Far module 2 Flashcards
rranty is for five years and can be sold separately at a cost of $10,000. Which of the following statements is most accurate in regard to this transaction?
A. The warranty will represent 20 percent of the allocated contract price. B. The price of the contract will be allocated $10,000 to the warranty and $35,000 to the refrigerator. C. The refrigerator and warranty together represent a single performance obligation. D. The contract price should be adjusted to $50,000.
Choice “A” is correct. The warranty, because it can be sold separately, will be treated as a separate performance obligation from the sale of the refrigerator. As such, the $45,000 contract price will need to be allocated between the warranty and the refrigerator. Based on the separate values of $10,000 for the warranty and $40,000 for the refrigerator (totaling $50,000), the most appropriate allocation will be 20 percent of the contract price ($9,000) for the warranty and 80 percent of the price ($36,000) for the refrigerator.
Choice “B” is incorrect. Both the warranty and the refrigerator will be allocated values in proportion to their individual stand-alone values within the overall contract price of $45,000. The allocation should be $9,000 for the warranty and $36,000 for the refrigerator.
Choice “C” is incorrect. The refrigerator and warranty are separate performance obligations.
Choice “D” is incorrect. The contract price does not need to be adjusted. It should remain at $45,000 and the price allocated to each component.
Which of the following is used in calculating the income recognized in the fourth and final year of a contract when revenue is recognized over time?
Actual
Total Costs
Income Previously
Recognized
A. Yes
Yes
B. No
Yes
C. No
No
D. Yes
No
Choice “A” is correct. When revenue is recognized over time, annual gross profit equals [total cost incurred/total expected cost] × [total expected gross profit] less total gross profit previously recognized. In the final year of the contract, actual rather than expected amounts are used.
6
MCQ-05084
Application
Sonex Construction Co. incurred the following costs and made the following estimates in the first two years of a three-year construction project.
Year 1 Year 2
Actual current year costs incurred
1,200,000
1,000,000
Estimated costs to complete contract
1,800,000 550,000
Contract price
5,000,000 5,000,000
Billings and collections
2,500,000 1,500,000
If revenue is recognized over time, how much gross profit would Sonex recognize in Year 2?
A. $650,000 B. $562,500 C. $1,000,000 D. $800,000
Explanation
Choice “C” is correct.
Year 1 Year 2
Contract Price
5,000,000
5,000,000
Cumulative actual costs
1,200,000
2,200,000
Estimated remaining costs
1,800,000
550,000
Estimated total gross profit
2,000,000
2,250,000
Multiply by completion percentage
40%*
80%**
Cumulative gross profit recognized
800,000
1,800,000
Less previously recognized gross profit
0
800,000
Current year gross profit to be recognized
800,000
1,000,000
*[1,200,000 ÷ 3,000,000] = 40%
**[2,200,000 ÷ 2,750,000] = 80%
Choices “B”, “D”, and “A” are incorrect per the above calculation.
Frame construction company’s contract requires the construction of a bridge in three years. The expected total cost of the bridge is $2,000,000, and Frame will receive $2,500,000 for the project. The actual costs incurred to complete the project were $500,000, $900,000, and $600,000, respectively, during each of the three years. Progress payments received by Frame were $600,000, $1,200,000, and $700,000, respectively. Assuming that revenue is recognized over time, what amount of gross profit would Frame report during the last year of the project?
Choice “A” is correct. The expected gross profit from this contract is $500,000 ($2,500,000 sales price − $2,000,000 anticipated costs). The actual project costs are $2,000,000 ($500,000 + $900,000 + $600,000).
In the first year, the percentage of completion was 25% ($500,000 / $2,000,000), so gross profit of $125,000 (25% x $500,000) was recognized.
In the second year, the percentage of completion was 70% [($500,000 + $900,000) / $2,000,000], so cumulative gross profit was $350,000.
Finally, in the third year, the project was completed, so the remaining 30% of the profit is recognized: $500,000 x 30% = $150,000.
Choices “D”, “C”, and “B” are incorrect as per the explanation above.
Jersey Inc. is a retailer of home appliances and offers a service contract on each appliance sold. Jersey sells appliances on installment contracts, but all service contracts must be paid in full at the time of sale. Collections received for service contracts should be recorded as an increase in a:
A. Sales contracts receivable valuation account. B. Service revenue account for the amount paid in full. C. Unearned service revenue account. D. Stockholders' valuation account.
Explanation
Choice “C” is correct. Collections received for service contracts should be recorded as an increase in an unearned service revenue account.
Choices “A” and “D” are incorrect. Since service contracts must be paid in full at the time of sale, valuation accounts (receivables or equity) are not involved.
Choice “B” is incorrect. Service revenue is recognized over time as the customer receives the benefits of Jersey Inc.’s performance as it performs the service performance obligation.
If revenue is recognized over time, the calculation of the income recognized in the third year of a five-year construction contract includes the ratio of:
A. Costs incurred in year 3 to total estimated costs. B. Costs incurred in year 3 to total billings. C. Total costs incurred to date to total estimated costs. D. Total costs incurred to date to total billings.
Choice “C” is correct. When revenue is recognized over time, the percentage of completion is calculated as follows:
Total cost to date
Total estimated cost of contract
Choices “B”, “A”, and “D” are incorrect, per the explanation above.
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
14
MCQ-07538
Application
Loomis Inc. received $90,000 on March 1, Year 2, for work to be performed over the next six months. The company, which has a fiscal year-end of June 30, records revenue evenly over the period of work performance. In its June 30, Year 3, financial statements, Loomis will record a:
A. Debit to deferred revenue of $30,000. B. Credit to deferred revenue of $30,000. C. Credit to revenue of $60,000. D. Debit to revenue of $60,000.
Explanation
Choice “A” is correct. On March 1, Year 2, Loomis will record the following journal entry:
Debit (Dr) Credit (Cr)
Cash
$90,000
Deferred revenue
$90,000
On the Year 2 financial statements (ending June 30, Year 2), Loomis will record the following journal entry:
Debit (Dr) Credit (Cr)
Deferred revenue
$60,000
Revenue
$60,000*
- (recognizing four of the six months)
When work is completed on August 31, Year 3, Loomis will recognize the remaining two months of revenue:
Debit (Dr) Credit (Cr)
Deferred revenue
$30,000
Revenue
$30,000
This question asks about the June 30, Year 3 statements, so the company will record a debit to deferred revenue of $30,000, recognizing the remaining two months of revenue and removing the liability.
Choice “B” is incorrect. Deferred revenue is credited for $30,000 in Year 2 rather than in Year 3.
Choice “C” is incorrect. The revenue credit is $60,000 in Year 2.
Choice “D” is incorrect. Recognizing revenue requires a credit, rather than a debit. Also, revenue will be credited for $30,000 in Year 3.
