FIN 3716 CH 2
What are the four financial statements that all public companies must produce?
1. balance sheet 2. income statement 3. statement of cash flows 4. statement of stockholders' equity
What is the role of an auditor in financial statement analysis?
1. to ensure that the annual financial statements are prepared accurately 2. to ensure that the annual financial statements are prepared according to Generally Accepted Accounting Principles (GAAP) 3. to verify that the information used in preparing the annual financial statements is reliable
Company A has current assets of $42 billion and current liabilities of $41 billion. Company B has current assets of $2.7 billion and current liabilities of $1.8 billion. Which of the following statements is correct, based on this information? A) Company A is less likely than Company B to have sufficient working capital to meet its short-term needs. B) Company A has greater leverage than Company B. C) Company A has less leverage than Company B. D) Company A and Company B have roughly equivalent enterprise values.
A) Company A is less likely than Company B to have sufficient working capital to meet its short-term needs.
A manufacturer of plastic bottles for the medical trade purchases a new compression blow molder for its bottle production plant. How will the cost to the company of this piece of equipment be recorded? A) It will be depreciated over time on the income statement and subtracted as a capital expenditure on the statement of cash flows. B) It will be depreciated over time on the income statement and subtracted as Inventory on the statement of cash flows. C) It will be depreciated over time on the income statement and therefore not be recorded separately on the statement of cash flows. D) It will be subtracted from Gross Profit on the income statement and therefore, not be recorded separately on the statement of cash flows.
A) It will be depreciated over time on the income statement and subtracted as a capital expenditure on the statement of cash flows.
Manufacturer A has a profit margin of 2.2%, an asset turnover of 1.7 and an equity multiplier of 5.0. Manufacturer B has a profit margin of 2.5%, an asset turnover of 1.2 and an equity multiplier of 4.7. How much asset turnover should manufacturer B have to match manufacturer A's ROE? A) 1.59% B) 3.18% C) 2.23% D) 1.27%
A) ROEA = 2.2 × 1.7 × 5.0 = 18.7; 18.7 / (2.5 × 4.7) = 1.59
A small company has current assets of $112,000 and current liabilities of $117,000. Which of the following statements about that company is most likely to be true? A) Since net working capital is negative, the company will not have enough funds to meet its obligations. B) Since net working capital is high, the company will likely have little difficulty meeting its obligations. C) Since net working capital is very high, the company will have ample money to invest after it meets its obligations. D) Since net working capital is nearly zero, the company is well run and will have little difficulty attracting investors.
A) Since net working capital is negative, the company will not have enough funds to meet its obligations.
Which of the following is the LEAST likely explanation for a firm's high ROE? A) The firm is growing. B) The firm is able to find investment opportunities that are very profitable. C) The firm has very efficient use of its assets. D) The firm enjoys high sales margins.
A) The firm is growing.
Which of the following statements regarding the income statement is INCORRECT? A) The income statement shows the cash flows and expenses at a given point in time. B) The income statement shows the flow of revenues and expenses generated by a firm between two dates. C) The last or "bottom" line of the income statement shows a firm's net income. D) The first line of an income statement lists the revenues from the sales of products or services.
A) The income statement shows the cash flows and expenses at a given point in time.
What is the main problem in using a balance sheet to provide an accurate assessment of the value of a company's equity? A) Valuable assets such as the company's reputation, the quality of its work force, and the strength of its management are not captured on the balance sheet. B) The balance sheet does not accurately represent the book value of assets held by the company. C) The equity shown on the balance sheet does not reflect the market capitalization of the company. D) Knowing at a single point in time what assets a firm possesses and the liabilities a firm owes does not give any indication of what those assets can produce in the future.
A) Valuable assets such as the company's reputation, the quality of its work force, and the strength of its management are not captured on the balance sheet.
