understanding income statements(Reading 25)

Exercise Problems:

1. The percentage-of-completion method of accounting for long-term contracts:

A. Minimizes the present value of income tax payments.

B. Relies less on estimates of futures costs that a firm expects to incur.

C. More accurately reports the current status of uncompleted projects.

Ans. C.

The percentage-of-completion method recognizes revenue based on the construction activity completed for a period, the income statement thud more accurately reports the revenue/expense items of the uncompleted projects.

A is incorrect. With the percentage-of-completion method, the present value of income tax payments is maximized, not minimized, because revenue is recognized earlier and taxes are paid earlier.

B is incorrect. The percentage-of-completion method relies more, not less, on estimates of the degree of completion and the extent of future costs to be incurred.

2. An analyst complied the following information for Capital Company:

Basic earnings per share (EPS) for the one-year period ended Dec 31, 20x2 for Capital Company is closest to:

A.    $0.09

B.     $0.10

C.     $0.12

Ans:C.

Basic EPS=

                 =

                  =$0.12

3. Addy, Inc started a 3-year construction project on 1/1/20x2. Projected revenues are 30$ million and expenses (including taxes) are estimated at 75% of total revenue. The project is to be completed as follow: 25% by 12/31/20x2, 60% by 12/31/20x3, and 100% by 12/31/20x4. Cash will be received based on completion rates. All of the company’s revenue is generated by this project. The company’s equity is generated by the profits from this project and no dividends are expected to be paid. What will the return on average equity be in 20x4 under the percentage of completion?

A. 40.0%.

B. 46.9%.

C. 50.0%

Ans: C.

Note (1): average equity = ($1,875+4,500)/2= $3,188

Note (2): average equity = ($4,500+7,500)/2 =$6,000

Return on equity = net income/average equity

20x4 = $3,000/6,000 = 50% for percentage completion

A is incorrect. Year-end 20x4 equity was incorrectly used for both methods.

B is incorrect. Averages of 20x3 and 20x4 operating profit were incorrectly used for both methods.

4.  A company suffered a substantial loss when its production facility was destroyed in an earthquake against which it was not insured. Geological scientists were surprised by the earthquake as there was no evidence that one had ever occurred in that area in the past. Which of the following statements is most accurate? The company should report the loss on its income statement:

A. net of taxes if it reports under U.S. GAAP.

B. as an extraordinary item if it reports under IFRS.

C. as an unusual item if it reports under U.S. GAAP.

Ans: A.

To qualify as an extraordinary item, an item must be both unusual in nature and infrequent in occurrence: The description of the earthquake meets these criteria (-Geological scientists were surprised by the earthquake as there was no evidence that one had ever occurred in that area in the past). Extraordinary items are only allowed under U.S. GAAP and are reported on the income statement net of tax.

5. According to International Financial Reporting Standards, which of the following conditions should be satisfied in order to report revenue on the income statement?

A. Payment has been received.

B. Costs can be reliably measured.

C. Goods have been delivered to the customer.

Ans: B.

According to the International Accounting Standards Board (IASB), revenue is recognized from the sale of goods when:

1.       The risk and reward of ownership is transferred.

2.       There is no continuing control or management over the goods sold.

3.       Revenue can be reliably measured.

4.       There is a probable flow of economic benefits.

5.       The cost can be reliably measured.

The IFRS conditions that should be met include that the costs incurred can be reliably measured, and it is likely that the economic benefits will flow to the entity, not the actual receipt of any payment, and that the significant risks and rewards of ownership have been transferred, which is normally when the goods have been delivered, but not always.

C is incorrect. Receiving the payment is not a condition to report revenue under IFRS.

C is incorrect. According to the Financial Accounting Standards Board (FASB), revenue is recognized in the income statement when (a) realized or realizable and (b) earned. The Securities and Exchange Commission (SEC) provides additional guidance by listing four criteria to determine whether revenue should be recognized:

1.      There is evidence of an arrangement between the buyer and seller.

2.      The product has been delivered or the service has been rendered.

3.      The price is determined or determinable.

4.      The seller is reasonably sure of collecting money.

6.A company entered into a three-year construction project with a total contract price of $10.6 million and an expected total cost of $8.8 million. The following table provides cash flow information relating to the contract:

If the company uses the percentage-of-completion method, the amount of revenue recognized (in millions) in Year 2 is closest to:

A. $3.5.

B. $5.6.

C. $7.2.

Ans: C.

The revenue reported is equal to the percentage of the contract that is completed in that period, where percentage completion is based on costs.

Revenue recognized (in millions) in Year 2:

7.A retailer provides credit cards only to its most valued customers who pass a rigorous credit check. A credit card customer ordered an item from the retailer in May. The item was shipped and delivered in July. The item appeared on the customer’s July credit card statement and was paid in full by the due date in August. The most appropriate month in which the retailer should recognize the revenue is:

A. May.

B. July.

C. August.

Ans: B.

The appropriate time to recognize revenue would be in the month of July; the risks and rewards have been transferred to the buyer (shipped and delivered), the revenue can be reliably measured, and it is probable that the economic benefits will flow to the seller (the rigorous credit check was completed). Neither the actual payment date nor the credit card statement date is relevant here.

8. An analyst gathers the following information about a company’s common stock:

? 1 January 2011 200,000 shares outstanding

? 1 June 2011 50,000 shares issued

? 1 August 2011 2 for 1 stock split

? 31 December 2011 500,000 shares outstanding

To calculate earnings per share for 2011, the company’s weighted average number of shares outstanding is closest to:

A. 333,333.

B. 350,000.

C. 458,333.

Ans: C.

The weighted average number of shares is determined by the length of time each quantity of shares was outstanding. A stock split is treated as if it occurred at the beginning of the year.

