CFA Level 2 - Financial Reporting and Analysis Session 7 - Reading 25
CFA Level 2 – Financial Reporting and Analysis, Session 7 – Reading 25
(Practice Questions, Sample Questions)
- Duster Corporation’s year-end income statement reported the following:
Calculate Duster’s income from continuing operations for the year
- A) $103,500
- B) $106,800
- C) $114,300
Explanation: (B) Income from continuing operations includes all revenues and expenses except discontinued operations and extraordinary items: $187,000 operating income + $3,400 gain on sale of equipment – $12,400 interest expense – $71,200 income tax expense = $106,800
- Galaxy Company recognized a restructuring charge in its year-end income statement. Similar restructuring charges have occurred in the past.
In addition, Galaxy recognized an extraordinary loss. Galaxy uses the term “operational earnings” when discussing its financial results. According to Galaxy, “operational earnings” excludes special nonrecurring transactions such as restructuring charges, discontinued operations, and extraordinary items. Should the restructuring charge and extraordinary loss be included or excluded from “operational earnings” for analytical purposes?
A)One is included.
B)Both are included.
C)Both are excluded
Explanation: (A) The restructuring charge does not appear to be nonrecurring; thus, it should be included in “operational earnings.
” By definition, an extraordinary loss is unusual in nature and infrequent in occurrence. Therefore, the extraordinary loss should be excluded from “operational earnings.”
- Which of the following statements about financial disclosures are correct or incorrect?
Statement #1:
Transitory earnings are usually more important to investors than permanent earnings.
Statement #2: Pro-forma earnings are usually prepared in accordance with generally accepted accounting principles.
A)Both are incorrect.
B)Only statement #1 is incorrect.
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C)Only statement #2 is incorrect
Explanation: (A) Statement #1 is incorrect. Investors are usually more interested in permanent earnings. Statement #2 is incorrect. Pro-forma earnings are not prepared in accordance with generally accepted accounting principles because they may exclude certain transactions. This is why it is important for an analyst to understand the disclosures
- As compared to an operating lease, which of the following best describes the impact of a finance lease on earnings before interest and taxes (EBIT) and operating cash flow (OCF) according to U.S. generally accepted accounting principles?
Explanation: (A) With an operating lease, rent expense is included in EBIT. In a finance lease, rent expense is replaced by depreciation expense and interest expense. Since EBIT is calculated before interest and taxes, EBIT is higher with a finance lease. In an operating lease, the rent payment is included in operating cash flow. With a finance lease, the rent payment is replaced by principal and interest. Since principal payments are considered financing activities, operating cash flow is higher with a finance lease
- Which of the following statements about operating income and operating cash flow are correct or incorrect?
Statement #1:
If operating income is growing faster than operating cash flow over the long-term, the firm may be recognizing revenue too soon or delaying the recognition of expense.
Statement #2: Operating cash flow exceeding operating income is sustainable over the long-term.
A)Only one is correct.
B)Both are correct.
C)Both are incorrect
Explanation: (A) Statement #1 is correct. If operating income and operating cash flow are growing at different rates over the long-term, the firm may be engaging in earnings manipulation. Statement #2 is incorrect. Over the long-term, operating cash flow will eventually decline without the support of operating income
- Which of the following statements about operating income and operating cash flow is most accurate?
A)Operating income is more reliable than operating cash flow because of the judgments and estimates involved with accrual accounting.
B)Operating income is confirmed by operating cash flow when the growth rates of the two measures are relatively stable over time.
C)Operating cash flow usually increases faster than operating income when the firm is growing
Explanation: (B) When the growth rates of operating income and operating cash flow are stable over time, operating income is being confirmed by operating cash flow. Operating cash flow is more reliable than operating income. During growth, operating cash flow is usually lower
- Recently, Galaxy Corporation lowered its allowance for doubtful accounts by reducing bad debt expense from 2 percent of sales to 1 percent of sales. Ignoring taxes, what are the immediate effects on Galaxy’s operating income and operating cash flow?
