Chapter 3
True-False
1. The terms income, earnings, and profit are used interchangeably.
2. Earnings reported on the income statement is the same as cash generated during
the accounting period.
3. A multiple-step income statement presents several intermediate profit measures.
4. The common size income statement expresses each income statement item as a
percentage of net sales.
5. In general, higher quality earnings result when sales volume increases and sales
prices increase with inflation.
6. The FIFO method of inventory valuation generally results in the matching of
current costs and current revenues, especially during inflation.
7. Gross profit is equal to net sales plus cost of goods sold.
8. The gross profit margin and cost of goods sold percentage are complements of
each other and always add to 100%.
9. If the cost of goods sold percentage increases, this means that the cost to
acquire products has increased.
10. Sales volume changes in firms with high fixed costs will result in stable gross
profit margins.
11. Selling and administrative expenses include such items as advertising, salaries,
and interest expense.
12. The amount and trend of each operating expense should be evaluated as well
as its relationship to the volume of activity that is relevant to the expense.
13. Impairment charges are the expenses recognized to record a decline in value of
a long-term asset.
14. Gross profit margin does not impact operating profit margin.
15. Operating profit measures the overall performance of the company’s operations
separate from items that are not directly related to operations.
16. Since other income or expense items are not part of daily operations there is no
need to analyze these accounts.
17. The equity method of accounting should be used when the parent company
owns 100% of the voting stock in its subsidiaries.
18. Use of the equity method somewhat distorts earnings in the sense that income
is recognized even though no cash may ever be received.
19. The effective tax rate is calculated by dividing operating profit by income tax
expense.
20. Users of financial statements need to distinguish between earnings increasing
due to core operations versus items such as tax rate deductions.
21. Discontinued operations, extraordinary items, and gains or losses on sales of
plant assets are special items that must be disclosed separately on the income
statement.
22. Earnings per common share is the net cash available to common stockholders
for each share of stock owned.
23. Changes in the number of common stock shares outstanding will impact the
computation of earnings per share.
24. Total comprehensive income must now be disclosed on the face of the income
statement.
25. The statement of stockholders’ equity details the transactions that affect all
balance sheet accounts during an accounting period.
Multiple Choice
1. What can be found on an income statement?
a. Assets, revenues and expenses.
b. Revenues, expenses and net profit (loss).
c. Revenues, expenses, and stockholders’ equity.
d. Assets, liabilities and stockholders’ equity.
2. What are the two basic formats of the income statement?
a. Multiple-step and single-step.
b. Cash basis and single-step.
c. Accrual basis and single-step.
d. Accrual basis and multiple-step.
3. Which of the following is not an acceptable method to report total
comprehensive income?
a. On the face of the income statement.
b. In a separate statement of comprehensive income.
c. In the equity section of the balance sheet.
d. In the statement of stockholders’ equity.
4. Why is the common-size income statement valuable to the analyst?
a. The common-size income statement shows the relative magnitude of
revenues and expenses to total assets.
b. The common-size income statement allows the analyst to compare the
firm to itself from year-to-year, but not to its competitors.
c. The common-size income statement shows the relative magnitude of
revenues and expenses relative to profits.
d. The common-size income statement shows the relative magnitude of
expenses relative to net sales.
5. What could be the cause of an increase in a firm’s sales number?
a. The firm has decreased prices.
b. Fewer units of product have been sold.
c. The firm has increased prices and volume of sales.
d. The firm has decreased prices and volume of sales.
6. Which of the following statements is true?
a. Only service companies report both cost of goods sold and gross profit.
b. Cost of goods sold is the largest expense item for many firms.
c. Cost of goods sold is not affected by the choice of inventory valuation
method.
d. Cost of goods sold equals gross profit.
7. Of what value is the calculation of gross profit margin?
a. The gross profit margin helps the analyst assess the capital structure of the
firm.
b. The gross profit margin allows the analyst to determine if the firm has
been affected by inflation.
c. The gross profit margin indicates the profitability of a firm after
considering all operating expenses.
d. The gross profit margin is the first step of profit measurement indicating
how much profit the firm generates after deducting cost of goods sold.