9. A company uses the percentage-of-completion method to recognize revenue from its long term construction contracts and estimates percent completion based on expenditures incurred as a percentage of total estimated expenditures. A three-year contract for €10 million was undertaken with a 30% gross profit anticipated. The project is now at the end of its second year, and the following end-of-year information is available:

The gross profit recognized in year 2 is closest to:

A. €617,500.

B. €880,000.

C. €960,000.

Ans: A.

Percent completed=

Gross profit=

% Complete x Anticipated Profit - Profit Already Recognized

10. The following financial information is available at the end of the year.

The diluted EPS is closest to:

A. $2.91.

B. $2.93.

C. $3.08.

Ans: A.

The convertible preferred shares are anti-dilutive, as shown in the table below; therefore the diluted EPS is the same as the basic EPS, $2.91.

11. The following information is available on a company for the current year.

The company’s diluted EPS is closest to:

A. $7.57.

B. $7.69.

C. $7.72.

Ans: C.

Since both the preferred shares and bonds are dilutive, they should both be converted to calculate the diluted EPS. Diluted EPS is the lowest value. $7.72 has calculated in the following table.

12. During 2010, Company A sold a piece of land with a cost of $6 million to Company B for $10 million. Company B made a $2 million down payment with the remaining balance to be paid over the next 5 years. It has been determined that there is significant doubt about the ability and commitment of the buyer to complete all payments. Company A would most likely report a profit in 2010 of:

A. $4 million using the accrual method.

B. $0.8 million using the installment method.

C. $2 million using the cost recovery method.

Ans: B.

An installment sale occurs when a firm finances a sale and payments are expected to be received over an extended period. If collectability is certain, revenue is recognized at the time of sale using the normal revenue recognition criteria. If collectability cannot be reasonably estimated, the installment method is used.

Under installment method, profit is recognized as cash is collected.

Profit reported in 2010 is:

x2=0.8million

A is incorrect. It has been determined that there is significant doubt about the ability and commitment of the buyer to complete all payments. Normal revenue recognition method cannot be used here.

C is incorrect.Cost recovery method could be used in this case, but the reported profit would be $0. Because under the cost recovery method, profit is recognized only when cash collected exceeds costs incurred.

13. The table below shows changes to the number of common shares outstanding for a company during 2012:

To calculate earnings per share for 2012, the company’s weighted average number of shares outstanding is closest to:

A. 215,000.

B. 420,000.

C. 430,000.

Ans: C.

The weighted average number of shares outstanding is time weighted: 5/12 of the year there were 180,000 shares, and 7/12 of the year there were 240,000 (180,000+60,000) on a pre-split basis; the stock split is treated retroactively to the start of the year.

[(180,000 x 5/12) + (240,000 x 7/12)] x 2 = 430,000

14. A company entered into a three-year construction project with a total contract price of $5.3 million and an expected total cost of $4.4 million. The following table provides cash flow information relating to the contract:

If the company uses the percentage-of-completion method, the amount of revenue (in $) recognized in Year 2 will be closest to:

A. 2,800,000.

B. 3,372,727.

C. 3,616,636.

Ans: C.

The revenue reported is equal to the percentage of the contract that is completed in that period, where percentage completion is based on costs. In Year 2, the percent completed is $3,000,000/$4,400,000 = 68.2%, resulting in 68.2% x 5,300,000 = 3,616,636 revenue being recognized.

15. A company, with a tax rate of 40%, sold a capital asset with a net book value of $500,000 for $570,000 during the year. Which of the following amounts (in $) will most likely be reported on its income statement for the year related to the asset sale?

A. 42,000

B. 70,000

C. 570,000

Ans: B.

The disposition of a capital asset is reported as a net gain or loss ($570,000 – $500,000 = $70,000) on the income statement before tax affects.

16. A company reported net income of $400,000 for the year. At the end of the year, the company had an unrealized gain of $50,000 on its available-for-sale securities, an unrealized gain of $40,000 on held-to-maturity securities and an unrealized loss of $100,000 on its portfolio of held-for-trading securities. The company’s comprehensive income (in $) for the year is closest to:

A. 350,000.

B. 390,000.

C. 450,000.

Ans: C.

Comprehensive Income = Net Income + Other Comprehensive Income = NI + OCI

Other Comprehensive Income will include unrealized gains or losses on available for sale securities. Net Income includes unrealized gains or losses in trading securities, while securities classified as held to maturity are maintained at historical cost and therefore the unrealized gains won’t impact comprehensive income.

OCI = $50,000; Comprehensive Income = NI + OCI = $400,000 + $50,000=$450,000

17. According to International Financial Reporting Standards which of the following is one of the conditions that must be met for revenue recognition to occur?

A. Costs can be reliably measured

B. Payment has been partially received

C. Goods have been delivered to the customer

Ans: A.

The IASB’s conditions that must be met include that the costs incurred can be reliably measured, there is assurance of payment, not necessarily an actual receipt of any payment, and that the significant risks and rewards of ownership have been transferred, which is normally (but not always) when the goods have been delivered.

18. A company had 100,000 common shares outstanding on 1 January 2012. The company has no plans to issue additional shares or purchase treasury shares during the year, but is planning either a two-for-one stock split or a 100 percent stock dividend on 1 July. The number of shares used to determine earnings per share at 31 December 2012, will be closest to:

A. 200,000 for both the stock split and the stock dividend.

B. 200,000 for the stock split and 150,000 for the stock dividend.

C. 150,000 for the stock split and 200,000 for the stock dividend.

Ans: A.

Stock dividends and stock splits are treated in the same way for purposes of determining weighted average number of shares outstanding; the adjustment in the number of shares is made as if the stock split or dividend occurred at the beginning of the year.

