understanding balance sheet(Reading 26)

Exercise Problems:

1. IF a company’s current ratio is less than 1.0x, which of the following accounting actions will increase its current ratio?

A. Accruing direct labor costs.

B. Making a cash payment on accounts payable.

C. Using a short-term revolving credit facility to pay down long-term debt.

Ans: A

Accruing direct labor costs increases current asset (inventory) and current liabilities by the same amount. Since the initial current ratio is less than 1.0x, adding equal amounts to the numerator and denominator causes a larger percentage in crease to the numerator and the ratio will increase.

B. Paying accounts payable results in an equal reduction of current assets and current liabilities. Since the initial current ratio is less than 1.0x, equal decrease of the numerator and the denominator would decrease the ratio.

C. Borrowing on a short-term revolving credit facility will increase the current liability which is the denominator, thus reducing the current ratio.

2. At the beginning of the year, a firm sold half of its accounts receivable at book value without recourse and used the proceeds to pay down a long-term bank loan. Assuming that the transaction has met all conditions to constitute a sale of the receivables, this transaction will:

A. Increase the current ratio.

B. Reduce the debt-to-equity ratio.

C. Reduce the interest coverage ratio.

Ans. B.

By using the proceeds from the sale of the accounts receivable without recourse to reduce total debt, the debt-to-equity ratio will fall, as the numerator is now lower. Additionally, since the interest expense associated with the total debt is now lower, net income and equity (the denominator) will be higher.

A is incorrect. The current ratio will decrease rather than increase because the current assets were reduced as a result of the sale of the accounts receivable (cash received was used immediately to permanently pay down the long-term loan) while the current liabilities remained unchanged (the debt that was paid down did not represent a short-term liability).

C is incorrect. The reduction of debt from the transaction will result in lower interest expense and an increase in, rather than a reduction of, the interest coverage ratio.

3. Cash and marketable securities are included in the numerator of the:

A. Cash ratio.

B. Quick ratio.

C. Both the cash ratio and the quick ratio.

Ans: C.

The cash ratio is the most conservative solvency measure as its numerator includes only cash and marketable securities, the most liquid assets.

The quick ratio also includes accounts receivable in its numerator, making it less conservative than the cash ratio.

4. Which of the following best reflects the reporting of unrealized gains and losses for investments in trading and available-for-sale marketable securities under IFRS?

A. For both trading and available-for-sale securities report as income from continuing operations.

B. For trading securities report as income from continuing operations and for available-for-sale report in equity.

C. For trading securities report in equity and for available-for-sale report as income from continuing operations.

Ans. B.

Investment in marketable securities held as trading securities or available-for-sale securities are reported at fair value. Unrealized gains or losses (G/L) on the trading securities are reported on the income statement as a component of income from continuing operations. Unrealized GG/L on available-for-sale securities are reported in equity as a component of accumulated other comprehensive income under U.S.GAAP and as direct-to-equity adjustments under IFRS and do not affect reported earnings.

5. During 2010, the following events occurred at a company. The company:

·         purchased a customer list for $100,000, which is expected to provide equal annual benefits for the next 4 years.

·         recorded $200,000 of goodwill in the acquisition of a competitor. It is estimated that the acquisition would provide substantial benefits for the company for at least the next 10 years.

·         spent $300,000 on media placements announcing the company had donated products and services to the community. The CEO believes the firm’s reputation was enhanced substantially and the company will likely benefit from it for the next 5 years.

Based on those events, the amortization expense that the company should report in 2011 is closest to:

A. $25,000.

B. $45,000.

C. $85,000.

Ans: A.

The customer list is the only identifiable intangible asset, and it should be amortized on a straight-line basis over its expected future life: $100,000 ÷ 4 = $25,000/year. Goodwill is an unidentifiable intangible and should be tested for impairment but not amortized. All advertising and promotion costs, such as the media placements, are typically expensed. If the reputation of the company has been enhanced as the CEO suggests, this is an internally generated intangible that is not recorded on the balance sheet and is therefore not amortized.

6. During the three months ended 12/31/20x2, Delon Company reported net income of $1,800,000 and paid $360,000 in dividends to common stockholders (the dividends had been declared in the previous quarter). In addition Delon declared a dividend of $0.22 per share to be paid in the next quarter. The company currently has 1.8 million shares outstanding.

What was the increase in stockholders’ equity from 09/30/20x2 to 12/31/20x2?

A.    $1,440,000

B.     $1,404,000

C.     $1,044,000

Ans. B.

A is incorrect. This is the amount of dividends paid dducted from net income ($1,800,000-360,000), which decreases stockholders’ equity on the books.

C is incorrect. Both dividends declared and paid were incorrectly deducted from net income ($1,800,000-360,000-396,000).

