Chapter 1
True-False
1. A basic understanding of financial statements is needed due to ongoing
financial turmoil and major corporate failures.
2. The SEC requires all companies, both public and private, to file annually a
Form 10-K report.
3. Financial statements are currently prepared according to generally accepted
accounting principles in the U.S.
4. The FASB was given Congressional authority to write accounting rules.
5. The goal of the International Accounting Standards Board is the adoption of
uniform international accounting standards.
6. In 2006, the IASB and the FASB agreed to work on all major projects jointly.
7. Annual reports of public companies can only be found on the SEC’s EDGAR
database.
8. A corporate annual report contains three basic financial statements.
9. The notes to financial statements, while helpful, are not an integral part of the
statements.
10. Management is responsible for the preparation of the financial statements,
including the notes, and the auditor’s report attests to the fairness of the
presentation.
11. The Sarbanes-Oxley Act eliminated the need for internal auditors.
12. An unqualified auditor’s report states that the financial statements present
fairly the financial position, results of operation, and the cash flows of the entity.
13. The Sarbanes-Oxley Act of 2002 requires all members of management as well
as directors to certify the accuracy of the financial statements.
14. Despite the enactment of the Sarbanes-Oxley Act of 2002, corruption and
unethical behavior continued in the 2000s.
15. The management discussion and analysis is of potential interest to the analyst
because it contains information that cannot be found in the financial data.
16. The management discussion and analysis should contain a discussion of the
commitments for capital expenditures, the purpose of such commitments, and
expected sources of funding.
17. The shareholders‘ letter from the CEO of a firm offers factual information
needed to analyze the financial statements.
18. The proxy statement offers information about such items as corporate
governance, audit-related matters, directors and executive compensation, and
related party transactions.
19. Publicity in the media can impact a firm’s financial performance.
20. Conglomerates operating in diversified lines of business are required to create
separate annual reports for each line of business.
21. Accounting choices and estimates rarely have a significant impact on financial
statement numbers.
22. The accrual basis of accounting means that revenues are recognized when the
sale is made rather than when cash is received.
23. United States accounting rules have been perceived as being less complex than
international standards.
24. The matching principle requires that expenses be matched with the generation
of revenues in order to determine net income for an accounting period.
25. Examples of discretionary items include repairs and maintenance, research and
development and advertising.
Multiple Choice
1. Which report is not required to be filed by public companies to the SEC?
a. Annual reports (Form 10-K).
b. Financial Reporting Rulings.
c. A prospectus for any new security offering.
d. Quarterly reports (From 10-Q).
2. The globalization of business activity has resulted in which of the following?
a. Increased corruption and unethical behavior.
b. A uniform set of accounting rules in all countries.
c. The FASB and IASB working jointly on a project to converge accounting
standards.
d. The requirement that U.S. firms use international accounting rules as of
2006.
3. What basic financial statements can be found in a corporate annual report?
a. Balance sheet, income statement, statement of shareholders’ equity, and
statement of cash flows.
b. Balance sheet, auditor’s report and income statement.
c. Earnings statement and statement of retained earnings.
d. Statement of cash flows and five-year summary of key financial data.
4. What information can be found on a balance sheet?
a. Information to support that assets equal liabilities.
b. The profit or loss for the accounting period.
c. The reasons for changes in the cash account.
d. The financial position on a particular date; i.e. assets, liabilities and
shareholders’ equity.
5. What information can be found on an income statement?
a. The financing and investing activities during an accounting period.
b. Cash inflows and cash outflows.
c. A reconciliation of the beginning and ending balances of all revenue
accounts.
d. Revenues, expenditures, net profit or loss and net profit or loss per share.
6. What information can be found on a statement of stockholders’ equity?
a. A reconciliation of the cash account and the retained earnings account.
b. A reconciliation of the beginning and ending balances of all accounts that
appear in the stockholders’ equity section of the balance sheet.
c. A reconciliation of the operating, investing and financing activities of a
firm.
d. A reconciliation of net profit or loss and the cash account.
7. What item is not included in the notes to the financial statements?
a. Details about inventory and property, plant and equipment.
b. Information about major acquisitions or divestitutures.
c. The management discussion and analysis.
d. A summary of the firm’s accounting policies.
8. What type of audit report indicates that the financial statements have not been
presented fairly?
a. A disclaimer of opinion.
b. An unqualified report.
c. A qualified report.
d. An adverse opinion.
9. What type of audit report indicates that the financial statements have been
presented fairly?
a. An unqualified report.
b. A disclaimer of opinion.
c. A qualified report.
d. An adverse opinion.
