PROBLEM & SOLUTION PROGRES CHECK PART-3

Unit 3: Information Technology

Unit 4: Finance Management

1. Of the following, the greatest advantage of a database (server) architecture is

a. Data redundancy can be reduced.
b. Conversion to a database system is inexpensive and can be accomplished
quickly.
c. Multiple occurrences of data items are useful for consistency checking.
d. Backup and recovery procedures are minimized.

• Answer (A) is correct.

In a database system, storage structures are created that render the applications
programs independent of the physical or logical arrangement of the data.
Because separate files for different applications programs are unnecessary, data
redundancy can be substantially reduced.
• Answer (B) is incorrect.
Conversion to a database is often costly and time consuming.
• Answer (C) is incorrect.
A traditional flat-file system, not a database, has multiple occurrences of data
items.
• Answer (D) is incorrect.
Given the absence of data redundancy and the quick propagation of data errors
throughout applications, backup and recovery procedures are just as critical in a
database as in a flat-file system.

2. An insurance firm that follows the systems development life cycle concept for all major
information system projects is preparing to start a feasibility study for a proposed
underwriting system. Some of the primary factors the feasibility study should include are
a. Possible vendors for the system and their reputation for quality.
b. Exposure to computer viruses and other intrusions.
c. Methods of implementation, such as parallel or cutover.
d. Technology and related costs.

• Answer (A) is incorrect.

Possible vendors for the system and their reputation for quality would be
determined after the feasibility study.
• Answer (B) is incorrect.
Exposure to computer viruses and other intrusions is part of the information
requirements phase.
• Answer (C) is incorrect.
Methods of implementation, such as parallel or cutover, would be determined
during the implementation and operations stage.
• Answer (D) is correct.
The feasibility study should consider the activity to be automated, the needs of
the user, the type of equipment required, the cost, and the potential benefit to
the specific area and the company in general. Thus, technical feasibility and cost
are determined during this stage.

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Unit 3: Information Technology
Unit 4: Finance Management

3. For control purposes, which of the following should be organizationally segregated from
the computer operations function?
a. Data conversion.
b. Surveillance of screen display messages.
c. Systems development.
d. Minor maintenance according to a schedule.

• Answer (A) is incorrect.

Data conversion may be assigned to computer operations.
• Answer (B) is incorrect.
Surveillance of screen display messages may be assigned to computer
operations.
• Answer (C) is correct.
Systems development is performed by systems analysts and application
programmers.
• Answer (D) is incorrect.
Minor maintenance according to a schedule may be assigned to computer
operations.

4. Which of the following is a true statement about HTML?

a. The acronym stands for HyperText Material Listing.
b. The language is among the most difficult to learn.
c. The language is independent of hardware and software.
d. HTML is the only language that can be used for Internet documents.

• Answer (A) is incorrect.

HTML is the acronym for Hypertext Markup Language.
• Answer (B) is incorrect.
The language is relatively easy to learn. Almost anyone can learn and use HTML,
not just computer programmers.
• Answer (C) is correct.
HTML is the most popular language for authoring web pages. It is hardware and
software independent, which means that it can be read by several different
applications and on many different kinds of computer operating systems. HTML
uses tags to mark information for proper display on web pages.
• Answer (D) is incorrect.
A number of other languages can be used for Internet transmissions, including
Java and XML.

5. A local area network (LAN) is best described as a(n)

a. Computer system that connects computers of all sizes, workstations, terminals,
and other devices within a limited proximity.
b. System to allow computer users to meet and share ideas and information.
c. Electronic library containing millions of items of data that can be reviewed,
retrieved, and analyzed.
d. Method to offer specialized software, hardware, and data-handling techniques
that improve effectiveness and reduce costs.

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Unit 4: Finance Management

• Answer (A) is correct.

A LAN is a local distributed computer system, often housed within a single
building. Computers, communication devices, and other equipment are linked by
cable. Special software facilitates efficient data communication among the
hardware devices.
• Answer (B) is incorrect.
A LAN is more than a system to allow computer users to share information. In
addition, it is an interconnection of a computer system.
• Answer (C) is incorrect.
A LAN is not a library.
• Answer (D) is incorrect.
A LAN does not require specialized hardware.

6. An accounting information system (AIS) must include certain source documents in order
to control purchasing and accounts payable. For a manufacturing organization, the best
set of documents should include
a. Purchase requisitions, purchase orders, inventory reports of goods needed, and
vendor invoices.
b. Purchase orders, receiving reports, and inventory reports of goods needed.
c. Purchase orders, receiving reports, and vendor invoices.
d. Purchase requisitions, purchase orders, receiving reports, and vendor invoices.

• Answer (A) is incorrect.

