Unit 7
When reviewing a corporation's financial statements, shareholders' equity is computed by: A) subtracting current liabilities from current assets B) subtracting total liabilities from total assets C) adding together retained earnings, preferred and common stock, and long-term debts D) multiplying the current market price per share times the number of outstanding shares
B) subtracting total liabilities from total assets Shareholders' equity is the corporation's net worth, sometimes called owners' equity. It is computed by subtracting the total liabilities from the total assets. Current assets minus current liabilities is the working capital. Taking all of the equity capital, including retained earnings, and adding the long-term debt to that is the company's total capitalization, and the market price per share times the number of outstanding shares is the company's market capitalization.
An IAR is doing some research on a company. When viewing the corporation's financial statements, prepaid expenses would most likely be found as: A) a current asset on the balance sheet B) an expense on the income statement C) a fixed asset on the balance sheet D) a current liability on the balance sheet
A) a current asset on the balance sheet Prepaid expenses, such as rent, insurance, and postage, are considered current assets and are shown as such, sometimes under the listing "other assets." The amounts paid for those expenses will not appear on the income statement until the specific item is actually used. For example, if a company pays its property insurance premiums six months in advance, it isn't until the next premium is paid that the prepaid expense comes off the balance sheet and is reflected as an actual expense.
Debts that will come due more than one year after the date on the balance sheet are known as: A) fixed (or long-term) liabilities B) accounts payable C) deferred charges D) current liabilities
A) fixed (or long-term) liabilities Debts that will come due more than one year after the date on the balance sheet are known as fixed (or long-term) liabilities. Current liabilities are debts that may come due within one year from the date on the balance sheet.
Due to changes in customer preferences, a manufacturing company has decided to discontinue the operations of one of its subsidiaries. An explanation of this decision would most likely be found in the company's: A) footnotes to the financial statements B) income statement C) balance sheet D) tax return
A) footnotes to the financial statements Footnotes are used to explain extraordinary items such as the sale of a subsidiary.
A profitable company reports net income of $10 million. A cash dividend of $7 million is declared. From an accounting standpoint, the other $3 million will be credited to which balance sheet account? A) Retained earnings B) Capital surplus C) Dividends payable D) Working capital
A) Retained earnings Retained earnings are increased to the extent that company profits (net income) are undistributed—in essence, retained. Capital surplus comes from original investors purchasing stock at a price in excess of stated or par value. Working capital is not a balance sheet account; it is a computation. When the dividend is declared, it becomes a current liability (dividends payable), but this question is asking for the portion of the income that is not going to be paid out.
A term used to describe the results of subtracting a corporation's liabilities from its assets is: A) owners' equity B) operating income C) retained earnings D) net income
A) owners' equity
If a corporation issues mortgage bonds, all of the following would be affected except: A) total liabilities B) shareholders' equity C) total assets D) working capital
B) shareholders' equity When issued, the corporation receives the net proceeds in cash, increasing current assets (and thus total assets). Simultaneously, the corporation's long-term liabilities increase, reflecting the debt (and thus total liabilities). Working capital increases because of the increase in current assets. Shareholders' equity, or net worth, is only affected by the sale of new equity securities or by any profit or loss generated by the corporation.
SSS Corporation's total assets amount to $780,000, of which $260,000 represents current assets. Total liabilities equal $370,000, of which $200,000 is considered long-term or other liabilities. What is SSS Corporation's shareholders' equity? A) $980,000 B) $170,000 C) $410,000 D) $1,150,000
C) $410,000 Total assets minus total liabilities equals shareholders' equity ($780,000 − $370,000 = $410,000).
Which of the following is not affected by the issuance of a bond? A) Working capital B) Assets C) Shareholders' equity D) Total liabilities
C) Shareholders' equity When bonds are issued, cash is received (thus increasing current assets) and long-term debt increases (increasing total liabilities). Because there is no corresponding increase in current liabilities, working capital increases. There is no effect on shareholders' equity because the increased liability is offset by the asset (cash) received.
