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C213 Study Guide Solutions

Chapter 1: Nature and Purpose of Accounting

Describe the purpose of accounting.

Accounting is the recording of the day-to-day financial activities of a company and the
organization of that information into summary reports used to evaluate the company's
financial status.
Bookkeeping is a part of accounting. Bookkeeping refers to the process of recording
transactions into various accounts, which is the first step in accounting. The next step is
to analyze the accounts and organize them into financial statements and other useful
reports. (Reference topic 1.1)
Describe the three financial statements.

The balance sheet reports a company's assets, liabilities, and owners' equity. It
reports the financial position of a firm at a point in time.
The income statement reports the amount of net income earned by a company during
a period. Net income is the excess of a company's revenues over its expenses. It
reports the financial performance of a firm over a period of time.
The statement of cash flows reports the amount of cash collected and paid out by a
company in the following three types of activities: operating, investing, and financing
over a period of time. (Reference topic 1.2)
Identify users of financial statements for a particular situation.

Lenders
Banks use companies' financial statements in making decisions about commercial
loans. The financial statements are useful because they help the lender predict the
future ability of the borrower to repay the loan.

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Investors
Investors want information to help them estimate how much cash they can expect to
directly receive from the business in the future if they invest in it now.
Company Management
Managers use financial accounting data to formulate company goals, to compute
bonuses for employees, and to illuminate company weaknesses.
Suppliers and Customers
Suppliers, customers, and employees use financial statements to tell them about the
long-run prospects of a company.
Employees
Financial statement data, as mentioned earlier, are used in determining employee
bonuses. In addition, financial accounting information can help an employee evaluate
the employer's ability to fulfill its long-run promises, such as for pensions and retiree
health care benefits. Financial statements are also important in contract negotiations
between labor and management.
Competitors
Competitors use financial accounting information to reveal strategic opportunities within
their industry.
Government Agencies
Government agencies use financial statement data to bolster political and regulatory
positions for and against companies.
Politicians
Politicians use financial statement data to bolster political and regulatory positions for
and against companies.
The Press
Reporters use financial accounting data as background information and to indicate
which companies are undergoing significant changes in financial status. (Reference
Topic 1.3)
Differentiate the roles of important accreditation organizations.

CPA Accreditation - The American Institute of Certified Public Accountants (AICPA) is

the professional organization of certified public accountants (CPAs) in the United
States. A CPA is someone who has taken a minimum number of college-level
accounting classes, has passed the CPA exam, and has met other requirements set by
his or her state. A CPA firm is a company that provides freelance business advice,

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particularly in connection with accounting issues and executes the vast majority of
external audits in the US.
The AICPA sets ethical standards for CPAs, provides continuing education for them,
writes and grades the CPA exam, lobbies for legislation favored by CPAs, and provides
other support to CPAs. Its oversight of the CPA exam is its main role in accreditation.
However, to be accredited as a CPA you must meet the requirements of the state in
which you plan to practice. The requirements for each state are set by that state’s
legislature and overseen by that state’s Board of Accountancy, which is a state agency.
(Reference Topic 1.5)
Public Company Accounting Oversight Board (PCAOB) – The PCAOB determines
who can audit public companies regardless of whether the audit firm is accredited by a
state Board of Accountancy. Thus, they accredit firms that can audit public companies.
Describe current trends that are causing changes in the field of accounting.

Globalization – As more and more business do business globally, capital flows more
freely across national boundaries. This means investors can choose to invest in firms
all over the planet. To help them make investment decisions, the global accounting and
regulatory communities are working to bring accounting standards around the world into
agreement the IASB was one step in that direction, but nations still control the
accounting standards used within their borders and so much of the standardization is
being done through voluntary cooperation
Technology – Information technology has speeded up the pace with which accounting
data and reports are produced and dramatically increased the volume of accounting
information that firms can provide to investors. (Reference Topic 1.6)

Chapter 2: Overview of Financial Statements

Identify the purposes of financial statements in specific situations.

The main different uses of financial statements depends on how different users use
them. Here is a list of the major users and how their use of financial statements
differs.
Lenders
Banks use companies' financial statements in making decisions about commercial
loans. The financial statements are useful because they help the lender predict the
future ability of the borrower to repay the loan.
Investors
Investors want information to help them estimate how much cash they can expect to
directly receive from the business in the future if they invest in it now.