In 2009, an agricultural company introduced a new cropping process which reduced the cost of growing some of its crops. If sales in 2008 and 2009 were steady at $30 million, but the gross margin increased from 2.8% to 3.9% between those years, by what amount was the cost of sales reduced? A) $330,000 B) $660,000 C) $264,000 D) $462,000
A) [($30 × 3.9%) - ($20 × 2.8%)] × 1,000,000 = $330,000
Which of the following firms would be expected to have a high ROE based on that firm's high profitability? A) a medical supply company that provides very precise instruments at a high price to large medical establishments such as hospitals B) a low-end retailer that has a low mark-up on all items it sells C) a brokerage firm that has high levels of leverage D) a grocery store chain that has very high turnover, selling many multiples of its assets per year
A) a medical supply company that provides very precise instruments at a high price to large medical establishments such as hospitals
Which ratio would you use to measure the financial health of a firm by assessing that firm's leverage? A) debt-equity or equity multiplier ratio B) market-to-book ratio C) market debt-equity ratio D) current or quick ratio
A) debt-equity or equity multiplier ratio
Which of the following is NOT an operating expense? A) interest expense B) depreciation and amortization C) selling, general, and administrative expenses D) research and development
A) interest expense
A 30-year mortgage loan is a ________. A) long-term liability B) current liability C) current asset D) long-term asset
A) long-term liability
What role does Generally Accepted Accounting Principles (GAAP) play in the accounting process?
All firms quoted on a U.S. exchange are required to use GAAP in their financial reporting process. This standardization process makes it easier to adjust and/or compare the financial figures across different firms
What role do external auditors play in a firm's financial reporting process?
As the name implies, external auditors act as third party monitors to a firm's financial reporting process.
U.S. public companies are required to file their annual financial statements with the U.S. Securities and Exchange Commission on which form? A) 10-A B) 10-K C) 10-Q D) 10-SEC
B) 10-K
A public company has a book value of $128 million. They have 20 million shares outstanding, with a market price of $4 per share. Which of the following statements is true regarding this company? A) Investors may consider this firm to be a growth company. B) Investors believe the company's assets are not likely to be profitable since its market value is worth less than its book value. C) The firm's market value is more than its book value. D) The value of the firm's assets is greater than their liquidation value.
B) Investors believe the company's assets are not likely to be profitable since its market value is worth less than its book value.
Which of the following is a way that the operating activity section of the statement of cash flows adjusts Net Income from the balance sheet? A) It subtracts all expenses and costs related to a firm's operating activities. B) It adds all non-cash entries related to a firm's operating activities. C) It adds the cash that flows from investors to a firm. D) It removes the cash used for investment purposes.
B) It adds all non-cash entries related to a firm's operating activities.
Allen Company bought a new copy machine to be depreciated straight line for three years for use by sales personnel. Where would this purchase be reflected on the Statement of Cash Flows? A) It would be an expense on the income statement so it would be reflected in operating cash flows. B) It would be an addition to property, plant and equipment so it would be an investing activity. C) It would be an addition to cash so it would be reflected in the change in cash. D) None of the above answers is correct.
B) It would be an addition to property, plant and equipment so it would be an investing activity.
A printing company prints a brochure for a client and then bills them for this service. At the time the printing company's financial disclosure statements are prepared, the client has not yet paid the bill for this service. How will this transaction be recorded? A) The sale will be added to Net Income on the income statement and retained in Net Income on the statement of cash flows. B) The sale will be added to Net Income on the income statement but deducted from Net Income on the statement of cash flows. C) The sale will not be added to Net Income on the income statement but added to Net Income on the statement of cash flows. D) The sale will neither be added to Net Income on the income statement nor used to adjust Net Income on the statement of cash flows.
B) The sale will be added to Net Income on the income statement but deducted from Net Income on the statement of cash flows.
