Example Test Questions

Chapter 6

Multiple choice

1. The disposal of a significant component of a business is calleda. A change in accounting principleb. An extraordinary itemc. An other expensed. Discontinued operation

Answer d

2. If year one sales equal $800,000, year two equal $840,000 and year three equals $896,000 the percentage to be assigned for year two in a sales trend analysis, assuming that year 1 is the base year, isa. 100%b. 89%c. 105%d. 112%

Answer c

3. A measure of a company’s profitability is thea. Current ratiob. Current cash debt coverage ratioc. Return on assets ratiod. Debt to total assets ratio

Answer c

4. Which of the following is not an economic consequence of financial reporting?a. Financial information can affect the distribution of wealth among investors. More

informed investors, or investors employing security analysts, may be able to increase their wealth at the expense of less informed investors.

b. Financial information can affect the level of risk accepted by a firm. Focusing on short-term, less risky projects may have long-term detrimental effects.

c. Financial information can affect the rate of capital formation in the economy and result in a reallocation of wealth between consumption and investment within the economy.

d. Financial information can affects the allocation of psychic income among investors.

Answer d

5. Which of the following is not an income statement element?a. Assetb. Gainc. Revenued. Expense

Answer a

6. The statement, net income should reflect all items that affected the net increase or decrease in stockholders’ equity during the period is consistentwithwhich of the following concepts of income?a. Economicb. All inclusivec. Current operating performanced. Money

Answer b

7. The phrase events and transactions that are distinguished by both their unusual nature and their infrequency of occurrence describes:a. Changes in accounting principlesb. Prior period adjustmentsc. Extraordinary itemsd. Prior period adjustments

Answer c

8. Which of the following is not an accounting change?a. Change in accounting principleb. Change in accounting estimatec. Change in a reporting entityd. Change because of an error

Answer d

9. Which of the following is not an example of an error?a. A change from an accounting practice that is not generally acceptable to a practice that is

generally acceptable.b. Mathematical mistakes.c. A change from LIFO to FIFO inventory costingd. The incorrect classification of costs and expense

Answer c

10. The formula, Operating profit/Sales, is used to calculatea. Gross profit percentageb. Net profit percentagec. Comprehensive income percentaged. Operating profit percentage

Answer d

11. The accounts receivable turnover and inventory turnover ratios are used to analyzea. Long-term solvencyb. Profitabilityc. Liquidityd. Leverage

Answer c

12. A high accounts receivable turnover ratio indicates a. Customers are making payments quicklyb. A large portion of the company’s sales are on creditc. Many customers are not paying their receivables in a timely mannerd. The company’s sales have increased

Answer c

13. The return on assets ratio is comprised of a. Profit margin and debt to total assets ratio.b. Profit margin and asset turnover ratio.c. Times interest earned and debt to stockholders’ equity ratio.d. Profit margin and free cash flow.

Answer b

14. An example of the correction of an error in previously issued financial statements is a changea. From the completed contract to the percentage-of-completion method of

accounting for long-term construction-type contracts. b. In the depletion rate, based on new engineering studies of recoverable mineral

resources.c. From the sum-of-years-digits to the straight-line method of depreciation for all plant

assets.d. From the installment basis of recording sales to the accrual basis, when collection of the

sales price has been and continues to be reasonably assured

Answer d

15. Which of the following is characteristic of a change in an accounting estimate?a. It usually need not be disclosedb. It does not affect the financial statements of prior periodsc. It should be reported through the restatement of the financial statementsd. It makes necessary the reporting of pro forma amounts for prior periods

Answer b

16. Which of the following items, if material in amount would normally be considered an extraordinary item for reporting results of operations?a. Utilization of a net operating loss carryforwardb. Gains or losses on disposal of a segment of a businessc. Adjustments of accruals on long-term contractsd. Gains or losses from a fire

Answer d

17. Which of the following is an example of an extraordinary item in reporting results of operations?a. A loss incurred because of a strike by employeesb. The write-off of deferred research and development costs believed to have no future

benefitc. A gain resulting from the devaluation of the U.S. dollard. A gain resulting from the state exercising its right of eminent domain on a piece of land

used as a parking lot

Answer d

18. A company changed its method of inventory pricing from last-in, first-out to first-in, first-out during the current year. Generally accepting accounting principles require that this change in accounting method be reported by:a. Accounting for the effects of the change in the current and future periods.b. Showing the cumulative effect of the change in the current year’s financial statements

and pro forma effects on prior year’s financial statements in an appropriate footnotec. Disclosing the reason for the change in the “significant accounting policies” footnote for

the current year but not restating prior year financial statementsd. Applying retroactively the new method in restatements of prior years and appropriate

footnote disclosures

Answer d

19. A transaction that is material in amount, unusual in nature, but not infrequent in occurrence should be presented separately as a (an)a. Component of income from continuing operations, but not net of applicable income

taxesb. Component of income from continuing operations, net of applicable income taxes c. Extraordinary item, net of applicable income taxes d. Prior period adjustment, but not net of applicable income taxes

