Chapter 1: Accounting: The Key to Success

True/False
1-1. The primary function of accounting is to determine whether the business entity is
profitable or nonprofitable in its operations.
False. The primary function of accounting is to provide information that is useful in
making rational investment, credit, or similar decisions. Accountants serve decision
makers by providing relevant information.
1-2. The business entity principle applies to sole proprietorship but not to corporations,
since corporations have many owners known as shareholders.
False. The business entity principle applies to all forms of ownership. Under this
principle, every business is conceived to be and is treated as a separate entity, separate
and distinct from its owner(s) and from every other business.
1-3. Unlike a partnership, when a sole proprietorship is unable to meet its debts, the
creditors can secure the personal assets of the proprietor to satisfy the debt.
False. Creditors can satisfy unpaid debt by securing the personal assets of sole
proprietors AND the individual partners of a partnership. The partnership form of
ownership is not immune from such responsibility.
1-4. An accountant employed in the field of private accounting generally works in
auditing, providing management services, and tax services.
False. The public accountant works in the areas of auditing, providing management
services, and tax services. Private accountants work in the areas of preparing financial
statements and tax returns, and general accounting.
1-5. Bookkeeping is the clerical part of the accounting process.
True. While a critical part of the accounting process, it is much narrower in scope
(recording transactions) than accounting, which includes bookkeeping AND analyzing,
reporting, interpreting, and designing bookkeeping systems.
1-6. The CA, CGA, and CMA accounting designations are awarded in recognition of the
education and practical experience of an individual. The designations allow the individual
to practice accounting as a Chartered Accountant, Certified General Accountant, or a
Certified Management Accountant.
True. CA is awarded by the Institute of Chartered Accountants; CGA is awarded by the
Certified General Accountants Association; and CMA is awarded by the Society of
Management Accountants.

1-7. The purpose of an audit is to uncover theft and fraud so that the users of the financial
statements can have a high level of assurance that all money is accounted for.
False. An audit is designed to determine whether the statements fairly reflect the
company's financial position and operating results in accordance with GAAP; and to add
credibility to the information in the statements.
1-8. Profit is determined by subtracting sales from the total expenses of the business.
False. Profit or net income is calculated by subtracting the total expenses (costs of doing
business) from the sales (revenues earned during the same period). If sales are larger than
expenses, a profit will have been earned.
1-9. Corporations have limited liability while sole proprietorships and partnerships have
unlimited liability.
True. A major advantage of corporation ownership is the limited liability that it provides,
eliminating the risk to an owner's personal assets.
1-10. Shareholders are the owners of a corporation and have little or no risk to their
personal assets.
True. Shareholders are the owners of the shares of stock of the corporation and
corporation ownership provides limited liability (personal assets are not at risk).
1-11. External users of the accounting information include banks, shareholders, creditors,
suppliers, and customers.
True. The examples listed are those who are interested in the profitability and stability of
the business that they own or provide services for.
1-12. Internal users of accounting information include banks, shareholders, and
customers.
False. Internal users of accounting information include managers, officers, and other
important internal decision makers.
1-13. Good ethics is good business.
True. Ethical practices build trust which promotes loyalty and long-term relationships
with customers, suppliers, and employees.
1-14. Ethics and ethical behavior are important. Ethics are beliefs that separate right from
wrong.
True. Ethical behavior promotes trust. Trust promotes loyalty. Many unethical procedures

are also unlawful (harassment, cheating, bribery).

1-15. Managerial accounting provides information to the organization's decision makers.
True. Managerial accounting focuses on general accounting, cost accounting, budgeting,
internal auditing, and consulting. Managerial accounting is primarily providing
information for internal decision making.

MULTIPLE CHOICE
1-1. The phase of accounting that deals with collecting and controlling the costs of
producing a given product or service is called
a. internal auditing
b. bookkeeping
c. cost accounting
d. general accounting
Good management involves knowledge of costs, controlling costs, and assessing
management performance. Cost accounting principles and practices provide information
necessary to control costs of products or services.
1-2. Which of the following is a primary goal to provide managers with a clear
understanding of the activities to be undertaken and completed to accomplish the
company's objectives?
a. financial accounting
b. budgeting
c. auditing
d. cost accounting
Budgeting is the process of developing formal plans for an organization's future activities.
1-3. If revenues for the accounting period total $5,000, and the expenses total $1,000,
then the net income (loss) must total
a. $6,000
b. $4,000
c. ($6,000)
d. ($4,000)
The income statement shows Revenues Expenses = Net Income. Therefore, revenues of
$5,000 - expenses of $1,000 = net income of $4,000.

1-4. If revenues for the accounting period total $6,000, and the expenses totals $10,000,
then the net income (loss) must total
a. $16,000
b. $4,000
c. ($4,000)
d. ($16,000)
The income statement shows Revenues Expenses = Net Income. Therefore, revenues of
$6,000 - expenses of $10,000 = net income (loss) of ($4,000).
1-5. Allowing workers time to work for nonprofit organizations, making donations to
schools, hospitals, and community projects, sponsoring community programs such as the
special Olympics is a part of
a. ethics
b. regulations
c. research and development
d. social programs
Many companies are heavily involved in major social programs to help their employees,
the community, and the society in general. Canadian Tire, Nova, and Imperial Oil are a
few of the major players in practicing social responsibility.
1-6. The recording of financial transactions and events manually or electronically is
called
a. bookkeeping
b. information technology
c. reporting
d. auditing
Bookkeeping or record keeping is the actual entering of transactions and financial events
into the permanent records of the business.
1-7. Which of the following statements is false regarding a sole proprietorship?
a. A proprietorship has only one owner.
b. A proprietorship is legally a separate entity.
c. The owner is subject to unlimited liability.
d. Income of the proprietorship is taxes on the owner's personal return
A proprietorship is a separate accounting entity, but only the corporation form of business
is a separate legal entity.

1-8. Nike sold a pair of shoes to a retailer for $100. The retailer sold the shoes to you for
$125. It cost Nike $80 to make the shoe. It cost the retailer $105 total to buy and sell the
shoe. Which answer below is not correct?
a. Nike will make $20 on the transaction
b. The retailer will make $20 on the transaction
c. They both will have the same revenue on the sale
d. They both will have the same net profit on the sale
The revenue to Nike will be $100 while the revenue to the retailer will $125. The profit to
both will be $20.
1-9. External user of financial information include all of the following except:
a. Shareholders
b. Customers
c. Managers
d. Suppliers
Managers are internal users of financial information.
1-10. A partnership
a. is a legally separate business entity.
b. enables owners to limit their liability.
c. requires one or more owners.
d. is taxed on the partners' individual income tax return.
A partnership is not a legally separate entity and therefore, the partner's are subject to
unlimited liability. Partnerships are made up of two or more owners. A partnership is
taxed on the individual partners' income tax returns.

Fill-in the blanks.

ACCOUNTING is an information and measurement system that identifies, classifies,
records, and communicates relevant information to people to help them make better
decisions.
To check of an organization's accounting systems and records using various tests, an
accountant would perform an AUDIT.
BOOKKEEPING is the part of accounting that involves recording economic
transactions and events, either electronically or manually (also known as record keeping).

The notion that every business is accounted for separately from its owner's personal
activities is called the business ENTITY principle.
Capital stock or COMMON SHARE CAPITAL is the name for a corporation's stock
when only one class of stock is issued.
The chief accounting officer of an organization is called the CONTROLLER.
A business that is a separate legal entity under federal laws with owners that are called
shareholders is known as a CORPORATION.
COST accounting is a managerial accounting activity designed to help managers identify,
measure and control operating costs.
Persons using accounting information who are not directly involved in the running of the
organization; examples include shareholders, customers, regulators, and suppliers are
called EXTERNAL(EXTERNAL or INTERNAL) users.
Beliefs we have judging actions as right or wrong, fair or unfair, honest or dishonest are
known as ETHICS.
The area of accounting aimed at serving external users is
called FINANCIAL accounting.
When the expenses for a company exceed the sales (revenues), the company will have
a LOSS.
The amount a business earns after subtracting all expenses necessary for its sales is
called NET INCOME, profits, or earnings.
A PARTNERSHIP is a business that is owned by two or more people that is not
organized as a corporation.
The amounts earned from selling products or services are called REVENUES or sales.
MANAGEMENT consulting involves activities in which suggestions are offered for
improving a company's procedures.

Glossary Match
A check of an organization's accounting systems and records using various tests.
Audit

An accountant who has met the examination, education, and experience requirements of
the Institute of Chartered Accountants for an individual professionally competent in
accounting.
Chartered Accountant
A business that is a separate legal entity under provincial or federal laws with owners that
are called shareholders or stockholders.
Corporation
A managerial accounting activity designed to help managers identify, measure and
control operating costs.
Cost accounting.
The task of recording transactions, processing data, and preparing reports for managers;
includes preparing financial statements for disclosure to external users.
General accounting
Activity conducted by employees within organizations to assess whether managers are
following established operating procedures and to evaluate the efficiency of operating
procedures.
Internal auditing
Activity in which suggestions are offered for improving a company's procedures; the
suggestions may concern new accounting and internal control systems, new computer
systems, budgeting, and employee benefit plans; also called advisory services.
Management consulting
A business that is owned by two or more people that is not organized as a corporation.
Partnership
Accountants who work for a single employer other than the government.
Private accountants
Accountants who provide their services to many different clients.
Public accountants
The recording of financial transactions and events; either manually or electronically; also
called, bookkeeping.
Record keeping
A unit of ownership in a corporation also called stock.
Shares
A business owned by one individual that is not organized as a corporation; also called
sole proprietorship.
Single proprietorship

A business owned by one person that is not organized as a corporation (also called single
proprietorship).
Sole proprietorship
When debts of a proprietorship or partnership exceed its resources, the owner is
financially responsible.
Unlimited liability
An information and measurement system that identifies, records, classifies, and
communicates relevant information to people to help them make better decisions.
Accounting
One or more individuals selling products or services for profit.
Business
Every business is accounted for separately from its owner's personal activities.
Business entity principle
An accountant who has met the examination, education, and experience requirements of
the Certified Accountants Association for an individual professionally competent in
accounting.
Certified General Accountant
Another term for expenses.
Costs
The amount a business earns after subtracting all expenses necessary for its sales; also
called net income or profit.
Earnings
Beliefs that separate right from wrong, unfair, honest or dishonest.
Ethics
Examine and provide assurance that financial statements are prepared according to
generally accepted accounting principles.
External auditors
Persons using accounting information who are not directly involved in the running of the
organization. Examples include shareholders, customers, regulators, and suppliers.
External users
Generally accepted accounting principles are the rules that indicate acceptable accounting
practice.
GAAP

Procedures set up to protect assets, ensure reliable accounting reports, promote efficiency,
and encourage adherence to company policies.
Internal controls
Persons using accounting information who are directly involved in managing and
operating an organization; examples included managers and officers.
Internal users
Restricts partners' liabilities to their own acts and acts of individuals under their control.
Limited liability partnership
Includes both general partner(s) with unlimited liability and a limited partner(s) with
liability restricted to the amount invested.
Limited partnership
Arises when expenses total more than sales (revenues).
Loss
Involves considering the impact and being accountable for the effects that actions might
have on society.
Social responsibility
The part of accounting that involves recording economic transactions and events, either
electronically or manually; also called record keeping.
Bookkeeping
The process of developing formal plans for future activities, which often serve as a basis
for evaluating actual performance.
Budgeting
The federal agency that has the duty of collecting federal taxes and otherwise enforcing
tax laws.
CCRA
An accountant who has met the examination, education, and experience requirements of
the Society of Management Accountants for an individual professionally competent in all
areas of accounting and specializing in management accounting.
Certified Management Accountant
The name for a corporation's shares when only one class of share capital is issued; also
called capital stock.
Common share capital
The chief accounting officer of an organization.
Controller
The cost incurred to earn sales (or revenues).

Expenses
The area of accounting aimed at serving external users.
Financial accounting
The means organizations use to pay for resources like land, building, and machines.
Financing activities
Work for local, provincial and federal government agencies.
Government accountants
The area of accounting aimed at serving the decision-making needs of internal users.
Managerial accounting
The amount a business earns after subtracting all expenses necessary for its sales; also
called profits or earnings.
Net income
The amounts earned from selling products or services; also called sales.
Revenues
The amounts earned from selling products or services; also called revenues.
Sales
The owners of a corporation; also called stockholders.
Shareholders
The field of accounting that includes preparing tax returns and planning future
transactions to minimize the amount of tax; involves private, public, and government
accountants.
Tax accounting
Chapter 2: Financial Statements and Accounting Transactions
True/False
2-1. Net income is the result of the balance sheet reporting revenues that are larger than
operating expenses.
False. Net income is the result of revenues exceeding the expenses of the same period.
This information is reported on the income statement.
2-2. Assets are the economic resources that are expected to produce future benefits.
True. These assets include land, buildings, equipment, inventories, supplies, cash and all
investments needed to operate the business efficiently and effectively.

2-3. Land, buildings, and equipment are examples of business expenses.

False. The historical costs of these assets are not expenses. The costs of using and
maintaining these assets are expenses. Salaries, rent, utilities, supplies, and repairs are
typical examples of expenses.
2-4. Assets include cash, land, equipment, buildings, accounts receivable and other
resources owned and controlled by the company.
True. All the items listed plus supplies, prepaids, and all resources owned or being
purchased by the company are classified as assets. All of these items are listed at their
historical cost value on the company balance sheet.
2-5. Another name for net assets is liabilities.
False. Net assets are the difference between the assets and the liabilities of a business.
Owner's equity is also the difference between the total assets and the total liabilities.
2-6. GASS are the rules that govern auditing procedures for financial statements.
False. GAAS or generally accepted auditing standards are the accepted rules followed
when auditing financial statements.
2-7. The cost principle states that if $5,000 is spent for equipment that has a market value
of $6,000, The value listed on the records is the actual $5,000 cost.
True. Market value is not a factor in recording business asset transactions unless the
market value is the same as the actual asset value given in exchange for the assets
acquired.
2-8. Assets are equal to liabilities plus owner's equity.
True. A = L + OE is known as the accounting equation. If Assets total $15,000, and
Liabilities total $3,000, then the net worth or total Owner's Equity is $12,000.
2-9. If assets total $21,000 and liabilities total $6,000, then owner's equity is $27,000.
False. A = L + OE is known as the accounting equation. If Assets total $21,000, and
liabilities total $6,000, then owner's equity totals $15,000.
2-10. Assume assets total $24,000, liabilities total $5,000, and owner's equity is $19,000.
If assets increase by $3,000 and equity decreases by $1,000, then liabilities must increase
by $4,000.

True. A = L + OE is known as the accounting equation. If the asset side of the equation
increases by $3,000, then the equity + liability side of the equation must increase by
$3,000 (-$1,000 + $4,000 = $3,000).
2-11. The revenue recognition principle (realization) states that revenues should be
recognized when the cash for the transaction is received.
False. Revenue should be recognized when the revenue is earned, not when the cash is
received.
2-12. When cash is received on account, the Accounts Receivable account is decreased.
True. When cash is received on account (paid on the account balance) the Cash account
is increased by the amount received and the Accounts Receivable account is decreased.
2-13. When the owner withdraws cash from the business, the Cash account will decrease
and the Withdrawals account will decrease.
False. The Withdrawals account will actually increase in total but the equity of the
business will decrease.
2-14. Totals for the net income, additional investment, and withdrawals are found on the
Statement of Owner's Equity.
True. The Statement of Owner's Equity lists the beginning Capital balance plus
additional investments and total net income less the total withdrawals for the period.
2-15. The financial condition of the business is shown on the Income Statement.
False. The assets, liabilities, and owner's equity are shown on the Balance Sheet.
2-16. The financial statement that shows the results of a firm's operations over a specific
time period is called the balance sheet.
False. The income statement shows the results of operations. The balance sheet shows
the balances of assets, liabilities, and owner's equity at a specific date.
2-17. Inflows of cash or other properties received in exchange for goods or services
provided to customers as part of the major or central operations of the business are called
revenues.
True. The revenue recognition principle governs the definition of revenue; when to
recognize revenue; and at what amount. Remember, the reduction of a liability, as well as
an inflow of assets, might be a form of revenue.

2-18. Every business transaction has an affect on one or more of the elements of the
accounting equation.
True. Every business transaction will increase or decrease assets, increase or decrease
liabilities, or increase or decrease owner's equity.
2-19. After every business transaction is correctly recorded and reported, the accounting
equation will be in balance.
True. The accounting equation is an algebraic equation, and adherence to generally
accepted accounting principles and procedures when recording business transactions will
maintain the accounting equation in balance.
2-20. During the accounting period, the assets increased by $4,000 and the equity
increased by $1,000. For the balance sheet equation to balance, the liabilities must
increase by $5,000.
False. The balance sheet equation states that the assets = liabilities + owner's equity. If
assets increase by $4,000, then the total net change of liabilities and equity must be
$4,000. If equity increased by $1,000, then the liabilities increased by $3,000 ($4,000 =
$3000 + $1,000).
2-21. Under the revenue recognition principle revenue is recognized only after services
have been provided and cash has been received.
False. Revenue is recognized when the services have been completed and the revenue has
been earned, regardless of when the cash is received. Cash may be received long after the
services have been performed or before the services are started or completed.
Multiple Choice.
2-1. The financial position of the business on a given date is reported on the
a. Income Statement
b. Balance Sheet
c. Statement of Changes In Owner's Equity
d. Statement of Cash Flows
The assets, liabilities, and equity of a company are reported on the company Balance
Sheet. What the business owns (assets), owes (liabilities) and is worth, (owner's equity)
clearly gives all of the required data to determine the financial position or condition of the
business.
2-2. The net profit or loss for a particular period of time is reported on the

a. Income Statement
b. Balance Sheet
c. Trial Balance
d. Statement of Changes In Owner's Equity
The assets, liabilities, and equity of a company are reported on the company Balance
Sheet. What the business owns (assets), owes (liabilities) and is worth, (owner's equity)
clearly gives all of the required data to determine the financial position or condition of the
business.
2-3. The investment of cash into the business results in a/an
a. increase in cash and a decrease in capital
b. increase in cash and an increase in capital
c. decrease in cash and an increase in capital
d. increase in fees earned and an increase in capital
Cash will increase and the balance of the Capital account will increase. The net worth of
the business will increase by the exact amount of the investment.
2-4. The purchase of supplies for cash will result in a/an
a. increase in cash and a decrease in capital
b. increase in cash and an increase in supplies
c. increase in supplies and a decrease in cash
d. increase in equipment and an increase in capital
Supplies will increase and Cash will decrease.
2-5. Services rendered for cash will result in a/an
a. increase in cash and a decrease in capital
b. increase in cash and an increase in fees earned
c. decrease in cash and an increase in fees earned
d. increase in fees earned and an decrease in capital
Cash will increase and the balance of the Fees Earned account will increase.
2-6. Cash is received from a client for office rental space.
a. cash increases and rental fees earned decreases
b. cash increases and rental fees earned increases
c. cash decreases and capital increases
d. cash decreases and withdrawals increases
Cash will increase and the Rental Fees Earned account balance will increase.

2-7. Keeping the records of the business separate from the personal records of the owner
of the business is said to be adherence to which accounting principle or concept?
a. Continuing-concern concept
b. Business entity principle
c. Realization principle
d. Objectivity principle
All personal transactions should be kept separate from the records of business operations
under the business entity concept.
2-8. Which of the following is a formal written promise to pay a definite sum of money
on demand or at a fixed or determinable future date?
a. Account payable
b. Account receivable
c. Note payable
d. Prepaid insurance policy
2-9. Peter Atli decided to pay himself a salary of $3,000 per month for the work he
performs for his business, a single proprietorship. Each time a cheque is recorded for
$3,000, which account should be increased?
a. Salaries Expense
b. Capital
c. Peter Atli, Withdrawals
d. Owner Salary Expense
The owner of a single proprietorship cannot legally get paid a salary by the business
entity. No matter what the proprietor chooses to call it, it must be treated as a withdrawal
or drawing.
2-10. The personal telephone bill of Junior Sample was paid by issuing a cheque from the
business chequing account. No business calls had been made from Junior's personal
phone. What account must be charged for this transaction?
a. Junior, Capital
b. Cash
c. Junior, Withdrawals
d. Telephone Expense
All withdrawals of assets (cash or supplies) for personal use must be accounted for in the
Withdrawals account.
2-11. Which of the following accounts is NOT a liability?

a. Accounts Payable
b. Accounts Receivable
c. Salaries Payable
d. Notes Payable
Accounts Receivable is a major current asset account. All of the other accounts listed are
liabilities.
2-12. Assets total $50,000 and Liabilities total $10,000. The equity of the business must
total
a. $4,000
b. $40,000
c. $400
d. $40
The accounting equation is Assets = Liabilities + Owner's Equity. $50,000 = $10,000 +
$40,000.
2-13. The resulting amount when total liabilities are subtracted from total assets is known
as
a. owner's equity or net assets
b. net income or net loss
c. total expenses
d. total revenue
Total assets minus total liabilities equals net assets. Since assets = liabilities + owner's
equity, net assets and owner's equity are the same amount--the ownership (vested interest)
of assets by the owner.
2-14. A broad rule adopted by the accounting profession as a guide in measuring,
recording, and reporting the financial affairs and activities of a business is known as
a. an accounting concept
b. an accounting principle
c. the basic accounting equation
d. objectivity principle
Accounting principles are the rules or guides used by accountants for measuring,
recording, and reporting the financial affairs and activities of a business.
2-15. Using a sales invoice as the basis for recording a sale of merchandise is an example
of using which accounting principle or concept for recording transactions?

a. Recognition principle
b. Objectivity principle
c. Realization principle
d. Continuing-concern concept
Adherence to the objectivity principle requires the use of objective evidence
(documentation) that a business transaction has occurred.
2-16. Which of the following statements is true?
a. a salary paid to a partner is an expense to the partnership
b. a salary paid to a proprietor is an expense to the proprietorship
c. a salary paid to a shareholder is an expense of the corporation
d. the business entity principle does not apply to corporations
Unlike a sole proprietorship or partnership, a corporation is a separate LEGAL entity. As
such, it can hire shareholders (owners) who would have employee status. Therefore, their
wages or salaries are expenses.
2-17. Keith Manich deposited $5,000 in a bank account he established for a pet store that
he is going to own and operate as KM's Pets. Recording the deposit will
a. increase an asset, increase a liability
b. decrease an asset, decrease a liability
c. increase an asset, increase owner's equity
d. decrease an asset, decrease owner's equity
Investments in the form of cash or other assets will increase owner's equity. The
accounting equation will be in balance as: Assets of $5,000 = Owner's Equity of $5,000.
2-18. Better-Cars Selection, a used car dealer, has total assets and liabilities of $50,000
and $18,000, respectively. The firm constructed a shelter for its automobiles by promising
to pay the building contractor, upon completion of the building, $500 per month for
twenty-four months. Upon completion, owner's equity will:
a. increase by $12,000
b. remain unchanged
c. decrease by $12,000
d. increase by $500, each month
Upon completion of the building, the firm will increase its assets (the building) by
$12,000, and increase its liabilities (debt owed to the contractor) by $12,000. There will
be no change in owner's equity.

2-19. The owner of a computer services business was able to acquire a new computer,
valued at $5,000, by establishing an account with the computer vendor, Com Pewters
Unlimited. There was no down payment. Recording the transaction will
a. increase an asset, increase a liability
b. decrease an asset, decrease a liability
c. increase an asset, increase owner's equity
d. decrease an asset, decrease owner's equity
The computer is an asset and the account payable is a liability. There are many forms of
liabilities--accounts payable, notes payable, mortgage notes, and taxes payable, as
examples.
2-20. A sole proprietor recorded the payment of an account payable to an office supplies
store. Recording the transaction will
a. increase an asset, increase a liability
b. decrease an asset, decrease a liability
c. increase an asset, increase owner's equity
d. decrease an asset, decrease owner's equity
Payment of an account payable will reduce cash, an asset, and reduce the debt owed, a
liability, for supplies purchased on credit.
2-21. If during the accounting period the assets increased by $5,000, and the owner's
equity increased by $1,000, then the liabilities must have
a. increased by $6,000
b. increased by $4,000
c. decreased by $4,000
d. decreased by $6,000
The accounting equation is Assets = Liabilities + Owner's Equity. A $5,000 net increase
on the asset side of the equation must be matched by an equal $5,000 net increase on the
liability and equity side of the equation. $5,000 = $4,000 + $1,000.
2-22. If during the accounting period the assets increased by $7,000, and the owner's
equity decreased by $3,000, then the liabilities must have
a. increased by $10,000
b. increased by $4,000
c. decreased by $4,000
d. decreased by $10,000

The accounting equation is Assets = Liabilities + Owner's Equity. A $7,000 net increase
on the asset side of the equation must be matched by an equal $7,000 net increase on the
liability and equity side of the equation. $7,000 = $10,000 + ($3,000).
2-23. One of the local fast-food outlets hired a first-year accounting student to oversee the
cash-collection procedures. When the firm pays the student her weekly wage, the
transaction will
a. increase an asset, increase a liability
b. decrease an asset, decrease a liability
c. increase an asset, increase owner's equity
d. decrease an asset, decrease owner's equity
The wages or salaries of employees are treated as expenses. Expenses decrease owner's
equity. The payment resulted in a decrease in cash, an asset, and a decrease in owner's
equity (from an expense).

Fill-in the blanks:

The expression of Assets = Liabilities + Owner's Equity is called
the ACCOUNTING equation or balance sheet equation.
An account PAYABLE is a liability created by buying goods or services on credit.
An account RECEIVABLE is an asset created by selling products or services on credit.
Properties or economic resources owned by the business are called ASSETS.
A BALANCE SHEET is a financial statement providing information that helps users
understand a company's financial status.
The BUSINESS ENTITY principle requires every business to be accounted for
separately from its owner or owners.
An economic event that changes the financial position of an organization, and that often
takes the form of an exchange of economic consideration between two parties, is called a
business TRANSACTION.
The rule that requires financial statements to reflect the assumption that the business will
continue operating instead of being closed or sold, unless evidence shows that it will not
continue, is called the GOING-concern or continuing-concern principle.
The accounting principle that requires financial statement information to be based on
actual costs incurred in business transactions is the COST principle.

Individuals or organizations entitled to receive payments from a company are

called CREDTIORS.
DIVIDENDS are distributions of assets by a corporation to its owners
The residual interest in the assets of an entity that remains after deducting its liabilities is
called EQUITY or net assets
EXPENSES are outflows or the using up of assets as a result of the major or central
operations of a business.
FINANCIAL statements include the balance sheet, income statement, statement of
owner's equity and the statement of cash flows.
The financial statement that shows whether the business earned a profit by subtracting
expenses from revenues is the INCOME statement.
Debts, owed by a business or organization, are classified as LIABILITIES.
The MONETARY UNIT principle is based on the notion that transactions and events
should be measured and recorded in monetary units.
The excess of revenues over expenses for a period is called NET INCOME.
A NOTE payable is a liability expressed by a written promise to make a future payment
at a specific time.
The accounting guideline that requires financial statement information to be supported by
independent, unbiased evidence rather than someone's opinion is the
OBJECTIVITY principle
The revenue RECOGNITION principle provides guidance on when revenue should be
reflected on the income statement. This principle (rule) includes three guidelines.
Inflows of assets received in exchange for goods or services provided to customers as
part of the major or primary operations of the business are called REVENUES.
The statement of OWNER'S EQUITY reports the changes in equity over the reporting
period.
WITHDRAWALS are payments of cash or other assets from a proprietorship or
partnership to its owner or owners.

Glossary Match
A liability created by buying goods or services on credit.
Account payable
An asset created by selling products or services on credit.
Account receivable
A description of the relationship between a company's assets, liabilities, and equity;
expressed as Assets = Liabilities + Owner's Equity; also called the balance sheet equation.
Accounting Equation
A financial statement providing information that helps users understand a company's
financial status; lists the types and dollar amounts of assets, liabilities, and equity as of a
specific date; also called the statement of financial position.
Balance sheet
Another name for the accounting equation.
Balance sheet equation
An economic event that changes the financial position of an organization; often takes the
form of an exchange of economic consideration (such as goods, services, money, or rights
to collect money) between two parties.
Business transaction
An accounting year that begins January 1 and ends December 31.
Calendar year
A one-year reporting period.
Fiscal year
A committee that attempts to create more harmony among the accounting practices of
different countries by identifying preferred practices and encouraging their worldwide
acceptance.
International Accounting Standards Committee
Another name for equity.
Net assets
A liability expressed by a written promise to make a future payment at a specific time.
Note payable
A financial statement that describes where a company's cash came from (receipts) and
where it went during the period (payments); the cash flows are arranged by an
organization's major activities; operating, investing, and financing activities.
Statement of cash flows

A payment of cash or other assets from a proprietorship or partnership to its owner or

owners.
Withdrawals
Properties or economic resources owned by the business; more precisely, resources with
an ability to provide future benefits to the business.
Assets
Individuals or organizations entitled to receive payments from a company.
Creditors
Individuals or organizations that owe amounts to a business.
Debtors
Distributions of assets by a corporation to its owners.
Dividends
Outflows or the using up of assets as a result of the major or central operations of a
business; also, liabilities may be increased.
Expenses
Rules adopted by the accounting profession that make up acceptable accounting practices
for the preparation of financial statements.
GAAP
Rules adopted by the accounting profession as guides for conducting audits of financial
statements.
Generally accepted auditing standards (GAAS)
Debts owed by a business or organization or claims by others that will reduce the future
assets of a business or require future services or products.
Liabilities
Provides guidance on when revenue should be reflected on the income statement; the rule
includes three guidelines: (1) requires revenue to be recognized in the time it is earned,
(2) allows the inflow of assets associated with revenue to be in a form other than cash,
and (3) measures the amount of revenue as the cash equivalent of any non-cash assets
received from customers in exchange for goods and services.
Revenue recognition principle
Inflows of assets received in exchange for goods or services provided to customers as
part of the major or primary operations of the business; may occur as inflows of assets or
decreases in liabilities.
Revenues

Another name for the balance sheet.

Statement of financial position
Reports the changes in equity over the reporting period; beginning equity is adjusted for
increases such as owner investment or net income and for decreases such owner
withdrawals or a net loss.
Statement of owner's equity
The authoritative committee of the CICA that identifies generally accepted accounting
standards.
AcSB
The principle that requires every business to be accounted for separately from its owner
or owners. Based on the goal of providing relevant information about each business to
users.
Business entity principle
The publication of the CICA that establishes generally accepted accounting principles in
Canada.
CICA handbook
The accounting principle that requires financial statement information to be based on
actual costs incurred in business transaction; it requires assets and services to be recorded
initially at the cash or cash equivalent amount given in exchange.
Cost principle
The owner's claim on the assets of a business; more precisely, the residual interest in the
assets of an entity that remains after deducting its liabilities; also called net assets.
Equity
The most important products of accounting; include the balance sheet, income statement,
statement of changes in owner's equity, and the statement of cash flows.
Financial statements
The rule that requires financial statements to reflect the assumption that the business will
continue operating instead of being closed or sold, unless evidence shows that it will not
continue; also called continuing-concern principle.
Going-concern principle
The financial statement that shows whether the business earned a profit by subtracting
expenses from revenues; it lists the types and amounts of revenues earned and expenses
incurred by a business over a period of time.
Income statement
The expression of transactions and events in money units; examples include units such as
the dollar, peso, and pound sterling.

Monetary unit principle

The excess of revenues over expenses for a period.
Net income
The excess of expenses over revenues for a period.
Net loss
The accounting guideline that requires financial statement information to be supported by
independent, unbiased evidence rather than someone's opinion; objectivity adds to the
reliability, verifiability, and usefulness of accounting information.
Objectivity Principle
Chapter 3: Analyzing and Recording Transactions
TRUE/FALSE
3-1. Cheques, invoices, and sales receipts are examples of business papers.
True. Objective evidence in the form of business papers (or source documents) is used to
record external transactions.
3-2. An account is used to record and summarize the increases and decreases in each type
of revenue, expense, asset, liability, or owner's equity item.
True. Each balance sheet item (asset, liability, or owner's equity) and income statement
item (revenue or expense) has its own 'account', a bookkeeping form in which increases
and decreases are summarized.
3-3. Prepaid insurance is an example of an asset that will be consumed in the operation of
the business; and as it is consumed, it will become an expense for the time period in
which it was consumed.
True. Prepaid expenses, or prepaid assets, are assets that will be consumed in the course
of business operations. Their expiration is recorded as an expense for the time period in
which they provided a benefit to the firm.
3-4. When a firm collects money in advance of providing a service or delivering a
product to a customer, the amount should be recorded as a prepaid asset.
False. The collection of money (or other property) in advance of fulfilling a service or
delivering a product creates a liability to the firm. The cash represents unearned revenue,
and as such, is a liability.

3-5. The term credit, as it is used in recording journal entries, means to increase the
balance of an account.
False. The term credit, as it is used in recording journal entries, refers to the right hand
side of an account--ONLY. Increases in some accounts are shown on the credit side
(liabilities), others on the debit side (assets).
3-6. Any transaction, no matter how complex, can be recorded in a general journal under
the double-entry accounting system.
True. The double-entry accounting system requires a balancing of equal debits and
credits. No matter how complex the transaction, the general journal can accommodate it's
recording with equal debits and credits.
3-7. A journal entry in which more than two accounts are involved is known as a
combined journal entry.
False. A journal entry in which more than one debit or more than one credit is recorded
(more than two accounts are involved) is known as a compound journal entry.
3-8. A journal is known as a book of final entry.
False. A journal is known as a book of original entry (where a transaction is first
recorded). A ledger is known as a book of final entry (where the effect of the transaction
on account balances is summarized).
3-9. The group of accounts used by a business in recording its transactions is known as
the ledger.
True. A ledger (or general ledger), the accounts used by the business in recording its
transactions, contains an account for each balance sheet item and each income statement
item. It is also called a book of final entry.
3-10. Transcribing the debit amounts and the credit amounts from the general journal to
the accounts in the ledger for summarization is known as posting.
True. Posting is the process of summarizing the effects of the transactions on the various
accounts by transferring the increase or decrease in each account as shown by the journal
entry to the account in the general ledger.
3-11. When posting manually to the general ledger, it is not necessary to record the
number of the posted account in the general journal when you are certain that you have
posted to the correct account.
False. You must always show the account number in the posting reference column. It
shows that the item has been posted and to which account it has been posted.

3-12. Electronic posting is more complicated than manual posting.

False. While the process might seem to be complicated to a developer of the program, the
actual process to the accountant is an automatic process completed by the program after
an entry has been recorded and verified.
3-13. A list of all the accounts with balances, and their respective balances, is called a
balance sheet or statement of financial position.
False. A list of all the accounts and their respective balances is called a trial balance. A
balance sheet (statement of financial position) shows the asset, liability, and owner's
equity accounts and balances, only.
3-14. A trial balance with equal debit and credit totals is proof that no errors occurred in
the journalizing or posting procedures used by the bookkeeper.
False. While there is a certain level of assurance, it is not absolute. The incorrect account
might have been debited or credited, or the incorrect account posted. As an accountant,
you must be attentive and thorough.
3-15. Cash, Prepaid Insurance, Office Supplies, and Rent Expense are accounts that will
increase when debited.
True. The Cash, Prepaid Insurance, and Office Supplies accounts are assets that are
debited for increases and credited for decreases. Rent Expense is an expense account and
is also debited for increases and credited for decreases.
3-16. Prepaid Insurance, Cash, Accounts Receivable, Notes Receivable, Land, and
Unearned Revenues are all classified as asset accounts.
False. All of the accounts are assets except Unearned Revenues, which is a liability
account.
3-17. All receivables are classified as liability accounts and all payables are classified as
asset accounts.
False. Accounts Receivable and Notes Receivable are asset accounts. Notes Payable,
Accounts Payable, Taxes Payable, Salaries Payable, as well as Unearned Revenues are
liability accounts.
3-18. The owner's Capital account will increase with additional investment, increase with
net income (revenues larger than expenses) and decrease with withdrawals by the owner.
True. While net income will increase the capital balance, a net loss will decrease the
capital balance. A net loss plus withdrawals can result in a significant decrease to the
capital and may require additional cash investment to keep the business running.

3-19. On the chart of accounts revenues may be numbered in the 400's followed by
expenses numbered in the 500's.
True. Revenues will be listed before the expenses. While the number of 400's for
revenues and 500's for expenses are quite common, always check the chart of accounts
for the list of accounts that are to be used when recording the transactions and the number
that has been assigned to that account. Cash is not always account 101.
3-20. The left side of an account is always the debit side and always the increase side.
False. While the left side is always the debit side, it is the increase side for assets and
expenses, and the decrease side for liabilities, equity, and revenues.
3-21. The normal balance for assets and expenses is a debit balance. The normal balance
for liabilities, equities (except withdrawals), and revenues is a credit balance.
True. Withdrawals is debited when increasing because it is really a reduction to the total
amount of equity. A withdrawal is the opposite of an investment into the business.
3-22. The Cash account has debits totaling $4,500 and credits totaling
False. he Cash account has been overdrawn and it currently has a $100 abnormal credit
balance.

Multiple Choice:
3-1. The proprietor of a restaurant purchased a three-year insurance policy. Recording the
purchase of the policy requires
a. an asset to be debited, a liability to be credited
b. a liability to be debited, an asset to be credited
c. one asset to be debited, another asset to be credited
d. withdrawals to be debited, an asset to be credited
The asset prepaid insurance increased, its account should be debited. The asset cash
decreased, its account should be credited. Assets are debited for increases and credited for
decreases.
3-2. A business purchased equipment by issuing a one-year note payable. The entire
amount of the note is due at the end of one year. Recording the transaction requires
a. an asset to be debited, a liability to be credited
b. a liability to be debited, an asset to be credited

c. an asset to be debited, capital to be credited

d. withdrawals to be debited, an asset to be credited
The equipment is an asset which increased, and the account should be debited. The note
payable is a liability which has increased and the account should be credited.
3-3. Olivia, the proprietor, deposited $40,000 in the company's bank account. She got the
money from selling all of her General Motors common stock. Recording the transaction
on the company books will require
a. an asset to be debited, a liability to be credited
b. a liability to be debited, an asset to be credited
c. an asset to be debited, capital to be credited
d. withdrawals to be debited, an asset to be credited
The cash is an asset that increased; it's account should be debited for the increase.
Owner's equity also increased and the owner's Capital account should be credited.
3-4. Solar Mow, makers and sellers of solar powered lawn mowers, paid the rent for the
month of January on January 1. Recording the transaction requires
a. an asset to be debited, a liability to be credited
b. a liability to be debited, an asset to be credited
c. an expense to be debited, an asset to be credited
d. an asset to be debited, a revenue to be credited
The asset cash decreased, its account should be credited. The rent is an expense (IT IS
PAID FOR ONE MONTH ONLY), and its account (Rent Expense) should be debited.
3-5. Solar Mow, makers and sellers of solar powered lawn mowers, determined that its
chief executive officer should attend a workshop on solar energy to be held on the beach
at Waikiki, Honolulu. The workshop cost $2,000, including air fare, meals, and lodging.
The firm charged the cost of the trip with a local travel agency. Recording the transaction
requires
a. an asset to be debited, a liability to be credited
b. a liability to be debited, an asset to be credited
c. an expense to be debited, a liability to be credited
d. an asset to be debited, revenue to be credited
The cost of the workshop is an expense to the firm. Expenses increased and an
appropriate expense account should be debited. The trip was charged on an account
payable and requires a credit to a liability account.

3-6. Peter Atli received $5,000 for some excavation work to be done when the weather
permits. Peter figures it will be at least three weeks before he can start the job. Recording
the transaction requires
a. an asset to be debited, a liability to be credited
b. a liability to be debited, an asset to be credited
c. withdrawal to be debited, an asset to be credited
d. an asset to be debited, revenue to be credited
The cash is an asset which increased, its account should be debited. The revenue is not
earned; it is therefore unearned revenue and should be treated as a liability (unearned
revenues).
3-7. Which of the following statements is not true?
a. Journalizing errors should be erased and a correct entry made
b. Asset accounts are increased by debit entries
c. Debit entries are entries involving the left-hand side of an account
d. Journalizing precedes posting
When an error is discovered, a correcting entry should be made. As an accountant,
NEVER hide or erase your errors--admit them and make appropriate correction entries.
Maintain your integrity.
3-8. The personal telephone bill of Junior Sample was paid by issuing a cheque from the
business chequing account. No business calls had been made from Junior's personal
phone. What account must be debited for this transaction?
a. Junior, Capital
b. Cash
c. Junior, Withdrawals
d. Telephone Expense
All withdrawals of assets (cash or supplies) for personal use must be accounted for in the
Withdrawals account.
3-9. An account entitled Unearned Fees would be classified as a/an
a. asset account
b. liability account
c. revenue account
d. expense account
All unearned accounts (unearned revenues, unearned rent, unearned fees) are liability
accounts. These accounts are credited when funds are received in advance for services to
be performed in the future.

Fill in the blanks:

An ACCOUNT is a place or location within an accounting system in which the increases
and decreases in a specific asset, liability, equity, revenue, or expense are recorded and
stored.
The difference between the increases (including the beginning balance) and decreases
recorded in an account is called the account BALANCE
An account with debit and credit columns for recording entries and a third column for
showing the balance of the account after each entry is posted is called a
BALANCE COLUMN ledger account.
A CHART of accounts acts as an index to all the accounts used by a company.
A journal entry in which cash and accounts receivable are debited and revenue is credited
is an example of a COMPOUND journal entry.
A CREDIT entry decreases asset and expense accounts or increases liability, owner's
equity, and revenue accounts.
A DEBIT entry increases asset and expense accounts or decreases liability, owner's
equity, and revenue accounts.
A DOUBLE-ENTRY accounting system is an accounting system where every
transaction affects and is recorded in at least two accounts.
Exchanges between the entity and some other person or organization are
called EXTERNAL transactions.
The most flexible type of journal is the GENERAL journal.
A record where transactions are recorded before they are recorded in accounts is called
a JOURNAL. It is also called a book of original entry.
JOURNALIZING is the process of recording transactions in a journal.
A LEDGER is a record containing all accounts used by a business.
An unconditional written promise from a customer to pay a definite sum of money on
demand or on a defined future date(s) is called a note RECEIVABLE.
POSTING is the process of transferring journal entry information to the ledger.
Another name for business papers is SOURCE documents.

The T-ACCOUNT is a simple account form used as a helpful tool in showing the effects
of transactions and events on specific accounts.
A TRIAL BALANCE is a list of accounts and their balances at a point in time.
Liabilities created when customers pay in advance for products or services are
called UNEARNED revenues.

Glossary Match:
A place or location within an accounting system in which the increases and decreases in a
specific asset, liability, stockholders' equity, revenue, or expense are recorded and stored.
Account
An account with debit and credit columns for recording entries and a third column for
showing the balance of the account after each entry is posted.
Balance column ledger account
A list of all accounts used by a company; includes the identification number assigned to
each account.
Chart of accounts
A journal entry that affects at least three accounts.
Compound journal entry
An accounting system where every transaction affects and is recorded in at least two
accounts; the sum of the debits for all entries must equal the sum of the credits for all
entries.
Double-entry accounting
A record where transactions are recorded before they are recorded in accounts; amounts
are posted from the journal to the ledger; also called the book of original entry.
Journal
A record containing all accounts used by a business.
Ledger
A column in journals where individual account numbers are entered when entries are
posted to the ledger.
Posting Reference (PR) column
An asset account containing payments made for assets that are not used until later.
Prepaid Expenses

A simple account form used as a helpful tool in showing the effects of transactions and
events on specific accounts.
T-account
A list of accounts and their balances at a point in time; the total debit balances should
equal the total credit balances.
Trial balance
The difference between the increases (including the beginning balance) and decreases
recorded in an account.
Account balance
An entry that decreases asset and expense accounts or increases liability, owner's equity,
and revenue accounts; recorded on the right side of a T-accounts.
Credit
An entry that increases asset and expense accounts or decreases liability, owner's equity,
and revenue accounts; recorded on the left side of a T-account.
Debit
Exchanges between the entity and some outside person or organization.
External transactions
The most flexible type of journal; can be used to record any kind of transaction.
General Journal
Exchanges within an organization that can also effect the accounting equation.
Internal transactions
The process of recording transactions in a journal.
Journalizing
An unconditional written promise to pay a definite sum of money on demand or on a
defined future date(s); also called promissory note.
Note Receivable
The process of transferring journal entry information to the ledger.
Posting
An unconditional written promise to pay a definite sum of money on demand or on a
defined future date(s); also called note receivable.
Promissory Note
Another name for business papers; these documents are the source of information
recorded with accounting entries and can be in either paper or electronic form.
Source documents

Liabilities created when customers pay in advance for products or services; created when
cash is received before revenues are earned; satisfied by delivering the products or
services in the future.
Unearned revenues

Chapter 4: Adjusting Accounts for Financial Statements

TRUE/FALSE
4-1. Recognizing revenue when cash is received and recognizing expenses when they are
paid in cash is adherence to the accrual basis of accounting.
False. Recognizing revenues and expenses when cash is exchanged is adherence to cashbasis accounting. Accrual-basis accounting requires the recognition of revenue when
earned and the recognition of expenses when incurred.
4-2. Because of its simplicity and ease of use, most businesses keep their accounting
records on the cash basis of accounting.
False. For those businesses where prepaid, unearned, and accrued items are unimportant,
the cash basis is acceptable. However, most businesses use the accrual basis of
accounting. Cash basis accounting makes no attempt to match revenues and expenses.
4-3. Cash basis accounting matches revenues and expenses and is consistent with
accepted accounting principles.
False. Cash basis accounting makes no attempt to match revenues and expenses. It
matches only cash receipts and cash disbursements. Cash basis is not consistent with
accepted accounting principles.
4-4. The purpose of an adjusting entry in which insurance expense is debited and prepaid
insurance is credited, is to remove the expired portion of the prepaid expense.
True. The time-period concept assumes that the life of a business can be divided into
equal increments. Insurance cost is allocated over equal increments for the period of
coverage to adhere to the matching principle.
4-5. Recording amortization is a cost allocation process.
True. A debit to Amortization Expense and a credit to Accumulated Amortization,
Equipment is allocating a fair share of the equipment cost as an expense for the period
that the equipment was used to help generate revenues.

