BARUCH COLLEGE - CUNY
EMBA - INTRODUCTION TO FINANCIAL
ACCOUNTING
Professor Jan Sweeney – Fall 2003
TAKE HOME MIDTERM EXAM
1. The cash basis of accounting measures
revenues and expenses in terms of cash received or cash paid. The timing of
these payments determines the period in which revenues and expenses are
recorded. While such a basis appears simple and easy to follow, it unfortunately
provides a distorted picture of the company's true operating performance. Using
cash as the basis for accounting may delay the recording of revenue until cash
is actually received (but the effort and/or duties needed to earn the revenue
have already occurred). Management may also try to influence the amount and
timing of the revenues and expenses by receiving or spending cash when it would
appear to be most advantageous.
Accrual accounting attempts to recognize
revenue in the period when the effort and/or duties occur, not when the cash
moves. Likewise, accrual accounting attempts to match expenses to their
revenues (recording the related expenses in the same period as the revenues).
While accrual accounting is not without its own challenges (such as when the
efforts are actually made or estimates of returns are needed), it provides a
more accurate picture of a company's revenues and expenses.
2.
XYZ Company Income Statement For the Year Ended December 31, Year 2 |
||
|
|
Cash Flow |
Sales revenue, 75% on credit |
$200,000 |
$190,000 |
Accounts receivable
balance |
|
|
December
31, Year 1, $50,000 |
|
|
December
31, Year 2, $60,000 |
|
|
Cost of good sold, 100% on credit |
60,000 |
(63,000) |
Accounts payable
balance |
|
|
December
31, Year 1, $15,000 |
|
|
December
31, Year 2, $12,000 |
|
|
Expenses: |
|
|
Salaries and Wages |
26,000 |
25,900 |
Accrued
wages payable balance |
|
|
December
31, Year 1, $1,500 |
|
|
December
31, Year 2, $1,600 |
|
|
Depreciation expense |
2,500 |
0 |
Rent expense |
1,500 |
(1,500) |
No
accruals |
|
|
Income tax expense |
$ 5,500 |
$ (4,500) |
Taxes
payable balance |
|
|
December
31, Year 1, $1,000 |
|
|
December
31, Year 2, $2,000 |
|
|
Total expenses |
$ 35,500 |
|
Net income |
|
$104,500 |
Cash flow from operating activities |
|
$ 95,100 |
3.
a. |
Financing, increase |
b. |
Financing, decrease |
c. |
Operating, decrease |
d. |
No cash effect, added to net income
using the indirect method |
e. |
No cash effect |
4.
a. |
The calculation of selected financial
ratios for All-Things Inc. for the fiscal year Year 6 is as follows. |
|
|
|
Current ratio = Current assets / Current
liabilities =~ $9,900 / $6,300 = 1.57 |
|
|
|
Acid-test ratio = (Cash + Marketable
securities + Net receivables) / Current liabilities = ($400 + $500 + $3,200)
/ $6,300 = 0.65 |
|
|
|
Total asset turnover = Net sales /
Average total assets = $30,500 / ($17,000+$16,000)/2 = 1.85 times |
|
|
|
Inventory turnover = Cost of goods sold
/ Average inventory = $17,600 / ($5,800 + $5,400)/2 = 3.14 times |
|
|
|
Times interest earned = Income before
interest & taxes / Interest expense = ($7,060 + $900) / $900 = 8.84 |
|
|
|
Total debt to net worth = Total debt /
Total shareholders' equity = $8,300 / $8,700 = 0.95 |
|
|
|
Net profit margin = Net income / Net
sales = $4,160 / $30,500 = 13.64% |
b. |
The analytical use of each of the seven
ratios and what investors can learn about All-Things Inc.'s financial
stability and operating efficiency is presented below. |
|
Current ratio |
• |
Measures the ability to meet short-term
obligations using short-term assets. |
• |
All-Things' ratio has declined over the
last three years from 1.62 to 1.57. This declining trend, coupled with the
fact that it is below the industry average, is not yet a major concern;
however, the company should be watched in the future. |
|
Acid-test ratio |
• |
Measures the ability to meet short-term
debt using the most liquid (quick) assets; i.e., excluding the amount
invested in inventory. |
• |
All-Things has improved its acid-test
ratio over the last three years, but it is still below the industry average.
