Mid-term Examination with Answers.
Please complete and send/bring the completed exam by February 25 before class. All questions are True/False or multiple-choice. Please make sure to include the rationale for the answer(s) you give – no need to cite a reference – just your reasoning for your answer. You may any source except help from another human being (no loose definitions of a human being! ) or old exam answers. Have fun and hopefully solidify your learning to date.
1. If a company reports retained earnings of $175. 3 million on its balance sheet, it must also report $175. million in cash.
Answer: False Rationale: The accounting equation requires total assets to equal total liabilities plus stockholders’ equity. That does not imply, however, that liability and equity accounts relate directly to specific assets.
2. The income statement reports net income which is defined as the company’s profit after all expenses and dividends have been paid.
Answer: False Rationale: The statement contains two errors. First, net income does not include any dividends during the period; these are a distribution of profits and not part of its calculation. Second, the income statement is prepared on an accrual basis and thus includes expenses incurred (as opposed to paid).
3. Consider two companies (A and B) with equal profit margins of 15%. Company A has an asset turnover of 1. 2 and Company B has an asset turnover of 1. 5. If all else is equal, Company B with its’ higher asset turnover, is less profitable because it is expensive to turn assets over.
Answer: False Rationale: “Profitability” is not clearly defined: it could be “profit margin/return on sales on the one hand or it could be returned on assets (e. g. , ROA). If the former, the statement is false since it states that the two are equally profitable. If the latter, it is also false since the higher the turnover, the more efficient the company is with its assets, and thus, the more profitable. Algebraically, ROA = PM? AT. Company A is less profitable: 15% ? 1. 2 = 18% whereas Company B’s ROA is 15% ? 1. 5 = 22. 5% so B is more not less profitable.
4. Assets, expenses, and dividends increase with debits.
Answer: True Rationale: Assets increase with debits and equity decreases with debits. Therefore, higher expenses and dividends paid decrease equity so they are debits.
5. Revenues and expenses affect the income statement but not the balance sheet.
Answer: False Rationale: Revenue and expense recognition change retained earnings on the balance sheet.
6. Accrual accounting recognizes revenues only when cash is received and expenses only when cash is paid.
Answer: False Rationale: Accrual accounting refers to the recognition of revenue when earned and the matching of expenses when incurred. The recognition of revenues and expenses does not, necessarily, relate to the receipt or payment of cash.
7. Highly leveraged firms have higher RNOA than firms with lower leverage.
Answer: False Rationale: Financial leverage (ratio of assets to equity) does not affect the RNOA (Net operating profit after taxes/average net operating assets) computation because RNOA is based on operating profit. High financial leverage will increase ROE, however.
8. Repurchasing shares near year-end will increase a firm’s return on equity (ROE).
Answer: True Rationale: Repurchasing shares will decrease equity because treasury stock is a contra-account (it reduces total equity). If the repurchases happen at year-end, there are likely no significant profit impacts and thus, the numerator in the ROE ratio will be largely unaffected. Thus, the ratio will increase.
9. If Company A has a higher net operating profit margin (NOPM) than Company B, then Company A’s RNOA will be higher.
Answer: False Rationale: RNOA depends on NOPM but also depends on operating asset productivity (NOAT). If Company B had a much higher operating asset productivity, its RNOA could be higher despite the lower profitability.
10. All else being equal, higher financial leverage will decrease a company’s debt rating and increase the interest rate it must pay.
Answer: True Rationale: Higher levels of financial leverage increase the probability of default and of bankruptcy. This reduces credit ratings and increases costs for borrowed funds.
11. Bed Bath and Beyond have a 60-day return policy. The company can report revenue on the full amount as soon as the merchandise is sold. Answer: False Rationale: Revenue will be recognized as soon as the merchandise is sold but only for the portion that the company estimates will not be returned within the 60-day return period. The estimated returns are netted against sales and set up as a liability (reserve).
12. In 2009, Dow Chemical Corporation plans to build a laboratory dedicated to a special project. The company will not use the laboratory after the project is finished. Under GAAP, this laboratory should be expensed.
Answer: True Rationale: If the project is an R & D project, R&D costs must be expensed under GAAP unless they have alternative future uses. If not, then the asset should be depreciated over the life of the project. If these assets do, indeed, have alternative future uses, they will be capitalized and depreciated over their normal useful life.
13. Overestimating the allowance for uncollectible accounts receivable can shift income from the current period into one or more future periods.
Answer: True Rationale: By overestimating current accounts receivable provisions, current income decreases because expenses are increased. However, due to the overestimation, future year provisions will need to decrease to compensate, thus increasing future profitability. Income has been shifted to future periods from the present.
14. Increasing inventory turnover rates will always improve profitability.
Answer: False Rationale: Profitability depends on both turnover and profit margin on the inventory. A company could increase turnover by dropping prices to zero. Items would fly off the shelves, but that would mean no profit.
15. A company’s net cash flow will equal its net income …
a. Almost always
d. Only when the company has no investing cash flow for the period
e. Only when the company has no investing or financing cash flow for the period
Answer: b Rationale: Net income reflects the company’s revenue minus expenses for the given period. Net cash flow represents the amount of money received (spent) on operating, investing, and financing activities for the given period. These values are rarely the same.
16. In 2008, Southwest Airlines had net working capital of $87 million and current assets of $2,893 million. The firm’s current liabilities are:
a. $2,980 million
b. $2,806 million
c. $87 million
d. $2,893 million
e. There is not enough information to calculate the amount.
