Solutions are provided in Appendix B.

1. Why should an individual learn to read and interpret financial statements?

a) Understanding financial statements will guarantee at least a 20% return on investments.
b) An individual need not learn to read and interpret financial statements because auditors
offer a report indicating whether the company is financially sound or not.
c) Learning to read and interpret financial statements will enable individuals to gain
employment.
d) Individuals cannot necessarily rely on auditors and management of firms to offer
honest information about the financial well-being of firms.

2. Which of the following organizations write accounting rules?

a) FASB and Congress.
b) EDGAR and IASB.
c) FASB, SEC, and IASB.
d) SOX, SEC, and IASB.

3. What is the goal of the IASB?

a) To have worldwide acceptance of a set of international financial reporting standards.
b) To create a set of accounting rules that Europe and the United States will follow.
c) To create a set of accounting rules for countries other than the United States.
d) To work with the SEC to create a set of accounting rules for publicly held companies.

4. What are the basic financial statements provided in an annual report?

a) Balance sheet and income statement.
b) Statement of financial earnings and statement of stockholders’ equity.
c) Balance sheet, income statement, and statement of cash flows.
d) Balance sheet, income statement, statement of cash flows, and statement of stockholders’
equity.

5. What items are included in the notes to the financial statements?

a) Summary of accounting policies.
b) Changes in accounting policies, if any.
c) Detail about particular accounts.
d) All of the above.

6. What does an unqualified auditor’s report indicate?

a) The financial statements unfairly and inaccurately present the company’s financial position for
the accounting period.
b) The financial statements present fairly the financial position, the results of operations,
and the changes in cash flows for the company.
c) There are certain factors that might impair the firm’s ability to continue as a going concern.
d) Certain managers within the firm are unqualified and, as such, are not fairly or adequately
representing the interests of the shareholders.

7. Which of the following statements is false?

a) The Sarbanes-Oxley Act of 2002 was the cause of the demise of Enron.
b) The FASB and the IASB are working closely to develop a set of accounting rules that would
ultimately be used by all publicly traded companies worldwide.
c) The Public Company Accounting Oversight Board is responsible for monitoring auditors of all
publicly owned companies.
d) The Sarbanes-Oxley Act of 2002 requires the chief executive officer and the chief financial
officer of a publicly traded company to certify the accuracy of the financial statements.
8. What does Section 404 of the Sarbanes-Oxley Act of 2002 require?
a) A ten-year jail sentence and $1 million fine for violations of the act.
b) Rotation of audit partners every five years.
c) A statement by the company regarding the effectiveness of internal controls and a
disclosure of any material weaknesses in a firm’s internal control system.
d) Auditor independence, which prohibits audit firms from offering any services other than audit
services.

9. What subject(s) should the management discussion and analysis section discuss?
a) Liquidity.
b) Commitments for capital expenditures.
c) A breakdown of sales increases into price and volume components.
d) All of the above.

10. Which of the following statements is true?

a) Annual reports only contain glossy pictures.
b) Public relations material should be used cautiously.
c) Market data refers to the advertising budget of a firm.
d) The shareholders’ letter should be ignored.

11. What information can be found in a proxy statement?

a) Information on voting procedures.
b) Information on executive compensation.
c) Information on the breakdown of audit and nonaudit fees paid to the audit firm.
d) All of the above.

12. Which information is hard to find or missing from the financial statements?
a) Total long-term debt.
b) Net income.
c) Five-year summary of selected financial data.
d) Reputation of the firm with its customers.

13. What is the accrual basis of accounting?

a) Recognition of revenue when it is received in cash.
b) Recognition of revenue in the accounting period when the sale is made rather than when cash
is received.
c) Matching expenses with revenue in the appropriate accounting period.
d) Both (b) and (c).

14. Which of the following are methods by which management can manipulate earnings and
possibly lower the quality of reported earnings?
a) Changing an accounting policy to increase earnings.
b) Refusing to take a loss on inventory in an accounting period when the inventory is known to be
obsolete.
c) Decreasing discretionary expenses.
d) All of the above.

