Kaplan Mock 4 - Part 1 - Revision

Question 1

The Better Building Company has a contract to build a building for $100 million. The estimate of the cost of the project is $75 million. In the first year of the project, BB had costs of $30 million. The Better Building Company’s reported profit for the first year of the contract is:

Based on the percentage incurred of estimated total costs, the reported profit for the first year is ($30 / $75)($100 − $75) = $10 million.

(Module 18.2, LOS 18.c)

Question 2

Mechanisms that enforce discipline over financial reporting quality least likely include:

A)
government securities regulators.
Incorrect Answer
B)
accounting standard-setting bodies.
Correct Answer
C)
counterparties to private contracts.
Incorrect Answer

Answer 2

Accounting standard-setting bodies issue financial reporting standards but do not enforce compliance with them.

Securities regulators and counterparties to private contracts are among the mechanisms that discipline financial reporting quality.

The counterparties to private contracts with the firm have an incentive to see that the firm produces high-quality financial reports.

Question 3

A lessor who enters into a finance lease is least likely to:

A)
add an asset to her balance sheet.
Incorrect Answer
B)
amortize a receivable.
Incorrect Answer
C)
record a profit.
Correct Answer

Explanation
A lessor will recognize a profit or loss on entering a finance lease only if the lease value is greater than its net book value asset on the lessor’s balance sheet. At inception, a lessor adds a lease receivable to her balance sheet and amortizes it over the term of the lease.

(Module 25.4, LOS 25.h)

Answer 3

Under both IFRS and U.S GAAP, there are two lease classifications for lessors, finance leases and operating leases, just as for lessees. At the initiation of a finance lease, the lessor removes the leased asset from its balance sheet and adds a lease receivable asset, equal to the value of the expected lease payments. If this value is different from the asset’s book value, the lessor will recognize a gain or a loss. Over the term of the lease, the lessor will use the effective interest method (the same method we have just seen for lessees) to amortize the lease receivable and will report the interest portion of the lease payments as income. This interest income is included in the lessor’s revenues for the period if leasing is one of its primary business activities. On the cash flow statement, the entire cash inflow is classified as cash from operations.

For an operating lease, the lessor does not remove the leased asset from its balance sheet. The lessor will continue to record the depreciation expense over the life of the asset. On the income statement, the lessor reports the lease payments as income, while depreciation and other costs associated with leasing the asset are reported as expenses. As with a finance lease, the entire cash inflow is classified as cash from operations.

Question 4

Which of the following statements about the calculation of earnings per share (EPS) is least accurate?

A)
Shares issued after a stock split must be adjusted for the split.
Correct Answer
B)
Options outstanding may have no effect on diluted EPS.
Incorrect Answer
C)
Reacquired shares are excluded from the computation from the date of reacquisition.
Incorrect Answer
Explanation
Shares issued post-split need not be adjusted for the split as they are already “new” shares. Options with an exercise price greater than the average share price do not affect diluted EPS. (Module 18.4, LOS 18.g)

Question 5

For a firm financed with common stock and long-term fixed-rate debt, an analyst should most appropriately adjust which of the following items for a change in market interest rates?

A)
Interest paid.
Incorrect Answer
B)
Debt-to-equity ratio.
Correct Answer
C)
Cash flow from financing.
Incorrect Answer

Answer 5

For the purpose of analysis, the value of debt should be adjusted for a change in interest rates. This will change the debt-to-equity ratio.

(Module 25.2, LOS 25.b)

For a bond issued at a premium or discount, interest expense and coupon interest payments are not equal. Interest expense includes amortization of any discount or premium. Using the effective interest rate method, interest expense is equal to the book value of the bond liability at the beginning of the period, multiplied by the bond’s yield at issuance.

Question 6

Maine Company’s stock transactions during the year are described below:

January 1 100,000 common shares outstanding
March 1 2 for 1 stock split
August 1 10% stock dividend
The weighted average number of shares outstanding used to calculate earnings per share is:

A)
211,111.
Incorrect Answer
B)
201,666.
Incorrect Answer
C)
220,000.
Correct Answer

The January 1 balance of common shares outstanding is adjusted retroactively for both stock dividends and stock splits. The weighted average shares outstanding for the year = 100,000 × 2 × 1.1 = 220,000.

