Chap 005

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Chapter 005: Communicating and Interpreting Accounting Information
True / False Questions

1. The users of accounting information are decision makers such as investors, creditors, and
financial analysis who provide investment advice.
TRUE
AACSB Tag: Relative Thinking

Difficulty: Easy
L.O.: 1
2. For information to be reliable it should be accurate, unbiased, and verifiable.

TRUE

Difficulty: Medium
L.O.: 1
3. Independent auditors are advisors who analyze financial and other economic information to
formulate forecasts and stock recommendations.
FALSE

Difficulty: Easy
L.O.: 1
4. The Sarbanes-Oxley Act is intended to strengthen financial reporting and corporate

governance for public companies.
TRUE
AACSB Tag: Ethics

Difficulty: Medium
L.O.: 1
5-1
2009 McGraw-Hill Inc. Test Bank to accompany Libby Financial Accounting 6/e
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5. Financial analysts perform the basic analysis of a company's financial reports in order to
make earnings projections.
TRUE

Difficulty: Easy
L.O.: 1
6. A form 10-Q is a brief unaudited report for a quarter normally containing a summary
income statement and balance sheet.
TRUE
AACSB Tag: Communications

Difficulty: Easy
L.O.: 2
7. The financial statements of all public companies, both large and small, must follow
generally accepted accounting principles as well as the Securities and Exchange
Commission's accounting rules.
FALSE

Difficulty: Medium
L.O.: 2
8. Form 10-K is the annual report that must be filed with the Securities and Exchange
Commission (SEC) by publicly traded companies.
TRUE

Difficulty: Easy
L.O.: 2
5-2
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9. Intangible assets have no physical existence and a short life.

FALSE

Difficulty: Medium
L.O.: 3
10. The materiality constraint holds that amounts that are of low significance need not be
recorded nor reported.
FALSE

Difficulty: Medium
L.O.: 3
11. The conservatism constraint means that assets and revenues should not be overstated and
that liabilities and expenses should not be understated.
TRUE

Difficulty: Medium
L.O.: 3
12. Par value is a legal amount per share established by the board of directors.
TRUE

Difficulty: Easy
L.O.: 3
13. Gross profit is an important profit measure for companies that sell inventory because it
shows the profit left from net sales after all operating expenses have been deducted.
FALSE

Difficulty: Medium
L.O.: 3
5-3
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14. Income tax expense for continuing operations is shown as a deduction from operating
income and then any tax effect connected to an extraordinary item is shown parenthetically so
the item is added to or deducted from after tax income from operations at a net of tax amount.
TRUE

Difficulty: Hard
L.O.: 3
15. The operating activities section of the statement of cash flows can be prepared under
either the direct or indirect method.
TRUE

Difficulty: Medium
L.O.: 3
16. We calculate return on equity (ROE) by dividing operating income by average common
stockholders' equity.
FALSE

Difficulty: Medium
L.O.: 4
17. A company's return on equity (ROE) that has been increasing over the past three years
means the company has generated greater profit for the common stockholders.
TRUE

Difficulty: Medium
L.O.: 4
5-4
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18. An increase in return on equity (ROE), over the three most recent years reported, can be a
signal that a company has not invested in modernization of plant and equipment or research
and development which in the long run might lead to declining profits.
TRUE

Difficulty: Hard
L.O.: 4
19. Return on equity (ROE) is really a combination of three separate ratios which explain
what drives ROE up or down.
TRUE

Difficulty: Medium
L.O.: 4
20. In comparing Wal-Mart to Abercrombie & Fitch, Wal-Mart would be a better example of
a low-cost strategy company that relies on efficient asset management to keep costs low and
investment in assets low.
TRUE

Difficulty: Hard
L.O.: 4
Multiple Choice Questions

21. The comparability principle assumes that
A. users can compare financial data across businesses.
B. accounting data should be based on objective data and transactions.
C. accounting data should be supported by appropriate documents when possible.
D. information can be compared over time because similar accounting methods have been
applied from year to year.

Difficulty: Medium
L.O.: 1
5-5
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22. For accounting information to be useful, it must be:

A. consistent and comparable.
B. relevant and reliable.
C. comparable and reliable.
D. relevant and consistent.

Difficulty: Easy
L.O.: 1
23. Conservatism requires that special care must be taken to avoid

A. overstating assets and liabilities and understating revenues and expenses.
B. understating assets and liabilities and overstating revenues and expenses.
C. overstating assets and revenues and understating liabilities and expenses.
D. understating assets and revenues and overstating liabilities and expenses.

