Chap 003

Chapter 003 Accounting and Finance
True / False Questions
1. An asset's liquidity is determined by how readily the asset can be converted to an

appropriate amount of cash.
TRUE
AACSB: Communication Abilities

Bloom's: Knowledge
Difficulty: Easy
Learning Objective: 3-1
2. The principal reason for excluding many intangible assets from the balance sheet is that
they are difficult to value.
TRUE
AACSB: Reflective Thinking Skills

Bloom's: Understanding
Difficulty: Medium
3. The difference between gross fixed assets and net fixed assets is accumulated depreciation.
TRUE

Difficulty: Easy
4. Fixed assets can be either tangible or intangible assets.

TRUE

Bloom's: Knowledge
Difficulty: Medium
3-1
5. Balance sheets have traditionally recorded amounts in terms of market values.

FALSE

Bloom's: Knowledge
Difficulty: Easy
6. All items in the common-size balance sheet are expressed as a percentage of total assets.
TRUE

Bloom's: Knowledge
Difficulty: Medium
7. The income statement resembles a snapshot of the firm at a specific time.

FALSE

Difficulty: Easy
8. If the market value of assets is high, then the market value of liabilities must be high also.
FALSE

Difficulty: Hard
3-2
9. One reason for the difference between profits and cash is that the cost of capital equipment
is spread over the forecast life.
TRUE

Difficulty: Easy
10. Accrual accounting aims to provide a fairer measure of the firm's profitability.
TRUE

Difficulty: Easy
11. If net income is positive, then cash flow from operations is positive also for that period.
FALSE

Difficulty: Medium
12. Purchases of marketable securities are not considered to be cash used by investments on
the statement of cash flows.
TRUE

Bloom's: Knowledge
Difficulty: Hard
3-3
13. An increase in accounts receivable balance provides an increase in cash flow.

FALSE

Difficulty: Medium
14. The payment of interest expense is considered cash flow from financing on the statement
of cash flows.
FALSE

Bloom's: Knowledge
Difficulty: Hard
15. Accounting practices are not standardized across countries.

TRUE

Bloom's: Knowledge
Difficulty: Medium
16. Businesses that aggressively exploit any means to increase current earnings may cross
over into fraudulent account practices.
TRUE
AACSB: Ethical Understanding & Reasoning Abilities

Difficulty: Medium
3-4
17. A company may deduct the interest paid to debtholders and the dividends paid to
shareholders when calculating its taxable income.
FALSE

Bloom's: Knowledge
Difficulty: Medium
18. Both the dividends and interest payments that companies make to individuals are subject
to personal tax.
TRUE

Bloom's: Knowledge
Difficulty: Medium
19. The balance sheet presents a snapshot of the firm's assets and liabilities at one particular
moment.
TRUE

Difficulty: Medium
20. Book values are "forward-looking" measures of value.

FALSE

Difficulty: Medium
3-5
21. The difference between the market values of assets and liabilities is the market value of
the shareholders' equity claim.
TRUE

Difficulty: Medium
22. To calculate the cash produced by the business it is necessary to add back the depreciation
charge and to subtract the expenditure on new capital equipment.
TRUE

Difficulty: Medium
23. Depreciation charge is a cash payment.

FALSE

Difficulty: Easy
24. Expenditure on new capital equipment is a cash payment.

TRUE

Difficulty: Easy
3-6
25. The statement of cash flows shows the firm's cash inflows and outflows from operations
as well as from its investments and financing activities.
TRUE

Difficulty: Easy
26. An increase in inventories uses cash, reducing the firm's net cash balance.
TRUE

Difficulty: Medium
27. A reduction in accounts payable uses cash, reducing the firm's net cash balance.
TRUE

Difficulty: Medium
28. The purchase of new equipment is a use of cash, and it reduces the firm's net cash
balance.
TRUE

Difficulty: Medium
3-7
Multiple Choice Questions
29. In general, what is changing as you read down the left hand side of a balance sheet?
A. The assets are more fully depreciated.
B. The assets are growing in value.
C. The assets are increasing in maturity.
D. The assets are becoming less liquid.

Difficulty: Easy
30. A balance sheet portrays the value of a firm's assets and liabilities:
A. over an annual period.
B. over any stated period of time.
C. at any stated point in time.
D. at the end of the calendar year.

Difficulty: Easy
31. Which of the following items should not be included in a listing of current assets?
A. Marketable securities
B. Accounts payable
C. Accounts receivable
D. Inventories

Difficulty: Easy
3-8
32. Which of the following assets is likely to be considered the most liquid?
A. Marketable securities
B. Net fixed assets
C. Accounts payable
D. Inventories

Difficulty: Easy
33. If the value of a firm's net fixed assets equals the value of the accumulated depreciation,
then, from an accounting context, the fixed assets are:
A. new.
B. fully depreciated.
C. one-half depreciated.
D. equal in value to the firm's current assets.