Receiving reports should be included.
• Answer (B) is incorrect.
Requisitions and vendor invoices should be included.
• Answer (C) is incorrect.
Purchase requisitions should be included.
• Answer (D) is correct.
An AIS is a subsystem of a management information system that processes
financial and transactional data relevant to managerial and financial accounting.
The AIS supports operations by collecting and sorting data about an
organization’s transactions. An AIS is concerned not only with external parties but
also with the internal activities needed for management decision making at all
levels. An AIS is best suited to solve problems when reporting requirements are
well defined. A manufacturer has well-defined reporting needs for routine
information about purchasing and payables. Purchase requisitions document
user department needs, and purchase orders provide evidence that purchase
transactions were appropriately authorized. A formal receiving procedure
segregates the purchasing and receiving functions and establishes the quantity,
quality, and timeliness of goods received. Vendor invoices establish the liability
for payment and should be compared with the foregoing documents.

7. Which of the following are the intended users of control frameworks such as COBIT?
a. Persons with IT control responsibilities.
b. Senior management only.
c. Internal and external auditors only.
d. Everyone in the organization.

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Unit 4: Finance Management

• Answer (A) is correct.

Control frameworks are intended for use by anyone in the organization who has
control responsibilities, not just auditors or senior management. Control
frameworks also can be used to communicate with senior management and the
board.
• Answer (B) is incorrect.
Intended users include anyone with control responsibilities.
• Answer (C) is incorrect.
Auditors are not the only persons who are intended users.
• Answer (D) is incorrect.
Some members of the organization are not responsible for control.

8. Which of the following characteristics distinguishes computer processing from manual

processing?
a. Computer processing virtually eliminates the occurrence of computational error
normally associated with manual processing.
b. Errors or fraud in computer processing will be detected soon after their
occurrence.
c. The potential for systematic errors is ordinarily greater in manual processing
than in computerized processing.
d. Most computer systems are designed so that transaction trails useful for audit
purposes do not exist.

• Answer (A) is correct.

Computer processing uniformly subjects like transactions to the same processing
instructions. A computer program defines the processing steps to accomplish a
task. Once the program is written and tested appropriately, it will perform the
task repetitively and without error. However, if the program contains an error, all
transactions will be processed incorrectly.
• Answer (B) is incorrect.
When an error does occur, for example, in input, it may not be discovered on a
timely basis. Ordinarily, much less human intervention occurs once the
transaction is processed.
• Answer (C) is incorrect.
Systematic (repetitive) errors will occur in computerized processing if an error
exists in the program.
• Answer (D) is incorrect.
Adequately designed systems maintain transaction, console, and error logs that
create useful audit trails.

9. When assessing application controls, which one of the following input controls or edit
checks is most likely to be used to detect a data input error in the customer account
number field?
a. Limit check.
b. Validity check.
c. Control total.
d. Hash total.

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• Answer (A) is incorrect.

Reasonableness, limit, and range checks are based upon known limits for given
information. For example, the hours worked per week is not likely to be greater
than 45.
• Answer (B) is correct.
Validity checks are tests of identification numbers or transaction codes for
validity by comparison with items already known to be correct or authorized. For
example, Social Security numbers on payroll input records can be compared with
Social Security numbers authorized by the personnel department.
• nswer (C) is incorrect.
A record count is a control total of the number of records processed during the
operation of a program. Financial totals summarize dollar amounts in an
information field in a group of records.
• Answer (D) is incorrect.
A hash total is the number obtained from totaling the same field value for each
transaction in a batch. The total has no meaning or value other than as a
comparison with another hash total.

10. Contingency plans for information systems should include appropriate backup
agreements. Which of the following arrangements would be considered too vendor-
dependent when vital operations require almost immediate availability of computer
resources?
a. A “hot site” arrangement.
b. A “cold site” arrangement.
c. A “cold and hot site” combination arrangement.
d. Using excess capacity at another data center within the organization.

• Answer (A) is incorrect.

A hot site has all needed assets in place and is not vendor-dependent.
• Answer (B) is correct.
Organizations should maintain contingency plans for operations in the case of a
disaster. These plans usually include off-site storage of important backup data
and an arrangement for the continuation of operations at another location. A
cold site has all needed assets in place except the needed computer equipment
and is vendor-dependent for timely delivery of equipment.
• Answer (C) is incorrect.
A cold and hot site combination allows the hot site to be used until the cold site is
prepared and is thus not too vendor-dependent.
• Answer (D) is incorrect.
Excess capacity would ensure that needed assets are available and would not be
vendor-dependent.

11. A newly acquired plant asset is to be depreciated over its useful life. The rationale for this
process is the
a. Economic entity assumption.
b. Monetary unit assumption.
c. Materiality assumption.
d. Going concern assumption.

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Unit 4: Finance Management

• Answer (A) is incorrect.

