Chapter Review Problems

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1 Chapter Review Problems Unit 17.1 Income statements 1. When revenues exceed expenses, is the result (a) net income or (b) net loss? (a) net income 2. Do income statements reflect profits of a business (a) on a certain date or (b) over a given period of time? (b) over a given period of time 3. Cost of goods sold is an important part of an income statement for service companies. (T or F) False For Problems 4 6, fill in the missing amounts. Each problem represents a different situation. Negative values are in parentheses Revenues $108,000 $120,000 $ 69,000 Total expenses $ 28,000 $130,000 $42,000 Net income (or loss) $ 80,000 ($10,000) $27, Calculate net sales based on gross sales of $805,000; sales returns of $5,400; and sales discounts of $15,700. Net sales = Gross sales - Sales returns - Sales discounts = $805,000 - $5,400 - $15,700 = $783, Calculate cost of goods sold based on $82,400 beginning inventory; $264,000 cost of goods purchased; and $94,800 ending inventory. Cost of goods sold = Beginning inventory + Cost of goods purchased - Ending inventory = $82,400 + $264,000 - $94,800 = $251, Refer to Problems 7 and 8. Calculate gross profit. Gross profit = Net sales - Cost of goods sold = $783,900 - $251,600 = $532, Refer to Problem 9. Calculate net income based on operating expenses of $371,300. Net income = Gross profit - Operating expenses = $532,300 - $371,300 = $161,000 Unit 17.2 Balance sheets For Problems 11 20, identify the item by placing the appropriate letter in the space. Item Choose from 11. A Accounts receivable A. Current asset 12. E Accounts payable B. Plant and equipment 13. B Office equipment C. Investment asset 14. G Owner s equity D. Intangible asset 15. A Cash E. Current liability 16. C Land held for future expansion F. Long-term liability 17. D Trademark G. Equity item 18. E&F* Mortgage payable (monthly payments) *Note: For Problem 18, part of the mortgage will be paid within 1 year (or operating cycle); this amount (principal portion only, without interest) is a current 19. B Building and land for present location 20. G Retained earnings liability. The remainder of the mortgage balance is a long-term liability. 21. Bihn Pham owns an engineering consulting business. Total assets are $135,700. Total liabilities are $24,800. What is Bihn s equity in the business? Owner s equity = Assets - Liabilities = $135,700 - $24,800 = $110, Assets should be shown on balance sheets at current value, not original cost. (T or F) False Chapter Review Problems 383

2 For Problems 23 25, fill in the missing amounts. Each problem represents a different situation Total assets $128,000 $820,000 $219,000 Total liabilities $ 65,000 $148,000 $192,000 Equity $ 63,000 $672,000 $27, For corporations, the equity section of a balance sheet is called corporate equity. (T or F) False. The equity section is called stockholders equity. 27. For a personal financial statement, assets are often shown at current value, not at cost. (T or F) True 28. For a personal financial statement, the difference between assets and liabilities is referred to as personal equity. (T or F) False. The difference is called net worth. Unit 17.3 Trend and ratio analysis 29. Vertical and horizontal analysis are used to evaluate the progress of a company over two or more accounting periods. (T or F) True 30. Comparative data for BBB Office Supply is given in the first two columns of the following pair of tables. Complete the remaining columns using vertical and horizontal analysis. Show percents with 1 decimal place. BBB OFFICE SUPPLY, INC. Comparative Income Statement (2005 vs 2004) Annual Amounts Percent of Net Sales Increase (or Decrease) Amount Percent Gross sales $346,200 $364, ($18,700) (5.1) Sales returns 3,800 1, , Net sales $342,400 $363, ($20,800) (5.7) Cost of goods sold 153, , , Gross profit $189,300 $214, ($25,200) (11.7) Total operating expenses 177, , , Net income (before income taxes) $11,600 $61, ($49,500) (81.0) Less income taxes 4,000 22, (18,000) (81.8) Net income (after income taxes) $7,600 $39, ($31,500) (80.6) BBB OFFICE SUPPLY, INC. Comparative Balance Sheet (Dec. 31, 2005 vs Dec. 31, 2004) Year-end Amounts Percent of Total Increase (or Decrease) Amount Percent Assets Current assets Cash $23,100 $36, ($13,000) (36.0) Accounts receivable 42,000 45, (3,100) (6.9) Merchandise inventory 58,100 73, (15,700) (21.3) Prepaid expenses Total current assets $123,500 $155, ($31,800) (20.5) Plant and equipment, net 7,100 7, (800) (10.1) Total assets $130,600 $163, ($32,600) (20.0) Liabilities Accounts payable $18,000 $19, ($1,000) (5.3) Total liabilities $18,000 $19, ($1,000) (5.3) Stockholders Equity Common stock $100,000 $100, $0 0 Retained earnings 12,600 44, (31,600) (71.5) Total stockholders equity $112,600 $144, ($31,600) (21.9) Total liabilities and SH equity $130,600 $163, ($32,600) (20.0) 384 Chapter 17 Financial Statements: How to Read and Interpret

