Chapter 11

Business Essentials, Canadian Edition, 9e (Ebert)
Chapter 11 Understanding Accounting
11.1 Multiple Choice Questions
1) ________ is the comprehensive information system for collecting, analyzing, and

communicating financial information, while ________ is the recording of financial transactions.
A) Financial accounting; managerial accounting
B) Managerial accounting; financial accounting
C) Bookkeeping; accounting
D) Accounting; bookkeeping
E) Controlling; accounting
Answer: D
Diff: 2 Type: MC Page Ref: 240
Skill: Knowledge
Objective: 11.1
2) Employees and unions use accounting information

A) to plan for tax inflows.
B) to set goals, develop plans, set budgets, and evaluate prospects.
C) to estimate returns.
D) to decide if the company is a good credit risk.
E) to plan for benefits.
Answer: E
Skill: Comprehension
Objective: 11.1
3) Janice is a bookkeeper. Her primary function would be to

A) generate financial statements.
B) measure business performance.
C) record accounting transactions.
D) complete the same tasks as accountants do.
E) determine the value of the firm to investors.
Answer: C
Objective: 11.1
1
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4) The field of accounting that is concerned with external users of a company's financial
information is called
A) managerial accounting.
B) bookkeeping.
C) public accounting.
D) financial accounting.
E) auditing.
Answer: D
Skill: Knowledge
Objective: 11.1
5) The field of accounting that serves internal users of a company's financial information is
A) financial accounting.
B) auditing.
D) bookkeeping.
E) managerial accounting.
Answer: E
Skill: Knowledge
Objective: 11.1
6) David is an accountant who calls attention to problems and helps managers carry out the
planning, decision making, and controlling functions. David is involved in ________ accounting.
A) budgeting
B) financial
C) auditing
D) managerial
E) generally accepted accounting principles
Answer: D
Objective: 11.1
7) Marshall is preparing a statement of estimated profits and losses for a new product that has
just been introduced by his company. The field of accounting that Marshall is working in is
A) managerial accounting.
B) auditing.
D) financial accounting.
E) bookkeeping.
Answer: A
Objective: 11.1
2
8) Arthur's primary responsibility as an auditor is
A) publishing the audit report results in the Financial Post.
B) preparing budgets for the forthcoming year.
C) ensuring the firm's accounting practices adhere to generally accepted accounting principles.
D) collecting taxes.
E) determining that the company has the inventory that it says it has.
Answer: C
Objective: 11.1
9) Which of the following is correct with respect to generally accepted accounting principles?
A) Public and private businesses can no longer use generally accepted accounting principles.
B) They are used in many foreign countries but not in Canada.
C) Public companies in Canada have moved away from using generally accepted accounting
principles and have adopted International Financial Reporting Standards (IFRS).
D) Private companies must use the new International Financial Reporting Standards (IFRS).
E) None of these statements is correct.
Answer: C
Objective: 11.1
10) The CPA Canada Handbook now has various parts, Part I is known as ________ and is
designed for publicly accountable enterprises and government private enterprises; Part II is
known by the abbreviation ________ and is designed for private companies.
A) ASPE, IMF
B) IFRS, ASPE
C) Global GAAP, GAAP
D) CPA, CGA
E) GAAP, IPRS
Answer: B
Skill: Knowledge
Objective: 11.1
11) ________ call(s) attention to problems and helps managers carry out the planning, decision
making, and controlling functions.
A) Budgeting
B) Financial accounting
C) Auditing
D) Managerial accounting
E) Generally accepted accounting principles
Answer: D
Skill: Knowledge
Objective: 11.1
3
12) Who manages the entire firm's accounting activities?
A) Venture capitalist
B) Private accountant
C) Controller
D) Public (not chartered) accountant
E) Auditor
Answer: C
Skill: Knowledge
Objective: 11.1
13) Government agencies would be most interested in the output of ________ accountants, while
company salespeople would be most interested in the output of ________ accountants.
A) public; private
B) private; public
C) managerial; financial
D) financial; managerial
E) financial; financial
Answer: D
Skill: Knowledge
Objective: 11.1
14) Rose is reviewing a company's accounting system, checking the ledgers and journals, and
tracking some transactions to see how they were handled. Rose is engaged in
A) financial accounting.
B) managerial accounting.
C) auditing.
D) public accounting.
E) bookkeeping.
Answer: C
Objective: 11.1
15) Martin is a salaried accountant who has been hired by Lexar Corp. to carry out its day-to-day
financial activities. Martin is a(n)
A) public accountant.
B) auditor.
C) controller.
D) private accountant.
E) advisor.
Answer: D
Objective: 11.1
4
16) A(n) ________ examines a company's accounting system to determine whether its financial
reports fairly present its operations.
A) tax analysis
B) preliminary examination
C) company-wide analysis
D) portfolio analysis
E) audit
Answer: E
Skill: Knowledge
Objective: 11.1
17) Forensic accountants are sometimes used to

A) ensure that the accounting system adheres to GAAP.
B) track down hidden funds in business firms.
C) ensure auditors follow auditing standards.
D) ensure businesses remain profitable.
E) do all of these.
Answer: B
Objective: 11.1
18) Which of the following is correct with regard to auditing?

A) An audit focuses specifically on whether the inventory the company claims it has is actually
there.
B) Companies do not normally have to supply audited financial statements when they apply for
loans or when selling stock.
C) Audits determine if the firm has controls in place to prevent errors or fraud from going
undetected.
D) Auditors generally do not have to examine documents such as cancelled cheques, payroll
record, and cash receipts in order to conduct their audit.
E) Auditors ensures that the financial state of the company will be accurately reported.
Answer: C
Objective: 11.1
5
19) Al Rosen is working as a private investigator of white-collar crimes. He is
A) an IFRS accountant.
B) a financial scanner.
C) a whistleblower.
D) an auditor.
E) a forensic accountant.
Answer: E
Objective: 11.1
20) Which of the following is correct with regard to private accountants?

A) They are hired by business firms who do not want to use the services of CPAs.
B) They are employed by business firms in areas such as marketing research, law, and
production technology.
C) They are becoming less common as CPAs become more prominent and skilled.
D) They are almost exclusively found at the head office of business firms.
E) They are hired to deal with companies' day-to-day accounting needs.
Answer: E
Objective: 11.1
21) Janice is a private accountant. The first thing she must do when working through the
accounting cycle is to
A) record transactions in a journal.
B) do a trial balance.
C) analyze transaction documents.
D) analyze the financial statements using ratio analysis.
E) transfer entries from the journal to the ledger.
Answer: C
Skill: Application
Objective: 11.1
22) Barry is a private accountant who is working through the accounting cycle. He has already
analyzed transaction documents. His next step is to
C) prepare financial statements.
Answer: A
Skill: Application
Objective: 11.1
6
23) Sheena is a private accountant who is working through the accounting cycle. She has
completed transferring entries from the journal to a ledger. Her next step is to
C) prepare financial statements.
Answer: B
Skill: Application
Objective: 11.1
24) The accounting equation is

A) owners' equity - assets = liabilities.
B) owners' equity - liabilities = assets.
C) assets + liabilities = owners' equity.
D) assets + owners' equity = liabilities.
E) assets = liabilities + owners' equity.
Answer: E
Skill: Knowledge
Objective: 11.2
25) A(n) ________ is any economic resource expected to benefit a firm or the individual who
owns it.
A) owners' equity
B) asset
C) debit
D) liability
E) credit
Answer: B
Skill: Knowledge
Objective: 11.2
26) A(n) ________ is a debt owed by a firm to an outside organization or individual.

A) liability
B) owners' equity
C) debit
D) asset
E) credit
Answer: A
Skill: Knowledge
Objective: 11.2
7
27) ________ is the amount of money owners would theoretically receive if they sold all of a
firm's assets and paid all of its liabilities.
A) Asset
B) Debit
C) Credit
D) Liability
E) Owners' equity
Answer: E
Skill: Knowledge
Objective: 11.2
28) What is the formula for determining owners' equity?

A) Assets minus liabilities
B) Assets plus liabilities
C) Assets minus goodwill
D) Current assets minus current liabilities
E) There is no formula for computing owners' equity.
Answer: A
Skill: Knowledge
Objective: 11.2
29) Owners' equity consists of two sources of capital. They are

A) the amount that the owners originally invested, and profits earned by and reinvested in the
company.
B) bank loans and money received from factoring accounts receivable.
C) bank loans and proceeds from the sale of stock.
D) trade credit and bank loans.
E) dividends received by investors and bank loans.
Answer: A
Skill: Knowledge
Objective: 11.2
30) An asset is
A) the amount of money originally invested in a business by its owners.
B) the amount of money that owners would receive if they sold all a firm's assets and paid all of
its liabilities.
C) the profits earned by and reinvested in the company.
D) any economic resource expected to benefit a firm or an individual who owns it.
E) a debt owed by a firm to an outside organization or individual.
Answer: D
Objective: 11.2
8
31) Owners' equity is
A) the profits earned by and reinvested in the company.
B) the amount of money that owners would receive if they sold all a firm's assets and paid all of
its liabilities.
C) the amount of money originally invested in a business by its owners.
D) a debt owed by a firm to an outside organization or individual.
E) any economic resource expected to benefit a firm or an individual who owns it.
Answer: B
Objective: 11.2
32) Under which condition is owners' equity positive?

A) Assets are greater than liabilities.
B) Assets and liabilities are equal.
C) Credits exceed debits.
D) Liabilities are greater than assets.
E) Debits exceed credits.
Answer: A
Objective: 11.2
33) Under which condition is owners' equity negative?

