Understanding Financial Statements 11th Edition By Ormiston Frasier -Test Bank

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Understanding Financial Statements 11th Edition By Ormiston Frasier -Test Bank

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WITH ANSWERS

Understanding Financial Statements 11th Edition By Ormiston Frasier -Test Bank

Chapter 3

 

True-False

 

  1. The income statement presents cash revenues, cash expenses, net income, and earnings per share for an accounting period.

 

  1. The statement of stockholders equity is an important link between the balance sheet and the income statement.

 

  1. The income statement comes in two basic formats, the multiple-step and the single-step versions; however, for analysis purposes the single-step version should be used.

 

  1. The common size income statement expresses each income statement item as a percentage of total assets.

 

  1. Gross profit is the difference between sales and all operating expenses.

 

  1. If the cost of goods sold percentage increases or decreases, this does not necessarily mean that costs have increased or decreased.

 

  1. In volatile industries, such as high technology, gross profit margin may increase or decrease significantly each year.

 

  1. Operating profit margin is impacted by sales and all operating expenses except cost of goods sold.

 

  1. Users of financial statements need to distinguish between earnings increasing due to core operations versus items such as tax rate deductions.

 

  1. Two special items, discontinued operations and extraordinary items, must be disclosed separately on the income statement.

 

Fill in the Blank

 

  1. Two other terms used interchangeably with income are and                      .

 

  1. income is the change in equity of a company during a period from transactions, other events, and circumstances relating to nonowner sources.

 

  1. The method of inventory generally results in the matching of current costs with current revenues and therefore produces higher-quality earnings.

 

  1. The gross profit margin and are complements of each other and the two percentages always add up to 100%.

 

  1. costs are or should be a major expense in the budgets of companies for which marketing is an important element of success.

 

  1. and                       represent the cost of assets other than land that will benefit a business enterprise for more than a year.

 

  1. charges are the expenses recognized to record a decline in value of a long-term asset.

 

  1. The method of accounting for investments should be used when the investor can exercise significant influence over the investees operating and financing policies.

 

  1. Foreign currency translation effects, unrealized gains and losses, additional pension liabilities and cash flow hedges are items that may comprise a companys other  income.

 

  1. Stock and stock                       result in the issuance of additional shares of stock to existing shareholders.

 

Multiple Choice

 

  1. Which equation represents an income statement?
  2. Assets = liabilities + stockholders equity.
  3. Cash in cash out = net income.
  4. Revenues expenses = net income.
  5. Beginning retained earnings + revenues expenses = ending retained earnings.

 

  1. Which format of the income statement should be used for analysis purposes?
  2. Multiple-step.
  3. Cash basis.
  4. Single-step.
  5. Accrual basis.

 

  1. Which of the following is an acceptable method to report total comprehensive income?
  2. On the face of the balance sheet.
  3. Total comprehensive income does not have to be reported.
  4. In the operating section of the cash flow statement.
  5. In the statement of stockholders equity.

 

  1. How is a common-size income statement prepared?
  2. Each income statement item is expressed as a percentage of total assets.
  3. Each income statement item is expressed as a percentage of net sales.
  4. Each income statement item is expressed as a percentage of net income.
  5. Each income statement item is expressed as a percentage of cash flow.

 

  1. How are sales reported on the income statement?
  2. Sales are shown for three years net of returns and allowances.
  3. Sales amounts are inflation-adjusted.
  4. Sales are shown for two years and are reported in nominal terms.
  5. Sales are shown at gross amounts, adjusted for inflation.

 

  1. Which of the following statements is true?
  2. In stable industries, such as retailers, the gross profit margin is generally volatile from year to year.
  3. Gross profit margin and operating profit margin are complements of each other and the two percentages add up to 100%.
  4. Fixed costs do not vary proportionately with volume changes but remain the same within a relevant range of activity.
  5. In capital intensive industries sales volume changes result in a stable gross profit margin.

 

  1. How should companies with more than one revenue source report revenue and cost of goods sold?
  2. Each revenue source should be reported separately, but all cost of goods sold should be added together and reported as a single amount.
  3. The revenues and cost of goods sold should be netted together and reported as a single line item.
  4. All revenue sources should be added together and shown as one line item and all cost of goods sold should be added together and shown as one line item.
  5. Each revenue line should be shown separately with a corresponding cost of goods sold line for each revenue source.

