Financial Statements - Chapter 2

Victor Chow

Which of the following is an investing activity?

A Declaration of a cash dividend

B Sale of equipment at book value

C Sale of merchandise on credit

B.

Dealings in long-term assets are investing activities.

Merchandise is a current asset, therefore operating.

Bonds and dividends are long-term liabilities and equity respectively, hence financing.

Making and collecting loans and disposing of property, plant, and equipment are what kind of activities?

A Investing

B Operating

C Financing

A.

Changes in long-term assets such as PP&E and loans receivable are signs of investing activity.

Repurchase of a company's own shares at an amount greater than that for which they were originally issued is an example of what kind of activity?

A Operating

B Financing

C Investing

B.

Dealings in long-term liabilities or equity are signs of financing activity.

Which of the following items would most unlikely be classified as an operating activity?

A issuance of loans by a commercial bank

B issuance of debt for an acquisition of a competitor

C sale of automobiles by an automobile dealer

B.

Which of the following elements represents an economic resource?

A asset

B liability

C owners’ equity

A.

An asset is an economic resource of an entity that will either be converted into cash or consumed.

A decrease in net assets arising from peripheral or incidental transactions is called a(n):

A cost

B expense

C loss

C.

ABC Ltd. reported $65,000 in salaries expense for 20x8. Accrued salaries payable were $4,200 at the beginning of the year and $8,900 at the end of the year. How much cash was paid for salaries in the year?

A $69,700

B $60,300

C $60,800

B.

$65,000 +$4,200 - $8,900 = $60,300

In classifying the elements of financial statements, the primary distinction between revenues and gains is:

A the nature of the activities that gave rise to the transactions.

B the likelihood that the events will recur.

C the materiality of the amounts.

A.

Gains are generally from non-core activities, and revenues from day-to-day business.

Materiality is not an issue, nor should disclosure depend on external factors such as cost to do so.

Frequency of recurrence is a good answer but not the best one, as non-core activities are not always non-recurring.

Under GAAP, in a cash flow statement, interest payments to lenders and other creditors should be classified as cash outflows for which kind of activity?

A investing

B operating

C financing

B.

Although the principal amounts of debt are financing items, GAAP has decreed that interest payments must be classed as operating.

Net income is equal to:

A. revenues minus expenses plus gains minus losses plus investments by owners minus distributions to owners.

B. revenues minus expenses plus gains minus losses.

C. revenues minus expenses plus gains minus losses plus investments by owners minus distributions to owners plus assets minus liabilities.

B.

Gains and losses are included in net income, but not the results of transactions with owners.

An analyst has collected the following information regarding a company in advance of its year-end earnings announcement (in millions):

Estimated net income 200

Beginning retained earnings 1,400

Estimated distributions to owners 100

The analyst’s estimate of ending retained earnings (in millions) should be closest to:

A 1,300

B 1,500

C 1,700

B.

Ending retained earnings =

Beginning retained earnings + Net income - Distributions to owners

= 1,400 + 200 – 100 = 1,500

= 1,500

An analyst has compiled the following information regarding Rubsam, Inc.

Liabilities at year-end 1,000

Contributed capital at year-end 500

Beginning retained earnings 600

Revenue during the year 5,000

Expenses during the year 4,300

There have been no distributions to owners. The analyst’s most likely estimate of total assets at year-end should be closest to:

A 2,100

B 2,300

C 2,800

C.

Asset =

Liabilities + Contributed capital + Beginning retained earnings – Distributions to owners + Revenues – Expenses

= 1,000 + 500 + 600 – 0 + 5,000 – 4,300 = 2,800

HVG, LLC paid $12,000 of cash to a real estate company upon signing a lease on 31 December 20x5. The payment represents a $4,000 security deposit and $4,000 of rent for each of January 20x6 and February 20x6. Assuming that the correct accounting is to reflect both January and February rent as prepaid, the most likely effect on HVG’s accounting equation in December 20x5 is:

A no net change in assets

B a decrease in assets of $8,000

C a decrease in assets of $12,000

A.

The payment of January rent represents prepaid rent (an asset), which will be adjusted at the end of January to record rent expense. Cash (an asset) decreases by $12,000. Deposits (an asset) increase by $4,000. Prepaid rent (an asset) increases by $8,000. There is no net change in assets.

