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TRANSCRIPT
Chapter 3Financial Statements, Cash Flows, and Taxes
LEARNING OBJECTIVES
1. Discuss generally accepted accounting principles (GAAP) and their importance to
the economy.
GAAP are a set of authoritative guidelines that define accounting practices at a particular point
in time. Thus, GAAP principles determine the rules for how a company maintains its accounting
system and how it prepares financial statements. Accounting standards are important because
without them, each firm could develop its own unique accounting practices, which would make it
difficult for stakeholders to monitor the firm’s true performance or compare the performance of
different firms. The result would be a loss of confidence in the accounting system and the
financial reports it produces.
2. Know the balance sheet identity, and explain why a balance sheet must balance.
A balance sheet provides a summary of a firm’s financial position at a particular point in time.
The balance sheet identifies the productive resources (assets) that a firm uses to generate income,
as well as the sources of funding from creditors (liabilities) and owners (shareholders’ equity)
that were used to buy the assets. The balance sheet identity is: Total assets = Total liabilities +
Total stockholders’ equity. Stockholders’ equity represents ownership in the firm and is the
residual claim of the owners after all other obligations to creditors, employees, and vendors have
been paid. The balance sheet must always balance because the owners get what is left over after
all creditors have been paid—that is, Total stockholders’ equity = Total assets – Total liabilities.
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3. Describe how market-value balance sheets differ from book-value balance sheets.
Book value is the amount a firm paid for its assets at the time of purchase. The current market
value of an asset is the amount that a firm would receive for the asset if it was sold on the open
market (not in a forced liquidation). Most managers and investors are more concerned about
what a firm’s assets can earn in the future than in what the assets cost in the past. Thus, balance
sheets marked to market are more helpful in showing a company’s true financial condition than
balance sheets based on historical costs. Of course, the problem with marked-to-market balance
sheets is that it is difficult to estimate market values for some assets and liabilities. In addition,
there are fears that the management of some firms may be tempted to manipulate the estimates of
market value to favorably distort their firm’s true financial picture.
4. Identify the basic equation for the income statement and the information it
provides.
An income statement is a snapshot that provides a picture of the firm’s profit or loss for a period
of time, usually a month, quarter, or year. The income statement identifies the major sources of
revenues generated by the firm and the corresponding expenses that were needed to generate
those revenues. The equation for the income statement is: Net income = Revenues – Expenses. If
revenues exceed expenses, the firm generates a net profit for the period. If expenses exceed
revenues, the firm generates a net loss. Net profit or income is the most comprehensive
accounting measure of a firm’s performance.
5. Explain the difference between cash flows and accounting income.
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Cash flows represent the movement of cash within the firm. Cash flows are important in finance
because the value of any asset—stocks, bonds, or a business—is determined by the future cash
flows generated by the asset. Accounting profits, in contrast, are calculated according to GAAP
to determine taxes and to report to stakeholders in a consistent manner. Accounting profits
include noncash revenues (such as prepaid rent) and noncash expenses (such as depreciation),
whereas cash flows do not include these items.
6. Explain how the four financial statements discussed in this chapter are related.
The four financial statements discussed in this chapter are the balance sheet, the income
statement, the statement of cash flows, and the statement of retained earnings. The key financial
statement that ties the other three statements together is the statement of cash flows, which
summarizes changes in the balance sheet from the beginning of the year to the end. These
changes reflect the information in the income statement and in the statement of retained earnings.
7. Discuss the difference between the average and marginal tax rates.
The average tax rate is the total taxes divided by taxable income. It takes into account the taxes
paid at all levels of income, and therefore it will be lower than the marginal tax rate, which is the
rate that is paid on the last dollar of income earned. However, for very high income earners,
these two rates can be equal. When companies are making financial decisions, they use the
marginal tax rate, because new projects are expected to generate additional cash flows, which
will be taxed at the firm’s marginal tax rate.
