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2006 Schweser Study Program Page 61

Study Session 7Cross-Reference to CFA Institute Assigned Reading White et al., Chapter 2

EXAM FLASHBACKS

Required CFA Institute disclaimer:Due to CFA curriculum changes from year to year, published sample exam questions and guideline answers prior to the current year may not reflect the current curriculum.

Exam Flashback # 1Source: Question #87 from 91 actual exam.

As a general rule, revenue is normally recognized when:A. it is measurable.B. it is measurable and received.C. the earnings process is complete and cash receipt is assured.D. the measurement process is complete.

Exam Flashback # 2Source: Question #65 from 9903 sample exam.

If a company recognizes revenue earlier than justified under accrual accounting, which of the following best describes the impact on accounts receivable and inventory, respectively?

Accounts Receivable InventoryA. Overstated OverstatedB. Overstated UnderstatedC. Understated OverstatedD. Understated Understated


The following are examples of unusual or infrequent items EXCEPT:A. Gains or losses from disposal of a portion of a business segment.B. Losses resulting from foreign government expropriation of assets.C. Provisions for environmental remediation.D. Impairments, write-offs, write-downs, and restructuring costs.

Exam Flashback # 4Source: Question #51 from 93 actual exam and 9798 sample exam.

For a material item to be classified as an extraordinary item on the income statement, the item must be:A. estimated and probable.B. current and unusual in frequency.C. probable and infrequent in nature.D. unusual in nature and infrequent in occurrence.

Exam Flashback # 5Source: Question #52 from 93 and 96 actual exams and 9798 sample exam.

When a company discontinues and disposes of an operation, the action is considered:A. an extraordinary item.B. a prior period adjustment.C. a cumulative effect of a change in an accounting principle.D. separately and shown net of taxes on the income statement.

2006 Schweser Study Program


Exam Flashback # 6 Source: Question #58 from 93 and 96 actual exams and 9798 sample exams.

Which one of the following is a change in an accounting principle?A. A change from FIFO to LIFO.B. Recording a prior period adjustment.C. A change in the estimated service life of machinery.D. Recording depreciation expense for the first time on machinery purchased five years ago.


All of the following are general categories of nonrecurring items EXCEPT:A. unusual or infrequent items.B. discontinued operations.C. capitalization of leases.D. accounting changes.

Exam Flashback # 8Source: Question #58 from 1996 actual exam and 9798 sample exams.

A firm discovered that it had used an incorrect accounting principle in 1996. On the firms 1997 financial statements, this firm should report the impact of this error as:A. an extraordinary item. B. a nonrecurring item. C. part of cost of goods sold. D. a prior period adjustment.


At the time Marsh became a subsidiary of Ross, Marsh switched depreciation of its plant assets from sum-of-the-years digits to straight-line that was used by Ross. With respect to Marsh, this change was a:A. change in an accounting estimate.B. change in a reporting entity.C. correction of an error.D. change in accounting principle.



ANSWERS EXAM FLASHBACKS

1. C The firm must have provided virtually all of the goods or services for which it is to be paid, and the expected cost of providing the service must be measurable. The company must also be able to reasonably estimate the probability of payment.

2. B Premature recognition of revenue will result in an artificially high accounts receivable balance. If COGS is measured under the matching principle, then it too will be overstated along with revenue. This results in inventories being understated.

3. B Losses resulting from foreign government expropriation of assets are considered to be extraordinary items.

4. D Extraordinary items are events that are both unusual and infrequent in occurrence, and material in nature.

5. D The income or loss from discontinued operations is reported separately and net of taxes. Past income statements must be restated, separating the income or loss from the discontinued operations.

6. A A change from FIFO to LIFO is a change in accounting principle.

7. C The capitalization of leases is not considered a nonrecurring item.

8. D Using an incorrect accounting principle is a nonrecurring item that can be remedied with an accounting adjustment so it is reported as a prior period adjustment.

9. D Changing depreciation methods is a change in accounting principle.



EXAM FLASHBACKS

Required CFA Institute disclaimer: Due to CFA curriculum changes from year to year, published sample exam questions and guideline answers prior to the current year may not reflect the current curriculum.

Exam Flashback # 1Source: Question #68 from 9903 sample exams.

In the Statement of Cash Flows, which of the following best describes whether interest received and interest paid, respectively, are classified as operating or investing cash flows?

Interest Received Interest PaidA. Operating OperatingB. Operating InvestingC. Investing OperatingD. Investing Investing


Which of the following is reported as a noncash financing transaction on a firms statement of cash flows?A. Repayment of long-term debt.B. Purchase of treasury stock.C. Sale of preferred stock.D. Conversion of bonds payable into common stock.

Exam Flashback # 3 Source: Question #61 from 9903 sample exams.

