Question #1 of 84
Question ID: 462513ᅞ A) ᅞ B) ᅚ C)
Question #2 of 84
Question ID: 462511ᅚ A) ᅞ B) ᅞ C)
Question #3 of 84
Question ID: 462498ᅞ A) ᅞ B) ᅚ C)
Financial Reporting and Analysis
:
Quality of Financial Reports and
Financial Statement Analysis
Test ID: 7440516
Holdall Corporation recently reclassified many of their assets such that the average useful life of their depreciable assets was reduced.
Which of the following is the mostlikelyresult from this change onnet income and inventory turnover? (Assume everything else remains constant.) Net income will:
decrease and inventory turnover will rise. increase and inventory turnover will not change.
decrease and inventory turnover may or may not change.
Explanation
Depreciation expense increases as the depreciable life ofanasset decreases. Thus, net income will decline. Depreciation will only affect inventory turnover ifdepreciation has beenallocated to individual inventory items; whenand why this happens is outside the scope of the Level II curriculum.
Afirm seeking to lowercurrent tax liability may elect to use which method of inventory valuationduringan inflationary period?
LIFO. FIFO. Average cost.
Explanation
Duringa inflationary period, using LIFO would increase COGS, since the most recent (highest cost) inventory would be sold. Therefore, earnings and taxes would be lowest under LIFO.
Jeremy Jennings is explaining the concept of earnings quality to his new colleagues. Which of the following measures is most indicative ofa higher quality of earnings whenattempting to forecast future earnings?
Higher level of earnings.
Higherdegree ofconservatism of earnings. Higherdegree ofpersistence of earnings.
Explanation
Question #4 of 84
Question ID: 462495ᅚ A)
ᅞ B)
ᅞ C)
Question #
5
of 84
Question ID: 462526ᅞ A) ᅞ B) ᅚ C)
Measuring earnings quality based onconservative earnings is an inferior measure whenattempting to forecast future earnings because most accruals will self-correct over time. For example, the lower earnings that result from accelerateddepreciation will increase in the later years of the asset's life. Focusing onaccruals anddeferrals is a more effective way of measuring earnings quality.
A higher level of earnings has no impact on increasing the quality of earnings since the former may be derived largely from earnings manipulation on the part of management.
With regard to specific measures to analyze indetecting manipulation in the financial reportingprocess, which of the following statements is the leastaccurate?
A decreasing days' sales outstanding (DSO) measure may be an indication of lower quality revenue.
Negativenonrecurringornon-operatingitems may beindicativeofmisclassifyingan operatingexpense.
Anincreasingdays' inventoryon hand (DOH)measuremay beindicativeofobsolete inventory.
Explanation
Days' sales outstanding (DSO)measures thenumberofdays it takes toconvert receivables intocash andis calculated by dividing thenumberofdays in theperiod by theaccounts receivable turnoverratio. Anincreasing DSO (decreasing
receivables turnover)may beanindicationoflower qualityrevenue; that is, thelongerit takes tocollect fromcustomers, the morelikely thereceivables will turninto baddebt.
Days' inventoryon hand (DOH)is equal to thenumberofdays in theperioddivided byinventory turnoverratioandit measures thenumberofdays it takes to sellinventory. Anincreasing DOH may beindicativeofobsoleteinventory. Analysts shouldcomparechanges in thecoreoperatingmarginover timeandlookfornegativenonrecurring (e.g.,
restructuringcharges, asset impairments, and write-downs)ornon-operatingitems that occurred when theratioincreased. This may be theresult ofmisclassifyinganoperatingexpense.
Due toachangeinaccounting standards, TRK Construction's QSPE must now beconsolidated. TheQSPE has purchased, TRK's accounts receivables and hadfinanced those with notes payables. Assume that TRK's current ratio beforeconsolidation is 1.10. Consolidation willmostlikelyresult in which of thefollowing:
an increase in the current ratio. nochangein thecurrent ratio. adecreasein thecurrent ratio.
Explanation
Question #6 of 84
Question ID: 462480ᅚ A) ᅞ B) ᅞ C)
Question #7 of 84
Question ID: 472492ᅞ A) ᅞ B) ᅚ C)
Question #8 of 84
Question ID: 472508Thefollowinginformationpertains to Morley Inc. (Morley)andCrowell Inc. (Crowell)for 2007and 2008:
Accrual
Ratio
2
008
2
007
M
orley
1
6.
1
%
14
.
7
%
Cro
w
ell
6.9%
8
.5%
Basedon theinformationprovided, which of thefollowingconclusions about the twocompanies is mostappropriate?
Crowell's earnings quality is higher than Morley's. Morley's earnings qualityis higher thanCrowell's.
Crowell's earnings qualityis deterioratingcompared to Morley's.
Explanation
Crowell's earnings qualityis higher becauseits accrualratiois lowerin both years. Furthermore, Crowell's earnings qualityis alsoimproving (due to thedecreaseinits accrualratio) while Morley's is deteriorating (due to theincreaseinits accrualratio).
Aggressiverevenuerecognitionpractices areleastlikely toincrease:
reported expenses reportedassets
reportedendinginventory
Explanation
Aggressiverevenuerecognitionpractices wouldincreaseaccounts receivable, revenues, expenses, incomeand stockholder's equity. Endinginventory woulddecline but byless than theincreaseinaccounts receivableresultinginincreasein totalassets. Earlyrecognitionofrevenues alsoaccelerates recognitionofexpenses (COGS).
Samuel Maskin, CFAis evaluating thefinancial statements of Northern Energy Inc. Thefollowingis anextract from Northern's cash flow statement for thepast threeyears:
20x6 20x5 20x4
Net Income $1,023 $988 $744
Depreciation $187 $145 $128
ᅚ A)
ᅞ B)
ᅞ C)
Question #9 of 84
Question ID: 462514ᅚ A) ᅞ B) ᅞ C)
Accounts Payable $38 $37 $33
OCF $550 $719 $904
Therestructuringcharges for Northern has most likely:
Reduced reported earnings in 20x4 while increasing reported earnings in 20x5 and 20x6.
Increasedreportedearnings for 20x4 whilereducingreportedearnings in 20x5 and 20x6.
Increasedreportedearnings in 20x6 whilereducingreportedearnings in 20x4and 20x5.
Explanation
Restructuringcharges contributepositively to 20x4cash flow indicating that it was anon-cash chargeagainst that year's income. In thefollowing twoyears, thereis areversalof that chargeleading toanartificialincreaseinreportedearnings for 20x5 and 20x6.
StarChemical Inc. (SCI)reported thefollowingyear-enddata:
D
epreci
a
t
ion
e
x
pen
s
e
$25
million
N
e
t
income
$35
million
D
i
v
idend
s
$
10
million
To
t
a
l
a
ss
e
ts
$25
0
million
S
ha
re
h
older
'
s
e
q
ui
t
y
$
1
95
million
E
ffec
t
i
v
e
t
ax
r
a
t
e
35
percen
t
SCI alsoreported that it changedfromanaccelerateddepreciationmethod to straight linedepreciation. Thechangeresulted inadecreaseindepreciationexpenseof $5 million. Management felt that thechange "wouldnot haveamaterialeffect on financialperformancemeasures." Ignoringdeferred taxes, what are thereturnonassets (ROA)andreturnonequity (ROE) measures under theolddepreciationmethods?
ROA is 12.96% and ROE is 16.56%. ROAis 13.30% andROE is 17.05%. ROAis 13.50% andROE is 17.51%.
Explanation
Question #10 of 84
Question ID: 414656ᅞ A) ᅚ B) ᅞ C)
Question #11 of 84
Question ID: 462536ᅞ A) ᅞ B) ᅚ C)
D
epreci
a
t
ion
e
x
pen
s
e
$3
0
million
($25 + $5
)
N
e
t
income
$3
1
.
7
5
million
($35 - $3.25
)
To
t
a
l
a
ss
e
ts
$2
4
5
million
($25
0
- $5
)
S
h
a
re
h
older
's
e
q
ui
t
y
$
1
9
1
.
7
5
million
($
1
95 − $3.25
)
Note that assets would have beenlower by $5 milliondue to theaccelerateddepreciationandequity would belower by $3.25 million ($5 × (1 − 0.35))due tolowerretainedearnings. Inorder to balance the $5 millionreductioninassets, equity willfall by $3.25 millionand tax liabilities willfall by $1.75 million. Therefore, ROA would have been12.96% ($31.75 / $245)andROE would have been16.56% ($31.75 / $191.75).