A) Credits exceed debits.
B) Assets are greater than liabilities.
C) Assets and liabilities are equal.
D) Debits exceed credits.
E) Liabilities are greater than assets.
Answer: E
Objective: 11.2
34) According to the accounting equation, if assets equal $4000 and liabilities equal $1500, then
owner's equity would equal
A) $5500.
B) $2500.
C) $3500.
D) $8000.
E) It is not possible to tell with the information given.
Answer: B
Skill: Application
Objective: 11.2
9
35) Which of the following is correct with respect to the issue of owners' equity?
A) It is the amount of cash listed on the balance sheet.
B) It is the amount of money the owners would receive if they sold all a company's assets and
paid all its liabilities.
C) If a company's assets exceed its liabilities, owners' equity equals $10 000 for each dollar of
assets.
D) If a company's liabilities exceed its assets, owners' equity equals minus $10 000 for each
dollar of liabilities.
E) All of these are correct.
Answer: B
Objective: 11.2
36) Financial statements fall into three broad categories, which are
A) debits, credits, and loans.
B) income statements, balance sheets, and statements of cash flows.
C) assets, liabilities, and owners' equity.
D) cash, marketable securities, and goodwill.
E) budgets, income statements, and profit-and-loss statements.
Answer: B
Skill: Knowledge
Objective: 11.3
37) Which of the following ensures that the accounting equation is always kept in balance?
A) Credits
B) Debits
C) Double-entry accounting
D) Balance sheet
E) T-accounts
Answer: C
Skill: Knowledge
Objective: 11.3
38) Peter, an accountant, enters every transaction in the journal to reflect its impact on assets and
its impact on liabilities and owners' equity. He is using
A) a double-entry accounting system.
B) a balance sheet.
C) a financial ratio.
D) breakeven analysis.
E) a financial statement.
Answer: A
Objective: 11.3
10
39) The financial statement detailing a firm's assets, liabilities, and owners' equity is the
A) income statement.
B) statement of cash flows.
C) balance sheet.
D) manufacturing statement.
E) statement of retained earnings.
Answer: C
Skill: Knowledge
Objective: 11.3
40) What are the three types of assets that will typically be found on a balance sheet?
A) Local, national, and international
B) Positive, negative, and neutral
C) Land, buildings, and equipment
D) Current, fixed, and intangible
E) Short term, long term, and medium term
Answer: D
Diff: 2 Type: MC Page Ref: 245-246
Skill: Knowledge
Objective: 11.3
41) A balance sheet would not be able to help a manager answer which question?
A) Is it a good time to try to grow the business?
B) Can the company survive if a period of low revenues happens?
C) Does the company have an excessive number of employees?
D) Is the company able to take on more debt?
E) What is the total value of all the company's assets?
Answer: C
Objective: 11.3
42) If the following facts were known, which one would strengthen the argument that a company
would be able to meet its current financial obligations?
A) The level of accounts payable is high.
B) Liabilities exceed assets.
C) The company currently has a negative cash flow.
D) The company needs to increase the number of customers it serves.
E) Assets exceed liabilities.
Answer: E
Skill: Analysis
Objective: 11.3
11
43) A current asset is
A) an expense, such as rent, that is paid before the upcoming period in which it is due.
B) a nonphysical asset, such as a patent or trademark, that has economic value in the form of
expected benefit.
C) an amount due from a customer who has purchased goods on credit.
D) an asset with long-term use or value, such as land, buildings, and equipment.
E) an asset that can or will be converted to cash within the following year.
Answer: E
Objective: 11.3
44) ________ are purchased as short-term investments and are only slightly less liquid than cash.
A) Prepaid expenses
B) Patents
C) Accounts receivable
D) Marketable securities
E) Futures
Answer: D
Skill: Knowledge
Objective: 11.3
45) Stephen is looking at a financial statement that shows detailed information about the
accounting equation factors. He is looking at the company's
A) T-accounts.
B) income statement.
C) balance sheet.
D) double-entry accounting system.
E) profit-and-loss statement.
Answer: C
Objective: 11.3
46) What purpose does the balance sheet serve?

A) It shows the stock price of the firm during the last year and how much fluctuation there have
been in the stock price.
B) It shows short- and long-term liquidity ratios, profitability ratios, and activity ratios.
C) It shows a firm's financial condition on a particular date in terms of its assets, liabilities, and
owners' equity.
D) It shows investors how much profit the firm made during the last year.
E) It shows a firm's sources and uses of cash.
Answer: C
Objective: 11.3
12
47) Which term is used to identify how quickly assets can be converted into cash?
A) Acid-test ratio
B) Activity
C) Accounts receivable
D) Current ratio
E) Liquidity
Answer: E
Skill: Knowledge
Objective: 11.3
48) ________ are amounts due from customers who have purchased goods on credit.
A) Accounts owed
B) Accounts receivable
C) Accounts forwarded
D) Accounts payable
E) Account balances
Answer: B
Skill: Knowledge
Objective: 11.3
49) ________ is an asset that represents the cost of merchandise which was made or bought for
sale to customers and that is still on hand.
A) Accounts payable
B) Prepaid expenses
C) Cost of goods sold
D) Merchandise inventory
E) Accounts receivable
Answer: D
Skill: Knowledge
Objective: 11.3
50) Which of the following is an intangible asset?

A) An inventory level of 1000 copies of a book
B) The copyright for a textbook
C) A printing press used in the publication of a book
D) A $1000 Canada Savings Bond
E) The building in which a book was printed
Answer: B
Objective: 11.3
13
51) What is the accounting term that describes an amount paid for an existing business above the
value of its other assets?
A) A patent
B) A copyright
C) Goodwill
D) A franchise fee
E) Reputation
Answer: C
Skill: Knowledge
Objective: 11.3
52) ________ are non-physical assets, such as a patent or trademark, that have economic value in
the form of expected benefits.
A) Intangible assets
B) Fixed assets
C) Prepaid assets
D) Current assets
E) Long-term assets
Answer: A
Skill: Knowledge
Objective: 11.3
53) An account receivable represents

A) an asset with long-term use or value, such as land, buildings, and equipment.
B) an amount due from a customer who has purchased goods on credit.
C) an expense, such as rent, that is paid before the upcoming period in which it is due.
D) a nonphysical asset, such as a patent or trademark, that has economic value in the form of
expected benefit.
E) an asset that can or will be converted to cash within the following year.
Answer: B
Objective: 11.3
54) If you wanted to see how much Mega Computer owed your company, where would be the
best place to look?
A) Income statement
B) Balance sheet
C) Cash flow statement
D) Budget
E) Net income statement
Answer: B
Objective: 11.3
14
55) Due to a downturn in the local economy, Bob is concerned about converting his assets to
cash quickly. In accounting terms, he is apprehensive about
A) current assets.
B) liquidity.
C) turnover.
D) net income.
E) marketable securities.
Answer: B
Objective: 11.3
56) Rent for the period to come is included in which account on the balance sheet?
A) Inventory
B) Cost of goods sold
C) Merchandise inventory
D) Accounts payable
E) Prepaid expenses
Answer: E
Skill: Knowledge
Objective: 11.3
57) Andy's line of credit with a local bank is likely a(n)

A) intangible asset.
B) prepaid expense.
C) current liability.
D) account receivable.
E) long-term liability.
Answer: C
Objective: 11.3
58) Current liabilities consisting of bills owed to suppliers plus wages and taxes due within the
upcoming year are known as
A) accounts receivable.
B) accounts payable.
C) prepaid expenses.
D) marketable securities.
E) net liabilities.
Answer: B
Skill: Knowledge
Objective: 11.3
15
59) A prepaid expense is
A) an expense, such as rent, that is paid before the upcoming period in which it is due.
B) a nonphysical asset, such as a patent or trademark, that has economic value in the form of
expected benefit.
C) an amount due from a customer who has purchased goods on credit.
D) an asset that can or will be converted to cash within the following year.
E) an asset with long-term use or value, such as land, buildings, and equipment.
Answer: A
Objective: 11.3
60) A fixed asset is

A) an amount due from a customer who has purchased goods on credit.
B) an asset with long-term use or value, such as land, buildings, and equipment.
C) an expense, such as rent, that is paid before the upcoming period in which it is due.
D) an asset that can or will be converted to cash within the following year.
E) a nonphysical asset, such as a patent or trademark, that has economic value in the form of
expected benefit.
Answer: B
Objective: 11.3
61) As buildings and equipment wear out or become obsolete, their value decreases. To reflect
decreasing value, accountants use
A) prepaid expenses.
B) licensing.
C) subtracting methods.
D) depreciation.
E) all of these.
Answer: D
Skill: Knowledge
Objective: 11.3
62) The process of distributing the cost of an asset over its life is known as
A) licensing.
B) subtracting methods.
C) cost averaging.
D) prepaid expenses.
E) depreciation.
Answer: E
Skill: Knowledge
Objective: 11.3
16
63) A current liability is
A) additional money, above proceeds from a stock sale, paid directly to a firm by its owners.
B) the process of distributing the cost of an asset over its useful life.
C) the amount paid for an existing business above the value of its other assets.
D) a debt that is not due for at least one year.
E) a debt that must be paid within the year.
Answer: E
Objective: 11.3
64) Which of the following statements best describes the difference between current and long-
term liabilities?
A) Current liabilities are debts that need to be paid immediately, whereas long-term liabilities do
not.
B) Current liabilities are those which will cost less in debt interest than long-term liabilities.
C) Current liabilities are debts that are settled sooner than long-term debts.
D) Current liabilities are debts on tangible assets, whereas long-term liabilities are debts on
intangible assets.
E) Current liabilities are debts on current assets, whereas long-term liabilities are debts on fixed
and intangible assets.
Answer: C
Objective: 11.3
65) A company's owners invested $10 000 total into the company, which made a profit of $3500
last year. Its total liabilities are currently at $7000. What is the value of the total assets of this
company?
A) $3000
B) $3500
C) $6500
D) $13 500
E) $27 500
Answer: C
Objective: 11.3
17
66) Meredith recently bought a business. But she paid more for the business than the total of its
current and fixed assets. What did she pay extra for?
A) Land the company owns
B) Equipment in the company's factory
C) Goodwill
D) The franchise fee
E) Accounts receivable that are on the company's books
Answer: C
Objective: 11.3
67) Paid-in capital is

A) a debt that must be paid within the year.
B) the process of distributing the cost of an asset over its useful life.
C) the amount paid for an existing business above the value of its other assets.
D) a debt that is not due for at least one year.
E) additional money, above proceeds from a stock sale, paid directly to a firm by its owners.
Answer: E
Objective: 11.3
68) If a firm has $1 000 000 in retained earnings, what does this mean?
A) That the firm had $2 000 000 at the beginning of year but paid out $1 000 000 during the year
in dividends
B) That the company is owed $1 000 000 by its creditors but has not yet collected the money
C) That the firm has $1 000 000 in the bank
D) That the company's net profits less its dividend payments equals $1 000 000
E) That the company has saved $1 000 000 during the period since the last balance sheet was
made up
Answer: D
Objective: 11.3
18
69) Gem Corp. has $100 million in assets and $50 million in liabilities. Last year, the company
earned $10 million in net profit and paid out $5 million in dividends to shareholders. What are
the retained earnings for the company?
A) $50 million
B) $5 million
C) $45 million
D) $90 million
E) $95 million
Answer: B
Skill: Application
Objective: 11.3
70) Prahbat is looking at a financial statement produced by Iron Corp. The statement lists the
company's annual revenues, its expenses, and its profit. Prahbat is looking at a(n)
A) cash flow statement.
B) revenue-expense statement.
C) balance sheet.
D) budget.
E) income statement.
Answer: E
Objective: 11.3
71) The amount of profit or loss will be reflected in the

