Foundations of Finance, 9e (Keown/Martin/Petty)

Chapter 3 Understanding Financial Statements and Cash Flows

Learning Objective 3.1

1) An income statement reports a firm's cumulative revenues and expenses from the inception of the firm
through the income statement date.
Answer: FALSE
Diff: 1 Page Ref: 56
Keywords: Income Statement, Revenues, Expenses
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking

2) Owners equity increases each period by the amount of the corporation's positive net cash flow.
Answer: FALSE
Diff: 1 Page Ref: 57
Keywords: Income Statement, Balance Sheet, Owners' Equity
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking

3) If two companies have the same revenues and operating expenses, their net incomes will still be
different if one company finances its assets with more debt and the other company with more equity.
Answer: TRUE
Diff: 2 Page Ref: 57
Keywords: Income Statement, EBIT, Financing Cost
Learning Obj.: L.O. 3.1
AACSB: Analytical Thinking

4) Common-sized income statements are used to compare companies that have the same amount of
revenues.
Answer: FALSE
Diff: 1 Page Ref: 59
Keywords: Common-Sized Income Statement
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking

5) Common-sized income statements restate the numbers in the income statement as a percentage of sales
to assist in the comparison of a firm's financial performance across time and with competitors.
Answer: TRUE
Diff: 1 Page Ref: 59
Keywords: Common-Sized Income Statement
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking

6) Net profit margin is equal to the gross profit margin times the operating profit margin.
Answer: FALSE
Diff: 1 Page Ref: 59
Keywords: Net Profit Margin, Gross Profit Margin, Operating Profit Margin
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking

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7) Earnings before taxes, or taxable income, is equal to operating income minus financing costs.
Answer: TRUE
Diff: 1 Page Ref: 57
Keywords: Earnings Before Taxes, Operating Income, Financing Costs
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking

8) The more debt a company uses to finance its assets, the lower will be its operating income due to
higher interest expense.
Answer: FALSE
Diff: 2 Page Ref: 57
Keywords: Operating Income, EBIT
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking

9) Changes in depreciation expense do not affect operating income because depreciation is a non-cash
expense.
Answer: FALSE
Diff: 1 Page Ref: 57
Keywords: Depreciation, EBIT, Operating Income
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking

10) Earnings available to common shareholders represents income that may be reinvested in the firm or
distributed to its owners.
Answer: TRUE
Diff: 1 Page Ref: 57
Keywords: Earnings Available to Common Shareholders
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking

11) Earnings available to common shareholders is equal to a corporation's positive net cash flow over a
given period, typically one year.
Answer: FALSE
Diff: 1 Page Ref: 57
Keywords: Earnings Available to Common Shareholders
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking

12) Profits-to-Sales relationships are defined as profit margins.

Answer: TRUE
Diff: 1 Page Ref: 59
Keywords: Profit Margins
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking

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13) Company A and Company B both report the same level of sales and net income. Therefore,
A) both A and B will report the same Earnings Per Share.
B) both A and B will report the same Gross Profit Margin.
C) both A and B will report the same Net Profit Margin.
D) both A and C are true.
Answer: C
Diff: 2 Page Ref: 57
Keywords: Earnings Per Share, Net Profit Margin, Gross Profit Margin
Learning Obj.: L.O. 3.1
AACSB: Analytical Thinking

14) The A corporation has an operating profit margin of 20%, operating expenses of $500,000, and
financing costs of $15,000. Therefore,
A) the corporation's gross profit margin is less than 20%.
B) the corporation's net profit margin is greater than 20%.
C) the corporation's gross profit margin is greater than 20%.
D) the corporation's gross profit margin is equal to 20% because gross profit is not affected by operating
expenses or financing costs.
Answer: C
Diff: 2 Page Ref: 57
Keywords: Operating Profit Margin, Gross Profit Margin
Learning Obj.: L.O. 3.1
AACSB: Analytical Thinking

15) The basic format of an income statement is

A) Sales - Expenses = Profits.
B) Income - Expenses = EBIT.
C) Sales - Liabilities = Profits.
D) Assets - Liabilities = Profits.
Answer: A
Diff: 1 Page Ref: 57
Keywords: Income Statement
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking

16) Rogue Industries reported the following items for the current year: Sales = $3,000,000; Cost of Goods
Sold = $1,500,000; Depreciation Expense = $170,000; Administrative Expenses = $150,000; Interest Expense
= $30,000; Marketing Expenses = $80,000; and Taxes = $300,000. Rogue's gross profit is equal to
A) $770,000.
B) $1,070,000.
C) $1,100,000.
D) $1,500,000.
Answer: D
Diff: 1 Page Ref: 57
Keywords: Gross Profit
Learning Obj.: L.O. 3.1
AACSB: Analytical Thinking

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17) Rogue Industries reported the following items for the current year: Sales = $3,000,000; Cost of Goods
Sold = $1,500,000; Depreciation Expense = $170,000; Administrative Expenses = $150,000; Interest Expense
= $30,000; Marketing Expenses = $80,000; and Taxes = $300,000. Rogue's operating income is equal to
A) $770,000.
B) $1,070,000.
C) $1,100,000.
D) $1,500,000.
Answer: C
Diff: 2 Page Ref: 57
Keywords: Operating Income, EBIT
Learning Obj.: L.O. 3.1
AACSB: Analytical Thinking

18) Rogue Industries reported the following items for the current year: Sales = $3,000,000; Cost of Goods
Sold = $1,500,000; Depreciation Expense = $170,000; Administrative Expenses = $150,000; Interest Expense
= $30,000; Marketing Expenses = $80,000; and Taxes = $300,000. Rogue's net profit margin is equal to
A) 25.67%.
B) 35.67%.
C) 36.67%.
D) 50.00%.
Answer: A
Diff: 2 Page Ref: 57, 59
Keywords: Net Profit Margin
Learning Obj.: L.O. 3.1
AACSB: Analytical Thinking

19) Rogue Industries reported the following items for the current year: Sales = $3,000,000; Cost of Goods
Sold = $1,500,000; Depreciation Expense = $170,000; Administrative Expenses = $150,000; Interest Expense
= $30,000; Marketing Expenses = $80,000; and Taxes = $300,000; Rogue's operating profit margin is equal
to
A) 25.67%.
B) 35.67%.
C) 36.67%.
D) 50.00%.
Answer: C
Diff: 2 Page Ref: 57, 59
Keywords: Operating Profit Margin, EBIT
Learning Obj.: L.O. 3.1
AACSB: Analytical Thinking

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20) Use the following information to calculate the company's accounting net income for the year.