An analyst gathered the following information about a company for a fiscal year:

Cash paid for land $30,000Depreciation expense 10,000Cash paid for salaries 60,000Cash paid to suppliers 40,000Cash collected from customers 150,000Cash paid for interest to bondholders 20,000Cash collected from the sale of equipment 75,000

If the company is not subject to income taxes, the net cash flow from operations for the fiscal year is closest to:A. $20,000.B. $30,000.C. $50,000.D. $75,000.



Exam Flashbacks # 4, 5, & 6The following questions should be answered according to the provisions of SFAS 95 Statement of Cash Flows and using the following data.

Cash payment for interest ($12)Retirement of common stock (32)Cash payment to merchandise suppliers (85)Purchase of land (8)Sale of equipment 30Payments of dividends (37)Cash payment for salaries (35)Cash collection from customers 260Purchase of equipment (40)

Exam Flashback # 4Source: Question #53 from 91, 94, and 96 actual exams and 9798 sample exams.

Cash flows from operating activities are:A. $91.B. $128.C. $140.D. $175.


Using the data above, cash flows from investing activities are:A. $67.B. $48.C. $18.D. $10.


Using the data above, cash flows from financing activities are:A. $81.B. $69.C. $49.D. $37.

Exam Flashbacks # 7, 8, 9, 10Use the following data to answer the next four questions. The cash flow data of Palomba Pizza Stores for the year ended December 31, 1991, is as follows:

Cash payment of dividends $35,000Purchase of land 14,000Cash payments for interest 10,000Cash payments for salaries 45,000Sale of equipment 38,000Retirement of common stock 25,000Purchase of equipment 30,000Cash payments to suppliers 85,000Cash collections from customers 250,000Cash at beginning of year 50,000




What is the net cash provided by operating activities?A. $95,000.B. $100,000.C. $110,000.D. $125,000.


What is the net cash provided by or used in investing activities?A. ($6,000).B. $0.C. $6,000.D. $20,000.


What is the net cash provided by or used in financing activities?A. ($60,000).B. ($24,000).C. $38,000.D. $60,000.


What is Palombas cash balance at year end?A. $44,000.B. $50,000.C. $87,000.D. $94,000.


A firm has new sales of $3,000, cash expenses (including taxes) of $1,400 and depreciation of $500. If accounts receivable increase over the period by $400, cash flow from operations equals:A. $1,200.B. $1,600.C. $1,700.D. $2,100.




The following information was available for the Saunders Company for 1990:

Net Income $132Exchanged equity for debt 34Amortization of bond premium 18Decrease in inventory 42Increase in accounts payable 30Retirement of common stock 45Payment of dividends 18Depreciation expense 25

What was Saunders net cash flows from operations?A. $169.B. $211.C. $245.D. $246.




1. A Both interest paid and interest received are classified as operating cash flows.

2. D Conversion of bonds to common stock is an exchange of one security or claim on the firms assets for another. It is a noncash transaction.

3. B The direct method for calculating CFO can be used to answer the question.

Cash collected from customers $150,000Cash paid for salaries ($60,000 )Cash paid to suppliers ($40,000 )Cash paid for interest to bondholders ($20,000 )CFO $30,000

Depreciation expense is a noncash item and is not used in the direct method calculation. Cash paid for land and received from the sale of equipment are components of CFI.

4. B The direct method for calculating CFO can be used to answer the question.

Cash collection from customers 260 Cash payment to merchandise suppliers (85 )Cash payment for salaries (35 )Cash payment for interest (12 )CFO 128

5. C The components of CFI include cash used to acquire long-term assets (plant, property, and equipment) and cash received from the sale of these assets. CFI is calculated as:

Purchase of land $(8 )Sale of equipment 30Purchase of equipment (40 )CFI (18 )

6. B The components of CFF include cash used to retire debt, repurchase equity, and to pay dividends. Cash received from new borrowing and equity issues is also included. In this case CFF is calculated as:

Retirement of common stock $(32 )Payments of dividends (37 )CFF (69 )

7. C The direct method for calculating CFO can be used to answer the question.

Cash collection from customers $250,000

Cash payment to suppliers (85,000)Cash payment for salaries (45,000)Cash payment for interest (10,000)

CFO 110,000



8. A The components of CFI include cash used to acquire long-term assets (plant, property, and equipment) and cash received from the sale of these assets. CFI is calculated as:

9. A The components of CFF include cash used to retire debt, repurchase equity, and to pay dividends. Cash received from new borrowing and equity issues is also included. In this case CFF is calculated as:

Retirement of common stock $(25,000)Payments of dividends (35,000)CFF (60,000)

10. D The ending cash balance is equal to the beginning cash balance plus the net cash flow for the period.

CFO $110,000CFI (6,000 )CFF (60,000 )Net increase in cash 44,000Beginning cash 50,000Ending cash 94,000

