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Subject 6. Financial Statements

Here are financial statements based on previous transactions for ABC Realty.

Practice Question 1

When preparing financial statements for a company, net income from the income statement is carried over and included in which of the following financial statements?

I. Balance sheet
II. Statement of cash flows
III. Statement of owners' equity

Correct Answer: II and III

Net income is carried from the income statement to the statement of owners' equity. Items affecting retained earnings include net income or loss and payment of dividends. However, net income is not carried over to the balance sheet; it is carried over to the statement of cash flows under cash flows from operating activities.

Practice Question 2

True or False? If the cash balance reported on the balance sheet as of December 31, 20x2 is $45,600, then cash at end of month, reported on the statement of cash flows for the month ending December 31, 20x2, will also be $45,600.

Correct Answer: True

The two amounts will be the same. The balance sheet reports the cash balance as of a certain date and the statement of cash flows reports the types and total amounts of transactions that produced that balance over a certain period of time.

Practice Question 3

Which group of accounts affects both the income statement and the statement of owners' equity?

I. Revenue accounts
II. Expense accounts

Correct Answer: I and II

Both revenue and expense accounts affect both the income statement and the statement of owners' equity. The income statement is a summary of revenues and expenses and the statement of owners' equity shows changes in the retained earnings account, which is affected by dividends and net income or loss from the income statement.

Practice Question 4

Assume U.S. GAAP. A company receives a payment of $10,000 on 1 December, for rent on a property for December and January. On receipt, they correctly record it as cash and unearned revenue. If, on 31 December, their year-end, they failed to make an adjusting entry related to this payment, ignoring taxes, what is the effect on the financial statements for the year?

A. Assets are overstated by $5,000 and liabilities are overstated by $5,000.
B. Assets are overstated by $5,000 and owner's equity is overstated by $5,000.
C. Liabilities are overstated by $5,000 and owners' equity is understated by $5,000.

Correct Answer: C

The company should have made an adjusting entry to reduce the unearned revenue account (a liability) by $5,000 and increase revenue (and hence net income and retained earnings) by $5,000. As the company failed to make the adjusting entry, the liabilities are overstated and owners' equity is understated.

Practice Question 5

Which account does not affect retained earnings?

A. Dividends
B. Sales revenue/rent expense
C. Common stock

Correct Answer: C

The dividends account does affect retained earnings because it is closed to the retained earnings account during the closing process. The sales revenue and rent expense accounts also affect retained earnings because they are closed to the income summary account, which is closed to the retained earnings account. The common stock account does not affect retained earnings. Common stock represents stockholders' claims arising from their investment in the company. Retained earnings represent stockholders' claims arising from profitable operations.

Study notes from a previous year's CFA exam:

6. Financial Statements