FIN 4010 Exam 2 - Conceptual Questions
Identify the three typical categories of restructuring costs and their effects on the balance sheet and the income statement.
(1) asset write-downs, (2) accruals for severance and relocation costs, and (3) accruals of other restructuring- related costs.
If inventory costs are rising, which inventory costing method—first-in, first-out; last-in, first-out; or average cost—yields the (a) lowest ending inventory? (b) lowest net income? (c) largest ending inventory? (d) largest net income?, assuming the same method is used for tax purposes
(a) Lowest ending inventory: Last-in, First-out (b) Lowest net income: Last-in, First-out (c) Largest ending inventory: First-in, First-out (d) Largest net income: First-in, First-out Under the first-in, first-out inventory costing method, the later purchases at the higher cost will remain in the ending inventory resulting in largest ending inventory and thus the largest net income. Under the last-in, first-out inventory costing method, the later purchases at the higher cost will be consumed while the earlier purchases at the lower cost will remain in the ending inventory resulting in the lowest ending inventory and thus the lowest net income.
Distinguish between authorized shares and issued shares. Why might the number of shares issued be more than the number of shares outstanding?
- Authorized stock is higher than issued and outstanding stock because companies need the flexibility of issuing additional shares without having to return to the regulatory authorities for approval
What three metrics comprise the cash conversion cycle? How could companies manage each of the three components to improve CCC?
- DIO, DSO, DPO - as salvage value increases, the numerator decreases and decreases depreciation expense - as useful life increases, the denominator decreases which decreases depreciation expense
Describe the difference between contributed capital and earned capital. Specifically, how can earned capital be considered as an investment by the company's stockholders?
- Earned capital represents the cumulative net income that the company has earned, less the portion of that income that has been paid out to shareholders in the form of dividends.
When a company reports negative retained earnings on the balance sheet (a deficit), can we conclude that the company has reported significant net losses on the income statement?
- It's typically referred to as an accumulated deficit on a separate line of the balance sheet - Negative retained earnings often show that a company is experiencing long-ter losses and can be an indicator of bankruptcy - It can also indicate that the business distributed borrowed funds to its shareholders as dividends
Employee stock options potentially dilute earnings per share (EPS). What can companies do to offset these dilutive effects and how might this action affect the balance sheet?
- Many companies repurchase shares (as treasury stock) in order to offset the dilutive effects of stock options, because stock options increase the number of outstanding shares in the diluted EPS calculation
What is meant by preferred dividends in arrears? If dividends are two years in arrears on $500,000 of 6% preferred stock, and dividends are declared at the end of this year, what amount of total dividends must the company pay to preferred stockholders before paying any dividends to common stockholders?
- Total dividends that the company must pay to the preferred shareholders = 500,000 * 0.06 * 3 - Total dividends that the company must pay to the preferred shareholders = $90,000
What are the four criteria that distinguish a finance lease from an operating lease?
- Transfer of title/ownership to the lessee. - A purchase option the lessee is reasonably certain to exercise. - Lease term is over a major part of the economic life of the asset. - Present value equals or exceeds substantially all of the fair value of the asset.
What is a valuation allowance for deferred tax assets?
- a mechanism that offsets a deferred tax asset account
How would a company recognize revenue on a sale that includes equipment and a multi‑year service contract all for one price?
- identifying performance obligations - allocating transaction price accordingly
What features make preferred stock similar to debt? Similar to common stock?
- it pays fixed dividends, and equity, in that it has the potential to appreciate in price - they both hold stock and get dividends
Is the expense of a lease over its entire life the same for operating and finance leases? Explain.
- operating leases are expenses straight line over the lease term - finance leases are expensed over whole life
Under the lease standards effective for 2019, how are leases treated on the balance sheet?
- operating leases of 12 months or more must be reflected on the balance sheet as both assets and liabilities
What are the basic differences between preferred stock and common stock? That is, what are the typical features of preferred stock?
- preferred stock gives no voting rights to shareholders while common stock does - having priority over a company's income, meaning they are paid dividends before common shareholders
What items are typically reported under the stockholders' equity category of accumulated other com‑ prehensive income (AOCI)?
- profits or losses related to foreign currency transactions, unrealized profits or losses that are yet to reach maturity, and costs related to operating a pension plan
What are three common forms of stock‑based compensation and why do companies use such forms of compensation?
