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3.5 End-of-Chapter Exercises


  1. Why do businesses produce financial statements?
  2. What are the four financial statements that are typically prepared and distributed by a business or other organization?
  3. What is the purpose of the notes that are attached to financial statements?
  4. On which financial statement are revenues and expenses reported?
  5. How does a gain differ from a revenue?
  6. What is a loss?
  7. The Bestron Corporation has a loss of $32,000 and an expense of $74,000. How does a loss differ from an expense?
  8. In producing an income statement, why are revenues and expenses reported separately from gains and losses?
  9. What three pieces of information are typically listed at the top of a financial statement?
  10. Define “cost of goods sold.”
  11. The Amherst Company reported a “gross profit” of $743,800. What is the meaning of this term?
  12. The Algernon Corporation incurs a cost of $327,000. The company’s accountant is now trying to decide whether to report this balance as an asset or an expense. How do companies determine if a cost is an expense or an asset?
  13. From an accounting perspective, define “conservatism.”
  14. A company has experienced a situation where it is going to incur a loss. Officials believe the chances are 60 percent that the loss will be $13,000. However, there is also a 40 percent chance that the loss might be $98,000. What reporting should be made?
  15. Explain why dividends are not reported on the income statement.
  16. What are retained earnings?
  17. A business has been in operation for nine years and is now reporting a retained earnings balance of $127,000. What makes up that figure?
  18. The Olson Company reports a $116,000 figure that is labeled “capital stock” on its balance sheet. What information is being communicated?
  19. On which financial statement would assets and liabilities be reported?
  20. What differentiates a current asset from a noncurrent asset?
  21. What is the accounting equation, and explain why it is true.
  22. What are the three categories of cash flows that are reported on the statement of cash flow?
  23. On its statement of cash flows, the Jackson Company reported a total cash inflow of $226,000 from operating activities. It also reported a cash outflow of $142,000 from investing activities and a cash inflow of $34,000 from financing activities. How do operating, investing, and financing cash flows differ from one another?

