FIN 686 Exam 2

Profitability Ratios

"Return on" or "Margin" ratios Measures ability of company to generate profits from its resources

Under US GAAP, a lease must be classified as a finance (capital) lease if an one of the following five criteria are met:

1. Ownership of the leased assets transfers to lessee at end of lease 2. Lease contains option to buy at "bargain" price 3. Covers a period of time that is a substantial part of the assets useful life (>75%) 4. Involve lease payments that exceed the asset's fair value 5. Involve a highly specialized asset that will have no use to the lessor after the lease period ends

Written reports often include

3-10 years of data to form opinions and conclusions

Which of the following situations will most likely require a company to record a valuation allowance on its balance sheet?

A firm is unlikely to have taxable income that would enable it to take advantage of deferred tax assets

What is excluded from inventory?

Abnormal costs as a result of waste of materials, labor, etc Storage costs (unless required as production cost) Administrative overhead and selling costs Classifying an excluded cost as inventory will understate expenses and overstate assets

Specific Identification

Actual costs of items specifically identified as sold allocated to COGS

When taxable income > accounting profit

Actual income taxes payable will exceed the financial accounting income tax expense Deferred tax assets arise

Typical adjustments with LIFO Reserve

Add LIFO reserve to ending inventory to get FIFO ending inventory Subtract the change in LIFO reserve from COGS to get COGS under FIFO

La Crosse Partners LLC has a franchise agreement with Almonds Crispy Fry that expires in seven years, but is renewable at each expiration date for a nominal fee. If the franchise agreement is initially valued at $60,000

Amortization expense in the sixth year will be zero

Carrying amount

Amount at which the asset or liability is valued according to accounting principles

Tax base

Amount at which the asset or liability is valued for tax purposes

Accounting Profit

Amount reported in accordance with financial accounting standards (also know as pretax income or EBT)

The most likely effect of a write-down of inventory to net realizable on a firm's total asset turnover is

An increase

Which of the following would result in a lease being classified as an operating lease under US GAAP?

An option to purchase the asset for FMV at the end of the lease

Long-lived assets

Assets that are expected to provide economic benefits over a future period of time, typically greater than one year Types: - Tangible (Property, Plant, and Equipment or Investment Property) - Intangible - Financial assets

LIFO

Assumes most recent items purchased were sold first. Last in to inventory = first out to COGS LIFO not permitted under IFRS

FIFO

Assumes that earliest items purchased were sold first. First in to inventory = first out to COGS

Weighted Average Cost

Averages total costs over total units available

Vertical common-size

Balance sheet: Each item as a percent of total assets Income statement: Each item as a percent of total net revenues Cash flow: Each line as a percent sales, assets, or total in and out Highlights composition and identifies what's important

Statement 1: As compared to the price-to-earnings ratio, the price-to-cash flow ratio is easier to manipulate because management can easily control the timing of the cash flows. Statement 2: One of the benefits of earnings per share as a valuation metric is that it facilitates the comparison of firms of different sizes. With respect to these statements:

Both are incorrect

Credit Analysis

Business Risk - Operating environment - Industry characteristics -SWOT analysis -Competitive position Financial Risk - Capital structure, interest coverage, profitability, etc -Examine debt covenants Evaluation of management

Effect of expenditures on financial statements

Capitalizing an expenditure increases assets, decreases expenses in current period Expensing an expenditure decreases assets, increases expenses in current period

Which of the following statements is least accurate? When a bond issued at a discount

Cash flows from financing will be increased by the par value of the bond issue

Should an expenditure be capitalized or expensed?

Cost of a tangible asset includes all expenditures necessary to get asset ready for intended use

Solvency Ratios

Coverage Ratios Measures ability to meet long-term obligations Sometimes called "leverage" ratios

How would the collection of accounts receivable most likely affect the current and cash ratios?

Current Ratio --> No effect Cash Ratio --> Increase

A firm has deferred tax assets of $315,000 and deferred tax liabilities of $190,000. If the tax rate increases, adjusting the value of the firm's deferred tax items will

Decrease income tax expense

Which of the following factors is least likely to cause a difference between a firm's effective tax rate and statutory rate?