 

  1. Selling and administrative expenses include which of the following income statement items?
  2. Salaries, insurance, interest.
  3. Salaries, rent, advertising.
  4. Rent, interest, cost of goods.
  5. Advertising, research & development, amortization.

 

  1. What is amortization?
  2. The process used to allocate the cost of natural resources.
  3. The process used to allocate the cost of tangible fixed assets.
  4. The process used to allocate the cost of capital leases, leasehold improvements and intangible assets.
  5. The process used to allocate the cost of oil, gas, minerals and standing timber.

 

  1. Which item would not be classified as an operating expense?
  2. Interest expense.
  3. Rent expense.
  4. Depreciation.
  5. Repairs and maintenance.

 

  1. Which of the following statements is true?
  2. It is unnecessary to analyze operating expenses over which management exercises discretion.
  3. Impairment charges do not need to be analyzed since they are generally a non-recurring expense.
  4. A good way to improve operating profit is to cut repairs and maintenance costs as much as possible.
  5. Operating expenses can be easily analyzed by preparing a common-size income statement.

 

  1. Why is it important to assess operating profit?
  2. Operating profit represents the firms profits after consideration of all revenues, expenses and comprehensive income.
  3. The figure for operating profit provides a basis for assessing the success of the firm apart from its financing and investing activities and separate from    tax considerations.
  4. Operating profit represents the firms profits after consideration of all revenues and expenses.
  5. Operating profit represents the firms profits after consideration of all revenues and expenses, except for taxes.

 

  1. Which of the items below would be included under Other income and expense?
  2. Salaries, interest expense, equity losses.
  3. Equity earnings, gains from sale of assets, interest income.
  4. Research and development, dividend income, interest expense.
  5. Advertising, cost of goods sold, selling and administrative expenses.

 

  1. How does the equity method distort earnings?
  2. Income is recognized even though cash may never be received.
  3. Equity earnings are recorded even if the investor cannot exercise influence over the investees policies.
  4. Equity earnings are only recorded on a cash basis of accounting.
  5. Equity earnings are recorded when investment ownership is 100%.

 

  1. How is it possible for a U.S. firm to have increasing earnings but a lower effective tax rate?
  2. The firm has expenses that are not deductible for tax purposes.
  3. Tax rates in foreign countries where the firm operates are higher.
  4. Tax rates in foreign countries where the firm operates are lower.
  5. It is not possible for a firm to have an effective tax rate different from the U.S. federal statutory tax rate.

 

  1. Which item is not a special item that must be disclosed separately on the income statement?
  2. Extraordinary gain.
  3. Extraordinary loss.
  4. Foreign currency translation adjustments.
  5. Discontinued operations.

 

  1. How is earnings per common share calculated?
  2. Operating profit divided by the average number of common stock shares outstanding.
  3. Net profit divided by the average number of common and preferred stock shares outstanding.
  4. Operating profit divided by the average number of repurchased common stock shares.
  5. Net profit divided by the average number of common stock shares outstanding.

 

  1. Which of the following items could be found on a statement of shareholders equity?
  2. Reasons for retained earnings increases or decreases.
  3. A reconciliation of beginning to ending cash.
  4. The market value of the firms common stock.
  5. Assets = Liabilities + Stockholders Equity.

 

Use the following information for Jett Co. to answer questions 19 and 20.

 

2015           2014

Sales                                                 1,200          1,000

COGS                                                 850             700

Operating expenses                              200              200

Income taxes                                          30               35

 

  1. Jett Co.s gross profit, operating profit and net profit margins for 2015 are:
  2. 50.0%, 32.5%, 22.5% respectively.
  3. 29.2%, 12.5%, 10.0%, respectively.
  4. 27.0%, 11.0%, 10.5%, respectively.
  5. 21.5%, 17.5%, 12.0%, respectively.

 

  1. Jett Co.s average tax rates for 2015 and 2014 are:
  2. 15.5% and 10.0%
  3. 20.0% and 35.0%
  4. 25.8% and 35.4%.
  5. 31.4% and 36.8%.

 


 

Short Answer/Problem

 

  1. Explain why the multiple-step format of the income statement is best for analysis?

 

  1. What questions should the analyst try to answer when analyzing the trend of a firms sales number?

 

  1. The gross profit margin is increasing for a firm. Give three reasons that could explain the increase.

 

  1. Discuss the following statement: Gross profit margin should be stable for all firms.

 

  1. Why might it be unfavorable for a firm to reduce repairs and maintenance, advertising, and research and development expenses?

