Advanced Accounting Quiz Flashcards
When financial newspapers such as the Wall Street Journal or Financial Times refer to “mark-to-market” accounting or losses, which method of classification of marketable securities are they referring to?
Most of the time they are referring to portfolios accounted for as trading securities. Among the categories listed above, only answer choice C requires both realized and unrealized gains and losses to not only be accounted for on the balance sheet, but also to flow through to net income on the income statement. Mark-to-market accounting does not have a big impact on HTM and AFS securities because gains and losses don’t hit the income statement until the securities are sold.
The value of Trading Securities on your Balance Sheet declines by 10. You have not sold anything yet. How much does Cash change by as a result (assume a 40% tax rate)?
On the IS, Pre-Tax Income falls by 10 because Unrealized Gains / (Losses) are reported on the IS for Trading Securities. Net Income decreases by 6 assuming a 40% tax rate. On the CFS, Net Income is down by 6 but the Loss was non-cash, so you add it back and cash is up by 4 at the bottom. On the BS, Cash is up by 4 but the Trading Securities are down by 10, so the Assets side is down by 6. On the other side, Shareholders’ Equity is also down by 6 due to the reduced Net Income. Intuition: We save on taxes with this Loss, but haven’t actually paid anything in cash.
True or False: Management can manipulate or otherwise smooth reported earnings based on its classification of marketable securities.
True. There’s always a level of discretion with classifying securities, so management could easily do this - a hypothetical scenario might be a portfolio of marketable securities classified as available-for sale. This portfolio might have lots of unrecognized gains and losses that do not flow through to net income on the P&L. Management will have the ability to “smooth” reported earnings by selling certain appreciated securities so as to recognize the profit in reported earnings on the P&L while leaving other unrecognized losses remaining hidden in shareholder’s equity and thus not reducing reportable income.
Of the classifications for marketable securities, which of the categories below recognize both realized and unrealized gains and losses?
Both available-for-sale and trading securities recognize both realized and unrealized gains and losses. But unrealized gains and losses are treated differently between the two – so this is a bit of a trick question, because we did not say “on the income statement.” Both realized and unrealized gains and losses flow through into the income statement for trading securities. However, in the case of available-for-sale classification, only realized gains and losses flow through into the P&L, whereas unrealized gains and losses do not show up on the income statement but rather get recognized in an account on the balance sheet under Shareholder’s Equity named Accumulated Other Comprehensive Income (“AOCI”). The point to remember with available-for-sale classification is that until the marketable security is actually sold – thus resulting in realized gains flowing into the income statement – any changes in market values are reflected as unrealized within AOCI section of Shareholder’s Equity. Once the unrealized gain or loss is recognized by means of an actual disposal of the asset, the gain or loss will at that time flow into the income statement (and the accumulated unrecognized gain or loss for the marketable security under AOCI will be netted out).
On December 31, Parent Co. invests 300 in the equity of Sub Co. In return, Parent Co. receives 30% ownership in the shares of Sub Co. (thereby implying a value of 1,000 for Sub Co.). The following year, Sub Co. earns net income of 100 and pays out a cash dividend of 20. At the end of that year, what is the correct number for the Investments in Equity Interests line item on the Balance Sheet?
Initially, Parent Co. would record a 300 asset on its balance sheet for this investment. Since Parent Co. owns less than 50% of Sub Co., it must recognize its proportion of Sub Co.’s net income and dividends in each subsequent year. On the income statement in the following year, Parent Co. adds 30 (100 * 30%) to its own net income. On the CFS, net income is higher by 30 but then it subtracts that 30 because it was non-cash. It also records 6 in dividends received (20 * 30%) under CFO, so cash at the bottom of the CFS is up by 6. On the BS, cash is up by 6 on the assets side and the Investments in Equity Interests line item is up by 30 due to the 30 of net income that Parent Co. is entitled to, but is down by 6 due to the dividends that Sub Co. issued… so the Assets side is up by 30. The other side is up by the same amount due to the 30 of additional net income. The Investments in Equity Interests line item started at 300, increased by 30, and then decreased by 6, so its final value is 324.
A company owns 10% of another company. If the Parent Company wants to maximize its earnings on the income statement, should it classify its 10% ownership in the other company as an Available-for-Sale Security, or an Equity Interest (AKA Associate Company)?
“It depends on whether the other company has positive or negative earnings.
If the other company is classified as an AFS Security, net income from it does not show up at all on the income statement. Whereas if it is classified as an Equity Interest, the Parent Company’s proportion of net income is added on the income statement. However, if the other company has negative earnings, the Parent Company’s net income will actually decrease as a result because you subtract out the proportion when it’s negative. So E is the correct answer – if the other company’s earnings are positive, the Equity method is better, but if they’re negative, the AFS method is better.”