A software company acquires a smaller company in order to acquire the patents that it holds. Where will the cost of this acquisition be recorded on the statement of cash flows? A) as an outflow under operating activities B) as an outflow under investment activities C) as an outflow under financial activities D) not recorded on the statement of cash flows
B) as an outflow under investment activities
Which of the following is NOT considered to be an operating expense on the income statement? A) administrative expenses and overhead B) corporate taxes C) salaries D) depreciation and amortization
B) corporate taxes
Cash is a ________. A) long-term asset B) current asset C) current liability D) long-term liability
B) current asset
A delivery company is creating a balance sheet. Which of the following would most likely be considered a short-term liability on this balance sheet? A) the depreciation over the last year in the value of the vehicles owned by the company B) revenue received for the delivery of items that have not yet been delivered C) a loan which must paid back in two years D) prepaid rent on the offices occupied by the company
B) revenue received for the delivery of items that have not yet been delivered
Which of the following is NOT a financial statement that every public company is required to produce? A) income statement B) statement of sources and uses of cash C) balance sheet D) statement of stockholders' equity
B) statement of sources and uses of cash
What is a firm's gross profit? A) the difference between the sales and other income generated by the firm, and all costs, taxes, and expenses incurred by a firm in a given period B) the difference between sales revenues and the costs C) the difference between sales revenues and cash expenditures associated with those sales D) all of the above
B) the difference between sales revenues and the costs
The notes to the financial statements would LEAST likely be used for which of the following purposes? A) to provide information regarding the context in which these financial numbers were generated B) to disclose the financial implications of any off-balance sheet transactions C) to show how the value of assets listed in the financial statements were arrived at D) to explain the method of accounting that was used in the preparation of the financial statements
B) to disclose the financial implications of any off-balance sheet transactions
Which of the following balance sheet equations is INCORRECT? A) Assets - Liabilities = Shareholders' equity B) Assets = Liabilities + Shareholders' equity C) Assets - Current liabilities = Long-term liabilities D) Assets - Current liabilities = Long-term liabilities + Shareholders' equity
C) Assets - Current liabilities = Long-term liabilities
Which of the following best describes why the left and right sides of a balance sheet are equal? A) In a properly run business, the value of liabilities will not exceed the assets held by the company. B) By definition, the assets plus the liabilities will be the same as the stockholders' equity. C) The assets must equal liabilities plus stockholders' equity because stockholders' equity is the difference between the assets and the liabilities. D) By accounting convention, the assets of a company must be equal to the liabilities of that company.
C) The assets must equal liabilities plus stockholders' equity because stockholders' equity is the difference between the assets and the liabilities.
The exchanges in which of the following countries or regions do NOT accept the International Financial Reporting Standards set out by the International Accounting Standards Board? A) Germany B) France C) United States D) United Kingdom
C) United States
A company that produces drugs is preparing a balance sheet. Which of the following would be most likely to be considered a long-term asset on this balance sheet? A) commercial paper held by the company B) the inventory of chemicals used to produce the drugs made by the company C) a patent for a drug held by the company D) the cash reserves of the company
C) a patent for a drug held by the company
WorldCom classified $3.85 billion in operating expenses as long-term investments. How would this make WorldCom's financial statements more attractive to investors? A) by decreasing depreciation B) by reducing capital expenditures C) by raising its reported earnings D) by boosting its cash flow
C) by raising its reported earnings
The major components of stockholders' equity are ________. A) cash, common stock, and paid-in surplus B) common stock, paid-in surplus, and net income C) common stock, paid-in surplus, and retained earnings D) common stock, liabilities, and retained earnings
C) common stock, paid-in surplus, and retained earnings
A firm whose primary business is in a line of regional grocery stores would be most likely to have to include which of the following facts, if true, in the firm's management discussion and analysis (MD&A)? A) that a large number of funds were allocated to advertising to increase awareness of the firm's brand in new areas it had expanded into this year B) that some senior members of the management team have retired in this financial year C) that the company has lost a class action suit brought against the firm by its employees and is expected to have to pay a large amount of damages D) that the firm has plans to expand into the organic food business in the next financial year by purchasing several small organic food retailers
C) that the company has lost a class action suit brought against the firm by its employees and is expected to have to pay a large amount of damages
Which of the following amounts would be included on the right side of a balance sheet? A) the value of government bonds held by the company B) the cash held by the company C) the amount of deferred tax liability held by the company D) the amount of money owed to the company by customers who have not yet paid for goods and services they have received
C) the amount of deferred tax liability held by the company
Which of the following best describes why a firm produces financial statements? A) to use as a tool when planning future investments within a firm B) to increase the intrinsic value of a firm C) to provide a means for interested outside parties such as creditors to obtain information about a firm, with an overview of the short- and long-term financial condition of a business D) to show the daily activities a firm has undertaken in the previous financial year, and what activities are planned for the near future
C) to provide a means for interested outside parties such as creditors to obtain information about a firm, with an overview of the short- and long-term financial condition of a business
Gross profit is calculated as ________. A) total sales - cost of sales - selling, general, and administrative expenses - depreciation and amortization B) total sales - cost of sales - selling, general, and administrative expenses C) total sales - cost of sales D) none of the above
C) total sales - cost of sales
A company has a share price of $22.15 and 118 million shares outstanding. Its market-to-book ratio is 4.2, its book debt-equity ratio is 3.2, and it has cash of $800 million. How much would it cost to take over this business assuming you pay its enterprise value? A) $1.9 billion B) $3.044 billion C) $4.566 billion D) $3.8 billion
D) $3.8 billion
GenCorp. has a total debt of $140 million and stockholders' equity of $50 million. It also has 26 million shares outstanding, with a market price of $4.00 per share. What is GenCorp's market debt-equity ratio? A) 0.67 B) 1.08 C) 2.80 D) 1.35
D) 140 / ($4.00 × 26) = 1.35
Convex Industries has inventories of $218 million, current assets of $1.4 billion, and current liabilities of $504 million. What is its quick ratio? A) 1.17 B) 0.94 C) 2.81 D) 2.35
D) 2.35
Consider the above statement of cash flows. Which of the following is true of AOS Industries' operating cash flows? A) It collected more cash from its customers than it charged. B) It sold more inventory than it bought. C) It charged more on its accounts payable back than it paid back. D) All of the above are true.
