Study Unit One

1.1 Concepts of Financial Accounting

- The objective of general-purpose financial reporting is to report financial information that is useful in making decisions

- Users need to differentiate between changes in economic resources and claims arising from the entity’s performance
(income statement) and other events and transactions, such as issuing debt and equity (balance sheet). Information
about financial performance is useful for
● Understanding the return on economic resources, its variability, and its components
● Evaluating management
● Predicting future returns

- For general-purpose financial statements to be useful to external parties, they must be prepared in conformity with
accounting principles that are generally accepted in the United States (GAAP).

- Financial accounting differs from management accounting. Management accounting assists management decision
making, planning, and control. Management accounting information is therefore primarily directed to specific internal
users

Users of Financial Statements

External users are the primary users of financial statements. External users use financial statements to determine
whether doing business with the firm will be beneficial.

● Investors need information to decide whether to increase, decrease, or obtain an investment in a firm.

● Creditors need information to determine whether to extend credit and under what terms.

● Stock exchanges need financial statements to evaluate whether to accept a firm’s stock for listing or whether to
suspend the stock’s trading. ‫تحتاج أسواق األوراق المالٌة إلى بٌانات مالٌة لتمٌٌم ما إذا كان سٌتم لبول إدراج أسهم الشركة أو تعلٌك تداول األسهم‬.

● Regulatory agencies may need financial statements to evaluate the firm’s conformity with regulations and to determine
price levels in regulated industries. ‫لد تحتاج الهٌئات التنظٌمٌة إلى بٌانات مالٌة لتمٌٌم مدى امتثال الشركة للوائح ولتحدٌد مستوٌات األسعار فً الصناعات‬
‫الخاضعة للتنظٌم‬.

Internal users also use financial statements to make decisions affecting the operations of the business. These users
include management, employees, and the board of directors.

Features of Financial Statements

Financial statements are the primary means of communicating financial information to external parties. Additional
information is provided by financial statement notes, supplementary information (such as management’s discussion and
analysis), and other disclosures. Information typically disclosed in notes is essential to understanding the financial
statements.
● The notes are considered part of the basic financial statements. They amplify or explain information recognized in the
statements and are an integral part of statements prepared in accordance with GAAP.

■ The first footnote accompanying any set of complete financial statements is generally one describing significant
accounting policies, such as the use of estimates and assumptions, and policies relating to, among others, revenue
recognition and allocation of asset (tangible and intangible) costs to current and future periods.

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 A full set of financial statements includes the following statements:
● Statement of financial position (also called a balance sheet)
● Income statement
● Statement of comprehensive income
● Statement of changes in equity
● Statement of cash flows

- To be useful, information presented in the financial statements must be relevant and faithfully represented.
- Usefulness is enhanced when the information is comparable with similar information for other entities and the same
entity for another period or date. Comparability allows users to understand similarities and differences.

Financial statements are prepared under the going-concern assumption, which means that the entity is assumed to
continue operating .

Financial Statement Relationships

Financial statements complement each other. They describe different aspects of the same transactions, and more than
one statement is necessary to provide information for a specific economic decision.
The components (elements) of one statement relate to those of other statements. Among the relationships are:
● Net income or loss from the statement of income is reported and accumulated in the retained earnings account, a
component of the equity section of the statement of financial position.

● The components of cash and equivalents from the statement of financial position are reconciled with the corresponding
items in the statement of cash flows.

● Items of equity from the statement of financial position are reconciled with the balances on the statement of changes in
equity.

● Ending inventories are reported in current assets on the statement of financial position and are reflected in the
calculation of cost of goods sold on the statement of income.

● Amortization and depreciation reported in the statement of income also are reflected in asset and liability balances in
the statement of financial position.

Accrual Basis of Accounting

Financial statements are prepared under the accrual basis of accounting. Accrual accounting records the financial
effects of transactions and other events and circumstances when they occur rather than when their associated cash is
paid or received.

● Revenues are recognized in the period in which they were earned even if the cash will be received in a future
period. This is referred to as the revenue recognition principle.

● Expenses are recognized in the period in which they were incurred even if the cash will be paid in a future period.

■ Under the matching principle, expenses are recognized in the same period as the related revenue.

■ Expense recognition principles associate cause and effect, systematic and rational allocation, and immediate
recognition.

- Under the cash basis, revenues are recognized when cash is received and expenses are recognized when cash is
paid.
- Under GAAP, financial statements cannot be prepared under the cash basis of accounting.

