Introduction to Financial Accounting, 11/E solutions manual and test bank by Charles T. Horngren, Gary L. Sundem,
CHAPTER 2
COVERAGE OF LEARNING OBJECTIVES
| LEARNING OBJECTIVES | QUESTIONS | EXERCISES | PROBLEMS | OTHER |
| LO1: Explain how accountants measure income. | 1,2,3,4,26,27 | 32, 36 | 45,49,51 | 67 |
| LO2: Determine when a company should record revenue from a sale.</P></OBJ> | 5,6 | 31 | 45,46,49,51,61 | 67 |
| LO3: Use the concept of matching to record the expenses for a period. | 7,8,9 | 34, 36 | 45,47,48,50, 52,53,54,56 | |
| LO4: Prepare an income statement and show how it is related to a balance sheet. | 10,11,12 | 30,35,36,37,38,39, | 45,47,48,50,52, 53,54,55, 56,57,58 | 65,66,67 |
| LO5: Account for cash dividends and prepare a statement of stockholders’ equity. | 13,14,15, 28 | 33,35, 38, | 54,55,57,58 | 65,66 |
| LO6: Compute and explain earnings per share, price-earnings ratio, dividend-yield ratio, and dividend-payout ratio. | 17,18,19,20,29 | 42,43 | 59, 60 | 64,66 |
| LO7: Explain how the conceptual framework guides the standard setting process and how accounting regulators trade off relevance and faithful representation in setting accounting standards. | 21,22,23 | 62 | ||
| LO8: Explain how the following concepts affect financial statements: entity, going concern, materiality, stable monetary unit, periodicity and reliability. | 16,24,25,26 | 44 | 63 |
CHAPTER 2
2-1 The length of the operating cycle depends on the nature of the company. It is the time it takes the company to use cash to acquire goods and services, to sell those goods and services to customers, and to collect cash from the sales.
2-2 A fiscal year is the year used for financial reporting. It may be the same as a calendar year, but often it is not. Many companies elect to begin and end a fiscal year at the low point in their annual business activity.
2-3 Expenses are reductions in stockholders’ equity; thus they may be described as negative stockholders’ equity accounts.
2-4 The cash basis fails to match accomplishments with efforts in a single accounting period. In particular, the cash basis fails to match revenues and expenses properly. Inventory may be bought and paid for in one period, and sold in the second with the collection from customers in a third period. Accrual accounting matches revenue and cost of goods sold in the second period, although the cash outlay occurred in the first and the collection was made in the third.
2-5 The two criteria for revenue recognition are earning and realization (realized or realizable).
2-6 Revenue recognition is delayed when a company sells a magazine subscription because the company does not recognize revenue until it is earned by delivery of the magazines. Revenue recognition is also delayed if collection of the account receivable is not reasonably certain, which means that it is not realized or realizable. This may happen with speculative land sales.
2-7 Product costs are naturally linked to revenues, while period costs support a company’s operations for a given period. Product costs become expenses when the company recognizes the related revenue. Period costs become expenses in the period in which they are incurred.
2-8 In theory, all expenses are goods and services that were first purchased as assets and that have now been consumed or used in the conduct of operations.
2-9 Managers acquire assets (goods and services) that are then either used instantaneously or at a later time. When the assets are used, they become expenses.
2-10 The balance sheet is a financial picture of a company at one point in time, like a snapshot. In contrast, an income statement shows activity over a period of time. It shows the series of events that take a company from one “snapshot” (balance sheet) to another, just as a moving picture shows movement from one position to the next.
2-11 Synonyms for the income statement include statement of earnings, statement of operations, and operating statement. A major reason to learn accounting is to be able to read real financial statements. Such statements contain a variety of terms that may differ from the one first leaned in an introductory accounting course. To be able to read and interpret the financial statements, users need to understand the terminology, including synonyms used for the major accounting terms.
2-12 Managers are often optimistic and feel that things are bound to get better, so they do not like to report bad news. In addition, they may have bonuses or possible promotions that depend on the financial results, so they want the reports to be as good as possible. Finally, financial reports are often the “scorecard” for business success, and competitive managers want to report a high score.
2-13 Cash dividends are not necessary in the conduct of revenue-producing operations. Therefore, they are not expenses but are voluntary distributions of assets to owners. These distributions are made possible because of profitable operations, but are not part of the profitable operations.
2-14 Retained earnings is a stockholders’ equity account (a residual claim against assets), and not an asset account. It is a claim against resources, not a resource itself.
2-15 The statement of stockholders’ equity provides information on what caused the stockholders’ equity accounts to change during a given period. The three main items that affect stockholders’ equity are net income, transactions with stockholders (sale of stock, distribution of dividends), and other comprehensive income—a catch-all category of all equity changes that are neither part of net income nor arise from transactions with owners.
2-16 No. An accounting entity can be a part of an organization, such as a division or department. It can also be an entire economy, such as national income accounting for the United States or another country.
2-17 No. One financial ratio, earnings per share (EPS), is presented on the income statement.
2-18 A high P-E ratio suggests that investors expect future earnings to significantly exceed current earnings. This is likely to be true for fast growing companies.
2-19 Two dividend ratios are as follows:
· Dividend-yield ratio—The amount of dividends paid per dollar invested in a stock at the current market price. The dividend-yield ratio is computed as Dividends per share ÷ Market price per share.
· Dividend-payout ratio—The percentage of a company’s earnings that is paid out in dividends The dividend-payout ratio is computed as Dividends per share ÷ EPS.
2-20 No. A high dividend-payout ratio may be a bad sign. Companies with a high dividend-payout ratio tend to be slow-growing companies. They return a larger percentage of their income to shareholders because they do not have profitable opportunities in which to invest.