The cumulative effect of a change in accounting estimate should be shown separately:
A. It should not be recorded separately on any financial statement. B. On the retained earnings statement as an adjustment to the beginning balance. C. On the income statement after income from continuing operations and before discontinued operations. D. On the income statement above income from continuing operations.
Choice “A” is correct. A change in estimate is handled prospectively. No cumulative effect adjustment is made and no separate line item presentation is made on any financial statement. If a material change is being made, appropriate footnote disclosure is necessary.
Choices “D”, “C”, and “B” are incorrect, per the above explanation.
What amount, before income taxes, should be reported in the Year 4 retained earnings statement as the cumulative effect of the change in accounting principle?
A. $5,000 decrease. B. $2,000 increase. C. $0. D. $3,000 decrease.
Choice “A” is correct. $5,000 decrease.
The cumulative effect of change in accounting principle is determined as of the beginning of the year of change if comparative financial statements are not presented. In this case, the year of change is Year 4, so the cumulative effect is the difference in inventory as of the end of Year 3. [Note that inventory is a balance sheet item, so the change is based on the balances at the end of the last year the prior method was used. Had this question shown annual income statement amounts of cost of goods sold, we would have had to look at all the past years in the aggregate.] This will allow us to arrive at the adjustment to obtain the amount of retained earnings that would have been reported at the beginning of the period of change if the new accounting principle had been used for all prior periods.
Year 3
FIFO (current method)
83,000
Weighted average (new method)
(78,000)
Decrease in retained earnings
5,000
On January 1, Year 1, Pell Corp. purchased a machine having an estimated useful life of 10 years and no salvage. The machine was depreciated by the double declining balance method for both financial statement and income tax reporting. On January 1, Year 6, Pell changed to the straight-line method for financial statement reporting but not for income tax reporting. Accumulated depreciation at December 31, Year 5, was $560,000. If the straight-line method had been used, the accumulated depreciation at December 31, Year 5, would have been $420,000. Pell’s enacted income tax rate for Year 6 and thereafter is 30%. The amount shown in the Year 6 income statement for the cumulative effect of changing to the straight-line method should be:
A. $0. B. $98,000 credit. C. $98,000 debit. D. $140,000 credit.
Choice “A” is correct. A change in the method of depreciation is now considered to be both a change in method and a change in estimate. These changes should be accounted for as changes in estimate and handled prospectively. The new depreciation method should be used as of the beginning of the year of change and should start with the current book value of the underlying asset. No retroactive or retrospective calculations should be made, and no adjustment should be made to retained earnings. And, certainly, the cumulative effect should not be reflected on the income statement any more.
Choices “C”, “B”, and “D” are incorrect, per the above explanation.
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
26
MCQ-00226
Application
While preparing its Year 3 financial statements, Dek Corp. discovered computational errors in its Year 2 and Year 1 depreciation expense. These errors resulted in overstatement of each year’s income by $25,000, net of income taxes. The following amounts were reported in the previously issued financial statements:
Year 2 Year 1
Retained earnings, 1/1
700,000
500,000
Net income
150,000
200,000
Retained earnings, 12/31
850,000
700,000
Dek’s Year 3 net income is correctly reported at $180,000. Which of the following amounts should be reported as prior period adjustments and net income in Dek’s Year 3 and Year 2 comparative financial statements?
Year
Prior Period
Adjustment
Net Income
A.
Year 2
-
$150,000
Year 3
($50,000)
$180,000
B. Year 2
($25,000)
$125,000
Year 3
-
$180,000
C. Year 2
($50,000)
$150,000
Year 3
-
$180,000
D. Year 2
-
$125,000
Year 3
-
$180,000
Explanation
Choice “B” is correct. Because these are comparative financial statements, prior period adjustments require retroactive treatment for the years presented. Because Year 1 is not presented, the Year 1 correction is shown as a prior period adjustment of $25,000 to retained earnings statement of Year 2. The Year 2 net income is decreased by $25,000 to correct the overstatement of net income in that period.
Mill Co. reported pretax income of $152,500 for the year ended December 31. During the year-end audit, the external auditors discovered the following errors:
Ending inventory
$30,000 overstated
Depreciation expense
$64,000 understated
What amount should Mill report as the correct pretax income for the year ended December 31?
A. $186,500 B. $246,500 C. $118,500 D. $58,500
Choice “D” is correct. The pretax income of $152,500 is too high as a result of both errors.
Ending inventory that is overstated by $30,000 implies that cost of goods sold (COGS) is understated by the same amount. $30,000 should be added to COGS, which will reduce pretax income.
Depreciation expense is understated by $64,000. Adding in this expense will also reduce pretax income.
$152,500 − $30,000 − $64,000 = $58,500.
Choice “A” is incorrect. This choice implies that depreciation is overstated (not understated) by $64,000.
Choice “B” is incorrect. This choice incorrectly adds back both the $30,000 in overstated ending inventory and $64,000 in understated depreciation expense.
Choice “C” is incorrect. This choice implies that COGS is overstated (not understated) by $30,000.
On January 2, Year 4, Raft Corp. discovered that it had incorrectly expensed a $210,000 machine purchased on January 2, Year 1. Raft estimated the machine’s original useful life to be 10 years and its salvage value at $10,000. Raft uses the straight-line method of depreciation and is subject to a 30% tax rate. In its December 31, Year 4, financial statements, what amount should Raft report as a prior period adjustment?
A. $168,000 B. $165,900 C. $105,000 D. $102,900
Choice “C” is correct. If the machine had been correctly capitalized in Year 1, Raft would have recorded annual depreciation of $20,000 [($210,000 cost - $10,000 salvage)/10 year life] in Year 1, Year 2 and Year 3, for total accumulated depreciation of $60,000. The prior period adjustment is the difference between the $60,000 in total expense that should have been reflected in retained earnings on January 1, Year 4 and the $210,000 that was incorrectly recorded:
Correct accounting - Depreciation expense Year 1 - Year 3
60,000
Incorrect accounting - Asset purchased expense in Year 1
-210,000
Prior period adjustment, before tax
150,000
The prior period adjustment must be reported net of tax:
$150,000 x (1 - 30%) = $105,000
Which of the following phrases best describes a Level 1 input for measuring the fair value of an asset or liability?
A. Unadjusted quoted prices for identical assets or liabilities in active markets. B. Inputs that are principally derived from or corroborated by observable market data. C. Quoted prices for similar assets or liabilities in active markets. D. Inputs for the asset or liability based on the reporting entity’s internal data.
Choice “A” is correct. Level 1 inputs are quoted prices in active markets for identical assets and liabilities on the measurement dates when no adjustments are required.
Choice “B” is incorrect. Inputs that are principally derived from or corroborated by observable market data are examples of Level 2 inputs.
Choice “C” is incorrect. Quoted prices for similar assets or liabilities in active markets are Level 2 inputs.
Choice “D” is incorrect. Inputs based on the reporting entity’s internal data are examples of Level 3 inputs.
A change from the cost approach to the market approach of measuring fair value is considered to be what type of accounting change?
