Chapters 3-5

Question 1

The objective of accounting analysis is typically NOT to
A. Identify areas in the financial statements that are most strongly affected by management’s
discretionary accounting choices.
B. Identify accounting choices that are most critical to a firm’s accounting performance.
C. Assess whether the financial statements fully comply with accounting conventions and
regulations.
D. Understand management’s reporting incentives and strategy.
E. Undo the financial statements from distortions.

Answer 1

C. Assess whether the financial statements fully comply with accounting conventions and
regulations.

Question 2

T/F: Consider the following statement: “International Financial Reporting Standards (IFRS) are
typically considered to be more principles-based than US Generally Accepted Accounting Principles
(US GAAP).”

Answer 2

TRUE

Question 3

T/F: Consider the following statement: “The use of rules-based standards rather than principles-based
standards decreases the verifiability of financial statements but increases the extent to which
financial statements reflect the economic substance of a firm’s transaction.”

Answer 3

FALSE

Question 4

Which of the following statements is true?
A. Managers of firms that are close to violating accounting-based debt covenants have an
incentive to manage earnings and working capital ratios downwards.
B. In share-for-share mergers managers of the acquiring firm have an incentive to understate
their firm’s accounting performance.
C. Both statements are true.
D. None of the above statements is true.

Answer 4

D. None of the above statements is true.

Question 5

Which of the following statements is true?
A. Managers have an incentive to understate accounting performance shortly before a large
option award is granted to them.
B. Managers who aggressively manage their firm’s taxes have an incentive to consistently
overstate their firm’s accounting performance.
C. Both statements are true.
D. None of the above statements is true.

Answer 5

A. Managers have an incentive to understate accounting performance shortly before a large
option award is granted to them.

Question 6

Which of the following is NOT a potential “red flag” pointing to questionable accounting
quality?
A. Unexplained transactions that boost profit
B. Unexpected large asset write-offs
C. Volatility in the difference between reported profits and cash flows
D. Poor internal governance mechanisms
E. All of the above are potential red flags

Answer 6

C. Volatility in the difference between reported profits and cash flows

Question 7

Which of the following is not a potential “red flag” pointing to questionable accounting
quality?
A. An increasing gap between a firm’s reported profit and its tax profit
B. An increasing gap between a firm’s reported profit and its cash flow from operating activities
C. Unusual increases in inventories in relation to sales increases
D. The use of accelerated depreciation methods
E. All of the above are potential red flags

Answer 7

D. The use of accelerated depreciation methods

Question 8

Under IFRS firms can classify their operating expenses in the income statement either by
function or by nature. Which of the following two statements about operating expense classification
is true?
Statement I: Under the classification by nature firms distinguish “cost of sales” from “selling,
general and administrative (SG&A) expenses”.
Statement II: The International Financial Reporting Standards require that firms classifying their operating expenses by nature in the income statement disclose their operating expenses by function in the notes to the financial statements.
A. Statement I is true; statement II is not true.
B. Statement I is not true; statement II is true.
C. Both statements are true.
D. Both statements are not true.

Answer 8

D. Both statements are not true.

Question 9

Which of the following accounting policies is most likely to be a key accounting policy of
Carrefour, one of the world’s largest retailers?
A. Accounting for payables
B. Accounting for legal claims
C. Accounting for revenues
D. Accounting for property

Answer 9

D. Accounting for property

Question 10

Which of the following factors is not relevant in evaluating a firm’s accounting strategy?
A. Management’s incentives to manage earnings
B. The presence of mandatory changes in accounting policies
C. Average accounting choices in the industry
D. Accuracy of past accounting estimates
E. The presence of voluntary changes in accounting policies

Answer 10

B. The presence of mandatory changes in accounting policies

Question 11

Consider the following statements about standardization of financial statements.
Statement I: The income statement items “Result from associate companies” or “Equity income from associates” must be classified as “Profit or loss to non-controlling interest”.
Statement II: The balance sheet item “Provision for post-employment benefits” must be classified as “Non-current debt”.
A. Statement I is true; statement II is not true.
B. Statement I is not true; statement II is true.
C. Both statements are true.
D. Both statements are not true.

