Chapter 5 Intermediate Accounting: Questions

1. How does information from the balance sheet help users of the financial statements?

1. The balance sheet provides information about the nature and amounts of investments in enterprise resources, obligations to enterprise creditors, and the owners' equity in net enterprise resources. That information not only complements information about the components of income, but also contributes to financial reporting by providing a basis for (1) computing rates of return, (2) evaluating the capital structure of the enterprise, and (3) assessing the liquidity and financial flexibility of the enterprise.

10. In its December 31, 2014, balance sheet Oakley Corporation reported as an asset, "Net notes and accounts receivable, $7,100,000." What other disclosures are necessary?

10. Separate amounts should be reported for accounts receivable and notes receivable. The amounts should be reported gross, and an amount for the allowance for doubtful accounts should be deducted. The amount and nature of any nontrade receivables, and any amounts designated or pledged as collateral, should be clearly identified.

11. Should available-for-sale securities always be reported as a current asset? Explain.

11. No. Available-for-sale securities should be reported as a current asset only if management expects to convert them into cash as needed within one year or the operating cycle, whichever is longer. If available-for-sale securities are not held with this expectation, they should be reported as long-term investments.

12. What is the relationship between current assets and current liabilities?

12. The relationship between current assets and current liabilities is that current liabilities are those obligations that are reasonably expected to be liquidated either through the use of current assets or the creation of other current liabilities.

13. The New York Knicks, Inc. sold 10,000 season tickets at $2,000 each. By December 31, 2014, 16 of the 40 home games had been played. What amount should be reported as a current liability at December 31, 2014?

13. The total selling price of the season tickets is $20,000,000 (10,000 X $2,000). Of this amount, $8,000,000 has been earned by 12/31/14 (16/40 X $20,000,000). The remaining $12,000,000 should be reported as unearned revenue, a current liability in the 12/31/14 balance sheet (24/40 X $20,000,000).

14. What is working capital? How does working capital relate to the operating cycle?

14. Working capital is the excess of total current assets over total current liabilities. This excess is sometimes called net working capital. Working capital represents the net amount of a company's relatively liquid resources. That is, it is the liquidity buffer available to meet the financial demands of the operating cycle.

15. In what section of the balance sheet should the following items appear, and what balance sheet terminology would you use? (a) Treasury stock (recorded at cost). (b) Checking account at bank. (c) Land (held as an investment). (d) Sinking fund. (e) Unamortized premium on bonds payable. (f) Copyrights. (g) Pension fund assets. (h) Premium on capital stock. (i) Long-term investments (pledged against bank loans payable).

15. (a) Stockholders' Equity. "Treasury stock (at cost)." Note: This is a reduction of total stockholders' equity (reported as contra-equity). (b) Current Assets. Included in "Cash." (c) Long-Term Investments. "Land held as an investment." (d) Long-Term Investments. "Sinking fund." (e) Long-term debt (adjunct account to bonds payable). "Unamortized premium on bonds payable." (f) Intangible Assets. "Copyrights." (g) Investments. "Employees' pension fund," with subcaptions of "Cash" and "Securities" if desired. (Assumes that the company still owns these assets.) (h) Stockholders' Equity. "Additional paid-in capital." (i) Investments. Nature of investments should be given together with parenthetical information as follows: "pledged to secure loans payable to banks."

16. Where should the following items be shown on the balance sheet, if shown at all? (a) Allowance for doubtful accounts. (b) Merchandise held on consignment. (c) Advances received on sales contract. (d) Cash surrender value of life insurance. (e) Land. (f) Merchandise out on consignment. (g) Franchises. (h) Accumulated depreciation of equipment. (i) Materials in transit—purchased f.o.b. destination.