11. A Direct method:

Step #1 Net sales $3,000 A/R (use) (400 )Cash collections 2,600

Step #2 Cash inputs 0Step #3 Expenses (1,400 )

Cash flow from operations 1,200

12. B The indirect method for calculating CFO can be used to answer the question.

Net income $132Decrease in inventory $42Increase in accounts payable $30Depreciation expense $25Amortization of bond premium ($18 )CFO $211

Amortization of the bond premium is included because if a bond is issued at a premium, the booked interest expense will be less than the actual cash interest paid. The premium amortization represents the difference between the booked interest expense and the actual cash interest paid; therefore, it must be deducted to fully reflect the cash outlay related to the cost of the debt. Retirement of common stock and payment of dividends are both financing cash flows. The exchange of equity for debt is a noncash transaction. These details are covered in our review of bond discounts and premia in Study Session 10.

Purchase of land (14,000)

Sale of equipment 38,000Purchase of equipment (30,000)CFI (6,000)


Study Session 8Cross-Reference to CFA Institute Assigned Reading Reilly and Brown, Chapter 10

EXAM FLASHBACKS

Required CFA Institute disclaimer:Due to CFA curriculum changes from year to year, published sample exam questions and guideline answers prior to the current year may not reflect the current curriculum.

Exam Flashback # 1Source: Question #52 from 9903 sample exams and question #39 from 96 actual exam.

A companys current ratio is 2.0. If the company uses cash to retire notes payable that are due within one year, would this transaction most likely increase or decrease the current ratio and asset turnover ratio, respectively?

Current Ratio Asset Turnover RatioA. Increase IncreaseB. Increase DecreaseC. Decrease IncreaseD. Decrease Decrease

Exam Flashback # 2 Source: Question #54 from '99, '0103 sample exams.

Two companies are identical except for substantially different dividend payout ratios. After several years, the company with the lower dividend payout ratio is most likely to have:A. lower stock price.B. higher debt-to-equity ratio.C. less rapid growth of earnings per share.D. more rapid growth of earnings per share.


An analyst applied the DuPont system to the following data for a company:

Equity turnover 4.2Net profit margin 5.5%Total asset turnover 2.0Dividend payout ratio 31.8%

The companys return on equity is closest to:A. 1.3%.B. 11.0%.C. 23.1%.D. 63.6%.


Study Session 8Cross-Reference to CFA Institute Assigned Reading Reilly and Brown, Chapter 10


1. A The current ratio will likely increase because there are twice as many current assets as there are liabilities. Thus, for a fixed dollar reduction in both, the proportion of decline in liabilities will be greater than that for the assets. Likewise, for a given level of sales, the asset turnover ratio will increase due to the reduction in assets.

If you dont have good intuition for this type of question, create a simple example for yourself. To illustrate, suppose we have a firm with net sales = 1,000, total assets = 500, current assets = 200, and current liabilities = 100. Thus, the current ratio = 200 / 100 = 2 and the total asset turnover ratio = 1,000 / 500 = 2. Now consider a reduction in notes payable by 50. Both cash and notes payable fall by 50 as will current assets, current liabilities, and total assets. The new current ratio is 150 / 50 = 3 and the new asset turnover ratio is 1,000 / 450 = 2.2.

2. D All else equal, a higher retention ratio will result in more rapid earnings growth.

3. C ROE is equal to the net profit margin multiplied by the equity turnover ratio.Thus, ROE = 0.055 4.2 = 0.231 or 23.1%.


Study Session 8Cross-Reference to CFA Institute Assigned Reading Kieso and Weygandt, Chapter 16

EXAM FLASHBACKS



A company is deemed to have a complex capital structure if it has:A. potentially dilutive securities.B. both preferred and common stock outstanding.C. weighted average cost of capital greater than the rate of return on equity.D. common stock that is less than 20% of its total capital structure.


An analyst gathered the following information about a company whose fiscal year end is December 31:

Net income for the year was $10.5 million.Preferred stock dividends of $2 million were paid for the year.Common Stock dividends of $3.5 million were paid for the year.20 million shares of common stock were outstanding on January 1, 2001.The company issued 6 million new shares of common stock April 1, 2001.The capital structure does not include any potentially dilutive convertible securities, options, warrants, and other contingent securities.

The companys basic earnings per share for 2001 was closest to:A. $0.35.B. $0.37.C. $0.43.D. $0.46.


In computing the weighted average number of shares for the computation of earnings per share, reacquired shares should:A. not be included at all.B. be excluded from the date of acquisition.C. be included as though they had been outstanding for the entire period.D. be treated the same as stock splits or stock dividends.


