Chapter 5

* (L.O. 2) Of the following items, the one which should be classified as a current asset is A. trade installment receivables normally collectible in 20 months. B. a deposit on equipment ordered, delivery of which will be made within 7 months. C. cash designated for the redemption of callable bonds. D. cash surrender value of a life insurance policy of which the company is a beneficiary.

(A) A current asset is either cash, something that will be converted into cash or consumed in one year or the operating cycle, whichever is longer. If installment sales are a normal part of operations, they may be classified as current assets because they will be converted into cash within the company's normal operating cycle. Answer (B) is incorrect because the cash deposit is a part of the cost of the machinery ordered and should be classified as a noncurrent asset. Answer (C) is incorrect because cash that is restricted for an indefinite period of time should be classified as a noncurrent asset. Answer (D) is incorrect because a life insurance policy is not likely to be canceled in the near future; therefore, its cash surrender value would be most appropriately reported in the long-term investment section of the balance sheet.

*L.O. 2) One of the main reasons for separating liabilities into current and longterm is: A. to provide decision makers with information regarding currently maturing debts. B. to separate large and small debts. C. to separate capital into its component parts. D. to separate total equity into its two basic parts.

(A) Alternative (B) is incorrect because dividing liabilities between current and long-term has nothing to do with the amount of the debt. Alternative (C) is incorrect because the term "capital" is not a correct term to use in describing debt. Alternative (D) is incorrect because total equity includes six components, none of which are liabilities.

*(L.O. 1) Solvency refers to: A. the ability of an enterprise to pay its debts as they mature. B. the amount of time that is expected to elapse until an asset is realized. C. the amount of time that is expected to elapse until a liability has to be paid. D. the amount of time that is expected to elapse until an asset is converted into cash.

(A) Solvency refers to the ability of an enterprise to pay its debts as they mature. Alternatives (B), (C) and (D) are all part of the definition of liquidity.

*(L.O. 2) If 1,240 cash and a 4,760 note are given in exchange for a delivery truck to be used in a business: A. assets and liabilities will change by the same amount. B. owners' equity will be increased. C. assets will increase and liabilities decrease. D. assets and liabilities will increase but by different amounts.

(A) This transaction causes assets to increase by $4,760. The asset account truck increases by $6,000 (the purchase price), but assets also decrease by $1,240 due to the cash payment. Liabilities increase by $4,760 as a result of the issuance of the note

*(L.O. 3) One of the benefits of the statement of cash flows is that it helps users evaluate financial flexibility. Which of the following explanations is a description of financial flexibility? A. The nearness to cash of assets and liabilities. B. The firm's ability to respond and adapt to financial adversity and unexpected needs and opportunities. C. The firm's ability to pay its debts as they mature. D. The firm's ability to invest in a number of projects with different objectives and costs.

(B) Financial flexibility refers to a firm's ability to respond and adapt to financial adversity and unexpected needs and opportunities. Alternative "D" is an indication of flexibility, but does not take into account adversity and unexpected needs. The nearness to cash of assets and liabilities is a firm's liquidity, and the firm's ability to pay its debts refers to solvency.

*(L.O. 3) The payment of cash dividends to the common shareholders would be reported on a company's statement of cash flows under the classification of A. Operating Activities. B. Financing Activities. C. Investing Activities. D. Significant Transactions.

(B) Financing activities involve liability and owners' equity items. They include (1) obtaining capital from owners and providing them with a return on (and a return of) their investment and (b) borrowing money from creditors and repaying the amounts borrowed.

*(L.O. 2) Which of the following is not a current asset? A. Prepaid property taxes that relate to the next operating period. B. The cash surrender value of a life insurance policy carried by a corporation on its president. C. Marketable securities purchased as a temporary investment of cash. D. Installment notes receivable due over 15 months in accordance with normal trade practices.

(B) Generally, the rule is that if an asset is to be turned into cash, sold, or consumed either in one year or the operating cycle, whichever is longer, it is classified as current. The cash surrender value of a life insurance policy is not expected to be turned into cash, etc. within a year or the operating cycle. This item is normally shown in the long-term investments section of the balance sheet.

*(L.O. 2) Prepaid expenses are included in the current assets section of the balance sheet because A. they will be converted into cash within one year or the operating cycle, whichever is longer. B. if they had not been already paid they would require the use of cash during the next year or operating cycle. C. they were already included in operating expenses on the income statement in the year cash was expended. D. they reflect payments that were made in a prior period that will not be charged to expense in the current period.

