Understanding Financial Statements 11th Edition by Lyn M. Fraser Aileen Ormiston Test bank

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Understanding Financial Statements 11th Edition by Lyn M. Fraser Aileen Ormiston Test bank

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Test Questions and Solutions

Chapter 1

True-False

1. A firms annual report contains only two pieces of information: the financial statements and the notes to the financial statements.

2. The SEC regulates U.S. companies that issue securities to the public and requires the issuance of a prospectus for any new security offering.

3. The FASB has congressional authority to set accounting policies.

4. The European Union began requiring publicly traded companies to use U.S. GAAP in 2005.

5. External auditors are required to audit the internal control assessment of the company as well as the financial statements.

6. Congress passed the Sarbanes-Oxley Act of 2002 in hopes of ending future accounting scandals and renewing investor confidence in the marketplace.

7. The Management Discussion and Analysis is of potential interest to the analyst because it contains information that cannot be found in the financial data.

8. Information that is significant enough to make a difference in a decision is considered to be immaterial.

9. The time period assumption assumes a two year time frame with interim reporting occurring daily and weekly.

10. GAAP-based financial statements are prepared according to the accrual basis of accounting.

Fill in the Blank

1. The requires all public companies to file a Form 10-K report annually.

2. A corporate annual report contains financial statements.

3. is responsible for the preparation of the financial statements, including the notes, and the attests to the fairness of the presentation.

4. The was passed in 2002 and was one of the most sweeping corporate reforms since the Securities Act of 1934.

5. The is a document used to solicit shareholder votes.

6. The Assumption is the assumed unit of measurement when preparing financial statements.

7. The cash basis of accounting recognizes when cash is received and recognizes when cash is paid.

8. The sharper and clearer the picture presented through the financial data and the closer that picture is to financial reality, the higher the financial statements and reported earnings.

9. One of the generally accepted accounting principles that provide the foundation for preparing financial statements is the principle.

10. Management exercises control over the budget level and timing of expenditures.

Multiple Choice

1. What information would not be found in a firms annual report?
a. Notes to the financial statements.
b. Financial Reporting Rulings.
c. Auditors report.
d. High and low stock prices.

2. Which agency requires the filing of Form 10-Ks, Form 10-Qs and Form 8-Ks?
a. FASB.
b. IASB.
c. SEC.
d. GAAP.
3. Which of the following statements is true?
a. Foreign firms registered with the SEC may file reports based on IFRS.
b. U.S. firms registered with the SEC may file reports based on IFRS.
c. The European Union requires firms to report based on GAAP.
d. Foreign firms registered with the SEC may file reports based on IFRS only if they reconcile all amounts to GAAP.

4. Which financial statement presents the results of operations?
a. Balance sheet.
b. Statement of financial position.
c. Income statement.
d. Statement of cash flows.

5. Which financial statement shows the assets, liabilities and stockholders equity of the firm on a particular date?
a. Statement of stockholders equity.
b. Statement of cash flows.
c. Earnings statement.
d. Balance sheet.

6. Which financial statement provides information about operating, financing and investing activities?
a. Statement of financial position.
b. Statement of cash flows.
c. Statement of stockholders equity.
d. Income statement.

7. What information can be found on a statement of stockholders equity?
a. A reconciliation of the cash account and the retained earnings account.
b. A reconciliation of the beginning and ending balances of all accounts that appears in the stockholders equity section of the balance sheet.
c. A reconciliation of the operating, investing and financing activities of a firm.
d. A reconciliation of net profit or loss and the cash account.

8. What basic financial statements can be found in a corporate annual report?
a. Balance sheet, income statement, statement of shareholders equity, and statement of cash flows.
b. Balance sheet, auditors report and income statement.
c. Earnings statement and statement of retained earnings.
d. Statement of cash flows and five-year summary of key financial data.

9. What is an unqualified audit report?
a. A report stating that the auditors are not qualified to report on a firm.
b. A report that states the financial statements are in violation of GAAP.
c. A report that states that departures from GAAP exist in the firms financial statements.
d. A report that states the financial statements are presented fairly, in all material respects, and are in conformity with GAAP.

10. What is a qualified report?
a. A report stating that the auditors are not qualified to report on a firm.
b. A report that states the financial statements are in violation of GAAP.
c. A report that states that departures from GAAP exist in the firms financial statements.
d. A report that states the financial statements are presented fairly, in all material respects, and are in conformity with GAAP.

11. What organization has the authority to register, inspect, and discipline auditors of all publicly owned companies?
a. Public Company Accounting Oversight Board.
b. SOX.
c. Congress.
d. FASB.

12. According to Section 302 of the Sarbanes-Oxley Act, who must certify the accuracy of the financial statements of a public company?
a. Public Company Accounting Oversight Board.
b. SEC.
c. External auditor.
d. CEO and CFO.