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 Question: 1A primary objective of external financial reporting is
A. Direct measurement of the value of a business enterprise.
B. Provision of information that is useful to present and potential investors, creditors, and others in making
rational financial decisions regarding the enterprise.
C. Establishment of rules for accruing liabilities.
D. Direct measurement of the enterprise’s stock price.

Question: 2Which of the following is true regarding the comparison of managerial and financial accounting?
A. Managerial accounting is generally more precise.
B. Managerial accounting has a past focus, and financial accounting has a future focus.
C. The emphasis on managerial accounting is relevance, and the emphasis on financial accounting is timeliness.
D. Managerial accounting need not follow generally accepted accounting principles (GAAP), while financial accounting must follow
them.

Question: 3 An objective of financial reporting is

A. Providing information useful to investors, creditors, donors, and other users for decision making.
B. Assessing the adequacy of internal control.
C. Evaluating management results compared with standards.
D. Providing information on compliance with established procedures.

Question: 4 An entity that sprays chemicals in residences to eliminate or prevent infestation of insects requires
that customers prepay for 3 months’ service at the beginning of each new quarter. Select the term that appropriately
describes this situation from the viewpoint of the entity.
A. Deferred income.
B. Earned income.
C. Accrued income.
D. Prepaid expense.

Question: 5 The financial statements included in the annual report to the shareholders are least useful to which
one of the following?
A. Stockbrokers.
B. Bankers preparing to lend money.
C. Competing businesses.
D. Managers in charge of operating activities.

Question: 6The accounting measurement that is not consistent with the going concern concept is
A. Historical cost.
B. Realization.
C. The transaction approach.
D. Liquidation value.

Question: 7Which of the following is a true statement about the objective of general-purpose financial reporting?
A. Financial reporting is ordinarily focused on industries rather than individual entities.
B. The objective applies only to information that is useful for investment professionals.
C. Financial reporting directly measures management performance.
D. The information provided relates to the entity’s economic resources and claims.

Question: 8Which basis of accounting is most likely to provide the best assessment of an entity’s past and future
ability to generate net cash inflows?
A. Cash basis of accounting.
B. Modified cash basis of accounting.
C. Accrual basis of accounting.
D. Tax basis of accounting.

Question: 9Which of the following is least likely to be accomplished by providing general-purpose financial
information useful for making decisions about providing resources to an entity?
A. To provide information about changes in an entity’s economic resources and claims to them.
B. To provide information to help investors and creditors assess the amount, timing, and uncertainty of prospective net cash inflows
to the entity.
C. To provide sufficient information to determine the value of the entity.
D. To provide information about management’s performance.

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 Question: 10All of the following support the objective of financial reporting except providing information that
A. Is useful for making investment and credit decisions.
B. Helps management evaluate alternative projects.
C. Concerns enterprise resources and claims to those resources.
D. Helps investors and creditors predict future cash flows.

Question: 11General purpose external financial reporting of a corporation focuses primarily on the needs of which of the following
users?
A. Regulatory and taxing authorities.
B. Investors and creditors and their advisors.
C. The board of directors of the corporation.
D. The management of the corporation.

Question: 12For financial reporting to be useful, it must

A. Be in accordance with generally accepted accounting principles.
B. Provide information useful for making business and investment decisions.
C. Be understandable to those who have a limited knowledge of business activities.
D. Directly measure the value of the entity being reported on.

Question: 13What is the primary objective of financial reporting?

A. To provide economic information that is comprehensible to all users.
B. To provide management with an accurate evaluation of their financial performance.
C. To provide forecasts for future cash flows and financial performance.
D. To provide information that is useful for economic decision making.

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 1.2 Statement of Financial Position (Balance Sheet)
Overview

- Reports the amounts of assets (items of value), liabilities (debt), and equity (net worth) and their relationships at a
moment in time

- It helps users assess liquidity, financial flexibility, the efficiency with which assets are used, capital structure

- The basic accounting equation presents a perfect balance between the entity’s resources and its capital structure.

- The capital structure consists of the amounts contributed by creditors (liabilities) and investors (stockholders’
equity).

- Assets = Liabilities + Stockholders’ Equity [ The equation is based on the fund theory.]

- Assets – Liabilities = Stockholders’ Equity [The basic equation can be derived to form the proprietary theory:]
According to this theory, equity in an enterprise is what remains after the economic obligations of the enterprise are
deducted from its economic resources

Transaction Analysis

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 Elements of the Balance Sheet
- Assets are resources controlled by the entity as a result of past events. They represent probable future economic
benefits to the entity.
● Examples include inventory; accounts receivable; investments; and property, plant, and equipment.

