1. Which of the following statements about accrual accounting is false?

A. Accrual accounting is concerned with the process by which cash expended on resources and
activities is returned as more (or perhaps less) cash to the entity, not just with the beginning and
end of that process.
B. Accrual accounting recognizes that buying, producing, selling, and other operations of an entity
during a period often do not coincide with the cash receipts and payments of the period.
C. Accrual accounting attempts to record the financial effects on an entity of transactions and other
events and circumstances that have cash consequences for an entity.
D. Accrual accounting is primarily concerned with the cash receipts and cash payments of an entity.
E. None of the above is true.
Answer (D) is correct. Accrual accounting attempts to record the financial effects on an entity of
transactions and other events and circumstances that have cash consequences in the periods in which
those transactions, events, and circumstances occur, rather than only in the periods in which cash is
received or paid by the entity. Thus, the focus of accrual accounting is not primarily on the actual cash
receipts and cash payments. It is concerned with the process by which cash expended on resources is
returned as more (or perhaps less) cash to the entity, not just with the beginning and end of the process.

2. Which of the following best describes the distinction between expenses and losses?
A. Losses are reported net of related tax effect, but expenses are not reported net of tax.
B. Losses are extraordinary charges, but expenses are ordinary charges.
C. Losses are material items, but expenses are immaterial items.
D. Losses result from peripheral or incidental transactions, but expenses result from ongoing major
or central operations of the entity.
E. None of the above is true.
Answer (D) is correct. SFAC 6, Elements of Financial Statements, defines expenses as “outflows or other
using up of assets or incurrences of liabilities (or a combination of both) from delivering or producing
goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or
central operations.” Losses are defined as “decreases in equity (net assets) from peripheral or incidental
transactions of an entity and from all other transactions and other events and circumstances affecting the
entity except those that result from expenses or distributions to owners.

3. Some costs cannot be directly related to particular revenues but are incurred to obtain benefits that
are exhausted in the period in which the costs are incurred. An example of such a cost is
A. Salespersons’ monthly salaries.
B. Salespersons’ commissions.
C. Transportation to customers.
D. Prepaid insurance.
E. None of the above is true.

Answer (A) is correct. Expenses should be recognized when benefits have been consumed. The
consumption of benefit may occur when (1) the expenses are matched with the revenues, (2) they are
allocated on a systematic and rational basis to the periods in which the related assets are expected to
provide benefits, or (3) the cash is spent or liabilities are incurred for goods and services that are used up
either simultaneously with the acquisition or soon after. Salespersons’ monthly salaries is an example of a
cost that cannot be directly related to particular revenues but is incurred to obtain benefits that are
exhausted in the period in which the cost is incurred.

4. When bad debt expense is estimated on the basis of the percentage of past actual losses from bad
debts to past net credit sales, and this percentage is adjusted for anticipated conditions, the
accounting concept of
A. Matching is being followed.
B. Matching is not being followed.
C. Substance over form is being followed.
D. Going concern is not being followed.
E. More than one of the above is true.
Answer (A) is correct. When bad debt expense is estimated on the basis of net credit sales, a cost (bad
debt expense) is being directly associated with a revenue of the period (net credit sales). This practice
applies the expense recognition principle of associating cause and effect, also known as matching.
Answer (B) is incorrect. Matching is being followed. Answer (C) is incorrect. Substance over form refers
to that feature of financial accounting that emphasizes the economic substance of a transaction rather
than its legal form. For example, a lease may actually be a purchase. Answer (D) is incorrect. The going-
concern assumption is that the entity will continue in operation, and liquidation values do not have to be
used.

5. On November 1, Fitz Co. paid $3,600 to renew its insurance policy for 3 years. On December 31,
Fitz’s unadjusted trial balance showed a balance of $90 for prepaid insurance and $4,410 for
insurance expense. What amounts should be reported for prepaid insurance and insurance expense
in Fitz’s December 31 financial statements?
Prepaid Expense Insurance Expense
A. $3,300 $1,200
B. $3,400 $1,200
C. $3,400 $1,100
D. $3,490 $1,010
E. None of the above.
Answer (C) is correct. At year end, the expense and prepaid insurance accounts should be adjusted to
reflect the expired amounts. The entry to record the insurance renewal included a debit to insurance
expense for $3,600. The balance in prepaid insurance has expired. The 3-year prepayment is amortized at
$100 per month ($3,600 ÷ 36 months), or $200 for the first calendar year. Consequently, insurance
expense for the year should be $1,100 [$90 prepaid insurance balance + ($4,410 – $3,400 unexpired
amount of the November 1 prepayment)]. The $3,400 unexpired amount should be reported as prepaid
insurance.

6. A characteristic of all assets and liabilities included in working capital is that they are
A. Cash equivalents.
B. Current.
C. Monetary.
D. Marketable.
E. None of the above.
Answer (B) is correct. Working capital is the excess of current assets over current liabilities. Working
capital identifies the relatively liquid portion of the capital of the entity available for meeting obligations
within the operating cycle of the firm.