13. All of the following items should be discussed in the management discussion and analysis except for:
a. Anticipated changes in the mix and cost of financing resources.
b. The market value of all assets.
c. The internal and external sources of liquidity.
d. Unusual or infrequent transactions that affect income from continuing operations.

14. Which of the following is an internal source of liquidity?
a. Borrowing.
b. Sales of stock.
c. Gifts and donations.
d. Sales of products or services.

15. Which of the following is an external source of liquidity?
a. Sales of services.
b. Repurchase of stock.
c. Borrowing.
d. Sales of products.

16. Which of the following is not a condition that must be met for an item to be recorded as revenue?
a. Revenues must be earned.
b. The amount of the revenue must be measurable.
c. The revenue must be received in cash.
d. The costs of generating the revenue can be determined.

17. How are revenues and expenses recognized under the accrual basis of accounting?
a. Revenues are recognized when cash is received and expenses are recognized when cash is paid.
b. Revenues and expenses are recognized equally over a twelve month period.
c. Revenues and expenses are recognized based on the choices of management.
d. Revenues are recognized in the accounting period when the sale is made and expenses are recognized in the period in which they relate to the sale of the product.

18. In what industry would it be expected that companies would spend a significant amount on research and development activities?
a. Pharmaceutical.
b. Clothes retailer.
c. Groceries.
d. Wholesale distributor of computer parts.

19. Which of the following items is a discretionary expenditure?
a. Union wages.
b. Factory building to produce inventory.
c. Advertising.
d. Taxes.

20. Which of the following statements is false with regard to quality of financial reporting?
a. Financial statements should reflect an accurate picture of a companys financial condition and performance.
b. It is unlikely that management can manipulate the bottom line due to the regulations in place to enforce GAAP.
c. Financial information should be useful both to assess the past and predict the future.
d. The closer that the picture presented through the financial data is to reality, the higher the quality of financial reporting.

Short Answer

1. Write a short essay explaining the following statement: Unfortunately, there are mazelike interferences in financial statement data that hinder understanding the valuable information they contain.

2. Describe the relationship between the FASB and the SEC.

3. Explain why the notes are an integral part of the financial statements.

4. Discuss the impact that the Sarbanes-Oxley Act of 2002 had on internal auditing.

5. Define internal and external sources of liquidity. What is a material deficiency in liquidity? If a firm has a material deficiency in liquidity what should be reported in the management discussion and analysis?

6. What types of information may be missing or hard to find in the financial statements?

7. Explain why the characteristics of comparability and consistency are important in financial reporting?

8. Write an essay discussing the two key principles that are the foundation of the accrual basis of accounting.
Solutions Chapter 1

True-False

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

Fill in the Blank

1. SEC
2. Four
3. Management, auditors report
4. Sarbanes Oxley Act
5. Proxy statement
6. Monetary unit
7. Revenues, expenses
8. Quality
9. Matching
10. Discretionary

Multiple Choice

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

Short Answer

1. The following items make it more difficult for a user of financial statements to understand the financial data:
Quantity of information
Clean audit reports do not mean the firm will not fail
Complex accounting policies that may be confusing
Accounting rules are constantly changing
Management has discretion in presenting financial information
Some information is not available or is difficult to find in the financial statements

2. The FASB and the SEC work closely together in the development of accounting policy, with the SEC playing largely a supportive role. Pressures from the private sector have caused controversy at times. Congress has given accounting rulemaking authority to the SEC, who, in turn, has passed that role to the FASB. The SEC maintains veto power over any rule written by the FASB. Reporting companies must use the rules written by both the SEC and the FASB and if these companies do not like the rules they will most likely lobby their congressmen to force the SEC to change those rules.

3. The notes must be read in order to understand the presentation on the face of the financial statements. Key information that can be found in the notes includes a summary of the firms accounting policies and any changes that may have been made to those policies during the reporting period. Detail about particular accounts such as inventory, property, plant and equipment, investments, long-term debt, and equity accounts can be found in the notes. Information about acquisitions, divestitures, pension and stock option plans, leases, legal proceedings, income taxes, contingencies and commitments, quarterly results of operations and operating segments can also be found in the notes.

4. Section 404 of SOX requires companies to include in their annual reports a statement regarding the effectiveness of internal controls and the disclosure of any material weaknesses in a firms internal controls system. This requirement has greatly boosted the need for internal auditors and SOX compliance specialists, but more important, has enhanced the value of the internal audit function within companies, as businesses have strengthened internal controls in response to SOX.

