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Chapter 2
The Financial Statements
Multiple Choice Questions
1. Current assets are:
a. all assets except inventory.
b. all assets that provide benefits extending beyond one year.
c. cash, accounts receivable, and buildings.
d. all assets that are expected to be converted to cash in the near future.
Answer: D
2. Intangible assets are:
a. goodwill, patents, copyrights, and trademarks.
b. property, plant, and equipment.
c. all assets except current assets.
d. those assets that an owner can purchase with cash only.
Answer: A
3. Long-term investments can include all of the following except:
a. notes receivable maturing in nine months.
b. equity securities of another company to be held for more than a year.
c. ten-year debt securities of another company.
d. land to be held beyond one year.
Answer: A
4. Which one of the following is an asset?
a. A patent of a company’s secret formula for reverse osmosis.
b. Retained earnings.

c. Notes payable.
d. Accounts payable.
Answer: A
5. Which one of the following groups of accounts contains only assets?
a. Equipment, patents, accounts receivable.
b. Accounts receivable, building, retained earnings.
c. Accounts payable, notes payable, contributed capital.
d. Retained earnings, goodwill, and accounts payable.
Answer: A
6. Which one of the following groups of accounts contains only assets?
a. Contributed capital, retained earnings, revenues.
b. Cash, contributed capital, retained earnings.
c. Prepaid expenses, land, accounts receivable.
d. Building, equipment, depreciation expense.
Answer: C
7. Which one of the following is a liability?
a. Interest receivable.
b. Contributed capital.
c. Retained earnings.
d. Wages payable.
Answer: D
8. Which one of the following groups of accounts contains only current assets?
a. Inventory, accounts receivable, equipment.
b. Cash, equipment, copyrights.

c. Cash, accounts receivable, merchandise inventory.
d. Patents, copyrights, and trademarks.
Answer: C
9. Which one of the following creates a decrease in retained earnings?
a. Prepaid assets.
b. Equipment.
c. Dividends.
d. Merchandise inventory not sold.
Answer: C
10. At the end of 2009, Campbell Company has total assets and liabilities at $45,000 and
$13,000, respectively. Campbell reported net income for 2010 in the amount of $10,000. How
much is shareholders’ equity at the end of 2010?
a. $20,000
b. $22,000
c. $31,000
d. $42,000
Answer: D
$45,000 - $13,000 + $10,000 = $42,000
11. Which account is associated with the sale of inventory?
a. Cost of goods sold.
b. Depreciation.
c. Inventory expense.
d. Equipment.
Answer: A
12. Which account is associated with borrowing money?

a. Interest expense.
b. Goodwill.
c. Cost of goods sold.
d. Depreciation.
Answer: A
13. Which expense is associated with long-term assets?
a. Dividends.
b. Depreciation.
c. Cost of goods sold.
d. Interest.
Answer: B
14. Which expense is associated with the use of patents?
a. Interest.
b. Amortization.
c. Cost of goods sold.
d. Depreciation.
Answer: B
15. The major accounting difference between interest expenses for creditors and dividends
declared and paid to shareholders is that interest expenses:
a. decrease retained earnings and dividends increase retained earnings.
b. impact cash flows, while dividends do not.
c. are not on the income statement while dividends declared and paid are.
d. are on the income statement and dividends declared and paid are not.
Answer: D

16. Desert Company has retained earnings of $12,000, total assets totaling $39,000, and total
liabilities of $20,000. How much is total shareholders’ equity?
a. $6,000
b. $17,000
c. $19,000
d. $27,000
Answer: C
$39,000 - $20,000 = $19,000
17. Valley Company has cash, current liabilities, and long-term liabilities of $110,000,
$20,000, and $31,000, respectively. Valley has no current assets other than cash. How much
cash can Valley use to acquire equipment so that amount of current assets is double the
amount of current liabilities?
a. $10,000
b. $70,000
c. $91,000
d. $60,000
Answer: B
$110,000 - [2 x $20,000] = $70,000
18. Favre Company has current assets, shareholders’ equity, current liabilities, and long-term
liabilities of $8,000, $26,000, $4,000, and $8,000, respectively. How much are long-term
assets?
a. $12,000
b. $30,000
c. $32,000
d. $46,000
Answer: B

