CHAPTER 4

Preparation of Financial Statements

Answers to Questions

1. The basic purpose of a statement of financial position is to provide information that is useful to investors,
creditors, and other interested parties in assessing the financial strength, flexibility, and liquidity of an
enterprise. This assessment is useful in projecting future cash flows of the entity.
2. A statement of financial position is a financial statement that reports the assets, liabilities, and
shareholders’ equity, at a specific date, measured in conformity with generally accepted accounting
principles.
It is dated differently than the income statement and SCF because it is a presentation of the cumulative
financial position at a specific date in time, whereas the other two statements cover a specified period of
time.
3. Full disclosure requires the reporting of all relevant financial information necessary to avoid misleading
inferences. Therefore, full disclosure requires a complete statement of financial position, including
supporting notes.
4. Current assets are those assets which are reasonably expected to be realized in cash, sold, or consumed
during the normal operating cycle of the business or within one year from the statement of financial
position date, whichever is longer.
Current liabilities are those liabilities whose liquidation is reasonably expected to require the use of
existing resources properly classified as current assets, or the creation of the other current liabilities. This
emphasizes the interrelationship between two categories.
Both current assets and current liabilities are reasonably expected to be realized or paid in the normal
operating cycle of the business or within one year of the statement of financial position date, whichever is
longer. Thus, they are short-term categories. They represent the “circulating funds” of an enterprise.
5. A current liability is an obligation that will require the use of current assets or create another current
liability during the next operating cycle or during the next year, whichever is longer. A long-term liability
does not require the use of current assets during the next year or operating cycle, whichever is longer.
Reclassification occurs when a long-term liability is due within the time period that defines a current
liability, that is, the last period before maturity. Also, when an installment payment is due during the next
year (or operating cycle), that installment is reclassified as a current liability if it will be paid out of current
assets. A long-term liability that will be paid out of a noncurrent asset (e.g., a noncurrent fund) is not
reclassified as a current liability.
6. Shareholders’ equity is the residual interest in the assets of an entity after deducting is liabilities. In a
business, the main components are (a) contributed, or paid-in capital, capital (capital stock and contributed,
or pa id-in, capital in excess of par), (b) retained earnings, and (c) unrealized capital losses and gains.
The various components are reported because (a) the sources and amounts may be useful to decision
makers and (b) laws often specify the use that can be made of the various sources.
7. A restriction, or appropriation, of retained earnings is a limitation on the use of retained earnings. The
restricted or appropriated amount is not available for dividends. Restrictions and appropriations usually are
reported in the notes to the financial statements. Sometimes they are separately reported in the statement of
retained earnings.
8. Current assets are cash and other assets that are
(1) expected to be realized in, or is held for sale or consumption in the normal course of the enterprise’s
operating cycle; or
(2) held primarily for trading purposes or for the short-term and expected to be realized within twelve
months of the statement of financial position date; or
(3) cash or a cash equivalent asset which is not restricted in its use.
 Current assets may include five items: (1) cash (and cash equivalents), (2) temporary investments in
marketable securities, (3) receivables, (4) inventories, and (5) prepaid items.

Current liabilities are obligations whose liquidation is

(1) expected to be settled in the normal course of the enterprise’s operating cycle; or
(2) due to be settled within twelve months of the statement of financial position date.
Examples of current liabilities are accounts payable, taxes payable, unearned rent, salaries payable,
estimated liabilities for warranties, and the current portion of long-term debt.
9. Obligations that are not expected to require the use of current assets or are not expected to create current
liabilities within one year or the normal operating cycle (whichever is longer) are classified as long-term
liabilities. They include:
a. Bonds payable
b. Long-term notes payable
c. Capital lease contract obligations
d. Mortgage payable
e. Pension obligations
f. Obligations under noncurrent financial instruments
10.
a. Capital stock are the shares of stock that a corporation is authorized to issue as evidence of ownership in
that corporation. There are two types of capital stock, preferred stock and common stock. Preferred
stock has a preference over common stock as to dividends. Common stock carries the right to vote at the
annual stockholders’ meeting and to share in residual profits.
b. Additional paid-in capital represents the amount paid to the corporation by stockholders in excess of the
par value of the stock issued.
c. Treasury stock is the capital stock of a corporation that has been issued but reacquired by the
corporation.
d. Retained earnings is the amount of corporate earnings that has not been distributed to stockholders as
dividends.
e. Deficit is the term used to describe a negative retained earnings balance.
f. Accumulated other comprehensive income is the other comprehensive income [from items such as
unrealized increases (gains) or decreases (losses) in the market value of investments in available-for-sale
securities] that a corporation has accumulated to date.
11. Investment by owners are increases in the equity of a company resulting from transfers of something
valuable to the company from other entities in order to obtain or increase ownership interests.
Distributions to owners are decreases in the equity of a company caused by transferring assets, rendering
services, or incurring liabilities to owners. Many companies report these items in a statement of changes in
stockholders’ equity.
12. Revenues are earned from the entity’s ongoing major or central operations, whereas gains arise from the
entity’s peripheral or incidental transactions.
13. Expenses are incurred by the entity’s ongoing major or central operations, whereas losses arise from the
entity’s peripheral or incidental transactions.
14. Net sales revenue minus cost of goods sold equals gross margin (also called gross profit). Gross margin is
not applicable to service companies because cost of goods sold does not exist.
15. The purposes of the SCF are to (a) provide information about the sources and uses of cash, and (b) help
decision makers assess and project future cash flows.
16. The three major captions on a SCF are:
a. Cash flows from operating activities – reports the cash inflows (e.g., from sales to customers) and the
cash outflows (e.g., for salaries and wages).
b. Cash flows from investing activities – reports the cash inflows (e.g., sale of investment securities) and
the cash outflows (e.g., payment for a productive asset).
 c. Cash flows from financing activities – reports cash inflows (e.g., borrowing) and cash outflows
(dividends paid to owners).