15. Where would you find the following information?

(1) An attestation to the fairness of financial statements.
(2) Summary of significant accounting policies.
(3) Cash flow from operating, financing, and investing activities.
(4) A qualified opinion.
(5) Information about principal, interest, and maturity of long-term debt.
 (6) Financial position on a particular date.
(7) Discussion of the company’s results of operations.
(8) Description of pension plans.
(9) Anticipated commitments for capital expenditures.
(10) Reconciliation of beginning and ending balances of equity accounts.
Financial statements. Notes to the financial statements. Auditor’s report. Management discussion
and analysis.

Chap2
Solutions are provided in Appendix B.
1. What does the balance sheet summarize for a business enterprise?
a) Operating results for a period.
b) Financial position at a point in time.
c) Financing and investment activities for a period.
d) Profit or loss at a point in time.

2. What is the balancing equation for the balance sheet?

a) Assets=Liabilities+Stockholders' equity.
b) Assets+Stockholders' equity=Liabilities.
c) Assets+Liabilities=Stockholders' equity.
d) Revenues−Expenses=Net income.

3. What is a common-size balance sheet?

a) A statement that expresses each account on the balance sheet as a percentage of net
income.
b) A statement that is common to an industry.
c) A statement that expresses each account on the balance sheet as a percentage of
total assets.
d) A statement that expresses each asset account on the balance sheet as a percentage of
total assets and each liability account on the balance sheet as a percentage of total
liabilities.

4. Which of the following assets would be classified as current assets on the balance sheet?
a) Cash, accounts payable, deferred income taxes.
b) Cash equivalents, inventory, prepaid expenses.
c) Accounts receivable; prepaid expenses; property, plant, and equipment.
d) Inventory, goodwill, unearned revenue.

5. What items should be calculated when analyzing the accounts receivable and allowance for
doubtful accounts?
a) The growth rates of sales and inventories.
b) The growth rates of sales, accounts receivable, and the allowance for doubtful
accounts, as well as the percentage of the allowance account relative to the total or
gross accounts receivable.
c) The common-size balance sheet.
d) The growth rates of all assets and liabilities.
6. What type of firm generally has the highest proportion of inventory to total assets?
a) Retailers.
b) Wholesalers
c) . Manufacturers.
d) Service-oriented firms.

7. Why is the method of valuing inventory important?

a) Inventory valuation is based on the actual flow of goods.
b) Inventories always account for more than 50% of total assets and therefore have a
considerable impact on a company’s financial position.
c) Companies desire to use the inventory valuation method that minimizes the cost of goods
sold expense.
d) The inventory valuation method chosen determines the value of inventory on the
balance sheet and the cost of goods sold expense on the income statement, two
items having considerable impact on the financial position of a company.

8. What are three major cost flow assumptions used by U.S. companies in valuing inventory?
a) LIFO, FIFO, average market.
b) LIFO, FIFO, actual cost.
c) LIFO, FIFO, average cost.
d) LIFO, FIFO, double-declining balance.

9. Assuming a period of inflation, which statement is true?

a) The FIFO method understates balance sheet inventory.
b) The FIFO method understates cost of goods sold on the income statement.
c) The LIFO method overstates balance sheet inventory.
d) The LIFO method understates cost of goods sold on the income statement.

10. Why would a company switch to the LIFO method of inventory valuation?
a) By switching to LIFO, reported earnings will be higher.
b) A new tax law requires companies using LIFO for reporting purposes also to use LIFO for
figuring taxable income.
c) LIFO produces the largest cost of goods sold expense in a period of inflation and
thereby lowers taxable income and taxes.
d) A survey by Accounting Trends and Techniques revealed that the switch to LIFO is a
current accounting “fad.”

11. Where can one most typically find the cost flow assumption used for inventory valuation for a
specific company?
a) In The Risk Management Association, Annual Statement Studies.
b) In the statement of retained earnings.
c) On the face of the balance sheet with the total current asset amount.
d) In the notes to the financial statements.

12. What type of firm generally has the highest proportion of fixed assets to total assets?
a) Manufacturers.
b) Retailers.
c) Wholesalers.
d) Retailers and wholesalers.