Deductible expenses

A temporary difference between income tax expense and taxes payable results in a(n):

Deferred tax item

At the date of issuance the market interest rate was above the coupon rate. Bonds of this nature will sell for

Discount

When bonds are issued at a premium

Earnings of the firm increase over the life of the bond as the bond premium is amortized

Intangible Assets Developed Internally IFRS

Expenditures on research are expensed, initial stages Expenditures on development are capitalized, once we realize we have a good prototype and begin developing the actual product

If prices are decreasing, the best estimates of inventory and cost of goods sold from an analyst's point of view are provided by

FIFO inventory and LIFO COGS

For a company that pays dividends, if the price of the stock increases, the dividend yield also increases

False

For the lessor, a capital lease requires that they report the leased asset on their balance sheet

False

If a company that has positive net income increases its leverage by repurchasing shares, ROE will likely decrease

False

If the debt to asset ratio decreases, it means the company has increased its financial leverage

False

Land is generally depreciation over its useful life under US GAAP

False

Most large companies today have a periodic inventory system

False

When interest rates rise, bond prices also generally rise

False

When taxable income is less than accounting profit, actual income taxes payable will exceed the financial accounting income tax expense

False

When taxable income < accounting profit

Financial accounting income tax expense exceeds income taxes payable Deferred ta liabilities arise

Proceeds from issuing a bond are recorded on the statement of cash flows as an inflow from

Financing (CFF)

Firm 1 has deferred tax liability and Firm 2 has a deferred tax asset. If the tax rate decrease, the balance sheet values of these deferred tax items will

Firm 1 --> Decrease Firm 2 --> Decrease

Which of the following statements about depreciation is least accurate

For a firm with capital expenditures, accelerated depreciation methods tend to increase both net income and stockholders' equity when compared to straight-line depreciation

If LIFO is used,

GAAP also requires that it disclose the LIFO Reserve - Basically the difference between inventory as reported by LIFO and if inventory had been reported under FIFO

Intangible Assets Developed Internally US GAAP

Generally, both research and development costs are expensed Exception: For costs related to software development - Products for sale: Both research and development expenditures are expensed until technology feasibility is established; then they are subsequently capitalized - Software for internal use: Both research and development expenditures are expensed until probable completion is demonstrated; they are subsequently capitalized

Inventory

Goods held by a company for resale or used to produce a finished product May typically consist of: - Raw materials - Work in progress - Finished goods (only type for a merchandiser)

Nearly all leases (including operating leases)

Have to be reported on the lessee's balance sheet under the revised rules

In period of increasing inventory costs, LIFO will result in:

Higher COGS Lower ending inventory Lower net income Lower tax liability (this is why companies use it)

Compared with firms that expense costs, firms that capitalize costs can be expected to report

Higher asset levels and higher equity levels in the early years of the asset's life

Accelerated depreciation methods for financial reporting are most likely to have which of the following effects on a company's financial ratios during the early years of an asset's life?

Higher asset turnover ratio

The accelerated method of depreciation, compared with the straight-line method, will result in

Higher depreciation expense in earlier periods, so lower operating profit margin and operating return on assets (ROA) in the early periods and higher operating profit margin and operating ROA in the later periods Lower average total assets in earlier periods and thus higher asset turnover ratio

On January 1, 20X4, Cayman Corporation brought manufacturing equipment for $30 million. On December 31, 20X6, Cayman determined the equipment was impaired and recognized a $5 million impairment loss in its income statement. As of December 31, 20X7, the fair value of the equipment exceeded the book value by $7 million. Cayman may recognize a gain in its 20X7 income statement if it reports under:

IFRS, but not US GAAP

Impairment IFRS vs GAAP

Impairment reversals for identifiable, long-lived assets are permitted under IFRS but not under US GAAP IFRS and US GAAP define recoverability differently

Other things equal, and ignoring issuance costs, a firm that raises cash by issuing a new bond is most likely to

Increase its leverage ratios and decrease its coverage ratios

Capitalized interest refers to

Interest paid on loans related to the construction of long-term assets

For a firm that uses the LIFO inventory cost method, a LIFO liquidation occurs if

Inventory quantity decreases during a reporting period

Capitalized interest costs are typically reported in the cash flow statement as an outflow from

Investing

Permanent Differences in Tax

Items of income recognized in financial reports are not taxable Expenses recognized in financial reports are not deductible for tax purposes

During periods of rising prices, which of the following is most likely to occur?