Credit Sales $800,000

Cash Sales $500,000
Operating Expenses on Credit $200,000
Cash Operating Expenses $700,000
Accounts Receivable (Beg. of Year) $50,000
Accounts Receivable (End of Year) $80,000
Accounts Payable (Beg. of Year) $50,000
Accounts Payable (End of Year) $100,000
Corporate Tax Rate 40%

A) $300,000
B) $240,000
C) $125,000
D) $120,000
Answer: B
Diff: 2 Page Ref: 57
Keywords: Net Income, Accrual Accounting, Income Statement
Learning Obj.: L.O. 3.1
AACSB: Analytical Thinking

21) A corporation's operating profit margin is equal to

A) net income divided by sales.
B) EBIT divided by sales.
C) EBIT divided by net income.
D) sales divided by EBIT.
Answer: B
Diff: 1 Page Ref: 59
Keywords: Operating Profit Margin, EBIT
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking

22) Which of the following statements concerning net income is MOST correct?
A) Net income represents cash available to pay dividends.
B) Net income represents sales minus operating expenses at a specific point in time.
C) Negative net income reduces a company's cash balance.
D) Net income represents income that may be reinvested in the firm or distributed to its owners.
Answer: D
Diff: 1 Page Ref: 57
Keywords: Net Income
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking

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23) Which of the following represents an attempt to measure the net results of the firm's operations
(revenues versus expenses) over a given time period?
A) balance sheet
B) statement of cash flows
C) income statement
D) sources and uses of funds statement
Answer: C
Diff: 1 Page Ref: 56
Keywords: Income Statement, Revenues, Expenses
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking

24) What information does a firm's income statement provide to the viewing public?
A) an itemization of all of a firm's assets and liabilities for a defined period of time
B) a complete listing of all of a firm's cash receipts and cash expenditures for a defined period of time
C) a report of revenues and expenses for a defined period of time
D) a report of investments made and their cost for a specific period of time
Answer: C
Diff: 1 Page Ref: 56
Keywords: Income Statement, Revenues, Expenses
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking

25) California Retailing Inc. has sales of $4,000,000; the firm's cost of goods sold is $2,500,000; and its total
operating expenses are $600,000. What is California Retailing's EBIT?
A) $850,000
B) $875,000
C) $900,000
D) $1,300,000
Answer: C
Diff: 2 Page Ref: 57
Keywords: EBIT, Operating Income
Learning Obj.: L.O. 3.1
AACSB: Analytical Thinking

26) California Retailing Inc. has sales of $4,000,000; the firm's cost of goods sold is $2,500,000; and its total
operating expenses are $600,000. The firm's interest expense is $250,000, and the corporate tax rate is 40%.
What is California Retailing's net income?
A) $288,000
B) $350,000
C) $377,000
D) $390,000
Answer: D
Diff: 2 Page Ref: 57
Keywords: Net Income
Learning Obj.: L.O. 3.1
AACSB: Analytical Thinking

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27) Corporation B reported earnings per share of $10. Corporation B has 100,000 shares of common stock
outstanding and reported an increase in owners' equity of $400,000 for the period. Corporation B paid
$50,000 in interest expense during the period. Corporation B paid dividends per share of
A) $6.00.
B) $5.50.
C) $6.50.
D) $14.003.
Answer: A
Diff: 3 Page Ref: 58, 59
Keywords: Earnings Per Share, Dividends Per Share, Income Statement
Learning Obj.: L.O. 3.1
AACSB: Analytical Thinking

28) The increase in owners' equity for a given period is equal to

A) positive net cash flow minus dividends.
B) net income minus dividends.
C) sales minus dividends.
D) gross profit minus distributions to shareholders.
Answer: B
Diff: 2 Page Ref: 57
Keywords: Owners Equity, Income Statement, Dividends
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking

29) A firm's financing costs include

A) depreciation expense.
B) interest expense
C) costs of goods sold.
D) both A and B.
Answer: B
Diff: 1 Page Ref: 57
Keywords: Financing Costs, Interest Exposure
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking

30) Corporation A decides to borrow $1,000,000 and use the money to buy back $1,000,000 of its common
stock. The corporation pays 6% interest on its borrowed funds which exactly equals the amount of the
dividend it used to pay on the common stock it repurchased. Therefore,
A) Corporation A's operating income will decrease due to higher interest expense.
B) Corporation A's net income will increase due to the tax deductibility of interest expense.
C) Corporation A will have no change in its operating income since the interest expense exactly offsets
the prior dividend payment.
D) Corporation A's gross profit will decrease.
Answer: B
Diff: 3 Page Ref: 57
Keywords: Income Statement, Financing Costs, Net Income
Learning Obj.: L.O. 3.1
AACSB: Analytical Thinking

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31) Gross profit is equal to
A) profits plus depreciation.
B) revenues - expenses.
C) earnings before taxes minus taxes payable.
D) sales - cost of goods sold.
Answer: D
Diff: 1 Page Ref: 57
Keywords: Gross Profit, Income Statement
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking

32) An income statement may be represented as follows:

A) Sales - Liabilities = Profits.
B) Revenues - Liabilities = Net Income.
C) Sales - Expenses = Retained Earnings.
D) Sales - Expenses = Profits.
Answer: D
Diff: 1 Page Ref: 57
Keywords: Income Statement
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking

33) All of the following are income statement items EXCEPT

A) accrued expenses.
B) depreciation expense.
C) cost of goods sold.
D) interest expense.
Answer: A
Diff: 1 Page Ref: 57
Keywords: Income Statement, Accrued Expenses
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking

34) Two companies have identical assets and operating activities. Which of the follow statements is true?
A) Both companies have the same net income.
B) The company with more debt will have lower operating income due to interest expense.
C) The company with more debt will have higher operating income due to leverage.
D) The company with more debt will have lower net income due to interest expense.
Answer: D
Diff: 2 Page Ref: 57
Keywords: Operating Income, Net Income, Interest Expense
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking

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35) Prepare an income statement using the information given below. Make sure to identify gross profit,
operating income, and net income.

Inventories $50,000
Cost of Goods Sold $250,000
Administrative Expenses $50,000
Accumulated Depreciation $150,000
Sales $600,000
Depreciation Expense $25,000
Selling Expenses $150,000
Common Stock Dividends $8,000
Interest Expense $8,000
Corporate Tax Rate 40%

Answer:
Sales $600,000
Cost of Goods Sold 250,000
Gross Profit 350,000
Selling Expenses 150,000
Administrative Expenses 50,000
Depreciation Expense 25,000
Operating Income (EBIT) 125,000
Interest Expense 8,000
Earnings Before Taxes (EBT) 117,000
Taxes (40%) 46,800
Net Income $70,200

Diff: 2 Page Ref: 59

Keywords: Income Statement, Gross Profit, Operating Income (EBIT), Net Income
Learning Obj.: L.O. 3.1
AACSB: Analytical Thinking

36) How do gross profits, operating income, and net income relate to the areas of business activity
reported in the income statement?
Answer: The income statement begins with sales or revenue, from which we subtract the cost of goods
sold (the cost of producing or acquiring the product or service to be sold) to yield gross profits. 1. Sales
(revenues), which is equal to the selling price of the products or services to be sold times the number of
units sold (selling price * units sold = total sales) 2. Cost of goods sold, which is the cost of producing or
acquiring the goods or services that were sold 3. Operating expenses, which include: a. Marketing and
selling expenses (the expenses related to marketing, selling, and distributing the products or services) b.
The firm's overhead expenses (general and administrative expenses, and depreciation expense).
Diff: 2 Page Ref: 56
Keywords: Income Statement
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking

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Learning Objective 3.2

1) Common-sized balance sheets show each account as a percentage of total sales to help analysts in
comparing companies of difference sizes.
Answer: FALSE
Diff: 1 Page Ref: 65
Keywords: Common-Sized Balance Sheet
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

2) The balance sheet equation is Total Assets = Total Revenues - Total Liabilities.
Answer: FALSE
Diff: 1 Page Ref: 61
Keywords: Balance Sheet
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

