T/F Questions for 313 Final

Consider two companies (A and B) with equal profit margins of 15%. Company A has an asset turnover of 1.2 and Company B has an asset turnover of 1.5. If all else is equal, Company B with its' higher asset turnover, is less profitable because it is expensive to turn assets over.

Answer: False Rationale: Asset turnover is an efficiency metric. The higher the turnover, the more efficient the company is with its assets and thus, the more profitable. Algebraically, ROA = PM × AT. Company A above is less profitable: 15% × 1.2 = 18% whereas Company B's ROA is 15% × 1.5 = 22.5%.

Assets are reported on the balance sheet at their current market value.

Answer: False Rationale: Assets are generally reported at historical costs. An exception is marketable securities.

For an item to be classified as extraordinary, it needs to be both unusual and infrequent. However, there is an exception for material items - for one-time items that are extremely large, firms have the option of classify these items as extraordinary to provide better information to investors.

Answer: False Rationale: Both of the above conditions need to be fulfilled for an item to be categorized extraordinary. There is no materiality exception.

For an item to be classified as extraordinary, it needs to be both unusual and infrequent. However, there is an exception for material items - for one-time items that are extremely large, firms have the option of classifying these items as extraordinary to provide better information to investors.

Answer: False Rationale: Both of the above conditions need to be fulfilled for an item to be categorized extraordinary. There is no materiality exception.

Unearned revenue, which is a current operating liability, arises when a company receives cash before any goods are delivered or services are rendered.

Answer: False Rationale: Deferred revenues can also be long-term liabilities.

Publicly traded companies provide financial information primarily to meet the demands of the Securities Exchange Commission, the tax authorities (e.g. the Internal Revenue Service), and suppliers.

Answer: False Rationale: Demand for information extends to many users; the regulators such as the SEC and the IRS are only one class of users.

The only difference between adjusted return on assets (ROA) and return on net operating assets (RNOA) is that the denominator in RNOA is typically smaller than the denominator in ROA because the former is net of operating liabilities.

Answer: False Rationale: It is true that the denominator in RNOA is typically smaller but the other difference between the ratios is that the numerators are different. ROA includes all net income whereas RNOA includes only net profits from operating activities.

LIFO inventory costing yields more accurate reporting of the inventory balance on the balance sheet.

Answer: False Rationale: LIFO assumes that the most recently purchased goods are sold, thus the cost of the oldest items remain in the inventory balance. Hence, the balance sheet reports inventories at less current costs.

Retained earnings articulate across time which means that last period's retained earnings plus current period net income (or loss) is equal to the current period's retained earnings.

Answer: False Rationale: Last period's retained earnings plus current period net income (or loss) less any dividends paid, is equal to the current period's retained earnings.

Net operating profit after tax (NOPAT) is equal to net income less interest expense incurred during the year.

Answer: False Rationale: NOPAT is computed from the income statement and equals operating revenues less operating expenses, all of which is expressed on an after-tax basis.

Operating leases appear as liabilities on the lessee's balance sheet.

Answer: False Rationale: Operating leases do not appear on the lessee's balance sheet. An operating lease is considered a form of off-balance sheet financing for the lessee. The company merely footnotes their existence and key details in the annual report. Lease payments are reported as rent expense on the lessee's income statement.

Operating leases increase interest expense in the income statement, while decreasing net cash flows in the cash flow statement, compared with capital leases.

Answer: False Rationale: Operating leases record rent expense, rather than interest and depreciation. Further, the lease payments (e.g., cash outflows) are the same, whether or not the lease is capitalized.

Using the capital lease method requires that both the lease asset and lease liability be reported off the balance sheet.

Answer: False Rationale: The capital lease method requires that both the lease asset and lease liability be reported on the balance sheet. The leased asset is depreciated like any other long-term asset. The lease liability is amortized like a note, with lease payments separated into interest and principal repayment.

For tax reporting purposes, companies typically transfer more of the asset's cost from the balance sheet to the income statement in the earlier years of the asset's life. This is called accelerated depreciation and it is a benefit to the company. Thus, companies record deferred tax assets (benefits) for this accelerated depreciation.

Answer: False Rationale: Accelerated depreciation reduces taxable income and, consequently, the current tax liability and, thereby, increases cash flows early in the asset's life. Over the life of the asset, the company must make up these taxes, thus accelerated depreciation creates a deferred tax liability and not an asset.

Failure to recognize lease assets and liabilities results in understated financial leverage and understated net operating profit (NOPAT).

Answer: False Rationale: Failure to recognize lease assets and liabilities usually overstates NOPAT because the entire lease payment is deducted from NOPAT instead of just the depreciation portion.