The economic entity assumption is that economic activity can be identified with a
particular unit of accountability.
• Answer (B) is incorrect.
The monetary unit assumption is that all transactions and events can be
measured in terms of a common denominator, e.g., the euro.
• Answer (C) is incorrect.
Information is material if it can influence a user’s decision. Thus, in the case of
plant assets, certain items may be expensed rather than capitalized and
depreciated because they are not material. The difference is not enough to
influence users if the item is not material.
• Answer (D) is correct.
A basic feature of financial accounting is that an entity is assumed to be a going
concern in the absence of evidence to the contrary. The going concern concept is
based on the observation that many entities have an indefinite life. The reporting
entity is assumed to exist long enough to meet its objectives and commitments
and therefore to depreciate wasting assets over their useful lives.

12. The primary purpose of the statement of financial position is to reflect

a. The fair value of the firm’s assets at some moment in time.
b. The status of the firm’s assets in case of forced liquidation of the firm.
c. The success of a company’s operations for a given amount of time.
d. Items of value, debt, and net worth.

• Answer (A) is incorrect.

The measurement attributes of assets include but are not limited to fair value.
• Answer (B) is incorrect.
Financial statements reflect the going concern assumption. Hence, they usually
do not report forced liquidation values.
• Answer (C) is incorrect.
The income statement provides this type of information.
• Answer (D) is correct.
The balance sheet presents three major financial accounting elements: assets
(items of value), liabilities (debts), and equity (net worth). According to the FASB’s
Conceptual Framework, assets are probable future economic benefits resulting
from past transactions or events. Liabilities are probable future sacrifices of
economic benefits arising from present obligations as a result of past
transactions or events. Equity is the residual interest in the assets after deduction
of liabilities.

13. On April 1, a company arranged a $100,000, 10% bank loan. Interest payments of
$10,000 are due on April 1 of each year during the 5-year term of the loan. If the
company reports expenses on an accrual basis, interest expense for the first year of
operations is
a. $0
b. $7,500
c. $10,000
d. $12,500

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• Answer (A) is incorrect.

Interest expense under the cash basis is $0.
• Answer (B) is correct.
Interest expense for the first year equals the 9 months’ accrued interest at year
end, or $7,500 [$10,000 × (9 ÷ 12)].
• Answer (C) is incorrect.
Interest expense for a full year is $10,000.
• Answer (D) is incorrect.
Interest expense for 15 months is $12,500.

14. In performing an audit, you encounter an adjusting journal entry recorded at year end
that contains a debit to rental revenue and a credit to a contract liability. The purpose of
this journal entry is to record an
a. Accrued revenue.
b. Unexpired cost.
c. Expired cost.
d. Adjustment.

• Answer (A) is incorrect.

An accrued revenue has met the recognition criteria but has not yet been
received. The journal entry described indicates that collection has been made.
• Answer (B) is incorrect.
The entry concerns a revenue rather than an expense transaction.
• Answer (C) is incorrect.
The entry concerns a revenue rather than an expense transaction.
• Answer (D) is correct.
A contract liability is a revenue item that has been received but for which a
performance obligation has not been satisfied. The journal entry described in the
question is an adjusting entry to transfer an amount from the revenue account to
a contract liability. The initial collection of cash in advance from the tenant was
apparently recorded by a credit to revenue. An adjusting entry is therefore
required at year end to transfer any remaining amount that does not qualify for
revenue recognition.

15. The relationship between the present value of a future sum and the future value of a
present sum can be expressed in terms of their respective interest factors. If the present
value of $200,000 due at the end of 8 years, at 10%, is $93,300, what is the approximate
future value of $200,000 invested for the same length of time and at the same rate?
a. $93,300
b. $200,000
c. $293,300
d. $428,724

• Answer (A) is incorrect.

The amount of $93,300 is the present value of $200,000 to be received in 8 years.
• Answer (B) is incorrect.
The amount of $200,000 is the present value, not the future value, of $200,000
invested today.

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Unit 4: Finance Management

• Answer (C) is incorrect.

The addition of the present and future values has no accounting meaning.
• Answer (D) is correct.
The interest factor for the future value of a present sum is equal to the reciprocal
of the interest factor for the present value of a future sum. Thus, the future value
is $428,724 [($200,000 ÷ $93,300) × $200,000].

16. Which of the following changes in accounting policies resulting from a significant change
in the expected pattern of economic benefit will increase profit?
a. A change from FIFO to LIFO inventory valuation when costs are rising.
b. A change from FIFO to weighted-average inventory valuation when costs are
falling.
c. A change from accelerated to straight-line depreciation in the later years of the
depreciable lives of the assets.
d. A change from straight-line to accelerated depreciation in the early years of the
depreciable lives of the assets.

• Answer (A) is incorrect.

If costs are rising, applying LIFO (last in, first out) expenses the more recently
acquired and more costly inventory items. Its effect is to reduce profit compared
with FIFO, which expenses the earlier acquired and less costly items (a change to
LIFO is allowed under U.S. GAAP but not IFRS).
• Answer (B) is correct.
In a period of falling costs, FIFO results in higher cost of goods sold than the
weighted-average method. FIFO includes the higher, earlier costs in cost of goods
sold, and the weighted-average method averages the later, lower costs with the
higher, earlier costs. Thus, a change from FIFO to weighted-average costing
reduces cost of goods sold and increases reported profit.
• Answer (C) is incorrect.
In the later years of the depreciable life of an asset, accelerated depreciation
results in lower depreciation expense than does the straight-line method.
A change to straight line increases depreciation expense and reduces reported
profit.
• Answer (D) is incorrect.
In the early years of the depreciable life of an asset, straight-line depreciation
results in lower depreciation expense than accelerated depreciation. A change to
accelerated depreciation increases depreciation expense and reduces reported
profit.

