mgt Chapter 03 - Answer

MANAGEMENT ACCOUNTING - Solutions Manual

CHAPTER 3 UNDERSTANDING FINANCIAL STATEMENTS I.

Questions 1. A financial statement is a means of communicating information about an enterprise in financial (i.e., peso) terms. It represents information that the accountant believes is a true and fair representation of the financial activity of the enterprise. 2. Every financial statement relates to time in one way or another. A statement of financial position, or balance sheet, represent a “picture” of the enterprise at a point in time (e.g., the end of a month or year). An income statement and a statement of cash flows, on the other hand, cover activity that took place over a period of time (e.g., a month or year). 3. a. Creditors are interested in financial statements to assist them in evaluating the ability of a business to repay its debts. No one wants to extend credit to a company that is unable to meet its obligations as they come due. b. Potential investors use financial statements in selecting among alternative investment opportunities. They are interested in investing in companies in which the value of their investment will increase as a result of future profitable operations. c. Labor unions are interested in financial statements because the financial position of a company and its profits are important factors in the company’s ability to pay higher wages and to employ more people. 4. Business transactions affect a company’s financial position, and as a result they change the statement of financial position or balance sheet. The other financial statements – the income statement and the statement of cash flows – are detailed expansions of certain aspects of the statement of financial position and help explain how the company’s position changed over time. 5. The cost principle indicates that many assets are included in the financial records, and therefore, in the statement of financial position, at their original cost to the reporting enterprise. This principle affects accounting 3-1

Chapter 3 Understanding Financial Statements

for assets in several ways, one of which is that the amount of most assets is not adjusted periodically for changes in the market value of the assets. Instead, cost is retained as the basic method of accounting, regardless of changes in the market value of those assets. 6. The going concern assumption states that in the absence of evidence to the contrary (i.e., bankruptcy proceedings), an enterprise is expected to continue to operate in the foreseeable future. This means, for example, that it will continue to use the assets it has in its financial statements for the purpose for which they were acquired. 7. The three categories and the information included in each are: Operating activities – Cash provided by and used in revenue and expense transactions. Investing activities – Cash provided by and used as a result of investments in assets, such as machinery, equipment, land, and buildings. Financial activities – Cash provided by and used in debt and equity financing, such as borrowing and repaying loans, and investments from and dividends paid to the enterprise’s owners. 8. Adequate disclosure refers to the requirement that financial statements, including accompanying notes, must include information necessary for reasonably informed users of financial statements to understand the company’s financial activities. This requirement is often met, in part, by the addition of notes to the financial statements. Financial statement notes include both quantitative and qualitative information that is not included in the body of the financial statements. 9. A strong income statement is one that has significantly more pesos of revenue than expenses, resulting in net income that is a relatively high percentage of the revenue figure. A trend of relatively high income numbers over time signals a particularly strong income situation. 10. A strong statement of cash flows is one that shows significant amounts of cash generated from operating activities. This means that the enterprise is generating cash from its ongoing activities and is not required to rely on continuous debt and equity financing, or the sale of its major assets.

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Understanding Financial Statements Chapter 3

11. The purpose of classifications in financial statements is to develop useful subtotals, which help users analyze the statements. The most commonly used classifications are: In a balance sheet: current assets, plant and equipment, other assets, current liabilities, long-term liabilities and equity. In a multiple-step income statement: revenue, cost of goods sold, operating expenses, and nonoperating items. The operating expense section often includes subclassifications for selling expenses and for general and administrative expenses. In a statement of cash flows: operating activities, investing activities, and financing activities. 12. In classified financial statements, similar items are grouped together to produce subtotals which may assist users in their analyses. Comparative financial statements show financial statements for two or more time periods in side-by-side columns. Consolidated statements include not only the financial statement amounts for the company itself but also for any subsidiary companies that it owns. The financial statements of large corporations often possess all three of these characteristics. 13. In a multiple-step income statement, different categories of expenses are deducted from revenue in a series of steps, thus resulting in various subtotals, such as gross profit and operating income. In a single-step income statement, all expenses are combined and deducted from total revenue in a single step. Both formats result in the same amount of net income. II. Matching Type 1. 1. d 2. g

