Financial Reporting, Financial Statement Analysis and Valuation 10th Edition by Wahlen TEST BANK by ACADEMIAMILL

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Chap 01_10e Indicate the answer choice that best completes the statement or answers the question. 1. Which forces typically represent vertical competition in a value chain? a. Potential entry and substitutes. b. Buyer power and rivalry among existing firms c. Supplier power and potential entry. d. Buyer power and supplier power 2. Cash and cash equivalents are considered ______ assets. Select the best term to complete the sentence. a. Intangible b. Monetary 3. On the statement of cash flows, depreciation would be classified as? a. A financing activity. b. An operating activity. c. An investing activity. d. A noncash activity. 4. How easily can customers switch to substitute products is a question one might ask when assessing the ______. a. threat of entrants b. threat of substitutes 5. The five economic attributes that are normally studied are demand, supply, manufacturing, ______, and investing and financing. Select the best term to complete the sentence. a. marketing b. sustainability 6. The threat of new entrants is measured by whether there are entry barriers, such as capital investment, ______, patents, or regulation that inhibit new entrants. Select the best term to complete the sentence. a. labor shortages b. technological expertise 7. The accrual basis of accounting recognizes: a. Revenue when cash is received from customers b. Expenses when paid c. Revenue when all or a substantial portion is performed d. Revenue when contracts are signed 8. Extraordinary gains and losses arise from events that have all the following characteristics except: a. They are unusual given the nature of the firm’s activity. b. They are nonrecurring. c. They are material in amount. d. They result from terminated involvement in a line of business.

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Chap 01_10e 9. Which of the following is not considered to be a liability? a. Wages payable. b. Accounts payable. c. Notes payable. d. Cost of goods sold. 10. The ______ sets forth the sequence of activities involved in the creation, manufacture and distribution of its products and services. Select the best term to complete the sentence. a. sales to cash cycle b. value chain 11. The cash basis method of accounting can be best described as: a. The recording of transactions and adjustments so that debits equal credits. b. The method that equates assets with liabilities and owners’ equity. c. The method that recognizes revenue when money is received and expenses when money is paid. d. The method that matches incurred expenses with related revenues when they are earned. 12. An example of an intangible asset is: a. A patent b. Land c. Investment in another company d. Raw material inventory 13. On a common size basis, which of the following assets is normally largest for an electric utility? a. Accounts receivable b. Inventory c. Property, Plant and Equipment d. Cash and Marketable Securities 14. When assessing buyer power using Porter’s five forces, which of the following is not consistent with low buyer power? a. Brand loyalty b. Control of distribution channel c. Large number of suppliers d. Low price 15. All of the following are the building blocks for financial statement analysis except: a. Targeting growth opportunities that diversify exchange rates, risk exposure, and political uncertainty. b. Describing strategies that a firm pursues to differentiate itself from competitors in order to evaluate competitive advantages, sustainability of the firm’s earnings, and its risks. c. Evaluating the financial statements, including the accounting concepts and methods that underlie them and the quality of the information they provide d. Identification of the economic characteristics of the industries and the relation of those economic characteristics to the various financial statement ratios. Copyright Cengage Learning. Powered by Cognero.

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Chap 01_10e 16. Statements that express all items in a particular financial statement as a percentage of some common base are called ______ statements. Select the best term to complete the sentence. a. common size b. income 17. Which of the following is not one of Porter’s five forces? a. Buyer Power b. Supplier Power c. Threat of Regulation d. Threat of Substitutes 18. Which of the following economic characteristics is consistent with a grocery store chain? a. Low barriers to entry. b. High levels of research and development. c. High profit margins. d. Low capital intensity. 19. The fourth step in financial statement analysis is using the financial statements to analyze the current profitability, growth and ______ of the firm. Select the best term to complete the sentence. a. size b. risk 20. Which of the following would not appear as a liability on the balance sheet? a. A labor contract b. A note due to a bank c. Salary due employees at year-end d. Accounts payable 21. Current assets are defined as: a. Cash and cash equivalents. b. All assets expected to be quickly used by the firm. c. Cash and other assets that the firm expects to sell or consume during the normal operating cycle of a business, usually one year. d. Cash and other assets that the firm expects maintain for a period including the normal operating cycle of a business, usually one year. 22. Which of the following is not an activity reported in the Statement of cash Flows? a. Operating b. Investing c. Manufacturing d. Financing

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Chap 01_10e 23. Which forces typically represent horizontal competition in a value chain? a. Rivalry among existing firms and supplier power. b. Potential entry and buyer power. c. Substitutes and potential entry. d. Buyer power and supplier power. 24. Resources that have the potential for providing a firm with future economic benefits are called ______. a. assets b. liabilities 25. ______ assets include the rights established by law or contract to the future use of property. Select the best term to complete the sentence. a. Monetary b. Intangible 26. Assets for a particular business might include: a. Cash, retained earnings, and accounts payable. b. Cash, common shareholders’ equity, and accounts receivable. c. Cash, property, plant, and equipment, and accumulated other comprehensive income. d. Cash, inventories, and goodwill. 27. Which strategy is used when a firm is attempting to create unique products or services for particular market? a. A quality strategy b. A low-cost leadership strategy c. A vertical integration strategy d. A product differentiation strategy 28. Accounts payable represent: a. Amounts which are due to stockholders. b. Amounts which have been borrowed to finance operations. c. Amounts which are owed to the company by its customers resulting from credit sales. d. Amounts which are owed by the company to its suppliers for past purchases. 29. The primary purpose of the balance sheet is to: a. Report the current value of the business. b. Measure the net income of a business up to a particular point in time. c. Report the difference between cash inflows and cash outflows for the period. d. Report the financial position of the reporting entity at a particular point in time. 30. The tools for studying industry economics does not include: a. Value chain analysis b. Classification using Porter’s five forces c. Classification of cash flows d. Economic attributes framework Copyright Cengage Learning. Powered by Cognero.

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Chap 01_10e 31. Which SEC form may be the best place to start learning about the economics of an industry and the particular strategy a firm has selected for competing in the industry? a. Form 8-K b. Form 10-K c. Form MD&A d. Form FSAP 32. Under the ______ basis of accounting, a firm recognizes revenue when it performs all or a substantial portion, of the services it expects to perform and receives either cash or a receivable. Select the best term to complete the sentence. a. accrual b. cash 33. Which of the following economic characteristics is consistent with a commercial bank? a. Low barriers to entry. b. High levels of research and development. c. Low profit margin on lending activities. d. Low profit margin on fee-based financial services, such as merger consulting. 34. Which form does the balance sheet equation take in the United Kingdom? a. Noncurrent Assets + Noncurrent Liabilities = Shareholders’ Equity b. Revenues - Expenses = Shareholders’ Equity c. Noncurrent Assets + [Current assets - Current Liabilities] - Noncurrent Liabilities = Shareholders’ Equity d. Noncurrent Assets - Current assets = Noncurrent Liabilities - Current Liabilities + Shareholders’ Equity 35. ______ relates to the relative number of buyers and sellers in a particular industry. Select the best term to complete the sentence. a. Buyer power b. Supply chain 36. Most financial statement analysis aims to assess a firm's profitability and ______. a. ability to produce products b. risk 37. The third step in financial statement analysis is to assess the quality of the firm’s financial statements. Which of the following is a question an analyst should ask when performing this step? a. Are industry sales growing rapidly or slowly? b. Do earnings include revenues that appear mismatched with the business model employed by the firm? c. Does the industry include a large number of firms selling similar products? d. What is the company’s degree of geographical diversification? 38. ______ equals net income for a period plus or minus the changes in shareholders' equity accounts other than from net income and transactions with owners. Select the best term to complete the sentence. a. Comprehensive income b. Earnings per share Copyright Cengage Learning. Powered by Cognero.

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Chap 01_10e 39. Which financial statement would you look at to determine whether a company will be able to pay for the goods when payment is due in 30 days? a. Statement of cash flows. b. Statement of stockholders’ equity. c. Income statement. d. Balance sheet. 40. ______ financial statements are helpful in highlighting the relative magnitude of changes in financial statement data from year to year. Select the best term to complete the sentence. a. Stand alone b. Percentage change 41. The ______ defines more clearly the explicit responsibility of managers for financial statements, the relation between the independent auditor and the firm audited and the kinds of services permitted and not permitted. Select the best term to complete the sentence. a. Financial Accounting Standards Board b. Sarbanes-Oxley Act of 2002 42. Nonmonetary assets include assets that are tangible, such as inventories, and assets that are intangible such as _________. a. brand names b. cash c. equipment d. investments 43. What is the principal activity of security analysts? a. To assign credit ratings. b. To apply IFRS adjustments. c. To value firms. d. To assess the need for audits. 44. Normally, intense rivalries have a tendency to reduce ______. a. value b. profitability 45. Which of the following would not inhibit new entrants into a market? a. Existing technological expertise. b. Large required capital investment. c. Lack of rivalry among current participants. d. Existing patented technology.

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Chap 01_10e 46. Which of the following is not a characteristic of an extraordinary item? a. Material in amount. b. Nonrecurring. c. Unusual given the nature of the firm’s activities. d. Requires a cash outflow. 47. Labor contracts and purchase order commitments are examples of ______ contracts. Select the best term to complete the sentence. a. executory b. fixed 48. Which of these would be considered Property, Plant, and Equipment? a. Trademark b. Office Building c. Patent d. Goodwill 49. Basic EPS is calculated as net income minus ______ divided by the weighted average number of shares outstanding. Select the best term to complete the sentence. a. taxes b. dividends on preferred stock 50. When identifying the strategies that a particular firm pursues to gain a competitive advantage it is important to determine if its products are designed to meet the needs of a specific market segment or are they intended for a ______. a. broader consumer market b. specific customer 51. Which two organizations are working together to harmonize financial reporting worldwide? a. FASB and IASB b. GAAP and FASB c. SEC and FASB d. EU and SEC 52. Which of the following economic characteristics is consistent with a grocery store chain? a. Minimal competition b. Extensive competition c. High net income to sales d. Differentiated product 53. How easily can new firms enter a market is a question one might ask when assessing ______. a. threat of entrants b. threat of substitutes

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Chap 01_10e 54. Which of the following economic characteristics is consistent with a pharmaceutical company? a. Low barriers to entry. b. High levels of research and development. c. Low profit margins. d. Low business risk. 55. All of the following are principal provisions of the Sarbanes-Oxley Act of 2002 except: a. At least one member of the audit committee of the board of directors must be a “financial expert.” b. The lead audit or coordinating partner and the reviewing partner of the public accounting firm must rotate, or change, every five years. c. The firm’s chief executive officer and the chief financial officer must issue a statement along with the audit report stating that the financial statements and notes fairly present the operations and financial position of the firm. d. The FASB has oversight and enforcement authority over the SEC. 56. Obtaining a competitive advantage by being the first company to introduce new concepts or ideas is referred to as ______. a. first mover advantage b. price leader advantage 57. The tools of effective financial statement analysis are useful for assessing whether to extend ______ to a firm, either for a short-term or for a long-term. Select the best term to complete the sentence. a. debit b. credit 58. A value chain for an industry sets forth: a. The layers of management the needed to be successful b. Sequence of activities involved in the creation, manufacture, and distribution of its products. c. Sequence of activities involved in a firm's research and development activities. d. Whether the industry is horizontally or vertically integrated. 59. Opinions on the effectiveness of the internal control system and the fairness of the amounts reported in the financial statements are known as: a. Management Discussion and Analysis. b. Assurance Opinions. c. Notes to the Financial Statements d. Management Assessments. 60. The second step in financial statement analysis is to identify the company strategy. Which of the following is a question an analyst should ask when performing a strategy analysis? a. Are industry sales growing rapidly or slowly? b. Do earnings include revenues that appear mismatched with the business model employed by the firm? c. Does the industry include a large number of firms selling similar products? d. What is the company’s degree of geographical diversification? Copyright Cengage Learning. Powered by Cognero.

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Chap 01_10e 61. The prospectus must be filed with the ______ before the company can sell new issues of stocks or bonds. Select the best term to complete the sentence. a. FASB b. SEC 62. All of the following are reasons that pharmaceutical companies have higher barriers for entry than grocery stores except: a. There is lengthy government testing and approval required. b. Research and development is a lengthy and uncertain process. c. Patent protection is needed for exclusive rights. d. The largest asset is typically capital intensive Property, Plant and Equipment. 63. Under the Sarbanes-Oxley Act ______ assumes responsibility for establishing and maintaining adequate internal control structure and procedures. Select the best term to complete the sentence. a. auditors b. management 64. Why is the operating activities section of the statement of cash flows often believed to be the most important part of the statement? a. Because it shows the dividends that have been paid to stockholders. b. Because it indicates a company's ability to generate cash from sales to meet current cash payments for goods or services. c. Because shows the net increase or decrease in cash during the period. d. Because it gives the most information about how operations have been financed. 65. Which of the following is an independent entity comprising 15 members and a full-time professional staff that specifies acceptable accounting principles known as IFRS? a. FASB b. IASB c. SEC d. GAAP 66. Which of the following activities is an operating activity? a. Collections of accounts receivable. b. Investing in equity securities of other companies. c. Payment of dividends. d. Issuing common stock 67. Which of the following is a question an analyst would ask when assessing the quality of a firm’s financial statements? a. Are the company’s products designed to meet a specific market segment? b. Has the firm integrated forward into retailing to final consumers? c. Is the firm diversified across several geographical markets? d. Do earnings include nonrecurring gains or losses? Copyright Cengage Learning. Powered by Cognero.

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Chap 01_10e 68. When attempting to identify the economic characteristics of the industry in which a particular firm participates an analyst might ask which of the following questions? a. Does technological change play an important role in the firm maintaining a competitive advantage? b. Has the firm diversified across several geographic markets? c. Has the firm recognized revenues at the proper time? d. Has the firm structured transactions to make it look more profitable than economic conditions suggest? 69. The higher the value added from any activity, the higher should be the ______ from engaging in that activity. Select the best term to complete the sentence. a. cost b. profitability 70. Another important step in financial statement analysis is to assess the quality of a firm's ______ and if necessary adjust them for such characteristics as sustainability or comparability. Select the best term to complete the sentence. a. financial statements b. bank statements c. marketing plans 71. Depreciation is a ______ added back to net income when preparing the operating activities section of the Statement of Cash Flows. Select the best term to complete the sentence. a. Cash expenditure b. Non-cash expenditure 72. Which financial statement for a business would you look at to determine the company's earnings performance during an accounting period? a. Balance sheet. b. Income statement. c. Statement of cash flows. d. The Management Assessment. 73. The main components that make up the stockholder's equity section of the balance sheet are retained earnings and ______. a. common stock b. notes payable

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Chap 01_10e 74. The following steps make up the steps in financial statement analysis: 1. Identify the strategies the firm pursues to gain and sustain a competitive advantage. 2. Analyze the current profitability and risk of the firm using information in the financial statements. 3. Value the firm. 4. Identify the economic characteristics and competitive dynamics of the industry in which a particular firm participates. 5. Assess the quality of the firm’s financial statements and, if necessary, adjust them for such desirable characteristics as sustainability or comparability. 6. Prepare forecasted financial statements. Which of the following is the proper order for these interrelated sequential steps? a. 4,1,5,2,6,3 b. 1,2,3,4,5,6 c. 4,6,2,5,1,3 d. 1,4,2,5,3,6 75. On a common size basis, which of the following assets is normally largest for a commercial bank? a. Accounts and Notes Receivable b. Inventory c. Property, Plant and Equipment d. Cash and Marketable Securities 76. Which of the following assets would appear on the balance sheet at an amount greatly below its fair market value? a. Inventory b. Marketable securities c. Equipment d. Brand name 77. The Second step in financial statement analysis requires businesses to analyze strategies that will ______ itself from the firms' competitors. Select the best term to complete the sentence. a. associate b. differentiate 78. Net income is equal to: a. Assets minus Liabilities b. Revenues and Gains minus Expenses and Losses c. Shareholders’ Equity minus Assets d. Revenues and Assets minus Expenses and Liabilities

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Chap 01_10e 79. Which of the following is not an expense of a business? a. Depreciation b. Dividends c. Salaries d. Advertising 80. The two categories of shareholders' equity usually found on the balance sheet of a corporation are: a. Contributed capital and property, plant, and equipment. b. Retained earnings and notes payable. c. Common stock and retained earnings. d. Contributed capital and equity securities. 81. Describe what is meant by income from continuing operations?

82. Under the Sarbanes-Oxley Act of 2002, financial statements must include both a Management Assessment and an Assurance Opinion. What information do the Management Assessment and an Assurance Opinion provide to financial statement users?

83. What three financial statements are prepared by business firms and what information does each provide?

84. Identify Porters’ Five Forces?

85. What are three activities reported in the statement of cash flows and what information does each activity provide?

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Chap 01_10e 86. When a company sells a subsidiary or a product line on what financial statement is it reported and how is it reported?

87. Many people view the balance sheet as being a representation of a firm’s economic position. What are some issues that reduce the quality of this representation?

88. What is an industry’s value chain?

89. What is the rationale for the statement of cash flows?

90. What is comprehensive income?

91. What are the six interconnected activities related to financial statement analysis?

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Chap 01_10e Answer Key 1. d 2. b 3. b 4. b 5. a 6. b 7. c 8. d 9. d 10. b 11. c 12. a 13. c 14. c 15. a 16. a 17. c 18. a 19. b 20. a 21. c 22. c 23. c 24. a 25. b 26. d

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Chap 01_10e 27. d 28. d 29. d 30. c 31. b 32. a 33. c 34. c 35. a 36. b 37. b 38. a 39. d 40. b 41. b 42. a 43. c 44. b 45. c 46. d 47. a 48. b 49. b 50. a 51. a 52. b 53. a 54. b Copyright Cengage Learning. Powered by Cognero.

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Chap 01_10e 55. d 56. a 57. b 58. b 59. b 60. d 61. b 62. d 63. b 64. b 65. b 66. a 67. d 68. a 69. b 70. a 71. b 72. b 73. b 74. a 75. a 76. d 77. b 78. b 79. b 80. c 81. Income from continuing operations represent all of the cash inflows (sales) and the cash outflows (expenses) that are normally recurring in the daily operations of the company. Copyright Cengage Learning. Powered by Cognero.

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Chap 01_10e 82. The Management Assessment makes explicit management’s responsibility for not only the financial statements but for the underlying accounting and control system that generates the financial statements. The Assurance Opinion is provided by the independent auditor and is included with the opinion on the fairness of the amounts reported in the financial statements. The Assurance Opinion provides the auditor’s opinion on the effectiveness of the internal control system. 83. 1. Balance sheet--Point in time reporting of assets, liabilities and stockholders’ equity. 2. Income statement--Measurement of operating performance for a period of time. 3. Statement of cash flows--The net cash flows for a period of time from the three business activities: operating, investing and financing. 84. 1. How easily can new firms enter the market? Rivalry among existing firms 2. Do new firms require a large capital investment? Threat of new entrants 3. Do new firms require large amounts of technological expertise? Threat of substitutes 4. Does regulation inhibit new firms from entering the market? Buyer Power 5. Supplier Power

85. 1. 2.

Operating activities - Provides information on cash generated and used by a firm in its normal activities of selling goods and providing services. Investing activities - Provides information about the firm’s use of cash in the acquisition of long-lived productive assets and cash provided by the disposal of long-lived productive assets. In addition, cash provided and used by investment in debt and equity securities are included in this category. Financing activities - Provides information about cash provided and used by short- and long-term borrowing and from issuing or repurchasing capital stock. In addition, cash used for dividends is reported in this category.

86. The sale of a company’s subsidiary or a product line is reported on the income statement as a gain or loss from discontinued operations and is reported net of applicable income taxes. 87. 1. Many valuable resources of a firm that generate cash flows, such as a patent, will only appear as assets if acquired, not when they are internally developed. 2. Nonmonetary assets appear at acquisition cost, even though their current market values might exceed acquisition cost. 3. Certain rights to use resources and commitments to make future payments may not appear as assets and liabilities. 4. Noncurrent liabilities appear at the present value of expected cash flows discounted at an interest rate determined when the liability arose, not at the current rate.

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Chap 01_10e 88. An industry’s value chain is the sequence of activities involved in the creation, manufacture and distribution of its products and services. 89. The statement of cash flows provides information on the sources and uses of cash. Even profitable firms sometimes find themselves in need of cash and unable to pay suppliers, employees, and other creditors. This may occur for two reasons: 1.

The timing of cash receipts from customers does not necessarily coincide with the recognition of revenue, and the timing of cash expenditures does not necessarily coincide with the recognition of expenses under the accrual basis of accounting.

Normally cash expenditures precede the recognition of expenses and cash receipts occur after the recognition of revenue. 10.

The firm may need to acquire new property, plant, and equipment; retire outstanding debt; or reacquire shares of its common stock when there is insufficient cash available.

90. Comprehensive income equals net income for a period plus or minus the changes in shareholders’ equity accounts other than from net income and transactions with owners. Items affecting comprehensive income include foreign currency translation adjustments, cash flow hedge accounting, minimum pension liability adjustments and unrealized gains and losses from holding investment securities classified as available for sale. 91. 1. Identify the economic characteristics of the industry in which a firm participates. 2. Identify the strategies that a particular firm pursues to gain and sustain a competitive advantage. 3. Assess the quality of a firm’s financial statements and, if necessary, adjust them for such desirable characteristics such as sustainability or comparability. 4. Analyze the current profitability and risk of the firm using information in the financial statements. 5. Prepare forecasted financial statements. 6. Value the particular firm.

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Chap 02_10e Indicate the answer choice that best completes the statement or answers the question. 1. Future tax deductions: a. result in deferred tax assets. b. result in deferred tax liabilities. c. occur where the tax basis of liabilities is more than the financial reporting basis. d. occur where the tax basis of assets is less than financial reporting basis. 2. The difference between income tax payable and income tax expense is reported on the balance sheet as either a deferred tax asset or a ______. a. deferred tax liability b. deferred tax revenue c. 3. Revenues and expenses that firms include in both net income to shareholders and in taxable income, but in different periods are referred to as ______. a. permanent differences b. temporary differences 4. Firms recognize the reduction in service potential of assets such as patents and trademarks using the process of ______. a. amortization b. nonpayment 5. The net amount a firm would receive if it sold an asset or the net amount it would pay to settle a liability is referred to as: a. current replacement cost b. net realizable value c. current cost d. acquisition cost 6. When recognizing deferred tax assets and liabilities, the income statement approach and the balance sheet approach yield identical results: a. when enacted tax rates applicable to future periods do not change. b. when the firm recognizes no valuation allowance on deferred tax assets. c. Both “when enacted tax rates applicable to future periods do not change” and “when the firm recognizes no valuation allowance on deferred tax assets” are correct. d. None of these answers is correct. 7. The traditional accounting model delays the recognition of value changes of assets and liabilities until what event occurs? a. A change in value. b. A market transaction. c. A balance sheet date. d. Cash is received or cash is paid. Copyright Cengage Learning. Powered by Cognero.

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Chap 02_10e 8. Valuation methods that reflect current values or a combination of historical and current values include all of the following except: a. fair value for assets and liabilities. b. current replacement cost for assets. c. net realizable value for assets. d. adjusted acquisition costs for assets. 9. What level are inputs for estimating fair values based on a firm’s own assumptions about the fair value of an asset or a liability, such as using various data to estimate present values? a. Level 1. b. Level 2. c. Level 3. d. None of these. 10. Interest on Municipal Bonds represents what kind of tax difference? a. Permanent timing difference that results in that income item not being taxed. b. Temporary difference that will reversed in the future c. Tax rate on Municipal bonds are based on estimated tax rates. d. Not recognized in taxable income on the accrual basis of accounting. 11. Permanent tax differences are revenues and expenses: a. that firms include in income tax returns, but do not appear in the income statement. b. that are included in both the tax return and income statement, but in different accounting periods. c. that firms include in the income statement, but do not appear in income tax returns. d. that are not included in either the tax return or the income statement. 12. Balance Sheet Equation Cash + Non-Cash Assets = Liabilities + Contributed Capital + Accumulated Other Comprehensive Income + Retained Earnings Refer to Balance Sheet Equation. The payment of a note payable by a firm reduces cash and ______. a. contributed capital b. liabilities c. retained earnings d. accumulated other comprehensive income 13. Items, such as interest revenue on municipal bond holdings, that do not affect taxable income or income taxes paid in any year are referred to as ______. a. permanent differences b. temporary differences

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Chap 02_10e 14. Stockholders' equity can be expanded into the following three accounts: Accumulated other comprehensive income, retained earnings and ______. a. contributed capital b. liabilities 15. All of the following can be used to describe reliability of accounting information except: a. biased. b. credible. c. verifiable. d. supported by source documents. 16. Present value methods are often used with receivables and liabilities: a. With payment schedules in excess of one year. b. With payment schedules of less than one year. c. When fair values can be easily determined. d. When asset are sold in the middle of the accounting cycle. 17. The income statement approach to measuring income tax expense: a. is required by FASB Statement No. 109. b. compares revenues and expenses recognized for book and tax purposes, eliminates permanent differences, and computes income tax expense based on book income before taxes excluding permanent differences. c. computes income tax expense as a difference between the tax basis of an asset or a liability and its reported amount in the [balance sheet] that will result in taxable or deductible amounts in some future year(s) when the reported amounts of assets are recovered and the reported amounts of liabilities are settled. d. is required by IAS 12. 18. Future taxable income is characteristic of all of the following situations except: a. where deferred tax assets result. b. where deferred tax liabilities result. c. where the tax basis of liabilities exceeds the financial reporting basis. d. where the tax basis of assets is less than financial reporting basis. 19. Which of the following is not one of methods used by GAAP for treating value changes? a. Recognize value changes on the balance sheet and income statement when they are realized in a market transaction b. Recognize value changes in the income statement when the value changes occur over time, but recognize them on the balance sheet when they are realized in a market transaction c. Recognize value changes on the balance sheet when the value changes occur over time, but recognize them in the income statement when they are realized in a market transaction d. Recognize value changes on the balance sheet and income statement when they occur over time, even though they are not realized in a market transaction

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Chap 02_10e 20. When income tax expense for a period is greater than income tax payable the difference will be reported how and on which financial statement? a. Deferred tax asset and Statement of Cash Flows b. Deferred tax asset and Balance Sheet c. Deferred tax liability and Statement of Cash Flows d. Deferred tax liability and Balance Sheet 21. Historical costs include all of the following except: a. acquisition costs for assets b. net realizable values for assets. c. adjusted acquisition costs for assets. d. initial present value for assets and liabilities 22. If a portfolio manager had to estimate the fair value of privately placed bond issues, which of the following would he/she most likely identify as the level of inputs to determine this? a. Level 1. b. Level 2. c. Level 3. d. None of these. 23. Relevant asset valuations refer to all of the following except: a. they are timely. b. they have the capacity to affect a user’s decisions, based on the information. c. they incorporate all available information. d. they are always subjective. 24. A change in the interest rate or ______ will not change a preset series of cash flows, however it will change the present value of those cash flows. Select the best term to complete the sentence. a. terms b. discount rate 25. Disregarding cash flows with owners, over sufficiently long periods of time, net income equals: a. revenues minus dividends and expenses b. assets minus liabilities c. stockholders’ equity d. cash inflows minus cash outflows 26. The amount initially paid to acquire an asset is called ______. a. acquisition cost b. current cost c. current replacement cost d. historical cost

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Chap 02_10e 27. Which of the following transactions is consistent with recognizing value changes on the balance sheet and income statement when they are realized in a market transaction? a. Selling land at a cost greater than its original purchase price. b. Recording an increase in the fair value of investments at year end. c. Translating foreign operations accounted for in Yen back to U.S. dollars in order to prepare consolidated financial statements. d. Writing down the value of an asset due to obsolescent. 28. Net income equals revenues plus gains minus expenses and ______. a. losses b. other income 29. The amount that a company would have to pay today to acquire an asset it now holds is called ______. a. acquisition cost b. current cost c. current replacement cost d. historical cost 30. What level are inputs for estimating fair values are based on inputs that are readily available via prices for identical assets or liabilities in actively traded markets such as securities exchanges? a. Level 1. b. Level 2. c. Level 3. d. None of these. 31. The use of acquisition cost as a valuation method is justified on the basis that acquisition cost is: a. timely b. relevant c. subjective d. objective 32. Acquisition costs includes all costs necessary to get an asset ready for ______. a. sale b. its intended use 33. Balance Sheet Equation Cash + Non-Cash Assets = Liabilities + Contributed Capital + Accumulated Other Comprehensive Income + Retained Earnings Refer to the Balance Sheet Equation. To recognize the cost of goods sold ORP Corporation will reduce retained earnings and reduce ______. a. cash b. liabilities c. non-cash assets Copyright Cengage Learning. Powered by Cognero.

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Chap 02_10e 34. Current replacement cost represents: a. the amount a firm would have to pay currently to acquire an asset it now holds b. the amount a firm would have to pay currently to acquire an asset it does not now hold c. the amount a firm would have to pay in the future to acquire an asset it now holds d. the amount a firm would have to pay to purchase a comparably depreciated version of the asset it now holds 35. Plaxo Corporation has a tax rate of 35% and uses the straight-line method of depreciation for its equipment, which has a useful life of four years. Tax legislation requires the company to depreciate its equipment using the following schedule: year 1- 50%, year 2 - 30%, year 3 - 15% and year 4 - 5%. On January 1, Year 1 Plaxo purchases a piece of equipment with a four year life and an original cost of $100,000. What amount will Plaxo record as a deferred tax asset or liability on the December 31, Year 1 balance sheet? a. Deferred tax asset of $25,000. b. Deferred tax liability of $25,000. c. Deferred tax asset of $8,750. d. Deferred tax liability of $8,750. 36. Firms use acquisition cost valuations and adjusted acquisition cost valuations for which of the following types of assets? a. Assets that do not have fixed amounts of future cash flows. b. Assets that have fixed amounts of future cash flows. c. Assets with certain future economic benefits. d. monetary 37. Which of the following valuation methods reflects current values? a. acquisition cost b. present value of cash flows using historical interest rates c. net realizable value d. adjusted acquisition cost 38. ______ assets and liabilities represent amounts of cash a firm can expect to receive or pay in the future. Select the best term to complete the sentence. a. Long-term b. Monetary 39. Firms may not include all income taxes for a period on the line for income tax expense in the income statement. Other places that income tax expenses may occur include all of the following except: a. Discontinued Operations b. Extraordinary Items c. Other Comprehensive Income d. Common Stock

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Chap 02_10e 40. ______ is the net amount that a firm would receive if it sold an asset or the net amount it would have to pay to settle a liability. a. Current replacement cost b. Net realizable value 41. U.S. GAAP, IFRS, and other major accounting standards are best characterized as: a. historical accounting models. b. current value accounting models. c. acquisition cost accounting models. d. mixed attribute accounting models. 42. Balance Sheet Equation Cash + Non-Cash Assets = Liabilities + Contributed Capital + Accumulated Other Comprehensive Income + Retained Earnings Refer to Balance Sheet Equation. ORP Corporation Purchases land for $9,000 cash and 1,000 shares of common stock values at 10 per share. This transaction results in ORP recording a decrease in cash of $9,000, an increase in non-cash assets of $ 19,000, and an increase in ______ of $10,000. Select the best term to complete the sentence. a. contributed capital b. liabilities c. retained earnings d. accumulated other comprehensive income 43. Balance Sheet Equation Cash + Non-Cash Assets = Liabilities + Contributed Capital + Accumulated Other Comprehensive Income + Retained Earnings Refer to Balance Sheet Equation. JCP Company purchased marketable securities for $5,000 during the year, at the end of the year the company revalues the securities to $5,700. This revaluation would result in an increase to non-cash assets and ______. a. contributed capital b. liabilities c. retained earnings d. accumulated other comprehensive income 44. The accounting equation is represented by Assets= Liabilities + Stockholders’ Equity which of the following would cause a change in the stockholders’ equity accounts: a. Sale of Land for cash and a note receivable for the balance b. Collection of an account receivable c. Purchased an asset for cash and 10,000 shares of preferred stock d. Purchased inventory on account

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Chap 02_10e 45. Fish Farm Corporation purchases a new tract of land on which it is going to build new growing and holding tanks in order to expand its business. Which of the following costs would not be part of the cost of the land? a. costs to run a title search b. costs of grading to level the land c. costs of tearing down an existing structure d. cost of the new holding tanks 46. If a portfolio manager had to estimate the fair value of real estate, which of the following would he/she most likely identify as the level of inputs to determine this? a. Level 1. b. Level 2. c. Level 3. d. None of these. 47. Reporting financial assets and liabilities at fair values also is referred to as: a. historical cost. b. acquisition cost. c. mark-to-market. d. mortgage-backed cost 48. At origination which of the following temporary differences would create a deferred tax asset? a. Tax basis of an asset exceeds its financial reporting basis. b. Tax basis of a liability exceeds its financial reporting basis. c. Financial reporting basis of an asset is equal to its tax basis. d. Financial reporting basis of an asset exceeds its tax basis. 49. Balance Sheet Equation Cash + Non-Cash Assets = Liabilities + Contributed Capital + Accumulated Other Comprehensive Income + Retained Earnings Refer to the Balance Sheet Equation. If ORP Corporation sells $25,000 of its product on account, it will see an increase in non-cash assets and ______. a. contributed capital b. liabilities c. retained earnings d. accumulated other comprehensive income

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Chap 02_10e 50. The existence of subjectivity in an asset valuation does not necessarily mean the valuation will not be reliable. All of the following are examples of this except: a. where historical cost is used for accounts receivable, fixed assets, and other assets with values that remain relatively stable. b. where market value is used for marketable equity securities, commodities, and financial assets are traded in liquid markets c. where historical cost is used for LIFO inventory layers where inventory has seen an inflationary increase in costs. d. where historical cost is used for internally generated intangible asset valuations. 51. If a portfolio manager had to estimate the fair value of private equity funds invested in a young, privately-held start-up company, which of the following would he/she most likely identify as the level of inputs to determine this? a. Level 1. b. Level 2. c. Level 3. d. None of these. 52. Shareholders’ equity consists of what three components: a. Assets, liabilities, and contributed capital. b. Contributed capital, accumulated other comprehensive income, and retained earnings. c. Liabilities, contributed capital, and retained earnings. d. Liabilities, contributed capital, and accumulated other comprehensive income. 53. Which of the following assets appears on the balance sheet at Historical cost? a. Equipment b. Notes Payable c. Investments in Marketable Securities d. Accounts Payable 54. Which of the following would not represent an acquisition cost to be added to the purchase price of building: a. Sales Tax. b. Cost of grading the land. c. Capital repairs to get the building ready for occupancy. d. Renovations that would extend the life of the building. 55. If a portfolio manager had to estimate the fair value of investments in timber, which of the following would he/she most likely identify as the level of inputs to determine this? a. Level 1. b. Levels 1 and 2. c. Levels 2 or 3. d. All levels would be applicable.

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Chap 02_10e 56. If a portfolio manager had to estimate the fair value of illiquid mortgage-backed securities, which of the following would he/she most likely identify as the level of inputs to determine this? a. Level 1. b. Level 2. c. Level 3. d. None of these. 57. What level are inputs for estimating fair values are those inputs include quoted prices for similar assets or liabilities in active or inactive markets, other observable information such as yield curves and price indexes, and other observable data such as market-based correlation estimates? a. Level 1. b. Level 2. c. Level 3. d. None of these. Enter the appropriate word(s) to complete the statement. 58. Discuss the two principal reasons income before taxes for financial reporting differs from taxable income.

59. Assuming that Plaxo Corporation decides to use accelerated depreciation for both financial and tax reporting purposes for Year 1, would there still be a deferred tax liability?

60. What valuation methods reflect current values? Discuss the advantage(s) and disadvantage(s) of valuing assets and liabilities using current values.

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Chap 02_10e 61. The analytical framework used to evaluate transactions is reproduced below: Cash

+ Non-Cash Assets

= Liabilities

+ Contributed Capital

+ Accumulated Other Comprehensive Income

+ Retained Earnings

Using this analytical framework indicate the effect of each of the following transactions for TX Corporation: 1. 2. 3.

TX Corporation sold additional shares of common stock for $250,000 cash. At the end of the period TX Corporation revalued the securities to $125,000. During the next period TX Corporation sells equipment with a book value of $100,000 for $90,000.

62. For some transactions GAAP requires that value changes are recognized on the balance sheet and the income statement when they occur, even if not realized. Discuss what types of transactions get this type of treatment and the logic behind this accounting.

63. Accord Inc. income tax return shows taxes currently payable of $85,000. The company reported deferred tax assets of $35,000 at the beginning of the year and $24,000 at the end of the year. Accord reported deferred tax liabilities of $48,000 at the beginning of the year and $54,000 at the end of the year. Determine the amount of income tax expense reported by Accord for the year.

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Chap 02_10e 64. H. Solo Company purchased a new piece of equipment with a list price of $175,000 and subject to a 5 percent discount if paid within 45 days. H. Solo paid within the discount period. The company also paid $1,500 to obtain title to the equipment and $600 as the license fee for the first year of operation. It paid $2,500 to level the area in which the equipment would be located and $12,500 to relocate other equipment that would have interfered with the proper operation of the new equipment. H. Solo paid $400 for property and liability insurance for the first year of operation. What is the acquisition cost of this equipment that H. Solo should record in its accounting records? Indicate the treatment of any amount not included in acquisition cost.