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 Company Management
Managers use financial accounting data to formulate company goals, to compute
bonuses for employees, and to illuminate company weaknesses.
Suppliers and Customers
Suppliers, customers, and employees use financial statements to tell them about the
long-run prospects of a company.
Employees
Financial statement data, as mentioned earlier, are used in determining employee
bonuses. In addition, financial accounting information can help an employee
evaluate the employer's ability to fulfill its long-run promises, such as for pensions
and retiree health care benefits. Financial statements are also important in contract
negotiations between labor and management.
Competitors
Competitors use financial accounting information to reveal strategic opportunities
within their industry.
Government Agencies
Government agencies use financial statement data to bolster political and regulatory
positions for and against companies.
Politicians
Politicians use financial statement data to bolster political and regulatory positions
for and against companies.
The Press
Reporters use financial accounting data as background information and to indicate
which companies are undergoing significant changes in financial status. (Reference
Topic 1.3)
Identify components of a balance sheet.

The three main sections of the Balance Sheet are Assets, Liabilities, and Equity. Both
assets and liabilities are further separated into current and long term based on whether
the asset is expected to be consumed or the liability paid within a year. Assets
expected to be consumed and liabilities expected to be paid within a year are current
and those that will be consumed or paid after a year are long-term.
Equity is separated into paid in capital (also referred to as capital stock) and retained
earnings. Paid in capital is created when an owner buys stock from the firm. Retained
earnings are the accumulated earnings of the firm (i.e., net income over time) that have
not been paid back in dividends. Paid in capital also is referred to as contributed capital
while retained earnings is earned capital.

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Use the accounting equation to calculate total assets, total liabilities, or total
stockholders’ equity.

The Balance Sheet equation: Assets = Liabilities + Equity. Given values for any two of
the three components you can always calculate to third component using this equation.
For example, if you know a firm’s total assets and liabilities, you can calculate owners’
equity by: Assets – Liabilities = Equity
Identify components of the income statement.

The Income Statement describes a company’s financial performance for a period of

time. A company's expenses are subtracted from its revenues and gains and losses are
also factored in computing net income. Net income helps explain the change in
retained earnings between two Balance Sheet dates, along with dividends and
unrealized gains and losses.
A single step income statement lumps all revenues together and subtracts all expenses
to calculate net income. A multiple-step presents subtotals that highlight key
performance measures. Its categories include:
Sales or revenues
- Cost of goods sold (COGS) (Product costs of items sold)
= Gross profit
- Selling and Administrative expenses (also called operating expenses)
= Operating income or earnings before interest and taxes (EBIT)
+ Other income - other expenses + gains - losses
= Earnings before taxes (EBT)
- Taxes
= Net Income (Profit)
If the firm has experienced a discontinued operation or extraordinary item, the effects of
these events are subtracted from all the income statement line items and the income
statement will include another subtotal – income from continuing operations that will be
followed by a single line item that presents to effects of the extraordinary item
discontinued operations and then net income.
Identify components of the cash flow statement.

The Statement of Cash Flows details how a company obtained and spent cash during a
certain period of time. Thus, the cash flow statement explains the change in the firm’s
cash account for a period of time. All of a company's cash transactions are categorized
as either operating, investing, or financing activities.

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i) Operating cash flows are those associate with any activity on the income
statement. The operating section of the cash flow statement is what the income
statement would show if the income statement were prepared on a cash basis and not
accrual basis.
ii) Investing cash flow are those related to a firm investing in itself (purchasing and
selling property, plant and equipment or other businesses) and investing in others
(buying the stocks and bonds of another firm or lending another firm money).
iii) Financing cash flows are those associated with someone investing in your firm,
either stockholders (buying and selling your stock and paying dividends) and creditors
(borrowing and paying back debt).
Explain the purpose of notes to financial statements.

There are four main areas that must be covered in the financial statement footnotes:
 A summary of significant accounting policies. GAAP frequently allows firms to
make choices in preparing their financial statements and so GAAP requires that
those choices be reported in the footnotes. For example, the firm must report the
method they are using to calculation depreciation along with the average useful
lives for major classes of depreciable assets.
 Additional information about the summary totals found in the statements. For
example if a firm as a notes payable account in their long-term liabilities, they
must list all the individual notes that make up the balance and present the life of
the loan and its interest rate.

 Disclosure of important information not recognized in the statements. For

example, if the firm is the defendant in a lawsuit but the outcome of the suit is
unclear, the firm must report the existence of the suit in the footnotes. Since the
outcome is uncertain, GAAP does not require the firm to accrue a liability for the
possible loss thus the possible loss has not been recognized in the financial
statements (i.e., no liability has been reported on the balance sheet).

 Supplementary information required by the Financial Accounting Standards

Board (FASB) or the Securities and Exchange Commission (SEC). This is a
broad category. One example is reporting summary financial data for different
segments of the firm operates in different industries.

