MANAGEMENT ACCOUNTING - Solutions Manual

UNDERSTANDING FINANCIAL STATEMENTS

I.

Questions
1. A financial statement is a means of communicating information about an
enterprise in financial (i.e., peso) terms. It represents information that the
accountant believes is a true and fair representation of the financial
activity of the enterprise.
2. Every financial statement relates to time in one way or another. A
statement of financial position, or balance sheet, represent a picture of
the enterprise at a point in time (e.g., the end of a month or year). An
income statement and a statement of cash flows, on the other hand, cover
activity that took place over a period of time (e.g., a month or year).
3. a. Creditors are interested in financial statements to assist them in
evaluating the ability of a business to repay its debts. No one wants
to extend credit to a company that is unable to meet its obligations as
they come due.
b. Potential investors use financial statements in selecting among
alternative investment opportunities. They are interested in investing
in companies in which the value of their investment will increase as a
result of future profitable operations.
c. Labor unions are interested in financial statements because the
financial position of a company and its profits are important factors in
the companys ability to pay higher wages and to employ more people.
4. Business transactions affect a companys financial position, and as a
result they change the statement of financial position or balance sheet. The
other financial statements the income statement and the statement of
cash flows are detailed expansions of certain aspects of the statement of
financial position and help explain how the companys position changed
over time.
5. The cost principle indicates that many assets are included in the financial
records, and therefore, in the statement of financial position, at their
original cost to the reporting enterprise. This principle affects accounting
for assets in several ways, one of which is that the amount of most assets
is not adjusted periodically for changes in the market value of the assets.
3-1

Chapter 3 Understanding Financial Statements

Instead, cost is retained as the basic method of accounting, regardless of

changes in the market value of those assets.
6. The going concern assumption states that in the absence of evidence to the
contrary (i.e., bankruptcy proceedings), an enterprise is expected to
continue to operate in the foreseeable future. This means, for example,
that it will continue to use the assets it has in its financial statements for
the purpose for which they were acquired.
7. The three categories and the information included in each are:
Operating activities Cash provided by and used in revenue and expense
transactions.
Investing activities Cash provided by and used as a result of investments
in assets, such as machinery, equipment, land, and buildings.
Financial activities Cash provided by and used in debt and equity
financing, such as borrowing and repaying loans, and investments from
and dividends paid to the enterprises owners.
8. Adequate disclosure refers to the requirement that financial statements,
including accompanying notes, must include information necessary for
reasonably informed users of financial statements to understand the
companys financial activities. This requirement is often met, in part, by
the addition of notes to the financial statements. Financial statement notes
include both quantitative and qualitative information that is not included
in the body of the financial statements.
9. A strong income statement is one that has significantly more pesos of
revenue than expenses, resulting in net income that is a relatively high
percentage of the revenue figure. A trend of relatively high income
numbers over time signals a particularly strong income situation.
10. A strong statement of cash flows is one that shows significant amounts of
cash generated from operating activities. This means that the enterprise is
generating cash from its ongoing activities and is not required to rely on
continuous debt and equity financing, or the sale of its major assets.
11. The purpose of classifications in financial statements is to develop useful
subtotals, which help users analyze the statements. The most commonly
used classifications are:

3-2

Understanding Financial Statements Chapter 3

In a balance sheet: current assets, plant and equipment, other assets,

current liabilities, long-term liabilities and equity.
In a multiple-step income statement: revenue, cost of goods sold,
operating expenses, and nonoperating items. The operating expense
section often includes subclassifications for selling expenses and for
general and administrative expenses.
In a statement of cash flows: operating activities, investing activities, and
financing activities.
12. In classified financial statements, similar items are grouped together to
produce subtotals which may assist users in their analyses. Comparative
financial statements show financial statements for two or more time
periods in side-by-side columns. Consolidated statements include not
only the financial statement amounts for the company itself but also for
any subsidiary companies that it owns. The financial statements of large
corporations often possess all three of these characteristics.
13. In a multiple-step income statement, different categories of expenses are
deducted from revenue in a series of steps, thus resulting in various
subtotals, such as gross profit and operating income. In a single-step
income statement, all expenses are combined and deducted from total
revenue in a single step. Both formats result in the same amount of net
income.
II. Matching Type
1.
1. d
2. g

3. a
4. j

5. e
6. h

7. f
8. b

9. c
10. i

2.
1. d
2. a

3. i
4. g

5. m
6. c

7. h
8. n

9. f
10. k

11. b
12. j

13. e
14. l

3.
a. F
b. I

c. F
d. I

e. I
f. F

g. F
h. F

I.
j.

I
F

III. Problems
Problem 1 (Preparing a Balance Sheet A Second Problem)
3-3

k. F
l. I

Chapter 3 Understanding Financial Statements

Requirement (a)
SM Farms
Balance Sheet
September 30, 2005
Assets
Cash
Accounts receivable