65. The analytical framework used to evaluate transactions is reproduced below: Cash

+ Non-Cash Assets

= Liabilities

+ Contributed Capital

+ Accumulated Other Comprehensive Income

+ Retained Earnings

Using this analytical framework indicate the effect of each of the following transactions for CX Corporation: 1. CX Corporation purchases land for $450,000 cash. 2. At the end of the period CX Corporation receives an appraisal that values the land at $540,000. 3. During the next period CX Corporation sells the land for $665,000. 4. CX pays taxes at a rate of 40%.

66. Plaxo Corporation has a tax rate of 35% and uses the straight-line method of depreciation for its equipment, which has a useful life of four years. Tax legislation requires the company to depreciate this type of equipment using the following schedule: year 1 - 50%, year 2 - 30%, year 3 - 15% and year 4 - 5%. Plaxo purchases a piece of equipment with a four-year life and an original cost of $100,000. Discuss how this transaction will affect Plaxo’s income taxes.

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Chap 02_10e 67. When income tax expense differs from income taxes currently payable on taxable income companies recognize deferred tax assets and deferred tax liabilities. What type of event would create a deferred tax asset and deferred tax liability?

68. Deferred tax assets and liabilities are created due to temporary differences between the tax and financial reporting basis of certain assets and liabilities. Discuss which scenarios result in a deferred tax asset and which result in deferred tax liabilities.

69. Discuss the three ways in which GAAP allows value changes to be treated in the financial statements. Provide an example of each value change treatment.

70. What valuation methods reflect historical cost? Discuss the advantages and disadvantages of valuing assets and liabilities using historical valuations.

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Chap 02_10e Answer Key 1. a 2. a 3. b 4. a 5. b 6. c 7. b 8. d 9. c 10. a 11. c 12. b 13. a 14. a 15. a 16. a 17. b 18. a 19. b 20. d 21. b 22. b 23. d 24. b 25. d 26. a

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Chap 02_10e 27. a 28. a 29. c 30. a 31. d 32. b 33. c 34. a 35. d 36. a 37. c 38. b 39. d 40. b 41. d 42. a 43. d 44. c 45. d 46. b 47. c 48. a 49. c 50. d 51. c 52. b 53. a 54. b Copyright Cengage Learning. Powered by Cognero.

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Chap 02_10e 55. c 56. c 57. b 58. 1.

Permanent Differences--Revenues and expenses that firms include in net income to shareholders, but which never appear in the income tax return. 2. Temporary Differences--Revenues and expenses that firms include in both net income to shareholders and in taxable income but in different periods.

59. The depreciation amounts would be exactly the same, so there would be no deferred tax liability. A deferred tax liability only occurs when the accelerated depreciation method exceeds the straight line method of calculating depreciation expense. 60. Valuation methods reflecting current values include: 1. current replacement cost 2. net realizable value 3. present value of cash flows using current interest rates The main advantage of using current values is increased relevance for financial statement users. The disadvantages include greater subjectivity. 61. Cash

1. +250,000 2. 3. +90,000

+ Non-Cash Assets

= Liabilities + Contributed Capital

+ Accumulated Other Comprehensive Income

+ Retained Earnings

+250,000 -125,000 -100,000

-125,000 -10,000

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Chap 02_10e 62. The application of GAAP requires firms to write down assets whose fair values decrease below their book values. For example, GAAP requires that firms recognize a loss on equipment in which its fair value has decreased below its book value due to obsolescence or other permanent valuation effect. GAAP does not allow firms to revalue upward the values of assets whose fair values have increased. Firms must await the validation of the value increase through a market transaction to justify this type of gain. 63. Accord’s income tax expense can be determined by this journal entry: Income tax expense Deferred Tax Asset Deferred Tax Liability Income taxes payable

$102,000 $11,000 $6,000 $85,000

64. H. Solo should record the equipment at the following cost: Purchase price = $175,000 less 5% discount = $166,250 title = $1,500 leveling = $2,500 relocation = $12,500 TOTAL COST = $182,750 The $600 license for the first year of operations is a period expense, $400 should be treated as insurance expense for the period. 65. Cash

1. 2. 3. 4.

-450,000 No Entry +665,000 -86,000

+ Non-Cash Assets

= Liabilities + Contributed Capital

+ Accumulated Other Comprehensive Income

+ Retained Earnings

+450,000 -450,000

+215,000 -86,000

66. The difference in depreciation rates results in Plaxo recording a deferred tax liability in Year 1 equal to the difference in the tax and financial depreciation expense multiplied by the firm’s tax rate. Plaxo’s tax depreciation expense in Year 1 will be (50% *$100,000) $50,000, while its financial reporting depreciation expense will be (25% * $100,000) $25,000. The $25,000 difference is multiplied by Plaxo’s 35% tax rate to result in a deferred tax liability of $8,750.

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Chap 02_10e 67. Deferred tax assets arise when taxable income exceeds book income. An example would be warranty expense. Deferred tax liabilities arise when book income exceeds taxable income. An example would be recognized more depreciation expense for tax purposes than for book purposes. 68. Deferred tax assets result from the following two scenarios: 1. The tax basis of assets exceeds the financial reporting basis 2. The tax basis of liabilities is less than the financial reporting basis Deferred tax liabilities result from the following two scenarios: 1. The tax basis of assets is less than the financial reporting basis 2. The tax basis of liabilities exceeds the financial reporting basis 69. 1. 2. 3.

Value changes recognized on the balance sheet and the income statement when realized in a market transaction. Examples include selling inventory or land. Value changes recognized on the balance sheet when they occur, but recognized on the income statement when realized. Examples include marketable securities. Value changes recognized on the balance sheet and the income statement when they occur. Examples include impairment losses.

70. Valuation methods reflecting historical cost include: 1. acquisition cost 2. adjusted acquisition cost 3. present value of cash flows using historical interest rates The main advantages of using historical valuations are simplicity, less subjectivity and reliability. The disadvantages include lack of relevance.

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Chap 03_10e Indicate the answer choice that best completes the statement or answers the question. 1. As products move through the maturity phase, companies invest to ___________ productive capacity. a. increase b. decrease c. maintain d. Not enough information to answer this question. 2. Which of the following statements is false? a. Purchase of equipment is an investing cash outflow. b. Sale of equipment creates investing cash outflow equal to its selling price. c. Purchase of short-term investments is an investing cash outflow. d. Purchase of a patent is an investing cash outflow. 3. The expense incurred by issuing stock options should be: a. classified as a financing activity. b. added back to net income in the operating activities section. c. subtracted from net income in the operating activities section. d. does not appear in the statement of cash flows. 4. A company in the growth phase of its product life cycle will normally have which of the following patterns of cash flows? a. Negative cash flows from operations, negative cash flows from investing and positive cash flows from financing. b. Negative or positive cash flows from operations, negative cash flows from investing and positive cash flows from financing. c. Positive cash flows from operations, positive cash flows from investing and positive cash flows from financing. d. Negative or positive cash flows from operations, negative cash flows from investing and negative cash flows from financing. 5. Under the ______, firms begin with net income to calculate cash flow from operations for the period. Select the best term to complete the sentence. a. direct method b. indirect method 6. When net income is high relative to operating cash flows, we describe the firm as having recorded: a. income-decreasing accruals. b. income-increasing accruals. c. income-neutral accruals. d. abnormal accruals.

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Chap 03_10e 7. The issuance of debt would be classified as a(n) ______ activity in the statement of cash flows. Select the best term to complete the sentence. a. financing b. investing c. operating 8. The payment of dividends would be classified as ______ activities in the statement of cash flows. Select the best term to complete the sentence. a. financing b. investing c. operating 9. The length of the operating cycle is another factor that may cause cash flow from operations to differ from ______ a. net income b. cash flow from financing activities 10. Which of the following is a cash flow from operating activities? a. Sale of long-term investments in common stock. b. Purchase of merchandise for resale. c. Payment of a note payable. d. Sale of a piece of land no longer used in operations. 11. One rationale for the statement of cash flows is to: a. ensure that the cash account balances at year-end. b. reconcile differences between net income and cash receipts and disbursements. c. calculate the company’s free cash flow. d. examine the cash effects of income from discontinued operations, extraordinary items and changes in accounting principles. 12. Which of the following statements is true? a. A cash dividend is an operating cash outflow. b. Cash paid to repurchase treasury stock is an investing cash outflow. c. Cash paid to acquire stock in another company is a financing outflow. d. Purchase of a patent is an investing cash outflow.

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Chap 03_10e 13. As a complement to the balance sheet and the income statement, the statement of cash flows is an informative statement for analysts for all the following reasons except: a. The statement of cash flows provides information to assess the financial health of a firm. Analysts increasingly recognize that cash flows do not necessarily track income flows. A firm with a healthy income statement is not necessarily financially healthy, and vice versa. Cash requirements to service debt, for example, may outstrip the ability of operations to generate cash. b. The existence of negative cash flows from operations can be eliminated by using this financial statement. c. The statement of cash flows highlights accounting accruals, which can provide insight into the overall sustainability and quality of a firm’s reported earnings. d. Analysts who understand the types of information this statement presents and the kinds of interpretations that are appropriate find that the statement of cash flows reveals information about the economic characteristics of a firm’s industry, its strategy, and the stage in its life cycle. 14. The receipt of cash when employees exercise stock options is a(n) ______ activity. Select the best term to complete the sentence. a. financing b. investing c. operating 15. ______ activities relate to the acquisition and sale of noncurrent assets, particularly property, plant and equipment. Select the best term to complete the sentence. a. Financing b. Investing c. Operating 16. Firms with short operating cycles will experience less of a lag between the creation and delivery of their products and the collection of cash from customers because: a. their cash flow from operations will be much greater than their working capital from operations. b. their cash flow from operations will not differ much from their working capital from operations. c. their cash flow from operations will be much less than their working capital from operations. d. there will be no relation between their cash flow from operations and working capital from operations. 17. Lagos Corp. recorded sales of $345,000 for the year. In addition, its accounts receivable and accounts payable balances at the beginning and end of the year were as follows:

Accounts Receivable Accounts Payable

Jan. 1 $65,000 $32,000

Dec. 31 $90,000 $28,000

How much cash did Lagos collect from customers during the year? a. $345,000 b. $320,000 c. $324,000 d. $316,000 Copyright Cengage Learning. Powered by Cognero.

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Chap 03_10e 18. The acquisition of new investments would be classified as ______ activities in the statement of cash flows. Select the best term to complete the sentence. a. financing b. investing c. operating 19. The financial statements for Warren Company show the following:

Cost of goods sold $725,000

Merchandise Inventory Accounts Receivable Accounts Payable

Beginning Balance $45,000 53,000 37,000

Ending Balance $56,000 50,000 42,000

Based on this information, cash paid for merchandise was: a. $736,000 b. $719,000 c. $731,000 d. $741,000 20. Normally, cash flows from investing activities will start providing cash during which phase of the product life cycle? a. Introduction b. Growth c. Maturity d. Decline 21. Lui Company's income statement reported total sales revenue of $350,000. The comparative balance sheets showed that accounts receivable increased by $20,000. The "cash receipts from customers" would be: a. $270,000 b. $250,000 c. $330,000 d. $40,000 22. ______ activities relate to the normal operations of the firm, selling goods and providing services. Select the best term to complete the sentence. a. Financing b. Investing c. Operating

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Chap 03_10e 23. Which of the following is an adjustment that would need to be made to net income when calculating cash flows from operations under the indirect method? a. Subtract amortization expense b. subtract gain on sale of subsidiary c. add an increase in accounts receivable d. add a decrease in accounts payable 24. In a statement of cash flows, interest received from sources other than a company’s investments would be classified as cash inflows from: a. lending activities. b. operating activities. c. investing activities. d. financing activities. 25. One factor that may cause cash flow from operations to differ from net income is the length of the ______. a. cash cycle b. operating cycle 26. ______ equals current assets minus current liabilities. Select the best term to complete the sentence. a. Net income b. Working capital c. Current ratio 27. Which of the following is not one of the reasons why net income differs from cash flows from operations under the indirect method of calculating cash flows? a. non-cash items, such as depreciation and amortization b. changes in working capital accounts c. gains and losses related to the sale of plant, property and equipment d. sale or repurchase of capital stock 28. When preparing the statement of cash flows using the indirect method, the payment of dividends would appear as: a. a decrease in the operating activities section b. an increase in the operating activities section c. a use of cash in the financing activities section d. a source of cash in the financing activities section 29. Fizzzle Inc. sold a piece of equipment during the period for $230,000 and recorded a gain of $45,000 on the sale. How should this gain be treated when preparing the operating activities section of the statement of cash flows using the indirect method? a. A sale of equipment is an investing activity; the transaction will not affect the operating activities section. b. The gain is added back to net income in the operating activities section. c. The gain is subtracted from net income in the operating activities section. d. The entire sales price is subtracted from net income in the operating activities section. Copyright Cengage Learning. Powered by Cognero.

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Chap 03_10e 30. Which of the following companies would you expect to report significant amounts of cash provided by financing activities? a. A yet-to-be-profitable biotechnology company. b. A mature company operating in the oil refinery industry. c. A profitable established company in the retail industry. d. A large multinational pharmaceutical company. 31. Krenshaw Company reported total sales revenue of $80,000, total expenses of $72,000, and net income of

$8,000 for the year. During the year, accounts receivable increased by $3,000, merchandise inventory decreased by $2,000, accounts payable increased by $1,000, and $5,000 in depreciation expense was recorded. Assuming no other adjustments to net income are needed, the net cash inflow from operating activities using the indirect method was: a. $19,000 b. $13,000 c. $10,000 d. $11,000 32. A decrease in accounts receivable during a period indicates that a firm collected more ______ as the amount of revenues included in net income. Select the best term to complete the sentence. a. cash b. inventory 33. Adophus, Inc.'s income statement reported total revenues of $850,000 and total expenses (including $40,000 depreciation) of $720,000. The balance sheet reported the following: accounts receivable beginning balance of $50,000 and ending balance of $40,000; accounts payable beginning balance of $22,000 and ending balance of $28,000. Therefore, based only on this information and using the indirect method, the net cash inflow from operating activities was: a. $126,000 b. $186,000 c. $166,000 d. $174,000 34. An example of an item that is deducted from net income when preparing the operating activities section of the statement of cash using the indirect method is: a. depreciation expense. b. compensation expense related to stock option plans. c. income from an investment accounted for using the equity method. d. unrealized losses on trading investments

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Chap 03_10e 35. When preparing the statement of cash flows using the indirect method, an increase in accounts payable would appear as: a. a decrease in the operating activities section b. an increase in the operating activities section c. a use of cash in the investing activities section d. a source of cash in the investing activities section 36. Cash flow from operations should include none of the cash flows associated with marketable securities if such transactions are viewed as ______. a. financing activities b. investing activities c. operating activities 37. Toro Company recognized $655,000 of cost of goods sold for the year, in addition its implementation of a just-intime inventory system allowed it to reduce its inventory from $325,000 at the beginning of the year to $230,000 at the end of the year. How much cash did Toro spend on inventory for the year? a. $655,000 b. $980,000 c. $560,000 d. $620,000 38. When preparing the statement of cash flows using the indirect method, an increase in inventories would appear as: a. a decrease in the operating activities section b. an increase in the operating activities section c. a use of cash in the investing activities section d. a source of cash in the investing activities section 39. A firm’s cash flows will differ from net income each period for all of the following reasons except: a. cash receipts from customers do not necessarily occur in the same period in which a firm recognizes revenues. b. cash expenditures to employees, suppliers, and governments do not necessarily occur in the same period in which a firm recognizes expenses. c. the company is sustaining losses each period. d. cash inflows and outflows that pertain to investing and financing activities do not immediately flow through the income statement. 40. Kraco Corporation reported net income of $450,000, including the effects of depreciation expense of

$60,000, and amortization expense on a patent of $10,000. Also, cash of $50,000 was borrowed on a 5year note payable. Based on this data, total cash inflow from operating activities using the indirect method was: a. $570,000 b. $520,000 c. $470,000 d. $440,000 Copyright Cengage Learning. Powered by Cognero.

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Chap 03_10e 41. A cash inflow from financing activities includes: a. receipt of interest payments. b. proceeds from selling equipment. c. proceeds from issuance of bonds payable. d. proceeds from selling investments in equity securities of another company. 42. Which of the following statements about the statement of cash flows is correct? a. A purchase of equipment is classified as a cash inflow from investing activities. b. Cash dividends paid are classified as cash flows from operating activities. c. Cash dividends received on stock investments are classified as cash flows from operating activities. d. A company with a net loss on the income statement will always have a net cash outflow from operating

activities. 43. Free cash flows to all debt and common equity shareholders represents the excess of cash flow from operations over cash flows from ______. a. financing activities b. investing activities 44. Tinker Company reported sales revenue of $500,000 and total expenses of $450,000 (including depreciation)

for the year. During the year, accounts receivable decreased by $5,000, merchandise inventory increased by $4,000, accounts payable increased by $6,000, and depreciation expense of $10,000 was recorded. Assuming no other data is needed and using the indirect method, the net cash inflow from operating activities was: a. $60,000 b. $67,000 c. $44,000 d. $51,000 45. Norton Company reported total sales revenue of $55,000, total expenses of $45,000, and net income of

$10,000 on its income statement. For the same period, accounts receivable increased by $4,000, merchandise inventory increased by $6,000, accounts payable decreased by $2,000, and depreciation of $18,000 was recorded. Therefore, based only on this information, the net cash flow from operating activities using the indirect method was: a. $30,000 b. $10,000 c. $16,000 d. $19,000

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Chap 03_10e 46. When preparing the statement of cash flows using the indirect method, the sale of marketable securities would appear as: a. a use of cash in the investing activities section b. a source of cash in the investing activities section c. a use of cash in the financing activities section d. a source of cash in the financing activities section 47. When net income is low relative to operating cash flows, we describe the firm as having recorded: a. income-decreasing accruals. b. income-increasing accruals. c. income neutral accruals. d. abnormal accruals. 48. Amortization of bond discount and premiums would be additions or subtractions from net income in the ______ section of the statement of cash flows. Select the best term to complete the sentence. a. financing activities b. investing activities c. operating activities 49. Normally, cash flows from financing will start using cash during which phase of the product life cycle? a. Introduction b. Growth c. Maturity d. Decline 50. Which of the following transactions would not create a cash flow? a. Payment of a cash dividend. b. The company purchased some of its own stock from a stockholder. c. Amortization of patent for the period. d. Sale of equipment at book value (i.e. no gain or loss). 51. Under the indirect method of preparing the statement of cash flows, add backs to net income include all of the following except: a. depreciation expense b. deferred tax expense c. gains on sale of equipment d. share-based compensation

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Chap 03_10e 52. Which statement is false regarding the preparation of the indirect method of the statement of cash flows? a. An increase in merchandise inventory is subtracted from net income. b. Depreciation expense is added to net income. c. An increase in accounts receivable is added to net income. d. An increase in accounts payable is added to net income. 53. Free cash flows to all debt and common equity shareholders represents the excess of cash flows from: a. operating activities over cash flows for financing activities b. investing over cash flows for operating activities c. investing over cash flows for financing activities d. operating activities over cash flows for investing activities 54. If a firm is growing and expanding its accounts receivable and inventories faster than its current operating liabilities its cash flow from operation will normally be: a. greater than net income b. less than net income c. greater than the change in working capital from operations d. greater than the change in cash 55. Which of the following is the correct formula for calculating cash collections from customers? a. sales for the period plus accounts receivable at the beginning of the period b. sales for the period plus accounts receivable at the beginning of the period minus accounts receivable at the end of the period c. sales for the period plus accounts receivable at the end of the period d. sales for the period plus accounts receivable at the end of the period minus accounts receivable at the beginning of the period 56. Outback Corp. recorded sales of $1,300,000 during the current period, in addition the company's accounts receivable balance grew from $120,000 at the beginning of the period to $165,000 at the end of the period. How much cash did Outback collect from customers during the period? a. $1,300,000 b. $1,345,000 c. $1,255,000 d. $1,135,000 57. Cash collected from customers would appear in the operating activities section of a statement of cash flows prepared using the ______ method. Select the best term to complete the sentence. a. direct b. indirect 58. The period in which a firm commences the manufacture of its product to the time it receives cash is called the ______ a. cash cycle b. operating cycle Copyright Cengage Learning. Powered by Cognero.

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Chap 03_10e 59. Normally, cash flows from operations will peak during which phase of the product life cycle? a. Introduction b. Growth c. Maturity d. Decline 60. All of the following are firms that may experience a long lag between the expenditures of cash and the receipt of cash from customers, except: a. restaurants b. wineries c. construction companies d. aerospace manufacturers 61. Under the ______ of preparing the statement of cash flow's operating activities section firms list the cash flows from selling goods and services and then subtract the cash outflows to providers of goods and services. Select the best term to complete the sentence. a. direct method b. indirect method 62. Academic research has found that market rates of return on common stock are the most highly correlated with: a. net income. b. cash flow from operations. c. EBITDA. d. cash flow from investing activities. 63. Which of the following would not be a cash flow from investing activities? a. Sale of a patent. b. Collection of interest revenue on a long-term note receivable. c. Collection of principal of a note receivable. d. Purchase of long-term investments. 64. Interest expense and interest revenue would be classified as ______ activities in the statement of cash flows. Select the best term to complete the sentence. a. financing b. investing c. operating 65. The receipt of dividends from an investee would be classified as ______ activities in the statement of cash flows. Select the best term to complete the sentence. a. financing b. investing c. operating

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Chap 03_10e 66. Cash flows from ______ activities will normally be negative during the introduction and growth phase of the product life cycle. Select the best term to complete the sentence. a. financing b. investing c. operating 67. Cilca Corporation is a supplier to the pulp and paper industry. Selected financial information about Cilca is listed below: · · · · · · · ·

Purchased real estate for $440,000 in cash. The cash was borrowed from a bank. Sold investments for $400,000. Paid dividends of $480,000. Issued shares of common stock for $200,000. Purchased machinery and equipment for $100,000 cash. Paid $360,000 on a bank loan. Reduced accounts receivable by $80,000. Increased accounts payable $160,000. Sales for the period were $450,000

Use the above information to calculate Cilca’s: a. cash used or provided by operating activities b. cash used or provided by financing activities

68. What is working capital from operations? Discuss what types of firms will have similar net income and working capital from operations? For which types of firms will net income and working capital from operations be significantly different?

69. Discuss the correlations that have been found between net income, net income plus or minus Type 1 adjustments (i.e., adjustments to net income for revenues, expenses, gains, and losses that are recognized in income and are associated with changes in noncurrent assets, noncurrent liabilities, and shareholders’ equity, but do not affect cash by the same amounts for the period), and cash flow from operations.

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Chap 03_10e 70. For the following types of companies, discuss whether you think their cash flows from operations, investing, and financing will be positive (the activity provides cash) or negative (the activity uses cash). Provide support for your answer. 1.

Tech Corporation is a developer of computer software for the gaming industry. The company recently launched its first software title. The company is expanding its operations by hiring additional developers and administrative staff. The company is not yet profitable, but expects to break even within two years. Investors view it as having a first mover advantage and have been happy to invest in the company. Midwest Corporation is a supplier to the agricultural industry. The company is experiencing its 25th year of profitability, but is concerned that sales have contracted for the fifth year in a row. Midwest prides itself in paying dividends and having no debt on its balance sheet. Semi Inc. manufactures semiconductors. The company has just introduced its ninth new product and is the leader in market share for the industry. The company continues to invest in research and development and expand by purchasing competitors. The company has yet to pay dividends, but is considering it in the future. The company’s largest current asset is cash, due to its high profit margin.

71. The calculation of cash flow from operations under the indirect method involves two types of adjustments. Discuss each type of adjustment and provide an example of each type of adjustment.

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Chap 03_10e 72. Luke Corporation is a manufacturer of home furnishings. Selected financial information about Luke is listed below: · · · · · · · · · ·

Borrowed $850,000 from a bank. Purchased equipment for $210,000 in cash. Purchase investments for $285,000. Received dividends of $51,000 from an investment in Davis Corp. Paid dividends of $55,000. Issued shares of preferred stock for $500,000. Repurchased outstanding common shares using $100,000 in cash. Purchased land for $100,000 cash. Paid $36,000 interest expense on a bank loan. Increased Inventories by $320,000 Increased accounts receivable by $217,000. Increased accounts payable $85,000.

Use the above information to calculate Luke’s: a. cash used or provided by investing activities b. cash used or provided by financing activities

73. Discuss operating, investing, and financing cash flows in relation to the various stages of the product life cycle.

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Chap 03_10e 74. Selected financial statement information for Filmco appears below: Balance Sheet accounts Inventory Accounts Receivable Income Statement (partial) Sales Cost of Goods Sold Gross Profit

Jan. 1

Dec. 31 $210,000 $85,000

$90,000 $45,000

For the year ended Dec. 31 $900,000 $730,000 $170,000

Calculate the amount of cash collected from customers and the amount of cash spent on inventory for the year by Filmco.

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Chap 03_10e Answer Key 1. c 2. b 3. b 4. b 5. b 6. b 7. a 8. a 9. a 10. b 11. b 12. d 13. b 14. a 15. b 16. b 17. b 18. b 19. c 20. c 21. c 22. c 23. b 24. b 25. b 26. b

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Chap 03_10e 27. d 28. c 29. c 30. a 31. b 32. a 33. b 34. c 35. b 36. b 37. c 38. a 39. c 40. b 41. c 42. c 43. b 44. b 45. c 46. b 47. a 48. c 49. c 50. c 51. c 52. c 53. d 54. b Copyright Cengage Learning. Powered by Cognero.

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Chap 03_10e 55. b 56. c 57. a 58. b 59. c 60. a 61. a 62. a 63. b 64. c 65. c 66. b 67. a.

cash used or provided by operating activities: Sales for the period 450,000 +reduction in accounts receivable $80,000 +Increased accounts payable $160,000 = $690,000 provided by operating activities

cash used or provided by financing activities +Received $440,000 of cash that was borrowed from a bank to purchase real estate +Issued shares of common stock for $200,000 - Paid dividends of $480,000 - Paid $360,000 on a bank loan. = ($200,000) cash used for financing activities

68. Working capital from operations is defined as net income adjusted for changes in non-working capital accounts. These changes include depreciation, amortization, the equity method, deferred tax amounts, the minority interest in the earnings of consolidated subsidiaries and some restructuring charges. Companies that have mostly current operating assets, such as retailers who rent their space, will likely have similar net income and working capital from operations. Capital-intensive firms are more likely to have significantly different net incomes and working capital from operations.

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Chap 03_10e 69. The study by Robert M. Bowen, David Burgstahler, and Lane A. Daley, “Evidence on the Relationships Between Earnings and Various Measures of Cash Flow,” Accounting Review (October, 1986) revealed (1) a high correlation between net income and net income plus or minus Type 1 adjustments, and (2) a low correlation between net income and cash flow from operations, and (3) a low correlation between cash flow from operations and net income plus or minus Type 1 adjustments over time 70. 1. 2. 3.

This company is in the introduction phase. CFO--negative, CFI--negative, CFF--positive. This company is in the late mature to early decline phase. CFO--positive and declining, CFI-positive and declining, CFF--negative due to dividends. This company is in the growth phase. CFO--positive, CFI--negative, CFF--positive maybe starting to turn negative.

71. 1. 2.

Adjusting revenues and expenses for changes in non-working capital accounts, for example depreciation, amortization and deferred income tax. Adjusting revenues and expenses for changes in operating working capital accounts, for example accounts receivable and accounts payable, inventories.

72. a.

cash used or provided by investing activities: -Purchased investments for $285,000 - Purchased land for $100,000 - Purchased equipment for $210,000 cash. = ($595,000) cash used by investing activities.

cash used or provided by financing activities +Received $850,000 from bank borrowing +Issued shares of preferred stock for $500,000 - Paid dividends of $55,000 - Paid $100,000 to repurchase outstanding common stock = $1,1950,000 cash provided by financing activities

Operating cash flows begin negative in the introduction phase and start becoming positive in the growth phase. Operating cash flows reach their peak in the maturity phase and start to decrease at the end of the maturity phase and into the decline phase. Investing cash flows begin negative in the introduction phase and stays negative in the growth phase. Investing cash flows become positive in the maturity phase and start to decrease at the end of the maturity phase and into the decline phase. Financing cash flows are positive in the introduction and growth phase. Financing cash flows start to decrease at the end of the maturity phase and continue to decrease in the decline phase.

73.

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Chap 03_10e 74. Cash collected from customers: $ 900,000+85,000-45,000=$940,000 Cash spent on inventory: $730,000 + $90,000 - $210,000=$610,000

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Chap 04_10e Indicate the answer choice that best completes the statement or answers the question. 1. Which of the following are better indicated by percentage change statements than common-size statements? a. monetary changes b. profitability c. stability d. growth and decline 2. The statutory tax rate differs from a firm’s average tax rate due to which of the following reasons? a. The statutory tax rate is a marginal tax rate. b. Some expenses are included in book income but do not enter into taxable income. c. The average tax rate is for a period of three years. d. The statutory tax rate does not affect GAAP measures of revenues and expenses. 3. The rationale for adding back the ______ relates to attaining consistency in the numerator and denominator of ROA. Select the best term to complete the sentence. a. minority interest in earnings b. depreciation c. losses d. 4. Refer to the information for Carl Industries. In a common size balance sheet for Year 0, total liabilities and equity are expressed as: a. 25.9% b. 100% c. 74.1% d. 103.6%

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Chap 04_10e Carl Industries Carl Industries has condensed balance sheets as shown: Year 2 Assets: Current assets 65,000 Plant & equipment, net 600,000 Intangible assets, net 15,000 Total assets 680,000 Liabilities & Stockholders’ Equity: Current liabilities Long-term liabilities Stockholders’ equity Total liabilities & equity

$70,000 420,000 190,000 $680,000

Year 1

Year 0

$46,500 420,000 36,500 $503,000

$80,000 410,000 50,000 540,000

$25,000 290,000 188,000 $503,000

$33,500 400,000 106,500 540,000

5. Refer to the information for Carl Industries. In a common size balance sheet for Year 2, plant and equipment (net) is expressed as: a. 74.5% b. 93.2% c. 83.5% d. 30.5% 6. The profit margin for ROA indicates the ability of a firm to generate earnings for a particular level of: a. sales b. assets c. working capital d. shareholders’ equity 7. Asset turnover represents: a. The ability of the firm to generate income from operations for a particular level of sales. b. The ability to generate sales from a particular investment in assets. c. The ability to manage the level of investment in assets for a particular level of assets. d. The number of days, on average, it takes management to turnover assets. 8. Refer to the information for Orca Industries. The profit margin for computing ROA for Orca Industries is: a. 9.4% b. 13.5% c. 4.8% d. 12.3%

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Chap 04_10e 9. Firms that have either convertible securities or stock options or warrants outstanding have ______. a. simple capital structures b. complex capital structures Net Devices Inc. The following balance sheets and income statements are for Net Devices Inc., a manufacturer of small electronic devices, including calculators, personal digital assistants and mp3 players. For purposes of these questions assume that the company has an effective tax rate of 35%. BALANCE SHEETS ASSETS ($ in thousands) Fiscal year end Cash Marketable securities Receivables Inventories Other current assets Total current assets

Year 2 $875,650 6,560 771,580 1,320,150 249,000 3,222,940

Year 1 $571,250 0 775,250 1,254,600 231,200 2,832,300

Year 0 $154,230 0 902,000 1,418,500 229,900 2,704,630

Property, plant & equipment

1,118,750

1,100,300

1,122,400

Intangibles Deposits & other assets Total assets

263,050 184,500 $4,789,240

241,000 168,250 $4,341,850

215,600 168,900 $4,211,530

Fiscal year end Accounts payable Current long term debt Accrued expenses Income taxes payable Other current liabilities Total current liabilities

Year 2 $1,178,540 18,100 664,100 138,900 0 1,999,640

Year 1 $1,061,100 316,500 615,900 108,400 0 2,101,900

Year 0 $1,138,250 150,900 585,400 38,200 0 1,912,750

Long term debt Other long term liabilities Total liabilities

478,250 13,350 2,491,240

378,400 0 2,480,300

599,630 0 2,512,380

Preferred stock Common stock net Additional Paid-in Capital Retained earnings Treasury stock Shareholders' equity

850,000 4,000 869,000 1,430,500 (855,500) 2,298,000

850,000 3,950 758,000 1,055,000 (805,400) 1,861,550

550,000 3,800 689,500 1,245,050 (789,200) 1,699,150

LIABILITIES ($ in thousands)

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Chap 04_10e Total Liab. & Equity

$4,789,240

$4,341,850

$4,211,530

Fiscal year end Net sales Cost of Goods Sold Gross profit

Year 2 $11,455,500 (8,026,450) 3,429,050

Year 1 $11,082,100 (7,940,065) 3,142,035

Selling, general & admin. Exp. Income before deprec. & amort.

(1,836,400) 1,592,650

(1,789,200) 1,352,835

Depreciation & amortization Interest expense

(785,250) (46,195)

(757,250) (43,340)

Income before tax Provision for income taxes Minority interest

761,205 (157,725) --

552,245 (112,290) --

Net income

$603,480

$439,955

Outstanding shares (in thousands) Preferred Dividends (in thousands)

308,515 $85,000

303,095 $85,000

INCOME STATEMENTS ($ in thousands)

10. Refer to the information for Net Devices Inc. What is the rate of return on assets for Net Devices for Year 2? a. 11.64% b. 14.50% c. 12.60% d. 13.88% 11. Refer to the information for Ramos Company. In a percentage change income statement over the period of 2009 to 2011, what is the change in sales? a. 100% b. 87.2% c. 12.8% d. 14.7%

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Chap 04_10e 12. Refer to the information for Orca Industries. Orca’s accounts receivable turnover is (assume that Orca makes all sales on account): a. 7.0 b. .53 c. 11.2 d. 10 13. Firms with ______ levels of operating leverage experience greater variability in their return on assets. Select the best term to complete the sentence. a. high b. low 14. Refer to the information for Orca Industries. Orca’s asset turnover is: a. 1.31 b. 1 c. 1.58 d. 1.44 15. Return on assets will likely differ across firms and across time. Three elements of risk that will help explain these differences are ______, cyclicality of sales and stage and length of product life cycle. Select the best term to complete the sentence. a. financial leverage b. product life cycle c. operating leverage 16. Refer to the information for Orca Industries. Orca’s basic earnings per share is: a. .22 b. .13 c. .25 d. .30 17. Another term for earnings power is: a. nonrecurrent revenue. b. nonrecurrent gains. c. sustainable earnings. d. net change in equity. 18. When the financial analysts multiplies the profit margin for ROA with the assets turnover ratio the result is called ______. a. return on assets b. return on common shareholder's equity

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Chap 04_10e 19. To calculate diluted EPS, the accountant does all of the following except: a. adds back to net income any compensation expense recognized on the employee stock options b. adds back any interest expense (net of taxes) on convertible bonds c. adds back any dividends on convertible preferred stock the firm subtracted in computing net income to common shareholders. d. enters only the net incremental shares issued (shares issued under options minus assumed shares repurchased) in the computation of diluted EPS. 20. Which of the following scenarios is consistent with an increasing cost of goods sold to sales percentage and increasing inventory turnover? a. Firm raises prices to increase its gross margin but inventory sells more slowly. b. Weak economic conditions lead to reduced demand for a firm’s products, necessitating price reductions to move goods. c. Strong economic conditions lead to increased demand for a firm’s products, allowing price increases. d. Firm shifts its product mix toward lower margin, faster moving products. 21. Which factor does not explain differences or changes in ROA? a. Operating leverage b. Cyclicality of sales c. Product life cycle d. Financial leverage 22. The computation of the additional shares to be issued on the exercise of stock options assumes that the firm would repurchase common shares on the open market using an amount equal to the sum of all the following except: a. any cash proceeds from such exercise b. net incremental shares issued c. any unamortized compensation expense on those options d. any tax benefits that would be credited to additional paid-in capital

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Chap 04_10e Ramos Company Ramos Company included the following information in its annual report: Year 2 Year 1 Sales $178,400 $162,500 Cost of goods sold 115,000 102,500 Operating expenses 50,000 50,000 Net income 13,400 10,000

Year 0 $155,500 100,000 45,000 10,500

23. Refer to the information for Ramos Company. In a common size income statement for Year 2, the operating expenses are expressed as: a. 30.3% b. 28.0% c. 43.8% d. 100% 24. Which of the following is the primary objective in most financial statement analysis? a. To value a firm’s equity securities b. To look for unrecorded liabilities c. To establish a firm’s strategy within the industry d. To define markets for the firm 25. Refer to the information for Carl Industries. In a percentage change balance sheet over the period of Year 0 to Year 2, what is the change in long-term liabilities? a. 94.7% b. 15.4% c. 5.3% d. 5% 26. Refer to the information for Extreme Sports Company and All Sports Corporation. Calculate All Sports’ inventory turnover ratio. a. 5.3 b. 1.2 c. 3.9 d. .256 27. Time-series analysis helps answer all of the following questions except: a. Is the firm becoming more or less profitable over time? b. Is the firm becoming more or less risky? c. How is management of the firm responding to external economic forces? d. What is the amount of assets or capital required to generate a particular level of earnings?