A. Change in accounting estimate. B. Change in accounting principle. C. Change in valuation technique. D. Error correction.
Choice “A” is correct. A change in the valuation technique used to measure fair value is a change in accounting estimate.
Choice “B” is incorrect. Per SFAS No. 157, a change in valuation technique is a change in accounting estimate, not a change in accounting principle.
Choice “C” is incorrect. Although a change from the cost approach to the market approach is a change in valuation technique, a change in valuation technique is not defined as a type of accounting change, but instead falls into the category of changes in accounting estimate.
Choice “D” is incorrect. Both the market approach and the cost approach are acceptable methods of measuring fair value per SFAS No. 157; therefore, switching between these methods is not the correction of an error. Additionally, an error correction is not a type of accounting change.
Each of the following would be considered a Level 2 observable input that could be used to determine an asset or liability’s fair value, except:
A. Quoted prices for similar assets and liabilities in markets that are active. B. Interest rates that are observable at commonly quoted intervals. C. Internally generated cash flow projections for a related asset or liability. D. Quoted prices for identical assets and liabilities in markets that are not active.
Choice “C” is correct. Internally generated cash flow projections for a related asset or liability would be better classified as a Level 3 input rather than a Level 2 input because the internally generated cash flow projection is based on “unobservable” inputs reflecting a company’s “own assumptions” about the way the related asset or liability would be priced.
Choice “A” is incorrect. Quoted prices for similar assets and liabilities in markets that are active are a Level 2 input.
Choice “B” is incorrect. Interest rates that are observable at commonly quoted intervals are a Level 2 observable input.
Choice “D” is incorrect. Quoted prices for identical assets and liabilities in markets that are not active are a Level 2 observable input.
Crossroads Co. chooses to report a financial asset at its fair value. The asset trades in two different markets; however, neither market is the principal market for the financial asset. In the first market, sales proceeds are $76, which is net of transaction costs of $6. In the second market, the sales proceeds are $80, which is net of transaction costs of $1. What amount should Crossroads report as the fair value of the asset?
A. $80 B. $76 C. $82 D. $81
Choice “D” is correct. If the principal market (the market with the greatest volume and level of activity) cannot be identified, the most advantageous market should be used when determining the fair value of a financial asset. The most advantageous market will be the one which generates the highest net price, after considering transaction costs. However, the transaction costs will not be incorporated into the fair value. The second market generates the highest net price of $80 after considering transaction costs; therefore, it should be used for fair value purposes. The fair value amount will exclude transaction costs, which results in a fair value of $81 for the asset.
Choice “A” is incorrect. Though the transaction costs are used to determine the most advantageous market, they are not used to determine the fair value of the asset.
Choice “B” is incorrect. The first market is not the most advantageous market since the selling price less transaction costs results in the lower of the two market values.
Choice “C” is incorrect. This answer correctly adds back the transaction costs in determining fair value, but it incorrectly uses the price provided in the first market. The first market is not the most advantageous market since the selling price less transaction costs results in the lower of the two market values.
A company records items on the cash basis throughout the year and converts to an accrual basis for year-end reporting. Its cash-basis net income for the year is $70,000. The company has gathered the following comparative balance sheet information:
Beginning
of year End
of year
Accounts payable
3,000
1,000
Unearned revenue
300
500
Wages payable
300
400
Prepaid rent
1,200
1,500
Accounts receivable
1,400
600
What amount should the company report as its accrual-based net income for the current year?
A. $68,800 B. $71,200 C. $70,200 D. $73,200
Explanation
Choice “B” is correct. One approach for converting from cash-basis to accrual-basis is as follows:
Add increases in current assets. For example, when AR increases, the increase is not considered to be income under the cash basis because the cash has not been collected, but the increase is income under the accrual basis.
Subtract decreases in current assets. Conversely, when AR decreases, then cash-basis counted it as revenue when the cash was collected, but under the accrual basis, the income was recognized in a prior period and should not be recognized again in the current period.
Add decreases in current liabilities. For example, when AP decreases, this represents a cash outflow that is recorded as an expense under the cash basis. However, under the accrual basis the paid expenses were recorded in a prior period and should not be recorded again in the current period.
Subtract increases in current liabilities. Conversely, when AP increases, this represents expenses incurred under the accrual basis method that have not been recorded under the cash basis method because they have not been paid.
Therefore, starting with the $70,000, we add the $2,000 decrease in AP, subtract the $200 and $100 increases in unearned revenue and wages payable, add the $300 increase in prepaid rent, and finally subtract the $800 decrease in accounts receivable:
$70,000 + $2,000 - $300 + $300 - $800 = $71,200
Ward, a consultant, keeps her accounting records on a cash basis. During Year 2, Ward collected $200,000 in fees from clients. At December 31, Year 1, Ward had accounts receivable of $40,000. At December 31, Year 2, Ward had accounts receivable of $60,000, and unearned fees of $5,000. On an accrual basis, what was Ward’s service revenue for Year 2?
A. $175,000 B. $180,000 C. $225,000 D. $215,000
Choice “D” is correct. $215,000 service revenue for Year 2.
Cash basis revenue
$200,000
+ Ending AR
+ 60,000
- Beginning AR
- 40,000
- Ending unearned fees
- 5,000
Accrual basis revenue
$215,000
Dannon Co. mistakenly reported its expenses of $35,200 on the cash basis. Corporate records revealed the following information:
Beginning prepaid expense
1,300
Beginning accrued expense
1,650
Ending prepaid expense
1,800
Ending accrued expense
1,200
What amount of expense should Dannon report on its books under the accrual basis?
A. $35,300 B. $34,250 C. $35,150 D. $36,150
Choice “B” is correct. The cash basis does not account for expenses incurred where there was no cash outflow, and it may include cash payments that did not relate to expenses incurred during the period. The cash basis expense of $35,200 must be reduced by $500 for the change in prepaid expenses, as this change indicates that more cash was paid than expense incurred. It must also be reduced by the change in accrued expenses as this $450 decrease indicates more cash was paid than expense incurred. Once these two adjustments are made ($35,200 – $500 – $450), Dannon Co. will report the correct accrual basis expense number of $34,250.
Prepaid Expenses
Accrued Expense
$1,300
|
|
$1,650
Cash
→
Expense
Cash
→
| →
Expense
$1,800
|
|
$1,200
An alternative way to answer this problem is to adjust for the beginning and ending balances.
35,200
Cash basis expense.
+ 1,300
Beginning balance is an expense that will be incurred this period (cash paid last period).
− 1,800
Ending balance relates to cash payment for expense that will be incurred next year.
− 1,650
Beginning balance was expensed last year and will be paid in cash this year.
+ 1,200
Ending balance is expense this year that will be paid in cash next year.
34,250
Accrual basis expense.
Choice “A” is incorrect. Adjusting in any way for the change in prepaid expenses and the change in accrued expenses does not result in $35,300.