Difficulty: Medium
L.O.: 1
24. The primary responsibility for the information reported by a company rests with
A. the Internal Revenue Service.
B. the company's auditors.
C. the local city council.
D. the company's management.

Difficulty: Easy
L.O.: 1
5-6
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25. The primary purpose of hiring a public accounting firm to examine the financial
statements of the company is
A. to provide a forecast of future earnings.
B. to assure no fraud has been committed by the company's management.
C. to provide credibility and assurance that the financial information conforms with generally
accepted accounting principles in all material respects.
D. to detect all accounting errors made by the accounting system and employees.
AACSB Tag: Ethics

Difficulty: Medium
L.O.: 1
26. The Securities and Exchange Commission (SEC) is empowered to do the following:
A. set reporting standards for firms with publicly traded debt or equity securities.
B. bring enforcement actions against company executives and auditors for accounting related
violations.
C. force companies to use a specific auditor.
D. bring enforcement actions against company executives and auditors for accounting related
violations and set reporting standards for firms with publicly traded debt or equity securities.
AACSB Tag: Ethics

Difficulty: Hard
L.O.: 1
27. In an attempt to restore investor confidence, Congress passed the Public Accounting
Reform and Investor Protection Act otherwise known as the
A. Safe Investment Practices Act.
B. National Investment Protection Act.
C. Sarbanes-Oxley Act.
D. Accounting Protection Act.
AACSB Tag: Ethics

Difficulty: Medium
L.O.: 1
5-7
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28. When the actual earnings reported exceed the expected earnings for a company, what
typically occurs?
A. There is no stock price reaction because forecasts of earnings almost never reflect actual
results.
B. There is a favorable reaction by the market.
C. There is an unfavorable reaction by the market.
D. The difference will be paid to shareholders in the form of dividends.

Difficulty: Medium
L.O.: 1
29. Which of the following describes the conservatism constraint?

A. Avoid overstating assets and revenues and avoid understating expenses and liabilities.
B. The benefits of accounting for and reporting information should outweigh the costs.
C. Amounts that are large enough to influence a user's decisions.
D. Differences due to long-standing and accepted accounting and reporting in a particular
industry.

Difficulty: Easy
L.O.: 1
30. Which of the following is false?

A. Relevance is the characteristic of accounting information that says the information would
make a difference in a user's decision.
B. Accounts receivable would normally be classified as a current asset.
C. Accumulated depreciation would normally appear in the income statement.
D. The matching principle holds that all expenses incurred in the generation of revenue should
be recognized in the same period as the revenue is earned.

Difficulty: Medium
L.O.: 1
5-8
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31. Materiality, cost-benefit, and conservatism are

A. Qualitative characteristics.
B. Elements of financial statements.
C. Accounting principles.
D. Guiding principles for communicating useful information

Difficulty: Easy
L.O.: 1
32. The Securities and Exchange Commission's (SEC) report that is required to be filed if any
special event occurs that is material in amount is the
A. Form 10K.
B. Form 8K.
C. Form 10Q.
D. Prospectus.
AACSB Tag: Ethics

Difficulty: Medium
L.O.: 2
33. In what order are current assets usually reported on the balance sheet?
A. From the most liquid to the least liquid.
B. From the least liquid to the most liquid.
C. In alphabetical order of accounts.
D. From the largest balance to the smallest balance.

Difficulty: Easy
L.O.: 3
5-9
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34. Which of the following is not commonly classified as a current asset?

A. Accounts receivable.
B. Property and equipment.
C. Merchandise inventory.
D. Office supplies inventory.

Difficulty: Easy
L.O.: 3
35. When a corporation issues stock at an amount over the par value, what account is used to
record that amount received over par?
A. Common stock
B. Cash
C. Additional paid in capital
D. Retained earnings

Difficulty: Medium
L.O.: 3
36. Contributed capital I usually shown as which two accounts?