JoeCarter, CFA, believes Triangle Equipment, amakeroflarge, specializedindustrialequipment, has overstated the salvage valueofits equipment. This would:
overstate liabilities. overstateearnings. understateearnings.
Explanation
Overstating the salvage valuereduces depreciationexpense, which in turnincreases earnings.
Ananalyst finds return-on-equity (ROE)agoodmeasureofmanagement performanceand wants tocompare twofirms: Firm AandFirmB. FirmAreports net incomeof $3.2 millionand has aROE of18. FirmBreports incomeof $16 millionand has an ROE of16.
Areview of thenotes to thefinancial statements forFirmA, shows that theearnings includealoss from smeltingoperations of $400,000and that thefirm has exited this business. Inaddition, thefirm sold the smeltingequipment and hadagainon the saleof $300,000.
A similarreview of thenotes forFirmBdiscloses that the $16 millioninnet incomeincludes $2.6 milliongainon the saleofno longerneededofficeproperty. Assume that the tax ratefor both firms is 36%, and that thenotes describepre-tax amounts. Which of thefollowingis closest to the "normalized" ROE forFirmAandforFirmB, respectively?
16.0 and 18.0. 17.1and16.9. 18.4and14.3.
Question #14 of 84
Question ID: 462481ᅞ A)
ᅚ B)
ᅞ C)
Question #15 of 84
Question ID: 414657ᅞ A) ᅚ B) ᅞ C)
Costiuk Inc. (Costiuk) saw a largeincreaseinits net operatingassets (NOA) over the year. During the year, it also reported a number of nonoperatingrevenues and deferred revenues. Which of the following statements regarding Costiuk's increasein NOA and the most likely item to self-correct is most accurate?
Increasein NOA Most likely item to se lf-correct
suggests lower earning
quality nonoperating revenues
suggests lowerearning quality deferred revenues
suggests higherearning qualitynonoperatingrevenues
Explanation
Deferrals and accruals are most likely to self-correct.
The largeincreaseinnet operatingassets is indicative of a high accruals ratio as demonstrated by the followingequation:
Accruals = NOA − NOA
Ininterpreting theratio, the higher theratio, the lower theearnings quality.
Nonrecurringand nonoperatingrevenues do not typically self-correct like deferrals and accruals, thereby providingagreater manipulation benefit to the firm.
Analyst Jane Kilgoreis worried that some of Maxwell Research's accrual accountingpractices will lead to excessive operating earnings recognitionin thenear-term. Examples of Kilgore's concerns include the following:
Accelerated revenuerecognition of serviceagreements. Classification of recurringrevenueas nonrecurringrevenue. Understated inventory obsolescence.
Which of Kilgore's concerns is least likely to overstate current operatingearnings?
Understated inventory obsolescence.
Classification of recurringrevenueas nonrecurringrevenue. Accelerated revenuerecognition of serviceagreements.
Explanation
Classification of recurringrevenueas nonrecurringrevenue will understate current operating earnings. The other two items act BS
Question #1
6
of 84
Question ID: 462517ᅞ A) ᅚ B) ᅞ C)
Question #17 of 84
Question ID: 462492ᅞ A)
ᅚ B)
ᅞ C)
Question #18 of 84
Question ID: 462503to overstaterevenueand understateexpenses.
A firm has booked as a sale, the transfer of $100 million in short-term accounts receivable to Public Finance Co., subject to recourse. Thenotes to the financial statements disclose that as of theend of the fiscal year, $80 millionremained uncollected. In order to reflect this on the balance sheet, which of the following adjustments must be made?
Decrease retained earnings and increase accounts receivable.
Increaseaccounts receivableand increase current liabilities. Decrease cash and increaseaccounts receivable.
Explanation
Since theaccounts receivable were sold with recourse, therisk on uncollected accounts remains with the company.
De Freitas Inc. (De Freitas) is a conglomerate. Its computer division was very profitable in the current year because it
launched a successful new lightweight laptop computer. Prices in theautomobile division have beenrising over the years but it is engaged ina LIFO liquidation in the current year. Which of the following best describes theeffect on the long-runearnings of the computer divisionand theautomobile division compared to the most recent year?
Computer division earnings
Automobile division earnings
Decrease Increase
Decrease Decrease
Increase Decrease
Explanation
Whenexamining earnings, analysts should beaware that earnings at extreme levels tend to revert back to normal levels over time. This phenomenon is knownas meanreversion. Forexample, capital is attracted to successful projects (i.e. thenew laptop) thereby increasing competitionand decreasing earnings in the long-run.
A LIFO liquidation involves selling more goods thanarereplaced. Thus, theautomobile division penetrated the older, lower cost layers of inventory thereby increasing profit. This higher profitability is not sustainable, however, because the firm will eventually run out of lower priced inventory. In the long-run, theearnings will decrease (to normal levels).
ᅚ A) ᅞ B) ᅞ C)
Question #1
9
of 84
Question ID: 472490ᅚ A) ᅞ B) ᅞ C)
Question #
2
0 of 84
Question ID: 462509ᅞ A) ᅞ B) ᅚ C)
facilitate an economic decision.
justify trading decisions for purposes of the Statement of Codeand Standards. document portfolio changes for purposes of the Prudent Investor Rule.
Explanation
The primary goal of financial statement analysis is to facilitateaneconomic decision. Forexample, the firm may use financial analysis to decide whether to recommend a stock to its clients. Documentationand justification of trading decisions may be aided by financial statement analysis, but thesearenot the primary purposes.
To assess the quality of financial reports, which question is least necessary forananalyst to answer?
Are reported earnings consistent with the firm's budget? Do earnings represent anadequate level of return?
Are the financial reports decision useful and GAAP compliant?
Explanation
Quality of financial reports is assessed by answering two questions: Whether the financial reports are decision useful and GAAP compliant and whether theresults quality is high (i.e., earnings provideadequatereturn on capital and are sustainable).
Express Delivery Inc. (EDI) reported the following year-end data:
D
ep
r
eci
a
t
io
n
e
x
pe
ns
e
$3
0
millio
n
N
e
t
i
n
come
$3
0
millio
n
To
t
a
l
ass
e
t
s
$535
millio
n
S
h
ar
e
h
ol
d
e
r
'
s
e
q
u
i
t
y
$
1
5
0
millio
n
E
ffec
t
i
v
e
t
a
x
ra
t
e
35
pe
r
ce
n
t
Last year EDI purchased a fleet of delivery vehicles for $140 million. For the first year, straight-line depreciation was used assuming a depreciable life of 7 years with no salvage value. However, at year-end EDI's management determined that assumptions of a useful life of 5 years with a salvage value of 10 percent of the original value were moreappropriate. How would thereturn onassets (ROA) and return onequity (ROE) for last year change due to the change in depreciation assumptions? ROA and ROE would beclosest to:
ROA 5.7% and ROE 19.5%. ROA 5.3% and ROE 20.5%.
Question #
22
of 84
Question ID: 414668ᅚ A) ᅞ B) ᅞ C)
Question #
23
of 84
Question ID: 462491ᅞ A) ᅚ B) ᅞ C)
Question #
2
4 of 84
Question ID: 462535ᅞ A)
Junioranalyst Xander Marshall sends ane-mail to his boss, Janet Jacobs, CFA, suggesting that Peterson Novelties is manipulating its results to artificially inflate profits. He cites fourreasons for his conclusion:
The LIFO reserve is declining.
Earnings are much higher in the September quarter than in other quarters. Many nonoperating and nonrecurring gains are being recorded as revenue.
Much of Peterson's earnings come from equity investments not reflected on the cash-flow statement.
Jacobs is less concerned about Peterson's earnings than Marshall is, though she does resolve to check out one of his concerns. Which of Marshall's observations best supports his conclusion?
Equity investment earnings not reflected on the cash-flow statement.
The declining LIFO reserve.
Nonoperating and nonrecurring gains recorded as revenue.
Explanation
On its own, a declining LIFO reserve is not a sign of fraud. Peterson Novelties could have simply moved a lot of inventory and disclosed the LIFO liquidation in its footnotes. When unusual gains arerecorded as revenue they will artificially boost sales growth. Each of theabove issues are potential danger signs, but canalso beeasily explained ina manner beyond reproach. However, earnings from equity investments that do not generate cash flow are of very low quality and warrant further examination.
