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Flashcards in A4-A Deck (14)
1

To measure how effectively an entity employs its resources, an auditor calculates inventory turnover by dividing average inventory into:

a.

Cost of goods sold.

b.

Net sales.

c.

Operating income.

d.

Gross sales.

Choice "a" is correct. The appropriate numerator for calculating inventory turnover is cost of goods sold. Cost of goods sold is the expense most clearly associated with the sale (turnover) of inventory, which is priced at acquisition cost, not selling price.

Choice "b" is incorrect. Net sales is a measure of revenue that reflects the price at which inventory was sold, not its recorded inventoriable value.

Choice "c" is incorrect. Operating income does not tie specifically to the recorded value of inventory sold because it reflects the sales price after all operating expenses.

Choice "d" is incorrect. Gross sales is a measure of revenue that reflects the price at which inventory was sold, not its recorded inventoriable value.

2

What effect would the sale of a company's trading securities at their carrying amounts for cash have on each of the following ratios?

~Current ratio
~Quick ratio
a.

Increase

No effect

b.

No effect

No effect

c.

No effect

Increase

d.

Increase

Increase

Choice "b" is correct. Trading securities are both current assets and quick assets. If they are sold for their carrying value, then both total current assets and total quick assets remain constant since one type of current asset and quick asset is traded for another. Thus, both the current ratio and the quick ratio would be unaffected by the sale of trading securities.

Choices "d", "c", and "a" are incorrect, per the above explanation.

3

The following data pertain to Cowl, Inc., for the year ended December 31, Year 4:

Net sales

$600,000

Net income

150,000

Total assets, January 1, Year 4

2,000,000

Total assets, December 31, Year 4

3,000,000

What was Cowl's rate of return on assets for Year 4?

a.

6%

b.

20%

c.

5%

d.

24%

Choice "a" is correct. Rate of return on assets is defined as the net income divided by the average total assets. In this case:

$150,000 / [($2,000,000 + $3,000,000) / 2]

or [$150,000 / $2,500,000] = 6% rate of return.

Choice "c" is incorrect. Average total assets ($2,500,000) should be used, not ending assets ($3,000,000).

Choice "b" is incorrect. Net income ($150,000) and average total assets ($2,500,000) should be used, not net sales ($600,000) and ending assets ($3,000,000).

Choice "d" is incorrect. Net income ($150,000) should be used, not net sales ($600,000).

4

Selected data pertaining to Lore Co. for the calendar Year 4 is as follows:

Net cash sales

$3,000

Cost of goods sold

18,000

Inventory at beginning of year

6,000

Purchases

24,000

Accounts receivable at beginning of year

20,000

Accounts receivable at end of year

22,000

The accounts receivable turnover for Year 4 was 5.0 times. What were Lore's Year 4 net credit sales?

a.

$210,000

b.

$107,000

c.

$110,000

d.

$105,000

Choice "d" is correct. The accounts receivable turnover ratio equals net credit sales divided by average accounts receivable. 5.0 = net credit sales / [($20,000 + $22,000) / 2]. Net credit sales equal $105,000.

Choice "b" is incorrect. The accounts receivable turnover ratio equals net credit sales divided by average accounts receivable.

Choice "c" is incorrect. The accounts receivable turnover ratio equals net credit sales divided by average accounts receivable, not by year-end accounts receivable.

Choice "a" is incorrect. The accounts receivable turnover ratio equals net credit sales divided by average accounts receivable, not by the sum of beginning and ending accounts receivable.

5

Selected data pertaining to Lore Co. for the calendar Year 4 is as follows:

Net cash sales

$3,000

Cost of goods sold

18,000

Inventory at beginning of year

6,000

Purchases

24,000

Accounts receivable at beginning of year

20,000

Accounts receivable at end of year

22,000

What was the inventory turnover for Year 4?

a.

1.5 times.

b.

3.0 times.

c.

1.2 times.

d.

2.0 times.

Choice "d" is correct. Inventory turnover equals cost of goods sold divided by average inventory. Beginning inventory ($6,000) plus purchases ($24,000) less ending inventory equals cost of goods sold ($18,000). Thus, ending inventory equals $12,000 and inventory turnover = $18,000 / [($6,000 + $12,000) / 2] = 2.0.

Choice "c" is incorrect. Inventory turnover equals cost of goods sold divided by average inventory.

Choice "a" is incorrect. Cost of goods sold should be divided by average inventory, not by ending inventory.

Choice "b" is incorrect. Cost of goods sold should be divided by average inventory, not by beginning inventory.

6

Selected data pertaining to Lore Co. for the calendar Year 4 is as follows:

Net cash sales   $3,000

Cost of goods sold    18,000

Inventory at beginning of year   6,000

Purchases 24,000

Accounts receivable at beginning of year  20,000

Accounts receivable at end of year  22,000

Lore would use which of the following to determine the average days sales in inventory?