Answer a

20. An extraordinary item should be reported separately as a component of incomea. After discontinued operations of a component of a businessb. Before discontinued operations of a component of a businessc. After cumulative effect of accounting changes and after discontinued operations of a

component of a businessd. After cumulative effect of accounting changes and before discontinued operations of a

component of a business

Answer b

21. The correction of an error in the financial statements of a prior period should be reflected, net of applicable income taxes, in the current a. Income statement after income from continuing operations and before extraordinary

itemsb. Income statement after income from continuing operations and after extraordinary itemsc. Retained earnings statement as an adjustment of the opening balanced. Retained earnings statement after net income but before dividends

Answer c

22. A loss from the disposal of a component of a business enterprise should be reported separately as a component of incomea. Before extraordinary itemsb. After extraordinary itemsc. After extraordinary items and cumulative effect of accounting changesd. Before extraordinary items and cumulative effect of accounting changes

Answer a

23. A prior period adjustment should be reflected, net of applicable income taxes, in the financial statements of a business entity in the a. Retained earnings statement after net income but before dividendsb. Retained earnings statement as an adjustment of the opening balancec. Income statement after income from continuing operationsd. Income statement as part of income from continuing operations

Answer b

24. Antidilutive securities would generally be used in the calculation of Basic Diluted

Earnings per share Earnings per sharea. Yes Yesb. No Yesc. No Nod. Yes No

Answer c

25. A change in the salvage value of an asset depreciated on a straight-line basis and arising because additional information has been obtained is a. An accounting change that should be reported in the period of change and future

periods of change if the change affects both

b. An accounting change that should be reported by restating the financial statements of all prior periods presented

c. A correction of an errord. Not an accounting change

Answer b

26. A loss should be separately as a component of net income when it is unusual in nature and which of the following?

Material Infrequent In Amount In Occurrence

a. No Yesb. No Noc. Yes Nod. Yes Yes

Answer d

27. When a component of a business has been discontinued during the year, this s’ component s operating losses of the current period up to the measurement date should be included in the a. Income statement as part of the income (loss) from operations of the discontinued

componentb. Income statement as part of the loss on disposal of the discontinued componentc. Income statement as part of the income (loss) from continuing operationsd. Retained earnings statement as a direct decrease in retained earnings

Answer aEssay

1. Discuss the economic consequences of financial reporting.

Income measurement and financial reporting involve economic consequences, including:

Financial information can affect the distribution of wealth among investors. More informed investors, or investors employing security analysts, may be able to increase their wealth at the expense of less informed investors.

Financial information can affect the level of risk accepted by a firm. As discussed in Chapter 4, focusing on short-term, less risky projects may have long-term detrimental effects.

Financial information can affect the rate of capital formation in the economy and result in a reallocation of wealth between consumption and investment within the economy.

Financial information can affect how investment is allocated among firms.

Since economic consequences may affect different users of information differently, the selection of financial reporting methods by the FASB and the SEC involves trade-offs. The deliberations of accounting standard setters should consider these economic consequences.

2. Discuss the four income statements elements defined by SFAC No. 2.

The income statement elements are defined in SFAC No. 6 as follows:

Revenues. Inflows or other enhancements of assets of an entity or settlement of its liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.

Gains. Increases in net assets from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from revenues or investments by owners.

Expenses. Outflows or other using-up of assets or incurrences of liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations.

Losses. Decreases in net assets from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except from expenses or distributions to owners.