4-6. Amortization expense is an example of a contra account.

False. Accumulated Amortization is an example of a contra account. A contra account's
balance is subtracted from the balance of an associated account to provide more
information in the financial statements. Amortization expense is the cost of using the
asset for the specific accounting period.
4-7. For every accrued expense there is an offsetting and equal amount of liability.
True. Accrued expenses are expenses incurred (they have happened) but are not yet paid.
Recognition of the expense requires the creation of a current liability. The expense is paid
later with the liquidation of the liability.
4-8. Accounts receivable represent accrued revenue.
True. Accrued revenue is revenue earned but not yet received. The adjustment process
requires the accrual of revenue earned but not yet received by debiting a receivable
account and crediting an appropriate revenue account.
4-9. A balance sheet prepared on one page in a vertical format that shows the assets above
the liabilities and the liabilities above the owner's equity is called an account form or
balance form balance sheet.
False. The balance sheet described is called a report form balance sheet. Account form
balance sheets have assets on the left side of the page and liabilities and owner's equity on
the right side of the page.
4-10. Revenue recognition and matching are two of the main features of cash basis
accounting.
False. Accrual accounting makes every attempt to match the revenues of the period
against the expenses and costs of the period. Revenues are always recognized when they
are earned, not when they are received. Cash basis accounting does not match revenues
and expenses and recognizes these items only when cash is received or paid.
4-11. When cash is received in advance, the most common entry would be to credit a
revenue account.
False. An alternative method to recording cash received in advance is to record the
amount directly into a revenue account and then adjust the account later, if necessary, to
report any unearned revenues. The most common method is to credit a liability account
for cash received in advance.
4-12. Before the adjusting entries are recorded, prepaid expense accounts are overstated
and expense accounts are understated.

True. An adjusting entry debiting Supplies Expense and crediting Supplies will lower the
balance of the asset account and increase the balance of the expense account.
4-13. Before the adjusting entries for accrued revenues are recorded, assets are overstated
and revenues are overstated.
False. An adjusting entry debiting Accounts Receivable and crediting Fees Earned will
increase assets and increase revenues. Prior to the adjustment these accounts were
understated.
4-14. Unearned revenues are also called deferred revenues.
True. Cash received in advance is usually recorded as a liability. Cash received in
advance for services to be completed in the future is an example of an unearned revenue
or deferred revenue. The revenue will be recorded as earned when the services paid for
have been completed.
4-15. Accumulated Amortization, Equipment is classified as an expense account.
False. Accumulated Amortization, Equipment is a contra-asset account linked to the
Equipment account in the chart of accounts and on the balance sheet. It accumulates the
total amortization taken over the life of the asset. Amortization Expense, Equipment is an
expense account.
4-16. Salaries were accrued for the last few days in March. They are now being paid in
the month of April. This entry will debit Salaries Expense and credit Cash.
False. The expense was recorded in the March adjusting entries and is not an expense for
April. The April entry is a debit to Salaries Payable and a credit to Cash.

MULTIPLE CHOICE:
4-1. At the end of the fiscal year, an adjusting entry was made for accrued salaries of
$500. The salaries for one week, $1,250, were paid on the first Friday of the new fiscal
period. The entry to record paying the salaries expense for the week would be a
a. Sal. Exp., dr., $750; Salaries Payable, dr., $500; Cash, cr., $1,250
b. Sal. Exp., dr., $500; Salaries Payable, dr., $750; Cash, cr., $1,250
c. Salaries Exp., dr., $1,250; Cash, cr., $1,250
d. Salaries Exp., dr., $1,250; Salaries Payable, cr., $1,250

A total of $500 was expensed in the adjustment entry and is now the payable amount
being paid. Of the $1,250, $750 is a salary expense for the days worked during the new
accounting period.
4-2. The ________________ is the length of time into which the life of a business is
divided for the purpose of preparing periodic financial statements.
a. natural business year
b. calendar year
c. accounting period
d. interim period
The accounting period is the length of time into which the life of a business is divided for
the purpose of preparing periodic financial statements.
4-3. The notion that the life of a business is divisible into equal time periods of equal
length is known as the
a. continuing concern principle
b. time-period principle
c. business entity principle
d. recognition principle
The continuing concern principle is based on the notion that a business has an unknown
life and no immediate expectation of being sold or ending. The time-period principle is
based on the idea of equal time periods occurring over the life of the firm.
4-4. The adjusting process is based on two accounting principles. The two accounting
principles are
a. realization and recognition
b. revenue recognition and matching
c. cost and business entity
d. continuing-concern and realization
The revenue recognition (realization) principle prescribes the recognition of income when
it is earned; the matching principle prescribes that expenses be reported in the same time
period as the revenues that resulted from the expenditures.
4-5. At the beginning of the year, a business had a two-year, $1,200 insurance policy on
its office equipment. On July 1, it purchased a three-year, $1,800 policy on a newly
constructed building. The December 31, year-end, adjusting entry would be
a. Insurance Expense, debit, $3,000; Prepaid Insurance, credit, $3,000
b. Insurance Expense, debit, $1,200; Prepaid Insurance, credit, $1,200

c. Insurance Expense, debit, $1,000; Prepaid Insurance, credit, $1,000

d. Insurance Expense, debit, $900; Prepaid Insurance, credit, $900
The two-year policy would be reduced by $600 ($1,200 /2). The new three-policy would
be reduced by $300 (($1,800 / 3) /2). The total expired portion of the prepaid expense is
$900 ($600 + $300).
4-6. At the beginning of the year, a business had a two-year, $1,200 insurance policy on
its office equipment. On July 1 it purchased a three-year, $1,800 policy on a newly
constructed building. A December 31, year-end, adjusting entry was made for the policy
on the building but not for the policy on the office equipment. As a consequence of the
oversight
a. expenses are understated and assets are overstated
b. expenses are overstated and assets are understated
c. expenses are understated and assets are understated
d. expenses are overstated and assets are overstated
The prepaid insurance of $1,200 was not adjusted to remove the expired portion (1 year,
or $600). Therefore, the insurance expense is understated and a prepaid asset (prepaid
insurance) is overstated. As a result, expenses will be understated and net income
overstated.
4-7. At the end of the accounting period, the business had $450 of office supplies on
hand, which was a 50% increase over the beginning balance. If the business purchased
$1,200 of office supplies during the year, then $_____ of office supplies were used during
the year.
a. $975
b. $1,050
c. $1,650
d. $1,425
The beginning balance was $300 ($450 / 1.5). A beginning balance of $300 plus the
purchases of $1,200 makes $1,500 of office supplies available for use. The amount used
was $1,500 - $450 (ending balance), or $1,050.
4-8. A tenant rented space in our companies office building on September 1 at $450 per
month, paying six months' rent in advance. The bookkeeper recognized a current liability
of $2,700. The December 31, year-end adjusting entry would be
a. Unearned Rent, dr., $1,800; Rent Revenue, cr., $1,800
b. Unearned Rent, dr., $1,350; Rent Revenue, cr., $1,350
c. Rent Revenue, dr., $900; Unearned Rent, cr., $900
d. Cash, dr., $2,700; Rent Rev., cr., $1,800; Unearned Rent, cr., $900

The $2,700 was recorded as Unearned Rent (a current liability). At December 31, 2/3 of
the rent will have been earned (September 1 to December 31). The amount of rent
revenue to be recognized is 2/3 of $2,700 or $1,800.
4-9. A tenant rented space in an office building on October 1 at $450 per month, paying
six months' rent in advance. The bookkeeper recorded the October entry with a debit to
Cash and a credit to Rent Revenue. The December 31, year-end adjusting entry would be
a. Unearned Rent, dr., $1,800; Rent Revenue, cr., $1,800
b. Unearned Rent, dr., $1,350; Rent Revenue, cr., $1,350
c. Rent Revenue, dr., $1,350; Unearned Rent, cr., $1,350
d. Cash, dr., $2,700; Rent Rev. cr., $1,350; Unearned Rent, cr., $1,350
The $2,700 was recorded as Rent Revenue on October 1. At December 31, 1/2 of the rent
will have been earned (October 1 to December 31). The amount of rent revenue to be
recognized is 1/2 of $2,700 or $1,350.
4-10. A tenant rented space in an office building on October 1, at $450 per month, paying
six months' rent in advance. The bookkeeper recognized a current liability upon receipt of
the $2,700. No year-end adjustment was recorded. As a consequence of overlooking the
required adjustment,
a. revenue was overstated and liabilities were understated
b. revenue was understated and liabilities were understated
c. revenue was overstated and liabilities were overstated
d. revenue was understated and liabilities were overstated
The current liability, Unearned Rent, was never adjusted to recognize the earned portion
of the unearned rent. Therefore, the revenue was understated and the liability (unearned
rent) remains overstated.
4-11. Dee Preciated rented an office space to Core Poration for three months at $500 per
month, payable at the end of the third month, January 31. No year-end adjusting entry
was recorded on December 31. As a consequence of this oversight,
a. assets were overstated and revenue was overstated
b. assets were overstated and revenue was understated
c. assets were understated and revenue was overstated
d. assets were understated and revenue was understated
An account receivable (Rent Receivable) should have been debited for the rent due (2
months at $500) and a revenue account (Rental Revenue) credited for the amount of rent
earned (2 months at $500).
4-12. You have agreed to keep the accounting records for a business that has agreed to
pay you $800 per month, beginning December 16. You use the accrual basis of

accounting and recorded adjusting entries on December 31. When you receive the $800
on January 16, you will record the following entry
a. Cash, dr., $800; Acc. Rec., cr., $400; Fees Earned, credit, $400
b. Cash, dr., $400; Acc. Rec., cr., $400
c. Cash, dr., $800; Fees Earned, cr., $800
d. Acc. Rec., dr., $800; Cash, cr., $400; Fees Earned, cr., $400
Cash is received on January 16 and should be debited. At the end of December, the
Accounts Receivable account should have been debited for 1/2 months' services of $400,
and the Fees Earned account credited for $400.
Fill in the blanks:
An ACCOUNT FORM balance sheet lists assets on the left and liabilities and owner's
equity on the right side of the balance sheet.
A REPORT FORM balance sheet lists items vertically with assets above the liabilities
and owner's equity.
Another term for reporting period is ACCOUNTING period.
The approach to preparing financial statements that uses the adjusting process to
recognize revenues when earned and expenses when incurred, not when cash is paid or
received, is called ACCRUAL BASIS accounting.
Costs incurred in a period that are both unpaid and unrecorded are
called ACCRUED expenses.
Revenues earned in a period that are both unrecorded and not yet received in cash (or
other assets) are called ACCRUED revenues.
The ADJUSTED trial balance is prepared after adjustments are recorded and posted to
the ledger.
A journal entry at the end of an accounting period to bring asset and liability account
balances to its proper amount while also updating the related expense or revenue account
is called an ADJUSTING entry.
Revenues are recognized when cash is received and expenses are recorded when cash is
paid when using a CASH basis accounting system.The Accumulated Amortization
account is an example of a CONTRA account.
AMORTIZATION is an expense created by allocating the cost of plant and equipment
to the periods in which they are used.

When a company with a fiscal year that ends on December 31 prepares financial reports
for the month of March, the reports are called INTERIM financial reports or statements.
The MATCHING principle is a broad principle that requires expenses to be reported in
the same period as the revenues that were earned as a result of the expenses.
Plant and equipment are examples of TANGIBLE long-lived assets used to produce
goods or services.
Items paid for in advance of receiving their benefits are called PREPAID expenses.
A company that is amortizing an asset at $3,000 per year for five years is using
the STRAIGHT-LINE amortization method.
The TIME PERIOD principle is a broad principle that assumes that an organization's
activities can be divided into specific time periods such as months, quarters, or years.
A listing of accounts and balances prepared before adjustments are recorded and posted to
the ledger is called an UNADJUSTED trial balance.
When cash is received prior to providing the products or services to the customer, the
amount received is called UNEARNED revenue.

GLOSSARY MATCH:
A balance sheet that lists assets on the left and liabilities and owner's equity on the right
side of the balance sheet.
Account form balance sheet
Costs incurred in a period that are both unpaid and unrecorded; adjusting entries for
recording these types of expenses involve increasing (debiting) expenses and increasing
(crediting) liabilities.
Accrued expenses
A listing of accounts and balances prepared after adjustments are recorded and posted to
the ledger.
Adjusted trial balance
A journal entry at the end of an accounting period to bring asset and liability account
balances to their proper amounts while also updating the related expense or revenue
account.
Adjusting entry

Include long-term tangible assets, such as plant and equipment, and intangible assets,
such as patents. These assets are expected to provide benefits for more than one period.
Capital assets
An account linked with another account and having an opposite normal balance; reported
as a subtraction from the other account's balance so that more complete information than
simply the net amount is provided.
Contra account
Financial reports covering less than one year; usually based on one- or three- or sixmonth periods.
Interim financial reports
A balance sheet that lists items vertically with assets above the liabilities and owner's
equity.
Report form balance sheet
Allocates equal amounts of an asset's cost to amortization expense in each accounting
period during its useful life.
Straight-line amortization
A broad principle that assumes that an organization's activities can be divided into
specific time periods such as months, quarters, or years.
Time period principle
A listing of accounts and balances prepared before adjustments are recorded and posted to
the ledger.
Unadjusted trial balance
The length of time covered by financial statements and other reports; also called reporting
periods.
Accounting period
The approach to preparing financial statements that uses the adjusting process to
recognize revenues when earned and expenses when incurred, not when cash is paid or
received; the basis for generally accepted accounting principles.
Accrual basis accounting
Revenues earned in a period that are both unrecorded and not yet received in cash (or
other assets); adjusting entries for recording these types of revenues involve increasing
(debiting) assets and increasing (crediting) revenues.
Accrued revenues
The expense created by allocating the cost of capital assets to the periods in which they
are used; represents the cost of using assets.
Amortization

Revenues are recognized when cash is received and expenses are recorded when cash is
paid.
Cash basis accounting
Long lived (capital) assets which have no physical substance but convey a right to use a
product or process.
Intangible assets
The broad principle that requires expenses to be reported in the same period as the
revenues that were earned as a result of the expenses.
Matching principle
The cost of an asset less its accumulated amortization.
Net Book Value
Tangible long-lived assets used to produce goods or services.
Plant and equipment
Items paid for in advance of receiving their benefits; classified as assets.
Prepaid expenses
Chapter 5: Completing the Accounting Cycle and Classifying Accounts
True/False
5-1. Recording and posting the closing entries (closing the temporary accounts) is the
final step in the accounting cycle.
False. The required final step in the accounting cycle is the preparation of the postclosing (after-closing) trial balance, which should be in balance and contain balances of
real accounts only.
5-2. The Income Summary account is a real or permanent account and is closed to the
Capital account of a sole proprietorship, or is closed in an agreed upon basis to the capital
accounts of partners in a partnership.
False. A temporary account used to facilitate the closing procedure, the Income Summary
account is closed to the capital account of a single proprietor, the capital accounts of
partners, and the retained earnings account of a corporation. Income Summary is a
temporary account.
5-3. After the accounts are closed, there should be no unearned revenue accounts with
balances.
False. Unearned revenue accounts are classified as current liabilities; real accounts
representing revenues yet to be earned. Only earned revenue accounts are closed.

5-4. The proper procedure for closing a revenue account with a normal balance is to debit
the revenue account and credit the Income Summary account.
True. The closing procedure transfers the net effect of increases and decreases in revenue
and expense accounts to the owner's capital account. Revenue accounts are debited when
closed.
5-5. When the final totals of the work sheet Income Statement columns are equal and the
final totals of the work sheet Statement of Owner's Equity and Balance Sheet columns are
equal, it provides proof that no errors occurred in the preparation of the work sheet.
False. While it is a good assurance of accuracy, it is not absolute proof. An expense in the
Debit column of the Balance sheet or a liability in the Credit column of the Income
Statement will not cause out-of-balance errors.
5-6. Preparation of the work sheet and completion of the adjustments columns of the
work sheet eliminates the need to journalize and post the adjusting entries.
False. The accounts are not 'adjusted' until the adjusting entries are journalized and
posted.
5-7. All of the temporary accounts with balances, except the Income Summary and
Withdrawal account, appear in the Income Statement columns of the work sheet.
True. All income statement accounts (revenues and expenses) are temporary accounts
and are closed and summarized through the Income Summary account at the end of the
accounting period.
5-8. The Unadjusted Trial Balance on the work sheet contains all of the accounts used by
the business.
False. The Unadjusted Trial Balance on the work sheet contains only the accounts that
have balances. Other accounts, as they are needed for adjustment purposes, are added to
the work sheet.
5-9. The work sheet is one of the formal financial statements.
False. The work sheet is only one of many working papers an accountant uses in the
preparation of the formal financial statements--income statement, statement of changes in
owner's equity, balance sheet, and statement of cash flows.
5-10. The Capital account balance shown on the work sheet does not reflect the increase
or decrease from net income or net loss.

True. The Capital account balance is the trial balance amount and will not reflect the
results of operations (income or loss) until the closing entries have been journalized and
posted.
5-11. If a single proprietorship business sustains a loss for the period, the closing entries
will include a debit to the Capital account and a credit to the Income Summary account.
True. The Income Summary account will have a debit balance because the total expenses
will exceed the total revenues. This debit balance must be closed (credited) and the
Capital account decreased (debited) for the amount of the loss.
5-12. The net loss sustained by a corporation is closed to the Cash account.
False. The net loss sustained by a corporation is closed to the Retained Earnings account
in the closing entry process. The Retained Earnings account is debited for the decrease
(loss), and the Income Summary account is credited to close the account.
5-13. After the closing entries have been recorded and posted, the balance of the Income
Summary account will equal the net income of the business.
False. All temporary accounts must have a zero balance after the closing entries have
been recorded and posted. The Income Summary account is a special temporary account
used in the closing process.
5-14. The last account listed on a post-closing trial balance will be the owner's
withdrawal account.
False. Only permanent accounts are found on the post-closing trial balance. The Capital
account is the last account listed for a single proprietorship business and the Retained
Earnings account is the last account listed for a corporation.
5-15. An asset that may reasonably be expected to be realized in cash or be consumed
within one year or one operating cycle of the business, whichever is longer, is classified
as a current asset.
True. Assets may be classified as current assets, long-term investments, plant and
equipment, or intangible assets.
5-16. A debt or obligation that must be paid or liquidated within one year or one operating
cycle of the business, is classified as a current liability.
True. The payment or liquidation of current liabilities will require the use of current
assets (most often cash).
5-17. Revenue and expense accounts are called income statement accounts and nominal
account.

True. Revenue and expense accounts are also called temporary accounts and all of them
are closed at the end of each accounting period.
5-18. A balance sheet with current asset and plant and equipment sections is an
unclassified balance sheet.
False. The statement above is a description of a classified balance sheet.
5-19. The last step is the accounting cycle is optional.
True. Recording reversing entries (an option) is done by some businesses as part of their
adjusting and recording procedure. Some consider the reversing entries a startup process
for the beginning of the period rather than an end-of-the-period procedure.
5-20. The reversing entry for an adjusting entry that debited Accounts Receivable and
credited Fees Earned would be a debit to Fees Earned and a credit to Accounts
Receivable.
True. The title reversing entry means that certain adjusting entries may be 'reversed' to
simplify the regular entries associated with the adjustment that will be recorded in the
next accounting period.

Multiple Choice:
5-1. Which of the following accounts is not a temporary account?
a. Income Summary
b. Rental Revenue
c. Capital
d. Withdrawals
Capital is a part of owners' equity and is a real (permanent) account.
5-2. The subtotals of the Income Statement columns of the work sheet are $3,500 and
$4,900, respectively. If the subtotal of the Balance Sheet Debit column is $9,600, then the
subtotal of the Balance Sheet Credit column should be
a. $1,400
b. $11,000
c. $8,200
d. $6,800

The net income was $1,400 (the Credit column of the work sheet Income Statement less
its Debit column). The subtotal of the Balance Sheet Credit column will be $8,200
($9,600 - $1,400).
5-3. The subtotals of the Income Statement columns of the work sheet are $6,200 and
$4,900, respectively. If the subtotal of the Balance Sheet Debit column is $19,000, then
the subtotal of the Balance Sheet Credit column should be
a. $20,300
b. $1,300
c. $17,700
d. $14,400
The net loss was $1,300 (the Credit column of the work sheet Income Statement less its
Debit column). The subtotal of the Balance Sheet Credit column will be $20,300
($19,000 + $1,300).
5-4. Revenue and expense accounts at the beginning and end of the accounting period
should have
a. a balance of zero
b. balances of cumulative amounts of activity during the period
c. a net balance (credits minus debits) equal to the capital account
d. a net balance equal to assets minus liabilities
The accounts start with zero and are closed to end with a zero balance, so they are ready
for summarizing the business activities of the following accounting period.
5-5. Which is true about an adjusting entry?
a. only a permanent account is adjusted
b. only a temporary account is adjusted
c. a permanent account and a temporary account is adjusted
d. it is required to satisfy the realization principle only
Each adjusting entry affects a temporary account and a permanent account (a review of
adjusting entries will support this statement) and they are required when adhering to the
realization and matching principles.
5-6. After the closing procedure is complete, which of the documents proves the equality
of debits and credits?
a. Income Statement
b. Account form balance sheet
c. Post-Closing Trial Balance
d. Work Sheet

The post-closing trial balance is specifically designed and prepared to prove the equality
of debits and credits, and partially test the clerical accuracy of the adjusting and closing
procedures.
5-7. At the end of the fiscal year, an adjusting entry was made for accrued salaries of
$500. On the first day of the new year the adjusting entry was reversed. The salaries for
one week, $1,250, were paid on the first Friday. The entry to record paying the salaries
expense for the week would be a
a. Sal. Exp., dr., $750; Salaries Payable, dr., $500; Cash, cr., $1,250
b. Sal. Exp., dr., $500; Salaries Payable, dr., $750; Cash, cr., $1,250
c. Salaries Exp., dr., $1,250; Cash, cr., $1,250
d. Salaries Exp., dr., $1,250; Salaries Payable, cr., $1,250
A reversing entry eliminated the need to debit the accrued salaries account on the date of
payment. The reversing entry eliminated the balance of the Salaries Payable account and
placed the liability in the expense account.
5-8. Optional entries that transfer the balances in balance sheet accounts which arose as a
result of certain adjusting entries to income statement accounts is the definition for which
term below?
a. adjusting entries
b. reversing entries
c. closing entries
d. declarations of cash dividends
Reversing entries are optional and facilitate maintaining the normal bookkeeping routines
of the business.
5-9. The last account listed on the post-closing trial balance for a corporation is the
a. Capital account
b. Withdrawals account
c. Retained Earnings account
d. Common Stock account
Only real accounts are listed on the post-closing trial balance. The last account listed for a
corporation is the Retained Earnings account. Capital and withdrawals are single
proprietorship accounts.
5-10. The last account listed on the post-closing trial balance for a single proprietorship
business is the
a. Capital account
b. Withdrawals account

c. Retained Earnings account

d. Common Stock account
Only real accounts are listed on the post-closing trial balance. The last account listed for a
single proprietorship business is the Capital account. The last account listed for a
corporation is the Retained Earnings account.
Fill in the Blanks:
The recurring steps performed each accounting period, starting with recording
transactions in the journal and continuing through the post-closing trial balance, are
called the ACCOUNTING cycle.
A balance sheet that presents the assets and liabilities in relevant subgroups is called
a CLASSIFIED balance sheet.
CLOSING entries update the owner's capital account for the events of the period just
finished.
CURRENT assets are cash or other assets that are expected to be sold, collected, or used
within the longer of one year or the company's operating cycle.
CURRENT liabilities are obligations due to be paid or settled within the longer of one
year or the operating cycle.
The Income Summary account is an example of a TEMPORARY account, an account
that is closed at the end of the reporting period.
Long-term assets (resources used to produce or sell products or services) that lack
physical form and their benefits are uncertain are called INTANGIBLE assets.
Assets such as notes receivable or investments in stocks and bonds which are held for
more than one year or the operating cycle are called LONG-TERM investments.
A twenty-year mortgage note is an example of a LONG-TERM liability.
The terms temporary accounts and NOMINAL accounts refer to the same type of
account.
The average time between paying cash for employee salaries or merchandise and
receiving cash from customers is called the OPERATING CYCLE of a business.
The owner's claim on the assets of a company is called the owner's EQUITY.

Accounts that are used to report on activities related to one or more future accounting
periods, and whose balances are carried into the next period, are called real or
PERMANENT accounts.
Plant and equipment is sometimes referred to as PLANT assets.
A list of permanent accounts and their balances from the ledger after all closing entries
are journalized and posted is called a POST-CLOSING trial balance.
Statements that show the effects of the proposed transactions as if the transactions had
already occurred are called PRO FORMA statements.
The optional entries recorded at the beginning of a new year that prepare the accounts for
simplified journal entries subsequent to accrual adjusting entries are called
REVERSING entries.
Accounts that are used to describe revenues, expenses, and owner's withdrawals for one
accounting period are called TEMPORARY or nominal accounts.
An UNCLASSIFIED balance sheet broadly groups the assets, liabilities and owner's
equity.
A 10-column spreadsheet used to draft a company's unadjusted trial balance, adjusting
entries, adjusted trial balance, and financial statements is called a WORKSHEET.
WORKING papers are internal documents that are used to assist the preparers in doing
the analyses and organizing the information for reports to be presented to internal and
external decision makers.

Glossary Match:
A balance sheet that presents the assets and liabilities in relevant subgroups.
Classified balance sheet
A step at the end of the accounting period that prepares accounts for recording the
transactions of the next period.
Closing process
Cash or other assets that are expected to be sold, collected, or used within the longer of
one year or the company's operating cycle.
Current assets
A temporary account used only in the closing process to where the balances of revenue
and expense accounts are transferred; its balance equals net income or net loss and is

transferred to the owner's capital account or the Retained Earnings account for a
corporation.
Income Summary
Assets such as notes receivable or investments in stocks and bonds which are held for
more than one year or the operating cycle.
Long-term investments
Another name for temporary accounts.
Nominal accounts
Accounts that are used to report on activities related to one or more future accounting
periods; their balances are carried into the next period, and include all balance sheet
accounts; real account balances are not closed as long as the company continues to own
the assets, owe the liabilities, and have owner's equity; also called real accounts.
Permanent accounts
A list of permanent accounts and their balances from the ledger after all closing entries
are journalized and posted; a list of balances for all accounts not closed.
Post-closing trial balance
Another name for permanent accounts.
Real accounts
Accounts that are used to describe revenues, expenses, and owner's withdrawals for one
accounting period; they are closed at the end of the reporting period; also called nominal
accounts.
Temporary accounts
A balance sheet that broadly groups the assets, liabilities and owner's equity.
Unclassified balance sheet
A 10-column spreadsheet used to draft a company's unadjusted trial balance, adjusting
entries, adjusted trial balance, and financial statements; an optional step in the accounting
process.
Work sheet
Recurring steps performed each accounting period, starting with recording transactions in
the journal and continuing through the post-closing trial balance.
Accounting cycle
Journal entries recorded at the end of each accounting period that transfer the end-ofperiod balances in revenue, expense, and withdrawals accounts to the permanent owner's
capital account in order to prepare for the upcoming period and update the owner's capital
account for the events of the period just finished.
Closing entries

Obligations due to be paid or settled within the longer of one year or the operating cycle.
Current liabilities
Long-term assets (resources) used to produce or sell products or services; these assets
lack physical form.
Intangible assets
Obligations that are not due to be paid within the longer of one year or the operating
cycle.
Long-term liabilities
The average time between paying cash for employee salaries or merchandise and
receiving cash from customers.
Operating cycle of a business
The owner's claim on the assets of a company.
Owner's equity
Tangible long-lived assets used to produce or sell products and services; also called plant
assets.
Plant and equipment
Statements that show the effects of the proposed transactions as if the transactions had
already occurred.
Pro forma statements
Optional entries recorded at the beginning of a new year that prepare the accounts for
simplified journal entries subsequent to accrual adjusting entries.
Reversing entries
Internal documents that are used to assist the preparers in doing the analyses and
organizing the information for reports to be presented to internal and external decision
makers.
Working papers

Chapter 6: Accounting for Merchandising Activities

TRUE/FALSE
6-1. When merchandise inventory is purchased with credit terms of 2/10, n/60, the credit
period is 60 days from date of the invoice.

True. The credit period is the final, expected, agreed upon date of payment. In this case,
60 days from the date of the invoice.
6-2. Merchandise purchased on June 8 with credit terms of 2/10, n/30, must be paid
sooner than with credit terms of n/10 EOM.
True. Under 2/10, n/30, the credit period would expire on July 8. Under the credit terms
n/10 EOM, payment is due by July 10, ten days after the end of the month (EOM) in
which the purchase was made.
6-3. Under the periodic inventory system, inventory shrinkage, theft, and spoilage are
accounted for in a special account.
False. Under periodic inventory, a physical count is used to determine the ending
inventory balance. When this amount is deducted from the total goods available, the
result represents the value of goods sold, stolen, or otherwise depleted.
6-4. An inventory system in which the business has up-to-date data as to the quantity of
goods on hand is called a periodic inventory system.
False. Under a periodic inventory system, the quantity of goods on hand is determined by
a physical count, usually at the end of the accounting period. The inventory system that
provides up-to-date inventory data is called a perpetual inventory system.
6-5. A deduction allowed from the invoice price of goods if payment is made within a
specified period of time is called a trade discount.
False. Cash discounts are given for paying the invoice price within a specified period of
time (the discount period). Cash discounts are treated as sales discounts by the seller and
as purchases discounts by the buyer.
6-6. Merchandise with a list price of $100, subject to a trade discount of 40 percent and
sold with credit terms of 2/10, n/60, would cost the buyer $58.80 if payment is made
within the discount period.
True. The list price would be reduced to an invoice price of $60 ($100 x .6). The credit
terms would apply to the invoice price. The cash discount (a purchases discount) to the
buyer would be $1.20 ($60 x .02). The net price paid would be $60.00 - $1.20, or $58.80.
6-7. When goods are shipped under freight terms of FOB shipping point (FOB factory),
the buyer of the goods pays the freight charges.
True. FOB factory (or shipping point) indicates that the buyer pays the freight charges.
FOB destination indicates that the seller pays the freight charges.

6-8. When a return of merchandise requires the buyer to notify the seller of the reduction
in the invoice due to the return, the memorandum sent by the buyer is called a debit
memorandum.
True. When the originator of the memorandum debits (reduces) a liability to account for
the return, the memo is called a debit memorandum. When the originator receives the
goods and credits an account receivable, the memo they send is called a credit
memorandum.
6-9. The cost of goods sold is determined by adding the cost of purchases to the
beginning merchandise inventory and subtracting the ending merchandise inventory.
True. The beginning merchandise inventory added to the cost of goods purchased is the
amount of merchandise that is available for sale. Deducting the amount of remaining or
ending inventory determines the amount of merchandise (at cost) that was sold.
6-10. An income statement in which the details of the cost of goods sold are shown is
called a single-step income statement.
False. It is called a multiple-step income statement. A single-step income statement
shows revenues, cost of goods sold, and expense categories as single amounts, without
detail.
6-11. In a periodic inventory system, transportation charges for merchandise are added to
net purchases to determine the cost of goods purchased.
True. Net purchases are calculated by subtracting purchases discounts and purchases
returns and allowances from gross purchases. Transportation charges are added to net
purchases to determine the cost of goods purchased.
6-12. In a perpetual inventory system, transportation charges are recorded with a debit to
the merchandise inventory account.
True. The entry is a debit to Merchandise Inventory and a credit to Cash or Accounts
Payable.
6-13. Transportation-In, Freight-In, and Delivery Expense are all the same account.
False. Transportation-In and Freight-In are the same and account for the cost incurred to
get merchandise items into the inventory. Delivery Expense is a normal operating
expense account the keeps a record of the cost incurred in shipping merchandise items to
customers.
6-14. Under a periodic system with inventory included in the closing entry procedure, the
Credit column of the Income Statement columns of the work sheet will likely contain
more than revenue account balances.

True. The account balances of ending merchandise inventory, purchases discounts,

purchases returns and allowances, as well as sales will appear in the Credit column of the
Income Statement columns of the work sheet.
6-15. The purpose of including the Merchandise Inventory account (a real account) in the
closing procedure is to close the beginning balance to the Income Summary account and
enter the unsold balance in the Merchandise Inventory account (periodic system).
True. The adjustment for merchandise inventory (removing the beginning balance and
entering the ending balance) is most often accomplished by including the beginning and
ending inventory balances in the closing entries at the end of the period.
6-16. The steps in the accounting cycle are different for a merchandising business than
they are for a service business.
False. The accounting cycle is identical--analyzing, journalizing, posting, trial balance
preparation, adjustments and work sheet completion, financial statements preparation,
closing, post-closing trial balance and possibly the optional reversing entries.
6-17. If net sales for the business totals $150,000, gross profit is $65,000, and net income
is $40,000, then the cost of goods sold will total $25,000.
False. Net sales of $150,000 less cost of goods sold of $85,000 equals gross profit (or
gross margin) of $65,000.
6-18. If net sales for the business totals $50,000, gross margin is $24,000, and net income
is $4,000, then the operating expenses for this company will total $20,000.
True. Sales of $50,000 less cost of goods sold of $26,000 equals a gross profit of
$24,000. Gross margin of $24,000 less operating expenses of $20,000 equals a net
income of $4,000.
6-19. The income statement for the period shows a net loss for the year of $4,500. When
the closing entries are prepared, this net loss will be closed into the Capital account of a
proprietorship business with a debit to the Income Summary account and a credit to the
Retained Earnings account.
False. When closing a net loss for a single-proprietorship business, the Capital account
must be debited (decreased) and the Income Summary account (with the debit balance)
must be credited.
6-20. Operating expenses include general expenses, administrative expenses, and cost of
goods sold.

False. Operating expenses are subtracted from the gross margin or gross profit to arrive
at the net income or net loss. Operating expenses include selling expenses and general
and administrative expenses.
6-21. Merchandise with a list price of $2,000 is sold with a trade discount of 30% and
cash terms of 2/10, n/30. If the merchandise is paid for within the discount period, the
total cost will be $1,372.
True. $2,000 x .70 = $1,400 cost after the trade discount. $1,400 x .98 = a final cost of
$1,372.
6-22. Merchandise is purchased FOB shipping point. The seller will pay the freight
charges.
False. The buyer will be responsible for the freight charges if the terms are FOB shipping
point (FOB factory). If the terms are FOB destination the seller will incur the costs for the
delivery of the goods.

Multiple choice:
6-1. Gross profit from sales is the difference between
a. net sales and operating expenses
b. net sales and the cost of goods sold
c. net sales and the cost of goods sold plus all the expenses
d. gross sales less the sales discounts and sales returns and allowances
Gross margin from sales is the difference between net sales and the cost of goods sold.
The amount of gross margin as a percentage of net sales is often used as an indicator of
the effectiveness of management.
6-2. The buyer received an invoice from the seller for merchandise with a list price of
$400 and credit terms of 2/10, n/60. The number 10 in the credit terms is the
a. credit period
b. cash discount allowed for early payment of the invoice
c. discount period
d. trade discount
The first number indicates the cash discount allowed, the second number indicates the
discount period (when the invoice must be paid to take advantage of the discount), n/60
means that a 60-day credit period passes before the net amount is due.
6-3. The records for Uptown Pet Shop showed the following:

Sales
Purchases

$75,000 Beginning merchandise inventory

45,000 Cost of goods sold

$10,000
50,000

The ending merchandise inventory must have been

a. $5,000
b. $15,000
c. $25,000
d. $40,000
The cost of goods sold is the beginning inventory + purchases - ending merchandise
inventory. Therefore, the ending merchandise inventory is $5,000 ($10,000 + $45,000 - X
= $50,000; X = $5,000).
6-4. Under the periodic inventory system, the Purchases account is used to record
a. only cash purchases of merchandise inventory
b. purchases of any asset on account or note payable
c. only purchases of merchandise inventory on account
d. purchases of merchandise inventory for cash or on account
The Purchases account is used ONLY to record the purchases of merchandise inventory,
whether with cash or on account. The purchases of other assets is recorded in accounts
which identify the assets.
6-5. The Sun Set Shade Company purchased three pieces of office equipment for a total
price of $2,100. One piece of equipment costing $800 was damaged on delivery and was
returned to the vendor. The invoice has not been paid. The proper journal entry for the
return is
a. Merchandise Inventory, debit, $800; Accounts Payable, credit, $800
b. Acc. Payable, debit, $800; Merchandise Inventory, credit, $800
c. Accounts Payable, debit $800; Office Equipment, credit, $800
d. Accounts Payable, debit $2,100; Purchases, credit, $2,100
The correct entry is: Accounts Payable, debit, $800 and Office Equipment, credit, $800.
The Merchandise Inventory account is only used for the return of merchandise inventory.
6-6. Company records disclose the following:
Sales
Purchases
Transportation-In

$95,000 Beginning merchandise inventory

$10,000

45,000 Gross profit from sales

50,000

500 Purchases discounts

1,000

The ending merchandise inventory (periodic)

a. must be $5,000
b. must be $6,000
c. must be $9,500
d. must be $10,000
The cost of purchases is $44,500 ($45,000 purchases - $1,000 discount + $500
transportation). The cost of goods sold is $45,000 ($95,000 sales - $50,000 gross profit).
The ending inventory is $9,500 ($10,000 beginning inventory + $44,500 purchases - X =
$45,000 - the cost of goods sold; X = $9,500).
6-7. Which of the following is used to determine the cost of goods available for sale
(periodic inventory)?
a. beginning merchandise inventory + purchases + ending merchandise inventory
b. ending merchandise inventory + purchases - freight charges
c. beginning merchandise inventory + purchases - freight charges
d. beginning merchandise inventory + purchases - purchases discount + freight
charges
The cost of goods available for sale includes the beginning merchandise inventory plus
the cost of purchases (purchases - purchases discounts and purchases returns and
allowances, plus freight charges).
6-8. Under a perpetual inventory system merchandise is purchased on account. The
correct journal entry for this purchase will be a
a. debit to Purchases and a credit to Cash
b. debit to Merchandise Inventory and a credit to Accounts Payable
c. debit to Merchandise Inventory and a credit to Cash
d. debit to Purchases Returns and a credit to Cost of Goods Sold
The Purchases account is not used in a perpetual inventory system. The journal entry is a
direct debit to Merchandise Inventory and a credit to Accounts Payable. The liability will
be paid at a future time.
6-9. Under a perpetual inventory system part of the merchandise purchased on account at
an earlier time is now being returned. None of the goods have been paid for. The correct
journal entry for this return will be a
a. debit to Cash and a credit to Purchases
b. debit to Merchandise Inventory and a credit to Accounts Payable
c. debit to Accounts Payable and a credit to Merchandise Inventory
d. debit to Purchases Returns and a credit to Cost of Goods Sold

The Purchases account is not used in a perpetual inventory system. The journal entry is a
debit to Accounts Payable and a credit to Merchandise Inventory.
6-10. Under a perpetual inventory system supplies are purchased for cash. The correct
journal entry for this purchase will be a
a. debit to Purchases and a credit to Cash
b. debit to Merchandise Inventory and a credit to Cash
c. debit to Supplies and credit Cost of Goods Sold
d. debit to Supplies and a credit to Cash
The Purchases account is not used in a perpetual inventory system. The entry is NOT a
purchase of merchandise that will be resold. Supplies are prepaid assets that will be used
in running the business.
6-11. An item of merchandise was sold with an invoice price of $400 and credit terms of
2/10, n/30. The entry to record the sale would include a credit to Sales of
a. $400.00
b. $396.00
c. $408.00
d. $392.00
The sale is for $400 and should be recorded at $400. The sales discount will be $8.00 if it
is earned through early payment of the invoice. The cash discount will be recognized, if
earned, at the time of payment.
6-12. An item of merchandise was sold for $800 cash by a business using the perpetual
inventory system. The product sold cost the business $600. After the sale entry has been
recorded, a second entry will
a. debit Cash and credit Sales for $800
b. debit Sales and credit Merchandise Inventory for $600
c. debit Cost of Goods Sold and credit Merchandise Inventory $600
d. debit Merchandise Inventory and credit Cost of Goods Sold $800
The perpetual inventory system requires an immediate update to the value of the
merchandise inventory as well as the cost of goods sold. Cost of goods sold has increased
by $600 and the merchandise inventory has decreased by $600.
6-13. Under the periodic inventory system, which of the following is a correct closing
entry?
a. Income Summary, debit; Sales, credit
b. Income Summary, credit; Sales Returns and Allowances, debit

c. Income Summary, debit; Merchandise Inventory (beginning), credit

d. Purchases, debit; Income Summary, credit
It is a correct closing entry if the credit is for the amount of the beginning merchandise
inventory. Sales are debited to close, Sales Returns and Allowances are credited to close,
and Purchases are credited to close.
6-14. When ____________________________, the cost of goods sold will be the same
as the cost of purchases.
a. there is no beginning merchandise inventory (first year of business)
b. there is no ending merchandise inventory
c. purchases are equal to net sales
d. the beginning and ending merchandise inventory values are the same
Example: if beginning merchandise inventory is $10,000, ending merchandise inventory
is $10,000, and the cost of purchases is $40,000, the cost of goods sold will be $40,000
($10,000 + $40,000 - $10,000 = $40,000).
6-15. An item of merchandise with a list price of $100 was purchased with a trade
discount of 40% and credit terms of 2/10, n/30. If the vendor is paid within the discount
period, the journal entry to record the payment would be
a. Purchases, dr., $100.00; Purchase Discounts, cr., $42.00; Cash, cr., $58.00
b. Accounts Payable, dr., $60.00; Purchase Discounts, cr., $1.20; Cash, cr., $58.80
c. Accounts Payable, dr., $100.00; Purchase Discounts, cr., $42.00; Cash, cr., $58.00
d. Accounts Payable, dr., $40.00; Purchase Discounts, cr., $.80; Cash, cr., $39.20
The purchase would have been recorded at $60.00. Trade discounts are not recorded. The
cash discount is deducted from the invoice price to arrive at the net amount of cash paid
to the vendor.
6-16. If gross sales is $40,000, sales returns and allowances $1,000, sales discounts $400,
and delivery expenses $100, the net sales of the business will total
a. $38,500
b. $38,600
c. $40,000
d. $39,000
Net sales of $40,000, less sales returns and allowances of $1,000 and sales discounts of
$400, equals net sales of $38,600. Delivery expenses are operating expenses and are not a
part of the net sales calculation.
Fill in the blanks:

A CASH discount, called a sales discount by the seller and a purchase discount by the
buyer, is a reduction in the price of merchandise that is granted by a seller to a purchaser.
A PURCHASE discount is a cash discount granted to the purchaser for paying within the
discount period.
A SALES discount is a cash discount granted to customers for paying within the discount
period.
An income statement format that shows intermediate totals between sales and net income
and detailed computations of net sales and costs of goods sold is called a
classified, MULTIPLE-STEP income statement.
Another term for the 'cost of merchandise sold' is the cost of GOODS sold
A notification that the sender has entered a credit in the recipient's account maintained by
the sender is called a CREDIT (DEBIT or CREDIT) memorandum.
Credit terms of 2/10, n/30 indicate a CREDIT period of thirty days.
Terms of 2/10, n/60 shown on an invoice are called CREDIT terms.
Credit terms of 2/10, n/60 indicate a DISCOUNT period of ten days.
The terms EOM mean payment is due at the END-OF-MONTH.
FOB DESTINATION means that the seller pays the shipping costs and the ownership of
the goods transfers to the buyer at the buyer's place of business.
FOB SHIPPING POINT (also called factory) means that the buyer pays the shipping
costs and the ownership of the goods transfers to the buyer at the shipper's place of
business.
Expenses that support the overall obligations of a business and include the expenses of
such activities as providing accounting services, human resource management, and
financial management are called general and ADMINISTRATIVE expenses.
Another term for gross margin is gross PROFIT.
The LIST price is the catalogue price of an item before any trade discount is deducted.
Products, also called goods, are MERCHANDISE that a company acquires for the
purpose of reselling them to customers.
A MERCHANDISER earns net income by buying and selling merchandise.

