CHAPTER 1



CHAPTER 4

ACCOUNTING ANALYSIS AND

THE FINANCIAL STATEMENTS

LEARNING OBJECTIVES

1. Why analysts must know how financial statements are prepared.

2. The balance sheet, income, and cash flow statements, and the relationship among them.

3. The recognition criteria and valuation methods used for common balance sheet and income statement items.

4. How management choices, estimates, and judgment affect the quality of the three primary financial statements.

TRUE/FALSE QUESTIONS

1. As a part of the second phase of security analysis, the analyst may make adjustments to the financial statements.

(easy, L.O. 1, Introduction, true)

2. The security analyst is like an accountant searching for clues in the financial statements by using ratios as the “magnifying glass” to solve the case.

(moderate, L.O. 1, Introduction, false)

3. The accounting equation is different from the balance sheet equation.

(moderate, L.O.2, Section 1, false)

4. The first tier of the GAAP Hierarchy consists of major pronouncements which are so straightforward they receive very little due process.

(moderate, L.O. 2, Section 1, false)

5. The income statement is considered to be more important to investors and creditors than the balance sheet.

(easy, L.O. 2, Section 2, true)

6. GAAP defines a firm’s income to be the change in its net assets, excluding stock issuances and dividends.

(moderate, L.O. 2, Section 2, true)

7. Extraordinary items are gains and losses that are deemed to be both unusual and nonrecurring.

(easy, L.O. 2, Section 2, true)

8. Conservative accounting methods are those that tend to accelerate recognition of assets and delay recognition of liabilities.

(moderate, L.O. 2, Section 2, false)

9. Regarding the statement of cash flows, cash flow from financing includes the items that relate to the determination of net income

(moderate, L.O. 2, Section 3, false)

10. Quality issues are less problematic for the cash flow statement than for the income statement or balance sheet.

(moderate, L.O. 2, Section 3, true)

11. Current assets are not expected to be converted to cash or used to satisfy a liability within one year.

(easy, L.O. 2, Section 4, false)

12. Minority interest represents the portion of the book value of net assets of a firm’s subsidiary that is owned by shareholders other than the firm.

(moderate, L.O. 2, Section 4, true)

13. A joint venture may be accounted for under the equity method when the company is deemed to have substantial influence over the operations of another company.

(moderate, L.O. 3, Section 4, true)

14. Preferred stockholders have preference over common stockholders in a bankruptcy and always have voting rights.

(moderate, L.O. 3, Section 4, false)

15. Warrants and options give the holder the right to purchase stock from the company at a fixed price, depending on the stock’s market price at the time.

(moderate, L.O. 2, Section 4, false)

MULTIPLE CHOICE QUESTIONS

16. Management plays an important role in preparing the financial statements. Management’s choices affect financial statements. The effects of such choices is known as:

a. management’s priorities

b. management responsibility

c. financial statement materiality

d. financial statement quality

(moderate, L.O. 1, Introduction, d)

17. In FASB Statement of Financial Accounting Concepts No. 6, probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events are called:

a. assets

b. liabilities

c. shareholders’ equity

d. valuation rules

(moderate, L.O. 2, Section 1, a)

18. Shareholders’ equity is described as a residual claim. This can be demonstrated by the following equation:

a. Assets – Liabilities – Shareholders’ equity = Net Assets

b. Assets + Shareholders’ equity = Liabilities

c. Shareholders’ equity = Assets – Liabilities = Net Assets

d. Shareholders’ equity = Assets – Net Assets = Liabilities

(moderate, L.O. 2, Section 1, c)

19. When recognition criteria or valuation methods are __________, there is __________ opportunity for managers to influence reported results.

a. selected; moderate

b. selected; significant

c. dictated; significant

d. fact-dependent; little

(moderate, L.O. 3, Section 1, b)

20. Within the GAAP Hierarchy, a FASB Concepts Statement falls within:

a. Tier 5

b. Tier 4

c. Tier 2

d. Tier 1

(difficult, L.O. 2, Section 1, a)

21. An increase in assets that does not arise in the ordinary course of business is known as a:

a. revenue

b. gain

c. expense

d. extraordinary item

(easy, L.O. 2, Section 2, b)

