Chapter 3The Balance Sheet and Notes to the Financial Statements

MULTIPLE CHOICE

1. Balance sheet analysis is useful in assessing a firm's liquidity, which is the ability to
a. satisfy short-term obligations.
b. main profitable operations.
c. maintain past levels of preferred and common dividends.
d. survive a major economic downturn.
ANS: A OBJ: LO 1

2. For a liability to exist,

a. there must be a past transaction or event.
b. the exact amount must be known.
c. the identity of the party to whom the liability is owed must be known.
d. there must be an obligation to pay cash in the future.
ANS: A OBJ: LO 1

3. Accrued revenues would normally appear on the balance sheet as

a. plant assets.
b. current liabilities.
c. long-term liabilities.
d. current assets.
ANS: D OBJ: LO 1

4. Which of the following would not be classified as a current asset on a classified balance sheet?
a. Investment securities (trading).
b. Short-term investments.
c. Prepaid expenses.
d. Intangible assets.
ANS: D OBJ: LO 1

5. The correct order to present current assets is

a. cash, inventories, prepaid items, accounts receivable.
b. cash, inventories, accounts receivable, prepaid items.
c. cash, accounts receivable, prepaid items, inventories.
d. cash, accounts receivable, inventories, prepaid items.
ANS: D OBJ: LO 1

6. Unearned rent would normally appear on the balance sheet as a

a. plant asset.
b. current liability.
c. long-term liability.
d. current asset.
ANS: B OBJ: LO 1

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7.Investment securities held for the purpose of retiring bonds should be classified on a balance sheet as
a. current assets.
b. investments.
c. deferred bond liability.
d. intangible assets.
ANS: B OBJ: LO 1

8. Which of the following is not a long-term investment?

a. Stock held to exert influence on another company.
b. Land held for speculation.
c. Trademarks.
d. Cash surrender value of life insurance.
ANS: C OBJ: LO 1

9. Which of the following characteristics may result in the classification of a liability being changed
from current to noncurrent?
a. Violation of a subjective acceleration clause.
b. Violation of an objective acceleration clause.
c. A demand provision for payment.
d. Refinancing after the balance sheet date.
ANS: D OBJ: LO 1

10. Which of the following characteristics may result in the classification of a liability as current?
a. Short-term obligations expected to be refinanced with long-term debt.
b. Debts to be liquidated from funds that have been accumulated and are reported as
noncurrent assets.
c. Violation of provisions of a debt agreement.
d. Obligations for advance collections that involve long-term deferment of the delivery of
goods or services.
ANS: C OBJ: LO 1

11. Which of the following would not be classified as a current liability on a classified balance sheet?
a. Unearned revenue.
b. Deferred income tax liability.
c. The currently maturing portion of long-term debt.
d. Accrued salaries payable to management.
ANS: B OBJ: LO 1

12. Which of the following would not be considered an element of working capital?
a. Investment securities (current)
b. Organization costs
c. Accrued interest on notes payable
d. Work in process inventories
ANS: B OBJ: LO 1

13. Pending litigation would generally be considered a(n)

a. nonmonetary liability.
b. contingent liability.
c. estimated liability.
d. current liability.
ANS: B OBJ: LO 1

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14. Which of the following statements regarding assets is not true?
a. An asset represents a probable future economic benefit.
b. Assets are obtained or controlled as a result of past or probable future transactions or
events.
c. Assets reported on the balance sheet include both monetary and nonmonetary resources.
d. Assets include costs that have not yet been matched with revenues.
ANS: B OBJ: LO 1

15. Which of the following would not be reported for capital stock in the contributed capital section
of a classified balance sheet?
a. Dividends per share
b. Shares authorized
c. Shares issued
d. Shares outstanding
ANS: A OBJ: LO 1

16. Which of the following circumstances would require recording an accrual for a loss contingency
under current generally accepted accounting principles?
a. Event is unusual in nature and occurrence of event is probable
b. Event is unusual in nature and event occurs infrequently
c. Amount of loss is reasonably estimable and occurrence of event is probable
d. Amount of loss is reasonably estimable and event occurs infrequently
ANS: C OBJ: LO 1

17. Which of the following would not be reported in the stockholders' equity section of the balance
sheet?
a. Retained earnings appropriated for future plant expansion
b. Dividends declared on preferred stock
c. Paid-in capital in excess of par value
d. Deficit in retained earnings
ANS: B OBJ: LO 1

18. Which of the following best describes contributed capital?

a. The amount that would be distributed to the stockholders in a liquidation of the
corporation.
b. The amount of capital provided by stockholders' investments.
c. The amount of capital provided by stockholders' investments and undistributed earnings.
d. The value of the common and preferred stock.
ANS: B OBJ: LO 1

19. A contingent liability should be recorded when

a. any lawsuit is actually filed against a company.
b. it is certain that funds are available to pay the amount of the claim.
c. it is probable that a liability has been incurred even though the amount of the loss cannot
be reasonably estimated.
d. the amount of the loss can be reasonably estimated and it is probable prior to issuance of
financial statements that a liability has been incurred.
ANS: D OBJ: LO 1

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20. How should a contingent liability be reported in the financial statements when it is "reasonably
possible" the company will have to pay the liability at a future date?
a. As a deferred liability.
b. As an accrued liability.
c. As a disclosure only.
d. As an account payable with an additional disclosure explaining the nature of the
transaction.
ANS: C OBJ: LO 1

21. Which of the following statements best describes a subsequent event?

a. A subsequent event affects only subsequent reporting periods.
b. A subsequent event may occur any time after financial statements are issued.
c. A subsequent event is, in some cases, reflected in the statements of the preceding period.
d. A subsequent event is not covered by the independent auditor's report.
ANS: C OBJ: LO 1