Peak Products had two million shares outstanding on December 31, 1997. On March 31, 1998, Peak paid a 10% stock dividend. On June 30, 1998, Peak sold $10 million of 7% convertible debentures, convertible into common at $5 per share. On September 30, 1998, Peak issued and sold 100,000 shares of common stock at par. Basic earnings per share for 1998 will be computed on the following number of shares:A. 2,225,000.B. 2,250,000.C. 3,225,000.D. 3,250,000.



Exam Flashback # 5, 6, 7

The Wrestling Federation of America, Inc.Capital Structure and Earnings for the Year 1987Number of Common Shares Outstanding at Year End 2,700,000Weighted Average Number of Common Shares Outstanding During 1987 2,500,000Weighted Average Market Price per Common Share During 1987 $20300,000 Options Outstanding During 1987: Exercise Price $15$1,000 Par Value Convertible Bonds Outstanding (December 1983 Issue): Number 10,000Shares of Common Issuable on Conversion (per Bond) 10Coupon Rate 5.0%Net Income for 1987 $6,500,000Tax Rate for 1987 40.0%


Basic earnings per share for 1987 were:A. $2.45.B. $2.57.C. $2.60.D. $2.65.


Using the treasury stock method, how many shares should be added to the denominator to adjust it for the options in calculating diluted earnings per share?A. 50,000.B. 75,000.C. 100,000.D. 225,000.


Diluted earnings per share for 1987 were:A. $2.43.B. $2.48.C. $2.52.D. $2.54.




1. A A complex capital structure contains potentially dilutive securities such as options, warrants, or convertible securities.

2. A Basic EPS = (net income preferred dividends) / weighted average shares outstanding

3. B Reacquired shares should be excluded from the computation from the date of reacquisition.

4. A Note: you are doing basic so dont consider convertibles.

Original shares 2,000,000 (12) = 24,000,000Stock dividends 200,000 (12) = 2,400,000New shares 100,000 (3) = 300,000Sum 26,700,000/12 = 2,225,000

5. C

6. B

7. C First determine whether the conversion of the bonds is dilutive or antidilutive. To do this, we first need to calculate the after-tax interest payments, or (interest paid)(1 tax rate) = ($1,000 10,000 0.05)(1 0.40) = $300,000. The bonds are convertible into 100,000 shares of common stock.

The bond conversion is antidilutive because its per share impact is greater than basic EPS of $2.60.

Without knowing the bond is antidilutive, the calculation would be:

Keep an eye out for this kind of question on the exam; the obvious answer may not always be the correct one.

[(20,000,000 12) (6,000,000 9)]weighted average number of shares outstanding 24,500,000

12

+ = =

10,500,000 2,000,000basic EPS $0.347

24,500,000= =

$6,500,000basic EPS $2.60

2,500,000= =

$20 $15300,000 shares 75,000 shares

$20 =

$300,000$3.00

100,000=

$6,500,000 $2.52 fully-diluted EPS

2,500,000 75,000= =+

6,500,000 300,0002.54

2,500,000 75,000 100,000

+ =+ +



Exam Flashback # 4Under FIFO, the 1989 retained earnings of Zeta would have been different by:A. ($4,000).B. $4,000.C. $17,500.D. $32,500.

Exam Flashback # 5If FIFO had been used for both years, the 1989 cost of goods sold would have changed by:A. ($4,000).B. ($2,600).C. $1,400.D. $4,000.

Exam Flashback # 6If FIFO has been used for both years, the 1989 net income would have changed by:A. ($2,600).B. $1,400.C. $2,600.D. $4,000.

Exam Flashback # 7Source: Question #62 from 94 actual exam and 0103 sample exams.

During a period of rising price levels, the financial statements of a company using FIFO instead of LIFO for inventory accounting will show:A. lower total assets and lower net income.B. lower total assets and higher net income.C. higher total assets and lower net income.D. higher total assets and higher net income.


During a period of falling price levels, the financial statements of a company using FIFO instead of LIFO for inventory accounting would show:A. lower total assets and lower net income.B. lower total assets and higher net income.C. higher total assets and lower net income.D. higher total assets and higher net income.

Exam Flashback # 9Source: Question #62 from 92, 96 sample exams.

Which of the following combinations of accounting practices will lead to the highest reported earnings in an inflationary environment?

Depreciation Method Inventory MethodA. straight-line FIFOB. double declining balance LIFOC. double declining balance FIFOD. straight-line LIFO



Exam Flashback # 10 Source: Question #53 from 97, 98 sample exams.

A firm has a current ratio greater than 1.0. If the firms ending inventory is understated by $3,000 and the beginning inventory is overstated by $5,000, the firms operating income and the current ratio will be:

Net Income Current RatioA. understated by $2,000 lowerB. overstated by $2,000 lowerC. understated by $8,000 lowerD. understated by $8,000 higher

Exam Flashback # 11Source: Question #54 from 93, 96 actual exams and 97,98 sample exams.

