Accounting Information for Business Decisions 1st

Edition Cunningham

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Chapter 7—The Income Statement: Content and Use

COMPLETION

1. The income statement’s key role is to communicate ____________________ –

____________________ = ____________________ to decision users.

ANS: revenue, expense, net income

PTS: 1 DIF: Moderate TOP: Why the income statement is important

2. The income statement summarises the results of a business’ operating activities for a
____________________ accounting period.

ANS: specific

PTS: 1 DIF: Moderate TOP: Why the income statement is important

3. ____________________ is equal to net revenues minus cost of goods sold.

ANS: Gross profit

PTS: 1 DIF: Moderate TOP: Cost of goods sold and gross profit

4. ____________________ are the expenses (other than cost of goods sold) that a business incurs in
its day-to-day operations.

ANS: Operating expenses

PTS: 1 DIF: Moderate TOP: Operating expenses

5. ____________________ consists of calculations in which an item on the financial statements is

divided by another, related item.

ANS: Ratio analysis

PTS: 1 DIF: Difficult TOP: Ratios

6. The ____________________ is calculated by dividing net income by net sales.

 ANS: profit margin

PTS: 1 DIF: Moderate TOP: Profit margin

TRUE/FALSE

1. The income statement’s key role is to communicate revenue – expenses = net income to users.

ANS: T PTS: 1 DIF: Moderate TOP: Why the income

statement is important

2. The income statement’s key role is to communicate assets – liabilities = net income to users.

ANS: F PTS: 1 DIF: Moderate TOP: Why the income

statement is important

3. A projected income statement would be used by internal decision makers.

ANS: T PTS: 1 DIF: Moderate TOP: Why the income

statement is important

4. A projected income statement would be used by external decision makers.

ANS: F PTS: 1 DIF: Moderate TOP: Why the income

statement is important

5. The income statement summarises the results of a business’ operations for a specific accounting
period.

ANS: T PTS: 1 DIF: Moderate TOP: Why the income

statement is important

6. Revenues result in an increase in assets or a decrease in liabilities.

ANS: T PTS: 1 DIF: Moderate TOP: Revenues

7. Expenses result in increases in assets or decreases in liabilities.

ANS: F PTS: 1 DIF: Moderate TOP: Expenses

8. Expenses result in a decrease in assets or an increase in liabilities.

ANS: T PTS: 1 DIF: Moderate TOP: Expenses

9. Revenues result in decreases in assets or increases in liabilities.

ANS: F PTS: 1 DIF: Moderate TOP: Revenues

10. The cost of goods sold is the cost of inventory that has been sold.

ANS: T PTS: 1 DIF: Moderate TOP: Cost of goods sold

11. The cost of goods sold is the sales price of inventory that has been sold.
 ANS: F PTS: 1 DIF: Moderate TOP: Cost of goods sold

