FINANCIAL ACCOUNTING 7TH EDITION BY MICHELLE HANLON, ROBERT MAGEE, GLENN PFEIFFER TEST BANK by QuentinAxel

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Chapter 1 Introducing Financial Accounting Learning Objectives – Coverage by question True/False

Multiple Choice

Exercises

LO1-1 Identify the users of accounting information and discuss the costs and benefits of disclosure. (p. 1-3)

1, 2

1-3

1, 2

2, 5, 6

LO1-2 Describe a company's business activities and explain how these activities are represented by the accounting equation. (p. 1-7)

3-6

4, 5

1, 6

LO1-3 Introduce the four key financial statements including the balance sheet, income statement, statement of stockholders' equity, and statement of cash flows. (p. 1-11)

7-9

4, 6-11

4-11

LO1-4 Describe the institutions that regulate financial accounting and their role in establishing generally accepted accounting principles. (p. 1-16)

10-12

12, 19, 20

LO1-5 Compute two key ratios that are commonly used to assess profitability and risk return on equity and the debt-toequity ratio. (p. 1-21)

13, 14

13-18

13, 14

LO1-6 Appendix 1A: Explain the conceptual framework for financial reporting. (p. 1-25)

15, 16

21, 22

Problems

Essay Questions

1-5

3, 4

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Chapter 1: Introducing Financial Accounting

True/False Topic: Cost and benefits of disclosure LO: 1 1. One reason companies are motivated to disclose financial information to external decision makers is that it may lower financing and operating costs. Answer: True Rationale: For example, when a company applies for a loan, the bank uses the company’s financial statements to help determine the appropriate interest rate. Without this financial information, a company may have a higher cost of borrowing or not obtain the loan at all. Topic: Demand for accounting information LO: 1 2. Financial accounting is designed primarily for decision makers within the company. Answer: False Rationale: Financial accounting is designed primarily to provide information to decision makers outside of the company, while managerial accounting is designed primarily for decision makers within the company. Topic: Investing activities LO: 2 3. Investing activities are the acquiring and disposing of liabilities that a company needs in order to finance its operating activities. Answer: False Rationale: Investing activities are the acquiring and disposing of assets that a company needs for the production and sale of a company’s products and services. Topic: Accounting equation LO: 2 4. Assets must always equal liabilities plus stockholders’ equity. Answer: True Rationale: The accounting equation is Assets = Liabilities + Stockholders’ Equity. This relation must always stay in balance.

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Topic: Financing activities LO: 2 5. Other than operating profit, there are three main sources of external financing. Answer: False Rationale: There are two main sources of financing: owner (also called shareholder or equity) financing and nonowner (also called creditor or lender) financing. Topic: Financing and investing activities LO: 2 6. Financing activities are defined as the acquiring and disposing of resources for the purpose

of selling products and services. Answer: False Rationale: Financing activities are defined as methods a company uses to raise funds to pay for resources. Investing activities are defined as the acquiring and disposing of resources for the purpose of selling products and services. Topic: Statement of cash flows LO: 3 7. A statement of cash flows reports on cash flows for operating, investing and financing activities at a point in time. Answer: False Rationale: A statement of cash flows reports on cash flows for operating, investing, and financing activities over a period of time. Topic: Retained earnings LO: 3 8. Retained earnings are present on both the income statement and the statement of stockholders’ equity. Answer: False Rationale: Retained earnings are present in the statement of stockholders’ equity and the balance sheet. The income statement represents current period earnings. Topic: Balance sheet LO: 3 9. If Beatty Company reports retained earnings of $242.6 million on its balance sheet, it will also

report $242.6 million in cash. Answer: False Rationale: The accounting equation requires total assets to equal total liabilities plus stockholders’ equity. That does not imply, however, that liability and equity accounts relate directly to specific assets.

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Topic: Regulation and Oversight LO: 4 10. The goal of the Sarbanes-Oxley Act of 2002 was to increase the level of confidence that external users have in the financial statements. Answer: True Rationale: In the wake of scandals, like those that took down Enron, the U.S. Congress passed the Sarbanes-Oxley Act to improve external user confidence in financial statement reporting. Topic: Global accounting perspective LO: 4 11. The International Accounting Standards Board (IASB) has legal authority to impose accounting standards on any country. Answer: False Rationale: The IASB works with standard setters within many countries, but does not have legal authority to impose IASB standards on any country. It was charged with creating International Financial Reporting Standards with the intention of unifying all public companies under one global set of reporting standards. Topic: IFRS LO: 4 12. Foreign companies using international accounting standards must reconcile their financial statements to American rules if they wish to sell securities in the U.S. Answer: False Rationale: The SEC adopted a rule in 2007 that allows foreign companies to stop reconciling to American rules. Topic: Financial statement analysis LO: 5 13. One key measure of profitability is the debt-to-equity ratio. Answer: False Rationale: Return on equity is a key profitability metric. The debt-to-equity ratio is a measure of longterm solvency when looking at credit risk. Topic: Credit risk analysis LO: 5 14. The greater the risk of any decision, the greater the expected return. Answer: True Rationale: The riskier an investment is, the greater the return demanded by investors.

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Topic: Qualitative characteristics of accounting information LO: 6 15. The enhanced qualitative characteristic of accounting information known as comparability means that the financial statements of different companies should be presented in a way that allows users to make comparisons across companies concerning their activities, financial condition, and performance. Answer: True Rationale: Comparability means that information should enable users to identify similarities and differences between sets of economic phenomena. Topic: Conceptual framework for financial reporting LO: 6 16. The amended conceptual framework, issued by the FASB in 2018, includes a statement of the objective of financial reporting and a discussion about the two fundamental qualitative characteristics of accounting information. Answer: True Rationale: The conceptual framework states that the objective of financial reporting is “to provide information that is useful to present and potential equity investors, as well as lenders and other creditors, in making decisions about providing resources to the entity”. It also identifies relevance and faithful representation as the two fundamental qualitative characteristics of financial information necessary to fulfill the objective.

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Multiple Choice Topic: Business organizations LO: 1 1. Which of the following forms of business organizations exists as a legal entity? A) A sole proprietorship B) A partnership C) A corporation D) A labor union Answer: C Rationale: A corporation is a form of business organization that exists as a legal entity that issues shares of stock to its owners or shareholders in exchange for cash or other resources. Topic: Financial accounting information users LO: 1 2. All of the following are proper uses of financial accounting information by a company’s board of directors except: A) To review the results of operations B) To evaluate future strategy C) To assess management performance D) To distribute buy/sell recommendations prior to company release of information Answer: D Rationale: Providing buy or sell recommendations prior to release by the company is a type of fraud known as insider trading and is not a way that directors should use financial accounting information. Topic: Financial accounting information users LO: 1 3. Which one of the following is not an external user of financial information? A) Stockholders B) Creditors C) Internal Revenue Service D) Top company management Answer: D Rationale: Decision makers outside the company include stockholders, creditors, and tax agencies such as the Internal Revenue Service. Topic: Accounting equation LO: 2, 3 4. On which statement are assets, liabilities and equity reported? A) Balance sheet B) Income statement C) Statement of stockholders’ equity D) Statement of cash flows Answer: A Rationale: A balance sheet reports on investing and financing activities. It lists amounts for assets, liabilities, and equity at a point in time.

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Topic: Accounting equation LO: 2 5. Which of the following is a correct statement of the accounting equation in terms of activities? A) Investing = Operating assets + Financial assets B) Investing = Creditor financing + Owner financing C) Investing = Nonowner financing – Owner financing D) Nonowner financing = Investing + Operating Answer: B Rationale: The accounting equation is Assets = Liabilities + Stockholders’ equity. Another way of viewing this equation is Investing = Creditor financing + Owner financing Topic Financial statement format LO: 3 6. Which of the following is not part of the standard heading of each financial statement? A) The company name B) The statement title C) The date or time period of the statement D) The company’s industry Answer: D Rationale: Each financial statement identifies the company, the statement title, and the date or time period of the statement. Topic: Balance sheet and income statement LO: 3 7. Which of the following items are in the balance sheet? (Select all that apply.) A) Inventory B) Operating expenses C) Account receivable D) Equipment E) Cash payments Answer: A, C, and D Rationale: Statement B) is incorrect – operating expenses are found in the income statement, not the balance sheet. Statement E) is incorrect – cash payments are found on the statement of cash flows. Topic: Expenses LO: 3 8. Which of the four basic financial statements would contain a line item for expenses? A) Balance sheet B) Income statement C) Statement of equity D) Statement of cash flows Answer: B Rationale: The income statement reports on the revenues less the expenses over the reporting period. Expenses only appear on the income statement.

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Topic: Account classification LO: 3 9. Which of the following would be reported on a statement of stockholders’ equity? A) Cash B) Total expenses C) Dividends D) Financing cash flows Answer: C Rationale: Dividends are a return of capital to stockholders and are found only on the statement of stockholders’ equity. Cash is found on the balance sheet. Total expenses is an income statement amount. Financing cash flows are found on the statement of cash flows. Topic: Articulation of financial statements LO: 3 10. How are the balance sheet and the statement of cash flows linked? A) By the cash balance B) By the amount of total retained earnings C) By the total shareholder equity D) By the amount of net income Answer: A Rationale: The balance sheet and the statement of cash flows are linked by the cash balance. The statement of cash flows shows the inflows and outflows of cash during the period. Then ending cash balance is on the balance sheet. Topic: Financial Statement Linkages LO: 3 11. Which one of the following is not a key linkage among the four primary financial statements? A) The expenses in the income statement link to the total liability balance. B) The statement of cash flows links to ending cash in the balance sheet. C) The income statement links to the ending retained earnings in the statement of stockholders’ equity. D) The statement of stockholders’ equity links to ending equity in the balance sheet. Answer: A Rationale: The expenses in the income statement are not linked to the total liability balance. An unpaid expense might at one point in time be listed as a liability; however, the total of liabilities and expenses is rarely the same. Topic: Regulation and oversight LO: 4 12. Which of the following organizations was established by the Sarbanes-Oxley Act to approve auditing standards and monitor the quality of financial statements and audits? A) The Securities and Exchange Commission B) The American Institute of Certified Public Accountants C) The Financial Accounting Standards Board D) The Public Company Accounting Oversight Board Answer: D Rationale: The Sarbanes-Oxley Act of 2002 established the Public Company Accounting Oversight Board to approve auditor standards and monitor the quality of financial statements and audits.

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Use the following information to answer Questions 13, 14, 15, and 16. Data from the financial statements of Sunrise Foods and HealthMart, Inc., two national grocery chains are presented below: Sunrise Foods

HealthMart, Inc.

Total liabilities, 2024

$43,610

$23,817

Total liabilities 2023 Total assets, 2024 Total assets 2023 Revenue, 2024 Net income, 2024

48,239 64,743 67,582 200,693 2,312

21,935 29,652 32,589 81,494 1,062

Topic: Profitability analysis LO: 5 13. To the nearest hundredth of a percent, what is the 2024 return on equity ratio for Sunrise Foods? A) 10.94% B) 11.42% C) 11.95% D) 5.30% Answer: B Rationale: ROE = Net income / Average stockholders’ equity = $ 2,312 / [($21,133 + $19,343)/2] = $2,312 / $20,238 = 11.42% Stockholders’ equity 2024 = $64,743 – $43,610 = $21,133 Stockholders’ equity 2023 = $67,582 – $48,239 = $19,343 Topic: Credit risk analysis LO: 5 14. To the nearest hundredth, what is the 2024 debt-to-equity ratio for Sunrise Foods? A) 2.06 B) 0.67 C) 2.27 D) 2.49 Answer: A Rationale: Debt-to-equity = Total liabilities / Total stockholders’ equity = $43,610/ $21,133 = 2.06 Stockholders’ equity 2024 = $64,743 – $43,610 = $21,133

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Topic: Profitability analysis LO: 5 15. To the nearest hundredth of a percent, what is the 2024 return on equity ratio for HealthMart? A) 18.20% B) 9.97% C) 3.58% D) 12.88% Answer D Rationale: ROE = Net income / Average stockholders’ equity = $ 1,062 / [($5,835+ $10,654)/2] = $ 1,062 / $8,245 = 12.88% Stockholders’ equity 2024 = $29,652 – $23,817 = $ 5,835 Stockholders’ equity 2023 = $32,589 – $21,935 = $ 10,654 Topic: Credit risk analysis LO: 5 16. To the nearest hundredth, what is the 2024 debt-to-equity ratio for HealthMart? A) 2.89 B) 2.06 C) 4.08 D) 2.77 Answer: C Rationale: Debt-to-equity = Total liabilities / Total stockholders’ equity = $23,817 / $5,835 = 4.08 Stockholders’ equity 2024 = $29,652 – $23,817 = $ 5,835 Topic: Financial statement analysis LO: 5 17. Hammer, Inc. has an ROE of 19.27% and Arrow Company has an ROE of 15.45%. Which of the following statements is true? A) Hammer reported more dollars of profit than Arrow B) Hammer is able to bring its product to market more efficiently than Arrow C) Hammer has more of the firm financed with debt than Arrow does D) Arrow would likely be able to borrow money at a lower interest rate than would Hammer Answer: B Rationale: ROE measures profitability and how efficiently a company markets its products to produce profit. The debt-to-equity ratio measures the extent to which a company relies on debt versus owner financing. Hammer shows a higher return on equity, which means that it is able to bring its product to market more efficiently than Arrow.

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Topic: Financial statement analysis LO: 5 18. Hammer, Inc. has a debt-to-equity ratio of 0.42 and Arrow Company has 0.28. Which of the following statements is true? A) Hammer reported more dollars of profit than Arrow B) Hammer has more total debt than does Arrow C) Arrow would likely be able to borrow money at a lower interest rate than would Hammer D) Hammer is able to bring its product to market more efficiently than Arrow Answer: C Rationale: Arrow Company is the lower risk borrower of these two companies with a lower debt-toequity ratio. Arrow would likely be able to borrow money at a lower interest rate than Hammer. Hammer’s higher debt-to-equity means that the firm relies more on creditor financing than Arrow. Topic: Generally Accepted Accounting Principles LO: 4 19. Which of the following statements is true regarding generally accepted accounting principles (GAAP)? A) GAAP is a set of laws B) GAAP is subject to change as conditions warrant C) Under GAAP, if two companies engage in the same transactions, they must choose the same accounting methods D) U.S. GAAP is the same as GAAP in other countries Answer: B Rationale: Specific rules under GAAP are altered or new practices are formulated to fit changes in underlying economic circumstances of business transactions. Topic: IFRS LO: 4 20. Which statement is true about IFRS? A) It has legal authority to impose accounting standards world-wide B) It is working to reduce diversity in financial reporting practices across the world C) It has replaced GAAP financial accounting standards D) It is under the control of the SEC Answer: B Rationale: U.S. GAAP reporting still exists and has no control over the IASB who creates IFRS’s accounting standards. Topic: Assumptions for the preparation of financial statements LO: 6 21. Which of the following assumptions that underlies the preparation of financial statements assumes that companies will continue their operations over time? A) Separate economic entity B) Going concern C) Accounting period D) Measuring unit Answer: B Rationale: Under the going concern assumption, companies are assumed to have continuity in that they can be expected to continue in operations over time.

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Topic: Qualitative characteristics of accounting information LO: 6 22. Which one of the following is not a quality of relevant accounting information? A) Materiality B) Predictive value C) Confirmatory value D) Understandability Answer: D Rationale: Accounting information is relevant when it has the ability to make a difference in a decision. Such information may be useful in making predictions about future performance of a company or in providing confirmatory feedback to evaluate past events. Accounting information can still be relevant, even though it may not be understandable to all users.

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Exercises Topic: Financial accounting information LO: 1 1. Match each of the following terms (1-8) on the left with related explanations (A – H) on the right. 1.

Partnership

Board of directors

Managerial accounting

Stock market regulators

Creditors

Shareholders

Designed primarily for decision makers outside of the company Elected by the shareholders to oversee management Owners of a corporation

Financial accounting

Securities and Exchange Commission

Publicly traded corporations

Designed primarily for decision makers within the company

Answer: 1. B 2. E

3. H

4. G

5. C

6. F

Corporations with stock traded on public exchanges The common form of business ownership used by lawyers and CPAs Lenders of resources

7. D

8. A

Topic: Financial accounting information LO: 1 2. Match the following decision makers with the most likely decisions they seek to answer from accounting information. Use each answer only once. 1.

Suppliers and customers

Launch a new product or not?

Productions and operations

Purchase/sell goods from/to the company?

Creditors

Develop a new company strategy?

Investors and analysts

Lend to the company or not?

Top management

Manage operations?

Marketing teams

Buy or sell stock of the company?

Answer: 1. B 2. E

3. D

4. F

5. C

6. A

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Topic: Applying the accounting equation LO: 2 3. Compute the missing financial amounts (a) and (b): ($ millions) Company A Company B

Assets $ 28,800 $ 95,000

Liabilities (a) $ 79,600

Equity $5,670 (b)

Answer: (a) Liabilities = Assets – Equity = $28,800 - $5,670 = $23,130 (b) Equity = Assets – Liabilities = $95,000 - $79,600 = $15,400 Topic: Links between financial statements LO: 3 4. To which financial statements are each of the following financial values linked, and how are they linked? A. Retained earnings B. Net income C. Cash Answer: A. Retained earnings is linked to the income statement, the statement of shareholder’s equity, and the balance sheet. Net income on the income statement appears as an amount added to beginning retained earnings on the statement of stockholders’ equity. Ending retained earnings on the statement of stockholders’ equity is an amount in the stockholders’ equity section of the balance sheet. B. Net income is linked to the income statement and the statement of stockholder’s equity. Net income on the income statement appears as an amount added to beginning retained earnings on the statement of stockholders’ equity. C. Cash is linked to the statement of cash flows and the balance sheet. The ending balance is on the balance sheet and the changes in cash are shown on the statement of cash flows.

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Topic: Constructing a balance sheet LO: 3 5. Construct a balance sheet from the financial statements components listed below. Cash Revenues Other expenses Retained earnings Operating cash flows Contributed capital Liabilities Noncash assets Cost of goods sold

$22,100 38,900 10,600 25,600 19,500 52,600 31,800 87,900 26,400

Answer:

Assets Cash Noncash assets

Total assets

$22,100 87,900

$110,000

Balance Sheet Liabilities and Equity Liabilities Equity Contributed capital Retained earnings Stockholders’ equity Total liabilities and equity

$31,800

52,600 25,600 78,200 $ 110,000

Topic: Compute stockholders’ equity LO: 3 6. At April 30, 2023, the end of Stussie, Inc.’s financial period, Stussie’s retained earnings were $75,220 million. During the following year, Stussie reported net income of $10,465 million and paid a dividend of $6,532 million. Determine Stussie’s retained earnings as of April 30, 2024. Answer: $75,220+ $10,465 ‒ $6,532 = $79,153 million

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Topic: Identifying sources of key financial data LO: 3 7. Match each item with the financial statement in which each item would most likely appear: Use (I) for Income Statement, (B) for Balance Sheet and (CF) for Statement of Cash Flow. _______

a. Cost of goods sold

_______

b. Revenue

_______

d. Contributed capital

_______

e. Retained earnings

_______

g. Net change in cash

Answer: a. I b. I c. B d. B

Liabilities

Cash from investing activities

e. B f. CF g. CF

Topic: Statement of cash flows LO: 3 8. Prepare a statement of cash flows for Kulp Company for 2024 given its information below (amounts in millions): Net income $1,681 Operating cash flows ? Investing cash flows Net decrease in cash Financing cash flows

(8,538) (495) 3,096

Answer: Operating cash flows + Investing cash flows + Financing cash flows = Net change in cash Operating cash flows ‒ $8,538 + 3,096 = $ (495) Operating cash flows = $ 4,947 Operating cash flows Investing cash flows Financing cash flows Net decrease in cash

$4,947 (8,538) 3,096 $ (495)

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Topic: Financial statement relationships LO: 3 9. At the beginning of 2024 Sundial International, Inc. had $14,672 million in assets and $2,326 million in equity. During 2024, Sundial International’s assets decreased by $549 million while its equity increased by $392 million. How much were Sundial International’s liabilities at the beginning and end of 2024? Answer: Beginning liabilities = $14,672 million – $2,326 million = $12,346 million. Ending liabilities = ($14,672 million – $549 million) – ($2,326 million + $ 392 million) = $11,405 million. Topic: Retained earnings LO: 3 10. In its 2024 annual report, Cycle City reported net income of $37,960 thousand, retained earnings at the beginning of 2024 of $76,480 thousand, and dividends of $25,900 thousand. What is the amount of Cycle City’s retained earnings at the end of 2024? Answer: Retained earnings beginning + Net income – Dividends = Retained earnings ending = $76,480 + $37,960 - $25,900 = $88,540 thousand Topic: Other financial information LO: 3 11. In addition to the financial statements, list 3 other sources of information reported to external stakeholders? Answer: • Management Discussion and Analysis (MD&A) • Management report • Auditor report • Explanatory notes to financial statements • Proxy statements • Various regulatory filings

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Topic: Conceptual framework for financial reporting LO: 6 12. Match each of the following statements to the best qualitative characteristic or underlying assumption of accounting information that should be considered. Each answer is used only once. 1. Comparability

Although several accounting methods are acceptable, the information supplied to the decision makers should exhibit conformity from one accounting period to the next. A change in accounting methods should be rare.

2. Relevance

The company’s accountant ignores a $1.60 error in recording an invoice, discovered after the final financial statements were prepared.

3. Benefits > Costs

The accountant estimates the value of accounts receivable, based on recent information about economic forecasts and prior collection trends applicable to the company.

4. Going concern

Before each board meeting, the company prepares a number of reports that are time-consuming and expensive that are never used.

5. Separate economic entity

In estimating the life of a new piece of equipment, the accounting department assumes that the business will last indefinitely.

6. Materiality

George Bush, a stockholder of Halliburton, owes a debt to Union Bank for $3,000. This $3,000 is not a debt of Halliburton.

Answer: 1. A 2. C

3. D 4. E

5. F 6. B

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Topic: Return on equity and debt-to equity ratio LO: 5 13. Omni reported the following amounts in its December 31, 2024 and 2023 financial statements.

Sales revenue Cost of sales Net income Total assets Stockholders’ equity

2024 $250,000 172,000 4,300 62,000 23,500

2023 $265,000 180,000 4,500 65,800 27,200

Calculate to the nearest hundredth: A. Return on equity for 2024. B. Debt-to-equity ratio as of December 31, 2024 Answer: A. ROE = Net Income / Average stockholders’ equity = $4,300 / [($23,500+ $27,200)/2] = 16.96% B. Debt-to-equity = Total liabilities / Total stockholders’ equity = $ 38,500/ $23,500= 1.64 Total liabilities = $62,000– $23,500 = $ 38,500 Topic: Return on equity and debt-to equity ratio LO: 5 14. Beyer, Inc. has a debt-to-equity ratio of 0.32 and a ROE of 12.5%. The median ROE for similar companies in the same industry as Beyer is about 15.1%. The median debt-to-equity ratio for similar companies in the same industry is 0.49. Based on this industry information, how does Beyer compare to similar companies and what are the causes of these differences? Answer: As the return on equity shows, Beyer is underperforming similar companies in its industry as far as its ability to generate profit for its stockholders at 12.5%. On average, other companies in its industry are more efficient in bringing their product or service to the market and produce a product or service that the market values. Beyer’s debt-to-equity ratio, as compared to similar companies in its industry, indicates that the company is less aggressive with debt financing. Beyer’s ratio indicates that the company is using approximately one part debt and two parts equity financing, contributing to less credit risk and more solvency than the industry average which is well above 0.32.

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Problems Topic: Preparation of financial statements LO: 3 1. The following is selected financial information of Cambridge Media for the year ended December 31, 2024. Cash Net income Total liabilities Stockholders’ equity Cost of goods sold Investing cash flows Sales Noncash assets Financing cash flows Other expenses Operating cash flows Cash at beginning of the year

$ 35,000 6,300 80,000 185,000 165,000 (6,400) 210,500 230,000 (87,000) 39,200 92,100 36,300

Prepare an income statement, balance sheet and statement of cash flows for Cambridge Media at December 31, 2024. Answer: Cambridge Media Income Statement For Year Ended December 31, 2024 Sales Cost of goods sold Gross profit Other expenses Net income

Assets Cash Noncash assets Total assets

$210,500 165,000 45,500 39,200 $ 6,300 Cambridge Media Balance Sheet December 31, 2024 Liabilities and Equity $ 35,000 Total liabilities 230,000 Equity ______ Stockholders’ equity $ 265,000 Total liabilities and equity

$ 80,000 185,000 $ 265,000

Cambridge Media Statement of Cash Flows For Year Ended December 31, 2024 Operating cash flows Investing cash flows Financing cash flows Net change in cash Cash, January 1 Cash, December 31

$ 92,100 (6,400) (87,000) (1,300) 36,300 $ 35,000 .

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Topic: Preparation of statement of stockholders' equity LO: 3 2. The following is selected financial information for Tech Shack, Inc. for its year ending January 31, 2024: Retained earnings, January 31, 2023 ………….. Stock issuance …………………………………… Contributed capital, January 31, 2023 …………. Net income ………………………………………… Other stockholders’ equity changes…………….. Dividends ………………………………………….. Other stockholders’ equity, January 31, 2023....

$153,790 1,235 9,470 32,560 (592) 14,930 2,463

Prepare a statement of stockholders' equity for 2024 for Tech Shack. Answer: Tech Shack, Inc. Statement of Stockholders' Equity For Year Ended January 31, 2024

Balance, January 31, 2023 Stock issuance

Contributed Capital

Retained Earnings

Other

Total

$ 9,470

$ 153,790

$2,463

$165,723

1,235

Net income

32,560

Dividends

(14,930)

Other stockholders’ equity changes

_______

(592)

Balance, January 31, 2024

$10,705

$171,420

$1,871

$183,996

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Topic: Preparation of balance sheet and statement of cash flows LO: 3 3. The following is selected financial information from Pandit, Inc. for the year ended December 31, 2024. Cash Stockholders’ equity Sales Operating cash flows Cost of goods sold Financing cash flows Other expenses Noncash assets Total liabilities Investing cash flows

$2,565 1,661 25,125 14,650 20,621 8,308 4,218 32,950 33,854 (22,865)

Construct a balance sheet and statement of cash flows for Pandit for 2024. Answer: Pandit, Inc. Balance Sheet December 31, 2024 Assets

Liabilities and Equity

Cash

Noncash assets Total assets

2,565

Total liabilities

32,950

Equity

$ 33,854

______

Stockholders’ equity

$ 35,515

Total liabilities and equity

1,661 $ 35,515

. Pandit, Inc. Statement of Cash Flows For Year Ended December 31, 2024 Operating cash flows

$14,650

Investing cash flows

(22,865)

Financing cash flows

8,308

Net change in cash

Cash, January 1, 2024

2,472

Cash, December 31, 2024

$ 2,565

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Topic: Preparation of the financial statements LO: 3 4. The following is selected financial information for Paleo Foods from its Form 10-K filed with the SEC for the year ended July 31, 2024: Cash Other expenses Operating cash flows Sales Stockholders’ equity Investing cash flows Cost of goods sold Total liabilities Financing cash flows Noncash assets

$ 1,050 5,846 2,722 24,740 2,358 (3,439) 18,218 14,382 683 15,690

Prepare each of the following financial statements for Paleo Foods in proper form: • Income statement • Balance sheet • Statement of cash flows Answer: Paleo Foods Income Statement For Year Ended July 31, 2024 Sales Cost of goods sold Gross profit Other expenses Net income

Assets Cash Noncash assets Total assets

$24,740 18,218 6,522 5,846 $ 676 Paleo Foods Balance Sheet July 31, 2024 Liabilities and Equity $ 1,050 Total liabilities 15,690 Equity Stockholders’ equity $16,740 Total liabilities and equity

$14,382 2,358 $16,740

Paleo Foods Statement of Cash Flows For Year Ended July 31, 2024 Operating cash flows Investing cash flows Financing cash flows Net change in cash Cash, August 1, 2023 Cash, July 31, 2024

$2,722 (3,439) 683 (34) 1,084 $1,050

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Topic: Preparing a statement of stockholders’ equity LO: 3 5. Healthy Grub reported the following selected information at July 31, 2024: Contributed capital, July 31, 2023 Stock issuance, August 1, 2023 to July 31, 2024 Retained Earnings, July 31, 2023 Net income Dividends Other stockholders’ equity, July 31, 2023 Other stockholders’ equity changes

$25,280 521 36,172 2,478 893 1,665 (120)

Use this information to prepare a statement of stockholders’ equity for Healthy Grub for the year ending July 31, 2024. Answer: Healthy Grub Statement of Stockholders' Equity For Year Ended July 31, 2024

Balance, August 1, 2023 Stock issuance Net income Dividends Other stockholders’ equity changes Balance July 31, 2024

Contributed Capital $25,280 521

Retained Earnings $36,172

Other 1,665

Total $63,117 521 2,478 (893)

(120) $1,545

(120) $65,103

2,478 (893) ______ $25,801

______ $37,757

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Essays Topic: Business activities LO: 2 1. Describe the four basic business activities conducted by a company in the production and sale of its products and services. Answer: The four activities include planning, financing, operating and investing. The planning activities are part of the creation of the company’s business plan, which is used to articulate and describe the company’s strategy for operations and earning income. Financing activities include all activities to acquire the capital used to pay for resources such as property, equipment and buildings. This financing can be either owner financing (i.e., money invested by the owner of the company), or non-owner financing (i.e., money contributed by those other than the owner). Operating activities refer to the processes by which resources owned by the company will be used to develop products and services. These activities will result in revenue (i.e., money coming into the company), and expenses (i.e., money used by the company as part of the operating activities). Investing activities encompass the steps involved in deciding which assets the company should acquire or sell with the money that was made available as a result of the financing activities. These assets are ultimately used in the operating activities to generate sales and revenues. Topic: Demand of financial accounting information LO: 1 2. List three users of financial accounting information and explain the significance of this information for each user. Answer: Shareholders and potential shareholders – Shareholders demand financial accounting information to assess the profitability and risks of companies. Shareholders look for information useful in their investment decisions. They use accounting information to evaluate manager performance. Creditors and suppliers – Creditors and other lenders demand financial accounting information to help decide loan terms, dollar amounts, interest rates and collateral. Suppliers similarly demand financial information to establish credit sales terms and to determine their long-term commitment to supply-chain relations. Both creditors and suppliers use financial information to continuously monitor and adjust their contracts and commitments with a debtor company. Managers and directors – Managers and directors demand financial information on the financial condition, profitability and prospects of their companies for their own well-being and future earnings potential. They also demand comparative financial information on competing companies and other business opportunities. This permits them to conduct comparative analyses to benchmark company performance and condition. Managers similarly use such information to request further compensation and managerial power from directors. Outside directors are crucial to determining who runs the company, and these directors use accounting information to evaluate manager performance. continued next page

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Financial analysts – Financial analysts publish financial statistics about companies and disseminate financial information about specific industries. Labor unions – These groups examine financial statements in order to assess the financial health of firms prior to negotiating labor contracts on behalf of the firms’ employees. Customers– Customers demand accounting information to assess the ability of the company to provide products or services as agreed and to assess the company’s staying power and reliability. Customers also wish to estimate the company’s profitability to assess fairness of returns on mutual transactions. Tax agencies –Tax agencies use information to help establish tax policies. Over government agencies. They use accounting information to develop and enforce regulations, including public protection, price setting, import-export and various other uses. Topic: Use of estimates in financial reporting LO: 4, 6 3. Financial statements rely on countless estimates by accountants, including the useful life of building and equipment, the dollar amounts that will be collected from customers who purchase on credit, the prediction of future costs related to warranty claims or future pension obligations. Prepare a short argument to explain why estimates are an acceptable and important ingredient in the preparation of financial statements. Answer: Certain financial figures or costs cannot be quantified in exact terms, but still must be disclosed to shareholders in order to provide them with timely financial reporting. A practical way of disclosing such items is to quantify them in terms of conservative estimates. A company can then revise such estimates, prospectively, as future events, or data affect the original estimate. Topic: The effect of the Sarbanes-Oxley Act LO: 4 4. Accounting debacles, such as in the case of Enron, brought to light the necessity of accuracy in financial reporting and accountability of management. Describe how the introduction of the Sarbanes-Oxley Act has changed the requirements of financial reporting. Answer: Congress introduced the Sarbanes-Oxley act as a way of restoring confidence in the integrity of financial statement reporting of publicly traded companies. The Act requires the chief executive officer and chief financial officer of the company to personally sign-off on the accuracy and completeness of financial statements and the integrity of the company’s system of internal controls. This requirement is designed to hold management personally accountable for negligence in financial reporting and encourage vigilance in monitoring the company’s financial accounting system.

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Topic: Costs and benefits of disclosure LO: 1, 6 5. Explain the benefits and costs associated with a company's disclosure of information. Answer: Supplying information benefits a company by helping it to compete in capital, labor, input, and output markets. Performance of a company hinges on successful business activities and the markets’ awareness of that success. Economic incentives exist for those companies that disclose reliable accounting information, especially when good news about products, processes, management, etc. is disclosed. Costs associated with the disclosure of information are associated with its preparation and dissemination. Other costs include competitive disadvantage, litigation potential, and political costs. Topic: Owner vs. Nonowner financing LO: 1, 2 6. Businesses rely on financing activities to fund their operating and investments. Explain the difference between owner and non-owner financing, and explain the benefits and risks involved in relying more heavily on each type of financing. Answer: Owner financing, also called equity refers to money given to the business in exchange for partial control of the company. Stock is the most common form of owner financing. Companies are not obligated to guarantee a return on owner investments. However, if returns are unacceptable to owners, they may use their power to take the business in different directions. In sum, owner financing provides cash inflow to the company without any guarantee of repayment. Control over the company is vested in the shareholders. Non-owner financing refers to money given to the business in exchange for a guaranteed repayment, usually with interest. Loans and bonds are very common examples of non-owner investment. The risk to the company lies in potential default if operations decline. The benefit is that the company does not need to cede operational control to its creditors, unless it defaults on its repayment. In sum, non-owner financing allows the current owners to maintain full control of the company, but requires repayment with interest. Companies that rely more heavily on owner financing are said to be financed conservatively; Companies that rely more heavily on non-owner financing are said to be financed less conservatively.

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Chapter 2 Constructing Financial Statements Learning Objectives – Coverage by question Multiple Choice

Exercises

Problems

Essay Questions

1-4

1, 3-5, 7, 21

1, 2, 5, 10, 13

1, 2, 4

1-3

6, 9, 14, 15, 17

6, 7

5, 6

6, 7

8, 10-12

3, 8, 12

LO 2-4 Explain revenue recognition, accrual accounting, and their effects on retained earnings. (p. 2-14)

8, 9

9, 12-14

7, 10

2, 5, 6

LO 2-5 Illustrate equity transactions and the statement of stockholders' equity. (p. 2-19)

10, 11

4, 5, 9-11, 13

LO 2-6 Use journal entries and T-accounts to analyze and record transactions. (p. 2-21)

12, 13

16, 17

LO 2-7 Compute net working capital, the current ratio, and the quick ratio, and explain how they reflect liquidity. (p. 2-30)

14, 15

18-20

14, 15

True/False LO 2-1 Describe and construct the balance sheet and understand how it can be used for analysis. (p. 2-3) LO 2-2 Use the financial statement effects template (FSET) to analyze transactions. (p. 2-8) LO 2-3 Describe and construct the income statement and discuss how it can be used to evaluate management performance. (p. 2-12)

. 2-1

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Chapter 2: Constructing Financial Statements True/False

Topic: Assets LO: 1 1. Companies may not report internally created assets, such as the value of a successful marketing campaign, design innovations and a highly motivated work force on their balance sheets. Answer: True Rationale: Even though these “assets” probably provide future benefits to the company that will be reflected in the company’s market value and in future revenues, these amounts cannot be reliably measured. They are excluded from the balance sheet under GAAP. Topic: Historical cost LO: 1 2. Assets such as inventory and property, plant, and equipment are reported on the balance sheet at their current market value. Answer: False Rationale: These assets are generally reported at historical cost. Topic: Reporting of assets LO: 1 3. Assets are listed on the balance sheet in order of liquidity and liabilities are listed in order of amount. Answer: False Rationale: Assets are reported in the order of liquidity which reflects the ease of converting into cash. Receivables are reported before inventories, and inventories before PPE. Liabilities are reported in order of maturity, with current liabilities expected to be paid within one year or within the operating cycle, and long-term liabilities expected to be paid over a longer period of time. Topic: The double-entry accounting system LO: 1 4. Under the double-entry accounting system, no more than two accounts can be affected by each transaction. Answer: False Rationale: Each transaction recorded under the double-entry accounting system must affect at least two accounts. It can affect more than two.

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Topic: Transaction analysis LO: 2 5. If Burr, Inc. purchased inventory on credit from Gillis Company, then the transaction recorded by Burr would include an increase in a liability and an increase in asset. Answer: True Rationale: The transaction recorded by Burr would include an increase to an asset (inventory) and an increase to a liability (accounts payable). Topic: Reporting financial performance LO: 3 6. Operating expenses include interest expense related to a company’s financing activities. Answer: False Rationale: Interest expense is considered to be a nonoperating expense. Topic: Reporting financial performance LO: 3 7. The income statement is also called the statement of earnings. Answer: True Rationale: Another name for the income statement is the statement of earnings. Topic: Accrual accounting LO: 4 8. Accrual accounting recognizes revenues only when cash is received and expenses only when cash is paid. Answer: False Rationale: Accrual accounting refers to the recognition of revenue when earned and the matching of expenses when incurred. The recognition of revenues and expenses does not always relate to the receipt or payment of cash. Topic: Matching principle LO: 4 9. Under the matching principle, the cost of inventory should be reported as an expense in the income statement when it is purchased, even if it is purchased on credit and will not be paid until the next reporting period. Answer: False Rationale: Under the matching principle, the cost of inventory should only be reported as expense in the period in which it is used up, typically at the point of sale. Purchased inventories that have not yet been sold are reported as assets. Unpaid amounts to suppliers are reported as liabilities.

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Topic: Analyzing and recording equity transactions LO: 5 10. If McConnell Company paid $15,000 cash dividends to its shareholders, contributed capital would be reduced by $15,000. Answer: False Rationale: A cash dividend results in a reduction of retained earnings, not contributed capital. Topic: Analyzing and recording equity transactions LO: 5 11. If stockholders’ equity is $100,000 on January 1, 2024, and decreases to $90,000 on December 31, 2024, this could only be due to a dividend payment of $10,000. Answer: False Rationale: A reduction in stockholders’ equity could also be due to a net loss for the year. Topic: Debit and credit system LO: 6 12. A compound entry does not necessarily have to maintain total debits equal to total credits. Answer: False Rationale: A compound entry must adhere to the rule: total debits equal total credits. Topic: T-account LO: 6 13. The typical form of a T-account shows debits on the right and credits on the left. Answer: False Rationale: A T-account tracks debits on the left and credits on the right. Topic: Net working capital LO: 7 14. Net working capital = Current assets + Current liabilities Answer: False Rationale: Net working capital = Current assets less current liabilities. Topic: Assessing Liquidity LO: 7 15. Quick ratio is another name for a current ratio. Answer: False Rationale: The quick ratio differs from the current ratio in that the numerator only contains cash, shortterm securities, and accounts receivable.

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Multiple Choice

Topic: Current assets LO: 1 1. Which one of the following is included in current assets? A) B) C) D)

Accounts receivable Taxes payable Automobiles Common stock

Answer: A Rationale: Accounts receivable is included in current assets as it represents amount owed by customers that are expected to be paid within one year or the operating cycle. Topic: Stockholders’ equity LO: 5 2. Which of the following is not shown in the statement of stockholder’s equity? A) B) C) D)

Unearned revenue Dividends Retained earnings Common stock

Answer: A Rationale: Unearned revenue is a liability that represents amounts collected in advance from customers. It is an obligation that must be satisfied with a future cash payment or delivery of goods or services. Topic: Reporting of assets LO: 1 3. Assets are recorded in the balance sheet in order of: A) B) C) D)

Market value Historic value Liquidity Maturity

Answer: C Rationale: Liquidity refers to the ease of conversation to cash. Current assets are to be used during the current operating cycle (starting with cash, short-term investments, accounts receivables, inventories and other assets). Market value and historic value refer to the measurement of assets. Maturity refers to the order in which liabilities are recorded in the balance sheet.

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Topic: Liabilities LO: 1 4. Which one of the following is not a current liability? A) B) C) D)

Taxes payable Accounts payable Wages payable Wage expense

Answer: D Rationale: Wages expense is an income statement account, not a balance sheet account. Current liabilities are amounts owed and due to be repaid within one year or within one operating cycle. Topic: Reporting of assets LO: 1 5. What are probable future sacrifices called and how are they reported? A) B) C) D)

Assets on the balance sheet Stockholders’ equity on the balance sheet Dividends on the statement of stockholders’ equity Liabilities on the balance sheet

Answer: D Rationale: Liabilities are probably future economic sacrifices resulting from a current or past event. They are obligations that must be satisfied with a future cash payment or delivery of goods or services. Topic: Chart of accounts LO: 2 6. Account titles are commonly grouped into what five categories in the chart of accounts? A) Current assets, Current liabilities, Noncurrent assets, Noncurrent liabilities, Stockholders’ equity B) Assets, Liabilities, Equity, Revenue, Expenses C) Common stock, Additional paid-in capital, Treasury stock, Retained earnings, Accumulated other comprehensive income or loss D) Cash, Marketable securities, Accounts payable, Long-term debt, Common stock Answer: B Rationale: In the chart of accounts, account titles are commonly grouped into the five categories of: Assets, Liabilities, Equity, Revenues, and Expenses. Topic: Stockholders’ equity LO: 1 7. Which one of the following does not impact retained earnings directly? A) B) C) D)

Net income Net loss Dividends Stock issuances

Answer: D Rationale: Stock issuances impact stockholders’ equity through the common stock account.

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Topic: Income statement LO: 3 8. An income statement does not include which of the following? A) B) C) D)

Operating expenses Cost of goods sold Retained earnings Sales

Answer: C Rationale: Retained earnings represent accumulated earnings from previous accounting periods that has not been distributed to stockholders as dividends. Topic: Effects of accrued wages LO: 2, 4 9. An accrual of wages expense would produce what effect on the balance sheet? A) B) C) D)

Increase liabilities and decrease equity Decrease liabilities and increase equity Increase assets and increase liabilities Decrease assets and decrease liabilities

Answer: A Rationale: An accrual of wages expense produces an increase in wages payable (liability) and a decrease in retained earnings (stockholders’ equity), resulting in a decrease of profit. Topic: Gross profit LO: 3 10. Sales less cost of goods sold equals: A) B) C) D)

Net income Net profit margin Gross profit Gross profit margin

Answer: C Rationale: Sales – Cost of goods sold = Gross profit. The gross profit margin is gross profit divided by sales. Topic: Reporting financial performance LO: 3 11. Pearlman Industries recorded and paid $2,000 in wages. Which occurred? A) B) C) D)

Current assets increase. Gross profit decreases. Retained earnings increases. Operating income decreases.

Answer: D Rationale: Assets (cash) decrease and Wages Expense (an operating expense) increases, causing operating income to decrease.

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Topic: Recognition of costs as expense LO: 3, 4 12. As inventory and PPE assets on the balance sheet are consumed, they are reflected: A) B) C) D)

As a revenue on the income statement As an expense on the income statement As common stock on the balance sheet Assets are never consumed

Answer: B Rationale: As assets are consumed (used up), their cost is transferred into the income statement as an expense. Topic: Analyzing and recording income statement transactions LO: 4 13. Which of the following will properly record the payment of a one-year insurance policy? A) B) C) D)

Increase assets and increase retained earnings Increase liabilities and decrease retained earnings Increase and decrease assets Decrease assets and decrease liabilities

Answer: C Rationale: Prepaid insurance in increased and cash is decreased, both of which are assets. Topic: Collection of a receivable LO: 2, 4 14. Cash collected on accounts receivable would produce what effect on the balance sheet? A) B) C) D)

Increase liabilities and decrease equity Decrease liabilities and increase equity Increase assets and decrease assets Decrease assets and decrease liabilities

Answer: C Rationale: Cash collected on accounts receivable produces an increase in cash and a decrease in accounts receivable, both asset accounts. There is no impact on profit and on equity. Topic: Transaction analysis LO: 2 15. Which of the following is one effect of a purchase of $2,500 of equipment on credit? A) B) C) D)

It would decrease retained earnings by $2,500 It would increase assets by $2,500 It would decrease liabilities by $2,500 It would decrease cash by $2,500

Answer: B Rationale: The purchase on credit creates an account payable. It would increase liabilities by $2,500. In addition, the equipment account in the asset section of the balance sheet would also increase.

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Topic: Journalizing and posting transactions LO: 6 16. The Cash T-account has a beginning balance of $52,000. During the year, $365,000 was debited and $360,000 was credited to the account. What is the ending balance of cash? A) B) C) D)

$ 5,000 $57,000 $47,000 $(5,000)

Answer: B Rationale: $52,000 + $365,000 - $360,000 = $57,000 Topic: Journalizing and posting transactions LO: 2, 6 17. On January 1, 2024, Zhao Company paid $45,000 in cash for insurance covering the year 2024. Which of the following would be the correct journal entry to record this transaction? A) Insurance expense Cash

45,000

B) Cash

45,000

Insurance expense

45,000

C) Prepaid insurance Cash

45,000

D) Cash

45,000

Prepaid insurance

45,000

Answer: C Rationale: Prepaid insurance is debited and Cash is credited for $45,000. Topic: Net working capital LO: 7 18. Net working capital is defined as: A) B) C) D)

Assets – liabilities Current assets Current assets – Current liabilities Market value – Book value

Answer: C Rationale: Net working capital = Current assets – Current liabilities

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Topic: Assessing liquidity LO: 7 19. Which of the following statements is true regarding the current ratio? A) A company with a high current ratio cannot have liquidity problems B) A low current ratio suggests inefficient use of resources C) The current ratio can be improved by paying creditors immediately prior to the preparation of financial statements D) The current ratio presents a more conservative liquidity measure than does the quick ratio Answer: C Rationale: A current ratio can be manipulated by management and improved if creditors are paid immediately prior to the close of a financial statement period. Topic: Assessing Liquidity LO: 7 20. If Wang Toys has working capital of $2,000,000, which of the following will cause its working capital to decrease? A) B) C) D)

Recorded interest payable in the amount of $150,000 Paid wages payable in the amount of $150,000 Borrowed $150,000 from a bank to be repaid in 90 days Purchased $150,000 of inventory on credit

Answer: A Rationale: Working capital will remain the same in B, C, and D, because current assets and current liabilities are equally affected. Only option A will show a decrease in working capital, because current assets are not affected but current liabilities increase. Topic: Measuring assets LO: 1 21. Which of the following is the justification of reporting certain assets at historical cost? A) B) C) D)

Executory Reliability Relevance Accrual

Answer: B Rationale: Historical cost is used because it is objective and reliable. It can easily be verified as it represents the cost originally paid.

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Exercises Topic: Balance sheet accounts LO: 1 1. Identify the following as an asset (A), liability (L), or equity (E) by writing the letter of the correct classification in the space provided. Account

Answer: A. Liability B. Asset

Accounts payable

B. C. D. E. F. G.

Office equipment Accounts receivable Common stock Cash Contributed capital Wages payable

Unearned revenue C. Asset D. Equity

Classification

E. Asset F. Equity

G. Liability H. Liability

Topic: Balance sheet relations LO: 1 2. Compute the missing amounts in the table below: Year 1 $190,000 A $ 24,000 $145,000 $190,000

Total assets Contributed capital Retained earnings Total liabilities Liabilities and equity

Year 2 B $ 10,000 C $165,000 $206,000

Answer: A. Liabilities and equity ‒ equity = Liabilities $190,000 ‒ equity = $145,000 Equity = $45,000 Contributed capital + retained earnings = Equity Contributed capital + $24,000 = $45,000 Contributed capital = $21,000 B. Total assets = Liabilities and equity Total assets = $206,000 C. Liabilities and equity ‒ liabilities = Equity $206,000 ‒ $165,000 = $41,000 Contributed capital + retained earnings = Equity $10,000 + $? = $41,000 Retained earnings = $31,000 . 2-11

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Topic: Prepare an income statement LO: 3 3. Prepare an income statement for the month ended July 31, 2024 for Pages Books. Pages’ account balances for the month ending July 31, 2024 are: Cash Utilities expense Supplies Equipment Land Miscellaneous expenses Common stock

$ 3,000 2,200 8,000 85,000 100,000 1,300 150,000

Rent expense Accounts receivable Salaries expense Sales Retained earnings, July 1 Dividends Accounts payable

$ 41,000 40,000 192,000 250,000 27,800 4,500 49,200

Answer: Pages Books Income Statement For the Month Ended July 31, 2024 Revenues Sales Expenses Salaries expense Rent expense Utilities expense Miscellaneous expenses Total expenses Net income

$250,000 $192,000 41,000 2,200 1,300 236,500 $13,500

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Topic: Prepare a statement of stockholders’ equity LO: 5 4. Prepare a statement of stockholders’ equity for the month ended July 31, 2024 for Pages Books. Assume no changes in contributed capital during the month. Pages’ account balances for the month ending July 31, 2024 are: Cash Utilities expense Supplies Equipment Land Miscellaneous expenses Common stock

$ 3,000 2,200 8,000 85,000 100,000 1,300 150,000

Rent expense Accounts receivable Salaries expense Sales Retained earnings, July 1 Dividends Accounts payable

$ 41,000 40,000 192,000 250,000 27,800 4,500 49,200

Answer: Pages Books Statement of Stockholders’ Equity For the Month Ended July 31, 2024

Balance, July 1, 2024 Common stock issued Add: Net income Less: Dividends Balance, July 31, 2024

Contributed Capital $150,000 0 0 $150,000

Retained Earnings $27,800 13,500 (4,500) $36,800

Total Equity $177,800 0 13,500 (4,500) $186,800

Net Income: $250,000 ‒ $192,000 ‒ $41,000 ‒ 2,200 ‒ $1,300 = $13,500

. 2-13

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Topic: Prepare a balance sheet LO: 1, 5 5. Prepare a balance sheet for Pages Books as of July 31, 2024. Pages’ account balances for the month ending July 31, 2024 are: Cash Utilities expense Supplies Equipment Land Miscellaneous expenses Common stock

$ 3,000 2,200 8,000 85,000 100,000 1,300 150,000

Rent expense Accounts receivable Salaries expense Sales Retained earnings, July 1 Dividends Accounts payable

$ 41,000 40,000 192,000 250,000 27,800 4,500 49,200

Answer:

Assets Cash Accounts receivable Supplies Total current assets Equipment Land Total noncurrent assets Total assets

Pages Books Balance Sheet July 31, 2024 Liabilities $ 3,000 Accounts payable 40,000 8,000 Equity 51,000 Common stock 85,000 Retained earnings 100,000 Total equity 185,000 $236,000 Total liabilities and equity

$ 49,200

150,000 36,800 186,800 _______ $236,000

Topic: Identifying transactions that yield statement effects LO: 2, 6 6. Provide an example of a transaction that creates each of following effects: A. B. C. D.

Increase assets and increase equity Decrease asset and decrease liability Decrease asset and decrease equity Increase asset and increase liability

Answer: A. Owner invests cash into business B. Pay cash to settle a liability in accounts payable C. Business incurs an expense and it is paid with cash D. Business buys a new machine on credit

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Topic: Transaction analysis LO: 2, 4 7. Record the effects of each transaction or event in the table below: Balance Sheet Transaction

Cash

Noncash Assets

Income Statement Contrib. + Capital

= Liabilities +

Earned Capital

Revenues

Expenses

Net Income

(1) Purchase $20,000 of supplies for cash

(2) Paid $4,000 cash for rent expense

(3) Collected $120,000 cash from accounts receivable

(4) Employees earn $15,000 in wages that are not paid in cash

(5) Paid $35,000 cash toward accounts payable

(6) Made $150,000 in credit sales

Answer: Balance Sheet Transaction

Cash

(1) Purchase $20,000 of supplies for cash

-20,000 Cash

(2) Paid $4,000 cash for rent expense

-4,000 Cash

(3) Collected $120,000 cash from accounts receivable

+120,000 Cash

(4) Employees earn $15,000 in wages that are not paid in cash (5) Paid $35,000 cash toward accounts payable (6) Made $150,000 in credit sales

Noncash Assets +20,000 Supplies

= Liabilities

Earned Capital

Revenues

Expenses

Net Income

= -4,000 Retained Earnings

+4,000 Rent Expense

-120,000 Accounts Receivable =

= -35,000 Cash

Income Statement Contrib. + Capital

-4,000 =

= +15,000 Wages Payable

-15,000 Retained Earnings

+15,000 Wages Expense

-35,000 = Accounts Payable +150,000 Accounts = Receivable

-15,000 =

= +150,000 Retained Earnings

. 2-15

+150,000 Sales Revenue

+150,000 =

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Topic: Preparing income statement LO: 3 8. The following items and amounts are taken from the 2024 financial records of Terrapin Co.: Supplies expense…………. Equipment………………….. Salaries expense……………. Utilities expense……………. Dividends………………….… Accounts payable…………… Accounts receivable……….

$ 32,000 72,000 150,000 8,200 1,000 6,000 26,800

Salaries payable…………………….. Common stock………………………. Cash………………………………….. Retained earnings, Jan. 1, 2024…… Insurance expense………………….. Repair expense……………….…….. Service revenue……………………..

$ 5,000 50,000 12,000 47,000 12,000 14,000 220,000

Prepare an income statement for the year ending December 31, 2024: Answer: Terrapin Co. Income Statement For the Year Ended December 31, 2024 Revenues Service revenue $220,000 Expenses Salaries expense $150,000 Utilities expense 8,200 Supplies expense 32,000 Repair expense 14,000 Insurance expense 12,000 Total expense 216,200 Net Income $ 3,800

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Topic: Preparing a statement of stockholders’ equity LO: 5 9. The following items and amounts are taken from the 2024 financial records of Terrapin Co.: Supplies expense…………. Equipment………………….. Salaries expense……………. Utilities expense……………. Dividends………………….… Accounts payable…………… Accounts receivable……….

$ 32,000 72,000 150,000 8,200 1,000 6,000 26,800

$ 5,000 50,000 12,000 47,000 12,000 14,000 220,000

Prepare a statement of stockholders’ equity for Terrapin Co. for the year ending December 31, 2024. Assume no changes in common stock during the year. Answer: Terrapin Co. Statement of Stockholders’ Equity For the Year Ended December 31, 2024

Balance, January 1, 2024 Add: Net income Less: Dividends Balance, December 31, 2024

Contributed Capital $50,000 0 $50,000

Retained Earnings $47,000 3,800 (1,000) $ 49,800

Total Equity $97,000 3,800 (1,000) $ 99,800

Net Income: $220,000 ‒ $150,000 ‒ $8,200 ‒ $32,000 ‒ $14,000 ‒$12,000 = $3,800

. 2-17

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Topic: Preparing a balance sheet LO: 1, 4, 5 10. The following items and amounts are taken from the 2024 financial records of Terrapin Co.: Supplies expense…………. Equipment………………….. Salaries expense……………. Utilities expense……………. Dividends………………….… Accounts payable…………… Accounts receivable……….

$ 32,000 72,000 150,000 8,200 1,000 6,000 26,800

$ 5,000 50,000 12,000 47,000 12,000 14,000 220,000

Prepare a balance sheet for Terrapin Co. for the year ending December 31, 2024. Answer: Net Income: $220,000 ‒ $150,000 ‒ $8,200 ‒ $32,000 ‒ $14,000 ‒$12,000 = $3,800 Retained earnings, December 31, 2024: $47,000 + $3,800 ‒ $1,000 = $49,800 Terrapin Co. Balance Sheet December 31, 2024 Assets

Liabilities

Cash Accounts receivable Total current assets Equipment Total noncurrent assets

$ 12,000 26,800 38,800 72,000 72,000

Total assets

_______ $ 110,800

Accounts payable Salaries payable Total liabilities Equity Common stock Retained earnings Total equity Total liabilities and equity

$ 6,000 5,000 11,000 50,000 49,800 99,800 $ 110,800

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Topic: Statement of stockholders’ equity LO: 5 11. The records of Field Corp. show the following information after all transactions are recorded for the year ended December 31, 2024. Notes payable Service fees earned Supplies expense Insurance expense Miscellaneous expense Common stock, January 1 Accounts payable Dividends

28,000 200,000 42,000 12,000 1,000 35,000 11,800 3,000

Supplies Cash Advertising expense Salaries expense Rent expense Retained earnings, January 1 Accounts receivable Equipment

$ 30,600 7,300 9,200 68,000 59,000 17,000 8,700 61,000

Field raised $10,000 cash through the issuance of additional common stock during the year. Based on this information, prepare Field’s statement of stockholders’ equity for the year ending December 31, 2024. Answer: Field Corp Statement of Stockholders’ Equity For Year Ended December 31, 2024 Balance at January 1, 2024 Stock issuance Dividends Net income* Balance at December 31, 2024

Common Stock

Retained Earnings

$35,000 10,000

$17,000

_______ $45,000

(3,000) 8,800 $22,800

Total Equity

$52,000 10,000 (3,000) 8,800 $67,800

*$8,800 = $200,000 – $42,000 – $12,000 – $1,000 – $9,200 – $68,000 ‒ $59,000

. 2-19

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Topic: Preparing income statement from account balances LO: 3 12. On December 31, 2024, Yin Corporation’s records show the following selected amounts. Cash Accounts receivable Rent expense Equipment Utilities expense Common stock Retained earnings, Dec. 31, 2024

$ 12,800 14,000 21,000 38,000 5,000 2,500 52,300

Dividends Sales Supplies Salaries expense Accounts payable Miscellaneous expense

$ 4,000 75,000 5,000 40,000 15,000 4,000

Prepare an income statement for Yin for its year ending December 31, 2024. Answer: Yin Corporation Income Statement For the Year Ended December 31, 2024 Revenues Sales $75,000 Expenses Salaries expense $40,000 Rent expense 21,000 Utilities expense 5,000 Miscellaneous expense 4,000 Total expense 70,000 Net Income $ 5,000 Topic: Equity changes LO: 1, 5 13. At the end of 2024, Sol Company reported the following amounts on its balance sheet: Cash Accounts receivable Equipment Land Accounts payable Common stock Retained earnings

$ 27,600 129,100 78,300 250,000 105,000 200,000 180,000

Answer each of the following independent questions: A. Assume that Sol’s stockholders’ equity on January 1, 2024 was $310,000. Sol did not issue common stock during the year, but it paid $15,000 cash in dividends. How much is Sol’s net income or loss for 2024? B. Assume that Sol’s stockholders’ equity on January 1, 2024 was $357,000, and that Sol issued additional common stock of $50,000 and paid $24,000 in cash dividends before the end of 2024. What was Sol’s net income or loss for 2024?

. Test Bank, Chapter 2

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Answer: A. Increase in equity ($200,000 + $ 180,000 ‒ $310,000) Add: Dividends Net Income for 2024

$ 70,000 15,000 $ 85,000

B. Increase in equity ($200,000 + $180,000 ‒ $357,000) Add: Dividends Less: Additional Investment Net Loss for 2024

$ 23,000 24,000 (50,000) $ (3,000)

Topic: Net working capital and current ratio LO: 7 14. Wishpop, Inc. has $6,720 net working capital and $12,320 of current assets. What is the amount of the firm’s current liabilities? What is its current ratio? Answer: Net working capital = Current assets – Current liabilities. $6,720 = $12,320 ‒ Current liabilities Current liabilities = $5,600 Current ratio = Current assets / Current liabilities $12,320/$5,600 = 2.2 Topic: Operating cycle LO: 7 15. Companies strive to reduce operating cycles (time between paying cash for goods and receiving cash from customers). List 2 ways by which companies can achieve this. Answer: 1. Increase trade credit to minimize the cash invested in inventories, 2. Reduce inventory levels from improved production systems and management, 3. Better underwriting and collection of receivables to reduce past due accounts, 4. Offer incentives to customers for early payment of receivables.

. 2-21

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Problems Topic: Balance sheet accounts LO: 1 1. In the blank space beside each numbered balance sheet item, enter the letter of its balance sheet classification. If the item should not appear on the balance sheet, enter a Z in the blank. 1. 2. 3. 4.

Cash Inventory Land Machine

A. B. C. D.

Current assets Long-term investments Long-term assets Intangible assets

5. 6. 7. 8. 9. 10.

Building Income taxes payable in 30 days Utilities payable Note receivable due in 30 days Common Stock Goodwill

E. F. G.

Current liabilities Noncurrent liabilities Equity

11. 12. 13. 14. 15.

Value of company logo Wages expense Value of land in excess of cost Mortgage payable Accounts receivable

Answer: 1. A 2. A 3. C 4. C 5. C 6. E 7. E 8. A

9. 10. 11. 12. 13. 14. 15.