Answer 11

B. Statement I is not true; statement II is true.

Question 12

Which of the following statements is correct?
A. “General and Administrative Expense” is an income statement line item that firms use under a classification of operating expenses by function.
B. “Raw Materials” is an income statement line item that firms use under a classification of
operating expenses by function.
C. “Marketing and Selling Expense” is an income statement line item that firms use under a classification of operating expenses by nature.
D. “Cost of Services” is an income statement line item that firms use under a classification of operating expenses by nature.

Answer 12

A. “General and Administrative Expense” is an income statement line item that firms use under a classification of operating expenses by function.

Question 13

Which of the following relationships between income statement line item and standard
income statement account is correct?
A. Servicing and maintenance -> SG&A (by function)
B. Dividend income -> Interest income
C. Asset impairments -> Cost of sales (by function)
D. Share-based payments -> Investment income

Answer 13

A. Servicing and maintenance -> SG&A (by function)

Question 14

Which of the following relationships between balance sheet line item and standard balance
sheet account is correct?
A. Amounts due from affiliates -> Trade receivables
B. Goodwill -> Non-current tangible assets
C. Work-in-progress -> Inventories
D. Provision for post-employment benefits -> Other current liabilities

Answer 14

C. Work-in-progress -> Inventories

Question 15

Which of the following relationships between cash flow statement line item and standard
cash flow statement account is correct?
A. Depreciation and amortization -> Non-operating losses (gains)
B. Deferred tax expense -> Non-current operating accruals
C. Stock bonus awards -> Net investments in operating working capital
D. Capital expenditures -> Net investments in operating working capital

Answer 15

B. Deferred tax expense -> Non-current operating accruals

Question 16

Company A’s non-current assets have a residual value of zero, a beginning book value of €5,000, and an initial cost of €10,000. Company A uses an annual depreciation percentage of 10%. Its statutory (and effective) tax rate is 30 percent. What adjustments would an analyst make to company A’s beginning equity and non-current assets if she assumes that company A’s depreciation
percentage should be 12%?
A. Decrease non-current assets by €1,000; decrease equity by €1,000
B. Decrease non-current assets by €2,000; decrease equity by €2,000
C. Decrease non-current assets by €1,000; decrease equity by €700
D. Decrease non-current assets by €2,000; decrease equity by €1,400

Answer 16

C. Decrease non-current assets by €1,000; decrease equity by €700

Question 17

Company A’s non-current assets have a residual value of zero, a beginning book value of €5,000, and an initial cost of €10,000. Company A uses an annual depreciation percentage of 10%. Its statutory (and effective) tax rate is 30 percent. What adjustments would an analyst make to company A’s current year’s tax expense if she assumes that company A’s depreciation percentage should be 12%?
A. Decrease tax expense by €60
B. Increase tax expense by €60
C. Decrease tax expense by €30
D. Increase tax expense by €30
E. No adjustment

Answer 17

A. Decrease tax expense by €60

Question 18

An analyst makes an adjustment for understated depreciation, increasing Company ABC’s Accumulated Depreciation (on PP&E) by an amount of €10 million. The Company’s tax rate is 40 percent. In the financial statements, this adjustment
A. Decreases net non-current assets by €10 million and decreases equity by €10 million.
B. Increases net non-current assets by €10 million and increases equity by €10 million.
C. Decreases net non-current assets by €10 million, decreases equity by €6 million, and
decreases other non-current liabilities by €4 million.
D. Decreases net non-current assets by €10 million, decreases equity by €6 million, and
decreases net debt by €4 million.

Answer 18

C. Decreases net non-current assets by €10 million, decreases equity by €6 million, and
decreases other non-current liabilities by €4 million.

Question 19

Prior to the implementation of IFRS 16, incorrectly treating finance leases as operating leases in the financial statements helped firms to
A. Overstate asset turnover and overstate leverage.
B. Overstate profit margins and understate asset turnover.
C. Understate asset turnover and overstate leverage.
D. Overstate asset turnover and understate leverage.

