CFA Level 1 - Financial Reporting and Analysis Session 8 - Reading 26

University:
CFA Institute
Course:
CFA Program Level 2 | Financial Reporting and Analysis
Academic year:

2023
Views:

8

Pages:

12
Author:

anon

CFA Level 1 - Financial Reporting and Analysis Session 8 - Reading 26 (Notes, Practice Questions, Sample Questions) 1. Which of the following characteristics are required for recognition of a balance sheet asset? Characteristic #1: Future economic benefits to the firm are probable. Characteristic #2: The asset is tangible and is obtained at a cost. Characteristic #1 Characteristic #2 A)Yes No B)Yes Yes C)No No : A) An asset is recognized on the balance sheet only if it is probable that it will provide future economic benefits. Assets can be tangible or intangible. In some cases, assets are acquired without cost, but will be reported to the extent that they will provide future economic benefit, and thus have value 2. Galaxy Corporation manufactures custom motorcycles. Galaxy finances the motorcycles over 36 months for customers who make a minimum down payment of 10%. Historically, Galaxy has experienced bad debt losses equal to 1% of sales. Galaxy also provides a 24 month unlimited warranty on all new motorcycles. In the past, warranty expense has averaged 3% of sales. Ignoring taxes, how does the recognition of bad debt expense and warranty expense at the time of sale affect Galaxy’s liabilities? A) Bad debt expense Warranty expense No effect No effect B) Increase Increase C) No effect Increase : C) The recognition of bad debt expense has no effect on liabilities, current revenues are reduced by the expected amount of uncollectable accounts. Bad debt expense reduces net income and reduces assets. The recognition of expected warranty expense decreases net income (following the matching principle), and since it is not currently paid (doesn’t reduce assets) it creates or increases a liability at the time of sale 3. Which of the following statements about a classified balance sheet is least likely accurate? A classified balance sheet: A)groups accounts by subcategories. B)presents the net equity of each asset by subtracting its related liability. C)distinguishes between current and noncurrent assets : B) A classified balance sheet groups assets and liabilities by subcategories. It distinguishes between current and noncurrent assets and current and noncurrent liabilities. The assets and related liabilities are reported separately, they are not netted 4. Do the following characteristics have to be met in order to classify a liability as current on the balance sheet? Characteristic #1 – Settlement is expected within one year or operating cycle, whichever is less. Characteristic #2 – Settlement will require the use of cash within one year or operating cycle, whichever is greater A) Characteristic #1 Characteristic #2 Yes No B) No Yes C) No No : C) A current liability is expected to be settled within one year or operating cycle, whichever is greater. It is not necessary to settle a current liability with cash. There are a number of ways to settle a current liability. For example, unearned revenue is a liability that is settled by providing goods or services 5. GTO Corporation purchased all of the common stock of Charger Company for $4 million. At the time, Charger reported total assets of $3 million and total liabilities of $1 million. At the acquisition date, the fair value of Charger’s assets was $3.5 million and the fair value of Charger’s liabilities was $1.3 million. What amount of goodwill should GTO report as a result of the acquisition and is it necessary for GTO to amortize the goodwill? Goodwill Amortization required A) $1.8 million No B) $1.8 million Yes C) $2.2 million No : A) The acquisition goodwill is equal to $1.8 million [$4 million purchase price – $2.2 million fair value of net assets acquired ($3.5 million assets at fair value – $1.3 million liabilities at fair value)]. Under IFRS or U.S. GAAP, goodwill is not amortized but is subject to an annual impairment test 6. Consider the following:Statement #1 – Copyrights and patents are tangible assets that can be separately identified. Statement #2 – Purchased copyrights and patents are amortized on a straight line basis over 30 years. With respect to the statements about copyrights and patents acquired from an independent third party: A)only statement #2 is incorrect. B)only statement #1 is incorrect. C)both are incorrect. : A) Acquired copyrights and patents are intangible assets that can be separately identified. Identifiable intangible assets are amortized over their useful lives 7. According to the Financial Accounting Standards Board, what is the appropriate measurement basis for equipment used in the manufacturing process and inventory that is held for sale? Equipment Inventory A) Historical cost Lower of cost or market B) Historical cost Historical cost C) Fair value Lower of cost or market : A) Equipment is reported in the balance sheet at historical cost less accumulated depreciation. Inventory is reported in the balance sheet at the lower of cost or market 8. According to International Financial Reporting Standards, how do cash dividends received from trading securities and available-for-sale securities affect net