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Chap 04_10e 28. The incremental effect of interest expense on net income equals one minus the marginal tax rate times ______. a. interest expense b. income tax expense 29. When an analyst uses measures of past profitability to forecast the firm's future profitability the expectation is that those revenues, gains, expenses and losses will ______. a. persist b. not persist 30. Which of the following would be considered a committed fixed cost (a cost that is incurred regardless of the level of activity during the period)? a. depreciation expense b. bad debt expense c. advertising expense d. cost of goods sold 31. Firms and industries characterized by heavy fixed capacity costs and lengthy periods required to add new capacity operate under a(n) ______. a. capacity constraint b. timing difference 32. Sustainable earnings represent: a. the level of earnings expected to persist in the future. b. the level of earnings and the growth in the levels of earnings expected to persist in the future. c. the growth rate of future earnings. d. retained earnings. 33. Refer to the information for Extreme Sports Company and All Sports Corporation. What is the return on assets for All Sports? a. 11.9% b. 18.2% c. 2.15 d. 8.6% 34. All else being equal, firms with high levels of ______ incur more risk in their operations and should earn higher rates of return. Select the best term to complete the sentence. a. inventory b. assets c. operating leverage

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Chap 04_10e 35. Refer to the information for Ramos Company. In a common size income statement for Year 2, the cost of goods sold is expressed as: a. 130% b. 115% c. 64.5% d. 63.1% 36. Which of the following is not a way a company can achieve a low-cost position? a. economies of scale b. production efficiency c. customer service d. outsourcing 37. Inventory turnover is calculated by dividing ______ by average inventories. Select the best term to complete the sentence. a. cost of goods sold b. total assets c. net sales on account 38. The three elements of risk that help in understanding differences across firms and changes over time in ROAs are: a. product life cycles, cyclicality of sales, competitive constraint. b. operating leverage, cyclicality of sales, product life cycles. c. cyclicality of sales, competitive constraint, operating leverage. d. operating leverage, competitive constraint, product life cycles. 39. Refer to the information for Net Devices Inc. What is the profit margin for ROA for Net Devices for Year 1? a. 7.26% b. 4.22% c. 5.00% d. 3.97% 40. Common-size analysis requires the analyst to be aware that percentages can change because of all of the following except: a. changes in expenses in the numerator independent of changes in sales b. changes in sales independent of changes in expenses c. interaction effects between the numerator and denominator d. All of these are possible explanations.

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Chap 04_10e 41. Refer to the information for Net Devices Inc. What is Net Devices’ earnings per share for Year 2? a. $1.00 b. $1.70 c. $1.96 d. $0 42. Return on assets can be disaggregated into asset turnover and ______. a. profit margin for return on assets b. profit margin for common shareholder's equity 43. Refer to the information for Carl Industries. In a percentage change balance sheet over the period of Year 0 to Year 2, what is the change in current assets? a. 78.6% b. (27.3%) c. (21.4%) d. (18.75%) 44. EPS is an ambiguous measure of profitability because it reflects operating performance in the numerator and ______ in the denominator. Select the best term to complete the sentence. a. capital structure b. assets c. profit margin 45. The effect of interest expense on net income equals one minus the ______ times the interest expense. Select the best term to complete the sentence. a. marginal tax rate b. interest rate 46. Firms with complex capital structures can use which of the following in calculating EPS? a. Outstanding convertible bonds. b. Stock options exercised c. Stock warrants issued d. All of these are correct. 47. Refer to the information for Net Devices Inc. What is Net Devices’ return on common shareholders’ equity for Year 2? a. 26.54% b. 30.89% c. 35.81% d. 42.16% 48. Economic theory suggests that higher levels of risk in any activity should lead to higher levels of ______. a. expected return b. turnover Copyright Cengage Learning. Powered by Cognero.

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Chap 04_10e 49. Return on assets will likely differ across firms and across time. Three elements of risk that will help explain these differences are operating leverage, ______, and stage and length of product life cycle. Select the best term to complete the sentence. a. the sales cycle b. financial leverage 50. Operating income is negative in an amount equal to ______ when revenues are zero. Select the best term to complete the sentence. a. fixed costs b. variable cost Extreme Sports Company and All Sports Corporation Below is financial information for two sporting goods retailers. Extreme Sports Company operates a retail business and franchising business. At the end of the year, Extreme Sports had 263 Company-owned and 120 franchise-operated retail stores. Extreme’s stores are located in suburban, strip mall and regional mall locations, the company operates in 32 states. All Sports Corporation sells sporting goods and related products at over 2,500 Company-operated retail stores. Selected Data for All Sports and Extreme Sports (amounts in millions) Sales Cost of Goods Sold Interest Expense Net Income Average Inventory Average Fixed Assets Average Total Assets Average Tax Rate

All Sports $5,320 3,897 138 212 998 1,163 2,472 40%

Extreme Sports $1,344 887 43 33 286 130 662 40%

51. Refer to the information for Extreme Sports Company and All Sports Corporation. Compute the Asset Turnover for All Sports. a. 8.6% b. 2.15 c. 18.2% d. 4.57 52. Which of the following might an analyst not want to eliminate from past earnings when using past earnings to forecast future earnings? a. Nonrecurring gains from the sale of assets b. Unusual asset impairment charges c. Nonrecurring restructuring charges d. Revenue from the sale of inventory

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Chap 04_10e 53. Critics of EPS as a measure of profitability point out that it does not consider: a. simple capital structures. b. the amount of assets or capital required to generate a particular level of earnings. c. the deduction of preferred stock dividends from net income. d. adjustments for dilutive securities and the adjustment to weighted average number of shares outstanding for complex capital structures. 54. Refer to the information for Orca Industries. The return on common shareholders’ equity for Orca Industries is: a. 15.2% b. 13.5% c. 10% d. 11.9% 55. Return on assets can be a misleading ratio when analyzing technology firms because two important assets, their employees and ______ do not appear on their balance sheets. Select the best term to complete the sentence. a. their operations b. their technologies c. their credit policies 56. To reduce the risk inherent in ______ a company should strive for a high proportion of variable costs in its cost structure. Select the best term to complete the sentence. a. high levels of inventory b. low levels of fixed assets c. operating leverage

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Chap 04_10e Orca Industries Below are the two most recent balance sheets and most recent income statement for Orca Industries. The company has an effective tax rate of 35%. Balance Sheet Current Year

Prior Year

Assets: Cash Accounts Receivable (net) Inventory Long-lived assets Less:Accumulated depreciation Total assets

$10,000 6,000 8,000 12,000 (4,000) $32,000

$6,000 1,500 10,000 11,000 (2,000) $26,500

Liabilities and Stockholders’ Equity: Accounts payable Deferred revenues Long-term note payable Less: Discount on note payable Common stock Retained earnings Total liabilities and stockholders’ equity

$5,000 1,000 10,000 (800) 12,000 4,800 $32,000

$6,000 2,000 10,000 (1,000) 6,000 3,500 $26,500

Income Statement For the year ended December 31 Revenues Cost of goods sold Depreciation expense Interest expense Bad debt expense Other expense (including income taxes) Net income

$42,000 (24,000) (2,000) (3,000) (2,000) (9,000) $2,000

57. Refer to the information for Orca Industries. The return on assets for Orca Industries is: a. 6.8% b. 13.5% c. 10% d. 12.3% 58. Refer to the information for Net Devices Inc. What is Net Devices’ capital structure leverage ratio for Year 2? a. 3.89 b. 1.68 c. 3.71 d. 10.32 Copyright Cengage Learning. Powered by Cognero.

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Chap 04_10e 59. Adjustments for dilutive securities and the adjustment to weighted average number of shares outstanding presumes that the dilutive securities are converted to common shares: a. as of the beginning of the year. b. as of the end of the year. c. as of the middle of the year. d. as of the point in time where the maximum number of shares are outstanding. 60. Firms with high operating leverage have a higher proportion of ______ in their cost structure. Select the best term to complete the sentence. a. fixed costs b. variable cost 61. When calculating Basic earnings per share net income is adjusted by ______. a. outstanding shares b. preferred dividends 62. Hall and Porter argue that firms have two generic alternative strategies for any particular product. These strategies are: a. low risk focus, low risk focus b. retail customer focus, wholesale customer focus c. product differentiation, low-cost leadership d. low operating leverage, high operating leverage 63. Return on common shareholders’ equity (ROCE) can be disaggregated into three components. Which of the following is not one of the components? a. Assets Turnover ratio b. Profit Margin ratio c. Debt to Equity ratio d. Capital Structure Leverage ratio 64. Which of the following industries would you expect to have, on average, high asset turnover and low profit margin? a. Hotels b. Grocery stores c. Utilities d. Oil and Gas extraction 65. ______ is the level of earnings and the growth in the levels of earnings expected to persist in the future. Select the best term to complete the sentence. a. Minority interest in earnings b. Retained earnings c. Sustainable earnings

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Chap 04_10e 66. Multiples of EPS to value firms are referred to as: a. ROA b. price-earnings ratios c. ROCE d. Weighted average number of common shares outstanding 67. Refer to the information for Net Devices Inc. What is the inventory turnover for Net Devices for Year 2? a. 10.32 b. 8.90 c. 2.51 d. 6.23 68. When calculating the return on fixed assets sales is divided by ______. a. Average fixed assets b. Average inventory c. Average total assets 69. One important difference between return on assets (ROA) and return on common shareholder’s equity (ROCE) is that: a. ROA does not differentiate based on how a company finances its assets; ROCE does. b. ROA does not distinguish between the different types of income items, such as income from continuing operations, discontinued operations, extraordinary items and changes in accounting principles; ROCE does. c. ROCE does not distinguish between the different types of income items, such as income from continuing operations, discontinued operations, extraordinary items and changes in accounting principles; ROA does. d. ROCE does not differentiate based on how a company finances its assets; ROA does. 70. In order to measure how profitable a firm is in generating a return for its common shareholders, a financial analyst would examine the return on ______. a. assets b. common shareholders' equity 71. The ability of a firm to generate income from operations given a particular level of sales is measured by the ______. a. asset turnover b. profit margin c. inventory turnover 72. Return on common equity can be disaggregated into profit margin for ROCE, capital structure leverage and ______. a. asset turnover b. net income c. profit margin

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Chap 04_10e 73. Accounts receivable turnover is calculated by dividing ______ by average net accounts receivable. Select the best term to complete the sentence. a. cost of goods sold b. total assets c. net sales on account 74. Refer to the information for Ramos Company. In a common size income statement for Year 0, the cost of goods sold is expressed as: a. 64.3% b. 40.0% c. 87% d. 103% 75. One problem with using EPS as a measure of profitability is that it does not consider the amount of assets or ______ required to generate a particular level of earnings. Select the best term to complete the sentence. a. capital b. profit margin c. shareholders' equity 76. Refer to the information for Net Devices Inc. What is the accounts receivable turnover ratio for Net Devices for Year 2? a. 24.65 b. 14.85 c. 14.81 d. 10.50 77. Firms with high levels of operating leverage experience which of the following in comparison to firms with low levels of operating leverage? a. Higher levels of risk in operations. b. Lower expected rates of return. c. Lower variability in returns on assets. d. Higher sales. 78. Refer to the information for Ramos Company. In a percentage change income statement over the period of Year 0 to Year 2, what is the change in net income? a. 100% b. 21.6% c. 72.4% d. 27.6%

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Chap 04_10e 79. The ability of a firm to manage the level of investment in assets for a particular level of sales is measured by the ______. a. asset turnover b. profit margin c. inventory turnover 80. Below is financial information for two restaurant retailers. Popper’s Company operates an innovative retail bakery-cafe business and franchising business. At the end of the year, Popper’s had 132 company-owned and 346 franchise-operated bakery-cafes. Popper’s located most of their unique bakery-cafe concept stores in suburban, strip mall, and regional mall locations. As a first mover in this concept, the company operates in 32 states. Simmer Corporation began operations five years earlier than Popper’s and purchases and roasts whole bean coffees and sells them, along with numerous coffee drinks and related products at over 2,900 Companyoperated retail stores. Selected Data for Popper’s Company and Simmer Corporation (amounts in millions) Simmer $5,000 4,076 1,686 0 268 2,598 303 2,163

Popper’s $300 278 97 0 22 120 4 130

Sales Net Sales Cost of Goods Sold Interest Expense Net Income Average Accounts Receivable Average Inventory Average Fixed Assets Required: a. Compute the Inventory turnover, fixed asset turnover, and accounts receivable turnover. b. Describe the likely reasons for the difference in the accounts receivable turnover and the inventory turnover

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Chap 04_10e 81. Sensitron and Douglas Tools manufacture and market power tools and accessories. Sensitron targets customers in the professional contractor market, while Douglas Tools focuses on home users and professionals. Selected financial data for the companies appears below. Sensitron Sales Average Accounts Receivable Change in Sales from previous year

Year 2 $2,109,100 564,500 0.64%

Year 1 $2,095,700 608,650 -3.68%

Year 0 $2,175,700 631,072 11.83%

Douglas Tools Sales Average Accounts Receivable Change in Sales from previous year

Year 2 $4,394,000 718,800 3.50%

Year 1 $4,245,600 745,850 -5.12%

Year 0 $4,474,900 803,150 0.59%

Required: 1. Calculate the accounts receivable turnover ratio for each firm for years 2-0. 2. Suggest reasons for the differences in the accounts receivable turnover ratios for these two firms.

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Chap 04_10e 82. Below is financial information for two sporting goods retailers. Extreme Sports Company operates a retail business and franchising business. At the end 2011, Extreme Sports had 263 Company-owned and 120 franchiseoperated retail stores. Extreme’s stores are located in suburban, strip mall and regional mall locations, the company operates in 32 states. All Sports Corporation sells sporting goods and related products at over 2,500 Company-operated retail stores. Selected Data for All Sports and Extreme Sports (amounts in millions) Sales Cost of Goods Sold Interest Expense Net Income Average Accounts Receivable Average Inventory Average Fixed Assets Average Total Assets Average Tax Rate

All Sports $5,320 3,897 138 212 114 998 1,163 2,472 40%

Extreme Sports $1,344 887 43 33 18 286 130 662 40%

Calculate the following ratios for All Sports and Extreme Sports: a. Return on assets b. Profit margin for ROA c. Assets turnover d. Accounts receivable turnover e. Inventory turnover f. Fixed asset turnover

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Chap 04_10e 83. Linda’s Clothing is a retailer of contemporary women’s clothing. Selected financial information for Linda’s appears below:

Net Income Total Assets at year-end Weighted Average number of shares Outstanding Total Liabilities at year-end Common Stockholders' Equity at year-end Interest Expense

Year 3 $56,759 $381,500

Year 2 $31,150 $246,250

Year 1 $15,375 $145,490

Year 0 $14,750 $71,268

84,215 205,967 $175,533 165

80,546 119,657 $126,593 195

77,965 60,522 $84,968 258

75,888 17,623 $53,645 368

Required: a. Compute the rate of return on assets for the years 3-1. Linda’s has an effective tax rate of 35%. b. Compute the rate of return on common shareholders’ equity for the years 3-1. c. Compute basic earnings per share for the years 3-1. d. Interpret the changes in ROA versus ROCE and EPS over the three-year period.

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Chap 04_10e 84. Sensitron and Douglas Tools manufacture and market power tools and accessories. Sensitron targets customers in the professional contractor market, while Douglas Tools focuses on home users and professionals. Both firms use the same cost flow assumption for valuing inventories and cost of goods sold. Selected financial data for the companies appears below. Sensitron Cost of Goods Sold Average Inventory Change in Sales from previous year

Year 2 $1,144,200 372,550 0.64%

Year 1 $1,134,100 397,050 -3.68%

Year 0 $1,169,400 436,870 11.83%

Douglas Tools Cost of Goods Sold Average Inventory Change in Sales from previous year

Year 2 $2,876,100 730,550 3.50%

Year 1 $2,846,600 778,100 -5.12%

Year 0 $2,889,000 797,500 0.59%

Required: 1. Calculate the inventory turnover ratio for each firm for years 2-0. 2. Suggest reasons for the differences in the Inventory turnover ratios for these two firms.

85. Explain the difference between a simple and complex capital structure as the terms are used in the calculation of EPS.

86. Discuss the economic characteristics of firms that have the following mix of profit margin and asset turnover. In addition provide an example of an industry that would have the relevant profit margin asset turnover mix: A. High profit margin and low asset turnover. B. Low profit margin and high asset turnover

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Chap 04_10e Answer Key 1. d 2. b 3. a 4. b 5. c 6. a 7. b 8. a 9. b 10. d 11. d 12. c 13. a 14. d 15. c 16. a 17. c 18. a 19. a 20. d 21. d 22. b 23. b 24. a 25. d 26. c

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Chap 04_10e 27. d 28. a 29. a 30. c 31. a 32. b 33. a 34. c 35. c 36. c 37. a 38. b 39. b 40. d 41. b 42. a 43. d 44. a 45. a 46. d 47. d 48. a 49. a 50. a 51. b 52. d 53. b 54. a Copyright Cengage Learning. Powered by Cognero.

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Chap 04_10e 55. b 56. c 57. b 58. c 59. a 60. a 61. b 62. c 63. c 64. b 65. c 66. b 67. d 68. a 69. a 70. b 71. b 72. a 73. c 74. a 75. a 76. c 77. a 78. d 79. a

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Chap 04_10e 80. a. Inventory turnover

Simmer $1,686/$303=5.56

Popper’s $97/$22=4.41

Fixed assets turnover

$5,000/$2,163= 2.31

$300/130=2.31

Accounts receivable turnover

$4,076/$2,598=1.57

$278/120 = 2.32

The differences between the two companies accounts receivable turnover can be explained by looking at the individual company’s credit policies and the general economic conditions. As the economy weakens companies may take longer to pay off their accounts receivable. Companies that have looser credit policies are assuming more default risk than their counterparts with stricter credit policies. Simmer may be having some collection issues and need to re-evaluate their credit policies. Popper’s has the lower inventory turnover ratio and this could be accounted for because Popper’s sells higher priced bakery goods and as a result has less sales. Additionally bakery goods have a shorter life span than does coffee beans and drinks made to order. 81. 1. A/R Turnover-Sensitron A/R Turnover-Douglas Tools

Year 2 $2,109,100 / 564,500 =3.74 $4,394,000 / 718,800 =6.11

Year 1 $2,095,700 / 608, 650 =3.44 $4,245,600 / 745,850 =5.69

Year 0 $2,175,700 / 631,072 =3.45 $4,474,900 / 803,150 =5.57

2. The main reason for the difference is that Sensitron are sold at more specialty retail stores. Sensitron probably allows these customers to have more lenient credit terms. 82. a. b. c. d. e. f.

Return on assets Profit Margin for ROA Assets turnover Accounts Receivable turnover Inventory turnover Fixed Asset turnover

All Sports 0.119 0.055 2.15 46.67 3.90 4.57

Extreme Sports 0.089 0.044 2.03 74.67 3.10 10.34

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Chap 04_10e 83. a. b. c. d.

Year 3 Year 2 Year 1 ROA 18.08% 15.90% 14.19% ROCE 37.57% 29.45% 22.18% EPS $0.67 $0.39 $0.20 As Linda’s Clothing begins to finance more of its assets with liabilities the gap between ROA and ROCE increases. The company is extremely profitable and all ratios are increasing. As the company has become more profitable it has been able to fund operations and expansion with internally generated funds as opposed to issuing large amounts of additional equity (relative to the increase in assets). This allows the company to increase EPS.

84. 1. Year 2 Inventory Turnover-Sensitron Inventory Turnover-Douglas Tools

Year 1

Year 0

$1,144,200 / 372,550 =3.07

$1,134,100 / 397,050 $1,169,400 / 436, 870 =2.86 =2.68

$2,876,100 / 730,550 =3.94

$2,846,600 / 778,100 =3.66

$2,889,000 / 797,500 =3.62

2. The main reason for the difference is that Sensitron sells more of a specialty product. 85. A simple capital structure consists only of common stock and includes no potentially dilutive securities such as stock warrants, convertible bonds, etc. that can dilute earnings per share. A complex capital structure includes convertible bonds, stock rights, stock warrants, and stock options that when exercised can potentially lower (dilute) the company’s earnings per share. 86. 1.

Firms and industries characterized by heavy fixed capacity costs and lengthy periods required to add new capacity operate under a capacity constraint. There is an upper limit on the size of assets turnover achievable. In order to attract sufficient capital, these firms must generate a relatively high profit margin. Some of the industries in this space are oil and gas extraction, hotels, and utilities. Firms whose products are commodity-like in nature, where there are few entry barriers, and where competition is intense, operate under a competitive constraint. There is an upper limit on the level of profit margin for ROA achievable. In order to attract sufficient capital, these firms must strive for high assets turnovers. Some of the industries in this space are retailers and wholesalers.

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Chap 05_10e Indicate the answer choice that best completes the statement or answers the question. 1. The quick acid test ratio contains all of the following except: a. cash b. accounts receivable c. marketable securities d. prepaid assets 2. When a company wants to calculate the current ratio they would divide the current assets by the ______. a. total assets b. current liabilities 3. Long-term ______ represents the longer-term ability of the firm to generate cash internally or from external sources to satisfy plant capacity and debt repayment needs. Select the best term to complete the sentence. a. liquidity risk b. solvency risk c. systemic risk 4. Refer to the information for Mobile Company. Mobile's days receivables outstanding at the end of Year 1 was: a. 43.20 days b. 40.50 days c. 45.25 days d. 8.50 days 5. When management takes deliberate steps at a balance sheet date to produce a better current ratio than is normal it is called ______. a. fraud b. window dressing 6. Which of the following states of financial distress would be considered the most troubling for an investor or creditor? a. failing to make a required interest payment on time b. paying an accounts payable after the billing date c. restructuring debt d. defaulting on a principal payment on debt 7. Working capital is defined as current assets minus ______. a. cash b. current liabilities

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Chap 05_10e 8. The best indicator for assessing a firm's long-term solvency risk is its ability to generate what over a period of years? a. Sales b. Earnings c. Positive cash flows d. Income from continuing operations 9. All of the following are common industry risks faced by companies except: a. litigation b. technology c. regulation d. competition 10. Which of the following properly links the factors affecting a firm’s ability to generate cash with its need to use cash in investing? Ability to generate cash Need to use cash a. Profitability of goods and services sold Working capital requirements b. Sales of existing plant assets Plant capacity requirements c. Borrowing capacity Debt service requirements d. Profitability of goods and services sold Debt service requirements 11. Below are various states of financial distress: 1. defaulting on a principal payment on debt 2. restructuring debt 3. liquidating a firm 4. filing for bankruptcy 5. failing to make a required interest payment on time What is the order of increasing gravity that analysts typically consider when assessing credit risk and bankruptcy risk according to a continuum of financial distress? a. 5, 1, 2, 3, 4 b. 5, 2, 1, 4, 3 c. 1, 5, 2, 4, 3 d. 1, 5, 2, 3, 4 12. Bankruptcy prediction research has identified three broad factors influencing long-term solvency risk, which of the following is not one of the factors? a. Investment factors b. Financing factors c. Operating factors d. Credit factors

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Chap 05_10e 13. Refer to the information for Mobile Company. Mobile's quick ratio changed by what percentage from Year 0 to Year 1? a. 30% b. 107% c. 25% d. 82% 14. Marker’s Year 1 Long-term Debt to Long-Term Capital ratio is: a. 31.4% b. 29.4% c. 34.0% d. 25.4% 15. Which of the following can companies use as collateral for a loan? a. prepaid insurance b. prepaid rent c. property, plant, and equipment d. retained earnings 16. The source of risk related to interest rate changes and demographic changes is ______. a. domestic b. firm specific c. industry d. international 17. Doran Corp. has a current ratio of 6. Under which of the following scenarios might this indicate a problem? a. inventories are increasing due to the introduction of a new product b. the company is holding cash in expectation of making a large investment in equipment c. receivables are increasing due to increasing sales d. inventories are increasing and the industry in which Doran Corp. operates is experiencing a recession 18. Which of the following properly links the factors affecting a firm’s ability to generate cash with its need to use cash in operations? Ability to generate cash a. Profitability of goods and services sold b. Sales of existing plant assets c. Borrowing capacity d. Profitability of goods and services sold

Need to use cash Working capital requirements Plant capacity requirements Debt service requirements Debt service requirements

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Chap 05_10e 19. The operating cycle must not only generate cash for______ , it must generate sufficient cash to service debt. Select the best term to complete the sentence. a. working capital b. fixed assets c. investments 20. Economic theory teaches that differences in market returns must relate to differences in: a. book value b. perceived risk c. price-earnings ratio d. bankruptcy risk 21. Refer to the information for Mobile Company. Mobile's Operating Cash Flow to Current Liabilities ratio in Year 1 was: a. .70 b. 1.39 c. 1.00 d. .72 22. Marker’s Year 1 Interest Coverage ratio is: a. 7.66 b. 1.00 c. 11.35 d. 4.35 23. Financially healthy firms frequently close any cash flow gaps in their operating cycles with ______. a. capital b. long-term debt c. short-term borrowing 24. Marker’s Year 1 Long-term Debt to Shareholders’ Equity ratio is: a. 31.4% b. 29.4% c. 34.0% d. 45.8%

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Chap 05_10e 25. For each of the following scenarios, determine if it is an indicator of potential cash flow problems: Potential future cashflow problems Yes/No a. Growth in accounts receivable or inventories that is less the growth rate in sales. ______ b. Increases in accounts payable that exceed the increase in inventories. ______ c. Capital expenditures that substantially exceed cash flow from operations. ______ d. Sales of marketable securities are less than purchases of marketable securities. ______ e. Other operating current liabilities that grow at a lesser rate than sales. ______ f. A reduction or elimination of dividend payments. ______ g. A substantial shift from long-term borrowing to short-term borrowing. ______ a. Yes, Yes, No, Yes, No, Yes, Yes b. No, Yes, Yes, No, No, Yes, Yes c. Yes, No, Yes, Yes, No, No, No d. No, No, Yes, No, No, Yes, Yes 26. An analyst can view the revenues to cash ratio as a(n) ______. a. a purchases turnover ratio b. an accounts payable turnover 27. The source of risk related to political unrest and exchange rate changes are ______. a. domestic b. firm specific c. industry d. international 28. One problem with debt ratios is that they provide no information about the ability of the firm to generate ______ to service debt. Select the best term to complete the sentence. a. cash flow from operations b. income 29. If a customer wanted to obtain bank financing which of the following will the bank inquire about before granting a loan? a. Firms credit history b. financial position of the firms creditors c. firms cash flow d. a and c 30. When the excess of ROA over the after-tax cost of borrowing declines, additional ______ begins to reduce the return to common shareholders. Select the best term to complete the sentence. a. financial leverage b. operating cash flow c. cash flow from investing activities

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Chap 05_10e 31. One common problem with the current ratio is that it is susceptible to “window dressing.” If prior to the end of the accounting period Saxon Company has a current ratio of 1.5 and management wishes to boost its current ratio it may decide to: a. pay off accounts payable prior to year-end. b. purchase more inventory on account. c. purchase short-term investments with cash. d. purchase more inventory with cash. 32. Univariate bankruptcy prediction models help identify factors related to bankruptcy, but they do not provide information about: a. specific ratios that are important. b. the amount of Type I and Type II errors. c. which specific company will go bankrupt. d. the relative importance of individual financial statement ratios. 33. All of the following are common international risks faced by companies except: a. asset expropriation b. exchange rate changes c. political unrest d. dependence on one or a few suppliers 34. Refer to the information for Mobile Company. Mobile's days accounts payable outstanding at the end of Year 1 is: a. 7.53 days b. 48.09 days c. 45.51 days d. 50 days 35. ______ concerns a firm's ability to make interest and principal payments on borrowings as they become due. Select the best term to complete the sentence. a. Credit risk b. Solvency risk c. Systemic risk 36. Marker’s Year 1 Liabilities to Shareholders’ Equity ratio is: a. 100.0% b. 170.9% c. 63.1% d. 129.3%

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Chap 05_10e 37. Here are several ratios calculated from Midas Company's financial statements: Days in Receivables = 45 Days in Payables = 36 Days in Inventory = 30 How many days of working capital financing does Midas need to obtain from other sources? a. 39 days b. 36 days c. 56 days d. 26 days 38. Which of the following properly links the factors affecting a firm’s ability to generate cash with its need to use cash in financing? Ability to generate cash Need to use cash a. Profitability of goods and services sold Working capital requirements b. Sales of existing plant assets Plant capacity requirements c. Borrowing capacity Debt service requirements d. Profitability of goods and services sold Debt service requirements 39. By adding the number of days that inventory is held to the number of days that accounts receivable is outstanding an analyst can calculate the number of days of ______ the firm requires. Select the best term to complete the sentence. a. sales in receivables b. working capital financing 40. The ______ ratio indicates the number of times that net income before interest expense and income taxes exceeds interest expense. Select the best term to complete the sentence. a. debt b. interest coverage c. operating cash flow to total liabilities 41. Refer to the information for Mobile Company. Days of other financing required by Mobile at the end of Year 1 would be: a. 54.36 days b. 75.36 days c. 102.94 days d. 5.27 days 42. The beta coefficient measures the ______ of a firm's returns with those of all shares traded in the market (in excess of the risk-free interest rate). Select the best term to complete the sentence. a. covariability b. liquidity

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Chap 05_10e 43. The current ratio is one of the measures of the ______ of the firm. Select the best term to complete the sentence. a. covariability b. liquidity 44. Short-term ______ represents a firm's near-term ability to generate cash to service working capital needs and debt service requirements. Select the best term to complete the sentence. a. liquidity risk b. solvency risk c. systemic risk 45. The source of risk related to technology, regulation and availability of raw materials is ______. a. domestic b. firm specific c. industry d. international

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Chap 05_10e Mobile Company Mobile Company manufactures computer technology devices. Selected financial data for Mobile is presented below; use the information to answer the following questions:

Current Assets Cash and short-term investments Accounts Receivable (net) Inventories Prepaid Expenses and other current assets Total Current Assets Current Liabilities Short-term borrowings Current portion of long-term debt Accounts payable Accrued liabilities Income taxes payable Total Current Liabilities

Dec. 31, Year 1 Dec. 31, Year 0 $1,267,038 $ 616,604 490,816 665,828 338,599 487,505 292,511 291,915 $2,388,964 $2,061,852

$ 25,190 182,295 296,307 941,912 203,049 1,648,753

$ 38,108 210,090 334,247 743,999 239,793 1,566,237

Selected Income Statement Data - for the year ending December 31, Year 1: Net Sales Cost of Goods Sold Operating Income Net Income

$4,885,340 2,542,353 733,541 230,101

Selected Statement of Cash Flow Data - for the year ending December 31, Year 1: Cash Flows from Operations

$1,156,084

46. Refer to the information for Mobile Company. Mobile's current ratio in Year 1 was: a. 1.07 b. 1.45 c. 1 d. .69 47. Changes in foreign exchange rates can affect a firm in all of the following ways except: a. The prices a firm pays to acquire raw materials from suppliers abroad. b. The amount of cash a firm receives when it collects an account receivable, a loan receivable, or another receivable denominated in a currency other than its own. c. The value of domestic liabilities with fixed interest rates. d. The prices a firm charges for products sold to customers abroad.

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Chap 05_10e 48. All of the following are common domestic risks faced by companies except: a. recessions b. technology c. inflation d. demographic shifts 49. The analysis of short-term liquidity risk requires an understanding of the ______ of a firm. Select the best term to complete the sentence. a. management b. owners c. operating cycle 50. The Johnson Company has a current ratio of 1.45. The company has just sold $600,000 worth of merchandise on credit. What will the current ratio be after the sales on credit? a. greater than 1.45 b. 1.45 c. less than 1.45 d. unable to determine without more information 51. Changes in interest rates can typically affect firms in all of the following ways except: a. The value of investments in bonds or other investment securities with fixed interest rates. b. The value of liabilities with fixed interest rates. c. The returns a firm generates from pension fund investments. d. The cash-equivalent value of assets invested abroad. 52. Common shareholders benefit with increasing proportions of debt in the capital structure as long as the firm maintains an excess of ______ over the after-tax cost of debt. Select the best term to complete the sentence. a. ROA b. ROE c. RONA 53. Which of the following is not one of the three explanatory variables that determine a firm's market beta? a. Degree of investing leverage. b. Degree of operating leverage. c. Degree of financial leverage. d. Variability of sales.

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Chap 05_10e Below is selected information from Marker’s financial statements:

Cash and short-term investments Accounts Receivable (net) Inventories Prepaid Expenses and other current assets Total Current Assets Plant, Property and Equipment, net Intangible Assets Total Assets

Short-term borrowings Current portion of long-term debt Accounts payable Accrued liabilities Income taxes payable Total Current Liabilities Long-term Debt Total Liabilities Shareholders' Equity Total Liabilities and Shareholders' Equity

Dec. 31, Year 1 $ 958,245 125,850 195,650 45,300 $1,325,045 1,478,320 125,600

Dec. 31, Year 0 $ 745,800 135,400 175,840 30,860 $1,087,900 1,358,700 120,400

$2,928,965

$2,567,000

$ 25,190 45,000 285,400 916,722 125,400 $1,397,712 450,000 $1,847,712 $1,081,253 $2,928,965

$ 38,108 40,000 325,900 705,891 115,600 $1,225,499 430,000 $1,655,499 $ 911,501 $2,567,000

Selected Income Statement Data - for the year ending December 31, Year 1: Net Sales $3,210,645 Cost of Goods Sold (2,310,210) Operating Income $ 900,435 Net Income $ 324,850 Selected Statement of Cash Flow Data - for the year ending December 31, Year 1: Cash Flows from Operations $584,750 Interest Expense 42,400 Income Tax Expense 114,200

54. Marker’s Liabilities to Assets Ratio for Year 1 is: a. 105.1% b. 63.1% c. 78.3% d. 100.0% 55. In general, the shorter the number of days of needed financing, the ______ is the cash flow from operations. Select the best term to complete the sentence. a. larger b. smaller Copyright Cengage Learning. Powered by Cognero.

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Chap 05_10e 56. The source of risk related to management competence, strategic direction and lawsuits is ______. a. domestic b. firm specific c. industry d. international 57. ______ current ratios indicate the availability of cash and near cash assets to pay obligations coming due within the next year. Select the best term to complete the sentence. a. Large b. Small 58. Market equity beta measures the covariability of a firm's returns with the returns of: a. all industry competitors in the market. b. risk free securities. c. all securities in the market. d. all firms of comparable market value. 59. Refer to the information for Mobile Company. Mobile's Year 1 Inventory Turnover ratio is: a. 7.46 b. 11.83 c. 6.16 d. 5.62 60. All of the following typically drive firm-specific risks except: a. the nature of the business b. competition c. supplier relationships d. demographic shifts 61. Which of the following ratios is not a measure of long-term solvency risk? a. Debt /Equity Ratio b. Interest Coverage Ratio c. Operating Cash Flows to Current Liabilities Ratio d. Liabilities to Assets Ratio 62. Cash flow from operations indicates the amount of cash that the firm derived from operations after funding ______. a. debt service b. plant capacity c. working capital

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Chap 05_10e 63. When calculating the quick ratio, an analyst would include in the numerator cash, ______, and receivables. Select the best term to complete the sentence. a. accounts payable b. marketable securities c. prepaid assets Enter the appropriate word(s) to complete the statement. 64. When a financial analyst examines the credit risk of a company, it is common that he or she uses a set of factors that all begin with the letter "C." Each factor provides a consideration that enters into the lending decision. List and discuss how each of the factors affects a company's credit risk.

65. One criticism of the interest and fixed charges coverage ratios as measures of long-term solvency risk is that they use earnings rather than cash flows in the numerator. Detail how the interest coverage ratio and fixed charges coverage ratio are calculated. In addition, discuss why using earnings in the numerator is a problem and what method could be used to alleviate this problem.

66. The main ratio used by many financial analysts to examine a company's short-term liquidity risk is the current ratio. However, there are a number of problems that arise when this ratio is used to examine short-term liquidity risk that may make the current ratio less useful than initially thought. Discuss the interpretative problems of using the current ratio.

67. The current risk-free rate of return in the economy is 6%. In addition, the market rate of return is currently 8.5%. A. Given this information, what would be the expected return on common stock for a company with a systemic risk level (Beta) of 1.3? Show your calculations. B. Describe systemic risk.

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Chap 05_10e 68. Bankruptcy analysis research has gone through many iterations, from univariate bankruptcy prediction models to sophisticated logit models. However, after examining the results of the research there appear to be a number of common factors that consistently explain bankruptcy. These factors can be grouped into investment factors, financing factors, operating factors. For each of the three groups discuss specific factors that have been found to significantly explain bankruptcy.