19. Which of the following transactions will most likely result in a decrease in a company’s current ratio? The:

A. recording of a warranty expense.

B. recording of revenue before cash is received.

C. payment of a property insurance policy for the following year.

Ans: A.

The recording of a warranty expense will create a warranty liability and the resulting increase in current liabilities will decrease the current ratio.

B is incorrect. Recording the revenue will increase the CA while having no affect on the CL, so the current ratio will increase.

C is incorrect. The payment of a property insurance policy for the following year has no effect both on CA or Cl, so current ratio stays the same.

20. A company has just completed the sale of a tract of land for €3.5 million which was originally acquired at a cost of €2.0 million. The purchaser made a down-payment of €200,000 with the remainder to be paid in equal installments over the next 10 years. A short time after the sale, significant doubt arose about the purchaser’s ability to meet the future obligations for the land purchase. When compared to the cost recovery method of revenue recognition, the profit (in €) that the company will recognize in the year of the sale under the installment method is most likely to be higher by:

A. 85,714.

B. 114,286.

C. 150,000.

Ans: A.

Under the installment method, the portion of the total profit of the sale (3.5 – 2.0 = 1.5) that is recognized in each period is determined by the percentage of the total sales price for which the seller has received cash, which is €1.5/€3.5 x €200,000 = €85,714; under the cost recovery method, no profit is recognized until the cash amounts received have exceed the seller’s cost of the property.

21. 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.

Ans: B.

The loss on the disposal of fixed assets is an unusual or infrequent item but it is still part of normal operating activities.

A is incorrect. The interest expense is the result of financing activities and would be classified as a nonoperating expense by nonfinancial service companies.

C is incorrect.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.

22. An analyst gathers the following information about a company:

Using the treasury stock method, the number of incremental shares used to compute diluted earnings per share is closest to:

A. 5,000.

B. 15,000.

C. 20,000.

Ans: A.

Diluted EPS is calculated using the treasury stock method that considers what would be the effect if the options or warrants had been exercised. Only options or warrants that are in-the-money are included, as out-of-the-money options would not be exercised. Therefore only the warrants are dilutive: their exercise price is below the average market price of the stock. Using the treasury stock method, the number of new shares issued on exercise is reduced by the number of shares that could be purchased with the cash received upon exercise of the warrants: 20,000($30) = $600,000 in proceeds. $600,000 / $40 = 15,000 shares treasury stock. Incremental shares using the treasury stock method = 20,000 – 15,000 = 5,000.

23. An analyst gathers the following information about a company:

The bonds were issued at par and can be converted into 300,000 common shares. All securities were outstanding for the entire year. Diluted earnings per share is closest to:

A. $1.05.

B. $1.26.

C. $1.36.

Ans: B.

Dividends of $140,000 (0.07 x 2,000,000) should be deducted from net income to determine the amount available to common shareholders:

$1,360,000 = (1,500,000 –140,000).

Basic EPS would be $1,360,000 / 1,000,000 or $1.36 per share.

Diluted EPS would consider the convertible bonds if they were dilutive.

Interest on the bonds is $400,000 and the after-tax amount add back to net income is

$400,000 (1-.30) = $280,000.

Diluted EPS, assuming conversion, is

($1,360,000 + 280,000) / (1,000,000 +300,000) = 1,640,000/1,300,000= $1.26 per share.

The bonds are dilutive.

24. An analyst gathers the following data about a company and the industry in which it

operates:

Which of the following conclusions is most reasonable? Compared to the industry, the company:

A. has the same cost structure and net profit margin.

B. has a lower gross profit margin and spends more on its operating costs.

C. is better at controlling product costs, but less effective at controlling operating costs.

Ans: C.

25. An analyst is forecasting EPS for a company. She prepares the following common sized data from its recent annual report and estimates sales for 2009.

The capital structure of the company has not changed and the company has no short term interest bearing debt outstanding. The projected net income (in $ millions) for

2009 is closest to:

A. 162.8.

B. 164.9.

C. 167.4.

Ans: C.

The cost of goods sold and operating expenses are constant over the two-year period and they can reasonably be used to forecast 2009. Interest expense is declining as a percent of sales, implying it is a fixed cost. Conversion into dollars for each year shows what interest expense has been; 2008 =$80 (3.72% x 2,150); 2007=$80 (4.02 x 1,990) and that would be a reasonable projected amount to use. The restructuring charge should not be included as it is a non-recurring item. The tax rate, 35%, is given.

Sales                                                   $2,250.00

COGS (45%)                                        1,012.50

Operating expenses (40%)                       900.00

Interest expense                                          80.00

Pretax margin                                            257.50

Tax (35%)                                                      90.1

Net Income                                                 167.40

26. The unrealized gains and losses arising from changes in the market value of available-for-sale securities are reported under U.S. GAAP and International Financial Reporting Standards (IFRS) in the:

A. equity section for both.

B. equity section for U.S. GAAP and the income statement for IFRS.

C. income statement for U.S. GAAP and the equity section for IFRS.

Ans: A.

Under both U.S. GAAP and IFRS the unrealized gains and losses arising from carrying available-for-sale securities at market value are reported in equity as part of accumulated other comprehensive income.

27.  The following information is available from a company’s according records:

The company’s total comprehensive income (in million) is closest to:

A.    €1,150

B.     €3,150

C.     €3,650

Ans: C.

Total comprehensive income= net income + other comprehensive income

Net income  revenue – expenses

Other comprehensive income includes gains or losses on available-for-sale securities and translation adjustments on foreign subsidiaries.