3) The accounting book value of an asset represents the historical cost of the asset rather than its current
market value or replacement cost.
Answer: TRUE
Diff: 1 Page Ref: 61
Keywords: Accounting Book Value, Market Value
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

4) Intangible assets such as copyrights and goodwill are not included on the balance sheet because they
are impossible to value objectively.
Answer: FALSE
Diff: 1 Page Ref: 63
Keywords: Intangible Assets, Balance Sheet
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

5) Additional Paid in Capital on the balance sheet equals the amount paid by investors for the company's
common stock that exceeds the market price of the stock at the time of purchase.
Answer: FALSE
Diff: 1 Page Ref: 64
Keywords: Additional Paid in Capital, Balance Sheet
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

6) A firm's income statement reports the results from operating the business for a period of time, while the
firm's balance sheet provides a snapshot of the firm's financial position at a specific point in time.
Answer: TRUE
Diff: 1 Page Ref: 61
Keywords: Income Statement, Balance Sheet
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

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7) If a company's cash balance increases during the year, and the company also reports positive net
income, then the company's retained earnings balance must increase.
Answer: FALSE
Diff: 2 Page Ref: 65
Keywords: Retained Earnings
Learning Obj.: L.O. 3.2
AACSB: Analytical Thinking

8) Fixed assets are assets whose balances will remain the same throughout the year.
Answer: FALSE
Diff: 1 Page Ref: 62, 63
Keywords: Fixed Assets
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

9) Inventories are considered fixed assets because inventory levels remain fairly constant throughout the
year.
Answer: FALSE
Diff: 1 Page Ref: 62
Keywords: Inventory, Fixed Assets
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

10) Finished goods held for sale are inventory, but raw materials to be used in the production process are
considered other assets.
Answer: FALSE
Diff: 1 Page Ref: 62
Keywords: Finished Goods Inventory, Raw Materials Inventory, Other Assets
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

11) Accounting rules specify that assets on the balance sheet must be reported at current market value,
because this is the valuation most useful to potential investors.
Answer: FALSE
Diff: 1 Page Ref: 61
Keywords: Accounting Book Value
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

12) The retained earnings balance on IBM's balance sheet at the end of 2010 is equal to IBM's 2010 net
income minus dividends paid in 2010.
Answer: FALSE
Diff: 1 Page Ref: 65
Keywords: Retained Earnings, Dividends
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

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13) Financing activities have no impact on the income statement, but rather are reflected in changes in
long-term debt and short-term debt on the balance sheet.
Answer: FALSE
Diff: 1 Page Ref: 64
Keywords: Financing Activities, Income Statement, Balance Sheet
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

14) Common stockholders' equity equals common stock issued minus treasury stock.
Answer: FALSE
Diff: 1 Page Ref: 64
Keywords: Stockholders' Equity, Common Stock, Treasury Stock
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

15) An income statement reports the firm's revenues and expenses for a specific period of time such as
one year.
Answer: TRUE
Diff: 1 Page Ref: 61
Keywords: Income Statement, Revenues, Expenses
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

16) A balance sheet is a statement of the financial position of the firm on a given date, including its asset
holdings, liabilities, and equity.
Answer: TRUE
Diff: 1 Page Ref: 61
Keywords: Balance Sheet, Assets, Liabilities, Equity
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

17) The profit and loss (income) statement is compiled on a cash basis.
Answer: FALSE
Diff: 1 Page Ref: 69
Keywords: Income Statement, Cash Basis
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

18) The income statement describes the financial position of a firm on a given date.
Answer: FALSE
Diff: 1 Page Ref: 61
Keywords: Income Statement
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

19) Under current accounting rules, the plant and equipment account shows the historical cost (purchase
price) of, plus any subsequent improvements to, the plant and equipment.
Answer: TRUE
Diff: 1 Page Ref: 63
Keywords: Plant and Equipment, Historical Cost
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking
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20) A balance sheet reflects the current market value of a firm's assets and liabilities.
Answer: FALSE
Diff: 1 Page Ref: 61
Keywords: Balance Sheet, Current Market Value
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

21) Net working capital is equal to gross working capital minus depreciation.
Answer: FALSE
Diff: 1 Page Ref: 66
Keywords: Net Working Capital
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

22) The balance sheet reflects the accounting equation: Assets = Liabilities + Owners' Equity.
Answer: TRUE
Diff: 1 Page Ref: 61
Keywords: Profit Margins
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

23) Liquidity refers to the ability to quickly convert an asset into cash without lowering the selling price.
Answer: TRUE
Diff: 1 Page Ref: 61
Keywords: Liquidity
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

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Please refer to Table 3-1 for the following questions.

Table 3-1
Jones Company
Financial Information

December 2009 December 2010

Net Income $2,000 $4,000

Accounts receivable 750 950
Accumulated depreciation 1,000 1,500
Common stock 4,500 5000
Paid-in capital 7,500 8500
Retained earnings 1,500 3,500
Accounts payable 750 750

24) Based on the information in Table 3-1, calculate the amount of dividends paid by Jones Company in
2010 (no assets were disposed of during the year, and there was no change in interest payable or taxes
payable).
A) $2,000
B) $2,500
C) $3,500
D) $4,000
Answer: A
Diff: 2 Page Ref: 65
Keywords: Dividends, Retained Earnings
Learning Obj.: L.O. 3.2
AACSB: Analytical Thinking

25) Based on the information in Table 3-1, assuming that no assets were disposed of during 2010, the
amount of depreciation expense was
A) $375.
B) $500.
C) $2,500.
D) $3,500.
Answer: B
Diff: 1 Page Ref: 63
Keywords: Depreciation Expense
Learning Obj.: L.O. 3.2
AACSB: Analytical Thinking

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26) Based on the information in Table 3-1, assuming that no common stock was repurchased during the
year, the firm issued how much new common stock during 2010?
A) $500
B) $1,000
C) $1,500
D) $2,000
Answer: C
Diff: 2 Page Ref: 64
Keywords: Common Stock, Balance Sheet
Learning Obj.: L.O. 3.2
AACSB: Analytical Thinking

27) The December 31, 2009 balance sheet shows net fixed assets of $150,000 and the December 31, 2010
balance sheet shows net fixed assets of $250,000. Depreciation expense for 2009 is $25,000 and
depreciation expense for 2010 is $35,000. Based on this information, the cost of fixed assets purchased
during 2010 is
A) $100,000.
B) $110,000.
C) $135,000.
D) $160,000.
Answer: C
Diff: 2 Page Ref: 63
Keywords: Net Fixed Assets, Depreciation Expense, Accumulated Depreciation, Balance Sheet
Learning Obj.: L.O. 3.2
AACSB: Analytical Thinking

28) All of the following would result in an increase in stockholders equity EXCEPT
A) the company sold common stock at par value.
B) the company sold common stock above par value.
C) the company purchased treasury stock.
D) the company had positive net income greater than dividends paid.
Answer: C
Diff: 2 Page Ref: 64
Keywords: Stockholders' Equity, Treasury Stock, Balance Sheet
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