7. Lonic Company purchased 10,000 shares of its common stock for the treasury at $30 per shares at the end of 20x2. The par value of the stock is $1 and the shares were originally issed at $10 per share. The effect of the repurchase on common stockholders’ equity and return on equity are a decrease in stockholders’ equity of:

A. $300,000 and a higher return-on equity.

B. $300,000 and a lower return-on equity

C. $200,000 and a lower return-on equity

Ans: A.

The treasury stock was recorded at the purchase price (10,000 shares *$30). Since the balance in the treasury stock is deducted from the total of common stock, additional paid-in capital, and retained earnings to determine stockholders’ equity, the purchase reduces stockholders’ equity by the same amount of the purchase price. Return on equity for 20x2 is higher since the equity is lower.

B is incorrect. Return on equity will be higher, not lower.

C is incorrect. The purchased shares are recorded at the purchased price, not the difference between the purchase price and the original issue price ($30 -10=$20*10,000 shares).

8. The following data are available for a company and its industry:

Which of the following statements about the company is most appropriate? The company:

A. operates in the manufacturing industry.

B. has made significant acquisitions in the past.

C. has higher financial leverage than the industry.

Ans: B.

Goodwill makes up 40% of total assets; therefore, the company has made significant acquisitions at some point because goodwill is only recognized during acquisitions.

A is incorrect. The low PP&E and inventory levels indicate the company is not likely a manufacturer.

C is incorrect. Leverage is below the industry average for both the debt-to-equity ratio of 40% [(20.1 + 1.6) ÷ 54] versus the industry average of 50% and long-term debt-to-equity ratio of 37% [20.1 ÷ 54] versus the industry average of 40%.

9. To gain insight into what portion of the company’s assets is liquid, an analyst will most likely use:

A. the cash ratio.

B. the current ratio.

C. common-size balance sheets.

Ans: C.

A common-size balance sheet expresses all balance sheet accounts as a percentage of total assets and provides insight into what portion of a company’s assets is liquid.

A is incorrect.

Cash ratios measure liquidity relative to current liabilities, not relative to total assets.

C is incorrect.

Current ratios measure liquidity relative to current liabilities, not relative to total assets.

10. Assume a company has the following portfolio of marketable securities which was acquired at the end of 2009:

If the company reports under IFRS instead of U.S. GAAP, its net income will most likely be:

A. the same.

B. €500,000 lower.

C. €500,000 higher.

Ans: A.

Whether securities are classified as held for trading or available for sale, they are measured at their fair value on the balance sheet, but all gains/losses on held for trading securities are reported on the income statements. The unrealized gains/losses on available for sale securities are reported in equity. However, this treatment is the same for both IFRS and U.S. GAAP reporting.

11. Which of the following statements is most accurate?

A. Treasury stock is non-voting and receives no dividends.

B. Minority interest on the balance sheet represents a position the company owns in other companies.

C. A classified balance sheet arises when in an auditor’s opinion the financial statements materially depart from accounting standards and are not presented fairly.

Ans: A.

Treasury stock is stock that has been reacquired by the issuing firm but not yet retired. Treasury stock reduces stockholders’ equity. It does not represent an investment in the firm. Treasury stock has no voting rights and does not receive dividends.

B is incorrect. Minority interest (noncontrolling interest) is the minority shareholders’ pro-rata share of the net assets (equity) of a subsidiary that is not wholly owned by the parent.

C is incorrect. The balance sheet reports the firm’s financial position at a point of time. Most entities should present a classified balance sheet showing current and noncurrent assets and liabilities.

When in an auditor’s opinion the financial statements materially depart from accounting standards and are not presented fairly, an auditor will issue an adverse opinion.

12. A company’s balance sheet shows the following:

The company’s quick ratio is closest to:

A. 0.4.

B. 0.9.

C. 1.3.

Ans: B.

Quick ratio =

                    =

                     =0.93

13. The following information is from a company’s investment portfolio:

Ans: B.

Held-for-trading and available-for-sale securities are carried at market value, whereas held-to-maturity securities are carried at amortized cost. If the investment is reclassified as available-for-sale in 2010, the carrying amount should be adjusted to its market value, which is $10,000. Compared with the amortized cost of $20,000, it’s a decrease of $10,000.

14. Which of the following is the least appropriate accounting treatment for marketable securities under IAS No. 39?

Ans: C.

All categories treat realized gains or losses in the same way - they are reported on the income statement. It is the unrealized gains and losses that are included in other comprehensive income (in equity) for available for sale securities carried at market value.

Reference: question 4.

15. Under International Financial Reporting Standards (IFRS) a bank, or other financial institution, would normally use which type of balance sheet format?

A. Classified

B. Liquidity-based

C. Market-value based

Ans: B.

Liquidity-based format presents assets and liabilities in the order of liquidity. Under IAS No. 1 liquidity-based presentation is recommended when it provides information that is more relevant and reliable than the current/noncurrent format, such as in the case of banks and financial institutions.

