1 02 Income Determination
18. Basic earnings per share is computed by dividing net income by the
Income Determination weighted average number of common shares of stock outstanding.
True-False 19. The change in equity of an entity during a period from transactions
and other events from non-owner sources is known as comprehensive income.
1. To measure earnings under accrual accounting, revenues are recog-
nized when they are received. 20. The basic accounting equation may be expressed as assets = liabilities –
owners’ equity.
2. Revenues are earned when the seller substantially completes perform-
ance required by an agreement. 21. Debit means increase.
3. The matching principle requires that expenses be recognized in the 22. A contra account is an account that is subtracted from a related ac-
same period in which the revenues are recognized that were produced by the count.
expenses. 23. Revenues increase owners’ equity and expenses decrease owners’ eq-
4. Recognition of revenue under the cash basis occurs when the revenue is uity.
received. 24. To get revenue and expense account balances to zero an adjusting
5. Under the cash basis, expenses are recognized when the costs expire entry is made.
or assets are used.
6. Cash-basis accounting provides the most useful measure of future op-
erating performance. Multiple-Choice Questions
7. Accrual accounting recognition rules for revenues and expenses are Select the best answer from those provided.
designed to alleviate mismatching problems that exist under cash basis account-
25. Revenues are earned when
ing.
a. a contract is signed by both parties.
8. According to generally accepted accounting principles, revenue should b. the seller substantially completes performance required by an agree-
be recognized at the earliest time that the “critical event” has taken place and ment.
the proceeds are collected. c. the buyer completes payment required under an agreement.
9. A ship building company is likely to recognize revenue at the comple- d. the buyer accepts delivery and completes required payments.
tion of production.
10. Costs matched with the passage of time are called period costs. 26. The matching principle requires that expenses be recognized
a. in the same period as the costs expire or assets are used.
11. Traceable costs are also called period costs.
b. in the same period in which the revenues are recognized that the ex-
12. The process of reporting transitory income items net of tax on the in- penses help to produce.
come statement is known as intraperiod income tax allocation. c. when the costs are paid by the entity.
13. To be reported as an extraordinary item on the income statement, an d. in the same period that the revenue is received that the expenses help
event must be either unusual in nature or an infrequent occurrence. to produce.
14. If a material event is either unusual in nature or an infrequent occur-
rence it is classified on the income statement as a special or unusual item in Table 2-1
continuing operations. The IBM Corporation sells ten copiers to the Title Company on October 15 for
15. The write-off of obsolete inventory would be reported on the income $40,000. Canon delivers the copiers to Title on October 20; Title pays $16,000,
statement as a special item in continuing operations. and agrees to pay the balance on November 10.
16. When a company changes from LIFO to another inventory method, the
change is reported as a retroactive adjustment. 27. Refer to Table 2-1. Under the cash basis, how much revenue is recog-
17. When accounting estimates are changed, the income effect of the nized in October?
changed estimate is accounted for in the period of the change and in future a. $0
periods. b. $ 16,000
2 02 Income Determination
c. $ 24,000 a. defined by generally accepted accounting principles for every situation.
d. $ 40,000 b. the same for every industry.
c. dependent upon the exact nature of the business and industry.
28. Refer to Table 2-1. Under the accrual basis, how much revenue is rec- d. easily defined by the FASB.
ognized in November?
a. $0 34. To recognize revenue during the production phase, a specific customer
b. $ 16,000 must be identified, an exchange price agreed upon, remaining costs to complete
c. $ 24,000 are reliably estimable, a significant portion of the services contracted are per-
d. $ 40,000 formed, and
a. a reasonable estimate of cash collection determined.
29. Refer to Table 2-1. Using the accrual basis, which one of the following b. the seller has the right to terminate the exchange.
entries would properly record the revenue recognition for October? c. a firm delivery date established.
d. the product is immediately salable at quoted market prices.
a. DR Cash 40,000
35. Which one of the following businesses is likely to recognize revenue
CR Copier sales 40,000
during the production phase?
b. DR Cash 16,000
CR Copier sales 16,000 a. Mining company
c. DR Cash 16,000 b. Cruise ship builder
DR Accounts receivable 24,000 c. Citrus grower
CR Copier sales 40,000 d. Department store
d. DR Accounts receivable 40,000
CR Copier sales 40,000 36. To recognize revenue upon completion of production, the product must
be immediately saleable at quoted market prices, no significant uncertainty ex-
30. Income recognition always increases ists regarding cost of distributing the product, and
a. assets. a. the seller has the right to terminate the exchange.
b. net assets. b. the units are homogeneous.
c. liabilities. c. a firm delivery date must be established.
d. net liabilities. d. a specific customer must be identified.