Difficulty: Hard
34. If the balance sheet of a firm indicates that total assets exceed current liabilities plus
shareholders' equity, then the firm has:
A. no retained earnings.
B. long-term debt.
C. no accumulated depreciation.
D. current assets.

Difficulty: Easy
3-9
35. Which of the following terms is out of place as a typical form of inventory?
A. Raw materials inventory
B. Current goods inventory
C. Finished goods inventory
D. Work-in-process

Difficulty: Easy
36. What balancing entry is most likely to be called for if previously excluded intangible
assets were added to a firm's balance sheet?
A. Increase accumulated depreciation
B. Decrease long-term debt
C. Increase shareholders' equity
D. Decrease current assets

Difficulty: Medium
37. What happens to a firm's net worth as it uses cash to repay accounts payable?
A. Net worth increases.
B. Net worth decreases.
C. New worth remains constant.
D. Net worth decreases temporarily, until cash is replenished.

Difficulty: Medium
3-10
38. If a payment of principal is due in thirteen months on a long-term liability, that payment
will now appear as:
A. a current liability.
B. long-term debt.
C. cash.
D. interest expense.

Bloom's: Knowledge
Difficulty: Easy
39. Net working capital is a measure of the company's:

A. goodwill.
B. short-term liabilities.
C. estimated liquidity.
D. shareholders' equity.

Difficulty: Easy
40. Net working capital is calculated by taking the difference between:

A. total assets and total liabilities.
B. inventory and accounts payable.
C. current assets and current liabilities.
D. cash and long-term debt.

Difficulty: Easy
3-11
41. Which of the following statements about net working capital (NWC) is correct?
A. NWC is positive for all firms.
B. As NWC decreases, potential liquidity increases.
C. NWC excludes inventory, which is deemed illiquid.
D. Decreases in NWC can increase the firm's risk.

Difficulty: Easy
42. The existence of "goodwill" on a corporate balance sheet indicates that the corporation
has:
A. been profitable in the past.
B. depreciated its tangible assets.
C. intangible assets from past acquisitions.
D. retained earnings resulting from past income.

Difficulty: Medium
43. A balance sheet may be considered "backward looking," from the perspective that:
A. works backward, starting with net income.
B. it records historic, not current values.
C. it cannot forecast the future.
D. it records costs over many previous periods.

Difficulty: Easy
3-12
44. According to GAAP, assets and liabilities are typically recorded on the balance sheet at:
A. historical cost.
B. market value.
C. salvage value.
D. historical cost less depreciation.

Bloom's: Knowledge
Difficulty: Easy
45. Which of the following is correct for a fully depreciated asset?

A. Market value is zero.
B. Market value is greater than book value.
C. Book value is greater than market value.
D. The relationship between market and book values is indeterminable.

Difficulty: Medium
46. Depreciation expense is used to:

A. allocate costs to all departments of the firm.
B. determine when an asset is fully paid off.
C. allocate historical cost over the life of an asset.
D. equate the historical cost and market values of an asset.

Difficulty: Easy
3-13
47. When subtracting an asset's accumulated depreciation from its historic cost, the resulting
value is termed the:
A. book value of the asset.
B. market value of the asset.
C. depreciation expense.
D. current asset value.

Difficulty: Easy
48. ABC Corp.'s balance sheet shows their long-term debt to be $20 million. The debt was
issued with a 10% interest rate, and the current interest rate is 7%. Based on this information,
the market value of this debt would be:
A. less than $20 million.
B. more than $20 million.
C. equal to $20 million.
D. unknown without knowing the maturity of the debt.

Bloom's: Application
Difficulty: Medium
49. Which of the following statements about depreciation is correct?

A. Depreciation is subtracted from cost of goods sold to calculate net income.
B. When depreciation expense is incurred, cash balances are reduced.
C. Depreciation expense does not affect net income.
D. Depreciation reduces the book value of assets.

Difficulty: Easy
3-14
50. If market interest rates have increased since a company last borrowed long-term funds, the
market value of these long-term funds will likely be:
A. greater than their book value.
B. less than their book value.
C. equal to their book value.
D. unknown without knowing the maturity of the debt.

Difficulty: Medium
51. Which of the following values would most likely interest a shareholder?
A. Book value of equity.
B. Market value of equity.
C. Historical cost of equity.
D. Retained earnings component of equity.