If net purchases are overstated by $1,000 and ending inventory is overstated by $4,000, then net income is:A. overstated by $5,000.B. overstated by $3,000.C. overstated by $1,000.D. understated by $4,000.




1. B Ending inventory under LIFO = (400 $20) + (200 $22) = $8000 + $4400 = $12,400Ending inventory under FIFO = (200 $28) + (300 $26) + (100 $24) = $5600 + $7800 + $2400 = $15,800

2. C COGS FIFO = COGS LIFO (ending LIFO reserve beginning LIFO reserve)COGS FIFO = $16,000 ($4,000 $1,500) = $16,000 $2,500 = $13,500

3. D FIFO inventory = LIFO inventory + LIFO reserve$420,000 + 50,000 = $470,000

4. D Retained earnings = LIFO reserve (1 tax rate)Retained earnings = 50,000 (1 0.35) = $32,500

5. A COGS = LIFO reserveIf LIFO reserve increases, COGS will fall (), causing income to rise.

6. C Net income = LIFO reserve (1 tax rate)Net income = 4,000 (1 0.35) = $2,600

7. D FIFO results in higher inventory values and thus, higher total asset values. FIFO also results in lower COGS and higher net income.

8. A FIFO results in lower inventory values and, thus, lower total asset values. FIFO also results in higher COGS and lower net income.

9. A Remember, FIFO gives you a large inventory and a small COGS, so reported income is greater.

10. C From the relation COGS = purchases + beginning inv ending inv we can see that if the beginning inventory is overstated by $5,000, COGS is overstated by $5,000 and operating income is understated by $5,000. If ending inventory is understated by $3,000, COGS is overstated by $3,000 and operating income is understated by $3,000. Thus, the total understatement of operating income is $5,000 + $3,000 = $8,000. The ending inventory is understated, so current assets are understated and the current ratio (CA/CL) is lower than it otherwise would be if inventory was accounted for properly.

11. B Beg inventory + purchases COGS = ending inventoryBI (known) + P (over 1,000) COGS (+/ ?) = EI (over 4,000)COGS must be understated by 3,000Sales COGS = gross income Sales (known) COGS (under 3,000) = gross income (+/ ?)Gross income must be overstated by 3,000.



EXAM FLASHBACKS



Compared with firms that expense costs, firms that capitalize costs can be expected to report:A. higher asset levels and lower equity levels.B. lower asset levels and lower equity levels.C. higher asset levels and higher equity levels.D. lower asset levels and higher equity levels.


Which of the following expenditures to build a new plant is least likely to be capitalized as property, plant, and equipment?A. Interest costs during construction.B. Freight expenses incurred shipping new machinery to the plant.C. Increases in the fair value of the plant assets during construction.D. Personnel expenses incurred to set up the new machinery before the plant begins operations.

Exam Flashback # 3Source: Question #60 from 93 and 96 actual exams and 9798 sample exams.

The capitalization of interest costs during construction:A. increases future net income.B. increases future depreciation expense.C. decreases net income during the construction phase.D. decreases future depreciation expense.

Exam Flashback # 4Source: Question #61 from 92 and 96 actual exams and 97-98 sample exams.

For companies in an expansion phase, capitalization of interest may result in a gain in earnings over an extended period because:A. the amount of interest amortization will not catch up with the amount of interest capitalized in the current period.B. the average projected expenditures for the period exceed specific borrowings.C. the cost of financing project debt exceeds the cost of equity financing.D. earnings are greater under capitalization than under the expense method over the life of the qualifying asset.


Software development costs incurred before and after a product is proven economically feasible are:A. expensed both before and after.B. capitalized both before and after.C. expensed before and capitalized after.D. capitalized before and expensed after.




1. C Capitalization causes asset levels to increase, which in turn increases equity levels.

2. C Under U.S. GAAP, increases in the fair value of the plant assets during construction are not capitalized. However, under IASB standards firms may report plant, property and equipment at fair value less accumulated depreciation. There appears to be no clear answer to this question. However, when faced with this dilemma, focus on two possible solutions: (1) review the question for a clearer understandingin this case, the italicized words least likely are one clarifying clue, and (2) if the conflict arises due to differences in U.S. GAAP and IASB GAAP, favor the response consistent with U.S. GAAP.

3. B The capitalization of interest costs will increase the book value of the asset and future depreciation expense. This will result in higher income during the construction phase and lower future net income.

4. A For firms in an expansion phase, and therefore incurring large amounts of investment outlays and financing, the amount of interest amortization will not likely catch up with the amount of interest capitalized in the current period for an extended period of time.

