MANAGEMENT ACCOUNTING (VOLUME I) - Solutions Manual

CHAPTER 3

UNDERSTANDING FINANCIAL STATEMENTS

I. Questions

1. A financial statement is a means of communicating information about an

enterprise in financial (i.e., peso) terms. It represents information that
the accountant believes is a true and fair representation of the financial
activity of the enterprise.

2. Every financial statement relates to time in one way or another. A

statement of financial position, or balance sheet, represent a “picture” of
the enterprise at a point in time (e.g., the end of a month or year). An
income statement and a statement of cash flows, on the other hand, cover
activity that took place over a period of time (e.g., a month or year).

3. a. Creditors are interested in financial statements to assist them in

evaluating the ability of a business to repay its debts. No one wants
to extend credit to a company that is unable to meet its obligations
as they come due.
b. Potential investors use financial statements in selecting among
alternative investment opportunities. They are interested in
investing in companies in which the value of their investment will
increase as a result of future profitable operations.
c. Labor unions are interested in financial statements because the
financial position of a company and its profits are important factors
in the company’s ability to pay higher wages and to employ more
people.

4. Business transactions affect a company’s financial position, and as a

result they change the statement of financial position or balance sheet.
The other financial statements – the income statement and the statement
of cash flows – are detailed expansions of certain aspects of the
statement of financial position and help explain how the company’s
position changed over time.
5. The cost principle indicates that many assets are included in the financial
records, and therefore, in the statement of financial position, at their
original cost to the reporting enterprise. This principle affects

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accounting for assets in several ways, one of which is that the amount of
most assets is not adjusted periodically for changes in the market value
of the assets. Instead, cost is retained as the basic method of accounting,
regardless of changes in the market value of those assets.

6. The going concern assumption states that in the absence of evidence to

the contrary (i.e., bankruptcy proceedings), an enterprise is expected to
continue to operate in the foreseeable future. This means, for example,
that it will continue to use the assets it has in its financial statements for
the purpose for which they were acquired.

7. The three categories and the information included in each are:

Operating activities – Cash provided by and used in revenue and expense
transactions.
Investing activities – Cash provided by and used as a result of
investments in assets, such as machinery, equipment, land, and
buildings.
Financial activities – Cash provided by and used in debt and equity
financing, such as borrowing and repaying loans, and investments from
and dividends paid to the enterprise’s owners.

8. Adequate disclosure refers to the requirement that financial statements,

including accompanying notes, must include information necessary for
reasonably informed users of financial statements to understand the
company’s financial activities. This requirement is often met, in part, by
the addition of notes to the financial statements. Financial statement
notes include both quantitative and qualitative information that is not
included in the body of the financial statements.

9. A strong income statement is one that has significantly more pesos of

revenue than expenses, resulting in net income that is a relatively high
percentage of the revenue figure. A trend of relatively high income
numbers over time signals a particularly strong income situation.

10. A strong statement of cash flows is one that shows significant amounts
of cash generated from operating activities. This means that the
enterprise is generating cash from its ongoing activities and is not
required to rely on continuous debt and equity financing, or the sale of
its major assets.

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11. The purpose of classifications in financial statements is to develop useful

subtotals, which help users analyze the statements. The most commonly
used classifications are:
In a balance sheet: current assets, plant and equipment, other assets,
current liabilities, long-term liabilities and equity.
In a multiple-step income statement: revenue, cost of goods sold,
operating expenses, and nonoperating items. The operating expense
section often includes subclassifications for selling expenses and for
general and administrative expenses.
In a statement of cash flows: operating activities, investing activities,
and financing activities.

12. In classified financial statements, similar items are grouped together to

produce subtotals which may assist users in their analyses. Comparative
financial statements show financial statements for two or more time
periods in side-by-side columns. Consolidated statements include not
only the financial statement amounts for the company itself but also for
any subsidiary companies that it owns. The financial statements of large
corporations often possess all three of these characteristics.

13. In a multiple-step income statement, different categories of expenses are

deducted from revenue in a series of steps, thus resulting in various
subtotals, such as gross profit and operating income. In a single-step
income statement, all expenses are combined and deducted from total
revenue in a single step. Both formats result in the same amount of net
income.