3. Discuss the all inclusive vs. current operating performance views of income.

An important distinction between revenues and gains and expenses and losses is whether or not they are associated with ongoing operations. Over the years, this distinction has generated questions concerning the nature of income reporting desired by various financial-statement users. Two viewpoints have dominated this dialogue and are termed the current operating performance concept and the all-inclusive concept of income reporting. The proponents of the current operating performance concept of income base their arguments on the belief that only changes and events controllable by management that result from current-period decisions should be included in income. This concept implies that normal and recurring items should constitute the principal measure of enterprise performance. That is, net income should reflect the day-to-day, profit-directed activities of the enterprise, and the inclusion of other items of profit or loss distorts the meaning of the term net income.Alternatively, advocates of the all-inclusive concept of income hold that net income should reflect all items that affected the net increase or decrease in stockholders’ equity during the period, with the exception of capital transactions. They believe that the total net income for the life of an enterprise should be determinable by summing the periodic net income figures.The underlying assumption behind the current operating performance versus all-inclusive concept controversy is that the manner in which financial information is presented is important. In essence, both viewpoints agree on the information to be presented but disagree on where to disclose certain revenues, expenses, gains, and losses. As discussed in Chapters 4 and 5, research indicates that investors are not influenced by where items are reported in financial statements so long as the statements disclose the same information. So, perhaps, the concern over the current operating performance versus the all-inclusive concept of income is unwarranted. In the following paragraphs we review the history of the issue.

4. Define and discuss the accounting treatment for discontinued operations.

In order to qualify for treatment as a discontinued operation, an item must meet several criteria. First, the unit being discontinued must be considered a “component” of the business. The

definition of component is based on the notion of distinguishable operations and cash flows. Specifically, FASB ASC 205-10-20 defines a component of an entity as comprising operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity.Certain units—segments, operating divisions, lines of business, subsidiaries—are usually considered components. But depending on the business in which an entity operates, other units may be considered components as well.Assuming the unit to be discontinued is a “component” of the business, it must meet two additional criteria before the transaction can be reported as a discontinued operation. First, the operations and cash flows of the component being disposed of must be eliminated from the operations and cash flows of the entity as a result of the transaction. The company is not allowed to retain an interest in the cash flows of the operation and still account for it as a discontinued operation. Second, and finally, the entity must retain no significant involvement in the operations of the component after the disposal takes place.Once management decides to sell a component, its assets and liabilities are classified as “held-for-sale” on its balance sheet. Then, if a business has a component classified as held-for-sale, or if it actually disposes of the component during the accounting period, it is to report the results of the operations of the component in that period, and in all periods presented on a comparative Income Statement, as a discontinued operation. It should report these results directly under the income subtotal “Income from Continuing Operations.” These results would be reported net of applicable income taxes or benefit. In the period in which the component is actually sold (or otherwise disposed of), the results of operations and the gain or loss on the sale should be combined and reported on the Income Statement as the gain or loss from the operations of the discontinued unit. The gain or loss on disposal may then be disclosed on the face of the Income Statement or in the notes to the financial statements.

5. Define and discuss the accounting treatment for extraordinary items.

In APB Opinion No. 30, “Reporting the Results of Operations,” extraordinary items were defined as events and transactions that are distinguished by both their unusual nature and their infrequency of occurrence. These characteristics were originally defined as follows.

Unusual nature. —the event or transaction should possess a high degree of abnormality and be unrelated or only incidentally related to ordinary activities.

Infrequency of occurrence. —the event or transaction would not reasonably be expected to recur in the foreseeable future. Question: given the ASC, should we remove footnotes to original sources?

In APB Opinion No. 30, several types of transactions were defined as not meeting these criteria. These included write-downs and write-offs of receivables, inventories, equipment leased to others, deferred research and development costs, or other intangible assets; gains or losses in foreign currency transactions or devaluations; gains or losses on disposals of segments of a business; other gains or losses on the sale or abandonment of property, plant, and equipment used in business; effects of strikes; and adjustments of accruals on long-term contracts. The position expressed in Opinion No. 30 was, therefore, somewhat of a reversal in philosophy; some items previously defined as extraordinary in APB Opinion No. 9 were now specifically excluded from that classification. The result was the retention of the extraordinary item classification on the income statement. However, the number of revenue and expense items allowed to be reported as extraordinary was significantly reduced.

6. What are accounting changes and why is it an issue. List and define the three types of accounting changes.

The accounting standard of consistency indicates that similar transactions should be reported in the same manner each year. Stated differently, management should choose the set of accounting practices that most correctly presents the resources and performance of the reporting unit and continue to use those practices each year. However, companies may occasionally find that reporting is improved by changing the methods and procedures previously used or that changes in reporting may be dictated by the FASB or the SEC.

The APB originally studied this problem and issued its findings in APB Opinion No. 20, “Accounting Changes.” This release identified three types of accounting changes, discussed the general question of errors in the preparation of financial statements, and defined these changes as follows.