12. A perpetual inventory system requires a physical count of inventory at year end.

ANS: F PTS: 1 DIF: Moderate TOP: Perpetual inventory

system

13. A periodic inventory system requires a physical count of inventory at year end.

ANS: T PTS: 1 DIF: Moderate TOP: Periodic inventory system

14. Gross profit is the gross sales price charged for the goods sold.

ANS: F PTS: 1 DIF: Moderate TOP: Cost of goods sold and

gross profit

15. Cost of goods sold would be considered an operating expense.

ANS: F PTS: 1 DIF: Moderate TOP: Cost of goods sold and

gross profit

16. To make business decisions external users evaluate a business’ risk, operating capability and
financial flexibility.

ANS: T PTS: 1 DIF: Difficult TOP: Uses of the income

statement for evaluation

17. Risk is the uncertainty about the future earnings potential of a business.

ANS: T PTS: 1 DIF: Easy TOP: Uses of the income

statement for evaluation

18. The profit margin ratio indicates the percent of each sales dollar that will become profit.

ANS: T PTS: 1 DIF: Moderate TOP: Profit Margin

19. The profit margin ratio indicates the total dollars of profit from gross sales.

ANS: F PTS: 1 DIF: Moderate TOP: Profit Margin

20. Withdrawals by an owner are found on the income statement as an expense.

ANS: F PTS: 1 DIF: Difficult TOP: Operating expenses

21. Permanent accounts refer to assets, liabilities and owner’s equity as they are used for the life of the
business.

ANS: T PTS: 1 DIF: Difficult TOP: Expanded accounting

system

22. Permanent accounts refer to revenue and expense as they are used for the life of the business.

ANS: F PTS: 1 DIF: Moderate TOP: Expanded accounting

 system
MULTIPLE CHOICE

1. Why is the income statement important?

a. Because it balances all of the assets, liabilities, and owner's equity of a business.
b. Because it determines the cash flow of a business for the current period.
c. Because it plays a key role in the decision-making of the business’ users by
communicating revenues, expenses, and net income (or net loss) for the period.
d. Because it’s good to know these things.
ANS: C PTS: 1 DIF: Easy TOP: Why the income
statement is important

2. The income statement reports:

a. revenues, expenses, and net income.
b. assets, liabilities, and owner's equity.
c. revenues, liabilities, and assets.
d. expenses, cash, and owner's equity.
ANS: A PTS: 1 DIF: Moderate TOP: Expanded Accounting
System

3. Asset, liability, and owner's equity accounts are:

a. temporary accounts.
b. short-term accounts.
c. long-term accounts.
d. permanent accounts.
ANS: D PTS: 1 DIF: Moderate TOP: Expanded Accounting
System

4. A revenue account is referred to as a temporary account because:

a. it relates to only one specific accounting period.
b. it only appears on the income statement.
c. once it is recorded it may be deleted.
d. it only appears on the balance sheet.
ANS: A PTS: 1 DIF: Difficult TOP: Expanded Accounting
System

5. A cash account is referred to as a permanent account because:

a. it flows into the statement of owner’s equity.
b. it is around for the life of the business.
c. it has a physical presence.
d. it is in the account at the bank.
ANS: B PTS: 1 DIF: Moderate TOP: Expanded Accounting
System

6. Expenses are the cost of providing goods and services and result in:
a. increased assets or decreased liabilities.
b. decreased assets or increased liabilities.
c. decreases in both assets and liabilities.
d. increases in both assets and liabilities.
 ANS: B PTS: 1 DIF: Moderate TOP: Expenses

7. Revenues are the prices charged to customers and result in:

a. increased assets or decreased liabilities.
b. decreased assets or increased liabilities.
c. decreases in both assets and liabilities.
d. increases in both assets and liabilities.
ANS: A PTS: 1 DIF: Moderate TOP: Revenues

8. A business made a $500 credit sale subject to terms of 2/10, net/30. How would the receipt of cash
within the discount period be recorded?
a. Increase cash and decrease accounts receivable by $500.
b. Increase cash and decrease accounts receivable by $490.
c. Increase cash by $490, decrease accounts receivable by $500, and decrease sales revenue
by $10.
d. Increase cash by $490, decrease accounts receivable by $500, and increase sales revenue
by $10.
ANS: C PTS: 1 DIF: Difficult TOP: How sales policies affect
income statement reporting

9. A business made a $500 credit sale subject to terms of 2/10, net/30. How would the receipt of cash,
after the discount period had expired, be recorded?
a. Increase cash and decrease accounts receivable by $500.
b. Increase cash and decrease accounts receivable by $490.
c. Increase cash by $490, decrease accounts receivable by $500, and decrease sales revenue
by $10.
d. Increase cash by $490, decrease accounts receivable by $500, and increase sales revenue
by $10.
ANS: A PTS: 1 DIF: Difficult TOP: How sales policies affect
income statement reporting