(B) Prepaid expenses are expenditures already made for benefits to be received within one year or the operating cycle, whichever is longer. The cash has already been expended, but its inclusion on the income statement will not occur until the benefit has been received by the company.

*(L.O. 1) One criticism not normally aimed at a balance sheet prepared using current accounting and reporting standards is: A. failure to reflect current value information. B. the extensive use of separate classifications. C. an extensive use of estimates. D. failure to include items of financial value that cannot be recorded objectively.

(B) The balance sheet is criticized for its failure to reflect current value (A), the extensive use of estimates in its preparation (C), and its failure to include items of financial value that cannot be measured objectively (D). The balance sheet is rarely, if ever, criticized for its division of items into separate classifications

*(L.O. 1) The primary purpose of the balance sheet is to reflect A. the firm's potential for growth in stock values in the stock market. B. items of value, debts, and net worth. C. the value of items owned by the firm. D. the status of the firm's assets in case of forced liquidation of the firm.

(B) The primary purpose of the balance sheet is to reflect items of value, debts, and net worth. The three classes of items that appear on the balance sheet are assets (items of value measured by historical costs or net realizable values), liabilities (debts and obligations of the firm which represent creditor claims to the assets of the firm), and owners' equity (the net worth of the owners as represented by their claims to the firm's assets). The balance sheet reflects these items as of a particular date

*(L.O. 2) A characteristic of all assets and liabilities comprising working capital is that they are A. monetary. B. marketable. C. current. D. cash equivalents.

(C) A characteristic of all assets and liabilities comprising working capital is that they are current. The accounting profession defines working capital as the excess of current assets over current liabilities. Answers (A), (B), and (D) are incorrect because not all working capital assets and liabilities are monetary (e.g., inventory), marketable (e.g., federal income taxes payable), or cash equivalents (e.g., prepaid expenses).

*(L.O. 3) Which of the following would not be considered a basic source of information useful in preparing a statement of cash flows? A. Selected transaction data. B. Comparative balance sheets. C. An analysis of sales by territory. D. The current income statement.

(C) A statement of cash flows deals with gross inflows and outflows of cash. An analysis of sales by territory would generate no information about the cash flow from the sales.

*(L.O. 2) If a company converted a short-term note payable into a long-term note payable, this transaction would A. increase both working capital and net income. B. decrease only working capital. C. increase only working capital. D. decrease both working capital and owners' equity.

(C) Conversion of a short-term note payable (current liability) into a long-term note payable (noncurrent liability) would increase working capital. Working capital is the difference between current assets and current liabilities. Conversion of the shortterm note payable reduces current liabilities and does not affect current assets. Answers (A) and (D) are incorrect because there is no effect on net income or owners' equity.

*(L.O. 1) The balance sheet contributes to financial reporting by providing a basis for all of the following except A. computing rates of return. B. evaluating the capital structure of the enterprise. C. determining the increase in cash due to operations. D. assessing the liquidity and financial flexibility of the enterprise.

(C) The balance sheet provides a basis for computing rates of return based on asset growth. The balance sheet also includes information used in evaluating capital structure (equity section) and assessing the liquidity and financial flexibility (assets and liabilities) of the enterprise. However, to determine the increase in cash due to operations one should refer to the statement of cash flows.

*(L.O. 2) For accounting purposes the "operating cycle concept" A. has become obsolete. B. affects the income statement but not the balance sheet. C. permits some assets to be classified as current even though they are more than one year removed from becoming cash. D. causes the distinction between current and noncurrent items to depend on whether they will affect cash within one year.

(C) The operating cycle concept is used as a basis for classifying current items. The operating cycle of a firm is the length of time elapsed from the time cash is expended for such items as inventory to the time it converts the inventory back to cash. When the operating cycle is longer than 12 months, the longer period should be used. Therefore, the operating cycle concept does allow some assets to be classified as current even though their conversion into cash will not take place within one year.

*(L.O. 3) The statement of cash flows provides answers to all of the following questions except: A. Where did the cash come from during the period? B. What was the cash used for during the period? C. What is the impact of inflation on the cash balance at the end of the year? D. What was the change in the cash balance during the period?

(C) The statement of cash flows does not adjust the cash balance for the effects of inflation or deflation during the period. Such an amount can be determined by the use of certain indices, but this is not a function of the statement of cash flows.

* (L.O. 5) Lindsey Corp. is concerned with measuring its ability to meet interest payments as they come due. Lindsey Corp. would most likely use which following ratio? A. Payout ratio. B. Inventory turnover. C. Times interest earned. D. Price earnings ratio.

(C) The times interest earned ratio measures the ability of a company to meet its interest payments as they come due.