P 16,710
22,365

Liabilities and Equity

Liabilities:
Notes payable
P530,000

Land
Barns and sheds
Citrus trees
Livestock
Irrigation system
Farm machinery
Fences & gates
Total

550,000
78,300
76,650
120,780
20,125
42,970
33,570
P961,470

Accounts payable
Property taxes payable
Wages payable
Total liabilities
Equity:
Share capital
Retained earnings*
Total

77,095
9,135
1,820
P618,050
250,000
93,420
P961,470

* Total assets, P961,470, minus total liabilities, P618,050, less share capital,
P250,000.

Requirement (b)
The loss of an asset, Barns and Sheds, from a typhoon would cause a decrease
in total assets. When total assets are decreased, the balance sheet total of
liabilities and equity must also decrease. Since there is no change in liabilities
as a result of the destruction of an asset, the decrease on the right-hand side of
the balance sheet must be in the retained earnings account. The amount of the
decrease in Barns and Sheds, in the equity, and in both balance sheet totals, is
P23,800.
Problem 2 (Preparing a Balance Sheet and Cash Flow Statement; Effects
of Business Transactions)
Requirement (a)
The Tasty Bakery
Balance Sheet
August 1, 2005
Assets
Cash
Accounts receivable
Supplies
Land
Building

6,940
11,260
7,000
67,000
84,000
3-4

Liabilities and Equity

Liabilities:
Notes payable
P 74,900
Accounts payable
Salaries payable
Total liabilities

16,200
8,900
P100,000

Understanding Financial Statements Chapter 3

Equipment and fixtures
Total

44,500
P220,700

Equity:
Share capital
Retained earnings
Total

80,000
40,700
P220,700

Requirement (b)
The Tasty Bakery
Balance Sheet
August 3, 2005
Assets
Cash
Accounts receivable

P 14,490
11,260

Supplies
Land
Building
Equipment and fixtures

8,250
67,000
84,000
51,700

Total

P236,700

Liabilities and Equity

Liabilities:
Notes payable
P 74,900
Accounts payable
Salaries payable
Total liabilities
Equity:
Share capital
Retained earnings
Total

7,200
8,900
P 91,000
105,000
40,700
P236,700

The Tasty Bakery

Statement of Cash Flows
For the Period August 1 - 3, 2005
Cash flows from operating activities:
Cash payment of accounts payable
Cash purchase of supplies
Cash used in operating activities

P(16,200)
(1,250)
P(17,450)

Cash flows from investing activities:

None
Cash flows from financing activities:
Sale of share capital

P25,000

Increase in cash

P 7,550
3-5

Chapter 3 Understanding Financial Statements

Cash balance, August 1, 2005
Cash balance, August 3, 2005

6,940
P14,490

Requirement (c)
The Tasty Bakery is in a stronger financial position on August 3 than it was on
August 1.
On August 1, the highly liquid assets (cash and accounts receivable) total only
P18,200, but the company has P25,100 in debts due in the near future
(accounts payable plus salaries payable).
On August 3, after additional infusion of cash from the sale of stock, the liquid
assets total P25,750, and debts due in the near future amount to P16,100.
Note to Instructor: The analysis of financial position strength in requirement
(c) is based solely upon the balance sheets at August 1 and August 3.
Hopefully, students will raise many legitimate issues regarding necessity of
information about operations, rate at which cash flows into the business, etc.
In this problem, the improvement in financial position results solely from the
sale of share capital.

Problem 3 (Preparing Financial Statements;

Transactions)

Effects of Business

Requirement (a)
The First Malt Shop
Balance Sheet
September 30, 2005
Assets
Cash
Accounts receivable
Supplies
Land
Building
Furniture & fixtures
Total

P 7,400
1,250
3,440
55,000
45,500
20,000
P132,590

3-6

Liabilities and Equity

Liabilities:
Notes payable*
P 70,000
Accounts payable
Total liabilities
Equity:
Share capital
Retained earnings
Total

8,500
P 78,500
50,000
4,090
P132,590

Understanding Financial Statements Chapter 3

* Total assets, P132,590, less equity, P54,090, less accounts payable, P8,500, equals
notes payable.

