Chapter 10-Understanding A Firm's Financial Statements: True/False

Chapter 10—Understanding a Firm's Financial Statements
TRUE/FALSE
1. Total assets less outstanding debt equals ownership equity.
ANS: F
Total assets less total debt equals owner’s equity.
PTS: 1 DIF: Difficulty: Moderate REF: p. 256

OBJ: LO: 10-0 NAT: BUSPROG: Analytic STA: DISC: Finance
KEY: Bloom’s: Knowledge
2. The income statement shows a firm's financial position on a specific date.
ANS: F
The income statement indicates the amount of profit or loss generated by a firm over a given period of
time, often one year.
PTS: 1 DIF: Difficulty: Easy REF: p. 259

KEY: Bloom’s: Comprehension
3. Jan’s bank has asked her to show them how her firm’s financial position has changed in the past year.
She should provide the company’s balance sheet.
ANS: F
An income statement reflects the firm's position over a period of time, whereas a balance sheet
provides a snapshot of a firm's financial position at a given point in time.

KEY: Bloom’s: Application | Bloom’s: Comprehension
4. The income statement answers the question: "How profitable is the business?"
ANS: T PTS: 1 DIF: Difficulty: Easy

REF: p. 259 OBJ: LO: 10-1 NAT: BUSPROG: Analytic
STA: DISC: Finance KEY: Bloom’s: Comprehension
5. The terms earnings, profits and income refer to different amounts on the income statement.
ANS: F
All three terms can be interchangeable.

6. Profits reward owners for investing in a company, but they do little to promote future growth.
ANS: F
Profits can be used for dividends or kept in the business as retained earnings for financing future
growth.

7. Depreciation is the cost of a firm’s land and building allocated over its useful life.
ANS: F PTS: 1 DIF: Difficulty: Moderate

8. Dividends to a firm’s owners are not considered an expense in the income statement.

9. The balance sheet shows a firm's assets, liabilities, and owners' equity at a specific point in time.

10. Assets that can be converted to cash relatively quickly are said to be liquid.

REF: p. 265 OBJ: LO: 10-2a NAT: BUSPROG: Analytic
11. Accounts payable consist of payments due from a firm's customers.
ANS: F
Accounts receivables are payments due from a firm's customers; accounts payable is money owed by
the firm to suppliers

OBJ: LO: 10-2b NAT: BUSPROG: Analytic STA: DISC: Finance
12. Accounts payable, accrued expenses, 2-year notes payable, and 90-day notes are all short-term
liabilities.
ANS: F
All of the above liabilities are short term liabilities except for the 2-year notes payable. Since this debt
is due after 12 months, it is considered long-term debt.

13. Ownership equity represents the owner’s investment in the company, which can be either his/her cash
invested in the company or money borrowed from a bank to purchase fixed assets.
ANS: F
Money borrowed from a bank would be considered a liability and not included in owner’s equity.

OBJ: LO: 10-2c NAT: BUSPROG: Analytic STA: DISC: Finance
14. Jane is determining the overall financial situation for her business. Since she has to report to a group
of investors, she should just give them the income statement.
ANS: F
The income statement and balance sheet compliment each other to give an overall picture of the firm’s
financial situation.

15. The cash flow statement answers the questions “From where did the cash come?’ and “Where did the
cash go?”

STA: DISC: Finance KEY: Bloom’s: Knowledge
16. A profitable company may not have positive cash flows.
ANS: T PTS: 1 DIF: Difficulty: Moderate

17. A new business needs to manage cash flows carefully because if a firm runs out of cash, it is out of
business.

18. The major difference between cash-basis accounting and accrual-basis accounting is when the firm
recognizes revenue and profits.

19. The three activities that explain the cash inflows and outflows of a business are the selling, investment
and financing activities.
ANS: F
The three activities are called operating, investing and financing activities.

20. In order to determine the cash flows from day-to-day operations, the firm must convert the company’s
income statement from a cash basis to an accrual basis.
ANS: F
The company’s income statement is converted from an accrual basis to a cash basis.

21. Liquidity represents the degree to which a firm can meet maturing short-term debt obligations with
available working capital.

22. The best financial ratio to determine a company’s ability to pay debt is the debt ratio.
ANS: F
The current ratio is the best way to determine a company’s ability to pay debt.

OBJ: LO: 10-5a NAT: BUSPROG: Analytic STA: DISC: Finance
23. A conventional measure of a firm's liquidity is a comparison of current assets to current liabilities.