22. Which of the following generally is considered a limitation of the balance sheet?
a. The balance sheet reflects the current value of a business.
b. The balance sheet reflects the instability of the dollar.
c. Balance sheet formats and classifications do not vary to reflect industry differences.
d. Due to measurement problems, some enterprise resources and obligations are not reported
on the balance sheet.
ANS: D OBJ: LO 5

23. The operating cycle

a. measures the time elapsed between cash disbursement for inventory and cash collection of
the sales price.
b. refers to the seasonal variations experienced by business enterprises.
c. should be used to classify assets and liabilities as current if it is less than one year.
d. cannot exceed one year.
ANS: A OBJ: LO 1

24. Lobo Co. was incorporated on July 1, 2004, with $200,000 from the issuance of stock and
borrowed funds of $30,000. During the first year of operations, net income was $10,000. On
December 15, Lobo paid an $800 cash dividend. No additional activities affected owners' equity
in 2004. At December 31, 2004, Lobo's liabilities had increased to $37,600. In Lobo's December
31, 2004, balance sheet, total assets should be reported at
a. $239,200.
b. $240,000.
c. $246,800.
d. $276,800.
ANS: C OBJ: LO 1

25. Mejarus Co.'s adjusted trial balance at December 31, 2004, includes the following account
balances:

Common Stock, $3 par .................................... $360,000

Additional Paid-In Capital .............................. 480,000
Treasury Stock, at cost ................................. 30,000
Net Unrealized Loss on Available-for-Sale Securities .... 12,000

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 Retained Earnings: Appropriated for Uninsured Earthquake 90,000
Losses ................................................
Retained Earnings: Unappropriated ....................... 120,000

What amount should Mejarus report as total stockholders' equity in its December 31, 2004,
balance sheet?
a. $1,008,000
b. $1,032,000
c. $1,068,000
d. $1,092,000
ANS: A OBJ: LO 1

26. The following changes in Patriot Corporation's account balances occurred during 2004:

Increase
Assets .................................................. $267,000
Liabilities ............................................. 81,000
Capital Stock ........................................... 198,000

Patriot paid dividends of $39,000 during the year. There were no changes in Retained Earnings
for 2004 except dividends and net income. What was Patriot's net income for 2004?
a. $12,000
b. $27,000
c. $39,000
d. $51,000
ANS: B OBJ: LO 1

27. Blues Corporation's trial balance included the following account balances at December 31, 2004:

Accounts Payable ........................................ $45,000

Bonds Payable, due 2005 ................................. 75,000
Discount on Bonds Payable, due 2005 ..................... 9,000
Dividends Payable January 31, 2005 ...................... 24,000
Notes Payable, due January 31, 2008 ..................... 60,000

What amount should be included in the current liability section of Blues' December 31, 2004,
balance sheet?
a. $135,000
b. $153,000
c. $195,000
d. $234,000
ANS: A OBJ: LO 1

28. Hogi-Yogi Co. has total debt of $252,000 and stockholders' equity of $420,000. Hogi-Yogi is
seeking capital to fund an expansion. Hogi-Yogi is planning to issue an additional $180,000 in
common stock, and is negotiating with a bank to borrow additional funds. The bank requires a
maximum debt ratio of .75. What is the maximum additional amount Hogi-Yogi will be able to
borrow after the common stock is issued?
a. $639,000
b. $852,000
c. $1,236,000
d. $1,548,000
ANS: D OBJ: LO 3

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29. The following data were taken from the financial statements of Jensen Corporation for the year
ended December 31, 2004:

Net sales ............................................... $120,000

Net income .............................................. 30,000
Total assets, January 1, 2004 ........................... 400,000
Total assets, December 31, 2004 ......................... 600,000

What was Jensen's rate of return on assets for 2004?

a. 5 percent
b. 6 percent
c. 20 percent
d. 24 percent
ANS: B OBJ: LO 3

30. Barney Co.'s current ratio is 2:1. Which of the following transactions would normally increase
Barney's current ratio?
a. Purchasing inventory on account
b. Borrowing money by signing a long-term note
c. Collecting an account receivable
d. Purchasing land for cash
ANS: B OBJ: LO 3

31. The accounts and balances shown below were gathered from Paynter Corporation's trial balance
on December 31, 2004. All adjusting entries have been made.

Wages Payable ........................................... $ 25,600

Cash .................................................... 17,700
Mortgage Payable ........................................ 151,600
Dividends Payable ....................................... 14,000
Prepaid Rent ............................................ 13,600
Inventory ............................................... 81,800
Sinking Fund Assets ..................................... 52,400
Short-Term Investments .................................. 15,200
Premium on Bonds Payable ................................ 4,600
Stock Investment in Subsidiary .......................... 102,400
Taxes Payable ........................................... 22,800
Accounts Payable ........................................ 24,800
Accounts Receivable ..................................... 36,600

The amount that should be reported as current assets on Paynter Corporation's balance sheet is
a. $151,300.
b. $164,900.
c. $217,300.
d. $267,300.
ANS: B OBJ: LO 1

32. Neptune Corporation's trial balance contained the following account balances at December 31,
2004:

Accumulated Depreciation--Equipment ..................... $45,000

Short-Term Investments .................................. 15,000
Prepaid Insurance ....................................... 3,000

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 Cash .................................................... 33,000
Inventory of Merchandise ................................ 90,000
Equipment and Furniture ................................. 54,000
Patent .................................................. 12,000
Accounts Receivable (net) ............................... 48,000
Land Held for Future Business Site ...................... 75,000

On Neptune's December 31, 2004, balance sheet, the current assets total should be
a. $189,000.
b. $201,000.
c. $219,000.
d. $243,000.
ANS: A OBJ: LO 1

33. The accounts and balances shown below were gathered from Paynter Corporation's trial balance
on December 31, 2004. All adjusting entries have been made.

