TEST BANK for Financial Accounting in an Economic Context 8e Jamie Pratt by StudyGuide

Chapter 1 Financial Accounting and Its Economic Context

MULTIPLE CHOICE QUESTIONS 1.

The balance sheet communicates a. proof to the investor that the company is profitable. b. assets, liabilities, and shareholders’ equity with all transactions reflected through the year. c. assets, liabilities, and shareholders’ equity as of a certain date. d. operating, investing, and financing activities. Ans: C KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

The income statement communicates a. assets, liabilities, and shareholders’ equity as of a certain date. b. how much cash the owner received during the period. c. information about dividends the company paid to its owners. d. revenues less expenses during a period of time. Ans: D KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Who prepares financial reports for a particular company? a. The Securities and Exchange Commission b. The Board of Directors c. The company’s management d. The company’s auditors Ans: C KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

To run a company effectively, which one of the following might be a source from which management might acquire capital? a. Customers b. FASB c. Debt and equity investors d. Auditors Ans: C KP 4 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

1-1

1-2

Test Bank – Chapter 1 – Financial Accounting and Its Economic Context

Considering and understanding how business decisions affect the financial statements is a. the sole responsibility of the Securities and Exchange Commission. b. provided in the auditor’s report. c. referred to as an economic consequence perspective. d. interpreted strictly by the company’s suppliers. Ans: C KP 1,2,5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

A Certified Public Accountant a. reviews every transaction that a company conducts during any given year. b. performs a company’s audit. c. is one of the investors of a company. d. is responsible for the preparation and integrity of a company’s financial statements. Ans: B KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Footnotes to financial statements a. more fully explain certain items in the financial statements. b. reflect financial notes personalized by the company’s executive team. c. show the detail of salaries of every employee. d. justify fraudulent business practices. Ans: A KP 2,3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

An internal control system a. is maintained to ensure that transactions of a company are properly recorded and reported and the assets are safeguarded. b. is included in the set of footnotes to the financial statements. c. is an estimate of the profits a company expects to earn in the future. d. measures how much control management has over its staff. Ans: A KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Where would you find information on the amount of net income for the year? a. Factory production reports on units produced b. Auditor’s report c. Income statement d. Internal Revenue Service Ans: C KP 3 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 1 – Financial Accounting and Its Economic Context

10.

1-3

The statement of cash flows communicates a. assets, liabilities, and owners’ equity at a point of time. b. operating, investing, and financing activities. c. beginning balance plus income less dividends. d. how much cash the company owes its employees. Ans: B KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

11.

The retained earnings section of the statement of shareholders’ equity communicates a. beginning balance plus income less dividends. b. revenues less expenses during a period of time. c. how much cash that management has paid for bonuses. d. operating, investing, and financing activities. Ans: A KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

12.

An investor wants to find the amount of cash and land that a company has. Where will the investor look? a. Statement of shareholders’ equity b. Income statement c. Balance sheet d. Statement of cash flows Ans: C KP 3 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13.

Dividends declared and paid to the owners are found in the a. management letter. b. income statement. c. dividends statement. d. statement of shareholders’ equity. Ans: D KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

14.

Cash received by a company from its regular operations during the year is found in its a. balance sheet. b. statement of cash flows. c. statement of shareholders’ equity. d. auditor’s report. Ans: B KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

1-4

Test Bank – Chapter 1 – Financial Accounting and Its Economic Context

15.

A company’s profits during its most recent year are found in its a. balance sheet and income statement. b. statement of cash flows only. c. statement of shareholders’ equity only. d. income statement and statement of shareholders’ equity. Ans: D KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

16.

The cash paid during the year to satisfy a company’s debt is found in its a. statement of cash flows. b. income statement. c. statement of shareholders’ equity. d. auditor’s report. Ans: A KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

17.

The amount which a company’s customers owe the company for products delivered or services rendered is found in the a. footnotes only. b. income statement. c. balance sheet. d. statement of cash flows. Ans: C KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

18.

Solvency may be described as a. an amount owed that must be paid in the future. b. amounts that can be distributed to owners only. c. the amount invested in the firm by its owners. d. the ability to generate enough cash to pay its debt as the amounts become due. Ans: D KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

19.

Retained earnings may be described as a. the total past profits retained in the business. b. a company’s future growth. c. the amount invested in the firm by its owners. d. amounts retained for payments to vendors. Ans: A KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 1 – Financial Accounting and Its Economic Context

20.

1-5

Liabilities may be described as a. amounts that will be used for future growth. b. the amounts owed that must be paid in the future. c. the total measured past growth of a firm less the amount distributed to the owners. d. amounts the company paid during the past year. Ans: B KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

21.

Public stock exchanges a. are operated by managers of a company. b. are markets that sell annual reports. c. provide a forum for buying and selling of equity interests in other companies. d. are used to evaluate debt and equity investments. Ans: C KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

22.

A statement that “the financial statements were prepared in accordance with generally accepted accounting principles” is found in the a. collateral. b. stock market. c. footnotes to the balance sheet. d. auditor’s report. Ans: D KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

23.

A statement that financial statement information “is the responsibility of the company” issuing the statements is found in the a. footnotes to the financial statements. b. loan contract. c. management letter. d. board of directors’ report. Ans: C KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

24.

CPA is an abbreviation for a. Certified Public Accountant. b. Certified Production Accountant. c. Consumer Protection Agency. d. Certified Permissible Accounting. Ans: A KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

1-6

Test Bank – Chapter 1 – Financial Accounting and Its Economic Context

25.

An equity investor is a. a person who provides money to a company with the expectation that it will be paid back with interest. b. a creditor that has a regular trade relationship. c. a person who provides money to a company as a gift with a stipulation that it will be used as agreed. d. a person who provides money to a company, though the original money never has to be repaid, and who may be entitled to receive periodic cash payments. Ans: D KP 4 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

26.

An explanation about the assumptions, estimates, and choices of alternative accounting methods used in the financial statements is found in the a. footnotes to the balance sheet. b. auditor’s report. c. statement of shareholders’ equity. d. president’s letter to the shareholders. Ans: A KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

27.

A debt investor is a. a person who provides money to a company with the expectation that it will be paid back with interest. b. a person who provides money to a company and expects periodic cash payments in return, though the original money never has to be repaid. c. a person who provides money to a company as a gift with a stipulation that it will be used as agreed. d. often referred to as a stockholder. Ans: A KP 4 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

28.

The board of directors a. provides money to a company with the expectation that it will be paid back with interest. b. makes corporate decisions such as hiring and firing management and setting company policy. c. is responsible for the future profits of a company. d. is in charge of accounting and human resources on a daily basis. Ans: B KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 1 – Financial Accounting and Its Economic Context

29.

As a potential creditor, you are interested in a company’s ability to pay loan interest and principal as they come due. Which of the following would be of the greatest interest to you in your analysis? a. statement of shareholders’ equity. b. income statement. c. statement of cash flows. d. Statement of Financial Accounting Standards. Ans: C KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

30.

Which one of the following statements is true? a. Financial accounting is the only accounting used in the United States. b. Companies that have a profit objective use not-for-profit accounting. c. Managerial accounting targets operating decisions. d. Financial and tax accounting are virtually the same. Ans: C KP App1A BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

31.

A bank that loans money to a company is called a. a supplier. b. a creditor. c. an equity investor. d. a shareholder. Ans: B KP 1 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

32.

Which one of the following is an equity investor? a. A supplier of inventory waiting for payment b. A person who purchases common stock of a corporation c. A bank that loans money to a firm d. A person who has a savings account in a bank e. An employee that plans on investing in the company 10 years from now Ans: B KP 4 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

33.

1-7

As used in accounting, SEC is an abbreviation for a. Securities and Exchange Commission. b. South Eccentric Commissioners. c. Shareholders’ Equity Commission. d. Southeastern Conference. Ans: A KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

1-8

Test Bank – Chapter 1 – Financial Accounting and Its Economic Context

34.

The independence of the auditor is subject to question when the a. auditor is paid by the management of the company being audited. b. auditor is independent. c. audit firm is also responsible for preparing the tax return. d. auditor is paid 1% of the company’s profits for the audit services provided. Ans: D KP 5 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

35.

Which of the following statements is true? a. Shopping for favorable audit opinions is permitted by the SEC. b. No formal reporting of auditor switches is required by the SEC. c. The SEC has enacted rules to help ensure financial literacy among audit committee members. d. Since management constructs the financial statements, auditors have no legal liability to those who rely upon these reports. Ans: C KP 5 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

36.

The advantage to the user of financial accounting statements that are audited by independent certified public accountants is assurance that the a. statements are produced in accordance with generally accepted accounting principles. b. company will be solvent for at least one more year. c. company cannot remain profitable for more than 2 to 3 years. d. company pays its fair share of income taxes. Ans: A KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

37.

GAAP is an acronym for a. General Asset Accounting Procedures. b. Government Agency Accounting Procedures. c. Generally Accepted Accounting Principles. d. Global Accounting Activity Principles. Ans: C KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

38.

Debt investments a. require payments to the shareholders for periodic dividends. b. are found on a company’s income statement. c. may be secured with collateral. d. return payments at the discretion of the board of directors. Ans: C KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 1 – Financial Accounting and Its Economic Context

39.

1-9

Annual reports of public companies a. are published once per year. b. include financial statements adjusted for inflation. c. are also known as Form 10-K. d. are published by companies 4 times per year. Ans: A KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

40.

Equity investments are bought and sold a. only on the first day of each year. b. in stock exchanges such as the NASDAQ. c. by a company’s independent auditors. d. from and to the SEC. Ans: B KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

41.

Generally accepted accounting principles are determined by a. annual voting by all certified public accountants. b. a privately financed body known as the FASB. c. the SEC. d. a congressional committee that passes laws governing accounting practice. Ans: B KP 5 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

42.

Shareholders a. and employees are the owners of a company. b. receive repayment of the cash they have invested in a business. c. receive payment from a company regardless if the company is profitable or not. d. may benefit from increases in the value of their investment of a company. Ans: D KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

43.

When management goes beyond ethical boundaries in its attempt to make financial statements appear attractive, management a. should be commended for its creativity. b. will not need an annual audit. c. should pay its employees larger bonuses. d. is perpetrating fraud or possible criminal activity. Ans: D KP 5 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

1-10

44.

Test Bank – Chapter 1 – Financial Accounting and Its Economic Context

Generally accepted accounting principles a. are laws created and enacted by Congress. b. define the standards for internal management reporting. c. increase the level of credibility in financial statements. d. are created by the Securities and Exchange Commission. Ans: C KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

45.

Financial accounting practices and standards used in other countries a. are the same as practices used by United States companies. b. have different systems of financial accounting. c. are more progressive than those used by United States companies. d. will often have common practices similar to U.S. GAAP. Ans: D KP 6 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

46.

International Financial Reporting Standards (IFRS) are recognized as acceptable by major stock exchanges throughout the world except in a. England. b. Japan. c. The United States. d. France. Ans: C KP 6 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

47.

International Financial Reporting Standards (IFRS) are promulgated by a. the United Nations. b. the World Bank. c. the Big Four accounting firms. d. the IASB. Ans: D KP 6 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

48.

Which one of the following is true concerning the International Accounting Standards Board? a. It is the international accounting standards setting body that is attempting to bring greater uniformity to worldwide accounting practices. b. It approves all financial statements before they are distributed to users. c. It consistently disagrees with the FASB on its rulemaking. d. It requires both national and international companies around the world apply the same accounting principles. Ans: A KP 6 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 1 – Financial Accounting and Its Economic Context

49.

1-11

The auditors are charged with responsibility a. to detect financial fraud committed by employees during the course of their audit b. to conduct a thorough and independent audit c. to correct all errors in the financial statements d. for the accuracy and completeness of the financial statements Ans: B KP 1 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

50.

Select the name that doesn’t fit with the others on the list. a. PricewaterhouseCoopers b. Sarbanes-Oxley c. Deloitte & Touche d. KPMG Peat Marwick Ans: B KP 5 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

51.

What encourages management to refrain from pressuring auditors too strongly? a. Possible legal liability b. Outside investors and creditors c. Prospects of higher net income d. Economic incentives from outsiders Ans: A KP 5 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

52.

Which of the following best describes the two perspectives of the financial reporting process that managers need to understand in investing decisions? a. Economic consequences and user orientation. b. Corporate governance and user orientation. c. User orientation and debt covenants. d. Economic consequences and corporate governance. Ans: A KP 1 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

53.

All of the following might be found in the auditor's report except: a. A statement about conformity with GAAP. b. A statement about the fair presentation of the financial conditions and operations of the audited company. c. A statement about the effectiveness of the company's internal control system. d. A statement about the function of the company's board of directors. Ans: D KP 3 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

1-12

54.

Test Bank – Chapter 1 – Financial Accounting and Its Economic Context

Which of the following best describes assets paid to owners of a company as a return for their initial investment? a. payables b. compensation contracts c. dividends d. interest Ans: C KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

55.

Where would you most likely find a detailed explanation about estimates used in the financial statements of a company? a. management letter b. financial footnotes c. debt restrictions d. debt contracts Ans: B KP 3 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

56.

All of the following would likely be part of a loan contract except: a. maturity date b. earning power c. collateral d. annual interest Ans: B KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

57.

Which of the following statements is true? a. Dividend payments are determined by management. b. Dividend payments are specified by a contract. c. Dividend payments are based on company collateral. d. Dividend payments are paid at the board of director's discretion. Ans: D KP 4 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

58.

All of the following are functions of the board of directors except: a. Attending quarterly meetings. b. Conducting performance review for management. c. Declaring dividends. d. Firing staff personnel. Ans: D KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 1 – Financial Accounting and Its Economic Context

59.

1-13

Which of the following is a measure of past profits that have been retained in a business? a liabilities b. common stock. c. retained earnings. d. assets Ans: C KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

60.

Which of the following is least likely to be a by-product of ethical business practices? a. fewer lawsuits. b. higher profits. c. higher audit fees. d. public trust. Ans: C KP 5 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

61.

Which of the following factors is least likely to encourage managers and auditors to act professionally? a. professional reputation. b. tax structure c. legal liability d. ethics Ans: B KP 5 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

62.

Ownership of an equity security entitles the holder to which basic right? a. The right to management outstanding loans. b. The right to pay dividends. c. The right to vote for company directors at the annual shareholders' meeting. d. The right to certify financial report reviews. Ans: C KP 4 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

63.

Which of the following is a public exchange for equity and debt securities? a. The Federal Trade Commission. b. The New York Stock Exchange. c. The Securities and Exchange Commission. d. The Financial Accounting Standards Board. Ans: B KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

1-14

64.

Test Bank – Chapter 1 – Financial Accounting and Its Economic Context

Which of the following groups make up a company’s audit committee? a. Auditors. b. Outside directors from the Board. c. Company officers. d. All of the individuals in (a), (b), and (c) are included in the audit committee. Ans: B KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

65.

Which of the following groups enacted the Sarbanes Oxley Act? a. FASB b. AICPA c. U.S. Congress d. PCAOB Ans: C KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

66.

All of the following are false regarding international accounting standards (IAS) except which of the following? a. The SEC requires all companies to use IAS. b. There are no substantive differences between U.S. GAAP and IFRS. c. The SEC prohibits U.S. stock exchanges from listing non-U.S. companies who follow IFRS. d. All public companies in the European Union are required to report using IFRS and IAS. Ans: D KP 6 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 1 – Financial Accounting and Its Economic Context

1-15

MATCHING QUESTIONS 1.

Identify which of the users of financial statement information listed in A through E would most likely desire and/or benefit from the economic aspects listed in items 1 through 5 below. You may use each letter more than once or not at all. A. B. C. D. E.

Users bankers potential investors government agencies customers managers

_______

Want to choose a company to earn returns potentially higher than fixed income instruments

_______

Need to predict future cash flows necessary for repayment

_______

Want to determine how much tax a company must pay

_______

Want the best product possible for the money

_______

Want to maintain a level of compensation

Solution: 1. B 2. A 3. C 4. D 5. E KP 1,2,4 BT: C Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

1-16

Test Bank – Chapter 1 – Financial Accounting and Its Economic Context

For each description listed in items 1 through 4 below, select the letter of the accounting term (A through F) it best describes. You may use each letter more than once. Accounting Terms A. Asset B. Liability C. Retained earnings D. Revenue E. Expenses F. Equity investment _______

1. Total measured past growth less the amount distributed to owners

_______

2. A measure of assets generated from the products and services sold

_______

3. Owed and must be paid in the future

_______

4. Amount invested in the firm by its owners

Solution: 1. C 2. D 3. B 4. F KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

For each financial statement listed in 1 through 4 below, place the letter (A through D) of the best description in the space provided. You may use each letter more than once or not at all. A. B. C. D.

Descriptions Assets, liabilities, and shareholders’ equity Increased by net income and decreased by dividends Operating, investing, and financing activities Revenues less expenses

_______

1. Balance sheet

_______

2. Income statement

_______

3. The retained earnings section of the statement of shareholders’ equity

_______

4. Statement of cash flows

Solution: 1. A 2. D 3. B 4. C KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 1 – Financial Accounting and Its Economic Context

1-17

Identify which accounting document(s) listed in A through D would always provide the information indicated in items 1 through 5 below. You may use each letter more than once or not at all. Some items may require more than one answer. Accounting Documents A. Auditor’s report B. Management letter C. Financial statements D. Footnotes _______

1. Represents that the financial statements are stated fairly, in all material respects

_______

2. Indicates that financial statements were prepared in conformity with GAAP

_______

3. Contains assets, liabilities, and equity, as well as income from operations

_______

4. Explains certain items on the balance sheet

_______

5. An acceptance of responsibility of financial information provided

Solution: 1. A 2. A, B, D 3. C 4. D 5. B KP 2,3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting SHORT ANSWER QUESTIONS 1.

Which financial statement would you review to determine the amount of cash a company received from an issue of capital stock during the year? Solution:

statement of cash flows

KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting 2.

Which financial statement would you review to determine a company’s interest expense? Solution:

income statement

KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

1-18

Test Bank – Chapter 1 – Financial Accounting and Its Economic Context

What independent party attests that the balance sheet and income statement present fairly the financial position of the company? Solution:

auditor

KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting 4.

Identify the financial statement in which revenues less expenses are reported. Solution:

income statement

KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

What financial shareholders? Solution:

statement

communicates

profits

retained

and

distributions

statement of shareholders’ equity

KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting 6.

What financial statement communicates cash flows from operating activities? Solution:

statement of cash flows

KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

What financial statement lists and measures assets, liabilities, and shareholders’ equity at a certain date? Solution:

balance sheet

KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

What financial statement shows where the money came from and where it went? Solution:

statement of cash flows

KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 1 – Financial Accounting and Its Economic Context

1-19

Identify which financial statement you would review to determine the amount of cash a company paid to retire its debt. Solution:

statement of cash flows

KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

10.

Which source would you review to determine that the financial statements are fairly stated in accordance with GAAP? Solution:

auditor’s report

KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

11.

Which financial statement would you review to determine if a company’s operating cash flow is sufficient to pay day-to-day obligations? Solution:

statement of cash flows

KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

12.

Which financial statement would best help you understand the increases and decreases in cash over a period of time? Solution:

statement of cash flows

KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13.

What financial statement would you review to determine if a company’s payroll exceeds $1,000,000? Solution:

income statement

KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

14.

What financial statement would you review to determine the profitability ratio? Solution:

income statement

KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

1-20

15.

Test Bank – Chapter 1 – Financial Accounting and Its Economic Context

What financial statement would you review to determine whether or not dividends were distributed during the year? Solution:

statement of shareholders’ equity and the statement of cash flow

KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

16.

On which financial statement would you find the amount invested by a company’s owners? What is the name of this amount? Solution: equity

balance sheet; equity investment (stock), also statement of shareholders’

KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

17.

On which financial statement(s) would you find the accumulation of total profits and losses less distributions to owners since the company began operations? What is the name of this amount? Solution:

balance sheet and statement of shareholders’ equity; retained earnings

KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

18.

What accounting name is given to one who provides money to a company with the expectation that it will be paid back with interest? Solution:

debt investor or creditor and lender

KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

19.

What is the name of a person who provides money to a company who never has to be paid back but expects periodic cash payments? Solution:

equity investor or owner

KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 1 – Financial Accounting and Its Economic Context

20.

1-21

Identify the responsibilities of the board of directors. Solution:

Sets company policies; declares dividends; sets management compensation; hires and fires management; appoints the audit committee

KP 4 BT: K Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

21.

Who assesses whether the financial statements fairly represent the financial position and results of operations? Solution:

independent auditor

KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

22.

Where would you most likely find statements revealing the assumptions, estimates, and choices of alternative accounting methods used in the balance sheet? Solution:

footnotes to the financial statements

KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

23.

List the names of the financial statements that appear in an annual report. Solution:

balance sheet, income statement, statement of cash flows, statement of shareholders’ equity

KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

1-22

Test Bank – Chapter 1 – Financial Accounting and Its Economic Context

SHORT PROBLEMS 1.

Bricklin Company has $600 in its checking account. A customer owes Bricklin $1,000. The company has store equipment that cost $1,500 and a truck that cost $5,000. Bricklin Company owes the bank $3,500 on the truck loan of which one payment of $700 is due in one week, and owes $4,000 to creditors for its monthly operating expenses, including rent, all of which is due in the next 30 days. A. List Bricklin Company’s assets and the dollar amount of each. B. List Bricklin Company’s liabilities and the dollar amount of each. C. Is Bricklin Company solvent? Explain. Solution: A. ASSETS Cash Accounts receivable Truck Store equipment Total

$ 600 1,000 5,000 1,500 $8,100

B. LIABILITIES Note payable (truck loan) Accounts payable Total

$3,500 4,000 $7,500

C. Solvency is the ability of a company to generate cash in order to meet its debts as they come due. While Bricklin Company’s assets exceed its liabilities by $600, the company is not solvent. A truck payment of $700 is due in one week, but only $600 of cash is available. Bricklin cannot be sure when the customer will pay the $1,000 amount owed. Bricklin Company appears to have a cash flow problem. KP 3 BT: AN Difficulty: Moderate TOT: 7 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 1 – Financial Accounting and Its Economic Context

1-23

Matura, Inc. reported the following activities for the year: • Borrowed $300,000 from the bank to be repaid in 5 years • Issued stock to investors for $35,000 cash • Paid dividends to shareholders totaling $10,000 • Purchased equipment by promising to pay $145,000 to a creditor over the next 3 years A. Identify which activities are debt investments. B. Identify which activities are equity investments. Solution: A. Debt investments:

B. Equity investments:

Borrowed $300,000 from the bank to be repaid in 5 years Promising to pay $145,000 to a creditor over the next 3 years Issued stock to investors for $35,000 cash

KP 4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Sonnan Company showed profits for the last two years totaling $115,000 and $250,000, respectively. Sonnan Company paid a total of $94,000 to its owners over the two-year period. A. How much remains in Sonnan Company as retained earnings at the end of the second year of business? B. Briefly explain the concept of ‘earning power’ as it pertains to Sonnan Company. Solution: A. Total profits ($115,000 + $250,000) Distributions to owners

$365,000 ( 94,000) $271,000

B. Earning power is the ability to grow and provide a substantial return to its owners. Sonnan Company demonstrates earning power given by the fact that it paid a portion of its earnings to its owners, yet retained a sizable portion to finance the business for future income production. KP 3 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

1-24

Test Bank – Chapter 1 – Financial Accounting and Its Economic Context

SHORT ESSAY QUESTIONS 1.

What is the role of the Securities and Exchange Commission? Solution: The Securities and Exchange Commission is an agency of the federal government that was commissioned to implement and enforce the Securities Act of 1933 and the Securities Exchange Act of 1934. KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Veronica Ingram is the CEO of a small corporation whose stock is traded on public stock exchange. She has been concerned with the high cost of producing and distributing annual financial statements. She has proposed that the corporation stop producing these financial reports which would save the company $240,000 annually. Briefly explain to Ms. Ingram why her proposal cannot be adopted. Solution: Although the $240,000 savings is significant, failure to comply with the Securities Exchange Act of 1934 is a violation of regulatory practices for publicly held companies. This Act requires companies with equity securities that are listed on public security markets to (1) annually file a Form 10-K (audited financial reports), (2) quarterly 10-Qs (unaudited quarterly financial statements) and (3) annually provide audited financial reports to the shareholders. Violations lead to being barred from public trading. KP 1 BT: AP Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Why might corporate management want to lobby the FASB? Solution: Corporate management and other interested parties wish to influence generally accepted accounting principles (GAAP). Because financial statements are prepared by management using GAAP, management is very concerned that accounting principles used provide benefits to investors, creditors, and the others associated with financial reporting. KP 5 BT: AP Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 1 – Financial Accounting and Its Economic Context

1-25

Describe the three components of the statement of cash flows. Solution: The three components of the statement of cash flows are operating, investing, and financing activities. Operating activities are associated with the actual products and services provided by a company. Investing activities include the purchase and sale of assets, such as equipment and land. Financing activities refer to the collections and payments related to a company’s capital resources, such as cash borrowings, loan payments, cash from owners, and payment of dividends to owners. KP 3 BT: K Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

The Sarbanes-Oxley Act was passed by Congress in 2002 in response to a series of financial and accounting scandals. The purpose of the Act was to bolster corporate governance and restore confidence in the financial reporting system. Describe one of the new things that the management of a US public corporation is required to do under this act. Solution: • • • •

certification that the financial statements have been reviewed by the CEO and CFO, or file an annual report on internal controls over financial reporting, or additional responsibilities to ensure that adequate internal controls and in place, or provide reasonable assurance that financial records are complete and accurate.

KP 5 BT: K Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Frank Smithson, chief operating officer for Star Master Corporation, has discovered that two separate and distinct sets of financial statements are being provided—one to the Internal Revenue Service and the other to its shareholders. He objected to this policy and is insisting that one set of financial statements be provided to all interested parties. Provide examples of the needs of the two parties. Solution: Although one might initially react favorably to Frank’s proposal of one set of financial statements for all users, it would be impossible. Various rules for determining income and financial position are specified by each user. These rules reflect different uses of accounting information. The IRS raises money to support government operations and has codified rules designed to accomplish this task. The public information provided to shareholders and other outside parties is governed by generally accepted accounting principles that are designed to provide the general users with information required for investment decisions. KP 5 BT: AP Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

1-26

Test Bank – Chapter 1 – Financial Accounting and Its Economic Context

Describe the two components of the income statement. Solution: The two components of the income statement are revenues and expenses, the difference of which represents net income or loss for a period of time. Revenues are a measure of the assets generated from the products sold and services provided. Expenses are a measure of the asset outflows or costs associated with selling the products and providing the services. KP 3 BT: K Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Why must managers understand financial reporting? Solution: Managers often use financial statements to assess the financial condition and performance of their own company, its competitors, and other companies of which investments in stocks and bonds of other companies might be undertaken. Managers must understand how business decisions affect the financial statements and how capital providers and other outsiders use financial statements to evaluate and control their actions. KP 1 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

What information is provided in a management letter? Who signs it? Solution: The CEO and CFO provide a management letter that acknowledges responsibility for the financial information provided in the financial statements and notes. KP 2 BT: K Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

10.

What powers does the Securities and Exchange Commission have? Solution: The Securities and Exchange Commission has the power to prescribe the accounting practices and standards to be employed by companies within its jurisdiction—public companies. However, the SEC has chosen to delegate the responsibility for establishing accounting practices and standards to the Financial Accounting Standards Board (FASB). The SEC also is responsible for ensuring that listed companies prepare and file registration statements before they issue new securities, and file periodic quarterly and annual reports. KP 5 BT: K Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 1 – Financial Accounting and Its Economic Context

11.

1-27

What are the two fundamental economic reasons why investors and creditors demand financial accounting information? Solution: Creditors need financial information to monitor and enforce the debt and compensation contracts written with management, and investors need financial information to help decide where to invest their funds. KP 1 BT: K Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

12.

What methods of controlling the ethical decisions by managers are common? Why are these methods necessary? Solution: The methods of controlling the quality of management decisions are financial statements, debt and compensation contracts, the board of directors, auditors, and the audit committee. These methods are necessary in order to protect the investments of shareholders and creditors. KP 5 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Chapter 2 The Financial Statements

MULTIPLE CHOICE QUESTIONS 1.

Current assets are: a. all assets except inventory. b. all assets that provide benefits extending beyond one year. c. cash, accounts receivable, and buildings. d. all assets that are expected to be converted to cash in the near future. Ans: D KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Intangible assets are: a. goodwill, patents, copyrights, and trademarks. b. property, plant, and equipment. c. all assets except current assets. d. those assets that an owner can purchase with cash only. Ans: A KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Long-term investments can include all of the following except: a. notes receivable maturing in nine months. b. equity securities of another company to be held for more than a year. c. ten-year debt securities of another company. d. land to be held beyond one year. Ans: A KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Which one of the following is an asset? a. A patent of a company’s secret formula for reverse osmosis. b. Retained earnings. c. Notes payable. d. Accounts payable. Ans: A KP 2 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

2-1

2-2

Test Bank – Chapter 2 – The Financial Statements

Which one of the following groups of accounts contains only assets? a. Equipment, patents, accounts receivable. b. Accounts receivable, building, retained earnings. c. Accounts payable, notes payable, contributed capital. d. Retained earnings, goodwill, and accounts payable. Ans: A KP 2 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Which one of the following groups of accounts contains only assets? a. Contributed capital, retained earnings, revenues. b. Cash, contributed capital, retained earnings. c. Prepaid expenses, land, accounts receivable. d. Building, equipment, depreciation expense. Ans: C KP 2 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Which one of the following is a liability? a. Interest receivable. b. Contributed capital. c. Retained earnings. d. Wages payable. Ans: D KP 2 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Which one of the following groups of accounts contains only current assets? a. Inventory, accounts receivable, equipment. b. Cash, equipment, copyrights. c. Cash, accounts receivable, merchandise inventory. d. Patents, copyrights, and trademarks. Ans: C KP 2 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Which one of the following creates a decrease in retained earnings? a. Prepaid assets. b. Equipment. c. Dividends. d. Merchandise inventory not sold. Ans: C KP 2 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 2 – The Financial Statements

10.

At the end of 2009, Campbell Company has total assets and liabilities at $45,000 and $13,000, respectively. Campbell reported net income for 2010 in the amount of $10,000. How much is shareholders’ equity at the end of 2010? a. $20,000 b. $22,000 c. $31,000 d. $42,000 Ans: D KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement Solution:

11.

$45,000  $13,000 + $10,000 = $42,000

Which account is associated with the sale of inventory? a. Cost of goods sold. b. Depreciation. c. Inventory expense. d. Equipment. Ans: A KP 2 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

12.

Which account is associated with borrowing money? a. Interest expense. b. Goodwill. c. Cost of goods sold. d. Depreciation. Ans: A KP 2 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13.

Which expense is associated with long-term assets? a. Dividends. b. Depreciation. c. Cost of goods sold. d. Interest. Ans: B KP 2 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

14.

2-3

Which expense is associated with the use of patents? a. Interest. b. Amortization. c. Cost of goods sold. d. Depreciation. Ans: B KP 2 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

2-4

Test Bank – Chapter 2 – The Financial Statements

15.

The major accounting difference between interest expenses for creditors and dividends declared and paid to shareholders is that interest expenses: a. decrease retained earnings and dividends increase retained earnings. b. impact cash flows, while dividends do not. c. are not on the income statement while dividends declared and paid are. d. are on the income statement and dividends declared and paid are not. Ans: D KP 2 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

16.

Desert Company has retained earnings of $12,000, total assets totaling $39,000, and total liabilities of $20,000. How much is total shareholders’ equity? a. $6,000 b. $17,000 c. $19,000 d. $27,000 Ans: C KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement Solution:

17.

$39,000 − $20,000 = $19,000

Valley Company has cash, current liabilities, and long-term liabilities of $110,000, $20,000, and $31,000, respectively. Valley has no current assets other than cash. How much cash can Valley use to acquire equipment so that amount of current assets is double the amount of current liabilities? a. $10,000 b. $70,000 c. $91,000 d. $60,000 Ans: B KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement Solution:

18.

$110,000 − [2 x $20,000] = $70,000

Favre Company has current assets, shareholders’ equity, current liabilities, and longterm liabilities of $8,000, $26,000, $4,000, and $8,000, respectively. How much are longterm assets? a. $12,000 b. $30,000 c. $32,000 d. $46,000 Ans: B KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 2 – The Financial Statements

Solution:

19.

2-5

[$26,000 + $8,000 + $4,000] − $8,000 = $30,000

Which one of the following equations represents retained earnings activity for a year? a. Beginning balance + expenses – dividends = ending balance. b. Beginning balance + cash receipts – cash payments = ending balance. c. Beginning balance + dividends – net income = ending balance. d. Beginning balance + net income – dividends = ending balance. Ans: D KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

20.

Which one of the following appears on the income statement? a. Inventory. b. Retained earnings. c. Dividends. d. Interest revenue. Ans: D KP 2 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

21.

Which one of the following groups of accounts contains only liabilities? a. Accounts payable, retained earnings, notes payable. b. Supplies expense, cost of goods sold, interest expense. c. Wages payable, mortgage payable, taxes payable. d. Contributed capital, accounts payable, retained earnings. Ans: C KP 2 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

22.

When an entrepreneur wishes to start a business, capital must be attracted in the form of: a. net income. b. cost of goods sold. c. operating activities. d. equity or debt financing. Ans: D KP 1 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking, Industry AICPA FN: Measurement

23.

If the beginning and ending balances in retained earnings are $13,000 and $10,000, respectively, and dividends during the year are $10,000, then net income for the year is: a. $14,000. b. $7,000. c. $18,000. d. $32,000. Ans: B KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

2-6

Test Bank – Chapter 2 – The Financial Statements

Solution:

24.

$13,000 + X − $10,000 = $10,000 X = $7,000

Kelly Company has total assets, liabilities, and shareholders’ equity of $30,000, $17,000, and $13,000, respectively at the beginning of 2010. If Kelly reports revenues of $130,000, expenses of $85,000, and pays dividends of $30,000, how much is shareholders’ equity at the end of 2010? a. $28,000 b. $53,000 c. $44,000 d. Not enough information to determine. Ans: A KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement Solution:

25.

$13,000 + [$130,000 − $85,000] − $30,000 = $28,000

Sanchez Corporation has total assets, current liabilities, and long-term liabilities of $38,000, $2,000, and $13,000, respectively. If Sanchez purchases equipment for $4,000 for cash, how much would shareholders’ equity be? a. $23,000 b. $10,000 c. $24,000 d. $11,000 Ans: A KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement Solution:

26.

$38,000 − $2,000 − $13,000 + $4,000 − $4,000 = $23,000

The acquisition of equity and debt financing is considered: a. a financing activity. b. net income. c. an investing activity. d. an operating activity. Ans: A KP 1 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

27.

Which one of the following is considered an operating activity? a. Payment to a vendor for supplies. b. Purchase of company trucks for cash. c. Payment of dividends to shareholders. d. Issuing stock to investors. Ans: A KP 1 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 2 – The Financial Statements

28.

2-7

Smith Corp. earned $200,000 profit during 2010. On which financial statement(s) will the exact dollar amount of the profit be clearly stated? a. Statement of shareholders’ equity and income statement. b. Income statement only. c. Balance sheet and income statement. d. Statement of shareholders’ equity, income statement, and the balance sheet. Ans: A KP 1 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

29.

On which financial statements will you find a company’s financial position at a specific point in time? a. All financial statements combined. b. Income statement and balance sheet. c. Balance sheet and statement of shareholders’ equity. d. Balance sheet only. Ans: D KP 2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

30.

Why are liabilities separated into current and long-term? a. Users want to know which amounts will be paid using current assets. b. Because current and long-term classifications are just common sense. c. This format helps a company determine how much profit was made. d. The SEC requires companies to do so. Ans: A KP 2 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

31.

Which one of the following statements is true? a. A company’s own stock is its most liquid asset. b. Profits are normally kept in a company’s retained earnings until distributed as dividends. c. Long-term investments will be used to pay current liabilities. d. Current assets have no physical substance. Ans: B KP 2 BT: K Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

32.

Cash reported on a company’s balance sheet represents a. the profit a company made during the current year. b. the amount the President of the Company has in his or her personal account. c. the amount collected from customers during the current year less the amount paid for expenses. d. the currency a company has access to at the balance sheet date. Ans: D KP 2 BT: K Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

2-8

Test Bank – Chapter 2 – The Financial Statements

33.

The amount a company expects to collect from its customers is: a. accounts receivable. b. short-term equity securities. c. inventory. d. accounts payable. Ans: A KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

34.

As used in accounting, “notes” may be reported: a. only as company debt offerings. b. only as assets on the balance sheet. c. as either assets or liabilities. d. on the income statement or the balance sheet. Ans: C KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

35.

Property, plant and equipment may include which of the following? a. Intangible assets and land. b. Inventory and equipment. c. Buildings and cash. d. Land and office buildings. Ans: D KP 2 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

36.

On the balance sheet, a company should report the cost of intangible assets: a. in the current assets section. b. as an amount owed to shareholders. c. as an amount that is estimated by the CFO. d. at acquired cost less any accumulated amortization. Ans: D KP 2 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

37.

A partnership and a corporation differ in that: a. a partnership is a legal entity, while a corporation is not. b. the equity sections of partnership and corporation balance sheets report different items. c. partnerships always have more cash than corporations. d. a corporation has an income statement and a partnership does not. Ans: B KP 2 BT: K Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 2 – The Financial Statements

38.

2-9

Below are several accounts from Norel Company’s accounting records. Total assets, end of year Total liabilities, end of year Contributed capital, end of year Retained earnings, beginning of year Dividends for the period Net income

$100,000 36,000 12,000 18,000 31,000 65,000

The amount of retained earnings at the end of the year is: a. $34,000. b. $40,000. c. $52,000. d. $64,000. Ans: C KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement Solution:

39.

$18,000 + 65,000 − $31,000 = $52,000 or $100,000 − $36,000 − $12,000 = $52,000

The most common revenue account is: a. cash. b. sales. c. shareholders’ equity. d. liabilities. Ans: B KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

40.

Your bank loaned ten million dollars to Hamilton Stores to finance the construction of a manufacturing plant. In which section of Hamilton’s statement of cash flows would you be able to determine whether the company used the cash to build the new plant? a. Operating activities b. Owner activities c. Financing activities d. Investing activities Ans: D KP 1 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

41.

Most investors believe that the statement of cash flows is a. a useful source of information regarding the cash flow of an entity. b. the only statement in an annual report whose results correlates to stock price value. c. too complicated. d. a useful measure of a company’s profit. Ans: A KP 2 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

2-10

42.

Test Bank – Chapter 2 – The Financial Statements

The amount reported on a company’s balance sheet as retained earnings is the same as the amount reported on the company’s: a. income statement as net income. b. statement of shareholders’ equity as beginning retained earnings. c. statement of cash flows as cash received from operating activities. d. statement of shareholders’ equity as ending retained earnings. Ans: D KP 2 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

43.

Which one of the following is not an asset? a. A company’s equity in the common stock of another company. b. A company’s trademarked name for a process. c. Retained earnings. d. Notes receivable. Ans: C KP 2 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

44.

Given below are several accounts from Caterpillar Company’s accounting records. Cash Accumulated depreciation Retained earnings, beginning of year Contributed capital Patents Dividends

$ 14,000 7,000 22,000 25,000 2,000 5,000

Net income for the year was $37,000. How much is total shareholders’ equity at the end of the year? a. $86,000. b. $82,000. c. $87,000. d. $79,000. Ans: D KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement Solution: 45.

$22,000 + $25,000 – $5,000 + $37,000 = $79,000

Seuss Company determined its total sales were $535,000, salaries expense was $210,000, dividends paid were $15,000, rent expense was $25,000, other operating expenses were $13,000, and customers still owed $4,000 at the end of the year. How much is net income for the year? a. $267,000. b. $287,000. c. $263,000. d. $530,000. Ans: B KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement Solution: $535,000 – $210,000 – $25,000 – $13,000 = $287,000

Test Bank – Chapter 2 – The Financial Statements

46.

2-11

The information below was taken from the 2010 annual report of Jena Corporation. 2010 2009 2008 Beginning cash balance $ 11,596 ? $6,925 Net cash flow from operating activities 7,987 ? 9,000 Net cash flow from investing activities 2,450 4,330 ? Net cash flow from financing activities ? (9,612) (7,500) Ending cash balance $12,983 ? $12,478 Which of the following is the missing amount for the net cash flow from investing activities for 2008? a. $4,053 b. $9,947 c. $19,827 d. $2,447 Ans: A KP 1,2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

47.

The information below was taken from the 2010 annual report of Jena Corp. 2010 2009 2008 Beginning cash balance $ 11,596 ? $6,925 Net cash flow from operating activities 7,987 ? 9,000 Net cash flow from investing activities 2,450 4,330 ? Net cash flow from financing activities ? (9,612) (7,500) Ending cash balance $12,983 ? $12,478 Which of the following is the missing amount for the beginning cash balance for 2009? a. $5,925 b. $8,741 c. $12,478 d. $5,282 Ans: C KP 1,2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

2-12

48.

Test Bank – Chapter 2 – The Financial Statements

The information below was taken from the 2010 annual report of Jena Corp. 2010 2009 Beginning cash balance $ 11,596 ? Net cash flow from operating activities 7,987 ? Net cash flow from investing activities 2,450 4,330 Net cash flow from financing activities ? (9,612) Ending cash balance $12,983 ?

2008 $6,925 9,000 ? (7,500) $12,478

Which of the following is the missing amount for the net cash flow from operating activities for 2009? a. $8,110 b. $4,400 c. $8,475 d. $3,874 Ans: B KP 1,2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

49.

The information below was taken from the 2010 annual report of Jena Corp. 2010 2009 Beginning cash balance $11,596 ? Net cash flow from operating activities 7,987 ? Net cash flow from investing activities 2,450 4,330 Net cash flow from financing activities ? (9,612) Ending cash balance $12,983 ?

2008 $6,925 9,000 ? (7,500) $12,478

Which of the following is the missing amount for the ending cash balance for 2009? a. $2,759 b. $7,158 c. $12,703 d. $11,596 Ans: D KP 1,2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

50.

2008 $6,925 9,00 ? (7,500) $12,478

Which of the following is the missing amount for the net cash flow from financing activities for 2010? a. ($21,994) b. ($9,050) c. ($1,120) d. ($14,085)

Test Bank – Chapter 2 – The Financial Statements

Ans: B KP 1,2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

51.

Garrison Corporation has the following transactions: 1. 2. 3. 4. 5. 6. 7. 8.

Dividends are paid to the shareholders. A utility bill for July is paid in August. A new warehouse facility is purchased Principal payments on outstanding debt are paid. Employees wages are paid. Forty-five units of inventory are sold for $100 each Common stock is issued for $230,000 in cash. A delivery van used for 5-years is sold for $12,000, which is its book value.

Which of the above transaction(s) are examples of financing activities? a. 1,4,7 b. 1,7,8 c. 3,8 d. 1,3,4,7,8 Ans: A KP 1,2 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

52.

Garrison Corporation has the following transactions: 1. 2. 3. 4. 5. 6. 7. 8.

Which of the above transaction(s) are examples of investing activities? a. 3,4,7,8 b. 1,4,7 c. 4,7 d. 3,8 Ans: D KP 1,2 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

53.

Garrison Corporation has the following transactions: 1. 2. 3. 4. 5. 6.

2-13

2-14

Test Bank – Chapter 2 – The Financial Statements

7. Common stock is issued for $230,000 in cash. 8. A delivery van used for 5-years is sold for $12,000, which is its book value. Which of the above transaction(s) are examples of operating activities? a. 2,3,5 b. 5,6,8 c. 2,3,5,6,8 d. 2,5,6 Ans: D KP 1,2 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

54.

Baron Company has six major headings in its income statement, which include Sales, Fees earned, Other Revenues, Cost of Goods Sold, Operating Expenses, and Other Expenses. Below are some of the income statement accounts for Baron: 1. 2. 3. 4. 5. 6.

Sales of inventories Depreciation expense Income from interest on savings account Income from dividends on investments Advertising expense. Loss on sale of building

7. 8. 9. 10. 11. 12.

Salespeople commission expense Office salary expense Gain on sale of short-term investments Sales of services provided Cost of sold inventories Interest expense on outstanding loans

Which of these would be found under the heading “Other Revenues”? a. 1,10 b. 1,3,4 c. 3,4,10 d. 3,4,9 Ans: D KP 2 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

55.

Sales of inventories Depreciation expense Income from interest on savings account Income from interest on investments Advertising expense. Loss on sale of building Salespeople commission expense

8. 9. 10. 11. 12.

Insurance expense Gain on sale of short-term investments Sales of services provided Cost of sold inventories Interest expense on outstanding loans

Which of these would be found under the heading “Operating Expenses”? a. 2,8,12

Test Bank – Chapter 2 – The Financial Statements

2-15

b. 2,7,8,12 c. 2,5,7,8,11 d. 2,5,11 Ans: C KP 2 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

56.

Hsu Company has eight major section headings in its balance sheet, which include Current Assets, Long-term investments, Property, Plant, and Equipment, Intangible Assets, Current Liabilities, Long-Term Liabilities, and Shareholders’ Equity. Below are some of the balance sheet accounts for Hsu: 1. 2. 3. 4. 5. 6.

Dividends Payable Prepaid Rent Trademarks Bonds Payable Investment Funds for Plant Expansion Inventories

7. 8. 9. 10. 11.

Wages Payable Deferred Revenues Accumulated Depreciation Building Accounts Receivable Accounts Payable

Which of these would be found under the heading “Current Assets”? a. 2,10 b. 2,6,8,10 c. 2,6,10 d. 2,5,10 Ans: C KP 2 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

57.

Dividends Payable Prepaid Rent Trademarks Bonds Payable Investment Funds for Plant Expansion Inventories

7. 8. 9. 10. 11.

Wages Payable Deferred Revenues Accumulated Depreciation Building Accounts Receivable Accounts Payable

Which of these would be found under the heading “Property, Plant, and Equipment”? a. 5,9 b. 5,6,9 c. 3,5,6,9 d. 9 Ans: D KP 2 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

2-16

Test Bank – Chapter 2 – The Financial Statements

MATCHING QUESTIONS 1. For items 1 through 3, select the appropriate section of the balance sheet in which the item would be reported. A B C D E Section

Sections Long-term Investments Property, Plant, & Equipment Current Liabilities Long-term Liabilities Shareholders’ Equity

Balance Sheet Item 1. Amounts owed for purchasing inventory from creditors (due next month). 2. Cumulative profits retained by the company since operations began. 3. Cost of a building expected to be used by the company for ten more years.

Solution:

KP 2 BT: C Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

For each item numbered 1 through 6 below, identify which accounting element(s) listed in A through H each statement describes. You may use each letter more than once or not at all. Accounting Elements A. Assets E. Revenues B. Liabilities F. Expenses C. Contributed capital G. Net income D. Retained earnings H. Dividends 1.

Total past earnings not distributed to the owners

Inflow of assets from the regular operating activities

Obligations which must be met at some future date

That which will be used to generate future economic benefits

The net growth during a period of time measured as revenues less expenses

Amount invested by equity investors

Solution: 1. D

2. E

3. B

4. A

5. G

KP 2 BT: K Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

6. C

Test Bank – Chapter 2 – The Financial Statements

2-17

For each financial statement item listed in 1 through 5 below, identify the best description by selecting from items a through f below. You may use each letter more than once or not at all. Write the letter ‘X’ for each item for which no description is listed.

a. b. c. d. e. f.

Descriptions Amount of net income or loss less distributions to the owners of the company Must be settled within one year Converted to cash within one year Amount of owners’ investment Portion of equity to which dividends reduce Land used as a site for production

Current liability

The property part of property, plant, and equipment

Retained earnings

Contributed capital

Current asset

Solution: 1. b

2. f

3. a, e

4. d

5. c

KP 2 BT: K Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

For each statement listed in 1 through 5 below, state whether it is correct or not by writing ‘Yes’ or ‘No’ in the space provided. 1. Property differs from plant and equipment in that property has no physical substance, while plant and equipment does. 2. Current assets of a major retailer, such as Sears, typically exceed 50 percent of total assets because of merchandise inventory. 3. Goodwill is common on many major U.S. companies’ balance sheets because of the numerous mergers and acquisitions that occur. 4. Yard Mart Company owes $4,700. If Yard Mart uses assets listed in the current asset section of the balance sheet to pay off this debt next year, Yard Mart must report the $4,700 in the current liability section of its balance sheet. 5. Haloid, Inc. issued common stock for cash. This is an investing activity.

. Solution: 1. No

2. Yes

3. Yes

4. Yes

KP 1,2 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

5. No

2-18

Test Bank – Chapter 2 – The Financial Statements

For each financial statement item listed in 1 through 5 below, identify in which balance sheet category (listed in a through h) it should be reported. You may use each letter more than once or not at all.

a. b. c. d. e. f. g. h.

Solution: 1. g

2. a

Financial Statement Categories Current assets Long-term investments Property, plant, and equipment Intangible assets Current liabilities Long-term liabilities Shareholders’ equity Not disclosed on the balance sheet

Contributed capital

Prepaid insurance

Accounts payable

Sales revenue

Delivery truck

3. e

4. h

5. c

KP 2 BT: C Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

For each statement listed in 1 through 5 below, state whether it is correct or not by writing ‘Yes’ or ‘No’ in the space provided. 1. Financing activities involve the sale of goods and services of a business. 2. The income statement is often referred to as a statement of financial condition. 3. The most liquid of all assets is cash. 4. The asset sections found on a classified balance sheet include current assets, current liabilities, and owners’ equity. 5. Dividends payable, Inventories, Contributed capital, and Accumulated Depreciation all appear on a company’s balance sheet.

. Solution:

1. No

2. No

3. Yes

4. No

5. Yes

KP 2 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 2 – The Financial Statements

2-19

For each financial statement item listed in 1 through 7 below, identify in which balance sheet category (listed in a through h) it should be reported. You may use each letter more than once or not at all.

a. b. c. d. e. f. g. h.

Solution: 1. c

2. a

Accumulated depreciation

Accounts receivable

Trademarks

Investment in bonds

Retained earnings

Short-term investments

Prepaid insurance

3. d

4. b

5. g

KP 2 BT: C Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

6. a

7. a

2-20

Test Bank – Chapter 2 – The Financial Statements

SHORT PROBLEMS 1.

Given below are several accounts from Kramer Company’s accounting records. Cash Accumulated depreciation Retained earnings, beginning of year Contributed capital Patents Dividends

$11,500 8,000 17,000 14,000 3,000 2,000

Net income for the year was $20,000. How much is total shareholders’ equity at the end of the year? Solution: $14,000 + 17,000 – $2,000 + $20,000 = $49,000 KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Below are several amounts from Netcom Company’s accounting records. Answer the questions that follow. Total assets, end of year Total liabilities, end of year Contributed capital, end of year Retained earnings, beginning of year Dividends for the period Net income

$190,000 30,000 20,000 65,000 15,000 32,000

A. Calculate the amount of retained earnings at the end of the year. B. If revenue amounts to $220,000, how much is ‘total expenses’? C. How do you know the company has been profitable since it began operations? Solution: A. $65,000 + $32,000 –$15,000 = $82,000 B. $220,000 – X = $32,000 Expenses = X = $188,000 C. Retained earnings, which represents the total profits since the company began operations, less all amounts distributed as dividends, has a positive balance. KP 2 BT: AN Difficulty: Moderate TOT: 5 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 2 – The Financial Statements

2-21

Following are several items from Arbor Company’s financial statements. Use this information to calculate the amounts for the questions that follow. Cost of goods sold Sales revenue Operating expenses Income taxes Dividends Accounts receivable

$2,300 8,400 500 600 400 800

Calculate the dollar amount of net income.

How much is inventory expense?

Was the company profitable during the current year? How do you know?

Solution: a. $8,400 – $2,300 – $500 – $600 = $5,000 b. $2,300 c. Yes. The amount of expenses is less than the amount of revenue.

KP 2 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

At the beginning of 2010, Kristol Company sold stock and began operations. Information from Kristol’s accounting records for the year ending December 31, 2010, follows: Sales Selling expenses Cost of goods sold Dividends General and administrative expenses Contributed capital

$500,000 240,000 180,000 100,000 50,000 60,000

Circle the names of any accounts above that would not be reported on the income statement.

Determine the amount of net income.

Solution: a. Circled accounts should be: Dividends and Contributed Capital b. $500,000 – $240,000 – $180,000 – $50,000 = $30,000 KP 2 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

2-22

Test Bank – Chapter 2 – The Financial Statements

The following are account balances of Phineas Company on 12/31/10. Accounts payable Accounts receivable Buildings and equipment Contributed capital Bonds payable Cash Retained earnings Accumulated depreciation Inventory Patents

$ 1,000 6,000 54,000 20,000 15,000 8,500 17,000 24,000 5,500 3,000

Prepare a classified balance sheet for Phineas Company on December 31, 2010. Solution: Phineas Company Classified Balance Sheet December 31, 2010 Assets Current assets: Cash Accounts receivable Inventory Total current assets Property, plant, and equipment: Buildings and equipment Less: Accumulated depreciation Total property, plant, and equipment Intangible assets: Patents Total assets Liabilities & Shareholders’ Equity Current liabilities: Accounts payable Total current liabilities Long-term liabilities: Bonds payable Total long-term liabilities Shareholders’ equity: Contributed capital Retained earnings Total shareholders’ equity Total liabilities & shareholders’ equity

$ 8,500 6,000 5,500 $20,000 $54,000 24,000 30,000 3,000 $53,000

$ 1,000 $ 1,000 15,000 15,000 $20,000 17,000 37,000 $53,000

KP 2 BT: AP Difficulty: Difficult TOT: 10 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 2 – The Financial Statements

2-23

The following is the balance sheet of Able Corporation immediately prior to deciding how to finance the purchase of a $300 addition to its building. Able Corporation Balance Sheet December 31, 2010 Assets Cash Accounts receivable Building Land Total assets

$ 300 260 390 370 $1,320

Liabilities and Shareholders’ Equity Accounts payable Long-term bonds payable Contributed capital Retained earnings Total liabilities & shareholders’ equity

$ 190 620 340 170 $1,320

The bonds payable contract agreement requires current assets to be twice as much as current liabilities. Assume the $300 addition to the building is to be paid in cash and financed by issuing more stock. Calculate and explain the maximum cash that Able can pay and still honor its debt agreement. Solution: Able’s current liabilities are $190. Under the bond agreement, its current assets must be at least $380. If Almond used $180 of cash to purchase the building addition, then it would have the $380 of current assets required by the debt covenant ($190 × 2). Therefore, Able can pay $180 and issue stock for $120 in order to finance the building project. KP 2 BT: AN Difficulty: Difficult TOT: 8 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement, Decision modeling Use the information that follows concerning Ulrich Computer for the year ending December 31, 2010 for problems 7 through 10. Several accounts and amounts from the financial statements of Ulrich Computer appear below for the year ending December 31, 2010. Cash Sales Revenue Notes Receivable, 6-month Cost of goods sold Taxes Payable Salaries Expense Accounts Receivable Dividends Equipment Accounts Payable Contributed Capital Retained Earnings Rent and Utilities Expense Income Tax Expense Inventory

$ 10,000 140,000 90,000 60,000 31,000 7,000 32,000 42,000 150,000 7,000 30,000 40,000 4,000 20,000 21,000

2-24

Test Bank – Chapter 2 – The Financial Statements

What is the total amount owed to Ulrich by its customers at the end of 2010? Solution:

$32,000

KP 2 BT: AN Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Calculate total expenses for Ulrich. Solution: $60,000 + $7,000 + $4,000 + $20,000 = $91,000 KP 2 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Calculate Ulrich’s total current assets. Solution: $10,000 + $32,000 + $90,000 + $21,000 = $153,000 KP 2 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

10.

How much must Ulrich pay out during its next accounting period for amounts owed? Solution: $7,000 + $31,000 = $38,000 KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

11.

Below is all of the account information from Chamber Company’s balance sheet, with the exception of Retained Earnings. Cash Inventory Equipment Accounts Payable Long-term Payable Contributed capital

$12,000 15,000 50,000 17,000 10,000 30,000

Using this information, please calculate the following: A.

The total amount of retained earnings for Chamber Company.

The total amount of shareholders’ equity for the company at the end in the year.

Solution: A. ($12,000 + $15,000 + $50,000) – $17,000 – $10,000 – $30,000 = $20,000 B. $30,000 + $20,000 = $50,000 KP 2 BT: AN Difficulty: Moderate TOT: 8 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 2 – The Financial Statements

12.

2-25

The following information is shown on Morris Company’s balance sheet. Answer the questions that follow. Cash Inventory Equipment Accounts Payable Bonds Payable Contributed capital

$12,000 15,000 50,000 15,000 30,000 20,000

How much did debt investors provide to Morris Company?

What is the amount of money provided by equity investors to Morris Company?

How much would be classified as property, plant, and equipment?

Solution: A. $30,000 B. $20,000 C. $50,000

KP 2 BT: AN Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

13.

Autry Company determined its total sales were $380,000, salaries expense was $120,000, dividends paid were $8,000, rent expense was $14,000, other operating expenses were $20,000, and customers still owed $2,000 at the end of the year. How much is net income for the year? Solution:

$380,000 – $120,000 – $14,000 – $20,000 = $226,000

KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

14.

If cash flows from operating activities were $3,000, cash outflows for financing activities were $2,500, and the net increase in cash was $5,000, how much are cash flows from investing activities? Solution:

$5,000 - $2,500 - $3,000 = $4,500

KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

2-26

15.

Test Bank – Chapter 2 – The Financial Statements

The following is the balance sheet of Columbus Corporation immediately prior to deciding how to finance the purchase of an additional $200,000 parcel of land. Answer the question that follows. Columbus Corporation Balance Sheet December 31, 2010 Assets Cash Accounts receivable Land Total assets

$ 180,000 60,000 270,000 $510,000

Liabilities and Shareholders’ Equity Accounts payable Contributed capital Retained earnings Total liabilities & shareholders’ equity

$ 90,000 250,000 170,000 $510,000

REQUIRED: Columbus will finance the $200,000 investment in land by issuing either $200,000 of common stock or using $200,000 of additional accounts payable that will be due in 90 days. Indicate which method of financing is preferable for Columbus. Consider the effects on short-term solvency positions. Solution: If Columbus financed the land through accounts payable, its current liabilities would exceed its current assets by $50,000. This would question Columbus’s capability to pay its current liabilities when they are due. However, if Columbus financed the investment in land by issuing common stock, its current assets would exceed its current liabilities by $150,000. This would enhance its short-term solvency position. Therefore, Columbus should issue common stock to finance the purchase of land. KP 2 BT: AN Difficulty: Difficult TOT: 8 min. AACSB: Analytic, Communication, Reflective AICPA BB: Critical Thinking AICPA FN: Measurement, Decision modeling

Test Bank – Chapter 2 – The Financial Statements

2-27

SHORT ESSAY QUESTIONS 1.

Describe operating activities. Solution: Operating activities involve the sale of goods and services and the related cost of providing the goods and services. These activities produce additional capital that can be reinvested in producing assets, used to pay debt, or distributed to the owners in the form of dividends. KP 1 BT: K Difficulty: Easy TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Which business activity occurs first for a business? Why does this business activity occur first? Solution: Financing activities typically occur first in a business. A business must acquire cash or other operating capital before any investments can be made. KP 1 BT: C Difficulty: Easy TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

What business aspect does the income statement measure? Solution: period.

The income statement measures operating performance over a particular

KP 1 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

Which asset is more liquid, inventory or accounts receivable? Why? Solution: Since amounts in the Accounts Receivable account represent inventory that is already sold, this account will generate cash more quickly than inventory that has not yet been sold. Therefore, accounts receivable is more liquid than inventory. KP 2 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

What business aspect does the statement of shareholders’ equity measure? Solution: The statement of shareholders’ equity measures changes in 1) the contributed capital accounts, representing the value of owners’ investments in the business, and in 2) the retained earnings account, which measures the extent to which the business reinvests its earnings and pays dividends. KP 1 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

2-28

Test Bank – Chapter 2 – The Financial Statements

Use the information provided from Haloid Company’s accounting records to answer questions 6 and 7. For the Years Ended December 31, 2010, and 2009 Assets 2010 Cash $ 80 Accounts receivable 40 Short-term investment in property 40 Property, plant, and equipment 350 Total assets $510 Liabilities and Shareholders’ Equity Accounts payable $ 85 Contributed capital 300 Retained earnings 125 Total liabilities & shareholders’ equity $510 Income Statement: Sales revenue $850 Expenses 800 Net Income $ 50

2009 $60 40 60 310 $470 $90 300 80 $470

How is it possible that Haloid reports “property” in two different places on its balance sheet? Solution: ‘Short-term investment in property’ is property that Haloid owns with the intention of selling in the future. However, property in ‘property, plant, and equipment’ is space that is being used for “supporting” the operations in Haloid’s business. KP 2 BT: C Difficulty: Moderate TOT: 5 min. AACSB: Analytic, Communication, Reflective AICPA BB: Critical Thinking AICPA FN: Reporting

Comment on the following statement: “On December 31, 2010, Haloid’s accounts payable exceeds its cash by $5. If Haloid needs additional money to pay its accounts payable, it can use the $125 stashed in its retained earnings”. Solution: The amount in the retained earnings account does not represent stashes of money or other tangible items. This amount simply communicates that Haloid earned and retained $125 of income in its business since it began operations. The difference between assets and liabilities is total shareholders’ equity. Retained earnings is part of shareholders’ equity. It represents earnings retained in a business—a residual amount. It is not cash. KP 2 BT: E Difficulty: Difficult TOT: 8 min. AACSB: Analytic, Communication, Reflective AICPA BB: Critical Thinking AICPA FN: Decision modeling

Explain the concept of liquidity. Solution: Liquidity is a representation of how close an asset is to cash. Assets are listed in order of liquidity on the balance sheet, with the most liquid assets first. Since cash is the most liquid asset, it is presented as the first item in the asset section of the balance sheet. KP 2 BT: C Difficulty: Easy TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 2 – The Financial Statements

10.

2-29

Give an example of a prepaid expense. Why would a company use this account? Solution: Prepaid expenses may include items such as prepaid rent, prepaid insurance, and other amounts of which payment must be made up front. KP 2 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

11.

What type of assets are included in short-term investments? Solution: Short-term investments include stock, bonds, and similar investments. Generally these securities are readily marketable and are intended by management to be sold within a short period of time, usually less than one year. KP 2 BT: K Difficulty: Moderate TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

12.

What is unique about the way plant and equipment appear on the balance sheet? Solution: Plant and equipment includes the actual costs of acquiring assets such as warehouses, office buildings, equipment, machinery, vehicles, etc. In the balance sheet, total accumulated depreciation is shown as a deduction from the cost of the plant and equipment. The balance in the accumulated depreciation account represents the total cost of the plant and equipment that has been transferred to the income statement (expensed) as it represented an allocation of the cost used up that related to past accounting periods. KP 2 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

13.

Describe how the equity sections of balance sheets differ for each of the three types of business entities. Solution: The shareholders’ equity section of the balance sheet for corporations consists of two components—contributed capital and retained earnings. Partnerships have one capital account for each owner in the owners’ equity section of the balance sheet. A proprietorship has only one capital account. Neither a partnership nor a proprietorship has a retained earnings account. KP 2 BT: C Difficulty: Moderate TOT: 5 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

14.

Why would a company use a notes receivable account?

Solution: A notes receivable account arises because companies accept notes in exchange for a sale with extended credit terms. Notes represent amounts that customers or employees have agreed to repay. Notes typically have an interest component.

2-30

Test Bank – Chapter 2 – The Financial Statements

KP 2 BT: C Difficulty: Easy TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

15.

What is the account, Accounts Payable, used for? Solution: Accounts payable represents the amount of money a company expects to pays its vendors. The payables arise from the purchase of supplies from vendors/suppliers. KP 2 BT: C Difficulty: Easy TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

16.

Describe how the amount of net income relates to the balance sheet. Solution: The balance sheet reports an item called retained earnings that represents an accumulation of all the profits earned by the company since operations began, less all the dividends paid out to shareholders. Net income for the current period is added and dividends declared are subtracted from the beginning retained earnings amount to determine the ending balance of retained earnings, which in turn is reported on the balance sheet. KP 2 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

17.

Where in a company’s financial statements would you locate the ‘book value’ of the company? Solution: The dollar amount reported as total shareholders’ equity represents the net book value of the company. Shareholders’ equity is found on the balance sheet. To calculate the book value, subtract liabilities from assets. KP 2 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

18.

Which group of financial statement users would be most concerned with the amount of a company’s total current assets and current liabilities? Solution: Creditors, such as bankers in other lenders, would be very interested in the liquidity of a company. Comparing the amount of current assets with current liabilities is a common analysis tool used by those interested in liquidity. If a company has more current liabilities than current assets, it is possible the company will not be able to pay its current bills when they come due. KP 2 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Analytic, Communication, Reflective AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 2 – The Financial Statements

19.

2-31

Which assets on a company's balance sheet have no physical substance? Explain. Solution: Intangible assets have no physical substance. They are reported as longterm assets on the balance sheet and represent the legal right to produce and sell certain products. Like other assets, they represent a potential future benefit for the company. KP 2 BT: C Difficulty: Easy TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

20.

A company sold 10 widgets. How will the amounts the company reports as ‘Sales’ differ from amounts reported as ‘Cost of Goods Sold’? Solution: The amount reported as sales represents the dollar amount for which the widgets were sold to the customers. Cost of goods sold represents the original cost paid by the company to acquire the inventory item. The difference between the dollar amount of sales and the dollar amount of cost of goods sold represents gross profit for the company. KP 2 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

21.

What concerns might you have if you examined a company's balance sheet and found a negative amount in retained earnings? Solution: A negative amount in retained earnings is common for young companies because it often takes several years to become profitable. Retained earnings may also decline and produce a negative balance (if allowed under the respective state laws) if a company pays large dividends. If the dollar amount in retained earnings is negative because of continual losses, there should be a cause for concern. KP 2 BT: E Difficulty: Difficult TOT: 7 min. AACSB: Analytic, Communication, Reflective AICPA BB: Critical Thinking AICPA FN: Decision modeling

22.

Distinguish between the amounts reported on the income statement compared to the amounts reported on the statement of cash flows. Solution: Amounts reported on the income statement are revenues and expenses. These amounts reflect general asset and liability inflows and outflows. The amounts reported on the statement of cash flows include only the cash received and the cash paid out. KP 2 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

2-32

23.

Test Bank – Chapter 2 – The Financial Statements

Explain the difference between net income and cash flow from operations. Solution: Net income, reported on the income statement, consists of revenues and expenses or more general asset and liability inflows and outflows, that may not necessarily include cash. Cash flows from operations, reported on the statement of cash flows, include only the cash inflows and outflows. KP 2 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 2 – The Financial Statements

2-33

IFRS QUESTIONS 1. Income statements prepared under IFRS sometimes use the term “turnover”, which in GAAP income statements would equate to the term: a. Return on investment b. Revenue c. Expenses d. Net Income KP 3 BT: B Difficulty: Easy TOT: 1 min. AACSB: Diversity AICPA BB: Critical Thinking AICPA FN: Reporting

2. Many non-U.S. companies preparing a balance sheet present the accounts in the following order: a. Non-current assets + current assets – current liabilities = Non-current liabilities + shareholders’ equity b. Non-current assets + current assets + current liabilities = Non-current liabilities + shareholders’ equity c. Non-current assets + current liabilities + current assets = Non-current liabilities + shareholders’ equity d. Non-current assets + current assets – current liabilities = Non-current liabilities shareholders’ equity KP 3 BT: A Difficulty: Moderate TOT: 1 min. AACSB: Diversity AICPA BB: Critical Thinking AICPA FN: Reporting

Chapter 3 The Measurement Fundamentals of Financial Accounting

MULTIPLE CHOICE QUESTIONS

When preparing the financial statements, we assume that the life of the entity will continue beyond the current period. Which assumption are we most likely following? a. Stable dollar theory. b. Going concern assumption. c. Economic entity assumption. d. Fiscal period assumption. Ans: B KP 1,2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

By recognizing the economic effects of inflation on the accounting financial statements, which accounting assumption is ignored? a. Economic entity assumption b. Going concern assumption c. Stable dollar assumption d. Fiscal period assumption Ans: C KP 1 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

A company prepares financial statements once every year. What practice does this assumption illustrate? a. Going concern assumption b. Fiscal period assumption c. The five-year moving theory d. Stable dollar assumption Ans: B KP 1 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Which assumption is applied when Laramie recognizes the operations of its wholly owned subsidiary, Big Sky, separately and distinctly from its own operations? a. Economic entity assumption b. Going concern assumption c. Fiscal period assumption d. The subsidiary stability assumption Ans: A KP 1 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement 2-1

3-2

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

Original cost may be defined as the: a. cash price of the asset when purchased. b. discounted future cash flows. c. selling price. d. price you bought the item for when it was first released for consumer sales. Ans: A KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Expensing the cost of a pencil holder that cost $1.25 instead of capitalizing it as a plant asset and depreciating it over its estimated useful life of 10 years: a. violates the economic entity assumption. b. violates GAAP since pencil holders are important assets. c. is justified because of materiality. d. is appropriate because of the stable dollar assumption. Ans: C KP 1,5 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Today’s fair market value would be the same as: a. the cash price of the asset when it was originally purchased. b. the current price paid for an item in the input market. c. the value of an item in the output market or sales price. d. the discounted future cash flows from input and output markets. Ans: C KP 2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Net realizable value is: a. the input price of liabilities. b. a form of market value. c. a present value concept. d. the current input cost. Ans: B KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Present value, as of today, would be the same as: a. the cash price of the asset when it was purchased. b. the present price of any given product or service. c. the selling price. d. the discounted value of future cash flows. Ans: D KP 2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

10.

3-3

Recognition of increases in purchasing power of monetary units is inconsistent with the: a. economic entity assumption. b. going concern assumption. c. consistency principle. d. stable dollar assumption. Ans: D KP 1 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

11.

Which one of the following statements best describes the concept of consistency? a. When uncertainty exists, understating assets, overstating liabilities, accelerating recognition of losses, and delaying recognition of gains is preferred. b. Accounting numbers are consistently market value. c. Different firms use identical accounting measurement methods for similar events. d. Similar events are measured using identical accounting procedures from period to period. Ans: D KP 4 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

12.

The valuation basis used to measure long-term liabilities is: a. present value. b. replacement cost. c. fair market value. d. historical cost. Ans: A KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

13.

The valuation basis used to measure accounts payable is: a. fair value. b. replacement cost. c. face value. d. present value. Ans: C KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

14.

Most companies prepare annual financial statements: a. with a fiscal ending date of June 30. b. on the calendar year. c. at a different date each year. d. every two weeks. Ans: B KP 1 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

3-4

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

15.

Which one of the following statements best describes objectivity? a. When uncertainty exists, understating assets, overstating liabilities, accelerating recognition of losses, and delaying recognition of gains is preferred. b. The measurement of an event is verifiable and reliable. c. Different firms use identical accounting measurement methods for similar events. d. Objectives are laid out that are conservative or too aggressive by management. Ans: B KP 3 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

16.

Which one of the following is violated when a firm has a policy of accelerating the recognition of depreciation expense during good years and decreasing depreciation expense during lean years? a. Relevance b. Matching c. Consistency d. Conservatism Ans: C KP 5 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

17.

Which one of the following is violated when a firm measures property, plant, and equipment at its estimated selling price? a. Objectivity b. Economic entity assumption c. Materiality d. Input markets Ans: A KP 2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

18.

Ten years after a company purchases a plot of land, it is measured on the balance sheet at its cost from the year it was purchased instead of its current selling price. This accounting practice is justified by the: a. financial period assumption. b. going concern assumption. c. fiscal period assumption. d. original cost base. Ans: D KP 1,2,5 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

19.

3-5

The shareholders’ equity section of the balance sheet is: a. a residual interest based on the book value of the company. b. the amount for which the owner could sell the company. c. valued at the present value of the dividends paid to shareholders. d. the difference between the fair market value and the original cost of the company’s assets. Ans: A KP 2 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

20.

The valuation basis used to measure short-term investments is: a. fair market value. b. replacement cost. c. original cost. d. present value. Ans: A KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

21.

Which one of the following statements best describes the concept of conservatism? a. Profits should be accelerated in all cases. b. The measurement of an event is verifiable and reliable. c. The value of goods and services provided is recognized when earned. d. When uncertainty exists, understating assets, overstating liabilities, accelerating recognition of losses, and delaying recognition of gains is preferred. Ans: D KP 5 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

22.

The valuation basis used to measure accounts receivable is: a. the original cost of the goods sold. b. current input cost c. net realizable value. d. replacement cost. Ans: C KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

23.

The valuation basis used to measure equipment and other plant assets on the balance sheet is: a. the dollar amount for which the assets can be sold. b. the cash expected to be received in the future. c. the original cost adjusted for depreciation. d. the assets’ net realizable value. Ans: C KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

3-6

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

24.

Technically, the valuation basis used to measure shareholders' equity is: a. original cost adjusted to net book value. b. replacement value. c. net realizable value. d. None of these. Ans: D KP 2 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

25.

Which one of the following is violated when a department store records revenue for gift certificates sold to customers that are not expected to be redeemed until next year? a. Matching b. Revenue recognition criteria c. Going concern d. Expense versus revenue concept Ans: B KP 4 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

26.

Which one of the following is violated when a retail store records revenue for a bank credit card sale prior to receiving the money from the bank? a. No violation occurred b. Objectivity c. Going concern d. Revenue recognition criteria Ans: A KP 4 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

27.

Which one of the following is violated when a company recognizes revenue upon the receipt of cash from a customer who has paid in advance for services? a. Expense policy b. Objectivity c. Matching d. Revenue recognition criteria Ans: D KP 4 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

28.

Which one of the following is violated when a firm measures accounts receivable at its face amount even though knowing some customers may not pay the amounts due? a. Consistency b. Conservatism c. Materiality d. Revenue recognition criteria

Ans: B KP 5 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

29.

3-7

Which of the following are exceptions to financial accounting measurement? a. Consistency and conservatism b. Objectivity and materiality c. Going concern and materiality d. Conservatism and materiality Ans: D KP 5 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

30.

Which one of the following is most likely violated if firm increases the dollar amount reported for unsold inventory on the balance sheet to a cost it anticipates it will have to pay for future inventory items? a. Consistency b. Conservatism c. Going concern d. Economic entity Ans: B KP 4,5 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

31.

Which one of the following reflects the proper inventory valuation on a company’s balance sheet? a. Lower of original cost or face value b. Net realizable value c. Lower of cost or market d. Expected selling price Ans: C KP 2 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

32.

Which one of the following is violated when a company records cost of goods sold expense at the time when inventory is purchased? a. Relevance b. Historical cost c. Matching d. Revenue recognition criteria Ans: C KP 4 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

33.

Which one of the following is violated when a firm reports its long-term debt at the present value of the cash flows associated with that debt? a. Matching b. No violations occurred. This accounting is correct. c. Revenue recognition d. Gross value of the debt Ans: B KP 2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

3-8

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

34.

A business entity operates in two general markets. They are: a. a producer and a consumer market. b. an economic and a fiscal market. c. an input and an output market. d. a profit and a non-profit market. Ans: C KP 2 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking, Resource Management AICPA FN: Measurement

35.

Which one of the following is violated when a sole proprietor records its magazine stand at the present value of the cash flows expected to be earned from the sale of magazine over the expected life of the stand? a. Original cost b. Fair market value c. Going concern d. Revenue recognition Ans: A KP 2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

36.

Which one of the following is violated when a company pays for its CEO’s personal groceries using the company’s bank account? a. Stable dollar b. Economic entity c. Going concern d. Ethical principle of accounting Ans: B KP 1 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

37.

Why must measures of performance and financial position be available on a timely basis? a. For the users of the financial information to make decisions b. For the SEC to determine whether the company should be shut down or not c. FASB requires this information to be submitted to them for approval d. For management to have time to manipulate income Ans: A KP 1,4 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

38.

The fiscal period assumption states that the operating life of an economic entity: a. is generally for a period of one year. b. can be any period management decides it to be. c. must be an entity separately distinct from its owners. d. can be divided into time periods over which measures can be developed and applied. Ans: D KP 1 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

39.

3-9

As fiscal periods become shorter, the application of certain accounting methods become: a. more arbitrary and subjective. b. more objective. c. more accurate. d. more conservative. Ans: A KP 1 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

40.

The stable dollar assumption assumes that: a. the monetary unit is the functional currency of any country in which a company operates. b. inflationary effects should be recognized in the financial statements c. economic wealth is not measurable. d. the monetary unit is stable across time. Ans: D KP 1 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

41.

The monetary unit that a company uses to measure economic transactions is primarily determined by the: a. stable dollar concept adjusted for inflationary effects. b. markets in which a company operates. c. fiscal period a company has chosen. d. decision by management to elect to use a given currency. Ans: B KP 1,2 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

42.

Which one of the following is considered an unrealistic assumption in accounting? a. Economic entity b. Stable dollar c. Going concern d. Fiscal period concept Ans: B KP 2 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

43.

Objective accounting information: a. cannot be used in the financial statements. b. requires that values of transactions and related assets and liabilities created by them be arbitrarily determined. c. ensures that revenue matches expenses for every accounting period. d. states that financial accounting information must be reliable and verifiable. Ans: D KP 3 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

3-10

44.

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

The matching principle states that: a. expenses should be recognized in the period that the related revenue is recognized. b. after expenses have been identified in a particular accounting period in which they were incurred, revenues can be recognized. c. each company should use the same accounting principles as other companies use. d. for every dollar of revenue recognized, the company should recognize a corresponding dollar of expenses. Ans: A KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

45.

Morgan Shipping held cash of $1 million throughout 2010 when the general price level decreased by over 30 percent. Morgan Shipping: a. has more than $1 million of purchasing power at the end of the period. b. has less than $1 million purchasing power at the end of the period. c. must recognize the gain due to general price level increases in its income statement. d. has the same $1 million purchasing power at the end of the period as at the beginning of the period. Ans: A KP 1 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

47.

The most common point of revenue recognition is: a. when the cash is collected from the customer. b. when the customer elects to issue the check to pay for goods shipped. c. when the goods are delivered to the customer. d. as the goods are being produced. Ans: C KP 4 BT: K Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

48.

The principle of consistency states that: a. companies should choose a set of accounting methods and use them from one period to the next. b. once a company selects an accounting method, it must use that method throughout the company's entire existence. c. a company may change any accounting method, provided the SEC approves the change. d. companies should elect to use methods that consistently inflate profits. Ans: A KP 4 BT: K Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

49.

3-11

Everett, Inc.’s reporting period ends on June 30th every year. This is an example of: a. matching. b. fiscal period. c. materiality. d. relevance. Ans: B KP 1 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

50.

Which of the following represents two of the four criteria that must be met before revenue can be included in the income statement? a. The amount of revenue must be objectively measurable and the cash must be collected. b. The company elects to record the revenue and the cash for payment is relatively certain. c. The company must intend to transfer the goods or services to the buyer and the collection of cash must be reasonably assured. d. The collection of cash must be reasonably assured and the amount of revenue can be objectively measured. Ans: D KP 4 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

51.

Information is considered material if: a. it would have a bearing on decisions of those who use the financial statements. b. there is a substantial likelihood that a reasonable investor would not be concerned about the information. c. an item is so insignificant that users would likely ignore it. d. the FASB explicitly rules the transaction or item to be material. Ans: A KP 5 BT: K Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

52.

Why would a company recognize the cost of an asset on its balance sheet rather than treat it as an expense on the date it is acquired? a. Conservatism requires this recognition. b. Matching requires costs to be matched against the related revenues of the asset. c. Strictly to record the amount in the most economically favorable manner possible for the company. d. The stable dollar concept will not allow inflation to be added to expenses, but does allow inflation to be added to assets. Ans: B KP 4 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

3-12

53.

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

When in doubt, financial statements should: a. understate assets, overstate liabilities, delay the recognition of gains, and accelerate the recognition of losses. b. understate assets and liabilities and delay the recognition of gains and losses. c. understate assets, overstate liabilities, and delay the recognition of gains and losses. d. overstate assets and understate liabilities. Ans: A KP 5 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

54.

Jeter Company ordered 400 toy wagons from Lamar, Inc. on May 1, 2010. Jeter Company paid for them on May 20 at a cost of $2 each. Jeter sold 50 of them on June 2, 2010, for $4 each to Gilloz Company. Gilloz Company paid Jeter on June 10. On which date should Jeter Company recognize revenue? a. May 1 b. May 20 c. June 10 d. June 2 Ans: D KP 4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

55.

Jeter Company ordered 400 toy wagons from Lamar, Inc. on May 1, 2010. Jeter Company paid for them on May 20 at a cost of $2 each. Jeter sold 50 of them on June 2, 2010, for $4 each to Gilloz Company. Gilloz Company paid Jeter on June 10. How much revenue should Jeter Company recognize at the preferred point of revenue recognition? a. $240 b. $100 c. $1,000 d. $200 Ans: D KP 4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

56.

Jeter Company ordered 400 toy wagons from Lamar, Inc. on May 1, 2010. Jeter Company paid for them on May 20 at a cost of $2 each. Jeter sold 50 of them on June 2, 2010, for $4 each to Gilloz Company. Gilloz Company paid Jeter on June 10. Which amount represents Jeter Company’s input markets related to this sale? a. $300 b. $800 c. $1,600 d. $250 Ans: B KP 2,4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

57.

3-13

Equipment with an original cost of $39,000 has a fair market value of $34,000, current replacement cost of $41,000, and a depreciated value of $36,000 on December 31, 2010. At what amount would net equipment be measured on the December 31, 2010 balance sheet? a. $38,000 b. $36,000 c. $41,000 d. $34,000 Ans: B KP 2 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

58.

Short-term investments have an original cost of $29,000 and a market price of $31,000 at December 31, 2010. At what amount would the investments be measured on the December 31, 2010 balance sheet? a. $29,000 b. $31,000 c. ($2,000) d. $2,000 Ans: B KP 2 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

59.

Sheena Company has accounts receivable of $13,000, with an estimated net realizable value of $12,000 on December 31, 2010. At what amount would the accounts receivable be measured on the December 31, 2010 balance sheet? a. $1,000 b. $13,000 c. $12,000 d. ($1,000) Ans: C KP 2 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

60.

Seinfeld Company has land with an original cost of $68,000 and a fair market value of $81,000. Seinfeld has considered selling its business next year and listing the land with a realtor for $100,000. At what amount would land be measured on the December 31, 2010 balance sheet? a. $100,000 b. $81,000 c. $15,000 d. $68,000 Ans: D KP 2 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

3-14

61.

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

On October 1, 2010, $24,000 of annual magazine subscriptions were sold by Cat World Magazines. The subscribed magazines are delivered on the first day of each month beginning on October 1, 2010. The total cost of the subscribed magazines is $12,000, equal to $1,000 per month. What is the amount of revenue to be recognized during 2010? a. $24,000 b. $3,000 c. $6,000 d. $8,400 Solution: Revenue for 2010 is the amount earned for the 3 months of subscriptions delivered for a total of $6,000 ($24,000 x 3/12). Cost of goods sold is $3,000 (3 months x $1,000 per month). Ans: C KP 4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

62.

On October 1, 2010, $24,000 of annual magazine subscriptions were sold by Cat World Magazines. The total cost of the subscribed magazines is $12,000, equal to $1,000 per month. The subscribed magazines are delivered on the first day of each month beginning on October 1, 2010. What is the amount of the cost of the magazines to be recognized during 2010? a. $12,000 b. $8,400 c. $1,600 d. $3,000 Solution: Revenue for 2010 is the amount earned for the 3 months of subscriptions delivered for a total of $4,500 ($18,000 x 3/12). Cost of goods sold is $3,000 (3 months x $1,000 per month). Ans: D KP 4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

63.

On March 1, 2010, $72,000 of annual magazine subscriptions were sold by Traveler’s Monthly Magazines. The subscribed magazines are delivered on the first day of each month beginning on March 1, 2010. The total cost of the subscribed magazines is $30,000 or $2,500 per month. How much profit will the company recognize during 2010? a. $60,000 b. $33,000 c. $35,000 d. $24,750 Solution: Revenue: ($72,000 X 10/12) ($72,000 X 2/12) Cost of goods sold: ($30,000 X 10/12) ($30,000 X 2/12)

2010 $60,000

2011 $12,000

Profit

25,000 _____ $35,000

5,000 $7,000

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

3-15

Ans: C KP 4 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

64.

On March 1, 2010, $72,000 of annual magazine subscriptions were sold by Traveler’s Monthly Magazines. The subscribed magazines are delivered on the first day of each month beginning on March 1, 2010. The total cost of the subscribed magazines is $30,000 or $2,500 per month. How much profit will the company recognize during 2011? a. $7,000 b. $8,250 c. $10,000 d. $2,750 Solution: Revenue: (($72,000/12) x 10 months) (($72,000/12) x 2 months) Cost of goods sold: (($30,000/12) x 10 months) (($30,000/12) x 2 months)

2010 $60,000

2011 $12,000

Profit

25,000 _____ $35,000

5,000 $7,000

Ans: A KP 4 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

65.

Joseph Corporation purchased an extruding machine on January 1, 2009 for $25,000. The machine is expected to be used for 5 years, and the company believes an equal portion of the cost should be allocated to each accounting period. Based on this information, what is the net book value of the machine on January 1, 2011? a. $5,000 b. $15,000 c. $10,000 d. $25,000 Solution:

$25,000 / 5 = $5,000 x 2 = $10,000; $25,000 – 10,000 = $15,000

Ans: B KP 4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

3-16

66.

Karr Construction built a levee for the state of Mississippi over a three-year period. The contracted price for the levee was $1,200,000. The costs incurred by Karr and the payments from the state over the three year period are as follows:

Costs incurred by Karr Payments from Mississippi

2009 $300,000

2010 $200,000

2011 $100,000

Total $600,000

$600,000

$400,000

$500,000

$1,500,000

If revenue is recognized when payments are received, which of the following present the net income amounts reported in 2009, 2010, and 2011, respectively? a. $600,000; $400,000; $500,000 b. $300,000; $200,000; $400,000 c. $400,000; $400,000; $400,000 d. $300,000; $200,000; $100,000 Ans: B KP 4 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

67.

Costs incurred by Karr Payments from Mississippi

2009 $300,000

2010 $200,000

2011 $100,000

Total $600,000

$600,000

$400,000

$500,000

$1,500,000

If revenue is recognized in proportion to the costs incurred by Karr, how much net income is reported in 2010? a. $100,000 b. $200,000 c. $300,000 d. $400,000 Ans: C KP 4 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement Solution: Karr Construction Income Statement For the Year Ending December 31 Revenues from long-term contracts Construction expenses Net income a b c

2009 a $750,000 300,000 $ 450,000

$750,000 = ($300,000 ÷ $600,000)  $1,500,000 $500,000 = ($200,000 ÷ $600,000)  $1,500,000 $250,000 = ($100,000 ÷ $600,000)  $1,500,000

2010 b $ 500,000 200,000 $ 300,000

2011 $250,000c 100,000 $ 150,000

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

68.

3-17

Costs incurred by Karr Payments from Mississippi

2009 $300,000

2010 $200,000

2011 $100,000

Total $600,000

$600,000

$400,000

$500,000

$1,500,000

If revenue is recognized in proportion to the costs incurred by Karr, how much net income is reported in 2011? a. $600,000 b. $400,000 c. $300,000 d. $150,000 Ans: D KP 4 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement Solution: Karr Construction Income Statement For the Year Ending December 31 Revenues from long-term contracts Construction expenses Net income a b c

69.

2009 a $750,000 300,000 $ 450,000

2010 b $ 500,000 200,000 $ 300,000

2011 $250,000c 100,000 $ 150,000

$750,000 = ($300,000 ÷ $600,000)  $1,500,000 $500,000 = ($200,000 ÷ $600,000)  $1,500,000 $250,000 = ($100,000 ÷ $600,000)  $1,500,000

Three years ago, Astro Masters, Inc. purchased the three assets listed in the following table. The chief financial officer, Bill Moss, is presently trying to decide what to do with each asset. He has three options for each asset: (1) sell it; (2) keep it; and (3) sell it and replace it with an equivalent asset. The following information is provided to aid his decision. Asset

Original Cost

Replacement Cost

A B C

$4,500 $2,000 $2,500

$1,500 $2,500 $4,000

Fair Market Value $2,000 $1,000 $3,500

Present Value of Future Cash Flows Produced by Old Asset $3,000 $3,000 $3,000

Present Value of Future Cash Flows of Equivalent Asset $5,500 $4,000 $5,500

Based on your calculations of total cash flows, which of the following options is the best for Bill to pursue with respect to Asset A? a. Option 1 b. Option 2 c. Option 3 d. Both Options 2 & 3 provide the same total cash flows.