69. A. What are the three measures that are used to analyze long-term solvency risk? B. describe each measure briefly

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Chap 05_10e Answer Key 1. d 2. b 3. b 4. a 5. b 6. d 7. b 8. b 9. a 10. b 11. b 12. d 13. a 14. a 15. c 16. a 17. d 18. a 19. a 20. b 21. d 22. c 23. c 24. d 25. b 26. b

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Chap 05_10e 27. d 28. a 29. d 30. a 31. a 32. d 33. d 34. b 35. a 36. b 37. a 38. c 39. b 40. b 41. a 42. a 43. b 44. a 45. c 46. b 47. c 48. b 49. c 50. a 51. d 52. a 53. a 54. b Copyright Cengage Learning. Powered by Cognero.

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Chap 05_10e 55. a 56. b 57. a 58. c 59. c 60. d 61. c 62. c 63. b 64. 1. Circumstances leading to need for the loan - The reasons that the company needs to borrow affect the riskiness of the loan and the likelihood of repayment. 2. Credit History - Has the firm borrowed in the past and successfully repaid the loan. 3. Cash flows - Is the lender generating sufficient cash flows to pay interest and repay the principal on a loan rather than having to rely on selling the collateral. 4. Collateral - Is the collateral sufficient to repay the loan and does the lender have the right to take possession of the collateral. 5. Capacity for debt - Has the company borrowed up to its capacity or is there a margin of safety remaining. 6. Contingencies - Are there any events on the horizon that would harm the company if Copyright Cengage Learning. Powered by Cognero.

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Chap 05_10e their outcome is negative. 7. Character of management - An intangible factor, has the management team been successful in difficult times, are they honest and forthcoming. 8. Communication - Developing relations with lenders requires effective communication both initially and on an ongoing basis. 9. Conditions - What are the restrictions or covenants put in place to protect the lender.

Each of these factors must be examined in the multivariate manner so that the total credit risk profile of the company can be determined. 65. Net Income + Interest Expense Interest Coverage Ratio = + Income Tax Expense + Minority Interest in Earnings Interest Expense If a firm must make other required periodic payments (for example, pensions, leases), then the analyst could include these amounts in the calculation as well. If so, the analyst refers to the ratio as the fixed charges coverage ratio. One criticism of the interest and the fixed charges coverage ratios as measures of long-term solvency risk is that they use earnings rather than cash flows in the numerator. Firms pay interest and other fixed charges with cash, not with earnings. The analyst can create cash-flow-based variations of these coverage ratios by using cash flow from operations (before interest and income taxes) in the numerator.

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Chap 05_10e 66. There are a number of interpretative problems with using the current ratio as a measure of short-term liquidity risk: 1.

One of the main inputs into the numerator, inventories, is stated at acquisition cost, which is an amount less than what the company should expect the asset to generate in sales dollars. This will result in understating the current ratio. When the current ratio is above one, an equal increase in current assets and current liabilities will result in a decrease in the ratio. This is opposite the result if the current ratio is below one. This makes analysis difficult. A very high current ratio may not be the result of prosperous business conditions, while a decreasing current ratio may end up being good news. The current ratio must be examined within the context of the total business. The current ratio is susceptible to "window dressing." At fiscal period ends, managers can take steps to improve the current ratio without actually improving the business.

67. A. Expected Return = Risk-free Interest Rate + Market Beta [Market Return - Risk-free Interest] Expected Return = .06 + 1.3[.085-.06] = 9.25% B. Systemic Risk is the risk that affects all investments in common; it is the risk that cannot be reduced by a welldiversified portfolio. 68. Investment factors: 1. Relative liquidity of a firm's assets - The higher the proportion of current assets relative to current liabilities, the less likely the company will experience bankruptcy. 2. Rate of asset turnover - The faster that a company turns over its assets, the more quickly funds work their way toward cash on the balance and the less chance that the company will experience bankruptcy. Financing factors: 1. Relative proportion of debt in the capital structure - The higher the proportion of liabilities in the capital structure, the more likely the company will experience bankruptcy. 2. Relative proportion of short-term debt in the capital structure - Just as in the above factor, the higher the proportion of short-term liabilities in the capital structure that will be coming due within one fiscal period, the more likely the company will experience bankruptcy. Operating factors: 1. Relative level of profitability - Because profitable firms ultimately turn profits into cash, they are less likely to experience bankruptcy. 2. Variability of operations - Firms that experience a cyclical sales pattern are often more at risk for bankruptcy due to their need for cash during the down times in the cycle, which may extend beyond the point of safety.

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Chap 05_10e 69. Answer part A: 1. Debt ratios 2. Interest coverage ratios 3. Operating cash flow to total liabilities ratio ANS part B: 1. Debt ratios- measure the relative amount of liabilities especially long-term debt that a business has in its capital structure. The higher the debt ratio, the greater the long-term solvency risk. 2. Interest coverage ratios- measure the number of times a firms income or cash flows can cover interest payments when they become due. 3. Operating cash flow to total liabilities ratio- measures what percentage of the cash flows the firm has to pay its liabilities.

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Chap 06_10e Indicate the answer choice that best completes the statement or answers the question. 1. As transitory components become a more important part of a firm's reported earnings, the reported earnings: a. are more quality enhanced. b. become a more reliable indicator of sustainable cash flows. c. are a less reliable indicator of sustainable cash flows. d. are a more reliable indicator of fundamental value. 2. When evaluating the quality of accounting information the user should consider the reliability of the measurements made. a. true b. false 3. An example of an accounting principle that does not faithfully portray underlying circumstances is the ______ principle. Select the best term to complete the sentence. a. cost b. monetary unit c. economic entity 4. Which one of the following is an example of sustainable earnings? a. A gain from corporate restructuring. b. A loss from debt retirement. c. A settlement paid by the company for a class action suit. d. Earnings from repeat customers. 5. In a restructuring it is possible that managers may use the opportunity to write down assets that do not even relate directly to the restructuring action. Why might a manager decide to write down an asset that is not included in the restructuring action? a. The manager is practicing conservatism. b. The write down relieves future periods of depreciation expense, which increases cash flows. c. Normally the stock market reacts positively to restructuring and the greater the amount the better. d. The write down relieves future periods of depreciation expense, which increases earnings. 6. Quality accounting information should be informative as to both the ______ of the current period's earnings and the long-run sustainability of profits. Select the best term to complete the sentence. a. economic value implications b. reliability

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Chap 06_10e 7. Accounting information should provide a fair and complete representation about a number of a firm's characteristics. Which of the following is not one of those characteristics? a. risk b. position c. performance d. conservatism 8. When evaluating the quality of accounting information, an analyst should consider all of the following except: a. reliability of the measurements made b. adequacy of disclosures c. comparability of estimates d. economic faithfulness of the measurements made 9. U.S. GAAP requires that changes in estimates be accounted for by recognizing the effect ______ periods. Select the best term to complete the sentence. a. over current and future b. over prior 10. All of the following are criteria that financial reporting requires before recognizing an obligation as a liability except: a. The transaction or event that gave rise to the obligation has already occurred. b. The firm has a present obligation and little or no discretion to avoid the transfer. c. The firm must know the precise amount of the obligation before recording it. d. The obligation involves a probable future sacrifice of economic benefits—a future transfer of cash, goods, or services; the forgoing of a future cash receipt; or the transfer of equity shares—at a specified or determinable date. The firm can measure with reasonable precision the cash-equivalent value of the resources needed to satisfy the obligation. 11. Earnings that are high quality would: a. be informative about current performance and provide information about the long-run sustainability of profits. b. be informative about past performance and provide information about the long-run sustainability of profits. c. be informative about current performance and provide information about the long-run sustainability of assets. d. be informative about past performance and provide information about the long-run sustainability of assets and liabilities. 12. Gains and losses differ from revenues and expenses in that they are produced by ______ activities. Select the best term to complete the sentence. a. operating b. peripheral

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Chap 06_10e 13. One of the conditions that must be met to recognize an estimated loss from a contingency is that the amount of loss can be estimated with ______ precision. Select the best term to complete the sentence. a. absolute b. reasonable 14. All of the following are the general principles underlying the valuation of liabilities except: a. Liabilities requiring future cash payments appear at the present value of the required future cash flows discounted at an interest rate that reflects the uncertainty that the firm will be able to make the cash payments. b. The fair value of a liability cannot differ from the amount appearing on the balance sheet, particularly for long-term debt. c. Liabilities representing cash advances from customers appear at the amount of the cash advance. d. Liabilities requiring the future delivery of goods or services appear at the estimated cost of those goods and services. 15. Accounting information should provide relevant information to forecast the firm's expected future earnings and ______. a. dividends b. cash flows c. market share 16. Accounting information should be a fair and complete representation of the firm's economic performance, position, and ______. a. benefits b. risk 17. In bankruptcy prediction analysis, a type of error is involves predicting earnings ________. a. manipulation b. growth 18. When evaluating the quality of accounting information the user should consider______ of the firm's disclosures. Select the best term to complete the sentence. a. only the most impactful b. the adequacy 19. The SEC ______ financial reports prepared in accordance with IFRS as legislated by the IASB without reconciliation to U.S. GAAP. Select the best term to complete the sentence. a. accepts b. does not accept

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Chap 06_10e 20. The Orbus Company has a 30,000 unrealized gain and a 10,000 unrealized loss. Where would Orbus Company report these transactions? a. Only in non-current assets and liabilities b. In stockholders' equity c. Other comprehensive income d. On the balance sheet as a current asset 21. Which of the following is not considered a motive to manage earnings? a. To create optimal manager compensation payments b. To create optimal job security for senior management c. To create optimal job security for senior management d. To manage reported earnings in order to reduce industry-specific actions 22. Some firms attempt to _______ the amount of restructuring charge in a particular year in order to communicate the “bad news” all at once. Select the best term to complete the sentence. a. maximize b. minimize 23. Accounting standards dictate that firms must report changes in accounting principle in the current and prior years as if the new accounting principle had been applied all along. The rationale for this is: a. comparability. b. conservatism. c. monetary unit. d. materiality. 24. A ______ of operations differs from a discontinuation of operations because the firm continues to operate in the business segment. Select the best term to complete the sentence. a. layoff b. restructuring 25. During July Year 1, Ralston Company decides to dispose of one of its subsidiaries, which qualifies for accounting as a discontinued operation. At the July Year 1 measurement date, Ralston Company estimates that it will report net income of $300,0000 dollars from the measurement date until the disposal date, which is expected to be in April Year 2. In addition, Ralston estimates that it will lose 100,000 on the sale of the segment. How much gain or loss on discontinued operations will Ralston report in its Year 1 income statement (net of income taxes)? a. $200,000 gain b. $0 c. $100,000 loss d. $300,000 loss 26. Under current GAAP unrealized gains and losses are reported in ______. a. accumulated other comprehensive income or loss b. net income

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Chap 06_10e 27. Which of the following items is consistent with earnings being informative about current performance and informing the analyst that level of current earnings are not sustainable? a. The firm recognizes an unexpected gain b. The firm recognizes a fair value gain on a financial asset as a result of a favorable move in interest rates. c. The firm recognizes additional expenses this period due to pre-opening costs associated with new stores. d. The firm experiences a large jump in sales and earnings as a result of successful research and development of new products. 28. Warranties payable and Notes payable are considered which of the following? a. Accounting Liabilities b. Assets c. Stockholders’ Equity d. Other Financial Assets 29. Quality accounting information seeks to _______ relevance and economic faithfulness, subject to the constraints of the reliability of the measurements. Select the best term to complete the sentence. a. maximize b. minimize 30. Examples of poor earnings quality that hinder the forecasting of expected future earnings include all of the following except: a. Earnings dominated by a substantial one-time gain from the sale of real estate tangential to the firm’s operations. b. Reporting a large expense from a warehouse fire that was not covered by insurance. c. A local government corrects a processing error and a firm receives an unexpected rebate on property taxes previously paid. d. The company adds equipment that reduces carbon emissions in response to EPA requirements and increases production efficiency. 31. The assessment of earnings quality is best accomplished through the use of which one of the following? a. Balance sheet and cash flow statement. b. Single-step financial statements. c. Single-step income statement, balance sheet, and cash flow statement. d. Multi-step income statement, balance sheet, and cash flow statement. 32. All of the following are typically recognized as accounting liabilities except: a. Bonds Payable b. Rental Fees Received in Advance c. Loan Guarantees d. Taxes Payable

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Chap 06_10e 33. Income or loss from discontinued operations would best be regarded by an analyst as: a. sustainable earnings. b. impairments. c. transitory earnings. d. permanent earnings. 34. How is a disposal of a segment of the business reported? a. separately stated item on the income statement b. balance sheet c. statement of cash flows d. statement of retained earnings 35. Which of the following items is consistent with earnings being informative about current performance but not informative about future earnings? a. The firm recognizes an unexpected gain b. The firm recognizes a fair value gain on a financial asset as a result of a favorable move in interest rates. c. The firm recognizes additional expenses this period due to pre-opening costs associated with new stores. d. The firm experiences a large jump in sales and earnings as a result of successful research and development of new products. 36. One definition of earnings management is that it occurs when managers use: a. judgment in financial reporting to alter financial reports to mislead stakeholder. b. an accounting method that is inconsistent with other industry members. c. more conservative accounting estimates than other companies. d. pro forma accounting results as opposed to GAAP results. 37. During July Year 1, Ralston Company decides to dispose of one of its subsidiaries, which qualifies for accounting as a discontinued operation. At the July Year 1 measurement date, Ralston Company estimates that it will report net losses of $1,500,000 dollars from the measurement date until the disposal date, which is expected to be in April Year 2. In addition, Ralston estimates that it will lose $300,000 on the sale of the segment. How much gain or loss on discontinued operations will Ralston report in its Year 1 income statement (net of income taxes)? a. $1,500,000 loss b. $0 c. $1,800,000 loss d. $300,000 loss 38. Which of the following does not describe an extraordinary gain or loss? a. infrequent in occurrence b. peripheral to the company’s core business c. unusual in nature d. material in amount

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Chap 06_10e 39. All of the following are typically recognized as accounting liabilities except: a. Obligations with Fixed Payment Dates and Amounts b. Obligations under Mutually Unexecuted Contracts c. Obligations Arising from Advances from Customers on Unexecuted Contracts and Agreements d. Obligations with Fixed Payment Amounts but Estimated Payment Dates 40. On the income statement, income from discontinued operations is shown: a. as an accounting principle change. b. without any income tax effect. c. as a separate section of income from continuing operations. d. net of taxes after income from continuing operations. 41. When evaluating the quality of accounting information the user should consider the reasonableness of the ______ made in applying GAAP. Select the best term to complete the sentence. a. estimates b. policy 42. Which of the following items is consistent with earnings being informative about current performance and informing the analyst that level of current earnings is sustainable? a. The firm recognizes an unexpected gain b. The firm recognizes a fair value gain on a financial asset as a result of a favorable move in interest rates. c. The firm recognizes additional expenses this period due to pre-opening costs associated with new stores. d. The firm experiences a large jump in sales and earnings as a result of successful research and development of new products. 43. The best measure of a firm's sustainable income is: a. net income. b. income from continuing operations. c. income before extraordinary items. d. income before extraordinary item and change in accounting principle. 44. On the income statement the disposal of a segment of a business should be shown ______. a. before taxes b. net of applicable income taxes 45. Which of the following items is consistent with earnings not being informative about current performance but are informative about future earnings? a. The firm recognizes an unexpected gain b. The firm recognizes a fair value gain on a financial asset as a result of a favorable move in interest rates. c. The firm recognizes additional expenses this period due to pre-opening costs associated with new stores. d. The firm experiences a large jump in sales and earnings as a result of successful research and development of new products.

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Chap 06_10e 46. The ______ is the date on which a firm commits itself to a formal plan to dispose of a business segment. Select the best term to complete the sentence. a. disposal date b. measurement date c. payment date 47. All of the following are true regarding a high quality balance sheet except: a. It should portray the economic resources that can be reasonably expected to generate future economic benefits. b. It should provide a complete and fair portrayal of all of the firm’s obligations at a point in time, including the present value of long-term liabilities for future payments. c. It should minimize measurement error and bias. d. It should be optimistic in terms of accounting numbers. 48. Which of the following are characteristics of an extraordinary item? a. Unusual in nature b. Infrequent in occurrence c. Material in amount d. All of these are correct. 49. When a company makes a change in an estimate that it has used in its financial statements, it should account for the change by: a. retroactively restating all prior financial statements b. treat the change as a cumulative effect change in accounting estimate c. spread the effect of the change over the current and future periods d. companies are not allowed to make changes to estimates 50. Users of financial statements should consider which of the following when evaluating the quality of accounting information? a. Economic faithfulness of accounting measurements and classifications. b. Reliability of the measurements. c. Reasonableness of the estimates made in applying GAAP or IFRS. d. All of these should be considered. 51. Some firms attempt to maximize the amount of restructuring charge in a particular year; analysts refer to this as the ______ approach. Select the best term to complete the sentence. a. big bath b. window dressing 52. Firm's choices and estimates within U.S. GAAP should be determined by: a. how the industry operates. b. the firm's underlying economic circumstances. c. SEC interpretations regarding specific choices. d. the firm's auditor. Copyright Cengage Learning. Powered by Cognero.

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Chap 06_10e 53. ______ represents the concept of being able to compare financial statement data across years for any particular firm. Select the best term to complete the sentence. a. Reliability b. Comparability 54. A change in the useful life of an asset is treated as a ______. a. change in accounting estimate b. change in accounting policy 55. Many times a financial analyst may decide to make adjustments to the financial statements in order to make the statements more useful. Which of the following would not require an adjustment to the financial statement? a. A company signs a new contract with a customer. b. A delivery company incurs a loss from disposition of used delivery trucks. c. A company changes the useful life of its equipment from 5 years to 8 years. d. A company incurs a charge related restructuring its operations. 56. In January 2015, the Financial Accounting Standards board (FASB) eliminated the concept of extraordinary items. An extraordinary gain or loss was unusual in nature, ______, and material in amount. Select the best term to complete the sentence. a. infrequent in occurrence b. part of the company’s core business 57. Firms’ choices and estimates within U.S. GAAP or IFRS should be determined by all of the following except: a. firms’ underlying economic circumstances. b. conditions in the company’s industry. c. the company’s competitive strategy. d. accelerated management efforts to meet earnings projections. 58. For each of the following factors, determine if the given change or level of that factor would lead an analyst to believe that managers of a firm are more or less likely to engage in earnings manipulation: Earnings Manipulation More likely/Less likely 1. Days Sales in Receivable Index increases 2. Gross Margin Index decreases below 1 3. Asset Quality Index increases 4. Depreciation Index decreases to below 1 5. Leverage Index increases a. Less likely, More likely, More likely, More likely, Less likely b. Less likely, Less likely, More likely, Less likely, More likely c. More likely, More likely, Less likely, More likely, More likely d. More likely, Less likely, More likely, Less likely, More likely

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Chap 06_10e 59. Healy and Wahlen state that one type of earnings management occurs when managers use judgement in financial reporting to alter financial reports in order to mislead some stakeholder about the economic performance of the company. Earnings management is a consequence of a judgement by management which results in lower economic information content of the financial reports. Discuss five motives that encourage managers to practice earnings management.

60. Healy and Wahlen state that one type of earnings management occurs when managers use judgement in financial reporting to alter financial reports in order to mislead some stakeholder about the economic performance of the company. Earnings management is a consequence of a judgement by management which results in lower economic information content of the financial reports. Discuss four reasons that discourage managers from practicing earnings management.

61. First Bank recognized an extraordinary loss from the settlement of a lawsuit with Fifth Street Bank that it had impeded on a processing patent. The extraordinary loss was in the amount of $4,250,000 and First Bank Corporation has an effective tax rate of 35%. First Bank paid the settlement immediately and recognized the tax benefit as a receivable to offset the current period's taxes. Instructions: a. Prepare the extraordinary item portion of First Bank Corporation's financial statement. b. Using the analytical framework discussed in the text and reprinted below show the effect of following event on First Bank Corporation's financial statements. Analytical Framework: Shareholders’ Equity Entry

Assets

Liabilities

AOCI

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Chap 06_10e 62. Many times an analyst will have to make judgments as to whether to include unrealized gains and losses when assessing earnings persistence and predicting future profitability. Discuss the case for and the case against including unrealized gains and losses as part of sustainable earnings when examining earnings persistence and future profitability.

63. Creighton Corp., a textile manufacturer, reported net income of $258,000. During the same period Creighton reported a gain of $29,800 from the sale of three used delivery trucks. The gain was included as part of income from continuing operations. Assuming that the gain is a one-time event and that Creighton has an effective tax rate of 35% calculate Creighton's adjusted net income. Show all of your calculations for credit. In addition, discuss why analysts might make an adjustment of this type.

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Chap 06_10e 64. Penny Corp. manufactures telecommunication equipment and has been profitable each year for the past ten years. During the current year the company saw its core market decline sharply when a competitor introduced a significant new product technology. In response to the decline in business Penny Corp. announced a major restructuring of its operations. The restructuring plan which would be implemented in the current year would involve the following changes (all of the charges are material): a. b. c. d.

Severance payments to reduce work force Write-down of inventory Penalty payment for termination of lease on manufacturing facility Write-down of equipment associated with manufacturing facility Total 2010 restructuring charge

$ 9 million $13 million $ 6 million $12 million $40 million

Penny Corp. has never previously restructured its operations and believes that it can return to profitability within two years based on its current research and development activity. Required: 1. Discuss whether or not you would eliminate the restructuring charge from the income statement of Penny Corp. when using earnings to forecast future profitability. 2. Penny Corp.'s restructuring charges cover a wide range of different cost categories; identify those that entail a cash payment and those that do not require a cash payment. For those charges not requiring a cash payment how would they be treated in the Statement of Cash Flows?

65. A company may try to paint a favorable picture of itself by accelerating the timing of revenues or estimating the collectible amounts too aggressively. In these cases the quality of accounting information declines because it does not represent the company's true economic condition and may not be sustainable. List four conditions which might suggest that a company is recognizing revenues too early?

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Chap 06_10e 66. In the empirical research on earnings manipulation discussed in the chapter, a number of firm characteristics are found to be associated with the likelihood of engaging in earnings manipulation. For each of the characteristics listed below, discuss the rationale for their inclusion in the model: a. b. c. d. e.

Gross Margin Index Asset Quality Index Sales Growth Index Depreciation Index Leverage Index

67. Achieving comparability in financial reporting is important to the analysis of multinational firms. However, the data from the reconciliation of foreign firm’s financial statement to U.S. GAAP must be carefully interpreted. What types of things complicate the analysis of multinational firms?

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Chap 06_10e 68. A. Listed below are 12 accounting liabilities: 1. 2. 3.

Insurance paid in advance Interest payable Unsettled lawsuits where a reasonable estimate of loss can be determined and the loss is probable 4. Accounts payable 5. Warranties payable 6. Bonds payable 7. Accrued liabilities 8. Taxes payable 9. Employment commitments 10. Notes payable 11. Purchase commitments 12. Salaries payable Place each of these accounting liabilities into one of the following six categories: a. b. c. d. e. f.

Obligations with fixed payment dates and amounts Obligations with fixed payment amounts but estimated payment dates Obligations for which the firm must estimate both timing and amount of payment Obligations arising from advances from customers on unexecuted contracts and agreements Obligations under mutually executed contracts Contingent obligations

B. In addition, determine which of the liabilities would be recognized on the balance sheet as liabilities and which would not be recognized. Suggestion: format your answer as follows (this is not a correct sample answer): a. Obligations with fixed payment dates and amounts (not generally recognized): 1. Rent Payable

69. Many users of financial statements believe that the quality of accounting information for intangible assets is low because firms seldom report intangible asset resources on the balance sheet. However, from the perspective of accounting quality what are arguments in favor of expensing most intangibles and not recording them on the balance sheet?

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Chap 06_10e 70. Banks Corp. reported net income of $595,000. During the same period Banks reported a loss of $87,435 from a peripheral activity. The loss was included as part of income from continuing operations. Assuming that the loss is a one-time event and that Banks has an effective tax rate of 35%, calculate Banks’ adjusted net income. Show all of your calculations for credit. In addition, discuss why analysts might make an adjustment of this type.

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Chap 06_10e Answer Key 1. c 2. a 3. a 4. d 5. d 6. a 7. d 8. c 9. a 10. c 11. a 12. b 13. b 14. b 15. b 16. b 17. a 18. b 19. a 20. c 21. c 22. a 23. a 24. b 25. a 26. a

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Chap 06_10e 27. a 28. a 29. a 30. d 31. d 32. c 33. c 34. a 35. b 36. a 37. c 38. b 39. b 40. d 41. a 42. d 43. b 44. b 45. c 46. b 47. d 48. d 49. c 50. d 51. a 52. b 53. b 54. a Copyright Cengage Learning. Powered by Cognero.

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Chap 06_10e 55. a 56. a 57. d 58. d 59. Motives to manage earnings: 1. Managers want to maximize their compensation packages. 2. Managers want to protect their jobs and gain more job security. 3. Managers want to reduce risk in order to create a more optimal lending environment and to manage debt restrictions and covenants. 4. Managers want to influence short-term stock price movements for their advantage. 5. Managers want to manage earnings in order to thwart industry-specific and anti-trust actions against the firm. 60. Reasons to NOT manage earnings: 1. At some point earnings and cash flows come together and there is a settling up. If a manager manages earnings early on, later years will see lower earnings or losses to compensate. 2. Capital markets and regulators such as the SEC and state securities regulators can penalize firms that aggressively manage earnings. 3. Firms and managers that are perceived as practicing aggressive earnings management will lose reputation as being honest and trustworthy among capital market participants and stakeholders. 4. Legal consequences can result from aggressive earnings management, as well as from earnings management that reverts to earnings manipulation and fraud. 61. a.

Extraordinary loss on the settlement of lawsuit (net of $1,487,500 tax benefit)

-2,762,500

Analytical Framework: Shareholders’ Equity

Entry

Assets

Liabilities

-4,250,000 +$1,487,500

AOCI

-4,250,000 +$1,487,500

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Chap 06_10e 62. The case for including unrealized gains and losses: 1. Unrealized gains and losses closely relate to ongoing operating activities and will likely recur. 2. Measuring the amount of unrealized gain or loss on certain assets is relatively objective in that active markets exist to indicate the amount of the value changes. The case against including unrealized gains and losses: 1. The amount of gain or loss that a firm will ultimately realize when it sells the asset or settles the liability will differ from the amount reported as an unrealized gain or loss in the current period. 2. The unrealized gains or losses could easily reverse in future periods. 3. The unrealized gains or losses have no immediate cash flow effect. 4. Measuring the amount of unrealized gain or loss on certain assets can be subjective if the asset or liability is not traded in an active market. 63. =$258,000-[$29,800*(1-0.35)]=$238,630

The analyst may decide to adjust income totals because the gains or losses do not relate to the sale of the company's principal products and services. Normally, only gains and losses from the sale of principal products and services should enter the forecasts of future earnings and profitability. 64. Suggested answer: 1.

From the information provided it appears that this would be a case in which the restructuring charges should be adjusted. The company does not have a history of incurring restructuring charges and it has been profitable for a long period. The case against adjusting for the restructuring charges is that a return to profitability is not guaranteed, only forecasted by management based on current research and development.

The following two charges would require a cash payment: Severance payments to reduce work force Penalty payment for termination of lease on manufacturing facility

$ 9 million $ 6 million

The following two charges would not require a cash payment and would be added back to income: Write-down of inventory Write-down of equipment associated with manufacturing facility

$13 million $12 million

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Chap 06_10e 65. 1. 2. 3. 4.

Large and volatile amounts of uncollectible accounts receivable. Unusually large amounts of returned goods. Excessive warranty expenditures. A significant increase in days accounts receivable are outstanding.

Gross Margin Index - Firms with weaker profitability in a given year are more likely to engage in earnings manipulation in the future. Asset Quality Index - Represents the proportion of total assets comprising assets other than current assets and PP&E and investments in securities. The index represents the proportion of lower quality assets relative to the prior year. An increase in this factor suggests the company may be trying to capitalize and defer costs that should have been expensed. Sales Growth Index - Sales growth this period relative to the prior period. The need for low cost external financing might motivate managers to manipulate earnings and sales. Depreciation Index - Depreciation expense as a proportion of PP&E before depreciation, this period relative to the prior period. A higher ratio implies that the company has slowed its rate of depreciation, resulting in increased earnings. Leverage Index - The proportion of total financing comprised of current liabilities and longterm debt for the current year relative to the prior period. An increase in the proportion of debt puts the company at greater risk of violating debt covenants and needing to manipulate earnings and sales.

66.

c. d.

67. Financial analysis of multinational firms is complicated by the fact that the environments in which the firms operate may vary extensively across countries. Operational strategies may exist in one firm’s home country that are not common in another. Institutional arrangements, such as significant alliances with banks and extensive intercorporate holdings, may be common in one country and not in another. Cultural characteristics may exist in one country that affect how firms do business in that country—with those same characteristics foreign to other business settings.

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Chap 06_10e 68. a. Obligations with fixed payment dates and amounts 1. Rent Payable 2. Interest payable 6. Bonds payable 10. Notes payable b. Obligations with fixed payment amounts but estimated payment dates 4. Accounts payable 8. Taxes payable 12. Salaries payable c. Obligations for which the firm must estimate both timing and amount of payment 5. Warranties payable d. Obligations arising from advances from customers on unexecuted contracts and agreements 7. Subscription fees received in advance e. Obligations under mutually unexecuted contracts - NOT GENERALLY RECOGNIZED 9. Employment commitments 11. Purchase commitments f. Contingent obligations 3. Unsettled lawsuits where a reasonable estimate of loss can be determined and the loss is probable. 69. 1. 2. 3. 4.

The expense occurs in the same period as the cash outflow when the economic resource is sacrificed. Firms must replace intangibles that are consumed if they expect to continue operating profitably. Immediate expensing reduces the opportunities for earnings management that arise when firms must decide on an amortization period and pattern for capitalized intangibles. For a stable or moderate-growth firm, the expense each year from immediate expensing is approximately the same as the expense from capitalizing expenditures and subsequently amortizing them.

70. $595,000+[$87,435*(1-0.35)]=$651,833 The analyst may decide to adjust income totals because the gains or losses do not relate to the sale of the company's principal products and services. Normally, only gains and losses from the sale of principal products and services should enter the forecasts of future earnings and profitability.

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Chap 07_10e Indicate the answer choice that best completes the statement or answers the question. 1. FASB has set forth all of the following conditions for recognizing transfers of receivables as sales only if the following conditions of surrendering control of the receivables are met except: a. The assets transferred have been isolated from the selling firm. b. The buying firm obtains the right to pledge or exchange the transferred assets, and no condition both constrains the transferee from taking advantage of its right and provides more than a trivial benefit to the transferor. c. The selling firm does not maintain effective control over the assets transferred through (a) an agreement that both entitles and obligates it to repurchase the assets or (b) the ability to unilaterally cause the transferee to return specific assets. d. A creditor of the selling firm can access the receivables in the event of the seller’s bankruptcy. 2. Which kind of dividend typically pays dividends with investments in other corporations’ stock? a. property dividend b. stock dividend c. liquidating dividend d. scrip dividend 3. Gains and losses on cash flow hedges affect earnings ______ than those on fair value hedges. Select the best term to complete the sentence. a. before b. later 4. Which of the following is the date on which a company incurs a legal liability to distribute the dividend to owners of the stock? a. date of record b. commitment date c. date of declaration d. date of payment 5. Which of the following does not represent an acceptable method of transferring receivables to increase cash flow? a. With recourse b. Without recourse c. Factoring d. Tax deferred Method

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Chap 07_10e Porter Corporation NOTE: The following multiple choice questions require present value information. On January 1, Year 1, Porter Corporation signed a five-year non-cancelable lease for certain machinery. The terms of the lease called for: 1) 2) 3) 4) 5)

Price to make annual payments of $60,000 at the end of each year (starting on Dec. 31, Year 1) for five years. Porter must return the equipment to the lessor end of this period. The machinery has an estimated useful life of 6 years and no expected salvage value. Porter uses the straight-line method of depreciation for all of its fixed assets. Porter’s incremental borrowing rate is 8%. The fair value of the asset at January 1, Year 1 is $275,000.

6. What accounting method should Porter use to account for the equipment lease? a. Operating Lease method b. Capital Lease method c. Equipment Lease method d. Lessee Accounting method 7. Derivative instruments acquired to hedge exposure to variability in expected future cash are ______ hedges. Select the best term to complete the sentence. a. cash flow b. fair value 8. U.S. GAAP and IFRS lease accounting rules which were passed in 2016 and became effective beginning in 2019, address “off balance sheet” ______ which were allowable under the old lease accounting rules. Select the best term to complete the sentence. a. assets and liabilities b. expenses 9. Financial reporting requires that firms recognize product financing arrangements as liabilities if which of the following conditions is met? a. The arrangement requires the sponsoring firm to purchase the inventory, substantially identical inventory, or processed goods of which the inventory is a component at specified prices. b. The selling or sponsoring firm physically controls the inventory. c. The payments made to the other entity cover all acquisition, holding, and financing costs. d. Both "the arrangement requires the sponsoring firm to purchase the inventory, substantially identical inventory, or processed goods of which the inventory is a component at specified prices" and "the payments made to the other entity cover all acquisition, holding, and financing costs" are correct.

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Chap 07_10e 10. Under U.S. GAAP, which of the following items would require a lessee to classify a lease of equipment as a direct financing lease? a. The lease term is less than a year. b. The lessor maintains control of the asset. c. The lease term is 90% of the estimated economic life of the lease property. d. The lease does not contain a specific asset, rather an option to use a variety of assets. 11. Regarding accounting for troubled debt, which of the following statements is true? a. The treatment for troubled debt is the same under both U.S. GAAP and IFRS. b. The settlement of troubled debt results in an economic loss to the debtor because the creditor accepts more than the book value of the debt to settle the debt. c. U.S. GAAP uses a “10 percent rule” to determine whether a gain is recognized by the debtor in a troubled debt situation. d. Because IFRS uses the present value approach to determine the magnitude of the settlement for troubled debt, the magnitude of the new book value of the restructured debt will be lower and the gain recognition will be larger under IFRS. 12. According to U.S. GAAP, which of the following provides the most reliable measure for fair value measurement? a. Observable market data serving as inputs into estimates into present value-based measurements such as foreign exchange rates. b. Quoted market prices of identical assets or liabilities in inactive markets c. Observable quoted market prices in active markets for identical assets or liabilities d. Unobservable inputs used by the reporting entity when modeling how the market would determine the fair value of the asset or liability in question 13. ______ means that a company will buy back those receivables that are not collected by the company they are factored to. Select the best term to complete the sentence. a. Factoring b. With recourse c. Without recourse 14. For the year ended December 31, Year 1, Porter should record depreciation expense for the leased equipment equal to: a. $55,000 b. $60,000 c. $47,912 d. $0

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Chap 07_10e 15. Assuming that Santa Corporation was required to capitalize its operating lease, how would the company’s fixed asset ratio change under this assumption? a. increase b. decrease c. no effect d. unable to determine 16. Which of the following is not one of the GAAP classifications for derivatives? a. Speculative investment b. Fair value hedge c. Asset-liability hedge d. Cash flow hedge 17. All of the following are correct regarding operating leases except: a. Cash outflow is in the form of rent payments. b. The rights to use the property for a specified period of time are conferred to the lessee by the lessor. c. At the end of the lease the lessee returns the property to the lessor d. Depreciation expense can be recorded on the books by the lessee 18. Derivative instruments acquired to hedge exposure to changes in the fair value of an asset or liability are ______ hedges. Select the best term to complete the sentence. a. cash flow b. fair value 19. Which is the date when employees elect to exchange the option and cash for shares of common stock? a. vesting date b. grant date c. exercise date d. market date 20. Which of the following is not a distinguishing characteristic of a derivative instrument? a. Derivative instruments have terms that require or permit net settlement. b. Derivative instruments have a low initial net investment. c. Derivative instruments are highly effective throughout their term. d. Derivative instruments have one or more underlyings and notional amounts. 21. Gaines and losses on cashflow hedges affect earnings later than those of ______ hedges. Select the best term to complete the sentence. a. fair value b. currency

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Chap 07_10e 22. Which kind of dividend is a return of the original investment by shareholders? a. cash dividend b. stock dividend c. liquidating dividend d. scrip dividend 23. Under current U.S. GAAP, unrealized gains and losses from four balance sheet items are reported in accumulated other comprehensive income or loss. Which of the following is not one of the balance sheet items? a. Derivatives held as cash flow hedges b. Deferred tax assets related to net operating loss carryforwards c. Minimum pension obligations d. Investment securities classified as available for sale 24. Which of the following is not one of the three criteria for recognition of a liability? a. The obligation involves a probable future sacrifice of resources at a specified or determinable date. b. The firm is required to make a cash payment for the goods or services. c. The firm has little or no discretion to avoid the transfer. d. The transaction or event giving rise to the liability has already occurred. 25. Under the fair value method of accounting for stock options, firms must value stock options on the date of ______. a. grant b. vesting 26. The ______ is the date a firm gives a stock option to employees. Select the best term to complete the sentence. a. exercise date b. grant date 27. Which of the following is the date on which a company determines the owners of the stock that will receive a dividend? a. date of record b. measurement date c. date of declaration d. date of payment 28. Which of the following is not true concerning the recognition of unrealized gains and losses on foreign currency translation during the consolidation process? a. Firms do not recognize these gains/losses in current income. b. Firms recognize these gain/losses in the statement of other comprehensive income c. Firms increase/reduce their investment accounts by the translation gains/losses d. Unrealized gains and losses increase/decrease other accumulated comprehensive income in shareholders’ equity.