22. It is true that the change in shareholders’ equity during a year is equal to the change in net assets in that year. This equation is important because:

a. net income is the change in shareholders’ equity that is due to distributions of capital

b. net income is the change in shareholders’ equity that is due to contributions of capital

c. GAAP defines net income implicitly, based on the change in shareholders’ equity

d. GAAP defines net income explicitly, based on the change in shareholders’ equity

(difficult, L.O. 2, Section 2, c)

23. Accounting analysis of the income statement focuses on earnings quality. Different analysts use the term differently. Most analysts agree that:

a. earnings quality includes nonrecurring items

b. earnings quality is independent of conservative accounting methods

c. a firm has good earnings quality if earnings are free of manipulation

d. conservative accounting methods always result in lower reported, and therefore quality, earnings

(moderate, L.O. 3, Section 2, c)

24. The income statement summarizes the transactions that led to the firm’s net income. The income statement consists of several categories of items. Which category would not provide a helpful clue in forecasting based on the income statement?

a. revenues

b. expenses

c. a special item

d. a residual claim

(moderate, L.O. 2, Section 2, d)

25. Special items are generally of a nonrecurring nature. Which item below is not considered a special item?

a. a change in accounting principle

b. a gain from the sale of a manufacturing plant

c. discontinued operations

d. an extraordinary item

(easy, L.O. 2, Section 2, b)

26. Which item below is not considered an extraordinary item?

a. the September 11, 2001 attack on the World Trade Center in New York

b. a category F5 tornado that destroyed a factory in Colorado

c. an earthquake in Virginia that destroys a local winery

d. a major flood through Las Vegas, Nevada, that ruins a convention center

(moderate, L.O. 2, Section 2, a)

27. The GAAP statement of cash flows divides cash flow into three categories. The purchase of property, plant, and equipment is classified as a cash flow from:

a. operations

b. investing

c. financing

d. In this situation all of the above answers are correct.

(moderate, L.O. 2, Section 3, b)

28. Which item below is not considered a reconciling item when a GAAP statement of cash flows is prepared using the indirect method?

a. depreciation

b. a change in inventory

c. a change in current debt

d. net income

(difficult, L.O. 3, Section 2, d)

29. Cash equivalents are a financial statement example of:

a. depreciable assets

b. current liabilities

c. current assets

d. residual equity

(easy, L.O. 2, Section 4, c)

30. Almost all filings with the SEC today are made electronically. Such documents are available via the SEC’s EDGAR system. A firm must file a report with the SEC whenever there are material events that must be disclosed to the public. This report is known as the:

a. Form 10-K

b. Form 10-Q

c. Form 8-K

d. Form 8-Q

(moderate, L.O. 2, Section 4, c)

31. Equity is broken down into one or more classes of stock on a firm’s balance sheet. Assume that a firm has both common and preferred stock outstanding. The common equity for the firm is equal to:

a. net assets less preferred stock

b. net assets less common stock

c. the residual claim of the preferred stockholders

d. the basic earnings per share of all classes of common stock

(moderate, L.O. 3, Section 4, a)

32. Analysts are interested in a firm’s earnings per share (EPS) because it expresses the firm’s income in the same units as its stock price. The numerator found in the basic EPS formula is:

a. net income – common stock dividends

b. weighted-average number of shares outstanding + convertible securities outstanding

c. weighted-average number of shares outstanding

d. net income – preferred dividends

(difficult, L.O. 3, Section 4, d)

33. Many different valuation methods can be used on a balance sheet under GAAP. A balance sheet item that is generally valued at the lower of cost or market is:

a. a cash equivalent

b. a marketable security

c. accounts receivable

d. inventory

(easy, L.O. 4, Section 4, d)

34. Investments subject to SFAS No. 115 are divided into several categories. Debt and equity securities that management plans to sell in the near term are known as:

a. trading securities

b. held-to-maturity securities

c. available-for-sale securities

d. common stock

(moderate, L.O. 3, Section A4.1, a)

35. Firms invest in another company’s stock when they have excess cash available to invest for a period of time or when they make a strategic investment for the longer term. The accounting treatment for the investment depends on the degree to which the investor can influence the operations of the investee. If a firm owns between 20% and 50% of the investee, the presumption is that:

a. the investment is a marketable security

b. there is a controlling equity investment

c. there is a significant influence

d. the investment is not sanctioned by the FASB and it violates GAAP

(moderate, L.O. 3, Section A4.1, c)

