CFA Level 1 - Financial Reporting and Analysis Session 10 - Reading 34

CFA Level 1 - Financial Reporting and Analysis Session 10 - Reading 34 (Notes, Practice Questions, Sample Questions) 1. Earlier this year, Barracuda Company issued 5,000 employee stock options. Recently, 2,000 options were exercised at a price of $10 per share. To avoid dilution, Barracuda purchased 2,000 shares at an average price of $12 per share. Barracuda reported both transactions as financing activities in its cash flow statement. For analytical purposes, what adjustment is necessary to better reflect the substance of the stock repurchase? Operating cash flow Financing cash flow A)Decrease $4,000 No adjustment B)No adjustment Increase $4,000 C)Decrease $4,000 Increase $4,000 {Explanation} — Barracuda reported a $4,000 net outflow from financing activities [2,000 options × ($12 average market price – $10 exercise price)]. However, since the options are a form of compensation, the $4,000 outflow should be reclassified as an operating activity for analytical purposes. This is accomplished by increasing financing cash flow $4,000 and decreasing operating cash flow $4,000 2. Charger Corporation offers extended payment terms to its customers. In order to finance its accounts receivable, Charger is considering two alternatives. The first alternative is to borrow against the receivables. The second alternative is to securitize the receivables through a special purpose entity. Which alternative would result in lower operating cash flow and lower financing cash flow? Lower operating cash flow Lower financing cash flow A) Securitize Securitize B) Securitize Borrow C) Borrow Securitize {Explanation} — The cash received from borrowing would be reported as a financing inflow. The cash received from securitizing the receivables would be reported as an operating inflow. So, borrowing would result in lower operating cash flow and higher financing cash flow. Securitizing would result in lower financing cash flow and higher operating cash flow 3. Which of the following statements about cash flow is (are) CORRECT? Statement #1: The cash effects of decreasing accounts payable turnover are unlimited. Statement #2: The tax benefits from employee stock options can result in a significant source of investing cash flow. Statement #1 Statement #2 A) Incorrect Incorrect B) Correct Incorrect C) Incorrect Correct {Explanation} — Statement #1 is an incorrect statement. The cash effects of decreasing accounts payable turnover are limited. Suppliers will eventually stop extending credit because of delayed payments. Statement #2 is an incorrect statement. The tax benefits from employee stock options can result in a significant source of operating and financing cash flows. Tax benefits do not affect investing cash flows 4. Earlier this year, Barracuda Company issued 5,000 employee stock options. Recently, 2,000 options were exercised at a price of $10 per share. To avoid dilution, Barracuda purchased 2,000 shares at an average price of $12 per share. Barracuda reported both transactions as financing activities in its cash flow statement. For analytical purposes, what adjustment is necessary to better reflect the substance of the stock repurchase? Operating cash flow Financing cash flow A) Decrease $4,000 No adjustment B) No adjustment Increase $4,000 C) Decrease $4,000 Increase $4,000 {Explanation} — Barracuda reported a $4,000 net outflow from financing activities [2,000 options × ($12 average market price – $10 exercise price)]. However, since the options are a form of compensation, the $4,000 outflow should be reclassified as an operating activity for analytical purposes. This is accomplished by increasing financing cash flow $4,000 and decreasing operating cash flow $4,000