G D Z Z Z F A

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Topic: Transaction analysis LO: 2, 4 2. Based on the following list of transactions, indicate their effect on Stevenson’s assets, liabilities and equity for one month of operations. A. Stevenson buys a cooler and a George Foreman grill for $800 cash. B. Stevenson takes out a loan for $2,500. C. Stevenson pays cash for 600 hot dogs at $0.75 each, 500 buns at $0.25 each, 800 cans of soft drinks at $0.65 each and a huge bottle of ketchup for $40. D. Stevenson sells 160 hot dog / drink combos for $7.50 each. E. Stevenson records the product cost for the sales in (D) above, including ketchup, at $1.90 each. F. Stevenson pays his hot dog salesmen $650 for the month. G. Stevenson pays $100 of his loan. Cash

Inventory

Equipment

Accounts Payable

Loans Payable

Equity

Cash

Inventory

Equipment

Accounts Payable

Loans Payable

Equity

A B C D E F G

Answer:

(800)

+2,500

(1,135)

+1,200

+800 +2,500 +1,135 +1,200 (304)

(650)

(100)

(304) (650) (100)

C: (600 × $0.75) + (500 × $0.25) + (800 × $0.65) + $40 = $1,135 D: 160 × $7.50 = $1,200 E: $1.90 × 160 = $304

. 2-23

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Topic: Income statement relations LO: 3 3. Information concerning Ralph’s earnings for three years appears below. Ralph’s Income Statement Information ($ millions) Year

2024

2023

Sales

$26,250

$14,980

Cost of goods sold

2022

10,200

Gross profit

7,625

9,650 (2,340)

Operating expenses

2,900

Other income (loss)

3,160

220

Net income

(200)

1,870

1,700

Calculate the missing amounts. Answer: Ralph’s Income Statement Information ($ millions) Year

2024

2023

2022

Sales

$26,250

$14,980

$11,990

Cost of goods sold

18,625

10,200

9,650

Gross profit

7,625

4,780

2,340

Operating expenses

5,975

2,900

3,160

Other income (loss)

220

(180)

(200)

1,870

1,700

(1,020)

Net income

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Topic: Constructing a balance sheet LO: 1 4. Compute the missing amounts for each of the last 3 years for North City Inc. (millions)

2024

Current assets

$14,650

Noncurrent assets

121,090

2023

$10,194 118,740

Total assets Current liabilities

25,793

Noncurrent liabilities

77,182

Total liabilities

102,975

2022

131,285

122,460

21,973

18,544 68,846

92,714

Stockholders’ equity

38,571

35,060

Liabilities and equity Answer:

Current assets Noncurrent assets Total assets

2024 $ 14,650 121,090 $135,740

2023 $ 12,545 118,740 $131,285

2022 $10,194 112,266 $122,460

Current liabilities

$25,793

$21,973

$18,554

Noncurrent liabilities Total liabilities Stockholders’ equity Liabilities and equity

77,182 102,975 32,765 $135,740

70,741 92,714 38,571 $131,285

68,846 87,400 35,060 $122,460

. 2-25

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Topic: Transaction analysis LO: 2, 4, 6 5. Identify the effects of the following transactions in the table below: Balance Sheet Transaction

Cash

Noncash Assets

(1) Paid $1,400 cash interest on borrowings (2) $1,000 of employee wages payable are paid in cash

= Liabilities

Income Statement Contrib. + Capital

Earned Capital

Revenues

Expenses

(3) $2,500 of inventory is purchased for cash

(4) Sold goods for $2,800 on account

(5) Record $1,500 for the cost of inventory sold in (4) above

(6) Collected $2,000 cash from transaction (4) above

(7) $4,500 of equipment is financed by a loan

(8) Paid $20,000 on a note payable that came due

Net Income

Answer: Balance Sheet +

Noncash Assets

Transaction

Cash

(1) Paid $1,400 cash interest on borrowings

-1,400 Cash

(2) $1,000 of employee wages payable are paid in cash

-1,000 Cash

(3) $2,500 of inventory is purchased for cash

-2,500 Cash

+2,500 Inventory

(4) Sold goods for $2,800 on account

+2,000 Cash

(7) $4,500 of equipment is financed by a loan (8) Paid $20,000 on a note payable that came due

Liabilities

Revenues

Expenses

+1,400 Interest Expense

= +2,800 Retained Earnings -1,500 Retained Earnings

+2,800 Sales Revenue

+2,800 = +1,500 Cost of Goods Sold

-2,000 Accounts = Receivable

Net Income -1,400

+4,500 Equipment = -20,000 Cash

Earned Capital -1,400 Retained Earnings

-1,000 Wages Payable

+2,800 Accounts = Receivable -1,500 Inventory =

(5) Record $1,500 for the cost of inventory in (4) above (6) Collected $2,000 cash from transaction (4) above

Income Statement Contrib. + Capital

-1,500 =

= +4,500 Loan Payable

-20,000 Note Payable

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Topic: Transaction analysis LO: 2, 4, 6 6. Identify the effects of the following transactions in the table below: Balance Sheet Transaction

Cash

Noncash Assets

Liabilities +

Income Statement Contrib. + Capital

Earned Capital

Revenues

Expenses

(1) Sold gift cards for $500 cash

(2) Signed a loan agreement and received $6,000 cash

(3) Purchased inventory for $4,200 on credit

(4) Sold goods for $5,800 on account

(5) Recorded $2,200 for the cost of merchandise sold in (4) above

(6) Collected $3,100 cash from transaction (4) above

(7) Paid $2,700 on the account payable in transaction (3) above

(8) Employees earn $1,600 in wages to be paid the following month

Net Income

Answer: Balance Sheet Transaction

Cash

(1) Sold gift cards for $500 cash

+500 Cash

(2) Signed a loan agreement and received $6,000 cash

+6,000 Cash

Noncash Assets

+4,200 Inventory

(4) Sold goods for $5,800 on account

+5,800 Accounts = Receivable -2,200 Inventory =

(7) Paid $2,700 on the account payable in transaction (3) above (8) Employees earn $1,600 in wages to be paid the following month

+3,100 Cash -2,700 Cash

Earned Capital

Revenues

Expenses

+500 = Unearned Revenue +6,000 = Loan Payable +4,200 = Accounts Payable

(3) Purchased inventory for $4,200 on credit

(5) Recorded $2,200 for the cost of merchandise sold in (4) above (6) Collected $3,100 cash from transaction (4) above

Liabilities +

Income Statement Contrib. + Capital

Net Income

= +5,800 Retained Earnings -2,200 Retained Earnings

+5,800 Sales Revenue

+5,800 = +2,200 Cost of Goods Sold

-3,100 Accounts = Receivable =

-2,200 =

= -2,700 Accounts Payable +1,600 Wages Payable

. 2-27

= -1,600 Retained Earnings

+1,600 Wage Expense

-1,600 =

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Essays Topic: Historical cost vs. Market value LO: 1 1. With few exceptions, why do we report most assets at their original acquisition price (historical cost) and not at current market value? Answer: When company valuation is the goal, accurate and current market values of assets are preferred. For some assets like marketable securities, values are readily obtained from online quotes. For other assets like property, plant and equipment, we can only estimate their market values until they are ultimately sold. Allowing companies to report estimates of market values for assets would introduce potential bias into financial reporting, thus lessening financial statement reliability and usefulness. Topic: Intangible assets vs. Tangible assets LO: 1 2. Compare and contrast intangible and tangible assets. Answer: Intangible assets are similar to property, plant and equipment (PP&E) in that they are owned and controlled by the company and the company expects to realize future benefits from the use of the asset. For example, an internally created intangible asset, such as Mickey Mouse in the case of Walt Disney, is owned and controlled by Walt Disney and the company certainly anticipates that it will generate future sales from Mickey Mouse. Despite these similarities, Mickey Mouse cannot be capitalized because its historical cost is not reliably measurable. In contrast, the historical cost of PP&E is reliably measurable, and, therefore, can be capitalized on the balance sheet. Topic: Undervalued assets LO: 1 3. Prepare a list of two possible undervalued assets on the balance sheet of a company. Indicate how these items can be undervalued. Answer: Land is an asset that can often be undervalued on a balance sheet because it is typically an appreciating asset. Inventories are often carried at cost, below their current market price if prices rise since the items were acquired.

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Chapter 3 Adjusting Accounts for Financial Statements Learning Objectives – Coverage by question True/False

Multiple Choice

Exercises

LO 3-1 Analyze transactions and review the process of journalizing and posting transactions. (p. 3-3)

1-5

1-4

2, 5, 14-16

LO 3-2 Describe the adjusting process and illustrate adjusting entries. (p. 3-11)

6-11, 14, 15

5-12, 1517, 20

1-3, 5, 10,13-18

LO 3-3 Prepare financial statements from adjusted accounts. (p. 3-19)

4, 6-8, 13, 18

LO 3-4 Describe the process of closing temporary accounts. (p. 3-24)

14, 18

9, 13

10-12

1, 4, 6

LO 3-5 Analyze changes in balance sheet accounts. (p. 3-27)

. 3-1

Problems

Essay Questions

1, 2

2, 3, 7

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Chapter 3: Adjusting Accounts for Financial Statements

True/False

Topic: Fiscal year LO: 1 1. A company’s fiscal year cannot coincide with the calendar year. Answer: False Rationale: A company’s fiscal year often coincides with the calendar year, but it need not. Topic: Fiscal year LO: 1 2. All companies have a fiscal year ending on December 31. Answer: False Rationale: Only about 60% of companies have fiscal year ends that correspond to their calendar year end. Topic: Chart of accounts LO: 1 3. The chart of accounts is a tabular record in which business activities are analyzed in terms of debits and credits and recorded in chronological order. Answer: False Rationale: The chart of accounts lists the titles and numbers of all accounts found in the general ledger. Topic: Chart of accounts LO: 1 4. The chart of accounts is also known as the book of original entry. Answer: False Rationale: The general journal is also known as the book of original entry. Topic: Posting LO: 1 5. The process of transferring debit and credit entries from the journal to their related general ledger accounts is called “posting.” Answer: True Rationale: Posting results when debits and credits are entered into the general ledger from the journal.

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Topic: Accrued expense LO: 2 6. An accrued expense is one that has been incurred but not yet paid. Answer: True Rationale: An expense is accrued when it becomes owed if it has not yet been paid. Topic: Adjusted trial balance LO: 2 7. An adjusted trial balance is a listing of all the year-end balance sheet accounts, since all the income statement accounts have been closed to zero. Answer: False Rationale: The adjusted trial balance lists all general ledger accounts after adjustments have been posted. It contains much of the data needed to construct the financial statements, including the income statement. Topic: Deferred revenue LO: 2 8. Deferred revenue and unearned revenue both refer to cash that has been received but not yet earned. Answer: True Rationale: Both unearned revenue and deferred revenue refer to fees received before services are performed to earn those fees. Topic: Prepaid asset LO: 2 9. Prepaid rent is an example of a contra account, and is used to record a reduction to its related account, rent expense. Answer: False Rationale: Prepaid rent is an asset account reflecting the benefit owed the company from paying cash in advance for rent. Rent expense is used to accumulate costs associated with using property rented from others. Topic: Unadjusted trial balance LO: 2 10. The purpose of an unadjusted trial balance is to be sure the general ledger is in balance. Answer: True Rationale: The primary purpose of the unadjusted trial balance is to ensure the general ledger is in balance before management posts adjusting entries.

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Topic: Adjusting entries LO: 2 11. Adjusting entries always impact the income statement and the cash account. Answer: False Rationale: Adjusting entries affect a balance sheet account and an income statement account, but never the cash account. Topic: Preparing financial statements LO: 5 12. The income statement, statement of stockholders’ equity, and statement of cash flows report on time periods that depict flows. Answer: True Rationale: Specific periods of time are reported on all financial statements, except the balance sheet. They depict changes or flows in levels over a period of time. Topic: Temporary accounts LO: 4 13. All accounts in the general ledger are closed at a company’s fiscal year end in order to facilitate preparation of the financial statements and to ready the accounts for the activities of the next year. Answer: False Rationale: Only temporary accounts (revenue, expense and dividends) are closed at the end of the period. Balance sheet accounts, also known as permanent accounts, are not closed as the balances are carried over to the next accounting period. Topic: Asset book value LO: 2 14. The book value of a building is equivalent to its historical cost. Answer: False Rationale: A building’s book value is its historical cost minus the accumulated depreciation associated with the building. Topic: Adjusting unearned revenues LO: 2 15. Adjusting unearned revenues causes a liability to decline. Answer: True Rationale: The adjustment of unearned revenues reduces Unearned Revenue, a liability, and increases Service Revenue or Sales.

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Multiple Choice

Topic: Accounting cycle LO: 1 1. Which of the following is the correct order of the steps in the accounting cycle? A) B) C) D)

Adjust, report, analyze, record, and close Record, report, analyze, adjust, and close Report, analyze, close, record, and adjust Analyze, record, adjust, report, and close

Answer: D Rationale: The steps in the cycle are to first analyze the transaction, the record it, then make any necessary adjustments, report the results, and finally to close the temporary accounts to ready them for the next period’s activity. Topic: Fiscal year LO: 1 2. A company’s fiscal year may: A) B) C) D)

Be any portion of a year including a month or quarter Be for a period either greater or less than 12 months Be the same as the calendar year All of the above are true of a company’s fiscal year

Answer: C Rationale: A company’s fiscal year must be a complete year, may not be for a period greater or less than 12 months, and may be the same as the calendar year. Topic: Recording transactions LO: 2 3. Which of the following journal entries will record the payment of a $1,500 salaries payable originally incurred for Salaries Expense? A) B) C) D)

Debit Salaries Payable; credit Cash Debit Salaries Expense; credit Cash Debit Salaries Expense; credit Salaries Payable Debit Cash; credit Salaries Payable

Answer: A Rationale: The original entry was: Salaries Expense Salaries payable

1,500 1,500

The entry to record the payment of cash reduces the liability and reduces cash. Salaries payable Cash

1,500 1,500

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Topic: Recording Transactions LO: 2 4. A company bills customers for services rendered on account. Which of the following is one part of recording this transaction? A) B) C) D)

Debit Service Revenue Credit Cash Debit Accounts Receivable Credit Unearned Revenue

Answer: C Rationale: The journal entry includes a debit to Accounts Receivable and a credit to Service Revenue. Topic: Adjusting entries LO: 3 5. Which one of the following is not a reason for which adjusting entries are made? A) B) C) D)

To close the income statement accounts and ready them for the following year’s activity To allocate used or expired assets to reflect expenses incurred in the period To allocate the earned portion of unearned revenue to reflect revenues earned during the period To accrue expenses to reflect expenses incurred in the period that are not yet paid or recorded

Answer: A Rationale: Adjusting entries are made for all the reasons above except to close out the accounts. Answer A describes closing entries.

Use the following information to answer questions 6, 7, and 8: On the last day of December 2024, Brickhouse Trucks entered into a transaction that resulted in a receipt of $300,000 cash in advance related to services that will be provided during January 2025. During December of 2024, the company also performed $165,000 of services which were neither billed nor paid. Prior to December adjustments and before these two transactions were recorded, the company’s trial balance showed service revenue of $1,425,790 at December 31, 2024. There are no other prepaid services yet to be delivered, and during the month all outstanding accounts receivable from prior months were collected. Topic: Adjusting entries LO: 3, 4 6. If Brickhouse Trucks makes the appropriate adjusting entry, how much service revenue will be reflected on the December 31, 2024 income statement? A) B) C) D)

$1,590,790 $1,425,790 $1,725,790 $1,890,790

Answer: A Rationale: Service revenue = $1,425,790 + $165,000 = $1,590,790

. Test Bank, Chapter 3

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Topic: Adjusting entries LO: 3, 4 7. If Brickhouse Trucks makes the appropriate adjusting entry, how much will be reported on the December 31, 2024 balance sheet as unearned revenue? A) B) C) D)

$465,000 $135,000 $300,000 $165,000

Answer: C Rationale: Unearned revenue represents the amount collected in advance that the company has not yet earned. Topic: Adjusting entries LO: 3, 4 8. If Brickhouse Trucks makes the appropriate adjusting entry, how much will be reported on the December 31, 2024 balance sheet as accounts receivable? A) B) C) D)

$165,000 $465,000 $300,000 $135,000

Answer: A Rationale: Outstanding receivables are the amount earned but not yet received from customers.

Use the following information to answer questions 9 and 10: On May 1, 2024, Maple Corp. paid $432,000 for rent on warehouse space one year in advance. On November 1, 2024, Maple Corp. entered into a lease agreement to rent out its old warehouse space it was no longer using. This agreement calls for Maple to receive $10,000 per month from the lessee, due and payable at the end of the 5-month lease term. At December 31, 2024, none of the rental payments from the lessee had yet been received. Topic: Adjusting entries LO: 3, 4 9. If Maple makes the appropriate adjusting entry, how much will be reported on the December 31, 2024 income statement for rent expense? A) B) C) D)

$288,000 $268,000 $144,000 $432,000

Answer: A Rationale: Rent expense = $432,000 × 8/12 = $288,000

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Topic: Adjusting entries LO: 3, 4 10. If Maple makes the appropriate adjusting entry, how much will be reported on the December 31, 2024 balance sheet as prepaid rent and rent receivable, respectively? A) B) C) D)

$288,000 and $20,000 $144,000 and $20,000 $432,000 and $50,000 $144,000 and $30,000

Answer: B Rationale: Prepaid rent remaining = $432,000 × 4/12 = $144,000 Rent receivable = $10,000 × 2 = $20,000 Topic: Deferral LO: 3 11. Which of the following is a distinguishing characteristic of a deferral? A) B) C) D)

It affects at least one liability account. It always impacts the cash account. It includes the adjustment of an amount previously recorded in a balance sheet account. It increases a balance sheet account and decreases an income statement account.

Answer: C Rationale: A deferral adjusts an amount previously recorded in a balance sheet account. Topic: Accruals LO: 3 12. A company provides services to clients during the period that are neither paid for, nor billed to the clients. What must the company do? A) B) C) D)

Bill the client prior to year-end in order to recognize the revenue. Record the revenues as a liability at the end of the year. Accrue revenue by making an adjusting entry at the end of the period. All of the above are true.

Answer: C Rationale: Services earned but not yet billed or collected require an accrual to recognize the revenue and the account receivable at the end of the period. The bill does not have to be sent prior to yearend and there is no liability at year end since money is owed to the company.

. Test Bank, Chapter 3

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Topic: Statement of stockholders’ equity LO: 4 13. Which statement is true of the statement of stockholders’ equity? A) B) C) D)

It reports a company’s assets, liabilities, and equities. It reports a company’s revenue and expenses for a period. It is prepared using the unadjusted trial balance in order to facilitate the closing process. It shows a company’s stock issuances and dividends paid to shareholders.

Answer: D Rationale: The balance sheet is described in “A,” the income statement in “B,” and “C” applies primarily to the income statement. Answer “D” is the best choice as it shows changes in all equity accounts. Topic: Closing entries LO: 5 14. Zhang Corporation has the following account balances in its general ledger at the end of a period: Service revenue Utilities expense

$ 1,650,000 200,000

Which of the following gives the correct entry required to close the accounts above? A) Utilities Expense Retained Earnings Service Revenue

200,000 1,450,000

B) Service Revenue Utilities Expense Retained Earnings

1,650,000 200,000

C) Retained Earnings Utilities Expense Service Revenue

1,850,000

D) Service Revenue Utilities Expense Retained Earnings

1,650,000

1,850,000

200,000 1,650,000 200,000 1,450,000

Answer: D Rationale: The closing process requires that revenue accounts are debited and retained earnings are credited for the amount equal to the revenue balance. The closing process also requires that expense accounts are credited and retained earnings debited for an amount equal to the expense balance. The net amount of retained earnings credited in this problem is equal to $1,450,000 (or $1,650,000 – $200,000), since revenues are greater than expenses.

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Use the following information to answer questions 15, 16, and 17: Russel’s Croissants has 10 employees who are paid $20 per hour. The company purchases its inventory, on account, daily. At December 31, 2024, each of Russel’s Croissants’ employees had worked 15 hours which had not been paid or recorded. Also on this date, the company had taken receipt of $80,400 of inventory from its suppliers which had not been recorded in the accounts. As of the beginning of 2024, the company had equipment totaling $2,650,000 which was depreciated at $265,000 per year. Prior to adjustments, the company’s trial balance showed $310,550 in the wage expense account and $110,375 of inventory. Topic: Adjusting entries LO: 3, 4 15. If Russel’s Croissants makes the appropriate adjusting entry, how much will be reported on the December 31, 2024 income statement as wage expense? A) B) C) D)

$310,550 $575,550 $313,550 $578,550

Answer: C Rationale: Wage expense = 15 hours x 10 employees x $20 = $3,000 + $310,550= $313,550 Topic: Adjusting entries LO: 3, 4 16. If Russel’s Croissants makes the appropriate adjusting entry, how much will be reported on the December 31, 2024 balance sheet as inventory? A) B) C) D)

$190,775 $110,375 $345,400 $ 80,400

Answer: A Rationale: $110,375 + $80,400 = $190,775 Topic: Adjusting entries LO: 3, 4 17. If Russel’s Croissants makes the appropriate adjusting entry, which of the following is one part of the journal entry that will be made when the payment of wages is made in January? A) B) C) D)

Credit Wages Expense for $2,000 Debit Wages Payable for $3,000 Credit Wages Payable for $310,550 Debit Cash for $3,000

Answer: B Rationale: The entry will debit Wages Payable for $3,000 and credit cash for the same amount.

. Test Bank, Chapter 3

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Topic: Post-closing trial balance LO: 5 18. Which one of the following will never appear on a post-closing trial balance? A) B) C) D)

Unearned revenue Retained earnings Rent expense Common stock

Answer: C Rationale: All temporary accounts (revenues and expenses) have zero balance after closing, so only balance sheet accounts appear on the post-closing trial balance. Topic: Financial statement flows LO: 6 19. What is a ‘flow’ as it relates to financial statements? A) B) C) D)

An amount that varies over time A change in a level over a period of time An amount depicted on the balance sheet A balance at the end of the period that appears on the income statement

Answer: B Rationale: The income statement portrays changes in balance sheet levels over time. Topic: Adjusting for depreciation LO: 3 20. When adjusting for depreciation, which of the following is one effect of the adjustment? A) B) C) D)

Accumulated depreciation is debited. The asset’s book value declines. The cost of the equipment declines. The market value of the equipment declines.

Answer: B Rationale: The adjusting entry creates a credit to accumulated depreciation and a debit to depreciation expense. The credit causes the book value to decline because it increases the contra account that is shown as a deduction from the cost of the equipment on the balance sheet.

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Exercises Topic: Adjusting unearned revenue LO: 3 1. Purvis Company received an advance payment of $160,000 for a consulting contract during the year. The balance in the Unearned Consulting Fees account at the beginning of the year was $15,000. At the end of the year, $18,000 was still unearned. Required: a. Create T-accounts for the accounts involved in the adjusting entry needed at year end, and post all amounts to them, including the adjusting entry necessary, and calculate the account balances. b. How much will Purvis report as Consulting Revenue on its income statement for the year? Answer: a. Unearned Consulting Revenue 157,000

Consulting Revenue

15,000 160,000 18,000

157,000 157,000

b. Purvis will report $157,000 consulting revenue for the year.

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Topic: Journal and adjusting entries LO: 2, 3 2. Below are several accounts from Matilda Company’s accounting records. Columns representing the accounting equation appear to the right of each transaction listed below. Next to each transaction in the column of the respective account classification, write the 1) name of each account, 2) the dollar amount by which each account increases or decreases, and 3) either debit or credit to indicate the effect on the account, for each of the adjustments necessary at the end of April 2024. The company records adjustments monthly. Assets

Liabilities

Equity

Revenues

Expenses

a. Provided services to customers in the amount of $25,000. Customers will pay next month b. Recognized equipment depreciation of $3,500 for the current month c. Provided services totaling $10,000 to customers that had paid for services in advance. d. Recognized April’s insurance cost. On February 1, the company had paid $32,000 for 5 months coverage from February 1 to June 30. e. Recognized interest owed on a loan payable for $250. f. Recognized supplies used during the month. At the beginning of the month, the total of supplies on hand was $4,000, while $4,200 of supplies were left at the end of the month. During the month, $30,000 of additional supplies were purchased. g. Accrued wages earned by employees for the last 4 days of the month. Employees work 5 days per week and the weekly wages total $40,000.

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Answer: Assets a. Provided services to customers in the amount of $25,000. Customers will pay next month

Accounts Receivable Debit $25,000

b. Recognized equipment depreciation of $3,500 for the current month

Accumulated Depreciation Credit 3,500

g. Accrued wages earned by employees for the last 4 days of the month. Employees work 5 days per week and the weekly wages total $40,000.

Revenues

Expenses

Service Revenue Credit $25,000 Depreciation Expense Debit $3,500 Service Revenue Credit $10,000

Prepaid Insurance Credit $6,400

Insurance Expense Debit $6,400

Interest Payable Credit $250

e. Recognized interest owed on a loan payable for $250. f. Recognized supplies used during the month. At the beginning of the month, the total of supplies on hand was $4,000, while $4,200 of supplies were left at the end of the month. During the month, $30,000 of additional supplies were purchased.

Equity

Unearned Service Revenue Debit $10,000

c. Provided services totaling $10,000 to customers that had paid for services in advance. d. Recognized April’s insurance cost. On February 1, the company had paid $32,000 for 5 months coverage from February 1 to June 30.

Liabilities

Interest Expense Debit $250

Supplies Credit $29,800

Supplies Expense Debit $29,800

$4,000 + $30,000 $4,200 = $29,800

Wages Payable Credit $32,000

Wages Expense Debit $32,000

$40,000 × 4/5 = $32,000

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Topic: Asset prepayments LO: 3 3. Stanton Corporation took out a 3-year insurance policy and paid a $334,800 premium for coverage beginning on June 1, 2024. Fill the missing parts of the statements below: Prepaid Insurance on the Balance Sheet Accrual Basis

Insurance Expense

Cash Basis

Accrual Basis

Cash Basis

Dec. 31, 2024 .............................

2024 ...........................................

Dec. 31, 2025 .............................

2025 ...........................................

Dec. 31, 2026 .............................

2026 ...........................................

Dec. 31, 2027 .............................

2027 ........................................... Total ...........................................

Answer: Monthly cost = $334,800 / 36 = $9,300 Balance Sheet Accrual Basis

Insurance Expense

Cash Basis

Accrual Basis

Cash Basis

Dec. 31, 2024 ............................. $269,700

$ 0

2024 ........................................... $ 65,100

$334,800

Dec. 31, 2025 ............................. 158,100

2025 ........................................... 111,600

Dec. 31, 2026 ............................. 46,500

2026 ........................................... 111,600

Dec. 31, 2027 ............................. 0

2027 ........................................... 46,500 Total ........................................... $334,800

0 $334,800

Topic: Preparing a statement of stockholders’ equity after closing LO: 4 4. Gretchen’s Cleaning provides janitorial services for commercial customers. On December 31, 2023, the credit balance of the Common Stock and Retained Earnings accounts were $56,000 and $27,000, respectively. During 2024, the company issued $5,200 of stock, and paid $3,000 in dividends. The income statement reported a profit of $10,800. Prepare a 2024 statement of stockholders’ equity for Gretchen’s Cleaning. Answer: Gretchen’s Cleaning Statement of Stockholders’ Equity For Year Ended December 31, 2024 Common Retained Stock Earnings Balance at December 31, 2023 ........................... $56,000 Stock issuance .................................................. 5,200 Dividends .......................................................... Net income ........................................................ ______ Balance at December 31, 2024 ........................... $61,200

$27,000 (3,000) 10,800 $34,800

. 3-15

Total Stockholders’ Equity $83,000 5,200 (3,000) 10,800 $96,000

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Topic: Journalizing transactions and adjusting accounts LO: 2, 3 5. Waterworld offers pool and spa cleaning services to hotels and residential customers. Commercial (hotels) customers pay on a monthly contract basis, while residential customers pay an hourly rate based on services provided. In July 2024, Waterworld signed a 6-month contract with Resorts Unlimited to provide pool and spa cleaning services for its hotel sites. The contract price of $210,000 was collected on July 1, 2024. The services will be provided evenly over the 6 months. During July 2024, Waterworld also provided 100 hours of residential pool services at $65 per hour. Payment is expected in August. a.

Prepare the entry on July 1, 2024 to record the receipt of $210,000 cash related to the contract with Resorts Unlimited (1) using the financial statements effect template and (2) in journal entry form. Prepare the adjusting entry to be made on July 31, 2024 for the contract work performed for Resorts Unlimited during the month (1) using the financial statements effect template and (2) in journal entry form. Prepare the adjusting entry needed on July 31, 2024 to reflect the residential pool services performed during the month (1) using the financial statements effect template and (2) in journal entry form.

Answer: a. Balance Sheet Transaction Received $ 210,000 in advance for contract work

July 1

Cash Noncash + Asset Assets + 210,000 Cash

= Liabilities

Income Statement Contrib. + + Capital

Earned Capital

Revenues

+ 210,000 Unearned = Service Fees

Expenses

Cash

Net Income

210,000

Unearned Service Fees To record cash received in advance

210,000

b. Balance Sheet Transaction

Cash Asset

Noncash Assets

Adjusting entry for services provided in July

July 31

= Liabilities

Income Statement +

Contrib. + Capital

Earned Capital +35,000 Retained Earnings

- 35,000 Unearned Service Fees

Revenues

+ 35,000 Service Fees Revenue

Expenses

Net Income + 35,000

Unearned Service Fees 35,000 Service Fees Revenue 35,000 To reflect July service fees earned on contract ($210,000/6 = $35,000)

c. Transaction Adjusting entry for fees earned but not paid

July 31

Cash Asset

Noncash + Assets +6,500 Accounts Receivable

Balance Sheet Liabil= + ities

Income Statement Contrib. + Capital

Earned Capital +6,500 Retained Earnings

Revenues

+6,500 Service Fees Revenue

Expenses

Net Income + 6,500

Accounts Receivable 6,500 Service Fees Revenue 6,500 To record unbilled service fees earned at July 31, 2024: 100 hours x $ 65/hr. .

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Use the following adjusted trial balance for Riverwalk Corporation to answer Exercises 6, 7, 8, and 9. Riverwalk Corporation Adjusted Trial Balance For the Year Ending December 31, 2024 Debit $ 57,000 72,000 490,000

Cash Accounts receivable Equipment Accumulated depreciation Loan payable Common stock Retained earnings Sales revenue Utilities expense Salaries expense Depreciation expense Totals

Credit

15,000 405,500 20,000 $1,059,500

85,000 145,000 250,000 119,500 460,000

0 $1,059,500

Topic: Preparing an income statement LO: 4 6. Use Riverwalk’s adjusted trial balance to prepare the company’s income statement. Answer: Riverwalk Corporation Income Statement For Year Ended December 31, 2024 Sales revenue Utilities expense Salaries expense Depreciation expense Net income

$460,000 15,000 405,500 20,000 $19,500

Topic: Preparing the statement of stockholders’ equity LO: 4 7. Use Riverwalk’s adjusted trial balance to prepare Riverwalk’s statement of stockholders’ equity for 2024. There were no stock issuances or repurchases during 2024. Answer: Riverwalk Corporation Statement of Stockholders’ Equity For Year Ended December 31, 2024

Balance at December 31, 2023 Net income Balance at December 31, 2024

Common Stock $250,000 _______ $250,000

Retained Earnings $ 119,500 19,500 $139,000

. 3-17

Total Stockholders Equity $369,500 19,500 $389,000

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Topic: Preparing a balance sheet LO: 4 8. Use Riverwalk’s adjusted trial balance above to prepare Riverwalk’s balance sheet for the current year-end. Answer: Riverwalk Corporation Balance Sheet December 31, 2024 $ 57,000 Loan payable 72,000 Total liabilities 490,000 (85,000) Common stock Retained earnings $ 534,000 Total liabilities and equity

Cash Accounts receivable Equipment Accumulated depreciation Total assets

$ 145,000 145,000 250,000 139,000 $ 534,000

Topic: Closing temporary accounts LO: 5 9. Use Riverwalk’s adjusted trial balance to prepare entries to close Riverwalk’s temporary accounts in journal entry form. Answer: 1. Sales revenue Retained earnings

460,000

440,500

460,000

Retained earnings Utilities expense Salaries expense Depreciation expense

15,000 405,500 20,000

Topic: Analyzing transactions with T-accounts LO: 2, 4 10. Use the T-account below, to answer the following questions. 1/1

Accounts Receivable (A) 160,000

5/1

1,420,000

12/31

1,480,000

7/1

A. What journal entry is most likely represented by $ 1,420,000 in the T-account? What business event caused this? B. What journal entry is most likely represented by the $1,480,000 in the T-account? What business event caused this? C. What is the balance of Accounts Receivable on December 31?

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Answer: A. 5/1 Accounts receivable 1,420,000 Sales revenue 1,420,000 The company sold merchandise (or services) on account. B. 7/1

Cash

1,480,000 Accounts receivable The company collected cash from customers.

1,480,000

C. 160,000 + $ 1,420,000 – $1,480,000 = $ 100,000 Topic: Inferring transactions LO: 2, 4 11. Kara’s Kitchen sells meal kits to consumers. During 2024, the company purchased inventory on account at a cost of $18,960,000. The following T-accounts reflect information contained in the company’s 2024 and 2023 balance sheets. Accounts Payable 375,000

2023 Bal.

…

Merchandise Inventories 2023 Bal. 945,000 2024 Bal. 962,000

388,000

2024 Bal.

A. Prepare the journal entry, using the financial statement effects template and in journal entry form, to record Kara’s Kitchen’s purchases during 2024. B. How much will Kara’s Kitchen report at December 31, 2024 on its balance sheet for inventory? For Accounts Payable? C. How much will Kara’s Kitchen report for the year ending December 31, 2024 on its income statement as Cost of Goods Sold? Answer: A. Income Statement

Balance Sheet Transaction Purchase of inventory on account

Cash Asset

Noncash Assets + 18,960,000 Merch. inventory

Liabilities

Contrib. + Capital

Earned Capital

+ 18,960,000 = Accounts Payable

Revenues -

Expenses

Merchandise inventory (+A) .........................................................................18,960,000 Accounts payable (+L) ............................................................................ To recognize the purchase of merchandise inventory on account.

Net Income

18,960,000

B. Amount reported as Inventory = $962,000 Amount reported as Accounts Payable = $388,000 C. Amount reported as Cost of Goods Sold = $945,000 + $18,960,000 ‒ $962,000 = $18,943,000

. 3-19

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Topic: Inferring transactions from financial statements LO: 2, 4 12. Kara’s Kitchen sells meal kits to consumers. During 2024, the company purchased inventory on account at a cost of $18,960,000. The following T-accounts reflect information contained in the company’s 2024 and 2023 balance sheets. Accounts Payable 375,000

2023 Bal.

…

Merchandise Inventories 2023 Bal. 945,000 2024 Bal. 962,000

388,000

2024 Bal.

A. What amount did Kara’s Kitchen pay in cash to its suppliers during 2024? B. What amount will Kara’s Kitchen report as Accounts Payable on its balance sheet at December 31, 2024? Answer: A. $375,000 + $18,960,000 ‒ $388,000= $18,947,000 B. $388,000

Topic: Preparing entries across two periods LO: 2, 4, 5 13. Digital Intelligence Company closes its accounts on December 31 each year. On December 31, 2024, Digital Intelligence Company accrued interest income totaling $400 that was earned on a $50,000 investment but not yet received or recorded (the investment will pay interest of $690 cash on March 31, 2025). On March 31, 2025, the company received the $690 cash as interest on the investment. Prepare journal entries to: A. Accrue the interest earned on December 31, 2024. B. Close the Interest Income account on December 31, 2024 (the account has a year-end balance of $3,500 after adjustments). C. Record the cash receipt of interest on March 31, 2025. Answer: A. Dec. 31 Interest receivable Interest income To record accrued interest income

400 400

B. Dec. 31 Interest income Retained earnings To close the Interest Income account

3,500 3,500

C. Mar. 31 Cash Interest income Interest receivable To record cash receipt of interest

690 290 400

. Test Bank, Chapter 3

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Topic: Recording transactions and adjusting accounts LO: 2, 3, 14. On January 18, 2024, Honey Dew Co. paid $450,000 for a three-year insurance policy that covers February 1, 2024 through January 31, 2027. Honey Dew’s year end is June 30, 2024. A. What entry is made on January 18, 2024? B. What adjusting entry should be made on June 30, 2024 before the financial statements are prepared for the year ending June 30, 2024? Answer: A. Prepaid insurance Cash

450,000 450,000

B. Insurance expense 62,500 Prepaid insurance 62,500 ($450,000 / 36 months = $12,500 per month $12,500 × 5 months = $62,500 for February through June) Topic: Recording transactions and adjusting accounts LO: 2, 3, 4 15. On July 1, 2024, the first month of the fiscal year, the Gift Certificates account had a credit balance of $16,000. During July, customers purchased an added $90,000 worth of gift certificates. As of July 31, 2024, $15,000 of certificates were unredeemed. A. How will the adjustment for gift certificates redeemed affect the income statement for the month ending July 31, 2024? B. How will the adjustment for gift certificates redeemed affect the balance sheet prepared at July 31, 2024? Answer: A. Gift certificates redeemed (and related recognition of revenue earned) for the period = $16,000 + $90,000 ‒ $15,000= $91,000 This adjustment increases revenue and net income by $91,000. B. The adjustment reduces the Gift Certificates account (Unearned Revenue) to its July 31 balance of $15,000.

. 3-21

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Topic: Recording transactions and adjusting accounts LO: 2, 3 16. The publisher of Media Monthly, a monthly magazine, received $75,000 for two-year subscriptions on January 1, 2024. A. What entry would be made to record the cash receipt on January 1, 2024? B. What entry should be made before the financial statements are prepared for the month ending January 31, 2024? Answer: A. Jan.1

Cash

75,000 Unearned subscription revenue

75,000

B. Jan.31

Unearned subscription revenue Subscription revenue ($75,000/24 months = $3,125 per month)

3,125 3,125

Topic: Recording transactions and adjusting accounts LO: 1, 2, 3 17. Gamble Industries pays employees each Friday for the five day work-week ending on that day. Ignoring taxes and other withholdings, the company’s normal gross weekly payroll is $46,500. If the last Friday of the month falls on March 26, what adjusting entry should be made on March 31, the fiscal year end? Answer: Jan. 31 Wages expense Wages payable

27,900 27,900

Friday is March 26 and the next workday is Monday, March 29. The company will accrue Monday, March 29, through Wednesday, March 31, or 3 days. $46,500 × 3/5 = $27,900 Topic: Recording transactions and adjusting accounts LO: 2, 3, 4 18. Gamble Industries earns 4% annual interest on its $93,000 of investments. Interest is paid every six months on June 30 and December 31. A. If monthly financial statements are prepared, what adjusting entry should be made on March 31? B. What effect on the March 31 balance sheet does the adjusting entry have? Answer: A. Interest receivable Interest revenue $93,000 × 4% × 1/12 = $ 310

310 310

B. Interest receivable, an asset, is increased by $310.

. Test Bank, Chapter 3

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Problems Topic: Inferring transactions from financial statements LO: 2, 4 1. Giga Lab operates a kiosk in a local mall selling cell phones and other equipment. During 2024, the company purchased $172,000 of inventory, all on account. The following T-accounts reflect information contained in the company’s 2024 and 2023 balance sheets. Accounts Payable (L) 16,000 2023 Bal.

…

Merchandise Inventories (A) 2023 Bal. 43,000 2024 Bal.

38,700

20,800

2024 Bal.

A. Prepare the journal entry, using the financial statement effects template and in journal entry form, to record Giga Lab’s purchases during 2024. B. How much will Giga Lab report at December 31, 2024 on its balance sheet for Inventory? For Accounts Payable? C. If Giga Lab pays $5,000 of the amounts due for inventory on January 4, 2025, how much will the liability be on that date immediately after payment? D. How much will Giga Lab report for the year ending December 31, 2024 on its income statement as Cost of Goods Sold? Answer: A. Income Statement

Balance Sheet Transaction Purchase of inventory on account

Cash Asset

Noncash Assets

= Liabilities

Contrib. + Capital

Earned Revenues Capital

+ 172,000 + 172,000 Merchandise = Accounts inventory Payable

Expenses

‒

Merchandise inventory ............................................................................172,000 Accounts payable ................................................................ To recognize the purchase of merchandise inventory on account

Net Income

172,000

B. Amount reported as Inventory = $38,700 Amount reported as Accounts Payable = $20,800 C. Accounts payable due = $20,800 – $5,000 = $15,800 D. Amount reported as Cost of Goods Sold = $43,000 + $172,000 ‒ $38,700 = $176,300

. 3-23

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Topic: Adjusting entries LO: 3 2. Alpine Bakery had the following separate situations occur during 2024. The company’s accountant is preparing the annual financial statements at December 31, 2024 and has asked you to prepare the adjusting entries for each situation using the financial statement effects template. a.

On August 1, 2024, Alpine paid the annual lease amount on its warehouse space. The annual lease is $42,000 and was recorded by debiting Prepaid Rent and crediting Cash. No adjusting entries have been prepared since August 1, 2024.

The Unearned Revenue account has an unadjusted balance of $5,500 consisting of gift cards sold to customers. Redeemed gift cards that have not yet been recorded total $3,700.

The company has not yet received a bill or paid for utilities for the month of December. The expense is estimated to be $4,920

On December 1, 2024, Alpine received $1,200 cash from a customer related to a special order. The special order was delivered to the customer on December 29 but no entry has been made to record the delivery.

At December 31, 2024, employee wages of $11,600 have been incurred but not paid or recorded.

At December 31, 2024, $2,255 of interest on loans has been incurred, but not yet paid or recorded. Unrecorded depreciation on equipment is $15,900.

Answer: a. Rent expense = $42,000 × 5/12 = $ 17,500 Balance Sheet Transaction

a. Adjusting entry for rent expense

Cash + Asset

Noncash Assets - 17,500 Prepaid Rent

b. Adjusting entry for gift cards redeemed

Earned Capital -17,500 Retained Earnings

-3,700 Unearned = Revenue

+3,700 Retained Earnings

+ 4,920 Utilities Payable

- 4,920 Retained Earnings

-1,200 Unearned = Revenue

+1,200 Retained Earnings

+11,600 Wages Payable

- 11,600 Retained Earnings

+2,255 Interest Payable

= Liabilities

c. Adjusting entry for utilities expense

d. Adjusting entry for unearned revenues

e. Adjusting entry for wage expense

f. Adjusting entry for interest incurred

g. Adjusting entry for depreciation

-15,900 Accum. Deprec.

Income Statement Contrib. + + Capital

Revenues -

Expenses

+ 17,500 Rent Expense

+3,700 Sales Revenue

+3,700 -

+1,200 Sales Revenue

Net Income - 17,500

= + 4,920 Utilities Expense

- 4,920 = + 1,200

+11,600 Wage Expense

- 11,600

-2,255 Retained Earnings

+ 2,255 Interest Expense

-15,900 Retained Earnings

+ 15,900 - 15,900 - Depreciation = Expense

= - 2,255 =

. Test Bank, Chapter 3

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Topic: Adjusting entries LO: 3 3. Alpine Bakery had the following separate situations occur during 2024. The company’s accountant is preparing the annual financial statements at December 31, 2024 and has asked you to prepare the adjusting entries for each situation using the financial statement effects template. a.

The Unearned Revenue account has an unadjusted balance of $5,500 consisting of gift cards sold to customers. Redeemed gift cards that have not yet been recorded total $3,700.

The company has not yet received a bill or paid for utilities for the month of December. The expense is estimated to be $4,920

At December 31, 2024, employee wages of $11,600 have been incurred but not paid or recorded.

At December 31, 2024, $2,255 of interest on loans has been incurred, but not yet paid or recorded. Unrecorded depreciation on equipment is $15,900.

Answer: a. Rent expense Prepaid rent……………………………………………………………….. To record rent expense for the period ($42,000× 5/12 = $17,500)

17,500 17,500

b. Unearned revenue Sales revenue To record redeemed gift cards.

3,700

4,920

3,700

Utilities expense Utilities payable To record accrued utilities expense

4,920

d. Unearned revenue Sales revenue To record revenue earned.

1,200

e. Wage expense Wages payable To record accrued wages at the end of the year

11,600

2,255

1,200

Interest expense Interest payable To record accrued interest at the end of the period.

g. Depreciation expense-equipment Accumulated depreciation-equipment To record depreciation for the period.

. 3-25

11,600

2,255 15,900 15,900

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Topic: Financial analysis using adjusted data LO: 4 4. Selected T-account balances for Busy Corp. are shown below as of January 31, 2024. Adjusting entries have already been posted. The firm uses a calendar-year accounting period but prepares monthly adjustments. + Supplies (A) 3,750

Jan 31 Bal.

+ Supplies Expense (E) Jan 31 Bal. 15,900

+ Prepaid Insurance(A) 7,840

+ Insurance Expense (E) Jan 31 Bal. 980

- Wages Payable (L) + 3,800 Jan 31 Bal.

+ Wage Expense (E) Jan 31 Bal. 102,500

+ Truck (A) -

+ Accumulated Depreciation - Truck (XA) 24,750 Jan 31 Bal.

Jan 31 Bal. 118,800

A. During January, $17,600 worth of supplies were purchased. If the amount in Supplies Expense represents the January 31 adjustment for the supplies used in January, what was the January 1 beginning balance of Supplies? B. The insurance policy purchased was valid for one year. The amount in the Insurance Expense account represents the adjustment made at January 31 for January insurance expense. What was the amount of the initial annual premium and on what date did the insurance policy start? C. No beginning balance existed in Wages Payable or Wage Expense on January 1. How much cash was paid as wages during January? D. The truck has a useful life of six years. What is the monthly amount of depreciation expense and how many months has Busy Corp. owned the truck? Answer: A. Balance, January 1 = $3,750 ‒ $17,600 + $15,900= $2,050 B. Amount of premium = $ 980  12 = $11,760. Therefore, four months' premium ($11,760 − $7,840 = $3,920 / $980 = 4 months) has expired by January 31. The policy term began on October 1 of the previous year. C. Wages paid in January = $102,500 − $3,800 = $98,700 D. Monthly depreciation expense = $118,800 / 72 months = $1,650 per month Busy Corp. has owned the truck for 15 months ($24,750/ $1,650= 15 months).

. Test Bank, Chapter 3

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Topic: Preparing closing entries and post-closing trial balance LO: 5 5. Primped Pets provides pet grooming and boarding services. At December 31, 2024, Primped Pets’ adjusted trial balance is as follows: Primped Pets Adjusted Trial Balance December 31, 2024 Cash Accounts receivable Prepaid insurance Equipment Accumulated depreciation Accounts payable Common stock Retained earnings, Jan. 1 Service fees earned Miscellaneous income Salaries expense Rent expense Insurance expense Depreciation expense Income tax expense Income tax payable

Debit 22,000 41,000 12,300 650,000

Credit

175,000 36,700 300,000 155,100 792,000 11,400

620,000 52,500 22,300 35,800 18,200 $1,474,100

3,900 $ 1,474,100

A. Prepare closing entries in journal entry form. B. After Primped Pets’ closing entries are posted, what is the balance in the Retained Earnings account? C. Prepare Primped Pets’ post-closing trial balance. Answer: A. Dec. 31

Service fees earned Miscellaneous income Retained earnings To close the revenue accounts Retained Earnings Salaries expense Rent expense Insurance expense Depreciation expense Income tax expense To close the expense accounts

Debit 792,000 11,400

Credit 803,400

748,800

. 3-27

620,000 52,500 22,300 35,800 18,200

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B. Retained Earnings = $155,100 + $803,400 - $748,800 = $209,700 C. Primped Pets Post-Closing Trial Balance December 31, 2024 Debit Cash $ 22,000 Accounts receivable 41,000 Prepaid insurance 12,300 Equipment 650,000 Accumulated depreciation Accounts payable Income tax payable Common stock Retained earnings _______ $ 725,300

Credit

$ 175,000 36,700 3,900 300,000 209,700 $ 725,300

Topic: Inferring transactions from financial statements LO: 2, 3, 4 6. Sandra’s is a national grocery chain. Selected balance sheet data follows (all balances are normal): Selected Balance Sheet Data in thousands

June 31, 2024

June 31, 2023

$ 172,481 110,685

$ 160,987 115,492

Inventories Accounts payable

A. During its year ending June 31, 2024, Sandra’s purchased on account, $3,551,723 thousand of inventory for sale in its stores. Prepare the entry, using the financial statement effects template and in journal entry form, to record cost of goods sold for the year ended June 31, 2024. B. What amount of cash did Sandra’s pay to its suppliers during its year ending June 31, 2024? Answer: A. Cost of goods sold = $160,987 + $3,551,723 ‒ $172,481 = $ 3,540,229 thousand

Transaction Recognize cost of goods sold

Cash Asset

Noncash Assets -3,540,229 Inventory

Balance Sheet LiabiContrib. = + + lities Capital =

Income Statement Earned Net Revenues - Expenses = Capital Income - 3,540,229 +3,540,229 - 3,540,229 Retained COGS = Earnings Expense

Cost of goods sold ...................................................................................... 3,540,229 Inventory ................................................................................................ To recognize the cost of goods sold

3,540,229

B. Beg AP + Purchases – End AP = Payments made $115,492 + $3,551,723 – Payments = $110,685 Payments = $3,556,530 thousand

. Test Bank, Chapter 3

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Topic: Preparing an Unadjusted Trial Balance and Adjustments LO: 3 7. Ember’s Grill, an upscale restaurant on the beach, has just completed its first full year of operations on December 31, 2024. Selected balances from its general ledger before year-end adjustments follow. All balances are normal. Cash Accounts receivable Prepaid advertising Supplies Equipment Notes payable

$ 86,000 65,000 12,600 9,100 200,000 52,000

Accounts payable Common stock Sales revenue Wages expense Rent expense Utilities expense

93,400 52,700 375,000 290,000 30,000 12,000

An analysis of the firm’s records reveals the following. 1. The balance in Prepaid Advertising represents the amount paid for newspaper advertising for one year. The agreement, which calls for the same amount of space each month, covers the period from March 1, 2024, to February 28, 2025. 2. Equipment purchased January 1, 2024, has an estimated life of eight years. 3. Utilities expense does not include the expense for December, estimated at $ 1,500. The bill will not arrive until January, 2025. 4. At year-end, employees have earned $9,600 in wages that will not be paid until January. 5. Supplies available at year-end amounted to $1,400. 6. At year-end, unpaid interest of $ 260 has accrued on the notes payable. 7. The firm’s lease calls for rent of $2,500 per month payable on the first of each month, plus an amount equal to 1% of annual sales. The rental percentage is payable within 15 days after the end of the year. Prepare adjusting entries in journal entry form.

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Answer: Dec

Debit Advertising expense 10,500 Prepaid advertising To record 10 months' advertising expense ($ 12,600  10/12 = $ 10,500) Depreciation expense Accumulated depreciation To record depreciation for the year ($ 200,000/8 years = $ 25,000).

25,000

Utilities expense Utilities payable To record estimated December utilities expense.

1,500

Wages expense Wages payable To record unpaid wages at December 31.

9,600

Supplies expense Supplies To record supplies expense for the year ($9,100 ‒ $ 1,400 = $ 7,700)

7,700

Credit 10,500

25,000

1,500

9,600

Interest expense Interest payable To record accrual of interest expense at December 31

7,700 260 260

Rent expense 3,750 Rent payable To record additional rent owed under lease (1%  $ 375,000 = $3,750)

3,750

. Test Bank, Chapter 3

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Essays Topic: Fiscal year-end LO: 1 1. Why would a company want to have a fiscal year-end that does not match the calendar year-end? Answer: A company might set a fiscal year-end that is different from its calendar year end to allow them to prepare closing accounting records that does not coincide with the busiest shopping season of the year or busiest production time. Thus the decision about a fiscal year may minimize workload compression and move it to the slowest part of the business year. As such, the fiscal year serves as a period of accounting cycle reference, with the decision allowing a better match for submission of accounting documents to regulatory agencies and inspection by auditors. Topic: Accounting cycle LO: 1 2. Do the steps in the accounting cycle occur with equal frequency? Why or why not? Answer: No, the steps in the accounting cycle do not occur with equal frequency because companies analyze and record daily transactions throughout the accounting period. However, they only adjust and report when management requires financial statements, often monthly or quarterly, but at least annually. The last step in the accounting cycle is closing, which only occurs once during the accounting cycle, at the period-end. Topic: Closing process LO: 5 3. What are the two major steps in the closing process? Why is the closing process necessary? Answer: The first step is to close revenues to retained earnings. The second step is to close expenses to retained earnings. The closing process has two purposes: 1) to transfer temporary balances to the permanent accounts and 2) to ready the accounts for the next accounting period.

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Chapter 4 Reporting and Analyzing Cash Flows Learning Objectives – Coverage by question True/False

Multiple Choice

Exercises

Problems

Essay Questions

LO4-1 Explain the purpose of the statement of cash flows and classify cash transactions by type of business activity: operating, investing, or financing. (p. 4-3)

1-8

1-10

1, 3, 4, 16

2-4

1, 3

LO4-2 Construct the operating section of the statement of cash flows using the direct method. (p. 4-7)

9-13

16-19, 23, 25

9, 10

LO4-3 Reconcile cash flows from operations to net income and use the indirect method to compute operating cash flows. (p. 4-17)

11-14, 20

5, 6, 11, 13-15

1, 3, 4

1, 3

12, 17-19

1-4

1, 3

LO4-4 Construct the investing and financing activities sections of the statement of cash flows. (p. 4-19) LO4-5 Examine the sale of investing assets and the disclosure of noncash activities. (p. 4-23) LO4-6 Compute and interpret ratios that reflect a company's liquidity and solvency using information reported in the statement of cash flows. (p. 4-29)

15, 24

21, 22

7,8

. 4-1

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LO4-7 Appendix 4A: Use a spreadsheet to construct the statement of cash flows. (p. 4-33)

. Test Bank, Chapter 4

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Chapter 4: Reporting and Analyzing Cash Flows

True/False Topic: Statement of cash flows LO: 1 1. The statement of cash flows encompasses a firm’s cash equivalents such as money market funds, in addition to cash. Answer: True Rationale: The statement of cash flows explains the changes in cash and cash equivalents. Cash equivalents include highly liquid investments easily convertible into a known cash amount that are close to maturity. Topic: Categories for the statement of cash flows LO: 1 2. The statement of cash flows separates cash flows into operating, nonoperating, and investing categories. Answer: False Rationale: The statement of cash flows includes operating activities, investing activities, and financing activities. Topic: Cash flow activities LO: 1 3. Cash received from the sale of one of a company’s warehouses is classified as a cash flow from investing activities in a statement of cash flows. Answer: True Rationale: If a company sold a warehouse and received cash, this would be classified as an inflow of cash from investing activities. Topic: Cash flow activities LO: 1 4. Cash paid as dividends to stockholders is classified as a cash flow from investing activities in a statement of cash flows. Answer: False Rationale: Dividends paid to stockholders are classified as a cash outflow from financing activities. Topic: Cash flow activities LO: 1 5. Cash received from customers for services rendered is classified as a cash flow from operating activities in a statement of cash flows. Answer: True Rationale: Cash received from customers for services is an operating activity inflow of cash.

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Topic: Cash flow activities LO: 1 6. Cash paid for interest on a loan is classified as a cash flow from financing activities in a statement of cash flows. Answer: False Rationale: Cash interest payments are included in operating activities. Topic: Cash flow activities LO: 1 7. Information about noncash investing and financing activities must be disclosed in a schedule that is separate from the statement of cash flows. Answer: True Rationale: Noncash investing and financing activities are disclosed in a separate schedule to the statement of cash flows. Topic: Cash flow activities LO: 1 8. Two different methods of determining and presenting the net cash flows from operating activities are the indirect method and the reconciliation method. Answer: False Rationale: The indirect method and the direct method are two ways to determine and present the statement of cash flows. The indirect method is most popular. Topic: Statement of cash flows – direct method LO: 2 9. The operating activities section of the statement of cash flows shows a reconciliation of net income to the net cash provided by operating activities amount under the direct method. Answer: False Rationale: The direct method does not reconcile net income to the net operating cash flow in the operating activities section. The indirect method begins with net income and removes noncash amounts to arrive at cash flows provided by operating activities. Topic: Statement of cash flows – direct method LO: 2 10. The direct method of presenting the net cash flow from operating activities shows the major categories of operating cash receipts and payments. Answer: True Rationale: When the direct method is used to present net cash flows, it shows the major categories of operating cash receipts and payments.

. Test Bank, Chapter 4

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Topic: Convert to cash calculations LO: 2 11. If accounts payable increase during an accounting period, then the cash paid for merchandise purchased is less than the merchandise purchases for the period. Answer: True Rationale: Cash paid for merchandise purchased is less than the merchandise purchases for the period when accounts payable have increased during the period. Topic: Convert to cash calculations LO: 2 12. If prepaid insurance decreases during an accounting period, then the cash paid for insurance is less than the period’s insurance expense. Answer: True Rationale: It is true that cash paid for insurance is less than the period’s insurance expense when prepaid insurance decreases during a period. Topic: Convert to cash calculations LO: 2 13. If accounts receivable increase during an accounting period, then the cash received from customers is more than the sales revenue for the period for payment on credit sales. Answer: False Rationale: If accounts receivable is increasing, this means that the amount of sales on credit is greater than the cash received. Topic: Statement of cash flows – Indirect method LO: 3 14. Depreciation expense is deducted from net income in determining cash flows provided by operating activities under the indirect method. Answer: False Rationale: Depreciation does not involve cash. It is added back to net income in the operating section of the statement of cash flows under the indirect method because it was deducted in determining net income though it did not use cash. Topic: Cash flow financial ratios LO: 6 15. The operating cash flow to capital expenditures ratio in excess of 1.0 means that the firms’ current operating activities are providing cash in excess of the amount needed to provide the desired level of plant capacity. Answer: True Rationale: Since the operating cash flow to capital expenditures ratio is defined as operating cash flows divided by capital expenditures, firms with ratios greater than 1.0 have operating cash flows that exceed capital needs to acquire long-term assets.

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Multiple Choice Topic: Statement of cash flows LO: 1 1. The statement of cash flows explains changes in a firm’s: A) B) C) D)

Cash on hand and cash in the bank Cash and cash equivalents Cash, cash equivalents, and accounts receivable Working capital

Answer: B Rationale: Cash on hand and cash in bank are both considered to be cash. Accounts receivable is not part of cash or equivalents. Topic: Cash equivalents LO: 1 2. Which of the following is a cash equivalent for purposes of preparing a statement of cash flows? A) B) C) D)

Accounts receivable Investment in subsidiary company common stock Inventory Investment in a money market fund

Answer: D Rationale: Cash equivalents must be easily convertible into a known cash amount and close to maturity so that their value is not affected by interest rate changes. Topic: Cash equivalents LO: 1 3. To qualify as a cash equivalent, an investment must: A) B) C) D)

Be easily convertible into a known cash amount Be three months or more from maturity Be over $200,000 in amount All of the above

Answer: A Rationale: Cash equivalents must be easily convertible into a known cash amount and close to maturity so that their value is not affected by interest rate changes.

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Topic: Cash equivalents LO: 1 4. A typical example of a cash equivalent is an investment in: A) B) C) D)

Treasury stock Commercial paper Stock of other companies selling on an exchange All of the above

Answer: B Rationale: Cash equivalents must be easily convertible into a known cash amount and close to maturity so that their value is not affected by interest rate changes. Topic: Cash equivalents LO: 1 5. Which of the following is not a cash equivalent for purposes of preparing a statement of cash flows? A) B) C) D)

Investment in common stock of other companies Investment in Treasury bills Investment in a money market fund Investment in commercial paper

Answer: A Rationale: Cash equivalents must be easily convertible into a known cash amount and close to maturity so that their value is not affected by interest rate changes. Stock has no maturity date so it can never be a cash equivalent. Topic: Categories for the statement of cash flows LO: 1 6. Which of the following is not a category for classifying cash flows in a statement of cash flows? A) B) C) D)

Operating activities Nonoperating activities Financing activities Investing activities

Answer: B Rationale: There are three activities: operating, investing, and financing. Topic: Cash flow activities LO: 1 7. A firm’s net cash flow from operating activities includes: A) B) C) D)

Cash received from sale of equipment Cash received from issuance of common stock Cash received from sale of merchandise Cash received as payment of loan from a borrower

Answer: C Rationale: Operating activities are cash in- and outflows from selling goods or rendering services. Selling equipment is an investing activity. Issuing stock and paying loans are financing activities.

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Topic: Cash flow activities LO: 1 8. A firm’s cash flows from investing activities include: A) B) C) D)

Cash received from the sale of a plant asset Cash paid as dividends Cash received from the rendering of services to customers Cash paid to retire bonds payable

Answer: A Rationale: Investing activities are those involving the acquisition and disposal of property, plant, and equipment and intangible assets, and the purchase and sale of investments in government securities and other companies. Topic: Cash flow activities LO: 1 9. A firm’s cash flow from financing activities includes: A) B) C) D)

Cash paid to reacquire treasury stock Cash paid for merchandise purchased Cash received from sale of investment in bonds Cash received as interest income

Answer: A Rationale: Financing activities involve receiving capital from owners, providing returns to owners, and borrowing and repaying amounts from creditors. Topic: Cash flow activities LO: 1 10. In a statement of cash flows, interest paid to creditors is classified as a cash flow from: A) B) C) D)

Operating activities Trading activities Financing activities Investing activities

Answer: A Rationale: Interest paid and received are both operating activities. Topic: Statement of cash flows – Indirect method LO: 3 11. Which of the following is disclosed separately in a statement of cash flows using the indirect method? A) B) C) D)

Net income Cash received from customers Cash paid to employees and other suppliers Increase in retained earnings for the period

Answer: A Rationale: The operating cash flows section begins with net income using the indirect method. Answers B and C are separate items under the direct method.

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Topic: Statement of cash flows – Indirect method LO: 3 12. Rife Company has an accrual basis net income of $175,000 and the following related items: Depreciation expense Accounts receivable decrease Inventory increase Accounts payable increase

$ 85,000 15,000 24,000 18,000

How much is Rife’s net cash flow from operating activities? A) B) C) D)

$251,000 $260,000 $269,000 $317,000

Answer: C Rationale: $175,000 + $85,000 + $15,000 - $24,000 + $18,000 = $269,000 Topic: Statement of cash flows – Indirect method LO: 3 13. Sapra Inc. has an accrual basis net loss of $43,000 and the following related items: Depreciation expense Accounts receivable increase Inventory decrease Accounts payable decrease Accrued liabilities increase

$ 29,000 10,000 12,000 5,000 8,000

How much is Sapra Inc.’s net cash flow from operating activities? A) B) C) D)

$ (9,000) $(14,000) $(19,000) $(25,000)

Answer: A Rationale: ($43,000) + $29,000 - $10,000 + $12,000 - $5,000 + $8,000 = $(9,000)

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Topic: Statement of cash flows – Indirect method LO: 3 14. Nelson’s Cooking School has an accrual basis net income of $189,000 and the following related items: Amortization expense Accounts receivable increase Inventory increase Interest payable decrease Dividends paid

$68,000 24,000 17,000 8,000 10,000

What is Nelson’s Cooking School’s net cash flow from operating activities? A) B) C) D)

$198,000 $170,000 $208,000 $306,000

Answer: C Rationale: $189,000 + $68,000 - $24,000 - $17,000 - $8,000 = $208,000 Topic: Statement of cash flows – Supplemental disclosures LO: 5 15. Which of the following is a required separate disclosure for firms using the indirect method in the statement of cash flows? A) B) C) D)

Cash paid during the year for interest and income taxes All changes in cash equivalents Total operating expenses All of the above

Answer: A Rationale: Cash received from customers, cash paid for inventory, cash paid for interest, cash paid for income taxes, and cash paid for operating expenses are the major cash flows reporting under the direct method in the operating activities section. Topic: Convert to cash LO: 2 16. Stober company reported annual sales revenue of $950,000. During the year, accounts receivable increased from a $56,000 beginning balance to a $64,000 ending balance. Accounts payable increased from a $44,000 beginning balance to a $46,000 ending balance. How much is cash received from customers for the year? A) B) C) D)

$940,000 $958,000 $942,000 $960,000

Answer: C Rationale: $950,000 + $56,000 - $64,000 = $942,000

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Topic: Convert to cash LO: 2 17. Donovan company reported annual sales revenue of $840,000. During the year accounts receivable decreased from a $56,000 beginning balance to a $36,000 ending balance. Accounts payable increased from a $52,000 beginning balance to a $67,000 ending balance. How much is cash received from customers for the year? A) B) C) D)

$820,000 $835,000 $845,000 $860,000

Answer: D Rationale: $840,000 - $36,000 + $56,000 = $860,000 Topic: Convert to cash LO: 2 18. Singer company reported cost of goods sold of $1,520,000 for the year. During the year, inventory decreased from a $92,000 beginning balance to a $75,000 ending balance, and accounts payable decreased from a $48,000 beginning balance to a $38,000 ending balance. How much is the cash paid for merchandise purchased during the year? A) B) C) D)

$1,503,000 $1,547,000 $1,513,000 $1,527,000

Answer: C Rationale: $1,520,000 + $75,000 - $92,000 + $48,000 - $38,000 = $1,513,000 Topic: Convert to cash LO: 2 19. Wood company reported annual income tax expense of $250,000. During the year, income tax payable decreased from a $27,900 beginning balance to a $17,900 ending balance. How much is cash paid for income taxes during the year? A) B) C) D)

$240,000 $277,900 $267,900 $260,000

Answer: D Rationale: $250,000 + $27,900 - $17,900 = $260,000

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Topic: Statement of cash flows – indirect method LO: 3 20. With reference to the reporting of net cash flow from operating activities, which method do most companies use and why? A) Indirect method because it provides better information for decision making B) Direct method because it is based on the accrual basis of accounting C) Direct method because it requires a supplemental indirect method section D) Indirect method because it is less expensive to prepare Answer: D Rationale: The indirect method is easier and cheaper because it takes less time. The direct method requires an additional step in that companies must also present a supplemental indirect method section. Topic: Analysis of Cash Flows LO: 6 21. The following amounts have been taken from the recent financial statements for Stanton, Inc: Current Liabilities (1/1/2024)

Current Liabilities (12/31/2024)

Cash from Operations

Expenditures on PPE

$5,250,000

$5,071,100

$5,625,000

$3,010,000

To the closest hundredth, which of the following amounts is Stanton’s operating cash flow to current liabilities ratio? A) B) C) D)

0.51 1.09 1.11 0.54

Answer: B Rationale: $5,625,000 / [($5,250,000 + $5,071,100)/2] = 1.09 Topic: Analysis of Cash Flows LO: 6 22. The following amounts have been taken from the recent financial statements for Purvis Industries: Current liabilities

Cash from operations

Expenditures on PPE

Dividends (cash)

$1,210,000

$3,650,000

$2,940,000

$150,000

Which of the following amounts is the free cash flow for Purvis Industries? A) $2,440,000 B) $ 710,000 C) $ 560,000 D) $ (650,000) Answer: B Rationale: $3,650,000 – $2,940,000 = $710,000

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Topic: Statement of cash flows – Direct method LO: 2 23. The direct method of presenting net cash flow from operating activities: A) B) C) D)

Must be used in a statement of cash flows Reconciles accrual basis net income to a cash basis amount Shows the major categories of operating cash receipts and cash payments Is used when there are no cash flows from investing and financing activities

Answer: C Rationale: Cash received from customers, cash paid for inventory, cash paid for interest, cash paid for income taxes, and cash paid for operating expenses are the major cash flows reporting under the direct method in the operating activities section. Topic: Statement of cash flows – Supplemental disclosures LO: 5 24. Which of the following is a required separate disclosure for firms using the direct method in the statement of cash flows? A) A reconciliation of net income to net cash flows from operating activities B) A list of all noncash investing and financing transactions C) The policy for determining which highly liquid, short-term investments are treated as cash equivalents D) All of the above Answer: D Rationale: All three are required when the direct method is used. Only answer choices B and C are required with the indirect method. Topic: Statement of cash flows – Direct method LO: 2 25. Which of the following is not disclosed in a statement of cash flows using the direct method? A) B) C) D)

Cash paid for interest Cash received from customers Cash received from issuing stock Depreciation expense

Answer: D Rationale: Depreciation is not a cash flow. Answers A and B are operating activities. Answer C is a financing activity.