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I. True or False Questions
1. GAAP represents a set of guidelines that define accounting practice at a particular point
in time.
a. True
b. False
2. GAAP principles determine the rules for how a company can issue stock to raise money.
a. True
b. False
3. Hong Kong and India use a variant of U.K. GAAP.
a. True
b. False
4. The cost principle assumes that both parties to a transaction are economically rational and
are free to act independently of each other.
a. True
b. False
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5. The balance sheet identifies the productive resources (assets) that a firm uses to generate
income, as well as the sources of funding from creditors (liabilities) and owners
(shareholders’ equity) that were used to buy the assets.
a. True
b. False
6. The balance sheet identity can be stated as Total assets = Total liabilities + Total
stockholders’ equity.
a. True
b. False
7. The balance sheet identity can be stated as Total assets – Total liabilities = Total
stockholders’ equity.
a. True
b. False
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8. Book value is the amount a firm paid for its assets at the time of purchase.
a. True
b. False
9. The book value of an asset is the historical cost of the asset less the accumulated
depreciation.
a. True
b. False
10. The current market value of an asset is the amount that a firm would receive for the asset
if it was sold on the open market.
a. True
b. False
11. Preparing a market-value balance sheet is rather straightforward because it is easy to
obtain market values for all assets and liabilities.
a. True
b. False
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12. The net cash flow from operating activities (NCFOA) is another term for net income.
a. True
b. False
13. The income statement identifies the major sources of revenues generated by the firm and
the corresponding expenses that were needed to generate those revenues.
a. True
b. False
14. Accounting profits include noncash revenues (e.g., prepaid rent) and noncash expenses
(e.g., depreciation), whereas cash flows do not include these items.
a. True
b. False
15. The key financial statement that ties the other three statements together is the balance
sheet, which summarizes the firm’s investment and financing activities at a point in time.
a. True
b. False
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16. The average tax rate is the total taxes divided by taxable income. It takes into account the
taxes paid at all levels of income, and therefore it will usually be lower than the marginal
tax rate, which is the rate that is paid on the last dollar of income earned.
a. True
b. False
17. Depreciation and amortization are examples of prepaid expenses.
a. True
b. False
18. Cash flows from operations are the net cash flows that support a firm’s principal business
activities.
a. True
b. False
19. Rent and insurance are examples of depletion expenses.
a. True
b. False
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20. Cash flows from operating activities relate to the buying and selling of long-term assets.
a. True
b. False
21. Making and collecting loans, issuing and paying out on insurance contracts, and buying
and selling debt or equity instruments of other firms are examples of financing activities.
a. True
b. False
22. Typical financing activities include cash payments on the principal of long-term debt,
cash payments of dividends to shareholders, and cash purchases of treasury stock.
a. True
b. False
23. The going concern assumption states that a business will be shutting down its operation
in the near future.
a. True
b. False
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24. In a rising price environment, a company using the LIFO method assumes that the sale of
a product is from the newest, highest-cost inventory.
a. True
b. False
25. If a company values its inventory using the FIFO method, when the firm makes a sale in
a rising price environment, it assumes the sale is from the newest, highest-cost inventory.
a. True
b. False
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II. Multiple-Choice Questions
26. Which of the following sections do annual reports typically contain?
a. financial summary related to the past year’s performance
b. information about the company, its products, and its activities
c. audited financial statements, including limited historical financial data
d. All three of the above sections are included in the annual report.
27. Annual reports are prepared by a firm’s management to
a. communicate to shareholders the firm’s failures in the previous year.
b. provide overview of the firm’s financial and operating performance.
c. highlight the performance of its chief competitors.
d. provide a forecast of the economy in the coming years.
28. The generally accepted accounting principles (GAAP) are
a. rules that outline how a firm can operate ethically.
b. rules on how the firm will be valued in the event of a merger.
c. rules and procedures that define how companies are to maintain financial records
and prepare financial reports.
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d. rules for how a company can issue stock to raise money.
29. Accounting standards prescribed by GAAP are important because
a. they make the financial statements of all firms standardized.
b. they allow one to examine a firm’s performance over time.
c. they make it possible for management or analysts to compare the firm’s
performance to that of other competitors.
d. all of the above.
30. The assumption of arm’s-length transaction states that
a. both parties to a transaction can act independently of each other and make
economically rational decisions.
b. both parties to a transaction must have had previous transactions.
c. one of the parties to the transaction is a bank that has full knowledge of the firm’s
creditworthiness.
d. none of the above
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31. Your uncle, who has a second home in Bethany Beach, Delaware, is planning to sell it in
the next few weeks. You are interested in buying this beachside property, so your agent
negotiates a price for the house with your uncle’s agent. This transaction is an example of
a. The cost principle.
b. the assumption of arm’s-length transactions.
c. the realization principle.
d. the going-concern assumption.
e. the matching principle.
