FINA470 Test 3

When an acquisition accounted for as a purchase is effected for stock or other equity securities, discuss what our analysis should be alert to.

-Analysis should be alert to the appropriateness of the valuation of the net assets acquired in the combination -In periods of high stock market price levels, purchase accounting can introduce inflated values when net assets (particularly the intangibles) of acquired companies are valued on the basis of the high market price of the stock issued -Such values, while determined on the basis of temporarily inflated stock prices, remain on a company's balance sheet and may require future write-downs if impaired. This concern also extends to temporarily depressed stock prices and its related implications.

The equity method of accounting for investments requires:

-Company to have significant influence over investee -Pro-rata share of investee's earnings should be recorded as investment income

Distinguish between hedging and speculative activities with regard to derivatives.

-Hedging activities protect the company against fluctuations in market instruments -Speculative activities seek to profit on fluctuations in market instruments

Describe a futures contract

A futures contract is an agreement between two or more parties to purchase or sell a certain commodity or financial asset at a future date and at a definite price.

Describe a swap contract. How are swaps typically used by companies?

A swap contract is an arrangement between two or more parties to exchange future cash flows. Swaps are typically used to hedge risks such as interest rate and foreign currency risks.

Describe the computation of free cash flow. What is its relevance to financial analysis?

A valuable analytical derivative of the SCF is "free cash flow." As with any other analytical measure, analysts must pay careful attention to components of this computation. Here, as in the case of any cash flow measures, ulterior motives may sometimes affect the validity of the computation. One of the analytically most useful computations of free cash flow is: Cash from Operations (CFO) - Capital expenditures required to maintain productive capacity used in generating income - Dividends (on preferred stock and maintenance of desired payout on common stock) = Free Cash Flow (FCF) Positive FCF implies that this is the amount available for company purposes after provisions for financing outlays and expenditures to maintain productive capacity at current levels. Internal growth and financial flexibility depend on an adequate amount of FCF. Note that the amount of capital expenditures needed to maintain productive capacity at current levels is generally not disclosed by companies. It is included in total capital expenditures, which also can include outlays for expansion of productive capacity. Breaking down capital expenditures between these two components is difficult. The FASB considered this issue, but in SFAS 95 it decided not to require classification of investment expenditures into maintenance and expansion categories.

Which of the following items is not included in the calculation of net income but is included in the calculation of comprehensive income? A. Unrealized holding gain on available-for-sale marketable securities. B. Unrealized holding gain on trading marketable securities. C. Gain from early extinguishments of bonds. D. Gain arising from sale of available-for-sale marketable securities.

A. Unrealized holding gain on available-for-sale marketable securities.

Which of the following statements is incorrect? Employee stock options A. are not recorded as an expense when granted if they are at or out-of-the money under the intrinsic value method. B. will not affect the share price of the company when exercised. C. may reduce agency costs by more closely aligning interests of stockholders and managers. D. may increase the risk propensity of managers.

A. are not recorded as an expense when granted if they are at or out-of-the money under the intrinsic value method.

The classification of marketable equity securities as trading or available-for-sale is determined by: A. management's intent regarding the disposition of the securities. B. when the securities mature. C. whether the current assets are greater or less than the current liabilities. D. whether management wants to mark them to market or not.

A. management's intent regarding the disposition of the securities.

How does accounting define an extraordinary item? Cite three examples of such an item. What are the analysis implications of such an item?

Accounting standards (APB 30) restricted the use of the "extraordinary" category by requiring that an extraordinary item be both unusual in nature and infrequent in occurrence. These attributes are defined as follows: a. Unusual nature of the underlying event or transaction should possess a high degree of abnormality and be of a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the entity, taking into account the environment in which the entity operates. b. Infrequency of occurrence of the underlying event or transaction should be of a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the entity operates. Three examples of extraordinary items are: Major casualty losses from an event such as an earthquake, flood, or fire. A gain or loss from expropriation of property. A gain or loss from condemnation of land by eminent domain.

Describe an option contract. When is an option likely to be exercised?

An option contract gives a party the right, but not an obligation, to execute a transaction. An option to purchase a security at a specified price at a future date is an example of an option contract. This option is likely to be exercised if the security price on that future date is higher than the contract price and not otherwise.

