Financial Reporting Self Test Review

Victory Corp. received interest income from federally tax exempt bonds of $40,000 in the year 20X0. Its statutory tax rate is 40%. The effect of this difference between taxable and pre-tax income is most likely a(n): decrease in its effective tax rate to below 40%. increase in its deferred tax asset of $16,000. increase in its deferred tax liability of $16,000.

decrease in its effective tax rate to below 40%. The receipt of the tax-exempt interest income will create a permanent difference between pretax income and taxable income. Since the tax-free interest increases pre-tax income, but not income tax expense, the effective tax rate will be less than 40%. No deferred tax liability is created because the difference between pretax and taxable income will never reverse. 30f

Graphics, Inc. has a deferred tax asset of $4,000,000 on its books. As of December 31, it is probable that $2,000,000 of the deferred tax asset's value will never be realized because of the uncertainty about future income. Under U.S. GAAP, Graphics, Inc. should: reduce the deferred tax asset account by $2,000,000. establish a valuation allowance of $2,000,000. establish an offsetting deferred tax liability of $2,000,000.

establish a valuation allowance of $2,000,000. If it becomes probable that a portion of a deferred tax asset will not be realized, a valuation allowance should be established. A valuation allowance serves to reduce the value of a deferred tax asset for the probability that it will not be realized (the difference between tax payable and income tax expense will not reverse in future periods). 30g

A decrease in a firm's inventory turnover ratio is most likely to result from: a writedown of inventory. goods in inventory becoming obsolete. decreasing purchases in a period of stable sales.

goods in inventory becoming obsolete. Obsolescence can cause goods in inventory to remain unsold, which tends to reduce the inventory turnover ratio (COGS / average inventory). Writedowns of inventory increase the inventory turnover ratio by decreasing the denominator. If purchases decrease while sales remain stable, inventory decreases, which increases the inventory turnover ratio. 27b

Common size income statements express all income statement items as a percentage of:

sales. Common size income statements express all income statement items as a percentage of sales. Note that common size balance sheets express all balance sheet accounts as a percentage of total assets.

Quality of earnings relates to

sustainability the level and sustainability of a firm's earnings. Relevance and faithful representation (including completeness and neutrality) are characteristics of a firm's financial reporting quality.

An analyst is comparing two firms, one that reports under IFRS and one that reports under FASB standards. An analyst is least likely to do which of the following to facilitate comparison of the companies? Add the LIFO reserve to inventory for a U.S.-based firm that uses LIFO. Add the present values of each firm's future minimum operating lease payments to both assets and liabilities. Adjust the income statement of one of the firms if both have significant unrealized gains or losses from changes in the fair values of trading securities.

Adjust the income statement of one of the firms if both have significant unrealized gains or losses from changes in the fair values of trading securities. Unrealized gains and losses on trading securities are reported in the income statement under both U.S. and IFRS standards. Since LIFO is not permitted under IFRS, adjusting the inventory amount for a LIFO firm is a likely adjustment. To account for differences in how companies report leases, adding the present value of future minimum operating lease payments to both the assets and liabilities of a firm will remove the effects of lease reporting methods from solvency and leverage ratios. 33e

On January 1, Orange Computers issued employee stock options for 400,000 shares. Options on 200,000 shares have an exercise price of $18, and options on the other 200,000 shares have an exercise price of $22. The year-end stock price was $24, and the average stock price over the year was $20. The change in the number of shares used to calculate diluted earnings per share for the year due to these options is closest to:

Based on the average stock price, only the options at 18 are in the money (and therefore dilutive). Using the treasury stock method, the average shares outstanding for calculating diluted EPS would increase by [(20 - 18)/20] 200,000 = 20,000 shares. 24h

If a firm's management wishes to use its discretion to increase operating cash flows, they are most likely to: capitalize an expense. decrease the allowance for uncollectible accounts. change delivery terms from FOB destination to FOB shipping point.

By capitalizing a purchase instead of recognizing it as an expense in the current period, a firm increases operating cash flow by classifying the cash outflow as CFI rather than CFO. Decreasing the allowance for uncollectible accounts or changing delivery terms for shipments from FOB destination to FOB shipping point would increase earnings but would not affect operating cash flows.

Capitalizing vs expensing

Capitalizing costs creates higher cash flows from operations and lower cash flows from investing. Although net cash flows are not affected by the choice of capitalization or expensing, the components of cash flow are affected. Because, a firm that capitalizes classifies the expenditure as investing (not operations), cash flow from operations will be higher for firms that capitalize and investing cash flows will be lower than that of an expensing firm.