A is incorrect. Both IFRS and U.S.GAAP require firms to separately report their current assets and noncurrent assets and current and noncurrent liabilities. The current/noncurrent format is known as a classified balance sheet and is useful in evaluating liquidity. But banking industry often uses liquidity-based format.

C is incorrect. There is no market-value based format balance sheet.

16. A company presents its financial statements according to U.S. GAAP (generally accepted accounting principles) and has just issued $5 million of mandatory redeemable preferred shares with a par value of $100 per share and a 7% dividend. The issue matures in 5 years. Which of the following statements is least likely correct? At the time of the issue, the company’s:

A. debt-to-total capital ratio will improve

B. interest coverage ratio will deteriorate.

C. preferred shareholders will rank below debt holders should the company file for bankruptcy.

Ans: A.

SFAS 150 require that issuers report as liabilities any financial instruments that will require repayment of principal in the future. Mandatory redeemable preferred shares must be reported as debt; dividends on such stock must be reported as interest expense (consistent with the view that the preferred stock is debt) which will lower the interest coverage ratio.

In the Debt/(Debt + Equity) ratio, the Debt will increase making the debt/total capital increase, (the numerator will increase more than the denominator), thus the ratio will increase (deteriorate), not decrease (improve).

B is incorrect. Mandatory redeemable preferred shares must be reported as debt; dividends on such stock must be reported as interest expense (consistent with the view that the preferred stock is debt) which will lower the interest coverage ratio.

C is incorrect. It is true that preferred shareholders will rank below debt holders should the company file for bankruptcy.

17. A company issued bonds in 2009 that mature in 2019. The measurement basis that will most likely be used on the 2009 balance sheet for the bonds is:

A. market value.

B. historical cost.

C. amortized cost.

Ans: C.

Bonds payable issued by a company are financial liabilities that are measured at amortized cost.

18. Presented below are abbreviated balance sheets for two merchandising companies following the format found in each of their annual reports.

Which of the companies most likely prepares their financial statements in accordance with U.S. GAAP (generally accepted accounting principles)?

A. Both

B. Company A only

C. Company B only

Ans: C.

Company A prepares its financial statements under IFRS while company B uses U.S. GAAP. The common practice under IFRS presentation is to present noncurrent assets before current assets and long term liabilities before current ones. Minority interest must be shown as a component of equity under IFRS. Under U.S. GAAP, current assets are presented before long term assets and current liabilities before long term ones; under U.S. GAAP, minority interest is often shown “in-between” liabilities and equity (although it could also be shown as an equity component).

19. The following information is available from the accounting records of a company as at 31 December 2012 (all figures in $ thousands):

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

A. 64.

B. 72.

C.  C. 176.

Ans: A.

The Investments accounted for by the equity method and the

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

20. 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.

Ans: B.

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.

21.

Based on the above information about a company, the bad debt expense (in millions) for 2012 is closest to:

A.￡36

B.￡84

C.￡120

Ans: C.

The allowance for doubtful accounts increases by the bad debt recognized for the year and decreases by the amount written off during the year.

22. During late Dec. 2012 Popular Publishing Inc. acquired a small competitor, Max’s Magazines. In the evaluation of the acquisition it was determined that the customers lists of Max’s Magazines had a fair value of $50,000. Popular had spent $15,000 during the year updating and maintaining its own customer lists. What is the correct amount and asset account that will be recorded by Popular for the year ended Dec. 2012, related to customer lists?

A. $50,000 identifiable intangible asset.

B. $65,000 identifiable intangible asset.

C. $50,000 unidentifiable intangible asset.

Ans: A.

The purchased customer list is an identifiable intangible because it can be sold separately form 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 Popular on its own lists, $15,000, would have to be expensed because internally generated intangibles are not capitalized.

23. Which of the following statements about balance sheets is most accurate? Under:

A. U.S.GAAP, intangibles must be valued at historical cost.

B. IFRS, a commercial real estate company should use a liquidity based presentation.

C. IFRS, a classified balance sheet must present current assets before non-current assets.

Ans: A.

Under U.S.GAAP, intangibles must be valued at historical cost, where under IFRS, they can be valued at cost or revaluation.

B is incorrect. Under IFRS, firms can choose to use a liquidity-based format if the presentation is more relevant and reliable. Liquidity-based presentations, which are often used in the banking industry, present assets and liquidities in the order of liquidity.

C is incorrect. Both IFRS and U.S.GAAP require firms to separately report their current assets and noncurrent assets and current and noncurrent liabilities. The current/noncurrent format is known as a classified balance sheet and is useful in evaluating liquidity.

But the current assets are not necessarily presented before non-current assets.

