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Q. 1: Why are notes to statements necessary?

ANS: Footnotes (notes) increase the full disclosure of the statements by providing information on inventory and depreciation methods, subsequent events, contingent liabilities, etc.

Q. 2: What are contingent liabilities? Are lawsuits against the firm contingent liabilities?

ANS: Contingent liabilities are dependent on an occurrence to determine if payment will be necessary.  Liabilities from lawsuits are dependent on the outcome of the cases; they, therefore, represent contingent liabilities.

Q. 3: Describe a proxy statement.

ANS: A proxy is a solicitation sent to stockholders for the election of directors and for the approval of other corporate actions.  The proxy represents the shareholder authorization regarding the casting of that shareholder’s vote.

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Q. 4: Why are adjusting entries necessary?

ANS: Most of the accounts are not up to date at the end of the accounting period.  These accounts need to be adjusted so that all revenues and expenses are recognized and the balance sheet accounts have a correct ending balance.

Q. 5: Usually, current assets are listed in a specific order, starting with cash. What is the objective of this order of listing?

ANS: They are listed in order of liquidity, which is the ease with which they can be converted to cash.

Q. 6: Differentiate between marketable securities and long-term investments. What is the purpose of owning each?

ANS: Marketable securities are held as temporary investments or idle cash.  They are short-term, low risk, highly liquid, and low yield.  Examples are treasury bills and commercial paper.  Investments are long-term, held for control or future use in operations.  They are usually less liquid and expected to earn a higher return.

Q. 7: What is depreciation? Which tangible assets are depreciated, and which are not? Why?

ANS: Depreciation measures the wearing away of the usefulness of the asset.  Tools, machinery, and buildings are depreciated because they wear out.  The land is not depreciated, since its value typically does not decline. If the land has minerals or natural resources, it may be subject to depletion.

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Q. 8: What is redeemable preferred stock? Why should it be included with debt for purposes of financial statement analysis?

ANS: Redeemable preferred stock is subject to mandatory redemption requirements or has a redemption feature that is outside the control of the issuer.  Coupled with the typical characteristics of no vote and fixed return, this security is more like debt than equity for the issuing firm.

Q. 9: Describe fair value as it relates to assets and liabilities.

 ANS: Donated capital results from donations to the company by stockholders, creditors, or other parties.

Q. 10: Describe depreciation, amortization, and depletion. How do they differ?

ANS: Depreciation is the process of allocating the cost of building and machinery over periods of benefit. Spreading the cost of an intangible asset is called amortization while spreading the cost of a natural resource is called depletion.

Q. 11: What are extraordinary items? How are they shown on the income statement? Why are they shown in that manner?

items are events or transactions that are distinguished by their unusual nature and infrequency of occurrence.  They might include casualty losses or losses from expropriation or prohibition.  They must be shown separately, net of tax, in order that trend analysis can be made of income before extraordinary items.

Q. 12: What is the difference in the impact on financial statements of a stock dividend versus a stock split?

ANS: First, a stock split is usually for a larger number of shares.  Secondly, a stock dividend reduces retained earnings and increases paid-in capital.  A stock split merely increases the shares and reduces the par value, leaving the capital stock account intact.  Both require a restatement of any per share items.

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Q. 13: Explain the relationship between the income statement and the reconciliation of retained earnings.

ANS: The statement of retained earnings summarizes the changes to retained earnings.  Retained earnings represent the undistributed earnings of the corporation.  The income statement net income is added to retained earnings.  A loss is deducted from retained earnings.

Q. 14: What is the reason for separating current assets from the rest of the assets found on the balance sheet?

ANS: Current assets are assets that are in the form of cash or that will be realized in cash or that conserve the use of cash within an operating cycle of a business, or one year, whichever is the longer period of time.

The other assets are not expected to be realized in cash in the near future and should, therefore, be segregated from current assets.

Q. 15: Define the operating cycle.

ANS: The operating cycle is the period of time elapsing between the acquisition of goods and the final cash realization resulting from sales and subsequent collections.

Q. 16: Discuss how to use working capital in analysis.

ANS: The current working capital amount should be compared with past working capital amounts to determine if working capital is reasonable.  Caution must be exercised because the relative size of the firm may be expanding or contracting.  Comparing the working capital of one firm with the working capital of another firm will usually be meaningless because of the different sizes of the firms.

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Q. 17: List three situations in which the liquidity position of the firm may be better than that indicated by the liquidity ratios.


(1) Unused bank credit lines.

(2) Long-term assets that have the potential to be converted to cash quickly.

(3) Capability to issue debt or stock.

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Q. 18: List three situations in which the liquidity position of the firm may not be as good as that indicated by the liquidity ratios.

ANS: There are many situations where the liquidity position of the firm may not be as good as that indicated by the liquidity ratios.  Some of the situations are the following:

(1) Notes discounted in which the other party has full recourse against the firm.

(2) Guarantee of a bank note for another firm.

(3) Major pending lawsuits against the firm.

(4) A major portion of the inventory is obsolete.

(5) A major portion of the receivables are uncollectible

Q. 19: Indicate the objective of the sales to working capital ratio. ANS: The sales to working capital ratio give an indication of whether working capital is used unprofitably or is possibly overworked.

Q. 20: A relatively low sales to working capital ratio is a tentative indication of efficient use of working capital. Comment. A relatively high sales to working capital ratio is a tentative indication that the firm is undercapitalized. Comment.

ANS: No, a low sale to working capital ratio is an indication of an unprofitable use of working capital.  It indicates that low amounts of sales are being generated for each dollar of working capital.

Yes, a high ratio is a tentative indication that the firm is undercapitalized.  This firm will likely have a high inventory turnover and a low current ratio.

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