[ 2009 Mock Exam (AM) ] Financial Statement Analysis .Questions 45-68

 

 

45. An analyst finds information about significant uncertainties affecting a company’s liquidity, capital resources and results of operations in the: A. notes to the financial statements. B. balance sheet and income statement. C. management discussion and analysis. Answer: C “Financial Statement Analysis: An Introduction,” Thomas R. Robinson, CFA, Jan Hennie van Greuning, CFA, Elaine Henry, CFA, and Michael A. Broihahn, CFA 2009 Modular Level I, Volume 3, p.18 Study Session 7-29-c Discuss the importance of financial statement notes and supplementary information, (including disclosures of accounting methods, estimates and assumptions) and management’s discussion and analysis. Management must highlight any favorable and unfavorable trends and identify significant events and uncertainties that affect the company’s liquidity, capital resources and results of operations in the management discussion and analysis (MD&A). 46. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. Which of the following is least likely to be classified as a financial statement element? A. Asset. B. Revenue. C. Net income. Answer: C “Financial Reporting Mechanics,” Thomas R. Robinson, CFA, Hennie van Greuning, CFA, Karen O’Connor Rubsam, CFA, Elaine Henry, CFA, and Michael A. Broihahn, CFA 2009 Modular Level I, Volume 3, pp.35-38 Study Session 7-30-b Explain the relationship of financial statement elements and accounts, and classify accounts into the financial statement elements. Net income is not an element of the financial statements, but the net result of revenues less expenses. The elements are: assets, liabilities, owners’ equity, revenue and expenses. 47. An analyst prepares common-size balance sheets for two companies operating in the same industry. The analyst notes that both companies had the same proportion of current liabilities, long-term liabilities, and shareholders’ equity and the following ratios:        Company 1    Company 2     Current ratio       2.0      2.0    Cash ratio       0.3      0.3    Quick ratio       0.5      0.8 The most reasonable conclusion is that, compared with Company 2, Company 1had a: A. higher percentage of assets associated with inventory. B. higher percentage of assets associated with accounts receivable. C. lower percentage of assets associated with marketable securities. Answer: A “Financial Analysis Techniques,” Thomas R. Robinson, CFA, Hennie van Greuning, CFA, Elaine Henry, CFA, and Michael A. Broihahn CFA 2009 Modular Level I, Volume 3, pp.490-491, 506-509 “Working Capital Management,” Edgar A. Norton, Jr., CFA, Kenneth L. Parkinson, and Pamela P. Peterson, CFA 2009 Modular Level I, Volume 4, pp. 87-88 Study Session 10-39-a, c, 11-46-a Evaluate and compare companies using ratio analysis, common-size financial statements, and charts in financial analysis. Calculate, classify, and interpret activity, liquidity, solvency, profitability, and valuation ratios. Calculate and interpret liquidity measures using selected financial ratios for a company and compare it with peer companies. The current ratio includes inventory but the quick ratio does not. (Current ratio is higher than quick ratio and quick ratio is higher than cash ratio.) The quick ratio includes accounts receivable but the cash ratio does not. The denominator for all three ratios is current liabilities, which are the same proportion for both companies. The difference in ratios is therefore created by inventory and accounts receivable. Company 1 has the higher percentage of inventory because the difference between the current ratio and quick ratio is greater for that company. Company 2 had the higher percentage of accounts receivable because the difference between the quick ratio and the cash ratio is greater for Company 2.

48. If a company has a current ratio of 2.0, the effect of repaying $150,000 in short-term borrowing will most likely decrease:

A. the current ratio, but not the cash flow from operations.
B. the cash flow from operations, but not the current ratio.
C. neither the current ratio nor the cash flow from operations.