5. Internal sources of liquidity include the cash received from selling products and services; external sources of liquidity include cash received from outside sources such as borrowing or selling the firms stock to raise funds. A material deficiency in liquidity means that a firm may not have enough cash to make it through another operating cycle. If a firm has a material deficiency the firm must discuss how this deficiency will be remedied so that bankruptcy will hopefully be prevented.

6. Missing and hard to find information includes such intangibles as employee relations with management, the morale and efficiency of employees, the reputation of the firm with its customers, the firms prestige in the community, the effectiveness of management, provisions for management succession, and potential exposure to changes in regulationssuch as environmental or food and drug enforcement. Much information is available in the notes to the financial statements, but may be difficult for the user to find and analyze. Complicated financing schemes, while revealed in the notes, may be impossible for many users to understand without an extensive background in accounting.

7. The characteristics of comparability and consistency require companies to use the same accounting methods and choices from one period to another. This allows users to compare financial information of an entity to other entities as well as comparing financial information of that entity to itself from one time period to another. Changes in accounting methods and choices can distort trends that are useful when trying to predict the future of a firm.

8. The two key principles are the revenue recognition and the matching principle.

The revenue recognition principle requires that four conditions be met for a transaction to be recorded as a revenue item. The four conditions are (1) the revenues must be earned (the sale is complete), (2) the amount of the revenue must be measurable, (3) the costs of generating the revenue can be determined, and (4) the revenue must be realizable.

The matching principle requires revenues and expenses to be properly matched in the same time period. Once revenue has been recognized in an accounting period, expenses incurred to generate that revenue need to be recorded in the same accounting period. Revenues and expenses, therefore, are recorded when events take place, without regard to receipt or payment of cash.

Chapter 2

True-False

1. The balance sheet is also called the statement of condition or statement of financial position.

2. The balance sheet is prepared for a period of time, generally a year.

3. A classified balance sheet means that the asset and liability sections are categorized into key areas.

4. Companies that use IFRS may switch the order of presentation of assets and liabilities, listing noncurrent items before current items.

5. As part of an integrated disclosure system required by the SEC, the information presented in annual reports includes three-year audited balance sheets.

6. A common-size balance sheet is useful to the analyst because it facilitates the structural analysis of the firm.

7. Working capital refers to the investment in property, plant and equipment.

8. The valuation of marketable securities on the balance sheet requires the separation of investment securities into three categories: held to maturity, trading securities, and securities available for sale.

9. Accounts receivable are recorded on the balance sheet at gross realizable value.

10. Retained earnings is the unused stash of cash that a firm has accumulated since inception.

Fill in the Blank

1. A expresses each item on the balance sheet as a percentage of total assets.

2. are those assets expected to be converted into cash within one year or operating cycle, whichever is longer.

3. are also referred to as short-term investments.

4. The net realizable value of accounts receivable is the actual amount of the account less an .

5. Additional information helpful to the analysis of accounts receivable and the allowance account is provided in the schedule of .

6. The three cost flow assumptions most frequently used in the U.S. are , , and .

7. arises when one company acquires another company for a price in excess of the fair market value of the net identifiable assets.

8. Companies that are paid in advance for services or products record a liability on the receipt of cash in an account titled or .

9. A lease affects both the balance sheet and the income statement.

10. Many companies list an account titled on the balance sheet even though no dollar amount will appear.

Multiple Choice
1. The balancing equation is expressed as:
a. Assets + Liabilities = Stockholders Equity.
b. Revenues Expenses = Net Income.
c. Sales Costs = Net Profit.
d. Assets = Liabilities + Stockholders Equity.

2. Which of the following statements is false?
a. Common-size balance sheets allow for comparison of firms with different levels of total assets by introducing a common denominator.
b. The common-size balance sheet reveals the composition of assets within major categories.
c. Each item on a common-size balance sheet is expressed as a percentage of sales.
d. The common-size balance sheet reveals the capital and the debt structure of the firm.

3. Which of the following accounts would be classified as current assets on the balance sheet?
a. Accounts receivable, inventory, cash equivalents.
b. Marketable securities, accounts payable, property, plant and equipment.
c. Prepaid expenses, goodwill, long-term investments.
d. Property, plant and equipment, inventory, goodwill.

4. Which of the following items would not be classified as cash equivalents?
a. U.S. Treasury bills.
b. Trading securities.
c. Commercial paper.
d. Money market funds.

5. Which of the following marketable securities are reported at fair value?
a. Held to maturity and trading securities.
b. Trading securities and securities available for sale.
c. Held to maturity and securities available for sale.
d. Corporate bonds and convertible debt.

