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UO ACTG 211 - ch02r

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Copyright © 2013 John Wiley & Sons, Inc. Kimmel, Financial Accounting, 7/e, Solutions Manual (For Instructor Use Only) 2-1 CHAPTER 2 A Further Look at Financial Statements ANSWERS TO QUESTIONS 1. A company’s operating cycle is the average time that is required to go from cash to cash in prod-ucing revenue. 2. Current assets are assets that a company expects to convert to cash or use up within one year of the balance sheet date or the company’s operating cycle, whichever is longer. Current assets are listed in the order in which they are expected to be converted into cash. 3. Long-term investments are investments in stocks and bonds of other companies where the conversion into cash is not expected within one year or the operating cycle, whichever is longer and plant assets not currently in operational use. Property, plant, and equipment are tangible resources of a relatively permanent nature that are being used in the business and not intended for sale. 4. Current liabilities are obligations that will be paid within the coming year or operating cycle, whichever is longer. Long-term liabilities are obligations that will be paid after one year. 5. The two parts of stockholders’ equity and the purpose of each are: (1) Common stock is used to record investments of assets in the business by the owners (stockholders). (2) Retained earnings is used to record net income retained in the business. 6. (a) Lorie is not correct. There are three characteristics: liquidity, profitability, and solvency. (b) The three parties are not primarily interested in the same characteristics of a company. Short-term creditors are primarily interested in the liquidity of the company. In contrast, long-term creditors and stockholders are primarily interested in the profitability and solvency of the company. 7. (a) Liquidity ratios: Working capital and current ratio. (b) Solvency ratios: Debt to assets and free cash flow. (c) Profitability ratio: Earnings per share. 8. Debt financing is riskier than equity financing because debt must be repaid at specific points in time, whether the company is performing well or not. Thus, the higher the percentage of assets financed by debt, the riskier the company. 9. (a) Liquidity ratios measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. (b) Profitability ratios measure the income or operating success of a company for a given period of time.2-2 Copyright © 2013 John Wiley & Sons, Inc. Kimmel, Financial Accounting, 7/e, Solutions Manual (For Instructor Use Only) (c) Solvency ratios measure the company’s ability to survive over a long period of time.Copyright © 2013 John Wiley & Sons, Inc. Kimmel, Financial Accounting, 7/e, Solutions Manual (For Instructor Use Only) 2-3 Questions Chapter 2 (Continued) 10. (a) The increase in earnings per share is good news because it means that profitability has improved. (b) An increase in the current ratio signals good news because the company improved its ability to meet maturing short-term obligations. (c) The increase in the debt to assets ratio is bad news because it means that the company has increased its obligations to creditors and has lowered its equity “buffer.”$ (d) A decrease in free cash flow is bad news because it means that the company has become less solvent. The higher the free cash flow, the more solvent the company. 11. (a) The debt to assets ratio and free cash flow indicate the company’s ability to repay the face value of the debt at maturity and make periodic interest payments. (b) The current ratio and working capital indicate a company’s liquidity and short-term debt-paying ability. (c) Earnings per share indicates the earning power (profitability) of an investment. 12. (a) Generally accepted accounting principles (GAAP) are a set of rules and practices, having substantial support, that are recognized as a general guide for financial reporting purposes. (b) The body that provides authoritative support for GAAP is the Financial Accounting Standards Board (FASB). 13. (a) The primary objective of financial reporting is to provide information useful for decision making. (b) The fundamental qualitative characteristics are relevance and faithful representation. The enhancing qualities are comparability, consistency, verifiability, timeliness, and understandability. 14. Jantz is correct. Consistency means using the same accounting principles and accounting methods from period to period within a company. Without consistency in the application of accounting principles, it is difficult to determine whether a company is better off, worse off, or the same from period to period. 15. Comparability results when different companies use the same accounting principles. Consistency means using the same accounting principles and methods from year to year within the same company. 16. The cost constraint allows accounting standard-setters to weigh the cost that companies will incur to provide information against the benefit that financial statement users will gain from having the information available. 17. Accounting standards are not uniform because individual countries have separate standard-setting bodies. Currently many non-U.S. countries are choosing to adopt International Financial Reporting Standards (IFRS). It appears that accounting standards in the United States will move toward compliance with IFRS.2-4 Copyright © 2013 John Wiley & Sons, Inc. Kimmel, Financial Accounting, 7/e, Solutions Manual (For Instructor Use Only) Questions Chapter 2 (Continued) 18. Accounting relies primarily on two measurement principles. Fair value is sometimes used when market price information is readily available. However, in many situations reliable market price information is not available. In these instances, accounting relies on historical cost as its basis. 19. The economic entity assumption states that every economic entity can be separately identified and accounted for. This assumption requires that the activities of the entity be kept separate and distinct from (1) the activities of its owners (the shareholders) and (2) all other economic entities. A shareholder of a company charging


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