D) All of the above are true.
Which of the following is NOT a reason that the income statement does not accurately indicate how much cash a firm has earned? A) It includes entries for the depreciation of assets. B) It does not include entries for expenditures on inventory. C) It does not include entries for collection of money from account receivables. D) It includes cash inflows from services rendered.
D) It includes cash inflows from services rendered.
What is the main reason that it is necessary for public companies to follow the rules and format set out in the Generally Accepted Accounting Principles (GAAP) when creating financial statements? A) It ensures that the market value of assets and debt are reported accurately. B) It ensures that information on the performance of public companies is reported on cash-basis accounting. C) It ensures that important budgetary information is not omitted. D) It makes it easier to compare the financial results of different firms.
D) It makes it easier to compare the financial results of different firms.
What are the requirements of section 404 of SOX? A) It requires that senior management return any profits or bonuses resulting from stock sales during any period covered by financial statements that must later be restated. B) It requires that auditors do not perform any non-auditing tasks for the companies they audit. C) It requires that audit partners rotate every five years. D) It requires that senior management and the boards of public companies attest to the effectiveness and validity of their financial control process.
D) It requires that senior management and the boards of public companies attest to the effectiveness and validity of their financial control process.
Which of the following is the main lesson that analysts and investors should take from the cases of Enron and WorldCom? A) The usefulness of financial statements to investors is entirely dependent on the ethics of those constructing them. B) It is not possible to effectively evaluate a company unless all the financial statements are fully and correctly prepared. C) The information in financial statements should be viewed extremely critically. D) Readers of even fraudulent financial statements can spot signs of a firm's financial health, if those statements are read fully and with care.
D) Readers of even fraudulent financial statements can spot signs of a firm's financial health, if those statements are read fully and with care.
Why must care be taken when comparing a firm's share price to its operating income? A) Both share price and operating income are related to the whole firm. B) Share price is a quantity related to the entire firm, while operating income is an amount that is related solely to equity holders. C) Both share price and operating income are related solely to equity holders. D) Share price is a quantity related to equity holders, while operating income is an amount that is related to the whole firm.
D) Share price is a quantity related to equity holders, while operating income is an amount that is related to the whole firm.
Which of the following statements regarding the balance sheet is INCORRECT? A) The balance sheet provides a snapshot of a firm's financial position at a given point in time. B) The balance sheet lists a firm's assets and liabilities. C) The balance sheet reports stockholders' equity on the right-hand side. D) The balance sheet reports liabilities on the left-hand side.
D) The balance sheet reports liabilities on the left-hand side.
One way Enron manipulated its financial statements was to sell assets at inflated prices to other firms, while giving a promise to buy back those assets at a later date. The incoming cash was recorded as revenue, but the promise to buy back the assets was not disclosed. Which of the following is one of the ways that such a transaction is deceptive? A) The assets should have been listed on the balance sheet as long-term assets. B) Cash raised by selling assets should not be recorded as revenue. C) The cash raised should have been recorded as short-term loans. D) The off-balance sheet promises to repurchase assets should have been disclosed in management discussion and analysis (MD&A) or notes to the financial statement.
D) The off-balance sheet promises to repurchase assets should have been disclosed in management discussion and analysis (MD&A) or notes to the financial statement.
