FSA Flashcards
Q: What are the primary roles of analysts in the investment management industry?
A: Equity analysts evaluate potential equity investments and purchase prices. Credit analysts assess creditworthiness and terms for debt investments or credit ratings. Analysts may also evaluate subsidiaries, private equity investments, or overvalued stocks for short positions.
What are the five phases of the financial statement analysis framework?
A: (1) Articulate purpose and context, (2) Collect data, (3) Process data, (4) Analyze/interpret data, and (5) Develop and communicate conclusions and recommendations.
Q: Why is it important to articulate the purpose and context of an analysis?
A: It ensures the analysis is relevant to the decision-making process, aligns with institutional guidelines, and clarifies the intended audience, deliverables, timeframe, and resources needed.
Q: What data sources are typically collected during financial statement analysis?
A: Financial statements, industry and economic data, discussions with stakeholders, questionnaires, and site visits.
Q: What are common tools used to process financial data in analysis?
A: Tools include computing ratios, preparing common-size statements, creating graphs, statistical analyses (e.g., regressions), and sensitivity analyses.
Q: What elements should an equity analyst’s external report typically include?
A: Summary and investment conclusion, industry overview, competitive analysis, financial model (with scenarios), valuation, and investment risks.
Q: What are the primary tasks of equity and credit analysts?
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A: Equity analysts evaluate potential investments in equity securities and determine appropriate purchase prices. Credit analysts assess a company’s creditworthiness and determine terms for debt investments or credit ratings
What are the key phases of the financial statement analysis process?
A: (1) Articulate purpose and context, (2) Collect data, (3) Process data, (4) Analyze/interpret data, and (5) Communicate conclusions and recommendations.
Q: Why is defining the purpose and context crucial in financial analysis?
A: It ensures relevant techniques are applied, focuses on key questions, avoids unnecessary effort, and aligns with the intended audience and deliverables.
Q: Why is the follow-up phase important in financial analysis?
A: It involves revising forecasts and recommendations based on new information, ensuring decisions remain aligned with current conditions and updated analysis.
In September 2017, Sea Ltd, the Singapore-based technology company, filed a registration statement with the US SEC to register its initial public offering of securities (American Depositary Shares, each representing one Class A Ordinary Share) on the New York Stock Exchange. In addition to a large amount of financial information, the registration statement provided over 50 pages of discussion on Sea Ltd.’s business and industry.
Which of the following is most likely to have been included in Sea’s registration statement?
A - Underwriters’ fairness opinion of the offering
B - Assessment of risk factors involved in the business
C - Projected cash flows and earnings for the business
Solution:
B is correct. Information provided by companies in registration statements typically includes disclosures about the securities being offered for sale; the relationship of these new securities to the issuer’s other capital securities; the information typically provided in the annual filings; recent audited financial statements; and risk factors involved in the business. Companies provide information useful in developing projected cash flows and earnings but do not typically include these in the registration statement, nor do they provide opinions of the underwriters.
Why should analysts monitor developments in financial reporting standards?
A: Changes in financial reporting standards affect company valuations and comparability. Analysts must understand their implications for financial reports and investment decisions.
Q: What are some major differences between IFRS and US GAAP?
A:
Basis: IFRS is principles-based, US GAAP is rules-based.
Interest Paid: IFRS allows classification as operating or financing cash flows; US GAAP restricts it to operating.
Inventory Valuation: LIFO is permitted under US GAAP but not under IFRS.
Development Costs: Expensed under US GAAP; capitalized under IFRS if conditions are met.
Q: What challenges do analysts face when comparing financial statements under IFRS and US GAAP?
A: Reconciliation disclosures are not required, making direct adjustments difficult. Analysts must interpret comparative measures cautiously and understand differences in reporting standards.
Q: How can new products and transactions affect financial reporting and analysis?
A: They may lack explicit guidance in existing standards, requiring analysts to understand their business purpose, reporting implications, and potential cash flow effects.
Q: How can analysts influence the development of financial reporting standards?
A: Analysts can provide feedback through comment letters and position papers on proposed changes, sharing insights on how changes affect decision-making.
Q: What principles are essential for high-quality financial reporting?
A: Timeliness, transparency, comparability, consistency, decision relevance, and neutrality, along with detailed cash flow information using a direct format.
Q: What are some issuer-provided sources analysts use besides regulatory filings?
A: Earnings calls, investor presentations, press releases, conversations with management or investor relations, and company websites or physical properties.
Q: What are examples of third-party sources analysts use for financial analysis?
A:
Public third-party sources: Industry whitepapers, economic indicators, general and industry-specific news, and social media sentiment.
Proprietary third-party sources: Analyst reports, data from platforms like Bloomberg and FactSet, and industry-specific consultancy reports.
Q: How can analysts conduct proprietary primary research?
A: Through surveys, conversations, product comparisons, and studies directly commissioned or conducted by the analyst to assess products, industries, or regulations
Q: What is the fundamental principle of accrual accounting for revenue recognition?
A: Revenue is recognized when it is earned, often when the company delivers goods or services and transfers the risks and rewards of ownership.
Q: What are the five steps in the converged revenue recognition standards by IASB and FASB?
A:
Identify the contract(s) with a customer.
Identify the separate performance obligations in the contract.
Determine the transaction price.
Allocate the transaction price to performance obligations.
Recognize revenue when performance obligations are satisfied.
Q: Under IFRS, when is revenue considered highly probable?
A: When it is “more likely than not” to occur.
Q: How is revenue recognized for principal versus agent transactions?
A: A principal records the total consideration as revenue, while an agent records only their commission or fee as revenue.
Q: How does Mahjong Pizza recognize revenue from franchise royalties?
A: Royalties are recognized as a percentage of franchisee restaurant sales, while upfront fees are amortized over the term of the franchise agreement.
Q: How does CReaM Software differentiate revenue recognition between software licenses and cloud services?
A: Revenue for licenses is recognized at the time of transfer, while revenue for cloud services is recognized over the contract term.
Q: When is revenue recognized for long-term contracts under IFRS 15?
A: Revenue is recognized over time as work progresses, measured using either output or input methods.
Q: What conditions must be met for revenue recognition in bill-and-hold arrangements under IFRS 15?
A:
The arrangement must have a substantive reason.
The product must be identified for the customer.
The product must be ready for physical transfer.
The entity cannot use or direct the product to another customer.
To achieve the core principle, the standard describes the application of the following five steps in recognizing revenue:
1- Identify the contract(s) with a customer,
2- identify the separate or distinct performance obligations in the contract,
3- determine the transaction price,
4- allocate the transaction price to the performance obligations in the contract, and
5- recognize revenue when (or as) the entity satisfies a performance obligation.
According to the standard, a contract is :
An agreement and commitment with commercial substance between the contacting parties. It establishes each party’s obligations and rights, including payment terms.
Q: What are the general principles of expense recognition?
A: A company recognizes expenses in the period when it consumes the economic benefits or loses a previously recognized benefit. Common expense recognition models are matching, expensing as incurred, and capitalization with subsequent depreciation or amortization.
Q: What is the matching principle in expense recognition?
A: Under the matching principle, expenses (e.g., cost of goods sold) are recognized in the same period as the related revenues. This matching is for costs directly associated with specific revenues.
Q: How do period costs differ from matching principle costs?
A: Period costs are expenses that do not directly match revenues and are typically expensed as incurred. Examples include administrative, managerial, and research expenses, as well as payroll for non-product related employees.
Q: What is the difference between capitalizing and expensing costs?
A: Capitalizing an expense turns it into an asset on the balance sheet, and it is expensed gradually through depreciation or amortization. Expensing costs immediately recognizes the expenditure as a cost in the period incurred, impacting net income right away.
Q: What impact does capitalizing an expenditure have on financial statements?
A: Capitalizing increases reported net income initially, as the expense is spread out over time through depreciation. It also boosts cash from operations compared to immediate expensing. Over time, the effect of capitalizing diminishes as depreciation reduces profitability.
Q: What is the impact on profitability and equity when capitalizing versus expensing a purchase?
A: Capitalizing an expenditure enhances initial profitability (higher net income) and increases equity in the short term. Expensing the cost reduces profitability initially but boosts it in the long term as the depreciation impact diminishes.
Q: In the context of a capital-intensive company like AMRC, what is the effect of expensing rather than capitalizing track replacement costs?
A: Expensing these costs results in a lower net income for the period in which the expenses occur. However, it would also lead to higher profitability in future periods, as capitalizing would delay recognition of costs, reducing future profit growth.
Question: When must companies capitalize interest costs?
Answer: Companies must capitalize interest costs associated with acquiring or constructing an asset that requires a long period to get ready for its intended use.
Question: How do capitalized interest costs appear on financial statements?
Answer: Capitalized interest costs appear on the balance sheet as part of the asset’s cost and are expensed over time through depreciation (for self-use assets) or cost of sales (for assets intended for sale).
Question: How do capitalized interest costs affect cash flow statements?
Answer: Capitalized interest costs are included in investing cash outflows, whereas expensed interest costs reduce operating cash flow under US GAAP and can reduce operating or financing cash flow under IFRS.
Question: Why should analysts include capitalized interest in interest coverage ratios?
Answer: Including capitalized interest in coverage ratios provides a more accurate picture of a company’s solvency and ability to meet interest obligations.
Question: What should analysts evaluate regarding capitalized interest costs?
Answer: Analysts should assess how capitalized interest affects cash flow classification, interest coverage ratios, and solvency evaluations, as well as adjustments for depreciation of prior-period capitalized interest.
Q: How should non-recurring items be treated in financial reporting and analysis?
A: Non-recurring items, such as discontinued operations, unusual or infrequent items, and changes in accounting policies, should be disclosed separately. This allows analysts to distinguish between ongoing and one-time events, aiding in the assessment of a company’s future earnings.`
Q: What is the difference in the treatment of unusual or infrequent items under IFRS and US GAAP?
A: Under IFRS, material items relevant to understanding financial performance must be disclosed separately. Under US GAAP, such items are included in continuing operations but presented separately if they are material, unusual, or infrequent.
Q: How are discontinued operations reported on the income statement?
A: Discontinued operations are reported separately from continuing operations on a net basis at the bottom of the income statement, including per-share disclosures. This ensures clarity for analysts in distinguishing between continuing and discontinued operations.
Q: How are changes in accounting policies reflected in financial statements?
A: Changes in accounting policies are generally applied retrospectively unless impractical. Financial statements for prior periods are restated, and the notes disclose the nature, reason, and impact of the change, ensuring comparability across periods.
Q: What is the prospective treatment for changes in accounting estimates?
A: Changes in accounting estimates affect the financial statements only for the current and future periods. They are not applied retrospectively, and significant changes are disclosed in the notes for transparency.
