Chapter 3: The Income Statement Study Guide

When accrual basis accounting is used, net income equals the amount of cash generated by the business.

False! Accrual basis net income is the excess of revenues earned over expenses incurred. Revenues do not necessarily equal cash receipts and expenses that do not necessarily equal cash disbursements.

Expenses are the costs of operating the business that are paid for in the period covered by the income statement.

False! Expenses are costs of operating the business, incurred to generate revenues in the period covered by the income statement. Basically, whenever a business uses up its resources to generate revenues during the period, it reports an expense, regardless of when the company pays for the resources.

When cash is paid before the related expense is incurred, an asset is reported on the balance sheet.

True! It is common for businesses to pay for something that provides benefits only in future periods. Those costs are reported as assets because they benefit future periods; assets are reported on the balance sheet. For example, a company might buy office supplies now but not use them until next month. Supplies are reported as an asset when purchased. The expense from using these supplies (Supplies Expense) will be reported next month when the supplies are used.

During 2016, a company provided services for cash of $21,000 and services on credit of $15,000. The company collected accounts receivable of $8,000 and incurred operating expenses of $22,700, $14,000 of which were paid during the year. The amount of net income (loss) for the year is:

A) $13,300

Which of the following statements about the cash basis of accounting is correct?

A) It can lead to a distorted view of the company's financial performance.

Which of the following is not an operating activity?

A) Paying off a loan to the bank

Which of the following statements about accrual basis accounting is correct?

B) If a company uses accrual basis accounting, the company should, the company should record expenses in the same period as the revenues they generate.

Which of the following would not be considered an operating activity?

C) Purchase equipment for cash

A company's revenue recognition policy:

C) is usually described in the notes to a company's financial statements.

Which of the following statements about cash basis accounting and accrual basis accounting is correct?

D) Accrual basis accounting provides a better measure of operating performance than cash basis accounting.

Which of the following would not be reported on the income statement?

D) Cost of land purchased with cash for future use.

To evaluate a company's net profit margin, it is best to compare it to another company in the same industry.

True! Different industries have different cost structures which can affect financial ratios.

Which of the following represents a subtotal rather than an account?

D) Total Revenues

Which of the following is an operating activity?

D) Purchasing goods to be offered for sale

The Rainbow House Painting Company has been contracted to paint a house for $3,600. One-half of that amount will be paid up front; the rest will be paid upon satisfactory completion. Rainbow should recognize the revenue when:

D) the work is complete.

The Fastbank Motorcycle Service Company wins a $10 million bid to provide the repair services for a recall on a popular brand of motorcycles. No money is exchanged. The repair services are expected to be performed early next year. How will these events affect the balance sheet prepared at the end of this year?

D) These events will not impact the balance sheet.

Which of the following statements about the income statement of a company that was formed 10 years ago is correct?

B) Reports the financial effects of activities that have occurred since the company's inception.

During June, the Grass is Greener Company mows 100 lawns a week; the company was paid in advance during May by those customers. The company uses the accrual basis of accounting. How will these events affect the company's financial statements?

B) The income statement shows the effects of the transactions in June.

Which of the following items is not a specific account in a company's chart of accounts?

D) Net Income

If a company decides to record an expenditure made this period as an expense, when it should have been recorded as an asset, net income will be overstated in the current period as a result.

False! Erroneously recording an asset as an expense would overstate total expenses, which would understate net income.

If the total of debits equals the total of credits on the trial balance, it means that the accounting records do not contain any errors.

False! Even if debits equal credits on the trial balance, it is still possible that the wrong account was used, an entry was omitted or recorded twice, and/or the wrong amount was entered as both a debit and a credit.

When expenses exceed revenues in a period, stockholders' equity will increase.

False! It is called a net loss if expenses are greater than revenues. A net loss decreases stockholders' equity.

Net income is increased when accounts receivable are collected.

False! Recording the collection of accounts receivable would increase Cash and decrease Accounts Receivable. This journal entry has no effect on net income.

A company does not need to record the receipt of a bill for utilities used during this year if the company will not pay the bill until next year.

False! The expense recognition principle states that expenses should be recorded in the same period as the revenues they generate, not necessarily the period in which cash is paid for them. As such, an expense would be recorded this year since the utilities were used this year.

The period of time from buying goods and services to collecting cash from customers is the accounting cycle.

False! The time between buying assets to be sold to customers and collecting cash from customers is the operating cycle of the business.

A net profit margin of 15.4% means that the company used 84.6 cents of each sales dollar to cover costs and expenses.

True! A net profit margin of 15.4% means that the company earned 15.4 cents of net income for each dollar of revenue, which means that 84.6 cents (or $1.00 - $.154) went to cover costs and expenses.

GAAP does not allow cash basis accounting to be used in external financial reports.

True! According to GAAP, the accrual basis is the only acceptable method for external reporting of income. The cash basis can be used internally by some small companies, but GAAP does not allow it for external reporting.

It is possible for a company to be profitable, yet not have enough cash to pay its bills.

True! Accrual basis net income is the excess of revenues earned over expenses incurred. Revenues do not necessarily equal cash receipts and expenses that do not necessarily equal cash disbursements. A profitable company may not be able to pay its bills if it does not collect cash from customers quickly enough.

If revenues are not growing faster than expenses, then net income will decrease.

True! If revenues are increasing, but expenses are increasing even faster, then the amount of Net Income (Revenues - Expenses) will decrease.

Costs that benefit future periods are reported as assets.

True! It is common for businesses to pay for something that provides benefits only in future periods. Those costs are reported as assets because they benefit future periods. For example, a company might buy office supplies now but not use them until next month. Supplies are reported as an asset when purchased. The expense from using these supplies (Supplies Expense) will be reported next month when the supplies are used.

Net income is based on estimates.

True! Proper counting is critical to income measurement, but estimation also plays a role. For example, equipment will not last forever. Instead, it will be "used up" over time to generate the company's revenue. It should therefore be expensed over the period in which it is used. Doing so requires an estimate of the period over which each category of equipment will be used.

Dividing up the continuing life of a company into shorter periods is called the time period assumption.

True! The ongoing life of a company is divided up into shorter periods according to the time period assumption so that financial reports can be issued for specific periods of time and at a specific point in time.

Unearned Revenue is reported on the balance sheet as a liability.

True! Unearned Revenue is a liability representing a company's obligation to provide goods or services to customers in the future. Liability accounts are reported on the balance sheet.