Requirement (b)
The First Malt Shop
Balance Sheet
October 6, 2005
Assets
Cash
Accounts receivable
Supplies
Land
Building
Furniture & fixtures
Total

P 29,400
1,250
4,440
55,000
45,500
38,000
P173,590

Liabilities and Equity

Liabilities:
Notes payable
P 70,000
Accounts payable
Total liabilities
Equity:
Share capital
Retained earnings
Total

18,000
P 88,000
80,000
5,590
P173,590

The First Malt Shop

Income Statement
For the Period October 1-6, 2005
Revenues
Expenses
Net income

P 5,500
(4,000)
P 1,500
The First Malt Shop
Statement of Cash Flows
For the Period October 1-6, 2005

Cash flows from operating activities:

Cash received from revenues
Cash paid for expenses
Cash paid for accounts payable
Cash paid for supplies
Cash used in operating activities

P5,500
(4,000)
(8,500)
(1,000)

Cash flows from investing activities:

None
3-7

P(8,000)

Chapter 3 Understanding Financial Statements

Cash flows from financing activities:
Cash received from sale of share capital

P30,000

Increase in cash
Cash balance, October 1, 2005
Cash balance, October 6, 2005

P 22,000
7,400
P29,400

Requirement (c)
The First Malt Shop is in a stronger financial position on October 6 than on
September 30. On September 30, the company had highly liquid assets (cash
and accounts receivable) of P8,650, which barely exceeded the P8,500 in
liabilities (accounts payable) due in the near future. On October 6, after the
additional investment of cash by shareholders, the companys cash alone
exceeded its short-term obligations.

Problem 4 (Preparing a Balance Sheet; Discussion of Accounting

Principles)
Requirement (1)
Fil-Cinema Scripts
Balance Sheet
November 30, 2005
Assets
Cash
Notes receivable
Accounts receivable
Land
Building
Office furniture*
Total

P 3,940
2,200
2,450
39,000
54,320
12,825
P114,735

* P8,850 + P6,500 P2,525.

Requirement (2)

3-8

Liabilities and Equity

Liabilities:
Notes payable
P 73,500
Accounts payable
Total liabilities
Equity:
Share capital
Retained earnings
Total

32,700
P106,200
5,000
3,535
P114,735

Understanding Financial Statements Chapter 3

(1) The cash in Cruzs personal savings account is not an asset of the
business entity Fil-Cinema Scripts and should not appear in the balance
sheet of the business. The money on deposit in the business bank account
(P3,400) and in the company safe (P540) constitute cash owned by the
business. Thus, the cash owned by the business at November 30 totals
P3,940.
(2) The years-old IOU does not qualify as a business asset for two reasons.
First, it does not belong to the business entity. Second, it appears to be
uncollectible. A receivable that cannot be collected is not viewed as an
asset, as it represents no future economic benefit.
(3) The total amount to be included in Office furniture for the rug is
P9,400, the total cost, regardless of whether this amount was paid in cash.
Consequently, Office furniture should be increased by P6,500. The
P6,500 liability arising from the purchase of the rug came into existence
prior to the balance sheet date and must be added to the Notes payable
amount.
(4) The computer is no longer owned by Hollywood Scripts and therefore
cannot be included in the assets. To do so would cause an overstatement
of both assets and equity. The Office furniture amount must be reduced
by P2,525.
(5) The P22,400 described as Other assets is not an asset, because there is
no valid legal claim or any reasonable expectation of recovering the
income taxes paid. Also, the payment of income taxes by Cruz was not a
business transaction by Fil-Cinema Scripts. If a refund were obtained
from the government, it would come to Cruz personally, not to the
business entity.
(6) The proper valuation for the land is its historical cost of P39,000, the
amount established by the transaction in which the land was purchased.
Although the land may have a current fair value in excess of its cost, the
offer by the friend to buy the land if Cruz would move the building
appears to be mere conversation rather than solid, verifiable evidence of
the fair value of the land. The cost principle, although less than perfect,
produces far more reliable financial statements than would result if
owners could pull figures out of the air in recording asset values.
(7) The accounts payable should be limited to the debts of the business,
P32,700, and should not include Cruzs personal liabilities.

3-9

Chapter 3 Understanding Financial Statements

IV. Multiple Choice Questions

1.
2.
3.
4.
5.
6.
7.
8.
9.
10.

D
D
D
B
A
B
D
C
B
C

11.
12.
13.
14.
15.
16.
17.
18.
19.
20.

B
C
D
A
D
A
A
B
C
C

21.
22.
23.
24.
25.
26.
27.
28.
29.
30.

B
C
A
B
A
D
B
B
D
C

31.
32.
33.
34.
35.
36.
37.
38.

3-10

B
D
D
D
C
A
A
C