7. Cathay Co. owns a royalty interest in an oil well. The contract stipulates that Cathay will receive
royalty payments semiannually on January 31 and July 31. The January 31 payment will be for 20%
of the oil sold to jobbers between the previous June 1 and November 30, and the July 31 payment
will be for oil sold between the previous December 1 and May 31. Royalty receipts for Year 2
amounted to $80,000 and $100,000 on January 31 and July 31, respectively. On December 31, Year
1, accrued royalty revenue receivable amounted to $15,000. Production reports show the following
oil sales:
June 1, Year 1 – November 30, Year 1 $400,000
December 1, Year 1 – May 31, Year 2 500,000
June 1, Year 2 – November 30, Year 2 425,000
December 1, Year 2 – December 31, Year 2 70,000
What amount should Cathay report as royalty revenue for Year 2?
A. $179,000
B. $180,000
C. $184,000
D. $194,000
E. None of the above.
Answer (C) is correct. The royalty revenue for Year 2 is 20% of Year 2 oil sales. Given that 12/1/Year 1 –
5/31/Year 2 oil sales equaled $500,000 and that the accrued royalty for December Year 1 was $15,000, oil
sales for that month must have been $75,000 ($15,000 accrued ÷ 20%). Hence, oil sales for Year 2 are
$920,000 [($500,000 – $75,000) + $425,000 + $70,000]. Thus, royalty revenue for Year 2 is $184,000
($920,000 × 20%).

8. Which of the following items should be reported in other comprehensive income (OCI)?
A. Unrealized loss on an investment classified as a trading security.
B. Unrealized loss on an investment classified as an available-for-sale security.
C. Realized loss on an investment classified as an available-for-sale security.
D. Cumulative effect of a change in accounting principle.
E. None of the above.
Answer (B) is correct. Comprehensive income includes all changes in equity of a business entity except
those changes resulting from investments by owners and distributions to owners. Comprehensive income
includes two major categories: net income and OCI. Net income includes the results of operations
classified as income from continuing operations, discontinued operations and extraordinary items.
Components of comprehensive income not included in the determination of net income are included in
OCI, for example, unrealized gains and losses on availablefor- sale securities (except those that are
hedged items in a fair value hedge).

9. Henry Stores, Inc., had sales of $2,000,000 during December. Experience has shown that
merchandise equaling 7% of sales will be returned within 30 days and an additional 3% will be
returned within 90 days. Returned merchandise is readily resalable. In addition, merchandise
equaling 15% of sales will be exchanged for merchandise of equal or greater value. What amount
should Henry report for net sales in its income statement for the month of December?
A. $1,800,000
B. $1,700,000
C. $1,560,000
D. $1,500,000
E. None of the above.
Answer (A) is correct. Net sales equal gross sales minus net returns and allowances. No adjustments are
made for anticipated exchanges for merchandise of equal or greater value. Hence, net sales equal
$1,800,000 [$2,000,000 – ($2,000,000 × 10%)].

10. The Poirot Company began operations on January 1 of the year before last and uses the FIFO
method in costing its raw material inventory. Management is contemplating a change to the LIFO
method and is interested in determining what effect such a change will have on net income.
Accordingly, the following information has been developed:
Final Inventory Year 1 Year 2
FIFO $240,000 $270,000
LIFO 200,000 210,000
Net Income (per FIFO) $120,000 $170,000
Based upon the above information, a change to the LIFO method in Year 2 results in net income for Year
2 of
A. $110,000
B. $150,000
C. $170,000
D. $230,000
E. None of the above.
Answer (A) is correct. In the first year of operations, beginning inventory is the same under FIFO and
LIFO. The amount of purchases in any year is also the same. The difference in the first year was that FIFO
ending inventory was $40,000 greater ($240,000 FIFO – $200,000 LIFO). Thus, FIFO net income was also
$40,000 greater. The difference in income in the second year is equal to the $20,000 difference between
the FIFO inventory change and the LIFO inventory change (FIFO: $270,000 – $240,000 = $30,000
change; LIFO: $210,000 – $200,000 = $10,000 change; $30,000 – $10,000 = $20,000 difference). The
$170,000 FIFO net income will decrease by $60,000 ($40,000 cumulative effect on beginning retained
earnings + $20,000). Net LIFO income will therefore be $110,000 ($170,000 – $60,000).

11. Treasury stock transactions may result in

 A. Increases in the balance of retained earnings.
B. Increases or decreases in the amount of net income.
C. Decreases in the balance of retained earnings.
D. Increases or decreases in the amount of shares authorized to be issued.
E. None of the above.
Answer (C) is correct. Under the par-value method, when treasury shares are purchased for a price
greater than the par value, retained earnings is debited for the excess of the purchase price over the par
value if there is no existing paid-in capital from past treasury stock transactions or if the existing credit
balance is insufficient to absorb the excess. Under the cost method, if the subsequent resale price of the
treasury shares is less than the original acquisition price, it may be necessary to charge retained earnings
for a portion or all of the excess of the original purchase price over the sales price.