2-21 Yes, accountants make many trade-offs between relevance and faithful representation. Although both are desirable characteristics, sometimes it is necessary to sacrifice some of one to gain much of the other. A major trade-off is between market values, which are often more relevant but may raise questions about faithful representation, and historical costs, which faithfully represent an event but may be less relevant.
2-22 The two main characteristics that make accounting information relevant are predictive value—meaning that it helps users form their expectations about the future—and confirmatory value—meaning that it can confirm or contradict existing expectations.
2-23 These criteria support faithful representation. They help ensure that information truly captures the economic substance of the transactions, events, or circumstances it describes.
2-24 Reliable data require convincing evidence that can be verified by independent auditors. Accountants must make sure that data reported in the financial statements can be measured with enough accuracy to be useful to users of the statements.
2-25 Materiality means that items that are not large enough to influence users’ decisions can be omitted from the financial statements. Thus, you do not find pencils or paper clips listed separately among a company’s assets. Cost-benefit means, for example, that if the cost of measuring an item is greater than the value from knowing it, the item can be omitted. Thus, the financial statements of a division of a company may not include an expense for any portion of the company president’s salary, even though the president spends time overseeing the division’s activities. It would simply be too costly for the president to account for each minute spent on each different activity he or she undertakes, and there is little benefit to attempting to allocate the president’s salary to individual divisions. However, in the corporate financial statements, the president’s salary would be treated as an operating cost assigned to the corporation as a whole.
2-26 A year is a long time to wait for new information about a company’s performance. Preparing full financial statements is time consuming and costly. Quarterly financial disclosures are less complete than annual ones, but they represent a balanced answer to how often and how complete information should be. Within companies, managers get financial reports daily, weekly, or monthly depending on their needs. In different countries the tradition and the identity of investors have led to different customs. The United States relies on public ownership of companies and needs a system to keep large numbers of investors adequately informed. In countries where more of the ownership is closely held and more of the liabilities are bank financed, there is less need for frequent public disclosure.
2-27 The real choice is not between the cash basis and the accrual basis. We can have either one, but they provide very different information. The accrual-basis income statement is a better measure of overall performance over an accounting period. The cash-basis income statement provides better information about the risks of running out of cash. In the end, our choice between the two would depend on the question we are trying to answer.
2-28 Theoretically, the stock price will drop by the amount of the dividend per share. Just before the dividend, the stock is worth whatever it will be worth after the dividend plus the amount of the dividend. The chapter does not address details of exactly when rights to a dividend are created, when they accompany the sale of a share, or when they are retained by the seller. These issues are covered in the owners’ equity chapter (Chapter 10). The chapter also does not address the impact of other information that may affect the stock price at the time of the dividend.
2-29 Many investors would say that it does not matter because the security markets are efficient and the P-E ratios reflect the expected growth rates of future earnings for each firm. High-growth firms have high P-E ratios and low-growth firms have lower ones. Other investors would sort into two groups. Each group of investors believes the market tends to systematically misvalue firms, but they disagree on the nature of the market’s “error.” Value investors believe that the market undervalues good low-growth, low P-E firms and therefore buy these stocks. Growth investors believe that the market undervalues good high-growth, high P-E firms and therefore buy high P-E stocks. Empirically, we can find periods of time when value investors have had better results from their investments than growth investors and vice versa. The bottom line is that investing based on P-E ratios alone is never a good idea, although they are an important descriptor of what the market perceptions of a company are at a moment in time.
2-30 (10 min.)
Balance Sheet Income Statement
| 3. | Accumulated deficit | 1. | Sales | |
| 4. | Unexpired costs—asset | 2. | Net earnings | |
| 5. | Prepaid expenses—asset | 7. | Statement of earnings | |
| 6. | Accounts receivable—asset | 8. | Used up costs—expense | |
| 12. | Retained earnings | 9. | Net profits | |
| 14. | Statement of financial condition | 10. | Net income | |
| 16. | Statement of financial position | 11. | Revenues | |
| 13. | Expenses—expense | |||
| 15. | Statement of income | |||
| 17. | Operating statement | |||
| 18. | Cost of goods sold—expense |
2-31 (5-10 min.)
The dealer is confused. As used by accountants, revenue is a gross amount recorded for sales to customers. For example, sales and revenues are synonyms. Revenue is not “the bottom line” in accountants’ minds. “The bottom line” is net income, that is, revenue minus all expenses. The dealer has $280,000 more revenue per month, not $280,000 more in income.
Of course, many people use “bottom line” in a nontechnical sense to mean the important or significant result—the result that really matters. For example, “the bottom line is not how much you earn but how much you keep.”
2-32 (10 min.)
1. On the cash basis, Yankton’s net income would be as follows:
Revenue (cash received) $180,000*
Expenses 170,000
Net income $ 10,000
* Beginning receivables + Credit sales – Cash collections = Ending receivables
$50,000 + $240,000 – Cash collections = $110,000
$50,000 + $240,000 – $110,000 = Cash collections = $180,000
2. On an accrual basis, Yankton’s net income would be as follows:
Revenue (sales) $240,000
Expenses 170,000
Net income $ 70,000
3. The $70,000 net income on the accrual basis is generally the most relevant for assessing Yankton’s performance. It gives credit for all $240,000 of sales because, provided the accounts receivable are likely to be received (which is one criterion for the accrual recognition of revenue), Yankton has created value from all the sales, not just those for which cash has been received.
2-33 (15-20 min.) The theme of this solution is that retained earnings is not a pot of cash awaiting distribution to stockholders.
1. Cash $1,000 Paid-in capital $1,000
2. Cash $ 400 Paid-in capital $1,000
Inventory 600
Total $1,000
Note in both Requirements 1 and 2 that the ownership equity is fundamentally a claim against the total assets (in the aggregate). For example, none of the shareholders have a specific claim on cash, and none have a specific claim on inventory. Instead, they all have an undivided claim against (or interest in) all of the assets.