Difficulty: Easy
52. What happens to the market value of a firm's equity as the book value of the firm's equity
increases?
A. It increases by the same amount.
B. It decreases by the same amount.
C. It remains constant.
D. There is no set relationship to determine this outcome.

Difficulty: Medium
3-15
53. Which of the following statements is true for a corporation with $1 million market value
of equity, $2 million market value of assets, and 1,000 shares of outstanding stock?
A. Market value of liabilities exceeds book value of liabilities.
B. Market value of liabilities equals $1 million.
C. Market value per share equals $1,000.
D. Market value per share equals $2000.

Difficulty: Medium
54. Which of the following is more likely to be correct if market value of equity is less than
book value of equity?
A. Investors anticipate excellent earning potential.
B. Investors anticipate low earning potential.
C. Assets have been fully depreciated.
D. The company is bankrupt.

Difficulty: Medium
55. Market-value balance sheets differ from book-value balance sheets in that market values:
A. are higher than book values.
B. are lower than book values.
C. conform more to GAAP accounting.
D. conform to investors' expectations.

Difficulty: Easy
3-16
56. If market values of equity exceed book values of equity, then:

A. equity has been depreciated too rapidly.
B. the firm uses accrual-based accounting.
C. profit potential is expected to be attractive.
D. the firm is holding too much cash.

Difficulty: Medium
57. Perhaps the best method for estimating the market value of shareholders' equity is to:
A. read from the firm's balance sheet.
B. read from the firm's income statement.
C. multiply number of shares outstanding by the price of each share.
D. add the retained earnings plus total liabilities.

Difficulty: Medium
58. In which of the following asset accounts are you least likely to find a difference between
market value and book value?
A. Cash
B. Inventory
C. Land
D. Shareholders' equity

Difficulty: Easy
3-17
59. What occurs when the value of a firm's debt exceeds the value of shareholders' equity?
A. The firm is bankrupt.
B. The firm is very risky.
C. A high rate of interest is being paid on the debt.
D. The firm is financed more through debt than through equity.

Difficulty: Medium
60. Which of the following expense categories is subtracted from total revenues to arrive at a
firm's EBIT?
A. Cash dividends
B. Depreciation expense
C. Interest expense
D. Tax liability

Difficulty: Easy
61. Which of the following cash outflows does not reduce a firm's net income?
A. Income taxes
B. Interest expense
C. Dividends
D. Depreciation expense

Difficulty: Medium
3-18
62. Calculate the EBIT for a firm with $4 million total revenues, $3.5 million cost of goods
sold, $500,000 depreciation expense, and $120,000 interest expense.
A. $500,000
B. $380,000
C. $0
D. ($120,000)

Difficulty: Medium
63. The Net Income figure on an income statement is calculated before deducting:
A. interest expense.
B. depreciation expense.
C. cash dividends.
D. tax liability.

Difficulty: Medium
3-19
64. An increase in depreciation expense will (other things equal):

A. increase net income.
B. decrease net income.
C. increase cash flow.
D. decrease the market value of assets.
Total earnings before interest and taxes (EBIT) are

EBIT = total revenues - costs - depreciation

Difficulty: Medium
3-20
65. Current period depreciation expense is listed on:

A. the balance sheet.
B. the investment section of the cash flow statement.
C. the income statement.
D. neither the balance sheet nor the income statement; it is a noncash expense.

Bloom's: Knowledge
Difficulty: Easy
66. Retained earnings result from:

A. the sale of additional shares of stock to investors.
B. income not paid to shareholders in the form of cash dividends.
C. an excess of assets over liabilities.
D. market values that exceed book values.

Difficulty: Medium
67. The gathering of related revenues and expenses into the same period, regardless of when
they were incurred, is:
A. cash basis accounting.
B. market value accounting.
C. book value accounting.
D. accrual accounting.

Bloom's: Knowledge
Difficulty: Easy
3-21
68. According to accrual accounting, when goods are not sold until the period after they were
produced, then the cost of goods sold:
A. will be recognized in the first period.
B. will be recognized in the second period.
C. will be recognized when payment is received.
D. will be split between both periods.

Difficulty: Medium
69. Accrual accounting, which attempts to match sales revenues and the expenses associated
with the production of the goods, is conducted in an attempt to:
A. reduce income-tax liability.
B. reduce bias in reported profitability measures.
C. speed up the receipt of accounts receivable.
D. reduce the time necessary to depreciate assets.