[$26,000 + $8,000 + $4,000] - $8,000 = $30,000
19. Which one of the following equations represents retained earnings activity for a year?
a. Beginning balance + expenses – dividends = ending balance.
b. Beginning balance + cash receipts – cash payments = ending balance.
c. Beginning balance + dividends – net income = ending balance.
d. Beginning balance + net income – dividends = ending balance.
Answer: D
20. Which one of the following appears on the income statement?
a. Inventory.
b. Retained earnings.
c. Dividends.
d. Interest revenue.
Answer: D
21. Which one of the following groups of accounts contains only liabilities?
a. Accounts payable, retained earnings, notes payable.
b. Supplies expense, cost of goods sold, interest expense.
c. Wages payable, mortgage payable, taxes payable.
d. Contributed capital, accounts payable, retained earnings.
Answer: C
22. When an entrepreneur wishes to start a business, capital must be attracted in the form of:
a. net income.
b. cost of goods sold.
c. operating activities.
d. equity or debt financing.

Answer: D
23. If the beginning and ending balances in retained earnings are $13,000 and $10,000,
respectively, and dividends during the year are $10,000, then net income for the year is:
a. $14,000.
b. $7,000.
c. $18,000.
d. $32,000.
Answer: B

24. Kelly Company has total assets, liabilities, and shareholders’ equity of $30,000, $17,000,
and $13,000, respectively at the beginning of 2010. If Kelly reports revenues of $130,000,
expenses of $85,000, and pays dividends of $30,000, how much is shareholders’ equity at the
end of 2010?
a. $28,000
b. $53,000
c. $44,000
d. Not enough information to determine.
Answer: A
$13,000 + [$130,000 - $85,000] - $30,000 = $28,000
25. Sanchez Corporation has total assets, current liabilities, and long-term liabilities of
$38,000, $2,000, and $13,000, respectively. If Sanchez purchases equipment for $4,000 for
cash, how much would shareholders’ equity be?
a. $23,000
b. $10,000
c. $24,000

d. $11,000
Answer: A
$38,000 - $2,000 - $13,000 + $4,000 - $4,000 = $23,000
26. The acquisition of equity and debt financing is considered:
a. a financing activity.
b. net income.
c. an investing activity.
d. an operating activity.
Answer: A
27. Which one of the following is considered an operating activity?
a. Payment to a vendor for supplies.
b. Purchase of company trucks for cash.
c. Payment of dividends to shareholders.
d. Issuing stock to investors.
Answer: A
28. Smith Corp. earned $200,000 profit during 2010. On which financial statement(s) will the
exact dollar amount of the profit be clearly stated?
a. Statement of shareholders’ equity and income statement.
b. Income statement only.
c. Balance sheet and income statement.
d. Statement of shareholders’ equity, income statement, and the balance sheet.
Answer: A
29. On which financial statements will you find a company’s financial position at a specific
point in time?
a. All financial statements combined.

b. Income statement and balance sheet.
c. Balance sheet and statement of shareholders’ equity.
d. Balance sheet only.
Answer: D
30. Why are liabilities separated into current and long-term?
a. Users want to know which amounts will be paid using current assets.
b. Because current and long-term classifications are just common sense.
c. This format helps a company determine how much profit was made.
d. The SEC requires companies to do so.
Answer: A
31. Which one of the following statements is true?
a. A company’s own stock is its most liquid asset.
b. Profits are normally kept in a company’s retained earnings until distributed as dividends.
c. Long-term investments will be used to pay current liabilities.
d. Current assets have no physical substance.
Answer: B
32. Cash reported on a company’s balance sheet represents
a. the profit a company made during the current year.
b. the amount the President of the Company has in his or her personal account.
c. the amount collected from customers during the current year less the amount paid for
expenses.
d. the currency a company has access to at the balance sheet date.
Answer: D
33. The amount a company expects to collect from its customers is:
a. accounts receivable.

b. short-term equity securities.
c. inventory.
d. accounts payable.
Answer: A
34. As used in accounting, “notes” may be reported:
a. only as company debt offerings.
b. only as assets on the balance sheet.
c. as either assets or liabilities.
d. on the income statement or the balance sheet.
Answer: C
35. Property, plant and equipment may include which of the following?
a. Intangible assets and land.
b. Inventory and equipment.
c. Buildings and cash.
d. Land and office buildings.
Answer: D
36. On the balance sheet, a company should report the cost of intangible assets:
a. in the current assets section.
b. as an amount owed to shareholders.
c. as an amount that is estimated by the CFO.
d. at acquired cost less any accumulated amortization.
Answer: D
37. A partnership and a corporation differ in that:
a. a partnership is a legal entity, while a corporation is not.

b. the equity sections of partnership and corporation balance sheets report different items.
c. partnerships always have more cash than corporations.
d. a corporation has an income statement and a partnership does not.
Answer: B
38. Below are several accounts from Norel Company’s accounting records.