17. Which of the following is not an appropriate basis for measuring the cost of property,
plant, and equipment?
a. The purchase price, freight costs, and installation costs of a productive asset
should be included in the asset’s cost.
b. Proceeds obtained in the process of readying land for its intended purpose, such
as from the sale of cleared timber, should be recognized immediately as income.
c. The costs of improvements to equipment incurred after its acquisition should be
added to the asset’s cost if they increase future service potential.
d. All costs incurred in the construction of a plant building, from excavation to
completion, should be considered as part of the asset’s cost.

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• Answer (A) is incorrect.

The purchase price, freight costs, and installation costs of a productive asset are
included in the asset’s cost.
• Answer (B) is correct.
Accordingly, items of property, plant, and equipment (PPE) that meet the
recognition criterion are initially measured at cost. The cost includes the
purchase price (minus trade discounts and rebates, plus purchase taxes) and the
directly attributable costs of bringing the assets to working condition for their
intended use. Directly attributable costs include site preparation, installation,
initial delivery and handling, architect and equipment fees, costs of removing the
assets and restoring the site, etc. Accordingly, the cost of land includes the cost of
obtaining the land and readying it for its intended uses, but it is inappropriate to
recognize the proceeds related to site preparation immediately in profit or loss.
They should be treated as reductions in the price of the land.
• Answer (C) is incorrect.
Subsequent costs are added to the carrying amount of an item of PPE if it is
probable that, as a result, future economic benefits will be received, and the
costs are reliably measurable.
• Answer (D) is incorrect.
All costs of construction should be included as a part of the asset’s cost.

18. The publisher of a popular magazine offers a special discounted price for a 3-year
subscription. At the end of the reporting period, the amount that has already been
collected but for which a performance obligation has not been satisfied is best referred
to as
a. Accrued subscriptions revenue (an asset account).
b. A contract liability.
c. Earned subscriptions revenue (a revenue account).
d. Precollected subscriptions receivable (a deferred asset account).

• Answer (A) is incorrect.

An accrued revenue has met the recognition criteria but has not been received.
• Answer (B) is correct.
Revenue is recognized when the performance obligation is satisfied. When it is
received in advance, the amount applicable to future periods is a contract
liability. But, the entity still must satisfy an obligation to perform in the future
before it is entitled to the future economic benefits. The amount received in
advance is a liability because it represents a present obligation resulting from a
past event. Accordingly, a contract liability is an amount that has been received
but that has not met the recognition criteria for revenue.
• Answer (C) is incorrect.
The revenue will be recognized in future periods when a performance obligation
has been satisfied by distributing issues of the magazine to the subscribers.
• Answer (D) is incorrect.
“Precollected receivable” is not a standard accounting term.

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19. If bonds are initially sold at a discount and the effective-interest method of amortization
is used, interest expense
a. In the earlier periods will be less than interest expense in the later periods.
b. In the earlier periods will be greater than interest expense in the later periods.
c. Will equal the cash interest payment each period.
d. Will be less than the cash interest payment each period.

• Answer (A) is correct.

Interest expense equals the carrying amount of the liability at the beginning of
the period times the effective interest rate. The carrying amount of the liability
equals the face amount of the bond minus the discount. As the discount is
amortized over the life of the bond, the carrying amount increases.
Consequently, the interest expense increases over the term of the bond.
• Answer (B) is incorrect.
Interest expense increases over the term of the bonds.
• Answer (C) is incorrect.
Interest expense exceeds the cash interest payment when bonds are issued at a
discount because the effective rate is higher than the nominal rate. The excess of
interest expense is the discount amortized each period.
• Answer (D) is incorrect.
Interest expense exceeds the cash interest payment when bonds are issued at a
discount because the effective rate is higher than the nominal rate. The excess of
interest expense is the discount amortized each period.

20. Which statement is true regarding a defined benefit pension plan?

a. A defined benefit plan defines the annual amount of cash that an employer must
deposit to fulfill its pension obligation to employees.
b. No investment risk is borne by an employer.
c. At the end of the reporting period, an employer can measure exactly the total
amount of pension benefits that it is responsible for providing to employees in
the future.
d. The pension benefits to be paid to employees depend on future events that
cannot entirely be controlled by the employer.

• Answer (A) is incorrect.