- restricted stock awards (RSAs) - restricted stock units (RSUs) - nonqualified stock options (NQSOs) - incentive stock options (ISOs)
What information is reported in a statement of stockholders' equity?
- share capital plus retained earnings - it also represents the residual value of assets minus liabilities
Describe the accounting for a convertible bond. Can the conversion ever result in the recognition of a gain in the income statement?
- subtracting the present value of the debt which was calculated above from the actual financial proceeds which were received from investors
The income statement line item "discontinued operations" typically comprises two distinct components. What are they?
- the business must report component as disposed or held for sale - component must be distinguishable as a separate business that is being removed from operation intentionally or a subsidiary of a component being held with the intent to sell
Define par value stock. What is the significance of a stock's par value from an accounting and analysis perspective?
- the lowest legal price for which a company sells its shares - it is required for a bond or a fixed-income instrument and shows its maturity value and the dollar value of the coupon, or interest, payments due to the bondholder
What is meant by the market cap of a company and how is it determined?
- the total value of a company's outstanding shares of stock, which include publicly traded shares plus restricted shares held by company officers and insiders - To calculate market cap, you take the total number of a company's shares outstanding and multiply that figure by the company's current stock price
Define treasury stock. Why might a corporation acquire treasury stock? How is treasury stock reported in the balance sheet?
- treasury stock represents the number of shares repurchased from the open market - it reduces shareholders' equity by the amount paid for the stock
Define stock split. What are the major reasons for a stock split?
- when a company breaks up its existing shares to create a higher number of lower-value shares
How does the account "additional paid‑in capital" (APIC) arise? Does the amount of APIC reported on the balance sheet relative to the common stock amount provide any information about the financial condition of the company?
- when the issue price of a stock is greater than the par value - The amount of APIC reported on the balance sheet relative to the common stock amount may provide some information about the company. The larger the APIC account is compared to the common stock account, the more capital was contributed above par value. This could be indicative of a strong financial outlook and expectation for growth of the company when stock was issued. Purchasers were willing to pay a premium above the par value.
In what order do we normally forecast the financial statements? Explain the logic of this order.
1) Income Statement 2) Balance Sheet 3) Cash Flow - it's important because each statement uses information from the preceding statement
Under what circumstances will a company report a net pension asset? A net pension liability?
A company will report a net pension asset if the pension's funded status is positive (i.e., fair value of the plan assets exceeds the plan obligation). Otherwise, the company will report a net liability to represent the underfunding of the pension obligation (i.e., negative funded status)
What is a performance obligation and how is it related to revenue recognition?
A performance obligation is a promise to provide a distinct good or service or a series of distinct goods or services as defined by the revenue standard. They are satisfied when a customer obtains control of an asset or benefits from the services provided.
What is the benefit of accelerated depreciation for income tax purposes when the total depreciation taken over the asset's life is identical under any method of depreciation?
Accelerated depreciation method provides tax Shields to the company having higher tax liability in comparison to straight line method of depreciation
What is an accrual? How do accruals impact the balance sheet and the income statement?
Accruals are revenues earned or expenses incurred that impact a company's net income on the income statement, although cash related to the transaction has not yet changed hands. Accruals also affect the balance sheet, as they involve non-cash assets and liabilities
How do credit (debt) ratings affect the cost of borrowing for a company?
An issuer with a high rating will pay much less in borrowing costs, reflected by the interest rates paid, than a low-rated issuer, due to the relatively lower risk involved. It follows, then, that an investor may expect greater income in exchange for the higher risk involved in low-rated debt
What effect, if any, does a weakening $US have on reported sales and NI for subsidiaries of U.S. companies.
As the $US weakens vis-à-vis other currencies, sales and expenses that are denominated in foreign currencies increase when measured in US dollars. Since subsidiaries of many companies operate outside of the US and maintain their financial records in non-$US currencies, a weakening $US can significantly increase both reported profit and loss.
Explain why analysts might remove foreign exchange gains or losses when analyzing revenue and expenses for the year
Because foreign exchange is subject to change at any time, so analysts wait as late as possible to factor in accurate rates.
Explain how management can shift income from one period into another by using the allowance for uncollectible accounts.