Answer: C
“Understanding the Cash Flow Statement,” Thomas R. Robinson, CFA, Jan
Hendrik van Greuning, CFA, R. Elaine Henry, CFA and Michael A. Broihahn, CFA 2009 Modular Level I, Volume 3, pp. 243-244
“Financial Analysis Techniques,” Thomas R. Robinson, CFA, Jan Hendrik van
Greuning, CFA, R. Elaine Henry, CFA and Michael A. Broihahn, CFA 2009 Modular Level I, Volume 3, p. 507
Study Session 8-34-a, 10-39-c Compare and contrast cash flows from operating, investing, and financing activities, and classify cash flow items as relating to one of these three categories, given a description of the items.
Calculate, classify, and interpret activity, liquidity, solvency, profitability, and valuation ratios.
The repayment of short-term debt would reduce cash flow from financing, not cash flow from operations.
Any time the current ratio is above 1, equal changes in a current asset and a current liability will result in an increase in the current ratio: if current assets = 550 and current liabilities are 275, current ratio = 550/275 = 2.0. After the bank borrowing has been paid, the ratio becomes (550-150)/(275-150) = 3.2. Had the ratio initially been below 1, current assets = 250 and current liabilities are 275, current ratio = 250/275 = 0.91, the equal change in current assets and liabilities would decrease the current ratio: 100/125=0.80.

49. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. At the end of the year, a company sold equipment for $30,000 cash. The company paid $110,000 for the equipment several years ago and had recorded
accumulated depreciation of $70,000 at the time of its sale. All else equal, the equipment sale will result in the company’s cash flow from:

A. investing activities increasing by $30,000.
B. investing activities decreasing by $10,000.

C. operating activities being $10,000 less than net income.

 

Answer: A
“Understanding The Cash Flow Statement,” Thomas R. Robinson, CFA, Hennie van Greuning, CFA, Elaine Henry, CFA and Michael A. Broihahn, CFA 2009 Modular Level I, Volume 3, pp.243-45, 263-265, 267-68
Study Session 8-34-a, f
Compare and contrast cash flows from operating, investing, and financing activities, and classify cash flow items as relating to one of these three categories, given a description of the items.
Demonstrate the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data.
The book value of the equipment at the time of sale is $110,000 - $70,000 = $40,000. The proceeds are $30,000; therefore a loss of $10,000 is reported on the income statement. The loss reduces net income, but it is a non-cash amount, so is added back to net income in the calculation of the cash from operations.
Therefore, cash from operations is higher than net income, not lower. The total amount of the proceeds, $30,000, is the cash inflow from the transaction and is shown as a cash inflow from investing activities.

50. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. A company reports net income of $800,000 for the year. The table below indicates selected items which were included in net income and their associated
tax status.

	Included in determining Net Income	Tax Status
Depreciation Expense	$70,000	$90,000 allowed for tax purposes
Dividend Income	$120,000	Dividends not taxable
Fine related to environmental damage	$100,000	Not deductible for tax purposes
R&D Expenditures	$50,000	$20,000 allowed for tax purposes

The company’s tax rate is 35 percent. The company’s current income taxes payable (in $) is closest to:

A. 206,500.
B. 276,500.
C. 360,500.

Answer: B
“Income Taxes,” Elbie Antonites, CFA, and Michael Broihahn, CFA 2009 Modular Level I,Volume 3, pp. 393-395, 399
Study Session 9-37-d Calculate income tax expense, income taxes payable, deferred tax assets and deferred tax liabilities, and calculate and interpret the adjustment to the financial statements related to a change in the income tax rate.

Net income	$800,000
Add back book depreciation	70,000
Deduct tax allowed depreciation	(90,000)
Deduct Dividend income	(120,000)
Add back Fine	100,000
Add back book R&D	50,000
Deduct tax allowed R&D	(20,000)
Taxable income	790,000
Current taxes payable	35% x $790,000=276,500

51. An analyst gathers the following annual information ($ millions) about a company that pays no dividends and has no debt:

Net income	45.8
Depreciation	18.2
Loss on sale of equipment	1.6
Decrease in accounts receivable	4.2
Increase in inventories	3.4
Increase in accounts payable	2.5
Capital expenditures	7.3
Proceeds from sale of stock	8.5

The company’s annual free cash flow to equity ($ millions) is closest to:

A. 53.1.
B. 58.4.
C. 61.6.

Answer: C
“Understanding The Cash Flow Statement”, Thomas R. Robinson, CFA, Hennie van Greuning, CFA, Elaine Henry, CFA, and Michael A. Broihahn CFA 2009 Modular Level I, Volume 3, pp.267 - 270, 279-280
Study Session 8-34-i Explain and calculate free cash flow to the firm, free cash flow to equity, and other cash flow ratios.
Free cash flow to equity in a company without any debt is equal to cash flow from operations (CFO) less capital expenditures. CFO = net income + depreciation + loss on sale of equipment + decrease in accounts receivable – increase in inventories + increase in accounts payable. (The loss on sale of equipment is added back when calculating CFO. It would have been deducted in the calculation of net income but the loss is not the cash impact of the transaction (the proceeds received, if any, would be the cash effect) and cash flows related to equipment transactions are investing activities, not operating activities.
CFO = 45.8 + 18.2 +1.6 + 4.2 – 3.4 +2.5 = $68.9 million $68.9 – $7.3 = $61.6 million free cash flow to equity.