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Chap 07_10e 29. One criterion that must be satisfied for a firm to recognize an obligation is that the transaction or event giving rise to the obligation has already ______. a. been agreed upon b. occurred 30. Under which of the following conditions does the equipment lease qualify for capital lease accounting? a. The lease contains a bargain purchase option. b. The lease term is equal to or greater than 75% of the asset’s economic life. c. A, and B are correct answers. d. The lease transfers ownership to the lessee at the end of the lease term. 31. Where in the financial statements are changes in the fair value of cash flow hedges reported: a. On the Balance Sheet as part of retained earnings b. On the Income Statement as other gains/losses c. As other comprehensive income and accumulated in other comprehensive income on the Balance Sheet. d. On the Statement of Stockholder’s Equity 32. When firms use derivatives effectively to manage risks, the net gain or loss each period should be relatively ______. a. large b. small 33. At January 1, Year 1, Porter should record an asset and liability with respect to the equipment lease equal to: a. $258,726 b. $239,562 c. $275,000 d. $300,000 34. Under IFRS, cash payments for purchase of treasury stock are classified as a. operating cash outflows. b. investing cash outflows. c. financing cash outflows. d. operating cash outflows and financing cash outflows. 35. Using the information provided by Santa Corporation, calculate the company’s Year 2 fixed asset ratio. a. 1.01 b. 1.04 c. 0.09 d. 0.32

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Chap 07_10e Santa Corporation NOTE: These multiple choice questions require present value information. Santa Corporation manufactures Christmas decorations and supplies throughout the world. The company owns property, plants, and equipment and also enters into leases for certain facilities. Assume that Santa’s incremental borrowing rate is 8%. The company's tax rate is 40%. Listed below are selected financial data for Santa and a portion of the company's lease footnote.

Property, Plant, & Equipment (net) Total Assets Common Shareholders’ Equity

Year 2 $2,882,468 3,756,854 867,992

Year 1 $2,717,453 3,405,484 652,626

Sales Cost of Goods Sold Depreciation Expense Interest Expense Net Income

$2,922,915 2,016,811 78,584 106,663 248,448

$2,415,632 1,642,630 67,542 90,343 217,407

Year 0 $2,658,214 3,254,896 587,951

Santa Corp. Operating Lease Disclosure (amounts in thousands) Operating Lease Commitments at the end of Year 1

Year Year 3 Year 4 Year 5 Year 6 Year 7 Beyond Year 7

Reported Lease Commitments $148,239 $252,800 $278,327 $279,210 $285,452 $2,471,600

36. Using the information provided by Santa Corporation, estimate the average life of the leases. a. 8.66 years b. 13.66 years c. 10 years d. Not able to determine

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Chap 07_10e 37. Under the old standards, analysts has to use note information to convert future lease payment information into _______ to properly compute return on assets. Select the best term to complete the sentence. a. depreciation expense b. rent expense c. assets and liabilities 38. Which kind of dividend has an interest-bearing promise to pay dividends? a. property dividend b. stock dividend c. liquidating dividend d. scrip dividend 39. All of the following are benefits of leasing except: a. They have the ability to shift the tax benefits from depreciation and other deductions from a lessee to a lessor. b. They provide flexibility to change capacity as needed without having to purchase or sell assets. c. They have the ability to reduce the risk of technological obsolescence, relative to outright ownership, by maintaining the flexibility to shift to technologically more advanced assets. d. They have the ability to use lessor financing when other forms of financing are not available to the lessee. 40. Which of the following best describes the accounting treatment for derivative instruments not held for purposes of hedging? a. Record as an asset or liability and recognize changes in fair value in other comprehensive income. b. Do not record as an asset or liability; record income from the transaction at maturity and recognize in earnings. c. Record as an asset or liability; recognize changes in fair value currently in earnings. d. Record as an asset or liability if off-balance sheet risk is material. 41. The first date at which employees can exercise their stock options is termed the ______. a. grant date b. vesting date 42. Which is the first date when employees can exercise their stock options? a. vesting date b. grant date c. exercise date d. liquidating date 43. In some countries the account Reserve for Contingencies may be most comparable to which of the following accounts for a company reporting under U.S. GAAP? a. Contingency Expense b. Retained Earnings Appropriated for Contingencies c. Unearned Contingency Fees d. Contingency Losses Copyright Cengage Learning. Powered by Cognero.

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Chap 07_10e 44. Using the information provided by Santa Corporation, calculate the present value of the leases. a. $2,155,843 b. $2,024,945 c. $1,482,390 d. $2,854,452 45. Convertible preferred stock has both the attributes of equity and ______. a. assets b. debt 46. All of the following are primary events that typically lead to changes in book value of shareholders’ equity except: a. Investments by shareholders, usually net cash received by the company at equity issue date. b. Profitable operating and investing activities, with net income being a large component of this increase. c. Debtholders requiring firms to enter into debt covenants. d. Distributions to shareholders, usually in the form of periodic cash dividend payments to investors and sometimes in the form of share repurchases. 47. Under the fair value method of accounting for stock options, firms must value stock options on the: a. grant date b. intrinsic date c. measurement date d. fair value date 48. Which of the following is the typical tradeoff when issuing preferred stock? a. The tradeoff between different accounting for an initial issuance of preferred stock as compared to a common stock issuance. b. The tradeoff between maintaining corporate control and creating a class of shareholders with preference in all asset distributions. c. The tradeoff of giving common shareholders priority over preferred shareholders in corporate liquidations. d. The tradeoff of a convertibility feature of common shares into preferred shares. 49. Which of the following is the date on which the dividend distribution occurs? a. date of record b. commitment date c. date of declaration d. date of payment 50. Derivatives are financial instruments that derive their value from changes in any of the following underlying securities except: a. Stock prices b. Percentage discount on accounts receivable c. Interest rates d. Commodity prices Copyright Cengage Learning. Powered by Cognero.

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Chap 07_10e 51. The acceptable method of accounting for stock options is the ______ method. Select the best term to complete the sentence. a. fair value b. cost 52. Which kind of dividend typically pays dividends with additional shares of the corporation’s stock? a. property dividend b. stock dividend c. liquidating dividend d. scrip dividend 53. Which is the date when a firm gives a stock option to employees? a. vesting date b. grant date c. exercise date d. market date 54. Discuss the difference between transferring receivables with and without recourse.

55. There are three dates that are important to a corporation when they issue new shares of stock. Identify the three dates and explain the significance of each?

56. Discuss the method of accounting for employee stock options. In your answer discuss the how the accounting has changed during recent years.

57. Assume that you are currently negotiating a lease transaction in the role of the lessee. Discuss whether you would rather structure the lease as an operating lease or a capital lease and why. In addition, provide the conditions that would require that the lease be accounted for as a capital lease.

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Chap 07_10e 58. Why can exercising stock options create cash flow problems for managers at the exercise date? What is an alternative to this problem?

59. Derivative instruments acquired to hedge exposure may be classified as either a fair value hedge or a cash flow hedge. Distinguish between the two types of hedges.

60. Many firms use derivative instruments to hedge exposure to changes in the fair value of an asset or liability, or to hedge exposure to variability in expected future cash flows. As an analyst examining the financial reports of a company that uses derivative instruments to hedge, what questions should you ask when thinking about derivatives and accounting quality?

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Chap 07_10e Answer Key 1. d 2. a 3. b 4. c 5. d 6. b 7. a 8. a 9. d 10. c 11. d 12. c 13. b 14. c 15. b 16. c 17. d 18. b 19. c 20. c 21. a 22. c 23. b 24. b 25. a 26. b

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Chap 07_10e 27. a 28. c 29. b 30. c 31. c 32. b 33. b 34. c 35. b 36. b 37. c 38. d 39. a 40. c 41. b 42. a 43. b 44. a 45. b 46. c 47. a 48. b 49. d 50. b 51. a 52. b 53. b

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Chap 07_10e 54. When a company transfers receivables to the factor without recourse the factor pays the company a percentage of the total receivables and in effect it is a sale of the receivables to the factor. The factor takes the receivables with recourse if any uncollected receivables can be returned to the company for a refund. 55. Date of declaration- The board of directors declare a cash dividend and the dividend now becomes a legal liability of the corporation Date of record- On the date of record the corporation makes a list of the shareholders that are eligible for the cash dividend Payment date- On the payment date the company pays the shareholders on record their cash dividend. 56. The FASB requires the fair value method of accounting for stock options. The preferred valuation method for valuing stock options is the Black-Scholes options pricing model. Previously firms had the ability to choose between a method that did not recognize an expense related to stock options and the fair value method of accounting for stock options. Under old accounting rules stock options hardly ever resulted in companies recognizing option related salary expense because the expense was equal to the number of options multiplied by the difference in the grant price and the stock price on the date of the grant. An expense would only be recognized when the option grant is made at a price below the current market price, an event that is not common. The fair value method bases the option expense on the amount calculated from using the Black-Scholes option pricing formula. Firms then amortize this cost over the employees’ option vesting period. 57. Normally, most managers would probably want to structure a lessee transaction as an operating lease in order to keep the asset and liability off the balance sheet. In addition, if structured properly, an operating lease would shift expense recognition later, as opposed to earlier with a capital lease. The conditions requiring capital lease treatment are: 1. If the lease extends for at least 75% of the asset's total expected useful life, or 2. if the lease transfers ownership to the lessee at the end of the lease term, or 3. if the lease contains a bargain purchase option, or 4. the present value of the contractual minimum lease payments is equal or exceeds 90% of the fair market value of the asset at the time of the signing. 58. Because the manager must pay the exercise price and may have to pay taxes on compensation in order to acquire the stock, which he or she may want to hold rather than sell. An alternative share-based compensation program eliminates a manager’s need to pay the exercise price. At the grant date, the manager could be given shares of stock rather than options (far fewer shares than options because the fair value of a share is usually greater than the fair value of an option to purchase the stock). The stock cannot be traded until the vesting period is completed (restricted stock). Or the manager could receive non-tradable rights for a number of shares of stock once the vesting period is completed (RSUs). In concept, the accounting for stock options, restricted stock, and RSUs is similar except for the fact that stock is issued (or restrictions placed on trading already issued stock will be removed) once the vesting period ends.

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Chap 07_10e 59. Recommended Answer from the text: Derivative instruments acquired to hedge exposure to changes in the fair value of an asset or liability are fair value hedges. Fair value hedges are of two general types (1) hedges of a recognized asset or liability, and (2) hedges of an unrecognized firm commitment. Firm B in Examples 6 and 10 entered into the interest swap agreement to neutralize the effect of changes in interest rates on the market value of its notes payable, a hedge of a recognized liability. Firm A in Examples 5 and 9 acquired the forward foreign exchange contract to neutralize the effect of changes in exchange rates on its commitment to purchase the equipment, a hedge of an unrecognized firm commitment. These derivative instruments are therefore fair value hedges. Derivative instruments acquired to hedge exposure to variability in expected future cash flows are cash flow hedges. Cash flow hedges are of two general types: (1) hedges of cash flows of an existing asset or liability, and (2) hedges of cash flows of forecasted transactions. Firm C in Examples 7 and 11 entered into the interest swap agreement to neutralize changes in cash flows for interest payments on its variable rate notes payable, a hedge of an existing liability. Firm D in Examples 8 and 12 acquired the forward contract on whiskey to protect itself from changes in the selling price of whiskey between October 31, Year 1, and March 31, Year 2, a hedge involving a forecasted transaction. These derivative instruments are therefore cash flow hedges. 60. Items that should be considered are: 1. Of what quality are the market values that are being used to mark derivatives to market at the balance sheet date? Are the market values obtained from liquid markets with many participants? 2. Has the company done a fair job of classifying its derivative hedges as either fair value hedges or cash flow hedges? Gains and losses on cash flow hedges affect earnings later than those of fair value hedges. 3. Are the company's net gains or losses each period relatively small or large? Are the net gains or losses volatile? Large and volatile net gains or losses may signal a poor use of derivatives.

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Chap 08_10e Indicate the answer choice that best completes the statement or answers the question. 1. Goodwill represents: a. the synergies that will be achieved through the acquisition. b. the difference between the acquisition cost and the market value of the identifiable assets and liabilities. c. the difference between the acquisition cost and the book value of the identifiable assets and liabilities. d. the merger premium. 2. GAAP stipulates that firms should do what with expenditures that increase the service potential of an asset beyond that originally anticipated? a. Expense the expenditure immediately. b. Capitalize the expenditure and depreciate it over the remaining service life of the asset. c. Capitalize the expenditure, but do not depreciate the asset. d. Charge it off to shareholders’ equity. 3. Which of the following would not be used to determine the cost of an asset? a. cash paid b. sales and excise taxes c. cost incurred to get the asset ready for its intended use d. depreciation method 4. When dividends from an investment are recognized as income, the investment must have been of which type? a. Minority, Passive Investment b. Majority, Passive Investment c. Majority, Active Investment d. Minority, Active Investment 5. When a foreign entity operates as a relatively self-contained and integrated unit within a foreign country, normally, its functional currency is the ______. a. currency of the foreign country b. U.S. dollar 6. All of the following statements are true regarding accounting for software development costs except: a. Firms must expense as incurred all costs incurred internally in developing computer software until such development achieves the technological feasibility of a product. b. Firms must capitalize as incurred all costs incurred internally in developing computer software. c. Researchers have found a significant association between costs and future earnings, which support capitalizing and amortizing product development costs permitted by U.S. GAAP and IFRS. d. The interpretation of the meaning of technological feasibility has created diversity in the practice of accounting for software development costs.

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Chap 08_10e 7. Based on the information concerning Snowflake Corp. what is the value of the goodwill related to the acquisition? a. $1,775,000 b. $475,000 c. $2,250,000 d. $1,325,000 8. Managers are typically faced with all of the following primary choices and estimates when allocating acquisition costs of tangible assets and intangible assets to the periods benefited except: a. choosing an allocation method b. estimating useful life c. estimating salvage value d. establishing a reserve for obsolescence 9. Securities that are purchased in order to take advantage of short-term changes in market value should be classified as ______ securities. Select the best term to complete the sentence. a. available-for-sale b. trading 10. U.S. GAAP stipulates that firms should ______ expenditures that increase the service potential of an asset beyond that originally anticipated. Select the best term to complete the sentence. a. capitalize b. expense 11. Unrealized holding gains and losses from investments classified as trading are reported in the ______. a. income statement b. balance sheet 12. An analyst can estimate the average total life of depreciable assets by: a. dividing average depreciable assets by depreciation expense for the year. b. dividing depreciation expense for the year by average depreciable assets. c. dividing average gross depreciable assets by accumulated depreciation. d. Subtracting depreciation expense from accumulated depreciation. 13. All of the following are typically costs that fail the future benefits test of long-lived operating assets except: a. costs related to research and development b. costs related to marketing c. costs related to brand-building activities d. costs of equipment used in production

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Chap 08_10e 14. Based on the information concerning Record Corp., what amount of goodwill should CD record at the acquisition date? a. ($294,000) b. $614,000 c. $1,200,000 d. $350,000 15. The method used to account for oil and gas exploration costs that capitalizes the exploration costs of productive wells is the: a. reserve recognition accounting. b. successful efforts approach. c. soft asset approach. d. full-cost approach. 16. U.S. GAAP financial reporting requires firms to ______ all R&D costs incurred internally. Select the best term to complete the sentence. a. capitalize b. expense 17. Using the information below, calculate the average total depreciable life of the assets: Information from the Balance Sheet: Depreciable Assets Accumulated Depreciation Depreciable Assets (Net) From the Income Statement Depreciation Expense

Year 1 $2,458,600 (1,350,700) $1,107,900

Year 0 $1,985,400 (1,046,000) $939,400 Year 1 $384,500

a. 5.8 years b. 10 years c. 2.9 years d. 5.3 years

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Chap 08_10e 18. Using the information below, calculate the average total depreciable life of the assets: Information from the Balance Sheet: Depreciable Assets Accumulated Depreciation Depreciable Assets (Net) From the Income Statement Depreciation Expense

Year 1 $600,000 (175,000) $425,000

Year 0 $400,000 (100,000) $300,000 Year 1 $50,000

a. 6.54 years b. 7.25 years c. 6.91 years d. 9.15 years 19. Most publicly traded firms in the United States use the ______ method of depreciation for financial statement purposes. Select the best term to complete the sentence. a. straight-line b. accelerated

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Chap 08_10e Record Corporation CD Inc. acquires 100% of the outstanding shares of Record Corp. for $1,200,000 and accounts for the transaction using the purchase method. Record Corp’s balance sheet at the date of acquisition appears below: Record, Corp. Balance Sheet Acquisition Date Historical Cost Assets Cash Accounts Receivable Inventory Depreciable Assets less Accumulated Depreciation Note Receivable Goodwill Total Assets Liabilities and Equities Accounts Payable Note Payable Deferred Income Tax Liability Shareholders' Equity Total Liabilities and Equities

Current Market Value

$479,000 225,400 98,900 554,700

$479,000 210,000 105,000 600,000

100,000

$1,458,000

$458,000 325,000 125,000 550,000 $1,458,000

$458,000 325,000 125,000

20. Based on the information concerning Record Corp., what is the market value of the company's shareholders' equity at the acquisition date? a. $0 b. $908,000 c. $1,200,000 d. $1,458,000 21. Solo Corp. purchased $500,000 of bonds for $515,000 as an investment. If Solo expects to hold the bonds until they mature, the initial investment should be recorded at: a. Investment in Bonds - $500,000 Additional Investment Expense - $15,000 b. Investment in Bonds - $515,000 c. Investment in Bonds - $500,000 Prepaid Interest Revenue - $15,000 d. Accumulated Other Comprehensive Investment - $500,000

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Chap 08_10e 22. If Ashley Company accounts for the investment as a minority, active investment and uses the equity method to account for the investment, then the investment will appear in the December 31 balance sheet at what amount? a. $60,000 b. $65,000 c. $64,000 d. $75,000 23. When dividends from an investment are recognized as a reduction of the investment account, the investment must have been of which type? a. Minority, Passive Investment b. Majority, Passive Investment c. Majority, Active Investment d. Minority, Active Investment 24. A company would need to record an impairment loss for its equipment when: a. the original cost of the equipment exceeds its fair value and is deemed not recoverable. b. management determines that the equipment will no longer be used. c. the carrying amount of the equipment exceeds its fair value and is deemed not recoverable. d. the cash flows from the equipment are less than its fair value. 25. Olivia Co. owns 4,000 of the 10,000 outstanding shares of Hobbitt Corp. common stock and exercises significant influence over the company. During the year, Hobbitt earns $80,000 and pays cash dividends of $30,000. For the year ended December 31, Olivia should report income related to the investment equal to: a. $0 b. $12,000 c. $32,000 d. $20,000 Ashley Company Ashley Company purchased 2,000 of the 10,000 outstanding shares of Judd, Inc.'s common stock for $60,000 on January 1. During the year, Judd declared a dividend of $5 per share and reported net income of $75,000. At the end of the year the market value of a share of Judd, Inc. stock has increased to $32 per share. 26. If Ashley Company accounts for the investment as a minority, passive investment and classifies it as an available-for-sale security, then the investment will appear in the December 31 balance sheet at what amount? a. $60,000 b. $65,000 c. $64,000 d. $75,000

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Chap 08_10e 27. Which of the following is the least effective way for an analyst to understand whether existing long-lived assets must be replaced? a. understand industry conditions and firm strategies for capital expenditure growth b. calculate the average age of depreciable assets c. calculate the percentage of ownership the firm has in another entity d. calculate the proportion of depreciable assets consumed 28. When a foreign entity operates as a direct and integral extension of the U.S. parent, normally, its functional currency is the ______. a. currency of the foreign country b. U.S. dollar 29. Firms that capitalize routine maintenance and repair charges will end up with the result of having the current period's income being ______. a. overstated b. understated 30. Which of the following is a difficulty in determining current market values when determining the value of fixed assets? a. There is an absence of active markets for many fixed assets. b. It is difficult to identify comparable assets currently available in the marketplace to value assets in place. c. It is difficult to make assumptions about the effects of technology and other improvements when using the prices of new assets currently available on the market in the valuation process. d. All of these are correct. 31. The term used to describe the amount of a company’s annual interest cost that should be capitalized is known as: a. tangible interest b. actual interest c. average accumulated expenditures d. avoidable interest 32. When the purchase price of another entity exceeds the book value of the entity's net assets the purchaser allocates the excess to identifiable assets and liabilities in order to revalue them to market value and any additional excess is allocated to ______. a. brand recognition b. goodwill 33. When the functional currency is the U.S. dollar, financial reporting requires firms to use the ______ translation method. Select the best term to complete the sentence. a. all-current b. monetary/nonmonetary

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Chap 08_10e 34. Firms recognize an ______ when the carrying amount of a fixed asset exceeds its fair value and is deemed not recoverable. Select the best term to complete the sentence. a. impairment loss b. extraordinary expense 35. All of the following are consistent with the purpose of determining the useful life of a long-lived asset except: a. using the information to convey expectations about the future usefulness of the assets to stakeholders. b. using the information to help project a rational basis for depreciation c. using the information to help project a systematic basis for depreciation d. using the information to manage earnings upward. 36. Based on the information concerning Snowflake Corp. by what amount would Penguin increase depreciable assets when it consolidates Snowflake on the acquisition date? a. $1,775,000 b. $475,000 c. $2,250,000 d. $375,000 37. Olivia Co. owns 5,600 of the 14,000 outstanding shares of Hobbitt Corp. common stock and exercises significant influence over the company. During the year, Hobbitt earns $90,000 and pays cash dividends of $25,000. If the beginning balance in the investment account was $190,000, the balance at December 31 should be: a. $192,000 b. $172,000 c. $180,000 d. $216,000 38. Ownership of 50% or more of the voting stock of another company implies an ability to control the company and ______ financial statement should be prepared. Select the best term to complete the sentence. a. combination b. consolidated 39. Under IFRS, when an asset is revalued upwards, subsequent depreciation is based on: a. the asset's fair value. b. the asset's original cost. c. the method used for determining depreciation on the company's tax returns. d. the amount of future cash flows the asset is expected to generate. 40. ______ include trade and brand names, trademarks, patents, copyrights, franchise rights, customer lists and goodwill. a. Fixed assets b. Intangible assets

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Chap 08_10e 41. Unrealized holding gains or losses that are recognized in the income statement are from securities classified as: a. trading b. available for sale c. held-to-maturity d. equity 42. When a firm can exercise control or significantly influence the operations of a company it has only a minority interest in, it should account for the investment using the ______. a. equity method b. purchase method 43. When a foreign entity has the U.S. dollar as its functional currency, it uses which exchange rate to translate monetary assets and liabilities? a. the average exchange rate during the period b. the end of the period exchange rate c. the historical exchange rate d. the exchange rate on the date the asset or liability was obtained 44. Which of the following terms is least consistent with the allocation of costs using a rational and systematic method? a. depreciation b. amortization c. depletion d. upward revaluation 45. Specifically identifiable intangible assets acquired from others are _______. a. capitalized b. expensed 46. When a company has a minority passive investment it will recognize changes in the market value of the investment as ______ gains and losses. Select the best term to complete the sentence. a. realized b. unrealized 47. Held-to-maturity securities are accounted for at ______. a. fair value b. amortized acquisition cost 48. When a company records the cost of cutting down timber, this cost is deemed to be: a. exploration cost. b. asset retirement obligation. c. development cost. d. depletion cost.

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Chap 08_10e 49. When a long-lived asset loses its ability to generate future benefits, U.S. GAAP requires firms to write down the assets to their fair values and recognize an impairment loss in _________. a. income from continuing operations b. other comprehensive income 50. Which one of the following is an example of the expected benefit approach for valuing long-lived assets? a. Current cost. b. Historical cost. c. Discounted present value. d. Current replacement value. 51. Currently, the FASB’s Statements of Accounting Concepts (Nos. 5 and 6) define an asset as having all of the following characteristics except: a. costs not guided by management’s judgment b. probable future benefits c. resulting from past transactions and events d. something that is obtained/controlled by the entity 52. Which of the following is not a classification for a minority, passive investment? a. trading securities b. equity securities c. available-for-sale securities d. held-to-maturity securities 53. When certain kinds of assets are built that require public welfare and safety expenditures at the end of the asset's life: a. these asset retirement costs are expensed when asset retirement occurs. b. a liability simultaneously arises. c. these estimated future expenditures are added to the carrying value of the asset. d. this fact is only reported in the financial statement footnotes. 54. When a foreign entity has the foreign currency as its functional currency, it uses which exchange rate to translate revenues and expenses in the income statement? a. the average exchange rate during the period b. the end of the period exchange rate c. the historical exchange rate d. the exchange rate on the date the asset or liability was obtained 55. Unrealized holding gains and losses from investments classified as available for sale are reported in ______. a. operating income b. other comprehensive income

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Chap 08_10e 56. Unrealized gains and losses that appear in accumulated other comprehensive income are from securities classified as ______ securities. Select the best term to complete the sentence. a. available-for-sale b. equity c. held-to-maturity d. trading 57. The functional currency of a foreign unit whose receivables and payables are denominated in foreign currency and not usually remitted to parent company is the ______. a. foreign currency b. U.S. dollar 58. Under which of the following scenarios would an entity not be classified as a variable interest entity? a. The equity investing firms do not have the obligation to absorb the expected losses of the variable interest entity if they occur. b. The investing firms do not have the right to receive the expected residual returns of the variable interest entity if they occur. c. The total equity investment at risk is sufficient to permit the variable interest entity to finance its activities without additional subordinated financial support from other parties. d. The equity investing firms do not have the direct or indirect ability to make decisions about the variable interest entity’s activities through voting rights or similar rights. 59. If Ashley Company accounts for the investment as a minority, passive and classifies the investment as an available-for-sale investment, then Ashley will recognize what amount of income from the investment? a. $4,000 b. $10,000 c. $25,000 d. $15,000

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Chap 08_10e Snowflake Corp. Penguin, Inc. acquires 100% of the outstanding shares of Snowflake Corp. for $2,250,000 and accounts for the transaction using the purchase method. Snowflake's balance sheet at the acquisition date is as follows: Snowflake, Corp. Balance Sheet Acquisition Date Historical Cost

Current Market Value

$900,000 $875,000

$900,000 $1,250,000

Assets Current Assets Depreciable Assets less Accumulated Depreciation Goodwill Total Assets

$1,775,000

Liabilities and Equities Liabilities Deferred Income Tax Liability Shareholders' Equity Total Liabilities and Equities

$1,100,000 $125,000 $550,000 $1,775,000

$1,100,000 $125,000

60. Based on the information concerning Snowflake Corp. what is the market value of the company's shareholders' equity at the acquisition date? a. $1,775,000 b. $475,000 c. $2,250,000 d. $0 61. A key characteristic of asset measurement is best described as: a. average value based on all assets held by the company b. disposal cost less depreciation c. fair value at the acquisition date d. fair value less depreciation 62. How should Focus Company record expenditures for research and development costs according to U.S. GAAP? a. expense as incurred b. capitalize and depreciate c. amortize them over 60 months d. None of these are correct.

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Chap 08_10e 63. All of the following are difficulties encountered in determining fair values except: a. the need to make assumptions about the effect of technological and other improvements when using the prices of new assets currently available on the market in the valuation process b. the need to identify comparable assets currently available in the market to value assets in place c. the absence of U.S. GAAP and IFRS standards related to reporting long-lived assets d. the absence of active markets for many used fixed assets, particularly those specific to a particular firm’s needs 64. All of the following are types of intercorporate investments in capital stock except: a. minority, passive b. minority, active c. majority, active d. majority, passive 65. Which of the following items would be charged to the cost of the building? a. Architectural fees. b. Cost of foundation. c. Capitalization of interest financing charges. d. All of these are correct. 66. When a firm sells a trading security, it recognizes: a. the average of the selling price and the book value as a gain or loss in measuring net income. b. the difference between the selling price and the book value as a gain or loss in measuring net income. c. amortizes any difference between the acquisition cost and maturity value as interest revenue over the life of the debt. d. the difference between the selling price and the acquisition cost of the security as a realized gain or loss on the income statement. 67. Expenditures included in the cost of a long-lived asset are: a. intangible. b. charged off. c. expensed. d. capitalized. 68. Under U.S. GAAP, when an asset's carrying amount is deemed ______, the asset is considered impaired. Select the best term to complete the sentence. a. "recoverable" b. "not recoverable"

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Chap 08_10e 69. Firms recognize an impairment loss when the carrying amount of a tangible fixed asset is deemed “not recoverable” as specified by GAAP. GAAP defines a carrying amount as “not recoverable” if: a. it is greater than the sum of the cash flows expected from the asset’s use and disposal. b. it is greater than the sum of the undiscounted cash flows expected from the asset’s use and disposal. c. it is less valuable than its current carrying value. d. it is less valuable than its current fair value. 70. If Ashley Company accounts for the investment as a minority, active investment and uses the equity method to account for the investment, then Ashley will recognize what amount of income from the investment? a. $4,000 b. $10,000 c. $25,000 d. $15,000 71. When an intangible asset has a finite life, it is reported on the balance sheet at original cost with no ______ taken. Select the best term to complete the sentence. a. amortization b. depreciation 72. Under the equity method the investor's share of investee income increases ________. a. dividends b. the investment account 73. When one company acquires another company it may not be able to estimate the potential losses inherent in the acquired assets or the potential liability of the acquired company, for these reasons the acquirer may establish ______. a. acquisition reserves b. impairment losses 74. An investing firm consolidates the variable interest entity if it is the primary beneficiary. The firm is the primary beneficiary if it has the obligation to absorb the entity’s ______. a. employees b. losses 75. The ______ method views a corporate acquisition as conceptually identical to the purchase of any single asset. Select the best term to complete the sentence. a. equity b. purchase 76. For U.S. GAAP, software development costs are capitalized as intangible assets: a. after a copyright is obtained. b. once the technological feasibility of the product is established. c. from the beginning of development. d. once the product is introduced into the marketplace.

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Chap 08_10e 77. When there are two or more investing firms in an entity, how is it determined which entity consolidates the variable interest entity?

78. Interpretation No. 46R relates to the issue of whether an investing firm is the primary beneficiary in a variableinterest entity. When is an entity classified as a variable interest entity?

79. Assume that Hsu Company needs to acquire a large special-purpose materials handling facility. Given that no outside vendor exists for this type of facility and that the company has available engineering, management, and productive capacity, the Hsu borrows funds and builds the facility. Identify the costs that should be capitalized as part of this facility.

80. Although the organizational structure and operating policies of a particular foreign unit determine its functional currency, discuss two actions that a management team might take to ensure that the foreign currency is the functional currency.

81. U.S. GAAP requires firms to expense immediately all internal expenditures for R&D costs. Alternatively, U.S. GAAP could require firms to capitalize and subsequently amortize all internal expenditures on R&D that have future potential. Required: Why have standard setters chosen not to allow the capitalization alternative? How would analysts be better served if U.S. GAAP required capitalization of R&D costs?

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Chap 08_10e 82. On January 1, Year 1, Brock Company purchased $200,000, 8% bonds of Universal Co. at par. Interest is payable annually on December 31. The bonds mature in five years on December 31, Year 5. Required a. At the date of purchase at what amount should Brock record the bond investment? b. Determine the amount of cash interest Brock would receive in Year 1. c. At December 31, Year 1 the bonds have a fair market value of $203,500 how will this information affect Brock’s financial statements given that the bonds are classified as: 1. Held-to-Maturity 2. Trading 3. Available for Sale

83. You are trying to determine the functional currency of a foreign unit. For the following three factors determine what conditions would result in the foreign currency being the functional currency: a. b. c.

Sales Prices Financing Relationships between the Parent and the Foreign Unit

84. Carlson Company began constructing a building for its own use in January. Carlson incurred interest of $75,000 on specific construction debt and $16,750 on other borrowings. Interest computed on the weighted-average amount of accumulated expenditures for the building was $55,000. Required: What amount of interest should Carlson capitalize?

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Chap 08_10e 85. Assume that Morrison Company used cash to acquire machinery expected to contribute to the generation of revenues over a three-year period and the company erroneously expensed the cost to acquire the machine. Required: a. Describe the effects on ROA of the error over the three-year period. b. Explain how the error would affect the statement of cash flows.

86. Discuss how firms should account for intangible assets under U.S. GAAP. Your answer should include discussion of the following areas: a. Internally generated intangible assets versus specifically identifiable intangible assets acquired from others b. Amortization and impairment testing

87. Coffee Corp. purchased 45% of the outstanding shares of Cream Corp. for $1,845,000. The investment allows Coffee to exert significant influence over the operations of Cream. Cream recognized net income of $2,500,000 and paid $650,000 in dividends. Discuss how Coffee should account for its investment in Cream and how the information would appear in Coffee's balance sheet, income statement, and cash flow statement.

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Chap 08_10e 88. Orman Company is a large international canning company. Orman uses straight-line depreciation for financial reporting purposes and accelerated depreciation for tax reporting. The company's tax rate is 35%. Selected financial information about Orman appears below. Orman Company Selected Financial data December 31,

Year 2

Year 1

Year 0

Property, Plant & Equipment (net) Total Assets Deferred Tax Liability relating to Temporary Depreciation Differences Common Shareholders’ Equity

$178,454 515,685

$162,369 424,545

$155,388 410,256

25,138 302,754

18,245 298,564

19,689 289,455

Sales Cost of Goods Sold Depreciation Expense Interest Expense Net Income

$986,258 693,857 48,265 84,253 124,581

$888,965 588,920 39,640 75,689 91,025

Required: a. Compute the amount of depreciation expense that Orman recognized for income tax purposes for year 2 and year 1. The amount reported as the deferred tax liability relating to temporary depreciation differences represents the cumulative income tax delayed as of each balance sheet date because Orman uses accelerated depreciation for tax purposes and straight-line depreciation for financial statement reporting. b. Compute the fixed asset turnover ratio for year 2 and year 1 using the amounts reported for financial statement purposes. c. Compute the fixed asset turnover ratio for year 2 and year 1 using the amounts reported for tax purposes.

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Chap 08_10e 89. The three types of costs incurred in coal production are acquisition costs (costs to acquire the coal rich lands plus the present value of future cash flows necessary to restore the sites minus the cost of the land), exploration costs (costs of mining), and development costs (pipes, roads, and so on, to extract and transport the coal to customers). Required: Should each of these costs be capitalized or expensed? Explain.

90. For some transactions U.S. GAAP requires that value changes are recognized on the balance sheet and the income statement when they occur, even if not realized. Discuss what types of transactions get this type of treatment and the logic behind this accounting.

91. United owns Estada, a European based subsidiary for which the Euro is the functional currency. Estada had a net asset position at January 1 of 1,200,000 Euros and reported income of 350,000 Euros, which was earned evenly throughout the year. In addition, Estada paid 100,000 Euros of dividends at December 31. The following were in effect during the year: January 1 1 Euros = $0.89 Average 1 Euros = $0.98 December 31 1 Euros = $1.10 Determine the amount of the unrealized translation gain or loss United should record with respect to Estada.

92. Harbour Company purchased a new piece of equipment with a list price of $200,000 and subject to a 6 percent discount if paid within 45 days. Harbour paid within the discount period. The company also paid $1,650 to obtain title to the equipment and $650 as the license fee for the first year of operation. It paid $2,475 to level the area in which the equipment would be located and $11,750 to relocate other equipment that would have interfered with the proper operation of the new equipment. Harbour paid $500 for property and liability insurance for the first year of operation. What is the acquisition cost of this equipment that Harbour should record in its accounting records? Indicate the treatment of any amount not included in acquisition cost.

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Chap 08_10e

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Chap 08_10e Answer Key 1. b 2. b 3. d 4. a 5. a 6. b 7. d 8. d 9. b 10. a 11. a 12. a 13. d 14. b 15. b 16. b 17. a 18. b 19. a 20. c 21. b 22. b 23. d 24. c 25. c 26. c

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Chap 08_10e 27. c 28. b 29. a 30. d 31. d 32. b 33. b 34. a 35. d 36. d 37. d 38. b 39. a 40. b 41. a 42. a 43. b 44. d 45. a 46. b 47. b 48. d 49. a 50. c 51. a 52. b 53. b 54. a Copyright Cengage Learning. Powered by Cognero.

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Chap 08_10e 55. b 56. a 57. a 58. c 59. b 60. c 61. c 62. a 63. c 64. d 65. d 66. b 67. d 68. b 69. b 70. d 71. a 72. b 73. a 74. b 75. b 76. b 77. Determining whether an investing firm should consolidate the VIE is at the heart of Interpretation No. 46R. An investing firm consolidates the VIE if it absorbs the majority of the entity’s expected losses if they occur, receives a majority of the entity’s expected residual returns if they occur, or both. The consolidating firm is labeled the primary beneficiary. The firm considers the rights and obligations conveyed by its variable interests and the relationship of its variable interests to variable interests held by other firms to determine whether it will absorb a majority of expected losses, receive a majority of expected residual returns, or both. If one firm absorbs a majority of the expected losses and another firm receives a majority of the expected residual returns, the firm absorbing a majority of the losses consolidates the variable interest entity. Copyright Cengage Learning. Powered by Cognero.