13. How is goodwill evaluated?

a) Goodwill must be amortized over a 40-year period.
 b) Goodwill should be written up each year.
c) Companies should determine whether goodwill has lost value, and if so, the loss in
value should be written off as an impairment expense.
d) Goodwill is to be written off at the end of the tenth year.
14. Which of the following liabilities would be included in the current liabilities section on the balance
sheet?
a) Capital lease obligations, notes payable, common stock.
b) Accounts payable, short-term debt, unearned revenues.
c) Accrued liabilities, deferred credits, retained earnings.
d) Current maturities of long-term debt, additional paid-in capital, pension obligations.

15. What do current liabilities and current assets have in common?

a) Current assets are claims against current liabilities.
b) If current assets increase, then there will be a corresponding increase in current liabilities.
c) Current liabilities and current assets are converted into cash.
d) Current liabilities and current assets are those items that will be satisfied and
converted into cash, respectively, in one year or one operating cycle, whichever is
longer.

16. Which of the following items could cause the recognition of accrued liabilities?
a) Sales, interest expense, rent.
b) Sales, taxes, interest income.
c) Salaries, rent, insurance.
d) Salaries, interest expense, interest income.

17. Which statement is false?

a) Deferred taxes are the product of temporary differences in the recognition of revenue and
expense for taxable income relative to reported income.
b) Deferred taxes arise from the use of the same method of depreciation for tax and
reporting purposes.
c) Deferred taxes arise when taxes actually paid are less than tax expense reported in the
financial statements.
d) Temporary differences causing the recognition of deferred taxes may arise from the
methods used to account for items such as depreciation, installment sales, leases, and
pensions.

18. Which of the following would be classified as long-term debt?

a) Mortgages, current maturities of long-term debt, bonds.
b) Mortgages, long-term notes payable, bonds due in 10 years.
c) Accounts payable, bonds, obligations under leases.
d) Accounts payable, long-term notes payable, long-term warranties.

19. What accounts are most likely to be found in the stockholders’ equity section of the balance
sheet?
a) Common stock, long-term debt, preferred stock.
b) Common stock, additional paid-in capital, liabilities.
c) Common stock, retained earnings, dividends payable.
d) Common stock, additional paid-in capital, retained earnings.

20. What does the additional paid-in capital account represent?

a) The difference between the par and the stated value of common stock.
b) The price changes that result for stock trading subsequent to its original issue.
c) The market price of all common stock issued.
 d) The amount by which the original sales price of stock exceeds the par value.

21. What does the retained earnings account measure?

a) Cash held by the company since its inception.
b) Payments made to shareholders in the form of cash or stock dividends.
c) All undistributed earnings.
d) Financial resources currently available to satisfy financial obligations.

22. Listed below are balance sheet accounts for Elf’s Gift Shop. Mark current accounts with “C” and
noncurrent accounts with “NC.”
(a) Long-term debt. NC
(b) Inventories. C
(c) Accounts payable. C
(d) Prepaid expenses. C OR NC
(e) Equipment. NC
(f) Accrued liabilities. C
(g) Accounts receivable. C
(h) Cash. C
(i) Bonds payable. NC
(j) Patents. NC

23. Dot’s Delicious Donuts has the following accounts on its balance sheet: 1) Current assets. 2)
Property, plant, and equipment.3) Intangible assets.4) Other assets. 5)Current liabilities. 6)Deferred
federal income taxes.7) Long-term debt.8) Stockholders’ equity. How would each of the following
items be classified?
(a) Land held for speculation. 4
(b) Current maturities on mortgage. 5
(c) Common stock. 8
(d) Mortgage payable. 7
(e) Balances outstanding on credit sales to customers. 1
(f) Accumulated depreciation. 2
(g) Buildings used in business. 2
(h) Accrued payroll. 5
(i) Preferred stock. 8
(j) Debt outstanding from credit extended by suppliers. 5
(k) Patents. 3
(l) Land on which warehouse is located. 2
(m) Allowance for doubtful accounts. 1
(n) Liability due to difference in taxes paid and taxes reported. 6
(o) Additional paid-in capital. 8