A) balance sheet.
B) cost of goods sold.
C) quick ratio.
D) income statement.
E) statement of cash flow.
Answer: D
Skill: Knowledge
Objective: 11.3
72) At Lexi Corp., sales revenue is $20 million, the cost of goods sold is $14 million, operating
expenses are $3 million, and income taxes are $1 million. What is the company's gross profit?
A) $6 million
B) $17 million
C) $16 million
D) $2 million
E) None of these
Answer: A
Skill: Application
Objective: 11.3
19
expenses are $3 million, and income taxes are $1 million. What is the company's net income?
A) $6 million
B) $17 million
C) $16 million
D) $2 million
E) The answer cannot be computed with the information provided.
Answer: D
Skill: Application
Objective: 11.3
expenses are $3 million, and income taxes are $1 million. What is the company's operating
income?
A) $6 million
B) $17 million
C) $3 million
D) $2 million
E) None of these
Answer: C
Skill: Application
Objective: 11.3
expenses are $3 million, and income taxes are $1 million. What are retained earnings?
A) $6 million
B) $17 million
C) $3 million
D) $2 million
E) It is not possible to tell with the information provided.
Answer: E
Skill: Application
Objective: 11.3
20
76) If the following facts were known, which one would strengthen the argument that a company
is profitable?
A) The company's sales revenue is low relative to its cost of goods sold.
B) The company's cost of goods sold is low relative to its sales revenue.
C) The number of customers has remained stable for some time.
D) The company has had the same owners over its lifetime.
E) The company's selling expenses are high compared to its administrative expenses.
Answer: B
Skill: Analysis
Objective: 11.3
77) Jerry wants to calculate gross profit for his business. Which formula should he use?
A) Operating expenses minus income taxes
B) Sales revenue minus income taxes
C) Sales revenue minus operating expenses
D) Sales revenue minus cost of goods sold
E) Operating income minus income taxes
Answer: D
Objective: 11.3
78) Which financial statement shows the cost of obtaining materials to make products that were
sold during the year?
A) Income statement
B) Balance sheet
C) Statement of cash flows
D) Operating expenses statement
E) Statement of retained earnings
Answer: A
Skill: Knowledge
Objective: 11.3
79) Which of the following calculates the cost of goods sold during the period?
A) Beginning inventory plus purchases minus ending inventory
B) Ending inventory minus beginning inventory plus purchases
C) Purchases minus beginning inventory plus ending inventory
D) Beginning inventory plus ending inventory minus purchases
E) (Ending inventory plus beginning inventory) divided by two
Answer: A
Skill: Knowledge
Objective: 11.3
21
80) A company has an assets-to-liabilities ratio of 3:2 and total assets worth $6 million. What is
its owners' equity?
A) $1 million
B) $2 million
C) $3 million
D) $9 million
E) $12 million
Answer: B
Skill: Knowledge
Objective: 11.3
81) How much profit does a company (which has a total of $5 million invested by its owners and
$4 million in liabilities) need to make in order to have an assets-to-liabilities ratio of 2:1?
A) $2 million
B) $3 million
C) $5 million
D) $7 million
E) $8 million
Answer: D
Skill: Knowledge
Objective: 11.3
82) If Eric wants to know the cost of obtaining materials to make products that were sold during
the year, he would look at the
A) income statement.
B) statement of cash flows.
C) operating expenses statement.
D) balance sheet.
E) none of these.
Answer: A
Objective: 11.4
22
83) Maggie's Antiques and Collectibles opened with $14 000 beginning inventory. Maggie
purchased an additional $5500 in antiques and sold all but $7500. What is Maggie's cost of
goods sold?
A) $27 000
B) $12 000
C) $19 500
D) $13 000
E) None of these
Answer: B
Skill: Application
Objective: 11.4
84) What is the difference between "profit" and "cash flow"?

A) Profit refers to what is left after expenses have been subtracted from revenues, while cash
flow refers to cash receipts and cash payments.
B) A firm cannot make a profit unless its cash flow is positive.
C) A firm can maximize its profit only at the expense of cash flow.
D) A firm can maximize its cash flow only at the expense of its profit.
E) There is no real difference between profit and cash flow.
Answer: A
Objective: 11.4
85) Cash flow from operations refers to

A) money received from borrowing or issuing stock.
B) cash transactions from buying and selling goods and services.
C) cash used in, or provided by, investing.
D) the cash outflow required to pay dividends.
E) all of these.
Answer: E
Objective: 11.4
23
86) A company has $3.25 million in revenue and has a revenue cost of $1 million. Which of the
following statements is true?
A) In order to have a net income of more than $1.5 million, the operating expenses and income
taxes need to be less than $0.25 million.
B) In order to have a net income of more than $1.5 million, the operating expenses and income
C) In order to have a net income of more than $1.5 million, the operating expenses and income
D) In order to have a net income of more than $1.5 million, the operating expenses and income
E) In order to have a net income of more than $1.5 million, the operating expenses and income
Answer: B
Objective: 11.4
87) Which of the following is designed primarily for internal use by a company's managers (e.g.,
the production manager)?
A) Income statements
B) Statement of retained earnings
C) Budget
D) Balance sheets
E) Statements of cash flow
Answer: C
Skill: Knowledge
Objective: 11.4
88) The earnings cycle is complete under two conditions: ________ and ________.
A) revenue recognition; matching
B) the sale is complete; the customer has paid the company
C) at least two years have passed; the customer has paid the company
D) the sale is complete; the customer has promised to pay the company
E) the cost of goods sold has been determined; operating revenues exceed operating expenses
Answer: B
Skill: Knowledge
Objective: 11.4
24
89) The matching principle states that
A) expenses will be matched with revenues to determine net income for an accounting period.
B) the costs of goods sold must match the total expenses of the firm.
C) the firm needs to match the assets and liabilities in order to record the transaction in its
journal.
D) revenue recognition occurs before the earnings cycle is completed.
E) the total receipts must match the expenditures for a given period of time.
Answer: A
Objective: 11.4
90) ________ is the formal recording and reporting of revenues in financial statements.
A) Compliance
B) Materiality
C) Full disclosure
D) Matching
E) Revenue recognition
Answer: E
Skill: Knowledge
Objective: 11.4
91) ________ allows financial statement users to see how much net gain results from the assets
that had to be given up in order to generate revenues during a given period.
A) Materiality
B) Revenue recognition
C) Compliance
D) Full disclosure
E) Matching
Answer: E
Skill: Knowledge
Objective: 11.4
25
92) A company ended the year with $4.5 million in cash. During this year, it had earned $2.4
million in operating and financing activities. Which of the following statements is necessarily
true?
A) The company started the year with less than $2.1 million.
B) The company started the year with more than $2.1 million.
C) The company started the year with $2.1 million minus the amount of investing activities
during the year.
D) The company started the year with $2.1 million plus the amount of investing activities during
the year.
E) The company started the year with $4.5 million in cash.
Answer: D
Skill: Knowledge
Objective: 11.4
93) Which of the following best illustrates cash flow from operations?
A) The revenue from selling bread at a local bakery
B) The revenue from selling stocks by an insurance company
C) The revenue from new investors in a software start-up
D) The revenue from selling obsolescent trucks by a delivery company
E) The revenue from issuing stock by a financial management firm
Answer: A
Skill: Knowledge
Objective: 11.4
94) Which of the following financial statements is designed primarily for internal use of the
corporation managers (e.g., the production manager)?
A) Income statements
B) Statement of retained earnings
C) Budget
D) Balance sheets
E) Statements of cash flow
Answer: C
Skill: Knowledge
Objective: 11.4
26
95) What is a budget?
A) The estimated number of people required to complete a manufacturing project
B) An estimate of costs submitted to a buyer in order to make a sale
C) An estimate of the cash balance for the year
D) A detailed estimate of receipts and expenditures for a given period of time
E) An estimate of research and development costs
Answer: D
Objective: 11.4
96) To compute the current ratio, current assets are divided by

A) debt.
B) current liabilities.
C) long-term assets.
D) owners' equity.
E) quick assets.
Answer: B
Skill: Knowledge
Objective: 11.5
97) With fixed assets of $4 billion and current assets of $1.7 billion, Realm Company has long-
term liabilities of $2 billion and current liabilities of $0.34 billion. What is Realm's current ratio?
A) 0.85
B) 2
C) 2.44
D) 5
E) 11.76
Answer: D
Skill: Knowledge
Objective: 11.5
98) Executives at Belize Inc. want to see the company's short-term solvency ratios. What
question do they most likely want to have answered?
A) Can immediate debts be paid without obtaining more loans?
B) Is there enough inventory to fulfill sales demands?
C) How much inventory does the company have on hand?
D) How much debt is the company carrying?
E) Are the company's products priced correctly to maximize revenue?
Answer: A
Skill: Analysis
Objective: 11.5
99) Suppose a company unexpectedly receives a huge order for its main product. To cope with
27
this, the owner borrows money to rent an additional facility to fill the orders and to pay the
temporary workers who will produce the large order. The owner does this hoping that the
additional costs will be more than covered by the revenue from selling the additional units of the
product. Which ratio will be most affected by these decisions?
A) The short-term solvency ratio
B) The long-term solvency ratio
C) The profitability ratio
D) The activity ratio
E) The equity ratio
Answer: A
Skill: Analysis
Objective: 11.5
100) What is the purpose of computing the current ratio?

A) To provide investors with some measurement of the returns they can expect from their
investment
B) To measure the extent to which a firm is financed through borrowed money
C) To measure how much cash the firm has
D) To measure the firm's ability to meet emergency demands for cash
E) To measure the firm's ability to meet its current obligations out of its current assets
Answer: E
Objective: 11.5
101) The debt-to-owners' equity ratio measures a firm's ability to meet

A) dividend payments.
B) long-term liabilities.
C) interest payments.
D) short-term liabilities.
E) all liabilities.
Answer: E
Objective: 11.5
28
102) Which of the following calculates the debt-to-owners' equity ratio?
A) Long-term liabilities divided by owners' equity
B) Current liabilities divided by owners' equity
C) Long-term liabilities divided by retained earnings
D) Total liabilities divided by retained earnings
E) Total liabilities divided by owners' equity
Answer: E
Skill: Knowledge
Objective: 11.5
103) How is the debt-to-owners'-equity ratio used?

A) To describe the extent to which the firm is financed through borrowed money
B) To determine how much net income the business earns for each dollar invested
C) To determine how readily the firm can meet unexpected demands for cash
D) To indicate the percentage of revenue which will be profit
E) To determine the percentage of profits paid out to debtholders
Answer: A
Objective: 11.5
104) ________ ratios give investors an idea of what returns they can expect on their investment;
dividing ________ by total owners' equity is one such ratio.
A) Profitability; earnings per share
B) Long-term liquidity; net income
C) Activity; average inventory
D) Short-term liquidity; earnings per share
E) Profitability; net income
Answer: E
Skill: Knowledge
Objective: 11.5
105) What is the purpose of computing profitability ratios?

A) To determine liquidity
B) To determine the most efficient use of resources
C) To determine the liquidity of the firm
D) To determine the potential risk of business activity
E) To determine the potential returns investors can expect
Answer: E
Objective: 11.5
29
106) A company ends the year with a net income of $7.5 million and earnings per share of $1.50.
What is the number of common shares outstanding for this company?
A) 3 million
B) 4.5 million
C) 5 million
D) 6.5 million
E) 11.25 million
Answer: C
Objective: 11.5
107) Don wants to compute the earnings per share for SFX Ltd. How does he do it?
A) Divide sales by the number of common shares outstanding
B) Divide cost of goods sold by the number of common shares
C) Divide net income by the number of common shares outstanding
D) Divide cost of goods sold by average inventory
E) Divide net income by sales
Answer: C
Objective: 11.5
108) What is the purpose of computing the earnings per share ratio?
A) To determine which firm gets the most out of its resources
B) To determine the net profit margin
C) To measure a firm's ability to meet its current liabilities
D) To attract investors
E) To measure the net income earned by a business for each dollar invested
Answer: E
Objective: 11.5
109) How is the return on equity ratio calculated?