Explanation: (B) Lower bad debt expense will result in higher operating income. Operating cash flow is not affected until Galaxy actually collects the receivables
- What value is used in the balance sheet when reporting a derivative instrument used in a cash flow hedge and where are the unrealized gains and losses on the derivative instrument reported?
Explanation: (C) A derivative instrument used in a cash flow hedge is reported on the balance sheet at fair value and the unrealized gains and losses are recognized in the other comprehensive income
- Recently, Firebird Corporation purchased 1,000 shares of GTO Corporation for $50 per share. GTO is a non-dividend paying stock and Firebird expects to sell the investment in the near term. To hedge the investment, Firebird purchases put options and designates the options as a fair value hedge. Ignoring the premium paid for the options, what is the net effect on Firebird’s total assets and net income if GTO declines $5 per share at year-end?
Explanation: (A) Total assets do not change. The decrease in the value of the investment is exactly offset by the increase in value of the options. Net income is also unaffected. The unrealized loss on the investment is offset by the unrealized gain on the options
- In measuring earnings quality, which of the following statements is most appropriate?
A)The higher the accruals ratio, the higher the earnings quality.
B)Accruals can be measured as the change in net operating assets (NOA) over a period of time.
C)Accruals can be measured as net income less cash flows from operations (CFO) less cash flows from financing (CFF)
Explanation: (B) Using the balance sheet, we can measure accruals as the change in net operating assets (NOA) over a period of time. NOA is the difference in operating assets and operating liabilities. Operating assets are equal to total assets minus cash, equivalents to cash, and marketable securities. Operating liabilities are equal to total liabilities minus total debt (both short-term and long-term). In summary, the formula for balance sheet based aggregate accruals is:
AccrualsBS = NOAEND − NOABEG.
We can also derive the aggregate accruals by subtracting cash flow from operating activities (CFO) and cash flow from investing activities (CFI) from reported earnings as follows:
AccrualsCF = NI − CFO − CFI.
The lower the accruals ratio, the higher the earnings quality
- Jeremy Jennings is explaining the concept of earnings quality to his new colleagues. Which of the following measures is most indicative of a higher quality of earnings when attempting to forecast future earnings?
A)Higher degree of conservatism of earnings.
B)Higher degree of persistence of earnings.
C)Higher level of earnings
Explanation: (B) The term earnings quality usually refers to the persistence and sustainability of a firm’s earnings; that is, more persistent and sustainable earnings are considered higher quality.Measuring earnings quality based on conservative earnings is an inferior measure when attempting to forecast future earnings because most accruals will self-correct over time. For example, the lower earnings that result from accelerated depreciation will increase in the later years of the asset’s life. Focusing on accruals and deferrals is a more effective way of measuring earnings quality.
A higher level of earnings has no impact on increasing the quality of earnings since the former may be derived largely from earnings manipulation on the part of management
- The following information pertains to Morley Inc. (Morley) and Crowell Inc. (Crowell) for 2007 and 2008:
Based on the information provided, which of the following conclusions about the two companies is most appropriate?
A) Crowell’s earnings quality is higher than Morley’s
B) Morley’s earnings quality is higher than Crowell’s
C) Crowell’s earnings quality is deteriorating compared to Morley’s
Explanation: (A) Crowell’s earnings quality is higher because its accrual ratio is lower in both years. Furthermore, Crowell’s earnings quality is also improving (due to the decrease in its accrual ratio) while Morley’s is deteriorating (due to the increase in its accrual ratio
- Costiuk Inc. (Costiuk) saw a large increase in its net operating assets (NOA) over the year. During the year, it also reported a number of nonoperating revenues and deferred revenues. Which of the following statements regarding Costiuk’s increase in NOA and the most likely item to self-correct is most accurate?
Explanation: (C) Deferrals and accruals are most likely to self-correct.