*L.O. 2) How are the following items handled in computing the total stockholders' equity section of the balance sheet? Treasury Stock Additional Paid-in Capital A. Added Added B. Added Subtracted C. Subtracted Added D. Subtracted Subtracted

(C) Treasury stock (the company's own stock reacquired and not canceled) is shown as a reduction of stockholders' equity, while additional paid-in capital is added to the stockholders' equity section of the balance sheet.

*L.O. 2) A liability to be paid next year would not be included in the current liability section of the balance sheet if the debt is expected to be refinanced through another long-term issue, or A. the operating cycle is less than one year. B. the liability will be paid with cash that the company earns during the next year. C. when the debt is retired out of noncurrent assets. D. the liability is a nonoperating debt instrument due within the next year.

(C) When the operating cycle is less than one year and/or the debt will be paid with cash (alternatives A & B) the item is properly classified as a current liability. Also, operating or nonoperating debt due within the next year can be a current liability. However, when the debt is retired out of noncurrent assets it should not be classified as current even if it meets the operating cycle/one year criteria.

*(L.O. 2) Which of the following items should never be included in the current section of the balance sheet? A. Receivable from a customer outstanding for more than a year. B. Deferred income taxes resulting from interperiod tax allocation. C. Three-year premium for fire insurance on plant and equipment. D. A pension fund.

(D) A pension fund is an investment made by a company for the retirement benefits of its employees. These funds will not be converted to cash for use in the business nor will they be used to liquidate current liabilities. The other three alternatives (A, B, and C) include items that, although somewhat unusual, could be classified as current

*L.O. 2) Of the following statements, which best illustrates the fact that the formal distinction made between current and noncurrent assets is somewhat arbitrary? A. Cash in a checking account is a current asset, while cash in a savings account is more permanent and is normally classified as noncurrent. B. Inventory that may be sold next year, or in the subsequent year as demand dictates may be classified as current or noncurrent. C. Accounts receivable due in less than one year or the operating cycle are classified as current assets, while accounts receivable due in longer than one year or the operating cycle are classified as noncurrent. D. An amount equal to the current depreciation charge on buildings should be placed in the current assets section at the beginning of the year, because it will be consumed in the next operating cycle.

(D) Cash is a current asset whether it is in a checking or savings account. Inventory is a current asset at the time the balance sheet is prepared even though it may not all be sold in the subsequent year, as it is held for sale in the normal course of business. The accounts receivable that are not collectible in the coming year should be classified as a noncurrent asset. However, while the theoretical treatment of next year's depreciation should be shown as a current asset, common practice is to ignore the formal distinction in this case.

*(L.O. 4) Which of the following balance sheet classifications would normally require the greatest amount of supplementary disclosure? A. Current assets. B. Current liabilities. C. Plant assets. D. Long-term liabilities.

(D) Long-term liabilities normally require the greatest amount of supplementary disclosure. This is because the terms of all long-term liability agreements, including maturity date or dates, rate of interest, nature of obligation, and any security pledged to support the debt, should be disclosed. The other classifications do require supplementary disclosure, but rarely is it as extensive as that required for long-term liabilities.

*L.O. 4) Which of the following reflects proper use of the term "reserve" in the preparation of financial statements? A. The term used to describe amounts deducted from assets, such as "reserve for depreciation." B. The initial term used in connection with an estimated liability, such as "estimated reserve for product warranty." C. The term used to describe the setting aside of funds for the subsequent payment of an existing liability, such as "reserve for bonds payable." D. The term used to describe an appropriation of retained earnings in the stockholders' equity section of the balance sheet.

(D) The profession has recommended that the word "reserve" be used only to describe an appropriation of retained earnings. The term had been used to describe a number of items in the financial statements which has resulted in a great deal of confusion.

*(L.O. 5) Amy Carlson Company had current assets of 12,000, current liabilities of 20,000, net sales of 40,000, cost of goods sold of 24,000, and net income of 8,000. What is Amy Carlson's profit margin on sales? A. 80%. B. 60%. C. 50%. D. 20%.

(D) The profit margin on sales is 20%. Profit margin on sales is calculated by dividing net income by net sales ($8,000 ÷ $40,000).

*How would the two items shown below be handled in arriving at cash provided by operations in the statement of cash flows? Increase in Increase in Accounts Receivable Accounts Payable A. Add to net income Add to net income B. Deduct from net income Deduct from net income C. Add to net income Deduct from net income D. Deduct from net income Add to net income

. (D) To arrive at cash provided by operation, the increase in accounts receivable must be deducted from net income, and the increase in accounts payable must be added back to net income