Companies are able to use allowance for uncollectible accounts to take from when margins are low and deposit into when they want to lower sales
Why do companies allow sales returns, and how does this business practice affect reported revenue?
Companies do this to boost customer loyalty and increase customer base. These transactions are subtracted from sales.
What is the difference between a bond's coupon rate and its market interest rate (yield)?
Coupon yield, also known as the coupon rate, is the annual interest rate established when the bond is issued that does not change during the lifespan of the bond. Current yield is the bond's coupon yield divided by its current market price. If the current market price changes, the current yield will also change.
What does the term current liabilities mean? What assets are usually used to settle current liabilities?
Current liabilities are a company's short-term financial obligations that are due within one year or within a normal operating cycle. Current liabilities are typically settled using current assets, which are assets that are used up within one year.
Explain why using the FIFO inventory costing method will increase gross profit during periods of rising inventory costs.
FIFO holing gains occur when the costs of earlier purchased inventor are matched against current selling prices. Holding gains on inventories increase with a increase in inflation rate and a decrease in the inventory turnover rate.
Capital expenditures are usually an important cash outflow for a company, and they figure prominently into forecasts of net operating assets. What sources of information about capital expenditures can we draw upon?
Historical capital expenditures are reported in the statement of cash flows. Forecasted capital expenditures (CAPEX) are sometimes discussed in the Management Discussion and Analysis (MD&A) section of the 10-K and also in meetings with analysts or in other public disclosures.
How would you interpret a company's reported gain or loss on the repurchase of its bonds?
How would you interpret a company's reported gain or loss on the repurchase of its bonds? Gains and losses from bond redemptions typically arise during refinancing in which new bonds are issued to retire existing bonds. The resulting gains or losses are not real economic gains and losses
Why do relatively stable inventory costs across periods reduce the importance of management's choice of an inventory costing method?
If inventory costs are stable, the per unit dollar cost of inventories (beginning or ending) tends to be approximately the same under different inventory costing methods and the choice of method does not materially affect net income. To see this, remember that FIFO profits include holding gains on inventories. If the inflation rate is low (or inventories turn quickly), there will be less holding gains (inflationary profit) in inventory.
In addition to recent revenues trends, what other types and sources of information can we use to help us forecast revenues?
In addition to analyzing historical revenue trends, we can incorporate external (non-financial) information into the forecasting process. Some examples include incorporating the expected level of macroeconomic activity, the degree to which the competitive landscape is changing, recent changes in laws or regulations, any strategic initiatives that have been announced by management, and so forth.
What are the two components of income tax expense?
Income tax expense has two components. The first is the current income tax, which is based on the taxable income for the current year. The other component is deferred income tax, which relates to the movement of a deferred tax asset or liability
(6)In a recent annual report, Kaiser Aluminum Corp. made the following statement in reference to its inventories: "The Company recorded pretax charges of approximately $19.4 million because a reduction in the carrying values of its inventories caused principally by prevailing lower prices for alumina, primary aluminum, and fabricated products." What basic accounting principle caused Kaiser Aluminum to record this $19.4 million pretax charge? Briefly describe the rational for this principle.
Kaiser Aluminum Corporation is using the lower of cost or market (LCM) rule. When the replacement cost for inventory falls below its (FIFO or LIFO) historical cost, the inventory must be written down to its replacement cost (market value). The rationale is that, if market value has dropped, the inventory cost overstates the future economic benefit of selling the inventory.
Even though it may not reflect their physical flow of goods, why might companies adopt last‑in, first‑ out inventory costing in periods when costs are consistently rising?
Many firms adopt LIFO for tax purposes. Under LIFO conformity, those that use LIFO for tax purposes must also use it in their GAAP financial reports. If you report low to IRS, you have to report low to capital markets too
What are the economic and accounting differences between a defined contribution plan and a defined benefit plan?
The basic difference is what each plan promises its participants. A defined benefit plan (APERS) specifies exactly how much retirement income employees will get once they retire. A defined contribution plan only specifies what each party - the employer and employee - contributes to an employee's retirement account.
Why do companies report a gain or loss when they repurchase their bonds? Is this a real economic gain or loss?
The resulting gains or losses are not real economic gains and losses. Companies report gains or losses on bond redemption because they use historical cost accounting. The redemption gain or loss is offset by the present value of lower (higher) interest payments in the future
What effect does the use of expected returns on pension investments and the deferral of unexpected gains and losses on those investments have on income?