5. C All computer software development costs incurred to establish the technological or economic feasibility of software should be expensed (e.g., R&D). Subsequent costs may be capitalized as part of inventory.



EXAM FLASHBACKS


Exam Flashback # 1Source: Question #64 from 94, 96 actual exams and 97, 98 sample exams.

Which one of the following statements about straight-line depreciation is TRUE? Straight-line depreciation:A. results in a decreasing return on equity over the assets life.B. introduces a built-in increase in return on investment over the assets life.C. recognizes the increasing rate of obsolescence of an asset with the passage of time.D. results in higher total tax payments over the life of an asset than accelerated depreciation.

Exam Flashback # 2 Source: Question #63 from 93, 96 actual exams and 97, 98 sample exams.

To account for the purchase of a machine, a company may use either straight-line (SL) depreciation or the sum-of-the-years-digits depreciation (SYD). Return on investment for the machine will:A. initially be higher under SYD than under SL.B. remain constant under SL.C. decrease over time under SLD.D. initially be higher under SL than under SYD.

Exam Flashback # 3 Source: Question #100 from 90 actual exam.

The Haynes Company takes a full years depreciation expense in the year of an assets acquisition and no depreciation in the year of disposal. The following information is given on a depreciable asset:

Acquisition date 1/1/89Estimated useful life 5 yearsResidual value $20,000Cost $110,000Accumulated depreciation as of 12/31/89 $30,000

Assuming the company uses the same method in 1990, what will be the depreciation expense for 1990?A. $18,000.B. $22,000.C. $24,000.D. $30,000.

Exam Flashback # 4 Source: Question #75 from 00, 01, 02, 03 sample exams.

An analyst gathered the following information about a fixed asset purchase by a company:

Purchase price $12,000,000Estimated useful life 5 yearsEstimated salvage value $2,000,000

Using the double-declining-balance depreciation method, the companys depreciation expense in year 2 will be closest to:A. $2,000,000.B. $2,400,000.C. $2,880,000.D. $7,680,000.



Exam Flashback # 5 Source: Question #119 from 91 actual exam.

A machine is purchased for $3,000 and has an estimated useful life of five years. Its salvage value is estimated to be $550. Using double-declining balance, the depreciation charge for year three is:A. $360.00.B. $432.00.C. $500.00.D. $720.00.

Exam Flashback # 6 Source: Question #66 from 94, 96 actual exams and 97, 98 sample exams.

A firm using straight-line depreciation reports gross investment in fixed assets of $80 million, accumulated depreciation of $45 million, and annual depreciation expense of $5 million. The approximate average age of the fixed assets is:A. 7 years.B. 9 years.C. 15 years.D. 16 years.


Which of the following statements about impairment and appreciation of the value of long-lived assets is TRUE? Managers:A. may recognize gains and losses due to impaired assets only when those assets are sold.B. have considerable discretion about the timing and amount of recognized increase in value of appreciated assets.C. have considerable discretion about the timing and amount of impairment recognition for assets the firm intends to keep.D. may write-up the value of a previously-impaired asset to the original book value prior to impairment, if the asset recovers

its value.

Exam Flashback # 8 Source: Question #65 from 87, 88, 92, 96 actual exams.

Which of the following statements about accounting practices is TRUE?A. FIFO results in more conservative earnings figures, except during deflationary periods.B. Capitalization of interest results in higher earnings over the life of an asset.C. Interest may be capitalized for some assets intended for use by the firm, but not for

assets intended to be sold.D. In the absence of a decision to abandon or dispose of assets at a loss, the timing and amount of any write-down are largely

discretionary.


In 2001, Baxter Company owned machinery that became permanently impaired. As of December 31, 2001, the machinery had a book value of $800,000 and a market value of $100,000. Baxter also owned a warehouse that, as of December 31, 2001, had a book value of $1,200,000 and a market value of $2,500,000. Baxter:A. must recognize both the loss on the machinery and the gain on the warehouse in 2001.B. may recognize the loss on the machinery and the gain on the warehouse in 2001 or in later years.C. must recognize the loss on the machinery in 2001, but may not recognize the gain on the warehouse until it is sold.D. may recognize the loss on the machinery in 2001 or in later years, but may not recognize the gain on the warehouse until

it is sold.




1. B Straight-line depreciation will result in lower book values over time. Even with constant earnings, ROA will increase over time.

2. D Initially SYD depreciation is larger than SL depreciation. This will result in lower earnings and ROA for the SYD in the early years of investment.