Which of the following firms would be expected to have a high ROE? A) a medical supply company that provides very precise instruments at a high price to large medical establishments such as hospitals B) a high-end fashion retailer that has a very high mark-up on all items it sells C) a brokerage firm that has high levels of leverage D) a grocery store chain that has very high turnover, selling many multiples of its assets per year
D) a grocery store chain that has very high turnover, selling many multiples of its assets per year
What is a firm's net income? A) the difference between the sales and other income generated by a firm, and all costs, taxes, and expenses incurred by the firm in a given period B) the last or "bottom" line of the income statement C) a measure of the firm's profitability over a given period D) all of the above
D) all of the above
The third party who checks annual financial statements to ensure that they are prepared according to Generally Accepted Accounting Principles (GAAP) and verifies that the information reported is reliable is the ________. A) NYSE Enforcement Board B) Accounting Standards Board C) Securities and Exchange Commission (SEC) D) auditor
D) auditor
Which of the following is NOT one of the ways that the Sarbanes-Oxley Act sought to improve the accuracy of information given to both boards and shareholders? A) by increasing the penalties to firms for providing false information B) by increasing the independence of auditors and clients C) by decreasing the non-audit fees that an auditor can receive from a client D) by forcing companies to audit financial statements they release
D) by forcing companies to audit financial statements they release
Consider the above statement of cash flows. What were AOS Industries' major means of raising money in 2008? A) from investment activities B) by sale of stock C) from its operations D) by issuing debt
D) by issuing debt
Accounts payable is a ________. A) long-term liability B) current asset C) long-term asset D) current liability
D) current liability
Which of the following is NOT one of the financial statements that must be produced by a public company? A) the balance sheet B) the income statement C) the statement of cash flows D) the statement of activities
D) the statement of activities
State the names of some of the firms discussed in the chapter that had inaccurate reporting in their financial statements.
Examples of some firms that had practiced inaccurate reporting are Enron and WorldCom.
According to the text, did Enron and WorldCom follow Generally Accepted Accounting Principles (GAAP) in their financial reporting process?
Many of the problems of Enron and WorldCom were kept hidden from boards and shareholders, until it was too late. People felt that the accounting statements of these companies, while often remaining true to the letter of GAAP, did not present an accurate picture of the financial health of the company.
What is the need for the notes to the financial statements when a firm's operations are already documented in the financial statements?
Not all actions of the firm can be directly converted to an entry on the financial statements. For example, the firm may be involved in off balance sheet transactions, which have to be reported through notes to the financial statements.
What will be the effect on the balance sheet if a firm buys a new processing plant through a new loan?
The Assets side will increase under Net property, plant, and equipment with the net effect of the new processing plant, while the Liabilities side will correspondingly show the new debt that was incurred in paying for the plant.
How does a firm select the date for preparation of its balance sheet?
The balance sheet is prepared on the fiscal closing date for the accounts of a firm that may or may not coincide with the calendar year-end of December 31st.
What will be the effect on the income statement if a firm buys a new processing plant through a new loan?
The effect on the income statement will be in the form of a depreciation expense for the first year on the new processing plant.
How does a firm select the dates for preparation of its income statement?
The income statement is prepared on the fiscal closing date for the accounts of a firm that may or may not coincide with the calendar year-end of December 31st. Typically the income statement spans the flow between two adjacent balance sheets.
How can we cross check the statement of cash flows?
The last item in the statement of cash flows should equal the difference in cash balances between two adjacent balance sheets.
What will be the effect on the statement of cash flows if a firm buys a new processing plant through a new loan?
The new loan entry should show as a cash inflow for the firm, while the payment for the new processing plant will be entered as a cash outflow.
Financial statements are optional accounting reports issued periodically by a firm which present information on the past performance of the firm, a summary of the firm's assets and the financing of those assets, and a prediction of the firm's future performance.
false
In the United States, publicly traded companies can choose whether or not they wish to release periodic financial statements.
false
International Financial Reporting Standards are taking root throughout the world. However, it is unlikely that the U.S. will report according to IFRS before the second half of the twenty-first century.
false
The balance sheet shows the assets, liabilities, and stockholders' equity of a firm over a given length of time.
false
The management of public companies is not legally required to disclose any off-balance sheet transactions.
false
Use of Generally Accepted Accounting Principles (GAAP) and auditors have eliminated the danger of inadvertent or deliberate fraud in financial statements.
false
A firm's statement of cash flows uses the balance sheet and the income statement to determine the amount of cash a firm has generated and how it has used that cash during a given period.
true
In general, a successful firm will have a market-to-book ratio that is substantially greater than 1.
true
Price-earnings ratios tend to be high for fast-growing firms
true
Stockholders' equity is the difference between a firm's assets and liabilities, as shown on the balance sheet.
true
The income statement reports the firm's revenues and expenses, and it computes the firm's bottom line of net income, or earnings.
true