Wages Payable ........................................... $ 25,600

Cash .................................................... 17,700
Mortgage Payable ........................................ 151,600
Dividends Payable ....................................... 14,000
Prepaid Rent ............................................ 13,600
Inventory ............................................... 81,800
Sinking Fund Assets ..................................... 52,400
Short-Term Investments .................................. 15,200
Premium on Bonds Payable ................................ 4,600
Stock Investment in Subsidiary .......................... 102,400
Taxes Payable ........................................... 22,800
Accounts Payable ........................................ 24,800
Accounts Receivable ..................................... 36,600

The amount that should be reported as current liabilities on Paynter Corporation's balance sheet is
a. $87,200.
b. $91,800.
c. $73,200.
d. $238,800.
ANS: A OBJ: LO 1

34. The accounts and balances shown below were gathered from Paynter Corporation's trial balance
on December 31, 2004. All adjusting entries have been made.

Wages Payable ........................................... $ 25,600

Cash .................................................... 17,700
Mortgage Payable ........................................ 151,600
Dividends Payable ....................................... 14,000
Prepaid Rent ............................................ 13,600
Inventory ............................................... 81,800
Sinking Fund Assets ..................................... 52,400
Short-Term Investments .................................. 15,200
Premium on Bonds Payable ................................ 4,600
Stock Investment in Subsidiary .......................... 102,400
Taxes Payable ........................................... 22,800
Accounts Payable ........................................ 24,800
Accounts Receivable ..................................... 36,600

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 Paynter Corporation's working capital is
a. $62,500.
b. $73,100.
c. $77,700.
d. $125,700.
ANS: C OBJ: LO 2

35. Baggins Company prepared a draft of its 2004 balance sheet. The draft statement reported total
assets of $437,500. Included in this total assets figure were the following items:

Treasury stock of Baggins Company at cost, which $12,000

approximates market value on December 31 ................
Unamortized patents ..................................... 5,600
Cash surrender value of life insurance on corporate
executives .............................................. 6,850
Unrealized holding losses on available-for-sale
securities ............................................ 4,200

At which amount should Baggins' total assets be correctly reported in the December 31, 2004,
balance sheet?
a. $420,850
b. $421,300
c. $425,050
d. $425,500
ANS: D OBJ: LO 1

36. Maryk Electronics Inc. reported the following items on its December 31, 2004, trial balance:

Accounts Payable ........................................ $108,900

Advances to Employees ................................... 4,500
Unearned Rent Revenue ................................... 28,800
Estimated Liability Under Warranties .................... 25,800
Cash Surrender Value of Officers' Life Insurance ........ 7,500
Bonds Payable ........................................... 555,000
Discount on Bonds Payable ............................... 22,500
Trademarks .............................................. 3,900

The amount that should be recorded on Maryk's balance sheet as total liabilities is
a. $696,000.
b. $700,500.
c. $703,500.
d. $741,000.
ANS: A OBJ: LO 1

37. Troy Co. began operations on January 1, 2004, with $100,000 from the issuance of stock and
borrowed funds of $15,000. Net income for 2004 was $5,000 and Troy paid a $400 cash dividend
on December 15. No additional activities affected owners' equity in 2004. At December 31,
2004, Troy's liabilities had increased to $18,800. In Troy's December 31, 2004, balance sheet,
total assets should be reported at
a. $119,600.
b. $120,000.
c. $123,400.
d. $138,400.
ANS: C OBJ: LO 1

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38. Eagle Co. prepared a draft of its 2004 balance sheet. The draft statement reported current
liabilities totaling $200,000. However, none of the following items were included in this
preliminary total at December 31, 2004:

Accounts payable ........................................ $30,000

Bonds payable, due 2005 ................................. 50,000
Discount on bonds payable, due 2005 ..................... 6,000
Dividends payable on January 31, 2005 ................... 16,000
Notes payable, due 2006 ................................. 40,000

At which amount should Eagle's current liabilities be correctly reported in the December 31,
2004, balance sheet?
a. $230,000
b. $290,000
c. $296,000
d. $302,000
ANS: B OBJ: LO 1

39. The December 31, 2004, balance sheet of Madden Inc., reported total assets of $1,050,000 and
total liabilities of $680,000. The following information relates to the year 2005:

Madden Inc. issued an additional 5,000 shares of common stock at $25 per share on
July 1, 2005.
Madden Inc. paid dividends totaling $80,000.
Net income for 2005 was $110,000.
No other changes occurred in stockholders' equity during 2005.

