CHAPTER 2—FINANCIAL STATEMENTS, CASH FLOW, AND TAXES
TRUE/FALSE
1. The annual report contains four basic financial statements: the income statement, balance sheet,
statement of cash flows, and statement of stockholders’ equity.
2. The primary reason the annual report is important in finance is that it is used by investors when they
form expectations about the firm’s future earnings and dividends, and the riskiness of those cash flows.
3. Consider the balance sheet of Wilkes Industries as shown below. Because Wilkes has $800,000 of
retained earnings, the company would be able to pay cash to buy an asset with a cost of $200,000.
Cash
$ 50,000
Accounts payable
$ 100,000
Inventory
200,000
Accruals
100,000
Accounts receivable
250,000
Total CL
$ 200,000
Total CA
$ 500,000
Debt
200,000
Net fixed assets
$ 900,000
Common stock
200,000
_________
Retained earnings
800,000
Total assets
$1,400,000
Total L & E
$1,400,000
4. On the balance sheet, total assets must always equal total liabilities and equity.
5. Assets other than cash are expected to produce cash over time, but the amount of cash they eventually
produce could be higher or lower than the values at which these assets are carried on the books.
6. The income statement shows the difference between a firm’s income and its costs⎯i.e., its
profits⎯during a specified period of time. However, not all reported income comes in the form or
cash, and reported costs likewise may not correctly reflect cash outlays. Therefore, there may be a
substantial difference between a firm’s reported profits and its actual cash flow for the same period.
7. Net operating working capital is equal to operating current assets minus operating current liabilities.
8. Total net operating capital is equal to net fixed assets.
9. Net operating profit after taxes (NOPAT) is the amount of net income a company would generate from
its operations if it had no interest income or interest expense.
10. The fact that 70% of the interest income received by a corporation is excluded from its taxable income
encourages firms to use more debt financing than they would in the absence of this tax law provision.
11. If the tax laws were changed so that $0.50 out of every $1.00 of interest paid by a corporation was
allowed as a tax–deductible expense, this would probably encourage companies to use more debt
financing than they presently do, other things held constant.
12. The interest and dividends paid by a corporation are considered to be deductible operating expenses,
hence they decrease the firm’s tax liability.
13. The balance sheet is a financial statement that measures the flow of funds into and out of various
accounts over time, while the income statement measures the firm’s financial position at a point in
time.
14. Its retained earnings is the actual cash that the firm has generated through operations less the cash that
has been paid out to stockholders as dividends. Retained earnings are kept in cash or near cash
accounts and, thus, these cash accounts, when added together, will always be equal to the firm’s total
retained earnings.
15. The retained earnings account on the balance sheet does not represent cash. Rather, it represents part of
stockholders’ claims against the firm’s existing assets. This implies that retained earnings are in fact
stockholders’ reinvested earnings.
16. In accounting, emphasis is placed on determining net income in accordance with generally accepted
accounting principles. In finance, the primary emphasis is also on net income because that is what
investors use to value the firm. However, a secondary financial consideration is cash flow, because
cash is needed to operate the business.
17. To estimate the cash flow from operations, depreciation must be added back to net income because it
is a non-cash charge that has been deducted from revenue.
18. The current cash flow from existing assets is highly relevant to the investor. However, since the value
of the firm depends primarily upon its growth opportunities, profit projections from those
opportunities are the only relevant future flows with which investors are concerned.
19. Interest paid by a corporation is a tax deduction for the paying corporation, but dividends paid are not
deductible. This treatment, other things held constant, tends to encourage the use of debt financing by
corporations.
20. The time dimension is important in financial statement analysis. The balance sheet shows the firm’s
financial position at a given point in time, the income statement shows results over a period of time,
and the statement of cash flows reflects changes in the firm’s accounts over that period of time.
MULTIPLE CHOICE
21. Which of the following statements is CORRECT?
a.
The statement of cash needs tells us how much cash the firm will require during some
future period, generally a month or a year.
b.