Answer 19

D. Overstate asset turnover and understate leverage.

Question 20

A pharmaceutical company spends €5,000, €6,000, and €4,000 on research in 2019, 2020, and 2021, respectively. Assume that research investments have an expected life of two years and occur evenly throughout the year. If an analyst decides to capitalize all research expenditures and uses the straight-line method to amortize research assets, her estimate of the book value of the pharmaceutical’s research asset at the end of 2021 equals
A. €15,000
B. €10,000
C. €4,500
D. €0

Answer 20

C. €4,500

Question 21

A pharmaceutical company spends €5,000, €6,000, and €4,000 on research in 2019, 2020, and 2021, respectively. Assume that research investments have an expected life of two years and occur evenly throughout the year. If an analyst decides to capitalize all research expenditures and uses the straight-line method to amortize research assets, her estimate of the pharmaceutical’s research amortization expense in 2021 equals
A. €4,000
B. €5,000
C. €5,200
D. €5,250

Answer 21

D. €5,250

Question 22

A car manufacturer recognizes the sale of 40,000 cars in its income statement. The cars have a total selling price of €450,000 and a total cost of €350,000. All cars have been prepaid but not yet shipped to the customer. The car manufacturer’s statutory and effective tax rate is 0 percent. The recognition of this sale leads to the following distortions:

A. No overstatement/understatement of profit or loss and equity; overstatement of total
assets and total liabilities by €350,000.
B. Overstatement of profit or loss and equity by €100,000; overstatement of total assets by €350,000; overstatement of total liabilities by €250,000.
C. Overstatement of profit or loss and equity by €100,000; overstatement of total assets by €100,000.
D. Overstatement of profit or loss and equity by €100,000; understatement of total assets by €350,000; understatement of total liabilities by €450,000.

Answer 22

D. Overstatement of profit or loss and equity by €100,000; understatement of total assets by €350,000; understatement of total liabilities by €450,000.

Question 23

On December 31, 2021, a company reported the following values for its allowances for
doubtful accounts:

Allowance for doubtful accounts 31/12/2021
Balance at the beginning of the year €30,000
Provision for bad debts (=bad debt expense) 2,000
Write-offs 5,000
Balance at the end of the year €27,000

Gross trade receivables on December 31, 2021 and January 1, 2021 were €80,000 and €100,000, respectively. The company’s tax rate equals 30 percent.

If an analyst decides that the company’s allowance for doubtful accounts should have been 25 percent of gross trade receivables on 31 December 2021 and 1 January 2021, the adjustments to the income statement would be to
A. Zero.
B. Decrease the bad debt expense by €2,000, increase the tax expense by €600, and increase profit or loss by €1,400.
C. Increase the bad debt expense by €5,000, decrease the tax expense by €1,500, and decrease profit or loss by €3,500.
D. Increase the bad debt expense by €3,000, decrease the tax expense by €900, and decrease profit or loss by €2,100.

Answer 23

B. Decrease the bad debt expense by €2,000, increase the tax expense by €600, and increase profit or loss by €1,400.

Question 24

To improve comparability over time, an analyst has decided to capitalize the operating leases
of Company A in its pre-IFRS 16 financial statements. Using information in the notes to the company’s 2017 financial statements, she has determined that the present value of future minimum lease payments, at a discount rate of 10 percent, on December 31, 2017 equals €500 million. All lease contracts last another 5 years on December 31, 2017. As expected at the beginning of the year, the company reports an operating lease expense in its income statement for 2018 of €80 million. The company’s tax rate equals 30 percent. The company does not engage in any new operating leases in 2018. The following information is also available from Company A’s financial statements (all ratios use beginning-of-the-year balance sheet values):

Debt to capital (at beginning of 2018) 0.55
Return on beginning equity in 2018 0.10
Assets / Capital (at beginning of 2018) €3,400 million

The effect of capitalizing Company A’s operating leases on its leverage ratio (debt to capital) at the beginning of 2018 equals
A. An increase from 0.55 to 0.61 (rounded).
B. An increase from 0.55 to 0.74 (rounded).
C. An increase from 0.55 to 0.82 (rounded).
D. A decrease from 0.55 to 0.51 (rounded)

Answer 24

A. An increase from 0.55 to 0.61 (rounded).

Question 25

To improve comparability over time, an analyst has decided to capitalize the operating leases
of Company A in its pre-IFRS 16 financial statements. Using information in the notes to the company’s 2017 financial statements, she has determined that the present value of future minimum lease payments, at a discount rate of 10 percent, on December 31, 2017 equals €500 million. All lease contracts last another 5 years on December 31, 2017. As expected at the beginning of the year, the company reports an operating lease expense in its income statement for 2018 of €80 million. The company’s tax rate equals 30 percent. The company does not engage in any new operating leases in 2018. The following information is also available from Company A’s financial statements (all ratios use beginning-of-the-year balance sheet values):