A method of accounting that records the cost of inventory purchased but does not track
the quantity on hand or sold to customers is called a PERIODIC inventory system.
A method of accounting that maintains continuous records of the cost of inventory on
hand and the cost of goods sold is called a PERPETUAL inventory system.
A RETAILER is a middleman that buys products from manufacturers or wholesalers and
sells them to consumers.
Advertising expense is an example of a SELLING (GENERAL or SELLING) expense
on a multi-step income statement.
SHRINKAGE is the term used for inventory losses that occur as a result of shoplifting or
deterioration.
A SINGLE-STEP income statement includes cost of goods sold as an operating expense
and shows only one subtotal for total expenses.
A register of information outside the usual accounting records and accounts is called
a SUPPLEMENTARY record.
A TRADE discount is a reduction below a list or catalogue price that may vary in
amount for wholesalers, retailers, and final consumers.
A WHOLESALER is a middleman that buys products from manufacturers or other
wholesalers and sells them to retailers or other wholesalers.

Glossary Match:
A reduction in the price of merchandise that is granted by a seller to a purchaser in
exchange for the purchaser's making payment within a specified period of time called the
discount period.
Cash discount
A notification that the sender has entered a credit in the recipient's account maintained by
the sender.
Credit memorandum
A notification that the sender has entered a debit in the recipient's account maintained by
the sender.
Debit memorandum

A method of accounting that records the cost of inventory purchased but does not track
the quantity on hand or sold to customers; the records are updated at the end of each
period to reflect the results of physical counts of the items on hand.
Periodic inventory system
A method of accounting that maintains continuous records of the cost of inventory on
hand and the cost of goods sold.
Perpetual inventory system
A term used by a purchaser to describe a cash discount granted to the purchaser for
paying within the discount period.
Purchase discount
A middleman that buys products from manufacturers or wholesalers and sells them to
consumers.
Retailer
A term used by a seller to describe a cash discount granted to customers for paying within
the discount period.
Sales discount
An income statement format that includes cost of goods sold as an operating expense and
shows only one subtotal for total expenses.
Single-step income statement
A register of information outside the usual accounting records and accounts; also called
supplemental records.
Supplementary records
A reduction below a list or catalogue price that may vary in amount for wholesalers,
retailers, and final consumers.
Trade discount
A middleman that buys products from manufacturers or other wholesalers and sells them
to retailers or other wholesalers.
Wholesaler
An income statement format that shows intermediate totals between sales and net income
and detailed computations of net sales and costs of goods sold.
Classified multiple-step income statement
The cost of merchandise sold to customers during a period.
Cost of goods sold
The time period that can pass before a customer's payment is due.
Credit period

The description of the amounts and timing of payments that a buyer agrees to make in the
future.
Credit terms
The time period in which a cash discount is available and a reduced payment can be made
by the buyer.
Discount period
The abbreviation for end-of-month; used to describe credit terms for some transactions.
EOM
The abbreviation for free on board, the designated point at which ownership of goods
passes to the buyer; FOB shipping point (or factory) means that the buyer pays the
shipping costs and accepts ownership of the goods at the seller's place of business. FOB
destination means that the seller pays the shipping costs and transfers ownership to the
buyer at the buyer's place of business.
FOB
Expenses that support the overall obligations of a business and include the expenses of
such activities as providing accounting services, human resource management, and
financial management.
General and administration expenses.
The difference between net sales and the cost of goods sold; also called gross margin.
Gross profit
The catalogue price of an item before any trade discount is deducted.
List price
Products, also called goods, that a company acquires for the purpose of reselling them to
customers.
Merchandise
Products that a company owns for the purpose of selling them to customer.
Merchandise inventory
Earns net income by buying and selling merchandise.
Merchandiser
The expenses of promoting sales by displaying and advertising the merchandise, making
sales, and delivering goods to customers.
Selling expenses
Inventory losses that occur as a result of shoplifting or deterioration.
Shrinkage

Chapter 7: Merchandise Inventory and Cost of Sales

TRUE/FALSE
7-1. Goods in transit that were purchased under freight terms of FOB factory should be
included in the ending inventory of the buyer.
True. FOB factory (or shipping point) not only indicates that the buyer pays the freight
charges, but also indicates that the buyer takes ownership of the merchandise at time and
point of shipping.
7-2. When merchandise is left on consignment with a consignee, it should be included in
the ending inventory of the consignee.
False. The goods are not the property of the consignee and therefore should not be
included in the merchandise inventory of the consignee.
7-3. Merchandise received by a retailer to sell on consignment should be excluded from
the ending merchandise inventory of the retailer.
True. Merchandise held on consignment is not the property of the retailer (consignee).
The consignee has possession of the merchandise but not ownership of the merchandise.
7-4. The incidental costs of maintaining inventory (stocking, insuring, rotating, etc.) are
generally treated as costs of the reporting period in which these costs are incurred.
True. Taking advantage of the materiality principle, it is more expedient to charge the
incidental costs as selling expenses of the reporting period.
7-5. Under the FIFO method of inventory valuation, the assignment of cost to
merchandise sold is in the same order in which the merchandise was purchased.
True. FIFO means 'first-in, first-out'--the first items purchased are the first items sold,
therefore the cost is assigned to the merchandise sold in the same order in which the
purchases of merchandise were made.
7-6. Under the LIFO method of inventory valuation, the ending merchandise inventory
would be valued at the purchase price of the most recent purchases.
False. LIFO means 'last-in, first-out'--the last items purchased are the first items sold. The
merchandise on hand is considered to be from the oldest purchases of merchandise.

7-7. In a periodic system, if a retailer purchased 500 units of merchandise inventory at $8

per unit, and 800 units of inventory at $10 per unit, the weighted average cost of the
merchandise is $9 per unit.
False. Weighted-average inventory pricing takes into consideration both the unit price
and the number of units purchased at each price level. The weighted-average unit cost is
$9.23 (((500 X $8) + (800 X $10))/ 1,300).
7-8. During extended periods of rising prices, the FIFO method of inventory pricing will
yield a higher cost of merchandise sold and a lower ending merchandise inventory, when
compared to the LIFO method of inventory pricing.
False. The LIFO method will result in the higher cost of merchandise sold because it will
contain the last-in costs. The LIFO method will result in the lower ending merchandise
inventory because it will contain older costs.
7-9. During extended periods of rising prices, the use of LIFO will result in a greater
amount of gross profit than would result if FIFO were used.
False. Under LIFO, the most recent costs are charged to the cost of goods sold. The most
recent costs would be higher costs and therefore, the gross profit would be less than under
the FIFO method of inventory costing.
7-10. When the value of ending merchandise inventory is overstated, the net income of
the subsequent year will be understated by the amount of the overstatement of the ending
merchandise inventory.
True. The overstated ending inventory will become the beginning inventory of the
subsequent year, overstating the cost of merchandise available for sale and the cost of
goods sold of the subsequent year.
7-11. Should an error that understates the ending merchandise inventory not be
discovered, at the end of the subsequent year the capital account will be overstated.
False. If the error, which will understate current year income, is not discovered, the
overstatement of income in the subsequent year will cause the capital account to 'correct'
itself because of the offsetting errors.
7-12. FIFO, LIFO, weighted average, and specific invoice inventory pricing are terms
used to describe inventory systems.
False. An inventory system refers to the accounting, procedures, and records used by a
business to control its inventory. FIFO, LIFO, weighted average, and specific invoice
inventory pricing refer to methods of inventory costing.

7-13. If one hundred units of merchandise were purchased at $15 per unit and the current
market price of the merchandise is $8 per unit, the merchandise will be reported at $8 per
unit.
True. Applying LCM (the lower of cost or market rule), the merchandise would be
valued at $8 per unit, since the historical cost of the merchandise is greater than the
current replacement (market) cost.
7-14. Financial statements prepared between the first day and the last day of the fiscal
period are called interim statements.
True. Since they are between the beginning and end of the fiscal period, 'interim' is an
appropriate classification. The year-end statements are the official financial statements.
7-15. The ratio of goods available for sale at cost to the same goods available for sale at
retail prices is called the retail method cost ratio.
True. The retail method cost ratio is used to convert the retail value of the ending
inventory to its cost value.
7-16. Goods available for sale at cost total $65,000 and at retail total $100,000. Total net
sales at retail total $85,000. The cost ratio is 65%.
True. The cost ratio is calculated by dividing the goods available for sale at cost by the
goods available for sale at retail ($65,000 / $100,000 = .65 or 65%).
7-17. Goods available for sale at cost total $55,000 and at retail total $100,000. The cost
ratio is 55% and the net sales for the period total $80,000. The ending inventory at retail
totals $20,000 and the ending inventory at cost totals $11,000.
True. $100,000 goods available at retail - net sales of $80,000 = ending inventory at
retail of $20,000. $20,000 ending inventory at retail multiplied by the cost ratio of 55% =
an ending inventory at cost of $11,000.
7-18. Net Sales total $100,000. Beginning inventory totals $12,000 and the total cost of
merchandise purchases is $48,000. Gross profit is 60% of net sales. The ending inventory
using the gross profit method will be $30,000.
False. Goods available for sale will total $60,000 ($12,000 + $48,000). If the gross profit
is 60% ($60,000) then the cost of goods sold is $40,000. Goods available for sale of
$60,000 - cost of goods sold of $40,000 = an ending inventory of $20,000.
7-19. The formula for Merchandise Turnover is Average Merchandise Inventory / by Cost
of Goods Sold.

False. Cost of Goods Sold is divided by Average Merchandise Inventory to compute the
Merchandise Turnover. This ratio computes the number of times that the merchandise is
purchased and sold during a specific period. It helps to avoid overstocked or out-of-stock
situations.
7-20. The lowest ratio possible is the goal of the user of the merchandise turnover ratio.
False. The manager using the merchandise turnover ratio would seek the highest possible
ratio while providing enough inventory to meet demand and avoid out-of-stock situations.
7-21. If the ending inventory is overstated, the cost of goods sold is overstated and net
income is understated.
False. If the ending inventory is overstated, the cost of goods sold is understated and net
income is overstated.
7-22. If the ending inventory is overstated, the cost of goods sold is understated and net
income is overstated.
True. The beginning inventory of the next period will be overstated and net income of
the next period will be understated.
7-23. If the beginning inventory is overstated, the cost of goods sold is overstated and net
income is understated.
True. If the ending inventory of the period is correct, there will be no inventory error
carryover into the next accounting period.
7-24. If the beginning inventory is understated, the cost of goods sold is overstated and
net income is overstated.
False. If the beginning inventory is understated, the cost of goods sold is understated and
net income is overstated.
7-25. If the business uses LIFO for tax purposes they may use any other method of
inventory costing for their financial statements.
False. Lifo does provide some tax advantages when prices are steadily rising. If LIFO is
used on the tax return, then it must also be used by the business for financial statements.
7-26. Using one inventory costing system over another has really very little effect on the
amount of taxes that might be due in any given period.
False. Check the TREKKING Company example of a reduction in taxable income of
$680,000,000 by selecting LIFO over FIFO.

Multiple Choice:
7-1. Emerson Furniture prepared the following schedule:

Beginning merchandise inventory

Purchases for November

Cost

Retail

$40,000

$60,000

80,000

140,000

Sales in November

180,000

Using the retail method for estimating the value of ending inventory, the goods available
for sale at cost and retail is
a. $40,000 and $200,000
b. $100,000 and $140,000
c. $120,000 and $200,000
d. $120,000 and $320,000
$40,000 + $80,000 = $120,000 goods available for sale at cost. $60,000 + $140,000 =
$200,000 goods available for sale at retail. The cost ratio for Emerson Furniture will be .
60 or 60%.

7-2.
Quantity

Cost
Per Unit

Total
Cost

Jan 1, Beginning Inventory

100

$18.00

$1,800.00

Mar 4, Purchase

400

19.00

7,600.00

May 8, Purchase

800

20.00

16,000.00

Nov 3, Purchase

500

21.00

10,500.00

Date

Merchandise Available

1,800

$35,900.00

Five-hundred and twenty units are unsold. Using the LIFO (periodic) method, the cost
assigned to the ending merchandise inventory is

a. $10,900
b. $11,368
c. $9,800
d. $9,360
Using the LIFO method, the ending inventory would be calculated as: (100 X $18) + (400
X $19) + (20 X $20) or ($1,800 + $7,600 + $400 = $9,800).
7-3.
Quantity

Cost
Per Unit

Total Cost

Jan 1, Beginning Inventory

100

$18.00

$1,800.00

Mar 4, Purchase

400

19.00

7,600.00

May 8, Purchase

800

18.25

14,600.00

Nov 3, Purchase

500

20.40

10,200.00

Date

Merchandise Available

1,800

$34,200.00

Five-hundred units are unsold. Using the periodic weighted average method, the cost
assigned to the ending merchandise inventory is
a. $10,200
b. $9,500
c. $9,800
d. $10,500
Using the weighted average method, the ending inventory would be calculated as:
$34,200 / 1,800 = $19 unit cost. 500 X $19 = $9,500.
7-4.
Quantity

Cost
Per Unit

Total Cost

Jan 1, Beginning Inventory

100

$18.00

$1,800.00

Mar 4, Purchase

400

19.00

7,600.00

May 8, Purchase

800

20.00

16,000.00

Nov 3, Purchase

500

21.00

10,500.00

Date

Merchandise Available

1,800

$35,900.00

Five-hundred and seventy units are unsold. Using the FIFO (periodic) method, the cost
assigned to the ending merchandise inventory is

a. $10,800
b. $11,900
c. $11,970
d. $11,368
Using the FIFO method, the ending inventory would be calculated as: (500 x $21) + (70
X $20) or $10,500 + $1,400 = $11,900.
7-5.
Beginning inventory

10 units @ $10 per unit

First purchase

35 units @ $11 per unit

Second purchase

40 units @ $12 per unit

Third purchase

15 units @ $13 per unit

If 83 units are sold, the value of the ending inventory under periodic FIFO would be
a. $177
b. $905
c. $219
d. $204
The ending inventory would be composed of the most recent purchases (newest layers) of
15 X $13 plus 2 X $12, or $195 + $24 = $219.

7-6.
Beginning inventory

10 units @ $10 per unit

First purchase

35 units @ $11 per unit

First sale
Second purchase

20 units
40 units @ $12 per unit

Second sale
Third purchase

35 units
15 units @ $13 per unit

The value of the ending inventory using a perpetual inventory system with the LIFO
valuation method is
a. $485
b. $555

c. $520
d. $540
Twenty units of the first purchase were sold, leaving 10 @ $10 and 15 @ $11. Thirty-five
units of the second purchase were sold next, leaving 10 @ $10, 15 @ $11, and 5 @ $12.
The units of the third purchase are unsold. $100 + $165 + $60 + $195 = $520
7-7.
Beginning inventory

10 units @ $10 per unit

First purchase

35 units @ $11 per unit

First sale
Second purchase

20 units
40 units @ $12 per unit

Second sale
Third purchase

35 units
15 units @ $13 per unit

The value of the ending inventory using a perpetual inventory system with the FIFO
valuation method is
a. $555
b. $495
c. $520
d. $485
All 10 units of the beginning inventory were sold as well as 10 units of the first purchase.
The second sale removed 25 units of the first purchase 10 units of the second purchase
leaving 30 units (@ $12) of the second purchase and all 15 units (@ $13) of the third
purchase. $360 + 195 = $555.
7-8. Inventory at the end of the current period was erroneously understated. Which of the
following is true as a result of the understatement?
a. net income for the current year is overstated
b. the cost of goods sold for the current year is understated
c. capital at the end of the current year is overstated
d. net income at the end of the following year will be overstated
For the current year, the cost of goods sold is overstated, net income is understated, and
capital is understated. For the following year, the cost of goods sold will be understated
and net income overstated.
7-9. When perpetual inventory is maintained, the cost of goods sold is recorded by a
journal entry in which a credit is made to the

a. Cost of Goods Sold account

b. Merchandise Inventory account
c. Accounts Receivable account
d. Purchases account
After the sales entry has been recorded, the required second entry is a debit to the Cost of
Goods Sold account and a credit to the Merchandise Inventory account.
7-10. Which journal entry is an indication that a perpetual inventory system is being
used?
a. Accounts Receivable, dr., $500; Sales, cr., $500
b. Merchandise Inventory, dr., $45,000; Income Summary, cr., $45,000
c. Cost of Goods Sold, dr., 30,000; Merchandise Inventory, cr., $30,000
d. Income Summary, dr., $24,000; Merchandise Inventory, cr., $24,000
Under the perpetual inventory system, the merchandise inventory is updated for
purchases and for sales, maintaining a perpetual balance in the Merchandise Inventory
account.
7-11. Lipton Hardware prepared the following schedule of unit costs and market prices
for three items of merchandise inventory.

Item Units

Cost
per unit

Market
price
per unit

1,000

$.50

$.55

2,000

.45

.30

1,500

.60

.75

Applying the lower of cost or market price rule, the total value of the units would be
reported as
a. $2,300.00
b. $2,000.00
c. $2,080.00
d. $2,580.00
Under LCM, the lower of cost or market price will be used. In this case: (1,000 X $.50) +
(2,000 X $.30) + (1,500 X $.60), or $500 + $600 + $900 = $2,000.
7-12. Harrison Hardware prepared the following schedule:
Cost

Retail

Beginning merchandise
inventory

$40,000

$60,000

Purchases for November

100,000

140,000

Sales in November

180,000

Using the retail method for estimating the value of ending inventory, the estimated ending
merchandise inventory at cost is
a. $30,000
b. $180,000
c. $14,000
d. $20,000
The cost to retail percentage is 70% ($140,000 / $200,000). The estimated ending
inventory at retail is $20,000 ($200,000 - $180,000). The estimated ending inventory at
cost is $14,000 ($20,000 X 70%).
7-13. Work-Days Clothing had beginning merchandise inventory of $45,000. It made
purchases of $80,000 and recorded sales of $130,000 during November. Its estimated
gross profit on sales was 25%. On November 30, the store was destroyed by fire. The
merchandise inventory loss was
a. $27,500
b. $125,000
c. $97,500
d. $25,000
The cost of goods sold is the sales less the gross profit on sales, or $97,500 ($130,000 ($130,000 X .25)). The lost inventory will be estimated as available inventory at cost
($125,000) less the cost of goods sold ($97,500) or $27,500.
7-14. Beginning inventory totals $100,000 and ending inventory totals $140,000. Net
sales totals $400,000 and cost of goods sold is $300,000. The merchandise turnover ratio
will be
a. 2.25
b. 2.50
c. 3.00
d. 4.50
Cost of goods sold of $300,000 divided by the average inventory of $120,000 = a
merchandise turnover of 2.50.

7-15. Beginning inventory totals $100,000 and ending inventory totals $140,000. Net
sales totals $800,000 and cost of goods sold is $600,000. The days' sales in inventory will
be (to the nearest hundredth).
a. $22.25
b. $32.50
c. $55.33
d. $85.17
Days' sales in inventory is calculated by dividing the ending inventory of $140,000 by the
cost of goods sold of $600,000 and multiplying the total by 365 days. ($140,000 /
$600,000) x 365 = $85.17.

Fill in the Blanks

Another name for weighted-average inventory pricing is AVERAGE cost method.
The accounting principle that guides accountants to select the less optimistic estimate
when two estimates of amounts to be received or paid are about equally likely is
the CONSERVATISM principle.
The one who receives and hold goods owned by another party for the purpose of selling
the goods for the owner is a CONSIGNEE (CONSIGNEE or CONSIGNOR).
The CONSISTENCY principle is the accounting requirement that a company use the
same accounting methods period after period so that the financial statements of
succeeding periods will be comparable.
Dividing the ending inventory by cost of goods sold and multiplying the result by 365
results in a number that is called DAYS' SALES in inventory.
The pricing of an inventory under the assumption that inventory items are sold in the
order acquired is called FIFO (FIFO or LIFO) inventory pricing.
The pricing of an inventory under the assumption that costs for the most recent items
purchased are sold first and charged to cost of goods sold is called LIFO (FIFO or LIFO)
inventory pricing.
A procedure for estimating an ending inventory in which the past gross profit rate is used
to estimate cost of goods sold, which is then subtracted from the cost of goods available
for sale to determine the estimated ending inventory, is called
the GROSS PROFIT method of estimating ending an inventory.

For a company which has a fiscal year ending June 30, a balance sheet prepared on May
31 would be called an INTERIM statement.
The required method of reporting merchandise inventory in the balance sheet where
market value is reported when market is lower than cost is called the LOWER-OFCOST-OR-MARKET method.
Dividing the cost of goods sold by the average merchandise inventory balance results in a
number called merchandise TURNOVER.
An item that will sell for $45 and has a cost to sell of $32, has an
expected NET REALIZABLE value of $13.
A method for estimating an ending inventory based on the ratio of the amount of goods
for sale at cost to the amount of goods for sale at marked selling prices is called
the RETAIL inventory method.
Another name for specific invoice inventory pricing is SPECIFIC identification.
MATERIALITY states that an amount may be ignored if its affect on the financial
statements is not important to their users.
FULL DISCLOSURE requires financial statements (including footnotes) to report all
relevant information about the operations and financial position of the entity.

Glossary Match:
Another name for weighted-average inventory pricing.
Average cost method
The accounting principle that guides accountants to select the less optimistic estimate
when two estimates of amounts to be received or paid are about equally likely.
Conservatism principle
One who receives and holds goods owned by another party for the purpose of selling the
goods for owner.
Consignee
An owner of goods who ships them to another party who will then sell the goods for the
owner.
Consignor
The accounting requirement that a company use the same accounting methods period
after period so that the financial statements of succeeding periods will be comparable.
Consistency principle

An estimate of how many days it will take to convert the inventory on hand at the end of
the period into accounts receivable or cash; calculated by dividing the ending inventory
by cost of goods sold and multiplying the result by 365.
Days' sales in inventory
The GAAP that requires financial statements (including footnotes) to report all relevant
information about the operations and financial position of the entity.
Full Disclosure
A procedure for estimating an ending inventory in which the past gross profit rate is used
to estimate cost of goods sold, which is then subtracted from the cost of goods available
for sale to determine the estimated ending inventory.
Gross profit method
Gross profit (net sales minus cost of goods sold) divided by net sales; also called gross
margin ratio.
Gross profit ratio
The expected sales price of an item minus the cost of making the sale.
Net Realizable value
Current cost of purchasing an item.
Replacement Cost
A method for estimating an ending inventory based on the ratio of the amount of goods
for sale at cost to the amount of goods for sale at marked selling prices.
Retail inventory method
Another name for specific invoice inventory pricing
Specific identification method
An inventory pricing system in which the unit prices of the beginning inventory and of
each purchase are weighted by the number of units in the beginning inventory and each
purchase. The total of these amounts is then divided by the total number of units available
for sale to find the unit cost of the ending inventory and of the units that were sold.
Weighted-average inventory pricing
The pricing of an inventory under the assumption that inventory items are sold in the
order acquired; the first items received were the first items sold.
FIFO inventory pricing
The pricing of an inventory under the assumption that costs for the most recent items
purchased are sold first and charged to cost of goods sold.
LIFO inventory pricing

The required method of reporting merchandise inventory in the balance sheet where
market value is reported when market is lower than cost; usually the market value is
defined as net realizable value or current replacement cost on the date of the balance
sheet.
Lower of cost or market (LCM)
This GAAP states that an amount may be ignored if its affect on the financial statements
is not important to their users.
Materiality
The number of times a company's average inventory was sold during an accounting
period, calculated by dividing cost of goods sold by the average merchandise inventory
balance.
Merchandise Turnover
To count merchandise inventory for the purpose of reconciling goods actually on hand to
the inventory control account in the general ledger.
Physical Count
The selling price of merchandise inventory. Retail
The pricing of an inventory where the purchase invoice of each item in the ending
inventory is identified and used to determine the cost assigned to the inventory.
Specific invoice inventory pricing

Chapter 8: Accounting Information Systems

TRUE/FALSE
8-1. Accounting systems are comprised of the people, forms, procedures, and equipment
that are used to capture data about the transactions of an entity and to generate from that
data a variety of financial, managerial, and tax accounting reports.
True. Accounting systems, both manual and computerized, should be designed to process
accounting information efficiently, accurately, and conveniently. Computerized
accounting systems add the attribute of process speed.
8-2. Source documents are the basis for making accounting entries.
True. Examples of source documents include invoices, receipts, billings, employee
earnings records, cheques, and bank statements. These documents provide the data that
are entered in and processed by the accounting system.

8-3. A columnar journal is a type of special journal.

True. A columnar journal is a type of special journal which is a book of original entry
having columns, each of which is designated as the place for entering specific data about
each transaction of a group of similar transactions; and used for recording specified types
of transactions.
8-4. The Accounts Receivable account and the Accounts Payable account are controlling
accounts.
True. When an account, such as Accounts Receivable or Accounts Payable, has an
accompanying subsidiary ledger containing the names and balances of individual debtor
or creditor accounts, it is called a controlling account.
8-5. The purpose of crossfooting a special, columnar journal, is to verify the accuracy of
totals of the columns in the journal.
False. The purpose of crossfooting a columnar journal is to verify that the total of all the
debit column totals is equal to the total of all the credit column totals.
8-6. At the end of the month, all entries in the columns of a columnar.
False. If the columnar journal contains a column for Other Accounts, the entries in that
column should be posted daily. The total of that column is not posted.
8-7. A Cheque Register is used for recording receipts and disbursements of cash.
False. The Cheque Register is used to record the disbursements of cash through the
issuance of cheques.
8-8. The posting of a sales return for an item that was originally purchased by a credit
customer will involve a subsidiary ledger.
True. The Sales Return and Allowances account will be debited and the Accounts
Receivable account will be credited. An entry involving accounts receivable requires an
entry to the individual account of the credit customer found in the subsidiary ledger for
accounts receivable.
8-9. Enterprise application software is having only a modest effect on the business
operations using these applications and the future market for this software looks bleek.
False. Businesses like Shoppers Drug Mart estimate that enterprise application software
will yield substantial savings as well as better customer service. The market for these
special applications is soaring.

8-10. A listing of each credit customer with an outstanding balance can be found printed
on the Schedule of Accounts Payable.
False. The list of each customer with a balance owed to the business is found on the
Schedule of Accounts Receivable. The Schedule of Accounts Payable is a list of all of the
creditors/vendors with whom the company has an outstanding balance.
8-11. A listing of each supplier with an outstanding balance can be found printed on the
Schedule of Accounts Payable.
True. The list of each supplier with a balance owed to the business is found on the
Schedule of Accounts Payable.
8-12. The sales journal is used to record the sale of merchandise on credit.
True. The sales journal is used to record all credit sales of merchandise. The cash receipts
journal is used to record the sale of merchandise for cash.
8-13. The purchase of merchandise, supplies, and equipment on account is recorded in the
purchases journal.
True. On occasion a simplified purchases journal may be used to record only the
purchases of merchandise on credit. When that is the design of the purchases journal,
other asset purchases on account, like supplies and equipment, are journalized in a
general journal.

Multiple Choice:
8-1. When using a single column Sales Journal, the column total is:
a. not posted
b. posted to Sales, only
c. posted to Sales (cr.) and Accounts Receivable (dr.)
d. posted to a Subsidiary Ledger
The individual entries are posted to the customer accounts in the subsidiary ledger for
accounts receivable. The column total is posted as a debit to the Accounts Receivable
account and as a credit to the Sales account.
8-2. Which of the following is never a controlling account?

a. Capital
b. Office Equipment
c. Accounts Payable
d. Merchandise Inventory
Many asset accounts are used as controlling accounts. Whenever individual items of
similar nature are numerous and the company wants better control over the individual
items, a control account with a subsidiary ledger or record is appropriate. Capital is not an
asset and is not a controlling account.
8-3. To determine the collectability of a customer's account would require evaluation of
the records found in the
a. Balance Sheet
b. Schedule of Accounts Payable
c. Accounts Receivable Subsidiary Ledger
d. Schedule of Accounts Receivable
Detailed information about the customer's account activity will be found in the Accounts
Receivable Subsidiary Ledger.
8-4. The total of the Schedule of Accounts Payable must be the same as the
a. cash balance
b. trial balance total
c. balance of the Account Payable account
d. balance of the Accounts Receivable account
The balance of Account Payable (the control account) must always agree with the total of
the Schedule of Accounts Payable.
8-5. Many large companies have saved millions of dollars by using specialized,
sometimes custom written, software to increase speed and efficiency of their extended
operations. This software is called
a. Windows 98
b. Peachtree
c. Enterprise application software
d. Networks
Shoppers Drug Mart records savings and increased customer service by using enterprise
application software that increased both quality and quantity of operational information
and linked national operations.
8-6. Which of the following statements is false with regard to a Cash Receipts Journal?

a. All receipts of cash from customers should be recorded in it

b. Receipts of cash from the owner should not be recorded in it
c. Receipt of cash from cash sales should be recorded in it
d. Receipt of cash from borrowing should be recorded in it
All receipts of cash, from whatever source, should be recorded in the Cash Receipts
Journal.
8-7. The process of verifying that total debits equal total credits in a columnar journal is
called:
a. crossfooting
b. journalizing
c. posting
d. Footing
To crossfoot is to verify that the total of all the debit column totals in a columnar journal
is equal to the total of all the credit column totals.
8-8. When special journals are used, a General Journal is
a. still required
b. not needed
c. used only to record sales returns and allowances
d. used only to record cash deposits of owner investments
The General Journal is used to record those type of transactions that are not conveniently
recorded in a special journal, and it is used to record adjusting, closing, and correcting
entries.
8-9. Supplies were purchased on credit and the entry was recorded in the Purchases
Journal. When a part of this supply purchase is returned to the vendor, the entry to record
the return will be in the general journal. What will be the journal entry for this return?
a. debit Cash and credit Supplies
b. debit Supplies and credit Accounts Receivable
c. debit Accounts Payable and credit Supplies
d. debit Supplies and credit Cash
The Accounts Payable account will be debited to lower the balance owed. The Supplies
account will be credited because the balance of this asset account is lower.
8-10. Which of the following is a combination of other sales taxes in the Atlantic
Provinces?

a. GST
b. HST
c. PST
d. CCRA
The HST (Harmomized Sales Tax) is a combination of the GST (goods and services tax)
and the PST (Provincial sales tax).

Fill in the Blanks.

An accounting INFORMATION system is made up of the people, records, methods, and
equipment that collect and process data from transactions and events, organize them in
useful forms, and communicate results to decision makers.
A cash DISBURSEMENTS journal is a special journal that is used to record all
payments of cash. It is also called a cash payments journal.
The special journal that is used to record all receipts of cash is called a
cash RECEIPTS journal.
A cash disbursements journal that has a column for cheque numbers is called
a CHEQUE register.
A COLUMNAR journal has more than one column.
An information system principle requiring that an accounting information system
conform with a company's activities, personnel, and structure is the COMPATIBILITY
principle.
The physical equipment in a computerized accounting information system is called
computer HARDWARE (HARDWARE or SOFTWARE).
A CONTROLLING account is a general ledger account, the balance of which (after
posting) equals the sum of the balances of the accounts in a related subsidiary ledger.
The CONTROL standard is an information system standard requiring that an accounting
information system aid managers in controlling and monitoring business activities.
An information system standard requiring that the benefits from an activity in an
accounting information system outweigh the costs of that activity is called the cost
BENEFIT standard.

Programs that manage a company's vital operations which range from order-taking
programs to manufacturing to accounting are called ENTERPRISEAPPLICATION software.
A PURCHASES journal is used to record all purchases on credit.
A SALES journal is used to records sales of merchandise on credit.
An information system standard requiring that an accounting information system reports
useful, understandable, timely and pertinent information for effective decision-making is
called the RELEVANCE standard.
A list of the balances of all the accounts in the accounts payable ledger that is summed to
show the total amount of accounts payable outstanding is called a SCHEDULE of
accounts payable.
The GST (GST, HST, PST) is a federal tax on the consumer on almost all goods and
services.
The HST (GST, HST, PST) is a sales tax in the Atlantic Provinces that is a combination
of other sales taxes.
The PST (GST, HST, PST) is a provincial tax collected by retailers on customer
purchases.

Glossary Match:
A subsidiary ledger listing individual credit supplier accounts.
Accounts payable ledger
A subsidiary ledger listing individual credit customer accounts.
Accounts receivable ledger
A journal with more than one column.
Columnar Journal
An information system standard requiring that an accounting information system conform
with a company's activities, personnel, and structure.
Compatibility Standard
A general ledger account the balance of which (after posting) equals the sum of the
balances of the accounts in a related subsidiary ledger.
Controlling account

A federal tax on the consumer on almost all goods and services.

GST (goods and services tax)
A provincial tax collected by retailers on customer purchases.
PST (Provincial sales tax)
A journal that is used to record all purchases on credit.
Purchases Journal
A journal used to record sales of merchandise on credit.
Sales Journal
A list of the balances of all the accounts in the Accounts Payable Ledger that is summed
to show the total amount of accounts payable outstanding.
Schedule of accounts payable
A list of the balances of all the accounts in the Accounts Receivable Ledger that is
summed to show the total amount of accounts receivable outstanding.
Schedule of accounts receivable
A listing of individual accounts with a common characteristic, such as customer accounts
receivable or vendor accounts payable.
Subsidiary ledger
The people, records, methods, and equipment that collect and process data from
transactions and events, organize them in useful forms, and communicate results to
decision makers.
Accounting information system
The special journal that is used to record all payments of cash; also called cash payments
journal.
Cash disbursements journal
The special journal that is used to record all receipts of cash.
Cash receipts journal
Another name for a cash disbursements journal when the journal has a column for cheque
numbers.
Cheque Register
The physical equipment in a computerized accounting information system.
Computer hardware
The programs that direct the operations of computer hardware.
Computer software

An information system standard requiring that an accounting information system aid

managers in controlling and monitoring business activities.
Control Standard
An information system standard requiring that the benefits from an activity in an
accounting information system outweigh the costs of that activity.
Cost Benefit Standard
Programs that manage a company's vital operations which range from order-taking
programs to manufacturing to accounting.
Enterprise-application software
An information system standard that requires an accounting information system adapt to
changes in the company, business environment, and needs of decision makers.
Flexibility Standard
The sales tax in the Atlantic Provinces which is a combination of GST and PST.
HST (Harmonized Sales Tax)
An information system standard requiring that an accounting information system report
useful, understandable, timely and pertinent information for effective decision-making.
Relevance Standard
Any journal that is used for recording and posting transactions of a similar type.
Special journal

Chapter 9: Internal Control and Cash

True/False:
9-1. The procedures for protecting cash from fraud and theft are a basic part of internal
control procedures.
True. Internal control procedures apply to all assets and are those procedures that ensure
compliance to managerial policies and ensure accurate and reliable accounting data.
9-2. With the increasing use of computers for processing accounting information, internal
control may depend more on reviews of the design and operations of the computerized
accounting system and less on the reviews of documents left behind by the system.
True. Because the computer performs many data-processing steps, less hard evidence in
the form of written forms and analyses may be available for review.

9-3. For good cash control, the custody of cash should be included with the record
keeping of cash.
False. The responsibility for the custody of cash should be separated from the record
keeping of cash to prevent the record keepers from using the cash or creating records to
cover the misuse, or theft, of the cash.
9-4. The business form used by the purchasing department authorizing a vendor to ship
merchandise or supplies is called a purchase requisition.
False. A purchase requisition is an internal document that is used by personnel to request
merchandise or supplies be ordered or provided. The purchasing department issues a
purchase order to vendors.
9-5. An analysis prepared to explain the difference between the balance of the chequing
account of the depositor and the balance as shown by the bank statement is called a bank
reconciliation.
True. To 'reconcile' is to explain or account for the difference between two amounts.
9-6. The purchaser of goods or services may be known as a vendee.
True. The vendee is one who is buying goods or services. A vendor, on the other hand, is
one who is selling goods or services.
9-7. The reimbursement of a petty cash fund will require a debit to the Petty Cash account
for the amount of the replenishment.
False. The reimbursement requires debits to the accounts for the expenses, assets, or
costs for which the petty cash was used. The Petty Cash account is only debited when it is
established or increased in amount.
9-8. When a bank reduces the depositor's chequing account for service charges or other
items, the bank debits the depositor's account and sends the depositor a debit
memorandum.
True. When a bank reduces a depositor's chequing account, it reduces the amount of its
liability to the depositor (the amount of cash it holds for the depositor).
9-9. It is not possible for the bank statement to show a larger ending cash balance than the
ending cash balance shown on the balance sheet.
False. The balance sheet should show the reconciled cash balance, which can be larger or
smaller than the amount shown on the bank statement.

9-10. During the reconciliation analysis, if it is determined that the depositor's bank has
made an error in recording a deposit, then the depositor should record a correcting entry
for the amount of the error.
False. Bank errors are to be corrected by the bank. The depositor needs to notify the bank
of the error, but does not make any correcting entry.
9-11. The Cash Over and Short account should be closed to the Capital account during
the closing process.
False. The Cash Over and Short account usually has a debit balance, which is treated as
an expense; if it has a credit balance, it is treated as miscellaneous revenue. In either case,
its balance is closed to the Income Summary account.
9-12. Cash is considered to be a liquid asset.
True. Liquidity refers to how easily an asset can be converted into another type of asset
or used to buy services or to satisfy obligations.
9-13. On the bank statement the bank has recorded a deposit of $1,112 in error as $1,121.
After the bank is notified and the error is verified, a journal entry will be required on the
books of the depositor.
False. An error by the bank will not require a journal entry on the books of the depositor
because the cash balance on the books is correct.
9-14. In preparing the bank reconciliation, it is discovered that a cheque for the $87.00
telephone bill was written correctly for that amount but recorded in error in the journal at
$78.00. This error will require a journal entry to correct the balance of the Cash account.
True. The bank has correctly subtracted $87.00 from the depositor's account. The
business records report a reduction to cash of only $78.00. A correction entry debiting the
Telephone Expense account and crediting the Cash account for $9.00 will correct this
error.
9-15. Technology and internal control has reduced processing errors and provided much
more extensive testing of the records.
True. Because hardware and software working properly can complete in seconds the
work that humans would work on for hours, employees can devote more of their time to
more analysis and decision-making rather than just preparing data.
9-16. Separation of duties is really not a critical item of control procedures.
False. Separation of duties is one of the most crucial control areas. From simple clerical
items such as writing cheques to control over access to computer files and records.

9-17. One of the key limitations of internal control is the cost of the control weighed
against the benefit of incurring the cost of the control.
True. This is called the cost-benefit principle. Some internal control procedures are
extremely expensive.
9-18. The cash in the register totals $405 after deducting the beginning change fund. The
master tape in the register reports sales for the day at $404. The register has a $1 cash
shortage.
False. The register has one dollar more than the amount reported by the master tape. The
register is over by one dollar.
9-19. Cash Over and Short can be either a miscellaneous revenue account or a
miscellaneous expense account.
True. If the account has a debit balance, it is a miscellaneous expense account. If the
account has a credit balance, it is a miscellaneous revenue account.
9-20. In a voucher control system a purchase requisition is prepared before a purchase
order is completed.
True. If funds allow and the price is right, a purchase order is prepared for the items
requested on the purchase requisition.
9-21. Verification that all goods ordered and listed on the purchase invoice have arrived is
competed on the invoice approval form.
False. The receiving report verifies that the merchandise has arrived. The invoice
approval form verifies the costs, extensions, and terms of the purchase.

Multiple Choice:
9-1. Which of the following is not a broad principle of internal control?
a. Responsibilities should be clearly established
b. Adequate records should be maintained
c. Assets should be insured and employees bonded
d. Record-keeping and custody should be combined
Record-keeping and custody should be separated, so that the record keepers do not have
access to the assets.

9-2. Which of the following is not a broad principle of internal control?

a. Responsibilities should be clearly established
b. Adequate records should be maintained
c. Regular and dependent reviews
d. Responsibility for related transactions should be divided
Internal control procedures should include regular and independent reviews. Independent
reviews are performed by external auditors (CAs) who audit the accounting system and
financial statements.
9-3. The proper treatment of outstanding cheques on a bank reconciliation is to show
them as a(an)
a. addition per book balance of cash
b. deduction per book balance of cash
c. addition per bank statement balance
d. deduction per bank statement balance
The outstanding cheques have been recorded by the depositor but not by the bank;
therefore the bank balance will decrease by the amount of the outstanding cheques, once
they clear (are paid by) the bank.
9-4. The proper treatment of unrecorded deposits (deposits in transit) on a bank
reconciliation is to show them as a(an)
a. addition per book balance of cash
b. deduction per book balance of cash
c. addition per bank statement balance
d. deduction per bank statement balance
The unrecorded deposits have been recorded by the depositor but not by the bank;
therefore the bank balance will increase by the amount of the unrecorded deposits, once
they are recorded by the bank.
9-5. The proper treatment on the bank reconciliation of a debit memorandum issued by
the bank is to show it as a(an)
a. addition per book balance of cash
b. deduction per book balance of cash
c. addition per bank statement balance
d. deduction per bank statement balance
A debit memorandum is issued by a bank when it reduces a depositor's bank account for
services or other items. Since the item has been recorded by the bank but not by the
depositor, it is deducted from the book balance.

9-6. The proper treatment on the bank reconciliation of a note collected by the bank for
the depositor is to show it as a(an)
a. addition per book balance of cash
b. deduction per book balance of cash
c. addition per bank statement balance
d. deduction per bank statement balance
The collection of a note would be evidenced by a bank credit memorandum. Since the
note was recorded by the bank but not by the depositor, the amount of the note and any
interest should be added to the book balance.
9-7. The proper treatment on the bank reconciliation of an NSF cheque of a customer that
is returned with the bank statement is to show it as a(an)
a. addition per book balance of cash
b. deduction per book balance of cash
c. addition per bank statement balance
d. deduction per bank statement balance
An NSF cheque reduces the depositor's chequing account. Having been recorded by the
bank but not by the depositor, it must be deducted from the chequing account and a
receivable established for the maker of the cheque.
9-8. Which of the following would require the Petty Cash account to be credited?
a. the petty cash fund is short by $3.50
b. the petty cash fund is over by $4.50
c. the petty cash account is being increased
d. the petty cash account is being decreased
The Petty Cash account is debited when a petty cash fund is established or when it is
increased. The Petty Cash account is credited to eliminate the petty cash fund or to
decrease its balance.
9-9. If the petty cash fund is not replenished at the end of the accounting reporting period,
a. the income statement and the balance sheet will not be correct
b. liabilities will be overstated on the balance sheet
c. the cash account will be understated
d. it indicates that the petty cash fund is probably short
Expenses will be understated by the amount of any expenses paid from petty cash. In
addition, the Petty Cash account balance shown on the balance sheet will not be equal to
the actual petty cash on hand.

9-10. The bookkeeper recorded a bank deposit at $450, but the bank recorded the deposit
at its correct amount of $540. The bank reconciliation will require a(an)
a. addition per book balance of cash
b. deduction per book balance of cash
c. addition per bank statement balance
d. deduction per bank statement balance
A bookkeeping error by the depositor requires a correcting entry. In this case, the
depositor has $90 more than originally recorded; therefore, the correcting entry would
include a debit to Cash for $90.00.
9-11. The bookkeeper recorded a cheque at $340.56 for store supplies. The cheque was
recorded by the bank at its correct amount of $430.65. The bank reconciliation will
require a(an)
a. addition per book balance of cash
b. deduction per book balance of cash
c. addition per bank statement balance
d. deduction per bank statement balance
A bookkeeping error by the depositor requires a correcting entry be made. In this case,
the depositor has $90.09 less than originally recorded; therefore, the correcting entry
would require a credit to Cash for $90.09.
9-12. At the end of the day, the cashier: (1) counts the money in the cash drawer, (2)
compares the cash count with the recorded sales for the day, and (3) makes notations of
differences on a special report that is forwarded, along with the cash, to the accounting
department. This procedure is
a. acceptable practice, adhering to internal control principles
b. designed to provide adequate internal control over cash
c. unacceptable practice, not following internal control principles
d. follows the broad principle of internal control of insuring assets
The procedure violates the broad principles of internal control of separating recordkeeping and asset custody, and of dividing responsibility for related transactions.
9-13. Management's ability to monitor and control business operations is greatly
improved with a computerized accounting system because
a. computers provide more rapid access to large quantities of information
b. more hard evidence in the form of written forms and documents are used
c. separation of duties does not have to be maintained
d. data entry errors are always discovered in the early stages

Once data has been entered correctly, computers can be used to provide that data quickly,
and in many different formats, to managers to help them make informed decisions.
9-14. To establish a petty cash fund for a department requires a journal entry that will
a. debit Cash and credit Petty Cash
b. debit Petty Cash and credit Cash
c. debit Miscellaneous Expense and credit Cash
d. debit Accounts Receivable and credit Petty Cash
The journal entry requires a debit to Petty Cash and a credit to Cash.
9-15. Which of the following is not one of the principles of internal control.
a. Maintain adequate records
b. Separate record keeping from custody of assets
c. Apply technological controls
d. Make cash deposits at least every other day
Cash deposits should be made at least once a day and more often if a large amount of
cash is taken in each day.