Describe the purpose of an external audit.

Audit conducted by external (independent) qualified accountant(s). These accountants

are usually CPAs, but they may not be. Each state determines who can be a CPA in
that state and states have slightly different requirements.
The independent accounting firm conducts tests to determine whether the financial
statements fairly reflect the financial status of the company issuing them and whether

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the financial statements were prepared using Generally Accepted Accounting Principles
(GAAP). The tests include an examination of the original documents underlying key
transactions, a spot check to verify that reported inventory actually does exist, and
contact with a sample of customers and suppliers to confirm the sales and purchases
reported by the company. The external auditor would also carefully review the system
of procedures and controls within the company to determine whether the accounting
records are maintained in a reliable fashion.
Firms hire independent external auditors for a variety of reasons. In some cases, laws
and regulations mandate that they do so. Aside for regulations, firms benefit when
raising funds through stock sales or by borrowing by being able to show the potential
investor or creditor that their financial statements have been audited because that
increases the credibility of those financial statements.
Explain the concepts of comparability, conservatism, materiality, and articulation.

Comparability - Information that becomes much more useful when it can be related to a
benchmark or standard. Also, other firm’s results or the firm’s own history.
Conservatism - A pervasive factor in accounting that can be summarized as follows:
when doubt exists concerning two or more reporting alternatives, users should select
the alternative with the least favorable impact on reported income, assets, and liabilities.
Materiality - The question of whether an item is large enough to make any difference to
anyone.
Articulation - In an accounting context, articulation means that the three
primary financial statements are not isolated lists of numbers but are an
integrated set of reports on a company's financial status. The statement
of cash flows contains the detailed explanation for why the balance sheet
cash amount changed from beginning of year to end of year. The income
statement, combined with the amount of dividends declared during the
year, explains the change in retained earnings shown on the balance
sheet. Cash from operations on the statement of cash flows is
transformed into net income through the accounting adjustments applied
to the raw cash flow data.

Chapter 3: The Balance Sheet

Identify the order of assets, liabilities, and stockholders’ equity accounts on a
balance sheet.

The three main sections of the Balance Sheet are Assets, Liabilities, and Equity. Both
assets and liabilities are further separated into current and long term based on whether
the asset is expected to be consumed or the liability paid within a year. Assets

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expected to be consumed and liabilities expected to be paid within a year are current
and those that will be consumed or paid after a year are long-term.
Equity is separated into paid in capital (also referred to as capital stock) and retained
earnings. Paid in capital is created when an owner buys stock from the firm. Retained
earnings are the accumulated earnings of the firm (i.e., net income over time) that have
not been paid back in dividends. Paid in capital also is referred to as contributed capital
while retained earnings is earned capital.
The Balance Sheet equation – Assets = Liabilities + Equity. Whenever any transaction
is recorded in the firm’s accounting records, the recording must always maintain this
balance. However, some transactions only affect one side of the equal sign with two
offsetting entries. For example, selling an asset for cash would only affect the asset
side of the equation but would create a net zero effect on Assets since one asset is
being converted to another.
Liquidity or the speed with which it can be turned into cash. Current assets come
before long-term assets because they are expected to be liquidated in one year. Within
current assets, cash comes first because it is already cash. Accounts receivable
usually comes next because all the firm has to do is collect the receivable to receive the
cash. Inventory usually follows accounts receivable because it has to be sold and then
the money has to be collected to convert it into cash.

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 Record the proper values for items on a balance sheet in a particular situation.