3. a 4. j

5. e 6. h

7. f 8. b

9. c 10. i

2. 1. d 2. a

3. i 4. g

5. m 6. c

7. h 8. n

9. f 10. k

11. b 12. j

13. e 14. l

3. a. F b. I

c. F d. I

e. I f. F

g. F h. F

3-3

I. j.

I F

k. F l. I

Chapter 3 Understanding Financial Statements

III. Problems Problem 1 (Preparing a Balance Sheet – A Second Problem) Requirement (a) SM Farms Balance Sheet September 30, 2005 Assets Cash Accounts receivable

P 16,710 22,365

Liabilities and Equity Liabilities: Notes payable P530,000

Land Barns and sheds Citrus trees Livestock Irrigation system Farm machinery Fences & gates Total

550,000 78,300 76,650 120,780 20,125 42,970 33,570 P961,470

Accounts payable Property taxes payable Wages payable Total liabilities Equity: Share capital Retained earnings* Total

77,095 9,135 1,820 P618,050 250,000 93,420 P961,470

* Total assets, P961,470, minus total liabilities, P618,050, less share capital, P250,000.

Requirement (b) The loss of an asset, Barns and Sheds, from a typhoon would cause a decrease in total assets. When total assets are decreased, the balance sheet total of liabilities and equity must also decrease. Since there is no change in liabilities as a result of the destruction of an asset, the decrease on the right-hand side of the balance sheet must be in the retained earnings account. The amount of the decrease in Barns and Sheds, in the equity, and in both balance sheet totals, is P23,800. Problem 2 (Preparing a Balance Sheet and Cash Flow Statement; Effects of Business Transactions) Requirement (a) The Tasty Bakery Balance Sheet August 1, 2005 Assets Cash

P

6,940 3-4

Liabilities and Equity Liabilities:

Understanding Financial Statements Chapter 3 Accounts receivable

11,260

Supplies Land Building Equipment and fixtures

7,000 67,000 84,000 44,500

Total

P220,700

Notes payable Accounts payable Salaries payable Total liabilities Equity: Share capital Retained earnings Total

P 74,900 16,200 8,900 P100,000 80,000 40,700 P220,700

Requirement (b) The Tasty Bakery Balance Sheet August 3, 2005 Assets Cash Accounts receivable

P 14,490 11,260

Supplies Land Building Equipment and fixtures

8,250 67,000 84,000 51,700

Total

P236,700

Liabilities and Equity Liabilities: Notes payable P 74,900 Accounts payable Salaries payable Total liabilities Equity: Share capital Retained earnings Total

7,200 8,900 P 91,000 105,000 40,700 P236,700

The Tasty Bakery Statement of Cash Flows For the Period August 1 - 3, 2005 Cash flows from operating activities: Cash payment of accounts payable Cash purchase of supplies Cash used in operating activities

P(16,200) (1,250)

Cash flows from investing activities: None 3-5

P(17,450)

Chapter 3 Understanding Financial Statements Cash flows from financing activities: Sale of share capital

P25,000

Increase in cash Cash balance, August 1, 2005 Cash balance, August 3, 2005

P 7,550 6,940 P14,490

Requirement (c) The Tasty Bakery is in a stronger financial position on August 3 than it was on August 1. On August 1, the highly liquid assets (cash and accounts receivable) total only P18,200, but the company has P25,100 in debts due in the near future (accounts payable plus salaries payable). On August 3, after additional infusion of cash from the sale of stock, the liquid assets total P25,750, and debts due in the near future amount to P16,100. Note to Instructor: The analysis of financial position strength in requirement (c) is based solely upon the balance sheets at August 1 and August 3. Hopefully, students will raise many legitimate issues regarding necessity of information about operations, rate at which cash flows into the business, etc. In this problem, the improvement in financial position results solely from the sale of share capital.

Problem 3 (Preparing Financial Statements; Transactions)

Effects of Business

Requirement (a) The First Malt Shop Balance Sheet September 30, 2005 Assets Cash Accounts receivable Supplies Land

P 7,400 1,250 3,440 55,000 3-6

Liabilities and Equity Liabilities: Notes payable* P 70,000 Accounts payable Total liabilities

8,500 P 78,500

Understanding Financial Statements Chapter 3 Building Furniture & fixtures Total

45,500 20,000 P132,590

Equity: Share capital Retained earnings Total

50,000 4,090 P132,590

* Total assets, P132,590, less equity, P54,090, less accounts payable, P8,500, equals notes payable.