. 4-13

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Exercises Topic: Cash flow activities LO: 1 1. In which of the three activity categories of a statement of cash flows would each of the following items appear and do they represent a cash inflow or cash outflow? Use the following abbreviations: Op Out = Operating Cash Outflow Op In = Operating Cash Inflow Inv Out = Investing Cash Outflow

Inv In = Investing Cash Inflow Fin Out = Financing Cash Outflow Fin In = Financing Cash Inflow

________ a. Cash dividends received ________ b. Cash interest received ________ c.

Cash receipts from customers

________ d. Cash collection on loans ________ e. Cash proceeds from the issuance of stock ________ f.

Cash interest paid

________ g. Cash purchase of equipment ________ h. Cash dividends paid Answer: a. Op-In b. Op-In c. Op-In d. Inv-In

e. f. g. h.

Fin-In Op-Out Inv-Out Fin-Out

Topic: Statement of cash flows – Supplemental disclosures LO: 5 2. Noe Industries acquired a $1,800,000 building by issuing a $1,800,000 note payable due to Community Bank. a. In terms of cash flow reporting, what type of transaction is this? b. What special disclosure is required for this transaction? Answer: a. This is a noncash investing and financing transaction. b. It must be reported in a supplementary schedule to the statement of cash flows.

. Test Bank, Chapter 4

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Topic: Cash flow activities LO: 1 3. Write an X in the appropriate column to show whether each of the following cash flows should be classified as an operating, investing, or financing. Cash Flow

Operating

Investing

Financing

a. Received from issuance of common stock

________

b. Paid as interest to creditors

________

d. Received as dividends

________

e. Received as a lawsuit settlement

________

g. Paid to settle a note payable

________

h. Received for services rendered

________

Received from sale of used equipment

Paid to purchase treasury stock

Answer: Operating

Investing

a. b.

Financing X

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Topic: Cash flow activities LO: 1 4. Put an X in the appropriate column to show whether each of the following cash flows should be classified as an operating, investing, or financing cash flow. Cash Flow

Operating

Investing

Financing

a. Paid to purchase new computer

________

b. Received from issuance of bonds payable

________

Paid as dividends

________

d. Received as interest

________

e. Received payment on a note receivable

________

Paid as a charitable contribution

________

g. Received from sale of bond investment

________

h. Paid as income taxes

________

Answer: Operating a.

Investing

Financing

e. f.

X X

g. h.

X X

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Topic: Statement of cash flows –Indirect method LO: 3 5. Koester Company had the following income statement for 2024: Sales Cost of goods sold Depreciation expense Other operating expenses and taxes Net Income

$2,575,000 1,820,000 360,000 180,000 $ 215,000

Additional information about the company follows:

Accounts receivable Inventory Prepaid expenses Accounts payable

End of Year

Beginning of Year

$142,000 150,000 16,000 103,000

$129,000 165,000 13,000 92,000

Calculate Koester’s cash flows provided by operating activities for 2024 using the indirect method. Answer: Net Income Add (deduct) items to convert net income to cash basis: Depreciation Accounts receivable increase Inventory decrease Prepaid expenses increase Accounts payable increase Net cash provided by operating activities

$215,000 360,000 (13,000) 15,000 (3,000) 11,000 $585,000

Topic: Statement of cash flows – Indirect method LO: 3 6. The following information relates to Hamlen Company for 2024. Sales Cost of goods sold Operating expenses and income taxes (other than depreciation and amortization) Depreciation of plant assets Amortization of intangible assets Increase in accounts receivable Decrease in inventory Decrease in accounts payable Increase in accrued liabilities

$1,845,000 1,160,000 365,000 215,000 50,000 38,000 62,000 30,000 8,000

Calculate the 2024 net cash flow from operating activities using the indirect method.

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Answer: Net Income Add (deduct) items to convert net income to cash basis: Depreciation Amortization Accounts receivable increase Inventory decrease Accounts payable decrease Accrued liabilities increase Net cash provided by operating activities

$ 55,000 215,000 50,000 (38,000) 62,000 (30,000) 8,000 $322,000

Net income = $1,845,000 - $1,160,000 - $365,000 - $215,000 - $50,000 = $55,000 Topic: Comparing firms using ratio analysis LO: 6 7. Consider the following 2024 data for two manufacturing firms ($ in millions): Average Current Liabilities

Cash from Operations

Expenditures on PPE

Dividends (cash)

Finn Industries

$93,800

$112,500

$12,500

$22,000

Klein Company

120,200

100,950

20,190

35,000

a. Compute the operating cash flow to current liabilities ratio for each firm for 2024, to the nearest hundredth. b. Compute the operating cash flow to capital expenditures ratio for 2024, to the nearest hundredth. c. Comment on the results of your computations. Answer: a. Finn: $112,500 / $93,800 = 1.20 Klein: $100,950 / $120,200 = 0.84 b. Finn: $112,500 / $12,500 = 9.00 Klein: $100,950 / $20,190 = 5.00 c.

Only Finn has sufficient cash flow to cover their current liabilities and there is some cash left over to consider using on other activities that could strengthen the firm’s operating or financial position. Should either company elect in the future to reduce its dividend, it would generate a sizeable additional free cash flow. Given that these firms are of different sizes and have different successes, it is difficult to generalize further. It is possible that Klein may well be in need of conserving its cash for investment.

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Topic: Comparing firms using ratio analysis LO: 6 8. Consider the following 2024 data for three manufacturing firms ($ in millions): Current liabilities

Cash from operations

Expenditures on PPE

Dividends (cash)

Frankel Industries

$200,500

$209,300

$65,000

$40,000

Bowen Company

181,300

(160,480)

68,000

40,000

Caskey Corporation

149,000

168,000

75,000

40,000

a. Compute the operating cash flow to capital expenditures ratio for each firm for 2024. b. Compute the free cash flow for each firm for 2024. c. Comment on the results of your computations. Answer: a. Frankel: $209,300 / $65,000 = 3.22 Bowen: $(160,480) / $68,000 = (2.36) Caskey: $168,000 / $75,000 = 2.24 b. Frankel: $209,300 – 65,000 = $144,300 Bowen: $(160,480) – 68,000 = $(228,480) Caskey: $168,000 – 75,000 = $93,000 c.

Bowen’s operating cash flows are negative which means Bowen will likely need to borrow just to pay its bills, as well as for any additional plant improvements it wishes to make. The firm is undergoing difficult times. Frankel appears to be in the best position, with a substantial amount of its operating cash flows available for expansion and other business pursuits. Caskey has sufficient operating cash flows for expansion as well as a reasonable operating cash flow to capital expenditures ratio.

. 4-19

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Topic: Statement of cash flows – Direct method LO: 2 9. Endure Athletics Co. had the following income statement for the current year: Sales Cost of goods sold Gross profit Operating expenses: Depreciation expense Wages expense Interest expense Net income

$3,579,000 2,268,000 1,311,000 $450,000 670,000 50,000

1,170,000 $ 141,000

Additional information about the company follows. All balances are normal.

Cash Accounts receivable Inventory Accounts payable Interest payable Wages payable Loan payable

End of Year

Beginning of Year

$72,000 165,000 272,000 82,000 20,000 13,000 225,000

$64,000 160,000 250,000 85,000 25,000 8,000 100,000

Calculate Endure Athletics’ net cash flow provided by operating activities for the current year using the direct method. Show a separate cash flow for each revenue and expense. Answer: Cash received from customers Cash paid for merchandise purchased Cash paid to employees Cash paid for interest Net cash provided by operating activities (a) (b) (c) (d)

(a) $3,574,000 (b) $2,293,000 (c) 665,000 (d) 55,000

3,013,000 $ 561,000

$3,579,000 + $160,000 - $165,000 = $3,574,000 $2,268,000 - $250,000 + $272,000 – $82,000 + $85,000 = $2,293,000 $670,000 + $8,000 - $13,000 = $665,000 $50,000 + $25,000 - $20,000 = $55,000

There is no cash flow associated with depreciation expense.

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Topic: Statement of cash flows – Direct method LO: 2 10. Sinha Company had the following income statement for the current year: Sales Cost of goods sold Gross profit Operating expenses: Depreciation expense Wages expense Advertising expense Net income

$2,400,000 1,900,000 500,000 $100,000 300,000 60,000

460,000 $ 40,000

Additional information about the company follows. All balances are normal.

Cash Accounts receivable Inventory Prepaid advertising Accounts payable Wages payable

End of Year

Beginning of Year

$ 84,000 72,000 185,000 25,000 110,000 25,000

$ 48,000 92,000 160,000 30,000 80,000 15,000

Calculate Sinha’s net cash flow provided by operating activities for the current year using the direct method. Show a separate cash flow for each revenue and expense. Answer: Cash received from customers Cash paid for merchandise purchased Cash paid to employees Cash paid for advertising Net cash provided by operating activities (a) (b) (c) (d)

(a) $2,420,000 (b) $1,895,000 (c) 290,000 (d) 55,000

2,240,000 $ 180,000

$2,400,000 + $92,000 - $72,000 = $2,420,000 $1,900,000 + $185,000 - $160,000 + $80,000 - $110,000 = $1,895,000 $300,000 + $15,000 - $25,000 = $290,000 $60,000 - $30,000 + $25,000 = $55,000

There is no cash flow associated with depreciation expense.

. 4-21

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Topic: Identifying the impact of account changes on cash flow from operating activities LO: 3 11. The following account changes were presented in a recent balance sheet for Nelson Company ($ in millions). a. b. c. d.

$4,000 increase in accounts payable $1,000 in depreciation and amortization $1,500 decrease in accounts receivable $2,500 decrease in accrued liabilities

$3,000 increase in inventory

Determine whether the amount of change would be added to (+) or subtracted from (‒) Nelson’s net income for the period when calculating cash flow from operations using the indirect method. Answer: a. b. c. d.

+ + + –

$4,000 increase in accounts payable $1,000 in depreciation and amortization $1,500 decrease in accounts receivable $2,500 decrease in accrued liabilities

–

$3,000 increase in inventory

Topic: Investing and financing cash flows LO: 4 12. During 2024, Hurley Company’s long-term investments account (at cost) increased $50,000, which was the net result of purchasing stock costing $200,000 and selling stock costing $150,000 at a $15,000 gain. Hurley’s notes payable account increased $60,000, the net result of issuing $125,000 of notes and paying $65,000 during the year on notes. What items and amounts appear in these sections of Hurley Company’s 2024 statement of cash flows: a. Cash flows from investing activities b. Cash flows from financing activities Answer: a. Cash flows from investing activities: Purchase of stock investments Sale of stock investments ($ 150,000 + $ 15,000)

$(200,000) 165,000

b. Cash flows from financing activities: Issuance of notes Payment of notes

$ 125,000 (65,000)

. Test Bank, Chapter 4

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Topic: Indirect method – Operating activities LO: 3 13. Price Company uses the indirect method. Selected information appears below. How much is Price’s net cash flow from operating activities? Net income Accounts receivable increase Inventory increase Accounts payable decrease Income tax payable increase Increase in dividends payable Loss on disposal of equipment Depreciation expense

$2,500,000 100,000 75,000 90,000 10,000 12,000 30,000 340,000

Answer: Net income Add (deduct) items to convert net income to cash basis: Depreciation expense Loss on disposal of equipment Accounts receivable increase Inventory increase Accounts payable decrease Income tax payable increase Net cash provided by operating activities

$2,500,000 340,000 30,000 (100,000) (75,000) (90,000) 10,000 $2,615,000

Topic: Topic: Indirect method – Operating activities LO: 3 14. Sommers, Inc uses the indirect method. Selected information appears below. How much is its net cash flow from operating activities? Net income Accounts receivable decrease Inventory decrease Gain on sale of equipment Accounts payable increase Income tax payable increase Depreciation expense

$600,000 28,000 35,000 15,000 40,000 25,000 200,000

Answer: Net income Add (deduct) items to convert net income to cash basis Depreciation expense Gain on sale of equipment Accounts receivable decrease Inventory decrease Accounts payable increase Income tax payable increase Net cash provided by operating activities

$600,000 200,000 (15,000) 28,000 35,000 40,000 25,000 $913,000

. 4-23

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Topic: Net Cash Flow from Operating Activities (Indirect Method) LO: 3 15. Verdi Inc. had a $100,000 net loss from operations in 2024. Depreciation expense for 2024 was $120,000 and a 2024 cash dividend of $150,000 was declared and paid. Balances of the current asset and current liability accounts at the beginning and end of 2024 follow. All balances are normal. Cash Accounts receivable Inventory Prepaid insurance Accounts payable Note payable Accrued liabilities

Ending $174,000 61,000 62,000 30,000 27,000 97,000 32,000

Beginning $148,000 49,000 70,000 25,000 36,000 65,000 28,000

Did Verdi’s 2024 operating activities provide or use cash and by what amount? Use the indirect method to determine your answer. Show your work. Answer: Net loss Add (deduct) items to convert net income to cash basis Depreciation expense Accounts receivable increase ($ 61,000– $ 49,000) Inventory decrease ($ 70,000 – $ 62,000) Prepaid insurance increase ($ 30,000 – $ 25,000) Accounts payable decrease ($ 36,000 – $ 27,000) Accrued liabilities increase ($ 32,000 – $ 28,000) Net cash provided by operating activities

$(100,000) 120,000 (12,000) 8,000 (5,000) (9,000) 4,000 $ 6,000

Verdi, Inc.’s 2024 operating activities provided $6,000 cash.

. Test Bank, Chapter 4

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Topic: Statement of cash flows totals LO: 1 16. Dyckman, Inc. reported the following amounts during 2024 and 2023: Dec. 31, 2024 $ (75,000) 120,000 (150,000) ? 160,000

Net cash provided (used) by operating activities Net cash provided (used) by financing activities Net cash provided (used) by investing activities Cash balance Net income

Dec. 31, 2023 102,000 (25,000) (50,000) 230,000 190,000

a. How much is the net increase or decrease in cash during 2024? b. How much will the company report on its balance sheet at December 31, 2024 as ‘cash’? Answer: a. Net cash used by operating activities Net cash provided by financing activities Net cash used by investing activities Net decrease in cash during 2024

$ (75,000) 120,000 (150,000) $(105,000)

b. Beginning cash + change in cash = ending balance $230,000 - $105,000 = $125,000 Topic: Investing activities section LO: 4 17. The information below was provided by Soffer Company for 2024 and 2023: Equipment, December 31, 2023 Equipment, December 31, 2024 Accumulated depreciation, December 31, 2023 Accumulated depreciation, December 31, 2024

$ 275,000 250,000 150,000 180,000

During 2024, Soffer sold equipment with a cost of $85,000 and accumulated depreciation of $60,000. A gain of $10,000 was recognized on the sale of the equipment. Prepare the investing activities section of the statement of cash flows for 2024. Answer: Gain on sale of equipment = Selling price ‒ book value $10,000 = Selling price ‒ ($85,000 ‒ $60,000) Cash received from sale of equipment (selling price) = $35,000 Cost of new equipment: $275,000 - $85,000 -$250,000 = $(60,000) Cash flows from investing activities Proceeds from sale of equipment Cost of new equipment Cash flows used for investing activities

$ 35,000 (60,000) $(25,000)

. 4-25

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Topic: Financing activities section LO: 4 18. Sefcik, Inc. provided the following information for 2024 and 2023: Retained earnings, December 31, 2024 Retained earnings, December 31, 2023 Notes payable, December 31, 2024 Notes payable, December 31, 2023 Net income—2024

$222,000 182,000 122,000 100,000 85,000

Additional notes of $30,000 were issued in 2024. Prepare the financing activities section of the statement of cash flows for 2024. Answer: Dividends paid = Beginning retained earnings + net income ‒ ending retained earnings = $182,000 + $85,000 - $222,000 = $45,000 Cash paid on notes = Beginning notes payable + new notes issued ‒ ending notes payable = $100,000 + $30,000 - $122,000 = $8,000 Cash flows from financing activities: Cash paid for dividends Cash received for notes payable issued Cash paid for notes payable Cash flows used for financing activities

$(45,000) 30,000 (8,000) $(23,000)

Topic: Financing activities section LO: 4 19. During 2024, Badger, Inc. issued common stock for cash, paid $25,000 to retire stock, and borrowed $100,000 from the bank on a long-term loan. Badger, Inc. provided the following:

Common stock Retained earnings

2024 $ 240,000 290,000

2023 $200,000 150,000

How much cash was received in 2024 from issuing common stock? Answer: Beginning common stock balance + stock issued – stock retired = Ending common stock balance $200,000 + stock issued - $25,000 = $240,000 Stock issued = $65,000

. Test Bank, Chapter 4

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Problems

Topic: Statement of cash flows – indirect method LO: 3, 4 1. Weber Construction purchased equipment for $290,000 cash, sold equipment costing $150,000 with a book value of $100,000, and declared and paid dividends during 2024. No new notes payable were issued during the year. Financial data follows. All balances are normal. Dec. 31, 2024

Dec. 31, 2023

Change

Cash

$ 36,000

$29,000

$ 7,000

Sales revenue

$2,800,000

Accounts receivable

125,000

97,000

28,000

Cost of sales

1,600,000

Inventory

100,000

114,000

(14,000)

Salaries expense

900,000

Equipment

740,000

600,000

140,000

Depreciation expense

200,000

Accum. depreciation

370,000

220,000

150,000

Interest expense

20,000

Accounts payable

170,000

150,000

20,000

Gain on sale of equipment

10,000

Unearned revenue

74,000

44,000

30,000

Income tax expense

25,000

Accrued salaries

25,000

40,000

(15,000)

Net income

Taxes payable Long-term notes pay.

9,000

8,000

1,000

50,000

138,000

(88,000)

Common stock

215,000

200,000

15,000

Retained earnings

88,000

40,000

48,000

2024

$ 65,000

Prepare Weber Construction’s Statement of Cash Flows for 2024, using the indirect method.

. 4-27

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Answer: Cash flows from operating activities Net income Add (deduct) items to convert net income to cash basis Depreciation expense Gain on sale of equipment Accounts receivable increase Inventory decrease Accounts payable increase Unearned revenue increase Accrued salaries decrease Taxes payable increase Cash flows from operating activities Cash flows from investing activities Equipment purchases Equipment sales Cash flows from investing activities

$ 65,000 200,000 (10,000) (28,000) 14,000 20,000 30,000 (15,000) 1,000 $277,000

(290,000) 110,000 (180,000)

Cash flows from financing activities Paid notes Issued stock Paid dividends Cash flows from financing activities Net increase in cash Cash, beginning of year Cash, end of year

(88,000) 15,000 (17,000) (90,000) 7,000 29,000 $ 36,000

. Test Bank, Chapter 4

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Topic: Cash flow activities LO: 1, 2, 4 2. The following schedule of cash receipts and payments relates to Breit Company for the year 2024: Cash receipts: From customers From issuance of notes payable From sale of truck Cash payments: For income taxes For purchase of equipment To employees and suppliers For interest To stockholders as dividends For rent For purchase of treasury stock

$900,000 200,000 30,000 $ 70,000 300,000 550,000 20,000 100,000 40,000 15,000

Breit had $60,000 cash to start 2024 and ended the year with $95,000 cash. In good form, prepare a 2024 statement of cash flows for Breit Company using the direct method. Answer: Breit Company Statement of Cash Flows For the Year Ended December 31, 2024 Cash flows from operating activities Cash received from customers Cash paid to employees and suppliers Cash paid for interest Cash paid for rent Cash paid for income taxes Net cash provided by operating activities

$900,000 (550,000) (20,000) (40,000) (70,000)

Cash flows from investing activities Sale of delivery truck Purchase of equipment Net cash used by investing activities

30,000 (300,000)

Cash flows from financing activities Issuance of notes payable Payment of dividends Purchase of treasury stock Net cash provided by financing activities Net increase in cash Cash at beginning of year Cash at end of year

$220,000

(270,000)

$200,000 (100,000) (15,000)

. 4-29

85,000 $35,000 60,000 $95,000

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Topic: Statement of cash flows – Indirect method LO: 1, 3, 4 3. The following schedule of information relates to Wood, Inc. for the year 2024: Income statement data: Sales Depreciation expense Net income Cash receipts: From issuance of common stock From sale (at book value) of stock investment Cash payments: For purchase of equipment To stockholders as dividends To pay off notes payable Change in working capital accounts: Cash decrease Accounts receivable decrease Inventory increase Accounts payable decrease Accrued liabilities increase

$2,500,000 250,000 300,000 150,000 90,000 600,000 100,000 108,000 10,000 35,000 15,000 22,000 10,000

The cash balance was $32,000 at the beginning of 2024. In good form, prepare a 2024 statement of cash flows for Wood, Inc. using the indirect method. Answer: Wood, Inc. Statement of Cash Flows For the Year Ended December 31, 2024 Net cash flow from operating activities Net Income $300,000 Add (deduct) items to convert net income to cash basis: Depreciation 250,000 Accounts receivable decrease 35,000 Inventory increase (15,000) Accounts payable decrease (22,000) Accrued liabilities increase 10,000 Net cash provided by operating activities

$558,000

Cash flows from investing activities Sale of stock investment Purchase of equipment Net cash used by investing activities

(510,000)

90,000 (600,000)

Cash flows from financing activities Issuance of common stock Payment of notes payable Payment of dividends Net cash used by financing activities Net decrease in cash Cash at beginning of year Cash at end of year

150,000 (108,000) (100,000) (58,000) (10,000) 32,000 $ 22,000 .

Test Bank, Chapter 4

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Topic: Statement of cash flows – Indirect method LO: 1, 3, 4 4. The following schedule of information relates to Sampson Corporation for the year 2024: Income statement data: Sales Depreciation expense Net income Cash receipts: From issuance of common stock From sale of plant assets (at book value) From loan repayment by borrower Cash payments: For purchase of stock investment To stockholders as dividends Change in working capital accounts: Cash increase Accounts receivable decrease Inventory decrease Accounts payable increase Accrued liabilities decrease

$1,700,000 100,000 42,000 10,000 30,000 25,000 200,000 30,000 87,000 60,000 40,000 15,000 5,000

The cash balance was $50,000 at the beginning of 2024. In good form, prepare a 2024 statement of cash flows for Sampson Corporation using the indirect method. Answer: Sampson Corporation Statement of Cash Flows For the Year Ended December 31, 2024 Net cash flow from operating activities Net Income $ 42,000 Add (deduct) items to convert net income to cash basis: Depreciation 100,000 Accounts receivable decrease 60,000 Inventory decrease 40,000 Accounts payable increase 15,000 Accrued liabilities decrease (5,000) Net cash provided by operating activities

$252,000

Cash flows from investing activities Sale of plant assets Loan repayment by borrower Purchase of stock investment Net cash used by investing activities

(145,000)

Cash flows from financing activities Issuance of common stock Payment of dividends Net cash used by financing activities Net increase in cash Cash at beginning of year Cash at end of year . 4-31

30,000 25,000 (200,000)

10,000 (30,000) (20,000) 87,000 50,000 $137,000

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Essay Topic: Statement of cash flows analysis LO: 1, 3, 4, 6 1. Geis Industries, a company that manufactures athletic equipment, began business in September 2024. Below is the operating section of the company’s statement of cash flows. Although management has not disclosed a sales forecast, they forecast an increase in sales next year. Because of this, management plans to add $2,000,000 to inventory. However, at the end of the year, the company has less than $100,000 in cash. Geis Industries Statement of Cash Flows For the Year Ended December 31, 2024 Cash flows from operating activities: Net loss Depreciation Deposits with suppliers Increase in accounts receivable Increase in accounts payable Increase in accrued liabilities Net cash used by operating activities

$(500,000) 200,000 (350,000) (80,000) 375,000 70,000 $(285,000)

You have just taken the position of financial analyst with a major investment bank. Your supervisor, Sally Fields, has asked you to write a short memo about problems facing Geis. You know that losses and negative cash flow during start-up phases of businesses are common. In your memo, include discussion about the typical sources of financing that may or may not be available to support Geis’s inventory expansion. Answer: Date: To: From: Re:

(today’s date) Sally Fields, Supervisor (your name) Evaluation: Geis Industries’ Planned Expansion

While it is common for companies to experience losses and negative cash flows during their early years of operations, the cash situation for Geis is very problematic. Unfortunately, there appears to be no obvious source to finance the acquisition of the $2,000,000 of inventory. Since the statement of cash flows shows that the company has to make cash deposits to its suppliers, these suppliers will probably not be a major source of funding for the new inventory and Geis’s cash on hand is insufficient for this purpose. Increases in accounts payable and accrued liabilities indicate growing cash needs for repayment of these liabilities. Additionally, the increase in accounts receivable appears to provide a very small cushion for other expenses that will come due in future periods. The company has provided no evidence of how it plans to expand its sales volume to warrant this new inventory. Generally, this requires additional expenditures, like increased advertising or newly hired sales personnel. This, too, requires cash that Geis does not have. With the expansion will also come an increase in accounts receivable, along with the resources tied up in inventory. In order to proceed with the plan, it appears that Geis needs to seek additional capital to support an increased level of operations and it likely will not continue its business operations without this extra capital.

. Test Bank, Chapter 4

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Topic: Analysis of cash flows LO: 6 2. Researchers have noted a reported growth in free cash flow over the past few years as company management, financial analysts, and investors are increasingly focusing on cash flows to validate reported earnings. Explain what is problematic about this and what might be responsible for this growth? Answer: Unfortunately, the free cash flow calculation has limitations, just like earnings. For example, as capital expenditures decrease, free cash flow increases by the same amount. Therefore, a temporary reduction in capital expenditures could cause reported free cash flow to increase in such a way that it would be unsustainable without further manipulation of cash flows from operations, capital expenditures, or dividends. As such, the definition of capital expenditures is also very important in analyzing free cash flow. Topic: Analysis of cash flows LO: 1, 3, 4, 6 3. You took a job as the new accountant for Kennedy Company, a small company with significant overdrafts in a checking account. The previous accountant prepared the financial statements for last period and classified the overdrafts as a vendor accounts payable. He also reported the overdraft as a cash inflow in the operating section of the statement of cash flows. Briefly discuss the issues surrounding this treatment of the overdraft. Answer: While an overdraft in a checking account can be reported as a current liability on the balance sheet under GAAP, they should not be grouped with other accounts payable generated through operations. As such, disclosure should be forthcoming regarding their true nature. The exception to this is when checking accounts are linked to another account with funds in the same bank. In this case, the cash account can be reported as a netted balance of the two accounts, since there is typically an agreement with the bank to use the funds from the other account to cover the overdraft. If this is not the case, then the overdraft should be treated as short-term borrowing and reported as a financing inflow on the statement of cash flows. Repayment would correspondingly be treated as a financing outflow. To incorrectly treat the overdraft as an accounts payable in the operating section of the statement of cash flows would not correctly classify the amount and would not clearly reflect the cash source as unsustainable, from an operating perspective. As such, operating cash flow ratios and free cash flow could be manipulated by the overdraft inclusion in the operating section. The result is that analysts and investors could be misled into thinking that there is more cash on hand than is the case.

. 4-33

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Chapter 5 Analyzing and Interpreting Financial Statements Learning Objectives – Coverage by question True/False

Multiple Choice

LO5-1 Prepare and analyze common-size financial statements. (p. 5-4)

4, 8, 13, 15

20, 21

LO5-2 Compute and interpret measures of return on investment, including return on equity (ROE), return on assets (ROA), and return on financial leverage (ROFL). (p. 5-8)

4, 5, 7

9-11, 18

1, 2, 14

LO5-3 Disaggregate ROA into profitability (profit margin) and efficiency (asset turnover) components. (p. 5-11)

1, 4, 6, 10, 12

1, 3, 4, 9, 15-17, 19

7- 9, 12, 13

2, 5

1-3

LO5-4 Compute and interpret measures of liquidity and solvency. (p. 5-15)

4, 9, 11, 14

2, 3, 5, 6, 8

4-6, 10, 11

1, 3, 4

2, 3

LO5-5 Appendix 5A: Measure and analyze the effect of operating activities on ROE. (p. 5-23)

2, 3

7, 12-14

LO5-6 Appendix 5B: Prepare pro forma financial statements. (p. 5-25)

Exercises

. 5-1

Problems

Essay Questions

6, 8

2, 3

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Chapter 5: Analyzing and Interpreting Financial Statements

True False Topic: Asset turnover LO: 3 1. Asset turnover measures a company’s profitability. Answer: False Rationale: Asset turnover is a productivity concept. It indicates the amount of sales revenue a company generates from using its asset investment. Topic: NOPAT LO: 5 2. NOPAT is equivalent to income from operating activities. Answer: False Rationale: NOPAT is net operating income after taxes. It excludes nonoperating amounts and focuses on operating activities. Topic: Profitability and RNOA LO: 5 3. If Company A is more profitable than Company B, then Company A will have a higher RNOA than Company B. Answer: False Rationale: RNOA depends on profitability but also depends on asset productivity. If Company B has a much higher asset productivity, its RNOA could be higher despite the lower profitability. Topic: Use of ratios LO: 1, 2, 3, 4 4. Ratios provide one way to compare companies in the same industry regardless of their size. Answer: True Rationale: Ratios mitigate problems arising from attempting to compare companies of different sizes. Topic: Financial leverage and ROE LO: 2 5. Highly leveraged firms have higher ROE than lower leveraged firms. Answer: False Rationale: Financial leverage does not affect the ROE computation because it is based on operating profit. Return on financial leverage is ROE less ROA, so the higher the ROE, the higher the financial leverage.

. Test Bank, Chapter 5

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Topic: Inventory turnover rate LO: 3 6. All things equal, the higher a company’s inventory turnover rate, the better. Answer: True Rationale: Companies want to minimize inventory levels but still be able to meet demand and avoid stock-outs. Higher inventory turnover means the company is selling its inventory more quickly which reduces the number of days that inventory is held. Topic: Financial leverage and debt ratings LO: 2 7. All else being equal, a higher financial leverage will increase a company’s debt rating and decrease the interest rate it must pay. Answer: False Rationale: Higher levels of financial leverage increase the probability of bankruptcy and resulting lower credit ratings and higher costs for borrowed funds. Topic: Horizontal and vertical analysis. LO: 1 8. Vertical analysis examines changes in financial data across time. Answer: False Rationale: Vertical analysis is a method that attempts to overcome the size of a company by stating financial information is a ratio form. Horizontal analysis examines changes in financial data across time. Topic: Current ratio LO: 4 9. A current ratio greater than 1.0 is generally desirable for a company. Answer: True Rationale: A company with a current ratio greater that 1.0 indicates positive net working capital. Companies prefer greater levels of current assets than current liabilities because higher liquidity indicates a more likely chance the company can pay its debts as they become due. Topic: Disaggregation of profit margin and asset turnover LO: 3 10. Return on assets can be disaggregated into profit margin and an expense-to-sales ratio. Answer: False Rationale: Return on assets can be disaggregated into profit margin and asset turnover. The expenseto-sales ratio measures the percentage of each sales dollar that goes to cover a specific expense item.

. 5-3

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Topic: Times interest earned LO: 4 11. The times interest earned ratio reflects the number of times that the company earned interest during the year. Answer: False Rationale: Times interest earned ratio reflects the operating income available to pay interest expense during the year. Topic: ROA meaning LO: 3 12. Charlie Plumbing Supplies has a return on assets (ROA) of 24%, while the industry average of similar companies is 13%. This means that Charlie Plumbing Supplies’ asset turnover is higher than the industry average. Answer: False Rationale: This is not necessarily the case, since ROA is made up of two components, profit margin times asset turnover. Without any more information, we cannot determine if it is the asset turnover or the profit margin, or both, that is driving the higher ROA . Topic: Limitations of ratio analysis LO: 1 13. One benefit of using ratio analysis to compare two firms in the same industry is that ratios are immune to size and current accounting rules. Answer: False Rationale: By using percentage comparisons, ratio analysis makes firms of different sizes more comparably. However, two firms in the same industry may use very different accounting methods, which would flow through to the ratios and make them non-comparable. Topic: Solvency LO: 4 14. Solvency ratios measure a company’s ability to meet its debt obligations. Answer: True Rationale: A solvent company is one that can meet its debt obligations, including principal and interest payments as they come due. Topic: Vertical analysis LO: 1 15. A common size balance sheet expresses the balance sheet items as a percentage of total assets. Answer: True Rationale: A common size balance sheet shows the proportion of the company’s assets and liabilities in terms of their relative size.

. Test Bank, Chapter 5

5-4

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Topic: Proforma financial statements LO: 6 16. When determining forecasted revenues for proforma purposes, managers should consider economic conditions, potential company changes, and changes in the company’s competitive environment. Answer: True Rationale: A company can use publicly available information from competitors, suppliers, customers, industry organizations, and governmental agencies.

. 5-5

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Multiple Choice

Topic: Turnover rates and company value LO: 3 1. All things equal, increasing turnover, increases: A) B) C) D)

Sales Expenses Assets Shareholder value

Answer: D Rationale: All things equal, increasing turnover rates increases ROE which also increases shareholder value. Topic: Liquidity LO: 4 2. Liquidity refers to: A) B) C) D)

The life cycle of the company The amount of receivables the company has in its balance sheet The amount of financial leverage None of the above

Answer: D Rationale: Liquidity refers to cash, the amount on hand available to pay current obligations as they become due. Topic: Ratios LO: 3, 4 3. Which one of the following ratios does not involve assets? A) B) C) D)

Account receivable turnover Current ratio Profit margin Inventory turnover

Answer: C Rationale: Profit margin measures net income against sales revenue, both components of which are income statement amounts and not assets.

. Test Bank, Chapter 5

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Topic: Inventory turnover rate LO: 3 4. Which ratio provides an indication of the salability of the company’s products? A) B) C) D)

Account receivable turnover Current ratio Inventory turnover Gross profit margin

Answer: C Rationale: Inventory turnover measures the number of times during a period a company sells its inventory. Trends in this metric can provide an indication of the salability of the company’s products. Topic: Current ratio LO: 4 5. What does the current ratio measure? A) B) C) D)

Solvency Profitability Short-term debt paying ability Leverage

Answer: C Rationale: The current ratio is a measure of short-term debt paying ability. It measures a company’s ability to pay its current obligations as they become due. Topic: Liquidity analysis LO: 4 6. Liquidity analysis of a company includes the following useful measures: (select all that apply) A) B) C) D)

Current ratio Quick ratio Times interest earned Working capital

Answer: A, B, and D Rationale: Times interest earned ratio measures solvency. Solvency is a company’s ability to meets its debt obligations, both principal and interest, on a timely basis. Topic: NOPAT LO: 5 7. Which one of the following is removed from net income when determining NOPAT? A) B) C) D)

Cost of goods sold Taxes on operating income Selling, general and administrative expenses Interest expense

Answer: D Rationale: NOPAT is net operating profit after tax. Amounts removed are investment income and interest expense.

. 5-7

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Topic: Liquidity measure LO: 4 8. Which of the following is one measure of liquidity? A) B) C) D)

Debt-to-equity ratio Times interest earned Quick ratio None of the above

Answer: C Rationale: The only measure of liquidity listed above is the quick ratio which is a variation of the current ratio (Current Ratio = Current assets / Current liabilities) to focus on quick assets (cash, securities, and receivables). The debt-to-equity ratio is a common measure of financial leverage, and the times interest earned ratio is a metric of solvency analysis. Topic: ROA computation LO: 2, 3 9. ROA is computed as: A) B) C) D)

Net income / Average stockholders’ equity Earnings without interest expense (EWI)/ Average total assets Profit margin × Asset turnover B or C

Answer: D Rationale: ROA is return on assets. It can be disaggregated into profit margin and asset turnover components to provide insight into performance drivers that capture profitability and efficiency. Topic: ROE computation LO: 2 10. Healthy Foods’ 2024 balance sheet shows average shareholders’ equity of $10,500 million, net income of $2,049 million, and common shares issued of 1,900 million. The company has no preferred shares issued. Healthy Foods’ return on common equity for the year is: A) 10.78% B) 19.51% C) 1.42% D) 92.73% Answer: B Rationale: ROE = Net income/Average shareholders’ equity = $2,049 million / $10,500 million = 19.51%

. Test Bank, Chapter 5

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Topic: ROA computation LO: 2 11. Healthy Foods’ 2024 financial statements show average shareholders’ equity of $10,500 million, net income of $2,049 million, interest expense of $930 million, and average total assets of $ 54,000 million. How much is Healthy Foods’ return on assets for the year? Assume that the statutory tax rate is 30%. A) B) C) D)

3.8% 5.5% 4.3% 5.0%

Answer: D Rationale: ROA = EWI / Average total assets = $2,049 + [$930 x (1 - 0.3)] / $54,000 million = 5.0% Topic: NOA computation LO: 5 12. Healthy Foods’ 2024 financial statements show total operating assets of $50,000 million, total operating liabilities of $23,000 million, and net income totaling $2,049 million. How much are Healthy Foods’ net operating assets (NOA) for the year? A) B) C) D)

$50,000 million $17,951 million $27,000 million $29,049 million

Answer: C Rationale: NOA = Total operating assets - Total operating liabilities = $50,000 - $23,000 = $27,000 million Topic: RNOA Disaggregation LO: 5 13. Into what two measures can return on net operating assets be disaggregated? A) B) C) D)

Profit margin and Return on equity Net operating profit margin and Asset turnover Net operating asset turnover and Return on equity Net operating profit margin and Net operating asset turnover

Answer: D Rationale: RNOA is disaggregated into net operating profit margin and net operating asset turnover.

. 5-9

Financial Accounting, 7th Edition

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Topic: Return on net operating assets LO: 5 14. Which one of the following is not true concerning return on net operating assets? A) An infinite number of combinations of net operating profit margin and net operating asset turnover will yield a given RNOA B) When comparing companies in different industries, a higher profit margin always indicates which company has better management performance C) In industries with relatively low operating asset turnover, a higher profit margin must be maintained to achieve sufficient RNOA D) When analyzing conglomerates, analysts use a weighted average of margin and turnover rates to look at RNOA Answer: B Rationale: A higher profit margin in one industry compared with another industry is not necessarily the result of better management and should not be used blindly across industries. Topic: Asset turnover computation LO: 3 15. Healthy Foods’ 2024 financial statements show net income of $2,049 million, sales of $336,040 million, and average total assets of $62,000 million. How much is Healthy Foods’ asset turnover for the year? A) B) C) D)

3.30 6.10 5.42 5.39

Answer: C Rationale: Asset turnover = Sales / Average total assets = $336,040 million / $62,000 million = 5.42 Topic: Profit margin computation LO: 3 16. Healthy Foods’ 2024 financial statements show interest expense of $930 million, net income of $2,049 million, sales of $336,040 million, and average total assets of $62,000 million. Assume that the statutory tax rate is 30%. How much is Healthy Foods’ profit margin for the year? A) B) C) D)

0.61% 0.80% 0.89% 0.69%

Answer: B Rationale: Profit margin = EWI / Sales = $2,049 million + [$930 million x (1 - 0.3)] / $336,040 million = 0.80%.

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Topic: Compute Profit Margin LO: 3 17. Use the following selected balance sheet and income statement information for Fenema Co. to compute the profit margin, to the nearest hundredth of a percent. Operating profit before tax

Earnings without interest expense (EWI)

Average total assets

Sales

Tax rate on operating profit

$120,000

$192,500

$653,000

$1,250,000

35%

A) 9.60% B) 18.38% C) 29.48% D) 15.40% Answer: D Rationale: Profit margin = EWI / Sales revenue = $192,500 / $1,250,000 = 15.40% Topic: Compute ROA LO: 2 18. Use the following selected balance sheet and income statement information for Fenema Co. to compute ROA, to the nearest hundredth. Operating profit before tax

Earnings without interest expense (EWI)

Average total assets

Sales

Tax rate on operating profit

$120,000

$192,500

$653,000

$1,250,000

35%

A) 9.60% B) 18.38% C) 29.48% D) 15.40% Answer: C Rationale: ROA = EWI / Average total assets = $192,500 / $653,000 = 29.48% Topic: Compute asset turnover LO: 3 19. Use the following selected balance sheet and income statement information for Fenema Co. to compute asset turnover, to the nearest hundredth of a percent.

A) B) C) D)

Operating profit before tax

Earnings without interest expense (EWI)

Average total assets

Sales

Tax rate on operating profit

$120,000

$192,500

$653,000

$1,250,000

35%

1.91 0.52 0.29 1.34

Answer: A Rationale: Asset turnover = Sales revenue / average total assets = $1,250,000 / $653,000 = 1.91 . 5-11

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Topic: Horizontal analysis LO: 1 20. In horizontal analysis, of what amount is each item expressed as a percentage? A) B) C) D)

Net income Average total assets Sales revenue A base year amount

Answer: D Rationale: A base year is selected. Each account is converted to a percentage of that base year amount so users can see the change from year to year. Topic: Horizontal analysis LO: 1 21. Leone Industries reported sales revenue totaling $1,200,000, $1,500,000, and $1,775,000 in the years, 2022, 2023, and 2024, respectively. Performing horizontal analysis, what is the percentage change for 2024? A) B) C) D)

15.49% 18.33% 22.92% 25.00%

Answer: B Rationale: Change in revenue / Revenue in previous year = ($1,775,000 - $1,500,000) / $1,500,000 = 18.33%

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Exercises

Topic: Compute ROE LO: 2 1. Selected balance sheet and income statement information from the 2024 fiscal year end for Hawk Clothing follows in thousands: Earnings before interest Average net operating assets Net income Average stockholders’ equity

$ 742,000 3,691,000 582,000 4,728,000

A. Calculate the company’s return on equity (ROE) to the nearest hundredth of a percent. B. Explain what information this provides to management. Answer: A. ROE = $582,000 / $4,728,000 = 12.31% B. Return on equity provides management with the understanding of how effectively it is deploying shareholder capital to generate a return on the company’s investment. Topic: ROA and ROE LO: 2 2. Sutherland Company’s recent balance sheet (fiscal year 2024) reported average equity of $165,000 and average total assets of $389,000. Assume that the company’s statutory tax rate is 35%. Sutherland’s recent income statement showed the following): Sutherland Company Income Statement Net sales Cost of products sold Selling, general and administrative expense Goodwill and indefinite lived intangible asset and impairment charges Operating income Interest expense Other nonoperating expense, net Earnings before income taxes Income taxes Net earnings from continuing operations Net earnings from discontinued operations Net earnings

$275,000 160,000 68,000 4,000 43,000 2,500 750 39,750 11,530 28,220 3,000 $ 31,220

A. Calculate the income tax rate on earnings before income taxes, to the nearest tenth of a percent. B. How much is EWI? C. Calculate ROE and ROA, to the nearest tenth of a percent. Answer: A. Tax rate on income from continuing operations = $11,530/ $39,750= 29.0% B. Earnings without interest expense = $31,220+ [$2,500 x (1 - 0.35)] = $32,845. C. ROE = Net income / Average stockholders’ equity = $31,220/ $165,000 = 18.9% ROA = Earnings without interest expense (EWI) / average total assets = $32,845 / $389,000 = 8.4% . 5-13

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Topic: Compute RNOA LO: 5 3. Selected balance sheet and income statement information from the 2024 fiscal year end for Barton Corporation follows: ($ millions) Net operating profit after tax (NOPAT) Average net operating assets (NOA) Net income Sales revenue Average stockholders’ equity

$ 3,775 88,915 3,762 180,000 40,000

A. Compute return on net operating profit (RNOA). B. Show that RNOA = Net operating profit margin (NOPM) × Net operating asset turnover (NOAT) Answer: A. RNOA= NOPAT / Average NOA = $3,775 / $88,915 = 4.25% B. NOPM = NOPAT / Sales revenue = $3,775 / $180,000 = 2.10% NOAT = Sales revenue / Average net operating assets = $180,000 / $88,915 = 2.02 RNOA = NOPM × NOAT = 0.0210 x 2.02 = 0.0424 = 4.24% (difference due to rounding). Topic: Compute and interpret times interest earned and financial leverage LO: 4 4. Selected balance sheet and income statement information from Rocket Inc. for fiscal years 2022 through 2024 follows: Period 2022

Current assets $ 16,725

Current liabilities $11,700

Pretax income $6,720

Interest expense $450

Total assets $45,685

Equity $ 20,000

2023

18,700

12,900

4,910

600

47,725

21,100

2024

20,250

14,300

5,650

650

47,640

20,900

A. Compute times interest earned for each year and discuss any trends. B. What concerns about Rocket’s ability to meet its interest obligations might creditors have? Explain. Answer: A. Times interest earned = Earnings before taxes and interest / Interest expense 2022: ($6,720 + $450) / $450 = 15.93 2023: ($4,910 + $600) / $600 = 9.18 2024: ($5,650 + $650) / $650 = 9.69 B. Rocket’s times interest earned ratio decreased sharply from 15.93 in 2022 to 9.18 in 2023, then increased slightly the following year to 9.69. The times interest earned ratio is an indication of Rocket’s solvency. The ratio measures how much profitability is available to service debt. With a times interest earned at over 9 times its interest expense, Rocket seems capable of servicing its debt.

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Topic: Compute and interpret liquidity and solvency ratios for two competitors LO: 4 5. Selected 2024 balance sheet and income statement information for Cost Club Warehouse and PriceCut Superstore follow:

Cash Accounts receivable Inventory Other current assets Total current liabilities Total liabilities Total equity Pre-tax income Interest expense A. B. C. D.

Cost Club Warehouse (in millions) $ 21,000 14,000 88,000 4,000 150,000 250,000 210,000 50,000 4,000

PriceCut Superstore (in thousands) $ 2,000 15,000 16,000 3,500 30,000 70,000 45,000 9,000 1,500

Calculate the current ratio and quick ratio for both companies. Which company is more liquid? Calculate the times interest earned and debt-to-equity ratio for both companies. Which company is more solvent? Explain.

Answer: A. Cost Club Warehouse Current Ratio = Current assets / Current liabilities Quick Ratio = [Cash + Marketable securities + AR] / Current liabilities

PriceCut Superstore

($21,000 + $14,000 + $88,000 + ($2,000 + $15,000 + $16,000 $4,000) / $150,000 = 0.85 + $3,500) / $30,000 = 1.22 ($21,000 +$0 + $14,000) / $150,000 = 0.23

($2,000 + $0 + $15,000) / $30,000 = 0.57

B. Cost Club Warehouse is less liquid as shown by its lower current ratio and quick ratio. Both ratios include accounts receivable, some of which may not be received for months. Cost Club Warehouse has only about 23% of the needed liquid assets available to pay its current obligations as they become due during the very short term. C. Cost Club Warehouse

PriceCut Superstore

Times interest earned = (Pre-tax income + Interest expense) / Interest expense

($50,000 + $4,000) / $4,000 = 13.5

($9,000 + $ 1,500) / $1,500 = 7.0

Debt-to-equity = Total liabilities / Total equity

$250,000 / $210,000 = 1.19

$70,000 / $ 45,000 = 1.56

D. Both companies are solvent. Both have a debt-to-equity ratio under 2.0. Cost Club Warehouse appears to be healthier, having a higher times interest earned ratio and a lower debt-to-equity ratio.

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Topic: Compute and interpret liquidity and solvency ratios LO: 4 6. Selected 2024 balance sheet and income statement information for two manufacturing companies, Tiger, Inc. and Snowball Corporation, follows:

Cash Marketable securities Accounts receivable All other current assets Total current liabilities Total liabilities Total equity Pre-tax income Interest expense A. B. C. D.

Tiger (in $ millions)

Snowball (in $ millions)

$ 30,000 500 35,000 50,000 65,000 236,000 75,000 3,900 1,800

$ 3,600 100 6,500 8,500 25,000 15,100 22,000 6,200 100

Answer: A. Tiger

Snowball

Current Ratio = Current assets / Current liabilities

($30,000 + $500 + $35,000 + $50,000) / $65,000 = 1.78

($3,600 + $100 + $6,500 + $8,500) / $25,000 = 0.75

Quick Ratio = [Cash + Marketable securities + AR] / Current liabilities

($30,000 + $500 +$35,000) / $65,000 = 1.01

($3,600 + $100 + $6,500) / $25,000 = 0.41

B. Tiger is considerably more liquid as shown by its higher current and quick ratios. C. ($ millions)

Tiger

Snowball

Times interest earned = (Pre-tax income + interest expense) / Interest expense

($3,900 + $1,800) / $1,800 = 3.17

($6,200 + $100) / $100 = 63.00

Debt-to-equity = Total liabilities / Total equity

$236,000 / $75,000 =3.15

$15,100 / $ 22,000 = 0.69

D. Snowball has a higher times interest earned ratio and a lower debt-to-equity ratio. Snowball is solvent and has a much stronger balance sheet and more conservative use of leverage. Tiger’s times interest earned is substantially lower, and it has a significantly higher debt to equity ratio.

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Topic: Compute and interpret turnover ratios for two years LO: 3 7. Selected recent balance sheet and income statement information for Dejavus, Inc. follows: (in millions) Average inventory Average accounts receivable Average accounts payable Sales Cost of goods sold

2024 150 1,600 900 20,000 14,000

2023 200 1,500 800 15,000 10,000

A. Calculate accounts receivable turnover (ART) for 2024 and 2023. Has ART improved during the year or worsened? B. Calculate inventory turnover (INVT) for 2024 and 2023. Has INVT improved during the year or worsened? Answer: A. 2024 ART = $20,000 / $1,600 = 12.50 2023 ART = $15,000 / $1,500 = 10.00 Accounts receivable turnover has improved during the year. The company collects its receivables balance 12.5 times in 2024 compared to 10 times in 2023. B. 2024 INVT = $14,000 / $150 = 93.33 2023 INVT = $10,000 / $200 = 50.00 Inventory turnover is strong and has significantly increased during the year. The company sold its entire average inventory cost over 93 times in 2024. Topic: Compute and interpret turnover ratios for two years LO: 3 8. Selected recent balance sheet and income statement information for Gillette Corporation follows: (in millions) Average inventory Average accounts receivable Average accounts payable Sales Cost of goods sold

2024 $ 16,600 42,000 35,000 400,000 240,000

2023 $ 15,900 40,000 30,000 350,000 250,000

Calculate accounts receivable turnover (ART) for 2024 and 2023. Has ART improved during the year or worsened? B. Calculate inventory turnover (INVT) for 2024 and 2023. Has INVT improved during the year or worsened? Answer: A. 2024 ART = $400,000 / $42,000 = 9.52 2023 ART = $350,000 / $40,000 = 8.75 During the year, Happy Valley’s ART improved, collecting its average receivables 9.52 times in 2024. B. 2024 INVT = $240,000 / $16,600 = 14.46 2023 INVT = $250,000 / $15,900 = 15.72 During the year, inventory turnover worsened to 14.46 times the average cost of the inventory in 2024, compared to 15.72 in 2023.

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Topic: Compute and interpret turnover ratios for two years LO: 3 9. Selected recent balance sheet and income statement information for Zeff, Inc. follows: (in millions) Average inventory Average accounts receivable Average accounts payable Sales Cost of goods sold

2024 $ 6,500 4,500 3,200 55,000 37,000

2023 $ 5,000 6,000 3,000 50,000 35,000

A. Calculate accounts receivable turnover (ART) for 2024 and 2023. Has ART improved during the year or worsened? B. Calculate inventory turnover (INVT) for 2024 and 2023. Has INVT improved during the year or worsened? Answer: A. 2024 ART = $55,000 / $4,500 = 12.22 2023 ART = $50,000 / $6,000 = 8.33 During the year, Zeff’s ART improved from collecting its receivables 8.33 times in 2023 compared to 12.22 times in 2024. B. 2024 INVT = $37,000 / $6,500 = 5.69 2023 INVT = $35,000 / $5,000 = 7.00 During the year, Zeff’s INVT worsened from selling 7 times the average cost of the inventory in 2023 to 5.69 times in 2024. Topic: Solvency ratio LO: 4 10. Use the selected balance sheet and income statement information below for Mozart, Inc. to compute the times interest earned ratio. Explain what information this ratio provides. Current assets

Current liabilities

Pretax income

Interest expense

$20,000,000

$8,000,000

$1,700,000

$700,000

Answer: Times interest earned = Earnings before interest expense and taxes / Interest expense = ($1,700,000 + $700,000) / $700,000 = 3.43 Mozart, Inc. has income available to pay its annual interest expense of 3.43 times for the year.

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Topic: Liquidity ratio LO: 4 11. Use the selected balance sheet and income statement information below for Mozart, Inc. to compute the current ratio. Explain what information this ratio provides. Current assets

Current liabilities

Pretax income

Interest expense

$20,000,000

$8,000,000

$1,700,000

$700,000

Answer: Current ratio = Current assets / Current liabilities = $20,000,000 / $8,000,000 = 2.5. Mozart, Inc. is able to cover its current debt 2.5 times with its current assets. Topic: Calculate and interpret turnover ratios LO: 3 12. Selected 2024 balance sheet and income statement information for two large communication companies, Omni Communication, Inc., and Verio, Inc., follow: ($ millions) Average accounts receivable Average accounts payable Net sales Cost of goods sold Net income Income tax expense

Omni $ 30,000 35,000 450,000 60,000 25,000 1,500

Verio $ 28,000 42,000 400,000 175,000 20,000 3,200

A. Compute accounts receivable turnover for Omni and Verio. B. Interpret and comment on the differences between the receivables turnover rates between the companies, assuming the industry average is 12.0 times. Answer: A. Omni: Verio:

$450,000 / $30,000 = 15.00 $400,000 / $28,000 = 14.29

B. Omni has a slightly higher accounts receivable turnover rate than Verio. Omni collected its receivables 15 times in 2024, while Verio collected its receivables 14.29 times. Turnover rates for both companies are above the 12 times industry average.

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Topic: ART, INVT LO: 3 13. Selected 2024 balance sheet and income statement information for an office supply retailer, Office Mart, Inc., follows (in $ millions): Average accounts receivable Average inventory Net sales Cost of goods sold Pretax income Net income

$ 4,000 5,000 65,000 45,000 600 50

Compute accounts receivable turnover and inventory turnover for Office Mart, Inc. Answer: Accounts receivable turnover = Sales / Average accounts receivable = $65,000 / $4,000 = 16.25 Inventory turnover = Cost of goods sold / Average inventory = $45,000 / $5,000 = 9.00 Topic: Financial leverage LO: 2 14. Selected balance sheet and income statement information for Young Corporation for 2022 through 2024 follows (millions):

2022

Current Assets $38,000

Net Income $23,900

2023 2024

44,000 45,000

27,000 28,750

Earnings Without Interest Expense (EWI) $25,000 28,000 30,000

Interest Expense $1,250

Average Total Assets $240,000

Average Stockholders’ Equity $100,000

1,500 1,310

232,000 230,000

110,000 115,000

Compute the return on financial leverage for each year. Interpret these values for Young Corporation Answer: ROE = Net income / Average stockholders’ equity 2022: $23,900 / $100,000 = 23.90% 2023: $27,000 / $110,000 = 24.55% 2024: $28,750 / $115,000 = 25.00% ROA = Earnings without interest (EWI) / Average total assets 2022: $25,000 / $240,000 = 10.42% 2023: $28,000 / $232,000 = 12.07% 2024: $30,000 / $230,000 = 13.04% Return on financial leverage = ROE ‒ ROA 2022: 23.90% - 10.42% = 13.48% 2023: 24.55% - 12.07% = 12.48% 2024: 25.00% - 13.04% = 11.96% Young Corporation’s ROA and ROE have both increased over the period, while its ROFL has decreased. This indicates that Young is not using its financial leverage as productively as in the past.

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Problems Topic: Liquidity and solvency ratios LO: 4 1. Selected balance sheet and income statement information for jewelry retailer Glover, Inc for 2022 through 2024 follows: ($millions) Net sales Interest expense Pretax income Net income Current assets Total assets Current liabilities

2024

2023

2022

$7,600 275 1,680 1,120 10,000 72,000 1,600

$7,300 250 1,425 1,100 9,000 75,000 1,190

$6,400 200 1,500 1,240 7,000 71,000 1,000

A. Compute the current ratio for each year and discuss any trends. Do you feel that Glover, Inc is sufficiently liquid? Explain. What additional information might be helpful in analyzing liquidity? B. Compute times interest earned for each year and discuss any trends. Do you have any concerns about Glover, Inc ’s level of financial leverage and its ability to meet interest obligations? Explain. Answer: A. Current ratio = Current assets / Current liabilities ($ millions) Current assets ÷ Current liabilities = Current Ratio

2024

2023

2022

$10,000 1,600 6.25

$9,000 1,190 7.56

$7,000 1,000 7.00

Glover, Inc ’s current ratio increased from 2022 to 2023 but decreased from 2023 through 2024. Overall, Glover, Inc ’s current ratio seems strong. However, the company can still run into liquidity problems if its liabilities mature quicker than their current assets are converted into cash. We might benefit from additional information on the maturity schedule of liabilities and the expected conversion of its current assets into cash in order to evaluate the company’s short-term liquidity with more accuracy. B. Times interest earned = (Pretax Income + Interest expense) / Interest expense 2024: ($1,680 + $275) / $275 = 7.11 2023: ($1,425 + $250) / $250 = 6.70 2022: ($1,500 + $200) / $200 = 8.50 Times interest earned seems to be at a relatively safe level, despite fluctuations between years.

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Topic: Compute and interpret turnover ratios for two competitors LO: 3 2. Selected 2024 balance sheet and income statement information from Letterman, Inc. and Kimmel Company follows: ($ millions) Sales Cost of goods sold Average accounts receivable Average inventory Average total assets

Letterman $13,800 10,600 345 2,525 6,200

Kimmel $7,500 5,400 50 900 2,500

A. Compute the following turnover rates for each company: 1. Accounts receivable turnover 2. Inventory turnover 3. Asset turnover B. Interpret and comment on any differences you observe between the turnover rates for these two companies. What are some characteristics of their respective businesses that would likely lead to the differences identified? Answer: A. 1. ART = Sales / Average accounts receivable Letterman = $13,800 / $345 = 40.00 Kimmel = $7,500 / $50 = 150.00 2. INVT = COGS / Average inventory Letterman = $10,600 / $2,525 = 4.20 Kimmel = $5,400 / $900 = 6.00 3. AT = Sales / Average assets Letterman = $13,800 / $6,200 = 2.23 Kimmel = $7,500 / $2,500 = 3.00 B. We see from the calculations above that Kimmel has a considerably higher accounts receivable turnover (150.00) compared to that of Letterman (40.00). Accounts receivable turnover (ART) reflects on the necessary investment in receivables to generate a dollar of sales. In 2024, Kimmel collected its entire amount of receivables 150 times, while Letterman collected only 40 times, since Letterman has proportionately more investment in receivables. Several issues could account for Kimmel’s higher inventory turnover. For instance, it is possible that Kimmel may be more efficient at ensuring ‘just-in-time’ deliveries, which means that inventories sit with suppliers. Kimmel also has a higher AT than Letterman. Therefore, Kimmel has done a more effective job at optimizing investments in total assets required to generate its sales.

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Topic: Use financial statements to calculate and interpret liquidity and solvency ratios LO 4 3. The balance sheets and income statements for BBC Media follow: Consolidated Balance Sheets December 31, 2024 and December 31, 2023 (in thousands) 2024 ASSETS Current assets: Cash and cash equivalents Receivables, net Inventories, net Prepaid expenses Syndicated programs Deferred income taxes TOTAL CURRENT ASSETS Property and equipment: Land and land improvements Buildings and building improvements Equipment Less accumulated depreciation Net property and equipment Syndicated programs Goodwill Broadcast licenses Other intangible assets, net Deferred income taxes Other assets TOTAL ASSETS

4,000 200,000 15,000 8,000 10,000 3,000 240,000

65,000 240,000 290,000 595,000 157,500 437,500 10,000 100,000 130,000 45,000 40,000 5,000 $1,007,500

2023

3,000 150,000 10,800 9,000 14,000 3,200 190,000

60,000 250,000 300,000 610,000 152,000 458,000 25,000 65,000 150,000 40,000 120,000 10,000 $1,058,000

Table continued next page

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Table continued Consolidated Balance Sheets - continued December 31, 2024 and December 31, 2023 (in thousands) 2024 LIABILITIES AND SHAREHOLDERS’ EQUITY Current liabilities: Accounts payable Accrued compensation Accrued employee benefits Deferred revenue Accrued income taxes Syndicated programs Other current liabilities Current portion of long-term liabilities

TOTAL CURRENT LIABILITIES Accrued employee benefits Syndicated programs Long-term notes payable to banks Other long-term liabilities TOTAL LIABILITIES Shareholders’ equity: Common stock Additional paid-in capital Accumulated other comprehensive loss Retained earnings TOTAL SHAREHOLDERS’ EQUITY TOTAL LIABILITIES AND EQUITY

45,950 21,000 9,500 33,000 7,400 11,000 20,000 300 148,150

2023

38,400 20,600 10,000 30,000 5,500 15,000 17,000 200 136,700

130,000 5,000 264,350 10,000 557,500

120,000 6,000 320,000 15,300 598,000

1,600 598,000 (174,600) 25,000 450,000 $1,007,500

1,500 600,000 (100,000) (41,500) 460,000 $1,058,000

Continued next page

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3. continued Consolidated Income Statement Years Ended December 31, 2024 and December 31, 2023 (in thousands) 2024 Total revenue $980,000 Operating costs and expenses: Broadcasting 205,000 Publishing 346,400 Total operating costs and expenses 551,400 Selling and administrative expenses 310,000 Broadcast license impairment 2,000 Total expenses 863,400 Operating earnings 116,600 Other income and expense: Interest income 1,000 Interest (expense) (12,000) Total other income and expense (11,000) Earnings before income taxes 105,600 Provision for income taxes 42,300 Net earnings $ 63,300

2023 $850,000 185,000 224,190 409,190 315,000 6,000 730,190 119,810 670 (11,000) (10,330) 109,480 43,000 $ 66,480

A. Compute the company’s current ratio for 2024 and 2023. Comment on any observed trend. B. Compute the company’s times interest earned and debt-to-equity ratio for 2024 and 2023. Comment on any observed trend. C. Summarize your findings in a conclusion about the company’s liquidity and solvency. Do you have any concerns about the company’s ability to meet its debt obligations? Answer: A. 2024 current ratio = $240,000 / $148,150 = 1.62 2023 current ratio = $190,000 / $136,700 = 1.39 During the year, the company’s current ratio has improved. Plus it is above the rule of thumb cut-off of 1.0. B. 2024 times interest earned = ($105,600 + $12,000) / $12,000 = 9.80 2023 times interest earned = ($109,480 + $11,000) / $11,000 = 10.95 2024 debt-to-equity ratio = $557,500/ $450,000 = 1.24 2023 debt-to-equity ratio = $598,000/ $460,000 = 1.30 Overall levels of debt have declined somewhat during the year. Times interest earned is very good. BBC is able to service its debt. C. BBC is both liquid and solvent. Based on the ratios above, there are no immediate concerns about the company’s ability to meet its debt obligations. However, if the current ratio goes below 1, management may need to address larger issues.

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Topic: Liquidity and solvency LO: 4 4. Selected balance sheet and income statement information for Office Mart, Inc., a retail office supplier, for 2022 through 2024 follows: ($ thousands) Interest expense Pretax income Net income Current assets Total assets Current liabilities

2024 $ 400 1,800 250 15,000 20,000 14,500

2023 425 1,913 1,750 13,900 18,000 14,330

2022 400 2,800 1,900 17,600 24,000 16,000

A. Compute the current ratio for each year and discuss any trends. Do you feel that the company is sufficiently liquid? Explain. What additional information might be helpful in analyzing the liquidity? B. Compute times interest earned ratio for each year and discuss any trends. Do you have any concerns about Office Mart’s level of financial leverage and its ability to meet interest obligations? Explain. Answer: A. 2024: $15,000 / $14,500 = 1.03 2023: $13,900 / $14,330 = 0.97 2022: $17,600 / $16,000 = 1.10 Office Mart’s current ratio declined below 1.0 in 2023, although it rebounded slightly in 2024. Overall, Office Mart runs the risk of not being able to pay its current liabilities as they come due. The company can easily run into liquidity problems if liabilities mature quicker than current assets are converted into cash. We could benefit from additional information like their maturity schedule of liabilities and the expected conversion of its current assets into cash in order to evaluate the company with more accuracy and identify whether they are truly in danger of not covering their current liabilities. B. 2024: ($1,800 + $400) / $400 = 5.5 2023: ($1,913 + $425) / $425 = 5.5 2022: ($2,800 + $400) / $400 = 8.0 Office Mart’s times interest earned showed a significant decline in 2023, with no improvement in 2024. Although coverage seems reasonably high, the significant decrease to 5.5 in 2023 and 2024 is concerning. Management should closely monitor leverage.