The use of expected returns and the deferral of unexpected gains and losses act to smooth corporate earnings by removing the effects of swings in the market values of investments and variation in pension liabilities resulting from changes in actuarial assumptions or plan amendments.
What is unearned revenue?
Unearned revenue is money received by an individual or company for a service or product that has yet to be provided or delivered. Some examples would be: rent payments made in advance, prepaid insurance, legal retainers, airline tickets
Why do we refine the forecasted cash balance? How might we deal with a cash balance that is much too low compared with the company's normal cash level?
We calculate the cash balance last by taking total stockholders equity and liabilities and subtracting all assets. This is done to balance out the forecasted balance sheet
If a corporation purchases 10,000 shares of its own common stock at $10 per share and resells them at $14 per share, where would the $40,000 increase in capital be reported in the financial statements? Why is no gain reported?
When a company issues shares at a price higher then the face value of the shares, then such amount is premium received on shares from the stockholders and not gain for the company, it will make no difference if the company has earlier purchased those shares at a buy back made by the company at a price lower then the reissue price.
How might a company affect its depreciation expense computation by selecting useful life and salvage value?
When a company revises its estimate of an asset's useful life or its salvage value, depreciation expense must be recalculated. One way is to depreciate the current undepreciated cost of the asset (original cost - accumulated depreciation) using the revised assumptions of remaining useful life and salvage value
What is meant by "aging" of accounts receivable?
a periodic report that categorizes a company's accounts receivable according to the length of time an invoice has been outstanding
What is a tax loss carryforward and how does it create an economic benefit for a company?
a provision that allows a taxpayer to move a tax loss to future years to offset a profit
Cash is forecast as the last item on the balance sheet. Why is this the case?
because it is the culmination of all the projections made/
How do companies compute income tax expense for financial reporting purposes?
by multiplying the tax rate of the individual or business by the income received or generated before taxes
Identify at least three sources of additional information we could use to refine our forecast assumptions.
can use info from: - financial footnotes - MD&A - other corporate filings required by SEC - investor relations section of corporate websites
What is the concept of pro forma income and why has this income measure been criticized?
earnings that exclude certain costs that a company believes result in a distorted picture of its true profitability
Under what circumstances is it appropriate to use the cost‑to‑cost method to measure revenue?
for those firms and business that want to find out the expected revenue related to a project at some early stage of the project
What is the current U.S. GAAP accounting treatment for research and development costs?
must be expensed in the current period due to the uncertainty surrounding any future economic benefit
Describe the income statement effect if a company reduced a deferred tax asset valuation allowance by $10 million.
net income increases
What factors determine the gain or loss on the sale of a PPE asset?
the difference between the sales proceeds and the asset's net book value.
What are the components of pension expense that are reported in the income statement?
the employer must report the service and interest cost, expected return on plan assets, amortization of prior service cost and effects of gains and losses.
What does the concept of financial statement articulation mean in the forecasting process?
the process of ensuring that the information presented in a company's financial statements is consistent and accurate
What does the cash conversion cycle measure
the time a company takes to encash its inventory
Why do we begin the forecasting process by adjusting the financial statements?
to ensure spending is in line with factors that can impact overall financial performance
Analysts commonly perform a sensitivity analysis following preparation of financial forecasts. What is meant by sensitivity analysis, and why is it important?
to understand the effect of a set of independent variables on some dependent variable under certain specific conditions
Identify at least two applications that use forecasted financial statements.
to value equity and debt securities, and to rate firms' credit
Why do deferred taxes arise?
when there are differences between tax rules and accounting rules
Explain the concept of lower of cost or market. What benefit does the LCM rule create for financial statement users?
when valuing a company's inventory, it is recorded on the balance sheet at either the historical cost or the market value. The LCM method takes into account that the value of a good can fluctuate. Under this scenario, if the price at which the inventory may be sold dips below the net realizable value of the item, which consequently results in a loss, the LCM method can be employed to record the loss.
A corporation has total stockholders' equity of $18,995,250 and one class of $2 par value common stock. The corporation has 500,000 shares authorized; 300,000 shares issued; and 15,000 shares as treasury stock. What is its book value per share?
x
