Question #1 of 86 Question ID: 1685330

When comparing companies that hold equity investments in other corporations, which of the
following statements is most accurate? All else being equal, leverage measures for a firm using
consolidation will appear:

A) more or less favorable depending on the leverage of the investee company.

B) less favorable than those for a comparable firm using the equity method.
C) more favorable than those for a comparable firm using the equity method.

Question #2 of 86 Question ID: 1685291

GTH Corporation has just purchased 18% of the common stock of Pittor Corporation, one of
their major suppliers, making GTH the largest single shareholder in Pittor. The primary
motivation for the purchase is that managerial problems at Pittor have resulted in quality
control difficulties, thereby affecting the reliability of several critical component parts for GTH
products. At the time of the purchase, GTH management announced they plan to be an active
investor and exercise significant influence on Pittor so the quality problems can be resolved.
Given these circumstances, the accounting method used to record the intercorporate
investment will most likely be the:

A) equity method.
B) investment in financial assets method.
C) acquisition method.

Question #3 of 86 Question ID: 1685293

Harter Company recently acquired a 40% stake in Compton Corp. for $40 million in cash by
borrowing at 10%. Harter will account for this acquisition using which of the following methods:

A) Equity method.
B) Held to maturity debt securities method.
C) Acquisition Method.

Question #4 of 86 Question ID: 1685324

A company reports an intercorporate investment using the acquisition method. Which of the
following statements is most accurate?

The use of the acquisition method by a company will generally report the less
A)
favorable results.
The use of the acquisition method by a company will generally report the more
B)
favorable results.
C) The use of the equity method by a company will generally report the same results.

Question #5 of 86 Question ID: 1685346

Milburne Company purchased 1,000 shares of Marino Co. for $20 per share on January 1. By
December 31, shares of Marino were trading at $15 per share in the open market. Marino Co.
has 100,000 shares outstanding with a dividend yield of 2% at year end. Milburne choose FVOCI
classification for these shares. The impact of the Marino holding on the Milburne income
statement is:

A) -$5,000.
B) -$4,700.
C) $300.

Birch Corporation is a large conglomerate based in the U.S. that has grown primarily through
acquisition. On the first day of this reporting year, January 1, 2012, Birch acquired 1,500,000
shares of the common stock of TRQ Inc. TRQ Inc. produces high quality fabrics for use in the
fashion industry. Exhibit 1 shows key numbers from TRQ Inc.'s accounts.

Exhibit 1 - TRQ Financial Statement Extracts

 TRQ Inc

Income – year ending 31 Dec 12 $700,000

Dividend paid $210,000

Number of common shares in issue 6,000,000

Number preferred shares in issue 3,000,000

Total number of shares in issue 9,000,000

Both Birch and TRQ prepare their accounts using US GAAP.

Dan Fitzroy is the CFO of Birch, and is currently preparing with a meeting with the auditors to
discuss the correct treatment of the TRQ investment in Birch's group accounts. Fitzroy is of the
opinion that the equity method of accounting should be used for the following reasons:

1. The proportion of TRQ's common shares owned by Birch suggests that Birch has
significant influence over TRQ's operations
2. The lack of ownership of preferred shares suggests that Birch has no significant influence
over TRQ's operations
3. The proportion of TRQ's total shares owned by Birch suggests that Birch has significant
influence over TRQ's operations

Question #6 - 9 of 86 Question ID: 1685339

Assuming the equity method of accounting is used, what will be the reported investment
income for Birch?

A) $60,000.00.
B) $175,000.00.
C) $115,000.00.

Question #7 - 9 of 86 Question ID: 1685340

Assuming the equity method of accounting is used, what will be the cash flow received by Birch,
due to their investment in TRQ?
A) $65,400.
B) $227,500.
C) $52,500.

Question #8 - 9 of 86 Question ID: 1685341

If the consolidation method is used, how much of TRQ's net income will Birch recognize in the
group income statement?

A) $122,500.
B) $175,000.
C) $700,000.

Question #9 - 9 of 86 Question ID: 1685342

Which of Fitzroy's reasons would most likely support the equity accounting method being
appropriate for TRQ?

A) Reason 2.
B) Reason 1.
C) Reason 3.

Question #10 of 86 Question ID: 1685322

Under U.S. GAAP rules, where an investor owns 41% of the voting shares of an investee and is
able to control the investee, which of the following methods of accounting is most appropriate
to use?

A) Proportionate consolidation method.

B) Acquisition method.
C) Equity method.

Question #11 of 86 Question ID: 1685323

Which of the following methods of accounting for investments will reflect the highest assets
and liabilities on a company's balance sheet?

A) Equity method.
B) Acquisition method.
C) Both methods result in reporting the same balances for assets and liabilities.

Question #12 of 86 Question ID: 1685321

Sawbuck Corporation recently acquired a 60% stake in Rawboard Inc. for $70 million in newly
issued common stock. Given this information, which of the following methods should be used
to account for the acquisition of Rawboard?

A) Acquisition.
B) Proportionate consolidation.
C) The pooling of interest method.

Question #13 of 86 Question ID: 1685314

When comparing companies that hold equity investments in other corporations, which of the
following statements is most accurate? All else being equal, return on asset measures for a firm
using the acquisition method will appear:

A) same as for a comparable firm using the equity method.

B) more favorable than those for a comparable firm using the equity method.
C) less favorable than those for a comparable firm using the equity method.
Omricon Capital Associates specializes in making investments in the small cap market sector. In
some cases the firm operates as a supplier of private equity for restructurings. In this instance,
the firm views itself as having a value investment focus. In others, it acts as a venture capital
firm. Here, the investment focus is usually growth. Finally, in some cases it simply takes passive
investment positions in publicly-traded firms. The positions in marketable securities are
sometimes considered trading positions, and other times the view is to hold for a longer period
until valuation parameters are met or exceeded.

Omricon's chief compliance officer, Raymond "Buzz" Richards has recently become concerned
that the firm may not be correctly following the relevant accounting standards for these
investments. To ensure that the rules are being effectively adhered to, he is seeking advice
from the accounting firm of Merz-Brokaw and Associates on the matter. Sally Lee is the Merz-
Brokaw partner heading up the consulting team assigned to review the situation.

The size of the investments ranges from a few percent of the firm's outstanding equity, to
positions of greater than 50%. Richards says that it has always been his understanding that the
percentage of the equity held is the major determinant with respect to which accounting
method applies. Lee reminds him that the firm's intent for its investments also plays a role in
determining how they are accounted for.

Some of the firm's investments have not worked out as planned. Richards has conferred with
the firm's portfolio managers regarding securities being held by the firm that are worth less
than when they were acquired, and has presented a list of these investments to Lee. His
concern is what this implies for the accounting for these investments. Lee tells him that the
issue here is whether or not the security can be considered impaired, and that designating a
security as impaired implies that the decline in value is permanent.

Top managers at Omricon have asked Lee to help them evaluate the impact of the choice of
accounting method on the firm's profitability. Some members of the management team are of
the belief that the accounting method does not affect financial measures because these are
driven by underlying economic factors. Others believe that these measures can be affected by
the accounting method chosen.

Question #14 - 16 of 86 Question ID: 1685295

Assuming no significant influence exists, which of the following statements concerning

percentage ownership and accounting method is most accurate?
 When the ownership is less than 20%, both US GAAP and IFRS require the equity
A)
method.
When the ownership is less than 20%, both US GAAP and IFRS require the investment
B)
in financial assets method.
When the ownership is less than 20%, US GAAP requires the investment in financial
C)
assets method, IFRS the equity method.

Question #15 - 16 of 86 Question ID: 1685296

For instances in which Omricon holds exactly 50% of the outstanding equity of the investee
firm's equity (i.e., the investee firm is a joint venture), which of the following statements is most
accurate?

A) Both US GAAP and IFRS require that the equity method be used.
IFRS and US GAAP both permit a choice between the equity method and proportional
B)
consolidation.
IFRS requires that the equity method be used; US GAAP permits a choice between the
C)
equity method and proportional consolidation.

Question #16 - 16 of 86 Question ID: 1685297

Relative to consolidation, using the equity method of accounting for investments results in:

A) ROA being higher than under consolidation.

B) ROA being lower and leverage being higher than under consolidation.
C) ROA being higher and leverage being higher than under consolidation.

Question #17 of 86 Question ID: 1685351

The equity method of accounting is most likely to be required to be used for joint ventures
under:

A) IFRS but not U.S. GAAP.

B) neither IFRS nor U.S. GAAP.
C) both IFRS and U.S. GAAP.

Assume that on the balance sheet date shown below TME Corporation acquires 70% of Abcor,
Inc. common stock for $25,000 in cash.

Pre-acquisition Balance Sheets

December 31, 2001

TME Corp. Abcor, Inc.

Current assets $80,000 $38,000

Other assets 28,000 15,000

Total assets $108,000 $53,000

Current liabilities $60,000 $32,000

Common stock 15,000 14,000

Retained earnings 33,000 7,000

Total liabilities and equity $108,000 $53,000

Question #18 - 20 of 86 Question ID: 1685326

What will be the post-acquisition current ratio, using both the acquisition method and the
equity method, respectively, for TME? The choices below represent Acquisition and Equity,
respectively.

A) 1.21, 1.02.
B) 1.04, 1.11.
C) 1.01, 0.92.
Question #19 - 20 of 86 Question ID: 1685327

Using the acquisition method to account for the acquisition, what will be the post-acquisition
current assets of TME?

A) $105,000.
B) $93,000.
C) $118,000.

Question #20 - 20 of 86 Question ID: 1685328

Using the acquisition method to account for the acquisition, which of the following is closest to
the post-acquisition amount that will be recorded as the minority interest under US GAAP?

A) $10,700.
B) $6,300.
C) $21,000.

Evergreen Brothers is a large producer of bedding plants and shrubs that are sold to various
retail nurseries and home improvement stores located across the western coast of the United
States with approximately $85 million in annual sales. Evergreen grows its products at two
facilities, one in Northern California and the other in the Southern part of the state. Each
production facility currently distributes its products within an approximate 150 mile radius of
its location. All aspects of the shipping and delivery of products have historically been provided
by an independent, third-party distribution company.

Because of impressive growth in the company's sales over the past several years, management
has decided to pursue plans to bring "in-house" the distribution of the company's products.
They believe that the projected decreased freight costs as well as the increased efficiencies in
more actively managing the distribution of their production should immediately yield increased
profit margins. As an initial step, Evergreen has negotiated the price for ten delivery trucks,
which could provide all distribution capacity needed for the company's Northern production
facility for the upcoming season. Current plans are to continue the use of the independent
distribution company for the needs of the firm's Southern facility for at least the next several
years.

Under advice from the company's CFO, Evergreen has created a new special purpose entity
(SPE), QuickTime, Inc., which will serve as the entity that will purchase the trucks from the
dealer. The purchase will be financed through a combination of debt and equity, with the dealer
lending 75% of the total cost. The loan is collateralized by both the trucks and Evergreen's
guarantee of the debt, as required by the dealer.

Evergreen has arranged for an outside investor to provide the remaining 25% of the upfront
costs of the equipment in exchange for 100% of QuickTime's nonvoting stock. In addition, the
outside investor is guaranteed an 8% annual return for the life of the financing term. At the end
of seven years, QuickTime will be liquidated and Evergreen will have the option of purchasing
the equipment for its fair value at that time. The proceeds of the liquidation will be used to
repurchase the outside investor's stock at par value. In the event that the liquidation value is
insufficient to buy back the outside investor's stock, Evergreen has committed to fund the
shortfall.

Management has given its tentative approval of the project and the proposed structure.
Questions remain, however, as to the effect of the creation of QuickTime on Evergreen's
financial statements. With the relatively recent issuance of FASB Interpretation No. 46(R),
"Consolidation of Variable Interest Entities" (FIN 46(R)), the management of Evergreen has not
had prior experience with the new consolidation requirements for SPEs.

Question #21 - 24 of 86 Question ID: 1685360

Which of the following statements regarding special purpose entities (SPEs) is least accurate?

An SPE can be established as one of several legal forms, such as corporations,

A) partnerships, or trusts, but must establish separate management from that of the
sponsor.
In general, the equity investors in an SPE can expect to receive a limited rate of return
B)
on their investment in exchange for limited risk exposure.
An SPE can be formed to isolate specific assets from the sponsor, thus lowering the
C) cost of capital by protecting the assets of the SPE in the event the sponsor experiences
financial distress.
Question #22 - 24 of 86 Question ID: 1685361

According to US GAAP, if an SPE is to be considered a variable interest entity (VIE), it must meet
which of the following conditions?

The equity investors in the VIE must bear all of the SPE's risk up to a pre-determined
A)
level as outlined in the governing documents.
The SPE must be consolidated by the primary beneficiary, whose status as primary
B)
beneficiary is defined by the level of the firm's percentage of voting control.
The total at-risk equity of the SPE is not sufficient to finance the entity's activities
C)
without additional subordinated financial support.

Question #23 - 24 of 86 Question ID: 1685362

As outlined in FIN 46(R), the primary beneficiary of a VIE is that entity which meets which of the
following conditions?

Holds the majority voting control of the VIE and has separate management from the
A)
VIE.
Has exposure to the majority of the loss risks or receives the majority of the residual
B)
benefits of the VIE.
C) Holds the majority voting control of the VIE and shares management with the VIE.

Question #24 - 24 of 86 Question ID: 1685363

Assuming that QuickTime is considered a VIE in accordance with FIN 46(R), which of the
following statements regarding the consolidation of QuickTime on Evergreen's financial
statements is most accurate?

The truck dealer is supplying the financing for the majority (75%) of QuickTime's debt,
A)
so Evergreen may not consolidate QuickTime on its financial statements.
 Evergreen is exposed to the majority of QuickTime's risks and rewards, so Evergreen
B)
must consolidate QuickTime on its financial statements.
Because the outside investor holds only nonvoting stock, Evergreen holds the majority
C) controlling financial interest in QuickTime and must consolidate QuickTime on its
financial statements.

Rocky Mountain Air Cargo is a privately held commercial aviation company serving the western
United States. It publishes financial statements in accordance with U.S. GAAP and uses a fiscal
year that matches the calendar year.

Rocky Mountain was in good financial shape heading into 2003, with assets of $50 million at the
beginning of the fiscal year. That year, it earned $3 million in net income and was easily able to
maintain its traditional 50% dividend payout ratio. However, Rocky Mountain had a very difficult
year in 2004, reporting a loss of $800,000. It managed to pay $1 million in dividends, but the
decision to pay dividends in such a weak financial year further undermined the company's fiscal
stability.

Flitenight Air Lines, a publicly-traded aviation firm serving the central and Midwestern United
States, wanted to expand its range of service by coordinating its flight schedule with airlines
serving different geographic regions of North America. One of these airlines was Rocky
Mountain Air Cargo.

To cement the relationship, Flitenight's CEO, John "Bulldog" Basten, decided to make a
significant investment in Rocky Mountain Air Cargo. He was easily able to convince both boards
of the wisdom of the deal, and, in his usual brash style, personally negotiated the terms with his
counterpart at Rocky Mountain, Buck Matthews. Flitenight Air Lines acquired a 20% stake in
Rocky Mountain Air Cargo (with an option to purchase 40% more) for $10 million cash. The deal
closed on January 1, 2003 and Flitenight accounted for the investment using the equity method.

Basten was not happy to find that he had invested right at the peak of Rocky Mountain's
profitability and wound up with a money-losing airline. He had a difficult conversation with
Matthews in early 2005, complaining about the impact of the Rocky Mountain investment on
Flitenight's financials. Basten pointed out that he had a loss on his books: the original $10
million investment in Rocky Mountain was carried at only $9,940,000 on Flitenight's December
31, 2004 balance sheet. Matthews countered that this was just an accounting entry: on a cash
basis, Flitenight had a gain of 5% on its investment over the two years.
Matthews' insistence that the investment had earned money for Flitenight did not sit well with
Basten. Basten decided that Rocky Mountain was clearly being mismanaged and concluded it
was time to gain control of the company.

Basten notified Matthews and Rocky Mountain's board that Flitenight intended to exercise its
option. At the direction of Basten and Glenn, Flitenight purchased the additional shares for cash
and gained control of Rocky Mountain on December 31, 2004.

Question #25 - 28 of 86 Question ID: 1685304

In 2003, Flitenight would reflect its investment in Rocky Mountain on its income statement by
recording:

A) $300,000.
B) $600,000.
C) −$200,000.

Question #26 - 28 of 86 Question ID: 1685305

If Flitenight were to account for its Rocky Mountain investment as an investment in financial
assets instead of the equity method, Flitenight's 2004 income statement would reflect its
investment in Rocky Mountain by including which of the following?

A) Nothing, since the cost of the acquisition is not adjusted until the asset is sold.
B) Only income of $200,000.
C) Only a loss of $160,000.

Question #27 - 28 of 86 Question ID: 1685306

Under the acquisition method, minority interest is considered:

A) a liability under IFRS and US GAAP.

B) equity under IFRS and a liability under US GAAP.
C) equity under IFRS and US GAAP.

Question #28 - 28 of 86 Question ID: 1685307

Regarding Basten's and Matthews' statements about the gain/loss that Flitenight had at the end
of 2004 on its investment in Rocky Mountain, which is most accurate?

A) Basten’s statement is correct and Matthews’ statement is incorrect.

B) Basten’s statement is incorrect and Matthews’ statement is correct.
C) Basten’s statement is correct and Matthews’ statement is correct.

Question #29 of 86 Question ID: 1685266

Accounting standards for intercorporate investments establish different categories of securities

with distinct ways of treating them on the financial statements of the company. One category
requires the securities to be carried at fair value on the balance sheet with unrealized gains and
losses excluded from the income statement. This category of security classification is called
debt:

A) and equity classified as fair value through P&L securities.

B) securities classified at amortized cost.
C) and equity securities classified as fair value through OCI.

Question #30 of 86 Question ID: 1685354

Which of the following statements about variable interest entities (VIE) are correct or incorrect?

One potential benefit of a VIE is a lower cost of capital since the assets and
Statement #1: liabilities of the VIE are isolated in the event the sponsor experiences
financial difficulties.

The organizational form of a VIE must be either a partnership or a joint

Statement #2: venture and it is necessary for the VIE to have separate management and
employees.

A) Only one is correct.

B) Both are incorrect.
C) Both are correct.

Question #31 of 86 Question ID: 1685344

Company X owns 15% of company S and exerts significant influence over the operations of the
company. The book value of the investment on December 31, 2008, is $48,000. In 2009,
company S earned $100,000 and paid dividends of $20,000. The impact of the investment on
the income statement of company X is:

A) $15,000.
B) $12,000.
C) $3,000.

Question #32 of 86 Question ID: 1685320

On December 31, 2008 Company P invests $5,000 in Company S in exchange for 25% of the
company. During 2009, Company S earns $2,000 and pays a dividend of $500. If Company P
uses the equity method of accounting, what values will be reported on the balance sheet and
income statement? How much cash will be recognized from the investment?

Income
Balance Sheet Cash
Statement

A) $5,500 $0 $0

B) $5,375 $500 $125

C) $5,375 $125 $125

Question #33 of 86 Question ID: 1685284

Company X owns 15% of company S and exerts significant influence over the operations of the
company. The book value of the investment on December 31, 2001, is $48,000. In 2002,
company S earned $100,000 and paid dividends of $20,000. The value of the investment
account on December 31, 2002, is:

A) $63,000.
B) $60,000.
C) $48,000.

Joseph Haggs, CFA, is an analyst working for Garvess Jones, a large publicly traded investment-
banking firm. Haggs covers the internet sector. Recently, one of the more successful companies
Haggs covers, Simpson Corporation, made an aggressive move to acquire another internet
company, Bailey Corporation (BC). BC is a company specializing in graphics and animation on
the World Wide Web and has 1,000,000 shares outstanding. Simpson also holds minimal
investments in other technology companies both public and private. In 1999 Simpson saw an
opportunity to substantially increase its share in BC. Simpson feels that their sophisticated
animation can greatly improve Simpson's market share and sees an acquisition as an
opportunity to expand their business. The relevant financial data are in the following tables.
 Bailey Corporation

Selected Financial Data, Years Ended December 31

(in Thousands)

Item 1998 1999 2000

Sales $50,000 $60,000 $70,000

Less: cost of goods sold

37,000 43,700 47,250
(COGS)

Earnings before interest &

13,000 16,300 22,750
taxes (EBIT)

Less: Interest 10,000 13,000 19,000

EBT 3,000 3,300 3,750

Less: Taxes 1,000 1,100 1,250

Net Income $2,000 $2,200 $2,500

Dividends Paid $1,000 $1,200 $1,500

Total Shares Outstanding 1,000,000

Simpson's Purchase Transactions in BC's Stock

Date January 1, 1998 January 1, 1999 January 1, 2000

Number of Shares 10,000 290,000 700,000

Price per Share 10 11 15

Because this is the largest acquisition in Simpson's history, Mr. Haggs' supervisor has asked him
to prepare a report for Garvess Jones' clients detailing the effects of the acquisition on
Simpson's financial statements.

Question #34 - 37 of 86 Question ID: 1685316

Haggs wonders which accounting method Simpson uses to calculate the book value of the BC
investment for the year ending December 31, 1999. Which is the correct method?
A) Equity method.
B) Acquisition method.
C) Investment in Financial Assets method.

Question #35 - 37 of 86 Question ID: 1685317

Haggs wonders which accounting method Simpson uses to calculate the book value of the BC
investment for the year ending December 31, 1998. Which is the correct method?

A) Investment in Financial Assets method.

B) Equity method.
C) Acquisition method.

Question #36 - 37 of 86 Question ID: 1685318

Haggs wonders which accounting method Simpson uses to calculate the book value of the BC
investment for the year ending December 31, 2000. Which is the correct method?

A) Acquisition method.
B) Proportional consolidation method.
C) Equity method.

Question #37 - 37 of 86 Question ID: 1685319

Haggs wants to make sure that he assumes the proper accounting method when he does his
analysis. The acquisition of BC stock will lead to Simpson's total net cash flow equaling which of
the following for the year ending December 31, 1999?

A) $360,000.
B) $−2,830,000.
C) $−3,190,000.

Question #38 of 86 Question ID: 1685343

Carter Schmitz, Inc. (Schmitz) purchased 200 shares of Intelismart at $21 a share in June 2006
and classifies 80 shares as fair value through profit or loss securities and holds the remaining
120 shares as classified as fair value through OCI. Intelismart's closing price was $26 on
December 31, 2006, and Schmitz did not sell any of its shares.

What amount should Schmitz report on this investment under the income statement?

A) $400.
B) $1,000.
C) $600.

Global Life Insurance (GLI) holds a wide range of assets in a range of different portfolios across
its various divisions. Some of these assets are held long term to meet future liabilities, whereas
others are held short term to make profits and meet shorter term liquidity needs.

GLI set up a small portfolio of U.S. equities in one of its smaller divisions last year. GLI's chief
investment officer has recently contacted the accounting department to discuss the correct
treatment of the portfolio in the group accounts.

Details of the portfolio's transactions and results for the previous period are shown below in
Exhibit 1.

Exhibit 1 - Equity Portfolio Results

2013 Q1 2013 Q2 2013 Q3 2013 Q4

Shares purchased (sold) 1,000 (200) 700 0

Total shares quarter-end 1,000 800 1,500 1,500

Purchase price 50.00 45.00

Sale price 45.00

Quarter-end market price 52.00 43.00 52.00 60.00

 Total dividends 500 400 750 750

The chief investment officer's also provides the following extract from the portfolio's
investment policy statement:

IPS Extract

1. The portfolio should consist solely of U.S. mid-cap equities.

2. The number of transactions in the portfolio should be kept to a minimum. Shares should
not be purchased on a speculative basis for short term profits.
3. The anticipated average holding period for securities in the portfolio is 3.5 − 4 years.
4. Securities should only be sold to meet urgent liquidity needs.

Another reporting issue the accounting department is looking at concerns a fixed income
portfolio. An overview of the portfolio is given in Exhibit 2:

Exhibit 2 – Fixed Income Portfolio

Par Value $25,000,000

Coupon rate 5% (paid semi-annually)

Current Market Value $27,000,000

The portfolio consists of $1000 par value, 5 year bonds issued by RTF Inc. They were purchased
on the date of issue 1st January 2012 for $25,893,577. For the year ending 31st December the
bonds were carried at amortized cost.

The chief investment officer believes a more appropriate classification would be fair value
through profit or loss, as he is not convinced the bonds will be held for the remaining 3 years.

Question #39 - 42 of 86 Question ID: 1685268

What is the income from the equity portfolio if the securities are classified as FVPL?

A) $19,900.
B) $20,900.
C) –$6,600.
Question #40 - 42 of 86 Question ID: 1685269

What is the balance sheet carrying value of the securities under each of the classifications at
year-end?

FVPL FVOCI

A) $71,500 $71,500

B) $90,000 $71,500

C) $90,000 $90,000

Question #41 - 42 of 86 Question ID: 1685270

If the fixed income portfolio outlined in Exhibit 2 is remains classified as amortized cost, which
of the following is closest to the interest income reported in the income statement for the year
ending 31st December 2013?

A) $1,079,000.
B) $1,086,000.
C) $1,088,000.

Question #42 - 42 of 86 Question ID: 1685271

If the bonds are reclassified as suggested by the chief investment officer, which of the following
statements is most likely correct?

The difference between the amortized cost and fair value will be shown in other
A)
comprehensive income.
B) The difference between the amortized cost and fair value will be shown in net income.
The difference between the purchase price and fair value will be shown in other
C)
comprehensive income.
Question #43 of 86 Question ID: 1685313

Which of the following methods of accounting for investments will reflect the highest net
income on a company's income statement?

A) Equity method.
B) Both methods report the same net income.
C) Acquisition method.

On January 9, 20X6, Company X, reporting under IFRS, purchased $1,000,000 of government

bonds at par and 100,000 shares of stock in Company S for $2,000,000. The stock investment
was held at fair value through OCI while the bonds were held at amortized cost. As of
December 31, the bonds were valued at $900,000, and the stocks were valued at $2,200,000.
The bonds paid $50,000 of interest and the stocks paid $20,000 of dividends. In 2006, Company
S had earnings per share of $0.90.

Question #44 - 47 of 86 Question ID: 1685275

The marketable securities balance amount shown on the balance sheet is:

A) $3,000,000.00.
B) $3,100,000.00.
C) $3,200,000.00.

Question #45 - 47 of 86 Question ID: 1685276

In late 20X6, Company X decided to reclassify the investments in stock. What classification can
the company classify the investment in stocks to?

A) Fair value through profit or loss or amortized cost.

B) Reclassification would not be allowed.
C) Fair value through profit or loss only.

Question #46 - 47 of 86 Question ID: 1685277

The appropriate classification for the investment in government bonds would be:

A) amortized cost, fair value through OCI, or fair value through profit or loss.
B) amortized cost or fair value through OCI.
C) amortized cost or fair value through profit or loss.

Question #47 - 47 of 86 Question ID: 1685278

Assuming that the investments were initially classified as fair value through profit or loss. The
company can reclassify:

A) debt security only if the business model has changed.

B) equity security but only into fair value through OCI.
C) both debt and equity securities into fair value through OCI.

On January 9, 2006, Company X paid $2,000,000 for 100,000 shares of stock in Company S.
Originally the company classified the shares as fair value through OCI. As of December 31, the
stocks were valued at $2,200,000. In 2006, Company S had earnings per share of $0.90 and paid
dividends per share of $0.20. In late December 2006 the company wonders what would be the
change if the company had classified the shares as fair value through P&L.

Question #48 - 49 of 86 Question ID: 1685280

What is the impact if the company had originally classified the shares as fair value through P&L
on the value of the assets of Company X?

A) $200,000.00
B) $70,000.00
C) $0.00

Question #49 - 49 of 86 Question ID: 1685281

If the shares were classified as fair value through P&L, what would have been the impact on the
income and the stockholders' equity of Company X?

A) Stockholders' equity will rise by $200,000, but income will not change.
B) Income will rise by $200,000, but stockholders' equity will not change.
C) Income and stockholder's equity will rise by $200,000.

The Anderson Company acquired 100,000 shares of the Birschbach Company on January 1,
2012, at $25 per share. The market price of a share of Birschbach stock on December 31, 2012,
was $35 per share. During 2012, Birschbach paid dividends of $1.50 per share and had earnings
of $2.50 per share.

The Anderson Company did not buy or sell any additional shares in 2013. The market price of
Birschbach stock on December 31, 2013 was $42.50 per share. During 2013 Birschbach paid
dividends of $1.75 per share and had earnings of $2.25 per share.

Question #50 - 53 of 86 Question ID: 1685286

If Anderson Company accounts for the Birschbach Company shares as classified as fair value
through OCI, the carrying amount of these shares on Anderson's balance sheet at the end of
2012 is:

A) $3.5 million.
B) $2.5 million.
C) $2.6 million.
Question #51 - 53 of 86 Question ID: 1685287

If Anderson Company accounts for the Birschbach Company shares using the equity method,
the carrying amount of these shares on Anderson's balance sheet at the end of 2012 is closest
to:

A) $2.8 million.
B) $2.6 million.
C) $3.5 million.

Question #52 - 53 of 86 Question ID: 1685288

For the year 2012, the investment income that Anderson Company reports on its investment in
Birschbach Company shares, if Anderson classifies the shares as fair value through OCI, is:

A) $250,000.
B) $150,000.
C) $100,000.

Question #53 - 53 of 86 Question ID: 1685289

If Anderson Company accounts for the Birschbach Company shares using the equity method,
the change in carrying value from 2012 to 2013 is closest to:

A) +$2,650,000.
B) +$50,000.
C) +$225,000.

Question #54 of 86 Question ID: 1685364

Which of the following statements regarding special purpose entities (SPEs) is least accurate?
 According to U.S. GAAP, if a SPE is considered a VIE, it must be only consolidated by the
A)
primary beneficiary.
Under IFRS, a special purpose entity must be consolidated by the entity which
B)
exercises control over that entity.
According to U.S. GAAP, a special purpose entity is classified as a variable interest
C) entity (VIE) if it has at-risk equity that is sufficient to finance its own activities without
additional financial support.

Question #55 of 86 Question ID: 1685337

Assuming that the purchase price of an acquisition exceeds the pro-rata share of the fair value
of net assets, which of the following statements is true:

A) Full goodwill method will result in a higher ROE.

B) Full goodwill under U.S. GAAP would report a lower debt-to-equity ratio.
C) Partial goodwill under IFRS will report a lower debt-to-equity ratio.

Question #56 of 86 Question ID: 1685349

Last year, Parent Company acquired Sub Company for $2,000,000. On the date of acquisition,
the fair value of Sub's net assets was $1,700,000.

At the end of the year, the fair value of Sub is $1,950,000, and the fair value of Sub's net assets
is $1,775,000. If the carrying value of Sub is $1,980,000, the impairment loss under U.S. GAAP is
closest to:

A) $30,000.
B) $125,000.
C) $0.
Question #57 of 86 Question ID: 1685302

Equity method is:

A) recommended under IFRS and U.S. GAAP for jointly controlled entities.
B) required under IFRS and under U.S. GAAP for jointly controlled entities.
recommended under U.S. GAAP for jointly controlled entities, but is not normally
C)
permitted under IFRS.

Question #58 of 86 Question ID: 1685331

Under which of the following is a minority interest account most likely to appear on the
consolidated balance sheet?

I. The acquisition method.

II. Equity method.

A) II only.
B) Both I and II.
C) I only.

Question #59 of 86 Question ID: 1685352

Maverick Incorporated formed a special purpose entity (SPE) to purchase and lease a 50,000
acre ranch. The SPE financed 95% of the purchase price with debt. The remaining 5% was
financed with equity capital received from two separate independent investors. The lender
would not make the loan without Maverick's guarantee. How should Maverick treat the SPE in
its financial statements if Maverick is the lessee?

A) Maverick must consolidate the SPE.

B) No firm must consolidate the SPE.
C) Each equity investor must proportionately consolidate the SPE.
Luna Life Insurance is a publicly traded corporation with total assets in excess of $500 million.
Joy Manning, CFA, has served as Luna's chief investment officer for the past decade. Recent
poor performance of Luna investment portfolio has led to the formation of a special task force
to review Luna's investment holdings as well as its operating policies. The task force is
composed of two current Luna board members (who are not employees of Luna) and three
independent investment professionals. Their assignment is to thoroughly review Luna's
financial statements for evidence of impropriety or mishandling of corporate assets. The task
force is expected to complete their review within one month and report back to Luna's board of
directors shortly thereafter.

Luna's most recent financial statements reflect approximately $200 million in various equity
holdings and $100 million in debt instruments. A broad classification of the portfolio (in millions
of $) as of December 31, 2006 is as follows:

Held-to-Maturity Available-for-Sale Trading

Equity $0 $125 $75

Debt $50 $25 $25

In the footnotes, there is a reference to $10 million of available-for-sale securities that were
transferred to the held-to-maturity portfolio last year. The securities were transferred at fair
market value, and an unrealized loss of $1 million was included in that period's income. Several
members of the task force believe the transaction deserves further analysis to determine if the
securities' transfer between portfolios was executed in accordance with SFAS 115, "Accounting
for Certain Investments in Debt and Equity Securities" as Manning has represented.

Also, in 2006, Luna transferred $5 million of shares in ABC Corp from the available-for-sale
portfolio to the trading portfolio. In association with this transaction, $1 million in unrealized
gains were included in the year's income. The task force observes that after the transfer, there
are $2.5 million of ABC Corp remaining in the available-for-sale portfolio. Manning has stated
that the firm's desire to reduce exposure to the equity market was the reason for selling only a
portion of the position in ABC Corp.

In addition, the group is performing its own analysis on the impact of last year's acquisition of a
20% stake in Instate, a regional provider of commercial insurance. Instate reported $15 million
in earnings for the year ending December 31, 2006, and paid approximately $1 million in
dividends. Manning directed Luna's accountants to record the purchase using the equity
method, and thus has included a proportional share of Instate's net income for the year. The
acquisition was effective as of January 1st of 2006, and operating results for the investment
stake in Instate are incorporated into Luna's 2006 financial statements. The group will perform
basic analysis both with and without the operating results of Instate in order to better evaluate
what financial impact the inclusion of Luna's results had on Instate's overall performance.

Question #60 - 61 of 86 Question ID: 1685299

Which of the following investments would most likely be reported under the equity method?

An investment in 5% of the equity of an entity that gives the owner significant influence
A)
over that entity.
An investment in 80% of the equity of an entity that gives the owner control over that
B)
entity.
An investment in 40% of the equity of an entity that gives the owner control over that
C)
entity.

Question #61 - 61 of 86 Question ID: 1685300

Luna has recorded its investment in Instate utilizing the equity method of accounting for
intercorporate investments. According to FASB, which of the following statements most
accurately reflects the impact on an investor's financial statements by using the equity method?

Market values can be compared with the carrying amount for analysis purposes, but
A)
only market values may be used in the financial statements.
The investing firm will not make any adjustments to its financial statements to reflect
B) its proportionate share of the investee’s net assets, but will reference the investment in
the footnotes.
The investing firm can include a proportionate share of the investee’s income in its
C)
earnings, regardless of whether or not there are actual cash flows (i.e. dividends).

Question #62 of 86 Question ID: 1685273

Cosmo Inc. (Cosmo) invests in two portfolios – Portfolio 1 and Portfolio 2. Portfolio 1 contains
securities classified as fair value through P&L. Portfolio 2 contains equity securities classified as
fair value through OCI. Which of the following treatments of Cosmo's reporting of the
investments in Portfolios 1 and 2, respectively, is most accurate?

Portfolio 1 Portfolio 2

Unrealized
amounts Assets
A) reported on reported at fair
income value.
statement.

Unrealized
Assets
amounts
B) reported at fair
reported on
value.
balance sheet.

Unrealized
amounts Assets
C) reported on reported at
income cost.
statement.

Question #63 of 86 Question ID: 1685356

Which of the following statements about special purpose entities (SPE) are correct or incorrect?

The sponsor usually maintains the decision-making power and voting

Statement #1:
control over the SPE.

The equity owners of an SPE usually receive a rate of return that is tied to
Statement #2:
the performance of the SPE.

A) Only one is correct.

B) Both are incorrect.
C) Both are correct.

Question #64 of 86 Question ID: 1685357

Mustang Corporation formed a special purpose entity (SPE) for purposes of providing research
and development. An unrelated firm absorbs the expected losses of the SPE and the
independent shareholders of the SPE receive the expected residual returns. Is the SPE
considered a variable interest entity (VIE) according to FASB Interpretation No. 46(R) and is
consolidation required by Mustang, respectively?

A) No ; No.
B) Yes ; No.
C) Yes ; Yes.

Question #65 of 86 Question ID: 1685355

Barrett Inc. is advised by its banker to create a special purpose entity (SPE) to convert its
existing $15 million loan off-balance sheet. Under the terms of the deal, SPE would obtain a
loan for $15 million from the bank with Barrett providing loan guarantee. Barrett would then
sell $15 million of accounts receivable to the SPE and use the proceeds to pay off the current
loan. Barrett prepares its financial statements under U.S. GAAP. Which of the following
statements is most accurate regarding the impact of such an arrangement on Barrett's ratios?

A) Barrett’s leverage would decrease and receivable turnover would increase.

