Chapter 02: Financial Statements, Cash Flow, and Taxes
1. The annual report contains four basic financial statements: the income statement, balance sheet, statement of cash
flows, and statement of stockholders’ equity.
a. True
b. False
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.
a. True
b. False
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
a. True
b. False
Chapter 02: Financial Statements, Cash Flow, and Taxes
4. On the balance sheet, total assets must always equal total liabilities and equity.
a. True
b. False
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.
a. True
b. False
6. Which of the following statements is CORRECT?
Chapter 02: Financial Statements, Cash Flow, and Taxes
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 is designed to give us an idea of what happened to the firm during that year.
c. The balance sheet for a given year 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.
7. 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.
8. Which of the following items is NOT included in current assets?
a. Short-term, highly liquid, marketable securities.
b. Accounts receivable.
c. Inventory.
Chapter 02: Financial Statements, Cash Flow, and Taxes
d. Bonds.
e. Cash.
9. 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.
10. Below are the year-end balance sheets for Wolken Enterprises:
Assets: 2020 2019
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
Chapter 02: Financial Statements, Cash Flow, and Taxes
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 2019. As of the end of 2020, none of the principal on this debt had been repaid. Assume that the company’s sales in
2019 and 2020 were the same. Which of the following statements must be CORRECT?
a. Wolken increased its short-term bank debt in 2020.
b. Wolken issued long-term debt in 2020.
c. Wolken issued new common stock in 2020.
d. Wolken repurchased some common stock in 2020.
e. Wolken had negative net income in 2020.
11. On its 2019 balance sheet, Barngrover Books showed $510 million of retained earnings, and exactly that same amount
was shown the following year in 2020. Assuming that no earnings restatements were issued, which of the following
statements is CORRECT?
a. Dividends could have been paid in 2020, but they would have had to equal the earnings for the year.
b. If the company lost money in 2020, they must have paid dividends.
c. The company must have had zero net income in 2020.
d. The company must have paid out half of its earnings as dividends.
e. The company must have paid no dividends in 2020.
Chapter 02: Financial Statements, Cash Flow, and Taxes
12. Below is the common equity section (in millions) of Fethe Industries’ last two year-end balance sheets:
2020 2019
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 2019 was higher than in 2020.
b. The company issued common stock in 2020.
c. The market price of the company’s stock doubled in 2020.
d. The company had positive net income in both 2019 and 2020, but the company’s net income in 2019 was lower
than it was in 2020.
e. The company has more equity than debt on its balance sheet.
13. Tucker Electronic System’s current balance sheet shows total common equity of $3,125,000. The company has
125,000 shares of stock outstanding, and they sell at a price of $52.50 per share. By how much do the firm’s market and
book values per share differ?
a. $27.50
b. $28.88
c. $30.32
d. $31.83
e. $33.43
Chapter 02: Financial Statements, Cash Flow, and Taxes
14. Hunter Manufacturing Inc.’s December 31, 2019 balance sheet showed total common equity of $2,050,000 and
100,000 shares of stock outstanding. During 2020, Hunter had $250,000 of net income, and it paid out $100,000 as
dividends. What was the book value per share at 12/31/2020, assuming that Hunter neither issued nor retired any common
stock during 2020?
a. $20.90
b. $22.00
c. $23.10
d. $24.26
e. $25.47
15. 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.
Chapter 02: Financial Statements, Cash Flow, and Taxes
a. True
b. False
16. 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.
a. True
b. False
17. Which of the following statements is CORRECT?
a. The income statement for a given year 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 provided (used) by operating activities.
Chapter 02: Financial Statements, Cash Flow, and Taxes
18. 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.
19. Companies generate income from their “regular” operations and from other sources like interest earned on the
securities they hold, which is called non-operating income. Lindley Textiles recently reported $12,500 of sales, $7,250 of
operating costs other than depreciation, and $1,000 of depreciation. The company had no amortization charges and no
non-operating income. It had $8,000 of bonds outstanding that carry a 7.5% interest rate, and its federal-plus-state income
tax rate was 25%. How much was Lindley’s operating income, or EBIT?
a. $3,462
b. $3,644
c. $3,836
d. $4,038
e. $4,250
Chapter 02: Financial Statements, Cash Flow, and Taxes
20. Frederickson Office Supplies recently reported $12,500 of sales, $7,250 of operating costs other than depreciation, and
$1,250 of depreciation. The company had no amortization charges and no non-operating income. It had $8,000 of bonds
outstanding that carry a 7.5% interest rate, and its federal-plus-state income tax rate was 25%. How much was the firm’s
taxable income, or earnings before taxes (EBT)?