3-18

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

Solution: Cash Inflows From Sale Asset A: Option 1 Option 2 Option 3

$2,000 0 2,000

Cash Outflow for Replacement $

0 0 (1,500)

Future Cash Flows $

Total Cash Flows

0 3,000 5,500

$2,000 3,000 6,000

Therefore, Bill should sell and replace with an equivalent asset (Option 3). Ans: C KP 3 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Reflective AICPA BB: Critical Thinking AICPA FN: Decision Modeling

70.

Original Cost

Replacement Cost

A B C

$4,500 $2,000 $2,500

$1,500 $2,500 $4,000

Fair Market Value $2,000 $1,000 $3,500

Present Value of Future Cash Flows Produced by Old Asset $3,000 $3,000 $3,000

Present Value of Future Cash Flows of Equivalent Asset $5,500 $4,000 $5,500

Based on your calculations, what would be the total cash flows associated with selling and replacing Asset C with an equivalent asset? a. $2,500 b. $5,500 c. $5,000 d. $4,500 Ans: C KP 3 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic , Reflective AICPA BB: Critical Thinking AICPA FN: Decision Modeling Solution: Cash Inflows From Sale Asset C: Option 3

71.

3,500

Cash Outflow for Replacement

Future Cash Flows

Total Cash Flows

(4,000)

5,500

5,000

Original Cost

Replacement Cost

A B C

$4,500 $2,000 $2,500

$1,500 $2,500 $4,000

Fair Market Value $2,000 $1,000 $3,500

Present Value of Future Cash Flows Produced by Old Asset $3,000 $3,000 $3,000

Present Value of Future Cash Flows of Equivalent Asset $5,500 $4,000 $5,500

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

3-19

Based on your calculations of total cash flows, which of the following options is the best for Bill to pursue with respect to Asset B? a. Option 1 b. Option 2 c. Option 3 d. Both Options 2 & 3 provide the same total cash flows. Solution: Cash Inflows From Sale

Cash Outflow for Replacement

Future Cash Flows

Total Cash Flows

1,000 0 1,000

0 0 (2,500)

0 3,000 4,000

1,000 3,000 2,500

Asset B: Option 1 Option 2 Option 3

Ans: B KP 3 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic, Reflective AICPA BB: Critical Thinking AICPA FN: Decision Modeling

72.

Original Cost

Replacement Cost

A B C

$4,500 $2,000 $2,500

$1,500 $2,500 $4,000

Fair Market Value $2,000 $1,000 $3,500

Present Value of Future Cash Flows Produced by Old Asset $3,000 $3,000 $3,000

Present Value of Future Cash Flows of Equivalent Asset $5,500 $4,000 $5,500

On December 31, 2009, just before preparing the company’s financial statements, Bill decides to replace Asset A and keep both Assets B and C. According to generally accepted accounting principles, at what dollar amount he report each of these respective assets on the balance sheet? a. $4,500; $2,000; $2,500 b. $1,500; $2,000; $2,500 c. $2,000; $1,000; $3,500 d. $1,500; $2,500; $4,000 Ans: B KP 3 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

3-20

MATCHING QUESTIONS

Match the descriptions listed in letters a through e below with the proper assumption numbered from 1 through 4 below. Descriptions a. The economic life of an entity can be divided into time periods. b. The financial statements should contain transactions related to only the business and not the individual owners. c. Purchasing power of money is constant over time. d. The dollar value attached to an item on a company’s balance sheet is determined by the market in which the company operates. e. Life of the entity is indefinite. ____

1. Economic entity assumption

____

2. Stable dollar assumption

____

3. Going concern assumption

____

4. Fiscal period assumption

Solution:

1. b

2. c

3. e

4. a

KP 1 BT: K Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

For each financial statement item listed in 1 through 5 below, identify the financial statement valuation (listed in a through h) at which it should be reported. You may use each letter more than once or not at all.

Financial Statement Valuations a. b. c. d.

Residual value Face value Original cost Fair market value

e. f. g. h.

Net realizable value Original cost less accumulated depreciation Present value Estimated sales price

____

1. Cash

____

2. Short-term investments

____

3. Accounts receivable

____

4. Long-term liabilities

____

5. Office building

Solution:

1. b

2. d

3. e

4. c 5. f

KP 2 BT: C Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

3-21

Match the descriptions listed in letters a through e below with the proper valuation numbered from 1 through 4. Descriptions a. Amount paid is reduced by the measured amount used up b. Amount that would have to be paid to acquire the same asset at the balance sheet date c. Discounted cash flows d. Amount derived from net equity of company e. Amount received if the asset were sold ____

1. Present value

____

2. Fair market value

____

3. Replacement cost

____

4. Residual interest

Solution:

1. c

2. e

3. b

4. d

KP 2 BT: C Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

For each financial statement item listed in 1 through 5 below, identify at which financial statement valuation (listed in a through g) the item should be reported. You may use each letter more than once or not at all.

a. b. c. d. e. f. g.

Financial Statement Valuations Present value Fair market value Original cost Face value Net realizable value Original cost less accumulated depreciation Lower of cost or market

____

1. Inventory

____

2. Plant and equipment (book value)

____

3. Land used for plant site

____

4. Current liabilities

____

5. Long-term notes receivable

Solution:

1. g

2. f

3. c

4. d

KP 2 BT: C Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

5. a

3-22

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

For each financial concept listed in 1 through 5 below, identify in which category (listed in a through f) it should be matched. You may use each letter more than once or not at all. Categories a. Similar events are measured using identical accounting methods from one period to the next. b. Expense is recognized in the same period that its generated revenue is recognized. c. Different firms use identical accounting methods to measure similar events. d. Present value of future cash flows. e. Significant portion of effort made; major portion of cost incurred, objectively measured, and reasonably assured of ultimate cash receipt. f. Reliable measure that is verified by documented evidence. ____

1. Comparability

____

2. Objectivity

____

3. Revenue recognition criteria

____

4. Matching concept

____

5. Consistency

Solution:

1. c

2. f

3. e

4. b

5. a

KP 2,3,4,5 BT: K Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

3-23

SHORT PROBLEMS 1.

On May 1, 2009, $9,000 of annual magazine subscriptions were sold by Glolar, Inc. The subscribed magazines are delivered on the first day of each month beginning on May 1, 2009. The total cost of the subscribed magazines is $3,600 or $300 per month. A. Determine the amount of revenue during 2009. B. Explain how the matching concept is applied relative to the magazines. Solution: A. The amount of revenue to be recognized for 2009 is $6,000, the amount earned (8 months at $750 per month.) B. Matching is achieved by reporting the cost of goods sold expense ($300 x 8 = $2,400) in the same accounting period as the revenue of $6,000 that relates to the same accounting period (May 1 through December 31). KP 2 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

During 2010, Hamot Company sold $30,000 of computer chips to a distributor on account. The distributor planned to sell those chips to a German company. The sold chips were shipped to a warehouse owned by Hamot and were still there on December 31, 2010. Hamot’s CFO left two messages for the distributor but received no return calls. The distributor has had no prior dealings with Hamot or any other manufacturer of computer chips. None of the past due balance of $30,000 has been paid. How much sales revenue associated with this transaction would be reported on the income statement for the year ending December 31, 2010? Explain your selection. Solution: $0 would be reported because all four of the revenue recognition criteria were not met. While Hamot Company had completed a significant portion of the production, the goods had not been delivered to the company that placed the order, i.e., the sales effort was not complete. In addition, the eventual collection of the amount due from the company was not assured. KP 4 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Decision Modeling

During January of 2010, Barry Corporation purchased five acres of land for cash of $110,000 from Foley Company. On December 31, 2010, after Barry built its plant, it was estimated that the land's fair market value was $140,000. At what amount would land be measured on Barry’s December 31, 2010 balance sheet? Solution:

$110,000

KP 2 BT: AN Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

3-24

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

On December 31, 2010, total assets and liabilities are measured at $16,000 and $12,000, respectively. The total market value of the company's common stock is $7,000. At what amount would shareholders' equity be measured on the December 31, 2010 balance sheet? Solution:

$16,000 – $12,000 = $4,000

KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Equipment with an original cost of $23,000 has a fair market value of $19,000, current replacement cost of $26,000, and a depreciated value of $20,000 on December 31, 2010. At what amount would net equipment be measured on the December 31, 2010 balance sheet? Solution:

$20,000

KP 2 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Short-term investments have an original cost of $2,500 and a market price of $3,000 at December 31, 2010. At what amount would the investments be measured on the December 31, 2010 balance sheet? Solution:

$3,000

KP 2 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Accounts receivable have a face value of $10,000 and estimated net realizable value of $8,000 on December 31, 2010. At what amount would the accounts receivable be measured on the December 31, 2010 balance sheet? Solution:

$8,000

KP 2 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Equipment with an original cost of $50,000 has a fair market value of $65,000 and accumulated depreciation of $15,000 on December 31, 2010. What amount would the December 31, 2010 balance sheet show as the equipment’s net book value? Solution:

$50,000 - $15,000 = $35,000

KP 2 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

3-25

On December 1, 2010, Karr Company purchased inventory for $55,000. On December 31, 2010, the replacement cost of that inventory is $57,000. At what amount would inventory be measured on the December 31, 2010 balance sheet? Solution:

$55,000

KP 2 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

10.

On October 1, 2010, $24,000 of annual magazine subscriptions were sold by Kitchen Design Magazines. The subscribed magazines are delivered on the first day of each month beginning on October 1, 2010. The total cost of the subscribed magazines is $6,000, equal to $500 per month. Determine the amount of revenue and the cost of the magazines to be recognized during 2010. Solution: Revenue for 2010 is the amount earned for the 3 months of subscriptions delivered for a total of $6,000 ($24,000 x 3/12). Cost of goods sold is $1,500 (3 months x $500 per month). KP 4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

11.

On October 1, 2010, $36,000 of annual magazine subscriptions were sold by Motocross Monthly Magazines. The subscribed magazines are delivered on the first day of each month beginning on October 1, 2010. The total cost of the subscribed magazines is $15,000 or $1,250 per month. Determine the amount of revenue and the cost of the magazines to be recognized during 2010 and 2011, respectively. How much profit will the company recognize during 2010 and 2011? Solution: Revenue: ($36,000 X 3/12) ($36,000 X 9/12) Cost of goods sold: ($15,000 X 3/12) ($15,000 X 9/12)

2010 $9,000

2011 $27,000

Profit

3,750 _____ $5,250

KP 4 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

11,250 $15,750

3-26

12.

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

Zurich Corporation sells cases of champagne to customers for $200 a case. Each customer pays $40 when the case is picked up and then $40 a month for the next four months. The cost of a case of champagne is $60. Although the payment plan has significantly increased sales, Zurich has decided to delay the recognition of revenue until cash is received because of the questionable credit history of the new customers. During January, 2010, 10 cases of champagne were sold and the initial payment of $40 per case was collected. The normal first payment of $40 a case was collected on February 1, 2010. List the four revenue recognition criteria and state how each criterion is either met or not met based on the information provided. Solution: 1. The company must have completed a significant portion of the production and sales effort. The customers have received the champagne, so the sales effort is complete. This condition is met. 2. The amount of revenue can be objectively measured. The revenue amount is given at $200 per case. This condition is met. 3. The major portion of the costs has been incurred, and the remaining costs can be reasonably estimated. The cost is provided at $60 per case. This condition is met. 4. The eventual collection of the cash is reasonably assured. Zurich questions the credit history of the customers, so this condition is not met. KP 4 BT: E Difficulty: Difficult TOT: 8 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Decision Modeling

13.

During 2009 and 2010, Orange Company recognized $100,000 and $120,000 of sales, respectively. The inflation rate between 2009 and 2010 was 10 percent. Did sales increase 20 percent from 2009 to 2010? Explain. Solution: No. A 10% increase because of inflation is $10,000 ($100,000 x 10%). Of the $20,000 increase, $10,000 represents inflation and $10,000 represents a real sales increase. KP 2,4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Decision Modeling

14.

Victor Corporation purchased a packaging machine on January 1, 2010 for $10,000. The machine is expected to be used for 3 years, and the company believes an equal portion of the cost should be allocated to each accounting period. How much expense should Victor recognize during 2010? What concept is illustrated? Solution: $10,000 / 3 = $3,333 for 2010 The matching concept is illustrated. KP 4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

15.

3-27

On January 27, 2010, Lock Company entered into a three-year agreement with Strong Enterprises to supply 2,000 ounces of platinum for $200 an ounce. During 2010, Lock mined and purified the 2,000 ounces of platinum at a cost of $200,000. The platinum was shipped on January 14, 2011 and arrived on January 15, 2011, at Strong’s warehouse. What is Lock’s revenue and gross profit recognized during 2010, consistent with the criteria for revenue recognition and the matching concept? Explain. Solution: Revenue and gross profit are $0 for 2010 because the sales effort was not complete by the end of 2010, i.e., the product was not delivered. KP 4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

16.

During 1995, Jeter Company purchased property for its plant for $100,000. During December of 2010, a similar neighboring plot of land was sold for $120,000. At what amount would land be measured on Jeter Company’s December 31, 2010 balance sheet? Solution:

$100,000

KP 2 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

3-28

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

SHORT ESSAY QUESTIONS 1.

Large public accounting firms employ graduates from state-supported universities, many of who are graduates with accounting degrees. These firms' reliance on and use of the product of subsidized educational institutions seem to imply that these colleges and universities are important assets. However, they are not recognized as assets on the balance sheets of these public accounting firms. Which one of the four basic assumptions might be used to justify the exclusion of educational assets from the balance sheets of the public accounting firms? Solution: Although the lack of ownership or other forms of direct and unchallengeable control might justify the exclusion of educational institutions from the balance sheets of public accounting firms, the basic assumption used is the economic entity assumption. The public accounting firms and educational institutions are considered to be separate economic entities in one economic society. KP 1 BT: E Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication, Reflective AICPA BB: Critical Thinking, Resource Management AICPA FN: Decision Modeling

What is the fiscal period assumption and why is it used? Solution: The fiscal period assumption states that the operating life of an economic entity must be divided into time periods over which performance measures can be developed and applied. If a company ignores the fiscal period assumption, and recognizes all revenue and all expenses only over the life of the business, the numbers would be enormous and the true meaning would be lost. With no fiscal period breakdown of time, a company would not be able to provide information to users to make decisions. KP 1 BT: C Difficulty: Easy TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

Explain the ‘markets’ in which a business entity operates. Solution: A business entity operates in an input market, where it purchases inputs (materials, labor, overhead) for its operations, and an output market, where it sells its outputs (services or inventories). Input market values (purchase prices) are normally less than output market values (sales prices). The input and output markets are defined in terms of specific entities. A sale for one company may be a purchase for another company. KP 2 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking, Resource Management, Industry AICPA FN: Measurement

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

3-29

Why is materiality a major problem in accounting? Solution: Materiality requires judgments that can differ considerably among investors, creditors, managers, auditors, and others. GAAP does not provide guidelines for determining the amount, so assumptions used in determining the dollar amount may be arbitrary. KP 5 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

On October 1, 2010, $20,000 of annual magazine subscriptions were sold by Boating Monthly. The subscribed magazines are delivered on the first day of each month beginning on October 1, 2010. The total cost of the subscribed magazines is $6,000 or $500 per monthly delivery. Using the four criteria necessary for revenue recognition, present an argument for not recognizing $10,000 of revenue during 2010. Solution: Although during 2010, revenue is objectively measured ($20,000), a significant portion of the earnings effort has not been made and a major portion of the costs have not been incurred. The earnings requirement will not be met until the magazines are produced, printed, and delivered. Only one-fourth of the $20,000 received in 2010 should be reported as revenue in 2010. KP 4 BT: E Difficulty: Difficult TOT: 5 min. AACSB: Analytic, Communication, Reflective AICPA BB: Critical Thinking AICPA FN: Decision Modeling

When is present value be used on the financial statements? Give an example in your explanation. Solution: Present value is used on the financial statements only in those cases where future cash flows can be objectively determined. Contractual agreements like notes receivable represent a case that meets this criteria. KP 3 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

Explain the concept of face value. Solution: A specific form of fair market value is called face value. It is a valuation to measure amounts reported on the financial statements used primarily for cash and all current liabilities. It reflects the cash expected to be received or paid in the near future. KP 2 BT: C Difficulty: Easy TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

3-30

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

Why are market values not used for property, plant, and equipment on the balance sheet? Solution: Property, plant, and equipment is sometimes objectively determinable, but most often not. For plant assets in various stages of useful life, determining the market value would require finding an identical plant asset in the same state of "used." If this is not possible, an estimate would be necessary. Estimates of this nature would likely fail to meet the principle of objectivity. KP 2,3 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

Why is inflation ignored in accounting? Solution: If companies were to include inflationary effects on their financial statements, the amounts would have to be estimated since the rate of inflation will not be the same for all commodities and categories of assets. Management would need to estimate the dollar amount assignable to the financial statement amounts, and would likely use various assumptions that would make the information subjective, instead of objective. Information that is not reliable and verifiable is not objective, and will likely cause the financial statements to be misleading for users. Original cost is used instead of inflation-adjusted costs in an effort to make the financial information reliable. It is also very costly to spend the time to make the conversion to inflationary amounts. KP 2 BT: E Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

10.

Name the four basic assumptions of financial accounting. Indicate why these assumptions, as a group, are important. Solution: The basic assumptions of financial accounting are: (1) economic entity, (2) fiscal period, (3) going concern, and (4) stable dollar. They are important because they form the building blocks upon which financial accounting measurement is based. KP 1 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

11.

What is the most critical question in the matching process? Why is it critical? Solution: The most critical question is: ‘In what time period will the revenue be realized?’ Matching requires first identifying in which time period the revenue is recognized. Then it is possible to determine which costs are associated with that particular revenue. The costs should then be recognized in the same time period to be properly matched against the revenue. KP 4 BT: E Difficulty: Moderate TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

12.

3-31

If a company changes its accounting method, does this mean that consistency is violated? Solution: Management must be able to convince the independent auditors that the environment facing the company has changed and an alternative accounting method is appropriate. The effects of the change must be clearly disclosed in the financial statements and the related notes. KP 4 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

3-32

Test Bank – Chapter 3 – The Measurement Fundamentals of Financial Accounting

IFRS QUESTIONS 1.

Compared to U.S. GAAP, IFRS tends to: a. require fewer disclosures. b. allow management to choose between fewer accounting method alternatives. c. be the same as U.S. GAAP in all respects. d. provide a stricter interpretation of objectivity than in the U.S. Ans: A KP 6 BT: C Difficulty: Easy TOT: 1 min. AACSB: Diversity AICPA BB: Global AICPA FN: Reporting

IFRS differs from GAAP in that IFRS tends to be: a. more rules-based b. more principles-based c. focused on historical cost d. focused more on hypothetical future values Ans: B KP 6 BT: C Difficulty: Easy TOT: 1 min. AACSB: Diversity AICPA BB: Global AICPA FN: Reporting

Chapter 4 The Mechanics of Financial Accounting

MULTIPLE CHOICE QUESTIONS 1.

The accounting period is the time a. the Controller decides to close the books. b. between selling a product to a customer and collecting the cash from the customer. c. that it usually takes to journalize and post events to the ledger. d. covered by the income, cash flow, and shareholders’ equity statements. Ans: D KP 2,5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

An event that affects assets, liabilities, or shareholders’ equity is considered to be a. timely. b. objectively measured. c. relevant. d. capitalized. Ans: C KP 1 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

An event for which an appropriate monetary measure can be derived is considered to be a. objectively measured. b. economically viable. c. relevant. d. capitalized. Ans: A KP 1 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

If an event is considered to change assets, liabilities, or shareholders’ equity with an appropriate monetary measure, then it is a. considered a financial changing event. b. listed on the U.S. stock exchange. c. considered a debt or payable of a company. d. recorded in the books of a company. Ans: D KP 1 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

4-1

4-2

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

If assets are $1,000, liabilities are $600, and contributed capital is $200, then shareholders' equity is a. $400. b. $1,500. c. $700. d. $300. Solution:

$1,000  $600 = $400

Ans: A KP 2 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Alberto Company paid its insurance premiums for a two-year insurance policy on May 1, 2009, and recorded them in a prepaid insurance account. The adjusting entry required at May 31, 2009, to recognize the one-month portion for the month of May will a. increase an expense account and increase a liability account. b. increase an expense account and decrease an asset account. c. increase an asset account and decrease an expense account. d. increase a revenue account and decrease an asset account. Ans: B KP 2,5 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Vera Company acquired a new forklift in exchange for signing a 6-month, 10%, $19,000 note dated May 1, 2009. Vera agreed to repay the entire principal at the end of the 6month period. Vera should: a. record one month of interest expense only if the forklift runs as intended. b. record all 6 months of expense when the interest is paid. c. accrue one month of interest expense at May 31, 2009. d. record the interest payments as prepaid interest when paid. Ans: C KP 2,3,5 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

On May 31, 2009, the physical count of office supplies was $2,300. During June, supplies were acquired at a cost of $1,600 and the company debited the Office Supplies Expense account. At June 30, actual supplies on hand totaled $500. The credit part of the adjusting entry required at the end of June is a. Office Supplies Expense of $1,800. b. Office Supplies of $1,800. c. Office Supplies Expense of $3,300. d. Office Supplies of $500. Ans: B KP 3,5 BT: AP Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

4-3

Liabilities are $2,000, retained earnings are $1,000, and contributed capital is $4,000. Assets must be a. $3,000. b. $7,000. c. $5,000. d. $6,000. Solution:

$2,000 + $1,000 + $4,000 = $7,000

Ans: B KP 2 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

10.

Which one of the following changes describes the receipt of $2,000 from the issuance of common stock? a. Assets and shareholders’ equity increase by $2,000. b. Assets and shareholders’ equity decrease by $2,000. c. Assets and liabilities increase by $2,000. d. Assets increase and shareholders’ equity decreases by $2,000. Ans: A KP 2 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

11.

A revenue account a. is increased with a debit. b. is not considered to be an item on the income statement. c. is reported on the balance sheet at the end of the accounting period. d. when offset with expenses ultimately leads to net income and an increase to retained earnings. Ans: D KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

12.

The declaration of dividends a. increases with a credit. b. decreases retained earnings. c. is necessary for proprietorships. d. is an expense account on the income statement. Ans: B KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13.

Which one of the following changes describes the receipt of $3,000 from the issuance of a long-term note payable? a. Assets and shareholders’ equity increase by $3,000. b. Assets and shareholders’ equity decrease by $3,000. c. Assets and liabilities increase by $3,000. d. Assets and liabilities decrease by $3,000. Ans: C KP 2 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

4-4

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

14.

Which of the following changes describes the purchase of $2,000 of inventory through payment on credit? a. Assets and shareholders’ equity increase by $2,000. b. Assets and shareholders’ equity decrease by $2,000. c. Assets and liabilities increase by $2,000. d. Assets and liabilities decrease by $2,000. Ans: C KP 2 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

15.

Providing $4,000 of services to customers on account causes a. assets and shareholders’ equity to decrease by $4,000. b. assets and shareholders’ equity to increase by $4,000. c. assets and liabilities to increase by $4,000. d. assets and liabilities to decrease by $4,000. Ans: B KP 2 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

16.

Which of the following changes describes the payment of $1,000 for cash dividends? a. Assets and shareholders’ equity increase by $1,000. b. Assets and shareholders’ equity decrease by $1,000. c. Assets and liabilities increase by $1,000. d. Assets and liabilities do not change. Ans: B KP 2 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

17.

The balance sheet reported supplies of $1,900 at December 31, 2009. On December 31, 2010, the actual supplies on hand amounted to $1,400. During the year, additional supplies costing $1,500 were acquired and debited to the Supplies account. The adjusting entry required at the end of December 31, 2010 is a.

b. c. d.

Supplies Supplies Expense Cash

1,900 1,500

Supplies Expense Supplies

1,900

Supplies Cash

1,400

Supplies Expense Supplies

2,000

3,400 1,900 1,400 2,000

Ans: D KP 3,5 BT: AP Difficulty: Moderate TOT: 2min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

18.

4-5

Which of the following changes describes the purchase of $3,000 of equipment financed by the issuance of a long-term note payable? a. Assets and shareholders’ equity increase by $3,000. b. Assets and shareholders’ equity decrease by $3,000. c. Assets and liabilities decrease by $3,000. d. Assets and liabilities increase by $3,000. Ans: D KP 2 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

19.

Acacia Company provided landscaping services and received $2,000 from customers immediately. Which of the following occurred? a. Assets and shareholders’ equity increase by $2,000. b. Assets and shareholders’ equity decrease by $2,000. c. Assets and liabilities increase by $2,000. d. Assets and liabilities decrease by $2,000. Ans: A KP 2 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

20.

Lakesha Corp. purchased $2,000 of supplies on account. The supplies will be used over the next few months. This event causes a. assets and shareholders’ equity to increase by $2,000. b. assets and shareholders’ equity to decrease by $2,000. c. assets and expenses to decrease by $2,000. d. assets and liabilities to increase by $2,000. Ans: D KP 2 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

21.

Which one of the following changes describes the payment of $800 for utilities for the current month? a. Assets and shareholders’ equity decrease by $800. b. Assets and shareholders’ equity don’t change. c. Assets and liabilities increase by $800. d. Assets and liabilities decrease by $800. Ans: A KP 2 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

22.

Which of the following changes describes the payment of $20,000 for a new bulldozer? a. Assets and shareholders’ equity decrease by $20,000. b. Assets decrease and shareholders’ equity increases by $20,000. c. No net change in total assets. d. Assets decrease by $20,000. Ans: C KP 2 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

4-6

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

23.

Which of the following changes describes the collection of $6,000 from customers who had charged on account for services preformed during a previous accounting period? a. Assets and shareholders’ equity increase by $6,000. b. Assets and liabilities increase by $6,000. c. Assets and liabilities decrease by $6,000. d. No changes in total assets, liabilities, or shareholders’ equity. Ans: D KP 2 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

24.

Employees were paid $8,000 on June 9, 2010 for five days work through Friday, June 3. What adjusting entry was necessary at the company’s year end, Tuesday, May 31, 2010, as a result of this? a. Debit Wages Expense and credit Cash for $8,000 b. Debit Wages Expense and credit Shareholders’ equity for $4,800. c. Debit Wages Payable and credit Wages Expense for $4,800. d. Debit Wages Expense and credit Wages Payable for $3,200. Ans: D KP 5 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

25.

Which of the following changes describes the distribution of $2,000 of dividends to owners? a. Assets and net income decrease by $2,000. b. Assets decreases and net income increases by $2,000. c. Assets and shareholders’ equity decrease by $2,000. d. Assets and liabilities decrease by $2,000. Ans: C KP 2 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

26.

An expense account a. is increased with a credit. b. ultimately decreases shareholders’ equity. c. appears on the balance sheet at the end of the accounting period. d. is not an income statement account. Ans: B KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

27.

In a trial balance, if total debits do not equal total credits when the accounts are totaled, a. the bookkeeper must have made an error. b. the expected inequality is corrected during the normal adjusting process. c. no change is made because the amount of assets will typically exceed the amount of liabilities. d. the company will report a loss on its income statement because expenses are greater than revenues. Ans: A KP 3 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

28.

4-7

Marks Corp. purchased supplies at a cost of $2,400 during 2010. At January 1, 2010, supplies on hand amounted to $800. At December 31, 2010, supplies on hand are $400. Supplies expense for 2010 are a. $1,200. b. $3,200. c. $1,600. d. $2,800. Ans: D KP 3,5 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

29.

On December 13, 2009, Michael Company received $8,000 in cash as a payment in advance from a customer and credited Unearned Service Revenue. The balance in the Unearned Service Revenue account was $2,000 at the beginning of December. At the end of December, all but $500 had been earned. What adjusting entry is necessary at the end of December? a. Cash Unearned Service Revenue Service Revenue

8,000 1,500

b. Unearned Service Revenue Service Revenue

6,500

Unearned Service Revenue Service Revenue

9,500

d. Service Revenue Unearned Service Revenue

8,000

9,500 6,500 9,500 8,000

Ans: C KP 3,5 BT: AP Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

30.

Which of the following describes the receipt of $5,000 from the issuance of common stock? a. No entry b. Debit shareholders’ equity and credit assets for $5,000 c. Debit assets and credit shareholders’ equity for $5,000 d. Debit liabilities and credit assets for $5,000 Ans: C KP 3 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

31.

Which of the following debits and credits describes the payment of interest and principal on a loan? a. Debit an asset and credit a liability b. Debit an asset, debit an expense, and debit a liability c. Credit an asset, debit an expense, and debit a liability d. Credit an asset and debit a liability Ans: C KP 2,3 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

4-8

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

32.

Favre Company paid for insurance in advance. Which transaction will Favre record? a. Debit Cash and credit Insurance Expense. b. Debit Prepaid Insurance and credit Cash. c. Debit Prepaid Insurance and credit Accounts Payable. d. Debit Cash and Credit Prepaid Insurance. Ans: B KP 2,3 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

33.

A company has a 4-month, 11%, $10,000 Notes Payable account in its general ledger at the end of the year. The note matures two months after the end of the accounting period. Which statement is true? a. Interest revenue must be accrued at the end of the accounting period. b. The notes payable could generate a gain if the note is paid off early. c. The interest was paid when the cash was borrowed. d. Interest expense must be accrued at the end of the accounting period. Ans: D KP 5 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

34.

Gilbert Company purchased equipment financed by the issuance of a 4-year note payable. To record this, Gilbert will a. debit assets and credit shareholders’ equity. b. debit shareholders’ equity and credit liabilities. c. debit assets and credit liabilities. d. debit liabilities and credit assets. Ans: C KP 2,3 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

35.

Goodyear Co. purchased $2,000 of equipment with a $2,000 cash payment. Goodyear Co. should a. debit one asset and credit another asset for $2,000.. b. debit shareholders’ equity and credit assets for $2,000. c. debit assets and credit liabilities for $2,000. d. no entry Ans: A KP 2,3 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

36.

Buckeye Company received $1,000 from customers for services provided during the current month. Buckeye will a. debit liabilities and credit revenue for $1,000. b. debit revenue and credit assets for $1,000. c. debit assets and credit revenue for $1,000. d. debit liabilities and credit assets for $1,000. Ans: C KP 3 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

37.

4-9

When an adjusting entry for depreciation expense for the accounting period is recorded, a. assets and shareholders’ equity increase. b. the amount of depreciation expense is subtracted from accumulated depreciation. c. assets and shareholders’ equity decrease. d. assets increase and shareholders’ equity decreases. Ans: C KP 5 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

38.

An asset account a. has a debit balance. b. is increased with a credit. c. is a shareholders’ equity account because it has a book value. d. will have a negative balance if the company’s expenses exceed revenues for the period. Ans: A KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

39.

When making adjustments to plant asset accounts, a. the total dollar amount in the accumulated depreciation account will determine the amount of depreciation expense for the current accounting period. b. depreciation expense is added to the plant asset account. c. depreciation expense reduces net income. d. the current market value of the long-lived asset determines the amount of depreciation expense. e. the accrual system is ignored. Ans: C KP 2,3,5 BT: K Difficulty: Moderate TOT: 2min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

40.

During April, Tempe Corp. paid $4,000 on account for supplies that were purchased, recorded, and used during March. In recording this transaction, Tempe will a. debit Accounts Payable and credit Cash. b. debit Shareholders’ equity and credit Accounts Payable. c. debit Supplies Expense and credit Accounts Payable. d. accrue an expense of $4,000. Ans: A KP 2,3 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

41.

When an adjusting entry that recognizes accrued interest revenue is recorded, a. assets increase and liabilities increase. b. shareholders’ equity increases and liabilities decrease. c. assets decrease and liabilities decrease. d. shareholders’ equity and assets increase. Ans: D KP 5 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

4-10

42.

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

All of the following statements are true except: a. All economic events recorded in financial statements must be relevant. b. All economic events recorded in financial statements must affect liabilities. c. All economic events recorded in financial statements must be objectively measurable in monetary terms. d. All economic events recorded in financial statements must maintain the equality of the accounting equation. Ans: B KP 1,2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

43.

If the balance sheet is in balance, a. assets must equal liabilities. b. assets must exceed liabilities. c. transactions recorded must be right. d. errors may still exist. Ans: D KP 2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

44.

Items and rights that a company acquires through objectively measurable transactions that can be used in the future to generate economic benefits are a. liabilities. b. assets. c. contributing capital. d. revenues. Ans: B KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

45.

Scottsdale Corp. received several invoices in the mail for oil changes performed on its company trucks during the last week of April. The total of the invoices was $800 and all are due on May 13. What entry should Scottsdale make at April 30 as a result of receiving the invoices? a. Debit Accounts Receivable and credit Cash for $800. b. Debit Maintenance Expense and credit Accounts Payable for $800. c. Debit Maintenance Expense and credit Cash for $800. d. Debit Prepaid Maintenance and credit Cash for $800. Ans: B KP 2,3 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

46.

4-11

Shareholders’ equity increases because of two primary reasons, which are the a. sale of stock and the earning of income. b. earning of income and the payment of dividends. c. payment of dividends and payment of expenses. d. collection of cash from customers and the payment of expenses to creditors. Ans: A KP 2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

47.

Dobson Company sold stock for cash and received cash for services performed during the current month. Which of the following summarizes the income statement impact of these transactions for the current month? a. Both the sale of stock and the performance of services increased revenues for the company. b. Only the performance of services caused an increase in revenues. c. Only the performance of services caused a decrease in revenues. d. Only the sale of stock caused revenues to increase. Ans: B KP 2,3 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

48.

Subdivisions of assets, liabilities, and shareholders’ equity are called a. revenues. b. accounts. c. contributed capital. d. journals. Ans: B KP 2 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

49.

Which of the following sets of accounts is closed at the end of an accounting period? a. Interest Expense, Interest Payable, Interest Receivable b. Unearned Revenue, Sales Revenue, Interest Revenue c. Interest Expense, Rent Revenue, Dividends d. Retained Earnings, Sales Revenue, Unearned Revenue Ans: C KP 2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

50.

The statement of cash flows provides information about a. operating activities. b. financing activities. c. investing activities. d. all of the above. Ans: D KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

4-12

51.

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

Phoenix Corp. paid rent of $12,000 per month for 3 months in advance on November 1, 2010. Phoenix accounting period ends on December 31, 2010. Which amount will be reported at December 31, 2010? a. Prepaid Rent of $4,000 on its December 31, 2010 balance sheet b. Rent Payable of $12,000 on its December 31, 2010 balance sheet c. Rent Expense of $12,000 on its income statement for the year ending December 31, 2010 d. Rent Expense of $4,000 on its income statement for the year ending December 31, 2010 Ans: A KP 5 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

52.

Which one of the following is a characteristic of the double entry system? a. For every debit in every account, there must be a corresponding credit of the same dollar amount in the same account. b. The total dollar value of debits must equal the total dollar amount of the credits in most of the accounts. c. For every asset recorded in the accounting records, there must be a corresponding liability of the same dollar amount. d. The total dollar amount of debits must equal the total dollar amount of the credits. Ans: D KP 3 BT: K Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

53.

The statement of shareholders’ equity is a record of activity over a period of time of the a. contributed capital accounts. b. retained earnings account. c. dividends account. d. both a and b. Ans: D KP 2 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

54.

Journal entries are used to indicate how a. much profit was earned during the accounting period. b. events affect the retained earnings account. c. events affect the accounting equation. d. much dividends were paid to shareholders. Ans: C KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

55.

4-13

The accounting concepts that underlie the accrual system of accounting are a. debits and credits. b. revenue recognition and matching. c. revenue recognition and debits equal credits. d. matching and deferrals. Ans: B KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

56.

Recognition of a gain or loss may result from a. the sale of goods to customers on account. b. the sale of a company's common stock to an investor. c. the sale of a non-current asset. d. the revenue recognition process associated with selling products to customers. Ans: C KP 3 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

57.

Which one of the following transactions will ultimately cause a decrease in retained earnings? a. Payment of the current month's telephone bill b. Collection of cash from a customer for services provided in the current month c. Payment of the prior month’s account payable balance d. Receipt of interest on a note receivable Ans: A KP 3 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

58.

What effect does recognizing accrued wages expense at the end of the accounting period have on the accounting equation? a. Assets decrease and shareholders’ equity decreases. b. Liabilities increase and shareholders’ equity decreases. c. Assets decrease and liabilities decrease. d. Liabilities decrease and shareholders’ equity decreases. Ans: B KP 3,5 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

59.

A company sold vacant land that it had owned for three years. The difference between the amount of cash receipts and the original cost of land owned by the company a. is reported as a revenue or expense on the income statement. b. represents the amount of gain or loss associated with the asset sold. c. represents the amount of cash associated with the asset sold. d. should be debited or credited directly to retained earnings. Ans: B KP 2,3,5 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

4-14

60.

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

What effect does recognizing revenue at the end of the accounting period for rent received in advance have on the accounting equation? a. Revenues increase and liabilities decrease. b. Assets increase and shareholders’ equity increases. c. Revenues decrease and liabilities decrease. d. Liabilities increase and revenues decrease. Ans: A KP 3,5 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

61.

Which one of the following statements is true? a. Accruals are adjustments that are recorded prior to the associated cash flow taking place. b. Cash is used in the accrual process. c. Accrual accounting recognizes revenues and expenses based on current period cash flows. d. Accrual accounting may use either two asset or two liability accounts. Ans: A KP 5 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

62.

Which one of the following is a required characteristic of accruals and deferrals? a. An asset or a liability will always be affected. b. Cash is either increased or decreased as a result of recording an accrual or deferral. c. Accruals record revenues, and expenses record deferrals. d. An asset and an expense item will always be affected. Ans: A KP 5 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

63.

The main purpose of the adjusting process is a. to remove the effects of all transactions recorded during the accounting period. b. to make the account balances reflect the company’s true position according to the guidelines of accrual accounting. c. to get the accounting records ready for a new accounting period. d. to identify the amount of cash available for dividends to be paid. Ans: B KP 5 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

64.

4-15

The biggest distinction between accruals and deferrals is a. one emphasizes conservatism while the other promotes aggressive accounting positions. b. how long a company must wait until the collection of cash occurs. c. with accruals, no record of the activity has been made prior to the adjustment process, and with deferrals, the activity has already been recorded in the accounting records, but the proper amount of revenue or expense has not been recognized. d. adjustments are necessary for accruals, whereas, adjustments are not necessary for deferrals. Ans: C KP 3 BT: K Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

65.

Closing entries result in net income being transferred to a. a revenue account. b. the cash account. b. the contributed capital account. d. the retained earnings account. Ans: D KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

66.

A multinational is a. a company that prepares accruals and deferrals throughout the year as well as yearend. b. a corporation that has no home country due to operations in several countries. c. a corporation that has its home in one country but operates under the laws of other countries as well. d. a type of adjusting entry necessary for companies that trade with corporations in other countries. Ans: C KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic, Diversity AICPA BB: Global, Critical Thinking AICPA FN: Reporting

67.

On December 31, 2010, immediately after all the adjustments were made to Kingman Corp’s accounting records for the 2010 fiscal year, but before the books were closed, the retained earnings account reflected a balance of $50,000. Kingman Corp’s net income for 2010 was $12,000. Kingman paid no dividends during 2010. On the balance sheet for January 1, 2011, the beginning balance in the retained earnings account will be a. $0 b. $62,000 c. $48,000 d. $50,000 Ans: B KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

4-16

68.

On December 31, 2010, immediately after all the adjustments were made to Gilbert Inc.’s accounting records for the 2010 fiscal year, but before the books were closed, the retained earnings account reflected a deficit balance of $80,000. The sum of the preclosing balances of all of Gilbert’s temporary accounts was a net credit balance of $18,000. Gilbert paid no dividends during 2010. On the balance sheet for January 1, 2011, the beginning balance in the retained earnings account will be a. $0 b. $62,000 debit c. $80,000 credit d. $98,000 credit Ans: B KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

69.

On December 13, 2010, Tucson Corp. paid $24,000 for a two year property insurance policy covering their corporate headquarters for the period December 15, 2010 to December 15, 2012. The payment was charged to insurance expense. What adjusting entry is needed at the end of December? a. Cash

24,000 Prepaid insurance

24,000

b. Prepaid insurance Insurance expense

23,500

Insurance expense Cash

24,000

d. Insurance expense Accounts payable

23,500

23,500 24,000 23,500

Ans: B KP 3,5 BT: AP Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

70.

During Bisbee’s first year of business, office supplies were purchased for cash in the amount of $4,300 and the amount was debited to supplies expense. At the end of the first year, the physical count indicated that $425 of supplies was unused. How much should be reported on the income statement at year end for office supplies expense? a. $4,300 b. $3,875 c. $4,725 d. $425 Solution: Office Supplies Expense = $4,300 – $425 = $3,875 Office Supplies = $425 (Unused supplies are reported on the balance sheet.) Ans: B KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

71.

4-17

During Bisbee’s first year of business, office supplies were purchased for cash in the amount of $4,300 and the amount was debited to supplies expense. At the end of the first year, the physical count indicated that $425 of supplies was unused. How much should be reported on the balance sheet for office supplies? a. $4,300 b. $3,875 c. $4,725 d. $425 Solution: Office Supplies Expense = $4,300 – $425 = $3,875 Office Supplies = $425 (Unused supplies are reported on the balance sheet.) Ans: D KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

72.

On January 1, Wages Payable for Flagstaff Company equals $18,500. By the end of the current year, Wage Expense equals $345,000, and cash payments for wages were $353,200. What is the balance in the T-account, Wages Payable, on December 31? a. $17,500 b. $8,200 c. $25,700 d. $10,300 Solution: Beginning balance – credit Additional wages accrued – credit Cash payments – debit Balance at December 31

$ 18,500 345,000 (353,200) $ 9,300

Ans: D KP 3,4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

73.

On July 1, 2010, Erie Company rented a building from another company for $90,000 for a three-year time period. Erie Company debited the rent expense account when the payment was made. What adjustment for rent is necessary at December 31, 2010? a. $20,000 b. $40,000 c. $75,000 d. $80,000 Solution: Prepaid Rent Rent Expense ($90,000 X 30/36)

75,000 75,000

Ans: C KP 3, 4, App4B BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

4-18

74.

Meadville, Inc. began operations during 2010. During January of 2010, the following transactions occurred: • • • • • • •

Received $80,000 from shareholders as initial investments Received cash of $90,000 for services performed during January Billed customers an additional $12,300 for services performed during January Borrowed $11,500 from Regions Bank Company, and signed a one-year note payable Paid rent in the amount of $4,925 for January Paid dividends in January amounting to $8,000 Paid wages equal to $33,220 for January

How much Net Income should Meadville, Inc. report for January? a. $119,655 b. $64,155 c. $131,155 d. $51,155 Solution: $90,000 + $12,300 – $4,925 – $33,220 = $64,155 Ans: B KP 2,3,4,5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

75.

On August 1, Amy Company borrowed $38,000 from another company on a 6%, oneyear note. The journal entry that Amy would record on August 1 would include which of the following? a. A debit to Notes Receivable for $38,000. b. A credit to Cash for $38,000. c. A credit to Notes Payable for $38,000. d. A debit to Interest Expense for $2,220. Solution: August 1: C Cash Notes Payable

38,000 38,000

Ans: C KP 3,4 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

76.

4-19

On August 1, Amy Company borrowed $38,000 from another company on a 6%, oneyear note. The journal entry on December 31 would include which of the following? a. A debit to Notes Payable for $38,000. b. A debit to Interest Receivable for $950. c. A credit to Interest Payable for $2,220. d. A debit to Interest Expense for $950. Solution: December 31: Interest Expense Interest Payable ($38,000 X 6% X 5/12)

950 950

Ans: D KP 3,4 BT: AP Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

77.

If accounts receivable on January 1 totals $17,375, and during the current year sales revenue is $112,000, and cash receipts from customers is $97,855, then what is the balance in Accounts Receivable on December 31? a. $14,145 b. $16,375 c. $31,520 d. $2,230 Solution: $17,375 + $112,000 – $97,855 = $ 31,520 Ans: C KP 3,4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

78.

Able Industries has the following information is related to its adjusting entries at the end of December. • On December 31, 2010, the insurance expired amounted to $100. • Of the unearned revenue, $335 of services had been performed. What is the net effect that the necessary adjusting entries for this information have on net income for Able? a. $435 increase. b. $435 decrease. c. $235 increase. d. $235 decrease. Solution: Decrease in net income for $100. Increase in net income for $335. Results are a net increase of $235. Ans: C KP 3, 5, App 4A BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

4-20

79.

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

Able Industries has the following information is related to its adjusting entries at the end of December. •

Services have been performed for customers that have not yet been billed or paid totaling $100.

•

The office equipment computation for 2010 depreciation amounts to $480.

What is the net effect that the necessary adjusting entries for this information have on net income for Able? a. $380 increase. b. $380 decrease. c. $580 increase. d. $580 decrease. Solution: Increase in net income for $100. Decrease in net income for $480. Results are a net decrease of $380. Ans: B KP 3, 5, App 4A BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement 80.

Interest receivable on January 1 and December 31 totals $3,780 and $3,450, respectively. During the year, cash received from interest is $11,000. Determine interest revenue for the current year. a. $3,115 b. $1,330 c. $12,330 d. $10,670 Solution: $3,450 + $11,000 – $3,780 = $10,670 Ans: D KP 3,5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

81.

Accounts receivable on January 1 and December 31 is $19,500 and $22,400, respectively. During the year, sales revenue is $223,000. What is the current year's cash received from customers? a. $3,900 b. $263,900 c. $220,100 d.$226,900 Solution: $19,500 + $223,000 – $22,400 = $220,100 Ans: C KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

82.

4-21

Inventory on January 1 and December 31 is $29,500 and $43,000, respectively. During the year, cash paid to suppliers of inventory is $80,000. If all purchases of inventory are for cash, how much is the current year's cost of goods sold? a. $14,500 b. $66,500 c. $94,500 d. $151,500 Solution: $29,500 + $80,000 – $43,000 = $66,500 Ans: B KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

83.

Inventory on January 1 and December 31 is $46,000 and $42,000, respectively. Accounts payable on January 1 and December 31 are $31,000 and $29,000, respectively. During the year, cost of goods sold is $186,000. How much is the current year's cash payments to suppliers of inventory? a. $184,000 b. $213,000 c. $181,000 d. $191,000 Solution: $46,000 – $31,000 + $29,000 – $42,000 – $186,000 = $184,000 Ans: A KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

84.

Retained earnings on January 1 and December 31 are $65,000 and $58,000, respectively. During the year, net income is $113,000. How much dividends did the company declare and pay to the shareholders? a. $177,000 b. $171,000 c. $107,000 d. $120,000 Solution: $65,000 + $113,000 – $58,000 = $120,000 Ans: D KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

4-22

MATCHING QUESTIONS 1.

For each transaction numbered 1 through 12 below, identify its effect on the accounting equation by selecting from a through h below. You may use each letter more than once or not at all. Accounting Equation Effects

a. b. c. d. e. f. g. h.

+ A and + L + A and + SE (Contributed Capital) + A and + SE (Retained Earnings)  A and  L  A and  SE (Contributed Capital)  A and  SE (Retained Earnings) + A and  A Not communicated by the formal accounting system

Effects

Transaction

Purchased computer equipment for cash

Received cash in exchange for the issue of a note payable

Purchased building and land in exchange for a mortgage note payable

Received cash in exchange for the issuance of common stock

Purchased computer supplies on account

Provided computer services to customers for cash

Paid an account payable

Provided computer services to customers on account

Used computer supplies in the regular operations of the business (acquired during a previous accounting period)

10.

Recognize part of the cost of the service potential of the company’s computer

11.

Secured a large contract with Allegheny Company to provide computer services during the forthcoming year

12.

Declared and paid dividends to the owners of common stock

Solution: 1. g 2. a 7. d 8. c

3. a 9. f

4. b 10. f

5. a 11. h

6. c 12. f

KP 2,3 BT: AP Difficulty: Moderate TOT: 8 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

4-23

For each transaction numbered 1 through 7 below, identify the effect (a through g) on the accounting equation by placing the letter of the effect in the space provided. You may use each letter more than once or not at all. a. b. c. d. e. f. g.

Accounting Equation Effects Decrease in revenue and decrease in an asset Increase in revenue and increase in an asset Decrease in expense and increase in an asset Increase in expense and decrease in an asset Increase in revenue and decrease in a liability Increase in expense and increase in a liability Decrease in revenue and increase in a liability

1. Adjusting for the accrual of wages 2. Adjusting for the earning of unearned revenue 3. Adjusting for the accrual of interest revenue 4. Adjusting for the accrual of interest expense 5. Adjusting supplies expense reflecting that part of the supplies expense that was not used 6. Adjusting inventory downward to reflect shrinkage resulting from shoplifting 7. Adjusting prepaid rent for the portion used Solution: 1. f 2. e 3. b 4. f 5. c 6. d 7. d KP 2,3,4 BT: AP Difficulty: Moderate TOT: 6 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

4-24

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

For each of the transactions listed in 1 through 5 below, indicate whether it involves a deferral (D) or an accrual (A) by placing the letter of the correct response in the space provided. Answers

Transactions

1. ________ Industrial conveyer belt system acquired for cash 2. ________ Cash collected from customers for rental of office space for next year 3. ________ One year’s premium on equipment insurance paid in advance 4. ________ Property taxes owed to the state but not paid at year end 5. ________ Rent owed to a landlord for the current month Solution: 1. D

2. D

3. D

4. A

5. A

KP 5 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

For each transaction numbered 1 through 6, identify its effect on the accounting equation by selecting from a through h below. You may use each letter more than once or not at all. a. b. c. d. e. f. g. h.

Accounting Equation Effects Debit assets and credit liabilities Debit one asset and credit another asset Debit assets and credit retained earnings/revenue Debit liabilities and credit assets Debit contributed capital and credit assets Debit retained earnings and credit assets Debit assets and credit contributed capital Not communicated by the formal accounting system

____

1. Received cash in exchange for the issue of common stock

____

2. Received cash in exchange for the issue of a note payable

____

3. Purchased building and land in exchange for a mortgage note payable

____

4. Purchased computer equipment for cash

____

5. Purchased computer supplies on account

____

6. Provided computer services to customers for cash

Solution: 1. g 2. a 3. a 4. b 5. a 6. c KP 2,3 BT: AP Difficulty: Moderate TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

4-25

For each transaction numbered 1 through 5 below, identify the effect (a through h) on the accounting equation by placing the letter of the effect in the space provided. You may use each letter more than once or not at all. a. b. c. d. e. f. g. h.

Accounting Equation Effects Debit assets and credit liabilities Debit assets and credit contributed capital Debit assets and credit revenue Debit retained earnings and credit assets Debit contributed capital and credit assets Debit expenses and credit assets Debit one asset and credit another asset Not communicated by the formal accounting system

Received payment from a customer for amount owed from a previous accounting period

Provided computer services to customers on account

Used supplies in the regular operations of the business

Used up part of the service potential of the computer equipment

5. Solution: 1. g 2. c 3. f 4. f 5. h

Hired a new office manager to start to work next week

KP 2,3 BT: AP Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

4-26

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

The accounts for Jalisa Company are listed below, identified by number. Following the list of accounts is a series of adjusting entries (a through f) prepared by Jalisa Company. For each entry, identify the number(s) of the accounts to be debited and credited and place them in the space provided adjacent to each adjusting entry. Accounts 1. Cash 11. Notes Payable 2. Accounts Receivable 12. Common Stock 3. Prepaid Rent 13. Retained Earnings 4. Office Supplies 14. Service Revenue 5. Automobiles 15. Office Supplies Expense 6. Accumulated Depreciation 16. Utilities Expense 7. Accounts Payable 17. Salaries and Wages Expense 8. Interest Payable 18. Depreciation Expense 9. Salaries and Wages Payable 19. Interest Expense 10. Income Tax Payable 20. Income Tax Expense Adjusting Entries

Debit

a. Provided legal services to clients that will pay next month b. Accrued wages earned by employees that will be paid next month c. Recognized office supplies used during the month d. Recorded the current month of depreciation expense e. Recorded monthly utilities expenses which are not yet paid f. Recognized the amount of interest due to the bank on a note

Solution: a. 2, 14 b. 17, 9 c. 15, 4 d. 18, 6 e. 16, 7 f. 19, 8 KP 2,3,5 BT: AP Difficulty: Moderate TOT: 10 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Credit

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

4-27

SHORT PROBLEMS 1.

Total assets, liabilities, and shareholders' equity are $7,000, $5,000, and $1,000 before a new machine is purchased for $500 cash. What are the new amounts of assets, liabilities, and shareholders' equity after this event? Solution: Assets = $7,000 Liabilities = $5,000 Shareholders' equity = $1,000 KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Total assets, liabilities, and shareholders' equity are $14,000, $7,000, and $7,000 before a new copy machine is purchased in exchange for a $1,000 note payable. What are the new amounts of assets, liabilities, and shareholders' equity after this event? Solution: Assets = $15,000 Liabilities = $8,000 Shareholders' equity = $7,000 KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Total assets, liabilities, and shareholders' equity are $5,000, $1,500, and $3,500 before common stock is issued for $500 cash. What are the new amounts of assets, liabilities, and shareholders' equity after this event? Solution: Assets = $5,500 Liabilities = $1,500 Shareholders' equity = $4,000 KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Total assets, liabilities, and shareholders' equity are $6,000, $4,000, and $2,000 before $1,000 is received in exchange for a $1,000 bond payable. What change occurred to liabilities? Why is there no change in shareholders' equity? Solution: Liabilities increased by $1,000, up to a total of $5,000. No change occurred to shareholders’ equity because the company acquired an additional asset, cash of $1,000. The transaction does not affect shareholders’ equity. KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

4-28

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

Mingo Company has been in business several years. During January of 2010, the following transactions occurred: • Paid employees $6,000 for wages during January. • Paid $2,000 cash for other operating expenses of which $1,000 related to December and the balance related to January. • Paid utilities and rent for January in the amount of $1,800. • Paid a cash dividend to shareholders in the amount of $900 during January. How much is total Expenses that Mingo Company will report for January 2010? Why is this amount different than the amount paid during the month? Solution: $6,000 + $1,000 + $1,800 = $8,800 This amount differs due to the fact that expenses are calculated on the accrual basis and the cash paid does not reflect the timing of when the amounts were incurred. In addition, dividends are not expenses. KP 2,3,5 BT: AN Difficulty: Moderate TOT: 5 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

Ohio Company, a corporation, began operations on December 1, 2010. During January of 2011, the following transactions occurred: • • •

Billed customers $12,000 for services performed during January. Received payment from customers in the amount of $6,000 for services performed and billed in December. Received cash of $7,000 for services performed during January for customers who paid cash immediately. (No bills were mailed.)

A. How much total Revenue should Ohio Company report for January, 2011? B. Determine the increase in cash during January of 2011 as a result of these transactions. Solution: A, $12,000 + $7,000 = $19,000 B. $6,000 + $7,000 = $13,000 KP 2,3,5 BT: AN Difficulty: Moderate TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

4-29

During the first year of business, office supplies were purchased for cash in the amount of $2,000 and the amount was debited to supplies expense. At the end of the first year, the physical count indicated that $500 of supplies was unused. How much should be reported on the income statement at year end for office supplies expense? On the balance sheet for office supplies? Solution: Supplies expense = $2,000 – $500 = $1,500 Office Supplies = $500 (Unused supplies are reported on the balance sheet.) KP 5 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Total assets, liabilities, and shareholders’ equity are $4,000, $1,000, and $3,000 before current period wages of $200 are paid. What are the new amounts of assets, liabilities, and shareholders' equity after this event? Solution: Assets = $3,800 Liabilities = $1,000 Shareholders' equity = $2,800 KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Wages Payable on January 1 equals $12,000. By the end of the current year, Wage Expense equals $420,000, and cash payments for wages were $424,000. What is the balance in the T-account, Wages Payable, on December 31? Solution: Beginning balance – credit Additional wages accrued – credit Cash payments – debit Balance at December 31 - credit

$ 12,000 420,000 (424,000) $ 8,000

KP 3,4 BT: AN Difficulty: Moderate TOT: 4min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

4-30

10.

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

When a landlord records rent received in advance from a tenant in a revenue account, the adjusting entry required at year end to allocate the rent to the proper periods has an impact on financial statement elements. What effect (increase, decrease, no effect) does the required adjustment have on each of the following elements? Assets

Revenues

Liabilities

Expenses

Shareholders’ equity Solution: Assets - No effect Liabilities – Increase Shareholders’ equity - Decrease

Revenues - Decrease Expenses - No effect

KP 2,3,5 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

11.

Total assets, liabilities, and shareholders' equity are $15,000, $6,000, and $9,000 before a $2,000 note payable is paid. Determine the new amounts of assets, liabilities, and shareholders' equity after this event? Solution: Assets = $15,000 – $2,000 = $13,000 Liabilities = $6,000 – $2,000 = $4,000 Shareholders' equity = $9,000 – no change KP 2 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

12.

Houston Times Publishing Inc. sells two-year magazine subscriptions. Cash receipts from subscribers are credited to Unearned Subscriptions. On December 31, 2010, immediately before the company made adjusting entries, the Unearned Subscriptions account had a balance of $8,000. Outstanding subscriptions relating to magazines that have not been delivered as of December 31, 2010, will be mailed to customers as follows: During 2011 During 2012

$3,800 2,200

At December 31, 2010, what amount should Houston Times Publishing Inc. report as the balance for Unearned Subscriptions? Where should this amount be reported? Solution: Unearned Subscriptions at December 31, 2010: $3,800 + $2,200 = $6,000 The Unearned Subscriptions should be reported on the balance sheet as a liability. KP 2,3,5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting, Measurement

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

13.

4-31

Total assets, liabilities, and shareholders' equity are $22,000, $5,000, and $17,000 before land costing $10,000 is purchased in exchange for a $1,000 note payable and $9,000 cash. During the year, the company earned $50,000 of revenues of which only $45,000 was collected. Expenses totaling $44,000 were incurred, but $2,000 of this had not been paid by the end of the year. Show the amounts that would be reported on the accounting equation as a result of these transactions. Solution: Beginning balances Purchase of land Revenues earned Expenses incurred Totals

Assets

Liabilities

Shareholders’ Equity

$ 22,000 +10,000 (9,000) +50,000 (42,000) $ 31,000

$ 5,000 +1,000

$ 17,000

+2,000 $ 8,000

+50,000 (44,000) $ 23,000

KP 2,3,5 BT: AN Difficulty: Moderate TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting, Measurement 14.

Marian Company collected $8,000 cash in advance during March for services to be performed in April and May. At the end of April an adjusting entry was made to debit Unearned Revenue and credit Service Revenue for $4,200. The ending balance in the Unearned Revenue account was $3,800. A. What entry was made during March when the original $8,000 was collected? B. How much will Marian report on its balance sheet as a liability at the end of April as a result of the transactions? Solution: A. Cash 8,000 Unearned Revenue 8,000 B. $3,800 – the balance of the unearned revenue account KP 3,4 BT: AP Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

15.

On October 1, 2010, Edinboro Company rented a building from another company for $90,000 for a two-year time period. Edinboro Company debited the rent expense account on October 1 when the payment was made. What adjustment for rent is necessary at December 31, 2010? Solution: Prepaid Rent Rent Expense ($90,000 X 21/24)

78,750 78,750

KP 3, 4, App4B BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

4-32

16.

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

On January 1, 2010, Somerville Co. received $3,600 for a three-year service subscription. Somerville credited a revenue account on January 1 for the cash received. What adjusting entry must be made on December 31, 2010? Solution: Service Revenue Unearned Service Revenue ($3,600 x 2/3)

2,400 2,400

KP 3, 4, App4B BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

17.

If interest payable on January 1 is $3,000, and during the current year interest expense is $62,000, and cash payments for interest is $63,000, then what is the balance in the Taccount, Interest Payable, on December 31? Solution: $3,000 + $62,000 – $63,000 = $2,000 KP 3 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

18.

Dena, Inc. began operations during 2010. During January of 2010, the following transactions occurred: • • • • • • •

Received $80,000 from shareholders as initial investments Received cash of $50,000 for services performed during January Billed customers an additional $12,000 for services performed during January Borrowed $12,000 from NationsBank Company, and signed a one-year note payable Paid rent in the amount of $5,000 for January Paid dividends in January amounting to $8,000 Paid wages of $35,000 for January

How much Net Income should Dena, Inc. report for January? Solution: $50,000 + $12,000 – $5,000 – $35,000 = $22,000 KP 2,3,4,5 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

19.

4-33

On July 1, Sanders, Inc. borrowed $12,000 from another company on a 12%, one-year note. Prepare the journal entries to record the note on July 1 and to accrue interest on December 31. Solution: July 1: Cash Notes Payable

12,000

December 31: Interest Expense Interest Payable ($12,000 X 12% X 6/12)

12,000 720 720

KP 3,4 BT: AP Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

20.

If interest payable on January 1 is $1,000, and during the current year interest is accrued for $2,200, and cash payments for interest amount to $2,000, then what is the balance in the T-account, Interest Expense, on December 31? Solution: $2,200 KP 3 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

21.

If accounts receivable on January 1 totals $21,000, and during the current year sales revenue is $300,000, and cash receipts from customers is $296,000, then what is the balance in Accounts Receivable on December 31? Solution: $21,000 + $300,000 – $296,000 = $25,000 KP 3,4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

22.

Interest receivable on January 1 is $5,000. During the current year interest revenue is $65,000, and cash receipts from interest is $60,000. How much is the balance of Interest Receivable on December 31? Solution: $5,000 + $65,000 – $60,000 = $10,000 KP 2,3,4,5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

4-34

23.

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

Retained earnings on January 1 was $27,000. During the current year net income is $160,000. Cash payments for dividends declared totals $145,000. What is the retained earnings balance on December 31? Solution: $27,000 + $160,000 – $145,000 = $42,000 KP 2,3,4,5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Use the information that follows taken from the unadjusted accounting records of Sheena, Inc. for the year ending December 31, 2010 to answer problems 24 through 26. Cash Accounts Receivable Prepaid Insurance Supplies Office Equipment Accumulated Depreciation Accounts Payable Unearned Revenue Contributed capital Retained Earnings Dividends Service Fees Revenue Wages Expense Rent Expense Supplies Expense Totals

$ 500 700 100 200 3,500 $ 1,000 1,600 400 1,200 800 800 4,900 2,000 1,500 600 $9,900

_____ $9,900

The following information is needed for adjusting entries at the end of December. a. On December 31, 2010, the insurance expired amounted to $80. b. Of the unearned revenue, $250 of services had been performed. c. Services have been performed for customers that have not yet been billed or paid totaling $180. d. The office equipment computation for 2010 depreciation amounts to $200. 24.

What is the effect on net income of each of the adjusting entries necessary for Sheena, Inc.? Solution: Entry a: Entry b: Entry c: Entry d:

Decrease in net income for $80. Increase in net income for $250. Increase in net income for $180. Decrease in net income for $200.

KP 3, 4, App4A BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

25.

4-35

How much net income will Sheena report for the year ending December 31, 2010? Solution: Service Fees Revenue ($4,900 + $250 + $180) $ 5,330 Expenses: Wages Expense $2,000 Rent Expense 1,500 Supplies Expense 600 Insurance Expense 80 Depreciation Expense 200 Total Expenses 4,380 Net income $ 950 KP 3,5 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

26.

Determine total liabilities for Sheena, Inc. for the year ending December 31, 2010. Solution: Accounts Payable Unearned Revenue ($400 - $250) Total Liabilities

$1,600 150 $1,750

KP 3,5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

27.

Interest receivable on January 1 and December 31 totals $4,800 and $3,600, respectively. During the year, cash received from interest is $15,000. Determine interest revenue for the current year. Solution: $3,600 + $15,000 – $4,800 = $13,800 KP 3,5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

28.

Accounts receivable on January 1 and December 31 is $18,000 and $21,500, respectively. During the year, sales revenue is $260,000. What is the current year's cash received from customers? Solution: $18,000 + $260,000 – $21,500 = $256,500 KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

4-36

29.

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

Inventory on January 1 and December 31 is $41,500 and $47,000, respectively. During the year, cash paid to suppliers of inventory is $100,000. If all purchases of inventory are for cash, how much is the current year's cost of goods sold? Solution: $41,500 + $100,000 – $47,000 = $94,500 KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

30.

Inventory on January 1 and December 31 is $40,000 and $35,000, respectively. Accounts payable on January 1 and December 31 are $25,000 and $29,000, respectively. During the year, cost of goods sold is $190,000. How much is the current year's cash payments to suppliers of inventory? Solution: $40,000 – $25,000 + $29,000 – $35,000 – $190,000 = $181,000 KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

31.

4-37

The following are amounts from the accounting records of Farley Company before adjusting entries have been for the year ending December 31, 2010. Cash $ 3,200 Accounts receivable 2,600 Supplies 2,100 Investment in Coca-Cola 10,000 stock Equipment 80,000 Accumulated depreciation 20,000 Accounts payable 4,800 Note payable 8% 20,000 Contributed capital 24,500 Retained earnings 11,800 Service revenue 42,600 Interest revenue 1,200 Supplies expense 5,000 Wage expense 20,000 Depreciation expense 0 Interest expense 2,000 The following adjustments have not been made as of December 31, 2010: 1. Wages accrued on 12/31/10 amounts to $1,100. 2. Three months' interest on the note payable has not been paid or recognized. 3. Depreciation for 2010 amounts to $3,000. 4. Supplies on hand at 12/31/10 amounts to $700. Prepare Farley’s balance sheet at December 31, 2010 after the adjusting process is completed. Omit the heading. Solution: Balance Sheet: Assets Cash Accounts receivable Supplies Investment in Coca Cola Stock Equipment Less: Accumulated depreciation Total Assets Liabilities and Shareholders’ Equity Liabilities: Accounts payable Wages payable Interest payable Note payable 8% Total Liabilities Shareholders’ Equity: Contributed capital Retained earnings Total liabilities and shareholders' equity

$ 3,200 2,600 700 10,000 80,000 (23,000) $73,500

$ 4,800 1,100 400 20,000 $26,300 24,500 22,700 $73,500

KP 4 BT: AP Difficulty: Difficult TOT: 10 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

4-38

32.

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

Given below is the Accounts Receivable T-account. Accounts receivable on January 1 was $1,700. During the year, customers charged on account sales totaling $255,000. The current year's cash received from customers is $250,000. Post all amounts to this account and calculate the account balance. Accounts Receivable

Solution: Debits of $1,700 and $255,000. Credit of $250,000. Balance is $6,700. KP 3 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

33.

Lebron Company provides you, its auditor, with the following information that pertains to its income for the year ending December 31, 2010: Service revenue Salaries expenses Rent expense

$20,000 3,000 10,400

After you review the process Lebron used to derive this income statement, you discover that the company had omitted adjusting entries on December 31, 2010. The following adjusting information was omitted: 1. $500 of the $20,000 service revenue is for plumbing that will not be done until January 10, 2011. 2. Employees earned $700 of salaries for work done on December 31, 2010, but they will not be paid until January 2, 2011. 3. Depreciation for Lebron’s truck and tools amounted to $2,400 for 2010. 4. Rent expense is $800 a month. On December 31, 2010, Lebron paid $800 rent for January, 2011, which is included in the rent expense given above. Prepare Lebron Company's income statement after you include the results of the adjusting information provided. Solution: Lebron Company Income Statement For the Year Ended December 31, 2010 Service revenue Expenses: Salaries expenses Depreciation expense Rent expense Net income

$19,500 $3,700 2,400 9,600

15,700 $ 3,800

KP 2,3,4,5 BT: AN Difficulty: Difficult TOT: 8 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

34.

4-39

Retained earnings on January 1 and December 31 are $72,000 and $69,000, respectively. During the year, net income is $100,000. How much dividends did the company declare and pay to the shareholders? Solution: $72,000 + $100,000 – $69,000 = $103,000 KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

35.

Given below is a listing of selected accounts before adjusting entries for Duane Corporation as of December 31. Account Names Cash Supplies Prepaid Rent Salaries Payable Unearned Revenue Contributed capital Retained Earnings Revenue Supplies Expense Salaries Expense Rent Expense

Account Balances Unadjusted Adjusted

$11,700 3,000 0 0 0 20,000 9,400 45,000 0 24,600 1,300

Complete the ‘Adjusted Account Balances’ column on the basis of the following information: a. Unused supplies amount to $400 on December 31. b. $300 of rent is prepaid on December 31. c. Unpaid salaries amount to $500 on December 31. d. $1,200 of the $45,000 service revenue is not yet earned on December 31. Solution: Adjusted Amounts

Cash Supplies Prepaid Rent Salaries Payable Unearned Revenue Contributed capital Retained Earnings Revenue Supplies Expense Salaries Expense Rent Expense

$11,700 400 300 500 1,200 20,000 9,400 43,800 2,600 25,100 1,000

KP 2,3,4,5 BT: AN Difficulty: Difficult TOT: 8 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

4-40

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

SHORT ESSAY QUESTIONS 1.

Dora Manufacturing, a capital-intensive company that manufactures commercial snow blowers, announced that it is expecting a record loss of $7,000,000 in 2010. However, it also stated that its business is generating sufficient cash to meet its obligations due in 2010. How can Dora lose $7 million and still generate cash necessary to meet obligations? Solution: Accounting accrual income includes charges (expenses) that do not require cash payments during the current year. Depreciation expense is typically the most significant expense that does not require a current cash payment. The cash payment associated with depreciation occurs when an investment in plant and equipment is made, not when those assets are used. Dora Manufacturing, having capital-intensive operations, records a significant amount of depreciation expense. As an approximation of cash flow from operations, the depreciation expense is added back into income (loss). Therefore, Dora would have a positive cash flow from operations if depreciation expense is greater than $7 million. KP 6 BT: E Difficulty: Difficult TOT: 5 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Decision Modeling

How does the information presented in an income statement relate to the information reported in a statement of shareholders’ equity? Solution: An income statement reports the amount of net income or loss for a period. The amount of net income or loss is added or subtracted to retained earnings, which is a component of shareholder’s equity to determine the ending retained earnings balance. The changes in retained earnings for the year are reported on the statement of shareholders’ equity. KP 2 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Describe a debit. How does it impact the accounts? Solution: Debit means ‘left.’ To debit an account means to place it on the left side of the journal entry. A debit increases assets, expenses, and dividends. A debit decreases revenues, liabilities, and shareholders’ equity. KP 3 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

4-41

How do the concepts of economic events and objectivity relate? Solution: Economic events are reflected in the financial statements. Before each event is recorded, two characteristics must be met. Each event must be relevant and objective. The dollar amounts to be assigned to the accounts on the financial statements must be determined in an objective manner. To be objective, the information must be unbiased and present a clear financial picture of the company. KP 1 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

Why are ‘expenses paid for in advance’ reported as assets? What happens to this ‘asset’ as time passes? Solution: When a company pays for an expense in advance, the company expects future benefits from that payment. Assets are defined as items expected to provide future benefits. As time passes, that future benefit is consumed, and the cost is then reported as an expense. KP 2,4,5 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Name two components of shareholders’ equity and describe what each consists of. Solution: Two components of shareholders’ equity are contributed capital and retained earnings. Contributed capital is the dollar value of the assets contributed by the shareholders. Retained earnings is the dollar value of the assets generated by operating activities that have been retained in the business. KP 2 BT: K Difficulty: Moderate TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

What are journal entries and how they used in accounting? Solution: Journal entries are used to record the economic effects of events that impact the financial statements of a company. Each entry consists of at least one debit and one credit. The components of a journal entry either increase or decrease individual accounts within the accounting system. Total debits must equal total credits in every journal entry. KP 2 BT: K Difficulty: Moderate TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

4-42

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

What are revaluation adjustments? Solution: Revaluation adjustments serve to ‘restate’ accounts to keep their reported values in line with existing facts. For example, most short-term investments are valued at fair value, the amount they are selling for in the market. Because the fair value at the end of the year is not always the same dollar amount as reported in the short-term investment account during the year, an adjustment must be made to the balance in the investment account so it will equal the fair value at the end of the year. KP 5 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Why is the acquisition of merchandise inventory capitalized as an asset? Solution: Assets are items and rights that a company acquires through objectively measurable transactions that can be used in the future to generate economic benefits (i.e., more assets). Inventories are capitalized because they are expected to generate revenues in the future when they are sold. KP 5 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

10.

How does the accrual for wages relate to the cash paid for wages expense? Solution: The payment of wages creates a debit to wages expense and a credit to cash. In situations where the cost of wages have been incurred but the actual cash outflow will not occur until the next accounting period, the wages expense must be accrued. The accrual creates a debit to wages expense and a credit to a liability account, wages payable. The cash flows associated with the expenses occur after the accruals have taken place. KP 5 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

11.

What purpose does a gain or loss associated with the sale of a plant asset serve? Solution: When a company sells a plant asset, receiving a dollar amount that does not match the recorded for the asset on the balance sheet, then a gain or loss must be recognized in the amount of the difference between the proceeds and the balance sheet carrying amount. KP 3 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

12.

4-43

Why are ‘unearned revenues’ considered liabilities? Solution: Unearned revenues are amounts received in advance of the actual earnings process. Since the amount represented by the unearned revenue represents a future outflow of assets or requires services to be provided, it represents an obligation and must be recorded as a liability. KP 5 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

13.

Why do managers need to understand how economic events affect the financial statements? Solution: Managers are often faced with situations that require a decision in which economic consequences must be considered. Managers must understand how transactions affect financial statements in order to prevent, modify, or otherwise change their presentation in the financial statements, so that records reflect accurate data. KP 4 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

14.

What is depreciation? Solution: Depreciation is a process of allocating the cost of buildings and equipment. When a plant asset is acquired, it is capitalized—placed on the balance sheet. As time passes, the cost of this plant asset is used in the earnings process and the cost is allocated against the related revenue according to the matching principle. KP 5 BT: K Difficulty: Easy TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

15.

Explain the difference between temporary and permanent accounts. Please give four examples of each. Solution Temporary accounts include all income statement accounts and the dividend account. They are called “temporary” accounts because their balances do not carry forward from one fiscal period to the next, but rather are restarted with a zero balance at the beginning of a new accounting period. Examples include sales, cost of goods sold, depreciation expense, and dividends. Permanent accounts are accounts that accumulate their balances from year to year. All the balance sheet accounts are considered permanent. Examples include cash, accumulated depreciation, accounts payable, and retained earnings. KP 3 BT: C Difficulty: Moderate TOT: 5 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

4-44

16.

Test Bank – Chapter 4 – The Mechanics of Financial Accounting

Explain what is meant by a “contra account” and give two examples of contra accounts that would be found on the balance sheet. Solution A contra account is a balance sheet account that is used to offset other balance sheet accounts. Examples include accumulated depreciation, accumulated amortization and the allowance for doubtful accounts. KP 3 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Chapter 5 Using Financial Statement Information MULTIPLE CHOICE QUESTIONS 1.

The current ratio is a. current assets divided by current liabilities. b. current liabilities divided by current assets. c. current assets divided by total liabilities. d. total assets divided by total liabilities. Ans: A KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

The current ratio a. provides users with an estimate of a company’s human resources. b. is reported on a company’s balance sheet in the asset section. c. is a measure of a company’s solvency. d. is a measure of a company’s liquidity. Ans: C KP 2,5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Earnings per share a. must appear on a company’s income statement if the company is publicly traded. b. is rarely used by analysts since it is not required by GAAP. c. is based on the market price of the company’s stock. d. is typically presented in its two forms: simple and advanced. Ans: A KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Return on equity compares a. the market price of the company’s stock to its dividend policy. b. a company’s earnings to the dividends paid for the year. c. the profits of a company to the investment made by its shareholders. d. the profits of a company to the selling price of each share of stock. Ans: C KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

5-1

5-2

Test Bank – Chapter 5 – Using Financial Statement Information

Operating performance is a company’s ability to a. control acquisitions of other companies in the same industry. b. generate cash from sources other than regular operations. c. increase its net assets through regular operations d. employ off-balance-sheet financing. Ans: C KP 4, App5A BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Financial statements help present and potential investors, creditors, and other users in assessing the amount, timing, and uncertainty of a. future income. b. future assets. c. future liabilities. d. future cash flows. Ans: D KP 1 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

The price-earnings ratio is a. the market price of an equity share divided by earnings per share. b. the amount of a company’s retained earnings. c. the purchase price of a firm's assets divided by net income. d. used to measure the speed at which the company sells its inventories. Ans: A KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Financial flexibility is a. a good indicator of a company’s ability to grow through operations. b. evident when a company’s assets are greater than its liabilities. c. the ability to convert existing assets into money. d. the ability to generate cash from sources other than regular operations. Ans: D KP App5A BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

A standard audit report a. states that a company has the right to select members of its board of directors. b. serves as the accounting profession’s seal of approval. c. states whether a company will be profitable or not in the future. d. serves as a guarantee that the financial statements are free of any errors. Ans: B KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 5 – Using Financial Statement Information

10.

5-3

Liquidity is the ability a. to increase net assets through regular operations. b. to generate cash from sources other than regular operations. c. to convert existing assets into cash. d. of financial statement users to predict a company’s cash flows. Ans: C KP App5A BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

11.

Which of the following may be a limitation of financial statements? a. Subject to biases of management b. Provides no information on the company’s accounting methods c. Typically reflects the view of inherently unethical managers d. Communicates only market values and no historical information Ans: A KP App5A BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

12.

Which one of the following is a reason a company’s reported book value and its true value may differ? a. Management calculates net worth different than shareholders. b. GAAP requires too many estimates. c. Statements are forward-looking. d. Statements do not reflect the company’s prospects within its business environment. Ans: D KP 1 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

13.

The current ratio helps assess a company’s a. profitability. b. asset turnover. c. capital structure leverage. d. solvency. Ans: D KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

14.

Return on equity helps assess a company’s a. marketability. b. solvency. c. profitability. d. leverage. Ans: C KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

5-4

Test Bank – Chapter 5 – Using Financial Statement Information

15.

The quick ratio helps assess a company’s a. annual stock price. b. solvency. c. inventory turnover. d. profit during the current period. Ans: B KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

16.

The dividend yield ratio helps assess the a. profitability of the current year. b. cash return on a shareholders’ investment. c. company’s ability to pay its current liabilities as they come due. d. solvency of a company. Ans: B KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

17.

Which of the following ratios would be of primary importance to a manager in evaluating the success of a new policy of reducing the stock of goods needed to meet customer demand? a. Total asset turnover b. Fixed assets turnover c. Receivables turnover d. Inventory turnover Ans: D KP 5 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking, Resource Management AICPA FN: Measurement

18.

Which of the following ratios might a potential investor use to determine if the return to shareholders is a large portion of the total return generated by a company? a. Earnings per share b. Common equity leverage c. Current ratio d. Total asset turnover Ans: B KP 5 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

19.

Assessing a company’s inventory turnover helps assess the a. effectiveness of a company’s collection activities. b. ability to measure the quality of the inventory on hand. c. speed at which inventories move through operations. d. efficiency of a company. Ans: C KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 5 – Using Financial Statement Information

20.

5-5

Which of the following ratios would be of primary importance to a supplier in deciding to extend credit for goods delivered? a. Earnings per share b. Debt/equity ratio c. Accounts receivable turnover d. Quick ratio Ans: D KP 5 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

21.

Which of the following ratios would be of primary importance to a creditor in deciding to extend long-term credit? a. Current ratio b. Debt/equity ratio c. Inventory turnover d. Earnings per share Ans: B KP 5 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

22.

Which of the following ratios would be of primary importance to a manager in evaluating the success of a computerized collection process? a. Accounts receivable turnover b. Account payable turnover c. Quick ratio d. Return of equity Ans: A KP 5 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

23.

Book value fails to reflect true value primarily because: a. b. c. d.

financial statements are irrelevant. financial statements are backward-looking. financial statements are forward-looking. financial statements are typically biased.

Ans: B KP 1 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

24.

Which of the following is a fundamental way in which financial accounting numbers are useful? a. They can predict the way the stock price will behave. b. They are used to assess the quality of a company’s products. c. They can be used to predict a company's future earnings. d. They identify the effect of inflation on the value of company’s assets. Ans: C KP 1 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

5-6

Test Bank – Chapter 5 – Using Financial Statement Information

25.

The long-term debt ratio a. measures the significance of long-term debt as a source of asset financing. b. measures the effect of management’s use of long-term debt. c. compares profits to the company’s total debt. d. is a measure of profitability. Ans: A KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

26.

The use of financial statements for predicting future earnings and cash flows is limited due to a. management bias, lack of forward-looking information, and certain inherent limitations. b. lack of judgment, management bias, and lack of inclusion of inflationary effects. c. lack of forward and backward-looking information. d. lack of backward-looking information, the likelihood of management bias, and the omission of historical costs. Ans: A KP 1 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

27.

Which one of the following is a step used in assessing whether a particular investment should be made or not? a. Determine the number of employees a company has. b. Obtain an understanding of the company and its industry. c. Determine the number of years the company has been in business. d. Calculate the amount of advertising costs incurred by the company during the previous year. Ans: B KP 2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking, Industry AICPA FN: Measurement

28.

A standard audit report states that the financial statements a. were examined in great detail and contain no errors. b. were prepared by management. c. were certified error free by the independent auditor. d. represent a substantial doubt of the ability of the company to continue as a going concern. Ans: B KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 5 – Using Financial Statement Information

29.

5-7

A company would likely "take a bath" a. in periods of extraordinary high net income. b. just prior to creating hidden reserves. c. when it has experienced an extremely poor year. d. when its quality of earnings is very high. Ans: C KP 4 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

30.

An analyst assessed a company and determined the company to have reported a "high quality of earnings." This implies that a. management issued a press release indicating it was not aware of any fraud during the current year. b. the company’s management exercised little or no discretionary influence in reporting financial statement information to shareholders. c. management has used its influence in determining the dollar amounts reported on financial statements. d. income statement items reported during the current period can be expected to reflect future income levels. Ans: B KP 4 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

31.

Managers that structure financing transactions and choose accounting methods that exclude debt on the company’s balance sheet are using a. hidden reserves. b. fraudulent methods by default. c. performance overstatement. d. off-balance-sheet financing. Ans: D KP 4 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

32.

Information concerning industry averages will likely be found in a. Barron’s. b. The Wall Street Journal. c. Dun & Bradstreet's Key Business Ratios. d. The New York Times. Ans: C KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

5-8

Test Bank – Chapter 5 – Using Financial Statement Information

33.

Common-size financial statements are expressed as a. percentages of other numbers on the same statements. b. a percent comparison of other companies in the same industry. c. a common way of preparing certain types of financial statements. d. percentages of increases and decreases compared to the previous accounting period. Ans: A KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

34.

The primary measure of the overall success of a company is a. total shareholders' equity. b. total assets. c. net income. d. the number of shares of stock it has sold to investors. Ans: C KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

35.

Many ratios require an average be used for the balance sheet numbers because the a. income statement refers to a point in time. b. accountants may have made errors in the financial statements. c. balance sheet numbers are a point in time and are being compared to an income statement number that covers a period of time. d. income statement numbers represent a point in time and are being compared to a balance sheet number that covers a period of time. Ans: C KP 5 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

36.

Using borrowed funds to generate returns for the shareholders is called a. leverage. b. profitability. c. taking a bath. d. solvency. Ans: A KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

37.

A company that reports high levels of common equity leverage is probably a. reporting higher earnings per share than other companies in the same industry. b. meeting its financing needs effectively. c. using leverage very effectively. d. demonstrating it has a large amount of off-balance-sheet financing. Ans: C KP 5 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 5 – Using Financial Statement Information

38.

5-9

The item that causes the greatest and most immediate effect on a company’s stock price will generally be a. cash on hand. b. the company's solvency. c. profits. d. dependent upon the industry in which the company operates. Ans: C KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

39.

Investors who use accounting information to guide trading in foreign securities a. should carefully compare expenses, but not revenues to companies in the same industry in the United States. b. must adjust the numbers of foreign-based companies’ financial statements and thoroughly understand the foreign environment. c. must contact the foreign CEO before any investment in stock occurs. d. should contact the foreign company’s auditors to find out how much dividends will be paid. Ans: B KP 7 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic, Diversity AICPA BB: Global, Critical Thinking AICPA FN: Reporting

The DuPont model is a. a method of off-balance sheet financing. b. a framework to analyze ROE changes and identify value drivers. c. a method of preparing a balance sheet. d. a solvency calculation. Ans: B KP 5, App5A BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

41.

Accounting numbers are useful in that they a. are easy to manipulate by management and help predict a company’s future earnings and cash flows. b. allow users to see management’s predictions of future profits and help predict a company’s future cash flows. c. help investors and creditors influence and monitor management’s business decisions and help predict a company’s future earnings and cash flows. d. help investors and creditors influence, manipulate, and monitor management’s business decisions so that future profits are high. Ans: C KP 1 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

5-10

42.

Test Bank – Chapter 5 – Using Financial Statement Information

The two fundamental ways in which financial accounting numbers are useful are a. prediction and influence. b. control and monitoring. c. prediction and monitoring. d. control and prediction. Ans: D KP 1 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

43.

True value of a company is determined by a. adding adjustments for the business environment, unrecorded events, and types of shareholders to the book value of a company. b. adding adjustments for the business environment, unrecorded events, and cumulative profits to the book value of a company. c. adding adjustments for the business environment, management bias, and cumulative profits to the book value of a company. d. adding adjustments for the business environment, unrecorded events, and management bias to the book value of a company. Ans: D KP 1 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

44.

What type of audit report do most companies receive from their auditors? a. standard audit reports b. no report unless the company has problems c. a GAAP report d. a comprehensive report Ans: A KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 5 – Using Financial Statement Information

5-11

Use the information that follows taken from Campbell Company’s financial statements for the years ending December 31, 2010 and 2009 to answer problems 45 through 48.

45.

Balance Sheet Information Assets Cash Accounts receivable Inventory Land, building, and equipment Total Assets

2010

2009

$ 35 60 40 225 $360

$ 60 70 30 250 $410

Liabilities and Shareholders' Equity Accounts payable Long term note payable Common stock Retained earnings Total Liabilities & Shareholders' Equity

$ 95 180 150 -65 $360

$ 110 200 150 -50 $410

Income Statement Information Sales (all sales are on credit) Cost of goods sold Gross profit Operating expenses Net income

$850 425 $425 440 $-15

Calculate Campbell’s current and quick ratios as of December 31, 2009 and December 31, 2010 and choose the correct answers below: a. Campbell’s quick and current ratios improved from December 31, 2009 to December 31, 2010. b. Campbell’s quick and current ratios worsened from December 31, 2009 to December 31, 2010. c. Campbell’s quick ratio improved but the current ratio worsened December 31, 2009 to December 31, 2010. d. Campbell’s quick ratio worsened but the current ratio improved from December 31, 2009 to December 31, 2010. Solution:

Campbell has the following solvency ratios on December 31: 2010 Current: Quick:

$135/$95 = 1.42 $95/$85 = 1.12

2009 Current: Quick:

$160/$110 = 1.45 $130/$110 = 1.18

The current ratio declined from 1.45 to 1.42 and the quick ratio declined from 1.18 to 1.12. Ans: B KP 5 BT: AN Difficulty: Difficult TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

5-12

46.

Test Bank – Chapter 5 – Using Financial Statement Information

Calculate Campbell’s inventory turnover ratio and accounts receivable turnover ratio for the year ended 2010. Further, assume that in Campbell’s industry, the industry average inventory turnover ratio is 12 and the industry average receivables turnover ratio is 14. a. b. c. d.

Campbell’s inventory turnover ratio and accounts receivable turnover ratios are better than average for Campbell’s industry. Campbell’s inventory turnover ratio and accounts receivable turnover ratios are worse than average for Campbell’s industry. Campbell’s inventory turnover ratio is better but the accounts receivable turnover ratio is worse than average for Campbell’s industry. Campbell’s inventory turnover ratio is worse and accounts receivable turnover ratio is better than average for Campbell’s industry.