1. On May 1, Jill Jones and her family invested $8,000 in JJ’s Lawn Care Service and
received 800 shares of stock.
2. On May 2, JJ’s purchased a riding lawn mower for $2,500 cash.
3. On May 8, JJ’s purchased a $15,000 truck. JJ’s paid $2,000 down in cash and issued
a note payable for the remaining $13,000.
4. On May 11, JJ’s purchased some repair parts (expense) for $300 on account.
5. On May 18, JJ provided lawn care services for $150 on account.
6. On May 25, JJ collected $75 of it‘s customer’s accounts receivable.
7. On May 28, JJ’s pays $150 of its accounts payable.
8. On May 29, JJ’s recorded lawn care services provided during May of $750. All
clients paid in cash.
9. On May 31, JJ’s purchased gasoline for the lawn mower and the truck for $50 cash.
JJ's Lawn Care Service Balance Sheet Transactions
Assets = Liabilities + Owners' Equity
Balance Sheet and Income Statement Transactions Cash A/R Prepaid Short-term Property, Total = A/P Note Total Paid in Retained Total
Expenses Investments Plant, & Assets Payable Liabilities Capital earnings Liabilities
Equip and
Equity
1 May 1 - Invested $8,000 and received 800 shares $ 8,000 $ 8,000 = $ - $ 8,000 $ 8,000
2 May 2 - purchase riding mower for $2,500 cash $ (2,500) $ 2,500 $ - = $ - $ -
3 May 8 - purchased $15,000 truck, $2,000 cash, $13,000 note $ (2,000) $ 15,000 $ 13,000 $ 13,000 $ 13,000 $ 13,000
4 May 11 - purchased repair parts (expensed) for $300 on account $ - = $ 300 $ 300 $ (300) $ -
5 May 18 - provided lawn care services for $150 on account $ 150 $ 150 = $ - $ 150 $ 150
6 May 25 - collected $75 from customer accounts receivable $ 75 $ (75) $ - $ - $ -
7 May 28 - pay $150 on accounts payable $ (150) $ (150) = $ (150) $ (150) $ (150)
8 May 29 - recorded $750 lawn care services for cash $ 750 $ 750 = $ - $ 750 $ 750
9 May 31 - purchased gasoline for $50 cash $ (50) $ (50) = $ - $ (50) $ (50)
Totals $ 4,125 $ 75 $ - $ - $ 17,500 $ 21,700 = $ 150 $ 13,000 $ 13,150 $ 8,000 $ 550 $ 21,700

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Chapter 4: The Income Statement
Describe the purpose of net income on an income statement.

The accountant’s attempt to summarize in one number the overall economic

performance of a company for a given period.

Explain when revenues and expenses are recognized for a particular situation.

Revenue recognition and cost/expense matching are the core of accrual accounting.
They insure that only and all revenue that has been earned in a given period is reported
on the Income Statement and that all costs and expenses incurred to generate that
revenue is include on the income statement for the same period.
Firms can only recognize revenues when they have delivered the goods and services to
the customer and are reasonably assured that they will be paid. They do not have to
receive the cash to recognize revenue if they are reasonably certain that they will be
paid in the future. They also cannot recognize revenue just because they have received
the cash. If they receive the cash prior to delivering the goods and services, they must
wait until they do deliver them before recognizing revenues. Because firms usually
don’t sell to customers that they don’t think will pay for the goods or services, revenue is
usually recognize when the goods and services are delivered, i.e. at point of sale.
Once the timing of revenue recognition has been determined, the firm matches all the
costs/expenses they incurred generating that revenue to the revenue in the same
period. “Incurred” means that they received the benefit of the cost/expense in the
period same period. That is, the cost/expense help generate the revenue in that period.
Payment is not a consideration, only when they gained the benefit or contribution to
revenue. Thus, expenses can be recognized in one period and paid for in the next.
The three main matching principles are:
 Direct matching – This principle applies to product costs, which are recorded in
cost of goods sold for the period. A firm will calculate the cost of producing each
product (as described in Topics 9 and 10) and place the item and its costs in
inventory. When the item is sold, the costs as well as the item come out of
inventory. The item is delivered and the costs included in cost of goods sold.
Thus, the product’s costs are directly matched to its selling price in the period it
was sold and the revenue recognized.
 Systematic and Rational allocation – This principle applies to period costs and
allocates the cost of a previously purchased asset to the period for which use of
the asset contributed to revenue generation. The two main examples are
depreciation on non-production property, plant, and equipment and prepaid

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 (PPE) expenses. The depreciation on production PPE is include with product
costs and directly matched to revenue when the product is sold.
 Direct Expensing – Direct expensing applies to period costs except for those
that are systematically allocated. Any expense that contributed to generating
revenue in a period is included in the income statement for that period, i.e.
matched to the revenue it helped generate. Direct expensing applies selling,
general, and administrative activities like paying non-production employees,
insurance on non-production activities and assets, advertising, and interest.
Analyze the impact of revenue transactions on the expanded accounting equation
and financial statements.

See transactions 4, 5, 8 and 9 in the above Transaction Analysis. Any transaction that
involves the income statement flows to the Balance Sheet through retained earnings.
Thus, revenues increase retained earnings and expenses decrease retained earnings.
Evaluate a historical income statement to forecast a future income statement.