If a firm's inventory turnover and number of days of payables both increase, the effect on a firm's cash conversion cycle is: to shorten it. to lengthen it. uncertain

Cash conversion cycle = collection period + inventory period - payables period. An increase in inventory turnover will decrease the inventory period and shorten the cash conversion cycle. An increase in the payables period will also shorten the cash conversion cycle. 27b

cross-sectional analysis.

Comparing a company's ratios with those of its competitors is known as cross-sectional analysis.

Which of the following is least likely to result in low-quality financial statements? Unsustainable cash flows. Activities that manage earnings. Conservative accounting choices.

Even if earnings or cash flows are unsustainable (i.e., low quality), the firm's financial statements can still be high quality. Conservative accounting choices are considered to be biased, compared to the ideal of neutral accounting choices. Earnings management is viewed as reducing the quality of a firm's financial statements. 28c

The following information is summarized from Famous, Inc.'s financial statements for the year ended December 31, 20X0: Sales were $800,000. Net profit margin was 20%. Sales to assets was 50%. Equity multiplier is 1.6. Interest expense was $30,000. Dividends declared were $32,000. Famous, Inc.'s sustainable growth rate based on results from this period is closest to:

Famous, Inc.'s sustainable growth rate = (retention rate)(ROE). ROE = 0.20(800,000) / [(800,000/0.5)(1/1.6)] = 160,000/1,000,000 = 16%. Alternatively: ROE = (0.20)(0.50)(1.6) = 0.16 = 16% Retention rate = (1 - dividend payout ratio) = 1 - {32,000/[(0.20)(800,000)]} = 0.80. Sustainable growth = 0.80 (16%) = 12.8%. 27e

A company must report separate financial information for any segment of their business which:

Financial statement items must be reported separately for any segment of a firm's business that is greater than 10% of revenue or assets and has risk and return characteristics that are distinguishable from those of the company's other lines of business. Requirements for reporting of geographic segments have the same size threshold and the segment must operate in a business environment that is different from that of the firm's other segments.

What would be the impact on a firm's return on assets ratio (ROA) of the following independent transactions, assuming ROA is less than one? Transaction #1 - A firm owned investment securities that were classified as available-for-sale and there was a recent decrease in the fair value of these securities. Transaction #2 - A firm owned investment securities that were classified as trading securities and there was recent increase in the fair value of the securities.

Higher:Higher Available-for-sale securities are reported on the balance sheet at fair value and any unrealized gains and losses bypass the income statement and are reported as an adjustment to equity. Thus, a decrease in fair value will result in a higher ROA ratio (lower assets). Trading securities are also reported on the balance sheet at fair value; however, the unrealized gains and losses are recognized in the income statement. Therefore, an increase in fair value will result in higher ROA. In this case, both the numerator and denominator are higher; however, since the ratio is less than one, the percentage change of the numerator is greater than the percentage change of the denominator, so the ratio will increase.

Interest Coverage ratio

ICR = operating profit ÷ I = EBIT ÷ I

A firm that purchases a building that it intends to rent out for income would report this asset as investment property using the cost model under:

IFRS Only. Under IFRS, a firm may value investment property using either the cost model or the fair value model. U.S. GAAP does not distinguish investment property from other types of long-lived assets. 29n

Adams Co.'s common sized balance sheet shows that: Current Liabilities = 20% Equity = 45% Current Assets = 45% Total Assets = $2,000 What are Adams' long-term debt to equity ratio and working capital?

If equity equals 45% of assets, and current liabilities equals 20%, then long-term debt must be 35%. Long-Term Debt / Equity = 0.35 / 0.45 = 0.78 Working capital = CA − CL = 45% - 20% = 25% of assets WC = 2,000(0.25) = $500

Baxter Company has 5,000 shares outstanding all year. Baxter had 2,000 outstanding warrants all year, convertible into one share each at $20 per share. The year-end price of Baxter stock was $40, and the average stock price was $30. What effect will these warrants have on the weighted average number of shares?

If the warrants are exercised, the company will receive 2,000 × $20 = $40,000 and issue 2,000 new shares. The treasury stock method assumes the company uses these funds to repurchase shares at the average market price of $30. The company would repurchase $40,000 / $30 = 1,333 shares. Net shares issued would be 2,000 - 1,333 = 667 shares.

Two firms are identical except that the first pays higher interest charges and lower dividends, while the second pays higher dividends and lower interest charges. Both prepare their financial statements under U.S. GAAP. Compared to the first, the second will have cash flow from financing (CFF) and earnings per share (EPS) that are:

Interest paid is an operating cash flow, and dividends paid are a financing cash flow, so the firm that pays higher dividends will have lower CFF. The firm with lower interest expense will have higher EPS. 26e

Which of the following is an analyst least likely to be able to find on or calculate from either a common-size income statement or a common-size balance sheet? Inventory turnover. Operating profit margin. Debt to equity ratio.