The four most important financial statements provided in the annual report are the balance
sheet, income statement, cash budget, and the statement of stockholders’ equity.
c.
The balance sheet gives us a picture of the firm’s financial position at a point in time.
d.
The income statement gives us a picture of the firm’s financial position at a point in time.
e.
The statement of cash flows tells us how much cash the firm has in the form of currency
and demand deposits.
22. Which of the following statements is CORRECT?
a.
A typical industrial company’s balance sheet lists the firm’s assets that will be converted to
cash first, and then goes on down to list the firm’s longest lived assets last.
b.
The balance sheet for a given year, say 2012, is designed to give us an idea of what
happened to the firm during that year.
c.
The balance sheet for a given year, say 2012, tells us how much money the company
earned during that year.
d.
The difference between the total assets reported on the balance sheet and the debts
reported on this statement tells us the current market value of the stockholders’ equity,
assuming the statements are prepared in accordance with generally accepted accounting
principles (GAAP).
e.
For most companies, the market value of the stock equals the book value of the stock as
reported on the balance sheet.
23. Other things held constant, which of the following actions would increase the amount of cash on a
company’s balance sheet?
a.
The company purchases a new piece of equipment.
b.
The company repurchases common stock.
c.
The company pays a dividend.
d.
The company issues new common stock.
e.
The company gives customers more time to pay their bills.
24. Which of the following items is NOT included in current assets?
a.
Short-term, highly liquid, marketable securities.
b.
Accounts receivable.
c.
Inventory.
d.
Bonds.
e.
Cash.
25. Which of the following items cannot be found on a firm’s balance sheet under current liabilities?
a.
Accrued payroll taxes.
b.
Accounts payable.
c.
Short-term notes payable to the bank.
d.
Accrued wages.
e.
Cost of goods sold.
26. Which of the following statements is CORRECT?
a.
The income statement for a given year, say 2012, is designed to give us an idea of how
much the firm earned during that year.
b.
The focal point of the income statement is the cash account, because that account cannot
be manipulated by “accounting tricks.”
c.
The reported income of two otherwise identical firms cannot be manipulated by different
accounting procedures provided the firms follow Generally Accepted Accounting
Principles (GAAP).
d.
The reported income of two otherwise identical firms must be identical if the firms are
publicly owned, provided they follow procedures that are permitted by the Securities and
Exchange Commission (SEC).
e.
If a firm follows Generally Accepted Accounting Principles (GAAP), then its reported net
income will be identical to its reported net cash flow.
27. Below are the year-end balance sheets for Wolken Enterprises:
Assets:
2013
2012
Cash
$ 200,000
$ 170,000
Accounts receivable
864,000
700,000
Inventories
2,000,000
1,400,000
Total current assets
$3,064,000
$2,270,000
Net fixed assets
6,000,000
5,600,000
Total assets
$9,064,000
$7,870,000
Liabilities and equity:
Accounts payable
$1,400,000
$1,090,000
Notes payable
1,600,000
1,800,000
Total current liabilities
$3,000,000
$2,890,000
Long-term debt
2,400,000
2,400,000
Common stock
3,000,000
2,000,000
Retained earnings
664,000
580,000
Total common equity
$3,664,000
$2,580,000
Total liabilities and equity
$9,064,000
$7,870,000
Wolken has never paid a dividend on its common stock, and it issued $2,400,000 of 10-year non-
callable, long-term debt in 2012. As of the end of 2013, none of the principal on this debt had been
repaid. Assume that the company’s sales in 2012 and 2013 were the same. Which of the following
statements must be CORRECT?
a.
Wolken increased its short-term bank debt in 2013.
b.
Wolken issued long-term debt in 2013.
c.
Wolken issued new common stock in 2013.
d.
Wolken repurchased some common stock in 2013.
e.
Wolken had negative net income in 2013.
28. On its 2012 balance sheet, Barngrover Books showed $510 million of retained earnings, and exactly
that same amount was shown the following year in 2013. Assuming that no earnings restatements were
issued, which of the following statements is CORRECT?
a.