Choice “C” is incorrect. The $35,150 results from adding the beginning accrued expense number and subtracting the ending accrued expense balance. Those adjustments are incorrect as they indicate more expense was incurred during the year than cash paid.
Choice “D” is incorrect. The $36,150 results from making the opposite adjustments for both accounts, as if an accrual basis expense number was being converted to a cash basis expense number.
→
Marr Corp. reported rental revenue of $2,210,000 in its cash basis federal income tax return for the year ended November 30, Year 2. Additional information is as follows:
Rents receivable - November 30, Year 2
1,060,000
Rents receivable - November 30, Year 1
800,000
Uncollectible rents written off during the fiscal year
30,000
Under the accrual basis, Marr should report rental revenue of:
A. $2,440,000 B. $1,980,000 C. $1,920,000 D. $2,500,000
Choice “D” is correct. $2,500,000 rental revenue under the accrual basis.
Rents receivable at begin 11/30/Year 1
800,000
Add: Billings accrued
2,500,000
Sub Total
3,300,000
Less: Cash collections
(2,210,000)
Write-offs
(30,000)
Rents receivable at end 11/30/Year 2
1,060,000
A company reports on the cash basis. During the company’s first year of business, it had sales on account of $1,000,000, inventory purchases on account of $400,000, and other expenses of $200,000. At the end of the year, the company had accounts receivable, inventory, and inventory-related accounts payable of $100,000, $10,000, and $50,000, respectively. What is the company’s cash basis income for its first year of operations?
A. $400,000 B. $300,000 C. $350,000 D. $450,000
Choice “C” is correct. Cash basis income is derived by comparing cash inflows to cash outflows. In Year 1, if credit sales totaled $1,000,000 and accounts receivable was $100,000 at year-end, this implies cash collected of $900,000. In Year 1, if credit purchases totaled $400,000 and accounts payable was $50,000 at year-end, this implies cash paid to vendors of $350,000. $200,000 in other expenses represents a cash outflow as well.
Cash basis income = $900,000 − $350,000 − $200,000 = $350,000. Note that the balance of $10,000 in inventory has no impact on the calculation.
Choice “A” is incorrect. This answer choice incorrectly ignores both the ending accounts payable balance and the ending accounts receivable balance.
Choice “B” is incorrect. This answer choice ignores the ending accounts payable balance of $50,000.
Choice “D” is incorrect. This answer choice ignores the ending accounts receivable balance of $100,000.
Ina Co. had the following beginning and ending balances in its prepaid expense and accrued liabilities accounts for the current year:
Prepaid
expenses
Accrued
liabilities
Beginning balance
5,000
8,000
Ending balance
10,000
20,000
Debits to operating expenses totaled $100,000. What amount did Ina pay for operating expenses during the current year?
A. $93,000 B. $107,000 C. $117,000 D. $83,000
Explanation
Choice “A” is correct. The starting point for this problem is the $100,000 of debits to operating expenses. The increase in accrued liabilities represents operating expenses which have been incurred or used but not paid. To determine the amount of operating expenses which have been paid, the $12,000 increase in accrued liabilities must be subtracted from the $100,000 of operating expenses, because operating expenses would have been debited each time the accrued liability account was credited in the following manner.
Debit (Dr) Credit (Cr)
Operating Expense
XXX
Accrued Liability
XXX
The increase in prepaid expenses represents operating expenses which have been paid but not yet used or incurred. To get the amount paid for operating expenses, the increase in prepaid expenses must be added to the $100,000 of operating expenses. An increase in the prepaid account represents cash payment of an operating expense not recorded as a debit to operating expense. The correct answer of $93,000 is calculated as $100,000 of debits to operating expenses less the $12,000 increase in accrued liabilities plus the $5,000 increase in prepaid expenses.
Choice “B” is incorrect. The $100,000, which represents the amount debited to operating expenses, must be adjusted downward by the increase in accrued liabilities of $12,000 and adjusted upward by the increase in prepaid expenses of $5,000 to calculate the amount of operating expenses which were paid. This answer does the opposite: $100,000 plus $12,000 minus $5,000.
Choice “C” is incorrect. This answer is incorrect because it adds both the increase in accrued liabilities and the increase in prepaids to the $100,000.
Choice “D” is incorrect. The increase in the prepaid expense represents operating expenses which have been purchased (paid) but not used. To correctly calculate the amount paid for operating expenses, the increase in the prepaid account must be included as a plus and not a minus.
In its cash flow statement for the current year, Ness Co. reported cash paid for interest of $70,000. Ness did not capitalize any interest during the current year. Decreases occurred in several balance sheet accounts as follows:
Accrued interest payable
$17,000
Prepaid interest
23,000
In its income statement for the current year, what amount should Ness report as interest expense?
A. $76,000 B. $30,000 C. $64,000 D. $110,000
Choice “A” is correct. Interest expense is reported on a cash basis in the Statement of Cash Flows, and on the accrual basis in the Income Statement. Convert from cash basis to accrual basis:
Cash basis interest expense
70,000
Add decrease in prepaid interest
23,000
Subtotal
93,000
Subtract decrease in interest payable
(17,000)
Accrual basis interest expense
76,000
The decrease in prepaid interest is added when calculating accrual basis interest expense because a decrease in prepaid interest increases interest expense:
Debit (Dr) Credit (Cr)
Interest expense
XX
Prepaid interest
XX
The decrease in interest payable is subtracted when calculating accrual basis interest expense because a decrease in interest payable implies that cash interest payments exceeded accrual basis interest expense.
MK Enterprises, Inc. started business on January, 1, Year 1 and keeps its books on the cash basis of accounting. The trial balance of the company at December 31, Year 1 is as follows:
Selling expenses
DEBIT CREDIT
Cash $5,000
Common stock $10,000
Sales 40,000
Cost of sales 20,000
Payroll expense 8,000
Selling expenses 3,000
Administrative expenses 5,000
Small tools expense 5,000
Income tax expense (estimated tax payments) 4,000
Other information about MK’s operations:
- Customers owe the company $20,000 on unpaid invoices at the end of the year.
- The company has goods with a cost of $12,000 in its warehouse at year end. The company owes its supplier for all of these goods, plus they owe another $2,000 on a prior shipment that was sold during the year.
- The amount the company shows as small tools is for the principal manufacturing asset of the company. The company depreciates its fixed assets on a straight line basis with a five year asset life. Fixed assets are assumed to be purchased at the beginning of the year.
- Included in administrative expenses is a payment on the company’s one year general liability insurance policy for $2,400. The policy was purchased and effective on July 1, Year 1.
- When reconciling the bank accounts for the year, the company discovered that it had received a $500 bad check from a customer. The check was re-deposited and paid in January of Year 2.
- The company estimates that 1.5% of its sales will eventually be uncollectible.
- The company pays its employees on a weekly basis 7 days after the end of the pay period. The last paycheck date for the year was on December 31st. The weekly payroll of the company is $1,300.