Difficulty: Medium
70. Which of the firm's financial statements most clearly recognizes the payment for new
equipment?
A. Balance Sheet
B. Income Statement
C. Statement of Cash Flows
D. Statement of Condition

Difficulty: Easy
3-22
71. Which of the following is not a typical reason for differences between profit and cash
flow?
A. Depreciation expense
B. Income taxes
C. Changing levels of accounts receivable
D. Accrual accounting practices

Difficulty: Medium
72. Which of the following best explains the combination of a high level of sales combined
with a low cash flow during an accounting period?
A. High depreciation expense.
B. Reduction of inventory levels.
C. Acquisition of equipment
D. Increase in accounts payable.

Difficulty: Easy
73. If a firm generates $2,000 in sales and has a $500 increase in accounts receivable during
an accounting period, then, based on these two categories, cash flow will increase by:
A. $2,500.
B. $2,000.
C. $1,500.
D. $500.

Difficulty: Medium
3-23
74. In a statement of cash flows, which category includes depreciation expense?

A. Operations
B. Investments
C. Financing
D. None of these; depreciation is a noncash expense.

Difficulty: Easy
75. Which of the following will occur in a statement of cash flows as a result of paying cash
dividends?
A. Cash flows from operations will increase.
B. Cash flows from investments will decrease.
C. Cash flows from financing will decrease.
D. Cash balances will not be affected.

Difficulty: Easy
76. Which of the following changes in working capital will result in an increase in cash
flows?
A. Increase in accounts payable
B. Increase in inventories
C. Increase in accounts receivable
D. Decrease in other current liabilities

Difficulty: Medium
3-24
77. Which of the following statements is more likely if cash and marketable securities
increase by $5,000 during a period in which cash provided by operations increases by $1,000
and cash used by investments decreases by $500?
A. Cash provided by financing increases by $3,500.
B. Cash used by financing decreases by $1,000.
C. Debt increased by more than cash dividends paid.
D. Debt was reduced by more than cash dividends paid.
As a plug figure, cash provided by financing must have increased by $4,500. If dividends paid
exceeded the increase to debt, this number would be negative.

Difficulty: Hard
78. If a firm's net income is positive and its noncash expenses are positive, which of the
following could account for a negative amount of cash provided by operations?
A. Current assets decrease more than current liabilities decrease.
B. Current assets increase more than current liabilities increase.
C. Current assets decrease more than current liabilities increase.
D. A large addition is made to plant and equipment.

Difficulty: Hard
3-25
79. What is the most likely conclusion for a firm whose statement of cash flows shows an
increase in cash balances and has negative cash flows from both operations and financing?
A. The firm has low depreciation expense.
B. The firm did not pay any dividends.
C. The firm sold more equipment than it purchased.
D. The firm has a low interest rate on its debt.

Difficulty: Hard
80. What happens when moving from net income to cash flows as the result of an increase in
inventory balances?
A. Cash flows increase.
B. Cash flows decrease.
C. Cash flows are unchanged.
D. The change in cash flows cannot be determined.

Difficulty: Medium
81. According to the statement of cash flows, cash flows from financing could be positive if:
A. the firm repaid more debt than it added.
B. the firm added more debt than it repaid.
C. interest rates were low on outstanding debt.
D. the firm sold portions of its plant and equipment.

Difficulty: Medium
3-26
82. Which of the following categories of a statement of cash flows is affected by the payment
of interest expense?
A. Cash flows from operations
B. Cash flows from noncash expenses
C. Cash flows from investments
D. Cash flows from financing

Difficulty: Hard
83. Which of the following could account for a firm that has a negative net income, yet has a
positive amount of cash provided by operations?
A. The net loss was greater than the amount of depreciation expense.
B. Inventory increased significantly more than accounts payable.
C. Accounts receivable decreased by significantly more than accounts payable.
D. Cash balances declined to the desired amount.

Difficulty: Medium
84. If a firm's cash-flow statement shows that cash was used for investments, which of the
following would seem most likely?
A. The inventory balance increased.
B. Common stock was repurchased.
C. New machines were acquired.
D. Cash dividends were paid.

Difficulty: Medium
3-27
85. Interest expense appears in the operations section of the cash-flows statement because:
A. firms cannot operate without incurring interest expense.
B. its payment is not within managerial discretion.
C. it is paid to finance a firm's inventory.
D. False statement; interest expense appears in the financing section of the cash-flows
statement.

Difficulty: Hard
86. When an accountant does not report all of the potentially relevant financial information on
the firm's financial statements, the accountant is most likely:
A. hiding transactions from the shareholders.
B. using the discretion that is built into GAAP.
C. not following GAAP.
D. not licensed to practice accounting.

Bloom's: Knowledge
Difficulty: Medium
87. Which of the following statements correctly compares international accounting

standards?
A. The standards are becoming less similar over time.
B. The standards are typically more lenient in the U.S.
C. The standards are more strict in the U.S. in some regards.
D. Balance sheets differ, but income statements are similar in all countries.