The equity method of accounting for investments requires: A. Investment should be marked to market each accounting period. B. Pro-rata share of investee's earnings should be recorded as investment income. C. Company should not have significant influence over investee. D. Goodwill related to purchase of investee stock to be recorded separately on balance sheet.

B. Pro-rata share of investee's earnings should be recorded as investment income.

Compared with companies that expense costs, firms that capitalize costs can be expected to report: A. higher asset levels and lower equity levels. B. higher asset levels and higher equity levels. C. lower asset levels and higher equity levels. D. lower asset levels and lower equity levels.

B. higher asset levels and higher equity levels.

When an acquisition is made and accounted for using the purchase method, the post-acquisition retained earnings account: A. is the sum of the pre-acquisition retained earnings accounts of the two combining companies. B. is the pre-acquisition retained earnings account of the acquiring company only. C. is the pre-acquisition retained earnings accounts of the acquiring company plus net income of acquired company in year of acquisition. D. is the pre-acquisition retained earnings accounts of the acquiring company less treasury stock of the acquired company.

B. is the pre-acquisition retained earnings account of the acquiring company only.

Compared with firms with capital leases, firms with operating leases generally report: A. higher cash flow from operations B. lower cash flow from operations C. identical cash flow from operations D. lower or higher cash flow from operations depending upon market interest rates

B. lower cash flow from operations

The cash flow adequacy ratio A. Measures a company's ability to generate sufficient cash flow from investing to cover debt repayments B. Measures a company's ability to generate sufficient cash flows from operations to cover capital expenditures and debt repayment C. Measures a company's ability to generate sufficient cash flows from operations to cover capital expenditures, inventory additions and dividends D. Measures a company's ability to generate sufficient cash flows from operations to cover capital expenditures, debt repayment and dividends

C. Measures a company's ability to generate sufficient cash flows from operations to cover capital expenditures, inventory additions and dividends

When an acquisition is made and accounted for using the purchase method, the post-acquisition common stock account: A. is the sum of the pre-acquisition common stock accounts of the two combining companies. B. is the pre-acquisition common stock account of the acquired company only. C. is the pre-acquisition common stock account of the acquiring company plus the par value of new stock issued to affect the acquisition. D. is the pre-acquisition common stock account of the acquiring company plus the fair value of new stock issued to affect the acquisition.

C. is the pre-acquisition common stock account of the acquiring company plus the par value of new stock issued to affect the acquisition.

Differences in taxable income and pretax accounting income that will not be offset by corresponding differences or "turn around" in future periods are called: A. timing differences. B. circular differences. C. permanent differences. D. reverse differences

C. permanent differences.

As a general rule, revenue is normally recognized when it is: A. measurable and earned. B. measurable and received. C. realizable and earned. D. realizable.

C. realizable and earned.

To determine a company's sustainable earning power, an analyst needs to first determine the recurring component of the current period's accounting income by excluding nonrecurring components of accounting income. Such adjusted earnings are often referred to as:

Core earnings

Analysts often refer to the core income of a company. What is meant by the term core income?

Core income is a measure of income that excludes all non-recurring items that are reported as separate items on the income statement.

Which of the following measures of accounting income is typically reported in an income statement? A. Net income B. Comprehensive income C. Continuing income D. All of the above

D. All of the above

Company A acquires 40% of Company B in a stock-for-stock exchange. With respect to preparing financial statements, which of the following statements is correct? A. Company A will most likely use pooling-of-interest accounting for consolidation purposes. B. Company A will most likely use purchase accounting. C. Company A will most likely use the cost method. D. Company A will most likely use the equity method.

D. Company A will most likely use the equity method.

Which of the following is true? The choice of LIFO versus FIFO will: A. not affect net income or cash flow from operations B. not affect net income but will affect cash flow from operations C. affect both net income and cash flow from operations D. affect net income but will not affect cash flow from operations

D. affect net income but will not affect cash flow from operations

Trading Marketable Securities: A. are considered non-current assets. B. are recorded at amortized cost. C. are marked to the lower of cost or market each accounting period. D. are marked to market each accounting period.