Inventory Turnover Inventory turnover involves sales (from the income statement) and average inventory (from the balance sheet) so it cannot be calculated from common-size statements. Debt to equity is debt/assets divided by equity/assets. Operating profits/sales can be read directly from the common-size income statement. 27a

Noncurrent assets on the balance sheet are most closely linked to which part of the cash flow statement?

Investing cash flows. Investing cash flows are most closely linked with a firm's noncurrent assets. For example, purchases and sales of property, plant, and equipment are classified as investing cash flows.

The revaluation model for investment property is permitted under IFRS or GAAP?

Neither IFRS or GAAP For long-lived assets classified as investment property, IFRS allows either the cost model or the fair value model. The revaluation model is permitted for long-lived assets that are not classified as investment property. U.S. GAAP only permits the cost model for valuation of long-lived assets and does not identify investment property as a specific subset of long-lived assets.

Use the following data from Delta's common size financial statement to answer the question: Earnings after taxes = 18% Equity = 40% Current assets = 60% Current liabilities = 30% Sales = $300 Total assets = $1,400 What is Delta's after-tax return on equity?

Net income after taxes = 300 × 0.18 = 54 Equity = 1400 × 0.40 = 560 ROE = Net Income / Equity = 54 / 560 = 0.0964 = 9.6%

The following data pertains to the McGuire Company: Net income equals $15,000. 5,000 shares of common stock issued on January 1. 10% stock dividend issued on June 1. 1000 shares of common stock were repurchased on July 1. 1000 shares of 10%, par $100 preferred stock each convertible into 8 shares of common were outstanding the whole year. What is the company's basic earnings per share (EPS)?

Number of average shares: 1/1 5,500 shares issued (includes 10% stock dividend on 6/1) × 12 = 66,000 7/1 1,000 shares repurchased × 6 months = 6,000 66,000 − 6,000 = 60,000 60,000 shares / 12 months = 5,000 average shares Preferred dividends = ($10)($1,000) = $10,000 Basic EPS = [$15,000(NI) - $10,000(preferred dividends)] / 5,000 shares = $5,000 / 5,000 shares = $1/share

Train Company paid $8 million to acquire a franchise at the beginning of 20X5 that was expensed in 20X5. If Train had elected to capitalize the franchise as an intangible asset and amortize the cost of the franchise over eight years, what effect would this decision have on Train's 20X5 cash flow from operations (CFO) and 20X6 debt-to-assets-ratio? Both would be higher with capitalization. Both would be lower with capitalization. One would be higher and one would be lower with capitalization.

One would be higher and one would be lower with capitalization. If the cost were amortized rather than expensed, the $8 million cost of the franchise would be classified as an investing cash flow rather than an operating cash flow, so CFO would increase (and CFI decrease). The asset created by capitalizing the cost would increase assets, so the debt-to-assets ratio would decrease.

Operating Profit Margin

Operating profit margin = (EBIT / sales)

If management is manipulating financial reporting to avoid breaching an interest coverage ratio covenant on the firm's debt, they are most likely to: A) capitalize leases. B) overstate earnings. C) understate assets

Overstate earnings Debt covenants may require a firm to maintain a minimum interest coverage ratio (EBIT / interest expense). Manipulating the financial statements to increase the interest coverage ratio would most likely involve overstating earnings, or possibly understating liabilities (for example by using operating leases instead of capital leases) to decrease interest expense. Understating or overstating assets would not affect the interest coverage ratio.

Under a defined contribution pension plan, which of the following is recognized as a pension expense? Actuarial gains and losses. Periodic contributions to the plan. Service costs incurred during the period.

Periodic contributions to the plan Under a defined contribution pension plan, a company's only pension expenses are the predetermined contributions required to be made to the plan for the period. 31j

Solving for ROE

ROE = tax burden × interest burden × EBIT margin × asset turnover × financial leverage tax burden = net income/EBT EBT = EBIT - I net income = (EBT)(1-t) interest burden = EBT/EBIT EBIT margin = EBIT/revenue asset turnover = revenue/total assets financial leverage = total assets/total equity ROE=(NI)/(Average total equity)

Sensitivity Analysis v Scenario Analysis

Sensitivity analysis develops a range of possible outcomes as specific inputs are changed one at a time. Sensitivity analysis is also known as "what-if" analysis. Scenario analysis is based on a specific set of outcomes for multiple variables. Computer generated analysis, based on developing probability distributions of key variables, is known as simulation analysis.