3. Cash $1,250 Paid-in capital $1,000
Retained earnings 250
Total $1,250
Retained Earnings is part of stockholders’ equity. Even though Cash and Retained Earnings have increased by identical amounts compared to the opening balance sheet given in number 1, the retained earnings is a general claim against total assets (just as paid-in capital is a general claim). Retained earnings is the net increase in ownership claim attributable to profitable operations. However, the assets themselves should not be confused with the claims against the assets.
4. Cash ($1,250 – $300 – $800) $ 150 Paid-in capital $1,000
Inventory 300 Retained earnings 250
Equipment 800
Total $1,250 Total $1,250
The same explanation applies here as in Requirement 3. However, Transaction 4 should clarify the lack of a specific link between retained earnings (and paid-in capital) and any particular assets. The ownership claims are general, not specific.
5. Cash $ 150 Account payable $ 500
Inventory ($300 + $500) 800 Paid-in capital 1,000
Equipment 800 Retained earnings 250
Total $1,750 Total $1,750
The meaning of retained earnings was explained above. Purchases on “open account” usually create a general liability; that is, the trade creditors hold only general claims against the total assets, not specific claims against particular assets (such as mortgages on buildings). In sum, both the creditors and the owners hold general claims against the assets. Of course, if the corporation is liquidated (all assets converted to cash to be distributed to claimants), the creditors’ general claims must be satisfied before the owners get one dollar. Thus, the stockholders are said to have a residual claim or residual interest.
2-34 (15-25 min.)
See Exhibit 2-34 on the following page.
2-35 (15-20 min.)
1. First calculate stockholders’ equity from the asset and liability amounts given.
Assets – Liabilities = Stockholders’ equity
Dec. 31: £126,000 – £55,000 = £71,000
Jan. 1: 110,000 – 50,000 = 60,000
Change: £ 16,000 – £ 5,000 = £11,000
Note that the £16,000 asset increase less the £5,000 liability increase yields the increase in stockholders’ equity of £11,000.
2. We can use knowledge of what changes stockholders’ equity to “deduce” the amount of net income. Net income increases stockholders’ equity and dividends decrease stockholders’ equity.
Beginning stockholders’ equity + net income – dividends = ending stockholders’ equity
£60,000 + net income – £5,000 = £71,000
net income = £71,000 + £5,000 – £60,000
= £16,000
3. Sales – Cost of goods sold – Operating expense = Net income
£360,000 – Cost of goods sold – £210,000 = £16,000
– Cost of goods sold = £16,000 + £210,000 – £360,000
Cost of goods sold = £134,000
2-36 (15 min.)
The cash balance on June 30 was $53,000, as shown in the balance sheet equation transactions in Exhibit 2-36. The cash balance is the only beginning or ending balance that is available from the data.
EXHIBIT 2–34 (Amounts are in thousands of dollars.)
GREENLEY COMPANY
Analysis of Transactions for July
Assets = Liabilities + Stockholders’ Equity
Prepaid Sup- Unexpired Unexpired
Cash + Rent + plies + Advertising + Training = + Retained Earnings
a1. – 18 + 18 =
a2. – 3 = – 3 (Rent Expense)
b1. – 2 + 2 =
b2. – 2 = – 2 (Supplies Expense)
c1. – 4 + 4 =
c2. – 4 = – 4 (Advertising Expense)
d1. – 8 + 8 =
d2. – 8 = – 8 (Training Expense)
The steps shown capture the essence of what is happening. The problem is not explicit that all of the supplies are used during the month, so some students may omit b2. The problem invites such discussion. You may wish to extend this example to reflect the more expedient procedure many accountants would use to record items that are immediately used up as expenses. For example, c and d might appear as follows:
c. – 4 = – 4 (Advertising Expense)
d. – 8 = – 8 (Training Expense)
Exhibit 2-36
Piedmont Company
Analysis of Transactions for June 20X1
(In Thousands of Dollars)
Assets = Liabilities and Stockholders’ Equity
Accounts Merchandise Accounts Paid–in Retained
Transactions Cash + Receivable + Inventory + Equipment = Payable + Capital Earnings
Balance,
6/1/X1 + 15 ? ? ? = ? ? ?
a. + 75 –75 =
b. – 45 = - 45
c. + 18 = + 18
d1. + 23 + 30 = + 53 (Sales Revenue)
d2. - 28 = –28 (Cost of Goods
Sold expense)
e. – 1 = – 1 (Depreciation
Expense)
f. – 15 = – 15 (Dividends)
Balance,
6/30/X1 + 53
2-37 (10-15 min.)
1. The name of the statement is antiquated. It should be titled income statement (or statement of earnings, statement of operations, or operating statement).
2. The line with the date should not be for a moment in time but for an indicated span of time: a year, a quarter, or a month ending on December 31, 20X0.
3. Increases in market values of land and buildings are not recognized under U. S. GAAP.
4. Dividends are not expenses and are not deducted before net profit is computed.
5. The appropriate deduction is the cost of goods sold, not the cost of the cars purchased.
6. The bottom line is more commonly titled net income or net earnings.
7. The cost of the products sold is usually listed right after revenue, not near the bottom of the statement.
8. Although it is not the major point of the problem, the income statement has apparently omitted some expenses; for example, neither rent nor depreciation is shown. As a minimum, one or the other would ordinarily be included.
2-38 (5-10 min.) Amounts are in millions.
1.
Revenues $39,304
Expenses 37,852
Net income (loss) $ 1,452
Beginning retained earnings $13,966
+ Net income (loss) 1,452
– Dividends _ ?