Solution:

Campbell has the following turnover ratios on December 31, 2010: Inventory turnover: A/R turnover

$425 / [(40+30) / 2] = 12.14 $850 / [(60+70) /2] = 13.07

Inventory turnover is 12.14 compared to 12 for the industry and receivables turnover is 13.07 as compared to the industry average of 14. So, inventory turnover is better and accounts receivable turnover is worse. Ans: C KP 5 BT: AN Difficulty: Difficult TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

47.

Calculate Campbell’s return on equity and return on assets for the year ended December 31, 2010. Assume that the income tax rate is 30%. Also assume that in Campbell’s industry, the industry average return on equity is 19% and the average return on assets is 11%. a. b. c. d.

Campbell’s return on equity and return on assets are better than average for Campbell’s industry. Campbell’s return on equity and return on assets are worse than average for Campbell’s industry. Campbell’s return on equity is better but return on assets is worse than average for Campbell’s industry. Campbell’s return on equity is worse but return on assets is better than average for Campbell’s industry.

Solution:

Because net income is negative, both of these ratios are less than zero and both ratios are worse than the industry average. Ans: B KP 5 BT: AN Difficulty: Difficult TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 5 – Using Financial Statement Information

48.

5-13

Calculate Campbell’s debt to equity ratio as of December 31, 2009 and as of December 31, 2010. Also assume that in Campbell’s industry, the industry average debt to equity ratio is 2.75 as of December 31, 2009 and as of December 31, 2010. a. b. c. d.

Campbell’s debt to equity ratio improved from 2009 to 2010. Campbell’s debt to equity ratio was better than average for the industry both years. Campbell’s debt to equity is worse than average for the industry for both years. Both a and b above, but not c.

Solution:

Campbell has the following debt to equity ratios on December 31: 2010

($95+180) / (150-65) = 3.24

2009

($110+200) / (150-50) = 3.10

Unlike the other ratios we study in this course, the lower the debt to equity ratio, the better. Hence, the ratio worsened from 2009 to 2010 and is worse than the industry average. Ans: C KP 5 BT: AN Difficulty: Difficult TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

49.

Devin Inc. has an inventory turnover ratio of 30. Devin’s average number of day’s inventory is: a. b. c. d.

Less than 10. Between 10 and 12. More than 12. Unable to be determined based on this limited information.

Solution:

365 / 30 = 12.2 days Ans: B KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

5-14

50.

Test Bank – Chapter 5 – Using Financial Statement Information

51.

Justin Company has total assets, liabilities, and shareholders' equity of $36,000, $15,000, and $21,000, respectively, at the beginning of 2010. At the end of 2010, total assets, liabilities, and shareholders' equity were reported at $32,000, $13,000, and $19,000, respectively. How much additional debt can Justin Company incur and still have its debt/equity ratio remain less than or equal to 1.00? a. $6,000 b. $25,000 c. $12,000 d. $24,000 Solution: A. Debt/equity ratio = Average total liabilities / Average total shareholders’ equity = (($15,000 + $13,000)/2) / (($21,000 + $19,000)/2) = .70 Average total liabilities can increase up to $20,000 and still maintain a debt/equity ratio of 1.0. In order to make the numerator equal to $20,000, the ending debt could increase up to $25,000: Average total liabilities = ($15,000 + $25,000)/2 = $20,000 Since total debt at the end of 2010 is $13,000, the increase in debt could be up to $12,000 ($25,000 less $13,000). Ans: C KP 5, App5A BT: AN Difficulty: Difficult TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement, Decision Modeling

Test Bank – Chapter 5 – Using Financial Statement Information

52.

5-15

Sheena Company has current assets, current liabilities, and long-term liabilities of $19,000, $13,000, and $17,000, respectively. Within these amounts, $3,000 is accounts payable, and $3,500 is accounts receivable. If $2,000 of cash were used to pay off the accounts payable, what effect would this have on the current ratio? a. The current ratio would increase by approximately 0.09. b. The current ratio would decrease by approximately 0.09. c. The current ratio would decrease by approximately 0.03. d. There would be no change in the current ratio. Solution: Current ratio before payment of payables = $19,000/$13,000 = 1.46 Current ratio after payment of payables = ($19,000 – $2,000)/($13,000 – $2,000) = 1.55 Ans: A KP 5 BT: AN Difficulty: Difficult TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

53.

Buffalo Company has current assets, current liabilities, and long-term liabilities of $9,000, $3,000, and $4,000, respectively at the end of 2010. How much cash can Buffalo use to acquire equipment and retain a current ratio of at least 2.0? a. $1,000 b. $3,000 c. $4,000 d. $6,000 Solution: Current ratio before acquisition of equipment = $9,000/$3,000 = 3.0 Current ratio after acquisition of equipment = ($9,000 – $X)/$3,000 = 2.0 So X = $3,000 If $3,000 of cash is used, then current assets = $6,000 and the current ratio = 2.0. Ans: B KP 5 BT: AN Difficulty: Difficult TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement, Decision Modeling

5-16

54.

Test Bank – Chapter 5 – Using Financial Statement Information

Rudy Company has total assets, liabilities, and shareholders' equity of $35,000, $28,000, and $7,000, respectively. Assume no material change occurred during the year to totals on the balance sheet. What amount of long-term debt must Rudy exchange for new shares of common stock issued in order to decrease its debt/equity ratio to 1.0? a. $17,500 b. $10,500 c. $14,000 d. $21,000 Solution: Actual debt/equity ratio = Average liabilities / Average shareholders’ equity = $28,000/$7,000 = 4.00 Rudy' debt/equity ratio is currently 4.00. In paying off new debt by issuing new stock, for every dollar added to common stock, Rudy must deduct $1 from its liabilities: = ($28,000 – X)/($7,000 + X) = 1.00 = $10,500 Rudy can exchange stock for debt up to $10,500 and still keep a debt/equity ratio of 100%, or 1.0. Ans: B KP 5 BT: AN Difficulty: Difficult TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement, Decision Modeling

55.

Samson Company has common stock of $150,000 and retained earnings of $140,000 at yearend. During the year, 20,000 shares of stock were outstanding. Net income was reported as $70,000. What is the company’s earnings per share? a. $3.50 b. $1.07 c. $0.73 d. $10.25 Solution: Earnings per share = Net income / Average number of common shares outstanding = $70,000/20,000 = $ 3.50 per common share Ans: KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 5 – Using Financial Statement Information

56.

5-17

Grey Company has a current ratio of 0.30 and return on equity of 0.05. Which of the following statements is the best regarding Grey’s profitability and solvency? a. Grey is very profitable, but not very solvent. b. Grey is very profitable and very solvent. c. Grey is not very profitable, but very solvent. d. Grey is not very profitable and not very solvent. Solution: Solvency:

Profitability:

Not very solvent—For every dollar of current liabilities, the company has only 30 cents of liquid assets available. It will likely not be able to pay its current debts when they become due. Not very profitable— Net income is only 5 percent of the amount of average shareholders’ equity.

Ans: D KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement, Decision Modeling

57.

Pasky Company has the following financial data on January 1, 2010 and January 1, 2009. 1/1/10 1/1/09 Cash $32,000 $68,000 Accounts receivable 69,000 33,000 Marketable securities 9,000 30,000 Inventory 87,000 105,000 Net plant and equipment 120,000 96,000 Current liabilities Long-term debt Shareholders' equity

$39,000 147,000 131,000

$68,000 90,000 174,000

In terms of the quick and current ratio, which of the following statements is true? a. Pasky’s short-term solvency position has improved. b. Pasky’s short-term solvency position has declined. c. Pasky’s short-term solvency position has remained the same d. Pasky’s quick ratio is increasing, but its current ratio is decreasing. Solution: (in thousands) Current ratio = Current assets / Current liabilities = = ($32 + $69 + $9 + $87)/$39 = = ($68 + $33 + $30 + $105)/$68 =

1/01/10 1/01/09 5.0 3.47

Quick ratio = Quick assets / Current liabilities = = ($32 + $69 + $9)/$39 = 2.82 = ($68 + $33 + $30)/$68 = 1.93 Pasky’s short-term solvency position has improved significantly. Its current ratio has increased from 3.47 to 5.0, and the quick ratio has increased from 1.93 to 2.82. Ans: A KP 2,5 BT: AN Difficulty: Difficult TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement, Decision Modeling

5-18

58.

Test Bank – Chapter 5 – Using Financial Statement Information

Walker Company has the following assets on January 1, 2010 and January 1, 2009.

Cash Accounts receivable Marketable securities Inventory Net plant and equipment

1/1/10 1/1/09 $439,000 $366,000 302,000 333,000 36,000 30,000 87,000 105,000 120,000 96,000

If Walker’s quick ratio is 3.00 for 2010, what is the amount of its current liabilities? a. $325,000 b. $259,000 c. $285,000 d. There is not enough information to answer this question. Solution: Quick ratio = ($439 + $302 + $36) / x = 3.0 X = $259,000 Ans: B KP 5 BT: AN Difficulty: Difficult TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

59.

Norton Company has the following assets on January 1, 2010 and January 1, 2009.

Cash Accounts receivables Marketable securities Inventory Net plant and equipment

1/1/10 1/1/09 $430,000 $366,000 ? 333,000 36,000 130,000 220,000 ? 120,000 129,000

If Norton’s current ratio is 2.20 for 2009 and its current liabilities are $550,000, what is the amount of its inventory? a. $197,000 b. $381,000 c. $238,636 d. There is not enough information to answer this question. Solution: $550,000 x 2.20 = $1,210,000 $1,210,000 - $366,000 – $333,000 – $130,000 = $381,000 Ans: B KP 5 BT: AN Difficulty: Difficult TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 5 – Using Financial Statement Information

60.

5-19

Norton Company has the following assets on January 1, 2010 and January 1, 2009. 1/1/10 1/1/09 $430,000 $366,000 ? 333,000 186,000 130,000 220,000 ? 120,000 129,000

Cash Accounts receivables Marketable securities Inventory Net plant and equipment

If Norton’s quick ratio is 2.60 for 2010 and its current liabilities are $512,000, what is the amount of its accounts receivables? a. $324,000 b. $204,800 c. $715,200 d. There is not enough information to answer this question. Solution: $512,000 x 2.60 = $1,331,200 $1,331,200 - $430,000 – $186,000 = $715,200 Ans: C KP 5 BT: AN Difficulty: Difficult TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

61.

The following ratios were computed from the financial statement of Darren Technologies:

Return on equity Return on assets Common equity leverage Capital structure leverage Profit margin Asset turnover

2011 0.30 0.17 0.87 2.22 0.11 1.69

2010 0.27 0.20 0.90 1.60 0.10 2.27

2009 0.24 0.22 0.92 1.24 0.09 2.87

Which of the following statements is true? a. There has been a steady decline in ROE from 2009 through 2011. b. The increase in ROA is due primarily to the changes in asset turnover. c. The changes in ROA could be due to increasing sales. d. The change in ROA could be due to a large increase in the asset base of the company. Ans: D KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

5-20

62.

Test Bank – Chapter 5 – Using Financial Statement Information

Assume that the following financial ratios were computed from the 2009 financial statements of Florida Industries: Return on sales (profit margin) Return on assets Common equity leverage Capital structure leverage Asset turnover

0.30 0.17 0.87 2.22 1.69

What was the return on equity for Florida in 2009? a. 4% b. 33% c. 51% d. 11% Solution: ROE = ROA X Common Equity Leverage ROE = 0.17 X 0.87 X 2.22 = 0.33

X Capital Structure Leverage

Ans: B KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

63.

0.29 0.17 0.87 2.22 1.69

If Florida holds its other ratios constant in 2010, but increases its capital structure leverage ratio to 3.00, what will be the 2010 return on equity? a. 15% b. 51% c. 86% d. 44% Solution: ROE = ROA X Common Equity Leverage ROE = 0.17 X 0.87 X 3.00 = 0.44

X Capital Structure Leverage

Ans: D KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 5 – Using Financial Statement Information

64.

5-21

0.30 0.17 0.87 2.22 1.69

If Florida holds its other ratios constant in 2010, but increases its profit margin to 36%, what will be the 2010 return on assets? a. 5% b. 78% c. 61% d. 51% Solution: ROA = ROA =

Profit Margin .36

* x

Asset Turnover 1.69 = 61%

Ans: C KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

MATCHING QUESTIONS

Match the correct ratio name from the list below labeled a through g with each formula appearing in items 1 through 5. Ratios

a. b. c. d. e. f. g.

Price/earnings ratio Quick ratio Earnings per share Current ratio Return on assets Return on equity Inventory turnover

____

(Cash + accounts receivable + marketable securities) / current liabilities

____

(Net income + interest expense) / average total assets

____

Current assets / current liabilities

____

Net income / average number of shares of common stock

____

Market price per share / earnings per share

Solution: 1. b

2. e

3. d

4. c

5. a

KP 5 BT: K Difficulty: Easy TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

5-22

Test Bank – Chapter 5 – Using Financial Statement Information

Match the correct ratio name from the list below labeled a through f with the ratio formulas appearing in items 1 through 4. Ratios

a. b. c. d. e. f.

Debt/equity ratio Financial leverage Return on sales Price/earnings ratio Return on equity Dividend yield ratio

____

1. Market price per share / earnings per share

____

2. Dividends per share / market price per share

____

3. Average total liabilities / average total shareholders' equity

____

4. Net income / average shareholders’ equity

Solution: 1. d

2. f

3. a

4. e

KP 5 BT: K Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Match the correct ratio category from the list below labeled a through e with each ratio that appears in items 1 through 12. Ratio Categories

a. b. c. d. e.

Profitability ratio Leverage ratio Solvency ratio Asset turnover ratio Market ratio

Current ratio

Debt/equity ratio

Return on equity

Inventory turnover

Receivables turnover

Return on assets

Return on sales

10.

Long-term debt ratio

Dividend yield ratio

11.

Price/earnings ratio

Quick ratio

12.

Return on investment

4. a 10. b

5. e 11. e

Solution: 1. c 7. b

2. a 8. d

3. d 9. a

KP 5 BT: K Difficulty: Easy TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

6. c 12. a

Test Bank – Chapter 5 – Using Financial Statement Information

5-23

For each characteristic which appears numbered from 1 through 5 below, select the correct factor which should be considered in each assessment as listed in items a through e. Factors to Consider

a. b. c. d. e.

Management bias Financial flexibility Liquidity Operating performance Off-balance-sheet financing

____

1. Ability to get cash from sale of assets and issuance of debt or stock

____

2. Avoiding reporting financial responsibilities on the balance sheet

____

3. Measured by profitability and activity ratios and cash provided by operations

____

4. Delaying the sale of inventory until the following year because current profits are satisfactory

____

5. Ability to convert existing assets into cash

Solution: 1. b

2. e

3. d

4. a

5. c

KP 3,4 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

5-24

Test Bank – Chapter 5 – Using Financial Statement Information

SHORT PROBLEMS 1.

Smith Company has total assets, liabilities, and shareholders' equity of $20,000, $7,000, and $13,000, respectively, at the beginning of 2010. At the end of 2010, total assets, liabilities, and shareholders' equity were reported at $16,000, $5,000, and $11,000, respectively. A. How much additional debt can Smith incur and still have its debt/equity ratio remain less than or equal to 1.00? B. What information does the debt/equity ratio provide you? Solution: A. Debt/equity ratio = Average total liabilities / Average total shareholders’ equity = (($7,000 + $5,000)/2) / (($13,000 + $11,000)/2) = .50 Average total liabilities can increase up to $12,000 and still maintain a debt/equity ratio of 1.0. In order to make the numerator equal to $12,000, the ending debt could increase up to $17,000: Average total liabilities = ($7,000 + $17,000)/2 = $12,000 Since total debt at the end of 2010 is $5,000, the increase in debt could be up to $12,000 ($17,000 less $5,000). B. The debt/equity ratio is a leverage ratio that indicates how the company financed its operations. At the end of 2010, Smith’ debt/equity ratio means that for every dollar of shareholders’ equity, the company has 50 cents of debt. This ratio is low compared to many U.S. companies. KP 5, App5A BT: AN Difficulty: Difficult TOT: 7 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

Monroe Company has current assets, current liabilities, and long-term liabilities of $12,000, $3,000, and $9,000, respectively. Within these amounts, $1,000 is accounts payable, and $1,500 is accounts receivable. What effect will the payment of the accounts payable have on the current ratio? Should Monroe pay the accounts payable on the last day of the year? Explain. Solution: Current ratio before payment of payables = $12,000/$4,000 = 4.0 Current ratio after payment of payables = ($12,000 – $1,000)/($3,000 – $1,000) = 5.5 If $1,000 of cash were used, the current ratio would increase to 5.5. Therefore, Monroe should pay off the debt at yearend given the favorable effect on current ratio. KP 5 BT: AN Difficulty: Difficult TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 5 – Using Financial Statement Information

5-25

Use the information that follows taken from Carter Company’s financial statements for the years ending December 31, 2010 and 2009 to answer problems 3 through 9.

Balance Sheet Information Assets Cash Accounts receivable Inventory Land, building, and equipment Total Assets

2010

2009

$ 60 40 40 290 $430

$ 70 40 60 310 $480

Liabilities and Shareholders' Equity Accounts payable Common stock Retained earnings Total Liabilities & Shareholders' Equity

$ 95 200 135 $430

$ 245 200 35 $480

Income Statement Information Sale revenue Cost of goods sold Gross profit Operating expenses Net income

$900 300 $600 500 $100

Using the two solvency ratios (current and quick), indicate whether Carter’s solvency position improved or deteriorated during 2010. Solution: Carter has the following solvency ratios on December 31: 2010 Current: $140/$95 = 1.47 Quick: $100/$95 = 1.05 2009 Current: $170/$245 = .69 Quick: $110/$245 = .45 Carter’s current and quick ratios increased significantly during 2010. Its solvency position has greatly improved. KP 5 BT: AN Difficulty: Difficult TOT: 5 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

5-26

Test Bank – Chapter 5 – Using Financial Statement Information

If the industry in which Carter is a member has an average accounts receivable turnover of 27 times, determine if in 2010, Carter is more or less efficient at converting sales to cash than the average firm in its industry. Assume all sales were credit sales. Solution: Accounts receivable turnover ratio = Net credit sales / Average accounts receivable = $900/$40 = 22.5 times Carter’s receivable turnover ratio is less than the industry average, indicating a larger than average accounts receivable balance relative to credit sales. This indicates that Carter is less efficient in collecting receivables from customers than the average firm in its industry. KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

If the industry in which Carter is a member has an average current ratio of 1.9, determine if, on December 31, 2010, Carter is more or less solvent than the average firm in its industry as measured by its current ratio. Solution: Current ratio = ($60 + $40 + $40)/$85 = 1.47 Carter’s current ratio of 1.47 is less than the industry current ratio of 1.9. This indicates that Carter is less solvent than the average firm in its industry. KP 5 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

If the industry in which Carter is a member has an average return on equity of 22%, determine if in 2010, Carter is more or less profitable than the average firm in its industry. Solution: Return on equity = Net income / Average shareholders’ equity = $100/((($200 + $35) + ($200 + $135))/2) = 35% Carter's return on equity is greater than the industry average. This implies that Carter is more profitable than the average firm in its industry. KP 5 BT: AN Difficulty: Difficult TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 5 – Using Financial Statement Information

5-27

The industry in which Carter is a member has an average return on assets of 18%. Carter reported no interest expense during 2010. Determine if Carter is more or less profitable in 2010 than the average firm in its industry. Solution: Return on assets = ((Net income + Interest expense (1–Tax rate))/Average total assets = ($100 + $0)/(($430 + $480)/2) = 22.0% Carter's return on assets is greater than its industry average. This indicates that Carter is more profitable than the average firm in its industry. KP 5 BT: AN Difficulty: Difficult TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

If the industry in which Carter is a member has an inventory turnover of 11 times, determine if in 2010, Carter is more or less efficient at converting inventory into sold units than the average firm in its industry. Explain what information this ratio provides you. Solution: Inventory turnover ratio = Cost of goods sold / Average inventory = $300/(($40 + $60)/2) = 6 times Carter's inventory turnover ratio is less than industry average, revealing a larger average inventory relative to cost of goods sold. Carter is less efficient than the average firm in its industry in selling its inventory. During 2010, Carter sold the entire cost of its inventory only six times compared to other companies in this industry which sold their inventory an average of 11 times during the year. KP 5 BT: AN Difficulty: Difficult TOT: 5 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

The industry in which Carter is a member has an average debt/equity ratio of 0.83. Determine if, as measured by the debt/equity ratio on December 31, 2010, Carter is taking full advantage of investing borrowed capital in its operations relative to that of the average firm in its industry. Explain. Solution: Debt/equity ratio = Average total liabilities / Average shareholders’ equity = (($95 + $245)/2)/(($335 + $235)/2) = 0.60 Carter's debt/equity ratio is much less than its industry average. Therefore, Carter has not issued as much debt, relative to its shareholders' equity, as that of the average firm in its industry. Thus, Carter is not taking advantage of leverage possibilities. Leverage is an indicator of whether the company uses borrowed funds to generate returns for the shareholders. KP 5 BT: AN Difficulty: Difficult TOT: 5 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

5-28

10.

Test Bank – Chapter 5 – Using Financial Statement Information

Washington Company has current assets, current liabilities, and long-term liabilities of $8,000, $2,000, and $5,000, respectively at the end of 2010. How much cash can Washington use to acquire equipment and retain a current ratio of at least 2.0? Solution: Current ratio before acquisition of equipment = $8,000/$2,000 = 4.0 Current ratio after acquisition of equipment = ($8,000 – $X)/$2,000 = 2.0 So X = $4,000 If $4,000 of cash is used, then current assets = $4,000 and the current ratio = 2.0. KP 5 BT: AN Difficulty: Difficult TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement, Decision Modeling

11.

Madison Company has current assets, current liabilities, and long-term liabilities of $8,000, $4,000, and $6,000, respectively. Within these amounts, inventory was $2,000, receivables were $2,000, cash was $4,000, and payables were $1,000. Calculate Madison’s quick ratio. What information does this provide? Solution: Quick ratio = Quick assets / Current liabilities = ($2,000 + $4,000)/$4,000 = 1.5 Madison has 1.5 times as much quick assets as current liabilities. Its ability to pay its current debts is clearly evident. KP 5 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

12.

Briefly describe the solvency and profitability of a company with a quick ratio of 4.74 and return on equity of 0.49. Solution: Solvency: Profitability:

Very solvent—The company has 4.74 times more quick assets than needed to pay current debt when it becomes due. Very profitable—Its net income is 49% of average total shareholders’ equity.

KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 5 – Using Financial Statement Information

5-29

Use the information that follows taken from Tyler Company’s financial statements for the years ending December 31, 2010 and 2009 to answer problems 13 through 19. Balance Sheet Information Assets Cash Accounts receivable Inventory Land, building, and equipment Total Assets

13.

2010

2009

$ 80 60 40 230 $410

$ 40 80 80 270 $470

Liabilities and Shareholders' Equity Accounts payable Common stock Retained earnings Total Liabilities & Shareholders' Equity

$ 5 250 155 $410

$ 85 250 135 $470

Income Statement Information Sale revenue Cost of goods sold Gross profit Operating expenses Net income

$850 600 $250 230 $ 20

If the industry in which Tyler is a member has an inventory turnover of 9 times, determine if Tyler is more or less efficient at converting inventory into sales than the average firm in its industry during 2010. Solution: Inventory turnover ratio = Cost of goods sold / Average inventory = $600/(($40 + $80)/2) = 10 times Tyler’s inventory turnover ratio is more than the industry average, revealing a smaller average inventory relative to cost of goods sold. Tyler is more efficient than the average firm in its industry in selling its inventory. During 2010, Tyler sold the entire cost of its inventory 10 times compared to other companies in this industry which sold their total inventory an average of 9 times during the year. KP 5 BT: AN Difficulty: Difficult TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

5-30

14.

Test Bank – Chapter 5 – Using Financial Statement Information

The industry in which Tyler is a member has an average accounts receivable turnover of 10 times. How does Tyler compare in 2010? Comment on what information is provided with this calculation and how credit managers might use it to make decisions. Assume all sales were credit sales. Solution: Accounts receivable turnover ratio = Net credit sales / Average accounts receivable = $850/($60 + $80)/2 = 12.14 times Tyler’s receivables turnover ratio is more than the industry average, indicating a smaller than average accounts receivable balance relative to credit sales. This indicates that Tyler is more efficient in collecting receivables from customers than the average firm in its industry. Tyler collects the entire dollar amount of its receivables approximate 12 times per year compared to the industry average of 10 times per year. KP 5 BT: AN Difficulty: Difficult TOT: 5 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

15.

If the industry in which Tyler is a member has an average return on assets of 11%, determine if in 2010, Tyler is more or less profitable than the average firm in its industry. Assume Tyler has no interest expense. Solution: Return on assets = Net income / Average total assets = $20/(($410 + $470)/2) = 4.5% Tyler's return on assets is substantially less than the industry average of 11%. Therefore, Tyler is less profitable than the average firm in its industry. KP 5 BT: AN Difficulty: Difficult TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

16.

The industry in which Tyler is a member has an average return on equity of 10%. For 2010, determine how Tyler compares. Solution: Return on equity = Net income / Average shareholders’ equity = $20/(($405 + $385)/2) = 5.1% Tyler's return on equity is less than the industry average of 10%. This implies that Tyler is less profitable than the average firm in its industry. KP 5 BT: AN Difficulty: Difficult TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 5 – Using Financial Statement Information

17.

5-31

The industry in which Tyler operates has an average current ratio of 2.1 on December 31, 2010. Comment on Tyler’s solvency compared to the industry average as measured by its current ratio. Solution: Current ratio = Current assets / Current liabilities = ($80 + $60 + $40)/$5 =36. Tyler's current ratio on December 31, 2010 is 36 , which is much higher than industry average. The current ratio indicates that Tyler is much more solvent than the average firm in its industry on December 31, 2010. KP 5 BT: AN Difficulty: Difficult TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

18.

The industry in which Tyler is a member has an average debt/equity ratio of 0.98. Determine if, as measured by Tyler’s debt/equity ratio on December 31, 2010, Tyler is taking full advantage of investing borrowed capital in its operations relative to that of the average firm in its industry. Solution: Debt/equity = Average liabilities / Average shareholders’ equity = (($5+ $85)/2)/((($250 + $155) + ($250 + $135))/2) = .114 = 11.4% Since Tyler's debt/equity ratio is much less than the industry average, this implies that Tyler has a much smaller percentage of debt compared to its shareholders’ equity, and that more of the company is financed with equity than with debt. Thus, Tyler is not taking advantage of leverage possibilities. KP 5 BT: AN Difficulty: Difficult TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

19.

Using the two solvency ratios (current and quick), indicate whether Tyler's solvency position improved or deteriorated during 2010. Solution: Current ratio = Current assets / Current liabilities = 2010 = ($80 + $60 + $40)/$5 = 36.00 2009 = ($40 + $80 + $80)/$85 = 2.35 Quick ratio = Quick assets / Current liabilities = 2010 = ($80 + $60)/$5 = 28.00 2009 = ($40 + $80)/$85 = 1.41 Tyler's current and quick ratio improved exponentially during 2010. However, upon closer inspection, Tyler's ratios increased because its accounts payable was nearly eliminated due to a possible sale of property and cash flow from operations being applied to current liabilities. KP 5 BT: AN Difficulty: Difficult TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

5-32

20.

Test Bank – Chapter 5 – Using Financial Statement Information

Monroe Company has total assets, liabilities, and shareholders' equity of $30,000, $23,000, and $7,000, respectively. Assume no material change occurred during the year to totals on the balance sheet. What amount of long-term debt must Monroe exchange for new shares of common stock issued in order to decrease its debt/equity ratio to 1.0? Solution: Actual debt/equity ratio = Average liabilities / Average shareholders’ equity = $23,000/$7,000 = 3.29 Monroe's debt/equity ratio is currently 3.29. In paying off new debt by issuing new stock, for every dollar added to common stock, Monroe must deduct $1 from its liabilities: = ($23,000 – X)/($7,000 + X) = 1.00 Solve for X = $8,000 Monroe can exchange stock for debt up to $8,000 and still keep a debt/equity ratio of 100%, or 1.0. KP 5 BT: AN Difficulty: Difficult TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement, Decision Modeling

21.

Harrison Company has common stock of $50,000 and retained earnings of $40,000 at yearend. During the year, 10,000 shares of stock were outstanding. Net income was reported as $5,000. A.

Calculate earnings per share.

How does earnings per share differ from most of the other ratios with respect to financial statements?

Solution: A. Earnings per share = Net income / Average number of common shares outstanding = $5,000/10,000 = $ 0.50 per common share B. Earnings per share must be reported on the face of the income statement whereas the other ratios are used primarily for analysis purposes and are never reported on the financial statements. KP 5 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement, Reporting

22.

Briefly describe a company with a current ratio of 0.33 and return on equity of 0.02. Solution: Solvency:

Profitability:

Not very solvent—For every dollar of current liabilities, the company has only 33 cents of liquid assets available. It will likely not be able to pay its current debts when they become due. Not very profitable— Net income is only 2 percent of the amount of average shareholders’ equity.

KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 5 – Using Financial Statement Information

23.

5-33

Taylor Company has the following financial data on January 1, 2010 and January 1, 2009. 1/1/10 1/1/09 Cash $10,000 $22,000 Accounts receivable 23,000 11,000 Marketable securities 3,000 10,000 Inventory 16,000 35,000 Net plant and equipment 40,000 32,000 Current liabilities Long-term debt Shareholders' equity

$13,000 49,000 30,000

$22,000 30,000 58,000

A. In terms of the quick and current ratio, has the short-term solvency position of Taylor improved, remained the same, or declined? B. If you were a potential short-term creditor to Taylor, would you be more willing to extend credit on either January 1, 2009 or 2010? Explain. Solution: A. (in thousands) Current ratio = Current assets / Current liabilities = = ($10 + $23 + $3 + $16)/$13 = = ($22 + $11 + $10 + $35)/$22 =

1/01/10 1/01/09 4.0 3.55

Quick ratio = Quick assets / Current liabilities = = ($10 + $23 + $3)/$13 = 2.77 = ($22 + $11 + $10)/$22 = 1.95 Taylor’s short-term solvency position has improved significantly. Its current ratio has increased from 3.55 to 4.0, and the quick ratio has increased from 1.95 to 2.77. B. Taylor’s short-term solvency position on 1/1/10 is acceptable and has increased since 1/01/09. A short-term creditor would definitely be more willing to extend credit to Taylor on 1/1/10 than on 1/1/09. KP 2,5 BT: AN Difficulty: Difficult TOT: 6 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

24.

Briefly describe a company with a quick ratio of 3.78 and return on equity of 0.05. Solution: Solvency: Profitability:

Currently very solvent—Quick assets are 3.78 times as much as current liabilities. Weak profitability—Net income is only 5 percent of the amount of average shareholders’ equity. Continuation of such a low profitability will likely affect the company's future solvency.

KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

5-34

Test Bank – Chapter 5 – Using Financial Statement Information

SHORT ESSAY QUESTIONS 1.

Distinguish between backward-looking and forward-looking as it pertains to financial statements. Solution: Backward-looking implies that financial statements reflect historical costs—amounts that pertain to accounting periods of our past, i.e., last year, and the year before, etc. Forward-looking information reflects the future prospects of a company. Companies do not issue financial statements with forward-looking amounts, although users attempt to predict what will happen in the future based on the backward-looking perspective. KP 1 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

What role do investment services, such as Moody’s and Standard & Poor's, play in the assessment of a business environment? Solution: Investment services provide extensive analyses of the operations and financial position of companies. The services also rate the riskiness of the company's outstanding debt. Analysts use these ratings to reflect a company's future prospects within its business environment and have a direct bearing on a company’s ability to issue debt with reasonable terms. KP 3 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking, Industry AICPA FN: Measurement

Comment on the following news headline: "Van Buren, Inc. Takes a Bath in Current Year." Solution: When a company experiences an extremely poor year, it sometimes chooses very conservative accounting methods, estimates, or judgments. Conservative accounting methods typically recognize expenses and losses in the current period. A poor year coupled with additional expenses and losses further reduces the company’s financial condition and operating performance in the year. This strategy, called ‘taking a bath,’ enables companies to recognize losses in years that are already very poor, in hopes that these losses may be less obvious. On the contrary, a company which reports an extremely poor year, that defers additional expenses and losses to the next accounting period will likely appear to users to be establishing a trend of losses. KP 4 BT: E Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement, Decision Modeling

Test Bank – Chapter 5 – Using Financial Statement Information

5-35

Indicate three reasons why reported book value and true value may differ. Solution: 1. The financial statements do not reflect the company's prospects within its business environment. 2. The financial statements themselves are inherently limited. 3. Management tends to prepare the reports in a biased manner. KP 1 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

What must an analyst learn first prior to assessing a particular business environment? Solution: An analyst must first learn about the company, its industry, and how the company and industry relate to the overall economy. KP 3 BT: C Difficulty: Easy TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking, Industry AICPA FN: Measurement

Identify two forms of analyzing financial statements at a particular point in time. Which of these forms is subject to great variation among different analysts? Solution: The two forms of financial statement analysis are common-size financial statements and ratio analysis. Ratio analysis is a manner of computing ratios based on information provided by the income statement and/or balance sheet. Analysts select various ratios on which to place emphasis based on the analysts’ company’s policies, personal opinion, or other judgment factors. KP 5 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement, Reporting

5-36

Test Bank – Chapter 5 – Using Financial Statement Information

Buchanan Company has the following financial data on December 31, 2010 and 2009:

Cash Accounts receivable Inventory Net plant and equipment Current liabilities Common stock Retained earnings

12/31/09 $14,000 12,000 15,000 5,000 8,000 5,000 31,000

Buchanan 's 2010 income statement reported: Revenue Cost of goods sold Gross margin Depreciation expense Net income

$160,000 150,000 $ 10,000 2,000 $ 8,000

Buchanan 's 2010 data from its statement of cash flows: Cash flow from operations Cash flow from investing activities Cash flow from financing activities, including dividends paid

$ 42,000 0 (22,000)

12/31/10 $19,000 4,000 12,000 3,000 18,000 5,000 2,000

Required: Using appropriate ratios, comment on the change in Buchanan's solvency position and assess the probable cause of the change from 2009 to 2010. Solution: Current ratio: 2009: ($14,000 + $12,000 + $15,000)/$8,000 = 5.13 Current ratio: 2010: ($19,000 + $4,000 + $12,000)/$18,000 = 1.94 Quick ratio: 2009: ($14,000 + $12,000)/$8,000 = 3.25 Quick ratio: 2010: ($19,000 + $4,000)/$18,000 = 1.28 Buchanan's solvency position has deteriorated during 2010.This is revealed by the decreases in its current ratio from 5.13 to 1.94 and quick ratio from 3.25 to 1.28. It may be difficult for Buchanan to meet its current liabilities when they are due. The reason for this deterioration is not caused by a lack of cash flows from operations. Buchanan also did not use cash to purchase investments nor did it receive cash from issuing long-term debt or common stock. The reason for Buchanan 's significant deterioration in its solvency position is that it paid $22,000 of dividends. This payment used cash that was needed for operating activities and caused the poor current and quick ratios. KP 5 BT: AN Difficulty: Difficult TOT: 12 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 5 – Using Financial Statement Information

5-37

Why are all companies not audited by certified public accountants? Solution: Only those companies whose equity securities are traded on public stock exchanges are legally required to retain the services of a certified public accountant for an audit. Given that a comprehensive audit can be very time-consuming and costly, and many of these companies do not rely on outside sources of capital, smaller companies may choose not to be audited. KP 3 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Briefly explain how management may influence the quality of earnings of a company. Solution: Managers can influence reported accounting numbers by manipulating the timing of when transactions/business events occur. The company with a very low quality of earnings normally means that management has used much of its discretionary influence to report the dollar amounts on the financial statements. A high quality of earnings implies that management has exercised little or no such influence. KP 4 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

10.

How might a company overstate performance? Why might this occur? Solution: A company might overstate performance by accelerating the recognition of revenues or deferring the recognition of expenses. Managers may use this strategy in an effort to attract capital, or in situations where companies face financial difficulties. KP 4 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

11.

How does off-balance sheet financing make a company appear less risky? Solution: Off-balance-sheet financing avoids the recognition of debt directly on the company’s balance sheet. Managers have been known to structure financing transactions and choose certain accounting methods so that debt need not be reported on the balance sheet. By keeping the debt off the company’s balance sheet, certain ratios are improved which provides a stronger financial picture. KP 4,5 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

5-38

12.

Test Bank – Chapter 5 – Using Financial Statement Information

Explain the concept of leverage. Solution: Leverage refers to using borrowed funds to generate returns for the shareholders. A company that borrows money at 9 percent interest then invests the funds to generate a 15 percent return is using leverage effectively. Leverage creates returns for the company’s shareholders without using stockholder’s money. In using leverage a company typically increases its risk because it's debt is increased. This increase in debt commits the company to future cash obligations. KP 5 BT: K Difficulty: Easy TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

13.

In what ways might an investor use accounting information provided by a foreign company differently from information provided by a domestic corporation? Solution: Accounting practices of different countries may differ significantly from U.S. GAAP. An investor would benefit from adjusting the foreign statements to reflect U.S. accounting principles. Unfortunately, adjustment by itself may not be sufficient to achieve meaningful comparisons. Differences across environments because of social, economic, legal, and cultural environmental influences further complicate the interpretation of the adjusted financial statements. KP 7 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic, Communication, Diversity AICPA BB: Critical Thinking, Global AICPA FN: Reporting

14.

How does operating performance differ from financial flexibility? Solution: Operating performance represents a company's ability to grow and increase its assets through operations. Financial flexibility refers to a company's ability to produce cash through means other than operations, i.e., issuing debt, issuing equity, and selling longterm assets. Companies capable of generating cash through means other than operations are considered to be financially flexible. A company with superior operating performance is likely to be evaluated as being financially solvent. KP App5A BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

Chapter 6 The Current Asset Classification, Cash, and Accounts Receivable

MULTIPLE CHOICE QUESTIONS 1.

Current assets are assets which a. can be used immediately to retire liabilities. b. are newly acquired. c. have been converted into cash in the previous year. d. are intended to be converted into cash within one year. Ans: D KP 1 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

A company’s operating cycle may be described as a. the period of time that is typically required for a company to convert cash into inventory and inventory into cash. b. the period of time from the beginning of operations until a company liquidates all of its assets. c. always a one-year time period. d. a cycle that is distinguished at the discretion of the Board of Directors on a daily basis. Ans: A KP 1 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Cash may consist of a. coin and currency, loans to employees, and money orders. b. petty cash, officer imprest accounts, and employee savings accounts. c. money orders, postage stamps, and currency. d. checking accounts, savings accounts, and bank drafts. Ans: D KP3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

A compensating balance is a. cash held by a foreign government. b. a balance maintained by the company to pay the employees’ payroll. c. a minimum cash balance that must be maintained on deposit. d. items which are not cash, but equivalent to cash. Ans: C KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

6-1

6-2

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

Which of the following are components of the quick ratio? a. Cash and notes payable b. Cash and accounts receivable c. Accounts receivable and inventory d. All current assets except accounts receivable Ans: B KP 1 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Which of the following are components of the current ratio? a. Accounts receivable and short term investments b. Inventory, retained earnings, and accounts payable c. Accounts payable, dividends, and cash d. Short term investments, equipment, and land Ans: A KP 1 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

‘Earnings management’ is described as deliberate managerial decisions and choices that are solely designed to a. increase selling prices of a company’s products. b. reduce repair costs on the company’s equipment. c. manipulate net income from one period to the next to boost the company’s stock price. d. increase working capital. Ans: C KP 1,2 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

If a company with a current ratio of 2.0 pays $2,000 of its salaries payable, then its current ratio will a. change, but not enough information is provided to determine if it will increase or decrease. b. decrease. c. remain the same. d. increase. Ans: D KP 1,2 BT: AN Difficulty: Difficult TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

On August 1, Compass Co. made a $10,000 credit sale under the terms 2/10, n/30. If Compass receives full payment of the account on August 8, how much cash will it receive? a. $9,700 b. $9,800 c. $9,000 d. $10,000 Ans: B KP 4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

10.

6-3

If a company with working capital of $210,000 pays $4,000 of bonds payable, then its working capital will a. increase. b. decrease. c. remain the same. d. Not enough information to determine Ans: B KP 1,2 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

11.

The allowance for doubtful accounts is a. an ‘other revenue’ account. b. a contra accounts receivable account. c. an ‘other expense’ account. d. a contra expense. Ans: B KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

12.

On November 3, Carol Company made a $2,000 credit sale under the terms 3/10, n/60. If Carol receives full payment of the account on November 14, how much cash will it receive? a. $1,400 b. $1,900 c. $1,940 d. $2,000 Ans: D KP 4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

13.

On January 2, Favre Co. made a $2,000 credit sale under the terms 3/10, n/30. If Favre uses the gross method of accounting for cash discounts, the proper entry on January 2 includes a. a debit to Accounts Receivable for $2,000, and a credit to Sales for $2,000. b. a debit to Accounts Receivable for $2,000, a credit to Cash Discounts for $1,940, and a credit to Sales for $60. c. a debit to Accounts Receivable for $1,940, and a credit to Sales for $1,940. d. a debit to Accounts Receivable for $1,940, a debit to Cash Discounts for $60, and a credit to Sales for $2,000. Ans: A KP 4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

14.

The net realizable value of receivables is calculated as the face value of the receivables less adjustments for a. sales returns and sales discounts. b. actual uncollected amounts adjusted for purchase discounts. c. bad debts already written off. d. sales returns, cash discounts, and estimated uncollectible accounts. Ans: D KP 4 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

6-4

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

15.

Montego Bay Resort Club offers a cash discount of 3% if its customers pay within 15 days after the customer eats dinner. Otherwise, the customer must pay within 30 days. If a customer does not take advantage of the cash discount, then he/she is paying an annual interest rate for not delaying payment for 15 days of a. 3%. b. 6%. c. 36%. d. 72%. Ans: D KP 3,4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

16.

The face amount of accounts receivable for Rio Inc. is $20,000. It was estimated that 5% of the accounts will not be collected, cash discounts of $500 will be exercised, and $200 of sales returns will be experienced. The net realizable value of accounts receivable is a. $19,500 b. $19,300 c. $20,000 d. $18,300 Ans: D KP 4,5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

17.

Under the allowance method of accounting for bad debts, the recognition of bad debts expense a. increases current assets and decreases net income. b. decreases current assets and increases net income. c. increases current assets and net income. d. decreases current assets and net income. Ans: D KP 5 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

18.

Under the direct write-off method of accounting for bad debts, the recognition of bad debts expense a. decreases current assets and net income. b. decreases current assets and increases net income. c. increases current assets and net income. d. increases current assets and decreases retained earnings. Ans: A KP 5 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

19.

Under the allowance method of accounting for bad debts, the write-off of an account receivable determined to be uncollectible a. decreases the current ratio. b. increases the current ratio. c. has no effect on the current ratio. d. decreases working capital. Ans: C KP 5 BT: AP Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

20.

6-5

Hummel Inc. and Nadia Co. have experienced identical economic performances for the last several years of growing sales. Each uses identical accounting measurement rules except that Hummel uses the allowance method and Nadia uses the direct write-off method of accounting for bad debts. Both companies have experienced a gradual increase in uncollectible accounts. Which one of the following statements is true in the first year of operations for both companies? a. Hummel ‘s net income is less than Nadia’s net income. b. Hummel ‘s net income is greater than Nadia’s net income. c. Hummel ‘s current ratio is greater than Nadia’s current ratio. d. Hummel will appear more solvent than Nadia will. Ans: A KP 1,5 BT: AP Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

21.

Delvin Co. uses the percentage of credit sales approach in estimating its bad debt expense. The total estimate that is calculated by multiplying the percentage times the net sales revenue for the period will be equal to a. the debit balance required in the allowance for doubtful accounts after the recognition of bad debts expense. b. the credit balance required in the allowance for doubtful accounts after the recognition of bad debts expense. c. the difference between the beginning and the ending accounts receivable balance. d. the amount of bad debt expense. Ans: D KP 5 BT: AP Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

22.

Maradonna Co. uses an aging schedule of accounts receivable in estimating its bad debt expense. The total estimate, which appears on the aging schedule, will be equal to a. the amount of bad debts expense on the company’s income statement. b. the debit balance required in the allowance account prior to the recognition of bad debts expense. c. the increase in bad debts expense as a result of the estimate. d. the credit balance required in the allowance account after the recognition of bad debts expense. Ans: D KP 5 BT: AP Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

23.

On December 1, 2010, Smith Company delivered a shipment of goods to a Danish customer for a price of 160,000 euros. If on that date 1.3 U.S. dollars could be exchanged for 1 euro. If Smith closes its books on December 31 and 1 U.S. dollar is trading for 1 euro at that time, the adjusting entry that Smith would record would include: a. a credit to Exchange Rate Gain for $48,000. b. a debit to Accounts Receivable for $20,800. c. a debit to Exchange Rate Loss for $48,000. d. a debit to Sales for $48,000. Ans: C KP 4 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

6-6

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

24.

Under the allowance method of accounting for bad debts, the actual write-off of an account receivable determined to be uncollectible a. decreases current assets. b. has no effect on current assets. c. increases current assets. d. occurs in the same accounting period as the sale. Ans: B KP 5 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

25.

Polo, Inc. uses the direct write-off method of accounting for bad debts. During July, Torey’s account was written off as uncollectible. The write-off of Torey’s account a. increases both the current and quick ratios. b. decreases the current ratio and has no effect on the quick ratio. c. decreases both the current and quick ratios. d. increases the current ratio and has no effect on the quick ratio.

Ans: C KP 5 BT: AP Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement 26.

Alma Company uses the allowance method of accounting for bad debts. Alma: a. is violating the matching principle. b. will record bad debt expense only when an account is determined to be uncollectible. c. will not sell to customers on account anymore. d. will report accounts receivable in the balance sheet at their net realizable value. Ans: D KP 5 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

27.

If a company decreases its cash discount offer from 3/10, n/30 to 2/10, n/60, then it would expect its accounts receivable collection period to a. increase. b. decrease. c. remain the same. d. There is not enough information to answer this question. Ans: A KP 5,6 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

28.

A company’s allowance for doubtful accounts is $4,000 and $3,000 on 1/1/11 and 1/1/10, respectively. During 2010, bad debts expenses were estimated to be 6% on net credit sales of $100,000. During 2010, the amount of accounts written off as uncollectible amounts to a. $6,000. b. $7,000. c. $5,000. d. $4,000. Ans: C KP 5 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

29.

6-7

The journal entry to record the recovery of a previously written-off $2,000 account receivable (for customer Leno Company) under the allowance method would include: a. a credit to Bad Debt Expense. b. a credit to Cash. c. a debit to Accounts Payable – Leno Company. d. a credit to Allowance for Doubtful Accounts. Ans: D KP 4,5,6 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

30.

The allowance method of accounting for bad debts emphasizes the net realizable value of accounts receivable on the balance sheet when a. the direct write-off method is used. b. the percentage of net credit sales approach is used to estimate uncollectibles. c. the percentage of accounts receivable approach is used to estimate uncollectibles. d. a company omits cash payments during the accounting period. Ans: C KP 4,5,6 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

31.

If a company’s collection period for accounts receivable is considered to be excessively long, then a. the company may want to invest excess cash from receivable collections in the stock market. b. the company might examine its billing procedures in order to expedite collection from customers. c. customer returns should be disallowed in order to increase the collection of cash. d. cash flows from operations will probably be more than sufficient. Ans: B KP 5,6 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

32.

During the year, Caltech Inc.’s accounts receivable turnover rate increased from 10 to 12 times. The company makes credit sales only with credit terms of 3/10, n/40. The best explanation for the increase is that a. the company’s credit department did a better follow up with customers whose account balances became past due. b. the company has recently dropped its credit check policy. c. the company makes all customers pay cash instead of allowing purchases to be charged. d. the company has more customers at the end of the year than it had at the beginning of the year. Ans: A KP 3,4,5,6 BT: AP Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

6-8

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

33.

Summers, Inc. uses the allowance method to account for bad debts. The entry to record the write-off of a customer’s account balance decreases a. assets and owners’ equity. b. assets and decreases liabilities. c. owners’ equity and revenues. d. none of these answers is correct. Ans: D KP 5 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

34.

If a company uses the allowance method to account for bad debts, the company’s owners’ equity will decrease a. at the end of the accounting period when an adjusting entry to estimate bad debts is recorded. b. on the date a customer’s account is determined to be uncollectible. c. when the accounts receivable amount becomes past due. d. on the date a customer’s account is written off. Ans: A KP 5 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

35.

Managers must understand how transactions affect working capital a. because GAAP does not allow companies with weak working capital to obtain loans. b. because lenders often use this to assess a company’s ability to meet current obligations. c. so that management can avoid transactions that increase working capital. d. in anticipation of meeting creditors guidelines before issuing new stock. Ans: B KP 2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

36. Which of the following would be separately reported as restricted cash in the balance sheet or footnotes to the financial statement? a. b. c. d.

$8,000 in the savings account at First Bank $200 in a petty cash drawer $10,000 cash in an escrow account at Guarantee Bank $4,000 in a checking account at Second Rate Bank

Ans: C KP 1 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

37.

6-9

On March 1, 2010, Silver Corp. sold goods to a Chinese company for 10,000 Chinese yuan (10,000 RMB) to be paid on April 1, 2010. The exchange rates on March 1 and April 1, 2010 are US$8.0 = 1 RMB and US$8.5 = 1 RMB, respectively. What is Silver’s revenue in US dollars and its 2009 exchange gain or loss? a. Sales revenue =US $80,000; Exchange gain US $5,000 b. Sales revenue = US $85,000; Exchange loss US $5,000 c. Sales revenue = US $80,000; Exchange loss US $5,000 d. Sales revenue = US $85,000; Exchange gain US $5,000 Ans: A KP4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

38.

The current ratio fails to accurately reflect a. the ability of a company to pay its current debts as they come due. b. amounts that will come due within the next accounting period. c. amounts due within the next operating cycle as of the end of the accounting period. d. cash flows anticipated in future accounting periods. Ans: D KP 1,2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

39.

Most companies a. use working capital and current and quick ratios as low-cost surrogates for cash flow measures. b. place little importance on managing current assets. c. have large amounts of current assets comprised of cash only. d. are moving away from cash flow accounting. Ans: A KP 1,2 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

40.

The procedures designed to ensure that the cash account on the balance sheet reflects the actual amount of cash in the company’s possession are referred to as a. compensating balances. b. record controls. c. physical controls. d. cash budgeting. Ans: B KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

41.

A company that maintains a cash balance of more than is necessary for its day-to-day needs a. is likely to have cash flow problems. b. is not using working capital to its ideal advantage. c. is likely to have a very low solvency. d. has a problem with physical controls. Ans: B KP 2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

6-10

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

42.

Accounts used to cover day-to-day office expenses are referred to as a. petty cash. b. bad debts. c. cash restrictions. d. compensating balances. Ans: A KP1,2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

43.

A cash discount differs from a trade discount in that the cash discount is a. a reduction in the per unit price of an item if a certain quantity is purchased. b. received in currency instead of by a check from the customer. c. typically associated with consumers and a trade discount associated with commercial vendors or suppliers. d. the same as a mark down. Ans: C KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

44.

The gross method refers to a. a method of accounting for uncollectible accounts. b. the expectation that the customer will not take advantage of a cash discount. c. a method of reporting cash on the balance sheet. d. the restriction placed on the company’s bank account by the bank. Ans: B KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

45.

An exchange rate a. is the cash amount received from a customer who takes advantage of a cash discount. b. is the value of one currency in terms of another currency. c. seldom varies from one accounting period to the next. d. is ignored by multinational companies. Ans: B KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

46.

Hedging is used to a. reduce risks associated with holding receivables denominated in foreign currencies. b. calculate the current ratio for multinational companies. c. translate foreign currency into U.S. dollars. d. ‘window dress’ uncollectible accounts. Ans: A KP 2,4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

47.

6-11

Tyson Corp. uses the aging method to estimate bad debts. The bookkeeper provided the following schedule as of March 30th, 2010: Account Age Current 1 -- 30 days past due 31 -- 60 days past due Over 60 days past due

Balance Noncollection Probability $50,000 3% 40,000 4% 10,000 8% 5,000 15%

What is the amount of receivables deemed uncollectible? a. $1,650 b. $4,650 c. $3,400 d. $105,000 Ans: B KP 4,5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement 48.

At the beginning of 2010, Cyrus Corp.’s allowance for doubtful accounts is $12,500. During 2010, $4,250 was written off as uncollectible. At December 31, the company used an aging schedule of accounts receivable and determined that $10,530 of the accounts receivable would probably be uncollectible. What would be the bad debts expense that should be reported on Cyrus’s 2010 income statement? a. $5,720 b. $26,780 c. $2,280 d.$18,280 Solution: $12,500 – $4,250 + X = $10,530

X = $2,280

Ans: C KP5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement 49. Before adjusting entries, Kilby Corp’s accounts receivable and allowance for doubtful accounts are $745,000 and $7,000 (credit balance), respectively. Using an aging schedule of accounts receivable, it is determined that $60,000 of the accounts receivable would probably be uncollectible. Calculate the net realizable value of Truman’s receivables at year end. a. $681,000 b. $695,000 c. $809,000 d. $685,000 Solution: $745,000 - $60,000 = $685,000 Ans: D KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

6-12

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

50.

$6,700 $7,900 (70)

7,830 2,270 500 $17,300

Current Liabilities Accounts payable Wages payable Taxes payable Rent payable Notes payable Total

$9,000 500 200 1,600 2,000 $13,300

Based on this information, how would the current ratio be affected if Mason collects the accounts receivable and then uses some of the cash to pay off the accounts payable? a. The current ratio would increase from 1.30 to 1.93. b. The current ratio would increase from 0.74 to 4.02. c. The current ratio would decrease from 1.30 to 0.62. d. The current ratio would increase from 1.09 to 1.61. Solution: Before: $17,300/$13,300 = 1.30; After: $8,300/$4,300 = 1.93 The current ratio would increase. Ans: A KP 2 BT: AN Difficulty: Difficult TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

51.

6-13

The following information concerning the current assets and current liabilities of Mason Company at December 31, 2010, is presented below. Current Assets Cash Accounts Receivable Less Allowance Inventory Prepaid expenses Total Current Liabilities Accounts payable Wages payable Taxes payable Rent payable Notes payable Total

$6,700 $7,900 (70)

7,830 2,270 500 $17,300 $9,000 500 200 1,600 2,000 $13,300

Based on this information, how would the quick ratio be affected if Mason purchased $1,300 of inventory on account? a. The quick ratio would decrease from 1.30 to 1.21. b. The quick ratio would not change. c. The quick ratio would decrease from 1.09 to 1.00. d. The quick ratio would decrease from 1.09 to 1.21. Solution: Before: ($6,700 + $7,830)/$13,300 = 1.09 After: ($6,700 + $7,830)/($13,300 + $1,300) = 1.00 The quick ratio would decrease. Note that inventory is not a quick asset. Ans: C KP 1 BT: AN Difficulty: Difficult TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

6-14

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

52.

$6,700 $7,900 (70)

Current Liabilities Accounts payable Wages payable Taxes payable Rent payable Notes payable Total

7,830 2,270 500 $17,300 $9,000 500 200 1,600 2,000 $13,300

Based on this information, what would the quick ratio be if Mason sold all of its inventory for $6,000 cash? a. The quick ratio would decrease from 1.09 to 0.19. b. The quick ratio would decrease from 1.30 to 0.85. c. The quick ratio would increase from 1.30 to 1.54. d. The quick ratio would increase from 1.09 to 1.54. Solution: Before: ($6,700 + $7,830)/$13,300 = 1.09 After: ($6,700 + $7,830 + $6,000)/$13,300 = 1.54 The quick ratio would increase. Ans: D KP 1 BT: AN Difficulty: Difficult TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement 53.

Sanchez Inc. sells to customers only on credit. For the year ended December 31, 2010, the following information is provided: Sales revenue Accounts receivable, 1/01/10 Allowance for doubtful accounts, 12/31/10(before adjustment for bad debts) Collections during 2010 Accounts written off as uncollectible during 2010 Sales returns

$850,000 230,000 600 470,000 13,000 7,000

What is the balance of the Accounts Receivable account at December 31, 2010? a. $1,525,000 b. $590,000 c. $205,000 d. $135,000 Solution: $230,000 + $850,000 – $470,000 – $7,000 – $13,000 = $590,000 Ans: B KP 3,4,5 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

54.

6-15

$850,000 230,000 600 470,000 13,000 7,000

If Sanchez estimates bad debts at 5% of net credit sales, how much is bad debt expense? a. $34,000 b. $15,200 c. $23,400 d. $42,150 Solution: 5% x ($850,000 – $7,000) = $42,150 Ans: D KP 3,4,5 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement 55.

The balances of the allowance for doubtful accounts on the balance sheets dated December 31 of 2010 and 2009 were $2,000 and $7,000, respectively. During 2010, bad debts expense was $12,000. What is the amount of accounts receivable that were written off as uncollectible during 2010? a. $22,000 b. $8,000 c. $17,000 d. $2,000 Solution: $7,000 + $12,000 - $2,000 = $17,000 Ans: C KP 3,4,5 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

6-16

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

56.

The following information is provided for Atlanta, Inc.. Balance Sheet Cash and cash equivalents Accounts Receivables, less allowance for doubtful accounts of $4,600 (2010) and $2,000 (2009)

2010 $89,000

2009 $106,000

198,000

154,000

How much is the balance in the Accounts Receivable account at December 31, 2010? a. $193,600 b. $158,600 c. $202,600 d. $203,600 Solution: $198,000 + $4,600 = $202,600 Ans: C KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement 57.

The following information is provided for Atlanta Inc. Balance Sheet Cash and cash equivalents Accounts Receivables, less allowance for doubtful accounts of $4,600 (2010) and $2,000 (2009)

2010 $89,000

2009 $106,000

198,000

154,000

What is the amount of the Net Realizable Value of the receivables at December 31, 2010? a. $198,000 b. $154,000 c. $193,600 d. $190,400 Solution: $198,000 Ans: A KP 5 BT: AN Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

58.

6-17

The following information was taken from the unadjusted trial balance and aging schedule of Diane Company on December 31, 2010. All sales are on account. Accounts and related balances at December 31, 2010 before adjustment: Debit $46,000

Accounts receivable Allowance for doubtful accounts Sales (all on account) Sales returns

Credit $ 680 500,000

3,000

Aging Schedule of Accounts Receivable: Age 0-30 days 30-60 days Over 60 days

Amount $14,000 20,000 12,000

% Uncollectible 5% 8% 12%

If Diane uses the aging schedule of accounts receivable to determine bad debts, what is the bad debts expense for the year ending December 31, 2010? a. $4,280 b. $3,600 c. $3,680 d. $3,060 Solution: Desired balance of Allowance for Uncollectible Accounts: $14,000 $20,000 $12,000

X X X

.05 = .08 = .12 =

Beginning balance Less desired balance Bad debt expense

$ 700 1,600 1,440 $3,740 $ 680 (3,740) $3,060

Ans: D KP 5 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

6-18

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

59.

Accounts receivable Allowance for doubtful accounts Sales (all on account) Sales returns

Credit $ 680 500,000

3,000

Aging Schedule of Accounts Receivable: Age 0-30 days 30-60 days Over 60 days

Amount $14,000 20,000 12,000

% Uncollectible 5% 8% 12%

If Diane uses the aging schedule of accounts receivable to determine bad debts, what is the Allowance for Doubtful Accounts balance at December 31, 2010? a. $3,000 b. $4,280 c. $2,920 d. $3,740

Ans: D KP 5 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

60.

6-19

Accounts receivable Allowance for doubtful accounts Sales (all on account) Sales returns

Credit $ 680 500,000

3,000

Aging Schedule of Accounts Receivable: Age 0-30 days 30-60 days Over 60 days

Amount $14,000 20,000 12,000

% Uncollectible 5% 8% 12%

If Diane uses the aging schedule of accounts receivable to determine bad debts, what is the net realizable value of accounts receivable on the 2010 financial statements? a. $46,000 b. $42,260 c. $42,320 d. $30,400 Solution: Net realizable value = $46,000 – $3,740 = $42,260 Ans: B KP 5 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

6-20

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

61.

Accounts receivable Allowance for doubtful accounts Sales (all on account) Sales returns

Credit $ 680 500,000

3,000

Aging Schedule of Accounts Receivable: Age 0-30 days 30-60 days Over 60 days

Amount $14,000 20,000 12,000

% Uncollectible 5% 8% 12%

If Diane Company estimates bad debts as 6% of net credit sales, what is the amount of bad debts expense to be reported on the income statement for the period ending December 31, 2010? a. $27,019 b. $29,820 c. $30,000 d. $29,779 Solution: Bad debts expense = ($500,000 – $3,000) X 6% = $29,820 Ans: B KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement 62.

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

63.

6-21

On December 1, 2010, Sedona Trading Co. sold goods to a German company for 25,000 German marks (25,000 DM) to be collected on January 12, 2011. The exchange rates on December 1 and December 31, 2010 are US$0.75 = 1 DM and US$.90 = 1 DM, respectively. What is Sedona’s exchange gain or loss for 2010? a.$22,500 Exchange Gain b. $3,750 Exchange Loss c. $3,750 Exchange Gain d. $18,750 Exchange Loss Solution: Exchange gain = ($0.90 − $0.75) x 25,000 = US$3,750 Ans: C KP 4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement MATCHING QUESTIONS 1. For each item listed in 1 through 5 below, place the letter of the best description selected from a through e in the space provided. You may use each letter more than once or not at all. a. b. c. d. e.

Descriptions (Accounts receivable∕sales) x 365 2/10, n/30 Proper matching achieved Expense recognized when an account is written off Cash-purchase-sale-cash

____

1. Operating cycle

____

2. Cash discount

____

3. Allowance method

____

4. Collection period

____

5. Direct write-off method

Solution: 1. e 2. b 3. c 4. a 5. d KP 5 BT: K Difficulty: Easy TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

6-22

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

For each item numbered 1 through 5 below, identify the letter of the best description by selecting from items a through e below. You may use each letter more than once or not at all. a. b. c. d. e.

Descriptions Intention is to convert into cash within one year Current assets/current liabilities Current assets – current liabilities Must pay within one year (Cash + marketable securities + accounts receivable) divided by current liabilities

____ ____ ____ ____ ____ Solution: 1. d

2. a

1. 2. 3. 4. 5.

Current liabilities Current assets Quick ratio Working capital Current ratio

3. e

4. c

5. b

KP 1 BT: K Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting 3.

For each item listed in 1 through 5, place the letter (a through e) of the best description in the space provided. You may use each letter more than once or not at all. a. b. c. d. e. f.

Descriptions Occurs when a customer brings back merchandise for a refund A reduction in the per-unit price if a certain quantity is purchased Decreases accounts receivable An incentive for customers to pay timely Estimated cash value Arises from normal credit sales transactions with customers

____

1. Sales returns

____

2. Accounts receivable

____

3. Sales discounts

____

4. Net realizable value

____

5. Quantity discounts

Solution: 1. a 2. f 3. d 4. e 5. b KP 4 BT: K Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

6-23

SHORT PROBLEMS 1.

At the beginning of 2010, Flagstaff Corp.’s allowance for doubtful accounts is $10,000. During 2010, $7,000 was written off as uncollectible. At December 31, the company used an aging schedule of accounts receivable and determined that $8,000 of the accounts receivable would probably be uncollectible. Calculate bad debts expense to be reported on Flagstaff’s 2010 income statement. Solution: $10,000 – $7,000 + X = $8,000 X = $5,000 KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Before adjusting entries, Dormont Corp’s accounts receivable and allowance for doubtful accounts are $800,000 and $7,000 (credit balance), respectively. Using an aging schedule of accounts receivable, it is determined that $44,000 of the accounts receivable would probably be uncollectible. Calculate the net realizable value of Dormont’s receivables at year end. Solution: $800,000 - $44,000 = $756,000 KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

6-24

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

Use the information that follows concerning the current assets and current liabilities of Ryan Company at December 31, 2010, to answer problems 3 through 8. Each problem is independent of the others. Current Assets Cash Accounts Receivable Less Allowance Inventory Prepaid expenses Total

$1,700 $2,900 (70)

Current Liabilities Accounts payable Wages payable Taxes payable Rent payable Notes payable Total

2,830 2,270 300 $7,100 $4,000 300 200 800 1,000 $6,300

3. How would the current ratio be affected if Ryan collects the accounts receivable and then uses some of the cash to pay off the accounts payable? Solution: Before: $7,100/$6,300 = 1.13; After: $3,100/$2,300 = 1.35 The current ratio would increase. KP 2 BT: AN Difficulty: Difficult TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Calculate Ryan’s working capital, current ratio, and quick ratio at December 31, 2010. Solution: Working capital: Current ratio: Quick ratio:

$7,100  $6,300 = $800 $7,100/$6,300 = 1.13 ($1,700 + $2,830)/$6,300 = 0.72

KP 2 BT: AN Difficulty: Difficult TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement 5.

How would the quick ratio be affected if Ryan purchased $500 of inventory on account? Solution: Before: ($1,700 + $2,830)/$6,300 = 0.72 After: ($1,700 + $2,830)/($6,300 + $500) = 0.67 The quick ratio would decrease. Note that inventory is not a quick asset. KP 1 BT: AN Difficulty: Difficult TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

6-25

How would the current ratio be affected if Ryan collects $600 from customers for amounts owed? Solution: Before: $7,100/$6,300 = 1.13; After: ($7,100 – $600 + $600)/$6,300 = 1.13 The current ratio would not change. Cash and accounts receivable are both current. KP 1 BT: AN Difficulty: Difficult TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

What would the quick ratio be if Ryan sold all of its inventory for $5,000 cash? Solution: Before: ($1,700 + $2,830)/$6,300 = 0.72 After: ($1,700 + $2,830 + $5,000)/$6,300 = 1.51 The quick ratio would increase. KP 1 BT: AN Difficulty: Difficult TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

How would the current ratio be affected if Ryan paid off its wages and taxes? Solution: Before: $7,100/$6,300 = 1.13 After: ($7,100 – $500)/($6,300 – $200 – $300) = 1.14 The current ratio would increase slightly. KP 1 BT: AN Difficulty: Difficult TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Brocton Inc. sells to customers only on credit. For the year ended December 31, 2010, the following information is provided: Sales revenue Accounts receivable, 1/01/10 Allowance for doubtful accounts, 12/31/10(before adjustment for bad debts) Collections during 2010 Accounts written off as uncollectible during 2010 Sales returns

$550,000 240,000 600 580,000 14,000 6,000

A. Determine the balance of the Accounts Receivable account at December 31, 2010. B. If Brocton estimates bad debts at 3% of net credit sales, how much is bad debt expense? Solution: A. $240,000 + $550,000 – $580,000 – $6,000 – $14,000 = $190,000 B. 3% x ($550,000 – $6,000) = $16,320 KP 3,4,5 BT: AN Difficulty: Difficult TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

6-26

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

10.

Before adjusting entries, Martin’s accounts receivable and allowance for doubtful accounts are $65,000 and $1,500 (debit balance), respectively. Using an aging schedule of accounts receivable, it is determined that $4,000 of the accounts receivable would probably be uncollectible. Calculate bad debts expense to be reported on Martin’s current year’s income statement? Solution: $1,500 + $4,000 = $5,500 KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

11.

The balances of the allowance for doubtful accounts on the balance sheets dated December 31 of 2010 and 2009 were $1,000 and $4,000, respectively. During 2010, bad debts expense was $9,000. What is the amount of accounts receivable that were written off as uncollectible during 2010? Solution: $4,000 + $9,000 - $1,000 = $12,000 KP 3,4,5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

12.

The following information is provided for Garland Inc. Answer the questions that follow. Balance Sheet Cash and cash equivalents Accounts Receivables, less allowance for doubtful accounts of $3,000 (2010) and $1,800 (2009)

2010 $98,000

2009 $114,000

165,000

132,000

A. How much is the balance in the Accounts Receivable account at December 31, 2010? B. What is the amount of the Net Realizable Value of the receivables at December 31, 2010? Solution: A. $165,000 + $3,000 = $168,000 B. $165,000 KP 5 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement 13.

The balances of the allowance for doubtful accounts on the balance sheets dated December 31 of 2010 and 2009 were $21,000 and $14,000, respectively. During 2010, $13,000 of accounts receivable were written off as uncollectible. How much bad debts expense is recognized during 2010? Solution: $14,000 – $13,000 – $21,000 = $20,000 KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

14.

6-27

Before adjusting entries, Clark’s accounts receivable and allowance for doubtful accounts are $42,000 and $300 (credit balance), respectively. Clark determined that 0.4% of net sales would probably be uncollectible. Sales during the year were $500,000 and sales returns amounted to $6,000. Calculate the net realizable value of accounts receivable on Clark’s balance sheet at year-end. Solution: $42,000 – [$300 + ($494,000 x .004)] = $39,724 KP 3,4,5 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Use the information that follows taken from the unadjusted trial balance and aging schedule of Behrend Company on December 31, 2010 to answer problems 15. All sales are on account. Accounts and related balances at December 31, 2010 before adjustment: Debit $47,000

Accounts receivable Allowance for doubtful accounts Sales (all on account) Sales returns

Credit $ 420 400,000

2,000

Aging Schedule of Accounts Receivable: Age 0-30 days 30-60 days Over 60 days

15.

Amount $15,000 18,000 14,000

% Uncollectible 2% 7% 13%

If Behrend uses the aging schedule of accounts receivable to determine bad debts, determine the following: A. Bad debts expense for the year ending December 31, 2010 B. Allowance for Doubtful Accounts balance at December 31, 2010 C. Net realizable value of accounts receivable on the 2010 financial statements Solution: A. Desired balance of Allowance for Uncollectible Accounts: $15,000 $18,000 $14,000

X X X

.02 = .07 = .13 =

Beginning balance Less desired balance Bad debt expense

$ 300 1,260 1,820 $3,380 $ 420 (3,380) $2,960

B. Allowance for uncollectible accounts Current period estimate Ending allowance for uncollectible accounts

$ 420 2,960 $3,380

C. Net realizable value = $47,000 – $3,380 = $43,620 KP 5 BT: AN Difficulty: Moderate TOT: 6 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

6-28

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

Use the information that follows from the financial statements of Pines Company at December 31, 2010, to answer questions 16 through 20 that follow. Accounts payable Accounts receivable Capital stock Cash Inventory Land Notes payable (short-term) Cost of goods sold Retained earnings Sales revenue

16.

$ 2,000 3,000 8,000 5,000 19,000 24,000 5,000 12,000 21,000 20,000

Calculate total current assets for Pines Company at December 31, 2010. Solution: $3,000 + $5,000 + $19,000 = $27,000 KP 1 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

17.

Calculate total current liabilities for Pines Company at December 31, 2010. Solution: $2,000 + $5,000 = $7,000 KP 1 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

18.

Calculate total working capital for Pines Company at December 31, 2010. Solution: ($3,000 + $5,000 + $19,000) – ($2,000 + $5,000) = $20,000 KP 1 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

19.

6-29

Calculate the current ratio for Pines Company at December 31, 2010. Solution: $27,000/$7,000 = 3.86 KP 1 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

20.

Calculate the quick ratio for Pines Company at December 31, 2010. Solution: ($3,000 + $5,000)/$7,000 = 1.14 KP3 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

21.

On December 1, 2010, Casio Trading Co. sold goods to a German company for 20,000 German marks (20,000 DM) to be collected on January 12, 2011. The exchange rates on December 1 and December 31, 2010 are US$0.50 = 1 DM and US$.60 = 1 DM, respectively. Calculate Casio’s revenue in U.S. dollars and its exchange gain or loss for 2010. Solution: Sales revenue = $0.50 x 20,000 = US$10,000 Exchange gain = ($0.60 − $0.50) x 20,000 = US$2,000 KP 4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

22.

On December 11, 2010, Bisbee Co. purchased capsules from a Canadian company for 10,000 Canadian dollars (10,000 C$) to be paid on January 2, 2011. The exchange rates on December 11 and December 31, 2010 are US$0.79 = 1C$ and US$0.82 = 1C$, respectively. What is the cost of the capsules in U.S. dollars and the 2010 exchange loss? Solution: Cost of capsules = $0.79 x 10,000 = US$7,900 Exchange loss = ($0.82 − $0.79) x 10,000 = US$300 KP 4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

23.

On December 1, 2009, Mason Company delivered a shipment of goods to a Swiss customer for a price of 150,000 euros. If on that date 1.3 U.S. dollars could be exchanged for 1 euro, what entry would Mason record to convert the receivable to equivalent U.S. dollars? Solution: Accounts receivable Sales

195,000 195,000

KP 4 BT: AN Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

6-30

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

24.

The following are partial balance sheets for Pedro Co, dated December 31: Accounts receivable Allowance for doubtful accounts Net realizable value

2009 $55,000 (5,000) $50,000

2010 $68,000 (11,000) $57,000

During 2010, $4,000 of accounts receivable were written off as uncollectible. Calculate the amount of bad debts expense recognized on Pedro’s 2010 income statement. Solution: $5,000 − $4,000 − $11,000 = $10,000 KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement 25.

Paxton’s aging schedule of its accounts receivable on December 31 follows: Account Age 1-30 days 31-90 days Over 90 days

Balance $100,000 70,000 40,000

Non-collection Likelihood 3% 7% 10%

The balance in Paxton’s allowance for doubtful accounts immediately prior to December 31 adjusting entries is $700 credit. Determine bad debts expense and the net realizable value of the December 31 accounts receivable. Solution: Balance in the allowance for doubtful accounts required on the balance sheet: (.03 x $100,000) + (.07 x $70,000) + (.1 x $40,000) = $11,900. Bad debts expense is $11,200 ($11,900 – $700). The net realizable value of accounts receivable is $210,000 – $11,900 = $198,100. KP 5 BT: AN Difficulty: Moderate TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement 26.

On 12/31/09, Phoebe Company’s balance sheet revealed a $7,000 balance in its allowance for doubtful accounts. During 2010, $2,000 of accounts were written off and $500 of accounts receivable previously written off were collected. On 12/31/10, bad debts expense was estimated to be 5% on net credit sales, which were $400,000. Calculate the balance in the allowance for doubtful accounts on 12/31/10. Solution: The balance in the allowance for doubtful accounts on 12/31/10 is $7,000 – $2,000 + $500 + $20,000 = $25,500. KP 5 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

6-31

SHORT ESSAY QUESTIONS 1.

Briefly described hedging. Solution: Hedging is commonly practiced to reduce the risk associated with holding receivables and payables in foreign currencies. Companies are susceptible to losses in situations where extreme exchange rates are constantly fluctuating. The fluctuating exchange rates can cause losses that cause income and other reported values (receivables and payables) to fluctuate substantially from one period to the next. Hedging involves taking a position in foreign currency in an amount that is equal and opposite of a particular receivable or payable expressed in the currency. Hedging can negate the effect of transaction losses much like an insurance policy can offset a loss to plant assets. KP 4 BT: K Difficulty: Moderate TOT: 4 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

The Porsha Bank has provided its auditor with the following selected financial data for 2010: Cash Loans receivable—current Allowance for doubtful accounts Total current assets Loans receivable—long-term Allowance for doubtful accounts Current liabilities 2010 net income

$ 7,000 $21,000 (3,000) $36,000 (4,000)

18,000 $25,000 $32,000 $19,000 $30,000

In reviewing the loans outstanding, the auditors were troubled by the fact that the collectability of some loans to Brazil was questionable. In fact, Porsha Bank has been making new loans to Brazil so that they can pay the interest on the loans already outstanding. The economic situation of Brazil has forced the auditors to insist that Porsha Bank increases its allowance for its current loans to $9,000 and for its noncurrent loans to $16,000. Porsha Bank decided to adhere to their auditors’ suggestions. Indicate the effects of adopting the auditor’s allowance requirements on Porsha Bank’s current ratio and 2010 net income. Solution: Increasing the allowance for doubtful accounts-current from $3,000 to $9,000 decreases current assets from $25,000 to $19,000. This decreases the current ratio from 1.32 to 1.0. Net income is decreased by $18,000 [($9,000 + $16,000) − ($4,000 + $3,000)], upon the increase of both current and long-term allowances for doubtful accounts. The adjusted 2010 net income is $12,000 ($30,000 − $18,000). There is no change in the current ratio as a result of the long-term increase. KP 5 BT: AN Difficulty: Difficult TOT: 10 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

6-32

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

Why might an operating cycle of one company differ from an operating cycle of another company? Solution: An operating cycle is the time it takes a company to convert its cash to inventory, sell the inventory, and collect cash from the sale. A company that grows Christmas trees will likely have a long operating cycle, because of the time it takes to grow a tree. A fast food restaurant will have a very quick operating cycle. The nature of a company’s industry determines its operating cycle. KP 1 BT: AP Difficulty: Moderate TOT: 3 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

What accounting requirements brought significant opposition from the banking industry? Solution: FASB has ruled that banks disclose the market value of their outstanding loans and create larger reserves (allowances) for bad debts. Banks were opposed to this rule because it reduced the balance sheet value of most U.S. banks. KP 5,6 BT: K Difficulty: Moderate TOT: 2 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Identify the limitations of current asset classification. Solution: The limitations are related to the fundamental fact that current assets and current liabilities fail to accurately reflect future cash inflows and outflows. The ability of the company to pay its debts as they come due is based upon whether cash flows will occur in the future. Since financial statements are based on historical facts and are not intended to predict information about future cash flows, this information cannot be determined solely by examining the current sections of the balance sheet. KP 1 BT: K Difficulty: Moderate TOT: 3 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

6-33

On December 31, 2010, Priya Co. has accounts receivable of $400,000. It uses the direct write-off method of accounting for bad debts because this is what is required for determining its U.S. taxable net income. The opinion of management is that what is acceptable to the Internal Revenue System should be acceptable under generally accepted accounting procedures. However, its independent auditor disagrees with this impassioned argument and does not accept the direct write-off method of accounting for bad debts. Present the reason(s) for the auditor’s objection to the direct write-off method, and indicate the method that must be used under GAAP. Indicate how Priya’s 2010 net income, current ratio, and quick ratio will be affected by following the auditor’s position. Solution: The direct write-off method of accounting for bad debts recognizes bad debts expense when an individual account is determined to be uncollectible. This does not achieve matching of expenses with the revenue that it generates. Also, accounts receivable would be measured at total face amount and not its net realizable value. Each reason makes the direct write-off method unacceptable under generally accepted accounting procedures. Taxable income for the IRS does not attempt to match expenses with revenues. To have a deduction for bad debts expense, the IRS wants evidence that a particular account is uncollectible and not a mere estimation of uncollectibility. The allowance method will initially increase bad debts expense and therefore decrease income. The carrying value of accounts receivable will decrease by the allowance for doubtful accounts and therefore decrease both the current and quick ratios. KP 5,6 BT: C Difficulty: Difficult TOT: 8 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

6-34

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

A company has a significant debit or credit accumulation in the preadjustment balance of allowance for doubtful accounts over several periods. Required: (1) What would this indicate? (2) How can users detect the source of this problem? Solution: (1) This may indicate that the estimates for bad debts are inaccurate and biased. Consistent overestimates give risk to preadjustment credit accumulations, while consistent underestimates create preadjustment accumulations on the debit side of allowance for doubtful accounts. Such accumulations, which often indicate that a company’s estimating formula should be revise, can lead to balance sheet misstatements in the allowance account because they are reflected in the year-end, post-adjustment balance. (2) Users can detect the balance sheet misstatements by comparing the amount in the allowance account to such numbers as sales and accounts receivable across time. Unusual deviations or well-defined trends may reveal a problem in estimating bad debts, which may raise questions about management’s competence and/or incentives. KP 5,6,7 BT: C Difficulty: Moderate TOT: 6 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Preston Bank has $50 million of loans outstanding on December 31 of the current year, in which it recorded net income of $770,000. Preston did not provide for any uncollectible loans because all of its loans are collateralized by real estate. That is, if the loans were to default, Preston would obtain the title to the real estate for which the loans were made. However, during the audit of Preston’s financial statements, the auditing company determined that $5 million of the outstanding loans would probably be dishonored (uncollectible). Because during the last three years real estate values have deteriorated, they also investigated the real estate that backed these collateralized loans. The market value of that real estate is negligible. Recalculate Preston’s loans receivable on December 31 and current net income to an amount that would be acceptable to the auditors. Solution: The allowance for uncollectible loans should be increased from $0 to $5,000,000. This would decrease the carrying value of Preston’s loans receivable from $50,000,000 to $45,000,000. Current net income would also decrease by $5 million because of bad debts expense, from net income of $770,000 to a net loss of $4,230,000. KP 6 BT: AN Difficulty: Difficult TOT: 5 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

6-35

Can a company use the direct write-off method rather than the allowance method to account for bad debts? Explain why or why not. Solution: Two accounting methods exist—the direct write off method and the allowance method. The direct write off method is not considered GAAP unless the dollar amount of uncollectible accounts is so small that using the direct write off method would not impact any users’ decisions. The allowance method is preferable since it matches a company’s expenses against the sales revenue and values receivables on the balance sheet at the net amount expected to be collected. KP 5,6,7 BT: AP Difficulty: Moderate TOT: 3 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

10.

What effect does ‘window dressing’ have on the solvency of a company? Solution: Managers who have discretion over the accounts in the current asset section of the balance sheet make efforts to inflate solvency measures by selecting accounting methods and making operating decisions that are designed solely to make the financial statements appear more attractive. Increasing the dollar amount of current assets increases working capital, the current ratio, and the quick ratio. This makes a company look much more solvent than it might be in reality. In the long run, a company may suffer and actually find its ability to raise debt and equity capital in the future hindered. KP 1,2 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

6-36

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

11. The following is a partial balance sheet for Quenton Company dated December 31, 2010: Current assets Cash Accounts receivable Allowance for doubtful accounts Net realizable value Inventory Total current assets Current liabilities

$20,000 $45,000 (3,000) 42,000 33,000 $95,000 $65,000

During 2010, $4,000 of accounts receivable were written off as uncollectible and bad debts expense recognized on Quenton’s 2010 net income statement was $8,000. However, the president of the company believes that $2,500 of these receivables were written off too soon. She believes that there is a good chance that they will be collected next year. There is some historical evidence to back the president’s position. A partial explanation for her position is that Quenton has a debt covenant requiring it to maintain a current ratio of 1.5. The president believes that by reversing the write-off of $2,500 of accounts receivable, the current assets will be $97,500 and the current ratio will be 1.5. However, the chief financial officer states that a better approach to getting the current ratio to 1.5 is to pay off some accounts payable. If the company paid $5,000 of accounts payable, the current ratio would become the minimum 1.5 required by the debt covenant. Comment, with numerical illustration, on the president’s and chief financial officer’s positions. Solution: If the write-off of $2,500 of accounts receivable were reversed, the carrying or net realizable value of accounts receivable will not change because a write off under the allowance method causes a decrease in accounts receivable and an increase in the allowance account. The new accounts receivable portion of current assets would be: Accounts receivable $47,500 Allowance for doubtful accounts (5,500) Net realizable value $42,000 Thus, total current assets and the current ratio would not change. Under the allowance method of accounting for bad debts, the write-off of an account decreases both accounts receivable and allowance for doubtful accounts, leaving the carrying value of net accounts receivable unaffected. If we follow the president’s suggestion, the current ratio is still 1.46 ($95,000/$65,000), which is less than the 1.5 required by the debt covenant. The only way to change accounting for accounts receivable so that a 1.5 current ratio can be achieved is to consider an aging schedule of accounts receivable and estimate that only $500 of allowance is required. This would increase the net realizable value of accounts receivable and current assets by the required $2,500. The position of the CFO is frequently referred to as window dressing. If $5,000 of accounts payable were paid, the current assets would decrease by $5,000 to $90,000, and current liabilities would also decrease by $5,000 to $60,000. The resulting current ratio meets the 1.5 minimum. KP 5 BT: AN Difficulty: Difficult TOT: 12 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 6 – The Current Asset Classification, Cash, and Accounts Receivable

12.

6-37

Why is too much cash undesirable? Solution: Cash that is not being used for immediate needs is idle. Idle cash provides no return, interest, or earnings power, and loses purchasing power during periods of inflation. Maintaining a proper balance of cash is one of management’s greatest challenges. KP 2 BT: C Difficulty: Easy TOT: 2 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

13.

Why is the timing of recording a receivable important? Solution: The timing of recording a receivable is important because of its relationship to revenue recognition. Note that the timing of revenue recognition can have a significant effect on important financial statement numbers. In other words, by recognizing the sale involving a receivable in an earlier period, the current ratio can be increased, as well as both working capital and net income can be increased. Such effects have economic significance, because they may influence a company’s credit rating or determine whether it violates the terms of debt agreements. Since the timing of revenue and receivable recognition has a direct effect on net income and current assets, financial statement users are tremendously impacted. KP 5,6 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Chapter 7 Merchandise Inventory

MULTIPLE CHOICE QUESTIONS 1.

Portland Supplies Co. mistakenly excluded $3,000 of goods from its December 31, 2010 physical inventory count. Its December 31, 2011 inventory amount was correct. As a result of this error, a. 2010 income is overstated by $3,000. b. 2010 ending inventory is overstated by $3,000. c. 2011 income is overstated by $3,000. d. 2011 cost of goods sold is overstated by $3,000. Ans: C KP 1,3 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Which one of the following expenditures should not be included in the cost of inventory? a. Transportation-out b. Purchase cost c. Packaging cost d. Transportation-in

Ans: A KP 2,3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Michael Manufacturers fraudulently overstated its December 31, 2010 and December 31, 2011 inventory by $3,000 and $6,000, respectively. As a result of these overstatements, a. 2010 income is overstated by $3,000 and 2011 income is overstated by $3,000. b. 2010 income is overstated by $3,000 and 2011 income is overstated by $6,000. c. 2010 income is overstated by $3,000 and 2011 income is accurate. d. 2010 and 2010 incomes are not affected. Ans: A KP 1,3 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

7-1

7-2

Test Bank – Chapter 7 – Merchandise Inventory

Jackson Roper fraudulently overstated its December 31, 2010 inventory by $8,000. As a result of this overstatement, a. the 2010 earnings per share is overstated. b. the 2010 current ratio is understated. c. the 2010 cost of goods sold amount is overstated. d. net income is overstated for 2011, and net income for 2010 is correct. Ans: A KP 1,3 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

If a company desires to increase its inventory, then it should: a. sell more goods than it purchases during the period. b. purchase more goods than it sells during the period. c. purchase the same amount of goods that it sells. d. increase its selling prices to a level that customers would not be willing to purchase. Ans: B KP 1 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Cagey Trading Inc. counted $2,000 of inventory twice during its December 31, 2010 physical inventory count. Its December 31, 2011 inventory amount is correct. As a result of this error, a. 2010 ending inventory is overstated by $2,000. b. 2010 income is understated by $2,000. c. 2011 income is overstated by $2,000. d. 2011 cost of goods sold is understated by $2,000. Ans: A KP 1,3 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Washington Co. mistakenly omitted $4,000 of merchandise from its inventory on December 31, 2010. Its December 31, 2011, inventory is correct. As a result of this error, a. earnings per share is overstated for 2010 and overstated for 2011. b. total income for 2010 and 2011 combined is correct. c. the current ratio is overstated on December 31, 2010 and is correct on December 31, 2011. d. ending inventory is understated at December 31, 2011. Ans: B KP 1,3 BT: AN Difficulty: Difficult TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 7 – Merchandise Inventory

7-3

Parker Books purchased 200 books, paying $10 each. Parker paid the $40 shipping costs and $30 binding repair fees so that those books could be sold. How much is the cost of inventory? a. $2,000 b. $2,040 c. $2,030 d. $2,070 Ans: D KP 2,3 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

A company deliberately and inappropriately included interest costs on its December 31 inventory. Which one of the following statements is true for the company’s December 31 financial statements? a. Earnings per share is understated. b. Inventory turnover ratio is understated. c. The current ratio is understated. d. Cost of goods sold is overstated. Ans: B KP 1,2,3 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

10.

Dole Produce Ltd. counted $700 of inventory twice in its December 31, 2010 inventory. On December 31, 2011, it mistakenly omitted $200 of merchandise from its inventory. As a result of these errors: a. net income is overstated by $700 in 2010 and understated by $200 in 2011. b. net income in understated by $700 in 2010 and overstated by $200 in 2011. c. net income is overstated by $700 in 2010 and understated by $900 in 2011. d. total net income for 2010 and 2011 is correct. Ans: C KP 1,3 BT: AN Difficulty: Difficult TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

11.