FILL IN THE BLANKS:

An analysis that explains the difference between the balance of a chequing account
shown in the depositor's records and the balance reported on the bank statement is called
a bank RECONCILIATION.
CANCELED cheques have been paid by the bank and deducted from the customer's
account.
The common term for describing currency and coins is CASH.
When there is difference between recorded cash sales and the count of cash in the cash
register, the difference is recorded in an account called the Cash OVER
AND SHORT account.
A CHEQUE is a document signed by the depositor instructing the bank to pay a
specified amount of money to a designated recipient.
When a depositor deposits coin, currency, and cheques in the depositor's account with the
bank, the depositor prepares a DEPOSIT SLIP.

The policy of rotating the duties of personnel is one of the several policies and procedures
that make up an INTERNAL CONTROL system.
An itemized statement of goods prepared by the vendor and sent to to the customer
(buyer) is called an INVOICE.
An invoice APPROVAL FORM contains a checklist of steps necessary for approving an
invoice for recording and payment.
An asset such as cash that is easily converted into other types of assets or used to buy
services or pay liabilities is called a LIQUID asset.
A characteristic of an asset that refers to how easily the asset can be converted into
another type of asset is called LIQUIDITY.
A business paper used by the purchasing department to place an order with the seller
(vendor) is called a purchase ORDER(ORDER or REQUISITION).
A form used within a company to notify the appropriate persons that ordered goods have
been received is the RECEIVING report.
The buyer or purchaser of goods or services is called the VENDEE(VENDEE or
VENDOR).
A VOUCHER is an internal business paper (or folder) used to accumulate other papers
and information needed to control cash disbursements.
A voucher SYSTEM is a set of procedures and approvals designed to control cash
disbursements and acceptance of obligations.

Glossary Match
A ratio used to assess the company's ability to settle its current debts with its existing
assets; it is the ratio between a company's quick assets (cash, short-term investments, and
receivables) and its current liabilities.
Acid-test ratio
An analysis that explains the difference between the balance of a chequing account
shown in the depositor's records and the balance reported on the bank statement.
Bank reconciliation
A document signed by the depositor instructing the bank to pay a specified amount of
money to a designated recipient.
Cheque

An act where two or more people agree to commit a fraud.

Collusion
All the policies and procedures managers use to protect assets, ensure reliable accounting,
promote efficient operations, and urge adherence to company policies.
Internal control system
A document containing a checklist of steps necessary for approving an invoice for
recording and payment; also called cheque authorization form.
Invoice approval form
An asset such as cash that is easily converted into other types of assets or used to buy
services or pay liabilities.
Liquid asset
A characteristic of an asset that refers to how easily the asset can be converted into cash
or another type of asset or used in paying for services or obligations.
Liquidity
A business paper used by the purchasing department to place an order with the seller
(vendor); authorizes the vendor to ship the ordered merchandise at the stated price and
terms.
Purchase order
A business paper listing the merchandise needed by a department and requests that it be
purchased.
Purchase requisition
A form used within a company to notify the appropriate persons that ordered goods are
received and to describe the quantities and condition of the goods.
Receiving report
A set of procedures and approvals designed to control cash disbursements and acceptance
of obligations.
Voucher system
n insurance policy purchased by a company to protect against losses from theft by
employees.
Bond
Cheques that the bank has paid and deducted from the customer's account during the
month.
Cancelled cheques
Includes currency, coins, and amounts on deposit in bank chequing or savings accounts.
Cash

An income statement account used to record cash shortages and cash overages arising
from omitted petty cash receipts and from errors in making change.
Cash Over and Short account
Lists the items such as currency, coins and cheques deposited along with each of their
dollar amounts.
Deposit slip
The use of electronic communication to transfer cash from one party to another.
Electronic funds transfer
An itemized statement of goods prepared by the vendor that lists the customer's name, the
items sold, the sales prices, and the terms of sale.
Invoice
Fundamental standards of internal control that apply to all companies requiring
management to establish responsibility, maintain adequate records, insure assets and bond
key employees, separate recordkeeping from custody of assets, divide responsibility for
related transactions, apply technological controls, and perform regular and independent
reviews.
Principles of internal control
Those assets which are most liquid, specifically, cash, short-term investments and
receivables.
Quick Assets
An internal control standard requiring the division of responsibility for related
transactions between two or more individuals or departments.
Segregation of Duties
Includes the signatures of each person authorized to sign cheques from the account.
Signature card
The buyer or purchaser of goods or services.
Vendee
The seller of goods or services, usually a manufacturer or wholesaler.
Vendor
An internal business paper (or folder) used to accumulate other papers and information
needed to control cash disbursements and to ensure that the transaction is properly
recorded.
Voucher

Chapter 10: Receivables

True/False:
10-1. Generally, when a customer uses a credit card issued by a bank, the firm records the
sale as a cash sale.
True. The business can deposit the bank credit card invoices with its bank, treating them
just like they were cash receipts.
10-2. The Credit Card Expense account should always be shown on the income statement
as a discount deducted from sales to determine the net amount received from the sale.
False. Treating the credit card expense as a sales discount is one way to disclose the
expense. Other acceptable alternatives include reporting it as a selling expense or an
administrative expense.
10-3. In order to meet the requirements of the matching principle, the direct write-off
method of recording bad debts should be used.
False. Under the direct write-off, the bad debt is not necessarily recognized in the year in
which the sale was made (revenue recognized), therefore, it does not provide adherence
to the matching principle.
10-4. The recognition of bad debts through the allowance method of accounting for bad
debts is accomplished with the closing entry that closes the Bad Debt Expense account to
the Income Summary account.
False. Under the allowance method, bad debts are recognized during the adjusting
process, when the bad debt expense is estimated and recorded.
10-5. The Allowance for Doubtful Accounts account is a contra account.
True. As an estimated amount of uncollectible receivables, the allowance account is
deducted from (contra to) the gross amount of accounts receivable to determine the net
realizable value of the accounts receivable.
10-6. Estimating bad debts by focusing on the income statement would involve the
determination of bad debts based on the history of uncollected credit sales.
True. The income statement approach to estimating bad debts is based on the idea that a
percentage of credit sales will prove to be uncollectible.

10-7. Using an aging of accounts receivable to estimate the amount of bad debt expense
is one example of estimating bad debts by focusing on the balance sheet.
True. The balance sheet approaches (simplified balance sheet approach and aging of
accounts receivable) are based on the amount of year-end accounts receivable and the
amount that is expected to become uncollectible.
10-8. The acceptability of the direct write-off approach to recognizing bad debts is
provided through the matching principle.
False. The direct write-off method is acceptable when the amount of write-offs under this
method will not materially affect reported income, thus the use of the direct write-off
method comes under the materiality principle.
10-9. A 60-day, 6%, $1,000 note receivable has a maturity value of $1,010.
True. The maturity value of a note is determined by adding the interest to the principal of
the note. The interest is $10 (1,000 X 6/100 X 60/360); the maturity value is $1,010
($1,000 + $10).
10-10. A 60-day note that is dated June 23 will have a maturity date of August 23.
False. The maturity date of the note is determined by subtracting the date of the note
from the number of days in the month in which the note was written, then adding monthdays to reach the due date (30 - 23 + 31 + 22).
10-11. When a note receivable is dishonoured, the firm has a contingent liability until the
dishonoured note is either paid or written off as a bad debt.
False. A contingent liability occurs when a note receivable is discounted, making the
endorser liable to the note holder (the bank) if the note is dishonoured at maturity.
10-12. The buyer of accounts receivable must pay a factoring fee to the seller.
False. The buyer (factor) of accounts receivable charges the seller a factoring fee. This
fee provides the profit margin to the buyer for the assumption of the risk of collecting the
accounts receivable.
10-13. A potential obligation that may become a realized obligation is called a contingent
liability.
True. A lawsuit that is lost may result in a large future outflow of assets. A suit against
the business is not a realized liability until the case is lost.
10-14. The maturity date of a 90-day note receivable dated August 29 is November 28.

False. This note spans 2 days in August, 30 days in September, 31 days in October, and
matures on the 27th of November.
10-15. To write-off a bad debt using the allowance method requires a debit to the Bad
Debt Expense account.
False. This write-off entry requires a debit to Allowance for Doubtful Accounts and a
credit to Accounts Receivable.
10-16. Bad debts are estimated to be 3% of the net sales of $120,000. The Allowance for
Doubtful Accounts account currently has a credit balance of $100. The amount of the
adjusting entry will be $3,700.
False. Using the income statement method (percentage of net sales) requires no direct
consideration of the balance of the allowance account when estimating the bad debt
expense for the period.

Multiple Choice
10-1. Which is the appropriate way to disclose the credit card expense on the income
statement?
a. as an addition to sales
b. as a selling expense
c. as an administrative expense
d. as part of cost of goods sold
As a selling expense or as a deduction in calculating net sales are both acceptable
disclosures on the income statement.
10-2. When a firm writes off a bad debt under the allowance method of accounting for
bad debts
a. the realizable value of accounts receivable decreases
b. total net current assets will decrease
c. the cash account will decrease
d. the realizable value of accounts receivable will not change
A write-off of a bad debt through the allowance account will reduce accounts receivable
and the allowance account, thus the net realizable value (accounts receivables less the
allowance account) will not change.
10-3. When a firm collects (recovers) an account receivable that was previously written
off under the allowance method of accounting for bad debts,

a. the realizable value of accounts receivable will decrease

b. the cash account will decrease by the full amount of the recovery
c. the allowance account will decrease by the amount collected
d. the realizable value of accounts receivable will increase
The allowance account will increase by the amount reinstated; the accounts receivable
will increase and decrease by the amount collected (no change); therefore, the realizable
value of the receivables will decrease.
10-4. The Allowance for Doubtful Accounts account has a year-end credit balance, prior
to adjustment, of $450. The bad debts are estimated at 3% of $650,000, the net credit
sales. After the appropriate adjusting entry for bad debts, the Allowance for Doubtful
Accounts should have a credit balance of
a. $19,500
b. $19,950
c. $19,050
d. $20,400
Bad debts expense based on a percentage of credit sales requires an adjusting entry equal
to the percentage of credit sales; no consideration is given to the ending balance of the
allowance account ($19,500 + $450).
10-5. The Allowance for Doubtful Accounts account has a year-end credit balance, prior
to adjustment of $500. The bad debts are estimated at 7% of $60,000 of outstanding
accounts receivable. After the appropriate adjusting entry to recognize the bad debt
expense, the Allowance for Doubtful Accounts should have a ___________ credit
balance.
a. $4,200
b. $3,200
c. $3,700
d. $5,200
Bad debts expense based on a percentage of accounts receivable requires an adjusting
entry that will bring the allowance account equal to the percentage of accounts receivable
($60,000 X .07) $4,200.
10-6. Which accounting principle or concept permits the direct write-off method of
accounting for bad debts?
a. full-disclosure principle
b. business entity concept
c. matching principle
d. materiality principle

The materiality principle allows the direct write-off method of accounting for bad debts
where the amount of bad debt expense does not materially effect the financial statements.
10-7. A firm using the allowance method of accounting for bad debts expense has
recovered a bad debt that was written off one year ago. The appropriate journal entry to
record the recovery would include a
a. credit to the Allowance for Doubtful Accounts account
b. debit to the Bad Debt Expense account
c. credit to the Bad Debt Expense account
d. debit to the Allowance for Doubtful Accounts account
Under the allowance method, the recovery of a debt previously written off is recorded in
two stages. First, a debit to Accounts Receivable and credit to the Allowance account and
then secondly, a debit to Cash and a credit to Accounts Receivable.
10-8. On July 18, a firm received from one of its customers, Algo Rythym, a written
promise to pay the firm $1,200, at 12% interest, on September 17, for merchandise that
Algo had purchased from the firm. Which of the following statements is true?
a. Algo is the payee of the note
b. the firm is the maker of the note
c. the firm is the endorser of the note
d. Algo is the maker of the note
The firm is the payee (the one who will collect the note at maturity) and Algo is the
maker of the note (the one promising to pay the sum certain, with interest, at a specific
date).
10-9. A 90-day, 11%, promissory note that is dated June 13 will have a maturity date of
a. September 11
b. September 10
c. September 9
d. September 8
To determine the maturity date, subtract the issue date from the number of days in the
month of issue, then add enough days to accumulate the days of the note (30 - 13 (June) +
31 (July) + 31 (August) + 11 (September)).
10-10. The interest on a $1,500, 15%, 4-month note is
a. $7.50
b. $75.00
c. $1,575.00
d. $225.00

Interest is calculated as: Principal X Rate X Time. $1,500 X 15/100 X 120/360 = $75.00.
10-11. Which of the following is not true with regard to a $3,000, 14%, 90-day note that
is dishonored?
a. an account receivable is charged with the maturity value of the note
b. the Interest Earned account is credited
c. the Notes Receivable account is credited for the maturity value
d. interest may be charged on the outstanding balance
The Notes Receivable account is credited for the face value (principal) of the note; the
Accounts Receivable account is debited for the maturity value of the note, which
increases assets by the amount of interest earned.
10-12. A $10,000, 12%, 60-day note receivable is received on January 12. The note is
discounted at 12% on January 18. The maturity value of the note is
a. $10,000
b. $10,100
c. $10,200
d. $11,200
The maturity value of the note is $10,200, the face value of $10,000 plus the $200 in
interest that the note will earn over the 60 days.
10-13. A $10,000, 12%, 60-day note receivable is received on January 12. The note is
discounted at 12% on January 18. The proceeds of the note will be
a. $10,000.00
b. $10,016.40
c. $10,184.60
d. $11,200.00
The proceeds for this note are determined by calculating the discount fee of $183.60
(maturity value x 12% x 54 days). The proceeds will be determined by subtracting the
discount fee of $183.60 from the maturity value of the note. $10,200 - $183.60 =
$10,016.40
Fill in the blanks:
Amounts due from customers for credit sales are called accounts RECEIVABLE.
A process of classifying accounts receivable in terms of how long they have been
outstanding is called an AGING of accounts receivable.

he Allowance for Doubtful Accounts is a CONTRA ASSET account with a balance

equal to the estimated amount of accounts receivable that will be uncollectible.
The accounts of customers who do not pay what they have promised to pay are
called BAD DEBTS.
An obligation to make a future payment if, and only if, an uncertain future event actually
occurs is called a CONTINGENT liability.
A method of accounting for bad debts that records the loss from an uncollectible account
receivable at the time it is determined to be uncollectible is called theDIRECT WRITEOFF method of accounting for bad debts.
When a note's maker is unable or refuses to pay at maturity the maker
is DISHONOURING the note.
In the formula of P X R X T = I, P is the principal, R is the rate, T is the time, and I is
the INTEREST.
One who signs a note and promises to pay it at maturity is the MAKER (MAKER or
PAYEE) of the note.
A 60-day note that is dated and issued on October 1 will have a MATURITY date of
December 1.
The signer of a promissory note has agreed to pay $3,000, plus $450 interest, to the payee
of the note, in thirty days. The $3,000 is referred to as the PRINCIPAL of the note.
A PROMISSORY note is a written promise to pay a specified amount of money either
on demand or at a definite future date.
A firm expects that it can generate $450,500 in cash by converting all of its assets into
cash. The $450,500 can be referred to as the REALIZABLE value of the assets.

Glossary Match
Amounts due from customers for credit sales.
Accounts receivable
A process of classifying accounts receivable in terms of how long they have been
outstanding for the purpose of estimating the amount of uncollectible accounts.
Aging accounts receivable

A contra asset account with a balance equal to the estimated amount of accounts
receivable that will be uncollectible; also called the Allowance for Uncollectible
Accounts.
Allowance for Doubtful Accounts
An accounting procedure that (1) estimates and reports bad debts expense from credit
sales during the period of the sales, and (2) reports accounts receivable at the amount of
cash proceeds that is expected from their collection (their estimated realizable value).
Allowance method
The accounts of customers who do not pay what they have promised to pay; the amount
is an expense of selling on credit; also called uncollectible accounts.
Bad debts
An obligation to make a future payment if, and only if, an uncertain future event actually
occurs.
Contingent liability
A method of accounting for bad debts that records the loss from an uncollectible account
receivable at the time it is determined to be uncollectible; no attempt is made to estimate
uncollectible accounts or bad debts expense.
Direct write-off method
When a note's maker is unable or refuses to pay at maturity.
Dishonouring a note
The charge for using (not paying) money until a later date.
Interest
One who signs a note and promises to pay it at maturity.
Maker of a note
Requires expenses to be reported in the same accounting period as the sales they helped
produce.
Matching principle
The date on which a note and any interest are due and payable.
Maturity date of a note
The one to whom a promissory note is made payable.
Payee of a note
The amount that the signer of a promissory note agrees to pay back when it matures, not
including the interest.
Principal of a note
A written promise to pay a specified amount of money either on demand or at a definite
future date.

Promissory note
The expected proceeds from converting assets into cash.
Realizable value

Chapter 11: Payroll Liabilities

True/False
11-1. The employer is required to remit employment insurance contributions equal to the
amount withheld from all employees.
False. The employer must contribute 1.4 times the amount deducted from employee
wages.
11-2. Income tax, employment insurance and Canada Pension Plan amounts withheld
plus the employer's portion of EI and CPP are paid directly to Revenue Canada.
False. The normal method of payment is to pay the amounts due at any chartered bank or
remit directly to the Receiver General of Canada. These must be made before the 15th of
the month following the month in which the deductions were made.
11-3. In 2000, CPP contributions are based on earnings, and applies with few exceptions
to everyone who is working.
True. Contributions are based on earnings with the first $3,500 of each employee's
annual income being exempt. On earnings above that amount and up to the 2000
maximum of $37,600 a year.
11-4. Employers commonly operate under contracts with their employee's union that
provide better terms than the employer would otherwise offer.
True. Union contracts often provide for time and one-half for work on Saturdays and
double time for Sundays and holidays. When an employer is under a union contract in
which the terms are better than those provided for by law, the contract takes precedence
over the law.
11-5. Regular pay plus overtime premium pay is the employee's net pay.
False. Regular pay plus overtime premium pay is gross pay. Net pay is gross pay minus
deductions.
11-6. An employee's Individual Earnings Record provides a monthly summary of the
employee's working time, gross earnings, deductions, and net pay.

False. An employee's Individual Earnings Record is a yearly summary of the employee's

working time, gross earnings, deductions, and net pay.
11-7. Under the provincial workers' compensation acts, employers may insure their
employees against injury disability that may arise as a result of employment.
False. Under provincial workers' compensation acts employers are, in effect, required to
insure their employees against injury, disability that may arise as a result of employment.
11-8. Employers are required to allow their employees paid vacation time as a benefit of
employment.
True. Employers are required to allow their employees paid vacation time (at a minimum
rate of 4% of gross earnings) as a benefit of employment. For example, many employees
receive two weeks' vacation in return for working 50 weeks each year.
11-9. Accrued wages and accrued deductions on the wages are always recorded at the end
of an accounting period.
False. Since the amounts of such deductions vary little from one period to another and
often are small in amount, many employers employ the materiality principle and do not
accrue payroll deductions. Mandatory payroll deductions are levied on wages actually
paid.

Multiple Choice:
11-1. A company deducts $230 in Employment Insurance and $195 in Canada Pension
from the weekly payroll of its employees. Calculate the company's expense for these
items for the week?
a. $517
b. $195
c. $425
d. $503
The company pays equally for CPP; it pays 1.4 times the employee rate for EI. Therefore,
[$195 + ($230 * 1.4)] = $517
11-2. Which of the following statements is false?
a. CPP is a national contributory retirement pension scheme
b. EI is an employee financed employment insurance plan
c. Gross pay is the amount of earnings before any deductions for taxes
d. Personal tax credits determine the amount of income taxes withheld

Employment Insurance is financed by employee and employer contributions.

11-3. An employee's Individual Earnings Record provides a(n) ___________ summary of
the employee's working time, gross earnings, deductions, and net pay.
a. monthly
b. hourly
c. yearly
d. weekly
The earnings record provides a yearly summary of working time, gross earnings,
deductions, and net pay.
11-4. Which of the following statements is true?
a. CPP is a national contributory retirement pension for employees
b. A payroll bank account is used for paying amounts withheld for taxes
c. A payroll deduction is based on the amount of an employee's net pay
d. Withholding table shows withholdings at various times of the year
(1) the CPP is for employees; (2) the payroll bank account is used to pay employees; (3)
payroll deductions are based on gross pay; and (4) the table shows withholding at various
levels of earning.
11-5. Which item is not an amount statutorily withheld from employees' wages?
a. Life insurance premium
b. Workers' compensation
c. Employment Insurance
d. Income tax
Life insurance premiums may be deducted but only at the employee's option. The other
items are statutory deductions.
11-6. The employer must remit an Employment Insurance tax ______________the
amount withheld from all employees.
a. equal to
b. of 1.5 times
c. of 1.4 times
d. of one-half
The employer must remit an employment tax that is 1.4 times the amount withheld from
all employees.

11-7. Which of the following statements is false regarding Employment Insurance

coverage?
a. Coverage excludes teachers, hospital workers, and top level executives
b. The collection function is carried on by Revenue Canada
c. The employer pays 1.4 times the amount withheld from all employees
d. The weekly Employment benefits are uniform throughout the regions
To obtain their maximum benefit, a claimant must work at least two weeks more than the
regional minimum requirement expressed in weeks. The benefit level will be calculated
by taking a claimant's total earnings within the preceding 26-week period and dividing by
the number of weeks worked, or the minimum divisor, whichever is higher.
11-8. Which of the following statements is true?
a. Revenue Canada performs the collection function for EI.
b. The employer's CPP liability is recorded at the time of payment.
c. Worker's compensation legislation insures employees' while off the job
d. CPP contributions are based on net earnings
EI contributions are based on insurable earnings and applies with few exceptions to
everyone who is working.
11-9. Sally works 48 hours in a week in June. She is paid $10 per hour for regular hours
and double-time for overtime. Employees are expected to work a standard 40-hour week.
Her gross pay is:
a. $560
b. $480
c. $620
d. $960
Gross pay includes both regular pay and overtime pay. [(40 hours * $10/hr) + (8 hours *
$20/hr)] = $560
11-10. Anne is paid a salary of $500 per week. Withholdings include CPP of $20, EI of
$15 and tax of $100. The journal entry to record her payroll will include
a. a debit to salary expense for $500
b. a debit to wage expense for $500
c. a credit of $500 to wages and salary payable
d. a debit to CPP expense of $20.
Gross salary earned is debited to salary expense while gross wages earned would be
debited to wage expense. The CPP would be recorded in CPP Payable and the credit to
wages and salary payable would be for her net pay (gross pay withholdings).

Fill in the blanks.

The card each employee takes from a rack and places in a slot in the time clock is called
a CLOCK CARD.
Employees' medical insurance, life insurance, and disability insurance examples
of EMPLOYEE FRINGE BENEFITS.
Statement 4 Regular pay, plus overtime premium is the EMPLOYEE's GROSS PAY.
A business with many employees will often use a
special PAYROLL BANK ACCOUNT to pay its employees.
To alleviate hardships caused through unemployment,
compulsory EMPLOYMENT INSURANCE was extended to all Canadian workers who
are not self-employed.
An EMPLOYEE's INDIVIDUAL EARNINGS RECORD provides for each employee
a full year's summary of the employees working time, gross earnings, deductions, and net
pay.
The amount of income taxes to be withheld from an employee's wages is determined by
his or her wages and the amount of PERSONAL TAX CREDITS.
An employee's gross pay less total deductions is the EMPLOYEE's NET PAY.
Employers may use WAGE BRACKET WITHHOLDING TABLES in determining
Canada Pension Plan and employment insurance to be withheld from employee's gross
earnings.

Glossary Match
A national contributory retirement pension scheme.
Canada Pension Plan
A card issued to each employee that the employee inserts in a time clock to record the
time of arrival and departure to and from work.
Clock card
Payments by an employer, in addition to wages and salaries, that are made to acquire
employee benefits such as insurance coverage and retirement income.
Employee fringe benefits

An employee/employer-financed unemployment insurance plan.

Employment insurance
The amount an employee earns before any deductions for taxes or other items such as
union dues or insurance premiums.
Employee's gross pay
A record of an employee's hours worked, gross pay, deductions, net pay, and certain
personal information about the employee.
Employee's Individual Earnings Record
The amount an employee is paid, determined by subtracting from gross pay all
deductions for taxes and other items that are withheld from the employee's earnings.
Employee's net pay
A special bank account a company uses solely for the purpose of paying employees by
depositing in the account each pay period an amount equal to the total employees' net pay
and drawing the employees' payroll cheques on the account.
Payroll bank account
An amount deducted from an employee's pay, usually based on the amount of an
employee's gross pay.
Payroll deduction
Amounts that may be deducted from an individual's income taxes and that determine the
amount of income taxes to be withheld.
Personal tax credit
The process of recording the time worked by each employee.
Timekeeping
A table showing the amounts to be withheld from employees' wages at various levels of
earnings.
Wage bracket withholding table

Chaper 12: Capital Assets: Plant, Equipment, Natural Resources amd Intangible
Assets

TRUE/FALSE
12-1. When a business constructs a new building, the cost of the building should include
the insurance on the building during the period of construction.
True. Insurance during construction is considered to be a cost necessary to prepare the
building for its intended use.
12-2. The cost to have a second-hand machine assembled at the time it is purchased
would be charged to an expense account since the machine is not new.
False. Whether the machine is second-hand or new, it is new to the business and any cost
to get the machine ready for its intended use should be charged (debited )to an asset
account (Machinery).
12-3. When a business acquires land as a site to construct a new store, the cost of
removing unwanted buildings, grading, clearing, and delinquent real estate taxes should
be recorded as part of the cost of the new store.
False. The costs of getting the land ready for its intended use should be recorded as costs
to an appropriate land account.
12-4. Land improvements are assets that increase the usefulness of land but that have a
limited useful life and are subject to amortization.
True. Land improvements (parking lot surfaces, fences, and lighting systems, as
examples) improve the usefulness of the land, but they have a limited useful life and
therefore are amortized.
12-5. Obsolescence refers to a condition in which the capacity of the plant assets becomes
too small for the productive demands of the business.
False. Obsolescence refers to a condition in which plant assets can no longer produce
goods or services with a competitive advantage. Inadequacy is a condition in which
production demands are greater than capacity.
12-6. The terms trade-in allowance and salvage value refer to the anticipated value of an
asset on its disposal date.
True. The terms refer to a residual value, the net amount realized for the asset less any
disposal costs. An asset may be discarded, sold or exchanged (traded in) during or at the
end of its useful life.
12-7. Book value is the recorded cost of a plant asset less its salvage value.

False. The book value of a plant asset is the unused or unamortized cost. Book value is
calculated as the recorded cost of the asset minus its accumulated amortization.
12-8. If an asset is purchased on April 1, 1999, for $30,000 and amortization is calculated
at $6.00 an hour, two thousand hours of service will require recording amortization of
$9,000 (2,000 x $6.00 x 9/12).
False. Under the units-of-production method of amortization, a partial week, month, or
year, is irrelevant since the amortization expense depends on the amount of use, not the
passage of time. Amortization would be properly recorded at $12,000 (2,000 hours x
$6.00 per hour).
12-9. An amortizable asset that is purchased on March 18 would be amortized for nine
months of the first year, if the fiscal year ends on December 31.
True. When an asset is purchased after the 15th of the month, the amortization starts the
month following the month of purchase.
12-10. An amortization method that applies a constant rate to a declining base is the
declining-balance method.
True. Using the declining-balance method requires multiplying a rate (greater than the
straight-line rate) times the book value which will decline each time period that the
amortization is recorded.
12-11. Major repairs that extend the useful life of a plant asset beyond the time period
originally estimated may be referred to as betterments.
False. Such repairs are referred to as betterments. Betterments are expenditures that
modify the asset to make it more efficient.
12-12. At the time a plant asset is being discarded or sold, it may be necessary to update
the accumulated amortization of the plant asset.
True. Amortization is the allocation of the cost of the asset over its service life to a
business. Failure to update the amortization to the date of disposal may result in an
understatement of gain or an overstatement of loss at disposal.
12-13. The book value of the asset is equal to the market value of the asset.
False. The market value of the asset is the price that would be paid for the asset should it
be bought or sold today. The book value of the asset is the unamortized value of the asset
(historical cost less the total accumulated amortization) on a given date.
12-14. An asset that cost $5,000 has a current book value of $2,000. A revision of the
useful life of the asset estimates the asset will last four years and will have a salvage

value of $400. Using the straight-line method, the revised amortization will be $500 per
year.
False. The asset has amortized $3,000 to date and with a new book value of $2,000, and a
salvage value of $400, will amortize a total of $1,600 over the next four years ($1,600 / 4
= $400 per year).
12-15. A parcel of land with a building is purchased for $200,000 cash. The assets are
appraised at $144,000 for the building and $96,000 for the land. The journal entry to
record this purchase will include a debit to the Land account for $80,000.
True. The appraisal value of the assets is $240,000. The land is valued at 40% ($96,000 /
$240,000) of the total. The actual cost of the land is $80,000 ($200,000 x 40%). The
building will be valued at $120,000.
12-16. The periodic allocation of the cost of a patent is called amortization.
True. The periodic allocation of the cost of intangible assets, such as patents, copyrights,
and trademarks, is called amortization. The amortization period should not exceed 40
years (GAAP).
12-17. An exclusive right granted by the federal government or by international
agreement to publish and sell a musical, literary, or artistic work for a period of years is
called a copyright.
True. Copyrights are exclusive rights granted by the federal government or by
international agreement to publish or sell literary or artistic work. Such a right is granted
for the life of the composer and for 50 years thereafter.
12-18. A contract under which the owner of property (the lessor) grants to the lessee the
right to use the property is called a lease.
True. Such contracts usually require monthly rent payments and any prepayment of the
last period rent is treated by the lessee as an asset (Leasehold) to be recognized as Rent
Expense during the last rental period.
12-19. Goodwill is an intangible asset of a business that represents future earnings greater
than the average in its industry and it is recognized on the balance sheet when such
earnings become a reality.
True. Goodwill is an intangible asset that results when earnings are greater than the
average for an industry in which a company operates; however, it is not recognized on the
financial statements unless it is acquired through the purchase of a company with
measurable goodwill.

12-20. A unique symbol used by a company in marketing its products or services is called
a trade name.
False. A unique name used by a company in marketing its products or services is called a
trade name. A unique symbol used by a company is called a trademark.
12-21. Grading, levelling, fencing, and adding lighting are all examples of
False. Fencing, lighting, and parking lots are land improvements that are amortized.
Grading and levelling are charged to the Land account.

Multiple Choice.
12-1. A business acquired land and two buildings for a single, lump-sum purchase price
of $140,000. The land was assessed for tax purposes at $50,000 and the buildings at
$30,000 and $20,000, respectively, for a total assessed value of $100,000. The land would
be recorded at a cost of
a. $50,000
b. $70,000
c. $60,000
d. $140,000
Since the land is 1/2 of the total assessed value of $100,000, it is allocated 1/2 of the
purchase price of $140,000 which is $70,000.
12-2. An asset having a four-year service life and a salvage value of $5,000 was acquired
for $45,000 cash on June 28. The amortization expense at the end of the first year,
December 31, will be
a. $10,000, using the straight-line method
b. $22,500, using the double declining-balance method
c. $7,000, using the straight-line method
d. $11,250, using the double declining-balance method
A fractional adjustment must be made for the first six months of asset use (July through
December). Under the declining-balance method the amortization will be $11,250
($45,000 x 50% x 1/2).
12-3. An asset having a four-year service life and a salvage value of $5,000 was acquired
for $45,000 cash on January 2 of Year One. The amortization expense for Year 2, ending
December 31, will be

a. $5,000, under the straight-line method

b. $11,250, under the double declining-balance method
c. $11,250, under the straight-line method
d. $22,500, under the double declining-balance method
Under declining-balance, salvage value is ignored in the amortization calculation, until
the final year of service life. Amortization for Year One would be $22,500 (45,000 x
50%) and for Year Two would be $11,250 (($45,000 - $22,500) x 50%).
12-4. Asset amortization is calculated to the nearest
a. hour
b. day
c. week
d. month
Assets put in service from the 1st to the 15th are amortized for that month. Assets put in
service from the 16th to the end of the month are not amortized for that month.
12-5. A(n) ______________________ is an expenditure that produces economic benefits
that do not fully expire before the end of the current period.
a. revenue expenditure
b. capital expenditure
c. operating expense
d. ordinary repair expense
e. recognition of amortization
Also known as a balance sheet expenditure, capital expenditures produce economic
benefits for more than one time period because they create or add to existing assets.
12-6. Failure to record the year-end adjustment for amortization will result in
a. an overstatement of income and an understatement of capital
b. an overstatement of income and an understatement of assets
c. an overstatement of income and an overstatement of assets
d. an understatement of income and an overstatement of capital
Failure to record the amortization expense will result in an overstatement of income and
capital, and an overstatement of assets since the book value of the asset will be
overstated.
12-7. An asset having a four-year service life and a salvage value of $5,000 was acquired
for $45,000 cash on April 5. Using straight-line amortization, the amortization expense at
the end of the first year, December 31, will be

a. $10,000
b. $7,500
c. $5,000
d. $11,250
The cost of the asset of $45,000, less its salvage value of $5,000, leaves a $40,000 value
to amortize over a four-year period, or $10,000 per year. The asset was used only 9
months (3/4) of the first year. Amortization for the first year is $7,500 ($10,000 x 3/4).
12-8. For which asset shown in the schedule below is a contra account maintained for the
recognition of writing-off its cost over its useful life?
a. mineral deposit
b. patent
c. copyright
d. trademark
The balance sheet accounts for natural resources have contra accounts (accumulated
depletion) for the depletion of the resource as it occurs over the life of the resource.
12-9. Which of the accounting procedures or the accounting rules applied to intangible
assets is not true?
a. patents have a legal life of 17 years
b. the maximum length of amortization for intangibles is 40 years
c. generally, the straight-line method of amortization is used
d. Accumulated Amortization accounts are maintained for intangible assets
No accumulated amortization account is maintained for intangible assets. The expired
portion of the cost of the intangible asset is credited directly to the asset account; similar
to the treatment for prepaid assets.
12-10. The Ophir Mining Company acquired an iron ore deposit for $2,000,000. The
company's geologist estimated the deposit to contain 1,500,000 tons of iron ore. At the
end of the first year, 60,000 tons had been extracted. The end-of-year journal entry to
record the depletion of the iron ore would:
a. require a credit to Iron Ore Deposit of $45,000
b. require a credit to Accumulated Depletion of $80,000
c. require a debit to Depletion Expense of $50,000
d. require a debit to Accumulated Depletion of $80,000
The iron ore would be depleted at $1.3333333 per ton ($2,000,000 / 1,500,000), or
$80,000 in the first year ($1.3333333 x 60,000). Alternate calculation: 60,000 / 1,500,000
= 4%. 4% of $2,000,000 is $80,000.

12-11. The Ophir Mining Company acquired an iron ore deposit for $2,000,000. The
company's geologist estimated the deposit to contain 1,500,000 tons of iron ore.
Extracting equipment with a 10-year service life and costing $450,000 was installed in
the mine. At the end of the first year, 60,000 tons had been extracted. The end-of-year
journal entry to record the amortization of the extracting equipment would:
a. require a credit to Accumulated Amortization of $45,000
b. require a credit to Accumulated Depletion of $90,000
c. require a credit to Accumulated Amortization of $18,000
d. be delayed until all of the ore is extracted
For extracting equipment, the rate of amortization is proportional to the amount of natural
resource removed, or 4% (60,000 / 1,500,000). The equipment amortization is $18,000
($450,000 x .04).
12-12. Which line of the following schedule is incorrect?
a. Item: trademark; Asset Classification: intangible; Estimated Useful Life:
indeterminable - 40 years maximum
b. Item: patent; Asset Classification: intangible; Estimated Useful Life: 17 years
c. Item: leasehold; Asset Classification: intangible; Estimated Useful Life: term of lease
d. Item: copyright; Asset Classification: intangible; Estimated Useful Life: less than
17 years
Copyrights are granted for the life of the person who developed the work that is
copyrighted, plus 50 years thereafter. However, generally accepted accounting principles
limits the amortization of copyrights to 40 years.
12-13. Which of the following assets has physical characteristics?
a. leasehold improvements
b. leaseholds
c. patents
d. copyrights
Leasehold improvements are generally physical improvements made to the asset that is
being leased. Such improvements are expected to provide benefits beyond the current
accounting period.
12-14. Equipment is purchased for $50,000 and is expected to last 10 years with no
salvage value. After using the asset for 4 years, the company estimates that at the end of
its useful life, the salvage value will be $6,000. In the 5th year of owning the asset,
amortization expense will be:
a. $5,000
b. $4,400

c. $4,000
d. $9,000
Revised amortization calculations require us to know the book value on the date we
change the estimates. We then use this book value - revised salvage value and divide by
remaining useful years. In this example, the original amortization was for $50,000/10
years = $5,000 per year. At the end of the 4th year, accumulated amortization would be
$5,000 x 4 years = $20,000. Book value then is $50,000 - 20,000 = $30,000. The new
amortization calculation in the 5th year would be $30,000 - 6,000 / 6 years remaining =
$4,000.
12-15. An asset that cost $65,000 has accumulated amortization of $23,000 is sold for
$50,000. The journal entry to record the sale of the asset would include:
a. a debit to Gain on Disposal of Asset of $8,000
b. a credit to Gain on Disposal of Asset of $8,000
c. a debit to Gain on Disposal of Asset of $15,000
d. a credit to Gain on Disposal of Asset of $15,000
Proceeds minus net book value = gain (loss) on disposal of the asset. Therefore, $50,000 (65,000 - 23,000) = $8,000 gain. Gains are recorded with credits (like revenues).

Fill in the Blanks

Amortization methods that produce larger amortization charges during the early years of
an asset's life and smaller changes in the later years are called
ACCELERATED amortization methods.
A process of systematically allocating the cost of a patent to expense over its estimated
useful life is called AMORTIZATION.
The cost of replacing a motor on a printing press to increase the printed pages per minute
is an example of a BETTERMENT or improvement.
If an asset cost $45,000, and has been amortized $35,000, the $10,000 unamortized value
of the asset is the asset's BOOK VALUE.
The publisher of this chapter review program has an exclusive right to publish and sell
this program. This exclusive right is granted the publisher through an intangible asset
called a COPYRIGHT.

The cost of freight to deliver a printing press to a printer should be charged to the asset
account (Printing Press) as part of the asset's COST.
When the accountant multiplies the cost an asset by 50% to determine the amortization
expense on an asset with a four-year life, the accountant is using the DECLININGBALANCE amortization method.
The process of allocating to expense the cost of a piece of production equipment to the
accounting periods benefiting from its use is called AMORTIZATION.
If a new roof is put on a building, thereby extending the life of the building ten years
beyond the original estimated life of the building, the cost of the new roof is called
a BETTERMENT.
If a company that has assets with a fair market value of $2,000,000 is sold for
$2,250,000, the $250,000 may be attributed to GOODWILL.
A printing press that currently prints 240 pages per minute, and has 5,000 estimated
remaining hours of use, is replaced with a faster printing press that will meet the growth
in customer demand. The old printing press is being replaced under a condition known as
(not obsolescence) INADEQUACY.
Patents, copyrights, leaseholds, leasehold improvements, goodwill, and trademarks are
examples of INTANGIBLE assets.
The cost of a constructing a parking lot beside a medical research building would be
shown on the balance sheet as land IMPROVEMENTS.
The party to a lease that secures the right to possess and use the property is called
the LESSEE (LESSOR or LESSEE).
A name for the rights granted to the lessee by the lessor by a lease is LEASEHOLD.
Timber, mineral deposits, and oil and gas fields are called NATURAL RESOURCES or
wasting assets.
A condition in which, because of new inventions and improvements, a plant asset can no
longer be used to produce goods or services with a competitive advantage is called (not
inadequacy) OBSOLESCENCE.
Repairs made to keep a plant asset in normal, good operating condition and are treated as
a revenue expenditures are called ORDINARY repairs.
Another term for residual value or scrap value is SALVAGE value.

A building that is being amortized at $10,000 per year is being amortized under
the STRAIGHT-LINE method of amortization.
Straight-line amortization is based, in part, on the useful or SERVICE life of the asset.
The UNITS-of-PRODUCTION amortization expense is computed by taking the cost of
the asset less its salvage value and dividing by the total number of units expected to be
produced during its useful life.

Glossary Match:
Amortization methods that produce larger amortization charges during the early years of
an asset's life and smaller changes in the later years.
Accelerated amortization method
An expenditure to make a capital asset more efficient or productive and extend the useful
life of a capital asset beyond original expectations; also called improvements.
Betterment
Assets used in the operation of a company that have a useful life of more than one
accounting period; also known as fixed assets, or property, plant and equipment.
Capital asset
Additional costs of capital assets that provide material benefits extending beyond the
current period.
Capital expenditure
A right granted by the federal government or by international agreement giving the owner
exclusive privilege to publish and sell musical, literary, or artistic work during the life of
the creator plus 50 years.
Copyright
An amortization method in which a capital asset's amortization charge for the period is
determined by applying a constant amortization rate (up to twice the straight-line rate)
each year to the asset's book value at the beginning of the year.
Declining-balance amortization
The process of allocating to expense the cost of a capital asset to the accounting periods
benefiting from its use; another term for amortization.
Depreciation
A condition in which the capacity of the company's capital assets is too small to meet the
company's productive demands.
Inadequacy

Assets that increase the usefulness of land but that have a limited useful life and are
subject to amortization.
Land improvements
The party to a lease that secures the right to possess and use the property.
Lessee
Alterations or improvements to leased property such as partitions, painting, and
storefronts.
Leasehold improvements
Assets that are physically consumed when used; examples include timber, mineral
deposits, and oil and gas fields; also called wasting assets.
Natural resources
An exclusive right granted to its owner by the federal government to manufacture and sell
a machine or device, or to use a process, for 17 years.
Patent
An expenditure that should appear on the current income statement as an expense and be
deducted from the period's revenues because it does not provide a material benefit in
future periods.
Revenue expenditure
A method that allocates an equal portion of the total amortization for a capital asset (cost
minus salvage) to each accounting period in its useful life.
Straight-line amortization
A method that charges a varying amount to expense for each period of an asset's useful
life depending on its usage; expense is computed by taking the cost of the asset less its
salvage value and dividing by the total number of units expected to be produced during
its useful life.
Units-of-production amortization
A process of systematically allocating the cost of a capital asset to expense over its
estimated useful life.
Amortization
The original cost of a capital asset less its accumulated amortization.
Book value
The system of amortization required by federal income tax law.
Captial Cost Allowance (CCA)

A change in a computed amount used in the financial statements that results from new
information or subsequent developments and from better insight or improved judgment.
Change in an accounting estimate
Includes all normal and reasonable expenditures necessary to get a capital asset in place
and ready for its intended use.
Cost
The process of allocating the cost of natural resources to the period in which they are
consumed; another term for amortization.
Depletion
The amount by which the value of a company exceeds the fair market value of the
company's net assets if purchased separately.
Goodwill
Rights, privileges and competitive advantages to the owner of capital assets used in
operations that have no physical substance; examples include patents, copyrights,
leaseholds, leasehold improvements, goodwill, and trademarks.
Intangible assets
A contract allowing property rental.
Lease
A name for the rights granted to the lessee by the lessor by a lease.
Leasehold
The party to a lease that grants the right to possess and use property to another.
Lessor
A condition in which, because of new inventions and improvements, a capital asset can
no longer be used to produce goods or services with a competitive advantage.
Obsolescence
Expenditures made to keep a capital asset in normal, good operating condition; treated as
a revenue expenditure.
Repairs
Management's estimate of the amount that will be recovered at the end of a capital asset's
useful life through a sale or as a trade-in allowance on the purchase of a new asset; also
called residual or scrap value.
Salvage value
Symbol, name, phrase, or jingle identified with a company or service.
Trademark or trade name

The length of time in which a capital asset will be productively used in the operations of
the business; also called service life.
Useful life

Chapter 13: Current and Long-Term Liabilities

TRUE/FALSE
13-1. When a 2-month, 12%, note payable is issued on March 15, no adjusting entry is
required at the end of March or April if the accounting period ends June 30.
True. No adjusting entry is necessary if the term of the note falls within the accounting
period of the business issuing the note.
13-2. The proceeds (amount received) from an interest-bearing note payable will be equal
to the principal or the face value of the note.
True. With an interest-bearing note, the borrower uses funds equal to the face value
(principal) of the note and repays principal plus interest.
13-3. A product warranty is an example of a definite liability.
False. In order to be a definite liability, the creditor, the date of repayment, and the
amount must be known. In the case of a product warranty, the date and amount are
generally unknown.
13-4. The lessor is the party who is providing the asset for the lessee to use.
True. The lessor owns the property and grants use of the property to the lessee. The
lessee secures the right to use the property.
13-5. The bank discount on a $4,000, 90-day, non-interest-bearing note discounted at
10% is $100.
True. Bank discount is calculated as: Principal x Rate x Time ($4,000 x 10/100 x 90/360
= $100).
13-6. A product warranty is an example of a contingent liability.