10. A business made a $250 credit sale subject to terms of 2/10, net/30. How would the receipt of cash,
after the discount period had expired, be recorded?
a. Increase cash by $245, decrease accounts receivable by $250, and decrease sales revenue
by $5.
b. Increase cash by $245, decrease accounts receivable by $250, and increase sales revenue
by $5.
c. Increase cash and decrease accounts receivable by $250.
d. Increase cash and decrease accounts receivable by $245.
ANS: C PTS: 1 DIF: Difficult TOP: How sales policies affect
income statement reporting

11. Why would a business choose not to keep perpetual inventory records?
a. The business is small enough that they can manage without it.
b. The business sells a high volume of similar and inexpensive goods.
c. Both of the options given.
d. None of the options given.
ANS: C PTS: 1 DIF: Moderate TOP: Perpetual Inventory
System
12. Blackstone Company uses a periodic inventory system. It had beginning inventory of $100 000,
purchases of $1 300 000, and ending inventory of $125 000. What was Blackstone's cost of goods
sold?
a. $1 300 000
b. $1 325 000
c. $1 275 000
d. None of options given
ANS: C PTS: 1 DIF: Moderate TOP: Cost of goods sold

13. The difference between a perpetual inventory system and a periodic inventory system is:
a. periodic will record the cost of goods sold amount at the sale.
b. perpetual requires a physical inventory count.
c. periodic will record inventory purchases in the inventory account.
d. periodic will adjust inventory at the end of each period with a physical count.
ANS: D PTS: 1 DIF: Easy TOP: Periodic inventory system

14. Gross profit is:

a. The amount left over after cost of goods sold is subtracted from net sales.
b. The amount of revenue a business has "leftover" to cover operating expenses.
c. Reported on the Income Statement.
d. All of the options given.
ANS: D PTS: 1 DIF: Easy TOP: Profit margin

15. How do you determine gross profit?

a. Cost of goods sold plus net sales.
b. Net sales minus cost of goods sold.
c. Cash plus net sales.
d. Cost of goods sold minus net sales.
ANS: B PTS: 1 DIF: Moderate TOP: Profit margin

16. Which of the following is a subheading under the operating expenses of an income statement?
a. Adjusting entries
b. Selling expenses
c. Both of the options given
ANS: C PTS: 1 DIF: Difficult TOP: Statement of
comprehensive income

17. Operating expenses are:

a. cost of goods sold.
b. the expenses a business incurs in its day-to-day operations, other than cost of goods sold.
c. long-term expenses.
d. cost of a new plant.
ANS: B PTS: 1 DIF: Moderate TOP: Expenses

Example 7.1
The information below is used for the following problems. Jones Sales Company had:

Net Sales 200 000

Gross Profit 90 000
Operating Profit 50 000
 Net Income 35 000

18. Refer to Example 7.1. Jones Sales Company’s gross profit percentage is:
a. 25%.
b. 38%.
c. 45%.
d. 55%.
ANS: C PTS: 1 DIF: Easy TOP: Gross profit percentage

19. Refer to Example 7.1. Jones Sales Company's profit margin is:
a. 17.5%.
b. 25%.
c. 45%.
d. None of the options given
ANS: A PTS: 1 DIF: Easy TOP: Profit margin

Example 7.2
The information below is used for the following problems.

Jones & Company had:

Net sales 500 000

Gross profit 290 000
Operating profit 150 000
Net income 85 000

20. Refer to Example 7.2. Jones & Company's Gross Profit Percentage is:
a. 17%.
b. 30%.
c. 58%.
d. 11%
ANS: C PTS: 1 DIF: Easy TOP: Gross profit percentage

21. Refer to Example 7.2. Jones & Company's profit margin is:
a. 17%.
b. 30%.
c. 58%.
d. 69%
ANS: A PTS: 1 DIF: Easy TOP: Profit margin

22. What are closing entries?

a. Entries made by a business at the end of an accounting period to create a zero balance in
the revenue and expense accounts.
b. Entries made by a business at the end of an accounting period to update owner's equity.
c. Both of the options given.
ANS: C PTS: 1 DIF: Easy TOP: Closing the temporary
accounts

SHORT ANSWER
1. What is the income statement and why is it important?

