Accounting Theory - Answers to Various Questions

This article provides answers to various questions related to accounting theory such as accounting identity, effective method of interest while recording the issuance of bonds, capital lease and operating lease, treasury stock, LIFO and FIFO method of inventories, basic EPS and diluted EPS, etc.

Running head: ACCOUNTING THEORY
Accounting theory
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1ACCOUNTING THEORY
Table of Contents
Answer 1....................................................................................................................................2
Answer 2....................................................................................................................................2
Answer 3....................................................................................................................................3
Answer 4....................................................................................................................................4
Answer 5....................................................................................................................................5
Answer 6....................................................................................................................................5
Answer 7....................................................................................................................................6
Answer 8....................................................................................................................................6
Answer 9....................................................................................................................................7
Footnotes and Bibliography.......................................................................................................8

2ACCOUNTING THEORY
Answer 1
Accounting identity – the accounting identity depicts that the liabilities and equity in total
shall be equal to the total assets. In other words, the amount of equity is the difference
between the amount of assets and liabilities1.
Identity of balance sheet – the accounting identity associated with the balance sheet is Assets
= Liabilities + Equities.
Dividends – when the stock dividends are issued the balance sheet size remains same as the
retained earnings reduced and common stock are increased by the same amount. On the other
hand, cash dividend has an impact on the balance sheet of the company through reducing the
cash balance in the asset side and reducing the retained earnings from equity. Therefore, the
cash dividends reduce the overall balance of the balance sheet.
Answer 2
Effective method of interest while recording the issuance of bonds – effective interest
rate is the method that is used by the purchaser of a bond for recording the accretion of bond
discount as the amount of balance is moved to interest income. It is also used to amortize the
bond premium in interest expenses. The effective rate of interest uses book value or carrying
amount of bond for computing the interest income. Generally, the bonds are issued at par or
at face value. However, if the bond is purchased at lower than the par value the amount
lower, the par value is bond discount. As the par amount is returned to purchaser on maturity,
discount is the additional income from bond to the purchaser2. When bonds are sold at
premium using the effective interest method at each of the subsequent date of interest
1 What Is Accounting Identity? Definition And Meaning (2018) BusinessDictionary.com
<http://www.businessdictionary.com/definition/accounting-identity.html>.
2 Effective-Interest Amortization Methods - Principlesofaccounting.Com (2018) principlesofaccounting.com
<https://www.principlesofaccounting.com/chapter-13/effective-interest/>.

3ACCOUNTING THEORY
payment, cash payment is more than the effective interest. On the contrary, when bonds are
sold at discount using the effective interest method at each of the subsequent date of interest
payment, cash payment is lower than the effective interest.
Answer 3
Capital lease and operating lease – under the capital lease, lessee owns the leased asset and
the asset are financed through the loan from lessor. On the basis of designation ownership
lessee records as capital lease as follows –
 The leased asset is recorded as fixed asset by the lessee
 The depreciation expenses related to the asset is recorded by the lessee
 Lessee accounts the liability for the asset’s present value through usage of discount
method
 After payment of lease amount, the lease payments are recorded by the lessee as
combination of interest expenses and reduction of the liability
On the other hand, under the operating lease, lessor is considered as the owner of the
asset and the asset is rented by the lessee. On the basis of the ownership designation the
lessee records the operating lease as operating lease for each lease payments3.
Owing to the differences among each kind of the lease the major difference among the
2 leases and its impact on income statement and balance sheet are as follows –
 The depreciation expenses from the capital lease are debited to the income statement.
However, depreciation is not charged against the operating lease.
 Capital leased asset is recorded under the balance sheet as fixed asset. However, in
case of operating lease no asset is recorded
3 Capital Lease Vs Operating Lease - Difference And Comparison | Diffen (2018) Diffen.com
<https://www.diffen.com/difference/Capital_Lease_vs_Operating_Lease>.

4ACCOUNTING THEORY
 Lease expenses for operating lease are charged in the income statement. On the
contrary, capital lease expenses are not charged to income statement rather the
expenses are segregated as interest expenses and depreciation expenses.
Answer 4
Treasury stock – the treasury stock is the stock that is repurchased by issuer and is intended
for resale to public or retirement. It reveals the difference among the number of outstanding
shares and number of issued shares. It includes the shares those are issued but are not
outstanding. Hence, the treasury shares are not taken into account while the dividends are
calculated or in the earning per share calculations. Moreover, the treasury stocks are not
applicable to have voting rights4.
Ways of handling troubled debts - troubled debt is the debt under which the creditor grants
the concession to debtor for legal or economic reasons owing to the financial difficulties of
the debtor that would have been considered otherwise in normal scenario. 2 ways of handling
the troubled debts are –
 Impairment – the debt is considered impaired while it is probable that on the basis of
current events and information the amount due for principle as well as interest both
will not be collected. However, in judging the collection probability the creditors
shall apply normal procedures for reviewing
 Restructuring that includes modifications of the terms or settlements – restructuring
takes place when the creditor grants the concession to debtor for legal or economic
reasons owing to the financial difficulties of the debtor that would have been
considered otherwise in normal scenario. In such circumstances, the debt is settled at
4 Treasury Stock - What Is It, Definition And Explanation (2018) Corporate Finance Institute
<https://corporatefinanceinstitute.com/resources/knowledge/finance/treasury-stock/>.