LIFO COGS > FIFO COGS, therefore LIFO Net Income < FIFO Net Income

During periods of decreasing prices, a firm using a periodic inventory system will report higher gross profit if its inventory cost assumption is

LIFO because during periods of decreasing prices, COGS will be lower, resulting in a higher gross profit

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

LIFO or Weighted Average Cost, but not FIFO

LIFO Liquidations

LIFO reserve should generally increase over time If LIFO reserve should decline, it results in what is called a "LIFO liquidation" Often arises if number of units in ending inventory is less than number of units in beginning inventory Effect on financial statements: - LIFO liquidation will artificially boost gross profit - But is a one time event and not sustainable If inventory is a material part of the company's business, and they use LIFO, an analyst should carefully examine the disclosures related to the LIFO reserve, and adjust the financial statements as needed

Long lived assets that are never depreciated or amortized over time

Land Intangible assets with indefinite lives (goodwill) Tested annually for impairment

Periodic Inventory System

Least common Inventory values and costs are determined at the end of an accounting period Uses a "purchases" account to aggregate all inventory purchases throughout the period Ending inventory usually determined through a physical count at end of period

Which of the following is least likely one of the criteria under US GAAP for classifying a lease as a finance lease? The

Lessor retains ownership of the property at the end of the lease term

Dobkin Company decides to expense costs that it would have otherwise capitalized. Compared to capitalizing, expensing these costs will result in

Lower asset levels and lower equity levels. Expensing instead of capitalizing results in lower assets. Since the entire expense is recognized in the current period (whereas only a portion of the expenditure is amortized when capitalizing), net income (and therefore equity, via retained earnings) is lower with expensing than with capitalizing. Liabilities are uneffected

In decreasing price environment, the FIFO inventory cost method results in

Lower gross profit compared to LIFO

Compared to firms that expense costs, firms that capitalize expenses will have

Lower variability of income

Costs that are included in the balance sheet value of inventory likely include

Manufacturing overhead

Liquidity Ratios

Measures ability to meet short-term obligations

Perpetual System

Most common Inventory values and costs of sales are continuously updated to reflect purchases and sales

The most likely effect of a write down of inventory to net realizable value on a firm's quick ratio is

No change

Under normal circumstances, intangible assets with indefinite lives are

Not amortized but subject to impairment

Larry Purcell, an entry-level fixed income analyst at Knowlton and Smeades LLC, was discussing debt covenants with his supervisor, Andy Holzman. During the meeting Purcell made the following statements regarding bond covenants: Statement 1: If a firm violates any of its debt covenants, the company will immediately go into bankruptcy and the creditors of the firm will take over the liquidation of its assets Statement 2: Debt covenants are important in evaluating a firm's credit risk and to better understand how the restrictions of the covenants can affect the firm's growth prospects and choice of accounting policies. With respect to these statements:

Only one is correct Lenders and other creditors use debt covenants in their lending agreements to restrict the activities of the debtor that could adversely impact the creditors' position. If any bond covenant is violated, the firm is in technical default on its debt. The creditors can demand payment of the debt, however, the terms are generally renegotiated. As such, the company does not automatically enter into bankruptcy and have its assets liquidated by the creditors

Under IFRS, a lessor retains the leased asset on its balance sheet for

Operating leases, but not finance leases

Horizontal common-size

Percentage increase or decrease of each item from the prior year or showing each year relative to a base year Highlights items that have changed unexpectedly or have unexpectedly remained unchanged

Taxable Income

Portion of income subject to income taxes under jurisdiction

Valuation Ratios

Price in computation Measure the quantity of asset or flow (earnings) associated with ownership of a specified claim (share or ownership)

Under US GAAP which of the following statements is MOST accurate

Purchased patent and copyright costs are not expensed

Typical analyst written report generally includes

Purpose of report Relevant aspects of the business context -Economic environment -Financial environment -Legal and regulatory environment Evaluation of corporate governance and assessment of management's strategy, including competitive advantages/disadvantages Assessment of financial and operational data, including any key assumptions made (generally forward looking) Conclusion and recommendations, including limitations of the analysis and risks

Inventory method changes

Rare, but does happen Under IFRS, a change is acceptable only if the change "results in the financial statements providing relatable and more relevant information..." Changes are applied retroactively Analysts should carefully evaluate management's motives for an inventory change

Temporary Differences for Tax

Rate of depreciaition or amortization differs between financial reports and taxes Timing of expensing an expenditure differs between financial reports and taxes Timing of recognizing revenue differs between financial reports and taxes

Under IFRS, if a firm reports investment property using the fair value model, unrealized gains and losses on investment property are

Recognized on the income statement

Derecognition of an asset

Remove it from the financial statements Occurs when the asset is disposed of or is expected to provide no future benefits from either use or disposal