24. Net income is used to measure the return on the firm’s total assets.
ANS: F
The return on assets uses operating profits divided by total assets.

25. To determine the debt ratio, the total debt is divided by the total income.
ANS: F PTS: 1 DIF: Difficulty: Moderate

REF: p. 281 OBJ: LO: 10-5c NAT: BUSPROG: Analytic
26. While increasing debt levels can increase the owner’s return on equity, it also reduces risk.
ANS: F PTS: 1 DIF: Difficulty: Easy

MULTIPLE CHOICE
1. Ignazio has just opened his business. One of the first things he should learn is:
a. how to prepare the financial statements.
b. which numbers are most important for him to watch and to watch them like a hawk.
c. whether to pay closer attention to monthly sales or to cash flow.
d. when to lease assets and when to buy them.
ANS: B PTS: 1 DIF: Difficulty: Moderate
KEY: Bloom’s: Application
2. Kevin wants to open his own car repair shop. To do that he will need tools and other equipment. The
two methods Kevin can use to pay for these items are:
a. cash flow and balance sheets.
b. accounts receivable and accounts payable.
c. assets and liabilities
d. debt and equity.
ANS: D PTS: 1 DIF: Difficulty: Easy
3. Bernard has just learned that on the balance sheet, the assets must equal the ___________ plus the
_______________.
a. money borrowed from others, money invested by the owners
b. accounts receivable, accounts payable
c. accumulated depreciation, asset value
d. net profit, retained earnings
ANS: A PTS: 1 DIF: Difficulty: Easy
4. Cameron and Ashley bought $40 of “premium pink lemonade mix” and paper cups for their lemonade
stand. These items are considered:
a. cash balance.
b. fixed assets.
c. inventory.
d. cost of goods sold.
ANS: C PTS: 1 DIF: Difficulty: Easy
STA: DISC: Finance KEY: Bloom’s: Application
5. When Cameron and Ashley allow a customer to buy on credit, which account increases?
a. debt
b. inventory
c. accounts payable
d. accounts receivable
6. Walter knows the result of the equation “Sales-Expenses = Profits” can be found on the:
a. cash flow
b. income statement
c. retained earnings
d. balance sheet
ANS: B PTS: 1 DIF: Difficulty: Easy
7. Horace is reviewing a document that shows the results of his firm's operations over a period of one
year. Horace is looking at the:
a. income statement
b. balance sheet
c. statement of cash flow
d. statement of financial position
8. Kate’s banker would like to know the profit of her business from January 1st through December 31.
She should show him the _______.
a. cash flow statement.
b. income statement.
c. balance sheet.
d. harvest plan.
9. To determine her company’s gross profits, Edith should:

a. subtract cost of goods sold from sales.
b. add interest paid and depreciation.
c. subtract cost of goods sold from operating income.
d. add taxes paid and income before taxes.
ANS: A PTS: 1 DIF: Difficulty: Moderate
10. To calculate his company’s _______________, Edgar will subtract operating expenses from gross
profits.
a. cost of goods sold
b. profits before taxes
c. operating income
d. retained earnings
ANS: C PTS: 1 DIF: Difficulty: Moderate
11. Marvin is preparing one of the annual financial statements and has asked you which of the following
should be included in operating expenses. You tell him it is:
a. marketing-related expenses.
b. the cost for independent dealers to prepare for the distribution of the product.
c. interest on all loans.
d. income taxes.
12. To determine her company’s profits before taxes, Marilyn will have to deduct the firm's interest
expense from its ____ income.
a. total
b. projected
c. net
d. operating
ANS: D PTS: 1 DIF: Difficulty: Moderate
13. From her sales income, Barbara has subtracted cost of goods sold, operating expenses, interest
expense, and taxes. What she has left is her company’s _____ income
a. total
b. projected
c. net
d. operating
REF: p. 260-261 OBJ: LO: 10-1 NAT: BUSPROG: Analytic
14. The owners of ABC, Inc. may expect to be paid a share of the profits of the company. These payments
to owners are called:
a. return on investment.
b. dividends.
c. current expenses.
d. long-term debt.
15. The items on the income statement are expressed in dollars but the corresponding margins are
expressed as:
a. incomes.
b. expenses.
c. profits.
d. percentages.
16. The income statement answers the question:
a. How much cash did the firm generate?
b. How profitable was the business?
c. How much money does the company owe?
d. How much money did the owners invest?
17. For investment purposes, Wilma needs a snapshot of the firm’s financial position at a specific point in
time. She should look at the
a. marketing plan.
b. statement of cash flows.
c. balance sheet.
d. income statement.
18. Xavier wants to know how much his company owns and how much it owes. He should look at the:
a. balance sheet.
b. income statement.
c. cash flow statement.
d. asset list.
19. If an asset can quickly be converted to cash, it is considered to be a(n):

