MGMT 600

Study Topics for Midterm 1

Midterm 1 is closed-book, closed-notes. You should bring a calculator to the exam.

Programmable calculators, calculators you can enter text into, and cell phones are not allowed
to be used during exams. University rules concerning student conduct will be strictly enforced.

Midterm 1 will cover the material in Chapters 1-5. The exam may consist of open-ended
questions, problems, matching questions, and multiple choice questions. The topics that may
be tested on the exam are listed below. Your focus should be on understanding the concepts
and interpreting financial statement information and ratios. You will not be asked to prepare a
financial statement or calculate a ratio, but you may be asked about your understanding of
them. I might make you write a journal entry or two.

Some practice problems are included in parentheses after the topics. Solutions to Multiple
Choice and Mid-Chapter Reviews are at the end of the chapter. Other solutions are copied
below.

General (because you should never forget these)

6 Things you must know + 1 other thing you dont need to know for the exam, but may be
useful for life
1. Debit = left; Credit = right
2. Debits = Credits
3. A = L + OE
4. Matching Principle
5. Qualitative Characteristics of Accounting Data
6. Conservatism
7. If you do something wrong, admit it. The cover-up always gets people in more
trouble than the original misdeed.
Know the difference between recognized and disclosed

Chapter 1 Introduction to Financial Accounting

What is financial accounting?
o Difference between financial and managerial accounting
o Target audiences for financial accounting information (E1-28)
Regulatory and standard setting bodies who they are and what they do (e.g. who they
oversee). (Q1-13)
o SEC, FASB, IASB, PCAOB (Q1-15)
Conceptual framework for financial reporting (E1-35)
o Qualitative Characteristics of Accounting Information (Q1-18)
o Underlying assumptions of the financial reporting model
Chapter 2 Constructing Financial Statements
Balance sheet classifications (e.g. assets, liabilities, etc.; current vs. noncurrent) (Mid-
Chapter Review p. 49; Q2-5; Q2-7)
Operating cycle
Income statement classifications (e.g. operating s. non-operating items) (Mid-Chapter
Review p. 49)
Accrual vs. cash basis accounting
Recording transactions (Mid-Chapter Review p. 73)
o Accounts
o Double-entry accounting
o Debits and credits
Ratios: Working capital and current ratio

Chapter 3 Adjusting Accounts (Multiple Choice Questions, p. 129)

Steps in the accounting cycle
Journals and ledgers
Adjustments Why are they done? (Mid-Chapter Review p. 117)
o Deferrals and accruals

Chapter 4 Statement of Cash Flows (Multiple Choice Questions 1-3, p. 190; Q4-1, Q4-2)
Purpose of SCF (Q4-7)
Sections of SCF
o What types of transactions are reported in each
o What the section is telling you (e.g. interpreting the SCF)
Supplemental disclosures
Free cash flow (Chapter End Review, p. 185)

Chapter 5 Analyzing and interpreting financial statements (Q5-1, Q5-2)

Horizontal and vertical analysis (Mid-Chapter Review p. 223)
ROE (Mid-Chapter Review p. 227)
ROA
Pro forma financial statements
 SOLUTIONS TO END OF CHAPTER PROBLEMS
CHAPTER 1

