Chapter 02: Review of Accounting
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
firm, the dividend payment policy, the quality of management, and a number of
other factors. The ratio tends to be future-oriented, and the more positive the
outlook, the higher it will be.
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.
Market value per share is based on the current assessed value of the firm in the
marketplace and may bear little relationship to original cost. Besides the
disparity between book and market value caused by the historical cost approach,
other contributing factors are the growth prospects for the firm, the quality of
management, and the industry outlook. To the extent these are quite negative or
positive; market value may differ widely from book value.
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
as a tax shield against reported income. This non-cash deduction may provide
cash flow equal to the tax rate times the depreciation charged. This much in
taxes will be saved, while no cash payments occur.
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
related in that the sum of all prior depreciation expense should be equal to
accumulated depreciation (subject to some differential related to asset
write-offs).
Chapter 02: Review of Accounting
Frantic Fast Foods
a. Year 20X1
Earnings after taxes
Earnings per share Shares outstanding
$420,000
= $1.36
309,000
=
=
$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
2-2. Solution:
Sosa Diet Supplements
a. Year 20X1
Earnings after taxes
Earnings per share = Shares outstanding
$800,000
= = $4.00
200,000
Chapter 02: Review of Accounting
A-Rod Fishing Supplies
Sales ……………………………………………………… $2,500,000
Cost of goods sold …………………………………… 1,710,000
Gross Profit ………………………………………… 790,000
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
2-5. Solution:
Sales
– Cost of goods sold
Gross profit
Chapter 02: Review of Accounting
2-14. (Continued)
Indicate
Whether
Item is on
Income
Statement or
Balance
Sheet
If Item Is
on
Balance
Sheet,
Designate
Which
Category
Item
BS
CA
Accounts Receivable
BS
SE
Retained Earnings
IS
Income Tax Expense
BS
CL
Accrued Expenses
BS
CA
Cash
IS
Selling and Administrative expenses
BS
FA
Plant & Equipment
IS
Operating Expenses
BS
CA
Marketable Securities
IS
Interest Expense
IS
Sales
BS
CL
Notes Payable (6 Months)
BS
LL
Bonds Payable (Maturity 2019)
BS
SE
Common Stock
IS
Depreciation Expense
BS
CA
Inventories
Chapter 02: Review of Accounting
Chapter 02: Review of Accounting
Elite Trailer Parks
a. Operating profit (EBIT) …………………………………… $200,000
Interest expense ………………………………………….. 10,000
Earnings before taxes (EBT) …………………………….. $190,000
Taxes …………………………..…………………………….. 61,250
Earnings after taxes (EAT)……………………………….. $128,750
17. Earnings per share and retained earnings (LO1 and 3) Quantum Technology had
$669,000 of retained earnings on December 31, 20X2. The company paid common
dividends of $35,500 in 20X2 and had retained earnings of $576,000 on December 31,
20X1. How much did Quantum Technology earn during 20X2, and what would earnings
per share be if 47,400 shares of common stock were outstanding?
2-17. Solution:
Quantum Technology
Retained earnings, December 31, 20X2 …………………… $669,000
Less: Retained earnings, December 31, 20X1 …………… 576,000