Q: How should analysts approach adjustments due to changes in scope and exchange rates?
A: While accounting standards do not require specific disclosures for changes in scope and exchange rates, analysts should examine summary information provided by management to assess their impact on financial results, such as revenue and EPS growth.
Q: What does EPS stand for, and why is it important to equity investors?
A: EPS stands for Earnings Per Share, indicating the portion of a company’s profit allocated to each outstanding share of common stock. It’s a key metric for assessing profitability.
Q: What types of EPS are companies required to report under IFRS and US GAAP?
A: Companies must report basic EPS, diluted EPS, and EPS from continuing operations.
Q: How is a simple capital structure defined?
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A: A company has a simple capital structure if it has no financial instruments that could potentially convert into common stock
Q: What is a complex capital structure?
A: A complex capital structure includes financial instruments like convertible bonds, convertible preferred stock, stock options, or warrants that could convert into common stock.
Q: What is the formula for calculating basic EPS?
A:
Basic EPS = (Net income − Preferred dividends) / Weighted average number of shares outstanding.
How do you account for a stock split or stock dividend in the EPS calculation?
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A: Reflect the stock split/dividend retroactively to the beginning of the period
Q: What is the formula for calculating diluted EPS when convertible preferred stock exists?
A:
Diluted EPS = Net income / (Weighted average shares outstanding + New shares issued at conversion).
Q: How does convertible debt affect diluted EPS?
A: Include the after-tax interest on convertible debt in net income and add the shares issued upon conversion to the denominator.
Q: What is the Treasury Stock Method?
A: A method to calculate diluted EPS for stock options, assuming proceeds from exercise are used to repurchase shares at the average market price.
Q: What is an antidilutive security, and how is it treated in EPS calculations?
A: An antidilutive security increases EPS rather than diluting it and is excluded from the diluted EPS calculation.
Q: Shopalot Company had net income of $1,950,000 and 1,500,000 shares of common stock. What is its basic EPS?
A: Basic EPS = $1.30 ($1,950,000 / 1,500,000).
Q: What is diluted EPS for Bright-Warm Utility if 20,000 preferred shares (convertible into 100,000 common shares) are outstanding with net income of $1,750,000?
A:
Basic EPS = $3.50.
Diluted EPS = $3.18 (($1,750,000) / (500,000 + 100,000)).
Q: What is the objective of analyzing a company’s financial performance using common-size income statements and financial ratios?
A: To assess a company’s performance over time relative to its own past performance or to that of another company.
Q: How is a common-size income statement prepared?
A: By stating each line item on the income statement as a percentage of revenue.
Q: Why is a common-size income statement useful?
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A: It facilitates comparison across time periods (time series analysis) and across companies (cross-sectional analysis) by standardizing each line item and removing the effect of size
Q: What does the common-size income statement in Panel B of Exhibit 18 reveal about Company C compared to Company B?
A: Company C has a higher operating profit margin (20%) than Company B (15%), despite lower absolute operating profit.
Q: What can an analyst infer by comparing gross profit percentages across companies?
A: Differences in strategies, such as higher research, development, or advertising expenditures, may lead to higher gross profit margins.
Q: What is vertical common-size analysis?
A: It involves comparing companies with each other for a specific time period or comparing a company with industry or sector data.
How is net profit margin calculated, and what does it indicate?
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A: Net profit margin = Net income ÷ Revenue. It measures the amount of income generated for each dollar of revenue, with higher values indicating higher profitability
How is gross profit margin calculated, and why is it important?
A: Gross profit margin = Gross profit ÷ Revenue. It indicates the gross profit generated for each dollar of revenue, reflecting a company’s strategy and efficiency.
How did AB InBev’s gross profit margin change from 2015 to 2017?
A: It increased slightly, from 60.7% in 2015 to 62.1% in 2017, showing consistent profitability in gross terms.
What caused AB InBev’s profitability to decline in 2016 despite a stable gross profit margin?
A: Increased operating expenses, particularly higher finance costs due to the merger with SABMiller.
Q: What is the significance of comparing a company’s performance with industry data, as shown in Exhibit 19?
A: It helps an analyst evaluate the company’s relative performance and identify areas of strength or weakness.
Q: Why might an analyst investigate differences in effective tax rates between companies?
A: To understand the underlying causes of tax rate differences and their implications for future net income projections.
An analyst gathers the following information (in € millions) about a manufacturing company:
Cost of sales 150
Gross profit 100
Selling, general, and administrative expenses 30
Based only on this information, applying vertical common-size analysis to the income statement, selling, general, and administrative expenses are:
A.12%.
B.20%.
C.30%.
Solution
A -Correct because a vertical common-size income statement divides each income statement item by revenue. Gross profit is the amount of revenue available after subtracting the costs of delivering goods or services. Accordingly, based only on this information, under vertical common-size analysis, selling, general, and administrative expenses can be expressed as = Selling, general, and administrative expenses / Revenue = Selling, general, and administrative expenses / (Gross profit + Cost of sales) = 30 / (100 + 150); or = 30 / 250 = 12%.
Question: What are intangible assets, and what is an example of one that is not separately identifiable?
Answer: Intangible assets are identifiable non-monetary assets without physical substance, such as patents, licenses, and trademarks. Goodwill is an example of an intangible asset that is not separately identifiable, arising during business combinations.
Question: How do IFRS and US GAAP differ in measuring intangible assets?
Answer: IFRS allows the use of a cost model or revaluation model if there is an active market, while US GAAP permits only the cost model.
Question: How are intangible assets with finite and indefinite useful lives treated?
Answer:
Finite life: Amortized systematically over the estimated useful life, with annual reviews. Impairment principles are the same as for PP&E.
Indefinite life: Not amortized but tested for impairment annually, with a review of the assumption of indefinite life.
Question: How are internally created intangible assets treated under IFRS and US GAAP?
Answer:
Under IFRS: Research phase costs are expensed; development phase costs can be capitalized if criteria are met.
Under US GAAP: Most costs, including research and development, are expensed.
Question: How are acquired intangible assets treated?
Answer: Acquired intangible assets are capitalized and reported if they arise from contractual or legal rights or can be separated and sold, such as customer lists and licensing agreements.
Question: How should Alpha Inc.’s costs for Projects 1 and 2 be treated under IFRS and US GAAP?
Answer:
Project 1: Costs are expensed under both IFRS and US GAAP, as they relate to research activities.
Project 2: Under IFRS, costs related to the development phase that meet capitalization criteria are capitalized; under US GAAP, all costs are expensed.
Question: How does IFRS define a financial instrument?
Answer: A financial instrument is a contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.
Question: What are examples of financial instruments classified as assets, liabilities, or derivatives?
Answer: Financial assets include investments in stocks, bonds, and notes. Financial liabilities include notes payable and bonds payable. Derivatives derive value from underlying factors like interest rates or exchange rates.
Question: What are the two primary methods for measuring financial instruments after acquisition?
Answer: Financial instruments are measured at either fair value or amortized cost.
Question: Under IFRS, what are the two categories for recognizing unrealized gains or losses of financial instruments measured at fair value?
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Answer: Unrealized gains or losses are recognized either through profit or loss on the income statement or through other comprehensive income
Question: How are debt securities classified under IFRS if they are held to maturity or traded?
Answer: Debt securities held to maturity are measured at amortized cost, while trading securities are measured at fair value through profit and loss.
Question: What disclosure is required for financial assets classified as “available-for-sale” under US GAAP?
Answer: Unrealized holding gains or losses must be reported in other comprehensive income, and the assets are shown on the balance sheet at fair value.
Q: What are non-current liabilities?
A: Liabilities that are not classified as current, meaning they are obligations expected to be settled beyond 12 months after the reporting period.
Q: What are common examples of non-current liabilities?
A: Long-term financial liabilities (e.g., loans, bonds payable), deferred tax liabilities, and deferred revenue for goods/services expected to be delivered in future periods.
Q: How are long-term financial liabilities, such as bonds payable, typically reported on the balance sheet?
A: They are usually reported at amortized cost, which equals the bond’s face value at maturity, or at fair value for trading/hedged liabilities.
Q: What causes deferred tax liabilities?
A: Timing differences between taxable income and financial statement income, such as using accelerated depreciation for tax purposes but straight-line depreciation for financial reporting.
What is the purpose of common-size balance sheet analysis?
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Answer: It helps compare the balance sheet composition of a company over time (time-series analysis) or between companies in the same industry (cross-sectional analysis) by expressing each balance sheet item as a percentage of total assets
Define liquidity and solvency in financial analysis.
Answer: Liquidity refers to a company’s ability to meet short-term financial commitments by converting assets into cash. Solvency refers to the company’s ability to meet long-term financial obligations and sustain its financial structure.
How does common-size analysis assist in evaluating a company’s financial strategies?
Answer: It highlights differences in asset composition, indicating strategies like internal growth, acquisitions (e.g., goodwill presence), or operational focus (e.g., higher investment in property, plant, and equipment).
Term: Balance Sheet Ratios
Definition: Financial ratios derived from the balance sheet that assess aspects like liquidity, solvency, and the overall financial health of a company
Term: Solvency
Definition: A company’s ability to meet long-term financial obligations and maintain a sustainable financial structure.
Term: Common-Size Analysis
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Definition: A technique that expresses each item on a balance sheet as a percentage of total assets, enabling comparisons across time and between companies of different sizes
Liquidity Ratios ; Current ratio
Current assets ÷ Current liabilities
Liquidity Ratios ; Quick (acid test) ratio
(Cash + Marketable securities + Receivables) ÷ Current liabilities
Liquidity Ratios ; Cash ratio
(Cash + Marketable securities) ÷ Current liabilities
Solvency Ratios ; Long-term debt-to-equity ratio
Total long-term debt ÷ Total equity
Solvency Ratios ; Debt-to-equity
Total debt ÷ Total equity
Solvency Ratios : Total debt
Total debt ÷ Total assets
Solvency Ratios : Financial leverage
Total assets ÷ Total equity
Q: What does the Balance Sheet show?
A: The Balance Sheet shows the financial position of an entity at a point in time, reporting assets and how they are financed through liabilities and equity.
Q: How does the Income Statement differ from the Balance Sheet?
A: The Income Statement is a “flow” statement that captures financial performance (revenue, expenses, gains, and losses) between two balance sheet dates, while the Balance Sheet is a “stock” statement showing financial position at a specific point in time.
Q: What are the three categories of activities reported in the Statement of Cash Flows?
A: The Statement of Cash Flows classifies cash inflows and outflows into operating, investing, and financing activities.
Q: What does the Statement of Shareholder’s Equity provide?
A: It provides information about changes in equity accounts, such as common stock and retained earnings, over a period of time, including impacts from net income and dividends.
Q: How are financial statements interrelated?