Dividends could have been paid in 2013, but they would have had to equal the earnings for
the year.
b.
If the company lost money in 2013, they must have paid dividends.
c.
The company must have had zero net income in 2013.
d.
The company must have paid out half of its earnings as dividends.
e.
The company must have paid no dividends in 2013.
29. Below is the common equity section (in millions) of Fethe Industries’ last two year-end balance sheets:
2012
2011
Common stock
$2,000
$1,000
Retained earnings
2,000
2,340
Total common equity
$4,000
$3,340
The company has never paid a dividend to its common stockholders. Which of the following
statements is CORRECT?
a.
The company’s net income in 2011 was higher than in 2012.
b.
The company issued common stock in 2012.
c.
The market price of the company’s stock doubled in 2012.
d.
The company had positive net income in both 2011 and 2012, but the company’s net
income in 2009 was lower than it was in 2011.
e.
The company has more equity than debt on its balance sheet.
30. Which of the following statements is CORRECT?
a.
The more depreciation a firm has in a given year, the higher its EPS, other things held
constant.
b.
Typically, a firm’s DPS should exceed its EPS.
c.
Typically, a firm’s EBIT should exceed its EBITDA.
d.
If a firm is more profitable than average (e.g., Google), we would normally expect to see
its stock price exceed its book value per share.
e.
If a firm is more profitable than most other firms, we would normally expect to see its
book value per share exceed its stock price, especially after several years of high inflation.
31. Which of the following statements is CORRECT?
a.
Depreciation and amortization are not cash charges, so neither of them has an effect on a
firm’s reported profits.
b.
The more depreciation a firm reports, the higher its tax bill, other things held constant.
c.
People sometimes talk about the firm’s net cash flow, which is shown as the lowest entry
on the income statement, hence it is often called “the bottom line.”
d.
Depreciation reduces a firm’s cash balance, so an increase in depreciation would normally
lead to a reduction in the firm’s net cash flow.
e.
Net cash flow (NCF) is often defined as follows:
Net Cash Flow = Net Income + Depreciation and Amortization Charges.
32. Which of the following would be most likely to occur in the year after Congress, in an effort to
increase tax revenue, passed legislation that forced companies to depreciate equipment over longer
lives? Assume that sales, other operating costs, and tax rates are not affected, and assume that the same
depreciation method is used for tax and stockholder reporting purposes.
a.
Companies’ reported net incomes would decline.
b.
Companies’ net operating profits after taxes (NOPAT) would decline.
c.
Companies’ physical stocks of fixed assets would increase.
d.
Companies’ net cash flows would increase.
e.
Companies’ cash positions would decline.
33. Which of the following factors could explain why Regal Industrial Fixtures had a negative net cash
flow last year, even though the cash on its balance sheet increased?
a.
The company repurchased 20% of its common stock.
b.
The company sold a new issue of bonds.
c.
The company made a large investment in new plant and equipment.
d.
The company paid a large dividend.
e.
The company had high amortization expenses.
34. Analysts following Armstrong Products recently noted that the company’s operating net cash flow
increased over the prior year, yet cash as reported on the balance sheet decreased. Which of the
following factors could explain this situation?
a.
The company issued new long-term debt.
b.
The company cut its dividend.
c.
The company made a large investment in a profitable new plant.
d.
The company sold a division and received cash in return.
e.
The company issued new common stock.
35. A security analyst obtained the following information from Prestopino Products’ financial statements:
•
Retained earnings at the end of 2011 were $700,000, but retained earnings at the end of
2012 had declined to $320,000.
•
The company does not pay dividends.
•
The company’s depreciation expense is its only non-cash expense; it has no amortization
charges.
•
The company has no non-cash revenues.
•
The company’s net cash flow (NCF) for 2012 was $150,000.
On the basis of this information, which of the following statements is CORRECT?
a.