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Chap 08_10e 78. 1. The total equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, including equity holders. The presumption is that an equity investment of less than 10 percent of the entity’s total assets is not sufficient to permit the entity to finance its activities without additional support. However, entities that are holding high-risk assets or are engaging in highrisk activities or that are exposed to risks beyond their reported assets and liabilities may be required to have more than a 10 percent investment. 2. The equity investing firms lack any one of the following three characteristics of a controlling financial interest: a. The direct or indirect ability to make decisions about the entity’s activities through voting rights or similar rights. Contractual arrangements with the subordinated providers of funds usually restrict the ability of the equity-investing firms to make decisions about the entity’s activities. b. The obligation to absorb the expected losses of the entity if they occur. The subordinated providers of funds absorb some of the expected losses. c. The right to receive the expected residual returns of the entity if they occur. The subordinated providers of funds have a claim on some of the expected residual returns. 79. Hsu Company should capitalize the full costs of construction, including direct labor, direct materials, and an allocation of overhead (both variable and fixed). Also, if interest is incurred during the project, interest cost on accumulated average expenditures should be capitalized. 80. 1. 2.

Decentralize decision making to the foreign unit. The greater the degree of autonomy of the foreign unit, the more likely its currency will be the functional currency. Minimize remittances/dividends. The greater the degree of earnings retention by the foreign unit, the more likely its currency will be the functional currency.

81. Standard setters require R&D costs to be expensed because of the uncertainty in judging their future revenuegenerating potential. Although it is debatable whether capitalization better serves investors, clearly in-depth disclosure of firms’ R&D expenditures serves the investor well. This is particularly true for firms with large R&D expenditures, such as biotechnology firms. To date, U.S. standard setters have shown no interest in revisiting Statement No. 2, the standard that addresses accounting for R&D costs. However, under IFRS, the product development portion of R&D is capitalized. 82. 1. 2. 3.

The bonds will be recorded at cost $200,000. Cash interest will equal 8% * $200,000 = $16,000 Unrealized holding gains and losses are not recognized for investments classified as Heldto-Maturity, however unrealized holding gains and losses are recognized for both trading and available for sale securities. The difference is that for trading securities the unrealized holding gains and losses appear in the income statement, while for available for sale securities the unrealized holding gains and losses appear in other comprehensive income.

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Chap 08_10e 83. a. b. c.

Sales Prices - Influenced primarily by local competitive conditions and not responsive on a short-term basis to exchange rate changes. Financing - Denominated in the currency of the foreign unit or generated internally by the foreign unit. Relationships between the Parent and the Foreign Unit - Low volume of intercompany transactions and little operational interrelations between the parent and foreign unit.

84. The interest on weighted average accumulated expenditures is the amount of avoidable interest. Since the avoidable interest ($55,000) is less than the interest actually accrued ($75,000+$16,750), only the avoidable interest is capitalized. 85. a. The effect for Morrison Company in the first year would be an equal decrease in both the numerator (adjusted net income) and the denominator (average total assets) of ROA. Because net income is substantially smaller than average total assets, the percentage decrease in the numerator would be greater, and ROA would be understated. However, in the next two years, Morrison’s net income would be overstated because it is not burdened by a depreciation charge, average total assets would remain understated, and ROA would be overstated. b. This error does not affect cash flows, but it does affect classification within the statement of cash flows. Expensing results in an operating cash outflow in year one. Capitalization results in an investing cash outflow.

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Chap 08_10e 86. Recommended answer: 1.

5. 6.

Firms expense the cost of developing intangibles in the period incurred. The rationale for immediate expensing of such costs is the difficulty and uncertainty in ascertaining whether a particular expenditure results in a future benefit (that is, an asset) or not (an expense). Accountants provide more conservative measures of earnings by expensing such costs immediately. Firms capitalize as an asset the costs to acquire intangible assets from others. In this case, the firm makes an expenditure on a specifically identifiable intangible asset. The existence of an external market transaction provides evidence of the value of the intangible asset. The acquiring firm must consider the future benefits of the intangible to at least equal the price paid. Specifically identifiable intangible assets acquired from others may have (a) a finite useful life, such as a patent, or (b) an indefinite useful life, such as a brand name. Firms amortize intangibles with a finite useful life over their expected useful lives, taking into consideration the legal, regulatory, economic, competitive or contractual provisions that may limit the useful life. Common practice uses straight-line amortization if the actual pattern in which the economic benefits are consumed or used up cannot be reliably determined. Firms do not amortize assets with an indefinite useful life. The intangible asset, goodwill, may be recorded by a firm when acquiring another firm in a business combination. Standard setters concluded that goodwill has an indefinite useful life and is not amortized. Firms periodically test intangible assets requiring amortization (that is, intangible assets with a finite useful life such as patents) for impairment. For intangibles not requiring amortization (that is, intangible assets with an indefinite life such as goodwill) firms must test annually for asset impairment, or more frequently if events and circumstances indicate that the asset may be impaired. The test compares the carrying value to the fair value of the intangibles and requires recognition of an impairment loss whenever the carrying value exceeds the fair value. Determining the fair value of nonamortizable intangibles such as goodwill often is a difficult task.

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Chap 08_10e 87. Coffee should use the equity method to account for its investment in Cream, because it owns between 20-50% of the outstanding shares and it can exert significant influence over its operations. Balance Sheet - The investment would appear at the following amount: $1,845,000 +1,125,000share of income -292,500 share of the dividends $2,677,500 Income Statement - Coffee would report its share of Cream's income ($1,125,000) as income from investment. Cash Flow Statement - Coffee would need to subtract its share of income and add back its share of dividends in cash flow from operations.

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Chap 08_10e 88. a.

Compute the amount of depreciation expense that Orman recognized for income tax purposes for year 2 and year 1. The amount reported as the deferred tax liability relating to temporary depreciation differences represents the cumulative income tax delayed as of each balance sheet date because Orman uses accelerated depreciation for tax purposes and straight-line depreciation for financial statement reporting. Year 2 $48,265

Depreciation Exp.-Fin. Statements Difference in Accel. and S-L Deprec. (Ending Amt. - Beg. Amt.)/.35 (25,138 - 18,245)/.35 (18,245 - 19,689)/.35

19,694 (4,126)

Deprec. Exp. - Tax Purposes b.

Year 1 $39,640

$67,959

$35,514

Compute the fixed asset turnover ratio for year 2 and year 1 using the amounts reported for financial statement purposes. Fixed Asset Turnover = Sales / Average Fixed Assets

Sales Average Fixed Assets

Year 2 $986,258 170,412

Year 1 $888,965 158,879

Fixed Asset Turnover

5.79

5.60

Compute the fixed asset turnover ratio for year 2 and year 1 using the amounts reported for tax purposes. Year 2 $178,454

Year 1 $162,369

Year 0 $155,388

-71,823 $106,631

-52,129 $110,240

-56,254 $ 99,134

Sales Average Fixed Assets

Year 2 $986,258 108,436

Year 1 $888,965 104,687

Fixed Asset Turnover

9.10

8.49

Property, Plant & Equipment (net) Adjustment for Additional Deprec. Def. Tax amount / .35 Property, Plant & Equipment - TAX (net)

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Chap 08_10e 89. All costs are capitalized except for exploration costs associated with mining operations that do not yield productive veins of coal to be mined, which may be capitalized if the firm chooses the full costing approach or expensed if the firm chooses the successful efforts approach. Capitalization is justified because most of the costs are necessary to yield probable future economic benefits. Proponents of expensing unsuccessful exploration efforts argue that no product was discovered and, thus, that the probable future economic benefits criterion is not met. 90. The application of U.S. GAAP requires firms to write down assets whose fair values decrease below their book values. For example, U.S. GAAP requires that firms recognize a loss on equipment in which its fair value has decreased below its book value due to obsolescence or other permanent valuation effect. U.S. GAAP does not allow firms to revalue upward the values of assets whose fair values have increased. Firms must await the validation of the value increase through a market transaction to justify this type of gain. 91. Net asset position 1/1 Plus income Less dividends Net asset position 12/31

1,200,000 Euros * $0.89 350,000 Euros * $0.98 (100,000)Euros * $1.10 1,450,000

$1,068,000 $343,000 ($110,000) $1,301,000

1,450,000 * $1.10

$1,595,000

Unrealized Translation Gain

$294,000

92. Harbour should record the equipment at the following cost: Purchase price = $200,000 less 6% discount = $188,000 Title = $1,650 Leveling = $2,475 Relocation = $11,750 TOTAL COST = $203,875 The $650 license for the first year of operations is a period expense; $500 should be treated as insurance expense for the period.

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Chap 09_10e Indicate the answer choice that best completes the statement or answers the question. 1. The projected benefit obligation measures: a. the pension obligation on the basis of the plan formula applied to years of service to date and based on existing salary levels. b. an estimated total benefit at retirement and then computes the level cost that will be sufficient, together with interest expected to accumulate at the assumed rate, to provide the total benefits at retirement. c. the pension obligation on the basis of the plan formula applied to years of service to date and based on future salary levels. d. the shortest possible period for funding to maximize the tax deduction. 2. If the portions of the firm’s foreign operations in higher-tax-rate countries grew more rapidly than foreign operations in lower-tax-rate countries, the company may seek out more tax effective ways of operating abroad through all of the following means except: a. Assess whether transfer prices or cost allocations can be adjusted to shift income from high-tax-rate to low-tax-rate jurisdictions. b. Shift from domestic to foreign borrowing to increase deductions for interest against foreign-source income. c. Shift from debt to equity financing of foreign operations to increase interest deductions against foreignsource income. d. Shift some operations, like marketing, to the United States where the average tax rate is lower.

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Chap 09_10e Falcon Networks Falcon Networks is a leading semiconductor company with operations in 17 different countries. Information about the company's taxes appears below: Falcon Networks Components of Income Tax Expense (in millions) Current - Federal - Foreign - State and Local Total Current

Year 2 $ 55.65 83.85 14.69 $154.19

Year 1 $ 47.52 78.95 12.5 $138.97

Deferred - Federal - Foreign Total Deferred

$ 30.28 23.89 $ 54.17

$ 42.90 14.58 $ 57.48

Total Income Tax Expense

$208.36

$196.45

Year 2 $256.35 236.85 $493.20

Year 1 $253.68 198.85 $452.53

Note: Falcon Networks has no current liability at year-end with respect to total current taxes. Components of Income before Taxes United States Foreign Total

3. Based on the information provided by Falcon Networks how much cash did income taxes use during Year 2? a. $154.19 million b. $54.17 million c. $208.36 million d. $284.84 million 4. Which of the following accounts would not be considered a reserve account? a. Allowance for Doubtful Accounts b. Estimated Warranty Liability c. Prepaid Expense d. Accumulated Depreciation 5. Income tax expense consists of two components, the current portion and the ______ portion. Select the best term to complete the sentence. a. deferred b. cash Copyright Cengage Learning. Powered by Cognero.

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Chap 09_10e 6. Which of the following calculations is used to determine the amount of the liability reported on the balance sheet for underfunding? a. Plan assets less projected benefit obligation. b. Projected benefit obligation less plan assets. c. Plan assets less accumulated benefit obligation. d. Accumulated benefit obligation less plan assets. 7. Dividing a company's income tax expense by its book income before income taxes provides the company's ______. a. effective tax rate b. federal tax rate 8. All of the following are conditions for revenue recognition outlined by SAB 104 except: a. There is pervasive evidence that an arrangement exists. b. Delivery has occurred or services have been performed. c. The seller’s price to the buyer can be variable. d. Collectability is reasonably assured. 9. Regarding actuarial assumptions, firms must disclose in notes to the financial statements all of the following except: a. the discount rate used to compute the pension benefit obligation. b. the expected rate of return on pension investments. c. estimates of the number of retirees over the future 10 years. d. the rate of compensation increase. Playtime Corporation Assume that Playtime Corp. has agreed to construct a new playground for Surrey County for $2,450,000. Construction of the new playground will begin on March 17, Year 1 and is expected to be completed in August Year 2. At the signing of the contract Playtime Corp. estimates that it will cost $1,750,000 to build the playground. 10. At the end of Year 1 Playtime provided the following information about the project: Costs incurred Estimated costs Year to date remaining 1 $1,200,000 $600,000 If Playtime uses the percentage of completion to recognize revenue on the long-term contract, how much gross margin should Playtime recognize in Year 1? a. $389,200 b. $278,000 c. $556,000 d. $433,550

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Chap 09_10e 11. Analysts concerns with postretirement benefits include all of the following except: a. Should the underfunded postretirement benefit obligation be added to liabilities in assessing risk? b. How reasonable are the firms’ assumptions regarding health care cost increases? c. Is the postretirement benefit fund adequately paying benefits? d. Is the postretirement benefit fund generating returns consistent with the expected rate of return? 12. Companies that engage in long-term contracts recognize revenue as the _____ is satisfied over time as long as certain criteria are met. Select the best term to complete the sentence. a. performance obligation b. customer 13. The ______ is equal to the actuarial present value of amounts that the employer expects to pay to retired employees, based on the employees' service to date and using expected future salary amounts. Select the best term to complete the sentence. a. defined contribution plan b. projected benefit obligation 14. Which of the following would not be suggestive of a company recognizing sales too early? a. large and volatile amounts of uncollectible accounts receivable b. excessive warranty expenditures c. large growth in accounts receivable d. unusually large amount of returned goods 15. All of the following are most likely to change the FMV of pension plan assets during a given period except: a. Employer cash payments are made to the plan trustee. b. Changes in Internal Revenue Service regulations for future tax deductible amounts of contributions. c. Actual returns on invested plan assets. d. Retirement benefits paid. 16. Differences between income before taxes and taxable income are either permanent or ______. a. long-term b. temporary 17. Which of the following is not part of the balance sheet approach when computing income tax expense? a. Identifying at each balance sheet date all differences between the book basis of assets, liabilities, and tax loss carryforwards b. Eliminating permanent differences between book and tax basis. c. Eliminating deferred tax assets. d. Assessing the likelihood that the firm will realize the benefits of deferred tax assets in the future.

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Chap 09_10e 18. A LIFO liquidation during periods when prices are increasing results in a company: a. recording a large inventory write down. b. recording higher earnings than it would have if it had used FIFO. c. recording lower earnings than it would have if it had used FIFO. d. having operational problems, but no financial statement effects. 19. Typical U.S. GAAP disclosures for deferred income taxes include all of the following except: a. Components of income tax expense b. Components of income before taxes c. Reconciliation of income taxes at statutory rate with income tax expense d. Components of permanent tax differences 20. To calculate a company's average tax rate an analyst would: a. Divide income tax payable by income before taxes b. Divide income tax expense by income before taxes c. Multiply the statutory income tax rate by income before tax d. Average a firm's Federal, State, Local and Foreign tax rates. 21. A contractor would not recognize _____ when there is substantial uncertainty regarding the total costs it will incur in completing the project. Select the best term to complete the sentence. a. revenue b. expenses 22. A company that uses LIFO will experience a ______ during a period it sells more units than it purchases. Select the best term to complete the sentence. a. FIFO liquidation b. LIFO liquidation 23. Recording municipal bond interest received in the general ledger will generate a ______ difference. Select the best term to complete the sentence. a. permanent b. temporary 24. The process of allocating the historical cost of certain assets to the periods of their use in a reasonably systematic manner is referred to as ______. a. depreciation b. inflation 25. The major difference between accounting for pensions and the accounting for other postretirement benefits is that firms: a. do not need to report an excess of the accumulated benefits obligations over assets in a postretirement benefits fund as a liability on the balance sheet. b. do not need to disclose any estimates used in calculating projected benefits. c. postretirement benefits are normally not material for most companies and do not need to be disclosed. d. do not need to set aside funds for future postretirement benefits as they do for pension benefits. Copyright Cengage Learning. Powered by Cognero.

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Chap 09_10e 26. All of the following examples represent complex revenue generation models except: a. Point-of-sale transactions b. Uncertain revenue timing c. Bundled service deliverables d. Bundled deliverables in leases 27. Which of the following statements best describes the difference between U.S. GAAP and IFRS with respect to revenue recognition? a. IFRS has a substantial amount of industry specific guidance for revenue recognition. b. IFRS revenue recognition is not consistent with U.S. GAAP in principle. c. There are subtle differences in the wording of U.S. GAAP as compared with IFRS. d. IFRS has four criteria and U.S. GAAP has five conditions for revenue recognition. 28. The accumulated benefit obligation measures: a. the pension obligation on the basis of the plan formula applied to years of service to date and based on existing salary levels. b. an estimated total benefit at retirement and then computes the level cost that will be sufficient, together with interest expected to accumulate at the assumed rate, to provide the total benefits at retirement. c. the pension obligation on the basis of the plan formula applied to years of service to date and based on future salary levels. d. the shortest possible period for funding to maximize the tax deduction. 29. Relative to when revenues are recognized, cash flows from operations are delayed with ______. a. accounts receivable b. accounts payable 30. Gorilla, Corp. implemented a defined-benefit pension plan for its employees on January 1. The following data are provided for the year: Accumulated benefit obligation Plan assets at fair value Net period pension expense Employer's contribution

$103,000 78,000 90,000 70,000

What amount should Gorilla record as additional minimum pension liability at December 31? a. $0 b. $5,000 c. $20,000 d. $45,000

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Chap 09_10e 31. Using the information provided by Falcon Networks, determine the foreign effective tax rate for Year 2. a. 33.52% b. 35.00% c. 42.25% d. 45.49% 32. Presented below is pension information related to Roberts Corp. for the year: Service cost Interest on projected benefit obligation Amortization of prior service cost due to increase in benefits Expected return on plan assets

36,000 12,000 6,000 8000

The amount of pension expense to be reported for the year is: a. $46,000 b. $48,000 c. $54,000 d. $40,000 33. A typical defined benefit pension plan formula includes all of the following except: a. the number of years of employee service b. the fair market value of pension plan assets c. a credit for each year of annual service d. the final salary at retirement date 34. Deferred tax assets result in future tax ______ when temporary differences reverse. a. payments b. savings 35. At the end of Year 1 Playtime provided the following information about the project: Costs incurred Estimated costs Year to date remaining 1 $1,200,000 $600,000 What percentage is the playground complete? a. 62.5% b. 66.7% c. 55.6% d. 50.0% 36. A company that uses FIFO will find that its ______ account tends to be somewhat out of date. Select the best term to complete the sentence. a. cost of goods sold b. ending inventory Copyright Cengage Learning. Powered by Cognero.

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Chap 09_10e 37. Under the completed contract method: a. revenue and cost are recognized during the production cycle, but gross profit recognition is deferred until the contract is completed. b. revenue, cost, and gross profit are recognized during the production cycle. c. revenue, cost, and gross profit are recognized at the time the contract is completed. d. None of these are correct. 38. A company that uses LIFO will find that its ______ account will be somewhat out of date. Select the best term to complete the sentence. a. cost of goods sold b. ending inventory 39. Deferred tax liabilities result in future tax ______ when temporary differences reverse. Select the best term to complete the sentence. a. payments b. savings 40. Upton Company has consistently used the percentage-of-completion method of recognizing income. In Year 1, Upton started on an $18,000,000 construction contract that was completed in Year 3. The following information was taken from Upton’s Year 1 accounting records: Progress billing Costs incurred Collections Estimated remaining costs to complete

$ 6,600,000 $ 5,400,000 $ 4,200,000 $10,800,000

What amount of revenue should Upton recognize on the contract in Year 1? a. $6,000,000 b. $5,400,000 c. $9,000,000 d. $0 41. A firm should recognize revenue when (or as) the entity satisfies a _______. a. performance obligation b. customer request 42. Which of the following will most likely help identify an increasing proportion of uncollectible sales? a. accounts receivable turnover b. the ratio of bad debt expense to sales c. the ratio of sales returns to sales d. the ratio of cost of sales to sales

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Chap 09_10e 43. Using the information provided by Falcon Networks determine the combined effective tax rate for 2012. a. 33.52% b. 35.00% c. 42.25% d. 45.49% 44. An inventory pricing procedure in which the current costs have a direct impact on the inventory is: a. FIFO b. LIFO c. Base stock d. Weighted-average 45. Which of the following is not a disclosure for derivatives required under SFAS No. 133? a. Firms must describe their risk management strategy and how particular derivatives help accomplish their hedging objectives. b. For fair value and cash flow hedges, firms must disclose the net gain or loss recognized in earnings resulting from the hedges’ ineffectiveness and the line item on the income statement that includes this net gain or loss. c. For cash flow hedges, firms must describe the transactions or events that will result in reclassifying gains and losses from other comprehensive income to net income and the estimated amount of such reclassifications during the next 12 months. d. The specifics of a model that simulates with a 95 percent or other confidence level the minimum, maximum, or average amount of loss that a firm would incur. 46. All of the following are events that can change the projected benefit obligation (PBO) during a period except: a. The payment of retirement benefits. b. Amendments to the pension plan agreement c. The interest accumulated on the liability. d. All of these can change the PBO. 47. U.S. GAAP requires firms to report the assets and liabilities of defined benefit plans ______. a. in the notes to the financial statements b. separately on the balance sheet 48. When input prices are increasing, companies that use the LIFO method of accounting for inventory will report: a. Lower cost of goods sold amounts in comparison to the FIFO method b. Higher sales amounts in comparison to the FIFO method c. Higher ending inventory amounts in comparison to the FIFO method d. Lower gross profit margins in comparison to the FIFO method

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Chap 09_10e 49. All of the following conditions signal that revenue recognition may have been recorded too early except: a. large and volatile amounts of uncollectible accounts receivable. b. a decrease in the number of days accounts receivable are outstanding. c. unusually large amounts of returned goods. d. excessive warranty expenditures. 50. All of the following are considered by analysts when assessing the quality of accounting except: a. Price variation and the speed at which inventory turns over b. Any liquidation of FIFO inventory layers c. Any physical deterioration or obsolescence of inventory d. The inventory cost-flow assumption chosen by management 51. One sign that a company may be recognizing sales too early is that it has unusually large amounts of ______. a. accounts payable b. returned goods 52. ______ differences result from including revenues and expenses in income before taxes in a different period than those items affect taxable income. Select the best term to complete the sentence. a. Permanent b. Temporary 53. A minimum liability for pension expense is reported when: a. the projected benefit obligation exceeds the fair value of pension plan assets. b. the pension expense reported for the period is greater than the funding amount for the same period. c. the accumulated benefit obligation exceeds the fair value of pension plan assets. d. vested benefits exceed the fair value of pension plan assets. 54. Using the information provided by Falcon Networks, determine the federal effective tax rate for 2012. a. 33.52% b. 35.00% c. 42.25% d. 45.49% 55. All of the following are true regarding accrual accounting except: a. Accrual basis measures operating success by the extent to which accomplishments exceed efforts. b. Accrual basis measures operating success by the extent to which revenues exceed expenses. c. Accrual basis reports operating activities in terms of their success in generating value. d. Accrual basis for the recognition of expenses is not required under IFRS. 56. In the insurance industry ______ is primarily a question of timing. Select the best term to complete the sentence. a. coverage b. revenue recognition

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Chap 09_10e 57. Although LIFO generally provides higher quality earnings measures, FIFO generally provides higher ______ measures. Select the best term to complete the sentence. a. cost b. financial position 58. The gist of revenue recognition guidance is that firms should recognize revenue in the amount ______. a. expected to be received b. invoiced to customers 59. What are the five steps to apply the core principles of revenue recognition?

60. Accountants use reserve accounts for various reasons, for each of the scenarios below describe a specific account example that matches the scenario. 1. 2. 3.

The use of a reserve account in order to match expense with revenues. The use of a reserve account in order to keep expense out of the income statement. The use of a reserve account in order to revalue an asset, but delay the income recognition effect.

61. Explain the difference between a temporary and a permanent timing difference for income tax purposes”

62. A company may try to paint a favorable picture of itself by accelerating the timing of revenues or estimating the collectible amounts too aggressively. In these cases the quality of accounting information declines because it does not represent the company's true economic condition and may not be sustainable. List four conditions that might suggest that a company is recognizing revenues too early?

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Chap 09_10e 63. What are the four disclosures required by U.S. GAAP relating to income taxes?

64. Assume that Madison Corp. has agreed to construct a new basketball arena for Gator Town for $70 million dollars. Construction of the new arena begins in July, Year 1 and is expected to be completed in March Year 3. At the signing of the contract Madison Corp. estimates that the new arena will cost $60 million dollars to build. Given the following cost and building schedule determine the cumulative degree of completion and how much revenue and gross margin Madison Corp. should recognize in years 1-3.

Year 1 2 3

Costs incurred to date $18,000,000 $48,000,000 $60,000,000

Estimated costs remaining $42,000,000 $12,000,000 $0

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Chap 09_10e 65. Pronto, Inc. is a major producer of printing equipment. Pronto uses a LIFO cost-flow assumption for inventories. The company's tax rate is 35%. Below is selected financial data for the company. Pronto, Inc. Selected Financial Data December 31, (amounts in thousands) Inventories (LIFO) Total Assets Common Shareholders’ Equity

Year 3

Year 2

Year 1

$ 48,454 395,685 102,754

$ 42,369 384,545 98,564

$ 45,388 378,122 89,455

Sales Cost of Goods Sold Interest Expense Net Income

$546,258 393,857 14,253 24,581

$488,965 348,920 15,689 21,025

Required: a. The excess of FIFO over LIFO inventories was $25 million on December 31, Year 3, $28.5 million on December 31, Year 2 and $22 million on December 31, Year 1. Compute the cost of goods sold for Pronto, Inc. for years 3 and 2 assuming that it had used a FIFO assumption. b. Compute the inventory turnover ratio for Pronto, Inc. for years 3 and 2 using a LIFO costflow assumption. c. Compute the inventory turnover ratio for Pronto, Inc. for years 3 and 2 using a FIFO costflow assumption. d. Compute the rate of return on assets for years 3 and 2 based on the reported amounts. Disaggregate ROA into profit margin and asset turnover components. e. Compute the rate of return on assets for years 3 and 2 assuming that Pronto, Inc. had used the FIFO method of accounting for inventories. Disaggregate ROA into profit margin and asset turnover components.

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Chap 09_10e 66. Global, Inc. provides consulting services throughout the world. The company pays taxes to the nation where revenues are earned. Information about the company's taxes is presented below: Global, Inc. Components of Income Tax Expense (in millions) Current - Federal - Foreign - State and Local Total Current

Year 2 $ 35.60 53.86 17.15 $106.61

Year 1 $ 29.80 65.85 15.28 $110.93

Deferred - Federal - Foreign Total Deferred

$ 10.56 3.28 $ 13.84

$ 8.54 6.57 $ 15.11

Total Income Tax Expense

$120.45

$126.04

Components of Income before Taxes United States Foreign Total

Year 2 $155.45 142.85 $298.30

Year 1 $150.29 134.50 $284.79

Required: a. Using the information provided for Global, prepare the company's journal entry to record income taxes for Year 2 and Year 1. b. Using the information provided for Global, determine the company's effective tax rate for Year 2 and Year 1.

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Chap 09_10e 67. Please answer the following questions about defined benefit pension plans: 1. Companies with defined benefit pension plans must recognize pension expense each period. What are the five components of pension expense? Briefly describe each component. 2. How does each component of pension expense effect pension expense during the period (increase, decrease, or uncertain)? 3. What is the difference between the accumulated pension obligation and the projected pension obligation? 4. What determines whether a pension plan is underfunded or overfunded?

68. Under U.S. GAAP, application of the LIFO and FIFO inventory methods result in differences in the balance sheet, income statement and cash flow statement. Compare and contrast the effect of the two methods on each financial statement and determine the advantages and disadvantages of each method.

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Chap 09_10e Answer Key 1. c 2. c 3. a 4. c 5. a 6. d 7. a 8. c 9. c 10. d 11. c 12. a 13. b 14. c 15. b 16. b 17. c 18. b 19. d 20. b 21. a 22. b 23. a 24. a 25. a 26. a

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Chap 09_10e 27. c 28. a 29. a 30. b 31. d 32. a 33. b 34. b 35. b 36. a 37. c 38. b 39. a 40. a 41. a 42. b 43. c 44. b 45. d 46. d 47. a 48. d 49. b 50. b 51. b 52. b 53. c 54. a Copyright Cengage Learning. Powered by Cognero.

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Chap 09_10e 55. d 56. b 57. b 58. a 59. 1) Identify the contract with a customer. 2) Identify the separate performance obligations in the contract. 3) Determine the transaction price. 4) Allocate the transaction price to the separate performance obligations in the contract. 5) Recognize revenue when (or as) the entity satisfies a performance obligation. 60. Some possible answers from Chapter 8 of the text: 1.

The reserve account might appear on the balance sheet as a reduction in an asset. Firms provide for bad debt expense and increase the account, Reserve for Bad Debts. This reserve account appears as a subtraction from Accounts Receivable on the balance sheet. Likewise, firms recognize depreciation expense and increase the account, Reserve for Depreciation (U.S. firms use the account, Accumulated Depreciation). The reserve account appears as a reduction from fixed assets on the balance sheet. Alternatively, the reserve account might appear as a liability on the balance sheet. For example, a firm might provide for warranty expense or pension expense and increase the accounts, Reserve for Warranties (Estimated Warranty Liability in the United States) or Reserve for Retirement Benefits (Accrued Retirement Liability in the United States). A practice in some countries is to create a reserve account by reducing the Retained Earnings account. For example, a firm might decrease Retained Earnings and increase Reserve for Price Increases or Reserve for Contingencies. These accounts appear among the shareholders’ equity accounts and may carry a title such as Retained Earnings Appropriated for Price Increases or Retained Earnings Appropriated for Contingencies. When firms later experience the price increase or contingency, they charge the cost against the reserve account rather than include it in expenses. These costs therefore bypass the income statement and usually result in an overstatement of earnings. Note that this use of reserves does not misstate total shareholders’ equity because all of the affected accounts (Retained Earnings, reserve accounts, expense accounts) are components of shareholders’ equity. Thus, the analyst’s primary concern with these reserves is assessing whether the reported net income that excludes these items is an appropriate base for estimating future earnings. The analyst can study the shareholders’ equity portion of the balance sheet to ascertain whether firms have used reserve accounts to avoid sending legitimate expenses through the income statement. Reserves of this type have been particularly common in the German reporting system. Firms might use reserves in situations where they revalue assets but do not desire the income effect of the revaluation to affect income of the current period. The next chapter points out that firms in the United States account for investments in marketable equity securities using the market value method. When market value differs from acquisition costs, U.S. firms write up or write down the investment account. Financial reporting in the

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Chap 09_10e United States does not generally permit the immediate recognition of this increase or decrease in market value in measuring income (except for securities held for “trading” purposes, as defined in the next chapter). Instead, these firms increase or decrease Accumulated Other Comprehensive Income, a shareholders’ equity account. When the firm sells the securities, it eliminates the unrealized gain or loss account and recognizes a realized gain or loss in measuring net income. Another example of this use of the reserve account relates to foreign currency translation (also discussed in the next chapter). U.S. firms with foreign operations usually translate the financial statements of their foreign entities into U.S. dollars each period using the exchange rate at the end of the period. Changes in the exchange rate cause an unrealized foreign currency gain or loss. Firms do not recognize this gain or loss in measuring income each period but instead increase or decrease Accumulated Other Comprehensive Income. When the firm disposes of the foreign unit, it eliminates the unrealized foreign currency adjustment from Accumulated Other Comprehensive Income and recognizes a gain or loss on disposal. 61. A permanent difference arises when, for example, a company is paid interest on municipal obligations. The IRS Code specifically states that municipal interest is not taxable so therefore it is never entered into the tax computation. Temporary differences arise when taxes are paid in different accounting periods. Straight line depreciation versus accelerated depreciation methods will overall incur the same tax liability at the end but the components will be recognized in different accounting periods. 62. 1. 2. 3. 4.

63. 1) Components of the provision for income taxes. 2) Reconciliation of income taxes at the statutory rate with the provision for income taxes. 3) Components of deferred tax assets and liabilities. 4) Information regarding uncertain tax positions and related reserves. 64. Year 1 2 3

Costs incurred to date $18,000,000 $48,000,000 $60,000,000

Percentage Complete 30% 80% 100%

Revenue $21 M $35 M $14 M

Gross Margin $3 M $5 M $2 M

65. Required: a. The excess of FIFO over LIFO inventories was $25 million on December 31, Year 3, $28.5 million on December 31, Year 2 and $22 million on December 31, Year 1. Compute the cost of goods sold for Pronto, Inc. for years 3 and 2 assuming that it had used a FIFO assumption. Year 3 Copyright Cengage Learning. Powered by Cognero.

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Chap 09_10e COGS (LIFO) Excess of FIFO over LIFO Beginning of year end of year COGS (FIFO) b.

28,500 (25,000) $397,357

22,000 (28,500) $342,420

Year 3 $393,857 45,412 8.67

Year 2 $348,920 43,879 7.95

Compute the inventory turnover ratio for Pronto, Inc. for years 3 and 2 using a FIFO costflow assumption.

COGS (FIFO) Average inventory(FIFO) Inventory turnover d.

$348,920

Compute the inventory turnover ratio for Pronto, Inc. for years 3 and 2 using a LIFO costflow assumption.

COGS (LIFO) Average inventory Inventory turnover c.

$393,857

Year 3 $397,357 72,161 5.51

Year 2 $342,420 69,128 4.95

Compute the rate of return on assets for years 3 and 2 based on the reported amounts. Disaggregate ROA into profit margin and asset turnover components.

Net Income + Int. Exp (1 - .35) Average Total Assets (LIFO) ROA

Year 3 $ 33,845 390,115 8.7%

Year 2 $ 31,223 381,334 8.2%

Sales

$546,258

$488,965

Profit margin -ROA

6.2%

6.4%

Asset Turnover

1.40

1.28

Compute the rate of return on assets for years 3 and 2 assuming that Pronto, Inc. had used the FIFO method of accounting for inventories. Disaggregate ROA into profit margin and asset turnover components.

Net Income + Int. Exp(1 - .35) FIFO adjustment Change ´ (1 - .35) Net income (FIFO) Average Total Assets (FIFO) ROA Copyright Cengage Learning. Powered by Cognero.

Year 3 $33,845

Year 2 $31,223

(2,275) 31,570 416,865 7.6%

4,225 35,448 406,584 8.7% Page 20

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Chap 09_10e Sales

$546,258

$488,965

Profit margin - ROA

5.8%

7.3%

Asset Turnover

1.31

1.20

66. a.

Income Tax Expense Income Tax Payable Deferred Tax Asset/Liab. b.

___________Year __________Year 2 1 120.45 126.04 106.61 110.93 13.84 15.11

The company's effective tax rate is calculated by dividing income tax expense by income before tax.

Income Tax Expense Income before Tax Effective tax rate

Year 2 $120.45 298.30 40.38%

Year 1 $126.04 284.79 44.26%

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Chap 09_10e 67. 1.

The components of pension expense are: a. Service Cost - the increase in the PBO due to employees working an additional year. b. Interest Cost - the increase in the PBO due to the passage of time. c. Expected Return on Pension Investments - the expected change in the market value of plan assets due to interest, dividends and changes in market value. d. Amortization of Prior Service Cost - the amortization of any plan changes that increase future benefits. e. Amortization of Gains/Losses - the amortization of the actuarial gains and losses when actual returns differ from expectations and when the actuarial assumptions underlying the pension plan change.

How each effects pension expense: a. Service Cost - increase b. Interest Cost - increase c. Expected Return on Plan Assets - decrease d. Amortization of net pension asset/liability - increase or decrease e. Amortization of Prior Service Cost - increase f. Amortization of Gains/Losses - could be an increase or decrease

The ABO is the present value of expected employees' benefits based on service to date using current salary amounts. The PBO is the present value of employees' benefits based on service to date, but using expected future salary amounts.

A pension plan is underfunded when the fair value of Plan Assets are less than the ABO.

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Chap 09_10e 68. Financial Statement

LIFO

FIFO

Balance Sheet

Disadvantage-Balance sheet inventory amount not reflective of current replacement cost

Advantage - Balance sheet inventory amount is more reflective of current replacement cost

Income Statement

Advantage - Income statement more closely matches current cost income when prices are rising.

Disadvantage - Income statement tends to overstate earnings in comparison to current cost income when prices are rising.

Advantage - LIFO results in lower pre-tax earnings, which leads to lower tax payments.

Disadvantage - results in higher pretax earnings, which leads to higher tax payments.

Disadvantage -LIFO leads to lower reported net income for external financial reports.

Advantage - FIFO leads to higher reported net income for external financial reports.

Cash Flow Statement

Advantage- Provides more cash from operations

Other Considerations

Disadvantage - Requires more record keeping. Disadvantage - If early LIFO inventory is liquidated then tax advantages of LIFO are lost and a larger than normal tax payment is required.

Advantage - Record keeping is easier. Advantage - There is no danger of LIFO liquidation.