A. Common stock and Additional paid in capital
B. Common stock and Retained earnings
C. Additional paid in capital and Retained earnings
D. Retained earnings and dividends

Difficulty: Easy
L.O.: 3
5-10
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37. The criteria for extraordinary items are

A. unusual in nature and occur frequently.
B. unusual in nature and occur infrequently.
C. unusual in nature or occur infrequently.
D. infrequent in occurrence only.

Difficulty: Easy
L.O.: 3
38. Which of the following is not an asset account?

A. Long-term investments.
B. Unearned revenue.
C. Machinery.
D. Patent.

Difficulty: Medium
L.O.: 3
39. Granger Corporation reported total assets of $5,200,000, total current liabilities of
$2,300,000, and total long-term liabilities of $1,200,000. Therefore, the stockholders' equity
was
A. $ 100,000.
B. $ 800,000.
C. $1,600,000.
D. $1,700,000.
AACSB Tag: Analytic

Difficulty: Easy
L.O.: 3
5-11
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40. What are the categories of cash flows that appear on a statement of cash flows?
A. Cash flows from investing, financing, and service activities.
B. Cash flows from investing, financing, and saving activities.
C. Cash flows from operating, investing, and financing activities.
D. Cash flows from operating, production, and investing activities.

Difficulty: Medium
L.O.: 3
41. On January 1, 2009, Madison Company had $60,000 of Retained Earnings. During 2009
Madison earned net income of $100,000 and declared and paid dividends of $15,000. In
addition, the company received cash of $25,000 as an additional investment by its owners.
Therefore, the ending balance in Retained Earnings at December 31, 2009 would be
A. $ 90,000.
B. $170,000.
C. $130,000.
D. $145,000.
AACSB Tag: Analytic

Difficulty: Medium
L.O.: 3
42. Which of the following would appear in the current asset section of a classified balance
sheet?
A. Intangible assets.
B. Bonds payable.
C. Accounts receivable.
D. Accumulated depreciation.

Difficulty: Medium
L.O.: 3
5-12
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43. Which of the following would appear in the intangible asset section of a classified balance
sheet?
A. Copyrights.
B. Accumulated depreciation.
C. Cash.
D. Accounts receivable.

Difficulty: Medium
L.O.: 3
44. Which of the following is true about gross profit (gross margin)?
A. It is a separate account in the general ledger.
B. It is net sales minus cost of goods sold.
C. It is sales plus cost of goods sold.
D. It is net sales minus all expenses.

Difficulty: Medium
L.O.: 3
45. Dallas Company issued 200,000 shares of its common stock for cash. The journal entry to
record the stock issue would include
A. a credit to Cash.
B. a debit to Common Stock.
C. a credit to Common Stock.
D. a debit to Retained Earnings.

Difficulty: Easy
L.O.: 3
5-13
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46. Which account would appear as a nonoperating (other) item on the income statement?
A. Cost of goods sold
B. Selling expenses
C. General and administrative expenses
D. Interest expense

Difficulty: Medium
L.O.: 3
47. Greeley Company purchased new equipment for its factory. In its statement of cash flows,
the purchase of equipment would be shown as cash flow used in
A. Operating activities.
B. Financing activities.
C. Investing activities.
D. Purchasing activities.

Difficulty: Medium
L.O.: 3
48. Ross, Inc. paid cash dividends of $20,000 during 2009. In its statement of cash flows, the
dividends would be shown as cash flow used in
D. Distributing activities.

Difficulty: Medium
L.O.: 3
5-14
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49. Short, Inc. issued capital stock for $500,000 during 2009. In its statement of cash flows,
the stock issue would be shown as a cash flow from
D. Selling activities.

Difficulty: Medium
L.O.: 3
50. Union Company collected $500,000 from customers and paid employees and suppliers
$380,000 during 2009. In addition, the company borrowed $50,000 from the bank and
purchased equipment for $90,000. The company's 2009 statement of cash flows would show
which of the following?
A. Increase in cash of $160,000.
B. Increase in cash of $80,000.
C. Decrease in cash of $180,000.
D. Increase in cash of $120,000.
AACSB Tag: Analytic

Difficulty: Hard
L.O.: 3
51. On January 1, 2010, Maplewood Corporation had the following balances in its
stockholders' equity accounts: Common stock, $100,000 (10,000 shares of $10 par value
stock); contributed capital in excess of par, $20,000; and retained earnings, $50,000. During
2010, the company issued 2,000 additional shares of common stock for $15 per share,
reported net income of $60,000 and paid cash dividends of $20,000. What amount of retained
earnings would Calley Corporation report on its December 31, 2010 balance sheet?
A. $110,000
B. $90,000
C. $210,000
D. $240,000
AACSB Tag: Analytic

Difficulty: Medium
L.O.: 3
5-15
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52. Which of the following statements is true?