- The company’s tax rate is 25%. There were no non-taxable transactions made by the company.
MK Enterprises, Inc. started business on January, 1, Year 1 and keeps its books on the cash basis of accounting. The trial balance of the company at December 31, Year 1 is as follows:
Selling expenses
DEBIT CREDIT
Cash $5,000
Common stock $10,000
Sales 40,000
Cost of sales 20,000
Payroll expense 8,000
Selling expenses 3,000
Administrative expenses 5,000
Small tools expense 5,000
Income tax expense (estimated tax payments) 4,000
Other information about MK’s operations:
- Customers owe the company $20,000 on unpaid invoices at the end of the year.
- The company has goods with a cost of $12,000 in its warehouse at year end. The company owes its supplier for all of these goods, plus they owe another $2,000 on a prior shipment that was sold during the year.
- The amount the company shows as small tools is for the principal manufacturing asset of the company. The company depreciates its fixed assets on a straight line basis with a five year asset life. Fixed assets are assumed to be purchased at the beginning of the year.
- Included in administrative expenses is a payment on the company’s one year general liability insurance policy for $2,400. The policy was purchased and effective on July 1, Year 1.
- When reconciling the bank accounts for the year, the company discovered that it had received a $500 bad check from a customer. The check was re-deposited and paid in January of Year 2.
- The company estimates that 1.5% of its sales will eventually be uncollectible.
- The company pays its employees on a weekly basis 7 days after the end of the pay period. The last paycheck date for the year was on December 31st. The weekly payroll of the company is $1,300.
- The company’s tax rate is 25%. There were no non-taxable transactions made by the company.
JE#1
Accounts receivable $20,000
Sales $20,000
To adjust to accrual basis sales revenue, the sales that were made in Year 1 but not yet collected at the end of the year are added to the sales already booked for the year under the cash basis. The amount uncollected at year-end is accounts receivable.
JE#2
Inventory $12,000
Accounts payable $12,000
Cost of sales $2,000
Accounts payable $2,000
Purchases made on the cash basis of accounting are not recorded until the invoice is paid. Since $12,000 of the goods are still on hand, the amount is recorded under the accrual basis with inventory as a debit and accounts payable as a credit.
The $2,000 of goods sold but not yet paid for is recorded under the accrual basis with a debit to cost of sales and a credit to accounts payable.
JE#3
Factory equipment $5,000
Small tools expense $5,000
Depreciation expense $1,000
Accumulated depreciation $1,000
The asset purchase of $5,000 was recorded as small tools expense under the cash basis. Under the accrual basis, the tools need to be reported as fixed assets with a debit to the factory equipment account. Depreciation is calculated on a straight line basis for one year and totals $1,000.
JE #4
Prepaid insurance $1,200
Administrative expenses $1,200
The insurance policy included as an administrative expense is for one year, from July 1, Year 1 to June 30, Year 2. Since six months are still to run on the policy, prepaid insurance of $1,200 ($2,400 × 6/12) should be reported under the accrual basis.
JE #5
Accounts receivable $500
Cash $500
Under the accrual basis, the bad check would be reported as accounts receivable since it was not paid as of December 31, Year 1.
JE #6
Bad debt expense $900
Allowance for uncollectible accounts $900
The bad debt expense account is calculated based on 1.5% of sales for the year. Sales revenue for the year is $60,000, after including the sales in JE #1. Bad debt expense is $900 ($60,000 × 1.5%).
JE #7
Payroll expense $1,300
Accrued payroll $1,300
Since the company pays its employees seven days after the end of the pay period and the last pay date recorded by the company was December 31st (for time worked through December 24th), under the accrual basis the company has to record accrued payroll for the additional one week that was worked in Year 1 and will be paid on January 7th, Year 2.
JE #8
Income tax expense $1,000
Income tax payable $1,000
On the accrual basis, the company will record the tax liability based on the income shown in the Year 1 accrual basis income statement. The taxable income is calculated as follows:
Cash basis pretax income (from trial balance) ($1,000)
JE #1 - Sales 20,000
JE #2 - Cost of sales (2,000)
JE #3 - Small tools 5,000
JE #3 - Depreciation expense (1,000)
JE #4 - Administrative expenses 1,200
JE #6 - Bad debt expense (900)
JE #7 - Payroll expense (1,300)
Taxable Income $20,000
Total income tax expense = $20,000 × 25% = $5,000
Income tax payable = Total income tax expense - Estimated tax payments = $5,000 - 4,000 = $1,000
The estimated income tax payments offset the total income tax expense and the remaining $1,000 is unpaid at year-end and shown as income tax payable.
Frame Co. has an 8% note receivable dated June 30, Year 1, in the original amount of $150,000. Payments of $50,000 in principal plus accrued interest are due annually on July 1, Year 2, Year 3, and Year 4. In its June 30, Year 3, balance sheet, what amount should Frame report as a current asset for interest on the note receivable?
A. $12,000 B. $4,000 C. $0 D. $8,000
Choice “D” is correct. The current asset for interest receivable on June 30, Year 3, is the interest to be received within one year. Interest to be received on July 1, Year 3 is:
$100,000 balance of note x 8% = $8,000
Choice “A” is incorrect. The current asset for interest receivable on June 30, Year 3, is the interest to be received within one year.
Choice “B” is incorrect. The current asset for interest receivable on June 30, Year 3, is the interest to be received within one year.
Choice “C” is incorrect. The current asset for interest receivable on June 30, Year 3, is the interest to be received within one year.
9
MCQ-00623
Application
Fay Corp. pays its outside salespersons fixed monthly salaries and commissions on net sales. Sales commissions are computed and paid on a monthly basis (in the month following the month of sale), and the fixed salaries are treated as advances against commissions. However, if the fixed salaries for salespersons exceed their sales commissions earned for a month, such excess is not charged back to them. Pertinent data for the month of March for the three salespersons are as follows:
Salesperson
Fixed
Salary
Net
Sales
Commission
Rate
A
10,000
200,000
4%
B
14,000
400,000
6%
C
18,000
600,000
6%
Totals
42,000
1,200,000
What amount should Fay accrue for sales commissions payable at March 31?
A. $68,000 B. $28,000 C. $70,000 D. $26,000
Explanation
Choice “B” is correct. $28,000 sales commissions payable at March 31.
Choice “B” is correct. $28,000 sales commissions payable at March 31.