6. Which of the following items should alert the analyst to the potential for manipulation when analyzing accounts receivable and the allowance for doubtful accounts?
a. Sales, accounts receivable and the allowance for doubtful accounts are all growing at approximately the same rate.
b. A company lowers its credit standards and also increases the balance in the allowance for doubtful accounts.
c. Accounts receivable is growing at a large rate and the allowance for doubtful accounts is decreasing.
d. An analysis of the Valuation and Qualifying Accounts schedule required in the Form 10-K reveals that the amounts recorded for bad debt expense are close in amount to the actual amounts written off each year.

7. Which method of inventory assumes the last units purchased will remain in ending inventory on the balance sheet?
a. FIFO.
b. LIFO.
c. Average cost.
d. LIFO and FIFO.

8. Which type of firm would most likely carry the most finished goods inventory?
a. A manufacturing firm.
b. A retail firm.
c. A service firm.
d. A wholesale firm.

9. Which method of inventory would be least likely to be used by a European firm?
a. FIFO.
b. LIFO.
c. Average cost.
d. LIFO and FIFO.

10. Which of the following statements is false?
a. Companies are allowed to use more than one inventory valuation method.
b. LIFO is an income tax concept.
c. Using FIFO for high-technology products makes sense if the firm is trying to reduce taxes because the technology industry is generally deflationary.
d. Companies using IFRS may not reverse entries for inventory write-downs if the market recovers.

Use the following information to answer questions 11 through 13:

ABC Company purchases five products for sale in the order and at the costs shown:

Unit Cost per Unit
1 $10
2 $12
3 $15
4 $18
5 $13

11. Assume ABC sells two items and uses the FIFO method of inventory valuation. What amount would appear in ending inventory on the balance sheet?
a. $22
b. $46
c. $45
d. $31

12. Assume ABC sells two items and uses the LIFO method of inventory valuation. What amount would appear for cost of goods sold on the income statement?
a. $37
b. $41
c. $22
d. $31

13. Assume ABC uses the average cost method of inventory valuation. What unit cost would be used to determine the amount in ending inventory or cost of goods sold?
a. $12.67
b. $13.60
c. $15.00
d. $13.00

14. Which of the following statements is true?
a. The straight-line method of depreciation allocates a decreasing amount of depreciation expense each year.
b. Straight-line depreciation is the least used method for financial reporting purposes.
c. Fixed assets are reported at historical cost less accumulated depreciation on the balance sheet.
d. The total amount of depreciation over the assets life is larger when using an accelerated method of depreciation.

15. When will a firm regard goodwill on its books?
a. When one company acquires another company for a price in excess of the fair market value of the net identifiable assets acquired.
b. When the firm donates property to charities.
c. When it is determined that there has been a loss of value of long-term assets.
d. When fixed assets are impaired.

16. Which of the following accounts could be categorized as either a current or noncurrent liability depending on date the debt is due?
a. Notes payable and deferred taxes.
b. Accounts payable and current portion of long-term debt.
c. Deferred taxes and mortgages due in 30 years.
d. Long-term warranties and accounts payable.

17. Which items would be classified as long-term debt?
a. Accounts payable, unearned revenue, pension liabilities.
b. Common stock, retained earnings, bonds payable.
c. Mortgages, convertible debentures, bonds payable.
d. Deferred taxes, accrued expenses, treasury stock.

18. How are deferred taxes recorded on the balance sheet?
a. As current or noncurrent liabilities.
b. As stockholders equity.
c. As noncurrent assets or noncurrent liabilities.
d. As current or noncurrent assets or liabilities.

19. Which stockholders equity account represents the sum of every dollar a company has earned since its inception, less any payments made to shareholders in the form of dividends?
a. Treasury stock.
b. Accumulated other comprehensive income
c. Retained earnings.
d. Preferred stock.

20. Which item below would not be a quality of financial reporting issue related to the balance sheet?
a. Mismatching the type of debt (short or long-term) used to finance assets.
b. Discretionary expenses.
c. Overvaluation of assets.
d. Off-balance sheet financing.

Short Answer/Problem
1. Explain the format and key components of a balance sheet prepared in the U.S. or overseas.

2. Define current assets and current liabilities and give two examples of each.

3. Why should the allowance for doubtful accounts and the valuation and qualifying accounts schedule be analyzed?

4. Write a short explanation of why you agree or disagree with the following statement:

The LIFO method of inventory valuation cannot be used by grocery stores.

5. Explain the impact of calculating depreciation using the straight-line method versus an accelerated method on the amounts shown on a balance sheet.

6. Using the following information analyze the accounts receivable and the allowance for doubtful accounts for this company:

2015 2014
Sales $11,230 $10,340
Accounts receivable, net 1,510 1,860
Allowance for doubtful accounts 43 32

7. Using the following excerpts from the most recent annual report of WooHoo, a high technology firm, analyze the accounts receivable and allowance for doubtful accounts. Be sure to show all calculations and write a thorough interpretation of those calculations.

