Financial Accounting Chapter 5

Payment of dividends would come under which activity on the statement of cash flows? (LO 5) (a)Financing. (b)Operating. (c)Investing. (d)None of the above.

(a)Financing.

Rate of return on assets is computed as: (LO 9) (a)Net income ÷ Average total assets. (b)Net sales ÷ Average total assets. (c)Dividends ÷ Average total assets. (d)Net cash provided by operating activities ÷ Average total assets.

(a)Net income ÷ Average total assets.

Elements of the Balance Sheet

1.ASSETS. Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. 2.LIABILITIES. Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. 3.EQUITY. Residual interest in the assets of an entity that remains after deducting its liabilities. In a business enterprise, the equity is the ownership interest.

Statement of Cash Flows

A basic financial statement that provides information about cash receipts, cash payments, and the net change in cash resulting from the operating, investing, and financing activities of a company during the period, in a format that reconciles the beginning and ending cash balances.

adjunct account

An account that increases either an asset, liability, or owners' equity account. An example is Premium on Bonds Payable, which, when added to the Bonds Payable account, describes the total bond liability of the company.

contra account

An account that reduces either an asset, liability, or owners' equity account. Examples include Accumulated Depreciation—Equipment and Discount on Bonds Payable. Use of contra accounts enables readers of financial statements to see the original cost of the asset, liability, or owners' equity account as well as the changes in the account to date.

Balance Sheet

Financial statement that shows the financial condition of a company at the end of a period by reporting its assets, liabilities, and stockholders' equity at a specific date sometimes referred to as the statement of financial position

Long-term investments

Investments that companies expect to hold for many years. Examples are (1) investments in securities, such as bonds or common stock; (2) investments in tangible fixed assets not currently used in operations, such as land held for speculation; (3) investments set aside in special funds, such as a pension fund; and (4) investments in nonconsolidated subsidiaries. Companies usually present long-term investments on the balance sheet just below current assets. a company does not include them as current assets unless it intends to convert them to cash in the short-term

Free Cash Flow

Measure of the cash remaining from operating activities after adjusting for capital expenditures and cash dividends paid. Some analysts prefer free cash flow to the measure of net cash provided by operating activities because free cash flow takes into account the outflows needed to maintain current operations. Calculated by: Net cash provided by operating activities - capital expenditures - cash dividends

Limitations of the Balance Sheet

Most assets and liabilities are reported at historical cost. Use of judgments and estimates. Many items of financial value are omitted.

working capital

The excess of total current assets over total current liabilities; represents the net amount of a company's relatively liquid resources. Also called net working capital.

Addison, Inc. reports: (LO 4) Cash provided by operating activities $2,300,000 Cash used by investing activities 640,000 Cash used by financing activities 220,000 Beginning cash balance 340,000 What is Addison's ending cash balance? (a)$1,440,000. (b)$1,780,000. (c)$3,060,000. (d)$3,500,000.

b)$1,780,000. $340,000 plus $2,300,000 less $640,000 less $220,000 equals $1,780,000, the ending balance of cash.

Content and Format of the Statement of Cash Flows

Companies classify cash receipts and cash payments during a period into three different activities in the statement of cash flows—operating, investing, and financing activities, defined as follows. 1.Operating activities involve the cash effects of transactions that enter into the determination of net income. 2.Investing activities include making and collecting loans and acquiring and disposing of investments (both debt and equity) and property, plant, and equipment. 3.Financing activities involve liability and owners' equity items. They include (a) obtaining resources from owners and providing them with a return on their investment, and (b) borrowing money from creditors and repaying the amounts borrowed. The statement's value is that it helps users evaluate liquidity, solvency, and financial flexibility

Preparation of the Statement of Cash Flows

Companies obtain the information to prepare the statement of cash flows from several sources: (1) comparative balance sheets, (2) the current income statement, and (3) selected transaction data. Preparing the statement of cash flows from these sources involves four steps: 1.Determine the net cash provided by (or used in) operating activities. 2.Determine the net cash provided by (or used in) investing and financing activities. 3.Determine the change (increase or decrease) in cash during the period. 4.Reconcile the change in cash with the beginning and the ending cash balances. Net cash provided by operating activities is the excess of cash receipts over cash payments from operating activities. Companies determine this amount by converting net income on an accrual basis to a cash basis. To do so, they adjust net income for items that do not affect cash. This procedure requires that a company analyze not only the current year's income statement but also the comparative balance sheets and selected transaction data.