3 31. Refer to Problem 30. List a few noteworthy items that might make stockholders happy or concerned. The answer is a bit subjective, but here are a few ideas. Sales decreased 5.1%. Cost of goods sold increased 3.0%, even though sales decreased. Expenses increased 15.8%, even though sales decreased. Total stockholders equity decreased $31,600. For Problems 32 38, use the data of Problem 30 to calculate the requested ratio or percent for Use one decimal place in all ratios or percents. Then, state what the ratio means. 32. Current ratio. For each dollar of current liabilities, BBB has about $6.90 of current assets. 33. Acid-test ratio. 34. Debt ratio. For each dollar of current liabilities, BBB has about $3.60 of highly liquid assets. For each dollar of assets, BBB owes Inventory turnover. Inventory was sold 2.3 times during the year. 36. Cost of goods sold as % of net sales. BBB s goods cost 44.7% of what they sold for. 37. Profit margin, before tax. BBB s profit is 3.4% of net sales. 38. Return on equity. Current ratio = Current assets = $123, Current liabilities $18,000 Acid-test ratio = Cash + Accounts receivable = $23,100 + $42,000 = $65, Current liabilities $18,000 $18,000 Debt ratio = Total liabilities = $18, % Total assets $130,600 Inventory turnover = Cost of goods sold = $153,100 = $153, Average inventory ($73,800 + $58,100) 2 $65,950 BBB s profit, after tax, is 6.7% of stockholders equity. Cost of goods sold as % of net sales = Cost of goods sold = $153, % Net sales $342,400 Profit margin, before tax = Net income, before tax = $11, % Net sales $342,400 Return on equity = Net income, after tax = $7, % Equity $112, LMN, Inc., has a current ratio of 1.3. The industry average for its type of business is 1.8. Is LMN s current ratio (a) better or (b) worse than the industry average? (b) Worse 40. Refer to Problem 39. What can LMN do to improve its current ratio? a. Increase profits. By increasing profits, LMN will have more cash or accounts receivable, thereby increasing current assets. b. Increase long-term financing. By doing this, LMN will increase long-term liabilities and increase cash. Because longterm liabilities do not affect the current ratio, the ratio will be improved. c. Reduce dividends. By reducing dividends, cash will not decrease as much. d. Sell additional stock. By doing this, cash will be increased without affecting current liabilities. 41. Would a business prefer having a (a) high or (b) low inventory turnover? (a) High. Businesses prefer selling their inventory quickly. 42. What can be done to improve inventory turnover? a. Do more advertising. By doing more advertising, sales should increase, thereby contributing to a quicker inventory turnover. b. Improve sales staff. Maybe the sales staff is not assisting customers adequately. By giving better assistance, sales should increase. c. Reduce inventory. If inventory is excessive, reducing inventory may be a good strategy. However, if the inventory is not excessive, decreasing inventory may lead to a decrease in sales. Chapter Review Problems 385

4 Challenge problems For Problems 43 47, answer from the following choices: sole proprietorship, general partnership, corporation, LLC. 43. For which entity or entities are the owner(s) personally responsible for the company s debts? Sole proprietorship and partnership 44. Which entity or entities file a federal income tax return? Partnership, corporation, and LLC 45. Which entity or entities pay federal income tax directly to the IRS? Corporation 46. For which entity or entities are distributions of extra cash taxable to the owners? Corporation 47. Which entity or entities can be owned by only one person? Sole proprietorship, corporation, and LLC 48. A three-person general partnership quits doing business and has only $60,000 with which to pay $90,000 of debt. Which statement is true? (a) The partners are not personally liable for the $30,000 difference; (b) each partner is liable for exactly $10,000; (c) any of the partners may be sued for the entire $30,000 difference. (c) 49. ABC Corporation had annual profit of $1,200,000. Assume that the corporation pays 40% of federal and state income taxes; the remainder is paid to stockholders as dividends. Assuming that stockholders pay 35% of dividends as federal and state income taxes, determine the total percent of income taxes paid as a result of the $1,200,000 profit. Income tax paid by corporation: $1,200,000 40% $480,000 Income tax paid by stockholders: Profit $1,200,000 Less income tax paid by corporation - 480,000 Available for dividends $ 720,000 35% + 252,000 Total $732,000 Percent of profit paid as income tax = $732,000 $1,200,000 =.610 = 61% 50. Prepare an income statement for Fisher s Clothing Store, Inc. Income statement items for the first 3 months of 2006 were as follows: gross sales, $1,653,800; sales returns, $143,700; beginning inventory, $436,000; purchases, $922,800; purchase returns, $5,300; purchase discounts, $13,800; transportation in, $3,400; ending inventory, $461,900; total operating expenses, $296,600; income taxes, $110,000. Use the format of Illustration FISHER S CLOTHING STORE, INC. Income Statement for the Quarter Ended March 31, 2006 Revenue from sales Gross sales $1,653,800 Less: Sales returns 143,700 Net sales $1,510,100 Cost of goods sold Merchandise inventory, January 1, 2006 $436,000 Purchases $922,800 Less: Purchase returns $5,300 Purchase discounts 13,800 Subtotal 19,100 Net purchases $903,700 Add transportation in 3,400 Cost of goods purchased 907,100 Goods available for sale $1,343,100 Merchandise inventory, March 31, ,900 Cost of goods sold 881,200 Gross profit from sales $628,900 Less operating expenses 296,600 Net income (before income taxes) $332,300 Less income tax expense 110,000 Net income (after income taxes) $222, Chapter 17 Financial Statements: How to Read and Interpret