(dollars in millions) 2015 2014
Net sales $7,200 $6,400
Accounts receivable less allowance for doubtful accounts of $22 at April 30, 2015 and $40 April 30, 2014 $1,000 $1,030

WooHoo
Valuation And Qualifying Accounts
For the Years Ended April 30, 2015, 2014 and 2013

Balance at beginning of period Charged to expenses Deductions Balance at end of period
Allowance for doubtful accounts
2015 $40 $5 ($23) $22
2014 $51 $4 ($15) $40
2013 $46 $25 ($20) $51

8. Why is the inventory accounting method chosen by a company important to the user of financial statement information?

9. Using the following information calculate the ending inventory balance and the cost of goods sold expense that would be reported at the end of the year if the following inventory valuation methods are used:

a. Average cost
b. FIFO
c. LIFO
Units Purchase Price
Beginning inventory 100 $25
Purchase #1 80 $26
Purchase #2 160 $23
Purchase #3 90 $24
Sales 260

10. Using the following information calculate the ending inventory balance and the cost of goods sold expense that would be reported at the end of the year if the following inventory valuation methods are used:

a. Average cost
b. FIFO
c. LIFO
Units Purchase Price
Beginning inventory 8 $8
Purchase #1 15 $9
Purchase #2 24 $11
Purchase #3 12 $13
Sales 40

11. The Breakfast Company purchases equipment for $100,000. Management estimates that the equipment will have a useful life of eight years and no salvage value.

a. Calculate depreciation expense and the book value of the equipment at the end of the first year using the straight-line method of depreciation.
b. Calculate depreciation expense and the book value at the end of the first year using the double-declining balance method of depreciation.

12. Redtop Co. purchased a piece of equipment last year for $300,000. Management estimates that the equipment will have a useful life of five years and no salvage value. The depreciation expense recorded for tax purposes will be $72,000 this year (Year 2). The company uses the straight-line method of depreciation for reporting purposes.

a. Calculate the amount of depreciation expense for reporting purposes this year (Year 2).
b. What will be the net book value of the equipment reported on the balance sheet at the end of this year (Year 2)?
c. Will a deferred tax asset or liability be created as a result of the depreciation recorded for tax and financial reporting purposes?
d. What amount will be added to the deferred tax account as a result of the depreciation timing difference?

13. Explain the differences between accounts payable, short-term debt, current maturities of long-term debt, accrued liabilities and unearned revenue.

14. Explain the differences between long-term notes payable, mortgages, debentures, bonds payable, and convertible debt.

15. Using the following balance sheet, prepare a common size balance sheet:

Assets Liabilities and stockholders equity
Current assets Current liabilities
Cash 4 Accounts payable 28
Short-term investments 9 Current portion of
Accounts receivable 32 long-term debt 12 Inventory 41 Total current liabilities 40
Prepaid expenses 2 Long-term liabilities
Deferred taxes, current 7 Long-term debt 48
Total current assets 95 Total liabilities 88
Long-term assets Stockholders equity
Property & equipment 53 Common stock and PIC 51 Goodwill 12 Retained earnings 30
Long-term investments 8
Other assets 1 Total stockholders equity 81
Total assets 169 Total liabilities and equity 169

16. Analyze the following common size balance sheet:

2015 2014
Current assets:
Cash 1% 16%
Accounts receivable 24 18
Inventory 35 30
Total current assets 60% 64%

Property, plant and equipment 37 26
Other assets 3 10
Total assets 100% 100%

Current liabilities:
Accounts payable 29% 27%
Short-term debt 23 33
Total current liabilities 52% 60%

Long-term debt 22 17
Total liabilities 74% 77%

Common stock and paid in capital 9 10
Retained earnings 17 13
Total stockholders equity 26% 23%
Total liabilities and stockholders equity 100% 100%


Solutions Chapter 2

True-False

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

Fill in the Blank

1. common-size balance sheet
2. Current assets
3. Marketable securities
4. allowance for doubtful accounts
5. valuation and qualifying accounts
6. FIFO, LIFO, average cost
7. Goodwill
8. unearned revenue, deferred credits
9. capital
10. commitments and contingencies

Multiple Choice

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

Short Answer/Problem

1. The balance sheet is a picture of the balancing equation: Assets = Liabilities + Stockholders equity. Two years of balance sheet data is included and the statement is prepared at a point in time. Many balance sheets are classified. This means that the asset and liability sections are categorized into key sections. Asset classifications generally include a section for current assets, property, plant and equipment, intangible assets and other assets, while liability classifications include current liabilities and noncurrent liabilities. In the U.S., accounts are usually listed in terms of liquidity within sections. The most liquid assets are listed first; liabilities are listed in order of maturity. The format used for companies using IFRS varies with some firms using the U.S. format. A common format used by international firms is to list assets and liabilities in reverse order with noncurrent assets listed before current assets and noncurrent liabilities listed before current liabilities. Some foreign firms also switch the order of stockholders equity and liabilities, listing equity before liabilities.