The amount of retained earnings at the end of the year is:
a. $34,000.
b. $40,000.
c. $52,000.
d. $64,000.
Answer: C

39. The most common revenue account is:
a. cash.
b. sales.
c. shareholders’ equity.
d. liabilities.
Answer: B
40. Your bank loaned ten million dollars to Hamilton Stores to finance the construction of a
manufacturing plant. In which section of Hamilton’s statement of cash flows would you be
able to determine whether the company used the cash to build the new plant?

a. Operating activities
b. Owner activities
c. Financing activities
d. Investing activities
Answer: D
41. Most investors believe that the statement of cash flows is
a. a useful source of information regarding the cash flow of an entity.
b. the only statement in an annual report whose results correlates to stock price value.
c. too complicated.
d. a useful measure of a company’s profit.
Answer: A
42. The amount reported on a company’s balance sheet as retained earnings is the same as the
amount reported on the company’s:
a. income statement as net income.
b. statement of shareholders’ equity as beginning retained earnings.
c. statement of cash flows as cash received from operating activities.
d. statement of shareholders’ equity as ending retained earnings.
Answer: D
43. Which one of the following is not an asset?
a. A company’s equity in the common stock of another company.
b. A company’s trademarked name for a process.
c. Retained earnings.
d. Notes receivable.
Answer: C
44. Given below are several accounts from Caterpillar Company’s accounting records.

Net income for the year was $37,000. How much is total shareholders’ equity at the end of
the year?
a. $86,000.
b. $82,000.
c. $87,000.
d. $79,000.
Answer: D
$22,000 + $25,000 – $5,000 + $37,000 = $79,000
45. Seuss Company determined its total sales were $535,000, salaries expense was $210,000,
dividends paid were $15,000, rent expense was $25,000, other operating expenses were
$13,000, and customers still owed $4,000 at the end of the year. How much is net income for
the year?
a. $267,000.
b. $287,000.
c. $263,000.
d. $530,000.
Answer: B
$535,000 – $210,000 – $25,000 – $13,000 = $287,000
46. The information below was taken from the 2010 annual report of Jena Corporation.

Which of the following is the missing amount for the net cash flow from investing activities
for 2008?
a. $4,053
b. $9,947
c. $19,827
d. $2,447
Answer: A
47. The information below was taken from the 2010 annual report of Jena Corp.

Which of the following is the missing amount for the beginning cash balance for 2009?
a. $5,925
b. $8,741
c. $12,478
d. $5,282
Answer: C
48. The information below was taken from the 2010 annual report of Jena Corp.

Which of the following is the missing amount for the net cash flow from operating activities
for 2009?

a. $8,110
b. $4,400
c. $8,475
d. $3,874
Answer: B
49. The information below was taken from the 2010 annual report of Jena Corp.

Which of the following is the missing amount for the ending cash balance for 2009?
a. $2,759
b. $7,158
c. $12,703
d. $11,596
Answer: D
50. The information below was taken from the 2010 annual report of Jena Corp.

Which of the following is the missing amount for the net cash flow from financing activities
for 2010?
a. ($21,994)
b. ($9,050)

c. ($1,120)
d. ($14,085)
Answer: B
51. Garrison Corporation has the following transactions:
1. Dividends are paid to the shareholders.
2. A utility bill for July is paid in August.
3. A new warehouse facility is purchased
4. Principal payments on outstanding debt are paid.
5. Employees wages are paid.
6. Forty-five units of inventory are sold for $100 each
7. Common stock is issued for $230,000 in cash.
8. A delivery van used for 5-years is sold for $12,000, which is its book value.
Which of the above transaction(s) are examples of financing activities?
a. 1,4,7
b. 1,7,8
c. 3,8
d. 1,3,4,7,8
Answer: A
52. Garrison Corporation has the following transactions:
1. Dividends are paid to the shareholders.
2. A utility bill for July is paid in August.
3. A new warehouse facility is purchased
4. Principal payments on outstanding debt are paid.
5. Employees wages are paid.