False. A product warranty requires service or payment when a product fails. It is probable
that some percentage of the products will fail, and that a reasonable estimation can be
made. It is an estimated liability.
13-7. In a loan transaction, the bank or lender collects the interest when the loan is repaid.
True. A loan is the process of lending money and collecting interest when the loan is
repaid. In a discount transaction, the interest is deducted, to determine the proceeds of the
note, when the maker issues the note payable.
13-8. Fixed costs such as interest expense can be advantageous when sales are declining.
False. Declining sales will usually result in declining net income. The number of times
the fixed costs (interest) is earned will also decline. When sales and net income increase,
the ability to cover the fixed costs will improve.
13-9. The times fixed interest charges earned ratio has increased from 4.5 to 7.5. This is a
favorable change in this ratio.
True. The 7.5 current ratio for fixed interest charges earned means that the ability of the
business to meet the current fixed interest charges has improved significantly over the
past period. Income before interest is 7.5 times the amount of the fixed interest charges
for the period.
13-10. On December 31, the accrued interest for a $10,000, 12%, 2-month note payable
dated December 16 will total $200.
False. The accrued interest will total $50 (10,000 x 12% x 15/360). Interest will have
accrued for only 15 days on December 31.
13-11. The accrued interest on December 31 for a $10,000, 12%, 2-month note payable
dated December 1 totals $100. The interest expense recorded on January 30, when the
note is paid in full, will total $100.
True. The accrued interest for December will total $100 (10,000 x 12% x 30/360).
Interest for the 30 days of the loan in January will also total $100. The payment of the
note will total $10,200 ($10,000 face amount plus interest of $200).
13-12. The goods and service tax (GST) rate varies from province to province.
False. The goods and service tax rate is always 7% on taxable supplies.
13-13. Input tax credits (ITC's) are added to the GST collected by a company to
determine the amount of GST owed to the federal government.

False. ITC's are deducted from the GST collected from sales to determine the net balance
owed to the government.
13-14. On the balance sheet the current portion of the long-term debt is listed as an asset.
False. This years portion of the long-term mortgage is listed as a current liability.

Multiple Choice:
13-1. Which of the following is NOT a contingent liability?
a. Product warranty
b. Discounted note receivable
c. Pending law suit for slander
d. Pending law suit for property damage
The CICA Handbook has held that if the occurrence of the future contingency is probable
and the amount can be reasonably estimated, it should be recorded as a liability.
13-2. A $6,000, 2-month, non-interest-bearing note payable was discounted by a bank at
9%. The amount of the proceeds were
a. $6,054
b. $5,910
c. $5,946
d. $6,000
The bank discount would be $90 ($6,000 x 9/100 x 60/360). The proceeds would be the
face value of the note less the bank discount, or $6,000 - $90.
13-3. Which of the following is created by the adjusting entry to recognize interest
expense incurred but not yet paid?
a. Prepaid asset
b. Accrued expense
c. Deferred expense
d. Accrued asset
The adjusting entry would involve a debit to an expense account and a credit to a liability
account. The expense is an accrued expense; it has been incurred and is being recognized
in advance of being paid.
13-4. The recording of a product warranty expense in the year the merchandise under
warranty is sold is supported by the

a. recognition principle
b. matching principle
c. realization principle
d. business entity concept
The matching principle requires that all expenses to produce the sale be recorded in the
same time period as the sale.
13-5. A $40,000, interest-bearing note payable is signed on December 26, 2002. If the
note is a 120-day note, what is the maturity date for this short-term liability?
a. March 25
b. March 26
c. April 25
d. April 26
Thirty-one (31) days for December - the 26th = 5 days. December 5 + January 31, +
February 28 (no leap-year), + March 31, + April 25 = 120 days.
13-6. $20,000 cash is borrowed on a 2-month note payable. If the interest cost to borrow
is $400, what is the actual interest rate on this note?
a. 10.00%
b. 12.00%
c. 20.00%
d. 22.50%
The true interest rate is determined by dividing the cost of borrowing by the amount of
money available to use and annualizing the final answer. $400 / $20,000 = 2.00% for 60
days which (times 6) is 12.00 percent for a year.
13-7. $20,000 cash is borrowed on a 2-month note payable. If the interest cost to borrow
is $400, and the cash proceeds received and available to use for the 60 day period is
$19,600, what is the actual interest rate on this note?
a. 10.00%
b. 12.00%
c. 12.24%
d. 12.45%
The true interest rate is determined by dividing the cost of borrowing by the amount of
money available to use and annualizing the final answer. $400 / $19,600 = 2.0408% for
60 days which (times 6) is 12.24 percent for a year.
13-8. Which of the following is a contra-liability account?

a. Taxes Payable
b. Notes Payable
c. Discount on Notes Payable
d. Accumulated Amortization
The Discount on Notes Payable account is a contra-liability account. Its balance is
deducted from the balance of the Notes Payable account for balance sheet presentations
of the net amount of notes payable. Accumulated amortization is a contra-asset account.

Fill in the Blanks:

A law suit brought against a company for dumping its toxic waste into a river is an
example of a CONTINGENT liability.
An invoice that is due within 60 days is an example of a CURRENT liability.
Twelve-thousand dollars of a five-year note payable that requires monthly payments of
$1,000 (excluding interest) should be shown under the CURRENT liability section of the
balance sheet.
Payments of income taxes that are deferred until future years because
of TEMPORARY differences between GAAP and tax rules are called deferred income
tax liabilities.
The face value of a note payable is $12,000, the amount actually borrowed was $11,200.
The $800 difference is called DISCOUNT on notes payable.
Obligation of an uncertain amount that can be reasonably estimated, such as property
taxes, are called (contingent, estimated, known, actual, real) ESTIMATED liabilities.
Obligations with little uncertainty are called KNOWN (CONTINGENT, ESTIMATED,
KNOWN, or REAL) liabilities.
A WARRANTY obligates the seller to pay for replacing or repairing the product (or
service) when it fails to perform as expected.

Glossary Match:
A potential liability that depends on a future event arising out of a past transaction; is not
an existing liability.
Contingent liability

The portion of long-term debt that is due within one year; reported under current
liabilities on the balance sheet.
Current portion of long-term debt
A liability not having a fixed due date that is payable on the creditor's demand.
Demand Loan
Obligation of an uncertain amount that can be reasonably estimated.
Estimated liability
A value-added tax on nearly all goods and services sold in Canada levied by the federal
government.
Goods and Services Tax (GST)
GST paid by the registrant on purchases of taxable supplies.
Input Tax Credit (ITC)
A probable future payment of assets or services that a company is presently obligated to
make as a result of past transactions or events.
Liability
A note that does not have a stated rate of interest; the interest is included in the face value
of the note.
Non-interest-bearing note
The amount that can be invested (borrowed) at a given interest rate to generate a total
future investment (debt) that will equal the amount of a specified future receipt
(payment).
Present value
Consumption tax levied by provincial governments on sales to the final consumers of
products calculated as a percentage of the sale price of the item being sold.
Provincial Sales Tax (PST)
Current obligation in the form of a written promissory note.
Short-term note payable
Amounts owed to suppliers regarding products or services purchased on credit.
Trade accounts payable
Goods including groceries, prescription drugs and medical devices, which are exempt
from GST.
Zero-rated supplies
Obligations due within a year or the company's operating cycle whichever is longer; paid
using current assets or by creating other current liabilities.

Current liability
Payments of income taxes that are deferred until future years because of temporary
differences between GAAP and tax rules.
Deferred (future) income tax liability
The difference between the face value of a non-interest-bearing note payable and the
amount borrowed; represents interest that will be paid on the note over its life.
Discount on note payable
GST exempt services that are educational, health care or financial services.
Exempt supplies
A combined GST and PST rate of 15% applied to taxable supplies.
Harmonized Sales Tax (HST)
Obligations of a company with little uncertainty; set by agreements, contracts or laws;
also called definitely determinable liabilities.
Known liability
Obligations of a company not requiring payment within one year or a longer operating
cycle.
Long-term liability
Employee compensation amounts owing to employees for work they have performed.
Payroll liabilities
A table that shows the present value of an amount to be received when discounted at
various interest rates for various periods of time, or the present value of a series of equal
payments to be received for a varying number of periods when discounted at various
rates.
Present value table
Registered individual or entity selling taxable supplies that is responsible for collecting
the GST on behalf of the government.
Registrant
Taxable goods or services on which GST is calculated and includes everything except
zero-rated and exempt supplies.
Taxable supplies
An agreement that obligates the seller or manufacturer to repair or replace a product
when it breaks or otherwise fails to perform properly within a specified period.
Warranty

Chapter 14: Partnerships

TRUE/FALSE
14-1. A partnership is an incorporated association of two or more persons to pursue a
business for profit as co-owners.
False. A partnership is an unincorporated form of business.
14-2. A written contract is necessary for the legal formation of a partnership.
False. Oral agreements are also binding. However, written agreements are preferred.
14-3. Partnerships are subject to income taxes.
False. Each partner's share of income, as reported on their individual income tax forms, is
subject to income taxes. The income of the partnership is not subject to income taxes.
14-4. Partners can agree to limit the power of negotiating contracts for the partnership to
any one or more of the partners. Such an agreement is binding on all outsiders, whether
or not they know it exists.
False. Such an agreement is binding only on outsiders who know that such an agreement
exists. Outsiders unaware of such an agreement have the right to assume each partner has
normal agency powers for the partnership.
14-5. If Partner A contributes cash of $20,000 to the partnership of A and B, and Partner
B contributes a building valued at $30,000 to the partnership, the investments become
joint property of both partners.
True. Partnership assets are owned jointly by all partners.
14-6. A general partnership may consist of limited partners and general partners.
False. A general partnership consists of general partners only. In a general partnership all
partners have unlimited liability for partnership debts, and all have mutual agency.
14-7. Limited partners are liable for any debt that cannot be paid through the resources of
the partnership.
False. Limited partners have limited liabilitylimited to the extent of their investment
in the partnership. Limited partners have no personal liability for debts of a limited
partnership.

14-8. General partners are included in limited partnerships.

True. Because of the limited liability accorded to limited partners, creditors are
protected, to a degree, when the limited partnership has at least one general partner (one
with unlimited liability).
14-9. If Partner A invested twice as much as Partner B, and there are only two partners,
the income must be divided in a ratio of 2:1, respectively.
False. While investments and time spent are commonly used as the basis for the
allocation of profits and losses, partners can and do select other criteria for allocating
profits and losses.
14-10. If partners agree to a method of sharing net income, but say nothing about net
losses, losses are shared in the same way as net income.
True. Unless a method of sharing net losses is spoken to separately, the agreement for
profit distribution will be used for both income and losses.
14-11. When a partnership agreement provides for the division of earnings based on time
spent and investment balances, the resulting amounts may be treated by the partners as
deductible salary expenses and interest expenses in determining the net income of the
partnership.
False. Partners are not employees of the partnership, and they cannot pay themselves
interest on capital balances. The allocated amounts of salaries and interest must be treated
as allowances (a means of dividing net income or net loss).
14-12. In the purchase of partnership interest, the capital accounts of the exiting
partner(s) will be reduced.
True. In a purchase of interest, the new partner is given credit for the portion capital
he/she is buying from each exiting partner whose capital account is reduced accordingly.
The cash or other assets given do not become property of the partnership. A purchase of
interest is a personal transaction between the seller and buyer.
14-13. With a 100% purchase of the interest of a partner, a new partner has all the rights
of the remaining partner(s) .
False. The new partner does not have a voice in management until being admitted as a
partner. The amount of interest purchased has no bearing on the issue of a voice in
management. An investment in a partnership is a transaction between the new partner and
the partnership.
14-14. The capital of an existing partnership is $160,000 after Keith invested $40,000 in
the partnership. Keith is entitled to 25% (1/4) of the income or loss of the partnership.

False. The division of income or loss is a separate matter on which the partners must
agree. The ratio of capital investments is not the only criteria used for the division of
partnership income or loss.
14-15. When the current value of the partnership is greater than the recorded amounts of
equity, the bonus resulting from a purchase of interest is given to the old partner(s).
True. When the current value of the partnership is greater than the recorded amounts of
equity, the old partners would receive proportional credit for any bonus resulting from the
purchase of interest.
14-16. The withdrawal of a partner from a partnership may result in an increase in the
capital accounts of the remaining partners.
True. Should a withdrawing partner accept less than the recorded value of his or her
equity, the difference (excess) is divided proportionately between the remaining partners
according to their profit and loss agreement.
14-17. There is more than one reason for giving a withdrawing partner assets of value
greater than the withdrawing partner's recorded equity.
True. First, the recorded equity may be understated. Second, the remaining partners may
agree to remove the exiting partner by giving assets of value greater than the partner's
recorded equity.
14-18. The death of a partner will require that all noncash assets are sold for cash, all
liabilities are paid, and remaining cash be distributed to the estate of the dead partner on
the basis of the partnership income and loss agreement.
False. A partner's death dissolves the partnership, it is not a cause for liquidation. A
deceased partner's estate is entitled to receive his or her partnership equity. The
partnership contract should contain provisions for settlement in the event the death of a
partner.
14-19. Partners will share gains and losses on liquidation in their capital
False. Gains and losses on liquidation are shared in accordance with the partnership
agreement on the division of income and loss.
14-20. A capital deficiency occurs when a partner has insufficient equity to cover his or
her share of losses resulting from liquidation.
True. A capital deficiency can arise from liquidation losses, excessive withdrawal before
liquidation, or recurring losses in prior periods. If a partner with a capital deficiency is
unable to pay the deficiency to the partnership, the remaining partners must absorb the
deficiency.

Fill in the Blanks:

A partner who assumes unlimited liability for the debts of the partnership is called
a GENERAL partner.
Partners who have no personal liability for debts of the partnership beyond the amounts
they have invested in the partnership are called LIMITED partners.
A partnership in which all partners have mutual agency and unlimited liability for
partnership debts is called a GENERAL partnership.
A partnership that has two classes of partners, limited partners and general partners, is
called a LIMITED partnership.
The legal relationship among the partners whereby each partner is an agent of the
partnership and is able to bind the partnership to contracts within the apparent scope of
the partnership's business is called MUTUAL AGENCY.
An unincorporated association of two or more persons to pursue a business for profit as
co-owners is called a PARTNERSHIP.
The dissolution of a business partnership by 1) selling non-cash assets for cash and
allocating the gain or loss according to partners' income-and-loss ratio 2) paying
liabilities 3) distributing remaining cash to partners based on capital balances is called
partnership LIQUIDATION.

Glossary Match:
A partner who assumes unlimited liability for the debts of the partnership; also, the
general partner in a limited partnership responsible for its management.
General partner
A partnership in which all partners have mutual agency and unlimited liability for
partnership debts.
General partnership
Partners who have no personal liability for debts of the partnership beyond the amounts
they have invested in the partnership.
Limited partners

A partnership that has two classes of partners, limited partners and general partners.
Limited partnership
The legal relationship among the partners whereby each partner is an agent of the
partnership and is able to bind the partnership to contracts within the apparent scope of
the partnership's business.
Mutual agency
An unincorporated association of two or more persons to pursue a business for profit as
co-owners.
Partnership
The agreement between partners that sets forth the terms under which the affairs of the
partnership will be conducted.
Partnership contract
The dissolution of a business partnership by 1) selling non-cash assets for cash and
allocating the gain or loss according to partners' income- and-loss ratio 2) paying
liabilities 3) distributing remaining cash to partners based on capital balances.
Partnership liquidation
Shows the capital balances at the beginning of the period, any additional investments
made by partners, the income or loss of the partnership, withdrawals by partners, and the
capital balances.
Statement of partners' equity
The legal relationship among general partners that makes each of them responsible for
paying all the debts of the partnership if the other partners are unable to pay their shares.
Unlimited liability of partners

Chapter 19: Reporting and Analyzing Cash Flows

TRUE/FALSE:
19-1. A major purpose of the statement of cash flows is to highlight the major activities
that have provided cash and that have used cash during an accounting period.
True. The statement of cash flows is used by managers, owners, and creditors to report
on the cash position of the business and how that position has changed.

19-2. Under the accrual basis of accounting, a business may show substantial profit on its
income statement but have a critical shortage of cash.
True. Under the accrual basis of accounting, revenue is recognized when it is earned,
regardless of when it is received. Thus, statements prepared under the accrual basis of
accounting provide little information about cash flow.
19-3. If a firm made a short-term investment of $10,000 in Canadian Treasury Bills
August 15, and the Bills mature on September 1 of the same year, the firm should
consider the Bills to be cash equivalents.
True. Cash equivalents may consist of short-term investments where the investments are
readily convertible to a known amount of cash, and are so close to their maturity date that
they are insensitive to interest rates.
19-4. A statement of cash flows is a required statement for every business that includes an
income statement and a balance sheet in its financial reports.
True. A new CICA section in Cash Flow Statements now requires a statement of cash
flows whenever an income statement and a balance sheet are included in the financial
reports of a business.
19-5. Cash flows are classified into four separate types of activities on the statement of
cash flows.
False. The statement of cash flows shows cash flows in three, not four, separate activities
operating, investing, and financing.
19-6. When cash dividends are received from an investment on the same day that the
investment is sold, the entire amount of cash received on that day should be shown as an
investing activity.
False. The sale of the investment is an investing activity, but the dividend earnings are
treated as an operating activity. Dividend earnings enter into the determination of net
income.
19-7. The lending of money and the collection of the principal and interest are classified
on the statement of cash flows as investing activities.
False. Lending money and collecting the principal are investing activities. The interest
earned is classified as an operating activity since interest earned enters into the
determination of net income.
19-8. On the statement of cash flows, financing activities include lending money and
collecting the principal, purchasing and selling plant assets, and purchasing and selling
investments made in other companies.

False. The activities described are classified on the statement of cash flows as investing
activities. Financing activities involve liability and owners' equity transactions, such as
issuing stock or issuing bonds.
19-9. When a firm sells a piece of equipment for an amount in excess of book value, the
sale of the equipment will be shown on the statement of cash flows as an investing
activity that provided cash equal to the book value.
False. The investing activity provided cash equal to the sales price, and therefore should
be shown on the statement at the sales price.
19-10. A withdrawal of assets by a sole proprietor or a partner, or the payment of
dividends to shareholders, is classified as an investing activity on the statement of cash
flows.
False. Financing activities (not investing activities) are transactions that involve liabilities
or owner's equitysuch as withdrawals or the payment of cash dividends.
19-11. If cash dividends of $45,000 were declared, but only $35,000 were paid, the
statement of cash flows should disclose $35,000 as a financing activity.
True. Retained earnings are decreased as a result of cash dividends being declared. Cash
is decreased and dividends payable are decreased at date of payment.
19-12. The issuance of common shares for cash is an example of a financing activity.
True. Transactions involving the equity of the owners are classified as financing
activities.
19-13. If 12% bonds are issued and 14% bonds are retired in the same accounting period,
the bond issue is treated as a financing activity (cash increased) and the bond retirement
is treated as an investing activity (cash decreased).
False. Both activities involved long-term creditors and are treated as financing activities.
Each is shown on the statement of cash flows.
19-14. The first step in preparing a statement of cash flows is to determine the 'bottom
line' figure for the statement of cash flows.
True. The 'bottom line' figure is the net increase or net decrease in cash and cash
equivalents during the accounting period.
19-15. The determination of cash inflows and cash outflows can be made by analyzing
changes in non-cash balance sheet accounts.

True. All cash transactions eventually affect non-cash balance sheet accounts. For
example: the sale of land, the purchase of machinery, the issuance of shares, the purchase
of treasury shares, and the retirement of bonds.
19-16. The major difference between a statement of cash flows prepared under the direct
method and a statement of cash flows prepared under the indirect method is the
presentation of the net cash flows from operating activities.
True. The direct method discloses each major class of cash receipts and disbursements
from operating activities. The indirect method starts with net income which is then
reconciled to cash provided by operations.
19-17. The CICA recommends and encourages the use of the direct method of
determining the cash flows provided or used by operations.
True. While the indirect method is allowed, the CICA prefers the direct method because
the indirect method does not disclose the individual categories of cash inflows and
outflows from operating activities.
19-18. If the ending balance of accounts receivable is less than the beginning balance, it
normally means that collections from credit sales were greater than credit sales billed
during the year (ignoring changes in the allowance for doubtful accounts).
True. A reduction in accounts receivable would indicate collections exceeded credit
sales.
19-19. Increases in merchandise inventories are deducted from the cost of goods sold to
determine the purchases of merchandise (direct method).
False. Cash payments for merchandise are the cost of goods sold plus the increase or less
the decrease in merchandise inventory, plus the decrease or less the increase in accounts
payable.
19-20. Under the accrual-basis method of accounting, the wages expense for the time
period may not be equal to the cash paid for wages during the time period.
True. The wages expense account may include accrued wages or a reversing entry for an
adjusting entry of the previous accounting period.
19-21. In the determination of cash paid for wages and other operating expenses (direct
method), a net increase in prepaid insurance should be deducted from the reported
amount of operating expenses.
False. The amount of increase should be added; it is considered to be an outflow of cash.
Decreases in prepaid assets are deducted since such decreases are the result of using up
prepaid assets, not cash.

19-22. To prepare a statement of cash flows, an increase in accrued liabilities would be

added to wages and other operating expenses (excluding amortization) to determine the
total cash paid for wages and other operating expenses (direct method).
False. An increase in accrued liabilities represents an accrual for an expense that is not
yet paid; thus, it represents a non-cash expense.
19-23. Under the direct method of determining net cash flow from operations, an increase
in interest payable is deducted from interest expense to determine the cash outflow from
payments of interest.
True. An increase in interest payable indicates an accrual (nonpayment) of interest
expense, therefore, the accrued increase in interest expense is not paid.
19-24. All expenses represent an outflow of cash during the accounting period being
covered by the statement of cash flows.
False. Some expenses do not involve cash. Amortization, depletion, and amortization
expense do not affect cash. The adjustments to record the used portion of prepaid assets
(expenses) do not involve cash. The adjustments to record accrued expenses do not
involve cash.
19-25. On a statement of cash flows prepared under the direct method, the gains and
losses from non-current assets are never reported on the statement of cash flows.
True. The cash flows from the sale of non-current assets are shown at the net amount
(plus gains or minus losses) of cash received for the non-current assets. These cash flows
are shown as investing activities on the statement of cash flows.
19-26. On a statement of cash flows prepared under the direct method, the gains and
losses from the retirement of debt is shown on the statement of cash flows.
False. The cash outflows from the retirement of debt is shown at the net amount (plus
gains or minus losses) of cash paid to retire the debt. These cash flows are shown as
financing activities on the statement of cash flows.
19-27. The indirect method does not report individual operating cash inflows and
outflows, but adjusts net income for operating activities not involving cash, eliminates
gains and losses from investing and financing activities, and changes in non-cash current
assets and non-cash current liabilities relating to operating activities.
True. Under the indirect method, net income is adjusted for the three types of
adjustments listed in the statement above.
19-28. Under the indirect method, expenses with no cash outflows are added back to net
income to determine the net cash flow from operating activities.

True. Expenses such as amortization, amortization, and depletion do not effect cash.
Adding these expense back to net income is part of the process of adjusting net income to
a cash basis.
19-29. Under the indirect method, a transaction in which an asset is sold for more than its
book value would be shown as an investing activity equal to the book value.
False. Under the indirect method and direct method, sales of assets are shown at the net
cash inflow (including gains). Under the indirect method, gains are subtracted from net
income to avoid the double count of the gains.
False. The declaration of a cash dividend creates a liability (Cash Dividends Payable) and
a contra-equity account (Cash Dividends Declared); cash is not involved. The payment of
a cash dividend does effect cash, and the payment is shown on the statement of cash
flows as a financing activity.
19-31. Cash flow on total assets is determined by dividing operating cash flow by average
total assets.
True. The cash flow on total assets ratio is one measure to help assess cash flows,
particularly when used as a comparative to other accounting periods or other entities with
similar goals and products.

Multiple Choice:
19-1. Which of the following activities is an operating activity?
a. issuing shares for a building
b. redemption of bonds at maturity
c. collecting the interest on an investment
d. purchasing the common shares of another corporation as an investment
The collection of interest on investments (or money loaned) is an operating activity, since
the interest earned enters into the determination of net income.
19-2. Which of the following activities would not be reported as an investing activity on a
statement of cash flows?
a. collection of a loan made to an officer of the company
b. purchase of a patent from an inventor
c. sale of a plant asset at a price equal to its book value
d. cash dividends received from an investment made in another company

Receipts of dividends or interest are not considered to be investing activities. They are
operating activities. Dividends earned and interest earned will appear on the income
statement as part of the determination of net income.
19-3. Which of the following is an investing activity?
a. collecting the principal of a long-term note
b. withdrawals by a partner
c. issuing common shares for cash
d. issuing bonds at a discount
The collection of a long-term note receivable is an investing activity. The other activities
(2 to 5) are financing activities, since they involve liability or owner's equity accounts.
19-4. Which of the following events represents an investing activity on a statement of
cash flows?
a. selling equipment for cash
b. issuing a short-term note to a bank for cash
c. collecting receivables from credit customers
d. purchasing a one-year insurance policy
Investing activities are transactions that involve making and collecting loans or involve
purchasing and selling plant assets, other productive assets, or investments (other than
cash equivalents.
19-5. Which of the following activities IS NOT an investing activity?
a. borrowing money
b. purchasing plant assets
c. purchasing an investment
d. collecting the principal of a note receivable
Borrowing money is a financing activity, that is, an activity in which the business raises
money for its operations or to acquire plant assets.
19-6. Which of the following activities would NOT be considered a financing activity?
a. retirement of preferred shares
b. issuing bonds payable
c. paying cash dividends
d. borrowing money by issuing a short-term note
e. purchasing land for cash
Purchasing land is an investing activity.

19-7. Which of the following activities would NOT be reported on a schedule of non-cash
investing and non-cash financing activities?
a. bonds payable were retired two years prior to maturity
b. convertible bonds were converted to common shares
c. a building was purchased through the issuance of a mortgage note
d. leasing a building where the title will revert to the lessee
The bond retirement is a financing activity which used cash.
19-8. A company issued common shares for land valued at $450,000. The transaction
would be reported on:
a. a statement of cash flows as both an investing and financing activity
b. a statement of cash flows as an investing activity, only
c. a separate schedule accompanying the statement of cash flows
d. a statement of retained earnings
This non-cash activity is of significance (non-current assets have increased and equity has
increased) and would be reported on a separate schedule - a schedule of noncash
investing and financing activities, or as a note to the financial statements.
19-9. Which of the following transactions would NOT be reported on a statement of cash
flows?
a. purchase of equipment
b. retirement of debt prior to maturity
c. exchange of common shares for equipment
d. sale of treasury shares at a price in excess of cost
The exchange of common shares for equipment is an example of a noncash investing
(increase in equipment) and a noncash financing (increase in equity) activity. Non-cash
investing and financing activities are disclosed in either a note or a separate schedule to
the statement.
19-10. Which of the following IS NOT a step in preparing the statement of cash flows?
a. compute and report non-cash investing and financing activities
b. compute and report the cash provided/used by operating activities
c. compute and report net cash provided/used by investing activities
d. compute and report net cash provided/used by financing activities
Non-cash investing and non-cash financing activities are disclosed in either a note or in a
separate schedule to the statement.

19-11. Beginning balance of Accounts Receivable was $45,000, and the ending balance
was $48,000. Sales were $430,000. What was the net cash inflow from customer
receipts?
a. $427,000
b. $433,000
c. $475,000
d. $382,000
If Accounts Receivable increased, the increase is subtracted from Sales to determine the
net cash inflow from customer receipts. If Accounts Receivable decreased, the decrease is
added to Sales to determine the net cash flow from customer receipts.
19-12. The cost of goods sold was $190,000. Beginning merchandise inventory was
$14,000, and ending merchandise inventory was $22,000. During the year, prepaid
expenses decreased by $6,000, accounts receivable increased by $6,200, and accounts
payable increased by $3,000. The amount reported for cash paid for merchandise would
be:
a. $201,000
b. $195,000
c. $198,000
d. $185,000
The cash payments for merchandise are: $190,000 + $8,000 - $3,000 = $195,000. The
cash paid for merchandise is the cost of goods sold plus the increase or less the decrease
in merchandise inventory, plus the decrease or less the increase in accounts payable.
19-13. The Prepaid Insurance account had a beginning balance of $14,000 and an ending
balance of $24,000. During the accounting period a 3-year policy was purchased for
$8,000. The Insurance Expense account has an ending balance of $9,000. What was the
net cash flow related to insurance expense?
a. $18,000
b. $19,000
c. $10,000
d. $2,000
A net increase in prepaids is deducted from the related expense accounts to determine the
amount of cash outflow for prepaids (24,000 - $14,000 + $9,000 = $19,000). A net
decrease in prepaids is added to the related expense accounts to determine the amount of
cash outflow for prepaids.
19-14. Which line is incorrect relative to the indirect method of preparing a statement of
cash flows?

a. Result: Increase in accounts receivable; Indirect method: Added to net income

b. Result: Increase in merchandise; Indirect method: Deducted from net income
c. Result: Depreciation expense; Indirect method: Added to net income
d. Result: Decrease in taxes payable; Indirect method: Deducted from net income
Under the indirect method, for current assets that effect operating activities, increases are
deducted from and decreases are added to net income. For current liabilities that effect
operating activities, increases are added to and decreases are deducted from net income.
19-15. Under the indirect method, the net cash provided by operating activities was
$92,000. Accounts receivable increased $4,000, merchandise inventory decreased
$10,000, accounts payable decreased $8,000, income taxes payable increased $3,000. No
other items except amortization were adjustments to reconcile net income of $80,000 to
net cash provided by operating activities. What was the amount of the amortization
expense?
a. $31,000
b. $11,000
c. $17,000
d. $3,000
$80,000 - $4,000 + $10,000 - $8,000 + $3,000 = $81,000. $92,000 - $81,000 = $11,000,
the amount of amortization expense. Amortization expense is added to net income in the
determination of net cash provided or used by operating activities.
19-16. The cash provided from operations was $23,000. The net increase in cash was
$22,000. If the net cash inflow from financing activities was $15,000, then the net cash
flow from investing activities was:
a. a net inflow of $16,000
b. a net outflow of $16,000
c. a net outflow of $14,000
d. a net inflow of $1,000
Total cash provided by operations ($23,000) and financing activities $15,000) was
$38,000. The investing activities used $16,000 ($23,000 + $15,000 - $22,000).
19-17. The beginning balance of the Equipment account was $45,000; the ending balance
was $54,000. The beginning balance of the Accumulated Amortization account was
$24,000; the ending balance was $33,000. Equipment with a cost of $6,000 and
accumulated amortization of $5,000 was sold for $1,200 cash. What was the amount of
amortization expense for the year?
a. $14,000
b. $9,000

c. $23,000
d. $5,000
The net change in the accumulated amortization account was $9,000 ($33,000 - $24,000).
The disposal of the equipment would have resulted in a debit to the accumulated
amortization account of $5,000. The amortization expense was $9,000 + $5,000 =
$14,000.
19-18. When a long-term asset is sold for cash at a price in excess of its book value, the
sale should be reported as an inflow of cash from an investing activity equal to the:
a. selling price (proceeds)
b. book value
c. selling price less the amount of the gain
d. selling price plus the amount of the gain
The proceeds (the amount of the selling price received in cash) should be reported as an
inflow of cash from an investing activity. When the indirect method of reporting cash
flows from operating activities is used, the gain is subtracted from net income to avoid
double counting it.
19-19. The following events occurred during the accounting period: Cash of $46,000 was
received from the issue of common shares. Cash dividends of $11,000 were paid to
shareholders. Cash of $19,000 was received from an investment. Cash of $14,000 was
paid for interest payments to bondholders. Cash of $10,000 was used to retire preferred
shares. Net cash provided or used by financing activities was:
a. $44,000 provided
b. $29,000 provided
c. $25,000 provided
d. $35,000 used
The financing activities are: issuing common shares ($46,000 provided), paying cash
dividends ($11,000 used), and retirement of preferred shares ($10,000 used). $46,000 $11,000 - $10,000 = $25,000.
19-20. Which of the following activities IS NOT a financing activity?
a. borrowing money
b. selling plant and equipment
c. retiring preferred shares
d. issuing common shares for cash
Selling plant and equipment is an investing activity. Financing activities involve liability
or owner's equity accounts.

19-21. a. Machinery was purchased for $4,500 cash. b. $10,000 was borrowed on a longterm note. c. 1,000 common shares were issued for cash, at $5 per share. d. Cash
dividends of $2,000 were declared and paid. e. An investment in another business was
sold for $23,000. f. $50,000 in bonds were retired at maturity. g. A plant asset with a book
value of $4,500 was sold for $4,500. The net cash flows from financing activities was a:
a. $14,000 decrease
b. $37,000 decrease
c. $23,000 increase
d. #14,000 increase
The inflows from financing activities were: $10,000 on the note and $5,000 from the
shares issue. Outflows from financing activities were: $2,000 of cash dividends and a
$50,000 bond retirement.
19-22. Cash dividends of $42,500 were declared. The beginning and ending balance of
the cash dividends payable account was $10,000 and $12,500, respectively. On the
statement of cash flows, the cash dividend activity would be shown as a(an):
a. investing activity of $45,000
b. financing activity of $40,000
c. financing activity of $42,500
d. investing activity of $12,500
The declared dividends plus the beginning cash dividends payable equal $52,500. An
ending balance of $12,500 indicates that $40,000 of cash dividends were paid.
19-23. The following events occurred during the accounting period: Cash of $33,000 was
used to purchase a second-hand forklift. Cash of $12,000 was received from the sale of an
investment at a loss. Cash dividends of $6,000 were received from an investment. Cash of
$15,000 was used to retire bonds. Plant assets were depreciated for $7,000 on the
declining balance method. Cash provided or used by investing activities was:
a. $21,000 used
b. $15,000 used
c. $7,000 used
d. $7,000 provided
The investing activities were the purchase of the forklift ($33,000 used) and the sale of an
investment ($12,000 provided). $33,000 used less $12,000 provided equals $21,000 used.

Fill in the blanks.

INDIRECT (DIRECT or INDIRECT) is the method of presenting a statement of cash

flows that reports net income and then adjusts the net income amount by adding and
subtracting items that are necessary to yield net cash provided or used by operating
activities.
Transactions with a company's owners and creditors are called FINANCING activities.
Transactions that involve making and collecting loans or that involve purchasing and
selling plant assets are called INVESTING activities.
Activities that involve the production or purchase of merchandise and the sale of goods
and services to customers, including expenditures related to administering the business
are called OPERATING activities.
A statement of CASH FLOWS reports the cash inflows and outflows for an accounting
period.
The collection of accounts receivable is a(n) OPERATING (FINANCING,
INVESTING, or OPERATING) activity.
The purchase of a building in which production machinery will be installed and operated
is a(n) INVESTING (FINANCING, INVESTING or OPERATING) activity.
The payment of cash dividends is a(n) FINANCING (FINANCING, INVESTING, or
OPERATING) activity.
A company sold a machine with a book value of $13,000 for $15,000. This transaction is
a(n) INVESTING (FINANCING, INVESTING, or OPERATING) activity.
The purchase of merchandise for resale is a(n) OPERATING (FINANCING,
INVESTING, or OPERATING) activity.
Paying the interest expense on a long term note is an example of
a(n) OPERATING (FINANCING, INVESTING, or OPERATING) activity.
A transaction that involves both investing and financing activities, but does not affect any
cash inflow or outflow is called a NONCASH investing and financing activity.
A cash EQUIVALENT is a security that is readily convertible to a known amount of
cash and is sufficiently close to its maturity date so its market value is unaffected by
interest rate changes.

Glossary Match:

A calculation of the net cash provided or used by operating activities that lists the major
classes of operating cash receipts, such as receipts from customers, and subtracts the
major classes of operating cash disbursements, such as cash paid for merchandise. This
method is recommended by CICA.
Direct method
Transactions with a company's owners and creditors which include getting cash from
issuing debt and repaying the amounts borrowed, and getting cash from or distributing
cash to owners and giving owners a return on investments.
Financing activities
A calculation that reports net income and then adjusts the net income amount by adding
and subtracting items that are necessary to yield net cash provided or used by operating
activities.
Indirect method
The acquisition and disposal of long-term assets and other investments that are not
classified as cash equivalents.
Investing activities
The principal revenue-producing activities that are not investing or financing activities.
These activities involve the production or purchase of merchandise and the sale of goods
and services to customers, including expenditures related to administering the business.
Operating activities
A financial statement that reports the cash inflows and outflows for an accounting period,
and that classifies those cash flows as operating activities, investing activities, and
financing activities.
Statement of cash flows

Chapter 20: Analyzing Financial Statements

True/False
20-1. The purpose of financial statement analysis is to help users make better business
decisions, therefore the only parties interested in financial statement analysis are external
to the company.
False. The users of financial statement analysis are both internal and external to the
company.
20-2. Liquidity and efficiency, solvency, profitability, and market are called the building
blocks of analysis.

True. Financial statement analysis addresses each of the four areas.

20-3. Financial reporting is not narrow in scope but broadly refers to useful information
for decision makers.
True. Financial reporting refers to the communication of relevant financial information to
decision makers. In addition to financial statements, it includes such things as tax return
information, news releases, forecasts, management letters, and auditor's reports.
20-4. Financial statement analysis requires no standards or very loose standards for
comparisons.
False. Standards for comparison would include intracompany prior performances,
competitor prior performances, industry prior performances, and guidelines (rules-ofthumb) developed from past experiences.
20-5. Should a business have no interest income in one year, and have $1,000 of interest
income the following year, the percentage of change in the interest income between the
two years is 100%.
False. When there is no base-year amount or the base-year amount is negative, the
percentage of change cannot be determined.
20-6. Generally, trend percentages are not adjusted for the effects of inflation or deflation.
True . Trend percentages are measurements of change in specific items over two or more
time periods compared to the same items of a base year selected from among the time
periods. The changes are expressed as percentages of historical dollars.
20-7. Common-size comparative statements show items appearing on them in percentage
form and in dollar form.
True. Each item on the statement is expressed in dollars and as a percentage of the total
of which it is a part (such as cash as a percentage of total assets).
20-8. If net sales increase by 10%, from $200,000 to $220,000, and the cost of goods sold
increases 10%, from $110,000 to $121,000, the gross profit from sales will increase by
10%.
True. Net income and gross profit from sales will both increase by 10%. $200,000 $110,000 = $90,000; $220,000 - $121,000 = $99,000. ($99,000 - $90,000) / $90,000 =
10%.
20-9. A ratio expresses a mathematical relation between two quantities.

True. Ratios are among the most popular and widely used tools of financial analysis.
Ratios can be expressed as a percent, rate, or proportion.
20-10. Liquidity and efficiency are used synonymously in ratio analysis.
False. Liquidity refers to the availability of resources to meet short-term cash
requirements. Efficiency refers to how productive a company is in using its assets.
20-11. The excess of current assets over current liabilities is known as working capital.
True. It is a measure of short-term liquidity, indicating the amount of excess current
assets available for other uses (as examples; early retirement of long-term debt,
dividends, or investments).
20-12. A high current ratio suggests a strong liquidity position, however the makeup of
the type of business, the composition of the current assets, and the turnover rate of assets
need to be considered before passing judgment on the current ratio.
True. Some businesses do not need a high current ratio to meet short-term cash
requirements; inventory valuation methods and high credit sales will affect the ratio; and
the liquidity of the current assets will affect the ratio.
20-13. When a company records a credit sale, the acid-test ratio will increase.
True. The acid-test ratio is determined by dividing the sum of quick assets by current
liabilities. The numerator in the formula will increase as a result of a credit sale;
therefore, the ratio will increase.
20-14. A firm can have a positive current ratio and a negative acid-test ratio.
True. The acid-test ratio is the relationship of quick assets (primarily current assets less
inventories and prepaid expenses) to current liabilities.
20-15. The accounts receivable turnover for 2001 was 3.56 times. In 2002 it was 3.87
times. This type of change would generally be considered a positive change.
True. The change indicates a faster collection of accounts receivable, generally indicating
a favourable trend.
20-16. The write off of an account receivable through an allowance for doubtful accounts
will increase the current ratio.
False. The net realizable value of the accounts receivable will not change; therefore, there
is no change in current assets or current liabilities, and the current ratio will remain
unchanged.

20-17. An increase in the accounts receivable turnover is always a favorable trend.

False. While generally looked upon as a favorable trend, too high a turnover may mean
that credit terms are too restrictive and are negatively affecting sales volume.
20-18. An increase in the merchandise inventory turnover is always a favourable trend.
False. While generally looked upon as a favourable trend, too high a turnover may mean
that sales volume is being restricted by too small an inventory.
20-19. Merchandise inventory turnover is calculated by dividing the cost of goods sold by
the average of merchandise inventory balances.
True. It is a measure of how often during the accounting period the average merchandise
inventory is sold.
20-20. Day's Sales Uncollected = (Accounts Receivable / Net Sales) x 365.
True. This measurement shows the number of days of sales represented by the ending
balance of Accounts Receivable. This ratio should be examined in light of company credit
terms and discounts taken by customers.
20-21. Day's Sales in Inventory = Ending Inventory / Cost of Goods Sold.
False. The calculation is (Ending Inventory / Cost of Goods Sold) x 365. This formula
indicates the length of time for the ending inventory to be converted into receivables (or
cash).
20-22. The debt ratio is calculated by dividing total liabilities by total shareholders'
equity.
False. The debt ratio is calculated by dividing total liabilities by total assets. The equity
ratio is calculated by dividing total shareholders' equity by total assets.
20-23. When a company records a credit sale, the debt ratio will decrease.
True. The debt ratio is determined by dividing total liabilities by total assets and
multiplying the result by 100. A credit sale will increase total assets and thereby decrease
the ratio.
20-24. The times fixed interest charges earned provides a measurement for evaluating the
operating efficiency and profitability of a business.
False. The times fixed interest charges earned is a measurement for evaluating the longterm risk to creditors. The return on total assets employed is a better measurement of
efficiency and profitability.

20-25. The profit margin indicates the amount of net income each dollar of sales
generates.
True. Profit margin = Net Income / Revenues. This ratio should be analyzed in light of
the industry in which the company operates, and its type of business (manufacturer,
wholesaler, or retailer).
20-26. If a company has a return on total assets of 18.0%, and net income of $36,000, its
average total assets are $180,000.
False. The Return on Total Assets = Net Income / Average Total Assets. 18.0% = $36,000
/ Average Total Assets; therefore, Average Total Assets = Net Income / Return on Total
Assets. Average Total Assets = $36,000 / .18 = $200,000.
20-27. The market price per share of stock decreased 4.0%, or $1.00. The earnings per
share decreased 10%, or $.15. The price earnings ratio will have increased.
True. The original market price was $25 and earnings per share were $1.50. The current
market price is $24 and earnings per share is $1.35. The old ratio was 16.7 ($25/$1.50).
The new ratio is 17.8 ($24/$1.35).
20-28. The relationship between the market price of a share of stock and the current
earnings of the stock is known as the dividend yield.
False. The relationship described is called the price-earnings ratio and is determined by
dividing the market price by the earnings per share.
20-29. The dividend yield is determined by dividing the annual dividends declared per
share by the market price per share.
True. It is a measure of the current return for an investment in the common shares of the
company.
20-30. An investor need only use the dividend yield as a measure to evaluate the
profitability of alternative share investments.
False. The price-earnings ratio is more appropriate because it measures the earnings per
share against the market price per share. The dividend yield is not a measure of
profitability but of dividend-paying performance, and is also helpful in evaluating
alternative stock investments.

Multiple Choice:
20-1.