A: The income statement, cash flow statement, and statement of shareholder’s equity link the balance sheet from one period to the next by reconciling beginning and ending balances and capturing transactions during the period.
Question: What is the first step in preparing the cash flow statement?
Answer: Determining cash flows from operating activities, which can be presented using either the direct or indirect method.
Question: How does the direct method differ from the indirect method in presenting cash flows from operating activities?
Answer: The direct method uses major categories of gross cash receipts and payments, while the indirect method reconciles net income to net cash flow.
Question: Are cash flows from investing and financing activities affected by the method chosen for operating cash flows?
Answer: No, cash flows from investing and financing activities are identical regardless of whether the direct or indirect method is used for operating cash flows.
Question: How do you calculate cash received from customers under the direct method?
Answer: Adjust revenue by the change in accounts receivable. If accounts receivable increased, subtract the change; if it decreased, add the change
Question: How is cash paid to suppliers calculated?
Answer: Adjust the cost of goods sold (COGS) by the change in inventory to calculate purchases, then adjust purchases by the change in accounts payable.
Question: What adjustment is made to determine cash paid to employees?
Answer: Adjust salary and wage expenses by the change in salary and wages payable.
Question: How do you calculate cash paid for other operating expenses?
Answer: Adjust other operating expenses for changes in prepaid expenses and accrued expense liabilities.
Question: How is cash paid for income taxes determined?
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Answer: Adjust income tax expense by the changes in taxes receivable, taxes payable, and deferred income taxes
Q: What are the key adjustments to net income in the indirect method for cash flows from operating activities?
A: Adjustments include:
Removing non-operating activities (e.g., gains/losses on asset sales).
Adding back non-cash expenses (e.g., depreciation).
Adjusting for changes in working capital accounts (current operating assets and liabilities).
Q: How are non-cash expenses treated in the indirect method?
A: Non-cash expenses like depreciation and amortization are added back to net income because they reduce income without affecting cash flow.
Q: How are changes in working capital handled in the indirect method?
A:
Increase in current operating assets: Subtracted from net income.
Decrease in current operating assets: Added to net income.
Increase in current operating liabilities: Added to net income.
Decrease in current operating liabilities: Subtracted from net income.
Q: What are some common additions and subtractions in the indirect method?
A:
Additions: Depreciation, loss on asset sale, increase in liabilities, decrease in assets.
Subtractions: Gain on asset sale, decrease in liabilities, increase in assets.
Q: In the indirect method, how does an increase in accounts receivable affect net cash flow?
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A: An increase in accounts receivable is subtracted from net income, as it represents revenue earned but not yet received in cash
Q: What are the three main steps to convert operating cash flows from the indirect method to the direct method?
A:
Disaggregate net income into total revenues and total expenses.
Remove non-operating and non-cash items (e.g., gain on sale of assets, depreciation).
Adjust for changes in working capital accounts to convert accrual-based revenues and expenses to cash flow amounts.
Q: In the conversion from indirect to direct method, what non-cash adjustments need to be made?
A: Non-cash adjustments include removing items like:
Non-operating gain on asset sales (e.g., gain on sale of equipment).
Non-cash expenses like depreciation (e.g., USD1,052 for Acme Corporation)
Q: How are changes in working capital used to calculate cash flows in the direct method?
A: In Step 3, working capital changes adjust accrual-based revenues and expenses to actual cash flows:
Cash received from customers: Total revenue less changes in accounts receivable.
Cash paid to suppliers: Adjust cost of goods sold by changes in inventory and accounts payable.
Cash paid for expenses: Adjust salary, operating expenses, interest, and taxes for changes in related liabilities and assets.
Q: How is cash received from the sale of equipment calculated?
A:
Historical cost of equipment sold: Beginning balance of equipment + purchases – ending balance of equipment.
Accumulated depreciation on equipment sold: Beginning accumulated depreciation + depreciation expense – ending accumulated depreciation.
Cash received: Book value of equipment sold + gain (or loss) on sale.
Q: What is the process for determining cash flows from investing activities in a cash flow statement?
A: The steps involve identifying purchases and sales of assets (e.g., equipment), then calculating cash inflows and outflows. The presentation is the same for both direct and indirect methods of reporting operating cash flows.
Q: How are changes in long-term debt and common stock reflected in cash flows from financing activities?
A:
A decrease in long-term debt (e.g., USD500) indicates a cash outflow from debt repayment.
A decrease in common stock (e.g., USD600) indicates a cash outflow from stock repurchase.
Q: How can dividends paid be computed using retained earnings?
A: Use the formula:
Beginning retained earnings + Net income – Dividends = Ending retained earnings.
Rearrange to find dividends:
Dividends = Beginning retained earnings + Net income – Ending retained earnings.
Q: How do IFRS and US GAAP differ in classifying interest received?
A:
IFRS: Can classify interest received as either operating or investing activities.
US GAAP: Classifies interest received as operating activities.
Q: How are interest payments classified under IFRS and US GAAP?
A:
IFRS: Can classify interest paid as either operating or financing activities.
US GAAP: Classifies interest paid as operating activities.
Q: How do IFRS and US GAAP treat dividends received?
A:
IFRS: Can classify dividends received as either operating or investing activities.
US GAAP: Classifies dividends received as operating activities.
: How are income taxes paid classified under IFRS and US GAAP?
A:
IFRS: Generally classified as operating, but can be allocated to investing or financing if specifically identified.
US GAAP: Classifies all income tax expenses as operating activities.
Which of the following is an example of a financing activity on the cash flow statement under US GAAP?
aPayment of interest
bReceipt of dividends
cPayment of dividends
Solution:
C is correct. Payment of dividends is a financing activity under US GAAP. Payment of interest and receipt of dividends are included in operating cash flows under US GAAP. Note that IFRS allow companies to include receipt of interest and dividends as either operating or investing cash flows and to include payment of interest and dividends as either operating or financing cash flows.
Interest paid is classified as an operating cash flow under:
US GAAP but may be classified as either operating or investing cash flows under IFRS.
IFRS but may be classified as either operating or investing cash flows under US GAAP.
US GAAP but may be classified as either operating or financing cash flows under IFRS.
Solution:
C is correct. Interest expense is always classified as an operating cash flow under US GAAP but may be classified as either an operating or financing cash flow under IFRS.
Cash flows from taxes on income must be separately disclosed under:
IFRS only.
US GAAP only.
both IFRS and US GAAP.
Solution:
C is correct. Taxes on income are required to be separately disclosed under IFRS and US GAAP. The disclosure may be in the cash flow statement or elsewhere.
Q: What is the focus when evaluating the major sources and uses of cash flow?
A:
Evaluate operating, investing, and financing activities.
For mature companies, operating activities should be the primary source of cash flow.
Negative operating cash flow over time may lead to reliance on financing activities (borrowing or issuing stock).
Operating cash flows should cover capital expenditures for sustainable business growth.q
Q: What should analysts focus on when evaluating operating cash flow?
A:
Examine changes in receivables, inventory, payables, etc., to assess cash usage or generation.
Compare operating cash flow with net income to assess earnings quality.
A high net income but low operating cash flow may signal poor earnings quality or aggressive accounting choices.
Evaluate the consistency of operating cash flows and their impact on future forecasts.
Q: What should analysts focus on when evaluating investing cash flows?
A:
Examine each line item in the investing section to understand where cash is being spent or received.
Look for investments in property, plant, equipment, acquisitions, and liquid assets like stocks and bonds.
Consider how major capital investments are being funded (operating cash flow vs. financing activities).
Q: What should analysts focus on when evaluating financing cash flows?
A:
Assess whether the company is raising or repaying capital and understand the nature of capital sources.
Examine borrowing activities to consider repayment schedules.
Evaluate dividend payments and stock repurchases as means of returning capital to owners.
Q: How should operating cash flow be evaluated for a mature company?
A:
Operating cash flow should be positive and sufficient to cover capital expenditures.
Consistent negative operating cash flow is unsustainable and may require external financing.
Evaluate whether operating cash flow can fund value-creative investments or if cash needs to be returned to capital providers.
Q: How should financing activities be evaluated in a cash flow statement?
A:
Determine if the company is borrowing or repaying debt and why.
Assess dividend payments and stock repurchases to understand how the company is returning capital to shareholders.
Examine the timing and nature of capital raised or repaid to understand the company’s financial strategy.
Q: What is free cash flow, and why is it important?
A: Free cash flow is the excess of operating cash flow over capital expenditures. It is important because it indicates the cash available for investment opportunities, debt repayment, or distribution to shareholders.
Q: What is FCFF, and who benefits from it?
A: FCFF is the cash flow available to both debt and equity investors after operating expenses, taxes, and necessary investments in working and fixed capital have been paid. It benefits both debt holders and equity holders.
Q: What is the formula for calculating FCFF starting with net income (NI)?
A:
FCFF = NI + NCC + Int(1 – Tax rate) – FCInv – WCInv
Where:
NCC = Non-cash charges (e.g., depreciation),
Int = Interest expense,
FCInv = Fixed capital investment,
WCInv = Working capital investment.
Q: What is the formula for calculating FCFF starting with cash flow from operating activities (CFO)?
.
A:
FCFF = CFO + Int(1 – Tax rate) – FCInv.
Adjustments for interest and dividends depend on whether they are classified as operating, investing, or financing activities (per IFRS or US GAAP)
Flashcard 5: Free Cash Flow to Equity (FCFE)
Q: What is FCFE, and how is it calculated?
A: FCFE is the cash flow available to common stockholders after operating expenses, borrowing costs, and necessary investments have been paid.
Formula:
FCFE = CFO – FCInv + Net borrowing
OR
FCFE = CFO – FCInv – Net debt repayment (if borrowing is negative).
Q: What does positive FCFE indicate?
A: Positive FCFE means the company has excess cash after covering capital expenditures and debt repayments. This cash can be distributed to shareholders or reinvested in the business.
Q: How does IFRS require inventories to be measured?
.
A: IFRS requires inventories to be measured at the lower of cost and net realizable value (NRV). NRV is the estimated selling price less the costs necessary to complete and sell the inventory. If the carrying amount exceeds NRV, the inventory must be written down, and the loss is recognized as an expense on the income statement
Q: How do IFRS and US GAAP differ in the treatment of inventory write-down reversals?
A: IFRS allows the reversal of inventory write-downs (up to the amount of the original write-down) if the inventory value increases in a subsequent period. US GAAP prohibits the reversal of inventory write-downs.
Q: What are the financial implications of an inventory write-down?
A: An inventory write-down reduces profit and the carrying amount of inventory on the balance sheet, negatively affecting profitability, liquidity, and solvency ratios. However, it improves activity ratios like inventory turnover and total asset turnover due to the reduced asset base.