Ending retained earnings $15,266
2. Dividends = $15,266 – $13,966 - $1,452 = $152
2-39 (20-30 min.) Amounts are in thousands of dollars.
The basic relations used in these problems are as follows:
Revenues – Expenses = Net income
Assets = Liabilities + Stockholders’ equity
Beginning retained earnings + Net income – Dividends = Ending retained earnings
Beginning paid-in-capital + additional investment = Ending paid-in-capital.
1. E = 165 – 130 = 35
D = 35 + 35 = 70
C = 15 because there were no additional investments by stockholders
A = 80 – 15 – 35 = 30; or 80 – (15 + 35) = 30
B = 95 – 15 – 70 = 10; or 95 – (15 + 70) = 10
2. K = 30 + 200 = 230
J = 60 + 30 – 7 = 83
H = 10 + 40 = 50
F = 60 + 10 + 90 = 160
G = 280 – 83 – 50 = 147
3. P = 290 – 250 = 40
Q = 120 + 40 – 130 = 30
N = 85 – 35 = 50
L = 105 + 50 + 120 = 275
M = 95 + 85 + 130 = 310
2-40 (10-15 min.)
This is straightforward. Computations are in millions of dollars:
A = 27,388 – 8,189 = 19,199
B = 10,655 – 841 = 9,814
C = 1,702 + 841 – 510 = 2,033
D = 21,015 + 8,482 = 29,497
2-41 (10-15 min.)
1. Income statement or operating statement is used instead of statement of income and expenses.
2. The end of the fiscal year is typically identified.
3. The terms income or earnings are used rather than surplus (and net income or net earnings rather than net surplus).
4. The term loss is used instead of deficit.
5. A profit-seeking organization would not receive a subsidy.
6. General Income might be best called General Revenue.
2-42 (10-15 min.)
This problem demonstrates how financial statements provide information for investor decisions. These ratios are compared with other companies in the industry and with the company’s ratios through the years.
1. EPS = £5,458,000,000 ÷ 5,099,000,000 = £1.07
2. P-E = £14.72 ÷ £1.07 = 13.8
3. Dividend− Yield = (£3,406,000,000 ÷ 5,099,000,000) ÷ £14.72 = 4.5%
4. Dividend− Payout = (£3,406,000,000 ÷ 5,099,000,000) ÷ £1.07 = 62.4%
2-43 (10-15 min.)
1. $26,895,000,000 ÷ $13.54 = 1,986,336,780 average shares
2. $13.54 × .228 = $3.09
3. (a) $3.09 ÷ $106.40 = 2.9% dividend yield
(b) $106.40 ÷ $13.54 = 7.86 P-E ratio
2-44 (10 min.)
1. Companies choose what details to report based partly on materiality. A $250,000 investment is definitely material to Dayton Service Stations. It is 27% of its total assets before the investment. However, it is not necessarily material to ExxonMobil—it is a very small fraction of 1% of its total assets.
2. A key question a company must ask is whether a potential investor would find the information relevant for assessing the position and prospects of the company. The investment would certainly be an important factor in assessing Dayton Service Stations, but it would be so small as to be insignificant for assessing ExxonMobil.
2-45 (20-30 min.)
1 and 2. See Exhibit 2-45 on the following page.
3. R. J. SEN CORPORATION
Income Statement
For the Month Ended June 30, 20X0
Accrual Basis Cash Basis
Sales $115,000 Revenue (cash collected
from customers*) $ 45,000
Deduct: Cost of Expenses (cash disbursed
goods sold 60,000 for merchandise) 85,000
Net cash used by
Net income $ 55,000 operating activities = Net loss $(40,000)
*Revenue consists of cash sales only. If any cash had been collected from credit customers during June, it would be added here.
The accrual basis provides a better measure of the economic accomplishments and efforts of the entity. The cash basis is inferior because it fails to recognize revenue as earned (the sales on credit), and it often recognizes expenses before they help generate revenues (for example, inventory acquired but not sold). Note that the June 28 acquisition of inventory on open account is irrelevant under both the accrual and cash basis.
EXHIBIT 2–45
R. J. SEN CORPORATION
Analysis of Transactions for June, 20X0
(In Thousands of Dollars)
Assets Liabilities and Stockholders’ Equity
Accounts Inven– Accounts Paid–in
Description of Transactions Cash + Receivable + tories = Payable + Capital + Retained Earnings
1. Original investment +100 = +100
2. Acquisition of inventory – 85 +85 =
3a. Sales for cash and credit + 45 +70 = +115 (Sales Revenue)
b. Cost of inventory sold –60 = – 60 (Cost of Goods
Sold expense)
4. Acquisition of inventory +34 = +34
+ 60 +70 +59 = +34 +100 + 55
189 189
R. J. SEN CORPORATION
Balance Sheet
June 30, 20X0
Assets Liabilities and Stockholders’ Equity
Liabilities:
Cash $ 60,000 Accounts payable $ 34,000
Accounts receivable 70,000 Stockholders’ equity:
Merchandise inventory 59,000 Paid–in capital $100,000
Retained earnings 55,000 155,000
Total assets $189,000 Total liabilities & stockholders’ equity $189,000
2-46 (10-15 min.)
1. The first two items in the first sentence of the footnote (i.e., reference to persuasive evidence of an arrangement and delivery) relate to the earning of the revenue, and the last two (i.e., fee fixed and determinable and collectability probable) relate to its realization. Microsoft used to recognize revenue on products licensed to OEMs when the OEMs shipped product to customers, based on the assumption that Microsoft does not earn the revenue until the product actually is sent to a final customer. However, a change in licensing earlier this decade made it possible to regard revenue as earned when Microsoft ships product to the OEMs. The licensing agreement may have been changed to make the OEMs more responsible for the products after Microsoft ships them. Microsoft decided not to wait until the OEM delivers product to customers to regard the revenue as earned; instead, it is deemed earned at the time Microsoft ships it. This accelerates Microsoft’s recognition of revenues.