a. current asset.
b. fixed asset.
c. short-term asset.
d. other asset.
20. When Darla prepares her company’s balance sheet, she should include ___________ in the list of
current assets.
a. equipment.
b. land.
c. leased property.
d. accounts receivable.
21. Denver wants to make sure he puts his company’s assets in the correct categories. Which of the
following is an example of a current asset?
a. Land
b. Inventories
c. Equipment
d. Buildings
22. Richard has in his warehouse some raw materials and finished goods that he has ready to fill customer
orders. These are two types of _____.
a. accounts payable.
b. accounts receivable.
c. cost of goods.
d. inventories.
23. Eugenia’s company bought a delivery truck to deliver merchandise to customers. This truck should
appear as ___________ on the balance sheet.
a. a current asset
b. inventory
c. a fixed asset
d. a short-term investment
24. Candace purchased a car for her company’s exclusive use. The value of this car:
a. is constant over time.
b. increases with each use of the asset.
c. decreases over time.
d. increases over time.
25. Astoria is using a software application to prepare the balance sheet. She wasn’t sure which of the
following should be included in the fixed asset category. What would you tell her?
a. Land
b. Copyrights
c. Contingency funds
d. Goodwill
26. A two year-old asset has a depreciable life of 10 years. Its initial purchase cost was $450,000 and it is
depreciated by 10 percent annually. What is the remaining depreciable value of the asset?
a. $ 0.00
b. $90,000
c. $200,000
d. $360,000
27. Some assets don’t seem to fit neatly into any category so accountants created a category called “other.”
Which asset would considered an other asset?
a. Land
b. Machinery
c. Contingency funds
d. Goodwill
28. Stephanie ordered merchandise from one of her vendors but she doesn’t have to pay for it right away.
The amount of this purchase will increase Stephanie’s:
a. accounts receivable
b. assets
c. balance sheet
d. accounts payable
REF: p. 267 OBJ: LO: 10-2b NAT: BUSPROG: Analytic
29. XYC Corporation pays its taxes quarterly but withholds payroll taxes from its employees’ paychecks
each week. Until the taxes are actually paid to the IRS, they appear on the balance sheet as:
a. an asset..
b. an account receivable.
c. a liability.
d. a long-term debt.
30. Ignatio applied for a loan for his business that he will repay in 9 months. The best way to describe this
loan is as a(n):
a. account payable.
b. accrued expense.
c. short-term note.
d. long-tern debt.
31. The debts that Rhonda’s company will repay within the next ______________ are considered to be
current debt.
a. 2 years
b. 6 months
c. 1 quarter
d. 12 months
32. Raul needed an expensive piece of equipment to expand his business. He borrowed the money from
the bank and pledged the equipment as ___________. If Raul does not repay the loan, the bank can
take his equipment.
a. a promissory note
b. collateral
c. asset in escrow
d. long term debt
33. Martina invested her savings into her business when she started it. Later she added more capital and
she has kept some of her profits. Together these are known as:
a. debt capital.
b. accrued expenses.
c. owners' long-term debt.
d. owners' equity.
REF: p. 267-268 OBJ: LO: 10-2c NAT: BUSPROG: Analytic
34. For Webster to understand how his company performed during calendar year 2012, he must begin with
firm’s financial position on:
a. January 1, 2012.
b. July 1, 2013.
c. September 30, 2010.
d. June 30, 2011.
35. The balance sheet and income statement are separate reports, but actually
a. complement each other.
b. contradict each other.
c. display information for the same time duration.
d. display vision and mission statements for the company.
36. For any business, both the _______ and ________ are needed to determine a firm’s financial position.
a. income statement; balance sheet
b. income statement; cash flow
c. balance sheet; line of credit
d. cash flow; balance sheet
37. It is important for Heather to monitor her cash flow because:

a. if she borrowed money to finance her business, the lenders will want to make sure she
used the money wisely.
b. her investors will want to make sure they get their money back.
c. cash flow is a measure of her success.
d. a business can go bankrupt with negative cash flows even though the income statement
shows a profit.
38. The cash flow statement measures cash flows on

a. an annual basis.
b. an accrual basis.
c. a cash basis.
d. a normalized basis.
39. Natalya is confused about the difference between cash-basis and accrual-basis accounting. So you tell
her that the:
a. cash method is easier to use.
b. cash method matches revenue and expenses better.
c. point of recognition of revenue and expenses is different.
d. cash method involves less record keeping.
STA: DISC: Finance KEY: Bloom’s: Application | Bloom’s: Comprehension
40. Coronado cannot use the income statement as a measure of cash flows because it is calculated on a(n)
_______ rather than a(n) _______ basis.
a. annual; cash
b. annual; accrual
c. accrual; cash
d. cash; accrual
41. Lucille is preparing the _____, which shows all cash receipts and payments involved in operating the
business and managing its financial activities.
a. income statement
b. balance sheet
c. cash flow statement
d. statement of financial position
REF: p. 273-274 OBJ: LO: 10-4b NAT: BUSPROG: Analytic
42. The cash flow activities on the cash flow statement are divided into these categories:
a. cash from operations, buying or selling assets, and financing the business.
b. payments on accounts receivable, payments on accounts payable, and changes in owner’s
equity.
c. cash from sales, cash from accounts receivable, and payments on accounts payable.
d. payment on debt, cash from sales, and increases to owner’s equity.
43. Depreciation is added back on the cash flow statement in which activity section?
a. Financing
b. Income
c. Investment
d. Operating
44. In order to derive a cash flow statement, the owner must add back the _____ to the income statement.
a. depreciation expense
b. increase in accounts receivable
c. increases in inventory
d. decrease in accounts payable
45. To determine how much Harlan sold to cash customers, he must:

a. add the increase in accounts receivable to total sales.
b. subtract the increase in accounts receivable from total sales.
c. add the increase in accounts payable to total cash.
d. subtract the increase in liabilities from owner’s equity.
46. Guenther bought merchandise for his retail business on credit and sold some of it for cash. To record
his purchases on his cash flow statement, Guenther will:
a. subtract the cash sales of this new inventory from total inventory purchased.
b. subtract the increase in accounts payable from the increase in inventory.
c. subtract the increase in inventory from the increase in accounts payable.
d. subtract the decrease in accounts receivable from the increase in inventory.
ANS: C PTS: 1 DIF: Difficulty: Challenging
KEY: Bloom’s: Analysis | Bloom’s: Application
47. Fatima borrowed money from the bank to expand her business. She plans to repay the loan within 12
months. How is this reflected on the cash flow statement?
a. As an increase in owner’s equity and an increase to cash.
b. As an increase to cash.
c. As a decrease to cash.
d. As an increase to current liabilities.
ANS: B PTS: 1 DIF: Difficulty: Challenging
48. The liquidity of a firm is

a. often measured by a ratio of current assets to current liabilities.
b. not important to a company's financial health.
c. the ability of the firm to sell its products quickly.
d. a measurement of spontaneous financing.
49. Comparing this year’s results to last year’s, Hector discovered that his firm’s current ratio improved
from 1.5 to 2.0. What has happened?
a. Current liabilities have decreased.
b. Fixed assets have increased.
c. Ownership equity has increased.
d. Long-term debt has decreased.
STA: DISC: Finance KEY: Bloom’s: Analysis
50. If Hector’s firm’s current ratio _____, its liquidity _____.

a. increases; increases
b. increases; decreases
c. decreases; increases
d. increases; remains the same
51. Irma’s current ratio is 2.5. This means that:

a. for every dollar of current assets, Irma has $2.50 in current liabilities.
b. for every dollar of current liabilities, Irma has $2.50 in current assets.
c. Irma has enough cash to pay her debts for the next 2.5 years.
d. Irma can borrow 2.5 times her annual sales.
REF: p. 279-280 OBJ: LO: 10-5a NAT: BUSPROG: Analytic
52. Jasper bought some new equipment for his business. Six months later he wants to know whether this
was a good idea. To do that, he can calculate the:
a. current ratio.
b. operating profit margin.
c. total asset turnover.
d. return on assets.
53. Kermit calculated his total asset turnover to be 1.13. This tells Kermit that:
a. every dollar of assets generates $1.13 in sales.
b. every dollar of sales costs Kermit $1.13 to generate.
c. every year he turns his inventory 1.13 times.
d. every dollar of assets generates $1.13 in profits.
KEY: Bloom’s: Comprehension | Bloom’s: Application
54. To determine his company’s debt ratio, Hector should divide the firm’s total debt by the total _____.
a. income
b. operating profits
c. assets
d. liabilities
55. Lance is trying to decide whether to purchase a new bulldozer to expand his business. He is confident
he has enough work to keep the bulldozer busy and that repaying the loan will not be a problem. What
advice would you give Lance?
a. If the interest rate on the loan is less than the return on assets for the dozer, buy.
b. If the return on this asset is more than the return on his equity, don’t buy.
c. If his current return on equity is greater than the return on this asset, buy.
d. If his total asset turnover rate is greater than one, don’t buy.
ANS: A PTS: 1 DIF: Difficulty: Challenging
KEY: Bloom’s: Application | Bloom’s: Analysis
56. To increase her return on equity, Latitia could:

a. increase the amount of assets he company owns.
b. increase the amount of debt on her balance sheet.
c. decrease the amount of liabilities on her balance sheet.
d. decrease the amount of inventory she carries.
REF: p. 282 OBJ: LO: 10-5d NAT: BUSPROG: Analytic
KEY: Bloom’s: Analysis | Bloom’s: Application
MATCHING
Match the term with its definition.
a. Accrual-basis accounting e. Liquidity
b. Cash-basis accounting f. Operating profit margin
c. Current ratio g. Return on assets
d. Financial statements h. Return on equity
1. An accounting method of recording profits when earned and expenses when incurred, whether or not
the profits have been received in cash or the expenses paid
2. A measure of a firm’s profitability relative to the amount of its assets, determined by dividing
operating profits by total assets
3. The degree to which a firm has working capital available to meet maturing debt obligations
4. An accounting method of recording profits when cash is received and recording expenses when they
are paid
5. A measure of how well a firm is controlling its cost of goods sold and operating expenses relative to
sales, determined by dividing operating profits by sales
6. A measure of the rate of return that owners receive on their equity investment, calculated by dividing
net profits by owners’ equity
7. A firm’s income statement, balance sheets, and cash flow statements
1. ANS: A PTS: 1 DIF: Difficulty: Easy

2. ANS: G PTS: 1 DIF: Difficulty: Easy
3. ANS: E PTS: 1 DIF: Difficulty: Easy
4. ANS: B PTS: 1 DIF: Difficulty: Easy
5. ANS: F PTS: 1 DIF: Difficulty: Easy
6. ANS: H PTS: 1 DIF: Difficulty: Easy
7. ANS: D PTS: 1 DIF: Difficulty: Easy

a. Accounts payable e. Current assets
b. Accounts receivable f. Current debt
c. Accumulated depreciation g. Current ratio
d. Common stock h. Depreciation expense
8. The cost of a firm’s building and equipment, allocated over the asset’s useful life
9. The amount of credit extended to customers that is currently outstanding
10. Stock shares that represent ownership in a corporation
11. Outstanding credit payable to suppliers
12. Assets that can be converted to cash relatively quickly
13. Borrowed money that must be repaid within 12 months
14. Total depreciation taken over time

14. ANS: C PTS: 1 DIF: Difficulty: Easy

a. Accrued expenses e. Gross fixed assets
b. Cash flow activities f. Long-term debt
c. Cash flow statement g. Other assets
d. Fixed assets h. Short-term notes
15. Physical assets that will be used in the business for more than one year
16. Operating, investing, and financing activities that result in cash inflows or outflows
17. Loans from banks or other sources with repayment terms of more than 12 months
18. A financial report showing a firm’s sources of cash as well as its uses of cash
19. Operating expenses that have been incurred and are owed but not yet paid
20. Depreciable assets at their original cost, before any depreciation expense has been taken
21. Agreements to repay cash amounts borrowed from banks or other lending sources within 12 months or
less


a. Balance sheet e. Mortgage
b. Debt f. Owners’ equity
c. Dividend g. Retained earnings
d. Financial leverage h. Working capital cycle
22. A long-term loan to purchase a building or land
23. Financing provided by creditors
24. Profits not paid out as dividends over the life of a business
25. The impact of financing with debt rather than with equity
26. Owners’ investments in a company plus cumulative net profits retained in the firm
27. The process of converting inventory to cash
28. A distribution of a firm’s profits to the owners