Prestopino had negative net income in 2012.
b.
Prestopino’s depreciation expense in 2012 was less than $150,000.
c.
Prestopino had positive net income in 2012, but its income was less than its 2011 income.
d.
Prestopino’s NCF in 2012 must be higher than its NCF in 2011.
e.
Prestopino’s cash on the balance sheet at the end of 2012 must be lower than the cash it
had on the balance sheet at the end of 2011.
36. Aubey Aircraft recently announced that its net income increased sharply from the previous year, yet its
net cash flow from operations declined. Which of the following could explain this performance?
a.
The company’s operating income declined.
b.
The company’s expenditures on fixed assets declined.
c.
The company’s cost of goods sold increased.
d.
The company’s depreciation and amortization expenses declined.
e.
The company’s interest expense increased.
37. Which of the following statements is CORRECT?
a.
The statement of cash flows shows how much the firm’s cash⎯the total of currency, bank
deposits, and short-term liquid securities (or cash equivalents)⎯increased or decreased
during a given year.
b.
The statement of cash flows reflects cash flows from operations, but it does not reflect the
effects of buying or selling fixed assets.
c.
The statement of cash flows shows where the firm’s cash is located; indeed, it provides a
listing of all banks and brokerage houses where cash is on deposit.
d.
The statement of cash flows reflects cash flows from continuing operations, but it does not
reflect the effects of changes in working capital.
e.
The statement of cash flows reflects cash flows from operations and from borrowings, but
it does not reflect cash obtained by selling new common stock.
38. Which of the following statements is CORRECT?
a.
In the statement of cash flows, a decrease in accounts receivable is reported as a use of
cash.
b.
Dividends do not show up in the statement of cash flows because dividends are considered
to be a financing activity, not an operating activity.
c.
In the statement of cash flows, a decrease in accounts payable is reported as a use of cash.
d.
In the statement of cash flows, depreciation charges are reported as a use of cash.
e.
In the statement of cash flows, a decrease in inventories is reported as a use of cash.
39. For managerial purposes, i.e., making decisions regarding the firm’s operations, the standard financial
statements as prepared by accountants under Generally Accepted Accounting Principles (GAAP) are
often modified and used to create alternative data and metrics that provide a somewhat different
picture of a firm’s operations. Related to these modifications, which of the following statements is
CORRECT?
a.
The standard statements make adjustments to reflect the effects of inflation on asset
values, and these adjustments are normally carried into any adjustment that managers
make to the standard statements.
b.
The standard statements focus on accounting income for the entire corporation, not cash
flows, and the two can be quite different during any given accounting period. However,
for valuation purposes we need to discount cash flows, not accounting income. Moreover,
since many firms have a number of separate divisions, and since division managers should
be compensated on their divisions’ performance, not that of the entire firm, information
that focuses on the divisions is needed. These factors have led to the development of
information that is focused on cash flows and the operations of individual units.
c.
The standard statements provide useful information on the firm’s individual operating
units, but management needs more information on the firm’s overall operations than the
standard statements provide.
d.
The standard statements focus on cash flows, but managers are less concerned with cash
flows than with accounting income as defined by GAAP.
e.
The best feature of standard statements is that, if they are prepared under GAAP, the data
are always consistent from firm to firm. Thus, under GAAP, there is no room for
accountants to “adjust” the results to make earnings look better.
40. Which of the following statements is CORRECT?
a.
Net cash flow (NCF) is defined as follows:
NCF = Net income – Depreciation and Amortization.
b.
Changes in working capital have no effect on free cash flow.
c.
Free cash flow (FCF) is defined as follows:
FCF = EBIT(1 − T)
+ Depreciation and Amortization
− Capital expenditures required to sustain operations
− Required changes in net operating working capital.
d.
Free cash flow (FCF) is defined as follows:
FCF = EBIT(1 − T)+ Depreciation and Amortization + Capital expenditures.
e.
Net cash flow is the same as free cash flow (FCF).