Liabilities are present obligations of the entity arising from past events. Their settlement is expected to result in an
outflow of economic benefits from the entity.
● Examples include loans payable, bonds issued by the entity, and accounts payable.

Equity is the residual interest in the assets of the entity after subtracting all its liabilities.
● Examples include a company’s common stock, preferred stock, and retained earnings.
● Equity is affected not only by operations but also by transactions with owners, such as dividends and
contributions.

- Assets and liabilities are separated in the statement of financial position into current and noncurrent categories.
Assets are generally reported in order of liquidity, which means the order in which the assets are expected to be
converted to cash.

NOTE: In some parts of the world, assets are listed in the order of reverse liquidity with intangibles
and property, plant, and equipment listed first. This is known as the “production order.” This method is not used in
the United States.

Current and Noncurrent Assets

- An asset is classified as current on the statement of financial position if it is expected to be realized in cash or sold or
consumed within the entity’s operating cycle or 1 year, whichever period is longer.
● The following are the major categories of current assets:
■ Cash and cash equivalents
■ Certain individual trading, available-for-sale, and held-to-maturity debt securities
■ Receivables
■ Inventories
■ Prepaid expenses
■ Certain individual investments in equity securities

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 Noncurrent assets (long term assets) are those not qualifying as current. The following are the major categories of
noncurrent assets:

● Investments and funds include non operating items intended to be held beyond the longer of 1 year or the operating
cycle. The following assets are typically included:
■ Investments in equity securities made to control or influence another entity and other noncurrent securities.
■ Certain available-for-sale and held-to-maturity debt securities may be noncurrent.

● Property, plant, and equipment (PPE) are tangible operating items recorded at cost and reported net of any
accumulated depreciation. They include
■ Land and natural resources subject to depletion, e.g., oil and gas
■ Buildings, equipment, furniture, fixtures, leasehold improvements, land improvements, a lessee’s right-of-use assets
held under finance and operating leases, noncurrent assets under construction, and other depreciable assets

● Intangible assets are non financial assets without physical substance. Examples are patents and goodwill.

Current and Noncurrent Liabilities

Current liabilities are expected to be settled or liquidated in the ordinary course of business during the longer of the
next year or the operating cycle. Generally speaking, current liabilities are expected to be settled or liquidated within 1
year from the balance sheet date.

The following are the major categories of current liabilities:

● Accounts (or trade) payables for items entering into the operating cycle, e.g., for materials and supplies used in
producing goods or services for sale.

● Other payables arising from operations, such as accrued wages, salaries, rentals, royalties, and taxes.

● Unearned revenues arising from collections in advance of delivering goods or performing services, e.g., ticket sales
revenue.

● Other obligations expected to be liquidated in the ordinary course of business during the longer of the next year or the
operating cycle. These include
■ Short-term notes given to acquire capital assets
■ Payments on the current portion of serial bonds or other noncurrent debt
■ Long-term obligations that are or will become callable by the creditor because of the debtor’s violation of a provision of
the debt agreement at the balance sheet date
■ Possible obligations for warranties (guarantees) and estimated returns

- Current liabilities do not include short-term debt if an entity intends to refinance them on a
noncurrent basis and demonstrates an ability to do so.
‫ا تتضمن االلتزامات المتداولة الدٌون لصٌرة األجل إذا كانت المنشأة تنوي إعادة تموٌلها على‬
‫أساس غٌر متداول وٌظهر المدرة على المٌام بذلن‬.

● The ability to refinance may be demonstrated by entering into a refinancing agreement before
the balance sheet is issued.‫ٌمكن إثبات المدرة على إعادة التموٌل من خالل الدخول فً اتفالٌة إعادة التموٌل من لبل‬
‫إصدار المٌزانٌة العمومٌة‬

Noncurrent liabilities (long term liabilities) are those not qualifying as current. The noncurrent portions of the following
items are reported in this section of the balance sheet:
● Noncurrent notes and bonds
● A lessee’s liabilities under finance and operating leases
● Deferred tax liabilities arising from interperiod tax allocation
● Obligations under product or service warranty agreements
● Deferred revenue
● Advances for noncurrent commitments to provide goods or services

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 Equity
Equity represents ownership interest in a firm. Owners of corporations are referred to as stockholders or shareholders.
The following are the major items of equity:

● Capital contributions by owners (par value of common and preferred stock issued and additional paid-in capital).
■ Additional paid-in (contributed) capital (APIC) is the amount received in excess of par value at the time stock was sold.