D. are marked to market each accounting period.

Which of the following items is deducted from net income to arrive at cash flow from operations when using the indirect method? A. depreciation expense B. amortization expense C. decrease in accounts receivable D. decrease in accounts payable

D. decrease in accounts payable

On a statement of cash flows that uses the indirect approach, calculation of cash flow from operations treats depreciation as an adjustment to reported net income because: A. depreciation is a direct source of cash B. depreciation is an outflow of cash to a reserve account for the replacement of assets C. depreciation reduces net income and involves an outflow of cash D. depreciation reduces net income but does not involve an outflow of cash

D. depreciation reduces net income but does not involve an outflow of cash

What is the purpose underlying the reporting of diluted EPS?

Diluted earnings per share is the amount of current earnings per share reflecting the maximum dilution that would result from conversions, exercises, and other contingent issuances that individually would decreased earnings per share and in the aggregate yield a dilutive effect. All such issuances are assumed to have taken place at the beginning of the period (or at the time the contingency arose, if later).

Accounting income attempts not to capture all elements of permanent income or economic income.

False

An increase in accounts receivable requires adjusting net income if preparing the statement of cash flows using the indirect method

False

Cash flow from operations is usually less volatile than net income

False

Cash flow from operations will most often be positive for companies experiencing tremendous growth

False

Held-to-maturity securities are equity securities that management intends and has the ability to hold to maturity.

False

Investment securities should always be reported at lower-of-cost-or-market.

False

Revenue from sales where the buyer has the right of return can only be recognized after the return period has expired

False

The Equity Conformity Rule requires that marketable securities must be marked to market for tax purposes.

False

The only time a company experiences a negative cash flow from operations is when they are in trouble.

False

Under accrual accounting, a company will recognize expenses as they are paid.

False

Is this an operating, investing, or financing activity? Increase in long-term note payable

Financing

Is this an operating, investing, or financing activity? Proceeds from issuance of Convertible Preferred stock

Financing

Is this an operating, investing, or financing activity? Proceeds from issuance of common stock

Financing

List insights that the statement of cash flows can provide to our analysis.

For financial statement analysis, the SCF provides clues to important matters such as: -Feasibility of financing capital expenditures and possible sources of such financing. -Sources of cash to finance an expansion in the business. -Dependence of the firm on external sources of financing (such as debt or equity). -Future dividend policies. -Ability to meet future debt service requirements. -Financial flexibility, that is, the firm's ability to generate sufficient cash so as to respond to unanticipated needs and opportunities. -Insight into the financial habits of management and indications of future policies. -Signals regarding the quality of earnings.

Is this an operating, investing, or financing activity? Acquisition of property, plant, and equipment

Investing

Is this an operating, investing, or financing activity? Purchase of marketable securities

Investing

Distinguish between net income, comprehensive incomes, and continuing income. Cite examples of items that create differences between these three income measures.

Net Income: also called the "bottom line" but certain unrealized holding gains and losses are charged directly to equity and bypass net income Comprehensive Income: the ultimate "bottom line income number" - includes all changes in equity that result from non-owner transactions (excluding items such as dividends and stock issuances) Items creating differences between net income and comprehensive income include unrealized gains and losses on available for sale securities, foreign currency translation adjustments, minimum pension liability adjustments, and unrealized holding gains or losses on derivative instruments. 5. Continuing income is a measure of net income earned by ongoing segments of the company. Continuing income differs from net income because continuing income excludes the income or loss of segments of the company that are to be discontinued or sold (it also excludes extraordinary items and effects from changes in accounting principles).

Is this an operating or nonoperating expense? Gain from sale of discontinued segment

Non operating

Is this an operating or nonoperating expense? Gain on extinguishment of debt

Non operating

Is this an operating or nonoperating expense? Interest expense

Non operating

Is this an operating or nonoperating expense? Investment income

Non operating

Is this an operating or nonoperating expense? Loss from operating discontinued

Non operating

Is this an operating or nonoperating expense? Unrealized holding gain on available for sale securities

Non operating

Is this an operating or nonoperating expense? Cost of goods sold

Operating

Is this an operating or nonoperating expense? Foreign currency translation adjustments