2. Current assets include cash or those assets expected to be converted into cash within one year or one operating cycle, whichever is longer. The operating cycle is the time required to purchase or manufacture inventory, sell the product, and collect the cash. Examples of current assets include cash, marketable securities, accounts receivable, inventory, prepaid expenses which expire in one year. Current liabilities represent claims against assets that must be satisfied in one year or one operating cycle, whichever is longer. Examples of current liability accounts include accounts payable, short-term debt, current maturities of long-term debt, accrued liabilities, unearned revenue.

3. The allowance for doubtful accounts can be important in assessing earnings quality. If, for instance, a company expands sales by lowering its credit standards, there should be a corresponding percentage increase in the allowance account. The estimation of this account will affect both the valuation of accounts receivable on the balance sheet and the recognition of bad debt expense on the income statement. The analyst should be alert to changes in the allowance accountboth relative to the level of sales and the amount of accounts receivable outstandingand to the justification for any variations from past practices. The analyst should use the valuation and qualifying accounts schedule to assess the probability that the firm is intentionally over- or underestimating the allowance account to manipulate the net earnings number on the income statement. This schedule shows the estimates of bed debt expense made each year as well as the actual amount of accounts receivable written off.

4. The statement is false. Inventory valuation is based on an assumption regarding the flow of goods and has nothing whatever to do with the actual order in which products are sold. The cost flow assumption is made in order to match the cost of products sold during an accounting period to the revenue generated from the sales and to assign a dollar value to the inventory remaining for sale at the end of the accounting period. The physical flow of products in a grocery store is on a first-in, first-out basis, however, GAAP does not require that the cost flow method used for accounting purposes match the physical flow of goods. Grocery stores may use LIFO.

5. When firms record depreciation expense each year, the amount recorded is also recorded in the accumulated depreciation account which is then deducted from the fixed assets on the balance sheet. If depreciation is recorded using the straight-line method a smaller amount of depreciation is recorded in the early years of the life of an asset compared to an accelerated method. In later years the straight-line method will cause a higher amount of depreciation to be recorded relative to an accelerated method. The total amount of depreciation recorded over the life of the asset is the same regardless of method.

6. 2015 2014
Allowance for doubtful accts.
Accts. Receivable + Allow. 2.8% 1.7%

Growth rates: Sales 8.6%
Accts. Receivable (net) (18.8%)(A/R, gross, (17.9%))
Allowance for doubt. accts. 34.4%

Sales for this company have increased so it is expected that the accounts receivable account would also increase. This is not necessarily a concern as it is possible the firm has done a better job collecting on accounts. It is also possible that large write-offs have occurred causing a drop in accounts receivable, however, the valuation schedule would need to be analyzed to determine if that was the reason for the decline. Since accounts receivable decreased it would be expected that the allowance for doubtful accounts would also decrease. Possible explanations for this inconsistency could be:

1. the company has loosened its credit policy,
2. prior bad debt estimates were too low and the company is correcting
for this, or
3. management has intentionally increased bad debts now with the intent to reduce the estimates in future years to report a higher net income in a later year.

7. 2015 2014
Allowance for doubtful accts.
Accts. Receivable + Allow. 2.2% 3.7%

Growth rates: Sales 12.5%
Accts. Receivable (net) (2.9%)(A/R, gross, (4.5%))
Allowance for doubt. accts. (45.0%)

WooHoo experienced an increase in sales in 2015; however, both the accounts receivable and allowance for doubtful accounts decreased. The estimated percentage of bad debt relative to total accounts receivable has declined from 3.7% in 2014 to 2.2% in 2015, indicating management is expecting to collect more of their accounts receivable in the future.

The valuation schedule indicates that the allowance balance was somewhat high compared to actual write-offs in 2013 and 2014. The firm charged very little to the bad expense account in 2014 and 2015 which would have resulted in higher net income in those years. The allowance account balance at the end of 2015 is now lower than the actual write-offs in 2015 and may be inadequate in the upcoming year.

WooHoo may have tightened their credit policy and is anticipating better collections in the future or they may be intentionally manipulating the account to report higher income in a year with poor earnings.