● Retained earnings is the accumulated net income not yet distributed to owners. Dividends can be paid when retained
earnings has a balance. A payment in excess of this balance is a return of capital, not a dividend.
■ Occasionally, the board of directors restricts retained earnings to prevent payment of dividends.
The usual reason is that the board plans to reinvest the earnings in the business.

● Treasury stock is the firm’s own stock that has been repurchased.
■ It is reflected in shareholders’ equity as a contra account (which reduces the balance of a related account).

● Accumulated other comprehensive income (all comprehensive income items not included in net income).

Limitations of the Balance Sheet

Limitations of using the balance sheet for decision making include the following:
● The balance sheet shows a company’s financial position at a single point in time. Accounts maybvary significantly a
few days before or after the publication of the balance sheet.
● Many balance sheet items, such as property, plant, and equipment, are recorded at historicalbcosts, which may not
equal their fair value.
● The preparation of the balance sheet requires estimates and management judgment.
● The balance sheet omits many items that cannot be recorded objectively but have financial valuebto the company.

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 Question: 1The primary purpose of the statement of financial position is to reflect
A. The fair value of the firm’s assets at some moment in time.
B. The status of the firm’s assets in case of forced liquidation of the firm.
C. The success of a company’s operations for a given amount of time.
D. Items of value, debt, and net worth.

Question: 2Prepaid expenses are valued on the statement of financial position at the
A. Cost to acquire the asset.
B. Face amount collectible at maturity.
C. Cost to acquire minus accumulated amortization.
D. Cost less expired or used portion.

Question: 3A statement of financial position allows investors to assess all of the following except the
A. Efficiency with which enterprise assets are used.
B. Liquidity and financial flexibility of the enterprise.
C. Capital structure of the enterprise.
D. Net realizable value of enterprise assets.

Question: 4The accounting equation (assets – liabilities = equity) reflects the

A. Entity point of view.
B. Fund theory.
C. Proprietary point of view.
D. Enterprise theory.

Question: 5Long-term obligations that are or will become callable by the creditor because of the debtor’s violation of a provision of
the debt agreement at the balance sheet date should be classified as
A. Long-term liabilities.
B. Current liabilities unless the debtor goes bankrupt.
C. Current liabilities unless the creditor has waived the right to demand repayment for more than 1 year from the balance sheet date.
D. Contingent liabilities until the violation is corrected.

Question: 6A statement of financial position is intended to help investors and creditors

A. Assess the amount, timing, and uncertainty of prospective net cash inflows of a firm.
B. Evaluate economic resources and obligations of a firm.
C. Evaluate economic performance of a firm.
D. Evaluate changes in the ownership equity of a firm.

Question: 7The purchase of treasury stock is recorded on the statement of financial position as a(n)
A. Increase in assets.
B. Decrease in liabilities.
C. Increase in shareholders’ equity.
D. Decrease in shareholders’ equity.

Question: 8When classifying assets as current and noncurrent for reporting purposes,
A. The amounts at which current assets are carried and reported must reflect realizable cash values.
B. Prepayments for items such as insurance or rent are included in an “other assets” group rather than as current assets as they will
ultimately be expensed.
C. The time period by which current assets are distinguished from noncurrent assets is determined by the seasonal nature of the
business.
D. Assets are classified as current if they are reasonably expected to be realized in cash or consumed during the normal operating
cycle.

Question: 9A corporation uses a calendar year for financial and tax reporting purposes and has $100 million of mortgage bonds
due on January 15, Year 2. By January 10, Year 2, the corporation intends to refinance this debt with new long-term mortgage bonds
and has entered into a financing agreement that clearly demonstrates its ability to consummate the refinancing. This debt is to be
A. Classified as a current liability on the statement of financial position at December 31, Year 1.
B. Classified as a long-term liability on the statement of financial position at December 31, Year 1.
C. Retired as of December 31, Year 1.
D. Considered off-balance-sheet debt.

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 10A statement of financial position provides a basis for all of the following except
A. Computing rates of return.
B. Evaluating capital structure.
C. Assessing liquidity and financial flexibility.
D. Determining profitability and assessing past performance.

Question: 11A company intends to refinance a portion of its short-term debt in Year 2 and is negotiating a longterm financing
agreement with a local bank. This agreement would be noncancelable and would extend for a period of 2 years. The amount of short-
term debt that the company can exclude from its statement of financial position at December 31, Year 1,
A. May exceed the amount available for refinancing under the agreement.
B. Depends on the demonstrated ability to consummate the refinancing.
C. Is reduced by the proportionate change in the working capital ratio.
D. Is zero unless the refinancing has occurred by year end.