The stockholders' equity section of the December 31, 2005, balance sheet would report a balance
of
a. $400,000.
b. $525,000.
c. $685,000.
d. $835,000.
ANS: B OBJ: LO 1

40. Information from Blain Company's balance sheet is as follows:

Current assets:
Cash .................................................... $ 1,200,000
Investment securities ................................... 3,750,000
Accounts receivable ..................................... 28,800,000
Inventories ............................................. 33,150,000
Prepaid expenses ........................................ 600,000
Total current assets .................................... $67,500,000
Current liabilities:
Notes payable ........................................... $ 750,000
Accounts payable ........................................ 9,750,000
Accrued expenses ........................................ 6,250,000
Income taxes payable .................................... 250,000
Payments due within one year on long-term debt .......... 1,750,000
Total current liabilities ............................... $18,750,000

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 What is Blain's quick (acid-test) ratio?
a. 0.26 to 1
b. 0.30 to 1
c. 1.80 to 1
d. 3.60 to 1
ANS: C OBJ: LO 3

41. Seahawk Company's adjusted trial balance at December 31, 2004, includes the following account
balances:

Common Stock, $3 par .................................... $300,000

Additional Paid-In Capital .............................. 400,000
Treasury Stock, at cost ................................. 25,000
Net Unrealized Holding Loss on Available-For-Sale
Securities ............................................ 10,000
Retained Earnings--Appropriated for Uninsured Earthquake
Losses ................................................ 75,000
Retained Earnings--Unappropriated ....................... 100,000

What amount should Seahawk report as total owners' equity in its December 31, 2004, balance
sheet?
a. $840,000
b. $860,000
c. $890,000
d. $910,000
ANS: A OBJ: LO 1

42. Martin Corporation was organized on January 3, 2004. Martin was authorized to issue 50,000
shares of common stock with a par value of $10 per share. On January 4, Martin issued 30,000
shares of common stock at $25 per share. On July 15, Martin issued an additional 10,000 shares
at $20 per share. Martin reported income of $33,000 during 2004. In addition, Martin declared a
dividend of $.50 per share on December 31, 2004. The amount reported on Martin Corporation's
December 31, 2004, balance sheet as additional paid-in capital was
a. $400,000.
b. $550,000.
c. $563,000.
d. $950,000.
ANS: B OBJ: LO 1

43. Martin Corporation was organized on January 3, 2004. Martin was authorized to issue 50,000
shares of common stock with a par value of $10 per share. On January 4, Martin issued 30,000
shares of common stock at $25 per share. On July 15, Martin issued an additional 10,000 shares
at $20 per share. Martin reported income of $33,000 during 2004. In addition, Martin declared a
dividend of $.50 per share on December 31, 2004. The amount reported on Martin Corporation's
December 31, 2004, balance sheet as stockholders' equity was
a. $400,000.
b. $550,000.
c. $950,000.
d. $963,000.
ANS: D OBJ: LO 1

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44. Information from Blain Company's balance sheet is as follows: Current assets:

Current assets:
Cash .................................................... $ 1,200,000
Investment securities ................................... 3,750,000
Accounts receivable ..................................... 28,800,000
Inventories ............................................. 33,150,000
Prepaid expenses ........................................ 600,000
Total current assets .................................... $67,500,000
Current liabilities:
Notes payable ........................................... $ 750,000
Accounts payable ........................................ 9,750,000
Accrued expenses ........................................ 6,250,000
Income taxes payable .................................... 250,000
Payments due within one year on long-term debt .......... 1,750,000
Total current liabilities ............................... $18,750,000

What is Blain's current ratio?

a. 0.26 to 1
b. 0.30 to 1
c. 1.80 to 1
d. 3.60 to 1
ANS: D OBJ: LO 3

45. What is the effect of the collection of accounts receivable on the current ratio and net working
capital, respectively?

Current Ratio Net Working Capital

a. No effect No effect
b. Increase Increase
c. Increase No effect
d. No effect Increase

ANS: A OBJ: LO 3

46. Which of the following is an appropriate computation for return on investment?

a. Net income divided by total assets
b. Net income divided by sales
c. Sales divided by total assets
d. Sales divided by stockholders' equity
ANS: A OBJ: LO 3

47. Which item describes whether the following accounts would be included in the calculation of the
acid-test (quick) ratio?

Accounts Receivable Inventories

a. No No
b. No Yes
c. Yes No
d. Yes Yes

ANS: C OBJ: LO 3

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48. Which of the following statements regarding intangible assets is incorrect?

a. Intangible assets represent long-term c. Intangible assets must be tested regularly

rights and privileges of a nonphysical to determine if their value has been
nature. impaired.
b. A trademark is an example of an d. Intangible assets should be amortized over
intangible asset. a period not exceed 40 years.
ANS: D

PROBLEMS

1. Below are selected accounts and their balances for the Stonefly Company as of December 31,
2004:

Accounts Payable ........................................ $ 98,000

Accounts Receivable ..................................... 216,000
Allowance for Doubtful Notes and Accounts ............... 25,000
Cash .................................................... 22,400
Wages Payable ........................................... 10,800
Trademarks .............................................. 45,000
Long-Term Advances to Officers .......................... 150,000
Inventory ............................................... 83,000
Income Taxes Payable .................................... 72,000
Notes Receivable (short-term) ........................... 97,000
Bond Redemption Fund .................................... 180,000
Bonds Payable ........................................... 500,000
Premium on Bonds Payable ................................ 40,000
Treasury Stock .......................................... 57,600

Based on the above information, determine the amount of working capital at December 31, 2004.

ANS:

Stonefly Company
Schedule of Working Capital
December 31, 2004

Current assets:
Cash ........................... $ 22,400
Notes receivable ............... $ 97,000
Accounts receivable ............ 216,000
$313,000
Less allowance for doubtful
notes and accounts ........... 25,000 288,000
Inventory ...................... 83,000 $393,400
Current liabilities: .............
Accounts payable ............... $ 98,000
Wages payable .................. 10,800
Income taxes payable ........... 72,000 180,800
Working capital .................. $212,600

OBJ: LO 2

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2. Account balances and supplemental information for the Bighorn Corporation as of December 31,
2004, are given below:

Accounts Payable ....................................... $ 75,900

Accounts Receivable .................................... 141,600
Accumulated Depreciation--Equipment .................... 84,000
Bonds Payable .......................................... 300,000
Cash ................................................... 243,900
Common Stock ........................................... 1,560,000
Deferred Income Tax Liability (noncurrent) ............. 6,900
Dividends Payable ...................................... 45,000
Equipment .............................................. 840,000
Income Taxes Payable ................................... 91,500
Inventory .............................................. 395,100
Investment in Land ..................................... 510,000
Investment in Stock of Subsidiary ...................... 492,000
Note Payable ........................................... 120,000
Notes Receivable ....................................... 150,000
Prepaid Insurance ...................................... 7,200
Retained Earnings ...................................... 453,600
Salaries and Wages Payable ............................. 42,900

(a) $300,000 of 12% bonds were sold on November 1, 2004, at par.