Firms can use historical financial statements to build a future (i.e., pro forma) income
statement in two steps. The first step assumes that future expenses will maintain their
same relative proportion to sales as they do in the current year. Thus, the first step is to
common size the current income statement by dividing all line items by sales and apply
those common size percentages to the projected sales for the future income statement.
The next step is to determine the percentage increase they expect in sales for the next
year. Note that revenue recognition and matching rules mean that sales tends to drive
most of the expenses on the income statement and thus the starting point is to
determine what the future year’s sales will be. While is this the process covered in the
text, these steps can be done in any order.
The following is an example of the process.
Projected growth for 2017 = 10% increase over 2016 sales.
Step 1: Convert the income statement into a common-sized income statement.

Step 1 Step 2

2016 2017

Sales 100,000 100% X 10% growth 110,000

COGS 60,000 60% 110,000 X 60% 66,000

Gross profit 40,000 40% 110,000 X 40% 44,000

Selling expenses 10,000 10% 110,000 X 10% 11,000

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General and admin exp. 20,000 20% 110,000 X 20% 22,000

Net income 10,000 10% 110,000 X 10% 11,000

Step 2: Multiply 2016 sales by 1.10 (10% growth) to get the forecasted 2017 sales.
Then multiply the projected 2017 sales by the percentages from step 1.

Chapter 5: The Statement of Cash Flows

Describe the purpose of the statement of cash flows.

The statement of cash flows explains how a company's cash was generated during the
period and how that cash was used. Explains change in cash account between two
balance sheet dates.
Identify the categories of a cash flow statement and cash flow activities included
in each category.

The Statement of Cash Flows details how a company obtained and spent cash during a
certain period of time. Thus, the cash flow statement explains the change in the firm’s
cash account for a period of time. All of a company's cash transactions are categorized
as either operating, investing, or financing activities.
Operating cash flows are those associate with any activity on the income statement.
The operating section of the cash flow statement is what the income statement would
show if the income statement were prepared on a cash basis and not accrual basis. In
addition, since current assets and current liabilities tend to be linked to revenues and
expenses on the income statement, any cash flows associated with current assets and
liabilities tend to be operating cash flow.
Investing cash flow are those related to a firm investing in itself (purchasing and selling
property, plant and equipment or other businesses) and investing in others (buying the
stocks and bonds of another firm or lending another firm money). However, any
revenues earned (i.e., interest and dividend income) from investments in other firms is
income on the income statement and, therefore, are operating cash flow.
Financing cash flows are those associated with someone investing in your firm, either
stockholders (buying and selling your stock and paying dividends) and creditors
(borrowing and paying back debt). However, any interest expense on loan payments is
an expense and therefore an operating cash flows. Dividends are not an expense but a
transfer of retained earnings back to the owners and is not an operating but a financing
cash flow.
Here is a summary diagram from the text:

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Describe the differences between the direct and indirect methods of the cash flow
statement.

The direct and indirect method only apply to the operating section of the cash flow
statement. The investing and financing are always prepared using a direct method.
The operating activities section of a statement of cash flows prepared using the direct
method is, in effect, a cash-basis income statement. Unlike the indirect method, the
direct method does not start with net income. Instead, this method reports directly the
major classes of operating cash receipts and payments of an entity during a period.
The direct method is favored by many users of financial statements because it is easy
to understand.
The indirect method begins with net income as reported in the income statement and
then details the adjustments needed to arrive at cash flow from operations. The indirect
method is favored and used by most companies because it is relatively easy to
construct from existing balance sheet and income statement data. In addition, the
indirect method highlights the reasons for the difference between net income and cash
from operations. In addition, GAAP required this reconciliation and so if a firm uses the
direct method, they must present the indirect method in the footnotes anyway, thus
having to do the calculations twice.

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Chapter 6: Introduction to Financial Statement Analysis
Recognize the purpose of financial statement analysis and financial ratios.

Financial statement analysis can be used to diagnose existing problems and to forecast
how a company might do in the future. The financial statement analysis process starts
with the financial statements and reviews the ratios and common-sizing results to spot
“red flags.” Those red flags are researched with additional data, including details of
significant transactions, market share information, competitors' plans, and customer
demand forecasts. Once the results are reviewed, you make a decision based on the
work and monitor the results.
Compute widely used financial ratios.

Chapter 8: Internal Controls

Identify common financial statement errors.

The text identifies three categories of sources of financial statement misstatement.