Debt to capital (at beginning of 2018) 0.55
Return on beginning equity in 2018 0.10
Assets / Capital (at beginning of 2018) €3,400 million

The effect of capitalizing Company A’s operating leases on its return on beginning equity in 2018 equals
A. An increase from 0.10 to 0.15 (rounded).
B. An increase from 0.10 to 0.13 (rounded).
C. A decrease from 0.10 to 0.07 (rounded).
D. A decrease from 0.10 to 0.05 (rounded).

Answer 25

C. A decrease from 0.10 to 0.07 (rounded).

Question 26

Company B reduces the discount rate it uses to estimate its post-employment benefit
obligation from 8 percent (at the beginning of fiscal year 2020) to 7 percent (at the beginning of fiscal year 2021). Analysts following company B believe that this reduction is unjustified. According to these analysts company B

A. Understates its 2021 interest cost, overstates its 2021 service cost; overstates the
cumulative actuarial losses at the beginning of 2021.
B. Understates its 2021 interest cost, overstates its 2021 service cost; overstates the fair value of plan assets at the beginning of 2021.
C. Overstates its 2021 interest cost, understates its 2021 service cost; understates the cumulative actuarial losses at the beginning of 2021.
D. Understates its 2021 interest cost, understates its 2021 service cost; understates the fair value of plan assets at the beginning of 2021.

Answer 26

A. Understates its 2021 interest cost, overstates its 2021 service cost; overstates the
cumulative actuarial losses at the beginning of 2021.

Question 27

Under IFRS the pension expense recognized in the income statement may not be equal to the economic cost of the post-employment benefit plan because
A. Firms can recognize current actuarial gains or losses in other comprehensive income.
B. Firms can recognize past service cost in other comprehensive income.
C. Firms can recognize unexpected plan contributions in other comprehensive income.
D. Both A and B are correct.
E. Both A and C are correct.

Answer 27

A. Firms can recognize current actuarial gains or losses in other comprehensive income.

Question 28

To assess the efficiency of a firm’s investment management, an analyst would analyze the
firm’s
A. NOPAT margin
B. Operating asset turnover
C. Financial spread
D. Financial leverage

Answer 28

B. Operating asset turnover

Question 29

To assess the efficiency of a firm’s operating management, an analyst would analyze the firm’s
A. NOPAT margin
B. Operating asset turnover
C. Financial spread
D. Financial leverage

Answer 29

A. NOPAT margin

Question 30

One difference between the traditional and the alternative approach to decomposing return on equity is that
A. The traditional approach defines leverage as debt-to-equity, whereas the alternative
approach defines leverage as assets-to-equity.
B. Only the traditional approach explicitly shows the impact of financial spread on return on equity.
C. The approaches use different definitions of profit margins and asset turnover.
D. One approach uses beginning-of-year balance sheet items to calculate ratios, whereas the other approach uses end-of-year balance sheet items.

Answer 30

C. The approaches use different definitions of profit margins and asset turnover.

Question 31

At the end of fiscal year 2022, company Z discloses the following balance sheet:

Assets:
Cash €500,000
Non-cash current assets €800,000
Non-current assets €1,300,000
Minority equity investments €300,000
Total €2,900,000

Equity and Liabilities
Current debt €300,000
Other current liabilities €700,000
Non-current debt €1,400,000
Deferred tax liability €150,000
Equity €350,000
Total €2,900,000

The company needs a cash balance of €300,000 for its operations. Company Z’s net non-current operating assets equal
A. €1,400,000
B. €1,300,000
C. €1,150,000
D. €2,900,000

Answer 31

C. €1,150,000

Question 32

At the end of fiscal year 2022, company Z discloses the following balance sheet:
Assets
Cash €500,000
Non-cash current assets €800,000
Non-current assets €1,300,000
Minority equity investments €300,000
Total €2,900,000

Equity and Liabilities
Current debt €300,000
Other current liabilities €700,000
Non-current debt €1,400,000
Deferred tax liability €150,000
Equity €350,000
Total €2,900,000