a. Cost of goods sold e. Operating profits
b. Gross profit f. Profit margins
c. Long-term notes g. Profits before taxes
d. Net profits h. Total asset turnover
29. Agreements to repay cash amounts borrowed from banks or other lending sources, plus interest, for
periods longer than 12 months
30. Earnings after operating expenses and interest expenses but before taxes
31. Earnings that may be distributed to the owners or reinvested in the company
32. Sales less the cost of goods sold
33. Profits as a percentage of sales
34. Earnings after operating expenses but before interest and taxes are paid
35. A measure of how efficiently a firm is using its assets to generate sales


a. Cost of goods sold e. Income statement
b. Current ratio f. Interest expense
c. Debt ratio g. Inventory
d. Depreciable assets h. Net fixed assets
36. A measure of what percentage of a firm’s assets is financed by debt
37. The cost of producing or acquiring goods or services to be sold by a firm
38. Gross fixed assets less accumulated depreciation
39. A measure of a company’s relative liquidity
40. A financial report showing the amount of profits or losses from a firm’s operations over a given period
of time
41. Assets whose value declines over time
42. The cost of borrowed money

ESSAY
1. What five areas of business activity need to be examined to answer the question “How profitable is the
business?”
ANS:
The areas are sales, the cost of producing or acquiring goods or services, operating expenses, interest
expense on borrowed funds, and tax payments. By monitoring these areas and comparing company
values to competitors and those with “best practices”, profitability has a greater chance.
PTS: 1 REF: p. 300 OBJ: LO: 10-1 NAT: BUSPROG: Communication

STA: DISC: Finance KEY: Bloom’s: C
2. What accounts would be included as operating activities and financing activities for an income
statement?
ANS:
Operating activities would include sales - cost of good sold = gross profit - operating expense =
operating profits.
Financing activities would include interest expense (which is subtracted from operating profits in the
operating activities section) to equal profits before tax.
PTS: 1 REF: p. 298 OBJ: LO: 10-1 NAT: BUSPROG: Communication

STA: DISC: Finance KEY: Bloom’s: D
3. Trucks for Stuff is a one year old company that provides statewide moving services to customers.
Describe the types of current, fixed and other assets Trucks for Stuff would have.
ANS:
Current Assets
Cash: The business should have cash on hand for day-to-day business operations. This money
should be easily accessible. A marketable security that could be sold and liquidated quickly might also
be expected.
Accounts Receivable: Trucks for Stuff probably has accounts receivable set-up for the
customer ease. This option is for people who do not have the cash at the time of the sale, but have
been given credit terms to pay the business for its services usually on a 30 day period.
Inventory: Trucks for Stuff may not have inventory since they are providing a service to the
customers instead of selling a product.
Fixed Assets
Machinery/Equipment: The company would have trucks as well as office equipment.
Building: It could also have a building to store the trucks not being used.
Land: The company could own the location of the business.
Other Assets
Long-term investments: These investments would be possible but may not expected for a
startup company. The company would have trucks as well as office equipment.
Patents/Copyrights: These assets would not be expected.
Goodwill: If the company has been successful in its first year, this asset would be possible.
PTS: 1 DIF: Difficulty: Challenging REF: p. 265-266

OBJ: LO: 10-2a NAT: BUSPROG: Communication STA: DISC: Finance
KEY: Bloom’s: Comprehension | Bloom’s: Application
4. Describe sources of current debt.
ANS:
Current debt (or short-term liabilities) involves borrowed money that must be repaid within 12 months.
The sources of current debt are:
· Accounts payable-the credit extended by suppliers to a firm when it purchases
inventories.
· Accrued expenses-short-term liabilities that have been incurred but not yet paid
(e.g., work performed for which payment has not been made).
· Short-term notes-cash amounts borrowed from a bank, or other lending source, for
a short period of time (e.g., 90 days).
PTS: 1 DIF: Difficulty: Challenging REF: p. 267

OBJ: LO: 10-2b NAT: BUSPROG: Communication STA: DISC: Finance
5. Compare and contrast the income statement and balance sheet. What is important to know about each
statement to determine how a company performed during the year?
ANS:
While the income statement and balance sheet are two separate reports, they complement each other to
give an overall picture of the firm’s financial situation. The income statement reports for a given
period of time while the balance sheet covers a specific point in time. Both of these entities are
important in understanding the full financial situation of the business.
To understand how a firm performed during a year, three values must be known:
the firm’s financial position at the beginning of the year (previous year’s balance sheet ending value),
the financial performance during the year (income statement for the year), and the financial position at
the end of the year (balance sheet ending value).