29) Wheeler Corporation had retained earnings as of 12/31/10 of $15 million. During 2011, Wheeler's net
income was $7 million. The retained earnings balance at the end of 2011 was equal to $20 million.
Therefore,
A) Wheeler paid a dividend in 2010 of $5 million.
B) Wheeler paid a dividend in 2010 of $2 million.
C) Wheeler sold common stock during 2010 for $5 million.
D) Wheeler purchased treasury stock in 2010 for $2 million.
Answer: B
Diff: 2 Page Ref: 65
Keywords: Retained Earnings, Dividends
Learning Obj.: L.O. 3.2
AACSB: Analytical Thinking

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30) All of the following are equity accounts on a balance sheet EXCEPT
A) retained earnings.
B) cash.
C) common stock.
D) paid-in capital.
Answer: B
Diff: 1 Page Ref: 64
Keywords: Balance Sheet, Equity
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

31) The two principal sources of financing for corporations are

A) debt and accounts payable.
B) debt and equity.
C) common equity and preferred equity.
D) cash and common equity.
Answer: B
Diff: 2 Page Ref: 63
Keywords: Sources of Financing, Debt, Equity
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

32) Net working capital is equal to

A) total assets minus total liabilities.
B) current assets minus total liabilities.
C) total operating capital minus net income.
D) current assets minus current liabilities.
Answer: D
Diff: 1 Page Ref: 66
Keywords: Net Working Capital, Current Assets, Current Liabilities
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

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33) Given the following financial statements for ACME Corporation, what amount did the company pay
in dividends for 2010?

Income Statement Balance Sheet

Year Ended 12/31/10 12/31/2010 12/31/2009
Sales $1,300,000 Current Assets $50,000 $45,000
Cost of Goods Sold 750,000 Gross Fixed Assets 880,000 650,000
Less Accumulated
Operating Expenses 200,000 Depreciation 450,000 350,000
Depreciation Expense 100,000 Fixed Assets 430,000 350,000
EBIT 250,000 Total Assets $480,000 $395,000
Interest Expense 50,000
EBT 200,000 Current Liabilities $35,000 $50,000
Taxes 80,000 Long-term Debt 330,000 270,000
Net Income $120,000 Common Stock 5,000 5,000
Retained Earnings 110,000 70,000
Total Liabilities & Equity $480,000 $395,000

A) $45,000
B) $25,000
C) $100,000
D) $80,000
Answer: D
Diff: 2 Page Ref: 65
Keywords: Retained Earnings, Dividends
Learning Obj.: L.O. 3.2
AACSB: Analytical Thinking

34) All of the following statements about balance sheets are true EXCEPT
A) Assets - Liabilities = Shareholders' Equity.
B) assets are reported at historical cost.
C) balance sheets show average asset balances over a one-year period.
D) a balance sheet reports a company's financial position at a specific point in time.
Answer: C
Diff: 1 Page Ref: 61
Keywords: Balance Sheet
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

17
Copyright © 2017 Pearson Education, Inc.
35) California Retailing Inc. has sales of $4,000,000; the firm's cost of goods sold is $2,500,000; and its total
operating expenses are $600,000. The firm's interest expense is $250,000, and the corporate tax rate is 40%.
The firm paid dividends to preferred stockholders of $40,000, and the firm distributed $60,000 in
dividend payments to common stockholders. What is California Retailing's "Addition to Retained
Earnings"?
A) $650,000
B) $390,000
C) $330,000
D) $290,000
Answer: D
Diff: 2 Page Ref: 65
Keywords: Retained Earnings, Common Dividends, Preferred Dividends
Learning Obj.: L.O. 3.2
AACSB: Analytical Thinking

36) What information does a firm's balance sheet provide to the viewing public?
A) a report of investments made and their cost for a specific period of time
B) a complete listing of all of a firm's cash receipts and cash expenditures for a defined period of time
C) a report of revenues and expenses for a defined period of time
D) an itemization of all of a firm's assets, liabilities, and equity as of the balance sheet date
Answer: D
Diff: 1 Page Ref: 61
Keywords: Balance Sheet, Assets, Liabilities, Equity
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

37) Which of the following accounts belongs on the asset side of a balance sheet?
A) depreciation expense
B) accounts payable
C) inventory
D) accruals
Answer: C
Diff: 1 Page Ref: 62
Keywords: Balance Sheet, Inventory, Assets
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

38) Which of the following accounts does NOT belong on the asset side of a balance sheet?
A) accounts receivable
B) marketable securities
C) cash
D) common stock
Answer: D
Diff: 1 Page Ref: 62, 63
Keywords: Balance Sheet, Assets
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

18
Copyright © 2017 Pearson Education, Inc.
39) Which of the following accounts does NOT belong on the asset side of a balance sheet?
A) accounts receivable
B) accumulated depreciation
C) cash
D) accruals
Answer: D
Diff: 1 Page Ref: 62, 63
Keywords: Balance Sheet, Assets
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

40) Which of the following accounts belongs in the liability section of a balance sheet?
A) interest expense
B) accumulated depreciation
C) accounts payable
D) preferred stock
Answer: C
Diff: 1 Page Ref: 64
Keywords: Balance Sheet, Liabilities, Accounts Payable
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

41) Which of the following accounts does NOT belong in the liability section of a balance sheet?
A) accruals
B) short-term debt
C) additional paid-in capital
D) long-term debt
Answer: C
Diff: 1 Page Ref: 64
Keywords: Balance Sheet, Liabilities
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

42) Which of the following accounts belongs in the equity section of a balance sheet?
A) retained earnings
B) cash
C) long-term debt
D) dividends
Answer: A
Diff: 1 Page Ref: 64
Keywords: Balance Sheet, Equity, Retained Earnings
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

19
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43) Which of the following accounts does NOT belong in the equity section of a balance sheet?
A) retained earnings
B) paid-in-surplus
C) long-term debt
D) preferred stock
Answer: C
Diff: 1 Page Ref: 64
Keywords: Balance Sheet, Equity
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

44) Universal Financial, Inc. has total current assets of $1,200,000; long-term debt of $600,000; total current
liabilities of $500,000; and long-term assets of $800,000. How much is the firm's net working capital?
A) $1,000,000
B) $900,000
C) $600,000
D) $700,000
Answer: D
Diff: 1 Page Ref: 66
Keywords: Balance Sheet, Net Working Capital
Learning Obj.: L.O. 3.2
AACSB: Analytical Thinking

45) Siskiyou Corp. has cash of $75,000; short-term notes payable of $100,000; accounts receivables of
$275,000; accounts payable of $135,000: inventories of $350,000; and accrued expenses of $75,000. What is
the firm's net working capital?
A) $390,000
B) $175,000
C) $700,000
D) $210,000
Answer: A
Diff: 2 Page Ref: 66
Keywords: Balance Sheet, Net Working Capital
Learning Obj.: L.O. 3.2
AACSB: Analytical Thinking

46) A corporation has annual sales of $18 million, total assets of $4 million, a debt ratio of 40%,
depreciation expense of $200,000, and a tax rate of 40%. The corporation's total stockholders' equity is
equal to
A) $5,600,000.
B) $2,800,000.
C) $2,400,000.
D) $1,800,000.
Answer: C
Diff: 2 Page Ref: 64-66
Keywords: Stockholders' Equity, Debt Ratio
Learning Obj.: L.O. 3.2
AACSB: Analytical Thinking

20
Copyright © 2017 Pearson Education, Inc.
47) Siskiyou, Inc. has total current assets of $1,200,000; total current liabilities of $500,000; and long-term
assets of $800,000. How much is the firm's Total Liabilities & Equity?
A) $2,500,000
B) $1,300,000
C) $2,000,000
D) $1,800,000
Answer: C
Diff: 2 Page Ref: 64
Keywords: Balance Sheet, Total Liabilities & Equity
Learning Obj.: L.O. 3.2
AACSB: Analytical Thinking

48) Siskiyou, Inc. has total current assets of $1,200,000; total current liabilities of $500,000; long-term assets
of $800,000; and long-term debt of $600,000. How much is the firm's total equity?
A) $1,200,000
B) $800,000
C) $900,000
D) $2,000,000
Answer: C
Diff: 2 Page Ref: 64
Keywords: Balance Sheet, Equity
Learning Obj.: L.O. 3.2
AACSB: Analytical Thinking

21
Copyright © 2017 Pearson Education, Inc.
49) Prepare a balance sheet using the information given below. Make sure to identify current assets, net
fixed assets, total assets, current liabilities, long-term debt, total equity, and total liabilities and equity.

