Financial Statement Analysis: an induction(Reading 22)

Exercise Problems:

1. Which of the following statements is most accurate about the responsibilities of an auditor for a publicly traded firm in the United States? The auditor:

A. Assures the reader that the financial statements are free from error, fraud, or illegal acts.

B. Must express an opinion about the effectiveness of the company’s internal control systems.

C. Must state that he prepared the financial statements according to generally accepted accounting principles.

Ans: B;

B is correct. For a publicly traded firm in the United States, the auditor must express an opinion as to whether the company’s internal control system is in accordance with the Public Company Accounting Oversight Board, under the Sarbanes–Oxley Act. This is done either as a final paragraph in the auditor’s report or as a separate opinion.

A is incorrect. An auditor can only provide reasonable assurance that the financial statements A.    are free from error, fraud, or illegal acts.

B is incorrect. Auditors’ responsibility is to express an opinion that the financial statements are free from error, fraud, or illegal acts. Preparing the financial statement is not the responsibility.

2. The financial statement that would be most helpful to an analyst in understanding the changes that have occurred in a company’s retained earnings over a year is the statement of:

A. changes in equity.

B. financial position.

C. comprehensive income.

Ans: A;

A is correct. The statement of changes in equity reports the changes in the components of shareholders’ equity over the year, which would include the retained earnings account.

B is incorrect. The statement of financial position (Balance Sheet) reports a company’s financial position at a specific time.

C is incorrect. The statement of comprehensive income illustrates the financial performance and results of operations of a particular company or entity for a period of time.

3. Providing information about the performance of a company, its financial position, and changes in financial position that is useful to a wide range of users is most accurately described as the role of:

A. financial reporting.

B. the auditor’s report.

C. financial statement analysis.

Ans: A

A is correct. The role of financial reporting is to provide information about the performance of a company, its financial position, and changes in financial position that is useful to a wide range of users in making economic decisions.

B is incorrect. The role of the auditor’s report is to provide reasonable assurance that the financial statements are free of material mistakes.

C is incorrect. The role of financial statement analysis is to help analysts or investors to make a wide array of economic decisions, including evaluating potential equity or venture capital investments, evaluating corporate division or subsidiaries and forecasting future financial performance.

4. Information about management compensation and any potential conflicts of interest that may exist between management and shareholders is most likely found in the:

A. Proxy statement.

B. Notes to the financial statements.

C. Management discussion and analysis

Ans: A

A is correct. Information about management compensation and any potential conflicts of interest that may exist between management and shareholders is typically provided in the proxy statement.

B is incorrect. Notes to the financial statement provide detailed disclosures. For example, a summary of the significant accounting policies, disclosures for most asset categories and income taxes.

C is incorrect. Management discussion and analysis includes topics: a review of the company’s consolidated operating performance and its financial condition, an assessment of the significant effects of known treads, the capital resources available to the firm and its liquidity, extraordinary or unusual events, and a review of the performance of operating segments.

5. Which of the following is least likely to appear in a company’s proxy statement?

A. Compensation arrangements for management and directors

B. Significant event and contingencies that may affect future operations

C. Potential conflicts of interest between management, directors, and shareholders.

Ans: B

Proxy statements are issued by publicly held companies in connection with shareholder meetings and contain useful information about board members and management, executive compensation, stock options and major shareholders.

Significant events, conditions, trends, and contingencies that may affect future operations are contained in Management’s Discussion and Analysis. Compensation agreements for directors and management and their potential conflicts of interest are required in the proxy statement.

6. Common-size financial statements are most likely an output of which step in the financial analysis framework?

A. Collect data

B. Process data

C. Analyze/interpret data

Ans: B.

The financial statement analysis framework consists of six steps:

1.  State the objective and context. Determine what questions the analysis seeks to answer, the form in which this information needs to be presented, and what resources and how much time are available to perform the analysis.

2.  Gather data. Acquire the company’s financial statements and other relevant data on its industry and the economy. Ask questions of the company’s management, suppliers, and customers, and visit company sites.

3.  Process the data. Make any appropriate adjustments to the financial statements. Calculate ratios. Prepare exhibits such as graphs and common-size balance sheets.

4.  Analyze and interpret the data. Use the data to answer the questions stated in the first step. Decide what conclusions or recommendations the information supports.