Assets
Cash
Other current assets
Plant and equipment
Total assets

2001
2000
1999
1998
$10,000 $15,000 $12,000 $8,000
18,000 15,000 13,000 10,000
20,000 23,000 24,000 15,000
48,000 53,000 49,000 33,000

Which of the following statements is true?

a. plant and equipment had the largest percentage gain from 1998 to 2000
b. cash had the greatest percentage decrease between 2000 and 2001
c. cash increased at a faster rate than total assets from 1998 to 2001
d. cash was always the same percentage of total assets
Plant and equipment had the greatest gain between 1998 and 1999 (Option #1, false).
Cash decreased 33.3% in 2001 (Option #2, true). Total assets increased at a faster rate
than cash (Option #3, false). Cash/Total assets = same percentage (Option #4, false).
20-2.
Sales
Cost of goods sold
Net income

2001
2000
1999
1998
$160,000 $130,000 $100,000 $ 80,000
96,000
71,500
53,000
41,600
28,000
26,000
25,000
24,000

Which of the following statements is NOT true?

a. sales have increased 200% since 1998
b. net income has increased 16.67% since 1998
c. gross profit on sales has increased 66.67% since 1998
d. net income as a percentage of sales has decreased
Sales have increased 100% since 1998 ($160,000 - $80,000 ) / $80,000 = 100%.
20-3. Which is NOT true of common-size comparative statements?
a. each item is shown as a percentage of some total of which it is a part
b. dollar amounts are generally not shown
c. the net change in each item, on a year-to-year basis, is not shown
d. total assets are used as a total against which all assets are measured
The dollar amount of each item is shown, along with the percentage each item represents
of some common base.
20-4.
Current assets

$120,000

Cash
Accounts receivable
Short-term investments
Merchandise inventory
Current liabilities

$20,000
$45,000
$12,000
$42,000
$68,000

Which of the following is true?

a. working capital is $52,000, current ratio is 1.17
b. current ratio is 2.0 , acid-test ratio is 1.15
c. working capital is $10,000 , acid-test ratio is 1.15
d. working capital is $52,000, current ratio is 1.76
The working capital is $120,000 - $68,000 = $52,000. The current ratio is $120,000 /
$68,000 = 1.76. The acid-test ratio is $78 / $68,000 = 1.15.
20-5. Net sales were $450,000, and the accounts receivable turnover was 5.5 times. What
is the average accounts receivable?
a. not determinable from the information provided
b. $24,750
c. $81,818
d. $90,000
Accounts Receivable Turnover = Net Sales / Average Accounts Receivable. 5.5 =
$450,000 / Average Accounts Receivable; therefore, the Average Accounts Receivable are
$450,000 / 05.5 = $81,818.
20-6. The cost of goods sold was $240,000. Beginning and ending merchandising
inventory balances were $20,000 and $30,000, respectively. The merchandise inventory
turnover was:
a. 8.0 times
b. 12.0 times
c. 7.0 times
d. 9.6 times
The turnover of merchandise inventory is calculated by dividing the cost of goods sold by
the average merchandise inventory: $240,000 / (($20,000 + $30,000) / 2) = $240,000 /
$25,000 = 9.6. The merchandise turnover is 9.6 times.
20-7. The days' sales in inventory is 73. The cost of goods sold is $720,000. The net sales
are $1,020,000. The beginning inventory was $82,000. What is the ending inventory?
a. $98,360
b. $144,000

c. $139,726
d. $82,000
Days' sales in inventory = (Ending inventory/Cost of goods sold) x 365. Letting Y
represent the ending inventory then:
73 = (Y / $720,000) x 365; 73 / 365 = Y / $720,000;
0.20 = Y / $720,000; 0.20 x $720,000 = Y; $144,000 = Y.
20-8. Total asset turnover is a component of:
a. solvency
b. profitability
c. comparability
d. operating efficiency
Total asset turnover is a basic component of operating efficiency, and is determined by
dividing revenues by average total assets. It expresses the number of sales dollars
generated for every dollar of assets.
20-9. Which change in the following ratios would be regarded as generally favourable by
creditors but generally unfavourable by shareholders?
a. debt to equity ratio changed from 1:2 to 1:2.5
b. current ratio changed from 2:5 to 3:4
c. debt to equity ratio changed from 2:5 to 1:3
d. return on total assets changed from 10% to 12.5%
The change from 2:5 to 1:3 indicates a possible reduction in leverage.
20-10. Which of the following formulas and its results is not correct?
a. Formula: Net sales/Average total assets
Result: Total asset turnover
b. Formula: (Net income/Net sales) x 100
Result: Profit margin
c. Formula: (Net inc./Average total assets) x 100
Result: Return on total assets employed
d. Formula: (Total liabilities/Total assets) x 100
Result: Equity ratio
Total liabilities divided by total liabilities and shareholders' equity (total assets),
multiplied by 100, measures the debt ratio; the relationship of total debt to total assets.
20-11. Which of the following ratios would not be considered a measurement of shortterm liquidity?

a. current ratio
b. days' sales uncollected
c. debt ratio
d. acid-test ratio
The debt ratio is a measurement of long-term risk for long-term creditors and potential
shareholders.
20-12. Which of the following ratios would be of the least interest to the short-term
creditor of the business?
a. current ratio
b. times interest earned
c. acid-test ratio
d. working capital ratio
Times interest earned measures the ability of the business to meet the interest obligation
on its long-term debt, before income taxes and interest.
20-13. Net income is not used as a numerator or a denominator in which of the following
financial ratios?
a. return on total assets employed
b. times fixed interest charges earned
c. return on common shareholders' equity
d. profit margin measurement
The times fixed interest earned ratio is calculated by dividing the total earnings, before
interest expense and income taxes, by the interest expense.
20-14. Net sales were $360,000. The cost of goods sold was $180,000. Operating
expenses were $120,000. The ending balance of the Accounts Receivable account was
$20,000. The merchandise turnover ratio was 12.75. The profit margin was:
a. 16.67%
b. 20.0%
c. 40.0%
d. 33.3%
Profit margin is calculated by dividing net income by revenues. The net income is
$360,000 - $180,000 - $120,000 = $60,000. The profit margin is $60,000 / $360.000 =
0.1666 = 16.67%.
20-15. The denominator in the formula to calculate the return on common shareholders'
equity is:

a. book value of the common shares

b. average total assets
c. total equity
d. total contributed capital
The denominator is the book value of the common shares. The formula is: (Net Income Preferred Dividends) / Average Common Shareholder's Equity.
20-16. Which of the following formulas is used to calculate a price-earnings ratio?
a. dividends per share / earnings per share
b. current market price per share / earnings per share
c. net income less preferred dividends / number of com. shares outstanding
d. dividends per share / market price per share
It provides an index as to whether the shares are relatively cheap or expensive when
compared to its earnings.
20-17. The balance of the Common Shares account was $400,000 for the entire fiscal
year. Net income for the year was $40,000, of which 25% was distributed to shareholders
as a cash dividend. The market price of the shares on the last day of the year was $12 per
share. The price earnings ratio was:
a. 40.0
b. 4.0
c. 12.0
d. 2.5
The price earnings ratio is calculated by dividing the market price per share by the
earnings per share. The number of common shares outstanding were $400,000 / $10 =
40,000. The earnings per share were $40,000 / 40,000 = $1. The price earnings ratio was
$12 / $1 = 12.
20-18. The market price per share is $32. The price earnings ratio is 5.0. The earnings per
share are:
a. $160
b. 50% of the market price per share
c. 25.60
d. $6.40
The price earnings ratio is calculated by dividing the market price per share by the
earnings per share. Letting Y represent the earnings per share, then $32 / Y = 5; Y = $32 /
5; Y = $6.40.

20-19.
Total liabilities
Shareholders' equity
Net income

2001
2000
1999
1998
$100,000 $150,000 $122,000 $80,000
80,000 150,000 130,000 100,000
20,000
23,000
24,000 15,000

If 50,000 common shares have been outstanding since 1998, then:

a. the 1998 debt-to-equity ratio was 1 to .80
b. the earnings per share in 2001 were $0.40
c. the book value per share in 1999 was $3.08
d. earnings per share in 1998 were $0.15
#1, $80,000 / $100,000 = .80 to 1; #2, $20,000 / 50,000 = $0.40; #3, $130,000 / 50,000 =
$2.60. #4, $15,000 / 50,000 = $0.30.
20-20. Which line is NOT correct?
a. Ratio: Current ratio; Type of measurement: Short-term liquidity
b. Ratio: Return on total assets; Type of measurement: Operating efficiency
c. Ratio: Dividend yield; Type of measurement: Capital structure
d. Ratio: Equity ratio; Type of measurement: Long-term risk and capital structure
The dividend yield is a measurement of profitability. Other measurements in this category
include profit margin, total asset turnover, return on total assets, return on shareholders'
equity, and price earnings ratio.

Fill in the blanks:

Comparative financial statements in which each amount is expressed as a percent of a
base amount are called COMMON-SIZE statements.
A financial statement with data for two or more successive accounting periods placed in
columns side by side is referred to as a COMPARATIVE statement.
How productive a company is in using its assets is referred to as EFFICIENCY.
The EQUITY ratio is calculated by dividing shareholders' equity by total assets.
The process of communicating information that is relevant to investors, creditors, and
others in making investment, credit, and similar decisions is called FINANCIAL
reporting.

The application of analytical tools, such as determining liquidity, profitability, and

solvency ratio, to general-purpose financial statements and related data for making
business decisions is called financial statement ANALYSIS.
The availability of resources to meet short-term cash requirements is referred to
as LIQUIDITY.
A company's ability to generate an adequate return on invested capital is referred to
as PROFITABILITY.
SOLVENCY refers to a company's long-run financial viability and its ability to cover
long-term obligations.
VERTICAL analysis is a tool to evaluate each financial statement item or group of items
in terms of a specific base amount.
Current assets minus current liabilities = WORKING CAPITAL.

Glossary Match:
Comparative financial statements in which each amount is expressed as a percent of a
base amount. In the balance sheet, the amount of total assets is usually selected as the
base amount and is expressed as 100%. In the income statement, net sales is usually
selected as the base amount.
Common-size statements
A financial statement with data for two or more successive accounting periods placed in
columns side by side, sometimes with changes shown in dollar amounts and percents.
Comparative statement
Refers to how productive a company is in using its assets; usually measured relative to
how much revenue is generated for a certain level of assets.
Efficiency
The portion of total assets provided by shareholders' equity, computed as shareholders'
equity divided by total assets.
Equity ratio
The process of communicating information that is relevant to investors, creditors, and
others in making investment, credit, and similar decisions.
Financial reporting
The application of analytical tools to general-purpose financial statements and related
data for making business decisions.
Financial statement analysis

Statements published periodically for use by a wide variety of interested parties; include
the income statement, balance sheet, statement of changes in shareholders' equity (or
statement of retained earnings), statement of cash flows, and notes related to the
statements.
General-purpose financial statements
Refers to the availability of resources to meet short-term cash requirements.
Liquidity
Refers to a company's ability to generate an adequate return on invested capital.
Profitability
Refers to a company's long-run financial viability and its ability to cover long-term
obligations.
Solvency
A tool to evaluate each financial statement item or group of items in terms of a specific
base amount; the base amount is commonly defined as 100% and is usually revenue on
the income statement and total assets on the balance sheet.
Vertical analysis
Current assets minus current liabilities.
Working capital

Chapter 21: Managerial Accounting Concepts and Principles

True/False:
21-1. An activity that provides financial and nonfinancial information to managers and
other internal decision makers of an organization is called managerial accounting.
True. Also called management accounting, managerial accounting shares much of the
same information as financial accounting. However, its main focus is providing
information to internal decision makers.
21-2. Planning is the process of monitoring planning decisions and evaluating an
organization's activities and employees.

False. What's described is 'control.' Planning is the process of setting goals and making
plans to achieve them. Much of managerial accounting is directed towards planning and
control decisions.
21-3. The purpose of using information provided by the accounting system is quite
different for investors and creditors than it is for managers of the firm.
True. Investors and creditors use the information for investing or lending decisions.
Managers use the information to plan and control the organization's activities.
21-4. The emphasis of the focus of information generated through managerial accounting
is on segments of the organization rather than the organization as a whole.
True. Outsiders deal primarily with the company as a whole, thus their need for financial
information. Managers deal with segments of the company and need information related
to the segments they control or administer.
21-5. The information that management needs to plan and control operations is provided
by the accounting system, and is under the rigid standards of GAAP.
False. Information (financial statements) provided for external entities must conform to
GAAP. The information for internal users (managerial accountants) need not be limited
by the authoritative standards of GAAP. Internal users have flexibility to modify systems
to meet their needs.
21-6. The accounting system will provide managers with accurate and precise
information for planning and decision making much faster than the information is
provided to external users.
False. Managers use the financial information before it is subjected to the checks and
balances of internal or external audit; as a consequence, the information is not necessarily
accurate or precise. It is, nevertheless, useful information for the work of the managerial
accountant.
21-7. The financial information provided to external users focuses on the entity as a
whole, whereas the financial information that is used by managerial accountants focuses
on segments of the entity.
True. Investors and creditors do not invest or lend to segments of the entity, they invest in
or lend to the entity. Managerial accountants, on the other hand, focus on specific
activities, projects, and subdivisions of the entity for which they are responsible.
21-8. Manufacturers have only two classes of inventory; goods in process and finished
goods.

False. Manufacturers maintain three inventories--raw materials (both direct and indirect
materials), goods in process (or work in process), and finished goods.
21-9. The three basic elements of a manufactured product are direct materials, direct
labor, and factory overhead.
True. All manufactured products contain the cost of materials, the cost of labour to create
the finished products, and factory overhead.
21-10. The labour cost for janitors, supervisors, materials handlers, engineers, and
maintenance personnel would be considered a direct labour cost.
False. They are indirect labour; direct labour, such as machine operators and assemblers,
is directly traceable to the creation of a product.
21-11. Indirect labour, indirect materials, factory heat and light, factory property taxes,
and amortization and insurance on production equipment would be classified as factory
overhead.
True. Excluding direct materials and direct labour, all costs related to manufacturing can
be classified as factory overhead (sometimes known as manufacturing overhead or
factory burden).
21-12. The income statement for a manufacturer does not contain the line item 'Cost of
Goods Sold'.
False. A manufacturer's cost of goods sold is comprised of beginning finished goods
inventory, plus the cost of goods manufactured, less the ending finished goods inventory.
21-13. Costs can be classified by their behaviour, which is a useful tool in management
accounting.
True. The two basic levels of cost behaviour are variable, which change in proportion
with increases in volume of activity, and fixed, which remain unchanged with changes in
volume of activity. Some costs have both components (fixed and variable) and are called
mixed costs.
21-14. Cost can be classified as to traceability.
True. Costs that are traceable to or benefit a particular product or activity (cost object)
are called direct costs. Costs that are incurred for the benefit of more than one cost object
are called indirect costs.
21-15. All costs are controllable.

True. While costs may be classified as controllable and not controllable, such
classification depends on one's responsibilities or level in the management hierarchy.
Every cost is controllable at some level.
21-16. Opportunity costs are irrelevant to future decisions.
False. Sunk costs (or out-of-pocket costs) are irrelevant to future decisions, since they
have already been incurred and cannot be avoided or changed. An opportunity cost is the
potential benefit lost by taking a specific course of action from two or more alternative
choices.
21-17. Costs are capitalized if they produce benefits that are expected to have value in the
future.
True. Some costs, such as direct materials and direct labour, are capitalized as inventory
(goods in process or finished goods) and are called product costs. Costs that are charged
to an expense as they are incurred, such as rent on office space, are called period costs.
21-18. Costs that are involved in the manufacture of a product are called period costs.
False. Such costs are called product costs. Period costs are deducted from revenue on a
time period basis and are not involved in the manufacturing of products or the purchasing
of merchandise.
21-19. Product costs can be incurred in one accounting period and recognized as a cost of
a subsequent accounting period.
True. Finished goods at the end of one accounting period contain capitalized costs of
direct material and direct labour of that accounting period. When the finished goods are
sold in a subsequent accounting period, they become part of the cost of goods sold of the
subsequent accounting period.
21-20. The concept of customer orientation calls for rigid product design and presentation
of products the seller has already manufactured.
False. Quite the opposite, customer orientation calls for flexible product design and
modifying products as they are manufactured to meet the buyer's need.
21-21. An attitude of constantly seeking ways to improve customer service, product
quality, product features, the production process, and employee interactions is called
customer orientation.
False. What is described is known as continuous improvement. Customer orientation is a
management concept that encourages all managers and all employees to be in tune with
the wants and needs of customers.

21-22. TQM (total quality management) focuses on the inspection of products to achieve
efficiency and quality.
False. TQM does not focus on inspection, but rather focuses on quality throughout the
production process. The purpose of TQM is to identify defective work when and where it
occurs.
21-23. A company that uses TQM rewards employees who find defects.
True. Without an incentive, employees are likely to ignore defects in partially completed
products for fear of hostile reactions from other employees.
21-24. Just-in-time (JIT) is an approach to managing inventories and production
operations so that units of materials and products are obtained and provided only as they
are needed.
True. A well-implemented just-in-time approach to managing inventories will reduce the
costs associated with maintaining and storing inventories in advance of their use.
21-25. In the traditional approach to inventory management, products are 'pushed'
through the manufacturing process by the insertion of raw materials and the application
of labour and overhead.
True. In a newer approach, just-in-time (JIT), products are 'demand-pulled' through the
manufacturing process by customer orders.
21-26. The theory of constraints is a management concept under which all managers and
employees at all stages of company operations strive toward higher standards and a
reduced number of defective units.
False. The theory of constraints is a management concept that asserts the primary focus
of managers should be to discover and then relax or overcome the factors that limit the
throughput of the company's operations.
21-27. Continuous improvement is the added value a company brings to its finished
products.
False. Throughput is the added value a company brings to its finished products.
Continuous improvement is a management concept where every manager and employee
continually looks for ways to improve operations.
21-28. The sales price of a product less the total variable cost of the product is called
contribution margin.

True. Contribution margin can be interpreted as the amount of each sales dollar that
remains after deducting variable cost. When described as a portion of the sales dollar, it is
referred to as contribution margin ratio (Contribution Margin / Sales Price per Product).

Multiple Choice:
21-1. Which of the following is not true?
a. managerial accounting information is prepared for internal users
b. managerial accounting information is not required by various laws
c. there are specific standards of acceptability for managerial accounting
d. the structure of managerial accounting practice is relatively flexible
Managerial accounting, its practices and structure, is used primarily by internal users; is
not required by law; and serves a primary function of helping managers make better
decisions.
21-2. Which of the following are basic inventories for a manufacturer?
a. indirect materials, goods in process, and raw materials
b. finished goods, raw materials, and direct materials
c. raw materials, goods in process, and finished goods
d. raw materials, factory overhead, and direct labour
The basic inventories are raw materials inventory (direct and indirect materials), goods in
process inventory (or work in process) and finished goods.
21-3. The three basic elements of the cost of a manufactured product are:
a. indirect materials, indirect labour, and manufacturing overhead
b. merchandise inventory, work in process, and finished goods inventory
c. direct materials, work in process, and finished goods inventory
d. direct materials, direct labour, and manufacturing overhead
A manufactured product consists of materials (direct), the labour (direct) to form it or
assemble it into final form, and the other costs (manufacturing overhead) of
manufacturing.
21-4. Which of the following would not be an element of factory overhead?
a. salary of a marketing manager
b. amortization on the maintenance equipment
c. salary of the plant supervisor
d. property taxes on the plant buildings

The marketing function is not directly related to the manufacturing function; all of the
other costs are elements of factory overhead.
21-5. A firm had beginning finished goods inventory of $20,000; its cost of goods
manufactured was $75,000; its gross margin was $80,000; and its sales were $140,000.
The ending finished goods inventory was:
a. $60,000
b. $40,000
c. $95,000
d. $35,000
Goods available were $95,000 ($20,000 + $75,000); the cost of goods sold was $60,000
($140,000 - $80,000); ending finished goods were $35,000.
21-6. A firm had beginning finished goods inventory of $15,000; ending finished goods
inventory of $20,000; and its cost of goods sold was $80,000. The cost of goods
manufactured was:
a. $80,000
b. $85,000
c. $75,000
d. $65,000
Beginning finished goods plus the cost of goods manufactured is equal to the ending
finished goods plus the cost of goods sold.
21-7. A firm had $200,000 in sales; $120,000 in goods available for sale; ending finished
goods inventory of $20,000; and selling and administrative expenses of $55,000. Which
of the following is true?
a. net income was 25.0% of sales
b. the cost of goods sold was $140,000
c. the gross profit was $80,000
d. the beginning finished goods inventory is not determinable
The statements A through C are false:
$200,000 - ($120,000 - $20,000) = $100,000 gross profit.
$100,000 - $55,000 = $45,000 of net income which is 22.5% of sales.
$120,000 - $20,000 = $100,000 cost of goods sold.
D. The beginning inventory cannot be calculated because we do not know the net
purchases figure.
21-8. A cost which changes in proportion to changes in volume of activity is called a:

a. fixed cost
b. controllable cost
c. variable cost
d. opportunity cost
A variable cost changes in proportion to changes in volume of activity.
21-9. A 'direct' cost is a cost that is classified by:
a. behaviour
b. traceability
c. controllability
d. relevance
A direct cost is one that is incurred for the benefit of one specific cost object and it can be
traced to the cost object.
21-10. A 'sunk' cost is a cost that is classified by:
a. behaviour
b. traceability
c. controllability
d. relevance
A sunk cost (or out-of-pocket cost) is one already incurred and cannot be avoided or
changed. Sunk costs are irrelevant to future decisions.
21-11. A 'product' cost is a cost that is classified by:
a. behaviour
b. function
c. controllability
d. relevance
Product costs refer to expenditures that are necessary and integral to finished products.
They include direct materials, direct labour, and overhead costs. They are costs that
pertain to activities that are carried out to manufacture the product.
21-12. Which of the following costs is not capitalized as inventory?
a. costs of delivering finished goods
b. factory (manufacturing) overhead
c. insurance of factory building and equipment
d. factory amortization

Once the product is completed and is moved from the factory to a storage facility
(warehouse) or directly to a customer, any costs associated with storing it or delivering it
to a customer are treated as period costs. Selling expenses are not incurred in the
manufacturing process.
21-13. Which of the following is a period cost?
a. direct materials
b. indirect materials
c. factory utilities
d. administrative expenses
Administrative costs are not directly related to the manufacturing function.
21-14. A management concept under which all managers and employees at all stages of
company operations strive toward higher standards and a reduced number of defective
units is called:
a. Continuous Improvement
b. Total Quality Management (TQM)
c. Theory of Constraints (TOC)
d. Total Quality Control (TQC)
Total Quality Management (TQM) requires a focus on quality throughout the production
process. The strategy is to find defective work when and where it occurs.

Fill in the blanks:

A CONSTRAINT is anything that prevents a company from achieving higher
performance in terms of its goals.
A management concept where every manager and employee continually looks for ways to
improve operations is called CONTINUOUS improvement.
A sales price of $120 less variable costs of $60 will result in a CONTRIBUTION margin
of $60.
With a sales price of $120 and a contribution margin of $48, the product has a
contribution margin RATIO of 40%.
CONTROL is the process of monitoring planning decisions and evaluating the
organization's activities and employees.

With regard to the salary of the company president, that salary would be NOT
CONTROLLABLE (CONTROLLABLE or NOT CONTROLLABLE) by the
production supervisor.
Expenditures incurred in the process of converting raw materials to finished goods are
called CONVERSION costs.
Costs that are incurred for the benefit of one specific cost object are
called DIRECT costs.
DIRECT labour is the efforts of employees who physically convert materials to finished
product.
The wages and salaries for direct labour that are separately and readily traced through the
manufacturing process to finished goods are called direct labour COSTS.
The raw materials that physically become part of the product and therefore are clearly
identified with specific units or batches of product are called DIRECT materials.
Factory heat and utilities are examples of factory OVERHEAD.
Products sold by a retailer are called merchandise. Products sold by a manufacturer are
called FINISHED goods.
Costs that do not change with changes in the volume of an activity are
called FIXED costs.
Products that are in the process of being manufactured but that are not yet complete are
called goods in PROCESS inventory.
The salaries and wages of the factory maintenance workers would be considered
an INDIRECT labour cost.
Materials used in support of the production process that do not become a part of the
product are called INDIRECT materials.
A company that acquires or produces inventory only when needed is using a JUST-INTIME inventory system.
When an accounting student chooses to attend a course in cost accounting rather than
work for 2 hours at $10 an hour, the wages that are given up to attend the course is
an OPPORTUNITY cost.
The salaries of the sales managers would be considered a PERIOD (PRODUCT or
PERIOD) cost.

The costs of direct materials and direct labour are called PRIME costs.
The costs of direct materials, direct labour, and factory overhead that are capitalized as
inventory are called PRODUCT costs.
Amortization is an example of a SUNK cost.
The theory of CONSTRAINTS is the process of identifying factors that constrain or
limit a company's operations.
The added value (selling price minus direct material costs) of finished products processed
through the system is called THROUGHPUT.
A management concept under which all managers and employees at all stages of
operations strive toward higher standards and a reduced number of defective units is
called total QUALITY management.
Direct material cost is an example of a VARIABLE (FIXED or VARIABLE) cost.

Glossary Match:
Anything that prevents a company from achieving higher performance in in terms of its
goals.
Constraint
A management concept where every manager and employee continually looks for ways to
improve operations.
Continuous improvement
A product's sale price less its total variable costs.
Contribution margin
A product's contribution margin divided by its sale price.
Contribution margin ratio
Process of monitoring planning decisions and evaluating the organization's activities and
employees.
Control
Whether a cost is controllable or not depending on a managers' responsibilities and
whether or not they are in a position to make decisions on expenditures.
Controllable or not controllable

Expenditures incurred in the process of converting raw materials to finished goods direct labour costs and factory overhead costs.
Conversion costs
A company's managers and employees are in tune with the changing wants and needs of
consumers.
Customer orientation
Costs that are incurred for the benefit of one specific cost object.
Direct cost
Efforts of employees who physically convert materials to finished product.
Direct labour
Wages and salaries for direct labour that are separately and readily traced through the
manufacturing process to finished goods.
Direct labour costs
Raw materials that physically become part of the product and therefore are clearly
identified with specific units or batches of product.
Direct materials
Expenditures for direct materials that are separately and readily traced through the
manufacturing process to finished goods.
Direct material costs
Factory activities supporting the manufacturing process and are not direct materials or
direct labour.
Factory overhead
Expenditures for factory overhead that cannot be separately or readily traced to finished
goods.
Factory overhead costs
Products that have completed the manufacturing process and are ready to be sold by the
manufacturer.
Finished goods inventory
Does not change with changes in the volume of an activity.
Fixed cost
Products that are in the process of being manufactured but that are not yet complete (also
called work in process inventory).
Goods in process inventory
Costs that are incurred for the benefit of more than one cost object or are immaterial in
value.

Indirect cost
Represents the efforts of manufacturing employees who do not work specifically on
converting direct materials into finished products and that is not clearly associated with
specific units or batches of product.
Indirect labour
Materials that are used in support of the production process but that do not become a part
of the product and are not clearly identified with units or batches of product.
Indirect materials
When a company acquires or produces inventory only when needed.
Just-in-time (JIT)
The potential benefit lost by taking a specific action from two or more alternative
choices.
Opportunity costs
Expenditures identified more with a time period than finished product costs--include
selling and general administration expenses.
Period costs
Process of setting goals and making plans to achieve them.
Planning
Expenditures directly associated with the manufacturing of finished goods, such as direct
material costs and direct labour costs.
Prime costs
Costs that are capitalized as inventory because they produce benefits that are expected to
have value in the future--include direct materials, direct labour and factory overhead
costs.
Product costs
A cost that has already been incurred and cannot be avoided or changed.
Sunk cost
Identifying factors that constrain or limit a company's operations.
Theory of constraints (TOC)
The added value (selling price minus direct material costs) of finished products processed
through the system.
Throughput
A management concept under which all managers and employees, at all stages of
operations, strive toward higher standards and a reduced number of defective units.

Total Quality Management (TQM)

Changes in proportion to changes in the volume of an activity.
Variable cost

Chapter 22: Manufacturing and Job-Order Costing

True/False:
22-1. An accounting system that uses periodic inventories in accounting for its
manufacturing operations is called a cost accounting system.
False. If periodic inventories are used, it is called a general accounting system. When
perpetual inventories are used, the accounting system is referred to as a cost accounting
system.
22-2. The four factors that come together in the production activity are: beginning goods
in process inventory, direct materials, direct labour, and overhead.
True. These four factors (production activity) result in finished and unfinished products.
22-3. The manufacturing statement (also called a schedule of manufacturing activities or
a schedule of cost of goods manufactured) contains information useful to outside parties
and is therefore included among the financial statements required by GAAP to be
published.
False. While some outside parties may find the information useful, the manufacturing
statement is not a general-purpose financial statement and is not a statement required by
GAAP to be published.
22-4. A schedule of cost of goods manufactured can be used in place of the section on the
income statement titled cost of goods sold.
False. The schedule of cost of goods manufactured, also called a manufacturing
statement, shows the calculation of the cost of goods manufactured, which appears on the
income statement.
22-5. The difference between a general accounting system and a cost accounting system
is the inventory system used under each system.

True. When manufacturing companies use a periodic inventory system, their accounting
system is referred to as a general accounting system. When manufacturers employ
perpetual inventory systems, their accounting system is called a cost accounting system.
22-6. There are two basic types of cost accounting systems: job order cost accounting and
manufacturing cost accounting.
False. The two basic types of cost accounting systems are (1) job order cost accounting
and process cost accounting, which is described in the next chapter.
22-7. A unique product or service that is produced to meet the demands of a particular
customer is called a 'job lot'.
True. In job order cost accounting, each product or service for a customer becomes a 'job
lot' or 'job', supported by a job cost sheet in which an accounting is made of all of the
costs to produce the product or service.
22-8. Job order operations are limited to manufacturing operations.
False. The concepts and practices of job order operations can be applied (and are used) in
service industries as well as manufacturing operations. Examples of where job order
operations may be applied are the operations of law and accounting practices, interior
designers, and architects.
22-9. Job costs sheets serve as a subsidiary ledger to the Goods in Process Inventory
account.
True. The job cost sheets are an integral part of the job order cost accounting system. The
end-of-month balance of the Goods In Process account should be equal to the total
amount of costs shown on the job cards of unfinished (goods in process) production.
22-10. A materials ledger card is a subsidiary record of a raw materials item that stores
data on the quantity and cost of units purchased, units issued for use in production, and
units that remain in the raw materials inventory.
True. The Raw Materials Inventory account can be a control account, with a subsidiary
ledger made up of records (materials ledger cards) on which is stored data on the quantity
and cost of units purchased, units issued for use in production, and units that remain in
raw materials inventory.
22-11. The accounting department records the transfer of raw materials to the goods in
process account when a purchases requisition is issued.
False. The source document that production managers use to request materials for use in
manufacturing and that is used to assign materials cost to specific jobs or to overhead is
called a materials requisition.

22-12. A clock card is a source document that an employee uses to report how much time
was spent working on a particular job.
False. A time ticket is the source document that an employee uses to report how much
time was spent working on particular jobs. A clock card is used to record the number of
hours an employee spends at work.
22-13. The application of factory overhead to goods in process (job cost sheets) is usually
accomplished by means of a predetermined overhead allocation rate.
True. Established prior to the beginning of a period, a predetermined overhead rate is
used to assign overhead to jobs on the basis of some selected variable such as direct
labour, direct labour hours, or machine-hours.
22-14. The ending balance of the overhead account, after application to the goods in
process, is always closed to the Cost of Goods Sold account at the end of the accounting
period.
False. If the ending balance is considered to be significant in amount, it is closed
proportionately to the Goods in Process Inventory, Finished Goods Inventory, and the
Cost of Goods Sold account. If it considered to be insignificant, it is closed to the Cost of
Goods Sold account.
22-15. Any underapplied or overapplied balance in the Factory Overhead account must be
allocated to the Goods in Process Inventory, Finished Goods Inventory, and Cost of
Goods Sold accounts.
False. Ideally, an underapplied or overapplied balance is allocated to the two inventory
accounts and the Cost of Goods Sold. However, if the amount is insignificant, it can be
closed directly to the Cost of Goods Sold account.
22-16. When the amount by which the overhead applied to jobs during a period using the
predetermined overhead application rate exceeds the overhead incurred during the period,
the overhead account will be overapplied.
True. The overhead account is debited for actual overhead expenditures and credited for
the amount applied to goods in process. If the credits to the overhead account exceed the
debits, the account is overapplied.

Multiple Choice:
22-1. Which of the following manufacturers is most likely to use a job order accounting
system?

a. a brewery
b. a ship builder of oil tankers
c. an oil refinery
d. a sugar refinery
The ship builder would construct the oil tankers to customer specifications. The other
products are normally produced on an assembly line of continuous production, to
specifications of the producer.
22-2. In a job order cost accounting system, which account would be debited in recording
a purchase invoice for raw materials?
a. Raw Materials Inventory
b. Goods in Process Inventory
c. Factory Overhead
d. Finished Goods Inventory
Upon receipt of the materials and the invoice from the vendor, Raw Materials Inventory
is debited and Accounts Payable (or Cash) is credited.
22-3. In a job order cost accounting system, which account would be debited in recording
a materials requisition for direct materials?
a. Raw Materials Inventory
b. Factory Overhead
c. Raw Materials Purchases
d. Goods in Process Inventory
A materials requisition is a request for materials (direct and/or indirect) to be shipped
from the storage facility for raw materials to production (factory). The Goods in Process
Inventory account is debited for the value of direct materials placed in process.
22-4. The predetermined overhead rate is $6.10 per direct labour hour. Job 213 required
210 direct labour hours of which 150 hours were incurred during the current accounting
period. How much overhead should be applied to Job 213 during the current accounting
period?
a. $ 366
b. $ 915
c. $1,218
d. $1,281
The overhead is applied at the end of each time period. Sixty hours would have been
applied in the past accounting period, and 150 hours at $6.10 for the current accounting
period.

22-5. Production reports for the second quarter show the following data:
Month
April
May
June

Direct Direct
Direct
MachineLabour Labour Materials
Hours
Hours
Cost
Cost
9,000 12,000 $60,000 $32,000
12,000 10,000 $50,000 $28,500
10,000 9,000 $44,000 $45,000

Actual
Overhead
$45,020
$60,000
$50,100

Which variable would be the most likely basis for allocating overhead?
a. Machine-hours
b. Labour Hours
c. Labour Cost
d. Materials Cost
The relationship between machine-hours and actual overhead is the most constant (about
$5 per machine-hour), which indicates a strong, projected cause and effect relationship
between the two costs.
22-6. Direct materials used: $20,000
Factory overhead: $40,000
Beginning goods in process: $0
Ending goods in process: $12,000
Cost of goods manufactured: $65,000
What was the amount of direct labour?
a. $17,000
b. $77,000
c. $ 5,000
d. $48,000
The cost of goods manufactured plus the ending goods in process equals the total goods
in process during the period. Since there was no beginning goods in process, the total
goods in process equals the total manufacturing costs of materials, labour, and overhead.
22-7. Company records show the following data:
Month
May
June
July

Labour
Cost
$60,000
$50,000
$44,000

Actual
Overhead
$91,020
$74,850
$66,120

Overhead is applied at 150% of direct labour cost. At the end of July, the balance of the
overhead account would be:
a. $1,290, debit
b. $1,050, debit
c. $ 960, debit
d. $ 990, debit
The overhead account would be underapplied $1,020 in May; overapplied $150 in June,
and underapplied $120 in July. 1,020 - $150 + $120 = $990 underapplied overhead
account balance at the end of July.
22-8. Job 21 was unfinished at the end of the accounting period. The total cost assigned
to the job is $12,000 of which $3,000 is direct material. Factory overhead is allocated to
goods in process at 150% of direct labour cost. What was the amount of direct labour
charged to Job 21?
a. $9,000
b. $3,600
c. $4,000
d. $3,000
The total of direct labour and factory overhead is $9,000 ($12,000 - $3,000). The $9,000
includes direct labour plus 150% of direct labour. Assigning Y as direct labour, Y + 1.5Y
= $9,000; 2.5Y = $9,000; Y = $9,000 / 2.5 = $3,600.
22-9. The production costs to produce one unit of finished goods was $45. Direct
materials were 1/3 of the total cost, and direct labour was 40% of the combined total of
direct labour and direct materials. The cost for direct materials, direct labour, and factory
overhead was:
a. $15, $18, and $12, respectively
b. $15, $12, and $18, respectively
c. $15, $16, and $14, respectively
d. $15, $10, and $20, respectively
Materials are 1/3 X $45 = $15. Direct labour is 40% of the combined cost of materials
and labour costs, and materials are 60% of the combined cost. The combined cost is $15 /
.6 = $25. Direct labour is $25 - $15 = $10. Factory overhead is $45 - $15 - $10 = $20.
22-10. The overapplied balance of the Factory Overhead ledger account is $36,000, a
significant amount. The ending balances of Goods in Process Inventory, Finished Goods
Inventory, and Cost of Goods Sold accounts are $12,000, $8,000, and $60,000,
respectively. On the basis of ending balances, how much of the overapplied balance
should be allocated to each of these accounts?

a. $5,400, $3,600, $27,000

b. $12,000, $12,000, $12,000
c. $12,000, $4,000, $20,000
d. $3,600, $5,400, $24,000
The proportion of ending balances to total ending balance is: 15% ($12,000 / $80,000),
10% ($8,000 / $80,000), and 75%, ($60,000 / $80,000) respectively. The allocation is
($36,000 x .15) $5,400; ($36,000 x .10) $3,600; and ($36,000 x .75) $27,000,
respectively.

Fill in the blanks:

A source document that an employee uses to record the number of hours at work is called
a CLOCK card.
When accounting for manufacturing activities based on the perpetual inventory system,
the accountant is going to use a COST accounting system.
When accounting for manufacturing activities based on the periodic inventory system, the
accountant is going to use a GENERAL accounting system.
The production of a unique product or service is called a JOB.
The cost of labour, materials, and overhead, for each job, are are maintained on
a JOB COST sheet.
Producing more than one unit of a unique product is called a JOB LOT.
A JOB ORDER cost accounting system is designed to determine the cost of producing
each job or job lot.
The production of products in response to special orders, also called customized
production, is called job order MANUFACTURING.
A source document that production managers use to request materials for manufacturing
and that is used to assign materials costs to specific jobs or to overhead is called
a MATERIALS REQUISITION.
When the amount of overhead applied to jobs during a period exceeds the overhead
incurred during the period, the overhead account is OVERAPPLIED(UNDERAPPLIED
or OVERAPPLIED)
The amount of overhead applied to jobs is based on a PREDETERMINED overhead
allocation rate.

An employee uses a clock card to report the number of hours at work each day. The
employee uses a TIME TICKET to report that amount of that time that was spent
working directly on a product or overhead activity.

Glossary Match:
A source document that an employee uses to record the number of hours at work and that
is used to determine the total labour cost for each pay period.
Clock card
An accounting system for manufacturing activities based on the perpetual inventory
system.
Cost accounting system
Products that have completed the manufacturing process and are ready to be sold by the
manufacturer.
Finished goods inventory
An accounting for manufacturing activities based on the periodic inventory system.
General accounting sytem
The production of a unique product or service.
Job
A separate record maintained for each job.
Job cost sheet
Producing more than one unit of a unique product.
Job lot
A cost accounting system that is designed to determine the cost of producing each job or
job lot.
Job order cost accounting system
The production of products in response to special orders, also called customized
production.
Job order manufacturing
A financial report that summarizes the types and amounts of costs incurred in a
company's manufacturing process for a period.
Manufacturing Statement
A source document that production managers use to request materials for manufacturing
and that is used to assign material costs to specific jobs or to overhead.
Materials requisition

The amount by which the overhead applied to jobs during a period with the
predetermined overhead application rate exceeds the overhead incurred during the period.
Overapplied overhead
The rate established prior to the beginning of a period that relates estimated overhead to
another variable such as estimated direct labour, and that is used to assign overhead cost
to jobs.
Predetermined overhead application rate
A source document that an employee uses to report how much time was spent working on
a job or on overhead activities and that is used to determine the amount of direct labour to
charge to the job or to determine the amount of indirect labour to charge to factory
overhead.
Time ticket
The amount by which overhead incurred during a period exceeds the overhead applied to
jobs with the predetermined overhead application rate.
Underapplied overhead

Chapter 23: Process Cost Accounting

True/False:
23-1. Process manufacturing is the mass production of products in a sequence of steps.
True. Also called process production, process manufacturing involves the production of
homogenous products, repetitively, with high production volume and standardization.
23-2. In process manufacturing operations, each process is identified as a separate
production department, workstation, or work centre.
True. In a process manufacturing operation, each department receives the output from the
prior department as a partially processed product, with the last department completing the
product for sale and distribution to customers.
23-3. The storeroom is where finished goods are stored before being shipped to
customers.

False. The warehouse is where finished goods are stored before being shipped to
customers. A storeroom is where raw materials are received and then distributed in
response to materials requisitions.
23-4. A system of accounting in which the costs of each process are accumulated
separately and then assigned to the units of product that pass through the process is
known as a process cost accounting system.
True. Unlike a job order accounting system in which costs are assigned to each job,
process cost accounting assigns costs to each production department and then assigns
costs to the units of product.
23-5. Process cost accounting systems use the concepts of direct and indirect
manufacturing costs.
True. Cost that can be clearly identified with a particular process or department are
assigned to that process or department. Other costs that are not clearly identified
(traceable) with a particular process or department are charged to factory overhead as
indirect costs.
23-6. When purchasing raw materials, the Raw Materials Purchases account is debited for
the amount of the vendor's invoice.
False. Process cost accounting systems use perpetual inventory systems. The purchase of
raw materials is debited to the Raw Materials Inventory account. As materials are placed
into production, the Raw Materials Inventory account is credited for their cost price.
23-7. The document that shows raw materials issued to a department during a period and
substitutes for materials requisitions is called the process cost summary.
False. The document described is the materials consumption report. The process cost
summary shows costs charged to a department, the equivalent units of production, and the
assignment of costs to output.
23-8. The wages and salaries of the manager and maintenance worker(s) of a production
department in a process operation are charged to factory overhead as indirect costs.
False. In a production department in a process operation, the salaries of the manager(s)
and maintenance personnel for that department are direct labour costs. The efforts of the
manager(s) and maintenance personnel are for the direct benefit of the production
department.
23-9. When using a process cost accounting system, it is not necessary or practical to use
a predetermined overhead rate as would be the case with job order accounting.

False. A predetermined overhead rate is used in both process cost and job order
accounting systems.
23-10. In a process cost accounting system, there is no overapplied or underapplied
factory overhead because the actual overhead for each production department is charged
directly to the individual departments.
False. In process cost accounting a predetermined overhead rate is used for each
production department. Any overapplied or underapplied overhead balance is closed in
the same manner as that used in job order costing (Chapter 22).
23-11. If there is no beginning or ending goods in process inventory, it is not necessary to
compute the equivalent units of production.
True. The number of units started in the department will be the same as the number of
units transferred out of the department, and those units will absorb the department's
production costs of the accounting period.
23-12. The notion that the cost of producing 300 units of product that are each 30%
complete as to material, labour, and overhead is equal to the cost of producing and
completing 90 units of product is supported by a concept known as 'equivalent units of
production.'
True. As an example, if a unit of product requires one hour of labour at $4 per hour, then
the cost of labour for 10 units of product that are 50% complete (10 X $4 X .5 = $20) is
the same as 5 completed units (5 X $4) = $20.
23-13. The cost flow assumption used in the presentation of process cost accounting is
FIFO; that is, units of product are accounted for on a first-in, first-out basis.
True. It is assumed that beginning goods in process are completed before any of the new
units are completed; and that new units started are completed before any additional new
units.
23-14. If the materials are applied in a production department only at the beginning of the
process, the equivalent units for material will include only the units of material started
and completed and the materials in the ending goods in process.
True. Under the condition described, all the goods in process at the beginning of the
period received all their materials in the previous period and are not assigned additional
materials entering into the process in the current period.
23-15. Very often, the equivalent units for labour are different than the equivalent units
for factory overhead.

False. Factory overhead is usually assigned on a basis of direct labour, such as directlabour cost or direct-labour hours; therefore, the equivalent units for labour and factory
overhead are usually the same.
23-16. Units of product spoiled in process can have a negative impact on the cost
assigned to equivalent units of production.
True. Unless they are accounted for separately, the cost of spoiled units is absorbed by
the good units.

Multiple Choice:
23-1. Which of the following is not a feature of a process production system?
a. Repetitive production
b. High production volume
c. Low product flexibility
d. Heterogeneous products
Homogenous products, such as computers, automobiles, shoes, paint, candy, canned
foods, and television sets, are manufactured in a process production system.
23-2. Which of the following is most likely to use a process cost accounting system?
a. Construction company
b. Print shop
c. Ship builder
d. Sugar refiner
Process cost accounting is used primarily with the production of a single product or line
of products made in a continuous, repetitive process.
23-3. Which of the following is not true regarding job order cost accounting and process
cost accounting systems?
a. Both assign costs by process
b. Both classify materials as direct and/or indirect
c. Both classify labour as direct and/or indirect
d. Direct materials under one system might be indirect in the other
Job order cost accounting involves assigning costs by job or job lot. Process cost
accounting involves assigning costs to production processes or production departments.