Complete the following sentence. The cash component of income is ___________ than theaccrual component.
the same persistence. more persistent. less persistent.
Explanation
Theaccrual component of income (accruals) is less persistent than the cash component. By persistent we mean the income is sustainable; that is, a dollar of earnings today implies a dollar of earnings in future periods. Lower persistency is partially due to theestimates involved with accrual accounting.
Endrun Company reported net income of $4.7 million in 1999, and $4.3 million in 2000. Inreviewing theannual report an analyst notices that the Endrun took a charge of $2.4 million in 1999 for the costs of relocating its main office, and in 2000 booked a gain of $900,000 on the sale of its previous office building. What would "normalized earnings" be for 1999 and 2000 if weassumea tax rate of 36% for both years?
ᅞ B) ᅚ C)
Questions #
25-26
of 84
$3.99 millionand $2.54 million. $6.236 millionand $3.724 million.Explanation
You will increase 1999 earnings by the tax-adjusted value of the 2.4 million one-time charge (2.4 × (1 - 0.36) = +1.536), and you would decrease Y2000 earnings by the tax-adjusted amount of the $0.9 million one-time gain (0.9 × (1 - 0.36) = -0.576).
George Edwards is a senioranalyst with The Edge Group, an independent equity research firm specializing in micro cap companies that haverecently had an initial public offering, orare likely to go public within thenext three years. Over the current market cycle, small company stocks have been the leading performers in theequity market, and micro cap money managers have had huge cash inflows due to their funds' strong performance. With anexcess amount of cash and few good investment opportunities due to the high valuations in the marketplace, fund managers have turned to independent research firms like The Edge Group to help them discovernew investment ideas.
With a largenumber of mutual fund managers asking them forresearch reports, business at The Edge Group is booming. To help handle the largeamount of business, Edwards has hired two new junioranalysts, Paul Kelley and Rachael Schmidt. Both Kelley and Schmidt have degrees in finance, and came highly recommended to Edwards.
In Kelley and Schmidt's orientation meeting, Edwards told them that what has made The Edge Group successful in delivering quality research to its clients is its willingness to dig into company financial statements and not take theaccounting numbers at face value. Every item in the financial statements should be scrutinized and adjusted if necessary. Edwards tells thenew analysts that if there is one lesson they should learn, it is that "there is a difference betweenaccounting reality and economic reality."
For their first assignment, Edwards has asked thenew analysts to put togethera draft of aresearch report on Landesign, an architecture firm specializing in landscape design for municipalities, residential developments, and wealthy individuals. The firm also sells various kinds of stoneand plastic products which are used in landscaping applications. Edwards tells thenew analysts that he will help put together thereport, but he would like them to do a majority of the legwork.
Since it was founded seven years ago, Landesign has grownat anannual rateexceeding 20%. Much of the growth comes from Landesign's acquisitions of regional competitors. Edwards points out to theanalysts that Landesign used purchase method accounting. Kelley, looking to impress Edwards with his knowledge, tells him that when one company acquires another, assets of both companies arerestated to fair market value, and that higher depreciation can lead to lower quality earnings. Not wanting to be outdone, Schmidt adds that liquidity measures such as the quick ratio and the cash ratio should improveas Landesign makes acquisitions.
Kelley decides to review Landesign's 2004 financial statements and makenotes about significant accounting practices being used. His notes are shown in theexhibit below:
Exh
i
b
i
t
1
: K
elley
'
s
N
o
t
e
s
o
n
L
and
e
s
ig
n
'
s
Acco
un
t
i
n
g
P
ra
c
t
ice
s
The firm uses First In, First Out (FIFO) accounting. As a sidenote, the current inflationrate has remained relatively constant at anannual rate of 3%.
Equipment and office furnitureare depreciated based on the 200% declining balance method. Fixed assets (equipment) are generally assigned short useful lifeestimates.
Theexpected return on defined benefit pension planassets is 2 to 3 percentage points below the long-term rate of return for similarassets.
Question #
25
of 84
Question ID: 462507ᅞ A)
ᅚ B) ᅞ C)
Question #
26
of 84
Question ID: 462508ᅚ A) ᅞ B) ᅞ C)
2003 and 2002, respectively.
Schmidt notices that the footnotes to Landesign's financial statements includeareference to anagreement to receivea minimum amount of stone used to construct landscape walls from a supplier. Under the terms of theagreement, Landesign will pay for the stone whether it is used in the current accounting period ornot. Theagreement allows Landesign to pay a price that is significantly less than the current market price for similar quality stone.
A second footnote indicates that Landesign has aneight-yearrental commitment fora greenhouse used to grow plants and store mulch that Landesign uses in the landscaping process. On the financial statements, $55,000 inrent expense for the greenhouse is listed on the income statement. The footnotealso states that the $55,000 rental expense payment was agreed upon with Fred's Nursery, the owner of the greenhouse, based uponan interest rate of 7%.
A third footnote indicates that Landesign has sold its accounts receivable to Dais Enterprises for 95% of their original value of $130,000. The footnote indicates that Landesignretains therisk of noncollection of thereceivables.
The final footnote on the page indicates that Landesign has arevolving line of credit at which it can borrow funds in the future at an interest rate of 6%.
After going through the information, Kelley and Schmidt discuss their findings and start to work on theirreport for Edwards.
Which of the following items noted in Kelley's Notes on Landesign's Accounting Practices would least likely be considered indicators of high earnings quality. Landesign's use of:
the 200% declining balance method of depreciation on its furniture and equipment.
FIFO accounting ina mildly inflationary economy. short useful lifeestimates for fixed assets.
Explanation
High earnings quality is established by a clearand conservativeapproach to stating earnings. Even though inflation is
relatively mild, FIFO accounting will result in lower cost of goods sold (COGS), and highernet income. This is moreaggressive than the use of Last In, First Out (LIFO) method. Short useful lives for fixed assets, use of accelerated depreciation, and using a conservativeestimate forreturns on pensionassets will all tend to increaseexpenses and areexamples of conservative accounting practices.
Which of the following adjustments should Schmidt make to Landesign's financial statements to account for the greenhouse that Landesign uses to grow plants and store mulch?
Increase both liabilities and assets by $341,500.
Increase both liabilities and assets by $328,400. Increase liabilities and decreaseequity by $440,000.
Explanation
Question #
2
7 of 84
Question ID: 456302ᅞ A) ᅞ B) ᅚ C)
Question #
2
8 of 84
Question ID: 462512ᅞ A)
ᅞ B) ᅚ C)
the firm's financing rate or therate implicit in the lease. Weare told that therental payments of $55,000 are based onan interest rate of 7%. However, weare told inanother footnote that Landesignexpects to beable to borrow funds in the futureat arate of 6%. We therefore use the lower firm financing rate of 6% in our computation. The present value of the lease
payments is: N = 8; I/Y = 6%; PMT = -55,000; FV = 0; CPT PV = $341,539.
Samson Therapeutics records all leases as operating leases. Compared to recording capital leases, this results in lower:
inventory. expenses. leverage.
Explanation
Finance (capital) leases arerecorded on the balance sheet, and by recording all leases as operating leases, the company can reduce its leverage. Leaseaccounting has no effect on inventory. "Expenses" is not the best answeras operating leases will result in higherexpenses in the later years relative to the finance (capital) lease.
Millennium Airlines Corp. (MAC) reported the following year-end data:
Rent expense $24 million Depreciationexpense $17 million
EBIT $88 million
Interest expense $22 million Total assets $500 million Long-term debt $150 million
Capital lease obligations$100 million Total equity $250 million
MAC also reported that the present value of its operating leases at the beginning of the year was $128 millionat 10% interest rate. The term on the leases was 8 years. Ignoring taxes, what are theeffects on the leverage (liabilities / total capital) and times interest earned if ananalyst chooses to capitalize the leases using a straight-line depreciation (zero salvage, life = lease term) assumption? Leverage measures:
increase to 65% from 50% and times interest earned decreases to 1.78 times from 4 times.
remain unchanged and times interest earned decreases to 1.78 times from 4 times. increase to 60% from 50% and times interest earned decreases to 2.76 times from 4 times.