Kemp Clothing has cost of goods sold of $14,000 with beginning and ending inventories of $4,000 and $2,000, respectively. Purchases during the period are: a. $ 8,000. b. $ 9,000. c. $10,000. d. $11,000. e. $12,000. Solution:

$14,000 + $2,000 − $4,000 = $12,000

Ans: E KP 1 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

7-4

Test Bank – Chapter 7 – Merchandise Inventory

12.

Which one of the following expenditures should not be included in the cost of inventory? a. Purchase cost b. Transportation-in c. Packaging cost d. Capitalized equipment cost

Ans: D KP 2,3 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13.

Mars Hardware sold 20 drills for $8 each. Each drill cost $4. Which journal entry is required at the time of sale under a perpetual inventory system? a. Cash 160 Sales 160 b. c.

Cash Inventory

160

Cash Cost of Goods Sold Sales Inventory

160 80

Cash Inventory Gain from Sale

160

160 80 80 80

Ans: C KP 1 BT: AP Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

14.

Wood Inc. sells automobiles at $6,000 above its costs and uses the specific identification method for inventory. Below are the cars and the costs Wood paid for the inventory before the sale. Auto 1: $35,000 Auto 2: $17,500 Auto 3: $19,500 Auto 4: $23,000 Auto 5: $26,000 If Wood sells Auto 3 and Auto 5 for cash, which of the following would be included in the journal entries it uses to record the sale and recognize the cost of the inventory? a. A debit to Cost of Goods Sold for $45,500. b. A credit to Sales for $45,500. c. A credit to Inventory for $57,500. d. A credit to Sales for $12,000. Ans: A KP 1 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 7 – Merchandise Inventory

15.

7-5

Vic’s Produce purchased 50 boxes of tomatoes for a total of $400. It paid $20 for shipping tomatoes to a customer and $15 for repackaging them into smaller boxes. The cost of these tomatoes is: a. $400. b. $420. c. $415. d. $435. Ans: C KP 2,3 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

16.

Simon Cereal purchased 100 pounds of cornflakes for $100. Transportation cost to Simon’s production facility was $25 for the barrel of cornflakes shipped FOB destination. Simon paid $60 for 100 one-pound biodegradable plastic bags into which the cornflakes were placed. The cost of each one-pound bag of cornflakes is: a. $1.00. b. $1.25. c. $1.60. d. $1.75. Ans: C KP 3 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

17.

Beginning inventory is valued at $7,000, purchases are $15,000 and ending inventory is valued at $9,000. Cost of goods sold is: a. $23,000. b. $16,000. c. $30,000. d. $13,000. e. $16,000. Ans: D KP 1 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

18.

Victoria Fashions Clothing Store uses the perpetual method of accounting for inventory. During the current year, purchases are $30,000 and cost of goods sold is $25,000. Beginning inventory is valued at $4,000 and ending inventory was taken on December 31 and valued at $6,000. Inventory shortage expense for the current year is: a. $0. b. $2,000. c. $3,000. d. $5,000. Ans: C KP 1 BT: AN Difficulty: Difficult TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

7-6

Test Bank – Chapter 7 – Merchandise Inventory

19.

During a year of decreasing prices and decreasing inventory, which cost flow assumption would measure the greatest net income? a. FIFO b. LIFO c. Averaging d. Both a and c are correct. Ans: B KP 4 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

20.

During a year of rising prices and increasing inventory, which cost flow assumption would yield the greatest current ratio? a. Averaging b. LIFO c. FIFO d. Both a and c are correct. Ans: C KP 4 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

21.

During a year of rising prices and increasing inventory, which cost flow assumption would measure the smallest net income? a. LIFO b. FIFO c. Averaging d. All methods measure income the same. Ans: A KP 4 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

22.

During a year of rising prices and increasing inventory, which cost flow assumption would measure the smallest working capital ratio? a. FIFO b. LIFO c. Averaging d. Working capital is not sensitive to inventory cost flow assumptions. Ans: B KP 4 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 7 – Merchandise Inventory

23.

7-7

The President and CEO of Quinn Manufacturing receives a cash bonus equal to 1% of audited net income during the current year. During a period of rising prices and increasing inventory, which inventory cost flow assumption would measure the smallest compensation expense and greatest cash position for Quinn Manufacturing? a. FIFO b. NIFO c. Averaging d. LIFO Ans: D KP 4 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

24.

Unusually high income resulted when Vincent Inc. cut back its inventory levels. This effect is: a. backed by the LIFO elimination rule. b. expected in most industries. c. achieved through using the lower-of-cost-or-market rule. d. called LIFO liquidation. Ans: D KP 4 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

25.

During a year of rising prices and increasing inventory, which cost flow assumption would measure the largest inventory turnover ratio? a. FIFO b. LIFO c. Averaging d. The inventory turnover ratio is not sensitive to inventory cost flow assumptions. Ans: B KP 5 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

26.

During a period of rising prices and increasing inventory, which cost flow assumption used on both federal income tax returns and financial reports would provide a company with the greatest cash position? a. FIFO b. LIFO c. Averaging d. TIFO Ans: B KP 4 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

7-8

Test Bank – Chapter 7 – Merchandise Inventory

27.

During a year of falling prices, which cost flow assumption would measure the strongest cash flow position? a. LIFO b. FIFO c. Averaging d. Net income will remain the same under all methods. Ans: B KP 4 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

28.

During a year of falling prices, which cost flow assumption would yield the greatest current ratio? a. FIFO b. LIFO c. Averaging d. Lower-of-cost or market Ans: B KP 4 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

29.

If a company uses the LIFO cost flow assumption on its federal income tax return in order to minimize its tax payment, then it: a. must use LIFO on its financial statements. b. must use FIFO on its financial statements. c. may use any cost flow assumption permitted by GAAP on its financial statements. d. must correct the error at the beginning of the next accounting period. Ans: A KP 4 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

30.

An excessively low inventory turnover ratio may reveal that: a. customers are delaying their payments on account. b. the selling price of inventory is too high. c. sales returns have decreased significantly. d. the company is selling too much inventory. Ans: B KP 4 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 7 – Merchandise Inventory

31.

7-9

Carmelo Inc. has an inventory turnover ratio of 25. Carmelo’s average number of day’s inventory is: a. Less than 10. b. Between 10 and 12. c. More than 12. d. Unable to be determined based on this limited information. Solution:

365 / 25 = 14.6 days

Ans: C KP 1 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

32.

Under generally accepted accounting principles, a company can choose a cost flow assumption for valuing cost of goods sold that can result in different income measurement. However, it can’t frequently change the cost flow assumption adopted in order to measure the highest income possible because of the: a. conservativism principle. b. going concern principle. c. stable-dollar principle. d. consistency principle. Ans: D KP 4 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

33.

During an extended period of constant prices, which cost flow assumption would generally measure the largest earnings per share? a. FIFO b. LIFO c. Weighted average d. All of the above assumptions would result in equal earnings per share during an extended period of constant prices. Ans: D KP 4 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

34.

At which point in accounting for inventory in a perpetual system is determining the cost of goods sold amount an issue? a. When the inventory is acquired. b. As the inventory is carried in the warehouse and held for sale. c. As the ending inventory is counted. d. As the inventory is sold. Ans: D KP 2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

7-10

35.

Test Bank – Chapter 7 – Merchandise Inventory

Items should be included in the company’s inventory if they are: a. being used in the production of income. b. held in anticipation of an increase in value. c. being held for sale. d. sold during the period. Ans: C KP 2,3 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

36.

Which one of the following should be included in Camden’s inventory at December 31, 2010? a. Goods shipped FOB shipping point on December 31, 2010, from Camden to a customer. b. Goods in the Camden’s warehouse on December 31, 2010, waiting to be shipped to a customer. c. Goods ordered from one of Camden’s suppliers on December 31, 2010, shipped FOB destination on December 31, 2010, which arrived January 2, 2011. d. Goods sold and shipped to a customer on December 31, 2010, terms FOB destination, which were delivered on December 31, 2011. Ans: B KP 3 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

37.

Which one of the following companies would likely carry the largest percentage of inventory as compared to its other assets? a. Ernst & Young, CPAs b. Merrill Lynch Investment Brokers c. The Magic Kingdom at Disney World d. Jim’s Ford Dealership Ans: D KP 1 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

38.

When prices remain the same, which cost flow assumption would generally measure the largest current ratio? a. FIFO b. LIFO c. Averaging d. All of the above assumptions would result in equal current ratios during an extended period of constant prices. Ans: D KP 4 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 7 – Merchandise Inventory

39.

7-11

When accounting for inventory consignments, the issue which helps determine whether or not the inventory cost should be included on a company’s balance sheet is: a. whether the inventory is physically located in the company’s warehouse. b. who actually owns title to the inventory. c. who will ultimately sell the inventory to the consumer. d. when the inventory will be sold. Ans: B KP 2,3 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

40.

Specific identification is a method of accounting for inventory: a. which eliminates the need for tracking the cost of inventory items. b. that allocates the oldest cost to the first units sold. c. that often allows a manager to manipulate net income and the ending inventory value. d. commonly used in periods of rising prices. Ans: C KP 4 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

41.

Selecting an inventory cost flow assumption will most likely be impacted by which one of the following? a. The physical flow of the inventory goods. b. The cost of the company’s plant and equipment. c. Income taxes. d. The cost flow assumptions most often used by other companies. Ans: C KP 2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

42.

All of the following are typically associated with Japanese business inventory accounting except: a. the use of the average assumption for inventory cost. b. shared business risks. c. slow inventory turnover. d. lower levels of inventory. Ans: C KP 1,4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Global AICPA FN: Reporting

7-12

43.

Test Bank – Chapter 7 – Merchandise Inventory

Inventory reported on the balance sheet of a manufacturing company consists of: a. raw materials and the cost of labor to convert the raw materials to finished products. b. raw materials, the cost of labor to convert the raw materials, and an allocated portion of manufacturing overhead cost. c. the cost of the raw materials used. d. raw materials, the cost of labor to convert the raw materials, and all major corporate overhead costs. Ans: B KP 3 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

44.

The LIFO conformity rule requires a company that uses: a. the LIFO assumption for computing cost of goods sold on its tax return to also use the LIFO assumption in preparing its financial statements. b. any inventory cost assumption to use the LIFO cost assumption for tax purposes. c. the LIFO assumption for computing cost of goods sold on its financial statements to also use LIFO on its tax return. d. the LIFO assumption to avoid paying taxes on inventory profits. Ans: A KP 1,4 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

45.

During a period of rising prices and inventories, a company whose current ratio is dangerously close to the minimum specified by agreement with a major creditor would prefer which cost flow assumption? a. FIFO b. LIFO c. Averaging d. The company would be indifferent as to which cost flow assumption is adopted. Ans: A KP 4 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

46.

Selling more inventory than was purchased during the current period may often cause old, smaller costs that were carried as part of the company's beginning inventory, to be moved to the income statement and reported as cost of goods sold. This is called: a. the LIFO conformity rule. b. LIFO liquidation. c. the LIFO reserve rule. d. lower-of-cost-or-market accounting. Ans: B KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 7 – Merchandise Inventory

47.

7-13

During a period of rising prices and inventories, a company whose debt/equity ratio is dangerously close to the minimum specified by agreement with a major creditor would prefer which cost flow assumption? a. FIFO b. LIFO c. Averaging d. The company would be indifferent as to which cost flow assumption is adopted. Ans: A KP 4 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

48.

During a period of changing inventory prices, which of the following is NOT immediately sensitive to the particular cost flow assumption adopted? a. Net income b. Current ratio c. Gross profit d. Working capital e. Quick ratio Ans: E KP 4 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

49.

Under the lower-of-cost-or-market rule, market is: a. the selling price of inventory items. b. the original cost paid for inventory. c. used to value inventory if it is less than its recorded cost. d. the amount of cash the company expects to collect from the sale of an inventory item. Ans: C KP 5 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

50.

Which of the following policies would increase a firm's current inventory turnover ratio? a. Reduction of the average inventory that supports a constant amount of sales b. An decrease in the units of inventory sold while holding average inventory constant c. Increase of inventory by adopting a Just-in-Time production schedule d. Saving new purchases of inventory until the following year instead of this year Ans: A KP 4 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

7-14

51.

Test Bank – Chapter 7 – Merchandise Inventory

If the market value of inventory is greater than its cost, then the application of the lowerof-cost-or-market rule would: a. decrease both the current ratio and net income. b. decrease the current ratio but not change net income. c. not change the current ratio but decrease net income. d. change neither the current ratio nor net income. Ans: D KP 5 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

52.

During a period of rising prices and inventories, which method causes cash flows to be stronger? a. FIFO b. LIFO c. Averaging d. The company would be indifferent as to which cost flow assumption is adopted. Ans: B KP 5 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

53.

Which of the following should not be included in inventory cost for a car dealership? a. The costs of transporting the cars from the factory to the dealership b. Cost of new car preparation for customers c. The salary and commission of the salesman who sells the vehicle d. The cost of adding a CD player to the vehicles before the vehicle is offered for sale Ans: C KP 2,3 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

54.

If the market value of inventory is less than its cost, then application of the lower-of-costor-market rule would: a. increase earnings and decrease the current ratio. b. decrease earnings and increase the current ratio. c. decrease earnings and decrease the current ratio. d. cause no change to earnings or the current ratio. Ans: C KP 5 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

55.

What is the impact on the financial statements of an overstatement of ending inventory? a. Next year’s ending inventory will be overstated. b. Next year’s net income will be overstated. c. Current year’s net income will be overstated. d. Next year’s ending inventory will be understated. Ans: C KP 1 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 7 – Merchandise Inventory

56.

The following information comes from the annual reports of Devin Designs. 2012 2011 2010 Beginning inventory ? ? 2,250 Purchases 12,652 ? ? Goods available for sale ? ? 12,899 Ending inventory ? 2,662 ? Cost of goods sold 12,213 10,908 10,490 What is the Purchases amount for 2010? a. $4,713 b. $2,397 c. $81 d. $10,649 Ans: D KP 1 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

57.

The following information comes from the annual reports of Devin Designs. 2012 2011 2010 Beginning inventory ? ? 2,250 Purchases 12,652 ? ? Goods available for sale ? ? 12,899 Ending inventory ? 2,662 ? Cost of goods sold 12,213 10,908 10,490 What is the ending inventory amount for 2010? a. $4,713 b. $2,409 c. $81 d. $10,583 Ans: B KP 1 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

7-15

7-16

58.

Test Bank – Chapter 7 – Merchandise Inventory

The following information comes from the annual reports of Devin Designs. 2012 2011 2010 Beginning inventory ? ? 2,250 Purchases 12,652 ? ? Goods available for sale ? ? 12,899 Ending inventory ? 2,662 ? Cost of goods sold 12,213 10,908 10,490 What is the beginning inventory amount for 2011? a. $2,409 b. $13,570 c. $10,502 d. $8,246 Ans: A KP 1 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

59.

The following information comes from the annual reports of Devin Designs. 2012 2011 2010 Beginning inventory ? ? 2,250 Purchases 12,652 ? ? Goods available for sale ? ? 12,899 Ending inventory ? 2,662 ? Cost of goods sold 12,213 10,908 10,490 What is the amount of purchases for 2011? a. $8,246 b. $11,161 c. $13,570 d. $10,643 Ans: B KP 1 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

60.

The following information comes from the annual reports of Devin Designs. 2012 2011 2010 Beginning inventory ? ? 2,250 Purchases 12,652 ? ? Goods available for sale ? ? 12,899 Ending inventory ? 2,662 ? Cost of goods sold 12,213 10,908 10,490 What is the amount of goods available for sale for 2011? a. $8,246 b. $11,173 c. $13,570 d. $10,643 Ans: C KP 1 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 7 – Merchandise Inventory

61.

The following information comes from the annual reports of Devin Designs. 2012 2011 2010 Beginning inventory ? ? 2,250 Purchases 12,652 ? ? Goods available for sale ? ? 12,899 Ending inventory ? 2,662 ? Cost of goods sold 12,213 10,908 10,490 What is the beginning inventory amount for 2012? a. $439 b. $8,246 c. $10,908 d. $2,662 Ans: D KP 1 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

62.

The following information comes from the annual reports of Devin Designs. 2012 2011 2010 Beginning inventory ? ? 2,250 Purchases 12,652 ? ? Goods available for sale ? ? 12,899 Ending inventory ? 2,662 ? Cost of goods sold 12,213 10,908 10,490 What is the amount of goods available for sale for 2012? a. $11,347 b. $15,314 c. $13,957 d. $24,865 Ans: B KP 1 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

63.

The following information comes from the annual reports of Devin Designs. 2012 2011 2010 Beginning inventory ? ? 2,250 Purchases 12,652 ? ? Goods available for sale ? ? 12,899 Ending inventory ? 2,662 ? Cost of goods sold 12,213 10,908 10,490 What is the ending inventory amount for 2012? a. $24,865 b. $3,101 c. $2,223 d. $15,314 Ans: B KP 1 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

7-17

7-18

64.

Test Bank – Chapter 7 – Merchandise Inventory

Forrest’s Crab House purchased Florida stone crab on account on November 10, 2009, for a gross price of $87,000. Forrest also purchased farm-raised catfish on account on November 11, 2009 for a gross price of $25,000. The terms of both sales were 2/15, n/30. Forrest paid for the first purchase on November 19, 2009, and for the second purchase on November 30. If he uses the perpetual inventory method, his journal entry for November 19 would include:

a. a debit to Inventory for $1,740. b. a debit to Inventory for $85,260. c. a credit to Inventory for $1,740. d. a credit to Accounts Payable for $87,000 Solution: Accounts Payable (–L) ................................................................ Cash (–A).............................................................................. Inventory (–A) ...................................................................... __________ * $1,740 = $87,000  2% discount

87,000 85,260 1,740*

Ans: C KP 1 BT: AP, AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

65.

Forrest’s Crab House purchased Florida stone crab on account on November 10, 2010, for a gross price of $87,000. Forrest also purchased farm-raised catfish on account on November 11, 2010 for a gross price of $25,000. The terms of both sales were 2/15, n/30. Forrest paid for the first purchase on November 19, 2010, and for the second purchase on November 30. If he uses the perpetual inventory method, which of the following journal entries would Forrest make for November 30? a. Inventory 25,000 Accounts Payable 25,000 b. Accounts Payable 25,000 Cash 25,000 c. Accounts Payable 25,000 Cash 24,500 Inventory 500 d. Accounts Payable 24,500 Cash 24,500 Ans: B KP 1 BT: AP, AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 7 – Merchandise Inventory

66.

7-19

Gump Supplies has the following information: Beginning inventory $39,000 Inventory purchases 92,000 Transportation-in 11,300 An inventory count taken at year end indicates that inventory with a cost of $56,000 is on hand as of December 31, 2010. Assume that inventory purchases and transportation-in are both reflected in the inventory account, which shows an ending balance of $59,000. What is the amount of the cost of goods sold? a. $123,300 b. $83,300 c. $60,700 d. $100,700 Solution: With the perpetual method, the balance in the Cost of Goods Sold account is perpetually updated for sales of inventory, as is the balance in the Inventory account for sales and acquisitions of inventory. This implies that the balance in Cost of Goods Sold should correspond to a balance in the Inventory account of $59,000, and that no entry is necessary at the end of the year to record Cost of Goods Sold. Ending Inventory = Beginning Inventory + Net Purchases – Cost of Goods Sold $59,000 = $39,000 + ($92,000 + $11,300) – COGS Cost of Goods Sold = $83,300 Ans: B KP 1 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

67.

Gump Supplies has the following information: Beginning inventory $39,000 Inventory purchases 92,000 Transportation-in 11,300 An inventory count taken at year end indicates that inventory with a cost of $56,000 is on hand as of December 31, 2010. Assume that inventory purchases and transportation-in are both reflected in the inventory account, which shows an ending balance of $59,000. Which of the following would be the best adjusting journal entry to make at the end of the period with respect to this information? a. Inventory Shrinkage 3,000 Inventory 3,000 b. Inventory 3,000 Inventory Overage 3,000 c. Inventory 3,000 Purchases 3,000 d. Cost of Goods Sold 3,000 Sales 3,000 Solution: Since the physical count indicates that Gump has $3,000 less inventory than is recorded in its Inventory account, the following adjusting entry is necessary at the end of the year. Inventory Shrinkage (E, –SE) ............................................ Inventory (–A) ..........................................................

3,000 3,000

7-20

Test Bank – Chapter 7 – Merchandise Inventory

Ans: A KP 1 BT: AP, AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

68.

Dakota Industries has two items in inventory as of December 31, 2010. Each item was purchased for $52. Company management chose to write down Item #1 to $39, which at year-end was assessed to be its market value. Management did not write down Item #2 because its market value was estimated to be greater than $52. During 2010, each item was sold for $63 cash. The journal entry for the write down of Item #1 would include which of the following? a. Loss on Inventory Write-down ........................................ 24 Inventory ............................................................ 24 b. Inventory ......................................................................... 13 Loss on Inventory Write-down ............................ 13 c. Loss on Inventory Write-down ........................................ 13 Inventory ............................................................ 13 d. Inventory ......................................................................... 24 Loss on Inventory Write-down ............................ 24 Ans: C KP 1 BT: AP, AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

69.

Test Bank – Chapter 7 – Merchandise Inventory

70.

7-21

Grey Manufacturing had the following transaction: • Grey received an order to sell inventory with a cost of $50,000, and debited Accounts Receivable and credited Sales. The goods were shipped to the customer on December 31, 2010, and received on January 2, 2011. If the terms of the sale were FOB shipping point and Grey included all these items in its ending inventory of 12/31/10, which of the following is the best statements regarding this treatment? a. Grey made no mistake and rightfully included the items in its inventory until January 2, 2011. b. Grey made a mistake and wrongly understated ending inventory. c. Grey made a mistake and wrongly understated Cost of Goods Sold. d. Grey made a mistake and wrongly understated Retained Earnings. Ans: C KP 1 BT: AP Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

71.

Grey Manufacturing had the following transaction: • Grey ordered $67,000 of inventory on December 30, 2010. The inventory was shipped on December 31, 2010, with the terms FOB destination. Grey received the inventory on January 3, 2011. If Grey included all these items in it ending inventory of 12/31/10, which of the following is the best statement regarding this treatment? a. Grey made no mistake and rightfully included the items in its ending inventory for 12/31/10. b. Grey made a mistake and wrongly overstated Inventory. c. Grey made a mistake and wrongly overstated Cost of Goods Sold. d. Grey made a mistake and wrongly overstated Retained Earnings. Ans: B KP 1 BT: AP Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

7-22

Test Bank – Chapter 7 – Merchandise Inventory

MATCHING QUESTIONS 1.

For each cost numbered 1 through 8 below, identify which accounting treatment (a through c) would most likely be used in accounting for the cost. You may use each letter more than once or not at all. a. b. c.

Users Added to cost of inventory Deducted from cost of inventory Not part of cost of inventory

Cash price of goods purchased for resale

Transportation cost of goods shipped to customers

Transportation cost of goods shipped from suppliers FOB shipping point

Cash discount taken on purchases of inventory

Transportation cost of goods being shipped to consignee

Assembly costs of products which will be sold to customers

Insurance cost paid while inventory is in transit from suppliers

Excise, sales, use, value added, and other fees and taxes paid on the purchase of inventory

Solution: 1. a 2. c 3. a 4. b

5. 6. 7. 8.

a a a a

KP 2,3 BT: K Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

For each item listed in 1 through 4, place the letter of the accounting effect (a through e) in the space provided. You may use each letter more than once or not at all. Accounting Effects a. b. c. d. e.

____ ____ ____ ____

Current ratio and earnings per share increase. Current ratio and earnings per share are not affected. Current ratio increases and earnings per share decreases. Current ratio decreases and earnings per share increases. Current ratio and earnings per share decrease.

1. During a period of increasing inventory and rising prices, a company decides to use FIFO instead of LIFO. 2. During a period of increasing inventory and rising prices, a company decides to use averaging instead of FIFO. 3. During a period of static prices, a company decides to use FIFO instead of LIFO. 4. A company applies lower-of-cost-or-market for valuing ending inventory when market price is less than cost.

Solution: 1. a

2. e

3. b

4. e

KP 4 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 7 – Merchandise Inventory

7-23

For each item listed in 1 through 2, place the letter of the accounting effect (a through e) in the space provided. You may use each letter more than once or not at all. Accounting Effects a. b. c. d. e.

Current ratio and earnings per share increase. Current ratio and earnings per share decrease. Current ratio increases and earnings per share decreases. Current ratio decreases and earnings per share increases. Current ratio and earnings per share are not affected.

____ 1. A company applies lower-of-cost-or-market for valuing ending inventory when cost is greater than market price. ____ 2. During an extended period of constant prices, a company uses LIFO instead of FIFO. Solution: 1. b

2. e

KP 4 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

For each item listed in 1 through 7, place the letter (a through e) of the accounting effect in the space provided. You may use each letter more than once or not at all. Accounting Effects a. b. c. d. e.

Assets and net income increase Assets and net income decrease Assets decrease and net income increases Assets increase and net income decreases Assets and net income are not affected

____ 1. During a period of increasing inventory and rising prices, a company decides to use FIFO instead of LIFO. ____ 2. During a period of increasing inventory and rising prices, a company decides to use averaging instead of FIFO. ____ 3. During a period of increasing inventory and increasing prices, a company uses the LIFO method, which creates the largest cost of goods sold. ____ 4. A company applies lower-of-cost-or-market for valuing ending inventory when market price is less than cost. ____ 5. A company applies lower-of-cost-or-market for valuing ending inventory when cost is less than market price. ____ 6. During an extended period of constant prices, a company adopts LIFO instead of FIFO. Solution: 1. a

2. b

3. b

4. b

5. e

KP 4 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

7-24

Test Bank – Chapter 7 – Merchandise Inventory

SHORT PROBLEMS 1.

Bisbee Ltd. has been fraudulently overstating its inventory in order to "pump up" a lagging income. It started this practice on January 1, 2010 and overstated the 2010 income by $9,000. By what amount will they have to overstate December 31, 2011 inventory in order to overstate 2011 income by $14,000? Solution:

($9,000) – $14,000 = $23,000

KP 1,3 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Use the information that follows concerning Bradley Corporation to answer problems 25. Bradley Corporation began business on January 1. During January, Bradley reported the following: January 1 purchase: January 10 purchase: January sales:

100 units @ $10 = 150 units @ $14 = 200 units

$1,000 $2,100

Determine the amount of inventory to report on Bradley’s balance sheet at January 31 under the FIFO cost flow assumption. Solution:

50 x $14 = $700

KP 4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement 3.

Determine the amount of inventory to report on Bradley’s balance sheet at January 31 under the LIFO cost flow assumption. Solution:

50 x $10 = $500

KP 4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Determine the amount of the inventory valuation on January 31 under the averaging cost flow assumption. Solution: [(100 x $10) + (150 x $14)]/250 = $12.40 per unit 50 x $12.40 = $620 KP 4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 7 – Merchandise Inventory

7-25

Determine the amount of cost of goods sold under the FIFO cost flow assumption for the month of January. Solution:

(100 x $10) + (100 x $14) = $2,400

KP 4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement 6.

Warren Trading pays for its inventory purchases with cash. Beginning inventory is $3,000, purchases were $19,000, and cost of goods sold is $18,000. Determine the cost of Warren’s ending inventory. Solution:

$3,000 + $19,000 – $18,000 = $4,000

KP 1,3 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Use the information that follows concerning Cinci Corporation to answer problems 7 and 8. Cinci Company began business on March 1. During March, Cinci made the following purchases. March 1: March 6: March sales:

100 units @ $8 200 units @ $10 240 units

800 2,000

How much will Cinci report as cost of goods sold using LIFO during March? Solution:

(200 x $10) + (40 x $8) = $2,320

KP 4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Calculate cost of goods sold during March under the averaging cost flow assumption. Solution:

$2,800/300 = $9.33 per unit; $9.33 x 240 = $2,240

KP 4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

7-26

Test Bank – Chapter 7 – Merchandise Inventory

The management of Dayton Ltd. erroneously understated its inventory during 2010 by $28,000. Using the information below and assuming there are no distributions of retained earnings: (1) present a brief analysis with the accurate numbers and the numbers in error and (2) explain whether retained earnings would be overstated, understated, or be indifferent to the error at the end of 2011. 2010 Sales: $60,000 2010 Purchases: $50,000 2010 Cost of Goods Sold (before inventory error) $20,000 2011 Sales: $210,000 2011 Purchases: $60,000 2011 Cost of Goods Sold (based on error numbers): $68,000 Solution: (1) If Accurate

With 2010 Error

2010 Sales Cost of Goods Sold Net Income

$60,000 20,000 $40,000

$60,000 22,000 $38,000

2011 Sales Cost of Goods Sold Net Income

$210,000 70,000 $140,000

$210,000 68,000 $142,000

(2) Since errors in inventory misstate net income in the subsequent period by an equal dollar amount in the opposite direction, retained earnings should be correctly stated at the end of 2011, if no further errors occur. Accurate Incomes = $40,000 + $140,000 = $180,000 Retained earnings Incomes associated with error = $38,000 + $142,000 = $180,000 Retained earnings KP 1,3 BT: AN Difficulty: Moderate TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

10.

Yale Co. has valued its beginning and ending inventories at $4,000 and $7,000, respectively, during a period where cost of goods sold was $22,000. An auditor found an error in the valuation of the ending inventory and insisted that it be restated to $6,000. Calculate the adjusted cost of goods sold resulting from the inventory restatement. Solution:

$22,000 + $1,000 = $23,000

KP 1,3 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 7 – Merchandise Inventory

11.

7-27

Summers Company began business on August 1, 2010. During August, Summers made the following purchases: August 3 August 21

100 units @ $10 300 units @ $20

$1,000 $6,000

Other information provided: August sales August expenses excluding cost of goods sold August 31 current assets excluding inventory August 31 current liabilities

350 units at $50 each $7,200 $34,000 $26,000

Calculate Summers’ August 31 ending inventory under the FIFO and LIFO cost flow assumptions. Solution: FIFO = 50 x $20 = $1,000 LIFO = 50 x $10 = $500 KP 4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

12.

Yogi Company began operations on July 1. Below is its July income statement and the current portion of its balance sheet dated July 31. Each unit is sold for $80. Under the LIFO method of inventory, Yogi reported the following: July 3 July 14 July 31

Purchased 60 units @ $50 Purchased 40 units @ $60 Cost of goods available Inventory (10 @ $50) Cost of goods sold

$3,000 2,400 $5,400 500 $4,900

Complete the following income statement and current portion of the balance sheet for Yogi for July using the FIFO cost flow assumption instead of LIFO. Sales revenue . . . . . . . . . . . . . . . . . _____________________ Cost of goods sold . . . . . . . . . . . . . ._____________________ Gross profit . . . . . . . . . . . . . . . . . . . _____________________ Solution: Sales revenue = $80 X 90 = $7,200 Cost of goods sold = (60 x $50) + (30 x $60) = $4,800 Gross profit = $7,200 – $4,800 = $2,400 KP 4 BT: AN Difficulty: Difficult TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

7-28

13.

Test Bank – Chapter 7 – Merchandise Inventory

A firm fraudulently overstated its December 31, 2009 and 2010 inventories by $4,000 and $7,000, respectively. What is the amount of 2009 and 2010 overstatements of cost of goods sold which results from these inventory overstatements? Solution: 2009 cost of goods sold is understated by $4,000. 2010 cost of goods sold is understated by $3,000. KP 1,3 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Use the information that follows concerning Yarley’s Gift Store to answer problems 14-17. Grandma’s Gift Store inventory and purchase information for July is as follows: July 1 July 10 July 31

14.

Beginning inventory Purchase Ending inventory

500 @ $4 800 @ $5 300

Grandma’s Gift Store uses the FIFO cost flow assumption. Calculate its cost of goods sold for the month of July and its ending inventory at July 31. Solution: Cost of goods sold = (500 x $4) + (500 x $5) = $4,500 Ending inventory = 300 x $5 = $1,500 KP 4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

15.

Grandma’s Gift Store uses the LIFO cost flow assumption. Calculate its cost of goods sold for July and its ending inventory at July 31. Solution: Cost of goods sold = (800 x $5) + (200 x $4) = $4,800 Ending inventory = 300 x $4 = $1,200 KP 4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

16.

Grandma’s Gift Store uses the averaging cost flow assumption. Calculate its cost of goods sold for July and its inventory at July 31. Solution: Cost of goods sold = $4.6153846 x 1,000 = $4,615.38 Ending inventory = $4.6153846 x 300 = $1,384.62 KP 4 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 7 – Merchandise Inventory

17.

7-29

By what amount would Grandma’s working capital on July 31 under FIFO exceed working capital using LIFO? Solution:

($5 x 300) – ($4 x 300) = $300

KP 4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Use the information that follows concerning Ruby Company to answer problems 18 through 20. Ruby Company sells office supplies. Below is a list of purchases and sales for the month of January: Date January 1 January 4 January 18 January 31

18.

Beginning inventory Purchase Purchase Ending inventory

Inventory Balances 10 @ $6

Purchases 40 @ $7 40 @ $8

20 units

Ruby uses the FIFO cost flow assumption. Calculate its January cost of goods sold. Solution:

(10 x $6) + (40 x $7) + (20 x $8) = $500

KP 4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

19.

Ruby uses the LIFO cost flow assumption. Calculate its January cost of goods sold. Solution:

(40 x $8) + (30 x $7) = $530

KP 4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

20.

Ruby uses the averaging cost flow assumption. Calculate its January cost of goods sold. Solution:

[(10 x $6) + (40 x $7) + (40 x $8)]/90 = $7.33; 70 x $7.33 = $513

KP 4 BT: K Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

7-30

21.

Test Bank – Chapter 7 – Merchandise Inventory

Toyz’s Retail Store sold $900 of merchandise to Ebony Inc. on April 3, terms, 2/10 EOM. On April 8, Ebony returned $200 of the merchandise that was defective. The original merchandise sold cost Toyz $600 with terms N30, but of this amount, $70 was returned. Toyz received payment from Ebony on April 10. What amount of sales and cost of goods sold should Toyz record for these transactions? Solution: Sales = ($900 – $200) x .98 = $686 Cost of goods sold = $530 KP 1,3 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Use the information that follows concerning Edward Company to answer problems 22 and 23. Edward Company began business on January 1. During January, Edward made the following purchases: January 3: January 21: January sales:

100 units @ $30 400 units @ $20 320 units @ $40

$3,000 $8,000 $12,800

January expenses excluding cost of goods sold January 31 current assets excluding inventory January 31 current liabilities Number of shares of common stock

$ 800 11,000 6,000 300

Other information:

22.

Calculate Edward’s January earnings per share under the FIFO and LIFO cost flow assumptions. Solution: FIFO net income: $12,800 − [(100 x $30) + (220 x $20)] − $800 = $4,600 LIFO net income: $12,800 − [320 x $20] − $800 = $5,600 FIFO EPS: $4,600/300 = $15.33 per share LIFO EPS: $5,600/300 = $18.67 per share KP 4 BT: AN Difficulty: Difficult TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

23.

Calculate Edward’s January current ratio under the FIFO and LIFO cost flow assumptions. Solution: FIFO: ($11,000 + $3,600)/$6,000 = 2.43;

LIFO: ($11,000 + $4,600)/$6,000 = 2.60

KP 4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement 24.

Nokia Inc. reported beginning inventory of $90,000, ending inventory of $23,000, purchases of $128,000, purchase returns of $2,000, and transportation-in of $3,000. Calculate cost of goods sold. Solution:

$90,000 + $128,000 – $2,000 + $3,000 – $23,000 = $196,000

KP 1 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 7 – Merchandise Inventory

25.

7-31

Ramiro Co. has valued its beginning and ending inventories at $4,000 and $5,000, respectively, during a period where purchases totaled $150,000. An auditor found errors in the ending inventory valuation and insisted that it be restated to $6,000. Calculate the adjusted cost of goods sold resulting from the inventory restatement. Solution:

[$4,000 + $150,000 – $5,000] – $1,000 = $148,000

KP 1,3 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement 26.

Morrie Produce began operations on July 1. Below is its income statement for the month of July and the current portion of its balance sheet dated July 31. Sales revenue Cost of goods sold (Note 1) Gross profit Operating expenses Net income Current assets: Cash Accounts receivable Inventory Total current assets Current liabilities: Accounts payable Notes payable Total current liabilities

$45,000 12,000 33,000 4,700 $28,300

$8,000 4,000 500 $12,500 $ 9,000 4,000 $13,000

Note 1: Morrie uses the LIFO method of inventory valuation. July 1 Purchased 80 units @ $30 July 17 Purchased 180 units @ $60 Cost of goods available July 31 Inventory (40 @ $30) Cost of goods sold

$ 2,400 10,800 13,200 1,200 $12,000

Complete the following income statement and current portion of the balance sheet for Morrie for July using the FIFO cost flow assumption instead of LIFO. Sales revenue . . . . . . . . . . . . . . . . . _____________________ Cost of goods sold . . . . . . . . . . . . . ._____________________ Gross profit . . . . . . . . . . . . . . . . . . . _____________________ Operating expenses. . . . . . . . . . . . . _____________________ Net income. . . . . . . . . . . . . . . . . . . . _____________________ Current assets: Inventory. . . . . . . . . . . . . . . . . . ._____________________ Solution: Sales revenue Cost of goods sold Gross profit Operating expenses Net income

$45,000 10,800 34,200 4,700 $29,500

Inventory (40 x $60)

$ 2,400

KP 3,4 BT: AN Difficulty: Difficult TOT: 8 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

7-32

27.

Test Bank – Chapter 7 – Merchandise Inventory

Mamma’s Cafe assigned the following costs to inventory on December 31: Cash purchase costs Commissions paid to Mamma’s sales staff Transportation-in costs Cell phone charges for Mamma’s’ CEO Handling cost associated with unloading the inventory Labor and overhead costs attributable to repackaging inventory Total cost

$6,000 230 310 400 150 280 $7,370

Current net income

$24,000

Determine the correct December 31 inventory and recalculate current net income that is appropriate under generally accepted accounting principles. Justify your new valuation of inventory. Solution: The cost of inventory is the cash or cash equivalent price of the asset plus all expenditures necessary to get the asset in place and ready for its intended use. Those expenditures for the inventory include: Cash price $6,000 Repackaging costs 280 Transportation-in 310 Handling costs 150 Total cost $6,740 The adjusted net income is $24,000 –$230 – $400 = $23,370. KP 1,3 BT: AN Difficulty: Difficult TOT: 6 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 7 – Merchandise Inventory

7-33

SHORT ESSAY QUESTIONS 1.

Please explain the statement that “a LIFO liquidation creates ‘phantom’ income”. Solution: A LIFO liquidation occurs when the current year’s higher-priced inventory is all sold off causing penetration (i.e., sale) of the LIFO inventory layers that had accumulated in prior years. Since the prior year layers had lower costs associated with them, the cost of goods sold for the goods in by these lower-cost layers is less than the current cost of inventory. The sale of inventory having these artificially low costs creates an artificially high gross profit. This extra gross profit is what is referred to by some as “phantom” income. KP 4 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Communication, Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Measurement

Identify the options a manager has in measuring the cost of inventory as it flows through the accounting system. Solution: Four cost flow options exist: specific identification, averaging, FIFO, and LIFO. The inventory cost of individual items sold is moved from the balance sheet to the income statement at the point-of-sale based on one of these assumptions. KP 2 BT: K Difficulty: Easy TOT: 2 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

What effect does management's perception of the ‘capital market’ have on selecting an inventory costing method? Solution: Investors in the capital market prefer companies with higher net income amounts and larger amounts of assets. In periods of rising prices, FIFO reports a lower cost of goods sold, which results in higher net income, and leaves the cost of the new or more expensive inventory on the balance sheet. However, the validity of this reasoning is open to question. Some research studies suggest that the stock market “looks through” a company’s accounting methods and values the company on the basis of underlying cash flows. Since using LIFO usually saves taxes, these studies suggest that LIFO companies are more highly valued by the market than the FIFO companies. However, evidence is mixed and conclusions are still tentative. KP 4 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Communication, Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Measurement

If an entity overstates its ending inventory for the current year, what are the effects on assets, cost of goods sold, retained earnings, and total stockholders’ equity for the current year? Solution: If ending inventory is overstated at the end of the year, assets will be overstated and cost of goods sold will be understated. When this occurs, expenses are less than expected, which causes net income to be overstated. When net income is overstated, the amount closed to retained earnings at the end of the accounting period is more than what it should be. This creates an overstatement of retained earnings. Since retained earnings is part of stockholders’ equity, this amount also will be overstated.

7-34

Test Bank – Chapter 7 – Merchandise Inventory

KP 1 BT: AP Difficulty: Moderate TOT: 3 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

During a period of rapidly rising inventory prices and a significant increase in inventory, a financial analyst made the following statement: "I rank a company's earning power by using earnings per share. You do not need to be a rocket scientist and know all that accounting mumbo-jumbo in order to compare earnings per share of two companies to obtain a ranking of their earnings power." Respond to the statement made by the financial analyst concerning the implications of choosing an inventory valuation method. Solution: During a period of significantly increasing prices and inventory, the choice of FIFO or LIFO inventory valuation methods can significantly influence measured current assets and income for corporations that carry significant inventory and whose cost of goods sold is a major expense. Under these conditions, the firm that uses FIFO will have a greater income number than that of the firm that uses LIFO. Thus, when their earnings per share are compared, adjustments for this difference should be made. These adjustments may involve an approximation of the difference in the EPS figure caused by the use of LIFO or FIFO. As a minimum, the user should realize the direction of the "bias" caused by the differing inventory valuation methods and digest the EPS numbers accordingly. However, if inventory and cost of goods sold are not a significant component of the firm's financial statements, or prices do not change significantly, then perhaps the financial analyst's position would be justified. KP 4 BT: AP Difficulty: Difficult TOT: 3 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

How do inventories of manufacturing companies differ from inventories of merchandising companies? Solution: Manufacturing companies have three inventories: raw materials, work in process, and finished goods. Three costs make up these inventories: direct materials, labor, and manufacturing overhead costs. A merchandising company has only one inventory account—often called merchandise inventory. This account is used for goods that are ready to sell. KP 3 BT: K Difficulty: Easy TOT: 2 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 7 – Merchandise Inventory

7-35

Explain the concept of hidden reserves as it applies to the lower-of-cost-or-market rule. Solution: The lower-of-cost-or-market rule recognizes price decreases immediately, but price increases are not recognized until the inventory is sold in an actual transaction. While this treatment is conservative, it is not consistent. The downward adjustment of inventory creates a 'hidden reserve' that is easily manipulated by managers. When management recognizes a price decrease in the current period, i.e., a loss, which is followed by a price increase in a subsequent period, the inventory can be sold for a larger profit. By reporting a larger profit in a different accounting period, management has manipulated income by deferring the gain. KP 5 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

The chief investment officer of a large mutual fund made the following statement: "I prefer to use the debt/equity ratio instead of the debt/asset ratio because the latter ratio is sensitive to the measure of inventory where accountants can choose LIFO, FIFO, or weighted averaging. Therefore, I use the debt/equity ratio so that I do not have to worry about which inventory valuation method the accountant used when I run comparisons between companies." Comment on the preceding statement. Solution: Although it is true that the particular inventory valuation method does influence the measure of assets and, therefore, the debt/asset ratio, it is not true that the debt/equity ratio is unaffected. If the choice of an inventory valuation method results in greater (smaller) measure of assets, it measures a greater (smaller) income. Thus, the amount of retained earnings and stockholders' equity is influenced by the inventory valuation method used and by the same amount that measured assets are affected. For example, if the application of FIFO measures assets $10,000 more than that under LIFO, then FIFO stockholders' equity will also be $10,000 greater than that resulting from the use of LIFO. KP 1,4 BT: AP Difficulty: Difficult TOT: 4 min. AACSB: Communication, Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Measurement

Why is the lower-of-cost-or-market rule necessary in accounting? Solution: When the market value of inventory, its replacement cost, is lower than the original cost of the inventory, the inventory amount reported on the balance sheet will be overstated. Conservatism justifies reducing the inventory value on the balance sheet to the lower of the two amounts. KP 5 BT: AP Difficulty: Moderate TOT: 2 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

7-36

10.

Test Bank – Chapter 7 – Merchandise Inventory

After studying a financial accounting text, your roommate asserts that what is interesting about accountants is that they always measure what actually happens. Having studied inventory, you disagree with your roommate's assertion. Present an argument refuting your roommate's position that accountants measure what actually happens in context of knowledge acquired after reading the chapter entitled "Merchandise Inventory." Solution: Accountants measure cost of goods sold and inventory by applying a cost flow assumption. Accountants may choose to represent inventory cost flows as First-In, First-Out (FIFO), Last-In, First-Out (LIFO), or a weighted averaging. The choice of a cost flow assumption is independent of the actual physical flow of inventory through the business. This is why the assumptions are referred to as cost flow instead of physical flow assumptions. The only time that accountants respect the actual flow of inventory through the business is when they use specific identification to value inventory. Therefore, with respect to inventory, accountants do not measure what actually happens. KP 4 BT: AP Difficulty: Moderate TOT: 3 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

11.

If an entity understates its ending inventory for the current period, what is the effect on cost of goods sold and inventory carry over to the next year. Explain why. Solution: If ending inventory is understated at the end of the year, cost of goods sold will be overstated for that year. Ending inventory from the first year then becomes the beginning inventory of the second year. This creates an equal, but opposite effect on financial statement items during the second accounting year. KP 1 BT: AP Difficulty: Moderate TOT: 3 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

12.

Explain the relationship between the valuation of inventory and income measurement. Solution: Inventory costs are capitalized on the balance sheet as assets because they provide future economic benefits. The dollar amount at which the inventory is carried on the books is the valuation of the inventory. Most often, original cost is the valuation, but in some cases, the lower-of-cost-or-market rule applies. When goods are sold, the accountant must measure cost of goods sold and ending inventory by applying a cost flow assumption. Cost flow assumptions include FIFO, LIFO, averaging, and specific identification. KP 1,2 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 7 – Merchandise Inventory

7-37

IFRS QUESTIONS 1.

Which of the following inventory cost flow assumptions is not allowed under IFRS? A. FIFO B. Average Cost C. FISH D. LIFO KP 6 BT: D Difficulty: Easy TOT: 1 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

When applying the lower-of-cost-or-market rule, IFRS uses the market value which is A. Normally the realizable value or the amount at which the inventory could be sold B. Normally the replacement cost or the cost of replacing the inventory C. Normally the hypothetical future value D. IFRS does not use the lower-of-cost or market rule. KP 6 BT: A Difficulty: Easy TOT: 1 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Chapter 8 Investments in Equity Securities

MULTIPLE CHOICE QUESTIONS 1.

Equity investments are: a. investments in bonds of a corporation. b. investments that pay dividends, not interest. c. classified as long-term liabilities. d. marketed by the SEC to any investor who wishes to buy bonds of a public company. Ans: B KP 1 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Investments in equity securities are current assets if: a. they can be sold and converted into cash on demand and a ready market exists. b. the fair market value can’t be determined. c. management intends to convert them into common stock within one year. d. management owns less than 50% of the outstanding stock. Ans: A KP 1 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Income from trading and available-for-sale equity securities is recognized when: a. dividends are received from the investee due to the uncertainty of payment. b. dividends are declared by the investee. c. adjusting entries are made to record fair value adjustments. d. the investee reports profits for the accounting period. Ans: B KP 1,4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

When a company accounts for an investment under the purchase method of accounting, a. the book value of the subsidiary's assets is added to the parent company's assets. b. the book value of the subsidiary's liabilities is added to the parent company's liabilities. c. the company obviously owns more than 50% of the stock of the investee. d. a year-end adjustment is made to increase or decrease the carrying value of the investment to fair market value. Ans: C KP 5, App8A BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

8-1

8-2

Test Bank – Chapter 8 – Investments in Equity Securities

Trading securities are: a. readily marketable investments that management intends to hold for extended periods. b. always short-term investments. c. current assets that require the equity method of accounting for investments. d. actively ‘traded’ on the open market, but can’t be sold until they mature. Ans: B KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Available-for-sale securities are: a. actively ‘traded’ on the open market, but can’t be sold until they mature. b. readily marketable investments that management intends to sell for short-term profits. c. always short-term investments in common stock. d. adjusted to fair value at yearend. Ans: D KP 2,4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Trading securities: a. are recorded on the balance sheet at market value. b. may have unrealized gains or losses on the balance sheet associated with price increases or decreases. c. are listed as long-term assets. d. Both a and b are correct. Ans: A KP 2,4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Benson Incorporated owns 32% of Denver Company's outstanding voting stock. Benson Incorporated should account for its investment in Denver using the: a. fair value method. b. cost method. c. consolidation procedure. d. equity method. Ans: D KP 4 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Dewey Inc. owns 64% of Felicity Corporation’s outstanding voting stock. Dewey should account for its investment in Felicity using the: a. fair value method. b. cost method. c. consolidation procedure. d. mark-to-market method Ans: C KP 4,5 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 8 - Investments in Equity Securities

10.

8-3

During 2010, the market price of trading securities declined. Which one of the following correctly reflects the effects on the financial statements as a result? a. Current ratio and earnings per share decrease. b. Current ratio and earnings per share increase. c. Current ratio is unchanged and earnings per share increases. d. Current ratio increases and earnings per share are unchanged. Ans: A KP 2,4 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

11.

Available-for-sale securities: a. are reported on the balance sheet at original cost. b. may have unrealized price increases or decreases, which increase or decrease shareholders’ equity. c. are reported in the shareholders’ equity section of the balance sheet at fair value. d. may have unrealized gains or losses on the income statement associated with price increases or decreases. Ans: B KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

12.

When a company recognizes unrealized losses on trading securities, its earnings per share: a. decreases. b. increases. c. is not affected. d. may increase or decrease depending on the related market value. Ans: A KP 2,4 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

13.

Torborg Corp. purchased available-for-sale securities from Hensley Company on December 23 for $3,000. On December 31, the market value of those securities is $3,600. Which one of the following journal entries is appropriate on December 31? a. Available-for-Sale Securities 3,600 Unrealized Gain on Available-for-Sale Securities 3,600 b. c.

Available-for-Sale Securities Unrealized Gain on Available-for-Sale Securities

600

Available-for-Sale Securities Unrealized Price Increase on Available-for-Sale Securities

600

No entry is required.

Ans: C KP 2,4 BT: AP Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

600 600

8-4

Test Bank – Chapter 8 – Investments in Equity Securities

14.

Trading securities of Sanchez Inc. were purchased by Hayden Company on December 14 for $1,000. On December 31, the market value of those securities is $1,300. Which one of the following adjusting journal entries is appropriate at December 31? a. Trading Securities 1,300 Unrealized Gain on Trading Securities 300 Cash 1,000 b. c. d.

Trading Securities Unrealized Gain on Trading Securities

300

Trading Securities Securities Revenue

300

300 300

No entry is required.

Ans: B KP 2,4 BT: AP Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

15.

On November 10, 2011, Clark Inc. purchased shares of Landon Corp. for $100,000 and shares of Norris Incorporated for $50,000. At the end of 2011, the fair market value of the stock of Landon was $80,000 and for Norris Incorporated was $65,000. How should Clark Inc. recognize these changes in market price? a. As a net unrealized loss of $20,000. b. As a net unrealized gain of $15,000. c. As a net unrealized loss of $5,000. d. No adjustment is required since the total fair value is higher than the total original cost. Ans: C KP 2,4 BT: AP Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

16.

Which one of the following is true of the equity method? a. The income recognized by the investor is based on the percentage of stock ownership and the amount of earnings reported by the investee. b. Market value adjustments are made at yearend. c. The receipt of dividends increases net income on the investor's financial statements. d. The percent of ownership must be greater than 50% to apply this method. Ans: A KP 4 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

17.

The recognition of unrealized gains on available-for-sale investments a. increases the current ratio. b. decreases the current ratio. c. does not affect the current ratio. d. increases the current ratio if the investment is classified as current, otherwise it has no effect. Ans: D KP 2,4 BT: AN Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 8 - Investments in Equity Securities

18.

8-5

An investor owns trading equity securities in Noah Company. Noah Company declared dividends of $300 during July. What entry is required in August when the dividends are received? a. Cash 300 Dividends Receivable 300 b. c. d.

Dividends Receivable Trading Securities

300

Dividends Receivable Dividend Revenue

300

Cash Trading Securities

300

300 300 300

Ans: A KP 1,2,4 BT: AP Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

19.

Which one of the following journal entries is appropriate for an investor who owns shortterm equity securities when dividends of $500 have been declared on those equity securities? a. Cash 500 Dividends Receivable 500 b. c. d.

Dividends Receivable Trading Securities

500

Cash Trading Securities

500

Dividends Receivable Dividend Revenue

500

500 500 500

Ans: D KP 1,2 BT: AP Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

20.

Which one of the following correctly reflects the effects on the financial statements caused by the increase in the market price of long-term available-for-sale securities? a. Current ratio is unchanged and earnings per share increases. b. Current ratio and earnings per share increase. c. Current ratio and earnings per share are unchanged. d. Current ratio is unchanged and earnings per share decreases. Ans: C KP 2,4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

8-6

Test Bank – Chapter 8 – Investments in Equity Securities

21.

Trading securities were purchased on April 1 for $900. On December 31, the market value of those securities is $700. Which of the following is part of the adjusting entry necessary on December 31? a. Debit Unrealized Loss on Trading Securities for $700 b. Debit Realized Loss on Trading Securities for $200 c. Credit Trading Securities for $200 d. Credit Unrealized Loss on Trading Securities for $200 Ans: C KP 2,4 BT: AP Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

22.

Available-for-sale securities were purchased on May 2 for $1,000. On December 31, the market value of those securities is $1,100. Which of the following is part of the adjusting entry necessary on December 31? a. Debit Unrealized Gain on Available-for-Sale Securities for $1,100 b. Debit Realized Gain on Available-for-Sale Securities for $100 c. Credit Available-for-Sale Securities for $100 d. Credit Unrealized Gain on Available-for-Sale Securities for $100 Ans: D KP 2,4 BT: AP Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

23.

The recognition of unrealized losses on trading securities: a. decreases the quick and current ratios. b. increases the quick and current ratios. c. does not affect the quick ratio, but decreases the current ratio. d. does not affect the current ratio, but decreases the quick ratio. Ans: A KP 2,4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

24.

Which of the following correctly reflects the effects on the financial statements caused by the increase in market price of trading securities? a. Current ratio and earnings per share decrease. b. Current ratio and earnings per share increase. c. Current ratio is unchanged but earnings per share decrease. d. Current ratio decreases and earnings per share are unchanged. Ans: B KP 2,4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

25.

The recognition of realized losses on short-term available-for-sale securities a. increases the current ratio. b. decreases working capital. c. decreases comprehensive income. d. decreases the debt/equity ratio. Ans: B KP 2,4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 8 - Investments in Equity Securities

26.

8-7

Which one of the following is an area of subjectivity which opens the incentive of window dressing to management as it relates to investments? a. The timing of when an investment is sold. b. The proclamation of the intention to sell an investment within the next year. c. The determination of the percentage of stock acquired. d. Whether management has available cash to acquire investments. Ans: B KP 1 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

27.

The cost method of accounting for long-term equity investments is typically used when: a. between 20% and 50% of the investee company is owned. b. over 50% of the investee company is owned. c. at least 20% of the investee company is owned. d. None of the above is a consideration in choosing the cost method. Ans: D KP 4,5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

28.

Which one of the following correctly reflects the effects on the financial statements caused by dividends declared on trading securities owned by a firm? a. Current ratio decreases. b. Earnings per share increases. c. Current ratio is unchanged. d. Earnings per share is unchanged. Ans: B KP 2,4 BT: AN Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

29.

The equity method of accounting for long-term equity investments is typically used when: a. less than 20% of the investee company is owned. b. between 20% and 50% of the investee company is owned. c. over 50% of the investee company is owned. d. any amount over 20% is acquired. Ans: B KP 4,5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

30.

The consolidation procedure of accounting for long-term equity investments is typically used: a. when less than 20% of the investee company is owned. b. in situations when over 50% of the investee company is owned. c. only when 100% of the investee company is owned. d. when between 20% and 50% of the investee company is owned. Ans: B KP 4,5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

8-8

Test Bank – Chapter 8 – Investments in Equity Securities

31.

Walsh Company purchased 1,000 shares of Pierce Company for $20 per share and classified the investment as trading securities. At the end of the year, the fair market value of the investment was $23 per share. How should Walsh recognize this change? a. Debit the investment account by $23,000. b. Credit the investment account by $3,000. c. Report an unrealized gain on the income statement. d. Show an unrealized loss on the balance sheet. Ans: C KP 2,4 BT: AP Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

32.

Which one of the following correctly reflects the effects on the financial statements caused by a decrease in the market price of long-term available-for-sale securities? a. Current ratio decreases. b. Earnings per share increases. c. Current ratio increases. d. Earnings per share remains unchanged. Ans: D KP 4,5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

33.

The recognition of unrealized gains on marketable securities: a. depends on the classification of the securities. b. causes net income to increase regardless of the securities’ classification. c. causes earnings per share to increase regardless of the securities’ classification. d. is a primary concern under the equity method. Ans: A KP 2,4 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

34.

Which one of the following must be met prior to classifying an investment as current? a. It must be an equity security accounted for under the equity method. b. The percentage of ownership must be greater than 50%. c. The investment must be readily marketable. d. Management must intend to hold the investment for an undetermined time period. Ans: C KP 2,4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

35.

Trading securities are held primarily for the purpose of: a. anticipated increases in value over extended time periods. b. increasing the current ratio. c. window dressing the balance sheet. d. generating profits on short-term price increases. Ans: D KP 1 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 8 - Investments in Equity Securities

36.

8-9

Which one of the following correctly reflects the effects on the financial statements of the investor caused by dividends declared on trading securities? a. Current ratio increases b. Working capital decreases c. Revenue and assets decrease d. Assets increase and shareholders’ equity decreases Ans: A KP 2,4 BT: AN Difficulty: Moderate TOT: 2min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

37.

Camber Corp. owns 10% of Nova Corp’s outstanding voting stock. Camber should account for its long-term equity investment in Nova Corp. using the: a. market value method if the stock is not traded on the market. b. cost method if the stock is traded on the market. c. cost method if the stock is not traded on the market. d. equity method if the stock is traded on the market. Ans: C KP 4 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

38.

Which one of the following is evidence of a ready market? a. The stock was purchased at a negotiated price from an outside party. b. The security is actively traded on a public stock exchange. c. A privately held corporation issued the stock. d. The stock was purchased from an outside investor. Ans: B KP 1 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

39.

An unrealized holding gain or loss that relates to trading securities represents: a. an undervalued investment. b. the profit or loss made when the trading securities were sold. c. the total dividends received from the investee company during the year. d. the extent to which an investor’s wealth increased or decreased due to holding the investment. Ans: D KP 2,4 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

8-10

40.

Test Bank – Chapter 8 – Investments in Equity Securities

All of the following statements are true regarding comprehensive income except: a. Comprehensive income includes all nonowner-related changes in shareholders’ equity that do not appear on the income statement and are not reflected in the balance of retained earnings. b. Comprehensive income includes adjustments to shareholders’ equity for holding gains associated with available-for-sale securities. c. Comprehensive income includes adjustments to shareholders’ equity for holding losses associated with available-for-sale securities.. d. Comprehensive income must be reported in a specific format established by the FASB. Ans: D KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

41.

A controlling interest in another company: a. exists whenever the relationship between the investor and investee gives the investor significant influence. b. requires the parent to prepare consolidated financial statements. c. is evidence that a merger will soon occur. d. can be as low as 20 percent. Ans: B KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

42.

Why might chief executives react very positively to current goodwill accounting? a. Goodwill increases in value. b. Goodwill is amortized creating expenses that reduce net income, enabling a company to pay less income tax. c. Its amortization increases earnings per share. d. Goodwill is no longer amortized so income is greater than prior accounting requirements. Ans: D KP 6 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

43.

James Corporation purchased 100% of the common stock of Rashaad Corporation for $50 million. James must account for this investment as: a. an available-for-sale security. b. an acquisition that requires consolidation accounting. c. a trading security. d. an equity security investment. Ans: B KP App8A BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 8 - Investments in Equity Securities

44.

8-11

Decuzzi, Inc. paid $10,000 for a stock investment and classified it as available-for-sale. On December 31, 2011, the company appropriately recognized an unrealized increase of $3,000. The stock is reported on Decuzzi’s balance sheet at December 31, 2011 at: a. $10,000. b. $13,000. c. $7,000. d. Not enough information to determine. Ans: B KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

45.

Which one of the following investments would most likely be held the shortest period of time? a. Available-for-sale debt securities b. Available-for-sale equity securities c. Trading securities d. An investment as a result of a merger Ans: C KP 5 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

46.

Multinational US companies usually have a number of foreign subsidiaries with financial statements expressed in foreign currency. When the consolidated financial statements are prepared, to combine the financial statements of the US parent and all of its subsidiaries, the consolidation process involves multiple steps. Which of the following statements about the combining process and the resultant consolidated financial statements is always true for multinational US companies? a. The foreign subsidiaries are separated into three categories, each of which receives different treatment. b. The foreign entity’s financial statements are converted into dollars. c. Foreign currency translation adjustments have no effect on cash flows. d. The foreign currency translation adjustments are included in consolidated income. Ans: B KP 5 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic, Diversity AICPA BB: Critical Thinking AICPA FN: Reporting

47.

Which of the following statements about Special Purpose Entities (SPEs) is not true? a. SPEs can take on various legal forms, like corporations or partnerships. b. It can be difficult to determine who actually controls an SPE. c. Management can structure a transaction using an SPE in such a manner that the accounting treatment fails to reflect the economic substance of the transaction. d. SPEs have been used to mislead investors. Ans: A KP 5 BT: C Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

8-12

48.

Test Bank – Chapter 8 – Investments in Equity Securities

Carmen Corporation purchased a 40% interest in Sahara Inc. on January 1, 2010, paying $200,000 for 40% of the outstanding voting stock of Sahara Inc. For its year ended December 31, 2010, Sahara Inc. reported net income of $40,000. On December 31, 2010, Carmen received a dividend payment from Sahara in the amount of $1,000. As a result of its ownership interest in Sahara, the financial statements for Carmen Corporation for the year ended December 31, 2010 will reflect which of the following: a. An asset in the amount of $200,000. b. Revenue of $1,000. c. Cash flows from operations of $1,000. d. Revenue of $16,000. Ans: D KP 5 BT: AP Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

49.

Before adjusting its current investments in equity securities, Caldwell Company has total current assets and current liabilities of $45,000 and $15,000, respectively. During the current year, Caldwell has net income of $243,750 with 75,000 shares of common stock outstanding. This amount excludes the effects of yearend adjustments related to the investments. Included in current assets are trading securities recorded at their original cost of $13,000. However, the current market value of those securities is $4,000 at yearend. If Caldwell properly accounts for trading securities, what is Caldwell’s current ratio before and after the investment adjustment? a. 3.0 and 2.1 b. 3.0 and 3.3 c. 3.0 and 3.6 d. 3.0 and 2.4 Solution: D Current ratio before = $45,000/$15,000 = 3.0 Current ratio after = $36,000/$15,000 = 2.4 Ans: D KP 5 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

50.

Before adjusting its current investments in equity securities, Caldwell Company has total current assets and current liabilities of $45,000 and $15,000, respectively. During the current year, Caldwell has net income of $243,750 with 75,000 shares of common stock outstanding. This amount excludes the effects of yearend adjustments related to the investments. Included in current assets are trading securities recorded at their original cost of $13,000. However, the current market value of those securities is $4,000 at yearend. If Caldwell properly accounts for trading securities, what is Caldwell’s earnings per share amount before and after the investment adjustment, respectively? a. $3.25 and $3.00 b. $3.25 and $3.13 c. $3.25 and $3.37 d. $3.25 and $2.77 Solution: B Earnings per share = $243,750/75,000 = $3.25 Earnings per share = $234,750/75,000 = $3.13 Ans: B KP 5 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 8 - Investments in Equity Securities

51.

8-13

On January 2, 2010, Pfizer Co. purchased 22% of Wiley Company's voting stock for $150,000. During 2010, Wiley recorded income of $102,000 and paid total dividends of $27,000. Pfizer uses the equity method to account for this investment. What is Pfizer’s income from the Wiley investment? a. $27,000 b. $28,380 c. $22,440 d. $33,000 Solution: C 2010 investment income = $102,000 x 22% = $22,440 Ans: C KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

52.

On January 2, 2010, Pfizer Co. purchased 22% of Wiley Company's voting stock for $150,000. During 2010, Wiley recorded income of $102,000 and paid total dividends of $27,000. Pfizer uses the equity method to account for this investment. What is the December 31, 2010, balance sheet value of its long-term equity investment in Wiley? a. $178,380 b. $225,000 c. $150,000 d. $166,500 Solution: D 2010 investment income = $102,000 x 22% = $22,440 December 31, 2010, investment in Wiley Company = $150,000 + $22,440 – ($27,000 x 22%) = $166,500 Ans: D KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

53.

If Howard Company’s balance sheet amount of goodwill is $20,000 and the fair market value of the goodwill is estimated to be $25,000, which of the following entries would be recorded in Howard’s books? a. Goodwill 5,000 Goodwill Market Gain 5,000 b. Goodwill Market Gain 5,000 Goodwill 5,000 c. Goodwill impairment Charge 5,000 Goodwill 5,000 d. No entry will be made. Solution: D Ans: D KP 5 BT: AP Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

8-14

54.

Test Bank – Chapter 8 – Investments in Equity Securities

On December 31, 2010, available-for-sale securities with an original cost of $15,000 have a carrying value on the balance sheet equal to their market value of $20,000. On January 5, 2011, those securities are sold for $18,000. Which of the following would be part of the appropriate entry to record the sale of the available-for-sale securities? a. A credit to Realized Gain on Available-for-Sale Securities for $5,000. b. A debit to Unrealized Price Increase on Available-for Sale Securities for $3,000. c. A debit to Unrealized Price Increase on Available-for Sale Securities for $5,000. d. A credit to Available-for Sale Securities for $15,000. Solution: C Cash Unrealized Price Increase on Available-for-Sale Securities Realized Gain on Available-for-Sale Securities Available-for-Sale Securities

18,000 5,000 3,000 20,000

Ans: C KP 5 BT: AP Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

55.

On January 2, 2010, Dellgate Corp. purchased 27% of Galaxy Corporation's voting stock for $125,000. During 2010, Galaxy recorded income of $214,000 and paid total dividends of $17,000. Dellgate uses the cost method to account for this investment. What is the December 31, 2010, balance sheet value of Dellgate’s long-term equity investment in Galaxy? a. $125,000 b. $178,190 c. $187,370 d. $86,940 Solution: A December 31, 2010, investment in Galaxy Corporation = $125,000 Ans: A KP 5 BT: AN Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

56.

Test Bank – Chapter 8 - Investments in Equity Securities

a. Trading Securities Unrealized Gain on Trading Securities b. Unrealized Loss on Trading Securities Trading Securities c. Unrealized Loss on Trading Securities Cash d. Trading Securities Realized Gain on Trading Securities

8-15

500 500 500 500 500 500 500 500

Ans: A KP 1,2,4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

57.

No. of Shares 100 250 150

Cost/Share $29 30 16

Total Cost $2,900 7,500 2,400 $12,800

Value/Share

Total Market Value $34 $3,400 28 7,000 20 3,000 $13,400

Early in 2010, the company sold 50 shares of BBB for $26 per share. During 2010, Solo received dividends of $3 per share on the remaining 200 shares of BBB. The per-share market value of BBB on December 31, 2010 was $24. During 2011, Solo sold the remaining 200 shares of BBB stock for $26 per share. The journal entry to record the 2009 revaluation of the BBB securities would be: a. Trading Securities 500 Unrealized Gain on Trading Securities 500 b. Unrealized Loss on Trading Securities 500 Trading Securities 500 c. Unrealized Loss on Trading Securities 500 Cash 500 d. Trading Securities 500 Realized Gain on Trading Securities 500 Ans: B KP 1,2,4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

8-16

58.

Test Bank – Chapter 8 – Investments in Equity Securities

No. of Shares 100 250 150

Cost/Share $29 30 16

Total Cost $2,900 7,500 2,400 $12,800

Total Market Value $3,400 7,000 3,000 $13,400

Value/Share $34 28 20

During 2010, Solo received word that dividends of $2.50 per share were declared, but not yet received on the 150 shares of CCC stock. The per-share market value of CCC on December 31, 2010, was $18. During 2011, Solo sold 150 shares of CCC for $22 per share. The journal entry to record the 2009 revaluation of the CCC securities would be: a. Available-for-Sale Securities 600 Realized Gain on Available-for-Sale Securities 600 b. Unrealized Loss on Available-for-Sale Securities 600 Available-for-Sale Securities 600 c. Realized Loss on Available-for-Sale Securities 600 Available-for-Sale Securities 600 d. Available-for-Sale Securities 600 Unrealized Price Increase on Available-for-Sale Securities 600 Ans: D KP 1,2,4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting 59.

No. of Shares 100 250 150

Cost/Share $29 30 16

Total Cost $2,900 7,500 2,400 $12,800

Value/Share $34 28 20

Total Market Value $3,400 7,000 3,000 $13,400

Early in 2010, Solo sold all of its investment in AAA securities for $36 per share. The journal entry to record the 100 shares of AAA stock sold in 2010 will include: a. A debit to Trading Securities for $3,400. b. A credit to Unrealized Loss on Trading Securities for $200. c. A credit to Realized Loss on Sale of Trading Securities for $200. d. A credit to Realized Gain on Sale of Trading Securities for $200. Ans: D KP 1,2,4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 8 - Investments in Equity Securities

60.

8-17

No. of Shares 100 250 150

Cost/Share $29 30 16

Total Cost $2,900 7,500 2,400 $12,800

Value/Share $34 28 20

Total Market Value $3,400 7,000 3,000 $13,400

Early in 2010, the company sold 50 shares of BBB for $26 per share. The journal entry to record the 50 shares of BBB stock sold in 2010 will include: a. A credit to Trading Securities for $1,400. b. A credit to Unrealized Loss on Trading Securities for $100. c. A credit to Realized Loss on Sale of Trading Securities for $100. d. A debit to Realized Gain on Sale of Trading Securities for $100. Ans: A KP 1,2,4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting 61.

No. of Shares 100 250 150

Cost/Share $29 30 16

Total Cost $2,900 7,500 2,400 $12,800

Value/Share $34 28 20

Total Market Value $3,400 7,000 3,000 $13,400

Early in 2010, the company sold 50 shares of BBB for $26 per share. During 2010, Solo received dividends of $3 per share on the remaining 200 shares of BBB, and dividends of $2.50 per share were declared, but not yet received on the 150 shares of CCC stock. The per-share market values of BBB and CCC on December 31, 2010, were $24 and $18, respectively. During 2011, Solo sold the remaining 200 shares of BBB stock for $26 per share and the 150 shares of CCC for $22 per share. The journal entry to record the dividends received on the BBB securities and the dividends declared on the CCC stock in 2010 will include: a. A credit to Dividend Revenue for $975. b. A credit to Dividend Payable for $375. c. A credit to Cash for $600. d. A debit to Dividend Expense for $375. Ans: A KP 1,2,4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

8-18

62.

Test Bank – Chapter 8 – Investments in Equity Securities

The following information related to the marketable security investments of Solo Company. Securities held on December 31, 2009, as described in the table below. AAA and BBB are classified as trading securities and CCC is classified as an available-forsale security. No. of Total Total Market Securities Cost/Share Value/Share Shares Cost Value AAA 100 $29 $2,900 $34 $3,400 BBB 250 30 7,500 28 7,000 CCC 150 16 2,400 20 3,000 $12,800 $13,400 Early in 2010, the company sold 50 shares of BBB for $26 per share. During 2010, Solo received dividends of $3 per share on the remaining 200 shares of BBB, and dividends of $2.50 per share were declared, but not yet received on the 150 shares of CCC stock. The per-share market values of BBB and CCC on December 31, 2010, were $24 and $18, respectively. During 2011, Solo sold the remaining 200 shares of BBB stock for $26 per share and the 150 shares of CCC for $22 per share. The journal entry to record the revaluation of BBB shares in 2010 is: a. Trading Securities 800 Unrealized Gain on Trading Securities 800 b. Unrealized Loss on Trading Securities 800 Trading Securities 800 c. Unrealized Loss on Trading Securities 600 Cash 600 d. Trading Securities 800 Realized Gain on Trading Securities 800 Ans: B KP 1,2,4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

63.

No. of Shares 100 250 150

Cost/Share $29 30 16

Total Cost $2,900 7,500 2,400 $12,800

Value/Share $34 28 20

Total Market Value $3,400 7,000 3,000 $13,400

Test Bank – Chapter 8 - Investments in Equity Securities

The journal entry to record the revaluation of CCC shares in 2010 is: a. Available-for-Sale Securities 300 Unrealized Gain on Available-for-Sale Securities b. Unrealized Price Increase on Available-for-Sale Securities 300 Available-for-Sale Securities c. Realized Loss on Available-for-Sale Securities 300 Available-for-Sale Securities d. Available-for-Sale Securities 400 Unrealized Price Increase on Available-for-Sale Securities

8-19

300 300 300 400

Ans: B KP 1,2,4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting 64.

No. of Shares 100 250 150

Cost/Share $29 30 16

Total Cost $2,900 7,500 2,400 $12,800

Value/Share $34 28 20

Total Market Value $3,400 7,000 3,000 $13,400

5,200

c. Cash

5,200

400 4,800

Trading Securities Realized Gain on Trading Securities d. Trading Securities Realized Gain on Trading Securities Cash

4,800 400 6,000 800 5,200

Ans: C KP 1,2,4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

8-20

65.

Test Bank – Chapter 8 – Investments in Equity Securities

No. of Shares 100 250 150

Cost/Share $29 30 16

Total Cost $2,900 7,500 2,400 $12,800

Value/Share $34 28 20

Total Market Value $3,400 7,000 3,000 $13,400

During 2010, Solo received word that dividends of $$2.50 per share were declared, but not yet received on the 150 shares of CCC stock. The per-share market value of CCC on December 31, 2010, was $18. During 2011, Solo sold 150 shares of CCC for $22 per share. The journal entry to record the sale of 150 shares of CCC stock in 2011 would include: a. A debit to Cash for $2,700. b. A debit to Unrealized Price Increase on Available-for-Sale Securities for $300. c. A debit to Unrealized Gain on Available-for-Sale Securities for $900. d. A debit to Available-for-Sale Securities for $3,300. Ans: B KP 1,2,4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 8 - Investments in Equity Securities

8-21

MATCHING QUESTIONS 1.

Each transaction numbered 1 through 5 below involves an equity security originally acquired at a cost of $1,000. Identify the effect each transaction has on the current ratio and earnings per share by selecting from the effects listed in a through f. You may use each letter more than once or not at all. a. b. c. d. e. f.

Effects Increase in current ratio and earnings per share. Does NOT change earnings per share or the current ratio. Does NOT change earnings per share; may impact the current ratio under certain conditions. Decrease in current ratio and earnings per share. Increases earnings per share. Can’t determine the direction of changes in at least one ratio from the event given.

____ ____ ____ ____ ____

1. Trading securities with a current balance sheet value of $1,200 are sold for $1,100. 2. Trading securities with a current balance sheet value of $800 are sold for $800. 3. Trading securities with a current balance sheet value of $1,200 are sold for $1,300. 4. Available-for-sale securities have a market value of $800 at yearend. 5. Available-for-sale securities have a market value of $1,200 at yearend.

Solution:

1. d

2. b

3. a

4. c

5. c

KP 2,4 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Each transaction listed in 1 through 4 relates to an investment in a long-term equity security. Place the letter that corresponds to the effect (a through h) the transaction has on the accounting equation in the space provided. You may use each letter more than once or not at all. a. b. c. d. e. f. g. h.

____ ____ ____ ____

1. 2. 3. 4.

Solution:

Accounting Effects + A and + L + A and + SE (Contributed Capital) + A and + SE (Retained Earnings) – A and – L – A and – SE (Contributed Capital) – A and – SE (Retained Earnings) + A and – A The event is not reported on financial statements.

Under the cost method, the investee company declares a cash dividend. Under the equity method, the investee company declares a cash dividend. Under the cost method, the investee company recognizes net income. Under the equity method, the investee company recognizes net income. 1. c

2. g

3. h

4. c

KP 4 BT: AP Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

8-22

Test Bank – Chapter 8 – Investments in Equity Securities

For each transaction numbered 1 through 4 below, identify which effect (a through f) the transaction is most likely to cause. You may use each letter more than once or not at all. a. b. c. d. e. f.

_____ _____ _____ _____

Solution:

Effects Increase in current ratio and earnings per share Decrease in current ratio and earnings per share Does NOT change the current ratio; increases earnings per share Increases the current ratio; does NOT change earnings per share Does not change the current ratio or earnings per share Can’t determine the effect

1. The cost method is used for an investment in long-term equity securities, and the investee company declares a cash dividend. 2. The equity method is used for an investment in long-term equity securities and the investee company declares a cash dividend. 3. The cost method is used for an investment in long-term equity securities and the investee company recognizes net income. 4. The equity method is used for an investment in long-term equity securities and the investee company recognizes net income. 1. a

2. d

3. e

4. c

KP 4 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement 4.

Each transaction listed in 1 through 4 below relates to a long-term investment is equity securities. Select the letters of the accounting effects (a through h) and place them in the space provided. Transactions may have more than one answer. a. b. c. d. e. f. g. h.

_____ _____ _____ _____

Accounting Terms Increase assets Increase shareholders’ equity (Contributed Capital) Increase shareholders’ equity (Retained Earnings) Decrease liabilities Decrease shareholders’ equity (Retained Earnings) Decrease assets Increase liabilities The event is not communicated on financial statements.

1. Using the equity method the market price of the investment increases above its cost. 2. Using the cost method the market price of the investment increases above its cost. 3. Using the equity method, the investee company recognizes a net loss for the year. 4. An investment in a 40%-owned subsidiary is sold for more than its carrying value.

Solution: 1. h

2. h

3. e, f

4. a, c

KP 4 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 8 - Investments in Equity Securities

8-23

For each transaction numbered 1 through 4 below, identify which effect (a through g) would most likely occur as a result of the transaction. You may use each letter more than once or not at all. a. b. c. d. e. f. g.

_____ _____ _____

1. 2. 3.

_____

Solution:

Effects Increase in current ratio and earnings per share Decreases current ratio; increases earnings per share Increases current ratio; does NOT change earnings per share Decrease in current ratio and earnings per share Decreases current ratio; does NOT change earnings per share Does not change the current ratio or earnings per share Can’t determine the direction of changes in the current ratio

Trading equity securities are purchased for $1,000 cash. Trading securities that cost $1,000 have a yearend market value of $800. Trading securities that cost $1,000 have a yearend market value of $1,200. Trading securities that cost $1,000 that have a current balance sheet value of $800 are sold for $900. 1. f

2. d

4. a

KP 4 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

For each transaction listed in 1 through 9, place the letter (a through g) of the best effect in the space provided. You may use each letter more than once or not at all. a. b. c. d. e. f. g.

Effects + A and + L + A and + SE (on income statement) + A and + SE (comprehensive income component) – A and – L – A and – SE (on income statement) – A and – SE (comprehensive income component) No change in total A, L, or SE

1. Trading equity securities are purchased for $900 cash. 2.

Trading securities with a cost of $600 have a market value of $350 when the financial statements are produced.

Trading securities with a cost of $12,000 have a market value of $14,000 when the financial statements are produced.

Trading securities with an original cost of $3,000 and a balance sheet value of $700 are sold for $800.

Trading securities with an original cost of $4,000 and a balance sheet value of $4,500 are sold for $4,300.

Trading securities with an original cost of $9,000 and a balance sheet value of $7,800 are sold for $7,800.

Trading securities with an original cost of $4,000 and a balance sheet value of $4,500 are sold for $4,600.

Available-for-sale securities with a cost of $7,000 have a market value of $5,200 when the financial statements are produced.

Available-for-sale securities with a cost of $7,000 have a market value of $7,200 when the financial statements are produced.

8-24

Test Bank – Chapter 8 – Investments in Equity Securities

Solution: 1. g

2. e

4. b

5. e

6. g

7. b

KP 5 BT: AP Difficulty: Moderate TOT: 7 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

8. f

9. c

Test Bank – Chapter 8 - Investments in Equity Securities

8-25

SHORT PROBLEMS 1.

Trading securities were purchased at a cost of $5,000. Their current market value is $4,000. Prepare the December 31 adjusting journal entry. Solution: Unrealized Loss on Trading Securities Trading Securities

1,000 1,000

KP 2 BT: AP Difficulty: Easy TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting 2.

Prepare the December 31 journal entry that adjusts available-for-sale securities that were purchased at a cost of $5,000 when current market value is $4,000. Solution: Unrealized Price Decrease on Available-for-Sale Securities Available-for-Sale Securities

1,000 1,000

KP 2 BT: AP Difficulty: Easy TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

On December 31, the cost and market price of trading securities are $5,000 and $9,000, respectively. Give the appropriate adjusting entry on December 31. Solution: Trading Securities Unrealized Gain on Trading Securities

4,000 4,000

KP 2 BT: AP Difficulty: Easy TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting 4.

On December 31, the cost and market price of available-for-sale securities are $5,000 and $9,000, respectively. Give the appropriate adjusting entry on December 31. Solution: Available-for-Sale Securities Unrealized Price Increase on Available-for-Sale Securities KP 2 BT: AP Difficulty: Easy TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

4,000 4,000

8-26

Test Bank – Chapter 8 – Investments in Equity Securities

On December 31, 2010, available-for-sale securities with an original cost of $10,000 have a carrying value on the balance sheet equal to their market value of $12,000. On January 5, 2011, those securities are sold for $11,000. Give the appropriate entry to record the sale of the available-for-sale securities. Solution: Cash Unrealized Price Increase on Available-for-Sale Securities Realized Gain on Available-for-Sale Securities Available-for-Sale Securities

11,000 2,000 1,000 12,000

KP 2 BT: AP Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

On December 31, 2010, trading securities with an original cost of $45,000 have a market value of $47,000. On January 11, 2011, those trading securities are sold for $51,000. Determine the gains or losses in 2009 and 2010 associated with these trading securities. Clearly label whether the gains or losses are realized or unrealized. Name the financial statement on which each is reported. Solution: Unrealized Gain on Trading Securities

2010 $2,000 Income statement

2011

$4,000 Income statement

Realized Gain on Trading Securities

KP 2,4 BT: AP Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

On December 31, 2010, available-for-sale securities with an original cost of $14,000 have a carrying value on the balance sheet equal to their market value of $16,000. On January 11, 2011, those securities are sold for $18,000. Give the appropriate entry to record the sale of the available-for-sale securities. Solution: Cash Unrealized Price Increase on Available-for-Sale Securities Available-for-Sale Securities Realized Gain on Available-for-Sale Security KP 2 BT: AP Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

18,000 2,000 16,000 4,000

Test Bank – Chapter 8 - Investments in Equity Securities

8-27

On December 31, 2010, trading securities with an original cost of $10,000 have a carrying value on the balance sheet equal to their market value of $12,000. On January 11, 2011, those trading securities are sold for $15,000. Prepare the appropriate entry to record the sale of the trading securities. Solution: Cash Trading Securities Realized Gain on Trading Securities

15,000 12,000 3,000

KP 2 BT: AP Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

On December 31, 2010, trading securities with an original cost of $10,000 have a carrying value on the balance sheet equal to their market value of $12,000. On January 5, 2011, those trading securities are sold for $10,000. Give the appropriate entry to record the sale of the trading securities. Solution: Cash Realized Loss on Trading Securities Trading Securities

10,000 2,000 12,000

KP 5 BT: AP Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

10.

On December 31, 2010, trading securities with an original cost of $45,000 have a market value of $47,000. On January 5, 2011, those trading securities are sold for $41,000. Determine the gains or losses in 2010 and 2011 associated with these trading securities. Clearly label whether the gains or losses are realized or unrealized. Name the financial statement on which each is reported. Solution: Unrealized Gain on Trading Securities

2010 $2,000 Income statement

Realized Loss on Trading Securities

KP 2,4 BT: AP Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

2011

$6,000 Income statement

8-28

11.

Test Bank – Chapter 8 – Investments in Equity Securities

On December 31, 2010, available-for-sale securities with an original cost of $100,000 have a market value of $110,000. On January 11, 2011, the available-for-sale securities are sold for $130,000. Determine the gains or losses in 2010 and 2011 associated with these securities that must be reported on the income statements. Indicate whether the gains or losses are realized or unrealized. Solution: Realized Gain on Available-for-Sale Securities

2010 $ 0

2011 $30,000

KP 2,4 BT: AP Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

12.

On October 10, 2010, Marcus Inc. buys trading securities with an original cost of $100,000. On December 31, 2010, they have a market value of $80,000. On March 9, 2011, those securities are sold for $120,000. Determine the gains or losses in 2010 and 2011 associated with these trading securities that will be reported on the income statement. Indicate whether the gains or losses are realized or unrealized. Solution: Unrealized Loss on Trading Securities Realized Gain on Trading Securities

2010 $20,000

2011 $40,000

KP 2,4 BT: AP Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13.

On January 4, 2010, Harrison Corp. purchased 26% of C Corporation's voting stock for $100,000. During 2010, C recorded income of $200,000 and paid total dividends of $13,000. Harrison uses the cost method to account for this investment. Calculate Harrison’s income from the C investment and the December 31, 2010, balance sheet value of its long-term equity investment in C. Solution: 2010 dividend income from investment = $13,000 x 26% = $3,380 December 31, 2010, investment in C Corporation = $100,000 KP 2,4 BT: AN Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 8 - Investments in Equity Securities

14.

8-29

Before adjusting its current investments in equity securities, Apex Company has total current assets and current liabilities of $23,000 and $12,000, respectively. During the current year, Apex has net income of $200,000 with 50,000 shares of common stock outstanding. This amount excludes the effects of yearend adjustments related to the investments. Included in current assets are trading securities recorded at their original cost of $3,000. However, the current market value of those securities is $4,000 at yearend. If Apex properly accounts for trading securities, determine the effect on Apex’s current ratio and earnings per share. Solution: Current ratio before = $23,000/$12,000 = 1.92 Current ratio after = $24,000/$12,000 = 2.0 Earnings per share = $200,000/50,000 = $4.00 Earnings per share = $201,000/50,000 = $4.02 KP 2,4 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

15.

On December 31, 2010, trading securities with an original cost of $100,000 have a market value of $109,000, and available-for-sale securities with an original cost of $45,000 have a market value of $60,000. It is management’s intent to hold the available for sale securities indefinitely. Fill in the partial balance sheet at December 31, 2010 provided below showing the results of the investments. Clearly label whether any gains or losses are realized or unrealized and clearly show the balance sheet classifications. Balance Sheet at December 31, 2010: Current Assets

Long-Term Assets

Shareholders’ Equity

Solution: Balance Sheet at December 31, 2010: Current Assets Trading Securities Long-Term Assets Available-for-Sale Securities Shareholders’ Equity Unrealized Price Increase on Available-for-Sale Securities

KP 2,4 BT: AP Difficulty: Moderate TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

$109,000 60,000 15,000

8-30

16.

Test Bank – Chapter 8 – Investments in Equity Securities

Falcon, Inc. acquired 30% of Dodson Corporation for $100,000 on December 31, 2009. During the calendar year 2010, Dodson had net earnings of $400,000 and paid total dividends of $50,000. The fair value of Dodson Corporation’s stock at yearend was $160,000. Falcon mistakenly recorded these transactions using the fair value method (available-for-sale classification) rather than the equity method of accounting. A. Determine the effect the error would have on the investment account at December 31, 2010. B. Determine the effect the error would have on net income for the year ending December 31, 2010. Solution: A. Fair value method: $160,000 Equity method: $100,000 + ($400,000 x 30%) – ($50,000 x 30%) = $205,000 Net effect using fair value: Understatement of investment account = $45,000 B. Fair value method: $50,000 x 30% = $15,000 Equity method: $400,000 x 30% = $120,000 Net effect using fair value: Understatement of investment income = $105,000 KP 4,5 BT: AN Difficulty: Moderate TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

17.