10. What does Section 404 of the Sarbanes-Oxley Act of 2002 require?
a. The external auditors must create an adequate internal control structure for
the firm being audited.
b. The external auditors must approve of all internal auditors hired by a firm.
c. The inclusion of an internal control report in the annual report.
d. The external auditors need to perform internal audit services.
11. Why does the management discussion and analysis help the analyst?
a. It contains information that cannot be found in the financial data.
b. It provides predictions of all future financial statement numbers.
c. It outlines the accounting choices made by the firm.
d. It explains the market valuation of the firm’s stock.
12. Which of the following items would not be discussed in the management
discussion and analysis?
a. Commitments for capital expenditures.
b. The market value of all assets.
c. The internal and external sources of liquidity.
d. A breakdown of sales increases into price and volume components.
13. What item is probably the least useful when analyzing financial statements?
a. Management discussion and analysis.
b. The notes to the financial statements.
c. The statement of cash flows.
d. Public relations materials.
14. What document is required by the SEC to solicit shareholder votes?
a. Proxy statement.
b. Five-year summary.
c. Shareholders’ letter.
d. Prospectus.
15. What types of information cannot be found in the financial statements?
a. Details about officer and employee retirement, pension, and stock option
plans.
b. Pending legal proceedings.
c. Reputation of the firm, morale of employees and prestige in the
community.
d. Disclosures about segments of an enterprise.
16. How are revenues and expenses recognized under the accrual basis of
accounting?
a. Revenues are recognized when cash is received and expenses are
recognized when cash is paid.
b. Revenues and expenses are recognized equally over a twelve month
period.
c. Revenues and expenses are recognized based on the choices of
management.
d. Revenues are recognized in the accounting period when the sale is made
and expenses are recognized in the period in which they relate to the sale of
the product.
17. Which of the following statements is true?
a. GAAP-based financial statements are prepared according to the “cash”
rather than the “accrual” basis of accounting.
b. Accounting choices and estimates can have a significant impact on the
outcome of financial statement numbers.
c. The accrual method means that the expense is recognized after the cash is
paid out.
d. The purpose of the accrual method is to attempt to “match” assets with
liabilities in appropriate accounting periods.
18. In what industries would it be expected that companies would spend a
significant amount on research and development activities?
a. Health.
b. Clothes retailer.
c. Auto.
d. Both (a) and (c).
19. Which of the following items is NOT discretionary in nature?
a. Union wages.
b. Repairs and maintenance.
c. Research and development.
d. Advertising.
20. Which of the following could be detrimental to a firm’s sales and earnings?
a. Using the matching principle when recording revenues and expenses.
b. Deferring repairs and maintenance on equipment.
c. Investing in research and development.
d. Increasing discretionary expenses.
For each of the following items indicate where you would most likely find the
information.
a. Balance sheet.
b. Income statement.
c. Statement of stockholders’ equity.
d. Statement of cash flows.
e. Notes to the financial statements.
f. Auditor’s report.
g. Management’s discussion and analysis.
21. Revenues.
22. Detailed information about the term, cost and maturity of debt.
23. Changes to the company’s equity accounts.
24. An unqualified opinion.
25. Assets.
26. Attestation to the fairness of financial statements.
27. Discussion of the company’s liquidity.
28. Cash inflows from investing activities.
29. A breakdown of sales increases into price and volume components.
30. Summary of significant accounting policies.
Short Answer
1. Write a short essay explaining the importance of financial statements and their
accompanying notes.
2. List and describe the four basic financial statements included in a corporate
annual report.
3. Discuss the similarities and differences between a company’s Form 10-K and an
annual report created especially to send to the stockholders.
4. Explain the importance of reading the notes to the financial statements.
5. Discuss the role of the SEC, the FASB, and the IASB.
6. Define the following terms related to the auditor’s report: unqualified, qualified,
adverse, and disclaimer of opinion.
7. According to the textbook “Internal auditors have become the ‘rock stars’ of the
accounting industry.” Explain what this means.
8. How did the Sarbanes-Oxley Act of 2002 change the regulatory model for
auditors?
9. Explain how Congress addressed the issue of auditor independence in the
Sarbanes-Oxley Act of 2002.
10. What regulations were included as part of the Sarbanes-Oxley Act of 2002 that
should encourage CEOs and CFOs to act ethically?
11. Explain what types of information can be learned from the management
discussion and analysis about liquidity? capital resources? operations?
12. What types of information are necessary to evaluate a company but cannot be
found in the financial statements?
13. How can management affect the quality of financial statements?
14. What are discretionary items and why are they important to the operating
success of a firm?
Solutions – Chapter 1
True-False
Multiple Choice
Short Answer