Numerator
Denominator
a.

Sales divided by 365

Inventory turnover

b.

Average inventory

Sales divided by 365

c.

365

Inventory turnover

d.

365

Average inventory


Explanation

Choice "c" is correct. Average number of days sales in inventory is defined as 365 days per year divided by the inventory turnover.

Choice "d" is incorrect. The denominator used to determine average days sales in inventory is inventory turnover. Inventory turnover is cost of goods sold divided by average inventory, not simply average inventory.

Choice "b" is incorrect. The days sales in inventory calculation uses the cost of goods sold figure, not the sales figure.

Choice "a" is incorrect. The days sales in inventory calculation uses 365 in the numerator, not sales divided by 365.

7

In analyzing a company's financial statements, which financial statement would a potential investor primarily use to assess the company's liquidity and financial flexibility?

a.

Income statement.

b.

Balance sheet.

c.

Statement of cash flows.

d.

Statement of retained earnings.


Explanation

Choice "b" is correct. Liquidity ratios and coverage ratios focus on balance sheet account balances.

Choice "a" is incorrect. Income statement information is primarily used for profitability analysis.

Choice "d" is incorrect. The statement of retained earnings is primarily a reconciliation of the retained earnings account.

Choice "c" is incorrect. The statement of cash flows assesses cash inflows and cash outflows.

8

At December 30, Year 3, Vida Co. had cash of $200,000, a current ratio of 1.5:1 and a quick ratio of .5:1. On December 31, Year 3, all cash was used to reduce accounts payable. How did these cash payments affect the ratios?

~Current ratio
~Quick ratio
a.

Decreased

No effect

b.

Increased

Decreased

c.

Increased

No effect

d.

Decreased

Increased

Choice "b" is correct. The current ratio equals current assets divided by current liabilities. Since the current assets exceed the current liabilities (as evidenced by a current ratio of 1.5:1), when each is decreased by the same amount, there will be a greater percentage reduction of the current liabilities. Thus, the ratio will increase since the current assets are now proportionately larger than the current liabilities. The quick ratio equals quick assets (including cash) divided by current liabilities. Since the quick assets are less than the current liabilities (as evidenced by a quick ratio of 0.5:1), when each is decreased by the same amount, the percentage decrease of the quick assets will be greater than that of the current liabilities. Thus, the ratio will decrease since the quick assets are now proportionately smaller than the current liabilities.

Choices "c", "d", and "a" are incorrect, per the above explanation.

9

At December 31, Year 2, Curry Co. had the following balances in selected asset accounts:

                          Year 2            Increase over Year 1
 
Cash                  $ 300               $ 100
 
Accounts receivable, net    1,200            400
 
Inventory           500                200
 
Prepaid expenses           100        40
 
Other assets           400            150
 
Total assets           $ 2,500          $ 890

Curry also had current liabilities of $1,000 at December 31, Year 2, and net credit sales of $7,200 for the year then ended.

What is Curry's acid-test ratio at December 31, Year 2?

a.

1.5

b.

1.6

c.

2.0

d.

2.1

Choice "a" is correct. The acid-test ratio is calculated by taking the current assets excluding inventory and prepaid expenses and dividing by current liabilities. In this case, cash and accounts receivable ($300 + $1,200 = $1,500) are divided by current liabilities ($1,000), resulting in a ratio of $1,500 / $1,000, or 1.5.

Choice "b" is incorrect. The numerator in the acid-test ratio formula includes only cash and accounts receivable. It would not include prepaid expenses.

Choice "c" is incorrect. The numerator in the acid-test ratio formula includes only cash and accounts receivable. It would not include inventory.

Choice "d" is incorrect. The numerator in the acid-test ratio formula includes only cash and accounts receivable. It would not include inventory and prepaid expenses.

10

At December 31, Year 2, Curry Co. had the following balances in selected asset accounts:

                   Year 2              Increase over Year 1
 
Cash  $ 300          $ 100
 
Accounts receivable, net      1,200        400
 
Inventory     500      200
 
Prepaid expenses    100    40
 
Other assets    400    150
 
Total assets     $ 2,500     $ 890

Curry also had current liabilities of $1,000 at December 31, Year 2, and net credit sales of $7,200 for the year then ended.

What was the average number of days to collect Curry's accounts receivable during Year 2?

a.

60.8

b.

50.7

c.

30.4

d.

40.6

Choice "b" is correct. The average number of days to collect accounts receivable is calculated by dividing 365 days by the accounts receivable turnover. Accounts receivable turnover is net credit sales divided by the average accounts receivable:

Average A/R = (beginning A/R + ending A/R) ÷ 2 = ($1,200 + $800) ÷ 2 = $1,000

A/R turnover = $7,200 ÷ $1,000 = 7.2

Average number of days in A/R = 365 days ÷ 7.2 = 50.7 days.