On January 3, 2010, Blanton Co. purchased 24% of Martin Company's voting stock for $100,000. During 2010, Martin recorded income of $90,000 and paid total dividends of $15,000. Blanton uses the equity method to account for this investment. Calculate Blanton’s income from the Martin investment and the December 31, 2010, balance sheet value of its long-term equity investment in Martin. Show your work. Solution: 2010 investment income = $90,000 x 24% = $21,600 December 31, 2010, investment in Martin Company = $100,000 + $21,600 – ($15,000 x 24%) = $118,000 KP 4 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 8 - Investments in Equity Securities

18.

8-31

Before adjusting its current investments in equity securities, Patton Company has total current assets and current liabilities of $200,000 and $60,000, respectively. During the current year, Patton has net income of $20,000 before the effects of any market value adjustments with 30,000 shares of common stock outstanding. Included in current assets are trading securities recorded at their original cost of $100,000 and available-forsale investments recorded at their original cost of $7,000. The current market value of both investments increased by 15%. Patton properly accounts for both securities. A. Determine how Paton’s current ratio and earnings per share will be affected by the yearend adjustments for its investments. B. Determine how the current ratio and earnings per share will differ if the available-forsale investment is classified as long-term. Solution: Current ratio before = $200,000/$60,000 = 3.33 Current ratio after = [$200,000 + (15% x $100,000) + (15% x $7,000)]/$60,000 = 3.61 Earnings per share before = $20,000/30,000 = $0.67 per share Earnings per share after = ($20,000 + $15,000)/30,000 = $1.17 per share KP 2 BT: AN Difficulty: Moderate TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

19.

On November 30, 2010, Arnold Company purchased 100% of the outstanding voting common stock of Compton Corporation for $100,000. At that date the fair market value of Compton assets less liabilities was $80,000. What amount, if any, of goodwill must Arnold recognize in connection with its purchase of Compton? Where should Arnold Company report this amount? Solution: Goodwill = $100,000 – $80,000 = $20,000 reported as a long-term, intangible asset on the balance sheet. KP App8A BT: AN Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

20.

On April 1, 2010, Parrish Company purchased 90% of the outstanding voting common stock of Hamilton Corporation for $400,000. At that date the fair market value of Hamilton’s assets less liabilities was $200,000. What amount, if any, of goodwill must Parrish recognize in its consolidated balance sheet on December 31, 2010? Show your work. Solution: Goodwill on 4/1 = $400,000 – (90% x $200,000) = $220,000 KP 5, App8A BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

8-32

21.

Test Bank – Chapter 8 – Investments in Equity Securities

On January 1, 2010, Simpson Company purchased all of the assets and assumed all of the liabilities of Dobson Company for $400,000. Dobson’s balance sheet showed total assets of $450,000 and total liabilities of $210,000 of this date. An appraiser determined all assets except for land are valued at fair market value. The land is worth $20,000 more than its book value. A. Calculate goodwill in connection with this business combination. B. Prepare the journal entry to record the combination. Solution: A. Book value of the assets Increase to fair value for land Fair value of assets Less fair value of liabilities Fair value of net assets Purchase price Goodwill B. Assets Goodwill Liabilities Cash

$ 450,000 20,000 470,000 (210,000) $ 260,000 400,000 $ 140,000

470,000 140,000 210,000 400,000

KP App8A BT: AN Difficulty: Moderate TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 8 - Investments in Equity Securities

22.

8-33

On May 6, 2010, Galen Company purchased equity securities. At December 31, 2010, three investments were still owned by Galen. The names, cost, and fair values at December 31, 2010, are indicated below. Name

Acquisition Cost

Fair Value

Guy Company Nordic Company Vernon Company

$10,000 $3,000 $7,000

$8,000 $4,500 $7,800

The investments have clearly determinable fair values. Galen can’t exercise significant influence on any of these investments. Galen has determined that the Guy stock will be held until 2011. Galen intends to sell the Vernon stock by January 2, 2011, for short-term profits. Galen has no idea how long it will hold the Nordic stock. Show how these investments and any related yearend adjustments will be reported by completing the balance sheet below at December 31, 2010. Balance Sheet at December 31, 2010: Current Assets

Long-Term Investments

Shareholders’ Equity

Solution: Balance Sheet at December 31, 2010: Current Assets Investment in Trading (Vernon) Long-Term Investments Investment in Available-for-Sale (Guy) Investment in Available-for-Sale (Nordic) Shareholders’ Equity Unrealized Net Price Decrease on Available-for-Sale Sec. ($2,000) + $1,500

$7,800 8,000 4,500 (500)

KP 2,4 BT: AN Difficulty: Moderate TOT:5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

8-34

23.

Test Bank – Chapter 8 – Investments in Equity Securities

On December 31, 2010, Celtic Inc. acquired a 24% interest in Romano Corp. for $100,000 and appropriately applied the equity method. During 2010, Romano had net income of $400,000 and paid cash dividends of $50,000. How much will Celtic report for the year ending December 31, 2011 on its income statement? Show your work. Solution: $400,000 x 24% = $96,000 KP 4,5 BT: AN Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

24.

On January 1, 2010, Danner Company purchased all of the assets and assumed all of the liabilities of Clancy Company for cash of $80,000. Clancy’s balance sheet showed total assets of $120,000 and total liabilities of $70,000. The equipment had a fair market value on the same date of $10,000 instead of the $6,000 reported on the balance sheet. Calculate goodwill in connection with this business combination. Prepare the journal entry to record the combination. Solution: Book value of assets Fair value for equipment difference Fair value of assets Less fair value of liabilities Fair value of net assets Purchase price Goodwill Assets Goodwill Liabilities Cash

$120,000 4,000 124,000 (70,000) 54,000 80,000 $ 26,000 124,000 26,000 70,000 80,000

KP App8A BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

25.

On December 31, 2010, Rory Corp. acquired an 18% interest in Batson Corp. for $100,000 and appropriately applied the cost method. During 2011, Batson had net income of $200,000 and paid cash dividends of $50,000. On the last day of 2011, Rory sold one-half of its investment in Batson Corp. for $180,000. How much should Rory report on its income statement for the year ending December 31, 2011? Show your work. Solution: Dividend income = $50,000 x 18% = $9,000 Gain on sale of investment = $180,000 – ($100,000 x 50%) = $130,000 KP 4 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 8 - Investments in Equity Securities

26.

8-35

York Corporation owns 25% of Carson, Inc. that it purchased on January 1, 2010, for $100,000. York uses the cost method for accounting for its investment in Carson, Inc. During 2010, Carson, Inc. paid a total of $45,000 of dividends and recorded income of $200,000. Determine how much York’s net income would differ if it used the equity method instead of the cost method. Show your work. Solution: Cost method: $45,000 x 25% = $11,250 Equity method: $200,000 x 25% = $50,000 Difference = $38,750 more income under the equity method KP 4 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

27.

On December 31, 2010, Tanner Corp. acquired a 20% interest in Gantry Corp. for $800,000 and appropriately applied the equity method. During 2011, Gantry had net income of $150,000 and paid cash dividends of $5,000. On last day of 2011, Tanner sold one-half of its investment in Gantry Corp. for $620,000. How much should Tanner report on its income statement for the year ending December 31, 2011? Show your work. Solution: Investment income = $150,000 x 20% Gain on sale of investment: Selling price Book value: Original cost $800,000 Net income (20% x $150,000) 30,000 Dividends (20% x $5,000) (1,000) Carrying Value 829,000 Portion Sold 50% Gain on sale Income statement effect of investment income and sale

$30,000 $620,000

414,500 205,500 $235,500

KP 4 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

28.

On January 2, 2011, Merton Co. acquired 30 percent of the outstanding voting common stock of Tilton, Inc., at a cost of $50,000. With this investment, Merton has the ability to exercise significant influence over Tilton, Inc. During 2011, Tilton, Inc. reported net income of $110,000 and paid total cash dividends of $35,000. What amount should be reported as investment and investment earnings by Merton for the year ending December 31, 2011? Show your work. Solution: Investment = $50,000 + [(30% x 110,000) – (30% x $35,000) = $72,500 Investment earnings = (30% x $110,000) = $33,000 KP 4 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

8-36

Test Bank – Chapter 8 – Investments in Equity Securities

SHORT ESSAY QUESTIONS 1.

Why should users be cautious when examining financial statements in which the company has accounted for investments using the equity method? Solution: The equity method requires accrual-based, year-end adjustments that cause net income to differ from cash flows from operations. This increase in the investment account is not equal to the amount of cash dividends received by the investor. Some call this misleading since the investor will never really see any nondividend cash from the investee company. The equity method also ignores market value changes in the investee company. Unless price decreases are considered permanent in nature, they are not recorded or reflected in the carrying value of the investment on the investor's balance sheet under the equity method. KP 3,4 BT: AN Difficulty: Easy TOT: 3 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

How is the purchase method used in accounting for business acquisitions? Solution: The purchase method requires that assets and liabilities of an acquired subsidiary be recorded on the balance sheet of the parent company at fair market value, and the difference between the purchase price and the net fair market value of the subsidiary’s assets and liabilities is recorded as goodwill. KP 5, App8A BT: AP Difficulty: Easy TOT: 3 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

How does the concept of "consolidated financial statements" relate to a business acquisition? Solution: A business acquisition occurs when the investing company acquires a controlling interest (more than 50 percent of the voting stock) in another company. The investor accounts for the investment using the equity method. At the end of the reporting period, the parent company prepares consolidated financial statements, which combine the assets and liabilities into financial statements of the parent and the subsidiary into one operating unit for reporting purposes. KP 5 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 8 - Investments in Equity Securities

8-37

On November 1, 2009, Nova Company purchased short-term marketable equity securities in Sandi Corporation and Exeter Corporation. The following valuation of Nationals' portfolio in short-term investments on December 31, 2009 is: Sandi Corporation Exeter Corporation

Cost $70,000 $45,000

Market $75,000 $60,000

Answer the following questions if you assume that only one of these short-term investments is to be classified as trading, while the other will be classified as availablefor-sale. A. If Nova Company wants to maximize its 2009 earnings per share, which investment should be classified as trading? Justify your choice. B. If Nova Company desires to minimize its December 31, 2009, debt/equity ratio, which investment should be classified as trading? Justify your choice. Solution: A. The market appreciation of investment in Sandi and Exeter is $5,000 and $15,000, respectively. If the investment in Exeter is classified as trading, then Nova will recognize an unrealized gain on its income statement of $15,000. Then the investment in Sandi will be classified as available-for-sale and its $5,000 market appreciation is recognized as an unrealized price increase which increases shareholders’ equity without affecting net income. Therefore, by classifying Exeter as trading instead of Sandi, Nova Company will increase its 2009 income by $15,000. B. The choice of which investment is trading or available-for-sale does not affect the debt/equity ratio. The market appreciation of both short-term investments increases shareholders’ equity independent of its classification. The only difference is that the market appreciation of trading securities travels through the income statement on its way to retained earnings, while that of available-for-sale securities goes directly to shareholders’ equity. KP 2 BT: AP Difficulty: Moderate TOT: 8 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

What are several features about the equity method that should cause financial report users to view it carefully? Solution: • First, the equity method provides another reason why a company’s net income (loss) differs from its cash flow from operations. The income recognized from the investee company rarely equals the cash dividends received by the investor. • Second, the equity method ignores price (market value) changes in the affiliate’s equity securities. For example, price decreases, even if substantial, are not recognized on the investor’s books. In fact, they may even be accompanied by the recognition of income and the receipt of dividends if the affiliate reports positive income and declares dividends during the period of the price decline. • Third, the percentage of ownership (20 – 50%) is not always a valid indication of “significant influence.” Influence comes in many different forms. • Finally, using the equity method can be considered a method of off-balancesheet financing because it fails to reflect the liabilities of the affiliate on the balance sheet of the investor company. KP 5 BT: AP Difficulty: Moderate TOT: 4 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

8-38

Test Bank – Chapter 8 – Investments in Equity Securities

What is the concept of ‘non-controlling interest’? Solution: Non-controlling interest is recognized when an investor purchases between 50 and 100 percent of the stock of another company at a price greater than the per-share market value of the net assets. It is recognized because non-controlling shareholders own a portion of the stock. It is reported on the consolidated balance sheet between the long-term liability and the shareholders’ equity sections. The noncontrolling interest is the interest held by outsiders (100 percent less the percentage owned by the controlling interest). KP App8A BT: C Difficulty: Easy TOT: 3 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

What two criteria must be met for an investment in a security to be considered as current on an investor’s balance sheet? Solution: In order to classify an investment as current, it must be readily marketable—it can be sold and converted into cash on demand—and management must intend to convert the investment into cash within the time period of current assets, typically one year. The intention to convert is much more difficult to determine objectively, especially in an environment in which managers have incentives to ‘window dress’. KP 1 BT: K Difficulty: Easy TOT: 3 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

How do current accounting rules put U.S. corporations at a distinct disadvantage compared to foreign corporations? Solution: When a U.S. corporation wishes to bid against foreign buyers for acquisitions, goodwill becomes a major issue. Companies using British GAAP do not recognize amortized goodwill as an expense on the income statement. Instead, the amortization is a direct reduction of shareholders’ equity, and does not appear to reduce earnings for the period. In the U.S., many chief executives are hesitant to bid on foreign companies because compensation is often based on earnings per share, which is reduced by goodwill amortization. KP 5 BT: C Difficulty: Easy TOT: 3 min. AACSB: Communication, Analytic, Diversity AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 8 - Investments in Equity Securities

8-39

On November 15, 2009, Torborg Company purchased short-term marketable equity securities in Radar Corporation and Booker Corporation. The following valuation of Twins' portfolio in short-term investments on December 31, 2009 is: Cost $34,000 $22,000

Radar Corporation Booker Corporation

Market $38,000 $35,000

It is management policy that only one of its short-term investments can be classified as trading, while the other, therefore, must be classified as available-for-sale. Because Torborg’s 2009 income exceeds market expectations and its 2010 income prospects are suspect, the management desires to classify its short-term investments so that 2010 income is maximized. On January 11, 2010, Torborg Company sells its investments in Radar and Booker for $40,000 and $39,000, respectively. In order to achieve management's desires, which investment should be classified as trading and which as available-for-sale? Numerically justify your response. Solution: The holding gains (losses) associated with a trading security are recognized during the period of market price appreciation (depreciation). Therefore, when a trading security is sold, the realized gain (loss) reflects only the market price increase (decrease) from the beginning of the current accounting period. However, the holding gains and losses of an available-for-sale security are not recognized until the security is sold. Thus, when an available-for-sale security is sold, the realized gain (loss) is the total market price appreciation (depreciation) from the date of purchase to the date of sale. The following chart illustrates the unrealized and realized gains recognized in 2009 and 2010 resulting from the two possible classifications of investments in Radar and Booker: Radar (trading) Booker (available-for-sale) Total gains

Radar (available-for-sale) Booker (trading) Total gains

2009 $ 4,000 0 $ 4,000

2010 $ 2,000 17,000 $19,000

2009 0 13,000 $13,000

2010 $ 6,000 4,000 $10,000

It is obvious that if Torborg wants to maximize 2010 income, it should classify the security with the greatest market appreciation in 2009 as available-for-sale. Therefore, Booker should be classified as available-for-sale and Radar as trading. KP 2,4 BT: AN Difficulty: Moderate TOT: 8 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

8-40

10.

Test Bank – Chapter 8 – Investments in Equity Securities

On December 1, 2009, Fox Corporation purchased 10,000 common shares of Daniels Corporation as a short-term investment. The valuations of these securities on December 31, 2009 are: Daniels Corporation

Cost

Market Value

$100,000

$70,000

On the afternoon of December 31, 2009, the management of Fox is deciding whether to sell its investment in Daniels before the 2009 statements are issued. However, it wants to avoid any loss on the 2009 income statement associated with its short-term investment in Daniels. A. What advice would you give the management of Fox if its investment in Daniels were classified as trading? Justify your advice. B. What advice would you give the management of Fox if its investment in Daniels were classified as available-for-sale? Justify your advice. Solution: A. If the short-term investment in Daniels is classified as a trading security, then 2009 net income is affected by the decision to sell or hold the security. The market price decline of $30,000 will decrease 2009 net income. If sold, this decrease would be classified as a realized loss. If not sold, it would be classified as an Unrealized Loss on Trading Securities. The advice to management is to make the decision to sell or not to sell the investment in Daniels based upon economic expectations of 2010, not how it would appear on the income statement. B. If the short-term investment in Daniels is classified as an available-for-sale security, then 2009 net income would be decreased by $30,000 if the decision to sell the security is executed by the close of the market on December 31, 2009. If the shortterm investment is not sold, then the market price depreciation of $30,000 will not affect 2009 net income but will decrease Fox’s shareholders’ equity. The market price decrease will be realized as a loss only in the accounting period in which it is sold. If not sold, it would be classified as an adjustment to equity. The advice to management is that if they want to keep the loss associated with the market price decrease of its investment in Daniels off its 2009 income statement, then they should not sell Daniels until 2010. KP 2,4 BT: AP Difficulty: Moderate TOT: 7 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

11.

How does the concept of ‘merger’ differ from an ‘acquisition’? Solution: A business acquisition occurs when the investing company acquires a controlling interest (more than 50 percent of the voting stock) in another company. A merger, sometimes called a business combination, occurs when two or more companies combine to form a single, legal entity. In most mergers, the assets and liabilities of the smaller company are merged into those of the larger, surviving company. KP 5, App8A BT: C Difficulty: Easy TOT: 3 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 8 - Investments in Equity Securities

12.

8-41

List the primary reasons a company might invest in equity securities. Explain how each of these reasons helps to achieve the primary goal of a business entity—to make profit. Solution: Companies make investments in equity securities for two basic reasons: (1) to earn investment income in the form of dividends and stock price appreciation, and (2) to exert influence or control over the Board of Directors and management of the investee company. As dividends are declared, they may be recognized as dividend income on a company's income statement. When a company accounts for equity investments under the mark-tomarket rules, end-of-period adjustments are made to recognize the increases or decreases from the cost of the investment to the year-end market price. If the company has classified the investment as a trading security, this change in value will be reported as an unrealized loss or gain on the income statement. When a company makes an investment in order to exercise significant influence over the management of an investee corporation, the hope is that the investee will prove profitable in future periods, both in dividend distributions and in stock price appreciation. KP 1,3 BT: AP Difficulty: Moderate TOT: 4 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13.

How does the concept of comprehensive income relate to accounting for investments? Solution: FASB requires companies to provide disclosure of comprehensive income, which includes all nonowner-related changes in shareholders’ equity that do not appear on the income statement and are not reflected in the balance of retained earnings. One item that falls into this category relates to adjustments made at the end of the accounting period for investments classified as available-for-sale securities. Traditionally, this unrealized holding gain or loss related to available-for-sale securities was reported under retained earnings in the shareholders’ equity section of the balance sheet. The dollar amount of the unrealized gain or loss is still included as part of shareholders’ equity, but now is re-labeled as ‘comprehensive income’ and disclosed as such. KP 2 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

14.

Magnolia Products has a trading security investment that has suffered a permanent market value decline and is not expected to recover? What should it do in this case? Solution: In such cases, the security should be written down to its market value, and a realized loss that reduces net income should be recognized immediately whether the security is classified as trading or available-for-sale. Determining a permanent decline is very subjective, and GAAP provide very few guidelines. Perhaps the best way to assess such a decline is to consider the financial condition of the firm that issued the security. KP 2 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Communication, Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

8-42

Test Bank – Chapter 8 – Investments in Equity Securities

IFRS QUESTIONS 1.

Under GAAP, A Statement of Comprehensive Income must be prepared by companies. The comparable statement under IFRS is called: a. The Statement of Recognized Income and Expense (SORIE) b. The Statement of Comprehensive Equity (SCE) c. The Statement of Comprehensive Assets and Income (SCAI) d. The Statement of Equity and Expenses (SEE) KP 2 BT: A Difficulty: Easy TOT: 1 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Under GAAP, investee companies that are 20 to 50 percent owned by investor companies are often referred to as affiliate companies. Under IFRS, affiliate companies are referred as: a. Sister companies b. Associate companies c. Brother companies d. Subordinate companies KP 2 BT: B Difficulty: Easy TOT: 1 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Under IFRS, market values based on quoted prices in active markets for identical securities are called: a. Level 1 measurements b. Level 2 measurements c. Level 3 measurements d. None of the above KP 2 BT: A Difficulty: Moderate TOT: 1 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Under IFRS, market values based on less reliable, unobservable inputs securities are called: a. Level 1 measurements b. Level 2 measurements c. Level 3 measurements d. None of the above KP 2 BT: B Difficulty: Moderate TOT: 1 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Chapter 9 Long-Lived Assets

MULTIPLE CHOICE QUESTIONS 1.

Which one of the following should be classified as land on the balance sheet? a. A shed that houses the company’s equipment. b. Mineral rights representing gold in the soil c. Two tracts of property that houses the company’s backup computer site d. Sidewalks and driveways which lead to the company’s office building Ans: C KP 1 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Which of the following long-lived assets is not amortized or depreciated to an expense? a. Equipment use in production of inventory goods b. Land improvements c. Land d. Company computers replaced every two years Ans: C KP 1,2 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

A company which complains that although their income is quite satisfactory, cash is not available for dividends because of the high cost of replacing fixed assets in operating in an economic environment where: a. inflation is non-existent. b. the balance sheet value of long-lived assets is more than their replacement value. c. the prices of long-lived assets have been decreasing over an extended period of time. d. expenditures required to replace long-lived assets are greater than depreciation expense. Ans: D KP 2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Which one of the following actions will help solve a cash shortage problem? a. Issue common stock in exchange for plant assets b. Recognize depreciation expense c. Purchased long-lived asset by issuing long-term debt d Retire plant assets at salvage value Ans: D KP 2 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

The purpose of recording depreciation expense is to: 9-1

9-2

Test Bank – Chapter 9 – Long-Lived Assets

a. b. c. d.

provide cash necessary to replace plant assets when they are used up. record the balance sheet amount of plant assets at replacement value. match expenses with revenues using a reasonable systematic method. gain a better understanding of estimating the extraction of natural resources.

Ans: C KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Monroe Co. purchased a tract of land paying $100,000 in cash and assumed an existing mortgage of $60,000. The municipal tax bill disclosed an assessed valuation of $180,000. The amount Monroe should record as land connected with this acquisition is: a. $100,000. b. $160,000. c. $180,000. d. $200,000. Ans: B KP 3 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

The process of allocating the cost of plant and equipment over the time period of which they are used is referred to as: a. depreciation. b. depletion. c. amortization. d. deferred costs. Ans: A KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

The process of expensing the cost of a gold mine as gold is withdrawn is referred to as: a. amortization. b. depletion. c. depreciation. d. decomposition. Ans: B KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

The process of expensing the cost of patents over an extended period of years is referred to as: a. classification. b. depletion. c. depreciation. d. amortization. Ans: D KP 1,2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 9 –Long-Lived Assets

10.

9-3

Accumulated depreciation is an account which: a. adjusts plant and equipment so that its balance sheet value approximates its replacement cost. b. is a long-term liability. c. is equal to total depreciation expense recorded and decreases total plant and equipment. d. reduces intangible assets. Ans: C KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

11.

An increase in accumulated depreciation: a. increases total assets. b. decreases total assets. c. decreases the current ratio. d. increases the quick ratio. Ans: B KP 2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

12.

During extended periods of rising prices of plant and equipment, the amount required to replace long-lived assets is typically: a. less than total accumulated depreciation of those assets. b. equal to the sum of all the depreciation recognized on those assets. c. less than the balance sheet value of those assets. d. greater than the sum of total depreciation expense recognized on those assets. Ans: D KP 2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

13.

On January 1, a company purchased land with a usable building on it for $270,000. At the time of purchase, the fair market values of the land and building were $120,000 and $200,000, respectively. The gain from the purchase of the land and building is: a. $0. b. $50,000. c. $80,000. d. $320,000. Ans: A KP 3 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

14.

Equipment with a cost of $22,000 and accumulated depreciation of $15,000 was retired with a gain of $1,000. The cash received from the disposition of equipment is: a. $7,000. b. $8,000. c. $6,000. d. $14,000. Ans: B KP 7 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

9-4

Test Bank – Chapter 9 – Long-Lived Assets

15.

Moss Company purchased a building costing $800,000 on January 1, 2010. Moss is depreciating the building over 80 years using the straight-line method with no salvage value. The economic life of the building is expected to be 40 years. As a result of Moss’s accounting procedure, its 2010: a. earnings per share is understated and debt/equity ratio is overstated. b. earnings per share is understated and debt/equity ratio is understated. c. earnings per share is overstated and debt/equity ratio is overstated. d. earnings per share is overstated and debt/equity ratio is understated. Ans: D KP 2 BT: AP Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

16.

The Favre Company made the following expenditures related to its building: Annual repainting of exterior Replacement of old fiberglass shingles with a fireproof tile roof Major improvements to electrical system required to run new machinery

$ 1,700 33,000 18,000

The amount of the preceding expenditures that should be immediately expensed is: a. $0. b. $1,700. c. $34,700. d. $19,700. Ans: B KP 4,5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

17.

Depreciation is an expense that does not use cash during the period in which it is recognized. When did (will) the cash outflow associated with the asset occur? a. When the asset is retired b. There is no cash outflow associated with depreciation or the asset. c. When the replacement cost of the asset increases d. When the asset was acquired Ans: D KP 5 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

18.

The balance in accumulated depreciation on January 1 and December 31 is $15,000 and $19,000, respectively, during a year in which no assets were disposed. Depreciation expense during the year is: a. $19,000. b. $15,000. c. $4,000. d. $34,000. Ans: C KP 2,7 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 9 –Long-Lived Assets

19.

9-5

On January 1, Comicon Corp. purchased land with a usable building on it for $300,000. At the time of purchase, the fair market values of the land and building were $100,000 and $150,000, respectively. Comicon depreciates the building using the straight-line method over 20 years with an expected $24,000 residual value. The annual depreciation expense on the building is: a. $0. b. $5,000. c. $7,800. d. $10,800. Ans: C KP 3 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

20.

On January 1, Scion Co. purchased land with a usable building on it for $210,000. At the time of purchase, the fair market values of the land and building were $80,000 and $160,000, respectively. Scion assigned the entire purchase cost of $240,000 to land. Scion should depreciate the building using the straight-line method over 20 years with an expected zero residual value. As a result of Scion’s treatment of the purchase of land and building, its current net income is: a. understated by $10,500. b. understated by $7,000. c. overstated by $7,000. d. overstated by $10,500. Ans: C KP 3 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

21.

The balance in accumulated depreciation on January 1 and December 31 is $12,000 and $9,000, respectively, during a year in which an asset with a cost of $4,000 and net book value of $0 was retired. Depreciation expense for the current year is: a. $9,000. b. $3,000. c. $1,000. d. $7,000. Ans: C KP 6 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

22.

Which one of the following depreciation methods will typically result in the smallest amount of current taxes paid during the early periods of an asset's life? a. 150% declining balance method. b. Units of production method. c. Double-declining-balance method. d. Straight-line method. Ans: C KP 6,7 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

9-6

Test Bank – Chapter 9 – Long-Lived Assets

23.

Which one of the following depreciation methods will typically result in the smallest earnings per share during the early periods of an asset's life? a. 150% declining balance method. b. Units of production method. c. Double-declining-balance method. d. Straight-line method. Ans: C KP 6 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

24.

Sandeep Inc. uses double-declining-balance depreciation for an asset with a 4-year life expectancy and no salvage value. Depreciation expense for the second year of the asset's life is calculated by: a. [2 x Book Value]/4 b. [2 x (Cost – Salvage Value]/4 c. [(2 x Book Value)/4] – Accumulated Depreciation d. [2 x Cost]/4 Ans: A KP 6 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

25.

Kristin, Inc. depreciates its plant assets over a 10-year life with a 10% salvage value. Using straight-line depreciation, which calculation will Kristin use during year 2 of the asset's life? a. 10% x (Cost – Salvage Value) b. (Cost – Salvage Value)/10 x 10% c. Book Value x 10% d. Book Value x [10% – Salvage Value] Ans: A KP 6 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

26.

Forgetting to record depreciation expense during 2010l: a. understates the debt/equity ratio. b. understates the current ratio. c. overstates the debt/equity ratio. d. overstates the current ratio. Ans: A KP 3 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

27.

If the straight-line method of depreciation of an asset with a 5-year life expectancy and no salvage value is used, then the percentage of cost that is recognized as depreciation expense for the first two years of the asset's life is, respectively, a. 25% and 25%. b. 40% and 20%. c. 40% and 40%. d. 20% and 20%. Ans: D KP 6 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 9 –Long-Lived Assets

28.

9-7

On January 1, 2010, Lane Company made a $12,000 expenditure on a fully depreciated machine. The expenditure increased the expected life of the new machine for two years until December 31, 2011. Lane uses straight-line depreciation with no salvage value. However, Lane erroneously expensed this capital expenditure. As a result of this error, a. 2010 income is overstated by $3,000 and 2011 income is understated by $3,000. b. 2010 income is understated by $6,000 and 2011 income is overstated by $6,000. c. 2010 income is understated by $6,000 and 2011 income is overstated by $3,000. d. 2010 income is understated by $6,000 and 2011 income is correctly stated. Ans: B KP 5 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

29.

A machine was purchased on January 1 for $50,000. The machine has an estimated useful life of 10 years with a salvage value of $2,000. Under the double-decliningbalance, depreciation expense for each of the first two years is, respectively, a. $12,000 and $12,000. b. $10,000 and $8,000. c. $12,000 and $9,500. d. $12,500 and $12,500. Solution:

$50,000 x 2/10 and ($50,000 − $10,000) x 2/10

Ans: B KP 6 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

30.

A machine was purchased on January 1 for $100,000. The machine has an estimated useful life of 5 years with a salvage value of $10,000. Under the double-decliningbalance method, depreciation expense for each of the first two years is, respectively, a. $45,000 and $22,500. b. $40,000 and $24,000. c. $45,000 and $ 27,500. d. $22,500 and $ 22,500. Solution:

2/5 x $100,000 and 2/5 x $60,000

Ans: B KP6 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

31.

Failure to record depreciation expense during a year: a. understates net income. b. overstates total assets. c. overstates total debt. d. overstates contributed capital. Ans: B KP 3 BT: AP Difficulty: Difficult TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

9-8

Test Bank – Chapter 9 – Long-Lived Assets

32.

A machine was purchased on January 1 for $100,000. The machine has an estimated useful life of 4 years with a salvage value of $20,000. Under the straight-line method, accumulated depreciation at the end of year 2 is: a. $25,000 b. $22,500 c. $50,000 d. $40,000 Solution:

($100,000 − $20,000)/4 x 2

Ans: D KP 6 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

33.

Natural resource costs: a. include rights, privileges, and benefits of an economic resource that have no physical existence. b. are depreciated. c. include the cost of the equipment used to extract the natural resource. d. include the cost of acquiring the rights to extract natural resources. Ans: D KP 1 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

34.

A machine was purchased on January 1 for $100,000. The machine has an estimated useful life of 5 years with a salvage value of $20,000. Under the straight-line method, the book value and the accumulated depreciation of the machine at the end of year two is respectively, a. $60,000 and $40,000 b. $68,000 and $32,000 c. $40,000 and $60,000 d. $48,000 and $32,000 Ans: B KP 6 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

35.

Which one of the following will impact the amount of depreciation expensed throughout the life of plant assets? a. The amount of capitalized cost. b. Maintenance costs throughout the asset’s useful life. c. The expected cost of a replacement asset. d. The current market value. Ans: A KP 2,3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 9 –Long-Lived Assets

36.

9-9

Which one of the costs below should be included as part of the cost of land? a. Razing an old building. b. Cost of a building permit. c. Cost of driveways. d. Shrubs and trees with limited lives. Ans: A KP 4 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

37.

When companies construct their own long-lived assets, all costs required to get the asset into operating condition must be: a. expensed immediately. b. included in the long-lived asset’s cost. c. recognized as a maintenance cost. d. treated as a cost necessary to maintain the plant asset’s current level of productivity. Ans: B KP 4,5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

38.

Salvage value is: a. a method of depreciating plant assets. b. the dollar amount that can be recovered when the asset is sold, traded, or scrapped. c. an asset’s current estimated market value. d. a physical obsolescence condition. Ans: B KP 6 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

39.

Which one of the following is not one of the questions asked when accounting for longlived assets? a. Over what period of time should this cost be allocated? b. What dollar amount should be included in the capitalized cost of the long-lived asset? c. At what rate should this cost be allocated? d. How much will a replacement asset cost? Ans: D KP 2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

40.

Which of the following is the least problematic factor to determine when preparing to calculate depreciation?

a. useful life. b. estimated salvage value. c. technical obsolescence. d. acquisition cost. Ans: D KP 6 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

9-10

41.

Test Bank – Chapter 9 – Long-Lived Assets

Once a company establishes that an estimated useful life of a plant asset has changed significantly: a. the plant asset must be disposed. b. the change must be made for the current and future years. c. a correcting journal entry must be made. d. the previous year's financial statements must be corrected. Ans: B KP 6 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

42.

The calculation of a ‘depreciation base’ requires subtracting: a. the salvage value from the asset’s book value. b. the asset’s book value from its original cost. c. the asset’s salvage value from its capitalized cost. d. accumulated depreciation from the asset’s original cost. Ans: C KP 6 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

43.

The units of production method of depreciation: a. allocates the cost of the long-lived asset based on an activity. b. allocates an equal amount of plant asset cost to each accounting period. c. is an accelerated method. d. is used when an asset has no salvage value. Ans: A KP 6 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

44.

During 2009, Erie Inc. developed a new process for packaging products. Erie paid its employees $450,000 over the past five years in developing this process. On January 1, 2009, Erie paid $12,000 to register the packaging patent. The company believes the patent will produce profits for 10 years. The patent has a 17-year legal life. How much amortization expense should be recognized during 2009? a. $27,118 b. $46,200 c. $1,200 d. $647 Solution:

$12,000/10

Ans: C KP 6 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

45.

One primary reason management may choose a particular depreciation method is: a. to save cash for the replacement of the plant asset. b. to avoid violation of debt covenants tied to net income. c. to decrease the cash flows of the company. d. to hide judgment errors that managers have made during the accounting period. Ans: B KP 6 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 9 –Long-Lived Assets

46.

9-11

Once a plant asset becomes fully depreciated, the: a. asset may no longer be used. b. asset may still be used. c. asset should be retired. d. cost of the asset must be removed from the accounting records. Ans: B KP 6,7 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

47.

When a plant asset is sold, its original cost and its: a. market value must be removed from the accounting records. b. accumulated depreciation must be removed from the accounting records. c. salvage value must be expensed immediately. d. related maintenance costs must be transferred to the income statement immediately. Ans: B KP 7 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

48.

When a plant asset is traded in for a similar asset, the valuation of the new plant asset should be: a. at the original cost of the old asset. b. at the fair market value of the asset given up, or the asset received, whichever is more clearly evident. c. at the replacement cost of the old asset. d. at the value at which the new asset received was carried in the accounting records of the manufacturer. Ans: B KP 7 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

49.

Intangible assets differ from plant assets in that they: a. are consumed in the current accounting period. b. include prepaid expenses that extend beyond the current accounting period. c. have no physical existence. d. are matched against the revenue in the period the related revenue is recognized. Ans: C KP 7 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

50.

Which one of the following costs would be capitalized as an ‘organizational cost’? a. Goodwill b. Underwriting a company's first stock issuance c. Copyrights d. None of the above Ans: D KP 4 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

9-12

51.

Test Bank – Chapter 9 – Long-Lived Assets

Jeter Inc. acquired machinery on January 1, 2004 at a cost of $55,000. The machinery was depreciated over five years using the straight line method and a salvage value of $2,000. In 2010 the machinery was sold for $3,000. The income statement for 2010 will reflect which of the following: a. Gain of $1,000 b. Gain of $3,000 c. Loss of $52,000 d. No gain or loss Ans: A KP 7 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

52.

On December 1, Douglas Corp. purchased a tract of land for $285,000 to be used as a factory site. An old unusable building on the land was razed (torn down), and the salvaged materials from the demolition were sold. These cash expenditures and receipts and other costs incurred during December are as follows: Demolition of old building Proceeds from sale of salvaged materials Legal fees to transfer land title Title guarantee insurance

$51,000 8,000 7,000 2,500

What would be the balance in Douglas’s Land account on its December 31 balance sheet? a. $285,000 b. $337,500 c. $340,500 d. $331,000 Solution: B $285,000 + $51,000 − $8,000 + $7,000 + $2,500 = $337,500 Ans: B KP 3,4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

53.

Land and a building were purchased for $240,000. A reliable market value of the land is $75,000 and for the building, $225,000. What are the respective separate costs assigned to the land and building? a. $75,000 and $225,000 b. $75,000 and $165,000 c. $60,000 and $180,000 d. $80,000 and $160,000 Solution: C Land: $60,000; Building: $180,000 Ans: C KP 3,4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 9 –Long-Lived Assets

54.

9-13

On January 1, Eagle Co. paid $65,000 for a new truck. It was estimated that the truck would be driven 300,000 miles during the next 5 years, at which time it would have a salvage value of $10,000. At the end of the first and second years, the odometer registered 55,000 and 115,000 miles, respectively. What is the book value of the truck using straight-line depreciation at the end of the second year? a. $47,000 b. $43,000 c. $43,533 d. $56,000 Solution: B Depreciation expense = ($65,000 – $10,000) / 5 years = $11,000 per year Cost $65,000 Less accumulated depreciation (22,000) Book value $43,000 Ans: B KP 3,6 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

55.

On July 31, 2010, equipment is purchased for $66,000 with a 4-year life expectancy and salvage value of $5,000. If the double-declining-balance method is used, calculate depreciation expense for the year ending December 31, 2010.

a. $13,750 b. $12,708 c. $33,000 d. $31,000 Solution: A ($66,000 x (2/4) x (5/12) = $13,750 Ans: A KP 3,6 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

56.

On February 1, 2008, James Co., which uses straight-line depreciation, purchased equipment for $88,000 with a useful life of 12 years and $4,000 salvage value. On February 1, 2012, the equipment was sold for $56,000. Which of the following would James recognize as a result of this disposition? a. $7,000 loss b. $4,000 loss c. $4,000 gain d. No gain or loss Solution: B Expense = ($88,000 – $4,000)/12 x 4 years = $28,000 Loss = $56,000 – [$88,000 – $28,000] = $4,000 Ans: B KP 7 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

9-14

57.

Test Bank – Chapter 9 – Long-Lived Assets

On January 1, Mondale Co. paid $92,000 for a new truck. It was estimated that the truck would be driven 200,000 miles during the next 8 years, at which time it would have a salvage value of $7,000. At the end of the first three years, the odometer registered 27,000, 53,000, and 78,000 miles, respectively. What is the book value of the truck using the activity method of depreciation at the end of the third year? a. $67,150 b. $24,850 c. $51,850 d. $58,850 Solution: D Accumulated depreciation expense = ($92,000 – $7,000) x (78,000 / 200,000) = $33,150 Cost $92,000 Less accumulated depreciation (33,150) Book value $58,850 Ans: D KP 3,6 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

58.

Farmdale Company purchased three assets for $400,000. market values as follows: Land $ 75,000 Equipment 125,000 Inventory 50,000

These assets have fair

If you were Farmdale’s accountant, how much of the lump sum purchase would you allocate to the inventory?

a. $100,000 b. $120,000 c. $200,000 d. $80,000 Solution: D ($50,000 / $250,000) x $400,000 = $80,000 Ans: D KP 4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

59.

Farmdale Company purchased three assets for $400,000. market values as follows: Land $ 75,000 Equipment 125,000 Inventory 50,000

These assets have fair

If you were Farmdale’s accountant, how much of the lump sum purchase would you allocate to the land? a. $75,000 b. $120,000 c. $200,000 d. $80,000 Solution: B

Test Bank – Chapter 9 –Long-Lived Assets

9-15

($75,000 / $250,000) x $400,000 = $120,000 Ans: B KP 4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

60.

Farmdale Company purchased three assets for $400,000. market values as follows: Land $ 75,000 Equipment 125,000 Inventory 50,000

These assets have fair

If you were Farmdale’s accountant, how much of the lump sum purchase would you allocate to the equipment?

a. $100,000 b. $120,000 c. $200,000 d. $80,000 Solution: C ($125,000 / $250,000) x $400,000 = $200,000 Ans: C KP 4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

61.

The following items represent common post acquisition expenditures incurred on equipment. A. An overhaul to increase useful life of the equipment B. Cost of a muffler to reduce equipment noise C. Lubrication service D. Costs of redesign to increase output Identify which of these items are considered to be betterments. a. A only b. A, B, and D c. A and D d. A and B Ans: C KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

9-16

62.

Test Bank – Chapter 9 – Long-Lived Assets

The following items represent common post acquisition expenditures incurred on equipment. A. Replacement of defective parts B. Rewiring costs to increase operating speed C. Painting costs D. Repair of the major circuitry of the equipment Identify which of these items are considered to be maintenance items. a. A and C b. C only c. A, B, and C d. A, C, and D Ans: D KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

63.

Rio Grande Company purchased equipment on January 1, 2010 for $75,000. The estimated useful life of the equipment is 5 years, the salvage value is $10,000, and the company uses the double-declining balance method to depreciate fixed assets. Which of the following journal entries would Rio Grande record if the equipment is scrapped after three years? a. Equipment .............................................................................. Gain on Disposal of Equipment ...................................... Accumulated Depreciation—Equipment .......................

75,000

b. Accumulated Depreciation—Equipment ............................... Loss on Disposal of Equipment ............................................. Equipment ......................................................................

58,800 16,200

c. Accumulated Depreciation—Equipment ............................... Cash ...................................................................................... Equipment ......................................................................

58,800 16,200

d. Depreciation Expense ............................................................ Loss on Disposal of Equipment ............................................. Equipment ......................................................................

58,800 16,200

16,200 58,800

75,000

Solution: B Assuming that Rio Grande Company kept the equipment for its entire five-year estimated useful life, the depreciation schedule on the equipment would be as follows.

Date

Depreciation Depreciation Factor Expense

1/1/10 12/31/10 40% 12/31/11 40% 12/31/12 40% 12/31/13 40% 12/31/14 40% __________________

$30,000 18,000 10,800 6,200* 0

Cost

Accumulated Depreciation

Book Value

$75,000 75,000 75,000 75,000 75,000 75,000

$ 0 30,000 48,000 58,800 65,000 65,000

$75,000 45,000 27,000 16,200 10,000 10,000

Test Bank – Chapter 9 –Long-Lived Assets

9-17

* Because the equipment's book value can’t drop below its estimated salvage value, depreciation expense for 2012 can’t exceed $6,200. Ans: B KP 7 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

64.

Rio Grande Company purchased equipment on January 1, 2010 for $75,000. The estimated useful life of the equipment is 5 years, the salvage value is $10,000, and the company uses the double-declining balance method to depreciate fixed assets. How much depreciation would Rio Grande record for the fourth year of the equipment’s use? a. $6,480 b. $6,200 c. $5,616 d. $6,000 Solution: B Assuming that Rio Grande Company kept the equipment for its entire five-year estimated useful life, the depreciation schedule on the equipment would be as follows.

Date

Depreciation Depreciation Factor Expense

Cost

Accumulated Depreciation

Book Value

1/1/10 $75,000 $ 0 $75,000 12/31/10 40% $30,000 75,000 30,000 45,000 12/31/11 40% 18,000 75,000 48,000 27,000 12/31/12 40% 10,800 75,000 58,800 16,200 12/31/13 40% 6,200* 75,000 65,000 10,000 12/31/14 40% 0 75,000 65,000 10,000 __________________ * Because the equipment's book value can’t drop below its estimated salvage value, depreciation expense for 2012 can’t exceed $6,200. Ans: B KP 3,6 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

65.

Rio Grande Company purchased equipment on January 1, 2010 for $75,000. The estimated useful life of the equipment is 5 years, the salvage value is $10,000, and the company uses the double-declining balance method to depreciate fixed assets. Which of the following journal entries would Rio Grande record if the equipment is scrapped after five years? a. Equipment ............................................................................... Gain on Disposal of Equipment ...................................... Accumulated Depreciation—Equipment ........................

75,000

b. Accumulated Depreciation—Equipment ................................ Equipment .......................................................................

75,000

c. Accumulated Depreciation—Equipment ................................ Loss on Disposal of Equipment .............................................. Equipment .......................................................................

65,000 10,000

10,000 65,000

75,000

9-18

Test Bank – Chapter 9 – Long-Lived Assets

65,000 10,000 75,000

Ans: C KP 7 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

66.

Rio Grande Company purchased equipment on January 1, 2010 for $75,000. The estimated useful life of the equipment is 5 years, the salvage value is $10,000, and the company uses the double-declining balance method to depreciate fixed assets. Which of the following journal entries would Rio Grande record if the equipment is sold for $17,000 after three years? a. Equipment .............................................................................. Loss on Disposal of Equipment ............................................. Cash ................................................................................ Accumulated Depreciation—Equipment .......................

75,000 800

b. Cash ........................................................................................ Gain on Disposal of Equipment ...................................... Equipment ......................................................................

17,000

Cash ...................................................................................... Depreciation Expense............................................................ Loss on Disposal of Equipment ............................................. Equipment ......................................................................

17,000 10,800 47,200

Cash ...................................................................................... Accumulated Depreciation—Equipment ............................. Equipment ...................................................................... Gain on Sale of Fixed Assets ..........................................

17,000 58,800

6,200 10,800

75,000

75,000 800

Solution: D Assuming that Rio Grande Company kept the equipment for its entire five-year estimated useful life, the depreciation schedule on the equipment would be as follows.

Date

Depreciation Depreciation Factor Expense

Cost

Accumulated Depreciation

Book Value

1/1/10 $75,000 $ 0 $75,000 12/31/10 40% $30,000 75,000 30,000 45,000 12/31/11 40% 18,000 75,000 48,000 27,000 12/31/12 40% 10,800 75,000 58,800 16,200 12/31/13 40% 6,200* 75,000 65,000 10,000 12/31/14 40% 0 75,000 65,000 10,000 __________________ * Because the equipment's book value can’t drop below its estimated salvage value, depreciation expense for 2012 can’t exceed $6,200. Ans: D KP 7 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 9 –Long-Lived Assets

67.

9-19

Rio Grande Company purchased equipment on January 1, 2009 for $75,000. The estimated useful life of the equipment is 5 years, the salvage value is $10,000, and the company uses the double-declining balance method to depreciate fixed assets. Which of the following would be included in the journal entry that Rio Grande would record at the end of the fifth year, if the equipment and $19,000 cash are traded for a dissimilar fixed asset with a FMV of $25,000? a. A credit to Fixed Assets for $25,000. b. A credit to Equipment for $10,000. c. A credit to Gain on Disposal of Equipment for $4,000. d. A debit to Loss on Disposal of Equipment for $4,000. Ans: D KP 7 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

9-20

Test Bank – Chapter 9 – Long-Lived Assets

MATCHING QUESTIONS 1.

For each account listed in 1 through 12 below, identify which reporting section (a through d) each would appear on a company’s financial statements. You may use each letter more than once or not at all.

a. b. c. d.

Reporting Sections of Financial Statements Balance sheet—property, plant, and equipment Balance sheet—intangible assets Balance sheet—other Income statement

_____ 1. _____ 2. _____ 3. _____ 4. _____ 5. _____ 6. _____ 7. _____ 8. _____ 9. _____ 10. _____ 11. _____ 12.

Depreciation expense Accumulated depreciation Betterments Oil reserve Land Organizational costs Amortization expense Total amortization since inception Gain on sale of patent Copyright Patents Goodwill

Solution: 1. d 2. a 3. a 4. c or a 5. a

6. d 7. d 8. b 9. d 10. b

11. b 12. b

KP 1,3,4 BT: K Difficulty: Easy TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

For each transaction numbered 1 through 6 below, identify its effects on the accounting equation by selecting from the effects listed in a through f. You may use each letter more than once or not at all. Accounting Effects a. b. c. d. e. f.

– A and – SE (Retained Earnings) + A and + SE (Retained Earnings) – A and – L – A and – SE (Contributed Capital) + A and + L No change in total A, L, or SE

____ 1. Equipment is purchased by incurring a long-term mortgage payable and paying the balance in cash ____ 2. Paid for transportation of equipment shipped from the vendor to our plant ____ 3. Paid for speeding ticket received while transporting the equipment to the manufacturing plant ____ 4. Depreciated the equipment during the first year of use ____ 5. Paid for lubrication and periodic tune ups of the equipment ____ 6. Sold the equipment, receiving more money than its book value Solution:

1. e

2. f

3. a

4. a

5. a

Test Bank – Chapter 9 –Long-Lived Assets

9-21

KP 2,4 BT: AP Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

For each transaction numbered 1 through 5 below, identify in which account listed in a through d it would be reported. You may use each letter more than once or not at all. a. b. c. d.

_____ _____ _____ _____ _____

Accounts Land Buildings Equipment Not capitalized

1. Freight charges related to the acquisition costs of a production machine 2. Interest costs incurred during the construction period of a building built by a company for its own use 3. Costs paid to clear land 4. Annual painting costs of an office building 5. Sales taxes paid related to a machine purchased

Solution:

1. c

2. b

3. a

4. d

5. c

KP 2,4 BT: C Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

For each cost that appears in items 1 through 6 below, select the account in which it would be included and reported from those listed in a through c. You may use more than one answer for each cost. If the cost is not capitalized, place an X in the space provided. Accounts a. Land b. Buildings c. Equipment

_____ _____ _____ _____ _____ _____

1. Installation costs of a special attachment to newly acquired equipment 2. Freight costs for shipping the equipment into our manufacturing facility 3. Costs of repairing a hole knocked in the wall during installation of new equipment 4. Interest costs on a mortgage loan used to purchase a newly acquired building 5. Property taxes paid on land for the current year on which a new building was erected 6. Training session to teach faculty how to use computer projection equipment recently installed in classrooms

Solution:

1. c

2. c

3. x

4. x

KP 4,5 BT: C Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

5. x

6. x

9-22

Test Bank – Chapter 9 – Long-Lived Assets

Select the method of depreciation listed in a through c that is best for each purpose listed in items 1 through 5. Methods a. Straight-line b. Units-of-production c. Double-declining-balance

1. _______

Creates the largest net income in the early years of life

2. _______

Erratic due to unpredictable sales levels

3. _______

Creates the smallest taxable income in the early years of life

4. _______ Technological competitive changes are rapid Solution:

1. a

2. b

3. c

4. c

KP 4 BT: K Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

For each transaction numbered 1 through 5 below, identify which effect(s) (a through d) that each transaction would have on the current and debt/equity ratios. You may use each letter more than once or not at all. Some transactions have two answers. Effects

____

____ ____ ____ ____

2. 3. 4. 5.

Solution:

a. Decreases current ratio b. Increases current ratio c. Decreases debt/equity ratio d. Increases debt/equity ratio Equipment is purchased by incurring a long-term note payable and paying the balance in cash Paid for transportation of equipment shipped from a supplier Depreciated the equipment during the first year of use Paid for lubrication and periodic maintenance of the equipment Sold the equipment, receiving more money than its book value 1. a, d

2. a

3. d

4. a, d

5. b, c

KP 2,4,5 BT: AP Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 9 –Long-Lived Assets

9-23

For each transaction numbered 1 through 6 below, identify which accounting treatment—capitalized or expensed—should be used to properly account for the transactions. You may use each letter more than once or not at all. Accounting Treatments E. C.

Expensed immediately Capitalized as part of the cost of the new asset

______1.

Freight costs on production equipment in transit

______2.

Sales tax on equipment purchase

______3.

Damaged during installation and repair costs

______4.

Interest paid on construction loan during the building period

______5.

Survey costs by contractor

______6.

Construction insurance to cover theft or vandalism during building construction

Solution:

1. C

2. C

3. E

4. C

5. C

KP 4 BT: AP Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

6. C

9-24

Test Bank – Chapter 9 – Long-Lived Assets

SHORT PROBLEMS 1.

Lincoln Co. purchased a piece of property (land and building) at a tax sale for $110,000. Reliable estimates of the fair market values of the land and building are $34,000 and $70,000, respectively. What is the gain that Lincoln Co. should record from this advantageous purchase? Solution:

$0 (No gain is realized at time of purchase.)

KP 3 BT: AN Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting 2.

On December 1, Dominican Corp. purchased a tract of land for $325,000 to be used as a factory site. An old unusable building on the land was razed (torn down), and the salvaged materials from the demolition were sold. These cash expenditures and receipts and other costs incurred during December are as follows: Demolition of old building Proceeds from sale of salvaged materials Legal fees to transfer land title Title guarantee insurance

$11,000 5,000 3,000 1,000

Calculate the balance in Dominican’s Land account on its December 31 balance sheet. Solution:

$325,000 + $11,000 − $5,000 + $3,000 + $1,000 = $335,000

KP 4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Land and a building were purchased for $90,000. A reliable market value of the land is $40,000 and for the building, $80,000. What are the separate costs assigned to the land and building? Solution:

Land: $30,000; Building: $60,000

KP 2,3 BT: AN Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Apple Inc. purchased a used pickup truck with an advertised price of $18,900 for $17,000 cash. While Jeff, the CEO, was driving the truck to get supplies, he was stopped by a highway patrol woman and received a $50 speeding ticket and a warning for a nonfunctioning brake light. Jeff had failed to notice when this problem when he purchased the truck. If Jeff knew about the brake light condition, he would have paid only $16,500 for the car. The cost, not under warranty, of replacing the brake light was $50. Calculate the cost to be capitalized to the truck account. Solution:

$17,000

KP 2,4 BT: AN Difficulty: Easy TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 9 –Long-Lived Assets

9-25

Arnez Company purchased a building and equipment for $110,000. Although a reliable market value of the building could not be determined, the equipment's market value is $70,000. What are the separate costs assigned to the building and equipment? Solution: Equipment is assigned its fair market value of $70,000 and the remaining $40,000 is assigned to the cost of the building. KP 3 BT: AN Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

On January 1, Hampton Company paid $48,000 for a new delivery truck. It was estimated that the truck would be driven 100,000 miles during the next 5 years, at which time it would have a salvage value of $3,000. During the first and second years, the odometer registered 22,000 and 40,000 miles, respectively. How much is accumulated depreciation using the activity (miles driven) method at the end of year 2? Solution: Depreciation expense = ($48,000 – $3,000)/100,000 = $0.45 per mile Year 1: $0.45 x 22,000 = $9,900 Year 2: $0.45 x (40,000 −22,000) = $8,100 Accumulated depreciation = $18,000 KP 6 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

On January 1, 2008, Blackwell Company paid $88,000 for a new delivery truck. It was estimated that the truck would be driven 300,000 miles during the next 6 years, at which time it would have a salvage value of $7,000. At the end of the first and second years, the odometer registered 48,000 and 88,000 miles, respectively. Show how the plant asset would appear in Blackwell Company’s balance sheet at December 31, 2009 assuming the company uses the activity method depreciation. Solution: Depreciation expense = ($88,000 – $7,000)/300,000 miles = $0.27 per mile Balance Sheet Delivery Truck $88,000 Less accumulated depreciation: ($0.27 x 88,000 miles) (23,760) Book value $64,240 KP 4,6 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Harvey Ltd. purchased land and building in exchange for 50,000 shares of its stock that is trading on the New York Stock Exchange at $20 a share. Although the market values of the purchased assets are unknown, the current assessed value of the land is $300,000 and the building is $600,000. How much is assigned to the land and to the building? Solution: Total purchase = $20 x 50,000 = $1,000,000 Land = ($300,000/$900,000) x $1,000,000 = $333,333

9-26

Test Bank – Chapter 9 – Long-Lived Assets

Building = ($600,000/$900,000) x $1,000,000 = $666,667 KP 3,4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

On January 1, Bisbee Co. paid $80,000 for a new truck. It was estimated that the truck would be driven 400,000 miles during the next 8 years, at which time it would have a salvage value of $8,000. At the end of the first and second years, the odometer registered 45,000 and 97,000 miles, respectively. Calculate the book value of the truck using straight-line depreciation at the end of the second year. Solution: Depreciation expense = ($80,000 – $8,000) / 8 years = $9,000 per year Cost $80,000 Less accumulated depreciation (18,000) Book value $62,000 KP 6 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

10.

On January 1, Marriott Company paid $80,000 for a copy machine. It was estimated that the machine would produce 200,000 copies over the next 8 years, at which time it would have a salvage value of $8,000. During the first and second years, the copies totaled 24,000 and 51,000, respectively. Calculate accumulated depreciation using the doubledeclining-balance method at the end of year two. Solution: Year 1: [(2 x $80,000)/8] = $20,000 Year 2: [(2 x ($80,000 – $20,000))/8] = $15,000 Accumulated = $20,000 + $15,000 = $35,000 KP 6 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

11.

On January 1, Weston Company paid $88,000 for a copy machine. It was estimated that the machine would produce 1,000,000 copies over the next 8 years, at which time it would have a salvage value of $8,000. During the first and second years, the copies totaled 180,000 and 300,000, respectively. Calculate depreciation expense using the activity method for each of the first two years. Solution: Year 1: [(180,000/1,000,000) x $80,000] = $14,400 Year 2: [(300,000/1,000,000) x $80,000] = $24,000 KP 6 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 9 –Long-Lived Assets

12.

9-27

On January 1, equipment is purchased for $55,000 with an 8-year life expectancy and salvage value of $5,000. If the double-declining-balance method is used, calculate the book value of the equipment at the end of year 2. Solution: Year 1 = ($55,000 x 2)/8 = Year 2 = ($41,250 x 2)/8 = Total accumulated depreciation Less cost Book value

$13,750 10,313 $24,063 (55,000) $30,937

KP 6 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13.

On January 1, equipment is purchased for $40,000 with an 20-year life expectancy and salvage value of $4,000. If the double-declining-balance method is used, how much depreciation expense is recorded for the first year? Solution:

Year 1 = [(2 x $40,000)/20)] = $4,000

KP 6 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

14.

On September 30, 2010, equipment is purchased for $50,000 with a 4-year life expectancy and salvage value of $2,000. If the double-declining-balance method is used, calculate depreciation expense for the year ending December 31, 2010. Solution:

($50,000 x 2)/4 x (3/12) = $6,250

KP 6 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

15.

Zack Co. incurred the following costs related to equipment during November 2009. 1. 2. 3. 4. 5.

Purchase equipment for $90,000, terms 3/15, net 45. Paid within 15 day. Had the equipment installed and paid the installer $2,000. Paid the freight bill for the truck that delivered the equipment for $1,000. Advertised a new product that will be produced by the new equipment, $3,400. Sales taxes paid on the equipment amounted to $3,800.

Calculate the cost of the equipment. Solution:

$90,000 – $2,700 + $2,000 + $1,000 + $3,800 = $94,100

KP 4 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

9-28

16.

Test Bank – Chapter 9 – Long-Lived Assets

Carson Co. purchased a printer for $10,000, for which it paid $1,000 a month for 10 months. Carson had the option of paying $9,500 cash for the printer but chose the delayed payment plan. It cost Carson $80 to transport the printer to its place of business and $200 for installing and initial timing adjustments to the printer. Calculate the cost of the printer. Solution:

$9,500 + $80 + $200 = $9,780

KP 4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting 17.

On January 1, Barton Co. purchased land with a usable building on it for $425,000. At the time of purchase, the fair market values of the land and building were $170,000 and $340,000, respectively. What is the cost Barton should allocate to land? Solution:

($170,000/$510,000) x $425,000 = $141,667

KP 3,4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

18.

On January 1, Summers Co. purchased equipment with a 10-year life and zero salvage value for $900,000. Summers uses the straight-line method on its financial statements and double-declining-balance method on its income tax returns. By what amount does the tax deduction for depreciation exceed depreciation expense on Summers’s income statements for each of the first two years? Solution: Year 1: SL = $900,000/10 = $90,000; DDB = $900,000/10 x 2 = $180,000 Difference = $180,000 − $90,000 = $90,000 Year 2: SL = $900,000/10 = $90,000; DDB = ($900,000 − $180,000)/10 x 2 = $144,000 Difference = $144,000 − $90,000 = $54,000 KP 6 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

19.

Farmdale Company’s President purchased an extremely used automobile on November 1 by paying $2,000. He immediately had it towed to his mechanic who overhauled the auto in order to get the car ready to be safely driven. The cost of the tow was $40 and the initial overhaul was $1,500. While driving from his mechanic’s garage, he ran over a nail that punctured a tire and cost $35 to repair. Calculate the cost of the auto. Solution:

$2,000 + $40 + $1,500 = $3,540

KP 4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 9 –Long-Lived Assets

20.

9-29

On April 1, Tarpon Co. made the following expenditures on its printing press: Purchase of stapling attachment Installation of attachment Cleaning and oiling press costs prior to renovation Replacement parts for renovation of printing press Labor used in press renovation

$8,000 2,000 1,000 1,000 3,000

The renovation increased the expected life and the attachment increased the productivity of the press. What are the total expenditures capitalized to the printing press? Solution:

$8,000 + $2,000 + $1,000 + $1,000 + $3,000 = $15,000

KP 4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

21.

On April 1, 2004, Cardot Co., which uses straight-line depreciation, purchased equipment for $60,000 with a useful life of 7 years and $4,000 salvage value. On April 1, 2008, the equipment was sold for $30,000. What gain should Cardot recognize as a result of this disposition? Solution: Expense = ($60,000 – $4,000)/7 x 4 years = $32,000 Gain = $30,000 – [$60,000 – $32,000] = $2,000 KP 7 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Use the information that follows concerning Harrahs, Inc. to answer problems 22 through 24. Harrahs Corporation purchased a dump truck at the beginning of 2008 at a cost of $60,000. The truck had an estimated life of 5 years and an estimated residual value of $5,000. On January 1, 2010, the company made major repairs of $3,000 to the truck that extended its life 2 more years. Starting with 2010, the truck has a remaining life of 5 years. The company uses the straight-line depreciation method. 22.

How much is the book value of the truck to be reported on the balance sheet at the end of 2009? Solution: Annual depreciation: ($60,000 – $5,000)/5 = $11,000 Book value at 12-31-2009: $60,000 – $11,000 – $11,000 = $38,000 KP 6 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

9-30

23.

Test Bank – Chapter 9 – Long-Lived Assets

What amount should be recorded as depreciation expense each year starting in 2010? Solution: Annual depreciation: ($60,000 – $5,000)/5 = $11,000 Book value at 12-31-2009: $60,000 – $11,000 – $11,000 = $38,000 2010 depreciation: ($38,000 + $3,000 – $5,000)/5 = $7,200 KP 6 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

24.

If Harrahs sells the truck at the end of 2010 for $20,000 cash, how much gain or loss would be recognized? Solution: Annual depreciation: ($60,000 – $5,000)/5 = $11,000 Book value at 12-31-2009: $60,000 – $11,000 – $11,000 = $38,000 2010 depreciation: ($38,000 + $3,000 – $5,000)/5 = $7,200 Accumulated depreciation at end of 2010 = $11,000 + $11,000 + $7,200 = $29,200 Loss on disposal: $20,000 – ($63,000 – $29,200) = ($13,800) KP 7 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

25.

Calculate depreciation expense for each of the first two full years of life for an airplane with a cost of $600,000, residual value of $40,000, and an estimated life of 4 years under the double-declining-balance depreciation method. Solution: Year 1: $600,000 x 2/4 = $300,000 Year 2: ($600,000 – $300,000) x 2/4 = $150,000 KP 6 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

26.

Courtney Corp. has significant stock that can be issued by the company. The managers are planning to sell the stock for a large profit by fraudulently inflating reported earnings. They plan to sell the stock after current earnings are reported, then leave for the carnival in Brazil. To accomplish their devious plans, they purchased inventory for $800,000 and charged the inventory purchase to equipment that is being depreciated using the straight-line method with a life of 8 years and no salvage value. If beginning and ending inventories were correctly stated and a full year's depreciation is recognized on the equipment, what is the amount of Courtney’s current net income overstatement? Solution:

$800,000 – ($800,000/8) = $700,000

KP 3,6 BT: AN Difficulty: Moderate TOT: 3min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 9 –Long-Lived Assets

27.

9-31

Raymond Corporation is a new business that recycles consumption leftovers. The investors in Raymond’s stock, expecting losses in the early stages of business, are impressed with its early net incomes resulting in the ballooning of its stock price to $32 a share. During the second year of operations, Raymond’s reported net income of $1,300,000. However, a few months later, independent auditors reported existence of accounting irregularities concerned with the capitalization of $3 million dollars of expenditures to Raymond’s land account that should have been expensed. What is the appropriately adjusted net income for the second year of operations? Solution:

$1.3 M – $3.0 M = $1.7 million loss

KP 3 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

28.

The balance in accumulated depreciation on January 1 and December 31 is $60,000 and $70,000, respectively, during a year in which an asset with a cost of $20,000 and net book value of $5,000 was sold for $3,000. Calculate the amount of depreciation expense for the current year. Solution:

$70,000 + [$20,000 – $5,000] – $60,000 = $25,000

KP 6 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Use the information that follows to answer problems 29 through 31. Laney Inc. and Monroe Company each ordered a new computer on January 1, 2009. The cost of each computer was $3,500. The economic life expectancy of each computer is three years with a $500 expected salvage value. During the current year Laney and Monroe experienced identical operating events with the only difference being that Laney used the straight-line depreciation method, while Monroe used the double-declining-balance depreciation method. Both became disenchanted with their computers during the year due to the introduction of a new generation of computers, and on December 31, 2009, each sold the computer for $800. 29.

Calculate Laney’s depreciation expense and loss (gain) from the disposal of the computer. Solution: Depreciation expense using the straight-line method = (1/3) x ($3,500 – $500) = $1,000 Loss from the disposal of the computer: $800 – ($3,500 – $1,000) = ($1,700) KP 6,7 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

9-32

30.

Test Bank – Chapter 9 – Long-Lived Assets

Calculate Monroe’s depreciation expense and loss (gain) from the disposal of the computer. Solution: Depreciation expense: ($3,500 x 2/3) = $2,333 Loss from the disposal of the computer: $800 – ($3,500 – 2,333) = ($367) KP 5 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

31.

Indicate how the current year's net income statements for Laney and Monroe would differ. Solution: Laney: Depreciation expense using the straight-line method = (1/3) x ($3,500 – $500) = $1,000 Loss from the disposal of the computer: $800 – ($3,500 – $1,000) = ($1,700) Total income statement effect = ($1,000) + ($1,700) = ($2,700) Monroe: Depreciation expense: ($3,500 x 2/3) = $2,333 Loss from the disposal of the computer: $800 – ($3,500 – $2,333) = ($367) Total income statement effect = ($2,333) + ($367) = ($2,700) The bottom line net incomes for both companies would be the same. However, Laney has a $1,333 greater operating net income that is neutralized by a $1,333 greater loss from the disposal of the computer, which is included in other revenues and expenses. KP 3,6,7 BT: AN Difficulty: Moderate TOT: 6 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

32.

Mondova Corporation began operations on January 1. Below is Mondova’s current net income statement and December 31 balance sheet calculated using straight-line depreciation. Income Statement Sales revenue Cost of goods sold Gross profit Depreciation (Note 1) Net income Balance Sheet Current assets Equipment Accumulated depreciation Total assets Liabilities (all current) Shareholders' equity Total liabilities & shareholders’ equity

$20,000 9,000 $ 11,000 3,000 $ 8,000 $44,000 $20,000 3,000

17,000 $61,000 $45,000 16,000 $61,000

Note 1: Equipment was purchased on January 1. Straight-line depreciation method was used with an estimated economic life of 5 years.

Test Bank – Chapter 9 –Long-Lived Assets

9-33

A. Determine the estimated salvage value of the equipment being depreciated using the straight-line method. B. Prepare an income statement and balance sheet in the same format as presented above assuming that Mondova Corporation uses the double-declining-balance depreciation method. The equipment has an estimated economic life of 5 years. C. Calculate and compare Mondova’s December 31 current ratio, debt/equity ratio, and debt to assets ratio using the financial statements constructed using the straight-line and double-declining-balance methods of depreciation. Solution: A. Straight-line depreciation expense = (1/life) x (cost - salvage) 3,000 = 1/5 x ($20,000 – S.V.) Salvage value = $5,000 B. DDB Depreciation expense and accumulated depreciation = 2/5 x $20,000 = $8,000 Income Statement Sales revenue Cost of goods sold Gross profit Depreciation (Note 1) Net income

$20,000 9,000 11,000 8,000 $ 3,000

Balance Sheet Current assets Equipment Accumulated depreciation Total assets

$44,000 $20,000 8,000

Liabilities (all current) Shareholders' equity Total liabilities & shareholders’ equity

12,000 $56,000 $45,000 11,000 $56,000

C. Current ratio Debt/Equity Debt/Assets

Straight-line 0.98 2.81 0.74

DDB 0.98 4.09 0.80

The current ratio is not affected by alternative depreciation methods used because the measure of current assets and current liabilities is not influenced by depreciation measurements. However, total assets and net income (retained earnings portion of shareholders' equity) are decreased when the double-declining-balance depreciation method is used instead of straight-line. Hence, the debt/assets and debt/equity ratios increased (deteriorated) when the accelerated depreciation method is applied during the early portion of the asset's life. KP 2,3,6 BT: AN Difficulty: Difficult TOT: 15 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

9-34

33.

Test Bank – Chapter 9 – Long-Lived Assets

Several years ago, Welch Company purchased a copyright. Amortizing occurs on a straight-line basis over its estimated useful life. The company’s balance sheets follow at December 31, 2009, and 2008: (In thousands)

December 31, 2009

December 31, 2008

$132,000

$135,000

A. How much amortization expense did Welch record during 2009? B. Calculate the original cost of the patent. C. As of December 31, 2009, over how many years has Welch amortized the copyright? Solution: A. $3,000 B. $15,000 + $135,000 = $150,000 C. $18,000 / $3,000 = 6 years KP 6 BT: AN Difficulty: Moderate TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

34.

On January 1, the balance in accumulated depreciation is $28,000. During the current year depreciation expense is $10,000 and equipment with a cost of $9,000 was sold for $3,000 at a loss of $1,000. Calculate the December 31 balance in accumulated depreciation. Solution:

$28,000 + $10,000 – [$9,000 – $3,000 – $1,000] = $33,000

KP 6 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

35.

The balance of accumulated depreciation on January 1 and December 31, 2008 is $54,000 and $58,000, respectively. During 2008, depreciation expense is $18,000, and equipment with a cost of $20,000 is sold for $4,000. Calculate the loss or gain from the sale of equipment. Solution: $58,000 – $18,000 – $54,000 = $14,000 accumulated depreciation removed $20,000 – $14,000 – $4,000 = $2,000 loss KP 7 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 9 –Long-Lived Assets

9-35

SHORT ESSAY QUESTIONS 1.

Dorman Company purchased a new web server on January 1. The following information and expenditures related to this acquisition were made: List price Cash price paid Transportation-in Insurance during transport Interest paid for the current year related to financing the web server Installation cost One-year maintenance contract Disk drive installed into the web server

$5,000 4,200 300 100 240 200 400 1,000

Specify and justify which of the preceding expenditures should be added to the cost of the web server and disclose that cost. Indicate how the expenditures excluded from the cost of the web server would be classified. Solution: The cost of the web server is its cash or cash equivalent price plus all expenditures necessary to get the asset in place and ready for its intended use. The list price does not measure the web server's cash price and therefore is irrelevant information. The cost includes the cash price ($4,200), transportation-in ($300), insurance during transport ($100), installation costs ($200), and the cost of the disk drive ($1,000). Hence, the total cost of the web server is $5,800. Interest paid for financing the purchases ($240) and the cost of the one-year maintenance contract ($400) are expensed during the first year of web server use. KP 2,4 BT: AN Difficulty: Moderate TOT: 7 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Many years ago, a well-known American company publicly advertised with the slogan "Our most important asset is our employees". More recently, other companies have realized that quality employees working in an excellent work environment that respects those employees produce quality products at a reasonable cost. Although this may be the foundation for American companies to become more internationally competitive, on the balance sheet and in your chapter on long-lived assets, there is no recognition of an employee asset. Why is there not an asset on the balance sheet that recognizes the contribution of employees to the future profit-making ability of a firm? Solution: Usually the difficulty of objectively measuring the contribution of a quality work force and excellent work environment is used to justify the exclusion of human assets from the balance sheet. In a wage labor organization of production consistent with capitalism, the employer purchases the employees' time, not the employee him/herself. Although the employer has considerable influence over employees, he/she does not own nor possess nor totally control those employees, as does the owner of an asset that is recognized on the balance sheet. KP 1,2 BT: AP Difficulty: Difficult TOT: 7 min. AACSB: Analytic, Communication, Diversity AICPA BB: Critical Thinking AICPA FN: Measurement

9-36

Test Bank – Chapter 9 – Long-Lived Assets

On January 1, 2009, Tavis Corp. sold a piece of equipment for $10,000 that it had used for several years. The equipment had cost $50,000, and the accumulated depreciation account had a balance of $34,000 at the time of the sale. Describe the effects on the accounting equation of selling the equipment. Solution: The entry to record the sale of a plant asset has the net effect of reducing assets and owners’ equity each by $6,000. Three items are impacted in the asset section of the balance sheet. First, cash is increased by $10,000. Second, the cost of the equipment, $50,000, is removed from assets. Third, the accumulated depreciation associated with the plant asset sold is removed from the accumulated depreciation account, thereby increasing assets by $34,000. The decrease in owners’ equity is a result of the $6,000 loss associated with the disposal. KP 7 BT: AN Difficulty: Moderate TOT: 6 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Identify the role of the matching principle in accounting for long-lived assets. Solution: Costs of long-lived assets are capitalized and reported as assets on the balance sheet. The estimated useful life is used as a basis for estimating the period of time in which the cost of the asset will be allocated. The depreciation method is chosen based on what method will best allocate the cost of the asset incurred to accounting periods in which the respective revenue was earned. KP 1 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

What primary objective should management attempt to accomplish when selecting the depreciation method for tax purposes? Solution: Management should use the depreciation strategy that provides the greatest economic benefit for the company. This normally means that management should choose the shortest allowable time and the most extreme form of accelerated depreciation. These methods save tax dollars in the early years of the assets’ lives, and thereby minimize the cash flows needed to make tax payments. KP 6 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

What problems are inherent in recording trade-ins of plant assets? Solution: It is difficult to determine the dollar amount at which the asset received should be valued on the balance sheet. The asset received in a trade-in should be valued on the balance sheet at either the fair market value of the assets given up, or the fair market value of the assets received, whichever is clearly more evident and objectively determinable. KP 7 BT: AP Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 9 –Long-Lived Assets

9-37

How do intangible assets differ from long-lived plant assets? Solution: Intangible assets are characterized by having rights, privileges, and benefits of possession with no physical existence. Plant assets are tangible and have a physical existence. Both are used in the operations of the business and provide benefits that extend beyond the current accounting period. KP 1,4 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

During a meeting of top executives of the Alcorn Corporation, a discussion of the current downturn of sales and profits was taking place. Expecting vigorous competition to extend this difficult situation well into the next decade, the executives searched for ways to soften its impact on the financial statements. Attention was focused upon the company controller who was answering inquiries concerning the possibility of changing accounting procedures in order to give shareholders' the "best view from a bad situation". Responding to the inquiries, the controller authoritatively observed: "Alcorn uses a 10year expected life on its long-term assets and a salvage value equal to 5% of cost in calculating depreciation expense using the straight-line method. This policy was quite conservative in light of the industry average of a 15-year life expectancy and a 10% of cost salvage value. In light of the 3 billion dollars of depreciable assets (net book value), switching to the industry average would certainly improve the measured results of operations." Everyone was thrilled about the possibility of improving measured profits except for one middle-top executive. She questioned whether the switch would be acceptable to the auditor. The controller responded that switching to industry average expectations would not violate GAAP and would be acceptable to the auditor (whose firms depends greatly on Alcorn’s account). Alcorn would disclose the change in the footnotes and the effect of this change on accounting estimates in the current year's net income. The questioning executive would not object to the plan to liberalize income measurement, but stated that it has always been known as a most conservative firm. And if things ultimately go from bad to worse, Alcorn may get some negative press concerning the change because of the appearance of delaying disclosure on the income statement of the financial trouble Alcorn is facing. It was decided to change the depreciation policy using the industry average expected life and salvage value. Comment on this change of depreciation measurement in light of generally accepted accounting principles and the problem of appearance. Include the amount of increase in net income caused by this change in depreciation parameters. Solution: Changing estimated life from 10 years to 15 years and salvage value from 5% to 10% of cost decreases annual depreciation expense on $3 billion of net assets by $105 million (from $285 million to $180 million). This significant increase in measured profits can certainly be justified under GAAP. After all, Alcorn is only changing depreciation parameters to that typically acceptable in the industry. (This can be referred to as the teenage justification: Everyone else is doing it.) Full disclosure of the change and its effect on the financial statements minimizes criticism. The auditor would not be justified in rejecting the changes in estimated life and salvage value that are acceptable in the industry. However, the general population interested in Alcorn’s financial position and results of operations may not consider the change in such a narrow accounting viewpoint. If Alcorn continues its financial slide, changes in accounting measurements will ultimately not be able to continue the liberal measures of Alcorn’s income statement and balance sheet. Ultimately, Alcorn may have to restructure operations by closing down plants and laying off employees. This results in huge charges (restructuring losses) against net income. Less depreciation expense now will result in more

9-38

Test Bank – Chapter 9 – Long-Lived Assets

restructuring losses later. (The piper will have to be paid.) At this time, the parties interested in Alcorn and those taking large losses on their investments in its stock will question the intent of such accounting changes. Alcorn is considered the steward of conservatism in accounting. This reliance and the ultimate disappointment will only cause the users of accounting information to question the reliability and usefulness of financial statements. KP 5,6 BT: AN Difficulty: Difficult TOT: 9 min. AACSB: Analytic, Communication, Reflective AICPA BB: Critical Thinking AICPA FN: Measurement

What are post-acquisition expenditures? How are they accounted for? Solution: Post-acquisition expenditures are costs that either improve an existing asset, not merely maintain it, or increase its useful life. Costs incurred to improve the asset are called betterments, and are capitalized as part of cost of the asset. Costs incurred to repair or maintain the assets’ current level of productivity are classified as maintenance. Maintenance costs are expensed immediately and reported on the income statement. KP 5 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

10.

How should management choose an acceptable cost allocation method for accounting purposes? Solution: The primary selection factor should be based on how well the cost allocation method matches expenses against the revenues produced. The straight-line method should be used in situations where revenues are constant across a period of time. The accelerated methods assume that revenues are higher in early periods and lower in later periods. The activity method assumes that revenues are generated in proportion to the assets’ activity. Management often chooses a method based on its desired effect on important financial ratios that are used by shareholders, investors, and creditors to evaluate management performance. The tax effects of different depreciation choices are also taken into consideration. KP 6 BT: AP Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

11.

Identify the steps necessary in recording the retirement of the long-lived asset. Solution: First, remove the cost basis of the asset with a credit to the specific plant asset account. Second, remove the associated accumulated depreciation with a debit. Record the cash received, if any, as a debit to Cash. Finally, if the selling price exceeds the asset’s book value, record a gain by crediting, “Gain on Retirement of Plant Assets,” or if the selling price was less than the asset’s book value, record the loss by debiting “Loss on Retirement of Plant Assets.” KP 7 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 9 –Long-Lived Assets

12.

9-39

Intangible assets can be divided into two broad categories; those with definite lives, and those with indefinite lives. Assets with indefinite lives are not subject to amortization while those with definite lives are. Explain why this is the case and give at least one example of an intangible asset with a definite life and one example of an intangible asset with an indefinite live. Solution: Copyrights and patents are examples of intangible assets with definite lives. Goodwill, trademarks, and organization costs, are examples of intangible assets with an indefinite life. Assets with indefinite lives are not subject to amortization because their cost can’t be allocated to a finite number of accounting periods, when their lives are infinite or indeterminable. Intangible assets with definite lives are amortized over their legal or useful lives, whichever is shorter. KP 2,7 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

13.

How do long-lived assets differ from inventory? Solution: Long-lived assets are assets used in the operations of the business, providing benefits that extend beyond the current accounting period. Inventory assets are classified as current on the balance sheet and are expected to help produce income (sold) in the current accounting period. Inventory assets are held for sale and are not used in the operations of the business, whereas long-lived assets are used to produce income. KP 1 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

14.

The Dayton Symphony recently acquired cellist Carlos Romono from the Cincinnati Symphony in exchange for violinist Elton Daal. These artists’ contracts are capitalized and reported as assets by the symphonies. What complications arise in determining the cost of each artist’s contract for accounting purposes? Solution: The asset received in a trade-in should be valued on the balance sheet at either the fair market value of the asset given up, or the fair market value of the asset received, whichever is clearly more evident and objectively determinable. The fair market value of the asset Dayton received (Carlos) is objectively hard to determine and may be difficult to quantify. The amount one symphony is willing to “pay” and another symphony is willing to accept is the best approach to determine a true fair market value. Since neither of these artists is being “sold” out right, this transaction represents a true absence of the real fair market value of either artist. A best guess at fair market value will have to suffice. KP 7 BT: AP Difficulty: Moderate TOT: 5 min. AACSB: Analytic, Communication, Reflective AICPA BB: Critical Thinking AICPA FN: Reporting

9-40

Test Bank – Chapter 9 – Long-Lived Assets

IFRS QUESTIONS 1.

Under IFRS a special land account is often found on the balance sheet. This account is called: a. Land Improvements b. Depreciable Land c. Investment Property d. Accumulated Depreciation – Land KP 6 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

A significant difference in depreciation accounting between US GAAP and IFRS accounting is that in IFRS: 1. Management has the option of periodically revaluing property, plant and equipment to market value 2. Management is mandated to revaluing property, plant and equipment to market value 3. Management may use hypothetical future value in depreciating assets 4. There are no differences in depreciation accounting between US GAAP and IFRS KP 6 BT: A Difficulty: Easy TOT: 1 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

In respect to accounting for fixed assets, IFRS appears to be: 1. Moving away from market-value accounting and toward historical cost accounting 2. Moving toward market-value accounting and away from historical cost accounting 3. Moving toward hypothetical future value accounting 4. There is no discernable trend KP 6 BT: B Difficulty: Easy TOT: 1 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Chapter 10 Introduction to Liabilities: Economic Consequences, Current Liabilities, and Contingencies MULTIPLE CHOICE QUESTIONS 1.

The recognition of a deferred tax liability that results from the use of straight-line depreciation on financial statements and double-declining balance on tax returns will a. increase the current ratio. b. increase the debt/equity ratio. c. increase the quick ratio. d. decrease the debt/asset ratio. Ans: B KP App10B BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Net worth is a. assets plus liabilities. b. total income since the company began operations. c. total shareholders' equity. d. another name for net income. Ans: C KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Which one of the following events increases working capital? a. Purchase of inventory on credit b. Payment of an installment of notes payable c. Payment of sales taxes for the state d. Selling merchandise on credit at a profit Ans: D KP 2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

An employee of Susann Inc. failed two drug tests. The employee has sued and Susann Inc.’s. lawyers appropriately believe that, at best, it is only reasonably probable that Susann Inc. will lose the court case. The proper accounting treatment of the lawsuit will a. increase earnings per share. b. increase the debt/asset ratio. c. decrease the current ratio. d. not affect the debt/equity ratio. Ans: D KP 2 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

10-1

10-2

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

Which one of the following events does not have any impact on total working capital? a. The board of directors declares a cash dividend to be paid next month. b. Warranty expense is accrued. c. Payment of salaries previously accrued. d. Debt which was previously long-term matures next year. Ans: C KP 2,4 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

If the current ratio is currently greater than 1.0, which one of the following events would increase the current ratio? a. Purchase of inventory on account b. Receipt of money from a customer prior to the performance of service c. Warranty expense is accrued d. Sale of plant asset at a gain Ans: D KP 2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

If the quick ratio is currently greater than 1.0, which one of the following events would increase the quick ratio? a. Warranty expense is accrued. b. A cash dividend previously declared is paid. c. Long-term debt is paid off. d. Inventory is purchased on account. Ans: B KP 2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Which one of the following events decreases the debt/asset ratio? a. Bonds are retired with a gain. b. Warranty expense is accrued. c. Some of the long-term debt matures next year. d. The board of directors declares a cash dividend to be paid next month. Ans: A KP 2 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Which one of the following transactions decreases a company’s quick assets? a. The board of directors declares a cash dividend to be paid next month. b. Salary expense is accrued. c. Depreciation expense is recorded. d. A prepaid account is created due to the payment of insurance in advance. Ans: D KP 1 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

10.

10-3

Which one of the following is the result of the amortization of a discount on a short-term note payable? a. Increases assets and decreases liabilities b. Decreases assets and increases liabilities c. Increases liabilities and decreases shareholders' equity d. Decreases liabilities and owners’ equity Ans: C KP 4 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

11.

One of Tonic Corp’s employees invented a revolutionary coffee lid that cools coffee as you drink it in order to prevent burns. Two children ordered coffee and burned their mouths after failing to properly secure the lids. The children’s parents sued. Tonic Corp’s. lawyers believe that it is highly probable that judgment will be rendered against Tonic Corp and it is likely a payment in excess of $2 million will be incurred. The proper accounting treatment of the lawsuit will a. decrease total liabilities. b. increase total liabilities. c. increase the current ratio. d. require accountants to wait until the suit is settled to account for the event. Ans: B KP 6 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

12.

Accounts payable typically arise because a. cash is received from a customer that will be paid back in the future. b. cash is received from customers prior to the rendering of services or delivery of products. c. the firm temporarily borrows cash for operations. d. amounts are owed to others for goods, supplies, and services purchased on open account. Ans: D KP 3,4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13.

Collecting sales taxes from customers a. decreases net income. b. increases the debt/equity ratio. c. increases the current ratio. d. decreases net worth. Ans: B KP 2,4 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

10-4

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

14.

If a contingent loss is accrued, this would: a. decrease the debt/equity ratio. b. decrease the debt/asset ratio. c. decrease the current ratio. d. have no change on the quick ratio. Ans: C KP 4,6 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

15.

Short-term notes payable typically arise because a. the firm temporarily requires cash for operations. b. cash is received from customers prior to the rendering of services or delivery of products. c. the board of directors have declared a dividend that will be paid at a later date. d. cash is received as security that will be paid back in the future. Ans: A KP 3,4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

16.

Dividends payable typically arise because a. creditors want a return on funds loaned to a company. b. cash is paid for dividends previously declared in another accounting period. c. the board of directors declare a dividend that will be paid at a later date. d. bond investors demand a return. Ans: C KP 3,4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

17.

If a loss contingency related to a lawsuit against a firm is deemed to have a reasonable probability of requiring ultimate payment, then the proper accounting treatment of the loss contingency will a. require note disclosure. b. decrease the debt/asset ratio. c. increase the accounts payable/sales ratio. d. decrease the debt/equity ratio. Ans: A KP 6 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

18.

Unearned revenue typically arises because a. cash is received as security that will be paid back in the future. b. cash is received from customers prior to the rendering of services or delivery of products. c. a company temporarily requires cash for operations. d. merchandise is sold to customers prior to payment. Ans: B KP 3,4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

19.

10-5

Deposits payable may arise because a. cash deposits are received from customers for layaways. b. cash is paid to a creditor as a security deposit that will be refunded in the future. c. the company deposits sales receipts too early. d. merchandise is delivered to customers prior to payment. Ans: A KP 3,4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

20.

Accruing warranty expense will a. increase the debt/equity ratio. b. increase the current ratio. c. reduce uncollectible accounts during the period. d. increase inventory turnover. Ans: A KP 6 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

21.

If a loss contingency related to a lawsuit against a firm is deemed to have a remote probability of requiring ultimate payment, then the proper accounting treatment of the loss contingency will a. increase the debt/equity ratio. b. increase the debt/asset ratio. c. have no effect on earnings per share. d. increase the quick ratio. Ans: C KP 6 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

22.

An increase in a deferred tax liability is recognized when a. the tax accountant omits taxable revenue from the tax returns. b. net income measured under GAAP is greater than taxable income on tax returns because of temporary timing differences. c. the amount of tax paid to the government is more than that calculated by the accountant on the company’s tax return. d. a tax audit by the IRS causes an increase in taxes due from a previous year’s tax return. Ans: B KP App10B BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

23.