TRR Enterprises sold products to customers on 30 June 20x6 for a total price of $10,000. The terms of the sale are that payment is due in 30 days. The cost of the products was $8,000. The most likely net change in TRR’s total liabilities on 30 June 20x6 related to this transaction is:

A $0

B $2,000

C $10,000

A.

The sale of products without receipt of cash results in an increase in accounts receivable (an asset) of $10,000. The balance in inventory (an asset) decreases by $8,000. The net increase in assets is 2,000.This would be balanced by an increase in revenue of $10,000 and an increase in expenses (costs of goods sold) of 8,000. There is no change in Liabilities.

ABC Corp. paid $4,800 on June 1, 20x1 for a two-year insurance policy, and recorded the entire amount as insurance expense. The adjusting entry as of December 31, 20x1 is:

A credit insurance expense and debit prepaid insurance for $3,400.

B debit prepaid insurance and credit insurance expense for $1,400.

C credit prepaid insurance and debit insurance expense for $3,400.

A.

Insurance expense is too high as part of the policy is unexpired. This portion of the cost must be prepaid.

17/24 of $4,800 is $3,400.

ABC Corp. paid $4,800 on June 1, 20x1 for a two-year insurance policy, and recorded the entire amount as insurance expense. Assume correct adjustments were made on December 31, 20x1. The adjusting entry as of December 31, 20x2 is:

A debit prepaid insurance and credit insurance expense for $2,400.

B debit insurance expense and credit prepaid insurance for $1,000.

C debit insurance expense and credit prepaid insurance for $2,400.

C.

Note the dates - only five months of the policy are still unexpired at the end of 20x1. This much is still prepaid (5/24 x $4,800 = $1,000), but if the proper adjustments were made at the 20x1 year-end, correctly setting up 17 months' worth of prepaid at that time, then it only remains to expense 12 months' worth ($2,400) of that prepaid in 20x2, leaving the final five months to be expensed in 20x1.

On 30 April 20x6, Pinto Products received a cash payment of $30,000 as a deposit on production of a custom machine to be delivered in August 20x6. This transaction would most likely result in which of the following on 30 April 20x6?

A no effect on liabilities

B an increase in assets of $30,000

C a decrease in liabilities of $30,000

B.

The receipt of cash in advance of delivering goods or services results in unearned revenue, which is a liability. The company has an obligation (liability) to deliver $30,000 in goods in the future. This balances the increase in cash (an asset) of $30,000.

Adjusting entries are necessary to:

A provide the figure for net income that management desires.

B adjust assets and liabilities to their fair market values.

C properly match revenues and expenses.

C.

Adjusting entries match revenues and expenses in the proper period. Fair market value and cash flow are not considerations, and management's wishes as per net income are not relevant.

A prepaid expense can best be described as an amount:

A paid and currently matched with revenues.

B paid and not currently matched with revenues.

C not paid and not currently matched with revenues.

B.

Prepaid means that cash has already been spent. The "pre" part denotes a disconnect between cash movement and revenue recognition - cash has moved, revenue has not yet happened. For example, rent paid at the start of the month. The revenue from use of the space has not yet been earned but the cash has been paid to the landlord.

When the cash associated with a sale is collected and recorded in advance of the sale, it is normally called a(n):

A accrued revenue

B unearned revenue

C prepaid revenue

B.

Accrued revenues are receivables. Prepaid revenue and cash revenue are not accounting terms.

An accrued expense can best be described as an amount:

A paid and currently matched with earnings.

B not paid and not currently matched with earnings.

C not paid and currently matched with earnings.

C.

The word accrued denotes both matching and lack of payment. If it was paid, it would not need to have been accrued. Accrual is the matching procedure itself.

When an item of expense is unpaid but recorded, it is normally called a(n):

A prepaid expense

B accrued expense

C estimated expense

B.

An accrued expense is a payable. Estimated and cash expenses are not accounting terms.

Why are certain costs of doing business capitalized when incurred and then amortized over subsequent accounting cycles?

A To match the costs of production with revenues as earned

B To aid management in cash flow analysis

C To reduce the income tax liability

A.

Amortization is a process of cost allocation, which achieves matching of the cost of an asset with the benefits to be received from them. It has nothing to do with cash flow, taxes, or conservatism.

If inventory at the end of the year is understated (too low), the effect will be to:

A overstate gross profit.

B understate purchases.

C overstate the cost of goods sold.

C.

Opening inventory plus purchases is goods available for sale. Ending inventory does not directly affect either of these, as both are historic facts and the total of the two is therefore fixed and known. However, goods available for sale consist of the cost of goods sold plus ending inventory (cost of goods not sold), so if one is too low, the other is too high, and vice versa.