(b) 40,000 shares of $30 par value common stock were sold for $1,560,000.
(c) All the equipment was purchased on January 2, 2003. The depreciation rate is 10
percent per year.
(d) 5 percent of accounts receivable are expected to be uncollectible.
(e) A two-year insurance policy was purchased on May 1, 2004, for $7,200.
(f) Accrued interest on $150,000 of short-term notes receivable from customers was
$5,100 at December 31, 2004.
(g) $120,000 was borrowed from the bank on a 5-year, 10% note payable dated July 1,
2004. The loan is to be repaid in 10 semiannual payments of $12,000 plus interest,
with the first payment due January 1, 2005.

Prepare a properly classified balance sheet in report form for Bighorn Corporation as of
December 31, 2004.

ANS:

Bighorn Corporation
Balance Sheet
December 31, 2004

Assets
Current assets:
Cash ....................................... $243,900
Notes receivable ........................... 150,000
Accounts receivable, less allowance for
doubtful accounts of $7,080 .............. 134,520
Interest receivable ........................ 5,100
Inventory .................................. 395,100
Prepaid insurance .......................... 4,800 $ 933,420

Investments:
Investment in land ......................... $510,000
Investment in stock of subsidiary .......... 492,000 1,002,000
Equipment .................................... $840,000

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 Less accumulated depreciation--equipment ..... 168,000 672,000
Total assets ................................. $2,607,420

Liabilities:
Current liabilities:
Accounts payable ........................... $ 75,900
Dividends payable .......................... 45,000
Income taxes payable ....................... 91,500
Salaries and wages payable ................. 42,900
Interest payable ........................... 6,000
Current portion of long-term note payable .. 24,000 $ 285,300

Noncurrent liabilities:
Long-term debt:
Note payable ............................. $ 96,000
Bonds payable ............................ 300,000
Deferred income tax liability .............. 6,900 402,900
Total liabilities ............................ $688,200

Owners' Equity:
Contributed capital:
Common stock, $30 par ...................... $1,200,000
Additional paid-in capital ................. 360,000
Retained earnings ($453,600 - $7,080 + $5,100 359,220 1,919,220
- $2,400 - $84,000 - $6,000 = $359,220) ....
Total liabilities and owners' equity ......... $2,607,420

OBJ: LO 1

3. McMaster, Inc., a nonpublic enterprise, is negotiating a loan for expansion purposes and the bank
requires audited financial statements. Before closing the accounting records for the year ended
December 31, 2004, McMaster's controller prepared the following comparative financial
statements for 2004 and 2003:

McMaster, Inc.
Balance Sheets
December 31, 2004 and 2003

2004 2003
Cash ...................................... $ 550,000 $ 300,000
Investment securities (reported at market;
cost, $142,000) ......................... 156,000 0
Accounts receivable ....................... 974,000 784,000
Allowance for doubtful accounts ........... (100,000) (64,000)
Inventories ............................... 850,000 770,000
Property and equipment .................... 620,000 434,000
Accumulated depreciation .................. (300,000) (242,000)
Total assets ............................ $2,750,000 $1,982,000

Accounts payable .......................... $ 180,000 $ 154,000

Accrued expenses .......................... 160,000 40,000
Note payable, 5-year ...................... 600,000 600,000
Estimated contingent liability ............ 200,000 0
Common stock, $10 par ..................... 420,000 420,000
Additional paid-in capital ................ 260,000 260,000
Retained earnings ......................... 930,000 508,000
Total liabilities & owners' equity ...... $2,750,000 $1,982,000

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 McMaster, Inc.
Income Statements
For the Years Ended December 31, 2004 and 2003

2004 2003
Net sales ................................. $3,160,000 $2,500,000
Operating expenses:
Cost of sales ............................. $1,510,000 $1,380,000
Selling & administrative .................. 984,000 730,000
Depreciation .............................. 58,000 36,000
Estimated loss from lawsuit ............... 200,000 0
$2,752,000 $2,146,000
Operating income .......................... $ 408,000 $ 354,000
Unrealized gain on investment securities .. 14,000 0
Net income ................................ $ 422,000 $ 354,000

During the audit, the following additional information was obtained:

(a) The investment portfolio consists of investments in trading securities with a total
market value of $156,000 at December 31, 2004. The securities were purchased
February 3, 2004, at a cost of $142,000.
(b) As a result of errors in physical count, inventories were overstated by $30,000 at
December 31, 2004.
(c) On January 2, 2004, the cost of equipment purchased for $80,000 was mistakenly
charged to repairs and maintenance. McMaster depreciates this type of equipment
over a 5-year life using the straight-line method, with no residual or salvage value.
(d) McMaster was named as a defendant in a lawsuit in October 2004. McMaster's
counsel is of the opinion that McMaster has a good defense and does not anticipate
any impairment of McMaster's assets or that any significant liability will be
incurred. However, McMaster's counsel admits that loss of the suit is "possible."
McMaster's management wished to be conservative and established a loss
contingency of $200,000 at December 31, 2004.
(e) On January 24, 2005, before the 2004 financial statements were issued, McMaster
was notified that one of its largest customers had filed for bankruptcy as the result
of a flood that destroyed a substantial portion of the company's assets on January
16, 2005. The customer's accounts receivable balance at December 31, 2004, was
$144,000.
(f) $100,000 of 5-year notes payable will mature September 30, 2005. In view of
McMaster's plans for expansion, management is seriously considering refinancing
the notes when they become due.