3. C 30,000 is one years depreciation. Straight-line depreciation = (110,000 20,000) / 5 = $18,000Double declining balance = (110,000 0) (2 / 5) = $44,000Sum of years digits = (110,000 20,000) (5 / 15) = $30,000Therefore the firm is using SYD. So in the second year where n = 4, the depreciation is:(4 / 15) (110,000 20,000) = $24,000

4. C DDB = (cost accumulated depreciation) (2 / life)DDB1 = ($12,000,000 0) (2 / 5) = $4,800,000DDB2 = ($12,000,000 $4,800,000) (2 / 5) = $2,880,000

5. B Double declining balance = (cost - accumulated depreciation)(2 / years)Year 1: 3,000(0.4) = $1,200Year 2: (3,000 1,200)(0.4) = $720Year 3: (3,000 1,920)(0.4) = $432

6. B Average age = (accumulated depreciation) / (depreciation expense) = 45 / 5 = 9 yearsThe average age equation can only be used for firms employing straight-line depreciation.

7. C Managers have considerable discretion about the timing and amount of impairment recognition for assets the firm intends to keep. Under U.S. GAAP, firms are not allowed to write-up the value of assets when they appreciate, even if the asset was previously impaired.

8. D The response to A is falseLIFO results in more conservative income. COGS is higher and income is lower under LIFO. In foil B, interest capitalization converts current interest expense to future depreciation expense. Foil C is nonsensical. D is true. Management holds a great deal of discretionary power over the decisions regarding impairment recognition.

9. C Baxter must recognize the loss on the machinery in 2001 but may not recognize the gain on the warehouse until it is sold. You may be tempted to pick D because of the managerial discretion allowed in the impairment process. However, conservative accounting practices require write-downs as soon as the impairment is recognized, so choice C is the better response.



EXAM FLASHBACKS


Exam Flashback # 1Source: Question #66 from 99-03 sample exams.

When analyzing a companys leverage and liquidity, an analyst should consider deferred tax liabilities on a companys balance sheet:A. as equity.B. as long-term debt.C. as short-term debt.D. on a case-by-case basis.

Exam Flashback # 2Source: Question #66 from 93 and 96 actual exams, and 97-98 sample exams.

Which of the following statements about deferred taxes is true? Deferred taxes:A. will decrease only when a cash payment is made.B. are not found on the liability side of the balance sheet.C. result from permanent differences between taxable and reported earnings.D. that arise from depreciation of a particular asset will ultimately reduce to zero as the item is depreciated.


When a deferred tax liability account reverses:A. the actual tax bill is lower than the expense in the income statement.B. the actual tax paid is the same as the expense in the income statement.C. cash outflow is increased by the amount of the reversal.D. cash outflow is lessened by the amount of the reversal.

Exam Flashback # 4Source: Question #63 from 01-03 sample exams.

Delta Corp., a highly profitable company, purchased a new asset on January 1, 2001, for $1,000,000. The following information applies to the asset:

Depreciated straight-line over 10 years with no salvage valueThree-year MACRS depreciation class, with first year MACRS factor = 0.333Tax rate of 40%

The effect of the asset purchase on Deltas deferred tax liability for 2001 is closest to a:A. $233,000 decrease.B. $93,200 decrease.C. $93,200 increase.D. $233,000 increase.

Professors Note: MACRS is an accelerated depreciation schedule permitted for tax purposes. The factor of 0.333 just means that first year depreciation is 33.3 percent.



Exam Flashback # 5Source: Question #24 from 92 and 96 actual exams and 97-98 sample exams.

White Company has a temporary difference between the tax liability it reported to the government and the tax liability that appears on its financial statement. There was a deferred tax liability of $30.6 million. Under Statement of Financial Accounting Standards 96, an increase in the tax rate would have which of the following impacts on deferred taxes and net income:

Deferred Taxes Net IncomeA. Increase No effectB. Increase DecreaseC. No effect No effectD. No effect Decrease




1. D If deferred liabilities are expected to reverse in the future, they are best classified as liabilities. If, however, they are not expected to reverse in the future, they are best classified as equity.

2. D A particular asset has a finite useful life and, by definition, any tax differences for any one asset will reverse by the end of the assets useful life.

3. C A deferred tax liability is created when actual cash tax payments to the government are less than the tax expense reported on the income statement (e.g., depreciation is higher on the tax statement and lower on the income statement, implying that taxable income is lower on the tax statement relative to the income statement). When this liability reverses, cash is being paid to the government in the amount of the reversal.

4. C MACRS depreciation = $1,000,000 0.333 = $333,000

SL depreciation = $1,000,000 / 10 = $100,000

Change in deferred tax liability = (MACRS depreciation SL depreciation) tax rate = ($333,000 $100,000) 0.40 = $93,200

5. B If the tax rate increases, deferred tax liabilities and the current tax expense increase. As a result, net income decreases.



EXAM FLASHBACKS



Empire Corporation issues a zero-coupon bond with $100,000 face value, a 5-year maturity, and a market rate of 8 percent. Interest on corporate bonds is normally paid semiannually. In the liability section of Empires balance sheet, the proceeds from selling the zero-coupon bond immediately after the issuance will be closest to:A. $60,000.B. $67,556.C. $68,058.D. $100,000.