(revenue - expense) + gain on AFS – loss on FX translation

(12,500-10,000)+1.475-325=3,650

28. During 2012, Nagano Incorporated, a manufacturing company, reported the following items on their income statement:

Under U.S.GAAP, the correct classification of each of these items on the income statement would be as a(n):

A.    Answer A.

B.     Answer B.

C.     Answer C.

Ans: B.

Under U.S.GAAP:

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.

29. Melbourne Manufacturing has equipment with an original cost of $850,000, accumulated amortization of $300,000 and 5 year of estimated remaining useful life. Due to a change in market conditions Melbourne now estimate that the equipment will only generate cash flow of $80,000 per year over its remaining useful life. The company’s incremental borrowing rate is 8%. What is the amount of the impairment loss closest to and what would be the effect on the company’s return on asset (ROA) in future periods?(under U.S.GAAP)

A.    Answer A.

B.     Answer B.

C.     Answer C.

Ans: C.

The equipment is impaired. NBV=$550,000, which is greater than the sum of the undiscounted cash flow 5 years x$80,000=$400,000

The amount of the impairment is

550,000-PV of the cash flow=550,000-319,417(PMT=80,000, N=5,i=8%)=230,583.

The company’s ROA will increase.

ROA=

There will be lower depreciation charges in the future, which will increase net income, and a lower carrying value of assets, which decreases total assets. Both factors would increase any future ROA.

30. An analyst gathered the following information about a company:

Using the treasury stock method, the number of incremental shares should be used to compute diluted earnings per share is closest to:

A.    5,000.

B.     12,500.

C.     15,000.

Ans: A.

Diluted EPS is calculated using the treasury stock method that considers what would be the effect if the options or warrants had been exercised. Only options or warrants that are in-the-money are included, as out-of-the-money options would not be e3xercised. Therefore, only the warrants are dilutive, the exercise preice is below the average market price of the stock. Using the treasury stock method:

20,000($30)=$600,000 in proceeds.

$600,000/$40=15,000 shares treasury stock. Incremental shares using the treasury stock method = 20,000 – 15,000 = 5,000.

31. The following information was obtained from a company’s 10-k.

Firm’s weighted average number of shares outstanding for the one-year period ended June 30,20x3 is closest to:

A.    3,000,000.

B.     4,500,000.

C.     6,000,000.

D.     

Ans: C.

The weighted average number of shares outstanding is time weighted: 3/12 of the year there were 1,500,000 shares, 3/12 of the year there were 2,500,000 (1,500,000+1,000,000),3/12 of the year there were 2,000,000 (1,500,000+1,000,000-500,000) on a pre-split basis (the stock split is treated retroactively to the start of the year), and 3/12 of the year there were 6,000,000 (=2,000,000 x 3)

Weighted average number of shares outstanding for the one-year period:

[(1,500,000 x 3/12) + (2,500,000 x 3/12)+(2,000,000 x 2/12)] x 3+6,000,000 x 3/12= 6,000,000

32. An analyst gathered the following information about a company:

The bonds were issued at par and can be converted into 300,000 common shares. All securities were outstanding for the entire year.

Diluted earnings per share for the company are closest to:

A. $1.05.

B. $1.26.

C. $1.36.

Ans: B.

33. Income statements for two companies (A and B) and the common-sized income statement for the industry are provided below:

The best conclusion an analyst can make is:

A. Company B’s interest rate is lower than the industry average.

B. Both companies’ tax rates are higher than the industry average.

C. Company A earns a higher gross margin than both Company B and the industry.

Ans: C.

Company A earns a higher gross margin than both Company B and the industry.

A is incorrect. The interest rate is not a function of sales and cannot be analyzed on a common sized income statement.

B is incorrect.

Tax rates are determined based on taxes ÷ pretax earnings, not as a percentage of sales (as shown in common sized analysis).

The tax rates for the companies are not higher than the industry.

34. The following information is available for Ajax Company’s most recent fiscal year:

The $100 par value preferred stock pays a 5% dividend. Each preferred share may be converted into five common shares. The preferred stock market price is $102 per share and the common stock trades at $19 per share.

Diluted earnings per share (EPS) for Ajax company is closest to:

A. $1.00.

B. $1.33.

C. $1.50.

Ans: B.

Diluted EPS is derived from the following calculation:

Diluted EPS=

To calculate the dilutive effect of the preferred shares, assume that the shares were converted at the beginning of the period. Assuming this conversion, the $5,000,000 preferred dividends would not have been paid and there would have been an additional 5,000,000 common shares (5 new shares for each preferred share outstanding). The formula is:

Net income available to common shareholders was $15,000,000 ($20m-$5m in preferred dividends). If the shares were converted, the $5m in preferred dividends is added back.

Diluted EPS cannot exceed basic EPS. Basic EPS is calculated as follows:

The diluted EPS does not exceed basic EPS. Had diluted EPS exceeded basic EPS, the convertible preferred stock would have been anti-dilutive and diluted EPS would be the same s basic EPS.

35. Which of the following transactions would typically be included as part of a company’s income from discontinued operations reported on the income statement?

A. A gain from the sale of an investment.

B. A loss incurred from the settlement of a lawsuit.

C. A loss from the operations of a business component classified as “held for sale.”

Ans: C.

A loss from the operations of “held for sale” business components that have separately identifiable operations, assets and cash flows would typically be reported under discontinued operations.

A and B are incorrect. Although each item is considered an unusual or infrequent item, it would be reported as part of income from continuing operations. If significant, the item may be reported as a separate line item as long as it is presented on a pretax basis, appears “above the line”, and is not presented as an extraordinary item.

36. Bao Company reported net income for the year ended December 31, 2012 of $6,000,000. The company’s tax rate was 40%. At the same date, the company had outstanding $30 million in 6% convertible bonds with a conversion price of $60 per share and 3 million common shares with a par value of $10. The only change in the capital structure during 2012 was the repurchase of 100,000 common shares on April 1.