Question: 12A manufacturer receives an advance payment for special-order goods that are to be manufactured and delivered
within the next year. The advance payment should be reported in the manufacturer’s current-year statement of financial position as
a(n)
A. Current liability.
B. Noncurrent liability.
C. Contra asset amount.
D. Accrued revenue.

Question: 13A company has outstanding accounts payable of $30,000 and a short-term construction loan in the amount of
$100,000 at year end. The loan was refinanced through issuance of long-term bonds after year end but before issuance of financial
statements. How should these liabilities be recorded in the balance sheet?
A. Noncurrent liabilities of $130,000.
B. Current liabilities of $130,000.
C. Current liabilities of $30,000, noncurrent liabilities of $100,000.
D. Current liabilities of $130,000, with required footnote disclosure of the refinancing of the loan.

Question: 14Noncurrent debt should be included in the current section of the statement of financial position if
A. It is to be converted into common stock before maturity.
B. It matures within the year and will be retired through the use of current assets.
C. Management plans to refinance it within the year.
D. A bond retirement fund has been set up for use in its scheduled retirement during the next year.

Question: 15A company has the following items recorded on its financial records:
Available-for-sale debt securities $200,000
Prepaid expenses 400,000
Treasury stock 100,000
The total amount of the above items to be shown as assets on the statement of financial position is
A. $400,000
B. $500,000
C. $600,000
D. $700,000

Question: 16A receivable classified as current on the statement of financial position is expected to be collected within
A. The current operating cycle.
B. 1 year.
C. The current operating cycle or 1 year, whichever is longer.
D. The current operating cycle or 1 year, whichever is shorter.

Question: 17Current assets are reasonably expected to be realized in cash or sold or consumed during the normal
operating cycle of the business. Current assets most likely include
A. Intangible assets.
B. Purchased goodwill.
C. Organizational costs.
D. Trading securities.

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 Question: 18A corporation was incorporated on January 1, Year 6, with $500,000 from the issuance of stock and borrowed funds
of $75,000. During the first year of operations, net income was $25,000. On December 15, the corporation paid a $2,000 cash
dividend. No additional activities affected equity in Year 6. At December 31, Year 6, the corporation’s liabilities had increased to
$94,000. In the corporation’s December 31, Year 6 balance sheet, total assets should be reported at
A. $598,000
B. $600,000
C. $617,000
D. $692,000

Question: 19An entity had the following account balances at year end.
Sales $452,000
Cash 23,400
Accounts payable 14,300
Rent expense 3,700
Accounts receivable 9,400
Cost of goods sold 214,000
Land 104,000
Unearned revenue 6,800
Gain on sale 17,500
Equipment 28,800
Inventories 2,200
Notes payable 67,000
What is the amount of total current assets reported on the balance sheet?
A. $35,000
B. $39,900
C. $59,300
D. $63,800

Question: 20All of the following are limitations of the balance sheet except that
A. The balance sheet is prepared using management judgments and estimates.
B. Assets and liabilities are usually recorded at historical cost, which might differ significantly from current market value.
C. The balance sheet provides information on the liquidity and solvency of the company.
D. The balance sheet omits many items that cannot be recorded objectively but which have financial value to the company.

Question: 21Which of the following is not an example of off-balance-sheet financing?

A. Use of debt covenants.
B. Factoring receivables.
C. Using special purpose entities.
D. Joint ventures.

Question: 22Heavy use of off-balance-sheet lease financing will tend to

A. Make a company appear riskier than it actually is because its stated debt ratio will appear higher.
B. Make a company appear less risky than it actually is because its stated debt ratio will appear lower.
C. Affect a company’s cash flows but not its degree of risk.
D. Have no effect on either cash flows or risk because the cash flows are already reflected in the income statement.

Question: 23Which one of the following would not be classified as a current liability?
A. Security deposits received from renters for a one-year lease.
B. Rent for the current year received on January 2 of the current year.
C. Undistributed stock dividends.
D. Ten-year bonds sold 110 months ago.

Question: 24A company received an invoice in January for the electricity used by its warehouse in December, and it recorded the
expense in January. The company uses the accrual basis of accounting. What is the impact to the company’s December financial
statements?
A. Current liabilities were understated, and retained earnings were overstated.
B. Operating expenses were overstated, and retained earnings were overstated.
C. Cash and cash equivalents were overstated, and retained earnings were understated.
D. Accrued expenses were overstated, and retained earnings were understated.

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 Question: 25When treasury stock is accounted for at cost, the cost is reported on the balance sheet as a(n)
A. Asset.
B. Reduction of retained earnings.
C. Reduction of additional paid-in-capital.
D. Unallocated reduction of equity.