A) Operation income divided by retained earnings
B) Net income divided by retained earnings
C) Net income divided by total owners' equity
D) Operating income divided by total owners' equity
E) Net income divided by common stock
Answer: C
Skill: Knowledge
Objective: 11.5
30
110) What does return on equity measure?
A) The amount of pre-tax profit earned for each dollar invested
B) The amount of profit earned for each share of stock
C) The amount of profit earned for each dollar of previous profit retained in the business
D) The amount of profit earned for each dollar invested
E) The amount of pre-tax profit earned for each share of stock
Answer: D
Objective: 11.5
111) An activity ratio measures a firm's

A) sales per employee.
B) frequency of purchases.
C) level of inventory.
D) efficiency in using its assets.
E) sales per selling expense dollar.
Answer: D
Skill: Knowledge
Objective: 11.5
112) The inventory turnover ratio is calculated by

A) dividing cost of goods sold by revenues.
B) dividing average inventory by cost of goods sold.
C) dividing revenues by cost of goods sold.
D) dividing cost of goods sold by average inventory.
E) dividing revenues by average inventory.
Answer: D
Skill: Knowledge
Objective: 11.5
113) Historically, it was thought that the current ratio should be ________, but more recently,
many firms that are financially strong operate with current ratios of ________.
A) at least 10:1; less than 5:0
B) more than 7:1; 2.0
C) less than 5:1; more than 10:1
D) 2:1; less than 2:1
E) 3:1; less than 5:1
Answer: D
Skill: Knowledge
Objective: 11.5
31
114) Sam's Smartphone Accessories Inc. (SMA) has fixed assets of $5 million, current assets of
$2 million, long-term liabilities of $2 million, current liabilities of $1 million, and owners' equity
of $2 million. What is SMA's debt-to-equity ratio?
A) 1.5
B) 0.9
C) 1.2
D) 0.4
E) 0.8
Answer: A
Skill: Application
Objective: 11.5
115) Jack wants to compare the earnings per share of two popular high-tech firms. Which
formula would Jack use?
A) Net income divided by the market value of the common shares
B) Net income divided by the market value of the preferred shares
C) Total assets divided by number of common and preferred shares outstanding
D) Total assets divided by value of common shares outstanding
E) Net income divided by number of common shares outstanding
Answer: E
Objective: 11.5
116) ABC Company has net income of $5 million, $40 million of assets, and $10 million of
liabilities. The number of outstanding shares of stock is 3 870 000 shares. What are earnings per
share?
A) $1.29
B) $0.77
C) $2.35
D) $7.75
E) Earnings per share cannot be computed with the information provided.
Answer: A
Skill: Application
Objective: 11.5
32
117) Which of the following is the most commonly used liquidity ratio?
A) Return on equity
B) Return on sales
C) Current ratio
D) Quick ratio
E) They are all equally used.
Answer: C
Objective: 11.5
118) ________ is the ability of a firm to finance an investment through borrowed funds.
A) Liquidity
B) Leverage
C) Solvency
D) Profitability
E) Activity
Answer: B
Skill: Knowledge
Objective: 11.5
119) With fixed assets of $4 billion and current assets of $1.7 billion, Realm Company has long-
term liabilities of $2 billion and current liabilities of $0.34 billion. What is Realm's current ratio?
A) 2
B) 5
C) 5.88
D) 5.1
E) 6.33
Answer: B
Skill: Application
Objective: 11.5
120) Firm A enjoys a better activity ratio than Firm B. What might this mean?
A) Firm A likely generates greater profits or sales.
B) Firm A uses its resources more efficiently than Firm B.
C) Firm A has more customers than Firm B.
D) Firm A generates greater profits on sales and uses its resources more efficiently than B.
E) It might not mean anything.
Answer: D
Objective: 11.5
33
121) A(n) ________ ratio estimates the risk associated with investing in a firm.
A) financial
B) solvency
C) managerial
D) activity
E) none of these
Answer: B
Skill: Knowledge
Objective: 11.5
122) A(n) ________ ratio evaluates management's use of assets.

A) financial
B) solvency
C) activity
D) profitability
E) liability
Answer: C
Skill: Knowledge
Objective: 11.5
123) The debt-to-equity ratio is calculated by dividing

A) current liabilities by owners' equity.
B) total liabilities by owners' equity.
C) long-term liabilities by retained earnings.
D) total liabilities by retained earnings.
E) long-term liabilities by owners' equity.
Answer: B
Skill: Knowledge
Objective: 11.5
124) What is the primary thing the inventory turnover ratio says about a business?
A) How profitable it is
B) How risky it is
C) How much inventory it has
D) How much average inventory it has
E) How often new merchandise replaces old merchandise
Answer: E
Objective: 11.5
34
125) Which of the following is correct with respect to accounting ethics?
A) It is difficult for one person to make a difference; rather, what is required is organization-
wide action to ensure ethical accounting behaviour.
B) The ultimate purpose of strong ethical standards in accounting is to maintain public
confidence in business institutions and financial markets.
C) The U.S. CPA Code of Ethics does not address the conflict of interest problem.
D) To date, there has been no legislation passed in either the United States or Canada which is
designed to ensure that the general public has confidence in the work of accountants.
E) All of these are correct.
Answer: B
Objective: 11.6
126) In terms of the evolving role of CPAs, which of the following is not true?
A) Accountants are increasingly being asked for advice on broad issues including business
development and the evaluation of strategic opportunities.
B) There are now fewer restrictions imposed by geographical boundaries.
C) CPAs continue to rely on face-to-face interactions at occasional professional meetings.
D) Accountants are increasingly serving as project managers.
E) Accountants need to know the nature of the client's business and its competitive environment.
Answer: C
Skill: Knowledge
Objective: 11.7
127) What is a comprehensive system for collecting, analyzing and communicating financial
information called?
A) Data collection
B) Bookkeeping
C) Balancing
D) Auditing
E) Accounting
Answer: E
Skill: Knowledge
Objective: 11.1
ESL: Alternate/ESL
35
128) What is the individual who manages all the firm's accounting activities called?
A) Accountant
B) Controller
C) Bookkeeper
D) Auditor
E) Data analyst
Answer: B
Skill: Knowledge
Objective: 11.1
ESL: Alternate/ESL
129) Which of the following are the internal procedures that alert managers to problems and aid
them in planning and decision making?
A) Managerial accounting
B) Financial accounting
C) Forensic accounting
D) Public accounting
E) Corporate accounting
Answer: A
Skill: Knowledge
Objective: 11.1
ESL: Alternate/ESL
130) What is the banner designation that is being used to unify the accounting profession in
Canada called?
A) Chartered Accountant (CA)
B) Certified Management Accountant (CMA)
C) Chartered General Accountant (CGA)
D) Certified Professional Accountant (CPA)
E) Canadian Advanced Accountants International (CAA)
Answer: D
Skill: Knowledge
Objective: 11.1
ESL: Alternate/ESL
36
131) Which of the following is an accountant's examination of a company's financial records to
determine if it used proper procedures to prepare its financial records?
A) Verification
B) Review
C) Investigation
D) Analysis
E) Audit
Answer: E
Skill: Knowledge
Objective: 11.1
ESL: Alternate/ESL
132) What are accountants who track down hidden funds in business called?
A) Private accountants
B) Investigative accountants
C) Forensic accountants
D) Fraud accountants
E) Criminal accountants
Answer: C
Skill: Knowledge
Objective: 11.1
ESL: Alternate/ESL
133) What is an accountant hired as a salaried employee to deal with a company's day-to-day
accounting needs called?
A) Private accountant
B) Public accountant
C) Corporate accountant
D) Managerial accountant
E) In house accountant
Answer: A
Skill: Knowledge
Objective: 11.1
ESL: Alternate/ESL
37
134) Which of the following is the formula used by accountants to balance data for the firm's
financial transactions at various points in the year?
A) Owner's equity = assets + liabilities
B) Liabilities = assets + owner's equity
C) Assets = capital + owner's equity
D) Owner's equity = assets + capital
E) Assets — liabilities = owner's equity
Answer: C
Skill: Knowledge
Objective: 11.2
ESL: Alternate/ESL
135) What is anything of economic value owned by a firm or individual called?

A) Asset
B) Capital
C) Owner's equity
D) Benefit
E) Credit
Answer: A
Skill: Knowledge
Objective: 11.2
ESL: Alternate/ESL
136) What is any debt owed by a firm or individual to others called?

