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Financial Accounting

Fall 2006
The midterm exam is closed book, however the cheat sheet is allowed. Calculators are
permitted, however computers are not allowed. The test consists of 5 independent problems,
most of which have multiple parts. The total points for the entire exam is 100.

Please use the space provided on the exam for your answers. If you need extra space, please
use the reverse sides of any page. If there is something written on the reverse sides of any
page that you feel we need to see in order to grade your exam, please mention this in the
space provided for each answer. You have 2 hours and 50 minute in which to complete the

Be sure to print your name on the cover sheet. It is also important that you print legibly.
Anything we cannot read we cannot grade.

If you have any questions during the test you may ask either your TA or professor. Talking
to any other individual is not allowed and could subject you to a zero score. Good luck!

Name (please print)

1. Multiple Choice 26

2. Abercrombie and Fitch 12

3. Hewlett Packard 22

4. Small World Day Care 18

5. The Missing Link Company 22


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Question 1: Multiple choice. Choose the one best answer.
1. The independent auditor is employed by the
a. creditors.
b. shareholders.
c. Governmental Accounting Office.
d. board of directors.

2. Which of the following financial statements is measured at a point of time?

a. Balance sheet
b. Income statement
c. Cash flows statement
d. Both b and c are correct responses.

3. Which of the following decreases retained earnings?

a. Dividends
b. Supplies expense
c. Rent expense
d. Cost of goods sold
e. All of the above decrease retained earnings.

4. Which of the following is NOT a characteristic of financial statements prepared under

a. Influenced by subjective judgments and incentives of
b. Based upon historical and conservative information.
c. Does not generally reflect market values.
d. All of the above are characteristics of accounting information.

5. Which of the following changes describes the collection of $1,000 from accounts
a. Assets and owners' equity increase by $1,000.
b. Assets and owners' equity decrease by $1,000.
c. Assets and liabilities increase by $1,000.
d. Assets and liabilities decrease by $1,000.
e. No changes in total assets, liabilities, or owners' equity.

6. If a firm with a current ratio of 2.0 pays $1,000 of accounts

payable, then its current ratio will
a. increase.
b. decrease.
c. remain the same.

7. Under the allowance method of accounting for bad debts, the write-off of an account
receivable determined to be uncollectible
a. decreases the current ratio.

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b. increases the current ratio.
c. has no effect on the current ratio.

8. If the maximum debt/equity ratio as specified by a debt covenant is close to being violated,
which of the following actions would help avoid violating the debt covenant?
a. Acquire money by issuing a non-interest-bearing note payable.
b. Skip current cash dividends.
c. Acquire money by issuing common stock.
d. Acquire money by collecting accounts receivable.
e. Both b and c are correct.

9. In an income statement, usual and frequent income events are found in

a. operating revenues and expenses.
b. other revenues or expenses.
c. disposal of a business segment.
d. extraordinary gains or losses.
e. cumulative effects.

10. If the direct method is used to construct the statement of cash flows, Depreciation
Expense of the current year can be found on the
a. balance sheet.
b. income statement.
c. statement of cash flows.
d. All of the above are correct.
e. Only b and c are correct.

11. Which of the following is consistent with a firm recording a large operating loss but still
having a healthy cash flow from operations?
a. A great amount of depreciation expense
b. A decrease in accounts receivable and inventory
c. An increase in accounts payable
d. All of the above are correct.
e. Only a and c are correct.

12. The category that is generally considered to be the best measure of a company's ability to
continue as a going concern is
a. cash flows from operating activities.
b. cash flows from investing activities.
c. cash flows from financing activities.
d. usually different from year to year.

13. ‘Earnings management’ is best described as deliberate managerial decisions and choices that
are solely designed to
a. increase selling prices of a company’s products.
b. reduce repair costs on the company’s equipment.

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c. manipulate net income from one period to the next by exploiting the flexibility inherent
within GAAP.
d. increase working capital.

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2 Abercrombie and Fitch

Abercrombie and Fitch (ANF) reports the following balances in Stockholders’ Equity.
2003 2002
Contributed capital $140,172 $143,590
Retained earnings $919,577 $714,475
Total equity $1,059,749 $858,085

a) During the year, ANF reported net income of $205,102. Did ANF pay a dividend? If so,
what was the amount of the dividend?

No dividend. 714,475 + 205,102 = 919,577

b) While analyzing the statement of cash flows, you notice that cash decreased from
2002 to 2003. Is this necessarily bad for ANF? Explain.

No. If cash is used in a productive way then it is a good thing. Examples may include investing
in positive NPV projects or retiring costly debt.

c) You also notice that the company’s book value of $1,059,749 differs from its market
value. Why might these values differ?

Historical costs, absence of intangibles, future versus past prospective, etc.

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3. Hewlett Packard

Following are the income statement accounts for a recent Hewlett Packard Company income statement.