41. Which of the following statements is CORRECT?
a.
The primary difference between EVA and accounting net income is that when net income
is calculated, a deduction is made to account for the cost of common equity, whereas EVA
represents net income before deducting the cost of the equity capital the firm uses.
b.
MVA gives us an idea about how much value a firm’s management has added during the
last year.
c.
MVA stands for market value added, and it is defined as follows:
MVA = (Shares outstanding)(Stock price) + Book value of common equity.
d.
EVA stands for economic value added, and it is defined as follows:
EVA = EBIT(1 − T) − (Investor-supplied op. capital) (A − T cost of capital).
e.
EVA gives us an idea about how much value a firm’s management has added over the
firm’s life.
42. Which of the following statements is CORRECT?
a.
The maximum federal tax rate on personal income in 2010 was 50%.
b.
Since companies can deduct dividends paid but not interest paid, our tax system favors the
use of equity financing over debt financing, and this causes companies’ debt ratios to be
lower than they would be if interest and dividends were both deductible.
c.
Interest paid to an individual is counted as income for tax purposes and taxed at the
individual’s regular tax rate, which in 2010 could go up to 35%, but dividends received
were taxed at a maximum rate of 15%.
d.
The maximum federal tax rate on corporate income in 2010 was 50%.
e.
Corporations obtain capital for use in their operations by borrowing and by raising equity
capital, either by selling new common stock or by retaining earnings. The cost of debt
capital is the interest paid on the debt, and the cost of the equity is the dividends paid on
the stock. Both of these costs are deductible from income when calculating income for tax
purposes.
43. Which of the following statements is CORRECT?
a.
All corporations other than non-profit corporations are subject to corporate income taxes,
which are 15% for the lowest amounts of income and 35% for the highest amounts of
income.
b.
The income of certain small corporations that qualify under the Tax Code is completely
exempt from corporate income taxes. Thus, the federal government receives no tax
revenue from these businesses.
c.
All businesses, regardless of their legal form of organization, are taxed under the Business
Tax Provisions of the Internal Revenue Code.
d.
Small businesses that qualify under the Tax Code can elect not to pay corporate taxes, but
then their owners must report their pro rata shares of the firm’s income as personal income
and pay taxes on that income.
e.
Congress recently changed the tax laws to make dividend income received by individuals
exempt from income taxes. Prior to the enactment of that law, corporate income was
subject to double taxation, where the firm was first taxed on the income and stockholders
were taxed again on the income when it was paid to them as dividends.
44. Danielle’s Sushi Shop last year had (1) a negative net cash flow from operations, (2) a negative free
cash flow, and (3) an increase in cash as reported on its balance sheet. Which of the following factors
could explain this situation?
a.
The company had a sharp increase in its depreciation and amortization expenses.
b.
The company had a sharp increase in its inventories.
c.
The company had a sharp increase in its accrued liabilities.
d.
The company sold a new issue of common stock.
e.
The company made a large capital investment early in the year.
45. Assume that Congress recently passed a provision that will enable Barton’s Rare Books (BRB) to
double its depreciation expense for the upcoming year but will have no effect on its sales revenue or
tax rate. Prior to the new provision, BRB’s net income after taxes was forecasted to be $4 million.
Which of the following best describes the impact of the new provision on BRB‘s financial statements
versus the statements without the provision? Assume that the company uses the same depreciation
method for tax and stockholder reporting purposes.
a.
Net fixed assets on the balance sheet will decrease.
b.
The provision will reduce the company’s net cash flow.
c.
The provision will increase the company’s tax payments.
d.
Net fixed assets on the balance sheet will increase.
e.
The provision will increase the company’s net income.
46. The LeMond Corporation just purchased a new production line. Assume that the firm planned to
depreciate the equipment over 5 years on a straight-line basis, but Congress then passed a provision
that requires the company to depreciate the equipment on a straight-line basis over 7 years. Other
things held constant, which of the following will occur as a result of this Congressional action?