Requirement (b) The First Malt Shop Balance Sheet October 6, 2005 Assets Cash Accounts receivable Supplies Land Building Furniture & fixtures Total

P 29,400 1,250 4,440 55,000 45,500 38,000 P173,590

Liabilities and Equity Liabilities: Notes payable P 70,000 Accounts payable Total liabilities Equity: Share capital Retained earnings Total

18,000 P 88,000 80,000 5,590 P173,590

The First Malt Shop Income Statement For the Period October 1-6, 2005 Revenues Expenses Net income

P 5,500 (4,000) P 1,500 The First Malt Shop Statement of Cash Flows For the Period October 1-6, 2005

Cash flows from operating activities: Cash received from revenues Cash paid for expenses

P5,500 (4,000) 3-7

Chapter 3 Understanding Financial Statements Cash paid for accounts payable Cash paid for supplies Cash used in operating activities

(8,500) (1,000) P(8,000)

Cash flows from investing activities: None Cash flows from financing activities: Cash received from sale of share capital

P30,000

Increase in cash Cash balance, October 1, 2005 Cash balance, October 6, 2005

P 22,000 7,400 P29,400

Requirement (c) The First Malt Shop is in a stronger financial position on October 6 than on September 30. On September 30, the company had highly liquid assets (cash and accounts receivable) of P8,650, which barely exceeded the P8,500 in liabilities (accounts payable) due in the near future. On October 6, after the additional investment of cash by shareholders, the company’s cash alone exceeded its short-term obligations.

Problem 4 (Preparing a Balance Sheet; Discussion of Accounting Principles) Requirement (1) Fil-Cinema Scripts Balance Sheet November 30, 2005 Cash Notes receivable

Assets

Accounts receivable Land Building Office furniture* Total

P 3,940 2,200 2,450 39,000 54,320 12,825 P114,735 3-8

Liabilities and Equity Liabilities: Notes payable P 73,500 Accounts payable Total liabilities Equity: Share capital Retained earnings Total

32,700 P106,200 5,000 3,535 P114,735

Understanding Financial Statements Chapter 3

* P8,850 + P6,500 – P2,525.

Requirement (2) (1) The cash in Cruz’s personal savings account is not an asset of the business entity Fil-Cinema Scripts and should not appear in the balance sheet of the business. The money on deposit in the business bank account (P3,400) and in the company safe (P540) constitute cash owned by the business. Thus, the cash owned by the business at November 30 totals P3,940. (2) The years-old IOU does not qualify as a business asset for two reasons. First, it does not belong to the business entity. Second, it appears to be uncollectible. A receivable that cannot be collected is not viewed as an asset, as it represents no future economic benefit. (3) The total amount to be included in “Office furniture” for the rug is P9,400, the total cost, regardless of whether this amount was paid in cash. Consequently, “Office furniture” should be increased by P6,500. The P6,500 liability arising from the purchase of the rug came into existence prior to the balance sheet date and must be added to the “Notes payable” amount. (4) The computer is no longer owned by Hollywood Scripts and therefore cannot be included in the assets. To do so would cause an overstatement of both assets and equity. The “Office furniture” amount must be reduced by P2,525. (5) The P22,400 described as “Other assets” is not an asset, because there is no valid legal claim or any reasonable expectation of recovering the income taxes paid. Also, the payment of income taxes by Cruz was not a business transaction by Fil-Cinema Scripts. If a refund were obtained from the government, it would come to Cruz personally, not to the business entity. (6) The proper valuation for the land is its historical cost of P39,000, the amount established by the transaction in which the land was purchased. Although the land may have a current fair value in excess of its cost, the offer by the friend to buy the land if Cruz would move the building appears to be mere conversation rather than solid, verifiable evidence of the fair value of the land. The “cost principle,” although less than perfect, produces far more reliable financial statements than would result if owners could “pull figures out of the air” in recording asset values. 3-9

Chapter 3 Understanding Financial Statements

(7) The accounts payable should be limited to the debts of the business, P32,700, and should not include Cruz’s personal liabilities. IV. Multiple Choice Questions 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

D D D B A B D C B C

11. 12. 13. 14. 15. 16. 17. 18. 19. 20.

B C D A D A A B C C

21. 22. 23. 24. 25. 26. 27. 28. 29. 30.

B C A B A D B B D C

31. 32. 33. 34. 35. 36. 37. 38.

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B D D D C A A C