. Test Bank, Chapter 5

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Topic: Use financial statements to calculate and interpret turnover ratios LO: 3 5. The partial balance sheets and income statements for Robinson, Inc. for fiscal years ending June 30, 2024 and 2023 follow: ($ millions) June 30,

2024

2023

Current assets Cash and cash equivalents Accounts receivable Inventories Deferred income taxes Prepaid expenses and other current assets Total current assets

$ 20,000 10,600 14,350 3,000 8,050 56,000

$ 2,000 10,400 14,150 1,000 2,450 30,000

Property, plant and equipment Accumulated depreciation Net property, plant and equipment Goodwill and other intangible assets Other noncurrent assets Total assets

124,000 (34,400) 89,600 160,000 15,000 $320,600

121,000 (35,000) 86,000 100,000 8,000 $224,000

($ millions) Years ended June 30, Net sales Cost of products sold Selling, general and administrative expense Goodwill and indefinite lived intangible asset impairment charges Operating income Interest expense Other non-operating expense, net Earnings from continuing operations before income taxes Income taxes Net earnings

2024

2023

$150,000 65,000 56,000 4,000 25,000

$142,000 60,000 50,000 0 32,000

1,500 600 22,900

1,200 300 30,500

6,850 $ 16,050

9,200 $ 21,300

A. Calculate accounts receivable turnover (ART) for 2024 and 2023. Accounts receivable in 2022 totaled $10,000 million. Has ART improved in 2024 or worsened? B. Calculate inventory turnover (INVT) for 2024 and 2023. Inventories in 2022 were $10,850 million. Has INVT improved in 2024 or worsened? C. Calculate asset turnover (AT) for 2024 and 2023 considering that 2022 total assets were $248,000 million. Has AT improved in 2024 or worsened?

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Answer: A. ART = Sales/ Average accounts receivable 2024 ART = $150,000 / [($10,600 + $10,400) /2] = 14.29 2023 ART = $142,000 / [($10,400 + $10,000) /2] = 13.92 Accounts receivable turnover improved during the year. The company collected its receivables 14.29 times during 2024. B. INVT = Cost of goods sold / Average inventory 2024 INVT = $65,000 / [(14,350 + 14,150) /2] = 4.56 2023 INVT = $60,000 / [($14,150 + $10,850) /2] = 4.80 Inventory turnover worsened during the year. The company sold its average inventory balance 4.56 times during 2024. C. AT = Sales / Average assets 2024 AT = $150,000 / [($320,600 + $224,000) / 2] = 0.55 2023 AT = $142,000 / [($224,000 + $248,000) / 2] = 0.60 Asset turnover worsened during the year. Topic: Common-size income statements LO: 1 6. The income statements for Lindsey Corporation for years ending December 31, 2024 and 2023 follow: ($ millions) Sales revenue Cost of sales Selling, general and administrative expenses Depreciation and amortization Earnings before interest expense and income taxes Net interest expense Earnings before income taxes Provision for income taxes Net earnings

2024

2023

$150,000 100,000 35,000 3,500 11,500 1,500 10,000 2,500 $ 7,500

$100,000 60,000 20,000 3,000 17,000 3,000 14,000 3,500 $ 10,500

A. Prepare common-size income statements for 2024 and 2023. B. Comment on the most significant changes.

. Test Bank, Chapter 5

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Answer: A. ($ millions) Total sales revenue Cost of sales Selling, general and administrative expenses Depreciation and amortization Earnings before interest expense and income taxes Net interest expense Earnings before income taxes Provision for income taxes Net earnings

2024 100.00% 66.67% 23.33% 2.33% 7.67% 1.00% 6.67% 1.67% 5.00%

2023 100.00% 60.00% 20.00% 3.00% 17.00% 3.00% 14.00% 3.50% 10.50%

B. Lindsey’s cost of sales has increased from 60% to 66.67% of sales, and SG&A expenses have increased from 20% to 23.33% of sales. These factors are the major cause of the decline in profit from 10.5% to 5% of sales. Topic: Forecasted income statements LO: 6 7. The 2024 income statement for Lindsey Corporation follows: ($ millions)

2024

Sales revenue Cost of sales Selling, general and administrative expenses Depreciation and amortization Earnings before interest expense and income taxes Net interest expense Earnings before income taxes Provision for income taxes Net earnings

$150,000 100,000 35,000 3,500 11,500 1,500 10,000 2,500 $ 7,500

Prepare a forecasted income statement for 2022 for Lindsey assuming the following: • • • •

Total sales revenue is $165,000 million. Cost of sales is 65% of sales revenue. Selling, general and administrative expenses increase by 10% from 2024. Depreciation and amortization increase by 15%

• •

Interest costs remain the same. The effective income tax rate is 30%.

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Answer: ($ millions)

2022 Forecast

$165,000 107,250 38,500 4,025 15,225 1,500 13,725 4,118 $ 9,607

Topic: Common size balance sheets LO: 1 8. The balance sheets for Lindsey Corporation for December 31, 2024 and 2023 follow: ($ millions) Assets Cash and cash equivalents Credit card receivables, net Inventory Other current assets Total current assets Property and equipment, net Other noncurrent assets Total assets

Dec. 31, 2024 $

1,600 12,300 20,000 1,100 35,000 62,000 3,000 $100,000

Dec. 31, 2023 $

1,450 14,000 24,000 700 40,150 49,750 100 $90,000

A. Prepare common-size statements for the asset section of Lindsey’s balance sheet for December 31, 2024 and 2023. B. Comment on the most significant changes. Answer: A. ($ millions) Assets Cash and cash equivalents Credit card receivables, net Inventory Other current assets Total current assets *Property and equipment Other noncurrent assets Total assets

Dec. 31, 2024

Dec. 31, 2023

1.6% 12.30% 20.00% 1.10% 35.00% 62.00% 3.00% 100.00%

1.61% 15.56% 26.67% 0.78% 44.61%* 55.28% 0.11% 100.00%

*Answer may vary due to rounding

B. Lindsey’s current assets comprise only 35% of total assets at the end of 2024, while they were 45% of total assets at the end of 2023. Correspondingly, noncurrent assets have increased from 55% to 65%. . Test Bank, Chapter 5

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Essay Topic: Margin and turnover LO: 3 1. Explain the trade-off between profit margin and asset turnover. Answer: There are an infinite number of combinations of margin and turnover that yield a given ROA. Companies need to demonstrate an ability to earn an acceptable return on capital in order to attract the capital they need to grow. Service companies can operate on a lower profit margin since they achieve a high turnover of assets. Manufacturers, however, require higher profit margins in order to offset a lower asset turn. Topic: Factors limiting usefulness of ratio analysis LO: 1, 2, 3, 4 2. Discuss factors that limit the usefulness of financial accounting information for ratio analysis. Answer: The first source is GAAP limitations such as non-measurable values, non-capitalized costs, and the irrelevance of historical costs. The second limitation is changes within the company. For example, a company may acquire or divest a subsidiary within the cycle, thus throwing the numbers off. The final limitation is the impact of conglomerates. Most companies are actually a formation of several smaller companies. Taken as a whole, their combined numbers impair the ability to compare ratios with other competitors. Topic: Conglomerates and ratio analysis LO: 1, 2, 3, 4 3. Ratio analysis is more complicated when a company is a conglomerate. Why? Answer: Conglomerates are difficult to analyze because they are a blend of several businesses under one parent company. Since the different companies operating under the conglomerate may participate in a wide variety of industries, it is difficult to compare the conglomerate’s consolidated financial statements with its competitors.

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Chapter 6 Reporting and Analyzing Revenues and Receivables Learning Objectives – Coverage by question True/False

Multiple Choice

Exercises

Problems

Essay Questions

LO6-1 Describe and apply the criteria for determining when revenue is recognized. (p. 6-5)

1, 2

1-4, 9

1, 3

LO6-2 Illustrate revenue and expense recognition when the transaction involves future deliverables and/or multiple elements. (p. 6-8)

15, 16

LO6-3 Illustrate revenue and expense recognition for long-term projects. (p. 6-11)

5, 13, 16

5, 6

1, 5

LO6-4 Estimate and account for uncollectible accounts receivable. (p. 6-14)

6, 9, 10, 12

5, 8, 10, 12,13

10, 12, 14

2, 3

LO6-5 Calculate return on net operating assets, net operating profit after taxes, net operation profit margin, accounts receivable turnover, and average collection period. (p.6-22)

14, 15

11, 13

3, 7

LO6-6 Discuss earnings management and explain how it affects analysis and interpretation of financial statements. (p. 6-27)

8, 14

1-5, 11

8, 9

LO6-7 Appendix 6A: Describe and illustrate the reporting for nonrecurring items. (p. 6-29)

3, 4, 7

2-4, 7

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Chapter 6: Reporting and Analyzing Revenues and Receivables True/False Topic: Revenue recognition LO: 1 1. According to GAAP revenue recognition criteria, in order for revenue to be recognized on the income statement, an amount must be either realized, realizable, or earned. Answer: False Rationale: According to GAAP revenue recognition criteria, revenue must be both realized (realizable) and earned, to be recognized on the income statement. Topic: Revenue recognition LO: 1 2. A computer retailer has a 30-day return policy. The company can report revenue on the full amount as soon as the merchandise is sold if returns are immaterial. Answer: True Rationale: Revenue can be recognized when sold if the estimated returns are a small enough amount to be considered immaterial. Topic: Discontinued operations LO: 7 3. Revenues from discontinued operations of a company are reported separately from revenues from continuing operations in the income statement. Answer: True Rationale: Discontinued operations refer to any identifiable business unit that the company intends to sell. The income (loss) of the discontinued operations (net of tax), and the after-tax gain (loss) on sale of the unit, are reported in a separate section of the income statement below income from continuing operations. Topic: Discontinued operations LO: 7 4. Income effects of discontinued operations are reported separately from continuing operations on the income statement. Answer: True Rationale: Discontinued operations are not expected to have further impact on income and are, therefore, disclosed separately from income from continuing operations on the income statement.

. Test Bank, Chapter 6

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Topic: Revenue recognition for long-term contracts LO: 3 5. The percentage-of-completion method is an application of the matching principle. Answer: True Rationale: Percentage-of-completion requires that revenue be recognized based on the costs incurred under the contract relative to its total expected costs. Topic: Accounts receivable LO: 4 6. The net accounts receivable reported in the current asset section of a company’s balance sheet represents all receivables expected to be collected within the next year. Answer: True Rationale: A company makes two representations when reporting receivables in the balance sheet. The first is that it expects to collect the amount reported on the balance sheet. The second is that it expects to collect within the next year or operating cycle. Topic: Restructuring costs LO: 7 7. Restructuring costs have two components: employee severance costs and extraordinary costs. Answer: False Rationale: Restructuring costs consist of employee severance costs and costs to consolidate and close facilities, including asset write-downs. Topic: Channel stuffing LO: 6 8. Channel stuffing arises when a company records a nonrecurring loss in a period of already depressed income. Answer: False Rationale: This statement describes a big bath. Channel stuffing arises when a company uses it market power over customers or distributors to induce them to purchase more goods than necessary to meet their normal needs. Topic: Reporting accounts receivable LO: 4 9. The balance in Allowance for Uncollectible Accounts represents the amount a company thinks it will not collect from a customer. Answer: True Rationale: On the balance sheet the net amount of receivables is reported which represents the net amount a company thinks it will collect.

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Topic: Earnings manipulation LO: 4 10. Underestimating the allowance for uncollectible accounts can shift income from future periods into the present period. Answer: True Rationale: By underestimating current accounts receivable provisions, current income increases because expenses are reduced. However, due to the underestimation, future year provisions will need to increase to compensate, thus lowering future profitability. Topic: Accounts receivable turnover LO: 5 11. The higher the accounts receivable turnover is, the faster receivables are being collected. Answer: True Rationale: More turns of accounts receivable indicate that receivables are being collected more quickly. Topic: Bad debt expense LO: 4 12. Income statement effects of uncollectibles occur at the point of estimation, not when an account is written-off. Answer: True Rationale: Under the matching principle, costs relating to anticipated bad debts expense are matched with sales in the period that the sales are recognized. Upon write-off, both the receivable and the allowance account are reduced, leaving net receivables unchanged. Topic: Revenue recognition LO: 3 13. The completed contract method recognizes revenue when the product is completed and transferred to the customer. Answer: True Rationale: Percentage-of-completion recognizes revenue during production. Topic: Quality of earnings LO: 6 14. One motive of earnings management is a desire to mislead some financial statement users about a company’s financial performance in order to gain economic advantage. Answer: True Rationale: A second reason is a desire to influence legal contracts that use reported accounting numbers to specify contractual obligations and outcomes.

. Test Bank, Chapter 6

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Topic: Bundled sales LO: 2 15. If a company sells two or more products or services under the same sales agreement for one lumpsum price, the sales price must be reduced by the cost of the goods or services. Answer: False Rationale: If a company sells two or more products or services under the same sales agreement for one lump-sum price (a bundled sale), the sales price must be allocated among the various elements of the sale in proportion to their fair value. Topic: Timing of revenue recognition LO: 2, 3 16. GAAP requires that companies recognize revenue subsequent to customer purchases by using the percentage-of-completion method. Answer: False Rationale: The percentage-of-completion method is used to recognize revenue during production, not after customers’ purchases.

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Multiple Choice Topic: Revenue recognition LO: 1, 6 1. Which of the below cases is not an example of potentially misleading reporting? A) B) C) D)

Channel stuffing Overly optimistic estimates Recognizing revenue after goods are delivered Mischaracterizing transactions as arm’s length

Answer: C Rationale: Revenue recognition requires that amounts be earned and realized, or realizable before recognizing as revenue. Topic: Revenue recognition LO: 1, 6 2. Which of the following is not considered an issue relating to proper revenue recognition? A) B) C) D)

Asset write-downs Channel stuffing Income smoothing Lack of arm’s length transactions

Answer: A Rationale: Asset write-downs are generally legitimate aspects of a company’s operating activities. Channel stuffing, income smoothing, and the lack of an arm’s length transaction present revenue recognition issues. Topic: Revenue recognition LO: 1, 6 3. Which of the following is an indicator of a revenue recognition issue? A) B) C) D)

Optimistic estimates in accrual accounting Receipt of payment prior to delivery Receipt of payment after completion of service or delivery of goods Sale to end-customer with no right of return

Answer: A Rationale: Overly optimistic estimates can shift income from one period to the next.

. Test Bank, Chapter 6

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Topic: Improper revenue recognition LO: 1, 6 4. Which of the following does not relate to improper revenue recognition? A) B) C) D)

Recording revenue in advance of the execution of sales agreement Recognized revenue prior to collecting payment Mischaracterizing transactions as arm’s-length Taking a big bath

Answer: B Rationale: If the revenue recognition criteria are met, revenue can be recognized prior to collecting payment. Topic: Persistent income items LO: 4, 6 5. Which of the following items can be considered as a persistent income statement item for analysis purposes? A) B) C) D)

Effects of a strike Gains and losses on the disposal of a business segment Bad debt expense Write-down or write-offs of receivables

Answer: C Rationale: Bad debt expense is a persistent (continuing) item. The other three items are all classified as transitory items, as income (loss) and cash flows from such items are not persistent. Topic: Percentage-of-completion method LO: 3 6. Apex Building Corp. has a $20 million contract to construct a building. The company estimates a gross profit of $4 million. During the current year, the company incurred $2 million of costs on the contract. Under the percentage-of-completion method, how much will Apex Building Corp. report as revenue in the current year? A) B) C) D)

$ 2,000,000 $10,000,000 $ 4,000,000 $ 2,500,000

Answer: D Rationale: The percentage-of-completion method recognizes revenues by determining the costs incurred per the contract as compared to its total expected cost. The revenue to be recognized in the year at hand is calculated by dividing cost incurred during the year by total estimated costs and multiplying this percentage by the total contract amount. $2/($20 – $4) × $20,000,000 = $2,500,000.

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Topic: Discontinued operations LO: 7 7. Which of the following is not true regarding a discontinued operation? A) The discontinued business unit has its own identifiable operations and cash flows. B) The operations and cash flows of the unit must be removed from the company’s continuing operations. C) The company must have no significant continuing involvement in the discontinued unit’s operations after its disposal. D) The company must have reported its intention to sell the related business unit in the previous year’s annual report notes. Answer: D Rationale: The company has no obligation to report its intention to sell any of its business units in its income statement or any other reports. The first three conditions, instead, are necessary for a business unit to be qualified as a discontinued operation. Topic: Uncollectible Accounts—Aging LO: 4 8. Anna’s Antiques estimates its uncollectible accounts by aging its accounts receivable and applying percentages to various aged categories of accounts. Anna’s computes a total of $8,120 in estimated losses as of December 31, 2024. Its Accounts Receivable account has a balance of $250,000 and its Allowance for Uncollectible Accounts has a balance of $1,625 before adjustment at December 31, 2024. How much bad debt expense will Anna’s Antiques report in 2024? A) B) C) D)

$6,495 $8,120 $9,745 $1,625

Answer: A Rationale: To bring the allowance to the desired balance of $8,120, the company will need to increase the allowance account by $6,495 (or $8,120 – $1,625) resulting in bad debt expense of the same amount. Topic: Revenue recognition subsequent to customer purchase LO: 1, 2 9. Why must amounts received in advance from customers be deferred? A) B) C) D)

The customer may not pay the entire balance due The company receiving payment has not earned the amount The customer has a right of return All of the above are reasons to defer

Answer: B Rationale: Revenue recognition requires that amounts be earned and realized, or realizable before recognizing as revenue.

. Test Bank, Chapter 6

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Topic: Accounts receivable LO: 4 10. On which financial statement and at what amount are accounts receivable reported? A) B) C) D)

Balance sheet at the amount owed by customers Income statement at the net uncollectible amount Income statement at the amount written off Balance sheet at the net realizable value

Answer: D Rationale: Accounts receivable are reported on the balance sheet at the amount expected to be collected which is accounts receivable less allowance for uncollectible accounts, also known as net realizable value. Topic: Earnings management LO: 6 11. Homer’s Pizza intentionally overestimates the amount of its write-downs of assets in order to record a nonrecurring loss in a period of already depressed income. What is this behavior called? A) B) C) D)

Restructuring costs Big Bath Arm’s length sales Income smoothing

Answer: B Rationale: Behavior such as this is referred to as a “big bath”. Topic: Carrying amount of accounts receivable LO: 4 12. At what amount will accounts receivable be reported on the balance sheet if the gross receivable balance is $100,000 and the allowance for uncollectible accounts is estimated at 6% of gross receivables? A) B) C) D)

$100,000 $106,000 $ 94,000 $ 60,000

Answer: C Rationale: Receivables are reported net of the allowance account. In this case, $100,000 – ($100,000 x 6%) = $94,000.

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Topic: Uncollectible accounts LO: 4 13. Which of the following does not occur when a company receives additional information that requires it to increase its expectations of uncollectible accounts receivable? A) B) C) D)

Accounts receivable (net) is reduced Bad debt expense is increased Net income is reduced The allowance account is decreased

Answer: D Rationale: The allowance account is increased, resulting in additional expense and a reduction of profit and retained earnings. Topic: Accounts receivable turnover rate LO: 5 14. Which of the following formula computes the average collection period? A) B) C) D)

Average daily sales / Account receivable Account receivable / Average daily sales Sales / Average accounts receivable Average accounts receivable / Average daily sales

Answer: D Rationale: Average collection period = Average accounts receivable / Average daily sales Topic: Receivable turnover rate LO: 5 15. If the collection period lengthens compared to historic figures and industry averages, what might the reason be? A) B) C) D) E)

Deterioration of collectability of receivables A change in sales mix to longer paying customers A decrease in the amount of sales generated A and B All of the above

Answer: D Rationale: A lengthened collection period means that receivables turnover slows Answers A and B are reasons for a slowdown in the receivables turnover.

. Test Bank, Chapter 6

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Exercises Topic: Revenue recognition determination LO: 1 1. Identify and explain when each of the following companies should recognize revenue for the sales of their products: A. Sears is a retail store that sells products with a 30-day period of right of return. B. United Airlines sells airplane tickets for the current and upcoming year. C. Apple sells computers and extended warranties for those computers. Answer: A. Revenue is recognized when merchandise is given to the customer and the 30-day period of right of return has expired. B. Revenue is recognized when the service is provided, even though cash is received in advance. C. Revenue of the computers is recognized when the merchandise is delivered to the customer and the right of return period has expired. The portion of the sales price relating to the extended warranty is recognized ratably over the warranty period. In order to be recognized, revenue must be realized or realizable and earned. This means that the company’s net assets have increased, that the seller has fulfilled its obligations under terms of the sales agreement, and that title has passed to the buyer with no right of return or other contingencies. Topic: Identify nonrecurring items LO: 7 2. Following is the income statement reported by Rocket Cable, Inc. from its 2024 annual report (amounts in millions). Total revenues Cost of goods sold Selling, general and administrative expenses Depreciation and amortization Loss on sale of property Restructuring costs Goodwill writeoff Interest expense, net Operating loss Other income, net Loss from continuing operations before income taxes Income tax provision Net loss from continuing operations Net loss from discontinued operations Net Loss

$50,000 28,000 10,000 3,000 6,000 1,000 4,000 500 (2,500) 900 (1,600) 200 (1,400) (900) $ (2,300)

Identify the items in Rocket Cable’s income statement that might be considered nonrecurring items.

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Answer: The following items might be identified as nonrecurring item: • • • •

Restructuring costs. These are one-time (transitory) costs as part of a restructuring plan. Loss on sale of property. While property sales are generally recurring, this is a particularly large loss that may be a one-time event. Goodwill writeoff. Writeoffs of intangible assets such as goodwill are triggered by negative events, which may be considered nonrecurring. Net loss from discontinued operations. Discontinuing a division or other part of the company is usually a one-time event.

Topic: Risk exposures to revenue recognition shams LO: 1, 7 3. Identify and explain potential revenue recognition issues relating to the following operations: A. Motor Bikes, Inc. is a store that sells second-hand motorcycles on consignment from sellers. It remits to the sellers the sale price less the commission. B. 1-800-MyFlowers is an internet flower store. It receives fees in advance to provide flowers all year long. Answer: A. This company doesn’t take title to the inventory and, as a result, cannot characterize the total revenue as sales. Motor Bikes, Inc. earns revenue as an agent for the seller. One revenue recognition issue would exist if Motor Bikes, Inc. recorded sales at the gross amount instead of only reporting the net commission that represented the true earnings of the agent on the sale. B. Even though cash is received, revenue is not recognized until the product is delivered. Until that time, the cash received is recognized as an asset on the balance sheet and a liability (deferred revenue) is recorded to reflect an obligation to deliver product. One revenue issue would exist if 1800-MyFlowers recorded the cash receipts as revenue when received, before the product is delivered, to boost current sales and profit.

. Test Bank, Chapter 6

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Topic: Identifying nonrecurring items in an income statement LO: 7 4. Following are the income statement accounts for a recent Foster’s Computers income statement. Net revenue Cost of sales Gross margin Research and development Selling, general and administrative Amortization of purchased intangible assets and goodwill Restructuring charges Acquisition-related charges Earnings (loss) from operations Interest and other, net Net loss on divestitures Losses on investments and other, net Litigation settlements Earnings (loss) before taxes Provision for (benefit from) taxes Net earnings (loss) Identify the items in Foster’s Computers’ statement that might be considered nonrecurring items. Answer: • • • •

Restructuring charges Acquisition-related charges Net loss on divestitures Litigation settlements

Topic: Percentage-of-completion LO: 3 5. A $10,000,000 contract is executed to build a warehouse. Total estimated costs to complete the project are $7,500,000. The construction company incurred the following costs during the project: $2,625,000 in 2022; $3,000,000 in 2023; and $1,875,000 in 2024. Compute revenues, expenses, and income for each year 2022 through 2024 using the percentage-ofcompletion method. Answer: Year 2022 2023 2024

Costs incurred $ 2,625,000 3,000,000 1,875,000 $7,500,000

Percent of total expected costs 35% 40% 25%

Revenue recognized $ 3,500,000 4,000,000 2,500,000 $10,000,000

Income (Revenue – Costs) $ 875,000 1,000,000 625,000 $2,500,000

The percentage-of-completion method recognizes revenue by determining the costs incurred per the contract as compared to the project’s total expected costs. . 6-13

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Topic: Revenue recognition using percentage-of-completion method LO: 3 6. Sparkle Flooring contracts to lay tile in a new school over a three-year period. The company’s accountants record the following details relating to the project:

Contract price

Contract Details $500,000

Estimated cost Estimated profit

Spending Pattern During Construction Year 1 $100,000

$400,000 $100,000

Year 2 Year 3

$250,000 $ 50,000

Compute the amount of revenue, expense and income for each year using the percentage-ofcompletion method. Answer:

Expense Percentage of total expense Revenue allocation

Year 1 $100,000 25% $125,000

Year 2 $250,000 62.5% $312,500

Year 3 $50,000 12.5% $62,500

Income allocation

$ 25,000

$ 62,500

$12,500

Topic: Discontinued operations LO: 7 7. Consider the following results for Adventure World:

Revenues ..................... Expenses ..................... Pretax income ..............

Continuing Operations $600,000 580,000 $ 20,000

Discontinued Operations $80,000 65,000 $15,000

Total $680,000 645,000 $ 35,000

Prepare the income statement for this company assuming a 25% income tax rate. Omit the statement heading. Answer: Revenues Expenses Pretax income from continuing operations Income tax expense Income from continuing operations Income from discontinued operations, net of taxes Net income

$600,000 580,000 20,000 5,000 15,000 11,250 $26,260

Results from discontinued operations are collapsed into one line item and reported net of income taxes; $15,000 – ($15,000 x 25%) = $11,250

. Test Bank, Chapter 6

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Topic: Earnings management LO: 6 8. Martha’s Marble, a national supplier of marble products, has enjoyed several years of strong earnings during the recent housing boom. However, economists believe construction spending will be down significantly over the next couple of years. In an effort to maintain its current level of profitability, Martha’s Marble has decided to decrease its allowance for uncollectible accounts estimate from 3.5% to 2%. What effect will this action have on current and future period profits? Answer: By avoiding the additional 1.5% expense, Martha’s Marble will inflate its current period profits. In future years, the allowance account will have to be increased, resulting in lower profitability. Martha’s Marble will have managed earnings by shifting income from future years into the current year. Topic: Earnings management LO: 6 9. Ten years ago, DeFond Industries began operating out of a new building that cost $100 million. At that time, DeFond’s management estimated the building had a useful life of 50 years. Management now revises its estimate of the remaining useful life of the building to 64 years, and records annual depreciation expense of $1,250,000. A. How would the change in the estimated useful life of the building impact DeFond’s income statement? B. What possible incentives might management have to overestimate or underestimate the useful life of a long-term asset? Answer: A. For the first 10 years, annual depreciation expense was $100 million divided by 50 years, or $2,000,000 per year. The income statement would show only $1,250,000 instead of $2,000,000 expense which results in a larger net income amount. B. By manipulating the useful life of an asset, management can effectively manage earnings to meet earnings targets and achieve desired earnings growth. If the useful life is overestimated, higher annual earnings are reported and a loss will be recorded when the under-depreciated asset is sold. If the useful life is underestimated, lower annual earnings are reported and a potential gain will be recorded when the over-depreciated asset is sold.

. 6-15

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Topic: Accounts receivable LO: 4 10. Gleeson Products reports the following analysis of potential losses in its accounts receivable: Age Past Due 0-30 days past due 31-60 days past due 61-90 days past due Over three months past due Total

Receivable Balance

Estimated Loss (%)

$ 70,000 45,000 30,000 5,000 $150,000

0.5% 2.5% 10.0% 95.0%

The balance of Allowance for Uncollectible Accounts is a credit of $500 on December 31, 2024 prior to adjustments. A. Compute bad debt expense for 2024. B. What is the amount of accounts receivable reported on Gleeson’s December 31, 2024 balance sheet? Answer: A. Age of Accounts 0-30 days 31 to 60 days 61 to 90 days Over 121 days Total

Receivables Balance $70,000 45,000 30,000 5,000 $150,000

Estimated % Uncollectible 0.5% 2.5% 10.0% 95.0%

Estimated Uncollectible Amount $ 350 1,125 3,000 4,750 $9,225

$9,225 - $500 = $8,725 bad debt expense B. Accounts receivable, net = $150,000 - $9,225 = $140,775

. Test Bank, Chapter 6

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Topic: Accounts receivable turnover rate LO: 5 11. Fischer Co. reports the following in its 2024 annual report: Sales Accounts receivable

2024 $ 2,650,000

2023 $2,800,000

2022 $2,500,000

250,000

240,000

200,000

Calculate the accounts receivable turnover and average collection period for 2024 and 2023. Comment on the findings. Answer: AR turnover: 2024: $2,650,000 / [($250,000 + $240,000) / 2] = 10.82 times 2023: $2,800,000 / [($240,000 + $200,000) / 2] = 12.73 times Average collection period:

2024: [($250,000 + $240,000) / 2] / ($2,650,000 / 365) = 33.75 days 2023: [($240,000 + $200,000) / 2] / ($2,800,000 / 365) = 28.68 days

The accounts receivable turnover declined from 12.73 times to 10.82 times during 2024. Fischer is not collecting amounts due from customers as efficiently as in 2023. Correspondingly, the average collection period increased from 28.68 days to 33.75 days during 2024. The findings suggest a decline in the quality of receivables collections. Topic: Receivables LO: 4 12. Hawkeye Industries estimated uncollectible accounts receivable at December 31, 2024 at $15,000, based on estimates on various ages of receivables and before learning of the bankruptcy of one of its customers. The customer owed $6,000, and the legal department has estimated costs to collect the balance owed by this customer at $8,500. The gross receivables balance on December 31, 2024 after write-offs is $350,000, and the allowance of uncollectible accounts balance was $12,000 at December 31, 2023. At December 12, 2024, the company wrote off $7,500 other accounts deemed uncollectible. A. How would the legal department advise Hawkeye Industries to handle the collection of the $6,000? B. Draw a t-account for Allowance for Uncollectible Accounts and post all 2024 amounts to it, assuming that both the $7,500 and $6,000 were written off. What is bad debt expense for 2024? C. What is the effect of the $7,500 write off on gross and net accounts receivable? Answer: A. The legal department would advise Hawkeye Industries to write off the $6,000 based on costs versus benefits. The estimated cost of $8,500 exceeds the $6,000 amount that might be collectible. B. Write-off Write-off

Allowance for Uncollectible Accounts 12,000 Beg. Bal. 7,500 6,000 16,500 Bad debt expense 15,000 End. Bal.

C. The write-off reduces gross accounts receivable by $7,500. The write-off has no effect on net accounts receivable, as the accounts receivable and the allowance account (contra account) are both reduced by the same amount. . 6-17

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Topic: RNOA, NOPAT, NOPM LO: 5 13. DigiSource engages in the manufacture and sale of books worldwide. Its income statement for the year ending June 30, 2024 and selected amounts from its June 30, 2024 balance sheet follow: Total revenue Cost of goods sold Gross profit Operating expenses Operating income or loss Total other income, net Earnings before interest and taxes Interest expense Income before tax Income tax expense Net Income

$220,000 90,000 130,000 85,000 45,000 2,000 47,000 1,800 45,200 12,000 $ 33,200

Assume the marginal tax rate is 30%.

Total operating assets Total operating liabilities

June 30, 2024 $280,000 175,000

June 30, 2023 $265,000 180,000

Determine the following for DigiSource for its year ending June 30, 2024: A. B. C. D.

NOPAT RNOA NOPM Interpret the meaning of these three amounts as it applies to DigiSource .

Answer: A. NOPAT = Net income ‒ [(Nonoperating revenues ‒ Nonoperating expenses) × (1 – marginal tax rate)] = $33,200 – [($2,000 - $1,800) x (1 – 30%)] = $33,060 B.

RNOA = NOPAT / Average net operating assets = $33,060 / [($280,000 – $175,000 + $265,000 – $180,000) / 2] = 34.8%

C. NOPM = NOPAT / Sales revenue = $33,060 / $220,000 = 15.03% D. The profit applicable to operating amounts is $33,060 for the year. DigiSource generated 34.8 cents of operating profit for each dollar of net operating assets invested in the company. The company generated about 15 cents of operating profit for each dollar of sales.

. Test Bank, Chapter 6

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Topic: Estimating Uncollectible Account Balance with aging analysis LO: 4 14. Zieman, Inc. provided the following aging of its receivables at December 31. Receivables Balance $420,000 200,000 75,000 35,000 15,000 $745,000

Age of Accounts 0-30 days 31 to 60 days 61 to 90 days 91 to 120 days Over 121 days Total

Estimated % Uncollectible 0.5% 5.2% 10.3% 21.5% 75.2%

During the year, $22,500 of receivables were written off. The balance at the beginning of the year in the allowance account was a credit of $25,000. A. How much will Zieman report as bad debt expense for the year? B. How much is the net realizable value of Zieman’s receivables at year end? Answer: A. Age of Accounts

Receivables Balance

0-30 days 31 to 60 days 61 to 90 days 91 to 120 days Over 121 days Total

$420,000 200,000 75,000 35,000 15,000 $745,000

Estimated % Uncollectible

Estimated Uncollectible Amount

0.5% 5.2% 10.3% 21.5% 75.2%

$ 2,100 10,400 7,725 7,525 11,280 $39,030

$25,000 + bad debt expense - $22,500 = $39,030 Bad debt expense = $36,530 B. Net realizable value = Accounts receivable balance ‒ Allowance for uncollectible accounts = $745,000 – $39,030 = $705,970

. 6-19

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Problems Topic: Analyzing and interpreting revenue recognition policies and risks LO: 1, 3 1. Leahy Corporation describes its revenue recognition policies in Note 1 to the financial information presented in its 2016 annual report. Our services and products are generally sold based upon purchase orders or contracts with our customers that include fixed or determinable prices but do not include right of return provisions or other significant post-delivery obligations. Our products are produced in a standard manufacturing operation, even if produced to our customer’s specifications. We recognize revenue from product sales when title passes to the customer, the customer assumes risks and rewards of ownership, collectability is reasonably assured, and delivery occurs as directed by our customer. Service revenue, including training and consulting services, is recognized when the services are rendered and collectability is reasonably assured. Rates for services are typically priced on a per day, per meter, per man-hour, or similar basis. Software sales. Sales of perpetual software licenses, net of any deferred maintenance and support fees, are recognized as revenue upon shipment. Sales of time-based licenses are recognized as revenue over the license period. Maintenance and support fees are recognized as revenue ratably over the contract period, usually a one-year duration. Percentage of completion. Revenue from certain long-term, integrated project management contracts to provide well construction, and completion services is reported on the percentage-of-completion method of accounting. Progress is generally based upon physical progress related to contractually defined units of work. Physical percent complete is determined as a combination of input and output measures as deemed appropriate by the circumstances. All known or anticipated losses on contracts are provided for when they become evident. Cost adjustments that are in the process of being negotiated with customers for extra work or changes in the scope of work are included in revenue when collection is deemed probable. A. Identify the main sources of revenues for Leahy B. What are the revenue recognition policies? Answer: A. Long-term integrated project management contracts providing well construction and completion services, software sales, training and consulting services B. Leahy recognizes revenue from product sales when title passes to the customer, the customer assumes risks and rewards of ownership, collectability is reasonably assured, and delivery occurs as directed by our customer. Service revenue, including training and consulting services, is recognized when the services are rendered and collectability is reasonably assured. Revenue from certain long-term, integrated project management contracts to provide well construction, and completion services is reported on the percentage-of-completion method of accounting. Sales of perpetual software licenses, net of any deferred maintenance and support fees, are recognized as revenue upon shipment.

. Test Bank, Chapter 6

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Topic: Bad debt expense LO: 4 2. At December 31, 2024, retailer Southern Sails had a balance of $340,000 in its Accounts Receivable account and an unadjusted credit balance of $870 in its Allowance for Uncollectible Accounts account. The company analyzed and aged its accounts receivable based on the following estimated uncollectible amounts: 2.0% of current balances of $200,000 6.3% of balances 31-60 days of $85,000 11.7% of balances of 61-90 days of $40,000 60.0% of balances over 91 days of $15,000 The company bases its provision for credit losses on the aging analysis. A. What is Southern Sails’ bad debt expense for 2024? B. How would Accounts Receivable and the Allowance for Uncollectible Accounts appear in its December 31, 2024, balance sheet? C. Why might Southern Sails opt to extend terms of credit on sales? Answer: A. As of December 31, 2024: Age of Accounts Current 31 to 60 days 61 to 90 days Over 91 days Total

Receivables Balance $ 200,000 85,000 40,000 15,000 $340,000

Estimated % Uncollectible 2.0% 6.3% 11.7% 60.0% Allowance balance Bad debt expense

Uncollectible Accounts $ 2,000 5,355 4,680 9,000 21,035 870 $20,165

B. Current asset section of balance sheet: Accounts receivable $340,000, net of $21,035 allowance……………$318,965 C. Often terms of credit are extended as a marketing tool, even in the face of an increased probability of payments defaulting. Southern Sails may feel the need to extend the grace period for payments because sailboats tend to be a seasonal item. Longer payment terms could induce more sales during the fall and winter months, thus aiding in stabilizing demand uncertainty and potentially boosting overall sales. This is quite common, especially in seasonal industries that see new entrants enter the market just before the next peak period. If the new models devalue the unsold inventories from the previous season, then the risk of non-payment may be more appealing than the loss of the inventory’s marketable value.

. 6-21

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Topic: Accounts receivable reporting, turnover, and collection period LO: 4, 5 3. Rural Outfitters’ accounts receivable financial data (in thousands) for three years are listed below:

Sales Gross accounts receivable Allowance for uncollectibles

2024

2023

2022

$140,000 6,000 600

$150,000 9,500 800

$175,000 10,000 1,000

A. Calculate the net realizable value of receivables that will be reported on Rural’s balance sheet for each year. B. Determine the accounts receivable turnover for 2024 and 2023. C. Compare the accounts receivable turnovers for 2024 and 2023 and comment on the differences. Answer: A. Amounts in thousands Gross accounts receivable Allowance for uncollectibles Net realizable value

2024 $6,000 600 $5,400

2023 $9,500 800 $8,700

2022 $10,000 1,000 $9,000

B. Sales / Average accounts receivable, net 2024: Turnover = $140,000 / (($5,400 + $8,700) / 2)) = 19.86 times 2023: Turnover = $150,000 / (($8,700 + $9,000) / 2)) = 16.95 times C. The accounts receivable turnover indicates how quickly the accounts receivable are collected. From the data above, the accounts receivable turnover increased from 2023 to 2024, indicating the company is collecting its receivables more aggressively.

. Test Bank, Chapter 6

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Topic: Nonrecurring items LO: 7 4. Wang Industries reports the following in its 2024 10-K filing (amounts in thousands): Period Ending

Dec. 31, 2024

Dec. 31, 2023

Dec. 31, 2022

$175,000 145,000 30,000

$160,000 135,000 25,000

$150,000 130,000 20,000

10,000 5,000 10 6,000 800 9,810 200 9,610 875 8,735 2,795 5,940

10,650 6,000 50 1,000 500 7,900 150 7,750 880 6,870 2,200 4,670

8,200 2,940 40 2,000 600 7,500 300 7,200 800 6,400 2,000 4,400

(100) $ 5,840

300 $ 4,970

(250) $ 4,150

Total revenue Cost of goods sold Gross profit Operating expenses Research and development Selling general and administrative Gain on dispositions, net Writeoff of operating property Income from operating investments, net Operating income Total other expenses net Earnings before interest and taxes Interest expense Income before tax Income tax expense Net income from continuing ops Net gain (loss) on disposal of discontinued operations Net income Identify nonrecurring items on Wang’s income statement. Answer:

Net gain (loss) on disposal of discontinued operations is a nonrecurring item. Gain on dispositions can be considered a nonrecurring item if it is related to restructuring. Similarly, writeoffs of operating property deemed to be worthless may be nonrecurring. Topic: Percentage-of-completion LO: 3 5. Sunder Construction entered into a $3,000,000 contract to build a restaurant. Total estimated costs to complete the project are $2,000,000. The construction company incurred the following costs during the project: $800,000 in 2022; $700,000 in 2023; and $500,000 in 2024. Compute revenues, expenses, and income for each year 2022 through 2024 using the percentage-ofcompletion method.

. 6-23

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Answer: Revenue recognized Percent of total (Percentage of costs incurred expected costs × Total contract amount) 40% $1,200,000

2022

Costs incurred $ 800,000

2023

700,000

35%

1,050,000

350,000

2024

500,000

25%

750,000

250,000

$3,000,000

$1,000,000

Year

$2,000,000

Income (revenue – costs incurred) $ 400,000

The percentage-of-completion method recognizes revenue by determining the costs incurred per the contract as compared to its total expected costs. Topic: Discontinued operations LO: 7 6. General Foods & Co., (GF & Co.) reports the following footnote relating to its discontinued operations from its 2022 10-K annual report. Management’s Discussion & Analysis Recent Developments: In May 2022, we completed the divestiture of our snacks business to The Crunch Cereal Company. In accordance with the applicable accounting guidance for the disposal of long-lived assets, the results of our snacks business are presented as discontinued operations and, as such, have been excluded from continuing operations and from segment results for all periods presented. As a result of this change, the pet care business is now included in the Fabric Care and Home Care segment. A. What are discontinued operations? B. Describe the accounting treatment in the income statement according to GAAP for discontinued operations. C. How should the results of the operations of the discontinued segment be interpreted when evaluating the financial performance for GF & Co. for 2021 and 2022? Answer: A. Discontinued operations refer to any separately identifiable business unit that the company sells or intends to sell. B. Revenues and expenses reflect those of the continuing operations only, and income from continuing operations is reported net of income tax expense. Results from the discontinued operations are collapsed into one line item and reported separately net of its own tax (this includes any gain or loss from sale of the discontinued unit’s assets). The bottom line net income of the company is unaffected by this presentation. C. Financial analysis is generally concerned with forecasts of future financial performance. Since the discontinued operations will no longer exist after its sale, many analysts ignore the operating results related to this unit except for the investment returns of the sale proceeds. That is, future predictions of financial performance are based on the continuing operations, excluding the discontinued operations. The segregation of discontinued operations is made in the current year and for the two prior years’ comparative results reported in the income statement.

. Test Bank, Chapter 6

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Topic: Financial statement analysis LO: 5 7. Wallace, Inc. is a large retailer. Its income statement for the year ending January 30, 2024 (in millions) follows: Sales Credit card revenues Total revenues Cost of sales Selling, general and administrative expenses Credit card expenses Depreciation and amortization Earnings before interest expense and income taxes Net interest expense Earnings before income taxes Provision for income taxes Net earnings

$140,000 5,000 145,000 98,000 23,550 800 5,750 16,900 1,500 15,400 5,000 $ 10,400

Selected amounts from Wallace’s 2024 and 2023 balance sheets follow (amounts in millions): In millions Total operating assets Total operating liabilities

Jan. 30, 2024 $92,000 28,000

Jan. 31, 2023 $89,000 27,000

Assume a marginal tax rate of 32%. Determine the following for Wallace for its year ending January 30, 2024: A. B. C. D.

NOPAT RNOA NOPM (Use total revenues for this calculation) Interpret the meaning of these three amounts as it applies to Wallace.

Answer: A. NOPAT = Net income ‒ [(Nonoperating revenues ‒ Nonoperating expenses) × (1 – marginal tax rate)] = $10,400 – [-$1,500 x (1 - 32%)] = $11,420 million B. RNOA = NOPAT / Average net operating assets = $11,420 / [(($92,000 ‒ $28,000) + ($89,000 ‒ $27,000)) / 2] = 18.13% C. NOPM = NOPAT / Total revenue = $11,420 / $145,000 = 7.88% D. Wallace’s profit applicable to operating amounts is $11,420 million for the year. The company generated a little over 18 cents of operating profit for each dollar of operating assets invested in the company. The company generated almost 8 cents of operating profit for each dollar of revenue.

. 6-25

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Essays Topic: Earnings management receivables LO: 4, 6 1. How do companies use accounts receivables for earnings management and why? Answer: The main effects of uncollectibles on the financial statements occur as a result of estimation, not the eventual write-off. The amount and timing of the allowances are at the discretion of management. Though a company’s auditors must approve the reasonableness of the allowance from uncollectible accounts, they do not possess the inside knowledge of management and are therefore at an information disadvantage in determining the accuracy of allowance estimates. As a result, management can use the estimates to shift income from one year to another. If management underestimates the provision, expense is reduced in the current year, which increases current income. In the future when write-offs do occur which had not been accounted for earlier, the future provision must be increased, thus reducing income in that future period. Hence, income has been shifted from the future into the current period. Companies do this to meet certain current targets which they fear they may fall short of, or to meet current obligations they may be in danger of defaulting on. On the other hand, companies may overestimate the provision for uncollectibles in order to create a cookie jar reserve to use current income to offset tougher times in the future. Companies may opt to take a “big bath” by using an overestimated allowance for uncollected accounts. This reserve can, then, be used to increase future earnings. Topic: Receivable turnover and average collection period LO: 5 2. Define accounts receivable turnover and the average collection period. What insights do these ratios offer an analysis of a company’s accounts receivable? Answer: Accounts receivable turnover = Sales / Average accounts receivable Average collection period = Average accounts receivable / Average daily sales Accounts receivable turnover reveals how many times receivables have turned (been collected) during the period. More turns indicate that receivables are being collected quickly. Average collection period, or days sales outstanding (DSO), indicates how long, on average, the receivable are outstanding before being collected. These two ratios offer two important insights. First, changes in turnover signal the quality of the accounts receivable. If turnover slows, it could be a sign of the deterioration of the collectibility of receivables. There may be alternative explanations including a change in credit policies, customer mix, etc. However, it is still something important to include in our analysis. Second, an increase in receivables ties up more cash, hampering asset utilization. Receivables must be financed, and slower turning receivables present an increased risk of loss.

. Test Bank, Chapter 6

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Topic: Revenue Recognition timing and determination LO: 1 3. Discuss when each of the following types of businesses should likely recognize revenue: A. A large software company, such as Microsoft, when significant production, modification, or customization does not exist. B. A clothing retailer such as Abercrombie & Fitch. Answer: A. Large software company 1. 2. 3. 4.

Persuasive evidence of an arrangement exists Delivery has occurred Fixed and determinable fee exists Collectibility is probable

B. Large clothing retailer 1. Customer takes possession of the merchandise and purchases are paid for, primarily with either cash or credit card. Catalogue and e-commerce sales are recorded upon customer receipt of merchandise. Amounts relating to shipping and handling billed to customers in a sale transaction are classified as revenue and the related costs are classified as cost of goods sold. 2. Employee discounts are classified as a reduction of revenue. 3. The company reserves for sales returns through estimates based on historical experience and various other assumptions that management believes to be reasonable.

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Chapter 7 Reporting and Analyzing Inventory Learning Objectives – Coverage by question True/False

Multiple Choice

Exercises

Problems

Essay Questions

LO 7-1 Interpret disclosures of information concerning operating expenses, including manufacturing and retail inventory costs. (p. 7-3)

1, 2, 15

1-4, 6

LO 7-2 Account for inventory and cost of goods sold using different costing methods. (p. 7-7)

3-5, 11

5, 9, 16, 17, 19-22

2, 4-6, 8

1, 2, 4, 5

7, 8, 15

LO 7-3 Apply the lower of cost or net realizable value rule to value inventory. (p. 7-13)

LO 7-4 Evaluate how inventory costing affects management decisions and outsiders’ interpretations of financial statements. (p. 7-14)

5, 6, 9, 10, 13

10, 11, 14, 18-20

3, 6, 8

LO 7-5 Define and interpret gross profit margin and inventory turnover ratios. Use inventory footnote information to make appropriate adjustments to ratios. (p. 7-20)

7, 12, 14

12, 13

7, 9-11

3, 6

LO 7-6 Appendix 7A: Analyze LIFO liquidations and the impact they have on the financial statements. (p. 7-25)

8, 9

3, 13, 14

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Chapter 7: Reporting and Analyzing Inventory

True/False Topic: Inventory LO: 1 1. Companies should recognize inventory as an expense when purchased. Answer: False Rationale: Companies capitalize inventories when purchased, and expense inventories when sold. Topic: Manufacturing costs in inventory LO: 1 2. Manufacturing firms typically report three categories of inventory as raw materials, work-in-process, and finished goods. Answer: True Rationale: These 3 accounts typically are the inventory accounts for manufacturing companies. Topic: Inventory costing and the balance sheet LO: 2 3. FIFO inventory costing yields more accurate reporting of the inventory balance on the balance sheet. Answer: True Rationale: FIFO assumes that the most recently purchased goods are remaining in inventory’s balance. Hence, the balance sheet reports inventories at more current costs. Topic: FIFO inventory costing and profit LO: 2 4. In general, in a period of rising prices, FIFO produces higher gross profits than LIFO. Answer: True Rationale: Gross profit is affected by the choice of inventory costing method. Specifically, in periods of rising costs and prices, FIFO produces higher gross profits then LIFO because lower cost inventories (i.e., first inventories bought are first out) are matched against sales revenues at current market prices. Topic: Inventory holding gains LO: 2, 4 5. In periods of rising prices, companies that use FIFO inventory costing report higher gross profit as a result of inventory holding gains. Answer: True Rationale: A holding gain represents the effect of inflation in inventories from the acquisition date to the date of sale. These gains increase reported gross profit for companies that use FIFO inventory costing in periods of rising prices.

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Topic: LIFO disclosures LO: 4 6. Companies using LIFO are required to disclose the amount at which inventory would have been reported had the company used FIFO. The difference between LIFO and FIFO inventories is called the LIFO reserve. Answer: True Rationale: The disclosure of the LIFO reserve is required for those companies using LIFO inventory costing. This disclosure allows analysts to adjust the balance sheet and income statement for LIFO effects when comparing LIFO and FIFO companies. Topic: Inventory turnover rate LO: 5 7. A low inventory turnover indicates that a firm is able to sell its inventory more quickly. Answer: False Rationale: Inventory turnover indicates how many times inventory turns (is sold) during a period. More turns indicate that inventory is sold more quickly. Topic: LIFO liquidation LO: 6 8. In the period of rising costs and prices, a reduction in inventory quantities when FIFO is used is known as FIFO liquidation, and it yields an increase in gross profit and income. Answer: False Rationale: In the period of rising costs and prices, a reduction in inventory quantities when LIFO (not FIFO) is used, known as LIFO (not FIFO) liquidation, yields an increase in gross profit and income. Topic: Inventory liquidation LO: 4, 6 9. When using the LIFO inventory method in periods of rising prices, upon the liquidation of inventory quantities, lower cost units are transferred from the balance sheet when a sale is recorded, resulting in lower gross profit. Answer: False Rationale: If lower cost units are transferred from the balance sheet when a sale is recorded, then gross profit will be higher. Topic: IFRS inventory costing LO: 4 10. Inventory costing procedures used by businesses are the same in all countries. Answer: False Rationale: Inventory costing procedures used by businesses in countries other than the U.S. are much the same as those in the U.S. with one exception—few countries allow companies to use LIFO costing for inventory reporting.

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Topic: Inventory costing methods LO 2 11. A company that uses LIFO must sell its oldest goods first. Answer: False Rationale: LIFO represents a cost flow, not the physical unit flow. Topic: Gross profit effects LO: 5 12. Companies can easily affect gross profit with selling price increases. Answer: False Rationale: Because of competitive pressures, companies rarely have the opportunity to affect gross profit with price increases. Topic: LIFO versus FIFO LO: 4 13. When a company uses LIFO and prices are declining, profits will be higher than if the company had used FIFO. Answer: True Rationale: If prices are declining, the cost of the most recently purchased units will be less than the cost of older units. These newer units will flow to the income statement with a smaller cost than under FIFO causing profits to be higher. Topic: Gross profit margin LO 5 14. A decline in gross profit margin can be caused by selling fewer units to customers. Answer: False Rationale: Gross profit margin is a percentage of gross profit to sales. It indicates the cents that are available from each dollar of sales that are available to cover operating costs and contribute to profits. A change in the number of units sold does not change the GPM unless the selling price or cost of goods sold changes. Topic: Net-of-discount method LO 1 15. The cost of acquiring inventory includes adding the cost of freight associated with obtaining the inventory and subtracting the amount of cash discount allowed from timely payment. Answer: True Rationale: The cost of inventory should include all costs necessary to get the inventory ready to sell, which includes the cost of freight and a deduction for cash discounts.

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Multiple Choice Topic: Inventory costs for manufacturing companies LO: 1 1. Which of the following is an inventory account for manufacturing companies? A) B) C) D)

Overhead Finished goods Cost of goods sold Direct labor

Answer: B Rationale: Answers A and D are manufacturing costs. Answer C is the account used for goods that are sold. Only amounts reported on the balance sheet are inventory accounts. Topic: Cost of goods sold LO: 1 2. On which financial statement would you look to find the total costs of merchandise that remains and the total that has flowed through a company’s accounting system? A) B) C) D)

Balance sheet and statement of cash flows Income statement and balance sheet Statement of cash flows and balance sheet Statement of stockholders’ equity and balance sheet

Answer: B Rationale: When inventories are used up in production or are sold, their costs are transferred from the balance sheet (inventory account) to the income statement as cost of goods sold. Topic: Gross profit calculation LO: 1 3. The average cost inventory costing method is used by Mission, Inc. Sales are $275,000, the number of units available for sale is 250, the number of units sold during the period is 220, and the average cost of the goods available for sale is $1,000 each. How much is gross profit for the company? A) B) C) D)

$0 $25,000 $35,000 $55,000

Answer: D Rationale: Gross profit = $275,000 (sales) – [$1,000(average cost) x 220 (units)] = $55,000

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Topic: Cost of goods sold LO: 1 4. Hank’s’s Goods purchases $100,000 of inventory during the year, has beginning of the year inventory of $15,000, and sells $85,000 of inventory during the year for $150,000. What is the company’s inventory balance to be reported on its balance sheet at year end? A) B) C) D)

$65,000 $15,000 $30,000 $70,000

Answer: C Rationale: $15,000 + $100,000 ‒ $85,000 = $30,000 Topic: Inventory costing and the balance sheet LO: 2 5. Assuming rising prices, which method will give the highest dollar value for cost of goods sold on the income statement? A) B) C) D)

FIFO Average Cost LIFO All of these give equal values for cost of goods sold

Answer: C Rationale: Under LIFO, the most costly units are the ones last purchased. LIFO matches these higher cost items against sales as cost of goods sold. Topic: Reporting operating expenses LO: 1 6. Which expense recognition system is used to recognize cost of goods sold? A) B) C) D)

Direct association Immediate recognition Systematic allocation Reserve association

Answer: A Rationale: Any cost that can be directly associated with a specific source of revenue should be recognized as an expense at the same time that the related revenue is recognized.

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Topic: Lower of cost of net realizable value LO: 3 7. The following data refer to Applegate Company’s ending inventory: Item Code

Quantity

Unit Cost

Unit NRV

Small Medium Large Extra-Large

100 400 600 250

$250 150 170 265

$246 145 162 270

What is the ending inventory balance if the lower of cost or net realizable value rule is applied to each item of inventory? A) B) C) D)

$248,050 $246,050 $253,250 $252,850

Answer: B Rationale: (100 x $246) + (400 x $145) + (600 x $162) + (250 x $265) = $246,050 Topic: IFRS reporting cost versus market LO: 3 8. Which statement is true concerning write-downs under U.S. GAAP and IFRS? A) B) C) D)

GAAP allows inventory that has been written down to be revalued later at higher levels IFRS allows inventory that has been written down to be revalued later at higher levels GAAP and IFRS both allow inventory to be revalued higher once it has been written down IFRS allows inventory revaluation only up to the point of a previous write down

Answer: B Rationale: Only IFRS allows inventory that has been written down to be revalued later at higher levels. GAAP applies the LCNRV rule which allows write downs but not subsequent write ups. Topic: LIFO LO: 2 9. Under which method of inventory cost flows is the cost flow assumed to be in the reverse order in which the expenditures were made? A) B) C) D)

First-in, first-out Last-in, first-out Average cost Lower of cost or net realizable value

Answer: B Rationale: Under LIFO, the cost flow is assumed to be in the reverse order in which the expenditures were made.

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Topic: LIFO impacts LO: 4 10. Assuming sales hold steady, which of the following actions would result in lowering income taxes for a company that uses the LIFO inventory method? A) B) C) D)

Increasing sales prices Buying extra inventory at the end of the year in an inflationary environment Allowing the inventory quantity at year end to fall below beginning year levels None of these. All would cause increasing taxes

Answer: B Rationale: LIFO transfers the cost of the most recent purchases to cost of goods sold. These recent purchases are likely to be higher than the cost of earlier purchases, causing income taxes to be lower. Buying extra inventory at year end with a higher cost would cause a lowering of taxes since these units would be part of cost of goods sold. Topic: LIFO reserve LO: 4 11. Brubeck Company uses the LIFO inventory costing method for both its tax reporting purposes and its financial reporting purposes. Brubeck Company’s inventories are reported at $1,004 million on its balance sheet. In its footnotes, Brubeck Company is required to report the amount at which inventories would have been reported under FIFO method. The difference between these two numbers is commonly referred to as what? A) B) C) D)

LCNRV disclosures LIFO holding gain LIFO liquidation LIFO reserve

Answer: D Rationale: Companies using LIFO are also required to state the amount at which inventory would have been reported had the company used FIFO. The difference between the two is called the LIFO reserve. Topic: Inventory turnover LO: 5 12. Das Company and Busta Company reported the following information in their financial statements:

$millions 2024 2023

Sales $60,000 52,000

Das Company (FIFO) COGS Inventories $45,000 $15,000 36,000 13,000

Busta Company (LIFO) Sales COGS Inventories $85,000 $75,000 $30,000 82,000 60,000 27,000

To the closest hundredth, how much is 2024 inventory turnover for Das Company? A) B) C) D)

4.29 3.00 2.57 3.21

Answer: D Rationale: $45,000 / [($15,000 + $13,000) / 2] = 3.21

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Topic: Inventory Turnover LO: 5 13. Das Company and Busta Company reported the following information in their financial statements:

$millions 2024 2023

Sales $60,000 52,000

Das Company (FIFO) COGS Inventories $45,000 $15,000 36,000 13,000

Busta Company (LIFO) Sales COGS Inventories $85,000 $75,000 $30,000 82,000 60,000 27,000

The LIFO reserve for Busta Company is $2,760 at the end of 2024 and $2,500 at the end of 2023. What is 2024 inventory turnover for Busta Company, assuming Busta Company had used FIFO? A) B) C) D)

2.40 2.63 2.29 2.73

Answer: A Rationale: [$ 75,000 - ($2,760 - $2,500)] / [($30,000 + $2,760 +$27,000 + $2,500) / 2] = 2.40 Topic: Inventory disclosure LO: 4 14. Which of the following is not a reason that so much attention is paid to inventory in financial statement analysis? A) B) C) D)

Risks of inventory losses are often high It can provide insight into future performance Low inventories may result in substantial costs for the company The magnitude of a company’s inventory investment is often very large

Answer: C Rationale: High inventory levels, not low levels, may result in substantial costs for the company. Topic: Lower of Cost or Net Realizable Value LO: 3 15. The following data refer to Huber Company’s ending inventory: Item code Small Medium Large Extra-Large

Quantity 50 75 60 30

Unit Cost $130 185 160 200

Unit NRV $128 187 168 193

How much is ending inventory if the lower of cost or net realizable value rule is applied to the total inventory? A) B) C) D)

$36,295 $35,665 $35,975 $36,605

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Answer: C Rationale: Cost: (50 x $130) + (75 x $185) + (60 x $160) + (30 x $200) = $35,975 NRV: (50 × $128) + (75 × $187) + (60 × $168) + (30 × $193) = $36,295 Lowest total is cost. Topic: FIFO LO: 2 16. The following units and costs of lawnmower Model 200 were available for sale during the year for Craftsmom Hardware: Beginning inventory …………….. First purchase …………………… Second purchase ……………….. Third purchase ……………………

10 units at $130 15 units at $135 30 units at $140 20 units at $145

Craftsmom has 30 units on hand at the end of the year. What is the dollar amount of inventory at the end of the year according to the first-in, first-out method? A) B) C) D)

$4,025 $4,350 $3,900 $4,300

Answer: D Rationale: The ending inventory is made up of 20 units in the third purchase plus 10 units in the second purchase. (20 × $145) + (10 × $140) = $4,300 Topic: FIFO LO: 2 17. The following units and costs of lawnmower Model 200 were available for sale during the year for Craftsmom Hardware: Beginning inventory …………….. First purchase …………………… Second purchase ……………….. Third purchase ……………………

10 units at $130 15 units at $135 30 units at $140 20 units at $145

Craftsmom has 35 units on hand at the end of the year. What is the dollar amount of cost of goods sold for the year according to the first-in, first-out method? A) B) C) D)

$5,000 $5,700 $5,425 $5,800

Answer: C Rationale: (10 + 15 + 30 + 20 units) – 35 units = 40 units sold. Cost of goods sold = (10 units × $130) + (15 units × $135) + (15 units × $140) = $5,425

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Topic: Financial statement effects of Inventory costing LO: 4 18. If inventory at the end of the year is understated by $60,000, what will this error cause? A) B) C) D)

An understatement of cost of goods sold for the year by $60,000 An overstatement of gross profit for the year by $60,000 An overstatement of inventory for the year by $60,000 An understatement of net income for the year by $60,000

Answer: D Rationale: A $60,000 understatement of inventory at the end of the year will cause the cost of goods sold to be overstated by $60,000, the gross profit for the year to be understated by $60,000, and net income for the year to be understated by $60,000.