(1) Prepare a properly classified balance sheet for McMaster, Inc., as of December 31,
2004. (Income tax considerations should be ignored.)
(2) Identify the events and other information that should be disclosed in the notes to
McMaster's financial statements. (Do not prepare the notes.)

15
 ANS:
(1)

McMaster, Inc.
Balance Sheet
December 31, 2004

Assets
Current assets:
Cash ..................................... $ 550,000
Investment securities (reported at market;
cost, $142,000) .......................... 156,000 (a)
Accounts receivable ...................... $974,000
Less allowance for doubtful accounts ..... 100,000 874,000
Inventories .............................. 820,000 (b)
Total current assets ..................... $2,400,000
Property and equipment ................... $700,000
Less accumulated depreciation ............ 316,000 384,000 (c)
Total assets ............................. $2,784,000

Liabilities & Stockholders' Equity

Current liabilities:
Accounts payable ......................... $ 180,000
Accrued expenses ......................... 160,000
Notes payable (due September 30, 2002) ... 100,000
Total current liabilities ................ $ 440,000
Long-term notes payable .................. 500,000
Total liabilities ........................ $ 940,000
Contributed capital:
Common stock, $10 par .................... $420,000
Additional paid-in capital ............... 260,000 680,000
Retained earnings [$930,000 - $30,000 (b)
+ $80,000 (c) - $16,000 (c) + $200,000 (d)] 1,164,000

Total liabilities & stockholders' equity . $2,784,000

Note: Letters correspond to letters in problem identifying additional information.

(2)
Notes to the financial statements of McMaster, Inc. should include:

Summary of significant accounting policies. A description of accounting principles

and methods used in recognizing revenues and allocating asset costs to current and
future periods. Specifically, McMaster should disclose accounting policies relating to
valuation of receivables, inventories, and depreciable assets and any other policies
that would influence the decisions of users.

Information regarding loss contingency. A description of the pending legal action,

including information and data to assist users in evaluating the risk of potential loss.
Based on the opinion of McMaster's counsel, the estimated loss of $200,000 should
not be reported in the financial statements, but the contingency should be described
in a note, since the incurrence of a loss is "reasonably possible."

Information regarding the bankruptcy of a major customer. This type of subsequent

event does not affect the amounts reported in the financial statements, because the
casualty giving rise to the bankruptcy occurred after McMaster's balance sheet date.

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 Additional information to support totals in financial statements. For example,
McMaster might present additional detail for inventory and cost of sales, property
and equipment, and/or selling and administrative expenses.

OBJ: LO 1

4. The following balance sheet was prepared by the accountant for Logan Farms Corp.:

Logan Farms Corp.

Balance Sheet
December 31, 2004

Assets
Cash ................................................... $ 271,500
Investment securities .................................. 315,000
Accounts receivable .................................... 270,000
Inventories ............................................ 501,000
Total current assets ................................. $1,357,500
Land, buildings, and equipment ......................... 1,452,000
Total assets ........................................... $2,809,500

Liabilities and Stockholders' Equity

Accounts payable ....................................... $ 342,420
Estimated losses from future crop failures ............. 360,000
Salaries payable ....................................... 150,000
Total current liabilities ............................ $ 852,420
10% Bonds payable (due in 10 years) .................... 525,000
Capital stock .......................................... 450,000
Retained earnings ...................................... 982,080
Total liabilities and stockholders' equity ............. $2,809,500

Additional information:

(a) Cash is held in a checking account and a savings account with balances of $69,450
and $202,050, respectively. The cash in the savings account will be used to support
operations in the event of a crop failure.
(b) A loan to the president for $180,000 that is to be repaid in quarterly installments of
$15,000 is included in "Accounts receivable." Other accounts receivable are
considered to be 95 percent collectible.

(c)

Inventories include:
Finished products ................................ $390,000
Supplies ......................................... 19,500
Storage buildings (net of $30,480 depreciation) .. 91,500
Total .......................................... $501,000

(d) "Land, buildings, and equipment" includes 5 tractors that were purchased near the
end of the year for $360,000 (shown net of a $300,000, 5-year loan used to buy the
tractors). The balance of the account consists of land that was purchased for
$1,200,000 and buildings that were purchased for $255,000 (shown net of
depreciation of $63,000).
(e) Included in "Accounts payable" are $105,000 of advances from customers for
delivery of goods in August of the next year.

17
 (f) The company has 90,000 shares of $5 par common stock issued and outstanding.
The common stock was originally sold for $7 per share, and the premium was
included in "Retained earnings."
(g) After reading a U.S. Meteorological Service report, the president believes that next
year will be a bad crop year due to freak hailstorms and estimates the company will
lose about $360,000. An appropriation of Retained Earnings has been made for this
amount.

Using the balance sheet and the additional information, prepare a properly classified and
corrected balance sheet.

ANS:

Logan Farms Corp.