Sales Persons
A B C Total
Net Sales
200,000
400,000
600,000
Label
× 4%
× 6%
× 6%
Commissions earned
8,000
24,000
36,000
Adjust “A” to fixed salary minimum
2,000
0
0
Commission accrual
10,000
24,000
36,000
70,000
Less fixed
Salary advances
(10,000)
(14,000)
(18,000)
(42,000)
Sales commissions payable
0
10,000
18,000
28,000
Aneen’s Video Mart sells one- and two-year mail order subscriptions for its video-of-the-month business. Subscriptions are collected in advance and credited to sales. An analysis of the recorded sales activity revealed the following:
Year 1 Year 2
Sales
420,000
500,000
Less cancellations
20,000
30,000
Net sales
400,000
470,000
Subscription expirations:
Subscriptions
Sold in Year 1 Subscriptions
Sold in Year 2
Year 1
$120,000
Year 2
155,000
$130,000
Year 3
125,000
200,000
Year 4
140,000
$400,000
$470,000
In Aneen’s December 31, Year 2, balance sheet, the balance for unearned subscription revenue should be:
A. $495,000 B. $470,000 C. $465,000 D. $340,000
Choice “C” is correct. $465,000 unearned subscription revenue.
Net Sales
Subscription Revenue
Subscription
Expirations Year 1
Year 2
Earned
Unearned
Year 1 Earned
120
+
=
120
Year 2 Earned
155
+
130
=
285
Year 3 Unearned
125
+
200
=
325
Year 4 Unearned
+
140
=
140
400
+
470
=
405
+
465
Pane Co. had the following borrowings on its books at the end of the current year:
$100,000, 12 percent interest rate, borrowed five years ago on September 30; interest payable March 31 and September 30.
$75,000, 10 percent interest rate, borrowed two years ago on July 1; interest paid April 1, July 1, October 1, and January 1.
$200,000, noninterest-bearing note, borrowed July 1 of current year, due January 2 of next year; proceeds $178,000.
What amount should Pane report as interest payable in its December 31 balance sheet?
A. $41,500 B. $26,875 C. $6,750 D. $4,875
Explanation
Choice “D” is correct. The interest payable will total the amount of interest incurred that has not been paid in cash. As interest payments are made periodically for both notes, the interest must be prorated based on the number of months outstanding (October–December for both notes). No interest payable will be recorded for the noninterest bearing note, as the interest is implicit in the face value of the note and will already be accounted for in the carrying value of the note payable on the balance sheet. The following is the correct calculation for the two interest bearing notes:
$100,000 × 12% × (3/12) =
3,000
$75,000 × 10% × (3/12) =
1,875
Interest payable =
4,875
Choice “A” is incorrect. The $41,500 amount includes not only the discount related to the noninterest bearing note, which is incorrect, but it also includes the yearly interest for both interest bearing notes ($22,000 + $12,000 + $7,500). Interest must be prorated and only related to the periods in which interest has been incurred but not paid in cash.
Choice “B” is incorrect. The $26,875 amount includes the correct amount of interest for the first two notes ($4,875) but also includes the $22,000 discount on the noninterest bearing note. This amount does represent interest as it is additional cash that will be paid in excess of the amount borrowed; however, it is already included in the carrying value of the note on the balance sheet and would not be separately recorded as interest payable.
Choice “C” is incorrect. The $6,750 amount includes the correct amount of interest for the $100,000 note ($3,000) but prorates the $75,000 for six months out of 12 instead of three months ($75,000 × 10% × 6/12 = $3,750). Only three months of interest should be accrued for the $75,000 note as the last interest payment occurred October 1.
Kemp Co. must determine the December 31, Year 1, year-end accruals for advertising and rent expenses. A $500 advertising bill was received January 7, Year 2, comprising costs of $375 for advertisements in December Year 1 issues, and $125 for advertisements in January Year 2 issues of the newspaper.
A store lease, effective December 16, Year 0, calls for fixed rent of $1,200 per month, payable one month from the effective date and monthly thereafter. In addition, rent equal to 5% of net sales over $300,000 per calendar year is payable on January 31 of the following year. Net sales for Year 1 were $550,000.
In its December 31, Year 1, balance sheet, Kemp should report accrued liabilities of:
A. $13,475 B. $13,000 C. $13,100 D. $12,875
Choice “A” is correct. $13,475 accrued liabilities at 12/31/ Year 1.
Accrued
Liabilities
12/31/Year 1
Advertising for December Year 1 issues
($125 for Jan. Year 2 issues pertain to Year 2)
375
Store lease fixed rent ($1,200 × 1/2 month)
600
Actual net sales
$550,000
Less base sales
(300,000)
Excess
250,000
Percentage
× 5%
Percentage rent
12,500
Total
$13,475
The journal entry to record advertising for December 31, Year 1, is:
DR Advertising Expense
375
CR
Accounts Payable
375
The journal entry to record rent for December 31, Year 1, is:
DR Rent Expense
600
CR
Accrued Liability
600
The lease started on December 16 and the fact pattern indicates the first payment is not due until mid-January (one month from December 16); therefore, a half month of rent should be accrued at the end of each month over the life of the lease.
When the rent payment is made on January 15, Year 2, the entry is:
DR
Accrued Liability
600
DR
Rent Expense
600
CR
Cash
1,200
This entry eliminates the accrued liability from December 31, Year 1, and records rent expense for the first half of January.
On January 31, Year 2, the accrual entry from December should be repeated for the second half of January. These entries began in December because the lease began on December 16, Year 1. Because the lease term occurs mid-month, the accrual will need to be made each month during the entire lease term.
Choice “B” is incorrect. This answer choice excludes the store lease rent of $600 that must be accrued for half of December and includes the $125 in advertisements that will be published in January Year 2. The store lease rent must be included and the $125 in advertisements must be excluded because it relates to January Year 2.
Choice “C” is incorrect. This answer choice incorrectly excludes the $375 in advertising for December Year 1. Because these ads were published in Year 1, the expense needs to be included even though the bill was not received and paid until Year 2.
Choice “D” is incorrect. This answer choice excludes the store lease rent of $600 that must be accrued for half of December. Because this expense relates to Year 1, it should be included as an accrued liability.
On December 31, special insurance costs, incurred but unpaid, were not recorded. If these insurance costs were related to work-in-process, what is the effect of the omission on accrued liabilities and retained earnings in the December 31 balance sheet?
Accrued
liabilities
Retained
earnings
A.
No effect
No effect
B. No effect
Overstated
C. Understated
No effect
D. Understated
Overstated
Choice “C” is correct. Understated. No effect. Since the unrecorded liability affects work-in-process inventory (rather than cost of sales/retained earnings), there is no effect on retained earnings, but accrued liabilities (and inventory) are understated.
Wellstar had $12,000 in earned sales in Year 1, $8,000 of which the company collected in cash by the end of the year. Wellstar recorded no journal entries related to the sale in Year 1. The remaining $4,000 was collected in Year 2, at which point the company recorded a journal entry debiting cash and crediting sales for $12,000.
The correct adjusting entry needed for Wellstar in Year 1 will include a:
A. Credit to sales of $12,000. B. Debit to cash of $4,000. C. Credit to sales of $4,000. D. Debit to cash of $12,000.
Explanation
Choice “A” is correct. Wellstar did not record any journal entries related to the sales in Year 1, so the adjusting entry will be the journal entry the company should have recorded in Year 1.