 

  1. If an investor wants to understand how well a firm is performing in their core industry, which profit number (gross, operating or net) would be the best to analyze? Explain why.

 

  1. RBO Company purchased 25% of the voting common stock of YJD Company on January 1 and paid $800,000 for the investment. YJD Company reported $50,000 of earnings for the year and paid $10,000 in cash dividends. Calculate investment income and the balance sheet investment account balance for RBO Company using the following methods:

 

  1. Cost method.
  2. Equity method.

 

  1. Using the single-step income statement for ABC Company prepare a multiple-step income statement.

ABC Company

Income Statement

 

Income

Net sales                                           $1,750

Interest income                                         90

1,840

 

Costs and expenses

Cost of goods sold                                        1,000

Interest expense                                       70

Depreciation expense                             220

Income tax expense                                  70

Advertising expense                               110

General and administrative expenses              180

Net earnings                                                           $ 190

 

  1. Prepare an income statement using the following information:

 

Gross profit margin                          40%

Gross profit                                               $7,500

Tax rate                                            35%

Operating profit                                $400

 

  1. Using the following information prepare a common size income statement:

 

Net sales                                           $9,500

Cost of goods sold                                        5,900

Gross profit                                                $3,600

General and administrative expenses           1,250

Selling expenses                                     920

Operating profit                                $1,430

Income tax expense                                460

Net profit                                          $   970

 

  1. The following information is available for Escalante Computer Company. Analyze the gross profit margin making any calculations deemed necessary.

 

2015           2014           2013

Product sales                           $2,700        $2,400        $1,960

Service revenues                           380               50               40

Total sales                               $3,080        $2,450        $2,000

Cost of products                     $2,100        $1,750        $1,450

Cost of services                            260               35               30

Total cost of sales                              $2,360        $1,785        $1,480

Gross profit                                      $   720        $   665        $   520

 

 

  1. Explain the possible causes of the trends in the following data:

 

  Year 1 Year 2 Year 3
Gross profit margin 35% 31% 28%
Operating profit margin 9% 11% 13%
Net profit margin 4% 10% 7%

 

  1. Use the following information to analyze BobKat Equipment Sales. Calculate any profit measures deemed necessary in order to discuss the profitability of the company.

BobKat Equipment Sales

Income Statement

For the Years Ended Dec. 31, 2015 and 2014

 

2015                     2014

Net sales                                                     $124,000              $138,000

COGS                                                             90,000                 95,000

Gross profit                                                         $  34,000              $  43,000

General and administrative expenses                       31,000                  36,000

Operating profit                                         $    3,000              $    7,000

Interest expense                                              (1,000)                 (1,000)

Earnings before taxes                                 $    2,000              $    6,000

Income taxes                                                        800                    1,800

Net income                                                 $    1,200              $    4,200

 

 

  1. Analyze the common size income statements below for Coast Company:

 

(in percent) 2015 2014
Net sales 100 100
COGS   62  65
      Gross margin   38   35
Research and development        9        5
Selling, general and administrative     11      17
Restructuring, asset impairments and other charges     1    8
       Income/(loss) from operations      17 5
Interest expense (3) (1)
     Income/(loss) before taxes  14 4
Provision for/(benefit from) income taxes    4   1
     Net income/(loss) 10       3

 

 

  1. Analyze the common size income statements below for 3T Company:

 

  2015 2014
Net sales 100% 100%
COGS   89   87
      Gross margin   11%  13%
Selling, general and administrative     7 9
Restructuring, asset impairments and other charges     0    9
       Income/(loss) from operations 4% (5)%
Interest expense (1) (2)
     Income/(loss) before taxes  3% (7%)
Provision for/(benefit from) income taxes    1   0
     Income/(loss) after taxes 2% (7)%
Discontinued operations, net 6 1
     Net income (loss) 8% (6)%

 

 

 

Solutions Chapter 3

 

True-False

 

  1. F 6.  T
  2. T 7.  T
  3. F 8.  F
  4. F 9.  T
  5. F          10. T

 

Fill in the Blank

 

  1. earnings, profit
  2. Comprehensive
  3. LIFO
  4. cost of goods sold percentage
  5. Advertising
  6. Depreciation, amortization
  7. Impairment
  8. equity
  9. comprehensive
  10. dividends, splits

 

Multiple Choice

 

  1. c 6.  c             11.  d           16.  c
  2. a 7. d             12.  b          17.  d
  3. d 8.  b            13.  b          18.  a
  4. b           9.  c             14.  a          19.  b
  5. a   10.  a            15.  c           20.  b