32. The going concern assumption implies that
a. a firm will continue to be in business for the foreseeable future.
b. a firm will be going out of business in the near future.
c. a firm will continue to operate in the near future but only after being acquired by
another firm.
d. none of the above
33. Dell Computer Corporation has receivables of $2.5 million and inventory worth $1.8
million. The firm plans to borrow $2 million for working capital purposes from Austin
First National Bank. In evaluating the loan request, the bank should place the most
emphasis on
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a. the matching principle.
b. the realization principle.
c. the going-concern assumption.
d. the assumption of arm’s-length transactions.
34. The matching principle calls for the accountant of a firm to
a. identify an asset with each liability of the firm.
b. associate the revenue generated from a sale to the costs incurred to produce the
product.
c. match each item of inventory with the historical cost at which it was acquired.
d. none of the above
35. Tyson Corporation bought raw materials on April 23, 2008 and also on July 2, 2008.
Products produced in the months of May were sold in July. The firm uses FIFO to value
its inventory. According to the matching principle, the firm’s accountant should associate
a. the inventory acquired on July 2 with the products sold.
b. the inventory acquired on April 23 with the products sold.
c. Neither of these dates is valid because the products were sold in July.
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d. None of the above.
36. According to the realization principle, revenue from a sale of the firm’s products are
recognized
a. when the products are shipped to the buyer.
b. when the buyer orders the goods.
c. when cash is realized from the sale of the products.
d. at the time of the sale.
37. On June 23, 2008, Mikhal Cosmetics sold $250,000 worth of its products to Rynex
Corporation, with the payment to be made in 90 days on September 20. The goods were
shipped to Rynex on July 2. The firm’s accountants should recognize the sale on
a. June 23, 2008.
b. July 2, 2008.
c. September 20, 2008.
d. none of the above.
38. The cost principle states that an asset should reflect its
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a. tmarket value.
b. market value less the accumulated depreciation on the asset.
c. historical cost.
d. none of the above.
39. Trekkers Footwear bought a piece of machinery on January 1, 2006 at a cost of $2.3
million, and the machinery is being depreciated annually at an amount of $230,000 for 10
years. Its market value on December 31, 2008 is $1.75 million. The firm’s accountant is
preparing its financial statement for the fiscal year end on December 31, 2008. The
asset’s value should be recognized on the balance sheet at
a. $2.3 million.
b. $1.61 million.
c. $230,000.
d. $1.75 million.
40. International accounting standards are said to be “principles based,” implying that
a. there are explicit rules to cover virtually every situation a firm may encounter.
b. they are no different than the U.S. GAAP in the directions provided to
accountants.
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c. it calls for relying more on general guidelines than on precise rules for how
companies must report transactions.
d. All of the above are true.
41. Current assets can generally considered to
a. have little value.
b. have been completely depreciated.
c. be converted to cash within one year.
d. have been financed with owners equity.
42. Petra, Inc., has $400,000 as current assets, $1.225 million as plant and equipment, and
$250,000 as goodwill. In preparing the balance sheet, these assets should be listed in
which of the following orders?
a. current assets, goodwill, and plant and equipment
b. current assets, plant and equipment, and goodwill
c. goodwill is not an asset and is not listed here
d. none of the above.
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43. When prices are rising, valuing ending inventory using the FIFO method rather than
LIFO gives
a. inventory a higher value but lowers net income.
b. inventory a lower value and also lowers net income.
c. both inventory and net income a higher value.
d. inventory a lower value and net income a higher value.
44. When prices are falling, valuing inventory using the LIFO method rather than FIFO gives
a. inventory a higher value but lowers net income.
b. inventory a lower value and also lowers net income.
c. both inventory and net income a higher value.
d. inventory a lower value and net income a higher value.
45. Which one of the following is NOT true about goodwill?
a. It is an intangible asset.
b. It represents the value of all unrecorded assets acquired in a merger.
c. It equals the premium paid over the fair market value of the assets acquired in a
merger.
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d. When goodwill appears on a firm’s balance sheet, it reduces the firm’s net worth
by that amount.
46. Which of the following is NOT true about treasury stock?
a. It is the firm’s own shares repurchased in the market by the firm.
b. It can be reissued under stock option and other employee benefit plans.
c. It lowers the value of the company.
d. It increases the net worth of the company.
