Question 1

1.A.1.b

tb.fin.inc.010_1805

LOS: 1.A.1.b

Lesson Reference: Overview of Financial Statements and the Income Statement

Difficulty: hard

Bloom Code: 4

The most likely use of an income statement prepared by a business enterprise is its use by which of the following?

Labor unions to examine earnings closely as a basis for salary discussions.

Government agencies to formulate tax and economic policy.

Customers to determine a company's ability to provide needed goods and services.

Rationale

 Investors interested in the financial performance of the entity.

The FASB's conceptual framework identifies potential investors and creditors as the primary focus of financial statements. An income statement

provides information about a business's profitability. Whether a business is profitable is likely to influence an investor's decision to invest in that

business as it is one aspect of its financial performance. Therefore, this is the correct answer.

Rationale

 Labor unions to examine earnings closely as a basis for salary discussions.

While labor unions may examine earnings as a basis for salary discussions, it is just one factor in those discussions. In addition, the FASB conceptual

framework identifies potential investors and creditors, not labor unions, as the primary focus of financial statements. Therefore, this is an incorrect

answer.

Rationale

 Government agencies to formulate tax and economic policy.

An income statement provides information about one business and is not likely to be very useful to formulate tax and economic policy. It is based

on accrual accounting, which is different from tax accounting. Therefore, this is an incorrect answer.

Rationale

 Customers to determine a company's ability to provide needed goods and services.

A customer may use an income statement to assess a company's financial performance as a company in poor financial condition may not be

reliable supplier. However, it is not likely to be the major factor in the decision. Therefore, this is an incorrect answer.

Investors interested in the financial performance of the entity.

Correct

Question 2

1.A.1.a

tb.fin.inc.001_1805

LOS: 1.A.1.a

Lesson Reference: Overview of Financial Statements and the Income Statement

Difficulty: medium

Bloom Code: 4

Which aspect of a firm's statement of cash flows most interests potential stockholders?

Changes in the firm's inventory balance

The firm's gains and losses from selling plant assets

Rationale

 The firm's investments in new plant assets

Potential shareholders are generally most interested in a firm's ability to increase its stock price and pay dividends. While investment in new plant

assets may give some information about a firm's growth potential, it does not provide the most useful information to potential shareholders

because it does not involve dividends. Therefore, this is an incorrect answer.

Rationale

 Changes in the firm's inventory balance

A change in a firm's inventory balance is important information. However, potential shareholders are more interested in cash flow generated.

Additionally, the change in inventory is better seen by looking at the balance sheet. Therefore, this is an incorrect answer.

Rationale

 The firm's gains and losses from selling plant assets

Gains and losses from selling plant assets is important information. However, potential shareholders are more interested in cash flow generated.

Therefore, this is an incorrect answer.

Rationale

 The firm's ability to pay dividends

Potential shareholders are generally interested in a firm's ability to increase its stock price and pay dividends. The statement of cash flows provides

information about cash generated (that can be used for future dividends) and cash used to pay dividends in the past. Therefore, this is the correct

answer.

The firm's ability to pay dividends

Correct

The firm's investments in new plant assets

Your Answer

Question 3

1.A.1.e

tb.fin.inc.018_1805

LOS: 1.A.1.e

Lesson Reference: Overview of Financial Statements and the Income Statement

Difficulty: medium

Bloom Code: 4

When using the indirect method, which statement provides the most accurate description of the relationship between accounts receivable and the

operating activities section on the statement of cash flows?

A decrease in accounts receivable results in a decrease in the operating activities section on the statement of cash flows.

A decrease in accounts receivable results in no change in the operating activities section on the statement of cash flows.

Rationale

 An increase in accounts receivable results in an increase in the operating activities section on the statement of cash flows.

An increase in accounts receivable means that sales made on credit exceeded collections from customers. Since net income (the starting point of

the operating activities section) uses cash sales and not cash collections, adding the increase in accounts receivable would result in “double

counting” cash collections. Therefore, this is an incorrect answer.

Rationale

 An increase in accounts receivable results in a decrease in the operating activities section on the statement of cash flows.

An increase in accounts receivable means that sales made on credit exceeded collections from customers. Since net income (the starting point of

the operating activities section) uses cash sales and not cash collections, the increase in accounts receivable must be subtracted when calculating

cash flow from operating activities. Therefore, this is the correct answer.

Rationale

 A decrease in accounts receivable results in a decrease in the operating activities section on the statement of cash flows.

A decrease in accounts receivable means that collections from customers exceeded sales made on credit. Since net income (the starting point of

the operating activities section) uses cash sales and not cash collections, the decrease in accounts receivable must be added when calculating cash

flow from operating activities, not subtracted. Otherwise, cash flow from operating activities would be understated. Therefore, this is an incorrect

answer.

Rationale

 A decrease in accounts receivable results in no change in the operating activities section on the statement of cash flows.

A decrease in accounts receivable means that collections from customers exceeded sales made on credit. Since net income (the starting point of

the operating activities section) uses cash sales and not cash collections, the decrease in accounts receivable must be added when calculating cash

flow from operating activities. Otherwise, cash flow from operating activities would be understated. Therefore, this is an incorrect answer.