A. Accumulated depreciation is a contra account on the income statement.
B. The last note to the financial statements is typically a summary of significant accounting
policies.
C. Intangible assets are assets that do not have a physical existence.
D. Book value of a building is the cost plus accumulated depreciation to date.

Difficulty: Easy
L.O.: 3

A. Accumulated depreciation is the amount of depreciation on the income statement for the
current year.
B. Current liabilities are debts expected to be paid within the next year.
C. Current assets are resources of a company that might include cash and copyrights.
D. Property, plant, and equipment are classified as intangible assets on the balance sheet.

Difficulty: Medium
L.O.: 3

A. Accumulated depreciation is a contra account in the income statement.
B. Par value is equal to the amount paid for the stock.
C. Retained earnings is the accumulated earnings plus the accumulated dividends paid.
D. Income before income taxes is also called pretax earnings.

Difficulty: Easy
L.O.: 3
5-16
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55. Centex, Inc. sold and issued 50,000 shares of its $1 par value common stock for $20 per
share. The journal entry to record the stock issue would include
A. a credit to cash for $1,000,000.
B. a credit to common stock for $1,000,000.
C. a debit to common stock for $50,000.
D. a credit to common stock for $50,000.
AACSB Tag: Analytic

Difficulty: Medium
L.O.: 3
56. Which statement about the classified balance sheet is false?

A. Current assets are listed in order of liquidity.
B. Current liabilities are listed in order of size with the largest account balances listed first.
C. Stockholders' equity is listed by source.
D. None of the other answers given is false.

Difficulty: Medium
L.O.: 3
57. Which of the following is an example of a long-term liability?

A. Accounts payable
B. Income taxes payable
C. Bonds Payable
D. Salaries payable

Difficulty: Easy
L.O.: 3
5-17
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58. An example of a noncurrent asset is

A. long term investments.
B. accounts receivable.
C. prepaid expenses.
D. inventory.

Difficulty: Medium
L.O.: 3
59. The two sections found on every income statement are

A. continuing operations and discontinued operations.
B. continuing operations and extraordinary items.
C. continuing operations and new operations.
D. continuing operations and earnings per share.

Difficulty: Medium
L.O.: 3
60. The indirect method of accounting for cash flow from operating activities
A. allows users to understand the causes of differences between net income on an accrual
basis and cash flow from operating activities.
B. allows users to see the connection of specific revenues and expenses from the income
statement to the cash received from those specific revenues or paid for those specific
expenses.
C. converts each specific revenue and expense to cash received or paid by adjusting for the
change in related asset and liability accounts from the balance sheet.
D. none of the other answers are true.

Difficulty: Hard
L.O.: 3
5-18
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61. The multiple step income statement discloses three subtotals of profit before reporting net
income. Those three intermediate profit figures are
A. gross profit, income from discontinued operations, and income from operations.
B. gross profit, income from operations, and income before taxes.
C. gross profit, gain or loss from an extraordinary item, and income before taxes.
D. gross profit, income or loss from discontinued operations, and income from operations.

Difficulty: Hard
L.O.: 3
62. On the multiple step income statement, an example of a non-operating (other) expense is
A. interest expense.
B. selling expense.
C. research and development costs.
D. all of these are non-operating.

Difficulty: Medium
L.O.: 3
63. Where would the statement of cash flows show cash paid for equipment?
B. Investing activities.
C. Financing activities.
D. Footnote to the statement of cash flows.

Difficulty: Medium
L.O.: 3
5-19
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64. Signing a long-term note payable in exchange for cash would be found in which section of
the statement of cash flows?
B. Investing activities.
C. Financing activities.
D. Footnote to the statement of cash flows.

Difficulty: Hard
L.O.: 3
65. What type of statement shows income statement items as a percentage of sales?
A. Classified income statement
B. Percentage income statement
C. Operating income statement
D. Common-size income statement

Difficulty: Easy
L.O.: 3
66. In a common size income statement, each line item is expressed as a percentage of
A. net income.
B. total expenses.
C. operating income.
D. net sales.

