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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
3
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
12
Problems
Essay Questions
1-5
3, 4
. 1-1
3, 5
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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
A.
2.
Board of directors
B.
3.
Managerial accounting
C.
4.
Stock market regulators
D.
5.
Creditors
E.
6.
Shareholders
F.
Designed primarily for decision makers outside of the company Elected by the shareholders to oversee management Owners of a corporation
7.
Financial accounting
G.
Securities and Exchange Commission
8.
Publicly traded corporations
H.
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
A.
Launch a new product or not?
2.
Productions and operations
B.
Purchase/sell goods from/to the company?
3.
Creditors
C.
Develop a new company strategy?
4.
Investors and analysts
D.
Lend to the company or not?
5.
Top management
E.
Manage operations?
6.
Marketing teams
F.
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
_______
c.
_______
d. Contributed capital
_______
e. Retained earnings
_______
f.
_______
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
A.
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
B.
The company’s accountant ignores a $1.60 error in recording an invoice, discovered after the final financial statements were prepared.
3. Benefits > Costs
C.
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
D.
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
E.
In estimating the life of a new piece of equipment, the accounting department assumes that the business will last indefinitely.
6. Materiality
F.
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 .
Test Bank, Chapter 1
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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
1,235
Net income
32,560
32,560
Dividends
(14,930)
(14,930)
Other stockholders’ equity changes
_______
_______
(592)
(592)
Balance, January 31, 2024
$10,705
$171,420
$1,871
$183,996
. 1-21
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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
93
Cash, January 1, 2024
2,472
Cash, December 31, 2024
$ 2,565
. Test Bank, Chapter 1
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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
. Test Bank, Chapter 1
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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 Accounting, 7th Edition
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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.
. Test Bank, Chapter 1
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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
5
6, 9, 14, 15, 17
6, 7
5, 6
6, 7
8, 10-12
3, 8, 12
3
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
2
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
6
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.
. Test Bank, Chapter 2
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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.
. Test Bank, Chapter 2
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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.
. 2-5
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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.
. Test Bank, Chapter 2
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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.
. 2-7
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