8. Given the relative magnitude of inventory, the accounting method chosen to value inventory and the associated measurement of cost of goods sold have a considerable impact on a companys financial position and operating results. The method chosen by a company to account for inventory determines the value of inventory on the balance sheet and the amount of expense recognized for cost of goods sold on the income statement. The significance of inventory accounting is underlined by the presence of inflation and by the implications for tax payments and cash flow. Inventory valuation is based on an assumption regarding the flow of goods and has nothing whatever to do with the actual order in which products are sold. The cost flow assumption is made in order to match the cost of products sold during an accounting period to the revenue generated from the sales and to assign a dollar value to the inventory remaining for sale at the end of the accounting period.


9. Total units available for sale 430
Units sold 260
Units in ending inventory 170

Cost of units purchased:
100 units x $25 = $2,500
80 units x $26 = $2,080
160 units x $23 = $3,680
90 units x $24 = $2,160
430 units $10,420

a. Weighted average cost per unit:

COGS = $24.2325 x 260 units = $ 6,300
EI = $24.2325 x 170 units = $ 4,120
Total goods available for sale = $10,420

b. FIFO
COGS: EI:
100@$25 = $ 2,500 90@$24 = $ 2,160
80@$26 = $ 2,080 80@$23 = $ 1,840
80@$23 = $ 1,840 170 units $ 4,000
260 units $6,420
Check answer: COGS $ 6,420 +EI $ 4,000
Total goods available $10,420

c. LIFO
COGS: EI:
90@$24 = $ 2,160 100@$25 = $2,500
160@$23 = $ 3,680 70@$26 = $1,820
10@$26 = $ 260 170 units $4,320
260 units $6,100
Check answer: COGS $ 6,100
+EI $ 4,320
Total goods available $10,420

10. Total units available for sale 59
Units sold 40
Units in ending inventory 19

Cost of units purchased:
8 units x $ 8 = $ 64
15 units x $ 9 = $135
24 units x $11 = $264
12 units x $13 = $156
59 units $619

a. Weighted average cost per unit:

COGS = $10.4915 x 40 units = $ 420
EI = $10.4915 x 19 units = $ 199
Total goods available for sale = $ 619

b. FIFO
COGS: EI:
8@$ 8 = $ 64 7@$11 = $ 77
15@$ 9 = $ 135 12@$13 = $ 156
17@$11 = $ 187 19 units $ 233
40 units $ 386
Check answer: COGS $ 386 +EI $ 233
Total goods available $ 619

c. LIFO
COGS: EI:
12@$13 = $ 156 8@$8 = $ 64
24@$11 = $ 264 11@$9 = $ 99
4@$ 9 = $ 36 19 units $ 163
40 units $ 456
Check answer: COGS $ 456
+EI $ 163
Total goods available $ 619

11. a. $100,000 = $12,500 per year
8 years

Book value = $100,000 $12,500 = $87,500

b. $100,000 x (2 x .125) = $25,000

Book value = $100,000 $25,000 = $75,000

12. a. $300,000 = $60,000 per year
5 years

b. $300,000 60,000 60,000 = $180,000

c. Deferred tax liability.

d. $72,000 60,000 = $12,000

13. Accounts payable are short-term obligations that arise from credit extended by suppliers for the purchase of goods and services. Short-term debt (also referred to as notes payable) consists of obligations in the form of promissory notes to suppliers or financial institutions due in one year or less. When a firm has bonds, mortgages, or other forms of long-term debt outstanding, the portion of the principal that will be repaid during the upcoming year is classified as a current liability. Accrued liabilities result from the recognition of an expense in the accounting records prior to the actual payment of cash. Companies that are paid in advance for services or products record a liability referred to as unearned revenue on the receipt of cash.

14. Long-term notes payable are contractual agreements between borrower and lender (generally a bank) which designate the principal and interest repayment schedule and other conditions of the loan. Mortgages are loan agreements secured by real estate. Debentures are unsecured debt backed by the companys general credit standing. Bonds payable are financial instruments used to raise cash which are traded in capital markets. Bonds are generally issued in denominations of $1,000 (face value or maturity value) and have a stated interest rate. Since bonds are traded on markets, the issue price investors are willing to pay may be more or less than the face or maturity value. Convertible debt is debt in the form of bonds or notes that allows the investor or lender the opportunity to exchange a companys debt for common stock of that company. The terms of the agreement are specified in a document referred to as the bond indenture. The conversion price, or dollar value at which the debt may be converted into common stock, is generally set at an amount higher than the current market price of the firms stock when the debt is issued.