47. The major disadvantages of market-value accounting include
a. the difficulty in estimating the current value for some assets.
b. the difficulty in applying some of the valuation models used to estimate market
values.
c. the resulting numbers are potentially open to abuse.
d. All of the above are disadvantages of market-value accounting.
48. Which one of the following does NOT belong on an income statement?
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a. depreciation and amortization
b. goodwill
c. extraordinary items
d. nonrecurring expenses
49. Which one of the following are NOT all noncash items?
a. depreciation, deferred taxes, and prepaid expenses
b. depletion charges, taxes, and amortization
c. depletion charges, deferred taxes, and prepaid expenses
d. depreciation, amortization, and prepaid taxes
50. Which one of the following is NOT a cash flow from operating activities?
a. cash payments on the principal of long-term debt
b. payments for utilities and rent
c. payments to purchase raw materials
d. cash receipts from selling goods and services
51. Cash flows from financing activities include all but one of the following:
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a. cash payments on the principal of long-term debt
b. issuing and paying out on insurance contracts
c. cash purchases of treasury stock
d. cash proceeds from a bank loan
52. Which one of the following is NOT a cash flow from investing activities?
a. buying and selling bonds or stock of other firms
b. buying or selling of land, buildings, and plant and equipment
c. cash payments of dividends to shareholders
d. issuing and paying out on insurance contracts
53. Trident Corporation had the following cash flows in the current year. Which one of the
following is a financing activity cash flow?
a. Rent on a warehouse amounting to $1.1 million
b. Purchase of $125,000 worth of five-year bonds issued by Towson Utilities
c. Preferred dividends to the tune of $330,000 paid to shareholders
d. Lease income received on a piece of land
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54. Clarity Music Company has a marginal tax rate of 34 percent and an average tax rate of
32 percent this year. It is planning to construct a new recording studio next year. The
appropriate tax rate to be applied on the income generated from the new studio is
a. the average tax rate.
b. the marginal tax rate.
c. either one.
d. none of the above.
55. Which one of the following is NOT true for a corporation?
a. Interest paid on bonds issued last year is tax deductible.
b. Common-stock dividends to be paid this year are not tax deductible.
c. Common-stock dividends to be paid this year will be tax deductible if the firm
has a net loss for the year.
d. Preferred stock dividends to be paid this year are not tax deductible.
56. Maddux, Inc., has completed its fiscal year and reported the following information. The
company had current assets of $153,413, net fixed assets of $ 412,331, and other assets of
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$7,822. The firm also has current liabilities worth $65,314, long-term debt of $178,334,
and common stock of $162,000. How much retained earnings does the firm have?
a. $ 405,648
b. $243,648
c. $167,918
d. $573,566
57. Galan Associates prepared its financial statement for 2008 based on the information
given here. The company had cash worth $1,234, inventory worth $13,480, and accounts
receivables of $7,789. The company’s net fixed assets are $42,331, and other assets are
$1,822. It had accounts payables of $9,558, notes payables of $2,756, common stock of
$22,000, and retained earnings of $14,008. How much long-term debt does the firm
have?
a. $54,342
b. $76,342
c. $12,314
d. $18,334
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58. Tumbling Haven, a gymnastic equipment manufacturer, provided the following
information to its accountants. The company had current assets of $145,332, net fixed
assets of $356,190, and other assets of $4,176. The firm has long-term debt of $76,445,
common stock of $200,000, and retained earnings of $134,461. What amount of current
liabilities does this firm have?
a. $94,792
b. $505,678
c. $171,217
d. none of the above
59. Teakap, Inc., has current assets of $ 1,456,312 and total assets of $4,812,369 for the year
ending September 30, 2006. It also has current liabilities of $1,041,012, common equity
of $1,500,000, and retained earnings of $1,468,347. How much long-term debt does the
firm have?
a. $1,844,022
b. $2,303,010
c. $2,123,612
d. $803,010
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60. Chandler Sporting Goods produces baseball and football equipment and lines of clothing.