Question #
29
of 84
Question ID: 462482ᅞ A) ᅞ B) ᅚ C)
Using thereported data the leverage measure is 0.50 ((150 + 100) / (150 + 100 + 250)) and times interest earned is 4 times (88 / 22). Following the capitalization of the operating leases the balance sheet values are:
Totalassets $612 million (500assets + 128leases - 16 depreciation onleases)
Valueofoperatingleases $116.80million(Ending Leaseliability = 128Beglia + 12.8
Int - 24Rentpayment)
Long-termdebt $150million unchanged
Capitalleaseobligations $100million unchanged
Totalequity $245.2 million (250 + 24rentpayment − 16 dep − 12.8 interest)
Therefore, the leverage measure is 0.60 ((116.80 + 150 + 100) / (116.8 + 150 + 100 + 245.2)).
The income statement is affected in the following way:
reported EBIT 88
+ rentexpense 24
= EBITexcludingcostofoperatingleases 112
- depreciationofoperatingleases 16 ($128million/8years)
= adjusted EBIT 96
Interest expense will increase by $12.8 million ($128 million × 0.10) to $34.8 million. Therefore times interest earned decreases to 2.76 times (96 / 34.8). Recall that when capitalizing operating leases interest expense is calculated as the present value of the lease obligations multiplied by implied interest rate.
Fero Inc. (Fero) is a successful computer consulting services firm that has anestablished policy of investing its excess cash in short-term, virtually riskless, and highly liquid money market securities. However, it has recently deviated from this policy by investing in commercial paperand medium-cap domestic equities. As well, Fero entered into a $1.0 million lease with Pasquale Inc. (Pasquale) for some specialized computerequipment on December 28, 2008 that will be shipped at the very start of its next fiscal period on January 1, 2009. Inexchange for the lease, Fero agrees to provide consulting services to Pasquale. Which of the following activities is one in which Fero is least likely involved?
Misclassifying cash flow.
Ignoring cash flow. Managing cash flow.
Explanation
Fero is ignoring cash flow, most likely misclassifying cash flow, but there is no evidence that Fero is managing cash flow. Firms can misrepresent their cash generating ability by misclassifying investing activities as operating activities and vice versa. For example, under U.S. GAAP, the cash flow statement reconciles the changes in cash and cash equivalents. Cash equivalents include short-term, highly liquid investments. Some firms park cash in longer-term investments such as marketable debt and equity securities. Typically, theacquisitionand disposal cash flows from these longer-term investments arereported as investing activities in the cash flow statement.
Question #
3
0 of 84
Question ID: 462494ᅞ A) ᅞ B) ᅚ C)
Questions #
3
1
-36
of 84
equivalent of borrowing the purchase price. However, sinceno cash is involved, the transaction is not reported (it is ignored) on the cash flow statement throughout the life of the lease.
Holding everything else constant, theexistence of which of the following items will most likelyresult in direct cash inflows or outflows fora firm in the future?
Deferred expenses.
Unearned revenue. Accrued expenses.
Explanation
Accrued expenses areexpenses that have been incurred but not yet paid. Forexample, a firm may recognize wageexpense in one period but actually pay the wages ina later period. In this case, when theexpense is recognized in the income
statement, a liability is increased on the balance sheet (i.e., wages payable). When the wages are paid, the liabilities decrease as does the firm's cash (cash outflow occurs in the future).
Unearned (deferred)revenueoccurs whenpaymentisreceived inadvanceof providinggoodsorservices. Unearned revenue
isreported asaliabilityonthe balancesheet. Oncetherevenueisearned, theliability decreases. Forexample, amagazine
subscriptionis usuallypaid inadvance. Whenreceived, thepublisherincreasesitscash and recordsaliability foritsobligation
to deliver (cash inflow occursnow). Once deliveryoccurs, revenueisrecognized and theliability decreases.
Deferredexpenses arecoststhat will benefit futureperiods. Thesecosts usuallyinvolvenoncurrentassetsand prepaid
assets. Forexample, atenantmust usuallypay hisrentinadvance. Theresultisa decreaseinthetenant'scash and an
increaseinaprepaid asset (cash outflow occursnow). Oncetherentexpires, expenseisrecognized and theasset decreases.
Hatfield Industriesisalargemanufacturingconglomerate based inthe United States with annualsalesinexcessof $300 million. Itssharesaretraded onthe New YorkStock Exchange, and haveamarketcapitalizationof nearly $750million. Hatfield iscurrently underinvestigation bytheSecuritiesand ExchangeCommission (SEC) foraccountingirregularitiesand
possiblelegal violationsinthepresentationof thecompany's financialstatements. A due diligenceteam fromtheSEC has
beensentto Hatfield'scorporate headquartersin Philadelphia foracompleteauditinorderto furtherassessthesituation.
Several uniquecircumstancesat Hatfield are discovered bytheSEC due diligenceteam duringthecourseof theinvestigation:
Management has beeninvolved inongoingnegotiations with thelocallabor union, of which approximately40% of its full
-timelabor forcearemembers. Laborofficialsareseekingincreased wagesand pension benefits, both of which Hatfield's managementstatesisnotpossibleatthistime dueto decreased profitabilityand atightcash flow situation. Laborofficials
haveaccused Hatfield'smanagementof manipulatingthecompany's financialstatementsinorderto haveareasontonot grantanyconcessions duringthecourseof negotiations.
Allnew equipmentobtained overthepastseveralyears has beenestablished on Hatfield's booksasoperatingleases,
although pastacquisitionsof similarequipment wasnearlyalwaysclassified ascapitalleases. Financialstatementsof
industrypeersindicatethatcapitalleases forthistypeof equipmentarethenorm. TheSEC wants Hatfield'smanagement toprovide justification forthisapparent deviation from "normal" accountingpractices.
Question #
3
4 of 84
Question ID: 462477ᅚ A) ᅞ B) ᅞ C)
Question #
35
of 84
Question ID: 462478ᅞ A) ᅚ B) ᅞ C)
Question #
36
of 84
Question ID: 462479ᅞ A) ᅞ B) ᅚ C)
Question #
3
7 of 84
Question ID: 462531inventory, thecostof goodssold islower, leadingto higherprofitability. (StudySession7, LOS 23.f)
Which of the following findingsismost likelyto beanindicatorof potentialrevenue qualityissues?
Large increases in trade receivables.
Reductionin volatilityof theratioof revenuetocash collection. Lessor useof theoperatingleaseclassification.
Explanation
Revenue qualityissuesmay beindicated bylargeincreasesinaccountsreceivableorlarge decreasesin unearned revenue,
an increaseinthe volatilityof theratioof revenuetocash collections, and bylessor useof capitalleases (StudySession7, LOS 23.f)
Theaccrualsratiocanmost accurately becomputed asthe:
change in net operating assets divided by 2.
changeinnetoperatingassets divided byaveragenetoperatingassets.
cash flow fromoperatingactivitiesminuscash flow frominvestingactivities.
Explanation
Accrualsratiocan becomputed aschangeinnetoperatingassets divided byaveragenetoperatingassets. (StudySession7, LOS 23.e)
Which of the followingisleast likelyto beanindicatorof improperaccountingto boostoperatingperformance?
Classification of ordinary expenses as nonrecurring.
Deferralof expenses bycapitalizing.
Decreasesincoreoperatingmarginaccompanied byspikesinnegativespecialitems.
Explanation
Classificationof ordinaryexpensesasnonrecurringand deferralof expenses viacapitalization would improvereported
operatingmarginsas would increases incoreoperatingmarginaccompanied byspikesinnegativespecialitems. (LOS 23.f)
Aninvestorrelationsspokesperson fortheSquare DoorCorporation was quoted assayingthatSquare Doorshares werea
bargain, sellingataprice-to-earnings (P/E) ratioof 12, relativetotheS&P 500average P/E of 15.3. The financialstatements
ᅞ A) ᅚ B) ᅞ C)
Question #
3
8 of 84
Question ID: 462496ᅞ A) ᅞ B) ᅚ C)
Question #
39
of 84
Question ID: 472503ᅞ A) ᅚ B) ᅞ C)
portfoliotoitstradingportfolio. What would bethenormalized P/E?
15. 16.
13.
Explanation
Sincethe P/E ratio was12 and EPS was $4, thepriceof thestock was $48 (12 × 4). Afterremovingthenonrecurringgain, earnings will be $94.5 million (126 − 31.5). Weknow thenumberof sharesis 31.5 million (126 Million ÷ 4). Sothenew EPS
numberis 3 (94.5 million ÷ 31.5 million) and new P/E ratiois16 (48 ÷ 3).
Completethe followingsentence. Whenearningsarerelatively freeof accruals, meanreversion willoccur __________.
at the same rate as usual.
relatively fasterthan usual. relativelyslowerthan usual.