income? A) Trading securities Available-for-sale securities No effect Increase B) Increase Increase C) Increase No effect : B) Dividends received from trading securities and available-for-sale securities are recognized in the income statement. The difference in trading and available-for-sale classifications relates to the treatment of any unrealized gains and losses 9. Current assets that arise from the accrual process most likely include: A)cash equivalents. B)accounts receivable. C)marketable securities : B) The accrual process refers to accounting for transactions when revenue or expense recognition does not coincide with the exchange of cash. Accounts receivable, for example, represent sales of goods and services that have been recognized as revenue, but for which the firm has not yet been paid cash. Cash equivalents are highly liquid marketable securities, such as Treasury bills, in which a firm typically invests its short-term cash balances 10. On January 1, 20X7, Omega Corporation paid $45,000 to renew its property insurance for 3 years. What amount of insurance expense should Omega report for the year-ended December 31, 20X7 and what is the balance of Omega’s prepaid insurance account on December 31, 20X8? Insurance expense Prepaid insurance A) $15,000 $30,000 B) $15,000 $15,000 C) $45,000 $15,000 : B) At the beginning of 20X7, the prepaid insurance account (asset) will have a balance of $45,000. Insurance expense will be recognized at a rate of $15,000 per year. At the end of 20X8, one year’s insurance remains; thus, the balance of the prepaid insurance account will equal $15,000 ($45,000 beginning balance – $15,000 insurance expense for 20X7 – $15,000 insurance expense for 20X8) 11. At the beginning of 20X7, Bryan’s Bakery Company purchased a secret cookie recipe for $25,000. In addition, Bryan developed a new cake recipe at a cost of $5,000. Bryan expects to use both recipes indefinitely; however, the useful (economic) life of similar recipes has been 10 years. Assuming straight-line amortization, what amount of recipe expense should Bryan report for the year ended 20X7 and what amount should Bryan report as assets related to these recipes on its balance sheet at the end of 20X7? Recipe expense Balance sheet A) $5,000 $25,000 B) $7,500 $22,500 C) $3,000 $30,000 : B) The recipes are intangible assets. The purchased cookie recipe is capitalized and amortized over 10 years at $2,500 per year ($25,000 cost / 10 years). Since the cake recipe was developed internally, it is expensed immediately. Thus, total expense for 20X7 is $7,500 ($2,500 amortization expense + $5,000 cake recipe expense). The balance sheet value of the purchased recipe at the end of 20X7 is $25,000 – $2,500 = $22,500 12. At the beginning of the year, Alpha Corporation purchased 10,000 shares of Beta Corporation for $20 per share. During the year, Beta paid a $2,000 cash dividend to Alpha. At the end of the year, Beta’s stock was selling for $22 per share. What amount should Alpha recognize in its year-end income statement if the investment is treated as an available-for-sale security and what amount should be recognized in the income statement if the investment is treated as a trading security? Available-for-sale Trading security A) $2,000 $22,000 B) $2,000 $20,000 C) $0 $22,000 : A) Unrealized gains and losses from trading securities are recognized in the income statement while unrealized gains and losses from available-for-sale securities bypass the income statement and are reported as other comprehensive income, a component of stockholders’ equity. Cash dividends are recognized in the income statement for both trading and available-for-sale securities. Thus, Alpha will recognize only the $2,000 dividend if the shares are considered available-for-sale and will recognize $22,000 ($2,000 dividend + $20,000 unrealized gain) if the shares are considered trading securities 13. When the market value of an investment in a debt security is less than its carrying value, how should the investor report the investment on the balance sheet if the security is classified as held-to-maturity and what amount should be reported if the security is classified as available-for-sale? Held-to-maturity Available-for-sale A) Amortized cost Amortized cost B) Amortized cost Fair value C) Fair value Fair value :B) Held-to-maturity securities are reported on the balance sheet at amortized cost while available-for-sale securities are reported at fair value. Amortized cost includes the amortization of a premium or discount that was created when the security was purchased 14. Consider the following statements. Statement #1: Par value is a nominal dollar value assigned to shares of stock in a corporation’s charter. Statement #2: The par value of common stock represents the amount the corporation received when the stock was issued. With respect to these statements: A)both statements are correct. B)only statement #2 is correct. C)only statement #1 is correct. : C) The par value of common stock is the stated or nominal value assigned to the stock. Par value has no relationship to market value. The amount the corporation receives from the issuance of common stock is equal to the par value plus the additional paid-in-capital (proceeds in excess of par) 15. Ascot Corporation