6. Forty-five units of inventory are sold for $100 each
7. Common stock is issued for $230,000 in cash.
8. A delivery van used for 5-years is sold for $12,000, which is its book value.
Which of the above transaction(s) are examples of investing activities?
a. 3,4,7,8
b. 1,4,7
c. 4,7
d. 3,8
Answer: D
53. Garrison Corporation has the following transactions:
1. Dividends are paid to the shareholders.
2. A utility bill for July is paid in August.
3. A new warehouse facility is purchased
4. Principal payments on outstanding debt are paid.
5. Employees wages are paid.
6. Forty-five units of inventory are sold for $100 each
7. Common stock is issued for $230,000 in cash.
8. A delivery van used for 5-years is sold for $12,000, which is its book value.
Which of the above transaction(s) are examples of operating activities?
a. 2,3,5
b. 5,6,8
c. 2,3,5,6,8
d. 2,5,6
Answer: D

54. Baron Company has six major headings in its income statement, which include Sales,
Fees earned, Other Revenues, Cost of Goods Sold, Operating Expenses, and Other Expenses.
Below are some of the income statement accounts for Baron:
1. 1. Sales of inventories
2. Depreciation expense
3. Income from interest on savings account
4. Income from dividends on investments
5. Advertising expense.
6. Loss on sale of building
7. Salespeople commission expense
8. Office salary expense
9. Gain on sale of short-term investments
10. Sales of services provided
11. Cost of sold inventories
12. Interest expense on outstanding loans
Which of these would be found under the heading “Other Revenues”?
a. 1,10
b. 1,3,4
c. 3,4,10
d. 3,4,9
Answer: D
55. Baron Company has six major headings in its income statement, which include Sales,
Fees earned, Other Revenues, Cost of Goods Sold, Operating Expenses, and Other Expenses.
Below are some of the income statement accounts for Baron:
1. Sales of inventories

2. Depreciation expense
3. Income from interest on savings account
4. Income from interest on investments
5. Advertising expense.
6. Loss on sale of building
7. Salespeople commission expense
8. Insurance expense
9. Gain on sale of short-term investments
10. Sales of services provided
11. Cost of sold inventories
12. Interest expense on outstanding loans
Which of these would be found under the heading “Operating Expenses”?
a. 2,8,12
b. 2,7,8,12
c. 2,5,7,8,11
d. 2,5,11
Answer: C
56. Hsu Company has eight major section headings in its balance sheet, which include
Current Assets, Long-term investments, Property, Plant, and Equipment, Intangible Assets,
Current Liabilities, Long-Term Liabilities, and Shareholders’ Equity. Below are some of the
balance sheet accounts for Hsu:
1. 1. Dividends Payable
2. Prepaid Rent
3. Trademarks
4. Bonds Payable

5. Investment Funds for Plant Expansion
6. Inventories
7. Wages Payable
8. Deferred Revenues
9. Accumulated Depreciation - Building
10. Accounts Receivable
11. Accounts Payable
Which of these would be found under the heading “Current Assets”?
a. 2,10
b. 2,6,8,10
c. 2,6,10
d. 2,5,10
Answer: C
57. Hsu Company has eight major section headings in its balance sheet, which include
Current Assets, Long-term investments, Property, Plant, and Equipment, Intangible Assets,
Current Liabilities, Long-Term Liabilities, and Shareholders’ Equity. Below are some of the
balance sheet accounts for Hsu:
1. Dividends Payable
2. Prepaid Rent
3. Trademarks
4. Bonds Payable
5. Investment Funds for Plant Expansion
6. Inventories
7. Wages Payable
8. Deferred Revenues

9. Accumulated Depreciation - Building
10. Accounts Receivable
11. Accounts Payable
Which of these would be found under the heading “Property, Plant, and Equipment”?
a. 5,9
b. 5,6,9
c. 3,5,6,9
d. 9
Answer: D
Matching Questions
1. For items 1 through 3, select the appropriate section of the balance sheet in which the item
would be reported.

Answer: 1. C
2. E
3. B
2. For each item numbered 1 through 6 below, identify which accounting element(s) listed in
A through H each statement describes. You may use each letter more than once or not at all.

Answer:
1. D
2. E
3. B
4. A
5. G
6. C
3. For each financial statement item listed in 1 through 5 below, identify the best description
by selecting from items a through f below. You may use each letter more than once or not at
all. Write the letter ‘X’ for each item for which no description is listed.