 

Short Answer/Problem

 

  1. The multiple-step format is best for analysis purposes because it provides several intermediate profit measuresgross profit, operating profit, and earnings before income taxprior to the amount of net earnings for the period. Gross profit is the first step of profit measurement on the multiple-step income statement and is a key analytical tool in assessing a firms operating performance. The gross profit figure indicates how much profit the firm is generating after deducting the cost of products or services sold. Operating profit is the second step of profit determination and measures the overall performance of the companys operations: sales revenue less the expenses associated with generating sales. The figure for operating profit provides a basis for assessing the success of a company apart from its financing and investing activities and separate from tax considerations. Net earnings, or the bottom line, represents the firms profit after consideration of all revenue and expense reported during the accounting period.

 

  1. Questions the analyst should attempt to answer include:
  2. Are sales growing because the firm is increasing prices or because more units are being sold, or both?
  3. Are sales growing in real (inflation-adjusted) as well as nominal (as reported) terms?

 

  1. Three reasons that gross profit margin might be increasing are:
  2. the selling price has increased without a proportional increase in cost of goods sold
  3. the cost of goods sold are decreasing without a proportional increase in sales
  4. cost of goods sold contains fixed costs and the volume of sales has increased

 

  1. It is highly desirable that gross profit margin would be stable for all firms, but it is unlikely that this would occur in all industries. As cost of goods sold increases for a firm, the firm will raise selling prices to maintain a stable gross profit margin; however, in some industries the competition is such that this is not possible. Grocery stores and retailers tend to have stable gross profit margins, but high technology firms tend to have volatile gross profit margins from year to year.

 

  1. Spending too little in these areas can impact the firm negatively. In capital intensive industries it is important for management to properly maintain plant and equipment. Expenditures in this area should correspond to the level of investment in capital equipment and to the age and condition of the assets. Poorly maintained equipment will result in waste and lost time and possibly poor quality products. Customers may choose to purchase products elsewhere, resulting in a decline of sales. Advertising is critical for certain types of industries. For example, firms operating in the beverage industry generally gain market share through extensive advertising. High-technology and pharmaceutical firms would cease to exist if they did not spend a certain amount on research and development. These industries depend on developing new products each year.

 

  1. Operating profit is the best indicator of how well a firm performs in its core industry. Operating profit includes the sales from its products and services less cost of goods sold and all other operating expenses incurred to sell its products and services. Operating profit does not include nonoperating revenues and expenses such as interest expense, dividend and interest income, gains and losses on sales of assets, equity earnings or taxes. The operating profit amount allows the analyst to assess the operational performance of the firm apart from financing and investing activities.

 

  Investment Income Investment Account
     
(a)  Cost method $2,500 * $800,000  
         
(b)  Equity method $12,500 ** $810,000 ***

 

* $10,000 cash dividends x 25%

** $50,000 earnings x 25%

*** $800,000 + $12,500 $2,500

 

8.

ABC Company

Income Statement

 

Net sales                                           $1,750

Cost of goods sold                                        1,000

Gross profit                                      $   750

Depreciation expense                             220

Advertising expense                               110

General and administrative expenses              180

Operating profit                      $   240

Interest income                                         90

Interest expense                                    (70)

Earnings before taxes                       $   260

Income tax expense                                  70

Net profit                                $   190

 

  1. Net sales $18,750

Cost of goods sold                                       11,250

Gross profit                                                    7,500

Operating expenses                              7,100

Operating profit                                       400

Income tax expense                                  140

Net profit                                               $260

 

  1. Net sales 100.0%

Cost of goods sold                                       62.1%

Gross profit                                                  37.9%

General and administrative expenses           13.2%

Selling expenses                                   9.7%

Operating profit                                  15.0%

Income tax expense                               4.8%

Net profit                                            10.2%

 

  1. 2015 2014           2013

Overall gross profit margin     23.4%         27.1%         26.0%

Gross profit         margin of:

Product sales                 22.2%         27.1%         26.0%

Service revenues            31.6%         30.0%         25.0%

 

The gross profit margin of Escalante Computer Company has decreased significantly in 2015. This is a result of product sales as service gross profit margins have been steadily increasing. Product sales make up the majority of the companys revenues although the service area appears to be expanding in 2015. In 2013 and 2014 the overall gross profit margin was the same percentage as the product sales gross profit margin due to the minimal service revenues. The overall gross profit margin was slightly higher than the product gross profit margin because of the increased amount of service revenue. Escalante Company has either lowered selling prices on products and/or cost of goods sold has increased. A volume decrease in product sales could account for the lower gross profit margin if the firm has significant fixed costs in cost of goods sold. Service revenues appear to be increasing in volume, or the price charged has increased, or cost of goods sold has decreased.

