Questions Chapter 7 (Continued)
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Cost is used because it is both relevant and reliable. Cost is relevant because it represents the
price paid, the assets sacrificed, or the commitment made at the date of acquisition. Cost is
reliable because it is objectively measurable, factual, and verifiable. It is the result of an
exchange transaction. As a result, cost is the basis used in preparing financial statements.
The two constraints are materiality and conservatism. The materiality constraint means that an
item may be so small that failure to follow generally accepted accounting principles will not influ-
ence the decision of a reasonably prudent investor or creditor. The conservatism constraint
means that when in doubt, the accountant chooses the accounting method that is least likely to
overstate assets and net income.
Recording Osterhaus’ additional investment of $5,000 as revenues is inappropriate. An invest-
ment in a corporation increases the common stock account, not revenues.
Three relationships that are helpful in assessing profitability are: (1) the profit margin percentage
(or return on sales), (2) return on assets, and (3) return on common stockholders’ equity. More
than one profitability relationship is useful in that the relationships help in different types of analy-
sis. Return on sales, for example, measures the percentage of each sales dollar that is included
in net income, whereas return on assets measures the contribution of each dollar of assets in
generating income. The former, then, helps analyze profits in terms of revenues alone; the latter
helps analyze profits in terms of the asset base in generating sales and profits. If the return on
assets is lower than warranted, the company may not be using its assets effectively; if return on
sales is lower than warranted, the company may not be controlling costs effectively.
Natasha Company’s working capital (a) is $60,000 – $20,000 = $40,000, and its current ratio (b)
is $60,000 ÷ $20,000 = 3:1.
Whenever current assets are less than current liabilities, working capital is negative and the cur-
rent ratio will be less than 1:1. (Whenever current assets are greater than current liabilities,
working capital is positive and the current ratio is greater than 1:1.)
A debt to total assets ratio of 62% is fairly substantial. But more is involved in a credit decision
than just one financial statement relationship. Extension of additional credit will depend on
Bozeman’s overall liquidity (current ratio) and profitability (ability to generate revenue and cash)
over the life of the loan. Similarly, Bozeman’s credit history is important—its patterns of loan
repayment in the past. No one analytical relationship can provide sufficient information to deter-
mine granting of additional credit.
There is little uniformity in accounting standards from country to country, although some efforts
have been made in this area by the International Accounting Standards Committee.
The International Accounting Standards Committee establishes international accounting stan-
dards, although they are by no means universally applied.
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