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Chap 10_10e Indicate the answer choice that best completes the statement or answers the question. 1. Financial statement forecasts should rely on ______ across financial statements in order to be internally consistent. Select the best term to complete the sentence. a. history b. articulation 2. For some types of assets, such as accounts receivable, asset growth typically ______ future sales growth. Select the best term to complete the sentence. a. leads b. lags 3. For some types of assets, such as plant, property and equipment, asset growth typically ______ future sales growth. Select the best term to complete the sentence. a. leads b. lags 4. Which of the following statements does not apply to preventing “garbage in, garbage out” when implementing a forecasting game plan? a. The quality of the financial statement forecasts will depend on the quality of the forecast assumptions. b. The quantities forecasted within financial statement forecasts will depend on the quantity of the forecast assumptions. c. Analysts should justify and evaluate the most important assumptions that reflect the critical risk and success factors of the firm’s strategy. d. Analysts can impose reality checks on the assumptions by analyzing the forecasted financial statements using ratios, common-size, and rate-of-change financial statements. Card Sharks, Inc. sells baseball cards and other memorabilia. The company tries to maintain a cash balance equivalent to approximately 30 days of sales. Sales in Year 1 amounted to $352,412 and the company expects growth in Year 2 of 30% and in Year 3 of 35%. 5. Given the information provided about Card Sharks, what are the company’s Year 3 projected annual sales? a. $656,191 b. $493,377 c. $618,482 d. $542,333 6. Sparky’s forecasts that sales will grow by 25% in Year 3 and that its cost of goods sold to sales ratio will be the same in Year 3 as it was in Year 2. If these assumptions prove correct and Sparky’s inventory turnover ratio for Year 3 is 4.5 what will be the level of inventory at the end of Year 3? a. $31,353 b. $26,475 c. $40,000 d. $42,314

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Chap 10_10e 7. Financial ratio, percentage, and trend comparisons can be distorted by all of the following except: a. aggressive revenue recognition practices. b. the timing of asset purchases. c. accounting for similar economic fundamentals in similar fashion. d. the presence of nonrecurring items among the firms being analyzed. 8. An analyst using the inventory turnover ratio to calculate future levels of inventory may face the problem that: a. the method reduces the potential understatement inherent in average balances. b. the method can introduce artificial volatility in ending balances. c. the method results in understating inventory each year. d. the method results in overstating inventory each year. 9. Financial statement forecasts rely on additivity within financial statements and articulation across financial statements. Given this information sales growth forecasts will most likely affect growth in: a. accounts receivables. b. accounts payable. c. depreciation. d. salary payable. 10. All of the following are the fundamental bases for future payoffs to equity shareholders and share value except: a. earnings b. cash flows c. dividends d. depreciation 11. All of the following are true regarding projected financial statements except: a. The statement of cash flows is the most critical forecast since it reflects profitability rather than viability. b. Preparing projected financial statements must incorporate a company's past performance records. c. Preparing projected financial statements must incorporate a company's current performance records. d. The income statement demonstrates immediate capability to service debt for banks or real potential for growth in returns for venture capital. 12. A firm in transition from the high growth to the mature phase of its life cycle, or a firm with significant technological improvements in its production processes, might expect increases in sales ______ and decreases in sales prices per unit. Select the best term to complete the sentence. a. territory b. volume 13. All of the following are true regarding the key principles of forecasting except: a. Financial statement forecasts need not be comprehensive. b. Forecasts should not manifest wishful thinking. c. Financial statement forecasts must be internally consistent. d. Financial statement forecasts must rely on assumptions that have external validity. Copyright Cengage Learning. Powered by Cognero.

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Chap 10_10e 14. Financial statement forecasts rely on additivity within financial statements and articulation across financial statements. Given this information forecasts of future growth in inventory will most likely affect growth in: a. accounts receivables. b. accounts payable. c. depreciation. d. salary payable. Sparky’s Sparky’s sells auto parts. Provided below is selected financial information from the company’s Year 2 annual report: Sparky’s Selected Financial Statement data Fiscal year end (amounts in thousands of dollars) Net sales Cost of Goods Sold Gross Profit

Year 2

Year 1

$125,410 -104,090 $21,320

$106,380 -89,359 $17,021

Inventory

$31,353

$30,850

15. Using Sparky’s financial information what is the company’s inventory turnover ratio for Year 2? a. 0.69 b. 1.00 c. 3.35 d. 4.03 16. Common-size financial statements recast each statement item as: a. a percentage of the "bottom line." b. a percentage using industry averages for the "base number." c. a percentage using a base year number for each line item. d. a percentage of some "base number" on the financial statement in question. 17. Financial statement forecasts should rely on ______ within financial statements in order to be internally consistent. Select the best term to complete the sentence. a. additivity b. management’s discussion 18. It may be difficult to forecast sales for firms with ______ sales patterns because their historical growth rates reflect wide variations in both direction and amount from year to year. Select the best term to complete the sentence. a. cyclical b. steady Copyright Cengage Learning. Powered by Cognero.

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Chap 10_10e 19. If a firm operates at less than full capacity, then price ______ are not likely. Select the best term to complete the sentence. a. decreases b. increases 20. To develop forecasts of individual assets, the analyst must first link historical growth rates for individual assets to historical growth rates in ______ and other activity-based drivers. Select the best term to complete the sentence. a. prices b. sales 21. A company that has a cost structure in which its costs grow at a lesser rate than its sale enjoys ______. a. economies of scale b. purchase price protection 22. Firms that have ______ characteristics for its products may have a greater potential to increase prices. Select the best term to complete the sentence. a. differentiated b. similar 23. If a company has very low operating leverage (i.e., a low proportion of fixed costs in the cost structure) and no changes are expected in operations: a. percentage change income statement percentages can serve as the basis for projecting operating expenses. b. using common-size income statement percentages will overstate future projected operating expenses. c. using common-size income statement percentages will understate future projected operating expenses. d. using common-size income statement percentages can serve as a reasonable basis for projecting future operating expenses. 24. Projecting sales price changes depends on factors specific to the firm and its industry that might affect demand and price elasticity. Which of the following types of companies would most likely be able to increase prices? a. A firm in a capital intensive industry that is expected to operate near capacity for the near future. b. A firm in a capital intensive industry in which excess capacity exists. c. A firm operating in an industry that is expected to experience technological improvements in its production process. d. A firm operating in an industry that is transitioning from the high growth to the maturity phase of its life cycle.

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Chap 10_10e Card Sharks, Inc. sells baseball cards and other memorabilia. The company tries to maintain a cash balance equivalent to approximately 30 days of sales. Sales in Year 1 amounted to $352,412 and the company expects growth in Year 2 of 30% and in Year 3 of 35%. 25. Given the information provided about Card Sharks, what is the company’s Year 3 projected cash balance? a. $53,934 b. $49,524 c. $21,873 d. $50,820 26. The formula for forecasting inventory is cost of goods sold/365x______. a. days sales in receivables b. inventory turnover days 27. Projected financial statements can be used to assess the sensitivity of all of the following except: a. a firm’s liquidity. b. a firm’s leverage to changes in assumptions. c. conditions under which the firm’s debt covenants may become binding. d. unusual patterns for projected total assets. 28. In developing forecasts of expenses the analyst must take into consideration that expenses can be broken down into ______ components. Select the best term to complete the sentence. a. current or long-term b. fixed or variable 29. All of the following statements are true regarding ratios and forecasts except: a. Ratios cannot confirm whether forecast assumptions will turn out to be correct. b. Ratios can tell whether future sales growth was accurately captured. c. Ratios cannot tell whether assumptions about future cash flows are realistic. d. Ratios can tell whether growth rates for sales are consistent with past sales growth performance. 30. If a firm competes in a capital-intensive industry with excess capacity, all of the following are true except: a. price increases will be less likely. b. price increases will be more likely. c. companies in competitive industries face high exit barriers. d. companies in competitive industries may experience future price decreases. 31. As a firm progresses through the introduction life-cycle stage, what type of flexible account will it be more likely to use to balance the balance sheet? a. dividends b. growth related assets c. issued equity d. stock buy-backs

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Chap 10_10e 32. A firm in a mature industry with little expected change in its market share might anticipate volume increases equal to the growth rate in the ______ within its geographic markets. Select the best term to complete the sentence. a. population b. production costs 33. Nichols and Wahlen's study showed that superior forecasting provides the potential to earn superior security returns. Nichols and Wahlen's findings indicate: a. that an investor could earn excess returns if the investor could predict accurately the sign of the change in earnings one year ahead. b. that an investor could earn excess returns if the investor could predict accurately the magnitude of the change in earnings one year ahead. c. that an investor could earn excess returns if the investor could predict accurately the sign of the change in cash flows from operations one year ahead. d. that an investor could earn excess returns if the investor could predict accurately the sign of the change in working capital one year ahead. 34. When projecting ______, the analyst should consider economy-wide factors such as the expected rate of general price inflation in the economy. Select the best term to complete the sentence. a. payroll b. prices 35. Projecting sales price changes depends on factors specific to the firm and its industry that might affect demand and price elasticity. Which of the following companies would most likely not be able to increase prices in the near future? a. A firm in a capital intensive industry that is expected to operate near capacity for the near future. b. A firm in a capital intensive industry in which excess capacity exists. c. A firm operating in an industry that is expected to maintain its current production processes. d. A firm operating in an industry that is transitioning from the introduction phase to the high growth phase of its life cycle. 36. Using common-size balance sheet percentages to project individual assets, liabilities, or shareholders’ equity has all of the following shortcomings except: a. Individual assets, liabilities, and shareholders’ equity are not independent of each other. b. If a company experiences changing proportions for investments in securities among its assets, other asset categories may show decreasing percentages in some years even though their dollar amounts are increasing. c. Individual assets, liabilities, and shareholders’ equity are independent of each other. d. The common-size percentages do not permit the analyst to easily change the assumptions about the future behavior of an individual asset or liability.

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Chap 10_10e Card Sharks, Inc. sells baseball cards and other memorabilia. The company tries to maintain a cash balance equivalent to approximately 30 days of sales. Sales in Year 1 amounted to $352,412 and the company expects growth in Year 2 of 30% and in Year 3 of 35%. 37. Given the information provided about Card Sharks, what is the company’s Year 2 projected year-end cash balance? a. $966 b. $37,654 c. $15,623 d. $38,524 38. Realistic expectations are objective and ______. a. absolute b. unbiased 39. Financial statement forecasts are important analysis tools because forecasts of future ______ play a central role in valuation and many other financial decision contexts. Select the best term to complete the sentence. a. payoffs b. sales 40. The objective of forecasting is to develop: a. stand-alone financial statements for future analysis. b. a set of realistic expectations for future value-relevant payoffs. c. a balance sheet and income statement that articulate. d. financial statements for comparison to industry averages. 41. To ensure that the financial statements articulate, it is important that the change in the cash balance on the balance sheet each year agrees with: a. the cash collections from sales in the projected income statement. b. the cash provided by or used by operations on the projected statement of cash flows. c. the net change in cash on the projected statement of cash flows. d. the net change in working capital from period to period. 42. As a firm progresses through the decline life-cycle stage, what type of flexible account will it be more likely to use to balance the balance sheet? a. issued debt b. growth related assets c. issued equity d. stock buy-backs 43. Analysts must develop realistic expectations for the outcomes of future business activities. To develop these expectations, analysts build a set of ______. a. develop forecasts b. financial statement forecasts

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Chap 10_10e 44. When projecting operating expenses, it is important to determine the mix of fixed and variable costs; one clue suggesting the presence of fixed costs is: a. the percentage change in cost of goods sold in prior years is significantly greater than the percentage change in sales. b. the percentage change in cost of goods sold in prior years is significantly less than the percentage change in sales. c. low capital intensity in the production process. d. the percentage change in sales in prior years is significantly greater than the percentage change in receivables. 45. As a firm progresses through the growth life-cycle stage, what type of flexible account will it be more likely to use to balance the balance sheet? a. issued debt b. paying down of debt c. dividends d. stock buy-backs 46. The authors set forth a seven-step forecasting game plan for preparing pro forma financial statements. Discuss the seven steps necessary to prepare the three principal financial statements.

47. Based on the following statement from the text—“to develop forecasts of individual operating assets and liabilities, you must first determine the underlying operating activities that drive them”—explain what those underlying activities are.

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Chap 10_10e 48. In comparison of 2010 to 2009 performance, Watson Company's inventory turnover decreased substantially, although sales and inventory amounts were essentially unchanged. Required: During a corporate meeting you heard the following managers postulate why the decreased inventory turnover ratio happened. Which statement best explains the decreased inventory turnover ratio and why? a. The marketing manager said: The decreased inventory turnover ratio is due to an increase in the cost of goods sold. b. The operations manager said: The decreased inventory turnover ratio is due to increased gross profit percentage. c. The credit manager said: The decreased inventory turnover ratio is due to a decrease in the accounts receivable turnover. d. The shipping manager said: The decreased inventory turnover ratio is due to inventory being shipped FOB destination point that keeps those items in inventory until they reach the purchasers warehouse.

49. As an analyst it is important when projecting sales to make estimates about future changes in sales volume. Compare how you might make estimates about future sales value for a company in a mature industry and one in a rapidly growing industry.

50. The first step in the forecasting game plan is to project sales and other operating activities. Sales numbers are determined by both a volume component and price component. Projecting prices depends on factors specific to the firm and its industry that might affect demand and price elasticity. For the following types of firms, discuss whether it would be likely that the firm would be able to raise future prices: a. A firm in a capital-intensive industry that is expected to operate near capacity for the near future. b. A firm in an industry that is expected to experience numerous technological improvements. c. A firm with products that are transitioning from the growth to maturity phase of the product life cycle. d. A firm that has established a well-known brand name and image.

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Chap 10_10e 51. One problem caused by using turnover ratios to calculate asset balances is that it can lead to volatility in projected ending balances. What might an analyst do to reduce the "sawtooth" pattern caused by using turnover ratios?

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Chap 10_10e Answer Key 1. b 2. b 3. a 4. b 5. c 6. b 7. c 8. b 9. a 10. d 11. a 12. b 13. a 14. b 15. c 16. d 17. a 18. a 19. b 20. b 21. a 22. a 23. d 24. a 25. d 26. b

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Chap 10_10e 27. d 28. b 29. b 30. b 31. c 32. a 33. a 34. b 35. b 36. c 37. b 38. b 39. a 40. b 41. c 42. d 43. b 44. b 45. a

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Chap 10_10e 46. The seven steps are: 1. Project revenues from sales and other operating activities. 2. Project operating expenses and derive projected operating income. 3. Project the operating assets that will be necessary to support the level of operations projected in Steps 1 and 2. Also project the operating liabilities that will be triggered by normal business operations. 4. Project the financial leverage, financial assets, and common equity capital that will be necessary to finance the net operating assets projected in Step 3. In addition, determine the financing costs triggered by the financial liabilities and any investment income from financial assets in the firm’s capital structure. From projected operating income from Step 2, subtract interest expense and add interest income. 5. Project nonrecurring gains or losses (if any) and derive projected income before tax. Subtract the projected provision for income taxes to derive the projected net income. Subtract expected dividends from net income to obtain the projected change in retained earnings. Also project any other comprehensive income items. 6. Check whether the projected balance sheet is in balance. Repeat Steps 4 and 5 until it is in balance. 7. Derive the projected statement of cash flows from the projected income statements and the changes in the projected balance sheet amounts. 47. For assets such as inventory and property, plant, and equipment, future growth leads future sales growth. For assets such as accounts receivable, they tend to lag behind sales growth. While certain operating liabilities will be determined by operating assets (accounts payable for inventory purchases), others will be determined by operating assets such as liabilities for accrued expenses. 48. The operations manager’s statement (b) best explains the decreased inventory turnover ratio. The gross profit margin increased. Sales were unchanged, so the gross profit margin increase would be due to decreased cost of goods sold. If inventory were also unchanged, the lower cost of goods sold would result in lower inventory turnover. 49. Suggested Solution from the text: For a stable firm in a mature industry (for example, consumer foods), an analyst may conclude that the firm will not significantly increase its market share, in which he or she might anticipate that sales volume with grow with population growth in the firm’s geographic markets. For a firm that has increased its production in an industry with high anticipated growth (for example, biotechnology or cell phones), the analyst can use the industry growth rate coupled with the expansion in the firm’s capacity to project sales volume increases.

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Chap 10_10e 50. Suggested answers: a. In this case, due to capacity constraints the firm should be able to raise prices. Because the industry is capital intensive it is not likely that a competitor could easily and quickly enter the market and steal market share by cutting prices. b. This firm would probably not be able to raise prices due to efficiencies brought on by the technological change, although sales volumes may increase. c. This firm may find it more difficult to raise prices, as the product's sales reach a level in which demand is more stable. Thus, price increases may result in consumers switching products, etc. d. Firms with well-known images and brand names may be better positioned to raise prices because consumers feel such brand loyalty. 51. One thing an analyst might do is estimate the average rate of growth in the asset balance expected over a long forecast period, and then smooth each year-end balance using the average growth rate.

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Chap 11_10e Indicate the answer choice that best completes the statement or answers the question. 1. Using the above information, calculate Zonk’s weighted-average cost of capital: a. 11.5% b. 7.97% c. 7.48% d. 10.90% 2. If a firm has a market beta of 0.9, is subject to an income tax rate of 35 percent, has a risk-free rate of 6 percent, a market risk premium of 7 percent, and has a market value of debt to market value of equity ratio of 60 percent, what does the market expect the firm to generate in terms of equity returns using CAPM? a. 6% b. 7% c. 12.3% d. 13% 3. Equity valuation models based on dividends, cash flows, and earnings have been the topic of many theoretical and empirical research studies in recent years. All of the following are true regarding these studies except: a. Share prices in the capital markets generally correlate closely with share value. b. Share prices do not always equal share values. c. Temporary deviations of price from value occur. d. Unexpected changes in earnings, dividends, and cash flows do not correlate closely with changes in stock prices. 4. Assume that Zonk is a potential leveraged buyout candidate. Assume that the buyer intends to put in place a capital structure that has 70 percent debt with a pretax borrowing cost of 14 percent and 30 percent common equity. Compute the revised equity beta for Zonk based on the new capital structure. a. 4.35 b. 4.77 c. 4.34 d. 3.91 5. If dividend projections include the effect of inflation, then the discount rate used should be a ______ rate. Select the best term to complete the sentence. a. discount b. nominal 6. One criticism in using the CAPM to calculate the cost of equity capital is that ______ are quite sensitive to the time period and methodology used in their computation. Select the best term to complete the sentence. a. market betas b. equity securities

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Chap 11_10e 7. Investors typically accept a lower risk-adjusted rate of return on debt capital than on equity capital because: a. debt is typically less risky because fixed claims bear less residual risk than equity claims. b. equity bears less residual risk than debt. c. equity capital costs are tax deductible. d. the yield to maturity on equity is inversely related to its market value. Zonk Corp. The following data pertains to Zonk Corp., a manufacturer of ball bearings (dollar amounts in millions): Total assets Interest-bearing debt Average pre-tax borrowing cost Common equity: Book value Market value Income tax rate Market equity beta

$7460 $3652 10.5% $2950 $13685 35% 1.13

8. Assuming that riskless rate is 4.6% and the market premium is 7.3%, calculate Zonk’s cost of equity capital: a. 10.4% b. 7.69% c. 8.28% d. 12.85% 9. Returns on systematic risk-free securities (like U.S. Treasury securities) should exhibit what type of correlation with returns on a diversified market wide portfolio of stocks? a. Nearly perfect correlation b. Perfect correlation c. No correlation d. Unable to tell without specifics about the portfolio 10. A company with a new capital structure will need to remove the effects of ______ from the market beta and then re-lever the market beta for the new capital structure. Select the best term to complete the sentence. a. leverage b. equity 11. With respect to dividends and priority in liquidation, what has priority over common stock? a. treasury stock b. debt capital c. preferred stock d. nonconvertible common equity

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Chap 11_10e 12. Dividends measure the cash that ______ ultimately receive from investing in an equity share. Select the best term to complete the sentence. a. borrower b. investors 13. The historical discount rate of the firm may be a good indicator of the appropriate discount rate to apply to the firm in the future, when all of the following conditions hold true except: a. The current risk of the firm is the same as the expected future risk of the firm. b. Expected future interest rates are likely to equal current interest rates. c. The existing capital structure of the firm is the same as the expected future capital structure of the firm. d. The current mix of debt and equity financing is equal. 14. Determine the weight on equity capital that should be used to calculate Zonk’s weighted-average cost of capital: a. 79.00% b. 78.3% c. 41.8% d. 50% 15. All of the following are steps in the analysis and valuation framework used to understand the fundamentals of a business and determine estimates of its value except: a. Analyze the firm’s strategy in terms of the competition. b. Assess the quality of the firm’s accounting and financial reporting. c. Derive forecasts of future earnings from the firm’s projected financial statements. d. Obtain the national ranking of the firm’s external auditors. 16. One rationale for using expected dividends in valuation is: a. Dividends are a necessary payment in order for a firm to have value. b. Dividends are paid in cash, and cash serves as a measurable common denominator for comparing the future benefits of alternative investment opportunities. c. Dividends are the most reliable measure of value because most companies payout dividends to shareholders. d. Dividend payout ratios are set based on profitability. 17. Determine the weight on debt capital that should be used to calculate Zonk’s weighted-average cost of capital: a. 21.7% b. 21.00% c. 50% d. 58.2% 18. Equity-based valuation models are based on all metrics except: a. dividends b. cash flow c. working capital d. earnings Copyright Cengage Learning. Powered by Cognero.

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Chap 11_10e 19. Normally, valuation methods are designed to produce reliable estimates of the value of a firm's ______. a. equity shares b. long-term debt 20. Which of the following is not a problem with using a dividend-based valuation formula? a. Dividends are arbitrarily established. b. Dividends represent a transfer of wealth to shareholders. c. Some firms do not pay a regular periodic dividend. d. It is a challenge to forecast the final liquidating dividend. 21. Because the market equity beta reflects the level of operating leverage, financial leverage, variability of sales, and other characteristics of a firm, there are situations where an analyst might have to adjust the beta because of changes in the capital structure. A situation that might require an analyst to estimate a new levered beta is a ______. a. leveraged buyout b. change in a sales forecast 22. Assume that Zonk is a potential leveraged buyout candidate. Assume that the buyer intends to put in place a capital structure that has 70 percent debt with a pretax borrowing cost of 14 percent and 30 percent common equity. Compute the weighted average cost of capital for Zonk based on the new capital structure. a. 8.85% b. 12.56% c. 13.01% d. 9.94% 23. Firm-specific factors that increase the firm’s nondiversifiable risk include all of the following except: a. Exposure to interest rate changes b. Exposure to inflation c. Exposure to management competence d. Exposure to cyclicality 24. Under the dividend valuation approach, the value of a share of common equity is the present value of expected future ______. a. dividends b. earnings 25. When deriving the equity value of a firm, an analyst forecasts the real dividends expected to be paid in the future. In this case, which discount rate should be used? a. The nominal rate of return b. The real rate of return c. The risk-free rate of return d. The risk adjusted rate of return

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Chap 11_10e 26. A company with a market beta of 1 has systemic risk ______ to the average amount of systemic risk of all equity securities in the market. Select the best term to complete the sentence. a. equal b. greater than 27. Under the cash-flow-based valuation approach, free cash flows can be used instead of dividends as the expected future payoffs to the investor in the numerator of the general valuation model because: a. this approach focuses on earnings as a measure of the capital that a firm creates. b. over the life of the firm, the free cash flows into the firm and cash flows paid out of the firm in dividends to shareholders will be equivalent. c. over the life of the firm, the free cash flows out of the firm for investments and cash flows paid into the firm in dividends from these investments will be equivalent. d. this approach focuses on wealth distribution to shareholders. 28. To determine the appropriate weights to use in the weighted average cost of capital, an analyst will need to determine the ______ of the debt, preferred stock and common equity capital. Select the best term to complete the sentence. a. market values b. present values 29. According to the text, dividends are value-relevant even though the firm’s dividend policy is irrelevant. How can that be true? What is the key assumption in the theory of dividend policy irrelevance?

30. Why is the dividends valuation approach applicable to firms that do not pay periodic (quarterly or annual) dividends?

31. Why do investors typically accept a lower risk-adjusted rate of return on debt capital than equity capital? Suppose a stable, financially healthy, profitable, tax-paying firm that has been financed with all equity and no debt decides to add a reasonable amount of debt to its capital structure. What effect will that change in capital structure likely have on the firm’s weighted average cost of capital?

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Chap 11_10e Bridgetron An analyst wants to value the sum of the debt and equity capital of the firm and is provided with the following information: Total Assets Interest-Bearing Debt Average Pre-tax borrowing cost Common Equity: Book Value Market Value Income Tax Rate Market Equity Beta Risk-free Rate Market Premium

$25,675 $18,525 9.25% $ 8,950 $34,956 35% 1.05 3.8% 5.7%

32. An analyst wants to value the common shareholders’ equity of Bridgetron, compute the relevant cost of capital that should be used.

33. In what case will using dividends expected to be paid to shareholders yield the same valuation for the firm as using free cash flows expected to be generated by the firm?

34. The CAPM computes expected rates of return on common equity capital using the following model: E[REj] = E[RF] + bj x {E[RM ] – E[RF]} What are the roles of each of the three components of this model?

35. Explain why analysts and investors use risk-adjusted expected rates of return as discount rates in valuation. Why do risk-adjusted expected rates of return increase with risk?

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Chap 11_10e 36. Implementing a dividend valuation model to determine the value of the common shareholders’ equity requires an analyst to measure three elements. What are the three elements that the analyst needs to measure?

37. Suppose a firm has a market beta of 1.24 and the risk-free interest rate is 6.25. In addition, the excess return over the risk-free rate is 6.3%. Calculate the firm's cost of equity capital using the CAPM model.

38. Identify the types of firm-specific factors that increase a firm’s nondiversifiable risk (systematic risk). Identify the types of firm-specific factors that increase a firm’s diversifiable risk (idiosyncratic risk or nonsystematic risk). Why do models of risk-adjusted expected returns include no expected return premia for diversifiable risk?

39. The dividends valuation approach measures value-relevant dividends to encompass various transactions between the firm and the common shareholders. What transactions should the analyst include in value-relevant dividends for purposes of implementing the dividends valuation model? Why?

40. Explain the theory behind the dividends valuation approach. Why are dividends value-relevant to common equity shareholders?

41. Under the assumption of clean surplus accounting, how would you compute total dividends paid to common equity holders in order to value the firm?

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Chap 11_10e 42. Why are dividends value-relevant to common equity shareholders?

43. Provide the rationale for using expected dividends in a valuation model.

44. Conceptually, why should an analyst expect the dividends valuation approach to yield equivalent value estimates to the valuation approach that is based on free cash flows available to be distributed to common equity shareholders?

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Chap 11_10e Answer Key 1. b 2. c 3. d 4. a 5. b 6. a 7. a 8. d 9. c 10. a 11. c 12. b 13. d 14. a 15. d 16. b 17. b 18. c 19. a 20. b 21. a 22. a 23. c 24. a 25. b 26. a

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Chap 11_10e 27. b 28. a 29. Dividends are relevant even though the firm’s dividend policy is irrelevant. The irrelevance of dividend policy depends on the assumption that the firm will reinvest capital to earn the rate of return required by the common equity investors. Thus, investors are indifferent as to whether they receive the capital in a form of dividend and invest it themselves to earn the required rate of return, or whether the firm retains the capital to earn the same return. It is possible that the irrelevance theorem may not hold, including when dividend payments signal information to shareholders or when a non-dividend-paying firm becomes increasingly vulnerable to agency problems because managers are underinvesting the firm’s resources. 30. The dividends valuation approach is applicable to firms that do not pay periodic (quarterly or annual) dividends because the capital reinvested in the firm is ultimately returned to the common equity shareholder via the final liquidating dividend or when the firm’s assets are liquidated, when the firm is acquired by another firm, or when the shareholder sells his or her shares. A simple analogy is a savings account in which the account holder reinvests all of the interest. 31. Investors typically accept a lower risk-adjusted rate of return on debt capital than on equity capital because debt is typically less risky because fixed claims bear less residual risk than equity claims. Also, in the United States and most other countries, debt capital costs such as interest expense are tax deductible for the firm, whereas equity capital costs such as dividends are not. If a stable, financially healthy, profitable, tax-paying firm that has been financed with all-equity and no debt decides to add a reasonable amount of debt to its capital structure, it should experience a drop in WACC because it will have a higher proportion of debt with a lower cost of capital than equity. 32. The analyst would need to use the cost of equity capital. 33. They will yield the same valuation as in the case when the firm generates a rate of return on reinvested free cash flow equal to the discount rate used by the investor (the equity cost of capital). 34. The first component (E[RF]) represents the return an investor can expect on a risk-free investment. This component represents the return to capital for forgoing current consumption. The second component (bj) reflects the relative level of the firm’s systematic risk. The third component ({E[RM ] – E[RF]}) reflects the average expected risk premium in the capital market for bearing the market-wide average level of systematic risk. The product of the second and third components represents the amount of return the investor should expect for bearing the level of systematic risk in an investment in Firm j relative to the average level of systematic risk in the market. 35. Analysts and investors use risk-adjusted expected rates of return as discount rates in valuation to capture the effects of the risk-return trade-off in their value estimates. When the value of an investment is estimated after discounting expected future payoffs to present value using a risk-adjusted discount rate, the value estimate reflects the price the analyst should be willing to pay for the investment to earn the expected risk-adjusted rate of return. Risk-adjusted expected returns increase with risk because investors are risk-averse. 36. 1. 2. 3.

The discount rate used to compute the present value of the future dividends. The expected future dividends over the forecast horizon. The expected dividend at the final period of the forecast horizon, called the continuing dividend, along with a forecast of long-term growth.

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Chap 11_10e 37. Cost of equity capital = 6.25+1.24(.063) = 14.1% 38. Firm-specific factors that increase the firm’s nondiversifiable risk (systematic risk) include the firm’s exposure to economy-wide risk factors such as interest rate changes, inflation, foreign exchange rate changes, and cyclicality. Firm-specific exposure to such risk factors is determined by factors such as the firm’s leverage, extent of fixed versus variable interest rate debt and investments, and the extent of exposure to foreign exchange rate fluctuations. The types of firm-specific factors that increase the firm’s diversifiable risk (idiosyncratic risk or nonsystematic risk) include the firm’s exposure to competition, technological change, labor problems, management competence, and operating control. Models of risk-adjusted expected returns include no expected return premia for diversifiable risk because, in theory, a risk-averse investor can avoid the positive and negative consequences of these types of risks on his or her portfolio through portfolio diversification. 39. The chapter emphasizes an “all-inclusive” measurement approach to “value-relevant” dividends. For dividends-based valuation, the analyst should measure all net cash flows between the firm and the common shareholders. The measurement of value-relevant dividends should encompass periodic dividends (such as quarterly or annual dividends under the firm’s dividend payout policy) plus capital returned to equity shareholders through stock repurchases less capital raised from equity shareholders through stock issues. 40. The theory behind the dividends valuation approach is straightforward. Dividends are value-relevant to common equity shareholders because the dividends are cash flows directly to the equity shareholders. 41. Under the assumption of clean surplus accounting, total dividends paid to common equity holders is calculated as: Comprehensive Income Available for Common Equity Plus: Beginning Book Value of Common Equity Less: Ending Book Value of Common Equity 42. Dividends are value-relevant to common equity shareholders because the dividends are cash flows directly to the equity shareholders. 43. 1.

Cash is the primary medium of exchange for consumption, which is the ultimate source of value. Dividends measure the cash that investors ultimately receive from investing in an equity share. Dividends are paid in cash, and cash serves as a measurable common denominator for comparing the future benefits of alternative investment opportunities. One might compare investment opportunities involving the holding of a bond, a stock, or an office building, but comparing these alternatives requires a common measuring unit of their future benefits. The future cash flows derived from their future services serve such a function.

44. Conceptually, the dividends valuation approach yields equivalent value estimates as the valuation approach that is based on free cash flows available to be distributed to common equity shareholders. At a conceptual level, dividends valuation and free cash flows to equity valuation are two sides to the same equation. The dividends approach is based on when cash is paid out to shareholders, whereas the free cash flows approach is based on when the firm generates cash that will eventually be paid out to shareholders.

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Chap 12_10e Indicate the answer choice that best completes the statement or answers the question. 1. The risk-adjusted discount rate used to compute the present value of all the projected free cash flows for common equity shareholders equals the ______. a. required rate of return on equity capital b. current LIBOR rate 2. ______ typically include accounts payable, accrued expenses, accrued taxes, deferred taxes, pension obligations and other retirement benefit obligations. Select the best term to complete the sentence. a. Operating assets b. Operating liabilities 3. Steady-state growth in free cash flows could be driven by long-run expectations for growth attributable to: a. interest rates b. national exports c. general economic productivity d. balance of payments 4. If a firm’s stock returns co-vary identically with returns to a market-wide portfolio, then its market beta from such a regression is: a. equal to zero. b. equal to one. c. less than one. d. greater than one. 5. Financial liabilities include all of the following except: a. mortgages payable b. current maturities of long-term debt c. accrued taxes d. bonds payable 6. The conceptual framework for free cash flows separates all assets and liabilities into the following categories: a. Current and non-current b. Monetary and non-monetary c. Operating and non-operating d. Operating and financial 7. Financial assets include all of the following except: a. excess cash b. short term investments c. intangible assets d. long-term investments

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Chap 12_10e 8. Steady-state growth in ______ could be driven by long-run expectations for growth attributable to economywide inflation, general economic productivity, the population, or long-run growth in industry's sales. Select the best term to complete the sentence. a. free cash flows b. expenditures 9. If cash flow projections include the effect of inflation then the discount rate used should be a ______ rate. Select the best term to complete the sentence. a. discount b. nominal 10. If an analyst wants to value a potential investment in the net operating assets of a division of another firm, the relevant cash flows the analyst should use are: a. free cash flow from operations. b. free cash flows for all debt and equity capital stakeholders. c. free cash flows to common equity shareholders. d. cash flow from operations. Plough Corporation reports the following information: Net cash provided by operating activities Average current liabilities Average long-term liabilities Dividends paid Capital expenditures Payments of debt 11. Plough’s free cash flow is: a. $80,000 b. $105,000 c. $45,000 d. $10,000

$300,000 150,000 100,000 80,000 140,000 35,000

12. An equity security with systematic risk equal to the average amount of systematic risk of all equity securities in the market: a. has a market beta equal to one. b. should expect to earn the same rate of return as the average stock in the market portfolio. c. gives no insight into the risk premium of stock. d. Both "has a market beta equal to one" and "should expect to earn the same rate of return as the average stock in the market portfolio" are correct.