A bond selling for lower market rate of interest than coupon rate is said to be selling at a discount.

Answer: False. A bond selling for lower market rate of interest than coupon rate is said to be selling at a premium.

Assets are listed on the balance sheet in order of solvency and liabilities are listed in order of maturity.

Answer: False. Assets are reported in the order of liquidity in that they are generally expected to be converted into cash. Receivables are, thus, reported before inventories, and inventories before PPE. Liabilities are reported in order of maturity, with current liabilities expected to be paid within one year and long-term liabilities expected to be paid over a longer period of time.

Publicly traded companies provide financial information primarily to satisfy demands for accounting information from the tax authorities such as IRS and regulators SEC.

Answer: False. Demand for information extends to many users; the regulators such as the SEC and the IRS are only one class of users.

Litigation liability is recorded on the balance sheet when it is probable that there will be litigation loss from the lawsuit.

Answer: False. For a litigation liability to be recorded on the balance sheet, the litigation loss has to be probable and estimable.

Operating leases are recorded as assets and liabilities on the lessee's balance sheet.

Answer: False. Operating leases do not appear on the lessee's balance sheet. An operating lease is considered a form of off-balance sheet financing for the lessee. The company merely footnotes their existence and key details in the 10-K annual report. Operating lease payments are reported as rent expense on the lessee's income statement.

Company Q builds a facility for research and development activities, as well as for general administrative purposes. Under GAAP, this facility should not be capitalized (i.e., recorded on the balance sheet as PP&E), but instead should be fully expensed.

Answer: False. R&D costs must be expensed under GAAP unless they have alternative future uses. If these assets have alternative uses other than research and development purposes, these assets will be capitalized and depreciated instead of being fully expensed.

Employee severance costs are reported in the income statement when the actual payment for these costs occurs.

Answer: False. Restructuring costs are recognized according to the GAAP rule that requires companies to satisfy its criteria (board approval of the plan, and notification to relevant parties) irrespective of the timing of actual payments of those costs.

The income statement reports net income which is defined as the company's profit after all expenses and dividends have been paid.

Answer: False. The statement contains two errors. First, net income does not include any dividends during the period; these are a distribution of profits and not part of its calculation. Second, the income statement is prepared on an accrual basis and thus includes expenses incurred (as opposed to paid).

A balance sheet shows a company's position over a period of time, whereas an income statement, statement of stockholders' equity, and statement of cash flows show its position at a point in time.

Answer: False. The statement is reversed: A balance sheet shows a company's position at a point in time, whereas an income statement, statement of equity, and statement of cash flows show its position over a period of time.

A customer's prepayment for services not yet rendered is initially recorded as unearned revenue (a liability). Then, at the end of the accounting period, the unearned revenue is moved from the balance sheet to the income statement. This is an example of the revenue recognition principle.

Answer: False. Unearned revenue is recorded for customer prepayments. But it is only moved to the income statement when the services have been rendered and not automatically at the end of the accounting period.

All else equal, operating leases have lower depreciation expense in the income statement, while higher net cash flows in the cash flow statement, compared with capital leases.

Answer: False. While operating leases record rent expense, capital leases record interest and depreciation expenses in the income statement. Further, the lease payments (e.g., cash outflows) are the same, whether or not the lease is capitalized or not.

Operating leases have higher depreciation expense in the income statement, while lower net cash flows in the cash flow statement, compared with capital leases.

Answer: False. While operating leases record rent expense, capital leases record interest and depreciation expenses in the income statement. Further, the lease payments (e.g., cash outflows) are the same, whether or not the lease is capitalized or not.

Unearned revenue, an operating liability, arises when a company receives cash before any goods are delivered or services are rendered.

Answer: True

R&D expense is treated as an operating expense, not a capital expenditure, unless the R&D assets acquired have an alternative future use.

Answer: True Rationale: Although the R&D assets are similar to regular plant assets, under GAAP, R&D costs are expensed unless the R&D assets have alternative future uses.

Assets generally are reported on the balance sheet at its cost.

Answer: True Rationale: Assets are generally reported at historical costs. An exception is marketable securities.

A bond selling for higher market rate of interest than coupon rate is said to be selling at a discount.

Answer: True Rationale: By definition of discount bond.

In 2006, Target paid $750 million of cash dividends. These dividends reduced assets and reduced retained earnings.

Answer: True Rationale: Cash dividends result in a reduction in cash and retained earnings.

Accrued liabilities are obligations for which there is no external transaction.

Answer: True Rationale: Companies must estimate accrued liabilities such as rent payable because there has been no bill received or no transaction.

Because diluted EPS include dilutive securities such as convertible securities and employee stock options, it must always be less than or equal to basic EPS.