15.
Assets Liabilities and stockholders equity
Current assets Current liabilities
Cash 3% Accounts payable 17
Short-term investments 5 Current portion of
Accounts receivable 19 long-term debt 7
Inventory 24 Current liabilities 24%
Prepaid expenses 1 Long-term liabilities
Deferred taxes, current 4 Long-term debt 28
Total current assets 56% Total liabilities 52%
Long-term assets Stockholders equity
Property & equipment 31 Common stock and PIC 30
Goodwill 7 Retained earnings 18
Long-term investments 5
Other assets 1 Total stockholders equity 48%
Total assets 100% Total liabilities and equity 100%

16. By looking at the common size balance sheet, one can see that there have been structural changes in the components of the balance sheet equation. Cash and other assets have decreased, while accounts receivable, inventory and property, plant and equipment have increased. The company appears to have used cash to purchase property, plant and equipment. The 8% decline in current liabilities is a result of a decrease in short-term debt. Long-term debt has increased so the firm is using more permanent financing to support their assets. Retained earnings has increased which could be due to an increasing net income.

Chapter 3

True-False

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

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

3. 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.

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

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

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

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

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

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

10. 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 .

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

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

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

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

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

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

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

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

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

Multiple Choice

1. Which equation represents an income statement?
a. Assets = liabilities + stockholders equity.
b. Cash in cash out = net income.
c. Revenues expenses = net income.
d. Beginning retained earnings + revenues expenses = ending retained earnings.

2. Which format of the income statement should be used for analysis purposes?
a. Multiple-step.
b. Cash basis.
c. Single-step.
d. Accrual basis.

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

4. How is a common-size income statement prepared?
a. Each income statement item is expressed as a percentage of total assets.
b. Each income statement item is expressed as a percentage of net sales.
c. Each income statement item is expressed as a percentage of net income.
d. Each income statement item is expressed as a percentage of cash flow.

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

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

7. How should companies with more than one revenue source report revenue and cost of goods sold?
a. Each revenue source should be reported separately, but all cost of goods sold should be added together and reported as a single amount.
b. The revenues and cost of goods sold should be netted together and reported as a single line item.
c. 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.
d. Each revenue line should be shown separately with a corresponding cost of goods sold line for each revenue source.

8. Selling and administrative expenses include which of the following income statement items?
a. Salaries, insurance, interest.
b. Salaries, rent, advertising.
c. Rent, interest, cost of goods.
d. Advertising, research & development, amortization.

9. What is amortization?
a. The process used to allocate the cost of natural resources.
b. The process used to allocate the cost of tangible fixed assets.
c. The process used to allocate the cost of capital leases, leasehold improvements and intangible assets.
d. The process used to allocate the cost of oil, gas, minerals and standing timber.

10. Which item would not be classified as an operating expense?
a. Interest expense.
b. Rent expense.
c. Depreciation.
d. Repairs and maintenance.

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

12. Why is it important to assess operating profit?
a. Operating profit represents the firms profits after consideration of all revenues, expenses and comprehensive income.
b. 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.
c. Operating profit represents the firms profits after consideration of all revenues and expenses.
d. Operating profit represents the firms profits after consideration of all revenues and expenses, except for taxes.

13. Which of the items below would be included under Other income and expense?
a. Salaries, interest expense, equity losses.
b. Equity earnings, gains from sale of assets, interest income.
c. Research and development, dividend income, interest expense.
d. Advertising, cost of goods sold, selling and administrative expenses.

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

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

16. Which item is not a special item that must be disclosed separately on the income statement?
a. Extraordinary gain.
b. Extraordinary loss.
c. Foreign currency translation adjustments.
d. Discontinued operations.

17. How is earnings per common share calculated?
a. Operating profit divided by the average number of common stock shares outstanding.
b. Net profit divided by the average number of common and preferred stock shares outstanding.
c. Operating profit divided by the average number of repurchased common stock shares.
d. Net profit divided by the average number of common stock shares outstanding.

18. Which of the following items could be found on a statement of shareholders equity?
a. Reasons for retained earnings increases or decreases.
b. A reconciliation of beginning to ending cash.
c. The market value of the firms common stock.
d. 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

19. Jett Co.s gross profit, operating profit and net profit margins for 2015 are:
a. 50.0%, 32.5%, 22.5% respectively.
b. 29.2%, 12.5%, 10.0%, respectively.
c. 27.0%, 11.0%, 10.5%, respectively.
d. 21.5%, 17.5%, 12.0%, respectively.

20. Jett Co.s average tax rates for 2015 and 2014 are:
a. 15.5% and 10.0%
b. 20.0% and 35.0%
c. 25.8% and 35.4%.
d. 31.4% and 36.8%.


Short Answer/Problem

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

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

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

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

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

6. 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.

7. 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:

a. Cost method.
b. Equity method.

8. 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

9. Prepare an income statement using the following information:

Gross profit margin 40%
Gross profit $7,500
Tax rate 35%
Operating profit $400

10. 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

11. 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

12. 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%

13. 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

14. 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

15. 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.

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

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

4. 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.

5. 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.

6. 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.

7.
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

9. 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

10. 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%

11. 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 decre

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