Current cash debt coverage

Measure of liquidity that indicates a company's ability to pay its short-term debts. Computed as net cash provided by operating activities divided by average current liabilities.

Cash Debt Coverage

Measure of solvency that indicates a company's ability to repay its liabilities from cash generated from operations (without having to liquidate productive assets). Computed as the ratio of net cash provided by operating activities to total debt, as represented by average total liabilities.

The current cash debt coverage ratio is computed by dividing net cash provided by operating activities by average (LO 6) (a)current liabilities. (b)total assets. (c)total liabilities. (d)total long-term liabilities.

(a)current liabilities.

The correct order to present current assets is (LO 2) (a)Cash, accounts receivable, prepaid items, inventories. (b)Cash, accounts receivable, inventories, prepaid items. (c)Cash, inventories, accounts receivable, prepaid items. (d)Cash, inventories, prepaid items, accounts receivable.

(b)Cash, accounts receivable, inventories, prepaid items.

Other assets include all of the following except: (LO 2) (a)Restricted cash. (b)Timberlands. (c)Property held for sale. (d)Assets in special funds.

(b)Timberlands. Other assets include restricted cash, property held for sale, and assets in special funds. Timberlands are reported as part of property, plant, and equipment.

Similarities between IFRS and U.S. GAAP requirements for balance sheet presentation include all of the following except: (LO 11) (a)both require disclosure of significant accounting policies. (b)both require that changes to the valuation reserve be disclosed in the notes to the financial statements. (c)both generally require the use of the current/non-current classification for both assets and liabilities. (d)both require the preparation of financial statements annually.

(b)both require that changes to the valuation reserve be disclosed in the notes to the financial statements. Under GAAP, there are no revaluations and thus, no valuation reserve in equity.

Activities that involve the cash effects of making and collecting loans and acquiring and disposing of property, plant, and equipment are classified as: (LO 5) (a)operating activities. (b)investing activities. (c)financing activities. (d)noncash activities.

(b)investing activities.

The balance sheet is useful for analyzing all of the following except (LO 1) (a)liquidity. (b)solvency. (c)profitability. (d)financial flexibility.

(c) profitability.

Peterson Enterprises reports the following information: (LO 5) Net income $5,000,000 Depreciation expense 680,000 Loss on the sale of investments 154,000 Increase in accounts receivable 320,000 Peterson should report cash provided by operating activities of (a)$3,846,000. (b)$5,000,000. (c)$5,514,000. (d)$6,154,000.

(c)$5,514,000. $5,000,000 plus $680,000 plus $154,000 less $320,000 equals $5,514,000, the cash provided by operating activities. Increase in assets = negative # Increase in liabilities = Positive #

Ostriker Company uses IFRS and has property and equipment on an historical cost basis of $3,600,000. At the end of the year, Ostriker appraises its property and equipment and determines it had a revaluation increase of $67,000. Ostriker records this revaluation under IFRS with (LO 11) (a)An increase to property and equipment and an increase on the income statement. (b)A decrease to property and equipment and a decrease on the income statement. (c)An increase to property and equipment and an increase to a valuation reserve in equity. (d)An increase to property and equipment and a decrease to accumulated depreciation.

(c)An increase to property and equipment and an increase to a valuation reserve in equity.

Which of the following statements shows the amount of cash used to pay dividends or purchase treasury stock? (LO 4) (a)statement of financial position. (b)income statement. (c)statement of stockholders' equity. (d)All of these answer choices are correct.

(c)statement of stockholders' equity.

Companies are not required to disclose information about: (LO 8) (a)inventory cost flow methods. (b)depreciation methods. (c)the identity of all stockholders. (d)the use of estimates.

(c)the identity of all stockholders.

Which of the following ratios measures how effectively the company uses its assets? (LO 9) (a)Profitability ratios. (b)Coverage ratios. (c)Liquidity ratios. (d)Activity ratios.