Difficulty: Medium
L.O.: 3
5-20
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67. Return on equity (ROE) primarily measures

A. the ability to generate revenue while holding assets steady.
B. the ability to generate sufficient profit on total assets.
C. the ability to earn income for the common stockholders.
D. None of these.

Difficulty: Medium
L.O.: 4
68. Return on equity is computed by taking

A. net income divided by ending stockholders' equity.
B. net income divided by average stockholders' equity.
C. net income divided by beginning stockholders' equity.
D. none of the other answers is correct.

Difficulty: Medium
L.O.: 4
69. Return on equity can be calculated by

A. multiplying net profit margin by asset turnover and financial leverage
B. dividing net profit margin by asset turnover and financial leverage
C. adding net profit margin to asset turnover and financial leverage
D. subtracting net profit margin from asset turnover and financial leverage

Difficulty: Medium
L.O.: 4
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70. Carrie's Coffee return on equity (ROE) was 11.4% in 2007 and 13.1% in 2008. The
increase in this ratio could be caused by which of the following?
A. An increase in net profit margin.
B. A decrease in the asset turnover ratio.
C. An increase in the relative portion of stockholders' equity to fund assets.
D. A decrease in net profit margin.
AACSB Tag: Analytic

Difficulty: Hard
L.O.: 4
71. The financial leverage ratio is computed by

A. dividing total liabilities by stockholders' equity.
B. dividing total assets by total liabilities.
C. dividing average total assets by average total liabilities.
D. dividing average total assets by average stockholders' equity.

Difficulty: Medium
L.O.: 4
72. Which of the following would most likely increase net profit margin?
A. Decreasing selling price
B. Increasing sales volume
C. Increasing expenses
D. Higher income taxes

Difficulty: Easy
L.O.: 4
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73. Asset turnover measures

A. the profit generated by efficient management of assets.
B. how quickly we liquidate our inventory.
C. the sales revenue generated by efficient management of assets.
D. the ability to generate income for the stockholders.

Difficulty: Medium
L.O.: 4
74. Financial leverage measures

A. the ability to convert sales dollars to income.
B. how many dollars of assets are employed for each dollar of stockholders' investment.
C. the income generated for every dollar of investment by the stockholders.
D. the sales revenue generated by effective asset management.

Difficulty: Medium
L.O.: 4
75. Which of the typically following will cause an increase in return on equity (ROE) as long
as expenses do not grow faster than revenue?
A. A decrease in average total assets
B. An increase in sales volume
C. An increase in net income
D. A decrease in expenses

Difficulty: Hard
L.O.: 4
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76. Which of the following is true?

A. An extraordinary gain would decrease net income.
B. Discontinued operations would be shown as a current asset on the balance sheet.
C. Discontinued operations are shown net of income tax effects.
D. Results from discontinued operations may be used to predict future company results.

Difficulty: Medium
L.O.: Chapter Supplement
77. Polk Company suffered a loss from earthquake damage at its plant in Nebraska. The loss
meets the criteria for an extraordinary item. Where will the company present the extraordinary
item in the income statement?
A. With other revenues and expenses.
B. Following sales revenue, but before cost of goods sold.
C. Following the section for discontinued operations.
D. These results are not reported in the income statement.

Difficulty: Medium
78. Discontinued operations are

A. the amount reflected on the income statement for adjustments made to balance sheet
accounts when applying different accounting principles.
B. the result of the disposal of a major segment of the business.
C. a gain or loss that is both unusual in nature and infrequent in occurrence.
D. a prediction of earnings for future accounting periods.

Difficulty: Medium
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79. An extraordinary item is

A. the amount reflected on the income statement for adjustments made to balance sheet
accounts when applying different accounting principles.
B. the result of the disposal of a major segment of the business.
C. a gain or loss that is both unusual in nature and infrequent in occurrence.
D. a prediction of earnings for future accounting periods.