Exam Flashback # 2Source: Question #88 from 93 and 96 actual exams.

Baldwin Assets holds a $100,000 non-interest-bearing note that is due in 10 years. Baldwin has a return on equity of 18%, a return on assets of 12%, and a borrowing rate of 14% (assume an annual pay bond). In Baldwins income statement, the interest income from the note is:A. $0.B. $3,438.C. $3,780.D. $3,864.


A firm has variable-rate long-term debt outstanding. All else equal, what effects will a rise in interest rates have on the firms debt-to-equity and net income?

Debt-to-Equity Ratio Net IncomeA. Decrease DecreaseB. No change IncreaseC. Decrease IncreaseD. Increase Decrease




1. B The present value of the zero-coupon bond is calculated as:

N = 52 =10; I/Y = 8/2 = 4; FV = 100,000. There is no PMT. CPT PV = $67,5562. C The loan value (or loan PV) is calculated as follows, assuming annual payments:

FV = 100,000; N = 10; I/Y = 14; CPT PV = $26,974 Income = implied interest rate times PV

(0.14)($26,974) = $3,776 3,780Note the other two answers follow directly from the other data given:

(0.18)(19,106) = $3,439 and (0.12)(32,197) = $3,864

3. D This is a difficult question. First, future net income will decline due to the rise in interest expense (cash interest expense on a variable rate loan will rise as market interest rates rise). That is the easy part. What about the debt-to-equity (D/E) ratio? Since earnings are down, retained earnings will also be lower in the future so the D/E ratio should increase (because equity has declined). Note that this assumes that expected increases in future borrowing are unchanged. The value of debt on the balance sheet remains unchanged.



EXAM FLASHBACKS



On January 1, a company entered into a capital lease resulting in an obligation of $10,000 being recorded on the balance sheet. The lessors implicit interest rate was 12 percent. At the end of the first year of the lease, the cash flow from financing activities section of the lessees statement of cash flows showed a use of cash of $1,300 applicable to the lease. The amount the company paid the lessor in the first year of the lease was closest to:A. $1,200.B. $1,300.C. $2,500.D. $10,000.

Exam Flashback # 2Source: Question #55 from 9903 sample exams (revised).

An analyst should consider whether a company acquired assets through a capital lease or an operating lease because the company may structure:A. operating leases to look like capital leases to enhance the companys profitability ratios during the early years of the

assets life.B. operating leases to look like capital leases to enhance the companys liquidity ratios.C. capital leases to look like operating leases to enhance the companys leverage ratios.D. capital leases to look like operating leases to enhance the companys receivables turnover ratio.


A lease is most likely to be classified as an operating lease if the:A. lease contains a bargain purchase option.B. collectiblity of the lease payments by the lessor is unpredictable.C. term of the lease is more than 75% of the estimated economic life of the leased property.D. present value of the minimum lease payments equals or exceeds 90% of the fair value of the leased property.


Which of the following is NOT an example of off-balance sheet financing:A. Participating in joint ventures.B. Using take-or-pay arrangements.C. Issuing convertible preferred stock.D. Selling accounts receivable to an unrelated party with limited recourse.


Firms that sell their accounts receivable and use the proceeds to reduce their debt distort the pattern of cash flow from:A. financing, but this distortion is offset by a similar distortion in the cash flow from operations, so no adjustment is

necessary when calculating the firms financial ratios.B. financing, so analysts should switch the amount of receivables sold from current liabilities to long-term debt when

calculating the firms financial ratios.C. operations, but this distortion is offset by a similar distortion in the cash flow from financing, so no adjustment is

necessary when calculating the firms financial ratios.D. operations, so analysts should reverse the sale by increasing the firms receivables and treating the proceeds of the sale as

debt in computing the firms financial ratios.




1. C In a capital lease part of the lease payment is interest (CFO) and the remainder is principal (CFF). The question states that the CFF part is $1,300. Interest is calculated as $10,000 0.12 = $1,200. The total payment is $1,300 + $1,200 = $2,500.

2. C If you restructure a capital lease to look like an operating lease, the leasehold liability is removed from the balance sheet and the debt-to-equity ratio will improve. Profitability ratios will not improve under a capital lease because the sum of interest expense plus depreciation will exceed the lease payment early in the life of the lease.

3. B If the collectiblity of the lease payments by the lessor is unpredictable, the lease is classified as an operating lease.

4. C Convertible preferred stock issues are reported on the balance sheet.

5. D The sale of receivables artificially reduces the receivables balance and short-term borrowings and increases cash from operations in the period of sale. For analytical purposes, the receivables and short-term debt should be added back to the book value balances.