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Chapter 2
Review of Accounting
Discussion Questions
2-1. Discuss some financial variables that affect the price-earnings ratio.
The price-earnings ratio will be influenced by the earnings and sales growth of
the firm, the risk or volatility in performance, the debt-equity structure of the
2-2. What is the difference between book value per share of common stock and
market value per share? Why does this disparity occur?
Book value per share is arrived at by taking the cost of the assets and
subtracting out liabilities and preferred stock and dividing by the number of
common shares outstanding. It is based on the historical cost of the assets.
2-3. Explain how depreciation generates actual cash flows for the company.
The only way depreciation generates cash flows for the company is by serving
2-4. What is the difference between accumulated depreciation and depreciation
expense? How are they related?
Accumulated depreciation is the sum of all past and present depreciation
charges, while depreciation expense is the current year’s charge. They are
2-5. How is the income statement related to the balance sheet?
the ownership section of the balance sheet as retained earnings. Thus, what we
2-6. Comment on why inflation may restrict the usefulness of the balance sheet as
normally presented.
The balance sheet is based on historical costs. When prices are rising rapidly,
2-7. Explain why the statement of cash flows provides useful information that goes
beyond income statement and balance sheet data.
The income statement and balance sheet are based on the accrual method of
accounting, which attempts to match revenues and expenses in the period in
2-8. What are the three primary sections of the statement of cash flows? In what
section would the payment of a cash dividend be shown?
The sections of the statement of cash flows are:
2-9. What is free cash flow? Why is it important to leveraged buyouts?
Free cash flow is equal to cash flow from operating activities:
The analyst or banker normally looks at free cash flow to determine whether
2-10. Why is interest expense said to cost the firm substantially less than the actual
expense, while dividends cost it 100 percent of the outlay?
Interest expense is a tax deductible item to the corporation, while dividend
Chapter 2
Problems
1. Income Statement (LO1) Frantic Fast Foods had earnings after taxes of $420,000 in the
year 20X1 with 309,000 shares outstanding. On January 1, 20X2, the firm issued 20,000
new shares. Because of the proceeds from these new shares and other operating
improvements, earnings after taxes increased by 30 percent.
2-1. Solution:
Frantic Fast Foods
a. Year 20X1
Earnings after taxes
Earnings per share Shares outstanding
$420,000
= $1.36
309,000
=
=
b. Year 20X2
Earnings after taxes $420,000 1.30 $546,000
Shares outstanding 309,000 20,000 329,000
$546,000
Earnings per share $1.66
329,000
= ´ =
= + =
= =
2. Income statement (LO1) Sosa Diet Supplements had earnings after taxes of $800,000 in
the year 20X1 with 200,000 shares of stock outstanding. On January 1, 20X2, the firm
issued 50,000 new shares. Because of the proceeds from these new shares and other
operating improvements, earnings after taxes increased by 30 percent.
2-2. Solution:
Sosa Diet Supplements
a. Year 20X1
Earnings after taxes
Earnings per share = Shares outstanding
$800,000
= = $4.00
200,000
b. Year 20X2
Earnings after taxes $800,000 1.30 $1,040,000
Shares outstanding 200,000 50,000 250,000
$1,040,000
Earning per share $4.16
250,000
= ´ =
= + =
= =
3. a. Gross profit (LO1) Swank Clothiers had sales of $383,000 and cost of goods sold of
$260,000. What is the gross profit margin (ratio of gross profit to sales)?
b. If the average firm in the clothing industry had a gross profit of 25 percent, how is the
2-3. Solution:
Swank Clothiers
a. Sales........................................................... $383,000
$123,000
Gross Profit
Gross Profit Margin = 32%
Sales $383,000
=
b. With a gross profit of 32 percent, the firm is outperforming the
4. Operating profit (LO1) A-Rod Fishing Supplies had sales of $2,500,000 and cost of
goods sold of $1,710,000. Selling and administrative expenses represented 10 percent of
sales. Depreciation was 6 percent of the total assets of $4,680,000. What was the firm’s
operating profit?
2-4. Solution:
A-Rod Fishing Supplies
Sales............................................................. $2,500,000
Cost of goods sold........................................ 1,710,000
5. Income statement (LO1) Arrange the following income statement items so they are in the
proper order of an income statement:
Taxes Earnings per share
Shares outstanding Earnings before taxes
Gross profit
2-5. Solution:
Sales
– Cost of goods sold
Gross profit
– Selling and administrative expense
Earnings available to common stockholders
6. Income statement (LO1) Given the following information, prepare an income statement
for the Dental Drilling Company.
Selling and administrative expense........................................ $ 112,000
2-6. Solution:
Dental Drilling Company
Income Statement
Sales............................................................. $ 489,000
Cost of goods sold........................................ $ 156,000
Gross profit.............................................. $ 333,000
7. Income statement (LO1) Given the following information, prepare in good form an
income statement for Jonas Brothers Cough Drops.
Selling and administrative expense........................................$ 328,000
Depreciation expense............................................................. 195,000
2-7. Solution:
Jonas Brothers Cough Drops
Income Statement
Sales............................................................. $1,660,000
Cost of goods sold........................................ 560,000
Gross profit.............................................. 1,100,000
8. Determination of profitability (LO1) Prepare in good form an income statement for
Franklin Kite Co. Inc. Take your calculations all the way to computing earnings per
share.
Sales....................................................................................... $900,000
Shares outstanding................................................................. 50,000
2-8. Solution:
Franklin Kite Company
Income Statement
Sales............................................................. $900,000
Depreciation expense.................................... 20,000
Operating profit........................................ $420,000
Interest expense............................................ 40,000
9. Determination of profitability (LO1) Prepare an income statement for Virginia Slim
Wear. Take your calculations all the way to computing earnings per share.
Sales.......................................................................................$1,360,000
Shares outstanding................................................................. 104,000
2-9. Solution:
Virginia Slim Wear
Income Statement
Sales............................................................. $1,360,000
Cost of goods sold........................................ 700,000
Gross profit.............................................. 660,000
Preferred stock dividends.............................. 86,000
10. Income statement (LO1) Precision Systems had sales of $820,000, cost of goods of
$510,000, selling and administrative expense of $60,000, and operating profit of $103,000.
2-10. Solution:
Precision Systems
Sales............................................................. $820,000
Cost of goods sold ....................................... 510,000
11. Depreciation and earnings (LO1) Stein Books Inc. sold 1,900 finance textbooks for $250
each to High Tuition University in 20X1. These books cost $210 to produce. Stein Books
spent $12,200 (selling expense) to convince the university to buy its books.
Depreciation expense for the year was $15,200. In addition, Stein Books borrowed
2-11. Solution:
Stein Books Inc.
Income Statement
For the Year Ending December 31, 20X1
Sales (1,900 books at $250 each)................................. $475,000
Cost of goods sold (1,900 books at $210 each) ........... 399,000
12. Determination of profitability (LO1) Lemon Auto Wholesalers had sales of $1,000,000
last year and cost of goods sold represented 78 percent of sales. Selling and administrative
expenses were 12 percent of sales. Depreciation expense was $11,000 and interest expense
for the year was $8,000. The firm’s tax rate is 30 percent.
b. Assume the firm hires Ms. Carr, an efficiency expert, as a consultant. She suggests
that by increasing selling and administrative expenses to 14 percent of sales, sales can
be increased to $1,050,900. The extra sales effort will also reduce cost of goods sold