16. (a) Allowance for doubtful accounts should be deducted from accounts receivable in current assets. (b) Merchandise held on consignment should not appear on the consignee's balance sheet except possibly as a note to the financial statements. (c) Advances received on sales contract are normally a current liability and should be shown as such in the balance sheet. (d) Cash surrender value of life insurance should be shown as a long-term investment. (e) Land should be reported in property, plant, and equipment unless held for investment. (f) Merchandise out on consignment should be shown among current assets under the heading of inventory. (g) Franchises should be itemized in a section for intangible assets. (h) Accumulated depreciation of plant and equipment should be deducted from the equipment account. (i) Materials in transit should not be shown on the balance sheet of the buyer, if purchased f.o.b. destination.

17. State the generally accepted accounting principle applicable to balance sheet valuation of each of the following assets. (a) Trade accounts receivable. (b) Land. (c) Inventories. (d) Trading securities (common stock of other companies). (e) Prepaid expenses.

17. (a) Trade accounts receivable should be stated at their estimated amount collectible, often referred to as net realizable value. The method most generally followed is to deduct from the total accounts receivable the amount of the allowance for doubtful accounts. (b) Land is generally stated in the balance sheet at cost. (c) Inventories are generally stated at the lower of cost or market. (d) Trading securities (consisting of common stock of other companies) are stated at fair value. (e) Prepaid expenses should be stated at cost less the amount apportioned to and written off over the previous accounting periods.

18. Refer to the definition of assets on page 216. Discuss how a leased building might qualify as an asset of the lessee (tenant) under this definition.

18. Assets are defined as probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. If a building is leased under a capital lease, the future economic benefits of using the building are controlled by the lessee (tenant) as the result of a past event (the signing of a lease agreement).

19. Kathleen Battle says, "Retained earnings should be reported as an asset, since it is earnings which are reinvested in the business." How would you respond to Battle?

19. Battle is incorrect. Retained earnings is a source of assets, but is not an asset itself. For example, even though the funds obtained from issuing a note payable are invested in the business, the note payable is not reported as an asset. It is a source of assets, but it is reported as a liability because the company has an obligation to repay the note in the future. Similarly, even though the earnings are invested in the business, retained earnings is not reported as an asset. It is reported as part of shareholders' equity because it is, in effect, an investment by owners which increases the ownership interest in the assets of an entity.

2. What is meant by solvency? What information in the balance sheet can be used to assess a company's solvency?

2. Solvency refers to the ability of an enterprise to pay its debts as they mature. For example, when a company carries a high level of long-term debt relative to assets, it has lower solvency. Information on long-term obligations, such as long-term debt and notes payable, in comparison to total assets can be used to assess resources that will be needed to meet these fixed obligations (such as interest and principal payments).

20. The creditors of Chester Company agree to accept promissory notes for the amount of its indebtedness with a proviso that two-thirds of the annual profits must be applied to their liquidation. How should these notes be reported on the balance sheet of the issuing company? Give a reason for your answer.

20. The notes should appear as long-term liabilities with full disclosure as to their terms. Each year, as the profit is determined, notes of an amount equal to two-thirds of the year's profits should be transferred from the long-term liabilities to current liabilities until all of the notes have been liquidated.

21. What is the purpose of a statement of cash flows? How does it differ from a balance sheet and an income statement?

21. The purpose of a statement of cash flows is to provide relevant information about the cash receipts and cash payments of an enterprise during a period. It differs from the balance sheet and the income statement in that it reports the sources and uses of cash by operating, investing, and financing activity classifications. While the income statement and the balance sheet are accrual basis statements, the statement of cash flows is a cash basis statement—noncash items are omitted.

22. The net income for the year for Genesis, Inc. is $750,000, but the statement of cash flows reports that the net cash provided by operating activities is $640,000. What might account for the difference?

22. The difference between these two amounts may be due to increases in current assets (e.g., an increase in accounts receivable from a sale on account would result in an increase in revenue and net income but have no effect yet on cash). Similarly a cash payment that results in a decrease in an existing current liability (e.g., accounts payable would decrease cash provided by operations without affecting net income).

23. Net income for the year for Carrie, Inc. was $750,000, but the statement of cash flows reports that net cash provided by operating activities was $860,000. What might account for the difference?