The financial statement which summarizes the operating, financing, and investing activities of a firm for a period of time is the:

A income statement.

B cash flow statement.

C retained earnings statement.

B.

The statement of financial position, or balance sheet, summarizes assets, liabilities, and equity at a point of time.

The income statement deals with revenues, expenses, gains, and losses for a period.

The statement of retained earnings details changes in that account for a period.

An analyst who is interested in assessing a company’s liquidity position is most likely to focus on which financial statement?

A balance sheet

B income statement

C statement of cash flows

C.

The collection of all business transactions sorted by account in an accounting system is referred to as:

A a trial balance

B a general ledger

C a general journal

B.

The general ledger is the collection of all business transactions sorted by account in an accounting system. The general journal is the collection of all business activities sorted by date.

If a company reported fictitious revenue, it could try to cover up its fraud by:

A decreasing assets

B increasing liabilities

C creating a fictitious asset

C.

In order to balance the accounting equation, the company would either need to increase assets or decrease liabilities. Creating a fictitious asset would be one way of attempting to cover up the fraud.

The groups into which business activities are classified for financial reporting
are:
A. current and non-current.
B. operating, investing, and financing.
C. assets, liabilities, equity, revenues, and expenses.

B.

Business activities are classified for financial reporting purposes as operating,
investing, or financing activities.

Accounts receivable and accounts payable are most likely classified as which
financial statement elements?
Accounts receivable - Accounts payable

A. Assets - Liabilities
B. Revenues - Liabilities
C. Revenues - Expenses

A.

Accounts receivable are an asset and accounts payable are a liability.

Annual depreciation and accumulated depreciation are most likely classified as
which financial statement elements?
Depreciation - Accumulated Depreciation
A. Expenses - Contra liabilities
B. Expenses - Contra assets
C. Liabilities - Contra assets

B.

Annual depreciation is an expense. Accumulated depreciation is a contra asset
account that typically offsets the historical cost of property, plant, and
equipment.

The accounting equation is least accurately stated as:
A. owners’ equity = liabilities – assets.
B. ending retained earnings = assets – contributed capital – liabilities.
C. assets = liabilities + contributed capital + beginning retained earnings +
revenue – expenses – dividends.

A.

Owners’ equity is equal to assets minus liabilities.

A decrease in assets would least likely be consistent with a(n):
A. increase in expenses.
B. decrease in revenues.
C. increase in contributed capital.

C.

The expanded accounting equation shows that assets = liabilities + contributed
capital + beginning retained earnings + revenue – expenses – dividends. A
decrease in assets is consistent with an increase in expenses or a decrease in
revenues but not with an increase in contributed capital.

An electrician repaired the light fixtures in a retail shop on October 24 and sent
the bill to the shop on November 3. If both the electrician and the shop
prepare financial statements under the accrual method on October 31, how
will they each record this transaction?

Electrician - Retail Shop
A. Accrued revenue - Accrued expense
B. Accrued revenue - Prepaid expense
C. Unearned revenue - Accrued expense

A.

The service is performed before cash is paid. This transaction represents
accrued revenue to the electrician and an accrued expense to the retail shop.
Since the invoice has not been sent as of the statement date, it is not shown in
accounts receivable or accounts payable.

If a firm raises $10 million by issuing new common stock, which of its financial
statements will reflect the transaction?
A. Income statement and statement of owners’ equity.
B. Balance sheet, income statement, and cash flow statement.
C. Balance sheet, cash flow statement, and statement of owners’ equity.

C.

The $10 million raised appears on the cash flow statement as a cash inflow
from financing and on the statement of owners’ equity as an increase in
contributed capital. Both assets (cash) and equity (common stock) increase on
the balance sheet. The income statement is unaffected by stock issuance.

An auditor needs to review all of a company’s transactions that took place
between August 15 and August 17 of the current year. To find this information,
she would most likely consult the company’s:
A. general ledger.
B. general journal.
C. financial statements.

B.

The general journal lists all of the company’s transactions by date. The general
ledger lists them by account.

Paul Schmidt, a representative for Westby Investments, is explaining how
security analysts use the results of the accounting process. He states, “Analysts
do not have access to all the entries that went into creating a company’s
financial statements. If the analyst carefully reviews the auditor’s report for
any instances where the financial statements deviate from the appropriate
accounting principles, he can then be confident that management is not
manipulating earnings.” Schmidt is:
A. correct.
B. incorrect, because the entries that went into creating a company’s
financial statements are publicly available.
C. incorrect, because management can manipulate earnings even within
the confines of generally accepted accounting principles.