Bloom's: Knowledge
Difficulty: Easy
3-28
88. Which of the following may not show up as an expense in the financial statements?
A. Cash bonus for employees
B. Value of options given to employees to buy the firm's stock
C. Allowance for bad debts
D. All of these

Bloom's: Knowledge
Difficulty: Medium
89. For many people, the most worrying aspect of the Enron failure was:
A. the ease with which companies could inflate their earnings and produce fraudulent
accounts.
B. the loss of thousands of jobs and investments.
C. the realization that even the financial statements of the largest companies in the U.S. could
not be trusted.
D. the fact that even the creditor banks were deceived.
AACSB: Ethical Understanding & Reasoning Abilities

Difficulty: Medium
3-29
90. What is the marginal tax rate for a corporation with $60,000 taxable income and an
average tax rate of 16.67% if the next-lowest marginal tax rate of 15% covers taxable incomes
up to $50,000?
A. 15.00%
B. 16.67%
C. 18.34%
D. 25.00%
Therefore, $10,000 x marginal tax rate = 2,500

marginal tax rate = 25%

Difficulty: Hard
91. Assuming that corporate tax rates change from 15% to 25% at $50,000 income, which of
the following statements is correct for a firm with $75,000 income?
A. Its marginal tax rate is 15%.
B. Its average tax rate is 25%.
C. Its marginal tax rate is 18.33%.
D. Its average tax rate is 18.33%.

Difficulty: Hard
3-30
92. For all U.S. corporations except those in the lowest and highest tax brackets, it is the case
that their:
A. marginal tax rate exceeds their average tax rate.
B. average tax rate exceeds their marginal tax rate.
C. marginal tax rate equals their average tax rate.
D. marginal tax rate equals 15%.

Difficulty: Medium
93. Which of the following expenses cannot be used to reduce taxable corporate income?
A. Cash dividends
B. Depreciation expense
C. Interest expense
D. Administrative expenses

Difficulty: Easy
94. For a corporation in the 25% marginal-tax bracket that incurs $70.00 in labor and
materials expense, plus $15.00 in depreciation expense while generating an incremental
revenue of $100, tax liability will increase by:
A. $3.75.
B. $7.50.
C. $13.75.
D. $25.00.
Taxable income will be increased by $15, which will increase tax liability by $3.75.

Difficulty: Medium
3-31
95. According to the current U.S. tax code, the marginal-tax rate for personal taxpayers in the
highest levels of income is:
A. 15.0%.
B. 25.0%.
C. 28.0%.
D. 35.0%.

Bloom's: Knowledge
Difficulty: Easy
96. Which of the following statements appears correct for a corporation with a negative net
income in both the present and the last fiscal year?
A. This year's loss can be carried back, but last year's loss cannot be used.
B. Neither of the losses can be used to reduce taxes.
C. Both losses can be carried forward but not backward.
D. Both losses can be carried forward and backward, within certain time limits.

Difficulty: Medium
97. Which of the following statements is correct for an individual with a net income of
$50,000, a tax liability of $10,704.50, and a 28% marginal-tax rate?
A. The average-tax rate is 21.41%.
B. The average-tax rate is 28.00%.
C. The average-tax rate is unknown, but less than the marginal-tax rate.
D. The average-tax rate is unknown, but greater than the marginal-tax rate.

Difficulty: Medium
3-32
98. An individual's income for the year includes both dividend and interest payments. Which
of the following statements will be correct concerning that individual's tax liability?
A. Dividends are taxed; tax on interest payments is paid at the corporate level.
B. Interest is taxed; tax on dividend payments is paid at the corporate level.
C. Both dividend and interest payments are taxed at the personal level.
D. All taxes on dividend and interest payments are paid at the corporate level.

Difficulty: Medium
99. Marginal tax rates are based on:

A. net income.
B. total income.
C. an additional dollar of income.
D. earnings before interest and taxes.

Difficulty: Medium
100. What is the marginal impact on taxes for a profitable corporation in the 35% marginal
tax bracket that incurs an additional dollar of depreciation expense?
A. A decrease of 65 cents
B. A decrease of 35 cents
C. An increase of 65 cents
D. Zero impact
Taxable income will be reduced by $1, which will lower tax liabilities by 35 cents.

Difficulty: Medium
3-33
101. Who pays the taxes on earnings distributed as dividends?

A. The corporation
B. The investor receiving the dividend
C. Both the corporation and the investor
D. Neither the corporation nor the investor

Difficulty: Medium
102. What is the tax liability for an individual with $52,000 of income, which includes $2,000
of dividends, if the tax rate is 15% on income up to $25,350 and 28% on income over
$25,350?
A. $11,704.50.
B. $11,264.50.
C. $14,000.00.
D. $14,560.00.