This year the company had cash and marketable securities worth $335,485, accounts
payables worth $1,159,357, inventory of $1,651,599, accounts receivables of $1,488,121,
short-term notes payable worth $313,663, and other current assets of $121,427. What is
the company’s net working capital?
a. $3,596,632
b. $1,801,784
c. $2,123,612
d. $1,673,421
61. Tre-Bien Bakeries generated net income of $233,412 this year. At year end, the company
had accounts receivables of $47,199, inventory of $63,781, and cash of $21,461. It also
had accounts payables of $51,369, short-term notes payables of $11,417, and accrued
taxes of $6,145. The net working capital of the firm is
a. $68,931
b. $63,510
c. $69,655
d. none of the above
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62. Spartan, Inc., is a manufacturer of automobile parts located in Greenville, South Carolina.
At the end of the current fiscal year, the company had net working capital of $157,903.
The company showed accounts payables of $94,233, accounts receivables of $83,112,
inventory of $171,284, and cash and marketable securities of $12,311. What amount of
notes payables does the firm have?
a. $14,571
b. $26,882
c. $15,471
d. none of the above
63. Centennial Brewery produced revenues of $1,145,227 in 2008. It has expenses (excluding
depreciation) of $812,640, depreciation of $131,335, and interest expense of $81,112. It
pays a marginal tax rate of 34 percent. What is the firm’s net income after taxes?
a. $120,140
b. $248,475
c. $79,292
d. $40,848
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64. Simplex Healthcare had net income of $5,411,623 after paying taxes at 34 percent. The
firm had revenues of $20,433,770. Their interest expense for the year was $1,122,376,
while depreciation expense was $2,079,112. What was the firm’s operating expenses
excluding depreciation?
a. $8,199,429
b. $9,032,853
c. $9,321,805
d. none of the above
65. Triumph Trading Company provided the following information to its auditors. For the
year ended March 31, 2008, the company had revenues of $1,122,878, operating
expenses (excluding depreciation and leasing expenses) of $612,663, depreciation
expenses of $231,415, leasing expenses of $126,193, and interest expenses equal to
$87,125. If the company’s tax rate was 34 percent, what is its net income after taxes?
a. $43,218
b. $65,482
c. $152,607
d. none of the above
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66. Parrino Corporation has announced that its net income for the year ended June 30, 2008,
is $1,824,214. The company had an EBITDA of $ 5,174,366, and its depreciation and
amortization expense was equal to $1,241,790. The company’s tax rate is 34 percent.
What is the amount of interest expense for the firm?
a. $2,763,961
b. $939,747
c. $1,187,720
d. $1,168,615
67. During 2008, Towson Recording Company increased its investment in marketable
securities by $36,845, funded fixed assets acquisition by $109,455, and had marketable
securities to the tune of $14,215 mature. What is the net cash used in investing activities?
a. $132,085
b. $145,940
c. –$132,085
d. none of the above
68. Trident Manufacturing Company’s treasurer identified the following cash flows during
this year as significant. It had repaid existing debt to the tune of $425,110, while raising
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additional debt capital of $750,000. It also repurchased stock in the open markets for a
total of $63,250. It paid $233,144 in dividends to its shareholders. What is the net cash
provided by financing activities?
a. $28,496
b. $91,746
c. –$28,496
d. –$91,746
69. Super Grocers, Inc., provided the following financial information for the quarter ending
September 30, 2006:
Depreciation and amortization – $133,414 Net income – $341,463
Increase in receivables – $ 112,709 Increase in inventory – $81,336
Increase in accounts payables – $62,411
Decrease in marketable securities – $31,225
What is the cash flow from operating activities generated during this quarter by the firm?
a. $308,458
b. $374,468
c. –$374,468
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d. –$308,458
The following information applies to the next three questions.
Thunderbird Amusement Park—Balance Sheet as of June 30
Assets 2007 2008
Cash $ 13,221 $ 11,729
Accounts receivables 31,323 37,909
Inventory 77,244 91,617
Total current assets $121,788 $141,255
Net fixed assets 344,712 390,836
Total assets $466,500 $532,091
Liabilities and Stockholders’ Equity
Accounts payable $ 38,549 $ 42,881
Notes payable 12,004 16,753
Deferred taxes 21,934 16,788
Total current liabilities $ 72,487 $ 76,422
Long-term debt 78,445 61,290
Common stock 125,000 175,000
Retained earnings 190,568 219,379
Total liabilities and stockholders’ equity $466,500 $532,091
The company had a net income of $248,462, and depreciation expenses were equal to $72,487.