Gross fixed assets $40,000

Cash $18,000
Other assets $5,000
Accumulated depreciation $30,000
Common stock $43,000
Short-term notes payable $12,000
Accounts payable $35,000
Inventories $122,000
Retained earnings $100,000
Accounts receivable $60,000
Long-term notes payable $10,000
Long-term bonds payable $15,000
Sales $300,000
Cost of goods sold $150,000
Depreciation expense $3,000

Answer:
Cash $18,000 Accounts payable $35,000
Accounts receivable 60,000 Short-term notes payable 12,000
Inventories 122,000 Current liabilities 47,000
Current assets 200,000 Long-term notes payable 10,000
Gross fixed assets 40,000 Long-term bonds payable 15,000
Less: Accumulated Depreciation (30,000) Long-term debt 25,000
Net fixed assets 10,000 Common stock 43,000
Other assets 5,000 Retained earnings 100,000
Total Equity 143,000
Total Assets $215,000 Total Liabilities & Equity $215,000

Diff: 2 Page Ref: 66

Keywords: Balance Sheet, Current Assets, Current Liabilities, Long-term Debt, Net Fixed Assets, Total Assets, Total
Equity, Total Liabilities & Equity
Learning Obj.: L.O. 3.2
AACSB: Analytical Thinking

22
Copyright © 2017 Pearson Education, Inc.
50) What are a firm's two principal sources of financing? Of what do these sources consist?
Answer: The total assets represent the resources owned by the firm, and total liabilities and total
shareholders' equity indicate how those resources were financed. Debt is money that has been borrowed
and must be repaid at some predetermined date to the creditors. Equity represents the shareholders'
(owners') investment—both preferred stockholders and common stockholders—in the firm.
Preferred stockholders generally receive a dividend that is fixed in amount. In the event of the firm being
liquidated, these stockholders are paid after the firm's creditors but before the common stockholders.
Common stockholders are the residual owners of a business. They receive whatever income is left over
after paying all expenses. In the event the firm is liquidated, the common stockholders receive only what
is left over—good or bad—after the creditors and preferred stockholders are paid. The amount of a firm's
common equity is equal to the sum of two items: (1) the amount a company receives from selling its stock
to investors, and (2) profits retained within the business.
Diff: 2 Page Ref: 63
Keywords: Financial Structure
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking

Learning Objective 3.3

1) Generally accepted accounting principles (GAAP) require finance statements prepared on a cash basis
because these statements are most useful for investors and managers.
Answer: FALSE
Diff: 1 Page Ref: 69
Keywords: Cash Basis, Accrual Basis, GAAP
Learning Obj.: L.O. 3.3
AACSB: Reflective Thinking

2) A company with negative net income will also have negative operating cash flow.
Answer: FALSE
Diff: 1 Page Ref: 69
Keywords: Operating Cash Flow, Net Income
Learning Obj.: L.O. 3.3
AACSB: Reflective Thinking

3) According to accrual accounting, revenues are recognized when earned and expenses are recognized
when incurred.
Answer: TRUE
Diff: 1 Page Ref: 69
Keywords: Accrual Accounting
Learning Obj.: L.O. 3.3
AACSB: Reflective Thinking

4) In order to be conservative, accrual accounting requires that expenses be recorded when incurred, but
revenues are recorded only after the cash has been received.
Answer: FALSE
Diff: 1 Page Ref: 69
Keywords: Accrual Accounting, Revenues, Expenses
Learning Obj.: L.O. 3.3
AACSB: Reflective Thinking

23
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5) The statement of cash flow explains the changes that took place in the firm's cash balance over the
period of interest.
Answer: TRUE
Diff: 1 Page Ref: 71
Keywords: Statement of Cash Flows
Learning Obj.: L.O. 3.3
AACSB: Reflective Thinking

6) On an accrual basis income statement, revenues equal cash receipts and expenses equal cash
expenditures.
Answer: FALSE
Diff: 1 Page Ref: 69
Keywords: Accrual Basis, Income Statement, Revenues, Expenses
Learning Obj.: L.O. 3.3
AACSB: Reflective Thinking

7) What financial statement explains the changes that took place in the firm's cash balance over a period?
A) statement of cash flow
B) balance sheet
C) income statement
D) reconciliation of free cash flow
Answer: A
Diff: 1 Page Ref: 71
Keywords: Financial Statements, Statement of Cash Flow
Learning Obj.: L.O. 3.3
AACSB: Reflective Thinking

24
Copyright © 2017 Pearson Education, Inc.
Please refer to Table 3-1 for the following questions.

Table 3-1
Jones Company
Financial Information

December 2009 December 2010

Net Income $2,000 $4,000

Accounts receivable 750 950
Accumulated depreciation 1,000 1,500
Common stock 4,500 5000
Paid-in capital 7,500 8500
Retained earnings 1,500 3,500
Accounts payable 750 750

8) Based on the information in Table 3-1, calculate the after-tax cash flow from operations for 2008 (no
assets were disposed of during the year, and there was no change in interest payable or taxes payable).
A) $4,300
B) $1,450
C) $5,500
D) $6,250
Answer: A
Diff: 2 Page Ref: 73
Keywords: After-tax Cash Flow from Operations
Learning Obj.: L.O. 3.3
AACSB: Analytical Thinking

9) Based on the information in Table 3-1, the change in cash for 2010 is
A) $4,000.
B) $4,950.
C) $5,800.
D) $5,500.
Answer: C
Diff: 2 Page Ref: 77
Keywords: Statement of Cash Flows
Learning Obj.: L.O. 3.3
AACSB: Analytical Thinking

25
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10) A company borrows $2,000,000 and uses the money to purchase high technology machinery for its
operations. These are examples of
A) cash flow from financing and cash flow from operations.
B) cash flow from investing and cash flow from operations.
C) cash flow from financing and cash flow from investing.
D) cash flow from investing and cash flow from financing.
Answer: C
Diff: 1 Page Ref: 72
Keywords: Statement of Cash Flows
Learning Obj.: L.O. 3.3
AACSB: Analytical Thinking

11) The Colorado Jet Boat Company had a cash balance of $3 million at the beginning of 2010. During
2010, Sales were $8 million and expenses were $7 million. Therefore,
A) the cash balance at the end of 2010 is $4 million.
B) the cash balance at the end of 2010 must be greater than $3 million.
C) the cash balance at the end of 2010 must be less than $11 million.
D) the cash balance at the end of 2010 cannot be determined from the information given.
Answer: D
Diff: 2 Page Ref: 69, 70
Keywords: Cash Flow, Accrual Accounting vs. Cash Accounting
Learning Obj.: L.O. 3.3
AACSB: Analytical Thinking

12) Use the following information to calculate the change in the company's cash balance for the year.