Difficulty: Medium
103. Which of the following forms of income can individuals defer from taxation?
A. Dividends
B. Interest
C. Realized capital gains
D. Unrealized capital gains

Difficulty: Medium
3-34
104. Which statement is correct about the tax treatment of dividend income and capital gains
for pension funds?
A. Dividends are taxable while capital gains are not taxable.
B. Capital gains are taxable while dividends are not taxable.
C. Both dividends and capital gains are taxable.
D. Neither dividends nor capital gains are taxable.

Difficulty: Medium
Essay Questions
105. If depreciation is a method of allocating cost rather than an actual cash flow, discuss how
depreciation impacts the income statement and overall cash flows.
Depreciation appears on the income statement as an expense prior to calculating EBIT. It

reduces the amount of income subject to taxation. As a result, the amount of tax liability is
reduced. Thus, profitable firms will show an increase in cash flow in the amount of the
depreciation expense times the marginal tax rate.
AACSB: Analytical Skills

Bloom's: Analysis
Difficulty: Medium
3-35
106. Professor Diehard found an effective antibiotic for the DEPRESS virus, and patented the
drug. He believes that he can sell the patent for $20 million. He then formed a corporation and
invested $400,000 in setting up a production plant. If the professor's belief is correct, what are
the book and market values of the firm? If there are 2 million shares of stock in the firm, what
would be the price per share and the book value per share?
Book value equals the $400,000 Professor Diehard has contributed in tangible assets. Market
value equals the value of his patent plus the value of the production plant: $20,000,000 +
$400,000 = $20,400,000. Price per share = $20.4 million/2 million shares = $10.20. Book
value per share = $400,000/2 million shares = $0.20.

Bloom's: Evaluation
Difficulty: Medium
107. Discuss reasons why a market-value balance sheet may be distinctly different from a
book-value balance sheet. (LO2)
For some assets, depreciation expense is an accurate portrayal of reduction in market value.
However, it is not at all uncommon for market value to be distinctly different from
depreciated book value. This can be especially true for land, which is not depreciated but has
often appreciated if it has been on the books for a long period of time. In a similar manner,
liabilities may have a different market value if market interest rates on similar liabilities have
changed sufficiently since the liability was issued. Finally, investors and analysts may have
critical information about the future prospects for the firm that has not been incorporated into
current generally accepted accounting principles.

Bloom's: Analysis
Difficulty: Medium
3-36
108. Determine earnings before interest and taxes, net income and also the cash flow from
operations for the following firm: $500,000 sales, $10,000 cash dividends, $300,000 cost of
goods sold, $20,000 administrative expense, $20,000 depreciation expense, $40,000 interest
expense, $10,000 purchase of productive equipment, no changes in working capital, and a tax
rate of 35%. (LO4)
Adding depreciation expense to net income provides a cash flow from operations of $98,000.

Bloom's: Evaluation
Difficulty: Hard
109. Why may it be difficult to rely on profits to get an overall impression of the firm's cash
flows?
Two important differences between cash flow and net income are: many assets (both tangible
and intangible) are depreciated (or amortized) rather than expensed in the period in which
they were acquired. Thus, the cash outflow may occur long before the corresponding expense.
Also, revenues and expenses are recognized in the period in which they are incurred
regardless of when the corresponding cash flows occur.

Bloom's: Analysis
Difficulty: Medium
3-37
110. Discuss the premise of accrual accounting. Why is it considered preferable over cash
basis accounting?
Accrual accounting attempts to gather all revenues and expenses that relate to a particular
accounting period, regardless of when the cash flows actually occurred. This should permit a
firm's financial statements to offer a more realistic picture of the firm's ability to generate a
profit, or for the firm to have value as a "going concern." For example, with cash basis
accounting a profitable firm could show a large loss in a period of adding to their productive
capacity, yet the new equipment has not yet depreciated in value.

Bloom's: Analysis
Difficulty: Medium
111. Determine the net cash flows for periods 1 through 3 for a firm with the following
transactions: $1,000 spent in period 1 and $2,000 spent in period 2 to produce goods to be
sold in the following periods, sales of $2,000 in period 2 and $4,000 in period 3, one-half of
all sales are in cash with the other half collected in the following period.

Bloom's: Evaluation
Difficulty: Hard
3-38
112. What is the overall change in working capital resulting from the following changes?
$300 increase in inventories, $150 increase in accounts payable, $120 decrease in accounts
receivable, $60 decrease in other current assets, $150 decrease in other current liabilities.