Johnson Corp. had the following financial results for the fiscal 2004 year: Current ratio 2.00 Quick ratio 1.25 Current liabilities $100,000 Inventory turnover 12 Gross profit % 25 The only current assets are cash, accounts receivable, and inventory. The balance in these accounts has remained constant throughout the year. Johnson's net sales for 2004 were:

The 25% GP indicates that the cost of goods sold is 75% of sales. The inventory is derived from the difference between current ratio and the quick ratio. The current ratio indicates that the current assets are $200,000 and the quick assets are $125,000. The difference represents the inventory of $75,000. The inventory turnover is used to obtain cost of goods sold of $900,000. The cost of goods sold is 75% of sales, indicating that sales are $1,200,000.

Inventory, cost of sales, and gross profit can be different under periodic and perpetual inventory systems if a firm uses which inventory cost method?

The LIFO and weighted average cost methods can provide different values for inventory, cost of sales, and gross profit depending on whether the firm uses a periodic or perpetual inventory system. FIFO produces the same values from either a periodic or perpetual inventory system.

When a company redeems bonds before they mature, the gain or loss on debt extinguishment is calculated as the bonds' carrying amount minus the: face or par value of the bonds. amount required to redeem the bonds. amortized historical cost of the bonds.

Under IFRS, when a company redeems bonds before they mature, the company records a gain or loss equal to the bonds' carrying amount minus the cash amount required to redeem the bonds. 31c

Required inventory disclosures are similar under U.S. GAAP and IFRS and include:

The cost flow method (LIFO, FIFO, etc.) used. Total carrying value of inventory, with carrying value by classification (raw materials, work-in-process, and finished goods) if appropriate. Carrying value of inventories reported at fair value less selling costs. The cost of inventory recognized as an expense (COGS) during the period. Amount of inventory writedowns during the period. Reversals of inventory writedowns during the period, including a discussion of the circumstances of reversal (IFRS only because U.S. GAAP does not allow reversals). Carrying value of inventories pledged as collateral.

Princeton Company calls its $1,000,000, 9% bonds for $1,010,000. On the call date, the bonds have a book value of $980,000 and unamortized issue costs of $24,000. Under U.S. GAAP, Princeton should report a: $54,000 loss. $30,000 loss. $10,000 gain.

Under U.S. GAAP, unamortized issue costs are reported on the balance sheet as an asset and are not included in the book value of the bond liability. Thus, the remainder of the issue costs must be written off when the bond is called. Gain or loss on redemption = book value - reacquisition price - unamortized issue costs = $980,000 - $1,010,000 - $24,000 = $54,000 loss 31a

Under U.S. GAAP, the criteria are conceptually similar, but are more specific than under IFRS. A lessee must treat a lease as a capital (finance) lease if any of the following criteria are met:

Title to the leased asset is transferred to the lessee at the end of the lease period. A bargain purchase option permits the lessee to purchase the leased asset for a price that is significantly lower than the fair market value of the asset at some future date. The lease period is 75% or more of the asset's economic life. The present value of the lease payments is 90% or more of the fair value of the leased asset. A lease not meeting any of these criteria is classified as an operating lease. Lessees often prefer operating leases because no liability is reported. Recall that with a finance lease, the lessee reports both an asset and a liability on the balance sheet.

A snowmobile manufacturer that uses LIFO begins the year with an inventory of 3,000 snowmobiles, at a carrying cost of $4,000 each. In January, the company sells 2,000 snowmobiles at a price of $10,000 each. In July, the company adds 4,000 snowmobiles to inventory at a cost of $5,000 each. Compared to using a perpetual inventory system, using a periodic system for the firm's annual financial statements would:

Under a perpetual inventory system, the snowmobiles sold in January are associated with the $4,000 cost of the beginning inventory. Cost of sales is $8 million, gross profit is $12 million, and end-of-year inventory is $24 million. Under a periodic inventory system, the snowmobiles sold in January would be associated with the $5,000 cost of the snowmobiles manufactured in July. Cost of sales would be higher by $2 million, gross profit would be lower by $2 million, and ending inventory would be lower by $2 million.

Long-lived assets cease to be depreciated when the firm's management decides to dispose of the assets by: sale. abandonment. exchange for another asset.