Use the following information for questions 19 & 20. Gramlich Company imports and sells a product produced in Canada. In the summer of 2024, a natural disaster disrupted production, affecting its supply of product. On January 1, 2024, Gramlich inventory records were as follows: Year purchased

Quantity (units)

Cost per unit

Total cost

2022 2023 Total

5,000 10,000 15,000

$150 $200

$ 750,000 2,000,000 $2,750,000

Through mid-December of 2024, purchases were limited to 14,000 units, because the cost had increased to $300 per unit. Gramlich sold 18,000 units during 2024 at a price of $400 per unit, which significantly depleted its inventory. Topic: Gross profit under LIFO LO: 2, 4 19. Assume that Gramlich makes no further purchases during 2024. Gramlich uses the LIFO inventory method. Compute Gramlich’s gross profit for 2024. A) B) C) D)

$3,550,000 $1,800,000 $2,200,000 $3,600,000

Answer: C Rationale: Sales revenue Cost of goods sold Gross profit

18,000 x $400 (14,000 x $300) + (4,000 x $200) =

$7,200,000 5,000,000 $2,200,000

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Topic: Gross profit under FIFO LO: 2, 4 20. Assume that Gramlich purchases 20,000 more of the $300 units on December 31, 2024. Gramlich uses the FIFO inventory method. Compute Gramlich’s gross profit for 2024. A) B) C) D)

$3,550,000 $1,800,000 $2,200,000 $3,600,000

Answer: A Rationale: Sales revenue Cost of goods sold Gross profit

18,000 x $400 = (5,000 x $150) + (10,000 x $200) + (3,000 x $300) =

$7,200,000 3,650,000 $3,550,000

Topic: Average cost LO: 2 21. The following amounts and costs of serving bowls were available for sale by Hirst’s Pottery during 2024: Beginning inventory First purchase Second purchase Third purchase

20 units at $45 15 units at $50 40 units at $55 25 units at $60

Hirst’s has 20 bowls on hand at the end of the year. What is the dollar amount of inventory at the end of the year according to the average cost method? A) B) C) D)

$1,000 $1,113 $1,070 $1,200

Answer: C Rationale: (20 units × $45) + (15 units × $50) + (40 units × $55) + (25 units × $60) = $5,350 $5,350 / 100 units = $53.50 20 units × $53.50 = $1,070

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Topic: Average cost LO: 2 22. The following amounts and costs of serving bowls were available for sale by Hirst’s Pottery during 2024: Beginning inventory First purchase Second purchase Third purchase

20 units at $45 15 units at $50 40 units at $55 25 units at $60

Hirst’s has 20 bowls on hand at the end of the year. How much is cost of goods sold at the end of the year according to the average cost method? A) B) C) D)

$4,350 $4,237 $4,280 $4,150

Answer C Rationale: (20 units × $45) + (15 units × $50) + (40 units × $55) + (25 units × $60) = $5,350 $5,350 / 100 units = $53.50 (20 + 15 + 40 + 25 units) – 20 units = 80 units sold 80 units × $53.50 = $4,280

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Exercises Topic: Accounts payable discounts LO: 1 1. Gilgen Co. owes $100,000 to Grant, Inc. for inventory acquired with terms of 2/15. A. How much will Gilgen pay if payment is made within the discount period? B. What transaction will Gilgen record on June 30, the company’s fiscal year end, if the invoice is dated June 28 and payment will be made on July 10? Answer: A. $100,000 ‒ ($100,000 x 2%) = $98,000 B. Inventory Accounts payable

98,000 98,000

Topic: Cost of goods sold LO: 2 2. Complete the grid to calculate Cost of Goods Sold: A. + Inventory Purchased Cost of Goods Available for Sale ‒ B. = Cost of Goods Sold Answer: A. Beginning Inventory B. Ending Inventory

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Topic: LIFO reserves LO: 4, 6 3. Hass Company’s 2024 balance sheet reveals that inventories reported on a LIFO basis are $25,000,000. In a footnote, management stated that the LIFO reserve was $3,500,000. A. How much would Hass’s ending inventory be using FIFO? B. What is the total cumulative tax effect of using LIFO given a 32% income tax rate? Answer: A. LIFO reserve is the difference in inventory carrying amount between the FIFO and LIFO cost methods. To adjust a LIFO inventory value to a FIFO inventory value, the LIFO reserve is added to LIFO inventories. LIFO inventory LIFO reserve Inventory with FIFO method

$25,000,000 3,500,000 $28,500,000

B. Using LIFO has decreased pre-tax profits by $ 3,500,000 due to higher cost of goods sold (i.e., lower inventory balance). Decrease in income taxes: $3,500,000 million × 32% = $1,120,000 Topic: FIFO LO: 2 4. Adler Enterprises’ inventories are determined using FIFO. Adler provided the following information for the first quarter of 2024: Beginning inventory, January 1, 2024 (1) Purchase (2) Purchase (3) Purchase Ending inventory, March 31, 2024

50 units @ $60 35 units @ $62 60 units @ $72 25 units @ $70 40 units

A. Compute the company’s cost of goods sold for the first quarter. B. Computer the ending inventory to be reported on Adler’s balance sheet at March 31, 2024. Answer: A. Units sold = 50 + 35 + 60 + 25 – 40 = 130 Costs of goods sold: (50 × $60) + (35 × $62) + (45 × $72) = $8,410 B. Ending inventory (15 units × $72) + (25 units × $70) = $2,830

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Topic: Average cost method LO: 2 5. A company reports the following in its inventory records for September: Units

Unit Cost

25 60 15

$20 18 22

Beginning Inventory Purchase #1 Purchase #2

During September, the company sold 80 units. Compute the cost of goods sold for September and the September 30 ending inventory balance for this product using the average cost method. Answer:

Beginning Inventory Purchase #1 Purchase #2 Totals Average unit cost Cost of goods sold Ending inventory

Units

Unit Cost

Total Cost

25 60 15 100

$20 18 22

$ 500 1,080 330 $1,910

= $1,910 / 100 = 80 x $19.10 = 20 × $19.10

= $19.10 = $1,528 = $ 382

Topic: Inventory costing methods LO: 2, 4 6. Chapman Inc. has 20 units in beginning inventory costing $50 each. It purchased 80 more for $45 each during the month. The company sold 75 units during the month. Calculate cost of goods sold for the month using: A. FIFO B. Average cost C. LIFO Answer: A. FIFO Cost of goods sold = (20 × $50) + (55 × $45) = $3,475 B. Beginning inventory Purchases

Units 20 80 100

Dollars/unit $50 45

Inventory $1,000 3,600 $4,600

Cost per unit = $4,600 / 100 = $46 Cost of goods sold = $46 x 75 = $3,450 C. LIFO Cost of goods sold = 75 × $45 = $3,375

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Topic: Inventory turnover LO: 5 7. Selected balance sheet and income statement information for Rogue Outfitters, Inc. and Sologear Inc. for 2024 follows: COGS $2,400,000 $1,320,000

Rogue Sologear

Average Inventory $800,000 $600,000

A. Compute the inventory turnover rate for Rogue Outfitters, Inc. and Sologear Inc. for 2024. B. Comment on the differences you observe between the turnover rates for these two companies. Answer: A. Inventory turnover = Cost of goods sold / Average inventory Rogue: Sologear:

$2,400,000 / $800,000 = 3.00 $1,320,000 / $600,000 = 2.20

B. Sologear maintains a higher inventory level in relation to its cost of goods sold, indicating a slower turnover rate. Rogue however maintains less inventory on hand in comparison with its cost of goods sold, yielding a higher turnover rate than Sologear. Topic: LIFO reserve LO: 2, 4 8. Mahoney, Inc. reports the following information in its annual report:

Inventory value at LIFO LIFO reserve Inventory value at FIFO

January 1, 2024 $1,500,000 40,000 $1,540,000

December 31, 2024 $1,600,000 50,000 $1,650,000

Sales for 2024 totaled $10,000,000. Cost of goods sold under LIFO totaled $6,700,000. Compute Mahoney’s cost of goods sold and gross profit, assuming it uses the FIFO method. Answer: Change in LIFO reserve = $50,000 ‒ $40,000 = $10,000 Sales revenue Cost of goods sold Gross profit

($6,700,000 ‒ $10,000) =

$10,000,000 6,690,000 $ 3,310,000

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Topic: Gross profit analysis LO: 5 9. As a shareholder of Southern Industries, a manufacturer of cellphone accessories, you are interested in comparing gross profits over a 3-year period. Calculate the gross profit margin for years 2024, 2023, and 2022 using the income statement items below (in thousands). Interpret your results. 2024 $37,000 31,302 $ 5,698

Sales revenue Cost of goods sold Gross Profit

2023 $36,000 28,980 $ 7,020

2022 $35,000 26,110 $ 8,890

Answer: Gross profit margin = Gross profit / Sales revenue

Gross profit margin

2024 15.4%

2023 19.5%

2022 25.4%

The gross profit ratio declines sequentially year to year. This is not a good sign and suggests that the company’s product line may be stale, competition may have increased, economic activity may have declined, or the company may be carrying too much inventory. In the case of cellphone accessories, it is likely that the product line is facing stiff competition.

Use the following financial statements to answer exercises 10 & 11. The following are the income statement, the assets section of the balance sheet, and inventory disclosures from Hoopes, Inc., a toy manufacturer, for 2024. STATEMENTS OF OPERATIONS

2024

Net sales Cost of sales Gross profit Selling and administrative expenses Operating Income Non-operating expense (income), net Income before income taxes Provision for income taxes Net income

$12,900,000 6,000,000 6,900,000 4,900,000 2,000,000 (12,000) 2,012,000 405,000 $ 1,607,000

2023 $12,500,000 6,200,000 6,300,000 4,200,000 2,100,000 6,500 2,093,500 420,000 $ 1,673,500

Continued

. Test Bank, Chapter 7

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ASSETS Current Assets Cash and equivalents Accounts receivable, less allowance Inventories Prepaid expenses and other current assets Total current assets Property, plant, and equipment, net Goodwill Other noncurrent assets Total Assets

December 31, 2024

December 31, 2023

$ 2,800,000 2,500,000 1,200,000 1,100,000 7,600,000 1,300,000 2,200,000 2,600,000 $13,700,000

$ 2,850,000 2,550,000 1,300,000 700,000 7,400,000 1,150,000 1,800,000 1,750,000 $12,100,000

Inventories Inventories, net of an allowance for excess quantities and obsolescence, are stated at the lower of cost or net realizable value. Cost is determined by the first-in, first-out method.

Topic: Inventory analysis LO: 5 10. Use the financial information presented for Hoopes, Inc. to answer the following: A. Compute the ratio of inventories to total current assets for 2024 and 2023. Explain the change. B. Compute the inventory turnover for both 2024 and 2023. The 2022 ending inventories were $1,350,000. Interpret and explain the change in inventory turnover as a positive or a negative for the company. C. What inventory costing method does Hoopes, Inc. use? Answer: A. Ratio of inventories to total current assets: 2024: $1,200,000 / $7,600,000 = 15.79% 2023: $1,300,000 / $7,400,000 = 17.57% The percentage of inventory as current assets has decreased in 2024 by 1.78%. This generally is viewed as a positive development since the composition of inventory is usually not as liquid as other assets. B. Inventory turnover = COGS/Average inventory: 2024: $6,000,000 / [($1,200,000 + $1,300,000) / 2] = 4.80 2023: $6,200,000 / [($1,300,000 + $1,350,000) / 2] = 4.68 Hoopes, Inc.’s inventory turnover increased in 2024. This small change may not be indicative of a major improvement in Hoopes’s inventory management but is a sign that Hoopes is investing in proportionately less inventory. C.

Hoopes, Inc. uses FIFO costing method as stated in the note disclosure.

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Topic: Inventory LO: 5 11. Using the financial information presented for Hoopes, Inc. to answer the following: A. Compute the average inventory days outstanding for Hoopes, Inc. for 2024 and 2023. Discuss what this measures and the importance of this measurement in analyzing company performance. B. Discuss what would be included in a detailed analysis of an inventory turnover decrease and possible reasons for a potential decrease in that ratio. C. Is there any adjustment required to Hoopes’s balance sheet amount of inventory for a LIFO reserve? Describe why such an adjustment is needed or not needed for Hoopes, Inc. Answer: A. Average inventory days outstanding = Average inventory/Average daily cost of goods sold 2024: $[($1,200,000 + $1,300,000) / 2]/[$6,000,000 / 365] = 76.04 days 2023: $[($1,300,000 + $1,350,000) / 2]/[$6,200,000 / 365] = 78.00 days Average inventory days outstanding is a measurement of how long, on average, inventories are on the shelves before being sold. In analyzing company performance, this measurement is important to determine if a company is optimizing its inventory levels while using the most cost efficient supply chains and management systems in place to reach this optimum level of inventory. The measurement can truly add some insight into a company’s performance for future periods. A decrease in average inventory days outstanding is generally viewed as a positive development for the firm because its inventory is turning faster, which means the inventory is spending fewer days on the shelf. B

In a detailed analysis of inventory turnover decrease, an analyst must look at the historical inventory turnover and industry averages to get a better idea of company performance. A decrease in inventory turnover may be realized through decreased promotion policies, excessive purchases or production, or increased competition. A detailed analysis of the company’s product mix may identify if a change should be made to higher margin products. It may identify if specific inventories caused the decrease.

Hoopes, Inc. is not required to have an adjustment to its balance sheet amount of inventory because it currently costs inventory using the FIFO inventory costing method. A restatement from FIFO to LIFO isn’t a requirement. An adjustment would be required if Hoopes used the LIFO costing method, that disclosed the amount to adjust inventories to the FIFO method.

. Test Bank, Chapter 7

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Topic: Lower of cost or net realizable value LO: 3 12. Trendy Clothing had the following inventory at December 31, 2024: Blouses

Quantity

Unit Cost

Unit NRV

Model 1 Model 2 Model 3 Skirts Model 4 Model 5 Model 6

300 275 500

$ 50 $ 60 $ 65

$ 52 $ 57 $ 62

600 325 200

$ 70 $ 85 $150

$ 73 $ 86 $140

A. Determine ending inventory by applying the lower of cost or net realizable value to: 1. Each item of inventory 2. Each major category of inventory 3. Total inventory B. Which of the LCNRV procedures from requirement A results in the lowest net income for 2024? Explain. Answer: Blouses Model 1 Model 2 Model 3 Total Blouses Skirts Model 4 Model 5 Model 6 Total skirts Total blouses and skirts

Quantity 300 275 500

Unit Cost $ 50 $ 60 $ 65

Unit NRV $ 52 $ 57 $ 62

Total Cost $ 15,000 16,500 32,500 64,000

Total NRV $ 15,600 15,675 31,000 62,275

600 325 200

$ 70 $ 85 $150

$ 73 $ 86 $140

42,000 27,625 30,000 99,625

43,800 27,950 28,000 99,750

$163,625

$162,025

A. 1. $15,000 + $15,675 + $31,000 + $42,000 + $27,625 + $28,000 = $159,300 2. Blouses: Skirts: Total

$ 62,275 99,625 $161,900

3. $162,025 B. Applying the lower of cost or net realizable value rule to individual items in inventory results in the lowest inventory amount, the highest cost of goods sold, and the lowest net income. This is because greater aggregation allows items with market > cost to offset items with cost > market.

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Topic: LIFO liquidation LO: 6 13. Harwell Company imports and sells a product produced in Denmark. In the summer of 2023, the producer’s plant was damaged by flooding, disrupting production and affecting Harwell’s supply of product. Harwell uses the LIFO inventory method. On January 1, 2024, Harwell’s inventory records were as follows: Year purchased 2022 2023 Total

Quantity (units) 22,000 5,000 27,000

Cost per unit $60 $85

Total cost $1,320,000 425,000 $1,745,000

Through mid-December of 2024, purchases were limited to 40,000 units, because the cost had increased to $100 per unit. Harwell sold 50,000 units during 2024, at a selling price of $200 per unit, which significantly depleted its inventory. A. Assume that Harwell makes no further purchases during 2024. Compute the gross profit for 2024. B. Assume that Harwell purchases 10,000 units before the end of December, 2024 at $100 each. Compute its gross profit for 2024. C. If Harwell’s corporate tax rate is 25%, how much tax savings will result from the purchase of inventory before year end? Answer: A. Sales revenue (50,000 × $200) Cost of goods sold (40,000 × $100)+ (5,000 × $85) + (5,000 × $60) Gross profit

$10,000,000 4,725,000 $5,275,000

B. Sales revenue (50,000 × $200) Cost of goods sold (50,000 × $100) Gross profit

$10,000,000 5,000,000 $5,000,000

C. ($5,275,000 - $5,000,000) x 25% = $68,750

. Test Bank, Chapter 7

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Topic: LIFO Liquidation LO: 6 14. At the beginning of July, Cornelsen Luggage holds 20 units of its only product with a per-unit cost of $500. During July, Cornelsen sells 65 units. A summary of purchases during July follows: Beginning inventory First purchase Second purchase Third purchase

20 units at $500 40 units at $550 20 units at $580 15 units at $620

Assume that Cornelsen utilizes the LIFO method and instead of making the third purchase during July, the company delays the third purchase until August. A. Compute cost of goods sold for July under both scenarios: 1. If the third purchase is made during July 2. If the third purchase is delayed to August B. Discuss the effect of LIFO liquidation on gross profit for this company. Answer: A. 1. Cost of goods sold = (15 × $620) + (20 × $580) + (30 × $550) = $37,400 2. Cost of goods sold = (20 × $580) + (40 × $550) + (5 x $500) = $36,100 B. The company’s LIFO gross profit increases by $1,300 ($37,400 - $36,100) if the purchase is delayed until August. This increase is from LIFO liquidation, which is the reduction of inventory quantities that results in matching older (lower) cost layers against current selling prices. The company has, in effect, dipped into lower-cost layers to boost current period profit, all from a simple delay of inventory purchases.

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Problems Topic: Inventory costing LO: 2 1. At the beginning of May, Hurley Industries has 200 units of a product with a unit cost of $500. Its inventory records report the following transactions for the month of May:

Beginning Inventory Purchase #1 Purchase #2 Purchase #3 Total

Units 200 250 100 60 610

Unit Cost $500 $550 $600 $650

Total Cost $100,000 137,500 60,000 39,000 $336,500

Hurley sells 500 units in May. Compute the cost of goods sold for May and the ending inventory balance for this product, assuming Hurley uses each of the following inventory methods: A. FIFO B. LIFO C. Average cost Answer: Ending inventory units = 200 + 250 + 100 + 60 – 500 = 110 A. FIFO: Units

Unit Cost

200 250 50 500

$500 550 600 Cost of goods sold

Units

Unit Cost

60 100 250 90 500

$650 600 550 500 Cost of goods sold

Cost

Units

Unit Cost

Cost

$100,000 137,500 30,000 $267,500

60 50 110

$650 600 Ending inventory

$ 39,000 30,000 $ 69,000

Cost

Units

Unit Cost

Cost

$ 39,000 60,000 137,500 45,000 $281,500

110

$500 Ending inventory

$ 55,000 $ 55,000

B. LIFO

C. Average Cost: Average unit cost = $336,500 / 610 = $551.64 Cost of goods sold = 500 × $551.64 = $275,820 Ending inventory = 110 × $551.64 = $60,680

. Test Bank, Chapter 7

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Topic: Inventory costing LO: 2 2. Stunts Company has the following inventory records for the month ending July 31, 2024: Units

Unit Cost

200 90 40 50 380

$70 $60 $65 $62

Beginning Inventory Purchase #1 Purchase #2 Purchase #3 Total

Total Cost $14,000 5,400 2,600 3,100 $25,100

Stunts sold 220 units during July. Compute the ending inventory and the cost of goods sold for July using FIFO, LIFO, and average cost inventory methods. Answer: Ending inventory units = 380 – 220 = 160 units FIFO Units 200 20

Unit Cost $70 60 Cost of goods sold

Cost $14,000 1,200 $15,200

Units 50 40 70

Unit Cost $62 65 60 Ending inventory

Cost $ 3,100 2,600 4,200 $ 9,900

Units 50 40 90 40

Unit Cost $62 65 60 70 Cost of goods sold

Cost $ 3,100 2,600 5,400 2,800 $13,900

Units 160

Unit Cost $70 Ending inventory

Cost $11,200 $11,200

LIFO

Average cost: Average unit cost = $25,100 / 380 = $66.05 Cost of goods sold = 220 × $66.05 = $14,532* Ending inventory = 160 × $66.05 = $10,568 *Answer may vary due to rounding.

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Topic: Gross margin LO: 5, 6 3. Barton Company’s sales totaled $15,000,000 for 2024. Information concerning Barton’s gross profit under three inventory costing methods follows: FIFO LIFO AC

$5,000,000 $4,200,000 $4,500,000

Compute the gross profit margin for each costing method. What method shows the highest gross profit margin? Explain the reasoning behind this. Answer:

FIFO LIFO AC

Gross profit $5,000,000 $4,200,000 $4,500,000

Gross profit margin 33.3% 28.0% 30.0%

The data indicate that inventory costs are rising. First-in, first-out shows the highest gross profit margin, because the older lower cost inventories are matched against sales revenues at the latest market prices, creating additional profits. These extra profits are actually the result of a holding gain. LIFO matches the newest inventory costs against current sales revenues, resulting in the lowest gross profit margin when inventory costs are rising. Average cost uses an average cost per unit to value both cost of goods sold and ending inventory, and therefore produces a gross margin that is between the FIFO and LIFO amounts. Topic: LIFO and FIFO LO: 2, 4 4. A summary of inventory records for Gokarn Company reveals the following: Inventory on January 1, 2024………………………. Inventory purchased in 2024 ……………………….. Total cost of goods available for sale in 2024 ……..

20 units @ $2,000 each …. . 40 units @ $2,200 each …. . 60 units ……………………..

$ 40,000 88,000 $128,000

During 2024, 40 units were sold at $2,900 per unit, generating total sales revenue of $116,000. A. Determine cost of goods sold, gross profit, and the inventory balance under the LIFO method and the FIFO method. B. Determine and explain the LIFO reserve for Gokarn Company.

. Test Bank, Chapter 7

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Answer: A. LIFO method Sales Cost of goods sold (40 units × $2,200) Gross profit

$116,000 88,000 $ 28,000

Inventory Balance: 20 units at $2,000 = $40,000 FIFO method. Sales COGS

$116,000 20 units × $2,000 = 20 units × $2,200 =

$40,000 44,000

Gross Profit

84,000 $ 32,000

Inventory Balance: 20 units at $2,200 = $44,000 B. LIFO reserve = $44,000 - $40,000 = $4,000 Analysts use this reserve to compute the amount by which income and taxes have been affected both cumulatively and for the current period from the use of LIFO. Topic: LIFO, FIFO, and average cost LO: 2 5. A summary of inventory records for Fishman Company reveals the following: Inventory on January 1, 2024 …………………… Inventory purchased in 2024 ……….................... Total cost of goods available for sale in 2024….

30 units @ $1,000 each ….... 40 units @ $1,875 each …… 70 units ………………………

$ 30,000 75,000 $105,000

During 2024, 50 units were sold at $2,500 per unit for total sales revenue of $125,000 Compute cost of goods sold, gross profit, and the inventory balance for 2024 under FIFO, LIFO, and average cost. Answer: FIFO: Sales Cost of goods sold (30 × $1,000) + (20 × $1,875) Gross profit

$125,000 67,500 $ 57,500

FIFO inventory balance: 20 units at $1,875 = $37,500 LIFO: Sales Cost of goods sold (40 × $1,875) + (10 × $1,000) Gross profit

$125,000 85,000 $ 40,000

LIFO inventory balance: 20 units at $1,000 = $20,000 Continued

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Average cost: Average cost per unit: $105,000/ 70 = $1,500 Sales Cost of goods sold (50 × $1,500) Gross profit

$125,000 75,000 $ 50,000

Average cost inventory balance: 20 units at $1,500 = $30,000 Topic: Inventory analysis LO: 1, 5 6. Waldorf is a national chain of drug stores. The following are excerpted from Waldorf’s 2024 financial statements (in millions). Waldorf has a June 30 year end. Assets Cash & cash equivalents Accounts receivable, net Inventories Other current assets Total current assets

2024 $ 1,600 2,900 16,000 1,000 $21,500

2023 $ 1,500 2,600 14,000 600 $18,700

Net sales Cost of sales Gross profit

2024 $150,000 110,000 $ 40,000

2023 $145,000 104,000 $ 41,000

Waldorf’s inventory footnote follows: Inventories Inventories are valued on a lower of last-in, first-out (LIFO) cost or market basis. At June 30, 2024 and 2023, inventories would have been greater by $2,500 million and $2,200 million, respectively, if they had been valued on a lower of first-in, first-out (FIFO) cost or market basis. Inventory includes product cost, inbound freight, warehousing costs and vendor allowances that are not included as a reduction of advertising expense. A. How much is Waldorf’s ratio of inventories to current assets for each year? Does this percentage make sense in Waldorf’s industry? What does the change suggest about Waldorf? B. Calculate the ratio of inventories to current assets under the FIFO method for both years. does it differ from your answer to part A?

Why

C. Compute the inventory turnover ratios for 2024 and 2023 (ending inventory in 2022 is $13,200). What does this say about the company? D. Is it correct to warehousing costs in Waldorf’s inventory cost? Why or why not?

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Answer: A. 2024: $16,000 / $21,500 = 74.42% 2023: $14,000 / $18,700 = 74.87% Retailers carry large amounts of inventory to satisfy demand, so the essentially flat inventory ratio suggests Waldorf’s inventory stocking processing is meeting demand. B. 2024: ($16,000 + $2,500) / ($21,500 + $2,500) = 77.08% 2023: ($14,000 + $2,200) / ($18,700 + $2,200) = 77.51% FIFO assumes that the first goods in are the first to sell. More recently purchased goods stay in the company’s inventory balance. Inventory costs appear to be rising, so FIFO inventory > LIFO inventory. C. 2024: $110,000 / [($16,000 + $14,000) / 2] = 7.33 2023: $104,000 / [($14,000 + $13,200) / 2] = 7.65 Waldorf’s inventory turnover declined slightly from 2023 to 2024. Given that inventory management is a key factor in Waldorf’s success, this trend should be carefully monitored. D. Yes, it is correct under GAAP to include any costs associated with securing ownership of the asset.

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Essays Topic: Capitalization of inventory costs LO: 1, 2 1. What does it mean to capitalize inventory cost, and what is the effect on the income statement? Answer: Capitalization means that a cost is recorded on the balance sheet and is not immediately expensed on the income statement. Once costs are capitalized, they remain on the balance sheet as assets until they are used up, at which time they are transferred from the balance sheet to the income statement as an expense. If costs are capitalized rather than expensed, then assets, current income, and current equity are higher. In the case of inventories, when they are used up in production or are sold, their costs are transferred from the balance sheet to the income statement as cost of goods sold (COGS). COGS is matched against sales revenue to determine gross profit. However, it is important to note that the manner in which inventory costs are transferred from the balance sheet to the income statement affects the level of inventories reported on the balance sheet and the gross profit on the income statement. Different methods of reporting inventory cost include the First-In, First-Out (FIFO), the Lastin, First-Out (LIFO), and the Average Cost methods. In addition, any inventory impairment or writedown, as a result of reporting inventories at the lower of cost or net realizable value, will reduce the asset value on the balance sheet and increase the COGS on the income statement, which reduces current period gross profit and income, and consequently, equity. Topic: Inventory costing LO: 5 2. When making investment decisions, why is it important to know what type of inventory costing system the company uses? Give examples of ratios and accounts that may be affected in your analysis. Answer: All investment decisions should be the product of some degree of analysis. Besides separating operating assets and liabilities from non-operating, overlooking transitory items, and the like, one must also investigate the inventory costing option used and its ramifications. If a company uses LIFO, inventories are not accurately portrayed. This can result in an often substantial adjustment (from LIFO to FIFO) to the inventory account, which would in turn affect the inventory turnover and average inventory days outstanding ratios.

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Topic: Lower of cost or net realizable value LO: 3 3. Mountain Gas Company, a large national company uses the LIFO inventory method for most of its inventories. Its inventory costs are heavily dependent on the price of petroleum. In 2021, when the price of oil was down, Mountain followed the lower of cost or net realizable value rule and wrote down its inventory by $880 million. In 2022, when the price of petroleum recovered, the company disclosed that the market price exceeded the LIFO carrying value by $10 billion. Explain why the lower of cost or net realizable value rule resulted in a write-down during 2021. What is inconsistent about the treatment for 2021 and 2022, in terms of conservatism in accounting? If the price of petroleum declines significantly in 2023, what is the likely consequence? Answer: Under the LIFO method in 2021, the lower of cost or net realizable value rule applies since the market value is $880 million less than cost under LIFO. Unfortunately, the inconsistency between 2021 and 2022 treatment occurs in the first year when income was reduced by the amount that cost exceeded market value. That is, followed by 2022 when market exceeded LIFO and income was not increased by that amount. This inconsistency is an example of conservatism in accounting, which states that losses (cost exceeds market) are recorded, but gains (market exceeds costs) are not recorded until a definite transaction occurs. If market falls below cost in 2023, then another write-down will occur on the income statement. Topic: Gross profit analysis LO: 5 4. Gross profit is calculated as net sales less the cost of goods sold. Gross profit margin (GPM = gross profit / sales) on the other hand, is considered a more useful metric for gross profit analysis. A. Why is GPM a more useful metric than gross profit in dollars? B. What factors most influence gross profit margin? Answer: A. Simply examining a company’s gross profit from a dollar amount perspective is not as insightful as is a profit analysis in ratio form. By performing an analysis of gross profit in this ratio form, we accomplish two things: it allows us to compare two different sized companies and to measure ‘average mark-up per unit sold’, which abstracts from the volume of units sold in the analysis. B. The two factors most influencing gross profit margin are competition and product mix. When competition increases, more substitutes become available, which limits a company’s ability to raise prices and to pass on cost increases to customers. Further, when “lower-priced, higher-volume” products increase in relation to “higher-priced, lower-volume” products, gross profit margin declines. Aside from product mix changes, a lower gross profit margin is viewed negatively because it suggests that a company’s products have lost some of their competitive edge. Other factors influencing gross profit margin include management of supply chains, production processes, and distribution networks.

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Chapter 8 Reporting and Analyzing Long-Term Operating Assets Learning Objectives – Coverage by question True/False LO8-1 Determine which costs to capitalize and report as tangible assets and which costs to expense. (p.8-3)

Multiple Choice

Exercises

Problems

Essay Questions

4, 5, 6, 9, 20, 21

1, 6

LO8-2 Apply different depreciation methods to allocate the cost of assets over time. (p.85)

2, 4, 8, 10, 16

1, 2, 3, 5, 6, 9, 12, 13, 14, 15, 16, 17, 18, 19

4, 7, 8, 14, 15

1, 4

LO8-3 Determine the effects of asset sales and impairments on financial statements. (p.8-10)

5, 6, 7, 9, 18

7, 10, 11, 16, 23

2, 12

1, 5

3, 6, 10, 11, 13

1, 3, 4, 5, 6

1, 5

1, 2

LO8-4 Analyze the effect of tangible assets on key performance measures. (p.8-13)

LO8-5 Describe the accounting and reporting for intangible assets. (p.8-17)

11, 12, 13, 14, 17

LO8-6 Analyze the effects of intangible assets on key performance measures. (p.8-23)

4, 8, 20, 21, 22

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Chapter 8: Reporting and Analyzing Long-Term Operating Assets True/False Topic: Capitalization of assets LO: 1 1. Once amounts are debited to a plant asset account on the balance sheet, the cost is then allocated to an expense on the income statement as that asset is used in operations. Answer: True Rationale: A firm may capitalize any asset that satisfies two conditions: 1) the asset is owned by the company, and 2) the asset provides future expected benefits. Topic: Depreciation assumptions LO: 2 2. Depreciation requires only two estimates—useful life and residual value—both of which are specified by GAAP depending on the asset type. Answer: False Rationale: GAAP does not specify useful life and residual value amounts. Managers must estimate these amounts based upon the time period that the asset is expected to generate resources for the company and a reasonable amount for which the asset can be sold at the end of its estimated life. Topic: Percent depreciated LO: 4 3. We can estimate the percent of a company’s depreciable assets that are “used up,” reflecting the percent of plant assets that are no longer productive, by the following formula: Accumulated depreciation / Cost of depreciable assets Answer: False Rationale: The correct formula is: Percent used up = Accumulated depreciation / Cost of depreciable assets. Only cost of depreciable assets should be used for the denominator. Topic: Changes in accounting estimates LO: 2 4. Changes in accounting estimates affect only the current and future periods’ income statements. Answer: True Rationale: Changes in accounting estimates require no cumulative effect adjustments or restatements of prior periods’ income statements. They are applied prospectively from the date of change.

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Topic: Asset impairments LO: 3 5. Companies that have property, plant, and equipment that increase in market value should recognize a gain on the income statement in the period the increase in value occurs. Answer: False Rationale: Impairment losses must be recognized as a loss on the income statement, but increases in value are not recognized. Topic: Gains and losses on sales LO: 3 6. A sale of a plant asset at less than cost requires that a company recognize a loss in the income statement. Answer: False Rationale: Gains and losses are determined based on the selling price compared to the book value, not the cost. Topic: Asset impairment LO: 3 7. Impairment of long-term plant assets is determined by comparing the sum of expected future (undiscounted) cash flows from the asset with the asset’s net book value. Answer: True Rationale: Impairment of long-term plant assets is determined by comparing the sum of expected future (undiscounted) cash flows from the asset with its net book value. If the asset is deemed to be impaired, it is written down to its market value and the write-down is recorded as a loss in the income statement. Topic: Depreciation LO: 2 8. Depreciation is the recognition of the change in market value of a plant asset over time. Answer: False Rationale: Depreciation is the process of allocating the cost of plant assets to the accounting periods in which the assets provide benefits. Depreciation does not parallel market value. Topic: Asset write-downs LO: 3 9. Asset write-downs have two potential challenges. One is making sure the write-down is not insufficient, and the other is to make sure the write-down is not too aggressive. Answer: True. Rationale: Asset write-downs present two potential challenges, 1) Insufficient write-down and 2) aggressive write-down. Neither is condoned under GAAP.

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Topic: Accelerated depreciation LO: 2 10. One purpose of using accelerated depreciation for tax purposes is it reduces income taxes payable in the early years of life of a plant asset. Answer: True Rationale: Both a reduction of income and the company’s income tax liability are effects of accelerated depreciation in the early years of life. Topic: Goodwill Impairment LO: 5 11. Goodwill is considered to be impaired if the market value of the acquired business is greater than the carrying amount on the balance sheet. Answer: False Rationale: Goodwill is impaired if the market value of the acquired business is less than its carrying amount on the balance sheet. Topic: Goodwill LO: 5 12. An analyst should consider any goodwill write-downs as a non-recurring operating expense. Answer: True Rationale: Goodwill impairments are operating and non-recurring. Topic: R&D costs LO: 5 13. R&D expense is treated as an operating expense, not a capital expenditure, unless the assets have an alternative future use. Answer: True Rationale: Although the R&D assets are similar to regular plant assets, under GAAP, R&D costs are expensed unless the R&D assets have alternative future uses. Topic: IFRS LO: 5 14. Under IFRS, research and development costs can be capitalized as intangible assets when specific criteria are met. Answer: False Rationale: Under IFRS, only development costs can be capitalized as intangible assets when specific criteria are met. U.S. GAAP requires both research and development costs be expensed when incurred.

. Test Bank, Chapter 8

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Topic: Intangible assets and performance measures LO: 6 15. Internally generated intangible assets are not capitalized, which allows the financial statements to be more transparent for users. Answer: False Rationale: Because internally generated intangible assets are not capitalized, an important component of a company’s assets is potentially hidden from users of the financial statements. Topic: Natural resources LO: 2 16. Natural resource assets, such as oil reserves or timberlands, as often referred to as wasting assets. Answer: True Rationale: Natural resource assets are often referred to as wasting assets, because the assets are consumed as they are used. Topic: Franchise rights LO: 5 17. Franchise rights are considered to be an identifiable intangible asset and must be amortized. Answer: True Rationale: Franchise rights are contractual agreements that give a company the right to operate a particular business in an area for a stated time period. Because these rights have a definite life, they are amortized over the expected franchise life. Topic: IFRS impairment LO: 3 18. U.S. GAAP requires recognition of the impairment of property, plant, and equipment, while IFRS does not. Answer: False Rationale: Accounting for impairment of property, plant, and equipment assets is required under both GAAP and IFRS. However, the process to determine the impairment amount differs under GAAP as compared to IFRS.

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Multiple Choice Topic: Depreciation expense using the double-declining-balance method LO: 2 1. On January 1, 2023, Bahnson Company purchased a copy machine. The machine cost $800,000, its estimated useful life is 5 years, and its expected salvage value is $50,000. What is the depreciation expense for 2024 using the double-declining-balance method? A) B) C) D)

$200,000 $128,000 $150,000 $192,000

Answer: D Rationale: Double-declining-balance rate = 1/5 × 2 = 40%. Depreciation expense for year 2023 is $800,000 × 40% = $320,000 Depreciation expense for year 2024 is $480,000 × 40% = $192,000 Topic: Depreciation assumptions LO: 2 2. Which of the following estimates are required when calculating depreciation expense? 1. Depreciation rate 2. Useful life 3. Expected maintenance costs 4. Salvage value A) B) C) D)

1, 2, and 4 1, 2, 3, and 4 2 and 4 2, 3, and 4

Answer: A Rationale: Expected maintenance costs are not capitalized, nor do they impact the amount of depreciation per period. Topic: Straight-line depreciation LO: 2 3. Which statement is true concerning the straight-line method of depreciation? A) B) C) D)

Depreciation is recognized evenly over the estimated useful life of the asset. Purchase cost is expensed in the year of acquisition. Depreciation is equal to the proceeds received on sale less the amount paid to acquire the asset. Annual depreciation expense is highest in the early years and decreases over the life of the asset.

Answer: A Rationale: When using the straight-line method of depreciation, depreciation is recognized evenly over the estimated useful life of the asset.

. Test Bank, Chapter 8

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Topic: Capitalization of asset cost LO: 1, 5 4. Which of the following purchased assets would not be capitalized? A) Factory machine used to fabricate part for new product to be introduced B) Building constructed as a warehouse for a company’s inventory C) Machine used to test the durability of high tech chair in development for a technology company. The machine will not be used to test any other products. D) Building constructed to house management and administrative personnel Answer: C Rationale: Items purchased for research and development purposes that have no alternative future uses are not capitalized and are expensed immediately. Topic: Depreciation assumptions LO: 1, 2 5. Which of the following is not necessary in calculating the depreciation expense for the first year for a newly purchased factory forklift? A) B) C) D) E)

Estimated useful life Market value of the forklift during its useful life Estimated salvage value Depreciation rate Total cost of the forklift at acquisition

Answer: B Rationale: The market value is not factor in calculating annual depreciation. Topic: Depreciation LO: 1, 2 6. An estimate of how an asset will be used up over its useful life is known as what? A) B) C) D)

Useful life Salvage value Depreciation rate Impairment value

Answer: C Rationale: A depreciation rate is the estimate of how an asset will be used up over its useful life. Some assets are used up more quickly at the beginning and others are used up equally over their useful lives.

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Topic: Gain (loss) on asset sales LO: 3 7. How is the gain (loss) on a plant asset sale calculated? A) B) C) D)

Asset sale price – Asset purchase cost Book value on balance sheet – Asset sale price Asset sale price – Book value on balance sheet Asset sale price – Total accumulated depreciation

Answer: C Rationale: The gain (loss) on the sale of a plant asset is computed as: Asset sale price – book value of the asset Topic: R&D costs LO: 5 8. Common Engines Co. plans to build a laboratory dedicated to testing car crashes. The company will not use the laboratory after the project is finished. Under GAAP, how should this laboratory be accounted for? A) B) C) D) E)

Capitalized and depreciated Expensed when acquired Capitalized, but not depreciated Depreciated and expensed Capitalized at its original cost and then tested for impairment annually

Answer: B Rationale: Project-directed or highly-specific research buildings and equipment with no alternate uses must be expensed as incurred. Topic: Depreciation expense LO: 1, 2 9. Under which section of an income statement would the amount of cost allocated to a particular accounting period for long-term depreciable assets most likely appear? A) B) C) D)

Nonoperating expense Selling, general, & administrative Accumulated depreciation Long-term assets

Answer: B Rationale: The statement describes depreciation expense and should be reported under SG&A expenses on the income statement.

. Test Bank, Chapter 8

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Topic: Sale of plant asset LO: 3 10. Under which section of a statement of cash flows would the proceeds received from the sale of longterm depreciable assets most likely appear? A) B) C) D)

Operating cash flows Investing cash flows Financing cash flows Long-term assets

Answer: B Rationale: The proceeds (cash received) should be reported under investing activities as a cash inflow on the statement of cash flows. Topic: Impairment LO: 3 11. At what point is an asset considered to be impaired? A) B) C) D)

When the net book value is greater than the sum of undiscounted expected cash flows When the net book value is less than the sum of discounted expected cash flows When the net book value is less than the sum of undiscounted expected cash flows When the net book value is greater than the sum of discounted expected cash flows

Answer: A Rationale: As asset is impaired if its net book value (purchase cost less accumulated depreciation) is greater than the sum of undiscounted cash flows expected to flow from that asset. Topic: Depreciation and its effects LO: 2 12. Dulin, Inc. purchased a bulldozer at a cost of $300,000. The bulldozer has an estimated residual value of $20,000 and an estimated life of 10 years, or 15,000 hours of operation. The bulldozer was purchased on January 1, 2023 and was used 500 hours in 2023 and 3,000 hours in 2024. What method of depreciation will produce the maximum depreciation expense in 2024? A) B) C) D)

Straight-line Double-declining-balance Units-of-production All methods produce the same expense in 2024

Answer: C Rationale: Straight-line: ($300,000 ‒ $20,000) / 10 = $28,000 per year Double-declining balance: $300,000 × (1/10 × 2) = $60,000 for 2023; $240,000 x (1/10 x 2) = $48,000 for 2024. Units of production: ($300,000 ‒ $20,000) × (3,000 hours / 15,000 hours) = $56,000 for 2024

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Topic: Depreciation and its effects LO: 2 13. Dulin, Inc. purchased a bulldozer at a cost of $300,000. The bulldozer has an estimated residual value of $20,000 and an estimated life of 10 years, or 15,000 hours of operation. The bulldozer was purchased on January 1, 2023 and was used 1,200 hours in 2027. What method of depreciation will produce the maximum depreciation expense in 2027 (fifth year)? A) Straight-line B) Double-declining-balance C) Units-of-production D) All methods produce the same expense in 2027 Answer: A Rationale: Straight-line: ($300,000 ‒ $20,000) / 10 = $28,000 per year Double-declining balance: rate = 1/10 x 2 = 20% 2023: $300,000 x 20% = $60,000; 2024: $240,000 x 20% = $48,000; 2025: $192,000 x 20% = $38,400; 2026: $153,600 x 20% = $30,720; 2027: $122,880 x 20% = $24,576 Units of production: ($300,000 - $20,000) × (1,200 hours / 15,000 hours) = $22,400 for 2027 Topic: Calculating depreciation LO: 2 14. Dulin, Inc. purchased farm equipment at a cost of $500,000 on January 1, 2023. The equipment has an estimated residual value of $25,000 and an estimated life of 10 years. What amount will Dulin, Inc. report as total depreciation expense over the 10-year life of the equipment using straight-line depreciation? A) B) C) D)

$ 50,000 $ 47,500 $500,000 $475,000

Answer: D Rationale: $500,000 – $25,000 = $475,000 Topic: Calculating book value LO: 2 15. Dulin, Inc. purchased farm equipment at a cost of $500,000 on January 1, 2023. The equipment has an estimated residual value of $25,000 and an estimated life of 10 years. If Dulin uses the straight-line method, what is the book value at December 31, 2027 (end of fifth year)? A) B) C) D)

$500,000 $475,000 $262,500 $237,500

Answer C Rationale: Accumulated depreciation = [($500,000 – $25,000) / 10] × 5 = $237,500 Book value = $500,000 ‒ $237,500 = $262,500 . Test Bank, Chapter 8

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Topic: Depreciation and effects LO: 2, 3 16. Kennedy Corporation purchased equipment at a cost of $500,000. The equipment has an estimated residual value of $50,000 and an estimated life of 5 years, or 10,000 hours of operation. The equipment was purchased on January 1, 2023 and was used 2,500 hours in 2023 and 2,100 hours in 2024. On January 1, 2025, the company decided to sell the equipment for $315,000. Kennedy Corporation uses the units-of- production method to account for the depreciation on the equipment. Based on this information, the entry to record the sale of the equipment will show a gain of: A) B) C) D)

$45,000 $72,000 $ 5,000 $22,000

Answer: D Rationale: Rate = ($500,000 ‒ $50,000) / 10,000 hours = $45 per hour Expense for 2 years = $45 × 4,600 hours = $207,000 Gain on sale = Selling price ‒ Book value = $315,000 ‒ ($500,000 ‒ $207,000) = $22,000 Topic: Changes in accounting estimates LO: 2 17. Kennedy Corporation purchased equipment on January 1, 2023 at a cost of $500,000. The equipment has an estimated residual value of $50,000 and an estimated life of 5 years. At the end of two years, Kennedy reevaluated the useful life of the equipment. Management extended the total useful life an additional 5 years but estimated that the equipment would have no residual value at the end of this time. If the company uses straight-line depreciation, what amount would be recorded as depreciation expense each year, beginning with the third year? A) B) C) D)

$50,000 $40,000 $32,000 $45,000

Answer: B Rationale: $500,000 – [($450,000 / 5) x 2] = $320,000 Revised remaining life = 5 – 2 + 5 = 8 years $320,000 / 8 years = $40,000

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Topic: Depletion LO: 2 18. Liberty Company acquired property for $17,000,000 containing a palladium mine on January 1, 2024. Liberty estimated that the mine would produce 1,800,000 tons of palladium and once mining is completed, the property could be sold for $1,700,000. During the first year, 300,000 tons were mined. What is the depletion expense per ton of palladium? A) B) C) D)

$ 9.44 per ton $10.20 per ton $11.33 per ton $ 8.50 per ton

Answer: D Rationale: ($17,000,000 – $1,700,000) / 1,800,000 = $8.50 per ton Topic: Depletion LO: 2 19. Trache Company acquired property for $20,000,000 containing a platinum ore mine on January 1, 2022. Trache estimated that the mine would produce 500,000 tons of ore and once mining is completed, the property could be sold for $200,000. During 2022, 2023, and 2024, Trache recovered 25,000, 50,000, and 125,000 tons of ore, respectively. As a result, the mine should appear on Trache’s balance sheet at December 31, 2024 at what amount (net of depletion)? A) B) C) D)

$11,880,000 $12,080,000 $12,000,000 $ 8,000,000

Answer: B Rationale: (25,000 + 50,000 + 125,000) / 500,000 = 40% depleted $20,000,000 – [(40% x ($20,000,000 – $200,000)] = $12,080,000 Topic: Goodwill LO: 1, 5 20. Goodwill can be recorded as an asset when A) B) C) D)

An offer is received to purchase the business at a price in excess of the value of the assets A business has above normal profitability compared to other businesses in its industry A business is purchased and payment is made in excess if the fair value of the net assets A business can determine that it has created customer goodwill and name recognition

Answer: C Rationale: Goodwill is an intangible asset that is only recorded when one company acquires another company at an excess purchase price over the fair market value of its identifiable net assets.

. Test Bank, Chapter 8

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Topic: Intangible assets LO: 1, 5 21. How should intangible assets be disclosed on the balance sheet? A) B) C) D)

At the estimated market value at the balance sheet date At cost in the current assets section Net of the costs already amortized As a reduction of stockholders’ equity

Answer: C Rationale: The cost of the intangible asset is presented in the balance sheet net of accumulated amortization. Topic: IFRS R&D LO: 5 22. Which statement is true as it relates to IFRS’ reporting requirements for internally-developed intangibles? A) B) C) D)

IFRS allows both research and development costs to be capitalized when specific criteria are met IFRS allows research costs to be capitalized when specific criteria are met IFRS allows development costs to be capitalized when specific criteria are met IFRS requires that both research and development costs be expensed when incurred

Answer: C Rationale: Development costs can be capitalized as intangible assets under IFRS, though GAAP requires both research and development costs be expensed when incurred. Topic: IFRS impairment accounting LO: 3 23. Which of the following is not part of IFRS’ accounting for impairment property, plant and equipment? A) The asset’s balance sheet book value is compared to its recoverable amount to determine if an impairment loss exists. B) The asset’s recoverable amount is measured by the higher of its fair value or the asset’s value in current use. C) The difference between an asset’s recoverable amount and its balance sheet book value is recognized as an impairment loss. D) The asset may be revalued down, but may not be revalued upward to fair value in the future. Answer: D Rationale: IFRS allows assets to be revalued upward to fair value if fair value can be reliably measured.

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Exercises Topic: Goodwill accounting LO: 5 1. Uncle Muscle, Inc. acquired Nohue, Inc. in 2023. The carrying amount of the investment on the balance sheet is reported as $500 million, including goodwill of $150 million. In performing its annual impairment test in 2024, Uncle Muscle estimates that the fair market value of Nohue’s assets and liabilities, including goodwill and identifiable intangible assets, to be $420 million, and attributes the decline in value to goodwill impairment. What effect, if any, will this analysis have on Uncle Muscle’s 2024 financial statements? Answer: The goodwill must be written down by $80 million, resulting in a decrease in assets (goodwill) of $80 million, recognition of the write-down as an expense in the income statement, causing a reduction in retained earnings as profit is reduced. Topic: Gains and losses on asset sales LO: 3 2. Sumantra Company sold a machine for $115,000. The company bought this machine for $175,000 five years ago and was depreciating it on a straight-line basis over 12 years to a $25,000 salvage value. What is the gain (loss) that Sumantra should report on the sale? Answer: Straight-line depreciation/year = ($175,000 - $25,000)/12 = $12,500 Book value = Historical cost – Accumulated depreciation = $175,000 – (5 years × $12,500 per year) = $112,500 When an asset is sold, the company recognizes a gain (loss) equal to the difference between selling price and its carrying value (book value). Gain (loss) on sale = Selling price of asset – Book value Gain (loss) on sale = $115,000 ‒ $112,500 = $2,500 gain This gain is reported in income from continuing operations, and causes an increase in reported income.

. Test Bank, Chapter 8

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Topic: Plant asset turnover LO: 4 3. Determine the 2024 PPE turnover for Cavalry Laboratories using the financial statement information below: ($ thousands) Plant, property, & equipment Goodwill Intangibles Sales revenue Cost of goods sold Net Income

2024 $ 2,000 800 900 12,000 6,300 750

2023 $ 1,600 800 850 10,500 6,000 900

Answer: PPE turnover = Sales revenue/Average PPE assets = $12,000 / [($2,000 + $1,600) / 2] = 6.67 Topic: Depreciation expense - straight-line method LO: 2 4. Schmink Enterprises, a large clothing mail-order retailer, purchased a new industrial sewing machine for $300,000. This machine is expected to operate for 5 years after which it will be sold for salvage value estimated to be $10,000. What is the yearly depreciation expense under the straight-line method? Answer: ($300,000 - $10,000)/5 = $58,000/year Topic: R&D LO: 5 5. A health care technology company purchases a machine in 2022 to conduct a 2-year test on the effectiveness of a product prototype that may revolutionize the health care industry. The product will either be produced or completely abandoned resulting in no future use of the machine. The machine costs $20 million. Technology is increasing such that it will only be useful for 2 years with no estimated value at the end of two years. A. How should the cost of this machine be accounted for under GAAP? B. What is the effect of the purchase of the machine on 2022’s net income? C. What is the effect of the purchase of the machine on 2023’s net income? Answer: A. This cost would be reported on the income statement as a research and development expense during the year acquired since the machine has no alternate use. B. The 2022 net income would be reduced by the amount of the purchase price, $20 million. C. There would be no effect on 2023’s net income since the item is fully expensed in 2022.

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Topic: Computing PPE percent depreciated LO: 4 6. Hookneadsdsham Industries provides the following information relating to its land, buildings and equipment: $ millions Land Buildings Machinery and equipment Total accumulated depreciation

2024 $ 1,000 2,000 30,000 $33,000 $22,000

Reported depreciation expense for 2024 is $2,500 million. depreciated for 2024.

2023 $ 600 2,000 27,000 $29,600 $19,500

Calculate the plant assets’ percent

Answer: Percent depreciated = Accumulated depreciation / Cost of depreciable assets = $22,000 / ($33,000 - $1,000) = 68.75% Almost 70% of the assets’ costs have been written off. Topic: Straight-line and double-declining-balance depreciation LO: 2 7. Magma Labor buys a specialty table saw for its metal fabrication business on January 1, 2024. The machine cost $350,000 and is expected to be used for five years. At the end of the five years it is expected that the machine can be sold for $15,000. Compute the depreciation expense for the third year (2026) using both straight-line and doubledeclining-balance depreciation methods. Answer: Straight-line expense per year = ($350,000 - $15,000) × 1/5 = $67,000 Double-declining-balance rate = 1/5 × 2 = 40%: Year 2024 2025 2026

Beginning Book Value $350,000 210,000 126,000

Depreciation Expense $140,000 84,000 50,400

Accumulated Depreciation $140,000 224,000 274,400

Ending Book Value $210,000 126,000 75,600

Depreciation expense for 2026 is $67,000 using the straight-line method, and $50,400 using the double-declining-balance method.

. Test Bank, Chapter 8

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Topic: Double-declining-balance method LO: 2 8. Dimond Publishing purchased a new machine for $100,000. This machine is expected to operate for 8 years, after which it will be sold for an estimated $5,000 salvage value. How much will the first and second year’s depreciation expense be under the double-declining-balance method? Answer: Rate = 1/8 × 2 = 25% Year 1: $100,000 × 0.25 = $25,000 Year 2: $ 75,000 × 0.25 = $18,750 Topic: Capitalize or expense tangible and intangible assets LO: 1 9. For each of the following items, indicate whether the costs should be capitalized or expensed immediately. 1. Equipment with a 5-year life is purchased for $32,000 for a specific R&D project. The equipment has no alternative use. 2. Purchased a customer list from another company for $100,000. 3. Spent $200,000 to develop a new software product. 4. Paid $10,000 for routine maintenance and lubrication of equipment. 5. Paid $22,000 to overhaul a manufacturing machine. The overhaul will extend the machine’s useful life by 2 years. 6. Paid $40,000 to install new equipment in a production line that will enhance the marketability of the product. 7. Purchased a license agreement for $500,000. Answer: 1. 2. 3. 4. 5. 6. 7.

Expense—This is R & D equipment for which uncertainty surrounds these activities. Capitalize—This is a purchased identifiable intangible asset. Expense—The future benefit is uncertain. Expense—This is a routine expense for normal wear and tear. Capitalize—The useful life is extended. Capitalize—The new equipment enhances the product line. Capitalize—This is a purchased identifiable intangible asset.

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Topic: PPE percent depreciated LO: 4 10. Larocque, Inc. has the following plant, property, and equipment assets on its balance sheet for 2024 and 2023: ($ thousands) Land Buildings Machinery and equipment Less Accumulated depreciation Total

2024

2023

$ 4,200 10,400 6,500 21,100 1,200 $ 19,900

$ 4,000 9,800 6,800 20,600 1,000 $ 19,600

Determine what percent of the company’s depreciable assets are depreciated at the end of 2023 and 2024. What does this tell you about the company’s future cash flows? Answer: Percent depreciated = Accumulated depreciation / Cost of depreciable assets 2023: $1,000 / ($20,600 - $4,000) = 6.02% 2024: $1,200 / ($21,100 - $4,200) = 7.10% Only 7% of Larocque’ depreciable assets have been written off, indicating that it is unlikely that it will be required to replace these assets in the near future. Larocque can concentrate on using its resources to invest in new assets. Topic: Percent depreciated LO: 4 11. Burley Foods, Inc. provides the following information in its 2024 10-K: ($ millions) Fiscal Year-End

2024

Land Buildings and leasehold improvements Capitalized real estate leases Fixtures and equipment Construction in progress

200 5,600 150 3,500 250 9,700 (2,800) $6,900

Less accumulated depreciation and amortization Net property, plant, and equipment Burley Foods reported depreciation expense of $600 million in 2024.

What percent depreciated are Burley Foods’ depreciable assets at the end of 2024? Answer: Accumulated depreciation / Acquisition cost of depreciable assets = $2,800 / ($9,700 - $200 - $250) = 30.27%

. Test Bank, Chapter 8

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Topic: Gains and losses on asset sales LO: 3 12. Hamlen Company has machinery that originally cost $500,000. The machinery is four years old and has been depreciated using the double-declining-balance method over a five-year useful life with a residual value of $25,000. Answer each of the following independent questions: A. If the company sold the machinery for $50,000, prepare a journal entry to record the sale. B. If the company sold the machinery for $100,000, prepare a journal entry to record the sale. Answer: Twice the straight-line rate = 1/5 x 2 = 40% Year 1: $500,000 × 0.40 = Year 2: ($500,000 ‒ $200,000) × 0.40 = Year 3: ($500,000 ‒ $200,000 ‒ $120,000) × 0.40 = Year 4: ($500,000 - $200,000 - $120,000 - $72,000) x 0.40 = Total accumulated depreciation A.

$ 200,000 120,000 72,000 43,200 $435,200

Cash Accumulated depreciation Loss on sale of machinery Machinery

50,000 435,200 14,800

Cash Accumulated depreciation Machinery Gain on sale of machinery

100,000 435,200

500,000

500,000 35,200

Topic: PPE turnover LO: 4 13. The following information is reported for two high-tech manufacturing companies, IOU Company and Swagtronix Corporation (amounts in millions):

2024 2023

IOU Company Sales PPE, net $200,000 $65,000 $150,000 $60,000

Swagtronix Corporation Sales PPE, net $252,000 $50,000 $210,000 $40,000

A. Compute the 2024 PPE turnover for both companies. Comment on any differences you observe. B. Discuss ways in which companies in this industry can increase their PPE turnover. Answer: A. IOU Company Swagtronix Corporation

PPE turnover rates for 2024 $200,000 / [($65,000 + $60,000) / 2] = 3.2 $252,000 / [($50,000 + $40,000) / 2] = 5.6

Swagtronix turns its PPE over more quickly than does IOU. Swagtronix generates more dollars of revenue for each dollar of PPE.

. 8-19

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B. PPE turnover rates increase with increases in sales volume relative to the dollar amount of PPE on the balance sheet. The PPE turnover rate is often a very difficult turnover rate to change, and typically requires creative thinking. Many companies are outsourcing the manufacturing process in whole or in part to others in the supply chain. This is beneficial so long as the benefits realized by the reduction of manufacturing assets more than offset the higher cost of the goods as these are now purchased rather than manufactured. Another approach is to utilize long-term operating assets in partnership with another firm, such as a joint venture. Topic: Depletion LO: 2 14. Plutonium Drilling estimated that the oil reserve that it acquired on January 1, 2022 would produce 6,000,000 barrels of oil. The company extracted 400,000 barrels in 2022, 450,000 barrels in 2023, and 425,000 barrels in 2024. Plutonium paid $72,200,000 for the oil reserve. The land is estimated to have a residual value of $200,000 once the oil is depleted. A. Compute the depletion expense for 2022, 2023, and 2024. B. Prepare the journal entries to record (1) the acquisition of the oil reserve and (2) the depletion for 2022, 2023, and 2024. C. Create T-accounts and post the entries for 2022. Answer: Depletion per barrel = ($72,200,000 - $200,000)/6,000,000 = $12 A. Year 2022 2023 2024

Depletion expense 400,000 x $12 = 450,000 x $12 = 425,000 x $12 =

$4,800,000 $5,400,000 $5,100,000

B. 2022 (1) 2022 (2) 2023 (2) 2024 (2)

Oil reserve Cash

72,200,000

Oil inventory Oil reserve

4,800,000

Oil inventory Oil reserve

5,400,000

Oil inventory Oil reserve

5,100,000

72,200,000 4,800,000 5,400,000 5,100,000

C. b(1) Balance

+ Oil Reserve (A) 72,200,000 b(2)

b(2)

Oil Inventory (A) 4,800,000

Balance

4,800,000

67,400,000

. Test Bank, Chapter 8

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Topic: Natural resources LO: 2 15. In 2023, Liberty Company purchased land for $50,000,000 that had a natural resource reserve estimated to be 500,000 tons. Development and road construction costs on the land were $2,000,000 and a building was constructed at a cost of $1,000,000. When the natural resources are completely extracted, the land has an estimated residual value of $4,000,000. In addition, the cost to restore the property to comply with environmental regulations is estimated to be $1,500,000. Production in 2023 and 2024 was 70,000 tons and 85,000 tons, respectively. A. Compute the depletion charge for 2023 and 2024. Include depreciation on the building as part of the depletion charge. B. Prepare a journal entry to record each year’s depletion expense. Answer: A. Cost of reserve: Residual value: Depletion base: Depletion rate:

$50,000,000 + $2,000,000 + $1,000,000 = $53,000,000 $4,000,000 – $1,500,000 = $2,500,000 $53,000,000 – $2,500,000 = $50,500,000 $50,500,000 / 500,000 tons = $101 per ton

2023: 70,000 x $101 = $7,070,000 2024: 85,000 x $101 = $8,585,000 B. 2023: 2024:

Reserve inventory Accumulated depletion

7,070,000

Reserve inventory Accumulated depletion

8,585,000

7,070,000

. 8-21

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Problems Topic: PPE assets LO: 1, 2, 3, 4, 5 1. Fran’s Supplies presented the following partial balance sheets, income statements, and note disclosure for its fiscal years ending in 2024 and 2023. ($ millions)

Sept. 30, 2024

Sept. 30, 2023

$12,000 3,000 3,100 10,000 3,500 400 $32,000

$22,000 2,000 2,900 6,000 500 300 $33,700

ASSETS Current assets Long-term investments Property, plant and equipment, net Goodwill Purchased technology and other identifiable intangible assets, net Deferred income taxes and other assets Total assets ($ millions) Fiscal Year Net sales Cost of products sold Gross margin Operating expenses: Research and development Selling, general and administrative Restructuring and impairments Income from operations Interest and other expenses, net Income before income taxes Provision for income taxes Net income

2024 $20,000 14,000 6,000

2023 $22,000 11,500 10,500

2,500 2,400 350 750 150 600 350 $ 250

2,100 1,900 (100) 6,600 125 6,475 1,500 $ 4,975

The following appeared in the footnotes of the company’s annual report: Property, Plant and Equipment Property, plant and equipment are stated at cost. Depreciation is provided over the estimated useful lives of the assets using the straight-line method. Estimated useful lives for financial reporting purposes are as follows: buildings and improvements, 3 to 30 years, and furniture, fixtures and other equipment, 3 to 15 years. ($ millions)

Sept. 30, 2024

Sept. 30, 2023

$1,000 4,000 1,500 100 6,600 (3,500) $3,100

$ 800 3,500 1,200 75 5,575 (2,675) $2,900

Property, Plant and Equipment, Net Land and improvements Buildings and improvements Furniture, fixtures and other equipment Construction in progress Gross property, plant and equipment Accumulated depreciation

Continued

. Test Bank, Chapter 8

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Analyze and interpret Fran’s PPE and the company’s related ratios and disclosures by answering the questions that follow: A. Compute PPE turnover for 2024 and 2023. Net PPE for 2022 is $2,800 million. Interpret and explain any change in turnover. B. What long-term assets might not be reflected on Fran’s balance sheet? C. Depreciation expense is $600 for 2024. Compute the percent depreciated for 2024. implication does this computation have for future cash flows?

What

Answer: A. 2024: Net sales / Average PP&E, net = $20,000/ [($3,100 + $2,900) / 2] = 6.67 2023: Net sales / Average PP&E, net = $22,000 / [($2,900 + $2,800) / 2] = 7.72 The decrease in plant asset turnover during 2024 is not a positive sign for the company. It is reasonable to assume that the decrease is a result of the decrease in net sales in 2024. Since net PPE increased in 2024, the result is that it takes more in plant assets to generate each dollar of revenue. B. Assets not reflected on the balance sheet include R&D, goodwill, and advertising. They are expensed immediately under GAAP because they cannot be directly linked to future cash flows. C. Percent depreciated = Accumulated depreciation / Cost of depreciable assets = $3,500 / ($6,600 - $1,000 - $100) = 0.6364 = 63.64% = 64% A percent depreciated computation of 64% indicates a moderate effect on future cash flows because we anticipate this would require some level of capital investment for balances that get closer to the final quartile of asset use. Topic: Analyzing and interpreting identifiable net assets LO: 5 2. Consider the following schedule from a footnote in Passive, Inc.’s 2024 financial statements related to its acquisition of Country Lanes, Inc. (amounts in millions): Cash Trade receivables Inventories Goodwill In-process research and development Other identifiable intangibles Other assets Deferred tax assets, net Accounts payable and other liabilities Deferred revenues Total purchase price for Backroads

$ 4,000 11,000 500 10,000 3,000 200 5,000 2,000 (10,000) (2,500) $23,200

Identify (1) the total value received by Country Lanes, Inc. shareholders for the acquisition, (2) what portion of the sale was for identifiable net assets?

. 8-23

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Answer: 1. The total value received was $23,200 million. 2. The portion of the value received that is reported as identifiable net assets is total net assets without goodwill, or $23,200 - $10,000 = $13,200. Topic: PPE turnover LO: 4 3. Following are selected financial information from Roisin Toys, Inc.’s 2024 10-K report: ($ thousands) Sales Depreciation expense

2024 $15,000,000 1,300

2023 $14,500,000 1,275

Land and improvements Buildings and improvements Machinery and equipment

Less accumulated depreciation Tools, dies and molds, net of depreciation Total property, plant & equipment, net

25,000 820,000 690,000 1,535,000 975,000 560,000 100,000 $ 660,000

23,000 800,000 665,000 1,488,000 971,000 517,000 120,000 $ 637,000

A. Compute the PPE turnover for 2024 and 2023 (net PP&E is $630,000 thousand for 2022). B. Is there an identifiable trend and is this an improvement for the company? Answer: A. PPE turnover: 2024: $15,000,000 / [($660,000 + $637,000) / 2] = 23.13 2023: $14,500,000 / [($637,000 + $630,000) / 2] = 22.89 B. Roisin Toys’ PPE turnover increased slightly in 2024 and appears to be adequate.

. Test Bank, Chapter 8

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Topic: PPE turnover and percent depreciated LO: 2, 4 4. Following is financial information from Minutia Company’s two segments as of June 30, 2024:

($ millions) Business Operations Land Buildings and building equipment Machinery and equipment Construction in progress Total cost Less accumulated depreciation Total Entertainment Services Land Buildings and building equipment Total cost Less accumulated depreciation Total Property and equipment, net

Useful Lives (Years)

23 11

2024

2023

500 8,000 12,500 2,000 23,000 13,500 $ 9,500

70 230 300 100 200 $ 9,700

450 6,200 12,000 1,500 20,150 11,150 $ 9,000 70 235 305 95 210 $ 9,210

Minutia uses straight-line depreciation. Depreciation expense for 2024 is $3,100 million. A. Compute PPE turnover for 2024 and 2023. PPE, net for 2022 is $9,000 million. Analyze your findings. Sales for 2024 are $85,000 million and are $75,000 million for 2023. B. By what percentage are Minutia’s depreciable assets depreciated at the end of 2024? Analyze your computations. Answer: A. PPE asset turnover = Sales / Average PPE, net 2024: $85,000 / [($9,700 + $9,210) / 2] = 8.99 2023: $75,000 / [($9,210 + $9,000) / 2] = 8.24 The change in PPE turnover suggests that Minutia has trended upward from the previous year. Companies want their asset turnovers to be as high as possible because companies seek to minimize the amount of investment to generate each dollar of sales. B.

Accumulated depreciation / Acquisition cost of depreciable assets = ($13,500 + $100) / ($8,000 + $12,500 + $230) = 65.61% Minutia has written off close to 66% of its depreciable assets at the end of 2024. Minutia should plan on devoting resources to replacing its depreciable assets over the next 5-10 years.