Bloom's: Evaluation
Difficulty: Medium
113. What is the change in cash balance for a firm with: $10,000 cash flow from operations,
$1,600 cash used for new investment, a reduction in the level of debt of $2,000, $1,000 in
cash dividends, and $200 in depreciation expense?

Bloom's: Evaluation
Difficulty: Medium
3-39
114. Compute the total tax liability, the average tax rate, and the marginal tax rate for the
following corporation: $1,000,000 in taxable income; 15% tax up to $50,000, 25% up to
$75,000, 34% up to $100,000, 39% over $100,000. (LO4)

Bloom's: Evaluation
Difficulty: Medium
3-40
115. Your bookstore is set up as an incorporated business. If you draw $70,000 from your
bookstore as your salary, such that your bookstore's taxable income for the year becomes
$30,000, how much personal tax and corporate tax must you pay to the federal government?
By how much would your taxes change if you reduce your salary to $27,950, such that your
bookstore's taxable income becomes $72,050? Assume that you pay personal taxes as an
unmarried taxpayer, and that the tax rates are as shown below.
For the case of $70,000 salary and $30,000 bookstore income:

Taxes on your salary = (0.10 x $6,000) + 0.15 x ($27,950 - $6,000)
+ 0.27 x ($67,700 - $27,950) + 0.30 x ($70,000 - $67,700) = $15,315
Taxes on corporate income = 0.15 x $30,000 = $4,500
Total taxes = $15,315 + $4,500 = $19,815
For the case of $27,950 salary and $72,050 bookstore income:

Taxes on your salary = (0.10 x $6,000) + 0.15 x ($27,950 - $6,000) = $3,892.50
Taxes on corporate income = (0.15 x $50,000) + 0.25 x ($72,050 - $50,000) = $13,012.50
Total taxes = $3,892.50 + $13,012.50 = $16,905
Therefore, total taxes are reduced by $19,815 - $16,905 = $2,910

Bloom's: Evaluation
Difficulty: Medium
3-41
116. Congress passed the Sarbanes-Oxley Act in 2001. The act attempts to ensure that the
firm's financial reports accurately represent its financial condition. However, general
consensus thinks that accounting rules still give firms considerable leeway when preparing
their financial statements. List three examples of gray areas that allow for judgment calls.
Cookie jar reserves. Firms know that in the course of business things occasionally will go
wrong. For example, some customers who buy on credit may not pay their bills. Firms
estimate a fair allowance for these events and create reserve accounts to recognize their
expected impact on earnings. But sometimes it can be tempting to take a rosy view of the
proportion of bills that will go unpaid, and thereby increase reported earnings. In other cases,
some firms have actually overestimated likely future expenses, or "over-reserved," so that
these reserves could be "released" later in a downturn, thus creating the illusion of smooth and
consistent earnings growth. In other words, when extra income is needed, the firm can raid its
"cookie jar reserves."
Off-balance sheet assets and liabilities. Suppose that one firm guarantees the debt of another
firm. This obligation may require payments down the road, but may not be reported as part of
the firm's outstanding debt. This appears to be one way that Enron was able to hide the extent
of its debt obligations from the public.
Revenue recognition. As we saw above, firms record a sale when it is made, not when the
customer actually pays. But there are occasions when it can be hard to know when a sale
occurs. An extreme (and potentially fraudulent) version of this problem is called "channel
stuffing." The firm "sells" large quantities of goods to customers, but gives them the right to
later refuse delivery or return the product.
The revenue from the "sale" is booked immediately, but the likely returns are not recognized
until they occur in a future accounting period. Channel stuffing hit the headlines in 1997 when
the head of Sunbeam Corporation, "Chainsaw" Al Dunlap, allegedly moved millions of
dollars of appliances to distributors and retailers to produce record earnings.

Bloom's: Knowledge
Difficulty: Medium
3-42
117. Describe the practice of "double taxation" of corporate earnings in the US.
The marginal tax rates on "ordinary income" apply primarily on income earned as salary or
wages. Interest earnings also are treated as ordinary income. Other investment income is
treated differently, however.
For example, dividend income for most individual investors in the U.S. is taxed at a 15
percent rate. Remember that each dollar of income that the company earns is taxed at the
corporate tax rate. If the company then pays a dividend out of this after-tax income, the
shareholder also pays personal income tax on the dividend, and so the company's original
earnings are taxed twice, first as corporate income, and then as dividend income. This
treatment is commonly dubbed the "double taxation" of corporate earnings.
Suppose instead that the company earns a dollar which is paid out as interest. The dollar
escapes corporate tax because the interest payment is considered a business expense that
reduces the firm's taxable income, but the individual who receives the interest must pay
personal tax at the rate on ordinary income.
Financial managers need to worry about the tax treatment of investment income, because tax
policy will affect the prices individuals are willing to pay for the company's stock or bonds.