Why do you subtract the Net Income Attributable to Noncontrolling Interests on the income statement?
“Because you’ve already consolidated the statements 100%, but want to show only the net income you’re entitled to at the bottom.
A and D are completely wrong because when the Parent Company owns over 50% of another company, it effectively controls it and receives all of its net income. So the proportion of the other company it does not own is not a cash expense at all, and nothing needs to be paid to the other company. C is incorrect because according to the rules of accounting, you consolidate revenue and expenses 100% as long as you own over 50% of another company. That leaves B as the only correct answer, for the reasons stated: it’s an accounting convention that you show only the amount of net income you’re entitled to, based on ownership percentages, at the bottom of the income statement.”
True or False: You own 70% of another company. When you acquire that ownership stake, you should add 100% of its assets and liabilities to your balance sheet, but only 70% of its shareholders’ equity – because you only own 70% of it.
“False.
As is the case when you acquire 100% of another company, you add 100% of its assets and liabilities regardless of the ownership percentage, but you assume that its shareholders’ equity is completely wiped out because it no longer exists as an independently operating entity. You create a Noncontrolling Interest for the 30% of the company that you do not own and may also create Goodwill and Other Intangible Assets as part of the purchase price allocation process.”
Where exactly does the Noncontrolling Interest line item show up on the balance sheet when a company owns more than 50%, but less than 100%, of another company?
“Shareholders’ Equity
The correct answer is C, and there’s not much of an explanation – that is just an accounting rule. Previously Noncontrolling Interests were called “Minority Interests” and they appeared between Long-Term Liabilities and Shareholders’ Equity.”
You’re analyzing a new high-tech start-up and are trying to build an operating model for the company. The first step is to build the revenue projections. What are the two elements you should use to project revenue for this company?
“Price per product, Volume of products sold.
In most cases the revenue build schedule is driven off of two items: 1) price per unit and 2) number of units sold, with this methodology known as a “bottoms-up” approach to revenue projection. For instance, if you are projecting revenues for an old-economy manufacturing company, total revenues in a given year will simply be the number of total “widgets” sold (aka volume of units) multiplied by the price per widget. The problem with using “supply and demand” is that there’s no way to tell in advance what the demand will be – and “limited supply” is not a relevant concept for a high-tech start-up, because typically they are more constrained by sales & marketing rather than inherent demand.”
What is the flaw with assuming a growth rate for expenses in a 3-statement model rather than linking them to revenue?
“The problem is that your margins could be severely off in future years if you do this.
C is correct - generally, mature companies’ margins stay in roughly the same range over time, perhaps increasing a bit due to economies of scale. If you assume a percentage growth rate instead, you could easily end up with a scenario where the margins are severely distorted in future years (e.g. revenue grows by 5% but expenses grow by 10%). So it is better to make expenses a percentage of revenue in most cases.”
Which of the following would not be an appropriate way to project Accounts Receivable?
”% of Cost of Goods Sold
Accounts Receivable has little, if anything, to do with Cost of Goods Sold, which is more linked to Inventory than anything else. AR is most closely linked to Sales, so both B and C are fine, and calculating AR Days (AR / Revenue * 365) also works. Credit Sales is a bit better because that’s what AR is really tied to, but Net Sales is also fine if you don’t have that information.”
True or False: By creating a detailed revenue projection (i.e. bottoms-up or tops-down build rather than simple percentage growth), we don’t necessarily get different or “better” numbers, but we do get more support for the revenue numbers in the model.
“True.
Fundamentally, you’re still making assumptions for the revenue growth rate regardless of how much detail goes into it – whether you take into account 2 variables or 20 variables, you can still simplify everything into a simple percentage growth assumption. The reason you create a more detailed revenue projection model is therefore to show where the numbers come from – volume growth or pricing growth, for example – and not necessarily to get different numbers.”
“What’s a valid interpretation for a Deferred Tax Asset on a company’s balance sheet?
1) It represents tax credits from Net Operating Losses in earlier periods.
2) It means that the company can pay less in cash taxes in future periods.
3) It means that the company has been recording expenses differently for book and tax purposes.
4) All of the above.”
Any of these is a valid interpretation – mechanically, a DTA means that the company pays less in cash taxes in the future. That can come as a result of NOLs, or because of expenses recorded differently for book vs. tax purposes, or because of M&A deals.
Initially, a company records higher Depreciation for tax purposes than it does for book purposes. What happens to its Deferred Tax Liability initially as a result?
If we record higher Depreciation for tax purposes, that means we pay less in cash taxes initially, which means we need to pay more in cash taxes later on. A DTL always reflects the fact that we need to pay more in cash taxes in the future, so A is the correct answer. C and D are both incorrect because while the specific numerical increase in the DTL depends on the numbers, the directional change does not.