2. Multi-year licensing agreements are treated as a magazine publisher would treat a subscription. When cash is received, Microsoft records a liability. The revenue is not earned until the customer uses the software for which it has a licensing agreement. Therefore, revenue recognition is spread over the life of the license.
3. Revenue related to games published by third parties is recognized when the games are manufactured, not when they are shipped to customers. Microsoft must believe that it sells the right to manufacture the games, and as soon as the manufacturing process is complete its revenue-earning process is complete.
2-47 (40-50 min.)
1. See Exhibit 2-47 on the following page.
Transactions 8 to 11 illustrate the culmination of the asset acquisition-asset expiration sequence: that is, most assets are “stored” as “unexpired” or “prepaid” costs that are expected to benefit future operations (inventory, prepaid rent, prepaid insurance and equipment). As these assets are “used up” or “expire,” they become expenses or “expired costs.”
2. MONTERO COMPANY
Income Statement
For the Month Ended July 31, 20X2
Sales $205,000
Deduct expenses:
Cost of goods sold $155,000
Rent 4,000
Depreciation 2,000
Insurance 1,000
Total expenses 162,000
Net income $ 43,000
3. MONTERO COMPANY
Balance Sheet
July 31, 20X2
Liabilities and
Assets Stockholders’ Equity
Liabilities:
Cash $148,000 Accounts payable $110,000
Accounts receivable 130,000 Note payable 60,000
Merchandise inventory 70,000 Total liabilities 170,000
Prepaid rent 44,000 Stockholders’ equity:
Prepaid insurance 23,000 Paid-in capital 300,000
Equipment 98,000 Retained earnings 43,000
Total stockholders’ equity 343,000
Total assets $513,000 Total liab. and stk. equity $513,000
Introduction to Financial Accounting, 11e (Horngren)
Chapter 2 Measuring Income to Assess Performance
Learning Objective 2.1 Questions
1) The operating cycle begins with
A) the acquisition of goods.
B) the receipt of cash from customers.
C) the payment for goods.
D) the initial investment by owners.
E) the sales to customers.
Answer: A
Diff: 1
Objective: L.O. 2-1
2) Net income is
A) the difference between revenues and dividends
B) the difference between revenues and retained earnings.
C) the difference between cash and dividends.
D) the difference between revenues and total assets.
E) the difference between revenues and expenses.
Answer: E
Diff: 1
Objective: L.O. 2-1
3) Revenues are
A) increases in liabilities resulting from delivering goods or services to customers.
B) decreases in net assets resulting from delivering goods or services to customers.
C) increases in net assets resulting from delivering goods or services to customers.
D) decreases in retained earnings resulting from delivering goods or services to customers.
E) another term for assets.
Answer: C
Diff: 2
Objective: L.O. 2-1
4) For which company would it seem sensible to use a fiscal year ending on June 30?
A) A landscaping company
B) A retail store that sells lawn mowers and lawn equipment
C) A swimming pool retailer
D) A snowboard retailer
E) A hardware store
Answer: D
Diff: 2
Objective: L.O. 2-1
5) Kronic Enterprises sold inventory costing $500 for $900 on account. If Kronic Enterprises operates under the accrual basis, what net effect will this transaction have on the owners' equity side of the balance sheet?
A) None, since the customer to whom the inventory was sold has not yet paid
B) None, since sales and/or cost of goods sold are income statement accounts
C) Decrease owners' equity by $1,400
D) Increase owners' equity by $400
E) Increase owners' equity by $1,400
Answer: D
Diff: 3
Objective: L.O. 2-1
6) An accountant records a transaction when cash is paid or received under which basis of accounting?
A) Cash
B) Accrual
C) Deferral
D) Prepaid
E) Cost recovery
Answer: A
Diff: 1
Objective: L.O. 2-1
7) Which of the following circumstances would result in a decrease in income under the accrual basis but would not result in a decrease in income under the cash basis?
A) Purchase of inventory on account
B) Payment of 2 months' rent in advance
C) The expiration of prepaid rent
D) The return of defective inventory purchased on account, where full credit was given
E) The payment of the current period's utility bill
Answer: C
Diff: 3
Objective: L.O. 2-1
8) Hilac Plumbing records revenue as cash is received. Which method of income measurement is Hilac Plumbing using?
A) The accrual basis
B) The cash basis
C) The recognition basis
D) The revenue basis
E) The realization basis
Answer: B
Diff: 2
Objective: L.O. 2-1
9) Which of the following circumstances would result in an increase in income under the cash basis and an increase in income under the accrual basis?
A) The return of defective inventory purchased on account, where full credit was given
B) Cash collection from a credit customer
C) The cash sale of inventory at a sales price in excess of cost
D) The expiration of prepaid rent
E) The sale of inventory on account, at a sales price in excess of cost
Answer: C
Diff: 3
Objective: L.O. 2-1
10) Which of the following circumstances would result in a decrease in income under both the accrual and cash basis?
A) The payment of last period's rent
B) The payment of this period's rent
C) The payment of next period's rent
D) The cash purchase of land
E) The purchase of equipment on account
Answer: B
Diff: 2
Objective: L.O. 2-1
11) An operating loss occurs when
A) revenues exceed expenses.
B) expenses exceed revenues.
C) assets exceed liabilities.
D) liabilities exceed assets.
E) liabilities exceed owners equity.
Answer: B
Diff: 1
Objective: L.O. 2-1
12) Expenses are
A) increases in net assets as a result of consuming resources in the process of providing services to a customer.