a. $3,230.00
b. $3,400.00
c. $3,570.00
d. $3,748.50
e. $3,935.93
Chapter 02: Financial Statements, Cash Flow, and Taxes
21. Meric Mining Inc. recently reported $15,000 of sales, $7,500 of operating costs other than depreciation, and $1,200 of
depreciation. The company had no amortization charges, it had outstanding $6,500 of bonds that carry a 6.25% interest
rate, and its federal-plus-state income tax rate was 25%. How much was the firm’s net income after taxes? Meric uses the
same depreciation expense for tax and stockholder reporting purposes.
a. $3,789.87
b. $3,989.33
c. $4,199.30
d. $4,420.31
e. $4,641.33
22. 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.
a. True
b. False
Chapter 02: Financial Statements, Cash Flow, and Taxes
23. 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.
a. True
b. False
24. On 12/31/2020, Heaton Industries Inc. reported retained earnings of $675,000 on its balance sheet, and it reported that
it had $172,500 of net income during the year. On its previous balance sheet, at 12/31/2019, the company had reported
$555,000 of retained earnings. No shares were repurchased during 20205. How much in dividends did Heaton pay during
2020?
a. $47,381
b. $49,875
c. $52,500
d. $55,125
e. $57,881
Chapter 02: Financial Statements, Cash Flow, and Taxes
25. Ullrich Printing Inc. paid out $21,750 of common dividends during the year. It ended the year with $187,500 of
retained earnings versus the prior year’s retained earnings of $132,250. How much net income did the firm earn during the
year?
a. $77,000
b. $80,850
c. $84,893
d. $89,137
e. $93,594
26. 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.
a. True
b. False
Chapter 02: Financial Statements, Cash Flow, and Taxes
27. 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.
a. True
b. False
28. 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.
Chapter 02: Financial Statements, Cash Flow, and Taxes
29. Which of the following factors could explain why Regal Industrial Fixtures had a negative net cash flow provided
(used) by operations 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 issued preferred stock.
30. Analysts following Armstrong Products recently noted that the company’s net cash flow from operations 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.
31. A security analyst obtained the following information from Prestopino Products’ financial statements:
∙ Retained earnings at the end of the previous year were $700,000, but retained earnings at the end of the current year
had declined to $320,000.
Chapter 02: Financial Statements, Cash Flow, and Taxes
∙ 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 provided (used) by operations for the current year was $150,000.
On the basis of this information, which of the following statements is CORRECT?
a. Prestopino had negative net income in the current year.
b. Prestopino’s depreciation expense in the current year was less than $150,000.
c. Prestopino had positive net income in the current year, but its income was less than its previous year’s income.
d. Prestopino’s cash flow provided by operations in the current year must be higher than in the previous year.
e. Prestopino’s cash on the balance sheet at the end of the current year must be lower than the cash it had on the
balance sheet at the previous year.
32. 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.
Chapter 02: Financial Statements, Cash Flow, and Taxes
33. 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.
34. Lucy’s Music Emporium purchased $50 million in fixed assets in January and their accountant told them that they
would have to depreciate the assets over 20 years (they use the same depreciation calculations for shareholder reporting
and income tax purposes). In December they learned that their accountant did not have a college degree and fired him.
They hired a new accountant with a college degree and she told them that they could depreciate the assets over 15 years.
How would the new depreciation assumption affect the company’s financial statements relative to the old assumption?
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 earnings per share would increase.
e. The firm’s cash position would increase, all else held equal.
Chapter 02: Financial Statements, Cash Flow, and Taxes
35. Last year Tiemann Technologies reported $10,500 of sales, $6,250 of operating costs other than depreciation, and
$1,300 of depreciation. The company had no amortization charges, it had $5,000 of bonds that carry a 6.5% interest rate,
and its federal-plus-state income tax rate was 25%. This year’s data are expected to remain unchanged except for one item,
depreciation, which is expected to increase by $750. By how much will net after-tax income change as a result of the
change in depreciation? The company uses the same depreciation calculations for tax and stockholder reporting purposes.
a. -534.38
b. -562.50
c. -590.63
d. -620.16
e. -651.16
36. 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.
Chapter 02: Financial Statements, Cash Flow, and Taxes
e. The retained earnings account as shown on the balance sheet shows the amount of cash that is available for paying
dividends.
37. 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?
a. The company had high depreciation expenses.
b. The company repurchased some of its common stock.
c. The company dramatically increased its capital expenditures.
d. The company retired a large amount of its long-term debt.
e. The company sold some of its fixed assets.
38. 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.
Chapter 02: Financial Statements, Cash Flow, and Taxes
39. 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.
a. True
b. False
40. 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 provided (used) by operations, 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 provided (used) by operations is often defined as follows:
Net cash flow provided (used) by operations = Net Income + Noncash Adjustments + Working Capital Adjustments.