. 8-25

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Topic: Plant assets LO: 3, 4 5. The following income statements, balance sheet excerpts, and plant asset disclosures are presented by Herman Manufacturing in its 2024 annual report. ($ thousands) STATEMENTS OF OPERATIONS

2024

Net sales Cost of sales Gross profit Selling and administrative expenses Operating Income Interest expense Income before income taxes Provision for income taxes Net income

$15,000 6,500 8,500 6,100 2,400 200 2,200 450 $ 1,750

($ thousands) ASSETS Current assets Property, plant, and equipment, net Goodwill Other noncurrent assets Total Assets

December 31, 2024 $ 7,300 1,500 1,900 2,600 $13,300

2023 $12,500 6,200 6,300 4,100 2,200 150 2,050 420 $ 1,630 December 31, 2023 $ 6,900 1,450 1,600 1,800 $11,750

Herman’s plant asset note disclosure follows: Property, Plant, and Equipment Property, plant, and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is computed using the straight-line method over estimated useful lives of 10 to 30 years for buildings, 3 to 10 years for machinery and equipment, and 10 to 20 years, not to exceed the lease term, for leasehold improvements. Tools, dies, and molds are amortized using the straight-line method over 3 years. Estimated useful lives are periodically reviewed and, where appropriate, changes are made prospectively. The carrying value of property, plant, and equipment is reviewed when events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. Any potential impairment identified is assessed by evaluating the operating performance and future undiscounted cash flows of the underlying assets. When property is sold or retired, the cost of the property and the related accumulated depreciation are removed from the consolidated balance sheet and any resulting gain or loss is included in the results of operations. A. Compute PPE turnover for 2024 and 2023. Property, plant and equipment, net for 2022 was $1,350 thousand. Is there any significant change? What assets may not be reflected on Herman’s balance sheet? B. When does Herman check for asset impairment? What process do they use to assess impairment? Does this follow GAAP guidelines? Do these charges affect cash flows? How should these charges be treated for analysis purposes?

. Test Bank, Chapter 8

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Answer: A. PPE turnover 2024: PPE turnover 2023:

$15,000 / [($1,500 + $1,450) / 2] = 10.17 $12,500 / [($1,450 + $1,350 / 2] = 8.93

PPE turnover increased significantly in 2024, indicating increasingly effective asset utilization. Herman’s market research and intellectual property, if any, may not be reflected as assets on their balance sheet. B. According to the footnote, Herman tests for asset impairment when events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. Herman makes projections of revenues, operating costs and other investments for the asset over a multi-year period to estimate future cash flows from the asset, and records impairment if book value exceeds the sum of future undiscounted cash flows. This methodology does follow GAAP and reduces GAAP earnings if an impairment is reported; however, there is no direct impact to cash flow. Topic: Plant assets and intangibles LO: 1, 4, 6 6. The following are the income statements and a portion of the long-term asset sections of Wiley Group’s balance sheet for 2024 and 2023. Wiley Group is a marketing research firm specializing in data processing services. Its property and equipment is primarily data processing equipment. ($ millions) LONG-TERM ASSETS Property and equipment, net Non-current deferred tax assets Goodwill Intangible assets, net Other assets Total long-term assets

December 31, 2024 2023 $ 650 $ 600 600 800 11,000 10,000 4,000 3,200 300 250 $16,550 $14,850

($ millions) INCOME STATEMENT Revenues Cost of revenues Gross profit Asset impairment charges Other operating expenses Operating income Interest income Income before income taxes Income tax provision Net income

2024 $6,500 3,600 2,900 150 1,700 1,050 25 1,075 390 $ 685

2023 $6,800 3,500 3,300 45 2,000 1,255 35 1,290 430 $ 860

A. Compute PPE turnover for 2024 and 2023 and discuss any changes. Net plant and equipment for 2022 totaled $500 million. Are there any unique considerations for a company like Wiley Group? Explain. B. How much has Wiley Group invested in property plant and equipment as compared to intangibles in 2024? Does this seem unusual? What may account for this?

. 8-27

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Answer: A. PPE turnover 2024: $6,500 / ($650 + $600)/2] = 10.40 PPE turnover 2023: $6,800 / ($600 + $500)/2] = 12.36 PPE turnover is relatively high mostly due to the nature of the property owned, primarily shorterterm data processing equipment. This lack of capital that is long-term based makes Wiley Group appear to be managing its PPE very well. However, PPE comprises a very small part of the Group’s total long-term assets. B. PPE is only $650/$16,550 = 4% of Wiley Group’s total long-term assets, while intangibles (including goodwill) are ($11,000 + $4,000)/$16,550 = 91% of long-term assets. As a marketing research firm, little is invested in PPE. Instead, key assets are technological skill, service quality, reputation, and other intangible assets, many of which are likely not reported on Wiley’s balance sheet. The large amount of reported intangibles indicates that Wiley has acquired other companies, requiring that acquired identifiable intangibles and goodwill be recorded. These acquisitions may strengthen and expand Wiley’s technological services and reduce competition.

. Test Bank, Chapter 8

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Essays Topic: Gains (losses) on asset sales LO: 3 1. What are the main issues in reporting a company’s gains (losses) on asset sales? What is the related concern in the analysis of the company? Answer: Assets are recorded at cost when purchased and carried at these historical costs, even if they appreciate in value. When an asset is sold, the company’s gain (loss) on the sale is defined as the difference between the selling price of the asset and the carrying value of the asset on the balance sheet. All asset sales are reported in income. A problem arises when gains and losses from transitory items are also reported as part of income from continuing operations – which is not an unusual case. In a company analysis, it is preferable to exclude transitory items from the computation of continuing income. In addition, accounting standards require that companies need only disclose material gains and losses. Consequently, some companies include gains on asset sales in SG&A expenses as an offset in order to reduce SG&A expenses and make the company look more efficient than it is. Topic: Depreciation methods LO: 2 2. Explain the considerations a CFO would make when deciding between using the straight-line depreciation method, the double-declining-balance depreciation method, or another use-based depreciation. Answer: The intent of depreciation is to match the expenses incurred to provide assets required to produce a product with the revenue stream of that product. That said, there are different ways to achieve this, based on the different uses of the assets. The decision between straight-line, DDB, or use-based depreciation will depend on how the asset is used up. If the asset is used in the same amount each year, then the simplest way to depreciate it is straight-line. If an asset will be used more in its early years and less in its later years, it is a good candidate for double-declining-balance. If it is possible to estimate a total number of uses that is a good estimate of the lifetime production of that asset, it can be beneficial to depreciate based on the number of uses in the period divided by the total number of lifetime uses.

. 8-29

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Chapter 9 Reporting and Analyzing Liabilities Learning Objectives – Coverage by question True/False

Multiple Choice

Exercises

Problems

Essay Questions

LO9-1 Identify and account for current operating liabilities. (p. 9-4)

1-5, 17

1, 2, 6, 8, 9, 11, 21

2, 4, 8, 11, 12

LO9-2 Describe and account for current nonoperating (financial) liabilities. (p. 9-10)

2, 3, 6, 9, 12, 14, 19

1, 2, 4, 8, 9, 12

LO9-3 Explain and illustrate the pricing of long-term nonoperating liabilities. (p. 9-13)

6, 9, 10, 12, 13

5, 7, 10, 13, 16-19

4, 5, 7, 13

2, 3, 5, 6

LO9-4 Analyze and account for financial statement effects of long-term nonoperating liabilities. (p. 9-18)

11, 14

7, 15-18

3, 4, 6, 10

2, 5, 6

LO9-5 Explain how solvency ratios and debt ratings are determined and how they impact the cost of debt. (p. 9-27)

8, 15, 16

4, 20

1, 7

. 9-1

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Chapter 9: Reporting and Analyzing Liabilities True/False Topic: Accounts payable as a source of financing LO: 1 1. Accounts payable is a short-term source of non-interest bearing financing. Answer: True Rationale: Accounts payable amounts that arise from the purchase of goods and services usually do not carry any interest charges, and can represent a good source of short-term, inexpensive financing. Topic: Leaning on the trade LO: 1 2. Excessive ‘leaning on the trade’ by a company can often cause long-term profits. Answer: False Rationale: Long-term leaning on the trade can lead to increased costs of purchased goods and services and damaging of the supply chain. It may also mask underlying cash flow problems. Topic: Accounts payable as a source of financing LO: 1 3. Companies typically delay paying accounts payable as it represents an inexpensive form of financing. Answer: True Rationale: Since accounts payable is a form of interest-free financing, many companies hold off on payment for as long as possible. Topic: Operating liabilities LO: 1 4. Accrued liabilities are considered long-term operating liabilities. Answer: False Rationale: This is an example of a current operating liability. Accrued liabilities are actual and estimated amounts due for obligations other than those arising from inventory acquisitions. Topic: Contingent liabilities LO: 1 5. Contingent liabilities that a company considers to be reasonably possible and for which a company is able to reasonably estimate the amount of a loss are recognized on the balance sheet and the income statement. Answer: False Rationale: Only ‘probable’ contingent liabilities are estimated and recorded on the balance sheet and the income statement. Anything less than ‘probable,’ (such as ‘reasonably possible’) is disclosed in the financial statement footnotes.

. Test Bank, Chapter 9

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Topic: Issuing bonds LO: 3 6. A bond will sell for a discount when the market rate is greater than the coupon rate. Answer: True Rationale: Bonds sell at a discount when the coupon rate is less than the market rate. Topic: Reporting of short-term financing LO: 2 7. Both cash received and interest accrued on short-term bank loans used to finance seasonal swings in working capital are reported on the balance sheet. Answer: True Rationale: Cash received from a bank line of credit to finance seasonal swings in working capital should be recorded on the balance sheet as an increase in cash and liabilities. Interest accrued on the amount borrowed must be reported on the income statement as interest expense, and on the balance sheet as an increase in interest payable. As such both cash received and accrued interest are reported on the balance sheet. Topic: Security for debt LO: 5 8. Security for debt in the form of mortgages on assets is known as covenants. Answer: False Rationale: Collateral provides security for debt in the form of assets. Topic: Reporting of debt schedule LO: 3 9. Companies with current maturities of long-term debt are required to report an amortization schedule in their financial statements. Answer: False Rationale: Companies are required to provide a schedule of long-term debt maturities in the financial statement footnotes. An amortization schedule is used to determine the correct interest expense and book value of the debt. The schedule itself is not part of the financial statements. Topic: Secondary market for bonds LO: 3 10. Once sold, bonds can be traded in the market place similar to shares of stock. Answer: True Rationale: There exists a secondary market for previously issued bonds.

. 9-3

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Topic: Zero coupon notes LO: 4 11. Zero coupon notes do not pay periodic interest payments. Answer: True Rationale: Zero coupon notes do not pay interest during their lives. They are sold at a discount and mature at face value. The difference is the interest cost of the notes. Topic: Discount bond LO: 3 12. A bond selling for an amount above face value is said to be selling at a discount. Answer: False Rationale: This bond would sell at a premium, not a discount. Topic: Bond prices LO: 3 13. Market prices of bonds fluctuate because the company’s obligation (in the form of principal and interest payments) remains fixed. Answer: True Rationale: Market prices on bonds fluctuate similar to stocks. The reasoning behind this is that bond maturity values and periodic interest payments remain fixed, and because they compete with other investments, the amount for which a bond is issued must change to adjust to the market amount. Topic: Bond repurchase LO: 4 14. The bond issuing company can repurchase its bond at the bonds’ issuing price if the bond indenture has a call provision allowing a call of the bonds. Answer: False Rationale: A bond repurchase may occur only if a call provision is part of the bond indenture agreement. However, the repurchase price is at the call price specified. Topic: Secured debt holders LO: 5 15. Secured debt holders have a preferred position over other creditors. Answer: True Rationale: When a company provides collateral, it provides security for the debt in the form of liens on the company’s assets. Secured debt holders have a priority claim on those secured assets.

. Test Bank, Chapter 9

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Topic: Debt ratings LO: 5 16. Debt ratings specify the amount at which investors can buy bonds from companies. Answer: False Rationale: Debt ratings are published by companies such as Moody’s, Fitch and S&P and aim to rate debt so that its default risk is more accurately determined and priced by the market. Topic: IFRS contingent liabilities LO: 1 17. IFRS and U.S. GAAP are the same with reporting contingencies. Answer: False Rationale: IFRS uses the term “provisions” to refer to contingent liabilities that are accrued and reported on the balance sheet, while an obligation that is disclosed in the notes is labeled contingent liability. U.S. GAAP labels them both contingent liabilities. Also, if the best estimate of the future payments required to settle an obligation is a range of values, IFRS requires that the midpoint of the range be used as the estimated value of the contingent liability or provision. U.S. GAAP requires that the low end of the range be used, with disclosure of the maximum.

. 9-5

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Multiple Choice Topic: Contingent liabilities LO: 1 1. According to U.S. GAAP, which criteria must be met in order to recognize a contingent liability? A) B) C) D) E)

The obligation is certain to require payment at some point in the future The obligation is probable The obligation is estimable The obligation is reasonably possible B and C

Answer: E Rationale: Contingent liabilities are only recognized when the amount is probable and estimable. An obligation that is guaranteed at some point in the future is a definite liability. Contingencies that are reasonably possible do not need to be reported. Topic: Current liabilities LO: 1, 2 2. Which of the following does not affect the current liabilities section of the balance sheet? A) B) C) D) E)

Purchase of inventory on credit Wages owed to employees but not yet paid Insurance bill to be paid next month Sale of goods on credit A probable legal obligation, due within 12 months

Answer: D Rationale: The sale of goods on credit impacts current assets, accounts receivable. All the other items are liabilities that the company must pay within the next year, current liabilities. Topic: Interest accrual LO: 2 3. Paleo Foods, Inc. issued a 4 month note in the amount of $500,000 on October 1, 2024 with an annual rate of 5%. What amount of interest has accrued as of December 31, 2023? A) B) C) D)

$ 2,083 $ 6,250 $ 8,333 $25,000

Answer: B Rationale: $500,000 × 5% × 3/12 = $6,250

. Test Bank, Chapter 9

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Topic: Bond ratings LO: 5 4. Which of the following corporate debt ratings are listed in an increasing level of risk? A) B) C) D)

AAA, A, BB, C A, AAA, BB, C BB, C, A, AAA C, BB, A, AAA

Answer: A Rationale: As debt quality moves from AAA to C, the default risk increases. Thus, market interest rate required increases. Topic: Coupon rate LO: 3 5. For what is the coupon rate used to compute? A) B) C) D)

Rate that investors expect to earn on this investment Interest payments paid to bondholders during the life of the bond issue Bond issue price Fee paid to an underwriter for determining the bond price

Answer: B Rationale: Coupon rates are used to compute the dollar amount of interest payments paid to the bondholder semi-annually. This rate is often stated in the bond contract and, therefore, remains fixed. Answer A describes the market rate, a continuously fluctuating number, which is used to price the bond issue. Answer C equals the present value of the expected cash flows to the bondholder. Answer D is a fee set by the underwriters, which prepare and sell the bond issue. Topic: Transaction analysis of current liabilities LO: 1, 2 6. Which of the following transactions that impact current liabilities has a corresponding entry on the income statement? A) B) C) D)

Purchase inventory on credit from Company ABC on January 1 Payment to ABC on February 1 for a January 1 purchase Interest accrued on a note payable Payment to employees in March for wages earned in February

Answer: C Rationale: The purchase of inventory on credit is recorded as an increase in both inventory (noncash asset) and accounts payable (liability) on the balance sheet. Payment of accounts payable is recorded as a decrease in cash and accounts payable on the balance sheet. Interest accrued on a note payable is recorded as an increase in current liabilities (interest payable). An increase in interest expense is recorded on the income statement. Payment of accrued wages is recorded as a decrease in both cash and wages payable (liability).

. 9-7

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Topic: Bonds LO: 3, 4 7. Which one of the following is not correct? A) For debt issued at par, its interest expense reported on the income statement equals the cash interest payment. B) For bond repurchases: Net bonds payable = Repurchase payment + Gain (loss) on bond repurchase. C) For debt issued at a discount, interest expense reported on the income statement consists of the following two components: cash interest paid less the amortization of a discount. D) None of the above Answer: C Rationale: For debt issued at a discount, interest expense reported on the income statement consists of the following two components: cash interest paid plus amortization of the discount. Topic: Contingent liability LO: 1 8. Which one of the following would be considered a contingent liability? A) A company owes $44,000 on inventories purchased on credit B) A company has $980,000 worth of bonds outstanding C) A company estimates that it will probably have to pay $48,000 to the Department of Environment Protection for a chemical spill D) The company has access to a line of credit with a bank in the amount of $576,000 E) The company believes that it is reasonably possible it will lose a lawsuit but is unable to determine the possible damages Answer: C Rationale: For a liability to be a contingent liability, the amount must be able to be estimated and must be probable. Topic: Current liability LO: 1, 2 9. Which of the following does not represent a current liability? A) B) C) D)

Accrual of taxes payable Short-term loan Purchase of equipment on credit Bond issue

Answer: D Rationale: Bonds are issued to raise capital with repayment of the principal amount on a specified date in the future more than one year from the point of issue. Bonds are considered long-term liabilities.

. Test Bank, Chapter 9

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Topic: Bond payment periods LO: 3 10. How many payment periods are in a 10-year, 8% bond with an effective interest rate of 6%, and paid quarterly? A) 5 B) 10 C) 20 D) 40 Answer: D Rationale: 10 years × 4 = 40 payment periods Topic: Accrued liabilities LO: 1 11. Which of the following is an example of an accrued liability? A) B) C) D)

Wages payable Prepaid rent Bonds payable Accounts payable

Answer: A Rationale: A is considered an accrued liability. Item B is a current asset. Items C and D are not accrued. Accounts payable is a separate category of obligations resulting from inventory purchases on account. Topic: Transaction analysis LO: 2 12. What effects would the accrual of $200 of interest on a note payable have on financial statements? I. Balance sheet: II. Income statement: III. Balance sheet: IV. Balance sheet: V. Balance sheet: A) B) C) D)

Liabilities are decreased by $200 Expenses are increased by $200 Retained earnings are decreased by $200 Cash assets are decreased by $200 Liabilities are increased by $200

I, II and III II, III and V II, IV and V II, III and IV

Answer: B Rationale: Interest is recorded on the balance sheet as an accrued liability, increasing liabilities by $200, decreasing retained earnings by $200, and adding $200 to expenses on the income statement. Since no cash is spent to pay the note or the interest, cash assets are not affected.

. 9-9

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Topic: Bond pricing LO: 3 13. The price of a bond is equivalent to: I. II. III. IV. A) B) C) D)

Face value Projected interest payments discounted to the present The amortization amount of a bond The present value of the principal payment

I + III I – III II + IV I + II

Answer: C Rationale: The price of a bond is the present value of both the interest payments and the principal payment. Topic: Transaction analysis LO: 2 14. Bargain Basement borrows $400,000 on July 1 with a short-term loan that has an annual interest rate of 6%, payable on the first day of each subsequent quarter. What will Bargain Basement need to accrue on September 30, assuming that no accrual had been made since the last interest payment? A) B) C) D)

$6,000; Decrease liabilities, decrease cash $4,000; Increase liabilities, increase expenses $6,000; Increase expenses, increase liabilities $4,000; Increase expenses, decrease cash

Answer: C Rationale: Interest is calculated by multiplying the loan amount ($400,000) by the interest rate (6%) and then by the portion of the year outstanding (3/12), or $6,000 for the three months’ interest owed. The company needs to reflect the outstanding interest owed (accrued interest) by increasing liabilities and interest expense. Topic: Debt footnote LO: 4 15. Which of the following details of a company’s long-term liabilities are normally reported in footnote disclosures? A) B) C) D)

Collateral Interest rates Maturity dates All of the above

Answer: D Rationale: All of the details given are normally reported in the footnote disclosures.

. Test Bank, Chapter 9

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Topic: Bond retirement LO: 3, 4 16. On April 30, 2024, one year before maturity, Hill Corporation retired $500,000 of 6% bonds payable at 102. The book value of the bonds on April 30 was $492,500. Bond interest was last paid on April 30, 2024. What is the gain or loss on the retirement of the bonds? A) B) C) D)

$17,500 gain $ 7,500 gain $ 7,500 loss $17,500 loss

Answer: D Rationale: The loss is the difference between the retirement value and the book value of the bond: (102% x $500,000) – $492,500 = $17,500. Topic: Bond issuance LO: 3, 4 17. If 5% bonds are issued at 101.75, this means that: A) B) C) D)

A $2,000 bond sold for $2,035. The bonds sold at a discount. The bond rate of interest is 1.75% higher than the effective rate of interest. The effective rate of interest is higher than 5%.

Answer: A Rationale: Bonds are typically quoted at a percent of par: 101.75% × $2,000 = $2,035. Topic: Bond amortization LO: 3, 4 18. Magee Industries plans to issue 5-year, 6%, $500,000 bonds paying interest on an annual basis, at a $3,500 discount. Which one of the following statements is true? A) Magee will receive $503,500 as the issue price. B) Magee’s annual interest expense on the bonds will be greater than the amount of interest payments to bondholders each year. C) The effective rate of interest on the bonds is lower than 6%. D) The cash paid to bondholders will be $3,500 each year. Answer: B Rationale: The bonds are issued at a discount, which means the effective rate is greater than the coupon rate. Interest expense is based on the effective rate, while the cash payment is based on the coupon rate.

. 9-11

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Topic: Bond interest payments LO: 2, 3 19. On January 1, 2024, Pfeiffer Corporation issued $700,000, 5% bonds for $685,000, to yield 6%. The bonds pay interest on June 30 and December 31. How much is the interest expense on the bonds for the first interest payment on June 30, 2024? A) B) C) D)

$21,000 $42,000 $20,550 $41,100

Answer: C Rationale: $685,000 × 6% × 6/12 = $20,550 Topic: Debt analysis LO: 5 20. You have been asked to write a financial analysis report for Companies Alpha and Beta. Company Alpha has a debt-to-equity ratio that is much lower than the industry average, with Company Beta having a debt-to-equity ratio much higher than industry average. The times interest earned ratio for Company Alpha is much higher than the industry average, and the ratio for Company Beta is much lower. Which one of the following statements will not be part of your financial analysis report for these two companies? A) Company Alpha is a less leveraged company than Company Beta B) Company Alpha generates a larger amount of income compared to its obligatory payments to creditors than Company Beta C) Company Alpha is a less risky company than Company Beta D) Company Beta’s lower times interest earned means that it may experience more difficulties than Company Alpha in obtaining attractive financing terms on new borrowings. Answer: B Rationale: We don’t have information regarding the amount of income either company makes compared to its obligatory payments to creditors. Topic: IFRS reporting LO: 1 21. Which of the following is true concerning contingency reporting? A) IFRS uses the term “provisions” to refer to contingent liabilities that are accrued and reported on the balance sheet while an obligation that is disclosed in the notes is labeled “contingent liability.” B) IFRS allows companies to report contingent gains if a present obligation exists and the sacrifice of resources is probable. C) A key difference in reporting contingent liabilities under U.S. GAAP compared to IFRS is that only IFRS requires that the obligation is probable and the amount estimable to recognize the obligation. D) U.S. GAAP requires that a contingent liability be recognized instead of a contingent loss, whereas IFRS requires both. Answer: A Rationale: IFRS uses the term “provisions” to refer to contingent liabilities that are accrued and reported on the balance sheet while an obligation that is disclosed in the notes is labeled “contingent liability.” . Test Bank, Chapter 9

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. 9-13

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Exercises Topic: Accrued interest LO: 2 1. Spencer Company gave a creditor a 4 month, 5% note payable for $60,000 on December 1, 2024. What amount of interest will be accrued as of December 31, 2024? Where will this amount be reported in the company’s financial statements? Answer: $60,000 × 5% × 1/12 = $250 reported as a current liability as interest payable on the balance sheet, and as interest expense on the income statement. Topic: Current liabilities LO: 1, 2 2. For each of the following, indicate the liability, if any, which would be shown on a balance sheet of Rand Company as of December 31, 2024. 1. Rand received an invoice for supplies it ordered at the end of December totaling $5,000, but the supplies have not been received as of December 31. 2. Rand received an invoice for advertising services received in December, in the amount of $10,000. 3. Rand will receive a $10,000 loan from its bank on January 1, 2025. Answer: 1. This is not a current liability as the supplies have not yet been received. 2. This is a current liability as the services were received but the invoice has not yet been paid. 3. This is not a current liability, as the loan has not yet been received. Topic: Gain (loss) on bond repayment LO: 4 3. On June 30, one year before maturity, DigiSource, Inc. retired $800,000 of its 4% bonds payable at 101. The book value of the bonds on June 30 is $805,000. Bond interest is presently paid up to the date of retirement. How much is the gain or loss on the retirement of these bonds? Answer: Cash for retirement = $800,000 x 1.01 = $808,000 Gain (loss) = Net bonds payable ‒ Cash payment = $805,000 – $808,000 = $3,000 loss

. Test Bank, Chapter 9

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Topic: Financial statement classification LO: 1, 2, 3, 4 4. Indicate the proper financial classification (balance sheet or income statement) for each of the following accounts: A. B. C. D. E.

Loss on bond retirement Bonds payable Mortgage interest expense Gift certificates sold to customers Bonds due to be paid within 12 months

Answer: A. Shown in the income statement, typically included in income from continuing operations B. Shown in the balance sheet as long-term liability. C. Reported on the income statement. D. Reported on the balance sheet in the current liability section E. Reported as current maturities of long-term debt in the balance sheet. Topic: Accrued interest LO: 3 5. Calculate the interest accrued for each of the following notes payable owed by Purify, Inc. as of December 31, 2024: Lender Morgan Bank Heartland Bank City Bank

Date of Note 11/01/24 10/01/24 08/1/24

Principal $100,000 $ 50,000 $ 40,000

Interest Rate 3.0% 3.5% 4.5%

Term 3 months 6 months 1 year

Answer: Lender Morgan Bank Heartland Bank City Bank

Interest Accrued

Principal × Annual Rate × Time outstanding

$500.00 $437.50 $750.00

$100,000 × 3.0% × 2/12 $ 50,000 × 3.5% × 3/12 $ 40,000 × 4.5% × 5/12

. 9-15

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Topic: Bond retirement LO: 4 6. Morse Company issued $2,000,000 of 4%, 20-year bonds at 102 on January 1, 2010. Interest is payable semi-annually on July 1 and January 1. Through January 1, 2024, Morse amortized $31,500 of the bond premium. On January 1, 2024, Morse retires the bond at 101 (after making the interest payment on that date). Using the following table, indicate the effects on the company’s financial statements of the bond retirement for January 1, 2024. Balance Sheet Transaction

Cash Asset

Noncash Assets

Liabilities

Income Statement +

Contrib. Capital

Earned Capital

Revenues

Expenses

Net Income

To retire bonds at 101 =

Answer: Balance Sheet Transaction To retire bonds at 101

-2,020,000

- 2,000,000

-11,500

+11,500

-11,500

Cash

Bonds Payable

Retained Earnings

Loss on

Loss on Bond = Retirement

Noncash Assets

Income Statement

Cash Asset

Liabilities

Contrib. Capital

Earned Capital

Revenues

Expenses

Bond Retirement

Net Income

-8,500 Premium on Bond

$2,000,000 × 1.02 = $2,040,000 issue price $2,000,000 × 1.01 = $2,020,000 retirement amount Unamortized premium = $40,000 premium ‒ $31,500 amortized = $8,500 Book value of bonds on date of repurchase = $2,000,000 + $8,500 = $2,008,500 (Loss) on retirement = $2,008,500 - $2,020,000 = $(11,500)

. Test Bank, Chapter 9

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Topic: Bond pricing LO: 3 7. Paris Company issues $5,000,000 of 5% bonds that pay interest semiannually and mature in 10 years. Compute the bonds’ issue price assuming that the bonds’ effective interest rate is: A. 4% per year compounded semiannually B. 6% per year compounded semiannually Answer: Using the present value tables: Interest Payment = $5,000,000 × 5% × 6/12 = $125,000 A. Selling price of the bond discounted at 4%: Present value of principal repayment ($5,000,000 x 0.67297*) = Present value of interest payments ($125,000 x 16.3513**) =

$3,364,850 2,043,929 $5,408,779

*Present value of a sum, 20 periods at 2% **Present value of an annuity, 20 periods at 2%

B. Selling price of the bond discounted at 6%: Present value of principal repayment ($5,000,000 × 0.55368*) = Present value of interest payments ($125,000 × 14.87747**) =

$2,768,400 1,859,684 $4,629,084

*Present value of a sum, 20 periods at 3% **Present value of an annuity, 20 periods at 3%

Answer using Excel or a financial calculator: A. Rate = 2%, nper = 20, pmt = 125,000, fv = 5,000,000

$5,408,786

B. Rate = 3%, nper = 20, pmt = 125,000, fv = 5,000,000

$4,628,063

Topic: Transaction analysis LO: 1, 2 8. Determine how each of the following transactions affect liabilities. A. Payment to employees for wages previously accrued B. Accrue interest of $200 on a note payable C. Payment of $200 to bank for interest accrued on a note payable Answer: A. This transaction reduces current liabilities with a decrease in cash and a decrease in wages payable are recorded. B. Interest payable increases which is a current liability. Interest expense also increases on the income statement causing retained earnings to decrease. C. Interest payable, a current liability, decreases along with cash.

. 9-17

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Topic: Interest accrual LO: 2 9. Westmont, Inc. took out a one-year, 4%, $120,000 loan to be repaid on May 1, 2025. Interest is due when the loan is repaid. How much interest should be accrued at December 31, 2024, and how should it be recorded in the financial statements? Answer: Interest expense = Principal × Annual interest rate × Portion of year outstanding = $120,000 × 4% × 8/12 = $3,200 The $3,200 should be recorded as an increase in liabilities (interest payable) and an increase in interest expense on the income statement which in turn reduces retained earnings on the balance sheet. Topic: Gain (loss) on bond repurchase LO: 4 10. Hinsdale Manufacturing paid $10,200,000 to retire $10,000,000 in 4% bonds due in 5 years. The book value of the bonds was $9,600,000 at the date of retirement. A. How much is the net gain or loss on the redemption of these bonds? B. Prepare the journal entry to record the transaction. Answer: A. $10,200,000 paid ‒ $9,600,000 book value = $600,000 net loss B. Bonds payable Loss on bond retirement Bond discount Cash

10,000,000 600,000 400,000 10,200,000

Topic: Recognition and disclosure LO: 1 11. The following items represent various types of liabilities. 1. A manufacturing company is sued for alleged product liability. The company’s attorney does not feel that the suit will result in liability to the company, but a loss is possible. If adversely adjudicated, the liability would be material. 2. Mr. Gold, Inc. has sold products to Twinkle Jewelers, a retailer, which sold the products to customers. The manufacturer’s warranty offers replacement of the product if it is found to be defective within 90 days of the sale to the consumer. Historically, 0.06% of the products are returned for replacement. 3. A customer has filed a lawsuit for a minor amount against Twinkle Jewelers. Twinkle ’s attorneys have reviewed the case and have found that many similar cases have never been awarded to the plaintiff. Identify if the following independent situations should be (a) recorded in the financial statements, (b) disclosed in a footnote in the financial statements, or (c) neither.

. Test Bank, Chapter 9

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Answer: 1. (b) Disclosed in footnote because this is reasonably possible 2. (a) Recorded in the financial statements because the costs are probable and reasonably estimable 3. (c) Neither recorded nor disclosed because this is not even reasonably possible Topic: Account classification LO: 1, 2 12. Identify the following items numbered as 1 through 5 below as either of the following: A. Current operating liability B. Current non-operating liability 1. 2. 3. 4.

Short-term loans from a financial institution Rent payable Insurance premiums payable Current maturities of long-term debt

5. Utilities payable Answer: 1. 2.

Short-term loans from a financial institution Rent payable

B A

3. 4. 5.

Insurance premiums payable Current maturities of long-term debt Utilities payable

A B A

Topic: Bond pricing LO: 3 13. If Phoenix Company issues $3,500,000 in 3% bonds due in 4 years with semiannual interest payments, how much should it expect to raise if the market return for similar bonds is 4%? Answer: Using the present value tables: Interest Payment = $3,500,000 × 3% × 6/12 = $52,500 PV of the principal = 0.85349* × $3,500,000 PV of the interest payments = 7.32548** × $52,500 PV of the bonds

$ 2,987,215 384,588 $3,371,803

*Present value of a sum, 8 periods at 2% **Present value of an annuity, 8 periods at 2%

Answer using Excel or a financial calculator: Rate = 2%, nper = 8, pmt = 52,500, fv = 3,500,000 = $3,371,804 . 9-19

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Topic: Financial leverage LO: 5 14. The following data relates to Diamond Company and three of its competitors in the mining industry: Firm Gold Silver Copper Diamond

Debt-to-Equity (D/E) 1.21 1.89 1.45 2.91

Times Interest Earned (TIE) 1.23 0.88 0.53 2.44

Comment on the above industry ratios and address specific concerns about Diamond Company that you might have as a commercial lender. Answer: Diamond’s leverage, as measured by its debt-to-equity ratio, is higher than Firm Gold, Silver, or Copper, a significant concern for any lender. On the other hand, Diamond is in better shape than any of its competitors in terms of its ability to pay the interest on its debt as indicated by its greater TIE ratio. As a lender, the largest concern would be whether Diamond would be able to maintain its higher leverage in periods of significant recessionary periods or times where competitive pressures require less profitability to compete.

. Test Bank, Chapter 9

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Problems Topic: Ratios and bond ratings LO: 5 1. Verdi Company has the following values taken from its 2024 annual report: Interest expense Sales Earnings before interest and taxes Total liabilities Stockholders’ equity

20,000 640,000 400,000 750,000 500,000

A. Calculate Verdi Company’s times interest earned and debt-to-equity ratios. B. How are these ratios used in credit ratings? C. According to Standard & Poor’s, what are the 2 types of risk factors considered in credit analysis? Answer: A. Times interest earned = $400,000 / $20,000 = 20 times Debt-to-equity = $750,000 / $500,000 = 1.5 or 150% B. They are used to assess if a company can meet its debt service requirements and repayment of debt. Times interest earned provides an indication of the company’s ability to meet its interest obligations, and the debt-to-equity ratio shows solvency. C. Business risk and financial risk Topic: Bond pricing and retirement using a financial calculator or Excel LO: 3, 4 2. Jackson Corp. recently issued bonds with a face value of $5,000,000 and a coupon rate of 5% for 12 years. The market rate of interest is 6% and the bonds pay interest semiannually. A. Compute the market value of the bond, using a financial calculator or Excel. B. How much is the premium or discount at the bond issuance date? C. Assume that after one year, Jackson Corp. decides to retire this bond issuance at a cost of $5,010,000. Will there be a gain or loss on the retirement and what amount? How is this transaction recorded on Jackson’s income statement? Answer: A. Interest payment = $5,000,000 × 5% × 6/12 = $125,000 n = 24, i = 3%, PV = ?, PMT = 125,000, FV = 5,000,000 PV = $4,576,611 B. $5,000,000 ‒ $4,576,611 = $423,389 discount

. 9-21

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C. Period 0 1 2

Interest Expense*

Cash Interest Paid

$137,298 137,667

$125,000 $125,000

Discount Balance** $423,389 411,091 398,424

Bond Payable, Net*** $4,576,611 4,588,909 4,601,576

Loss on bond repurchase = $5,010,000 ‒ $4,601,576 = $408,424. This loss is recorded as part of income from continuing operations. *(Period -1) Bond Payable Balance x 3% **(Period -1) Discount Balance – (Interest Expense – Cash Interest Paid) *** $5,000,000 bond issue amount – Discount Balance

Topic: Bond pricing and amortization LO: 3 3. Evergreen Corporation issued $10,000,000 in bonds which mature in 8 years. The bonds pay a 3% semiannual coupon. The current market rate for similar bonds is 4%. A. At what price should this bond offering sell? B. Create a table showing the amortized premium or discount the first three periods of the bonds. C. How much is the book value of the bonds at the end of the first year (2 payments)? Answer: Using present value tables: A. Interest payment = $10,000,000 × 3% × 6/12 = $150,000 PV of principal = 0.72845* × $10,000,000 Present value of interest payments = 13.57771** × $150,000 PV of the sale

$7,284,500 2,036,657 $9,321,157

*Present value of a sum, 16 periods at 2% **Present value of interest payments, 16 periods at 2%

Using Excel or a financial calculator: n = 16, i = 2%, PV = ?, PMT = 150,000, FV = 10,000,000 PV = $9,321,515 B. Using Excel answer for A.: Period 0 1 2 3

Interest Expense*

Interest Paid

Amortization**

$186,430 $187,159 $187,902

$150,000 $150,000 $150,000

$36,430 $37,159 $37,902

Discount Balance*** $678,485 642,055 604,896 566,994

Bond Payable**** $9,321,515 9,357,945 9,395,104 9,433,006

*(Period -1) Bond Payable Balance x 2% ** Interest Expense – Interest Paid ***(Period -1) Discount - Amortization **** $10,000,000 bond issue amount – Discount Balance

C. $9,395,104 . Test Bank, Chapter 9

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Topic: Interpretation of balance sheet LO: 1 4. Following are the liability and equity sections of the consolidated balance sheet and related notes from Jill’s Restaurants, Inc.’s 2024 annual report (in thousands): LIABILITIES AND SHAREHOLDERS’ EQUITY 2024

2023

CURRENT LIABILITIES: Current maturities of long-term debt Accounts payable Accrued liabilities Total current liabilities Long-term debt, less current maturities Other long-term obligations and deferred credits Total liabilities

$ 3,000 30,000 50,000 83,000 60,000 45,000 188,000

$ 2,600 27,000 45,000 74,600 62,000 40,000 176,600

SHAREHOLDERS’ EQUITY: Common stock, no par Accumulated other comprehensive loss Accumulated deficit Total shareholders’ equity

100,000 (500) (28,000) 71,500

100,000 (600) (25,000) 74,400

$259,500

$251,000

Total liabilities and shareholders’ equity

A. Identify and describe the current liabilities recorded for Jill’s Restaurants as of December 31, 2024. B. What types of costs might be included in the accrued liabilities? Answer: A. Current liabilities at December 31, 2024: Current maturities of long-term debt are long-term debt payments due within the next year on bonds, notes, or loans, $3,000,000. Accounts payable are amounts owed to suppliers, $30,000,000. Accrued liabilities are expenses incurred but not yet paid, $50,000,000. B. Accrued liabilities may include compensation, vacation pay, taxes, fees for services, interest, rent, utilities, and warranties.

. 9-23

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Topic: Interpretation of debt footnote LO: 3, 4 5. Following is an excerpt from a footnote from the Soda Company 2019 annual report: NOTE10: DEBT AND BORROWING ARRANGEMENTS Short-Term Borrowings Loans and notes payable consist primarily of commercial paper issued in the United States. As of December 31, 2019 and 2018, we had $32,408 million and $24,270 million, respectively, in outstanding commercial paper borrowings. Our weighted-average interest rates for commercial paper outstanding were approximately 0.3 percent and 0.2 percent per year as of December 31, 2019 and 2018, respectively. In addition, we had $15,536 million in lines of credit and other short-term credit facilities as of December 31, 2019, of which $1,708 million was related to the Company's consolidated Philippine bottling operations that were classified as held for sale. The Company's total lines of credit included $186 million that was outstanding and primarily related to our international operations. Included in the credit facilities discussed above, the Company had $12,628 million in lines of credit for general corporate purposes. These backup lines of credit expire at various times from 2020 through 2024. There were no borrowings under these backup lines of credit during 2019. These credit facilities are subject to normal banking terms and conditions. Some of the financial arrangements require compensating balances, none of which is presently significant to our Company. Long-Term Debt During 2019, the Company retired $2,500 million of long-term notes upon maturity and issued $5,500 million of long-term debt. The general terms of the notes issued are as follows: o $2,000 million total principal amount of notes due March 14, 2021, at a variable interest rate equal to the three-month London Interbank Offered Rate ("LIBOR") minus 0.05 percent; o $2,000 million total principal amount of notes due March 13, 2022, at a fixed interest rate of 0.75 percent; and o $1,500 million total principal amount of notes due March 14, 2025, at a fixed interest rate of 1.65 percent. The Company's long-term debt consisted of the following (in millions, except average rate data): December 31, 2019 Amount

December 31, 2018

Average Rate

Amount

Average Rate

U.S. dollar notes due 2020–2100 U.S. dollar debentures due 2024–2105 U.S. dollar zero coupon notes due 2027 Other, due through 2105 Fair value adjustment

26,814 4,414 270 582 546

1.7% $ 3.7 8.4 4.4 N/A

24,540 4,964 260 1,168 462

1.9% 4.0 8.4 4.8 N/A

Total Less current portion

32,626 3,154

2.1% $

31,394 4,082

2.3%

Long-term debt

29,472

27,312

5,6

Continued

. Test Bank, Chapter 9

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Maturities of long-term debt for the five years succeeding December 31, 2019, are as follows (in millions): Maturities of Long-Term Debt

2020 2021 2022 2023 2024

3,154 5,266 4,902 3,410 2,878

The cash flows from financing activities section of Soda Company’s 2019 annual report contains the following cash flows provided by (used by) activities (in millions):

Issuances of debt Payments of debt Issuances of stock Purchases of stock for treasury Dividends Other financing activities Net cash provided by (used in) financing activities

2019 $85,582 (77,146) 2,978 (9,190) (9,190) 200 $ (6,766)

2018 $54,990 (45,060) 3,138 (9,026) (8,600) 90 $ (4,468)

2017 $30,502 (26,806) 3,332 (5,922) (8,136) 100 $ (6,930)

A. B. C. D.

What amount was issued in the form of debt in 2019? 2018? Does Soda Company finance its activities primarily through short-term or long-term debt? Based on the info above, what are the details of the long-term debt issuance for 2019? How would the issuance of debt in 2019 be reflected on the financial statements for The Soda Company? E. How would the payments of debt affect the financial statements in 2019? Answer: A. $85,582 million in 2019 and $54,990 million in 2018 as shown in the financing section of the statement of cash flows. B. For 2019, Soda appears to have an even spread of its debt between long-term and short-term, with just over $32 billion of each. C. During 2019, the Company retired $2,500 million of long-term notes upon maturity and issued $5,500 million of long-term debt. The general terms of the notes issued are as follows: • $2,000 million total principal amount of notes due March 14, 2021 at a variable interest rate equal to the three-month London Interbank Offered Rate ("LIBOR") minus 0.05%; • $2,000 million total principal amount of notes due March 13, 2022 at a fixed interest rate of 0.75%; and • $1,500 million total principal amount of notes due March 14, 2025 at a fixed interest rate of 1.65%. D. Notes payable, a liability, and cash, an asset, both increase by $85,582 million. E. Notes payable, a liability, and cash, an asset, both decrease by $77,146 million.

. 9-25

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Topic: Bond pricing and amortization LO: 3, 4 Note to instructor: This problem requires the use of a financial calculator. 6. YOLO Adventures is short on cash and facing a serious problem. The company does not have enough cash to pay the wages of its park employees, and paychecks are due. Several of the employees have indicated that they will quit if they do not receive their paychecks on time. The company has decided to make a public offering on May 1, 2024, of a $200,000, 5-year 8% bond with semiannual interest payments on October 31 and April 30, to cover the immediate problems as well as some long-term investments that the company hopes to make. Similar bonds demand an 6% return. A. Will the bond be sold at a premium or a discount? What is the amount of the premium or discount? Does this have an effect on the risk of the bond? B. Assuming negligible charges by the company’s discount investment banking firm, show effects of the initial offering using the financial statement equation format. C. Create a bond amortization table for the first 3 payments showing the effects of amortization on the liability balance and interest expense. D. How and by what amount would the amortization differ if YOLO Adventures issued zero-coupon debt? Answer: A. Interest payment = $200,000 x 8% x 6/12 = $8,000 n = 10, i = 3%, PV = ?, PMT = 8,000, FV = 200,000 PV = $217,060 This bond is being sold at a premium of $17,060. This is not related to the bond’s risk, except through comparing it to the return of other bonds. B. Balance Sheet Cash Asset

Transaction Bond Issuance

Noncash Assets

+217,060 Cash

Liabilities

+217,060 Bonds Payable

Income Statement +

Contrib .Capital

Earned Capital

Revenues

Expenses

Net Income

C. 0 1 2 3

Interest Expense*

Interest Paid

Amortization**

$6,512 6,467 6,421

$8,000 8,000 8,000

$1,488 1,533 1,579

Premium Balance *** $17,060 15,572 14,039 12,460

Bond Payable**** $217,060 215,572 214,039 212,460

*(Period -1) Bond Payable Balance x 3% ** Interest Paid – Interest Expense ***(Period -1) Premium Balance - Amortization ****Premium Balance + $200,000 bond issue amount

D. If the bond had been sold without coupon payments, it would have sold at a very deep discount, instead of a premium. Since there would be no interest payments, all the interest expense would be amortization of discount. The amortization amounts would be much larger than shown above.

. Test Bank, Chapter 9

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Topic: Bond investment comparison LO: 5 7. You are a pension fund manager looking for an investment vehicle that will provide your fund with a reliable stream of income over the next 10 years. You want to find the best yield possible while still conforming to the pension fund covenant of investing in investment grade bonds or better. You are trying to decide between the following investment options for your equity: A. Sushi King 10 years, 5.5% yield, EBIT Interest coverage ratio = 4.0, EBITDA Interest coverage ratio = 6.0, total debt of $480,000,000 (all of which is long term), total equity of $1,000,000,000, and a return on equity of 8.3 B. Super Home Store 10 years, 2.5% yield, EBIT Interest coverage ratio = 22.0, EBITDA Interest coverage ratio = 31.0, total debt of $320,000,000 (all of which is long term), total equity of $10,000,000,000, and a return on equity of 25.0 C. TechSource, Inc 10 years, 8.5% yield, EBIT Interest coverage ratio = 0.78, EBITDA Interest coverage ratio = 1.3, total debt of $210,000,000, total equity of $320,000,000, and a return on equity of 8.2 Using the table below, discuss each investment option’s pros and cons, attempt to determine the grade of each bond, and ultimately make an argument for which bond is the appropriate investment for your pension fund. Note: Bonds rated BB, or lower, are considered to be non-investment grade bonds. U.S Industrial long term debt Three-Year medians

AAA

BBB

CCC

EBIT Interest coverage (x)

21.4

10.1

6.1

3.7

2.1

0.8

0.1

EBITDA Int. Cov (X)

26.5

12.9

9.1

5.8

3.4

1.8

1.3

FCFO/total debt (%)

84.2

25.2

8.5

2.6

(3.2)

(12.9)

FFO/total debt (%)

128.8

43.2

30.8

18.8

7.8

1.6

Return on equity (%)

34.9

19.4

13.6

11.6

6.6

Operating income/Sales (%)

18.6

15.4

15.9

11.9

Long-term debt-to-equity (%)

13.3

33.9

42.5

57.2

69.7

68.8

Total debt-to-equity (%)

22.9

42.5

48.2

62.6

74.8

87.7

. 9-27

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Answer: A. Sushi King: Sushi King’s issue is teetering between a (low-medium) investment grade bond and a non-investment grade bond. With interest coverage ratios coming in right at the BBB benchmark and a debt-to-equity ratio of 48%, which is also approximately right at the BBB benchmark it is likely that this bond is a feasible investment option, especially attractive is the 5.5% yield. However, Sushi King’s ROE measure is well below the BBB benchmark and could be a cause for concern. B. Super Home Store: With a 3.2% debt-to-equity ratio, an attractive ROE of 25%, and AAA quality interest coverage ratios, Super Home Store’s bond looks to be approximately a AAA quality bond. Thus, this company is rather healthy, making this bond a relatively safe play. C. TechSource, Inc.: This bond is a non-investment grade bond based the fact that it has a profile that lies somewhere between a BB grade bond and a CCC grade bond. Especially troubling are the interest coverage ratios, which are both below B grade. ROE and the debt-to-equity ratio fall between a BB grade bond and a B grade bond. The high yield that this bond offers is inherent due to the high risk that is associated with it as well. There is a very good chance that it will default, and as a result it would be an inappropriate investment for a pension fund. Summary: The most appropriate bond for a pension fund is probably Super Home Store. While it offers a low yield relative to the other two options it also a relatively low risk investment, and considering you are investing employee’s retirement funds, you are more interested in preserving equity than high returns. Thus, it seems likely that the AAA Super Home Store bond would be the appropriate investment.

. Test Bank, Chapter 9

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Essays Topic: Contingent liabilities LO: 1 1. What are the requirements for determining the financial reporting of a contingent liability? Why would a company want to keep its contingent liability as low as possible? How could a company manipulate contingent liability to its advantage? Answer: A contingent liability is an uncertain accrual. The obligation must be “probable” and the amount “estimable” in order to require reporting on the face of the financial statements. A company would like to keep its contingent liability as low as possible as it appears on the balance sheet of a company as a liability. If the accruals are underestimated, it means that the income and retained earnings are overestimated. As a company can determine the amount of its contingent liability and whether its “probable” or “reasonably possible”, it could choose to aggressively recognize these as part of a “big bath” to relieve future periods of expense or provide a cookie jar if the expenses are over estimated. Topic: Bond ratings LO: 5 2. The following table lists some bond rankings: Company (Source: S&P) Viacom Time Warner Delta Air Lines Inc. Southwest Airlines Pfizer Wyeth Citigroup Alliance Cap Mgmt. L.P

A BBB+ C A AAA A AA A+

What impact does increased risk have on the credit rating of bonds issued by a company? Why do companies in the same industry have different bond rates? Answer: The more risky the investment, the higher the return required. Credit quality relates to default risk, which is the risk of nonpayment of interest and debt and the potential failure to adhere to various terms and conditions. In the above table, airlines are considered as being a more risky investment than financial companies, as the airline industry is currently in difficulty and the long term viability of its companies is questionable. Different companies in the same industry will have different bond rates, as the bond rate reflects the individual risk of the company. In the above table, Southwest and Delta are both in the airline business, but because of differences in profitability and long-term growth opportunities, their debt ratings different. In the case of Time Warner versus Viacom, while both are in the media industry, the mix of their subsidiary companies differs and this could account for the slight difference in ratings.

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Topic: Effective cost of debt LO: 4 3. Explain the differences in the components of interest expense for the bonds sold at par, discount, and at a premium. Answer: When a bond is sold at par value, the cost to the issuing company is only the cost of the cash interest paid. Interest expense, in this case, is equal to the cash interest paid. When a bond is sold at a discount, the interest expense is equal to the cash interest paid plus the amortization of the discount. When a bond is sold at a premium, the interest expense is equal to the cash interest paid less the amortization of the premium.

. Test Bank, Chapter 9

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Chapter 10 Reporting and Analyzing Leases, Pensions, Income Taxes, and Commitments and Contingencies Learning Objectives – Coverage by question True/False

Multiple Choice

Exercises

Problems

LO10-1 Account for leases using the operating lease method and the finance lease method. Compare and analyze the two methods. (p. 10-3)

1, 2, 5-7, 9

1, 2, 4, 69, 21, 23

1-4, 11, 12

1-4

LO10-2 Explain and interpret the reporting for pension plans, including the disclosure notes. (p. 10-15)

3, 8, 10, 12, 14

3, 5, 1013, 15, 23

4, 6-8, 10

5, 6

LO10-3 Describe and interpret accounting for income taxes. (p. 10-25)

13, 15

LO10-4 Describe disclosures regarding future commitments and contingencies. Analyze financial statements after converting off-balance-sheet items to be considered on balance sheet. (p. 10-36)

11, 16, 17

16-20

14, 22, 23

5, 9

Essay Questions

13, 14

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Chapter 10: Reporting and Analyzing Leases, Pensions, Income Taxes, and Commitments and Contingencies True/False Topic: Operating leases LO: 1 1. An operating lease with no purchase option and with a term of 10 months would appear as an asset on the lessee’s balance sheet. Answer: False Rationale: Short-term operating leases do not appear on the lessee’s balance sheet. Lease payments are reported as lease expense on the lessee’s income statement. Topic: Lease capitalization LO: 1 2. Erroneously reporting a lease as short-term when it should be reported as an operating lease has very little effect on a company’s return on assets (ROA) ratio. Answer: False Rationale: ROA is affected because although expenses are the same, operating leases report the lease as an asset while short-term leases do not. Topic: Pension service cost LO: 2 3. The increase in a defined benefit pension obligation due to an employee working an additional year for the employer will cause the net pension liability on the balance sheet to increase but have no direct effect on the income statement. Answer: False Rationale: Profit will decline due to additional pension expense. The pension obligation also increases due to an increase in service and interest costs, both components of pension expense. Topic: Leases as a financing source LO: 1 4. Leases are often a better financing vehicle than traditional bank loans because leases often require less equity investment. Answer: True Rationale: Leases generally require less up-front investment than traditional loan financing.

. Test Bank, Chapter 10

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Topic: Financial statement effects of lease misclassification LO: 1 5. Misclassification of finance leases as operating leases results in overstated profit for a company in the early years of a lease. Answer: True Rationale: The interest plus amortization expense in the early years of the lease would be greater than the lease payment. Topic: Expenses and cash flows relating to operating leases LO: 1 6. Operating leases increase interest expense in the income statement, while decreasing net cash flows in the cash flow statement, compared with finance leases. Answer: False Rationale: Operating leases record lease expense, rather than interest and amortization. Further, the lease payments (e.g., cash outflows) are the same, whether or not the lease is capitalized. Topic: Off-balance-sheet financing LO: 1 7. Off-balance-sheet financing is the financing of investing activities where neither the accounts associated with the financing or investing are reported on the balance sheet. Answer: True Rationale: Off-balance-sheet financing means that neither assets nor liabilities are reported on the balance sheet. Topic: Actual vs. expected returns on pension investments LO: 2 8. GAAP permits companies to choose to report the return on defined benefit pension plan assets component of pension expense based either on actual investment returns of pension investments or on expected returns. Answer: False Rationale: GAAP requires companies to report pension income based on the expected return of the pension investment. The aim is to stabilize long-term returns instead of reporting annual or quarterly swings due to the fluctuation in the market. Topic: Financial statement effects of finance and operating leases LO: 1 9. Recognizing a lease as a finance lease or as an operating lease requires that both the leased asset and lease liability be reported on the balance sheet. Answer: True Rationale: Both the leased asset and lease liability must be reported on the balance sheet when the lease qualifies as either a finance or operating lease.

. 10-3

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Topic: Reporting of pension assets and liabilities LO: 2 10. Companies are required to report total pension assets and total pension liabilities separately on their balance sheets. Answer: False Rationale: Companies are required to report only the funded status, the net pension asset or liability, on their balance sheets. Topic: Off-balance-sheet financing LO: 4 11. Off-balance-sheet financing instruments are not reported on the financial statements or the footnotes to those statements. Answer: False Rationale: Although not reported on the face of the financial statements, GAAP requires detailed footnote disclosures for off-balance-sheet financing. Topic: IFRS and pensions LO: 2 12. Both IFRS and U.S. GAAP require companies to report the funded status of defined benefit pension plans on the balance sheet. Answer: True Rationale: Companies must report the funded status of defined benefit pension plans on the balance sheet under both GAAP and IFRS. The IFRS’ calculation of the unfunded status differs from that under GAAP. Topic: Depreciation for tax purposes LO: 3 13. A company that uses an accelerated method of depreciation for tax reporting and straight-line depreciation for financial reporting purposes will create a deferred tax liability in the year the asset is acquired. Answer: True Rationale: MACRS, an accelerated method, is used for tax purposes because costs from the asset will be transferred to the income statement in larger amounts early in the asset’s life, thus reducing the current period tax liability. Taxes are considered to be deferred because they will be obligations in the later years of the asset’s life. Topic: Other post-employment benefits LO: 2 14. Health care and insurance benefits that companies provide to retired employees are referred to as other post-employment benefits. Answer: True Rationale: Many companies provide health care and insurance benefits to retired employees, commonly referred to as ‘other post-employment benefits.’

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Topic: Accounting for income taxes LO: 3 15. A deferred tax asset arises when tax reporting income is less than financial reporting income. Answer: False Rationale: This statement describes a deferred tax liability. A deferred tax asset arises when tax reporting income is greater than financial reporting income. Topic: Commitments disclosure LO: 4 16. All financial commitments disclosed in the notes to the financial statements must be included as liabilities on the balance sheet. Answer: False Rationale: Certain commitments disclosed in the notes are not included in the balance sheet. Examples of disclosed but not recorded commitments include purchase commitments and any unused lines of credit. Topic: Fixed commitments ratio LO: 4 17. A company’s fixed commitment total would include lease and debt payments as well as any purchase commitments. Answer: True Rationale: Fixed commitments include payments that a company is contractually bound to make.

. 10-5

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Multiple Choice Topic: Operating lease LO: 1 1. Which type of lease would be considered a form of off-balance-sheet financing? A) Finance lease B) Deferred tax lease C) Operating leases with terms greater than 12 months D) None of the above Answer: D Rationale: All leases, other than short-term leases that do not include purchase options, are reported on the balance sheet. Topic: Reporting of operating leases LO: 1 2. How are leases classified as operating leases initially reported in the lessee’s financial statements? I. As an asset that is amortized, similar to other company assets II. As a footnote disclosure III. As both a short-term and a long-term liability IV. As neither an asset nor a liability. A) B) C) D)

I and III I, II and III IV only II and IV

Answer: B Rationale: Operating leases are reported on a company’s balance sheet and described in the footnotes to the financial statements, which provide key details regarding the company’s current and future lease payment obligations. Topic: Pension expense LO: 2 3. What are the three basic components of pension expense for a defined benefit plan? A) Service cost, benefits paid, and actual return on plan assets B) Service cost, interest cost, and expected return on plan assets C) Service cost, benefits paid, and expected return on plan assets D) Service cost, interest cost, and actual return on plan assets Answer: B Rationale: Actual returns affect the pension assets but not the expense. Benefits paid affect the PBO and plan assets but not the expense.

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Topic: Financial statement impacts of operating and finance leases LO: 1 4. GAAP identifies two different approaches in reporting leases by the lessee: operating lease method and the finance lease method. Which option best describes the financial statement effects of leasing on the financial statements of the lessee? A) Lease Type

Assets

Liabilities

Expenses

Operating

Increased

Lease expense

Lease Type

Assets

Liabilities

Expenses

Finance

Increased

Lease expense

Lease Type

Assets

Liabilities

Expenses

Finance

None

Amortization and interest

Lease Type

Assets

Liabilities

Expenses

Operating

None

Lease expense

Answer: A Rationale: Assets and liabilities are recorded for operating leases. The payment is recognized as lease expense. Under finance leases, an asset is capitalized and amortized, and a liability is recorded which creates interest expense. Topic: Factors affecting pension obligation LO: 2 5. Which of the following is not a factor that changes a company’s defined benefit pension obligation during the year? A) Service cost B) Benefits paid C) Interest cost D) Contributions to the pension plan Answer: D Rationale: Options A, B, and C all affect a company’s pension obligation. Contributions to the pension plan affect pension assets, but not the obligation to employees. Topic: Benefits of leasing LO: 1 6. Which of the following would be a benefit to the lessee of utilizing operating leases rather than finance leases? A) Higher net income in the early years of the lease B) Measures of leverage are improved C) NOPAT is lower D) Net operating asset turnover is higher Answer: A Rationale: In early years, lease expense under operating leases is less than depreciation plus interest for finance leases. Lower NOPAT would not be considered a benefit. Options B and D are false; there would be no differences in leverage measures or the asset turnover ratio between operating and finance leases over the life of the lease. .10-7

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Topic: Effects of not capitalizing operating leases LO: 1 7. Reporting operating leases as short-term leases results in a number of distortions in the ROE disaggregation analysis. Which of the following is not a distortion? A) Operating income is lower. B) Net operating asset turnover is overstated. C) Financial leverage is understated. D) All of the above are distortions. Answer: A Rationale: Short-term leases and operating leases report the same amount as expense each year, equal to the lease payment. Topic: Lease capitalization amount LO: 1 8. FunTime Corp. disclosed the following finance lease information in its 2022 annual report (in millions). Aggregate expected maturities of long-term debt and scheduled finance lease payments for the years shown are as follows:

2023 2024 2025 2026 2027 Thereafter

Scheduled Finance Lease Payments $

Finance lease amount representing interest Present value of net scheduled lease payments

2,000 2,000 2,000 2,000 2,000 37,000 47,000

Long-Term Debt Maturities $ 16,286 16,286 16,286 446,286 136,286 16,284 647,714

(21,644) $

25,356

Total long-term debt and finance leases

25,356 $

673,070

What finance lease liability does FunTime’s report on its balance sheet at December 31, 2022 (in millions)? A) $ 21,644 B) $ 25,356 C) $ 47,000 D) $673,070 Answer: B Rationale: The present value of finance lease payments is reported on the balance sheet as a liability.

. Test Bank, Chapter 10

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Topic: Lease capitalization criteria LO: 1 9. Which of the following is not a condition requiring the use of the finance lease reporting method instead of the operating lease reporting method? A) The lease automatically transfers ownership of the leased asset from the lessor to the lessee at the termination of the lease B) The lease term covers the majority of the remaining economic life of the leased asset C) The lease allows the lessee to use the leased asset during the lease term D) The lease provides that the lessee can purchase the leased asset for a nominal amount (bargain purchase price) at the termination of the lease Answer: C Rationale: For both finance and operating leases, lease agreements allow the lessee to use the leased asset. Topic: IFRS and pensions LO: 3 10. Which of the following is a requirement under IFRS but not under U.S. GAAP? A) Companies must report the funded status of their defined benefit pension plans on the balance sheet. B) Companies must recognize the cost of plan amendments immediately in income. C) Companies must include interest cost as part of pension expense. D) Companies must report current period pension expense on the income statement. Answer: B Rationale: Answers A, C, and D are required under both GAAP and IFRS. Topic: Pension expense computation LO: 3 11. Tiger Corp. reported the following items in the 2022 pension footnote for its defined benefit plan. Service cost Benefits paid to retirees Interest cost Actual returns on pension plan assets Expected returns on pension plan assets Amortization of deferred costs

$1,610 220 780 1,140 1,200 62

How much is the company’s pension expense for the year? A) $ 4,212 B) $ 1,252 C) $ 328 D) $ 452 Answer: B Rationale: Pension Expense = Service cost + Interest cost + Amortization of deferred costs – Expected return on pension plan assets = $1,610 + $780 + $62 ‒ $1,200 = $1,252

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Topic: Pension obligation computation LO: 3 12. Tiger Corp. reported the following items in the 2022 pension footnote for its defined benefit plan. Service cost Benefits paid to retirees Interest cost Actual returns on pension plan assets Expected returns on pension plan assets Actuarial gain

$1,610 220 780 1,140 1,200 62

How much is the increase in the company’s pension obligation during the year? A) $1,308 B) $1,432 C) $ 552 D) $2,108 Answer: D Rationale: Pension obligation increase: Service cost + Interest cost – Actuarial gain – Benefits paid to retirees = $1,610 + $780 ‒ $62 ‒ $220 = $2,108 Topic: Pensions LO: 3 13. For a defined benefit plan, which of the following is correct? A) The plan defines the contribution the employer is to make, with no promise concerning the ultimate payout to employees. B) The plan requires that the pension expense and the cash funding amount be the same. C) The plan requires that the employee bears the risk of loss or benefit of gain from assets contributed to the plan. D) The plan defines the benefits that the employee will receive at retirement. Answer: D Rationale: A defined benefit plan means that a determinable benefit will be received by the employee at the future time of retirement.

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Topic: Off-balance-sheet financing LO: 4 14. The December 31, 2022 10-K filing for Fantastic Frisbee Company provides the following footnote information for purchase obligations for the next five years: Unconditional Purchase Obligations During the normal course of its business, the Company enters into agreements to purchase goods and services, including purchase commitments for production materials, endorsement agreements with professional golfers and other endorsers, employment and consulting agreements, and intellectual property licensing agreements pursuant to which the Company is required to pay royalty fees. It is not possible to determine the amounts the Company will ultimately be required to pay under these agreements as they are subject to many variables including performance-based bonuses, reductions in payment obligations if designated minimum performance criteria are not achieved, the Company’s sales levels, and severance arrangements. As of December 31, 2022, the Company has entered into many of these contractual agreements with terms ranging from one to six years. The minimum obligation that the Company is required to pay under these agreements is $158,436,000 over the next six years. In addition, the Company also enters into unconditional purchase obligations with various vendors and suppliers of goods and services in the normal course of operations through purchase orders or other documentation or that are undocumented except for an invoice. Such unconditional purchase obligations are generally outstanding for periods less than a year and are settled by cash payments upon delivery of goods and services and are not reflected in this total. Future purchase commitments as of December 31, 2022, are as follows (in thousands): 2023 2024 2025 2026 2027 Thereafter

100,194 48,918 6,726 1,786 812 —

158,436

No amounts are listed on Fantastic Frisbee’s balance sheet for commitments and contingencies. On its 2022 balance sheet, Fantastic Frisbee reported total liabilities and stockholders’ equity of $1,275,272,000 and total stockholders’ equity of $482,562,000. If Fantastic Frisbee reported the unconditional purchase obligations in its balance sheet, how would its debt-to-equity ratio change? (Ignore discounting.) A) It would increase by 0.328 B) It would increase by 0.164 C) It would not change D) Not enough information is provided to answer Answer: A Rationale: Total liabilities = $1,275,272,000 – $482,562,000 = $792,710,000 Current debt-to-equity ratio: $792,710,000 / $482,562,000 = 1.643 Total unconditional purchase obligations = $158,436,000 Adjusted debt-to-equity ratio: ($792,710,000 + $158,436,000) / $482,562,000 = 1.971 Difference = 1.971 – 1.643 = 0.328

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Topic: Pensions LO: 2 15. With respect to estimate changes in pension assumptions, an investment return increase will have what probable effect? A) A decrease in the expected return on plan assets B) A decrease in pension expense C) Both A and B are correct. D) None of these choices is correct. Answer: B Rationale: An estimate change of increased investment returns will most likely decrease pension expense.