Credit Sales $800,000

Cash Sales $500,000
Operating Expenses on Credit $200,000
Cash Operating Expenses $700,000
Accounts Receivable (Beg. of Year) $50,000
Accounts Receivable (End of Year) $80,000
Accounts Payable (Beg. of Year) $50,000
Accounts Payable (End of Year) $100,000
Income Taxes Paid $160,000

A) $145,000
B) $180,000
C) $260,000
D) $365,000
Answer: C
Diff: 2 Page Ref: 71
Keywords: Cash, Cash Flow
Learning Obj.: L.O. 3.3
AACSB: Analytical Thinking

26
Copyright © 2017 Pearson Education, Inc.
13) Given the following financial statements for ARGON Corporation, what is the company's after-tax
cash flow from operations?

Income Statement Balance Sheet

Year Ended 12/31/10 12/31/2010 12/31/2009
Sales $1,300,000 Current Assets $50,000 $45,000
Cost of Goods Sold 750,000 Fixed Assets 430,000 350,000
Operating Expenses 200,000 Total Assets $480,000 $395,000
Depreciation 100,000
EBIT 250,000 Current Liabilities $35,000 $50,000
Interest Expense 50,000 Long-term Debt 330,000 270,000
EBT 200,000 Common Stock 5,000 5,000
Taxes 80,000 Retained Earnings 110,000 70,000
Net Income $120,000 Total Liabilities & Equity $480,000 $395,000

A) $10,000
B) $270,000
C) $120,000
D) $295,000
Answer: B
Diff: 2 Page Ref: 73
Keywords: After-tax Cash Flow from Operations
Learning Obj.: L.O. 3.3
AACSB: Analytical Thinking

27
Copyright © 2017 Pearson Education, Inc.
14) Given the following financial statements for ARGON Corporation, and assuming that ARGON paid a
common dividend of $80,000 in 2010, what is the company's financing cash flow for 2010?

Income Statement Balance Sheet

Year Ended 12/31/10 12/31/2010 12/31/2009
Sales $1,300,000 Current Assets $50,000 $45,000
Cost of Goods Sold 750,000 Gross Fixed Assets 880,000 650,000
Operating Expenses 200,000 Less Accumulated Depreciation 450,000 350,000
Depreciation Expense 100,000 Fixed Assets 430,000 350,000
EBIT 250,000 Total Assets $480,000 $395,000
Interest Expense 50,000
EBT 200,000 Current Liabilities $35,000 $50,000
Taxes 80,000 Long-term Debt 330,000 270,000
Net Income $120,000 Common Stock 5,000 5,000
Retained Earnings 110,000 70,000
Total Liabilities & Equity $480,000 $395,000

A) -$10,000
B) -$15,000
C) -$65,000
D) -$70,000
Answer: D
Diff: 2 Page Ref: 75
Keywords: Financing Cash Flow
Learning Obj.: L.O. 3.3
AACSB: Analytical Thinking

15) Racing Horse Corporation reported net income for 2010 of $200,000, sales of $540,000, expenses
(excluding depreciation) of $180,000, and depreciation expense of $60,000. The company's accounts
receivable balance increased by $40,000 during the year and its accounts payable balance remained the
same. The company's change in cash for the year is estimated to be
A) $100,000.
B) $160,000.
C) $220,000.
D) $380,000.
Answer: C
Diff: 2 Page Ref: 72
Keywords: Cash Flow, Net Income, Depreciation Expense
Learning Obj.: L.O. 3.3
AACSB: Analytical Thinking

28
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16) Examples of uses of cash include
A) paying cash dividends to stockholders.
B) borrowing an additional amount using a secured loan.
C) selling machinery.
D) all of the above
Answer: A
Diff: 2 Page Ref: 71
Keywords: Uses of Cash
Learning Obj.: L.O. 3.3
AACSB: Reflective Thinking

17) What information does a firm's statement of cash flows provide to the viewing public?
A) a report of investments made and their cost for a specific period of time
B) a report documenting a firm's cash inflows and cash outflows from operating, financing, and investing
activities for a defined period of time
C) a report of revenues and expenses for a defined period of time
D) an itemization of all of a firm's assets, liabilities, and equity for a defined period of time
Answer: B
Diff: 1 Page Ref: 71
Keywords: Statement of Cash Flows
Learning Obj.: L.O. 3.3
AACSB: Reflective Thinking

18) Which of the following best describes cash flow from financing activities?
A) Interest income, plus dividend income, minus taxes
B) Interest expense, minus dividends paid
C) Interest paid, plus dividends paid, plus increase (or minus decrease) in stock, plus increase (or minus
decrease) in debt
D) Increase (or minus decrease) in stock, plus increase (or minus decrease) in debt, minus interest paid,
minus dividends paid
Answer: D
Diff: 2 Page Ref: 75
Keywords: Financial Statements, Statement of Cash Flow
Learning Obj.: L.O. 3.3
AACSB: Reflective Thinking

29
Copyright © 2017 Pearson Education, Inc.
Please refer to Table 3-2 for the following questions.

Table 3-2

Enigma has the following financial information:

Net Income $70,000

Taxable Income (EBT) $100,000
Interest Expense $20,000
Depreciation Expense $15,000
Tax Expense $30,000

Increase in Current Assets $20,000

Increase in A/P and Accruals $10,000
Decrease in Gross Fixed Assets $100,000

No changes were made in interest payable or taxes payable.

19) Based on the information in Table 3-2, what is Enigma's cash flow from operations?
A) $85,000
B) $100,000
C) $105,000
D) $75,000
Answer: D
Diff: 2 Page Ref: 73
Keywords: After-tax Cash Flow from Operations
Learning Obj.: L.O. 3.3
AACSB: Analytical Thinking

20) A firm has after-tax cash flow from operations equal to $100,000. Operating working capital increased
by $20,000, and the firm purchased $30,000 of fixed assets. The firm's free cash flow was
A) $50,000.
B) $90,000.
C) $110,000.
D) $150,000.
Answer: A
Diff: 2 Page Ref: 71
Keywords: Free Cash Flow
Learning Obj.: L.O. 3.3
AACSB: Analytical Thinking

30
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21) A firm paid dividends of $10,000, paid interest of $20,000, reduced debt principal outstanding (paid
off debt) in the amount of $100,000, and sold new stock for $150,000. What was the firm's cash flow from
financing activities?
A) +$20,000 ($20,000 flowed into the firm)
B) -$20,000 ($20,000 flowed out of the firm)
C) +$280,000 ($280,000 flowed into the firm)
D) -$280,000 ($280,000 flowed out of the firm)
Answer: A
Diff: 2 Page Ref: 75
Keywords: Free Cash Flow
Learning Obj.: L.O. 3.3
AACSB: Analytical Thinking

31
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22) Table 3-3
Marlett Company
Financial Information