(Module 18.4, LOS 18.g)

Answer 6

common shares outstanding is adjusted retroactively for both stock dividends and stock splits; the timing wont matter

Question 7

Duster Company reported the following financial information at the end of 2007:

in millions
Unearned revenue $240 L
Common stock at par 30 E
Capital in excess of par 440 E
Accounts payable 1,150 L
Treasury stock 2,000 -L
Retained earnings 5,160 E
Accrued expenses 830 L
Accumulated other comprehensive loss 210 -E
Long-term debt 1,570 L

Calculate Duster’s liabilities and stockholders’ equity as of December 31, 2007.
B)
$3,790 million $3,420 million

Question 8

JME Construction signs a contract in the amount of $10 million with the following data available:

Costs incurred in Year 1 $2,200,000
Billings in Year 1 $2,000,000
Cash collected in Year 1 $1,750,000
Total cost of project $8,800,000
How much revenue should JME recognize for Year 1?

Percentage of completion = 25%(2.2 / 8.8)

Revenue to be recognized in Year 1 = 0.25 × 10 million = 2.5 million

Answer 8

For long-term contracts, revenue is recognized based on a firm’s progress toward completing a performance obligation. Progress toward completion can be measured from the input side (e.g., using the percentage of completion costs incurred as of the statement date). Progress can also be measured from the output side, using engineering milestones or percentage of the total output delivered to date.

Question 9

Which of the following items would affect owners’ equity and also appear on the income statement?

A)
Unrealized gains and losses on available-for-sale securities.
Incorrect Answer
B)
Dividends paid to shareholders.
Incorrect Answer
C)
Unrealized gains and losses on trading securities.
Correct Answer

Answer 9

Unrealized gains and losses from trading securities are reflected in the income statement and affect owners’ equity. However, unrealized gains and losses from available-for-sale securities are included in other comprehensive income. Transactions included in other comprehensive income affect equity but not net income. Dividends paid to shareholders reduce owners’ equity but not net income. (Module 18.5, LOS 18.l)

Question 10

Securities that improve basic per share earnings, or reduce per share losses, if they are exercised or converted to common stock are called:

A)
embedded securities.
Incorrect Answer
B)
antidilutive securities.
Correct Answer
C)
dilutive securities.
Incorrect Answer

Antidilutive securities, upon exercise, increase basic EPS or decrease per share losses. Shares from conversion are not included in the calculation of basic or diluted EPS.

Answer 10

Dilutive securities are stock options, warrants, convertible debt, or convertible preferred stock that would decrease EPS if exercised or converted to common stock.

Antidilutive securities are stock options, warrants, convertible debt, or convertible preferred stock that would increase EPS if exercised or converted to common stock.

If convertible preferred stock is dilutive (meaning EPS will fall if it is converted to common stock), the convertible preferred dividends must be added to earnings available to common shareholders.
If convertible bonds are dilutive, then the bonds’ after-tax interest expense is not considered an interest expense for diluted EPS. Hence, interest expense multiplied by (1 – the tax rate) must be added back to the numerator.

Question 11

Pinto Corporation is an automobile manufacturer located in North America. Pinto owns a 5 percent interest in one of its suppliers, Continental Supply Company. Each year, Pinto receives a cash dividend from Continental. Pinto’s engine supplier, National Supply Company, recently increased prices on goods sold to all customers due to higher labor costs. Should Pinto report the dividends received from Continental and the price increase from National as an operating or nonoperating component on its year-end income statement?

A)
Both are nonoperating.
Incorrect Answer
B)
Both are operating.
Incorrect Answer
C)
Only one is operating.
Correct Answer

Answer 11

Since Pinto is a nonfinancial firm, dividends received would be considered a nonoperating component. An increase in cost of goods sold would be considered a part of normal operations.

Question 12

Earnings before interest, taxes, depreciation, and amortization

69,400 79,300
Quick assets 216,700 211,300
Average fixed assets 300,000 323,000
Current liabilities 361,000 404,400
Interest expense 44,000 58,100

Using the EBITDA coverage ratio (EBITDA / Interest expense), Omega’s EBITDA coverage is 1.4 ($79,300 EBITDA / $58,100 interest expense) and Alpha’s EBITDA coverage is 1.6 ($69,400 EBITDA / $44,000 interest expense). Using EBITDA to measure operating profit, Alpha has a lower operating profit margin than Omega. Alpha’s EBITDA margin is 4.2% ($69,400 EBITDA / $1,650,000 revenue) and Omega’s EBITDA margin is 5.5% ($79,300 EBITDA / $1,452,000 revenue). Using fixed asset turnover to measure the efficiency of fixed assets, Omega uses its fixed assets less efficiently than Alpha. Alpha’s fixed asset turnover is 5.5 ($1,650,000 revenue / $300,000 average fixed assets) and Omega’s fixed asset turnover is 4.5 ($1,452,000 revenue / $323,000 average fixed assets).

Question 13

Which expense recognition method is most appropriate for intangible assets with indefinite lives?

A)
Test for impairment but do not amortize.
Correct Answer

Question 14

Which expense recognition method is most appropriate for intangible assets with indefinite lives?