Q1-13. While businesses acknowledge the increasing need for more complete
disclosure of financial and nonfinancial information, they have resisted these
demands to protect their competitive position. These companies must weigh
the benefits they receive from the market as a result of more transparent and
revealing financial reporting against the costs of divulging proprietary
information.
Q1-15. International Financial Reporting Standards (IFRS) are the accounting
methods, rules and principles established by the International Accounting
Standards Board (IASB). The need for IFRS stems from the wide variety of
accounting principles adopted in various countries and the lack of comparability
that this variety creates. IFRS are intended to create a common set of
accounting guidelines that will make the financial statements of companies from
different countries more comparable.
The IASB has no enforcement authority. As a consequence, the strict
enforcement of IFRS is left to the accounting profession and/or securities
market regulators in each country. Many countries have reserved the right to
make exceptions to IFRS by applying their own (local) accounting rules in
selected areas. Some accountants and investors argue that a little diversity is
a good thing variations in accounting practice reflect differences in cultures
and business practices of various countries. However, one concern is that
IFRS may create the false impression that everyone is following the same
rules, even though some variation will continue to permeate international
financial reporting.
Q1-18.A The four qualitative characteristics of accounting information are relevance,
reliability, consistency and comparability. Relevant accounting information has
the ability to make a difference in a decision. Reliable accounting information is
accurate and free of misstatement or bias. These two characteristics are the
primary drivers of the quality of accounting information. Reliable information
increases the confidence of the decision maker. However, the information must
also be relevant to the decision at hand. These two characteristics can be at
odds, in that the most relevant information sometimes lacks reliability.
Comparability and consistency allow users to identify similarities and
differences between sets of economic phenomena. Comparability refers to the
use of similar accounting methods across companies, while consistency refers
to the use of similar methods over reporting periods. Both improve the users
ability to interpret the information by making comparisons to other companies or
earlier periods.
E1-28.

External users and some questions they seek to answer with accounting information
from financial statements include:

1. Shareholders (investors), who seek answers to questions such as:

a. Are resources owned by a business adequate to carry out plans?
b. Are the debts owed excessive in amount?
c. What is the current level of income (and its components)?

2. Creditors, who seek answers for questions such as:

a. Does the business have the ability to repay its debts?
b. Can the business take on additional debt?
c. Are resources sufficient to cover current amounts owed?

3. Employees (and potential employees), who seek answers to questions such as:
a. Is the business financially stable?
b. Can the business afford to pay higher salaries?
c. What are growth prospects for the organization?

E1-35.

1. e 6. g
2. f 7. j
3. i 8. c
4. a 9. d
5. h 10. b
CHAPTER 4

Q4-1. Cash equivalents are short-term, highly liquid investments that firms acquire with temporarily
idle cash to earn interest on these excess funds. To qualify as a cash equivalent, an investment
must (1) be easily convertible into a known cash amount and (2) be close enough to maturity
so that its market value is not sensitive to interest rate changes (generally, investments with
initial maturities of three months or less). Three examples of cash equivalents are treasury
bills, commercial paper, and money market funds.

Q4-2. Cash equivalents are included with cash in a statement of cash flows because the purchase
and sale of such investments are considered to be part of a firm's overall management of cash
rather than a source or use of cash. Similarly, as statement users evaluate cash flows, it may
matter very little to them whether the cash is on hand, deposited in a bank account, or
invested in cash equivalents.

Q4-7. A statement of cash flows helps external users assess the amount, timing, and uncertainty of
future cash flows to the enterprise. These assessments help users evaluate their own future
cash receipts from their investments in, or loans to, the firm. A statement of cash flows shows
the periodic cash effects of a firm's operating, investing, and financing activities. Distinguishing
among these different categories of cash flows helps users compare, evaluate, and predict
cash flows. With cash flow information, creditors and investors are better able to assess a
firm's ability to settle its liabilities and pay its dividends. Over time, the statement of cash
flows permits users to observe and analyze management's investing and financing policies. A
statement of cash flows also provides information useful in evaluating a firm's financial
flexibility (which is its ability to generate cash to respond to unanticipated needs and
opportunities).

CHAPTER 5

Q5-1. Return on investment measures profitability in relation to the amount of investment that
has been made in the business. A company can always increase dollar profit by
increasing the amount of investment (assuming it is a profitable investment). So, dollar
profits are not necessarily a meaningful way to look at financial performance. Using
return on investment in our analysis, whether as investors or business managers,
requires us to focus not only on the income statement, but also on the balance sheet.
Q5-2. ROE is the sum of return on assets (ROA) and the return that results from the effective
use of financial leverage (ROFL). Increasing leverage increases ROE as long as ROA
exceeds the after-tax interest rate. Financial leverage is also related to risk: the risk of
potential bankruptcy and the risk of increased variability of profits. Companies must,
therefore, balance the positive effects of financial leverage against their potential
negative consequences. It is for this reason that we do not witness companies entirely
financed with debt.