Financial Analysis Questions and Exercises

Why is accounting often referred to as the “language of business”?

Accounting is often called the “language of business” because it provides a means of communicating financial information to different parties. (Wild, 2005) These parties include almost all stakeholders of a business such as shareholders, lenders (creditors), suppliers, employees, customers, auditors, labor unions, government agencies and regulating bodies. Accounting gives a clear picture of the performance of an organization and enables these stakeholders to make informed decisions.

What are generally accepted accounting principles (GAAP)? Who currently develops and issues GAAP? What is the purpose of GAAP?

Generally Accepted Accounting Principles are the set of broad and specific rules and concepts that govern financial accounting practices (Wild, 2005). These are called “generally accepted” because they are widely accepted by business community. Otherwise, these rules will have no application in business.

In the USA, Financial Accounting Standard Board (FASB) develops GAAP. It is a private body that sets both broad and specific rules (Wild, 2005). Securities and Exchange Commission (SEC) is another government entity that sets reporting requirements for companies that issues stock to general public.

In addition to above-mentioned two bodies, there is another board called International Accounting Standards Board (IASB) that establishes International Financial Reporting Standards. This is an attempt to establish a harmonious and consistent system of accounting throughout the globe. However, IASB cannot impose these rules to organizations.

The main objective of GAAP is to make financial information “relevant, reliable and comparable” (Wild, 2005). Managers’ decisions are highly affected by the relevant financial information. Adherence to GAAP offers reliability to financial information and wins the trust of the user. Good understanding of these principles is necessary especially when you are comparing the performance of two or more companies, especially when the companies belong to different industries or countries.

Practice 3-1


a. The accounts impacted by the transaction are ‘Cash’ and ‘Notes Payable’

b. Both ‘Cash’ and ‘Notes Payable’ accounts increased.

c. ‘Cash’ and ‘Notes Payable’ accounts increased by $5,000.

d. Total Assets increased by $5,000, Total Liabilities increased by $5000, Total Equity, however remained unchanged.

Practice 3-2


a. The accounts impacted by the transaction are ‘Cash’ and ‘Land’

b. ‘Cash’ account decreased while ‘Land’ account increased.

c. ‘Cash’ decreased by $45,000. ‘Land’ increased by $45,000.

d. Total Assets, Total Liabilities and Total Equity remained unchanged.

Practice 3-11 Solution


May 1 Cash…………………………………………….. . 125,000

Notes Payable………………………………….. 125,000

Borrowed from Far West Bank signing a 2-yearnote at 14%

Practice 3-12 Solution


May 14 Land…………………………………………….. 45000

Cash…………………………………………….. 45000

Bought land on west side of Hatu Lake

Practice 3-16 Solution

Refer to Practice 3-11

Notes Payable

20XX 20XX

May1 Beg. Bal. 0

May1 Cash 125000

May30 End. Bal. 125000


20XX 20XX

May1 Beg. Bal. 0

May1 Notes Payable 125,000

May30 End. Bal. $125,000

Refer to Practice 3-12



20XX 20XX

May1 Beg. Bal. 0

May 14 Land 45000

20XX 20XX

May1 Beg. Bal. 0

May14 Cash 45000

May30 End. Bal. $45000

May30 End. Bal. $45000

Practice 3-19 Solution

Trial Balance XYZ Co. Ltd. For the year ended May 20XX

Account Debit Credit

Cash 80,000

Land 45,000

Notes Payable 125,000

Totals $125,000 $125,000

Exercise 3-12

a. Borrowed 35,000 from Far East Bank. Purchased new building for 90,000

b. Issued 2500 shares at $ 10 per share

c. Borrowed $40,000 from Far East Bank, signing a 12-month note at 10%

d. Paid salary to employees

e. Purchased inventory worth $1,25,000 on credit

f. Sale of $84,000 on Credit. Inventory costing $51,000

g. Received outstanding payment against credit sales

h. Paid cash for items purchased on credit

Why are adjusting entries necessary?

An adjusting entry is necessary to bring assets/ liabilities and revenue/expenses accounts to its proper level (Wild, 2005). Adjusting entries help measure income properly, correct any errors and are necessary for proper valuation of balance sheet accounts (Wild, 2005).

The analysis process for preparing adjusting entries involves two basic steps. Identify the two steps and explain why both are necessary.

The two basic steps in the process of analyzing adjusting entries are

1. Balance Sheet should be updated to reflect actual scenario. Debit or credit the relevant balance sheet account.

2. See which revenue ad expenses accounts have been affected due to above-mentioned adjustments. Debit or credit the relevant income statement account accordingly.

Both of these steps are necessary to carry out so that the financial statements reflect closely the real situation.

What is the purpose of closing entries?

Closing entries are used to shift the balances of revenue, expenses and dividend accounts to retained earning account (Wild, 2005).These are temporary accounts and need to be clear (i.e. brought to zero balance) before the next accounting cycle. Closing entries clear these accounts to zero balance, which can then be used for the next accounting cycle. In this way, Retained Earnings are brought to their proper level for that accounting period.

What is the purpose of the post-closing trial balance? Explain where the information for the post-closing trial balance comes from.

Post-Closing Trial balance is usually the last step of accounting cycle before financial statements, which is used to make sure that all temporary accounts i.e. revenues, expenses and dividends have been cleared i.e. have zero balance and all debits equal credits (Libby, Libby, Short, 2001). Moreover, this lists all accounts and their balances at one place which helps test arithmetical errors of posting. The information for the Trial balance comes from the ledger.

Works Cited

Libby, Robert, Libby Patricia A.,Short, Daniel G. (2001). Financial accounting NewYork,: McGrawHill.

Wild, John J. (2005). Financial accounting:Information for decisions. NewYork,: McGrawHill

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