Note that the term “error” is usually reserved for one of these categories.
Errors - Result when unintentional mistakes are made in recording transactions,
posting transactions, summarizing accounts, and so forth. Errors are not intentional and
when detected are immediately corrected. Errors can result from sloppy accounting, bad
assumptions, misinformation, miscalculations, and other factors.
Disagreement - Result when different people arrive at different conclusions based on
the same set of facts. Because accounting involves judgment and estimates,
opportunities for honest disagreements in judgment abound. These disagreements
often come about because of the different incentives that motivate those involved with
producing the financial statements. For example, there might be differing views about
what percentage of reported receivables will be collected or how long equipment and
other assets will last.
Frauds - Result from intentional errors. Fraudulent financial reporting occurs when
management chooses to intentionally manipulate the financial statements to serve their
own purposes, such as meeting Wall Street’s earnings forecasts as was the case with
WorldCom.
Recommend the proper internal controls to prevent accidental loss or intentional
theft or fraud for a particular situation.

The text doesn’t provide sufficient detail to cover this learning objective.

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Identify motivations and common techniques used to manage earnings.

Earnings management occurs when management attempts to manipulate the

impression the financial statements present to users. They can change the timing of
transactions, use aggressive accounting procedures, and alter transactions to achieve
these goals. Earnings management, exclusive of using fraud to management earnings,
is a gray area where there are no clear ethical rules to determine when it is ethical or
not.
Managers manage earnings to:
Meet internal targets – sometimes people that can influence the financial results are
also given bonuses based on those results, which gives those employees an incentive
to manage earnings.
Meet external expectations – Most publicly traded firms are followed and stock analysts
who make predictions about future performance for their clients. Firms try to guide
these analysts’ expectations to prevent surprises that might lower the firm’s stock price.
Income smoothing – Investors like predictable earnings because they make determining
the firm’s future performance easier to predict. Managers many manage earnings to
smooth out fluctuations that make future earnings harder to predict.
Window dressing for an IPO or a loan – If a firm plans to raise outside capital by selling
stock or borrowing money, the firm’s management has an incentive to make the
financial statement results more attractive to those outside creditors and investors.
Describe the role of auditors and their impact on the integrity of financial
statements.

External auditors are independent accountants (usually but not always CPAs) who are
retained by organizations to perform audits of financial statements to determine if they
are prepared and presented in accordance with GAAP and are free from material
misstatement.
Internal auditors are company employees whose role in the organization is structure to
keep them as independent as possible from management. They are a group of experts
(in controls, accounting, and operations) who monitor operating results and financial
records, evaluate internal controls, assist with increasing the efficiency and
effectiveness of operations, and detect fraud.
Internal auditors are not sufficiently independent to express opinions on the firm’s
financial statements, but their role is much broader than external auditors in that they
are the firm’s front link defense against fraud and they can engage in operational audits
that analyze a firm’ operating efficiency and effectiveness and external auditors don’t do
these types audits.

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Explain the role of the U.S. Securities and Exchange Commission (SEC) in
financial reporting.

The SEC is government body responsible for regulating the financial reporting practices
of most publicly owned corporations in connection with the buying and selling of stocks
and bonds.
The SEC is given broad enforcement powers under the 1934 Act. If the rules of
operation for stock exchanges prove to be ineffectual in implementing the requirements
of the SEC, the SEC can alter or supplement them. The SEC can even suspend trading
of a company’s stock. If substantive hearings show that the issuer failed to comply with
the requirements of the securities laws, the SEC can “de-list” any security.
Brokers and dealers can be prevented, either temporarily or permanently, from working
in the securities market, and investigations can be initiated, if necessary, to determine
violations of any of the acts or rules administered by the SEC.
The SEC has been granted by Congress legal authority to establish accounting
standards for companies soliciting investment funds from the American public; however,
for now, the SEC allows FASB to set U.S. accounting standards with a few exceptions.
Chapter 9: Managerial Accounting and Cost Concepts
Describe the purpose of management accounting.

Managerial accounting’s main purpose is to provide a firm’s management with

information they can use to run the business more efficiently and effectively. However,
managers also use financial accounting reports to accomplish these goals as well.
Differentiate between management and financial accounting.

The following table summarizes the main differences between managerial and financial
accounting.
Management Accounting Financial Accounting
Variability Unique competitive tool. There are no Uniform across companies and based
Across GAAP standards for management on generally accepted accounting
Companies accounting reports and these reports tend principles.
to be specifically designed by each firm
but usually follow some form of best
practices.
Type of Data Both financial and nonfinancial data Restricted to financial data
Availability of Data usually kept secret within the Data often made public
Data company
Use of Data Used for internal planning, control, and Used primarily by investors and
evaluation creditors in deciding whether to
provide capital to the company

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Describe the differences between accounting in a manufacturing environment
and a service environment.