5ACCOUNTING THEORY
lower than the carrying value of debt or the debt is continued with the modification
terms.
Answer 5
Depreciation – the depreciation expenses does not have any direct impact on the net income
of the company rather the total depreciation amount is charged against the net income of the
company over the assets useful life. Depreciation is shown in the asset side of the balance
sheet with the credit balance5.
Impairment – the assets are known as impaired if the net carrying value of the asset is more
than future undiscounted cash flows at which the asset can be disposed off. Under the balance
sheet the long-term assets are reduced by the amount of impairment loss. The impairment
loss amount is charged in the income statement which in turn reduces the retained earnings
reported under the equity section of balance sheet.
Answer 6
Trading securities – these securities are recorded at the fair values or marked to market. If the
market prices of trading securities increases the value of the trading securities increases and
vice versa.
Available for sale securities – these securities are recorded at the fair values or marked to
market. If the market prices of available for sale securities increases the value of the available
for sale securities increases and vice versa6.
5 Investment Banking Technical Interview Question How Does Depreciation Affect The 3 Financial Statments |
Ibankingfaq (2018) Ibankingfaq.com
<http://www.ibankingfaq.com/interviewing-technical-questions/accounting-and-financial-statements/if-a-
company-incurs-10-pretax-of-depreciation-expense-how-does-that-affect-the-three-financial-statements/>.
6 Fair Value Accounting Vs. Historical Cost Accounting (2018) researchgate.net
<https://www.researchgate.net/publication/291437467_Fair_Value_Accounting_vs_Historical_Cost_Accountin
g>.

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Held to maturity securities – these securities are recorded at the amortized cost. The value of
the held to maturity securities do not changes with the changes in the market price.
Answer 7
Equity method and cost method of accounting for the investment – cost method or equity
method of the accounting are used by the entities for accounting the investment made by
them in other entities. The cost method is used by the company while the company makes
long-term and passive investment that does not have an impact on the company. it is used
when investment results into ownership stake of lower than 20%. On the contrary, the equity
method is used when investment results into 20% - 50% holding in other company unless it is
clearly shown that investment will not result into significant value of control or influence7.
Goodwill – goodwill is the intangible asset that is generated while 1 entity purchases another
entity at premium value. Value of the company’s brand name good relations with customer,
solid base for customer, good relations with employees, proprietary technology or patents are
represented as goodwill.
Answer 8
LIFO and FIFO method of inventories – FIFO method provides better indication regarding
the value of the closing inventories. However, it increases the net income as the inventories
may be several years old for valuing the COGS. On the other hand, LIFO results into lower
net income as the COGS are higher. Cost of goods sold and inventories are interdependent8.
Owing to this, if the LIFO method is used under the rising price scenario and increasing
inventory scenario more of the higher cost goods are accounted for COGS as against FIFO.
7 Cost Method - Guide To Accounting For Investments, Examples (2018) Corporate Finance Institute
<https://corporatefinanceinstitute.com/resources/knowledge/accounting/cost-method/>.
8 Dennis Najjar, How To Value Inventory: FIFO, LIFO, Or Average? (2018) Accountingdepartment.com
<https://www.accountingdepartment.com/blog/value-inventory-fifo-lifo-average>.

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Under this circumstance, the net income will be less as compared to the company that uses
the FIFO method of accounting.
Answer 9
Basic EPS and diluted EPS – Basic EPS is the EPS that accrues to shareholders of the entity.
This is generated through dividing the net profit of the company by total number of
outstanding shares. On the other hand, diluted EPS is quite complicated as compared to basic
EPS. Diluted EPS is the performance metric for measuring the quality of the company’s EPS
if all the convertible securities are exercised9. The convertible securities are the outstanding
convertible preferred shares, stock options, warrants and convertible debentures. When the
company has any convertible securities, diluted EPS is lower than the basic EPS.
9 Basic EPS, Basic EPS Vs. Diluted EPS - Views On News From Equitymaster (2018) Equitymaster.com
<https://www.equitymaster.com/detail.asp?date=03/10/2011&story=1&title=Basic-EPS-vs-Diluted-EPS>.

8ACCOUNTING THEORY
Footnotes and Bibliography
Capital Lease Vs Operating Lease - Difference And Comparison | Diffen (2018) Diffen.com
https://www.diffen.com/difference/Capital_Lease_vs_Operating_Lease
Cost Method - Guide To Accounting For Investments, Examples (2018) Corporate Finance
Institute https://corporatefinanceinstitute.com/resources/knowledge/accounting/cost-method/
Effective-Interest Amortization Methods - Principlesofaccounting.Com (2018)
principlesofaccounting.com <https://www.principlesofaccounting.com/chapter-13/effective-
interest/>
EPS, Basic, Basic EPS Vs. Diluted EPS - Views On News From Equitymaster (2018)
Equitymaster.com https://www.equitymaster.com/detail.asp?
date=03/10/2011&story=1&title=Basic-EPS-vs-Diluted-EPS
Fair Value Accounting Vs. Historical Cost Accounting (2018) researchgate.net
https://www.researchgate.net/publication/291437467_Fair_Value_Accounting_vs_Historical
_Cost_Accounting
Investment Banking Technical Interview Question How Does Depreciation Affect The 3
Financial Statments | Ibankingfaq (2018) Ibankingfaq.com
http://www.ibankingfaq.com/interviewing-technical-questions/accounting-and-financial-
statements/if-a-company-incurs-10-pretax-of-depreciation-expense-how-does-that-affect-the-
three-financial-statements/
Najjar, Dennis, How To Value Inventory: FIFO, LIFO, Or Average? (2018)
Accountingdepartment.com https://www.accountingdepartment.com/blog/value-inventory-
fifo-lifo-average

9ACCOUNTING THEORY
Treasury Stock - What Is It, Definition And Explanation (2018) Corporate Finance Institute
https://corporatefinanceinstitute.com/resources/knowledge/finance/treasury-stock/
What Is Accounting Identity? Definition And Meaning (2018) BusinessDictionary.com
http://www.businessdictionary.com/definition/accounting-identity.html