A defined contribution plan, not a benefit plan, defines the annual amount that
an employer has to deposit to fulfill its pension obligation to employees.
• Answer (B) is incorrect.
The employer is responsible for providing the agreed future benefits to the
employees. Accordingly, it bears the actuarial risk and investment risk.
• Answer (C) is incorrect.
The total amount of benefits to be paid to employees is not precisely
determinable but can only be estimated by using actuarial assumptions.
• Answer (D) is correct.
A defined benefit plan defines an amount of pension benefits to be provided to
each employee. This amount depends on future events, such as (1) how long the
employee lives, (2) how many years of service the employee renders, and (3) the
employee’s compensation before retirement. Many of these events cannot be
controlled by the employer.

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21. Sales-type leases and operating leases differ in that the lessor
a. Obtains use of the asset only under a sales-type lease.
b. Must recognize a lease liability and a right-of-use asset for an operating lease.
c. Makes rent payments that are actually installment payments constituting a
payment of both principal and interest only under an operating lease.
d. Must derecognize the leased asset under a sales-type lease.

• Answer (A) is incorrect.

The lessor transfers use of the asset under both types of leases to the lessee. The
lessor does not obtain use of the asset.
• Answer (B) is incorrect.
For finance and operating leases, a lessee (not a lessor) must recognize a lease
liability and a right-of-use asset at the lease commencement date.
• Answer (C) is incorrect.
The lessee makes payments to the lessor under both types of leases. The lessor
does not make payments.
• Answer (D) is correct.
For sales-type leases, the lessor must derecognize the leased asset. For operating
leases, the lessor recognizes lease payments as lease (rental) income. The leased
asset continues to be reported on the lessor’s balance sheet.

22. An investor uses the equity method to account for an investment in common stock. After
the date of acquisition, the investment account of the investor is
a. Not affected by its share of the earnings or losses of the investee.
b. Not affected by its share of the earnings of the investee, but is decreased by its
share of the losses of the investee.
c. Increased by its share of the earnings of the investee, but is not affected by its
share of the losses of the investee.
d. Increased by its share of the earnings of the investee, and is decreased by its
share of the losses of the investee.

• Answer (A) is incorrect.

The investment account is affected by the investor’s share of both earnings and
losses of the investee.
• Answer (B) is incorrect.
The investment account is affected by the investor’s share of both earnings and
losses of the investee.
• Answer (C) is incorrect.
The investment account is affected by the investor’s share of both earnings and
losses of the investee.
• Answer (D) is correct.
After the date of acquisition, an equity-based investment in common stock of an
investor is increased by its share of the earnings of the investee, decreased by its
share of the losses of the investee, and decreased by its share of cash dividends
received from the investee.

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23. What is the method of presenting a noncontrolling interest in a consolidated statement

of financial position?
a. As a separate item within the deferred credits section.
b. As a deduction from (contra to) goodwill from consolidation, if any.
c. By means of notes to the statement of financial position.
d. As a separate item within the equity section.

• Answer (A) is incorrect.

The interests of noncontrolling shareholders represents an equity interest.
• Answer (B) is incorrect.
A noncontrolling interest is independent of any goodwill.
• Answer (C) is incorrect.
A noncontrolling interest must be recognized in the accounts.
• Answer (D) is correct.
A noncontrolling interest is classified as an equity account and separated from
the equity of majority shareholders within that section.

24. When the U.S. dollar is expected to rise in value against foreign currencies, a U.S.
company with foreign currency denominated receivables and payables should
a. Slow down collections and speed up payments.
b. Slow down collections and slow down payments.
c. Speed up collections and speed up payments.
d. Speed up collections and slow down payments.

• Answer (A) is incorrect.

Slowing collections and expediting payments increases the company’s real cost.
• Answer (B) is incorrect.
Slowing collections does not maximize the amount of U.S. dollars received.
• Answer (C) is incorrect.
Expediting payments does not maximize the amount of U.S. dollars received.
• Answer (D) is correct.
The U.S. firm should increase collections and decrease payments. Collections
should be made quickly because the foreign currency is expected to depreciate
against the U.S. dollar. Early conversion into dollars sustains the increase in their
value as the dollar appreciates. Decreasing payments is profitable because, as
the company exchanges dollars for foreign currency at a later date, it will receive
more of the foreign currency, thus lowering its real cost.

25. A call option on an ordinary share is more valuable when there is a lower
a. Market value of the underlying share.
b. Exercise price on the option.
c. Time to maturity on the option.
d. Variability of market price on the underlying share.

• Answer (A) is incorrect.

A call option is the right to purchase an ordinary share at a set price for a set time
period. If the underlying share has a lower market value, the call option is less,
not more, valuable.

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• Answer (B) is correct.

The lower the exercise price, the more valuable the call option. The exercise price
is the price at which the call holder has the right to purchase the underlying
share.
• Answer (C) is incorrect.
A call option is less, not more, valuable given less time to maturity. When the
option has less time to maturity, the chance that the share price will rise is
smaller.
• Answer (D) is incorrect.
A call option is less, not more, valuable if the price of the underlying share is less
variable. Less variability means a lower probability of a price increase.