A) Claim
B) Mortgage
C) Liability
D) Deficit
E) Asset
Answer: C
Skill: Knowledge
Objective: 11.2
ESL: Alternate/ESL
38
137) What is a type of financial statement that summarizes a firm's financial position on a
particular date in terms of its assets, liabilities and owners' equity called?
A) Income statement
B) Annual report
C) Balance sheet
D) Cash flow statement
E) Statement of owner's equity
Answer: C
Skill: Knowledge
Objective: 11.3
ESL: Alternate/ESL
138) What is cash and other assets that can be converted into cash within a year called?
A) Liquid assets
B) Convertible assets
C) Working assets
D) Fixed assets
E) Current assets
Answer: E
Skill: Knowledge
Objective: 11.3
ESL: Alternate/ESL
139) What is the ease and speed with which an asset can be converted to cash called?
A) Liquidity
B) Convertibility
C) Changeability
D) Reversibility
E) Adaptability
Answer: A
Skill: Knowledge
Objective: 11.3
ESL: Alternate/ESL
39
140) What are assets that have long-term use or value to the firm, such as land, buildings and
machinery called?
A) Intangible assets
B) Variable assets
C) Fixed assets
D) Current assets
E) Structural assets
Answer: C
Skill: Knowledge
Objective: 11.3
ESL: Alternate/ESL
141) What is the accounting method for distributing the cost of an asset over its useful life
called?
A) Writing off
B) Downloading
C) Spread financing
D) Depreciation
E) Downstreaming
Answer: D
Skill: Knowledge
Objective: 11.3
ESL: Alternate/ESL
142) What is a company's net profits less any dividend payments to shareholders called?
A) Current assets
B) Goodwill
C) Net income
D) Owners equity
E) Retained earnings
Answer: E
Skill: Knowledge
Objective: 11.3
ESL: Alternate/ESL
40
143) Which of the following is a type of financial statement that describes a firm's revenues and
expenses and indicates whether the firm has earned a profit or suffered a loss during a given
period?
A) Income statement
B) Balance sheet
C) Cash flow statement
D) Statement of financial position
E) Statement of owner's equity
Answer: A
Skill: Knowledge
Objective: 11.4
ESL: Alternate/ESL
144) What is any money received by a firm as a result of selling a good or service or from other
sources such as interest, rent and licensing fees called?
A) Revenue
B) Income
C) Profit
D) Retained earnings
E) Owner's equity
Answer: A
Skill: Knowledge
Objective: 11.4
ESL: Alternate/ESL
145) What are any expenses directly involved in producing or selling a good or service during a
given time period called?
A) Inventory expense
B) Work-in-progress expenses
C) Cost of goods sold
D) Depreciation
E) Sales expense
Answer: C
Skill: Knowledge
Objective: 11.4
ESL: Alternate/ESL
41
146) What are costs incurred by a firm other than those included in cost of goods sold called?
A) Sales expenses
B) Merchandise expenses
C) Miscellaneous expenses
D) Administrative expenses
E) Operating expenses
Answer: E
Skill: Knowledge
Objective: 11.4
ESL: Alternate/ESL
147) What is a financial statement that describes a firm's generation and use of cash during a
given period called?
A) Cash utilization statement
B) Statement of cash flows
C) Cash production flowsheet
D) Cash turnover statement
E) Cash generation statement
Answer: B
Skill: Knowledge
Objective: 11.4
ESL: Alternate/ESL
148) What is a detailed statement of estimated receipts and expenditures for a future period of
time called?
A) Financial plan
B) Budget
C) Balance sheet
D) Forecast
E) Income statement
Answer: B
Skill: Knowledge
Objective: 11.4
ESL: Alternate/ESL
42
149) What is using borrowed funds to make purchases, thus increasing the user's purchasing
power, potential rate of return and risk of loss called?
A) Pledging
B) Factoring
C) Bridging
D) Leverage
E) Credit
Answer: D
Skill: Knowledge
Objective: 11.5
ESL: Alternate/ESL
150) Which of the following is the ratio that is calculated by dividing net income by sales
revenue?
A) Return on sales ratio
B) Turnover ratio
C) Income ratio
D) Activity ratio
E) Liquidity ratio
Answer: A
Skill: Knowledge
Objective: 11.5
ESL: Alternate/ESL
151) Which of the following are measures of how efficiently a firm uses its resources?
A) Production ratio
B) Activity ratio
C) Quick ratio
D) Turnover ratio
E) Income ratio
Answer: B
Skill: Knowledge
Objective: 11.5
ESL: Alternate/ESL
43
11.2 Critical Thinking Questions
1) Julie, a recent college graduate, is interested in business and is considering pursuing a career
in accounting. Her parents are supportive, with her mother recommending that Julie become a
public accountant and her father recommending that she become a private accountant.
Which of the following, if true, supports the mother's position?
A) Julie has said that she wants to work for one of the accounting services firms like Ernst &
Young.
B) The demand for government accountants is expected to grow.
C) Two other recent grads in Julie's class chose to pursue public accounting.
D) A recent survey showed that about 45 percent of new accountants chose public accounting.
E) Julie has said that she wants to work as an in-house accountant for a large public interest
group like Sierra Club or Greenpeace.
Answer: A
Diff: 3 Type: MC
Skill: Analysis
Which of the following, if true, supports the father's position?
A) Julie has said she wants to work for one of the accounting firms like Ernst & Young.
B) The demand for external auditors is expected to grow.
C) Many accountants flooded the job market when the Arthur Andersen firm went out of
business.
D) Accountants for non-profits are more concerned with efficiency than with profit.
E) Julie has said that she wants to work as an in-house accountant for a large public interest
group like Sierra Club or Greenpeace.
Answer: E
Diff: 3 Type: MC
Skill: Analysis
Which of the following, if true, would support the position that Julie should consider a specialty
field in accounting?
A) Julie wants to eventually pursue an MBA degree.
B) Colleges have different policies on whether specialty accounting courses are required.
C) Julie is interested in financial crimes.
D) Julie is interested in helping a non-profit organization.
E) Julie wants to work directly for a private company.
Answer: C
Diff: 3 Type: MC
Skill: Analysis
44
4) Aardvark is a small pest-control business that has 30 employees. The company started
business within the past year and needs to decide on how best to manage its finances as the
company continues to grow its customer base and its business.
Which of the following, if true, would not strengthen the case that Aardvark needs to hire a full-
time controller?
A) The company needs its cash flow to be continuously monitored.
B) The company needs to determine how to market its products to reach the largest number of
customers.
C) The company needs to have its excess funds invested in high-growth opportunities.
D) The company needs to have financial goals mapped out for it.
E) The company needs to have good sources of funding identified.
Answer: B
Diff: 3 Type: MC
Skill: Analysis
Which of the following questions would be least relevant to a controller as he or she develops a
financial forecast for Aardvark?
A) What are the future plans of the company?
B) What is the current state of the local economy?
C) What is the future state of the local economy likely to be?
D) What subcontractors should the company use?
E) What is the company's competition likely to do?
Answer: D
Diff: 3 Type: MC
Skill: Analysis
Which of the following, if true, would not strengthen the case for Aardvark's closely monitoring
its cash flow?
A) The company needs to make sure it is not spending too much.
B) The company needs to make sure it is generating enough revenue.
C) The company needs to make sure its employees perform well.
D) The company needs to make sure it can always pay its bills.
E) The company needs to make sure it can make capital expenditures.
Answer: C
Diff: 3 Type: MC
Skill: Analysis
45
7) Streeter & Sons is a regional service company that has been in business for a few years but
has not employed a controller or anyone else full-time to keep track of its financial state. The
company needs to take a good look at its financial state to determine whether it needs to make
any changes in its practices, in order to prevent possible financial meltdown.
Which of the following questions would a balance sheet not be able to help answer about the
current state of Streeter & Sons?
A) Is it a good time for the business to grow?
B) Can the company survive a season of low revenues?
C) Does the company have too many employees?
D) Can the company take on more debt?
E) What is the value of the company's assets?
Answer: C
Diff: 3 Type: MC
Skill: Analysis
Which of the following, if true, would strengthen the case that Streeter & Sons will be able to
meet its current financial obligations?
A) The company has high levels of accounts payable.
B) The company's liabilities exceed its assets.
C) The company currently has a negative cash flow.
D) The company needs to expand its number of customers.
E) The company has more assets than it has liabilities.
Answer: E
Diff: 3 Type: MC
Skill: Analysis
Which of the following, if true, would strengthen the case that Streeter & Sons has too much
debt?
A) The company has grown only slowly since its beginning.
B) The company's customer base has steadily increased in the last few years.
C) The company is out-competing other similar companies in the area.
D) The company's current liabilities are higher than its current and fixed assets.
E) The company has built up a substantial amount of owners' equity.
Answer: D
Diff: 3 Type: MC
Skill: Analysis
46
Which of the following, if true, would strengthen the case that Streeter & Sons is profitable?
A) The company's sales revenue is low relative to its cost of goods sold.
B) The company's cost of goods sold is low relative to its sales revenue.
C) The company has had the same number of customers for some time.
D) The company has had the same owners over its lifetime.
E) The company's selling expenses are high relative to its administrative expenses.
Answer: B
Diff: 3 Type: MC
Skill: Analysis
Which of the following, if true, would weaken the case that more than one type of financial
statement should be examined in order to determine a company's financial health?
A) Nowadays, many companies burnish their balance sheet by claiming inflated figures for
goodwill.
B) An income statement from one year may be radically different from the one for the previous
year.
C) It can be difficult for auditors to independently verify certain figures in income statements.
D) The management by data trend has led companies to consider detailed and accurate financial
statements imperative.
E) In times of recession, companies often reduce their accounting and financial management
staffs.
Answer: D
Diff: 3 Type: MC
Skill: Analysis
12) Streeter & Sons is a regional service company that has been in business for a few years, but
Which of the following, if true, would strengthen the case that an income statement would show
Streeter & Sons where its problems lie?
A) The company does not have enough shareholders.
B) The company's expenses are too high.
C) The company's owners' equity is too low.
D) The company needs to hire more service specialists.
E) The company has few intangible assets.
Answer: B
Diff: 3 Type: MC
Skill: Analysis
47
13) Kershner says: "Our income statement should be looking good this year. We've been doing
excellent business this year, so we have a lot of gross sales. The company should be in good
shape."
Michaels replies: "It remains to be seen how our income statement will look overall. Despite
strong sales revenue, the overall income statement might not be as good as we might hope."
Which of the following does Kershner assume?
A) High revenues equate to a healthy income statement.
B) Many factors must be considered to calculate the income statement.
C) The company's revenue next year will be as good as this year's.
D) Operating expenses have been relatively high this year.
E) Gross profit is much lower than gross sales.
Answer: A
Diff: 3 Type: MC
Skill: Analysis
shape."
Which of the following does Michaels assume?
A) Revenues this year were not as high as last year's.
B) Revenues are not as high as Kershner thinks they are.
C) Selling expenses exceeded administrative expenses this year.
D) Other factors must be considered to arrive at an income statement.
E) Income taxes will be high this year.
Answer: D
Diff: 3 Type: MC
Skill: Analysis
shape."
Which of the following, if true, would strengthen Kershner's argument?
A) The total operating expenses were high in the current year.
B) The company's rent went up 30 percent from the previous year.
C) The cost of goods sold was low compared to gross sales.
D) The company is a small one compared to its competitors.
E) The company has a solid core of fixed assets.
Answer: C
Diff: 3 Type: MC
Skill: Analysis
48
shape."
Which of the following, if true, would strengthen Michaels's argument?
A) The company's gross sales went up from the previous year.
B) Total operating expenses were high in the current year.
C) The company has only one part-time accountant.
D) There were few sales returns in the current year.
E) Offshoring allowed the company to trim administrative salaries by 25 percent.
Answer: B
Diff: 3 Type: MC
Skill: Analysis
shape."
Which of the following points out a flaw in Kershner's reasoning?
A) Kershner is not accounting for all of the possible sources of revenue for the company.
B) Kershner is not including owners' equity as part of sales revenue.
C) Income statements are not as important as balance sheets in determining a company's fiscal
health.
D) Many employees are not happy with the direction the company is headed.
E) Kershner is not accounting for the contribution that expenses will make to the income
statement.
Answer: E
Diff: 3 Type: MC
Skill: Analysis
18) At the end of the fiscal year for Santos Industrial Machinery, management raised concerns
about the company's financial performance. The company's accountants have been asked to
analyze the current financial state of the company by using ratio analysis.
Santos needs to assess its debt situation with respect to the value of the company. Which of the
following, if true, would most strengthen the case that Santos's debt is manageable?
A) Santos has a high profitability ratio.
B) Santos has a high inventory turnover ratio.
C) Santos has a low inventory turnover ratio.
D) Santos has a high debt-to-owners'-equity ratio.
E) Santos has a low debt-to-owners'-equity ratio.
Answer: E
Diff: 3 Type: MC
Skill: Analysis
49
19) At the end of the fiscal year for Santos Industrial Machinery, management raised concerns
about the company's financial performance. The company's accountants have been asked to
analyze the current financial state of the company by using ratio analysis.
Santos's executives are most interested in seeing the company's short-term solvency ratios. Based
on this information, what question do they most likely want to have answered?
A) Can the company pay its immediate debts without obtaining further loans?
B) Does the company have enough inventory to meet sales demands?
C) How much inventory on hand does Santos have?
D) How much bonds payable debt is Santos carrying?
E) Is the company selling products at an appropriate price?
Answer: A
Diff: 3 Type: MC
Skill: Analysis
20) Bennequin Manufacturing was a highly profitable firm five years ago, but its net revenue has
since been severely declining, even though the amount of business has been stable. Marlena has
been hired as the new Chief Executive Officer to help turn things around for the company. She
would like to understand what happened financially to the company in the past five years in
order to start coming up with possible solutions. Which of the following documents would be
most useful for her?
A) Income statements from the past five years
B) Debt statements from the past five years
C) Statements of cash flows from the past five years
D) Budgets from the past five years
E) Balance sheets from the past five years
Answer: E
Diff: 3 Type: MC
Skill: Analysis
21) Which of the following scenarios would most likely occur with a company that has reported
disappointing earnings recently but still looks to be financially stable for quite some time?
A) High long-term solvency ratio but low profitability ratio
B) High short-term solvency ratio but low profitability ratio
C) High long-term solvency ratio but low activity ratio
D) High short-term solvency ratio but low activity ratio
E) High long-term solvency ratio but low short-term solvency ratio
Answer: A
Diff: 3 Type: MC
Skill: Analysis
50
11.3 True/False Questions
1) Accounting Information System (AIS) is defined as an organized procedure for identifying,

measuring, recording, and retaining financial information for use in accounting statements and
management reports.
Answer: TRUE
Diff: 1 Type: TF Page Ref: 240
Skill: Knowledge
Objective: 11.1
2) Bookkeeping is basically the recording of accounting transactions.