An analyst is viewing financial statements of Diderot Clothing Stores (DCS), a chain of high-fashion women's apparel. DCS had $7 million as its beginning-of-year retained earnings and it made post-tax profits of $3 million. The board of directors decides to pay a dividend of $1 million. Once paid, what will be the ending retained earnings? A) $7 million B) $10 million C) $9 million D) $3 million
C) $9 million The ending retained earnings = beginning retained earnings + net income - dividend. That means $7 million + $3 million - $1 million = $9 million.
A term used to describe the results of subtracting a corporation's liabilities from its assets is: A) retained earnings B) operating income C) owners' equity D) net income
C) owners' equity There are several terms used on the exam to express the results of the balance sheet formula. In most cases, it will be shown as assets minus liabilities equals net worth. Net worth can also be expressed as owners' equity or shareholders' equity. Income has nothing to do with assets and liabilities, and retained earnings is a component of owners' equity.
Current liabilities on a company's balance sheet would include: A) accounts receivable B) prepaid rent C) mortgage payable D) accounts payable
D) accounts payable Current liabilities are those that are expected to be paid within a normal operating cycle and would include accounts payable. A mortgage payable is a liability, but it is a long-term debt and would be included in fixed or long-term liabilities. Accounts receivable and prepaid expenses are current assets.
On a balance sheet, dividends payable would fall under the category of: A) fixed liabilities B) stockholders' equity C) assets D) current liabilities
D) current liabilities Dividends payable are dividends that have been declared but have not yet paid out. They are a type of current liability—that is, an obligation that will come due within one year from the date on the balance sheet.
Components of a company's net worth would include all of these except: A) inventory B) goodwill C) fixed assets D) operating income
D) operating income Net worth is all of the company's assets minus its liabilities as found on the balance sheet. Operating income is found on the income statement and is neither an asset nor a liability.
Current assets on a corporate balance sheet would include which of these? (2 answers) A) Accounts payable B) Accrued wages C) Cash D) Inventory
C) Cash D) Inventory Cash is the most obvious current asset. The general definition of current asset is one that is expected to be turned into cash within the year. One would certainly hope that to be true of inventory. Accounts payable and accrued wages are liabilities—obligations that must be paid on a current basis.
What is the term given to the item, typically found at the bottom of a corporation's balance sheet, that describes such things as significant accounting policies, commitments made by the company, and potential liabilities and potential losses? A) Footnotes B) Offline items C) Contingency statement D) Resource material
A) Footnotes Footnotes to the balance sheet, describing unusual items, are typically found at the bottom of the statement.
Which items would change if a company declared a cash dividend? (Multiple answers) A) Working capital B) Total assets C) Total liabilities D) Shareholders' equity
A) Working capital C) Total liabilities D) Shareholders' equity The key word is declared. Liabilities increase when a dividend is declared, and total assets decrease when it is paid. A declared dividend (but not yet paid) would increase current liabilities (and would therefore decrease working capital). It would increase total liabilities (this is a pending obligation) and reduce shareholders' equity because retained earnings would be decreased by the dividend. Total assets would not be affected until the dividend is actually paid.
A corporate executive decides that it is in the company's best interest to purchase a yacht. Over the years, the company has built up substantial retained earnings and will use accumulated funds to make the purchase. An analyst interested in how this purchase will affect the company's debt-to-asset ratio would examine: A) the balance sheet B) the statement of cash flows C) the seaworthiness of the ship D) the income statement
A) the balance sheet Where do we find a company's assets, liabilities, and retained earnings? On the balance sheet.
Which items change when a company pays a cash dividend? (2 answers) A) Working capital B) Total assets C) Total liabilities D) Shareholders' equity
B) Total assets C) Total liabilities From an accounting standpoint, once a corporation declares a cash dividend, it becomes a current liability on the company's balance sheet. When that dividend is paid, cash—a current asset—is decreased by the amount of the dividend. Payment of the dividend removes it from the balance sheet as a current liability. Therefore, there is no change to the company's working capital (current assets minus current liabilities) because they are both reduced by the same amount. The total assets (of which cash is one) and the total liabilities (of which the dividend payable is one) both decrease. Because assets and liabilities are changed by an identical amount, there is no change to shareholders' equity (net worth).