has 4 million shares of common stock authorized, 2.4 million shares of common stock issued, and 1.8 million shares of common stock outstanding. How many shares of treasury stock does Ascot own and is the treasury stock reported as an asset in Ascot’s balance sheet? Treasury shares Reported as an asset A) 600,000 Yes B) 600,000 No C) 1.6 million No :B) Shares that were issued previously but are not outstanding are treasury shares (owned by the firm). Thus, there are 600,000 treasury shares (2.4 million issued – 1.8 million outstanding). Treasury shares are reported as a reduction in shareholders’ equity on the balance sheet. Treasury stock is not an asset 16. Earlier this year, Slayton Corporation repurchased 5% of its total shares outstanding. At the time, the book value of Slayton shares exceeded their market value. The shares are expected to be reissued in the future when the market price of Slayton’s stock increases. Do Slayton’s repurchased shares continue to have voting rights and to pay cash dividends? Voting rights Cash dividends paid A) Yes No B) No No C) No Yes : B) Repurchased stock that is not cancelled is called treasury stock. Treasury stock does not have voting rights and does not receive cash dividends 17. Coleman Corporation’s unadjusted trial balance at the end of 2007 reflected compensation expense of $90 million. The trial balance did not include the following: ● Because of the holidays, no salary accrual was made for the last week of the year. Salaries for the last week totaled $3.5 million and were paid on January 4, 2008. ● Employee bonuses for 2007 totaled $5 million. The bonuses were paid on January 31, 2008. Ignoring payroll taxes, what is Coleman’s adjusted compensation expense for the year ended 2007 and what impact will the adjustment have on Coleman’s 2007 current ratio? Compensation expense Current ratio A) $98.5 million Decrease B) $94.5 million Decrease C) $98.5 million No effect : A) Because of the matching principle, compensation expense should be increased by the (accrued) salary expense for the last week of 2007 and the liability for the bonuses was incurred in 2007. Thus, total compensation expense for 2007 is $98.5 million ($90 million unadjusted compensation expense + $3.5 million salary accrual + $5 million bonus accrual). Since the salaries and bonuses were not paid in 2007, accrued liabilities would increase by $8.5 million. An increase in accrued liabilities, a current liability, would decrease the current ratio 18. The statement of changes in equity is least likely to provide information on the firm’s: A)payment of dividends. B)repayment of bond principal. C)comprehensive income. : B) The statement of changes in equity shows a firm’s comprehensive income (net income and other comprehensive income) and transactions with shareholders, such as dividends paid and issuance or repurchases of stock. Repayment of bond principal is not a change in equity: assets (cash) decrease and liabilities (long-term debt) decrease 19. Bug-Be-Gone is a residential pest control company that offers a 12 month home-service contract to eliminate insect infestation. Customers are required to prepay for the service at the beginning of each year. If Bug-Be-Gone erroneously records these payments as revenue and include the estimated cost of performing the service, what is the most likely effect on the firm’s liabilities and equity compared to the correct treatment? Liabilities Equity A) Overstated Overstated B) Overstated Understated C) Understated Overstated : C) When payment is received, the firm has an obligation to provide the service. This obligation is reported as a liability ‘unearned revenue’ as a liability, offsetting the increase in cash. If they book the revenue and estimated expenses of providing the service this will overstate equity (assuming revenue greater than expected expense) and liabilities will be understated 20. A key limitation of balance sheets in financial analysis is that: A)different balance sheet items may be measured differently. B)liquidity and solvency ratios require information from other financial statements. C)some items are recognized when they are unlikely to reflect a flow of economic benefits : A) Balance sheet values may use a mixture of measurement bases (historical cost, fair value, etc.). As a result, balance sheet values of assets, liabilities, and equity may not reflect their intrinsic values. Balance sheets provide the information necessary to calculate the firm’s solvency and liquidity ratios. Items are recognized on the balance sheet only if a flow of future economic benefits to or from the firm is probable 21. Common size balance sheets express all balance sheet items as a percentage of: A)sales. B)equity. C)assets. : C) Common size balance sheets express all balance sheet items as a percentage of assets. Note that common size income statements express all income statement items as a percentage of sales 22. The following data is from Delta's common size financial statement: Earnings after taxes Equity Current assets Current liabilities Sales Total assets 18% 40% 60% 30% $300 $1,400 What is Delta's total-liabilities-to-equity ratio? A) 1.5 B) 1.0 C) 2.0 : A) If equity = 40% of assets, total liabilities = 60% of assets, thus 60 / 40 = 1.5