Answer:
1. b
2. f
3. a, e
4. d
5. c
4. For each statement listed in 1 through 5 below, state whether it is correct or not by writing
‘Yes’ or ‘No’ in the space provided.

Answer:

1. No
2. Yes
3. Yes
4. Yes
5. No
5. For each financial statement item listed in 1 through 5 below, identify in which balance
sheet category (listed in a through h) it should be reported. You may use each letter more than
once or not at all.
Financial Statement Categories
a. Current assets
b. Long-term investments
c. Property, plant, and equipment
d. Intangible assets
e. Current liabilities
f. Long-term liabilities
g. Shareholders’ equity
h. Not disclosed on the balance sheet
1. Contributed capital
2. Prepaid insurance
3. Accounts payable
4. Sales revenue
5. Delivery truck
Answer:
1. g
2. a

3. e
4. h
5. c
6. For each statement listed in 1 through 5 below, state whether it is correct or not by writing
‘Yes’ or ‘No’ in the space provided.

Answer:
1. No
2. No
3. Yes
4. No
5. Yes
7. For each financial statement item listed in 1 through 7 below, identify in which balance
sheet category (listed in a through h) it should be reported. You may use each letter more than
once or not at all.

Answer:
1. c
2. a
3. d
4. b
5. g
6. a
7. a
Short Problems
1. Given below are several accounts from Kramer Company’s accounting records.

Net income for the year was $20,000. How much is total shareholders’ equity at the end of
the year?
Answer:
$14,000 + 17,000 – $2,000 + $20,000 = $49,000
2. Below are several amounts from Netcom Company’s accounting records. Answer the
questions that follow.

A. Calculate the amount of retained earnings at the end of the year.
B. If revenue amounts to $220,000, how much is ‘total expenses’?
C. How do you know the company has been profitable since it began operations?
Answer:
A. $65,000 + $32,000 –$15,000 = $82,000

C. Retained earnings, which represents the total profits since the company began operations,
less all amounts distributed as dividends, has a positive balance.
3. Following are several items from Arbor Company’s financial statements. Use this
information to calculate the amounts for the questions that follow.

A. Calculate the dollar amount of net income.
B. How much is inventory expense?

C. Was the company profitable during the current year? How do you know?
Answer:
a. $8,400 – $2,300 – $500 – $600 = $5,000
b. $2,300
c. Yes. The amount of expenses is less than the amount of revenue.
4. At the beginning of 2010, Kristol Company sold stock and began operations. Information
from Kristol’s accounting records for the year ending December 31, 2010, follows:

A. Circle the names of any accounts above that would not be reported on the income
statement.
B. Determine the amount of net income.
Answer: a. Circled accounts should be: Dividends and Contributed Capital
b. $500,000 – $240,000 – $180,000 – $50,000 = $30,000
5. The following are account balances of Phineas Company on 12/31/10.

Prepare a classified balance sheet for Phineas Company on December 31, 2010.
Answer:

6. The following is the balance sheet of Able Corporation immediately prior to deciding how
to finance the purchase of a $300 addition to its building.

The bonds payable contract agreement requires current assets to be twice as much as current
liabilities. Assume the $300 addition to the building is to be paid in cash and financed by

issuing more stock. Calculate and explain the maximum cash that Able can pay and still
honor its debt agreement.
Answer: Able’s current liabilities are $190. Under the bond agreement, its current assets must
be at least $380. If Almond used $180 of cash to purchase the building addition, then it would
have the $380 of current assets required by the debt covenant ($190 × 2). Therefore, Able can
pay $180 and issue stock for $120 in order to finance the building project.
Use the information that follows concerning Ulrich Computer for the year ending December
31, 2010 for problems 7 through 10.
Several accounts and amounts from the financial statements of Ulrich Computer appear
below for the year ending December 31, 2010.

7. What is the total amount owed to Ulrich by its customers at the end of 2010?
Answer: $32,000
8. Calculate total expenses for Ulrich.
Answer: $60,000 + $7,000 + $4,000 + $20,000 = $91,000
9. Calculate Ulrich’s total current assets.
Answer: $10,000 + $32,000 + $90,000 + $21,000 = $153,000
10. How much must Ulrich pay out during its next accounting period for amounts owed?
Answer: $7,000 + $31,000 = $38,000

11. Below is all of the account information from Chamber Company’s balance sheet, with the
exception of Retained Earnings.