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70. What is the firm’s cash flow from operating activities?
a. $304,322
b. $297,684
c. $192,602
d. none of the above
71. What is the firm’s cash flow from investing activities?
a. $0
b. $118,611
c. –$118,611
d. none of the above
72. What is the firm’s cash flow from financing activities?
a. –$54,749
b. -$54,749
c. $182,057
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d. -$182,057
73. Trimeton Corporation announced that in the year ended June 30, 2008, its earnings before
taxes amounted to $2,367,045. Calculate its taxes using the following table.
Tax
Rate Taxable Income
15% $0 to $50,000
25 50,001 75,000
34 75,001 100,000
39 100,001 335,000
34 335,001 10,000,000
35 10,000,001 15,000,000
38 15,000,001 18,333,333
35 More than $18,333,333
a. $804,795
b. $690,895
c. $713,145
d. none of the above
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74. Chartworth Associates’ financial statements indicated that the company had EBITDA of
$3,145,903. It had depreciation of $633,000, and its interest rate on debt of $1.25 million
was 7.5 percent. Calculate the amount of taxes the company is likely to owe.
Tax
Rate Taxable Income
15% $0 to $50,000
25 50,001 75,000
34 75,001 100,000
39 100,001 335,000
34 335,001 10,000,000
35 10,000,001 15,000,000
38 15,000,001 18,333,333
35 More than $18,333,333
a. $1,069,607
b. $1,037,732
c. $822,512
d. none of the above
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75. Refer to the information in Problem 74. What are the marginal and the average tax rates
for this company?
a. 34%, 35%
b. 35%, 34%
c. 34%, 34%
d. none of the above
III. Essay Questions
76. Identify and explain the five fundamental principles that form the basis of accounting
standards in the United States.
Answer: The U.S. GAAP is based on a set of five principles. These include the
assumption of arm’s-length transaction, the cost principle, the realization principle, the
matching principle, and the going concern assumption.
The assumption of arm’s-length transaction assumes that the two parties involved in
the transaction have the ability to make economic decisions independently and
rationally without having any influence on the other party’s decision making.
The cost principle calls for recording the value of an asset and its cost at the time of
acquisition. At any point in time, the book value represents a fair value for the asset.
This book value is determined by depreciating the cost of the asset over time.
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The realization principle reflects the fact that the revenue from a sale is recognized
only when the sale of a firm’s product or service is completed and can be reliably
confirmed.
The matching principle requires that any revenue generated from a sale is matched
with the costs associated with producing the revenue.
The going concern assumption refers to the idea that a firm is expected to continue
functioning for the near future.
77. Explain the differences in using FIFO versus LIFO in accounting for inventory.
Answer: There are two common approaches that firms can use to value inventory. The
first one is referred to as FIFO, or first in, first out, which requires a firm making a sale to
associate the sale with the oldest inventory on the balance sheet. The second method is
called LIFO, or last in, first out, and the firm using this approach is required to associate
any sale with the newest inventory on the balance sheet. Although firms may switch from
one approach to another, the switch cannot occur except under extraordinary
circumstances.
Choosing one approach over the other has an impact on a firm’s balance sheet and
income statement, especially during a time of changing prices. When prices are rising, a
firm using FIFO accounting has a lower cost of goods sold and a higher net income. In
addition, the remaining inventory will be valued at the more recent higher cost, which
will result in a higher inventory value on the balance sheet. When prices are declining,
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firms using LIFO benefit because LIFO provides the highest inventory valuation and net
income.
78. What are the advantages and disadvantages of using market-value accounting?
Answer: Using market-value financial statements has several advantages. Having current
information about a firm’s financial condition and the expected cash flows it is able to
generate will allow a firm’s management to make better decisions. It allows investors and
creditors to better evaluate the firm, and it improves its ability to raise capital.
There are also some negatives associated with market-value accounting. First,
assessing the market value of some assets is quite difficult, and accountants would be
wary of making estimates. Second, the valuation models used in practice are not easy to
use and could result in unreliable values. Third, unscrupulous executives could very well
use these estimates to their advantage.