Explanation
Earningsconsistof cash flow and accrualsand thereisaninverserelationship betweenaccrualsand cash flow. When earningsarerelatively freeof accruals, meanreversion willoccurataslowerrate. Theoppositeistrue whenearningsare
largelycomprised of accruals.
Pysha Heavy Metals Ltd. suppliesspecialized metalstothechip fabricationindustry. Selected financial data for Pysha, as well asindustrycomparables, areshown below:
Pyshaselected financial data (£ '000s):
20x7 20x8 20x9
Sales 1,169 1,312 1,414
Accountsreceivable 58.45 72.16 98.98
Industryaverage:
20x7 20x8 20x9
DSO 22.6 22.8 22.4
Receivablesturnover 16.2 16.0 16.3
Based onthetrend inrevenuesand receivables, itcan bemost accuratelyconcluded that:
Pysha's revenues are growing at a faster rate than its receivables.
Pysha'srevenuesaregrowingataslowerratethanitsreceivables
Question #40 of 84
Question ID: 462527ᅚ A)
ᅞ B) ᅞ C)
Question #41 of 84
Question ID: 462529ᅞ A) ᅞ B) ᅚ C) Explanation
Pysha'srevenuegrowth rateislaggingthereceivablesgrowth rate.
20x7 20x8 20x9
Revenuegrowth - 12.23% 7.77%
Receivablegrowth - 23.46% 37.17%
Ratio 52.15% 20.92%
Assumethatinventorycostsareincreasinginline with anoverallinflationrateof 3 percent. If a firmreportsinventory usingthe
lastin, firstout (LIFO) method, which of the followingismost accurate?
Lower profits and lower taxes are reported because new inventory is flowing out to COGS.
Thelessexpensiveinventoryis flowingouttoCOGS. LIFOreservemeasurestheaccumulationof taxespaid.
Explanation
LIFO firmreportslowerprofitsand lowertaxes becauseallof thenew, moresexpensiveinventoryis flowingouttoCOGSthus, LIFOreservemeasurestheaccumulationof taxesnot paid and profitsnot recognized.
Coastal DrillingCorp (CDC) reported the followingyear-end data:
E
B
I
T
$23
millio
n
E
BT
$2
0
millio
n
E
ffe
cti
v
e
ta
x
r
at
e
40
p
e
r
c
e
n
t
CDCreported inthe footnotestoits financialstatementsthatit had increased theexpected returnonpensionplanassets assumption which resulted inanincreaseof EBITof $2 million. Analyst WandaBrunner, CFA, thinksthischangein
assumptionsis unfounded and removesthe $2 millionincreasein EBIT. Which of the followingisclosest tothetax burden ratioafteradjustment?
55.6%.
61.9%. 60.0%.
Question #4
2
of 84
Question ID: 462518ᅞ A)
ᅞ B) ᅚ C)
Question #4
3
of 84
Question ID: 414673ᅞ A)
ᅞ B)
ᅚ C)
Question #44 of 84
Question ID: 462502Tax burden = NI/EBTor1 - theeffectivetax rate. Theincreaseinthereturnonpensionplanassetsassumptionincreased EBIT, EBT, IncomeTaxes, and Net Income from whatit would have been. Removing $2 million fromthereported numbers will
reduce EBIT, EBT, IncomeTaxes, and Net Income. However, thetax burdenratio willstill be1 - theeffectivetax rate.
LuckyStrike MiningCorp. (LSMC) reportsina footnotetothe financialstatementsthatitispartytoa variableinterestentity
(VIE) through which itleases heavyequipment. LSMC haschosennottoreportaresidual valueguaranteeof $120million for
theequipment becauseitisnotrequired to doso underaccountingstandards. However, thestandards willchangenextyear. Whatistheappropriateanalyticaltreatmentof thisresidual valueguarantee?
Ignore the liability because current accounting standards do not require it to
be included on the balance sheet.Include it in next year's balance sheet adjustments.
Increaselong-termliabilities by $120millionand decreaseequity by $120million. Increaselong-termliabilitiesand long-termassets by $120million.
Explanation
Increaselong-termliabilitiesand long-termassets by $120million.
ChargerCorporationoffersextended paymenttermstoitscustomers. Inorderto financeitsaccountsreceivable, Chargeris consideringtwoalternatives. The firstalternativeisto borrow againstthereceivables. Thesecond alternativeistosecuritize
thereceivablesthrough aspecialpurposeentity. Which alternative would resultinloweroperatingcash flow and lower financingcash flow?
Loweroperatingcash flow
Lower financingcash flow
Securitize Securitize
Securitize Borrow
Borrow Securitize
Explanation
Thecash received from borrowing would bereported asa financinginflow. Thecash received fromsecuritizingthe receivables would bereported asanoperatinginflow. So, borrowing would resultinloweroperatingcash flow and higher financingcash flow. Securitizing would resultinlower financingcash flow and higheroperatingcash flow.
ᅞ A) ᅚ B) ᅞ C)
Question #4
5
of 84
Question ID: 462530ᅞ A) ᅞ B) ᅚ C)
Question #4
6
of 84
Question ID: 462470ᅞ A) ᅚ B) ᅞ C)
processing data. Whenapplyingthe financialanalysis framework, which of the followingisthebest exampleof output from processing data?
Audited financial statements. Common-size financialstatements.
A writtenlistof questionsto beanswered bytheanalysis.
Explanation
Common-size financialstatementsarecreated inthe dataprocessingstepof the framework for financialanalysis. Audited financialstatements would beobtained duringthe "collectinput" phaseof the financialanalysis framework. Creatinga written
listof questionsto beanswered bytheanalysisispartof the "definethepurpose" phaseof the financialanalysis framework.
ABCTieCompanyreportsincome fortheyear 2009 as $450,000. Thenotestoits financialstatementsstatethatthe firm uses thelastin, firstout (LIFO) conventionto valueitsinventories, and that had it used firstin, firstout (FIFO) instead, inventories
would have been $62,000greater fortheyear 2008and $78,000greater fortheyear 2009. If earnings wererestated using FIFOto determinethecostof goodssold (COGS), what would thenetincome be fortheyear 2009? Assumeatax rateof 36%. Netincome would have been:
$439,760.
$455,760. $460,240.
Explanation
ThereductioninCOGS would resultinan increaseinnetincome (62,000 − 78,000) × (1 − 0.36).
The failuretorecognizeinventoryobsolescenceisanexampleof ___________.
Misclassifying expenses.
Understatingexpenses. Delayingexpenses.
Explanation
Inventorymust betested forobsolescence usingthelower-of-cost-or-marketmethod. Obsoleteinventorymust be written down (expensed) intheincomestatement which resultsinlowerearnings. Thus, failuretorecognizeobsolescence understatesexpensesand overstatesearnings.
Delayingexpensesinvolves deferringrecognitiontoa futureperiod. Delayingexpenseistheresultof capitalizingacost instead of immediatelyrecognizingthecostintheincomestatement. Thisisnotthesameas failingtorecognizeinventory obsolescence.
Question #47 of 84
Question ID: 462501ᅞ A) ᅚ B) ᅞ C)
Question #48 of 84
Question ID: 462532ᅞ A)
ᅚ B) ᅞ C)
Question #4
9
of 84
Question ID: 472507incentivetoincreaseoperatingincome bymisclassifyinganoperatingexpenseasanonrecurringornon-operatingitem.
Therefore, failuretorecognizeobsolescenceisnotanexampleof misclassification.
AnanalystisanalyzingTRK Construction (TRK) forpossiblerecommendationto his firm'sclients. He wantsto useTRK's
financialstatementstoanswersuch questionsas "IsTRK suitable for firmclients?", "IsTRK priced properlyrelativetopeers?", "WhatisTRK'searnings quality?" Theanalystismost likelyto begin with:
a DuPont analysis.
areview of his firm's framework foranalysisof financialstatements.
analystsadjustmentstothe financialstatements.
Explanation
Analysisof financialstatementsshould beperformed inthecontextof anoverall framework fortheanalysisof financial statements. Specificadjustmentsoranalysisof specificratiosisasecondaryconcern.
Which of the followingstatementsisCORRECT wheninventorypricesare falling?
LIFO results in higher COGS, lower earnings,higher taxes, and higher cash
flows.
LIFOresultsinlowerCOGS, higherearnings, highertaxes, and lowercash flows. LIFOresultsinlowerCOGS, lowerearnings, lowertaxes, and highercash flows.