24. Match the following terms to the correct definitions.

(a) Consolidated financial statements. 7
(b) Current assets. 1
(c)  Depreciation. 5
(d) Deferred taxes. 9
(e)  Allowance for doubtful accounts. 4
(f) Prepaid expenses. 6
(g) Current maturities. 10
(h) Accrued expenses. 2
(i) Capital lease. 3
(j) Market value of stock. 8
(1) Used up within one year or operating cycle, which
ever is longer.
(2) Expenses incurred prior to cash outflow.
(3) An agreement to use assets that is in substance a purchase.
(4) Estimation of uncollectible accounts receivable.
(5) Cost allocation of fixed assets other than land.
(6) Expenses paid in advance.
(7) Combined statements of parent company and controlled subsidiary companies.
(8) Price at which stock trades.
(9) Difference in taxes reported and taxes paid.
(10) Portion of debt to be repaid during the upcoming year.

Chapter 3

S ELF-T EST
Solutions are provided in Appendix B.
1. 1. What does the income statement measure for a firm?
a. The changes in assets and liabilities that occurred during the period.
b. The financing and investment activities for a period.
c. The results of operations for a period.
d. The financial position of a firm for a period.
2. 2. How are companies required to report total comprehensive
income?
a. On the face of the income statement.
b. In a separate statement of comprehensive income.
c. In the statement of stockholders’ equity.
d. All of the above.
3. 3. Which of the following items needs to be disclosed separately in
the income statement?
a. Discontinued operations.
b. Salary expense.
c. Warranty expense.
d. Bad debt expense.
4. 4. What is a common-size income statement?
a. An income statement that provides intermediate profit measures.
b. An income statement that groups all items of revenue together, then deducts
all categories of expense.
c. A statement that expresses each item on an income statement as a
percentage of net sales.
d. An income statement that includes all changes of equity during a period.
5. 5. Which of the following statements is incorrect with regard to
gross profit or gross profit margin?
 a. The gross profit margin and cost of goods sold percentage are complements
of each other.
b. Generally, firms want to maintain the relationship between gross profit and
sales, or, if possible, increase gross profit margin.
c. The gross profit margin tends to be more stable in industries such as
groceries.
d. When cost of goods sold increases, most firms do not raise prices.
6. 6. Why is it important to evaluate increases and decreases in
operating expenses?
a. Increases in operating expenses may indicate inefficiencies, and
decreases in operating expenses may be detrimental to long-term sales
growth.
b. It is important to determine whether companies are spending at least 10
cents of every sales dollar on advertising expenses.
c. Increases in operating expenses are always an indication that a firm will
increase sales in the future.
d. None of the above.
7. 7. Which of the following assets will not be depreciated over its
service life?
a. Buildings.
b. Furniture.
c. Land.
d. Equipment.
8. 8. How are costs of assets that benefit a firm for more than one year
allocated?
a. Depreciation.
b. Depletion and amortization.
c. Costs are divided by service lives of assets and allocated to repairs and
maintenance.
d. Both (a) and (b).
9. 9. Why should the expenditures for repairs and maintenance
correspond to the level of investment in capital equipment and to the age and
condition of that equipment?
a. Repairs and maintenance expense is calculated in the same manner as
depreciation expense.
b. Repairs and maintenance are depreciated over the remaining life of the
assets involved.
c. It is a generally accepted accounting principle that repairs and maintenance
expense is generally between 5% and 10% of fixed assets.
d. Inadequate repairs of equipment can impair the operating success of a
business enterprise.
10. 10. Why is the figure for operating profit important?
a. This is the figure used for calculating federal income tax expense.
b. The figure for operating profit provides a basis for assessing the
success of a company apart from its financing and investment activities
and separate from its tax status.
 c. The operating profit figure includes all operating revenues and expenses as
well as interest and taxes related to operations.
d. The figure for operating profit provides a basis for assessing the wealth of a
firm.
11. 11. Why can the equity method of accounting for investments in the
voting stock of other companies cause distortions in net earnings?
a. Significant influence may exist even if the ownership of voting stock is less
than 20%.