Q: How are inventories of agricultural, forest products, and minerals treated under IAS 2 and US GAAP?
A: For these inventories, IAS 2 and US GAAP allow measurement at net realizable value (fair value less costs to sell and complete) when active market prices or market-determined values exist. Changes in inventory value are recognized in profit or loss in the period of the change.
A manufacturing company reporting under US GAAP using the FIFO inventory valuation method should measure its finished goods’ inventory at the lower of:
A.cost and market value.
B.cost and net realizable value.
C.market value and net realizable value.
Solution
.
A Incorrect because US GAAP used to specify the lower of cost or market to value inventories. For fiscal years beginning after December 15, 2016, inventories measured using other than LIFO and retail inventory methods are measured at the lower of cost or net realizable value.
B Correct because under US GAAP for fiscal years beginning after December 15, 2016, inventories measured using other than LIFO and retail inventory methods are measured at the lower of cost or net realizable value
Q: How does FIFO affect financial statements in declining vs. rising inventory cost environments?
A: In a declining cost environment, FIFO results in higher cost of sales and lower ending inventory, reducing gross profit and income. In a rising cost environment, FIFO results in lower cost of sales and higher ending inventory, increasing gross profit and income.
Q: How do FIFO and LIFO impact the balance sheet and income statement differently?
A: FIFO ending inventory reflects current replacement costs, while LIFO cost of sales reflects current replacement costs. LIFO ending inventory may not reflect current replacement value because it consists of the oldest inventory costs.
Q: Which financial statement items and ratios are affected by the choice of inventory valuation method?
A: Inventory valuation affects cost of sales, gross profit, net income, inventories, current assets, total assets, and ratios like current ratio, return on assets, gross profit margin, and inventory turnover.
Q: What key disclosures about inventory does IFRS require?
A: IFRS requires disclosures on accounting policies, total carrying amounts (by classification), inventories at fair value, cost of sales, write-downs, reversals of write-downs (and circumstances), and inventories pledged as security.
Q: How do US GAAP inventory disclosure requirements differ from IFRS?
A: US GAAP does not permit the reversal of inventory write-downs and requires disclosure of significant estimates and income from LIFO liquidation.
Q: How are inventory turnover ratio and days of inventory on hand related?
A: They are inversely related. Inventory turnover measures how many times inventory is sold during a year, while days of inventory on hand is calculated as days in the period divided by inventory turnover.
Q: What could high inventory turnover and low days of inventory on hand indicate?
A: It may indicate effective inventory management, but could also reflect inadequate inventory levels or write-downs. Analysts should compare turnover and sales growth with industry norms to determine the cause.
Q: How do gross profit margin and inventory turnover differ across industries?
A: Highly competitive industries often have lower gross profit margins. Luxury product companies have higher margins but lower inventory turnover compared to staple product companies.
Q: What are intangible assets, and what are some examples?
A: Intangible assets are non-monetary assets lacking physical substance. Examples include patents, copyrights, trademarks, and franchises.
Q: What are the three definitional criteria for an identifiable intangible asset under IFRS?
A: An intangible asset must be (1) identifiable, (2) under the company’s control, and (3) expected to generate future economic benefits.
Q: How are intangible assets purchased outside of business combinations accounted for?
A: They are recorded at fair value, assumed to be the purchase price, and allocated accordingly if multiple assets are acquired.
Q: How are internally developed intangible assets treated under IFRS?
A: Research costs must be expensed, while development costs can be capitalized if certain criteria (e.g., technical feasibility, intent to use/sell) are met.
: How does the accounting for software development costs differ under IFRS and US GAAP?
A: Under IFRS, software development costs can be capitalized after meeting recognition criteria. Under US GAAP, costs are expensed until technological feasibility (for sale) or probable completion (for internal use) is established.
Q: How are intangible assets acquired in a business combination treated?
A: The purchase price is allocated based on fair value. Any excess over identifiable assets and liabilities is recorded as goodwill, which cannot be separately identified.
Q: What is the difference between depreciation/amortization and impairment charges?
A: Depreciation and amortization allocate an asset’s cost over its useful life, while impairment charges reflect an unexpected decline in asset value.
Q: How do IFRS and US GAAP differ in impairment reversals for long-lived assets?
A: IFRS allows impairment reversals, while US GAAP generally does not permit them except for assets held for sale.
Q: What is the impairment test for Property, Plant, and Equipment (PPE)?
A: PPE is tested for impairment if there are indicators such as obsolescence or decreased demand. If impaired, its carrying amount is reduced to its recoverable amount.
Q: How do IFRS and US GAAP define recoverable amounts?
A: IFRS defines recoverable amount as the higher of fair value less costs to sell and value in use (present value of future cash flows). US GAAP uses undiscounted cash flows for recoverability assessment and measures impairment loss as carrying amount minus fair value.
Q: How are intangible assets with a finite life tested for impairment?
A: They are amortized and tested for impairment only when significant events indicate potential impairment.
Q: How are intangible assets with indefinite lives tested for impairment?
A: They are not amortized but must be tested for impairment at least annually. Impairment exists if the carrying amount exceeds fair value.
Q: What happens when a long-lived asset is classified as held for sale?
A: It is tested for impairment and written down to fair value less costs to sell if necessary. It also ceases to be depreciated or amortized.
Q: How is a gain or loss on the sale of long-lived assets calculated?
A: The gain or loss equals the sale proceeds minus the asset’s carrying amount at the time of sale.
Q: What are the IFRS disclosure requirements for property, plant, and equipment?
A: Under IFRS, a company must disclose the measurement basis, depreciation method, useful life or rate, gross carrying amount, accumulated depreciation, and a reconciliation of the carrying amount at the beginning and end of the period. Additional disclosures include restrictions on title, security pledges, contractual acquisition agreements, and revaluation details if applicable.
Q: What are the IFRS disclosure requirements for intangible assets?
A: For each class of intangible assets, IFRS requires disclosure of whether useful lives are indefinite or finite. If finite, disclosures must include the amortization method, useful life or rate, gross carrying amount, accumulated amortization, reconciliation of carrying amounts, and where amortization is recorded on the income statement. Restrictions on title, security pledges, and revaluation details must also be disclosed.
Q: How do impairment loss disclosure requirements differ under IFRS and US GAAP?
A: Under IFRS, companies must disclose impairment losses and reversals by asset class, including the events leading to impairment and where the losses appear on financial statements. Under US GAAP, impairment losses for assets held for use cannot be reversed. Companies must disclose details of impaired assets, causes of impairment, fair value determination, and where losses are recognized.
Q: Where do disclosures about long-lived assets appear in financial statements?
A: Disclosures appear in the balance sheet (carrying value), income statement (depreciation/amortization expense), statement of cash flows (investing section for acquisitions/disposals, indirect method adjustments for depreciation), and financial statement notes (accounting methods, useful lives, historical cost, accumulated depreciation, and depreciation expense).
Q: What does the fixed asset turnover ratio measure?
A: The fixed asset turnover ratio (total revenue ÷ average net fixed assets) measures how efficiently a company generates revenue from its investment in property, plant, and equipment (PPE). A higher ratio indicates greater efficiency in utilizing fixed assets.
Q: What are asset age ratios, and why are they important?
A: Asset age ratios estimate the age and remaining useful life of a company’s assets, helping assess reinvestment needs. Key ratios include:
Average asset age = Accumulated depreciation ÷ Depreciation expense
Remaining useful life = Net PPE ÷ Depreciation expense
Q: How is the estimated total useful life of an asset calculated?
A: Assuming straight-line depreciation and no salvage value:
Estimated total useful life = (Historical cost ÷ Annual depreciation expense)
Or equivalently:
Estimated total useful life = (Accumulated depreciation ÷ Annual depreciation expense) + (Net PPE ÷ Annual depreciation expense)
Q: What does the capital expenditures to depreciation expense ratio indicate?
A: This ratio compares a company’s annual capital expenditures to annual depreciation expense. A higher ratio suggests reinvestment in PPE to maintain or expand productive capacity, while a lower ratio may indicate underinvestment in asset replacement.
Q: What is a lease?
A: A lease is a contract that grants the right to use an asset for a period of time in exchange for consideration. The lessee pays to use the asset, while the lessor owns the asset and receives payment.
Q: What are the three key requirements for lease accounting?
A: A contract is a lease if it:
Identifies a specific underlying asset.
Gives the customer rights to the asset’s economic benefits.
Gives the customer control over how the asset is used.
Q: What are the advantages of leasing over purchasing an asset?
A: Leasing requires less upfront cash, has lower effective interest rates due to secured borrowing, and reduces ownership risks such as asset obsolescence.
Q: How are leases classified?
A: Leases are classified as:
Finance leases (resemble asset purchases) if they meet any of five criteria (e.g., ownership transfer, major part of useful life).
Operating leases (resemble rentals) if they meet none of the criteria.
Q: What are the five criteria for a finance lease?
A: A lease is a finance lease if any of these apply:
Ownership transfers to lessee.
Lessee has a purchase option it’s likely to use.
Lease term covers most of asset’s useful life.
Present value of lease payments equals or exceeds fair value.
Asset has no alternative use to the lessor.
Q: How are leases reported under IFRS for lessees?
A: Lessees recognize a lease liability and right-of-use (ROU) asset equal to the present value of lease payments. The lease liability decreases with payments, while the ROU asset is amortized.
Q: How does US GAAP lessee accounting differ from IFRS?
A: - Finance leases are treated like IFRS leases.
Operating leases recognize a single lease expense, with lease payments recorded under operating activities in cash flows.
Q: How do lessors classify and report leases?
A: - Finance leases: Recognize lease receivable, derecognize leased asset, report interest income.
Operating leases: Keep asset on balance sheet, recognize straight-line lease revenue, and continue depreciating the asset.
Q: What are the main objectives of employee compensation packages?
A: Employee compensation packages aim to satisfy employees’ liquidity needs, retain employees, and motivate performance.
Q: What are the two main types of pension plans, and how do they differ?
A: Defined contribution plans have fixed employer contributions with no future obligations, while defined benefit plans promise future payments requiring actuarial assumptions and funding.
Q: How is compensation expense for short-term employee benefits accounted for?
A: It is recorded as an expense in the period it vests, with a corresponding cash outflow or accrued liability.
Q: What are the three components of pension accounting under IFRS?
A: (1) Service costs, (2) net interest expense or income, and (3) remeasurements recognized in other comprehensive income.
Q: How does share-based compensation affect financial statements?
A: It is recognized as an expense over the vesting period and can dilute earnings per share, even without a cash outlay.
Q: What are common forms of equity-settled share-based compensation?
A: Stock grants, restricted stock units (RSUs), and stock options, all recognized based on fair value at the grant date.
Q: What is the accounting treatment for the exercise of stock options?