Use the following information to answer Questions 16 through 20. Compton Company began operations in 2021. The company reported $128,000 of depreciation expense on its income statement in 2021 and $84,000 in 2022. On its tax returns, the company deducted $192,000 for depreciation in 2021 and $112,000 in 2022. The 2022 tax return shows a tax obligation (liability) of $132,000 based on a 25% tax rate. Topic: Deferred income taxes LO: 3 16. What is the temporary difference between the book value of depreciable assets and the tax basis of these assets at the end of 2021? A) $12,800 B) $60,000 C) $32,000 D) $64,000 Answer: D Rationale: $192,000 – $128,000 = $64,000 Topic: Deferred income taxes LO: 3 17. What is the temporary difference between the book value of depreciable assets and the tax basis of these assets at the end of 2022? A) $60,000 B) $92,000 C) $24,000 D) $ 4,000 Answer: B Rationale: ($192,000 + $112,000) – ($128,000 + $84,000) = $92,000

. Test Bank, Chapter 10

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Topic: Deferred income taxes LO: 3 18. How much deferred tax liability will Compton report at the end of 2021? A) $ 8,000 B) $16,000 C) $ 3,200 D) $15,000 Answer: B Rationale: $64,000 × 25% = $16,000 Topic: Deferred income taxes LO: 3 19. What is Compton’s deferred tax liability at the end of 2022? A) $23,000 B) $28,000 C) $88,000 D) $24,000 Answer: A Rationale: $92,000 × 25% = $23,000 Topic: Deferred income taxes LO: 3 20. What is Compton’s income tax expense for 2022? A) B) C) D)

$ 76,800 $139,000 $ 44,800 $ 99,200

Answer: B Rationale: $132,000 + [($112,000 – $84,000) × 25%] = $139,000 Topic: IFRS and leases LO: 1 21. Which one of the following statements is required by IFRS for reporting of leases by lessees, but not required for GAAP reporting? A) Leases must be capitalized if the leased asset’s risks and rewards are transferred to the lessee B) All leases should be accounted for by lessees using a single accounting model. C) Capitalizing a lease requires that the lessee amortize the leased asset D) Operating lease payments are reported as lease expense Answer: B Rationale: IFRS uses a single accounting model for all leases. GAAP requires classification of leases by lessees as either operating or finance leases.

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Topic: Fixed commitment ratio LO: 4 22. Which of the following fixed commitments would not be added back to operating cash flow when determining the fixed commitments ratio? A) B) C) D)

Pension benefit payments Other postretirement benefit payments Long-term debt principal payments Payments under operating leases

Answer: C Rationale: Debt repayments are reported in the financing section of the cash flow statement and would not be added back to cash flows from operations. Topic: Off-balance-sheet liabilities LO: 4 23. Which of the following would not be reported as a liability in the balance sheet? A) Future principal payments due on long-term debt B) Future principal payments on finance leases C) Pension plan benefit obligations D) Contractual commitments to purchase inventory in the future Answer: D Rationale: Purchase commitments are not reported on the balance sheet. Debt, lease liabilities, and pension plan obligations are all reported on the balance sheet.

. Test Bank, Chapter 10

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Exercises Topic: Operating leases LO: 1 1. FunTime Corp. disclosed the following footnote in its 2022 annual report related to its leasing activities. The Company leases various buildings, computer and other equipment, and storage space under operating leases with terms greater than 12 months. The leases expire on various dates through January 2040. Rent expense on these leases was $27,210, $19,081, and $15,012, for 2022, 2021, and 2020, respectively. Required a. What effect, if any, do these operating leases have on FunTime’s 2022 balance sheet and income statement? b. Would operating leases be considered an on or off-balance-sheet form of financing? Answer: a. Because all these leases have terms greater than 12 months, they would appear on the balance sheet of FunTime as both an asset and a liability. FunTime would record rental payments, on a straight-line basis, as lease expense on its income statement. b. The leased asset and the lease liability are recorded on the balance sheet of FunTime. This is not a form of off-balance-sheet financing. Topic: Operating versus finance leases LO: 1 2. Veritable Foods Markets enters into an equipment lease agreement with the following terms: Lease Fair value of asset Expected economic life of equipment Lease term (nonrenewable) Discount rate used by DuPage Annual end of year lease payments Option to purchase the equipment at the end of lease term for $25,000

$450,000 8 years 3 years 6% $140,000

Would this lease be accounted for as an operating lease or a finance lease? Why? Answer: The lease would be accounted for as a finance lease. The lessee would be reasonably expected to exercise the purchase option. The PV of the lease payments and the $25,000 purchase price is less than the $450,000 fair value of the equipment. (PV of the lease payments = $374,222. PV of the purchase price = $20,990. Total PV = $395,212.)

. 10-15

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Topic: Present value of operating lease payments LO: 1 3. Decorah Supply Company disclosed the following footnote regarding operating leases in its 2022 annual report: Minimum lease payments under operating leases with terms greater than 12 months are as follows: Minimum operating lease payments 2023 2024 2025 2026 2027 2028 Total

Amount (in millions) $ 172 72 44 38 28 24 $378

Decorah Supply has an 8% discount rate. How much is reported as the Operating Lease Liability on the balance sheet included in the annual report? Answer: The liability would be reported using the present value of the operating lease payments. Using the NPV function in Excel, the present value of the operating leases is $318.028* million. *Answers may vary if tables or financial calculator are used to compute NPV.

Topic: Understanding lease and pension estimates LO: 1, 2 4. Beyer Corporation includes the following in its 2022 annual report. On an ongoing basis, we evaluate our estimates, including those related to the value of deferred acquisition costs, incentive compensation, income taxes, pension benefits and contingencies and litigation. Our estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Our actual results may differ from these estimates under different assumptions or conditions. Required a. What estimates does the company make when accounting for finance leases? b. What estimates does the company make when accounting for defined benefit pensions? Answer: a. To account for a finance lease liability, the company must estimate the discount rate. The other inputs are given by the lease contract. Accounting for the leased assets involves estimating the assets’ expected life, salvage value, and the amortization method. b. The pension obligation requires the company to estimate discount rate, growth rate in wages, expected rate of return on plan assets, life span of employees, retirement rates, attrition rates and inflation rates. Many of these estimates will be made by the actuaries but the company likely has some input.

. Test Bank, Chapter 10

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Topic: Income taxes LO: 3 5. Matsumoto Sporting Goods reported annual depreciation on a newly acquired asset in the amount of $80,000 using the straight-line method. For tax purposes, the company used the following schedule of depreciation expense: Year 1: Year 2: Year 3: Year 4: Year 5: Year 6: Year 7: Year 8:

$144,000 $116,000 $ 92,000 $ 84,000 $ 64,000 $ 56,000 $ 48,000 $ 36,000

Annual income before depreciation expense for each year is steady at $440,000 and the income tax rate is 25%. Show the financial statement effects relating only to taxes in years 3 to 5 assuming taxes are paid at the same time they are accrued using the following template: Assets

Equity Revenue (Expense)

Liabilities

Year 3 Year 4 Year 5 Answer: Year 3

Year 4

Year 5

Income before depreciation and taxes Financial reporting depreciation Financial reporting income Financial reporting tax expense Net income

$440,000 80,000 360,000 90,000 $270,000

Income before depreciation and taxes Tax reporting depreciation Tax reporting (taxable) income Taxes to be paid

$440,000 92,000 $348,000 $87,000

$440,000 84,000 $356,000 $89,000

$440,000 64,000 $376,000 $94,000

The company records these effects in its financial statements as follows (in accounting equation format):

Year 3 Year 4 Year 5

Assets (cash) $(87,000) $(89,000) $(94,000)

= = = =

Deferred Tax Liability $3,000 $1,000 $(4,000)

+ + + +

Equity Provision for Income Taxes $(90,000) $(90,000) $(90,000)

The asset reduction in the first column reflects the cash outflow in the payment of taxes and the $90,000 equity reduction in the last column reflects the income tax expense reported on the income statement for financial reporting. The liability is to an account called Deferred Tax Liability. . 10-17

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Topic: Pension expense computation LO: 2 6. Chen Corp. reported the following items in the 2022 pension footnote for its defined benefit plan. Use the information to calculate the pension expense for the year. Service cost Benefits paid to retirees Interest cost Actual returns on pension plan assets Expected returns on pension plan assets Amortization of deferred costs

$1,400 220 280 1,140 440 102

Answer: Pension expense = Service cost + Interest cost + Amortization of deferred costs – Expected return on plan assets = $1,400 + 280 + $102 ‒ $440 = $1,342 Topic: Understanding pension footnotes LO: 2 7. Dharan Laboratories’ 2022 annual report includes the following excerpt about its defined benefit plans (in millions): Projected benefit obligations, January 1 Service cost — benefits earned during the year Interest cost on projected benefit obligations Losses (gains), primarily changes in discount rates, plan design changes, law changes and differences between actual and estimated health care costs Benefits paid Acquisition of Solvay's pharmaceuticals business Settlement Other, primarily foreign currency translation

17,926 752 894

Projected benefit obligations, December 31

22,008

Plans' assets at fair value, January 1 Actual return on plans' assets Company contributions Benefits paid Acquisition of Solvay's pharmaceuticals business Settlement Other, primarily foreign currency translation

13,922 1,756 758 (604) — — 66

Plans' assets at fair value, December 31

15,898

Projected benefit obligations greater than plans' assets, December 31

(6,110)

2,824 (604) — — 216

Required a. What is service cost? b. What is interest cost? c. What pension payments did Dharan Labs’ retired employees receive during the year?

. Test Bank, Chapter 10

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Answer: a. The service cost represents the additional (future) pension benefits earned by employees during the current year. b. Interest cost accrues on the outstanding pension liability, just as it would with any other long-term liability. Because there are no scheduled interest payments on the pension liability, the interest cost accrues each year, that is, interest is added to the existing liability. c.

During 2022, Dharan Labs’ former employees received payments totaling $604,000,000.

Topic: Reading pension footnotes LO: 2 8. The following pension information was disclosed by Spacefire International (in thousands): Employee Benefit Plans The company sponsors defined contribution retirement plans covering substantially all of its domestic employees and certain employees of its foreign subsidiaries. Contributions are determined at the discretion of the Board of Directors. Aggregate amounts charged to operations under the plans in 2022, 2021, and 2020 were $55,740, $58,400, and $46,576, respectively. In addition, certain foreign subsidiaries are required to provide benefits pursuant to government regulations. Required a. How does Spacefire account for its contributions to its retirement plan? b. How is Spacefire’s obligation to its retirement plan reported on its balance sheet? Answer: a. Because the plan is a defined contribution plan, the company expenses the contribution when made. There are no accruals for future costs. b. The obligation is reported on Spacefire’s balance sheet as a liability only if a part of the obligation is not funded, since defined contribution plans are expensed as the contributions are made. Defined contribution plans result in much less recognized liability than defined benefit plans.

. 10-19

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Topic: Income tax expense LO: 3 9. The income tax footnote to the financial statements of Kifftey, Inc. for the year ending December 31, 2022 is as follows. In millions Current U.S. federal and state Foreign Total current Deferred U.S. federal and state Foreign Total deferred Income tax expense

2022 $

236 598 834 216 16 232 1,066

Required a. How much income tax expense is reported in Kifftey, Inc.’s income statement for 2022? b. How much of the income tax expense is payable in cash in 2022? c. Provide an example to explain how the deferred tax expenses could be positive in 2022? Answer: a. $1,066 million b. $834 million is payable in 2022 based on the current tax provision ($236 + $598). c.

The positive figure indicates that the income reported for tax purposes (taxable income) is less than that for financial reporting purposes (GAAP income). A typical example is higher depreciation expense for tax purposes than for book purposes.

Topic: Changes in pension assumptions LO: 2 10. The following pension information was disclosed by Parcel Portage Service (PPS):

Discount rate Rate of compensation increase Expected return on plan assets

2022 5.52% 4.25% 8.75%

2021 5.98% 4.25% 8.75%

Required a. Identify possible reasons that PPS might have decreased its discount rate in 2022. b. What effect(s) did these changes have on PPS’ income statement and balance sheet? Answer: a. PPS may have decreased the rate due to changes in market interest rates. The rate could also have been lowered to reflect lower inflation. b. Because the pension obligation is the present value of expected pension payments, a decrease in the discount rate increases the present value reported on the balance sheet. The effect on the income statement is more difficult to predict. The interest cost component of pension expense is the product of the beginning of the year pension obligation and the discount rate. In 2022, the effect of a decrease in the discount rate is to apply a lower discount rate to a higher pension obligation. These two effects are offsetting, but can result in a higher or lower expense.

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Topic: Analyzing a lease footnote LO: 1 11. The following is an excerpt from the Mississippi Steam, Inc.’s 2022 annual report: In Millions Debt Equity

2022

2021

$60,744 49,693

$59,484 46,445

Required a. Calculate the debt-to-equity ratio for Mississippi Steam, Inc. for 2022 and 2021. b. Mississippi Steam, Inc. had a number of operating leases with terms ranging from 2 to 5 years during both 2022 and 2021? Would those leases have been included in the debt figures provided above? Why or why not? c. The present values of the operating leases totaled $6,192 and $6,448 in 2022 and 2021, respectively. Assume that the leases were capitalized (were included in the total amount of debt reported). Recalculate the debt-to-equity ratio for Mississippi Steam, Inc. for 2022 and 2021 without including the operating leases. Did capitalizing the leases significantly affect the company’s debt to equity ratio? Does capitalizing the leases improve or worsen the company’s debt to equity ratio? Answer: a. 2022 Debt-to-equity = $60,744 / $49,693 = 1.222 2021 Debt-to-equity = $59,484 / $46,445 = 1.281 b. The debt that Mississippi Steam, Inc. reports would include the net present value of operating leases because operating leases with terms greater than 12 months are carried on the balance sheet. c.

2022 Debt-to-equity = ($60,744 - $6,192) / $49,693 = 1.098 2021 Debt-to-equity = ($59,484 - $6,448) / $46,445 = 1.142 Capitalizing the leases increases the debt to equity ratio significantly, worsening the solvency ratio (making the company appear riskier).

. 10-21

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Topic: Analyzing lease footnote LO: 1 12. FunTime Corp. disclosed the following lease information in its 2022 annual report related to its leasing activities. (In millions) Operating Leases Operating lease right-of-use assets

2022

2021

$3,155

$2,855

$750 3,550

$685 3,125

$2,580 (250)

$1,450 (185)

$180 2,235

$75 1,410

Other current liabilities Operating lease liabilities Finance Leases Property and equipment, at cost Accumulated depreciation Other current liabilities Other long-term liabilities

Required a. What amounts did FunTime’s report on its balance sheet, in total for 2022, related to leased assets? b. Where would the principal payments on the finance leases appear in the statement of cash flows? Answer: a. FunTime would report $5,485 million in assets ($3,155 + $2,580 - $250) and $6,715 million in liabilities ($750 + $3,550 + $180 + $2,235). b. Principal payments would be reported in the cash flows from (used in) financing activities section of the statement of cash flows.

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Topic: Fixed commitments ratio LO: 4 13. Hoopes Industries reported the following in its 2022 annual report: In Thousands Cash from operating activities Long term debt maturities – subsequent year Required operating lease payments – subsequent year

2022

2021

$55,700 10,500 6,000

$65,200 8,500 7,000

Required a. Calculate the fixed commitments ratios for 2022 and 2021. b. Did Hoopes’ liquidity position improve or worsen in 2022? Is there reason for investors or lenders to be concerned? Answer: a. 2022 Fixed commitments ratio = ($55,700 + $6,000) / ($10,500 + $6,000) = 3.74 2021 Fixed commitments ratio = ($65,200 + $7,000) / ($8,500 + $7,000) = 4.66 b. Hoopes’ position worsened in 2022. The ratio shows that Hoopes generates enough cash from operations to cover fixed commitments. Given the 20% drop in the ratio, users of the financials would likely look at other liquidity and solvency ratios. Topic: Fixed commitments ratio LO: 4 14. Huang, Inc. (a merchandising company) reported the following in its 2022 annual report: In Millions

2022

Cash from operating activities Long term debt maturities – 2023 Product purchase commitment – 2023

$20,600 25,500 18,300

Required a. Calculate Huang’s fixed commitments ratio for 2022. b. What does the ratio say about Huang’s ability to generate sufficient cash flow to cover costs in 2023? What steps could Huang take in 2023 to improve the ratio? Answer: a. 2022 Fixed commitments ratio = ($20,600 + $18,300) / ($25,500 + $18,300) = 0.89 b. The ratio of less than 1.0 indicates that Lindell may not have sufficient cash in the upcoming year to cover all costs. Huang’s ratio would improve if debt was renegotiated resulting in lower payments, revenues were increased, or expenses were decreased.

. 10-23

Financial Accounting, 7th Edition

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Problems Topic: Operating leases LO: 1 1. Arctic Enterprises entered into the lease of office space on January 1 with the following terms. Lease term (nonrenewable) Annual end of year lease payments

10 Years $240,000

Arctic Enterprises uses its incremental borrowing rate (5%) as a discount rate and the straight-line method for amortizing leases. The lease is appropriately recorded as an operating lease. What are the reported amounts on the balance sheet at December 31, 2022 related to this lease? What was the impact of the lease on equity in 2022 assuming an effective tax rate of 25%? Answers: Using the NPV function in Excel, the present value of the operating lease payments, at a discount rate of 5%, is $1,853,126. Effective “interest” in year one is $92,656. Amortization is $240,000 - $92,656 = $147,344. Asset: $1,853,126 – $147,344 = $1,705,782 Liability: $1,853,126 - $240,000 + $92,656 = $1,705,782 Equity: ($240,000) *.75 = ($180,000) *Answers may vary if tables or financial calculator are used to compute NPV.

Equity is reduced by the after tax effect of the operating lease expense. Topic: Lease Analysis LO: 1 2. LaSalle Company is interested in leasing a machine and has identified the following possible lease that it may acquire. Lease $1,100,000 5 years 1st day of year 10% $300,000 $1,137,236

Fair value of asset Lease term (nonrenewable) Lease start date Discount rate used by DuPage Annual end of year lease payments Present value of minimum lease payments

If LaSalle does not proceed with leasing the machine, LaSalle Company expects to report the following amounts in the year-end financial statements: • • • • •

Assets: $5,500,000 Liabilities: $4,500,000 Equity: $1,000,000 Income before lease expense and taxes: $750,000 Income tax rate 25%

Assuming no changes in activity other than the lease, and that taxes are unpaid at year-end, prepare an independent analysis for the lease that includes the assets and liabilities sections of the balance sheet and an income statement after the first year, as well as a comparison of debt-to-equity ratios and return on asset ratios. Briefly summarize the effect on the two ratios. . Test Bank, Chapter 10

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Answer: The lease is classified as a finance lease, since the PV of the payments > FV of the asset. Leased asset depreciation = $1,137,236 / 5 = $227,447 Lease payment interest = $1,137,236 × 10% = $113,724 Lease payment principal = $300,000 ‒ $113,724 = $186,276 Adjustment $1,137,236 ‒ $227,447 $1,137,236 ‒ $186,276

Adjusted Balance $909,789 $950,960

Balance Sheet Assets: Leased assets Other assets Total assets Liabilities: Lease obligations Other liabilities Total liabilities Equity: Total equity

With the Lease

With No Lease

Leased assets Lease obligations

Original Amount $0 $0

909,789 5,200,000 $6,109,789

$ 0 5,500,000 $5,500000

950,960 4,414,707 $5,365,667

$ 0 4,500,000 $4,500,000

$744,122

$1,000,000

Income Statement Income before lease-related expenses Depreciation of leased asset (straight-line) Interest on lease obligation Income before taxes Income tax expense (25%) Net income

With the Lease $ 750,000 227,447 113,724 408,829 102,207 $ 306,622

With No Lease $ 750,000 0 0 750,000 187,500 $ 562,500

Ratio Comparison Debt-to-equity ratio Return on assets

With the Lease 7.21 5.02%

With No Lease 4.50 10.23%

The accounting records reflect the effects of the leased asset and amortization and the lease obligation and interest on the financial statements. The debt-to-equity ratio will increase from 4.50 to 7.21 and the return on assets ratio will decrease from 10.23% to 5.02%.

. 10-25

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Topic: Lease Analysis LO: 1 3. LaSalle Company is interested in leasing a machine and has identified the following possible lease that it may acquire. Lease $1,100,000 5 years 1st day of year 10% $200,000 No None 15 years

Fair value of machine Lease term (nonrenewable) Lease start date Discount rate used by DuPage Annual end of year lease payments Transfer of ownership at end of lease Purchase options Economic life of machine

If LaSalle does not proceed with leasing the machine, LaSalle Company expects to report the following amounts in the year-end financial statements: • • • • •

Assets: $5,500,000 Liabilities: $4,500,000 Equity: $1,000,000 Income before lease expense and taxes: $750,000 Income tax rate 25%

Assuming no changes in activity other than the lease, and taxes are unpaid at year-end, prepare an independent analysis for the lease that includes the assets and liabilities sections of the balance sheet and an income statement after the first year, as well as a comparison of debt-to-equity ratios and return on asset ratios. Briefly summarize the effect on the two ratios. Answer: The lease is reported as an operating lease, since it does not meet any of the five classification criteria. PV of lease payments = $758,157 Lease payment “interest” = $758,157 × 10% = $75,816 Lease amortization = $200,000 ‒ $75,816= $124,184

Leased assets Lease obligations Balance Sheet Assets: Leased assets Other assets Total assets Liabilities: Lease obligations Other liabilities Total liabilities Equity: Total equity

Original Amount $0 $0

Adjustment $758,157 ‒ $124,184 $758,157-200,000 + $75,816 With the Lease

Adjusted Balance $633,973 $633,973 With No Lease

633,973 5,300,000 $5,933,973

$ 0 5,500,000 $5,500000

633,973 4,450,000 $5,083,973

$ 0 4,500,000 $4,500,000

$850,000

$1,000,000

continued

. Test Bank, Chapter 10

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Income Statement Income before lease-related expenses Lease expense Income before taxes Income tax expense (25%) Net income Ratio Comparison Debt-to-equity ratio Return on assets

With the Lease $ 750,000 200,000 550,000 137,500 $ 412,500

With No Lease $ 750,000 0 750,000 187,500 $ 562,500

With the Lease 5.98 6.95%

With No Lease 4.50 10.23%

The debt-to-equity ratio will increase from 4.50 to 5.98 and the return on assets ratio will decrease from 10.23% to 6.95%. Topic: Effect of failure to capitalize operating lease LO: 1 4. Samuel Anderson Company entered into a 4-year lease agreement on January 1, 2023. Lease payments were set at $155,000 per year (payable at the end of each year). Samuel Anderson failed to capitalize the lease as an operating lease as required under ASC 842. The year-end lease payment was recorded. Required a. What adjustments would have to be made to the 2023 financial statements to comply with GAAP? Assume Anderson’s tax rate was 25% and its discount rate was 7%. b. How would these changes affect Anderson’s ROE and Debt to equity ratios for 2023? Answer: a. PV of the lease payments = $525,018 “Interest” portion of year 1 payment = $36,751 Lease liability at year end = $525,018-$155,000+$36,751 = $406,769 Right-of-Use asset at year end = $525,018 - $118,249 = $406,769. Anderson would need to debit Right-of-Use asset for $406,769 and credit Lease Liabilities for $406,769. No entry needed for the entry to lease expense. b. ROE would not be impacted since there is no adjustment to the expense account. Debt to equity would increase (Liabilities are increased by the balance in Lease Liabilities. Equity remains constant.)

. 10-27

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Topic: Interpreting pension footnote LO: 2 5. The following pension information was disclosed by Hatch, Inc. regarding its defined benefit plan (in millions). 2022

2021

Change in projected benefit obligation: Benefit obligation at January 1 Service cost Interest cost Benefits paid Actuarial loss Currency translation and other Participant contributions

$ 3,616.2 128.2 162.8 (142.2) 327.6 36.6 6.8

2,971.2 91.0 163.2 (119.0) 518.2 (15.0) 6.6

Projected benefit obligation at December 31

$ 4,136.0

3,616.2

Change in plan assets: Fair value of plan assets at January 1 Employer contributions Actual return on plan assets Benefits paid Currency translation and other Participant contributions

$ 3,099.8 381.6 417.6 (142.2) 38.4 6.8

2,890.8 169.4 158.0 (119.0) (6.0) 6.6

Fair value of plan assets at December 31 Funded status at December 31

3,802.0 $

(334.0)

Amounts recorded on balance sheet: Other noncurrent assets Other liabilities Accumulated other comprehensive loss: Actuarial loss Prior service cost Net initial transition amount

3,099.8 $

2022 $

20.0 (254.0) 580.8 11.4 0.8

(516.4) 2021

0.8 (317.2) 538.6 16.6 1.0

Required a. What is “service cost”? How does it affect Hatch’s total pension expense for the year? b. Hatch reports an actuarial loss of $327.6 million for 2022. What is this loss and how does Hatch account for it? c. How much did Hatch contribute to the pension plan during 2022? d. What amount of pension benefits were paid to former Hatch employees during the year? e. Explain the funded status of the pension plan in 2022 and compare it to the funded status in 2021. Are these amounts significant?

. Test Bank, Chapter 10

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Answer: a. The service cost represents the additional (future) pension benefits earned by employees during the current year. Service cost is directly related to the year’s pension expense because it is one component of pension expense. Hatch includes service cost of $128.2 million in calculating pension expense for the year. b. Actuarial losses (and gains), arise when companies make changes in their pension plans or make changes in actuarial assumptions including assumptions that are used to estimate the PBO, such as the rate of wage inflation, termination and mortality rates, and the discount rate used to compute the present value of future obligations. Hatch includes the $327.6 million loss in calculating pension expense for the year. c.

During 2022, Hatch contributed $381.6 million to the pension plan.

d. During 2022, Hatch former employees received $142.2 million. e. At the end of 2022, Hatch’s pension plan was underfunded by $334.0 million. In 2021, the plan was underfunded by $516.4 million. The increase in return on plan assets and a larger employer contribution were factors leading to the improvement in funding status.

Pension plan assets PBO Funded status

2022

2021

$3,802.0 4,136.0 $ 334.0

$3,099.8 3,616.2 $ 516.4

. 10-29

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Topic: Interpreting pension footnote LO: 2 6. The following pension information was disclosed by Prestige Paper Inc. concerning its U.S. defined benefit pension costs:

In millions Service cost Interest cost Expected return on plan assets Actuarial loss / (gain) Amortization of prior service cost Net periodic pension expense

2022

2021

2020

U.S. Plans

304 1,208 (1,506) 614 64 684

242 1,088 (1,426) 424 62 390

232 1,082 (1,262) 347 62 461

Required a. Briefly explain the following components of the company’s pension expense for the year: service cost, interest cost, and actuarial loss. b. Prestige Paper reports an actual return on plan assets of $2,366 for 2022. Why is this different from the expected return of $1,506 million reported above? c. What cash contribution did the company make to the pension plan during the year? d. Comment on the three-year trend you observe for net pension expense. What explains the trend? Answer: a. Service cost: The annual service cost represents the additional (future) pension benefits earned by employees during the current year. Interest cost: Interest cost accrues on the outstanding pension liability, just as it would with any other long-term liability. Because there are no scheduled interest payments on the PBO, the interest cost accrues each year, that is, interest is added to the existing liability. Actuarial losses (and gains) arise when companies make changes in their pension plans or make changes in actuarial assumptions (including assumptions that are used to estimate the PBO, such as the rate of wage inflation, termination and mortality rates, and the discount rate used to compute the present value of future obligations). b. The “actual return” is what the plan assets actually earned during the year. The long-term expected rate of return on the pension plan assets is what the managers anticipate the assets will earn. It is the expected return that decreases pension expense instead of actual because the latter may experience short-term fluctuations from year to year, which would distort the pension expense. c.

The disclosure about pension expense is not related to the cash contribution the company made. That information is found in the pension asset table.

d. Prestige Paper’s pension expense has been very erratic over the past three years. Actuarial losses and return on plan assets seem to be a main contributing factor. Further analysis should seek to determine what the actuarial losses are and if the company anticipates further losses.

. Test Bank, Chapter 10

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Essays Topic: Deferred taxes LO: 3 1. What are deferred taxes? When do they arise? Answer: There are two kinds of deferred taxes: deferred tax liabilities and deferred tax assets. The former arise when a company’s taxable income is less than its book income, typically resulting from higher depreciation expense for tax reporting. The company records this effect in its financial statements as an increase in deferred tax liability to recognize the taxes that will be paid when the item causing the difference reverses. The second type of deferred taxes, deferred tax assets, arise for the opposite reason: taxable income is greater than financial reporting income. This can arise, for example, when a company reports a restructuring expense that is recognized for financial reporting purposes when incurred, but is not deductible for tax purposes until paid. Topic: Income smoothing features of pension accounting LO: 2 2. Discuss the concept of “income smoothing” that is built into GAAP as it relates to pensions. Answer: GAAP permits companies to compute pension expenses using the expected return on fund assets rather than the actual return on those pension investments. Because investment returns fluctuate from year to year, the FASB agreed to allow a firm’s managers to report the long term expected returns rather than the short term returns that would reflect the true effects of a bull or bear market. This has the effect of “income smoothing” as it “smooths” out the ups and downs from the bond and stock markets In addition, pension expense reflects amortization of deferred amounts for changes in assumptions and plan amendments, rather than reporting them as they happen.

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Chapter 11 Reporting and Analyzing Stockholders’ Equity Learning Objectives – Coverage by question True/False

Multiple Choice

Exercises

Problems

Essay Questions

LO11-1 Describe and account for business financing through stock issuances and repurchases. (p. 11-3)

1, 2, 4, 5, 9, 11, 12, 16

1, 2, 4, 7, 9, 12, 15

2-4, 7, 8, 10-12

1, 2, 4, 5

1, 2

LO11-2 Describe the effect on equity of earnings, dividends, and stock splits. (p. 11-11)

3, 4, 6, 10, 13, 14

3, 6, 10, 11, 13, 14, 17

2-7, 9, 10

3-6

LO11-3 Define and illustrate comprehensive income. (p. 11-16)

10, 15

LO11-4 Describe and illustrate the basic and diluted earnings per share computations. (p. 11-19)

7, 17

16, 18

1, 4

LO11-5 Appendix 11A Analyze the accounting for convertible securities, stock rights, and stock options. (p. 11-22)

13, 15

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Chapter 11: Reporting and Analyzing Stockholders’ Equity

True False Topic: Cost vs. market value of stockholders’ equity LO: 1 1. Stockholders’ equity represents the current market value of a company. Answer: False Rationale: Stockholders’ equity is accounted for at historical cost. Topic: Gains (losses) on stock transactions LO: 1 2. Companies must report ‘gains and losses’ on transactions relating to purchases and sales of their own stock as nonoperating amounts on the income statement. Answer: False Rationale: Companies are prohibited by GAAP from reporting ‘gains and losses’ of their own stock on the income statement. Instead, the “gain” (“loss”) is credited (debited) to Additional Paid-in Capital. Topic: Earned capital LO: 2 3. Earned capital includes the positive or negative effects of accumulated other comprehensive income. Answer: True Rationale: Earned capital represents the cumulative profit retained by a company and also includes both the positive and negative effects of accumulated other comprehensive income. Topic: Gains (losses) on stock transactions LO: 1, 2 4. There are never any income statement effects recognized when a purchase or sale of stock or payment of dividends occurs. Answer: True Rationale: Any “gains” or “losses” incurred due to the purchase and sale of stock are reflected as increases (decreases) in the paid-in-capital component of stockholders’ equity. Dividends are reflected as decreases in the retained earnings component of stockholders’ equity. Topic: Stock repurchases LO: 1 5. One reason a company may repurchase stock is because it wants to send a signal to the market that its shares are overvalued. Answer: False Rationale: A stock repurchase by a company should send a signal to the market that the company feels its shares are undervalued.

. Test Bank, Chapter 11

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Topic: Income statement treatment of dividends LO: 2 6. A company’s profit declines when dividends are paid because a company must recognize an expense for the amount of the dividend. Answer: False Rationale: Declaration and payment of cash dividends reduces cash and retained earnings, and is not recorded as an expense in the income statement. Topic: Complex capital structures and EPS LO: 4 7. Most analysts prefer to concentrate their attention on basic EPS, rather than the diluted EPS, because it is more useful. Answer: False Rationale: Most analysts prefer to concentrate their attention on diluted EPS versus basic EPS as the more important measure because it considers possible issuances of stock that may cause EPS to become smaller than basic EPS. Topic: Convertible securities LO: 5 8. All conversion options for convertible securities are reported on the balance sheet. Answer: False Rationale: Conversion options are reported on the balance sheet only if detachable from the security. Topic: Preferred preference in bankruptcy LO: 1 9. If French’s loses its dominance in the mustard market and eventually goes “belly up”, its preferred shareholders carry senior positions as claimants in bankruptcy over the common shareholders. Answer: True Rationale: Preferred shareholders carry senior positions to common shareholders in liquidation distributions. Topic: Paid-in capital LO: 2, 3 10. Retained earnings and accumulated other comprehensive income can be found in the paid-in capital section of stockholders’ equity. Answer: False Rationale: Retained earnings and AOCI are found in the “earned capital” portion of the stockholders’ equity section of the balance sheet.

. 11-3

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Topic: Stock issuance LO: 1 11. When a company issues its stock, the equity increase is equal to the number of shares sold multiplied by the market price of the stock on the issue date. Answer: True Rationale: Common stock increases by the number of shares sold times the par value of stock. Additional paid-in capital increases by the number of shares sold times the difference between market price and par value. Cash increases for the total market value of the issued shares. Topic: Sale of treasury stock LO: 1 12. A re-issuance of treasury stock has the potential to yield a gain or loss on the income statement. Answer: False Rationale: There is no gain or loss on the re-issuance of treasury stock in the income statement. Instead, the difference between the proceeds received and the original repurchase price of the treasury stock is reflected as an increase or decrease in the additional paid-in capital component of stockholders’ equity. Topic: Cash dividends LO: 2 13. Cash dividends reduce both cash and retained earnings by the amount of the dividends paid. Answer: True Rationale: Cash dividends reduce both cash and retained earnings by the amount of the dividends paid. Topic: Large stock dividends LO: 2 14. When a “large” stock dividend is paid out, retained earnings are reduced by the market value of the dividend. Answer: False Rationale: A stock dividend is considered to be large if the percentage of outstanding shares distributed is greater than 20 – 25%. Retained earnings is reduced by the par value of the dividend. Retained earnings is reduced by the market value of the stock dividend if it is considered to be a “small” stock dividend. Topic: Comprehensive income LO: 3 15. Net income is generally viewed as a more inclusive measure of performance than comprehensive income. Answer: False Rationale: Comprehensive income is a more inclusive notion of company performance because it includes all recognized changes in equity that occur during a period, except those resulting from investments by owners and distribution to owners.

. Test Bank, Chapter 11

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Topic: Convertible securities under IFRS LO: 1 16. The conversion feature of stock has a value even if it not detachable for sale under IFRS. Answer: True Rationale: Convertible securities are termed compound financial instruments under IFRS and the conversion feature has a value that is separately reported even if it not detachable for sale under IFRS. Topic: EPS LO: 4 17. Earnings per share is the amount a company earns and pays out as dividends for each share of common stock outstanding. Answer: False Rationale: Earnings per share is the amount a company earns for each share of common stock outstanding. It is not tied to the amount of dividends paid.

. 11-5

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Multiple Choice Topic: Stock repurchase LO: 1 1. Why might a company repurchase its own stock? A) B) C) D)

It feels that the market undervalues its shares To offset dilutive effects of employee stock options To increase the number of shares outstanding A and B

Answer: D Rationale: Companies may repurchase stocks to send a ‘signal’ to the market that the stock is undervalued. The company may also repurchase shares to keep the outstanding shares constant in order to reduce the dilutive effect on earnings per share that may occur when employees exercise stock options. Treasury stock acquisitions decrease the number of shares outstanding. Topic: Par value LO: 1 2. Which best describes par value for stock? A) B) C) D)

An arbitrary amount set by the company for each share of stock The value at which stock shares were issued The current market value of the stock The amount expected to be paid out as a dividend on a share of stock

Answer: A Rationale: The par value is an arbitrary amount specified in the corporate charter for each share of stock. Generally it has no substance from a financial reporting or statement analysis perspective. Topic: Small stock dividends LO: 2 3. For small stock dividends, by what amount are retained earnings reduced? A) B) C) D)

Par value of the dividend Book value of the dividend Par value of the stock Market value of the dividend

Answer: D Rationale: For small stock dividends, retained earnings are reduced by the market value of the shares. For large stock dividends, retained earnings are reduced by the par value of the shares.

. Test Bank, Chapter 11

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Topic: Book value of common stock LO: 1 4. What is the net book value of the company that is available to common shareholders called? A) B) C) D)

Additional paid-in capital Total contributed capital Book value per share Comprehensive income

Answer: C Rationale: The book value per share is stockholders’ equity less preferred stock less equity attributable to noncontrolling interest divided by the number of common shares outstanding. Topic: Convertible securities LO: 5 5. Which benefits do convertible preferred stockholders hold? I. The securities carry a fixed dividend yield. II. The securities carry a senior claimant position in bankruptcy. III. The owner can convert the debt or equity security into another equity security. A) B) C) D)

I and II I, II and III I only III only

Answer: B Rationale: A convertible security has all of the benefits listed. Topic: Contributed capital LO: 2 6. Which one of the following selections is a not component of contributed capital? A) B) C) D)

Retained earnings Common stock Additional paid-in capital All of the above

Answer: A Rationale: Retained earnings is component of the earned capital section of stockholders’ equity.

. 11-7

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Topic: Accounting for stock issuance LO: 1 7. If a company issues 10,000 shares of $1 par value common stock at a market price of $50 per share, which of the following is the correct balance sheet entry? A) B) C) D)

Increase common stock and cash by $10,000 Increase cash by $500,000 and increase earned capital by $500,000 Increase revenues by $500,000 Increase cash by $500,000 and increase contributed capital by $500,000

Answer: D Rationale: Cash increases by the number of shares issued times the market price; contributed capital also increases by the same amount. The latter is broken down into two segments: 1) common stock, which increases by the original par value of the shares sold, and 2) additional paid-in capital, which makes up the balance. Revenue is an income statement category and therefore irrelevant in this case. Topic: Comprehensive income LO: 3 8. Which is not an item that should be included in the computation of ‘other comprehensive income’? A) B) C) D)

Interest expense Foreign currency translation adjustment Unrealized gains (losses) Adjustments to pension plans

Answer: A Rationale: Interest expense is a non-operating expense shown on the income statement, while the other three items should be categorized within comprehensive income. Topic: Dividend preference for preferred stock LO: 1 9. In October, 2022, Virgin Corporation distributed profits to its preferred shareholders before its common shareholders. What is the name of the preference that allows this? A) B) C) D)

Dividend preference Treasury preference Liquidation preference Profits preference

Answer: A Rationale: Dividend preference refers to the fact that preferred shareholders receive dividends on their shares before common shareholders receive their dividends.

. Test Bank, Chapter 11

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Topic: Stock split LO: 2 10. During May, 2024, Riptide Corporation announced a 2-for-1 stock split. This brought the number of shares outstanding from 25,000,000 shares to _____ shares, and its $2.00 par value to _____ per share. A) B) C) D)

12,500,000; $4.00 12,500,000; $2.00 50,000,000; $2.00 50,000,000; $1.00

Answer: D Rationale: In a 2-for-1 stock split, the company distributes one additional share of stock for each share owned by a current shareholder, and the par value is adjusted so the total par value of shares issued remains the same. 25,000,000 × 2 = 50,000,000 shares Par value = $2.00/2 = $1.00 per share Topic: Dividend payments and stock prices LO: 2 11. Assume Company X has been paying out consistent dividends over the past 40 years. This fiscal year, the company reports a sharp decline in the dividend it plans to pay out. The most likely reaction of the market will be: A) B) C) D)

Company X’s stock price will decrease Company X’s stock price will increase initially and then decline Company X’s stock price will remain constant None of the above

Answer: A Rationale: Outsiders closely monitor dividend payments. It is generally perceived that the level of dividend payments is related to the expected long term “core earnings.” Accordingly, dividend increases are usually accompanied by stock price increases while dividend reductions are most often met with stock price declines. Topic: Dividends and stock prices LO: 1 12. If a company feels that its shares are undervalued and it wants to send a signal to the market, the company may: A) B) C) D)

Issue more stock (as allowed under its charter) Decrease regular cash dividends in an attempt to increase share price Repurchase shares Do nothing and wait - the market will realize the undervaluation

Answer: C Rationale: One reason a company may repurchase shares is if it feels that the market undervalues them. The logic is that the repurchase sends a “signal” to the market and the company is able to realize a subsequent “gain” on resale of the shares. However, these gains are never reflected on the income statement. Instead, the excess of the resale price over the original repurchase price is credited to additional paid-in capital.

. 11-9

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Topic: Large stock dividend LO: 2 13. Venus Company plans to issue a large stock dividend. In accounting for this transaction, what effects occur to the contributed capital section of stockholders’ equity? A) Common stock increases by the total market value of the dividend. B) Common stock increases by the number of dividend shares × par value per share, and retained earnings decreases for the same amount. C) Common stock increases by the number of dividend shares × par value per share, and retained earnings increases for the balance. D) Retained earnings increases by the number of dividend shares × par value per share, and additional paid-in capital increases for the balance. Answer: B Rationale: Common stock increased by: Dividend shares × Par value per share. Retained earnings is decreased by the same amount. Topic: Dividends LO: 2 14. Tarling Company has 10,000 shares of $200 par value, 6% cumulative preferred stock and 150,000 shares of $50 par value common stock. Howard declares and pays cash dividends amounting to $800,000. If no arrearage on the preferred stock exists, how much in total dividends is paid to each class of stock? A) Preferred $12,000

Common $788,000

Preferred $800,000

Common $0

Preferred $120,000

Common $680,000

Preferred $60,000

Common $740,000

B) C) D)

Answer: C Rationale: $200 × 10,000 × 6% = $120,000 Balance to common: $800,000 ‒ $120,000 = $680,000

. Test Bank, Chapter 11

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Topic: Liquidation preference LO: 1 15. As a preferred stockholder, you are entitled to numerous preferences and privileges over common stockholders. If you are a preferred stockholder of a company that has fallen on economic hardship and is likely to go bankrupt, which preference or privilege of preferred stock is going to be most useful to you? A) B) C) D)

Dividend preference Liquidation preference Conversion privileges Participation privilege

Answer: B Rationale: If a company fails, its assets are sold and the proceeds are paid to debt holders and stockholders, in that order. Preferred shareholders receive payment in full before common shareholders. Topic: EPS LO: 4 16. Stone Company reported net income of $4,500,000 in 2024. The weighted average number of common shares outstanding during 2024 was 200,000 shares. Stone paid $250,000 in dividends on preferred stock, which was convertible into 40,000 shares of common stock. How much is basic earnings per share for 2024? A) B) C) D)

$22.50 $21.25 $18.75 $17.71

Answer: B Rationale: ($4,500,000 – $250,000) / 200,000 = $21.25 Topic: Contributed capital LO: 2 17. In what section of the stockholders’ equity portion of the balance sheet can preferred stock, common stock, and additional paid-in capital be found? A) B) C) D)

Contributed capital Treasury stock Earned capital Retained earnings

Answer: A Rationale: All stock accounts are found in the contributed capital section of stockholders’ equity.

. 11-11

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Topic: EPS LO: 4 18. Stone Company reported net income of $4,500,000 in 2024. The weighted average number of common shares outstanding during 2024 was 200,000 shares. Stone paid $250,000 in dividends on preferred stock, which was convertible into 40,000 shares of common stock. How much is diluted earnings per share for 2024? A) B) C) D)

$22.50 $21.25 $18.75 $17.71

Answer: C Rationale: $4,500,000 / (200,000 + 40,000) = $18.75

Use the following information to answer questions 19 & 20. On August 1, 2024, Saugatuck Company’s balance sheet indicates there are 2,000,000 shares of $12 par value common shares in the Common Stock account and $25,000,000 in the Additional Paid-in Capital account. There are 10,000,000 shares authorized. On August 2, Saugatuck splits its stock 4 for 1. Topic: Stock split LO: 2 19. How many of Saugatuck’s shares of common stock are issued and outstanding immediately after the stock split? A) 500,000 B) 4,000,000 C) 2,000,000 D) 8,000,000 Answer: D Rationale: Immediately after the 4 for 1 stock split, the company has 8,000,000 shares of $3 par value common stock [2,000,000 shares  (4/1) = 8,000,000 shares] issued and outstanding. Topic: Stock split LO: 2 20. What is the dollar balance of Saugatuck’s common stock account immediately after the stock split? A) B) C) D)

$ 24,000,000 $ 2,000,000 $ 12,000,000 $ 96,000,000

Answer: A Rationale: The dollar balance in the Common Stock account is unchanged by the stock split; the balance remains at $24,000,000 (8,000,000 shares at the new $3 par value per share).

. Test Bank, Chapter 11

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Topic: Dividends LO: 2 21. Shroff Company has 50,000 shares of $100 par value, 4% cumulative preferred stock and 150,000 shares of $10 par value common stock. Sunny declares and pays cash dividends amounting to $470,000. If no arrearage on the preferred stock exists, how much in dividends per share is paid to the common stockholders? A) B) C) D)

$3.13 $4.00 $5.40 $1.80

Answer: D Rationale:

$100 × 50,000 × 4% Balance to common Per share to common: $270,000/150,000 shares

Distribution to Preferred Common $200,000 $270,000 $1.80

Topic: Earned Capital LO: 2 22. Where is accumulated other comprehensive income generally listed in the balance sheet? A) B) C) D)

In the liabilities section below unearned income In the shareholders’ equity section before common stock In the asset section before prepaid expenses In the shareholders’ equity section below retained earnings

Answer: D Rationale: Earned capital also includes the positive or negative effects of accumulated other comprehensive income. It is generally listed below retained earnings in the shareholders’ equity section of the balance sheet

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Exercises Topic: Computing BEPS and DEPS LO: 4 1. During 2024, Cambridge Company had 100,000 shares of $5 par value common stock and 5,000 shares of 5%, $100 par value convertible preferred stock outstanding. Each share of preferred stock may be converted into two shares of common stock. Cambridge Company’s 2024 net income was $1,500,000. A. Compute basic earnings per share for 2024. B. Compute diluted earnings per share for 2024. Answer: A. Basic EPS: [$1,500,000 – (5,000 × $100 × 5%)] / 100,000 = $14.75 per share B. Diluted EPS: $1,500,000 / [(100,000 + (5,000 × 2)] = $13.64 per share Topic: Reporting stockholders’ equity LO: 1, 2 2. Stussy Company began business on January 1 and immediately issued 500,000 shares of its $5 par value common stock for $12,500,000. At the end of the year it paid $200,000 in cash dividends. In midyear, the firm bought back some of its own shares. The company reports the following additional information at December 31: Net income Retained earnings beginning of year Common shares authorized Shares outstanding at year end

$2,000,000 $0 5,000,000 450,000

A. How much is the Additional Paid-in Capital account at the end of the year? B. Determine the retained earnings amount at the end of the year. C. How many shares of stock are in the treasury at the end of the year? Answer: A. $12,500,000 ‒ (500,000 x $5) = $10,000,000 B. $2,000,000 – $200,000 = $1,800,000 C. 500,000 – 450,000 = 50,000 shares

. Test Bank, Chapter 11

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Topic: Interpreting stockholders’ equity LO: 1, 2 3. Use the following consolidated statement of stockholders’ equity to show the summary transactions by preparing an entry in journal form with explanation for each item A through C. SUERTE COMPANY, INC. Consolidated Statement of Stockholders’ Equity For the Year Ended December 31, 2024 Common Stock, $1 par value

Paid-in Capital C.S.

Retained Earnings

Treasury Stock, Common

Total

$3,000

$ 4,000

$ 15,000

$ 120,000

($1,000)

$141,000

---

15,000

---

15,000

(3,000)

---

(3,000)

---

950

---

1,000

---

(16,250)

---

150

4,350

---

4,500

---

200

11,800

---

12,000

---

(6,000)

---

(6,000)

---

$ 4,400

$32,100

$129,000

($17,250)

$148,250

Preferred Stock

($ in thousands) Balance at 12/31/23 Net income (1) Redemption and retirement of preferred stock (30,000 shares) (2) Stock options exercised (50,000 shares) (3) Purchases of common stock (250,000 shares) for treasury (4) Issuance of common stock (150,000 shares) in exchange for convertible subordinated debentures (5) Issuance of common stock (200,000 shares) for cash (6) Cash dividends – Common stock Balance December 31, 2024

A. Purchase treasury shares (item 3) B. Issue common stock (item 5) C. Pay cash dividends (item 6) Answer: A. Treasury stock, common Cash Purchase 250,000 shares for the treasury.

16,250,000

B. Cash Common stock Additional paid-in capital Issue 200,000 shares of $1 par common stock.

12,000,000

C. Retained earnings Cash To pay cash dividends

6,000,000

16,250,000

200,000 11,800,000

6,000,000

. 11-15

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Topic: Stock transactions LO: 1, 2, 4 4. Singer Company had the following transactions: Year 1: Year 2: Year 3:

Sells 15,000 shares of its no-par common stock for $20 per share. Buys 1,000 shares of its no-par common stock for $21 per share. Declares and pays a dividend on its no-par common stock of $4 per share.

Indicate the effect (increase, decrease, no effect) of each of these transactions for each year on the items listed below. Year

Total Assets

Total Liabilities

Total Equity

Basic EPS

Operating Income

1 2 3 Answer: Year

Total Assets

Total Liabilities

Total Equity

Basic EPS

Operating Income

1 2 3

Increase Decrease Decrease

No effect No effect No effect

Increase Decrease Decrease

Decrease Increase No effect

No effect No effect No effect

Topic: Small stock dividend LO: 2 5. Dosojos Corporation has 750,000 shares of $3 par value common stock outstanding. The current market price of the stock is $65 per share. Dosojos distributes a small stock dividend of 10% of the outstanding shares of common stock. Record the financial statement effects of the stock dividend in the financial statement template. Balance Sheet Transaction

Cash

Noncash + Assets

= Liabilities

Income Statement Contrib. Capital

Earned Capital

Revenues

Expenses

Net Income

. Test Bank, Chapter 11

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Answer: Retained Earnings is reduced by 750,000 shares ×10% × $65 = $4,875,000. Common Stock is increased by 750,000 shares × 10% × $3 par = $225,000 par value. Additional Paid-in Capital is increased by the remainder of $4,875,000 ‒ $225,000 = $4,650,000. Balance Sheet Transaction

Cash

Noncash + Assets

Distributed 75,000 shares as a small stock dividend

= Liabilities

Income Statement

Contrib. + Capital + +225,000 Common Stock -------+4,650,000 Additional Paid-in Capital

Earned Capital

Revenues

Expenses

Net Income

‒4,875,000 Retained Earnings

Topic: Large stock dividend LO: 2 6. Lake View Company announces a large stock dividend of 40% of the 2 million outstanding shares of common stock. The current price per share is $20. Par value of the stock is $0.50 per share. Illustrate the financial effects of this large stock dividend in the balance sheet template. Balance Sheet Transaction

Cash

Noncash + Assets

= Liabilities

Income Statement Contrib. Capital

Earned Capital

Revenues

Expenses

Net Income

Answer: Retained earnings are reduced by the par value of the stock. 2 million shares × 40% × $0.50 = $400,000 Common Stock is increased by the par value of the stock. There is no effect on paid-in capital because the stock dividend is reported at par value. Balance Sheet Transaction

Distributed 800,000 shares as a large stock dividend

Cash

Noncash + Assets

= Liabilities

Income Statement Contrib. Capital

+400,000 Common Stock

Earned Capital ‒400,000 Retained Earnings

. 11-17

Revenues

Expenses

Net Income

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Topic: Balance sheet presentation of stockholders’ equity LO: 1, 2 7. Use the following information to prepare the shareholders’ equity section of the balance sheet for Canalport Incorporated: •

Common Stock—$0.50 par value: 100,000 shares authorized, 40,000 shares outstanding as of December 31, 2024

•

Retained Earnings, December 31, 2024—$275,000

•

Treasury Stock—2,000 shares repurchased at an average cost of $35 per share as of December 31, 2024

•

Total Shareholders’ Equity as of December 31, 2024 is $1,035,000

Answer: Common stock ($0.50 par value) Additional paid-in capital Treasury stock at $35 per share Retained earnings Total shareholders’ equity

$ 21,000 809,000 (70,000) 275,000 $1,035,000

Calculations: Common stock = 40,000 outstanding + 2,000 treasury stock = 42,000 shares issued × $0.50 per share = $21,000 Treasury stock = 2,000 shares repurchased × $35 per share = $70,000 Additional paid-in capital: $21,000 + $275,000 + X ‒ $70,000= $1,035,000; X = $809,000 Topic: Stock computations LO: 1 8. Steel Town Trucking has 200,000 common shares outstanding with a $0.40 par value and $75 current market value per share. The treasury stock account is reported at $650,000 with an average cost of $65 per share. How much is the total common stock (par value) account reported on the balance sheet? Answer: Number of shares in treasury stock account = $650,000 / $65 per share = 10,000 shares Total number of shares = 200,000 + 10,000 = 210,000 Par value of common stock account = 210,000 shares × $0.40 per share = $84,000.

. Test Bank, Chapter 11

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Topic: Analyzing and explaining the effects of a stock split LO: 2 9. The July 1, 2024 balance sheet for Collins Company reported 35,000 shares of $0.60 par value common stock that were issued and outstanding: Common Stock Additional Paid-in Capital

$ 21,000 $360,000

On July 2, 2024, the company splits its stock 3-for-1. A. How many shares of common stock are issued and outstanding immediately after the stock split? B. What is the dollar balance of common stock immediately after the stock split? Answer: A. The company has 105,000 shares of $0.20 par value common stock immediately after the stock split (35,000 x 3/1). B. The balance of the common stock account is unchanged (105,000 shares × $0.20= $21,000). Topic: Computation of outstanding shares LO: 1, 2 10. Zeff Company initially has 75,000 shares of common stock outstanding on January 1, 2024. It has the following changes during 2024 in terms of shares. Feb Mar Oct Nov

2-for-1 stock split 3-for-2 stock split Repurchased 25,000 shares 5-for-4 stock split

Calculate the number of shares outstanding at the end of 2024. Answer: 2-for-1 stock split 3-for-2 stock split Repurchased 25,000 shares in October 5-for-4 stock split

(75,000 x 2/1) (150,000 x 3/2) (225,000 – 25,000) (200,000 x 5/4)

. 11-19

150,000 shares 225,000 shares 200,000 shares 250,000 shares

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Topic: Analyzing and identifying the financial statement effects of stock issuances LO: 1 11. On July 1, 2024, Sunnyvale, Inc. issues 15,000 shares of $10 par value preferred stock at $100 cash per share and 100,000 shares of $0.50 par value common stock at $40 cash per share. Indicate the financial statement effects of these two issuances using the following template: Balance Sheet Transaction

Cash

Noncash + Assets

Liabilities

Income Statement +

Contrib. Capital

Earned Capital

Revenues

Expenses

Net Income

Answer: Balance Sheet Transaction Issue 15,000 shares, $10 par value, for $100 cash per share

Issue 100,000 shares, $0.50 par value, for $40 cash per share

Cash

+1,500,000

+4,000,000

Noncash + Assets

Liabilities

Income Statement +

Contrib. Capital

Earned Capital

Revenues

Expenses

+150,000 Preferred Stock ----------+1,350,000 Additional Paid-in Capital

+50,000 Common Stock ----------+3,950,000 Additional Paid-in Capital

. Test Bank, Chapter 11

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Topic: Computations relating to shares issued and average price LO: 1 12. Following is the stockholder’s equity section of Silver, Inc. at December 31, 2024: Stockholders' Equity

December 31, 2024

Common stock - $0.50 par value, authorized 1,000,000 shares Additional paid-in capital Treasury stock—5,000 shares Retained earnings Total stockholders' equity

$ 100,000 980,000 (30,000) 250,000 $1,300,000

A. Compute the number of shares that have been issued. B. At what average issue price were the shares issued? C. At what average cost were the treasury stock purchased? Answer: A. Total Par value / Unit par value = $100,000 / $0.50 = 200,000 shares B. (Common stock + Additional paid-in capital) / Shares issued = Issue price ($100,000 + $980,000) / 200,000 = $5.40 C. Treasury stock / Treasury shares = Treasury cost per share $30,000 / 5,000 = $6 per treasury share Topic: Convertible preferred LO: 5 13. Xue, Inc. has 25,000 shares of convertible preferred stock issued at its par value of $100. On December 1, the preferred stock was converted into 50,000 shares of common stock with a par value of $2. A. Show the effect on the balance sheet and income statement using the following template. Balance Sheet Transaction or Event

Converted preferred stock into common stock

Cash

Noncash + Assets =

Liabilities

Preferred Stock

Income Statement +

Common Stock

Earned + Capital

Revenues - Expenses =

Net Income

B. What is the effect on income from the conversion?

. 11-21

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Answer: A. 25,000 × $100 = $2,500,000; $2 × 50,000 = $100,000 Balance Sheet Transaction or Event

Cash

Converted preferred stock into common stock

Noncash + Assets =

Liabilities

Preferred Stock

‒2,500,000 Preferred Stock

Income Statement +

Common Stock

Earned + Capital

Revenues

- Expenses =

Net Income

+100,000 Common Stock -----+2,400,000 Additional Paid-in Capital

B. There is no effect on income. Topic: Analyzing the sources and effects of comprehensive income LO: 3 14. Showalter Corporation reports the following components of its comprehensive income in its 2024 consolidated statements of shareholders’ equity ($ in millions): Comprehensive Income Net income Foreign currency translation adjustment, net Other comprehensive income Total comprehensive income

$4,000 1,200 150 $5,350

Identify the primary sources of comprehensive income, and explain why comprehensive income is a more inclusive notion of company performance than net income alone. Answer: The primary sources of comprehensive income are net income and all changes in equity other than those resulting from investments by owners and distributions to owners. Comprehensive income includes foreign currency adjustments, unrealized changes in values of passive investments in debt securities, and minimum pension liability adjustments. Comprehensive income is often thought to be a more comprehensive measure of a company’s performance to reflect events that are outside of management’s control. In the case of Showalter Corporation, net income accounts for 75% of total comprehensive income, indicating that most of the income for the year 2024 can be attributed to the performance of the management team.

. Test Bank, Chapter 11

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Topic: Analyzing the financial statement effects of convertible securities LO: 5 15. Shields Company has $2,000 par value convertible bonds with an unamortized discount of $100. The bonds are converted into 200 shares of $3 par value common stock. A. What is the effect of this conversion on the balance sheet? B. What is the effect of this conversion on the income statement? C. What is one benefit and one cost of the conversion privilege of a security? Answer: A. Debit Bonds Payable for $1,900 (par value less unamortized discount) Credit Common Stock for $600, which is $3 x 200 Credit Additional Paid-in Capital for $1,300 B. There is no effect on the income statement. C. One benefit of the conversion privilege is the resulting higher market price of the convertible security. One drawback of the conversion privilege is the cost imposed on common shareholders or subordinate securities in the form of dilution.

. 11-23

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Problems Topic: Preferred stock conversion to common stock LO: 1, 5 1. Moondust Company has preferred stock with a par value of $100 that is convertible into common stock at the ratio of 2 to 1. The common stock has a par value of $2. The following table presents the components of stockholders’ equity for Moondust Company: Convertible Redeemable Preferred Stock

Common Stock

Additional Paid-in Capital

$500,000

$200,000

$ 800,000

20,000

120,000

4,000 $224,000

96,000 $1,016,000

Balance at Dec. 31, 2023 Net Income Issuance of common shares Conversion of redeemable preferred stock Balance at Dec. 31, 2024 A. B. C. D. E.

(100,000) $400,000

Retained Earnings

Total

$225,000 40,000

$1,725,000 40,000 140,000

________ $265,000

0 $1,905,000

How many shares of common stock were sold during the year and at what price? How many shares of preferred stock were converted this year? Explain why Common Stock is credited for $4,000 when the conversion is recorded. Why would a company offer a conversion privilege? List two reasons a shareholder might exercise the conversion privilege.

Answer: A. $20,000 / $2 = 10,000 shares; [$20,000 + $120,000] /10,000 shares = $14 per share B. $100,000 / $100 = 1,000 shares C. 1,000 shares of preferred stock are converted to (1,000 x 2/1) = 2,000 shares of common stock, with a par value of (2,000 x $2) = $4,000. D. When a conversion option is offered, the security yields a higher price than it would otherwise. E. 1) To gain voting rights, and 2) to participate in value creation

. Test Bank, Chapter 11

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Topic: Various stockholders’ equity issues LO: 1, 3 2. Following is the stockholders’ equity section of the Acending Air Lines (AAL) Corporation’s 2019 Consolidated Balance Sheet ($ in millions): Stockholders’ Deficit:

2019

2018

—

Common stock at $0.00011 par value; 1,500,000,000 shares authorized, 867,866,505 and 861,499,734 shares issued at December 31, 2019 and 2018, respectively Additional paid-in capital

28,138

27,998

Accumulated deficit

(14,778)

(16,796)

Accumulated other comprehensive loss Treasury stock, at cost, 18,225,197 and 16,253,791 shares at December 31, 2019 and 2018, respectively

(17,154)

(13,532)

(468)

(462)

Total stockholders' deficit

(4,262)

(2,792)

Total liabilities and stockholders' deficit

$89,100

$86,998

A. In general, what is meant by “accumulated other comprehensive loss”? B. AAL has 1.5 billion shares of common stock authorized, with 867,866,505 of these shares issued as of the end 2019. Why is there a difference between these two numbers? C. How many common shares did AAL have outstanding at the end of 2019? D. Verify that AAL’s common stock balance as of December 31, 2010 is approximately $95,000. E. Calculate the average cost at which AAL repurchased its 18,225,197 million shares of common stock. F. AAL’s repurchase of 18,225,197 million shares in 2019 represents approximately 2.1% of the shares that are issued at year end. Give several reasons for this given the current economic conditions. Answer: A. Accumulated other comprehensive loss includes changes to equity (except those resulting from contributions by and distributions to owners) that are not included in income and are, therefore, not reflected in retained earnings. Since the loss amounts exceed the income amounts, the net is a loss. B. The number of shares authorized is formally set forth in a corporate charter created in conjunction with the establishment of a corporation. It can only be increased or decreased by an affirmative shareholder vote. A firm can issue any number of shares up to the amount formally authorized. The shares issued is the actual number of shares that have been sold to stockholders by the corporation. C. Common shares outstanding = Common shares issued – treasury shares repurchased 867,866,505 – 18,225,197 = 849,641,308 outstanding D. 867,866,505 shares issued x $.00011 par value = $95,465.32 or $95,000 (rounded) E. $468,000,000 / 18,225,197 = $25.68 per share F. A company typically repurchases stock for two reasons: 1) it feels their stock is undervalued in the marketplace and wishes to send a signal to investors, and 2) to offset the dilutive effects of employee stock option programs. More AAL employees may be cashing in on stock options if they anticipate AAL’s market value to do well in the future. In this case, AAL would repurchase shares in an attempt to preserve earnings per share and equalize the number of shares outstanding.

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Topic: Large stock dividend LO: 2 3. A particular investor prefers the stock of a company with a higher ratio of retained earnings against contributed capital, preferably above 2. The investor finds ABC Company acceptable because the equity breakdown at June 30, its year end, is as follows: Common stock, $1 par value Additional paid-in capital Retained earnings

$50,000 $70,000 $300,000

On July 1, the day after its year end, ABC announced it will declare a 24% stock dividend. The stock price on this date is $15 per share. Calculate the ratio of retained earnings to contributed capital if ABC reports the dividend as a large stock dividend, and as a small stock dividend. With which accounting treatment will the investor be more pleased? Answer: A small stock dividend is assumed to be up to 20 to 25% of outstanding shares while a large dividend is above 20 to 25%. Small stock dividend Common stock Additional paid-in capital Retained earnings

$ 50,000 + (24% × 50,000 × $1) = $ 70,000 + (24% × 50,000 × $14) = $300,000 ‒ (24% × 50,000 × $15) =

Retained earnings/Contributed capital Large stock dividend Common stock Additional paid-in capital Retained earnings Retained earnings/Contributed capital =

$120,000/ ($62,000 + $238,000)

$ 62,000 $238,000 $120,000

0.40

$ 50,000 + (24% × 50,000 × $1) = $ 70,000 (no change) $300,000 ‒ (24% × 50,000 × $1) =

$62,000 $70,000 $288,000

$288,000/ ($62,000 + $70,000) =

2.18

The investor would be happier with a large stock dividend as the decrease to retained earnings is much smaller than with a small stock dividend and it keeps the ratio of retained earnings to contributed capital above 2.