C.

Schmidt is correct in stating that analysts do not have access to the detailed
accounting entries that went into a company’s financial statements. However,
he is incorrect in stating that an analyst can be sure management is not
manipulating earnings if the audit report does not list deviations from
accounting principles. Because accruals and many valuations require
management’s judgment, there is considerable room within the accounting
standards for management to manipulate earnings.

Which would be a valid reason to not immediately record an event in an
accounting information system?
A The problem measuring it is too complex.
B The amount is not material.
C The service has not been performed, although the cash has been received.

A.

Transactions are recorded when either the cash or the services change hands.
Materiality is not an issue; everything gets recorded in the system, although
perhaps not disclosed separately on the financial statements.
Difficulty of measurement may be a reason to not record something, at least until
a better, more reliable measurement is available.

Which of the following is not part of an original general journal entry?
A an explanation
B a date
C the reference to where the accounts were posted.

C.

The original entry contains one or more debited accounts and amounts, one or
more credited accounts and amounts, the date, and a brief explanation. The cross-
references to the ledger are added later at the posting stage.

The debit and credit analysis of a transaction normally takes place:
A when the trial balance is prepared.
B when the entry is posted to the ledger.
C before an entry is recorded in a journal.

C.

Transaction analysis is the first step in the accounting process. Journal entries can only be
prepared once the debits and credits have been determined. Posting to the ledger and
the preparation of trial balances and financial statements are later steps in the process.

JKL Co. collected $25,900 in interest during 20x8. Interest receivable was
$2,900 at the beginning of the year and $3,700 at the end of the year. How much
interest revenue will the company report on its 20x8 income statement?
A $25,100
B $19,300
C $26,700

C.

Interest income for 20x8 on an accrual basis is:
$25,900 - $2,900 + $3,700 = $26,700

Which of the following is not a requirement for an event to be recorded?
A The event is relevant and reliable.
B The event involves a collection or payment of cash.
C The event can be measured objectively in financial terms.

B.

Cash collection or payment is not a requirement for an event to be a recordable
transaction. Many transactions are recorded before (or after) the cash is
transferred, or when no cash is ever transferred (e.g., depreciation).

A factor that would not be taken into account when designing an accounting
information system is:
A the size of the firm.
B the nature of the business or industry.
C the company's fiscal year-end date.

C.

The specific date of the fiscal year end has no bearing on the accounting system,
as all systems can handle any cut-off date. The nature, size, and volume of the
business would determine the specific accounts needed.

Which of the following is not an accounting transaction?
A Receiving cash from a customer prior to performing the service
B Recording of amortization
C Hiring of a controller

C.

Personnel changes are not accounting transactions because human resources are
not financial assets. Receivables, payables, and amortization are all items found
on financial statements, and transactions can occur therein even without any cash
changing hands.

Which of the following is not a component of comprehensive income?
A Revenues
B Dividends paid
C Dividends received

B.

Dividends paid are a direct deduction from retained earnings.

FGH Inc. paid $125,200 in salaries during 20x6. Salaries payable were
$10,600 at the beginning of the year and $12,300 at the end of the year. How much
will the company report as salaries expense on its 20x6 income statement?
A $123,500
B $126,900
C $102,300

B.

$125,200 - $10,600 + $12,300 = $126,900

XYZ Inc. reported $75,500 in interest revenue during 20x8. Interest receivable
at the beginning of the year was $7,500, and at the end of the year, $9,100. How
much cash was received for interest during the year?
A $73,900
B $66,400
C $75,500

A.

Interest receivable increased by $9,100 - $7,500 or $1,600.
Therefore, the cash interest received equals $75,500 - $1,600 or $73,900.

An unearned revenue can best be described as an amount:
A collected and currently matched with expenses.
B not collected and currently matched with expenses.
C collected and not currently matched with expenses.

C.

An unearned revenue has been collected, but the services to be performed have
not been completed yet, so there are, as yet, no expenses to match the cash with.

An accounting record into which the essential facts and figures about
transactions are initially recorded is called the:
A General ledger
B Book of original entry
C Account

B.

Entries are first made into books of original entry, such as journals of various types.
They are then posted into the accounts of the general ledger, and subsequently
summarized into the trial balance.