Explanation
Remember, prices arefalling. Under LIFO, themostrecentpurchases flow toCOGS. So, LIFOresultsinlowerCOGS, higher earnings, highertaxes, and lowercash flows.
Samuel Maskin, CFAisevaluatingthe financialstatementsof Northern Energy Inc. The followingisanextract from Northern's cash flow statement forthepastthreeyears:
20x6 20x5 20x4
Net Income $1,023 $988 $744
Depreciation $187 $145 $128
RestructuringCharges $(108) $(104) $212
Accountsreceivable $(172) $(145) $(33) Inventories $(418) $(202) $(180)
Accounts Payable $38 $37 $33
OCF $550 $719 $904
ᅞ A) ᅚ B) ᅞ C)
Question #
5
0 of 84
Question ID: 462534ᅞ A) ᅚ B) ᅞ C)
Question #
5
1 of 84
Question ID: 462519ᅚ A)
ᅞ B) ᅞ C)
Question #
52
of 84
Question ID: 462483Days sales outstanding is probably increasing.
Northernisstretchingpayables.
Northernmay haveaccelerated revenuerecognition.
Explanation
Wearenotprovided with incomestatement datasuch asrevenuesand COGSand hence havetomakeinferences fromthe
informationprovided. Accountspayableseemto bestableand decreasingasapercentageof netincomemakingthe
conclusionof stretchingpayablesleastlikely. Revenueaccelerationcan beconcluded based onlargeincreaseininventoryin 20x6 (possiblyreflectingreturns fromcustomers) combined with increasesinaccountsreceivableovertime. Increasesin
accountsreceivable (relativetoearnings) also would indicatethat dayssalesoutstanding would mostlikely beincreasing.
A firm hasreported netincomeof $136 million, butthenotesto financialstatementsincludesastatementthattheresults
"includea $27millioncharge fornon-insured earthquake damage" and a "gainonthesaleof certainassets during
restructuringof $16 million." If weassumethat both of theseitemsaregivenonapre-tax basisand theeffectivetax rateis
36%, what would bethe "normalincome"?
$147.00 million.
$143.04million. $94.08million.
Explanation
Tonormalizeearningsyou would increaseit bythenon-recurringchargeof $27millionand decreaseit bythenon-recurring gain, both tax adjusted.
$136 + (27 - 16)(1 - 0.36) = $143.04.
Adjustmentsforoff-balance-sheetitemsincludeall but which ofthefollowing?
Using the equity method in place of the proportionate consolidation to reflect the
investment in affiliates.
Capitalizingoperatingleases, includingthisamountasanassetandaliability.
Estimatingtheprobableobligationforcontingentliabilities.
Explanation
ᅞ A)
Accruals can be measured as net income less cash flows from operations
Question #
55
of 84
Question ID: 462493ᅞ A) ᅚ B) ᅞ C)
Question #
56
of 84
Question ID: 472501ᅞ A) ᅞ B) ᅚ C)
Question #
5
7 of 84
Question ID: 485740ᅞ A) ᅚ B) ᅞ C)
Whilean unusually high sales-growth ratemayindicate fraud, itcould alsoindicategood management. It'sayellow flag, but
notthe bestindicatorof accountingshenanigans. Risinginventoryisalsoa dualsignal. Itcould bemeanttooverstateprofits,
oritcould simplyreflectanactual buildupof inventoryinresponsetomarket forcesorcorporateoperations. However,
companiesshould notrecognizerevenue from bartertransactions. Theadditionalrevenueislikelytoimproperly boostprofits.
Completethe followingsentence. Ananalyst would apply _________ tothecash componentof incomecompared tothe
accrualcomponent whenevaluatingcompanyperformance.
the same weighting. a higher weighting.
alower weighting.
Explanation
Sincethecash component hasmoresustainabilityinthe futurethantheaccrualcomponent, ananalyst would applya higher weightingtothecash componentof incomethantheaccrualcomponent whenevaluatingcompanyperformance.
Meanreversioninearningsmeansthat:
Extreme high earnings will revert to the mean but extreme low earnings will not.
Extremelow earnings willreverttothemean butextreme high earnings willnot. Extreme high as wellaslow levelsof earnings willreverttothemean.
Explanation
Meanreversioninearningsmeansthatextreme high orlow earningsarenotsustainableand willmeanrevert.
Classificationof non-operatingincomeasoperating would lead tostated earningsthatarelikelyto be:
non-compliant withGAAP.
compliant with GAAP butnotsustainable.
compliant with GAAP and sustainable.
Explanation
Question #
5
8 of 84
Question ID: 472499ᅚ A) ᅞ B) ᅞ C)
Question #
59
of 84
Question ID: 462516ᅚ A) ᅞ B) ᅞ C)
Question #
6
0 of 84
Question ID: 472511ᅚ A) ᅞ B) ᅞ C)
Which oneof the followingchoicesisleast likelyto beanindicatorof poor-qualityearnings?
Reported earnings handily beat analyst estimates. Aninvestigation bythemarketregulatoryauthorityisinitiated.
Restatementof previouslyissued financialstatements.
Explanation
Enforcementactions byregulatoryauthoritiesand restatementsof previouslyissued financialstatementsaretwo (external)
indicatorsof poor-qualityearnings. Earningsthatmeetornarrowly beatanalystestimatesareconsidered to besuspect for
poor quality. Handily beatinganalystestimatesisnotconsidered to beanindicatorof poor-qualityearnings.
NorthernBottling (NB) currentlyshowsminimumexpected operatingleasepaymentsoverthenext 5 yearsof $3 million, $2.5
million, $2 million, $2 million, and $1.5 million. The firm's footnotesshow apresent valueof futurecapitalleasepaymentsof $10.55m discounted atarateof 6.75%. Whatadjustments would ananalystmaketomodifythe balancesheetof NBtoinclude
thisoff-balancesheet financing? Increaselong-term:
assets and long-term liabilities by $9.27 million.
liabilities by $9.27millionand decreaseequity by $9.27million.
assetsand long-termliabilities by $9.22 million.
Explanation
Theoperatingleaseshould becapitalized attherate used tocalculatethe PV of futurecapitalleasepaymentsinthe footnotes. Therefore, the PV (operatingleases) is:
= 3 / (1 + 0.0675) + 2.5 / (1 + 0.0675) + 2 / (1+ 0.0675) + 2 / (1 + 0.0675) + 1.5 / (1 + 0.0675)
= 9.2
7
millio
n
Theproperadjustmentistoincrease both long-termassetsand liabilities bythesameamount.
Asma Pharma hasmadeseveralstrategicinvestmentsinotherpharmaceuticalcompanies. Ineach instance, Asma haskept itsstake just below 50% soitcanaccount fortheinvestment usingtheequitymethod of consolidation.
Asma's balancesheet qualitycan bemost accuratelycharacterized as:
Low-quality due to lack of completeness.
Low-quality dueto biasinmeasurement. High-quality duetocompliance with local GAAP.
Explanation
Question #
6
1 of 84
Question ID: 472505ᅞ A) ᅞ B) ᅚ C)
Question #
62
of 84
Question ID: 472496ᅞ A) ᅚ B) ᅞ C)
Question #
63
of 84
Question ID: 462515One-lineconsolidation undertheequitymethod obscuresthecomponentsof balancesheetand artificially boostscertain
profitabilityratios (e.g., returnonassetsorprofitmargin). Thisreducesthecompletenessand qualityof the firm's balance
sheet. Compliance with GAAP isanecessary butnotsufficientcondition forevaluating qualityof financialstatements. Equity method of accounting doesnot byitself lead tomeasurement bias.
High-qualitycash flow isleast likelyto becharacterized by:
Volatility of operating cash flowbeing lower than that of the firm's peers.
Nosignificant differences betweenoperatingcash flow and reported earnings.
Financingcash flowssufficienttocovercapitalexpenditures, dividendsand debt
repayments.
Explanation
High-qualitycash flow ischaracterized bypositiveOCFthatis derived fromsustainablesourcesand isadequatetocover
capitalexpenditures, dividends, and debtrepayments. Furthermore, high-qualityOCFischaracterized bylower volatilitythan
thatof the firm'speers. Significant differences betweenOCFand earnings, or differencesthat widenovertime, can bean
indicatorof earningsmanipulation.