The large increase in net operating assets is indicative of a high accruals ratio as demonstrated by the following equation: AccrualsBS = NOAEND − NOABEG
In interpreting the ratio, the higher the ratio, the lower the earnings quality.
Nonrecurring and nonoperating revenues do not typically self-correct like deferrals and accruals, thereby providing a greater manipulation benefit to the firm
- Alex Fisher, CFA, is examining the phenomenon of mean reversion on the earnings of several firms. Which of the following statements regarding mean reversion is least accurate?
A)Low earnings should not be expected to continue indefinitely.
B)High earnings should not be expected to continue indefinitely.
C)Normal earnings should not be expected to continue indefinitely
Explanation: (C) When examining net income, analysts should be aware that earnings at extreme levels tend to revert back to normal levels over time. This phenomenon is known as mean reversion. As a result of mean reversion, analysts must understand that extreme earnings (high or low) should not be expected to continue indefinitely
- Complete the following sentence. When earnings are relatively free of accruals, mean reversion will occur
A) relatively faster than usual.
B) at the same rate as usual.
C) relatively slower than usual
Explanation: (C) Earnings consist of cash flow and accruals and there is an inverse relationship between accruals and cash flow. When earnings are relatively free of accruals, mean reversion will occur at a slower rate. The opposite is true when earnings are largely comprised of accruals
- De Freitas Inc. (De Freitas) is a conglomerate. Its computer division was very profitable in the current year because it launched a successful new lightweight laptop computer. Prices in the automobile division have been rising over the years but it is engaged in a LIFO liquidation in the current year. Which of the following best describes the effect on the long-run earnings of the computer division and the automobile division compared to the most recent year?
Explanation: (C) When examining earnings, analysts should be aware that earnings at extreme levels tend to revert back to normal levels over time. This phenomenon is known as mean reversion. For example, capital is attracted to successful projects (i.e. the new laptop) thereby increasing competition and decreasing earnings in the long-run.
A LIFO liquidation involves selling more goods than are replaced. Thus, the automobile division penetrates the older, lower cost layers of inventory thereby increasing profit. The profitability is not sustainable, however, because the firm will eventually run out of inventory. In the long-run, the earnings will decrease
- Junior analyst Xander Marshall sends an e-mail to his boss, Janet Jacobs, CFA, suggesting that Peterson Novelties is manipulating its results to artificially inflate profits. He cites four reasons for his conclusion:
- The LIFO reserve is declining.
- Earnings are much higher in the September quarter than in other quarters.
- Many nonoperating and nonrecurring gains are being recorded as revenue.
- Much of Peterson’s earnings come from equity investments not reflected on the cash-flow statement.
Jacobs is less concerned about Peterson’s earnings than Marshall is, though she does resolve to check out one of his concerns. Which of Marshall’s observations best supports his conclusion?
A) Nonoperating and nonrecurring gains recorded as revenue
B) Equity investment earnings not reflected on the cash-flow statement
C) The declining LIFO reserve
Explanation: (B) On its own, a declining LIFO reserve is not a sign of fraud. Peterson Novelties could have simply moved a lot of inventory and disclosed the LIFO liquidation in its footnotes. When unusual gains are recorded as revenue they will artificially boost sales growth. Each of the above issues are potential danger signs, but can also be easily explained in a manner beyond reproach. However, earnings from equity investments that do not generate cash flow are of very low quality and warrant further examination
- Which of the following statements about cash flow is (are) CORRECT?
Statement #1: The cash effects of decreasing accounts payable turnover are unlimited
Statement #2: The tax benefits from employee stock options can result in a significant source of investing cash flow.