A: Upon exercise of stock options, the company increases its cash by the amount of the exercise price paid by the employee. The par value of the stock issued is credited to common stock, and any additional value (difference between par value and the fair value at grant date) is credited to additional paid-in capital. The compensation expense is based on the fair value of the options at the grant date, not the market price at the time of exercise.
How is compensation expense for stock options recognized and allocated?
A: Compensation expense for stock options is recognized based on the fair value of the options at the grant date and is expensed ratably over the service period, which is typically between the grant date and vesting date. If the options vest immediately, the expense is recognized on the grant date. If the options vest over time or are subject to performance conditions, the expense is allocated over the vesting period.
Information about accounting estimates, assumptions, and methods chosen for reporting is most likely found in:
A)
the auditor’s opinion.
B)
financial statement notes.
C)
management discussion and analysis.
the auditor’s opinion.
Incorrect Answer
B)
financial statement notes.
Correct Answer
C)
management discussion and analysis.
Incorrect Answer
Explanation
Information about accounting methods and estimates is contained in the footnotes to the financial statements. (Module 27.1, LOS 27.c)
Which of the following is least likely to be a part of segment disclosure?
A)
Segment sales.
B)
Segment cost of goods sold.
C)
Segment earnings.
Explanation
Firms are not required to provide detailed financial statements for segments that would include line items such as cost of goods sold, but the following should be disclosed in the segment data:
Revenue (external and between segments)
A measure of profit or loss
A measure of assets and liabilities
Interest (revenue and expense)
Acquisitions of PP&E and intangibles
Depreciation and amortization
Other noncash expenses
Income tax expense
Share of equity-accounted investments results
he first step in the revenue recognition process is to:
A)
determine the price.
B)
identify the contract.
C)
identify the obligations.
Explanation
The five steps in revenue recognition are as follows:
Step 1: Identify the contract or contracts with the customer.
Step 2: Identify the performance obligations in the contract(s).
Step 3: Determine a transaction price.
Step 4: Allocate the transaction price to the performance obligations.
Step 5: Recognize revenue when (or as) the performance obligations have been satisfied.
A contractor agrees to build a bridge for a total price of $10 million. The project is expected to take four years to complete, at a total cost of $6.5 million. After Year 1, costs of $2.5 million have been incurred, and a further $1 million in costs are incurred in Year 2. The client pays $2 million in each of the first two years. The amount of revenue the contractor should recognize in Year 2 is closest to:
A)
$1.54 million.
B)
$2.00 million.
C)
$5.38 million.
Explanation
In Year 1, the contractor has incurred 38.5% ($2.5 million / $6.5 million) of expected total costs and should recognize 38.5% of total revenue ($10 million × 38.5% = $3.85 million). By the end of Year 2, a total of $3.5 million costs have been incurred, 53.8% of expected total costs. Cumulatively, by the end of Year 2, total revenue of 53.8% × $10 million = $5.38 million should have been recognized, leaving $1.53 million ($5.38 million - $3.85 million) to be recognized in Year 2. The amount paid by the client does not affect revenue
Red Company immediately expenses its development costs, while Black Company capitalizes its development costs. All else equal, Red Company will:
A)
show smoother reported earnings than Black Company.
B)
report higher operating cash flow than Black Company.
C)
report higher asset turnover than Black Company.
Correct Answer
Explanation
As compared to a firm that capitalizes its expenditures, a firm that immediately expenses expenditures will report lower assets. Thus, asset turnover (revenue / average assets) will be higher for the expensing firm (lower denominator). (Module 28.2, LOS 28.b)
If a company purchases an asset with future economic benefits that are highly uncertain, the company should:
A)
expense the purchase.
B)
use straight-line depreciation.
C)
use an accelerated depreciation method.
Explanation
If the future economic benefits of a purchase are highly uncertain, a company should expense the purchase in the period it is incurred. (Module 28.2, LOS 28.b)
Which of the following transactions would most likely be reported below income from continuing operations, net of tax?
A)
Gain or loss from the sale of equipment used in a firm’s manufacturing operation.
B)
A change from the accelerated method of depreciation to the straight-line method.
C)
The operating income of a physically and operationally distinct division that is currently for sale, but not yet sold.
Explanation
A physically and operationally distinct division that is currently for sale is treated as a discontinued operation. The income from the division is reported net of tax below income from continuing operations. Gains and losses on sales of operating assets, as well as depreciation expense, are reported pretax, above income from continuing operations. (Module 28.3, LOS 28.c)
Which of the following statements about nonrecurring items is least accurate?
A)
Discontinued operations are reported net of taxes, at the bottom of the income statement before net income.
B)
Unusual or infrequent items are reported before taxes, above net income from continuing operations.
C)
A change in accounting principle is reported in the income statement net of taxes, before net income.
Explanation
A change in accounting principle requires retrospective application; that is, all prior-period financial statements currently presented are restated to reflect the change. (Module 28.3, LOS 28.c)
A vertical common-size income statement expresses each category of the income statement as a percentage of:
A)
assets.
B)
gross profit.
C)
revenue.
Explanation
Each category of the income statement is expressed as a percentage of revenue (sales). (Module 28.5, LOS 28.e)
Which of the following would most likely result in higher gross profit margin, assuming no fixed costs?
A)
A 10% increase in the number of units sold.
B)
A 5% decrease in production cost per unit.
C)
A 7% decrease in administrative expenses.
Explanation
A 5% decrease in per unit production cost will increase gross profit by reducing the cost of goods sold. Assuming no fixed costs, gross profit margin will remain the same if sale quantities increase. Administrative expenses are not included in gross profit margin. (Module 28.5, LOS 28.e)
For a company reporting under IFRS, product development costs:
A)
must always be capitalized.
B)
may be capitalized.
C)
must be expensed.
Explanation
Product development costs may be capitalized under IFRS if certain criteria are met (e.g., the company has identified a customer base, has sufficient resources to complete the product, and intends to sell the product). U.S. GAAP requires all product development expenditure to be expensed. (Module 29.1, LOS 29.a)
At the beginning of the year, the Parent Company purchased all 500,000 shares of Sub, Inc. for $15 per share. Just before the acquisition date, Sub’s balance sheet reported net assets of $6 million. Parent determined the fair value of Sub’s property and equipment was $1 million higher than reported by Sub. What amount of goodwill should Parent report as a result of its acquisition of Sub?
A)
$0.
B)
$500,000.
C)
$1,500,000.
The purchase price of $7,500,000 ($15 per share × 500,000 shares) – fair value of net assets of $7,000,000 ($6,000,000 book value + $1,000,000 increase in property and equipment) = goodwill of $500,000. (Module 29.1, LOS 29.a)
A vertical common-size balance sheet expresses each category of the balance sheet as a percentage of:
A)
assets.
B)
equity.
C)
revenue.
Explanation
Each category of the balance sheet is expressed as a percentage of total assets. (Module 29.2, LOS 29.e)
Which of the following ratios are used to measure a firm’s liquidity and solvency?
Liquidity Solvency
A)
Current ratio Quick ratio
B)
Debt-to-equity ratio Financial leverage ratio
C)
Cash ratio Total debt ratio
Explanation
The current ratio, quick ratio, and cash ratio measure liquidity. The debt-to-equity, the total debt ratio, and the financial leverage ratio measure solvency. (Module 29.2, LOS 29.e)
Q: How does LIFO impact COGS and net income during inflationary periods?
A: LIFO results in higher COGS because the last units purchased have higher costs, leading to lower gross profit and net income compared to FIFO.
Q: What happens to ending inventory valuation under FIFO vs. LIFO during inflation?
A: FIFO ending inventory is higher because it includes the most recent (higher-cost) purchases, while LIFO ending inventory is lower as it reflects older (lower-cost) purchases.
Q: How do LIFO and FIFO affect financial ratios when prices are rising?
A: FIFO results in higher profitability, liquidity (higher current ratio and working capital), and lower debt ratios. LIFO leads to higher inventory turnover but lower profitability and liquidity.
Q: What is LIFO liquidation, and how does it impact financial statements?
A: LIFO liquidation occurs when inventory levels decrease, causing older, lower-cost inventory to be recognized in COGS, leading to artificially higher profit margins and increased taxable income.
Q: When would LIFO gross profit be higher than FIFO despite rising prices?
A: If a LIFO liquidation occurs (inventory declines), older lower-cost inventory is used for COGS, temporarily boosting gross profit margins.
Q: How does the average cost method compare to FIFO and LIFO?
A: The average cost method produces COGS and ending inventory values between those of FIFO and LIFO, smoothing out fluctuations in price changes.
Which of the following statements relating to U.S. GAAP inventory valuation is most accurate?
A)
Companies using FIFO should report inventory in the balance sheet at the lower of cost or market value.
B)
Inventory can be written up, but not by more than it was previously written down.
C)
When establishing market value, net realizable value should be used as the upper limit if replacement cost exceeds net realizable value.
Explanation
When establishing market value, replacement cost should be used subject to upper and lower limits. The upper limit is net realizable value, and the lower limit is net realizable value minus the normal profit margin. The lower of cost or market value is only applicable to companies using either the LIFO or retail sales method. Companies using specific identification, FIFO, or average cost should use the lower of cost or NRV. Inventory write-downs under U.S. GAAP cannot be reversed. (Module 32.1, LOS 32.a)
Under which inventory cost flow assumption does inventory on the balance sheet best approximate its current cost?
A)
First-in, first-out.
B)
Weighted average cost.
C)
Last-in, first-out.
Explanation
Under FIFO, ending inventory is made up of the most recent purchases, thereby providing a closer approximation of current cost. (Module 32.2, LOS 32.b)
Which of the following is most likely for a firm with high inventory turnover and lower sales growth than the industry average? The firm:
A)
is managing its inventory effectively.
B)
may have obsolete inventory that requires a write-down.
C)
may be losing sales by not carrying enough inventory.
Explanation
High inventory turnover coupled with low sales growth relative to the industry may be an indication of inadequate inventory levels. In this case, the firm may be losing sales by not carrying enough inventory. (Module 32.3, LOS 32.c)
During a period of increasing prices, compared to reporting under LIFO, a firm that reports using FIFO for inventory will have a:
A)
lower gross margin.
Incorrect Answer
B)
higher current ratio.
Correct Answer
C)
higher asset turnover.
Incorrect Answer
Explanation
Compared to using LIFO, using FIFO would produce lower COGS, higher gross operating income, and higher ending inventory, so current assets and the current ratio would be higher. Consequently, gross margin would be higher and asset turnover would be lower under the FIFO inventory method. (Module 32.3, LOS 32.c)
In the year after an impairment charge on a finite-lived identifiable intangible asset, compared to not taking the charge, net income is most likely to be:
A)
lower.