5 51. Wayne s Corner Market, Inc., had assets and liabilities on June 30, 2006, as follows: cash, $22,800; accounts payable, $38,100; store equipment, $42,000 less accumulated depreciation of $10,500; merchandise inventory, $42,200; notes payable, $5,000 (the entire amount is due in 18 months); prepaid expenses, $800. So far, 1,000 shares of stock have been issued (at $20 per share). Prepare a classified balance sheet like that of Illustration In the process, determine the amount of retained earnings. WAYNE S CORNER MARKET, INC. Balance Sheet: June 30, 2006 Assets Current assets Cash $22,800 Merchandise inventory 42,200 Prepaid expenses 800 Total current assets $65,800 Plant and equipment Store equipment $42,000 Less accumulated depreciation 10,500 31,500 Total assets $97,300 Liabilities Current liabilities Accounts payable $38,100 Long-term liabilities Notes payable 5,000 Total liabilities $43,100 Stockholders Equity Common stock: 1,000 $20 $20,000 Retained earnings 34,200 Total stockholders equity 54,200 Total liabilities and stockholders equity $97,300 Practice Test 1. What, if anything, is wrong with this income statement heading? ALPINE ENGINEERING Income Statement June 30, 2006 An income statement is for a period of time, not a certain date. The last line should read something like For June 2006, For quarter ending June 30, 2006, or For six months ending June 30, Given: gross sales, $220,000; sales returns, $1,500; sales discounts, $2,000; beginning inventory, $92,000; cost of goods purchased, $145,000; ending inventory, $95,000; operating expenses, $30,000. Calculate: (a) net sales, (b) cost of goods sold, (c) gross profit, and (d) net income. a. Net sales = Gross sales - Sales returns - Sales discounts = $220,000 - $1,500 - $2,000 = $216,500 b. Cost of goods sold = Beginning inventory + Cost of goods purchased - Ending inventory = $92,000 + $145,000 - $95,000 = $142,000 c. Gross profit = Net sales - Cost of goods sold = $216,500 - $142,000 = $74,500 d. Net income = Gross profit - Operating expenses = $74,500 - $30,000 = $44, Given: cash, $28,000; accounts receivable, $52,000; merchandise inventory, $60,000; prepaid expenses, $2,000; land for future expansion, $50,000; accounts payable, $24,000. Calculate the equity of the business. Assets: $28,000 + $52,000 + $60,000 + $2,000 + $50,000 = $192,000 Liabilities - 24,000 Equity $168,000 Practice Test 387

6 4. Given: net sales, $152,800; total operating expenses, $42,100. What percent of net sales are operating expenses? Round to the nearest tenth of a percent. $42,100 $152, % 5. For each item, calculate (a) the dollar amount of increase and (b) the percent change (rounded to the nearest tenth of a percent). Increase (or Decrease) Item Amount Percent Cash $27,000 $23,000 $4, Accounts receivable $52,000 $58,000 ($6,000) (10.3) 6. Given: total current assets, $120,000; total assets, $280,000; total current liabilities, $72,000; total liabilities, $150,000; beginning inventory, $60,000; ending inventory, $68,000; cost of goods sold, $140,000. Calculate (a) current ratio, (b) debt ratio, and (c) inventory turnover. Use 1 decimal place in each ratio. For each ratio, tell what it means. a. b. c. Current ratio = Current assets = $120, Current liabilities $72,000 For each dollar of current liabilities, the company has about $1.70 of current assets. Debt ratio = Total liabilities = $150, % Total assets $280,000 For each dollar of assets, the company owes about Inventory turnover = Cost of goods sold = $140,000 = $140, Average inventory ($60,000 + $68,000) 2 $64,000 Inventory was sold 2.2 times during the year. 388 Chapter 17 Financial Statements: How to Read and Interpret

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