B) Barrett’s leverage would remain the same while receivable turnover would increase.
C) Barrett’s leverage as well as receivables turnover would remain the same.

Question #66 of 86 Question ID: 1685345

Mashburn Company acquired 25% of the 100,000 outstanding shares of Humm Co. on January
1 for $250,000 in cash. Humm Co. earned $1 per share and had a dividend payout ratio of 40%.
As of December 31, Humm Co. shares were trading in the open market at $12 per share.
Calculate the income statement treatment of the Humm Co. investment as of December 31.

A) $10,000.
B) $25,000.
C) $75,000.

Question #67 of 86 Question ID: 1685348

Alpha Inc. owns 70% of the outstanding shares of Beta Inc. Compared to the debt-to-equity
ratio under the partial goodwill method, Alpha's debt-to-equity ratio under the full goodwill
method is most likely be:

A) lower.
B) higher.
C) the same.

Question #68 of 86 Question ID: 1685358

Firm A recently leased equipment used in its manufacturing plant. If the leased asset is worth
less than $100,000 at the end of the lease, Firm A will pay the lessor the difference.

Firm B provided debt financing to an unrelated entity. The debt has a provision whereby Firm B
cannot be repaid until all other senior debt is satisfied.

Do Firm A and Firm B have a variable interest?

A) Both have a variable interest.

B) Only one has a variable interest.
C) Neither have a variable interest.
Question #69 of 86 Question ID: 1685290

Company A acquired a 50% stake in Company T on January 1, 2003 by paying T's shareholders
$100,000 in cash. Pre-acquisition balance sheets for the two firms are presented below:

Balance Sheet

Company A Company T

Current assets $400,000 $60,000

Fixed assets 600,000 100,000

Total $1,000,000 $160,000

Current liabilities $50,000 $ 30,000

Common stock 350,000 60,000

Retained earnings 600,000 70,000

Total $1,000,000 $160,000

The fair values of company T assets and liabilities was same as the book value. Company A
reports under U.S. GAAP. What are the post-acquisition balance sheet values for total assets for
Company A under the equity and acquisition methods of accounting respectively?

A) $1,000,000 and $1,095,000.

B) $1,000,000 and $1,130,000.
C) $1,060,000 and $1,095,000.

Question #70 of 86 Question ID: 1685353

Which of the following statements regarding asset securitizations and special purpose entities
(SPEs) is most accurate?

When receivables are securitized, the sponsor reports the cash inflow as an investing
A)
activity in the cash flow statement.
B) The SPE usually issues debt to purchase receivables from the sponsor.
 If the sponsor has no recourse, then the transaction is nothing more than a
C)
collateralized borrowing.

Question #71 of 86 Question ID: 1685292

Acme Corporation purchases a 3% interest in Bandy Company to become the single largest
shareholder of Bandy. Acme will hold a seat on the Board of Directors of Bandy. Acme will
account for its investment in Bandy using the:

A) equity method.
B) lower of cost or market method.
C) acquisition method.

On December 15, 2009, the Zeisler Company faces a financial crisis. Zeisler's industry has gone
into recession and net income has declined to nearly zero. Jeremiah Welch, the company's CFO,
is extremely concerned that, when the final figures for 2009 come in, the poor operating results
will throw the firm into violation of its debt covenants, which specify that it must meet a certain
return on assets (ROA) and not exceed a certain debt-to-asset ratio. A violation of either
covenant would trigger a provision in the lending agreement allowing lenders to put Zeisler's
debt back to the firm and likely force Zeisler into bankruptcy.

With only two weeks before the close of the firm's fiscal year on December 31, there is no way
to avoid bankruptcy through improved operations. Welch calls an emergency meeting with
Olivia Dupree, the firm's controller, to come up with a plan of action to keep Zeisler out of
bankruptcy. He explains to Dupree that they need to increase Zeigler's reported ROA and
reduce its reported debt-to-assets ratio relative to the numbers that would otherwise be
reported for 2009.

Dupree suggests that Zeisler's equity investments might be useful in staving off bankruptcy.
Zeisler acquired 100,000 shares of the Market Square Corporation on January 1, 2009, at $25
per share.

Market Square paid dividends during 2009 of $1.50 per share and was expected to have
earnings for 2009 of $2.50 per share. Zeisler also holds 250,000 shares of General Nuclear,
purchased for $72 per share. General Nuclear has no dividends and is expected to report a loss
for 2009. Both securities are classified on the financial statements as FVOCI.

Dupree left the meeting with Welch for a moment to check the stock market. She found that
Market Square was trading at $35 per share and General Nuclear was at $43.

Question #72 - 75 of 86 Question ID: 1685309

What is the investment income that Zeisler Company will report for the year 2009 on its
investment in Market Square Corporation shares if it continues to account for the shares as an
FVOCI investment?

A) $150,000.
B) $200,000.
C) $250,000.

Question #73 - 75 of 86 Question ID: 1685310

If Zeisler were to account for the Market Square Corporation shares as FVPL, assuming that the
securities do not change in value between the December 15th meeting and the end of the year,
the carrying amount of these shares on Zeisler's December 31, 2009 balance sheet would be:

A) $2.50 million.
B) $2.75 million.
C) $3.50 million.

Question #74 - 75 of 86 Question ID: 1685311

If Zeisler reclassified the common stock of General Nuclear as FVPL, what effect would it have
on Zeisler's 2009 income statement?

Reclassifying the security would have no effect on the income statement because gains
A)
and losses would be recognized in equity.
B) Net income would increase.
C) None, reclassification is prohibited under IFRS 9.

Question #75 - 75 of 86 Question ID: 1685312

If Zeisler were to account for the Market Square Corporation shares using the equity method,
assuming that the securities do not change in value between the December 15th meeting and
the end of the year, the carrying amount of these shares on Zeisler's December 31, 2009
balance sheet would be:

A) $2.75 million.
B) $2.60 million.
C) $3.50 million.

Question #76 of 86 Question ID: 1685347

According to U.S. GAAP, goodwill is most likely to be considered impaired if the reporting unit's:

A) tangible assets acquired in a business combination decrease in value.

B) carrying value (including goodwill) is greater than its fair value.
C) implied value of goodwill is less than book value of goodwill.

Question #77 of 86 Question ID: 1685301

Under IFRS rules, which of the following accounting treatments is most preferred for joint
ventures where there is shared control?

A) Acquisition method.
B) Proportionate consolidation method.
C) Equity method.
Question #78 of 86 Question ID: 1685350

Regarding accounting for joint ventures using the equity method or using proportionate
consolidation, it would be most accurate to state that:

both IFRS and US GAAP require the proportionate consolidation method be used to
A)
account for joint ventures.
the equity method results in a single line item on the income statement, and a single
B)
line item on the balance sheet.
total net assets of the investor will differ between proportionate consolidation and the
C)
equity method.

Question #79 of 86 Question ID: 1685283

Milburne Company purchased 1,000 shares of Marino Co. for $20 per share on January 1
classified as FVPL. By December 31, shares of Marino were trading at $15 per share in the open
market. Marino Co. has 100,000 shares outstanding with a dividend yield of 2% at year end. The
impact of the Marino holding on the Milburne income statement is:

A) −$4,700.
B) −$5,000.
C) −$5,300.

Prior to 2007, Company X (reporting under U.S. GAAP) had never made any acquisitions of
other companies. However, on January 2, 2007, it went on a buying spree, purchasing 10% of
Company A for $10,000; 30% of Company B for $20,000; 40% of Company C for $80,000; and
70% of Company D for $168,000.

Below are the balance sheets for the five companies (in thousands) just prior to the purchase.

Company X A B C D

Cash 400 10 20 30 40
 Other assets 1,600 90 180 270 360

Total assets 2,000 100 200 300 400

Liabilities 300 40 80 120 160

Equity 1,700 60 120 180 240

Total 2,000 100 200 300 400

During 2007, the companies generated the following sales, income, and dividends:

Company X A B C D

Revenue 2,000 100 200 300 400

Net income 200 10 20 30 40

Dividends 4 8 12 16

The company accounts for the acquisitions based on typical ownership proportion guidelines.
Investment in financial assets are classified as FVOCI.

Question #80 - 83 of 86 Question ID: 1685333

After the acquisitions, the liabilities reported by Company X will be:

A) $300,000.
B) $480,000.
C) $460,000.

Question #81 - 83 of 86 Question ID: 1685334

After the acquisitions, minority interest reported by Company X will be:

A) $168,000.
B) $0.
C) $72,000.
Question #82 - 83 of 86 Question ID: 1685335

Company X will report revenue for 2007 of:

A) $2,280,000.
B) $2,000,000.
C) $2,400,000.

Question #83 - 83 of 86 Question ID: 1685336

The change in the investment in the associates account (the account that reflects all non-
consolidated investments in other companies) between January 3 and December 31 is:

A) $11,400.
B) $10,800.
C) $27,600.

Question #84 of 86 Question ID: 1685329

The consolidation method results in:

A) same net income as the equity method but different shareholders' equity.
B) same net income and shareholders' equity as the equity method.
C) same equity as the cost method.

Question #85 of 86 Question ID: 1685282

Fiduciary Investors held two portfolios of marketable securities:

$50 million in Portfolio A was accounted for as Fair value through profit or loss.
$50 million in Portfolio B was accounted for as amortized cost securities.

Assume that Fiduciary reclassified securities ($10 million carrying value, $8 million market
value) from Portfolio B into Portfolio A. If no previous write downs were made, Fiduciary must:

A) charge $2 million to the equity section of its balance sheet.

B) charge $2 million to its income statement.
C) do nothing to its income statement or equity section of its balance sheet.

Question #86 of 86 Question ID: 1685272

Under IFRS, where an investor owns a significant number (39%) of the voting shares of an
investee but has no involvement in policy making and no Board of Directors' representation,
which of the following investment classifications is most appropriate to characterize the
situation?

A) Significant influence.
B) Investment in financial assets.
C) Investment in associates.
Question #1 of 86 Question ID: 1685330

When comparing companies that hold equity investments in other corporations, which of the
following statements is most accurate? All else being equal, leverage measures for a firm using
consolidation will appear:

A) more or less favorable depending on the leverage of the investee company.

B) less favorable than those for a comparable firm using the equity method.
C) more favorable than those for a comparable firm using the equity method.

Explanation

Under consolidation, the debt of the subsidiary is included in the parent company balance
sheet. Parent company's equity is also increased due to minority interest. The impact on
leverage will depend on the leverage employed by the subsidiary.

(Module 7.4, LOS 7.c)

Question #2 of 86 Question ID: 1685291

GTH Corporation has just purchased 18% of the common stock of Pittor Corporation, one of
their major suppliers, making GTH the largest single shareholder in Pittor. The primary
motivation for the purchase is that managerial problems at Pittor have resulted in quality
control difficulties, thereby affecting the reliability of several critical component parts for GTH
products. At the time of the purchase, GTH management announced they plan to be an active
investor and exercise significant influence on Pittor so the quality problems can be resolved.
Given these circumstances, the accounting method used to record the intercorporate
investment will most likely be the:

A) equity method.
B) investment in financial assets method.
C) acquisition method.

Explanation
Normally, due to the less than 20% ownership stake, investment in financial assets
accounting would be used to record this investment. However, percentage ownership rules
are guidelines only and the appropriate accounting method is dependent on the degree of
influence the acquirer intends to exert. In this case, GTH has announced their desire to exert
significant influence, hence, the equity method is the appropriate choice.

(Module 7.3, LOS 7.a)

Question #3 of 86 Question ID: 1685293

Harter Company recently acquired a 40% stake in Compton Corp. for $40 million in cash by
borrowing at 10%. Harter will account for this acquisition using which of the following methods:

A) Equity method.
B) Held to maturity debt securities method.
C) Acquisition Method.

Explanation

The 40% ownership stake would indicate that significant influence has been gained over the
affiliate company. The equity method would be used.

(Module 7.3, LOS 7.a)

Question #4 of 86 Question ID: 1685324

A company reports an intercorporate investment using the acquisition method. Which of the
following statements is most accurate?

The use of the acquisition method by a company will generally report the less
A)
favorable results.
The use of the acquisition method by a company will generally report the more
B)
favorable results.
C) The use of the equity method by a company will generally report the same results.

Explanation
The equity method will provide more favorable results, while the acquisition method will
provide less favorable results. (Under the equity method, liabilities and leverage are lower
than under the acquisition method, while net profit margin, ROE, and ROA are higher.)

(Module 7.4, LOS 7.c)

Question #5 of 86 Question ID: 1685346

Milburne Company purchased 1,000 shares of Marino Co. for $20 per share on January 1. By
December 31, shares of Marino were trading at $15 per share in the open market. Marino Co.
has 100,000 shares outstanding with a dividend yield of 2% at year end. Milburne choose FVOCI
classification for these shares. The impact of the Marino holding on the Milburne income
statement is:

A) -$5,000.
B) -$4,700.
C) $300.

Explanation

These securities are to be classified as FVOCI and hence, all unrealized gains and losses are
taken to OCI in shareholder's equity on the balance sheet. Hence, the only income statement
impact is the $300 dividend = 0.02 × $15 × 1,000.

(Module 7.6, LOS 7.c)

Question #6 - 9 of 86 Question ID: 1685339

Assuming the equity method of accounting is used, what will be the reported investment
income for Birch?

A) $60,000.00.
B) $175,000.00.
C) $115,000.00.

Explanation
Under the equity method, dividends are not included as income to the acquirer. ($700,000 ×
0.25) = $175,000 will be the reported investment income for Birch.

(Module 7.6, LOS 7.a)

Question #7 - 9 of 86 Question ID: 1685340

Assuming the equity method of accounting is used, what will be the cash flow received by Birch,
due to their investment in TRQ?

A) $65,400.
B) $227,500.
C) $52,500.

Explanation

The cash flow to Birch will be the dividend received ($700,000)(0.30)(0.25) = $52,500.

(Module 7.6, LOS 7.a)

Question #8 - 9 of 86 Question ID: 1685341

If the consolidation method is used, how much of TRQ's net income will Birch recognize in the
group income statement?

A) $122,500.
B) $175,000.
C) $700,000.

Explanation
Birch would recognize 25% of the net income = $700,000 × 0.25 = $175,000. This would be
recognized line by line to include the full $700,000, then 75% would be removed as belonging
to the noncontrolling interest.

(Module 7.6, LOS 7.a)

Question #9 - 9 of 86 Question ID: 1685342

Which of Fitzroy's reasons would most likely support the equity accounting method being
appropriate for TRQ?

A) Reason 2.
B) Reason 1.
C) Reason 3.

Explanation

Birch owns 1,500/6,000 = 25% of the common shares of TRQ. This suggests significant
influence which would make equity accounting appropriate. The percentage of preferred
shares owned is not relevant.

(Module 7.6, LOS 7.a)

Question #10 of 86 Question ID: 1685322

Under U.S. GAAP rules, where an investor owns 41% of the voting shares of an investee and is
able to control the investee, which of the following methods of accounting is most appropriate
to use?

A) Proportionate consolidation method.

B) Acquisition method.
C) Equity method.

Explanation
It is possible to control with less than a 50% ownership interest. In this case, the investment
is still considered controlling and the acquisition method would be most appropriate.

(Module 7.4, LOS 7.b)

Question #11 of 86 Question ID: 1685323

Which of the following methods of accounting for investments will reflect the highest assets
and liabilities on a company's balance sheet?

A) Equity method.
B) Acquisition method.
C) Both methods result in reporting the same balances for assets and liabilities.

Explanation

The consolidation method will reflect the highest assets and liabilities. The equity method
would reflect the lowest.

(Module 7.4, LOS 7.c)

Question #12 of 86 Question ID: 1685321

Sawbuck Corporation recently acquired a 60% stake in Rawboard Inc. for $70 million in newly
issued common stock. Given this information, which of the following methods should be used
to account for the acquisition of Rawboard?

A) Acquisition.
B) Proportionate consolidation.
C) The pooling of interest method.

Explanation

When the parent company has at least a 50% ownership stake and control over the
subsidiary, the acquisition method is used.

(Module 7.4, LOS 7.a)

Question #13 of 86 Question ID: 1685314

When comparing companies that hold equity investments in other corporations, which of the
following statements is most accurate? All else being equal, return on asset measures for a firm
using the acquisition method will appear:

A) same as for a comparable firm using the equity method.

B) more favorable than those for a comparable firm using the equity method.
C) less favorable than those for a comparable firm using the equity method.

Explanation

All else being equal, return on asset measures for a firm using consolidation will appear less
favorable than those for a comparable firm using the equity method. This is because the
choice of accounting method will affect the book value of assets, while the level of net income
remains the same.

(Module 7.3, LOS 7.c)

Question #14 - 16 of 86 Question ID: 1685295

Assuming no significant influence exists, which of the following statements concerning

percentage ownership and accounting method is most accurate?

When the ownership is less than 20%, both US GAAP and IFRS require the equity
A)
method.
When the ownership is less than 20%, both US GAAP and IFRS require the
B)
investment in financial assets method.
When the ownership is less than 20%, US GAAP requires the investment in
C)
financial assets method, IFRS the equity method.

Explanation

When the percentage ownership is less than 20% (with no significant influence over the
investee firm), both US GAAP and IFRS require the investment in financial assets method.

(Module 7.3, LOS 7.a)

Question #15 - 16 of 86 Question ID: 1685296

For instances in which Omricon holds exactly 50% of the outstanding equity of the investee
firm's equity (i.e., the investee firm is a joint venture), which of the following statements is most
accurate?

A) Both US GAAP and IFRS require that the equity method be used.
IFRS and US GAAP both permit a choice between the equity method and
B)
proportional consolidation.
IFRS requires that the equity method be used; US GAAP permits a choice between
C)
the equity method and proportional consolidation.

Explanation

Equity method is required accounting method under both IFRS and U.S. GAAP for joint
ventures.

(Module 7.3, LOS 7.a)

Question #16 - 16 of 86 Question ID: 1685297

Relative to consolidation, using the equity method of accounting for investments results in:

A) ROA being higher than under consolidation.

B) ROA being lower and leverage being higher than under consolidation.
C) ROA being higher and leverage being higher than under consolidation.

Explanation

Since consolidation results in inclusion of investee's assets in the investor's balance sheet,
the total assets would be higher under consolidation as compared to equity method. Net
income is same under either methods. ROA would be higher under equity method as
compared to under consolidation. Leverage effects will depend on the debt of the investee
company. Under consolidation, all of investee's debt would be included in investors balance
sheet. However, total equity in the consolidated balance sheet will also be higher due to
inclusion of minority interest.

(Module 7.3, LOS 7.a)

Question #17 of 86 Question ID: 1685351

The equity method of accounting is most likely to be required to be used for joint ventures
under:

A) IFRS but not U.S. GAAP.

B) neither IFRS nor U.S. GAAP.
C) both IFRS and U.S. GAAP.

Explanation

Both IFRS and US GAAP require the equity method of accounting for joint ventures.(Only
under rare circumstances will joint ventures be allowed to use proportionate consolidation
under IFRS and US GAAP.)

(Module 7.8, LOS 7.a)

Question #18 - 20 of 86 Question ID: 1685326

What will be the post-acquisition current ratio, using both the acquisition method and the
equity method, respectively, for TME? The choices below represent Acquisition and Equity,
respectively.

A) 1.21, 1.02.
B) 1.04, 1.11.
C) 1.01, 0.92.

Explanation

With the acquisition method: The current assets are ($80,000 + $38,000 - $25,000) = $93,000.
The current liabilities are ($60,000 + $32,000) = $92,000. The current ratio is $93,000/$92,000
= 1.01. With the equity method: The current assets are ($80,000 - $25,000) = $55,000. The
current liabilities are $60,000. The current ratio is $55,000/$60,000 = 0.92.

(Module 7.2, LOS 7.c)

Question #19 - 20 of 86 Question ID: 1685327

Using the acquisition method to account for the acquisition, what will be the post-acquisition
current assets of TME?

A) $105,000.
B) $93,000.
C) $118,000.

Explanation

Using the acquisition basis of accounting, the post-acquisition level of the current assets is
the amount of the current assets prior to acquisition minus the amount of cash used for the
acquisition. ($80,000 + 38,000 – 25,000) = $93,000.

(Module 7.4, LOS 7.c)

Question #20 - 20 of 86 Question ID: 1685328

Using the acquisition method to account for the acquisition, which of the following is closest to
the post-acquisition amount that will be recorded as the minority interest under US GAAP?

A) $10,700.
B) $6,300.
C) $21,000.

Explanation

Since only 70% of Abcor was purchased by TME there is a minority interest that must be
accounted for, equal to the percentage of Abcor not owned by TME times Abcor's fair value.

Abcor's fair value = 25,000/0.7 = 35,714.29

Under US GAAP, only full goodwill.

Minority interest = 35,714.29 (0.3) = 10, 714.29

(Module 7.4, LOS 7.c)

Question #21 - 24 of 86 Question ID: 1685360

Which of the following statements regarding special purpose entities (SPEs) is least accurate?
 An SPE can be established as one of several legal forms, such as corporations,
A) partnerships, or trusts, but must establish separate management from that of the
sponsor.
In general, the equity investors in an SPE can expect to receive a limited rate of
B)
return on their investment in exchange for limited risk exposure.
An SPE can be formed to isolate specific assets from the sponsor, thus lowering the
C) cost of capital by protecting the assets of the SPE in the event the sponsor
experiences financial distress.

Explanation

An SPE can take on one of many legal forms, but does not necessarily have to have separate
management or employees from that of the sponsor.

(Module 7.9, LOS 7.a)

Question #22 - 24 of 86 Question ID: 1685361

According to US GAAP, if an SPE is to be considered a variable interest entity (VIE), it must meet
which of the following conditions?

The equity investors in the VIE must bear all of the SPE's risk up to a pre-
A)
determined level as outlined in the governing documents.
The SPE must be consolidated by the primary beneficiary, whose status as primary
B)
beneficiary is defined by the level of the firm's percentage of voting control.
The total at-risk equity of the SPE is not sufficient to finance the entity's activities
C)
without additional subordinated financial support.

Explanation

To qualify as a VIE under US GAAP, any one of four conditions must be met, one of which is
the presence of an insufficient at-risk equity investment.

(Module 7.6, LOS 7.a)

Question #23 - 24 of 86 Question ID: 1685362

As outlined in FIN 46(R), the primary beneficiary of a VIE is that entity which meets which of the
following conditions?

Holds the majority voting control of the VIE and has separate management from
A)
the VIE.
Has exposure to the majority of the loss risks or receives the majority of the
B)
residual benefits of the VIE.
C) Holds the majority voting control of the VIE and shares management with the VIE.

Explanation

Unlike past accounting treatments of VIEs where consolidation was based upon voting
control, FIN 46(R) recognizes the primary beneficiary of a VIE as that entity that absorbs the
majority of the risks and enjoys the majority of the benefits of the VIE. The primary
beneficiary is required to consolidate the VIE on their financial statements.

(Module 7.6, LOS 7.a)

Question #24 - 24 of 86 Question ID: 1685363

Assuming that QuickTime is considered a VIE in accordance with FIN 46(R), which of the
following statements regarding the consolidation of QuickTime on Evergreen's financial
statements is most accurate?

The truck dealer is supplying the financing for the majority (75%) of QuickTime's
A)
debt, so Evergreen may not consolidate QuickTime on its financial statements.
Evergreen is exposed to the majority of QuickTime's risks and rewards, so
B)
Evergreen must consolidate QuickTime on its financial statements.
Because the outside investor holds only nonvoting stock, Evergreen holds the
C) majority controlling financial interest in QuickTime and must consolidate
QuickTime on its financial statements.

Explanation
Before the issuance of FIN 46(R), consolidation was based upon possession of voting control
of an entity. FIN 46(R) uses a risk/reward approach when determining which firm must
consolidate the VIE on its financial statements. Since Evergreen is the sole entity exposed to
variability in QuickTime's net income, as well asset value, QuickTime should be consolidated
on their financial statements.

(Module 7.6, LOS 7.a)

Question #25 - 28 of 86 Question ID: 1685304

In 2003, Flitenight would reflect its investment in Rocky Mountain on its income statement by
recording:

A) $300,000.
B) $600,000.
C) −$200,000.

Explanation

Under the equity method, Flitenight would record $600,000 (= $3 million × 0.2) on its 2003
income statement as its share of Rocky Mountain's earnings. The dividends received by
Flitenight are already included as part of its share of Rocky Mountain's net income in the
equity method.

(Module 7.3, LOS 7.b)

Question #26 - 28 of 86 Question ID: 1685305

If Flitenight were to account for its Rocky Mountain investment as an investment in financial
assets instead of the equity method, Flitenight's 2004 income statement would reflect its
investment in Rocky Mountain by including which of the following?

A) Nothing, since the cost of the acquisition is not adjusted until the asset is sold.
B) Only income of $200,000.
C) Only a loss of $160,000.
Explanation

If Flitenight accounted for its Rocky Mountain investment as an investment in financial assets,
in 2004 it would record on its income statement $200,000 (= $1 million × 0.2) in dividends.
That method would not be a permissible choice for Flitenight, however, since it controls more
than 20% of Rocky Mountain.

(Module 7.3, LOS 7.b)

Question #27 - 28 of 86 Question ID: 1685306

Under the acquisition method, minority interest is considered:

A) a liability under IFRS and US GAAP.

B) equity under IFRS and a liability under US GAAP.
C) equity under IFRS and US GAAP.

Explanation

Under the acquisition method, minority interest is now considered equity under IFRS and US
GAAP. Prior to SFAS 160 minority interest was considered either a liability or a
mezzanine(hybrid) item under US GAAP.

(Module 7.3, LOS 7.b)

Question #28 - 28 of 86 Question ID: 1685307

Regarding Basten's and Matthews' statements about the gain/loss that Flitenight had at the end
of 2004 on its investment in Rocky Mountain, which is most accurate?

A) Basten’s statement is correct and Matthews’ statement is incorrect.

B) Basten’s statement is incorrect and Matthews’ statement is correct.
C) Basten’s statement is correct and Matthews’ statement is correct.

Explanation
If Flitenight accounted for its Rocky Mountain investment using the equity method, the value
of the investment as of December 31, 2004, would be:

Flitenight's original $10 million investment + (Flitenight's share of Rocky Mountain's 2003
earnings less dividends Flitenight received in 2003) + (Flitenight's share of Rocky Mountain's
2004 earnings less dividends Flitenight received in 2004).

Since we know that Flitenight owns 20% of Rocky Mountain and consequently receives 20% of
the dividends that Rocky Mountain pays, we can calculate:

Value of Rocky Mountain on Flitenight's books at the end of 2004 =

$10 million + (0.20 × $3 million in 2003 earnings − 0.20 × $1.5 million in

2003 dividends) + (0.20 × −$800,000 in 2004 earnings − 0.20 × $1 million in
2004 dividends) =

$10 million + ($600,000 − $300,000) + (−$160,000 − $200,000) =

$10,000,000 + $300,000 − $360,000 = $9,940,000

Basten's statement is correct.

On a cash basis, Flitenight spent $10 million to acquire its stake in Rocky Mountain, and
received $500,000 (= $300,000 in 2003 dividends + $200,000 in 2004 dividends) in dividends
over the two years. $500,000 in cash return on a $10,000,000 cash investment equals 5% over
the two years. Matthews' statement is also correct.

(Module 7.3, LOS 7.b)

Question #29 of 86 Question ID: 1685266

Accounting standards for intercorporate investments establish different categories of securities

with distinct ways of treating them on the financial statements of the company. One category
requires the securities to be carried at fair value on the balance sheet with unrealized gains and
losses excluded from the income statement. This category of security classification is called
debt:

A) and equity classified as fair value through P&L securities.

B) securities classified at amortized cost.
C) and equity securities classified as fair value through OCI.

Explanation
If securities are designated as debt and equity securities classified as fair value through OCI
they are to be carried at fair value on the balance sheet with unrealized gains and losses
excluded from the income statement (but go into equity via OCI).

(Module 7.1, LOS 7.a)

Question #30 of 86 Question ID: 1685354

Which of the following statements about variable interest entities (VIE) are correct or incorrect?

One potential benefit of a VIE is a lower cost of capital since the assets and
Statement #1: liabilities of the VIE are isolated in the event the sponsor experiences
financial difficulties.

The organizational form of a VIE must be either a partnership or a joint

Statement #2: venture and it is necessary for the VIE to have separate management and
employees.

A) Only one is correct.

B) Both are incorrect.
C) Both are correct.

Explanation

Statement #1 is a correct statement. A lower cost of capital is a potential benefit of forming a

VIE. Statement #2 is an incorrect statement. The organizational form can be a corporation,
partnership, joint venture or trust. It is not necessary for the VIE to have separate
management and employees.

(Module 7.9, LOS 7.a)

Question #31 of 86 Question ID: 1685344

Company X owns 15% of company S and exerts significant influence over the operations of the
company. The book value of the investment on December 31, 2008, is $48,000. In 2009,
company S earned $100,000 and paid dividends of $20,000. The impact of the investment on
the income statement of company X is:
A) $15,000.
B) $12,000.
C) $3,000.

Explanation

Because company X exerts significant influence over company S, the investment will be
treated using the equity method, even though the ownership is less than the 20% guideline.
The impact on the income statement is the proportionate income of company S, which is 0.15
× 100,000 = 15,000.

(Module 7.6, LOS 7.a)

Question #32 of 86 Question ID: 1685320

On December 31, 2008 Company P invests $5,000 in Company S in exchange for 25% of the
company. During 2009, Company S earns $2,000 and pays a dividend of $500. If Company P
uses the equity method of accounting, what values will be reported on the balance sheet and
income statement? How much cash will be recognized from the investment?

Income
Balance Sheet Cash
Statement

A) $5,500 $0 $0

B) $5,375 $500 $125

C) $5,375 $125 $125

Explanation
The carrying value on the balance sheet is $5,375, the income statement will show $500 of
income, and the cash recognized is equal to the dividend of $125.

Using the equity method, for 2008, Company P will:

Recognize $500 ($2000 × 0.25) on its income statement as equity in the net income of
Company S.
Increase the investment in the Company S account on the balance sheet to $5,500,
reflecting its share of the net assets of Company S.
Receive $125 in cash dividends from Company S and reduce its investment in Company
S by that amount to reflect the decline in the net assets of Company S due to the
dividend payment.

At the end of 2008, the carrying value of Company S on Company P's balance sheet will be
($5,000 original investment + $500 proportional share of Company S earnings – $125
dividend received = $5,375).

(Module 7.3, LOS 7.c)

Question #33 of 86 Question ID: 1685284

Company X owns 15% of company S and exerts significant influence over the operations of the
company. The book value of the investment on December 31, 2001, is $48,000. In 2002,
company S earned $100,000 and paid dividends of $20,000. The value of the investment
account on December 31, 2002, is:

A) $63,000.
B) $60,000.
C) $48,000.

Explanation

Because company X exerts significant influence over company S, the investment will be
treated using the equity method, even though the ownership is less than the 20% guideline.
The value of the investment account is equal to the beginning balance plus the proportionate
income of company S minus the dividends received from company S, which equals 48,000 +
(0.15 x 100,000) − (0.15 x 20,000) = 60,000.

(Module 7.3, LOS 7.a)

Question #34 - 37 of 86 Question ID: 1685316

Haggs wonders which accounting method Simpson uses to calculate the book value of the BC
investment for the year ending December 31, 1999. Which is the correct method?

A) Equity method.
B) Acquisition method.
C) Investment in Financial Assets method.

Explanation

When a company owns an influential but non-controlling interest in another company,

commonly 20-50%, it must account for it under the equity method.

(Module 7.3, LOS 7.c)

Question #35 - 37 of 86 Question ID: 1685317

Haggs wonders which accounting method Simpson uses to calculate the book value of the BC
investment for the year ending December 31, 1998. Which is the correct method?

A) Investment in Financial Assets method.

B) Equity method.
C) Acquisition method.

Explanation

When a company owns a non-influential and non-controlling interest in another company the
investment must be carried at fair value. Simpson must carry its BC investment at fair value
for 1998.

(Module 7.3, LOS 7.c)

Question #36 - 37 of 86 Question ID: 1685318

Haggs wonders which accounting method Simpson uses to calculate the book value of the BC
investment for the year ending December 31, 2000. Which is the correct method?

A) Acquisition method.
B) Proportional consolidation method.
C) Equity method.

Explanation

When a company's interest in another exceeds 50% it is considered to have controlling

interest and must consolidate the financial statements.

(Module 7.3, LOS 7.c)

Question #37 - 37 of 86 Question ID: 1685319

Haggs wants to make sure that he assumes the proper accounting method when he does his
analysis. The acquisition of BC stock will lead to Simpson's total net cash flow equaling which of
the following for the year ending December 31, 1999?

A) $360,000.
B) $−2,830,000.
C) $−3,190,000.

Explanation

Simpson paid a total of $−3,190,000 (290,000 shares × $11) however, they also received a
dividend from BC of $360,000. For 1999 Bailey Corporation is paying $1.20 in dividends per
share (1,200,000 / 1,000,000). As of December 1999, Simpson has purchased 300,000 shares
of BC (= 290,000 + 10,000). So dividends received is 300,000 × $1.20 = $360,000. This will
make the total cash flow for the year $−2,830,000.

(Module 7.3, LOS 7.c)

Question #38 of 86 Question ID: 1685343

Carter Schmitz, Inc. (Schmitz) purchased 200 shares of Intelismart at $21 a share in June 2006
and classifies 80 shares as fair value through profit or loss securities and holds the remaining
120 shares as classified as fair value through OCI. Intelismart's closing price was $26 on
December 31, 2006, and Schmitz did not sell any of its shares.

What amount should Schmitz report on this investment under the income statement?

A) $400.
B) $1,000.
C) $600.

Explanation

The unrealized gain on the 120 shares available for sale is $600 (26 - 21 = 5 × 120 shares).
There is also an unrealized gain of $400 (5 × 80) related to the 80 shares that are classified as
fair value through profit or loss which would be reported on the income statement. For
securities classified as fair value through profit or loss, realized and unrealized gains and
losses are reported on the income statement. For securities classified as fair value through
OCI, only realized gains and losses are reported on the income statement.

(Module 7.6, LOS 7.a)

Question #39 - 42 of 86 Question ID: 1685268

What is the income from the equity portfolio if the securities are classified as FVPL?

A) $19,900.
B) $20,900.
C) –$6,600.

Explanation

FVPL income is calculated as dividends plus all gains and losses (realized and unrealized).
Total dividends are 2,400. GLI realized a loss on the sale of 200 shares at 45.00 per share for
a total realized loss of 1,000. GLI has an unrealized gain of 8,000 (800 × (60 – 50)) on the
shares purchased in Q1 and 10,500 (700 × (60 – 45)) the shares purchased in Q3, or total
unrealized gains of 18,500. Therefore, total income under the FVPL classification is 19,900
(2,400 – 1,000 + 18,500).

(Module 7.1, LOS 7.a)

Question #40 - 42 of 86 Question ID: 1685269

What is the balance sheet carrying value of the securities under each of the classifications at
year-end?

FVPL FVOCI

A) $71,500 $71,500

B) $90,000 $71,500

C) $90,000 $90,000

Explanation

Under the FVPL and FVOCI classifications the balance sheet carrying values are the market
values of the shares or 90,000 = (1,500 × 60).

(Module 7.1, LOS 7.a)

Question #41 - 42 of 86 Question ID: 1685270

If the fixed income portfolio outlined in Exhibit 2 is remains classified as amortized cost, which
of the following is closest to the interest income reported in the income statement for the year
ending 31st December 2013?

A) $1,079,000.
B) $1,086,000.
C) $1,088,000.

Explanation
The bonds will be accounted for using the amortized cost method. Interest will be calculated
using the yield at the date of purchase.

Yield at date of purchase can be calculated as follows:

10 N, −25,893,577 PV, 625,000 PMT, 25,000,000 FV

CPT I/Y = 2.1%. This is semiannual. The annual yield is 4.2%.

Asset Interest (2.1%) Coupon

6m 25,893,577 543,765 625,000
1yr 25,812,342 542,059 625,000
18m 25,729,401 540,317 625,000
2yr 25,644,718 538,539 625,000

Total interest in 2013 (i.e., year 2) is $540,317 + $538,539 = $1,078,856.

(Module 7.1, LOS 7.a)

Question #42 - 42 of 86 Question ID: 1685271

If the bonds are reclassified as suggested by the chief investment officer, which of the following
statements is most likely correct?

The difference between the amortized cost and fair value will be shown in other
A)
comprehensive income.
The difference between the amortized cost and fair value will be shown in net
B)
income.
The difference between the purchase price and fair value will be shown in other
C)
comprehensive income.

Explanation

The bonds will be shown at amortized cost. When reclassified to FVPL, the bond will be
restated at fair value and the difference taken to the income statement.

(Module 7.1, LOS 7.a)

Question #43 of 86 Question ID: 1685313

Which of the following methods of accounting for investments will reflect the highest net
income on a company's income statement?

A) Equity method.
B) Both methods report the same net income.
C) Acquisition method.

Explanation

Both methods will report the same net income.

(Module 7.3, LOS 7.c)

Question #44 - 47 of 86 Question ID: 1685275

The marketable securities balance amount shown on the balance sheet is:

A) $3,000,000.00.
B) $3,100,000.00.
C) $3,200,000.00.

Explanation

The bonds are classified as debt securities at amortized cost. Since the bonds were
purchased at par, the amortized cost = cost (par). The stocks are valued at market value.