Question: 26Which one of the following statements regarding treasury stock is correct?
A. It is unretired but no longer outstanding, yet it has all the rights of outstanding shares.
B. It is an asset representing shares that can be sold in the future or otherwise issued in stock option plans or in effectuating
business combinations.
C. It is unable to participate in the liquidation proceeds of the firm but able to participate in regular cash dividend distributions as well
as stock dividends and stock splits.
D. It is reflected in shareholders’ equity as a contra account.

Question: 27A corporation purchased 10,000 shares of its own $5 par-value common stock for $25 per share. This stock originally
sold for $28 per share. The corporation used the cost method to record this transaction. If the par-value method had been used
rather than the cost method, which of the following accounts would show a different dollar amount?
A. Treasury stock and total shareholders’ equity.
B. Additional paid-in capital and retained earnings.
C. Paid-in capital from treasury stock and retained earnings.
D. Additional paid-in capital and treasury stock.

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 1.3 Income Statement and
Statement of Comprehensive Income

Income Statement Elements

The income statement reports the results of an entity’s operations over a period of time, such as a year.

The Income Equation

Income (Loss) = Revenues + Gains – Expenses – Losses
The following are the elements of an income statement:
● Revenues are inflows or other enhancements of assets or settlements of liabilities (or both) from delivering or
producing goods, providing services, or other activities that qualify as ongoing major or central operations.

● Gains are increases in equity (or net assets) other than from revenues or investments by owners.

● Expenses are outflows or other usage of assets or incurrences of liabilities (or both) from delivering or producing
goods, providing services, or other activities that qualify as ongoing major or central operations.

● Losses are decreases in equity (or net assets) other than from expenses or distributions to owners.

● All transactions affecting the net change in equity during the period are included in income except
■ Transactions with owners
■ Prior-period adjustments (such as error correction or a change in accounting principle,
■ Items reported initially in other comprehensive income
■ Transfers to and from appropriated retained earnings

Cost of Goods Sold and Cost of Goods Manufactured

Cost of goods sold is an expense account reported on the income statement.
● For a retailer, cost of goods sold represents the cost of the items being sold to customers and is
calculated based on changes in inventory:

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 ● For a manufacturer, cost of goods sold represents the cost of items that were produced (manufactured) by the firm
and are being sold to customers.
■ Manufacturers must calculate the cost of goods manufactured in order to calculate the cost of goods sold. The cost of
goods manufactured is the cost of goods completed during the current year. It represents the cost of goods transferred
out of work-in-process inventory to finished goods inventory.
■ Manufacturers calculate cost of goods sold as follows:

● Cost of goods sold is recognized at the time the goods are sold, which follows the matching principle.
Gross profit is the net difference between sales revenue and cost of goods sold.

● Gross profit margin as a percentage of sales is calculated as follows: Gross profit margin (%) = Gross profit ÷ Sales

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 Other Expenses
General and administrative expenses are incurred for the benefit of the enterprise as a whole and are not related wholly
to a specific function, e.g., selling or manufacturing.

● They include accounting, legal, and other fees for professional services; officers’ salaries; insurance; wages of office
staff; miscellaneous supplies; and office occupancy costs. Selling expenses are those incurred in selling or marketing.

● Examples include sales representatives’ salaries, commissions, and traveling expenses; sales department salaries and
expenses, including rent; advertising; and credit and collection costs.

● Shipping costs are also often classified as selling expenses. Interest expense is recognized based on the passage of
time. In the case of bonds, notes, and finance leases, the effective interest method is used.

Income Statement Formats

The single-step income statement provides one grouping for revenue items and one for expense items. The single step
is the one subtraction necessary to arrive at net income.
The multiple-step income statement presents operating revenues and expenses in a section separate from
nonoperating items.
● The most common way to present the income statement is the condensed format of the multiplestep income statement,
which includes only the section totals.

Discontinued Operations
When an entity reports a discontinued operation, it must be presented in a separate section between income from
continuing operations and net income.

● Because these items are reported after the presentation of income taxes, they must be shown net of tax.
● The term “continuing operations” is used only when a discontinued operation is reported.