Answer: b Rationale: Networking capital = current assets – current liabilities. Current liabilities = Current assets – Net working capital = $2,893 – $87 = $2,806
17. As inventory and property plant and equipment on the balance sheet are consumed, they are reflected:
a. As a revenue on the income statement
b. As an expense on the income statement
c. As the use of cash on the statement of cash flows
d. On the balance sheet because assets are never consumed
e. Both b and c because the financial statements articulate
Answer: b Rationale: As assets are consumed (used up), their cost is transferred to the income statement as expenses. Cash is not involved so c and e are incorrect (only changes in inventory are reflected as uses or sources of cash).
18. How would purchase $100 of inventory on credit affect the income statement?
a. It would increase liabilities by $100
b. It would decrease liabilities by $100
c. It would increase non-cash assets by $100
d. Both a and c
e. None of the above
Answer: e Rationale: There is no income statement effect of an inventory purchase.
19. During fiscal 2007, Kenneth Cole Productions recorded inventory purchases on the credit of $289. 2 million. Inventory at the start of the year was $46. 3 million and at the end of the year was $48 million. Which of the following describes how these transactions would be entered on the financial statement effects template?
a.Increase liabilities (Accounts payable) by $287. 5 million
b. Increase expenses (Cost of goods sold) by $289. 2 million
c. Increase expenses (Cost of goods sold) by $287. 5 million
d. Decrease non-cash assets (Inventory) by $1. 7 million e. Both a and c
Answer: c Rationale: The cost of goods sold is purchased less than the increase in inventory = $287. 5 (c is correct) Liabilities increase by $289. 2 when the inventory was purchased (not $287. 5) so a. is incorrect. Inventory decreased during the year by $1. 7million but not because of a transaction being entered (d is incorrect).
20. Mattel Inc. ’s 2008 financial statements show operating profit before tax of $541,792 thousand, net income of $379,636 thousand, provision for income taxes of $108,328 thousand, and net nonoperating expense before tax of $53,828 thousand. Mattel’s statutory tax rate for 2007 is 35. 4%. Mattel’s 2008 effective tax rate is:
a. 35. 4%
b. 28. 5%
c. 23. 5%
d. 22. 2%
e. None of the above.
Answer: d Rationale: Effective tax rate = Provision for income taxes / Income before tax = $108,328 / ($379,636 + $108,328) = 22. 2%
21. The 2008 balance sheet of The Washington Post Company shows average shareholders’ equity of $3,171,176 thousand, net operating profit after tax of $79,895 thousand, net income of $65,722 thousand, and average net operating assets of $3,279,742 thousand. The company’s return on net operating assets (RNOA) for the year is:
a. 2. 5%
b. 2. 4%
c. 2. 1%
d. 2. 0%
e. There is not enough information to calculate the ratio.
Answer: b Rationale: RNOA = NOPAT / average NOA = $79,895 / $3,279,742 = 2. 4%.
22. Life Technologies Corporation and Affymetrix Inc. are competitors in the life sciences and clinical healthcare industry.
Following is a table of Total revenue and R&D expenses for both companies.
Life Technologies Corporation
Which of the following is true?
a. Life Technologies Corporation is the more R&D intensive company of the two.
b. Life Technologies Corporation has become more R&D intensive for over three years.
c. Affymetrix grew its R&D by more in 2008 as compared to Life Technologies. Affymetrix is less R&D intensive in 2008 than in 2006.
e. None of the above
Answer: d Rationale: To make comparisons, we need to common size the R&D expenditures of both firms by scaling by total revenues and calculate growth rates.
Life Technologies Corporation
Common sized R&D
Affymetrix spends proportionately (relative to sales) more on R&D than Life Technologies, thus a. is not true. Life Technologies has spent less on R&D over the three year period, thus b is not true. Affymetrix grew R&D by 14% in 2008 compared to Life Technologies’ growth of 23%, thus c is not true. Affymetrix decreased R&D from 24. 2% in 2006 to 20. 6% in 2008, thus d is true.
23. The 2008 income statements of Leggett & Platt, Inc. reports net sales of $4,076. 1 million. The balance sheet reports account receivable, net of $550. 5 million at December 31, 2008, and $640. 2 million at December 31, 2007. The number of days that receivables were outstanding in 2008 was:
a. 7 days
b. 9 days
c. 53 days
d. 57 days
e. none of the above
Answer: b. Rationale: 365 days / ($4,076. 1 / $550. 5) = 49 days If you use average A/R as denominator (as I prefer) then days = 365/($4,076. 1/(($550. 5+$640. 2))2 = 53 days or c.
24. At what amount will accounts receivable be reported on the balance sheet if the gross receivable balance is $20,000 and the allowance for uncollectible accounts is estimated at 10% of gross receivables?
Answer: b Rationale: Receivables are reported net of the allowance account. In this case, $20,000 – ($20,000 ? 0%) = $18,000.
25. Myrtle Beach Pro-Shop receives information that requires the company to increase its expectations of uncollectible accounts receivable. Which of the following does NOT occur on the company’s financial statements?
a. Bad debt expense is increased
b. Accounts receivables (gross) is reduced
c. Net income is reduced
d. The allowance account is increased e. none of the above
Answer: b. Rationale: Both bad debt and the allowance account is increased, resulting in lower NET accounts receivable and lower net income. The gross amount of receivables is unchanged.
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