(Module 7.2, LOS 7.a)

Question #45 - 47 of 86 Question ID: 1685276

In late 20X6, Company X decided to reclassify the investments in stock. What classification can
the company classify the investment in stocks to?

A) Fair value through profit or loss or amortized cost.

B) Reclassification would not be allowed.
C) Fair value through profit or loss only.

Explanation

The initial choice of classification into fair value through OCI is irrevocable and
reclassification is not allowed for equity securities.

(Module 7.2, LOS 7.a)

Question #46 - 47 of 86 Question ID: 1685277

The appropriate classification for the investment in government bonds would be:

A) amortized cost, fair value through OCI, or fair value through profit or loss.
B) amortized cost or fair value through OCI.
C) amortized cost or fair value through profit or loss.

Explanation

Under IFRS 9 debt securities can be classified at amortized cost (if they meet business model
and cash flow characteristic test), fair value through OCI, or fair value through profit or loss.

(Module 7.2, LOS 7.a)

Question #47 - 47 of 86 Question ID: 1685278

Assuming that the investments were initially classified as fair value through profit or loss. The
company can reclassify:

A) debt security only if the business model has changed.

B) equity security but only into fair value through OCI.
C) both debt and equity securities into fair value through OCI.

Explanation
Reclassification of equity securities under the standards is not permitted as the initial
designation (FVPL or FVOCI) is irrevocable. Reclassification of debt securities from amortized
cost to FVPL (or vice versa) is permitted only if the business model has changed.

(Module 7.2, LOS 7.a)

Question #48 - 49 of 86 Question ID: 1685280

What is the impact if the company had originally classified the shares as fair value through P&L
on the value of the assets of Company X?

A) $200,000.00
B) $70,000.00
C) $0.00

Explanation

If the company had originally classified the shares as fair value through P&L, the value of the
assets would be the same (i.e., fair value) but the net income would have been different.

(Module 7.2, LOS 7.c)

Question #49 - 49 of 86 Question ID: 1685281

If the shares were classified as fair value through P&L, what would have been the impact on the
income and the stockholders' equity of Company X?

A) Stockholders' equity will rise by $200,000, but income will not change.
B) Income will rise by $200,000, but stockholders' equity will not change.
C) Income and stockholder's equity will rise by $200,000.

Explanation

The unrealized gain of $200,000 would have been reported on the income statement. Assets
and equity would be the same under either classification.

(Module 7.2, LOS 7.c)

Question #50 - 53 of 86 Question ID: 1685286

If Anderson Company accounts for the Birschbach Company shares as classified as fair value
through OCI, the carrying amount of these shares on Anderson's balance sheet at the end of
2012 is:

A) $3.5 million.
B) $2.5 million.
C) $2.6 million.

Explanation

Fair value through OCI securities are measured at fair market value.

(100,000)($35) = $3,500,000

(Module 7.3, LOS 7.a)

Question #51 - 53 of 86 Question ID: 1685287

If Anderson Company accounts for the Birschbach Company shares using the equity method,
the carrying amount of these shares on Anderson's balance sheet at the end of 2012 is closest
to:

A) $2.8 million.
B) $2.6 million.
C) $3.5 million.

Explanation

Under the equity method, market value is ignored. The carrying value of the shares is: the
original investment + proportional share of earnings − dividend received.

[(100,000)($25)] + [(100,000)($2.50 − 1.50)] = $2,600,000

(Module 7.3, LOS 7.a)

Question #52 - 53 of 86 Question ID: 1685288

For the year 2012, the investment income that Anderson Company reports on its investment in
Birschbach Company shares, if Anderson classifies the shares as fair value through OCI, is:

A) $250,000.
B) $150,000.
C) $100,000.

Explanation

Under the fair value through OCI classification, unrealized gains and losses are not
recognized on the income statement, so the only impact on the income statement is the
dividend received:

(100,000 shares)($1.50 per share) = $150,000

(Module 7.3, LOS 7.a)

Question #53 - 53 of 86 Question ID: 1685289

If Anderson Company accounts for the Birschbach Company shares using the equity method,
the change in carrying value from 2012 to 2013 is closest to:

A) +$2,650,000.
B) +$50,000.
C) +$225,000.

Explanation
For the equity method, the ending carrying value on the balance sheet is the beginning
carrying value plus a proportion of earnings minus a proportion of dividends. For the
Anderson Company, the change in the carrying value is the difference between the earnings
per share and the dividends per share. Dividends per share in 2013 were $1.75 per share and
the earnings per share were $2.25 per share. 100,000 shares × ($2.25 – $1.75) = +$50,000.
The actual carrying value on the balance sheet is $2,600,00 + $225,000 - $175,000 =
$2,650,000.

(Module 7.3, LOS 7.a)

Question #54 of 86 Question ID: 1685364

Which of the following statements regarding special purpose entities (SPEs) is least accurate?

According to U.S. GAAP, if a SPE is considered a VIE, it must be only consolidated by

A)
the primary beneficiary.
Under IFRS, a special purpose entity must be consolidated by the entity which
B)
exercises control over that entity.
According to U.S. GAAP, a special purpose entity is classified as a variable interest
C) entity (VIE) if it has at-risk equity that is sufficient to finance its own activities
without additional financial support.

Explanation

Under U.S. GAAP rules, a VIE could include a SPE that has at-risk equity that is insufficient to
finance the entity's activities without additional financial support.

(Module 7.9, LOS 7.b)

Question #55 of 86 Question ID: 1685337

Assuming that the purchase price of an acquisition exceeds the pro-rata share of the fair value
of net assets, which of the following statements is true:

A) Full goodwill method will result in a higher ROE.

B) Full goodwill under U.S. GAAP would report a lower debt-to-equity ratio.
C) Partial goodwill under IFRS will report a lower debt-to-equity ratio.
Explanation

Since purchase price > prorate share of FVNA, goodwill is positive. Full goodwill > partial
goodwill and minority interest under full goodwill will be higher than minority interest under
partial goodwill. Because minority interest is part of equity, equity will be higher under full
goodwill and debt-to-equity ratio will be lower. Net income would be the same and hence
ROE under full goodwill will be lower.

(Module 7.5, LOS 7.b)

Question #56 of 86 Question ID: 1685349

Last year, Parent Company acquired Sub Company for $2,000,000. On the date of acquisition,
the fair value of Sub's net assets was $1,700,000.

At the end of the year, the fair value of Sub is $1,950,000, and the fair value of Sub's net assets
is $1,775,000. If the carrying value of Sub is $1,980,000, the impairment loss under U.S. GAAP is
closest to:

A) $30,000.
B) $125,000.
C) $0.

Explanation

Parent reported acquisition goodwill of $300,000 ($2,000,000 purchase price − $1,700,000 fair
value of Sub's net assets). Since the carrying value of 1,980,000 exceeds the fair value of
1,950,000, an impairment exists.

= fair value
of
subsidiary
New goodwill – fair value
of
subsidiary's
assets
= 1,950,000
– 1,775,000
= 175,000

Impairment loss = 300,000 – 175,000 = $125,000

(Module 7.7, LOS 7.a)

Question #57 of 86 Question ID: 1685302

Equity method is:

A) recommended under IFRS and U.S. GAAP for jointly controlled entities.
B) required under IFRS and under U.S. GAAP for jointly controlled entities.
recommended under U.S. GAAP for jointly controlled entities, but is not normally
C)
permitted under IFRS.

Explanation

Equity method is required under both U.S. GAAP and IFRS for jointly controlled entities.

(Module 7.3, LOS 7.b)

Question #58 of 86 Question ID: 1685331

Under which of the following is a minority interest account most likely to appear on the
consolidated balance sheet?

I. The acquisition method.

II. Equity method.

A) II only.
B) Both I and II.
C) I only.

Explanation

Minority interest is included in the parent's company's equity under consolidation method
only.

(Module 7.5, LOS 7.a)

Question #59 of 86 Question ID: 1685352

Maverick Incorporated formed a special purpose entity (SPE) to purchase and lease a 50,000
acre ranch. The SPE financed 95% of the purchase price with debt. The remaining 5% was
financed with equity capital received from two separate independent investors. The lender
would not make the loan without Maverick's guarantee. How should Maverick treat the SPE in
its financial statements if Maverick is the lessee?

A) Maverick must consolidate the SPE.

B) No firm must consolidate the SPE.
C) Each equity investor must proportionately consolidate the SPE.

Explanation

The 5% at-risk equity investment is not sufficient to support the activities of the SPE without
Maverick's guarantee. Thus, the SPE is considered a variable interest entity (VIE). Since
Maverick is responsible for the guarantee, Maverick is the primary beneficiary and must
consolidate the SPE.

(Module 7.9, LOS 7.a)

Question #60 - 61 of 86 Question ID: 1685299

Which of the following investments would most likely be reported under the equity method?

An investment in 5% of the equity of an entity that gives the owner significant

A)
influence over that entity.
An investment in 80% of the equity of an entity that gives the owner control over
B)
that entity.
An investment in 40% of the equity of an entity that gives the owner control over
C)
that entity.

Explanation

The parent-company must have significant influence over the management of the affiliate.
Control would require the consolidation method.

(Module 7.3, LOS 7.a)

Question #61 - 61 of 86 Question ID: 1685300

Luna has recorded its investment in Instate utilizing the equity method of accounting for
intercorporate investments. According to FASB, which of the following statements most
accurately reflects the impact on an investor's financial statements by using the equity method?

Market values can be compared with the carrying amount for analysis purposes,
A)
but only market values may be used in the financial statements.
The investing firm will not make any adjustments to its financial statements to
B) reflect its proportionate share of the investee’s net assets, but will reference the
investment in the footnotes.
The investing firm can include a proportionate share of the investee’s income in its
C)
earnings, regardless of whether or not there are actual cash flows (i.e. dividends).

Explanation

The proportionate share of the investee's income is included in the parent's income
statement. Changes in the market value of the investee are not reflected in the investing
firm's income statement so long as the decline in value is not considered to be permanent.

(Module 7.3, LOS 7.a)

Question #62 of 86 Question ID: 1685273

Cosmo Inc. (Cosmo) invests in two portfolios – Portfolio 1 and Portfolio 2. Portfolio 1 contains
securities classified as fair value through P&L. Portfolio 2 contains equity securities classified as
fair value through OCI. Which of the following treatments of Cosmo's reporting of the
investments in Portfolios 1 and 2, respectively, is most accurate?

Portfolio 1 Portfolio 2

Unrealized
amounts Assets
A) reported on reported at fair
income value.
statement.
 Unrealized
Assets
amounts
B) reported at fair
reported on
value.
balance sheet.

Unrealized
amounts Assets
C) reported on reported at
income cost.
statement.

Explanation

Portfolio 1 contains FVPL. Therefore, the unrealized gains and losses would be reported
immediately in the income statement.

Portfolio 2 contains FVOCI. Therefore, the securities (assets) would be reported at fair value.

(Module 7.2, LOS 7.a)

Question #63 of 86 Question ID: 1685356

Which of the following statements about special purpose entities (SPE) are correct or incorrect?

The sponsor usually maintains the decision-making power and voting

Statement #1:
control over the SPE.

The equity owners of an SPE usually receive a rate of return that is tied to
Statement #2:
the performance of the SPE.

A) Only one is correct.

B) Both are incorrect.
C) Both are correct.

Explanation
Both statements are incorrect. The sponsor does not usually have voting control over the
SPE; the activities of an SPE are specifically detailed in governing documents created at the
origination of the SPE. The structure of the SPE transfers the risks and rewards from the
equity owners to the variable interest owners. In return, the equity owners usually receive a
fixed rate of return.

(Module 7.9, LOS 7.a)

Question #64 of 86 Question ID: 1685357

Mustang Corporation formed a special purpose entity (SPE) for purposes of providing research
and development. An unrelated firm absorbs the expected losses of the SPE and the
independent shareholders of the SPE receive the expected residual returns. Is the SPE
considered a variable interest entity (VIE) according to FASB Interpretation No. 46(R) and is
consolidation required by Mustang, respectively?

A) No ; No.
B) Yes ; No.
C) Yes ; Yes.

Explanation

Since the shareholders do not absorb the expected losses, the SPE is considered a VIE. The
unrelated firm (not Mustang) that absorbs the losses is the primary beneficiary and must
consolidate the VIE.

(Module 7.9, LOS 7.a)

Question #65 of 86 Question ID: 1685355

Barrett Inc. is advised by its banker to create a special purpose entity (SPE) to convert its
existing $15 million loan off-balance sheet. Under the terms of the deal, SPE would obtain a
loan for $15 million from the bank with Barrett providing loan guarantee. Barrett would then
sell $15 million of accounts receivable to the SPE and use the proceeds to pay off the current
loan. Barrett prepares its financial statements under U.S. GAAP. Which of the following
statements is most accurate regarding the impact of such an arrangement on Barrett's ratios?

A) Barrett’s leverage would decrease and receivable turnover would increase.

 Barrett’s leverage would remain the same while receivable turnover would
B)
increase.
C) Barrett’s leverage as well as receivables turnover would remain the same.

Explanation

Under U.S. GAAP, the sponsor needs to consolidate SPEs using acquisition method. The
underlying loan and accounts receivable would then be included in the consolidated balance
sheet and none of the financial ratios would be affected.

(Module 7.9, LOS 7.a)

Question #66 of 86 Question ID: 1685345

Mashburn Company acquired 25% of the 100,000 outstanding shares of Humm Co. on January
1 for $250,000 in cash. Humm Co. earned $1 per share and had a dividend payout ratio of 40%.
As of December 31, Humm Co. shares were trading in the open market at $12 per share.
Calculate the income statement treatment of the Humm Co. investment as of December 31.

A) $10,000.
B) $25,000.
C) $75,000.

Explanation

Under the equity method, the investor recognizes its pro-rata share of the affiliate's income
on the income statement. Since Mashburn owns 25,000 shares of Humm and Humm earned
$1, the income statement impact of the investment is $25,000.

(Module 7.6, LOS 7.a)

Question #67 of 86 Question ID: 1685348

Alpha Inc. owns 70% of the outstanding shares of Beta Inc. Compared to the debt-to-equity
ratio under the partial goodwill method, Alpha's debt-to-equity ratio under the full goodwill
method is most likely be:

A) lower.
B) higher.
C) the same.

Explanation

The choice of full vs. partial goodwill will not impact consolidated debt. Compared to partial
goodwill method, Alpha's equity will be higher under the full goodwill method (due to a
higher minority interest value). Hence, full goodwill will report a lower debt-to-equity ratio
(due to the higher denominator).

(Module 7.7, LOS 7.a)

Question #68 of 86 Question ID: 1685358

Firm A recently leased equipment used in its manufacturing plant. If the leased asset is worth
less than $100,000 at the end of the lease, Firm A will pay the lessor the difference.

Firm B provided debt financing to an unrelated entity. The debt has a provision whereby Firm B
cannot be repaid until all other senior debt is satisfied.

Do Firm A and Firm B have a variable interest?

A) Both have a variable interest.

B) Only one has a variable interest.
C) Neither have a variable interest.

Explanation

A lease residual guarantee and subordinated debt are both examples of variable interests.
Firm A will experience a loss if the leased asset is worth less than $100,000 at the end of the
lease. Firm B will experience a loss if the senior debt is not paid in full.

(Module 7.9, LOS 7.a)

Question #69 of 86 Question ID: 1685290

Company A acquired a 50% stake in Company T on January 1, 2003 by paying T's shareholders
$100,000 in cash. Pre-acquisition balance sheets for the two firms are presented below:

Balance Sheet

Company A Company T

Current assets $400,000 $60,000

Fixed assets 600,000 100,000

Total $1,000,000 $160,000

Current liabilities $50,000 $ 30,000

Common stock 350,000 60,000

Retained earnings 600,000 70,000

Total $1,000,000 $160,000

The fair values of company T assets and liabilities was same as the book value. Company A
reports under U.S. GAAP. What are the post-acquisition balance sheet values for total assets for
Company A under the equity and acquisition methods of accounting respectively?

A) $1,000,000 and $1,095,000.

B) $1,000,000 and $1,130,000.
C) $1,060,000 and $1,095,000.

Explanation

Using the equity method will result in a decrease of the current asset account to $300,000
because of the cash outflow. However, a new non-current asset called "Investment in
Company T" will be added to the balance sheet. This amount will be $100,000, so the total
assets will remain unchanged. Under U.S. GAAP, only full goodwill is allowed. Full goodwill =
fair value of company T – Book value of company T. Fair value of company T = (100,000 / 0.50
= 200,000). Book value of company T = 130,000 (total stock holder's equity = common stock +
retained earnings). Goodwill = 70,000. Under acquisition, total assets will be $1,130,000
(70,000 + 400,000 + 60,000 + 600,000 + 100,000 – 100,000).

(Module 7.3, LOS 7.a)

Question #70 of 86 Question ID: 1685353

Which of the following statements regarding asset securitizations and special purpose entities
(SPEs) is most accurate?

When receivables are securitized, the sponsor reports the cash inflow as an
A)
investing activity in the cash flow statement.
B) The SPE usually issues debt to purchase receivables from the sponsor.
If the sponsor has no recourse, then the transaction is nothing more than a
C)
collateralized borrowing.

Explanation

SPEs are often created to securitize assets, usually receivables of the sponsor. Typically, the
SPE issues debt to purchase the receivables from the sponsor and the debt is repaid as the
receivables are collected.

When the receivables are securitized, the sponsor removes the receivables from the balance
sheet and reports the cash inflow as an operating activity in the cash flow statement. If the
sponsor still has recourse, the transaction is nothing more than a collateralized borrowing.

(Module 7.9, LOS 7.a)

Question #71 of 86 Question ID: 1685292

Acme Corporation purchases a 3% interest in Bandy Company to become the single largest
shareholder of Bandy. Acme will hold a seat on the Board of Directors of Bandy. Acme will
account for its investment in Bandy using the:

A) equity method.
B) lower of cost or market method.
C) acquisition method.

Explanation

Even though Acme's interest is low at only 3%, they have significant influence by having a seat
on Bandy's Board of Directors. As such, they must use the equity method.

(Module 7.3, LOS 7.a)

Question #72 - 75 of 86 Question ID: 1685309

What is the investment income that Zeisler Company will report for the year 2009 on its
investment in Market Square Corporation shares if it continues to account for the shares as an
FVOCI investment?

A) $150,000.
B) $200,000.
C) $250,000.

Explanation

The investment income (for FVOCI securities) includes dividends and interest. In this case, the
investment income from Market Square Corporation would be the dividends it paid to the
number of shares Zeisler owns:

100,000 shares × $1.50 per share = $150,000.

(Module 7.3, LOS 7.c)

Question #73 - 75 of 86 Question ID: 1685310

If Zeisler were to account for the Market Square Corporation shares as FVPL, assuming that the
securities do not change in value between the December 15th meeting and the end of the year,
the carrying amount of these shares on Zeisler's December 31, 2009 balance sheet would be:

A) $2.50 million.
B) $2.75 million.
C) $3.50 million.

Explanation

Regardless of the FVOCI or FVPL classification, securities are carried at fair market value:

100,000 shares × $35 per share = $3,500,000.

(Module 7.3, LOS 7.c)

Question #74 - 75 of 86 Question ID: 1685311

If Zeisler reclassified the common stock of General Nuclear as FVPL, what effect would it have
on Zeisler's 2009 income statement?

Reclassifying the security would have no effect on the income statement because
A)
gains and losses would be recognized in equity.
B) Net income would increase.
C) None, reclassification is prohibited under IFRS 9.

Explanation

Initial designation for equity securities is irrevocable under IFRS 9 and hence reclassification
is prohibited.

(Module 7.3, LOS 7.c)

Question #75 - 75 of 86 Question ID: 1685312

If Zeisler were to account for the Market Square Corporation shares using the equity method,
assuming that the securities do not change in value between the December 15th meeting and
the end of the year, the carrying amount of these shares on Zeisler's December 31, 2009
balance sheet would be:

A) $2.75 million.
B) $2.60 million.
C) $3.50 million.

Explanation

Under the equity method the market value of the stock is ignored but the proportionate
share of the earnings are added to the original investment and the proportionate share of
the dividends are subtracted from the earnings. Hence, we have the original investment +
(earnings − dividends) = total value of the investment.

[(100,000 shares)($25)] + [(100,000 shares)($2.50 earnings − 1.50 dividend)] =

$2,600,000.

(Module 7.3, LOS 7.c)

Question #76 of 86 Question ID: 1685347

According to U.S. GAAP, goodwill is most likely to be considered impaired if the reporting unit's:

A) tangible assets acquired in a business combination decrease in value.

B) carrying value (including goodwill) is greater than its fair value.
C) implied value of goodwill is less than book value of goodwill.

Explanation

To test goodwill for impairment under U.S. GAAP, the carrying value of the reporting unit
(including goodwill) is compared to the fair value of the reporting unit. After an impairment
has been detected, the loss is calculated as the difference between the book value of
goodwill and the implied value of goodwill.

(Module 7.7, LOS 7.a)

Question #77 of 86 Question ID: 1685301

Under IFRS rules, which of the following accounting treatments is most preferred for joint
ventures where there is shared control?

A) Acquisition method.
B) Proportionate consolidation method.
C) Equity method.

Explanation

Only equity method is now permitted under both IFRS and U.S. GAAP.

(Module 7.3, LOS 7.b)

Question #78 of 86 Question ID: 1685350

Regarding accounting for joint ventures using the equity method or using proportionate
consolidation, it would be most accurate to state that:
 both IFRS and US GAAP require the proportionate consolidation method be used
A)
to account for joint ventures.
the equity method results in a single line item on the income statement, and a
B)
single line item on the balance sheet.
total net assets of the investor will differ between proportionate consolidation and
C)
the equity method.

Explanation

On the income statement, the equity method results in a single line item (equity in income of
the joint venture). On the balance sheet, the equity method also results in a single line item
(investment in joint venture). Both IFRS and U.S. GAAP require the equity method of
accounting for joint ventures; only under rare circumstances will proportionate consolidation
be allowed for reporting of joint ventures under IFRS and U.S. GAAP. Total net assets of the
investor is identical under the two methods.

(Module 7.8, LOS 7.a)

Question #79 of 86 Question ID: 1685283

Milburne Company purchased 1,000 shares of Marino Co. for $20 per share on January 1
classified as FVPL. By December 31, shares of Marino were trading at $15 per share in the open
market. Marino Co. has 100,000 shares outstanding with a dividend yield of 2% at year end. The
impact of the Marino holding on the Milburne income statement is:

A) −$4,700.
B) −$5,000.
C) −$5,300.

Explanation

Since these securities are to be classified as FVPL securities, both the dividend received and
the unrealized loss are posted to the income statement. The dividend is computed as 0.02 ×
$15 × 1,000 = $300 whereas the unrealized loss is $5,000 = ($15 - $20) × 1,000. The net
income statement impact is $300 - $5,000 = -$4,700.

(Module 7.2, LOS 7.c)

Question #80 - 83 of 86 Question ID: 1685333

After the acquisitions, the liabilities reported by Company X will be:

A) $300,000.
B) $480,000.
C) $460,000.

Explanation

Liabilities will be equal to the starting balance plus the liability balance for Company D, which
equals 300,000 + 160,000 = 460,000.

(Module 7.5, LOS 7.a)

Question #81 - 83 of 86 Question ID: 1685334

After the acquisitions, minority interest reported by Company X will be:

A) $168,000.
B) $0.
C) $72,000.

Explanation

Minority interest will be equal to the proportion not owned of Company D multiplied by the
equity of Company D, which is (1 − 0.7) × 240,000 = 72,000.

(Module 7.5, LOS 7.a)

Question #82 - 83 of 86 Question ID: 1685335

Company X will report revenue for 2007 of:

A) $2,280,000.
B) $2,000,000.
C) $2,400,000.

Explanation

Revenues will equal the revenue of Company X and D, which is 2,000,000 + 400,000.

(Module 7.5, LOS 7.a)

Question #83 - 83 of 86 Question ID: 1685336

The change in the investment in the associates account (the account that reflects all non-
consolidated investments in other companies) between January 3 and December 31 is:

A) $11,400.
B) $10,800.
C) $27,600.

Explanation

The investment in the associates account will increase from the proportionate income of
Companies B and C, and will decrease from the dividends received from Companies B and C.
The changes will be (0.3 × 20,000) + (0.4 × 30,000) − (0.3 × 8,000) − (0.4 × 12,000) = 10,800.

(Module 7.5, LOS 7.a)

Question #84 of 86 Question ID: 1685329

The consolidation method results in:

A) same net income as the equity method but different shareholders' equity.
B) same net income and shareholders' equity as the equity method.
C) same equity as the cost method.

Explanation
Consolidation results in the SAME net income and higher equity as compared to the equity
method.

(Module 7.4, LOS 7.c)

Question #85 of 86 Question ID: 1685282

Fiduciary Investors held two portfolios of marketable securities:

$50 million in Portfolio A was accounted for as Fair value through profit or loss.
$50 million in Portfolio B was accounted for as amortized cost securities.

Assume that Fiduciary reclassified securities ($10 million carrying value, $8 million market
value) from Portfolio B into Portfolio A. If no previous write downs were made, Fiduciary must:

A) charge $2 million to the equity section of its balance sheet.

B) charge $2 million to its income statement.
C) do nothing to its income statement or equity section of its balance sheet.

Explanation

Reclassification of debt securities into FVPL is allowed if the business model has changed.
Unrealized gain or loss on reclassification is recognized in the income statement.

(Module 7.2, LOS 7.c)

Question #86 of 86 Question ID: 1685272

Under IFRS, where an investor owns a significant number (39%) of the voting shares of an
investee but has no involvement in policy making and no Board of Directors' representation,
which of the following investment classifications is most appropriate to characterize the
situation?

A) Significant influence.
B) Investment in financial assets.
C) Investment in associates.

Explanation
Investment in financial assets is the correct classification here because there is no significant
influence (i.e. no involvement in policy marking, no Board of Directors' representation).
Although the ownership interest level is significant at 39% (it is between 20% and 50%), the
lack of control classifies the investment as an investment in financial assets.

Significant influence is not in investment classification per se. It is a measure of relative

degree of influence.

(Module 7.1, LOS 7.b)

Question #1 of 33 Question ID: 1685380

Which of the following is NOT an advantage of share based compensation over cash
compensation?

A) Share based compensation does not require a cash outlay.

Share based compensation serves to align employee interest with the interests of
B)
stockholders.
In a share based compensation plan, expense is not recognized, unless the exercise
C)
price is set below the market price.

Question #2 of 33 Question ID: 1685387

Under U.S. GAAP, capitalized periodic pension costs included in the value of ending inventory is
most likely:

A) to be expensed as part of cost of goods sold when the inventory is sold.

B) to be amortized over the service lives of employees.
C) not allowed.

Question #3 of 33 Question ID: 1685392

In order to decrease the projected benefit obligation (PBO) of a pension plan, which of the
following changes in pension assumptions can be made to yield the desired result?

A) Decrease the discount rate.

B) Increase the expected rate of return.
C) Decrease the rate of compensation growth.
Question #4 of 33 Question ID: 1685367

Which of the following statements about share-based compensation is most accurate?

A) Only the intrinsic value of an option is shown as an expense in the income statement.
B) The fair value of an option is expensed when the option is in-the-money.
The compensation expense is amortized over the vesting period in the income
C)
statement.

Question #5 of 33 Question ID: 1685385

Which of the following statements regarding pension accounting is most accurate?

Changes in the projected benefit obligation (PBO) and plan assets fully and
A)
immediately affect the balance sheet.
A reconciliation between the funded status and the net pension asset (liability)
B)
reported on the balance is required.
Changes in actuarial assumptions and past service costs fully and immediately affect
C)
the income statement.

Question #6 of 33 Question ID: 1685394

Wonderful Manufacturing has implemented a change in its pension plan, that will increase the
future benefits for all of its current employees. Which of the following is the most likely effect
on the company's financial statements of this change in promised benefits under current U.S.
GAAP standards?

The pension expense for the next reporting period will increase by the projected
A)
increase in pension benefits due to employees.
B) The firm’s prior financial statements will be adjusted to reflect the increase in benefits.
The net pension liability will increase immediately by the projected increase in pension
C)
benefits due to employees.
Question #7 of 33 Question ID: 1685366

The period at the end of which the employee is unconditionally entitled to a compensation is
called the:

A) entitlement date.
B) vesting date.
C) settlement date.

Question #8 of 33 Question ID: 1685389

Fly-By-Night Airlines is a U.S. company planning to change its pension plan so that it can reduce
its costs. It is considering reducing its defined benefit percentage from 10% to 5% of ending
salary, retroactive for 10 years. In addition, since the firm is anticipating substantially reduced
salary increases in the future, it is planning to reduce its compensation growth rate
assumption. From a pension accounting perspective, the change in the:

Compensation growth rate assumption is a change in actuarial assumption that will

A)
reduce the defined benefit obligation and future pension expense.
Benefit percentage is a change in actuarial assumption that will be recognized in full in
B)
current period pension expense.
Benefit percentage is a past service cost that will be amortized into and thus increase
C)
pension expense over the remaining service lives of its employees.

Question #9 of 33 Question ID: 1685365

Which type of compensation is most likely to increase current liability for a company?

A) Stock grants.
B) Salary and wages.
C) Stock-option grants.
Question #10 of 33 Question ID: 1685388

A company reporting under U.S. GAAP reduced the discount rate for its pension obligation from
10% to 8%, reduced the expected long-term rate of return on the assets in its pension plan
from 8% to 6%, and changed its compensation growth rate assumption from 4% to 5%. What is
the most likely impact of these changes on the current year ending defined benefit obligation
and pension expense?

The reduction in the discount rate will decrease the defined benefit obligation and will
A)
increase reported pension expense.
The decrease in the long-term rate of return on plan assets will decrease reported
B)
pension expense.
The decrease in the long-term rate of return will have no impact on the defined benefit
C)
obligation and will increase reported pension expense.

Question #11 of 33 Question ID: 1685384

Which of the following statements regarding the projected benefit obligation (PBO) and the
value of the pension plan assets is most accurate?

Plan amendments during the year generally result in a decrease of the PBO at the end
A)
of the year.
The fair value of plan assets is increased by the amount of the expected return on
B)
assets.
If the PBO and the plan assets are the same, then nothing needs to be reported on the
C)
balance sheet.

Question #12 of 33 Question ID: 1685386

Federal Companies' reports under U.S. GAAP included the following information in the
footnotes to its most recent financial statements:

Beginning Projected Benefit Obligation (PBO) $65,000,000

Beginning FV of Plan Assets 60,000,000

Service Cost 27,000,000

Interest Cost 3,000,000

Unamortized Actuarial Losses (Start of the Year) 5,000,000

Actual Return on Plan Assets 7,500,000

Expected Return on Plan Assets 8,500,000

Given the information above, calculate Federal's total periodic pension cost for the year.

A) $27,500,000.00
B) $41,000,000.00
C) $21,500,000.00

Paul Roberts, CPA, is a partner in Roberts & Smith, an accounting firm that is located in Chicago.
The firm has recently been retained by Midwest Manufacturing, a major producer of heavy
machinery and tractor parts in the U.S. Midwest has been in operation since 1965, and
currently has approximately 700 full-time employees. The company had its initial public offering
in 1986. The company has hired Roberts's firm to ensure that the accounting for Midwest's
employee pension plan is fully in compliance U.S. GAAP standards.

Selected year-end pension plan information for Midwest Manufacturing

2006 2007

PBO $21 million $23 million

Discount Rate 6.0% 7.5%

Rate of Compensation Increase 4.0% 4.0%

Benefits paid $0.8m $1m

Interest cost $1.6m

 Service cost $3m

Roberts will educate Midwest's accounting department on pension plan accounting that would
be relevant to their situation.

Question #13 - 16 of 33 Question ID: 1685396

As of January 1st, 2007, the fair value of plan assets was $19 million. Which three components
are necessary to calculate the fair value of the plan assets at the end of the year?

A) actual return on assets, employer contributions, and benefits paid.

B) service cost, interest cost, and benefits paid.
expected return on plan assets, employer and participant contributions, and benefits
C)
paid.

Question #14 - 16 of 33 Question ID: 1685397

Current U.S. GAAP pension accounting standards require public companies to report which of
the following in the balance sheet?

A) The expected return on plan assets.

B) The pension liability adjusted for unrecognized items.
C) The funded status of the plan.

Question #15 - 16 of 33 Question ID: 1685398

As of December 31st, 2007, the fair value of plan assets was $21 million. For this question only,
assume that the sum of the unrecognized prior service cost and the unrecognized actuarial
losses equals $1.5 million. Calculate the amount attributable to Midwest's pension plan as of
December 31st, 2007 that must be reported on the balance sheet under U.S. GAAP.

A) $2.0 million.
B) −$2.0 million.
C) −$500,000.

Question #16 - 16 of 33 Question ID: 1685399

Which of the following statements regarding the U.S. GAAP pension accounting standards is
most accurate?

The balance sheet will now reflect the true economic position of the pension plan, but
A) the income statement will not necessarily reflect a true measure of economic pension
expense.
For most companies, the pension liability will increase while financial leverage may
B)
increase or decrease as a result of applying the standard.
The changes in GAAP now cause U.S. standards to be consistent with the International
C)
Financial Reporting Standards (IFRS) for pension plans.

Question #17 of 33 Question ID: 1685383

The actuarial present value of all future pension benefits earned to date, based on expected
future salary increases, is called the:

A) total projected pension cost.

B) pension liability.
C) projected benefit obligation (PBO).

Question #18 of 33 Question ID: 1685382

The projected benefit obligation (PBO) is defined as the:

A) actuarial future value of all post-retirement healthcare benefits earned to date.

 actuarial present value of all future pension benefits earned to date and based on
B)
current salary levels.
actuarial present value of all future pension benefits earned to date based on expected
C)
future salary increases.

Question #19 of 33 Question ID: 1685369

For a stock grant, from the company's perspective, a tax windfall is most likely to result when
the:

A) stock price at settlement was lower than the stock price on the grant date.
B) stock price at settlement was higher than the stock price on the grant date.
C) intrinsic value at settlement was lower than the fair value on the grant date.

Question #20 of 33 Question ID: 1685391

Tim Gresham, CFO of Alpha Logistics is concerned about changes in the business environment
which could lead to Alpha violating some of the covenants of their outstanding debentures.
Specifically Gresham is concerned about leverage and profitability ratios. Gresham reviews
Alpha's most recent financial statements and decides that changing the assumptions for the
company's defined benefit pension plan may provide some relief in the short-run. Alpha
reports under U.S. GAAP.

Which of the following changes in the pension plan's assumptions would most likely lead to
lower reported leverage and higher reported profitability?

A) Increasing the discount rate.

B) Increasing the growth rate in compensation expense.
C) Increasing expected return on plan assets.
Question #21 of 33 Question ID: 1685390

An analyst views the assumptions made by a company reporting under U.S. GAAP regarding its
pension liabilities as unrealistic, and thinks the discount rate and expected rate of return
should both be increased. The most likely effect of increasing the discount rate and expected
rate of return on the pension benefit obligation (PBO) is:

Expected rate
Discount rate
of return

A) No effect Decrease

B) Increase Decrease

C) Decrease No effect

Question #22 of 33 Question ID: 1685393

Wes Livingston is the founder and CEO of Bigwell Corporation. Livingston is interested in
Bigwell being acquired by a larger competitor and wants to have his company's financial
statements appear as attractive as possible to a potential suitor. In order to decrease the
projected benefit obligation (PBO) of the company's pension plan, which of the following
changes in actuarial assumptions could be made?

A) Increase the rate of compensation growth.

B) Increase the discount rate.
C) Decrease the discount rate.

Question #23 of 33 Question ID: 1685379

Jon Horton, CFA, is the Chief Financial Officer (CFO) for Springtown Corporation, a manufacturer
of windows for residential and commercial applications. As part of an ongoing diversification
strategy, Springtown Corp. has recently entered into a preliminary agreement to purchase all of
the assets of Prime Doors, a manufacturer and distributor of doors to the same residential and
commercial market in which Springtown sells its windows. Horton is head of the due diligence
team that will fully evaluate Prime Doors' financial statements prior to the proposed
acquisition.

Prime Doors has been in operation for thirty years, and currently has approximately 800
employees at two operating facilities. Horton observes in the notes to the financial statements
that Prime Doors has a defined benefit pension plan, for which all employees are eligible.
Employees are vested at the rate of 20% per year of employment, and are fully vested upon
completion of five years of employment. Springtown does not offer a pension plan to its
employees, but encourages employees to contribute to Individual Retirement Accounts (IRAs)
and offers a 401(k) program.

Horton wants to fully evaluate the financial implications of Springtown's assumption of Prime
Doors' pension assets and the associated future liabilities and expenses. Like most companies,
the pension plan for Prime Doors' employees is not fully funded, but Horton wants to review all
assumptions used by Prime Doors' accountants in the valuation of the plan's current liabilities.
The most current information regarding the pension plans is as follows:

Select Pension Plan Information for Prime Doors (as of 12/31/05)

Projected benefit obligation (PBO) $15,500,000

Accumulated benefit obligation (ABO) $13,750,000

Market value of plan assets $11,875,000

Horton notices a paragraph in the pension plan footnotes that the original pension plan was
amended last year, effectively increasing the level of benefits to be paid to employees with
more than ten years of service. However, he is not able to detect what effect, if any, this change
in projected benefits has had on Prime Doors' financial statements or is expected to have in the
future.