 

  1. Gross profit margin is declining significantly. This could be a result of a decrease in prices caused by competition, deflation, or slow-moving goods that have been discounted. Another possibility is that the prices have remained the same, but the cost of goods has increased and the firm has been unable to pass along the increases to customers.

 

Operating profit margin has increased each year despite the decreasing gross profit margin. The firm has been able to cut operating costs. Hopefully this has been achieved by cutting waste and not by cutting discretionary expenses such as advertising, repairs and maintenance and research and development. Cutting necessary discretionary expenses may negatively impact the firms sales in future years.

 

Net profit margin has been volatile. The large increase in Year 2 appears to be the result of a one-time, nonrecurring item. Excluding this item, net profits have increased more than operating profits. This could be a result of decreasing interest expense, decreasing taxes, an increase in interest income or other miscellaneous revenue, or a decrease in miscellaneous expenses.

 

  1. 2015           2014

Cost of goods sold percentage 72.6%         68.8%

Gross profit margin                 27.4%         31.2%

G&A/Net sales                         25.0%         26.1%

Operating profit margin            2.4%           5.1%

Effective tax rate                     40.0%         30.0%

Net profit margin                      1.0%           3.1%

 

The COGS percentage has increased causing gross profit margin to decline. Either prices of the products have decreased or cost of goods sold has increased and management has been unable to pass on the cost in the form of higher selling prices. General and administrative expenses have been cut, but not enough to mitigate the change in gross profit margin. This has resulted in a declining operating profit margin. The dollar amount of interest expense remained unchanged. Despite declining profits, BobKats effective tax rate has increased 10% and caused further decline in the net profit margin.

 

  1. Gross profit margin has increased three percent from 2014 to 2015. Either selling prices have increased and/or cost of goods sold has decreased. If there are fixed costs within the cost of goods sold category then an increase in volume of sales may be responsible for the increase in gross profit margin.

 

Operating profit margin has increased significantly. The increase is due to not only the increase in gross profit margin, but also significant cost cuts in selling, general and administrative (SG&A) expenses and restructuring and impairment charges. Reducing waste in SG&A expenses would constitute a beneficial cut; however, if these areas have been cut only for the purpose of increasing earnings, this could be highly detrimental to the long-term success of the firm. Cuts in advertising may result in lower sales. If layoffs have been used to reduce operating expenses, lower morale in the work force may result in lower quality and lower sales. Restructuring could explain how the firm was able to lower selling, general and administrative expenses. It is noteworthy that even though the firm has cut many costs, research and development expenses have more than doubled from 2014 to 2015 relative to sales. It is good for the firm to focus on new and innovative products.

 

Net profit has increased as a result of the increased operating profit. Interest expense has increased which implies higher debt or higher interest rates. Income tax expense has risen which is expected since the firm is more profitable.

 

  1. Gross profit margin has declined two percent from 2014 to 2015. Either selling prices have declined and/or cost of goods sold has increased. If there are fixed costs within the cost of goods sold category then a decline in volume of sales may be responsible for the drop in gross profit margin.

 

Operating profit margin has increased from a loss to a profit, despite the decrease in gross profit margin. It appears 3T Company has compensated for the drop in gross profit by cutting costs in selling, general and administrative expenses. Reducing waste in these areas would constitute a beneficial cut; however, if these areas have been cut only for the purpose of increasing earnings, this could be highly detrimental to the long-term success of the firm. Cuts in advertising may result in lower sales. If layoffs have been used to reduce operating expenses, lower morale in the work force may result in lower quality and lower sales. The main reason for the increase in operating profit has been the lack of restructuring and asset impairment costs in 2015 compared to 2014. Restructuring could explain how the firm was able to lower selling, general and administrative expenses.

 

Net profit has increased as a result of the increased operating profit. Interest expense has declined slightly which implies lower debt or lower interest rates. Income tax expense has risen which is expected since the firm is no longer generating losses. In addition, net profit is higher than it otherwise would be as a result of gains from discontinued operations, a one-time event.

 

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