CHAPTER 2
FINANCIAL STATEMENTS, TAXES AND
CASH FLOW
Answers to Concepts Review and Critical Thinking Questions
1. Liquidity measures how quickly and easily an asset can be converted to cash without significant loss
in value. It’s desirable for firms to have high liquidity so that they have a large factor of safety in
meeting short-term creditor demands. However, since liquidity also has an opportunity cost
2. The recognition and matching principles in financial accounting call for revenues, and the costs
associated with producing those revenues, to be “booked” when the revenue process is essentially
3. Historical costs can be objectively and precisely measured whereas market values can be difficult to
4. Depreciation is a non-cash deduction that reflects adjustments made in asset book values in
5. Market values can never be negative. Imagine a share of stock selling for –$20. This would mean
that if you placed an order for 100 shares, you would get the stock along with a check for $2,000.
6. For a successful company that is rapidly expanding, for example, capital outlays will be large,
7. It’s probably not a good sign for an established company, but it would be fairly ordinary for a start-
up, so it depends.
8. For example, if a company were to become more efficient in inventory management, the amount of
inventory needed would decline. The same might be true if it becomes better at collecting its
CHAPTER 2 B-5
9. If a company raises more money from selling stock than it pays in dividends in a particular period,
10. The adjustments discussed were purely accounting changes; they had no cash flow or market value
consequences unless the new accounting information caused stockholders to revalue the derivatives.
11. Enterprise value is the theoretical takeover price. In the event of a takeover, an acquirer would have
to take on the company’s debt, but would pocket its cash. Enterprise value differs significantly from
simple market capitalization in several ways, and it may be a more accurate representation of a firm’s
12. In general, it appears that investors prefer companies that have a steady earnings stream. If true, this
encourages companies to manage earnings. Under GAAP, there are numerous choices for the way a
company reports its financial statements. Although not the reason for the choices under GAAP, one
outcome is the ability of a company to manage earnings, which is not an ethical decision. Even
Solutions to Questions and Problems
NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this
solutions manual, rounding may appear to have occurred. However, the final answer for each problem is
found without rounding during any step in the problem.
Basic
1. To find owner’s equity, we must construct a balance sheet as follows:
Balance Sheet
CA $5,100 CL $4,300
NFA 23,800 LTD 7,400
OE ??
TA $28,900 TL & OE $28,900