23. The difference between these two amounts could be due to noncash charges that appear in the income statement. Examples of noncash charges are depreciation, depletion, and amortization of intangibles. Expenses recorded but unpaid (e.g., increase in accounts payable) and collection of previously recorded sales on credit (i.e., now decreasing accounts receivable) also would cause cash provided by operating activities to exceed net income.

24. Differentiate between operating activities, investing activities, and financing activities.

24. Operating activities involve the cash effects of transactions that enter into the determination of net income. Investing activities include making and collecting loans and acquiring and disposing of debt and equity instruments; property, plant, and equipment and intangibles. Financing activities involve long-term liability and stockholders' equity items and include obtaining capital from owners and providing them with a return on (dividends) and a return of their investment and borrowing money from creditors and repaying the amounts borrowed.

25. Each of the following items must be considered in preparing a statement of cash flows. Indicate where each item is to be reported in the statement, if at all. Assume that net income is reported as $90,000. (a) Accounts receivable increased from $34,000 to $39,000 from the beginning to the end of the year. (b) During the year, 10,000 shares of preferred stock with a par value of $100 per share were issued at $115 per share. (c) Depreciation expense amounted to $14,000, and bond premium amortization amounted to $5,000. (d) Land increased from $10,000 to $30,000.

25. (a) Net income is adjusted downward by deducting $5,000 from $90,000 and reporting cash provided by operating activities as $85,000. (b) The issuance of the preferred stock is a financing activity. The issuance is reported as follows: Cash flows from financing activities Issuance of preferred stock $1,150,000 (c) Net income is adjusted as follows: Cash flows from operating activities Net income $90,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense 14,000 Bond premium amortization (5,000) Net cash provided by operating activities $99,000 (d) The increase of $20,000 reflects an investing activity. The increase in Land is reported as follows: Cash flows from investing activities: Purchase Land $(20,000)

26. Sergey Co. has net cash provided by operating activities of $1,200,000. Its average current liabilities for the period are $1,000,000, and its average total liabilities are $1,500,000. Comment on the company's liquidity and financial flexibility, given this information.

26. The company appears to have good liquidity and reasonable financial flexibility. Its current cash debt coverage is 1.20 , which indicates that it can pay off its current liabilities in a given year from its operations. In addition, its cash debt coverage is also good at 0.80 , which indicates that it can pay off approximately 80% of its debt out of current operations.

27. Net income for the year for Tanizaki, Inc. was $750,000, but the statement of cash flows reports that net cash provided by operating activities was $860,000. Tanizaki also reported capital expenditures of $75,000 and paid dividends in the amount of $30,000. Compute Tanizaki's free cash flow.

27. Free cash flow = $860,000 - $75,000 - $30,000 = $755,000.

28. What is the purpose of a free cash flow analysis?

28. Free cash flow is net cash provided by operating activities less capital expenditures and dividends. The purpose of free cash flow analysis is to determine the amount of discretionary cash flow a company has for purchasing additional investments, retiring its debt, purchasing treasury stock, or simply adding to its liquidity and financial flexibility.

29. What are some of the techniques of disclosure for the balance sheet?

29. Some of the techniques of disclosure for the balance sheet are: (a) Parenthetical explanations. (b) Notes to the financial statements. (c) Cross references and contra items. (d) Supporting schedules.

3. A recent financial magazine indicated that the airline industry has poor financial flexibility. What is meant by financial flexibility, and why is it important?

3. Financial flexibility is the ability of an enterprise to take effective actions to alter the amounts and timing of cash flows so it can respond to unexpected needs and opportunities. An enterprise with a high degree of financial flexibility is better able to survive bad times, to recover from unexpected setbacks, and to take advantage of profitable and unexpected investment opportunities. Generally, the greater the financial flexibility, the lower the risk of enterprise failure.

30. What is a "Summary of Significant Accounting Policies"?

30. A note entitled "Summary of Significant Accounting Policies" would indicate the basic accounting principles used by that enterprise. This note should be very useful from a comparative standpoint, since it should be easy to determine whether the company uses the same accounting policies as other companies in the same industry.