79. Explain the following income statement items.
a. Amortization expense
b. Nonrecurring expense
c. Extraordinary items
d. EBITDA
Answer:
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a. Amortization expense is similar to depreciation. Just as depreciation is used to
write off the cost of real assets such as plant and equipment, amortization is a
means of writing off expenses for intangible assets—such as patents, licenses,
copyrights, trademarks, and goodwill. The costs are assigned to the fiscal periods
in which the firm is assumed to have benefited from these intangible assets.
b. A nonrecurring expense is typically a one-time expense that arises from situations
such as closing down or consolidating obsolete or unprofitable operations, as well
as any restructuring of the firm’s operations.
c. Extraordinary items are also expenses that are unusual and unlikely to occur
frequently. These are gains or losses that do not arise from operations and are a
result of occurrences such as floods, fires, and earthquakes.
d. EBITDA represents a firm’s earnings after accounting for cost of goods sold, but
not expenses related to the asset base that was used to produce the revenues for
the firm. The higher the value of the earnings before interest, taxes, depreciation,
and amortization, the more efficiently the firm is operating.
80. Identify the noncash items that a firm may have on its financial statement and explain
their impact on the shareholders of the firm.
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Answer: Several noncash items can be found on a firm’s financial statement. Although
some firms may have all of these items, others may not. But one noncash item that all
firms will have is depreciation. This is typically the largest noncash item. Another is
amortization. Other noncash items include the following:
Depletion charges, which are like depreciation but apply to extractive natural
resources, such as crude oil, natural gas, timber, and mineral deposits.
Deferred taxes, which are the portion of a firm’s income tax expense that is postponed
because of differences in the accounting policies adopted for management financial
reporting and tax reporting.
Prepaid expenses, such as prepaid rent and insurance.
Deferred revenues, which are revenues received as cash but not yet earned. An
example of deferred revenue would be prepaid magazine subscriptions to a publishing
company.
The noncash expenses on a firm’s income statement reduce the taxable income
and hence the tax paid by the firm. This in turn increases the cash flow available to
shareholders. Noncash revenue items reduce the cash flow available to the firm but are
typically nowhere near the magnitude of the largest noncash expenses.
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IV. Answers to True or False Questions
1. True
2. False
3. True
4. False
5. True
6. True
7. True
8. True
9. False
10. True
11. False
12. False
13. True
14. True
15. True
16. True
17. False
18. True
19. False
20. False
21. False
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22. True
23. False
24. True
25. False
40
V. Answers to Multiple-Choice Questions
26. d
27. b
28. c
29. d
30. a
31. b
32. a
33. c
34. b
35. b
36. d
37. a
38. c
39. a
40. c
41. c
42. b
43. c
44. c
45. d
46. c
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47. d
48. b
49. b
50. a
51. b
52. c
53. c
54. b
55. c
56. c
57. d
58. a
59. d
60. c
61. b
62. a
63. c
64. b
65. a
66. d
67. c
68. a
69. b
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70. b
71. c
72. d
73. a
74. c
75. c
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VI. Solutions to Multiple-Choice Questions
56. Solution:
Total assets = $153,413 + $412,331 + $7,822 = $573,566
Total liabilities = $65,314 + $178,334 = $243,648
Total stockholders’ equity = Total assets – Total liabilities
= $573,466 – $243,648 = $329,918
Retained earnings = Stockholders’ equity – Common stock
= $329,918 – $162,000 = $167,918
57. Solution:
Current assets = $1,234 + $7,789 + $13,480 = $22,503
Total assets = $22,503 + $42,331 + $1,822 = $66,656
Current liabilities = $9,558 + $2,756 = $12,314
Stockholders’ equity = $22,000 + $14,008 = $36,008
Long-term debt = Total assets – Current liabilities – Stockholders’ equity
= $66,656 – $12,314 – $36,008 = $18,334
58. Solution:
Total assets = $145,332 + 356,190 + $4,176 = $505,698
Stockholders’ equity = $200,000 + $134,461 = $334,461
Current liabilities = Total liabilities – Long-term debt – Stockholders’ equity
= $505,698 – $76,445 – $334,461 = $94,792