B) decreases in net assets as a result of consuming resources in the process of providing services to a customer.
C) increases in liabilities resulting from purchasing assets.
D) increases in retained earnings resulting from operations.
E) increases in equity resulting from operations.
Answer: B
Diff: 2
Objective: L.O. 2-1
13) The operating cycle is the time it takes for a company to buy goods.
Answer: FALSE
Diff: 1
Objective: L.O. 2-1
14) Because of the difficulty of measuring income, there is no reason to compare income levels between different companies.
Answer: FALSE
Diff: 1
Objective: L.O. 2-1
15) The additional owners' equity generated by net income or net profits is used to increase retained earnings.
Answer: TRUE
Diff: 1
Objective: L.O. 2-1
16) Because net income is the excess of revenues over liabilities, retained earnings increases by the amount of net income reported during the period less any dividends.
Answer: FALSE
Diff: 1
Objective: L.O. 2-1
17) According to accounting rules, fiscal years are required to be established over calendar years.
Answer: FALSE
Diff: 1
Objective: L.O. 2-1
18) An interim period is a time span that is less than a year and is established for accounting purposes.
Answer: TRUE
Diff: 1
Objective: L.O. 2-1
19) For revenue to be earned under the cash basis of accounting, the cash from the customer must be received.
Answer: TRUE
Diff: 1
Objective: L.O. 2-1
20) Cash for services performed in 20X8 is received in 20X9. Using the accrual basis of accounting, the revenue would appear on the 20X9 income statement.
Answer: FALSE
Diff: 2
Objective: L.O. 2-1
21) Revenue is recorded when accounts receivable are collected under the cash basis of accounting.
Answer: TRUE
Diff: 1
Objective: L.O. 2-1
22) Under the cash method, revenue is recorded when cash is collected.
Answer: TRUE
Diff: 1
Objective: L.O. 2-1
23) The accrual basis of accounting provides a better measure of economic performance than the cash basis.
Answer: TRUE
Diff: 1
Objective: L.O. 2-1
24) Analyze the following transactions in the accounting equation using the following worksheet.
1. Sales of inventory for $20,000 on account; merchandise cost is $13,000.
2. Rent payment made in advance for $1,500.
3. Acquire additional inventory for $8,000; paid $2,000 cash with remainder on credit.
4. Received payment of $4,000 from customer who purchased goods on credit last month.
5. Returned defective inventory in the amount of $500. The inventory was purchased on account.
Accounts Prepaid Accounts Retained
Cash Receivable Inventory Rent Payable Earnings
| 1 | ||||||
| 1 | ||||||
| 2 | ||||||
| 3 | ||||||
| 4 | ||||||
| 5 |
Answer:
Accounts Prepaid Accounts Retained
Cash Receivable Inventory Rent Payable Earnings
| 1 | +20,000 | +20,000 | ||||
| 1 | -13,000 | -13,000 | ||||
| 2 | -1,500 | +1,500 | ||||
| 3 | -2,000 | +8,000 | +6,000 | |||
| 4 | +4,000 | -4,000 | ||||
| 5 | -500 | -500 |
Diff: 3
Objective: L.O. 2-1
25) Why doesn't the cash basis of accounting require adjusting accounts with accruals?
Answer: The cash basis of accounting only records revenues and expenses when cash changes hands, while the accrual basis of accounting recognizes revenues when they are earned and expenses when they are incurred. Adjustments are necessary under the accrual basis of accounting since revenue can be earned even if cash is not received and expenses can be incurred even if cash is not paid.
Diff: 2
Objective: L.O. 2-1
26) Describe the advantages of the accrual basis of accounting and the cash basis of accounting.
Answer: The cash basis of accounting has the advantage of producing financial statements when cash is received and paid, giving users a clearer picture of the company's cash position. Proponents suggest that this is important since companies can appear to be doing well based on net income, yet go bankrupt for a lack of cash. The accrual basis of accounting has the advantage of producing a more complete summary of the entity's value-producing activities since it recognizes revenues when they are earned and expenses when they are incurred.
Diff: 2
Objective: L.O. 2-1
Learning Objective 2.2 Questions
1) According to U.S. GAAP, revenue is recognized when it is
A) realized or realizable only.
B) earned only.
C) received in a timely fashion.
D) earned and realized or realizable.
E) received in cash.
Answer: D
Diff: 2
Objective: L.O. 2-2
2) Which of the following is an example of revenue that may be realized but not yet earned?
A) A customer paying in advance for services to be performed in the future.
B) A credit sale made to a customer who has a strong credit history. The goods have been delivered.
C) A credit sale made to a customer with a weak credit history such that the collection of the outstanding receivable is questionable. The goods have been delivered.
D) The cash sale of a fixed asset, as opposed to the sale of inventory. The fixed asset has been delivered.
E) It is impossible to have revenue that is realized but not earned.
Answer: A
Diff: 3
Objective: L.O. 2-2
3) Performing a service and receiving a promise to pay from the customer would
A) increase revenue.
B) decrease assets.
C) increase liabilities.
D) decrease expenses.
E) decrease revenue.
Answer: A
Diff: 1
Objective: L.O. 2-2
4) Ace Office Equipment is an office equipment company specializing in sales of printers, scanners, and copiers. When should Ace Office Equipment recognize revenue from its sales?
A) When the customer calls to accept delivery of a new copier
B) When the customer signs a contract to buy a copier
C) When the copier is delivered to the customer
D) When the payment is received from the customer
E) When the financial statements are prepared that includes this sale
Answer: C
Diff: 2
Objective: L.O. 2-2
5) Armingham Cable Company sells cable services and related accessories. Which of these situations demonstrate proper revenue recognition for Armingham Cable Company?