True or False

  1. ____ The income statement reports a company’s revenues and expenses for one particular day of the year.
  2. ____ An increase in the net assets of a business that results from the sale of inventory is reported as a gain.
  3. ____ A business reports a retained earnings balance of $156,000. This figure represents the monetary amounts contributed to the business by its owners.
  4. ____ Assets and liabilities can be broken down into the categories of current and noncurrent.
  5. ____ Income tax expense is typically reported separately from other expenses.
  6. ____ Conservatism helps reporting companies look better to potential investors.
  7. ____ The dividends paid balance is reported on the balance sheet.
  8. ____ Companies receive money each time their stock is sold on a stock exchange such as the New York Stock Exchange.
  9. ____ A balance sheet must always balance.
  10. ____ The statement of cash flows is broken up into operating, investing, and financing activities.
  11. ____ If a business reports current assets of $300,000 and current liabilities of $200,000, it has working capital of $500,000.
  12. ____ Sales revenue less cost of goods sold is referred to as net income.
  13. ____ A gain is the amount of net income earned by a company over its life less any dividends it has paid.
  14. ____ The purpose of the balance sheet is to report the assets and liabilities of a company on a specific date.
  15. ____ The accounting equation identifies how retained earnings are calculated.
  16. ____ If a company has a possible loss, conservatism requires that this loss must always be reported.
  17. ____ A company buys merchandise for $175,000 and sells it to various customers for $240,000. The gross profit is $65,000.
  18. _____The Bagranoff Company has a current ratio of 3:1. The company collects a $20,000 accounts receivable. The current ratio will rise as a result of this collection.
  19. _____ The Clikeman Company has been in business for several years. The company starts the current year with net assets of $300,000 and ends the year with net assets of $430,000. For the current year, the company’s net income less its dividends must have been $130,000.
  20. _____ The Richmond Company has been in business for five years and now reports contributed capital as $310,000. This figure means that the owners put $310,000 worth of assets (probably cash) into the business five years ago when it was created.
  21. ______ A company needs money to build a new warehouse. Near the end of the current year (Year One), the company borrows $900,000 in cash from a bank on a ten-year loan. The company does not start the construction project until the next year (Year Two). On a statement of cash flows for Year One, a cash inflow of $900,000 should be reported as a financing activity.
  22. ______ Near the end of the current year, a company spent $27,000 in cash on a project that the accountant believed had future economic benefit. The accountant reported it in that manner. In truth, the project only had past economic benefit. The company went on to report net income of $200,000 for the current year along with total assets of $800,000. The company should have reported net income of $227,000 for the year and total assets of $773,000.
  23. ______ Assume the Albemarle Company buys inventory for $9,000. It pays 60 percent immediately and will pay the rest next year. The company then spends $900 in cash on advertising in order to sell 70 percent of the inventory for $14,000. Of that amount, it collects 80 percent immediately and will collect the remainder next year. The company pays a cash dividend this year of $2,000. As a result of just the operating activities, the company will report that its cash increased by $4,900 during the period.
  24. ______ A company is being sued because a product it made has apparently injured a few people. The company believes that it will win the lawsuit, but there is uncertainty. There is some chance (a 33 percent chance) that the company might lose $20,000. To arrive at fairly presented financial statements in connection with this uncertainty, this lawsuit should be reported on the income statement of this year as a $6,600 loss.
  25. ______ A company has the following account balances: revenues—$120,000, salary payable—$7,000, cost of goods sold—$50,000, dividends paid—$3,000, rent expense—$12,000, gain on sale of land—$4,000, accounts receivable—$13,000, cash—$15,000, and advertising expense—$8,000. Reported net income for the period is $54,000.
  26. ______ A company gets $10,000 cash from its owners when it is started at the beginning of Year One. It gets another $15,000 from a bank loan. Revenues for that year were $70,000, expenses were $39,000, and dividends paid to the owners were $3,000. The retained earnings balance at the start of Year Two was $38,000.
  27. ______ The Watson Corporation reported net income of $334,000. During the year, a $10,000 expenditure was erroneously recorded by this business as an asset when it should have been reported as an expense. For an error, $10,000 is not viewed as material by this company. Therefore, net income is fairly presented as reported at $334,000.

Multiple Choice

  1. You are the chief executive officer of Fisher Corporation. You are very concerned with presenting the best financial picture possible to the owners so you can get a big bonus at the end of this year. Unfortunately, Fisher has a lawsuit pending that could result in the company having to pay a large sum of money. Lawyers believe the company will win and pay nothing. However, they believe there is a 20 percent chance of a $100,000 loss and a 10 percent chance of a $300,000 loss. What amount should be reported?

    1. Zero
    2. $50,000
    3. $100,000
    4. $300,000
  2. Henderson Inc. reports the following: assets of $500,000, liabilities of $350,000 and capital stock of $100,000. What is the balance reported as retained earnings?

    1. $50,000
    2. $250,000
    3. $450,000
    4. $750,000
  3. Giles Corporation borrowed $675,000 from Midwest Bank during the year. Where is this event be reported on Giles’s statement of cash flows?

    1. Operating activities
    2. Investing activities
    3. Financing activities
    4. It would not be reported on the statement of cash flows
  4. You are considering investing in the stock of Mogul Corporation. On which of the following statements would you find information about what the company holds in inventory at the end of the most recent year?

    1. Income statement
    2. Statement of retained earnings
    3. Balance sheet
    4. Statement of cash flows
  5. You are considering investing in the stock of the Maintland Corporation. On which of the following statements would you find information about the cost of the merchandise that the company sold to its customers this past year?