Debit (Dr) Credit (Cr)
Cash
8,000
Accounts receivable
4,000
Sales
12,000
Choice “B” is incorrect. The cash debit should be for $8,000, which reflects the amount of cash the company received in Year 1.
Choice “C” is incorrect. Because the sales were earned in full in Year 1, the credit should be for the full $12,000.
Choice “D” is incorrect. The stated amount of cash received was $8,000, not $12,000.
Zach Corp. pays commissions to its sales staff at the rate of 3% of net sales. Sales staff are not paid salaries but are given monthly advances of $15,000. Advances are charged to commission expense, and reconciliations against commissions are prepared quarterly. Net sales for the year ended March 31 were $15,000,000. The unadjusted balance in the commissions expense account on March 31 was $400,000. March advances were paid on April 3. In its income statement for the year ended March 31, what amount should Zach report as commission expense?
A. $400,000 B. $450,000 C. $415,000 D. $465,000
Choice “B” is correct. $450,000 commission expense for the year ended 3/31.
Sales of $15,000,000 x 3% = $450,000
Note: “Advances” affect cash flow but do not affect accrual basis expense, thus information on “advances” is a “distractor.”
Encora Inc. uses the accrual basis of accounting and earned $45,000 of sales revenue in Year 1. Encora received cash of $15,000 in Year 1 and $30,000 in Year 2. In Year 1, Encora recorded a debit to cash for $15,000 and a comparable credit to sales revenue. In Year 2, the company records a debit to cash and a credit to sales revenue for the remaining $30,000.
Encora’s adjusting entries for Years 1 and 2 will include a:
A. Debit to accounts receivable and credit to sales of $30,000 in Year 2. B. Debit to accounts receivable and credit to sales of $30,000 in Year 1. C. Debit to sales and credit to accounts receivable of $30,000 in Year 1. D. Debit to cash and credit to accounts receivable of $30,000 in Year 2.
Explanation
Choice “B” is correct. In Year 1, Encora recorded:
Debit (Dr) Credit (Cr)
Cash
15,000
Sales
15,000
Encora should have recorded:
Debit (Dr) Credit (Cr)
Cash
15,000
Accounts receivable
30,000
Sales
45,000
The adjusting entry is:
Debit (Dr) Credit (Cr)
Accounts receivable
30,000
Sales
30,000
Choice “A” is incorrect. In Year 2, Encora recorded:
Debit (Dr) Credit (Cr)
Cash
30,000
Sales
30,000
Encora should have recorded:
Debit (Dr) Credit (Cr)
Cash
30,000
Accounts receivable
30,000
The adjusting entry is:
Debit (Dr) Credit (Cr)
Sales
30,000
Accounts receivable
30,000
Choice “C” is incorrect. The amounts are correct, but the debits and credits are reversed.
Choice “D” is incorrect. The cash debits were already correct in both Years 1 and 2.
At December 31, Year 1, a $1,200,000 note payable was included in Cobb Corp.’s liability account balances. The note is dated October 1, Year 1, bears interest at 15%, and is payable in three equal annual payments of $400,000. The first interest and principal payment was made on October 1, Year 2. In its December 31, Year 2 balance sheet, what amount should Cobb report as accrued interest payable for this note?
A. $45,000 B. $135,000 C. $90,000 D. $30,000
Choice “D” is correct. $30,000 accrued interest payable at Dec. 31, Year 2.
Note Payable
Note payable balance at Dec. 31, Year 1
1,200,000
Less: First payment made Oct. 1, Year 2
(400,000)
Note payable balance at Oct. 1, Year 2
800,000
Annual interest rate
15%
Annual interest
120,000
Adjustment factor for 3 mos. From 10-1-Year 2 to 12-31-Year 2
x 3/12
Accrued interest payable at Dec. 31, Year 2
30,000
Rice Co. salaried employees are paid biweekly. Advances made to employees are paid back by payroll deductions. Information relating to salaries follows:
12/31/Year 1 12/31/Year 2
Employee Advances
24,000
36,000
Accrued Salaries Payable
40,000
?
Salaries Expense During the Year
420,000
Salaries Paid During the Year (Gross)
390,000
In Rice’s December 31, Year 2, balance sheet, accrued salaries payable was:
A. $30,000 B. $70,000 C. $82,000 D. $94,000
Explanation
Choice “B” is correct. $70,000 accrued salaries payable at Dec 31, Year 2.
Accrued
Salaries
Payable
Beginning balance 12/31/Year 1
40,000
Add: Salaries expense during the year
420,000
Sub Total
460,000
Less: Salaries paid during the year (gross)
(390,000)
Ending balance 12/31/Year 2
70,000
Which of the following is not a disclosure requirement related to risks and uncertainties under U.S. GAAP?
A. Disclosure of significant estimates when it is probable that the estimate will change in the near term, even if the effect of the change will be immaterial. B. Disclosure of concentrations when it is reasonably possible that a concentration could cause a severe impact in the near term. C. Disclosure of the use of estimates in the preparation of the financial statements. D. Disclosure of an entity's major products or services and its principle markets.
Explanation
Choice “A” is correct. Significant estimates should be disclosed when it is reasonably possible (not probable) that the estimate will change in the near term and that the effect of the change will be material. Immaterial items are not disclosed.
Choice “B” is incorrect. This is a disclosure requirement.
Choice “C” is incorrect. This is a disclosure requirement.
Choice “D” is incorrect. This is a disclosure requirement.
Question
Which of the following should be disclosed in a summary of significant accounting policies?
Choice “C” is correct. The summary of significant accounting policies should disclose policies. The only policy in this question is the “basis” of profit recognition on long-term construction contracts. The other disclosures are accounting details and would be disclosed in other footnotes, but not in the summary of significant accounting policies.
Choice “A” is incorrect. The future minimum lease payments should be disclosed, but not in the summary of significant accounting policies.
Choice “B” is incorrect. Depreciation expense should certainly be disclosed, but not in the summary of significant accounting policies.
Choice “D” is incorrect. The composition of sales by segment should be disclosed, but not in the summary of significant accounting policies.
1
MCQ-05932
Application
Redwood Co.’s financial statements had the following information at year end:
Cash
60,000
Accounts receivable
180,000
Allowance for uncollectible accounts
8,000
Inventory
240,000
Short-term marketable securities
90,000
Prepaid rent
18,000
Current liabilities
400,000
Long-term debt
220,000
What was Redwood’s quick ratio?
A. 1.46 B. 0.83 C. 0.81 D. 0.94
Choice “C” is correct. The quick ratio is calculated as follows:
Image af70049d2598a19a79a19c6e0f1b1143
Choice “A” is incorrect. This answer incorrectly uses long-term debt instead of current liabilities in the denominator of the calculation.
Choice “B” is incorrect. This answer incorrectly excludes the allowance for uncollectible accounts from the calculation.
Choice “D” is incorrect. This answer is not supported by the given facts.
2
MCQ-04951
Application
The following data have been extracted from the financial statements of Hutton Inc.