B)
higher.
C)
unaffected.
Incorrect Answer
Explanation
Because a finite-lived identifiable intangible asset would be amortized, amortization expense in the year after the reduction from the impairment charge would be lower (the carrying value of the asset would most likely be lower), increasing net income. (Module 33.2, LOS 33.b)
Sinclair S.r.l. has recently exchanged an old asset for a new asset. Which of the following comments is least accurate?
A)
The difference between the fair value and the carrying value of the disposed asset will be recognized in the income statement as a gain or loss.
B)
The new asset will be recorded in the balance sheet at the fair value of the assets disposed of.
C)
If the fair value of the asset received and the fair value of the asset disposed of cannot be established, a disposal loss will be recorded in the income statement equal to the carrying value of the disposed asset.
Explanation
The gain or loss on an asset’s exchange is calculated as the difference between the fair value of the asset that has been disposed of and the carrying value of the disposed asset. The new asset should be recorded in the balance sheet at the fair value of the asset disposed of. If the fair value of the disposed asset is difficult to estimate, then the gain or loss on disposal is computed as the fair value of the asset acquired in the exchange less the carrying value of the asset disposed of. The new asset would be recorded at its fair value in the balance sheet. If neither the fair value of the asset disposed of nor acquired can be established, the new asset will be recorded at the carrying value of the disposed asset. In this situation, there will be no gain or loss recorded on disposal. (Module 33.2, LOS 33.b)
Q: What are the key PP&E disclosures required under IFRS?
A: Firms must disclose:
Basis for measurement (usually historical cost)
Depreciation method & expense
Useful lives or depreciation rates
Gross carrying value & accumulated depreciation
Reconciliation of carrying amounts from beginning to end of the period
Q: What additional disclosures are required under IFRS for PP&E?
A:
Title restrictions and assets pledged as collateral
Agreements to acquire PP&E in the future
If using the revaluation model: revaluation date, fair value determination, historical cost carrying value, and revaluation surplus in OCI
Flashcard 3: U.S. GAAP PP&E Disclosure Requirements
Q: What are the key PP&E disclosures required under U.S. GAAP?
A:
Depreciation expense for the period
Balances of major asset classes (e.g., land, buildings, machinery)
Accumulated depreciation (by major class or total)
Description of depreciation methods
Q: What impairment disclosures are required under IFRS and U.S. GAAP?
A:
IFRS: Amounts of impairment losses & reversals, recognition in the income statement, and causes of impairment
U.S. GAAP: Description of the impaired asset, cause of impairment, fair value determination, loss amount, and where the loss is recognized
Q: How can analysts estimate a firm’s asset age and useful life?
A:
Average Age = Accumulated Depreciation / Annual Depreciation Expense
Total Useful Life = Historical Cost / Annual Depreciation Expense
Remaining Useful Life = Ending Net PP&E / Annual Depreciation Expense
Q: What are two key ratios for analyzing PP&E efficiency?
A:
Fixed-Asset Turnover = Revenue / Average Fixed Assets (higher ratio = more efficiency)
CapEx to Depreciation Ratio = Annual Capital Expenditures / Depreciation Expense (indicates if the firm is maintaining production capacity)
Q: What are the three requirements for a contract to be considered a lease?
.
A: 1. It must refer to a specific asset.
2. It must give the lessee all the asset’s economic benefits during the lease term.
3. It must give the lessee the right to determine how to use the asset during the lease term
Q: What are three advantages of leasing over purchasing an asset?
A: 1. Less initial cash outflow.
2. Less costly financing due to the asset acting as security.
3. Less risk of obsolescence since the lessee often returns the asset at the end of the lease.
Q: What conditions must be met for a lease to be classified as a finance lease under IFRS and U.S. GAAP?
A: A lease is classified as a finance lease if it meets any of these five conditions:
Ownership transfers to the lessee.
Lessee has an option to buy the asset and is expected to exercise it.
Lease covers most of the asset’s useful life.
Present value of lease payments ≥ asset’s fair value.
The asset has no alternative use for the lessor.
Q: How are finance leases recorded under IFRS on the lessee’s balance sheet?
A: The lessee records a Right-of-Use (ROU) asset and a lease liability, both equal to the present value of lease payments. The ROU asset is amortized over the lease term, and the liability decreases with each lease payment.
Q: What is the difference between finance lease and operating lease accounting under U.S. GAAP?
A: - Finance Lease: ROU asset and lease liability recorded separately; interest and amortization are reported separately.
Operating Lease: ROU asset and lease liability are equal each period; lease expense is reported as a single amount (interest + amortization).
Q: How are short-term or low-value leases treated under IFRS and U.S. GAAP?
A: - IFRS: Expensed straight-line, no asset or liability recorded for leases <12 months or <$5,000.
U.S. GAAP: Expensed straight-line for short-term leases, no balance sheet impact.
Q: How does a finance lease impact financial statements compared to an operating lease?
A: - Balance Sheet: Finance lease ROU asset is lower, liabilities are the same.
Income Statement: Finance lease results in lower earnings in early years, higher earnings later.
Cash Flow Statement: Finance lease has higher CFO and lower CFF, while operating lease has lower CFO and higher CQ: How does lessor accounting differ for finance leases vs. operating leases?
A: - Finance Lease: The lessor removes the asset and records a lease receivable. Interest income is recognized over time.
Operating Lease: The lessor retains the asset and recognizes lease payments as rental income.F.
Q: How does lessor accounting differ for finance leases vs. operating leases?
A: - Finance Lease: The lessor removes the asset and records a lease receivable. Interest income is recognized over time.
Operating Lease: The lessor retains the asset and recognizes lease payments as rental income.`
Under IFRS, which of the following lease types least likely requires a lessee to create a right-of-use (ROU) asset and a lease liability?
A)
Low-value leases.
B)
Operating leases.
C)
Finance leases.
Explanation
Both operating leases and finance leases report an ROU asset and a lease liability, and both are accounted for identically. Under U.S. GAAP, operating and financing leases also report both an ROU asset and lease liability; however, the accounting for the two types is slightly different. Exceptions exist for low-value assets and leases with durations of less than one year under IFRS (U.S. GAAP has no monetary value criteria). (Module 34.1, LOS 34.a)
During the life of a long-term lease under IFRS, the lessee recognizes:
A)
interest expense only.
B)
amortization expense and interest expense.
C)
neither amortization expense nor interest expense.
Incorrect Answer
Explanation
At lease inception, the lessee records a right-of-use (ROU) asset and a lease liability, both equal to the present value of the lease payments. In each period over the life of the lease, the lessee recognizes interest expense for the interest portion of the lease payments and amortization expense on the ROU asset. (Module 34.1, LOS 34.a)
Criteria for reporting a lease as a finance lease least likely include that the:
A)
present value of the lease payments is less than the fair value of the asset.
B)
lease term is for substantially most of the asset’s useful life.
C)
lessee directs the use of the asset and retains the benefits from the asset’s use.
Explanation
IFRS and U.S. GAAP treat a lease as a finance lease (for both lessee and lessor) if any of the following criteria are met:
Ownership of the leased asset transfers to the lessee.
The lessee has an option to buy the asset and is expected to exercise it.
The lease is for most of the asset’s useful life.
The present value of the lease payments is greater than or equal to the asset’s fair value.
The lessor has no other use for the asset (i.e., the asset is of a specialized nature only suitable for use by the lessee).
For a lessor, operating leases result in:
A)
interest income recorded in the income statement.
B)
a profit or loss at the beginning of the lease.
C)
depreciation on the leased asset.
Correct Answer
Explanation
For a lessor, the asset remains in their balance sheet if treated as an operating lease, and is depreciated over its life. There is no derecognition of the asset, so there is no gain or loss at the outset of the lease. Payments from the lessee are treated as rental income. (Module 34.1, LOS 34.a)
For a lessee with an operating lease, which of the following is most accurate?
A)
Both IFRS and U.S. GAAP report interest and amortization in the income statement.
B)
For both IFRS and U.S. GAAP, the right-of-use (ROU) asset will equal the lease liability over the life of the lease.
C)
IFRS will typically result in a lower ROU asset than U.S. GAAP.
Explanation
U.S. GAAP reports an income statement expense that is equal to the lease payment. While conceptually, the amount contains both interest and amortization, they are not shown separately on the income statement. IFRS reports both interest and amortization in the income statement, and the aggregate of the two amounts will not equal the lease payment. Under U.S. GAAP, the ROU asset and the lease liability are equal at all points over the lease’s life. Under IFRS, the only points where the ROU asset is the same as the lease liability are at initiation and the end of the lease. IFRS will result in a lower ROU asset than U.S. GAAP. Under IFRS, the ROU asset is amortized over the life of the asset (using either straight-line or accelerated methods). Under U.S. GAAP, the amortization is equal to the principal payment on the liability. Principal payments initially are lower due to the high interest cost, but as the lease ages and the liability decreases, the interest element of each payment will decrease and the principal element will increase. The result is that accumulated amortization under IFRS is greater than U.S. GAAP, resulting in a lower ROU asset. (Module 34.1, LOS 34.a)
For a lessor, cash flows from a lease are classified as:
A)
operating.
Correct Answer
B)
investing.
C)
financing.
Incorrect Answer
Explanation
Cash flows from a lease are operating cash inflows for the lessor. (Module 34.1, LOS 34.a)
If the lessor in a finance lease is a manufacturer or dealer of leased equipment, the lessor will:
A)
retain the asset in its balance sheet and continue to depreciate it.
B)
record higher revenues at lease inception when compared to an operating lease.
C)
record lease revenue in its income statement rather than interest and amortization.
Explanation
Finance leases for a lessor may be classified as either sales-type leases or direct financing leases. If the lessor is a manufacturer or dealer of the leased equipment, the asset is treated as inventory sold at the outset of the lease. Revenue is reported as well as a cost of sales amount. The revenue is the present value of lease receipts. Cost of sales is the carrying value of the asset less the present value of any residual value. The lease is a direct financing lease if the lessor is a financing company (buying an asset on behalf of the lessee and leasing it out). Any gain or loss on derecognition of the asset does not affect the income statement on lease initiation. The gain or loss is deferred and recognized in the income statement, as interest, over the life of the lease. For an operating lease, revenue is recognized when lease payments from the lessee fall due. (Module 34.1, LOS 34.a)
Q: What are the two main types of pension plans?
A: Defined Contribution Plans and Defined Benefit Plans.
Q: What are the three elements that change a defined benefit plan’s funded status under IFRS?
A: 1) Service cost, 2) Net interest expense or income, 3) Remeasurements (actuarial gains/losses and differences between actual and expected returns on plan assets).
Q: How is pension expense recognized for a defined contribution plan?
A: The pension expense equals the employer’s contribution, with no further obligations reported on the balance sheet.