    1. Income statement
    2. Statement of retained earnings
    3. Balance sheet
    4. Statement of cash flows
  6. The Drexel Company began operations on January 1, Year One. In Year One, the company reported net income of $23,000 and, in Year Two, reported net income of another $31,000. In the current year of Year Three, the company reported net income of $37,000. Drexel paid no dividends in Year One but paid $10,000 in Year Two and $12,000 in Year Three. On the December 31, Year Three, balance sheet, what is reported as retained earnings?

    1. $22,000
    2. $25,000
    3. $69,000
    4. $91,000
  7. The Shelby Corporation has been in business now for six years. At the end of its latest fiscal year, the company reported $560,000 in assets, $320,000 in liabilities, $100,000 in contributed capital, and $140,000 in retained earnings. What is the total of stockholders’ equity?

    1. $140,000
    2. $240,000
    3. $420,000
    4. $560,000
  8. The Valdese Corporation operates a restaurant and has sales revenue of $300,000, cost of goods sold of $170,000, other expenses of $50,000, and a gain on the sale of a truck of $14,000. Which of the following statements is true?

    1. Gross profit is $80,000, and net income is $80,000.
    2. Gross profit is $80,000, and net income is $94,000.
    3. Gross profit is $130,000, and net income is $94,000.
    4. Gross profit is $144,000, and net income is $80,000.
  9. Which of the following is true about the usual reporting of income taxes?

    1. They are reported within cost of goods sold.
    2. They are reported the same as any other expense.
    3. They are netted against sales revenue.
    4. They are reported separately at the bottom of the income statement.
  10. A company had a number of cash transactions this year. It paid $22,000 in dividends to its owners, borrowed $100,000 from a bank on a long-term loan, bought a building for $288,000, sold equipment for $23,000, sold inventory for $16,000, and issued capital stock to an investor for $35,000. On a statement of cash flows, what is the net amount to be reported as financing activities?

    1. Cash inflow of $78,000
    2. Cash inflow of $113,000
    3. Cash inflow of $157,000
    4. Cash inflow of $265,000
  11. A company had a number of cash transactions this year. It paid $43,000 in dividends to its owners, borrowed $200,000 from a bank on a long-term loan, bought a building for $312,000, sold equipment for $51,000, sold inventory for $25,000, and issued capital stock to an investor for $85,000. On a statement of cash flows, what is the net amount to be reported as investing activities?

    1. Cash outflow of $112,000
    2. Cash outflow of $176,000
    3. Cash outflow of $242,000
    4. Cash outflow of $261,000
  12. A company reports total assets of $500,000 ($300,000 current and $200,000 noncurrent). The same company reports total liabilities of $350,000 ($75,000 current and $275,000 noncurrent). What is the amount of working capital?

    1. $150,000
    2. $225,000
    3. $300,000
    4. $500,000
  13. A company is producing financial statements. Which statements should be prepared initially?

    1. Income statement and balance sheet
    2. Income statement and statement of retained earnings
    3. Statement of cash flows and statement of retained earnings
    4. Statement of cash flows and balance sheet

Video Problems

Professor Joe Hoyle discusses the answers to these two problems at the links that are indicated. After formulating your answers, watch each video to see how Professor Hoyle answers these questions.

  1. Your roommate is an English major. The roommate’s parents own an ice cream shop in a resort community in Florida. They often try to talk with your roommate about their business and use terms such as financial statements, inventory, assets, liabilities, revenue, expenses, contributed capital, and gross profit. The roommate is usually lost in these conversations and feels dumb. One evening on the way to see a movie, your roommate mentions that you are taking a financial accounting course and asks you to explain these terms in some relatively simple fashion. How would you respond?

  2. Your uncle and two friends started a small office supply store three years ago (January 1, Year One). They each invested $20,000 in cash. They then rented a building for $2,000 per month and hired an employee for $3,000 per month. The business buys $9,000 in merchandise per month and sells it for cash of $16,000 in that same month. For convenience, assume that all transactions are for cash. Each owner takes out $4,000 in cash each year as a dividend.