52. Which of the following statements best describes the level of accuracy provided by a standard audit report with respect to errors? The audited financial statements are:

A. fully assured to be free of material errors.
B. reasonable assured to be free of all errors.
C. reasonable assured to be free of material errors.

Answer: C
“Financial Statement Analysis: An Introduction,” Thomas R. Robinson, CFA, Jan
Hendrik van Greuning, CFA, R. Elaine Henry, CFA, and Michael A. Broihahn, CFA
2009 Modular Level I, Volume 3, p.19
Study Session 7-29-d Discuss the objective of audits of financial statements, the types of audit reports, and the importance of effective internal controls.
Audits provide reasonable assurance that the financial statements are fairly presented, meaning that there is a high degree of probability that they are free of material error, fraud or illegal acts.

53. Making any necessary adjustments to the financial statements to facilitate comparison with respect to accounting choices is done in which step of the financial statement analysis framework?

A. Collect data.
B. Process data.
C. Analyze/interpret the processed data.

Answer: B
“Financial Statement Analysis: An Introduction,” Thomas R. Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry, CFA, and Michael A. Broihahn., CFA 2009 Modular Level I, Volume 3, pp.24-27
Study Session 7-29-f Describe the steps in the financial statement analysis framework.
Making any adjustments is part of the processing data step. Commonly used data bases (part of the collection phase) do not make adjustments for differences in accounting choices.

 

54. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. For the most recent year a manufacturing company reports the following items on their income statement:
     Interest expense                                                 $62,500
     Loss on disposal of fixed assets                            $50,000
     Realized gain on sale of available-for-sale securities $17,750
Which of the items is classified as an operating item in the company’s income statement?

A. Interest expense.
B. Loss on disposal of fixed assets.
C. Realized gain on sale of available-for-sale securities.

Answer: B
“Understanding the Income Statement,” Thomas R. Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry, CFA, and Michael A. Broihahn, CFA 2009 Modular Level I, Volume 3, pp.163-165
Study Session 8-32-f Distinguish between the operating and nonoperating components of the income statement.
The loss on the disposal of fixed assets is an unusual or infrequent item but it is still part of normal operating activities. The interest expense is the result of financing activities and would be classified as a nonoperating expense by nonfinancial service companies. The realized gain on sale of available for sale securities is an investing activity and would also be classified as a nonoperating gain by a manufacturing company.

55. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. The following information is available from the accounting records of a company as at 31 December 2008 (all figures in $ thousands):

Account:	$
Accounts payable	20
Accounts receivable	82
Bank loan, due on demand	44
Cash	12
Income taxes payable	5
Inventory	47
Investments accounted for by the equity method	112
Loan payable, due 30 June 30 2010	50
Deposits from customers for deliveries in 2009	8

The working capital for the company (in $ thousands) is closest to:

A. 64.
B. 72.
C. 176.

Answer: A
“Understanding the Balance Sheet,” Thomas R. Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry, CFA, and Michael A. Broihahn, CFA 2009 Modular Level I, Volume 3, pp.195-201 Study Session 8-33-a, d Illustrate and interpret the components of the assets, liabilities, and equity sections of the balance sheet, and discuss the uses of the balance sheet in financial analysis.
Compare and contrast current and noncurrent assets and liabilities.

Current Assets:
Cash	12
Accounts receivable	82
Inventory	47
	141
Current Liabilities
Bank loan, due on demand	44
Accounts payable	20
Income taxes payable	5
Deposits from customers for deliveries in 2009	8
	77
Working capital (CA – CL)	64.0
The Investments accounted for by the equity method and the

Loan payable due June 2010 are non-current assets and liabilities respectively.

56. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. During late December 2008 Company A acquires a small competitor, Company B. During the evaluation of the acquisition it is determined that the customer lists of Company B have a fair value of $50,000. Company A has spent $15,000 during the year updating and maintaining its own customer lists. What will be the value of the customer list intangible asset on Company A’s 31 December 2008 consolidated financial statements?

A. $15,000.
B. $50,000.
C. $65,000.

Answer: B
“Understanding the Balance Sheet,” Thomas R. Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry, CFA and Michael A. Broihahn, CFA 2009 Modular Level 1, Vol.3, pp.212-214
“Long-Lived Assets,” R. Elaine Henry, CFA and Elizabeth Gordon 2009 Modular Level I, Volume 3, pp.340-341
Study Session 8-33-e, 9-36-a Explain the measurement bases (e.g., historical cost and fair value) of assets and liabilities, including current assets, current liabilities, tangible assets, and intangible assets.
Explain the accounting standards related to the capitalization of expenditures as part of long-lived assets, including interest costs.
The purchased customer list is an identifiable intangible because it can be sold separately from the company and it would be recorded at its fair market value, the amount paid for it in the acquisition, $50,000. The amount spent by Company A on its own lists, $15,000, would have to be expensed because internally generated intangibles are not capitalized.
Loan payable due June 2010 are non-current assets and liabilities respectively.

57. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. A company has equipment with an original cost of $850,000, accumulated amortization of $300,000 and 5 years of estimated remaining useful life. Due to a change in market conditions the company now estimates that the equipment will only generate cash flows of $80,000 per year over its remaining useful life. The company’s incremental borrowing rate is 8 percent. Which of the following statements concerning impairment and future return on assets (ROA) is most accurate? The asset is:

A. impaired and future ROA increases.
B. impaired and future ROA decreases.
C. not impaired and future ROA increases.

Answer: A
“Long-Lived Assets,” R. Elaine Henry, CFA and Elizabeth Gordon
2009 Modular Level I, Volume 3, pp.368-371
Study Session 9-36-i Define impairment of long-lived tangible and intangible assets and explain what effect such impairment has on a company’s financial statements and ratios.
The equipment is impaired. NBV = $550,000 which is greater than the sum of the undiscounted cash flows 5 yrs x $80,000 = $400,000. The company’s future ROA will increase. Once the asset is written down, there will be lower depreciation charges, which will increase net income, and a lower carrying value of assets, which decreases total assets. Both factors would increase any future ROA.

58. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. On 1 January 2008 a company enters into a lease agreement to lease a piece of machinery as the lessor with the following terms:

Annual lease payment due 31 December	$50,000
Lease term	5 years
Estimated useful life of the machine	6 years
Estimated salvage value of the machine	$0
Carrying value (cost) of leased asset	$160,000
Implied interest rate on lease	8%

The firm is reasonably assured of the collection of the lease payments.

Which of the following best describes the classification of the lease on the company’s financial statements for 2008?

A. Operating lease.
B. Sales type lease.
C. Direct financing lease.

Answer: B
“Long-term Liabilities and Leases,” Elizabeth Gordon and R. Elaine Henry, CFA 2009 Modular Level I, Volume 3, pp. 458-464
Study Session 9-38-h Distinguish between sales-type leases and a direct financing lease and determine the effects on the financial statements and ratios of the lessors.
It is a sales type lease: the lease period covers more than 75% of its useful life (5/6=83.3%) and the asset is on its books at less than the present value of the lease payments ($199,635) (PMT = $50,000, N=5, i=8%). The firm must have acquired or manufactured the asset if it is recorded at less than the present value of the lease payments.

59. Which of the following is the most useful to an analyst assessing the credit worthiness of a company? Information related to:

A. operating cash flow.
B. the scale and diversity of a company’s operations.
C. operational efficiency of the company’s operations.

Answer: A
“Financial Statement Analysis: Applications,” Thomas R. Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry, CFA and Michael A. Broihahn, CFA
2009 Modular Level I, Volume 3, pp.591-593
Study Session 10-42-c Describe the role of financial statement analysis in assessing the credit quality of a potential debt investment.
Credit analysis is concerned with a company’s debt-paying ability. Returns to creditors are normally paid in cash, so the company’s ability to generate cash internally is the most important factor in credit analysis.