(d)Activity ratios.

Which of the following is an intangible asset? (LO 2) (a)Prepaid pension costs. (b)Restricted cash. (c)Deferred income taxes. (d)Customer lists.

(d)Customer lists. Intangible assets include patents, copyrights, franchises, goodwill, trademarks, trade names, and customer lists.

Typical loss contingencies include all of the following except: (LO 8) (a)Possible tax assessments. (b)Government investigations. (c)Environmental issues. (d)Tax operating-loss carryforwards.

(d)Tax operating-loss carryforwards.

Which of the following is a coverage ratio? (LO 9) (a)Asset turnover. (b)Profit margin on sales. (c)Payout ratio. (d)Times interest earned.

(d)Times interest earned. Coverage ratios include debt to total assets, times interest earned, cash debt coverage ratio, book value per share, and free cash flow.

A company with a ________ is better able to survive bad times, to recover from unexpected setbacks, and to take advantage of profitable and unexpected investment opportunities (LO 1) (a)low degree of financial flexibility. (b)a high degree of liquidity. (c)a low degree of solvency. (d)a high degree of financial flexibility.

(d)a high degree of financial flexibility.

Supplemental Disclosures

1.CONTINGENCIES. Material events that have an uncertain outcome. 2.ACCOUNTING POLICIES. Explanations of the valuation methods used or the basic assumptions made concerning inventory valuations, depreciation methods, investments in subsidiaries, etc. 3.CONTRACTUAL SITUATIONS. Explanations of certain restrictions or covenants attached to specific assets or, more likely, to liabilities. 4.FAIR VALUES. Disclosures of fair values, particularly for financial instruments.

Liquidity

An indicator of the speed to which an asset will be realized or otherwise converted into cash or until a liability has to be paid. In general, the greater a company's liquidity, the lower its risk of failure.

Property, Plant, and Equipment

Assets of a durable nature used in the regular operations of the business. These assets consist of physical property (such as land, buildings, machinery) and wasting resources (timberland, minerals). With the exception of land, a company either depreciates (e.g., buildings) or depletes (e.g., oil reserves) these assets.

intangible assets

Assets that lack physical substance and that are not financial instruments. Intangible assets derive their value from the rights and privileges granted to the company using them. They are normally classified as long-term assets. Companies write off (amortize) limited-life intangible assets over their useful lives, and they periodically assess indefinite-life intangibles (including goodwill) for impairment. Ex: patents, copyrights, franchises, goodwill, trademarks, trade names, and customer lists

Usefulness of the Balance Sheet

By reporting information on assets, liabilities, and stockholders' equity, the balance sheet provides a basis for computing rates of return and evaluating the capital structure of the enterprise. Analysts also use information in the balance sheet to assess a company's risk and future cash flows. In this regard, analysts use the balance sheet to assess a company's liquidity, solvency, and financial flexibility.

Significant Noncash Activities

Not all of a company's significant activities involve cash. Examples of significant noncash activities are: 1.Issuance of common stock to purchase assets. 2.Conversion of bonds into common stock. 3.Issuance of debt to purchase assets. 4.Exchanges of long-lived assets.

Current Liabilities

The obligations that a company reasonably expects to liquidate either through the use of current assets or the creation of other current liabilities. This concept includes payables resulting from the acquisition of goods and services, (2) collections received in advance for the delivery of goods or performance of services, and (3) other liabilities whose liquidation will take place within the operating cycle. Ex: notes payable accounts payable accrued interest on notes payable income tax payable accrued salaries and wages customer's deposits

Which of the following pairings of an item and a basis of valuation is incorrect? (LO 2) (a)Prepaid expenses — Cost. (b)Cash — Fair value. (c)Short-term investments — Fair value. (d)Receivables — Lower-of-cost-or-market.

d)Receivables — Lower-of-cost-or-market. Receivables are valued at estimated amount collectible and inventories are valued at lower-of-cost-or-market. The other pairings are all correct.

current assets

are cash and other assets a company expects to convert into cash, sell, or consume either in one year or in the operating cycle, whichever is longer. Current assets are presented in the balance sheet in order of liquidity. Generally, if a company expects to convert an asset into cash or to use it to pay a current liability within a year or the operating cycle, whichever is longer, it classifies the asset as current. Examples: cash trading securities accts receivable notes receivable inventories at avg cost supplies on hand prepaid expenses

cash equivalents

are short-term highly liquid investments that will mature within three months or less Short-term, highly liquid investments that can be readily converted to a specific amount of cash and which are relatively insensitive to interest rate changes.