Balance Sheet
December 31, 2004

Assets
Current assets:
Cash ..................................... $ 69,450
Investment securities .................... 315,000
Accounts receivable ...................... $ 90,000
Less allowance for doubtful accounts ..... 4,500 85,500
Inventories .............................. 390,000
Advances to officers (due in 1 year) ..... 60,000
Supplies ................................. 19,500
Total current assets ..................... $ 939,450

Investments:
Cash fund for future losses .............. 202,050

Land, buildings, and equipment:

Land ..................................... $1,200,000
Buildings ................................ 376,980
Equipment ................................ 360,000
Less accumulated depreciation--buildings
(93,480) 1,843,500
and equipment ............................
Other noncurrent assets:
Advances to officers (long-term) ......... 120,000
Total assets ............................... $3,105,000

Liabilities
Current liabilities:
Accounts payable ......................... $ 237,420
Salaries payable ......................... 150,000
Advances from customers .................. 105,000
Total current liabilities ................ $ 492,420
Long-term debt:
5-year loan payable ...................... $ 300,000
10% bonds payable ........................ 525,000 825,000
Total liabilities .......................... $1,317,420

Stockholders' Equity
Contributed capital:
Common stock ($5 par, 90,000 shares issued

18
 and outstanding) ....................... $ 450,000
Additional paid-in capital ............... 180,000 $ 630,000
Retained earnings:
Appropriated for future losses ........... $ 360,000
Unappropriated [$982,080 - $4,500(b) -
$180,000(f) + $360,000(g) = $1,157,580
(adjusted total retained earnings);
$1,157,580 - $360,000 = $797,580] ....... 797,580 1,157,580
Total stockholders' equity ................. $1,787,580
Total liabilities and stockholders' equity . $3,105,000

OBJ: LO 1

5. The following totals are taken from the December 31, 2004, balance sheet of Streamer Company:

Current assets ....................................... $350,000

Long-term assets ..................................... 800,000
Current liabilities .................................. 240,000
Long-term liabilities ................................ 270,000

Additional information:

(a) Cash of $38,000 has been placed in a fund for the retirement of long-term debt. The
cash and long-term debt have been offset and are not reflected in the financial
statements.
(b) Long-term assets include $50,000 in treasury stock.
(c) Cash of $14,000 has been set aside to pay taxes due. The cash and taxes payable
have been offset and do not appear in the financial statements.
(d) Advances on salespersons' commissions in the amount of $21,000 have been made.
Also, sales commissions payable total $24,000. The net liability of $3,000 is
included in Current Liabilities.

After making any necessary changes, what are the totals for Streamer's current assets and current
liabilities?

ANS:

Current Current
Assets Liabilities
Beginning ............................... $350,000 $240,000
(a) No adjustment .....................
(b) No adjustment .....................
(c) Offsetting cash and taxes payable . 14,000 14,000
Netting commission advances and
(d) 21,000 21,000
commissions payable .............
Totals ............................ $385,000 $275,000

OBJ: LO 1

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6.The following totals are taken from the December 31, 2004, balance sheet of Bartholomew
Company:

Current assets ....................................... $350,000

Long-term assets ..................................... 800,000
Current liabilities .................................. 240,000
Long-term liabilities ................................ 270,000

Additional information:

(a) A building costing $100,000 was purchased by taking out a $100,000 mortgage.
Since the building serves as collateral on the mortgage loan, both have been
excluded from the financial statements.
(b) Cash in the amount of $45,000 is in a restricted fund for the purchase of equipment.
This cash has been included in Current Assets.
(c) Long-term liabilities include a bank loan of $80,000. Of this loan, $15,000 must be
repaid within the coming year.
(d) Investment securities totaling $27,000 are included in Current Assets. These
securities represent stock purchases made as a long-term equity investment in a
major supplier.

After making any necessary changes, what are the totals for Bartholomew's long-term assets and
long-term liabilities?

ANS:

Long-Term Long-Term
Assets Liabilities
Beginning ............................... $800,000 $270,000
(a) Offsetting building and mortgage .. 100,000 100,000
(b) Restricted fund ................... 45,000
(c) Current portion of long-term debt . (15,000)
(d) Long-term investment .............. 27,000
Totals ............................ $972,000 $355,000

OBJ: LO 1

7. Berton Company reported assets totaling $870,000 as of December 31, 2004. The following
information relates to those assets:

(a) Breakstone Labs, a rival company, recently offered to give a $100,000 signing
bonus to the head of Berton's fabrication department if she would leave Berton and
join Breakstone. She declined. Berton has consequently recorded a long-term asset,
"Employees Under Contract," for $100,000.
(b) Berton purchased a patent from a small research firm for $75,000. Subsequent
research has shown that the patented technology doesn't work as well as originally
thought and the technology actually has no economic use. Berton reports the patent
at its amortized cost of $60,000.
(c) An independent appraiser recently set Berton's market value at $500,000. This
exceeded the book value of equity by $120,000. Accordingly, Berton recorded
Goodwill totaling $120,000.
(d) Near the end of the year, Berton paid $30,000 for the exclusive right to market
electronic equipment to be imported from abroad. Berton reported this as a $30,000
"Intangible Asset."

20
 (e) When Berton started business three years ago, it was required to deposit $5,000
with the local electric utility. The deposit is refundable if Berton cancels its electric
service. Berton earns no interest on the deposit. The deposit is recorded as an
"Other Long-Term Asset."

After considering the items above, what should be the total of Berton's reported assets?