December 2009 December 2010

Net Income $2,000 $4,000

Accounts receivable 750 1,250
Accumulated depreciation 1,000 1,400
Common stock 4,500 5500
Paid-in capital 7,500 8500
Retained earnings 1,500 3,500
Accounts payable 750 950

Based on the information in Table 3-3, prepare a statement of cash flows for 2010. Assume that there were
no changes in any other asset or liability accounts, and that the ending cash balance for 2009 was $100.
Answer:

Marlett Company
Statement of Cash Flows
For the Year Ended Dec. 31, 2008

Operating Activities
Net Income $4,000
Depreciation Expense 400
Increase in Accounts Receivable (500)
Increase in Accounts Payable 200
Cash Flow from Operations $4,100

Investing Activities
Cash Flow from Investing Activities $0

Financing Activities
Increase in Common Stock $1,000
Increase in Paid-in-Capital 1,000
Dividends Paid (2,000)
Cash Flow from Financing Activities $0

Change in Cash $4,100

Beginning Cash Balance 100
Ending Cash Balance $4,200

Diff: 2 Page Ref: 76

Keywords: Cash Flow
Learning Obj.: L.O. 3.3
AACSB: Analytical Thinking

32
Copyright © 2017 Pearson Education, Inc.
23) Is it possible for a company that has negative net income and negative operating cash flow to end the
year with an increase in cash and an increase in stock price? Explain your answer.
Answer: Yes! Many start-up companies or research companies in high growth industries are financed by
borrowing money or selling more shares of stock to cover operating losses and finance development costs
until, hopefully, the companies become profitable and cash-flow positive. Many of the familiar Internet
companies of today, such as Amazon and Yahoo, began with negative income and high negative
operating cash flows as infrastructure and business relationships were put into place. Investors are
willing to provide capital to such companies hoping that business growth will lead to positive and
growing cash flows in the future. If financing cash flows are more than enough to cover operating losses
and additional investments in working capital and long-term assets, then the company's cash balance
could actually increase despite negative net income and negative operating cash flow.
Diff: 2 Page Ref: 72
Keywords: Cash Flow
Learning Obj.: L.O. 3.3
AACSB: Reflective Thinking

24) Mr. Wizard's Magic Shoppe had the following condensed balance sheet at the end of operation for
2010:

Mr. Wizard's Magic Shoppe

Balance Sheet
December 31, 2010

Cash $40,000 Current Liabilities $35,000

Other current assets 60,000 Long-term Notes Payable 40,000
Total current assets $100,000 Bonds Payable 50,000
Investments $25,000 Capital Stock 150,000
Fixed assets (net) 110,000 Retained earnings 80,000
Land $120,000
Total assets $355,000 Total Liabilities and Equity $355,000

During 2011, the following occurred

a. Mr. Wizard's sold some of its investments for $13,000 which resulted in a gain of
$300 after taxes. The gain (net of taxes) has been included in the company's 2011 net income.
b. Additional land for a plant expansion was purchased for $25,000.
c. Bonds payable were paid in the amount of $10,000.
d. An additional $35,000 in capital stock was issued.
e. Dividends of $15,000 were paid to stockholders.
f. Net income for 2011 was $48,000 after allowing for $15,000 in depreciation.
g. A second parcel of land was purchased through the issuance of $10,000 in bonds,
and $5,000 in long-term notes payable.

Required:

a. Prepare a statement of cash flows for the year ended 12/31/2011.

(check figure: ending cash balance = $72,500)
b. Prepare a condensed balance sheet for Mr. Wizard's at December 31, 2011.

33
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Answer:
Mr. Wizard's Magic Shoppe
Statement of Cash Flow
For the Year Ended December 31, 2011

Cash balance (December 31, 2010) $40,000

Net Income (from the statement of income) $48,000

Add (deduct) to reconcile net income to net cash flow:
Depreciation Expense 15,000
Loss (Gain) from the sale of investments (300)
Net cash inflow from operating activities $62,700

Cash flows from investing activities:

Sale of Investments 13,000
Purchase of Land (25,000+10,000+5,000) (40,000)
Net cash flow from investing activities: (27,000)

Cash flows from financing activities:

Issuance of capital stock 35,000
Issuance of bonds 10,000
Issuance of notes payable 5,000
Repayment of bonds payable (10,000)
Dividends (15,000)
Net cash flow from financing activities: 25,000

Net increase (decrease) in cash during the period $60,700

Cash balance (December 31, 2011) $100,700

Mr. Wizard's Magic Shoppe

Balance Sheet
December 31, 2011

Cash $100,700 Current Liabilities $35,000

Other current assets 60,000 Long-term Notes Payable 45,000
Total current assets $160,700 Bonds Payable 50,000
Investments $12,300 Capital Stock 185,000
Fixed assets (net) 95,000 Retained earnings 113,000
Land $160,000
Total assets $428,000 Total Liabilities and Equity $428,000

Diff: 3 Page Ref: 71

Keywords: Statement of Cash Flows, Balance Sheet
Learning Obj.: L.O. 3.3
AACSB: Analytical Thinking

34
Copyright © 2017 Pearson Education, Inc.
25) Given the information below, calculate the company's cash balance at the end of the year.

Cash Balance at Beginning of Year $80,000

Activity During the Year

Increase in Accounts Payable $60,000
Decrease in Accounts Receivable $40,000
Depreciation Expense $500,000
Net Income $2,000,000
Purchase of Fixed Assets $800,000
Sales of Common Stock $100,000
Decrease in Notes Payable $85,000
Dividends Paid $15,000

Answer:
Increase in Accounts Payable $60,000 (source)
Decrease in Accounts Receivable $40,000 (source)
Depreciation Expense $500,000 (source)
Net Income $2,000,000
Purchase of Fixed Assets $800,000 (use)
Sales of Common Stock $100,000 (source)
Decrease in Notes Payable $85,000 (use)
Dividends Paid $15,000 (use)
Change in Cash for the Year $1,800,000

Cash Balance at the End of Year = $80,000 + $1,800,000 = $1,880,000

Diff: 3 Page Ref: 71
Keywords: Statement of Cash Flows, Sources and Uses of Cash
Learning Obj.: L.O. 3.3
AACSB: Analytical Thinking

26) Why doesn't an income statement provide a measure of a firm's cash flows?
Answer: An income statement is not a measure of cash flows because it is calculated on an accrual basis
rather than a cash basis. In accrual basis accounting, profits are recorded when earned–whether or not the
profits have been received in cash–and expenses are recorded when they are incurred–even if money has
not actually been paid out. In cash basis accounting, profits are reported when cash is received and
expenses are recorded when they are paid.
For a number of reasons, profits based on an accrual accounting system will differ from the firm's cash
flows. These reasons include the following: 1. Sales reported in an income statement include both cash
sales and credit sales. 2. Some inventory purchases are financed by credit, so inventory purchases do not
exactly equal cash spent for inventory. 3. The depreciation expense shown in the income statement is a
noncash expense.
Diff: 3 Page Ref: 69
Keywords: Accrual Accounting
Learning Obj.: L.O. 3.3
AACSB: Reflective Thinking

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Learning Objective 3.4

1) Generally Accepted Accounting Principles (GAAP) is a set of principle-based accounting standards

established by the Financial Accounting Standards Board (FASB).
Answer: FALSE
Diff: 1 Page Ref: 79
Keywords: GAAP and IFRS
Learning Obj.: L.O. 3.4
AACSB: Reflective Thinking