Bao’s diluted earnings per share for 2012 were closest to:

A. $2.01.

B. $1.98.

C. $1.91.

Ans: B.

Weighted average shares outstanding =

3,100,000 outstanding before treasury repurchase for ? of the year = 775,000

3,000,000 outstanding before treasury repurchase for ?  of the year = 2,250,000

Weighted average shares = 775,000+2,250,000 = 3,025,000

Basic EPS= income from continuing operations/ WASO

                 =$6,000,000/3,025,000 = $1.98

Potential common shares from bond conversion

=$30,000,000 /$60 = 500,000 shares

Reduction of interest expense net of taxes

=$30 million x 6% x (1-0.4) = $1,080,000

Adjusted EPS assuming conversion

=($6,000,000+1,080,000)/(3,025,000+500,000)

=$2.01

The adjustment for the bond conversion is anti-dilutive (the diluted EPS as calculated is smaller than basic EPS) so basic EPS and diluted EPS are the same at $1.98.

37. A company’s comparative income statements and balance sheets are presented below.

The cash collected from customers in 2012 is closest to:

A.    $88,500.

B.     $96,100.

C.     $111,500.

Ans: A.

Cash collected from customers = revenues – increase in AR

                                                   = $100 – (25-13.5)

                                                   =88.5

38.  Under U.S.GAAP, foreign currency translation adjustments are most likely reported in the company’s:

A. income statement.

B. statement of cash flows.

C. statement of stockholders’ equity.

Ans: C.

The statement of stockholders’ equity includes accumulated other comprehensive income that contains the foreign currency translation adjustment.

Note: other comprehensive income includes transactions that are not included in net income, such as:

·         Foreign currency translation gains and losses.

·         Adjustments for minimum pension liability.

·         Unrealized gains and losses from cash flow hedging derivatives.

·         Unrealized gains and losses from available-for-sale securities.

39.Is the reporting of an extraordinary item, net of tax, allowed under U.S.GAAP and IFRS?

A. Yes, under both.

B. Yes under IFRS, but not under U.S.GAAP.

C. Yes under U.S.GAAP, but not under IFRS.

Ans: C.

Under U.S.GAAP, an extraordinary item is a material transaction or event that is both unusual and infrequent in occurrence.

IFRS does not allow extraordinary items to be separated from operating results in the income statement.

40. under U.S.GAAP, disclosures related to the valuation allowance for changes in the carrying amount of a company’s noncurrent investment securities will most likely be included in the company’s:

A. income statement.

B. statement of cash flows.

C. statement of stockholders’ equity.

Ans: C.

The statement of stockholders’ equity includes accumulated other comprehensive income that contains the unrealized gains and losses on available-for-sale securities.

41. Under U.S.GAAP, compared to the completed contract method of revenue recognition, the percentage-of-completion  method most likely result in higher:

A. total asset.

B. total liabilities.

C. both total asset and total liabilities.

Ans: A.

Compared to the completed-contract method, the percentage-of-completion method will most likely result in higher total assets, reflecting the accrual of gross profit during the contract period and lower liabilities, as the higher level of construction-in-progress provides a larger offset to advance billings.

42. Which of the following items affects owners’ equity but is not included as a component of net income?

A. Depreciation.

B. Dividends received on shares of another company classified as available for sale.

C. Foreign currency translation gains and losses.

Ans: C.

Foreign currency translation gains and losses are nor reported on the income statement as a component of net income, but affect owners’ equity because they are included as other comprehensive income. The other items are included on the income statement so they affect both net income and owners’ equity.

43. IFRS and U.S.GAAP are most similar in their requirements for:

A. extraordinary items.

B. discontinued operations.

C. valuation of fixed assets.

Ans: B.

IFRS and U.S.GAAP both require discontinued operations to be reported on the income statement separately from continuing operations and net of tax.

A is incorrect. U.S.GAAP permits unusual and infrequent items to be treated as extraordinary items. But IFRS does not permit extraordinary items.

C is incorrect. Fixed assets can be revalued upward under IFRS but not under U.S.GAAP.

44. An analyst gathered the following data about a company:

·         1,000,000 shares of common are outstanding at the beginning of the year.

·         10,000 6% convertible bonds (conversion ratio is 20 to 1) were issued at par June 30 of this year.

·         The company has 100,000 warrants outstanding all year with an exercise price $25 per share.

·         The average stock price for the period is $20, and the ending stock price is $30.

If the convertible bonds are considered dilutive, the number of shares of common stock that the analyst should use to calculate diluted earnings per share is:

A.    1,000,000.

B.     1,100,000.

C.     1,266,667.

Ans: B.

When the capital structure contains options or warrants, the treasury stock method uses the average price. In this situation, the warrants are antidilutive because the exercise price of the warrant ($25) is higher than the market price of the stock ($20). Thus, warrants are excluded. Otherwise, common shares would be reduced.

Original shares of common stock = 1,000,000x(12/12)

The add the impact of the bond conversion:

(10,000)(20) x (6/12)=100,000.

Thus, the adjusted denominator for gully diluted EPS is:

1,000,000+100,000=1,100,000

45. Which of the following statements about the approaches for calculating EPS in simple versus complex capital structure is least accurate?

A. If convertible bonds are dilutive, the numerator in the diluted EPS calculation is increased by the interest expense on the bonds.

B. If convertible preferred stock is dilutive, the convertible preferred dividends must be added back to the numerator to calculate diluted EPS.

C. The denominator in the basic EPS equation contains the number of shares of common stock issued, weighed by the days that the shares have been outstanding.

Ans: A.

If convertible bonds are dilutive, interest expense multiplied by (1- tax rate) must be added back to the numerator to calculate diluted EPS.