Ways accounting profit and taxable income can differ

Revenues and expenses being recognized in one period for accounting purposes and a different period for tax purposes Specific revenues and expenses being recognized for accounting purposes and not for tax purposes, or not recognzed for accounting purposes but recognized for tax purposes The carrying amount and tax base of assets and/or liabilities differ Deductibility of gains and losses varying for accounging and income tax purposes Tax loss carrying-forwards Adjustments of reported financial data from prior years not being recognized equally for accounting and tax purposes or recognized in different periods

Disposal of a long-lived asset

Sale - Gain or loss = Sales proceeds - Carrying amount of asset - Non-operating gain or loss Exchange Abandonment

Using financial ratios to build a model and predict future financial results

Sensitivity analysis - A "what if" analysis to show the range of possible outcomes if certain assumptions are changed Scenario analysis -What is financial impact of possible specific events (loss of major customer, recession, etc) Simulation - Conduct multiple iterations of sensitivity or scenario analysis based on probabilities of factors that drive outcomes. (sometimes called Monte Carlo analysis)

Under IFRS, when a lessee recognizes a balance sheet asset and liability for a new lease

The asset and liability are equal

In general, when an asset's carrying amount is not recoverable

The carrying amount of the impaired asset is written down, An impairment loss is recognized

The current ratio of a company has decreased from 2.5 in the prior period to 2.0 in the current period. Which of the following would most likely explain the decrease in this ratio?

The company acquired inventory on account

An employer offers a defined benefit pension plan and a defined contribution pension plan. The employer's balance sheet is most likely to present an asset or liability related to

The defined benefit plan

For a firm that uses the LIFO inventory cost method, the LIFO reserve is

The difference between LIFO inventory and FIFO inventory

Limitations of Ratio Analysis

The diversity or focus of a company's operating activities. -Into what industry would you classify GE? (Not good for conglomerate type components) The need to determine whether the results of the ratio analysis are consistent - Are the ratios being compared calculated in the same manner? -Do two different ratios provide conflicting results? The need to use judgment - Is the ratio within a reasonable range? The use of alternative accounting methods may make ratios incomparable without adjustments - Inventory, depreciation, etc

Defined benefit pension plan

The investment risk lies with the employer

Interest expense is reported on the income statement as a function of

The market rate

Which of the following statements for a bond issued with a coupon rate above the market rate of interest is lease accurate?

The value of the bond will be amortized toward zero over the life of the bond

A short-term operating lease is essentially equivalent to renting the asset

True

Impairment reversals for identifiable, long-lived assets are permitted under IFRS but not under US GAAP

True

The double declining balance method ignores salvage value when computing the first year's depreciation expense

True

Under the recently revised lease rules, nearly all long-term leases must be reported on the balance sheet of the lessee

True

Activity Ratios

Turnover, Days in, or Days of Measures the efficiency of a company's operations

What gets included as inventory?

Under IFRS "... all costs of purchase, costs of conversions, and other costs incurred in bringing the inventories to their present location and condition" are included as inventory costs

Key questions to address when doing financial analysis

What aspects of performance are critical for company to successfully compete in its industry? How well did the company's performance meet these critical aspects? (relative to benchmark) What were the key causes of this performance, and how does the performance reflect the company's strategy? Why did Return on Assets increase? Does this fit the overall strategy? Why was performance better or worse than expected?

Forward looking questions to consider when doing financial analysis

What is the likely impact of some event or trend? What is the likely response of management to this trend? What is the likely impact of trends in company/industry/economy on future cash flows? What are analyst recommendations? (Might do this to check your findings as well) What risks should be highlighted? (sensitivity analysis is helpful)

Impairment charges reflect

an unanticipated decline in the value of an asset

When using specific identification or FIFO cost methods

periodic and perpetual systems will yield the same COGS and ending inventory

A long-term liability only arises for company's that

support a defined benefit plan. This is why many employers have eliminated defined benefit plans, and replaced them with a defined contribution plan

Defined contribution pension plan

the investment risk lies with the employee

Right-of-use assets and liabilities are calculcated as

the present value of fixed lease payments

If a company uses LIFO for tax purposes,

they must also use it for financial reporting purposes under the "LIFO conformity rule"

Under the new rules, a lesse only

treats leases as off-balance sheet in very limited circumstances. Nearly all leases are now "on-balance-sheet" for the lessee

If you divide a "period of time" item by (or into) a "point in time" item,

you should generally average the point in time item. Example: ROA is actually Net Income/Avg Total Assets