Operating

Is this an operating or nonoperating expense? Gross profit

Operating

Is this an operating or nonoperating expense? Post retirement benefits adjustment

Operating

Is this an operating or nonoperating expense? Research and development

Operating

Is this an operating or nonoperating expense? Restructuring charge

Operating

Is this an operating or nonoperating expense? Selling and administrative

Operating

Is this an operating or nonoperating expense? Gain on sale of fixed assets

Operating

Is this an operating or nonoperating expense? Sales

Operating

Is this an operating, investing, or financing activity? Decrease in accounts payable

Operating

Is this an operating, investing, or financing activity? Depreciation and amortization

Operating

Is this an operating, investing, or financing activity? Increase in accounts receivable

Operating

Is this an operating, investing, or financing activity? Increase in prepaid expenses

Operating

Is this an operating, investing, or financing activity? Net income

Operating

Distinguish between operating and non-operating income. Cite examples of items that are typically included in each category.

Operating income is a measure of firm performance from operating activities. Examples of operating income include product sales, cost of product sales, and selling, general, and administrative costs. Non-operating income includes all components of income not included in operating income. Examples of non-operating income include interest revenue and interest expense.

Distinguish between operating and non-operating income and recurring vs. non-recurring income.

Operating versus non-operating and recurring versus non-recurring are distinct dimensions of classifying income. While there is overlap across selected items, these dimensions reflect different characteristics of business activities. For example, the interest income and interest expense of most companies recur in net income; hence, they are included in recurring income. However, these items are non-operating in nature. Similarly, non-recurring items such as restructuring charge are operating in nature.

What is option overhang? What does it measure? How is it determined?

Option overhang refers to the intrinsic value of outstanding options (both exercisable and otherwise) as a proportion of the company's market value. It is a measure of the value of potential dilution that arises from option grants to employees. It measured by aggregating the intrinsic value of all outstanding employee stock options, using the current stock price, and dividing it by the current market capitalization of the company's equity.

Distinguish between the two major methods used to account for revenue under long-term contracts.

Percentage‑of‑completion method is preferred when estimates of costs to complete along with estimates of progress toward completion of the contract can be made with reasonable dependability. A common basis of profit estimation is to record that part of the estimated total profit that corresponds to the ratio that costs incurred to date bears to expected total costs. Other methods of estimation of completion can be based on units completed or on qualified engineering estimates or on units delivered. Completed‑contract method of accounting is preferable where the conditions inherent in the contract present risks and uncertainties that result in an inability to make reasonable estimates of costs and completion time. Problems under this method concern the point at which completion of the contract is deemed to have occurred as well as the kind of expenses to be deferred. For example, some companies defer all costs to the completion date, including general and administrative overhead while others consider such costs as period costs to be expensed as they are incurred. Under either of the two contract accounting methods, losses (present or anticipated) must be fully provided for in the period in which the loss first becomes apparent.

Does timing or permanent result in a different effective tax rate?

Permanent

Is this timing or permanent? IRS tax penalties

Permanent

Is this timing or permanent? Tax credits related to hiring additional employees

Permanent

Is this timing or permanent? Tax exempt interest income

Permanent

As a general rule, revenue is normally recognized when it is:

Realized and earned

Describe the calculation of compensation expense associated with employee stock options. Is it necessary for a company to charge option-related compensation expense to income? Where in the income statement is compensation expenses reported?

SFAS 123 requires that the company amortize the fair value of employee stock options (estimated using various option pricing models) at the grant date over the expected life of the option. The cumulative amortization of all employee stock options granted in the past is collectively called the option compensation expense. Until recently, option compensation expense was not charged to income. However, a recent revision of the standard, SFAS 123R, requires that the option compensation expense be charged to income. Compensation expense may be included in various expense categories such as cost of goods sold, SG&A, R&D etc. based on which area of the company the respective employee works for.

Explain what special items are. Give three examples of special items.

Special items refer to transactions and events that are unusual or infrequent, not both. These items are reported as separate line items on the income statement before continuing income. Examples of special items include restructuring charges, impairments of long-lived assets, and asset write-offs.

When a balance sheet reports a substantial dollar amount for goodwill, discuss what we should be concerned with in our analysis.