5.  Report the conclusion or recommendations. Prepare a report and communicate it to its intended audience. Be sure the report and its dissemination comply with the Code and Standards that relate to investment analysis and recommendations.

6.  Update the analysis. Repeat these steps periodically and change the conclusions or recommendations when necessary.

7. An analyst’s examination of the performance of a company is least likely to include an assessment of a company’s:

A. profitability.

B. cash flow generating ability.

C. assets relative to its liabilities.

Ans: C.

Assessment of performance includes analysis of profitability and cash flow generating ability. The relationship between assets and liabilities is used to assess a company’s financial position, not its performance.

8. 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.

Ans: C.

Management discussion and analysis includes topics: a review of the company’s consolidated operating performance and its financial condition, an assessment of the significant effects of known treads, the capital resources available to the firm and its liquidity, extraordinary or unusual events, and a review of the performance of operating segments.

Management must highlight any favorable and unfavorable trends and identify significant events and uncertainties that affect the company’s liquidity, capitalresources and results of operations in the management discussion and analysis (MD&A).

A is incorrect. Notes to the financial statement provide detailed disclosures. For example, a summary of the significant accounting policies, disclosures for most asset categories and income taxes.

B is incorrect. Balance sheet reports major classes and amounts of assets, liabilities, and equity capital at a specific point in time. The income statement reports on the performance of the firm for a specific period of time.

9. 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.

Ans: C.

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.

10.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.

Ans: B.

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.

A is incorrect. Collect data includes: Acquire the company’s financial statements and other relevant data on its industry and the economy. Ask questions of the company’s management, suppliers, and customers, and visit company sites.

C is incorrect. Analyze/interpret the processed data includes: Use the data to answer the questions stated in the first step. Decide what conclusions or recommendations the information supports.

11. When the financial statements materially depart from accounting standards and are not fairly presented, the audit opinion would be a(n):

A. adverse opinion.

B. qualified opinion.

C. disclaimer of opinion.

Ans: A.

An adverse opinion occurs when the financial statements materially depart from accounting standards and are not fairly presented. A qualified opinion is one in which there is some limitation or exception to accounting standards.

B is incorrect. A qualified opinion is issued when there is a material instance of noncompliance with applicable accounting standards or there is a limitation on the auditor’s ability to complete the audit as required by auditing standards. A qualified opinion will include an explanatory paragraph describing the problem that prevents the auditors from issuing an unqualified opinion.

C is incorrect. A disclaimer of opinion s issued when the auditor doer not have the ability to issue an opinion for some reason.

12. An issue subject to a vote at a stockholders’ meeting is presented in a(n):

A. interim report.

B. proxy statement.

C. management statement of responsibility.

Ans: B.

Proxy statements are prepared and distributed to shareholders on matters that are to be put to a vote at shareholder meetings.

B is incorrect. Public companies are generally required to provide interim financial information, either quarterly or semiannually. Interim financial reports, which include the key financial statements and footnotes, are not audited. They provide updates to a company’s audited annual financial information so that investors, analysts, and other interested parties can assess a company’s incremental financial performance.

C is incorrect. The issue subject to a vote at a stockholders’ meeting will not be presented in management statement of responsibility.

13.  Information regarding which of the following items is usually included in the footnotes to financial statements?

A. A five-year summary of the company’s financial performance.

B. A summary of significant accounting policies.

C. A review of the company’s operating performance and financial condition.

Ans: B.

The summary of significant accounting policies is generally the first of the footnotes presented with audited financial statements prepared in conformity with generally accepted accounting principles. The footnotes are an integral part of statements.

A is incorrect. A five-year summary of financial performance is generally included with the (unaudited) supplementary schedules, which are not part of the footnotes.

C is incorrect. A review of the company’s operating performance and financial condition is included as part of the management discussion and analysis (MD&A) section, which is not part of the footnotes.

14. Which of the following is least likely to be a fundamental principle in the preparation of financial statements within the IFRS Framework?

A. Matching

B. Materiality

C. Accrual basis

Ans: B.

The five fundamental principles underlying the preparation of financial statements under the IFRS Framework are fair presentation, going concern, accrual basis, consistency, and materiality. Matching is a general principle of expense recognition.

15. Which of the following financial statement elements most accurately represents inflows of economic resources to a company?