31. What types of contractual obligations must be disclosed in great detail in the notes to the balance sheet? Why do you think these detailed provisions should be disclosed?

31. General debt obligations, lease contracts, pension arrangements and stock option plans are four items for which disclosure is mandatory in the financial statements. The reason for disclosing these contractual situations is that these commitments are of a long-term nature, are often significant in amount, and are very important to the company's well-being.

32. What is the profession's recommendation in regard to the use of the term "surplus"? Explain.

32. The profession has recommended that the use of the term "surplus" be discontinued in balance sheet presentations of stockholders' equity. This term has a connotation outside accounting that is quite different from its meaning in the accounts or in the balance sheet. The use of the terms capital surplus, paid-in surplus, and earned surplus is confusing to the nonaccountant and leads to misinterpretation.

4. Discuss at least two situations in which estimates could affect the usefulness of information in the balance sheet.

4. Some situations in which estimates affect amounts reported in the balance sheet include: (a) allowance for doubtful accounts. (b) depreciable lives and estimated salvage values for plant and equipment. (c) warranty returns. (d) determining the amount of revenues that should be recorded as unearned. When estimates are required, there is subjectivity in determining the amounts. Such subjectivity can impact the usefulness of the information by reducing the faithful representation of the measures, either because of bias or lack of verifiability.

5. Perez Company reported an increase in inventories in the past year. Discuss the effect of this change on the current ratio (current assets/current liabilities). What does this tell a statement user about Perez Company's liquidity?

5. An increase in inventories increases current assets, which is in the numerator of the current ratio. Therefore, inventory increases will increase the current ratio. In general, an increase in the current ratio indicates a company has better liquidity, since there are more current assets relative to current liabilities. Note to instructors—When inventories increase faster than sales, this may not be a good signal about liquidity. That is, inventory can only be used to meet current obligations when it is sold (and converted to cash). That is why some analysts use a liquidity ratio—the acid-test ratio—that excludes inventories from current assets in the numerator.

6. What is meant by liquidity? Rank the following assets from one to five in order of liquidity. (a) Goodwill. (b) Inventory. (c) Buildings. (d) Short-term investments. (e) Accounts receivable.

6. Liquidity describes the amount of time that is expected to elapse until an asset is converted into cash or until a liability has to be paid. The ranking of the assets given in order of liquidity is: (1) (d) Short-term investments. (2) (e) Accounts receivable. (3) (b) Inventory. (4) (c) Buildings. (5) (a) Goodwill.

7. What are the major limitations of the balance sheet as a source of information?

7. The major limitations of the balance sheet are: (a) The values stated are generally historical and not at fair value. (b) Estimates have to be used in many instances, such as in the determination of collectibility of receivables or finding the approximate useful life of long-term tangible and intangible assets. (c) Many items, even though they have financial value to the business, presently are not recorded. One example is the value of a company's human resources.

8. Discuss at least two items that are important to the value of companies like Intel or IBM but that are not recorded in their balance sheets. What are some reasons why these items are not recorded in the balance sheet?

8. Some items of value to technology companies such as Intel or IBM are the value of research and development (new products that are being developed but which are not yet marketable), the value of the "intellectual capital" of its workforce (the ability of the companies' employees to come up with new ideas and products in the fast changing technology industry), and the value of the company reputation or name brand (e.g., the "Intel Inside" logo). In most cases, the reasons why the value of these items are not recorded in the balance sheet concern the lack of faithful representation of the estimates of the future cash flows that will be generated by these "assets" (for all three types) and the ability to control the use of the asset (in the case of employees). Being able to reliably measure the expected future benefits and to control the use of an item are essential elements of the definition of an asset, according to the Conceptual Framework.

9. How does separating current assets from property, plant, and equipment in the balance sheet help analysts?

9. Classification in financial statements helps users by grouping items with similar characteristics and separating items with different characteristics. Current assets are expected to be converted to cash within one year or the operating cycle, whichever is longer—property, plant and equipment will provide cash inflows over a longer period of time. Thus, separating long-term assets from current assets facilitates computation of useful ratios such as the current ratio.