Answer: TRUE
Skill: Knowledge
Objective: 11.1
3) Accounting and bookkeeping are essentially synonymous.

Answer: FALSE
Objective: 11.1
4) The most important user of accounting information is the government.

Answer: FALSE
Objective: 11.1
5) If a company does not produce accurate accounting information, the group that is hurt the
most is investors.
Answer: FALSE
Objective: 11.1
6) Financial and managerial accounting are differentiated based on the different users they serve.
Answer: TRUE
Skill: Knowledge
Objective: 11.1
51
7) Documents generated by the financial accounting system focus on the activities of the
company as a whole, rather than on individual departments or divisions. By contrast, documents
generated by the management accounting system focus on individual departments.
Answer: TRUE
Objective: 11.1
8) A CPA receives an operating licence from the federal government that must be renewed every
three years.
Answer: FALSE
Skill: Knowledge
Objective: 11.1
9) The controller is a company's chief accounting officer.

Answer: TRUE
Skill: Knowledge
Objective: 11.1
10) An audit involves an examination of a firm's accounting system to determine whether the
financial reports fairly present its financial operations.
Answer: TRUE
Skill: Knowledge
Objective: 11.1
11) Accountants have historically used generally accepted accounting principles when preparing
financial reports, but many companies have now switched to the new international accounting
standards.
Answer: TRUE
Skill: Knowledge
Objective: 11.1
12) A forensic accountant is a special type of accountant who audits companies that have gone
bankrupt.
Answer: FALSE
Skill: Knowledge
Objective: 11.1
52
13) A private accountant deals with a company's day-to-day activities.
Answer: TRUE
Skill: Knowledge
Objective: 11.1
14) Marla is a private accountant who uses a six-step process to develop and analyze a
company's financial reports. The first step in the process is to do a trial balance.
Answer: FALSE
Skill: Application
Objective: 11.1
15) The accounting equation is: assets = liabilities + owners' equity.

Answer: TRUE
Skill: Knowledge
Objective: 11.2
16) Owners' equity equals assets plus liabilities.

Answer: FALSE
Skill: Knowledge
Objective: 11.2
17) Owners' equity is meaningful information for investors, but not for lenders.
Answer: FALSE
Objective: 11.2
18) Double-entry accounting is used by private-sector firms, but cannnot be used by public-
sector organizations.
Answer: FALSE
Objective: 11.3
19) The equity that a homeowner has in a house is the amount of money that could be made by
selling the house and paying off the mortgage. This idea is like the idea of owners' equity in a
business.
Answer: TRUE
Objective: 11.3
53
20) Depreciation is used to recognize the cost of an asset in the year in which it is purchased.
Answer: FALSE
Skill: Knowledge
Objective: 11.3
21) Intangible assets include patents, trademarks, and copyrights.

Answer: TRUE
Skill: Knowledge
Objective: 11.3
22) The financial statement that shows the status of assets, liabilities, and owners' equity at a
particular point in time is the balance sheet.
Answer: TRUE
Skill: Knowledge
Objective: 11.3
23) Liabilities reflected on the balance sheet are divided into two general categories: current
(debts to be paid within one year) and long term (due more than a year into the future).
Answer: TRUE
Skill: Knowledge
Objective: 11.3
24) Owners' equity consists of two sources: the amount that the owners originally invested, and
profits earned by and reinvested in the company.
Answer: TRUE
Skill: Knowledge
Objective: 11.3
25) Retained earnings equal net profits plus dividend payments to stockholders.
Answer: FALSE
Skill: Knowledge
Objective: 11.3
26) If a company needs cash for emergencies, it typically uses the money in retained earnings.
Answer: FALSE
Objective: 11.3
54
27) A budget is a detailed financial plan of estimated receipts and expenditures for the future.
Answer: TRUE
Skill: Knowledge
Objective: 11.4
28) All firms are legally required to issue a statement of cash flows.
Answer: FALSE
Skill: Knowledge
Objective: 11.4
29) If a corporation has gross profit of $151 660 and total operating expenses of $130 685, then
net income is .
Answer: FALSE
Objective: 11.4
30) John wants to determine gross profit for his company. To do so, he must subtract the cost of
goods sold from gross sales revenue.
Answer: TRUE
Objective: 11.4
31) The income statement details a firm's yearly cash receipts and cash payments.
Answer: FALSE
Skill: Knowledge
Objective: 11.4
32) Operating income is income before taxes are taken into account.
Answer: TRUE
Skill: Knowledge
Objective: 11.4
33) Madeline wants to determine operating income for her company. To do so, she must subtract
both the cost of goods sold and all operating expenses from gross sales revenue.
Answer: TRUE
Objective: 11.4
55
34) Gross profit percentages don't vary much across industries, with most companies making
about 6 percent.
Answer: FALSE
Skill: Knowledge
Objective: 11.4
35) Based on the revenue recognition principle, earnings may not be reported until the earnings
cycle is completed.
Answer: TRUE
Objective: 11.4
36) The matching principle takes precedence over the income statement.
Answer: FALSE
Objective: 11.4
37) The most important of all financial ratios is earnings per share.
Answer: FALSE
Objective: 11.5
38) If current assets are $10 000 and current liabilities are $5000, the current ratio is 0.5.
Answer: FALSE
Skill: Application
Objective: 11.5
39) Corporation L has debt of $20 million and equity of $100 million. Its debt-to-equity ratio is
therefore 5.00.
Answer: FALSE
Objective: 11.5
40) Last year, Mainline Corporation's gross profit was $5 million, its net income was $2 million,
and operating expenses were $1 million. Its owners' equity is $100 million. Its return on equity is
therefore 2 percent.
Answer: TRUE
Skill: Application
Objective: 11.5
56
41) Short-term solvency ratios are used primarily to measure the profitability of a business firm,
but they can also be used to measure long-term profitability.
Answer: FALSE
Objective: 11.5
42) The current ratio is used to determine the percentage of sales revenue that is generated by
new products, while the earnings per share ratio takes into account sales of both old and new
products.
Answer: FALSE
Objective: 11.5
43) Activity ratios are used to determine the amount of sales the company generates each year.
Answer: FALSE
Objective: 11.5
44) Marlin wants to calculate the inventory turnover ratio for his company. He has the following
information: beginning inventory = $30 000; ending inventory = $20 000; the cost of goods sold
= $100 000. From this he concludes that the inventory turnover ratio is 4.0.
Answer: TRUE
Skill: Application
Objective: 11.3
45) Leverage measures the ability of the firm to pay bills as they come due.
Answer: FALSE
Objective: 11.5
46) At Ex-Pro, operating income is $80 000 and the number of common shares outstanding is
. This means that earnings per share is $2.00.
Answer: FALSE
Objective: 11.5
47) The lower the inventory turnover ratio, the higher the efficiency of operations.
Answer: FALSE
Objective: 11.5
57
48) Bookkeeping is a comprehensive system for collecting, analyzing, and communicating
financial information.
Answer: FALSE
Skill: Knowledge
Objective: 11.1
ESL: Alternate/ESL
49) An accountant's examination of a company's financial records to determine if it used proper

procedures to prepare its financial reports is known as an audit.
Answer: TRUE
Skill: Knowledge
Objective: 11.1
ESL: Alternate/ESL
50) Anything of economic value owned by a firm or individual is an asset.

Answer: TRUE
Skill: Knowledge
Objective: 11.2
ESL: Alternate/ESL
51) Cash and other assets that can be converted into cash within a year are called current assets.
Answer: TRUE
Skill: Knowledge
Objective: 11.3
ESL: Alternate/ESL
52) The accounting method for distributing the cost of an asset over its useful life is called
retained earnings.
Answer: FALSE
Skill: Knowledge
Objective: 11.3
ESL: Alternate/ESL
53) All expenses directly involved in producing or selling a good or service during a given time
period is called cost of goods sold.
Answer: TRUE
Skill: Knowledge
Objective: 11.4
ESL: Alternate/ESL
58
54) Net income is a firm's gross profit less its operating expenses and income taxes.
Answer: TRUE
Skill: Knowledge
Objective: 11.5
ESL: Alternate/ESL
55) A solvency ratio is an activity ratio that measures the average number of times inventory is
sold and restocked during the year.
Answer: FALSE
Skill: Knowledge
Objective: 11.5
ESL: Alternate/ESL
56) A new Canadian Chartered Professional Accounting Code of Ethics is evolving that borrows
from the best practices of the three current designations.
Answer: TRUE
Skill: Knowledge
Objective: 11.6
ESL: Alternate/ESL
57) There is an increasing expectation for modern CPAs to provide more leadership in
demonstrating financial implications for many areas of a business, including its overall
operations, strategy, data management, human resources, and technical resources.
Answer: TRUE
Skill: Knowledge
Objective: 11.7
ESL: Alternate/ESL
11.4 Short Answer Questions
1) List the potential users of accounting information.

Answer: The potential users of accounting information include business managers, employees,
unions, investors, creditors, tax authorities, and government regulatory agencies.
Diff: 2 Type: SA Page Ref: 240
Skill: Knowledge
Objective: 11.1
2) What is a controller?
Answer: A controller is the person who manages all of a firm's accounting activities (the chief
accounting officer).
Objective: 11.1
59
3) What is an audit?
Answer: An audit is a systematic examination of a company's accounting system to determine
whether its financial reports fairly represent its operations.
Objective: 11.1
4) What is the difference between public and private accountants?

Answer: Public accountants work in accounting firms and assess the financial statements of
other companies, while private accountants work within a given company to deal with the
company's day-to-day accounting needs.
Objective: 11.1
5) What do forensic accountants do?

Answer: Forensic accountants assist in the investigation of business and financial issues that
may have application to a court of law. Forensic accountants may be called upon by law
enforcement agencies, insurance companies, law firms, and business firms. They may conduct
criminal investigations of Internet scams and misuse of government funds. Forensic accountants
also assist business firms in tracing and recovering lost assets from employee business fraud or
theft.
Objective: 11.1
6) What is the accounting equation?