A. Gains.

B. Assets.

C. Revenues.

Ans: C.

Revenues are inflows from delivering or producing goods, rending services, or other activities that constitute the entity’s ongoing major or central operations.

A is incorrect. Assets are the resources controlled by the firm, but not inflows.

C is incorrect. Gains are an account, not an element of the financial statements.

16. An analyst’s examination of the performance of a company is least likely to include an assessment of a company’s:

A. profitability.

B. cash flow generating ability.

C. assets relative to its liabilities.

Ans: C.

Assessment of performance includes analysis of profitability and cash flow generating ability. The relationship between assets and liabilities is used to assess a company’s position, not its performance.

17. Information about a company’s financial position at a point in time is most likely found in the:

A. balance sheet.

B. income statement.

C. cash flow statement.

Ans: A.

The balance sheet reports the company’s financial position ar a point in time.

The income statement reports on financial performance over a period of time.

The cash flow statement reports a company’s cash receipts and payments over a period of time.

18. Which of the following items is least likely to contain details about carious accruals, adjustments, balances, and management assumptions?

A. Income statement.

B. Supplementary schedules.

C. Discussion and analysis by management.

Ans: A.

The income statement reports the amounts for each of the major line items within the general categories of revenues and expenses. The various accruals, adjustments, and management assumptions are implicit in the reported amounts but are not specifically explained in the income statement.

B is incorrect. Supplementary schedules contain additional information, including a more detailed breakdown of certain large account balances.

C is incorrect. Much of the detail contained in carious accruals, adjustments, and managements assumptions that go into the financial statements can be found in the footnotes to the statements and Management’s discussion and Analysis.

19. Which of the following statements about a corporation’s annual reports, SEC filings, and press releases is most accurate?

A. Annual and quarterly SEC filings must be audited.

B. Interim SEC filings typically update the major financial statements and footnotes.

C. Annual reports top shareholders are generally viewed as the most factual and objective source of information about a company.

Ans: B.

Besides the annual SEC filings, an analyst should examine a company’s quarterly or semiannual filings. These interim filings tropically update the major financial statements and footnotes, but are not necessarily audited. Annual reports to shareholders and press releases are written by management and are often viewed as public relations or sales materials.

20. Which of the following statements regarding an audit and a standard auditor’s opinion is most accurate?

A. The objective of an audit is to enable the auditor to provide an opinion on the numerical accuracy of the financial statements.

B. To provide an independent review of a company’s financial statements, an independent certified public accounting firm is appointed by the company’s management.

C. The absence of an explanatory paragraph in the audit report relating to the going concern assumption suggests that there are no serious problems that require a close examination of that assumption by the analyst.

Ans: C.

A specific explanatory paragraph that makes reference to (questions) the going concern assumption may be a signal of serious problems and call for close examination by the analyst. Therefore, in the absence of such a paragraph, there is no need for a close examination of the going concern assumption by the analyst.

A is incorrect. The objective of an audit is to enable the auditor to provide an opinion on the fairness and reliability of the financial statements. This is not the same as numerical accuracy. The auditor generally only provides reasonable assurance that there are no material errors in the financial statements, not an opinion about their numerical accuracy.

C is incorrect. An independent certified public accounting firm must be appointed by the audit committee of the company’s board of directors, not by its management. Appointment of the auditors by management would reduce the level of perceived independence.

21. Which of the following sources of information should an analyst consider the least reliable?

A. Form 10-Q.

B. Proxy statement.

C. Corporate press release.

Ans: C.

Corporate press releases are written by management and are often view as public relations or sales materials because of the great possibility of inherent management bias in such documents. Often, little or none of the material is independently reviewed by outside auditors. Such documents are not mandated by the securities regulators.

A and B are incorrect. Form 10-Q (quarterly financial statements) and Proxy statement are mandatory SEC filings in the U.S., which inherently increases their reliability given the penalties that can be imposed by the SEC if any serious irregularities are subsequently found.

22. The two primary assumptions in preparing financial statements under IFRS are:

A. accrual and going concern.

B. reasonable accuracy and accrual.

C. going concern and reasonable accuracy.

Ans: A.

In the IFRS framework, the two primary assumptions in preparing financial statements are the accrual basis and the going concern assumption.