31. The real accounting issue in income recognition is the 37. To recognize revenue after the time of sale, there must be extreme
uncertainty regarding the amount of cash to be collected or
a. quantity of income recognized.
b. type of income recognized. a. substantial future services required whose costs are not reasonably
c. timing of the recognition. estimable.
d. basis of income recognition. b. units are heterogeneous.
c. the product is immediately salable at quoted market prices.
d. a formal contract must be signed.
32. According to generally accepted accounting principles, revenue should
be recognized at the earliest time that
Table 2-2
a. the “critical event” has taken place and the proceeds are collected.
b. the “critical event” has taken place and the amount of revenue col- Hickory Furniture Company had the following costs paid during the month of
lected is reasonably assured. May:
c. collection is reasonably assured and the “critical event” can be measured. Inventory purchases $40,000
d. collection has taken place and the “critical event” can be measured. Marketing costs 8,000
Delivery costs 2,000
33. The “critical event” for revenue recognition is Huntington’s sold $32,000 of the inventory and has agreed to pay the warranty
3 02 Income Determination
expenses of $1,600 spread evenly over the next four months for its customers. c. income before extraordinary item and change in accounting principle.
d. net income.
38. Refer to Table 2-2. What is the amount of Hickory’s cash-basis expense
45. On the income statement, income from discontinued operations is
for the month of May?
shown
a. $33,600
a. as a separate section of income from continuing operations.
b. $42,400
b. as an accounting principle change.
c. $50,000
c. without any income tax effect.
d. $51,600
d. net of taxes after income from continuing operations.
39. Refer to Table 2-2. What is the amount of Hickory’s May expense when
46. Black & Decker decides to discontinue producing toasters in favor of
applying the matching principle?
more versatile toaster oven. In the process of discontinuing this line, the com-
a. $33,600 pany disposes of the old equipment and buys new. The disposal of the old
b. $42,400 equipment would be reported in the income statement as
c. $50,000
a. gain or loss on the sale of equipment as part of continuing operations.
d. $51,600
b. gain or loss on the sale of production equipment as part of extraordi-
nary gains and losses.
40. Refer to Table 2-2. What type of cost is the advertising expense? c. gain or loss on the disposal of discontinued business component.
a. Product cost d. income from operation of a discontinued business component.
b. Traceable cost
c. Inventory cost 47. A component of an entity may be a/an
d. Period cost
a. reportable or operating segment.
b. subsidiary.
41. Traceable costs are also called c. asset group.
a. period costs. d. All of the above.
b. expired costs.
c. product costs.
d. administrative costs. 48. The discontinued operations section of the income statement is com-
prised of which one of the following?
42. Income statements are classified into sections to a. Income from the operation of discontinued business component and
gain or loss from the disposal of the discontinued component.
a. separate earned income from unearned income.
b. Income from the operation of discontinued business component, net of
b. distinguish between sustainable and transitory income.
tax, and gain or loss from the disposal of the discontinued component,
c. separate real income from book income.
net of tax.
d. distinguish between book income and taxable income.
c. Income from the operation of discontinued business component, net of
tax and gain or loss from the disposal of the discontinued component.
43. The rationale behind the rules for multiple-step income statements is d. Gain or loss from the disposal of the discontinued component, net of tax.
to subdivide the statement in a manner that facilitates
a. cash flows. 49. To be reported as an extraordinary item on the income statement, an
b. forecasting. event must be
c. tax return preparation.
a. both unusual in nature and an infrequent occurrence.
d. audits.
b. either unusual in nature or an infrequent occurrence.
c. unusual in nature.
44. The best measure of a firm’s sustainable income is d. an infrequent occurrence.
a. income from continuing operations.
b. income before extraordinary items. 50. If a material event is either unusual in nature or an infrequent occur-
4 02 Income Determination
rence it is classified on the income statement as a/an current disclosure rules require that
a. special item in continuing operations. a. all prior years’ income statements be restated to reflect use of the new
b. special item in continuing operations shown net of tax. principle.
c. extraordinary item. b. all prior years’ income statements be restated to reflect use of the new
d. extraordinary item shown net of tax. principle, and include a pro forma income figure of the previously re-
ported income.
51. Which one of the following events would be considered an extraordi- c. no prior years’ income statements be restated, but a pro forma income
nary event? figure be provided to reflect use of the new principle for each year pre-
a. A tornado in Kansas sented.
b. An earthquake in New York d. no prior years’ income statements be restated, and no pro forma in-
c. A flood in St. Louis near the Mississippi River come figures be provided.
d. An earthquake in southern California
56. When a company changes from LIFO to another inventory method, the
52. A special one-time charge resulting from corporate restructurings change is reported as a/an
would be reported on the income statement as a/an a. cumulative effect change.
a. extraordinary item shown net of tax. b. error correction.
b. special item in continuing operations. c. change in an accounting estimate.
c. special item in continuing operations, shown net of tax. d. retroactive adjustment.
d. special item in discontinued operations, shown net of tax.