Answer: Assets = Liabilities + Owners' Equity
Skill: Knowledge
Objective: 11.2
7) What is an asset?
Answer: Any economic resource that is expected to benefit a firm or an individual who owns it.
Diff: 1 Type: SA Page Ref: 245-246
Objective: 11.2
8) What is owners' equity?

Answer: The amount of money that business owners would receive if they sold all of the
company's assets and paid all of its liabilities.
Objective: 11.2
60
9) Owners' equity consists of two sources of capital. What are they?
Answer: This figure includes the amount that the owners originally invested, and profits earned
by and reinvested in the company.
Objective: 11.2
10) What does a balance sheet show?

Answer: The information on a balance sheet shows a firm's financial condition at one point in
time. It focuses on information regarding the three factors in the accounting equation: assets,
liabilities, and owners' equity. Looking at balance sheets at various points in time allows for an
assessment of how well the company is doing over time.
Objective: 11.3
11) How do accountants define merchandise inventory?

Answer: Merchandise inventory is the cost of merchandise that has been acquired for sale for
customers and is still on hand.
Skill: Knowledge
Objective: 11.3
12) What happens to assets, liabilities, and owners' equity when a company is operating
profitably?
Answer: Assets increase faster than liabilities and owners' equity increases if profits are retained
in the business instead of being paid out as dividends.
Objective: 11.2
13) Define the term current assets as found on a balance sheet.

Answer: Current assets include cash and assets that can be converted into cash within the
following year.
Skill: Knowledge
Objective: 11.3
14) What is the difference between current and long-term liabilities?

Answer: Current liabilities are debts that must be paid within one year. Long-term liabilities are
debts that are not due for at least one year.
Objective: 11.3
61
15) What is goodwill?
Answer: Goodwill is the amount paid for an existing business beyond the value of its other
assets.
Objective: 11.3
16) What is an income statement?

Answer: An income statement reports revenues and expenses, and results in a figure showing a
company's annual profit or loss.
Objective: 11.3
17) What is a budget?

Answer: A budget is a detailed statement of estimated receipts and expenditures for a period of
time in the future.
Objective: 11.3
18) What is the difference between operating income and net income?
Answer: Operating income is income before income taxes, while net income (also called net
profit or net earnings) is income after income taxes.
Objective: 11.3
19) What is a statement of cash flows?

Answer: A statement of cash flows describes a company's yearly cash receipts and cash
payments.
Objective: 11.3
20) How is gross profit calculated?

Answer: Revenues minus the cost of goods sold
Skill: Knowledge
Objective: 11.3
21) What is the matching principle?

Answer: The matching principle states that expenses must be matched with revenues to
determine net income for an accounting period.
Skill: Knowledge
Objective: 11.4
62
22) What is the formula for the current ratio?
Answer: Current assets divided by current liabilities
Skill: Knowledge
Objective: 11.5
23) Manhattan Corporation has total assets of $700 000, total liabilities of $200 000, and owners'
equity of $500 000. What is Manhattan Corporation's debt-to-equity ratio?
Answer: $200 000/$500 000 = .40 or 40 percent
Skill: Application
Objective: 11.5
24) What is the formula for return on equity?

Answer: Net income divided by total owner's equity
Skill: Knowledge
Objective: 11.5
25) Carter Industries had net income of $250 000 for the year. They had 50 000 shares of
preferred stock and 200 000 shares of common stock outstanding. What is Carter Industries
earnings per share?
Answer: $250 000/200 000 = $1.25.
Skill: Application
Objective: 11.5
26) What is the formula for inventory turnover?

Answer: Cost of goods sold divided by average inventory.
Skill: Knowledge
Objective: 11.5
27) What do activity ratios show?

Answer: Activity ratios measure the efficiency with which a firm uses resources.
Objective: 11.5
28) Define earnings per share. How do investors use this information?
Answer: Earnings per share is defined as net income divided by the number of shares of
common stock outstanding. It determines the size of the dividend that a firm can pay
shareholders. Investors use this ratio to decide whether to buy or sell a company's stock.
Objective: 11.5
63
29) What is the fundamental purpose of strong ethical standards in accounting?
Answer: The purpose is to maintain public confidence in business institutions, financial markets,
and the products and services of the accounting profession.
Objective: 11.6
30) List four trends that are contributing to additional roles for the modern accountant.
Answer: (1) Fewer restrictions from physical and geographic boundaries; (2) social media tools
have changed relationships and the way business is conducted; (3) accountants must be effective
communicators; (4) accountants are increasingly serving as project managers because they
provide guidance on the client's strategy, overall operations, and business development.
Objective: 11.6
11.5 Essay Questions
1) Who are the users of financial statements? Why would they be interested in these statements?
Answer:
- Business managers: to set goals, develop plans, set budgets, evaluate prospects
- Employees and unions: to get paid and to know how the company they work for is doing
- Investors and creditors: to help decide whether or not the company is a sound one to invest in
- Taxing authorities: to plan for tax inflows, to determine tax liabilities
- Government regulatory agencies: to ensure that the companies are providing proper disclosure
to the public
Diff: 2 Type: ES Page Ref: 240
Objective: 11.1
2) What is the difference between financial accounting and managerial accounting?

Answer: Financial accounting is the process whereby interested groups are kept informed about
the financial condition of a firm; it is concerned with external users of information. Managerial
accounting focuses on procedures that alert managers to problems and aid them in planning and
decision making; it serves internal users.
Objective: 11.1
64
3) What types of services did CAs, CGAs, and CMAs provide before the three groups merged?
How will the merger change the situation?
Answer: Services include auditing (examination of a company's financial records to determine if
it used proper procedures to prepare its financial reports), tax services (helping a company
structure, or restructure its operations and investments), and management services (which range
from personal financial planning to planning corporate mergers to executive recruitment). Once
the merger is complete, all three groups will use the new "CPA" designation.
Objective: 11.1
4) Explain how the new International Accounting Standards Board rules have been applied in
Canada.
Answer: For many years, Canadian accountants followed standard rules simply referred to as
Generally Accepted Accounting Rules (GAAP), and each nation had its own version that its
professional body regulated. The International Accounting Standards Board (IASB) developed
International Financial Reporting Standards (IFRS), a sort of "global GAAP," which is now
being used by more than 140 countries including Canada. Canadian companies adopted the IFRS
on January 1, 2011. IASB financial statements require an income statement, balance sheet, and
statement of cash flows, which are similar to those that have historically been developed in
Canada. The CPA Canada Handbook now has various parts, including Part I for publicly
accountable enterprises (IFRS) and government private enterprises; Part II Accounting Standards
for Private Enterprises (ASPE); Part III for not-for-profit organizations; and Part IV for pension
plans.
Skill: Knowledge
Objective: 11.1
5) Why do business firms have private accountants? What do these individuals do for the
company?
Answer: Private accountants are hired as salaried employees to deal with a company's day-to-
day accounting needs. They may be employed in areas such as budgets, financial planning,
internal auditing, payroll, and taxation.
Objective: 11.1
65
6) Explain the role of accountants and distinguish between the kinds of work done by public
accountants, private accountants, management accountants, and forensic accountants.
Answer: The role of accountants is to maintain a comprehensive system for collecting,
analyzing, and communicating financial information for use by external constituents and within
firms for planning and decision-making. The system measures business performance and
translates the results into information for management decisions. Professional accountants (CA's,
CGA's, and CMA's) provide auditing, tax, and management advisory services for other firms and
individuals. These designations have now merged under the banner of a CPA. Many businesses
hire their own employees (private accountants) to perform internal accounting activities such as
auditing, taxation, cost analysis, and budgeting. Most private accountants are management
accountants who provide services to support managers. Forensic accountants use accounting for
legal purposes by providing investigative and litigation support in crimes against companies,
crimes by companies, and civil cases.
Objective: 11.1
7) What are the steps in the accounting cycle?

Answer: The steps are (1) analyze data that are generated as a result of the company's regular
business operations, (2) enter the transactions in a journal, (3) enter the transactions in a ledger,
(4) develop a trial balance, (5) prepare financial statements, and (6) analyze the financial
statements.
Skill: Knowledge
Objective: 11.1
8) Explain the accounting equation.

Answer: The accounting equation is Assets = Liabilities + Owners' Equity. Assets are economic
resources that a company owns and from which it can expect to derive some future benefit.
Assets are classified as current (e.g., cash, marketable securities, inventory, accounts receivable)
and fixed (e.g., land and buildings). Liabilities (current or long-term) are claims on those assets
from outside the firm. Owners' equity is the total claims on those assets from within the firm.
Objective: 11.2
9) What does the term "double-entry" accounting mean?

Answer: Double-entry accounting is a system that requires every transaction to be entered in
two ways: how it affects assets and how it affects liabilities and owners' equity, so that the
accounting equation is always in balance.
Objective: 11.3
66
10) Explain how the accounting equation and double-entry accounting are used in record
keeping.
Answer: Accountants use the accounting equation to balance the data pertaining to financial
transactions: Assets = Liabilities + Owner's equity. An asset is any economic resource that is
expected to benefit its owner (building, equipment, inventory, receivables). A liability is a debt
that the firm owes to an outside party. Owner's equity is the residual interest that the owners
would receive if they sold all the company's assets and paid all of its liabilities. Because every
transaction affects two accounts, accountants use a double-entry system to record the dual
effects. Because the double-entry system requires at least two bookkeeping entries for each
transaction, it keeps the accounting equation in balance.
Objective: 11.3
11) Explain the three basic financial statements and show how they reflect the activity and
financial condition of a business.
Answer: Accounting summarizes the results of a firm's transactions and issues reports to help
internal and external users of financial information to make decisions. The three basic forms of
financial statements are (1) Balance Sheet — supplies detailed information about the accounting
equation, listing the balances of all assets, liabilities, and owner's equity at one point in time; (2)
Income Statement — describes revenues and expenses to show a firms profit or loss over a
period of time; (3) Statement of Cash Flow — reports cash receipts and payments from
operating, investing, and financing activities over a period of time.
Diff: 3 Type: ES Page Ref: 246-248
Objective: 11.3
12) What is the purpose of a balance sheet? What are the major types of information shown on
the balance sheet?
Answer:
- A balance sheet is a type of financial statement that summarizes a firm's financial position on a
particular date in terms of its assets, liabilities, and owners' equity
- Balance sheets supply a considerable amount of information including detailed, technical
descriptions of complex accounts and transactions
- The major types of information on the balance sheet are the components of the accounting
equation: assets, liabilities and owners' equity
Objective: 11.3
67
13) How does a current asset differ from a fixed asset?
Answer:
- A current asset is cash and other assets that can or will be converted into cash in the following
year
- Fixed assets are those that have a long-term use or value to the firm such as land, and buildings
Objective: 11.3
14) What is the purpose of an income statement? What important information is reflected in this
statement?
Answer:
- An income statement describes a firm's revenues and expenses and indicates whether the firm
has earned a profit or suffered a loss during a given period
- All forms of revenue are disclosed on the income statement
- All forms of expenditures, including taxes and interest are also disclosed on the statement
Objective: 11.3
15) Describe the major elements of an income statement.