. Test Bank, Chapter 11

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Topic: Stockholders’ equity questions LO: 1, 2 4. The stockholders’ equity section of Price Corporation’s balance sheet follows together with a portion of its statement of cash flows: Shareholders' Equity ($ millions) Common stock, $0.20 par value: Authorized, 1.0 billion shares; Issued and outstanding, 565,400,000 and 558,300,000 shares, respectively Additional paid-in capital Retained earnings Accumulated other comprehensive income (loss) Shareholders' equity Noncontrolling interests

2024 $

Total shareholders' equity Financing Activities ($ millions) Issuance of common stock Dividends paid Repayments of debt Proceeds from issuance of debt Acquisition of noncontrolling interests Total cash provided by financing activities

113 820 10,100 100 11,133 1,400

2023 $

112 560 8,500 (300) 8,872 1,050

$ 12,533

$ 9,922

2024 261 (500) (11,400) 12,200 (350)

2023 $ 190 (450) (9,500) 10,200 (160)

211

280

A. Calculate the net income of Mandrell Corporation for 2024. B. Calculate the average dollar per share received for common stock issued during 2024. C. What is the dividend per share paid in 2024? Answer: A. Retained earnings of 2023 + Net income ‒ Dividends paid = Retained earnings of 2024 $8,500 M + Net income - $500 M = $10,100 M Net income = $2,100 million B. New stock issued: 565,400,000 ‒ 558,300,000 = 7,100,000 shares Cash received: $261 million Average price: $261,000,000 / 7,100,000 = $36.76/share C. Cash outflow from dividend: $500,000,000 Outstanding shares: 565,400,000 Dividend per share: $500,000,000 / 565,400,000 = $0.88/share

. 11-27

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Topic: Financial statement effects of stock transactions LO: 1, 2 5. Following are selected stock transactions and information for Country Time Industries. •

Authorization for initial public offering of 500,000 shares of common stock with par value of $0.01 to be issued at $65 per share Authorization for 5,000 shares of 5% preferred stock with par value of $150 Transactions:

• •

1. May 14 2. May 30 3. November 11

500,000 common shares sold at $65 per share 2,000 shares of preferred stock sold at par $90,000 total cash dividends paid

A. Show the financial statement effects of the three equity transactions in the template. Balance Sheet Cash

Date

Noncash + Assets = Liabilities

Income Statement Contrib. Capital

Earned + Capital

Revenues

Net Income

- Expenses =

1. May 14

2. May 30

3. Nov 11

B. How much was the per share cash dividend for common stock for the November 11 payment? Answer: A. Balance Sheet Noncash + Assets = Liabilities

Cash

Date

1. May 14

+32,500,000 Cash

2. May 30

+300,000 Cash

3. Nov 11

-90,000 Cash

Income Statement +

Contrib. Capital +5,000 Common Stock

Earned + Capital

Revenues

----------

Expenses =

Net Income

+32,495,000 Additional Paid-in Capital +300,000 Preferred Stock -

= -90,000 Retained Earnings

1. Cash = 500,000 shares × $65 = $32,500,000 Common stock = 500,000 shares × $0.01 par value = $5,000 Additional paid-in capital = 500,000 × $64.99 = $32,495,000 2. Cash = 2,000 shares × $150 per share = $300,000 Preferred stock = $300,000 3. Preferred stock dividend = $150 par value × 5% × 2,000 shares = $15,000 Balance to common = $90,000 ‒ $15,000 = $75,000 B. $75,000 / 500,000 shares = $0.15 per share . Test Bank, Chapter 11

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Topic: Financial statement effects of stock transactions LO: 2 6. Hallowen Inc. has 50,000 outstanding shares of common stock with par value of $0.50 per share and market price on January 1 of $80. A. Show the financial statement effects of the two independent equity transactions in the template below. 1. 10% stock dividend paid to common shareholders with current market price at $80 2. 30% stock dividend paid to common shareholders with current market price at $100 Balance Sheet Transaction

Cash

Noncash Assets = Liabilities

Income Statement Contrib. Capital

Earned + Capital

Revenues

Net Income

- Expenses =

1. 10% stock dividend

2. 30% stock dividend

B. How have these two transactions changed the overall valuation of the firm? Answer: A. Balance Sheet Transaction

Cash

Noncash + Assets = Liabilities

1. 10% stock dividend

2. 30% stock dividend

Income Statement Contrib. Capital +2,500 Common Stock ----------

+397,500 Additional Paid-in Capital +7,500 Common Stock

Earned Capital

Revenues

Expenses =

‒400,000 Retained Earnings

‒7,500 Retained Earnings

Net Income

1. Common stock = 50,000 shares × 10% × $0.50 par value = $2,500 Additional paid-in capital = 50,000 shares × 10% × ($80.00 - $0.50) = $397,500 Retained earnings = 50,000 shares × 10% × $80.00 = $400,000 2. Common stock = 50,000 shares × 30% × $0.50 par value = $7,500 Retained earnings = $7,500 (Note: Since a 30% stock dividend is considered to be a large stock dividend, retained earnings are reduced by the par value of the shares distributed and common stock is increased by the same amount. There is no change to additional paid-in capital.)

B. Since these two stock dividends merely increased the number of shares available in an equal way to all shareholders, the overall value of the firm should remain unchanged. Any market price changes may be caused by naïve investors or in the market reading signals into the transaction (either good or bad).

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Essays Topic: Stock buyback LO: 1 1. Many companies buy back their outstanding stock on an annual basis. List several reasons a company might want to repurchase shares of its stock, as well as the financial statement effects of this action. Answer: A company may repurchase shares of its stock for several reasons. First, if a company feels that the market undervalues its stock, it may wish to repurchase shares in hopes that this will send a signal to the market. If the market value of the shares does indeed rise, the company will be able to realize a “gain” (not reported in the income statement, however) on the resale of the shares. A firm may also buy back shares to offset the dilutive effects of executive stock option programs. When executives (or any employees with stock options) exercise their stock options, the number of shares outstanding increases along with the cash received. These additional shares are viewed as dilutive, as they reduce the earnings per share amount. Thus, many companies will repurchase an equivalent number of shares in order to keep outstanding shares constant. The repurchase of a firm’s stock has the opposite effects of a stock issuance and serves to downsize the company. Cash and stockholders’ equity are both reduced by the price of the shares repurchased (calculated as the number of shares repurchased times the market value per share). Topic: Preferred preferences LO: 1 2. Identify the benefits received from being a preferred stockholder compared to a common stock holder. Describe the nature of each privilege or preference of each. Answer: A. Dividend Preference: Preferred shareholders receive dividends on their shares before common shareholders do. Also, in the event that dividends are not paid in a year and are in arrears, some preferred stock contracts include a cumulative provision that stipulates that any dividends in arrears must first be paid to preferred shareholders, together with the current year’s dividends, before any dividends are paid to common shareholders. B. Liquidation Preference: If a company fails, its assets are sold and the proceeds are paid to the debtholders and stockholders of the company. Preferred stockholders receive payment in full before common stockholders. C. Conversion privileges: The par value received upon liquidation of a company limits the upside potential in that the claim of preferred shareholder is fixed. This constraint can be overcome by inclusion of a conversion privilege that allows preferred stockholders to convert their shares into common shares at a predetermined conversion ratio. D. Participation feature: This feature allows preferred shareholders to share ratably with common stockholders in dividends. The dividend preference over common shares can be a benefit when dividend payments are meager. But a fixed dividend yield limits upside potential of preferred stock if the company performs exceptionally well. This limitation can be overcome with a participation feature.

. Test Bank, Chapter 11

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Topic: Convertible preferred stock LO: 5 3. Describe the benefits for an individual investor in purchasing convertible preferred stock. What are the effects on the financial statements of conversion? Answer: For an individual, the reason for buying preferred stock is to avail herself of the upside return on common stock while preserving the fixed yield and dividend and liquidation preferences afforded to a preferred shareholder. Upon conversion, the book value of the preferred stock is removed from stockholders’ equity and additional common stock is issued at a “price” equal to the preferred book value. Common stock is increased by its par value and additional paid-in capital is increased for the balance. There is no gain or loss recorded upon conversion.

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Chapter 12 Reporting and Analyzing Financial Investments Learning Objectives – Coverage by question True/False LO12-1 Explain and interpret the three levels of investor influence over an investee—passive, significant, and controlling. (p. 12-3)

3, 5, 6, 8, 9

LO12-2 Describe the term “fair value” and the fair value hierarchy (p. 12-5)

Multiple Choice

Exercises

Problems

Essay Questions

1, 4, 10, 12, 13

2, 11

1, 5

LO3 Describe and analyze accounting for passive investments. (p. 12-6)

8-11, 16

1, 6, 10- 13, 15

2-4, 11

LO12-4 Explain and analyze accounting for investments with significant influence. (p. 12-17)

1, 2, 5-7, 12, 14, 17

2-5, 7, 11, 12, 14, 18-20

1, 3-5, 8

LO12-5 Describe and analyze accounting for investments with control. (p. 12-22)

3, 4, 12, 13, 16

8, 9, 16, 21

6, 7, 9, 10

LO12-6 Appendix 12A: Illustrate and analyze accounting mechanics for equity method investments. (p. 12-31)

LO12-7 Appendix 12B: Apply consolidation accounting mechanics. (p. 12-33)

LO12-8 Appendix 12C: Discuss the reporting of derivative securities. (p. 12-35)

3, 5

2, 3

4, 6

6, 7, 9

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Chapter 12:

Reporting and Analyzing Financial Investments

True/False Topic: Equity method LO: 4 1. If company A accounts for its investment in company B using the equity method, then all of company B’s earnings are reported on company A’s income statement. Answer: False Rationale: Only the proportion owned of Company B’s earnings are included as equity earnings for Company A. Topic: Equity method LO: 4 2. Under the equity method, if the fair value of the investee company increases, and the increases are deemed other-than-temporary, the book value of the investment on the investor’s balance sheet is adjusted upward to reflect in the increase in value. Answer: False Rationale: Unrealized gains on equity method investments are not recognized until the investment is sold. Topic: Control LO: 1, 5 3. An investor company can be considered to have control over the investee company even if it owns less than 50% of the outstanding voting stock of the investee company. Answer: True Rationale: Circumstances may point to control even if stock ownership is less than 50%. Examples include contracts and licenses that confer control in the absence of majority stock ownership. Topic: IFRS and significant influence LO: 5 4. IFRS uses the term ‘associate’ to describe an investment involving significant influence. Answer: True Rationale: GAAP uses the term ‘equity.’ Topic: Equity method LO: 1, 4 5. Under equity method accounting, dividends paid by the investee company are reported as investment income by the investor company. Answer: False Rationale: Under equity method accounting, dividends are treated as a return of investment, thereby reducing the investment account, not as income.

. Test Bank, Chapter 12

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Topic: Significant influence LO: 1, 4 6. In addition to the ownership of a sufficient percentage of outstanding common stock, significant influence can result by virtue of legal agreements and technology licensing. Answer: True Rationale: Usually, the investor company can exert significant influence over the activities of the investee company when it owns 20% to 50% of the voting stock of the investee company. An investor company might also exert significant influence if it is the sole customer or supplier of the investee customer, or has contractual rights. Topic: Equity method LO: 4 7. Under the equity method, the investment account is adjusted to the fair value of the stock at the end of the period. Answer: False Rationale: The investment account represents the investor’s percentage ownership in the investee company’s stockholders’ equity. The underlying assets and liabilities of the investee company are reflected in the investment account balance. Topic: Available-for-sale investments LO: 1, 3 8. When investments are classified as available-for-sale, fair value changes are recognized in the income statement as unrealized gains or losses. Answer: False Rationale: Unrealized gains and losses on available-for-sale investments bypass the income statement. Fair value changes are recorded as other comprehensive income (OCI), a component of stockholders’ equity. Topic: Trading securities LO: 1, 3 9. Unrealized gains and losses on investments classified as trading securities are reported as a component of a company’s net income. Answer: True Rationale: The “trading” classification implies that those investments are actively bought and sold; therefore, any unrealized gains/losses are presented as investment gains or losses on the income statement. Topic: Passive investments LO: 3 10. When a passive investment is sold, any gain (loss) is typically reported in “other” income. Answer: True Rationale: The gain (loss) on sale is reported as a component of “other” income, which is commonly commingled with interest and dividend income.

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Topic: Available-for-sale and trading classification LO: 3 11. Available-for-sale securities are those that management intends to actively trade for profits as market prices fluctuate. Answer: False Rationale: Available-for-sale securities are those that management intends to hold for dividend income. Trading securities are those that management intends to actively trade for profits as market prices fluctuate. Topic: Equity method vs. Consolidation LO: 4, 5 12. Shareholders’ equity of the investor company will be same using either equity method accounting or the consolidation accounting method for an investment. Answer: True Rationale: Shareholders’ equity will be same using either equity method accounting or consolidation accounting for an investment. Topic: Goodwill LO: 5 13. Goodwill is not amortized but is tested at least annually and written down to current fair value if found to be impaired, and written up to fair value if the fair value increases. Answer: False Rationale: Although goodwill is written down if impaired, it is never written up if its value increases. Topic: Equity method mechanics LO: 4 14. Under equity method accounting, dividends received from the investee are treated as a return on the investment rather than a return of the investment. Answer: False Rationale: Equity method accounting treats dividends received from the investee as a return of the investment. Topic: Accounting for derivatives LO: 8 15. Companies are only required to disclose quantitative information about derivatives in financial statement notes. Answer: False Rationale: Companies are required to disclose both qualitative and quantitative information about derivatives in notes to the financial statements and elsewhere, like the Management’s Discussion and Analysis section of SEC reports.

. Test Bank, Chapter 12

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Topic: IFRS accounting for passive investments in equity securities LO: 3, 5 16. Under IFRS, passive investments in equity securities are accounted for similar to GAAP. Answer: False Rationale: While GAAP requires all passive investments in equity securities to be reported using the fair value (trading) method, IFRS allows such investments to be categorized as AFS, with gains and losses reported in OCI. Topic: Significant influence LO: 4 17. One reason a company makes investments with significant influence is to gain a seat on the board of directors from which it can learn much about the investee company. Answer: True Rationale: There are a number of ways to influence an investee.

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Multiple Choice Topic: Unrealized gains LO: 1, 3 1. In which one of the following intercorporate investment classifications are unrealized gains and losses in marketable securities always reflected in the income statement of the investor company? A) B) C) D) E)

Equity method securities Passive securities Trading securities Available-for-sale securities Purchase method securities

Answer: C Rationale: Unrealized gains for trading securities are reflected in the income statement of the investor company because the company holds these securities for active trading. Unrealized gains and losses on some passive investments are reported in income, but not for debt securities classified as AFS or HTM, or for equity method securities. Topic: Equity method LO: 4 2. If Pandit & Pearlman, Inc. paid $8,000 at book value for its 25% stake in Zeff Company, and in the next year total shareholders’ equity for Zeff Company increases by 75%, what will Pandit & Pearlman’s interest of Zeff’s equity be? A) B) C) D)

$ 7,000 $ 1,750 $ 3,000 $14,000

Answer: D Rationale: If the investment is purchased at book value, the investment balance bears a proportional relation to the stockholders’ equity of the investee company. $8,000 × 175% = $14,000 Topic: Equity method LO: 4, 6 3. If Trout Company buys 26% of Salmon Company’s stock, and pays $4,000 more than current book value for these shares, what percentage of Salmon Company’s shareholder equity belongs to Trout Company? A) B) C) D)

25% It depends on the dollar value of total shareholders’ equity for Salmon Company. 35% 26%

Answer: D Rationale: Regardless of the purchase price, the investor company’s claim on the stockholders’ equity of the investee company is determined by the percentage of the stock that it owns.

. Test Bank, Chapter 12

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Topic: Significant influence LO: 1, 4 4. At what level of investment ownership is significant influence often presumed? A) B) C) D)

Greater than 20% of the voting stock of the investee Between 20% and 50% of the voting stock of the investee Greater than 50% of the voting stock of the investee Greater than 20% of the voting stock or of the fair value of the investee

Answer: B Rationale: Ownership between 20% and 50% is often sufficient. However, significant influence can also exist when ownership is less than 20%, if the investor company gains a seat on the board of directors due to its investment, or if the investor controls some sort of technical know-how or patents that the investee uses. Topic: Equity method income LO: 4 5. Team Fuzzbuddy owns 40% of Nice Racquets, Inc. and accounts for the investment using the equity method. During the year, Nice Racquets reports a net loss of $2,400,000 and pays total dividends of $50,000. Which of the following describes the change in Team Fuzzybuddy’s investment in Nice Racquets during the year? A) B) C) D)

The investment increases by $50,000 The investment decreases by $2,450,000 The investment decreases by $735,000 The investment decreases by $980,000

Answer: D Rationale: Equity method investments increase with net income of the investee and decrease with net loss and with dividends. 40% × ($2,400,000 + $50,000) = $980,000 decrease. Topic: Cost method LO: 3 6. Which of the following statements is true for the cost method? A) B) C) D)

Passive equity investments may be reported using the cost method. Trading investments are reported using the cost method Dividends and interest earned are recognized in current income The investment is adjusted to fair value at year end

Answer: C Rationale: Under the cost method, any dividends and interest earned are recognized in current income, but the investment remains at cost and no unrealized gains and losses are reported. Trading investments and passive equity investment are reported at fair value.

. 12-7

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Topic: ROE and equity method accounting LO: 4 7. Which of the following statements is not correct concerning the effects on the components of return on equity (ROE) under equity method accounting? A) B) C) D)

Financial leverage is understated NOPAT is correctly stated Net operating profit margin is overstated Asset turnover is understated

Answer: D Rationale: Asset turnover equals Sales/Average assets. The total asset turnover is understated due to nonrecognition of sales, but it is overstated by the nonrecognition of assets. As such, the net effect of equity method accounting on total asset turnover is indeterminate. Financial leverage is understated due to the nonrecognition of assets and the correct reporting of equity. NOPAT is correctly stated since equity income is included. Net operating profit margin is overstated due to nonrecognition of sales and the correct reporting of income. Topic: Intangible asset LO: 5 8. Which of the following would not be capitalized as an identifiable intangible asset by an investor company when an entire company is acquired? A) B) C) D)

Trademarks Customer relationships Patents Currency translation adjustments

Answer: D Rationale: Intangible assets is a term applied to a group of long-term assets, including patents, copyrights, franchises, trademarks, and goodwill, that benefit an entity but do not have a physical substance. Currency translation adjustments are a component of comprehensive income. Topic: Goodwill impairment LO: 5 9. Which of the following is correct about impairment of goodwill for a subsidiary? A) The fair value of the subsidiary is compared with the fair value of the investor’s equity investment account. B) If the fair value of the subsidiary is less than the investment balance, the investment is deemed impaired. C) If the book value of the subsidiary is less than the investment balance, the investment is deemed impaired. D) The future expected cash flows of the investment are compared with the book value of the investment. Answer: B Rationale: If the fair value of the subsidiary is less than the investment balance, the investment is deemed impaired. The fair value of the investee company is compared with the book value of the investor’s equity investment account.

. Test Bank, Chapter 12

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Topic: Available-for-sale LO: 1, 3 10. When the fair value of a company’s available-for-sale investments is lower than its book value, how should the unrealized loss be handled? A) B) C) D) E)

Written off as an impairment Not reported Recorded as an expense on the company’s income statement Deducted from the investment account Added to stockholders’ equity of the investor

Answer: D Rationale: Available-for-sale securities are accounted for on a fair value basis. A decrease in fair value results in a reduction of the investment account and a reduction of stockholders’ equity (through other comprehensive income/loss). Gains and losses on available-for-sale securities are not recorded on the income statement unless they are realized. A loss of fair value results in a reduction of stockholders’ equity rather than an addition to it. Topic: Dividends received under equity method and passive investments LO: 3, 4 11. Tarpley Brothers. Company holds a 15% equity investment in Boat Bunker and treats it as a passive investment. Freddie M.. Company holds 30% of Boat Bunker’s stock and has a significant influence over Boat. On November 1, 2022, Boat Bunker declares and pays dividends to its stockholders. How will the dividend affect each company’s investment account? A) Tarpley Brothers Decrease

Freddie M. No effect

Tarpley Brothers Decrease

Freddie M. Decrease

Tarpley Brothers No effect

Freddie M. No effect

Tarpley Brothers No effect

Freddie M. Decrease

B) C)

Answer: D Rationale: Tarpley Brothers Company should use the fair value method to account for its investment in Boat Bunker, so its dividend will not affect its investment account. Freddie M. Company should use the equity method to account for its investment, so its dividend will be deducted from its investment account.

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Topic: Levels of influence LO: 1, 3, 4 12. GAAP identifies three levels of influence/control. Which level of influence/control would a company likely use if it was investing in a company that gave it 15% of the outstanding voting stock? A) B) C) D)

Passive Significant Influence Control Market-level

Answer: A Rationale: A passive investment would be used when owning up to 20% of the investee company. Significant Influence would be used for investments of between 20% and 50%. Consolidation is required if more than 50% is owned. Topic: Effect of fair value changes LO: 1, 3 13. In which investment classification do fair value changes affect the income statement? A) B) C) D)

Trading Available-for-sale Equity method Both A and B

Answer: A Rationale: Changes in the fair value of trading securities flow to the income statement. Changes in the fair value of available-for-sale securities flow to other comprehensive income in the equity section of the balance sheet. Topic: ROE and equity method LO: 4 14. When equity method accounting is used for an investment, which component of ROE will always be understated? A) B) C) D)

Net profit margin Total asset turnover Financial leverage Return on equity

Answer: C Rationale: Financial leverage is understated due to nonrecognition of assets and liabilities and the correct reporting of equity.

. Test Bank, Chapter 12

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Topic: Fair value method LO: 2, 3 15. Which of the following statements is false for fair value method accounting? A) B) C) D) E)

The investment account is recorded at current fair value Interim changes in fair value may or may not affect income depending on classification Dividends are not reported as income but instead are treated as a return of the capital invested Generally used when an investor company owns less than 20% of the acquired company Uses current fair value to report investments that are actively traded.

Answer: C Rationale: Dividends are reported as income under the fair value method, rather than a return of the capital invested which is the case for equity method investments. Topic: Consolidations LO: 5, 7 16. Verdi Brothers owns 100% of Schweinfurt Company. At year-end, Schweinfurt owes Verdi Brothers $52,000. If a consolidated balance sheet is prepared at year-end, how is the $52,000 handled? A) B) C) D)

The $52,000 is eliminated on the consolidated balance sheet The $52,000 is reported as goodwill on the consolidated balance sheet The $52,000 is amortized as an intangible asset on the consolidated balance sheet The $52,000 is shown as an unearned revenue on the consolidated balance sheet

Answer: A Rationale: The $52,000 accounts payable on Schweinfurt’s balance sheet and the $52,000 accounts receivable on Verdi Brothers’ balance sheet are eliminated. In a consolidation, all intercompany items are eliminated so that the consolidated statements show only the interests of outsiders. Topic: Derivatives LO: 8 17. At what amount is a derivative contract reported? A) B) C) D)

At book value At historical cost At fair value At the average of book and fair value

Answer: C Rationale: A derivative contract is reported at fair value.

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Topic: Equity method investment LO: 4 18. Under the equity method, how are unrealized gains (losses) reported? A) B) C) D)

As goodwill As a separate component of stockholders' equity As part of net income Not recognized

Answer: D Rationale: In contrast to the fair value method, the equity method of accounting does not recognize unrealized holding gains (losses) in either the balance sheet or the income statement. Topic: Significant influence LO: 4 19. Which of the following is not an example of the ability to exercise significant influence over an investee? A) B) C) D)

Technological dependency Material intercompany transactions Interchange of managerial personnel Clearly determinable fair market value

Answer: D Rationale: Market valuation is not considered in the ability to exercise significant influence. Topic: Equity method investment LO: 4 20. Under the equity method, which of the following does not cause a decrease in the investment account? A) B) C) D)

The losses of the investee Dividends paid by the investee Declines in the fair value of the investment All of the choices would decrease the investment account

Answer: C Rationale: The investment account is not affected by changes in the investment's fair value under the equity method. Topic: IFRS vs. GAAP LO: 5 21. Which are accounted for differently from GAAP under IFRS? A) B) C) D)

Trading securities Available-for-sale debt securities Equity method investments None of the above

Answer: D Rationale: All of the above are accounted for in a similar manner under IFRS as GAAP.

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Exercises Topic: Analyzing and interpreting equity method Investments LO: 4 1. Jaguar Company purchases an investment in South America Preserve Company at the purchase price of $6 million cash. This represents 25% of the book value of South America Preserve. During the year, South America Preserve reports net income of $1,200,000 and pays cash dividends of $100,000. At the end of the year, the fair value of Jaguar’s investment is $6.4 million. Required A. At what amount is the investment reported on Jaguar’s balance sheet at year-end? B. What amount of income from investments does Jaguar report? Explain. C. Prepare journal entries to record the transactions for Jaguar Company. Answer: A. Given the 25% ownership, “significant influence” is presumed and the investment must be accounted for using the equity method. Beginning balance % South America Preserve income earned % Dividends received Ending balance

$6,000,000 300,000

($1,200,000  0.25)

(25,000) ($100,000  0.25) $6,275,000

B. $1,200,000  0.25 = $300,000 Equity earnings are computed as the reported net income of the investee (South America Preserve Company) multiplied by the percentage of the outstanding common stock owned. C. 1. 2. 3.

Investment in South America Preserve Cash

6,000,000

Investment in South America Preserve Investment income

300,000

Cash

25,000

6,000,000 300,000

Investment in South America Preserve

. 12-13

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Topic: Accounting for available-for-sale securities LO: 1, 3 2. The following is from the financial statement footnotes from Compact Container Retailers: As of December 31, 2022, the Company’s marketable securities approximated the fair market values of the securities and the unrealized gains and losses on these securities were not significant. As of September 30, 2022, the Company had recorded an unrealized gain of approximately $4.6 million in other comprehensive income on its investment in a certain private company. In 2023, the Company sold this investment in its entirety and realized a gain on the sale of $5.8 million. Required A. How did Compact Container classify these marketable securities? How do you know? B. How did the unrealized gain of $4.6 million affect Compact Container’s 2022 net income? Answer: A. The type of marketable security Compact Container is most likely to be holding is available-for-sale securities. In the case of available-for-sale securities, any fair value changes bypass the income statement and are reported in the other comprehensive income section of the balance sheet. B. Unrealized gains and losses on available-for-sale securities do not affect net income. Topic: Passive investments compared to equity method investments LO: 3, 4 3. On January 1, Arctic Bunny acquired common stock of B-Team Company at book value. At the time of acquisition, the book value and the fair value of B-Team’s net assets were $200 million. During the current year, B-Team earned $80 million and declared dividends of $10 million. Indicate the amount shown for Investment in B-Team on Arctic Bunny’s balance sheet on December 31 and the amount of income Arctic Bunny would report for the year related to its investment under the assumption that Arctic Bunny did the following: A. Paid $20 million for a 10-percent interest in B-Team and classifies the investment as a passive investment. The fair value of B-Team on December 31 was $240 million. B. Paid $70 million for a 35-percent interest in B-Team and uses the equity method. Answer: Part

Investment Account (Asset)

(10%)

= $240M x 10% = $24M

(35%)

= $70M + 0.35 ($80M ‒ $10M) = $94.5M

Net Income 10% × ($10M + ($240M - $200M)) = $5M 35% × $80M = $28M

. Test Bank, Chapter 12

12-14

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Topic: Computing income for fair value and equity method investments LO: 3, 4 4. On January 1, Farmer Fran Corporation acquired common stock of Bails O’ Plenty Corporation. At the time of acquisition, the book value and the fair value of Bails O’ Plenty Corporation’s net assets were $1 billion. During the year, Bails O’ Plenty Corporation reported net income of $480 million and declared dividends of $160 million. The fair value of the shares increased by 10 percent during the year. How much income would Farmer Fran Corporation report for the year related to its investment under the assumption that it: A. Paid $150 million for 15 percent of the common stock and uses the fair value method to account for its investment in Bails O’ Plenty Corporation. B. Paid $300 million for 30 percent of the common stock and uses the equity method to account for its investment in Bails O’ Plenty Corporation. Answer: A. (15% × $160 million) + (10% x $150M) = $39 million Dividends and unrealized gains are reported as other income. B. 30% × $480 million = $144 million Equity earnings are computed as the reported net income of the investee company multiplied by the percentage of the outstanding common stock owned. Topic: Analyzing and interpreting equity method LO: 4 5. Whitten Corporation purchases an investment in Jerry,Inc. at a purchase price of $6 million cash, representing 25% of the book value of Jerry,Inc. During the year, Jerry,Inc. reports net income of $700,000 and pays $120,000 of cash dividends. At the end of the year, the fair value of Whitten’s investment is $6.4 million. Required A. What is the year-end balance of the equity investment account? B. What amount of equity earnings would be reported by Whitten Corporation? C. How are dividends treated in equity method accounting? What amount in dividends is reported? D. What is the amount of the unrealized gain or loss to be reported for the year? Answer: A. The year-end balance of the investment account is computed as follows: Beginning balance $6,000,000 Percentage of investee income earned 175,000 ($700,000 × 25%) Dividends received (30,000) ($120,000 × 25%) Ending balance $6,145,000 B. The amount of income that Whitten reports equals $175,000 ($700,000 × 25%). The equity earnings are computed by multiplying the net income reported by the investee company and the percentage of the outstanding common stock owned. C. Dividends reduce the year-end balance of the investment account by $30,000 ($120,000 x 25%). Dividends are calculated by multiplying the dividends reported by the investee company by the percentage of the investee company’s book value purchased by the investor company. D. No unrealized gain or loss is reported under the equity method.

. 12-15

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Topic: Consolidation accounting LO: 5, 7 6. Investor C acquired 100% of Investee N at book value. At the date of acquisition, Investor C had $160,000 in assets (including the investment in Investee N), $30,000 in liabilities, and $130,000 in equity. Investee N had $60,000 in assets, $16,000 in liabilities, and $44,000 in equity on the date of acquisition. What will the assets, liabilities, and equity be on the consolidated balance sheet immediately following the acquisition?

Assets

Investor C $160,000

Investee N $60,000

Liabilities

$30,000

$16,000

Equity

$130,000

$44,000

Consolidated Company

Answer: Assets = $160,000 + $60,000 ‒ $44,000 = $176,000 Liabilities = $30,000 + $16,000 = $46,000 Equity = $130 000 + $44,000 ‒ $44,000 = $130,000 Topic: Consolidation accounting LO: 5, 7 7. Investor P acquired (at book value) 100% of Investee G. At the date of acquisition, Investor P had $160,000 in assets (including the investment account at $22,000) and $36,000 in equity. Investee G had $30,000 in assets and $8,000 in liabilities at the date of acquisition. What will the assets, liabilities, and equity be on the consolidated balance sheet immediately following the acquisition?

Assets

Investor P $160,000

Liabilities Equity

Consolidated Company

Investee G $30,000 $8,000

$36,000

Answer: Assets = $160,000 ‒ $22,000 + $30,000 = $168,000 Liabilities = ($160,000 ‒ $36,000) + $8,000 = $132,000 Equity = $36,000 + $22,000 ‒ $22,000 = $36,000

. Test Bank, Chapter 12

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Topic: Accounting for equity method investments LO: 4 8. On December 31, 2021, Hakka Company acquired 45% of Paiwan Company’s common stock for $3.0 million, representing 45% of Paiwan Company’s book value. In 2022, the fair value of Hakka’s investment in Paiwan Company increased to $3.7 million. On December 31, 2022, Paiwan declared net income of $800,000. It also paid its stockholders a dividend of 20% of its 2022 income. Required A. How would you classify Hakka Company’s investment in Paiwan Company? Explain. B. What will Hakka report on its income statement for the investment in Paiwan for 2022? C. What will be the ending balance of Hakka’s Investment account on December 31, 2022? Answer: A. Because Hakka ownership in Paiwan is more than 20% but less than 50%, the investment should be classified as significant influence and should be accounted for using the equity method. B. In 2022, Hakka would report $360,000 (0.45 × $800,000) as investment revenue from Paiwan. C. The December 31, 2022 balance of the Investment Account is computed as follows: Balance December 31, 2021 Percentage of investee’s income earned (0.45 × $800,000) Less: Dividends Received (0.45 × 0.20 × $800,000) Balance December 31, 2022

$3,000,000 360,000 (72,000) $3,288,000

Topic: Consolidation LO: 5, 7 9. Consider two companies with the pre-acquisition balance sheets presented below. BigGuy Investor Company purchases 100% of WittleGuy Investee Company’s stock at book value by exchanging newly issued common stock. Complete the columns for Investor’s post-acquisition balance sheet and the Consolidated Company post-acquisition balance sheet. Pre-acquisition Balance Sheets BigGuy WittleGuy Investor Investee Company Company Current assets

$100,000

$50,000

Other assets

80,000

38,000

Total assets

$180,000

$88,000

Liabilities

$60,000

$20,000

Common stock

60,000

50,000

Retained earnings

60,000

18,000

$180,000

$88,000

Post-acquisition balance sheets BigGuy Investor Company

Consolidated Company

Investment

Total liabilities and equity

. 12-17

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Answer: Post-acquisition balance sheets BigGuy Investor Company

Consolidated Company

$ 100,000

$ 150,000

Investment

68,000

Other assets

80,000

118,000

Total assets

$248,000

$268,000

Liabilities

$ 60,000

$80,000

Common stock

128,000

128,000*

Retained earnings

60,000

60,000**

Current assets

Total liabilities and equity

$248,000

$268,000

*($128,000 + 50,000 - $50,000) = $128,000 **($60,000 + $18,000 -$18,000) = $60,000

Topic: Consolidation of Financial Statements LO: 5 10. Eduardo Corp. owns 100% of Arkansas Group, Inc.’s stock. Eduardo Corp. prepares consolidated financial statements. Data from the annual reports of the two companies are:

Eduardo Corp. (consolidated) Arkansas Group, Inc.

Sales

Net Income

Dividends

$3,000,000 $ 600,000

$800,000 $ 140,000

$100,000 $ 20,000

Required A. How much of the $3,000,000 consolidated sales reported by Eduardo Corp. is from operations of Arkansas Group? B. How much of the $800,000 consolidated net income reported by Eduardo Corp. is from operations of Arkansas Group? Answer: A. Eduardo Corp. reports 100% of Arkansas Group, Inc.’s sales, $600,000. B. Net income from Arkansas Group, Inc. = 100% × $140,000 = $140,000. The consolidated income statement includes the gross sales and expenses of the investee.

. Test Bank, Chapter 12

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Topic: Analyzing financial effects of trading securities LO: 1, 2, 3 11. Trellis Company had the following transactions and adjustment related to a stock investment. 2021 Nov. 18

Purchased 25,000 shares of Rocks & Mud Company common stock at $30 per share plus a brokerage commission of $5,000. Brick expects to sell the stock in the near future.

Dec. 22

Received a cash dividend of $2.60 per share of common stock from Rocks & Mud.

Made the adjusting entry to reflect year-end fair value of the stock investment in Rocks & Mud. The year-end market price of the Rocks & Mud common stock is $32 per share.

2022 Feb. 20

Sold all 25,000 shares of the Rocks & Mud common stock for $866,000.

Prepare the journal entries to record these transactions. Answer: 2021 11/18 12/22

Investment in Rocks & Mud Company Cash

755,000

Cash

65,000

755,000

Dividend income 12/31

65,000

Investment in Rocks & Mud Company. Unrealized gain (income) Year-end fair value: $32 x 25,000 shares = $800,000. Subtract current book value of $755,000, to record an unrealized gain of $45,000.

45,000

Cash

866,000

45,000

2022 2/20

Investment in Rocks & Mud Company Gain on sale of investment in Rocks & Mud Company (income)

. 12-19

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Problems Topic: Available-for-sale securities LO: 1, 3 1. Following is a portion of the investments footnote from Sports Suppliers’ 2022 annual report.

In millions

2022 Available-for-sale securities: Economic development bonds Asset-backed securities

Gross Cost

Unrealized Gains

Unrealized Losses

Fair Value

$223,630 153,968 $377,598

$ 1,998 31,442 $33,440

$ (8,646) — $ (8,646)

$216,982 185,410 $402,392

$245,002

$(19,902)

$225,172

2021 Available-for-sale securities: Economic development bonds

Required A. At what amount does Sports Suppliers report its available-for-sale securities on its balance sheets for 2022 and 2021? B. How does Sports Suppliers account for its trading securities? How does the accounting differ from their accounting method for available-for-sale securities? C. What are the net unrealized gains (losses) for 2022 and 2021? How did these unrealized gains (losses) affect the company’s reported income in 2022 and 2021? D. What is the difference between realized and unrealized gains and losses? Are realized gains and losses treated differently in the income statement than unrealized gains and losses for the available-for-sale securities? Answer: A. Available-for-sale securities are reported at fair value on the balance sheet. Thus, Sports Suppliers’ available-for-sale investments are reported at: $402,392 million as of 2022 and $225,172 million as of 2021. B. Like available-for-sale securities, trading securities are reported at fair value on the balance sheet. Unlike available-for-sale securities, the unrealized gains or losses on trading securities would be reported in the income statement. C. Net unrealized gains for 2022 are $24,794 million ($33,440 million gains – $8,646 million losses). Net unrealized losses for 2021 are $(19,830) million ($72 million – $19,902 million). These unrealized losses correspond to the available-for-sale portfolio so they bypass the income statement and are reported directly in the balance sheet. D. Unrealized gains and losses occur when the investment increases or decreases in value after the investor buys the investment (i.e. “paper profits”). Realized gains and losses occur when the investor sells the investment. For available-for-sale securities, unrealized gains and losses flow through other comprehensive income in the equity section of the balance sheet (i.e. no income statement effects). When available-for-sale securities are sold (assuming there is a gain), other comprehensive income is reduced and a gain is realized in the income statement.

. Test Bank, Chapter 12

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Topic: Allocating purchase price LO: 2, 5 2. Computer Castle Corporation reported the following in its 2022 annual report regarding acquisition of Mary’s Motherboards: Acquisition of Mary’s Motherboards, Inc. On January 31, 2022 we completed our acquisition of Mary’s Motherboards, Inc., a provider of hardware systems, software and services, by means of a merger of one of our wholly owned subsidiaries with and into Motherboards such that Motherboards became a wholly owned subsidiary of See the Future. We acquired Motherboards to, among other things, expand our product offerings by adding Motherboards’s existing hardware systems business and broadening our software and services offerings. We have included the financial results of Motherboards in our consolidated financial statements from the date of acquisition. (in millions) Cash, cash equivalents and marketable securities Trade receivables Inventories Goodwill Intangible assets In-process research and development Other assets Deferred tax assets, net Accounts payable and other liabilities Deferred revenues Total preliminary purchase price

$ 5,142 4,860 662 2,582 7,694 830 4,070 2,500 (7,900) (2,230) $18,210

Required A. Of the total assets acquired, what portion is allocated to tangible assets and what portion to intangible assets? B. Are Motherboards’s assets (both tangible and intangible) reported on the consolidated balance sheet at the book value or at the fair market value on the date of the acquisition? Explain. C. Explain how the intangible assets are valued at the time of the acquisition. D. How are the tangible and intangible assets accounted for subsequent to the acquisition?

. 12-21

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Answer: A. Cash and securities Trade receivables Other assets Inventories Deferred taxes assets, net Total tangible assets

$ million $ 5,142 4,860 4,070 662 2,500 $17,234

Goodwill Intangible assets In process R&D Total intangible assets

$ 2,582 7,694 830 $11,106

60.8%

39.2%

B. All assets of the acquired company are reported on the consolidated balance sheet at their fair market values on the date of the acquisition, not at their net book values. Fair values are the most objective value at acquisition. They are the “historic cost” of the new assets. C. Intangible assets are valued as an estimate of the value of future economic benefits. This is very imprecise and involves significant estimates, both of the timing and amount of expected cash flows and of the discount rate. D. Subsequent to the acquisition, the tangible assets are accounted for like any other acquired asset: the receivables are removed when collected, inventories become future cost of goods sold, and depreciable assets are depreciated over their estimated useful lives. Intangible assets with a determinable life are amortized over their useful lives. Finally, because indefinite life intangibles and goodwill have indeterminate useful lives, they are not amortized, but are tested annually for impairment, or more often if circumstances require.

. Test Bank, Chapter 12

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Topic: Interpreting goodwill and intangible footnote LO: 5 3. The following is from footnotes to the Dependent Power, Inc. 2022 annual report (in millions): The following table summarizes the changes in the carrying amount of goodwill for 2022 and 2021: In millions Goodwill at December 31, 2020 Divestitures Translation and other Goodwill at December 31, 2021 Acquisitions Translation and other Goodwill at December 31, 2022

Components $ 676 (50) (4) 622 182 12 $ 816

Distribution $ 22 — (2) 20 18 — $ 38

Power Generation $ 24 — — 24 — — $ 24

Engine Total 12 $ 734 — (50) — (6) 12 678 — 200 — 12 $ 12 $ 890 $

Intangible assets that have finite useful lives are amortized over their estimated useful lives. The following table summarizes our other intangible assets with finite useful lives that are subject to amortization: In millions Software Less: Accumulated amortization Net software Trademarks, patents and other Less: Accumulated amortization Net trademarks, patents and other Total

December 31, 2022 2021 990 $ 818 (436) (382) 554 436 280 88 (96) (70) 184 18 738 $ 454

Amortization expense for software and other intangibles totaled $128 million, $114 million and $138 million for the years ended December 31, 2022, 2021, and 2020, respectively. Internal and external software costs (excluding those related to research, re-engineering and training), trademarks and patents are amortized generally over a three to 12 year period. The following table represents the projected amortization expense of our intangible assets, assuming no further acquisitions or dispositions. In millions

2023

Projected amortization expense

154

2024

For the years ended 2025 2026

148

144

132

2027 - 2028 $

112

Under GAAP for goodwill, we have the option to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value as a basis for determining whether it is necessary to perform an annual two-step goodwill impairment test. The two-step impairment test is now only required if an entity determines through this qualitative analysis that it is more likely than not that the fair value of the reporting unit is less than its carrying value. In addition, carrying value of goodwill must be tested for impairment on an interim basis in certain circumstances where impairment may be indicated. When we are required or opt to perform the two-step impairment test, the fair value of each reporting unit is estimated by discounting the after tax future cash flows less requirements for working capital and fixed asset additions. Our reporting units are generally defined as one level below an operating segment. However, there were two situations where we have aggregated two or more components which share similar economic characteristics and thus are aggregated into a single reporting unit for testing purposes. These two situations are described further below. This analysis has resulted in the following reporting units for our goodwill testing: Continued next page

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• • • • •

Within our Components segment, emission solutions and filtration have been aggregated into a single reporting unit. Also within our Components segment, our turbo technologies business is considered a separate reporting unit. Within our Power Generation segment, our generator technologies business is considered a separate reporting unit. Within our Engine segment, our new and recon parts business is considered a separate reporting unit. This reporting unit is in the business of selling new parts and remanufacturing and reconditioning engines and certain engine components. Our Distribution segment is considered a single reporting unit as it is managed geographically and all regions share similar economic characteristics and provide similar products and services.

No other reporting units have goodwill. Our valuation method requires us to make projections of revenue, operating expenses, working capital investment and fixed asset additions for the reporting units over a multiyear period. Additionally, management must estimate a weighted-average cost of capital, which reflects a market rate, for each reporting unit for use as a discount rate. The discounted cash flows are compared to the carrying value of the reporting unit and, if less than the carrying value, a separate valuation of the goodwill is required to determine if an impairment loss has occurred. In addition, we also perform a sensitivity analysis to determine how much our forecasts can fluctuate before the fair value of a reporting unit would be lower than its carrying amount. We performed the required procedures as of the end of our fiscal third quarter and determined that our goodwill was not impaired. At December 31, 2022, our recorded goodwill was $890 million, approximately 90 percent of which resided in the emission solutions plus filtration reporting unit. For this reporting unit, the fair value of the reporting unit exceeded its carrying value by a substantial margin. Changes in our projections or estimates, a deterioration of our operating results and the related cash flow effect or a significant increase in the discount rate could decrease the estimated fair value of our reporting units and result in a future impairment of goodwill. Required A. How much goodwill did Dependent Power, Inc. report on its 2022 balance sheet? How much accumulated amortization was included in that amount? Explain. B. How much impairment charge relating to goodwill did Dependent Power, Inc. report in 2022 and what was the reason for this? C. What was the value of intangible assets with finite lives on Dependent Power, Inc.’s 2022 balance sheet? How much accumulated amortization was included in that amount? Answer: A. Dependent Power, Inc. reports goodwill of $890 million on its 2022 balance sheet. No accumulated amortization was included in that amount. Goodwill is not routinely amortized because it is an asset with indefinite life. Instead the company periodically reviews goodwill for over-valuation. B. As explained in the footnotes above, the Company did not record an impairment since a discounted present value test did not yield a fair value below the carrying amount of the reporting unit. C. Dependent Power, Inc.’s 2022 balance sheet included intangible assets of $738 million. This is net of accumulated amortization of $532 million ($436 + $96).

. Test Bank, Chapter 12

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Essays Topic: Motivations for investment LO: 1 1. Why do corporations undertake intercorporate investments? How might our understanding of these reasons influence our analysis of such investments? Answer: There are several reasons for intercorporate investments and the various accounting methods reflect this. •

Passive ownership, (trading, available-for-sale, or HTM debt securities or equity securities with insignificant influence), is generally used as a way to put excess cash to good use. However, in our analysis we should watch for investor companies that place a disproportionate amount of their wealth in marketable securities, rather than into their core operations. If these securities are held for trading, then we should be even more attuned to the possibility that the investor company is attempting to “play the market” in an unwise fashion, mimicking the practices of a financial services corporation.

•

Significant-influence equity ownership often stems from a strategic alliance with the investee company, and such relations are often very sensible business arrangements. Unfortunately, these relations cloud our ability to analyze the investor company because some of the investee’s assets and all of its liabilities are not represented. Additionally, even though the investor company is not legally liable for the debts of the investee, business realities may dictate that the practical exposure of the investor company is more significant.

•

Investments with control allow the investor company access to new markets, new technologies, or new products. Acquisitions often bring skilled personnel, such as researchers or sales staff. Even though consolidation of the balance sheet makes many details of the investment more transparent, complications can arise, especially with regards to income. Many things about the structure and policy of the investee company may differ from the investor company, and these differences are allowed to persist after consolidation. Some of these differences can pertain to dividend policy or restrictions, varying international regulations, and the power of noncontrolling shareholders.

. 12-25

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Topic: Derivatives LO: 2, 8 2. Companies are required to disclose both qualitative and quantitative information about the potential risks underlying derivatives. A. In general, what types of qualitative information must be disclosed? B. Explain the reporting of quantitative information in financial statements that relates to derivatives. Answer: A. In general, the fair value of the derivative must be disclosed unless it is not possible to derive this value. When the fair value is disclosed the assumptions to calculate the fair value should be presented. If it is not possible to derive fair value, then the company should disclose information that it has, which would normally be used in a valuation, including the carrying value, effective interest rate, and maturity date. Risk issues should also be disclosed and include collateral that could be lost, potential loss, the transactions for which hedges manage risk, and the reason derivatives are used. B. The asset or the liability to which the derivative is related is reported on the balance sheet at fair value. If the hedge is effective and not speculative, then the asset and liability will be offsetting so that net equity is unaffected. Likewise, the related gains and losses of a derivative are relatively offsetting in effective hedging activities, so that income is unaffected. Unrealized gains and losses of cash flow hedges (for example, hedging of planned commodity purchases) accumulate in other comprehensive income until the transaction is complete and current income is recognized. Unrealized gains and losses for fair value hedges (like swaps or hedged securities) are reported in current income along with changes in the hedged assets or liabilities. Topic: Equity method investments LO: 4 3. Refuse Disposal Inc. reports the following in the 2022 Form 10-K (in millions): 2022

2021

2020

From the Income Statement: Equity in losses of unconsolidated entities

$(92)

$(62)

$(42)

From the Operating section of the Cash Flow Statement: Equity in net losses of unconsolidated entities, net of dividends

$92

$62

$42

Required A.W hy does Refuse Disposal’s income statement deduct its share of net losses of the unconsolidated entities? B.E xplain the reconciling item on Refuse Disposal’s statement of cash flow that adds back equity in net losses of unconsolidated entities, net of dividends. Answer: A. Refuse Disposal uses the equity method for its unconsolidated entities. The investor’s share of net income, or in this case, a net loss, is included as income. This reduced Refuse Disposal’s net income – the losses amounts are deducted to arrive at net income. B.T he net losses of unconsolidated entities is a non-cash expense for the year. Therefore to reconcile net income to cash from operations, the amount must be added back to net income because it was originally subtracted in arriving at net income. However, dividends received are an operating cash inflow but do not affect net income; they are therefore added to net income. . Test Bank, Chapter 12

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Topic: Equity method vs. consolidation LO: 4, 5 4. Explain the standards which determine if an investor company will report its investment in an investee company using the equity method vs. consolidation. Why might the investor company prefer the equity method? Answer: Consolidation must be used if the investor has “control,” usually indicated by the share of investee company voting stock held by investor company greater than 50%. Other contractual agreements can result in the relevant “control” status, even if the percentage held is less than 50%. The relevant test is whether or not the investor company can dictate key strategic policies. The equity method is used when a lesser standard of “significant influence” is met, typically assumed when the portion of the investee company shares owned lies between 20-50%. Consolidation (purchase) requires that the balance sheet of the investee company be combined with that of the investor company. This increases both the assets and liabilities of the investor company. As long as the investor holds just enough of the investee company to maintain equity-method status, some of assets and (more importantly) all of the liabilities of the investee company are missing from the investor company’s balance sheet. Topic: Definition of significant influence LO: 1, 4 5. What is meant by significant influence? Describe situations in which you believe a company has significant influence over the operations of another company. How is significant influence in investments accounted for? Answer: Significant influence is determined by such factors as representation on the board of directors of the investee company, participation in decision making processes, sharing of managerial personnel, legal agreements (such as license to use technology, a formula or a trade secret) or substantial intercompany transactions (such as sole supplier, sole customer relationships). Unless there is evidence to the contrary, significant influence is presumed if a company owns more than 20% and no more than 50% of the outstanding voting stock of an investee. Significant influence can be determined, however, in cases when the investor owns less than 20% of the outstanding common stock of another entity, if one or more of the above described situations exist. In general, if a company can exercise some control over the operations of another entity, it should be scrutinized for significant influence over that entity. Significant influence investments are accounted for using the equity method: the investor sets up an investment account and records the percent of its ownership in the investee’s equity. The percent of investee’s income/loss is added to the investment account and any dividends are subtracted. Equity method does not present the actual assets and liabilities associated with the investment.

. 12-27

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Topic: Limitations of consolidated financial statements LO: 5 6. Describe the limitations of the consolidated financial statements. Answer: While consolidated financial statements can be helpful in analyzing the state of a company, the financial statements have limitations which should be considered. First, there can be difficulty in comparing the financial statements of individual subsidiaries. Differences in accounting procedures, etc., means that the financial statements were arrived at differently, and therefore, are not directly comparable. Second, because the assets for all the subsidiaries are lumped together on the consolidated balance sheet, there is no indication of the cash flows of individual subsidiaries. Potential problems with liquidity may not be easily recognizable. Next, in some cases a financially strong company will combine with a financially weak company. Because the assets, liabilities, etc., are all rolled into one, the strength or weakness of individual companies is hidden. This is inaccurate partly because the resources of one company will not necessarily be used to settle the debts of another. Fourth, the consolidated financial statements generally do not indicate intercompany transactions. Last, the consolidation of finance and insurance subsidiaries can be particularly problematic for analysis. Because the companies are so dissimilar, the consolidated numbers will be very distorted.

. Test Bank, Chapter 12

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Appendix A Compound Interest and the Time-Value of Money True/False

Topic: Compound interest 1. When interest is earned on interest in a savings account in a bank, this is called compound interest. Answer: True Rationale: As interest accumulates on an investment, both the original investment and the accumulated interest will earn a return in subsequent periods. Topic: Time value of money 2. A dollar received today is worth more than a dollar received two years ago. Answer: False Rationale: It is much better to receive money as soon as possible as it can be invested and will earn additional interest. Topic: Financial calculator 3. The interest rate on a financial calculator to be inputted using the I/Yr key means to enter the rate per period. Answer: True Rationale: I/Yr is the interest rate per period. Topic: Compounding 4. If an investment is made that pays 5% annual interest for a 3-year period with semiannual compounding, the number of periods is 6. Answer: True Rationale: There are 6 semiannual periods in three years: 3 years × 2 times per year = 6 periods of compounding.

. A-1

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Topic: Installment loans 5. Installment loans require a series of equal payments that often vary in the time period between each payment. Answer: False Rationale: Installment notes have equal payments on a periodic basis, such that the time period between each payment must be the same. Topic: Bond valuation 6. There are two cash flows associated with bonds—a balloon payment and periodic interest payments. Answer: True Rationale: The balloon payment is the principal due when the bond matures. Interest payments are most often paid semiannually.

. Test Bank, Appendix A

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. A-3

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Multiple Choice

Topic: Bond pricing (using a financial calculator or Excel) 1. TJ Services issued bonds with a face value of $5,000,000 and a coupon rate of 4% paid semiannually for 5 years. The market rate of interest is 3%. How much is the market value of the bonds? A. B. C. D.

$4,308,336 $4,573,490 $5,228,985 $5,230,555

Answer: D Rationale: Interest payment = $5,000,000 × 4% × 1/2 = $100,000 N = 10 (5 *2)

I/Y = 1.5 (3% / 2)

PV = ?

PMT = 100,000

FV = 5,000,000

PV = $5,230,555 Topic: Time value of money 2. Why is one dollar now worth more than one dollar in the future? A. B. C. D.

The time value of money depreciates over long periods of time The amount to be received in the future is smaller than the amount to be paid off today The value of interest declines over time Funds can be invested in earning assets to yield a positive return

Answer: D Rationale: Investing money received today generates interest so that the investor will have more accumulated funds compared to waiting to receive funds in the future. . Test Bank, Appendix A

A-4

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Topic: Future value (using a financial calculator or Excel) 3. If an investor invests $2,500,000 today at 4% interest compounded semiannually, how much will be in the bank account two years from the date invested? (Select the closest amount) A. B. C. D.

$2,706,080 $2,924,646 $2,704,000 $2,601,000

Answer: A Rationale: N = 4 (2 * 2)

I/Y = 2.0 (4% / 2)

PV = 2,500,000

PMT = 0

FV = ?

FV = $2,706,080

. A-5

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Topic: Bond pricing (using a financial calculator or Excel) 4. Geoglyph Industries issued bonds with a face value of $10,000,000 and a coupon rate of 4% paid semiannually for 5 years. The market rate of interest is 5%. How much is the market value of the bonds using a financial calculator? A. B. C. D.

$ 7,683,480 $10,449,129 $ 9,562,397 $ 8,701,157

Answer: C Rationale: Interest payment = $10,000,000 × 4% × 1/2 = $200,000 N = 10 (5*2)

I/Y = 2.5 (5%/2)

PV = ?

PMT = 200,000

FV = 10,000,000

PV = $9,562,397 Topic: Bond pricing (using a financial calculator or Excel) 5. Geoglyph Industries issued bonds with a face value of $10,000,000 and a coupon rate of 4% paid semiannually for 4 years. The market rate of interest is 5%. How much is the market value of the bonds? A. B. C. D.

$8,207,466 $9,641,493 $8,936,215 $9,645,405

Answer: B Rationale: Interest payment = $10,000,000 × 4% × 1/2 = $200,000 N =8 (4* 2)

I/Y = 2.5 (5% /2)

PV = ?

PMT = 200,000

FV = 10,000,000

PV = $9,641,493 Topic: Present value of a single amount 6. Which of the following determines the present value of a single cash payment? A. B. C. D.

Future value × (1 + discount rate) Future value ÷ (1 + discount rate) Future value × (1 ‒ discount rate) Future value ÷ (1 ‒ discount rate)

Answer: B Rationale: 1 plus the discount rate is divided into the future amount.

. Test Bank, Appendix A

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Topic: Present value of an investment (using a financial calculator or Excel) 7. Saucy, Inc. wishes to accumulate $1,500,000 to be used to pay off a note at the end of 5 years. How much will Saucy, Inc. invest today to accumulate the desired amount if the investment earns an annual rate of 6% compounded quarterly? (Select the closest amount) A. B. C. D.

$ 830,514 $1,113,706 $1,116,141 $1,293,913

Answer: B Rationale: N =20 (5*4)

I/Y = 1.5 (6%/4)

PV = ?

FV = 1,500,000

PV = $1,113,706 Topic: Future value of annuity (using a financial calculator or Excel) 8. Saucy, Inc. wishes to accumulate $1,500,000 to be used to pay off a loan at the end of 3 years. How much will Saucy, Inc. deposit each month for three years, beginning at the end of the first month, to accumulate the desired amount if the investment earns an annual rate of 6%, compounded monthly? (Select the closest amount) A. B. C. D.

$ 15,652 $ 34,821 $115,020 $ 38,133

Answer: D Rationale: N = 36 (3*12)

I/Y = 0.5 (6%/12)

PMT = ?

FV =1,500,000

PMT = $38,133

. A-7

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Exercises Topic: Present value of a sum (using a financial calculator or Excel) 1. Salbador Motor Company wants to accumulate $2,000,000 to pay off an equipment loan due in 6 years. How much should Salbador Motor Company deposit today if the bank pays 5% interest compounded annually? Answer: N=6

I/ Y = 5

PV = ?

PMT = 0

FV = 2,000,000

PV = $1,492,431 Topic: Present value of a sum (using a financial calculator or Excel) 2. Salbador Motor Company wants to accumulate $2,000,000 to pay off an equipment loan due in 6 years. How much should Salbador Motor Company deposit today if the bank pays 5% interest compounded semiannually? Answer: N = 12(6*2)

I/Y = 2.5 (5%/2)

PV = ?

PMT = 0

FV = 2,000,000

PV = $1,487,112 Topic: Future value of an annuity (using a financial calculator or Excel) 3. Salbador Motor Company wants to accumulate $1,500,000 to pay off an equipment note due in 4 years. How much should Salbador Motor Company deposit each quarter beginning one quarter from today to accumulate the amount required if the bank pays 5% annual interest compounded quarterly? Answer: N = 16 (4 * 4)

I/Y = 1.25 (5% /4)

PV = 0

PMT = ?

FV = 1,500,000

PMT = $85,270 Topic: Future value of an annuity (using a financial calculator or Excel) 4. Salbador Motor Company wants to accumulate $1,500,000 to pay off an equipment loan due in 3 years. How much should Salbador Motor Company deposit each month beginning one month from today in order to accumulate $1,500,000 if the bank pays 6% annual interest with monthly compounding? Answer: N = 36 (3 * 12)

I/Y = 0.5 (6% / 12)

PV = 0

PMT = ?

FV = 1,500,000

PMT = $38,133

. Test Bank, Appendix A

A-8

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Topic: Present value of a sum (using a financial calculator or Excel) 5. Colt Co. needs to have $250 million accumulated to fund health insurance payments for its retirees. Will Colt Co. have enough accumulated at the end of 4 years if it deposits $200 million today if compounding occurs semiannually with an annual rate of 6%? Answer: N = 8 (4*2)

I/Y = 3 (6% /2)

PV = 200,000,000

PMT = 0

FV = ?

FV = $253,354,016 Yes, it will have over $253.3 million accumulated, which is enough to fund the health insurance. Topic: Installment note (using a financial calculator or Excel) 6. Colt Co. borrowed $2,000,000 to buy equipment to be repaid as a installment note monthly over 4 years. How much will Colt Co. pay each month if payments begin one month from now and the annual loan rate is 6% compounded monthly? Answer: N = 48(4 * 12)

I/Y = 0.5 (6% /12)

PV = 2,000,000

PMT = ?

FV = 0

PMT = $46,970 Topic: Balloon note (using a financial calculator or Excel) 7. Colt Co. borrowed $500,000,000 to buy equipment with the total principal and interest to be repaid as a balloon note at the end of 4 years. How much will Colt Co. pay to liquidate the note at the maturity date if interest is 6% compounded quarterly? Answer: N = 16 (4 *4)

I/Y =1.5 (6% /4)

PV = 500,000,000

PMT = 0

FV = ?

FV = $634,492,774 Topic: Present value of bonds (using a financial calculator or Excel) 8. Top Notch Investments recently issued bonds with a face value of $4,000,000 and a coupon rate of 4% for 5 years. The market rate of interest is 3% and the bonds pay interest semiannually. Compute the market value of the bond on the issue date. Answer: Interest payment = $4,000,000 × 4% × 1/2 = $80,000 N = 10 (5 *2) I/Y = 1.5 (3% /2) PV = ?

PMT =80,000

FV = 4,000,000

PV = $4,184,444

. A-9

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Topic: Present value of notes (using a financial calculator or Excel) 9. Walsh Pharmaceuticals is a new drug company entering the market. It plans to issue notes with a face value of $10,000,000 and a coupon rate of 5% for 10 years. The market rate of interest is 4%. Compute the market value of the notes on the issue date if interest is paid semiannually. Answer: Interest payment = $10,000,000 × 5% × 1/2 = $250,000 N = 20 (10 * 2) I/Y = 2 (4% / 2) PV = ?

PMT = 250,000

FV = 10,000,000

PV = $10,817,572

. Test Bank, Appendix A

A-10

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Problems Topic: Bond pricing (using a financial calculator or Excel) 1. McQuade Services recently issued bonds with a face value of $15,000,000 and a coupon rate of 5% for 20 years. The market rate of interest is 4%. A. Compute the market value of the bonds if interest is paid annually. B. Computer the market value of the bonds if interest is paid semiannually. C. Explain the difference in the market value determined in parts A and B. Answer: A. Interest payment = $15,000,000 × 5% = $750,000 N = 20 I/Y = 4 PV = ?

PMT = 750,000

FV = 15,000,000

PV = $17,038,549 B. Interest payment = $15,000,000 × 5% × 1/2 = $375,000 N = 40 (20 * 2)

I/Y = 2 (4% / 2)

PV = ?

PMT = 375,000

FV = 15,000,000

PV = $17,051,661 C. The present value differs because interest is compounded more frequently with the semiannual payments providing a better return to the investor, so the investor is willing to pay $13,112 (= $17,051,661 - $17,038,549) more if the interest is compounded semiannually. Topic: Present value calculations (using a financial calculator or Excel) 2. An investment of $2,200,000 will return $500,000 per year for 5 years. Should the investment be undertaken if the market interest rate is 5% and interest is compounded annually? Answer: N=5

I/Y = 5

PV = ?

PMT = 500,000

FV = 0

PV = $2,164,738 No. Based on the financial aspects of the investment, it should not be undertaken as the present value of $2,164,738 is less than the required initial investment.

. A-11

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Topic: Bond pricing (using a financial calculator or Excel) 3. Amber Restaurants, Inc. plans to issue 10-year notes with a face value of $20,000,000 and a coupon rate of 4.5%. The market rate of interest is 4%. Interest payments will be made semiannually. A. Compute the market value of the notes. B. Assume the market rate remains at 4% after 4 years. How much cash will Amber Restaurants, Inc. need to pay off the notes at this time? Answer: A. Interest payment = $20,000,000 × 4.5% × 1/2 = $450,000 N = 20 (10 * 2) I/Y = 2 (4% / 2) PV = ? 20,000,000

PMT = 450,000

FV =

PMT = 450,000

FV =

PV = $20,817,572 B. Interest payment = $20,000,000 × 4.5% × 1/2 = $450,000 N = 12 (6 * 2) I/Y = 2 (4% / 2) PV = ? 20,000,000 PV = $20,528,767 Topic: Present value (using a financial calculator or Excel) 4. Compute the present value for each of the following amounts. A. $100,000 received in 5 years if annual interest rate is: (1) 8% compounded annually or (2) 8% compounded semiannually B. $15,000 received at the end of each year for the next 6 years if the market rate of interest is 5% per year compounded annually Answer: A. (1) N = 5 PV = $68,058 (2) N = 10 (5*2) PV = $67,556 B. N = 6 PV = $76,135

I/Y = 8

PV = ?

FV = 100,000

I/Y = 4 (8% / 2)

PV = ?

FV = 100,000

I/Y = 5

PV = ?

PMT = 15,000

. Test Bank, Appendix A

A-12

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Essays Topic: Present value 1. Why is one dollar now worth more than one dollar in the future? Answer: In periods of inflation, the purchasing power of a dollar declines over time. Consequently, a dollar in hand today is worth more than one to be received in the future. Even in the absence of inflation, funds can be invested in earning assets to yield a positive return.

. A-13

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