Q: How do U.S. GAAP and IFRS differ in recognizing past service costs for defined benefit plans?
A: Under IFRS, past service costs are included in the income statement as part of service costs. Under U.S. GAAP, they are recorded in other comprehensive income (OCI) and amortized over time.
Q: How is the fair value of stock-based compensation determined and expensed?
A: It is estimated at the grant date and expensed over the vesting period using valuation models like Black-Scholes or binomial models for stock options.
Q: What are Stock Appreciation Rights (SARs), and how do they differ from stock options?
A: SARs provide cash payments based on stock price increases without issuing new shares, avoiding shareholder dilution but creating cash outflow obligations for the company.
A net pension asset or liability can be associated with:
A)
defined benefit pension plans only.
B)
defined contribution pension plans only.
C)
either defined benefit or defined contribution pension plans.
Explanation
Defined benefit pension plans can be overfunded and result in a net pension asset, or they can be underfunded and result in a net pension liability. Defined contribution plans do not result in balance sheet assets or liabilities because they are neither owned by the sponsoring firm nor obligations of the sponsoring firm. (Module 34.2, LOS 34.b)
Which of the following is most accurate concerning defined benefit pension plans under both IFRS and U.S. GAAP?
A)
The income statement expense is the same.
B)
The amounts taken to other comprehensive income (OCI) are the same.
C)
The total periodic cost of the plan is the same.
Explanation
The total cost of the defined benefit pension plan is identical for both IFRS and U.S. GAAP. IFRS and U.S. GAAP differ in the amounts recognized in the income statement and the amounts taken to OCI. (Module 34.2, LOS 34.b)
Which of the following is least likely a criticism of employee stock options?
A)
The binary nature of option payoffs may encourage excessive risk taking.
Incorrect Answer
B)
The fair value requires subjective estimates at the grant date.
C)
They result in cash outflows for the company on exercise.
Explanation
On exercise, the company receives the option’s exercise price (a cash inflow to the company) and creates new shares. This dilutes existing stockholders’ ownership proportions in the company. The fair value of the option at the grant date requires subjective estimation—in particular, the volatility of the company’s stock price over the service period. By nature, options have binary payoffs, being either zero if the stock price is below the exercise price or positive if the stock price is above the exercise price. This may lead to excessive risk taking because the option holder gains if the stock price increases, but if the stock price decreases the option holder does not experience losses except in the sense that the options go unexercised. (Module 34.2, LOS 34.b)
Q: What are the two main types of pension plans?
A: Defined Contribution Plans and Defined Benefit Plans.
Q: How is pension expense recognized for a defined contribution plan?
A: The pension expense equals the employer’s contribution, with no further obligations reported on the balance sheet.
Q: What are the three elements that change a defined benefit plan’s funded status under IFRS?
A: 1) Service cost, 2) Net interest expense or income, 3) Remeasurements (actuarial gains/losses and differences between actual and expected returns on plan assets).
Q: How do U.S. GAAP and IFRS differ in recognizing past service costs for defined benefit plans?
A: Under IFRS, past service costs are included in the income statement as part of service costs. Under U.S. GAAP, they are recorded in other comprehensive income (OCI) and amortized over time.
Q: How is the fair value of stock-based compensation determined and expensed?
A: It is estimated at the grant date and expensed over the vesting period using valuation models like Black-Scholes or binomial models for stock options.
Q: What are Stock Appreciation Rights (SARs), and how do they differ from stock options?
A: SARs provide cash payments based on stock price increases without issuing new shares, avoiding shareholder dilution but creating cash outflow obligations for the company.
Q: What is taxable income?
A: Taxable income is the amount of income subject to tax according to the tax return, based on tax laws and regulations.
Q: What are taxes payable?
A: Taxes payable represent the tax liability owed to the government due to taxable income. Also called “current tax expense,” but distinct from income tax expense.
Q: What is income tax paid?
A: Income tax paid is the actual cash outflow for taxes, including payments or refunds from prior years.
Q: What is a tax loss carryforward?
A: A tax loss carryforward is a current or past loss that can reduce taxable income (and taxes payable) in future periods, potentially creating a deferred tax asset.
Q: What is tax base?
.
A: Tax base is the net value of an asset or liability used for tax reporting purposes, which may differ from its financial statement carrying value
Q: What is accounting profit?
A: Accounting profit is pretax financial income based on financial reporting standards, also known as income before tax or earnings before tax.
Q: What is income tax expense?
A: Income tax expense is the tax expense recognized in the income statement, including taxes payable and changes in deferred tax liabilities and assets.
Q: What are deferred tax liabilities?
A: Deferred tax liabilities arise when income tax expense exceeds taxes payable due to temporary differences, leading to expected future tax payments.
Q: What are deferred tax assets?
A: Deferred tax assets arise when taxes payable exceed income tax expense, allowing future tax benefits, often due to deductible temporary differences or tax loss carryforwards.
Q: What is a valuation allowance?
A: A valuation allowance is a reduction in deferred tax assets when it is unlikely that the assets will be fully realized in the future.
Q: What is carrying value?
A: Carrying value is the net value of an asset or liability reported on the balance sheet, which may differ from its tax base.
Q: What is a permanent difference?
A: A permanent difference is a discrepancy between taxable income and pretax income that will not reverse in the future, such as tax-exempt income.
Q: What is a temporary difference?
A: A temporary difference is a difference between the tax base and the carrying value of an asset or liability that leads to future taxable or deductible amounts.
If the tax base of an asset is less than the carrying value of the asset and the difference is not expected to reverse in the future, this will result in:
A)
the creation of a DTL.
Incorrect Answer
B)
the creation of a DTA.
C)
neither the creation of a DTA nor a DTL.
Explanation
Timing differences that do not reverse, referred to as permanent differences, do not result in the creation of DTAs or DTLs. If the timing difference was expected to reverse, a DTL would be created because carrying value > tax base. (Module 35.1, LOS 35.a)
Which of the following is least likely to result in the creation of a deferred tax asset (DTA)?
A)
Expenses or losses that are tax deductible before they are recognized in the income statement.
B)
Revenues or gains that are taxable before they are recognized in the income statement.
C)
Tax loss carryforwards that are available to reduce future taxable income.
Explanation
Expenses that are tax deductible before they are recognized in the income statement result in deferred tax liabilities. For example, accelerated depreciation in the tax returns versus straight-line depreciation in the accounts results in more depreciation being recognized in the tax returns, in early periods, and results in carrying value exceeding the tax base. If revenues or gains are taxable before they are recognized in the income statement, DTAs are created. Unearned revenue is a good example of this. Tax loss carryforwards result from negative taxable income. Rather than triggering the tax authorities to pay tax to the firm, they are deferred and can be offset against future taxable income. As a result, the firm will pay less tax in the future, and a DTA is created. (Module 35.1, LOS 35.a)
Sidewinder Corporation has a year-end accounts receivable carrying value of $500,000 after including a doubtful debt provision of 5% of year-end receivables. In the tax returns, bad debt is only deducted when it is written off. This treatment will most likely result in:
A)
the creation of a DTL.
B)
the creation of a DTA.
C)
neither the creation of a DTA nor a DTL.
Explanation
The doubtful debt provision reduces the balance sheet carrying value, but not the tax base of receivables. If the tax base of the asset is greater than the carrying value, this results in a DTA. (Module 35.1, LOS 35.a)
An increase in the tax rate causes the balance sheet value of a DTA to:
A)
decrease.
B)
increase.
C)
remain unchanged.
Explanation
An increase in the tax rate will increase any DTAs and DTLs.
(Module 35.1, LOS 35.a)
A U.S. GAAP reporting firm reports an increased valuation allowance at the end of the current period. What effect will this have on the firm’s income tax expense in the current period?
A)
Increase.
B)
Decrease.
C)
No effect.
Explanation
Recognizing a greater valuation allowance reduces the net value of a DTA, which increases income tax expense in the current period. (Module 35.2, LOS 35.b)
An analyst is comparing a firm to its competitors. The firm has a DTL that results from accelerated depreciation for tax purposes. The firm is expected to continue increasing its purchases of PP&E in the foreseeable future. How should the liability be treated for analysis purposes?
A)
It should be treated as equity at its full value.
B)
It should be treated as a liability at its full value.
C)
The present value should be treated as a liability, with the remainder being treated as equity.
Explanation
The DTL is not expected to reverse in the foreseeable future because the firm is expected to continue to increase its investment in depreciable assets, and accelerated depreciation for tax on the newly acquired assets delays the reversal of the DTL. The liability should be treated as equity at its full value. (Module 35.2, LOS 35.b)
Which of the following rates is most likely to be useful for the analyst for forecasting future earnings?
A)
The statutory tax rate.
B)
The effective tax rate.
C)
The cash tax rate.
Explanation
The effective rate is most useful for forecasting future earnings; however, it may need to be adjusted to remove the impact of transitory components. The statutory rate is the tax rate where the company is domiciled for reporting purposes. The cash tax rate is most applicable when forecasting future tax payments and cash flows.(Module 35.3, LOS 35.c)
Valkyrie AG is a German company that has a wholly owned subsidiary in Italy. Valkyrie earns pretax income of €100 million in each country. If the tax rate in Germany is 30% and the tax rate in Italy is 20%, what is the company’s effective tax rate?
A)
20%.
B)
25%.
C)
30%.
Explanation
Tax in Germany = €100 million × 30% = €30 million
Tax in Italy = €100 million × 20% = €20 million
Effective tax rate =
30 + 20
100 + 100
=
50
200
= 25%
(Module 35.3, LOS 35.c)
Which of the following is least likely to explain why the statutory and effective tax rates differ?
A)
The presence of permanent timing differences.
B)
Overseas business operations.
C)
Changes in deferred tax assets (DTAs) and deferred tax liabilities (DTLs).
Explanation
Changes in DTAs and DTLs do not cause statutory and effective rates to differ. Permanent timing differences do cause the rates to differ, as these items affect either taxable income or pretax earnings, but not both. Overseas business operations result in tax being paid to overseas tax authorities, which are unlikely to have the same statutory rate as the firm’s domicile country. (Module 35.3, LOS 35.c)
Q: Why can reported income tax expense differ from the amount based on the statutory tax rate?
A: Differences arise from:
Different tax rates in various jurisdictions
Permanent tax differences (e.g., tax credits, tax-exempt income, nondeductible expenses)
Tax rate changes and new tax laws
Tax holidays in some countries
Note: Temporary timing differences do not usually cause this difference.
Q: What are the three key tax rates analysts should consider?
A:
Statutory tax rate – The corporate income tax rate in the firm’s jurisdiction
Effective tax rate = Income tax expense ÷ Pretax income
Cash tax rate = Cash taxes paid ÷ Pretax income
Analysts should review footnotes to reconcile statutory and effective tax rates and assess future trends.
