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