Contingent liabilities whose ultimate payment is highly probable and can be reasonably estimated must be a. ignored until actual payment is made. b. disclosed only in the footnotes to the financial statements. c. recorded in the body of the balance sheet. d. disclosed in the auditor's report. Ans: C KP 6 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

10-6

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

24.

Contingent liabilities whose ultimate payment is remote should be a. recorded in the body of the balance sheet. b. disclosed in the footnotes to the financial statements. c. disclosed in the auditor's report. d. ignored. Ans: D KP 6 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

25.

Contingent liabilities whose ultimate payment is reasonably probable should be a. recorded in the body of the balance sheet. b. disclosed in the footnotes to the financial statements. c. ignored. d. disclosed in the auditor's report. Ans: B KP 6 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

26.

If a loss contingency related to a lawsuit against a firm is deemed to have a high probability of requiring ultimate payment and can be reasonably estimated, then the proper accounting treatment of the loss contingency will a. decrease the debt/equity ratio. b. decrease the debt/asset ratio. c. decrease earnings per share. d. increase net income. Ans: C KP 6 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

27.

Sweeney, Inc. borrowed $30,000 from the bank by signing a 9-month note payable. The proper accounting treatment of recording the note will a. increase assets and liabilities. b. decrease assets and increase liabilities. c. increase liabilities and owners’ equity. d. increase assets and decrease owners’ equity. Ans: A KP 4 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

28.

An income tax accrual at yearend will most likely a. decrease earnings per share. b. decrease the debt/asset ratio. c. decrease the debt/equity ratio. d. be a contingency. Ans: A KP 4 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

29.

10-7

Ranch Company estimates warranty expense as 5% of sales. On January 1, warranties payable was $13,000. During the year Ranch paid $5,000 to meet its warranty obligations and recorded sales of $120,000. The December 31 liability for the warranty is a. $10,000. b. $12,000. c. $6,000. d. $14,000. Solution:

$13,000 + ($120,000 x 5%) − $5,000 = $14,000

Ans: D KP 6 BT: AP Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

30.

Which one of the following would increase the bonus for a CEO who is paid a bonus equal to a percentage of current GAAP net income? a. Recording a decrease in the company’s self-insured worker’s compensation expense b. Decreasing the estimated life of plant and equipment by an average of 8 years c. Increasing wages for the warehouse employees d. Collecting payments in advance from customers Ans: A KP 5 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

31.

A suit for breach of contract seeking damages of $3,000,000 was filed against Clark Corporation on March 1, 2009. Clark’s legal counsel believes that a negative outcome is highly probable. A reasonable estimate of the court’s award to the plaintiff is $600,000. Settlement is expected to occur during the latter part of 2009. What accounting is necessary for the year ending June 30, 2009? a. Note disclosure only b. Accrue a contingent liability of $3,000,000 and provide note disclosure explaining the contingency c. Accrue a contingent liability of $600,000 and provide note disclosure explaining the contingency d. No disclosure or accrual necessary Ans: C KP 3 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

32.

Abbott Co. has 5 employees who worked the entire year. Each employee earns 6 paid vacation days annually. Vacation days may be taken during December of 2009 and all of 2010. All unused vacation days are paid when the employee leaves the company. The daily wage in 2009 per employee is $100. This is an example of a. a definite liability. b. a third party liability. c. a gain contingency. d. unearned revenue. Ans: A KP 3,4 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

10-8

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

33.

Which one of the following is a current liability? a. Portions of notes payable due beyond the next accounting period b. Sales taxes paid on new equipment acquired c. Estimated costs of hurricanes which might develop in the Caribbean during next hurricane season d. Football tickets sold to customers for games in the coming season Ans: D KP 1,4 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

34.

Current liabilities include a. amounts due from suppliers for credits on accounts given on returns which had previously been paid. b. taxes withheld from employees' payroll checks which must be remitted to the IRS. c. amounts paid for warranty repairs during the current year. d. cash dividends to be declared by the board of directors during the next six months. Ans: B KP 1,3,4 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Use the information from Cen, Inc. to answer questions 35 and 36. Cen, Inc. reported the following on its December 31, 2010, balance sheet: Current liabilities: One-year short-term notes payable, net of discount of $300 and $400, respectively Accrued interest on notes payable Current portion of long-term debt Trade accounts payable

35.

2010 $ 9,800

2009 $6,400

340 1,250 500

280 2,340 700

How much is the maturity value of the one-year note payable that is outstanding at the end of 2010? a. $9,500 b. $9,800 c. $10,100 d. $10,400 Ans: C KP 4 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

36.

Which statement is true concerning Cen’s interest? a. Central paid a total of $60 interest during 2010. b. Interest was incurred during the year on more than one note. c. Interest of $3,200 was accrued and paid during 2010. d. The ‘accrued interest on notes payable’ amount relates to the one-year short-term notes payable. Ans: B KP 4 BT: AP Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

37.

10-9

Which one of the following would most likely be reported as a current liability? a. Frequent flyer program miles accumulated by airline travelers b. Self insurance risks on anticipated losses c. Customers merchandise returns exchanged for different merchandise d. The CEO’s stock option package for the current year Ans: A KP 4,5 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

38.

Liabilities are a. sometimes credit and other times debit balances. b. deferred amounts which will be recognized on the balance sheet when the actual due date arrives. c. obligations arising from past transactions and payable in assets or services in the future. d. obligations to transfer ownership of one company to other entities. Ans: C KP 1 BT: K Difficulty: Easy TOT: 1 min. AACSB: Measurement AICPA BB: Critical Thinking AICPA FN: Reporting

39.

What business transaction must occur in order to reduce Estimated Warranty Payable? a. Goods under warranty are repaired in the period after the sale b. Warranty costs are accrued at the end of the accounting period c. Sale of goods on account d. Customers take advantage of cash discounts for early payment Ans: A KP 3 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

40.

A contingent liability a. is definite in existence, but its amount and due date are not yet known. b. has the same requirements as a contingent gain. c. must be accrued even when it is not reasonably estimable. d. is disclosed only in the financial statement notes if highly probable and the amount can be estimated. Ans: A KP 3,6 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

41.

Gain contingencies a. should be accrued when probable and the amount can be reasonably estimated. b. are reported as revenues on the income statement. c. should be accrued for anticipated lottery winnings. d. are almost never accrued and are rarely disclosed. Ans: D KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

10-10

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

42.

A company has a decreasing current ratio. Creditors should be concerned a. with long-term solvency. b. about the company’s ability to pay current debts as they come due. c. about the company’s profitability. d. about whether earnings per share is increasing or decreasing. Ans: B KP 2,4 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

43.

A pension is a. a cost such as health insurance paid on behalf of a retired or disabled employee. b. a contingent inflow of cash anticipated from assets earning interest. c. required of all employers. d. usually determined by the employees’ years of service. Ans: D KP App10A BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

44.

Alpine, Inc. sells baseball tickets for professional baseball games. Cash receipts for baseball tickets are credited to Unearned Ticket Revenue. During 2010, Alpine collected $30,000 for a September, 2010 baseball game and $42,000 for a March, 2011 baseball game. The September game was played as scheduled, although $2,000 of tickets was refunded to fans that canceled because they had been permanently kicked out of the stadium for disorderly conduct. How much should be reported as Unearned Ticket Revenue at December 31, 2010? a. $0 b. $42,000 c. $72,000 d. $40,000 Ans: B KP 3,4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

45.

A measure of the extent to which reported income is conservative is called a. ERISA. b. a gain contingency. c. the conservatism ratio. d. a line of credit. Ans: C KP App10B BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

46.

10-11

Warranties should be accrued if it is a. probable that an expense will be incurred and the amount is reasonably estimable. b. possible that an expense will be incurred regardless of whether the amount is estimable or not. c. possible that an expense will be incurred and the amount is reasonably estimable. d. remote that any costs will be incurred. Ans: A KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

47.

In addition to recognizing income tax expense, the accounting necessary to record income taxes requires a. a credit to income tax payable based on net income times the tax rate. b. a debit to the income tax expense account for the amount of cash that must be paid for taxes. c. computations of the amounts to record in the deferred income tax account. d. all companies to report taxable income on the income statement Ans: C KP App10B BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

48.

Two types of differences exist between computing income for tax purposes and computing income for financial accounting purposes. The differences are a. defined benefit taxes and defined contribution taxes. b. deferred tax assets and deferred tax liabilities. c. revenues and expenses. d. temporary and permanent. Ans: D KP App10B BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

49.

The economic essence of one of the following should not be reported in the balance sheet as a current liability. Which one is not reported? a. Free sandwich offers printed on hockey ticket stubs b. Amounts sued for damages associated with injuries from an allegedly defective weed eater c. Mail-in rebates from software by software companies d. Amounts payable to an employee for a recent expense report Ans: B KP 1,4 BT:C Difficulty: Difficult TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

10-12

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

50.

A defined benefit plan differs from a defined contribution plan in that a defined benefit plan a. has a liability that must be actuarially computed. b. is required by ERISA. c. requires a corporation to make a series of payments of a specified amount to a pension fund. d. requires journal entries, and the defined contribution plan does not. Ans: A KP App10A BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

51.

Pension expense is a. accrued each period as employees require payments. b. recognized as a long-term deferred asset. c. accrued as employees earn their rights to future benefits. d. calculated by dividing an employee’s annual salary into the number of years the employee is expected to require pension payments. Ans: C KP App10A BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

52.

Simpson Incorporated sells fishing lures and monofilament leader material. During June, Simpson distributed 6,000 coupons to receive a free lure to each customer who purchased a dozen spools of monofilament leader material. Through December 31, 2010, Simpson honored 1,200 coupons redeemed. Simpson expects a total of 5,200 total coupons to be redeemed. Simpson sells lures for $1.00 each. The cost of each lure to Simpson is 45 cents. How much should Simpson report as a liability at December 31, 2010? a. $6,000 b. $1,800 c. $3,600 d. $2,340 Solution:

($5,200 − $1,200) x $0.45 = $1,800

Ans: B KP 3,4 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

53.

10-13

= =

Current Assets ÷ Current Liabilities ($120,000 + $50,000) ÷ $68,000 = 2.50

Ans: B KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

54.

Jake Company borrowed $100,000 from Guaranty Trust Bank to finance the purchase of new equipment. The loan contract provides for a 12 percent annual interest rate and states that the principal must be paid in full in ten years. The contract also requires that Jake maintains a current ratio of 1.5:1. Before Jake borrowed the $100,000, the company’s current assets and current liabilities were $120,000 and $68,000 respectively. If Jake invests $50,000 of the borrowed funds in equipment and keeps the rest as cash or short-term investment, what is the maximum amount of current liabilities it could have without violating the debt contract? a. $45,333 b. $146,667 c. $125,333 d. $113,333 Solution: Current assets cannot fall below 1.5 times current liabilities. Therefore, dividing current assets by 1.5 indicates the maximum level that Jake can allow current liabilities to grow to without violating the debt covenant. So current liabilities can grow to $113,333 ($170,000 ÷ 1.5). Ans: D KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

10-14

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

55.

($120,000 + $20,000) ÷ $68,000 = 2.06

Ans: C KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

56.

Current assets cannot fall below 1.5 times current liabilities. Therefore, dividing current assets by 1.5 indicates the maximum level that Jake can allow current liabilities to grow to without violating the debt covenant. So current liabilities can grow to $93,333 ($140,000 ÷ 1.5). Ans: A KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

57.

10-15

= ($120,000 + $0) ÷ $68,000 = 1.76

Ans: B KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

58.

Jake Company borrowed $100,000 from Guaranty Trust Bank to finance the purchase of new equipment. The loan contract provides for a 12 percent annual interest rate and states that the principal must be paid in full in ten years. The contract also requires that Jake maintains a current ratio of 1.5:1. Before Jake borrowed the $100,000, the company’s current assets and current liabilities were $120,000 and $68,000 respectively. If Jake invests the entire $100,000 of the borrowed funds in equipment, what is the maximum amount of current liabilities it could have without violating the debt contract? a. $146,667 b. $102,000 c. $80,000 d. $125,333 Solution: The current liabilities can grow to $80,000 ($120,000 ÷ 1.5). Ans: C KP 2 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

10-16

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

59.

Meadville Industries sells gift certificates that are redeemable in merchandise. During 2009, Meadville sold gift certificates for $88,000. Merchandise with the total price of $52,000 was redeemed during the year. For Meadville, the cost of the merchandise sold was $32,000. Meadville sold gift certificates for the first time in 2009. The journal entry recording the sale of the gift certificates will include: a. a debit to Certificate Liability for $88,000 b. a debit to Deferred Revenue for $88,000 c. a credit to Sales for $88,000 d. a credit to Deferred Revenue for $88,000 Solution: Cash (+A) ............................................................................ Deferred Revenue (+L) ..................................................

88,000 88,000

Ans: D KP 4 BT: AP Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

60.

Meadville Industries sells gift certificates that are redeemable in merchandise. During 2009, Meadville sold gift certificates for $88,000. Merchandise with the total price of $52,000 was redeemed during the year. For Meadville, the cost of the merchandise sold was $32,000. Meadville sold gift certificates for the first time in 2009. Assuming that Meadville uses the perpetual inventory method, the journal entry recording the redemption of the gift certificates during 2009 will include: a. a credit to Cost of Goods Sold for $32,000 b. a debit to Deferred Revenue for $88,000 c. a credit to Sales for $52,000 d. a credit to Deferred Revenue for $52,000 Solution: Deferred Revenue (–L)........................................................ Sales (R, +SE) ...............................................................

52,000

Cost of Goods Sold (E, –SE) ............................................... Inventory (–A)................................................................

32,000

52,000

Ans: C KP 4 BT: AP Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

32,000

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

61.

10-17

The following information was taken from the annual report of Jones Inc.

BALANCE SHEET Deferred income tax liability INCOME STATEMENT Income before taxes Income tax expense Net income Effective income tax rate 40%

2010

2009

$29,700

$28,300

$88,000 (30,400) $57,600

What is Jones’s conservatism ratio? a. 1.02 b. 1.52 c. 2.89 d. 1.21 Solution: Conservatism Ratio = =

Reported Income Before Taxes ÷ Taxable Income $88,000 ÷ $72,500*

Income Tax Expense ........................................................................... Deferred Income Tax ($29,700 – $28,300) .................................... Income Tax Payable (Plug) .............................................................

1.21 30,400

* $29,000 ÷ 40% = $72,500 Ans: D KP App10B BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

1,400 29,000

10-18

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

62.

The following information was taken from the annual report of Jones Inc.

BALANCE SHEET Deferred income tax liability INCOME STATEMENT Income before taxes Income tax expense Net income Effective income tax rate 40%

2010

2009

$29,700

$28,300

$88,000 (30,400) $57,600

Based on this information, what journal entry should Jones make in 2010 to record its income taxes? a. Income Tax Expense...................................................... Deferred Income Tax ..................................................... Deferred Income Tax ................................................. Income Tax Payable .................................................. b. Income Tax Expense...................................................... Deferred Income Tax ................................................. Income Tax Payable .................................................. c. Income Tax Expense ...................................................... Deferred Income Tax ................................................. Income Tax Payable .................................................. d. Income Tax Expense...................................................... Deferred Income Tax ................................................. Income Tax Payable ..................................................

30,400 29,700 28,300 31,800 30,400 29,700 700 31,800 1,400 30,400 30,400 1,400 29,000

Solution: Income Tax Expense........................................................... Deferred Income Tax ($29,700 – $28,300) .................... Income Tax Payable .....................................................

30,400 1,400 29,000

Ans: D KP App10B BT: AP Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

63.

10-19

The following information was taken from the annual report of Leno Inc.

BALANCE SHEET Deferred income tax liability INCOME STATEMENT Income before taxes Income tax expense Net income Effective income tax rate 35%

2010

2009

$58,300

$59,400

$108,000 (40,400) $67,600

What is Leno’s conservatism ratio? a. 0.63 b. 0.91 c. 0.69 d. 0.86 Solution: Conservatism Ratio

Reported Income Before Taxes ÷ Taxable Income

$108,000 ÷ $118,571* =

Income Tax Expense ............................................................................... Deferred Income Tax ($59,400 – $58,300) ...................................... Income Tax Liability (Plug) ..............................................................

0.91 40,400 1,100

*$41,500 ÷ 35% = $118,571 Ans: B KP App10B BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

41,500

10-20

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

64.

The following information was taken from the annual report of Leno Inc.

BALANCE SHEET Deferred income tax liability INCOME STATEMENT Income before taxes Income tax expense Net income Effective income tax rate 35%

2010

2009

$58,300

$59,400

$108,000 (40,400) $67,600

Based on this information, what journal entry should Leno make in 2010 to record its income taxes? a. Income Tax Expense...................................................... Deferred Income Tax ..................................................... Deferred Income Tax ................................................. Income Tax Payable .................................................. b. Income Tax Expense...................................................... Deferred Income Tax ..................................................... Income Tax Payable .................................................. c. Income Tax Expense ...................................................... Deferred Income Tax ..................................................... Income Tax Payable .................................................. d. Income Tax Expense...................................................... Deferred Income Tax ..................................................... Income Tax Payable ..................................................

40,400 58,300 59,400 39,300 40,400 19,000 59,400 40,400 1,100 41,500 40,400 17,900 58,300

Solution: Income Tax Expense ...................................................................... Deferred Income Tax ($59,400 – $58,300).................................... Income Tax Liability .................................................................

40,400 1,100

Ans: C KP App10B BT: AP Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

41,500

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

65.

10-21

Julia Used Cars offers a one-year warranty from the date of sale on all cars it sells. From historic data, Bill Julia estimates that, on average, each car will require the company to incur warranty cost of $820. The cars sold for an average of $9,500 each. The following activities occurred during 2010. Feb Mar May July Sep Nov Dec

4 23 20 6 1 14 22

Sold five cars. Sold ten cars. Incurred warranty costs of $6,000 on four cars sold in 2008. Sold eight cars. Incurred warranty costs of $5,000 on five cars sold in 2008. Incurred warranty costs of $4,000 on one car sold in 2008. Sold twelve cars.

If Julia accrued its warranty liability with a single adjusting entry at year-end, the journal entry would include: a. a debit to Contingent Warranty Liability for $28,700 b. a debit to Warranty Expense for $28,700 c. a credit to Parts for $17,220 d. a credit to Cash for $28,700 Solution: Warranty Expense (E, –SE) ................................................ Contingent Warranty Liability (+L) .................................

28,700*

* $28,700 = 35 cars sold  $820 estimated warranty cost per car Ans: B KP 4 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

28,700

10-22

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

66.

Feb Mar May July Sep Nov Dec

4 23 20 6 1 14 22

Sold five cars. Sold ten cars. Incurred warranty costs of $6,000 on four cars sold in 2009. Sold eight cars. Incurred warranty costs of $5,000 on five cars sold in 2009. Incurred warranty costs of $4,000 on one car sold in 2009. Sold twelve cars.

If the January 1, 2010 beginning balance in the warranty liability account was $2,500, what would be the year-end warranty liability balance? a. $31,200 b. $16,200 c. $11,200 d. $13,700 Solution: Ending Balance

= Beginning Balance + Warranty Expense for the Year – Cost of Repairs Under Warranty = $2,500 + $28,700 – ($6,000 + $5,000 + $4,000) = $16,200

Ans: B KP 4 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

67.

10-23

4 23 20 6 1 14 22

Sold five cars. Sold ten cars. Incurred warranty costs of $3,000 on four cars sold in 2009. Sold eight cars. Incurred warranty costs of $5,000 on five cars sold in 2009. Incurred warranty costs of $6,000 on one car sold in 2009. Sold twelve cars.

Assume that the breakdown of warranty costs is 40% parts and 60% wages (paid in cash). Based on this information, which of the following journal entries would be made on September 1? a. Warranty Expense 5,000 Contingent Warranty Liability

5,000

b. Warranty Expense Cash Parts

3,000 2,000

5,000

c. Cash 3,000 Parts 2,000 Contingent Warranty Liability

5,000

d. Contingent Warranty Liability Cash Parts

3,000 2,000

5,000

Ans: D KP 4 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

10-24

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

MATCHING QUESTIONS 1.

Select the letter of the effect on the debt/equity ratio (a through c) as a result of each transaction listed in items 1 through 9. Effects a. Increase in debt/equity ratio b. Decrease in debt/equity ratio c. Does not change debt/equity ratio ____ 1. Amortized the discount of the long-term note payable ____ 2. A portion of long-term debt is paid ____ 3. Accrued salaries at yearend ____ 4. Paid accrued payroll taxes which were accrued last month ____ 5. Paid a bonus amounting to 5% on reported income to the CEO that was previously accrued ____ 6. Paid costs associated with warranties that were previously accrued ____ 7. Taxes paid which are accrued ____ 8. Accrued income taxes at yearend ____ 9. Accrued estimated coupon redemptions Solution: 1. a 2. b 3. a 4. b 5. b 6. b 7. b 8. a 9. a KP 3,4 BT: C Difficulty: Moderate TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

10-25

For each item numbered 1 through 16 below, select the appropriate effect on liabilities listed in a through e that each transaction describes. You may use each letter more than once or not at all. In some cases, two effects are correct. a. b. c. d. e.

Effects on Liabilities Decrease current liabilities Increase current liabilities No effect on recorded current liabilities Accrued contingent liability Contingent liability disclosed in the notes only

____

1. Purchased supplies on account.

____

2. Paid accounts payable.

____

3. Issued a $1,000 short-term note payable for $970.

____

4. Amortized the discount of the short-term note payable.

____

5. A portion of long-term debt is due next year.

____

6. Declared cash dividends to holders of stock.

____

7. Paid the cash dividend previously declared.

____

8. Received money from customers prior to delivery of the product to the customer.

____

9. Delivered products to a customer who previously paid for that product.

____

10. Collected sales tax on behalf of the state government.

____

11. Accrued payroll taxes that the firm has to pay to the federal government within three months.

____

12. Accrued a bonus amounting to 5% on reported income to the CEO.

____

13. In a lawsuit filed against the firm, counsel indicates that the potential $10,000 loss is remote.

____

14. In a lawsuit filed against the firm, counsel indicates that the potential $10,000 loss is reasonably possible.

____

15. In a lawsuit filed against the firm, counsel indicates that the potential $10,000 loss is highly probable.

____

16. Accrued warranty expense.

Solution: 1. b 2. a 3. b 4. b 5. b 6. b

7. a 8. b 9. a 10. b 11. b 12. b

KP 1,3,4 BT: C Difficulty: Moderate TOT: 8 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13. c 14. e, c 15. b, d 16. b, d

10-26

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

Select the letter of the effect on the ratios (a through c) as a result of each transaction listed in items 1 through 16. Effects a. Increase in debt/equity ratio b. Decrease in debt/equity ratio c. Does not change debt/equity ratio ____

Purchased supplies on account to be used next month.

____

Paid accounts payable.

____

Issued a $1,000 short-term note payable for $970.

____

Amortized the discount of the short-term note payable.

____

A portion of long-term debt is due next year.

____

Declared cash dividends to holders of stock.

____

Paid the cash dividend previously declared.

____

Received money from customer prior to delivery of the product to the customer.

____

Delivered product to a customer who previously paid for that product.

____

10. Collected sales tax on behalf of the state government.

____

11. Accrued payroll taxes the firm has to pay to the federal government within three months.

____

12. Paid a bonus (not previously accrued) amounting to 5% on reported income to the CEO for the current year.

____

13. A large payment is remotely probable resulting from a lawsuit filed against the firm.

____

14. A large payment is reasonably probable resulting from a lawsuit filed against the firm.

____

15. A $10,000 payment is highly probable resulting from a lawsuit filed against the firm.

____

16. Bondholder converted bond into stock through conversion feature.

Solution: 1. a 2. b 3. a 4. a 5. c 6. a 7. b 8. a

9. b 10. a 11. a 12. a 13. c 14. c 15. a 16. b

KP 2,3,4 BT: AP Difficulty: Moderate TOT: 8 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

10-27

SHORT PROBLEMS 1.

On July 1, Falcon Company borrowed $2,000 in return for a one-year note payable with a maturity value of $2,200. Calculate the balance sheet value of the note on December 31. Solution: ($200/12) X 6 = $100 $2,200 –$100 = $2,100 KP 4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

On October 1, Accurate Company borrowed $2,000 in return for a nine-month note payable with a maturity value of $2,600. Calculate the amount of interest expense and the balance sheet value for the year ending December 31. Solution: (1/3) x ($2,600 - $2,000) = $200 expense $2,000 + $200 = $2,200 balance sheet value KP 4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

On October 1, 2009, Brooks Company borrowed $6,000 in return for a nine-month note payable with a maturity value of $6,600. Fill in the partial balance sheet that appears below as of December 31, 2009. Current Liabilities

Solution: $600 − ($600 x 3/9) = $400 Note Payable Less Discount on Notes Payable

$6,600 (400) $6,200

KP 4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

On July 1, Gordon Company borrowed $10,000 in return for an eight-month note payable with a maturity value of $10,600. Calculate the amount of interest expense for the current year. Solution: (6/8) x ($10,600 – $10,000) = $450 KP 2,4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic

10-28

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

AICPA BB: Critical Thinking AICPA FN: Measurement

Bradley Incorporated owns a chain of retail stores. During December of 2009, a customer slipped in a doorway of its Missouri store and broke his ribs. He is suing Bradley for $200,000 for negligence. Bradley’s legal counsel believes that it is only reasonably probable that Bradley will lose its defense of the lawsuit because, although the doorway was icy due to an ice storm that was occurring at the time of the fall, a sign on the door warned customers that the doorway was slippery when icy. On December 30, 2009, before considering the effects of this lawsuit, Bradley’s current assets, total assets, current liabilities, and total liabilities were $420,000, $840,000, $100,000, and $300,000, respectively. After this event is properly accounted for, calculate Bradley’s debt/equity ratio on December 31, 2009. Solution: The reasonably probable obligation resulting from the negligent lawsuit is not recognized on the financial statements. It is, however, disclosed in the footnotes to the financial statements. Therefore, the debt/equity ratio is $300,000/[$840,000 − $300,000] = 0.56. KP 2,6 BT: AN Difficulty: Difficult TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Pitts Incorporated owns a chain of retail stores. During December of 2009, a customer slipped in a doorway of its Nebraska store and broke his ribs. He is suing Pitts for $200,000 for negligence. The legal counsel of Pitts believes that it is remote that Pitts will lose its defense of the lawsuit because the doorway recently was rebuilt with allweather traction stripping and a sign on the door warned customers that the doorway was slippery when icy. On December 30, 2009, before considering the effects of this lawsuit, The company’s current assets, total assets, current liabilities, and total liabilities were $420,000, $840,000, $100,000, and $300,000, respectively. After this event is properly accounted for, calculate the company’s debt/equity ratio on December 31, 2009. Solution: The remote obligation resulting from the negligent lawsuit is not recognized on the financial statements. The debt to equity ratio is $300,000/[$840,000 − $300,000] = .56. KP 2,6 BT: AN Difficulty: Difficult TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Pacific Company estimates warranty expense as 10% of sales. On January 1, warranties payable was $10,000. During the year, Pacific paid $8,000 to meet its warranty obligations and recorded sales of $300,000. Calculate warranties payable on December 31. Solution: $10,000 + [$300,000 x 10%] – $8,000 = $32,000 KP 6 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

10-29

On January 1 and December 31, warranties payable were $6,000 and $4,000, respectively. During the current year, sales were $100,000, upon which 3% was estimated to be the amount required for future warranty payments. Calculate the amount paid for warranties during the current year. Solution: $6,000 + (3% x $100,000) – $4,000 = $5,000 KP 6 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Beacon Incorporated owns a chain of retail stores. During December of 2009, a customer slipped in a doorway of its Virginia store and broke his ribs. He is suing Beacon for $200,000 for negligence. Beacon's legal counsel believes that it is remote that Beacon will lose its defense of the lawsuit because the doorway recently was rebuilt with all-weather traction stripping and a sign on the door warned customers that the doorway was slippery when icy. On December 30, 2009, before considering the effects of this lawsuit, Beacon's current assets, total assets, current liabilities, and total liabilities were $420,000, $840,000, $100,000, and $300,000, respectively. After this event is properly accounted for, calculate Beacon’s debt/asset ratio on December 31, 2009. Solution: The remotely probable obligation resulting from the negligent lawsuit is not recognized on the financial statements. Therefore, the debt/asset ratio is $300,000/$840,000 = 0.36. KP 2,6 BT: AN Difficulty: Difficult TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

10.

On December 31, 2009, Roper Company had current assets of $15,000 in cash and current liabilities of $8,000 in accounts payable, resulting in a current ratio of 1.88. The company needs to increase its current ratio to 2.75 by December 31, 2010. Calculate the amount of accounts payable that needs to be paid in order to boost the current ratio to 2.75. Solution: If Roper pays $4,000 of accounts payable, then current assets and current liabilities will be $11,000 and $4,000, respectively, resulting in a current ratio of 2.75. KP 2 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

10-30

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

11.

On December 31, 2008, Seminole Co. had current assets of $25,000 in cash and current liabilities of $8,000 in accounts payable, resulting in a current ratio of 3.13. The company estimates that warranty expense for 2009 is 6% of sales that totaled $200,000. Calculate Seminole’s current ratio after warranty expense is recognized. Solution: Warranties payable of $12,000 will be recognized when warranty expense is accrued. This results in current assets of $25,000, current liabilities of $20,000, and a current ratio of 1.25 ($25,000/$20,000). KP 2 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

12.

As a security analyst for Market Masters, Inc., you have chosen to invest in one hightech firm. You have narrowed your choice between RamTech Company or Accutrex Industries, firms of similar size and direct competitors in the industry. The following information was taken from their 2009 annual reports:

Deferred income tax liability Income before taxes Income tax expense Net income Effective income tax rate

RamTech Accutrex 2010 2009 2010 2009 $ 19,400 $15,600 $ 19,800 $21,800 163,000 158,500 (50,000) (52,500) 113,000 106,000 35% 35%

Solution: Based on the information provided in this problem, we can compute the conservatism ratio of each company: The lower the ratio, the higher the earning power of the company. Conservatism Ratio

Reported Income Before Taxes ÷ Taxable Income

RamTech Company Income Tax Expense (I/S)..................................................................... Deferred Income Tax ($19,400 – $15,600) .................................... Income Tax Liability (Plug) ............................................................. Taxable Income =

$46,200 ÷ 35% =

$132,000

Conservatism Ratio =

$163,000 ÷ $132,000

50,000 3,800 46,200

1.235

Accutrex Industries Income Tax Expense (I/S) ..................................................................... Deferred Income Tax ($19,800 – $21,800) ........................................... Income Tax Liability (Plug) ............................................................ Taxable Income = Conservatism Ratio =

$54,500 ÷ 35% = $158,500 ÷ $155,714

52,500 2,000 54,500

$155,714 = 1.018

Accutrex Industries’ conservatism ratio is lower than RamTech Company’s. Therefore, it has stronger earning power than RamTech.

KP App 10B BT: AN Difficulty: Difficult TOT: 8 min. AACSB: Analytic

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

10-31

AICPA BB: Critical Thinking AICPA FN: Measurement

13.

Porter Products recognizes expenses for wages, interest and rent when cash payments are made. The following related cash payments were made during December 2009: December 5 & 20

December 15

Wages in the amount of $15,000 are paid on the 5th and the 20th of each month for the fifteen days just ended. The next payment will be on January 5, 2010. Paid a semi-annual $300 interest payment on an outstanding note payable with a face value of $10,000 and a 6 percent annual interest rate.

As of December 31, the current assets and current liabilities reported on Porter’s balance sheet were $36,000 and $22,500, respectively. Porter’s income statement reported net income of $11,250. Required: Compute Porter’s current ratio and net income if the company were to account for wages, interest, and rent on an accrual basis. Solution: Current Assets

Current Liabilities

Net Income

$ 36,000

$ 22,500

$ 11,250

$ 36,000

10,000a 25b $ 32,525

(10,000)a (25)b $ 1,225

Reported amounts Adjustments: Wages Interest Adjusted amounts

a $10,000 = ($15,000 ÷ 15 days per pay period)  10 days left in December b $25 = $10,000  6%  15/360

Current Ratio = Current Assets ÷ Current Liabilities = $36,000 ÷ $32,525 = 1.11 Net Income = $1,225

KP 2,4 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

10-32

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

14.

Farley Incorporated instituted a defined benefit pension plan for its employees at the beginning of 2006. An actuarial method that is acceptable under GAAP indicates that the company should contribute $80,000 each year to the pension fund to cover the benefits that will be paid to the employees. Farley funded 80% in 2006 and 2007, 90% in 2008 and 2009, and 100 percent in 2010. Required: (1) Prepare the journal entries to accrue the pension liability and fund it for 2006 through 2010. (2) Compute the balance in the pension liability account as of December 31, 2010. Solution: a.

2006

Pension Expense (E, –SE) ............ Cash (–A) ................................. Pension Liability (+L) ................ Funded pension.

2007

80,000

80,000 64,000 16,000

2008 Pension Expense (E, –SE) ............. 80,000 Cash (–A) .................................. Pension Liability (+L) ................. Funded pension.

64,000 16,000

2009 80,000 72,000 8,000

72,000 8,000

2010 Pension Expense (E, –SE) ............ Cash (–A) ................................. Funded pension.

80,000

Pension Expense

Amount Funded

2006 2007 2008 2009 2010

$ 80,000 80,000 80,000 80,000 80,000 $400,000

$ 64,000 64,000 72,000 72,000 80,000 $352,000

80,000

Pension Liability $16,000 16,000 8,000 8,000 0 $48,000

Thus, the balance in the Pension Liability account as of December 31, 2010 is $48,000.

KP App10A BT: AN Difficulty: Moderate TOT: 8 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

15.

10-33

On December 31, 2009, Barton Incorporated had total liabilities of $60,000 and total shareholders' equity of $90,000, resulting in a debt/equity ratio of 0.67 before income tax expense is recognized. On December 31, 2009, Barton paid its 2009 income taxes of $6,000 while its income tax expense on its 2009 income statement was $8,000. This difference exists because Barton uses straight-line depreciation on its books and doubledeclining-balance depreciation on its tax returns. What is Barton’s debt/equity ratio after the tax expense and deferred tax liability are recognized? Solution: Tax expense of $8,000 causes a decrease in shareholders' equity from $90,000 to $82,000. The deferred tax liability of $2,000 increases liabilities to $62,000. The post-tax debt/equity ratio is 0.76. KP App10B BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

16.

On December 31, 2009, Carlson Incorporated had total liabilities of $60,000 and total shareholders' equity of $100,000, resulting in a debt/equity ratio of 0.60 before warranty expense is recognized. On December 31, 2009, Carlson estimated warranty expense to be 5% of sales of $100,000. What is Carlson’s debt/equity ratio after the warranty expense and related liability is recognized? Solution: Warranty expense of $5,000 decreases shareholders' equity from $100,000 to $95,000. The $5,000 estimated warranty liability increases liabilities to $65,000. The debt/equity ratio is 0.684. KP 2,6 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

10-34

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

17.

On March 2, 2010, Knight Company’s CFO, Bob Martin, will receive a bonus equal to 6% of net income before income taxes as reported for the year ended December 31, 2009. The current 2009 income statement shows net income before income taxes as $600,000. Required: (1) What journal entry should be made on December 31, 2009? (2) What journal entry should be made on March 2, 2010? (3) If Bob decides to postpone $50,000 of 2009 research and development expenditures until 2010, what impact would this have on his bonus? Explain and show your calculations. Solution: (1) Dec 31

Bonus Expense Bonus Liability

36,000

Bonus Liability Cash

36,000

(2) Mar 2

36,000

(3) This postponement will increase net income to $650,000 instead of $600,000. Bob’s bonus would then increase to $39,000 (or $650,000 x 6%).

KP 2,5 BT: AN Difficulty: Easy TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

18.

On December 31, 2010, Stanley Co. had current assets of $20,000 (all cash) and current liabilities of $9,000 in accounts payable, resulting in a current ratio of 2.22. On December 31, 2010, Stanley purchases $6,000 of inventory on account. Calculate Stanley’s current ratio after the inventory has been purchased. Solution: The purchase of $6,000 of inventory on account results in current assets of $26,000, current liabilities of $15,000, and a current ratio of 1.73. KP 2 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

19.

10-35

Vista Corporation, producer of computer software packages, began operations on January 1. It acquired financing from the issuance of common stock for $60,000,000 and long-term debt for $80,000,000. At the beginning of business operations, Vista produced the following projected income statement and balance sheet for the first year. All amounts are in thousands. Vista Corporation Projected Income Statement First Year of Operations Sales Expenses: Warranty Depreciation Research Operating income before bonus Bonus Operating income Interest expense Income before taxes Income taxes (40%) Net income

$100,000 $10,000 40,000 20,000

70,000 $ 30,000 3,000 $ 27,000 7,000 $ 20,000 8,000 $ 12,000

Vista Corporation Projected Balance Sheet December 31 of First Year Assets: Cash Accounts receivable Net computers Total assets

$ 30,000 24,000 158,000 $212,000

Liabilities & Shareholders' Equity: Accounts payable Warranty payable Long-term debt Common stock Retained earnings Total liabilities and shareholders' equity

$ 50,000 10,000 80,000 60,000 12,000 $212,000

The new president is rather disappointed with these projected results having just quit a job of which his compensation package was $4,000,000. After examining the forecasts of a bonus of only $3,000,000, the president decides to use his knowledge of financial statements to modify his bonus. He meets with the company's CFO the next day to see what could be done. He suggested the following possibilities that would boost the first year's income: 1. Slash research and development expenditures, which are paid in cash, from $20 million to $10 million. 2. Double the estimated life of the computers, which will decrease depreciation expense from $40 million to $20 million. Because identical accounting procedures are used for taxes, no deferred taxes will be generated. Taxes require immediate payment. 3. Reduce estimated warranty expense from 10% of sales to 7% of sales. 4. Any resultant change in the bonus of 10% of operating income before the bonus will be paid to the president in cash. A. Adjacent to the income statement for Year 1, create a new statement using the alternative accounting procedures and operating decisions. B. Compare the president’s compensation if the changes in part A are enacted with his current compensation. What are the ramifications of these changes on the future?

10-36

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

Solution: A. (in thousands) Sales Expenses: Warranty Depreciation Research Operating income before bonus Bonus Operating income Interest expense Income before taxes Income taxes (40%) Net income

$100,000 $ 7,000 20,000 10,000

37,000 $ 63,000 6,300 $ 56,700 7,000 $ 49,700 19,880 $ 29,820

B. Although the president now makes $6.3 million, the costs to the company could be very high. Underestimating warranty expense will require larger warranty expense in the very near future (an additional $3,000,000 of warranty expense for a total of $13,000,000 may be needed next year). Increasing the estimated life of its computers beyond that which is reasonable will overstate these assets and will result in major losses when they are retired or the firm is "restructured." Cutting research and development expenditures could result in an early death of the company. In such a competitive environment, firms live or die on the results of their research. The employees laid off from the restructuring of R&D will be lost to competitors. If the income boosting policies are enacted, it is suggested that the president move on to another corporation next year (before the piper has to be paid) and that the shareholders sell their stock before the future negative events occur. KP 4,6 BT: AN Difficulty: Difficult TOT: 10 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

20.

On December 31, 2010, Cocoa Incorporated had total liabilities of $80,000 and total shareholders' equity of $100,000, resulting in a debt/equity ratio of 0.80 before executive bonus expense is recognized. During 2010, Cocoa’s CEO earned a 5% bonus on net income before bonus of $100,000. If Cocoa pays the bonus due its CEO on December 31, 2010, what is Cocoa’s debt/equity ratio after the bonus expense and what related liability is recognized? Solution: Bonus expense of $5,000 decreases shareholders' equity from $100,000 to $95,000. Because Cocoa pays its CEO before the end of the year, liabilities did not change. The debt/equity ratio is 0.85. KP 2 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

21.

10-37

Howell Incorporated current income statement and December 31 balance sheet follow: Income Statement Revenue Expenses and losses Net income

$180,000 130,000 $ 50,000

Balance Sheet Current assets Long-lived assets Total assets

$ 10,000 200,000 $210,000

Current liabilities Long-term liabilities Shareholders' equity Total liabilities and shareholders' equity

$ 5,000 95,000 110,000 $210,000

During an audit of Howell’s current financial statements, its auditor discovered that Howell is a defendant in a $20,000 lawsuit for infringement of patent rights. Howell’s management, under the advice of its legal counsel, decided that it was only reasonably probable that they would lose the suit and have to pay $20,000. However, its auditor disagreed with the treatment of the contingent loss and effectively argued that it is probable that the lawsuit will require Howell to pay $20,000 in the forthcoming year. The management of Howell decided to "take a bath" and treat the $20,000 lawsuit consistent with GAAP on probable conditional liabilities. A. Reconstruct Howell current income statement and 12/31 balance sheet under the auditor's judgment concerning the $20,000 lawsuit B. Calculate and compare current, debt/equity, and debt/asset ratios resulting from Howell’s initial and reconstructed financial statements. Comment on Howell’s solvency. Solution: A. Income Statement Revenue Expenses and losses Net income

$180,000 150,000 $ 30,000

Balance Sheet Current assets Long-lived assets Total assets

$ 10,000 200,000 $210,000

Current liabilities Long-term liabilities Shareholders' equity Total liabilities and shareholders' equity

$ 25,000 95,000 90,000 $210,000

B. Current ratio Debt/Equity ratio Debt/Asset ratio

Initial 2.0 0.91 0.48

Revised 0.40 1.33 0.57

All ratios as an indication of solvency have deteriorated. The current ratio decreasing to less than 1.0 puts short-term solvency in question. Howell’s long-term solvency position as measured by the debt/equity and debt/asset ratios have also deteriorated. KP 2,6 BT: AN Difficulty: Difficult TOT: 10 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

10-38

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

SHORT ESSAY QUESTIONS 1.

State laws generally require insurance companies to maintain certain debt and solvency ratios. Those companies who fail to maintain minimum levels, are subject to severe penalties, most often affecting the insurance company’s continuation as a going concern. How may regulatory requirements such as these impact management decisions? Solution: Some debt restrictions discourage management from reporting current liabilities on the balance sheet. In order to control current and quick ratios, a company may be forced to pay outstanding balances immediately, rather than wait until the actual due date. Often this requires management to make costly concessions, sometimes in the form of higher interest rates or pledging additional collateral on loans. Reporting restrictions give management an incentive to ignore existing current liabilities, postpone them, or structure transactions so that current liabilities do not have to be recorded. KP 2 BT: AP Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

A major airline issues frequent flyer credits that allow the passenger to receive credit toward future flights. For every ticket sold the customer receives a credit which, when 40 are collected, can be exchanged for a free ticket. During the year, the airline company recorded revenues of $60 million, which represented 100,000 tickets. The airline did not recognize the flyer credits on its income statement or its balance sheet. In the context of contingent liabilities, comment on the airline’s accounting procedures. Solution: If it is highly probable that the frequent flyer credits will be exercised and the number of tickets can be reasonably estimated, the liability should be accrued. In this case the value would be 1/40 times 100,000, or 2,500 tickets. Because this contingent liability is measurable and probable, it should be recognized as an increase in an expense and liability (part current; part long-term). By not recognizing these frequent flyer credits, the airline industry is overstating its net income and understating its liabilities. KP 6 BT: AP Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

10-39

What concerns might exist when a company's debt ratio increases? Solution: A debt ratio is calculated by dividing total liabilities by total assets. This ratio tells users the percentage of financing that is debt. A general average ranges from 40 to 60 percent. Creditors should be concerned about increases in the debt ratio because too much debt may be an indication the company may not be able to pay its current and long-term debts as they become due. Shareholders generally feel more comfortable with higher levels of debt than creditors do because of their affinity toward strategically leveraged decision making. KP 2 BT: AP Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

What concerns might management have with additional debt on its balance sheet? Solution: Additional debt on the balance sheet can reduce a company's credit rating making it difficult to attract capital in the future. If a credit rating service reduces a company's credit rating, analysts and investors may question the reasons. Additional debt on the balance sheet can also decrease the current ratio, increase the debt/asset ratio, and increase the debt/equity ratio. These changes may cause a company to violate its debt covenants and cause users to view a company as more risky. In situations where management believes it has a strong equity position, it may wish to accelerate the recognition of liabilities by recognizing them earlier. This latter effort helps management to "smooth" earnings over a several year period. KP 2 BT: AP Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

What three characteristics should all liabilities that appear on the balance sheet have in common? Solution: The characteristics are: 1. They should be present obligations that entail settlements by probable future transfers or uses of cash, goods, or services. 2. They should be unavoidable obligations. 3. The transaction or event obligating the enterprise must have happened already. KP 1 BT: AP Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

10-40

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

During the 1990's, Golden Inc. entered into long-term contracts with corporate customers to supply one million ounces of ore for $100 an ounce over the next 5 years. During the following years, the price of ore increased to $175 an ounce, which Golden Inc., because it did not hedge the price, would have to pay in order to meet its sales contracts. Although Golden Inc.'s auditor argued that a $75 million loss and liability should be recognized, Golden Inc. stated that the amount of the loss cannot be reasonably estimated prior to the results of renegotiations it was conducting with its corporate customers. Golden Inc. expected to renegotiate an increase in the initial contract price of $150 or reduce the amount of ounces to be delivered under the longterm sales contract. Defend a position of how the long-term contract should be treated from an accounting perspective. Solution: Certainly it appears probable that Golden Inc. will have to pay cash in order to meet its long-term sales contract. The maximum would be a $75 million loss and liability. However, Golden Inc.'s position that the amount cannot be reasonably (objectively) measured has merit, given the renegotiations of the contracts being conducted. Therefore, an effective argument can be made that no loss or liability can be recognized prior to the results of the renegotiations or court settlement. However, the difficulty of objectively measuring the loss might be considered a ploy in order to delay the recognition of the loss resulting from an extremely bad decision to enter the long-term sales contract without hedging a future long-term obligation in ore. This position would argue that the loss and liability should be recognized and measured at a reasonable estimation of the ultimate cost to Golden, Inc. KP 6 BT: AN Difficulty: Moderate TOT: 6 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Identify the primary problem related to current liabilities. Solution: The primary problem is insuring that all existing current liabilities are reported on the balance sheet. Failure to report all liabilities will overstate the solvency position of a company. KP 2 BT: AP Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

How do ‘determinable’ current liabilities differ from ‘contingent’ liabilities? Solution: Determinable current liabilities can be precisely measured and the amount of cash needed to satisfy these obligations and the date of payment are reasonably certain. Contingent liabilities possess uncertainties concerning the amount, the date, and probability of actual required payment. KP 3 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

10-41

Sunshine Company obtained a line of credit with its bank of $4 million. How should Sunshine Company disclose the line of credit on its financial statements? Solution: A line of credit is granted to a company by a bank allowing it to borrow up to a certain maximum dollar amount, with interest normally being charged only on the outstanding balance. These financing arrangements should be extensively described in financial statement footnotes. Any amount actually borrowed should be reported as a liability on the balance sheet. KP 3 BT: AP Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

10.

Identify two different third-party collections and explain why they should be reported as liabilities. Solution: Third party collections include payroll tax deductions, insurance premiums or union dues deducted from employees’ paychecks, and sales taxes collected from retail customers. Amounts deducted from employees’ paychecks must be accumulated and submitted to the proper regulatory agencies. The amounts represent neither revenue nor an expense for the employer, but are considered an expense of the employee. Companies also act as collection agencies for state government entities by collecting sales taxes. Sales taxes on purchases are an expense to a customer, but represent amounts collected by a company on behalf of the state entity that assesses the sales taxes. An employer acts as a collecting agency for the Internal Revenue Service and other entities, and submits these amounts once collected. KP 3 BT: C Difficulty: Moderate TOT: 5 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

11.

Explain why short-term notes often have a face amount that differs from the cash received upon signing a note payable. Describe what this difference represents. Solution: The face value of a note is the amount that must be paid on the maturity date—the date a loan is due. A financial institution will often deduct the entire interest when a debtor signs the note. The difference, Discount on Notes Payable, represents unamortized interest that is not yet owed to the financial institution, but will be recognized in the future. KP 3 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

10-42

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

12.

How is unamortized interest on short-term notes payable reported on a balance sheet? Solution: Financial institutions often deduct interest from the cash received by the borrower when a short-term note is executed. The unamortized interest is not yet owed to the financial institution, but will be recognized in the future. The borrowing company accounts for the unearned interest in an account called ‘Discount on Notes Payable.’ This amount is a contra liability and appears as a deduction from the face amount of the note in the liabilities section on a company's balance sheet. KP 3 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

13.

Harrison Inc. issues community concert season tickets to a number of corporations for $1,000 each. Revenue is accrued equally throughout the season that the pass is valid. How should Harrison Inc. report any amounts that have not yet been recognized as revenue? Solution: Before the services are rendered, i.e., before the residents attend the games, they should be reported as unearned revenues in the current liabilities section of Harrison Inc. KP 3 BT: AP Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

14.

Why are gain contingencies typically omitted from financial statement disclosure? Solution: Gain contingencies are almost never accrued and are rarely disclosed in footnotes because they are most often not objectively determinable. Even though a company may determine that a gain contingency is probable and reasonably estimable, disclosing information of this nature in the financial statements may mislead investors. The approach is sometimes referred to as, “Don’t count your chickens before they hatch.” Conservatism encourages recognition of losses and deferrals of gains in order to avoid over statement of assets and revenues. KP 3,6 BT: AP Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 10 – Introduction to Liabilities: Economic Consequences, Current Liabilities, & Contingencies

15.

10-43

What impact have environmental cleanup costs had on corporate disclosures? Solution: The U.S. government established a fund to cleanup pollution and mandate companies to cleanup existing waste sites. Many companies are now viewing environmental costs as reality, and finding that certain business activities that occurred long before there was much public concern about the environment have created potential liabilities. A company must recognize the effects of the EPA's enforcement of environmental cleanup as liabilities because they represent a future outflow of assets as a result of a past transaction. KP 6 BT: AP Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Chapter 11 Long-Term Liabilities: Notes, Bonds, and Leases

MULTIPLE CHOICE QUESTIONS 1.

Which one of the following will result from receiving cash upon issuing long-term debt? a. Increase of the company's indebtedness b. Decrease of the current ratio c. Increase of retained earnings d. Increase of total shareholders’ equity Ans: A KP 2 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

If the maximum debt/equity ratio as specified by a debt covenant is close to being violated, which one of the following actions would increase the likelihood of violating the debt covenant? a. Issuing capital stock b. Skip current cash dividends c. Acquire money by issuing a non-interest-bearing note payable d. Acquire money by collecting accounts receivable Ans: C KP 2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

If the maximum debt/equity ratio as specified by a debt covenant is close to being violated, which of the following actions would help avoid a violation of the covenant? a. Purchase long-term investments b. Increase current cash dividends declared c. Exchange bonds payable for common stock d. Acquire money by selling land at its balance sheet value Ans: C KP 2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

The debt/equity ratio will increase if a company a. pays off its long-term debt. b. decides to pay cash for more of its capital purchases. c. purchases long-term investments for cash. d. declares more current cash dividends. Ans: D KP 2 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

11-1

11-2

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

A non-interest-bearing obligation a. requires recognition of interest expense over the life of the obligation. b. is an example of an installment obligation. c. requires collateral. d. is free of interest expense. Ans: A KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

The difference in computing the effective interest rate for non-interest-bearing obligations as compared to installment obligations is a. one has an interest rate of zero, while the other is determined using present value factors. b. one uses the ‘present value of a single sum’ table and the other uses the ‘present value of an ordinary annuity’ table. c. one is based on the market rate of interest, while the other is based on a stated rate of interest. d. determined by the length of the debt maturity period. Ans: B KP 1,4 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Interest expense recognized over the life of an obligation is the difference between cash received at the time of issuance and cash paid over the life of the obligation for a. dividends declared. b. convertible bonds. c. non-interest-bearing obligations. d. receivables due from customers. Ans: C KP 3 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Payments on an installment obligation typically include the payment of a. principal only. b. both principal and interest. c. interest only. d. interest, but only if collateral is involved. Ans: B KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Which one of the following is needed in order to find the present value of an obligation? a. The discount rate of the associated cash flows b. All debt covenants that are a component of the obligation c. The gross profit rate of the borrower d. The rate of inflation during the year Ans: A KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

10.

11-3

How is interest expense calculated according to GAAP? a. Stated rate of interest x maturity value. b. Effective interest rate x maturity value of the obligation. c. Effective interest rate x balance sheet value. d. Stated rate of interest x balance sheet value. Ans: C KP 4,5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

11.

Interest expense calculated under GAAP is equal to the stated rate of interest times the maturity value if the interest-bearing obligation is issued at a. a discount. b. either a discount or a premium. c. a premium. d. par. Ans: D KP 4,5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

12.

If a company issues a non-interest-bearing note payable, then a. no interest expense will be recognized over the life of the note. b. no principal payments will be made over the life of the note. c. no interest payments will be made over the life of the note. d. the covenants should be rewritten to conform to GAAP. Ans: C KP 4 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

13.

If a company issues a non-interest-bearing note payable, then a. the cash received will exceed the maturity value of the note. b. the interest is not accrued. c. the cash received will be less than the maturity value of the note. d. the cash received will be more than the maturity value of the note. Ans: C KP 4 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

14.

If a company issues a note payable when the market rate of interest is greater than the stated rate, then a. the cash received will exceed the maturity value of the note. b. the note will be issued at a discount. c. the note will be issued at a premium. d. the cash received will be equal to the maturity value of the note. Ans: B KP 4 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

11-4

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

15.

If a company issues a note payable when the market rate of interest is less than the stated rate, then a. the note will be discounted at maturity. b. the cash received will be equal to the maturity value of the note. c. the cash received will exceed the maturity value of the note. d. the note will be issued at a discount. Ans: C KP 4 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

16.

If a company issues a note payable when the market rate of interest is equal to the stated rate, then a. the cash received will exceed the maturity value of the note. b. the note will be issued at a discount. c. the note will be issued at a premium. d. the note will be issued at par. Ans: D KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

17.

If an interest-bearing note payable is issued at par, then the contractual cash payment for interest is a. equal to interest expense. b. less than interest expense. c. greater than interest expense. d. It cannot be determined from the information given. Ans: A KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

18.

If an interest-bearing note payable is issued at a discount, then the contractual cash payment for interest is a. less than interest expense. b. greater than interest expense. c. equal to interest expense. d. ignored since no interest payment will be made. Ans: A KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

19.

If an interest-bearing note payable is issued at a premium, then the contractual cash payment for interest is a. greater than interest expense. b. less than interest expense. c. equal to interest expense. d. based on the market rate of interest. Ans: A KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

20.

11-5

If interest expense is greater than the contractual interest payment, then a. the note was issued at par. b. a debt covenant violation occurred. c. the note was issued at a premium. d. the note was issued at a discount. Ans: D KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

21.

If interest expense is less than the contractual interest payment, then a. the note was issued at a premium. b. the note was issued at a discount. c. the note was issued at par. d. the company should refinance the note to get a better interest rate. Ans: A KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

22.

If interest expense is equal to the contractual interest payment, then a. the note was issued at a premium. b. the note was issued at a discount. c. the note was issued at par. d. It cannot be determined from the information given. Ans: C KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

23.

A debt covenant a. serves to give assurance to a creditor that the debtor will have the ability to pay interest and principal at maturity. b. serves to give assurance to the debtor that the interest rate is reasonable. c. allows the creditor to become an owner of the company if the covenant is violated. d. allows the debtor to forego any interest on the debt. Ans: A KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

24.

On January 1, a 6-year, $5,000, non-interest-bearing note payable was issued when the market rate of interest was 8%. The present value of the note is a. $3,151. b. $2,080. c. $865. d. $5,000. Solution:

$5,000 x .6302 = $3,151

Ans: A KP 3,4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

11-6

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

25.

On January 1, a 3-year, $8,000, non-interest-bearing note payable was issued when the market rate of interest was 11%. To determine the amount at which the note will be valued on the balance sheet on the issue date, use the a. present value of $1 table. b. future value of an annuity due table. c. present value of an annuity table. d. future value of an annuity table. Ans: A KP 3,4 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

26.

On January 1, a 7-year, $8,000, non-interest-bearing note payable was issued when the market rate of interest was 7%. What amount should be recorded for the note on the balance sheet at the issue date? a. $3,570 b. $4,982 c. $11,241 d. $37,725 Solution:

$8,000 x .6227 = $4,982

Ans: B KP 3 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

27.

Companies generate assets in three different ways. They are a. equity contributed by owners, borrowings, and receivables from affiliates. b. equity issuances, borrowings, and interest rates. c. borrowings, profitable operations, and equity issuances. d. equity issuances, debt issuances, and financial instruments. Ans: C KP 1 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

28.

Which one of the following is not one of the possible kinds of notes? a. Non-interest-bearing note b. Interest-bearing notes c. Installment notes d. Bank notes Ans: D KP 1,3 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

29.

11-7

Which type of note consists of periodic payments covering both interest and principal? a. Interest-bearing bond b. Receivable note c. Non-interest-bearing note d. Installment note Ans: D KP 1,3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

30.

A provision of a contractual obligation that is designed to protect the interest of lenders is called a. a lenders’ security provision b. a restrictive covenant. c. a non-interest-bearing obligation. d. collateral. Ans: B KP 1,3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

31.

The actual interest rate used to calculate the interest payments by the issuer of the obligation is a. the market rate of interest. b. the effective interest rate. c. the stated interest rate. d. equal to the actual interest expense rate. Ans: C KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

32.

A non-interest-bearing note was recorded in the accounting records. The book value of the note a. remains the same during the maturity period. b. decreases during the maturity period. c. increases throughout the maturity period. d. is reported on income statement. Ans: C KP 1,4 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

11-8

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

33.

A five-year, non-interest-bearing, $5,000 note, dated January 1, 2010, has a present value of $3,917. The market rate of interest is 5%. Interest expense for the period ending December 31, 2010, is a. $392. b. $196. c. $250. d. $217. Solution: B

$3,917 x 5% = $196

Ans: B KP 4,5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

34.

A coupon payment is a. the payment of principal that is the ‘coupon’ of the total payments. b. the amount of interest expense reported on the income statement. c. calculated by multiplying the book value of the bonds times the effective rate of interest. d. the amount paid to bondholders on each interest payment date. Ans: D KP 1,4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

35.

A call provision in a bond contract may specify that the issuing company a. can issue the bonds at any interest rate it can entice the investors to accept. b. must make periodic interest payments. c. must deposit cash in the bank to be available when the bonds mature. d. may buy back bonds from the investors. Ans: D KP 1,4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

36.

Which one of the following bonds is considered unsecured? a. $50,000, 8%, debenture bonds b. $100,000, 12%, restricted bonds c. $20,000, 10%, five-year callable bonds d. $40,000, 6%, collateralized bonds Ans: A KP 1,4 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

37.

RJC Company issued $8,000 of 10% bonds on January 1, 2009. The bonds were issued at a premium. The cash payment for annual interest on the bonds a. is equal to annual interest expense. b. is greater than annual interest expense. c. is less than annual interest expense. d. equals the balance in Premium on Bonds Payable on the day the bonds were issued. Ans: B KP 1,5,6 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

38.

11-9

Darren Company issued $8,000 of 8% bonds on January 1, 2010, at a discount of $940. The market rate of interest on the issue date was 10%. The carrying value of the bonds on December 31, 2010 is a. $6,994. b. $7,060. c. $8,940. d. $7,126. Solution: D

$7,060 + [($7,060 x .10) − ($8,000 x .08)] = $7,126

Ans: D KP 5 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

39.

The amount of amortized bond premium a. reduces interest expense on the income statement. b. is reported as a deduction from bonds payable on the balance sheet. c. is reported as an addition to bonds payable on the balance sheet. d. is added to the present value of bonds. Ans: A KP 5 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

40.

Bonds payable that are redeemed by the issuer a. typically pay far less interest than the market rate of interest. b. are considered unsecured. c. have no market value. d. are repurchased or retired . Ans: D KP 1,5 BT: CK Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

41.

Financial instruments that are not listed on the balance sheet of a company a. may involve significant risks that must be disclosed in the notes to the financial statements. b. are reported as assets if the company can determine the fair value. c. must be reported as a liability on the balance sheet at the end of the accounting period. d. must be reported on the income statement. Ans: A KP 7 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

11-10

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

42.

Which one of the following is not a financial instrument? a. Dividends paid b. Short-term investment in equity securities c. Bonds payable d. Notes receivable Ans: A KP 1,4 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

43.

Capital leases are rental agreements of which a. periodic rental payments are recorded as rental revenue on the asset owner’s income statement. b. the contractual arrangements are similar to a purchase in all respects. c. the period of the lease is generally a very small portion of the leased asset's useful life. d. the lessee desires to have rights to use the asset but not ownership of such asset. Ans: D KP 7 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

44.

Woodsman Company issued $400,000 of 6-year, 6% bonds with interest payments occurring annually at the end of each year. What additional information is needed in order to determine the selling price of these bonds? a. The face amount of the bonds b. The bond covenants c. The market rate of interest d. The stated rate of interest Ans: C KP 4,5 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

45.

Gibson Corporation amortizes its bonds using the effective interest method. Which statement is correct? a. [Interest expense] = [Stated rate] X [Carrying value of the bonds] b. [Interest expense] – [Cash interest paid] = [Increase in carrying value if sold at a discount] c. [Cash interest payment] = [Bond face amount] X [Market interest rate] d. [Interest expense] – [Cash interest paid] = [Increase in carrying value if sold at a premium] Ans: B KP 4,5 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

46.

11-11

GAAP requires the lessee party to a capital lease a. to record the lease on its balance sheet at the present value of future lease payments. b. to record rental revenue as each lease payment is received. c. to depreciate the leased asset. d. to transfer ownership to the lessee. Ans: A KP 7 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

47.

Operating leases are treated as a. increases in liabilities for both the lessor and the lessee. b. a sale if the leased asset has been transferred from the lessor to the lessee. c. capital leases by the lessee. d. rental expense by the lessee. Ans: D KP 7 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

48.

Which one of the following is one of the capital lease criteria? a. The lease term is 75% or more of the useful life of the leased property. b. Ownership of the property is transferred back to lessor at the end of the lease term. c. The present value of the lease payments equals or exceeds 75% of the FMV of the property. d. The lease does not contain a bargain purchase option. Ans: A KP 7 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

49.

Countries throughout the world typically a. pay extremely large dividends to shareholders. b. rely heavily on local stock and bond markets. c. have less comprehensive accounting disclosure requirements than the U.S. d. carry a normal debt/equity ratio that is less than 25%. Ans: C KP 1 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic, Diversity AICPA BB: Critical Thinking AICPA FN: Reporting

50.

Investments in bonds are accounted for using a. historical cost. b. capital leases. c. the effective interest method. d. net realizable value. Ans: C KP App11B BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

11-12

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

51.

Perfectly effective hedges using interest rate swaps will always a. exactly match maturity dates with the underlying debt. b. minimize interest expense. c. maximize gains in bond values caused by interest rate fluctuations. d. all of the above. Ans: A KP App11C BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

52.

McCourt Investment Advisors purchased newly issued bonds on October 1, 2005, paying $108,983. The bonds had a face value of $100,000, maturing on September 30, 2010, and pay interest semiannually on March 31 and September 30. The stated interest rate is 6%. What is the effective interest rate? a. b. c. d.

4%. 5%. 6%. 7%.

Solution: A Because the bonds were issued at a premium, we know that the effective interest rate is lower than the stated rate. This eliminates answers c. and d. Our tables do not allow us to compute the present value of the interest at 5% because our table doesn’t include a 2.5% column. This leaves 4% as a possible solution. The following computation of the present value of the future cash flows at 4% arrives at our purchase price, proving that 4% is the effective rate. PV of interest payments $3,000 * 8.98259 (table 5, p=10, i = 2%) = $26,948 PV of principal $100,000 * .82035 (table 4, p=10, i = 2%) = $82,035 Total principal and interest $108,983 Ans: A KP 5, App11B BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

53.

11-13

The following information was extracted from the financial records of Lewis Company. 2010

2009

Balance Sheet Notes payable Less: Discount on notes payable

$400,000 24,000

$400,000 28,800

Income Statement Interest expense

$32,800

$32,400

Based on this information, what is the effective interest rate on the notes payable? a. 8.2% b. 8.8% c. 6.0% d. 2.2% Solution: B Interest Expense = Effective Rate  Book Value of Debt at Beginning of the Period $32,800 = Effective Rate  ($400,000 – $28,800) Effective Interest Rate = 8.8% (rounded)

Ans: B KP 4 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

54.

The following information was extracted from the financial records of Lewis Company. 2010

2009

Balance Sheet Notes payable Less: Discount on notes payable

$400,000 24,000

$400,000 28,800

Income Statement Interest expense

$32,800

$32,400

Based on this information, the journal entry Lewis Company should prepare to record interest expense during 2010 would include: a. a credit to Interest Payable for $32,800. b. a credit to Discount on Notes Payable for $24,000. c. a credit to Cash for $28,000. d. a credit to Notes Payable for $4,800. Solution: C Interest Expense ................................................................ Discount on Notes Payable .......................................... Cash ............................................................................ *

32,800

$4,800 = Change in the balance of Discount on Notes Payable

Ans: C KP 4,5 BT: K Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

4,800* 28,000

11-14

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

55.

On September 10, 2009, Humbert Company issued bonds with a face value of $600,000 for a price of 96. During 2012, Humbert exercised a call provision and redeemed the bonds for 101. At the time of the redemption, the bonds had a balance sheet value of $590,000. The journal entry to record the redemption includes: a. a credit to Bonds Payable for $576,000. b. a debit to Loss on Redemption for $16,000. c. a credit to Discount on Bonds for $24,000. d. a debit to Discount on Bonds Payable for $10,000. Solution: B Cash paid to redeem the bonds = Face value  101% = $600,000  101% = $606,000 Bonds Payable ................................................................... 600,000 Loss on Redemption .......................................................... 16,000 Discount on Bonds Payable ......................................... Cash .............................................................................

10,000* 606,000

* $10,000 = Face Value – Book Value = $600,000 – $590,000

Ans: B KP 1 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

56.

On September 10, 2009, Humbert Company issued bonds with a face value of $600,000 for a price of 102. During 2012, Humbert exercised a call provision and redeemed the bonds for 101. At the time of the redemption, the bonds had a balance sheet value of $607,000. The journal entry to record the redemption includes: a. a credit to Gain on Redemption for $1,000. b. a debit to Premium on Bonds for $7,000. c. a credit to Discount on Bonds for $7,000. d. a credit to Bonds Payable for $600,000. Solution: Bonds Payable ................................................................... 600,000 Premium on Bonds Payable ............................................... 7,000 Cash ............................................................................. Gain on Redemption .................................................... Ans: B KP 1 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

606,000 1,000

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

57.

11-15

Brown Company is about to issue $300,000 of 8-year bonds paying a 12% interest rate with interest payable semiannually. The effective interest rate for such securities is 10%. Below are available time value of money factors that Brown chooses from to calculate compounded interest.

Present Value of 1 Future Value of 1 Present Value of an Annuity of 1 Future Value of an Annuity of 1

8 periods, 10% 0.46651 2.14359 5.33493 11.43589

16 periods, 5% 0.45811 2.18287 10.83777 23.65749

8 periods, 12% 0.40388 2.47596 4.96764 12.29969

16 periods, 6% 0.39365 2.54035 10.10590 25.67253

To the closest dollar, how much can Brown expect to receive for the sale of these bonds? a. $319,339 b. $229,371 c. $332,513 d. $540,000 Ans: C KP 4,5 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

58.

Stevens Company is about to issue $400,000 of 10-year bonds paying an 8% interest rate with interest payable semiannually. The effective interest rate for such securities is 10%. Below are available time value of money factors that Stevens chooses from to calculate compounded interest.

Present Value of 1 Future Value of 1 Present Value of an Annuity of 1 Future Value of an Annuity of 1

10 periods, 8% 0.46319 2.15892 6.71008

20 periods, 4% 0.45639 2.19112 13.59033

10 periods, 10% 0.38554 2.59374 6.14457

20 periods, 5% 0.37689 2.65330 12.46221

14.48656

29.77808

15.93743

33.06595

To the closest dollar, how much can Stevens expect to receive for the sale of these bonds? a. $350,151 b. $292,637 c. $800,000 d. $1,405,503 Ans: A KP 4,5 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

11-16

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

59.

Torrey Corporation issued $1,000,000 of ten-year, 10 percent bonds payable dated January 1, 2009. The market rate of interest at that time was 11 percent. The journal entry to record this transaction will include a: a. debit to Bond Discount. b. credit to Bond Premium. c. credit to Bond Discount. d. credit to Cash. Ans: A KP 1,3 BT: AP Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

60.

Crosson Company uses the straight-line method of amortization and had a ten-year, 12 percent, $1,000,000 bond issue outstanding that had been sold at a $12,000 discount in 2008. The bonds pay interest on June 30 and December 31, and the company’s fiscal year end is December 31. The journal entry on June 30, 2011, will include: a. a $6,000 credit to Cash. b. a $1,200 credit to Bond Premium. c. a $58,800 debit to Interest Expense d. a $600 credit to Bond Discount. Ans: D KP 1,3 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

61.

Duncan Industries sold $100,000 of 12 percent bonds on January 1, 2006, when the market interest rate was 10 percent and received $107,732 for them. The bonds mature on January 1, 2011 and pay interest on June 30 and December 31. Duncan uses the effective interest method of amortization. The annual cash payment for interest on the bonds are: a. $10,000 b. $12,000 c. $5,000 d. $6,000 Ans: B KP 4,5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

62.

Duncan Industries sold $100,000 of 12 percent bonds on January 1, 2006, when the market interest rate was 10 percent and received $107,732 for them. The bonds mature on January 1, 2011 and pay interest on June 30 and December 31. Duncan uses the effective interest method of amortization. The June 30, 2006 entry will include: a. A $5,000 debit to Interest Expense. b. A $5,386.60 debit to Interest Expense c. A $5,000 credit to Cash d. A $5,386.60 debit to Bond Premium Ans: B KP 4,5 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

63.

11-17

a. $12,000.00 b. $10,000.00 c. $107,734 d. $9,246 Ans: C KP 4,5 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

64.

Bowlin Company issued $1,000,000 of 9 percent, ten-year bonds for $937,790 on July 1, 2008, when the market rate of interest was 10 percent. The bonds mature in ten years and pay interest on June 30 and December 31. Bowlin’s fiscal year ends on December 31and the company uses the effective interest method of amortization. The interest expense for the six months ending December 31, 2008 is: a. $50,000.00 b. $45,000.00 c. $46,889.50 d. $93,779.00 Ans: C KP 4,5 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

65.

Bowlin Company issued $1,000,000 of 9 percent, ten-year bonds for $937,790 on July 1, 2008, when the market rate of interest was 10 percent. The bonds mature in ten years and pay interest on June 30 and December 31. Bowlin’s fiscal year ends on December 31and the company uses the effective interest method of amortization. The book value of the bonds on December 31, 2008 is: a. $1,000,000.00 b. $944,011.00 c. $941,452.90 d. $939,679.50 Ans: D KP 4,5 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

11-18

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

66.

Burns Company issued $1,000,000 of 9 percent, ten-year bonds for $937,790 on July 1, 2010, when the market rate of interest was 10 percent. The bonds mature in ten years and pay interest on June 30 and December 31. Burn’s fiscal year ends on December 31 and the company uses the effective interest method of amortization. The journal entry on December 31, 2010 will include: a. a debit to Interest Expense for $45,000.00 b. a credit to Bond Discount for $1,889.50 c. a credit to Interest Payable for $45,000.00 d. a credit to Cash for $46,973.95 Ans: B KP 4,5 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

67.

Barkley Brothers Inc. shows the following information on its balance sheet for December 31, 2010. Bonds payable Less Unamortized discount

$100,000 5,350

$94,650

The bonds have a stated annual interest rate of 5 percent and will mature on December 31, 2012. The market value of the bonds as of December 31, 2010, is $98,167. Assume that Barkley retired the bonds by purchasing them on the open market. The journal entry to record this purchase would include: a. a credit to Bonds Payable for $100,000. b. a debit to Discount on Bonds Payable for $5,350. c. a credit to Discount on Bonds Payable for $5,350. d. a debit to Cash for $98,167. Solution: Loss on Retirement of Debt ............................................................ Bonds Payable ................................................................................. Discount on Bonds Payable ....................................................... Cash ...........................................................................................

3,517 100,000

Ans: C KP 4,5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

5,350 98,167

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

11-19

MATCHING QUESTIONS 1.

Identify the balance sheet classification (a through e) in which each account description numbered 1 through 7 would be reported. You may use each letter more than once or not at all. You may assign more than one category to an account if it can be classified in more than one category.

a. b. c. d. e.

Balance Sheet Classifications Current assets Long-term assets Current liabilities Long-term liabilities Not reported on the balance sheet

____1.

Loss on redemption

____2.

1-year non-interest-bearing note receivable

____3.

Discount on bonds that mature in 3 years

____4. ____5.

6-month note payable Premium on bonds issued that mature in 8 months

____6.

Discount on notes payable due in 12 months

____7.

Lease liability on a 5-year capital lease paid annually

Solution: 1. e 2. a 3. d 4. c 5. c 6. c 7. c and d KP 1,7 BT: C Difficulty: Moderate TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

11-20

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

Identify the effect(s) as a result of each transaction listed as 1 through 4 below by placing the letter of the effect on total liabilities and the effect on net income in the two columns provided. Keep in mind that there are currently no accrued expenses recorded on the balance sheet as liabilities. Effects I. Increase D. Decrease X. Does not change Liabilities

Net Income

1. Acquired the use of equipment under a capital lease 2. A capital lease payment is paid (principal and interest) 3. Periodic interest and amortization of bond discount is recognized 4. Paid interest on bonds issued at par Solution: 1. I, X 2. D, D 3. I, D 4. X, D KP 3,7 BT: AP Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

11-21

Identify which accounting effect (a through e) occurs as a result of each transaction numbered 1 through 6. You may use each letter more than once or not at all.

a. b. c. d. e.

Accounting Effects + A and + L + A and – L – A and – L and – SE – A and – SE – A and + L and – SE

____

1. Issued a bond payable at a premium

____

2. Issued a bond payable at a discount

____

3. Issued a non-interest-bearing note at a discount

____

4. Paid periodic interest and amortized discount to interest expense

____

5. Paid periodic interest and amortized premium to interest expense

____

6. Paid interest on bond payable which was issued at par

Solution: 1. a 2. a 3. a 4. e 5. c 6. d KP 2 BT: AP Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

11-22

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

Identify the effect(s) on the debt/equity ratio (a through c) as a result of each transaction numbered 1 through 6 below. You may use each letter more than once or not at all. Effects a. Increase in debt/equity ratio b. Decrease in debt/equity ratio c. Does not change debt/equity ratio ____

Acquired the use of equipment under a capital lease

____

Paid the interest portion of the payment on a capital lease

____

Paid the principal portion of the payment on a capital lease

____

Acquired the use of equipment under an operating lease

____

Payment required on an operating lease

Solution: 1. a 2. a 3. b 4. c 5. a KP 7 BT: AP Difficulty: Moderate TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

11-23

Identify which accounting effect (a through e) occurs as a result of each transaction numbered 1 through 6. You may use each letter more than once or not at all.

a. b. c. d. e.

Accounting Effects + A and + L + A and + SE – A and – L – A and – SE No change in total A, L, SE

____

1. Acquired the use of equipment under a capital lease

____

2. Paid the interest portion of the payment on a capital lease

____

3. Paid the principal portion of the payment on a capital lease

____

4. Depreciation of equipment leased under a capital lease

____

5. Acquired the use of equipment under an operating lease

____

6. Payment required on an operating lease

Solution: 1. a 2. d 3. c 4. d 5. e 6. d KP 7 BT: AP Difficulty: Moderate TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

11-24

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

Identify the effect(s) on the debt/equity ratio (a through c) as a result of each transaction numbered 1 through 6 below. You may use each letter more than once or not at all.

a. b. c.

Effects Increase in debt/equity ratio Decrease in debt/equity ratio Does not change debt/equity ratio

____

Issued a bond payable at a discount

____

Issued a non-interest-bearing note at a discount

____

Issued an interest-bearing note at a premium

____

Amortized discount to interest expense

____

Paid interest on bonds payable that was issued at par

____

Market value of bonds payable increased after issue date

____

Retired a bond issue by paying cash

Solution: 1. a 2. a 3. a 4. a 5. a 6. c 7. b KP 1,2 BT: AP Difficulty: Moderate TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

SHORT PROBLEMS

On January 1, 2010, Lukens Corporation issued 5-year bonds with a $50,000 face amount and a 6% annual coupon rate paid annually on January 1. The bonds were issued at $44,166 when the market rate of interest was 9%. A. Prepare the journal entry to record the issuance of the bonds on January 1, 2010. Round to the nearest dollar. B. Were the bonds issued at a premium or discount? How do you know? Solution: A. Cash Discount on Bonds Payable Bonds Payable

44,166 5,834 50,000

B. The bonds were issued at a discount. Two items reflect this—the issue price is less than the face amount of the bonds, and the market rate of interest is greater than the stated rate of interest.

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

11-25

KP 4,5 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

On January 1, a 3-year, $1,090 non-interest-bearing note payable was issued for $942 when the market rate of interest was 5%. How much interest expense will Hamlen recognize in each of the first two years using the effective interest method? Round to the nearest dollar. Solution: First year interest expense: $942 x .05 = $47 Second year interest expense: ($942 + $47) x .05 = $49 KP 4,5 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

On January 1, 2010, Hooper Corporation issued 3-year bonds with a $40,000 face amount and a 6% annual coupon rate paid annually on December 31. The bonds were issued at $36,021 when the market rate of interest was 10%. Complete the amortization table for the bonds using the effective interest method. Round all amounts to the nearest dollar. Date

Cash

Interest Expense

Amortization

Carrying Value

Cash

Interest Expense

Amortization

3,602 3,722 3,855

1,202 1,322 1,455

Carrying Value $36,021 37,223 38,545 40,000

1/1/10 12/31/10 12/31/11 12/31/012

Solution: 1/1/2010 12/31/2010 12/31/2011 12/31/2012

2,400 2,400 2,400

KP 5 BT: AN Difficulty: Moderate TOT: 7 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

On January 1, a 5-year, $5,000 non-interest-bearing note payable was issued when the market rate of interest was 9%. What are the proceeds from this issue? Round your final answer to the nearest dollar. Solution: $5,000 x .6499 = $3,249 KP 3,4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

11-26

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

On January 1, a 5-year, $4,000 non-interest-bearing note payable was issued for $2,600 when the market rate of interest was 9%. What is the total interest expense that will be recognized over the life of the note? Round your final answer to the nearest dollar. Solution: Cash paid ($4,000) – Cash received ($2,600) = $1,400 KP 3,4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

On January 1, a 3-year, $10,000 non-interest-bearing note payable was issued for $7,938 when the market rate of interest was 8%. Interest expense is recognized using the effective interest method. Calculate the balance sheet value of the note a year after its issuance. Round your final answer to the nearest dollar. Solution: $7,938 + $635 = $8,573 KP 4,5 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Samuels Corporation issued a $40,000, 3-year, non-interest-bearing note payable on January 1, 2009. Reflecting a market rate of interest of 10%, Garrison received $30,053. Calculate interest expense (to the nearest dollar) for 2009 and 2010. Solution: 2009: $30,053 x .10 = $3,005 2010: ($30,053 + $3,005) x .10 = $3,306 KP 3,5 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

On January 1, 2009, Pacific Corporation issued a 3-year, 8%, $5,000 bond payable. Beginning in 2010, interest is payable every January 1 over the life of the bond. The market rate of interest on January 1, 2009 is 10%. The bond was issued at $4,750. Calculate the total interest expense over the 3-year life of the bond independent of the particular accounting method used to recognize interest expense each year. Solution: [$5,000 – $4,750] + (3 x (8% x $5,000)] = $1,450 KP 5 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

11-27

On January 1, 2009, Mango Corporation issued a 3-year, 4%, $3,000 bond payable. Beginning in 2010, interest is payable every year on January 1 over the life of the bond. The market rate of interest on January 1, 2009 is 6%. What are the proceeds received by Mercer from the issue of this bond on January 1, 2009? Solution: Present value of interest at n=3, I = 6: Present value of principal at n=3, I = 6: Total proceeds

$120 x 2.673 = $321 $3,000 x .840 = $2,520 $321 + $2,520 = $2,841

KP 3,5 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

10.

On January 1, 2009, Sheena Corporation issued a 3-year, 7%, $4,000 bond payable. Beginning in 2010, interest is payable every January 1 over the life of the bond. The bonds were issued at 104¼. Calculate the issue price. Solution: 104¼ x $4,000 /100 = $4,170 KP 5, App11A BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

11.

On January 1, 2009, Enron Corporation issued a 4-year, 7%, $9,000 bond payable. Beginning in 2010, interest is payable annually every January 1. The market rate of interest at issuance is 9%. How much are the interest payments by Enron? Why is the amount of interest expense different than the cash payments? Solution: 7% x $9,000 = $630 per year for 4 years Interest expense is different since it is based on the market rate of interest of 9%. The investor will earn and the issuer must incur the market rate for both parties to be in agreement on the bond transactions, i.e., the investor demands to earn 9% on this bond since he can earn 9% on other investments in the market. Conversely, the issuer will not attract any investors unless it provides a return of 9% to the investors. KP 5 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

12.

On January 1, 2009, Precision Corporation issued a 3-year, 7%, $2,000 bond payable. Beginning in 2010, interest is payable every January 1 over the life of the bond. The market rate of interest on January 1, 2009 is 10%. If Precision uses the effective interest method, what is the balance sheet value of the bond payable on January 1, 2009? Solution: PV of principal of $2,000 for n=3, I=10: $2,000 x .7513 = $1,503 PV of interest of $140 for n=3, I=10: $140 x 2.487 = $348 Total: $1,503 + $348 = $1,851 KP 5 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

11-28

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

13.

On January 1, 2009, Edison Corporation issued a 4-year, 8%, $5,000 bond payable. Beginning in 2010, interest is payable every January 1 over the life of the bond. The market rate of interest on January 1, 2009 is 10%. A. Calculate the contracted cash interest payments by Edison as specified by this bond. B. Will the total interest expense over the life of the bond be less than or greater than the total cash payments for interest? Explain. Solution: A. .08 x $5,000 = $400 per year for 4 years B. Interest expense will be greater than the total of the cash interest payments because the cost to the bond issuer is based on the market rate, which is greater than the stated rate of interest. KP 4,5 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

14.

On January 1, 2009, Lundell Corporation issued a 5-year, 4%, $2,000 bond payable. Beginning in 2010, interest is payable every January 1 over the life of the bond. The bonds were issued at 105 3/4. How much cash did Lundell receive from issuing the bonds on January 1, 2009? Solution: 105 3/4 x $2,000 /100 = $2,115 KP 4,5 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

15.

On January 1, 2009 Frank Corporation issued a 3-year, 9%, $5,000 bond payable. Beginning in 2010, interest is payable every January 1 over the life of the bond. The market rate of interest on January 1, 2009 is 6% when the bonds were issued at 108. Calculate the total interest expense over the 3-year life of the bond independent of the particular accounting method used to recognize interest expense each year. Solution: Total cash paid: $5,000 + (9% x $5,000 x 3) = $6,350 Cash received: 108 x $5,000 /100 = $5,400 Interest expense: $6,350 – $5,400 = $950 KP 5 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

16.

11-29

On January 1, 2009, Field Corporation issued a 3-year, 9%, $5,000 bond payable. Beginning in 2010, interest is payable every January 1 over the life of the bond. The market rate of interest on January 1, 2009 is 6%. What is the impact of the debt/equity ratio as a result of the issuance? Solution: The issuance causes an increase in assets (cash) and liabilities (bonds payable). The debt/equity ratio increases. KP 5 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

17.

On December 31, 2009, Creative Corporation issued a 3-year, 9%, $1,000 bond payable. Beginning in 2010, interest is payable every January 1 over the life of the bond. The market rate of interest on December 31, 2009 is 5%. If Creative uses the effective interest method, show how the bonds will appear on Creative’s balance sheet at December 31, 2009. Solution: Interest: 9% x $1,000 x 2.723 = $245 Principal: $1,000 x .864 = $864 Principal and interest = $245 + $864 = $1,109 Long-term Liabilities Bonds payable Premium on bonds payable Net bonds payable

$1,000 109 $1,109

KP 5 BT: AN Difficulty: Moderate TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

18.

On January 1, 2009, Luna Corporation issued a 5-year, 7%, $5,000 bond payable. Beginning in 2010, interest is payable every January 1 over the life of the bond. The market rate of interest on January 1, 2009 is 7%. Luna uses the effective interest method. Calculate the balance sheet value of the bond payable on January 1, 2010. Solution: $5,000 (issued at par) KP 5 BT: AN Difficulty: Easy TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

11-30

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

19.

On January 1, 2009, Richardson Company leased equipment under a 3-year lease with payments of $8,000 on January 1, 2010, 2011, and 2012. The present value of the lease payments at a discount rate of 7% is $20,992. RIchardson uses straight-line depreciation with no salvage value. The lease is considered a capital lease. Calculate depreciation expense and interest expense for 2009. Solution: Depreciation expense: $20,992 / 3 = $6,997 Interest expense: $20,992 x 7% = $1,470 KP 4,7 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

20.

On January 1, 2010, Foster Corporation issued a 2-year, non-interest-bearing, $4,000 note payable. Interest is payable each December 31 during the life of the note. When the note was issued, the market rate of interest was 6%. Complete the following amortization schedule: Date

Interest Expense

Cash Payment

Balance Sheet Value

Cash Payment

Balance Sheet Value

1/1/10 12/31/10 12/31/11

Solution: $4,000 x .89 = $3,560 Date 1/1/10 12/31/10 12/31/11

Interest Expense

$214 226

$0 0

$3,560 3,774 4,000

KP 1,3 BT: AN Difficulty: Moderate TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

21.

11-31

On January 1, 2009, Parker Company leased equipment under a 3-year lease with payments of $5,000 on each December 31 of the lease term. The present value of the lease payments at a discount rate of 12% is $12,010. If the lease is considered a capital lease, depreciation expense (straight-line) and interest expense are recognized. If the lease is considered an operating lease, then rent expense is recognized. What is the difference in the total combined net incomes of 2009, 2010, and 2011, if the lease is considered a capital lease instead of an operating lease? Solution: The total expense for the next three years under the 3-year lease will be the total cash paid of $15,000. If the lease is an operating lease, then the $15,000 is recognized as rent expense. If the lease is a capital lease, then the $12,010 is recognized as depreciation expense. Interest expense would then be the difference between the present value of $12,010 and the principal of $15,000, for a total of $2,990. The total expense for either type of lease will be $15,000 so there is no difference in the total net incomes. KP 4,7 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

22.

On January 1, 2009, Action Corporation issued a two-year, 5%, $1,000 bond payable. Beginning in 2010, interest is payable every January 1 over the life of the bond. The market rate of interest on January 1, 2009 is 3%. Calculate the present value of the bond issued by Action on January 1, 2009. Solution: $50 x 1.913 = $96 $1,000 x .943 = $943 Principal and interest = $96 + $943 = $1,039 KP 5 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

23.

On January 1, 2009, Alcon Corporation issued a 5-year, 10%, $10,000 bond payable. Beginning in 2010, interest is payable every January 1 over the life of the bond. The market rate of interest on the issue date is 10%. Calculate the interest expense for 2009 using the effective interest method. Solution: First year interest expense: $10,000 x 10% = $1,000 (issued at par) KP 5 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

11-32

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

24.

On January 1, 2009, Mega Company leased equipment under a 5-year lease with payments of $7,000 on each December 31 of the lease term. The present value of the lease payments at a discount rate of 9% is $27,230. The lease is considered a capital lease. A. Determine the amount of the leased asset and lease obligation on January 1, 2009. B. Why are some leases accounted for as purchases by the lessee? Solution: A. Leased asset: Lease obligation:

$27,230 $27,230

B. The lessee treats a lease as a purchase when the rights, risks, and benefits of ownership have in substance, been acquired. KP 5,7 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

25.

On January 1, 2009, Seaside Company leased equipment under a 5-year lease with payments of $3,000 on each December 31 of the lease term. The present value of the lease payments at a discount rate of 7% is $12,300. The lease is considered a capital lease. Calculate depreciation expense (straight-line with no salvage) and interest expense for 2009. Solution: Depreciation expense: $12,300/5 = $2,460 Interest expense: $12,300 x 7% = $861 KP 5 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

26.