Horton is aware that a commonly used method can be used to adjust the income statement
and provide a better measure of Prime Doors' economic pension cost than reported pension
expense. He is not quite sure which components of the financial statements are utilized to
derive an adjusted pension expense, but intends to investigate what analysis he can perform to
gain more insight into the company's position with regards to its pension plan.
What effect will an increased discount rate and increased expected rate of return have on a
company's projected benefit obligation (PBO) and fair value of plan assets (FVPL) as reflected in
the financial statements?

A) Both will decrease.

B) Both will increase.
C) Only one will decrease.

Question #24 of 33 Question ID: 1685381

For forecasting the dilution from future grants of share-based compensation and its effects on
valuation, which of the following approaches is least appropriate?

A) Discount the estimated value of equity by a dilution factor.

Add share-based compensation expense estimates to free cash flow estimates and
B)
increase the number of shares outstanding based on the same estimates.
Deduct share-based compensation expense from estimates of free cash flows and
C)
ignore dilution.

Prisma Inc. started an employee stock option and RSU grant plan. On Jan 1, 20X1, the company
made a grant of 150,000 at-the-money options (maturing in five years) and 25,000 shares. The
fair value of the options was $1.79 and the stock price on the date of the grant was $16. Both
awards vest after 3 years. The average stock price during the year was $17 and it was $17.50 at
the end of the year.

Question #25 - 31 of 33 Question ID: 1685372

The expense reported for 20X1 is closest to:

A) $133,333.
B) $222,833.
C) $187,033.
Question #26 - 31 of 33 Question ID: 1685373

The cash outflow reported on account of share-based compensation is:

A) $133,333.
B) $222,833.
C) $0.

Question #27 - 31 of 33 Question ID: 1685374

The change in stock-holder's equity at the end of 20X1 on account of the share-based
compensation is closest to:

A) $0.
B) $133,333.
C) $222,833.

Question #28 - 31 of 33 Question ID: 1685375

For this question only, assume that the stock price on the settlement date is $18.50. This will
most likely result in a(n):

A) extraordinary loss.
B) tax shortfall.
C) tax windfall.

Question #29 - 31 of 33 Question ID: 1685376

For this question only, suppose that Prisma reports a net loss for 20X1. Which of the following
statements is most accurate?

A) Prisma’s basic EPS and fully diluted EPS would be the same.
B) Unvested options that are out-of-money are considered dilutive.
Under the treasury method, the number of hypothetically repurchased shares is based
C)
on the share price at the end of the reporting period.

Question #30 - 31 of 33 Question ID: 1685377

The number of potentially dilutive securities for the option grant at the end of 20X1 is closest
to:

A) 50,000.
B) 100,000.
C) 3,559.

Question #31 - 31 of 33 Question ID: 1685378

The number of potentially dilutive securities for the stock grant at the end of 20X1 is closest to:

A) 16,667.
B) 25,000.
C) 17,157.

Question #32 of 33 Question ID: 1685368

A company wants to start a stock option grant for their senior executives. The most likely
impact on the company after the grant is that the leverage would be:

A) higher.
B) lower.
C) unchanged.

Question #33 of 33 Question ID: 1685370

A company is reporting a tax windfall arising from a share-based compensation plan. Which of
the following is least accurate?

A) The company would report a lower tax expense in the income statement under IFRS.
B) The company would take the gain directly to equity under IFRS.
C) The company would report a higher net income under U.S. GAAP.
Question #1 of 33 Question ID: 1685380

Which of the following is NOT an advantage of share based compensation over cash
compensation?

A) Share based compensation does not require a cash outlay.

Share based compensation serves to align employee interest with the interests of
B)
stockholders.
In a share based compensation plan, expense is not recognized, unless the
C)
exercise price is set below the market price.

Explanation

Share based compensation needs to be recognized at fair value under both U.S. GAAP and
IFRS. Intrinsic value does not matter. However, the expense does not require a cash outlay
and serves to align the interests of employees and stockholders.

(Module 8.1, LOS 8.b)

Question #2 of 33 Question ID: 1685387

Under U.S. GAAP, capitalized periodic pension costs included in the value of ending inventory is
most likely:

A) to be expensed as part of cost of goods sold when the inventory is sold.

B) to be amortized over the service lives of employees.
C) not allowed.

Explanation

Pension costs included in the cost of production of goods (e.g., labor costs included in the
value of work-in-process or finished goods) may be capitalized as part of valuation of ending
inventory. When this inventory is eventually sold, such costs are expensed as a component of
cost of goods sold.

(Module 8.2, LOS 8.d)

Question #3 of 33 Question ID: 1685392

In order to decrease the projected benefit obligation (PBO) of a pension plan, which of the
following changes in pension assumptions can be made to yield the desired result?

A) Decrease the discount rate.

B) Increase the expected rate of return.
C) Decrease the rate of compensation growth.

Explanation

A decrease in the rate of compensation growth will lower future pension payments and in
turn, lower the PBO.

(Module 8.2, LOS 8.d)

Question #4 of 33 Question ID: 1685367

Which of the following statements about share-based compensation is most accurate?

Only the intrinsic value of an option is shown as an expense in the income

A)
statement.
B) The fair value of an option is expensed when the option is in-the-money.
The compensation expense is amortized over the vesting period in the income
C)
statement.

Explanation

Compensation expense is based on the fair value of the options on the grant date. The
compensation expense is then allocated straight line (i.e., amortized in equal installments) in
the income statement over the vesting period, which is the time between the grant date and
the vesting date.

(Module 8.1, LOS 8.b)

Question #5 of 33 Question ID: 1685385

Which of the following statements regarding pension accounting is most accurate?

 Changes in the projected benefit obligation (PBO) and plan assets fully and
A)
immediately affect the balance sheet.
A reconciliation between the funded status and the net pension asset (liability)
B)
reported on the balance is required.
Changes in actuarial assumptions and past service costs fully and immediately
C)
affect the income statement.

Explanation

Changes in the projected benefit obligation (PBO) and plan assets immediately affect the
funded status (difference in PBO and plan assets) and the full amount of the changes is
reflected on the balance sheet when the change occurs.

Changes in actuarial assumptions and past service costs are recognized in the income
statement over time under U.S. GAAP. Under IFRS, vested past service costs are recognized
immediately and changes in actuarial assumptions are called re-measurements, which are
taken to OCI and not amortized.

Since the funded status is equal to the net pension asset (liability) reported on the balance
sheet under no reconciliation is required.

(Module 8.2, LOS 8.d)

Question #6 of 33 Question ID: 1685394

Wonderful Manufacturing has implemented a change in its pension plan, that will increase the
future benefits for all of its current employees. Which of the following is the most likely effect
on the company's financial statements of this change in promised benefits under current U.S.
GAAP standards?

The pension expense for the next reporting period will increase by the projected
A)
increase in pension benefits due to employees.
The firm’s prior financial statements will be adjusted to reflect the increase in
B)
benefits.
The net pension liability will increase immediately by the projected increase in
C)
pension benefits due to employees.

Explanation
A plan amendment will result in an immediate increase in the PBO. Under current U.S.
accounting standards, an increase in PBO will result in an increase in the net pension liability
(decrease in funded status).

(Module 8.2, LOS 8.e)

Question #7 of 33 Question ID: 1685366

The period at the end of which the employee is unconditionally entitled to a compensation is
called the:

A) entitlement date.
B) vesting date.
C) settlement date.

Explanation

The vesting date is the date the employee earns (or becomes unconditionally entitled to) the
compensation.

(Module 8.1, LOS 8.a)

Question #8 of 33 Question ID: 1685389

Fly-By-Night Airlines is a U.S. company planning to change its pension plan so that it can reduce
its costs. It is considering reducing its defined benefit percentage from 10% to 5% of ending
salary, retroactive for 10 years. In addition, since the firm is anticipating substantially reduced
salary increases in the future, it is planning to reduce its compensation growth rate
assumption. From a pension accounting perspective, the change in the:

Compensation growth rate assumption is a change in actuarial assumption that

A)
will reduce the defined benefit obligation and future pension expense.
Benefit percentage is a change in actuarial assumption that will be recognized in
B)
full in current period pension expense.
Benefit percentage is a past service cost that will be amortized into and thus
C)
increase pension expense over the remaining service lives of its employees.
Explanation

The change in the compensation growth rate assumption is a change in actuarial assumption
that will reduce the defined benefit obligation and future pension expense, as the effect is
amortized into pension expense over time. In this question, the change is a reduction in both
the defined benefit obligation and pension expense.

The change in the contribution percentage is not a change in actuarial assumption but a plan
amendment (which would be reflected as negative past service cost and either amortized
under US GAAP or expensed in full under IFRS).

Amortization of negative past service cost (applicable only under US GAAP) would decrease,
not increase, pension expense over the remaining service lives of its employees.

(Module 8.2, LOS 8.d)

Question #9 of 33 Question ID: 1685365

Which type of compensation is most likely to increase current liability for a company?

A) Stock grants.
B) Salary and wages.
C) Stock-option grants.

Explanation

Unpaid earned salary and wages would be shown as a current liability. Options and stock
grants do not result in a liability.

(Module 8.1, LOS 8.a)

Question #10 of 33 Question ID: 1685388

A company reporting under U.S. GAAP reduced the discount rate for its pension obligation from
10% to 8%, reduced the expected long-term rate of return on the assets in its pension plan
from 8% to 6%, and changed its compensation growth rate assumption from 4% to 5%. What is
the most likely impact of these changes on the current year ending defined benefit obligation
and pension expense?

The reduction in the discount rate will decrease the defined benefit obligation and
A)
will increase reported pension expense.
 The decrease in the long-term rate of return on plan assets will decrease reported
B)
pension expense.
The decrease in the long-term rate of return will have no impact on the defined
C)
benefit obligation and will increase reported pension expense.

Explanation

The decrease in the expected long-term rate of return on plan assets from 8% to 6% will have
no effect on the defined benefit obligation (after all, it is an obligation and not an asset). The
reduction will, however, increase reported pension expense for current and future periods
because the expected return is subtracted while computing pension expense.

The reduction in the discount rate from 10% to 8% will increase (not decrease) the defined
benefit obligation and will also increase reported pension expense because it will increase
the current service cost. Additionally, the actuarial gains and losses resulting from this
change (the difference between the defined benefit obligation after the increase and the
defined benefit obligation before the increase) will be amortized into pension expense over
time using the corridor approach. Amortization will start in the period after the change is
made.

The decrease in the expected long-term rate of return on its plan assets from 8% to 6% will
increase, not decrease, reported pension expense. Expected return reduces pension
expense.

(Module 8.2, LOS 8.d)

Question #11 of 33 Question ID: 1685384

Which of the following statements regarding the projected benefit obligation (PBO) and the
value of the pension plan assets is most accurate?

Plan amendments during the year generally result in a decrease of the PBO at the
A)
end of the year.
The fair value of plan assets is increased by the amount of the expected return on
B)
assets.
If the PBO and the plan assets are the same, then nothing needs to be reported on
C)
the balance sheet.

Explanation
Neither the PBO nor the plan assets are separately reported on the balance sheet. The
funded status is the difference in the PBO and the plan assets. If the PBO exceeds the plan
assets, the difference is reported as a liability. If the plan assets exceed the PBO, the
difference is reported as an asset. If the amounts are the same, then neither a liability nor
asset needs to be reported.

Plan amendments (i.e. additional benefits provided that increase the amount of the
employer's obligation to plan participants) generally result in an increase of the PBO.

The fair value of plan assets at the beginning of the period is increased by the actual return
on plan assets as well as any employer contributions. It is reduced by the amount of benefits
paid.

(Module 8.2, LOS 8.d)

Question #12 of 33 Question ID: 1685386

Federal Companies' reports under U.S. GAAP included the following information in the
footnotes to its most recent financial statements:

Beginning Projected Benefit Obligation (PBO) $65,000,000

Beginning FV of Plan Assets 60,000,000

Service Cost 27,000,000

Interest Cost 3,000,000

Unamortized Actuarial Losses (Start of the Year) 5,000,000

Actual Return on Plan Assets 7,500,000

Expected Return on Plan Assets 8,500,000

Given the information above, calculate Federal's total periodic pension cost for the year.

A) $27,500,000.00
B) $41,000,000.00
C) $21,500,000.00

Explanation
 Periodic pension cost = service cost + interest cost – expected return on plan assets

Therefore, $27,000,000 + 3,000,000 – 8,500,000 = $21,500,000

Since the unamortized actuarial loss is less than 10% of beginning PBO, no amortization is
needed.

(Module 8.2, LOS 8.d)

Question #13 - 16 of 33 Question ID: 1685396

As of January 1st, 2007, the fair value of plan assets was $19 million. Which three components
are necessary to calculate the fair value of the plan assets at the end of the year?

A) actual return on assets, employer contributions, and benefits paid.

B) service cost, interest cost, and benefits paid.
expected return on plan assets, employer and participant contributions, and
C)
benefits paid.

Explanation

Companies are required to disclose a reconciliation of the beginning and ending balances of
the fair value of plan assets, which can be calculated as follows:

Fair value of plan assets at the beginning of the year

+ Actual return on assets

+ Employer contributions

− Benefits paid

= Fair value of plan assets at the end of the year

(Module 8.2, LOS 8.e)

Question #14 - 16 of 33 Question ID: 1685397

Current U.S. GAAP pension accounting standards require public companies to report which of
the following in the balance sheet?
A) The expected return on plan assets.
B) The pension liability adjusted for unrecognized items.
C) The funded status of the plan.

Explanation

The current standard requires companies to report the funded status of the plan, which is
the difference between the PBO and the fair value of plan assets.

(Module 8.2, LOS 8.e)

Question #15 - 16 of 33 Question ID: 1685398

As of December 31st, 2007, the fair value of plan assets was $21 million. For this question only,
assume that the sum of the unrecognized prior service cost and the unrecognized actuarial
losses equals $1.5 million. Calculate the amount attributable to Midwest's pension plan as of
December 31st, 2007 that must be reported on the balance sheet under U.S. GAAP.

A) $2.0 million.
B) −$2.0 million.
C) −$500,000.

Explanation

The funded status is the difference between the PBO and the fair value of plan assets as of
the reporting date. For Midwest's plan, $21,000,000 − 23,000,000 = −$2,000,000. PBO figure is
already given – and it includes all unrecognized items (and hence need not be adjusted).

(Module 8.2, LOS 8.e)

Question #16 - 16 of 33 Question ID: 1685399

Which of the following statements regarding the U.S. GAAP pension accounting standards is
most accurate?
 The balance sheet will now reflect the true economic position of the pension plan,
A) but the income statement will not necessarily reflect a true measure of economic
pension expense.
For most companies, the pension liability will increase while financial leverage may
B)
increase or decrease as a result of applying the standard.
The changes in GAAP now cause U.S. standards to be consistent with the
C)
International Financial Reporting Standards (IFRS) for pension plans.

Explanation

Because deferred and unrecognized items are required to be reported on the balance sheet
but not the income statement, the balance sheet will reflect the true economic position of the
pension plan, but the income statement will not necessarily reflect a true measure of
economic pension expense. U.S. GAAP and IFRS still differ with respect to reporting pension
expense.

(Module 8.2, LOS 8.e)

Question #17 of 33 Question ID: 1685383

The actuarial present value of all future pension benefits earned to date, based on expected
future salary increases, is called the:

A) total projected pension cost.

B) pension liability.
C) projected benefit obligation (PBO).

Explanation

The PBO is the actuarial present value (at an assumed discount rate) of all future pension
benefits earned to date, based on expected future salary increases. It measures the value of
the obligation, assuming the firm is a going concern and that the employees will continue to
work for the firm until they retire. Pension cost is periodic and not total projected. Pension
liability is the net amount of PBO and fair value of plan assets.

(Module 8.2, LOS 8.d)

Question #18 of 33 Question ID: 1685382

The projected benefit obligation (PBO) is defined as the:

A) actuarial future value of all post-retirement healthcare benefits earned to date.

actuarial present value of all future pension benefits earned to date and based on
B)
current salary levels.
actuarial present value of all future pension benefits earned to date based on
C)
expected future salary increases.

Explanation

The projected benefit obligation (PBO) is defined as the actuarial present value of all future
pension benefits earned to date based on expected future salary increases.

(Module 8.2, LOS 8.d)

Question #19 of 33 Question ID: 1685369

For a stock grant, from the company's perspective, a tax windfall is most likely to result when
the:

A) stock price at settlement was lower than the stock price on the grant date.
B) stock price at settlement was higher than the stock price on the grant date.
C) intrinsic value at settlement was lower than the fair value on the grant date.

Explanation

Tax deduction for stock grant = share price on settlement date x number of shares vested

If the stock price on the settlement date is higher than the price on the grant date, there
would a higher tax deduction than the cumulative compensation expense reported, resulting
in a tax windfall or excess tax benefit.

(Module 8.1, LOS 8.b)

Question #20 of 33 Question ID: 1685391

Tim Gresham, CFO of Alpha Logistics is concerned about changes in the business environment
which could lead to Alpha violating some of the covenants of their outstanding debentures.
Specifically Gresham is concerned about leverage and profitability ratios. Gresham reviews
Alpha's most recent financial statements and decides that changing the assumptions for the
company's defined benefit pension plan may provide some relief in the short-run. Alpha
reports under U.S. GAAP.

Which of the following changes in the pension plan's assumptions would most likely lead to
lower reported leverage and higher reported profitability?

A) Increasing the discount rate.

B) Increasing the growth rate in compensation expense.
C) Increasing expected return on plan assets.

Explanation

Increasing discount rate leads to lower present values and reduces reported pension liability
in the balance sheet and also reduces pension expense by reducing the service cost
component. Increasing expected return on plan assets does reduce pension expense but
does not affect reported assets or liabilities. Increasing the growth rate in compensation
expense increases service cost as well as reported pension liability.

(Module 8.2, LOS 8.d)

Question #21 of 33 Question ID: 1685390

An analyst views the assumptions made by a company reporting under U.S. GAAP regarding its
pension liabilities as unrealistic, and thinks the discount rate and expected rate of return
should both be increased. The most likely effect of increasing the discount rate and expected
rate of return on the pension benefit obligation (PBO) is:

Expected rate
Discount rate
of return

A) No effect Decrease

B) Increase Decrease

C) Decrease No effect
Explanation

The PBO will decrease because a higher discount rate will cause the present value of the
future obligations to decline. There will be no effect from changing the expected rate of
return because expected return relates to the pension expense, not to the size of the
obligation.

(Module 8.2, LOS 8.d)

Question #22 of 33 Question ID: 1685393

Wes Livingston is the founder and CEO of Bigwell Corporation. Livingston is interested in
Bigwell being acquired by a larger competitor and wants to have his company's financial
statements appear as attractive as possible to a potential suitor. In order to decrease the
projected benefit obligation (PBO) of the company's pension plan, which of the following
changes in actuarial assumptions could be made?

A) Increase the rate of compensation growth.

B) Increase the discount rate.
C) Decrease the discount rate.

Explanation

Increasing the assumed discount rate of a pension plan will result in lower projected benefit
obligation (PBO). Increasing rate of compensation growth and decreasing discount rate would
increase the PBO.

(Module 8.2, LOS 8.e)

Question #23 of 33 Question ID: 1685379

Jon Horton, CFA, is the Chief Financial Officer (CFO) for Springtown Corporation, a manufacturer
of windows for residential and commercial applications. As part of an ongoing diversification
strategy, Springtown Corp. has recently entered into a preliminary agreement to purchase all of
the assets of Prime Doors, a manufacturer and distributor of doors to the same residential and
commercial market in which Springtown sells its windows. Horton is head of the due diligence
team that will fully evaluate Prime Doors' financial statements prior to the proposed
acquisition.

Prime Doors has been in operation for thirty years, and currently has approximately 800
employees at two operating facilities. Horton observes in the notes to the financial statements
that Prime Doors has a defined benefit pension plan, for which all employees are eligible.
Employees are vested at the rate of 20% per year of employment, and are fully vested upon
completion of five years of employment. Springtown does not offer a pension plan to its
employees, but encourages employees to contribute to Individual Retirement Accounts (IRAs)
and offers a 401(k) program.

Horton wants to fully evaluate the financial implications of Springtown's assumption of Prime
Doors' pension assets and the associated future liabilities and expenses. Like most companies,
the pension plan for Prime Doors' employees is not fully funded, but Horton wants to review all
assumptions used by Prime Doors' accountants in the valuation of the plan's current liabilities.
The most current information regarding the pension plans is as follows:

Select Pension Plan Information for Prime Doors (as of 12/31/05)

Projected benefit obligation (PBO) $15,500,000

Accumulated benefit obligation (ABO) $13,750,000

Market value of plan assets $11,875,000

Horton notices a paragraph in the pension plan footnotes that the original pension plan was
amended last year, effectively increasing the level of benefits to be paid to employees with
more than ten years of service. However, he is not able to detect what effect, if any, this change
in projected benefits has had on Prime Doors' financial statements or is expected to have in the
future.

Horton is aware that a commonly used method can be used to adjust the income statement
and provide a better measure of Prime Doors' economic pension cost than reported pension
expense. He is not quite sure which components of the financial statements are utilized to
derive an adjusted pension expense, but intends to investigate what analysis he can perform to
gain more insight into the company's position with regards to its pension plan.
What effect will an increased discount rate and increased expected rate of return have on a
company's projected benefit obligation (PBO) and fair value of plan assets (FVPL) as reflected in
the financial statements?

A) Both will decrease.

B) Both will increase.
C) Only one will decrease.

Explanation

The use of a higher discount rate will decrease a company's PBO. The expected rate of return
has no impact on pension obligations or the fair value of plan assets.

(Module 8.1, LOS 8.b)

Question #24 of 33 Question ID: 1685381

For forecasting the dilution from future grants of share-based compensation and its effects on
valuation, which of the following approaches is least appropriate?

A) Discount the estimated value of equity by a dilution factor.

Add share-based compensation expense estimates to free cash flow estimates and
B)
increase the number of shares outstanding based on the same estimates.
Deduct share-based compensation expense from estimates of free cash flows and
C)
ignore dilution.

Explanation

Free cash flows are already estimated by adding share-based compensation, so adding them
again would be incorrect. The dilution from future grants can be addressed by discounting
the estimated value of equity by a dilution factor or by estimating an increase in the number
of shares outstanding. Alternatively, we can just deduct share-based compensation expense
from estimates of free cash flows and not worry about forecasting dilutive shares.

(Module 8.1, LOS 8.c)

Question #25 - 31 of 33 Question ID: 1685372

The expense reported for 20X1 is closest to:

A) $133,333.
B) $222,833.
C) $187,033.

Explanation

Value of the options on grant date = 1.79 x 150,000 = $268,500

Value of stock grant = 16 x 25,000 = $400,000

Both are amortized straight line over the 3-year vesting period.

Expense = (268,500+400,000) / 3 = $222,833 per year

(Module 8.1, LOS 8.b)

Question #26 - 31 of 33 Question ID: 1685373

The cash outflow reported on account of share-based compensation is:

A) $133,333.
B) $222,833.
C) $0.

Explanation

Option and stock grants have zero cash-flow implications (they are non-cash grants).

(Module 8.1, LOS 8.b)

Question #27 - 31 of 33 Question ID: 1685374

The change in stock-holder's equity at the end of 20X1 on account of the share-based
compensation is closest to:

A) $0.
B) $133,333.
C) $222,833.

Explanation

The compensation expense reduces net income and hence retained earnings. An identical
amount is taken to compensation reserve account in equity and hence there is zero net
change in equity.

(Module 8.1, LOS 8.b)

Question #28 - 31 of 33 Question ID: 1685375

For this question only, assume that the stock price on the settlement date is $18.50. This will
most likely result in a(n):

A) extraordinary loss.
B) tax shortfall.
C) tax windfall.

Explanation

If the stock price on the settlement date ($18.50) is greater than the price on the grant date
($16), it will result in a tax windfall as a higher expense would be deductible for tax purposes.

(Module 8.1, LOS 8.b)

Question #29 - 31 of 33 Question ID: 1685376

For this question only, suppose that Prisma reports a net loss for 20X1. Which of the following
statements is most accurate?

A) Prisma’s basic EPS and fully diluted EPS would be the same.
B) Unvested options that are out-of-money are considered dilutive.
Under the treasury method, the number of hypothetically repurchased shares is
C)
based on the share price at the end of the reporting period.

Explanation
If a company reports net loss, basic EPS and fully diluted EPS would be the same (i.e., dilutive
securities = 0). The treasury stock method nets the number of hypothetically repurchased
shares against the total number of potentially dilutive securities. Unvested options that are
in-the-money are considered dilutive. The number of hypothetically repurchased shares is
based on the average share price during the reporting period.

(Module 8.1, LOS 8.b)

Question #30 - 31 of 33 Question ID: 1685377

The number of potentially dilutive securities for the option grant at the end of 20X1 is closest
to:

A) 50,000.
B) 100,000.
C) 3,559.

Explanation

Cash proceeds = number of options x exercise price = 150,000 x 16 = $2,400,000

Unrecognized compensation expense at the beginning of the year = 0 (plan just started)

Unrecognized compensation expense at the end of the first year = 268,500 – 89,500 =
$179,000

Average unrecognized share-based compensation expense = (179,000 + 0)/2 = $89,500

Assumed proceeds = 2,400,000 + 89,500 = 2,489,500

Number of treasury shares = assumed proceeds / average share price during the reporting
period

= 2,489,500 / 17 = 146,441

Dilutive shares = 150,000 – 146,441 = 3,559

(Module 8.1, LOS 8.b)

Question #31 - 31 of 33 Question ID: 1685378

The number of potentially dilutive securities for the stock grant at the end of 20X1 is closest to:
A) 16,667.
B) 25,000.
C) 17,157.

Explanation

Cash proceeds = $0.

Unrecognized compensation expense at the beginning of the year = 0 (plan just started)

Unrecognized compensation expense at the end of the first year = 400,000 – 133,333 =
$266,667

Average unrecognized share-based compensation expense = (266,667 + 0)/2 = 133,333

Assumed proceeds = 0 + 133,333 = 133,333

Number of treasury shares = assumed proceeds / average share price during the reporting
period.

= 133,333 / 17 = 7,843 shares

Dilutive shares = 25,000 – 7,843 = 17,157 shares

(Module 8.1, LOS 8.b)

Question #32 of 33 Question ID: 1685368

A company wants to start a stock option grant for their senior executives. The most likely
impact on the company after the grant is that the leverage would be:

A) higher.
B) lower.
C) unchanged.

Explanation

Share-based compensation does not affect debt levels, nor does it change the shareholder's
equity. Compensation expense reduces net income (and retained earnings) but would
increase compensation expense reserve – leading to no net change in equity.

(Module 8.1, LOS 8.b)

Question #33 of 33 Question ID: 1685370

A company is reporting a tax windfall arising from a share-based compensation plan. Which of
the following is least accurate?

The company would report a lower tax expense in the income statement under
A)
IFRS.
B) The company would take the gain directly to equity under IFRS.
C) The company would report a higher net income under U.S. GAAP.

Explanation

Tax windfalls (shortfalls) are reported directly to equity under IFRS. Under U.S. GAAP, tax
windfalls (shortfalls) reduce (increase) tax expense in the income statement.

(Module 8.1, LOS 8.b)

Hise Home Supply is a large, profitable home improvement retailer located in the United
Kingdom. Hise has recently been acquiring niche retailers with popular brand names in certain
segments of the home improvement market. One of these retailers was Wilson Tile and Stone,
a U.S. business that derived a large part of its sales from the UK.

The management team for Hise now makes all operating, financing, and investment decisions.
Brian Heltzel, a financial analyst for Hise, is responsible for translating Wilson's financial
statements from U.S. dollars to the reporting currency. Hise conducts its business and issues
financial statements in British pounds (£). Extracts from the financial statements of Wilson are
shown below in Exhibit 1.

Exhibit 1: Wilson Financial Statement Extracts

Wilson Tile and Stone – December 31, 20X7 and 20X8 Balance Sheets

20X7 20X8

Cash $1,200 $1,400

Accounts receivable 6,500 9,900

Inventory 10,400 12,400

Current assets $18,100 $23,700

Fixed assets 40,000 40,000

Accumulated depreciation 10,000 15,000

Net fixed assets $30,000 $25,000

TOTAL ASSETS $48,100 $48,700

Accounts payable $5,000 $6,000

Current portion of LT debt 1,500 1,500

Long term debt 25,000 23,500

Total liabilities $31,500 $31,000

Common stock 10,000 10,000

Retained earnings 6,600 7,700

Total equity $16,600 $17,700

TOTAL LIABILITIES and EQUITY $48,100 $48,700

Wilson Tile and Stone – 20X8 Income Statement

Revenue $75,000

Cost of goods sold (60,000)

Gross margin $15,000

Other expenses (2,300)

Depreciation expense (5,000)

Net Income 7,700

Wilson uses the FIFO method for inventory accounting.

Applicable exchange rates are as follows:

December 31, 20X7: £1.00 = $1.60

December 31, 20X8: £1.00 = $1.80
Average for 20X8 = £1.00 = $1.70
Historical rate for fixed assets, inventory, and equity: £1.00 = $1.50
Dividend declaration date: £1.00 = $1.75.

Heltzel is also using some information that has been provided by the accounts department of
Wilson. He made the notes shown below in Exhibit 2 from an email the accounts department
sent.

Exhibit 2: Accounting Department Notes

20X8 income before remeasurement gain/loss £4,138

Dividends paid during the year £2,250

Opening retained earnings £5,150

Ending retained earnings £7,323

Hertzel has also discussed the future of Wilson's role in the group with board members from
both Wilson and Hise. These discussions resulted in a concern as outline below.
Concern

Wilson's board have warned Heltzel that they are likely to engage in transactions next year
which will lead to significant deferred revenue balances remaining on the balance sheet at the
year end.

Question #1 - 4 of 127 Question ID: 1685518

As Heltzel is translating the balance sheet and income statement, which of the following are
closest to the values Heltzel determines for revenues and accounts payable for 20X8?

Accounts
Revenues
Payable

A) £41,667 £3,333

B) £44,118 £3,333

C) £44,118 £3,529

Question #2 - 4 of 127 Question ID: 1685519

If Wilson assumes the numbers in Exhibit 2 are correct, the remeasurement gain/loss for 20X8
will be closest to:

A) £1,012.
B) £285.
C) –£77.

Question #3 - 4 of 127 Question ID: 1685520

Which of the following treatments is most likely correct regarding the items outlined in Heltzel's
concern?
A) The balance should be translated at the historic rate as it is a non-monetary item.
B) The balance should be translated at the historic rate as it is a monetary item.
C) The balance should be translated at the closing rate as it is a monetary item.

Question #4 - 4 of 127 Question ID: 1685521

Which of the following statements regarding the treatment of subsidiaries in a hyper-

inflationary environment under U.S. GAAP is most likely correct?

The subsidiary should be translated using the temporal method regardless of the level
A)
of autonomy, and non-monetary items restated for the effect of local inflation.
The subsidiary should be translated using the temporal method regardless of the level
B)
of autonomy, and then no further restatement is required.
The subsidiary should be translated using the current rate method regardless of the
C)
level of autonomy, and non-monetary items restated for the effect of local inflation.

Question #5 of 127 Question ID: 1685419

Under the current rate method, common stock is translated by using the:

A) exchange rate as of the balance sheet date.

B) present value of weighted average rate.
C) rate that existed when the equity was issued.

Question #6 of 127 Question ID: 1685538

A hyperinflationary economy is typically defined as one that has:

A) cumulative inflation that exceeds 100% over a three-year period.

B) cumulative inflation that exceeds 100% over a twelve-year period.
C) an inflation rate that exceeds 10% per year for three consecutive years.

Question #7 of 127 Question ID: 1685477

Hann Company is a U.S. multinational firm with operations in several foreign countries. Hann
has a 100 percent stake in a French subsidiary. The foreign subsidiary's local currency has
appreciated against the U.S. dollar over the latest financial statement reporting period. In
addition, the French firm accounts for inventories using the FIFO inventory cost-flow
assumption. The net profit margin as computed under the current rate method would most
likely be:

A) lower than the same ratio computed under the temporal method.
B) either higher or lower than the same ratio computed under the temporal method.
C) higher than the same ratio computed under the temporal method.

Question #8 of 127 Question ID: 1685500

Which example least accurately describes pure balance sheet and income statement ratios?

A) All pure balance sheet ratios are affected by the all-current translation method.
B) The current ratio is a pure balance sheet ratio.
When multiplying both the numerator and denominator by the current exchange rate,
C)
the current rate is cancelled.

Question #9 of 127 Question ID: 1685456

An important distinction between the temporal method and the current rate method is that:

the current rate method results in an adjustment to the equity account on the balance
A) sheet. The temporal method results in a gain or loss appearing on the income
statement.
 monetary assets and liabilities are remeasured (temporal method) at historical rates
B)
but translated (current rate method) at current rates.
depreciation and cost of goods sold (COGS) are a function of the current rate under
C) translation (current rate method), but a function of the average rate under
remeasurement (temporal method).

Question #10 of 127 Question ID: 1685494

The Herlitzka Company, a U.S. multinational firm, has a 100% stake in a Swiss subsidiary. The
Swiss franc (SF) has been determined to be the functional currency. All the common stock of
the subsidiary was issued at the beginning of the year and the subsidiary uses the FIFO
inventory cost-flow assumption. In addition, the value of the SF is as follows:

Beginning of year $0.5902

Average throughout the year $0.6002

End of year $0.6150

The SF-based balance sheet and income statement data for the Swiss subsidiary are as follows:

Accounts receivable = 3,000

Inventory = 4,000

Fixed assets = 12,000

Accounts payable = 2,000

Long-term debt = 5,000

Common stock = 10,000

Retained earnings = 2,000

Net income = 2,000

The translated value of common stock and long-term debt respectively are:

A) $5,902 and $3,001.

B) $6,150 and $3,075.
C) $5,902 and $3,075.

Question #11 of 127 Question ID: 1685450

Which of the following statements regarding the foreign currency translation under US GAAP is
least accurate? The functional currency is the:

A) subsidiary's local currency for self-contained, independent foreign subsidiaries.

B) parent firm's home currency for self-contained independent foreign subsidiaries.
parent firm's home currency if the foreign subsidiary operates in a country with high
C)
inflation.

South Seas Inc, a subsidiary of Seven Seas Inc., reported its most recent performance in its local
currency (LC) which is the functional currency. The reporting currency of Seven Seas is the U.S.
dollar (USD). South Seas also paid a dividend of 16,000LC at year end, at which time the
exchange rate was 2 LC/USD. Last year, Seven Seas reported balance sheet retained earnings of
90,000 USD for its South Seas subsidiary.

Rates LC/US$

Current rate 2.00

Average rate 2.20

Historical rate for common stock 2.50

Historical rate for COGS 2.30

Historical rate for depreciation 2.10

Historical rate for ending inventory 2.30

Historical rate for fixed assets 2.10

LC

Revenues 520,000

Cost of Goods Sold (COGS) 225,000

SG&A 100,000

Depreciation 80,000

Income Taxes 46,000

Net Income 69,000

The balance sheet for South Seas is given below.

LC

Cash 25,000

Accounts Receivable 30,000

Inventory 35,000

Net Fixed Assets 500,000

Total Assets 590,000

Accounts Payable 20,000

Long term debt 100,000

Common Stock 250,000

Retained Earnings 220,000

Total Liabilities & Equity 590,000

Question #12 - 15 of 127 Question ID: 1685441

What is the amount of income Seven Seas should report from its South Seas subsidiary?

A) 34,500 USD.
B) 31,400 USD.
C) 27,600 USD.
Question #13 - 15 of 127 Question ID: 1685442

The currency translation adjustment that results from the translation of South Sea's data is
closest to?

Zero because there is no currency translation adjustment under the current rate
A)
method.
B) −3,300 USD.
C) 21,600 USD.

Question #14 - 15 of 127 Question ID: 1685443

If the temporal method is used, the retaining earnings is closest to:

A) 21,600 USD.
B) 120,800 USD.
C) 90,000 USD.

Question #15 - 15 of 127 Question ID: 1685444

If the functional currency is the USD, then the net income before a translation gain/loss is
closest to:

A) 8,000 USD.
B) 4,700 USD.
C) 34,100 USD.

Question #16 of 127 Question ID: 1685492

Which of the following statements concerning the translation of a subsidiary's financial

statement and the subsidiary's ratios is least accurate?
 Ratios calculated under the current rate method will not differ from those calculated
A)
under the temporal method.
The subsidiary's ratios in the local currency will differ from ratios calculated after
B)
translation.
C) The statement of cash flows is not affected by the choice of translation.

Question #17 of 127 Question ID: 1685493

The Schuldes Company had the following reported assets in euros at historical cost for the
period ending December 31, 2005.

Cash 134

Accounts receivable 270

Inventory 404

Net fixed assets 1347

Total assets 2155

The exchange rate per euro was $0.8734 on January 1, 2005 and $0.9896 on December 31,
2005. The average exchange rate for the year 2005 was $0.8925. The total assets of Schuldes
using the current rate method are:

A) $2,178.
B) $2,133.
C) $1,923.