Bloom's: Knowledge
Difficulty: Medium
118. Why should financial managers be concerned about "double taxation" of corporate
earnings?
Financial managers need to worry about the tax treatment of investment income, because tax
policy will affect the prices individuals are willing to pay for the company's stock or bonds.

Bloom's: Analysis
Difficulty: Medium
3-43
119. What information is contained in the balance sheet/Income statement, and statement of
cash flows?
Investors and other stakeholders in the firm need regular financial information to help them
monitor the firm's progress. Accountants summarize this information in a balance sheet,
income statement, and statement of cash flows.
The balance sheet provides a snapshot of the firm's assets and liabilities. The assets consist of
current assets that can be rapidly turned into cash and fixed assets such as plant and
machinery. The liabilities consist of current liabilities that are due for payment within a year
and long-term debts. The difference between the assets and the liabilities represents the
amount of the shareholders' equity.
The income statement measures the profitability of the company during the year. It shows the
difference between revenues and expenses.
The statement of cash flows measures the sources and uses of cash during the year. The
change in the company's cash balance is the difference between sources and uses.

Bloom's: Knowledge
Difficulty: Medium
120. Why does accounting Income differ from cash flow?
Income is not the same as cash flow. There are two reasons for this: (1) investment in fixed
assets is not deducted immediately from income but is instead spread over the expected life of
the equipment, and (2) the accountant records revenues when the sale is made rather than
when the customer actually pays the bill, and at the same time deducts the production costs
even though those costs may have been incurred earlier.

Bloom's: Analysis
Difficulty: Medium
3-44
121. What are the essential features of the taxation of corporate and personal income?
For large companies the marginal rate of tax on income is 35 percent. In calculating taxable
income the company deducts an allowance for depreciation and interest payments. It cannot
deduct dividend payments to the shareholders.
Individuals are also taxed on their income, which includes dividends and interest on their
investments. Capital gains are taxed, but only when the investment is sold and the gain
realized.

Bloom's: Knowledge
Difficulty: Medium
3-45
122. Consider the firm described in the following paragraph. It spends $200 to produce goods
in period 1. In period 2 it sells half of those goods for $150, but doesn't collect payment until
one period later. In period 3, it sells the other half of the goods for $150, and collects on these
sales in period 4. Calculate the profits and the cash flows for this firm in periods 1-4 by
completing a table as shown below.
The profits for the firm are recognized in periods 2 and 3 when the sales take place. In both of
those periods, profits are $150 - $100 = $50. Cash flows are derived as follows.
In period 2, half the units are sold for $150, but no cash is collected so the entire $150 is
treated as increase in accounts receivable. Half the $200 cost of production is recognized, and
a like amount is taken out of inventory. In period 3, the firm sells another $150 of product, but
collects $150 from its previous sales, so there is no change in outstanding accounts receivable.
Net cash flow is the $150 collected in this period on the sale that occurred in period 2. In
period 4, cash flow is again $150, as the accounts receivable from the sale in period 3 is
collected.

Bloom's: Evaluation
Difficulty: Medium
3-46
123. Would the following activities increase or decrease the firm's cash balance?
a. Inventories are increased.
b. The firm reduces its accounts payable.
c. The firm issues additional common stock.
d. The firm buys new equipment.
a. An increase in inventories uses cash, reducing the firm's net cash balance.
b. A reduction in accounts payable uses cash, reducing the firm's net cash balance.
c. An issue of common stock is a source of cash.
d. The purchase of new equipment is a use of cash, and it reduces the firm's net cash balance.

Difficulty: Medium
3-47

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Chapter 003 Accounting and Finance

True / False Questions

1. An asset's liquidity is determined by how readily the asset can be converted to an

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4. Fixed assets can be either tangible or intangible assets.

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5. Balance sheets have traditionally recorded amounts in terms of market values.

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7. The income statement resembles a snapshot of the firm at a specific time.

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13. An increase in accounts receivable balance provides an increase in cash flow.

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15. Accounting practices are not standardized across countries.

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20. Book values are "forward-looking" measures of value.

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23. Depreciation charge is a cash payment.

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24. Expenditure on new capital equipment is a cash payment.

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Multiple Choice Questions

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39. Net working capital is a measure of the company's:

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40. Net working capital is calculated by taking the difference between:

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45. Which of the following is correct for a fully depreciated asset?

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46. Depreciation expense is used to:

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