Choice "c" is incorrect. The denominator should be net credit sales ($7,200) divided by average receivables $1,000), or 7.2, not 12.

Choice "d" is incorrect. The average receivable balance is $1,000, not $800. The right-hand column shows the increase over Year 1, so the Year 1 receivable balance was $1,200 - $400, or $800. Since the Year 2 receivable balance was given as $1,200, the average receivable balance is $1,000.

Choice "a" is incorrect. Average inventory ($1,000), not ending inventory ($1,200), should be used.

11

In a comparison of 20X2 to 20X1, Neir Co.'s inventory turnover ratio increased substantially although sales and inventory amounts were essentially unchanged. Which of the following statements explains the increased inventory turnover ratio?

a.

Cost of goods sold decreased.

b.

Accounts receivable turnover increased.

c.

Gross profit percentage decreased.

d.

Total asset turnover increased.

Choice "c" is correct. Gross profit percentage decreased.

Inventory turnover ratio = Cost of sales / Average inventory

In order for the inventory turnover ratio to increase, either cost of sales must increase or average inventory must decrease. Since the question indicates that inventory is unchanged, cost of sales must have increased.
If the cost of sales increased and sales remained constant, the gross profit percentage would decrease.

Choice "a" is incorrect. If cost of goods sold decreases, the inventory turnover ratio would also decrease.

Choice "b" is incorrect. Accounts receivable turnover is calculated as sales divided by receivables. If sales remain the same while this ratio increases, receivables have likely declined. This would have no impact on inventory turnover.

Choice "d" is incorrect. Total asset turnover is calculated as sales divided by total assets. If sales remain the same while this ratio increases, total assets have likely declined. This would have no impact on inventory turnover.

12

The accounts receivable turnover ratio increased significantly over a two-year period. This trend could indicate that:

a.

The company has eliminated its discount policy.

b.

The company is more aggressively collecting customer accounts.

c.

Customer sales have substantially decreased.

d.

The accounts receivable aging has deteriorated.

Choice "b" is correct. The accounts receivable turnover ratio is calculated as sales / average net receivables. More aggressive collection policies will result in a decrease in the receivables balance, which in turn causes the turnover ratio to increase.

Choice "d" is incorrect. A deterioration in the aging of receivables implies a greater receivables balance, which would cause the turnover ratio to decline.

Choice "a" is incorrect. Elimination of the company's discount policy would increase both the sales figure and the receivables balance. The net effect on the turnover ratio would depend upon the proportionate impact of each increase.

Choice "c" is incorrect. A decline in sales would cause a decrease in both sales and receivables. The net effect on the turnover ratio would depend upon the proportionate impact of each decrease.

13

An auditor discovered that a client's accounts receivable turnover is substantially lower for the current year than for the prior year. This may indicate that:

a.

An unusually large receivable was written off near the end of the year.

b.

Obsolete inventory has not yet been reduced to fair market value.

c.

The aging of accounts receivable was improperly performed in both years.

d.

There was an improper cutoff of sales at the end of the year.

Choice "d" is correct. Accounts receivable turnover is calculated as sales / average net receivables. A decline in this ratio may indicate that there was an improper cutoff of sales at the end of the year. For example, if sales made at the beginning of the subsequent year were inadvertently recorded in the current year, both sales and receivables would be overstated by the same amount. This would generally result in a larger proportionate effect on receivables (since the receivables balance is smaller than sales for the year), and an overall decrease in the ratio.

Choice "b" is incorrect. Failure to write down obsolete inventory would not affect sales or receivables, and so would have no effect on accounts receivable turnover.

Choice "a" is incorrect. Write-off of an unusually large receivable would reduce the receivables balance without affecting sales. This in turn would cause an increase in accounts receivable turnover.

Choice "c" is incorrect. The aging of accounts receivable does not affect the overall receivable balance, and therefore would have no effect on accounts receivable turnover.

14

Which of the following ratios would an engagement partner most likely consider in the overall review stage of an audit?

a.

Accounts receivable/inventory.

b.

Current assets/quick assets.

c.

Cost of goods sold/average inventory.

d.

Total liabilities/net sales.

Choice "c" is correct. Inventory turnover is a measure of how quickly inventory is sold, which can be used as an indicator of enterprise performance. In general, the higher the turnover, the better the entity's performance.

Choice "d" is incorrect. It does not make sense to divide total liabilities, which is a measure as of a point in time, by net sales, which is a measure that spans a year. This ratio could fluctuate wildly as liabilities are incurred and then paid.

Choice "a" is incorrect. It does not make sense to divide accounts receivable by inventory, since receivables are measured in sales dollars while inventory is measured in terms of cost figures.

Choice "b" is incorrect. Inventory and prepaid assets are included in current assets but not in quick assets, so dividing these two amounts provides some measure of the relative size of inventory and prepaids. It is not a commonly used ratio and would not be considered in the overall review stage of the audit.