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59. Solution:
Stockholders’ equity = $1,500,000 + $1,468,347 = $2,968,347
Long-term debt = Total assets – Current liabilities – Stockholders’ equity
= $4,812,369 – $1,041,012 – $2,968,347 = $803,010
60. Solution:
Total current assets = $335,485 + 1,488,121 + $1,651,599 + $121,427 = $3,596,632
Total current liabilities = $1,159,357 + $313,663 = $1,473,020
Net working capital = $3,596,632 – $1,473,020 = $2,123,612
61. Solution:
Total current assets = $21,461 + $47,199 +$63,781 = $132,481
Total current liabilities = $51,369 + $11,417 + $6,145 = $68,931
Net working capital = $132,481 – $68,931 = $63,510
62. Solution:
Total current assets = $12,311 + $83,112 + $171,284 = $266,707
Net working capital = $266,707 – Total current liabilities = $157,903
Total current liabilities = $266,707 – $157,903 = $108,804
Total current liabilities = $108,804 = Accounts payables + Notes payables
Notes payables = $108,804 - $94,233 = $14,571
63. Solution:
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Earnings before taxes = $1,145,227 – ($812,640 + $131,335 + $81,112) = $120,140
Net income = $120,140 (1 – 0.34) = $79,292
64. Solution:
Earnings before taxes = Net income / (1 – Tax rate)
= $5,411,623 / (1 – 0.34) = $8,199,429
EBIT = EBT + Interest expense = $8,199,429 + $1,122,376 = $9,321,805
Revenues – Operating expenses – Depreciation = EBIT
Operating expenses = Revenues – Depreciation – EBIT
= $20,433,770 – $2,079,112 – $9,321,805
= $9,032,853
65. Solution:
EBIT = $1,122,878 – ($612,663 + $231,415 + $126,193) = $152,607
Earnings before taxes = ($152,607 – $87,125) = $65,482
Net income = $65,482 (1 – 0.34) = $43,218
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66. Solution:
Amount
EBITDA $5,174,366.00
Depreciation 1,241,790.00
EBIT $3,932,576.00
Interest 1,168,615.39
EBT $2,763,960.61
Taxes (34%) 939,746.61
Net income $1,824,214.00
67. Solution:
Cash inflows from investing activities = $14,215
Cash outflows from investing activities = $36,845 + $ 109,455 = $146,300
Net cash flows from investing activities = $14,215 – $146,300 = $(132,085)
68. Solution:
Cash inflows from financing activities = $750,000
Cash outflows from financing activities = $425,110 + $63,250 + $233,144 = $721,504
Net cash flows from financing activities = $750,000 – $721,504 = $28,496
69. Solution:
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2008 Statement of Cash Flows ($ thousands)
Operating Activities
Net income $341,463
Additions (sources of cash)
Depreciation and amortization 133,414
Increase in accounts payable 62,411
Decrease in marketable securities 31,225
Subtractions (uses of cash)
Increase in accounts receivable (112,709)
Increase in inventories (81,336)
Net cash provided by operating activities $374,468
70. Solution:
Operating Activities
Net income $248,462
Additions (sources of cash)
Depreciation and amortization 72,487
Increase in accounts payable 4,332
Subtractions (uses of cash)
Decrease in cash (1,492)
Increase in accounts receivable (6,586)
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Increase in inventories (14,373)
Decrease in deferred taxes (5,146)
Net cash provided by operating activities $297,684
71. Solution:
Cash inflows from investing activities = $0
Cash outflows from investing activities = $46,124 + $72,487=118,611
Net cash flows from investing activities = –$$118,611
72. Solution:
Cash inflows from financing activities = $4,749 + $50,000 = $54,749
Cash outflows from financing activities = $17,155 + 219,651 (dividends) = $236,806
Net cash flows from financing activities = $54,749 – $236,806 = -$182,057
73. Solution:
Earnings before tax = $2,367,045
Tax rate Income Tax
15% $0 to $50,000 $ 7,500.00
25 50,001 75,000 6,250.00
34 75,001 100,000 8,500.00
39 100,001 335,000 91,650.00
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34 335,001 10,000,000 690,895.30
35 10,000,001 15,000,000
38 15,000,001 18,333,333
35 More than $18,333,333
Total taxes payable $804,795.30
74. Solution:
EBITDA $3,145,903
Depreciation (633,000)
Interest (93,750)
EBT $2,419,153
Tax rate Income Tax
15% $0 to $50,000 $ 7,500.00
25 50,001 75,000 6,250.00
34 75,001 100,000 8,500.00
39 100,001 335,000 91,650.00
34 335,001 10,000,000 690,895.30
35 10,000,001 15,000,000
38 15,000,001 18,333,333
35 More than $18,333,333
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Total taxes payable $822,512
75. Solution:
Marginal tax rate = 34%
Average tax rate = Total taxes ÷ Taxable income
= $822,512 ÷ $2,419,153
= 34%
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