Discontinued operations, if reported, may have two components:

1. Gain or loss from operations of the component that has been disposed of or is classified as held for sale from the first
day of the reporting period until the date of disposal (or the end of the reporting period if it is classified as held for sale)
2. Gain or loss on the disposal of this component

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 Statement of Comprehensive Income
Comprehensive income includes all changes in equity (net assets) of a business during a period except those from
investments by and distributions to owners. It consists of
● Net income or loss (the bottom line of the income statement)
● Other comprehensive income (OCI)

Certain income items are excluded from the calculation of net income and instead are included in other comprehensive
income. The following are the major items included in other comprehensive income:
● The effective portion of a gain or loss on a hedging instrument in a cash flow hedge
● Unrealized holding gains and losses due to changes in the fair value of available-for-sale debt securities
● Translation gains and losses for financial statements of foreign operations
● Certain amounts associated with accounting for defined benefit postretirement plans

All items of comprehensive income are recognized for the period in either
● One continuous financial statement that has two sections, net income and OCI, or
● Two separate but consecutive statements.
■ The first statement (the income statement) presents the components of net income and total net income.
■ The second statement (the statement of OCI) is presented immediately after the first. It presents a total of OCI with its
components and a total of comprehensive income.

Limitations of the Income Statement

The income statement does not always show all items of income and expense. Some of the items are reported on a
statement of other comprehensive income and not included in the calculation of net income.

The financial statements report accrual-basis results for the period. The company may recognize revenue and report net
income before any cash was actually received.

● For example, the data from the income statement itself is not sufficient enough for assessing liquidity. This statement
must be viewed in conjunction with other financial statements, such as the balance sheet and statement of cash flows.
The preparation of the income statement requires estimates and management judgment.

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 Question: 1The profit and loss statement of an entity includes the following information for the current fiscal year:
Sales $160,000
Gross profit 48,000
Year-end finished goods inventory 58,300
Opening finished goods inventory 60,190
The cost of goods manufactured by the entity for the current fiscal year is
A. $46,110
B. $49,890
C. $110,110
D. $113,890

Question: 2In a multiple-step income statement for a retail company, all of the following are included in the operating section
except
A. Sales.
B. Cost of goods sold.
C. Dividend revenue.
D. Administrative and selling expenses.

Question: 3Which one of the following would be shown on a multiple-step income statement but not on a single-step income
statement?
A. Loss from discontinued operations.
B. Gross profit.
C. Cost of goods sold.
D. Net income from continuing operations.

Question: 4A retail entity maintains a markup of 25% based on cost. The entity has the following information for the current year:
Purchases of merchandise $690,000
Freight-in on purchases 25,000
Sales 900,000
Ending inventory 80,000
Beginning inventory was
A. $40,000
B. $85,000
C. $110,000
D. $265,000

Question: 5The financial statement that provides a summary of the firm’s operations for a period of time is the
A. Income statement.
B. Statement of financial position.
C. Statement of shareholders’ equity.
D. Statement of retained earnings.

Question: 6Comprehensive income is best defined as

A. Net income excluding extraordinary gains and losses.
B. The change in net assets for the period including contributions by owners and distributions to owners.
C. Total revenues minus total expenses.
D. The change in net assets for the period excluding owner transactions.

Question: 7Which one of the following items is included in the determination of income from continuing operations?
A. Discontinued operations.
B. Extraordinary loss.
C. Cumulative effect of a change in an accounting principle.
D. Unusual loss from a write-down of inventory.

Question: 8Because of inexact estimates of the service life and the residual value of a plant asset, a fully depreciated asset was
sold in the current year at a material gain. This gain most likely should be reported
A. In the other revenues and gains section of the current income statement.
B. As part of sales revenue on the current income statement.
C. In the extraordinary item section of the current income statement.
D. As an adjustment to prior periods’ depreciation on the statement of changes in equity.

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 Question: 9In recording transactions, which of the following best describes the relation between expenses and losses?
A. Losses are extraordinary charges to income, whereas expenses are ordinary charges to income.
B. Losses are material items, whereas expenses are immaterial items.
C. Losses are expenses that may or may not arise in the course of ordinary activities.
D. Expenses can always be prevented, whereas losses can never be prevented.

Question: 10An entity has a 50% gross margin, general and administrative expenses of $50, interest expense of $20, and net
income of $10 for the year just ended. If the corporate tax rate is 50%, the level of sales revenue for the
year just ended was
A. $90
B. $135
C. $150
D. $180

Question: 11Assume that employees confessed to a $500,000 inventory theft but are not able to make restitution. How should this
material fraud be shown in the company’s financial statements?
A. Classified as a loss and shown as a separate line item in the income statement.
B. Initially classified as an accounts receivable because the employees are responsible for the goods.
Because they cannot pay, the loss would be recognized as a write-off of accounts receivable.
C. Included in cost of goods sold because the goods are not on hand, losses on inventory shrinkage are ordinary, and it would cause
the least amount of attention.
D. Recorded directly to retained earnings because it is not an income-producing item.