The company needs a cash balance of €300,000 for its operations. Company Z’s operating working capital and investment assets equal
A. €400,000 and €500,000, respectively
B. €100,000 and €500,000, respectively
C. €400,000 and €300,000, respectively
D. €100,000 and €300,000, respectively

Answer 32

A. €400,000 and €500,000, respectively

Question 33

At the end of fiscal year 2021, company X discloses the following income statement:
At the end of fiscal year 2021, company X discloses the following income statement:
Revenue €6.500,000
Operating expense (€4,800,000)
Interest income €600,000
Interest expense (€900,000)
Tax expense (€490,000)
Profit or loss €910,000
Company X’s interest expense after tax and net operating after taxes equal
A. €585,000 and €1,105,000, respectively
B. €195,000 and €1,105,000, respectively
C. €300,000 and €910,000, respectively
D. €300,000 and €1,105,000, respectively

Answer 33

A. €585,000 and €1,105,000, respectively

Question 34

Company A discloses the following information:

• Return on equity = 15 percent
• Net operating and investment profit after taxes (NOPAT + NIPAT) = €500,000
• Business assets = Invested capital = €4,000,000
• Effective interest rate after tax = 8 percent

Company A’s financial leverage (debt-to-equity ratio) is
A. Between 40 and 49.9 percent
B. Between 50 and 59.9 percent
C. Between 60 and 69.9 percent
D. Between 70 and 79.9 percent

Answer 34

B. Between 50 and 59.9 percent

Question 35

Company B discloses the following information:

• Return on net operating assets = 10 percent
• Net operating profit after taxes = €500,000
• Revenue = €3,000,000
• Equity = €2,000,000

Company B’s operating asset turnover is
A. Between 40 and 49.9 percent
B. Between 50 and 59.9 percent
C. Between 60 and 69.9 percent
D. Between 70 and 79.9 percent

Answer 35

C. Between 60 and 69.9 percent

Question 36

Industry peers C and D disclose the following information:
Company C
Operating asset turnover 5.6
Return on operating assets 10 percent

Company D
Operating asset turnover 2.3
Return on operating assets 10 percent

Which of the two companies is more likely to follow a cost leadership strategy?
A. Company C
B. Company D

Answer 36

A. Company C

Question 37

Company E discloses the following information:

• Inventories = €800,000
• Cost of sales = €4,500,000
• Business assets = €3,000,000

Company E’s days’ inventories is
A. Between 30 and 39.9 days
B. Between 40 and 49.9 days
C. Between 50 and 59.9 days
D. Between 60 and 69.9 days

Answer 37

D. Between 60 and 69.9 days

Question 38

If a firm’s return on equity is 20 percent, its return on invested capital is 14 percent, its revenue growth rate is 15 percent, and its dividend payout ratio is 50 percent, its sustainable growth rate equals
A. 7 percent
B. 7.5 percent
C. 10 percent
D. 15 percent

Answer 38

C. 10 percent

Question 39

At the end of fiscal year 2021, company Y discloses the following information:

Net operating and investment profit after taxes (NOPAT + NIPAT) €1,100,000
Interest expense after tax (= interest paid) €500,000
Net investment in operating working capital (increase) €700,000
Net investment in non-current assets / CAPX (increase) €900,000
Non-operating losses €90,000
Depreciation and amortization expense €910,000
Increase in debt €550,000
Dividends paid €300,000

Company Y’s free cash flow available to debt and equity is
A. €200,000 (positive)
B. €1,050,000 (positive)
C. €500,000 (positive)
D. (€500,000) (negative)

Answer 39

C. €500,000 (positive)

Question 40

At the end of fiscal year 2021, company Y discloses the following information:

Net operating and investment profit after taxes (NOPAT + NIPAT) €1,100,000
Interest expense after tax (= interest paid) €500,000
Net investment in operating working capital (increase) €700,000
Net investment in non-current assets / CAPX (increase) €900,000
Non-operating losses €90,000
Depreciation and amortization expense €910,000
Increase in debt €550,000
Dividends paid €300,000

Company Y’s free cash flow available to equity is
A. €200,000 (positive)
B. (€450,000) (negative)
C. (€550,000) (negative)
D. €550,000 (positive)

Answer 40

D. €550,000 (positive)