11-33

On January 1, 2010, Jackson Corporation issued a 4-year, 12%, $20,000 installment note payable. The payment on this note is $6,585 and is paid annually at year-end beginning December 31, 2010. Complete the following amortization schedule. Date

Cash

Interest Expense

Amortization

Carrying Value

Cash

Interest Expense

Amortization

Carrying Value

Jan. 1, 2010 Dec. 31, 2010 Dec. 31, 2011 Dec. 31, 2012 Dec. 31, 2013

Solution: Date Jan. 1, 2010 Dec. 31, 2010 Dec. 31, 2011 Dec. 31, 2012 Dec. 31, 2013

$6,585 6,585 6,585 6,585

$2,400 1,898 1,335 705

$4,185 4,687 5,250 5,878*

*rounded KP 6 BT: AN Difficulty: Moderate TOT: 6 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

$ 20,000 15,815 11,128 5,878 0

11-34

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

27.

On January 1, 2009, Standard Incorporated is going to issue long-term debt in order to obtain money required to finance the purchase of equipment. It will have to pay a market rate of interest of 10% on this borrowed money. Standard is considering two different financial instruments in order to obtain $10,494. The first instrument being considered is a 3-year, 12%, $10,000 note with interest payable every December 31 over the life of the note. Alternatively, a 3-year, non-interest-bearing note with maturity value of $13,657 will be issued. Show how Standard's January 1, 2009 balance sheet and 2009 income statement will differ if Standard chooses to issue the non-interest-bearing note instead of the 10% note. Solution: The present value of both financial instruments on January 1, 2009, at an 10% market rate of interest is $10,494. Because each note payable would be carried on the balance sheet at its present value, Standard’s January 1, 2009, balance sheet would be unaffected by the choice of financial instruments issued. The presentation under each of the alternative liabilities at January 1, 2009 would be:

Maturity value Premium (discount) Net book value

Non-Interest-Bearing Note $13,657 (3,163) $10,494

12% Note $10,000 494 $10,494

Because interest expense is the market rate of interest times the carrying value at the beginning of the year, during 2009 interest expense would also be the same. Under either financial instrument, interest expense would be .10 x $10,494 = $1,049. Net income for 2009 would be unaffected by the choice of notes. KP 4 BT: AN Difficulty: Difficult TOT: 8 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

28.

11-35

On January 1, 2010, Gee Company issued a 2-year, 8%, $20,000 installment note payable. The payment on this note is $11,215 and is paid annually at year-end beginning December 31, 2009. When the note was issued, the market rate of interest was 8%. Complete the following amortization schedule. Date

Cash

Interest Expense

Principal

Carrying Value

Cash

Interest Expense

Principal

Carrying Value $20,000

1/1/10 12/31/10 12/31/11

Solution: Date 1/1/10 12/31/10 12/31/11

$11,215 11,215

$1,600 831

$9,615 10,385*

10,385 -

*rounded KP 6 BT: AN Difficulty: Moderate TOT: 7 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

29.

On January 1, 2009, Grant Company leased telephone equipment from Xu, Inc. Grant uses straight-line depreciation. The contract requires Grant to pay $5,000 each December 31 for the next three years, at which time the equipment is to be returned to Xu. Using an interest rate of 8%, the present value of the lease payments is $12,885. The following is Grant’s January 1, 2009, balance sheet before the lease agreement. Current assets Equipment Accumulated depreciation Total assets Liabilities Shareholders' equity Total liabilities and shareholders' equity

$20,000 $25,000 (3,000)

22,000 $42,000 $20,000 22,000 $42,000

Calculate and compare Grant’s debt/equity ratios on January 1, 2009, immediately after the lease is signed, as an operating lease and a capital lease. Solution: The liability and shareholders' equity section would be: Operating Liabilities $20,000 Shareholders' equity 22,000 Total liabilities and shareholders' equity $42,000 Debt/equity ratio 0.91

Capital $32,885 22,000 $54,885 1.49

If the lease is considered a capital lease, the long-term solvency position of Grant as measured by the debt/equity ratio has deteriorated. However, it should be noted that under each condition, capital or operating lease, the future cash flows are the same. Therefore, Grant’s "real" long-term solvency position is the same. KP 7 BT: AN Difficulty: Difficult TOT: 8 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

11-36

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

Use the table below to answer the problems 30 through 33. Jan. 1, 2009 Dec. 31, 2009 Dec. 31, 2010 Dec. 31, 2011

30.

$2,400 2,400 2,400

3,602 3,722 3,855

1,202 1,322 1,455

$36,021 37,223 38,545 40,000

What is the nature of the table presented? What is being amortized? Solution: This is a bond amortization table. Bond discount is being amortized over a three-year period. KP 4,5 BT: C Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

31.

Were the bonds issued at a discount or premium? How do you know? Solution: The bonds were issued at a discount, evident by the fact that the issue price is less than the face amount of the bonds. KP 4,5 BT: C Difficulty: Easy TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

32.

Determine the coupon rate of interest on the bonds. What does this amount represent? Solution: The coupon rate of interest determines the cash payment made to bond investors by the bond issuer. The coupon rate is stated on the bond certificate. The coupon interest rate is multiplied by the face amount of the bonds to determine the interest payment: $40,000 (x) = $2,400 Solving for x, these bonds have an annual coupon interest rate of 6%. KP 4,5 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

33.

Calculate the effective interest rate on these bonds. Why is this amount different than the coupon rate? Solution: $3,602 = (X) $36,021, so the effective rate is 10%. This amount is different than the coupon rate because the market rate of interest changed during the time it took the bond issuers to get the bonds ready to issue. KP 4,5,6 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

34.

11-37

On January 1, 2009, Foresite Corporation issued a 10-year, 9%, $100,000 installment note payable. The payment on this note is $15,582 and is paid annually at year-end beginning December 31, 2009. How much total interest is paid over the loan period? Solution: $15,582 x 10 = $155,820 – $100,000 = $55,820 KP 6 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

35.

On January 1, 2009, Justin Corp. leased equipment under a five-year lease with payments of $20,000 on each December 31 of the lease period. The present value of the lease payments is $77,800, using a market interest rate of 9%. Justin depreciates its equipment straight-line over 5 years with zero salvage value. The capital lease criteria are met. Calculate depreciation expense for 2009. Solution: $77,800/5 years = $15,560 KP 7 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

36.

On January 1, 2009, Denver Company leased equipment under a 5-year lease with payments of $5,000 on each December 31 of the lease term. The present value of the lease payments at a discount rate of 12% is $18,024. If the lease is considered a capital lease, what is the balance sheet value of the lease obligation on January 1, 2010? Solution: $18,024 – [$5,000 – ($18,024 x 12%)] = $15,187 KP 4,7 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

11-38

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

37.

Crawford Company conducts a lottery system for Mississippi. The agreement specifies that the lottery must be conducted on a not-for-profit basis. Crawford’s monthly sales of lottery tickets amounts to $1,400,000. Monthly operating expenses are $400,000, including a management charge of $30,000. The payment schedule for the guaranteed $1 million dollar payout for a winning lottery ticket is $100,000 immediately and $100,000 each year for the next 9 years. Crawford produced the following income statement as evidence of its not-for-profit status: Ticket sales Expenses: Payout expense Operating expenses Net income

$1,400,000 $1,000,000 400,000

1,400,000 $ 0

A. If the market rate of interest is 4%, determine the present value of the $900,000 liability arising from the monthly winning lottery ticket. B. Recalculate the income statement to reflect GAAP measurement of payout expense. Solution: A. The present value of the liability is the present value of an annuity for 9 periods at 4% multiplied by $100,000. This results in a long-term liability of $743,533. B. Ticket sales Expenses: Payout expense ($743,533 + $100,000) Operating expenses Net income

$1,400,000 $843,533 400,000

1,243,533 $ 156,467

KP 4 BT: AN Difficulty: Moderate TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

38.

On January 1, 2010, Holly Company leased telephone equipment from ICON, Inc. Straight-line depreciation is used on all equipment with no salvage value. The contract required Holly to pay $5,000 each December 31 for the next three years, at which time the equipment is to be returned to ICON. Using an effective rate of interest of 8%, the present value of the lease payments is $12,885. Numerically derive the difference in Holly’s 2010 income if the lease is treated as an operating lease instead of a capital lease. Solution: Under an operating lease, total expense in 2010 is the cash paid of $5,000. If the lease is a capital lease, total 2010 expense is $5,326 (interest expense of $1,031* plus depreciation of $4,295**). Therefore, 2010 income is more by $326 if the lease is treated as an operating lease. * Interest = $12,885 x 8% = $1,031 (rounded) **Depreciation = $12,885 / 3 years = $4,295 per year KP 7 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

39.

11-39

On January 1, 2010, Everton Company leased equipment under a 3-year lease with payments of $10,000 on January 1, 2010, 2011, and 2012. The present value of the lease payments at a discount rate of 9% is $27,591, which includes the immediate cash payment on January 1, 2010. If the lease is considered an operating lease, how much is rent expense for 2010? Solution: $10,000 KP 7 BT: AN Difficulty: Easy TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

SHORT ESSAY QUESTIONS 1.

Branson Incorporated is considering leasing equipment. It can either lease the equipment for five or ten years. The five-year lease allows Branson to classify the lease as an operating lease. However, the ten-year lease requires Branson to classify the lease as a capital lease. Branson is operating under a debt covenant that sets a maximum on its debt/equity ratio. If Branson is close to violating this debt covenant, which lease contract would you advise Branson to sign? Why? Solution: If Branson is only concerned with the violation of its debt covenant that restricts its debt/equity ratio, then it should lease the equipment for only five years under an operating lease. Under an operating lease, the lease obligation is not recognized on the balance sheet and will, therefore, not increase the debt/equity ratio. However, the cash payment obligations under an operating lease are disclosed in the footnotes to the balance sheet. If Branson leased the equipment for ten years that was recorded as a capital lease agreement, then it must recognize the lease obligation equal to the present value of the minimum lease payments on the balance sheet. This would increase Branson 's debt/equity ratio that might violate the debt covenant. KP 7 BT: AP Difficulty: Moderate TOT: 5 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

11-40

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

Felton Incorporated is considering leasing equipment. It can either lease that equipment for five or ten years with the same annual lease payments under either agreement. The five-year lease allows Felton to classify the lease as an operating lease. However, the ten-year lease requires Felton to classify the lease as a capital lease. If Felton desires to measure net income higher in the initial year of the lease agreement, which lease contract would you advise Felton to sign? Why? Solution: If Felton enters into an operating lease, then rent expense equal to the lease payment is recognized on the income statement. However, if the lease is a capital lease, then the expense recognized on the income statement is equal to the depreciation expense associated with the leased asset and interest expense resulting from the lease liability. During the early periods of the lease contract, the depreciation and interest expense resulting from a capital lease exceed lease payments (expense) associated with an operating lease (assuming equal lease payments). The reason for this difference is that interest expense is recognized using the interest method that recognizes greater interest expense during the early periods of the lease. The difference is amplified if the lessee uses an accelerated depreciation method. Because the initial year's expenses under an operating lease are less than that under the capital lease, the net income under the operating lease is larger. Therefore, if Felton desires a higher net income in the first year of the lease, it should sign the five-year operating lease. However, it must be understood that total expense over the lease period will equal total cash paid for leasing the equipment, independent of the type of lease. KP 7 BT: AP Difficulty: Moderate TOT: 6 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

Distinguish between an installment obligation and a non-interest-bearing obligation. Solution: An installment obligation requires periodic payments that consist of both principal and interest. Under the effective interest method, the dollar amount of principal increases and the dollar amount of interest decreases as the maturity date becomes closer. A noninterest-bearing obligation typically requires one payment that consists of both principal and interest. Sometimes interest payments are made annually, and the entire principal is paid upon maturity. Present value calculations are required in order to calculate both types of obligations. KP 3 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

How do debt covenants impact a company's financial position? Solution: Debt covenants are imposed by debt holders to protect their interest and to restrict management by limiting long-term debt and lease obligations, by requiring that working capital must be a certain percent or dollar amount, by limiting short-term borrowings, or by restricting dividend payments. A company that violates restrictive covenants is said to be in default, and the bondholders often have recourse when this happens. KP 3,4 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

11-41

What is the risk premium of a bond issue and what role does it play in the determination of bond prices? Solution: The risk premium is expressed as a percentage and reflects the probability that a company will default on its periodic interest payments or the face value payment at maturity. If this probability is high, the bonds would be considered “high risk” and the risk premium would be relatively large (perhaps 5-10 percent). If the probability is low, the risk premium would be considerably less (perhaps 1-3 percent). The risk premium is associated specifically with the company issuing the bonds. It is determined by a number of factors, including the credit rating of the company and the bond issuance, the solvency and earning power of the company, future movements in the economy and how these movements may affect the operations of the company, and the terms of the bond issuance. Analyzing financial statements is an important part of assessing the risk premium associated with investing in a particular company. KP App 11A BT: C Difficulty: Easy TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

When the effective interest method is used to account for notes, the dollar amount of interest will increase or decrease throughout the maturity period. Explain why. Solution: The effective interest method assumes that larger amounts of interest relate to larger debt balances. The carrying value of the debt is used as a basis on which to calculate interest. If the carrying value the debt is larger, the dollar amount of the interest will be larger. KP 4 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

11-42

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

What are 'off-balance sheet risks'? What disclosures are required? Solution: Off-balance sheet risks may consist of financial instruments not listed on the balance sheet, many of which involve significant risk. Examples include commitments to guarantee the credit of third parties, commitments to provide financing to customers who purchase certain inventory items, and special financing arrangements that are designed to reduce the risk associated with fluctuations in interest rates and the value of foreign currencies relative to the U.S. dollar. Many of these are referred to as ‘derivative’ financial instruments. Extensive disclosure is required to make users aware of situations that may cause a company to experience a loss. KP 7 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Various contractual forms specify additional terms such as collateral. Describe collateral as it pertains to a company's debt. Solution: Assets are often pledged as security, i.e., collateral, on a loan. If the required cash payments, principal or interest are not met, the creditors (bond investors) can take the collateral as payment for the debt. KP 3 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

Describe the two cash flows associated with bonds. Solution: Bonds consist of two cash flows—interest payments, which occur periodically throughout the bond term, and the bond principal. Most often bond principal matures at the end of the bond term, but it might mature periodically in ‘chunks’ if the bonds are serial bonds. KP 3, App11A BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

10.

Why might a company redeem bonds before they mature? Solution: Economic conditions (especially interest rates) change. Companies may wish to retire debt with higher interest rates in order to secure debt with lower interest rates. KP 2 BT: C Difficulty: Easy TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

11.

11-43

How does the balance between debt and equity in non-U.S. companies compare to the balance of debt and equity in U.S. companies? Solution: U.S. companies rely heavily on both debt and equity capital. This reliance influences their accounting systems to provide information for both equity and debt investors. The importance of earning power and solvency in the assessment of a company’s financial health is emphasized in the U.S. Other countries such as Japan, Germany, and Switzerland are characterized by having a few, very large banks that satisfy the capital needs of most businesses. Stock and bond markets are not as heavily relied upon as they are in the U.S. Japan has experienced above normal debt/equity ratios, often to be well in excess of 75 percent, most of it in the form of long-term notes financed by banks. International operations such as these have disclosure requirements that are not as comprehensive as those in the U.S. due to investor and creditor needs. In these countries, it is not unusual for a bank to have members on a corporate Board of Directors for which they provide capital, in order to closely monitor the company’s financial health. Japanese accounting rules set the ceiling on profits available for dividends to shareholders. This ceiling insures there will be adequate cash available to meet debt payments. KP 7 BT: AP Difficulty: Moderate TOT: 5 min. AACSB: Analytic, Communication, Diversity AICPA BB: Critical Thinking AICPA FN: Measurement

12.

Describe the relationship between the stated rate of interest and the effective rate of interest as it relates to bonds. Solution: The stated rate is the rate of interest that is 'stated' specifically on the bond certificate and in the bond indenture. The issuer is required to make interest payments based on the stated rate. The effective interest rate is the rate the bond issuer will ultimately end up paying when the cost of a premium or discount is weighted in. If a bond investor can earn, say 12%, on a open market by acquiring investments of a similar risk, he will not be willing to accept a lower interest rate which may be stated on a particular bond issue. In order to entice the investor to purchase bonds at an interest rate that is lower than the effective market rate, a discount must be offered. The discount coupled with the higher stated interest rate averages to the interest rate the investor could earn in the market. The opposite effect occurs when the two interest rates are reversed. KP 4 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

11-44

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

13.

Why are some types of leases recorded as purchases? Solution: Many leases which appear on the surface to be rentals, are actually purchases financed with installment notes. The risk and benefits of ownership are essentially transferred to the lessee. Accounting rules require that the lease be recorded based on its substance from an accounting perspective. Legally, lease agreements do not transfer ownership, but in substance, the contractual arrangement may appear to have transferred the rights, risks, and benefits of ownership from the lessor to the lessee. KP 7 BT: C Difficulty: Easy TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

14.

How does an investor's required rate of return affect investing decisions? Solution: The decision to buy a bond requires the investor to compute the effective rate of return and compare it to his or her required rate. The required rate of return is determined by adding the return you could receive from investing your money in risk-free securities to the risk premium that would be attached to the particular investment. The risk premium varies from company to company. It is determined by a number of factors, including a company’s credit rating and solvency, the earning power of the company, future movements in the economy that may affect operations, and the terms of the bond issuance. Once an investor compares his required rate of return with the effective rate he will earn on a particular investment, he will make a decision. If the effective rate on the bond is less than in his required rate of return, he will not purchase the bond. KP App11A BT: AP Difficulty: Easy TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

15.

How do changes in market interest rates lead to misstated balance sheet values for long-term debt? Solution: If the market rate of interest remains constant over the life of a debt obligation, the obligation’s balance sheet value will equal its present value. As market interest rates change, the present value of the obligation discounted at the market rate of interest differs from the balance sheet value of the obligation, which is discounted at the original effective interest rate. This makes the balance sheet value of the debt inaccurate as a measure of the true present value. Economic gains and losses are experienced, but not recognized on the financial statements of the debtor. KP 6 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 11 – Long-Term Liabilities: Notes, Bonds, and Leases

16.

11-45

What is the purpose of interest rate swaps? Solution: Interest rate swaps are used to hedge market interest rate risk and to manage interest rate risk. KP App11C BT: K Difficulty: Easy TOT: 2 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

Chapter 12 Shareholders’ Equity

MULTIPLE CHOICE QUESTIONS 1.

A corporation issued common stock instead of debt to finance the purchase of nondepreciable property. Which statement is true? a. Ownership by existing shareholders will be diluted. b. The company’s debt/equity ratio will be higher. c. Income tax expense will be lower because expenses increase. d. Net income will be lower. Ans: A KP 1,2 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Which one of the following is a result of a company issuing common stock instead of debt to finance the purchase of property? a. Leverage will be more effective. b. The company will probably experience cash flow problems. c. It will have a lower debt/equity ratio. d. It will report a lower net income. Ans: C KP 1,2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

What is the effect of a corporation appropriating retained earnings for the cost of treasury stock purchased? a. Contributed capital is overstated. b. A portion of retained earnings is restricted from the payment of dividends. c. Owner’s equity is reduced by the amount of the appropriation. d. Income is overstated. Ans: B KP 5,6 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

12-1

12-2

Test Bank – Chapter 12 – Shareholders’ Equity

Information related to Lamar Co. for the years ending December 31, 2010 and 2009 follows: Common stock Retained earnings at year end (after closing)

12-31-10 $120,000 100,000

12-31-09 $80,000 70,000

Dividends declared for 2010 totaled $20,000. How much was generated through operations? a. $30,000 b. $50,000 c. $10,000 d. $70,000 Ans: B KP 1,2,3 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

A corporation generated assets by issuing equity securities and through profitable operations. Which effects likely occurred? a. Common stock and retained earnings increased. b. Common stock increased and retained earnings stayed the same. c. Retained earnings increased, and there was no effect on common stock. d. Liabilities and common stock increased. Ans: A KP 1,2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Which one of the following is a valid reason for a stock split? a. To increase ownership percentages of individual shareholders b. To adjust the market price of the shares to a level where more individuals can afford to invest in the stock c. To increase reported net income during subsequent accounting periods d. To increase the book value per share of common stock Ans: B KP 8 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Which one of the following transactions cause a decrease to retained earnings? a. Selling treasury stock b. Incurring net income for the period c. Declaring a stock dividend d. Paying a cash dividend that was previously declared Ans: C KP 2,7,8 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 12 – Shareholders’ Equity

12-3

On which date would you make no journal entry? a. Date of declaration of cash dividend b. Date of record of cash dividend c. Date of payment of cash dividend d. Date of declaring a stock dividend Ans: B KP 7,8 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Baker Company has 200,000 shares of common stock outstanding. The company declares a stock dividend of 58,000 shares. According to GAAP, this dividend should be treated as: a. a small stock dividend. b. a prior period adjustment. c. a large stock dividend. d. a purchase of treasury stock. Ans: C KP 8 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

10.

Cash dividends are paid based on the number of shares which are a. authorized. b. issued. c. outstanding. d. outstanding minus the number of treasury shares. Ans: C KP 7 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

11.

Which one of the following represents the economic effects of declaring and issuing a stock dividend? a. Has no effect on total assets or total shareholders' equity b. Decreases the debt/equity ratio c. Decreases total shareholders' equity d. Increases the current ratio Ans: A KP 8 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

12.

Which one of the following represents the economic effects of issuing a 2-for-1 stock split? a. No effect on par value per share or retained earnings b. Decrease par value per share, and no effect on retained earnings c. No effect on par value per share, and decrease retained earnings d. Increase par value per share and retained earnings Ans: B KP 8 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

12-4

13.

Test Bank – Chapter 12 – Shareholders’ Equity

Which one of the following is an effect when a company buys back it own shares of stock? a. Leverage is affected. b. It will pay more dividends. c. It will have a higher debt/equity ratio. d. Fixed assets will decrease. Ans: C KP 1,2,6 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

14.

On January 1, 2010, Garner Corp. had 10,000 shares of $1 par value common stock issued and outstanding. The stock was selling at $10 per share. During 2010, Garner declared and issued a 10% stock dividend. The stock dividend causes a. total shareholders' equity to increase by $1,000. b. net income to decrease by $1,000. c. earnings per share to decrease by $10,000. d. no change in total shareholders' equity Ans: D KP 2,8 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

15.

If a corporation uses retention of earnings to finance the purchase of property instead of issuing equity securities, then a. it will have a higher debt/equity ratio. b. it will pay more dividends. c. leverage is being used. d. a company’s earnings per share will decrease. Ans: A KP 1,2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

16.

If a corporation issues debt instead of common stock to finance the purchase of property, then the corporation has a. a disadvantage of higher tax payments because dividends are a bigger deduction than interest. b. no ability to avoid interest payments from the debt issuance under any circumstances. c. required dividend payments that are usually double-taxed. d. a higher earnings per share. Ans: B KP 2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 12 – Shareholders’ Equity

17.

12-5

Which one of the following is a characteristic of equity as opposed to debt? a. Voting rights are typically attached. b. There is a fixed maturity date. c. There is a legal contract. d. There is a fixed payment schedule. Ans: A KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

18.

Which one of the following serves to differentiate debt from equity? a. Interest on debt may be deferred, but dividends are a legal liability and must be paid every year. b. Interest on debt is tax deductible while dividends to equity investors are not. c. Debt has a maturity date which is much shorter than the maturity period of equity. d. Debt holders are appointed while the board of directors elects equity holders. Ans: B KP 1,2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

19.

Which of the following is considered to be an important economic consequence of incentive compensation plans using stock options? a. dilution of ownership interests. b. the current ratio is affected. c. the effects on the financial statements are costly to quantify. d. the effect on cash flows Ans: A KP 3 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

20.

If preferred stock, which can be exchanged for long-term debt in three years, is classified as an equity financial instrument instead of a liability, then a. the current ratio declines. b. earnings per share is less than if the preferred stock was reported as debt. c. fixed assets and net worth increase. d. the debt/equity ratio is less than if the preferred stock was reported as debt. Ans: D KP 3 BT: C Difficulty: Difficult TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

21.

Which one of the following is ‘debt’ with the appearance of ‘equity’? a. Long-term debt with a rate of interest that depends upon the current prime rate of interest b. Long-term debt that can be converted into common stock c. Notes payable in ten years d. Convertible bonds Ans: B KP 3 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

12-6

22.

Test Bank – Chapter 12 – Shareholders’ Equity

If preferred stock is cumulative, then a. preferred dividends are a percentage of corporate profits. b. dividends in arrears must be paid before common shareholders receive dividends. c. dividends are a percentage of the market value of the preferred stock. d. payment of dividends is legally guaranteed to shareholders each year. Ans: B KP 4,5 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

23.

If preferred stock is participating, then a. preferred dividends are a percentage of corporate profits. b. preferred shareholders vote in the election of the members of the board of directors. c. preferred shareholders share in the remaining amount of dividend with common shareholders. d. dividends in arrears must be paid before common shareholders receive dividends. Ans: C KP 4 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

24.

Which one of the following would most likely require a restriction of retained earnings? a. The sale of a plant asset b. A sale of treasury stock c. A declaration of cash dividends d. An appropriation declared by the Board of Directors Ans: D KP 2,3 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

25.

Simon Corp’s $1 par value, common stock was selling for $20 per share. Simon Corp’s owners’ equity accounts were as follows: Common stock Additional paid-in capital Retained earnings

$800,000 200,000 400,000

How many shares of common stock are outstanding? a. 30,000 b. 600,000 c. 800,000 d. Not enough information to determine. Ans: C KP 5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 12 – Shareholders’ Equity

26.

12-7

Which one of the following events increases the debt/equity ratio? a. Purchase of inventory on account b. Sale of treasury stock for less than its cost c. The payment of cash dividends that were previously recorded d. Recognition of net income for the year Ans: A KP 3,6 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

27.

Treasury stock is a. an asset representing a corporate investment in itself. b. highly-valued stock owned by a corporation. c. illegal for U.S. corporations. d. a decrease of shareholders' equity. Ans: D KP 6 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

28.

If preferred stock is specified as 8% preferred stock, then preferred a. dividends are a percentage of the par value of the preferred stock. b. shareholders vote in the election of the members of the board of directors. c. dividends are a percentage of corporate profits. d. dividends in arrears must be paid before common shareholders receive dividends. Ans: A KP 4 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

29.

Dividends in arrears a. are preferred dividends that have been declared but not paid. b. must be legally paid in the future. c. are dividends that have not been declared on cumulative preferred stock. d. are reported as a liability on the balance sheet until paid. Ans: C KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

30.

Preferred stock is preferred by investors as compared to common stock because a. it pays higher dividends than common. b. it has advantages of special rights to dividends and/or asset claims during liquidation. c. preferred stock pays dividends and common stock pays interest. d. dividends are expected to grow exponentially. Ans: B KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

12-8

31.

Test Bank – Chapter 12 – Shareholders’ Equity

Dividends in arrears on cumulative preferred stock a. increase liabilities. b. decrease retained earnings. c. have no effect on the balance sheet but are disclosed in the footnotes. d. increase the debt/equity ratio. Ans: C KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

32.

Which one of the following events decreases the current ratio? a. A decrease in the number of common shares outstanding b. Sale of treasury stock for more than its cost c. Sale of treasury stock for less than its cost d. Purchase of treasury stock Ans: D KP 3,6 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

33.

On January 1, 2010, Susann, Inc. declared a 15% stock dividend on its common stock when the market value of the common stock was $20 per share. Shareholders' equity before the stock dividend was declared consisted of: Common stock, $10 par value, authorized 40,000 shares; issued and outstanding 5,000 shares Additional paid-in capital on common stock Retained earnings Total shareholders' equity

$ 50,000 200,000 60,000 $310,000

What happened to retained earnings as a result of the stock dividend declaration? a. $6,000 decrease b. $7,500 decrease c. $15,000 decrease d. No change Ans: C KP 8 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting 34.

Dividends are not paid on a. noncumulative preferred stock. b. nonparticipating preferred stock. c. treasury common stock. d. outstanding common shares. Ans: C KP 7 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 12 – Shareholders’ Equity

35.

12-9

If a company sells its treasury stock for more than it cost and records a gain on the income statement, then a. income and shareholders' equity are overstated. b. only income is overstated. c. only shareholders' equity is overstated. d. the income statement and balance sheet are properly stated. Ans: B KP 6 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

36.

What effect will the acquisition of treasury stock have on shareholders' equity? a. No effect b. Increase c. Depends on whether it cost more or less than the par value of the stock d. Decrease Ans: D KP 3,6 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

37.

Which one of the following events increases the debt/equity ratio? a. Purchase of treasury stock b. Sale of treasury stock for more than its cost c. Sale of treasury stock for less than its cost d. Payment of cash dividends that were previously declared Ans: A KP 3,6,7 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

38.

A company declared cash dividends in 2009, and paid the dividends in 2010. The payment in 2010 a. decreases the debt/equity ratio. b. increases the number of shares of stock outstanding. c. decreases shareholders’ equity. d. decreases net income. Ans: A KP 3,7 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

39.

The declaration of cash dividends a. increases total expenses. b. decreases current liabilities. c. decreases earnings per share. d. increases the debt/equity ratio. Ans: D KP 3,7 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

12-10

40.

Test Bank – Chapter 12 – Shareholders’ Equity

The payment of previously declared cash dividends a. increases the debt/equity ratio. b. increases current liabilities. c. increases earnings per share. d. decreases total liabilities. Ans: D KP 3,7 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

41.

Dividends payable is recorded at the date of a. issue. b. record. c. declaration. d. payment. Ans: C KP 7 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

42.

If dividends paid are recorded as an expense, then a. income and retained earnings are understated. b. only income is understated. c. only retained earnings is understated. d. the income statement and balance sheet are correct. Ans: B KP 7 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

43.

An ordinary 20% stock dividend a. causes no change in retained earnings. b. decreases assets. c. increases contributed capital. d. is reported on the income statement. Ans: C KP 8 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

44.

All of the following statements are true regarding the appropriations of retained earnings except: a. Appropriations of retained earnings restrict retained earnings from future dividend payments. b. Appropriations of retained earnings involve the restriction of cash. c. Appropriations of retained earnings must be decided upon by the board of directors. d. Appropriations of retained earnings do not change the amount of total stockholders’ equity. Ans: B KP 8 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 12 – Shareholders’ Equity

45.

12-11

Chambers Corporation has total assets of $800,000 as of December 31, 2010 and total liabilities of $400,000. Contributed capital as of December 31, 2009 and December 31, 2010 is $150,000. Chambers Corporation incurred a $50,000 net loss for the year ended December 31, 2010. If Chambers declared and paid $80,000 in dividends in 2010, their retained earnings at the beginning of 2010 would have been. a. b. c. d.

$220,000. $280,000 $380,000. $440,000.

Ans: C KP 7 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

46.

Garnett Corporation’s balance sheet reflects total assets of $500,000 as of December 31, 2009 and total liabilities of $150,000. Garnett’s balance sheet also reflects $50,000 of preferred stock outstanding on December 31, 2009. In the early 1990’s, when Garnett was started up, Garnett issued 50,000 shares of no-par common stock, a one-time event that accounted for its entire contributed capital, other than the preferred stock. Garnett had repurchased 15,000 shares of its common stock in 2008 from a retiring shareholder, which is now treasury stock. As of December 31, 2009 the book value of each outstanding share of Garnett’s common stock is: a. b. c. d.

$6.00 $8.57 $10.00 $14.29.

Ans: B KP 5,6 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

47.

Smith Corporation’s balance sheet reflects total assets of $3 million as of December 31, 2010 and total liabilities of $1.8 million. Smith has 100,000 shares of common stock outstanding. The market value of the stock is $9 per share. Smith’s market to book ratio is: a. 0.75. b. 7.50. c. 12.00. d. 13.33. Ans: A KP 5,6 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 12 – Shareholders’ Equity

12-12

48.

Cavendish Corporation’s balance sheet reflects total assets of $250 million as of November 30, 2010 and total liabilities of $200 million. Cavendish issues $100 million of preferred stock, receiving $100 million in cash. After issuing the preferred stock Cavendish’s debt to equity ratio is: a. 0.67. b. 1.33. c. .4.00 d. 6.00 Ans: B KP 5,6 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

49.

Choice Corporation had 100,000 shares of commons stock outstanding on January 1, 1995. On January 1, 2010 Choice purchased 5,000 shares of its own common stock to fund a stock option plan for it’s executives. On December 31, 2010 Choice announced a 3 to 1 stock split. Choice’s net income for 2010 was $400,000. How much should Choice report as earnings per share for 2010? a. b. c. d.

$1.33. $1.40. $4.00 $4.21

Ans: B KP 5,6 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

50.

The following information was taken from the statement of shareholders’ equity of Carnival Industries: 2010 Preferred stock (no par) Common stock ($1 par value) Additional paid-in capital: Common stock Treasury stock Less: Treasury stock

2009 $900 1,000

$400 900

40 (10) 130

20 -150

The journal entry to record the issuance of preferred stock during 2010 would include: a. a debit to Preferred Stock for $900. b. a credit to Preferred Stock for $500. c. a credit to Additional Paid in Capital for $500. d. a credit to Cash for $500. Solution: Cash (+A) ............................................................................ Preferred Stock (+SE) ....................................................

500

Ans: B KP 4,5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

500

Test Bank – Chapter 12 – Shareholders’ Equity

51.

12-13

The shareholders’ equity section of Manning Company as of December 31, 2010 follows: Common stock (11,000 shares issued @ $6 par) $66,000 Additional paid-in capital (Common stock) 100,000 Retained earnings 60,000 Less: Treasury stock (1,000 share @ $12) (12,000) Total shareholders’ equity $214,000 The company declares and distributes a 3 percent stock dividend on the outstanding shares. The market price of the stock is $85 per share. The journal entry to record the stock dividend would include: a. a debit to Additional Paid-In Capital, Common Stock for $25,500. b. a credit to Common Stock for $1,800. c. a credit to Stock Dividend for $25,500. d. a debit to Additional Paid-In Capital, Common Stock for $23,700. Solution: Stock Dividend (–SE).......................................................... Common Stock (+SE) ................................................... Additional Paid-In Capital, Common Stock (+SE)..........

25,500* 1,800 23,700

* $25,500= (11,000 shares issued – 1,000 shares in treasury)  3%  $85 per share Ans: B KP 6,8 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

52.

The shareholders’ equity section of Manning Company as of December 31, 2010 follows: Common stock (11,000 shares issued @ $6 par) $66,000 Additional paid-in capital (Common stock) 100,000 Retained earnings 60,000 Less: Treasury stock (1,000 share @ $12) (12,000) Total shareholders’ equity $214,000 The company declares a 12 percent stock dividend on the outstanding shares. The market price of the stock is $90. The journal entry to record the stock dividend would include: a. a credit to Additional Paid-In Capital, Common Stock for $100,800. b. a debit to Common Stock for $7,200. c. a credit to Stock Dividend for $108,000. d. a debit to Additional Paid-In Capital, Common Stock for $108,000. Solution: Stock Dividend (–SE).......................................................... Common Stock (+SE) ................................................... Additional Paid-In Capital, Common Stock (+SE)..........

108,000*

* $108,000 = (11,000 shares issued – 1,000 shares in treasury)  12%  $90

7,200 100,800

12-14

Test Bank – Chapter 12 – Shareholders’ Equity

Ans: A KP 6,8 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

53.

The shareholders’ equity section of Jason Company as of December 31, 2010 follows: Common stock Additional paid-in capital (Common stock) Retained earnings Total shareholders’ equity

$180,000 110,000 160,000 $450,000

On January 15, the company repurchased 1,500 shares of its own common stock at $60 to hold as treasury stock. Which of the following would be included in the journal entry recorded on January 15? a. a credit to Retained Earnings for $90,000. b. a debit to Cash for $90,000. c. a debit to Treasury Stock for $90,000. d. a debit to Common Stock for $90,000. Solution: Treasury Stock (–SE) ...................................................... Cash (–A) ..................................................................

90,000 90,000

Ans: C KP 4,5,6 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 12 – Shareholders’ Equity

54.

12-15

The shareholders’ equity section of Jason Company as of December 31, 2010 follows: Common stock Additional paid-in capital (Common stock) Retained earnings Total shareholders’ equity

$180,000 110,000 160,000 $450,000

On January 15, the company repurchased 1,500 shares of its own stock at $60 for treasury stock. On January 16, as part of a compensation package, the company reissued half of the treasury shares to executives who exercised stock options for $20 per share. On January 28, the company reissued the remainder of the treasury stock on the open market for $66 per share. Which of the following would be included in the journal entry recorded on January 16? a. a debit to Cash for $15,000. b. a debit to Treasury Stock for $45,000. c. a credit to Additional Paid-In Capital for $45,000. d. a credit to Additional Paid-In Capital for $15,000. Solution: Cash (+A) ....................................................................... Additional Paid-In Capital (–SE) ..................................... Treasury Stock (+SE) ...............................................

15,000 30,000

Ans: A KP 4,5,6 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

45,000

12-16

55.

Test Bank – Chapter 12 – Shareholders’ Equity

The shareholders’ equity section of the Jason Company as of December 31, 2010 is as follows: Common stock Additional paid-in capital (Common stock) Retained earnings Total shareholders’ equity

$180,000 110,000 160,000 $450,000

On January 15, the company repurchased 1,500 shares of its own stock at $60 for treasury stock. On January 16, as part of a compensation package, the company reissued half of the treasury shares to executives who exercised stock options for $20 per share. On January 28, the company reissued the remainder of the treasury stock on the open market for $65 per share. Which of the following would be included in the journal entry recorded on January 28? a. a credit to Treasury Stock for $48,750. b. a credit to Additional Paid-In Capital, Treasury Stock for $48,750. c. a debit to Cash for $45,000. d. a credit to Additional Paid-In Capital, Treasury Stock for $3,750. Solution: Cash (+A)........................................................................ Treasury Stock (+SE) ................................................ Additional Paid-In Capital, Treasury Stock (+SE) ......

48,750

Ans: D KP 4,5,6 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

45,000 3,750

Test Bank – Chapter 12 – Shareholders’ Equity

56.

12-17

The shareholders’ equity section of Winters Company contained the following balances as of December 31, 2010: Preferred stock (10%, $15 par value, cumulative) Preferred stock (12%, $10 par value , noncumulative) Common stock ($1 par value, 5,000 shares authorized, 3,500 issued and 400 held in treasury) Additional paid-in capital: Preferred stock (10%) Preferred stock (12%) Common stock Retained earnings Less: Treasury stock Total shareholders’ equity

$1,500 1,500 3,500

1,050 1,275 2,345 4,256 (5,750) $9,676

During 2011, Winters entered into the following transaction: On May 13, the company repurchased 55 shares of its common stock in the open market at $25 per share. Which of the following would be included in the journal entry for May 13? a. a debit to Cash for $1,375. b. a credit to Common Stock for $1,375. c. a debit to Common Stock for $1,375. d. a debit to Treasury Stock for $1,375. Solution: Treasury Stock (–SE) ...................................................................... Cash (–A) .................................................................................

1,375

Ans: D KP 4,5,6 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

1,375

12-18

57.

Test Bank – Chapter 12 – Shareholders’ Equity

$1,500 1,500 3,500

1,050 1,275 2,345 4,256 (5,750) $9,676

During 2011, Winters entered into the following transaction: On September 26, the company issued 200 shares of its 10 percent preferred stock at $23 per share. Which of the following would be included in the September 26 journal entry? a. a debit to Preferred Stock for $3,000. b. a credit to Cash for $4,600. c. a debit to Cash for $3,000. d. a credit to Additional Paid-In Capital, 10% Preferred Stock for $1,600. Solution: Cash (+A)........................................................................ Preferred Stock (10%) (+SE) ..................................... Additional Paid-In Capital, 10% Preferred Stock (+SE)

4,600

Ans: D KP 4,5 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

3,000 1,600

Test Bank – Chapter 12 – Shareholders’ Equity

12-19

58. The shareholders’ equity section of Winters Company contained the following balances as of December 31, 2010: Preferred stock (10%, $15 par value, cumulative) Preferred stock (12%, $10 par value , noncumulative) Common stock ($1 par value, 5,000 shares authorized, 3,500 issued and 400 held in treasury) Additional paid-in capital: Preferred stock (10%) Preferred stock (12%) Common stock Retained earnings Less: Treasury stock Total shareholders’ equity

$1,500 1,500 3,500

1,050 1,275 2,345 4,256 (5,750) $9,676

On September 26,2011, Winters issued 200 shares of its 10 percent preferred stock at $23 per share. On December 2, the company declared a cash dividend of $1,050, which was paid on December 27. Winters did not declare or pay any dividends during 2010. If Winters uses a separate dividend account for each type of stock, which of the following would be included in the journal entry to record the declaration of the 10% Preferred stock dividend? a. b. c. d.

a credit to 10% Preferred Cash Dividend for $600. a debit to Dividend Expense for $600. a credit to Dividends Payable for $600. a debit to Cash for $600.

Solution: 10% Preferred Cash Dividend (–SE) ............................................... Dividends Payable (+L) ............................................................ a

$600 = =

600a

Dividends in arrears + current dividend ($1,500  10%) + ($4,500  10%)

Ans: C KP 7 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

600

Test Bank – Chapter 12 – Shareholders’ Equity

12-20

59.

$1,500 1,500 3,500

1,050 1,275 2,345 4,256 (5,750) $9,676

During 2011, Winters entered into the following transaction: On December 2, the company declared a cash dividend of $1,050, which was paid on December 27. Winters did not declare or pay any dividends during 2010. If Winters uses a separate dividend account for each type of stock, which of the following would be included in the journal entry to record the declaration of the 12% Preferred stock dividend? a. b. c. d.

a debit to 12% Preferred Cash Dividend for $180. a debit to Dividend Expense for $180. a debit to Dividends Payable for $180. a debit to Cash for $180.

Solution: 12% Preferred Cash Dividend (–SE) ............................................... Dividends Payable (+L) ............................................................ a

$180 = =

180a

Par value  12% $1,500  12%

Ans: A KP 7 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

180

Test Bank – Chapter 12 – Shareholders’ Equity

60.

12-21

$1,500 1,500 3,500

1,050 1,275 2,345 4,256 (5,750) $9,676

During 2011, Winters entered into the following transaction: On December 2, the company declared a cash dividend of $1,050, which was paid on December 27. Winters did not declare or pay any dividends during 2010. Based on this information, what amount of dividends should be declared and paid to shareholders’ with common stock? a. $350 b. $420 c. $570 d. $385 Solution: $1,050 – 300 – 180 = $570 Ans: C KP 7 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

12-22

61.

Test Bank – Chapter 12 – Shareholders’ Equity

The shareholders’ equity section of Samuels Company were reported on the balance sheets for December 31:

Preferred stock (9%, $50 par value) Common stock ($10 par value, 750,000 shares authorized, 90,000 issued and 5,000 held in treasury) Additional paid-in capital: Preferred stock Common stock Retained earnings Less: Treasury stock Total shareholders’ equity

2010 $200,000 540,000

2009 $120,000 396,000

155,000 336,000 575,000 (110,000) $1,696,000

55,000 300,000 495,000 -------$1,366,000

Based on this information, how many shares of preferred stock were issued in 2010 and what was the average issue price? a. 4,000 shares and $112.50 per share b. 160 shares and $88.75 per share c. 800 shares and $250 per share d. 1,600 shares and $112.50 per share Solution: Number of Shares Issued = Increase in Par Value ÷ Par Value per Share = ($200,000 – $120,000) ÷ $50 per Share = 1,600 Shares Average Issue Price = Increase in Contributed Capital ÷ Number of Shares = (Increase in Par Value + Increase in Additional Paid-in Capital) ÷ 1,600 Shares = [($200,000 – $120,000) + ($155,000 – $55,000)] ÷ 1,600 Shares = $112.50 per Share

Ans: D KP 4,5 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 12 – Shareholders’ Equity

62.

12-23

The shareholders’ equity section of Samuels Company were reported on the balance sheets for December 31:

Preferred stock (9%, $50 par value) Common stock ($6 par value, 750,000 shares authorized, 90,000 issued and 5,000 held in treasury) Additional paid-in capital: Preferred stock Common stock Retained earnings Less: Treasury stock Total shareholders’ equity

2010 $200,000 540,000

2009 $120,000 396,000

155,000 336,000 575,000 (110,000) $2,180,000

55,000 300,000 495,000 -------$1,688,000

Based on this information, how many shares of common stock were issued in 2010 and what was the average issue price?

a. 21,000 shares and $7.82 per share b. 30,000 share and $6.00 per share c. 85,000 shares and $9.73 per share d. 24,000 shares and $7.50 per share Solution: Number of Shares Issued = ($540,000 – $396,000) ÷ $6 per Share = 24,000 Shares Average Issue Price = [($540,000 – $396,000) + ($336,000 – $300,000)] ÷ 24,000 Shares = $7.50 per Share

Ans: D KP 4,5 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

12-24

Test Bank – Chapter 12 – Shareholders’ Equity

MATCHING QUESTIONS 1.

Management wishes to obtain financing. For each attribute/characteristic listed in 1 through 5, determine which type of financing it describes from management’s perspective by placing a D in the space if it applies to debt financing, or E if it applies to equity financing. 1. No tax savings 2. Credit rating effects 3. Contractual restrictions 4. Contractual future payments 5. Cash flows are discretionary Solution: 1. E 2. D 3. D 4. D 5. E KP 1,2 BT: AP Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 12 – Shareholders’ Equity

12-25

Identify the effect of the accounting equation (a through k) of each transaction in 1 through 9 below. You may use each letter more than once or not at all. a. b. c. d. e. f. g. h. i. j. k.

Accounting Effects – A and – L + A and + SE (Contributed Capital) + A and + SE (Retained Earnings) + A and – A + A and + L – A and – SE (Contributed Capital) – A and – SE (Retained Earnings) + L and –SE (Retained Earnings) – L and + SE (Retained Earnings) + SE (Contributed Capital) and – SE (Retained Earnings) No journal entry or effect

1. Issued debt to finance the purchase of property 2. Issued common stock to finance the purchase of property 3. Used money resulting from retained earnings to finance the purchase of property 4. Declared cash dividends to shareholders 5. Paid the previously declared dividends 6. Skipped dividends on cumulative preferred stock 7. Declared and distributed a 10% stock dividend 8. Declared a 3:1 stock split 9. The market value of common stock doubled during the year Solution: 1. e 2. b 3. d 4. h 5. a 6. k 7. j 8. k 9. k KP 2,3,4,7,8 BT: AP Difficulty: Moderate TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

12-26

Test Bank – Chapter 12 – Shareholders’ Equity

Select the effect (a, b, or c) that each transaction listed in 1 through 9 would most likely cause on the debt/equity ratio. Effects a. Decrease in debt/equity ratio b. Increase in debt/equity ratio c. Does not change debt/equity ratio

2. 4. 5. 6. 7. 8. 9.

1. Issued debt to finance the purchase of property 2. Issued common stock to finance the purchase of property 3. Used money resulting from profits to finance the purchase of property 4. Declared dividends to shareholders 5. Paid the previously declared dividends 6. Skipped dividends on cumulative preferred stock 7. Declared and paid a 10% stock dividend 8. Declared and paid a 200% stock dividend 9. Distributed a two-for-one stock split

Solution: 1. b 2. a 3. c 4. b 5. a 6. c 7. c 8. c 9. c KP 1,3,7,8 BT: AP Difficulty: Moderate TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 12 – Shareholders’ Equity

12-27

Indicate the effect of each of the following transactions (1 through 6) on total shareholders’ equity by selecting the letter of the effect (a, b, and c) and placing it in the space provided. Accounting Effects a. Decrease in total shareholders’ equity b. Increase in total shareholders’ equity c. Does not change total shareholders’ equity

1. Treasury stock is resold at more than cost 2. Operating loss for the period 3. Declaration of a stock dividend 4. Acquisition of machinery for common stock 5. Declaration of cash dividend 6. Payment of cash dividend previously recorded Solution: 1. b 2. a 3. c 4. b 5. a 6. c KP 4,6,7,8, BT: AP Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

SHORT PROBLEMS 1.

Total dividends of $7,000 are declared when one year of dividends are in arrears on 1,000 shares of $8 cumulative preferred stock. How much of the $7,000 of dividends goes to the common shareholders? Solution: Allocation to preferred = 1,000 x $8 = $8,000 limited to amount declared = $7,000 Allocation to common = $0

KP 4,7 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

12-28

Test Bank – Chapter 12 – Shareholders’ Equity

The following information from St. Paul Supply, Inc.is provided for 2010 and 2009: 12% Cumulative preferred stock, $20 par Common stock, $5 par Additional paid-in capital - common Retained earnings Net income

12/31/10 $200,000 40,000 80,000 500,000 60,000

12/31/09 $200,000 28,000 50,000 500,000 40,000

Additional information: No preferred dividends were declared during 2009. The market price of the common stock was $25 at December 31, 2010. Calculate the book value per share of common stock at December 31, 2010. Solution: ($40,000 + $80,000 + $500,000)/8,000 = $77.50 per common share KP 3,5 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Total dividends of $40,000 are declared when one year of dividends is in arrears on 5,000 shares of $3 cumulative preferred stock. Calculate dividends on common stock. Solution: $40,000 – [5,000 x $3 x 2] = $10,000 KP 4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Total dividends of $13,000 are declared when two years of dividends are in arrears on 1,000 shares of par $50, 10%, cumulative preferred stock. Calculate the dividends that were declared on common stock. Solution: Arrears for preferred: 10% x $50 x 1,000 x 2 years = $10,000 Arrears and current year for preferred: $10,000 + $3,000 = $13,000 $0 (current year is limited by total dividends declared) KP 4,7 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

The board of directors desires to pay $40,000 of dividends to its common shareholders when two years of dividends are in arrears on 1,000 shares of $20 par, 10% cumulative preferred stock. How much total dividends must be declared? Solution: (1,000 x $20 x 10%) x 3 years = $6,000 $6,000 + $40,000 = $46,000 KP 4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 12 – Shareholders’ Equity

12-29

On January 23, Borders Corporation purchased 1,000 shares of its own common stock for $30 a share. On March 31, it sold 600 of those shares for $42 a share. How much is the gain reported on the income statement resulting from the sale of treasury stock? Solution: $ 0 (no gains from treasury stock transactions) KP 6 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Canton Corporation shareholders' equity section of its balance sheet as of December 31, 2009 is as follows: Common stock, $5 par value; 40,000 shares authorized Additional paid-in capital Retained earnings Total

$50,000 100,000 180,000 $330,000

The following events occurred during 2010: • March 3 - 5,000 shares of authorized and unissued common stock were sold for $22 per share. • March 16 - Declared a cash dividend of $3 per share payable May 15 to holders of record on May 5. A. At March 31, 2010, how many more shares of stock can be issued? B. At March 31, 2010, how many shares are issued and outstanding? Solution: A. Authorized but not issued: 40,000 – (10,000 + 5,000) = 25,000 shares B. 10,000 + 5,000 = 15,000 KP 3 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

If an investor owns 8% of a corporation prior to a 2-for-1 stock split, what percentage does the investor own after receiving 2 shares of $5 par value stock for each $10 par value share of stock? Solution: 8% KP 8 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

12-30

Test Bank – Chapter 12 – Shareholders’ Equity

The shareholders' equity section of Campbell Co.’s balance sheet follows: Common stock, $2 par Additional paid-in capital – common Additional paid-in capital—treasury stock Retained earnings Treasury stock Total shareholders' equity

$ 80,000 50,000 600 25,400 (2,000) $154,000

A. Assume all of the treasury stock was sold for $4,800. Calculate the following amounts: 1. Additional paid-in capital—treasury stock 2. Retained earnings 3. Total shareholders' equity B. Assume all of the treasury stock was sold for $850. Calculate the following amounts: 1. Additional paid-in capital—treasury stock 2. Retained earnings 3. Total shareholders' equity Solution: A. Additional paid-in capital—treasury stock ($600 + $2,800) Retained earnings (no change) Total shareholders' equity ($80,000 + $50,000 + $3,400 + $25,400) B. Additional paid-in capital - Treasury stock ($600 – $600) Retained earnings ($25,400 – $550) Total shareholders' equity ($80,000 + $50,000 + $0 + $24,850 + $0)

$ 3,400 25,400 158,800

0 24,850 154,850

KP 3,6 BT: AN Difficulty: Difficult TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

10.

Immediately before Cavecreek Corporation purchased 4,000 shares of its own common stock for $25 a share, it had total liabilities of $200,000 and total shareholders' equity of $520,000. Calculate Cavecreek’s debt/equity ratio immediately subsequent to the purchase of the treasury stock. Solution: 4,000 x $25 = $100,000 Debt/equity ratio: $200,000/[$520,000 − $100,000] = 0.48 KP 3,6 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 12 – Shareholders’ Equity

11.

12-31

Immediately before Zorro Corporation sold 4,000 shares of its own common stock for $30 a share, it had total liabilities of $200,000 and total shareholders' equity of $520,000. Determine Zorro’s debt/equity ratio immediately subsequent to the stock issue. Solution: 4,000 x $30 = $120,000 Debt/equity ratio: $200,000/[$520,000 + $120,000] = 0.31 KP 3,6 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

12.

Immediately before Cayman Corporation issued 2,000 shares of its common stock for $15 a share, it had total liabilities of $150,000 and total shareholders' equity of $300,000. Cayman had 10,000 shares of common stock outstanding prior to the new issuance. Calculate Cayman’s debt/equity ratio immediately after the new issuance. Solution: 2,000 x $15 = $30,000 Debt/equity ratio: $150,000/[$300,000 + $30,000] = 0.45 KP 3.4 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

13.

On January 23, Bennington Corporation, for the first time in its short history, purchased 200 shares of its own common stock for $40 a share. On March 31, it sold 100 of those shares for $45 a share. Prepare the journal entry recording the March 31st transaction. Solution: Cash (100 x $45) Treasury Stock (100 x $40) Additional Paid-in Capital—Treasury Stock

4,500 4,000 500

KP 6 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

14.

On January 23, Oakley Co., for the first time in its short history, purchased 200 shares of its own common stock for $40 a share. On March 31, it sold 100 of those shares for $45 a share and properly recorded $500 as additional paid-in capital. On April 15, it sold the remaining 100 shares for $35 a share. Prepare the journal entry to record the April 15th transaction. Solution: Cash (100 x $35) Additional Paid-in Capital—Treasury Stock Treasury Stock (100 x $40)

3,500 500 4,000

KP 6 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

12-32

15.

Test Bank – Chapter 12 – Shareholders’ Equity

On January 23, Bayshore Corporation, for the first time in its short history, purchased 200 shares of its own common stock for $40 a share. On March 31, it sold 100 of those shares for $45 a share and properly recorded $500 as additional paid-in capital. On April 15, it sold the remaining 100 shares for $30 a share. Prepare the journal entry to record the April 15th transaction. Solution: Cash (100 x $30) Additional Paid-in Capital—Treasury Stock Retained Earnings Treasury Stock (100 x $40)

3,000 500 500 4,000

KP 6 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

16.

The shareholders' equity section of Maven Corporation's balance sheet as of December 31, 2008 is as follows: Common stock, $1 par; authorized, 6,000 shares; 2,000 shares issued Additional paid-in capital Retained earnings Total shareholders’ equity

2,000 60,000 58,000 $120,000

The following events occurred during 2009: • February 1 - 400 shares of authorized and unissued common stock were sold for $4 per share. • June 16 - A 15% stock dividend was declared and issued. Market value per share is currently $18. • October 11 - A three-for-one split was carried out. Market value was $21 per share. • November 4 - A cash dividend of $4.20 per share was declared, payable January 12 to shareholders of record on November 30. How many shares of common stock are outstanding at December 31, 2009? Determine the balance in the common stock account at December 31, 2009. Solution: Outstanding shares: [2,000 + 400 + (15% x 2,400)] x 3 = 8,280 Common stock: 8,280 x $1 = $8,280 KP 4,7,8 BT: AN Difficulty: Moderate TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

17.

An 8% stock dividend was declared and distributed on 3,000 shares of par $10 common stock when its market price was $32. Prepare the journal entry required by the stock dividend. Solution: Retained Earnings ($32 x 240) Common Stock ($10 x 240) Additional Paid-in Capital

7,680 2,400 5,280

KP 8 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 12 – Shareholders’ Equity

18.

12-33

Cullen Distribution Corporation's contributed capital section of its balance sheet follows: Preferred stock: $10 par, 4% Common stock: $8 par

$650,000 400,000

During the last two years, Cullen Distribution Corporation did not declare any dividends to its shareholders. This year, Cullen declares and pays total dividends of $100,000. Calculate the dividends paid separately to preferred and common shareholders if the preferred stock is cumulative. Solution: Preferred dividends = $650,000 x 4% x 3 years = $78,000 Common dividends = $100,000 – $78,000 = $22,000 KP 4,7 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

19.

A 10% stock dividend was declared and distributed to shareholders of 60,000 outstanding shares of Meadville Company’s $10 par value common stock; at that time the common stock’s market price was $32. Prepare the journal entry required by the stock dividend. Solution: Stock Dividend (-RE) (6,000 x $32) Common Stock (+CC) (6,000 x $10) Additional Paid-In Capital, Stock Dividend (+CC)

192,000 60,000 132,000

KP 8 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

20.

A sequence of events affecting the shareholders' equity section of Malabar Corporation follows: A. On January 21, 8,000 shares of $10 par value common stock were issued for $160,000. B. On May 16, a 3-for-1 stock split was distributed. C. On December 23, $8,000 of cash dividends on outstanding common stock were declared. The dividends will be paid in 30 days. For each entry, state how the event changed assets, liabilities, and shareholders' equity. Solution: A. Assets and shareholders' equity increase by $160,000 B. No change in assets, liabilities, or shareholders' equity C. Liabilities increase and shareholders' equity decreases by $8,000 KP 4,7,8 BT: AN Difficulty: Moderate TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

12-34

21.

Test Bank – Chapter 12 – Shareholders’ Equity

Immediately before a 15% stock dividend was declared and distributed on 20,000 shares of par $8 stock, the market price of the Coolidge Corporation’s stock was $18. Coolidge has total liabilities of $150,000 and total shareholders' equity of $450,000. Required: (1) Give the journal entry to record the declaration and distribution of the stock dividend. (2) Calculate Coolidge’s current ratio immediately after the stock dividend and comment. Solution: Stock Dividend (-RE) (3,000 x $18) Common Stock (+CC) (3,000 x $8) Additional Paid-In Capital, Stock Dividend (+CC)

54,000 24,000 30,000

Current ratio = $600,000/$150,000 = 4.0 No assets or liabilities are involved in the transaction, so the current ratio is not affected by a stock dividend. KP 3,8 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

22.

Immediately before a 3-for-1 stock split was declared and distributed on 20,000 shares of par $80 stock, Mikah Company has total liabilities of $260,000 and total shareholders' equity of $320,000. Calculate Mikah Company’s debt/equity ratio immediately after the stock split. Solution: Debt/equity ratio = $260,000/$320,000 = 0.81 KP 3,8 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

23.

Immediately before a $4,000 cash dividend was declared on 20,000 shares of par $80 stock, Sea Breeze Corporation has total liabilities of $220,000 and total shareholders’ equity of $180,000. Calculate Sea Breeze’s debt/equity ratio before and after the declaration of the cash dividend and indicate the effect the declaration had on this ratio. Solution: Before: Debt/equity ratio = $220,000/$180,000 = 1.22 Liabilities: $220,000 + $4,000 = $224,000; OE: $180,000 − $4,000 = $176,000 After: Debt/equity ratio = $224,000/$176,000 = 1.27 The debt/equity ratio increases because additional liabilities were incurred. KP 3,7 BT: AN Difficulty: Difficult TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 12 – Shareholders’ Equity

24.

12-35

Tropical Corporation has the following amounts as other revenue and expenses on its income statement. Other revenue and expenses: Gain from sale of treasury stock Interest revenue Gain from sale of land Appropriated retained earnings for self-insurance Preferred dividends Common dividends Total

$21,000 4,200 18,000 (1,000) (11,000) (6,000) $25,200

List the items that do not belong on the income statement and indicate where each should be reported. Solution: Gain from sale of treasury stock - $21,000 Report as Additional Paid-in Capital—Treasury Stock as an addition in shareholders’ equity on the balance sheet Appropriated retained earnings for self-insurance - $1,000 Report in shareholders’ equity on the balance sheet immediately below unappropriated retained earnings Preferred dividends - $11,000 Report as a deduction on the statement of shareholders’ equity Common dividends - $6,000 Report as a deduction on the statement of shareholders’ equity

KP 3,6,7 BT: AN Difficulty: Difficult TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

25.

If a corporation distributes a 4-for-3 stock split on its $5 common stock, how much is the par value after the split? Solution: (3 x $5)/4 = $3.75 KP 8 BT: AN Difficulty: Easy TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

12-36

26.

Test Bank – Chapter 12 – Shareholders’ Equity

Gomer Paper Corporation has the following balance sheet accounts immediately preceding an investing and financing decision: Current assets Long-lived assets Current liabilities Long-term liabilities Contributed capital Retained earnings

$67,000 75,000 28,500 22,000 60,000 30,000

A long-term debt covenant specifies that Gomer Paper’s debt/equity ratio cannot be greater than 1.0 and its current ratio must be at least 2.0. Gomer Paper is going to invest $70,000 in new equipment. It is considering two methods of financing the investment. It can use $10,000 of its own money and obtain $60,000 from the issue of long-term debt. Alternatively, Gomer Paper can use $15,000 of its own money and obtain the remaining financing from the issue of stock. A. Recalculate the balance sheet amounts given above for each of the two financing alternatives immediately after financing is achieved and the investment is undertaken. B. Use numerical calculations to determine if the debt covenants are respected under each of the two financing alternatives. If the covenants are broken for each alternative, suggest financing options that Gomer Paper might use to finance the $70,000 investment in equipment. Solution: A. Current assets Long-lived assets Current liabilities Long-term liabilities Contributed capital Retained earnings Debt/equity ratio Debt: ($28,500 + $82,000)/($60,000 + $30,000) Equity:($28,500 + $22,000)/($115,000 + $30,000) Current ratio Debt: $57,000/$28,500 Equity: $52,000/$28,500

Debt Issue Stock Issue $ 57,000 $ 52,000 145,000 145,000 28,500 82,000 60,000 30,000

28,500 22,000 115,000 30,000

1.23 0.35 2.00 1.82

B: The debt/equity ratio exceeds that allowed (1.0) by the debt covenant if debt is used to finance investment in equipment. The current ratio is less than that allowed (2.0) if the investment is financed by a stock issue. The maximum cash that Gomer Paper can use for investment is $10,000 and the most debt it can issue without issuing stock is $39,500. Therefore, Gomer Paper must issue more stock and use less of its own money or issue stock and debt using less of its own money. KP 1,2 BT: AN Difficulty: Difficult TOT: 8 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 12 – Shareholders’ Equity

12-37

SHORT ESSAY QUESTIONS 1.

Seneca Corporation has the following balance sheet accounts immediately preceding an investing and financing decision: Current assets Long-lived assets Current liabilities Long-term liabilities Contributed capital Retained earnings

$ 430,000 1,070,000 120,000 630,000 100,000 650,000

A long-term debt covenant specifies that Seneca’s debt/equity ratio cannot be greater than 1.0 and current ratio cannot be less than 2.0. Seneca is going to invest $600,000 in a new machine that will keep Seneca Corporation in an excellent competitive position in a very competitive industry. In order to finance this investment, Seneca will use its cash, issue long-term debt, and issue common stock. However, besides having to adhere to the debt covenants, Mr. Seneca, the sole owner of Seneca Corporation, will not issue more than $100,000 of common stock so that he can retain at least a 50% ownership in his corporation. Can Seneca Corporation finance the $600,000 investment and still adhere to the debt covenants and allow Seneca to retain at least 50% ownership? If Seneca cannot finance the machine within the parameters given, suggest possible means for Seneca to finance the needed acquisition of the machine. Solution: The $600,000 investment cannot be raised within the parameters set by the debt covenants or fulfill Mr. Seneca's desire to retain control of his corporation. The current ratio restriction limits Seneca Corp.'s ability to finance the investment from retained earnings (internally generated financing) to $190,000. Using this cash leaves the current ratio at a dangerous, but acceptable, level of 2.0 and $410,000 to be raised by debt or/and equity issues. If Seneca Corp. issues the maximum of $100,000 of common stock, then total shareholders' equity would be $850,000 and $310,000 would have to be raised from debt issue. However, the debt/equity restriction limits total debt to $850,000. Existing debt is $750,000. Therefore, only $100,000 financing from debt is available. This leaves Seneca $210,000 short of the financing required. There are not many options for Seneca. He might try to renegotiate the debt covenants, exhibiting to the creditors that their future money is more secure with a competitive company than one that adheres to the covenants. Alternatively, Mr. Seneca might have to lose control of his company. This might be quite costly to Mr. Seneca, personally, for frequently in these situations, the new corporation "retires" the old entrepreneur. There are several other financing possibilities not considered in the problem. First, if the purchase can be delayed for one year in which there are no dividends and there is a profit of at least $210,000 with good cash flows, then the $210,000 could be obtained from cash flow generated from operations and additional debt could be secured within the debt/equity ratio ceiling. Second, Seneca might try to secure the machine under an operating lease. Thus he would have use of the machine without the liability on the balance sheet. Third, nonvoting preferred stock might be issued. If this market is

12-38

Test Bank – Chapter 12 – Shareholders’ Equity

available, Mr. Seneca can increase shareholders' equity without diluting his ownership of the corporation. Finally, Seneca might be able to secure personal debt and use that money to buy stock in his company. If he could obtain $105,000 at what may likely be a high interest rate, and invest it in Seneca Corporation's common stock, then he could retain control and issue $105,000 more corporate debt. However, there are a lot of "ifs" in these possibilities. An algebraic "trick" would help Mr. Seneca use the money from retained earnings and still meet the current ratio minimum. Seneca Corporation now has current assets of $430,000 and current liabilities of $120,000. This releases $190,000 to use for the investment and still maintain a 2.0 current ratio. If $100,000 of current liabilities are paid, then Seneca would have $330,000 of current assets and $20,000 of current liabilities. This releases $290,000 for use in investment (assuming the current assets are very liquid). Also, by reducing current liabilities by $100,000, $100,000 more long-term debt can be issued and still have the debt/equity ratio be less than or equal to one. However, this is "operating on the edge" and any downturn in sales and cash provided by operations would result in financial disaster. A combination of all the above might be appropriate. KP 8 BT: AN Difficulty: Difficult TOT: 9 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

For what reasons might a company purchase treasury stock? Solution: The most common reason companies purchase treasury stock is to support employee compensation plans. This makes stock available to distribute to employees as they exercise stock options. Purchasing treasury stock can also increase the market price of a company's outstanding stock. Occasionally the announcements of a treasury repurchase trigger the market to purchase shares. As a result of supply and demand, the market values of stock rise. Acquiring treasury stock can increase a company's earnings per share, because it reduces the number of shares outstanding. Often treasury stock purchases are made to return cash to shareholders, much like a dividend. KP 3,6 BT: AP Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 12 – Shareholders’ Equity

12-39

What rights do preferred shareholders have that common shareholders do not? Solution: Preferred shareholders usually receive dividend payments before common shareholders, assuming that the board declares a dividend. Since the amount of preferred dividends is expressed based as a percentage of par value or is a dollar amount per share of the preferred stock, preferred shareholders typically feel more assured of receiving a fixed, or at least a more stable, minimum dividend. Cumulative preferred shareholders benefit by receiving dividends during the current period from periods in which dividends were not paid or declared in the past (dividends in arrears). Participating preferred stock allows preferred shareholders to share in any remaining dividends once the right to the annual dividend payment has been satisfied. KP 4 BT: K Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Identify the two components of shareholders' equity. How do they differ? Solution: Shareholders' equity consists of contributed capital and earned capital. Contributed capital reflects contributions from a company's owners, and includes preferred stock, common stock, and additional paid-in capital. Earned capital, also known as retained earnings, is a measure of assets that have been generated through a company’s profitable operations that have not been paid to the owners in the form of dividends. KP 1 BT: C Difficulty: Easy TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Explain par value. Solution: Par value is an arbitrary amount assigned to a share of stock. It has little legal or economic significance and only serves to determine a value to assign to a company's stock account. At one time par value represented a legal concept under state law in some states that was intended to protect creditors, but over time the concept proved to be largely ineffective. KP 5 BT: K Difficulty: Easy TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

12-40

Test Bank – Chapter 12 – Shareholders’ Equity

Which characteristics make equity financing more advantageous than debt financing? Solution: Equity financing represents amounts contributed from a company's owners. No legal contract is associated as with true debt financing. This allows the corporation no obligation towards the equity investors. Equity financing has no fixed maturity date, which allows the company to avoid the stress of meeting a payment deadline. Dividend payments are discretionary with equity financing, while debt financing requires periodic interest payments. KP 1,2 BT: K Difficulty: Moderate TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

What factors influence corporate dividend strategies? Solution: Factors that influence a company's dividend strategy include the nature, financial condition, legal constraints, and the desired image of the company. In order to declare cash dividends a company must have sufficient cash. Before declaring, a company must be sure that its operating cash needs are met. A company growing very quickly is likely to avoid dividend payments in order to reinvest the funds for leveraging. Investors in companies that pay little or no dividends receive their investment returns in the form of stock price appreciation. Some companies consistently increase dividends from year to year. This is often done to increase shareholder loyalty, and to demonstrate to shareholders consistent growth regardless of how well the company does from one year to the next. State laws and debt covenants may limit the payment of dividends. KP 7 BT: K Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

How does the behavior of stock prices relate to the riskiness of equity securities? Solution: Stock prices are usually more volatile than bond prices on the major security exchanges due to the risk associated with stock investments. As compared to debt investments, equity includes no security provisions, and debt holders have a higher priority claim if a company goes into liquidation. KP 2 BT: K Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 12 – Shareholders’ Equity

12-41

Why is debt financing considered less expensive than equity financing? Solution: Issuing debt is attractive because interest payments are tax deductible—that is, interest is reported as an expense on the tax return which reduces the amount of taxes a company is obligated to pay. Dividends are not considered an expense for either accounting or tax purposes, which allows a company to report a higher net income, but creates larger tax payments. Tax payments have a negative impact on cash flows of a company. KP 2 BT: K Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

10.

How do the book value and market value of stock compare? Solution: Market value is the amount at which stock can be exchanged on the open market. This amount changes from day-to-day based on changes in market conditions. Book value is based on the dollar amounts reported in shareholders’ equity. Book value is generally calculated per common share and represents the net assets per share of outstanding stock. KP 5 BT: K Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

11.

How is the excess of cash receipts over the original cost of treasury stock accounted for and reported in financial statements? Solution: When cash is received in an amount that exceeds the original cost of treasury stock, the difference is reported as a credit to Additional Paid-in Capital—Treasury Stock. This amount appears as an addition in the shareholders’ equity section of the balance sheet. While some may view this excess amount received as a profit, GAAP does not allow a company to report this item on the income statement as a gain or loss. A company earns profits through the earning power of its assets. Treasury stock is not an asset, so profits acquired as a result of using it are considered only a contributed capital amount for a company. KP 6 BT: K Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

12-42

12.

Test Bank – Chapter 12 – Shareholders’ Equity

What makes preferred stock questionable in classification? Solution: Preferred stock, an equity investment, has characteristics that resemble debt. Preferred stock dividends are sometimes construed as interest because of the percent or per share amount that is attached to each share of preferred stock. Preferred shareholders cannot vote, making the status of preferred investors closer to that of debt investors who also cannot vote. KP 5 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

13.

What balance sheet condition does a deficit create? Solution: A deficit is a negative balance in retained earnings on the balance sheet. In determining the net worth of a company, total liabilities are subtracted from total assets. A deficit in retained earnings combined with a normal balance in contributed capital accounts may make a company appear to have a positive net worth although a deficit could still exist. A deficit is not an attractive feature to users of financial statements. Note: It is public knowledge that the federal government has a deficit. A government entity is not a for-profit entity so the balance sheet structure is somewhat different. The government has no retained earnings and contributed capital, so the entire difference between assets and liabilities shows up as a negative amount. KP 3 BT: K Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

14.

What is the purpose of the date of record? Solution: The date of record serves as a point in time for determining specifically who the shareholders are. When dividends are declared, the list of shareholders on that date may be different than the list on the date of record. Only holders of stock on the date of record receive dividends. No journal entries are recorded on the date of record. KP 7 BT: K Difficulty: Easy TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 12 – Shareholders’ Equity

15.

12-43

How does an appropriation of retained earnings affect the income statement and assets of a company? Solution: An appropriation of retained earnings is a journal entry that restricts a portion of retained earnings from the payment of future dividends. No asset, liability, revenue, or expense is affected when an appropriation is made. The unappropriated retained earnings account is reduced with a debit and the amount is credited to appropriated retained earnings. An appropriation does not allocate cash or any other funds, nor does it recognize a loss for any purpose. KP 8 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

16.

What is the purpose of a prior period adjustment? Solution: A prior period adjustment is a correction in the current period of an accounting error made in a previous period. The journal entry necessary to correct the error increases or decreases the balance sheet account that contained the error and then increases or decreases retained earnings directly. KP 8 BT: K Difficulty: Moderate TOT: 3 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

17.

From a business perspective, how does a stock split differ from a small stock dividend? How are they similar? Solution: A stock dividend requires a company to distribute additional shares of stock to existing shareholders. An investor who previously held 10 shares when a company issues a 10 percent dividend now holds 11 shares. A stock split modifies the par value of stock. The corporation asks investors to return previous stock certificates, and then distributes new stock certificates that have a different par value. The corporation distributes no assets, and the investor receives no assets for both a stock split and a small stock dividend. In both cases, the number of shares issued is usually increased. (A reverse stock split will cause a decrease.) KP 8 BT: K Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

IFRS Question 1. Under US GAAP, companies must provide a description of the changes in comprehensive income as either a separate statement or as a part of the statement of changes in stockholders’ equity. Under IFRS, companies must also provide a description of the changes in comprehensive income in a: A. Statement of Recognized Income and Expense B. Statement of Unrecognized Income and Expense C. Statement of Retained Earnings D. Income Statement

12-44

Test Bank – Chapter 12 – Shareholders’ Equity

Ans: A KP 6 BT: C Difficulty: Easy TOT: 1 min. AACSB: Diversity AICPA BB: Global AICPA FN: Reporting

Chapter 13 The Complete Income Statement

MULTIPLE CHOICE QUESTIONS 1.

Which one of the following events is an operating transaction? a. Purchase of equipment b. Payment for equipment rental c. Purchase of land d. Issuing bonds for cash Ans: B KP 2 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Which one of the following events is an operating transaction? a. Payment of office supplies b. Change in depreciation accounting principle c. Purchase of another company for stock d. Disposal of a business segment Ans: A KP 2 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

On the income statement, the result of changing from double-declining-balance to straight-line depreciation is found in a. operating revenues and expenses. b. other revenues or expenses. c. extraordinary gains or losses. d. cumulative effects. Ans: D KP 3 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Financing transactions include a. exchanges with shareholders. b. revenues. c. expenses. d. most transactions that impact the income statement. Ans: A KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13-1

13-2

Test Bank – Chapter 13 – The Complete Income Statement

On the income statement, the loss of equipment caused by the eruption of a volcano in the Northeastern United States is found in a. operating revenues and expenses. b. extraordinary gains or losses. c. disposal of a business segment. d. other revenues or expenses.

Ans: B KP 3 BT: C Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Which one of the following events is not an operating transaction related to a company’s primary activity? a. Disposal of a business segment b. Purchase of equipment c. Payment for equipment maintenance d. Purchase of inventory Ans: A KP 2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

All of the following are termed considered to be operating revenues or expenses that are usual and frequent except a. the sale of furniture by a furniture company. b. interest expense related to financing with bonds. c. depreciation expense on machinery. d. delivery cost of goods . Ans: B KP 2,3 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Which one of the following is a nonoperating event that must be reported on the income statement? a. Acquisition of a plant asset to be used in operations b. Extraordinary items c. Recognition of inventory expense d. Consumption of office supplies Ans: B KP 2 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Non-operating items are found in the a. asset section of the balance sheet. b. liability section of the balance sheet. c. cash flows from operations section of the cash flow statement. d. income statement. Ans: D KP 2 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 13 – The Complete Income Statement

10.

A summary of operating events is found a. only in the asset section of the balance sheet. b. only in the investment and financing sections of the cash flow statement. c. only in the cash flows from operations section of the cash flow statement. d. only in the income statement. e. in the cash flows from operations section of the cash flow statement, and in the income statement. Ans: E KP 2 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

11.

Operating events include a. the payment of dividends and accounting principle changes. b. inflows and outflows of assets due to the generation of revenues. c. purchases, sales, and exchanges of long-term assets. d. expenses and costs of acquiring plant assets . Ans: B KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

12.

On the income statement, interest revenue is found in a. operating revenues and expenses. b. other revenues or expenses. c. the disposal of a business segment section. d. the extraordinary gains or losses section. e. the cumulative effects section. Ans: B KP 3 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13.

13-3

On the income statement, marketing expenses are reported as a. operating revenues and expenses. b. other revenues or expenses. c. the disposal of a business segment. d. an extraordinary gain or loss. e. a cumulative effect. Ans: A KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13-4

14.

Test Bank – Chapter 13 – The Complete Income Statement

On the income statement, a gain from the sale of stock is reported as a. operating revenues and expenses. b. other revenues or expenses. c. a disposal of a business segment. d. an extraordinary gain or loss. e. a cumulative effect of a change in accounting principle. Ans: B KP 3 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

15.

On the income statement, the loss from selling an independent business component of the company is reported as a(n) a. operating revenue or expense. b. other revenue or expense. c. disposal of a business segment. d. extraordinary gain or loss.

Ans: C KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

16.

Which of the following statements is false regarding diluted earnings per share? a. Reporting diluted earnings per share is required by GAAP when potentially significant dilution of EPS exists. b. Diluted earnings per share can be used to reflect the extent of potential share dilution. c. Diluted earnings per share is not reported by some companies. d. Diluted earnings per share is always the same as basic earnings per share. Ans: D KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

17.

Recognition of bad debt expense is an event considered to be a. an operating activity cash flow. b. both unusual and infrequent. c. neither unusual nor infrequent. d. a financing cash flow. Ans: C KP 2 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

18.

On the income statement, the result of selling equipment is reported as a(n) a. operating revenue or expense. b. other revenue or expense. c. disposal of a business segment. d. extraordinary gain or loss. e. cumulative effect of a change in accounting principle. Ans: B KP 3 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 13 – The Complete Income Statement

19.

13-5

On the income statement, interest expense is reported as a(n) a. operating revenue or expense. b. other revenue or expense. c. disposal of a business segment. d. extraordinary gain or loss. e. cumulative effect of a change in accounting principle. Ans: B KP 3 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

20.

On the income statement, usual and frequent income events are found in a. operating revenues and expenses. b. other revenues or expenses. c. disposal of a business segment. d. extraordinary gains or losses. e. cumulative effects. Ans: A KP 2,3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

21.

On the income statement, unusual OR infrequent income events are found in a. operating revenues and expenses. b. other revenues or expenses. c. disposal of a business segment. d. extraordinary gains or losses. e. cumulative effects. Ans: B KP 2,3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

22.

Which one of the following is true about earnings per share? a. Must be calculated as earnings per ‘preferred’ share b. Must be calculated as earnings per ‘common’ share c. May be increased or decreased because of outstanding stock options or convertible debt d. Appears with the gross profit percentage on the income statement Ans: B KP 5 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13-6

23.

Test Bank – Chapter 13 – The Complete Income Statement

Below are five categories of transaction. Generally accepted accounting principles consider which of these as financing transactions? 1. 2. 3. 4. 5.

Purchases, sales, and exchanges of assets Exchanges with shareholders Operating transactions like revenues and expenses Exchanges of liabilities and shareholders’ equity Issues and payments of debt

a. b. c. d.

1 only. 3, 4, and 5. 1,2, and 3. 2,4,and 5.

Ans: D KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

24.

Which one of the following should be NOT reported net of income taxes? a. Loss from early extinguishment of long-term debt b. Cumulative adjustments resulting from a change in depreciation methods c. Bad debt expense associated with a bankrupt customer d. Gains or loss from discontinuing the operations of a major segment of a business Ans: C KP 3,4 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

25.

Which one of the following transactions or events is never treated as an extraordinary item? a. Losses from the early extinguishment of long-term bonds b. Losses from flooding in locations where flooding is uncommon and has never occurred before c. Operating losses from the discontinued segment of a business d. Losses from volcanic eruptions in Kansas Ans: C KP 3 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

26.

Mountain Corp. experienced the following events and transactions during 2010: 1 = Dividends declared and paid to Mountain’s shareholders 2 = Cumulative change from FIFO to average cost of inventory 3 = Gain on disposal of a major segment of the business 4 = Depreciation expense 5 = Gain from early debt retirement

Using the numbers of the events and transactions, identify which of the following sequences is the correct order for presenting the items on the income statement. a. 5, 1, 3, 2 b. 4, 3, 5, 2 c. 4, 5, 2, 3 d. 1, 4, 3, 5, 2

Test Bank – Chapter 13 – The Complete Income Statement

13-7

Ans: B KP 2,3 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

27.

Management of Walker Corporation chose to classify its major losses as extraordinary items. Managers might be biased toward this approach because a. investors do not use extraordinary items when predicting future performance. b. this treatment reduces income taxes. c. extraordinary losses are considered a good predictor of the company’s future solvency. d. extraordinary losses bypass net income and are reported directly as part of comprehensive income. Ans: A KP 1,3 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

28.

If a loss is unusual in nature but not infrequent in occurrence, the loss should be disclosed a. as an extraordinary item, net of taxes. b. in the footnotes. c. as a separate component of income from continuing operations. d. as a separate item after the extraordinary items, net of taxes. Ans: C KP 3,4 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

29.

Carman, Inc. properly reported a change in accounting principle during 2009. This company must a. have violated GAAP by not applying accounting principles consistently. b. have convinced its auditors that the environment in which it operates has changed and another method is more appropriate. c. be trying to cover up accounting errors. d. have initially used the wrong method. Ans: B KP 3 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

30.

Publicly held companies must disclose earnings per share for all of the following except for a. income from continuing operations. b. losses from discontinued segments of a business. c. other revenue and expense items. d. cumulative effects resulting from changes in accounting principles. Ans: C KP 5 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13-8

31.

Test Bank – Chapter 13 – The Complete Income Statement

Comprehensive income a. may be reported on a separate statement or on the face of the income statement. b. can be used as an alternative format of the traditional income statement. c. includes some revenue and expense items that are part of continuing operations. d. can be prepared instead of the shareholders’ equity section of the balance sheet. Ans: A KP 2,3 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

32.

Paulson, Inc. reported net income of $60,000 during 2010. Throughout 2010, 20,000 shares of common stock and 5,000 shares of preferred stock were outstanding. The preferred stock has no dividend preference. Evans reported earnings only for continuing operations items. How much is earnings per share for 2010? a. $3.00 b. $12.00 c. $2.00 d. Not enough information is provided. Ans: A KP 3 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

33.

Intraperiod tax allocation a. is applied to each income statement item to provide creditors and investors a better indication of the company’s true revenues and expenses. b. is a method of allocating income taxes over multiple accounting periods. c. is applied only to revenues since expenses are not taxed. d. is applied to net income from continuing operations. Ans: D KP 4 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

34.

Which one of the following items is considered part of comprehensive income but not reported as part of net income? a. Accounting principle changes b. Foreign currency translation adjustments c. Gain on sale of land d. Dividend revenue Ans: B KP 1,3 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 13 – The Complete Income Statement

35.

13-9

Why is income so important to both investors and stock analysts? a. It is strongly correlated to the market price of stock and bond prices. b. It is equal to the amount that shareholders will receive as dividends. c. Income is tied directly to revenue, i.e., a company that reports a large amount of revenue will always report a large amount of income. d. It identifies if the company will be able to pay its current debts when they become due. Ans: A KP 1,3 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

36.

Which one of the following is true concerning discontinued operations? a. It relates primarily to product changes in a company. b. The gain or loss associated with the disposal is shown separately as a component of continuing operations on the income statement. c. It is reported with ‘other revenues and losses’ on the company’s income statement. d. One of two separate disclosures required is income or loss from the segment’s operations from the beginning of the current accounting period to the date of disposal. Ans: D KP 3 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

37.

An income statement prepared with separate components a. enables users to distinguish transactions that are due to operations from those that are not useful as predictors of future performance. b. is prepared for income items that are frequent and usual. c. is used primarily by companies involved with complex financing transactions. d. may replace a statement of cash flows.

. Ans: A KP 1,3 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

38.

Diluted earnings per share a. is required for companies that have the potential for liquidation. b. is a financing and investing activity. c. shows the effects of possible increases in the number of outstanding common shares. d. is reported for the ‘other revenues and expenses’ category on the income statement. Ans: C KP 5 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13-10

39.

Test Bank – Chapter 13 – The Complete Income Statement

A company should report a cumulative effect of an accounting principle change when a. consistency has been violated. b. errors are made and subsequently corrected. c. FASB mandates a change from one method to another. d. international reporting standards differ from GAAP methods. Ans: C KP 1,3 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

40.

One objective of financial reporting is to provide information that is a. helpful in assessing the amounts, timing, and uncertainty of future cash flows. b. useful for competitors who need to assess economic activities. c. a forecast of future operations. d. unavailable to management. Ans: A KP 1 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

41.

Changes in accounting methods must be disclosed in three prominent places. These are a. the auditor’s report, financial statement notes, and the balance sheet. b. financial statement notes, the income statement, and the auditor’s report. c. the balance sheet, the income statement, and the statement of cash flows. d. notes to financial statements, the management letter, and the income statement. Ans: B KP 3 BT: K Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 13 – The Complete Income Statement

43.

13-11

Makar Corporation reported net income before extraordinary items and taxes of $200,000 for the year 2010. During 2010, the average number of common shares outstanding was 35,000. Basic net earnings per share for 2010 are reported to be only $2.00. Makar’s income tax rate is 30%. How much was Makar’s extraordinary gain or loss (before tax) from a major earthquake? The earthquake was the only item that was reported net of tax in the income statement for 2010. a. $70,000. b. $100,000. c. $130,000. d. none of the above Ans: B KP 4,5 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

44.

Anderson Industries has the following transactions reported in the financial statements: 1. Income effect due to changing from the double-declining balance method to the straight-line method of depreciation. 2. Collection of accounts receivable. 3. Purchase of an insurance policy on December 31 that provides coverage for the following year. 4. Accrued wages earned by the employees. 5. Estimated uncollectible accounts receivable using the aging method. 6. Recognized a gain on the sale of plant equipment. Which of the above transactions would be considered as “usual and frequent” for income statement purposes? a. Transactions 1, 2, 3, 4, & 5 b. Transactions 4 & 5 c. Transactions 4, 5 & 6 d. All transactions 1 through 6 Ans: B KP 3 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13-12

45.

Test Bank – Chapter 13 – The Complete Income Statement

Anderson Industries has the following transactions reported in the financial statements: 1. Income effect due to changing from the double-declining balance method to the straight-line method of depreciation. 2. Collection of accounts receivable. 3. Purchase of an insurance policy on December 31 that provides coverage for the following year. 4. Accrued wages earned by the employees. 5. Estimated uncollectible accounts receivable using the aging method. 6. Recognized a gain on the sale of plant equipment. Which of the above transactions would be considered as “unusual or infrequent” for income statement purposes? a. Transactions 1, 5, & 6 b. Transactions1, 3, & 6 c. Transaction 6 d. All transactions 1 through 6 Ans: C KP 3 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

46.

Damron Inc. has the following transactions reported in the financial statements: 1. Recognized a loss when the government expropriated land to build a bridge. 2. Declared a dividend valued at $100,000. 3. A lender covenant required the company to appropriate a portion of retained earnings. 4. Received dividends on stocks held as short-term investments. The dividends were declared and paid on the same day. 5. Recognized the cost of inventory sold during the year under the periodic method. 6. The company paid rent for the current year. Which of the above transactions would be included on the company’s statement of shareholders’ equity? a. Transactions 2 & 4 b. Transactions 1, 2, 3, & 4 c. Transactions 2 & 3 d. All transactions 1 through 6 Ans: C KP 3 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 13 – The Complete Income Statement

47.