Question: 12An entity had the following opening and closing inventory balances during the current year:

Work-in-progress 220,000 175,000

The following transactions and events occurred during the current year:
$300,000 of raw materials were purchased, of which $20,000 were returned because of defects.
$600,000 of direct labor costs were incurred.
$750,000 of production overhead costs were incurred.
The cost of goods sold for the current year ended December 31 would be
A. $1,480,000
B. $1,500,000
C. $1,610,000
D. $1,650,000

Question: 13If the beginning balance for May of the materials inventory account was $27,500, the ending balance for May is
$28,750, and $128,900 of materials were used during the month, the materials purchased during
the month cost
A. $101,400
B. $127,650
C. $130,150
D. $157,650

Question: 14Given the following data for a company, what is the cost of goods sold?
Beginning inventory of finished goods $100,000
Cost of goods manufactured 700,000
Ending inventory of finished goods 200,000
Beginning work-in-process inventory 300,000
Ending work-in-process inventory 50,000
A. $500,000
B. $600,000
C. $800,000
D. $950,000

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 Question: 15The following information was taken from last year’s accounting records of a manufacturing company.

On the basis of this information, the company’s cost of goods manufactured and cost of goods sold are
A. $460,500 and $489,500, respectively.
B. $468,500 and $439,500, respectively.
C. $468,500 and $470,900, respectively.
D. $646,500 and $617,500, respectively.

Question: 16The following information pertains to a corporation’s income statement for the 12 months just
ended. The company has an effective income tax rate of 40%.
Discontinued operations $(70,000)
Income from continuing operations (net of tax) 72,000
Cumulative effect of change in accounting principle 60,000
Net income for the year is
A. $36,000
B. $12,000
C. $8,000
D. $30,000

Question: 17Which of the following items is not classified as other comprehensive income (OCI)?
A. Extraordinary gains from extinguishment of debt.
B. Foreign currency translation adjustments.
C. Prior service cost adjustment resulting from amendment of a defined benefit pension plan.
D. Unrealized gains for the year on available-for-sale debt securities.

Question: 18Which of the following are acceptable formats for reporting comprehensive income?
I. In one continuous financial statement
II. In a statement of changes in equity
III. In a separate statement of net income
IV. In two separate but consecutive financial statements
A. I and II only.
B. I, II, and III only.
C. III and IV only.
D. I and IV only.

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 Question: 19A company reports the following information as of December 31:
Sales revenue $800,000
Cost of goods sold 600,000
Operating expenses 90,000
Unrealized holding gain on available-for-sale debt securities, net of tax 30,000
What amount should the company report as comprehensive income as of December 31?
A. $30,000
B. $110,000
C. $140,000
D. $200,000

Question: 20All of the following are defined as elements of an income statement except
A. Expenses.
B. Shareholders’ equity.
C. Gains and losses.
D. Revenues.

Question: 21According to U.S. GAAP, where on the income statement should a multinational company report the loss from the
disposal sale of a major operating unit?
A. Report the loss, pretax, in a separate section between income from continuing operations and net income.
B. Report the loss, net of tax, in a separate section between income from continuing operations and net income.
C. Report the loss, pretax, in a separate section between income from operations and income before income tax.
D. Report the loss, net of tax, in a separate section between income before tax and net income.

Question: 22A company reported first quarter revenues of $10,000,000, gross profit margin of 25%, and
operating income of 15%. To reduce overhead expenses, a consultant recommends that the company outsource some
of its operating activities beginning with the second quarter. This recommendation is anticipated to reduce operating

expenses by 20% without affecting sales volume. The company has an income tax rate of 35%. Assuming cost of
sales remains at 75%, what is the impact on the income statement if the company implements the recommendation?
A. Gross profit will increase by 8.0%.
B. Operating income will increase by 8.7%.
C. Operating income will increase by $200,000.
D. Operating expenses will be reduced by $300,000.

Question: 23A company incurred $200,000 of manufacturing cost during the month, with a beginning finished goods inventory of
$20,000 and an ending finished goods inventory of $15,000. Assuming no work-in-process
inventories, the company’s cost of goods sold was
A. $220,000
B. $205,000
C. $200,000
D. $105,000

Question: 24To comply with the matching principle, the cost of labor services of an employee who participates in the
manufacturing of a product normally should be charged to the income statement in the period in which the
A. Work is performed.
B. Employee is paid.
C. Product is completed.
D. Product is sold.

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