Brent Jones, CFAisanalyzingthe financialstatementsof ImperialResorts Inc. Jones wantsto usetheBeneish modelto
evaluatetheprobabilityof earningsmanipulation.
Jonesmakesthe followingstatements:
1. Depreciationindex of lessthan1 would indicatethatthecompanyis depreciatingassetsata higherratethanitspeers. 2. IncreasesinAsset qualityindex indicatethattherevenuerecognitionpoliciesareconservative.
Regardingthestatements by Jones:
Only statement 1 is correct.
Noneof thestatementsiscorrect.
Onlystatement 2 iscorrect.
Explanation
Statement1isincorrect. Depreciationindex lessthan1indicatesthatthecompanyis depreciatingassetsata higherratethan
inprioryears (and notrelativetoitspeers). Statement 2 isincorrect. Asset qualityindex is used asanindicatorof excessive
capitalizationof expenses.
ᅞ A)
ᅚ B)
ᅞ C)
Question #
6
4 of 84
Question ID: 472504ᅞ A)
ᅞ B)
ᅚ C)
isleast accurate?
Income statement items that may require adjustment include accounting changes, one-time charges and restructuring charges.
Theincomestatementshould beadjusted toreflecttheliability forpurchases committed to underatake-or-paycontract.
Cash flow fromoperationsmay beaffected bytheexclusionof off-balancesheet obligations.
Explanation
Theliability forgoods undertakeorpaycontracts would beshownonthe balancesheet (notincomestatement). Off-balance
sheetobligationssuch asoperatinglease would affectCash flow fromoperations (asopposed totreatment undercapital lease).
Pysha Heavy Metals Ltd. suppliesspecialized metalstothechip fabricationindustry. Selected financial data for Pysha, as well asindustrycomparables, areshown below:
Pyshaselected financial data (£ '000s):
20x7 20x8 20x9
Sales 1,169 1,312 1,414
Accountsreceivable 58.45 72.16 98.98
Industryaverage:
20x7 20x8 20x9
DSO 22.6 22.8 22.4
Receivablesturnover 16.2 16.0 16.3
Relativetoindustryaverage, for 20x9, Pysha's DSOand Receivablesturnoveraremost likely:
DSO Receivablesturnover
Higher higher
Lower higher
Higher lower
Explanation
Pysha's DSOand receivablesturnoveriscalculated as follows:
DSO 18.25 20.08 25.55
receviablesturnover 20.00 18.18 14.29
Question #
65
of 84
Question ID: 485739ᅞ A) ᅚ B) ᅞ C)
Question #
66
of 84
Question ID: 472495ᅞ A) ᅚ B) ᅞ C)
Question #
6
7 of 84
Question ID: 462523ᅞ A)
ᅚ B)
ᅞ C)
Inthecontextof theBeneish modeltoevaluatetheprobabilityof earningsmanipulation, anincreasein DaysSalesReceivable Index isleast likelytosignify:
an increase in M-score.
a decreaseinprobabilityof earningsmanipulation. revenueinflation.
Explanation
Anincreasein DaysSalesReceivable Index indicatesrevenueinflationand increasesthe M-score, therebyincreasingthe
probabilityof earningsmanipulation.
Pritesh Deshmukh, CFAisanalyzingthe financialstatementsof BazaRestaurants Inc. Deshmukh wantsto usetheBeneish
modeltoevaluatetheprobabilityof earningsmanipulation.
Deshmukh makesthe followingstatements:
1. Depreciationindex of lessthan1 would indicatethatthecompanyis depreciatingassetsatalowerratethaninprioryears. 2. Salesgrowth index of morethan1indicatesrevenueinflation.
Which of thestatements by Deshmukh aremostaccurate?
Statement 1 only.
Noneof thestatementsisaccurate.
Statement 2 only.
Explanation
Statement1isincorrect. Depreciationindex of lessthan1indicatesthatthecompanyis depreciatingassetsata higherrate
thaninprioryears. Statement 2 isincorrect. Salesgrowth index of morethan1simplyimpliesthatthegrowth insalesis positive. Whilenotameasureof manipulation byitself, growth companiestend to find themselves underpressureto manipulateearningstomeetongoingexpectations.
Amanufacturing firmpurchasesequipment for useinitsoperations. With regard torecordingthepurchase usingthecash basis versustheaccrual basisof accounting, which of the followingstatementsismost appropriate?
With the accrual basis, the cost of the equipment is allocated to the cash flow
statements over the asset's life.
With thecash basis, revenuesand expensesrelatingtotheequipmentaregenerally
recognized in differentperiods.
With thecash basis, revenuesand expensesrelatingtotheequipmentaregenerally
Question #
6
8 of 84
Question ID: 462469ᅚ A) ᅞ B) ᅞ C)
Question #
69
of 84
Question ID: 472513ᅞ A) ᅚ B) ᅞ C)
Question #70 of 84
Question ID: 472509Explanation
With thecash basis of accounting, revenuesarerecognized whencash iscollected and expensesarerecognized whencash
ispaid. Therefore, thecash flowsmayoccurin differentperiodsthan whentherevenuesareactuallyearned or whenthe expensesareactuallyincurred. Forexample, thepurchaseof equipment used ina firm'smanufacturingoperationmayresult inanimmediatecash outflow buttheequipmentgeneratesrevenuesoverits usefullife. Inthiscase, therevenuesand expensearereported in differentperiods.
With the accrualbasis of accounting, revenuesarerecognized whenearned and expensesarerecognized whenincurred, regardlessof thetimingof thecash flows. With theequipmentpurchase, thecostof theequipment will beallocated tothe
incomestatement (notcash flow statement) overtheasset'slifeand atthesametime, matched with therevenuesgenerated.
Which of the followingitemsisleast likelytoinvolvethe useof subjectivemeasurementestimates bymanagement?
Use of criteria to determine treatment as an extraordinary item.
Useof straight-line depreciationmethod to depreciatetangibleassets. Useof FIFO (firstin-firstout) tocostinventories.
Explanation
The useof criteriato determinetreatmentasanextraordinaryitem (i.e. Istheitem withinmanagement's discretion? Isthe eventlikelytorecurinthe foreseeable future?) doesnotinvolvenumericaland subjectiveestimatesperse. Itismoreatestof qualitative factorsto determinetheproperclassification. ContrastthistoFIFO, which isclearlyanumericalestimatesincean
alternativeof using LIFO (lastin-firstout) ispossibleand this willresultina differentreported amountthanFIFO. Thesame
argumentcan bemade forthe useof thestraight-linemethod sinceanalternativeof usingthe declining-balancemethod is possibleto depreciatetangibleassets.
MKFConsolidated reports $500millioningoodwillonits balancesheet. Themarketconsensusindicatesthatthe valueof MKF'sintangibleassetsis $300million. How should ananalystadjust MKF's balancesheet? Reducegoodwilland:
equity by $500 million while increasing liabilities by $300 million.
equity by $200million.
increaseliabilities by $200million.
Explanation
If goodwill hasnoeconomic valueapart fromthe firm, itshould beeliminated fromthe balancesheet. If the valueof the
intangiblescan bereliablyestimated theycan besubstituted foraccountinggoodwill.
ᅞ A) ᅞ B) ᅚ C)
Question #71 of 84
Question ID: 462497ᅞ A) ᅚ B) ᅞ C)
Question #7
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Question ID: 472502ᅞ A) ᅚ B) ᅞ C)
Understatement of inventory impairment charges.
Understatementof valuationallowance for deferred tax assets. Presenceof substantialgoodwillon balancesheet.
Explanation
Presenceof substantialgoodwill doesnotinherentlymakeit biased measurement. Onlyif the valueof goodwillis unjustified (based onmarket valuesof theinvestments), would themeasurement beconsidered biased. Understatementof inventory impairmentchargesoverstates valueof inventory. Similarly understatementof valuationallowance for deferred tax assets overstatesthe valueof deferred tax assets.
Alex Fisher, CFA, isexaminingthephenomenonof meanreversionontheearningsof several firms. Which of the following statementsregardingmeanreversionisleast accurate?
High earnings should not be expected to continue indefinitely.
Normalearningsshould not beexpected tocontinueindefinitely. Low earningsshould not beexpected tocontinueindefinitely.
Explanation
Whenexaminingnetincome, analystsshould beawarethatearningsatextremelevelstend torevert backtonormallevels overtime. Thisphenomenonisknownasmeanreversion. Asaresultof meanreversion, analystsmust understand that
extremeearnings (high orlow) should not beexpected tocontinueindefinitely.