A) Insurance is paid one month in advance of the due date because the Armingham Cable Company has extra cash.
B) Cable services are sold to customers, and customers are billed in advance of receiving services. Revenue is recorded before rendering services.
C) Cable boxes are purchased for sale to customers, but the accountant has not yet paid the bill.
D) An interest bearing certificate of deposit is purchased. Interest will be received at the end of 60 days. Interest revenue will be recorded at the end of 60 days.
E) Employees are paid for hours worked last month.
Answer: D
Diff: 2
Objective: L.O. 2-2
6) Revenue is recognized when a customer's promise to pay exists, even if the company is not relatively certain that they will receive payment.
Answer: FALSE
Diff: 1
Objective: L.O. 2-2
Learning Objective 2.3 Questions
1) Mac's Computer Skills Training, purchased equipment for $30,000 on January 1, 20X8, and believes the equipment has a useful life of 36 months. What will be the effect of the equipment's depreciation on the balance sheet equation?
A) Decreases Equipment account and decreases Stockholders' Equity
B) Decreases Equipment account and increases Stockholders' Equity
C) Increases Equipment account and decreases Stockholders' Equity
D) Increases Equipment account and increases Stockholders' Equity
E) There is no effect on the balance sheet equation.
Answer: A
Diff: 2
Objective: L.O. 2-3
2) The recording of expenses in the same time period as the related revenues are recognized is known as
A) cost recovery.
B) realization.
C) matching.
D) recognition.
E) period costs.
Answer: C
Diff: 2
Objective: L.O. 2-3
3) Which of the following costs are identified directly as expenses of the time period in which they are incurred?
A) Product costs
B) Period costs
C) Both product and period costs
D) Neither product nor period costs
E) Period costs as long as the goods have not been sold
Answer: B
Diff: 2
Objective: L.O. 2-3
4) Which of the following costs are linked to the revenues earned during a period?
A) Product costs
B) Period costs
C) Both product and period costs
D) Neither product nor period costs
E) Product costs as long as the goods remain in inventory
Answer: A
Diff: 2
Objective: L.O. 2-3
5) Rent is paid one year in advance. The payment is recorded as an asset, Prepaid Rent, and 1/12 of the amount each month is recorded as Rent Expense. This is an example of which of the following concepts?
A) Recognition
B) Neutrality
C) Realization
D) Matching
E) Product costs
Answer: D
Diff: 2
Objective: L.O. 2-3
6) Which of the following accounts may be thought of as stored costs that are carried forward to future periods rather than immediately recorded as an expense?
A) Prepaid insurance
B) Utilities expense
C) Salaries expense
D) Depreciation expense
E) Cost of goods sold
Answer: A
Diff: 1
Objective: L.O. 2-3
7) What is the effect on a company's balance sheet equation when depreciation expense is recognized?
A) This transaction affects only the income statement, so no change on the balance sheet will occur.
B) Total assets and total stockholders' equity will decrease by the same amount.
C) There will be no change in the total assets, liabilities, and stockholders' equity account.
D) Total liabilities will increase and total stockholders' equity will decrease by the same amount.
E) Without knowing the exact dollar amount of depreciation, the effect on the balance sheet cannot be determined.
Answer: B
Diff: 3
Objective: L.O. 2-3
8) When a portion of prepaid rent expires, what will be the effect on the balance sheet equation?
A) This transaction affects only the income statement, so there will be no effect on the balance sheet.
B) There will be no overall effect on total assets, because two different asset accounts will change by the exact dollar amount, with one increasing and the other decreasing.
C) Total assets and total liabilities will go down by the exact same dollar amount.
D) Total assets and total stockholders' equity will go down by the exact same dollar amount.
E) Without knowing the dollar amount of the transaction, the effect on the balance sheet equation cannot be determined.
Answer: D
Diff: 3
Objective: L.O. 2-3
9) Expenses that are naturally linked to revenues are product costs. Examples of product costs include ________ and ________.
A) Advertising Expense; Utilities Expense
B) Rent Expense; Depreciation Expense
C) Interest Revenue; Interest Expense
D) Cost of Goods Sold; Sales Commissions Expense
E) Administrative Expense; Selling Expense
Answer: D
Diff: 2
Objective: L.O. 2-3
10) Floral Deliveries, Inc. paid $6,000 for January, February, March and April's rent in advance on January 1, 20X9. The company recorded this transaction by increasing the balance in the Prepaid Rent account. The balance in the Prepaid Rent account as of March 1, 20X9, will be
A) $-0-.
B) $1,500.
C) $2,000.
D) $3,000.
E) $6,000.
Answer: D
Diff: 2
Objective: L.O. 2-3
11) Floral Deliveries, Inc. paid $6,000 for January, February, March and April's rent in advance on January 1, 20X9. The company recorded this transaction by increasing the balance in the Prepaid Rent account. The balance in the Rent Expense account for the period, January 1, 20X9 through March 31, 20X9, as of March 31, 20X9, will be
A) $-0-.
B) $4,500.
C) $2,000.
D) $3,000.
E) $6,000.
Answer: B
Diff: 2
Objective: L.O. 2-3
12) On March 1, 20X9, Schmor Incorporated paid 6 months' insurance in advance, covering the period of March 1 to August 31, 20X9. The total payment was $4,200. At the time of the payment, the entire amount was used to increase the balance in the Prepaid Insurance account. What will be the balance in the Prepaid Insurance account as of March 31, 20X9?
A) $-0-
B) $700
C) $2,800
D) $3,500
E) $4,200
Answer: D
Diff: 2
Objective: L.O. 2-3
13) Which situation violates the matching principle?
A) Employees are paid for wages worked in a previous month. The wages expense was recorded in the previous month.