8. When will volume changes cause volatility in the gross profit margin?
a. If cost of goods sold includes fixed costs which do not vary
proportionately with volume changes.
b. In industries with little capital.
c. In industries having no fixed costs.
d. If cost of goods sold includes costs that vary proportionately with volume
changes.
9. How should gross profit margin be analyzed for firms having more than one
revenue source?
a. The overall gross profit margin should be calculated for all revenue
sources.
b. Gross profit margin cannot be analyzed if a firm has multiple revenue
sources.
c. A separate gross profit margin for each revenue source should be
calculated.
d. The gross profit margins from each revenue source should be calculated
and then averaged.
10. Which items below would be classified as operating expenses?
a. Depreciation, capital leases, operating profit.
b. Interest expense, interest income, rent expense.
c. Accounts payable, lease payments, depreciation.
d. Advertising, selling and administrative, repairs and maintenance.
11. Which of the following statements is false?
a. It is important to analyze operating expenses over which management
exercises discretion and that have considerable impact on the firm’s
profitability.
b. Impairment charges do not need to be analyzed since they are generally a
non-recurring expense.
c. Operating expenses should be tracked in terms of trends, absolute
amounts, relationship to sales, and relationship to industry competitors.
d. Operating expenses can be easily analyzed by preparing a common-size
income statement.
12. What is another term frequently used when referring to operating profit?
a. Earnings before interest and taxes (EBIT).
b. Earnings before interest, taxes, depreciation and amortization (EBITDA).
c. Net profit.
d. Earnings before interest (EBI).
13. Which of the items below would be analyzed separate from operating profit?
a. Salaries, interest expense, equity losses.
b. Equity earnings, discontinued operations, interest income.
c. Research and development, dividend income, interest expense.
d. Advertising, cost of goods sold, selling and administrative expenses.
14. Which of the following statements is true?
a. Equity earnings is an internal source of cash.
b. Equity earnings are recorded when investment ownership is over 50%.
c. Equity earnings may never result in the actual receipt of cash.
d. Equity earnings are recorded when investment ownership is 100%.
15. How is it possible for a U.S. firm to have an effective tax rate that is less than
the U.S. federal statutory tax rate?
a. The firm has expenses that are not deductible for tax purposes.
b. Tax rates in foreign countries where the firm operates are higher.
c. Tax rates in foreign countries where the firm operates are lower.
d. It is not possible for a firm to have an effective tax rate different from the
U.S. federal statutory tax rate.
16. How is a firm’s average income tax rate calculated?
a. Income taxes divided by earnings before income taxes.
b. Income taxes divided by net income.
c. Income taxes divided by sales.
d. Income taxes divided by gross profit.
17. What is the required reporting for discontinued operations?
a. The results of discontinued operations should be reported as an
extraordinary item.
b. The gain or loss on the disposal should be reported in comprehensive
income.
c. The operating results of discontinued operations should be reported as
part of continuing operations and any gain or loss on disposal should be
disclosed separately from continuing operations.
d. The operating results of discontinued operations should be reported
separately from continuing operations and any gain or loss on disposal
should be also be disclosed separately from continuing operations.
18. What information can be found on a statement of shareholders’ equity?
a. Details of assets and liabilities.
b. A reconciliation of beginning to ending cash..
c. Detail of changes in equity accounts.
d. Assets = Liabilities + Stockholders’ Equity.
Use the following information for Gray Co. to answer questions 19 and 20.
2011 2010
Sales 400 400
COGS 250 200
Operating expenses 80 70
Income taxes 22 40
19. Gray Co.’s gross profit, operating profit and net profit margins for 2011 are:
a. 50.0%, 32.5%, 22.5% respectively.
b. 37.5%, 17.5%, 12.0%, respectively.
c. 62.5%, 50.0%, 22.5%, respectively.
d. 62.5%, 17.5%, 12.0%, respectively.
20. Gray Co.’s average tax rates for 2011 and 2010 are:
a. 5.5% and 10.0%
b. 27.5% and 57.1%
c. 45.8% and 44.4%.
d. 31.4% and 30.8%.
In which section of the income statement should the following items be classified?
a. Net sales.
b. Operating expenses.
c. Other revenue/expense.
d. Special items.