12. Lorraine Co. has determined its fiscal year-end inventory on a FIFO basis to be $400,000.
Information pertaining to that inventory follows:
Estimated selling price $408,000
Estimated cost of disposal 20,000
Normal profit margin 60,000
Current replacement cost 360,000
Lorraine records losses that result from applying the lower-of-cost-or-market (LCM) rule. At its year end,
what should be the net carrying amount of Lorraine’s inventory?
A. $400,000
B. $388,000
C. $360,000
D. $328,000
E. None of the above
Answer (C) is correct. Under the LCM method, market is current replacement cost subject to a maximum
(ceiling) equal to net realizable value and a minimum (floor) equal to net realizable value minus a normal
profit. NRV equals selling price minus costs of completion and disposal. Here, original cost is $400,000
and replacement cost is $360,000. The LCM method uses the lower of the two, $360,000, to measure
inventory. However, the inventory measure cannot exceed the NRV of $388,000 ($408,000 selling price –
$20,000 cost of disposal). Furthermore, the inventory carrying amount cannot be lower than NRV minus
normal profit, or $328,000 ($388,000 NRV – $60,000 normal profit). Because the lower of cost or market
($360,000) is between $388,000 (ceiling) and $328,000 (floor), the net carrying amount is $360,000.

13. Interest should be capitalized for assets that are

A. In use or ready for their intended use in the earning activities of the entity.
B. Being constructed or otherwise being produced as discrete projects for an entity’s
own use.
C. Not being used in the earning activities of the entity and not undergoing the activities necessary to get
them ready for use.
D. Routinely produced.
E. None of the above.
Answer (B) is correct. GAAP require capitalization of material interest costs for assets constructed for
internal use and those constructed for sale or lease as discrete projects. It does not apply to products
routinely produced for inventory, assets in use or ready for use, assets not being used or being prepared
for use, and idle land.

14. When an investor uses the equity method to account for investments in common stock, the
investment account will be increased when the investor recognizes
A. A proportionate interest in the net income of the investee.
B. A cash dividend received from the investee.
C. Periodic amortization of the goodwill related to the purchase.
D. Depreciation related to the excess of fair value over the carrying amount of the investee’s depreciable
assets at the date of purchase by the investor.
E. None of the above.
Answer (A) is correct. Under the equity method, the investor’s share of the investee’s net income is
accounted for as an addition to the carrying amount of the investment on the investor’s books. Losses and
dividends are reflected as reductions of the carrying amount.

15. On January 2, Year 1, Kean Co. purchased a 30% interest in Pod Co. for $250,000. On this date,
Pod’s equity was $500,000. The carrying amounts of Pod’s net assets approximated their fair values
except for land, for which fair value exceeded its carrying amount by $200,000. Pod reported net
income of $100,000 for Year 1 and paid no dividends. Kean accounts for this investment using the
equity method. In its December 31, Year 1, balance sheet, what amount should Kean report as
investment in subsidiary?
A. $210,000
B. $220,000
C. $276,000
D. $280,000
E. None of the above.
Answer (D) is correct. The purchase price is allocated to the fair value of the net assets acquired, with the
remainder allocated to goodwill. The fair value of Kean’s 30% interest in Pod’s net assets is $210,000
[($500,000 + $200,000) × 30%]. Goodwill is $40,000 ($250,000 – $210,000). The equity method requires
the investor’s share of subsequent net income reported by the investee to be adjusted for the difference at
acquisition between the fair value and the carrying amount of the investee’s net assets when the net
assets are sold or consumed in operations. The land is assumed not to be sold, and the equity method
goodwill is not amortized or separately reviewed for impairment. Thus, Kean’s share of Pod’s net income
is $30,000 ($100,000 declared income × 30%), and the investment account at year end is $280,000
($250,000 acquisition balance + $30,000 investment income).

16. On March 1, Year 1, Clark Co. issued bonds at a discount. Clark incorrectly used the straight-line
method instead of the effective interest method to amortize the discount. How were the following
amounts, as of December 31, Year 1, affected by the error?
Bond Carrying Amount Retained Earnings
A. Overstated Overstated
B. Understated Understated
C. Overstated Understated
D. Understated Overstated
E. None of the above.
Answer (C) is correct. The straight-line method records the same amount of expense (cash interest paid +
proportionate share of discount amortization) for each period. The effective interest method applies a
constant rate to an increasing bond carrying amount (face amount – discount + accumulated discount
amortization), resulting in an increasing amortization of discount and increasing interest expense.
Accordingly, in the first 10 months of the life of the bond, since straight-line amortization of discount is
greater than under the interest method, interest expense is also greater. The effects are an
understatement of unamortized discount, an overstatement of the carrying amount of the bonds, an
understatement of net income, and an understatement of retained earnings.