Question #18 of 127 Question ID: 1685540

Which translation method should be used under a hyperinflationary economy when using U.S.
GAAP?
 Monetary/non-monetary, because all monetary accounts are translated at the
A)
historical rate.
All-current, because dividends are translated at the rate that applied when they were
B)
issued.
C) Temporal, because all non-monetary accounts are re-measured at the historical rate.

Question #19 of 127 Question ID: 1685414

Which of the following general statements is most accurate with respect to the temporal
method? Nonmonetary assets are translated at:

A) the current rate.

B) historical rates at the time of the transaction.
C) the average rate during the year.

Question #20 of 127 Question ID: 1685490

Which of the following statements is most accurate concerning foreign currency translation?

In the case in which a firm uses first in, first out (FIFO) inventory valuation, if the local
A) currency depreciates the cost of good sold under the temporal method is less than the
cost of goods sold using the current rate method.
The receivables turnover ratio is identical under both the temporal method and the
B)
current rate method.
In the case of an appreciating currency, the fixed asset turnover will be lower under the
C)
temporal method, as compared to the current rate method.

Question #21 of 127 Question ID: 1685461

Global International Corp. (GIC) has three subsidiaries: GIC Europe whose local currency is the
euro and whose functional currency is the euro; GIC China whose local currency is the yuan and
whose functional currency is the Hong Kong dollar; and GIC Bahamas whose local currency is
the Bahamian dollar and whose functional currency is the U.S. dollar. GIC's reporting currency
is the U.S. dollar. Which conversion methods should be used by GIC for each of its subsidiaries?

The financial data for all three subsidiaries should be remeasured under the temporal
A)
method.
GIC Europe’s data should be translated under the current rate method; GIC China’s
data should be remeasured under the temporal method into Hong Kong dollars, and
B)
then translated under the current rate method into U.S. dollars; and GIC Bahamas’
data should be remeasured under the temporal method into U.S. dollars.
GIC Europe’s data should be remeasured under the temporal method; GIC China’s data
should be remeasured under the temporal method into Hong Kong dollars, and then
C)
translated under the current rate method into U.S. dollars; and GIC Bahamas’ data
should be translated under the current rate method into U.S. dollars.

Question #22 of 127 Question ID: 1685479

The Herlitzka Company, a U.S. multinational firm, has a 100% stake in a Swiss subsidiary. The
Swiss franc (SF) has been determined to be the functional currency. All the common stock of
the subsidiary was issued at the beginning of the year and the subsidiary uses the FIFO
inventory cost-flow assumption. In addition, the value of the SF is as follows:

Beginning of year $0.5902

Average throughout the year $0.6002

End of year $0.6150

The SF-based balance sheet and income statement data for the Swiss subsidiary are as follows:

Accounts receivable = 3,000

Inventory = 4,000

Fixed assets = 12,000

Accounts payable = 2,000

Long-term debt = 5,000

Common stock = 10,000

Retained earnings = 2,000

Net income = 2,000

The translated value of accounts receivable and inventory respectively are:

A) $1,801 and $2,401.

B) $1,845 and $2,401.
C) $1,845 and $2,460.

Question #23 of 127 Question ID: 1685412

Edmonton Oilfield Supply has made an equipment sale in Venezuela in the amount of VEF
15,000,000. On the day of the sale, the exchange rate is 1.7519 VEF per 1 Canadian dollar. 90
days later, when the Venezuelan firm pays for the equipment, the exchange rate is 1.6326. As a
result of the change in the exchange rate, Edmonton will recognize a:
A) gain of $625,666.
B) gain of $1,096,104.
C) loss of $1,789,500.

Question #24 of 127 Question ID: 1685468

Which of the following statements about the methods of currency translation accounting least
accurately identifies a plug figure that makes the accounting equation balance?

A) Under the Monetary/Non-Monetary Method, common stock is the plug.

B) Under the Current Rate Method, cumulative translation adjustment is the plug.
C) Under the Temporal Method, retained earnings is the plug.

The Precision Screen Printers (PSP) Company has a foreign subsidiary, the Acer Tool & Die
Company, located in the country of Rolivia. The currency of Rolivia is the Chad. The balance
sheet and income statement of Acer Tool & Die Company for the year-ended December 31,
2005, is shown below. The balance sheet has been restated using the U.S. dollar as the
functional currency.

Acer Tool & Die Company Balance Sheet As of December 31, 2005

Chad Exchange Rate U.S. $

(millions) (Chad/US$) (millions)

Cash 20 0.25 $80

Accounts receivable 30 0.25 120

Inventory 100 0.3125 320

Fixed assets (net) 500 0.3333 1,500

Total assets 650 $2,020

Accounts payable 50 0.25 $200

Capital stock 380 0.3333 1,140

Retained earnings 220 -- 680

Total liabilities and equity 650 $2,020

Acer Tool & Die Company Income Statement

For year ending December 31, 2005

(Amounts in millions of Chad)

Revenues 1,000

Cost of sales 700

Depreciation expense 50

Selling expense 30

Translation gain (or loss)

Net income 220

Acer has determined that the exchange rate exposure at the beginning of 2005 is −260 Chad.

The exchange rate at the beginning of 2005 was 0.3333 Chad/US$ and that is the historical rate
applicable to beginning inventory of 90 Chad. The exchange rate at the end of 2005 was 0.25
Chad/US$. The average rate for 2005 is 0.3125 Chad/US$. Purchases occurred evenly
throughout the year. Acer Tool & Die uses FIFO inventory valuation and depreciates fixed assets
using the straight-line method. Assume that retained earnings at year end 2004 were zero, the
historical exchange rate for depreciation is 0.333, and no dividends were paid during 2005.

Question #25 - 26 of 127 Question ID: 1685487

What is Acer Tool & Die's cost of sales in U.S. dollars using the temporal method?

A) $2,242.00
B) $2,222.00
C) $2,240.00
Question #26 - 26 of 127 Question ID: 1685488

What is the remeasurement gain or loss for the period using the temporal method?

A) $52 loss.
B) $32 loss.
C) $50 gain.

Question #27 of 127 Question ID: 1685401

Which of the following statements describing the choice of the functional currency is least
accurate? The functional currency should be the same as the parent's reporting currency if the
subsidiary is:

highly integrated with the parent where the local currency, prices, and some costs are
A)
controlled or restricted.
B) mostly independent from the parent.
highly integrated with the parent where the local currency, prices, and some costs are
C)
not controlled or restricted.

Question #28 of 127 Question ID: 1685408

Sycamore Systems sold $5 million worth of software on December 1, 20X1 to a Japanese
company with payment denominated in Japanese yen to be received in two months.
Sycamore's year end is 31st December. Payment was received on 31 Jan 20X2.

Exchange rates (1 USD)

1 Dec 20X1 95

31 Dec 20X1 90

31 Jan 20X2 35

The amount of transaction gain/loss recorded by Sycamore on its income statement for the
year ending 31 Dec 20X1 is closest to:

A) loss of $300,000.
B) gain of $580,000.
C) gain of $280,000.

Question #29 of 127 Question ID: 1685476

The Herlitzka Company, a U.S. multinational firm, has a 100 percent stake in a Swiss subsidiary.
The U.S. dollar (USD) has been determined to be the functional currency. All the common stock
of the subsidiary was issued at the beginning of the year and the subsidiary uses the weighted-
average inventory cost-flow assumption. In addition, the value of the SF is as follows:

Beginning of year $0.5902

Average throughout the year $0.6002

End of year $0.6150

The SF-based balance sheet and income statement data for the Swiss subsidiary are as follows:

Accounts receivable = 3,000

Inventory = 4,000

Fixed assets = 12,000

Accounts payable = 2,000

Long-term debt = 5,000

Common stock = 10,000

Retained earnings = 2,000

Net income = 2,000

The remeasured value of accounts receivable and inventory respectively are closest to:

A) $1,771 and $2,361.

B) $1,845 and $2,401.
C) $1,845 and $2,361.

Question #30 of 127 Question ID: 1685420

Which of the following currency translation methods is most appropriate in a hyperinflationary

economy under US GAAP? The:

current/non-current method since current assets and liabilities are translated at the
A)
current exchange rate.
 current rate method since the translation gain or loss is shown on the income
B)
statement.
temporal method because all non-monetary accounts are translated at the historical
C)
rate.

Question #31 of 127 Question ID: 1685534

Under U.S. GAAP, the temporal method is preferred to the current rate method in
hyperinflationary economies because the temporal method:

A) is easier to perform under hyperinflation.

B) provides better conversions of subsidiary revenues.
results in non-monetary asset values that are a better proxy for the economic values of
C)
those assets.

Question #32 of 127 Question ID: 1685454

At what exchange rate are revenues and accounts receivable translated under the current rate
method?

Accounts
Revenues
receivable

A) Average rate Current rate

B) Average rate Historical rate

C) Current rate Current rate

Question #33 of 127 Question ID: 1685482

Where does the currency translation gain or loss appear in the financial statements under the
temporal method and the current rate method?

Temporal Current rate

method method

Income
A) Balance sheet
statement

Income
B) Balance sheet
statement

C) Balance sheet Balance sheet

Question #34 of 127 Question ID: 1685467

Regarding the different methods of consolidating foreign subsidiaries' operating results, it

would be most accurate to state that:

under the temporal method, monetary assets and monetary liabilities are translated at
A)
a historical exchange rate.
under the current rate method, revenues and expenses are translated at the exchange
B)
rate that existed when the underlying transaction occurred.
under the current rate method, individual components of stockholder’s equity are
C)
translated at the current exchange rates.

Deborah Ortiz, CFA®, is the director of Global Research for F.E. Horton & Co. Ortiz recently
hired two junior analysts, Tina Hirauye and Dominique Wilkins to assist in the financial
statement analysis of global conglomerates. Hirauye and Wilkins are both Level II candidates in
the CFA® Program, so Ortiz thought they would be the ideal people to work on a project dealing
with consolidating the results of foreign operating units in the financial statements of the global
parent.

Before starting on the project, Ortiz has a meeting with Hirauye and Wilkins to discuss the use
of different currencies in a company's operations. At the meeting, Hirauye states that when
analyzing multinational firms, there cannot be a difference between local and functional
currencies. Wilkins disagrees with her and states that there can be a difference between local
and functional currencies, but only if the parent of the subsidiary operates in a
hyperinflationary environment. After another 30 minutes of discussion, Ortiz concludes the
meeting by telling them to make sure they understand the different accounting rules for
remeasurement and translation, under SFAS 52.

Hirauye and Wilkins are given projects involving two different firms:

Molsan Industries is a Canadian multinational firm with a subsidiary in Japan. The

subsidiary has operations in both Japan and Singapore.
Neslarone is based in Switzerland and generates the majority of its cash in Swiss Francs
(CHF). The firm issues and prepares its consolidated financial statements in U.S. dollars.

Hirauye and Wilkins spend the morning reviewing the details of their assignment and decide to
take a break for lunch at a restaurant across the street from F.E. Horton & Co.'s headquarters.
They agree that they have a challenging task and both are nervous about turning in their
consolidated financial statements to Ortiz on the following day.

Question #35 - 38 of 127 Question ID: 1685404

Regarding the statements made at the meeting:

A) Hirauye’s statement is incorrect; Wilkins’ statement is correct.

B) Hirauye’s statement is incorrect; Wilkins’ statement is incorrect.
C) Hirauye’s statement is correct; Wilkins’ statement is correct.

Question #36 - 38 of 127 Question ID: 1685405

Hirauye is working on consolidating the financial statements of Molsan Industries' Japanese

subsidiary. Under SFAS 52, regarding Foreign Currency Translation, if:

more than half of the subsidiary's revenue is from Japanese sources, then the results
A) of the Singapore operation are translated into Japanese yen and then translated into
Canadian dollars.
 management determines that the subsidiary's functional currency is the Japanese yen,
B) the results of the Singapore operation are first remeasured into Japanese yen and then
translated into Canadian dollars.
management determines that the subsidiary's functional currency is the Singapore
C) dollar, then the results of the Singapore operation are remeasured into Canadian
dollars.

Question #37 - 38 of 127 Question ID: 1685406

Ortiz had told the junior analysts to make sure they understand the different accounting rules
under SFAS 52. When referring to foreign exchange rates, the difference between
remeasurement and translation is that remeasurement:

refers to the conversion of local currency into the functional currency; translation is the
A)
conversion of the functional currency into the reporting currency.
and translation refer to the same process of translating the functional currency into
B)
the reporting currency.
C) is used to describe historical exchange rates while translation is used for current rates.

Question #38 - 38 of 127 Question ID: 1685407

Wilkins and Hirauye are working on constructing the consolidated statements for Neslarone.
They know that after they convert from Swiss Francs (CHF) to U.S. dollars (USD), they will be left
with a foreign currency adjustment that needs to be included on the financial statements. To
convert from CHF to USD, the analysts should use the:

current rate method and they should record the foreign currency adjustment on the
A)
balance sheet.
current rate method and they should record the foreign currency adjustment on the
B)
income statement.
temporal method and they should record the foreign currency adjustment on the
C)
income statement.
Question #39 of 127 Question ID: 1685469

Gortal Inc., a U.S. company has a wholly owned subsidiary, Fortina GmBh, based in Germany.
The U.S. dollar has been appreciating relative to the Euro over the past year. The use of the
temporal method to translate a foreign subsidiary's financial statements to U.S. dollars will
most likely have which of the following effects on the fixed-asset turnover ratio (S/FA) relative to
what the ratio would have been without the effects of translation assuming no new fixed assets
were purchased throughout the year?

A) There will be no effect on the ratio.

B) The ratio will be higher.
C) The ratio will be lower.

Question #40 of 127 Question ID: 1685542

Organic growth in sales is most accurately defined as growth in sales excluding the effects of:

A) acquisitions/divestitures only.
B) acquisitions/divestitures and currency value fluctuations.
C) currency value fluctuations.

Question #41 of 127 Question ID: 1685418

Which of the following general statements is CORRECT with respect to the temporal method?
Revenues and operating expenses (excluding COGS) are translated at the:

A) average rate.
B) historical rate.
C) current rate.
Question #42 of 127 Question ID: 1685483

Which of the following ratios is unaffected by the choice between the current rate method and
the temporal method?

A) Inventory turnover.
B) Current ratio.
C) Quick ratio.

Question #43 of 127 Question ID: 1685423

Each of the following items is considered a monetary asset or liability account under the
temporal method for foreign currency translation EXCEPT:

A) accounts payable.
B) long-term debt.
C) inventory.

Giant Company is a U.S. firm that produces parts for nuclear reactors. Giant Company has a
subsidiary, Grande, Inc., that operates in Mexico and is responsible for designing and
manufacturing connection fittings that are vital for the proper operation of its parent
company's reactors.

Giant Company considers the U.S. dollar to be the functional currency of Grande, Inc.
Grande, Inc., began operations January 1, 2001.
Common Stock and Fixed Assets were acquired January 1, 2000.
Inventory is accounted for under the last in, first out (LIFO) cost flow assumption, and
was purchased evenly through the year.
The inventory in the January 1, 2001, Balance Sheet was acquired on January 1, 2001.

Exchange Rates were: January 1, 2000 $0.14/M peso

January 1, 2001 $0.12/M peso

June 30, 2001 $0.11/M peso (this is the 2001 average rate)
 December 31, 2001 $0.10/M peso

Grande, Inc.

Balance Sheet (in M Pesos)

Jan. 1, 2001 Dec. 31, 2001

Cash 5,000,000 20,000,000

Accounts Receivable 20,000,000 35,000,000

Inventory 15,000,000 15,000,000

Fixed Assets (net) 70,000,000 60,000,000

Accounts Payable 10,000,000 10,000,000

Long Term Debt 40,000,000 35,000,000

Common Stock 80,000,000 80,000,000

Retained Earnings 5,000,000

2001 Income Statement

(in M Pesos)

Sales 60,000,000

Cost of Goods Sold (45,000,000)

Depreciation (10,000,000)

Net Income 5,000,000

Question #44 - 47 of 127 Question ID: 1685471

Giant Company should use the following method to reflect the results of Grande, Inc., in its
financial statements:

A) the temporal method followed by the current rate method.

B) the current rate method.
C) the temporal method.
Question #45 - 47 of 127 Question ID: 1685472

Which of the following statements regarding the current rate method is the most accurate?

This method is not typically used when the subsidiary is relatively independent of the
A)
parent.
B) Translation gains and losses are reported in equity.
C) Income statements items are translated at the current exchange rate.

Question #46 - 47 of 127 Question ID: 1685473

The translation gain or loss from the activities of Grande, Inc., should be reported in:

A) the statement of shareholder’s equity.

B) the statement of cash flows.
C) the income statement.

Question #47 - 47 of 127 Question ID: 1685474

Revenues for 2001 translated into U.S. dollars amount to:

A) $6,000,000.
B) $7,800,000.
C) $6,600,000.

Question #48 of 127 Question ID: 1685539

(Assume U.S. GAAP for this question.) For a subsidiary in a hyperinflationary economy, the
functional currency should be the:

A) Local currency.
B) Parent's currency.
C) Subsidiary's operating currency.

Question #49 of 127 Question ID: 1685535

Which of the following asset or liability values is likely to be the most understated in a
hyperinflationary economy if translation occurs under the current rate method?

A) A plant purchased several years ago.

B) Dividends payable.
C) Accounts receivable.

Question #50 of 127 Question ID: 1685543

A company is exposed to foreign exchange risk due the impact of changes in currency values on
a:

A) company’s assets only.

B) company’s assets, liabilities, and future sales.
C) company’s assets and liabilities only.

Walter Jameson, CFA®, is an analyst for Continental Corp., a global investment bank. Jameson
has been assigned coverage of Wasson Brothers (WB), a large U.S. based conglomerate with
many subsidiaries in both the U.S. and abroad. Jameson has completed his review of the firm's
U.S. operations, but his research report is due at the end of the week and he has yet to assess
the impact of Wasson's foreign subsidiaries on his earnings model.
One of WB's wholly-owned foreign subsidiaries, Kasamatsu Industries, is based in Japan and
manufactures a hugely successful line of trading cards, toys, and other related products. All of
Kasamatsu's operations and sales take place in Japan, and the corresponding transactions are
denominated in Japanese yen. Additionally, Kasamatsu's books and records are all maintained
in yen. WB reports its earnings in U.S. dollars. The history of the exchange rate between the
dollar and the yen over the last two years is presented in the following table. Figures are
presented in yen/$.

Yen/Dollar Exchange Rate

December 31, 2002 150

December 31, 2001 130

2002 Average 140

2001 Average 120

Exchange rate on date that 2002

145
dividends were declared (payable to Wasson Brothers)

Exchange rate on date of stock

100
issue and acquisition of fixed assets

Kasamatsu Industries Financial Data (12/31/02)

Yen U.S. Dollars

Exchange Rate
(in thousands) (in thousands)

Sales 700,000

COGS 280,000

Depreciation 126,000

SG & A 77,000

Income Tax Expense 98,000

Net Income 119,000

2001 Retained Earnings 0

Dividends 58,000

2002 Retained Earnings 61,000

Current Assets 50,000

Fixed Assets 486,000

Current Liabilities 46,000

Long Term Debt 254,000

Capital Stock 175,000

Accumulated Translation
Adjustment

Question #51 - 54 of 127 Question ID: 1685496

The first step in Jameson's analysis is to compute Kasamatsu's impact on WB's net income.
What is Kasamatsu's impact on WB's net income (in thousands dollars)?

A) $821.
B) $793.
C) $850.

Question #52 - 54 of 127 Question ID: 1685497

Jameson now computes the adjustment to WB's financial data due to Kasamatsu's payment of
dividends. What is the U.S. dollar amount of this adjustment (in thousands)?

A) $446.
B) $400.
C) $414.
Question #53 - 54 of 127 Question ID: 1685498

The carrying value of Kasamatsu's total assets on December 31, 2002, using the current rate
method of accounting for translations is:

A) $2,938.
B) $3,573.
C) $3,240.

Question #54 - 54 of 127 Question ID: 1685499

Having converted all of Kasamatsu's accounts using the current rate methods, Jameson is
curious to compare the difference between the temporal and current rate methods on balance
sheet accounts. The difference in translated fixed assets and long term debt respectively if
Jameson were to use the temporal method rather than the current rate method is:

Long-Term
Fixed Assets
Debt

A) $0 $0

B) $1620 $0

C) $1620 $121

Question #55 of 127 Question ID: 1685537

In reality, what best describes the real value of non-monetary assets and liabilities in a
hyperinflationary environment?

A) All non-monetary accounts are re-measured at the current rate.

Typically not affected because their local currency-denominated values decrease to
B)
offset the impact of inflation.
 Typically not affected because their local currency-denominated values increase to
C)
offset the impact of inflation.

Neptune Corporation (Neptune) is a U.S. company located in Detroit, Michigan. Neptune

supplies exhaust emission systems to manufacturers of passenger cars and light duty trucks. In
January 2006, Neptune formed a wholly owned subsidiary, Continental Systems GmbH
(Continental), to supply automotive manufacturers located throughout Europe. Continental is
located in Stuttgart, Germany.

Neptune reports its consolidated financial statements in U.S. dollars. The euro has been
consistently appreciating against the dollar.

Continental accounts for its inventory using the first-in, first-out (FIFO) cost flow assumption.
Fixed assets consist of machinery, tools, and equipment.

Contintential has net monetary assets.

Question #56 - 59 of 127 Question ID: 1685463

Assuming the current rate method is used to translate Continental's financial statements, as
compared to the local currency ratios, which of the following statements about translated
operating profit margin and long-term debt to equity ratios is correct?

A) Operating profit margin will be higher.

B) Long-term debt-to-equity ratio will be higher.
C) Neither ratio will change.

Question #57 - 59 of 127 Question ID: 1685464

When stated in U.S. dollars, would Continental most likely report a higher fixed asset turnover
ratio and a higher quick ratio under the temporal method, as compared to the current rate
method?

A) Only the quick ratio will be higher under the temporal method.
B) Only fixed asset turnover will be higher under the temporal method.
C) Both ratios will be higher under the temporal method.

Question #58 - 59 of 127 Question ID: 1685465

Which of the following statements about the temporal method and the current rate method is
least accurate?

Subsidiaries whose operations are well integrated with the parent will generally use
A)
the current rate method.
Net income is generally more volatile under the temporal method than under the
B)
current rate method.
Subsidiaries that operate in highly inflationary environments will generally use the
C)
temporal method under U.S. GAAP.

Question #59 - 59 of 127 Question ID: 1685466

As compared to local currency ratios, which of the following are the most likely impacts on
gross profit margin and net profit margin, assuming the temporal method is used to remeasure
Continental's financial statements?

A) Both will be higher.

B) Higher net income, with a higher funded status.
C) Only net profit margin will be higher.

Geocorp is a global corporation with operations in North America, Asia, and Europe. Its primary
business is marketing industrial machinery for the construction industry. Geocorp has regional
headquarters located in New York, Tokyo, and Paris. All North American and U.S operations
report to its regional and world headquarters located in New York, while all Asian operations
report to Tokyo, and all European operations report to Paris.

The following information is relevant to Geocorp's subsidiaries:

 Geocorp has a Canadian subsidiary that reports its results in Canadian dollars (CAD). The
CAD is the functional currency.
All domestic U.S. operations report their results in U.S. dollars (USD).
Consolidated financial statements are reported in USD.
Geocorp's Asian operations report their results in Japanese yen (JPY). The JPY is the
functional currency.
Geocorp's European headquarters (in Paris) operations report their results in euros
(EUR). The EUR is the functional currency.
Geocorp has a British subsidiary that reports its results in British pounds (GBP). The USD
is the functional currency.

The following table is a summary of selected financial results from Geocorp's foreign
operations:

All values are in millions CAD JPY GBP EUR

Revenues 50 5,000 150 700

Cost of goods sold (COGS) 20 2,700 100 480

Gross profit 30 2,300 50 220

Selling, general & administrative (SGA)

18 1,000 29 200
expenses

EBIT 12 1,300 21 10

Cash 35 4,200 102 400

Accounts receivable 12 1,400 45 170

Inventory 20 3,900 123 300

Fixed assets 62 7,680 370 450

Accounts payable 27 3,300 68 350

Long-term debt 0 8,450 320 550

Common stock 10 2,000 50 350

The following exchange rates apply (USD per foreign currency unit):

Currency Historical Rate Average Rate December 31, 20X2

CAD USD 0.7013 USD 0.6803 USD 0.6592

JPY USD 0.0094 USD 0.0088 USD 0.0082

EUR USD 0.9801 USD 1.0318 USD 1.0834

GBP USD 1.4803 USD 1.5506 USD 1.6209

Question #60 - 63 of 127 Question ID: 1685523

With respect to the Canadian subsidiary, what method should be used to value its revenues,
what is the appropriate exchange rate, and what is the translated value (in USD)?

A) Temporal method, average rate, USD 34.0 million.

B) Current method, average rate, USD 34.0 million.
C) Current method, current rate, USD 33.0 million.

Question #61 - 63 of 127 Question ID: 1685524

With respect to the Japanese subsidiary, what method should be used to value its accounts
receivable, what is the appropriate exchange rate, and what is the translated value (in USD)?

A) Temporal method, current rate, USD 11.5 million.

B) Current method, current rate, USD 11.5 million.
C) Current method, average rate, USD 12.3 million.

Question #62 - 63 of 127 Question ID: 1685525

With respect to the European HQ subsidiary, what method should be used to value its SG&A
expenses, what is the appropriate exchange rate, and what is the translated value (USD)?

A) Current method, current rate, USD 216.7 million.

B) Current method, average rate, USD 206.4 million.
C) Temporal method, average rate, USD 206.4 million.
Question #63 - 63 of 127 Question ID: 1685526

With respect to the British subsidiary, what method should be used to value its fixed assets,
what is the appropriate exchange rate, and what is the translated value (USD)?

A) Current method, current rate, USD 599.7 million.

B) Temporal method, historical rate, USD 547.7 million.
C) Current method, historical rate, USD 547.7 million.

Scud Co. is a Swiss subsidiary of the U.S. firm Patriot, Inc. On December 31, 20X7 the $/SF
exchange rate was 0.77. Assume that this is the historical rate, except as noted below. One year
later the Swiss Franc had appreciated to 0.85 $/SF. Scud Co. pays no dividends. The average
exchange rate for the year was 0.80 $/SF. Scud pays no taxes. Assume that Scud uses a periodic
inventory system and that inventory is accounted for using the LIFO inventory assumption, was
bought and sold evenly throughout the year.

Scud Co. Int'l

Balance Sheet (in SF thousands)

Dec. 31, 20X7 Dec. 31, 20X8

Cash & A/R 400 600

Inventory 500 500

Net Fixed Assets 700 600

Total Assets 1,600 1,700

A/P 100 200

Long-term debt 200 100

Common Stock 1,300 1,300

Retained Earnings 0 100

Total Liabilities 1,600 1,700

Income Statement (in SF thousands)

 December 31, 20X8

In SF

Sales 7,000

COGS (6,800)

Depreciation (100)

Remeasurement Gain/Loss --

Net Income 100

Assume that the functional currency is the U.S. dollar when answering the following questions.

Question #64 - 67 of 127 Question ID: 1685513

Assuming closing retained earnings for the year 20X8 was $110, the translation gain on the
income statement would be:

A) $17.
B) $0.
C) $27.

Question #65 - 67 of 127 Question ID: 1685514

The level of net fixed assets on the remeasured 20X8 balance sheet would be:

A) $480.
B) $510.
C) $462.

Question #66 - 67 of 127 Question ID: 1685515

The level of retained earnings on the remeasured 20X8 balance sheet would be:

A) $101.
B) $305.
C) $85.

Question #67 - 67 of 127 Question ID: 1685516

As compared to the local currency ratio, fixed asset turnover in the reporting currency would
most likely be:

A) higher.
B) lower.
C) the same.

Question #68 of 127 Question ID: 1685485

Which of the following statements regarding the effects of translation on financial statement
items/ratios is most accurate?

Fixed assets are relatively overstated under the temporal method compared to the
A)
local currency if the local currency has appreciated.
Leverage is higher under the current rate method as compared to under the local
B)
currency.
Depreciation in the reporting currency under the current rate method is higher than
C)
under the temporal method if the local currency has appreciated.

Navratov Corp. is a designer and manufacturer of high end sporting goods. The majority of the
firm's business comes from Olympic athletes from Russia and the United States. On January 1,
2003, Navratov was purchased by a U.S. competitor, Evert Industries. Because Evert's business
focuses on professional athletes in North America and Asia, Evert's management feels the
acquisition of Navratov is a natural extension of their business and that buying the Russian firm
should generate economies of scale.

Peter Capriati is an analyst for Evert and has been assigned the task of integrating Navratov's
financial statements into Evert's. Capriati knows that Evert's management pays a great deal of
attention to making sure the firm's financial ratios are above the industry average. Because
Navratov's sales are split evenly between the U.S. and Russia, management has given him the
flexibility to designate the either the Ruble (Navratov's local currency) or the U.S. dollar (Evert's
reporting currency) as Navratov's functional currency. As a result of choosing the functional
currency, Capriati will use either the temporal or current rate method to convert Navratov's
financial statements, depending on which method will have the most favorable impact on
Evert's financial ratios.

Selected financial data for Navratov Corp is shown below:

Navratov Corporation

Income Statement (in Russian Rubles)

12 months ended December 31, 2003

Revenue 7,400,000

Cost of Goods Sold (COGS) (5,200,000)

Depreciation (1,200,000)

Taxes (250,000)

Net Income 750,000

Navratov Corporation

Balance Sheet (in Russian Rubles)

December 31, 2002

Assets Liabilities and Equity

Cash 500,000 Accounts Payable 3,450,000

Accounts Receivable 2,500,000 Long Term Debt 5,000,000

Inventory 3,700,000 Common Stock 3,500,000

Net Fixed Assets 6,000,000 Retained Earnings 750,000

Total Liabilities and

Total Assets 12,700,000 12,700,000
Equity

Navratov Corporation

Balance Sheet (in Russian Rubles)

December 31, 2003

Assets Liabilities and Equity

Cash 1,000,000 Accounts Payable 2,000,000

Accounts Receivable 2,500,000 Long Term Debt 5,000,000

Inventory 3,700,000 Common Stock 3,500,000

Net Fixed Assets 4,800,000 Retained Earnings 1,500,000

Total Liabilities and

Total Assets 12,000,000 12,000,000
Equity

Navratov Corp. did not pay dividends in 2003.

The common stock was acquired on January 1, 2002.
January 1, 2003 retained earnings in USD is $300,000.
Depreciation is being taken on a straight-line basis over ten years for equipment which
was acquired on January 1, 2002, at a cost of 12,000,000 rubles.
Navratov uses FIFO inventory accounting and goods were sold evenly throughout the
year. The average rate applicable to inventory and COGS is $0.37 / ruble.

Exchange rates:

January 1, 2002, $0.40 / ruble

January 1, 2003, $0.40 / ruble
June 30, 2003, $0.37 / ruble (avg. rate)
December 31, 2003, $0.33 / ruble

Question #69 - 72 of 127 Question ID: 1685503

Which of the following statements about the temporal method and the current rate method is
least accurate?

Subsidiaries whose operations are well integrated with the parent will generally use
A)
the current rate method.
Net income is generally more volatile under the temporal method than under the
B)
current rate method.
Subsidiaries that operate in highly inflationary environments will generally use the
C)
temporal method under U.S. GAAP.

Question #70 - 72 of 127 Question ID: 1685504

If Capriati uses the current rate method to translate Navratov's income statement, the net
profit margin will be:

A) 10.1%.
B) 11.7%.
C) 8.6%.

Question #71 - 72 of 127 Question ID: 1685505

What is the difference in the translated receivables turnover ratio for Navratov Corp. between
the temporal and current rate methods? The receivables turnover rate is:

A) lower under the current rate method by 0.30x.

B) higher under the current rate method by 0.36x.
C) the same under both methods.

Question #72 - 72 of 127 Question ID: 1685506

What is the difference in the total asset turnover ratio for Navratov Corp. between the temporal
and current rate methods? The total asset turnover ratio is:

A) lower under the current rate method.

B) higher under the current rate method.
C) the same under both methods.

Giant Company is a U.S. Company with a subsidiary, Grande, Inc., that operates in Mexico. Giant
Company uses either the temporal or the current rate method of foreign currency translation
for its subsidiaries.

Grande, Inc., began operations January 1, 2012.

Common Stock and Fixed Assets were acquired January 1, 2011.
Inventory is accounted for under the last in, first out (LIFO) cost flow assumption, with a
slow rate of turnover.
The beginning U.S. dollar value of Giant's retained earnings was $2,600,000.
The inventory in the January 1, 2012, Balance Sheet was acquired on January 1, 2012.

Exchange Rates were: January 1, 2011 $0.14/peso

January 1, 2012 $0.12/peso

$0.11/peso (this is the 2012 average

June 30, 2012
rate)

December 31, 2012 $0.10/peso

Grande, Inc.

Balance Sheet (in M Pesos)

Jan. 1, 2012 Dec. 31, 2012

Cash 5,000,000 20,000,000

Accounts Receivable (A/R) 20,000,000 35,000,000

Inventory 15,000,000 15,000,000

Fixed Assets (net) 90,000,000 60,000,000

Accounts Payable (A/P) 10,000,000 10,000,000

 Long Term Debt 40,000,000 35,000,000

Common Stock 80,000,000 80,000,000

Retained Earnings 5,000,000

2012 Income Statement

(in Pesos)

Sales 60,000,000

Cost of Goods Sold (COGS) (45,000,000)

Depreciation (10,000,000)

Net Income 5,000,000

Assume that Giant Company considers the Mexican peso to be both the local currency and the
functional currency of Grande, Inc.

Question #73 - 76 of 127 Question ID: 1685426

To reflect the results of Grande, Inc., in its financial statements, it would be most appropriate
for Giant Company to use the:

A) current rate method followed by the temporal method.

B) current rate method.
C) temporal method.

Question #74 - 76 of 127 Question ID: 1685427

The Net Income of Grande, Inc., expressed in U.S. dollars for the year ended December 31,
2012, is closest to:

A) $250,000.
B) $550,000.
C) $500,000.
Question #75 - 76 of 127 Question ID: 1685428

The translation gain or loss from the activities of Grande, Inc., should be reported in the:

A) statement of cash flows.

B) income statement.
C) equity accounts.

Question #76 - 76 of 127 Question ID: 1685429

Compared to the current ratio before translation, the current ratio after translation is most
likely to be:

A) lower.
B) the same.
C) higher.

Question #77 of 127 Question ID: 1685480

Which of the following ratios is affected by translation under the current rate method?

A) Fixed asset turnover ratio.

B) Debt/Assets ratio.
C) Net profit margin.

Question #78 of 127 Question ID: 1685478

Portinta Inc, a U.S. based pharmaceutical company, has a UK based subsidiary, Medaze plc. The
U.S. dollar has been appreciating relative to GBP over the past year. Using the current-rate
method to translate a foreign subsidiary's financial statements to U.S. dollars will most likely
have which of the following effects on the long-term debt to equity ratio relative to what the
ratio would have been without the effects of translation?

A) The ratio will be lower.

B) The ratio will be the same.
C) The ratio will be higher.

Question #79 of 127 Question ID: 1685489

The U.S. dollar (i.e., the reporting currency) has been depreciating relative to the local currency
over the past year. The use of the current rate method to translate a foreign subsidiary's
financial statements to U.S. dollars will most likely have which of the following effects on return
on equity (ROE) based on ending equity relative to what the ratio would have been without the
effects of translation?

A) ROE will most likely decline.

B) The impact of the depreciation of the US dollar on ROE is indeterminate.
C) ROE will most likely rise.

A U.S. company has a subsidiary based in Malaysia, which has the following income statement
for 20X6 and balance sheets for 20X5 and 20X6 (in million Ringgit).

Sales 1,000

Cost of goods sold 600

Depreciation 80

Operating expenses 120

Earnings before taxes 200

Taxes 60
 Net income 140

Dividends 20

20X5 20X6

Cash 50 60

Accounts receivables 100 110

Inventories 100 110

Other current assets 100 110

Gross PP&E 700 800

Less accumulated depreciation 70 150

Net PP&E 630 650

Other fixed assets 20 40

Total assets 1,000 1,080

Account payable 70 80

Current portion of LTD 100 100

Notes payable 100 150

Other current liabilities 30 30

Long-term debt 300 200

Common stock 100 100

Paid in capital 50 50

Retained earnings 250 370

The value of the Ringgit at various times over the past two years is as follows:

January 1, 20X5 $0.37

April 1, 20X5 $0.38

December 31, 20X5 $0.40

June 30, 20X6 $0.47

December 31, 20X6 $0.50

Average for 20X5 $0.39

Average for 20X6 $0.45

The common stock and long-term debt were originally issued in January of 20X5. The fixed
assets and first inventory purchases were made in April of 20X5. Additional fixed asset
purchases were made in June 20X6. Inventory is measured using the FIFO method. It can be
assumed that all of the ending inventory was acquired in June when the last major purchase
was made. The operations of the subsidiary are independent from the operations of the U.S.
parent. Inflation over the past three years has averaged 15% per year.

Question #80 - 83 of 127 Question ID: 1685508

The amount of 20X6 cost of goods sold in USD is:

(Note: if needed, use $0.40 as the rate to convert 20X5 ending inventory)

A) $262,800,000.00
B) $270,000,000.00
C) $300,000,000.00

Question #81 - 83 of 127 Question ID: 1685509

The value of December 31, 20X6, gross property, plant, and equipment reported in USD is:

A) $313,000,000.
B) $304,000,000.
C) $400,000,000.