Answer:
- Revenues: monies received as a result of selling a good or service or from other sources such as
interest, rent, and licensing fees
- Cost of goods sold: expenses directly involved in producing or selling a good or service
- Operating expenses: costs other than those included in cost of goods sold
Objective: 11.3
16) Mary Ann is considering buying an existing catering business that is up for sale. The current
owners claim that the business is highly profitable, but Mary Ann has her doubts. She also thinks
that the price that they are asking seems high. In reviewing the financial statements of the
catering business, she discovers that the current balance sheet shows that the business has more
liabilities than assets. Why would this explain why the owners want to sell the business?
Answer: The current owners face a negative owners' equity, which means that they might not be
able to settle any debts that are due soon. Thus, they would not be able to stay in business for
very long. The type of liabilities and assets could be a factor. For example, the assets may not be
very liquid, and the liabilities may be current (debts that must be paid within one year) or long-
term (debts that are not due for at least a year).
Objective: 11.3
68
17) Mary Ann is considering buying an existing catering business that is up for sale. The current
balance sheet of the business shows that there are has more liabilities than assets. Mary Ann's
friend Roland suggests that, even with the negative owners' equity, this business might still be
worth buying. What other indicators within the auditor's report should they consider for this
decision?
Answer: It must be determined whether the catering business is viable, i.e., does it have the
potential of turning a profit? To determine this, the income statement must be examined, in
particular the gross profit, just to see if there is a history of enough regular business to offset any
liabilities. If this is not the case, then Mary should look elsewhere. If gross profit exists, Mary
Ann might be able to turn the company around. Gross profit is a preliminary, quick-to-calculate
profit figure that considers just two pieces of data from the income statement: revenues and the
cost of revenues (the direct costs of getting those revenues). To calculate gross profit, subtract
cost of revenues from revenues obtained by selling the firm's products.
Objective: 11.3
18) What is a budget? Who uses a budget?

Answer: A budget is a detailed financial plan for estimated receipts and expenditures for a
period of time in the future. Budgets are used by internal accountants and managers as a guide to
how much to produce, stock, sell, and pay for items.
Objective: 11.4
19) Mary Ann is considering buying an existing catering business that is up for sale. An auditor
has found annual budgets for the catering business from the past few years. How can Mary Ann
benefit from these?
Answer: Mary Ann can evaluate the actual monthly performance of the business in comparison
to the current owners' expectations. This might help her decide whether the current financial
problems were caused by a nonviable business or simply by bad management. For planning,
controlling, and decision making, the most important internal financial statement is the budget,
which is a detailed report on estimated receipts and expenditures for a future period of time.
Objective: 11.1
69
20) Discuss the accounting principles of revenue recognition and matching.
Answer:
Revenue recognition:
- The formal recording and reporting of revenues in the financial statements
- Although firms earn revenues continuously as it makes sales, earnings are not reported until the
earnings cycle is completed
- This cycle is complete under two conditions: the sale is complete and the product has been
delivered; AND the sale price to the customer has been collected or is collectable (accounts
receivable)
- The completion of the earning cycle determines the timing for revenue recognition in the firm's
financial statements
Matching:
- Expenses will be matched with revenues to determine net income for an accounting period
Objective: 11.4
21) What are the three major classifications of ratios that are used to analyze financial
statements? What is measured by each of these types of ratios?
Answer:
- Solvency ratios, both short-term and long-term, estimate risk
- Profitability ratios measure potential earnings
- Activity ratios reflect management's use of assets
Objective: 11.5
22) Describe how computing financial ratios can help users get more information from financial
statements to determine the financial strengths of a business.
Answer: Financial statements provide data that can be applied to ratios. Ratios can then be used
to analyze the financial health of a company in terms of solvency, profitability, and efficiency in
performing activities. Ratios can help creditors, investors, and managers assess a firm's current
status and check a firm's progress by comparing current with past statements. Solvency ratios use
balance sheet data to measure the firm's ability to meet its debts. The current ratio measures the
ability to meet current liabilities out of current assets. Long-term solvency ratios compare the
firm's total liabilities against owners' equity. Profitability ratios such as earnings per share
measure current and potential earnings. Activity ratios reflect management's use of assets by
measuring the efficiency with which a firm uses its resources for a particular activity, such as
sales, advertising, or inventory management.
Objective: 11.5
70
23) Identify the solvency ratios and what they measure.
Answer: Solvency ratios measure risk, the ability to meet short-term and long-term obligations
Short-term solvency ratios:
- Current ratio: current assets divided by current liabilities; measures the ability to pay short-
term obligations out of current assets
- Working capital: difference between a firm's current assets and current liabilities; measures
ability to pay off short-term debts
- Quick (acid-test) ratio: quick assets divided by current liabilities; measures the ability to meet
emergency demands for cash
Long-term solvency ratio:
- Debt-to-equity ratio: debt divided by owners' equity; measures degree of debt used to fund
company operations
Objective: 11.5
24) Identify an activity ratio and what it measures.

Answer: Activity ratios measure management's efficiency in using the firm's assets. The
inventory turnover rate is calculated by dividing the cost of goods sold by average inventory. It
shows the average number of times that inventory is sold and restocked.
Objective: 11.5
25) Identify the profitability ratios and what they measure.

Answer: Profitability ratios give investors an idea of the returns they can expect. The return on
equity ratio is computed by dividing net income by total owners' equity. This ratio shows the net
income earned in a business for each dollar that has been invested. The return on sales ratio is
calculated by dividing net income by sales revenue. This ratio shows how much profit is
generated by each dollar of sales. The earnings per share ratio is calculated by dividing net
income by the number of shares of common stock outstanding. This ratio shows how much profit
has been generated for each share of common stock.
Objective: 11.5
26) Mary Ann is considering buying an existing catering business that is up for sale. An auditor
has expressed concerns about the company's ability to pay its bills as they are due. What type of
financial ratio might provide insight into this concern?
Answer: The auditor has probably evaluated the firm's current ratio. The current ratio is the most
commonly used liquidity ratio and is calculated by dividing current liabilities into current assets,
both of which are found on the balance sheet. The current ratio is often referred to as the
"banker's ratio" because it concerns a firm's creditworthiness.
Objective: 11.1
71
27) Why has accounting ethics become an important issue in recent years?
Answer: There has been increased interest in accounting ethics because there have recently been
multiple instances where managers demonstrated poor judgment or unethical/illegal behaviour
with respect to the presentation of accounting information. In some cases, this has led to the
demise of a company. The usefulness of accounting tools and methods depends on their honest
application. Ethics is an area where one person who is willing to "do the right thing" can make a
difference. With the unification process for accounting designations moving forward, a new
Canadian Chartered Professional Accounting Code of Ethics is being developed that will borrow
from the best practices from the three current designations.
Objective: 11.6
28) Explain four trends that are contributing to the additional roles of the modern accountant.
Answer: First, there are fewer restrictions from physical and geographic boundaries. With
increasing globalization many foreign-based firms are interacting with firms based elsewhere
around the world. Coupled with modern technology, accountants and clients in other countries
are working together remotely. An accountant based at a company office, or at an office-in-the-
home, in Calgary, Alberta, can provide services to a client located in Singapore. Second, social
media have changed relationships and the way business is conducted. Modern accountants
establish professional relationships through active participation through social media. No longer
do CPAs rely solely on face-to-face interactions at occasional professional meetings. Social
media such as LinkedIn provide platforms at-your-fingertips for remote interactions allowing
exchanges of (non-critical) information, professional advice, and temporary collaborations
among accountants to serve clients in need of particular skill sets. New business opportunities
arise, too, when accountants use a social networking presence to establish their business
reputations. Third, accountants must be effective communicators. Communication skills are vital
in the modern accountant's role in advising clients on global business trends and strategic
perspectives. The accountant's thorough knowledge, to be leveraged into meaningful advice,
must be communicated to clients on time, clearly and convincingly, both verbally and in writing.
Effectiveness can be critical in a variety of communications contexts, ranging from formal
presentations, to interactive group meetings, to one-to-one informal conversations, either face to
face or remotely. Fourth, accountants are increasingly serving as project managers because they
provide guidance on the client's strategy, overall operations, and business development. These
broad-based issues typically involve large-scale teams of specialists requiring long-term
participation in activities such as financial forecasting, product and process engineering,
financial interpretations, cost estimation, and human resources analysis. Success depends on the
project manager's ability to decompose the project into manageable tasks, gain acceptance of task
assignments, encourage timely reporting by task groups, and merge the project's many steps into
coherent conclusions.
Objective: 11.6
72

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Business Essentials, Canadian Edition, 9e (Ebert)

Chapter 11 Understanding Accounting

11.1 Multiple Choice Questions

1) ________ is the comprehensive information system for collecting, analyzing, and

2) Employees and unions use accounting information

3) Janice is a bookkeeper. Her primary function would be to

17) Forensic accountants are sometimes used to

18) Which of the following is correct with regard to auditing?

20) Which of the following is correct with regard to private accountants?

24) The accounting equation is

26) A(n) ________ is a debt owed by a firm to an outside organization or individual.

28) What is the formula for determining owners' equity?

29) Owners' equity consists of two sources of capital. They are

32) Under which condition is owners' equity positive?

33) Under which condition is owners' equity negative?

46) What purpose does the balance sheet serve?

50) Which of the following is an intangible asset?

53) An account receivable represents

57) Andy's line of credit with a local bank is likely a(n)

60) A fixed asset is

67) Paid-in capital is

71) The amount of profit or loss will be reflected in the

84) What is the difference between "profit" and "cash flow"?

85) Cash flow from operations refers to

96) To compute the current ratio, current assets are divided by

100) What is the purpose of computing the current ratio?

101) The debt-to-owners' equity ratio measures a firm's ability to meet

103) How is the debt-to-owners'-equity ratio used?

105) What is the purpose of computing profitability ratios?

109) How is the return on equity ratio calculated?

111) An activity ratio measures a firm's

112) The inventory turnover ratio is calculated by

122) A(n) ________ ratio evaluates management's use of assets.

123) The debt-to-equity ratio is calculated by dividing

135) What is anything of economic value owned by a firm or individual called?

136) What is any debt owed by a firm or individual to others called?

1) Accounting Information System (AIS) is defined as an organized procedure for identifying,

2) Bookkeeping is basically the recording of accounting transactions.

3) Accounting and bookkeeping are essentially synonymous.

4) The most important user of accounting information is the government.

9) The controller is a company's chief accounting officer.

15) The accounting equation is: assets = liabilities + owners' equity.

16) Owners' equity equals assets plus liabilities.

21) Intangible assets include patents, trademarks, and copyrights.

49) An accountant's examination of a company's financial records to determine if it used proper

50) Anything of economic value owned by a firm or individual is an asset.

11.4 Short Answer Questions

1) List the potential users of accounting information.

4) What is the difference between public and private accountants?

5) What do forensic accountants do?

6) What is the accounting equation?

8) What is owners' equity?

10) What does a balance sheet show?

11) How do accountants define merchandise inventory?

13) Define the term current assets as found on a balance sheet.

14) What is the difference between current and long-term liabilities?

16) What is an income statement?

17) What is a budget?

19) What is a statement of cash flows?

20) How is gross profit calculated?