21. Salaries expense.
22. Revenues.
23. Marketing expenses.
24. Discontinued operations.
25. Interest expense.
26. Interest income.
27. Sales returns.
28. Extraordinary gain.
29. Depreciation expense.
30. Research and development.
Short Answer/Problem
1. Explain the differences between the multiple-step and single-step format of the
income statement. Which format is best for analysis? Why?
2. What items should the analyst assess when analyzing the trend of a firm’s sales
number?
3. Explain what would cause the gross profit margin to increase or decrease in a
firm.
4. Discuss the importance of analyzing operating expense categories such as
repairs and maintenance, advertising, and research and development.
5. Explain the possible reasons for net profit margin to decrease if operating profit
margin is stable.
6. Explain how a firm should account for an investment in another firm’s common
stock if the amount owned is:
a. 1 percent.
b. 35 percent.
c. 60 percent.
7. What would cause the basic earnings per common share amount to increase or
decrease?
8. What is comprehensive income?
9. Prepare a multiple-step income statement for ABC Company from the
following data:
Cost of goods sold $450
Interest expense 30
Depreciation expense 120
Net sales 990
Interest income 80
Income tax expense 70
Advertising expense 100
General and administrative expenses 150
10. Prepare an income statement using the following information:
Gross profit margin 42%
Cost of goods sold $5,800
Tax rate 30%
Operating profit $600
11. Using the following information prepare a common size income statement:
Net sales $1,000
Cost of goods sold 600
Gross profit $ 400
General and administrative expenses 250
Selling expenses 120
Operating profit $ 30
Income tax expense 10
Net profit $ 20
12. The following information is available for Brown Theater Company. Analyze
the gross profit margin making any calculations deemed necessary.
2012 2011 2010
Movie ticket sales $ 500 $ 450 $420
Concession sales 800 600 500
Total sales $1,300 $1,050 $920
Movie rental expense 480 400 380
Cost of concession products 350 300 280
Gross profit $ 470 $ 350 $260
13. Explain the possible causes of the trends in the following data:
Year 1
Year 2
Year 3
Gross profit margin
45%
41%
38%
Operating profit margin
12%
14%
15%
Net profit margin
5%
20%
8%
14. Use the following information to analyze the PQ Company. Calculate any
profit measures deemed necessary in order to discuss the profitability of the
company.
PQ Company Income Statements
For the Years Ended Dec. 31, 2012 and 2011
2012 2011
Net sales $174,000 $167,000
COGS 114,000 115,000
Gross profit $ 60,000 $ 52,000
General and administrative expenses 54,000 46,000
Operating profit $ 6,000 $ 6,000
Interest expense (1,000) (1,000)
Earnings before taxes $ 5,000 $ 5,000
Income taxes 2,000 2,000
Net income $ 3,000 $ 3,000
15. Bright Company purchased 20% of the voting common stock of Bulb
Company on January 1 and paid $400,000 for the investment. Bulb Company
reported earnings of $300,000 for the fiscal year ended December 31. Cash
dividends were paid during the year in the amount of $20,000.
a. Calculate the investment income and the ending balance in the investment
account on the balance sheet for Bright Company on December 31 using the cost
method.
b. Calculate the investment income and the ending balance in the investment
account on the balance sheet for Bright Company on December 31 using the equity
method.
16. Analyze the common size income statements below for Key Company:
(in percent)
2011
Net sales
100
COGS
52
Gross margin
48
Research and development
8
Selling, general and administrative
27
Restructuring, asset impairments and other charges
1
Income/(loss) from operations
12
Interest expense
(1)
Income/(loss) before taxes
11
Provision for/(benefit from) income taxes
5
Net income/(loss)
6
17. Analyze the common size income statements below for Toby Company:
2011
Net sales
100%
COGS
63
Gross margin
37%
Research and development
20
Selling, general and administrative
9
Restructuring, asset impairments and other charges
8
Income/(loss) from operations
0%
Interest expense
(2)
Income/(loss) before taxes
(2%)
Provision for/(benefit from) income taxes
0
Net income/(loss)
(2)%
Sales growth
80%
Operating cost growth
31%
Solutions – Chapter 3
True-False
Multiple Choice
Short Answer/Problem