57. When a company changes from straight-line depreciation to double-
53. When reporting a change in an accounting principle, the general rule declining-balance depreciation, the change is reported as a/an
requires that the current year’s income from continuing operations reflect a. cumulative effect change.
a. use of the newly adopted principle for the current year recognition. b. error correction.
b. use of the old principle for the current year recognition. c. change in an accounting estimate.
c. management’s choice of either the old or newly adopted principle for d. retroactive adjustment.
the current year recognition.
d. FASB’s designation of either the old or newly-adopted principle based 58. When a company changes from any inventory method to LIFO, the
on the item being changed. cumulative effect on prior years is
a. reported as a cumulative effect change.
54. A cumulative effect of a change in an accounting principle is measured b. deemed to be indeterminable and is not disclosed.
as c. is not allowed under GAAP.
a. the difference between prior periods’ income under the old method d. reported as a retroactive adjustment.
and what would have been reported if the new method had been used
in the prior years. 59. Royal, Inc. discovered that equipment purchased three years ago for
b. the after-tax difference between prior periods’ income under the old $300,000 will not last as long as originally estimated. The firm was depreciating
method and what would have been reported if the new method had the equipment at the rate of $40,000 per year with an estimated salvage value
been used in the prior years. of $20,000. New estimates indicate that the equipment will last a total of five
c. the difference between prior periods’ income and current income under years with no salvage value. How much should Royal, Inc. record as deprecia-
the old method and what would have been reported if the new method tion in year four?
had been used in the prior years and the current year. a. $ 40,000
d. the after-tax difference between prior periods’ income and current in- b. $ 60,000
come under the old method and what would have been reported if the c. $ 90,000
new method had been used in the prior years and the current year. d. $ 120,000
55. When reporting a cumulative effect of a change in accounting principle, 60. The change in equity of an entity during a period from transactions
5 02 Income Determination
and other events from non-owner sources is known as
a. net income. 67. Adjusting entries must be made
b. net operating income. a. to correct errors in the accounts.
c. comprehensive income. b. to reconcile the accounts to the budget.
d. net change in assets. c. because auditing standards require them.
d. because certain types of events will not be recorded in the accounts
without them.
61. Which one of the following is part of comprehensive income?
a. Net operating income 68. Accumulated depreciation is a/an
b. Gains on sales of treasury stock
a. expense account.
c. Receipt of land donated by a governmental unit
b. liability account.
d. Sale of common stock above par
c. contra-asset account.
d. owners’ equity account.
62. SFAS No. 130 requires firms to report comprehensive income
a. at the end of the income statement. 69. Entering the DR or CR amount in the appropriate left or right side of
b. as a separate statement of comprehensive income. the affected T-account is called
c. in the statement of changes in stockholders’ equity. a. posting.
d. in a statement that is displayed with the same prominence as the fi- b. cross-referencing.
nancial statements. c. journalizing.
d. recording.
63. The basic accounting equation may be expressed as
a. assets = liabilities – owners’ equity 70. Which of the following is a true statement?
b. liabilities = assets + owners’ equity a. Revenues decrease owners’ equity and increase liabilities.
c. owners’ equity = assets – liabilities b. Expenses increase owners’ equity and decrease liabilities.
d. assets = owners’ equity – liabilities c. Revenues increase owners’ equity and expenses decrease owners’ eq-
uity.
64. Any increase in an asset may be offset by d. Revenues decrease owners’ equity and expenses increase owners’ eq-
a. a corresponding decrease in a liability. uity.
b. a decrease in some other asset account.
c. a corresponding decrease in owner’ equity. 71. To get revenue and expense account balances to zero a/an
d. an increase in another asset account. __________ entry is made.
a. adjusting
65. Which of the following statements is correct? Revenue and expense b. closing
accounts c. operating
a. are really owners’ equity accounts. d. reversing
b. are really contributed capital accounts.
c. have no impact on the balance sheet. 72. T-account analysis can be used to gain insights into why accrual basis
d. are balance sheet accounts. earnings and cash basis earnings differ and to
a. journalize future transactions.
66. A debit b. reconstruct transactions that have occurred during a given reporting
a. increases Accounts Payable. period.
b. increases Cost of Goods Sold. c. post transactions that have occurred during a given reporting period.
c. decreases Accounts Receivable. d. determine the current market price of common stock.
d. decreases Equipment.
73. Working capital accounts include
6 02 Income Determination
a. all assets. 2. M; True
b. all assets and liabilities.