Q: What are common sources of deferred tax assets (DTAs) and deferred tax liabilities (DTLs)?
A:
DTLs: Accelerated depreciation for tax vs. straight-line for financial reporting
DTAs: Impairments, restructuring costs, deferred compensation, tax loss carryforwards
No temporary differences for LIFO firms in the U.S.
Deferred tax adjustments also impact stockholders’ equity for unrealized gains/losses.
Q: How can deferred tax disclosures impact financial analysis?
A:
Companies disclose DTAs, DTLs, valuation allowances, and reconciliation items.
A growing DTL suggests higher future tax payments, while a growing DTA may indicate future tax savings.
A decrease in valuation allowance suggests management expects higher taxable income, increasing earnings.
Analyzing trends helps predict future earnings and cash flows.
Q: What is financial reporting quality, and how is it judged?
A: Financial reporting quality refers to the characteristics of a firm’s financial statements. It is judged primarily by adherence to GAAP, but high-quality reporting must also be decision-useful, meaning it is relevant and provides a faithful representation of the firm’s financial position.
Q: What is the difference between financial reporting quality and the quality of reported earnings?
A: A firm can have high financial reporting quality (GAAP-compliant and decision-useful) but low-quality earnings if earnings are unsustainable or inadequate. High-quality earnings are expected to persist in future periods and provide adequate returns to investors.
Q: What is the spectrum of financial reporting quality from best to worst?
A:
High quality: GAAP-compliant, decision-useful, with sustainable and adequate earnings.
GAAP-compliant, decision-useful, but earnings quality is low (unsustainable or inadequate).
GAAP-compliant, but biased reporting choices lower earnings quality.
GAAP-compliant, but earnings are actively managed (smoothing/manipulation).
Not GAAP-compliant, but numbers reflect actual economic activity.
Fraudulent reporting (fictitious numbers).
Q: How do conservative and aggressive accounting differ?
A:
Conservative accounting understates earnings and assets (e.g., early impairment recognition, shorter asset lives).
Aggressive accounting inflates earnings and assets (e.g., capitalizing costs, delaying impairments).
Both can be used to smooth earnings over time.
Q: What are some motivations for low-quality or fraudulent financial reporting?
A:
Meeting benchmarks (e.g., earnings targets, analyst expectations).
Managerial incentives (e.g., bonuses, stock prices).
Avoiding debt covenant violations.
Weak internal controls and poor corporate governance increase the opportunity for manipulation.
A firm reports net income of $40 million. The firm’s financial statements disclose in Management’s Discussion and Analysis that $30 million of net income is attributable to a gain on the sale of assets. Based only on this information, for this period, the firm is best described as having high quality of:
A)
financial reporting only.
B)
both earnings and financial reporting.
C)
neither earnings nor financial reporting.
Explanation
Because a large proportion of net income is due to a one-time gain, this period’s earnings are likely not sustainable and the firm may be said to have low quality of earnings for the period. Clear disclosure of this fact in the financial statements suggests high quality of financial reporting. (Module 36.1, LOS 36.a)
A limitation on the effectiveness of auditing in ensuring financial reporting quality is that:
A)
detecting fraud is not the objective of audits.
Correct Answer
B)
public firms are not required to obtain audit opinions.
C)
auditors may only issue a qualified or unqualified opinion but do not explain why.
Explanation
The objective of audits is to provide reasonable assurance that financial statements are presented fairly. A firm that is engaging in accounting fraud may deceive its auditor. Regulators in most countries require publicly traded firms to obtain independent audits of their financial statements. Auditors may issue a qualified opinion noting certain aspects of financial statements that are inconsistent with accounting principles or an adverse opinion if they find that financial statements are materially misstated and do not conform with GAAP. (Module 36.1, LOS 36.e)
Under IFRS, a firm that presents a nonstandard financial measure is least likely required to:
A)
provide the same measure for at least two prior periods.
B)
explain the reasons for presenting the nonstandard measure.
C)
reconcile the nonstandard measure to a comparable standard measure.
Explanation
IFRS require a firm that presents a nonstandard financial measure to reconcile that measure to an IFRS measure and explain why the firm believes the nonstandard measure is relevant to users of the financial statements. Presenting the nonstandard measure for prior periods is not a requirement. (Module 36.1, LOS 36.f)
Q: How can a firm’s choice of shipping terms affect revenue recognition?
A: A firm choosing FOB shipping point recognizes revenue earlier than FOB destination. This decision impacts financial statements by shifting revenue between periods.
Q: What is channel stuffing, and how does it affect revenue?
A: Channel stuffing is when a firm ships more goods than normally sold in a period to boost current revenue. This can inflate earnings temporarily but may reduce future revenue as distributors work through excess inventory.
Q: How does choosing between straight-line and accelerated depreciation affect financial statements?
A: Accelerated depreciation increases expenses and lowers net income early in an asset’s life, while straight-line spreads expenses evenly, leading to higher early-year profits.
Q: How does FIFO differ from the weighted-average inventory method during rising prices?
A: FIFO results in lower COGS, higher gross profit, and higher net income, while weighted-average provides a more accurate reflection of current costs in COGS.
Q: How does capitalizing an expense affect financial statements?
A: Capitalization turns an expense into an asset, spreading its cost over multiple periods, increasing current net income, and classifying cash outflows as investing rather than operating.
Q: What do activity ratios measure?
A: They measure how efficiently a firm uses its assets.
Q: What are some examples of activity ratios?
A: Inventory turnover, receivables turnover, and total asset turnover.
Q: What does a high turnover ratio indicate?
A: It may indicate efficiency but could also suggest overly strict credit terms or low inventory levels.
Q: What do liquidity ratios assess?
A: A company’s ability to meet short-term obligations.
Q: What are examples of liquidity ratios?
A: Current ratio, quick ratio, and cash ratio.
Q: What does a higher liquidity ratio generally indicate?
A: Better liquidity, but too high may suggest inefficient capital use.
Q: What do solvency ratios measure?
A: A firm’s financial leverage and ability to meet long-term debt obligations.
Q: What are some examples of solvency ratios?
A: Debt-to-equity ratio and interest coverage ratio.
Q: Why can high leverage be risky?
A: It may enhance returns but increases financial risk.
Q: What do profitability ratios evaluate?
A: A company’s ability to generate profits from sales.
Q: What are some examples of profitability ratios?
A: Gross margin, operating margin, and net profit margin.
Q: Why might high margins be a warning sign?
A: They indicate efficiency but may also reflect aggressive accounting practices.
Q: What does the cash conversion cycle (CCC) measure?
A: How long it takes to turn investments in inventory into cash.
Q: What is the formula for CCC?
A: Days’ Sales Outstanding + Days of Inventory - Days of Payables
A: Days’ Sales Outstanding + Days of Inventory - Days of Payables
Q: What does a high CCC indicate?
A: Excessive working capital investment, while a low or negative CCC suggests efficient operations.
Q: What does working capital turnover measure?
A: How efficiently a company uses its working capital to generate sales.
Q: What is the formula for working capital turnover?
A: Revenue ÷ Average Working Capital
Q: What does a very high or low ratio indicate?
A: A high ratio may suggest low working capital levels, while a low ratio may indicate inefficiency.
Q1: Why do different industries use specific financial ratios in analysis?
A1: Industries have unique key performance indicators, making certain ratios more relevant than others. For example, net income per employee is crucial for service firms, while same-store sales growth is key in retail.
Q2: What are some key industry-specific ratios used in financial analysis?
A2: - Retail & Restaurants: Same-store sales growth, sales per square foot
Hotels: Average daily rate, occupancy rate
Subscription Services: Average revenue per user
Banks & Financials: Capital adequacy ratios, reserve requirements, net interest margin
Q3: How can business risk be measured using financial ratios?
A3: Business risk can be assessed through the coefficient of variation (CV), which measures uncertainty in performance:
CV Sales: Standard deviation of sales / Mean sales
CV Operating Income: Standard deviation of operating income / Mean operating income
CV Net Income: Standard deviation of net income / Mean net income
Q4: How is ratio analysis used in earnings forecasting?
A4: Ratio analysis helps build pro forma financial statements by estimating future revenues and applying historical ratios (e.g., COGS % or operating margin). Sensitivity analysis, scenario analysis, and simulation techniques are used to model financial outcomes.
Q: How are Cost of Goods Sold (COGS) and SG&A estimated in a sales-based pro forma model?
A: COGS is estimated as a percentage of sales or using a detailed method; SG&A is estimated as fixed, growing with revenue, or using other techniques.
Q: What is the purpose of modeling the balance sheet in a pro forma model?
A: To ensure that working capital accounts, depreciation, capital expenditures, and net PP&E align with the income statement and cash flow projections.
How is the pro forma cash flow statement constructed?
A: By using the completed pro forma income statement and balance sheet to estimate cash inflows and outflows.
Q: What is the first step in developing a sales-based pro forma company model?
A: Estimate future revenue growth based on market growth, market share, trend growth, or GDP-relative growth.
Q: What is a sales-based pro forma company model?
A: A projected financial statement model based on estimated future revenues, considering market growth, competitive environment, and financial structure.
: Q: What is a sales-based pro forma company model?
A: A projected financial statement model based on estimated future revenues, considering market growth, competitive environment, and financial structure.
What is the first step in developing a sales-based pro forma company model?
A: Estimate future revenue growth based on market growth, market share, trend growth, or GDP-relative growth.
Q: How are Cost of Goods Sold (COGS) and SG&A estimated in a sales-based pro forma model?
A: COGS is estimated as a percentage of sales or using a detailed method; SG&A is estimated as fixed, growing with revenue, or using other techniques.
Q: What is the purpose of modeling the balance sheet in a pro forma model?
A: To ensure that working capital accounts, depreciation, capital expenditures, and net PP&E align with the income statement and cash flow projections.
Q: How is the pro forma cash flow statement constructed?
A: By using the completed pro forma income statement and balance sheet to estimate cash inflows and outflows.
Q: What is the primary purpose of a sales-based pro forma company model?
A: To project future financial statements based on estimated future revenues.
Q: What is the first step in developing a sales-based pro forma company model?
A: Estimate revenue growth and future revenue based on market growth, market share, trend growth, or growth relative to GDP.
Q: How is COGS typically estimated in a pro forma model?
A: As a percentage of sales or using a detailed approach based on business strategy and competition.
Q: What financial statement is modeled last in a sales-based pro forma?
A: The cash flow statement, which is constructed using the completed pro forma income statement and balance sheet.
Q: Why is estimating capital expenditures important in a pro forma balance sheet?
A: It helps project net PP&E and ensures accurate modeling of future capital investments for maintenance and growth.