1. Change in an accounting principle. This type of change occurs when an entity adopts a GAAP that differs from one previously used for reporting purposes. Examples of such changes are a change from LIFO to FIFO inventory pricing or a change in depreciation methods.

2. Change in an accounting estimate. These changes result from the necessary consequences of periodic presentation. That is, financial statement presentation requires estimation of future events, and such estimates are subject to periodic review. Examples of such changes are the life of depreciable assets and the estimated collectability of receivables.

3. Change in a reporting entity. Changes of this type are caused by changes in reporting units, which may be the result of consolidations, changes in specific subsidiaries, or a change in the number of companies consolidated.

7. Discuss the concept of simple vs. complex capital structures and how it relates to the reporting of earnings per share.

Under the provisions of APB Opinion No. 15, a company had either a simple or complex capital structure. A simple capital structure was comprised solely of common stock or other securities whose exercise or conversion would not in the aggregate dilute EPS by 3 percent or more.Companies with complex capital structures have securities that potentially could be exchanged for common stock. Consequently, these companies were required to disclose dual EPS figures: (1) primary EPS and (2) fully diluted EPS. Primary EPS was intended to display the most likely dilutive effect of exercise or conversion on EPS. It included only the dilutive effects of common stock equivalents. APB Opinion No. 15 described common stock equivalents as securities that are not, in form, common stock, but rather contain provisions that enable the holders of such securities to become common stockholders and to participate in any value appreciation of the common stock.

8. Define and discuss the accounting treatment for prior period adjustments.

Occasionally, companies make mistakes in their accounting records. Sometimes these “mistakes” occur because of intentional or fraudulent misapplication of accounting rules, principles, or estimates. Generally, mistakes are unintentional and arise because of errors in arithmetic, double entries, transposed numbers, or failure to record a transaction or adjustment. If the company

discovers the mistake in the period in which it occurred, an adjustment is made to the accounts affected to correct it. If, however, the mistake does not get discovered until a later period, the company will need to make a prior period adjustment. Prior period adjustments involve adjusting the beginning retained earnings balance and reporting the adjustment in either the statement of stockholders’ equity or in a separate statement of retained earnings. Since the error occurred in a prior period, it does not affect the current income statement, so it is not reported in the income statement in the period of correction. Also, since the prior period’s net income was closed to retained earnings at the end of that period, retained earnings is misstated in the current period and must be adjusted to remove the effect of the error. FASB ASC 250 specifies that the only items of profit and loss that should be reported as prior period adjustments were

a. Correction of an error in the financial statements of a prior period.

b. Adjustments that result from the realization of income tax benefits of preacquisition operating loss carry-forwards of purchased subsidiaries.

9. Define comprehensive income. What is the purpose of reporting comprehensive income?

Comprehensive income is defined as “the change in equity [net assets] of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.” The term comprehensive income is used to describe the total of all components of comprehensive income, including net income. FASB ASC 220-10-20 uses the term other comprehensive income to refer to revenues, expenses, gains, and losses included in comprehensive income but excluded from net income. The stated purpose of reporting comprehensive income is to report a measure of overall enterprise performance by disclosing all changes in equity of a business enterprise that result from recognized transactions and other economic events of the period other than transactions with owners in their capacity as owners.FASB ASC 220 requires the disclosure of comprehensive income and discusses how to report and disclose comprehensive income and its components, including net income. However, it does not specify when to recognize or how to measure the items that make up comprehensive income. The FASB indicated that existing and future accounting standards will provide guidance on items that are to be included in comprehensive income and its components. When used with related disclosures and information in the other financial statements, the information provided by reporting comprehensive income should help investors, creditors, and others in assessing an enterprise’s financial performance and the timing and magnitude of its future cash flows.

10. Obtain a company’s income statement and ask the students to compute the following:a. Gross profit percentageb. Net profit percentagec. Operating profit percentaged. Price earnings ratio

These answers depend on the company chosen.

11. Discuss the sources of guidance for recording accounting transactions outlined by IAS No. 8, Accounting Policies, Changes in Accounting Estimates and Errors.

IAS No 8 indicated that the following sources should be considered in descending order:

the requirements and guidance in IASB standards and interpretations dealing with similar and related issues; and

the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework for the Presentation of Financial Statements.

the most recent pronouncements of other standard-setting bodies that use a similar conceptual framework to develop accounting standards.

other accounting literature and accepted industry practices, to the extent that these do not conflict with the sources in paragraph.