II. Matching Type

1.
1. d 3. a 5. e 7. f 9. c
2. g 4. j 6. h 8. b 10. i

2.
1. d 3. i 5. m 7. h 9. f 11. b 13. e
2. a 4. g 6. c 8. n 10. k 12. j 14. l

3.
a. F c. F e. I g. F I. I k. F
b. I d. I f. F h. F j. F l. I

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III. Problems

Problem 1 (Preparing a Balance Sheet – A Second Problem)

Requirement (a)
SM Farms
Balance Sheet
September 30, 2005

Assets Liabilities and Equity

Cash P 16,710 Liabilities:
Accounts receivable 22,365 Notes payable P530,000

Land 550,000 Accounts payable 77,095

Barns and sheds 78,300 Property taxes payable 9,135
Citrus trees 76,650 Wages payable 1,820
Livestock 120,780 Total liabilities P618,050
Irrigation system 20,125 Equity:
Farm machinery 42,970 Share capital 250,000
Fences & gates 33,570 Retained earnings* 93,420
Total P961,470 Total P961,470

* Total assets, P961,470, minus total liabilities, P618,050, less share capital,
P250,000.

Requirement (b)
The loss of an asset, Barns and Sheds, from a typhoon would cause a
decrease in total assets. When total assets are decreased, the balance sheet
total of liabilities and equity must also decrease. Since there is no change in
liabilities as a result of the destruction of an asset, the decrease on the right-
hand side of the balance sheet must be in the retained earnings account. The
amount of the decrease in Barns and Sheds, in the equity, and in both
balance sheet totals, is P23,800.
Problem 2 (Preparing a Balance Sheet and Cash Flow Statement;
Effects of Business Transactions)

Requirement (a)
The Tasty Bakery
Balance Sheet
August 1, 2005

Assets Liabilities and Equity

Cash P 6,940 Liabilities:

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Accounts receivable 11,260 Notes payable P 74,900

Supplies 7,000 Accounts payable 16,200

Land 67,000 Salaries payable 8,900
Building 84,000 Total liabilities P100,000
Equipment and fixtures 44,500 Equity:
Share capital 80,000
Retained earnings 40,700
Total P220,700 Total P220,700

Requirement (b)
The Tasty Bakery
Balance Sheet
August 3, 2005

Assets Liabilities and Equity

Cash P 14,490 Liabilities:
Accounts receivable 11,260 Notes payable P 74,900

Supplies 8,250 Accounts payable 7,200

Land 67,000 Salaries payable 8,900
Building 84,000 Total liabilities P 91,000
Equipment and fixtures 51,700 Equity:
Share capital 105,000
Retained earnings 40,700
Total P236,700 Total P236,700

The Tasty Bakery

Statement of Cash Flows
For the Period August 1 - 3, 2005

Cash flows from operating activities:

Cash payment of accounts payable P(16,200)
Cash purchase of supplies (1,250)
Cash used in operating activities P(17,450)

Cash flows from investing activities:

None

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Cash flows from financing activities:

Sale of share capital P25,000

Increase in cash P 7,550

Cash balance, August 1, 2005 6,940
Cash balance, August 3, 2005 P14,490

Requirement (c)
The Tasty Bakery is in a stronger financial position on August 3 than it was
on August 1.

On August 1, the highly liquid assets (cash and accounts receivable) total
only P18,200, but the company has P25,100 in debts due in the near future
(accounts payable plus salaries payable).

On August 3, after additional infusion of cash from the sale of stock, the
liquid assets total P25,750, and debts due in the near future amount to
P16,100.

Note to Instructor: The analysis of financial position strength in requirement

(c) is based solely upon the balance sheets at August 1 and August 3.
Hopefully, students will raise many legitimate issues regarding necessity of
information about operations, rate at which cash flows into the business, etc.
In this problem, the improvement in financial position results solely from the
sale of share capital.

Problem 3 (Preparing Financial Statements; Effects of Business

Transactions)

Requirement (a)
The First Malt Shop
Balance Sheet
September 30, 2005

Assets Liabilities and Equity

Cash P 7,400 Liabilities:
Accounts receivable 1,250 Notes payable* P 70,000

Supplies 3,440 Accounts payable 8,500

Land 55,000 Total liabilities P 78,500

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Building 45,500 Equity:

Share capital 50,000
Furniture & fixtures 20,000 Retained earnings 4,090
Total P132,590 Total P132,590

* Total assets, P132,590, less equity, P54,090, less accounts payable, P8,500,
equals notes payable.