ANS:

Reported Assets
Beginning .......................................... $870,000
(a) Employees under contract ..................... (100,000)
(b) Obsolete patent .............................. (60,000)
(c) Unpurchased goodwill ......................... (120,000)
(d) No adjustment ................................
(e) No adjustment ................................
Total ...................................... $ 590,000

OBJ: LO 1

8. Orvis Company reported liabilities totaling $1,230,000 as of December 31, 2004. The following
information relates to those liabilities:

(a) Orvis reported a $100,000 bank loan payable. However, Orvis intends to repay this
loan on January 10, 2005.
(b) Orvis has reported a $40,000 liability for the estimated cost of future warranty
repairs based on product sales for the past year.
(c) Orvis is being sued for $350,000 by a disgruntled employee. Orvis' attorney thinks
that it is possible that Orvis will lose the case. Orvis has not yet recorded any
liability for this potential loss.
(d) Orvis receives consulting services from a local CPA. Expected services by the CPA
for the coming year will cost $35,000. No liability has been recorded.
(e) Orvis has reached an agreement with a major customer. Orvis expects to provide
services totaling $400,000 over the coming three years. The customer has already
paid Orvis $100,000. No liability has been recorded.

After considering these items, what should be the total of Orvis' reported liabilities?

ANS:

Reported Liabilities
Beginning .......................................... $1,230,000
(a) No adjustment ................................
(b) No adjustment ................................
(c) No adjustment ................................
(d) No adjustment ................................
(e) Unearned revenue ............................. 100,000
Total ...................................... $1,330,000

OBJ: LO 1

9. Knowledgeable users of financial statements recognize that the numbers reported

in company's financial statements depend on the accounting policies used to
generate the numbers. Various choices of accounting policies exist, such as LIFO

21
 vs. FIFO for inventory costing and straight-line vs. double-declining balance for
depreciation. APB Opinion No. 22 requires that a company disclose the accounting
policies used to ensure that statement users have the information they need to
make sound decisions.

What problems or problems arise from the large variety of accounting choices available?

ANS:
The greatest problem posed by the array of accounting choices available is the difficulty of
achieving comparability between firms (and even among firms in the same industry). A statement
user not only must be informed of the basic differences that exist, but also must adjust balances to
achieve comparability. As might be expected, differences between financial statement items (such
as inventory) can be significant as a result of the use of different accounting policies and
procedures.

OBJ: LO 4

10. Certain assets currently are omitted from the balance sheet. For example, the value of the human
resources of the firm are not reported. Nevertheless, investors and others might greatly benefit
from a knowledge of the extent to which human assets have increased or decreased during a
given period. Values certainly may be attributed to individuals or groups based on their ability to
render future economic services. A major issue is the method that should be employed in
measuring human assets.

Identify some possible ways of measuring human resources.

ANS:
Possible methods for measuring human assets would include:

1. The historical-cost method in which the costs associated with recruiting, selecting,
hiring, training, and developing an employee are capitalized and amortized over the
expected period over which the enterprise expects to benefit from the employee's
services.

2. The replacement cost method in which estimated costs of replacing a firm's existing
human resources are estimated and recorded. Such costs include all of the costs of
recruiting, selecting, hiring, training, and developing new employees until they reach
the competence of old employees.

3. The present value of the remaining earnings to be paid an employee.

OBJ: LO 4

11. As a member of the audit staff of Brown & Co., CPAs, you have been assigned to the audit of a
new client, Black Corporation. Upon arriving at the client's offices, the controller provides you
with copies of the company's annual financial statements. You quickly observe that the balance of
accounts receivable has increased materially over the amount reported on the prior year's balance
sheet. Your inquiry of the controller produces the following response:

"This year we have included several other items with our trade receivables. All of these items
represent receivables and include:

(a) Advances made to officers and employees,

22
 (b) Advances to our subsidiary company, and
(c) A refund from the Internal Revenue Service resulting from the favorable resolution
of a disputed tax matter.

I have included a description of the tax item in the note to the financial statements. Since the
other two items represent internal matters, I saw no reason to disclose them or present them as
separate items on the balance sheet."

Do you concur with the controller's treatment of these items? Explain.

ANS:
Trade receivables represent amounts owed by customers for goods sold and services rendered as
part of normal business operations. The term "accounts receivable: is assumed to connote trade
receivables. Inclusion of other forms of receivables under the caption "accounts receivable" thus
may be confusing and misleading. The nature of the items included with accounts receivable on
the Black Corporation statements suggests that they be classified and reported as separate items
on the balance sheet and in the notes to the financial statements where necessary. This is
particularly true of advances to officers, employees, and subsidiaries since these represent
transactions with related parties which may not have been conducted at arm's-length.

OBJ: LO 1

12. The balance sheet provides information concerning liquidity, financial flexibility, and information
for calculating various financial ratios. The balance sheet serves as a major indicator of an
enterprise's ability to survive. Nevertheless, the analysis of the balance sheet should be
approached with a clear understanding of the limitations of the statement.

What are the major limitations of the balance sheet that should be recognized in analyzing the
statement?

ANS:
Values reported in the balance sheet may represent a mixture of values. Cash is a current value
item but plant assets are not. A summation of these numbers is thus questionable as are the ratios
using these mixed values.

Some entity resources and obligations are not reported on the balance sheet. Many intangible
assets, such as a reputation for superior products or customer service, are not recognized on the
balance sheet. As a result, the numbers on the balance sheet frequently are not a good reflection
of what a company is worth.

Dollar amounts shown on the balance sheet represent different levels of purchasing power.
Assets, liabilities, and equities shown on the balance sheet are reflected in terms of unequal
purchasing power units. Variations in purchasing power of the amounts reported on the balance
sheet make comparisons among companies, and even within single companies, difficult.

Finally, all companies do not classify and report all like items similarly. Titles and account
classifications vary, some companies provide more detail than others, and different companies
report similar transactions in different manners. Comparisons between companies thus are made
more difficult.

OBJ: LO 5

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