B) Consulting fees incurred have been recorded as an expense even though a bill has not yet been received.
C) Depreciation was recorded for equipment even though the equipment was purchased on a date other than January 1.
D) A 1-year insurance policy was paid in full on January 1 and the total amount of the bill was recorded as an expense in January.
E) Customers are billed for services even though the company knows a portion of the customers will never pay.
Answer: D
Diff: 2
Objective: L.O. 2-3
14) On January 1, 2015, equipment is purchased for $100,000. The equipment will be used for ten years and has no salvage value. What is the depreciation expense for the year ending December 31, 2016?
A) $1,000
B) $2,000
C) $10,000
D) $20,000
E) $100,000
Answer: C
Diff: 2
Objective: L.O. 2-3
15) Accrual accounting uses the matching principle.
Answer: TRUE
Diff: 1
Objective: L.O. 2-3
16) The matching concept is closely related to the cash basis of accounting.
Answer: FALSE
Diff: 1
Objective: L.O. 2-3
17) Expenses, such as utilities, whose benefit is consumed by the passage of time rather than by the level of sales, are known as period costs.
Answer: TRUE
Diff: 2
Objective: L.O. 2-3
18) Costs that are linked with revenues and are charged as expenses when the related revenue is recognized are known as product costs.
Answer: TRUE
Diff: 2
Objective: L.O. 2-3
19) The process of allocating the cost of long-lived or fixed assets to expense is referred to as depreciation.
Answer: TRUE
Diff: 1
Objective: L.O. 2-3
20) Assets such as prepaid rent may be thought of as costs that are stored to be carried forward to future periods and recorded as expenses in the future.
Answer: TRUE
Diff: 2
Objective: L.O. 2-3
21) Under the accrual basis of accounting, prepaid assets become expenses when they expire.
Answer: TRUE
Diff: 1
Objective: L.O. 2-3
22) Use the following balance sheet equation format to show the effect of the following transactions. Write the account names that will be used for each transaction.
| Account name | Total assets | Total liabilities | Paid-in capital | Retained Earnings |
1. The owners invest $42,000 in the company.
2. The company purchases equipment costing $6,000, paying $2,000 with the remainder as a note payable.
3. The company acquires inventory costing $2,500, paying $1,500 with the remainder on account.
4. Depreciation on the equipment was $200.
Answer:
| Item | Account name | Total assets | Total liabilities | Paid-in capital | Retained Earnings |
| 1. | Cash | +42,000 | |||
| Paid-in capital | +42,000 | ||||
| 2. | Equipment | +6,000 | |||
| Cash | (2,000) | ||||
| Note payable | +4,000 | ||||
| 3. | Inventory | +2,500 | |||
| Cash | (1,500) | ||||
| Accounts Payable | +1,000 | ||||
| 4. | Depreciation expense | (200) | |||
| Accumulated Depreciation- Equipment | (200) |
Diff: 2
Objective: L.O. 2-2 & 2-3
23) Describe how the matching concept is necessary to produce an income statement.
Answer: The matching concept is necessary to relate product and period costs to the revenues that are generated in a given time period. Expenses are matched with revenues whenever it is reasonable and practicable to do so. Thus, the recognition of expense on the income statement is tied to the recognition of revenues.
Diff: 2
Objective: L.O. 2-1 & 2-3
Learning Objective 2.4 Questions
1) Net income is defined as
A) revenues minus expenses.
B) expenses minus revenues.
C) assets minus revenues.
D) assets plus revenues.
E) owners' equity assets minus expenses.
Answer: A
Diff: 1
Objective: L.O. 2-4
2) Under accrual basis accounting, the recognition of salaries earned and the immediate payment of salaries to employees would
A) increase assets.
B) increase owners' equity.
C) increase net income.
D) decrease net income.
E) increase revenue.
Answer: D
Diff: 1
Objective: L.O. 2-4
3) The following data pertains to Greenwold Manufacturing. Total assets at January 1, 20X9, were $290,000; at December 31, 20X9, total assets were $334,000. During 20X9, sales were $995,000; cash dividends declared were $10,000; and operating expenses (exclusive of cost of goods sold) were $545,000. Total liabilities at December 31, 20X9, were $128,000; at January 1, 20X9, total liabilities were $105,000. There was no additional paid-in capital during 20X9. What was the amount of stockholders' equity as of January 1, 20X9?
A) $450,000
B) $440,000
C) $185,000
D) $635,000
E) $175,000
Answer: C
Diff: 1
Objective: L.O. 2-4
4) The following data pertains to Greenwold Manufacturing. Total assets at January 1, 20X9, were $290,000; at December 31, 20X9, total assets were $334,000. During 20X9, sales were $995,000; cash dividends declared were $10,000; and operating expenses (exclusive of cost of goods sold) were $545,000. Total liabilities at December 31, 20X9, were $128,000; at January 1, 20X9, total liabilities were $105,000. There was no additional paid-in capital during 20X9. What was net income for 20X9?
A) $26,000
B) $31,000
C) $201,000
D) $440,000
E) $450,000
Answer: B
Diff: 3
Objective: L.O. 2-4
5) The following data pertains to Greenwold Manufacturing. Total assets at January 1, 20X9, were $290,000; at December 31, 20X9, total assets were $334,000. During 20X9, sales were $995,000; cash dividends declared were $10,000; and operating expenses (exclusive of cost of goods sold) were $545,000. Total liabilities at December 31, 20X9, were $128,000; at January 1, 20X9, total liabilities were $105,000. There was no additional paid-in capital during 20X9. What was cost of goods sold for 20X9?
A) $450,000
B) $435,000
C) $429,000
D) $419,000
E) $440,000
Answer: D
Diff: 3
Objective: L.O. 2-4
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