Requirement (b)
The First Malt Shop
Balance Sheet
October 6, 2005

Assets Liabilities and Equity

Cash P 29,400 Liabilities:
Accounts receivable 1,250 Notes payable P 70,000

Supplies 4,440 Accounts payable 18,000

Land 55,000 Total liabilities P 88,000
Building 45,500 Equity:
Share capital 80,000
Furniture & fixtures 38,000 Retained earnings 5,590
Total P173,590 Total P173,590

The First Malt Shop

Income Statement
For the Period October 1-6, 2005

Revenues P 5,500
Expenses (4,000)
Net income P 1,500

The First Malt Shop

Statement of Cash Flows
For the Period October 1-6, 2005

Cash flows from operating activities:

Cash received from revenues P5,500
Cash paid for expenses (4,000)

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Cash paid for accounts payable (8,500)

Cash paid for supplies (1,000)
Cash used in operating activities P(8,000)
Cash flows from investing activities:
None
Cash flows from financing activities:
Cash received from sale of share capital P30,000
Increase in cash P 22,000
Cash balance, October 1, 2005 7,400
Cash balance, October 6, 2005 P29,400

Requirement (c)
The First Malt Shop is in a stronger financial position on October 6 than on
September 30. On September 30, the company had highly liquid assets
(cash and accounts receivable) of P8,650, which barely exceeded the P8,500
in liabilities (accounts payable) due in the near future. On October 6, after
the additional investment of cash by shareholders, the company’s cash alone
exceeded its short-term obligations.

Problem 4 (Preparing a Balance Sheet; Discussion of Accounting

Principles)

Requirement (1)
Fil-Cinema Scripts
Balance Sheet
November 30, 2005

Assets Liabilities and Equity

Cash P 3,940 Liabilities:
Notes receivable 2,200 Notes payable P 73,500

Accounts receivable 2,450 Accounts payable 32,700

Land 39,000 Total liabilities P106,200
Building 54,320 Equity:
Share capital 5,000
Office furniture* 12,825 Retained earnings 3,535
Total P114,735 Total P114,735

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* P8,850 + P6,500 – P2,525.

Requirement (2)
(1) The cash in Cruz’s personal savings account is not an asset of the
business entity Fil-Cinema Scripts and should not appear in the balance
sheet of the business. The money on deposit in the business bank
account (P3,400) and in the company safe (P540) constitute cash owned
by the business. Thus, the cash owned by the business at November 30
totals P3,940.

(2) The years-old IOU does not qualify as a business asset for two reasons.
First, it does not belong to the business entity. Second, it appears to be
uncollectible. A receivable that cannot be collected is not viewed as an
asset, as it represents no future economic benefit.

(3) The total amount to be included in “Office furniture” for the rug is
P9,400, the total cost, regardless of whether this amount was paid in
cash. Consequently, “Office furniture” should be increased by P6,500.
The P6,500 liability arising from the purchase of the rug came into
existence prior to the balance sheet date and must be added to the “Notes
payable” amount.
(4) The computer is no longer owned by Hollywood Scripts and therefore
cannot be included in the assets. To do so would cause an overstatement
of both assets and equity. The “Office furniture” amount must be
reduced by P2,525.

(5) The P22,400 described as “Other assets” is not an asset, because there is
no valid legal claim or any reasonable expectation of recovering the
income taxes paid. Also, the payment of income taxes by Cruz was not
a business transaction by Fil-Cinema Scripts. If a refund were obtained
from the government, it would come to Cruz personally, not to the
business entity.

(6) The proper valuation for the land is its historical cost of P39,000, the
amount established by the transaction in which the land was purchased.
Although the land may have a current fair value in excess of its cost, the
offer by the friend to buy the land if Cruz would move the building
appears to be mere conversation rather than solid, verifiable evidence of
the fair value of the land. The “cost principle,” although less than
perfect, produces far more reliable financial statements than would result
if owners could “pull figures out of the air” in recording asset values.

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(7) The accounts payable should be limited to the debts of the business,
P32,700, and should not include Cruz’s personal liabilities.

IV. Multiple Choice Questions

1. D 11. B 21. B 31. B

2. D 12. C 22. C 32. D
3. D 13. D 23. A 33. D
4. B 14. A 24. B 34. D
5. A 15. D 25. A 35. C
6. B 16. A 26. D 36. A
7. D 17. A 27. B 37. A
8. C 18. B 28. B 38. C
9. B 19. C 29. D
10. C 20. C 30. C

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