26. During the year, an entity’s retained earnings increased by $25,000. Profit for the year
was $42,000. The only other change in retained earnings was for the declaration of cash
dividends. The amount of dividends declared was
a. $25,000
b. $17,000
c. $42,000
d. $67,000

• Answer (A) is incorrect.

The amount of $25,000 is the increase in retained earnings.
• Answer (B) is correct.
Retained earnings is accumulated net income or loss. It is increased by net
income and decreased by net loss and dividends. Ending retained earnings
equals beginning retained earnings plus net income, minus dividends declared in
the period. Given the increase of retained earnings of $25,000 and profits of
$42,000, dividends declared must have been $17,000 ($42,000 – $25,000).
• Answer (C) is incorrect.
The amount of $42,000 is the profit for the year.
• Answer (D) is incorrect.
The amount of $67,000 equals profit plus the increase in retained earnings.

27. Which of the following financial statement analyses is most useful in determining
whether the various expenses of a given entity are higher or lower than industry
averages?
a. Horizontal.
b. Vertical.
c. Activity ratio.
d. Defensive-interval ratio.

• Answer (A) is incorrect.

A horizontal analysis indicates the proportionate change over a period of time
and is useful in trend analysis of an individual entity.
• Answer (B) is correct.
Vertical analysis is the expression of each item on a financial statement in a given
period in relation to a base amount. On the income statement, each item is
stated as a percentage of sales. Thus, the percentages for the entity in question
can be compared with industry norms.

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• Answer (C) is incorrect.

Activity ratio analysis includes the preparation of turnover ratios such as those
for receivables, inventory, and total assets.
• Answer (D) is incorrect.
The defensive-interval ratio is part of a liquidity analysis.

28. North Bank is analyzing Belle Corp.’s financial statements for a possible extension of
credit. Belle’s quick ratio is significantly better than the industry average. Which of the
following factors should North consider as a possible limitation of using this ratio when
evaluating Belle’s creditworthiness?
a. Fluctuating market prices of short-term investments may adversely affect the
ratio.
b. Increasing market prices for Belle’s inventory may adversely affect the ratio.
c. Belle may need to sell its available-for-sale investments to meet its current
obligations.
d. Belle may need to liquidate its inventory to meet its long-term obligations.

• Answer (A) is correct.

The quick ratio equals cash plus short-term investment securities plus net
receivables, divided by current liabilities. Because short-term investment
securities are included in the numerator, fluctuating market prices of these
investments may adversely affect the ratio if Belle holds a substantial amount of
such current assets.
• Answer (B) is incorrect.
Inventory is excluded from the calculation of the quick ratio.
• Answer (C) is incorrect.
If the available-for-sale securities are not current, they are not included in the
calculation of the ratio. If they are classified as current, their sale to meet current
obligations is consistent with normal current assets management practices.
• Answer (D) is incorrect.
Inventory and noncurrent obligations are excluded from the calculation of the
quick ratio.

29. An entity purchased a new machine for $500,000 by borrowing the required funds from
a bank for 180 days. What will be the direct impact of this transaction?
a. Decrease the current ratio and increase the debt ratio.
b. Increase the current ratio and decrease the debt ratio.
c. Increase the current ratio and increase the debt ratio.
d. Decrease the current ratio and decrease the debt ratio.

• Answer (A) is correct.

The borrowing of funds for 180 days constitutes short-term borrowing. The new
machine is a fixed asset. Current liabilities have increased, and current assets
have remained constant. Consequently, the current ratio (Current assets ÷
Current liabilities) has decreased. Total debt and total assets increased by the
same absolute amount, and the debt ratio (Total debt ÷ Total assets) should have
increased, assuming total debt is less than total assets.

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• Answer (B) is incorrect.

The current ratio decreased and the debt ratio increased.
• Answer (C) is incorrect.
The current ratio decreased.
• Answer (D) is incorrect.
The debt ratio increased.

30. Net working capital is the difference between

a. Current assets and current liabilities.
b. Fixed assets and fixed liabilities.
c. Total assets and total liabilities.
d. Shareholders’ investment and cash.

• Answer (A) is correct.

Net working capital is defined by accountants as the difference between current
assets and current liabilities. Working capital is a measure of liquidity.
• Answer (B) is incorrect.
Working capital refers to the difference between current assets and current
liabilities; fixed assets are not a component.
• Answer (C) is incorrect.
Total assets and total liabilities are not components of working capital; only
current items are included.
• Answer (D) is incorrect.
Shareholders’ equity is not a component of working capital; only current items
are included in the concept of working capital.

31. The average collection period for a firm measures the number of days
a. After a typical credit sale is made until the firm receives the payment.
b. For a typical check to “clear” through the banking system.
c. Beyond the end of the credit period before a typical customer payment is
received.
d. Before a typical account becomes delinquent.

• Answer (A) is correct.