Using this information, please calculate the following:
A. The total amount of retained earnings for Chamber Company.
B. The total amount of shareholders’ equity for the company at the end in the year.
Answer:
A. ($12,000 + $15,000 + $50,000) – $17,000 – $10,000 – $30,000 = $20,000
B. $30,000 + $20,000 = $50,000
12. The following information is shown on Morris Company’s balance sheet. Answer the
questions that follow.

A. How much did debt investors provide to Morris Company?
B. What is the amount of money provided by equity investors to Morris Company?
C. How much would be classified as property, plant, and equipment?
Answer:
A. $30,000
B. $20,000
C. $50,000
13. Autry Company determined its total sales were $380,000, salaries expense was $120,000,
dividends paid were $8,000, rent expense was $14,000, other operating expenses were

$20,000, and customers still owed $2,000 at the end of the year. How much is net income for
the year?
Answer: $380,000 – $120,000 – $14,000 – $20,000 = $226,000
14. If cash flows from operating activities were $3,000, cash outflows for financing activities
were $2,500, and the net increase in cash was $5,000, how much are cash flows from
investing activities?
Answer: $5,000 - $2,500 - $3,000 = $4,500
15. The following is the balance sheet of Columbus Corporation immediately prior to
deciding how to finance the purchase of an additional $200,000 parcel of land. Answer the
question that follows.

REQUIRED: Columbus will finance the $200,000 investment in land by issuing either
$200,000 of common stock or using $200,000 of additional accounts payable that will be due
in 90 days. Indicate which method of financing is preferable for Columbus. Consider the
effects on short-term solvency positions.
Answer: If Columbus financed the land through accounts payable, its current liabilities would
exceed its current assets by $50,000. This would question Columbus’s capability to pay its
current liabilities when they are due. However, if Columbus financed the investment in land
by issuing common stock, its current assets would exceed its current liabilities by $150,000.
This would enhance its short-term solvency position. Therefore, Columbus should issue
common stock to finance the purchase of land.
Short Essay Questions

1. Describe operating activities.
Answer: Operating activities involve the sale of goods and services and the related cost of
providing the goods and services. These activities produce additional capital that can be
reinvested in producing assets, used to pay debt, or distributed to the owners in the form of
dividends.
2. Which business activity occurs first for a business? Why does this business activity occur
first?
Answer: Financing activities typically occur first in a business. A business must acquire cash
or other operating capital before any investments can be made.
3. What business aspect does the income statement measure?
Answer: The income statement measures operating performance over a particular period.
4. Which asset is more liquid, inventory or accounts receivable? Why?
Answer: Since amounts in the Accounts Receivable account represent inventory that is
already sold, this account will generate cash more quickly than inventory that has not yet
been sold. Therefore, accounts receivable is more liquid than inventory.
5. What business aspect does the statement of shareholders’ equity measure?
Answer: The statement of shareholders’ equity measures changes in 1) the contributed capital
accounts, representing the value of owners’ investments in the business, and in 2) the retained
earnings account, which measures the extent to which the business reinvests its earnings and
pays dividends.
Use the information provided from Haloid Company’s accounting records to answer
questions 6 and 7.

6. How is it possible that Haloid reports “property” in two different places on its balance
sheet?
Answer: ‘Short-term investment in property’ is property that Haloid owns with the intention
of selling in the future. However, property in ‘property, plant, and equipment’ is space that is
being used for “supporting” the operations in Haloid’s business.
7. Comment on the following statement: “On December 31, 2010, Haloid’s accounts payable
exceeds its cash by $5. If Haloid needs additional money to pay its accounts payable, it can
use the $125 stashed in its retained earnings”.
Answer: The amount in the retained earnings account does not represent stashes of money or
other tangible items. This amount simply communicates that Haloid earned and retained $125
of income in its business since it began operations. The difference between assets and
liabilities is total shareholders’ equity. Retained earnings is part of shareholders’ equity. It
represents earnings retained in a business—a residual amount. It is not cash.
9. Explain the concept of liquidity.
Answer: Liquidity is a representation of how close an asset is to cash. Assets are listed in
order of liquidity on the balance sheet, with the most liquid assets first. Since cash is the most
liquid asset, it is presented as the first item in the asset section of the balance sheet.
10. Give an example of a prepaid expense. Why would a company use this account?
Answer: Prepaid expenses may include items such as prepaid rent, prepaid insurance, and
other amounts of which payment must be made up front.