36. A contingent liability, or contingency, is a potential liability that may have been incurred as a result of a past transaction or event. A contingency that is __________ and __________ must be recognized.

a. remote; reasonably estimable

b. probable; reasonably estimable

c. reasonably possible; reasonably estimable

d. probable; not reasonably estimable

(moderate, L.O. 4, Section A4.2, b)

ESSAYS

37. Discuss the statement, “Generally accepted accounting principles are not a single set of rules.”

Suggested solution:

Generally accepted accounting principles (GAAP) can be thought of as a hierarchy of rules that have been established by several different regulatory bodies. This hierarchy has been officially recognized in the AICPA Statement of Auditing Standards (SAS) No. 69. This statement makes all accounting standards mandatory if they do not contradict a standard at a higher level.

The GAAP Hierarchy consists of five tiers according to SAS No. 69. Tier 1 consists of major pronouncements such as Statements of Financial Accounting Standards, which receive a great deal of due process. Due process here involves issuing proposals in various stages of development and receiving feedback from the public via letter and public hearings. FASB Technical Bulletins, and AICPA Statements of Position and Industry Audit and Accounting Guides comprise Tier 2. Tier 3 includes AICPA Practice Bulletins and consensus positions of the FASB Emerging Issues Task Force (EITF). Tier 4 has AICPA Accounting Interpretations and prevalent industry practices that are widely recognized. Tier 5 is made up of various accounting literature such as FASB Concepts Statements, AICPA Issue Papers and Technical Practice Aids, accounting textbooks, handbooks, and articles.

(moderate, L.O. 4, Section 1)

38. Explain the concepts of recognition criteria and valuation rules in accounting standards.

Suggested solution:

Accounting standards include both recognition criteria and valuation rules. Recognition criteria are rules for determining what items are shown on financial statements, such as assets and liabilities on the balance sheet. Valuation rules determine the amounts at which assets and liabilities are to be reported. Without such rules, accounting standards would be highly arbitrary and unreliable.

In applying such rules, managers have some degree of flexibility and discretion. GAAP dictates in some cases what can and cannot be done. In other cases, the facts and circumstances give management some latitude in preparing the firm’s financial statements. Three guidelines can be established that help clarify how recognition criteria and valuation rules are applied by management. The general guidelines are:

• If the recognition criteria or valuation method determined is dictated, there is little opportunity for management to influence results.

• If the recognition criteria or valuation method determined is fact-dependent, there is a moderate opportunity for management to influence results.

• If the recognition criteria or valuation method determined is selected, there is significant opportunity for management to influence results.

These guidelines form a continuum from one extreme to the other. This model has important implications for securities analysts, since they must comprehend what the accounting rules are, how they are applied, and what latitude management has and its impact on the preparation of the financial statements. Analysts must also recognize the meaning of dictated accounting standards and how a given valuation method impacts financial statement analysis. Experience and knowledge are two essential skill sets for the analyst in this area.

(moderate, L.O. 3, Section 1)

39. Comment on how gains and losses are different than revenues and expenses.

Suggested solution:

Revenues are increases in net assets resulting from selling goods or providing services in the normal course of business. Expenses are decreases in net assets resulting from activities that are related to preparing a product for sale or delivering services in the normal course of business. The key phrase here is “normal course of business,” which indicates that such transactions will recur frequently and are to be expected in the operation of the business.

Gains are similar to revenues because they also represent increases in net assets. Losses are similar to expenses because they represent decreases in net assets. Gains and losses can be very different from cash revenues and cash expenses because gains and losses do not increase or decrease cash. The key difference between revenues and expenses and gains and losses is that gains or losses do not arise in the ordinary course of business. From the standpoint of the regular operating activities of the business, gains and losses will occur infrequently. It should be remembered that gains and losses are not extraordinary items in and of themselves unless they arise as a result of an unusual and nonrecurring event of a large magnitude, such as earthquakes, floods, tornadoes, hurricanes, or some other disaster.

(moderate, L.O. 2, Section 2)

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