Difficulty: Medium
Essay Questions
80. Compute each of the following amounts:
A. Assume total liabilities are $40,000, total stockholders' equity $75,000, and all assets, other
than current assets, total $50,000. What would be the amount of current assets?
B. If earnings per share is $2.50 and the number of shares of capital stock outstanding is
6,000, then what would net income be?
A. ($40,000 + $30,000) / ($150,000) = .47 (to solve for stockholders' equity, subtract total
liabilities $70,000 from the $220,000 of total assets).
B. $2.50
6,000 shares = $15,000 net income
AACSB Tag: Analytic

Difficulty: Hard
L.O.: 3
5-25
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81. Three transactions are listed below. For each transaction, indicate whether each increased
(+), decreased ( ) or have no effect (NE) on current assets, current liabilities and cash flows
from operating activities.
A. Recorded sales on account of $54,000.
B. Recorded sales for cash of $12,000.
C. Purchased inventory on account for $22,000.
A. Current assets +, Current liabilities NE, Cash flows from operating activities NE.
B. Current assets +, Current liabilities NE, Cash flows from operating activities +.
C. Current assets +, Current liabilities +, Cash flows from operating activities NE.
AACSB Tag: Analytic

Difficulty: Medium
L.O.: 3
82. The balance sheet for Glenwood Corporation at December 31, 2011, showed the
following subtotals:
Based on the above data, give the following amounts:
A.$140,000 + $420,000 + $70,000 = $630,000.

B. $210,000
$80,000 = $130,000.
C. $420,000
$120,000 = $300,000.
D. $210,000 + $420,000 = $630,000.
AACSB Tag: Analytic

Difficulty: Hard
L.O.: 3
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83. Ridgetop Corporation reported the following amounts on its balance sheet at December
31, 2009:
On January 1, 2009, total assets were $2,000,000, total liabilities were $1,200,000 and total
equity was $800,000. Calculate East's return on equity.
$100,000
($900,000 + $800,000/2) = 11.8%.
AACSB Tag: Analytic

Difficulty: Medium
L.O.: 3
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84. Complete the following balance sheet by entering the appropriate amounts in the blanks
provided.
A. $40,000. ($90,000 Total Assets

$35,000 Carrying Value of Building
$15,000 Cash)
B. $25,000. ($60,000 Building
$35,000 Book Value)
C. $90,000. (Must equal to F.)
D. $ 2,000. ($25,000 Current liabilities
$11,000 Accounts Payable
$12,000 Notes
payable)
E. $40,000. ($25,000 Contributed capital + $15,000 Retained earnings)
F. $90,000. ($50,000 Total Liabilities + $40,000 Total Stockholders' Equity)

Difficulty: Hard
L.O.: 3
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85. FocusMore, Inc., had the following alphabetical list of accounts taken from its adjusted
trial balance at December 31, 2010:
Required:
Prepare a multiple step income statement for 2010. (Include gross profit, but ignore income
taxes.)
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AACSB Tag: Analytic

Difficulty: Medium
L.O.: 3
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86. The following data were taken from the adjusted trial balance of Kent Corporation.
Required:
Prepare a classified balance sheet in good form at December 31, 2009. (Ignore income taxes).
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AACSB Tag: Analytic
Difficulty: Hard
L.O.: 3
87. In 2011, Jeffrey Company disposed of a segment of its business and incurred a pretax loss
on the disposal of $40,000. In the same year, a flood caused $15,000 of damages to the
building. The flood damage qualified as an extraordinary item. Income from continuing
operations before taxes was $100,000 for 2011 and the 20 percent tax rate applied to all of the
items above. Prepare a partial income statement starting with income from continuing
operations before taxes for the year 2011 and concluding with net income.
AACSB Tag: Analytic

Difficulty: Medium
L.O.: 3
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88. Dakota Equipment, Inc issued 4,000 shares of its $1 par value common stock for $20 per
share on January 1, 2010. On the same day, the company purchased a piece of land valued at
$10,000 and a building valued at $40,000. The yearly depreciation on the building is $2,000.
Required: Prepare the general journal entries to record the stock issue and the purchase of the
land and building on January 1 and the depreciation expense on December 31, 2010.
AACSB Tag: Analytic

Difficulty: Medium
L.O.: 3
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89. Twin Lakes, Inc. reported the following December 31 amounts in its financial statements:
Compute the following for the 2010:

A. Net profit margin
B. Asset turnover
C. Financial leverage
D. Return on equity
A. ($28.0/$250.0) = .112 or 11.2%
B. ($250.0/$85.0) = 2.94
C. ($85.0/$38.0) = 2.24
D. ($28.0/$38.0) = .737 or 73.7%
AACSB Tag: Analytic

Difficulty: Medium
L.O.: 4
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90. Discount Toys is a retail toy store. The following are selected figures from their income
statement (in millions):
A. Compute the following ratios for 2009, 2008 and 2007: Net profit margin, Asset turnover,
Financial leverage, and Return on equity.
B. Write a short essay explaining what has happened to the return on equity for Discount Toys
and discuss the causes of changes in the ratio for the three years.
A. Net profit margin 3.6% in 2009, 2.4% in 2008, (1.2%) in 2007; Asset turnover 1.39 in
2009, 1.46 in 2008, 1.41 in 2007; Financial leverage 2.30 in 2009, 2.23 in 2008, 1.97 in 2007;
Return on equity 11.4% in 2009, 7.6% in 2008, (3.3%) in 2007
B. Discount Toys has improved its asset turnover ratio slightly from 2007 to 2008 but it
dropped in 2009 as sales decreased while average assets increased indicating less efficient
asset management in 2009. Discount Toys has a fairly high financial leverage ratio and it
continues to rise indicating that they use a great deal of debt to finance their assets. An
increase in this ratio usually indicates that debt is rising faster than the investment in assets so
the debt to equity ratio is increasing. The profit margin has improved from a negative 1.2% in
2004 to a positive 3.6% in 2009. The improvement in their net profit margin may indicate
they have been better at controlling their costs thereby improving profit margins even though
sales dropped in 2009. Since ROE is a negative (3.2%) in 2007 compared to the negative net
profit margin of (1.2%) in 2007, it demonstrates negative financial leverage. The ROE is a
larger negative ratio because of the use of so much debt in financing the company's assets. In
2008 and 2009 when the net profit margin was positive, it led to a significantly higher ROE
than the reported profit margins in those years, demonstrating the ability to generate a better
return for the stockholders through the use of leverage. Note: in 2009 Discount Toys reported
a $315 million gain from the IPO of Toys-Japan which makes their profit margin and return
ratios look better than they would with only the results of operating income reflected in their
bottom line.
AACSB Tag: Analytic

Difficulty: Hard
L.O.: 4
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91. The following information was taken from the income statement and balance sheet of The
Mickey Company for the years 2008 and 2009 (in millions):
Compute the following ratios for 2009: Net profit margin, Asset turnover, Financial leverage,
and Return on equity.
Net profit margin (2,345/30,752) = .076 or 7.6%
Asset turnover (30,752/51,945) = .59
Financial leverage (51,945/24,936) = 2.08
Return on equity (2,345/24,936) = .094 or 9.4%
AACSB Tag: Analytic

Difficulty: Medium
L.O.: 4
Matching Questions
92. Listed below are the essential characteristics of accounting information. This list is
followed by a series of related statements. Match each statement with the appropriate
characteristics.
1. Immaterial amounts need not be separately reported or
disclosed
2. Decision makers who need financial information, such
as an investor or creditor
3. Cost of developing an accounting analysis is $500 and
its usefulness to decision makers is valued at $10
4. Receiver of financial statements, such as stockholders,
creditors, or financial consultants
Users 2
Cost-benefit
constraint 3
Users 4
Materiality 1

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L.O.: 2
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93. Assume Doran Corporation has an accounting year end of December 31. For each
statement listed, indicate the preferred heading date by entering the appropriate letter in the
space provided.
1. Statement of Cash flows
2. Statement of Stockholders'
equity
3. Income statement
4. Balance sheet
As of December 31, 2009

For the Year Ended December 31,
2009
2009
2009
4
1
3
2

Difficulty: Medium
L.O.: 3
94. This question focuses on the financial statements. Match the statement to the description.
1. Reports retained earnings and changes in
contributed capital
2. Reports the results of operations
Statement of partners'
equity
Income statement
Statement of stockholders'
equity
Statement of cash flows
Balance sheet
3. Does not apply to a corporation