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Chap 12_10e 13. When calculating free cash flows to common equity shareholders, financing activities do not include: a. Debt cash flows b. Adjustments for capital expenditures c. Adjustments for Preferred stock cash flows d. Financial asset cash flows 14. If a firm generates a rate of return on ______ equal to the discount rate used by the investor then it does not matter if an analyst uses cash flows to the investor or cash flows to the firm. Select the best term to complete the sentence. a. peripheral business b. reinvested free cash flow 15. If the objective is to value operating assets net of operating liabilities of a firm then the appropriate free cash flow measure to be used is ______. a. free cash flow for all debt and equity capital b. free cash flows for common equity shareholders 16. Changes in general price levels due to inflation or deflation cause the ______ of the monetary unit to increase or decrease overtime. Select the best term to complete the sentence. a. purchasing power b. availability 17. Continuing free cash flows represent: a. the cash flows remaining after deducting cash flows attributable to debt holders. b. the free cash flows after the point at which the firm has settled into a long-run steady-state growth rate. c. all sustainable free cash flows. d. all after-tax free cash flows. Sun Corporation reports the following information: Net cash provided by operating activities Average current liabilities Average long-term liabilities Dividends paid Capital expenditures Payments of debt

$255,000 150,000 100,000 60,000 110,000 35,000

18. Sun’s free cash flow is: a. $195,000 b. $145,000 c. $50,000 d. $85,000

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Chap 12_10e 19. Even in relatively efficient securities markets, price is observable but ______ is not; therefore, it must be estimated. Select the best term to complete the sentence. a. real cost b. value 20. ______ is an estimate of systematic risk based on the degree of covariation between a firm's stock returns and an index of stock returns for all firms in the market. Select the best term to complete the sentence. a. Market beta b. Cost of equity capital 21. Free cash flows for common equity shareholders are the cash flows specifically available to the common shareholders after making all capital expenditures, debt service payments to lenders and ______. a. paying dividends to preferred shareholders b. paying suppliers for operating expenses 22. If an analyst wants to value a potential investment in the net operating assets of a division of another firm, the analyst should discount the projected free cash flows at the: a. cost of debt capital. b. cost of equity capital. c. weighted average cost of capital. d. risk-free rate. 23. The forecasting and valuation process is particularly difficult for ______ firms when the near term free cash flows tend to be negative. Select the best term to complete the sentence. a. growth b. mature 24. What is Houston’s free cash flow for common equity holders for year 2? a. $564 b. $399 c. $324 d. $412 25. Net cash flow from operations less ______ and dividends equals free cash flow. Select the best term to complete the sentence. a. capital expenditures b. depreciation 26. One advantage of the free cash flow valuation method is that cash is the medium of exchange and therefore is a fundamental source of ______. a. income b. value

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Chap 12_10e 27. Free cash flow is calculated as net cash provided by operating activities less: a. dividends. b. capital expenditures and depreciation. c. capital expenditures. d. capital expenditures and dividends. 28. Nonsystematic risk factors would include all of the following except: a. the sustainability of the firm’s strategy b. the firm’s ability to generate revenue growth c. the firm’s ability to control expenses d. unemployment levels 29. The conceptual framework for free cash flows separates the balance sheet equation into the following categories: a. CA + LT A = CL + LT L + SE b. OA + FA = OL + FL + SE c. OA + FA = OL + FL + OSE + FSE d. Non-FA + FA = Non-FL + FL + SE 30. A disadvantage of the free cash flow valuation method is: a. The terminal value tends to dominate the total value in many cases. b. The projection of free cash flows depends on earnings estimates. c. The free cash flow method is not rigorous. d. The free cash flow method is not used widely in practice. 31. The present value of future free cash flows valuation method focuses on free cash flows, a base that economists argue has more economic meaning than ______. a. current market value b. earnings 32. Starting with net cash flow from operations and adjusting for capital expenditures and dividends equals: a. free cash flows for all debt and equity capital stakeholders. b. free cash flow. c. free cash flows to common equity capital shareholders. d. free cash flow from operations. 33. The cash-flow-based valuation approach measures and values the cash flows that are "free" to be distributed to ______ unencumbered by necessary reinvestments in operating assets or required payments to debt holders. Select the best term to complete the sentence. a. financial institutions b. shareholders

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Chap 12_10e Houston, Inc. The following information pertains to Houston, Inc. a manufacturer of belt buckles: (dollar amounts in thousands) Net Cash Flow from Operations Interest Expense after tax Decrease (Increase) in Cash Required for Operations Net Cash Flow from Investing Net Cash from Debt Financing

Year 2 564 122 -75

Year 3 628 134 -54

Year 4 854 148 -48

Year 5 1059 145 -32

Year 6 1345 155 -61

Year 7 1655 148 -48

-287 210

-300 204

-310 140

-285 85

-294 -40

-277 -46

Present Value Factors for 8.5%

0.922

0.849

0.783

0.722

0.665

34. What is Houston’s free cash flow for all debt and equity holders for Year 2? a. $564 b. $399 c. $324 d. $202 35. Which of the following is not a problem with using a dividend-based valuation formula? a. Dividends are arbitrarily established. b. Dividends represent a transfer of wealth to shareholders. c. Some firms do not pay a regular periodic dividend. d. It is a challenge to forecast the final liquidating dividend. 36. If an analyst wants to value a potential investment in the common stock equity in a firm, the relevant cash flows the analyst should use are: a. free cash flow from operations. b. free cash flows for all debt and equity capital stakeholders. c. free cash flows to common equity shareholders. d. cash flow from operations. 37. The analyst can use expectations of the dividends to be paid to the investor or the free cash flows to be generated by the firm (that will ultimately be paid to the investor) as equivalent approaches to measure the ______ expected payoffs to shareholders. Select the best term to complete the sentence. a. value-relevant b. value-reliability

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Chap 12_10e 38. For most firms, ______ include cash and short-term investment securities, accounts receivable, inventory, property, plant and equipment, intangible assets and investments in affiliated companies. Select the best term to complete the sentence. a. operating assets b. free cash flows 39. All of the following are logical steps that enable the analyst to determine reliable estimates of value except: a. Understand the economics of the industry b. Assess the particular firm’s strategy c. Evaluate the quality of the firm’s accounting d. Derive a single point estimate of value for a share’s current price 40. If an analyst wants to value a potential investment in the common stock equity of a firm, the analyst should discount the projected free cash flows at the: a. required return on equity capital. b. weighted average cost of capital. c. risk-free rate. d. market risk premium. 41. Shady Sunglasses operates retail sunglass kiosks in shopping malls. Below is information related to the company: (dollar amounts in thousands) Net Cash Flow from Operations Interest Expense after Tax Decrease (Increase) in CashRequired for Operations Net Cash Flow from Investing Net Cash from Debt Financing

Year 1 564 122

Year 2 628 134

Year 3 854 148

Year 4 1059 145

Year 5 1345 155

Year 6 1655 148

-75 -287 210

-54 -300 204

-48 -310 140

-32 -285 85

-61 -294 -40

-48 -277 -46

Present Value Factors (Re = 8.5%)

0.922

0.849

0.783

0.722

0.665

Using a five-year forecast horizon, compute the sum of the present value of free cash flows accruing to common equity holders for years Year 1 to Year 5.

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Chap 12_10e 42. Regarding the equity buyout, compute the weighted average cost of capital of the new capital structure.

Simpson Department Store Simpson Department Stores operates retail department store chains throughout the United States. At the end of Year 10, Simpson reports debt of $5,897 million and common shareholders’ equity at book value of $4,400 million. The market value of its common stock is $6,895, and its market equity beta is 0.79. An equity buyout group is considering an LBO of Simpson as of the beginning of Year 11.The group intends to finance the buyout with 25 percent common equity and 75 percent debt carrying an interest rate of 10.65 percent. 43. Regarding the equity buyout, compute the unlevered market equity (asset) beta of Simpson before consideration of the LBO. Assume that the book value of the debt equals its market value. The income tax rate is 35 percent.

44. What is the purpose of a free cash flow analysis?

45. What three elements are needed to value a resource when using cash flows?

46. Starting with free cash flows from operations, discuss how an analyst would measure free cash flows to common equity shareholders.

47. Discuss under which scenario it is appropriate to use free cash flows for all debt and equity capital stakeholders.

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Chap 12_10e 48. Explain “free” cash flows. Describe which types of cash flows are free and which are not. How do free cash flows available for debt and equity stakeholders differ from free cash flows available for common equity shareholders?

49. Provide the rationale for using expected free cash flow in valuation.

50. When should an analyst use nominal cash flows and when should an analyst use real cash flows?

51. Regarding the equity buyout, compute the cost of equity capital with the new capital structure that results from the LBO. Assume a risk-free rate of 3.75percent and a market risk premium of 5.0 percent.

52. Currently, financial reporting does not take into account changes in prices, either at the general level or at the specific level. Many analysts believe that not taking price changes into account distorts the meaningfulness of financial reports. How do changing prices affect financial reports?

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Chap 12_10e Answer Key 1. a 2. b 3. c 4. b 5. c 6. d 7. c 8. a 9. b 10. b 11. a 12. d 13. b 14. b 15. a 16. a 17. b 18. d 19. b 20. a 21. a 22. c 23. a 24. d 25. a 26. b

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Chap 12_10e 27. d 28. d 29. b 30. a 31. b 32. b 33. b 34. c 35. b 36. c 37. b 38. a 39. d 40. a

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Chap 12_10e 41. Note that the present value amounts are subject to some rounding differences if present value factors are used rather than a financial calculator or spreadsheet. (dollar amounts in thousands) Net Cash Flow from Operations Interest Expense after Tax Decrease (Increase) in Cash Required for Operations Net Cash Flow from Investing Net Cash from Debt Financing

Year 1 564 122

Year 2 628 134

Year 3 854 148

Year 4 1059 145

Year 5 1345 155

Year 6 1655 148

-75 -287 210

-54 -300 204

-48 -310 140

-32 -285 85

-61 -294 -40

-48 -277 -46

Free Cash for Common Equity Holders

412

478

636

827

950

1284

Present Value Factors for 8.5%

0.922

0.849

0.783

0.722

0.665

PV of FCF for Common Equity Holders TOTAL YEARS 1-5

379.724 2,512

406.04

497.93 596.742

631.79

42. (.75)(1-.35)(.1065)+(.25)(.12)=.0819 43. .79=X[1+(1-.35)($4,400/$6,895] X=.56 44. Free cash flow is net cash provided by operating activities less capital expenditures and dividends. The purpose of free cash flow analysis is to determine the amount of discretionary cash flow a company has for purchasing additional investments, retiring its debt, purchasing treasury stock, or simply adding to its liquidity and financial flexibility. 45. 1. 2. 3.

The expected future free cash flows over the forecast horizon. The expected future free cash flows at the final period of the forecast horizon. The discount rate used to compute the present value of the future free cash flows.

46. Free cash flows from operations would be adjusted for capital expenditures, which would leave free cash flows for all debt and equity capital stakeholders. This amount would then be adjusted for financing activities, which would include debt cash flows, financial asset cash flows, and preferred stock cash flows.

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Chap 12_10e 47. Analysts should use free cash flows for all debt and equity capital stakeholders when the objective is to value the operating assets of a firm, net of the firm's operating liabilities. This would also be the case when the objective is to value the sum of debt and equity capital of the firm. 48. Cash flows are free if they are unencumbered and available to be distributed to financial claims, such as debt, preferred, and equity stakeholders. Cash flows are not free if it is necessary for the firm to use the cash to maintain working capital, invest in productive capacity, or make other strategic investments. Free cash flows available for debt and equity stakeholders include cash flows to satisfy all debt, preferred and common equity claims. They differ from the free cash flows that are available to common equity shareholders, which include only free cash that can be paid to common shareholders, the residual claimants of the firm, after debt and preferred claims have been satisfied. 49. 1. 2.

Cash is the ultimate source of value. Cash serves as a measurable common denominator for comparing the future benefits of alternative investment opportunities.

50. Nominal cash flows should be used when the projected free cash flows include the effects of changes in general purchasing power of the monetary unit. Real cash flows should be used when the projected free cash flows have general price changes stripped out. 51. Unlevered Beta = .79[1+(1-.35)($4,400/$6,895]=.56 Revised Equity Beta = .56[1+(1-.35)(.75/.25)] =1.65 Revised Cost of Equity Capital = .0375+(1.65x.05) =.12 52. Measuring Unit Problem Changes in the general level of prices in an economy (as measured by the prices of a broad basket of goods and services) affect the purchasing power of the monetary unit (for example, the U.S. dollar). During periods of inflation (deflation), the measuring unit loses (gains) purchasing power. Because the measuring unit does not reflect a constant amount of purchasing power over time, accounting measurements of assets, liabilities, revenues, and expenses made with this measuring unit are not comparable. Adding the acquisition cost of land acquired ten years ago for $10 million to the acquisition cost of land acquired this year for $10 million is as inappropriate as adding the cost of land acquired in the United States for $10 million to the cost of land acquired by a subsidiary in the United Kingdom for £10 million. We refer to the accounting issues created by changes in the general level of prices as a measuring unit problem. Valuation Problem Changes in the specific prices of individual assets and liabilities (for example, inventories, fixed assets) affect the measurement of revenues and expenses on the income statement, and the valuation of assets and liabilities on the balance sheet. Land acquired last year for $10 million may now have a market value of $14 million. Should the accountant report this land on the balance sheet at its acquisition cost of $10 million or at its current market value of $14 million? Should net income include an unrealized holding gain of $4 million? We refer to the accounting issues created by changes in the prices of specific assets and liabilities as a valuation problem.

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Chap 13_10e Indicate the answer choice that best completes the statement or answers the question. 1. The residual income valuation approach assumes that accounting for net income and book value of shareholders' equity follows ______. a. clean surplus accounting b. dirty surplus accounting 2. Assume that a firm’s book value at the beginning of the year is $17,800 and that the firm reports net income of $6,200. If the firm’s book value at the end of the year is $20,000 what was the amount of dividends paid during the year? a. $4,000 b. $8,800 c. $2,200 d. Insufficient information to determine 3. The appropriate discount rate for the residual income model is: a. weighted average cost of capital. b. the risk-free interest rate. c. the risk-free interest rate plus the market premium. d. cost of common equity capital. 4. Clean surplus accounting for most common stock transactions holds for shares accounted for at market value. An exception to this is: a. issuance of common equity shares for employee stock options exercises. b. repurchase of common shares. c. issuance of common shares to new shareholders in public exchanges. d. None of these. 5. Accounting principles make accrual accounting earnings closer than ______ to the firm's underlying economic performance in a given period. Select the best term to complete the sentence. a. cash flows b. dividends 6. Assume that a firm’s book value at the beginning of the year is $12,500 and that the firm reports net income of $3,200 and pays dividends of $1,100. What will the firm’s book value at the end of the year? a. $2,100 b. $15,700 c. $14,600 d. $16,800

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Chap 13_10e 7. Assume that a firm had shareholders' equity on the balance sheet at a book value of $1,600 at the beginning of the year. During the year the firm earns net income of $1,300, pays dividends to shareholders of $600, and uses $300 to repurchase common shares. The book value of shareholders’ equity at the end of the year is: a. $2,000 b. $400 c. $3,800 d. $2,600 8. The residual income valuation model is a rigorous and straightforward valuation approach, but the analyst should be aware of all of the following implementation issues that will hinder its ability to measure firm value correctly except: a. common stock transactions b. portions of net income attributable to equity claimants other than common shareholders c. dirty surplus accounting items d. positive book value of equity 9. ______ means that net income includes all of the recognized elements of income of the firm for common equity shareholders and dividends include all direct capital transactions between the firm and the common equity shareholders. Select the best term to complete the sentence. a. Clean surplus accounting b. Dirty surplus accounting 10. At the beginning of Year 2 investors had invested $125,000 of common equity in Jan Corp. and expect to earn a return of 15% per year. In addition, investors expect Jan Corp. to pay out 100% of income in dividends each year. Forecasts of Jan’s net income are as follows: Year 2 - $41,000 Year 3 - $35,400 Year 4 - $33,200 Year 5 and beyond - $25,000 Using this information, what is Jan’s residual income valuation at the beginning of Year 2? a. $125,000 b. $184,600 c. $190,262 d. $195,262

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Chap 13_10e 11. At the beginning of Year 2 investors had invested $25,000 of common equity in Grant Corp. and expect to earn a return of 11% per year. In addition, investors expect Grant Corp. to pay out 100% of income in dividends each year. Forecasts of Grant’s net income are as follows: Year 2 - $3,500 Year 3 - $3,200 Year 4 - $2,900 Year 5 and beyond - $2,750 Using this information, what is Grant’s residual income valuation at the beginning of Year 2? a. $25,000 b. $26,350 c. $26,151 d. $26,041 12. Dirty surplus items in U.S. GAAP typically arise from all of the following except: a. changes in investment security fair values b. foreign currency exchange rates c. interest rates d. realized gains 13. Early in a period in which sales were increasing at a modest rate and plan expansion and start-up costs were occurring at a rapid rate, a successful business would likely experience: a. increased profits and no change in financing requirements. b. decreased profits and increased financing requirements because of an increasing cash shortage. c. decreased profits and decreased financing requirements because of an increasing cash surplus. d. increased profits and increased financing requirements because of an increasing cash shortage. 14. What would be Jarrett’s residual income in Year 3? a. $24,552 b. $18,763 c. $5,789 d. $5,200 15. The value of a share of common equity should equal the present value of the ______ that the shareholders will receive. Select the best term to complete the sentence. a. expected cash flows b. expected future net income 16. The required earnings of the firm equals the product of the required rate of return on common equity capital times the ______ at the beginning of the period. Select the best term to complete the sentence. a. book value of common equity capital b. book value of assets

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Chap 13_10e 17. In theory, all three valuation models, when correctly implemented with internally consistent assumptions, will produce the same estimates of value. However, in practice, which of the following errors can result in different value estimates? a. Incomplete or inconsistent earnings and cash flow forecasts b. Inconsistent estimates of weighted average costs of capital c. Incorrect continuing value computations d. All of these errors result in different value estimates. 18. Clean surplus accounting assumes that accounting for net income and book value of shareholders’ equity include all income and ______ between the firm and the common equity shareholders. Select the best term to complete the sentence. a. all direct capital transactions b. expenses 19. Residual income is the: a. difference between the net sales that the analyst expects the firm to generate and the required earnings of the firm. b. difference between the net income that the analyst expects the firm to generate and the required earnings of the firm. c. difference between the common stock that the analyst expects the firm to issue and the required earnings of the firm. d. difference between the expenses that the analyst expects the firm to generate and the required earnings of the firm. 20. Residual income is: a. adjusted net income the firm reports. b. the difference between the net income the analyst expects the firm to generate and the required earnings of the firm. c. the difference between the net income the analyst expects the firm to generate and the reported earnings of the firm. d. the book value of common equity capital at the beginning of the period multiplied by the required rate of return on common equity capital. 21. In some industries, competitive dynamics eventually drive long-run projections of the future returns earned by the firm to an equilibrium level equal to the long-run expected cost of equity capital in the firm. At that point, a firm can be expected to earn ____________ residual income in the future. a. increasing b. zero c. decreasing d. There is not enough information to answer this question

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Chap 13_10e 22. Assume that a firm had shareholders' equity on the balance sheet at a book value of $1,500 at the beginning of the year. During the year the firm earns net income of $1,900, pays dividends to shareholders of $200, and issues new stock to raise $500 of capital. The book value of shareholders’ equity at the end of the year is: a. $2,750 b. $250 c. $1,450 d. $3,700 23. Residual income valuation focuses on ______ as a periodic measure of shareholder wealth creation. Select the best term to complete the sentence. a. dividends b. earnings 24. When debating the issue of whether to use free cash flows or earnings in a valuation model, economists sometimes argue that ______ can be subject to purposeful management by a firm and thus make them less useful. Select the best term to complete the sentence. a. dividends b. earnings 25. The two most popular discounted earnings models appear to be: a. free cash flow and dividend discount model. b. sales/market capitalization and price-earnings. c. discounted abnormal earnings and residual income. d. price-cash flow and dividend discount. 26. Residual income in a long-run steady-state growth period is referred to as: a. dynamic residual income b. realistic residual income c. continuing residual income d. equilibrium residual income 27. Over the life of the firm, the present value of future earnings, cash flows, and ______ will produce the same estimate of a firm's value. Select the best term to complete the sentence. a. dividends b. revenues 28. If an analyst expects a firm to generate net income each period exactly equal to required earnings, then the value of the firm will be equal to the ______ of common shareholders' equity. Select the best term to complete the sentence. a. book value b. market value

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Chap 13_10e 29. ______ is the amount by which expected future earnings exceed the required earnings. Select the best term to complete the sentence. a. Forecasted cash b. Residual income 30. What would be Jarrett’s common shareholders' equity at the end of Year 3? a. $180,909 b. $208,161 c. $95,540 d. $112,768 Jarrett Corp. At the end of Year 0 Jarrett Corp. developed the following forecasts of net income:

Year 1 2 3 4 5

Forecasted Net Income $20,856 $22,733 $24,552 $27,252 $29,978

Management believes that after Year 5 Jarrett will grow at a rate of 7% each year. Total common shareholders' equity was $112,768 on December 31, Year 0. Jarrett has not established a dividend and does not plan to paying dividends during Year 1-5. Its cost of equity capital is 12%. 31. Compute the value of Jarrett Corp. on January 1, Year 1, using the residual income valuation model. Use the half-year adjustment. a. $112,768 b. $185,329 c. $195,540 d. $133,624 32. Required earnings are the: a. adjusted net income multiplied by the required rate of return on common equity capital. b. net income the analyst expects the firm to generate multiplied by the required rate of return on common equity capital. c. the market value of common equity capital at the beginning of the period multiplied by the required rate of return on common equity capital. d. the book value of common equity capital at the beginning of the period multiplied by the required rate of return on common equity capital.

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Chap 13_10e 33. Residual income valuation focuses on: a. dividend-paying capacity in free-cash flows. b. earnings as a periodic measure of shareholder wealth creation. c. free cash flows as a periodic measure of shareholder wealth creation. d. dividends as a periodic measure of shareholder wealth creation. 34. Economists sometimes argue that earnings are not a ______ attribute on which to base valuation. Select the best term to complete the sentence. a. simple b. value-relevant 35. The residual income valuation model uses ______ and the book value of common shareholders' equity as the basis for valuation. Select the best term to complete the sentence. a. expected cash flows b. expected future net income 36. Over sufficiently long periods, ______ equals free cash flows to common equity. Select the best term to complete the sentence. a. earnings before interest and taxes b. net income 37. Residual income will be greater than zero when: a. the firm's reported net income exactly equals the required level of earnings necessary to cover the cost of equity capital. b. the firm's expected future income is greater than the required level of earnings necessary to cover the cost of equity capital. c. the firm's expected future income exactly equals the required level of earnings necessary to cover the cost of equity capital. d. the firm's expected future income is less than the required level of earnings necessary to cover the cost of equity capital. 38. Which of the following would likely be the most useful when valuing a dot.com company? a. Net asset value b. Dividend yield c. Discounted cash flow d. Price-earnings 39. Over the life of a firm, the capital invested in the firm by the shareholders plus the income of the firm will reflect: a. the dividend paying ability of the firm. b. the free cash flows available to shareholders. c. the value of the firm to shareholders. d. the value of the firm for debtholders and shareholders.

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Chap 13_10e 40. Clean surplus accounting uses ______ in the residual income valuation model. Select the best term to complete the sentence. a. comprehensive income b. net income 41. Accounting earnings numbers provide a basis for valuation because earnings are the primary measure of ______ produced by the accrual accounting system. Select the best term to complete the sentence. a. firm performance b. shareholder wealth creation 42. Which of the following is probably the least likely reason for acquirers to pay too much in an acquisition? a. Overbidding b. Over optimistic appraisal of market potential c. Over estimation of synergies d. Overuse of conventional financial statements 43. If an analyst expects a firm to generate net income each period exactly equal to required earnings, then the value of the firm will be: a. exactly equal to the book value of common shareholders' equity. b. greater than the book value of common shareholders' equity. c. less than the book value of common shareholders' equity. d. exactly equal to working capital. 44. Accounting for the residual income in a firm with 100% dividend payout can be expressed as follows: RIt = CIt - ______ x BVt-1 Select the best term to complete the sentence. a. D b. PV c. R 45. To measure a firm’s economic performance and position in a given period, it makes sense to measure all of the following except: a. The daily free cash flow published by the Wall Street Journal b. Expenses incurred for resources consumed in that period c. A portion of the long-lived resources consumed during that period d. The cost of commitments made during that period to pay retirement benefits to employees in future periods 46. If investors have invested $20,000 of common equity in a company and it is determined that the required earnings of the company are $1,250 each period, then investors must expect to earn what return? a. the risk free rate b. 9% c. 6.25% d. the market premium

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Chap 13_10e 47. Over the life of a firm, the capital invested in the firm by the shareholders plus the income of the firm will reflect the ______ to the shareholders. Select the best term to complete the sentence. a. dividends b. value of the firm 48. ______ are the fundamental, value-relevant attribute of expected future returns. Select the best term to complete the sentence. a. Cash balances b. Dividends c. Revenues 49. The foundation for residual income valuation is the classical ______. a. dividends-based valuation b. debt-based valuation

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Chap 13_10e Answer Key 1. a 2. a 3. d 4. a 5. a 6. c 7. a 8. d 9. a 10. c 11. c 12. d 13. b 14. c 15. a 16. a 17. d 18. a 19. b 20. b 21. b 22. d 23. b 24. b 25. c 26. c

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Chap 13_10e 27. a 28. a 29. b 30. a 31. b 32. d 33. b 34. b 35. b 36. b 37. b 38. c 39. c 40. a 41. a 42. d 43. a 44. c 45. a 46. c 47. b 48. b 49. a

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Chap 14_10e Indicate the answer choice that best completes the statement or answers the question. 1. Industries with relatively high market-to-book ratios are more likely to have ______ assets. Select the best term to complete the sentence. a. off-balance-sheet b. intangible 2. The risk of the firm increases the ______. a. equity capital b. equity cost of capital 3. The value-to-book ratio reflects an analyst's expectation of the firm's ______ value to book value. Select the best term to complete the sentence. a. absolute b. intrinsic 4. Under the value-to-book model new projects will be less profitable only when: a. ROCE equals ROA b. ROCE equals RE c. ROCE is greater than RE d. ROCE is less than RE 5. To estimate security's risk-neutral value we can use the ______ and risk-free rates of return. Select the best term to complete the sentence. a. residual income model b. dividend model 6. Which of the following normally does not introduce measurement error into the calculation of P/E ratios? a. differences in firm specific growth rates b. restructuring losses c. transitory gains d. deferred taxes 7. All of the following are economic factors that can cause a firm’s price-earnings ratio to be higher than that of

other firms in the same industry except: a. when investors expect that the firm’s strategy enables it to generate and sustain greater profitability for a given cost of equity capital b. when the firm earns the same profitability but with lower risk and, therefore, a lower cost of equity capital c. a firm’s business model that enables it to generate faster growth in earnings provided the growth creates positive residual ROCE d. a firm’s business model that results in slower growth in earnings and this creates negative residual ROCE

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Chap 14_10e 8. A company is expected to generate $175,000 in earnings next period and requires a 20% return on equity capital. Using the assumptions of the price-earnings ratio, what would be the company's value at the beginning of next period? a. $781,250 b. $1,250,000 c. $2,000,000 d. $875,000 9. The PE multiple assumes that firm value is the present value of a constant stream of expected ______, discounted at a constant expected future discount rate. Select the best term to complete the sentence. a. dividends b. future earnings 10. Firms with low P/E ratios tend to have current residual income that is greater than: a. future actual income. b. future residual income. c. past actual income. d. past residual income. 11. Which of the following is not a reason why price-earnings ratios would differ across firms? a. Risk b. Profitability c. Growth d. Operating leverage 12. All of the following are accounting factors that will cause a firm’s value-to-book ratio to decrease over time except: a. recognizing unrealized gains on assets b. a loss of competitive advantage through changes in technology or other factors c. earning a high ROCE (above the equity cost of capital) on off-balance-sheet R&D assets d. earning a high ROCE (above the equity cost of capital) on off-balance-sheet intangible assets (such as

brand equity) over time 13. In the value-to-book model growth adds value to shareholders only if the growth is ______. a. abnormally profitable or high b. constant 14. Companies value-to-book and market-to-book ratios may differ due to accounting reasons. An example of an accounting reason that would create a difference is: a. accelerated methods of depreciation. b. investments in successful research and development programs that are expensed according to conservative accounting principles. c. using LIFO versus FIFO for inventory. d. high operating leverage. Copyright Cengage Learning. Powered by Cognero.

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Chap 14_10e 15. Economics teaches that, in equilibrium, firms will earn a return equal to the ______. a. cost of capital b. cost of debt 16. The market price of a share of common equity reflects the ______ of all of the market participants following that particular stock. Select the best term to complete the sentence. a. aggregated expectations b. analysts' expectations 17. The theoretical VE model does not work when the growth rate in earnings ______ the cost of equity capital. Select the best term to complete the sentence. a. exceeds b. is less than 18. The ______ represents the value of the firm, based on book value of equity and forecasts of expected future earnings, in the absence of discounting for risk. Select the best term to complete the sentence. a. risk-inclusive value b. risk-neutral value 19. Wolverwine Company’s current stock price is $55 per share and the company’s trailing earnings per share were $2.10. Given that analysts are forecasting growth of 12% for Wolverwine, what is the company’s PEG ratio? a. 21.2 b. 2.18 c. 2.97 d. 1.52 20. Studies have shown that 50-70% of the variability in PE ratios across firms comes from ______ and growth. Select the best term to complete the sentence. a. risk b. errors 21. Under the value-to-book model a firm in steady state equilibrium earning ROCE = RE will: a. create additional shareholder wealth and be valued above book value. b. maintain shareholder wealth and be valued at book value. c. destroy shareholder wealth and be valued below book value. d. be in a no-growth state. 22. A company with a PEG ratio greater than one would be interpreted as having a stock price: a. that is underpriced given earnings and expected earnings growth. b. that is low relative to the company’s growth prospects. c. that is high relative to the company’s growth prospects. d. that is exactly valued relative to it's growth prospects.

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Chap 14_10e 23. When a company has a high market to book ratio this could be a result of the company having ______. a. off-balance-sheet assets b. off-balance-sheet liabilities 24. Residual income is defined as: a. Difference between expected comprehensive income and required earnings by the firm b. Difference between comprehensive income and retained earnings c. Difference between comprehensive income and the company’s book value d. The addition of comprehensive income to net income for the year 25. Under the value-to-book model a firm will be valued below book value when: a. the ROCE is greater than RE b. the ROCE is equal to RE c. the ROCE is less than RE d. the firm's growth rate is above the industry average 26. A company is expected to have a value of $142,857 at the start of next period and investors require a 14 percent return on equity capital. Using the assumptions of the price-earnings ratio, what would be the company's earnings for the current year? a. $20,000 b. $14,286 c. $2,800 d. $12,500 27. The PEG ratio does not take into account differences in ______ and cost of equity capital across firms. Select the best term to complete the sentence. a. growth b. risk 28. Which of the following ratios give a perspective on risk in the capital structure? a. Book value per share b. Price/earnings ratio c. Degree of financial leverage d. Dividend yield 29. Firms with low P/E ratios tend to have current residual income that is greater than ______. a. current cash flows b. future residual income 30. Market multiples capture ______ valuation per dollar of book value or per dollar of earnings. Select the best term to complete the sentence. a. absolute b. relative

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Chap 14_10e 31. Which of the following would not be an example of the use of a multiple when valuing common equity? a. Price-to-operating cash flow b. Price-to-book. c. Price-to-earnings. d. Multi-period discounted earnings models. 32. The market price of a share of common equity reflects: a. the aggregated expectations of all of the market participants following that particular stock. b. the present value of future residual income. c. book value plus the present value of future residual income. d. the correct value for the particular stock. 33. All of the following are economic factors that will decrease a firm’s value-to-book ratio over time except: a. decreasing competition that drives the firm’s ROCE down b. increasing systematic risk that increases the firm’s equity cost of capital over time c. a loss of competitive advantage through changes in technology or other factors d. retaining earnings or issuing equity capital and deploying the capital in activities that generate ROCE

levels that are lower than current levels 34. Valuation using market multiples captures: a. absolute valuation per dollar of book value or per dollar of earnings. b. dollar of book value or dollar of earnings per dollar of common equity. c. relative valuation per dollar of book value or per dollar of earnings. d. intrinsic valuation per dollar of book value or per dollar of earnings. 35. All of the following are accounting factors that can drive a firm’s price-earnings ratio in a given period to be

higher than that of other firms in the same industry except: a. non-recurring expenses or losses in that period b. a greater degree of accounting conservatism that requires expensing R&D or other intangible assetgenerating activities c. a less conservative accounting stance that uses straight-line depreciation rather than accelerated methods d. a greater degree of accounting conservatism regarding accelerated depreciation of PP&E 36. The differences in industry market-to-book ratios may be the result of differences in growth, ROCE relative to RE, as well as differences in accounting ______. a. methods b. principles

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Chap 14_10e 37. Strictly speaking, the price-earnings ratio assumes that firm value is the: a. future value of a constant stream of expected future earnings, discounted at a constant expected future risk-free rate. b. future value of a constant stream of expected future earnings, discounted at a constant expected future discount rate. c. present value of a constant stream of expected future earnings, discounted at a constant expected future risk-free rate. d. present value of a constant stream of expected future earnings, discounted at a constant expected future discount rate. 38. Trading on the equity is likely to be a good financial strategy for stockholders of companies having: a. Cyclically high and low amounts of reported earnings. b. Steadily declining amounts of reported earnings. c. Volatile fluctuations in reported earnings over short periods of time. d. Steady amounts of reported earnings. 39. Which of the following ratios usually reflects investor’s opinions of the future prospects for the firm? a. Earnings per share b. Dividend yield c. Price/earnings ratio d. Book value per share 40. Book value per share may not approximate market value per share because: a. Land may have substantially increased in value. b. Market value reflects future potential earning power. c. Investments may have a market value substantially above the original cost. d. All of these are reasons why book value per share may not approximate market value per share. 41. Assuming that Ska Company’s cost of equity capital is 14% and it expects to grow earnings at a rate of 8% per year, we would expect Ska’s P/E ratio to be: a. 8 b. 16.7 c. 14 d. 4.5 42. The value-to-book model indicates that a firm in steady state equilibrium earnings ROCE=RE will be valued at ______. a. book value b. intrinsic value 43. Analysts use the PEG ratio to assess share price relative to earnings and expected ______. a. inflation b. earnings growth

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Chap 14_10e 44. One problem with the price-earnings ratio commonly reported is that: a. it divides share price, which reflects the present value of future earnings by historical earnings. b. it divides share price, which reflects the present value of book value by historical earnings. c. it does not take into consideration the present value of future earnings. d. it is based on analysts' expectations. 45. A company with a PEG ratio of less than one would be interpreted as having a stock price that is low relative to ______. a. it's competitors b. growth prospects Enter the appropriate word(s) to complete the statement. 46. The use of P/E ratios in valuation can result in measurement bias. What two items can result in measurement error and why?

47. What information can a PEG ratio provide about a company’s stock price? What does a PEG ratio greater than one mean? Less than one?

48. What is the value of reverse engineering stock prices? How does the process work?

49. What is a price differential and how is it computed? What information does a price differential provide to an analyst?

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Chap 14_10e 50. Why is book value often meaningless? What improvements to financial statements would make it more meaningful?

51. In research examining market efficiency, Bernard and Thomas examined quarterly earnings announcements. Discuss how Bernard and Thomas test the issue of market efficiency and the results of their research.

52. If the market price of a share of stock is based on the expectations of all of the market participants and the trading volume in that stock, what would happen if the company’s reputation were damaged by a scandal or defective product that caused personal injury or death?

53. A firm's value-to-book and market-to-book ratios may differ from one for a number of reasons. Discuss how a successful, internally funded research and development program would create a situation where the value-tobook and market-to-book ratios differ from one another.

54. Explain the analysts’ role in making the capital markets efficient.

55. Discuss how risk and profitability factors cause differences in price-earnings ratios across firms. Explain the difference between abnormal and normal earnings.

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Chap 14_10e Answer Key 1. a 2. b 3. b 4. d 5. a 6. d 7. c 8. d 9. b 10. b 11. d 12. b 13. a 14. b 15. a 16. a 17. a 18. b 19. b 20. a 21. b 22. c 23. a 24. a 25. c 26. a

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Chap 14_10e 27. b 28. c 29. b 30. b 31. d 32. a 33. a 34. c 35. c 36. a 37. d 38. d 39. c 40. d 41. b 42. a 43. b 44. a 45. b

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Chap 14_10e 46. 1.

Growth - Simple P/E ratios do not take into account firm-specific differences in longterm earnings growth. 2. Transitory earnings - Past earnings are historical and may not be indicative of expected future “permanent” earnings levels. If historical earnings contain transitory gains or losses, or other components of income that are not expected to recur, they can cause P/E ratios to vary.

47. Analysts use the PEG ratio as a rule of thumb to assess share price relative to earnings and expected future earnings growth rates. Proponents assert that companies with PEG ratios greater (or less) than one have stock prices that are high (or low) relative to future growth prospects. 48. The process allows the analyst to infer a set of assumptions that appear to be impounded in a company’s stock price. The analyst can then assess whether the assumptions the market appears to be making are realistic, optimistic, or pessimistic. The process of reverse engineering stock prices assumes that intrinsic value equals market price and then solves for the assumptions the market appears to making in order to value the firm’s shares at the market price. 49. The price differential is the amount the market has discounted share price for risk. It is calculated by subtracting the market price from the residual income model price calculated using the risk-free rate of interest as opposed to the firm's equity cost of capital. It allows the analyst to gauge whether the market discount for risk is sufficient to compensate the investor to hold the firm's shares and bear risk. 50. Book value is based on a mixture of valuation bases, such as historical costs. Current value accounting should make book value closer to market. 51. Bernard and Thomas examined market efficiency by forming 10 portfolios each quarter over the period 1974 to 1986 based on the size of firms' standardized unexpected earnings (SUE). They then calculated the abnormal returns for each portfolio for the 60 days prior to and including the release of earnings. Portfolios made up of the largest SUEs increased during this period, while portfolios made up of the lowest SUEs decreased. However, post-announcement abnormal returns followed this same trend, suggesting that security participants do not immediately react to the information in earnings announcements. 52. The market participants probably would not want to be associated with a company whose reputation has been tarnished. They would sell off their shares, which would cause a high volume of trading for that stock, and price would fall due to the lack of faith in the company by the investing public. If the company does not rehabilitate their reputation, earnings may fall and the possibility of bankruptcy would be possible.

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Chap 14_10e 53. Because research and development activities are expensed when incurred under U.S. GAAP, a successful program would lead to a high amount of off-balance-sheet assets and off-balance-sheet common shareholders' equity. The offbalance-sheet assets generate income; however, the shareholders' equity is understated, so ROCE will be relatively high. 54. Analysts play a key role in making the capital markets efficient by being active acquirers and processors of valuerelevant information and actively seeking and trading on shares they believe to be temporarily mispriced. By acquiring and processing information and trading, analysts help make the capital markets more efficient. 55. Abnormal earnings are referred to as residual income. Residual income is the difference between expected comprehensive income in year x and required earnings of the firm in year x. Residual income measures the amount of wealth that the firm will create (or destroy). Normal earnings or required earnings is the product between the required rate of return on common stock equity times the book value of common stock equity at the beginning of the year.

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