46. Bao Corp. has a permanently impaired asset. The difference between its carrying value and the present value of its expected cash flows should be written down immediately and:

A. reported as an operating loss.

B. charged directly against retained earnings.

C. reported as a non-operating loss in other comprehensive income.

Ans: A.

Impairment writedowns are reported losses “above the line” and are included in income from continuing operations.

47. At the end of its last fiscal year, Bao Corp. reported retained earnings of $215,000. This year, Bao reported year-end retained earnings of $250,000 and net income of $20,000, paid received dividends of $5,000, paid interest expense of $5,000, and received dividends of $5,000. Bao’s other comprehensive income for this year is closest to:

A. $15,000.

B. $20,000.

C. $25,000.

Ans: B.

Since retained earnings increased by 250,000 – 215,000 = 35,000 and net income less dividends paid was 20,000 – 5,000 = 15,000, the difference, 35,000 – 15,000 = 20,000, must have been other comprehensive income. Dividends received and interest paid are both included in net income.

48. In actual accounting, the matching principle states that:

A. an entity should recognize revenue only when received and expenses only when they are paid.

B. transactions and events producing cash flows are allocated only to time periods in which the cash flows occur.

C. expenses incurred to generate revenue are recognized in the same time period as the revenue.

Ans: C.

The matching principle holds that expenses should be accounted for in the same performance measurement period as the revenue they generate.

49. Which of the following statements about revenue recognition methods is most accurate?

A. The completed contract method under U.S.GAAP recognizes long-term contract revenue only as each phase of production is complete.

B. The percentage of completion method recognizes profit corresponding to the costs incurred as a proportion of estimated total costs.

C. The installment method recognizes sales when cash is received, but no profit is recognized until cash collected exceeds cost.

Ans: B.

The description of the percentage-of-completion method is accurate. The completed contract method under U.S.GAAP recognizes revenue only when the entire project is complete. The installment method recognizes profit in proportion to cash collected. he entire projuect is complete. the s the revenue regerat

50. A company changes from an incorrect method of accounting to an acceptable one. Which of the following statements about his change is most accurate?

A. It is treated retrospectively and requires restatement of all prior period results that are presented in the current financial statements.

B. If the change is voluntary, it is a change in accounting principle and is reported below the line net of taxes.

C. If the change is mandated by a new accounting standard, it is an unusual or infrequent item and is reported as a separate line item in net income for continuing operating.

Ans: A.

This is the correct treatment of this change. The company must disclosure the nature of the error and its effect on net income and restate any prior period results that are presented in the current financial statements.

51. An analyst gathered the following data about a company:

The company had 500,000 shares of common stock outstanding for the entire year.

The company’s beginning stock price was $40, its ending price was $60, and its average price over the year was $50.

The company has 120,000 warrants outstanding for the entire year.

Each warrant allows the holder to buy one share of common stock at $45 per share.

How many shears of common stock should the company use in computing its diluted earnings per share?

A. 488,000.

B. 500,000.

C. 512,000.

Ans: C.

Dilution occurs since the exercise price for the warrants ($45) is less than the average market price for the shares ($50). The incremental number of shares outstanding is found from:

() x # warrants

=  x 120,000

=12,000

Number of shares to use in diluted EPS calculation

 = 500,000+12,000=512,000

52. Which of the following statements about dilutive securities is least accurate?

A. A simple capital structure is one that contains only common stick and antidilutive securities.

B.  A dilutive security is one that will case EPS to decrease if it is converted into common stock.

C. Warrants with exercise prices less than the current stock price can be antidilutive.

Ans: A.

A simple capital structure has only common stock or only common stock and nonconvertible stock. It contains no securities that could ever become or create common stock, even antidilutive ones. Whether warrants are antidilutive depends on the average stock price over the reporting period, not the value at the reporting date.

53. As of January 1, a company had 22,500 $10 par value commons shares outstanding. On July 1, the company repurchased 5,000 shares. The company also has 11,000, 10%, $100 par value preferred shares. If the company’s net income is $210,000, its diluted earnings per share is closest to:

A. $5.00.

B. $7.50.

C. $10.00.

Ans: A.

Since this company has a simple capital structure, basic and diluted EPS are equal.

The numerator equal net income-preferred dividends

=210,000-(11,000shares x 0.10dividend x 100 par)

=210,000-110,000=100,000.

The weighted average shares outstanding

=22,500-(5,000 shares repurchased x 0.5 midyear)

=22,500-2,500=20,000.

Then, basic EPS = diluted EPS=100,000/20,000=$5per share.

54. Which of the following statements about the appropriate revenue recognition method to use under U.S.GAAP, given the status of completion of the earning process and assurance of payment, is least accurate? Use the:

A. completed contract method when the firm cannot reliably estimate the outcome of the project.

B. percentage-of-completion method when ultimate payment is reasonably assured and revenue and costs can be reliably estimated.

C. installment method when collectability of payments for a sale can be reasonably estimated.

Ans: C.

The installment method should be used when future cash collection cannot be reasonably estimated.

55. An analyst gathers the following data about a company:

·         The company had 1 million shares of common stock outstanding for the entire year.

·         The company’s beginning stock price was $50, its ending price was $70, and its average price was $60.

·         The company had 100,000 warrants outstanding for the entire year. Each warrant allows the holder to buy one share of common stock at $50 per share.

How many shares of common stock should the company use in computing its diluted EPS?

A.    1,100,000.

B.     1,083,333.

C.     1,016,667.

D.     

Ans: C.

Use the Treasury stock method:

Step 1: determine the number of common shares created if the warrants are exercised = 100,000.

Step 2: calculate the cash inflow if the warrants are exercised:

(100,000)($50 per share)=$5,000,000.