4. Reports cash inflows and outflows
5. Reports financial position
3
2
1
4
5

Difficulty: Easy
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95. Match the following conceptual definitions with the elements of financial statements.
Probable future economic benefits owned by the entity from past transactions::Assets
1. Decrease in net assets from peripheral or incidental
transactions
2. Outflows, using up of assets, or incurrence of
liabilities for delivery of goods or services
3. Cash received during the accounting period
4. Increase in net assets from peripheral or incidental
transactions
5. Residual interest of owners after all debts are paid
6. Probable future sacrifices of economic benefits as a
result of past transactions; involves transfer of assets or
services
7. Inflows of net assets or settlements of liabilities from
the sale of goods and services; based on the ongoing
operations
8. Cash actually paid out during the accounting period
Expenses 2
Gains
Stockholders'
Equity
Sources of cash
(cash inflows)
Revenues
4
5
3
7
Liabilities 6
Uses of cash (cash
outflows) 8
Losses 1

Difficulty: Medium
L.O.: 3
96. Match the following terms with their definitions.

1. Information that is accurate, unbiased, and
verifiable
2. A gain or loss that is unusual in nature and
infrequent in occurrence
3. Auditors' statement that the financial statements
are fair presentations in all material respects in
conformity with GAAP
4. Total assets minus total liabilities
5. Accumulated earnings minus accumulated
dividends
6. Results from the disposal of a major segment of a
business and is reported net of tax effects
7. Government agency that regulates financial
disclosures for publicly traded companies
Retained earnings 5
Extraordinary item 2
Stockholders' equity 4
SEC 7
Reliable information 1
Discontinued
operations 6
Unqualified audit
report (clean opinion) 3

Difficulty: Medium
L.O.: 3
5-39

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Chapter 005: Communicating and Interpreting Accounting Information

True / False Questions

AACSB Tag: Relative Thinking

2. For information to be reliable it should be accurate, unbiased, and verifiable.

AACSB Tag: Relative Thinking

AACSB Tag: Relative Thinking

4. The Sarbanes-Oxley Act is intended to strengthen financial reporting and corporate

AACSB Tag: Ethics

Chapter 005: Communicating and Interpreting Accounting Information

AACSB Tag: Relative Thinking

AACSB Tag: Communications

AACSB Tag: Communications

AACSB Tag: Communications

Chapter 005: Communicating and Interpreting Accounting Information

9. Intangible assets have no physical existence and a short life.

AACSB Tag: Relative Thinking

AACSB Tag: Relative Thinking

AACSB Tag: Relative Thinking

AACSB Tag: Relative Thinking

AACSB Tag: Relative Thinking

Chapter 005: Communicating and Interpreting Accounting Information

AACSB Tag: Relative Thinking

AACSB Tag: Relative Thinking

AACSB Tag: Relative Thinking

AACSB Tag: Relative Thinking

Chapter 005: Communicating and Interpreting Accounting Information

AACSB Tag: Relative Thinking

AACSB Tag: Relative Thinking

AACSB Tag: Relative Thinking

Multiple Choice Questions

AACSB Tag: Relative Thinking

Chapter 005: Communicating and Interpreting Accounting Information

22. For accounting information to be useful, it must be:

AACSB Tag: Relative Thinking

23. Conservatism requires that special care must be taken to avoid

AACSB Tag: Relative Thinking

AACSB Tag: Relative Thinking

Chapter 005: Communicating and Interpreting Accounting Information

AACSB Tag: Ethics

AACSB Tag: Ethics

AACSB Tag: Ethics

Chapter 005: Communicating and Interpreting Accounting Information

AACSB Tag: Relative Thinking

29. Which of the following describes the conservatism constraint?

AACSB Tag: Relative Thinking

30. Which of the following is false?

AACSB Tag: Relative Thinking

Chapter 005: Communicating and Interpreting Accounting Information

31. Materiality, cost-benefit, and conservatism are

AACSB Tag: Relative Thinking

AACSB Tag: Ethics

AACSB Tag: Communications

Chapter 005: Communicating and Interpreting Accounting Information

34. Which of the following is not commonly classified as a current asset?

AACSB Tag: Communications

AACSB Tag: Relative Thinking

36. Contributed capital I usually shown as which two accounts?

AACSB Tag: Communications

Chapter 005: Communicating and Interpreting Accounting Information

37. The criteria for extraordinary items are

AACSB Tag: Relative Thinking

38. Which of the following is not an asset account?

AACSB Tag: Relative Thinking