The average collection period measures the number of days between the date of
sale and the date of collection. It should be related to a firm’s credit terms. For
example, a firm that allows terms of 2/15, net 30, should have an average
collection period of somewhere between 15 and 30 days.
• Answer (B) is incorrect.
It describes the concept of float.
• Answer (C) is incorrect.
The average collection period includes the total time before a payment is
received, including the periods both before and after the end of the normal
credit period.
• Answer (D) is incorrect.
It describes the normal credit period.

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32. Capital structure decisions involve determining the proportions of financing from
a. Short-term or long-term debt.
b. Debt or equity.
c. Short-term or long-term assets.
d. Retained earnings or common equity.

• Answer (A) is incorrect.

The capital structure also includes equity.
• Answer (B) is correct.
Debt and equity are the two elements of an entity’s capital structure.
• Answer (C) is incorrect.
Assets are not part of the capital structure.
• Answer (D) is incorrect.
The capital structure also includes debt and preferred equity.

33. An entity obtaining short-term financing with trade credit will pay a higher percentage
financing cost, everything else being equal, when the
a. Discount percentage is lower.
b. Items purchased have a higher price.
c. Items purchased have a lower price.
d. Supplier offers a longer discount period.

• Answer (A) is incorrect.

The lower the discount percentage, the lower the opportunity cost of forgoing
the discount and using the trade credit financing.
• Answer (B) is incorrect.
Percentage financing cost is unaffected by the purchase price of the items.
• Answer (C) is incorrect.
Percentage financing cost is unaffected by the purchase price of the items.
• Answer (D) is correct.
If the discount period is longer, the days of extra credit obtained by forgoing the
discount are fewer. Assuming other factors are constant, the result is that the
cost of trade credit, that is, the cost of not taking the discount, is greater.

34. An entity has made the decision to finance next year’s capital projects through debt
rather than additional equity. The benchmark cost of capital for these projects should be
the
a. Before-tax cost of new-debt financing.
b. After-tax cost of new-debt financing.
c. Cost of equity financing.
d. Weighted-average cost of capital.

• Answer (A) is incorrect.

The weighted-average cost of capital is calculated on an after-tax basis.
• Answer (B) is incorrect.
The weighted-average cost of capital consists of both debt and equity
components calculated on an after-tax basis.

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• Answer (C) is incorrect.

The cost of capital is an after-tax composite, or weighted average, of all financing
sources in their usual proportions.
• Answer (D) is correct.
A weighted average of the costs of all financing sources should be used, with the
weights determined by the usual financing proportions. The terms of any
financing raised at the time of initiating a particular project do not represent the
cost of capital for the entity. When an entity achieves its optimal capital structure,
the weighted-average cost of capital is minimized. The cost of capital is a
composite, or weighted average, of all financing sources in their usual
proportions. The cost of capital should also be calculated on an after-tax basis.

35. What is an internal rate of return?

a. A net present value.
b. An accounting rate of return.
c. A payback period expected from an investment.
d. A time-adjusted rate of return from an investment.

• Answer (A) is incorrect.

The net present value of a project is a dollar amount; the internal rate of return is
a percentage.
• Answer (B) is incorrect.
An accounting rate of return is a primitive tool for assessing capital projects that
uses accrual-basis numbers and ignores the time value of money.
• Answer (C) is incorrect.
A payback period is a time period; the internal rate of return is a percentage.
• Answer (D) is correct.
The internal rate of return is a convenient tool for assessing capital budgeting
projects. It is the discount rate at which the present value of all the net cash flows
equals $0.

36. In cost terminology, conversion costs consist of

a. Direct and indirect labor.
b. Direct labor and direct materials.
c. Direct labor and manufacturing overhead.
d. Indirect labor and variable manufacturing overhead.

• Answer (A) is incorrect.

All manufacturing overhead is included in conversion costs, not just indirect
labor.
• Answer (B) is incorrect.
Direct materials are not an element of conversion costs; they are a prime cost.
• Answer (C) is correct.
Conversion costs consist of direct labor and manufacturing overhead. These are
the costs of converting direct materials into a finished product.
• Answer (D) is incorrect.
Direct labor is also an element of conversion costs.

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37. An assembly plant accumulates its variable and fixed manufacturing overhead costs in a
single cost pool, which is then applied to work in process using a single application base.
The assembly plant management wants to estimate the magnitude of the total
manufacturing overhead costs for different volume levels of the application activity base
using a flexible budget formula. If there is an increase in the application activity base that
is within the relevant range of activity for the assembly plant, which one of the following
relationships regarding variable and fixed costs is true?
a. The variable cost per unit is constant, and the total fixed costs decrease.
b. The variable cost per unit is constant, and the total fixed costs increase.
c. The variable cost per unit and the total fixed costs remain constant.
d. The variable cost per unit increases, and the total fixed costs remain constant.

• Answer (A) is incorrect.