Under both IFRS and U.S. GAAP, long-lived assets that are reclassified as held for sale cease to be depreciated. Long-lived assets that are to be abandoned or exchanged are classified as held for use until disposal and continue to be depreciated. 29j

weighted average cost method

Weighted average = cost of goods available / total units available. COGS = Units sold × Weighted average cost Profit = Sales − COGS − Sales Expenses

If Lizard Inc., a lessee, treats a 5-year lease as a finance lease with straight line depreciation rather than as an operating lease: it will have greater equity at lease inception. its operating income will be less in the first year of the lease. its CFO will be greater and CFF will be less in the second year of the lease.

With a finance lease, only the interest portion of the lease payment is classified as CFO, so CFO will be greater than it would be with an equivalent operating lease. CFF will be less for a finance lease because the principal portion of each lease payment is classified as a financing cash outflow. Operating income, EBIT, will be reduced only by the (equal) annual depreciation expense with a finance lease, so operating income will be greater for a finance lease than for an operating lease (for which the entire lease payment will be an operating expense). At inception, a finance lease will increase assets and liabilities by the same amount so there is no effect on equity. 31g

An analyst wants to compare the cash flows of two U.S. companies, one that reports cash flow using the direct method and one that reports it using the indirect method. The analyst is most likely to: convert the indirect statement to the direct method to compare the firms' cash expenditures. adjust the reported CFO of the firm that reports under the direct method for depreciation and amortization expense. increase CFI for any dividends reported as investing cash flows by the firm reporting cash flow by the direct method.

convert the indirect statement to the direct method to compare the firms' cash expenditures. By converting a cash flow statement to the direct method, an analyst can view cash expenses and receipts by category, which will facilitate a comparison of two firms' cash outlays and receipts. CFO is correct under either method and requires no adjustment. Neither dividends received nor dividends paid are classified as CFI under U.S. GAAP.

Crawford Corp. and Vernon Corp. are lessors who have leased assets on identical terms to firms with similar credit ratings. Crawford reports its lease as a sales-type lease and Vernon reports its lease as a direct financing lease. It is most likely that: A) Crawford retains the leased asset on its balance sheet. B) both firms report under U.S. GAAP. C) Vernon reports under IFRS.

both firms report under U.S. GAAP. For a lessor, under U.S. GAAP, a capital lease may be reported as either a sales-type or direct financing lease. This distinction is not made for a financing (capital) lease under IFRS.

Accumulated other comprehensive income

includes all changes in stockholders' equity except for transactions recognized in the income statement (net income) and transactions with shareholders, such as issuing stock, reacquiring stock, and paying dividends.

Under U.S. GAAP, firms are required to capitalize: any asset with a useful economic life of more than one year. interest paid on loans to finance construction of a long-lived asset. research and development costs for a drug that will almost certainly provide a revenue stream of five years or more.

interest paid on loans to finance construction of a long-lived asset. Interest on loans that specifically fund construction of long-lived assets must be capitalized under U.S. GAAP. Assets of insignificant value (e.g., metal waste basket) are typically expensed even when their useful lives are many years. R&D costs are expensed under U.S. GAAP.

the two qualitative characteristics of financial statements

relevance and faithful representation

The fundamental qualitative characteristics of financial statements as described by the IASB conceptual framework least likely include:

reliability. It includes relevance and faithful representation. 23d.

Taking an impairment charge due to a decrease in the value of a long-lived depreciable asset is least likely, in the period the impairment is recognized, to reduce a firm's: net income. operating income. taxes payable.

taxes payable Impairment charges reduce operating income and net income in the period of the charge. Taxes are not affected because any loss in asset value will reduce taxes only when the asset is disposed of and the loss is actually realized. The debt to equity ratio increases in the period of the charge because equity is reduced. 29i

net pension asset or net pension liability defined benefit plan

the difference between the fair value of the plan's assets and the estimated benefit obligation. A plan with a net pension asset is said to be overfunded, and a plan with a net pension liability is said to be underfunded.

In the notes to its financial statements, Gilbert Company discloses a €400,000 reversal of an earlier writedown of inventory values, which increases this inventory's carrying value to €2,000,000. It is most likely that: the reasons for this reversal are also disclosed. a gain of 400,000 appears on the income statement. the net realizable value of this inventory is €2,000,000.

the reasons for this reversal are also disclosed. Required disclosures related to inventories under IFRS include the amount of any reversal of previous writedowns and the circumstances that led to the reversal. Under IFRS, the reversal of an inventory writedown is not recognized as a gain, but instead as a reduction in the cost of sales for the period. From only the information given, we cannot conclude that the net realizable value of the inventory is €2,000,000. This value may be the original cost of the inventory. 28i

retained earnings

the undistributed earnings (net income) of the firm since inception, the cumulative earnings that have not been paid out to shareholders as dividends. =(beginning balance)+(net income)-(dividends declared)