Step 3: Calculate the number of shares that can be purchased with these funds using the average market price ($60 per share):

5,000,000/60=83,333 shares.

Step 4: Calculate the net increase in common shares outstanding from the exercise of the warrants:

100,000-83,333=16,667.

Step 5: Add the net increase in common shares from the exercise of the warrants to the number of common shares outstanding for the entire year:

1,000,000+16,667=1,016,667

56. A company reports a gain of €100,000 on the sale of an asset and a loss of €100,000 due to foreign currency translation adjustment. Which of these items will be included in the company’s comprehensive income?

A. Both of these items are include in comprehensive income.

B. Neither of these items is include in comprehensive income.

C. Only one of these items is include in comprehensive income.

Ans: A.

Both items are included in comprehensive income. Comprehensive income includes all items that are included in net income are also included in comprehensive income. The gain on sale is reported in net income. The foreign currency translation loss is taken directly to owners’ equity.

57. Which of the following items for a financial services company is least likely to be considered an operating item on the income statement?

A. Interest income.

B. Financing expenses.

C. Income tax expense.

Ans: C.

For a financial services company, interest income, interest expense, and financing expense are likely considered operating activities. For both financial and nonfinancial companies, income tax expense is a non-operating item that is reported within “income from continuing operating” as opposed to “operating profit” as with the other answer considered an operating item.

58. Which of the following statements about nonrecurring items is most accurate?

A. The correction of an accounting error is reported net of taxes below extraordinary items on the income statement.

B. Discontinued operations are classified as unusual or infrequent and are reported as a component of net income from continuing operations.

C. Uninsured losses from earthquakes and expropriations by foreign governments can be classified as extraordinary items under U.S.GAAP but not under IFRS.

Ans: C.

These are examples of items that are typically treated as extraordinary under U.S.GAAP. There is no provision for accounting for an item as extraordinary under IFRS.

A is incorrect. Accounting errors are corrected with prior-period adjustments, which are made by restating results for any prior periods that are presented in the current financial statements.

B is incorrect. Discontinued operations are not classified as unusual or infrequent items and are reported (net of taxes) after net income from continuing operations but before net income.

59. Bao Company has the following changes in its stock:

The company had 2 million shares outstanding on December 31, 2011.

On March 31, 2012, the company paid a 10% stock dividend.

On June 30, 2012, the company sold $10 million face value of &% convertible debentures, convertible into common at $5 per share.

On September 30, 2012, the company issued and sold 100,000 shares of common stock.

The company should compute its 2012 basic EPS based on:

A.    2,225,000 shares.

B.     2,250,000 shares.

C.     3,225,000 shares.

D.     

Ans; A.

Basic EPS does not consider potential dilution from convertible bonds.

Original shares =2,000,000x12=24,000,000

+stock dividend=200,000x12=2,400,000

+new shares =100,000x3=300,000

==2,225,000

Alternatively, 2 million(1.1)+(1/4)(100,000)=2.225 million.

60. When a used delivery truck is sold, the gain or loss on disposal is most accurately stated as:

A. fair market value – book value.

B. selling price – original cost – accumulated depreciation.

C. selling price – original cost + accumulated depreciation.

Ans: C.

The gain (loss) on disposal is the amount by which the selling price exceeds (is less than) book value.

Book value= original price-accumulated depreciation.

Thus, gain or loss=selling price-(original price- accumulated depreciation), or selling price – original costs+ accumulated depreciation.

61. A firm that reports under IFRS is producing under a long-term contract for which it cannot measure the outcome reliably. In the first of the contract, the firm has spent €300,000 and collected €200,000 in cash. What amounts related to this contract should the firm recognize on its income statement for the year?

A. Revenue of €300,000, expenses of €300,000, and no profit.

B. No revenue, expenses, or profit until the contract is completed.

C. Revenue of €200,000, expenses of €300,000, and a loss of €100,000.

Ans: A.

Under IFRS, if the outcome of a long-term contract cannot be estimated reliably, the firm should expense costs when incurred, recognize revenue to the extent of the costs, and recognize profit only when the contract is complete.

62.  During 2012, Bao Inc. reported net income of $15,000 and had 2,000 shares of common stock outstanding for the entire year. Bao also had 2,000 shares of 10%, $50 par value preferred stock outstanding during 2012. During 2009, Bao issued 100, $1,000 par, 6% bonds for $100,000. Each of these is convertible to 50 shares of common stock. Bao’s tax rate is 40%. Assuming these bonds are dilutive, 2012 diluted EPS for Bao is closest to:

A. $0.71.

B. $1.23.

C. $2.50.

Ans: B.

Diluted EPS=

100(1,000)(6%)(1-0.4)=$3,600;

Convertible debt shares=50(100)=5,000

=$1.23

63. Which of the following statements about the calculation of earnings per share (EPS) is least accurate:

A. Shares issued after a stock split must be adjusted for the split.

B. Options outstanding may have no effect on diluted EPS.

C. Reacquired shares are excluded from the computation from the date of reacquisition.

Ans: A.

Shares issued post-split need not be adjusted for the split as they are already “new” shares. Options with an exercise price greater than the average share price do not affect diluted EPS.

64. Bao Company has 1,000,000 warrants outstanding at the beginning of the year, each convertible into one share of stock with an exercise price of $50. No new warrants were issued during the year. The average stock price during the period was $60, and the year-end stock price was $45. What adjustment for these warrants should be made, under the treasury stock method, to the number of shares used to calculate diluted earnings per share (EPS)?

A. 0.

B. 166,667.

C. 200,000.

Ans: B.

Diluted EPS uses average price. Since the average price is greater than the exe4rcise price, the warrants are dilutive.

x1,000,000=166,667.