The variable cost per unit and the total fixed costs are constant if the activity level
increases within the relevant range.
• Answer (B) is incorrect.
The variable cost per unit and the total fixed costs are constant if the activity level
increases within the relevant range.
• Answer (C) is correct.
Total variable cost changes when changes in the activity level occur within the
relevant range. The cost per unit for a variable cost is constant for all activity
levels within the relevant range. Thus, if the activity volume increases within the
relevant range, total variable costs will increase. A fixed cost does not change
when volume changes occur in the activity level within the relevant range. If the
activity volume increases within the relevant range, total fixed costs will remain
unchanged.
• Answer (D) is incorrect.
The variable cost per unit and the total fixed costs are constant if the activity level
increases within the relevant range.

38. Cost allocation is the process of assigning indirect costs to a cost object. The indirect
costs are grouped in cost pools and then allocated by a common allocation base to the
cost object. The base that is employed to allocate a homogeneous cost pool should
a. Have a cause-and-effect relationship with the cost items in the cost pool.
b. Assign the costs in the pool uniformly to cost objects even if the cost objects use
resources in a nonuniform way.
c. Be a nonfinancial measure (e.g., number of setups) because a nonfinancial
measure is more objective.
d. Have a high correlation with the cost items in the cost pool as the sole criterion
for selection.

• Answer (A) is correct.

A cost allocation base is the common denominator for systematically correlating
indirect costs and a cost object. The cost driver of the indirect costs is ordinarily
the allocation base. In a homogeneous cost pool, all costs should have the same
or a similar cause-and-effect relationship with the cost allocation base.

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• Answer (B) is incorrect.

If an allocation base uniformly assigns costs to cost objects when the cost objects
use resources in a nonuniform way, the base is smoothing or spreading the
costs. Smoothing can result in undercosting or overcosting of products, with
adverse effects on product pricing, cost management and control, and decision
making.
• Answer (C) is incorrect.
Financial measures (e.g., sales dollars and direct labor costs) and nonfinancial
measures (e.g., setups and units shipped) can be used as allocation bases.
• Answer (D) is incorrect.
High correlation between the cost items in a pool and the allocation base does
not necessarily mean that a cause-and-effect relationship exists. Two variables
may move together without such a relationship. The perceived relationship
between the cost driver (allocation base) and the indirect costs should have
economic plausibility and high correlation.

39. The loss of a key customer has temporarily caused Bedford Machining to have some
excess manufacturing capacity. Bedford is considering the acceptance of a special order,
one that involves Bedford’s most popular product. Consider the following types of costs.
I. Variable costs of the product
II. Fixed costs of the product
III. Direct fixed costs associated with the order
IV. Opportunity cost of the temporarily idle capacity
Which one of the following combinations of cost types should be considered in the
special order acceptance decision?
a. II and III.
b. I, III, and IV.
c. I and IV.
d. I and II.

• Answer (A) is incorrect.

Fixed costs of the product are not relevant.
• Answer (B) is correct.
Fixed costs of the product do not vary whether the special order is accepted or
not, making them irrelevant. All the other costs will change if the order is
accepted and are therefore relevant. The opportunity cost of the temporarily idle
facility, if there are any, should also be considered.
• Answer (C) is incorrect.
Direct fixed costs of the order are relevant also.
• Answer (D) is incorrect.
Fixed costs of the product are not relevant.

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40. The major objectives of any budget system are to

a. Define responsibility centers, provide a framework for performance evaluation,
and promote communication and coordination among organization segments.
b. Define responsibility centers, facilitate the fixing of blame for missed budget
predictions, and ensure goal congruence between superiors and subordinates.
c. Foster the planning of operations, provide a framework for performance
evaluation, and promote communication and coordination among organization
segments.
d. Foster the planning of operations, facilitate the fixing of blame for missed budget
predictions, and ensure goal congruence between superiors and subordinates.

• Answer (A) is incorrect.

Responsibility centers are determined prior to budgeting.
• Answer (B) is incorrect.
Responsibility centers are determined prior to budgeting, budgets do not fix
blame but rather measure performance, and goal congruence is promoted but
not ensured by budgets.
• Answer (C) is correct.
A budget is a realistic plan for the future expressed in quantitative terms. The
process of budgeting forces a company to establish goals, determine the
resources necessary to achieve those goals, and anticipate future difficulties in
their achievement. A budget also is a control tool because it establishes
standards and facilitates comparison of actual and budgeted performance.
Because a budget establishes standards and accountability, it motivates good
performance by highlighting the work of effective managers. Moreover, the
nature of the budgeting process fosters communication of goals to company
subunits and coordination of their efforts. Budgeting activities by entities within
the company must be coordinated because they are interdependent. Thus, the
sales budget is a necessary input to the formulation of the production budget. In
turn, production requirements must be known before purchases and expense
budgets can be developed, and all other budgets must be completed before
preparation of the cash budget.
• Answer (D) is incorrect.
Budgets do not fix blame but rather measure performance, and goal congruence
is promoted but not ensured by budgets.

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