CFA Level 1 - Financial Reporting and Analysis Session 8 - Reading 25

CFA Level 1 - Financial Reporting and Analysis Session 8 - Reading 25 (Notes, Practice Questions, Sample Questions) 1. Would an increase in the cost of raw materials used in the production of inventory and would an increase in marketing expenses result in lower gross profit? Increase in raw materials cost Increase in marketing expense A)Yes No B)No Yes C)Yes Yes Explanation: A — Gross profit is equal to sales minus cost of goods sold. Cost of goods sold includes the direct costs of producing a product or service such as raw materials, direct labor, and overhead (fixed costs). Thus, an increase in raw materials costs will result in higher cost of goods sold and lower gross profit. Marketing expenses are considered operating expenses (SG&A), not in cost of goods sold 2. Do gains and losses, as well as expenses appear on the income statement? A)Only expenses appear on the income statement. B)Only gains and losses appear on the income statement. C)Both appear on the income statement. Explanation: C — Gains and losses result from, transactions that are not a part of the firm’s normal business operations. Expenses are amounts that are incurred to generate revenue; thus, expenses result from the firm’s ongoing operations. Both are included on the income statement 3. During 2007, Topeka Corporation entered into the following transactions: Transaction #1 – Interest on a certificate of deposit owned by Topeka was credited to Topeka’s investment account. Transaction #2 – Topeka sold 10,000 shares of common stock at $30 that had been repurchased by Topeka last year for $20. Should Topeka recognize the results of these transactions as income on the income statement for the year ended December 31, 2007? A)Only one should be recognized. B)Neither should be recognized. C)Both should be recognized Explanation: A — Interest earned on the CD is recognized as interest income. The gain on the sale of treasury stock is not reported on the income statement but is relected on the statement of changes in stockholders’ equity and on the balance sheet. The sale proceeds simply increase equity and increase cash 4. In accounting for long-term construction contracts, the percentage-of-completion method is preferable to the completed contract method when: A)the contracts are of a relatively short duration (less than one year). B)estimates of the costs to complete and the extent of progress toward completion are reasonably dependable. C)lack of dependable cost estimates cause forecasts to be doubtful. Explanation: B — In accounting for long-term construction contracts, the percentage-of-completion method is preferable to the completed contract method when estimates of the costs to complete and the extent of progress toward completion are reasonably dependable 5. An airplane manufacturing company routinely builds fighter jets for the U.S. armed forces. It takes fourteen months to build one jet, and the government pays for them in installments over the fourteen-month period. Which revenue recognition method should be used? A)Percentage-of-completion method. B)Installment sales method. C)Completed contract method. Explanation: A — The percentage-of-completion method is appropriate in this case because payment is assured when dealing with the U.S. government, and cost and price estimates are assumed reliable due to the ongoing and routine nature of the contract 6. If a reliable estimate of total costs of the contract does not exist, which of the following revenue recognition methods should be used? A)Cost recovery method. B)Percentage-of-completion method. C)Completed contract method Explanation: C — The cost recovery method is used when future cash collections are not assured even after receipt of partial payments. Gross profit is not recognized until all of the cost of goods sold is collected. The percentage-of-completion method is used when ultimate payment is assured and revenue is earned as costs are incurred. Profit is recognized corresponding to the percentage of costs incurred to the total estimated 7. According to the Financial Accounting Standards Board, what is the appropriate balance sheet treatment for available-for-sale securities and where are the unrealized gains and losses reported? Balance sheet Unrealized gains and losses A) Amortized cost Other comprehensive income B) Fair value Other comprehensive income C) Fair value Net income Explanation: B — Available-for-sale securities are reported on the balance sheet at fair value. The unrealized gains and losses bypass the income statement and are reported as a component of stockholders’ equity as a part of other comprehensive income 8. Are dividends paid to common shareholders and foreign currency translation gains and losses included in a firm’s other comprehensive income? Dividends paid Foreign currency translation gains and losses A) Yes Yes B) No Yes C) No No Explanation: B — Other comprehensive income includes non-owner transactions that affect shareholders’ equity and are not recognized in net income. Dividends paid are transactions with the owners of the firm, so dividends paid are not included in other comprehensive income. Foreign currency translation gains and losses are non-owner transactions that are not recognized in net income. Thus, foreign currency translation gains and losses are included in other comprehensive income 9. At the beginning of 2007, Thunderbird Company started a 3-year construction project. The following data relates to the project: Contract price $100 million Costs incurred in 2007 $50 million Progress billings $40 million Collection of progress billings $37 million Because of cost overruns, Thunderbird cannot reliably estimate the total cost of the project. However, Thunderbird expects that its costs incurred so far are recoverable. What amount of revenue should Thunderbird recognize for the year ended 2007 under U.S. Generally Accepted Accounting Principles (U.S. GAAP) and International Financial Reporting Standards (IFRS)? U.S. GAAP IFRS A) $0 $0 B) $0 $50 million C) $37 million $40 million Explanation: B — The completed-contract method must be used under U.S. GAAP since Thunderbird cannot reliably estimate the project’s cost. Under the completed-contract method, no revenue is recognized until the project is complete. Under IFRS, when total cost cannot be reliably estimated, revenue is recognized to the extent that recovering contract costs is probable. Since Thunderbird incurred $50 million of cost in 2007, $50 million of revenue is recognized 10. The Better Building Company has a contract to build a building for $100 million. The estimate of the cost of the project is $75 million. In the first year of the project, BB had costs of $30 million. The Better Building Company’s reported profit for the first year of the contract, using the percentage-of-completion method, is: A)$10 million. B)$0. C)$20 million. Explanation: A — Reported profit (in millions) = ($30 / $75)($100 − 75) = $10 11. CPP Corporation has a contract to build a custom test chamber for a client for $100,000. CPP Corporation uses the percentage-of-completion method for accounting and estimates the total costs for the project to be equal to $80,000. CPP Corporation has promised to complete the project within three years. At year-end the customer has paid $60,000, equaling the total amount billed for the year, and total costs incurred to date are $40,000. On the income statement, net income for the year-end will be: A)$10,000. B)$20,000. C)-$10,000. Explanation: A — Under the percentage-of-completion method, one-half of the total revenue is recognized because one-half of the costs have been incurred ($40,000 / $80,000). Therefore, revenue will be equal to $50,000, expenses are $40,000, and net income will be $10,000