AndreBursh, isanalyzinglargeretailersand hascollected the followinginformationonthreecompanies based onthemost
recent financialstatements:
Allied StoresBeta MartCash-N-Carry Total Earnings
(pershare) $2.80 $1.33 $0.75
Cash element $1.90 $0.78 $0.25
Accrual
element $0.90 $0.55 $0.50
Bursh notesthatallthreecompanies havereported stellarearningsthispastyear. Bursh isconcerned aboutsustainabilityof
such high earnings. Which company'searnings willreverttoitsmean fastest?
Beta Mart. Cash-N-Carry.
Allied Stores.
Explanation
Question #7
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Question ID: 462472ᅞ A) ᅚ B) ᅞ C)
Question #74 of 84
Question ID: 472498ᅞ A) ᅞ B) ᅚ C)
Question #7
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Question ID: 434317ᅞ A)
(0.90/1.90) 47% of earningsand Beta'saccrualscomprise41% of earnings.
MarcelSchulteisanalyzing variousretailing firms. Which of the followingitemsisleast indicativeof apotentialproblem with revenuerecognitionand earnings quality?
Use of barter transactions.
Disproportionaterevenuesinthelast quarterof thecalendaryear. Implementinga "billand hold" arrangement.
Explanation
Disproportionaterevenuesinthelast quartermay beanindicationof aggressiverevenuerecognitiontomeetanalyst forecasts
butitismuch morelikelyif the firmisanon-seasonalone. Aretailing firmpresumably hasa disproportionateamountof sales
duringthe busyChristmasseasoninthelast quarterof thecalendaryearsothispointalone would not beindicativeof a potentialproblem.
Ina bartertransaction, twopartiesexchangegoodsorservices. Themainissueis whether: (a) asaletransaction hasactually occurred insubstance; (b) itisnota "sham" transaction; and (c) thetransactionamountisoverstated.
Billand hold occurs whentheretailer (seller) invoicesthecustomer but doesnotshipthegoods untilalater date. Alternatively,
thesellermayshipthegoodstoalocationotherthanthecustomer's. Ineithercase, thesellermay berecognizingrevenue
prematurely.
Classificationshiftingisleast likelytoresultina higher:
firm value derived when cash flow forecasts are based on core earnings.
equity value derived whenearnings forecastsare based onoperatingearnings. reported netincome.
Explanation
Classificationshiftingresultsininflationof coreorrecurringearnings whilekeepingthetotalreported incomesame. Thisis
used tomislead analystsinto usinga highernumberasa basis forgenerating forecastsof futureearningsand cash flows.
Such erroneous forecasts would thenresultininflated equityand firm valuation.
Charles Nicholls, chief investmentofficerof Gertmann Money Management, isreviewingtheyear-end financialstatementsof ZartnerCanneries. Inthosestatements heseesasharpincreaseininventories wellabovethesales-growth rate, and an
increaseinthe discountrate foritspensionliabilities. To determine whetherornot ZartnerCanneriesiscookingthe books, whatshould Nicholls do?
ᅞ B)
ᅚ C)
Question #7
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Question ID: 462504ᅞ A)
ᅞ B)
ᅚ C)
Question #77 of 84
Question ID: 462520ᅚ A)
ᅞ B) ᅞ C)
Question #78 of 84
Question ID: 462505Analyzetrendsin Zartner'sreceivablesand considerthechangingcharacteristicsof
its work force.
Calculate Zartner'sturnoverratiosand review the footnotesof itscompetitors.
Explanation
Toassessthemeaningof theinventoryincrease, look for declinesinindustryturnover. And if Zartnerchangesitspension
assumptions, Nichollsshould see how thosenew assumptionscomparetothose found inthe footnotesof financialstatements
fromothercompaniesinthesameindustry.
Ananalystis developinga framework for financialstatementanalysis for his firm. This frameworkismost likelytoinclude:
Determine the allocation of firm fees, interpret processed data, and communicate conclusions.
Maintainintegrityof capitalmarkets, perform dutiestoclientsand employers, and
avoid conflictsof interest.
Definethepurposeof theanalysis, processinput data, and follow up.
Explanation
Properanalysis frameworkshould include:
1. Definethepurposeof theanalysis. 2. Collectinput data.
3. Processinput data.
4. Interpretprocessed data.
5. Developand communicateconclusions. 6. Follow up.
What doesthe LIFOreservemeasure?
The accumulated difference between the reported inventory balance and the cost of that inventory if first in, first out (FIFO) had been used.
Theoverstatementrelativetothecurrentcostof inventory.
Theresultsof olderinventory flowingtocostof goodssold (COGS).
Explanation
ᅞ A) ᅚ B) ᅞ C)
Question #7
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Question ID: 472493ᅞ A) ᅞ B) ᅚ C)
Question #80 of 84
Question ID: 462499ᅞ A) ᅚ B) ᅞ C)
Question #81 of 84
Question ID: 472489Ananalystisanalyzinga discountmanufacturerof partsand supplies. She has followed her firm'ssuggested financialanalysis
frameworkand hascommunicated with companysuppliers, customers, and competitors. Thisisaninputthatoccurs while:
processing data. collecting data.
establishingtheobjectiveof theanalysis.
Explanation
Communication with management, suppliers, customers, and competitorsisaninput duringthe datacollectionstep. Processing dataisthethird phaseof the financialanalysis framework. Establishingtheobjectiveof theanalysisispartof the "definethepurpose" phaseof the financialanalysis framework.
Errorsthataffectmultiple financialstatementelementsaremostlikelytoarise from:
compound issues. classificationissues.
measurementand timingissues.
Explanation
Measurementand timingissuestypicallyaffectmultiple financialstatementelements whileclassificationissuestypicallyaffects categorizationof aspecificelementina financialstatement.
Which of the followingmeasuresisleast affected bythe useof estimatesinthe financialstatementpreparationprocess?
Net income. Cash flow. Netequity.
Explanation
Netincomeiseasilymanipulated becauseof accrualaccountingand themanyestimatesinvolved. Ontheother hand, cash flow is unaffected byestimates. However, firmscanstillmanipulatethecash flow statement bymisclassifyingcash flows,
ignoringcash flows, and managingcash flows.
Asaresultof itsrelationshiptotheincomestatement, netequity (which isgenerallyanaccumulationof earningsand losses less dividend paymentstoshareholders) is directlyaffected bytheestimates used to determinethelevelof earnings.
ᅞ A) ᅚ B) ᅞ C)
Question #8
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Question ID: 472500ᅞ A) ᅞ B) ᅚ C)
Question #8
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Question ID: 472512ᅞ A) ᅞ B) ᅚ C)
Question #84 of 84
Question ID: 472510ᅞ A) ᅚ B)
GAAP compliant financial reports that are decision useful. anadequatelevelof returnthatissustainable.
high levelof earnings determined conservatively.
Explanation
High results qualityoccursif thelevelof earningsprovidesanadequatelevelof returnand thattheearningsaresustainable.
Sustainableearningsaremostlikelyto be driven by:
Accruals element of earnings.
Conservativerevenuerecognitionpractices.
Cash flow elementof earnings.
Explanation
Sustainableand persistentearningsare driven bycash flow elementof earnings. Thestabilityand accuracyof earnings
forecastscan bereduced byestimationprocessthatgeneratestheaccrualscomponentof earnings. Conservativeand
aggressiverevenuerecognitionpractices both would resultinreversioninearnings (and hencelowersthesustainabilityof earnings).
Theleast valuablesourceof informationabouta businesses' riskis:
Notes to financial statements.
Management discussionand analysissectionof theannualreport.
Auditor'sreport.
Explanation
Becauseanauditreportprovidesonly historicalinformation, such areport's usefulnessasaninformationsourceislimited.
Companiesarerequired tomakecertainriskrelated disclosuresinthenotesto financialstatements. Both GAAP and IFRS
requirecompaniesto discloserisksrelated topension benefits, contingentobligationsand financialinstruments. Ideally,
companiesshould includeprincipalrisksthatare uniquetothe business (asopposed torisks faced bymost businesses) in
their MD&A.
Which of the followingisleast likelyanindicatorof biased measurementinassessing balancesheet quality?
ᅞ C) Overly high assumed discountrate forpensionobligations.
Explanation
Carryinginvestmentsin debt (orequity) securitiesatmarket valueenhances balancesheet qualityand doesnotintroducea