11. What type of assets are included in short-term investments?
Answer: Short-term investments include stock, bonds, and similar investments. Generally
these securities are readily marketable and are intended by management to be sold within a
short period of time, usually less than one year.
12. What is unique about the way plant and equipment appear on the balance sheet?
Answer: Plant and equipment includes the actual costs of acquiring assets such as
warehouses, office buildings, equipment, machinery, vehicles, etc. In the balance sheet, total
accumulated depreciation is shown as a deduction from the cost of the plant and equipment.
The balance in the accumulated depreciation account represents the total cost of the plant and
equipment that has been transferred to the income statement (expensed) as it represented an
allocation of the cost used up that related to past accounting periods.
13. Describe how the equity sections of balance sheets differ for each of the three types of
business entities.
Answer: The shareholders’ equity section of the balance sheet for corporations consists of
two components—contributed capital and retained earnings. Partnerships have one capital
account for each owner in the owners’ equity section of the balance sheet. A proprietorship
has only one capital account. Neither a partnership nor a proprietorship has a retained
earnings account.
14. Why would a company use a notes receivable account?
Answer: A notes receivable account arises because companies accept notes in exchange for a
sale with extended credit terms. Notes represent amounts that customers or employees have
agreed to repay. Notes typically have an interest component.
15. What is the account, Accounts Payable, used for?
Answer: Accounts payable represents the amount of money a company expects to pays its
vendors. The payables arise from the purchase of supplies from vendors/suppliers.
16. Describe how the amount of net income relates to the balance sheet.
Answer: The balance sheet reports an item called retained earnings that represents an
accumulation of all the profits earned by the company since operations began, less all the
dividends paid out to shareholders. Net income for the current period is added and dividends

declared are subtracted from the beginning retained earnings amount to determine the ending
balance of retained earnings, which in turn is reported on the balance sheet.
17. Where in a company’s financial statements would you locate the ‘book value’ of the
company?
Answer: The dollar amount reported as total shareholders’ equity represents the net book
value of the company. Shareholders’ equity is found on the balance sheet. To calculate the
book value, subtract liabilities from assets.
18. Which group of financial statement users would be most concerned with the amount of a
company’s total current assets and current liabilities?
Answer: Creditors, such as bankers in other lenders, would be very interested in the liquidity
of a company. Comparing the amount of current assets with current liabilities is a common
analysis tool used by those interested in liquidity. If a company has more current liabilities
than current assets, it is possible the company will not be able to pay its current bills when
they come due.
19. Which assets on a company's balance sheet have no physical substance? Explain.
Answer: Intangible assets have no physical substance. They are reported as long-term assets
on the balance sheet and represent the legal right to produce and sell certain products. Like
other assets, they represent a potential future benefit for the company.
20. A company sold 10 widgets. How will the amounts the company reports as ‘Sales’ differ
from amounts reported as ‘Cost of Goods Sold’?
Answer: The amount reported as sales represents the dollar amount for which the widgets
were sold to the customers. Cost of goods sold represents the original cost paid by the
company to acquire the inventory item. The difference between the dollar amount of sales
and the dollar amount of cost of goods sold represents gross profit for the company.
21. What concerns might you have if you examined a company's balance sheet and found a
negative amount in retained earnings?
Answer: A negative amount in retained earnings is common for young companies because it
often takes several years to become profitable. Retained earnings may also decline and
produce a negative balance (if allowed under the respective state laws) if a company pays

large dividends. If the dollar amount in retained earnings is negative because of continual
losses, there should be a cause for concern.
22. Distinguish between the amounts reported on the income statement compared to the
amounts reported on the statement of cash flows.
Answer: Amounts reported on the income statement are revenues and expenses. These
amounts reflect general asset and liability inflows and outflows. The amounts reported on the
statement of cash flows include only the cash received and the cash paid out.
23. Explain the difference between net income and cash flow from operations.
Answer: Net income, reported on the income statement, consists of revenues and expenses or
more general asset and liability inflows and outflows, that may not necessarily include cash.
Cash flows from operations, reported on the statement of cash flows, include only the cash
inflows and outflows.

Test Bank for Financial Accounting: In an Economic Context
Jamie Pratt, Michael F. Peters
9780470635292, 9781119537571, 9781119444367

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