OBJ: LO: 10-3 NAT: BUSPROG: Communication STA: DISC: Finance
6. Briefly explain the difference between accrual-basis accounting and cash-basis accounting.
ANS:
In accrual-basis accounting profits are recorded when they are earned, whether or not the profits have
been received in cash, and expenses are recorded when they occur, even if the money has not actually
been paid out.
In cash-basis accounting, profits are reported when cash is received and expenses are reported when
they are paid.

OBJ: LO: 10-4a NAT: BUSPROG: Communication STA: DISC: Finance
KEY: Bloom’s: Comprehension | Bloom’s: Knowledge
7. Why do profits based on an accrual accounting system differ from profits based on a cash-based
system?
ANS:
1. Sales reported in an income statement include both cash sales and credit sales.
2. Some inventory purchases are financed by credit
3. The depreciation expense shown in the income statement is a noncash expense.
4. Frequently, not all of the income tax shown in the income statement is paid in the
period reported.

KEY: Bloom’s: Analysis | Bloom’s: Comprehension
8. Warren needs to generate cash flow for his lawn mowing business. What three cash flow activities can
he engage to bring in cash for his company?
ANS:
- Cash flow generated from day-to-day business operations: Warren could schedule more lawns to
be mowed and/or find more customers who are willing to pay him the day of service. Selling his
service generates cash.
- Buying or selling fixed assets: If Warren has extra equipment that he is not using, it could be sold to
generate an inflow of cash.
- Financing the business: Warren could put more money into the business himself or take a loan from
a bank or investor to generate cash flow into his business. Depending on the investors, he could
postpone dividend payments to keep more cash in the business.

OBJ: LO: 10-4b NAT: BUSPROG: Communication STA: DISC: Finance
9. When an entrepreneur is trying to determine how management decisions have impacted the business
for the past year, what four areas are critical? What ratios would need to be calculated to find
answers?
ANS:
1. The firm’s ability to pay its short-term debt as it comes due (current ratio)
2. The company’s profitability from the assets (return on assets, operating profit margin, total asset
turnover)
3. The amount of debt the firm is using (debt ratio)
4. The rate of return earned on the equity investment (return on equity).
10. Erin, the owner of Sweets To Eat Ice Cream Shoppe, wants to know how her company is operating
from a financial perspective. Her CPA has given her the following numbers: Sales $325,000,
Operating Profits $50,000, Current Assets $125,000, Current Liabilities $40,000, Total Assets
$350,000. The ice cream retail industry norms include Operating Profit Margin 10%, Return on Assets
11% and Current Ratio 2.7. Determine the company’s liquidity and compare the value to the industry
ratios.
ANS:
Erin’s current ratio is 3.125 (Current Assets $125,000/Current Liabilities $40,000). While this number
indicates a very high liquidity value, Erin should check her cash values. If the shoppe has a high
balance in the cash account and it does not need the money soon to pay debt, investing the money
might be a better option. However this high liquidity shows management has a high capacity to cover
its short-term debt.

OBJ: LO: 10-5a NAT: BUSPROG: Communication | BUSPROG: Analytic
STA: DISC: Finance KEY: Bloom’s: Application | Bloom’s: Analysis
11. Erin, the owner of Sweets To Eat Ice Cream Shoppe, wants to know how her company is operating
from a financial perspective. Her CPA has given her the following numbers: Sales $325,000,
Operating Profits $50,000, Current Assets $125,000, Current Liabilities $40,000, and Total Assets
$350,000. The ice cream retail industry norms include Operating Profit Margin 10%, Return on Assets
11% and Current Ratio 2.7. Determine the company’s profitability on its assets and compare to the
industry ratios.
ANS:
Erin’s return on assets is 14.2% (Operating Profits $50,000/Total Assets $350,000). While this number
is above the industry’s ROA of 11%, the ice cream shop’s Total Asset Turnover is .929 (Sales
$325,000/Total Assets $350,000) below the industry norm of 1.1 (11%/10%) . This value indicates
that management is not using the shop’s assets to generate sales as well as the industry.