23-4. Which of the following shows the raw materials issued to a department during a
period and substitutes for materials requisitions?
a. Cost of production report
b. Equivalent units processing cost report
c. Process cost summary
d. Materials consumption report
The materials consumption report replaces the materials requisitions that are used in a job
order accounting system; and it provides a summary of all materials issued to production.
23-5. On May 1, the production department had 6,000 units 50% complete as to labour
and overhead; materials are added at the beginning of the process. During May, 30,000
units were started into process. At the end of May, the ending goods in process of 8,000
units were 80% complete as to labour and overhead. The number of units transferred to
the next department were:
a. 33,400
b. 28,000
c. 26,600
d. 31,000
The number of units transferred out is equal to the beginning units in process, plus the
number of units started, less the ending units in process (6,000 + 30,000 - 8,000), or
28,000 units.
23-6. The beginning goods in process were 3,000 units, which were 40% complete as to
labour and overhead. During the accounting period, 15,000 units were completed and
transferred to finished goods. Five hundred units remain in process and are 60%
completed. The number of units started during the accounting period were:
a. 15,500
b. 18,500
c. 12,000
d. 12,500
The beginning units plus the units started are equal to the units transferred out plus the
ending units (beginning units + units started = units transferred out + ending units). 3,000
+ x = 15,000 + 500. Units started (x) = 15,000 + 500 - 3,000 = 12,500.
23-7. In the process cost accounting system presented in the chapter, the flow of goods in
process inventories is assumed to be:
a. first-in, first-out (FIFO)
b. last-In, first-out (LIFO)

c. weighted average
d. specific invoice price
It is assumed that the beginning units in process will be completed before any new units
are completed; and that new units started will be completed before any additional new
units.
23-8. The total costs to process the beginning 5,000 units in process was $20,000. Thirty
thousand units were started and completed. There were no ending units in process. Costs
added during the period were: materials, $63,000, and labour and overhead, $28,500
each. The net change in the per unit cost of the units started and completed and the
beginning units completed is:
a. $.00 no change
b. $.10 increase
c. $.05 decrease
d. $.15 decrease
The cost per unit of the beginning units in process is $4 ($20,000/5,000). The cost per
unit of the units started and completed is $4 (($63,000 + $57,000)/30,000).
23-9. Direct materials cost $8 per unit, direct labour is $6 per unit, and overhead is
applied at 150% of direct labour cost. The 5,000 units of beginning goods in process were
100% complete as to materials, and 30% complete as to labour and overhead. The total
cost to process the beginning units:
a. cannot be determined from the information provided
b. is $100,000
c. is $ 92,500
d. is $115,000
The per unit cost is $23 [($8 + $6 + (1.5 x $6) = $23]. Five thousand units at $23 per unit
is $115,000 (5,000 x $23).
23-10. Direct materials cost $8 per unit, direct labour is $6 per unit, and overhead is
applied at 150% of direct labour cost. The 5,000 units of beginning goods in process were
100% complete as to materials, and 30% complete as to labour and overhead. The total
production costs of the current time period assigned to the beginning units:
a. cannot be determined from the information provided
b. is $52,500
c. is $92,500
d. is $31,500

The per unit cost to complete is: direct material, 0$; direct labour, 5,000 x .70 x $6 =
$21,000; and overhead, 5,000 x .70 x $9 = $31,500. The total current period costs
assigned to the beginning inventory: $21,000 + $31,500 = $52,500.
23-11. Beginning inventory of goods in process was 3,000 units that were 40% complete
as to labour and overhead. Fifteen thousand units were added to production. Five hundred
units remained in process, each 60% complete. The equivalent units for labour and
overhead were:
a. 16,600
b. 17,100
c. 16,500
d. 18,900
The equivalent units are: beginning units x percentage to complete + units started and
completed + ending units x percentage completed. (3,000 x .6) + (15,000 - 500) + (500 x .
6) = 16,600.
23-12. On a process cost summary, the total costs to be accounted for and the total costs
accounted for are
a. different in amount by the amount of underapplied overhead
b. different in amount by the amount of overapplied overhead
c. seldom the same, because of spoiled units
d. should be the same
The totals should be identical, if all the costs are accurately reported and recorded, and
the equivalent unit computation is correct.
23-13. The section of the process cost summary in which the details for the calculation of
the unit processing costs for materials, labour, and overhead are shown is the:
a. Costs charged to the department
b. Assignment of costs to the output of the department
c. Equivalent unit processing costs
d. Total costs to be accounted for
It is the section of the process cost summary where the equivalent units of production are
calculated in order to determine the unit process cost for each production cost.

Fill in the blanks:

The number of units that would be completed if all effort during a period had been
applied to units that were started and finished are called EQUIVALENT units of

production.
A materials CONSUMPTION report is a document that summarizes the materials used
by a department during a reporting period and replaces materials requisitions.
A PROCESS COST accounting system assigns direct materials, direct labour, and
overhead to specific manufacturing processes.
A primary managerial accounting report for a process cost accounting system is called a
process COST SUMMARY.
The mass production of products in a sequence of steps is
called PROCESS manufacturing (also called process production).

Glossary Match:
The number of units that would be completed if all effort during a period had been
applied to units that were started and finished.
Equivalent units of production
A document that summarizes the materials used by a department during a reporting
period and replaces materials requisitions.
Materials consumption report
A system of assigning direct materials, direct labour, and overhead to specific
manufacturing processes. The total costs associated with each process are then divided by
the number of units passing through that process to determine the cost per equivalent unit.
Process cost accounting system
A primary managerial accounting report for a process cost accounting system. The report
describes the costs charged to a department, the equivalent units of production by the
department, and how the costs were assigned to the output.
Process cost summary
The mass production of products in a sequence of steps (also called process production);
this means products pass through a series of sequential processes.
Process manufacturing

Chapter 24: Cost Allocation and Performance

True/False:

24-1. The first stage of a two-stage cost allocation is the computation of predetermined
overhead rates for each cost centre.
False. The first stage involves assigning costs from service departments to cost centres,
such as assigning janitorial costs to production departments.
24-2. Activity-based costing is an attempt to overcome the distortions of overhead
allocation that uses volume-based bases, such as machine hours or direct-labour hours.
True. The volume of production does not drive many overhead costs. As well,
inappropriate allocation can distort unit costs. For example, using direct-labour hours as
an allocation base will distort the allocation of amortization which is often machine-hour
driven.
24-3. Assigning costs to departments and products on the basis of a variety of activities
instead of only one is known as activity-based costing.
True. Information provided by assigning costs to departments or products is useful to
managers for the overall evaluation of the business and its subunits, and for identifying
the cost drivers.
24-4. A factor that affects the amount of a component of overhead, and is used in activitybased costing (ABC), is a cost driver.
True. Factors affecting the amount of a component of overhead are referred to as cost
drivers. In traditional allocation methods, costs are assigned with a single allocation basis.
In ABC, cost drivers are used.
24-5. Activity-based costing is a system of assigning costs to departments and products
on the basis of a single activity.
False. An activity-based costing system of assigning costs to departments and products is
done on a basis of a variety of activities instead of only one. Activities are pooled in a
logical manner into activity cost pools.
24-6. The differences between traditional allocation methods and activity-based costing
are mainly due to how many production departments are involved in the processing of a
product.
False. The differences are mainly due to how many cost drivers are used and the number
of allocations that are made. Activity-based costing is especially effective when many
different products are manufactured in the same department or departments.
24-7. Activity-based management is a result of activity-based costing.

True. Activity-based costing encourages each manager to increase the benefit derived
from each dollar of cost driver, resulting in activity-based management.
24-8. The first goal of departmental accounting is to assign costs and expenses to
managers who are responsible for managing each department.
False. The first goal of departmental accounting is to provide information managers use
to evaluate the profitability or cost effectiveness of each department's activities. The goal
of assigning costs to managers who are responsible for those costs is met through
responsibility accounting.
24-9. The two basic categories of departments are service and production.
True. Service departments, such as advertising, payroll, purchasing, and top
management, help both production and selling departments by providing support.
Production departments engage directly in manufacturing.
24-10. The manufacturing departments of a factory and the accounting and advertising
service departments are profit centres.
False. A profit centre is a unit of a business that not only incurs costs but also generates
revenues. The manufacturing departments and the accounting and advertising
departments are cost centres.
24-11. The supplies used in only one department are a direct expense of that department.
True. Direct expenses are defined as expenses that are easily traced and assigned to a
specific department for the sole benefit of that department.
24-12. Direct expenses and common costs are allocated to service departments on some
reasonable basis, such as time, space occupied, or levels of activity.
False. Direct expenses are not allocated, only the indirect expenses are allocated. Indirect
expenses (indirect costs) are incurred in producing or purchasing two or more essentially
different products. Indirect expenses require allocation.
24-13. The bases for allocating indirect costs among departments are influenced by
standards set within the industry in which the company operates.
False. There is no standard rule about what bases is best for the allocation of the various
indirect expenses, such as wages and salaries, rent, amortization, advertising, utilities, and
other services.
24-14. Preparing a departmental income statement requires three basic steps: (1)
accumulating direct expenses for each department, (2) allocating indirect expenses across
all departments, and (3) allocating service department expenses to selling departments.

True . These steps are often accomplished through the use of a departmental expense
allocation spreadsheet. The spreadsheets can be accomplished by hand or by using a
computerized spreadsheet.
24-15. Departmental income statements that are prepared without regard as to whether
expenses are direct or indirect are often not the best tools for evaluating department
performance.
True. This is especially true when indirect costs are a large portion of total expenses. This
is overcome by preparing departmental income statements by evaluating departmental
contributions to overhead.
24-16. It is possible for a sales department to show a net loss on a departmental income
statement but have a positive contribution to overhead.
True. A departmental income statement in which indirect expenses are allocated might
show a loss for a sales department; however, under the contribution approach statement,
it might have a positive contribution to overhead.
24-17. Departmental contribution to overhead is determined for each profit centre by
subtracting from the profit centre's net sales the direct expenses of that profit centre.
True. Subtracting the direct expenses (which include the profit centre's cost of goods
sold) from net sales results in the amount of contribution the centre is providing to cover
indirect expenses.
24-18. It is not possible for a firm to have a higher contribution percentage than one of its
selling departments.
False. A firm can have a higher or lower contribution percentage than one of its selling
departments since the firm's contribution percentage is based on total sales and total
costs.
24-19. When a department manager cannot control or influence a cost assigned to the
department, within a given accounting period, that cost is known as an inescapable
expense with reference to the manager and the department.
False. Within the context of the description given for the cost, the cost is an
uncontrollable cost. Inescapable expenses are expenses that will continue to be incurred
even when a department is eliminated.
24-20. A responsibility accounting budget is a report that shows comparisons of actual
costs of the previous accounting period with the budgeted costs of the subsequent
accounting period.

False. A responsibility accounting budget is a plan that specifies the expected costs and
expenses under the control of a manager.
24-21. A key to successful responsibility budgets and the subsequent responsibility
accounting reports is the noninvolvement of lower-level managers in establishing the
budget.
False. Lower-level managers should be closely involved in preparing their budgets. Their
effectiveness as managers is reported in a responsibility accounting report that should
compare against budgeted amounts, the actual costs and expenses for departments that
that managers can control.
24-22. A performance report accumulates costs and expenses, by manager, for those costs
for which the manager is responsible.
True. Performance reports show the differences between budgeted and actual
controllable costs for which each manager is responsible.
24-23. In the food processing industry, the cost of chickens for the purpose of processing
chicken legs, breasts, and thighs is a joint cost.
True. A joint cost is a single cost incurred in producing or purchasing two or more
essentially different products. The cost of crude oil to produce petroleum products is
another example of a joint cost.
24-24. The physical allocation approach to assigning joint costs to products will result in
each product showing a profit from its sales.
False. Because the physical allocation approach (based on physical measure of products)
can result in assigning costs in excess of selling prices, the value-based allocation
approach was developed.
24-25. One outcome of the value-based method of allocating costs to finished products is
that each product will have the same percentage of gross profit.
True. The total selling price of all the products is used as a denominator to determine the
share of expenses to be allocated to each product. As a result, the percentage of profit on
each product is identical.
24-26. An investment centre incurs investments and generates profits.
True. Companies may elect to evaluate a department as a profit centre, a cost centre, or
an investment centre, depending on the main focus and purpose of the department.
Investment centres are often evaluated by a measurement called return on investment.

Multiple Choice:
24-1.
Service Dept.
Janitorial
Maintenance

Costs
$40,000
$50,000

Production Dept.
Shaping Department
Assembly Department

Overhead Cost
$60,000
$80,000

The overhead costs shown are overhead costs prior to allocation. The service department
costs are allocated to production departments at a ratio of 7:3. The Shaping Department
overhead costs are allocated on a basis of 10,000 machine hours, of which 3,000 were
used on Job 599. What amount of overhead was assigned to Job 599 in the Shaping
Department?
a. $18,000
b. $36,900
c. $42,000
d. $24,000
The Shaping department will be charged with $63,000 ($28,000 + $35,000) of service
department costs, resulting in total overhead costs of $123,000 for the department.
$123,000 / 10,000 machine-hours = $12.30 per machine-hour. Job 599 overhead
allocation: 3,000 x $12.30 = $36,900.
24-2. Which of the following is least likely to express an appropriate cost driver for the
activities listed?
a. Cost/Activity: Personnel processing
Cost Driver: Number of employees hired or terminated
b. Cost/Activity: Quality inspection
Cost Driver: Number of units inspected
c. Cost/Activity: Materials handling
Cost Driver: Number of purchase orders
d. Cost/Activity: Equipment amortization
Cost Driver: Number of products produced or hours of use
Materials handling costs would more likely be based on number or units of materials
requisitioned. Materials purchasing costs would most likely by based on number of
purchase orders issued.
24-3. A cost that is incurred for the joint benefit of more than one department is called
a(n):

a. controllable cost
b. direct expense
c. escapable expense
d. indirect expense
Expenses that are incurred for the joint benefit of more than one department is called an
indirect cost. Indirect costs are allocated to separate departments on the basis of some
logical cost driver, such as space, time spent, or benefits acquired.
24-4. A cost that is easily traced and assigned to a specific department because it is
incurred for the sole benefit of that department is called a:
a. controllable cost
b. direct expense
c. escapable expense
d. indirect expense
Expenses that are easily traced and assigned to a specific department because they are
incurred for the sole benefit of that department are known as direct expenses. Direct
expenses do not require allocation.
24-5. Four departments (Paint, Lumber, Hardware, Roofing) in a builder's supply outlet
occupy floor space of 10,000, 50,000, 20,000, and 15,000 square metres, respectively.
How much of the rent of $104,500 on the building would allocated to the Hardware
Department?
a. $20,000
b. $ 5,500
c. $52,500
d. $22,000
Total floor space: 10,000 + 50,000 + 20,000 + 15,000 = 95,000 square metres. Cost per
square metre: $104,500 / 95,000 = $1.10. Allocation to the Hardware Department: 20,000
x $1.10 = $22,000.
24-6. A sales department of a department store generated a contribution overhead
percentage of 30.2%, and its departmental contribution to overhead was $45,300. The net
sales for the department were:
a. $150,000
b. $ 30,200
c. $ 45,300
d. $ 66,666

Departmental contribution to overhead divided by the contribution percentage will

determine the net sales (base) that was used to determine the contribution and the
percentage ($45,300 / 0.302) = $150,000.
24-7. Which line of the following schedule is incorrect?
a. Term: Indirect cost
Definition: Benefits more than one segment of the business.
b. Term: Cost centre
Definition: Incurs costs but does not generate revenues.
c. Term: Direct expense
Definition: Directly traceable to a cost objective.
d. Term: Uncontrollable cost
b.
Definition: Is eliminated with a segment discontinuance.
An uncontrollable cost is a cost not controllable by a manager at that manager's level of
responsibility. Whether the cost is controllable or uncontrollable is dependent upon the
point of reference.
24-8. The PeeDee Gravel Company produces 4 grades of gravel: Decorative, Basic,
Foundation, and Pea. From 10 tons of raw materials, the company produces 5 tons of
Decorative, 3 tons of Basic, 1 ton of Foundation, and 1 ton of Pea gravel grades. The cost
of raw material is $12.00 per ton. On a physical basis, how much of the cost of 90 tons of
raw materials should be allocated to the Pea gravel grade?
a. $ 90
b. $ 108
c. $ 297
d. $ 495
Total joint-product production from 90 tons is based on a ratio of 5:3:1:1. 45 tons of
Decorative, 27 tons of Basis, 9 tons of Foundation, and 9 tons of Pea. Total cost of 90
tons = 90 x $12 = $1,080. Joint-cost allocation to Pea gravel: 9 x $12 = $108.
24-9. The selling price of a joint product is $12,000. The total selling price of all of the
joint products is $60,000. Total cost for all the joint products is $36,000. The gross profit
rate on the joint product, based on an allocation of joint costs on a value basis, is:
a. 33.3%
b. 40.0%
c. 25.0%
d. 60.0%

The gross profit rate is determined by subtracting the allocated cost ($36,000 x ($12,000 /
$60,000) = $7,200) from the selling price ($12,000) and dividing the result ($4,800) by
the selling price ($12,000). $4,800 / $12,000 = .40 = 40%.
Fill-in the blanks:
ACTIVITY-BASED costing is a two stage allocation system.
A temporary account that accumulates the costs a company incurs to support an identified
activity is called an activity COST POOL.
CONTROLLABLE costs are costs with amounts that the manager has the power to
determine or at least strongly influence.
The maintenance department is an example of a COST centre.
A COST driver causes the cost of an activity to go up or down.
An accounting system that provides information that management can use to evaluate the
profitability or cost effectiveness of a department's activities is called a
DEPARTMENTAL accounting system.
A department's revenues exceed its direct costs and expenses by $45,000. This amount is
the department's DEPARTMENTAL
CONTRIBUTION to overhead.
One-third of the cost of newspaper advertisement in which 1/3 of the space is devoted to
merchandise in the Woman's Wear Department is a DIRECT expense of that department.
ESCAPABLE expenses are expenses that would not be incurred if a department were
eliminated.
The rent on a department store is an example of an INDIRECT expense.
INESCAPABLE expenses will continue even after a department is eliminated.
A centre in which a manager is responsible for revenues, costs and investments is called
an INVESTMENT centre.
The cost of acquiring pine logs for manufacturing into various sizes and grades of lumber
is an example of a JOINT cost.
A responsibility accounting report that compares actual costs and expenses for a
department with the budgeted amounts is called a responsibility PERFORMANCE
report.

The paint department of a hardware store is an example of a PROFIT centre.

A plan that specifies the expected costs and expenses under the control of a manager is
called a RESPONSIBILITY accounting budget.
An accounting system that provides information that management can use to evaluate the
performance of a department's manager is called a responsibility
ACCOUNTING SYSTEM.

Glossary Match:
A two stage allocation system where the first stage includes identifying the activities
involved in the manufacturing process and forming cost pools by combining activities
into sets and the second step includes computing the predetermined overhead cost
allocation rates for for each cost pool and assigning costs to jobs.
Activity-based costing
A temporary account that accumulates the costs a company incurs to support an identified
activity.
Activity cost pool
Costs with amounts that the manager has the power to determine or at least strongly
influence.
Controllable costs
A department or unit that incurs costs alone, such as the accounting department.
Cost centre
A driver that causes the cost of an activity to go up or down.
Cost driver
An accounting system that provides information that management can use to evaluate the
profitability or cost effectiveness of a department's activities.
Departmental accounting system
The amount by which a department's revenues exceed its direct costs and expenses.
Departmental contribution to overhead
Expenses that are easily traced to a specific department because they are incurred for the
sole benefit of that department.
Direct expenses
Expenses incurred for the joint benefit of more than one department.
Indirect expenses

A centre in which a manager is responsible for revenues, costs and investments.

Investment centre
A single cost incurred in producing or purchasing two or more essentially different
products.
Joint cost
A responsibility accounting report that compares actual costs and expenses for a
department with the budgeted amounts.
Performance report
A unit of a business that incurs costs and also generates revenues.
Profit centre
A plan that specifies the expected costs and expenses under the control of a manager.
Responsibility accounting budget
An accounting system that provides information that management can use to evaluate the
performance of a department's manager.
Responsibility accounting system
Costs that the manager does not have the power to determine or at least strongly
influence.
Uncontrollable costs

Chapter 25: Cost-Volume-Profit Analysis

True/False
25-1. Cost-volume-profit analysis is often referred to as break-even analysis.
True. Using cost-volume-profit analysis techniques will reveal the break-even point.
However, cost-profit-volume techniques will reveal more than the break-even point of a
firm.
25-2. A cost that remains unchanged in total within a relevant range of operations, yet
decreases per unit of product as production accelerates, is known as a variable cost.
False. Fixed costs remain unchanged in total from period to period. However, with each
additional unit of product produced, the fixed cost assigned to each unit decreases.

25-3. Variable costs change in proportion to changes in volume and, as a result, are
shown on a graph as curvilinear line.
False. Variable costs are shown as a straight line, with the beginning point at the zero cost
level, which slopes upward along the horizontal axis.
25-4. A mixed cost is a combination (or acts as if it contains a combination) of fixed and
variable costs.
True. A mixed cost is a combination of fixed and variable cost components. For costvolume-profit analysis, the fixed and variable cost portions of mixed costs must be
separated.
25-5. In cost-volume-profit analysis, some costs which do not have the characteristics of
fixed or variable costs are treated as either fixed or variable for the purposes of the
analysis.
True. One example of such a cost is a step-wise or stair-step cost, a cost which remains
fixed for a certain production volume, then increases with the next level of volume.
25-6. When a factory hires a new supervisor every time it adds a shift to its production
line, the salaries of the supervisors would be classified as a stair-step cost.
True. A stair-step or step-wise cost is a cost that remains constant over a range of
production, then increases by a lump sum if production is expanded beyond that range.
25-7. Variable costs and nonlinear costs are plotted on graphs as straight lines with a
positive slope.
False. Variable costs are graphed as straight lines. Nonlinear costs vary with production,
as do variable costs, but not in direct proportion. Therefore, nonlinear cost lines tend to
be curvilinear.
25-8. Curvilinear costs are linear in nature.
False. Curvilinear costs increase as volume increases but not at a constant ratio like pure
variable costs. In other words, curvilinear costs change with changes in production levels,
but not proportionately--they are nonlinear in nature.
25-9. One of the simplest methods of analyzing fixed and variable costs is to use a scatter
diagram, which requires a hand drawn 'best fit' line which begins on the vertical axis at
the level of total fixed costs, then slopes upward along the horizontal axis to illustrate the
slope of the variable cost line.
True. The weaknesses in using a scatter diagram are the estimates and judgment required
on the part of the preparer which are subject to interpretation.

25-10. Using the high-low method to draw an estimated line of cost behaviour on a
scatter diagram will result in a very precise line of estimated cost behaviour.
False. The high-low method considers only two plotted positions on the scatter diagram-the highest and the lowest, either or both of which may be extremes and not typical of the
conditions of the other plotted positions.
25-11. A method of estimating cost behaviour in which a line is drawn between the
highest and lowest total costs plotted on a scatter diagram is known as the least-squares
regression method.
False. The high-low method of estimating cost behaviour is based on the assumption that
the highest and lowest costs shown on a scatter diagram can be connected with a line
upon which all of the costs between the high and low costs will fall.
25-12. The least-squares regression method is a statistical method for deriving an
estimated line of cost behaviour that is more precise than the high-low method.
True. Least-squares regression is a method in which all of the costs of each activity level
within the period are plotted along a line which, when determined with statistical
analysis, is the best fit of the cost behaviour.
25-13. When a company's total contribution margin is $200,000 at the break-even point,
its fixed costs are greater than $200,000.
False. At the break-even point, the total contribution margin is equal to the total fixed
costs.
25-14. If one unit of product produces $2.00 of contribution margin when sold, and fixed
costs amount to $190, the pre-tax profit on the sale of 100 units will be $10 (assuming
taxes are not included in the determination of contribution margin or fixed costs).
True . Contribution margin is the result of revenues less all variable costs. It is used to
recover fixed costs and add to net profit: (100 x $2) - $190 = $10.
25-15. When the variable costs are 60% of sales dollars, the contribution ratio is 40%.
True. The contribution ratio is the complement of the variable costs expressed as a
percent of sales dollars.
25-16. If the contribution margin is $45,000 at the break-even point, the fixed costs must
be $45,000.
True . Contribution margin is the residual of revenues less variable costs. At the breakeven point, there must be a sufficient amount of contribution margin to cover the fixed
costs.

25-17. If the contribution ratio for a product is 65%, then the variable costs of the product
are 35% of the sales price of the product.
True. The contribution ratio is the percent that the contribution margin per unit is of the
sales price per unit. The contribution margin per unit is determined by subtracting the
variable costs from the sales price.
25-18. When the selling price of a unit is $10 and the variable costs to make and sell the
unit are $6, the contribution ratio is 40.0%.
True. The contribution margin is $4 ($10 - $6) and the contribution ratio (contribution
margin/sales price) is 40% ($4 / $10).
25-19. One of the assumptions for cost-volume-profit analysis is that the selling price per
unit remains unchanged for all units sold during the planning period.
True. While the statement is true, the assumptions used in cost-volume-profit analysis are
not always realistic; units selling prices can change, the cost per unit can change, and
fixed costs can change over the planning period.
25-20. While curvilinear costs are not illustrated as straight lines on a CVP graph, they
tend to be nearly straight within the relevant range of operations.
True. The relevant range of operations is the normal operating range of the business
which excludes extremely high and low operating levels that are unlikely to occur.
25-21. If fixed costs are $10,000 and the variable cost per unit is $2, then expected sales
of 20,000 units at $4 each should generate income (before taxes) of $30,000.
True. Income from expected sales can be determined by subtracting fixed costs and
variable costs (at the level of sales) from sales. (20,000 x $4) - (20,000 x $2) - $10,000 =
$30,000.
25-22. It is not possible to estimate the dollar of sales required to achieve a target income,
after taxes, using CVP analysis.
False. The formula for estimating the dollar sales required to achieve an after-tax target
income is: Dollar Sales = (Fixed Costs + Target Income + Income Taxes) / Contribution
Margin Ratio.
25-23. If the current level of sales if $450,000 and the break-even point is $300,000, the
margin of safety is 50%.
False. The margin of safety can be shown two ways: (1) as the difference between the
current level of sales (when sales exceed break-even) and the break-even point, or (2) as a
percent of the current level of sales (($450,000 - $300,000) / $450,000 = 0.333 = 33.3%).

25-24. The profit of a company is equal to its margin of safety.

False. The margin of safety is the difference between the current level of sales (which
exceeds break-even) and the break-even point; and includes the variable costs and
contribution margin after break-even.
25-25. A company with current sales of $450,000 and a break-even point of $460,000 has
a $10,000 margin of safety.
False. The margin of safety is the amount by which the current level of sales dollars
exceeds the break-even point. There is no margin of safety at sales levels less than the
break-even point.
25-26. It is not possible to apply break-even analysis to firms that sell more than one
product, when each product has a different variable cost.
False. A company that sells more than one product can estimate the break-even point by
using a composite unit composed of specific numbers of units of each product in
proportion to their expected sales mix.
25-27. If the degree of operating leverage is 1.5, then a 10% increase in sales (within the
relevant range of operations) will result in a 150% increase in income.
False. The degree of operating leverage (DOL) multiplied by the anticipated change in
sales determines the increase in income. The increase in income will be 1.5 x 10%, or
15%.
Multiple Choice:
25-1. A firm sells widgets for $14 each. The variable costs for each unit is $8. The
contribution margin per unit is:
a. $ 6
b. $12
c. $14
d. $ 8
The contribution margin per unit is calculated by subtracting the variable cost per unit
($8) from the selling price of the unit ($14).
25-2. Company A's fixed costs were $42,000, its variable costs were $24,000, and its
sales were $80,000 for the sale of 8,000 units. The company's break-even point in units
is:
a. 8,000
b. 5,000

c. 6,000
d. 7,000
The break-even point in units is calculated by dividing the fixed costs by the contribution
margin per unit. The break-even units are: ($80,000 - $24,000) / $7 = 6,000.
25-3. Janet sells a product for $6.25. The variable costs are $3.75. Janet's break-even
units are 35,000. What is the amount of fixed costs?
a. $ 87,500
b. $ 35,000
c. $131,250
d. $104,750
The contribution margin per unit is $6.25 - $3.75 = $2.50. At break-even, total
contribution margin is equal to total fixed costs. The total contribution margin at breakeven is 35,000 x $2.50 = $87,500; which is the amount of the fixed costs.
25-4. The current sales price is $25 per unit and the current variable cost is $17 per unit.
Fixed costs are $40,000. If the sales price is increased by $2, and all other costs remain
unchanged, the break-even point in units will:
a. increase by 1,000 units
b. decrease by 1,000 units
c. decrease by 2,000 units
d. decrease by 119 units (rounded to nearest unit)
The current contribution margin per unit is $25 - $17 = $8. The current break-even point
in units is $40,000 / $8 = 5,000. The new contribution margin will be $27 - $17 = $10.
The new break-even point in units will be $40,000 / $10 = 4,000; a decrease of 1,000
units.
25-5. Company A's fixed costs were $45,000, its variable costs were $24,000, and its
sales were $80,000. The company's break-even point in sales-dollars is:
a. $33,000
b. $64,286
c. $79,000
d. $88,000
The break-even point in sales can be calculated by dividing the fixed costs by the
contribution ratio, which is 1 minus the variable cost percentage ($24,000 / $80,000 =
0.30 = 30%). The break-even point is: $45,000 / .70 = $64,286.

25-6. Currently, a company has fixed costs of $32,500, a contribution ratio of 65%, and is
selling its product for $12 per unit. If the sales price per unit is increased by $4, how
much less will the break-even point in sales be when compared to the current condition?
a. $14,411
b. $13,414
c. $17,500
d. $ 5,932
TThe current break-even is $32,500 / .65, or $50,000. The new contribution ratio will be
73.75% ($12 x .65 = $7.80; $7.80 + $4.00 = $11.80; $11.80 / $16.00 = .7375 = 73.75%;
$32,500 /.7375 = $44,068; $50,000 - $44,068 = $5,932.
25-7. On a cost-volume-profit chart (break-even graph), the total fixed costs are:
a. the point where the sales line intersects the cost line (Y)
b. the point where the sales line crosses the total cost line
c. the point where the total cost line intersects the cost line (Y)
d. the point where the total cost line intersects the volume line (X)
The total cost line starts on the cost line (Y axis) at the dollar level of fixed costs. The
sales line starts at 0, and the point at which it crosses the total cost line is the break-even
point.
25-8. When using conventional cost-volume-profit analysis, some assumptions about
costs and sales prices are made. Which one of the following is not one of those
assumptions?
a. the costs can be expressed as straight lines in a break-even graph
b. the actual variable cost per unit must vary over the production range
c. the sales price will remain unchanged per unit
d. fixed costs will decrease per unit
The variable cost remains unchanged per unit of output. Assumptions #2, #3, and #4,
above, are the three basic assumptions; which also make #1 true.
25-9. A firm's fixed costs are $54,000, and it sold 350 units at $140 each. The total
variable costs were $35,000. The net income or loss of the firm was:
a. $40,000 loss
b. $40,000 income
c. $14,000 income
d. $ 9,000 loss
Total revenue - variable costs - fixed costs = net income or loss. Total revenue is $140 x
350 = $49,000. $49,000 - $35,000 - $54,000 = $40,000 net loss.

25-10. With a tax rate of 25%, fixed costs of $34,000, and a contribution ratio of 45%,
how much revenue is required to achieve a desired after-tax profit of $36,000?
a. $111,111
b. $182,222
c. $149,091
d. $ 83,636
After-tax profit is calculated by dividing the fixed costs, plus net income, plus income
tax, by the contribution ratio. Income before income tax is $36,000 / .75 = $48,000. The
income tax is $48,000 - $36,000 = $12,000. $34,000 + $36,000 + $12,000) / .45 =
$82,000. $82,000 / .45 = $182,222.
25-11. The dollar sales necessary to achieve a target income of $21,000 after taxes of
30% is $450,000. The fixed costs are $240,000. What is the contribution ratio (to the
nearest tenth)?
a. 53.3%
b. 65.0%
c. 58.0%
d. 60.0%
The income taxes are $9,000 ($21,000 / .70 = $30,000 income before taxes). (Fixed costs
+ target net income + income tax) / contribution ratio = dollar sales at the targeted
income. $450,000 = ($270,000 / contribution ratio). Contribution ratio = $270,000 /
$450,000 = 60%.
25-12. If a firm's margin of safety is 35% on sales of $200,000, then its margin of safety
on sales of $300,000 will be (assume fixed costs, the variable cost per unit, and the sales
price per unit do not change):
a. $105,000
b. $170,000
c. $100,000
d. $ 35,000
The break-even point is $130,000 ($200,000 x (1 - 0.35)). The margin of safety is the
excess of current sales over break-even sales. The margin of safety on sales of $300,000
will be $170,000 ($300,000 - $130,000).
25-13. Let:
BES = break-even sales, R = revenue per unit, F = fixed costs, V = variable cost per unit,
CMR = contribution ratio, CM = contribution margin per unit, S x R = sales dollars,
S = sales in units
(S x R) - (F / CMR) is the:

a. break-even point in units

b. break-even point in dollars
c. margin of safety
d. sales mix composite
The margin of safety is the excess of current sales dollars (S x R) less the break-even
point in dollars (F / CM R).
25-14. If the margin of safety is 40% of sales, which are $400,000, the break-even point:
a. is greater than $400,000
b. is $160,000
c. is $240,000
d. is less than $160,000
The margin of safety is the amount by which current sales exceed break-even dollars;
therefore, the complement of the margin of safety is the break-even point. $400,000 x (1 0.40) = $240,000.
25-15. The sales mix for Emory's Hardware is as follows:Product A: 4 units @ $8 sales
price; $6 variable cost per unit.
Product B: 6 units @ $7 sales price; $4 variable cost per unit.
Product C: 8 units @ $5 sales price; $3 variable cost per unit.
Emory's fixed costs are $42,000. The composite break-even units are:
a. 10,000
b. 100
c. 1,000
d. 2,000
The total sales revenue per mix is (4 x $8) + (6 x $7) + (8 x $5), or $114; the total
variable cost per mix is (4 x $6) + (6 x $4) + 8 x $3), or $72; the total contribution margin
per mix is $114 - $72, or $42. The composite units are: $42,000 / $42 = 1,000.
25-16. Data from a company's last period of operations shows sales of 2,000 units, total
contribution margin of $50,000, and income after subtracting fixed costs of $30,000 is
$20,000. Should the company experience sales of 2,400 units (within the relevant range,
no sales price increase), net income will be:
a. $40,000
b. $30,000
c. $10,000
d. $20,000
The degree of operating leverage (DOL) is 2.5 ($50,000 / $20,000). An increase in sales
of 20% ((2,400 - 2,000) / 2,000) multiplied by the DOL is 20% x 2.5, or 50%, the

percentage of increase in income from selling 400 additional units. The net income will
be $20,000 x 1.5 = $30,000.

Fill in the blanks:

When total sales revenue is equal to total fixed costs, a company has reached
its BREAK-EVEN point.
The amount that the sale of one unit contributes toward recovering fixed costs and profit
is called the CONTRIBUTION margin per unit
When the contribution margin per unit is expressed as a percentage of the product's
selling price it is called the contribution margin RATIO.
Predicting the volume of activity, the costs to be incurred, revenues to be received, and
profits to be earned is called CVP or COST-VOLUME-PROFIT analysis.
A cost that changes with volume but not at a constant rate like pure variable costs is
called a CURVILINEAR cost
A FIXED cost remains unchanged in total amount even when production volume varies
from period to period.
A method of drawing an estimated line of cost behaviour which connects the highest and
lowest costs on a scatter diagram with a straight line is called the HIGH-LOW method.
A method for deriving an estimated line of cost behaviour that is more precise than the
high-low method is the LEAST-SQUARES regression statistical method.
If company sales are $450,000 and break-even sales are $375,000, the $75,000 excess can
be called the MARGIN of SAFETY.
Sales personnel receive an hourly wage plus a commission on sales in excess of $10,000.
The sales salary expense account which includes the hourly pay and the commissions is
an example of a MIXED cost.
The range of sales volume that a business recognizes as its normal operating range is
called the RELEVANT RANGE of operations.
A company sells 6 tons of concrete mix, 3 tons of decorative rock, and 1 ton of structural
rock for every 10 tons of product it sells. The sales ratio (6:3:1) of volumes of the various
products is called the company's SALES MIX.

The cost of direct materials is $4 per unit. As production increases, the total cost of direct
material will increase proportionately, since direct material is an example of
a VARIABLE cost.

Glossary Match:
The unique sales level at which a company neither earns a profit nor incurs a loss.
Break-even point
The amount that the sale of one unit contributes toward recovering fixed costs and profit.
Contribution margin per unit
The contribution margin per unit expressed as a percentage of the product's selling price.
Contribution margin ratio
The first step in the planning phase is predicting the volume of activity, the costs to be
incurred, revenues to be received, and profits to be earned.
Cost-volume-profit analysis
A cost that changes with volume but not at a constant rate like pure variable costs.
Curvilinear cost
A graphic representation of the cost-volume-profit relationships.
CVP chart
A line on a scatter diagram drawn to identify the past relationship between cost and sales
volume.
Estimated line of cost behaviour
A cost that remains unchanged in total amount even when production volume varies from
period to period.
Fixed cost
A simple way to draw an estimated line of cost behaviour by connecting the highest and
lowest costs on a scatter diagram with a straight line.
High-low method
A statistical method for deriving an estimated line of cost behaviour that is more precise
than the high-low method.
Least-squares regression
The excess of expected sales over the sales at the break-even point.
Margin of safety

A cost that behaves like a combination of a fixed and a variable cost.

Mixed cost
A business's normal operating range; excludes extremely high and low volumes that are
not likely to be encountered.
Relevant range of operations
The ratio of the volumes of the various products sold by a company.
Sales mix
A graph used to display data about past cost behaviours and volumes for each period as
points on the diagram.
Scatter diagram
A cost that remains fixed over limited ranges of volumes but increases by a lump sum
when volume increases beyond maximum amounts.
Step-wise cost
A cost that changes in proportion to changes in production volume.
Variable cost

Chapter 26: Master Budgets and Planning

True/False:
26-1. The process of planning future business actions and expressing those plans in a
formal manner, usually in monetary terms, is called budgeting.
True. A budget is a statement of future plans, usually expressed in monetary terms.
Budgeting is part of the management functions of planning and control (budgeting is
planning and evaluation is control).
26-2. The budgeting process can be used to promote a positive effect on employees'
attitudes, but it can also yield a negative one.
True. Unless good budgeting procedures are followed which allow employees to have
input and knowledge of the process, poor employee morale can result since employees
will have no sense of 'responsibility' to meet the projections and goals of the company.
26-3. The task of preparing the budget normally is the responsibility of one department,
the controller's department or a department of one of the high-level managers.
False. The task of preparing the budget should not be the sole responsibility of a single
department. The budget process should involve all departments in a 'bottom up' process.

26-4. Most successful businesses generally prepare their budgets from 'the top down'.
These budgets are tightly controlled by upper management.
False. A 'from the bottom up' approach is more useful and more acceptable to those
responsible for the activities covered by the budget.
26-5. Since the budget period normally coincides with the accounting period, budgets of
less than one year or greater than one year are not normally prepared.
False. Successful businesses often divide the annual budget into monthly or quarterly
increments. And they will often prepare 5-, 10-, and 15-year plans for major capital
projects and long-range objectives.
26-6. When a company adds one increment of time to its budget period as one increment
of time expires, it is practicing continuous budgeting.
True. Continuous budgeting is the practice of adding a new increment of time (month,
quarter) to the budget, and preparing revisions, as an increment of time expires. Such
budgets are also called rolling budgets.
26-7. The cash budget is a financial budget.
True. Budgets are divided into three major categories: operating budgets, capital
expenditures budgets, and financial budgets. A cash budget is one of the financial
budgets.
26-8. The operating budgets provide all of the information necessary for the preparation
of the budgeted income statement.
False. The capital expenditures budget must also be included. The capital expenditures
budget is one source of information for expected amortization and interest expense, and
gains or losses from asset disposals.
26-9. Normally, the cash budget is the first subbudget prepared in the process of
developing the master budget.
False. Normally, the sales budget is the first sub-budget prepared. Many of the other subbudgets (manufacturing, merchandise purchases, and others) are prepared on the basis of
the data generated through the sales budget.
26-10. A quantity of merchandise or materials that is held as inventory to compensate for
unexpected demand or delays in receipts from suppliers is called the just-in-time
inventory stock.
False. What is described is called safety stock--the amount of inventory needed to avoid
stock-outs and delays in production or sales. 'Just-in-time' refers to an inventory system.

26-11. The total amount of budgeted expenses from the selling budget and the general
and administrative budget are shown as disbursements in the cash budget.
False. These budgeted expenses usually contain amortization expenses that must be
subtracted or eliminated to determine the total amounts of disbursements for the cash
budget.
26-12. The general and administrative expense budget should include any amortization on
equipment used by either function.
True. Except within a cash budget, amortization expenses should be budgeted.
26-13. The ending cash balance of the cash budget should be equal to the net income
shown on the budgeted income statement.
False. Cash budgets deal with cash inflows and outflows. Budgeted income statements
deal with revenues and expenses, determined under the accrual basis of accounting.
26-14. When a company starts each budgeting period at 'ground zero', the budgets are
prepared as if they are the first budget prepared for the company.
True. Called zero-based budgeting, this process requires managers to justify budgeted
amounts under the assumption that no previous history exists.
26-15. The manufacturing budget is a statement of the estimated cost of materials to
produce a product.
False. The manufacturing budget shows the budgeted costs for materials, labour, and
factory overhead, and is sometimes prepared in the form of three sub-budgets--materials,
labour, and factory overhead.
26-16. The production budget for a manufacturer and the merchandise purchases budget
for a retailer are similar in structure and content--both show the cost of obtaining the
product to be sold or manufactured.
False. A production budget does not show costs, as does a merchandise purchases budget;
it shows only units of production.
26-17. The direct materials budget shows the amount of cash outflow for the purchase of
direct materials over the period of the budget.
False. The direct material budget shows the dollar amount of direct materials to be
purchased. The cash disbursements schedule for purchases is used to determine the cash
outflow required to meet the purchases of direct materials demand.

26-18. The production budget, direct materials budget, direct labour budget, and
manufacturing overhead budget are all tied to the projections in the sales budget.
True. The sales budgets shows projected sales units, for which production, direct
materials, direct labour, and manufacturing overhead must be budgeted.
Multiple Choice:
26-1. Which of the following is not a benefit of budgeting?
a. It promotes study, research, and a focus on the future
b. It is a source of motivation
c. It will prevent net losses from occurring
d. It is a means of coordinating business activities
Budgeting will not prevent net losses from occurring, but budgeting can be used to
minimize net losses and their impact.
26-2. Which is not a responsibility of the budget committee?
a. Providing central guidance
b. Providing continued communication of the budget to the organization
c. Rejecting department budgets that do not reflect realistic amounts
d. Preparation and development of department budgets
Department managers and personnel should be responsible for the development of their
budgets, with the budget committee overseeing to ensure realistic and coordinated efforts
to meet the goals of the firm.
26-3. In which type of budgets is a budget period added as one budget period elapses?
a. Financial budgets
b. Rolling budgets
c. Production budgets
d. Selling and administrative expense budgets
Rolling, or continuous, budgets provide an advantage of requiring management to be
aware of budgets and projections on an on-going basis and to continually plan ahead.
26-4. Which of the following budgets is normally prepared first?
a. Cash budget
b. Sales budget
c. Merchandise purchases budget
d. Selling expense budget

The sales budget provides the basis for determining purchases (retailer), production
budgets (manufacturer), inflows of cash (cash sales and receivables collection), and
ending balances of some balance sheet accounts.
26-5. The following projections have been made:
1.
2.
3.
4.
5.
6.

Cash sales, $380,000.

Beginning cash balance, $30,000.
Operating expenses of $420,000, including depreciation of $20,000
Interest expense of $12,000 is included in operating expenses
Borrowing, $50,000.
End-of-period accrued liabilities of $20,000 for operating expenses.

What is the projected ending cash balance?

a. $80,000
b. $40,000
c. $52,000
d. $48,000
Cash disbursements for operating expenses will be: $420,000 - $20,000 (depreciation) $20,000 (accrued expenses) = $380,000. Ending cash balance will be: $30,000 +
$380,000 (cash sales) - $380,000 (cash disbursements for expenses) + $50,000 (loan) =
$80,000.
26-6.
Sales Budget
Month
October November December January
Credit Sales $40,000 $50,000
$60,000 $35,000
Expected cash collection pattern is 50% in the month of sale, 30% in the following
month, and 15% in the second following month. Five percent of the credit sales are
uncollectible. December collections will be:
a. $35,000
b. $51,000
c. $54,000
d. $50,000
50% of $60,000 ($30,000) plus 30% of $50,000 ($15,000) plus 15% of $40,000 ($6,000)
equals $51,000.