2) International Financial Reporting Standards (IFRS) is a set of principle-based accounting standards that
were established by the International Accounting Standards Board (IASB).
Answer: TRUE
Diff: 1 Page Ref: 79
Keywords: GAAP and IFRS
Learning Obj.: L.O. 3.4
AACSB: Reflective Thinking

3) Which of the following statements about International Financial Reporting Standards (IFRS) is NOT
true?
A) IFRS sets out broad and general principles that accountants should follow when preparing financial
statements.
B) IFRS leaves LESS room for discretion than GAAP does.
C) IFRS offers simplicity but also possibly more leeway for accounting malpractice than does GAAP.
D) In 2008, the Securities and Exchange Commission (SEC) announced its plan to convert U.S. companies
from GAAP to IFRS.
Answer: B
Diff: 1 Page Ref: 79
Keywords: GAAP and IFRS
Learning Obj.: L.O. 3.4
AACSB: Reflective Thinking

4) Which of the following statements about Generally Accepted Accounting Principles (GAAP) is NOT
true?
A) GAAP is a set of rule-based accounting standards established by the Financial Accounting Standards
Board (FASB).
B) GAAP sets out the standards, conventions, and rules that accountants must follow when preparing
audited financial statements.
C) GAAP is complex, providing more than 150 "pronouncements" as to how to account for different types
of transactions.
D) All of the statements above are true.
Answer: D
Diff: 1 Page Ref: 79
Keywords: GAAP and IFRS
Learning Obj.: L.O. 3.4
AACSB: Reflective Thinking

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5) What are the differences between GAAP and IFRS?
Answer: The United States follows Generally Accepted Accounting Principles (GAAP). GAAP is rule-
based accounting standards established by the Financial Accounting Standards Board (FASB). It sets out
the standards, conventions, and rules that accountants must follow when preparing audited financial
statements.
IFRS is principle-based accounting standards that were established by the International Accounting
Standards Board (IASB). IFRS sets out broad and general principles that accountants should follow when
preparing financial statements. It leaves more room for discretion than GAAP does, permitting managers
to exercise their own judgment when deciding what to report in their financial statements as long as they
follow the spirit of the standards. IFRS offers simplicity, but also possibly more leeway for accounting
malpractice than GAAP.
Diff: 2 Page Ref: 79
Keywords: GAAP and IFRS
Learning Obj.: L.O. 3.4
AACSB: Reflective Thinking

Learning Objective 3.5

1) When a company sells a piece of equipment or land, any gain (sales price less the book value of the
asset or residual value) is thought to be a capital gain.
Answer: FALSE
Diff: 1 Page Ref: 80
Keywords: Tax Effect, Sale of Old Asset, Book Value
Learning Obj.: L.O. 3.5
AACSB: Reflective Thinking

2) Rogue Corp. has sales of $4,250,000; the firm's cost of goods sold is $2,500,000; and its total operating
expenses are $600,000. The firm's interest expense is $250,000, and the corporate tax rate is 40%. What is
Rogue's tax liability?
A) $258,000
B) $260,000
C) $360,000
D) $600,000
Answer: C
Diff: 1 Page Ref: 80-82
Keywords: Tax Liability, Interest Expense
Learning Obj.: L.O. 3.5
AACSB: Analytical Thinking

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3) The income statement for Simpson, Inc. indicates that tax expense was $30,000. The balance sheet
indicates that taxes payable for the same year increased by $5,000. What amount did Simpson, Inc.
actually pay in taxes during this year?
A) $15,000
B) $20,000
C) $25,000
D) Cannot be determined without the cash balance
Answer: C
Diff: 2 Page Ref: 80
Keywords: Tax Expense, Taxes Payable, Accrual vs. Cash Accounting
Learning Obj.: L.O. 3.5
AACSB: Analytical Thinking

4) How is taxable income computed?

Answer: The taxable income for a corporation consists of two basic components: operating income and
capital gains. Operating income, as we have already defined, is essentially gross profits less any operating
expenses, such as marketing expenses, administrative expenses, and so forth. Capital gains occur when a
firm sells a capital asset, which is any asset that is not part of its ordinary operations. For example, when
a company sells a piece of equipment or land, any gain (sales price less the cost of the asset) is thought to
be a capital gain. Also, the interest expense paid on the firm's outstanding debt is a tax-deductible
expense. However, dividends paid to the firm's stockholders are not deductible expenses, but rather
distributions of income. Other taxable income includes the interest income and dividend income that the
corporation receives.
Diff: 2 Page Ref: 80
Keywords: Earnings Before Taxes, Operating Income, Financing Costs
Learning Obj.: L.O. 3.5
AACSB: Reflective Thinking

5) Why should we be more concerned with the marginal tax rate rather than the average tax rate?
Answer: For financial decision making, it's the marginal tax rate rather than the average tax rate that we
are concerned with. Why? Because, generally speaking, the marginal rate is the rate the corporation pays
on the next dollar that is earned. We always want to consider the tax consequences of any financial
decision. The marginal tax rate is the rate that will be applicable for any changes in earnings that occur as
a result of the decision being made.
Diff: 2 Page Ref: 82
Keywords: Marginal Tax Rate
Learning Obj.: L.O. 3.5
AACSB: Reflective Thinking

Learning Objective 3.6

1) It is possible for two companies to have the same financial performance, but their financial statements
can be different, depending on how and when the managers choose to report certain transactions.
Answer: TRUE
Diff: 1 Page Ref: 83, 84
Keywords: GAAP
Learning Obj.: L.O. 3.6
AACSB: Reflective Thinking

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2) In the United States, financial statements are prepared following the Financial Accounting Standards
Board's generally accepted accounting principles (GAAP).
Answer: TRUE
Diff: 1 Page Ref: 83
Keywords: GAAP
Learning Obj.: L.O. 3.6
AACSB: Reflective Thinking

3) What are the limitations of financial statements?

Answer: When reviewing financial statements, keep in mind that accounting rules give managers
discretion; thus, they may take advantage of the leeway, as long as it doesn't violate GAAP, to produce
the high or stable earnings that investors are looking for. Therefore, what we see from financial
statements may not exactly reflect the company's financial situation. In other words, if two companies
have the same financial condition, their financial statements can be different, depending on how and
when the managers choose to report certain transactions.
Diff: 1 Page Ref: 83, 84
Keywords: Financial Statements
Learning Obj.: L.O. 3.6
AACSB: Reflective Thinking

Learning Objective 3.7

1) Computing the change in long-term assets or net capital spending, it involves computing the change in
net fixed assets and other long-term assets.
Answer: FALSE
Diff: 2 Page Ref: 102
Keywords: Capital Budgeting
Learning Obj.: L.O. 3.7
AACSB: Reflective Thinking

2) Cash flows between investors and the firm, what we call financing cash flows, occur in one of four
ways EXCEPT:
A) Pay stock dividend.
B) Pay interest to lenders.
C) Pay dividends to stockholders.
D) Increase or decrease interest-bearing debt.
Answer: A
Diff: 2 Page Ref: 103
Keywords: Financing Cash Flow
Learning Obj.: L.O. 3.7
AACSB: Reflective Thinking

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