The amount of goodwill that is carried on the acquirer's statement too often bears little relation to its real value based on the demonstrated superior earning power of the acquired company. Should the goodwill become impaired, the resulting write-down could significantly impact earnings and the market value of the company

What are the economic costs to issuing employee stock options at the prevailing market price?

The economic cost of issuing options at the prevailing market price are: (1) the interest cost, which is that the employee is able to pay for the stock purchase many years later using the current stock price; and (2) cost of providing an option to exercise, which arises because the employee can share in the potential upside but is protected from sharing in the potential downside risk.

What factors cause the effective tax rate to differ from the statutory rate?

The effective tax rate paid by a corporation on its income will vary from the statutory rate because: -The basis of carrying property for accounting purposes may differ from that for tax purposes from reorganizations, business combinations, or other transactions. -Nonqualified and qualified stock‑option plans may result in book‑tax differences. Certain industries, such as savings and loan associations, shipping lines, and insurance companies enjoy special tax privileges. -Up to $100,000 of corporate income is taxed at lower tax rates. -Certain credits may apply, such as R&D credits and foreign tax credits. -State and local income taxes, net of federal tax benefit, are included in total tax expenses. What makes these differences and factors permanent is the fact that they do not have any future repercussions on a company's taxable income. Thus, they must be taken into account when reconciling a company's actual (effective) tax rate to the statutory rate.

List and discuss the factors that affect the fair value of an option.

The fair value of an option is affected by the exercise price, the current market price, the risk-free rate of interest, the expected life of the option, the expected volatility of the stock price, and the expected dividend yield.

Describe the conditions that are usually required before revenue is considered realized.

The following criteria exemplify the rules that have been established to prevent the premature anticipation of revenue. Realization is deemed to take place only after the following conditions have been met: The earning activities undertaken to create revenue are substantially complete; for example, no significant effort is necessary to complete the transaction. In the case of a sale, the risk of ownership has effectively passed to the buyer. The revenue, as well as the associated expenses, can be measured or estimated with substantial accuracy. The revenue recognized should normally result in an increase in cash, receivables, or marketable securities and, under certain conditions, in an increase in inventories or other assets, or a decrease in a liability. The business transactions giving rise to the income should be at arm's‑length with independent parties (that is, not with controlled parties). The transactions should not be subject to revocation, for example, carrying the right of return of merchandise sold.

Contrast the purpose of the income statement with that of cash flow from operations.

The function of the income statement is to measure the profitability of the enterprise for a given period. This is done by matching expenses and losses with the revenues and gains earned. While no other statement measures profitability as well as the income statement, it does not show the timing of cash flows and the effect of operations on liquidity and solvency. The latter is reported on by the SCF. Cash from operations (CFO) reflects a broader concept of operations relative to net income. It encompasses all earning‑related activities of the enterprise. CFO is concerned not only with expenses and revenues but also with the cash demands of these activities, such as investments in customer receivables and in inventories as well as the financing provided by suppliers of goods and services. CFO focuses on the liquidity aspect of operations and is not a measure of profitability because it does not include important costs such as the use of long‑lived assets in operations or important revenues such as the equity in the earnings of nonconsolidated subsidiaries or affiliates.

Net income computed on the basis of financial reporting often differs from taxable income due to permanent differences. What are permanent differences and how do they arise?

The net income computed on the basis of generally accepted accounting principles (also known as "book income") is usually not identical to the "taxable income" computed on the entity's tax return. This is due to two types of difference. Permanent differences (discussed here) and temporary, or timing, differences. Permanent differences result from provisions of the tax law under which: a.) Certain items may be nontaxable—for example, income on tax exempt obligations and proceeds of life insurance on an officer b.) Certain deductions are not allowed—for example, penalties for filing certain returns, government fines, and officer life insurance premiums. c.) Special deductions granted by law—for example, dividend exclusion on dividends from unconsolidated subsidiaries and from dividends received from other domestic corporations.

Describe the two methods of reporting cash flow from operations?