65. A software company holds a number of marketable securities as investments. For the most recent period, the company reports that the market value of its securities held for trading decreased by $2 million and the market value of its securities available for sale increased in value by $3 million. Together, these changes in value will:

A. reduce net income and shareholders’ equity by $2 million.

B. increase shareholders’ equity by $1 million and have no effect on net income.

C. reduce net income by $2 million and increase shareholders’ equity by $1 million.

Ans: C.

Unrealized gains and losses on securities held for trading are included in net income. Unrealized gains and losses on securities available for sale are not reported in net income but are included in comprehensive income. Net income will show a $2 million loss from the securities held for trading. Shareholders’ equity will reflect this loss as well as the $3 million unrealized gain from securities available for sale, for a net increase of $1 millions.

66. Analysts reviewing Amber Inc.’s and Bold Inc.’s long-term contracting activities observe that Amber’s contracts are being accounted for under the percentage-of-completion method while Bold’s are being accounted for under the completed contract method. This difference is least likely to affect the two companies’:

A. income statement.

B. statements of cash flows.

C. assets on the balance sheets.

Ans: B.

Cash flows are no different under the percentage-of-completion method compared with the completed-contract method. Income statement and balance sheet accounts will differ between the two firms.

67. Which of the following statements about types of nonrecurring items under U.S.GAAP is least accurate?

A. Unusual or infrequent items are included in income from continuing operations.

B. Extraordinary items are unusual and infrequent items that are reported net of taxes and included in nonrecurring income from continuing operations.

C. Discontinued operations are reported net of taxes below income from continuing operating.

Ans; B.

Extraordinary items are unusual and infrequent items that are reported separately, net of tax, after net income continuing operating.

68. Bao Company has the following sequence of events regarding its stock:

·         The company had 1,000,000 shares outstanding at the beginning of the year.

·         On June 30, the company declared and issued a 10% stock dividend.

·         On September 30, the company sold 400,000 shares of common stock at par.

The number of shares that should be used to compute basic earnings per share at year end is:

A.    1,000,000.

B.     1,100,000.

C.     1,200,000.

Ans: C.

Stock dividends are assumed to have been outstanding since the beginning of the year.

69. Consider a manufacturing company and a financial services company. Interest expense is most likely classified as a non-operating component of income for:

A. both of these companies.

B. neither of these companies.

C. only one of these companies.

Ans: C.

Interest expense is shown as a non-operating component of net income for a manufacturing company but would typical be classified as an operating expense for a financial services company.

70. Financial analyst, Zhan Wang, gathered the following data about a company:

·         1,000 common shares are outstanding (no change during the year).

·         Net income is $5,000.

·         The company paid $500 in preferred dividends.

·         The company paid $600 in common dividends.

·         The average market price of their common stock is $60 for the year.

·         The company had 100 warrants (for one share each) outstanding for the entire year, exercisable at $50.

The company’s diluted earnings per share is closest to:

A.    $4.42.

B.     $4.55.

C.     $4.83.

Ans: A.

The warrants are dilutive because their exercise price is less than the average market price.

Shares issued to warrant holders = 100

Warrants generate cash of 100 x 50 = $5,000

Repurchased shares = = 83

Net new shares created = 100 -83 = 17

Alternatively,  x 100=17

Diluted EPS = = =$4.42

71. Which of the following items would affect owners’ equity and also appear on the income statement?

A. Dividends paid to shareholders.

B. Unrealized gains and losses on trading securities.

C. Unrealized gains and losses on available-for-sale securities.

Ans: B.

Unrealized gains and losses from trading securities are reflected in the income statement and affect owners’ equity.

A is incorrect. Dividends paid to shareholders reduce owners’ equity but not net income.

C is incorrect. Unrealized gains and losses from available-for-sale securities are included in other comprehensive income. Transactions included in other comprehensive income affect but not net income.

72. For which of the following balance sheet items is a change in market value most likely to affect net income?

A. Debt securities issued by the firm.

B. Debt securities that the firm intends to hold until maturity.

C. Securities held with the intent to profit over the short term.

Ans: C.

Securities held with the intent to profit over the short term are classified as trading securities, and changes in their values are reflected in their balance sheet values and also reported on the income statement.

A and B are incorrect. Debt securities issued by the firm, and debt securities that the firm intends to hold until maturity, are both reported at amortized cost, not market value. Debt and equity securities that the firm does not expect to hold to maturity or to sell in the near term are marketed to market on the balance sheet, but unrealized gains and losses do not affect the income statement.

73. During the fourth quarter of the current year subject retail company reported the following:

·         $5,450,000 in credit sales, with $2,000,000 of cash collected during the quarter in connection with these credit sales. All sales were final with no uncertainties remaining.

·         The shipment of $750,000 in merchandise on consignment to a local specialty retailer. This merchandise can be returned within 60 days for a full refund is not sold.

·         $1,100,000 in cash sales during the quarter. All sales were final with no expense uncertainties remaining.

Under the accrual method, the amount of revenue to be recognized for the specific transactions listed during the quarter would be closest to:

A. $5,300,000.

B. $6,550,000.

C. $7,300,000.

Ans: B.

Under accrual method, all credit sales in the first transaction would be recognized as revenue earned (earnings process complete and no uncertainties remaining), despite only $2,000,000 in cash being collected from these sales. In the second transaction, no revenue would be recognized under the accrual method given that the consignment and the right of a return of all merchandise within 60 days means the revenue and earnings recognition process hasn’t been completed (a consignment is not really a sale). In the last transaction, the cash sales would all be recognized as revenue since the earnings process has been completed and no uncertainties remain.

Revenue = $5,450,000 + $1,100,000 = $6,550,000