12/31/Year 2
12/31/Year 1
Total assets
3,710,000
3,335,000
Sales (all on credit)
3,000,000
2,600,000
Cost of goods sold
(2,000,000)
(1,700,000)
Gross profit
1,000,000
900,000
Operating expenses
(450,000)
(400,000)
Interest expense
(50,000)
(60,000)
Net income before income taxes
500,000
440,000
Income taxes (30%)
(150,000)
(132,000)
Net income after income taxes
350,000
308,000
What was Hutton Inc.’s DuPont return on assets for Year 2?
A. 13.70% B. 9.94% C. 9.44% D. 28.39%
Choice “B” is correct. The DuPont return on assets is calculated as Net profit margin x Total asset turnover, as follows:
Net income
×
Net sales
Net sales
Average total assets
For Hutton Inc. for Year 2, the DuPont return on assets is calculated as follows:
$350,000
×
$3,000,000*
= 9.94%
$3,000,000
$3,522,500*
*Average total assets is calculated as the average of the beginning-of-year total assets ($3,710,000) and end-of-year total assets ($3,335,000)
Note that a more intuitive approach for determining return on assets is to simply divide net income by average total assets, as follows:
Net income
$350,000
= 9.94%
Average total assets
$3,522,500
However, the DuPont approach to determining return on assets makes it easier to analyze how return on assets is affected by net profit margin (net income/net sales) and by total asset turnover (net sales/average total assets).
Choice “A” is incorrect. This answer incorrectly multiplies the Net profit margin x Average total assets/net sales (instead of by Net sales/average total assets).
Choice “C” is incorrect. This answer incorrectly uses total assets at the end of Year 1 (instead of the average of total assets at the ends of Years 1 and 2) in the total asset turnover ratio.
Choice “D” is incorrect. This answer incorrectly uses gross profit (instead of net income) in the net profit margin.
If Hutton Inc. sold $100 of inventory for $100 of cash on December 31, Year 2, which of the following ratios would decrease?
A. Return on equity B. Working capital turnover C. Net profit margin D. Return on assets
Choice “C” is correct. Net profit margin is calculated as net income divided by net sales. If inventory is sold at cost, net income does not change but net sales increases. Therefore, the numerator does not change but the denominator increases, causing net profit margin to decrease.
Choice “A” is incorrect. Return on equity is calculated as [net income – preferred dividends] divided by average total equity. A sale of inventory at cost does not affect net income, preferred dividends, or average total equity. Since neither the numerator nor the denominator changes, return on equity does not change.
Choice “B” is incorrect. Working capital turnover is calculated as sales divided by average working capital. Working capital, in turn, is defined as current assets minus current liabilities. Since both cash and inventory are current assets, the use of cash to buy inventory would not affect current assets, nor would it affect current liabilities. Thus, average working capital would not be affected. An increase in sales with no change in average working capital would result in an increase in working capital turnover.
Choice “D” is incorrect. Return on assets is calculated as net income divided by average total assets. If inventory is sold at cost, net income does not change. Likewise, selling $100 of inventory for $100 of cash does not change total assets as both inventory and cash are assets. Since neither the numerator nor the denominator changes, return on assets does not change.
At December 30, Year 3, Vida Co. had cash of $200,000, a current ratio of 1.5:1 and a quick ratio of .5:1. On December 31, Year 3, all cash was used to reduce accounts payable. How did these cash payments affect the ratios?
Current ratio
Quick ratio
A.
Increased
Decreased
B. Decreased
No effect
C. Decreased
Increased
D. Increased
No effect
Choice “A” is correct. The current ratio equals current assets divided by current liabilities. Since the current assets exceed the current liabilities (as evidenced by a current ratio of 1.5:1), when each is decreased by the same amount, there will be a greater percentage reduction of the current liabilities. Thus, the ratio will increase since the current assets are now proportionately larger than the current liabilities. The quick ratio equals quick assets (including cash) divided by current liabilities. Since the quick assets are less than the current liabilities (as evidenced by a quick ratio of 0.5:1), when each is decreased by the same amount, the percentage decrease of the quick assets will be greater than that of the current liabilities. Thus, the ratio will decrease since the quick assets are now proportionately smaller than the current liabilities.
Choices “D”, “C”, and “B” are incorrect, per the above explanation.
The following data have been extracted from the financial statements of Hutton Inc.
12/31/Year 2
12/31/Year 1
Current assets:
Cash and cash equivalents
100,000
80,000
Marketable securities (at fair value)
110,000
140,000
Accounts receivable
700,000
600,000
Inventory (at lower of cost or market)
350,000
425,000
Total current assets
1,260,000
1,245,000
Sales (all on credit)
$ 3,000,000
$ 2,600,000
Cost of goods sold
(2,000,000)
(1,700,000)
Gross profit
1,000,000
900,000
Operating expenses
(450,000)
(400,000)
Interest expense
(50,000)
(60,000)
Net income before income taxes
500,000
440,000
Income taxes (30 percent)
(150,000)
(132,000)
Net income after income taxes
350,000
308,000
What was Hutton Inc.’s inventory turnover for Year 2?
A. 5.16 B. 4.77 C. 5.71 D. 7.74
Choice “A” is correct. Inventory turnover is calculated as:
Cost of goods sold
Average inventory
For Hutton Inc. for Year 2, inventory turnover is calculated as:
Cost of goods sold
$2,000,000
= 5.16
Average inventory
$387,500*
*Average inventory is calculated as the average of the beginning-of-year and end-of-year balances of inventory.
Choice “B” is incorrect. This answer uses the average of cost of goods sold for Years 1 and 2 instead of just the cost of goods sold for Year 2.
Choice “C” is incorrect. This answer uses the inventory balance at the end of Year 2 instead of the average inventory.
Choice “D” is incorrect. This answer uses sales in the numerator instead of cost of goods sold.
Selected data pertaining to Lore Co. for the calendar Year 4 is as follows:
Net cash sales
$3,000
Cost of goods sold
18,000
Inventory at beginning of year
6,000
Purchases
24,000
Accounts receivable at beginning of year
20,000
Accounts receivable at end of year
22,000
The accounts receivable turnover for Year 4 was 5.0 times. What were Lore’s Year 4 sales (net)?
A. $105,000 B. $107,000 C. $110,000 D. $210,000
Choice “A” is correct. The accounts receivable turnover ratio equals sales (net) divided by average accounts receivable. 5.0 = Sales (net) / [($20,000 + $22,000) / 2]. Sales (net) equal $105,000.
Choice “B” is incorrect. The accounts receivable turnover ratio equals sales (net) divided by average accounts receivable.
Choice “C” is incorrect. The accounts receivable turnover ratio equals sales (net) divided by average accounts receivable, not by year-end accounts receivable.
Choice “D” is incorrect. The accounts receivable turnover ratio equals sales (net) divided by average accounts receivable, not by the sum of beginning and ending accounts receivable.