Income Statement
1 Net revenue
2 Cost of sales

Gross margin
3 Research and development
4 Selling, general and administrative

5 Restructuring charges
6 Acquisition-related charges as part of a merger

Earnings (loss) from operations

7 Interest and other, net
8 Net loss on sale of a division of the company

9 Litigation settlements
Earnings (loss) before cumulative effect of change in accounting
principle and taxes
10 Provision for (benefit from) taxes
Net earnings (loss) before cumulative effect of change in
accounting principle
11 Cumulative effect of change in accounting principle, net of taxes
Net earnings (loss)

Identify the numbers of the items in its statement that likely should be considered transitory items..


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4. Small World Day Care

January 1, 2006 is the first day of operations for Small World Day Care. Assume no taxes. The
following summarizes the 2006 events for Small World Day Care:
1. On 1/1/06 common stock was issued for $20,000.
2. An interest-free government loan of $20,000 was received on 1/3/06. The loan is
to be repaid on 1/3/07.
3. Paid $24,000 cash for furniture and equipment on 1/4/06.
4. During 2006, $30,000 was paid for miscellaneous operating activities. All of
these cash payments were for services used in 2006 except for some of the food
and supplies. On 12/31/06, $1,500 of food and supplies were on hand.
5. During 2006, Small World charged the parents of its clients $40,000 for services
provided. However, on 12/31/06, the parents still owed $15,000 for those
services provided.
6. Annual depreciation expense of $6,000 is recognized in 2006.
7. Small World pays cash dividends to the owners equal to 40% of net income on

Instructions: Complete the following 2006 cash flow statement and comment on the solvency
of Small World on 12/31/06.

Small World Day Care

Cash Flow Statement
For the Year Ended 12/31/06
Cash provided by operations:

Receipts from customers 25,000

Misc. operating activities (30,000)

Cash flows from investment activities:

Purchase of furniture and equip. (24,000)

Cash flows from financing activities:

Issuance of common stock 20,000

Receipt of loan 20,000
Dividend payment (2,200) *

Net cash inflow (outflow) during 2006 $8,800

* Revenue 40,000
SG&A (28,500) 30,000 - 1,500
Depreciation (6,000)
Net income 5,500 Dividend = 5,500 x 40% = $2,200

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Firm is likely not solvent since it has a loan amount of $20,000 due in 3 days and insufficient
cash to make the payment.

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5 The Missing Link Company. Compute the missing amounts in the following
financial statements. You may assume that accounts receivable relate only to
credit sales and that accounts payable relate only to credit purchases of
inventory. There were no sales of property and equipment during 2005 and any
purchases of property and equipment were made using cash:

Balance Sheet at December 31, 2004 December 31, 2005

Current Assets
Cash 18,000 A
Marketable Securities 2,000 5,000
Accounts Receivable 8,000 B
Merchandise Inventory C 58,000
Prepaid Advertising 13,000 16,000
Total Current Assets 82,000 104,000

Property, Plant and Equipment (cost) D 201,000

Accumulated Depreciation (41,000) (52,000)
Land E F
Goodwill 12,000 G
Total Assets 227,000 282,000

Current Liabilities
Accounts Payable 18,000 H
Wages Payable I 18,000
Interest Payable 8000 6,000
Dividends Payable 2,000 4,000
Taxes Payable 5,000 1,000
Total Current Liabilities 48,000 50,000

Long-Term Debt J 52000

Shareholders’ Equity
Common Stock 121,000 160,000
Retained Earnings 22,000 32,000
Treasury Stock -10000 (12,000)
Total Liabilities and Shareholders’
Equity K L

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Income Statement for period ending December 31, 2005
Sales Revenue 140,000
Cost of Sales 87,000
Gross Profit M
Wages N
Advertising 5,000
Depreciation 11000
Goodwill Amortization 2,000
Total expenses 24,000
Operating profit 29,000
Interest 3,000
Income (Loss) Before Taxes 26,000
Tax Expense O
Net Income 18,000

Statement of Cash Flows for the Year Ended December 31, 2005

Cash Flow From Operating Activities

Cash Collections from Customers P
Cash Payments for:
Inventory (101,000)
Wages (3,000)
Taxes (12,000)
Interest (5,000)
Advertising (8,000)
Net Cash Provided by Operations 9,000

Cash Flow From Investing Activities

(Purchases) sale of Property, Plant and Equipment (39,000)
(Purchase) sale of Marketable Securities Q
(Purchase) sale of Land R
Net Cash Provided by Investing Activities (49,000)

Cash Flow From Financing Activities

Issue (repayment) Long-Term Debt S
Payment of Dividend T
Issuance (repurchase) of Common Stock U
(Purchase) sale of Treasury Stock (2,000)
Net Cash Provided by Financing Activities V

Net Cash Flow (3,000)

Change in Cash (3,000)

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Page 11 of 12
Record your answer under each letter.


15,000 10,000 41,000 162,000 12,000 19,000 10,000 21,000


15,000 46,000 227,000 282,000 53,000 6,000 8,000 138,000


(3,000) (7,000) 6,000 (6,000) 39,000 37,000

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