26-7.
Sales Budget
Month
October November December January
Credit Sales $40,000 $50,000
$60,000 $35,000
Expected cash collection pattern is 50% in the month of sale, 30% in the following
month, and 15% in the second following month. Five percent of the credit sales are
uncollectible. November collections were $46,000. September sales were:
a. $45,000
b. $60,000
c. $50,000
d. $55,000
50% of $50,000 ($25,000) plus 30% of $40,000 ($12,000) equals $37,000. September
sales were (($46,000 - $37,000) / .15), or $60,000.
26-8. Which of the following statements is true?
a. Budgeted bal. sheets are not dependent upon budgeted inc. statements
b. Budgeted income statements include amortization expenses
c. Cash budgets include amortization expenses
d. Production bud. shows the cost of the raw material to be purchased
The budgeted income statement includes all budgeted expenses, including amortization.
26-9. Which of the following budgets is prepared last?
a. Budgeted income statement
b. Capital expenditures budget
c. Manufacturing budget
d. Budgeted balance sheet
The budgeted balance sheet must be prepared last. It shows the results of expected
changes in cash, receivables, merchandise, other current assets, plant and equipment,
liabilities, and owner's equity.
26-10. A manufacturing firm would not have need for which of the following budgets?
a. Sales budget
b. Production budget
c. Cash budget
d. Merchandise purchases budget

The merchandise purchases budget would be used by a merchandising firm. A

manufacturing firm would use a production budget to determine the projected unit
product cost.
26-11.

Expected sales
Units produced

Production Budget
1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
7,000
5,000
8,000
6,000
6,800
To be determined

The previous year's 4th quarter ending inventory of 700 units meets the minimum
requirement. The expected production in the current 2nd Quarter is:
a. 5,300 units
b. 6,800 units
c. 4,500 units
d. 5,000 units
A ten percent ending inventory is required (ending inventory or 700 divided by 1st
quarter expected sales = 700 / 7,000 = 0.10). Therefore, required production is (8,000 X .
10) + 5,000 - (5,000 X .10), or 5,300 units.
26-12.
Time Period
1st Quarter 2nd Quarter 3rd Quarter
Beginning finished goods (units)
5,000
4,000
12,000
Projected sales units
50,000
40,000
120,000
Desired ending finished goods (units)
4,000
12,000
15,000
Direct labour completes 2 units per hour at $8 per hour.
Which of the following statements is false?
a. Direct labour hours for the 3rd quarter will be 66,000
b. Direct labour cost for the 4th quarter cannot be determined
c. Direct labour cost for the 2nd quarter will be $192,000
d. 150,000 sales units are projected for the 4th quarter
Third quarter units of production will be 123,000 (120,000 + 15,000 - 12,000). Direct
labour hours (at 2 units per hour) will be 123,000 / 2 = 61,500. The direct labour hours
for the 3rd quarter will be 61,500.
26-13.
Budgeted production (units)

9,000 10,000

8,500

Labour requirements per unit (hours)

Total labour hours needed
Total labour dollars

1.5
1.5
1.5
13,500 15,000 12,750
60,750 72,000 61,200

The labour rate per hour:

a. remained constant over the budgeted production
b. decreased over the budgeted production
c. increased over the budgeted production
d. cannot be determined from the information provided
The labour rate per hour at 9,000 units was $4.50 ($60,750 / 13,500). The labour rate per
hour at 10,000 units was $4.80 ($72,000 / 15,000). The labour rate per hour at 8,500 units
was $4.80 ($61,200 / 12,750). Possibilities exist that per-hour rates will change during the
budget period.
26-14.
Time period
Budgeted units of production
Budgeted variable overhead costs
Budgeted fixed overhead costs
Budgeted amortization included in total overhead
Budgeted cash disbursements for total overhead

1st qtr 2nd qtr

7,000 7,500
15,000 18,750
?
?
3,000 3,000
20,000 23,750

All budgeted overhead costs, except for budgeted fixed overhead, are shown. What is the
amount of budgeted fixed overhead?
a. $8,000
b. $6,000
c. $9,000
d. $3,000
Total budgeted overhead for the 1st quarter is $23,000 ($3,000 + $20,000). Fixed
budgeted overhead is $8,000 ($23,000 - $15,000). Total budgeted overhead for the 2nd
quarter is $26,750 ($3,000 + $23,750). Fixed budgeted overhead is $8,000 ($26,750 $18,750).

Fill in the blanks:

A formal statement of future plans, usually expressed in monetary terms, is called

a BUDGET.
A managerial accounting report that presents predicted amounts of the company's assets,
liabilities, and shareholders' equity as of the budget period is called a
budgeted BALANCE SHEET.
A managerial accounting report that presents predicted amounts of the company's
revenues and expenses for the budget period is called a budgeted INCOME
STATEMENT.
BUDGETING is the process of planning future business actions and expressing them as
formal plans.
The budget that deals with predicted acquisition(s) and disposal(s) of operating assets is
called a CAPITAL EXPENDITURES budget
A CASH budget is a plan that shows the expected inflows and outflows of cash during
the budget period.
Another term for a rolling budget is a CONTINUOUS budget.
Management by EXCEPTION is the principle that management should focus attention
on significant deviations from budget when evaluating performance.
The MANUFACTURING budget shows the predicted costs for materials, direct labour,
and overhead costs to be incurred in manufacturing the units in the production budget.
The combination and interaction of all the budgets (financial, operating, and budgeted
financial statements) prepared by a firm is called the MASTER budget.
One of the budgets that does not show dollar amounts but rather shows activities in terms
of units is called a PRODUCTION budget.
When a new budget period replaces the ones that have lapsed, a company is said to use
a ROLLING budget.
The excess of inventory requirements that is kept on hand to reduce the risk of running
out is called a SAFETY STOCK.

Glossary Match:
A formal statement of future plans, usually expressed in monetary terms.
Budget
A managerial accounting report that presents predicted amounts of the company's assets,
liabilities, and shareholders' equity as of the budget period.
Budgeted balance sheet
A managerial accounting report that presents predicted amounts of the company's
revenues and expenses for the budget period.
Budgeted income statement
The process of planning future business actions and expressing them as formal plans.
Budgeting
A plan that lists dollar amounts to be received from disposing of equipment and dollar
amounts to be spent on purchasing additional equipment if the proposed production
program is carried out.
Capital expenditures budget
A plan that shows the expected cash inflows and outflows during the budget period,
including receipts from loans needed to maintain a minimum cash balance and
repayments of such loans.
Cash budget
The practice of preparing budgets for each of several future periods and revising those
budgets as each period is completed; as one period is completed, a new budget is added,
with the result that the budget always covers the same number of future periods.
Continuous budgeting
A plan that shows the predicted operating expenses not included in the selling expenses
budget.
General and administrative expense budget
A plan that shows the predicted costs for materials, direct labour, and overhead costs to
be incurred in manufacturing the units in the production budget.
Manufacturing budget
A comprehensive or overall formal plan for a business that includes specific plans for
expected sales, the units of product to be produced, the merchandise (or materials) to be
purchased, the expense to be incurred, the long-term assets to be purchased, and the
amounts of cash to be borrowed or loans to be repaid, as well as a budgeted income
statement and balance sheet.
Master budget

A plan that states the units or costs of merchandise to be purchased by a merchandising

company during the budget period.
Merchandise purchases budget
A plan showing the number of units to be produced each month.
Production budget
As each monthly or quarterly budget period goes by, a firm adds new monthly or
quarterly budgets to replace the ones that have lapsed.
Rolling budgets
Inventory on hand to reduce the risk of running out; a quantity of merchandise or
materials over the minimum needed to satisfy budgeted demand.
Safety stock
A plan showing the units of goods to be sold and the revenue to be derived from the sales;
the starting point in the budgeting process because the plans for most departments are
related to sales.
Sales budget
A plan that lists the types and amounts of selling expenses expected during the budget
period.
Selling expense budget

Chapter 27: Flexible Budgets and Standard Costs

True/False:
27-1. A favourable variance occurs when a good or service costs less than the amount of
cost expected or budgeted.
True. Variances are measurements of differences between actual and budgeted costs.
When the actual cost is less than the budgeted cost, the variance is said to be 'favourable.'
27-2. To prepare a flexible budget, each type of cost must be examined to determine
whether it should be classified as a fixed cost or a variable cost.
True. Flexible budgets are budgets in which the expected results of operations at various
levels of output are shown. Since fixed costs remain unchanged, variable costs are shown
for each of the various levels.
27-3. Variance analysis is most appropriately used when the analysis is made of the actual
results of operations (actual performance) compared to a fixed budget.

False. Performance reports and analysis of variances based on actual results compared to
a fixed or static budget are misleading, unless the actual results occur at the activity level
basis of the fixed budget.
27-4. The budgeted cost for direct materials is determined by multiplying the standard
price per unit of material by the standard quantity budgeted for the production level
planned.
True. Budgeted cost refers to the total expected cost of an item. Budgeted costs are often
referred to as standard costs.
27-5. Standards are determined after the accounting period has ended, so comparisons
can be made between standard costs (budgeted costs) and actual total costs and actual
unit costs.
False. Standards are established before the accounting period begins so monitoring of
performance can be accomplished during the course of the accounting period.
27-6. Preparation of flexible budgets does not involve the use of standard costs.
False. Standard cost refers to the standard cost per unit of input (such as material, labour,
or overhead). Standard costs are used to determine the total budgeted cost for an item of
input at a specific level of activity.
27-7. Favourable variances are not analyzed for possible cause.
False. Both unfavourable and favourable variances should be analyzed for possible
causes. An analysis of a favourable variance may reveal outdated standards, inferior
workmanship, or neglected maintenance. Review the management by exception concept.
27-8. The price variance for materials is the difference between the actual quantity of
materials at the standard price and the standard quantity of materials at the standard price.
False. The price variance for materials is the difference between the actual quantity of
materials (AQ) at the actual price (AP) and the actual quantity of materials (AQ) at the
standard price (SP). (AQ X AP) - (AQ X SP) or (AP - SP) X AQ.
27-9. When the total direct labour cost variance is unfavourable, the direct labour rate
variance will (must) also be unfavourable.
False. The direct labour cost variance is the difference between actual direct labour and
budgeted direct labour. The difference can be attributed to efficiency (quantity) and/or
rate (price) variances, either of which can be favourable or unfavourable.
27-10. The labour efficiency variance is the difference between the actual quantity of
hours at the standard rate and the standard direct labour hours at the standard rate.

True. The labour efficiency variance refers to the difference in the number of hours of
labour used (AH) and the number of hours that should have been used (SH), multiplied
by the standard rate (SR). (AH - SH) X SR = QV.
27-11. The level of production that a company uses to establish the overhead rate per
hour is more than likely at some capacity less than 100%.
True. 100% capacity is very difficult to achieve. Companies will determine and use what
is a reasonable expectation level of achievement as the basis for determining overhead
standards and standard rates.
27-12. The controllable variance for overhead is the combined total of the variable
overhead spending and efficiency variances and the fixed overhead spending and volume
variances.
False. The controllable variance for overhead is the combined total of the variable
overhead spending and efficiency variances and the fixed overhead spending variance. A
fixed overhead volume variance is not included as part of controllable variance.
27-13. If a company's actual fixed overhead is $145,560 and its budgeted fixed overhead
at the level of capacity achieved is $144,000, the fixed overhead spending variance is an
unfavourable variance of $1,560.
True. The spending variance for fixed overhead is determined by subtracting the
budgeted overhead at the level of capacity achieved from the actual overhead.
27-14. If a company's actual variable overhead is $135,600 and the actual hours (AH)
multiplied by the standard variable rate (SVR) per hour equals $134,000, the variable
overhead spending variance is favourable.
False. The variable overhead spending variance would be unfavourable. $135,600 $134,000 = $1,600 unfavourable variance. (AH X AVR) - (AH X SVR) = Variable
overhead spending variance, where AH x AVR = actual variable overhead.
27-15. If a company's applied fixed overhead is $125,000 and its budgeted fixed
overhead is $124,600, the fixed overhead volume variance is favourable.
True. The fixed overhead volume variance would be favourable. $124,600 - $125,000 =
$400 favourable variance. Budgeted fixed overhead - applied fixed overhead = volume
variance.
27-16. When management investigates the cause of every variance, whether favourable or
unfavourable, it is using a management technique known as 'management by exception.'
False. Under the management technique known as 'management by exception', only the
exceptions (extreme or significant variances) would be investigated.

27-17. The techniques of determining material and labour cost variances can be applied to
many selling and administrative expenses.
True. When an expense is the result of units of use multiplied by the cost per unit of use
(a variable cost), it can be analyzed for quantity and price variances.
27-18. While standard costs can be used solely in the preparation of management reports,
in most standard cost systems such costs and resulting variances are recorded in the
accounts.
True. Recording the standards and the resulting variances into the accounts facilitates
both the record keeping and the preparation of the reports.

Multiple Choice:
27-1. The Sydney Manufacturing Company uses a fixed budget of 80,000 direct labour
hours, with planned overhead cost of $400,000 for variable overhead and $120,000 for
fixed overhead. Under a flexible budget with 100% capacity of 100,000 labour hours, the
variable and fixed costs at 100% capacity would be:
a. $400,000 and $120,000
b. $500,000 and $120,000
c. $400,000 and $150,000
d. $500,000 and $150,000
At 80,000 direct labour hours the variable cost is $5 per hour ($400,000 / 80,000), the
same amount per hour as at 100,000 hours. The fixed costs will remain unchanged at
80,000 hours or 100,000 hours. Variable costs: 100,000 x $5 = $500,000. Fixed costs:
$120,000.
27-2. Which of the following is true?
a. Flexible budget and fixed budget are synonymous terms
b. Quantity variance and price variance are synonymous terms
c. Flexible budget and variable budget are synonymous terms
d. Historical costs and standard costs are synonymous terms
Variable budget is another term used to describe a flexible budget. Fixed budgets and
static budgets are synonymous. Historical costs are costs of past transactions; standard
costs are expected costs.
27-3. The materials price variance may be computed by:

a. (Actual price - Standard price) X Actual quantity used

b. (Actual price - Standard price) X Standard quantity
c. (Actual quantity - Standard quantity) X Actual price
d. (Actual quantity - Standard quantity) X Standard price
The price variance is the difference between the actual price per unit (AP) and the
standard price per unit (SP) multiplied by the actual quantity of materials used (AQ); (AP
- SP) X AQ = PV.
27-4. The actual materials price (AP) was $3.50, the actual quantity (AQ) of material was
5,100 units, and the materials price variance (PV) was $1,275 unfavourable. The standard
materials price (SP):
a. was $3.75
b. was $3.30
c. was $3.00
d. was $3.25
The price variance (PV) was unfavourable, therefore the actual price (AP) exceeded the
standard price (SP). The unit price variance is: PV/AQ, or $1,275 / 5,100, or $.25. The
standard price was $3.25 ($3.50 - $.25).
27-5. Leland Manufacturing produced 3,700 units of finished product, using 15,000
pounds of raw material. Sixteen thousand pounds were purchased for $158,400. The
material standards for the product are 4 pounds at $10 per pound. What was the materials
price variance (PV)?
a. $1,500, favourable
b. $2,475, favourable
c. $ 150, favourable
d. $ 198, favourable
The materials price variance (PV) is determined by measuring the difference between the
actual price (AP) and the standard price (SP) and multiplying the result by the actual
quantity (AQ). The actual price was $158,400 / 16,000 = $9.90. ($9.90 - $10.00) x 1,500
= ($1,500).
27-6. Which of the following is correct with regard to using the standard quantity to
compute materials variances?
Standard quantity used:
a. Materials Price Variance: Yes
Materials Quantity Variance: No
b. Materials Price Variance: Yes
Materials Quantity Variance: Yes
c. Materials Price Variance: No

Materials Quantity Variance: No

d. Materials Price Variance: No
Materials Quantity Variance: Yes
The materials price variance can be computed by (AP - SP) X AQ = PV; standard
quantity (SQ) is not used. The materials quantity variance can be computed by (AQ - SQ)
X SP = QV; the standard quantity (SQ) is used.
27-7. The standard units (SQ) were 5,200, the standard price (SP) was $3.25, and the
materials quantity variance (QV) was $325 favourable. The actual units (AQ):
a. were 5,300
b. were 5,000
c. were 5,100
d. were 5,200
Since the quantity variance (QV) was favourable, the standard units exceeded the actual
units. The unit quantity variance is computed as QV/SP, or $325 / $3.25, or 100. The
actual units were 5,100, the standard units of 5,200 less the variance of 100 units.
27-8. Which of the following is correct with regard to using the standard unit price to
compute materials variances?
Standard unit price used:
a. Materials Price Variance: Yes
Materials Quantity Variance: No
b. Materials Price Variance: Yes
Materials Quantity Variance: Yes
c. Materials Price Variance: No
Materials Quantity Variance: No
d. Materials Price Variance: No
Materials Quantity Variance: Yes
The standard unit price is used in both variances. The materials price variance can be
computed by (AP - SP) X AQ. The materials quantity variance can be computed by (AQ SQ) X SP.
27-9. An unfavourable materials quantity variance may be the result of:
a. a greater than anticipated waste in the manufacturing process
b. an increase in the cost per unit of raw materials
c. a decrease in the cost per unit of raw materials
d. a lower than anticipated waste in the manufacturing process

The materials quantity variance (QV) is the difference between the actual quantity of
materials (AQ) and the standard quantity of materials (SQ) multiplied by the standard
price (SP), or (AQ - SQ) X SP.
27-10. Which of the following is correct with regard to the standard labour hours being
used to compute labour variances?
Standard labour hours used:
a. Labour Rate Variance: Yes
Labour Efficiency Variance: No
b. Labour Rate Variance: Yes
Labour Efficiency Variance: Yes
c. Labour Rate Variance: No
Labour Efficiency Variance: No
d. Labour Rate Variance: No
Labour Efficiency Variance: Yes
The labour rate variance can be computed by: (AR - SR) X AH; standard labour hours are
not used. The labour efficiency variance can be computed by: (AH - SH) X SR.
27-11. The labour rate variance may be computed by:
a. (Actual rate - Standard hours) X Actual hours
b. (Actual hours - Standard hours) X Standard price
c. (Actual hours - Standard rate) X Actual hours
d. (Actual rate - Standard rate) X Standard hours
The labour rate variance is the difference between the actual rate and the standard rate of
labour multiplied by the actual labour hours: (AR - SR) X AH.
27-12. The standard cost of one unit of product includes 2 hours of direct labour at $7.50
per hour. The company's labour rate variance was $80, unfavourable. The efficiency
variance was $30, favourable. Two-hundred and fifty units were produced. The actual
labour hours:
a. were 496 hours
b. were 500 hours
c. were 504 hours
d. were 514 hours
A favourable efficiency variance means fewer hours were used than were allowed for the
level achieved. Four hours were saved ($30.00 / $7.50). The standard hours allowed were
500 hours (2 X 250); actual hours used were 496 (500 - 4).

27-13. Which of the following is correct with regard to using the standard labour rate to
compute labour variances?
Standard labour rate used:
a. Labour Rate Variance: Yes
Labour Efficiency Variance: No
b. Labour Rate Variance: Yes
Labour Efficiency Variance: Yes
c. Labour Rate Variance: No
Labour Efficiency Variance: No
d. Labour Rate Variance: No
Labour Efficiency Variance: Yes
The standard labour rate is used in both variances. The labour rate variance can be
computed by: (AR - SR) X AH. The labour efficiency variance can be computed by: (AH
- SH) X SR.
27-14. The standard hourly rate was $1.40. The actual rate was $1.30. The labour rate
variance was $600, favourable. The actual labour hours:
a. were 6,000
b. were 6,400
c. were 1,000
d. were 1,500
(AR - SR) X AH = RV, therefore, the total variance ($600) divided by the hourly
difference ($1.30 - $1.40) will equal the actual hours; $600 / $.10 = 6,000 actual hours.
Proof: ($1.30 - $1.40) x 6,000 = $600.
27-15. The Big Company's expected production volume was 36,000 units at 9,000 hours
of labour. The fixed overhead rate is $3 per hour at 36,000 units. Actual fixed overhead
was $26,000 for 32,000 units of production. Which of the following is correct?
a. Spending variance, $3,000 F; volume variance, $2,000 U.
b. Spending variance, $1,000 U; volume variance, $3,000 U.
c. Spending variance, $1,000 U; volume variance, $3,000 F.
d. Spending variance, $1,000 F; volume variance, $3,000 U.
Standard hours allowed were 8,000 (32,000 / 4). The spending variance is actual fixed
overhead minus the budgeted overhead ($26,000 - $27,000). The volume variance is
budgeted fixed overhead minus the applied fixed overhead [$27,000 - (8,000 X $3), or
$27,000 - $24,000].
27-16. The Big Company's expected production volume was 36,000 units at 9,000 hours
of labour. The variable overhead rate is $5 per hour. Actual variable overhead was

$41,000 for 32,000 units of production at 8,500 hours of labour. Which of the following
is correct?
a. Spending variance, $1,500 unfav.; efficiency variance, $2,000 unfav.
b. Spending variance, $1,500 fav.; efficiency variance, $2,500 unfav.
c. Spending variance, $1,500 unfav.; efficiency variance, $2,500 fav.
d. Spending variance, $2,000 fav.,; efficiency variance, $2,500 unfav.
The standard hours were 8,000 (32,000 / 4). The spending variance is actual variable
overhead minus actual hours multiplied by the standard variable rate ($41,000 - (8,500 X
$5) = $1500 F). The efficiency variance is the actual hours multiplied by the standard
variable rate minus applied overhead (8,500 X $5) - (8,000 X $5) = $2,500 U.
27-17. The overhead variances for Big Company were:
Variable overhead spending variance: $450 unfavourable.
Variable overhead efficiency variance: $750 favourable.
Fixed overhead spending variance: $1,250 unfavourable.
Fixed overhead volume variance: $3,000 unfavourable.
What was the overhead controllable variance?
a. $950 unfavourable
b. $1,700 unfavourable
c. $3,000 unfavourable
d. $500 favourable
The controllable variance is the sum of the spending variances plus the efficiency
variance. $450 + $1,250 - $750 = $950 unfavourable controllable variance. The volume
variance is not considered a controllable variance.
27-18. Under a standard costing system, the overhead variances are recorded when:
a. the factory overhead is applied to the Goods in Process account
b. the factory labour is recorded
c. the materials price variance is recorded
d. the cost of goods sold is recorded
The overhead variances are recorded when the factory overhead is assigned to the Goods
in Process Inventory account at the standard predetermined overhead.
27-19. Under a standard cost system, the materials quantity variance was recorded at
$500 unfavourable, the materials price variance was recorded at $1,620 favourable, and
the Goods in Process was debited for $43,120. The actual materials used were 42,000
units at:
a. $0.10 each
b. $0.01 each

c. $1.00 each
d. $0.0988 each
The unit cost of materials: (Debit to Goods in Process + Debit to Materials Quantity
Variance - Credit to Materials Price Variance) / 42,000, or ($43,120 + $500 - $1,620) /
42,000. $42,000 / 42,000 = $1.00 per unit cost.

Fill n the blanks:

The CONTROLLABLE variance is the two overhead spending variances combined
with the variable overhead efficiency variance.
The difference between the actual incurred cost and the standard amount is called
the COST variance.
A FAVOURABLE variance occurs when the budgeted amount is less than the actual
amount, and the variance reduces costs or increases revenues.
A FIXED budget is a planning budget based on a single predicted amount of sales or
production volume.
A FLEXIBLE budget is prepared after an operating period is complete in order to help
managers evaluate past performance.
An internal report that compares actual revenue and cost amounts with their variable
budgeted amounts and identifies the differences between them as favourable or
unfavourable variances is called a flexible budget PERFORMANCE report.
Management by EXCEPTION is an analytical technique used by management to focus
on the most significant variances and give less attention to the areas where performance
is close enough to the standard to be satisfactory.
The difference between the total overhead cost applied to products and the total overhead
cost actually incurred at the end of a cost period is called the overhead cost VARIANCE.
A difference between actual and budgeted revenue or cost caused by the difference
between the actual price per unit and the budgeted price per unit is called
aPRICE variance.
The difference between actual and budgeted revenue or cost caused by the difference
between the actual number of units sold or used and the budgeted number of units is
called a QUANTITY variance.

A SPENDING variance occurs when management pays more or less than the budgeted
price or amount to acquire the overhead items.
STANDARD costs are the costs that should be incurred under normal conditions to
produce a specific product or component or to perform a specific service.
A variable overhead EFFICIENCY variance occurs when the standard direct labour
hours (the allocation base) allowed for actual production is different from the actual
direct labour hours consumed.
A process of examining the differences between actual and budgeted revenues or costs
and describing them in terms of the amounts that resulted from price and quantity
differences is called variance ANALYSIS.
The difference between the total budgeted overhead cost and the overhead cost allocated
(applied) to products using the predetermined fixed overhead rate is called
the VOLUME variance.

Glossary Match:
Two overhead spending variances and the variable overhead efficiency variance
combined together.
Controllable variance
The difference between the actual incurred cost and the standard amount.
Cost variance
Amount calculated when actual value is compared to the budget value, the actual cost or
revenue contributes to a higher income.
Favourable variance
A planning budget based on a single predicted amount of sales or production volume;
unsuitable for evaluations if the actual volume differs from the predicted volume.
Fixed budget
A budget prepared after an operating period is complete in order to help managers
evaluate past performance; uses fixed and variable costs in determining total costs.
Flexible budget
An internal report that helps management analyze the difference between actual
performance and budgeted performance based on actual sales volume (or other level of
activity); presents the differences between actual and budgeted amounts as variances.
Flexible budget performance report

An analytical technique used by management to focus on the most significant variances

and give less attention to areas where performance is close enough to the standard to be
satisfactory.
Management by exception
The difference between the total overhead cost applied to products and the total overhead
cost actually incurred at the end of a cost period.
Overhead cost variance
A difference between actual and budgeted revenue or cost caused by the difference
between the actual price per unit and the budgeted price per unit.
Price variance
The difference between actual and budgeted revenue or cost caused by the difference
between the actual number of units sold or used and the budgeted number of units.
Quantity variance
When management pays more or less than the budgeted price or amount to acquire the
overhead items.
Spending variance
The costs that should be incurred under normal conditions to produce a specific product
or component or to perform a specific service.
Standard costs
Amount calculated when actual value is compared to the budget value, the actual cost or
revenue contributes to a lower income.
Unfavourable variance
A process of examining the differences between actual and budgeted revenues or costs
and describing them in terms of the amounts that resulted from price and quantity
differences.
Variance analysis
The difference between two dollar amounts of fixed overhead cost. The first amount
equals the total budgeted overhead cost. The second number is the overhead cost
allocated to products using the predetermined fixed overhead rate.
Volume variance

Chapter 28: Capital Budgeting and Managerial Decisions

True/False:

28-1. Planning plant asset investments is called capital budgeting.

True. Capital budgeting involves plans for new buildings, new equipment, or new
projects, and often requiring risky and difficult decisions. Each proposal is examined on
the basis of cost and revenue estimates.
28-2. The payback period of an investment is determined by dividing the cost of the
investment by the revenues generated from the investment.
False. The payback period is determined by dividing the cost of the investment by the
annual net cash flow of the investment. It is the time required to recover the cost of the
investment. The time value of money is ignored in the payback period.
28-3. If the cost of an investment is $12,000 and the expected annual sales from the
investment is $4,000, then the payback period is 3.0 years.
False. The payback period, with equal annual cash flows, is computed by dividing the
cost of the investment by the expected annual net cash flow, not the expected annual
sales.
28-4. It is possible to determine a payback period when the net cash flows from the
project are uneven.
True. Accumulating the net cash flows until they are equal in total to the original cost of
the project determines the length of time necessary to recover the original cost of the
investment.
28-5. The major weaknesses of using the payback period as the sole criteria for capital
budgeting decisions is that it ignores the timing of the cash flows, the risk involved, and
the extent or amount of the cash flows beyond the payback period.
True. The payback period is the point at which the cash flows are equal to the cost of the
investment; however, no consideration is given to timing of the cash flows within the
payback period, or their present value.
28-6. The result of dividing the annual, after-tax income that results from using an asset
by the average investment in the asset is known as the accounting rate of return or the rate
of return on average investment.
True. Using the average of the investment makes the rate an average one; one of the
major weaknesses in its use, especially when the after-tax income flows are unequal
amounts.
28-7. The return on average investment for an investment in production machinery will
be lower if the ending book value is used in place of the final year's book value, when
determining the average investment.

False. The final year's book value is the ending book value of the previous time period,
thus its use provides a larger denominator than the ending book value, in the calculation
of the average investment. The Return on Average Investment = Annual After-tax Net
Income / Average Investment.
28-8. Using an accounting rate of return is limited because of its failure to distinguish
between two investments with the same average annual net income but where one yields
higher amounts in the early years and the other in later years.
True. The accounting rate of return ignores the time value of money, a major weakness of
using an accounting rate of return for investment decisions.
28-9. A project is acceptable if the total present value of its cash flows exceeds the
amount to be invested.
True. When there is a positive net present cash flow (the present value of the cash flows
exceed the cost of the investment), the investment has been fully recovered and there is a
cash flow in excess of its cost.
28-10. There is no advantage to using accelerated amortization methods for tax reporting
in so far as the present value of cash flows are affected.
False. Using accelerated amortization methods (sheltering revenue and reducing taxes)
creates larger net cash flows in the early years and smaller ones in later years. Early cash
flows are more valuable than later ones.
28-11. The use of the net present value method for investment decisions is limited to
those investments that generate equal annual net cash flows over the life of the
investment.
False. The net present value method can be used whether the net annual cash flows are
equal or unequal. However, its use is limited if the amount invested differs substantially
across proposed projects.
28-12. When using the internal rate of return to evaluate capital investments, the user
must determine the hurdle rate that the internal rate must exceed for the capital
investment to be acceptable.
True. The hurdle rate is a rate of return that will cover the interest cost on the investment
and provide an additional profit to reward the company for its risk.
28-13. A sunk cost arises from a past decision and cannot be avoided or changed.
True. Sunk costs are one of the types of costs irrelevant to decision making. Most of a
company's allocated fixed costs are sunk costs.

28-14. A cost incurred as a consequence of a past irrevocable decision and that, therefore,
cannot be avoided is known as an opportunity cost.
False. The cost described is a sunk cost; a cost that is irrelevant to decisions affecting the
future.
28-15. Opportunity costs, like sunk costs, are irrelevant to decision making.
False. Opportunity costs are the potential benefits lost by taking a specific action when
two or more alternative choices are available. Opportunity costs are relevant to decision
making.
28-16. In a decision to accept an additional volume of business, the costs relevant to
reaching a decision are the incremental or differential costs.
True. Incremental or differential costs are the additional costs, as in this case, to accept
an additional volume of business. These costs would not occur without the additional
volume.
28-17. In make or buy decisions, the predetermined overhead rate should be ignored
when determining the overhead associated with making a product.
True. An incremental overhead rate should be used, since fixed costs that are included in
the predetermined rate will not change if the units to be made do not increase volume
beyond the relevant range of operations.
28-18. Costs incurred in manufacturing units of product not meeting quality standards are
sunk costs and are irrelevant in any decision of whether to sell the units as scrap or
rework them so they meet quality standards.
True. Sunk costs cannot be avoided or changed in any way, so they are not relevant to the
decisions described.
28-19. The decision between selling units as scrap or reworking them so that they meet
the quality standards necessary for them to be sold will be influenced by the sunk costs
incurred in manufacturing the units that did not meet the quality standards.
False. Sunk costs are not a consideration. A major consideration is the difference in
selling the units as scrap and the net return on selling the units after the cost of reworking
them. Another consideration is the possible limitations reworking the units might place on
plant capacity.
28-20. Opportunity costs are not a factor in a rework or scrap decision.
False. An opportunity cost will exist if reworking defective units requires sacrificing the
production of new units to provide production facilities to rework the defective units.

28-21. The amount of incremental revenue is the determining factor in a 'sell or process
further' decision.
False. Incremental revenue needs to be determined; however, the incremental costs to
process further need to be subtracted from the incremental revenue to determine is there
is incremental income. Whether or not there is incremental income is the determining
factor.
28-22. In all cases where a company can manufacture more than one product, and the
company has no excess capacity, it should manufacture only the most profitable product.
False. This is only true if the market demand is equal to or greater than the number of the
most profitable product produced.
28-23. Avoidable and escapable costs are same costs.
True. An avoidable (or escapable) cost is a deduction that would not be incurred if a
segment were eliminated. Unavoidable (or inescapable) costs are deductions that would
continue even if a segment was eliminated.
28-24. A decision rule regarding eliminating a segment is that a segment is a candidate
for elimination if its revenues are less than its unavoidable expense.
False. The rule is: a segment is a candidate for elimination if its revenues are less than its
AVOIDABLE expenses.
28-25. Break-even time (BET) is a method of determining the payback period in terms of
discounted cash flows.
True. BET overcomes the limitation of not using the time value of money in the payback
period method of capital investment decisions.

Multiple Choice:
28-1. The cost of a new machine is $24,000. The machine has a 5-year service life and no
salvage. The annual cash flow will be 15% of the cost of the machine. The payback will
occur:
a. in 6.7 years
b. in 15.0 years
c. in 1.5 years
d. after the machine's service life has expired

The payback period is determined by dividing the cost of the investment by the annual
cash flow ($24,000 / ($24,000 / .15)) = 6.7 years.
28-2. Equipment will be purchased at a cost of $30,000. It will have no salvage value.
The cash flows are expected to be: $12,000, $10,000, $15,000, and $8,000, over the life
of the equipment. The payback period will occur in:
a. 3.1 years
b. 4.0 years
c. 2.50 years
d. 2.53 years
$22,000 is recovered in the first two years. The remaining $8,000 is recovered in year 3.
The portion of the $15,000 third-year cash flow that is required is .533 ($8,000 /
$15,000). The payback is 2.53 years.
28-3. The company expects an after-tax income of $2,400 per year over the life of an
investment that will cost $25,000, has a 5-year service life, and has no salvage value. The
average return on investment (accounting rate of return) is:
a. 19.2%
b. 9.2%
c. 10.4%
d. 9.6%
The average (accounting )rate of return is determined by dividing the annual after-tax net
income by the average cost of the investment, (beginning book value + ending book
value) / 2. (($25,000 + $0)/ 2)/ $2,400 = 19.2% accounting rate of return.
28-4. Which is not true of the net present value method of determining the acceptability
of an investment?
a. Net cash flows from the investment are estimated
b. The net cash flows are discounted at an acceptable rate of return
c. The initial cost of the investment is added to the net cash flows
d. A positive net present value of the cash flows is required
To determine if the net present value of the cash flows is positive (acceptable) or negative
(unacceptable), the cost of the original investment is subtracted from the total of the
discounted cash flows.
28-5. Each of the three projects cost $20,000, the amount available for investment. Each
project has a service life of 3 years and no salvage value. The investment cash flows and
present value of $1 at 10% are:
Project A Project B Project C PV factor

Year 1
Year 2
Year 3

$10,000
10,000
10,000

$28,000
1,000
1,000

$ 1,000
3,000
26,000

at 10%
.909
.826
.751

If 10% is an acceptable earnings rate, which project should be selected?

a. Project A
b. Project B
c. Project C
d. none of the projects
Project B has the greatest net present value of ($28,000 x 0.909) + $1,000 x 0.826) +
($1,000 x 0.751) - $20,000 = $7,029. Project A and Project C have net present values of
$4,860 and $2,913, respectively.
28-6. When selecting an earnings rate to use in evaluating projects under the net present
value method, a company will consider a rate that:
a. is equal to the current interest rate to borrow money
b. is equal to the current rate of return on assets
c. is equal to the current tax rate
d. exceeds the current interest rate to borrow money
Companies will select a rate that exceeds the current interest rate to borrow so that the
rate will cover the cost of borrowing and other risks involved in making the investment.
28-7. Which line of the following schedule is incorrect?
a. Payback period
Basis of Measurement: Cash Flows
Measure Expressed As: Number of Years
b. Net Present value
Basis of Measurement: Cash Flows
Measure Expressed As: Dollar Amount
c. Internal rate of return
Basis of Measurement: Accrual Income
Measure Expressed As: Percent
d. Accounting rate of return
Basis of Measurement: Accrual Income
Measure Expressed As: Percent
The internal rate of return (IRR) requires the use of cash flows, not accrual income. The
internal rate of return is computed as: Amount Invested / Net Cash Flows.
28-8. Which of the following is incorrect?

a. Payback period
Basis of Measurement: Cash Flows
Measure Expressed As: Number of Years
b. Net Present value
Basis of Measurement: Cash Flows
Measure Expressed As: Percent
c. Internal rate of return
Basis of Measurement: Cash Flows
Measure Expressed As: Percent
d. Accounting rate of return
Basis of Measurement: Accrual Income
Measure Expressed As: Percent
The net present value method of making capital investment decisions is expressed as a
dollar amount. The net present value is the excess of the present value of the cash flows
over the amount invested.
28-9. An additional cost that results from a particular course of action is known as a(an):
a. sunk cost
b. opportunity cost
c. incremental cost
d. net present cost
The definition given applies to an incremental cost; an additional cost that will result
when a particular course of action is taken.
28-10. A cost incurred as a consequence of a past irrevocable decision and that, therefore,
cannot be avoided, is known as a:
a. decremental cost
b. differential cost
c. sunk cost
d. opportunity cost
The definition given applies to a sunk cost. It is irrelevant to any decision effecting the
future.
28-11. Which of the following is not a relevant cost in decision making?
a. Opportunity cost
b. Relevant benefits
c. Avoidable costs
d. Sunk costs

Sunk costs arise from a past decision and cannot be avoided or changed. These costs are
irrelevant to future decisions.
28-12. The cost to produce 8,000 units at 70% capacity is:
Direct materials: $16,000
Direct labour: $8,000
Factory overhead, all fixed: $12,000
Selling expense (40% variable, 60% fixed): $8,000
What unit price would the company have to charge to make $2,000 on a sale of 500
additional units that would be shipped out of the normal market area?
a. $8.90
b. $7.80
c. $7.40
d. $7.00
The unit cost: materials, $2.00 ($16,000 / 8000); labour, $1.00 ($8,000 / 8,000); fixed
overhead, $0; selling expenses, variable only, $.40 (($8,000 x 0.40) / 8,000). Variable cost
per unit: $2.00 + $1.00 + $.40 = $3.40. ($3.40 X 500) + $2,000 = $3,700. $3,700 / 500 =
$7.40.
28-13. Given the following list of costs, which one should be ignored in a decision to
produce additional units of product for a factory that is operating at less than 100%
capacity, and the additional business will not use up the remainder of the plant capacity?
a. Fixed administrative expenses
b. Variable factory overhead
c. Per hour cost of direct labour
d. Variable selling expenses
You answered correctly! Generally, fixed costs will not change with additional units of
product when a plant is operating at less than 100% of its current capacity.
28-14. Henny-Penny has 8,000 defective units of a product that cost $4 per unit to
manufacture, and can be sold for $2 per unit. These units can be reworked for $1 per unit
and sold at their full price of $6 each. If Henny-Penny rework the defective units, how
much net return will result?
a. $ 24,000
b. $ 8,000
c. $(24,000
d. $ 48,000
Sales after reworking: 8,000 x $6 = $48,000. The cost to rework: 8,000 x $1 = $8,000.
The opportunity cost of not making new units: 8,000 x $2 = $16,000. The net return of

reworking: $48,000 - ($8,000 + $16,000) = $24,000. The net return of scrapping: 8,0000
x $2 = $16,000.
28-15. Henny-Penny has 8,000 defective units of a product that cost $3 per unit to
manufacture, and can be sold for $1 per unit. These units can be reworked for $3 per unit
and sold at their full price of $5 each. Should Henny-Penny rework the defective units,
how much incremental net return will result?
a. $24,000
b. $(8,000)
c. $16,000
d. $ 8,000
Sales after reworking: 8,000 x $5 = $40,000. The cost to rework: 8,000 x $3 = $24,000.
The opportunity cost of not making new units: 8,000 x $2 = $16,000. The net return of
reworking: $40,000 - ($24,000 + $16,000) = $0. The net return of scrapping is 8,0000 x
$1 = $8,000.
28-16. Sales of 50,000 units at $4 per unit are made monthly. The unit cost is $1.50.
Incremental costs of $1 per unit to further process the units will result in the 50,000 units
being sold for $4.75 each. The company should:
a. Do further processing and sell the units at $4.75
b. Sell the units at the current stage of completion (50,000 @ $4)
c. Do further processing on only one-half of the units
d. Commit its resources to a different product
The per unit cost will be $2.50 after further processing. The selling price of $4.75 will
provide a $2.25 per unit profit. Currently, the units generate a per unit profit of $2.50
($4.00 - $1.50).
28-17. Product A sells for $8 per unit. Its variable cost per unit is $5. Product B sells for
$12 per unit. Its variable cost per unit is $8. The plant capacity is 300,000 machine hours.
Which of the following will provide the best sales mix of Product A and Product B,
assuming that the market limitation of Product A is 200,000 units?
a. 200,000 units of Product A, 100,000 units of Product B
b. 100,000 units of Product A, 200,000 units of Product B
c. 150,000 units of Product A, 150,000 units of Product B
d. No units of Product A, 300,000 units of Product B
Product B has a greater contribution margin per unit ($12 - $8 = $4) than Product A ($8 $5 = $3). With no market limitation on Product B, Henny-Penny should produce 300,000
unit of Product B.

28-18. Segment Auburn generates total sales of $52,000, its direct expenses are $11,000,
and its indirect expenses are $13,000. Its cost of goods sold is $32,000. $3,000 of the
direct expenses and $4,000 of its indirect expenses are avoidable expenses.
a. The company will lose $13,000 if Segment Auburn is eliminated.
b. Segment Auburn's revenue is greater than its avoidable costs.
c. Segment Auburn is a candidate for elimination.
d. Segment Auburn's unavoidable costs are greater than avoidable costs.
Segment Auburn's avoidable costs are $32,000 + $3,000 + $4,000, or $39,000. A segment
is a candidate for elimination if its revenues are less than its avoidable cost. This is not
the case for Segment Auburn. The company will lose $13,000 of income if Segment
Auburn is eliminated.
28-19. The following incomplete information is provided for investment decisions.
Year
0
1
2
3

Dicounted
Cash
Flows
1.000 $(20,000)
.909
7,272
.826
.751

Cash Discount
Flow
Factor
$(20,000)
8,000
12,000
14,000

Cumulative
Cash Flows
$(20,000)

Using break-even time (BET) analysis, the investment will:

a. be recovered at the end of year 2
b. not be recovered in three years
c. be recovered in 2.27 years
d. be recovered in 2.73 years
The discounted cash flows for years 2 and 3 are $9,912 and $10,514, respectively. At the
end of year 2 the cumulative cash flows will be $(2,816). The discounted cash flow in
year 3 will absorb the negative cumulative cash flows. $2,816 / $10,514 = .267. Total
time is 2.27 years.

Fill in the blanks:

An expense (or cost) that would not be incurred if the department, product, or service is
eliminated is called a(n) AVOIDABLE cost.
The process of analyzing alternative investments and deciding which assets to acquire or
sell is called CAPITAL budgeting.

If the company accepts an additional volume of business that will increase variable costs
by $15,000, the variable cost increase can be referred to as an INCREMENTAL cost.
The NET PRESENT value is a dollar amount used to evaluate the acceptability of an
investment; it is an estimate of an asset's value to the company.
If you have given up 6 hours of work at $12 an hour to attend your accounting class, the
$72 of foregone wages is an OPPORTUNITY cost to you of attending class.
A cost incurred or avoided as a result of management's decisions is called an OUT-ofPOCKET cost.
The net cash inflows from a $20,000 investment will be $5,000 per year, which results in
a PAYBACK period of 4 years.
Amortization expense, which cannot be avoided or changed in any way because it arises
from a past decision, is an example of a SUNK cost.
UNAVOIDABLE expenses (or costs) will continue even if the department, product, or
service is eliminated.

Glossary Match:
An out-of-pocket cost/expense that requires a future outlay of cash and is relevant for
future decision making: costs/expenses that would not be incurred if the
department/product/service were eliminated.
Avoidable costs/expenses
The process of analyzing alternative investments and deciding which assets to acquire or
sell.
Capital budgeting
An additional cost incurred only if the company accepts the additional volume.
Incremental cost
A dollar amount used to evaluate the acceptability of an investment; an estimate of an
asset's value to the company; computed by discounting the future cash flows from the
investment at a satisfactory rate and then subtracting the initial cost of the investment.
Net present value
The costs that represent the potential benefits lost by choosing an alternative course of
action.

Opportunity cost
A cost incurred or avoided as a result of management's decisions.
Out-of-pocket cost
A time-based measurement used to evaluate the acceptability of an investment; the time
expected to pass before the net cash flows from an investment return its initial cost.
Payback period
A cost that cannot be avoided or changed in any way because it arises from a past
decision; irrelevant to future decisions.
Sunk cost
No further out-of-pocket cost/expense required regardless of future decison making,
cost/expenses that would continue even if the department/product/service were
eliminated.
Unavoidable costs/expenses