Trent Co. reports the following information: (LO 6) Net cash provided by operating activities $430,000 Average current liabilities 300,000 Average long-term liabilities 200,000 Dividends paid 120,000 Capital expenditures 220,000 Purchase of treasury stock 22,000 Payments of debt 70,000 Trent's free cash flow is (a)$20,000. (b)$90,000. (c)$210,000. (d)$310,000.

b)$90,000. Net cash provided by operating activities, $430,000, less capital expenditures, $220,000, less dividends paid, $120,000 equals a free cash flow of $90,000.

Long-Term Liabilities

Obligations that a company expects to pay at some date beyond the normal operating cycle. Examples are bonds payable, notes payable, deferred income tax amounts, lease obligations, and pension obligations. Also referred to as long-term debt. Companies provide a great deal of supplementary disclosure for long-term liabilities because they often are subject to covenants and restrictions for the protection of lenders. Companies classify long-term liabilities that mature within the current operating cycle as current liabilities if payment of the obligation requires the use of current assets. Generally, long-term liabilities are of three types: 1.Obligations arising from specific financing situations, such as the issuance of bonds, long-term lease obligations, and long-term notes payable. 2.Obligations arising from the ordinary operations of the company, such as pension obligations and deferred income tax liabilities. 3.Obligations that depend on the occurrence or non-occurrence of one or more future events to confirm the amount payable, the payee, or the date payable, such as service or product warranties and other contingencies.

Account Form

Presentation in a classified balance sheet that lists assets by sections on the left side and liabilities and stockholders' equity by sections on the right side.

Report Form

Presentation in a classified balance sheet that lists liabilities and stockholders' equity directly below assets on the same page.

Solvency

The ability of a company to pay its debts as they mature. A company with a high level of long-term debt relative to assets has lower solvency than a similar company with a low level of long-term debt.

financial flexibility

The ability of a company to take effective actions to alter the amounts and timing of cash flows so it can respond to unexpected needs and opportunities. A company's liquidity and solvency affect its financial flexibility.

Owners' Equity

The ownership claim on a company's total assets. The owners' equity section of the corporate balance sheet consists of capital stock, additional paid-in capital, and retained earnings. The ownership accounts (stockholders' equity) in a corporation differ considerably from ownership accounts in a partnership or proprietorship. Partners show separately their permanent capital accounts and the balance in their temporary accounts (drawing accounts). Proprietors ordinarily use a single capital account that handles all of the owner's equity transactions. One of the most difficult sections to prepare and understand. This is due to the complexity of capital stock agreements and the various restrictions on stockholders' equity imposed by state corporation laws, liability agreements, and boards of directors. Companies usually divide the section into six parts: 1.CAPITAL STOCK. The par or stated value of the shares issued. 2.ADDITIONAL PAID-IN CAPITAL. The excess of amounts paid in over the par or stated value. 3.RETAINED EARNINGS. The corporation's undistributed earnings. 4.ACCUMULATED OTHER COMPREHENSIVE INCOME. The aggregate amount of the other comprehensive income items. 5.TREASURY STOCK. Generally, the cost of shares repurchased. 6.NONCONTROLLING INTEREST (MINORITY INTEREST). A portion of the equity of subsidiaries not wholly owned by the reporting company.

Purpose of the Statement of Cash Flows

The primary 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. To achieve this purpose, the statement of cash flows reports the following: (1) the cash effects of operations during a period, (2) investing transactions, (3) financing transactions, and (4) the net increase or decrease in cash during the period. The statement of cash flows provides answers to the following simple but important questions: 1.Where did the cash come from during the period? 2.What was the cash used for during the period? 3.What was the change in the cash balance during the period? The statement of cash flows meets the objective of financial reporting—to help assess the amounts, timing, and uncertainty of future cash flows.