OBJ: LO: 10-5b NAT: BUSPROG: Communication | BUSPROG: Analytic
STA: DISC: Finance KEY: Bloom’s: Application | Bloom’s: Analysis

Chapter 10-Understanding A Firm's Financial Statements: True/False

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Chapter 10-Understanding A Firm's Financial Statements: True/False

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Chapter 10—Understanding a Firm's Financial Statements

1. Total assets less outstanding debt equals ownership equity.

PTS: 1 DIF: Difficulty: Moderate REF: p. 256

2. The income statement shows a firm's financial position on a specific date.

PTS: 1 DIF: Difficulty: Easy REF: p. 259

PTS: 1 DIF: Difficulty: Easy REF: p. 259

ANS: T PTS: 1 DIF: Difficulty: Easy

PTS: 1 DIF: Difficulty: Moderate REF: p. 259

PTS: 1 DIF: Difficulty: Easy REF: p. 261

ANS: F PTS: 1 DIF: Difficulty: Moderate

ANS: T PTS: 1 DIF: Difficulty: Easy

ANS: T PTS: 1 DIF: Difficulty: Easy

ANS: T PTS: 1 DIF: Difficulty: Easy

11. Accounts payable consist of payments due from a firm's customers.

PTS: 1 DIF: Difficulty: Easy REF: p. 267

PTS: 1 DIF: Difficulty: Easy REF: p. 267

PTS: 1 DIF: Difficulty: Easy REF: p. 267

PTS: 1 DIF: Difficulty: Easy REF: p. 270

ANS: T PTS: 1 DIF: Difficulty: Easy

16. A profitable company may not have positive cash flows.

ANS: T PTS: 1 DIF: Difficulty: Moderate

ANS: T PTS: 1 DIF: Difficulty: Easy

ANS: T PTS: 1 DIF: Difficulty: Easy

PTS: 1 DIF: Difficulty: Moderate REF: p. 274

PTS: 1 DIF: Difficulty: Easy REF: p. 274

ANS: T PTS: 1 DIF: Difficulty: Easy

PTS: 1 DIF: Difficulty: Easy REF: p. 279

ANS: T PTS: 1 DIF: Difficulty: Easy

PTS: 1 DIF: Difficulty: Moderate REF: p. 280

ANS: F PTS: 1 DIF: Difficulty: Moderate

ANS: F PTS: 1 DIF: Difficulty: Easy

9. To determine her company’s gross profits, Edith should:

19. If an asset can quickly be converted to cash, it is considered to be a(n):

37. It is important for Heather to monitor her cash flow because:

38. The cash flow statement measures cash flows on

45. To determine how much Harlan sold to cash customers, he must:

48. The liquidity of a firm is

50. If Hector’s firm’s current ratio _____, its liquidity _____.

51. Irma’s current ratio is 2.5. This means that:

56. To increase her return on equity, Latitia could:

1. ANS: A PTS: 1 DIF: Difficulty: Easy

Match the term with its definition.

8. ANS: H PTS: 1 DIF: Difficulty: Easy

Match the term with its definition.

15. ANS: D PTS: 1 DIF: Difficulty: Easy

Match the term with its definition.

22. ANS: E PTS: 1 DIF: Difficulty: Easy

Match the term with its definition.

29. ANS: C PTS: 1 DIF: Difficulty: Easy

Match the term with its definition.

36. ANS: C PTS: 1 DIF: Difficulty: Easy

PTS: 1 REF: p. 300 OBJ: LO: 10-1 NAT: BUSPROG: Communication

PTS: 1 REF: p. 298 OBJ: LO: 10-1 NAT: BUSPROG: Communication

PTS: 1 DIF: Difficulty: Challenging REF: p. 265-266

4. Describe sources of current debt.

PTS: 1 DIF: Difficulty: Challenging REF: p. 267

PTS: 1 DIF: Difficulty: Challenging REF: p. 270

PTS: 1 DIF: Difficulty: Challenging REF: p. 273

PTS: 1 DIF: Difficulty: Challenging REF: p. 273

PTS: 1 DIF: Difficulty: Challenging REF: p. 274

PTS: 1 DIF: Difficulty: Challenging REF: p. 279

PTS: 1 DIF: Difficulty: Challenging REF: p. 280

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50. If Hector’s firm’s current ratio _, its liquidity _.