Question #82 - 83 of 127 Question ID: 1685510

The value of December 31, 20X6, inventory reported in USD is:

A) $49,500,000.
B) $51,700,000.
C) $55,000,000.

Question #83 - 83 of 127 Question ID: 1685511

The value of all financing debt (notes payable, current portion of long-term debt, and long-term
debt) on December 31, 20X6, reported in USD is:

A) $202,500,000.
B) $171,000,000.
C) $225,000,000.

Question #84 of 127 Question ID: 1685402

Which of the following statements regarding the functional currency is least accurate? The
functional currency:

A) is remeasured into the reporting currency under the temporal method.

is the currency of the primary economic environment in which the foreign subsidiary
B)
generates and expends cash.
C) is determined by management.

Question #85 of 127 Question ID: 1685400

The local currency is:

the preferred functional currency for subsidiaries that are highly integrated with the
A)
parent.
B) translated into the functional currency under the current rate method.
C) the same as the functional currency under the current rate method.

Question #86 of 127 Question ID: 1685413

Which of the following situations does NOT require the use of the temporal method? The:

A) local currency is the functional currency.

B) foreign subsidiary is operating in a highly inflationary economy.
C) functional currency is some currency other that the local currency or the U.S. dollar.

Question #87 of 127 Question ID: 1685455

Which of the following statements regarding foreign currency translation are least accurate?
Under the:

current rate method, the foreign currency translation gain or loss appears on the
A)
parent firm's income statement.
B) temporal method, COGS and depreciation are remeasured using the historical rate.
C) temporal method, sales are remeasured using the average rate.

Question #88 of 127 Question ID: 1685460

The U.S. Deter Company operates a subsidiary in the UK, and the functional currency is the
British pound. The subsidiary's 2001 income statement shows £500 of net income and a £50
dividend that was paid on December 31, when the exchange rate was $1.50 per pound. The
current exchange rate is $1.65 per pound, and the average rate is $1.58 per pound. What is the
change in retained earnings for the period in U.S. dollars under U.S. GAAP?

A) $715.
B) $750.
C) $725.

Question #89 of 127 Question ID: 1685421

Dave Iverson, CFA, is analyzing the recently released financial statement of Global Corp., a large
multinational manufacturing company with production facilities across Europe and Southeast
Asia. The company's choice of functional currency is not disclosed, but Iverson does notice that
Global Corp. does not have any cumulative translation adjustments (CTA) on its balance sheet.
Which of the following statements is most accurate based upon Iverson's observation?

The temporal method of foreign currency translation is used for at least some of its
A)
subsidiaries.
B) The temporal method of foreign currency translation is used exclusively.
C) The current rate method of foreign currency translation is used exclusively.

Question #90 of 127 Question ID: 1685501

Which of the following measures is unaffected by the choice between translation under the
current rate method and remeasurement under the temporal method?

A) Cost of goods sold.

B) Tax expense.
C) Equity.

Question #91 of 127 Question ID: 1685452

Which of the following statements is least accurate regarding accounting for foreign currency
translations? The:
A) current rate method applies the current exchange rate to all balance sheet accounts.
current rate method applies the average exchange rate to all income statement
B)
accounts.
temporal method uses the historical exchange rate to translate non-monetary assets
C)
and liabilities into the currency of the country of the parent company.

Della Air Lines has recently acquired Australian Puddle Jumpers, Inc. (APJ), a small airline
located in Sydney. The Australian dollar has been chosen by Della as the functional currency for
APJ. The balance sheet of APJ is given below as of Dec. 31, 2011 in U.S. dollars.

Assets Liabilities and Equity

Cash $100 Accounts Payable (A/P) $90

Accounts Receivable (A/R) 120 Common Stock 360

Maintenance Supplies 90

Fixed Assets 140

Total Assets $450 Total Liabilities & Equity $450

APJ's income statement for the year ending Dec. 31, 2012 is expressed in Australian dollars as:

Sales 3,500

Total Costs 2,900

Net Income 600

The Australian dollar has steadily depreciated against the U.S. dollar. At Dec. 31, 2011, the
exchange rate was A$/US$ 2.50, the average rate during the year was A$/US$ 2.75 and A$/US$
3.0 on Dec. 31, 2012.

The Dec. 31, 2012 Balance Sheet for APJ is given in Australian dollars as follows:

Assets Liabilities and Equity

Cash 441 A/P 210

A/R 330 Common Stock 720

Supplies 291 Retained Earnings 600

 Fixed Assets 468

Total Assets 1,530 Total Liabilities & Equity 1,530

Question #92 - 95 of 127 Question ID: 1685436

On APJ's 2012 income statement, the level of sales in U.S. dollars would be closest to:

A) $1,985.
B) $1,272.
C) $1,377.

Question #93 - 95 of 127 Question ID: 1685437

On APJ's 2012 balance sheet, the level of accounts receivable is U.S. dollars would be closest to:

A) $110.
B) $132.
C) $330.

Question #94 - 95 of 127 Question ID: 1685438

For APJ, the conversion to US$ is most likely to result in:

A) remeasurement gain.
B) cumulative translation adjustment loss.
C) cumulative translation adjustment gain.

Question #95 - 95 of 127 Question ID: 1685439

If the functional currency is the reporting currency, the exposure and the foreign currency
movements are most likely to result in a:

A) remeasurement loss.
B) cumulative translation adjustment loss.
C) remeasurement gain.

Question #96 of 127 Question ID: 1685411

A Canadian firm owns a foreign subsidiary in the U.S. In 2002, sales were USD1,000,000 and the
USD/CAD exchange rate was 0.6329. In 2003, sales were also USD1,000,000 but the exchange
rate was 0.7484. What is the impact of the change in the value of the CAD on the parent
company's translated sales? Sales will:

A) decline by 15%.
B) decrease by 18%.
C) increase by 18%.

Scud Co. is a Swiss subsidiary of the U.S. firm Patriot, Inc. On December 31, 2012 the $/SF
exchange rate was 0.77. (Each Swiss Franc buys 77 cents) and is the historical rate applicable for
fixed assets and common stock. One year later the Swiss Franc had appreciated to 0.85 $/SF.
Scud Co. pays no dividends. The average exchange rate for the year was 0.80 $/SF. Scud pays no
taxes. Assume that inventory is accounted for using the last in, first out (LIFO) inventory
assumption and was bought and sold evenly throughout the year.

Scud Co. Int'l

Balance Sheet (in SF thousands)

Dec. 31, 2012 Dec. 31, 2013

Cash & accounts receivables (A/R) 400 600

Inventory 500 500

Net Fixed Assets 700 600

Total Assets 1,600 1,700

Accounts payable (A/P) 100 200

Long-term debt 200 100

Common Stock 1,300 1,300

Retained Earnings 0 100

Total Liabilities 1,600 1,700

Income Statement (in SF thousands)

December 31, 2013

In SF

Sales 7,000

Cost of Goods Sold (COGS) (6,800)

Depreciation (100)

Translation Gain/Loss --

Net Income 100

Assume that the functional currency is the U.S. dollar when answering the following questions.

Question #97 - 100 of 127 Question ID: 1685431

After remeasurement, depreciation will be closest to:

A) $85.
B) $80.
C) $77.

Question #98 - 100 of 127 Question ID: 1685432

The value of common stock on the 2013 balance sheet should be closest to:
A) $1,100.
B) $1,050.
C) $1,000.

Question #99 - 100 of 127 Question ID: 1685433

For Scud Co. under the temporal method, the monetary exposures and the foreign currency
movements resulted in a:

A) cumulative translation adjustment gain on the balance sheet.

B) remeasurement gain on the income statement.
C) remeasurement loss on the income statement.

Question #100 - 100 of 127 Question ID: 1685434

If Scud Co.'s functional currency is the Euro, then to adjust the currency exposure to the
parent's currency, the US$, start with the:

Swiss franc and use the temporal method to convert to the functional currency, the
A) Euro; then use the current rate method to convert to the presentation currency, the
US$.
Swiss franc and use the current rate method to convert to the functional currency, the
B)
Euro; then use the temporal method to convert to the presentation currency, the US$.
Euro and use the current rate method to convert to the local currency, the Swiss franc;
C)
then use the temporal method to convert to the presentation currency, the US$.

Question #101 of 127 Question ID: 1685475

The Herlitzka Company, a U.S. multinational firm, has a 100% stake in a Swiss subsidiary. The
U.S. dollar (USD) has been determined to be the functional currency. All the common stock of
the subsidiary was issued at the beginning of the year and the subsidiary uses the weighted-
average inventory cost-flow assumption. In addition, the value of the SF is as follows:

Beginning of year $0.5902

Average throughout the year $0.6002

End of year $0.6150

The SF-based balance sheet and income statement data for the Swiss subsidiary are as follows:

Accounts receivable = 3,000

Inventory = 4,000

Fixed assets = 12,000

Accounts payable = 2,000

Long-term debt = 5,000

Common stock = 10,000

Retained earnings = 2,000

Net income = 2,000

The total value of net monetary assets is equal to:

A) -4,000 SF.
B) 12,000 SF.
C) 3,000 SF.

Question #102 of 127 Question ID: 1685409

A U.S. firm owns a foreign subsidiary in France. In 2002, sales were EUR 1,000,000 and the
USD/EUR exchange rate was 1.0620. In 2003, sales were EUR 1,100,000 and the exchange rate
was 1.1417. What is the impact of the change in the value of the USD on the parent company's
translated sales?
A) Sales will increase by 7.5%.
B) Sales will decrease by 7.5%.
C) Sales will increase by 18.25%.

Question #103 of 127 Question ID: 1685417

Under the temporal method, the inventory and cost of goods sold (COGS) accounts are both
nonmonetary accounts. Which of the following statements is least accurate regarding these
accounts?

If the firm accounts for inventory using first in, first out (FIFO), then a more recent rate
A)
will be applied to the inventory account.
The Inventory account is remeasured using the historical rate under both LIFO and
B)
FIFO.
If the firm accounts for inventory using last in, first out (LIFO), then the beginning-of-
C)
period rate is used to remeasure COGS.

Dell Air Lines has recently acquired Australian Puddle Jumpers, Inc., a small airline located in
Sydney. The Australian dollar has been chosen by Dell as the functional currency for APJ. The
Balance Sheet of APJ is given below as of Dec. 31, 2004 in Australian dollars.

Assets Liabilities and Equity

Cash 200 A/P 180

A/R 240 Common Stock 720

Maintenance Supplies 180

Fixed Assets 280

Total Assets 900 Total Liab & Equity 900

APJ's income statement for the year ending Dec. 31, 2005 is expressed in Australian dollars as:

Sales 3,500
 Total Costs 2,900

Net Income 600

The Australian dollar has steadily depreciated against the U.S. dollar. At Dec. 31, 2004, the
exchange rate was 2 Australian dollars = $1 but at Dec. 31, 2005, the exchange rate had
deteriorated to 3 Australian dollars = $1.

The Dec. 31, 2005 Balance Sheet for APJ is given in Australian dollars as follows:

Assets Liabilities and Equity

Cash 441 A/P 210

A/R 330 Common Stock 720

Supplies 291 Retained Earnings 600

Fixed Assets 468

Total Assets 1,530 Total Liab. & Equity 1,530

Question #104 - 107 of 127 Question ID: 1685529

On APJ's 2005 income statement, the level of net income in U.S. dollars would be:

A) $200.00.
B) $300.00.
C) $240.00.

Question #105 - 107 of 127 Question ID: 1685530

On APJ's 2005 balance sheet, the level of common stock (not including retained earnings) in U.S.
dollars would be:

A) $288.
B) $360.
C) $240.
Question #106 - 107 of 127 Question ID: 1685531

On APJ's 2005 balance sheet, the foreign currency translation adjustment in U.S. dollars would
be:

A) −$220.
B) −$160.
C) −$280.

Question #107 - 107 of 127 Question ID: 1685532

Which one of the following statements correctly describes the effect on Dell's financial
statements if the U.S. dollar had been chosen as the functional currency?

A) The current rate method would apply.

B) The translation adjustment would appear as a line item on Dell's balance sheet.
C) The translation adjustment would appear as a line item on Dell's income statement.

Question #108 of 127 Question ID: 1685536

The nation of Deadoa is experiencing hyperinflation. A subsidiary of a multinational operating

in Deadoa will notice changes in its purchasing power and in its financial results as reported on
its parent company's financial statements. Which of the following best describes the situation
for a subsidiary operating in Deadoa? Purchasing power will:

dramatically appreciate and the local currency will be rapidly appreciating against the
A)
presentation currency.
quickly deteriorate and the local currency will be rapidly appreciating against the
B)
presentation currency.
quickly deteriorate and the local currency will be rapidly depreciating against the
C)
presentation currency.
Question #109 of 127 Question ID: 1685481

Hann Company is a U.S. multinational firm with operations in several foreign countries. Hann
has a 100% stake in a French subsidiary. The foreign subsidiary's local currency has appreciated
against the U.S. dollar over the latest financial statement reporting period. In addition, the
French firm accounts for inventories using the first in, first out (FIFO) inventory cost-flow
assumption. The gross profit margin as computed under the current rate method would most
likely be:

A) lower than the gross profit margin as computed under the temporal method.
B) higher than the gross profit margin as computed under the temporal method.
C) equal to the gross profit margin as computed under the temporal method.

Question #110 of 127 Question ID: 1685491

Which of the following subsidiary ratios will be affected by the translation adjustment under the
current rate method?

A) Return on equity.
B) Gross margin.
C) Net profit margin.

Question #111 of 127 Question ID: 1685484

The U.S. dollar has been depreciating relative to the local currency over the past year. The use
of the current rate method to translate a foreign subsidiary's financial statements to U.S.
dollars will most likely have which of the following effects on the operating profit margin
(EBIT/S) relative to what the ratio would have been without the effects of translation?

A) The ratio will fall.

B) There will be no effect on the ratio.
C) The ratio will rise.

Question #112 of 127 Question ID: 1685541

Sopgate is a manufacturer of branded fast moving consumer goods having business operations
in 28 countries (in each country, Sopgate has a wholly owned local subsidiary for production
and/or distribution). Following information is available from Sopgate's annual report:

Growth in pre-tax profits

Region Revenue Growth (USD)* Tax rate
(USD)*

Latin America 5% 4% 25%

North America 3% 3% 35%

Europe 2% −1% 45%

Asia pacific 4% 6% 20%

*Growth rate indicates expected growth rate over the next five years.

Sopgate's effective tax rate is most likely expected to:

A) remain unchanged.
B) decrease.
C) increase.

Question #113 of 127 Question ID: 1685410

A German company (reporting currency = Euro) owns a foreign subsidiary in the U.S. If the
results below are reported in local currency (USD), after translation what is the effect of the
change in the exchange rate on revenues? Round to the nearest dollar and/or percent.

$ per 1 Euro avg.

Year Sales
Exchange Rate

2001 $10,000 0.9

2002 $10,000 0.8

A) The company shows a 0.1% decline in revenues in 2002.

B) The company shows a 12.5% growth in revenues in 2002.
C) There is no change is revenue growth between 2001 and 2002.

Question #114 of 127 Question ID: 1685422

Which of the following statements regarding the functional currency under US GAAP is least
accurate?

Self-contained, independent subsidiaries whose operations are primarily located in the

A)
local market will use the local currency as the functional currency.
If a firm operates in a country or environment which is subject to cumulative inflation
B) of 100% or more over a three year period, that firm will use the parent's currency as
the functional currency.
The functional currency is defined as the primary currency of the economic
C)
environment in which the parent firm operates.

Wasson Brothers (WB) is a large U.S. based conglomerate with many subsidiaries in both the
U.S. and abroad. One of WB's wholly-owned foreign subsidiaries, Kasamatsu Industries, is
based in Japan and manufactures a hugely successful line of trading cards, toys, and other
related products. All of Kasamatsu's operations and sales take place in Japan, and the
corresponding transactions are denominated in Japanese yen. Additionally, Kasamatsu's books
and records are all maintained in yen. WB reports its earnings in U.S. dollars. The history of the
exchange rate between the dollar and the yen over the last two years is presented in the
following table. Figures are presented in Yen/dollars.

Yen/Dollar Exchange Rate

December 31, 2005 150

December 31, 2004 130

2005 Average 140

2004 Average 120

Exchange rate on date that 2005 dividends were

145
declared by Kasmatsu

Exchange rate on date of stock issue and acquisition of

100
fixed assets.

Ashley Jameson is an analyst with Henderson-Wells, an investment banking firm in New York,
and is the chief analyst covering WB. She believes that the enormous success of the trading
cards has contributed greatly to WB's bottom line. However, she believes that this effect may be
misstated in the company's financial statements because of the recent volatility in exchange
rates. Many analysts at other major investment banking firms have been raising their ratings on
WB because of the recent earnings growth. Jameson, however, wants to be absolutely certain
that these results are accurate and fully attributable to Kasamatsu's hot new product and not a
result of an exchange rate fluctuation. The following are the financial statements of Kasamatsu,
stated in thousands of yen.

Financial Statements for Year Ending December 31, 2005

(in thousands of yen)

Statement of Income and Retained Earnings

Sales 700,000

Expenses

Cost of Goods Sold (COGS) 280,000

 Depreciation 126,000

SG&A 77,000

Total Expenses 483,000

Earnings Before Taxes (EBT) 217,000

Income Tax Expense 98,000

Net Income 119,000

Retained Earnings: December 31, 2004 250,000

369,000

Dividends 58,000

Retained Earnings: December 31, 2005* 311,000

* Retained earnings on 12/31/2005 were US $2million

Balance Sheet

Assets

Cash and receivables 60,000

Inventory 180,000

Land 200,000

Fixed assets 346,000

Total assets 786,000

Liabilities and stockholders' equity

Liabilities 300,000

Capital stock 175,000

Retained earnings 311,000

Total liabilities and stockholders' equity 786,000

Question #115 - 116 of 127 Question ID: 1685458

Before Jameson can perform any financial statement analysis she needs to determine which
method WB uses to translate Kasamatsu's earnings into U.S. dollars (USD). Which of the
following is the most appropriate method to use?

A) The temporal method.

B) The current rate method.
C) First the temporal method, followed by the current rate method.

Question #116 - 116 of 127 Question ID: 1685459

Jameson must also determine how the fluctuation in the yen vs. the dollar has affected
Kasamatsu's earnings in the reporting currency. Which of the following best describes the effect
of changes in the yen/dollar rate has had on earnings in the reporting currency? Earnings have:

A) decreased because the yen is depreciating versus the USD.

B) increased because the yen is appreciating versus the USD.
C) increased because the yen is depreciating versus the USD.

Question #117 of 127 Question ID: 1685533

In a hyperinflationary economy, translation under the current rate method will most likely
result in relatively:

A) low balance sheet values for long term liabilities.

B) high balance sheet values for long term assets.
C) high translation gains.

Question #118 of 127 Question ID: 1685527

The Precision Screen Printers (PSP) Company has a foreign subsidiary, the Acer Tool & Die
Company, located in the country of Rolivia. The currency of Rolivia is the Chad. The balance
sheet and income statement of Acer Tool & Die Company for the year-ended December 31,
20X2, is shown below. The balance sheet has been restated using the U.S. dollar as the
functional currency.

Acer Tool & Die Company Balance Sheet As of December 31, 20X2

Chad Exchange Rate U.S. $

(millions) (Chad/US$) (millions)

Cash 20 0.25 $80

Accounts receivable 30 0.25 120

Inventory 100 0.3125 320

Fixed assets (net) 500 0.3333 1,500

Total assets 650 $2,020

Accounts payable 50 0.25 $200

Capital stock 380 0.3333 1,140

Retained earnings 220 -- 680

Total liabilities and equity 650 $2,020

Acer Tool & Die Company Income Statement

For year ending December 31, 20X2

(Amounts in millions of Chad)

Revenues 1,000

Cost of sales 700

Depreciation expense 50

Selling expense 30

Translation gain (or loss)

Net income 220

The exchange rate at the beginning of 20X2 was 0.3333 Chad/US$. The exchange rate at the
end of 20X2 was 0.25 Chad/US$. The average rate for 20X2 is 0.3125 Chad/US$. Beginning
inventory is 90 Chad, which was translated to $270 on the 20X1 balance sheet. Acer Tool & Die
uses FIFO inventory valuation and depreciates fixed assets using the straight-line method.

Purchases occurred evenly throughout the year. Assume that retained earnings at year-end
20X1 were zero, the historical exchange rate for depreciation is 0.333, and no dividends were
paid during 20X2.

Using the current rate method for the Acer Tool & Die Company, what is the value of total
assets after translation?

A) $1,950.
B) $2,600.
C) $2,020.

Wasson Brothers (WB) is a large U.S. based conglomerate with many subsidiaries in both the
U.S. and abroad. One of WB's wholly-owned foreign subsidiaries, Kasamatsu Industries, is
based in Japan. Kasamatsu manufactures a hugely successful line of trading cards, toys, and
related products. All of Kasamatsu's operations and sales take place in Japan, and the
corresponding transactions are denominated in Japanese yen. Additionally, Kasamatsu's books
and records are all maintained in yen. WB reports its earnings in U.S. dollars. The history of the
exchange rate between the dollar and the yen over the last two years is presented in the
following table. Figures are presented in yen/$.

Yen/Dollar Exchange Rate

December 31, 2013 150

December 31, 2012 130

2013 Average 140

2012 Average 120

Exchange rate on date that 2013 dividends were

145
declared by Kasamatsu
Exchange rate on date of stock issue and acquisition of
100
fixed assets.

Shelly Jameson is an analyst with Henderson-Wells, an investment banking firm in New York,
and is the chief analyst covering WB. She believes that the enormous success of the trading
cards has contributed greatly to WB's bottom line. However, Jameson believes that this effect
may be misstated in the company's financial statements because of the recent volatility in
exchange rates. Many analysts at other investment banking firms have been raising their
ratings on WB because of the recent earnings growth. Jameson, however, wants to be
absolutely certain that these results are accurate and fully attributable to Kasamatsu's hot new
product and not a result of an exchange rate fluctuation. The following are the financial
statements of Kasamatsu, stated in thousands of yen.

Financial Statements for Year Ending December 31, 2013

(in thousands of yen)

Statement of Income and Retained Earnings

Sales 700,000

Expenses

Cost of Goods Sold (COGS) 280,000

Depreciation 126,000

SG&A 77,000

Total Expenses 483,000

Earnings Before Taxes (EBT) 217,000

Income Tax Expense 98,000

Net Income 119,000

Retained Earnings: December 31, 2012 250,000

369,000

Dividends 58,000

Retained Earnings: December 31, 2013 * 311,000

* Retained earnings on 12/31/2013 were US $2 million

Balance Sheet

Assets

Cash and receivables 60,000

Inventory 180,000

Land 200,000

Fixed assets 346,000

Total assets 786,000

Liabilities and stockholders' equity

Liabilities 300,000

Capital stock 175,000

Retained earnings 311,000

Total liabilities and

786,000
stockholders' equity

Question #119 - 122 of 127 Question ID: 1685446

Jameson would like to examine WB's group accounts. What is the most appropriate exchange
rate (yen/$) to use in translating Kasamatsu's reported dividends into U.S. dollars?

A) 150.
B) 140.
C) 145.

Question #120 - 122 of 127 Question ID: 1685447

If Jameson wishes to convert any of the figures on Kasamatsu's Income Statement from yen to
dollars, she should most appropriately use which of the following exchange rates (yen/$)?

A) 140.
B) 145.
C) 150.

Question #121 - 122 of 127 Question ID: 1685448

Jameson has finally completed translating all the necessary figures into dollars and now wants
to compute by how much WB's reported sales in dollars will change due to Kasamatsu's sales.
Which of the following is closest to the amount of sales that WB will report as a result of
Kasamatsu's operations (in thousands of dollars)?

A) $4,828.
B) $5,000.
C) $4,667.

Question #122 - 122 of 127 Question ID: 1685449

Before Jameson can perform any financial statement analysis, she wants to determine which
method WB uses to translate Kasamatsu's earnings into U.S. dollars (USD). Which of the
following is the most accurate translation method and reasoning? WB should translate
Kasamatsu's earnings using the:

A) current rate method because the local currency is the USD.

B) temporal method because the local currency differs from the functional currency.
C) current rate method because the functional currency is the yen.

Question #123 of 127 Question ID: 1685451

Which of the following general statements is most accurate with respect to the current rate
method? Revenues:

are translated at the average rate while operating expenses are translated at the
A)
current rate.
B) and operating expenses are translated at the average rate.
C) and operating expenses are translated at the current rate.

Question #124 of 127 Question ID: 1685416

Which of the following statements is least accurate regarding the use of the temporal method
for foreign exchange accounting?

Under the temporal method, the foreign exchange gain or loss is placed on the balance
A)
sheet in the equity section.
B) All nonmonetary assets and liabilities are translated at the historical rate of exchange.
C) All monetary assets are translated at the current rate of exchange.

Question #125 of 127 Question ID: 1685415

Which of the following statements regarding the translation of a foreign subsidiary into the
reporting currency is most accurate?

If the reporting currency is the functional currency, the temporal method is applied
A)
and exposure is equal to net monetary assets.
A multinational firm with small liability balances generally has minimal foreign currency
B)
exposure on its balance sheet.
If the functional currency is equal to the local currency, exchange gains and losses on
C)
translation will be recognized in the income statement.
Question #126 of 127 Question ID: 1685453

Which of the following statements is NOT a characteristic of the current rate method of
accounting for foreign currency translation?

A) Nonmonetary liabilities are translated at the historical rate of exchange.

All asset accounts are translated at the current rate of exchange as of the balance
B)
sheet date.
The common stock account is translated at the rate of exchange that applied when the
C)
equity was issued.

Question #127 of 127 Question ID: 1685424

Which of the following general statements is CORRECT with respect to the temporal method?
Monetary assets are:

A) translated at the current rate.

B) not translated.
C) translated at the average rate.
Question #1 - 4 of 127 Question ID: 1685518

As Heltzel is translating the balance sheet and income statement, which of the following are
closest to the values Heltzel determines for revenues and accounts payable for 20X8?

Accounts
Revenues
Payable

A) £41,667 £3,333

B) £44,118 £3,333

C) £44,118 £3,529

Explanation

Since the British pound is the functional currency, the temporal method should be used.
Under both the current rate and temporal methods, revenues are translated at the average
rate. The value Heltzel will calculate for revenues is $75,000 / $1.70 = £44,118.

Also, under both the temporal and current rate methods, monetary assets and liabilities are
calculated using the current exchange rate. The value Heltzel will calculate for accounts
payable will be $6,000 / $1.80 = £3,333.

(Module 9.6, LOS 9.f)

Question #2 - 4 of 127 Question ID: 1685519

If Wilson assumes the numbers in Exhibit 2 are correct, the remeasurement gain/loss for 20X8
will be closest to:

A) £1,012.
B) £285.
C) –£77.

Explanation
 Net income = ending retained earnings − beginning retained earnings + dividends
paid.

Net income = 7323 − 5150 + 2250 = £4423.

Remeasurement gain = net income − net income before remeasurement gain =

4423 − 4138 = £285.

(Module 9.4, LOS 9.e)

Question #3 - 4 of 127 Question ID: 1685520

Which of the following treatments is most likely correct regarding the items outlined in Heltzel's
concern?

A) The balance should be translated at the historic rate as it is a non-monetary item.

B) The balance should be translated at the historic rate as it is a monetary item.
C) The balance should be translated at the closing rate as it is a monetary item.

Explanation

Deferred revenue is a non-monetary liability and should be translated at the historic rate.

(Module 9.4, LOS 9.e)

Question #4 - 4 of 127 Question ID: 1685521

Which of the following statements regarding the treatment of subsidiaries in a hyper-

inflationary environment under U.S. GAAP is most likely correct?

The subsidiary should be translated using the temporal method regardless of the
A) level of autonomy, and non-monetary items restated for the effect of local
inflation.
The subsidiary should be translated using the temporal method regardless of the
B)
level of autonomy, and then no further restatement is required.
The subsidiary should be translated using the current rate method regardless of
C) the level of autonomy, and non-monetary items restated for the effect of local
inflation.
Explanation

U.S. GAAP requires the use of the temporal method.

(Module 9.4, LOS 9.e)

Question #5 of 127 Question ID: 1685419

Under the current rate method, common stock is translated by using the:

A) exchange rate as of the balance sheet date.

B) present value of weighted average rate.
C) rate that existed when the equity was issued.

Explanation

The historical rate is used.

(Module 9.3, LOS 9.e)

Question #6 of 127 Question ID: 1685538

A hyperinflationary economy is typically defined as one that has:

A) cumulative inflation that exceeds 100% over a three-year period.

B) cumulative inflation that exceeds 100% over a twelve-year period.
C) an inflation rate that exceeds 10% per year for three consecutive years.

Explanation

The typical definition is that cumulative inflation exceeds 100% over a three-year period.

(Module 9.7, LOS 9.g)

Question #7 of 127 Question ID: 1685477

Hann Company is a U.S. multinational firm with operations in several foreign countries. Hann
has a 100 percent stake in a French subsidiary. The foreign subsidiary's local currency has
appreciated against the U.S. dollar over the latest financial statement reporting period. In
addition, the French firm accounts for inventories using the FIFO inventory cost-flow
assumption. The net profit margin as computed under the current rate method would most
likely be:

A) lower than the same ratio computed under the temporal method.
B) either higher or lower than the same ratio computed under the temporal method.
C) higher than the same ratio computed under the temporal method.

Explanation

The foreign currency gain or loss appears on the income statement under the temporal
method. Hence, to make any determinations regarding the movements of this ratio, we need
more information regarding the net monetary asset or liability position as of both the
beginning and ending balance sheet date.

(Module 9.6, LOS 9.f)

Question #8 of 127 Question ID: 1685500

Which example least accurately describes pure balance sheet and income statement ratios?

A) All pure balance sheet ratios are affected by the all-current translation method.
B) The current ratio is a pure balance sheet ratio.
When multiplying both the numerator and denominator by the current exchange
C)
rate, the current rate is cancelled.

Explanation

All pure balance sheet ratios are unaffected by the all-current translation method.

(Module 9.6, LOS 9.f)

Question #9 of 127 Question ID: 1685456

An important distinction between the temporal method and the current rate method is that:
 the current rate method results in an adjustment to the equity account on the
A) balance sheet. The temporal method results in a gain or loss appearing on the
income statement.
monetary assets and liabilities are remeasured (temporal method) at historical
B)
rates but translated (current rate method) at current rates.
depreciation and cost of goods sold (COGS) are a function of the current rate
C) under translation (current rate method), but a function of the average rate under
remeasurement (temporal method).

Explanation

The current rate method results in an adjustment to the equity account on the balance sheet.
The temporal method results in a gain or loss appearing on the income statement.
Depreciation and COGS are a function of the average rate under the current rate method, but
a function of the historical rate under the temporal method. Monetary assets and liabilities
are use the current rates under both methods.

(Module 9.4, LOS 9.e)

Question #10 of 127 Question ID: 1685494

The Herlitzka Company, a U.S. multinational firm, has a 100% stake in a Swiss subsidiary. The
Swiss franc (SF) has been determined to be the functional currency. All the common stock of
the subsidiary was issued at the beginning of the year and the subsidiary uses the FIFO
inventory cost-flow assumption. In addition, the value of the SF is as follows:

Beginning of year $0.5902

Average throughout the year $0.6002

End of year $0.6150

The SF-based balance sheet and income statement data for the Swiss subsidiary are as follows:

Accounts receivable = 3,000

Inventory = 4,000

Fixed assets = 12,000

Accounts payable = 2,000

Long-term debt = 5,000

Common stock = 10,000

Retained earnings = 2,000

Net income = 2,000

The translated value of common stock and long-term debt respectively are:

A) $5,902 and $3,001.

B) $6,150 and $3,075.
C) $5,902 and $3,075.

Explanation

The basis for using the current rate method is when Functional Currency is NOT the same as
Parent's Presentation (reporting) Currency. The basis for using the temporal method is when
Functional Currency = Parent's Presentation Currency.

Since the SF is the functional currency, use the current rate method. Common stock is
translated at the historical rate which is the rate that applied when the transaction was made
or $0.5902 and long-term debt is translated at the current rate of $0.615. 10,000 × 0.5902 =
$5,902 for common stock and 5000 × 0.6150 = $3,075 for long term debt.

(Module 9.6, LOS 9.f)

Question #11 of 127 Question ID: 1685450

Which of the following statements regarding the foreign currency translation under US GAAP is
least accurate? The functional currency is the:

A) subsidiary's local currency for self-contained, independent foreign subsidiaries.

B) parent firm's home currency for self-contained independent foreign subsidiaries.
parent firm's home currency if the foreign subsidiary operates in a country with
C)
high inflation.

Explanation

The basis for using the current rate method is when Functional Currency is NOT the same as
Parent's Presentation (reporting) Currency. The basis for using the temporal method is when
Functional Currency = Parent's Presentation Currency.

This statement is incorrect, both remaining statements are correct regarding rules that
govern the determination of the functional currency of subsidiaries.

(Module 9.4, LOS 9.e)

Question #12 - 15 of 127 Question ID: 1685441

What is the amount of income Seven Seas should report from its South Seas subsidiary?

A) 34,500 USD.
B) 31,400 USD.
C) 27,600 USD.

Explanation
The current rate method is used when the Functional Currency is NOT the same as the
Parent's Presentation (reporting) Currency. The temporal method is used when the
Functional Currency = the Parent's Presentation Currency.

LC Conversion USD
Revenues 520,000 /2.20 236,364 average rate
COGS 225,000 /2.20 102,273 average rate
SG&A 100,000 /2.20 45,455 average rate
Depreciation 80,000 /2.20 36,364 average rate
Income Taxes 46,000 /2.20 20,909 average rate
Net Income 69,000 31,364

(Module 9.4, LOS 9.d)

Question #13 - 15 of 127 Question ID: 1685442

The currency translation adjustment that results from the translation of South Sea's data is
closest to?

Zero because there is no currency translation adjustment under the current rate
A)
method.
B) −3,300 USD.
C) 21,600 USD.

Explanation
 LC Conversion USD
Cash 25,000 /2.00 12,500 current rate
Accounts Receivable 30,000 /2.00 15,000 current rate
Inventory 35,000 /2.00 17,500 current rate
Net Fixed Assets 500,000 /2.00 250,000 current rate

Total Assets 590,000 295,000

Accounts Payable 20,000 /2.00 10,000 current rate

Long Term Debt 100,000 /2.00 50,000 current rate
Common Stock 250,000 /2.50 100,000 historical rate
Retained Earnings 220,000 113,364 Note 1
Translation Adjustment 21,636 plug
Total Liabilities & Equity 590,000 295,000
Note 1: Ending RE = Beginning RE (given USD 90,000) + NI (calculated 31,364) – Div (16000/2 =
8000) = USD 113364

(Module 9.4, LOS 9.d)

Question #14 - 15 of 127 Question ID: 1685443

If the temporal method is used, the retaining earnings is closest to:

A) 21,600 USD.
B) 120,800 USD.
C) 90,000 USD.

Explanation
The retained earnings value is the plug figure. The value of total assets is $280,813.
Subtracting the accounts payable, long-term debt, and common stock from the total assets
leaves $120,813.

LC Conversion USD
Cash 25,000 /2.00 12,500 current rate
Accounts Receivable 30,000 /2.00 15,000 current rate
historical rate for
Inventory 35,000 /2.30 15,217
inventory
historical rate for fixed
Net Fixed Assets 500,000 /2.10 238,095
assets

Total Assets 590,000 280,813

Accounts Payable 20,000 /2.00 10,000 current rate

Long Term Debt 100,000 /2.00 50,000 current rate
Common Stock 250,000 /2.50 100,000 historical rate
280,813 − 10,000 −
Retained Earnings 220,000 120,813
50,000 − 100,000
Total Liabilities &
590,000 280,813
Equity

(Module 9.4, LOS 9.d)

Question #15 - 15 of 127 Question ID: 1685444

If the functional currency is the USD, then the net income before a translation gain/loss is
closest to:

A) 8,000 USD.
B) 4,700 USD.
C) 34,100 USD.

Explanation
Adjust the income statement by the appropriate rates. For COGS and depreciation, historical
rates were given. Average rate is used for all others.

LC Conversion USD
Revenues 520,000 /2.20 236,364 average rate
historical rate
COGS 225,000 /2.30 97,826
for COGS
SG&A 100,000 /2.20 45,455 average rate
historical rate
Depreciation 80,000 /2.10 38,095
for depreciation
Income Taxes 46,000 /2.20 20,909 average rate
Net Income Before
Translation 69,000 34,079
Gain/Loss

(Module 9.4, LOS 9.d)

Question #16 of 127 Question ID: 1685492

Which of the following statements concerning the translation of a subsidiary's financial

statement and the subsidiary's ratios is least accurate?

Ratios calculated under the current rate method will not differ from those
A)
calculated under the temporal method.
The subsidiary's ratios in the local currency will differ from ratios calculated after
B)
translation.
C) The statement of cash flows is not affected by the choice of translation.

Explanation

Ratios calculated under the current rate method will differ from those calculated under the
temporal method.