    At the end of Year Three, the owners decide to apply for a loan so they can purchase a building that will allow them to expand operations. The bank has asked for several pieces of information, and your uncle recently sent you an e-mail asking that you help him determine the appropriate amounts to report. What figures should be provided for each of the following?

    1. Gross profit for Year Three
    2. Gross profit percentage for Year Three
    3. Net income for Year Three
    4. Contributed capital as of the end of Year Three
    5. Retained earnings as of the end of Year Three


  1. On which financial statement will a decision maker find each of the following account balances?

    1. ____ Sales revenue
    2. ____ Cash
    3. ____ Gain on sale of building
    4. ____ Retained earnings
    5. ____ Salary expense
    6. ____ Salary payable
    7. ____ Capital stock
    8. ____ Dividends paid
    9. ____ Loss on the sale of land
    10. ____ Income tax expense
    11. ____ Net income
  2. The following relate to the Farr Corporation for the month of April:

    Sales Revenue $170,000
    Gain on the Sale of Land $20,000
    Equipment $125,000
    Tax Expense $14,000
    Inventory $10,000
    Dividends Paid $7,000
    Loss on Lawsuit $24,000
    Cost of Goods Sold $82,000
    Advertising Expense $15,000
    1. Determine Farr’s gross profit for the month of April.
    2. Determine Farr’s net income for the month of April.
    3. If retained earnings at the beginning of April is reported as $800,000, what should retained earnings be reported as at the end of April?
  3. The Maverick Company has the following account balances at the end of December. Show that Maverick’s balance sheet does balance using the accounting equation.

    Cash $8,000
    Capital Stock $120,000
    Inventory $16,000
    Note Payable $45,000
    Retained Earnings $29,000
    Building $158,000
    Equipment $30,000
    Accounts Payable $11,000
    Salary Payable $7,000
  4. The Ramond Company has hired you to prepare financial statements for the year ending December 31 of the current year. On your first day of work, your assistant uncovers several items that could be classified as expenses or could be classified as assets. The assistant has asked for your help. Determine whether the following items should be recorded as an expense or an asset within the financial statements currently being prepared.

    1. On December 31, Ramond paid $14,000 to rent office space for the next twelve months.
    2. On October 1, Ramond paid $40,000 for fire insurance that covered the company’s property for the last quarter of the year.
    3. On July 1, Ramond purchased $27,000 in supplies, all of which were used by the end of the year.
    4. On December 31, Ramond purchased $5,000 worth of supplies for the coming month.
  5. For each of the following, determine the missing balance.

    1. Net Income $82,900
      Cost of Goods Sold $459,030
      Advertising Expense $56,000
      Gain on Sale of Equipment $5,000
      Income Tax Expense $50,000
      Sales Revenue ?
    2. Net Income $6,500
      Retained Earnings, 12/31 $16,200
      Dividends $2,900
      Retained Earnings, 1/1 ?
    3. Cash $460,000
      Accounts Receivable $540,200
      Current Assets $1,670,000
      Inventory ?
    4. Total Assets $54,000
      Total Liabilities $32,000
      Capital Stock $15,000
      Retained Earnings ?
  6. Rescue Records needs rescuing. The downloading of songs over the Internet is killing its business. The owners of Rescue want to know if they made a net income or a net loss during the current year that ended on December 31, Year One. Given the following account balances, prepare an income statement for Rescue similar to the example shown in Figure 3.1 "Income Statement".

    Advertising Expense $4,600
    Salary Expense $25,470
    Cost of Goods Sold $109,000
    Sales Revenue $197,000
    Income Tax Expense $3,800
    Loss on Sale of Land $12,090
    Rent Expense $35,000
  7. Your lawn care business, A Cut Above, has grown beyond your wildest dreams—to the point where you would like to buy some new equipment and hire some people to help you. Unfortunately, you don’t have that kind of money sitting around, so you are applying for a loan. The bank has requested financial statements, including, of course, a balance sheet. The following are the balances you have on December 31, Year One. Prepare a classified balance sheet to submit to the bank.

