so the business owes them money. The expense is debited to record the cost in the correct period, and wages payable is credited because the obligation exists even though no cash has left.

Question 32

How do prepaid expenses such as insurance get recorded and then adjusted?

Accepted Answer

When a business pays a full year of insurance in advance, it records the payment as a prepaid asset rather than an expense. Each month, an adjusting entry debits insurance expense and credits prepaid insurance for one twelfth of the cost. This spreads the cost across the months covered.

Question 33

What are the three sections of the statement of cash flows?

Accepted Answer

The statement of cash flows has operating, investing, and financing sections. Operating activities cover cash from core business activities such as collecting from customers and paying suppliers and employees. Investing activities include buying and selling long term assets, while financing activities cover borrowing, repaying debt, and transactions with owners.

Question 34

Why can a profitable business still run out of cash?

Accepted Answer

Profit is measured on an accrual basis, so revenue may be recorded before customers pay and expenses may be recorded before cash leaves. A business can grow sales quickly while waiting on receivables, buying inventory, or repaying loans. Cash shortages can therefore arise even when the income statement shows a healthy net income.

Question 35

What are the two methods for presenting cash from operating activities?

Accepted Answer

The direct method lists major categories of operating cash receipts and payments, such as cash collected from customers and cash paid to suppliers. The indirect method starts with net income and adjusts it for noncash items and changes in working capital to arrive at the same operating cash flow.

Question 36

Under the indirect method, why is depreciation added back to net income?

Accepted Answer

Depreciation reduces net income but involves no cash leaving the business in the current period. The cash was spent when the asset was originally purchased, which appears in investing activities. Adding depreciation back therefore converts accrual based net income into cash generated from operations.

Question 37

Where would the purchase of new equipment for cash appear on the cash flow statement?

Accepted Answer

The purchase appears in the investing activities section as a cash outflow, because it involves acquiring a long term productive asset. It does not appear in operating activities, even though the equipment will later generate revenue. Later depreciation of the equipment is a noncash add back in the operating section.

Question 38

What is free cash flow, and why do analysts examine it?

Accepted Answer

Free cash flow is generally defined as operating cash flow minus capital expenditures, the money spent on maintaining or expanding long term assets. It shows the cash left over that could fund debt repayment, dividends, or new investment. Analysts examine it because it shows how much discretionary cash is generated.

Question 39

How does the statement of cash flows reconcile to the change in the cash balance?

Accepted Answer

The net increase or decrease in cash from operating, investing, and financing activities equals the change in the cash balance between two balance sheet dates. Adding the three section totals to the beginning cash balance must produce the ending cash balance shown on the balance sheet.

Question 40

Why do statement users compare cash flow from operations with net income?

Accepted Answer

Comparing the two shows how much of reported profit is backed by actual cash. Operating cash flow consistently near or above net income usually indicates high quality earnings, while a large gap may signal aggressive revenue recognition or heavy reliance on credit sales.

Financial Statement Preparation Flashcards

1Purpose and core principles

2Recording transactions and ledgers

3Income statement and balance sheet

4Adjusting entries and closing

5Cash flow statement and analysis

Learning Resources