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Chapter 2: Problem 11

Identify which of the following events should be reported on financial statements under 1\. the cash basis of accounting, 2\. the accrual basis of accounting, 3\. both methods, or 4\. neither method. Explain each choice. a. Agreed (verbally) to purchase a used car from Slee-Z-Auto. b. Paid \(\$ 300\) for a warranty on the used car. c. Took the car on a test drive, found it faulty, and asked the salesperson for a different car. d. The sales manager helped choose another car. e. The sales manager kindly transferred the warranty to the second vehicle. f. Paid \(\$ 6,500\) for the vehicle. g. Paid license and taxes of \(\$ 275\) h. Bought new tires for \(\$ 450\) on account. i. On a cold winter morning, the car failed to start. j. Purchased a new battery for \(\$ 65\) on account. k. Filed a warranty claim for the new battery. 1\. Received \(\$ 45\) payment under the warranty.

Short Answer

Expert verified
Events b, f, g and 1 would be recorded under both methods. Events h and j would be recorded under the Accrual basis method, and events a, c, d, e, i, and k are not recorded under either method.

Step by step solution

01

Understand Basic Accounting Methods

The cash basis of accounting recognizes revenue or expenses only when cash is exchanged. The accrual basis of accounting, on the other hand, recognizes revenue when earned and expenses when incurred, regardless of when cash is exchanged.
02

Evaluate The Events For Accounting Methods

a. Agreed (verbally) to purchase a used car from Slee-Z-Auto: Neither. It鈥檚 a verbal agreement, no money exchanged or obligation.b. Paid \(\$ 300\) on a warranty: Both, cash was paid.c. Took the car on a test drive: Neither, no money exchanged or obligation.d. The sales manager helped to choose another car: Neither, no money exchanged or obligation.e. Warranty transferred: Neither, no money exchanged or obligation.f. Paid \(\$ 6,500\) for the vehicle: Both, cash was paid.g. Paid license and taxes of \(\$ 275\): Both, cash was paid.h. Bought new tires for \(\$ 450\) on account: Accrual, obligation incurred, no cash paid yet.i. The car failed to start: Neither, no relevant financial transaction.j. Purchased a new battery for \(\$ 65\) on account: Accrual, obligation incurred, no cash paid yet.k. Filed a warranty claim for the new battery: Neither, filing a claim itself causes no financial impact.1. Received \(\$ 45\) payment under the warranty: Both, cash was received.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Cash Basis Accounting
Cash basis accounting is a straightforward method where transactions are recorded only when cash changes hands. For instance, revenue is recognized when you receive the money, and expenses are recorded when you pay something out. This method is simple but may not reflect the true financial position of a business at any given time. It's often used by small businesses or individuals who want to keep track of their immediate cash flow.
  • Advantages: Simple to use, and shows actual cash on hand.
  • Disadvantages: May not accurately represent a business's financial health or profitability over time.
For example, in a personal context, if you paid for a car warranty with cash, you'd record the expense at the time of payment, typical of cash basis accounting.
Accrual Basis Accounting
Accrual basis accounting takes a broader view of a company鈥檚 financial situation by recording revenues and expenses when they are earned or incurred, regardless of whether cash has been exchanged. This method gives a more accurate picture of a company鈥檚 profitability and longer-term financial health. It鈥檚 required by Generally Accepted Accounting Principles (GAAP) and is widely used by larger businesses.
  • Advantages: Provides a more comprehensive understanding of a business's true financial state.
  • Disadvantages: More complex and may require more detailed records.
Consider the purchase of new tires on credit. Under accrual basis accounting, this expense would be recorded when the tires are received, not when you ultimately pay the vendor.
Financial Statements
Financial statements are essential tools used by businesses to communicate their financial performance and condition. These include the income statement, balance sheet, and cash flow statement. Each statement presents different aspects of a company's operations:
  • The Income Statement shows revenue and expenses over a period, reflecting profitability.
  • The Balance Sheet provides a snapshot of assets, liabilities, and equity at a point in time.
  • The Cash Flow Statement tracks the flow of cash into and out of the business.
These statements help stakeholders make informed decisions. For instance, both paying for a car and the associated warranty would be reflected in the financial statements鈥攃ash outflows in the cash flow statement and as expenses in the income statement.
Revenue Recognition
Revenue recognition is a key accounting principle that determines the specific conditions under which revenue is recognized or accounted for. Under the accrual basis of accounting, revenue is recognized when it is earned and realizable, regardless of when the cash has been received. This principle ensures that revenue is recorded in the period it is actually earned.
  • Earned: When a product or service has been delivered to the customer.
  • Realizable: When payment is expected to be collected.
An example is when you receive payment under warranty for a car battery, the revenue is recognized when the claim is settled, not necessarily when cash is received. This way, businesses provide a clearer picture of their true revenue over time.

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Most popular questions from this chapter

Jane Goodrum established a sole proprietorship to sell and service personal computers. Use the balance sheet equation to analyze the effects of the following transactions: a. Invested \(\$ 50,000\) in the business. b. Purchased a four-wheel drive pickup truck for \(\$ 22,000\) (on account) that will be used in the business. c. The truck's fuel and repair annual costs were \(\$ 1,750\) (paid in cash). d. Shortly after buying the truck, it proved to be a "lemon" and Jane pushed it over a cliff! Explain to Jane how the loss of this truck affects her balance sheet. If Jane had not ever paid for the truck, who is responsible for the loss of the truck?

Define owners' equity. How does this differ from retained earnings? How can one firm's asset be another firm's equity?

Indicate whether each of the following statements concerning possible organization structures is true or false. If a statement is false, indicate why it is false. a. A corporation and its investors are legally the same entity. b. The shareholders of a corporation are not liable for the debts of the corporation. c. A publicly held corporation usually sends its financial statements to all of its owners (investors). d. A corporation is less risky (for its owners) than a partnership or sole proprietorship. e. It is more expensive to form a corporation than a sole proprietorship. f. shareholders are taxed on the corporation's net income.

Answer each of the following independent questions: a. Dennis Company has assets of \(\$ 125,000\) and owners' equity of \(\$ 40,000\). What are its liabilities? If these liabilities include an outstanding mortgage of \(\$ 60,000\) identify some of the other liabilities that Dennis Company might have. b. Bruce Company has assets of \(\$ 300,000\) and liabilities of \(\$ 110,000 .\) Suppose that the original owners invested \(\$ 200,000\) in this business. What might account for the difference between the original investment and the current balance in owners' equity? c. Pieter Company has liabilities of \(\$ 400,000\) and owners' equity of \(\$ 155,000\). What are its assets? Suppose that Pieter has conducted an appraisal and has found that its assets are valued at \(\$ 1,000,000 .\) How can such a difference occur? d. Elizabeth Company has assets of \(\$ 500,000\) and liabilities of \(\$ 600,000\). What conclusions can you draw about this firm?

Heidi's Golf and Swim Club borrowed \(\$ 500,000\) at \(12 \%\) per annum. Required a. Calculate Heidi's expected monthly and annual interest expense. b. Show the effect of the \(\$ 500,000\) loan on Heidi's accounting equation. c. Show the effects of the first and second months' interest accruals. d. Show the effects of Heidi's payment of two months' interest. e. Show the effects of the interest accruals for the remainder of the first year.
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