The two methods of reporting cash flow from operations are: Indirect Method: Under this method net income is adjusted for noncash items required to convert it to CFO. The advantage of this method is that it is a reconciliation that discloses the differences between net income and CFO. Some analysts estimate future cash flows by first estimating future income levels and then adjusting these for leads and lags between income and CFO (that is, noncash adjustments). Direct (or Inflow‑Outflow) Method: This method lists the gross cash receipts and disbursements related to operations. Most respondents to the Exposure Draft that preceded SFAS 95 preferred this method because this presentation discloses the total amount of cash that flows into the enterprise and out of the enterprise due to operations. This gives analysts a better measure of the size of cash inflows and outflows over which management has some degree of discretion. As the risks that lenders are exposed to relate more to fluctuations in CFO than to fluctuations in net income, information on the amounts of operating cash receipts and payments is important in assessing the nature of those fluctuations.

Does timing or permanent result in a deferred tax asset or liability?

Timing

Is this timing or permanent? Accelerate depreciation

Timing

Is this timing or permanent? Advance rent received

Timing

Is this timing or permanent? Bad debt allowance

Timing

Is this timing or permanent? Product warranty expense

Timing

Is this timing or permanent? Writing down of inventory or fixed assets

Timing

Differences in taxable income and pre-tax accounting income that will not be offset by corresponding differences or "turn around" in future periods are called:

Timing difference

What conditions are necessary for an item to qualify as a prior period adjustment?

To qualify as a prior period adjustment, an item must meet the following requirements: -Material in amount. -Specifically identifiable with the business activities of specific prior periods. -Not attributable to economic events occurring subsequent to the prior period. -Dependent primarily on determinations by persons other than management. -Not reasonably estimable prior to such determination.

Describe the accounting treatment for discontinued operations. How should an analyst treat discontinued operations?

To qualify as discontinued operations, the assets and business activities of the divested segment must be clearly distinguishable from the assets and business activities of the remaining entity. Accounting and reporting for discontinued operations is two-fold. First, the income statement for the current and prior two years are restated after excluding the effects of the discontinued operations from the line items that determine continuing income. Second, gains or losses pertaining to the discontinued operations are reported separately, net of related tax effects. An analyst should separate and ignore discontinued operations in predicting future performance and financial condition.

A gain on sale of an asset would not require adjusting net income if preparing the statement of cash flows using the indirect method

True

A long-term asset is said to be impaired when its fair value is below its book value

True

Accounting income attempts to capture elements to both permanent income and economic income, but with measurement error

True

All derivatives are recorded at market value on the balance sheet, based on management intent.

True

All derivatives are recorded at market value on the balance sheet.

True

Cash flow from operations will often be negative for companies experiencing tremendous growth

True

Companies can construct the statement of cash flows using either the direct method or the indirect method.

True

Comprehensive income is computed by adjusting net income for dirty surplus items.

True

Fair value option accounting allows companies to report a wide range of financial assets and liabilities on a fair value basis.

True

Held-to-maturity securities are are debt securities that management intends and has the ability to hold to maturity

True

If a company depreciates an asset at a faster rate for tax purposes than for financial reporting purposes this will give rise to a deferred tax liability.

True

If two firms are identical except that one firm uses percentage-of-completion accounting and the other uses completed contract accounting for revenue recognition, the cash flows of the firms will be identical.

True

One of the problems with consolidated financial statements is that all intercompany transactions are not reported.

True

Under accrual accounting, a company will recognize expenses in the period incurred.

True

Under current accounting standards, gains and losses relating to the extinguishment of debt must be both unusual and infrequent to be classified as an extraordinary item, and debt refinancing does not typically meet these criteria.

True

When using the current rate method to record foreign subsidiary results, all assets and liabilities are translated at a rate, in effect as of the statement date.

True

List four general cases giving rise to temporary differences between financial reporting and tax reporting?

a.) Revenues or gains are included in taxable income later than they are included in pretax accounting income. b.) Expenses or losses are deducted in determining taxable income later than they are deducted in determining pretax accounting income. c.) Revenues or gains are included in taxable income earlier than they are included in pretax accounting income. d.) Expenses or losses are deducted in determining taxable income earlier than they are deducted in determining pretax accounting income.

A cash flow adequacy ratio, when measured over the last several years, of less than one:

indicated that a company's internally generated cash flows have not been sufficient to cover dividend payments and support growth levels