Since the text also covers merchandising companies we have included a discussion of
those types of firms as well.
Merchandising companies buy finished goods and resell them to customers. This
category includes wholesalers and retailers.
Service companies do not produce products but provide services. These companies
do not tend to have inventories since inventories are limited to products for resale and
they don’t produce products.
Manufacturing company produce products for resale.
The following diagram from the text summarizes the differences between product and
period costs for these three types of firms. Note that period costs don’t vary, only
product costs do and that the term “product cost” is also applied to service companies to
describe the costs associated with producing the service.

Define common terms and concepts used in management accounting.

The following are definitions of key terms associated with managerial accounting.
Product costs - All costs used to produce a good or service. These costs include
direct materials, indirect materials and manufacturing overhead. Manufacturing
overhead include indirect materials and indirect labor plus all other manufacturing
overhead. You can identify other manufacturing overhead items because they will be
indicated using terms like production, manufacturing, or factory.
Period costs - Costs not used to produce a good or service, or capitalized as an asset.
They are charged as expenses to the income statement in the period in which they are
incurred. Some examples include:
President’s salary
Selling Costs
Office costs

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Sales salaries
Advertising
Legal and accounting fees
Dues and subscriptions
Office utility costs
Supplies
Direct materials - Materials that become part of the product and are traceable to it. For
example the ice cream in an ice cream cone.
Indirect materials - Materials that are necessary to a manufacturing or service
business but are not directly included in or are not a significant part of the actual
product. For example, the cleaning supplies used to clean the assembly line at night
once it is shut down.
Direct labor - Wages paid to those who physically work on direct materials to transform
them into a finished product and are traceable to specific products. For example, the
labor costs to assemble the ice cream cones.
Indirect labor - Labor that is necessary to a manufacturing or service business but is
not directly related to the actual production of the product. For example, the labor costs
to clean up the assembly line at the end of the day.
Manufacturing overhead - All costs incurred in the manufacturing process other than
direct materials and direct labor to include indirect materials and labor and any other
costs associated with the manufacturing facility. For example, the depreciation on the
manufacturing facility. These costs are usually indicated with the term factory,
manufacturing, or production.
Differential costs - Future costs that change as a result of a decision; also called
incremental or relevant costs. For example, if you are going to buy a new car, the
difference between your current insurance premiums and the new insurance premiums.
Sunk costs - Costs that are past costs and do not change as a result of a future
decision. For example if a business is buying a new piece of equipment, the
depreciation expenses on the old equipment would be sunk and not recoverable.
Opportunity costs - The benefits lost or forfeited as a result of selecting one alternative
course of action over another. For example, if you pay cash for your new cash, you
give up the opportunity to use the cash to pay for a vacation.
Variable costs - Variable costs, by definition, vary in total proportionately to the number
of units sold. However, the variable cost per unit sold is fixed within a relevant range.
Fixed costs - Fixed costs, by definition, stay the same in total as units sold changes.
However, because the total fixed costs stay the same, the per-unit fixed costs must vary
inversely with units sold. That is, if you sell one more unit and the total fixed costs stay

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the same, the per-unit fixed costs must fall because you are spreading the same fixed
costs over more units. The reverse is true if you sell on less unit.

Distinguish between product costs and period costs.

See the above definitions.

Describe the role of key ethical standards in the field of management accounting.

The main professional association for management accountants is the Institute of

Management Accounting (IMA). It has established a code of conduct to help guide
management accountants when they fact ethical dilemmas. Their members are
ethically required to:
 Be competent in their profession
 Not disclose confidential information
 Act with both actual and apparent integrity in all situations
 Maintain objectivity when communicating information to decision maker

Calculate the cost of a product.

The coverage of this material in the text is limited to identifying product costs in Chapter
9. More detailed coverage of how to allocate overhead to products is covered in
Chapter 10. The following problem used in our cohort presentation illustrates how to
calculate product costs:
C213 Workshop Calculations Product costs = Direct Materials + Direct Labor + Overhead, where
Cost Concepts Overhead = Indirect materials, Indirect labor plus any account with
Factory, Manufacturing, or Overhead in the title

January Costs
Direct labor $ 20,000 P Direct Labor
Indirect labor $ 5,000 P O Overhead (which includes indirect costs)
Direct material $ 25,000 P Direct Materials
Indirect materials $ 3,000 P O Overhead (which includes indirect costs)
Factory depreciation $ 8,000 P O Overhead (Anything with factory, manufacturing, or overhead in the title)
Factory supervisor $ 3,000 P O Overhead
Factory rent $ 7,000 P O Overhead
Rent $ 5,000 NO - Period costs
Depreciation $ 2,000 NO - Period costs

What are the product costs for the month? $ 71,000

What are the FACTORY overhead costs for the month? $ 26,000

Differentiate how the types of inventory affect calculations.