(Module 9.6, LOS 9.f)

Question #17 of 127 Question ID: 1685493

The Schuldes Company had the following reported assets in euros at historical cost for the
period ending December 31, 2005.

Cash 134

Accounts receivable 270

Inventory 404

Net fixed assets 1347

Total assets 2155

The exchange rate per euro was $0.8734 on January 1, 2005 and $0.9896 on December 31,
2005. The average exchange rate for the year 2005 was $0.8925. The total assets of Schuldes
using the current rate method are:

A) $2,178.
B) $2,133.
C) $1,923.

Explanation

With the current rate method all balance sheet items except common stock use the current
exchange rate to translate the functional currency into the reporting currency.

2155 × $0.9896 = $2,133.

(Module 9.6, LOS 9.f)

Question #18 of 127 Question ID: 1685540

Which translation method should be used under a hyperinflationary economy when using U.S.
GAAP?

Monetary/non-monetary, because all monetary accounts are translated at the

A)
historical rate.
All-current, because dividends are translated at the rate that applied when they
B)
were issued.
 Temporal, because all non-monetary accounts are re-measured at the historical
C)
rate.

Explanation

The temporal method is more appropriate because all non-monetary accounts are
remeasured at the historical rate. Under IFRS, the financials would be restated for inflation,
and then translated under the current rate method.

(Module 9.7, LOS 9.g)

Question #19 of 127 Question ID: 1685414

Which of the following general statements is most accurate with respect to the temporal
method? Nonmonetary assets are translated at:

A) the current rate.

B) historical rates at the time of the transaction.
C) the average rate during the year.

Explanation

As a general rule in using the temporal method, nonmonetary assets are translated using the
historical rate at the time of the transaction.

(Module 9.3, LOS 9.e)

Question #20 of 127 Question ID: 1685490

Which of the following statements is most accurate concerning foreign currency translation?

In the case in which a firm uses first in, first out (FIFO) inventory valuation, if the
A) local currency depreciates the cost of good sold under the temporal method is less
than the cost of goods sold using the current rate method.
The receivables turnover ratio is identical under both the temporal method and
B)
the current rate method.
In the case of an appreciating currency, the fixed asset turnover will be lower
C)
under the temporal method, as compared to the current rate method.
Explanation

The receivables turnover (sales / receivables) is unaffected because both methods translate
sales at the average rate and accounts receivable at the current rate.

When using FIFO and the temporal method we assume that the appropriate rates to use for
cost of goods sold (COGS) are the older historical rates. The average rate is used for COGS
under the current rate method. If the local currency depreciates, COGS would be higher
under the temporal method.

With an appreciating currency the fixed asset turnover ratio (sales / fixed assets) will be
higher using the temporal method because the temporal method uses the historical rate for
fixed assets whereas the current rate method uses the current rate. They both use the same
average rate for sales.

(Module 9.6, LOS 9.f)

Question #21 of 127 Question ID: 1685461

Global International Corp. (GIC) has three subsidiaries: GIC Europe whose local currency is the
euro and whose functional currency is the euro; GIC China whose local currency is the yuan and
whose functional currency is the Hong Kong dollar; and GIC Bahamas whose local currency is
the Bahamian dollar and whose functional currency is the U.S. dollar. GIC's reporting currency
is the U.S. dollar. Which conversion methods should be used by GIC for each of its subsidiaries?

The financial data for all three subsidiaries should be remeasured under the
A)
temporal method.
GIC Europe’s data should be translated under the current rate method; GIC China’s
data should be remeasured under the temporal method into Hong Kong dollars,
B) and then translated under the current rate method into U.S. dollars; and GIC
Bahamas’ data should be remeasured under the temporal method into U.S.
dollars.
GIC Europe’s data should be remeasured under the temporal method; GIC China’s
data should be remeasured under the temporal method into Hong Kong dollars,
C) and then translated under the current rate method into U.S. dollars; and GIC
Bahamas’ data should be translated under the current rate method into U.S.
dollars.

Explanation
The basis for using the current rate method is when Functional Currency is NOT the same as
Parent's Presentation (reporting) Currency. The basis for using the temporal method is when
Functional Currency = Parent's Presentation Currency.

GIC Europe's data should be translated under the current rate method; GIC China's data
should be remeasured under the temporal method into Hong Kong dollars, and then
translated under the current rate method into U.S. dollars; and GIC Bahamas' data should be
remeasured under the temporal method into U.S. dollars.

(Module 9.4, LOS 9.e)

Question #22 of 127 Question ID: 1685479

The Herlitzka Company, a U.S. multinational firm, has a 100% stake in a Swiss subsidiary. The
Swiss franc (SF) has been determined to be the functional currency. All the common stock of
the subsidiary was issued at the beginning of the year and the subsidiary uses the FIFO
inventory cost-flow assumption. In addition, the value of the SF is as follows:

Beginning of year $0.5902

Average throughout the year $0.6002

End of year $0.6150

The SF-based balance sheet and income statement data for the Swiss subsidiary are as follows:

Accounts receivable = 3,000

Inventory = 4,000

Fixed assets = 12,000

Accounts payable = 2,000

Long-term debt = 5,000

Common stock = 10,000

Retained earnings = 2,000

Net income = 2,000

The translated value of accounts receivable and inventory respectively are:

A) $1,801 and $2,401.

B) $1,845 and $2,401.
C) $1,845 and $2,460.

Explanation

The basis for using the current rate method is when Functional Currency is NOT the same as
Parent's Presentation (reporting) Currency. The basis for using the temporal method is when
Functional Currency = Parent's Presentation Currency.

Since the SF is the functional currency, then the current rate method is employed to translate
the SF amounts into USD. Hence, A/R = 0.615 × 3,000 = $1,845 and 0.615 × 4,000 = $2,460.

(Module 9.6, LOS 9.f)

Question #23 of 127 Question ID: 1685412

Edmonton Oilfield Supply has made an equipment sale in Venezuela in the amount of VEF
15,000,000. On the day of the sale, the exchange rate is 1.7519 VEF per 1 Canadian dollar. 90
days later, when the Venezuelan firm pays for the equipment, the exchange rate is 1.6326. As a
result of the change in the exchange rate, Edmonton will recognize a:

A) gain of $625,666.
B) gain of $1,096,104.
C) loss of $1,789,500.

Explanation

On the day of the sale, Edmonton will record an account receivable of 15m/1.7519 =
$8,562,133. When the payment is received and converted to CAD, the realized amount will be
15m/1.6326 = $9,187,799. As a result of the appreciating VEF, Edmonton will realize a gain of
$9,187,799 − 8,562,133 = CAD 625,666.

(Module 9.2, LOS 9.c)

Question #24 of 127 Question ID: 1685468

Which of the following statements about the methods of currency translation accounting least
accurately identifies a plug figure that makes the accounting equation balance?

A) Under the Monetary/Non-Monetary Method, common stock is the plug.

B) Under the Current Rate Method, cumulative translation adjustment is the plug.
C) Under the Temporal Method, retained earnings is the plug.

Explanation

The Monetary/Non-Monetary Method is not addressed in the CFA curriculum. Under the
Temporal Method retained earnings is a plug, while under the Current Rate Method the
cumulative translation adjustment is a plug.

(Module 9.5, LOS 9.e)

Question #25 - 26 of 127 Question ID: 1685487

What is Acer Tool & Die's cost of sales in U.S. dollars using the temporal method?

A) $2,242.00
B) $2,222.00
C) $2,240.00

Explanation

Purchases = COGS − Beginning inventory + ending inventory = 710 Chad

Chad Conversion US$

Beginning inventory 90 0.3333 $270
Purchases 710 0.3125 2,272
Ending inventory 100 0.3125 320
COGS 700 $2,222

(Module 9.6, LOS 9.f)

Question #26 - 26 of 127 Question ID: 1685488

What is the remeasurement gain or loss for the period using the temporal method?

A) $52 loss.
B) $32 loss.
C) $50 gain.

Explanation

Remeasured income statement under temporal method:

Revenues = 1000/0.3125 = 3200

COGS = 2222 (from previous question)

Depreciation = 50/0.3333 = 150

Selling expense = 30/0.3125 = 96

Income before remeasurement gain = 3200 − 2222 − 150 − 96 = 732

Net income = 680 (= retained earnings at year end 2005 − retained earnings at year
end 2004)

Remeasurement gain/loss = 680 − 732 = -52

(Module 9.6, LOS 9.f)

Question #27 of 127 Question ID: 1685401

Which of the following statements describing the choice of the functional currency is least
accurate? The functional currency should be the same as the parent's reporting currency if the
subsidiary is:

highly integrated with the parent where the local currency, prices, and some costs
A)
are controlled or restricted.
B) mostly independent from the parent.
highly integrated with the parent where the local currency, prices, and some costs
C)
are not controlled or restricted.

Explanation

The preferred functional currency for subsidiaries that are mostly independent of the parent
is the local currency. For highly integrated subsidiaries (regardless of local conditions), or for
subsidiaries operating in high-inflation environments, the parent's reporting currency should
be used as the functional currency.

(Module 9.1, LOS 9.a)

Question #28 of 127 Question ID: 1685408

Sycamore Systems sold $5 million worth of software on December 1, 20X1 to a Japanese

company with payment denominated in Japanese yen to be received in two months.
Sycamore's year end is 31st December. Payment was received on 31 Jan 20X2.

Exchange rates (1 USD)

1 Dec 20X1 95

31 Dec 20X1 90

31 Jan 20X2 35

The amount of transaction gain/loss recorded by Sycamore on its income statement for the
year ending 31 Dec 20X1 is closest to:

A) loss of $300,000.
B) gain of $580,000.
C) gain of $280,000.

Explanation

Sale amount = $5 million × 95 = 475 million yen. Accounts receivable on sale date = $5 million.

Accounts receivable at year-end = 475 million yen/90 = $5.28 million

The appreciation of the yen resulted in a gain of $280,000 on the balance sheet date and
would be recognized in the income statement.

(Module 9.1, LOS 9.b)

Question #29 of 127 Question ID: 1685476

The Herlitzka Company, a U.S. multinational firm, has a 100 percent stake in a Swiss subsidiary.
The U.S. dollar (USD) has been determined to be the functional currency. All the common stock
of the subsidiary was issued at the beginning of the year and the subsidiary uses the weighted-
average inventory cost-flow assumption. In addition, the value of the SF is as follows:

Beginning of year $0.5902

Average throughout the year $0.6002

End of year $0.6150

The SF-based balance sheet and income statement data for the Swiss subsidiary are as follows:

Accounts receivable = 3,000

Inventory = 4,000

Fixed assets = 12,000

Accounts payable = 2,000

Long-term debt = 5,000

Common stock = 10,000

Retained earnings = 2,000

Net income = 2,000

The remeasured value of accounts receivable and inventory respectively are closest to:

A) $1,771 and $2,361.

B) $1,845 and $2,401.
C) $1,845 and $2,361.

Explanation

The basis for using the current rate method is when Functional Currency is NOT the same as
Parent's Presentation (reporting) Currency. The basis for using the temporal method is when
Functional Currency = Parent's Presentation Currency.

Since the USD is the functional currency, use the temporal method. Under the temporal
method, inventory is remeasured using the historical rate. However, our best guess of the
historical rate under the weighted average inventory cost-flow assumption is the average rate
through the period. Hence, A/R = $0.615 × 3,000 = $1,845 and Inventory = $0.6002 × 4,000 =
$2,401.

(Module 9.6, LOS 9.f)

Question #30 of 127 Question ID: 1685420

Which of the following currency translation methods is most appropriate in a hyperinflationary

economy under US GAAP? The:

current/non-current method since current assets and liabilities are translated at

A)
the current exchange rate.
current rate method since the translation gain or loss is shown on the income
B)
statement.
temporal method because all non-monetary accounts are translated at the
C)
historical rate.

Explanation

The temporal rate method is most appropriate because the value of non-monetary assets
and liabilities is translated at the historical rate. Under IFRS, the firm restates the financials
using an inflation index, and then translates using the current rate method.

(Module 9.3, LOS 9.e)

Question #31 of 127 Question ID: 1685534

Under U.S. GAAP, the temporal method is preferred to the current rate method in
hyperinflationary economies because the temporal method:

A) is easier to perform under hyperinflation.

B) provides better conversions of subsidiary revenues.
results in non-monetary asset values that are a better proxy for the economic
C)
values of those assets.

Explanation

The temporal method results in non-monetary asset values that are a better proxy for the
economic values of those assets than those obtained under the current rate method. Both
methods convert revenues and SG&A at the average rate so there could be no clear
preference when considering these measures.

(Module 9.7, LOS 9.g)

Question #32 of 127 Question ID: 1685454

At what exchange rate are revenues and accounts receivable translated under the current rate
method?

Accounts
Revenues
receivable

A) Average rate Current rate

B) Average rate Historical rate

C) Current rate Current rate

Explanation

Under the current rate method, revenues are translated at the average rate; accounts
receivable are translated at the current rate.

(Module 9.4, LOS 9.e)

Question #33 of 127 Question ID: 1685482

Where does the currency translation gain or loss appear in the financial statements under the
temporal method and the current rate method?

Temporal Current rate

method method

Income
A) Balance sheet
statement

Income
B) Balance sheet
statement

C) Balance sheet Balance sheet

Explanation
Currency translation gain or loss appears on the income statement under the temporal
method and the balance sheet under the current rate method.

(Module 9.6, LOS 9.f)

Question #34 of 127 Question ID: 1685467

Regarding the different methods of consolidating foreign subsidiaries' operating results, it

would be most accurate to state that:

under the temporal method, monetary assets and monetary liabilities are
A)
translated at a historical exchange rate.
under the current rate method, revenues and expenses are translated at the
B)
exchange rate that existed when the underlying transaction occurred.
under the current rate method, individual components of stockholder’s equity are
C)
translated at the current exchange rates.

Explanation

Under the current rate method, revenues and expenses are translated at the exchange rate
that existed when the underlying transaction occurred. (Though, for practical reasons, an
average exchange rate is often used to translate income items.) Under the temporal method,
monetary assets and monetary liabilities are translated at the current exchange rate. Under
the current rate method, while shareholder's equity (as a whole, including CTA) is translated
at the current rate, common stock is translated at historical exchange rate.

(Module 9.5, LOS 9.e)

Question #35 - 38 of 127 Question ID: 1685404

Regarding the statements made at the meeting:

A) Hirauye’s statement is incorrect; Wilkins’ statement is correct.

B) Hirauye’s statement is incorrect; Wilkins’ statement is incorrect.
C) Hirauye’s statement is correct; Wilkins’ statement is correct.

Explanation
The basis for using the current rate method is when Functional Currency is NOT the same as
Parent's Presentation (reporting) Currency. The basis for using the temporal method is when
Functional Currency = Parent's Presentation Currency.

Hirauye and Wilkins both make incorrect statements regarding local and functional
currencies. A foreign subsidiary may have a local currency but designate another currency as
its functional currency. The functional currency is defined as the currency of the primary
environment in which the subsidiary generates and expends cash, but the choice of the
functional currency is ultimately a function of management's judgment. Wilkins is also
incorrect because the rate of inflation does not necessarily have an impact on designated
currencies.

(Module 9.1, LOS 9.a)

Question #36 - 38 of 127 Question ID: 1685405

Hirauye is working on consolidating the financial statements of Molsan Industries' Japanese

subsidiary. Under SFAS 52, regarding Foreign Currency Translation, if:

more than half of the subsidiary's revenue is from Japanese sources, then the
A) results of the Singapore operation are translated into Japanese yen and then
translated into Canadian dollars.
management determines that the subsidiary's functional currency is the Japanese
B) yen, the results of the Singapore operation are first remeasured into Japanese yen
and then translated into Canadian dollars.
management determines that the subsidiary's functional currency is the Singapore
C) dollar, then the results of the Singapore operation are remeasured into Canadian
dollars.

Explanation

The functional currency is determined by management. Financial data are remeasured into
the functional currency chosen by management and then translated into the reporting
currency.

(Module 9.1, LOS 9.a)

Question #37 - 38 of 127 Question ID: 1685406

Ortiz had told the junior analysts to make sure they understand the different accounting rules
under SFAS 52. When referring to foreign exchange rates, the difference between
remeasurement and translation is that remeasurement:

refers to the conversion of local currency into the functional currency; translation
A)
is the conversion of the functional currency into the reporting currency.
and translation refer to the same process of translating the functional currency
B)
into the reporting currency.
is used to describe historical exchange rates while translation is used for current
C)
rates.

Explanation

Translation is between functional and reporting currency. Remeasurement occurs between

local and functional currencies.

(Module 9.1, LOS 9.a)

Question #38 - 38 of 127 Question ID: 1685407

Wilkins and Hirauye are working on constructing the consolidated statements for Neslarone.
They know that after they convert from Swiss Francs (CHF) to U.S. dollars (USD), they will be left
with a foreign currency adjustment that needs to be included on the financial statements. To
convert from CHF to USD, the analysts should use the:

current rate method and they should record the foreign currency adjustment on
A)
the balance sheet.
current rate method and they should record the foreign currency adjustment on
B)
the income statement.
temporal method and they should record the foreign currency adjustment on the
C)
income statement.

Explanation
Neslarone is based in Switzerland and generates the majority of its cash in CHF, meaning the
local and functional currencies are both CHF. The firm issues financial reports in USD, so the
dollar is the reporting currency. The process of converting from the functional currency to
the reporting currency is translation and the correct method to use is the current rate
method. When using the current rate method, the foreign currency adjustment is recorded in
the equity section of the balance sheet.

(Module 9.1, LOS 9.a)

Question #39 of 127 Question ID: 1685469

Gortal Inc., a U.S. company has a wholly owned subsidiary, Fortina GmBh, based in Germany.
The U.S. dollar has been appreciating relative to the Euro over the past year. The use of the
temporal method to translate a foreign subsidiary's financial statements to U.S. dollars will
most likely have which of the following effects on the fixed-asset turnover ratio (S/FA) relative to
what the ratio would have been without the effects of translation assuming no new fixed assets
were purchased throughout the year?

A) There will be no effect on the ratio.

B) The ratio will be higher.
C) The ratio will be lower.

Explanation

Since the dollar has appreciated, the local currency has depreciated, so each foreign currency
unit bought more dollars in the past relative to the present. Fixed assets are remeasured at
the historical rate and sales are remeasured at the average rate under the temporal method.
Since the historical rate is buying more dollars relative to the average rate, the denominator
is staying the same whereas the numerator is getting smaller. Thus, the ratio is lower.

(Module 9.6, LOS 9.f)

Question #40 of 127 Question ID: 1685542

Organic growth in sales is most accurately defined as growth in sales excluding the effects of:

A) acquisitions/divestitures only.
B) acquisitions/divestitures and currency value fluctuations.
C) currency value fluctuations.

Explanation

Organic growth in sales is defined as growth in sales excluding the effects of acquisitions/
divestitures and currency effects.

(Module 9.8, LOS 9.i)

Question #41 of 127 Question ID: 1685418

Which of the following general statements is CORRECT with respect to the temporal method?
Revenues and operating expenses (excluding COGS) are translated at the:

A) average rate.
B) historical rate.
C) current rate.

Explanation

As a general rule for the temporal method, all revenues and operating expenses (excluding
COGS) are translated using the average rate.

(Module 9.3, LOS 9.e)

Question #42 of 127 Question ID: 1685483

Which of the following ratios is unaffected by the choice between the current rate method and
the temporal method?

A) Inventory turnover.
B) Current ratio.
C) Quick ratio.

Explanation
All of the components of the quick ratio (cash and cash equivalents, accounts receivable, and
accounts payable) are converted at the same rate under both methods so the ratio is
unaffected by the method. The current ratio is the same as the quick ratio except it also
contains inventory which is translated at the historical rate with the temporal method and at
the current rate with the current rate method. Inventory turnover ratio and current ratio
both would be similarly affected as they rely on the value of inventory.

(Module 9.6, LOS 9.f)

Question #43 of 127 Question ID: 1685423

Each of the following items is considered a monetary asset or liability account under the
temporal method for foreign currency translation EXCEPT:

A) accounts payable.
B) long-term debt.
C) inventory.

Explanation

The monetary asset and liability accounts under the temporal method are cash, accounts
receivable, accounts payable, and long-term debt.

(Module 9.3, LOS 9.e)

Question #44 - 47 of 127 Question ID: 1685471

Giant Company should use the following method to reflect the results of Grande, Inc., in its
financial statements:

A) the temporal method followed by the current rate method.

B) the current rate method.
C) the temporal method.

Explanation
The basis for using the current rate method is when Functional Currency is NOT the same as
Parent's Presentation (reporting) Currency. The basis for using the temporal method is when
Functional Currency = Parent's Presentation Currency.

The temporal method is used when the functional currency is the parent's currency.

(Module 9.6, LOS 9.f)

Question #45 - 47 of 127 Question ID: 1685472

Which of the following statements regarding the current rate method is the most accurate?

This method is not typically used when the subsidiary is relatively independent of
A)
the parent.
B) Translation gains and losses are reported in equity.
C) Income statements items are translated at the current exchange rate.

Explanation

Under the current rate method, translation gains and losses are reported in equity in the CTA
account. This method is typically used when the subsidiary is relatively independent of the
parent. Revenues and expenses are translated at the average rate.

(Module 9.4, LOS 9.e)

Question #46 - 47 of 127 Question ID: 1685473

The translation gain or loss from the activities of Grande, Inc., should be reported in:

A) the statement of shareholder’s equity.

B) the statement of cash flows.
C) the income statement.

Explanation
Under the temporal method, translation gains and losses are included in the income
statement.

(Module 9.4, LOS 9.e)

Question #47 - 47 of 127 Question ID: 1685474

Revenues for 2001 translated into U.S. dollars amount to:

A) $6,000,000.
B) $7,800,000.
C) $6,600,000.

Explanation

Under the temporal method, revenues are translated at the average rate during the reporting
period.

60,000,000 × 0.11 = $6,600,000

(Module 9.4, LOS 9.e)

Question #48 of 127 Question ID: 1685539

(Assume U.S. GAAP for this question.) For a subsidiary in a hyperinflationary economy, the
functional currency should be the:

A) Local currency.
B) Parent's currency.
C) Subsidiary's operating currency.

Explanation

The functional currency should be the parent's currency. Under IFRS, the firm would restate
the financials for inflation, and then translate under the current rate method.

(Module 9.7, LOS 9.g)

Question #49 of 127 Question ID: 1685535

Which of the following asset or liability values is likely to be the most understated in a
hyperinflationary economy if translation occurs under the current rate method?

A) A plant purchased several years ago.

B) Dividends payable.
C) Accounts receivable.

Explanation

The accounts receivable and dividends payable will each have book values that are closer to
their market values than a plant purchased many years ago.

(Module 9.7, LOS 9.g)

Question #50 of 127 Question ID: 1685543

A company is exposed to foreign exchange risk due the impact of changes in currency values on
a:

A) company’s assets only.

B) company’s assets, liabilities, and future sales.
C) company’s assets and liabilities only.

Explanation

Foreign exchange risks include the impact of changes in currency values on assets and
liabilities of a business, as well as on future sales.

(Module 9.8, LOS 9.j)

Question #51 - 54 of 127 Question ID: 1685496

The first step in Jameson's analysis is to compute Kasamatsu's impact on WB's net income.
What is Kasamatsu's impact on WB's net income (in thousands dollars)?
A) $821.
B) $793.
C) $850.

Explanation

The basis for using the current rate method is when Functional Currency is NOT the same as
Parent's Presentation (reporting) Currency. The basis for using the temporal method is when
Functional Currency = Parent's Presentation Currency.

Because Kasamatsu is a wholly owned subsidiary of WB, all of its net income will be included
in WB's. Kasamatsu's local currency is also the functional currency, so the current rate
method should be used to translate the financial statements into U.S. dollars. The
appropriate exchange rate to use would be the average exchange rate for 2002, and no
adjustment needs to be made for the dividend. The calculation is:

119,000 / 140 = 850

Therefore, WB will report an additional $850,000 of net income as a result of their

subsidiary's operating results. Both remaining answers use incorrect exchange rates.

(Module 9.6, LOS 9.f)

Question #52 - 54 of 127 Question ID: 1685497

Jameson now computes the adjustment to WB's financial data due to Kasamatsu's payment of
dividends. What is the U.S. dollar amount of this adjustment (in thousands)?

A) $446.
B) $400.
C) $414.

Explanation

WB receives a cash dividend from their subsidiary. This dividend must be translated at the
prevailing exchange rate on the date the dividend is declared (145/$). $58,000 / 145 = 400.
Both remaining answers use incorrect exchange rates.

(Module 9.4, LOS 9.e)

Question #53 - 54 of 127 Question ID: 1685498

The carrying value of Kasamatsu's total assets on December 31, 2002, using the current rate
method of accounting for translations is:

A) $2,938.
B) $3,573.
C) $3,240.

Explanation

Under the current rate method, all balance sheet accounts, with the exception of equity, are
translated at the current rate. At the current rate of 150 under the current rate method, the
amount is: (486,000 + 50,000) / 150 = $3,573.

(Module 9.4, LOS 9.e)

Question #54 - 54 of 127 Question ID: 1685499

Having converted all of Kasamatsu's accounts using the current rate methods, Jameson is
curious to compare the difference between the temporal and current rate methods on balance
sheet accounts. The difference in translated fixed assets and long term debt respectively if
Jameson were to use the temporal method rather than the current rate method is:

Long-Term
Fixed Assets
Debt

A) $0 $0

B) $1620 $0

C) $1620 $121

Explanation

Fixed assets under the temporal method, are reported at historical translation rates. 486,000
/ 100 = $4,860. Under current rate, fixed assets are translated at the current rate (486,000 /
150) = $3,240, a difference of $1,620.

Even though it is a balance sheet account, under the temporal method, long term debt is
considered a monetary liability and is translated at the current rate. Under the current rate
method, long-term debt is also translated at the current rate, so the difference between the
two methods is $0.

(Module 9.4, LOS 9.e)

Question #55 of 127 Question ID: 1685537

In reality, what best describes the real value of non-monetary assets and liabilities in a
hyperinflationary environment?

A) All non-monetary accounts are re-measured at the current rate.

Typically not affected because their local currency-denominated values decrease to
B)
offset the impact of inflation.
Typically not affected because their local currency-denominated values increase to
C)
offset the impact of inflation.

Explanation

Typically not affected because their local currency-denominated values increase to offset the
impact of inflation (i.e., real estate values typically rise with inflation).

(Module 9.7, LOS 9.g)

Question #56 - 59 of 127 Question ID: 1685463

Assuming the current rate method is used to translate Continental's financial statements, as
compared to the local currency ratios, which of the following statements about translated
operating profit margin and long-term debt to equity ratios is correct?

A) Operating profit margin will be higher.

B) Long-term debt-to-equity ratio will be higher.
C) Neither ratio will change.

Explanation
Under the current rate method, all revenues and all expenses are translated at the average
rate. Consequently, the subtotals (gross profit, operating profit, and net profit) are translated
at the average rate. Translating the numerator (operating profit) and the denominator (sales)
at the same rate will have no impact on the ratio.

Under the current rate method, all assets and all liabilities are translated at the current rate.
In order for the balance sheet equation to balance, total shareholders' equity must also be
translated at the current rate. Translating the numerator (long-term debt) and the
denominator (shareholders' equity) at the same rate will have no impact on the ratio.

(Module 9.4, LOS 9.e)

Question #57 - 59 of 127 Question ID: 1685464

When stated in U.S. dollars, would Continental most likely report a higher fixed asset turnover
ratio and a higher quick ratio under the temporal method, as compared to the current rate
method?

A) Only the quick ratio will be higher under the temporal method.
B) Only fixed asset turnover will be higher under the temporal method.
C) Both ratios will be higher under the temporal method.

Explanation

Continental would report a higher fixed asset turnover ratio (sales/fixed assets) under the
temporal method because sales are translated at the same rate under both methods (the
average rate), but fixed assets would be translated at the lower historical rate (because the
euro is appreciating) under the temporal method. Therefore, the ratio will be higher.

Continental would not report a higher quick ratio under the temporal method. Actually, the
quick ratio would be the same under both methods. Continental's quick assets include cash
and accounts receivable. Quick assets and current liabilities are converted at the current rate
under both methods.

(Module 9.4, LOS 9.e)

Question #58 - 59 of 127 Question ID: 1685465

Which of the following statements about the temporal method and the current rate method is
least accurate?
 Subsidiaries whose operations are well integrated with the parent will generally
A)
use the current rate method.
Net income is generally more volatile under the temporal method than under the
B)
current rate method.
Subsidiaries that operate in highly inflationary environments will generally use the
C)
temporal method under U.S. GAAP.

Explanation

Subsidiaries whose operations are well integrated with the parent will generally use the
parent's currency as the functional currency. Remeasurement from the local currency to the
functional currency is done with the temporal method.

(Module 9.4, LOS 9.e)

Question #59 - 59 of 127 Question ID: 1685466

As compared to local currency ratios, which of the following are the most likely impacts on
gross profit margin and net profit margin, assuming the temporal method is used to remeasure
Continental's financial statements?

A) Both will be higher.

B) Higher net income, with a higher funded status.
C) Only net profit margin will be higher.

Explanation

Under the temporal method, sales are remeasured at the average rate, and cost of goods
sold is remeasured at the historical rate. Since the euro is appreciating relative to the dollar,
sales will be higher when stated in dollars. Because cost of goods sold is remeasured at the
historical rate, it does not reflect the appreciating euro. Therefore, appreciating sales,
without a corresponding increase in cost of goods sold, will result in higher gross profit
margin.

Under the temporal method, exposure is defined as the firm's net monetary asset or net
monetary liability position. Continental is holding net monetary assets (monetary assets
exceed monetary liabilities), and the position is increasing. Holding net monetary assets
when the euro is appreciating will result in the recognition of a gain in the income statement.
The gain results in higher net income and, thus, higher net profit margin.

(Module 9.4, LOS 9.e)

Question #60 - 63 of 127 Question ID: 1685523

With respect to the Canadian subsidiary, what method should be used to value its revenues,
what is the appropriate exchange rate, and what is the translated value (in USD)?

A) Temporal method, average rate, USD 34.0 million.

B) Current method, average rate, USD 34.0 million.
C) Current method, current rate, USD 33.0 million.

Explanation

The basis for using the current rate method is when Functional Currency is NOT the same as
Parent's Presentation (reporting) Currency. The basis for using the temporal method is when
Functional Currency = Parent's Presentation Currency.

Self-contained, independent subsidiaries reporting their results in the local currency that is
also the functional currency use the current method. Revenues under the current method are
translated using the average rate. Hence, 50 × 0.6803 = USD 34.0 million.

(Module 9.6, LOS 9.f)

Question #61 - 63 of 127 Question ID: 1685524

With respect to the Japanese subsidiary, what method should be used to value its accounts
receivable, what is the appropriate exchange rate, and what is the translated value (in USD)?

A) Temporal method, current rate, USD 11.5 million.

B) Current method, current rate, USD 11.5 million.
C) Current method, average rate, USD 12.3 million.

Explanation

Self-contained, independent subsidiaries reporting their results in the local currency that is
also the functional currency use the current method. Assets under the current method are
translated using the current rate. Hence, 1400 × 0.0082 = USD 11.5 million.

(Module 9.4, LOS 9.e)

Question #62 - 63 of 127 Question ID: 1685525

With respect to the European HQ subsidiary, what method should be used to value its SG&A
expenses, what is the appropriate exchange rate, and what is the translated value (USD)?

A) Current method, current rate, USD 216.7 million.

B) Current method, average rate, USD 206.4 million.
C) Temporal method, average rate, USD 206.4 million.

Explanation

Self-contained, independent subsidiaries reporting their results in the local currency that is
also the functional currency use the current method. Expenses under the current method are
translated using the average rate. Hence, 200 × 1.0318 = USD 206.4 million.

(Module 9.4, LOS 9.e)

Question #63 - 63 of 127 Question ID: 1685526

With respect to the British subsidiary, what method should be used to value its fixed assets,
what is the appropriate exchange rate, and what is the translated value (USD)?

A) Current method, current rate, USD 599.7 million.

B) Temporal method, historical rate, USD 547.7 million.
C) Current method, historical rate, USD 547.7 million.

Explanation

Subsidiaries reporting their results in the local currency that is NOT the functional currency
use the temporal method. Fixed assets under the temporal method are translated using the
historical rate. Hence, 370 × 1.4803 = USD 547.7 million.

(Module 9.4, LOS 9.e)

Question #64 - 67 of 127 Question ID: 1685513

Assuming closing retained earnings for the year 20X8 was $110, the translation gain on the
income statement would be:

A) $17.
B) $0.
C) $27.

Explanation

We need to complete our remeasurement of the income statement. Since beginning retained
earnings for the year were zero, we know that net income on the remeasured income must
be equal to ending retained earnings. The remeasurement gain or loss is the plug figure that
causes this to be the case.

Income (in SF thousands) December 31, 20X8

$'000
Sales 7,000 × 0.80 5,600
COGS Working 1 (5,440)
Gross Profit 160
Depreciation 100 × 0.77 (77)
Remeasurement gain (plug) 27
Net Income 110

Working 1 COGS (LIFO)

Step 1: Calculate purchases in SF:

Beginning inventory 500(given) + Purchases (plug) 6,800 – Ending Inventory 500(given) =

COGS 6,800

Step 2: Remeasure COGS:

Beginning Inventory 500 SF @ 0.77 = $385

(+) Purchases 6,800 SF @ 0.80 = $5,440
(–) Ending inventory 500 SF @ 0.77 = $385
(=) COGS $5,440

Note that the amount of inventory did not change in the period. Given that the firm uses a
periodic inventory system and LIFO, the same purchases would be included in both beginning
and ending inventory and therefore the same historic exchange rate is applied to both.
Purchases were made evenly throughout the period and therefore the average rate has been
applied.

(Module 9.6, LOS 9.f)

Question #65 - 67 of 127 Question ID: 1685514

The level of net fixed assets on the remeasured 20X8 balance sheet would be:

A) $480.
B) $510.
C) $462.

Explanation

Net fixed assets are considered non-monetary assets. For non-monetary assets, the temporal
method uses the historical rate: 600SF × 0.77$/SF = $462.

(Module 9.4, LOS 9.e)

Question #66 - 67 of 127 Question ID: 1685515

The level of retained earnings on the remeasured 20X8 balance sheet would be:

A) $101.
B) $305.
C) $85.

Explanation
To get this value, we need to finish remeasuring our balance sheet at the appropriate rates.
The retained earnings figure will be what makes the balance sheet balance.

Scud Co. Int'l

Balance Sheet (in SF thousands)

Dec. 31, 20X8 Remeasured $

Cash & A/R 600 × 0.85 = 510
Inventory 500 × 0.77 = 385
Net Fixed Assets 600 × 0.77 = 462
Total Assets 1,700 1,357
A/P 200 × 0.85 = 170
Long-term debt 100 × 0.85 = 85
Common Stock 1,300 × 0.77 = 1001
Retained Earnings 100 101
Total Liabilities and Owner's Equity 1,700 1,357

(Module 9.4, LOS 9.e)

Question #67 - 67 of 127 Question ID: 1685516

As compared to the local currency ratio, fixed asset turnover in the reporting currency would
most likely be:

A) higher.
B) lower.
C) the same.

Explanation

Fixed asset turnover is calculated as sales / average fixed assets. The numerator is translated
at the average rate during the year ($0.80/SF) while fixed assets are translated at historical
rate ($0.77/SF). Hence the reporting currency numerator will be higher resulting in a higher
fixed-asset turnover ratio.

(Module 9.4, LOS 9.e)

Question #68 of 127 Question ID: 1685485

Which of the following statements regarding the effects of translation on financial statement
items/ratios is most accurate?

Fixed assets are relatively overstated under the temporal method compared to the
A)
local currency if the local currency has appreciated.
Leverage is higher under the current rate method as compared to under the local
B)
currency.
Depreciation in the reporting currency under the current rate method is higher
C)
than under the temporal method if the local currency has appreciated.

Explanation

Fixed assets are relatively understated under the temporal method if the local currency
appreciates as they are translated at the weaker historic rate. The leverage ratio will be
unaltered under the current rate method as it is a pure balance sheet ratio and hence all
translated at the current rate.

(Module 9.6, LOS 9.f)

Question #69 - 72 of 127 Question ID: 1685503

Which of the following statements about the temporal method and the current rate method is
least accurate?

Subsidiaries whose operations are well integrated with the parent will generally
A)
use the current rate method.
Net income is generally more volatile under the temporal method than under the
B)
current rate method.
Subsidiaries that operate in highly inflationary environments will generally use the
C)
temporal method under U.S. GAAP.

Explanation

Subsidiaries whose operations are well integrated with the parent will generally use the
parent's currency as the functional currency. Remeasurement from the local currency to the
functional currency is done with the temporal method.

(Module 9.6, LOS 9.f)

Question #70 - 72 of 127 Question ID: 1685504

If Capriati uses the current rate method to translate Navratov's income statement, the net
profit margin will be:

A) 10.1%.
B) 11.7%.
C) 8.6%.

Explanation

The net profit margin is a pure income statement ratio, meaning it will be unaffected by the
application of the current rate method. The calculation is shown below:

Under the current rate method, all income statement accounts will be translated at the
average rate.