A)
Test for impairment but do not amortize.
Correct Answer

Answer 14

Under IFRS and U.S. GAAP, intangible assets with indefinite lives (e.g., goodwill) are not amortized but are tested for impairment at least annually.

For PPE, it is called depreciation. For intangibles asset, it is called amortization.

Question 15

Question 24
The Allen Corporation had 100,000 shares of common stock outstanding at the beginning of the year. Allen issued 30,000 shares of common May 1. On July 1, the company issued a 10% stock dividend. On September 1, Allen issued 1,000, 10% bonds convertible into 21 shares of stock each. What is the weighted average number of shares to be used in computing basic and diluted earnings per share (EPS), assuming the convertible bonds are dilutive?

Basic Shares Diluted Shares
A)
130,000 132,000
Incorrect Answer
B)
132,000 146,000
Incorrect Answer
C)
132,000 139,000
Correct Answer
Explanation
Calculating Basic Shares:

Jan 1 100,000 shares outstanding

May 1 30,000 shares issued

July 1 10% stock dividend issued

The 10% stock dividend is retroactive therefore:

110,000 shares × 12 months = 1,320,000
33,000 shares × 8 months = 264,000
Total share-month = 1,584,000
Average shares = (1,584,000 / 12) = 132,000

Calculating diluted shares:

(1,000 bonds) × (21 shares each) × (4 months) = 84,000 total share-month

84,000 / 12 = 7,000 Average shares

Total diluted shares = 7,000 (from convertible bonds) + 132,000 (from stock) = 139,000

(Module 18.4, LOS 18.h)

Answer 15

The 10% stock dividend is retroactive.

The Diluted common stock can be calculated separately and added to the basic one.

Question 16

A firm engages in a new type of financial transaction that has a material effect on its earnings. An analyst should most likely be suspicious of the new transaction if:

A)
management has not explained its business purpose.
Correct Answer
B)
no accounting standard exists that applies to the transaction.
Incorrect Answer
C)
the transaction is not governed by existing regulations.
Incorrect Answer

Answer 16

Explanation
New types of transactions may emerge that are not covered by existing accounting standards or regulations. Analysts should obtain information from a firm’s management about the economic substance of such transactions to ensure that they serve a business purpose and have not been created primarily to manipulate the firm’s financial statements.

Question 17

A complex capital structure is one that has potentially dilutive elements. Here, Supple Moves and Perfect Collection both meet this criteria. (The warrants for Supple Moves will be dilutive if the average stock prices were over $50.00.)

Answer 17

Even if the contingent instruments are the used, it will still be complex capital structure.

Question 18

Comprehensive income includes all transactions that affect shareholders’ equity except transactions with shareholders. Thus, any transaction that affects net income would also affect comprehensive income. Since the inventory write-down is included in net income, it is part of comprehensive income. The acquisition of treasury stock is a transaction with shareholders; thus, it is not a part of comprehensive income.

(Module 18.5, LOS 18.k)

Answer 18

Is an acquisition of treasury stock or a loss from the write-down of inventory under the lower-of-cost-or-market rule included in comprehensive income?

Inventory write-down: Included in the I/S and Comprehensive Income
Acquisition of treasury stock: not included in comprehensive income

Question 19

When a firm recognizes revenue before cash is collected, equity increases (retained earnings) and assets increase (accounts receivable). When a product is sold on credit, accounts receivable (an asset) increases and inventory (also an asset) decreases. As long as the sale price of the product is more than the expense (reduction of inventory on the balance sheet), total assets will increase. Liabilities are not affected.

Question 20

Which costs are least likely to be reported as an expense in the current accounting period?

A)
Costs of producing inventory.
Correct Answer
B)
Period costs.
Incorrect Answer
C)
Loan interest that has not yet been paid.
Incorrect Answer

Answer 20

Inventory costs are expensed when items are sold under the matching principle.

As an extreme example, if no sales are made, no costs of inventory production are expensed for the period. Period costs are expensed during the period. Under the accrual method, interest accrued during the period is expensed, regardless of whether it has been paid during the period. (Module 18.3, LOS 18.d)

Question 21

During 2004, Covax Corp. reported net income of $2.4 million and 2 million shares of common stock. Covax paid cash dividends of $14,000 to its preferred shareholders and $30,000 to its common shareholders. In 2004, Covax issued 900, $1,000 par, 5.5 percent bonds for $900,000. Each bond is convertible to 50 shares of common stock. Assume the tax rate is 40%. Compute Covax’s basic and diluted EPS.

Basic EPS Diluted EPS
A)
$1.19 $1.18
Correct Answer

Answer 21

• ignore the cash dividends of 30,000 paid to common shareholders
• the dividend paid to preferred shareholders are not the same as debt interest from the convertible bonds