Answer: True Rationale: Diluted EPS includes dilutive securities in the denominator of the ratio. Therefore the diluted EPS ratio must always be less than or equal to basic EPS.

Contingent liabilities that are 'probable' and can be reasonably estimated are recorded on the balance sheet as a liability and as an expense in the income statement.

Answer: True Rationale: Only 'probable' contingent liabilities are estimated and recorded on the balance sheet or the income statement. Anything less than 'probable' liabilities (such as 'reasonably possible') are referenced in footnotes.

Companies that engage in long-term sales contracts such as construction projects often use the percentage of completion method to recognize revenue. This means that revenue is recognized in proportion to the project's completion.

Answer: True Rationale: Percentage of completion method recognizes revenue by determining the costs incurred under the contract relative to its total expected costs and not evenly over time.

Ratios provide one way to compare companies in the same industry regardless of their size.

Answer: True Rationale: Ratios mitigate problems arising from different sizes of companies.

Stockholders' equity is not accounted for at current fair value.

Answer: True Rationale: Stockholders' equity is accounted for at historical cost, just like assets and liabilities.

Credit ratings are an opinion of a company's relative default risk.

Answer: True Rationale: The credit rating agencies provide an assessment of their view of the likelihood that a company will default on its debt obligations.

An increase in treasury stock would be reflected in the statement of stockholders' equity.

Answer: True Rationale: The statement of stockholders' equity reports on changes in the accounts that make up stockholders' equity. This includes contributed capital, retained earnings, and treasury stock.

An increase in accumulated other comprehensive income would be reflected in the statement of stockholders' equity.

Answer: True Rationale: The statement of stockholders' equity reports on changes in the accounts that make up stockholders' equity. This includes contributed capital, retained earnings, treasury stock, and accumulated other comprehensive income.

Under accrual accounting principles, the cost of inventory should be reported as an expense in the income statement when it is sold, regardless of when it was purchased.

Answer: True Rationale: Under accrual accounting, the cost of inventory is reported as expense in the period in which it is used up, typically at the point of sale. Purchased inventories that have not yet been sold are reported as assets, notwithstanding whether or not they have been paid for.

Assets are listed on the balance sheet in order of liquidity and liabilities are listed in order of maturity.

Answer: True. Assets are reported in the order that they are generally expected to be converted into cash. Receivables are, thus, reported before inventories, and inventories before PPE. Liabilities are reported in order of maturity, with current liabilities expected to be paid within one year and long-term liabilities expected to be paid over a longer period of time.

In general, in a period of rising prices, LIFO results in higher cost of goods than FIFO.

Answer: True. Cost of goods sold is determined by the choice of inventory costing method. Specifically, in periods of rising costs and prices, LIFO produces higher cost of goods than FIFO. The converse holds true in periods of falling prices.

While pension assets are operating assets, pension liabilities are non-operating (i.e., financing) liabilities in the balance sheet.

Answer: True. Pension assets are contributed as part of future employee compensation expenses. Therefore, pension assets are considered as operating assets. However, pension liabilities incur interest expense per income statement, hence are financing liabilities.

Company Q builds a facility for research and development activities, as well as for general administrative purposes. Under GAAP, this facility should be capitalized (i.e., recorded on the balance sheet as PP&E) and depreciated over its useful life.

Answer: True. R&D costs must be expensed under GAAP unless they have alternative future uses. If these assets have alternative uses other than research and development purposes, these assets will be capitalized and depreciated instead of being fully expensed.

Employee severance costs, as part of board-approved restructuring plans, are reported in the income statement even if the actual payment for these costs occurs in subsequent periods.

Answer: True. Restructuring costs are recognized according to the GAAP rule that requires companies to satisfy its criteria irrespective of the timing of actual payments of those costs.

Return on Assets (ROA) measures the profit the company makes on each dollar of total assets it uses.

Answer: True. Return on Assets is a profitability metric that measures how much profit the company made for each dollar of assets the company holds on average during the year.

The increase in pension obligation due to an employee working an additional year for the employer will cause the net assets on the balance sheet to decrease.

Answer: True. The increase in the pension obligation arises from increases in service and interest costs. Because pension obligation (PBO) increase results in decrease in net pension assets, such increase due to increase in service costs would cause the net assets on the balance sheet to decrease.

For underfunded pension plan, the increase in pension obligation due to an employee working an additional year for the employer will cause the net liabilities on the balance sheet to increase.

Answer: True. The increase in the pension obligation arises from increases in service and interest costs. Because pension obligation (PBO) increase results in increase in net pension liabilities, such increase due to increase in service costs would cause the net assets on the balance sheet to decrease.