Due to changes in market rates, a corporation is able to purchase some of its outstanding 20-year bonds at a discount. Which of the following is correct? (2 answers) A) Working capital is increased B) Working capital is reduced C) Net worth is increased D) Net worth is reduced
B) Working capital is reduced C) Net worth is increased Even though the bonds are purchased for less than par value, working capital is reduced because the company is using a current asset—cash—to pay off a long-term liability. However, the fact that it is reducing its debt for less than the amount shown on the books will result in an increase to net worth.
A client asks her investment adviser representative what footnotes to the financial statements are for. The best reply would be that footnotes: A) serve as a bibliography indicating where additional information may be obtained B) contain information that doesn't have a place in the main body of the financial statements C) are used to explain how the various ratios are computed because companies recognize that many shareholders do not have a financial background D) contain a detailed history of the enterprise and its products or services
B) contain information that doesn't have a place in the main body of the financial statements There are many important financial details that cannot be properly placed in either the balance sheet or the income statement. Examples of these are the following: method of accounting used, collateral securing debt, pension liabilities, and many others. Footnotes are an integral part of the financial statements and are usually found with this notation: "The accompanying footnotes to the financial statements are an integral part of these statements."
Publicly traded corporations are generally required to have an annual independent audit of their financial records. What is the highest opinion offered under GAAP? A) Adverse opinion B) Qualified opinion C) Unqualified opinion D) Disclaimer of opinion
C) Unqualified opinion An unqualified or "clean" opinion is the best type of report a business can get. The term qualified means that the auditor has some reservations about the information contained in the financial statements. An adverse opinion means the auditor is not willing to vouch for the accuracy of the information.
The owners' equity portion of a corporation's balance sheet would contain all of the following except: A) paid-in capital B) preferred stock C) net income D) Treasury stock
C) net income Net income is only found on the income statement. The other three are part of stockholders' equity (net worth). Treasury stock is company stock that has been issued to the public and then reacquired by the issuer (the company). It appears as a negative number, so it reduces the net worth (owners' equity). Note, even though the Treasury stock reduces the owners' equity, the question is asking for the items you would see in the owners' equity section on the balance sheet, and if it exists, it would appear there as a deduction.
Net income: A) is paid out in cash to stockholders in addition to any declared dividends B) must be paid out in dividends C) reflects the operating profits of a firm only D) represents the amount of money remaining after all expenses, including taxes
D) represents the amount of money remaining after all expenses, including taxes Net income is not a cash item that is paid out to stockholders. Dividends, both preferred and common, are generally cash distributions paid out from net income. Net income after taxes can reflect all sources of income in addition to the operating income generated by business activities. Net income also reflects investment income, as well as operating income. Net income may be paid out in the form of dividends; however, most firms retain a portion of net income in order to reinvest the funds in the business.
Which of the following statements about balance sheets are true? (2 answers) A) Balance sheets provide a snapshot of a company's financial position on a given date B) Balance sheets represent the relationship between a company's assets, liabilities, and stockholders' equity C) Balance sheets provide a record of a company's earnings over a given period
A) Balance sheets provide a snapshot of a company's financial position on a given date B) Balance sheets represent the relationship between a company's assets, liabilities, and stockholders' equity A balance sheet shows a company's assets, liabilities, and stockholders' equity on a specific date. The financial statement that reflects a company's operating activities and earnings over a period of time is the income statement.
Which of the following best describe the balance sheet formula? (2 answers) A) Assets minus liabilities equals net worth B) Sales minus expenses equals operating income C) Liabilities plus equity equals assets D) Dividends plus retained earnings equals net income
A) Assets minus liabilities equals net worth C) Liabilities plus equity equals assets A balance sheet basically lists what is owned (assets) and what is owed (liabilities). The difference between these two is the net worth or equity. Sales, expenses, and dividends are all found on the income statement.
The issuance of a long-term debt instrument, such as a bond, by a company would have an immediate effect on which of the following balance sheet items? (Multiple answers) A) Total assets B) Total liabilities C) Working capital D) Shareholders' equity
A) Total assets B) Total liabilities C) Working capital The cash received from the sale of the bonds is a current asset of the company and, as such, would increase assets and working capital on the balance sheet. The bonds are debt of the company and would increase the liabilities of the company. Shareholders' equity is only affected by gains, losses, new invested capital, and the declaration of cash distributions (dividends) to shareholders.