13-13

Damron Inc. has the following transactions reported in the financial statements: 1. Recognized a loss when the government expropriated land to build a bridge. 2. Declared a dividend valued at $100,000. 3. A lender covenant required the company to appropriate a portion of retained earnings. 4. Received dividends on stocks held as short-term investments. The dividends were declared and paid on the same day. 5. Recognized the cost of inventory sold during the year under the periodic method. 6. The company paid rent for the current year. Which of the above transactions would be considered as “usual and frequent” for income statement purposes? a. Transactions 2, 4, 5, & 6 b. Transactions 2 through 6 c. Transactions 4, 5, & 6 d. Transactions 5 & 6 Ans: D KP 3 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

48.

Damron Inc. has the following transactions reported in the financial statements: 1. Recognized a loss when the government expropriated land to build a bridge. 2. Declared a dividend valued at $100,000. 3. A lender covenant required the company to appropriate a portion of retained earnings. 4. Received dividends on stocks held as short-term investments. The dividends were declared and paid on the same day. 5. Recognized the cost of inventory sold during the year under the periodic method. 6. The company paid rent for the current year. Which of the above transactions would be considered as “unusual or infrequent” for income statement purposes? a. Transaction 1 b. Transaction 3 c. Transaction 4 d. None of these transactions Ans: C KP 3 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13-14

49.

Test Bank – Chapter 13 – The Complete Income Statement

Damron Inc. has the following transactions reported in the financial statements: 1. Recognized a loss when the government expropriated land to build a bridge. 2. Declared a dividend valued at $100,000. 3. A lender covenant required the company to appropriate a portion of retained earnings. 4. Received dividends on stocks held as short-term investments. The dividends were declared and paid on the same day. 5. Recognized the cost of inventory sold during the year under the periodic method. 6. The company paid rent for the current year. Which of the above transactions would be considered as “unusual and infrequent” for income statement purposes? a. Transactions 1 & 4 b. Transaction 1 c. Transactions 1 & 3 d. None of these transactions Ans: B KP 3 BT: C Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 13 – The Complete Income Statement

50.

13-15

Sunrise Designs maintains a credit line with Ohio River Bank that allows the company to borrow up to $1 million. A covenant associated with the loan contract limits the company’s dividends in any one year. The 2010 income statement data for the company is as follows: Net sales Less: Cost of goods sold Gross profit Selling and administrative expenses Net operating income Gain on sale of securities Interest expense Net income from continuing operations before tax Less: Income tax Net income from continuing operations Extraordinary gain (net of tax) Net income before change in accounting principle Income effect due to change in accounting principle Net income

$840,000 500,000 $340,000 120,000 $220,000 24,000 (4,000) $240,000 51,200 $188,800 22,000 $210,800 52,000 $262,800

What is the maximum amount of dividends Sunrise can pay if the covenant associated with the credit line is expressed as 20 percent of net income? a. $55,000 b. $60,000 c. $52,560 d. $53,700 Solution: Net income Maximum Dividend = =

20%  $262,800 $52,560

Ans: C KP 1,3 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13-16

51.

Test Bank – Chapter 13 – The Complete Income Statement

$840,000 500,000 $340,000 120,000 $220,000 24,000 (4,000) $240,000 51,200 $188,800 22,000 $210,800 52,000 $262,800

What is the maximum amount of dividends Sunrise can pay if the covenant is expressed as 20 percent of income before change in accounting principle? a. $55,000 b. $60,000 c. $65,700 d. $42,160 Solution: Income before change in accounting method Maximum Dividend = 20%  $210,800 = $42,160

Ans: D KP 1,3 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 13 – The Complete Income Statement

52.

13-17

$840,000 500,000 $340,000 120,000 $220,000 24,000 (4,000) $240,000 51,200 $188,800 22,000 $210,800 52,000 $262,800

What is the maximum amount of dividends Sunrise can pay if the covenant is expressed as 20 percent of income before extraordinary items and change in accounting principle? a. $37,760 b. $60,000 c. $65,700 d. $52,700 Solution: Income before extraordinary items Maximum Dividend = 20%  $188,800 = $37,760 Ans: A KP 1,3 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13-18

53.

Test Bank – Chapter 13 – The Complete Income Statement

$840,000 500,000 $340,000 120,000 $220,000 24,000 (4,000) $240,000 51,200 $188,800 22,000 $210,800 52,000 $262,800

What is the maximum amount of dividends Sunrise can pay if the covenant is expressed as 20 percent of net operating income? a. $44,000 b. $60,000 c. $47,200 d. $52,700 Solution: Net operating income Maximum Dividend = 20%  $220,000 = $44,000 Ans: A KP 1,3 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 13 – The Complete Income Statement

54.

13-19

Gleeson Industries consists of four separate divisions: compressed wood products, chemicals, stone products, and plastics. On March 15, 2010, Gleeson sold the chemicals division for $625,000 cash. Financial information related to the chemicals division follows: Period from 1/1/10 to 3/15/10 Sales $175,000 Operating expenses 160,000 Net operating income (loss) $15,000 As of 3/15/10 Assets Liabilities

$1,850,000 1,400,000

The journal entry to record the sale of the chemicals division will include: a. a debit to Loss on Disposal of Business Segment for $175,000. b. a debit to Assets for $1,850,000. c . a debit to Extraordinary Gain for $175,000. d. a credit to Gain on Disposal of Business Segment for $175,000. Solution: Cash ................................................................................................... Liabilities ............................................................................................ Assets ........................................................................................... Gain on Disposal of Business Segment ........................................

625,000 1,400,000

Ans: D KP 4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

1,850,000 175,000

13-20

55.

Test Bank – Chapter 13 – The Complete Income Statement

Gleeson Industries consists of four separate divisions: compressed wood products, chemicals, stone products, and plastics. On March 15, 2010, Gleeson sold the chemicals division for $625,000 cash. Financial information related to the chemicals division follows: Period from 1/1/10 to 3/15/10 Sales Operating expenses Net operating income (loss) As of 3/15/10 Assets Liabilities

$175,000 160,000 $15,000

$1,850,000 1,400,000

If the income tax rate for the company is 35%, what amount of income tax liability on the disposal of the business segment will be recognized? a. $218,750 b. $61,250 c. $5,250 d. $157,500 Solution: Cash .................................................................................................... Liabilities ............................................................................................ Assets ............................................................................................ Gain on Disposal of Business Segment ......................................... Sold business segment.

625,000 1,400,000

Gain on Disposal of Business Segment .............................................. Income Tax Liability (+L) ................................................................ Recognized income tax liability on disposal of business segment.

61,250*

1,850,000 175,000

$61,250 = Gain on disposal of $175,000  Tax rate of 35% Ans: B KP 4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

61,250

Test Bank – Chapter 13 – The Complete Income Statement

56.

13-21

The management of Hammer Enterprises shares in a bonus that is determined and paid at the end of each year. The amount of the bonus is based on 12% of net income from continuing operations after tax. The bonus is not used in the calculation of income from continuing operations. During 2010, Hammer was sued and was ordered to pay $480,000 over and above the amount covered by insurance. The loss is tax deductible and the company’s tax rate is 35%. The company was last involved in a lawsuit five years ago. Net income from continuing operations before tax for 2010, excluding the lawsuit loss was $750,000. What would management’s 2010 bonus be if the lawsuit is considered unusual by not infrequent? a. $175,500 b. $32,400 c. $21,060 d. $20,160 Solution: If a lawsuit is considered unusual but not infrequent, then it would be classified under other expenses and losses. Consequently, the loss from the lawsuit would be used to compute net income from continuing operations.

Bonus = = =

12%  [($750,000 – $480,000)  (1 – Tax Rate)] 12%  [$270,000  (1 – 35%)] $21,060

Ans: C KP 3,4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13-22

57.

Test Bank – Chapter 13 – The Complete Income Statement

The management of Hammer Enterprises shares in a bonus that is determined and paid at the end of each year. The amount of the bonus is based on 12% of net income from continuing operations. The bonus is not used in the calculation of income from continuing operations. During 2010, Hammer was sued and was ordered to pay $480,000 over and above the amount covered by insurance. The loss is tax deductible and the company’s tax rate is 35%. The company was last involved in a lawsuit five years ago. Net income from continuing operations (before tax for 2010, excluding the lawsuit loss was $750,000. What would management’s 2010 bonus be if the lawsuit is considered extraordinary? a. $90,000 b. $57,600 c. $32,400 d. $58,500 Solution: If the loss from the lawsuit is considered extraordinary, then the loss would not be used to compute net income from continuing operations.

Bonus

= 12%  [$750,000  (1 – Tax Rate)] = 12%  [$750,000  (1 – 35%)] = $58,500

Ans: D KP 3,4 BT: AN Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 13 – The Complete Income Statement

58.

13-23

The following income statement was reported by Snappy Seacraft Company for the year ending December 31, 2010: Sales Rent revenue Interest income Total revenues Cost of goods sold Operating expenses Interest expense Loss on sale of fixed asset Total expenses Income from continuing operations (before tax) Less: Income tax Income from continuing operations Income from disposed segment (net of tax) Gain on sale of disposed segment (net of tax) Income before extraordinary items Extraordinary loss (net of tax) Income before change in accounting principle Income due to change in accounting principle (net of tax) Net income

$85,000 23,000 7,000 $115,000 $52,000 24,000 12,000 6,000 94,000 $21,000 10,000 $11,000 3,000 2,000 $16,000 7,000 $9,000 6,000 $15,000

Assume Snappy has an average of 15,000 shares of common stock outstanding during 2010. Based on this information, what amount of earnings per share would be reported on the income statement as the disposal of the business segment? a. $0.33 b. $0.20 c. $1.00 d. $0.73 Solution: Income from continuing operations ....................... Disposal of business segment* ............................. Extraordinary loss ................................................. Changes in accounting method............................. Net earnings per share .........................................

$ 0.73 0.33 (0.46) 0.40 $ 1.00

* The EPS disclosure for the disposal of the business segment includes both the income from the disposed segment and the gain on the sale of the disposed segment.

Ans: A KP 5 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13-24

59.

Test Bank – Chapter 13 – The Complete Income Statement

$85,000 23,000 7,000 $115,000 $52,000 24,000 12,000 6,000 94,000 $21,000 10,000 $11,000 3,000 2,000 $16,000 7,000 $9,000 6,000 $15,000

Assume Snappy has an average of 25,000 shares of common stock outstanding during 2010. Based on this information, what amount of earnings per share would be reported on the income statement as the disposal of the business segment? a. $0.12 b. $0.20 c. $0.08 d. $0.60 Solution: Income from continuing operations....................... Disposal of business segment* ............................ Extraordinary loss ................................................ Changes in accounting method ............................ Net earnings per share .........................................

$ 0.44 0.20 (0.28) 0.24 $ 0.60

* The EPS disclosure for the disposal of the business segment includes both the income from the disposed segment and the gain on the sale of the disposed segment.

Ans: B KP 5 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 13 – The Complete Income Statement

13-25

MATCHING QUESTIONS 1.

Indicate whether each event listed below in 1 through 6 is reported as a discontinued operation (D), extraordinary item (E), a change in accounting principle (A), or a component of continuing operations (C), by placing the letter of your choice in the space provided. If an item does not fall into one of these categories, place an X in the blank. 1. Gain on disposal of one of the company’s four corporate office buildings 2. Retired bonds early and incurred a loss 3. Received dividends on stock investments 4. Changed from straight-line to double declining-balance depreciation 5. Tornado damage to the corporate head office that cost $1 million to repair 6. Estimated uncollectible accounts at year-end Solution: 1. C 2. E 3. C 4. A 5. E 6. C KP 3 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13-26

Test Bank – Chapter 13 – The Complete Income Statement

Given below are several items (1 through 4) that will be reported on a company’s financial statements. Select the letter of the proper financial statement reporting section listed as a through f. You may use each letter more than once or not at all. a. b. c. d. e. f.

Financial Statement Reporting Sections Income from continuing operations section of the income statement Discontinued operations section of the income statement Extraordinary items section of the income statement Cumulative effect of a change in accounting principle section of the income statement A separate comprehensive income item Not reported on the income statement or comprehensive income statement

_____1. A loss incurred by Maranda Corporation due to a strike by employees of the company _____2. A large loss of inventory incurred by a meat-packing factory due to a government FDA inspection which found dangerously high levels of bacteria; no previous situations in the company’s history _____3. Manufacturing circuits were determined obsolete and had to be written down to a nominal scrap value due to an improved manufacturing process _____4. A loss due to a decline in market value on an available-for-sale investment _____5. Losses due to a hurricane damage _____6. Financial impacts of the adoption of a new FASB standard on goodwill. _____7. The financial effects of outsourcing the company’s industrial product division Solution: 1. a 2. a 3. a 4. e 5. c 6. d 7. b KP 3 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 13 – The Complete Income Statement

13-27

_____1. A gain due to an early payoff of debt that had a high interest rate _____2. Another loss of plant assets incurred by a company whose distribution warehouse is located on an island that has experienced severe flooding three times in the past 5 years _____3. A $1 billion loss due to a permanent shutdown of the company’s only subsidiary, Coastal, Inc, triggered by poor product development _____4. A foreign currency translation gain at yearend Solution: 1. c 2. a 3. b 4. e KP 3 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13-28

Test Bank – Chapter 13 – The Complete Income Statement

Select the financial statement section (a through f) in which each of the items listed in 1 through 6 would be reported by writing the letter of the best answer in the space provided. a. b. c. d. e. f.

Financial Statement Sections Income from continuing operations section of the income statement Discontinued operations section of the income statement Extraordinary items section of the income statement Cumulative effect of a change in accounting principle section of the income statement Balance sheet Not necessary to report on a financial statement

1. ____

Government expropriation of plant location in Venezuela

2. ____

Financial effects of the adoption of a new FASB standard regarding postretirement benefits

3. ____

Financial effects of dropping a company’s domestic product division

4. ____

Unusual and infrequent gain from a plant explosion

5. ____

Unrealized gain/loss from trading securities

6. ____

Interest revenue

Solution: 1. c 2. d 3. b 4. c 5. a 6. a KP 3 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 13 – The Complete Income Statement

13-29

Select the financial statement section (a through g) in which each of the items listed in 1 through 5 below would properly be reported by writing the letter of the best answer in the space provided. a. b. c. d. e. f. g.

Financial Statement Sections Income from continuing operations section of the income statement Discontinued operations section of the income statement Extraordinary items section of the income statement Cumulative effect of a change in accounting principle section of the income statement Statement of shareholders’ equity Balance sheet Not necessary to report on a financial statement

1. _____

Declared cash dividends for the first time in the history of the corporation

2. _____

Incurred a gain on the sale of four Preston franchise stores, but held onto the Little Steps chain

3. _____

Incurred a huge loss from a hurricane that destroyed the company’s Louisiana packaging plant; no previous hurricanes have occurred at this location

4. _____

Recorded interest income for the year

5. _____

Incurred $14,000 to replace the company’s office products (letterhead, envelopes, pens, etc.) with a new logo to promote a new product line

Solution: 1. 2. 3. 4. 5.

e b c a a

KP 3 BT: C Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

SHORT PROBLEMS 1.

Wellman Inc., a computer manufacturer located in Texas, lost an uninsured building due to the infrequent and unusual occurrence of a hurricane. The building has a balance sheet value of $20,000 and will cost $165,000 to rebuild. Wellman’s income tax rate is 40%. Calculate the amount of any extraordinary loss that should be reported on Wellman’s income statement. Prepare a partial income statement that shows how the item will be presented. Solution: $20,000 x (1 – 40%) = $12,000 Partial Income Statement Income from operations before extraordinary item Extraordinary loss due to hurricane, net of taxes

$ xxxx (12,000)

KP 3,4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13-30

Test Bank – Chapter 13 – The Complete Income Statement

The following information was taken from the 2010 financial records of Hopewell Company. Debit Operating revenues Operating expenses Gain on sale of short-term investments Loss on sale of business segment Income earned on disposed business segment Extraordinary loss Income due to change in accounting principle Retained earnings (beginning balance) Dividends declared

Credit 187,000

132,500 15,200 21,000 3,000 5,000 12,500 72,000 18,000

The company’s income tax rate is 35 percent, and the items above are treated identically for the financial reporting and tax purposes. REQUIRED: Prepare an income statement using this information. Solution: Hopewell Company Income Statement For the Year Ended December 31, 2010 Revenue: Operating revenues................................................. Total revenue .......................................................... Expenses: Operating expenses ................................................ Other revenue ............................................................. Income from continuing operations (before taxes) ....... Income tax expense .................................................... Income from continuing operations.............................. Discontinued operations: Income earned by discontinued segment (net of taxes of $1,050) .................................................... Loss on disposal of discontinued segment (net of tax benefit of $7,350) ............................................ Discontinued operations .......................................... Income before extraordinary items .............................. Extraordinary loss (net of tax benefit of $1,750) .......... Income before change in accounting method .............. Effect of change in accounting method (net of taxes of $4,375) ...................................................... Net income ..................................................................

$187,000 $187,000 132,500 15,200 $ 69,700 24,395 $45,305

$ 1,950 (13,650)

KP 3 BT: AN Difficulty: Difficult TOT: 8 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

(11,700) $ 33,605 (3,250) $ 30,355 8,125 $ 38,480

Test Bank – Chapter 13 – The Complete Income Statement

13-31

Canter Company operates a boat rental service in North Carolina. The company was involved in the following transactions and events during 2009: 1. The supplies, gasoline, and other maintenance item costs incurred associated with the rentals are $420,000. 2. Provided rental boats to customers during 2009 for total revenue of $880,000. 3. Damage by an earthquake to one of Canter’s uninsured rental centers in Georgia, during 2009 was $440,000. Earthquakes have never occurred here before. 4. Sued by a rental customer that got his head caught in the ladder of a rental boat. The customer will probably win the suit that is estimated at $80,000. Lawsuits are common in the rental industry. 5. Switched from double-declining-balance to straight-line depreciation. Effect was to decrease the accumulated depreciation account by $58,000. 6. Declared and paid $25,000 in dividends.

For each transaction, state in which section of the income statement it should be reported and give the dollar amount that should be reported. State whether each reporting amount is added or subtracted on the income statement and if the specific line item on the income statement is reported net of taxes. Canter’s income tax rate is 30%. Solution: 1. Income from continuing operations—cost of goods sold; $420,000, subtract, not net of tax 2. Income from continuing operations—sales revenue; $880,000, add, not net of tax 3. Extraordinary item section; $440,000 – $132,000 = $308,000, subtract, net of tax 4. Income from continuing operations—other expenses; $80,000, subtract, not net of tax 5. Cumulative effect of a change in principle section; $58,000 – $17,400 = $40,600, add, net of tax 6. Not on income statement KP 3,4 BT: AN Difficulty: Difficult TOT: 6 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13-32

Test Bank – Chapter 13 – The Complete Income Statement

The following are the revenue and expense accounts for the year ending August 31, 2009, for Hammer Corporation: Sales revenue Interest revenue Interest expense Gain from sale of land Cost of goods sold Administrative expense Extraordinary gain Income tax expense

$70,000 3,000 2,000 8,000 45,000 9,000 3,500 4,200

A. Calculate the amount of gross profit for Hammer Corporation for the year ending August 31, 2009. B. How much should be reported as ‘Other Revenues’? Solution: A. Gross profit = $70,000 – $45,000 = $25,000 B. Other Revenues = $3,000 + $8,000 = $11,000 KP 3 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Badger, Inc. is planning a major stock issuance in early 2010. During 2009, the company reported net income from operations of $530,000 before taxes. The items below describe major events that occurred during 2009. 1. A $52,000 gain was recognized on the sale of a subsidiary 2. Inventory was written down by $21,000 due to obsolescence 3. A forced government takeover of a company plant in India that had a book value of $320,000 4. A $31,000 gain was recognized due to the adoption of a new FASB statement

The company's tax rate is 30 percent. A. Which items should not be reported as a component of income from continuing operations? B. Suppose management decided to exclude all of the above items from income from continuing operations. What effect might this have on investor and creditor decisions? Solution: A. Exclude items 1, 3, and 4. B. Income from continuing operations is used as a predictor in determining future performance. Items that are excluded may appear to investors and creditors as oneshot occurrences. It is quite common for inventory to be written down as the result of obsolescence. Classifying it as a non-ongoing item will cause investors to disregard it in predicting future profits and losses. KP 5 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 13 – The Complete Income Statement

13-33

Hamilton Corp. had the following infrequent income statement items during 2009: • • • • •

$45,000 of dividends received from a stock investment $20,000 gain on the sale of a plant asset which became outdated because of new technology $19,000 loss due to the sale of treasury stock at a price less than its original cost $34,000 fair value adjustment increase to market for available-for-sale investments $50,000 interest expense for the year of which only $42,000 was actually paid

How much should Hamilton report as a component of ‘income from continuing operations’? Solution: $45,000 + $20,000 – $50,000 = $15,000 KP 3 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting 7.

On January 1, total assets and liabilities were $30,000 and $12,000, respectively. On December 31, total assets and liabilities were $28,000 and $20,000, respectively. During the year, $7,000 of dividends were declared and paid and no stock was purchased or issued. Calculate the amount of net income or loss for the year. Solution: Beginning shareholders’ equity ($30,000 – $12,000) Less dividends declared Less ending shareholders’ equity ($28,000 – $20,000) Net loss KP 2 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

$ 18,000 (7,000) (8,000) $ 3,000

Test Bank – Chapter 13 – The Complete Income Statement

13-34

Nigel Corporation reported income from continuing operations before taxes and before adjustment of the transactions below in the amount of $1,000,000. A review of the 2009 income statement revealed several items that appeared to be incorrectly categorized. The following items were flagged: a. Recorded a loss of $29,000 due to a vandalism attack by a gang on one of the company warehouses; vandalism attacks have occurred at least once per year since the company began operations b. Incurred an unusual and infrequent hurricane loss of $41,000 to a company warehouse c.

Closed all five of the company’s supermarkets in Manhattan after bag boys went on strike for an extended period of time; shutdown expenses totaled $38,000

d. Floods from overflowing toilets on the upper floors of a downtown office building in Denver caused more than $8 million in repairs. Flooding toilets are rare in this area and have never occurred in office buildings in Denver before. Insurance coverage paid $8.6 million to replace the damaged portions of the building.

Nigel has a 30% tax rate. Calculate income from continuing operations. For any item that is NOT a component of continuing operations, state how it would be reported. Solution: Income from continuing operations before taxes and before adjustments a. Vandalism loss c. Shutdown expenses due to strike Income from continuing operations before taxes Income taxes expense Income from continuing operations

$1,000,000 (29,000) (38,000) 933,000 (279,900) $ 653,100

Other items: Hurricane loss = extraordinary loss because it is both unusual and infrequent Gain from plumbing damage = extraordinary gain because it is both unusual and infrequent KP 2 BT: AN Difficulty: Moderate TOT: 6 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

On January 1, total assets and liabilities were $21,000 and $8,000, respectively. On December 31, total assets and liabilities were $30,000 and $7,000, respectively. During the year, $9,000 of dividends were declared and paid and $3,000 of stock was issued. Calculate net income for the year. Solution: Beginning shareholders’ equity ($21,000 – $8,000) Less dividends declared Less ending shareholders’ equity ($30,000 – $7,000) Add additional stock issued Net income

$ 13,000 (9,000) (23,000) 3,000 $16,000

KP 2 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 13 – The Complete Income Statement

10.

13-35

On January 1 and December 31, 2010, retained earnings were $23,000 and $42,000, respectively. During the year, the only dividends were an ordinary stock dividend recorded at $11,000. Calculate net income for 2010. Solution: Beginning retained earnings Less stock dividends declared Less ending retained earnings Net income

$ 23,000 (11,000) (42,000) $ 30,000

KP 2 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

11.

Cabell Inc. reported ‘income from operations before taxes’ in the amount of $402,000 before including the following items for the year ending December 31, 2009: • • • • • •

•

On December 31, 2009, borrowed long-term debt of $50,000 that limits dividends to 10 percent of net income from continuing operations $21,000 unrealized gain from fair value adjustment related to available-for-sale investments $30,000 loss recognized on the sale of a trading security $58,000 loss recognized on a lawsuit relating to patent violations $11,000 government fine for environmental violation $63,000 write-down of obsolete inventory $25,000 loss on the early retirement of debt.

The company's income tax rate is 30 percent. No taxes have been considered in any information provided. Prepare a calculation of income from operations starting with income from operations before taxes, as tentatively reported. Omit the heading. Be sure to label correctly. Solution: Income from operations before taxes, as tentatively reported Other revenues and expenses: Write-down of obsolete inventory Loss on sale of a trading security Loss on a lawsuit relating to patent violations Government fine for environmental violation Adjusted income from continuing operations before taxes Income taxes expense Income from continuing operations

$402,000 ($63,000) (30,000) (58,000) (11,000)

KP 1,2,3 BT: AN Difficulty: Difficult TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

(162,000) $240,000 72,000 $168,000

13-36

12.

Test Bank – Chapter 13 – The Complete Income Statement

Hubbell Service showed the following information for 2010: Net sales revenue, $410,000; interest revenue, $11,000; cost of goods sold, $220,000; operating expense, $15,000, extraordinary gain on retirement of debt, $30,000; and dividends declared, $14,000. Calculate operating income for 2010. Solution: $410,000 – $220,000 – $15,000 = $175,000 KP 3 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13.

The following are some accounts for Marvell Corp. for 2009: Sales revenue Cost of goods sold Administrative expense Interest expense Loss from disposal of segment Gain from sale of land Stock dividends declared Loss due to permanent value decline of plant asset Extraordinary loss from hurricane Unrealized gain from trading securities Interest revenue

$102,000 85,000 34,000 3,000 21,000 4,000 9,000 6,000 19,000 5,000 1,000

All amounts are before income taxes. Marvell has a 30% tax rate. Determine the amount of Marvell’ ‘other revenue’ and ‘other expenses’ for 2009. List all non-income statement items and indicate on which financial statement they are reported. Solution: Other revenue = $4,000 + $5,000 + $1,000 = $10,000 Other expenses = $3,000 + $6,000 = $9,000 Non-income statement items = Stock dividends declared of $9,000 must be reported on the statement of shareholders’ equity. KP 3 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 13 – The Complete Income Statement

14.

13-37

Hilton Corporation’s income statement for the year ending December 31, 2009, appears below. Net sales Cost of goods sold Gross profit Selling and administrative expenses Net operating income Gain on sale of securities Interest expense Income from continuing operations before tax Income tax expense Income from continuing operations Extraordinary gain (net of tax) Income before cumulative effect Income effect due to change in accounting principle Net income

$810,000 (610,000) 200,000 (90,000) 110,000 56,000 (3,000) 163,000 (48,900) 114,100 22,000 136,100 32,000 $168,100

Compute the maximum amount of dividends Hilton can pay if it has a debt covenant expressed as 20 percent of net income, and as 20 percent of net operating income. Which amount would a creditor more likely use as the restriction on dividends? Explain. Solution: Net income: 20% x $168,100 = $33,620 Net operating income: 20% x $110,000 = $22,000 A creditor would probably select net operating income, not because it is more conservative, but because it is a better indicator of amounts that are likely to continue into the future. KP 1,3 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13-38

15.

Test Bank – Chapter 13 – The Complete Income Statement

Jarvis Company provided the following information for the year ending December 31, 2009: Cost of goods sold Gain on sale of business segment Income tax rate Interest income Interest expense Loss from operation of discontinued business segment Operating expenses Revenue from sales Number of shares of common stock outstanding

$400,000 20,000 30% 5,000 7,000 12,000 23,000 730,000 100,000

Prepare an income statement in good form. You may omit the heading. Include all earnings per share amounts required for the year ending December 31, 2009. Solution: Revenue from sales Cost of goods sold Gross profit Operating expenses Other revenues(expenses): Interest income Interest expense Income from operations before taxes Income taxes expense Income from continuing operations Discontinued operations: Loss from operations of discontinued business segment, net ($12,000 – $3,600) Gain on sale of business segment, net ($20,000 – $6,000) Net income Earnings per share: Income from continuing operations Discontinued operations per share Net income per share

$730,000 (400,000) $330,000 (23,000) 5,000 (7,000) $305,000 (91,500) $213,500 ($8,400) 14,000

5,600 $219,100

$2.14 0.06 $2.20

KP 3,5 BT: AN Difficulty: Difficult TOT: 6 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 13 – The Complete Income Statement

13-39

Use the information that follows concerning Palomar Corp. to answer questions 16 through 19. Nichol Corp. has 20,000 shares of common stock outstanding. For the year ending December 31, 2009, the company tentatively reported income from continuing operations before taxes of $320,000. Nichol Corp. has a 30 percent tax rate. The additional information given below has not been recorded in the accounts unless specifically stated. a.

The company is located in Cheyenne, Wyoming . During the year, an earthquake destroyed some of Nichol’s assets amounting to a loss of $120,000. Earthquakes are considered infrequent in this area and are very unusual. The company’s employees went on strike for six weeks in March of 2009. Revenues would have been about $23,000 more had the strike not occurred. No adjustment was recorded.

During 2009, the company changed its method of accounting for inventories from FIFO to weighted average. Cost of goods sold related to prior years would have been $39,000 greater.

The company’s accounts include $47,000 as Unrealized Holding Gain from Trading Investments at December 31, 2009.

16.

How much should be reported on the income statement for the year ended December 31, 2009 as ‘Extraordinary Gains or Losses’? Solution: Extraordinary loss due to earthquake Tax effect Extraordinary loss, net of tax

($120,000) 36,000 ($84,000)

KP 3,4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

17.

Calculate how much should be reported on Nichol’s income statement as ‘Income from Continuing Operations’ for the period ended December 31, 2009. Solution: Income from continuing operations before taxes: ($320,000 + $47,000) Income taxes at 30% Income from continuing operations

$367,000 (110,100) $256,900

KP 3,4 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

18.

How much should be reported on the income statement for the year ended December 31, 2009, as ‘Cumulative Effect of a Change in Accounting Principle’? Solution: Cumulative effect of an accounting principle change Tax effect Cumulative effect of a principle change, net of tax

($39,000) 11,700 ($27,300)

KP 3,4 BT: AN Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13-40

19.

Test Bank – Chapter 13 – The Complete Income Statement

Name the specific items for which Nichol Corp. must apply intraperiod tax allocation in its financial statements. Solution: Income from continuing operations, extraordinary loss due to earthquake, the cumulative effect of an accounting principle change, and net income. KP 4 BT: AP Difficulty: Moderate TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

20.

On January 1 and December 31, retained earnings were $40,000 and $53,000, respectively. During the year, $21,000 of dividends were declared. Calculate net income during the year. Solution: $40,000 – $21,000 – $53,000 = $34,000 KP 2 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 13 – The Complete Income Statement

21.

13-41

The following information was taken from the accounting records of ABCO Corporation for the year ending December 31, 2009. Cost of sales Loss on sale of business segment Profit from operations of discontinued business segment Operating expenses Revenue from sales Number of shares of common stock outstanding Income tax rate Appropriated retained earnings for plant expansion Dividends Gain on sale of plant asset

$342,000 23,000 19,000 176,000 690,000 100,000 30% 176,000 130,000 23,000

A. In good form, prepare the section of the income statement that begins immediately under ‘income from continuing operations’. Do not be concerned with calculating the amount reported as ‘income from continuing operations.’ B. List all the items that would appear in the ‘Other Revenue/Other Expenses’ section of the income statement. C. How is the number of shares of common stock outstanding used on the income statement? Solution: A. Income from continuing operations Discontinued operations, net, ($19,000 – $5,700) Loss on sale of business segment, net, ($23,000 – $6,900) Net income

$ xxxx $ 13,300 (16,100)

(2,800) $xxxx

B. Gain on sale of plant asset, $23,000 C. The calculation of earnings per share amounts uses the number of common shares outstanding as its denominator. Earnings per share is required on the income statement. KP 3,5 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

22.

The following are the revenue and expense accounts of the current year for ABCO Corporation: Sales revenue Interest revenue Interest expense Gain from sale of land Cost of goods sold Administrative expense Gain due to hurricane loss – infrequent and unusual

$200,000 3,000 6,000 2,700 120,000 39,000 45,000

All items are before income taxes. The income tax rate is 20%. Calculate any extraordinary gain or loss that should be disclosed on the income statement. Solution: Extraordinary gain, net of taxes = $45,000 – (.20 x $45,000) = $36,000 KP 3 BT: AN Difficulty: Moderate TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13-42

23.

Test Bank – Chapter 13 – The Complete Income Statement

Balance sheet information of Digital Solutions, Inc. at December 31, 2008, is provided below. Assets Liabilities Shareholders' equity

$100,000 34,000 66,000

During 2009, the company entered into the following transactions: 1. Common stock was issued for $12,000 cash. 2. Services were performed for $45,000 cash. 3. Cash expenses of $31,000 were incurred. 4. Long-term liabilities of $18,000 were paid. 5. The market value of an available-for-sale investment owned at yearend exceeded its cost by $6,000. 6. Dividends of $9,000 were declared and paid.

A. Which transactions are operating? B. Compute net income for the year ending December 31, 2009. C. Compute comprehensive income for the year ending December 31, 2009. Solution: A. Transactions 2 and 3 are operating. B. $45,000 – $31,000 = $14,000 C. $14,000 + $6,000 = $20,000 KP 2 BT: AN Difficulty: Moderate TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

SHORT ESSAY QUESTIONS 1.

Identify types of transactions that are considered exchanges of liabilities and shareholders' equity. Why are these transactions considered ‘financing’? Solution: Exchanges involving liabilities can be exchanged for other liabilities or converted into shareholders' equity. Two examples of these include debt refinancing arrangements and the conversion of convertible bonds and preferred stock to common stock. They are considered financing transactions because they impact a company's capital structure. They do not affect the income statement. KP 2 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 13 – The Complete Income Statement

13-43

How do items at the top of the income statement differ from items at the bottom of the income statement? Solution: As one moves from the top to the bottom of the income statement, the events become increasingly less important to the operations of the business. The first of the five major components is 'net operating income' which reflects financial performance resulting from transactions that are both fundamental to a company's normal activities and recur frequently. Other revenues and expenses and disposals of business segments reflect the financial effects of events that are either not part of a company's normal operations or do not occur frequently. Extraordinary gains and losses result from events that are both highly unusual and infrequent, and gains and losses due to changes in accounting principles result simply from accounting entries. KP 2,3 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

How are operating transactions that are not based primarily on the normal operations of a company reported on the financial statements? Solution: Some revenues and expenses from activities not germane to a company's primary activities may occur infrequently. These consist of extraordinary items, disposals of segments, gains and losses due to changes in accounting principle, and other revenues and expenses. These items are reported separate from operating income on the income statement. The separation of these items allows investors and creditors to make betterinformed decisions. Income from continuing operations, which represents the company's primary activities, is expected to recur in future accounting periods. The separation of the special items allows users to clearly see the impact on total income, while at the same time allowing them to omit or separate infrequent items that may distort forecasts. KP 2 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

One of the three objectives of financial reporting directly relates to the income statement and measure of income. Indicate the context of this objective, and explain how it relates to the earnings process. Solution: This objective of financial reporting that directly relates to earnings states that the objective is to provide information to users to make decisions about economic resources, the claims to those resources, and changes in them. The changes in the resources appear as increases or decreases in shareholders' equity that corresponds to the ‘changes in them’ portion of the objective. KP 1 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

13-44

Test Bank – Chapter 13 – The Complete Income Statement

Identify the GAAP requirements of comprehensive income. Solution: SFAS No. 130 mandates comprehensive income reporting. It establishes the standards for reporting a display of comprehensive income and its components. It includes items not included in the computation of net income such as foreign currency translation adjustments and unrealized gains and losses on available-for-sale securities. KP 1 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

What is the definition of a business segment and what special reporting is required for discontinued segments? Solution: A business segment is defined as a separate line of business, product line, or class of customers involving operations that are independent from a company's other operations. In addition to reporting any gain or loss related to the disposal of the segment itself, the income or loss attributed to the segment's operations up to the time of the disposal must also be included under the caption ‘disposal of business segments.’ KP 3 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Is consistency violated when a company changes accounting principles? Solution: The concept of consistency generally means that once a company chooses an acceptable principle, it must continue to use that method consistently from one year to the next. Consistency helps to maintain the credibility of accounting reports, enabling investors, creditors, and other interested parties to make more meaningful comparisons and to identify more easily the trends in a company's performance across time. A company that changes an accounting principle, and properly discloses the nature of the change in the financial statements, does not violate consistency. KP 3 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Why are losses resulting from employee layoffs and write-downs such as inventory and receivables reported as 'other expenses and losses'? Solution: These items are considered to arise from normal operating business risks. As they can be expected to routinely occur in the business environment, they are included as part of income from continuing operations. KP 3 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 13 – The Complete Income Statement

13-45

Discuss the reasons for and the financial statement effects of intraperiod tax allocation. Solution: Intraperiod tax allocation is a concept that includes the income tax effect of a particular transaction with the transaction itself. Four items are reported 'net of tax' on the income statement. The first follows 'net income from continuing operations before taxes'. It represents the tax expense resulting from all taxable revenues and deductible expenses except for those listed below it on the income statement. The dollar amounts associated with the disposal of business segments, extraordinary items, and changes in accounting principle are all disclosed net of tax. Intraperiod tax allocation enables users to assess the total financial impact of the special transactions as well as the tax benefit or cost associated with them. KP 3 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

10.

What is ‘pro forma’ as it relates to the income statement? Solution: Pro forma is also called ‘as if.’ Changes in an accounting principle can make it more difficult to compare a company's financial performance across time. In order to provide enough information so the user can compare the method used in the current period with the old method, disclosure of the pro forma effects is required. The disclosure provides information ‘as if’ the alternate method had been used to calculate net income. It enables users to make more meaningful comparisons, at least across the periods presented on the face of the income statement. KP 3 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

11.

How does diluted earnings per share differ from the traditional basic earnings per share? Solution: Diluted earnings per share is calculated for companies that have a potential for significant dilution. Dilution is a reduction of the original earnings per share calculation that results from potential issuances of additional shares of common stock. Instruments that may cause dilution include preferred stock and bonds that can be converted to common stock, stock options and warrants, and other possible conversions by investors. KP 5 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

13-46

12.

Test Bank – Chapter 13 – The Complete Income Statement

What is earnings persistence? Solution: Earnings persistence reflects the extent to which particular dollar amounts of earnings can be expected to continue in the future and generate future cash flows. Earnings amounts with high levels of persistence are expected to continue in the future, while those with low levels of persistence are not. Income statement classifications are useful because for the most part, they are defined in terms of their persistence. KP 5 BT: K Difficulty: Easy TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Measurement

13.

How has the movement toward internationalization of many businesses increased reporting of the number of special gains and losses on the income statement? Solution: International operations are subject to certain risks and opportunities, including currency fluctuations, government actions, and investment earnings which are created by accounting for subsidiaries under the equity method. These aspects cause the number of special gains and losses to increase because without the international operations, many of them would not exist. Companies must closely monitor their methods of operating in each country. KP 5 BT: C Difficulty: Moderate TOT: 4 min. AACSB: Analytic, Communication, Diversity AICPA BB: Critical Thinking AICPA FN: Reporting

IFRS questions 1. Which of the following statements is true? a. IFRS relies less heavily on fair market value accounting than does US GAAP b. IFRS relies more heavily on fair market value accounting than does US GAAP c. Neither IFRS nor US GAAP will use fair market value accounting in the near future d. Only US GAAP uses fair value market accounting. Ans: B KP 6 BT: C Difficulty: Easy TOT: 1 min. AACSB: Diversity AICPA BB: Global AICPA FN: Reporting

Chapter 14 The Statement of Cash Flows

MULTIPLE CHOICE QUESTIONS 1.

How will a company classify ‘proceeds received from the issuance of long-term bonds’ on its statement of cash flows? a. Cash provided from operations b. Cash used in operations c. Cash provided from investing activities d. Cash provided from financing activities Ans: D KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

How will a company classify the exchange of common stock for land on its statement of cash flows? a. An operating activity b. An investing activity c. A financing activity d. A footnote Ans: D KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

How will a company classify money paid for the acquisition of land on its statement of cash flows? a. Cash provided from operations b. Cash used in financing activities c. Cash provided from investing activities d. Cash used for investing activities Ans: D KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

14-1

14-2

Test Bank – Chapter 14 – The Statement of Cash Flows

Equipment that cost $10,000 that had a book value of $6,000 was sold for $7,000. Data from the comparative balance sheets are: Equipment Accumulated Depreciation

12/31/09 $420,000 59,000

12/31/08 $310,000 36,000

Equipment purchased during 2009 cost a. $120,000. b. $110,000. c. $145,000. d. $10,000. Ans: A KP 6 BT: K Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

If an investor is interested in the solvency of a company, he/she should analyze the a. balance sheet and income statement. b. income statement, balance sheet, and statement of cash flows. c. balance sheet and statement of cash flows. d. statement of cash flows only. Ans: C KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

How will a company classify the sale of treasury stock at an amount equal to its cost on its statement of cash flows? a. Operating activity b. Investing activity c. Extraordinary activity d. Financing activity Ans: D KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

How will a company classify money paid to suppliers on its statement of cash flows? a. Cash provided from operations b. Cash used in operations c. Cash provided from investing activities d. Cash used in financing activities Ans: B KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 14 – The Statement of Cash Flows

14-3

Payments for purchases of property, plant, and equipment and other productive assets are classified as cash outflows from a. operating activities. b. financing activities. c. investing activities. d. selling activities. Ans: C KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

How will a company classify money paid for inventory acquisitions on its statement of cash flows? a. Cash provided from operations b. Cash used in operations c. Cash provided from investing activities d. Cash used for investing activities Ans: B KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

10.

How will a company classify money received from selling equipment no longer used in operations on its statement of cash flows? a. Cash provided from operations b. Cash provided from financing activities c. Cash provided from investing activities d. Cash used for investing activities Ans: C KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

11.

A company uses the indirect method of preparing the statement of cash flows. Current year depreciation expense can be found on the a. income statement and statement of cash flows. b. balance sheet and income statement. c. statement of cash flows and balance sheet. d. income statement and statement of comprehensive income. Ans: A KP 6 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

14-4

12.

Test Bank – Chapter 14 – The Statement of Cash Flows

A company uses the direct method of preparing the statement of cash flows. Current year depreciation expense can be found on the a. balance sheet and income statement. b. income statement and statement of cash flows. c. statement of cash flows and balance sheet. d. income statement only. e. statement of cash flows only. Ans: D KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13.

An investor is interested in assessing the effectiveness of a company’s cash management. Where will the investor look to evaluate this? a. Statement of cash flows b. Income statement c. Balance sheet d. Company’s bank statements Ans: A KP 3 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

14.

A company declares cash dividends on the last day of the year. Payment will be made during the following fiscal period. Cash flows a. from operations will be less than if dividends were not declared. b. from operations will be more than if dividends were not declared. c. from investing activities will be less than if dividends were not declared. d. from financing activities will be less than if dividends were not declared. e. will be the same as if dividends had not been declared. Ans: E KP 5,6 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

15.

What is reported on the statement of cash flows? a. Operating, investing, and financing activities of an entity for a period of time b. All revenues and expense listed by operating, financing, and operating activity c. Operating, investing, and financing activities of an entity at the balance sheet date d. A detail of all incoming and outgoing cash flows of a business Ans: A KP 1 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 14 – The Statement of Cash Flows

16.

14-5

Which statement is true with respect to the preparation of the cash flows from operating activities’ section? a. It can be calculated by using the direct or indirect methods. b. Cash flows are calculated as the difference between revenues and expenses. c. It is always equal to accrual accounting income. d. Cash payments for depreciation and dividends are reported in the operating activates sections. Ans: A KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

17.

Which one of the following transactions is an investing activity? a. Sale of equipment at book value b. Sale of merchandise on credit c. Declaration of cash dividend d. Issuance of bonds payable at a discount Ans: A KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

18.

How will a company classify the income tax payments on its statement of cash flows? a. Operating activities b. Taxing activities c. Lending activities d. Financing activities Ans: A KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

19.

A company uses straight-line instead of the units of production method of depreciation. Assuming a tax rate of zero, which statement is true as a result of its choice of depreciation methods? a. Cash flows from operations will be less than under the straight-line method b. Cash flows from operations will be more than under the straight-line method c. Cash used for investing activities will be more than under the straight-line method d. Cash used for investing activities will be less than under the straight-line method. e. Cash flows are the same as if the straight-line method had been used. Ans: E KP 5,6 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

20.

An acquisition of land by signing a 10-year mortgage payable is reported on the statement of cash flows as a. an operating activity. b. an investing activity. c. a financing activity. d. a footnote. Ans: D KP 4 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

14-6

21.

Test Bank – Chapter 14 – The Statement of Cash Flows

Which one of the following is consistent with a company recording a large operating loss but still having healthy cash flows from operations? a. A large amount of depreciation and/or amortization expense b. An increase in accounts receivable and inventory c. A decrease in accounts payable d. All sales are on a cash basis. Ans: A KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

22.

Which one of the following is consistent with a company recording a large operating income but having a net cash outflow from operations? a. A great amount of depreciation expense b. An increase in accounts receivable and inventory c. An increase in accounts payable d. Acquisition of new plant assets for cash Ans: B KP 5 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

23.

Which one of the following is added to net income in determining cash flows from operations? a. Decrease in amounts paid to reduce long-term notes b. Decrease in accounts payable c. Depreciation or amortization d. Cash received from selling treasury stock Ans: C KP 6 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

24.

Which one of the following is added to net income in determining cash flows from operations? a. Amortization of intangibles b. Decrease in accounts payable c. Increase in accounts receivable d. A gain on the sale of plant assets Ans: A KP 6 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 14 – The Statement of Cash Flows

25.

14-7

Which one of the following is added to net income in determining cash flows from operations? a. Cash dividends paid b. Increase in accounts payable and decrease in accounts receivable c. Decrease in accounts receivable and cash dividends declared d. Increase in prepaid expenses Ans: B KP 6 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

26.

Which one of the following is added to net income in determining cash flows from operations? a. Increase in inventory b. Decrease in wages payable c. Loss from sale of land d. Gain from selling treasury stock above its original cost Ans: C KP 6 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

27.

Which one of the following is subtracted from net income in determining cash flows from operations? a. Loss from sale of land b. Depreciation expense c. Stock dividends declared and distributed d. Gain from sale of equipment Ans: D KP 6 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

28.

Which one of the following is subtracted from net income in determining cash flows from operations? a. Increase in prepaid insurance b. Increase in accounts payable c. Decrease in accounts receivable d. Decrease in prepaid insurance Ans: A KP 6 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

29.

The primary purpose of the statement of cash flows is to provide information a. about the revenue and expenses of an entity’s operations during a period. b. that predicts future cash flows. c. about the operating, investing, and financing activities of an entity during a period. d. about the entity's ability to meet its obligations, its ability to pay dividends, and its needs for external financing. Ans: C KP 1 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

14-8

30.

Test Bank – Chapter 14 – The Statement of Cash Flows

An increase in inventory is reported in a statement of cash flows using the indirect method as a(n) a. addition to net income in arriving at net cash flows from operating activities. b. deduction from net income in arriving at net cash flows from operating activities. c. cash outflow from investing activities. d. cash outflow from financing activities. Ans: B KP 6 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

31.

Which one of the following would you expect to find as part of cash flows from investing activities? a. The issuance of common stock in exchange for a factory b. Cash dividends paid c. Cash inflows from the proceeds of a sale of a building d. The write-off of accounts receivable Ans: C KP 2 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

32.

When preparing a statement of cash flows using the indirect method, an increase in inventory will result in an adjustment to reported net income because a. cost of goods sold on an accrual basis is less than on a cash basis. b. inventory was paid for with cash, but is still on hand at the end of the period. c. acquisition of inventory is an investment activity. d. inventory purchased created smaller cash outflows than cash inflows received from inventory sales. Ans: B KP 6 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

33.

In determining cash flow from operating activities, which of the following adjustments will be made as a result of an increase in accounts receivable during a period? a. An addition to net income when the direct method is used b. An addition to net income when the indirect method is used c. A deduction to net income when the direct method is used d. A deduction to net income when the indirect method is used Ans: D KP 6 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 14 – The Statement of Cash Flows

34.

14-9

In determining net cash flows from operating activities, a decrease in salaries payable during a period a. means that income on an accrual basis is equal to income on a cash basis. b. must be added to net income under the indirect method. c. creates a cash outflow to pay for salaries that were previously accrued. d. creates a cash inflow from employees. Ans: C KP 6 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Use the information that follows concerning Calvin Corporation for the year ending December 31, 2009, to answer questions 35 and 36. Calvin Company provided the following information during 2009: Purchase of land by issuing bonds Proceeds from issuing long-term debt Dividends paid to shareholders Proceeds from issuing stock Proceeds from sale of building Purchases of inventories Purchase of treasury stock

35.

$ 550,000 300,000 120,000 300,000 360,000 800,000 430,000

How much is ‘net cash provided (used) by investing activities’ during 2009? a. $790,000 b. $360,000 c. $910,000 d. $(120,000) Ans: B KP 2,6 BT: K Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

36.

How much is ‘net cash provided by financing activities’ during 2009? a. $(500,000) b. $550,000 c. $50,000 d. $600,000 Solution: $300,000 − $120,000 + $300,000 − $430,000 = $50,000 Ans: C KP 2,6 BT: K Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

37.

Which of the following is subtracted from income in determining cash flows from operations? a. Decrease in accounts payable b. Depreciation c. Cash dividends declared and distributed d. Amounts due from customers at yearend Ans: A KP 6 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

14-10

38.

Test Bank – Chapter 14 – The Statement of Cash Flows

Selected information from Hsu Inc. is provided below for the years ending December 31, 2009 and 2008. Accumulated depreciation Equipment

2009 $32,000 60,000

2008 $29,000 55,000

During 2009, depreciation expense was recorded. New equipment was acquired for cash. Old equipment which was 70% depreciated with an original cost of $26,000 was sold for a gain of $4,000. For how much was the equipment sold? a. $11,800 b. $5,000 c. $3,800 d. $31,000 Ans: A KP 6 BT: K Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Use the information that follows concerning Martinez Corporation for the year ending December 31, 2009, to answer questions 39 and 43. Relevant account balances for Martinez Corporation are: Accounts receivable Inventory Prepaid insurance Accounts payable Income information: Revenue Cost of goods sold Insurance expense Operating expenses Depreciation Net income

39.

12/31/09 $18,000 24,000 1,500 25,000

1/01/09 $14,000 26,000 2,100 26,000 $120,000

$60,000 6,000 18,000 10,000

94,000 $ 26,000

How much cash was received from customers during 2009? a. $120,000 b. $116,000 c. $138,000 d. $124,000 Ans: B KP 6 BT: K Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

40.

How much cash was paid to suppliers for inventory during 2009? a. $2,000 b. $59,000 c. $63,000 d. $61,000 Ans: B KP 6 BT: K Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 14 – The Statement of Cash Flows

41.

14-11

How much cash was paid for insurance during 2009? a. $5,400 b. $6,000 c. $6,600 d. $600 Ans: A KP 6 BT: K Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

42.

How will depreciation appear on Martinez’s statement of cash flows under the direct method? a. Added in the operating activities section b. Subtracted in the operating activities section c. In the investing activities section since it relates to plant assets d. It will not be reported since it is not a cash flow. Ans: D KP 6 BT: K Difficulty: Easy TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

43.

How much is Martinez’s cash flows from operations for 2009? a. $28,400 b. $38,400 c. $23,600 d. $33,600 Ans: D KP 6 BT: K Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

44.

Selected information from Cooke Inc. is provided below for the years ending December 31, 2009 and 2008. Accumulated depreciation Equipment

2009 $32,000 60,000

2008 $29,000 55,000

During 2009, depreciation expense was recorded. New equipment was acquired for cash. Old equipment which was 70% depreciated with an original cost of $26,000 was sold for a gain of $4,000. What is the cost of the new equipment acquired? a. $11,800 b. $5,000 c. $21,000 d. $31,000 Ans: D KP 6 BT: K Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

14-12

45.

Test Bank – Chapter 14 – The Statement of Cash Flows

The May 1 and May 31 balances in accounts receivable are $35,000 and $36,000, respectively. During May, the company reported sales totaling $235,000 from its customers. The company incurred $211,000 of expenses, although $12,000 was not paid as of May 31. How much is cash flows from operations for May? a. $24,000 b. $37,000 c. $11,000 d. $35,000 Ans: D KP 6 BT: K Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Use the information for Forman Incorporated for the year ending December 31, 2009 that follows to answers questions 46 and 47. The following are relevant account balances from Forman Incorporated’s comparative balance sheet and 2009 income statement: Accounts receivable Unearned revenue Salaries payable Sales revenue Salaries expense

46.

December 31, 2009 $ 22,000 3,000 8,000 154,000 88,000

January 1, 2009 $19,000 4,000 5,000

Determine the amount of cash that Forman Incorporated collected from customers during 2009. a. $150,000 b. $158,000 c. $151,000 d. $156,000 Ans: A KP 6 BT: K Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

47.

Determine the amount of cash that Forman Incorporated paid for salaries during 2009. a. $91,000 b. $88,000 c. $85,000 d. $80,000 Ans: C KP 6 BT: K Difficulty: Easy TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 14 – The Statement of Cash Flows

48.

14-13

Johnson Company engaged in the following transactions during 2010: 1. 2. 3. 4. 5.

Johnson wrote off an open receivable as uncollected. Johnson purchased a piece of plant equipment Johnson reacquired 5,000 shares of its common stock. Johnson sold a building at a loss in exchange for a five-year note. Johnson declared, but did not pay a cash dividend.

If Johnson uses the indirect method, which of these transactions or parts of these transactions would be included in the operating activity section of the statement of cash flows? a. Transaction 4 b. Transaction 1 c. More than one of these transactions would be found in the operating activity section. d. None of these transactions would be found in the operating activity section. Ans: A KP 1,2,4,6 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

49.

Johnson Company engaged in the following transactions during 2010: 1. 2. 3. 4. 5.

Which of these transactions or parts of these transactions would be included in the financing activity section of the statement of cash flows? a. Transactions 2 and 4. b. Transactions 2 through 5 c. Transaction 3 d. None of these choices are correct. Ans: C KP 1,2,6 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 14 – The Statement of Cash Flows

14-14

50.

Johnson Company engaged in the following transactions during 2010: 1. 2. 3. 4. 5.

If Johnson uses the indirect method, which of these transactions or parts of these transactions would not appear on the statement of cash flows? a. Transaction 1 and 5 only. b. Transactions 4 and 5 only. c. Transactions 1, 4, and 5. d. None of these would appear on the statement of cash flows. Ans: C KP 1,2,4,6 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

51.

Denver Company prepares its statement of cash flows using the direct method and engaged in the following transactions during 2010: 1. 2. 3. 4. 5.

Denver retired bonds payable by issuing common stock. Denver collected on a long-term note receivable. Denver issued a stock dividend. Denver recorded depreciation on fixed assets. Denver paid interest on long-term debt.

Which of these transactions or parts of these transactions would be included in the operating activity section of the statement of cash flows? a. Transaction 2 b. Transaction 5 c. Transaction 4 d. None of these choices is correct. Ans: B KP 1,2,6 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 14 – The Statement of Cash Flows

52.

Denver Company prepares its statement of cash flows using the direct method and engaged in the following transactions during 2010: 1. 2. 3. 4. 5.

Which of these transactions or parts of these transactions would not appear on the statement of cash flows? a. Transactions 1 & 2 b. Transactions 2 & 3 c. Transactions 1, 2, 3, & 4 d. Transactions 1, 3, & 4 Ans: D KP 1,2,4,6 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

53.

Denver Company prepares its statement of cash flows using the direct method and engaged in the following transactions during 2010: 1. 2. 3. 4. 5.

Which of these transactions or parts of these transactions would be included in the financing activity section of the statement of cash flows? a. Transaction 1 b. Transaction 3 c. Transactions 1 & 3 d. None of these transactions would be found in the financing activity section. Ans: D KP 1,2,4,6 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

14-15

Test Bank – Chapter 14 – The Statement of Cash Flows

14-16

54.

Samuels Company prepares its statement of cash flows using the direct method and engaged in the following transactions during 2010: 1. 2. 3. 4. 5.

Samuels purchased inventory on account. Samuels collected open accounts receivable. Samuels exchanged a building for land and realized a gain. Samuels issued 75,000 shares of preferred stock. Samuels purchased a three-year fire insurance policy.

Which of these transactions or parts of these transactions would be included in the operating activity section of the statement of cash flows? a. Transactions 1,2 & 5 b. Transactions 2 & 5 only c. Transactions 2, 3, & 5 d. None of these choices is correct. Ans: B KP 1,2,6 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

55.

Samuels Company prepares its statement of cash flows using the direct method and engaged in the following transactions during 2010: 1. 2. 3. 4. 5.

Which of these transactions or parts of these transactions would be included in the financing activity section of the statement of cash flows? a. Transaction 3 only. b. Transaction 4 only. c. Transactions 3 & 4 d. None of these transactions would be found in the financing activity section. Ans: B KP 1,2,4,6 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 14 – The Statement of Cash Flows

56.

14-17

Samuels Company prepares its statement of cash flows using the direct method and engaged in the following transactions during 2010: 1. 2. 3. 4. 5.

Which of these transactions or parts of these transactions would be included in the investing activity section of the statement of cash flows? a. Transaction 3 only. b. Transaction 4 only. c. Transactions 3 & 4. d. None of these transactions would be found in the investing activity section. Ans: D KP 1,2,4,6 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

57.

Samuels Company prepares its statement of cash flows using the direct method and engaged in the following transactions during 2010: 1. 2. 3. 4. 5.

Which of these transactions or parts of these transactions would not be included on the statement of cash flows? a. Transaction 1 only. b. Transaction 5 only. c. Transactions 1, 3, & 5. d. Transactions 1 & 3. Ans: D KP 1,2,4,6 BT: AP Difficulty: Moderate TOT: 1 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

14-18

58.

Test Bank – Chapter 14 – The Statement of Cash Flows

The following information was taken from the records of Albert’s Fine Coffee:

Machinery Accumulated depreciation Depreciation expense Gain on sale of machinery

2010 $90,000 (30,000) 14,000 4,000

2009 $40,000 (20,000) 12,000 1,000

During 2010, machinery with a cost of $16,000 was sold. Based on this information, how much machinery was purchased during 2010? a. $50,000 b. $66,000 c. $40,000 d. $60,000 Solution: 2010 Ending machinery = $90,000 = Machinery purchased =

2010 Beginning machinery + Cost of machinery purchased during 2010 – Cost of machinery sold during 2010 $40,000 + Machinery purchased – $16,000 $66,000

Ans: B KP 6 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

Test Bank – Chapter 14 – The Statement of Cash Flows

59.

14-19

The following information was taken from the records of Albert’s Fine Coffee:

Machinery Accumulated depreciation Depreciation expense Gain on sale of machinery

2010 $90,000 (30,000) 14,000 4,000

2009 $40,000 (20,000) 12,000 1,000

During 2010, machinery with a cost of $16,000 was sold. Based on this information, how much cash was collected on the sale of the machinery during 2010? a. $10,000 b. $20,000 c. $4,000 d. $16,000 Solution: When the machinery was sold during 2010, Albert’s would prepare the appropriate entry using the following format. Cash (+A) ............................................. XX Accumulated Depreciation (+A) ............ XX Machinery (–A) ................................ Gain on Sale of Machinery (Ga, +SE)

XX XX

We can find the cash collected for the sale of the machinery by first calculating the other three amounts. Machinery It is given in the exercise that the cost of the machinery sold was $16,000. Gain on Sale of Machinery It is given in the exercise that the gain on the sale was $4,000. Accumulated Depreciation 2010 Ending accumulated depreciation = 2010 Beginning accumulated depreciation + 2010 Depreciation expense – Accumulated depreciation on items sold $30,000 = $20,000 + $14,000 – Accumulated depreciation on items sold Accumulated depreciation on items sold = $4,000 From the entry given above, Cash = Cost of machinery sold + Gain on sale of machinery – Accumulated depreciation on machinery sold = $16,000 + $4,000 – $4,000 = $16,000 Ans: D KP 6 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

14-20

60.

Test Bank – Chapter 14 – The Statement of Cash Flows

The following information was taken from the records of Albert’s Fine Coffee:

Machinery Accumulated depreciation Depreciation expense Gain on sale of machinery

2010 $90,000 (30,000) 14,000 4,000

2009 $40,000 (20,000) 12,000 1,000

During 2010, machinery with a cost of $16,000 was sold. The journal entry to record the sale of the machinery would include: a. a debit to Accumulated Depreciation of $4,000. b. a debit to Cash of $2,000. c. a debit to Machinery for $16,000. d. a credit to Gain on Sale for $3,000. Solution: Cash (+A) ............................................................................ Accumulated Depreciation (+A) ........................................... Machinery (–A) .............................................................. Gain on Sale of Machinery (Ga, +SE)............................

16,000 4,000

Ans: A KP 6 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

16,000 4,000

Test Bank – Chapter 14 – The Statement of Cash Flows

61.

14-21

The following year-end totals were taken from the records of Langston Company.

Prepaid insurance Wages payable Insurance expense Wage expense

2010 $8,000 7,000 4,000 9,500

2009 $5,200 0 5,700 4,000

What is the amount of cash outflow associated with insurance during 2010? a. $4,000 b. $2,800 c. $1,700 d. $6,800 Solution: Insurance 2010 Ending prepaid insurance = 2010 Beginning prepaid insurance + Insurance purchases during 2010 – 2010 Insurance expense $8,000 =$5,200 + Insurance purchases – $4,000;

Insurance purchases = $6,800

Ans: D KP 6 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

62.

The following year-end totals were taken from the records of Langston Company.

Prepaid insurance Wages payable Insurance expense Wage expense

2010 $8,000 7,000 4,000 9,500

2009 $5,200 0 5,700 4,000

What is the amount of cash outflow associated with wages during 2010? a. $9,500 b. $2,500 c. $5,500 d. $7,000 Solution: Wages 2010 Ending wages payable = 2010 Beginning wages payable + 2010 Wage expense – Wages paid during 2010 $7,000 = $0 + $9,500 – Wages paid;

Wages paid = $2,500

Ans: B KP 6 BT: AN Difficulty: Difficult TOT: 2 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement

14-22

Test Bank – Chapter 14 – The Statement of Cash Flows

MATCHING QUESTIONS 1.

For each transaction provided in items 1 through 12, select the proper section of the statement of cash flows in which it should be reported from the reporting categories provided below. A. B C. D.

Reporting Categories Cash provided/used by financing activities Cash provided/used by investing activities Cash provided/used by operating activities Disclosed in notes

1. Principal payment on long-term note payable 2. Customers paid cash for inventory items 3. Cash dividends paid to investors 4. Issuance of stock for more than its par value 5. Payment of employees' salaries 6. Issuance of common stock for cash 7. Payment of income taxes 8. Issuance of bonds at a premium 9. Sale of available-for-sale securities (long-term) 10. Purchase of equipment 11. Purchase of treasury stock 12. Sale of long-term investment Solution: 1. A 2. C 3. A 4. A 5. C 6. A 7. C 8. A 9. B 10. B 11. A 12. B KP 2 BT: K Difficulty: Easy TOT: 8 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 14 – The Statement of Cash Flows

14-23

For each transaction provided in items 1 through 5, select the proper section of the statement of cash flows in which it should be reported using the indirect method from the reporting categories provided in a through h below. If the item is not required to be reported on the statement of cash flows, place an ‘X’ in the space provided. Reporting Categories

a. b. c. d. e. f. g. h.

Cash flows from operating activities—will be added to net income Cash flows from operating activities—will be subtracted from net income Cash flows from investing activities—increase as a result of cash inflows Cash flows from investing activities—decrease as a result of cash outflows Cash flows from financing activities—increase as a result of cash inflows Cash flows from financing activities—decrease as a result of cash outflows Disclosed as a non-cash transaction in the notes Appears in operating activities only under the direct method

1. Accepted deposit for advance product offering 2. Pays cash dividends 3. Accrued income taxes for the period; to be paid next year 4. Adjustment to increase the book value of trading securities to market 5. Accounts receivable were collected from customers Solution: 1. a 2. f 3. x 4. x 5. a KP 2 BT: K Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

14-24

Test Bank – Chapter 14 – The Statement of Cash Flows

a. b. c. d. e. f. g. h.

Solution: 1. f 2. b 3. a 4. g or x 5. a KP 2 BT: K Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 14 – The Statement of Cash Flows

14-25

4. For each transaction provided in items 1 through 7, select the proper section of the statement of cash flows in which it should be reported using the indirect method from the reporting categories provided in a through h below. Reporting Categories

a. Cash flows from operating activities—will be added to net income b. Cash flows from operating activities—will be subtracted from net income c. Cash flows from investing activities—increase as a result of cash inflows d. Cash flows from investing activities—decrease as a result of cash outflows e. Cash flows from financing activities—increase as a result of cash inflows f. Cash flows from financing activities—decrease as a result of cash outflows g. Disclosed as a non-cash transaction in the notes h. Cash flows are already included in net income - not necessary to separately report on statement of cash flows 1. Loss on sale of old equipment 2. Declaration of stock (not cash) dividends 3. Recorded amortization on intangible assets 4. Sold trading investments at book value (no gain or loss) 5. Paid for salaries for the current period 6. Paid for salaries that were accrued during the previous period 7. Acquired machinery by issuing bonds payable Solution: 1. a 2. g 3. a 4. c 5. h 6. b 7. g KP 2,6 BT: K Difficulty: Easy TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

SHORT PROBLEMS 1.

Accrued wages payable on December 31, 2008 and 2009 are $9,000 and $4,000, respectively. During 2009, wages expense is $36,000. Calculate the amount of cash paid for wages during 2009. Solution: $36,000 + $5,000 = $41,000 KP 6 BT: K Difficulty: Easy TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

14-26

Test Bank – Chapter 14 – The Statement of Cash Flows

Graham, Inc. experienced the following changes in its cash balance during the current calendar year: Increases in Cash: From customers Sale of investments Collection of interest Issue of common stock Decreases in Cash: Payment to suppliers Wages Purchase of building Payment of interest Retirement of long-term debt Payment of dividends Payment of salespersons’ commissions

$6,000 3,000 800 3,000 $3,000 1,000 3,000 400 600 500 200

Prepare, in good form, a cash flow statement for the current year. Solution: Graham, Inc. Cash Flow Statement for Current Year Cash provided by operations: Add: From customers $6,000 Interest collections 800 Less: Payment to suppliers 3,000 Wages paid 1,000 Interest paid 400 Payment to salespersons 200 Cash inflow (outflow) from operations Cash flows from investment activities: Sale of investments $3,000 Purchase of building (3,000) Cash flows from financing activities: Issuance of stock $3,000 Retirement of debt (600) Dividend payment (500) Net increase (decrease) in cash flows

$6,800

(4,600) $2,200

1,900 $4,100

KP 6 BT: K Difficulty: Easy TOT: 7 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Beginning and ending balances for relevant balance sheet accounts are as follows: Merchandise inventory Accounts payable

12/31/09 $32,000 15,000

1/01/09 $21,000 8,000

During 2009, cost of goods sold was $102,000. Calculate the amount of cash paid to suppliers of merchandise inventory. Solution: $102,000 + $11,000 – $7,000 = $106,000 KP 6 BT: K Difficulty: Easy TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 14 – The Statement of Cash Flows

14-27

The following is the cash ledger account for Jensen Corp., which summarizes events that impacted the cash account during 2010. Balance 1/02/10 Receivable collections Cash sales Sale of land Issue of common stock Interest collections

CASH 15,000 Interest payments 26,000 Fixed asset purchases 59,000 Wages 48,000 Dividend payments 31,000 Accounts payable payments 3,000

4,000 56,000 12,000 7,000 36,000

Using the information contained in the cash ledger, complete the following cash flow statement. Cash provided by operations:

Amounts

Add:

Less:

Cash inflows (outflows) from operations Cash flows from investment activities:

Cash flows from financing activities:

Net increase (decrease) cash

Solution: Cash provided by operations: Add: From customers Interest collections Less: Interest payments Wages paid Payment on accounts payable Cash inflows (outflows) from operations

$85,000 3,000 $88,000 $(4,000) (12,000) (36,000) (52,000) $36,000

Cash flows from investment activities: Sale of land Fixed asset purchase

$48,000 (56,000)

(8,000)

Cash flows from financing activities: Issuance of stock Dividend payment

$31,000 (7,000)

24,000

Net increase in cash KP 2 BT: K Difficulty: Easy TOT: 10 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

$52,000

14-28

Test Bank – Chapter 14 – The Statement of Cash Flows

Richards Inc. presented its comparative financial data and other data as follows: Cash Accounts receivable Prepaid expenses Investment in stock (no fair value) Building and equipment Accumulated depreciation Accounts payable Notes payable (used for operations) Accrued expenses Mortgage payable Common stock Additional paid-in capital Retained earnings

Dec. 31, 2010 $ 16,000 22,000 3,800 8,000 103,200 (60,000) $ 93,000

Dec. 31, 2009 $ 9,000 16,000 3,000 21,000 80,000 (51,000) $ 78,000

$ 9,000 6,000 13,000 25,000 9,000 21,000 10,000 $ 93,000

$ 6,000 8,000 7,000 31,000 5,000 16,000 5,000 $78,000

Additional information: 1. Equipment was purchased for $43,200 and was paid in cash. Other equipment was sold at a $3,000 gain and was 50% depreciated at the time of sale. 2. During 2009, Richards Inc. declared and paid cash dividends. 3. Part of the investment in the stock portfolio was sold at book value. The stock is closely-held so no fair value adjustments are made. 4. Net income was $49,000. Prepare a statement of cash flows using the indirect method for 2010. You may omit the heading. Solution: Cash flows from operating activities: Net income Depreciation expense Gain on sale of equipment Increase in accounts receivable Increase in prepaid expenses Increase in accounts payable Decrease in short-term operating loan Increase in accrued expenses Cash provided by operations

$ 49,000 19,000 (3,000) (6,000) (800) 3,000 (2,000) 6,000

Cash flows from investing activities: Sale of investments Purchase of building and equipment Sale of building and equipment Cash used by investing activities

$ 13,000 (43,200) 13,000

Cash flows from financing activities: Payments on mortgage Sale of common stock Payment of dividends Cash provided by financing activities Net increase in cash flows

$ 65,200

(17,200) $(6,000) 9,000 (44,000) $

(41,000) 7,000

KP 6 BT: K Difficulty: Difficult TOT: 12 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 14 – The Statement of Cash Flows

14-29

The comparative balance sheets of Shad Inc. contain prepaid insurance of $48,000 on January 1, 2009 and $37,000 on December 31, 2009. Shad’s 2009 income statement contains insurance expense of $15,000. Calculate the amount of cash paid for insurance premiums during 2009. Solution: $15,000 – $11,000 = $4,000 KP 6 BT: K Difficulty: Easy TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Beginning and ending balances for relevant balance sheet accounts are as follows: Merchandise inventory Accounts payable

12/31/10 $32,000 13,000

1/01/10 $18,000 20,000

During 2010, cost of goods sold was $148,000. Calculate the amount of cash paid to suppliers of merchandise inventory. Solution: $148,000 + $14,000 + $7,000 = $169,000 KP 6 BT: K Difficulty: Easy TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

List two distinct examples of investing activities and two distinct examples of financing activities. Solution: Investing activities: Purchase or sale of noncurrent assets Purchase or sale of securities of other entities Loans or collection of principal of loans to other entities Financing activities: Issuance or reacquiring stock Issuance or redeeming debt Cash dividends paid to shareholders KP 2 BT: K Difficulty: Easy TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

14-30

Test Bank – Chapter 14 – The Statement of Cash Flows

The accounts receivable balances on January 1 and December 31 are $22,000 and $18,000, respectively. The income statement for the year included sales revenue of $120,000. Determine the amount of cash collected from customers during the year. Solution: $4,000 + $120,000 = $124,000 KP 6 BT: K Difficulty: Easy TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

10.

Selected information from Thompson Corporation is provided below for the years ending December 31, 2009 and 2008. Accumulated depreciation Accounts payable Equipment

2009 $41,000 39,000 55,000

2008 $35,000 25,000 49,000

During 2009 depreciation expense was recorded. New equipment was acquired for cash. Old equipment which was 60% depreciated with an original cost of $26,000 was sold for a loss of $4,000. Prepare the investing activities section of the statement of cash flows. Solution: Cash flows from investing activities: Purchase of plant assets Sale of plant assets Cash used by investing activities

$(32,000) 6,400 $(25,600)

KP 6 BT: K Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting 11.

Beginning and ending balances for selected accounts are as follows: Accounts receivable Revenue received in advance

12/31/09 $14,000 6,000

1/01/09 $19,000 3,000

During 2009, sales revenue is $110,000. Calculate the cash collected from customers. Solution: $110,000 + $3,000 + $5,000 = $118,000 KP 6 BT: K Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 14 – The Statement of Cash Flows

12.

14-31

The August 1 and August 31 balances in accounts receivable are $21,000 and $18,000, respectively. During August, the company collected $56,000 from its customers and incurred $37,000 of expenses, all paid in cash. Calculate the amount of cash flows from operations for August. Solution: $56,000 – $37,000 = $19,000 KP 6 BT: K Difficulty: Easy TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

13.

During the current year, Martini Foods reported sales of $250,000, and wrote off $7,000 of accounts receivable as uncollectible under the direct write-off method. On January 1 and December 31 of the current year, Richard Young had accounts receivable of $26,000 and $14,000, respectively. Determine the amount of cash collected from customers during the current year. Solution: $250,000 – $7,000 + $12,000 = $255,000 KP 6 BT: K Difficulty: Easy TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

14.

List two distinct examples of significant noncash transactions and two distinct examples of transactions not reported directly on a statement of cash flows Solution: Significant noncash transactions: Acquiring assets by issuing stock or liabilities Acquiring capital leases with plant asset Conversion of bonds or preferred stock into common stock Declaring dividends Not reported directly on a statement of cash flows: Stock dividends distributed Appropriations of retained earnings Fair value adjustments for available-for-sale investments KP 4 BT: K Difficulty: Easy TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

14-32

15.

Test Bank – Chapter 14 – The Statement of Cash Flows

During 2009, equipment was sold for $57,000. This equipment cost $90,000 and had a book value of $47,000. Accumulated depreciation for equipment was $184,000 at 12/31/05 and $147,000 at 12/31/04. Show how the results of the three items will appear on the statement of cash flows using the indirect method from this information. Solution: Cash flows from operating activities: Net income Gain on sale of equipment ($57,000 – $47,000) Depreciation expense ($147,000 – $43,000 – $184,000) Cash from investing activities: Sale of equipment

XX (10,000) 80,000

$57,000

KP 6 BT: K Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting 16.

Wilson Corporation reported cost of goods sold of $100,000. On January 1, Wilson Corporation had inventory and accounts payable of $21,000 and $33,000, respectively. On December 31, inventory and accounts payable were $28,000 and $20,000, respectively. Calculate cash payments to suppliers of inventory. Solution: $7,000 + $13,000 + $100,000 = $120,000 KP 6 BT: K Difficulty: Easy TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

17.

Parton Inc.. reported accounting service revenue of $450,000 for 2009. On January 1, 2009, Parton Inc. had $38,000 of accounts receivable and $0 of cash deposits received from customers. On December 31, 2009, accounts receivable and deposits received were $49,000 and $6,000, respectively. Calculate the amount of cash collected from clients during 2009. Solution: $450,000 – $11,000 + $6,000 = $445,000 KP 6 BT: K Difficulty: Easy TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 14 – The Statement of Cash Flows

18.

14-33

Lawson Co. sold equipment that cost $40,000 and a current book value of $18,000, for $20,000 cash. Lawson purchased additional equipment during the year. Data from the company’s balance sheets at December 31, 2009 and 2008 are: Equipment Accumulated depreciation

12/31/09 $650,000 106,000

12/31/08 $520,000 82,000

Show how the results of the transactions will appear on the statement of cash flows using the indirect method. Solution: Cash flows from operating activities: Net income Gain on sale of equipment ($20,000 – $18,000) Depreciation expense ($82,000 – $22,000 – $106,000)

$ XX (2,000) 46,000

Cash flows from investing activities: Sale of machine Purchase of machine ($520,000 – $40,000 – $650,000)

$ 20,000 (170,000)

KP 6 BT: K Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting 19.

Relevant account balances for Jeremy Supply Co. are: Accounts Accounts receivable Inventory Accounts payable Income information: Revenue Cost of goods sold Operating expenses Depreciation Net loss

12/31/09 $16,000 6,000 11,000

1/01/09 $ 9,000 3,000 20,000 $ 48,000

$27,000 18,000 5,000

50,000 $ (2,000)

Determine the amount of cash provided (used) by operations for 2009. Solution: Net loss Depreciation Increase in accounts receivable Increase in inventory Decrease in accounts payable Cash used by operations

($2,000) 5,000 (7,000) (3,000) (9,000) ($16,000)

KP 6 BT: K Difficulty: Easy TOT: 5 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

14-34

20.

Test Bank – Chapter 14 – The Statement of Cash Flows

Benton Company reported insurance expense of $301,000 during the current year. On January 1 and December 31 of the current year, prepaid insurance was $28,000 and $41,000, respectively. Calculate cash paid for insurance premiums for the current year. Solution: $301,000 + $13,000 = $314,000 KP 6 BT: K Difficulty: Easy TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Use the information for Winthrop Company for the year ending December 31, 2009 that follows to answers questions 21 through 23. The following are relevant account balances from Winthrop Company’s comparative balance sheet and 2009 income statement. Accounts receivable Prepaid insurance Unearned revenue Salaries payable

December 31, 2009 $15,000 5,000 8,000 9,000

January 1, 2009 $19,000 3,000 11,000 6,000

Winthrop’s 2009 income statement includes the following: Sales revenue Insurance expense Salaries expense

21.

$89,000 4,000 31,000

Determine the amount of cash collected from customers during 2009. Solution: $89,000 – $3,000 + $4,000 = $90,000 KP 6 BT: K Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

22.

Determine the amount of cash paid for insurance during 2009. Solution: $4,000 + $2,000 = $6,000 KP 6 BT: K Difficulty: Easy TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

23.

Determine the amount of cash paid for salaries during 2009. Solution: $31,000 – $3,000 = $28,000 KP 6 BT: K Difficulty: Easy TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 14 – The Statement of Cash Flows

24.

14-35

During 2009, Bacon Co. reported a net operating loss of $19,000. The only asset or liability changes during 2009 were a decrease in accounts receivable of $11,000 and an increase in accumulated depreciation of $42,000. Calculate cash flows from operations during 2009 (indicate outflow or inflow). Solution: ($19,000) + $11,000 + $42,000 = $34,000 cash inflow KP 6 BT: K Difficulty: Easy TOT: 3 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

Use the information for Hampton Inc. for the year ending December 31, 2009 that follows to answer questions 25 through 28. The following are relevant account balances from Hampton’s comparative balance sheet and 2009 income statement. Hampton’s balance sheets: Cash Accounts receivable Merchandise inventory Prepaid rent Equipment Accumulated depreciation Total assets

December 31, 2009 $ 6,000 8,000 29,000 6,000 100,000 (28,000) $121,000

Accounts payable Dividends payable Common stock Retained earnings Total liabilities and shareholders’ equity

January 1, 2009 $ 9,000 12,000 18,000 4,000 80,000 (13,000) $110,000

9,000 6,000 38,000 68,000 $121,000

$ 25,000 4,000 32,000 49,000 $110,000

Other information: No equipment was sold or retired during 2009. Hampton’s net income for 2009 was $33,000. 25.

Calculate depreciation expense for 2009. Solution: $28,000 – $13,000 = $15,000 KP 3,6 BT: K Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

26.

Calculate the amount of dividends paid during 2009. Solution: $49,000 + $33,000 – $68,000 = $14,000 declared; $4,000 + $14,000 – $6,000 = $12,000 paid KP 6 BT: K Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

14-36

27.

Test Bank – Chapter 14 – The Statement of Cash Flows

Determine the cost of the equipment purchased during 2009. Solution: $100,000 – $80,000 = $20,000 KP 6 BT: K Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

28.

Calculate the cash proceeds from the issuance of common stock during 2009. Solution: $38,000 – $32,000 = $6,000 KP 6 BT: K Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

29.

Selected information from the 2008 and 2009 accounting records of Roman Corp. is provided below: Net cash provided by operations Net cash provided (used) by investing activities Net cash provided (used) by financing activities Cash balance

12/31/09 $38,000 (19,000) 43,000 ?

12/31/08 $7,000 16,000 (9,000) 23,000

Calculate the December 31, 2009 ending cash balance. Solution: $38,000 – $19,000 + $43,000 + $23,000 = $85,000 KP 1 BT: K Difficulty: Easy TOT: 4 min. AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Reporting

SHORT ESSAY QUESTIONS 1.

How is the statement of cash flows linked to the balance sheet? Solution: The net increase or decrease on the statement of cash flows is linked to the change in the cash balance from one year to the next on the company’s comparative balance sheets. The statement of cash flows adds the beginning cash balance to the change in cash during the period (detailed by activity on the statement of cash flows) to determine the ending cash balance. The beginning and ending cash balances appear on the balance sheet as the current year and previous year’s cash balances. Under the indirect method, net income (loss) from the income statement is the starting point for the determination of net cash inflows (outflows) for operating activities on the statement of cash flows. The amount of net income also appears on the statement of retained earnings, which appears as the ending retained earnings balance on the balance sheet. The investing section of the statement of cash flows is closely related to the balance sheet in that it analyses changes in non-current assets. The financing section of the statement of cash flows is closely related to the liabilities and equity sections of the

Test Bank – Chapter 14 – The Statement of Cash Flows

14-37

balance sheet because it analyses changes in non-current liabilities and equity accounts. KP 3 BT: K Difficulty: Easy TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

How do 'cash equivalents' fit into the statement of cash flows? Solution: Cash equivalents include typical cash items such as coins, currency, available funds on deposit in the bank, money orders, certified checks, cashier's checks, personal checks, bank drafts, and certain short-term financial instruments including commercial paper and other debt investments with maturities of less than three months. These items can be converted to cash immediately and for all intents and purposes, they are virtually the same as cash. A statement of cash flows explains not only the change in cash but also the changes in cash equivalents. This means that instead of ‘net cash provided or used by operating activities,’ the statement of cash flows explains the change in ‘net cash and cash equivalents’ for the period. KP 1 BT: K Difficulty: Easy TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

How does the direct method of preparing the statement of cash flows differ from the indirect method? Solution: The direct method is so called because the computation of cash provided (used) by operating activities consists of cash inflows and outflows that can be directly traced to the cash T-account. The indirect method begins with net income and shows adjustments for non-cash items. These adjustments consist of additions and subtractions from net income to negate the effects of non-cash items. In essence, the accrual basis income statement is converted to a cash basis statement. KP 1 BT: K Difficulty: Easy TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

In the operating activities section of a statement of cash flows prepared using the indirect method certain items are added to net income. Why is depreciation added? Solution: Depreciation is added to net income because it is a non-cash item that was subtracted as an expense in order to determine net income on the income statement. Since the cash account is not impacted in the journal entry to record depreciation, there is no effect on cash. Adding back depreciation expense negates the expense that was subtracted on the income statement in order to convert net income to the cash basis. KP 6 BT: K Difficulty: Easy TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

14-38

Test Bank – Chapter 14 – The Statement of Cash Flows

In the operating activities section of a statement of cash flows prepared using the indirect method certain items are added to, or subtracted from, net income. Why are changes in current accounts added or subtracted? Solution: The operating activities section of the statement of cash flows somewhat resembles an income statement prepared on the cash basis. The traditional income statement reflects the accrual basis, which includes accruals and deferrals as necessary to reflect accrual income for the period. Most accrual and deferral effects appear as current assets and liabilities. These items appear as additions and subtractions in the operating activities section of the cash flow statement to reflect the removal of accrual and deferral aspects included in net of income for the period. KP 3,6 BT: K Difficulty: Easy TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

The international financial reporting standards are requiring a statement of cash flows. Why is this and what are some of the unique issues that multinational companies must understand when interpreting these statements? Solution: The importance of debt capital to many foreign companies places a premium on cash flow information, used by banks and other lenders to assess solvency. Interpreting a statement of cash flows for a multinational company can be difficult due to so many currencies used and received. The changes in the value of these currencies give rise to gains or losses reported on the income statement. However, foreign currency exchange gains and losses involve no cash flow. Consequently, when the statement of cash flows is prepared under the indirect method, an adjustment must be made to net income. Partly because these adjustments are becoming more significant, accounting pronouncements now require that they be disclosed separately at the bottom of the statement, immediately before “net increase or decrease in cash and cash equivalents.” KP 5 BT: K Difficulty: Easy TOT: 4 min. AACSB: Analytic, Communication, Diversity AICPA BB: Critical Thinking AICPA FN: Reporting

Why is cash generated from operating activities more important than cash generated from other sources? Solution: Cash generated from operating activities is a normality in business and is expected to recur. Funding a business through shareholders may not always be an option because shareholders may be unwilling to purchase stock in certain economic situations. Debt financing becomes very expensive, and is subject to economic pressures as well as the ability of the company to maintain a good credit rating. Not only is cash generated from operating activities less expensive, it is expected to provide the means on a long-term basis of maintaining and improving solvency. KP 5 BT: K Difficulty: Easy TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Test Bank – Chapter 14 – The Statement of Cash Flows

14-39

Presented below is a partial statement of cash flows for Santiago Company for the year ending June 30,2009. Net income Adjustments to net income: Add: Depreciation Decrease in accounts receivable Increase in salaries payable Less: Gain on sale of equipment Increase in inventories Decrease in accounts payable Net cash inflows from operating activities

$44,000 7,000 12,000 5,000 (1,000) (2,000) (5,000) $60,000

Mr. Santiago, the president of the Company, is puzzled by why a difference exists on the statement presented above, as compared to the company’s income statement for the same period that shows net income of $44,000. Provide justification why the two amounts might not be equal. Solution: The operating activities section of the statement of cash flows reflects only the cash basis of revenues—the cash inflows, and the cash basis of expenses—the cash outflows. The income statement reflects the accrual basis of accounting which recognizes revenues when they are earned instead of when received and expenses when incurred, instead of when paid. The indirect method used on the statement of cash flows begins with net income and removes all non-cash items in order to convert to cash basis income. The Company experienced non-cash items during the year. Non-cash items reduce net income, but have no impact on cash flows. This result is the appearance that something may be wrong with the amounts reported. KP 5 BT: K Difficulty: Easy TOT: 7 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

Explain financial flexibility and what information it provides. Solution: The ability to generate cash is determined by the strength of the company’s operating activities, as well as its financial flexibility. Financial flexibility reflects a company's capacity to borrow, issue equity, and sell nonoperating assets. This requires effective cash management of two competing objectives. On one hand, cash must be available to meet debt obligations as they come due, i.e., solvency must be maintained. On the other hand, cash must be invested in productive assets to provide returns. A company with financial flexibility provides a high return without creating a risk of insolvency. KP 5 BT: K Difficulty: Easy TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting

14-40

10.

Test Bank – Chapter 14 – The Statement of Cash Flows

How are changes in foreign currency valuations reported on a statement of cash flows? Solution: If a U.S. corporation sells goods or services to a customer in foreign country, a gain or loss on that transaction can result. These foreign currency exchange gains and losses are included in the computation of net income for the period. Since neither a gain nor a loss affect actual cash flows, the effects of the gains and losses must be removed in order to convert net income to the cash basis in determining cash flows from operating activities. U.S. GAAP currently requires disclosure to appear separately at the bottom of the statement of cash flows, immediately before the net increase (decrease) in cash and cash equivalents. KP 5 BT: K Difficulty: Easy TOT: 4 min. AACSB: Analytic, Communication, Diversity AICPA BB: Critical Thinking AICPA FN: Reporting

11.

Explain the ways in which management can ‘window dress’ the statement of cash flows. Solution: In the short run, it is relatively easy for management to present a favorable cash position. Delayed payments on short-term payables can significantly boost the amount of cash provided (used) by operating activities. Selling investments can increase cash inflows from investing activities, while dealing with debt payments and dividends can temporarily inflate cash from financing activities. Cash flows of a particular accounting period should not carry too much weight in assessing the company's cash position. Current period management decisions will likely impact future reporting periods negatively. KP 5 BT: K Difficulty: Easy TOT: 4 min. AACSB: Analytic, Communication AICPA BB: Critical Thinking AICPA FN: Reporting