Accounting: Users and Key Definitions

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Questions and Answers

Explain how the accounting equation (Assets = Liabilities + Owner’s Equity) reflects the concept of duality in accounting.

The accounting equation demonstrates duality because every transaction affects at least the equation twice, ensuring the equation remains balanced. For example, purchasing an asset on credit increases both assets and liabilities.

Differentiate between 'unlimited liability' and 'limited liability' and state which business structures are associated with each.

Unlimited liability means the owner is personally responsible for business debts (sole traders, partnerships). Limited liability protects the owner's personal assets from business debts (private and public companies).

Describe how the 'going concern' assumption influences the valuation of assets on a balance sheet.

The going concern assumption means assets are valued based on their use in ongoing operations rather than liquidation values. This justifies using historical cost for asset valuation.

Explain why the 'accounting entity' concept is important for providing reliable financial information.

The accounting entity concept ensures that the business's financial activities are kept separate from the owner's personal finances, providing a clear and unbiased view of the business's financial performance. Signup and view all the answers

A business has current assets of $30,000 and current liabilities of $20,000. Calculate the working capital ratio and interpret what this ratio indicates about the business's liquidity.

The working capital ratio is 1.5:1 ($30,000 / $20,000). This indicates the business has sufficient liquid assets to cover its short-term liabilities. Signup and view all the answers

Why is consistency important in accounting? Provide an example to illustrate your point.

Consistency ensures that financial statements are comparable across different accounting periods. For example, using the same depreciation method each year allows for meaningful comparisons of profit and asset values. Signup and view all the answers

If a business purchases equipment for $5,000 but its market value increases to $7,000, at what value should the asset be recorded on the balance sheet according to the historical cost principle, and why?

The equipment should be recorded at $5,000, its original purchase price, because the historical cost principle states that assets are recorded at their original cost, regardless of subsequent changes in market value. Signup and view all the answers

Explain the difference between a current asset and a non-current asset, providing an example of each for a retail business.

A current asset is expected to be converted to cash or used within one year (e.g., inventory). A non-current asset is long-term and not expected to be converted to cash within one year (e.g., equipment). Signup and view all the answers

How does the 'prudence' accounting concept impact how revenue and expenses are recognized?

Prudence dictates that revenue should only be recognized when it is virtually certain, and expenses should be recognized when they are probable, preventing overstatement of profits and assets. Signup and view all the answers

A company has a Quick Ratio (Acid-Test Ratio) of 0.7:1. What does this indicate about the company's short-term financial health, and what actions might the management take to improve it?

A Quick Ratio of 0.7:1 indicates that the company may struggle to meet its short-term obligations with its most liquid assets. Management might reduce liabilities or increase liquid assets. Signup and view all the answers

Explain the main advantage of changing a business structure from a sole proprietorship to a private company in terms of liability.

The main advantage is limited liability. As a private company, the owner's personal assets are protected from business debts, whereas, in a sole proprietorship, the owner has unlimited liability. Signup and view all the answers

Why are financial reports divided into accounting periods? What accounting concept is related to this practice?

Financial reports are divided into accounting periods to provide timely performance information. This relates to the accounting period concept, which allows for regular assessment of a business's financial health. Signup and view all the answers

What is 'owner's equity', and how is it calculated using the accounting equation?

Owner’s equity represents the owner’s stake in the business's assets after deducting liabilities. It is calculated as: Owner’s Equity = Assets - Liabilities. Signup and view all the answers

Describe two external user groups of accounting information and explain how they use this information to make decisions.

Investors use accounting information to assess profitability and risk before investing. Creditors use it to evaluate risk before lending money to a business. Signup and view all the answers

Explain how purchasing pottery clay on credit impacts the accounting equation.

Purchasing pottery clay on credit increases both assets (inventory) and liabilities (creditors) by the same amount, keeping the accounting equation in balance. Signup and view all the answers

Flashcards

What is Accounting?

A system for recording and processing financial data to help users make informed decisions.

Users of Accounting Information

Entities that utilize accounting information for decision-making, both within (internal) and outside (external) the organization.