Answers to Exercises

Exercise 1

1. A 11. B 21. X Treasury stock (at cost) should be subtracted from

2. G 12. A the sum of contributed capital, retained earnings,
3. C 13. B and accumulated other comprehensive income to
4. J* 14. F arrive at total stockholders’ equity.
5. A 15. H
6. D 16. I
7. B 17. G
8. F 18. A
9. C 19. I 22. K
10. D 20. C
* Although the letter is checked, the Deficit account is not a contra-account to retained earnings.
Instead, it is the title given to a negative retained earnings balance.

Exercise 2

No Answer Comment
.
1. C Example (land held as an investment)
2. E Merchandise inventory
3. D Assuming fair value is known (Market value). If not, valued at cost.
4. M Accounts receivable, trade (less allowance for doubtful accounts)
5. I Long-term investment in bonds of another company (cost less unamortized
discount)
6. C Plant site, in use (land in use as operational asset)
7. J Plant and equipment, in use (operational assets subject to depreciation)
8. B Patent, in use (amortization relates to intangibles)
9. A Accounts payable, trade (usually no interest because short term)
10. G Bonds payable, sold at a premium (par plus unamortized premium)
11. F Ordinary shares, par P10 per share and sold at par (record par value in the
ordinary shares account)
12. L Contributed capital in excess of par (a premium – above par)
13. K Retained earnings (a cumulative amount)
14. C Land, future plant site (other asset)
15. N Idle plant, awaiting disposal (other asset)
16. O Natural resource (depletion relates to natural resources)

Exercise 3

1. D 6. F 11. E
2. E 7. F 12. D
3. E 8. E 13. A
4. I 9. E 14. A
5. C 10. E 15. A
 Exercise 4

1. B 6. D/G 11. E
2. B/F 7. B 12. A/C
3. F/B 8. B 13. C
4. D 9. G 14. A/C
5. F 10. A
Exercise 5
(a) Liabilities.
(b) Equity.
(c) Equity.
(d) Income.
(e) Assets.
(f) Income, expenses.
(g) Equity.
(h) Income.
(i) Equity.

Exercise 6
1. Information about competitors might be useful for benchmarking the company’s results but if
management does have expertise in providing the information, it could lack reliability. In
addition, it is likely very costly for management to gather sufficiently reliable information of
this nature.
2. While users of financial statements might benefit from receiving internal information, such as
company plans and budgets, competitors might also be able to use this information to gain a
competitive advantage relative to the disclosing company.
3. In order to produce forecasted financial statements, management would have to make
numerous assumptions and estimates, which would be costly in terms of time and data
collection. Because of the subjectivity involved, the forecasted statements would lack
reliability, thereby detracting from any potential benefits. In addition, while management’s
forecasts of future profitability or statement of financial position amounts could be of benefit,
companies could be subject to shareholder lawsuits, if the amounts in the forecasted statements
are not realized.
4. It would be excessively costly for companies to gather and report information that is not used
in managing the business.
5. Flexible reporting allows companies to “fine-tune” their financial reporting to meet the
information needs of its varied users. In this way, they can avoid the cost of providing
information that is not demanded by its users.
6. Similar to number 3, concerning forecasted financial statements, if managers report forward-
looking information, the company could be exposed to liability if investors unduly rely on the
information in making investment decisions. Thus, if companies get protection from
unwarranted lawsuits (called a safe harbor), then they might be willing to provide potentially
beneficial forward-looking information.

Answers to Multiple Choice Questions

1. D 11. D 21. D
2. D 12. B 22. C
3. A 13. A 23. A
4. B 14. C 24. B
5. A 15. D 25. A
6. D 16. B 26. B
7. C 17. B 27. B
8. C 18. C 28. B
9. D 19. D 29. C
10. D 20. C