24. At the beginning of the year, a company had total shareholders’ equity consisting of ￥50,000 in retained earnings.

During the year, the following events occurred:

The total shareholders’ equity at the end of the year is closest to:

A.    ￥268,000

B.     ￥284,000

C.     ￥287,000

Ans: C.

25. At the beginning of the year, a company had total shareholders’ equity consisting of ￥200,000 in common share capital and ￥50,000 in retained earnings.

During the year, the following events occurred:

The total shareholders’ equity at the end of the year is closest to:

A. ￥276,000.

B. ￥279,000.

C. ￥282,000.

Ans: A.

26. At the start of the year, a company’s capital contributed by owners and retained earnings accounts had balances of $10,000 and $6,000, respectively. During the year, the following events took place:

The end-of-year owners’ equity is closest to:

A.    $19,400

B.     $19,900

C.     $20,400

Ans: C.

27. The item “noncontrolling interest” included as a component of equity represents the:

A. firm’s ownership of less than 50% of a subsidiary.

B. portion of a subsidiary the firm does not own.

C. firm’s ownership of less than 30% of a subsidiary.

Ans: B.

When a firm has a controlling interest (>50%) in a subsidiary, but less than 100% ownership, it includes (consolidates) the assets and liabilities of that firm on its own balance sheet. Noncontrolling (or minority) interest in the equity section of the balance sheet represents the portion of the subsidiary that is not owned by the reporting firm.

28. Under U.S.GAAP, land owned by the firm is most likely to be reported on the balance sheet at:

A. historical cost.

B. fair market value minus selling costs.

C. historical cost less accumulated depreciation.

Ans: A.

Unless impairment has been recognized, land is reported at historical cost and is not subject to depreciation. Increases in value are not reflected in balance sheet values under U.S.GAAP.

29.  A company’s investments in marketable securities include a 3-year tax-exempt bond classified as held-to-maturity and a 5-year Treasury not classified as available-for-sale. On its income statement, the company should report the coupon interest received from:

A. both of these securities.

B. neither of these securities.

C. only one of these securities.

Ans: A.

Interest and dividends received are reported as income, regardless of the balance sheet classification of marketable securities.

30. The category of items on the balance sheet that typically offers an analyst the best information on a non-financial firm’s investing activities is:

A. current assets.

B. current liabilities.

C. noncurrent assets.

Ans: C.

Noncurrent assets are those that will not be used up during the next year or during the firm’s operating cycle. Firm investment is typically in assets that are longer term in nature.

 A is incorrect.  Current assets include cash and other assets that will likely be converted into cash or used up within one year or one operating cycle, whichever is greater.

B is incorrect. Current liabilities are obligations that will be satisfied within one year or one operating cycle, whichever is greater.

31. Bao CORP. sells 1-year memberships to its Wine Club for $180. Wine Club members each received a bottle of white wine and a bottle of red wine, selected by the club director, four times each year at the beginning or each quarter. To properly account for sales of Wine Club memberships, Bao will record:

A. an asset for prepaid sales.

B. a liability for accrued expenses.

C. a liability for unearned revenue.

Ans: C.

Sales revenue for which the product or service has yet to be delivered gives rise to a liability account, unearned revenue. This liability will be reduced as the product or service is actually delivered.

32. Time-series analysis of a firm’s common-size balance sheets reveals the following data:

Based only on the data provided, an analyst can conclude that the firm’s:

A. debt ratio is decreasing.

B. quick ratio is decreasing.

C. inventory/ sales ratio is increasing.

Ans: A.

The debt ratio is total debt to total assets. Because common-size balance sheet data are stated as percentages of total assets, the debt ratio can be determined from the data given.

2010: 10%+24%=34%

2011: 11%+21%=32%

2012: 12%+18%=30%.

B and C are incorrect. The debt ratio is decreasing over the period shown. Neither the inventory/ sales ratio nor the quick ratio can be determined from the data given because the data do not include sales or current liabilities.

33. For which of the following investments in securities is a firm most likely to report unrealized gains or losses on its income statement?

A. Preferred stock, which the firm classifies as available-for-sale.

B. Five-year bonds, which the firm purchased in a private placement.

C. Listed call options, which the firm intends to exercise at expiration.

Ans: C.

Options are derivatives, which are reported at fair value on the balance sheet with unrealized gains and losses recognized on the income statement. Available-for-sale securities are marked on the balance sheet, but unrealized gains and losses are reported in owners’ equity as other comprehensive income. Bonds purchased in a private placement cannot be resold to the public and therefore are likely to be classified as held-to-maturity, in which case the firm does not recognize unrealized gains or losses.

34. If a company presents its balance sheet in a format that includes subtotals for current assets, current liabilities, noncurrent assets, and noncurrent liabilities, the balance sheet is most likely presented:

A. in a report format.

B. in an account format.

C. as a classified balance sheet.

Ans: C.

A classified balance sheet has accounts grouped by type and presents subtotals for these groups of assets.