Assume that the company uses the same depreciation method for tax and stockholder reporting
purposes.
a.
LeMond’s tax liability for the year will be lower.
b.
LeMond’s taxable income will be lower.
c.
LeMond’s net fixed assets as shown on the balance sheet will be higher at the end of the
year.
d.
LeMond’s cash position will improve (increase).
e.
LeMond’s reported net income after taxes for the year will be lower.
47. Lucy’s Music Emporium opened its doors on January 1, 2012, and it was granted permission to use the
same depreciation calculations for shareholder reporting and income tax purposes. The company
planned to depreciate its fixed assets over 20 years, but in December 2012 management realized that
the assets would last for only 15 years. The firm’s accountants plan to report the 2012 financial
statements based on this new information. How would the new depreciation assumption affect the
company’s financial statements?
a.
The firm’s net liabilities would increase.
b.
The firm’s reported net fixed assets would increase.
c.
The firm’s EBIT would increase.
d.
The firm’s reported 2012 earnings per share would increase.
e.
The firm’s cash position in 2012 and 2013 would increase.
48. DeYoung Devices Inc., a new high-tech instrumentation firm, is building and equipping a new
manufacturing facility. Assume that currently its equipment must be depreciated on a straight-line
basis over 10 years, but Congress is considering legislation that would require the firm to depreciate
the equipment over 7 years. If the legislation becomes law, which of the following would occur in the
year following the change?
a.
The firm’s reported net income would increase.
b.
The firm’s operating income (EBIT) would increase.
c.
The firm’s taxable income would increase.
d.
The firm’s net cash flow would increase.
e.
The firm’s tax payments would increase.
49. Which of the following statements is CORRECT?
a.
If a company pays more in dividends than it generates in net income, its retained earnings
as reported on the balance sheet will decline from the previous year’s balance.
b.
Dividends paid reduce the net income that is reported on a company’s income statement.
c.
If a company uses some of its bank deposits to buy short-term, highly liquid marketable
securities, this will cause a decline in its current assets as shown on the balance sheet.
d.
If a company issues new long-term bonds during the current year, this will increase its
reported current liabilities at the end of the year.
e.
Accounts receivable are reported as a current liability on the balance sheet.
50. Which of the following statements is CORRECT?
a.
One way to increase EVA is to achieve the same level of operating income but with more
investor-supplied capital.
b.
If a firm reports positive net income, its EVA must also be positive.
c.
One drawback of EVA as a performance measure is that it mistakenly assumes that equity
capital is free.
d.
One way to increase EVA is to generate the same level of operating income but with less
investor-supplied capital.
e.
Actions that increase reported net income will always increase net cash flow.
51. Which of the following statements is CORRECT?
a.
If a firm reports a loss on its income statement, then the retained earnings account as
shown on the balance sheet will be negative.
b.
Since depreciation is a source of funds, the more depreciation a company has, the larger its
retained earnings will be, other things held constant.
c.
A firm can show a large amount of retained earnings on its balance sheet yet need to
borrow cash to make required payments.
d.
Common equity includes common stock and retained earnings, less accumulated
depreciation.
e.
The retained earnings account as shown on the balance sheet shows the amount of cash
that is available for paying dividends.
52. Olivia Hardison, CFO of Impact United Athletic Designs, plans to have the company issue $500
million of new common stock and use the proceeds to pay off some of its outstanding bonds. Assume
that the company, which does not pay any dividends, takes this action, and that total assets, operating
income (EBIT), and its tax rate all remain constant. Which of the following would occur?
a.
The company would have to pay less taxes.
b.
The company’s taxable income would fall.
c.
The company’s interest expense would remain constant.
d.
The company would have less common equity than before.
e.
The company’s net income would increase.
53. Jessie’s Bobcat Rentals’ operations provided a negative net cash flow last year, yet the cash shown on
its balance sheet increased. Which of the following statements could explain the increase in cash,
assuming the company’s financial statements were prepared under generally accepted accounting
principles?