ANS:
The income statement summarises the revenues, expenses, and net income of the business for an
accounting period. These operating results stem from the planning and operating decisions that the
business’ managers made during the period. The income statement shows the relationship between
the manager's decisions and the results of those decisions. The information in the income statement
helps both internal and external users understand how well the business’ managers have managed
during the period. By comparing results from year to year, users can also infer manager's long-term
abilities.

PTS: 1 DIF: Easy TOP: Why the income statement is important

2. What are the differences between sales returns and sales allowances?

ANS:
A sales return occurs when a customer returns previously purchased merchandise. Effectively, the
sale is cancelled. A sales allowance occurs when a customer agrees to keep the merchandise, and
the business refunds a portion of the original price.

PTS: 1 DIF: Easy TOP: Sales returns and allowances

3. Describe a perpetual inventory system.

ANS:
A perpetual inventory system keeps a continuous record of the cost of inventory on hand and the
cost of inventory sold. When the business purchases inventory, it increases the inventory account
by the cost of the inventory plus any freight charges incurred to have the inventory delivered.
When the inventory is sold, the business reduces the inventory account, and increases cost of goods
sold. Therefore, the business’ inventory and cost of goods sold accounts are always up to date, and
the business always knows the number of units of inventory that it has.

PTS: 1 DIF: Moderate TOP: Perpetual inventory system

4. Describe a periodic inventory system.

ANS:
A periodic inventory system does not keep a continuous record of the inventory on hand and sold.
It determines the inventory at the end of each accounting period by physically counting it. Because
the periodic inventory system does not reduce the inventory account each time a sale occurs, the
only time a business knows the cost of inventory on hand or the cost of inventory sold is when it
counts its inventory.

PTS: 1 DIF: Moderate TOP: Periodic Inventory System

5. What is financial flexibility and why is it important?

ANS:
Financial flexibility refers to the business’ ability to adapt to change. It means that the business can
take advantage of new opportunities. Investors prefer businesses have financial flexibility. This is
an important component of assessing the risk associated with a business.

PTS: 1 DIF: Moderate TOP: Uses of the Income Statement for Evaluation
 6. How is the gross profit percentage calculated, and what does it signify?

ANS:
The gross profit percentage is calculated by dividing gross profit by net sales. It indicates the
portion of each dollar of sales that is available to cover operating expenses and other expenses, and
to increase the business’ net income. Changes in gross profit typically result in large changes in net
income.

PTS: 1 DIF: Difficult TOP: Gross Profit Percentage

7. What is the statement of changes in owner's equity, and why is it needed?

ANS:
The statement of changes in owner's equity summarises the transactions that affected owner's
equity during the accounting period. The statement is prepared to bridge the gap between the
income statement and the balance sheet. It helps to complete the picture of the business’ financial
activities for the accounting period.

PTS: 1 DIF: Moderate TOP: Statement of changes in owner's equity

8. What are closing entries and what is their purpose?

ANS:
Closing entries are entries made at the end of the business’ accounting period to create a zero
balance in each revenue, expense, and withdrawal account by transferring their balances to the
owner's capital account. The revenue, expense, and withdrawal accounts are used to accumulate
the effects of each period's transactions. By zeroing out the balances in these accounts at the end of
each period, any amounts in these accounts in the next period are clearly a result of next period's
transactions.

PTS: 1 DIF: Moderate TOP: Closing the Temporary Accounts

PROBLEM

1. Jones & Smith Company had:

Net sales 800 000

Gross profit 240 000
Operating profit 190 000
Net income 125 000

a. Jones & Smith Company's gross profit percentage is:

b. Jones & Smith Company's profit margin is:

ANS:

a. $240 000/$800 000 = 30%

b. $125 000/$800 000 = 15.625%

PTS: 1 DIF: Moderate TOP: Gross profit percentage