This isn’t covered in the text.

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Explain the difference between job costing and product costing.

This isn’t covered in the text.

Chapter 10: Activity-Based-Costing (ABC)

Compare and contrast traditional costing to activity-based costing (ABC).

Traditional Costing Method – The traditional costing method applies overhead costs
to products based on a predetermined overhead rate. The rate is usually based on a
general cost driver like direct labor hours. In short, the traditional method allocates over
to products based on a single cost driver. That is, it treats overhead costs as a single
pool of overhead costs and only uses one cost driver.
ABC Method - More accurate because it does a better job of identifying activities that
actually drive overhead costs and how different product’s production methods drive
those costs.
The ABC method is applied in steps as follows:
1. A company identifies business activities that create overhead costs, e.g. setting up
and shutting down an assembly line.
2. Measure those costs and accumulate in cost pools. That is a cost pool accumulates
the overhead costs of a single overhead generating activity.
3. Identify a driver, i.e. quantitative measure, of the level of activity like number of
setups for setting up and shutting down an assembly line.
4. Use driver counts per product to allocate cost pools to products.
5. Make decisions based on the results.
While ABC is more complex and costly to implement, it is more accurate. The process
of developing an ABC system can also help the firm identify problem areas in their
production process.
Using ABC tends to be worth the extra cost when a firm produces multiple products that
are produced in very different ways (i.e., have fairly complex production processes). If
the firm only has one produce or if their products are very similar in how they are
produced, then ABC.

Identify appropriate cost drivers for a particular situation.

Identifying the appropriate cost driver for a specific situation is done by finding a
quantitative measure that captures changes in the level of an overhead generating
activity. Beyond this general rule, you need to just look at the nature of the activity and
think about what might be the right quantities measure that would capture how the
activity varies in size.
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Which consideration is an appropriate cost driver?
 The amount of hours the director spends on organizing the race
 The amount of the registration fee
 The number of race participants and spectators
 The cost of liability insurance for the race
The correct answer is the number of race participants since the larger the crowed that
needs policing, the greater the number of police officers that would be needed.

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Justify a decision about a selling price based on traditional volume-based costing or activity-based costing
systems.

The following problem from the cohorts illustrates this process. However, it also contains an illustration of how you need
to read questions carefully.
Company B calculated the following information under traditional and activity based costing for the
production and sale of 1,000 units of Product C:

Traditional ABC

Sales $ 250,000 $ 250,000

COGS 150,000 275,000
Gross Profit $ 100,000 $ (25,000)

Which decision should be made about the selling price of Product C?

Explanations:
1 The number of production batches of Product C should be increased. Doesn't address the question about whether the selling price should be raised.
2 The price of Product C should be decreased. Would increase the negative gross profit
3 Traditional costing should be used instead of ABC Doesn't address the question about whether the selling price should be raised.
4 The price of Product C should be increased Only option that would increase sales and increase gross profit

Why should the firm alter the selling price of C to address the problem rather than just using the Traditional costs?

ABC is an inherently more accurate way to allocate overhead. The above results imply that the tradition method is allocating too little overhead to C
and not enough over head to the other products. Since all overhead is always allocated to products with either method, the total overhead costs
for the firm don't change regardless of which allocation method is used. Thus, the fact that ABC allocates more COGS through overhead allocation to
C than the traditional method, too much overhead is being allocated to the other products by the traditional method and they may be over priced.

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Chapter 11: Cost-Volume-Profit Analysis (C-V-P)
Describe cost-volume-profit analysis.

Cost-volume-profit analysis is a technique for determining how changes in revenues,

costs, and level of activity affect the profitability of an organization.
Describe how basic cost behavior patterns change as sales volumes change.

Variable costs - Variable costs, by definition, vary in total proportionately to the number
of units sold. However, the variable cost per unit sold is fixed within a relevant range.
Fixed costs - Fixed costs, by definition, stay the same in total as units sold changes.
However, because the total fixed costs stay the same, the per-unit fixed costs must vary
inversely with units sold. That is, if you sell one more unit and the total fixed costs stay
the same, the per-unit fixed costs must fall because you are spreading the same fixed
costs over more units. The reverse is true if you sell on less unit.

Analyze a cost-volume-profit graph to determine the level of variable costs, fixed

costs, break-even point, and profit.

The PA and OA can test your knowledge of graphs in two basic ways: by asking about
points and lines or by asking about regions. You can determine what a region means
by determining what the lines that bound the region are.

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