    Cash $2,400
    Prepaid Insurance $1,600
    Note Payable Due Two Years from Now (Loan from Mom) $5,000
    Capital Stock (Money You Invested to Start Business) $2,000
    Accounts Receivable $500
    Supplies Inventory $300
    Equipment $3,000
    Accounts Payable $200
    Retained Earnings, 12/31 $600
  8. Maria Sanchez, an accountant by trade, earns extra cash by working in the evenings as a personal trainer at the local gymnasium. Maria is curious about her cash inflows and outflows from this extra work. The following is the information that she gathered for the month of February. Prepare a statement of cash flows for Maria.

    Cash Paid for Supplies Inventory $500
    Cash Paid for Advertising $400
    Cash Paid for Equipment $900
    Cash Received from Bank Loan $1,000
    Cash Paid for Insurance $700
    Cash Received from Customers $2,200
    Cash Paid for Taxes $400
    Cash Balance, Beginning of February $500
  9. The Eli Company started business on January 1, Year One. In Year One, the company made a net income of $100,000 and paid cash dividends of $30,000. At the end of Year Two, the company has the following accounts and their appropriate balances:

    Repair Expense $10,000
    Cost of Goods Sold $170,000
    Advertising Expense $10,000
    Inventory $120,000
    Dividends Paid in Year Two $80,000
    Accounts Payable $40,000
    Salary Payable $10,000
    Land and Equipment $300,000
    Contributed Capital (Capital Stock) $120,000
    Notes Payable (Due in Year Six) $210,000
    Salary Expense $40,000
    Loss on Sale of Equipment $10,000
    Sales Revenue $470,000
    Income Tax Expense $30,000
    Cash $50,000
    Accounts Receivable $100,000

    Retained earnings at the beginning of Year Two can be computed from the information provided at the beginning of the problem.

    1. Prepare an income statement for the Eli Company for Year Two in the form presented in Figure 3.1 "Income Statement".
    2. Prepare a statement of retained earnings for the Eli Company for Year Two in the form presented in Figure 3.4 "Statement of Retained Earnings".
    3. Prepare a balance sheet for the Eli Company for the end of Year Two (December 31) in the form presented in Figure 3.6 "Balance Sheet".

Research Assignment

  1. Go to At The Hershey Company Web site, click on “Corporate Information” at the bottom of the page. Click on “Investors” on the top of the next screen. Then, click on “Financial Reports” on the left side of the screen. You should see a drop-down menu. Click on “Annual & Quarterly Reports.” Finally, click on “2010 Annual Report to Stockholders/Form 10-K” to download the form. The Form 10-K is the document that many businesses must file with the U.S. government each year. Because it requires that financial statements be included, some companies like Hershey also use it as the annual report for their stockholders.

    Using The Hershey Company’s Form 10-K, answer the following questions:

    1. On page 54 of the 2010 financial statements for The Hershey Company, an income statement is presented. For 2008 and also for 2010, determine the following balances. Has this company’s income picture improved from 2008 to 2010?

      • Gross profit
      • Gross profit percentage
      • Provision for income taxes (income tax expense)
      • Net Income
    2. On page 55 of the 2010 financial statements, a balance sheet is presented. Determine the following balances as of December 31, 2009, and also December 31, 2010.

      • Working capital
      • Current ratio
      • Retained earnings
    3. On page 56 of the 2010 financial statements, a statement of cash flows is presented. Determine the amount of cash that Hershey generated from its operating activities during 2010.
    4. On page 57 of the 2010 financial statements, a statement of stockholders’ equity is presented. The middle column is for retained earnings and serves the same purpose as a statement of retained earnings. How much did Hershey pay its stockholders as dividends in 2008, 2009, and 2010?