Explanation: (C) Statement #1 is an incorrect statement. The cash effects of decreasing accounts payable turnover are limited. Suppliers will eventually stop extending credit because of delayed payments. Statement #2 is an incorrect statement. The tax benefits from employee stock options can result in a significant source of operating and financing cash flows. Tax benefits do not affect investing cash flows
- Charger Corporation offers extended payment terms to its customers. In order to finance its accounts receivable, Charger is considering two alternatives. The first alternative is to borrow against the receivables. The second alternative is to securitize the receivables through a special purpose entity. Which alternative would result in lower operating cash flow and lower financing cash flow?
Explanation: (C) The cash received from borrowing would be reported as a financing inflow. The cash received from securitizing the receivables would be reported as an operating inflow. So, borrowing would result in lower operating cash flow and higher financing cash flow. Securitizing would result in lower financing cash flow and higher operating cash flow
- Samson Therapeutics records all leases as operating leases. The company most likely wanted to reduce:
A) expenses.
B) inventory.
C) leverage
Explanation: (C) Finance (capital) leases are recorded on the balance sheet, and by recording all leases as operating leases, the company can reduce its leverage. Lease accounting has no effect on inventory. “Expenses” is not the best answer as operating leases will result in higher expenses in the later years relative to the finance (capital) lease
- Joe Carter, CFA, believes Triangle Equipment, a maker of large, specialized industrial equipment, has overstated the salvage value of its equipment. This would:
A)overstate earnings.
B)overstate liabilities.
C)understate earnings.
Explanation: (A) Overstating the salvage value reduces depreciation expense, which in turn increases earnings
- The failure to recognize inventory obsolescence is an example of ___________.
A)Understating expenses.
B)Delaying expenses.
C)Misclassifying expenses
Explanation: (A) Inventory must be tested for obsolescence using the lower-of-cost-or-market method. Obsolete inventory must be written down (expensed) in the income statement which results in lower earnings. Thus, failure to recognize obsolescence understates expenses and overstates earnings.
Delaying expenses involves deferring recognition to a future period. Delaying expense is the result of capitalizing a cost instead of immediately recognizing the cost in the income statement. This is not the same as failing to recognize inventory obsolescence.
Investors typically focus more on operating income than nonrecurring and non-operating income. Thus, firms may have an incentive to increase operating income by misclassifying an operating expense as a nonrecurring or non-operating item. Therefore, failure to recognize obsolescence is not an example of misclassification
- Fero Inc. (Fero) is a successful computer consulting services firm that has an established policy of investing its excess cash in short-term, virtually riskless, and highly liquid money market securities. However, it has recently deviated from this policy by investing in commercial paper and medium-cap domestic equities. As well, Fero entered into a $1.0 million lease with Pasquale Inc. (Pasquale) for some specialized computer equipment on December 28, 2008 that will be shipped at the very start of its next fiscal period on January 1, 2009. In exchange for the lease, Fero agrees to provide consulting services to Pasquale. Which of the following activities is one in which Fero is least likely involved?
A)Managing cash flow.
B)Misclassifying cash flow.
C)Ignoring cash flow.
Explanation: (A) Fero is ignoring cash flow, most likely misclassifying cash flow, but there is no evidence that Fero is managing cash flow. Firms can misrepresent their cash generating ability by misclassifying investing activities as operating activities and vice versa. For example, under U.S. GAAP, the cash flow statement reconciles the changes in cash and cash equivalents. Cash equivalents include short-term, highly liquid investments. Some firms park cash in longer-term investments such as marketable debt and equity securities. Typically, the acquisition and disposal cash flows from these longer-term investments are reported as investing activities in the cash flow statement.
Noncash investing and financing activities are not reported in the cash flow statement since they do not result in an inflow or outflow of cash. For example, a capital lease is both an investing and financing decision in that the transaction is the equivalent of borrowing the purchase price. However, since no cash is involved, the transaction is not reported (it is ignored) on the cash flow statement throughout the life of the lease
CFA Level 2 - Financial Reporting and Analysis Session 7 - Reading 25. (2023, Aug 02). Retrieved from https://paperap.com/cfa-level-2-financial-reporting-and-analysis-session-7-reading-25/