b. Income is recognized where no cash may ever be received.
c. Income should be recognized in accordance with the accrual method of
accounting.
d. Income is recognized only to the extent of cash dividends received.
12. 12. Why should the effective tax rate be evaluated when assessing
earnings?
a. It is important to understand whether earnings have increased because
of tax techniques rather than from positive changes in core operations.
b. Effective tax rates are irrelevant because they are mandated by law.
c. Effective tax rates do not include the effects of foreign taxes.
d. Net operating losses allow a firm to change its effective tax rates for each of
the five years prior to the loss.
13. 13. Which of the following items should be recorded as other
comprehensive income?
a. Foreign currency translation effects.
b. Extraordinary gains and losses.
c. Realized gains and losses.
d. All of the above.
14. 14. What are three profit measures calculated from the income
statement?
a. Operating profit margin, net profit margin, repairs and maintenance to fixed
assets.
b. Gross profit margin, cost of goods sold percentage, EBIT.
c. Gross profit margin, operating profit margin, net profit margin.
d. None of the above.
15. 15. When is a dual presentation of basic and diluted earnings per
share required?
a. When a company has pension liabilities.
b. When convertible securities are in fact converted.
c. When a company has a simple capital structure.
d. When a company has a complex capital structure.
1. 16. What is a statement of stockholders’ equity?
a. It is the same as a retained earnings statement.
b. It is a statement that reconciles only the treasury stock account.
c. It is a statement that summarizes changes in the entire stockholders’
equity section of the balance sheet.
d. It is a statement reconciling the difference between stock issued at par value
and stock issued at market value.
 2. 17. What accounts can be found on a statement of stockholders’ equity?
a. Investments in other companies.
b. Treasury stock, accumulated other comprehensive income, and
retained earnings.
c. Market value of treasury stock.
d. Both (a) and (c).
3. 18. Which of the following cause(s) a change in the retained earnings
account balance?
a. Prior period adjustment.
b. Payment of dividends.
c. Net profit or loss.
d. All of the above.
4. 19. Match the following terms with the correct definitions:
1. 4 (a) Depreciation.
2. 9 (b) Depletion.
3. 13 (c) Amortization.
4. 8 (d) Gross profit.
5. 5 (e) Operating profit.
6. 14 (f) Net profit.
7. 1 (g) Equity method.
8. 6 (h) Cost method.
9. 11 (i) Single-step format.
10. 2 (j) Multiple-step format.
11. 10 (k) Basic earnings per share.
12. 12 (l) Diluted earnings per share.
13. 3 (m) Extraordinary events.
14. 7 (n) Discontinued operations.
Definitions
15. Proportionate recognition of investee’s net income for investments in voting stock
of other companies.
16. Presentation of income statement that provides several intermediate profit
measures.
17. Unusual events not expected to recur in the foreseeable future.
18. Allocation of costs of tangible fixed assets.
19. Difference between sales revenue and expenses associated with generating sales.
20. Recognition of income from investments in voting stock of other companies to the
extent of cash dividend received.
21. Operations that will not continue in the future because the firm sold a major portion
of its business.
22. Difference between net sales and cost of goods sold.
23. Allocation of costs of acquiring and developing natural resources.
24. Earnings per share figure calculated by dividing the average number of common
stock shares outstanding into the net earnings available to common stockholders.
25. Presentation of income statement that groups all revenue items, then deducts all
expenses, to arrive at net income.
26. Earnings per share figure based on the assumption that all potentially dilutive
securities have been converted to common stock.
27. Allocation of costs of intangible assets.
28. Difference between all revenues and expenses.
5. 20. The following categories appear on the income statement of Joshua Jeans
Company:
. Net sales.
a. Cost of sales.
b. Operating expenses.
c. Other revenue/expense.
d. Income tax expense.
Classify the following items according to income statement category:
1. c (1) Depreciation expense.
2. d (2) Interest revenue.
3. a (3) Sales revenue.
4. c (4) Advertising expense.
5. d (5) Interest expense.
6. a (6) Sales returns and allowances.
7. e (7) Federal income taxes.
8. c (8) Repairs and maintenance.
9. c (9) Selling and administrative expenses.
10. b (10) Cost of products sold.
11. d (11) Dividend income.
12. c (12) Lease payments.