Furthermore, an acid-test ratio below 1.0 indicates that All-Things may have
difficulty meeting its short-term obligations if inventory does not turn over
fast enough. |
|
Total asset turnover |
• |
Measures the efficiency of resource use,
i.e., the ability to generate sales through the use of assets. This ratio can
be significantly affected by the depreciation method used by the company, as
well as the age of assets |
• |
All-Things has been steadily improving
and is slightly above the industry average. |
|
Inventory turnover |
• |
Measures how quickly inventory is sold
as well as how effectively investment in inventory is used and managed. This
ratio can be significantly affected by the inventory costing method used. |
• |
All-Things' ratio has been steadily
declining and is below the industry average. This slower than average
situation may indicate a decline in operating efficiency, hidden obsolete
inventory, or overpriced stock items. |
|
Times interest earned |
• |
Measures the ability to meet interest
commitments from current earnings. The higher the ratio, the more safety
there is for long-term creditors. |
• |
All-Things' ratio has been improving
over the last three years and is above the industry average. This indicates
that All-Things has been paying down or refinancing debt, or increasing sales
and profits, which is a sign of long-term stability. |
|
Total debt to net worth |
• |
Measures the level of protection
creditors have in the case of possible insolvency. Measures the degree of
financial leverage and whether or not the firm will be able to obtain
additional financing through borrowing. |
• |
All Things' ratio has deteriorated
slightly in Year 6, but has been below the industry average over the last
three years. This indicates that All-Things should be able to raise
additional financing through debt and still remain below the industry
average, indicating long-term stability. |
|
Net profit margin |
• |
Measures the net income generated by
each dollar of sales. The net profit margin ratio provides some indication of
the ability of the firm to absorb cost increases or sales declines. |
• |
All-Things' net profit margin has been
improving and is currently above the industry average. Furthermore, this
improving net profit margin indicates the ability of the firm to weather soft
economic periods, pay down debt, or take on additional debt for expansion. |
c. |
At least two limitations of ratio
analysis include the following. |
• |
It is often difficult to make
comparisons among firms within an industry due to accounting differences.
Different numbers can be shown in the financial statements for the same
economic event because of different accounting methods, such as straight-line
depreciation versus accelerated methods, LIFO versus FIFO inventory
valuations. etc. |
• |
Ratios represent conditions that existed
in the past, and may not be an indication of the future trend. |
5.
a. |
192,000 Dr. = 700,000 - 500,000 - 8,000 |
b. |
6,000 Cr. = (.02 ´ 700,000) - 8,000 |
c. |
19,000 = 10,000 + 9,000 |
d. |
16,000 = 6,000 + 10,000 |
e. |
676,000 = 192,000 + 800,000 - 16,000 -
300,000 |
f. |
291,000 = 300,000 - 9,000 |
6.
a. |
|
Year 7 |
Year 8 |
|
Sales revenue |
$2,400,000 |
$3,000,000 |
|
Cost of goods sold |
(1,440,000) |
(1,920,000) |
|
Gross profit |
$ 960,000 |
$1,080,000 |
|
Other expenses |
(240,000) |
(360,000) |
|
Net income before taxes |
$ 720,000 |
$ 720,000 |
|
Income tax expense |
(216,000) |
(216,000) |
|
Net income |
$ 504,000 |
$ 504,000 |
|
|
|
|
b. |
|
Year 7 |
Year 8 |
|
Sales revenue-Year 7 |
$1,620,000 |
$ 480,000 |
|
Sales revenue-Year 8 |
- |
2,040,000 |
|
Cost of goods sold-Year 7 |
$ (972,000) |
$ (288,000) |
|
Cost of goods sold-Year 8 |
- |
(1,305,600) |
|
Gross profit |
$ 648,000 |
$ 926,400 |
|
Other expenses |
(240,000) |
(360,000) |
|
Taxable income |
$ 408,000 |
$ 566,400 |
7.
a. |
An earthquake would be considered a
nonrecurring item peripheral to primary operating activities. The sale of an
operating division would be a nonrecurring item related to primary operating
activities. |
b. |
Companies separate these times for users
so that they can evaluate ongoing, normal activities separately from
activities that are not expected to reoccur. |