3. M; True
c. current assets and all liabilities.
d. current assets and current liabilities. 4. E; True
5. E; False
6. M; False
Essay and Computational Questions
7. M; True
74. Some companies are thought to be managing their earnings upwards
in order to meet expectations, by increasing current revenues. This is often re- 8. M; False
ferred to as “Borrowing Revenues from the Future”. Provide an example journal 9. M; False
entry for this behavior:
10. E; True
75. Some companies are thought to be managing their earnings upwards
in order to meet expectations, by decreasing current expenses. This is often 11. E; False
referred to as “Deferring Expenses to the Future”. Provide an example journal 12. M; True
entry for this behavior.
13. M; False
76. Lazer Industries, Inc. manufactures medical equipment parts and ac-
14. M; True
cessories. The company had adopted SFAS No. 142, and accounted for its ef-
fects in a previous period. Assume all amounts are pre-tax and a 30% tax rate. 15. M; True
Provide a condensed income statement for Lazer Industries, Inc. based on the 16. M; True
available information.
Sales $ 1,200,000 17. M; True
Interest expense $ 150,000 18. M; False
Returns from customers $ 100,000
19. M; True
Rent expense $ 450,000
COGS $ 300,000 20. E; False
Other SG&A $ 170,000 21. E; False
Cumulative effect of accounting change $ 230,000
Goodwill impairment $ 20,000 22. M; True
23. M; True
77. Berg, Inc. provides exotic wedding planning services. Their facilities are 24. M; False
located in an elevated area with a dry climate. Assume all amounts are pre-tax
and a 30% tax rate. Based on the available information, provide a condensed
income statement for Berg, Inc. 25. M; (b)
Interest expense $ 230,000 26. M; (b)
Rent payments $ 390,000
27. M; (b)
Flood damage to facilities $ 270,000
Revenues $ 2,100,000 28. M; (a)
Salaries $ 450,000 29. M; (c)
Advertising expenses $ 170,000
Restructuring charges $ 55,000 30. M; (b)
31. M; (c)
Answers 32. M; (b)
1. E; False 33. D; (c)
7 02 Income Determination
34. M; (a) 67. M; (d)
35. M; (b) 68. M; (c)
36. M; (b) 69. E; (a)
37. M; (a) 70. M; (c)
38. E; (c) 71. E; (b)
39. M; (b) 72. D; (b)
40. M; (d) 73. M; (d)
41. E; (c) Explanation to Selected Multiple-Choice Questions
42. M; (b) 38. Cash expenses: Inventory purchases $40,000, Advertising $8,000, De-
43. M; (b) livery Costs $2,000.
44. M; (a) 39. Accrual expenses: Cost of Goods Sold $32,000, Advertising $8,000,
Delivery Costs $2,000, and Warranty Costs $400.
45. E; (d)
59. $300,000 – ($40,000 × 3) = $180,000/2 = $90,000
46. D; (a)
47. M; (d)
74 Recording Revenues too soon (e.g., Xerox)
48. D; (b)
• DR Cash • CR Revenue instead of
49. E; (a) DR Cash • CR Deferred revenue and
50. M; (a) DR Deferred revenue • CR Revenue
51. M; (b) 75 Deferring Expenses to the future (Capitalizing normal operating costs—
e.g., AOL)
52. M; (b)
53. M; (a)
DR Asset → DR Expense (amortz.) instead of DR Expense
CR Cash CR Asset CR Cash
54. D; (b)
55. D; (c)
76.
56. M; (d)
Sales $ 1,200,000
57. M; (a) Returns from customers $ (100,000)
58. D; (b) Net sales
$ 1,100,000
59. D; (c) COGS $ (300,000)
60. E; (c) Gross profit $ 800,000
Rent expense $ (450,000)
61. M; (a)
Other SG&A $ (170,000)
62. M; (d) Operating income $ 180,000
63. E; (c) Interest expense $ (150,000)
Income before special items $ 30,000
64. M; (b) Goodwill impairment $ (20,000)
65. M; (a) Income before tax $ 10,000
Tax $ (3,000)
66. M; (b)
Net income before cumulative effect of accounting change $ 7,000
8 02 Income Determination
Cumulative effect of accounting change (net) $ (161,000)
Net income (loss) $ (154,000)
77
Revenues $ 2,100,000
Salaries $ (450,000)
Rent payments $ (390,000)
Advertising expenses $ (170,000)
Operating income $ 1,090,000
Interest expense $ (230,000)
Income before special items $ 860,000
Restructuring charges $ (55,000)
Income before tax $ 805,000
Tax $ (241,500)
Net income before extraordinary item $ 563,500
Flood damage to facilities (net)* $ (189,000)
Net income $ 374,500
* Based on the facility location description, it is assumed floods are ex
tremely rare in that area.