Revenue 7,400,000 $0.37 $2,738,000

Cost of Goods Sold (COGS) (5,200,000) $0.37 (1,924,000)
Depreciation (1,200,000) $0.37 (444,000)
Taxes (250,000) $0.37 (92,500)
Net Income 750,000 $0.37 $277,500

Note that under the current rate method, since all income statement accounts are translated
at the same average rate, you do not have to translate the income statement to get the
correct answer. (750,000 / 7,400,000) = 10.1%.

(Module 9.4, LOS 9.e)

Question #71 - 72 of 127 Question ID: 1685505

What is the difference in the translated receivables turnover ratio for Navratov Corp. between
the temporal and current rate methods? The receivables turnover rate is:

A) lower under the current rate method by 0.30x.

B) higher under the current rate method by 0.36x.
C) the same under both methods.
Explanation

The receivables turnover ratio is calculated as (sales / receivables). Under the both the
current rate and temporal methods, sales are translated at the average rate, while
receivables are translated at the current rate. Since both the sales and receivables
components are translated at the same rate, there will be no difference in the ratios between
the two methods.

(Module 9.4, LOS 9.e)

Question #72 - 72 of 127 Question ID: 1685506

What is the difference in the total asset turnover ratio for Navratov Corp. between the temporal
and current rate methods? The total asset turnover ratio is:

A) lower under the current rate method.

B) higher under the current rate method.
C) the same under both methods.

Explanation

The total asset turnover ratio = (sales / total assets)

We can see from the exchange rates that the Russian ruble is depreciating (it takes fewer
dollars to buy a ruble). With a depreciating local currency, sales are going to be the same
under either method, since sales are translated at the average rate. Assets on the other hand
will be higher under the temporal method, and lower under the current rate method. This is
because all assets are translated at the current rate under the current rate method (which
has the lower exchange rate), and at different rates under the temporal method (which is has
fixed assets converted at the higher historical rate). With the same numerator and lower
denominator, the current rate method will lead to the higher total asset turnover ratio.

(Module 9.4, LOS 9.e)

Question #73 - 76 of 127 Question ID: 1685426

To reflect the results of Grande, Inc., in its financial statements, it would be most appropriate
for Giant Company to use the:

A) current rate method followed by the temporal method.

B) current rate method.
C) temporal method.

Explanation

The current rate method is used when the Functional Currency is NOT the same as the
Parent's Presentation (reporting) Currency. The temporal method is used when the
Functional Currency = the Parent's Presentation Currency.

The current rate method is used when the local currency and functional currency are the
same.

(Module 9.4, LOS 9.d)

Question #74 - 76 of 127 Question ID: 1685427

The Net Income of Grande, Inc., expressed in U.S. dollars for the year ended December 31,
2012, is closest to:

A) $250,000.
B) $550,000.
C) $500,000.

Explanation

Using the current rate method, the income statement is translated using the average rate for
all income statement accounts: Sales − COGS − Depreciation = Net Income. (60,000,000 ×
$0.11) − (45,000,000 × $0.11) − (10,000,000 × $0.11) = $550,000.

(Module 9.4, LOS 9.d)

Question #75 - 76 of 127 Question ID: 1685428

The translation gain or loss from the activities of Grande, Inc., should be reported in the:

A) statement of cash flows.

B) income statement.
C) equity accounts.

Explanation
Under the current rate method, translation gains or losses are accumulated on the balance
sheet in the equity section.

(Module 9.4, LOS 9.d)

Question #76 - 76 of 127 Question ID: 1685429

Compared to the current ratio before translation, the current ratio after translation is most
likely to be:

A) lower.
B) the same.
C) higher.

Explanation

Translation of the local currency means the current rate method is applied. The current ratio
is current assets divided by current liabilities. The current assets and the current liabilities
are both translated at the current rate. This leads to the ratio remaining the same in terms of
both the local currency and the presentation currency.

(Module 9.4, LOS 9.d)

Question #77 of 127 Question ID: 1685480

Which of the following ratios is affected by translation under the current rate method?

A) Fixed asset turnover ratio.

B) Debt/Assets ratio.
C) Net profit margin.

Explanation

Recall that all pure income statements and balance sheet ratios are unaffected by translation
under the current rate method. The fixed asset turnover ratio is not a pure ratio; it consists
of an income statement measure (sales, translated at the average rate) and a balance sheet
measure (fixed assets, translated at the current rate).

(Module 9.6, LOS 9.f)

Question #78 of 127 Question ID: 1685478

Portinta Inc, a U.S. based pharmaceutical company, has a UK based subsidiary, Medaze plc. The
U.S. dollar has been appreciating relative to GBP over the past year. Using the current-rate
method to translate a foreign subsidiary's financial statements to U.S. dollars will most likely
have which of the following effects on the long-term debt to equity ratio relative to what the
ratio would have been without the effects of translation?

A) The ratio will be lower.

B) The ratio will be the same.
C) The ratio will be higher.

Explanation

Under the current rate method, both LTD and equity are translated at the current rate of
exchange. Hence, since the same rate is applied in both the numerator and denominator, the
ratio will not change.

Note: When equity is broken out into separate accounts, common stock is taken at the
historical rate. When taken as a whole, equity should be translated at the current rate. In this
case we are not given any information on the common stock amount, so we translate equity
at the current rate.

(Module 9.6, LOS 9.f)

Question #79 of 127 Question ID: 1685489

The U.S. dollar (i.e., the reporting currency) has been depreciating relative to the local currency
over the past year. The use of the current rate method to translate a foreign subsidiary's
financial statements to U.S. dollars will most likely have which of the following effects on return
on equity (ROE) based on ending equity relative to what the ratio would have been without the
effects of translation?

A) ROE will most likely decline.

B) The impact of the depreciation of the US dollar on ROE is indeterminate.
C) ROE will most likely rise.

Explanation
ROE = Net Income / Equity. Under the current rate method, the equity accounts as a whole
are translated at the current rate whereas net income is translated at the average rate. Since
the dollar is depreciating, each foreign currency unit is buying more dollars in the
denominator relative to the numerator of the equation. Hence, the denominator is increasing
and the ratio falls.

(Module 9.6, LOS 9.f)

Question #80 - 83 of 127 Question ID: 1685508

The amount of 20X6 cost of goods sold in USD is:

(Note: if needed, use $0.40 as the rate to convert 20X5 ending inventory)

A) $262,800,000.00
B) $270,000,000.00
C) $300,000,000.00

Explanation

The basis for using the current rate method is when Functional Currency is NOT the same as
Parent's Presentation (reporting) Currency. The basis for using the temporal method is when
Functional Currency = Parent's Presentation Currency. Note that the 15% inflation over three
years results in cumulative price increases of (1.153) – 1 = 52% over three years. U.S. GAAP's
definition of hyperinflation, requiring the use of the temporal method, is a cumulative three-
year rate exceeding 100%.

Because the operations are independent from the parent, the current rate method will be
used. Cost of goods sold should be accounted for at the average rate for the past year. The
amount of cost of goods sold is 0.45 × 600,000,000 = $270,000,000.

(Module 9.6, LOS 9.f)

Question #81 - 83 of 127 Question ID: 1685509

The value of December 31, 20X6, gross property, plant, and equipment reported in USD is:

A) $313,000,000.
B) $304,000,000.
C) $400,000,000.
Explanation

Because the operations are independent from the parent, the current rate method will be
used. Fixed assets should be accounted for at the current rate. The value is 0.5 × 800,000,000
= $400,000,000.

(Module 9.4, LOS 9.e)

Question #82 - 83 of 127 Question ID: 1685510

The value of December 31, 20X6, inventory reported in USD is:

A) $49,500,000.
B) $51,700,000.
C) $55,000,000.

Explanation

Because the operations are independent from the parent, the current rate method will be
used. Inventory should be accounted for at the current rate. The value is 0.50 × 110,000,000 =
$55,000,000.

(Module 9.4, LOS 9.e)

Question #83 - 83 of 127 Question ID: 1685511

The value of all financing debt (notes payable, current portion of long-term debt, and long-term
debt) on December 31, 20X6, reported in USD is:

A) $202,500,000.
B) $171,000,000.
C) $225,000,000.

Explanation

Because the operations are independent from the parent, the current rate method will be
used. All debt should be accounted for at the current rate. The value is 0.50 × 450,000,000 =
$225,000,000.

(Module 9.4, LOS 9.e)

Question #84 of 127 Question ID: 1685402

Which of the following statements regarding the functional currency is least accurate? The
functional currency:

A) is remeasured into the reporting currency under the temporal method.

is the currency of the primary economic environment in which the foreign
B)
subsidiary generates and expends cash.
C) is determined by management.

Explanation

The basis for using the current rate method is when Functional Currency is NOT the same as
Parent's Presentation (reporting) Currency. The basis for using the temporal method is when
Functional Currency = Parent's Presentation Currency.

The local currency is remeasured into the functional currency under the temporal method.
The functional currency is translated into the reporting currency using the current rate
method.

(Module 9.1, LOS 9.a)

Question #85 of 127 Question ID: 1685400

The local currency is:

the preferred functional currency for subsidiaries that are highly integrated with
A)
the parent.
B) translated into the functional currency under the current rate method.
C) the same as the functional currency under the current rate method.

Explanation

The local currency is best described as the currency of the country in which the foreign
subsidiary is located. If a subsidiary is highly integrated with its parent or operating in a high-
inflation environment, the functional currency is the parent's currency. Local currencies are
remeasured under the temporal method.

(Module 9.1, LOS 9.a)

Question #86 of 127 Question ID: 1685413

Which of the following situations does NOT require the use of the temporal method? The:

A) local currency is the functional currency.

B) foreign subsidiary is operating in a highly inflationary economy.
functional currency is some currency other that the local currency or the U.S.
C)
dollar.

Explanation

The basis for using the current rate method is when Functional Currency is NOT the same as
Parent's Presentation (reporting) Currency. The basis for using the temporal method is when
Functional Currency = Parent's Presentation Currency.

The temporal method is not required in the situation when the local currency is the
functional currency.

(Module 9.3, LOS 9.e)

Question #87 of 127 Question ID: 1685455

Which of the following statements regarding foreign currency translation are least accurate?
Under the:

current rate method, the foreign currency translation gain or loss appears on the
A)
parent firm's income statement.
temporal method, COGS and depreciation are remeasured using the historical
B)
rate.
C) temporal method, sales are remeasured using the average rate.

Explanation

Under the current rate method, the foreign currency translation gain or loss appears on the
parent firm's balance sheet in the equity accounts.

(Module 9.4, LOS 9.e)

Question #88 of 127 Question ID: 1685460

The U.S. Deter Company operates a subsidiary in the UK, and the functional currency is the
British pound. The subsidiary's 2001 income statement shows £500 of net income and a £50
dividend that was paid on December 31, when the exchange rate was $1.50 per pound. The
current exchange rate is $1.65 per pound, and the average rate is $1.58 per pound. What is the
change in retained earnings for the period in U.S. dollars under U.S. GAAP?

A) $715.
B) $750.
C) $725.

Explanation

The basis for using the current rate method is when Functional Currency is NOT the same as
Parent's Presentation (reporting) Currency. The basis for using the temporal method is when
Functional Currency = Parent's Presentation Currency.

Since the functional currency is the local currency, use the current rate method. The net
income is translated at the average rate, and dividends are translated at the rate that applied
when they were paid. Hence: 1.58(£500) − 1.50(£50) = $715.

(Module 9.4, LOS 9.e)

Question #89 of 127 Question ID: 1685421

Dave Iverson, CFA, is analyzing the recently released financial statement of Global Corp., a large
multinational manufacturing company with production facilities across Europe and Southeast
Asia. The company's choice of functional currency is not disclosed, but Iverson does notice that
Global Corp. does not have any cumulative translation adjustments (CTA) on its balance sheet.
Which of the following statements is most accurate based upon Iverson's observation?

The temporal method of foreign currency translation is used for at least some of
A)
its subsidiaries.
B) The temporal method of foreign currency translation is used exclusively.
C) The current rate method of foreign currency translation is used exclusively.

Explanation
The choice of functional currency is the determining factor as to which method of foreign
currency translation is utilized. If no CTA appears on the balance sheet, then the parent
currency must be the functional currency for all of the company's subsidiaries and only the
temporal method is used.

(Module 9.3, LOS 9.e)

Question #90 of 127 Question ID: 1685501

Which of the following measures is unaffected by the choice between translation under the
current rate method and remeasurement under the temporal method?

A) Cost of goods sold.

B) Tax expense.
C) Equity.

Explanation

Taxes are converted at the same rate (average rate) under both methods. Equity under the
temporal method is a mixed rate whereas under the current rate method it is at the current
rate. COGS under the temporal method is at the historical rate and under the current rate
method it is at the average rate.

(Module 9.6, LOS 9.f)

Question #91 of 127 Question ID: 1685452

Which of the following statements is least accurate regarding accounting for foreign currency
translations? The:

current rate method applies the current exchange rate to all balance sheet
A)
accounts.
current rate method applies the average exchange rate to all income statement
B)
accounts.
temporal method uses the historical exchange rate to translate non-monetary
C)
assets and liabilities into the currency of the country of the parent company.

Explanation
The current rate method applies the current exchange rate to all balance sheet accounts
except for common stock, which is translated at a historical rate.

(Module 9.4, LOS 9.e)

Question #92 - 95 of 127 Question ID: 1685436

On APJ's 2012 income statement, the level of sales in U.S. dollars would be closest to:

A) $1,985.
B) $1,272.
C) $1,377.

Explanation

The basis for using the current rate method is when Functional Currency is NOT the same as
Parent's Presentation (reporting) Currency. The basis for using the temporal method is when
Functional Currency = Parent's Presentation Currency.

Since the Australian dollar is the functional currency, use the current rate method. The items
in the income statement are translated at the average exchange rate. The average rate is (2.5
+ 3) / 2 = 2.75 Australian dollars per = US$.

Income Statement (in $)

Sales (3,500 / 2.75) $1,272

Costs (2,900 / 2.75) $1,055
Net Income $217

(Module 9.4, LOS 9.d)

Question #93 - 95 of 127 Question ID: 1685437

On APJ's 2012 balance sheet, the level of accounts receivable is U.S. dollars would be closest to:

A) $110.
B) $132.
C) $330.
Explanation

Since we are using the current rate method, all balance sheet accounts are translated at the
current exchange rate, except for the common stock account, which is translated at the
historical rate.

A/R: (330 / 3) = 110

(Module 9.4, LOS 9.d)

Question #94 - 95 of 127 Question ID: 1685438

For APJ, the conversion to US$ is most likely to result in:

A) remeasurement gain.
B) cumulative translation adjustment loss.
C) cumulative translation adjustment gain.

Explanation

APJ shows a net asset:

Total assets A$1,530 / (3.00 A$/US$) = US$510

Total liabilities A$210 / (3.00 A$/US$) = US$70
Net asset = US$440

Because the functional currency is the local currency, the current rate method is used. When
we have a net asset balance sheet exposure, a weakening foreign currency will result in a
negative translation adjustment. AJP's net asset position will result in a cumulative
transaction adjustment loss as the foreign currency, the A$, is depreciating.

Exposure Foreign Currency

Current rate method: Appreciating Depreciating
Net assets Gain Loss
Net liabilities Loss Gain

(Module 9.4, LOS 9.d)

Question #95 - 95 of 127 Question ID: 1685439

If the functional currency is the reporting currency, the exposure and the foreign currency
movements are most likely to result in a:

A) remeasurement loss.
B) cumulative translation adjustment loss.
C) remeasurement gain.

Explanation

APJ has a net monetary asset exposure:

Total monetary assets: Cash + A/R A$771 / (3.00 A$/US$) = US$257

Total monetary liabilities: A$210 / (3.00 A$/US$) = US$70

Net monetary asset = US$187

Because the functional currency is the reporting currency, the temporal method is used and
this means there is remeasurement – a loss as the foreign currency, the A$, is depreciating.

Exposure Foreign Currency

Temporal method: Appreciating Depreciating
Net monetary assets Gain Loss
Net monetary liabilities Loss Gain

(Module 9.4, LOS 9.d)

Question #96 of 127 Question ID: 1685411

A Canadian firm owns a foreign subsidiary in the U.S. In 2002, sales were USD1,000,000 and the
USD/CAD exchange rate was 0.6329. In 2003, sales were also USD1,000,000 but the exchange
rate was 0.7484. What is the impact of the change in the value of the CAD on the parent
company's translated sales? Sales will:

A) decline by 15%.
B) decrease by 18%.
C) increase by 18%.
Explanation

While sales were flat at USD 1,000,000 in local currency terms, after translation the parent
firm would report sales of CAD 1,336,184 for 2003 (= USD 1,000,000 / 0.7484) versus sales of
CAD 1,580,028 for 2002 (= USD 1,000,000 / 0.6329). The 15% sales decline reported by the
Canadian firm (CAD 1,336,184 versus CAD 1,580,028) is a flow effect. Even though there was
no sales growth in the subsidiary, the parent firm still shows a 15% decrease in revenues
from the subsidiary due solely to exchange rate effects. Note that because the subsidiary
sales are constant the total exchange rate effect can be measured as (0.6329 / 0.7484) − 1 =
−0.15.

(Module 9.2, LOS 9.c)

Question #97 - 100 of 127 Question ID: 1685431

After remeasurement, depreciation will be closest to:

A) $85.
B) $80.
C) $77.

Explanation

Expenses related to assets translated at historical exchange rate, (e.g., cost of goods sold;
depreciation; amortization) are translated at historical rates under the temporal method.
Thus under the temporal method we should use the historical rate to remeasure
depreciation: 100SF × 0.77$/SF = $77.

(Module 9.4, LOS 9.d)

Question #98 - 100 of 127 Question ID: 1685432

The value of common stock on the 2013 balance sheet should be closest to:

A) $1,100.
B) $1,050.
C) $1,000.

Explanation
Common stock is translated using the historical rate under both the temporal method and
the current rate method: 1300SF × 0.77$/SF = $1001.

(Module 9.4, LOS 9.d)

Question #99 - 100 of 127 Question ID: 1685433

For Scud Co. under the temporal method, the monetary exposures and the foreign currency
movements resulted in a:

A) cumulative translation adjustment gain on the balance sheet.

B) remeasurement gain on the income statement.
C) remeasurement loss on the income statement.

Explanation

The net monetary exposure is the value of Cash & accounts receivables (A/R) minus Accounts
payable (A/P) and Long-term debt. This is Sf.600,000 – (Sf.200,000 +Sf.100,000) = Sf.300,000.
As the Swiss franc appreciates from 0.77 $/SF to 0.85 $/SF, there is a remeasurement gain
that is recorded as part of net income on the income statement.

Exposure Foreign Currency

Temporal method: Appreciating Depreciating
Net monetary assets Gain Loss
Net monetary liabilities Loss Gain

(Module 9.4, LOS 9.d)

Question #100 - 100 of 127 Question ID: 1685434

If Scud Co.'s functional currency is the Euro, then to adjust the currency exposure to the
parent's currency, the US$, start with the:

Swiss franc and use the temporal method to convert to the functional currency,
A) the Euro; then use the current rate method to convert to the presentation
currency, the US$.
 Swiss franc and use the current rate method to convert to the functional currency,
B) the Euro; then use the temporal method to convert to the presentation currency,
the US$.
Euro and use the current rate method to convert to the local currency, the Swiss
C) franc; then use the temporal method to convert to the presentation currency, the
US$.

Explanation

Because the functional currency is neither the local currency nor the presentation currency,
there will be two steps to the conversion. The functional currency is the intermediate step as
local currency is converted to the functional currency, and then to the presentation currency:
Sf → € → US$. The conversion from local currency to a functional currency uses the temporal
method; the conversion from functional currency to a presentation currency uses the current
rate method.

Translation: Remeasurement Temporal Current Rate & Temporal

Current Rate Method Method Methods

Presentation Currency Presentation Currency Presentation Currency

=
Functional Currency Functional Currency Functional Currency
=
Local Currency Local Currency Local Currency

(Module 9.4, LOS 9.d)

Question #101 of 127 Question ID: 1685475

The Herlitzka Company, a U.S. multinational firm, has a 100% stake in a Swiss subsidiary. The
U.S. dollar (USD) has been determined to be the functional currency. All the common stock of
the subsidiary was issued at the beginning of the year and the subsidiary uses the weighted-
average inventory cost-flow assumption. In addition, the value of the SF is as follows:

Beginning of year $0.5902

Average throughout the year $0.6002

End of year $0.6150

The SF-based balance sheet and income statement data for the Swiss subsidiary are as follows:

Accounts receivable = 3,000

Inventory = 4,000

Fixed assets = 12,000

Accounts payable = 2,000

Long-term debt = 5,000

Common stock = 10,000

Retained earnings = 2,000

Net income = 2,000

The total value of net monetary assets is equal to:

A) -4,000 SF.
B) 12,000 SF.
C) 3,000 SF.

Explanation

Monetary assets and liabilities include cash, A/R, A/P and Long-term debt. Hence, net
monetary assets is equal to 3,000 − (2,000 + 5,000) = -4,000 SF.

(Module 9.6, LOS 9.f)

Question #102 of 127 Question ID: 1685409

A U.S. firm owns a foreign subsidiary in France. In 2002, sales were EUR 1,000,000 and the
USD/EUR exchange rate was 1.0620. In 2003, sales were EUR 1,100,000 and the exchange rate
was 1.1417. What is the impact of the change in the value of the USD on the parent company's
translated sales?

A) Sales will increase by 7.5%.

B) Sales will decrease by 7.5%.
C) Sales will increase by 18.25%.

Explanation

The increase in sales due to the appreciating EUR is measured as 7.5% [= (1.1417 / 1.0620) −
1]. Sales for the subsidiary rose 10% [= (1,100,000 / 1,000,000) – 1] in the local currency (EUR).
After translation the parent firm will report sales of USD 1,062,000 (= EUR 1,000,000 × 1.0620)
for 2002 and USD 1,255,870 (= EUR 1,100,000 × 1.1417) for 2003.

Growth measured from the parent's perspective suggests sales rose 18.25% [= (1,255,870 /
1,062,000) − 1], but this includes the growth rate in sales measured in the local currency and
the rate of appreciation in the foreign currency, or (1.10 × 1.075) − 1 = 0.1825. The question
only asks for the impact of the change in the value of the USD.

(Module 9.2, LOS 9.c)

Question #103 of 127 Question ID: 1685417

Under the temporal method, the inventory and cost of goods sold (COGS) accounts are both
nonmonetary accounts. Which of the following statements is least accurate regarding these
accounts?

If the firm accounts for inventory using first in, first out (FIFO), then a more recent
A)
rate will be applied to the inventory account.
The Inventory account is remeasured using the historical rate under both LIFO and
B)
FIFO.
If the firm accounts for inventory using last in, first out (LIFO), then the beginning-
C)
of-period rate is used to remeasure COGS.

Explanation
Under LIFO, the last goods purchased are the first goods out to COGS. Hence, although
technically the historical rate is used to remeasure COGS, a more recent rate is typically more
appropriate for COGS under LIFO.

(Module 9.3, LOS 9.e)

Question #104 - 107 of 127 Question ID: 1685529

On APJ's 2005 income statement, the level of net income in U.S. dollars would be:

A) $200.00.
B) $300.00.
C) $240.00.

Explanation

The basis for using the current rate method is when Functional Currency is NOT the same as
Parent's Presentation (reporting) Currency. The basis for using the temporal method is when
Functional Currency = Parent's Presentation Currency.

Since the Australian dollar is both the local and the functional currency, use the current rate
method. The items in the income statement are translated at the average exchange rate. The
average rate is (2 + 3) / 2 = 2.5 Australian dollars = $1.

(Module 9.6, LOS 9.f)

Question #105 - 107 of 127 Question ID: 1685530

On APJ's 2005 balance sheet, the level of common stock (not including retained earnings) in U.S.
dollars would be:

A) $288.
B) $360.
C) $240.

Explanation
Since the Australian dollar is the local and the functional currency, use the current rate
method.

In the balance sheet, all accounts are translated at the current exchange rate, except for the
common stock account, which is translated at the historical rate.

Common Stock (720 / 2) = 360

(Module 9.4, LOS 9.e)

Question #106 - 107 of 127 Question ID: 1685531

On APJ's 2005 balance sheet, the foreign currency translation adjustment in U.S. dollars would
be:

A) −$220.
B) −$160.
C) −$280.

Explanation

Since the Australian dollar is both the local and the functional currency, use the current rate
method.

When using the current rate method, all assets and liabilities are translated at the current
rate. Total assets = 1530/3 = 510 and accounts payable = 210/3 = 70. The common stock is
translated at the historical rate on the date of purchase = 720/2 = 360. Beginning retained
earnings = 0, so ending retained earnings = translated net income = 240. The cumulative
translation adjustment is the plug figure that makes the balance sheet balance = 510 − 70 −
360 − 240 = −160.

(Module 9.4, LOS 9.e)

Question #107 - 107 of 127 Question ID: 1685532

Which one of the following statements correctly describes the effect on Dell's financial
statements if the U.S. dollar had been chosen as the functional currency?

A) The current rate method would apply.

B) The translation adjustment would appear as a line item on Dell's balance sheet.
 The translation adjustment would appear as a line item on Dell's income
C)
statement.

Explanation

If the U.S. dollar had been chosen as the functional currency, then the provisions of the
temporal method would apply. Under the temporal method, the translation adjustment
would appear as a line item on Dell's income statement and not as an element of equity.
Hence, earnings may become more volatile as a result.

(Module 9.4, LOS 9.e)

Question #108 of 127 Question ID: 1685536

The nation of Deadoa is experiencing hyperinflation. A subsidiary of a multinational operating

in Deadoa will notice changes in its purchasing power and in its financial results as reported on
its parent company's financial statements. Which of the following best describes the situation
for a subsidiary operating in Deadoa? Purchasing power will:

dramatically appreciate and the local currency will be rapidly appreciating against
A)
the presentation currency.
quickly deteriorate and the local currency will be rapidly appreciating against the
B)
presentation currency.
quickly deteriorate and the local currency will be rapidly depreciating against the
C)
presentation currency.

Explanation

Purchasing power and Deadoa currency will depreciate.

(Module 9.7, LOS 9.g)

Question #109 of 127 Question ID: 1685481

Hann Company is a U.S. multinational firm with operations in several foreign countries. Hann
has a 100% stake in a French subsidiary. The foreign subsidiary's local currency has appreciated
against the U.S. dollar over the latest financial statement reporting period. In addition, the
French firm accounts for inventories using the first in, first out (FIFO) inventory cost-flow
assumption. The gross profit margin as computed under the current rate method would most
likely be:

A) lower than the gross profit margin as computed under the temporal method.
B) higher than the gross profit margin as computed under the temporal method.
C) equal to the gross profit margin as computed under the temporal method.

Explanation

The average rate is used to convert sales under both the temporal method and the current
rate method. Hence, the only difference between the two computations is on cost of goods
sold (COGS). Since the firm uses FIFO, older materials are flowing into COGS and an older
exchange rate applies. Since in the past the foreign currency bought fewer dollars, the gross
profit under the temporal method will be higher than that of the current rate method. It may
help to 'think' that with the current rate method, you use the average rate for COGS, which
makes COGS higher because the currency has appreciated.

(Module 9.6, LOS 9.f)

Question #110 of 127 Question ID: 1685491

Which of the following subsidiary ratios will be affected by the translation adjustment under the
current rate method?

A) Return on equity.
B) Gross margin.
C) Net profit margin.

Explanation

The translation adjustment will affect the book value of equity and therefore the return on
equity ratio. The other ratios are pure ratios (both component of the ratio come from the
income statement) and are not affected by translation.

(Module 9.6, LOS 9.f)

Question #111 of 127 Question ID: 1685484

The U.S. dollar has been depreciating relative to the local currency over the past year. The use
of the current rate method to translate a foreign subsidiary's financial statements to U.S.
dollars will most likely have which of the following effects on the operating profit margin
(EBIT/S) relative to what the ratio would have been without the effects of translation?

A) The ratio will fall.

B) There will be no effect on the ratio.
C) The ratio will rise.

Explanation

Under the current rate method, the average rate is applied to all income statement accounts.
Hence, since the average rate is applied to both numerator and denominator of the equation
and the ratio will not change.

(Module 9.6, LOS 9.f)

Question #112 of 127 Question ID: 1685541

Sopgate is a manufacturer of branded fast moving consumer goods having business operations
in 28 countries (in each country, Sopgate has a wholly owned local subsidiary for production
and/or distribution). Following information is available from Sopgate's annual report:

Growth in pre-tax profits

Region Revenue Growth (USD)* Tax rate
(USD)*

Latin America 5% 4% 25%

North America 3% 3% 35%

Europe 2% −1% 45%

Asia pacific 4% 6% 20%

*Growth rate indicates expected growth rate over the next five years.

Sopgate's effective tax rate is most likely expected to:

A) remain unchanged.
B) decrease.
C) increase.

Explanation

Sopgate's profits are expected to grow at a faster rate for lower tax rate regions as compared
to higher tax regions. Hence the effective tax rate can be expected to decrease.

(Module 9.8, LOS 9.h)

Question #113 of 127 Question ID: 1685410

A German company (reporting currency = Euro) owns a foreign subsidiary in the U.S. If the
results below are reported in local currency (USD), after translation what is the effect of the
change in the exchange rate on revenues? Round to the nearest dollar and/or percent.

$ per 1 Euro avg.

Year Sales
Exchange Rate

2001 $10,000 0.9

2002 $10,000 0.8

A) The company shows a 0.1% decline in revenues in 2002.

B) The company shows a 12.5% growth in revenues in 2002.
C) There is no change is revenue growth between 2001 and 2002.

Explanation

While sales were flat in terms of local currency, after translation the reported revenue
increased 12.5%. 10,000/0.9 = 11,111; 10,000/0.8 = 12,500; 12,500/11,111 = 12.5% increase
due to exchange rate effects.

(Module 9.2, LOS 9.c)

Question #114 of 127 Question ID: 1685422

Which of the following statements regarding the functional currency under US GAAP is least
accurate?

Self-contained, independent subsidiaries whose operations are primarily located in

A)
the local market will use the local currency as the functional currency.
If a firm operates in a country or environment which is subject to cumulative
B) inflation of 100% or more over a three year period, that firm will use the parent's
currency as the functional currency.
The functional currency is defined as the primary currency of the economic
C)
environment in which the parent firm operates.

Explanation

The basis for using the current rate method is when Functional Currency is NOT the same as
Parent's Presentation (reporting) Currency. The basis for using the temporal method is when
Functional Currency = Parent's Presentation Currency.

The functional currency is defined as the primary currency of the economic environment in
which the foreign subsidiary operates.

(Module 9.3, LOS 9.e)

Question #115 - 116 of 127 Question ID: 1685458

Before Jameson can perform any financial statement analysis she needs to determine which
method WB uses to translate Kasamatsu's earnings into U.S. dollars (USD). Which of the
following is the most appropriate method to use?

A) The temporal method.

B) The current rate method.
C) First the temporal method, followed by the current rate method.

Explanation
The basis for using the current rate method is when Functional Currency is NOT the same as
Parent's Presentation (reporting) Currency. The basis for using the temporal method is when
Functional Currency = Parent's Presentation Currency.

Under US GAAP the current method must be used to translate the yen financial statements
into USD, the reporting currency. Had Kasamatsu been operating in a highly inflationary
environment or had the local and functional currency not been the same, then WB would be
required to use the temporal method.

(Module 9.4, LOS 9.e)

Question #116 - 116 of 127 Question ID: 1685459

Jameson must also determine how the fluctuation in the yen vs. the dollar has affected
Kasamatsu's earnings in the reporting currency. Which of the following best describes the effect
of changes in the yen/dollar rate has had on earnings in the reporting currency? Earnings have:

A) decreased because the yen is depreciating versus the USD.

B) increased because the yen is appreciating versus the USD.
C) increased because the yen is depreciating versus the USD.

Explanation

Examination of the history of the exchange rate shows that both the year-end and average
exchange rates are lower in 2005 than in 2004 (lower in that the yen has weakened vs. the
USD). Therefore, Kasamatsu has to earn more yen than it did in the previous year for WB to
be able to report the same dollar amount of net income. This means that the true economic
performance of Kasamatsu is understated when viewed as a component of WB's net income.

(Module 9.4, LOS 9.e)

Question #117 of 127 Question ID: 1685533

In a hyperinflationary economy, translation under the current rate method will most likely
result in relatively:

A) low balance sheet values for long term liabilities.

B) high balance sheet values for long term assets.
C) high translation gains.
Explanation

In a hyperinflationary economy, translation under the current rate method will most likely
result in relatively low balance sheet values for assets and liabilities. Translation losses will
also occur.

(Module 9.7, LOS 9.g)

Question #118 of 127 Question ID: 1685527

The Precision Screen Printers (PSP) Company has a foreign subsidiary, the Acer Tool & Die
Company, located in the country of Rolivia. The currency of Rolivia is the Chad. The balance
sheet and income statement of Acer Tool & Die Company for the year-ended December 31,
20X2, is shown below. The balance sheet has been restated using the U.S. dollar as the
functional currency.

Acer Tool & Die Company Balance Sheet As of December 31, 20X2

Chad Exchange Rate U.S. $

(millions) (Chad/US$) (millions)

Cash 20 0.25 $80

Accounts receivable 30 0.25 120

Inventory 100 0.3125 320

Fixed assets (net) 500 0.3333 1,500

Total assets 650 $2,020

Accounts payable 50 0.25 $200

Capital stock 380 0.3333 1,140

Retained earnings 220 -- 680

Total liabilities and equity 650 $2,020

Acer Tool & Die Company Income Statement

For year ending December 31, 20X2

(Amounts in millions of Chad)

Revenues 1,000

Cost of sales 700

Depreciation expense 50

Selling expense 30

Translation gain (or loss)

Net income 220

The exchange rate at the beginning of 20X2 was 0.3333 Chad/US$. The exchange rate at the
end of 20X2 was 0.25 Chad/US$. The average rate for 20X2 is 0.3125 Chad/US$. Beginning
inventory is 90 Chad, which was translated to $270 on the 20X1 balance sheet. Acer Tool & Die
uses FIFO inventory valuation and depreciates fixed assets using the straight-line method.

Purchases occurred evenly throughout the year. Assume that retained earnings at year-end
20X1 were zero, the historical exchange rate for depreciation is 0.333, and no dividends were
paid during 20X2.

Using the current rate method for the Acer Tool & Die Company, what is the value of total
assets after translation?

A) $1,950.
B) $2,600.
C) $2,020.

Explanation

With the current rate method, all balance sheet items except for common stock are
translated at the current rate.

Total assets = 650 / 0.25 = $2,600.

(Module 9.6, LOS 9.f)

Question #119 - 122 of 127 Question ID: 1685446

Jameson would like to examine WB's group accounts. What is the most appropriate exchange
rate (yen/$) to use in translating Kasamatsu's reported dividends into U.S. dollars?

A) 150.
B) 140.
C) 145.

Explanation
Dividends are translated at the exchange rate that existed on the dividend declaration date.

(Module 9.4, LOS 9.d)

Question #120 - 122 of 127 Question ID: 1685447

If Jameson wishes to convert any of the figures on Kasamatsu's Income Statement from yen to
dollars, she should most appropriately use which of the following exchange rates (yen/$)?

A) 140.
B) 145.
C) 150.

Explanation

Under the current rate method, all items in the income statement would be translated at the
average rate or 140JPY/USD. Because this question is asking only for translating sales, the
average rate would be used even under the temporal method.

(Module 9.4, LOS 9.d)

Question #121 - 122 of 127 Question ID: 1685448

Jameson has finally completed translating all the necessary figures into dollars and now wants
to compute by how much WB's reported sales in dollars will change due to Kasamatsu's sales.
Which of the following is closest to the amount of sales that WB will report as a result of
Kasamatsu's operations (in thousands of dollars)?

A) $4,828.
B) $5,000.
C) $4,667.

Explanation
The current rate method is used when the Functional Currency is NOT the same as the
Parent's Presentation (reporting) Currency. The basis for using the temporal method is when
the Functional Currency = the Parent's Presentation Currency.

Because sales as a financial item is on the income statement, the 2013 average exchange rate
of 140 JPY/USD must be used to calculate sales in the reporting currency. Kasamatsu's sales
were JPY 700,000. The calculation is:

700,000¥
= $5, 000
140¥/$

WB will report $5,000 of sales as a result of Kasamatsu's operations.

(Module 9.4, LOS 9.d)

Question #122 - 122 of 127 Question ID: 1685449

Before Jameson can perform any financial statement analysis, she wants to determine which
method WB uses to translate Kasamatsu's earnings into U.S. dollars (USD). Which of the
following is the most accurate translation method and reasoning? WB should translate
Kasamatsu's earnings using the:

A) current rate method because the local currency is the USD.

B) temporal method because the local currency differs from the functional currency.
C) current rate method because the functional currency is the yen.

Explanation

The current rate method is used when the functional currency is NOT the same as parent's
presentation (reporting) currency. The temporal method is used when Functional Currency =
Parent's Presentation Currency.

Under US GAAP the current rate method must be used to translate Kasamatsu's yen financial
statements into USD, the reporting currency. Had Kasamatsu been operating in a highly
inflationary environment or had the local and functional currency not been the same, then
WB would be required to use the temporal method.

(Module 9.4, LOS 9.d)

Question #123 of 127 Question ID: 1685451

Which of the following general statements is most accurate with respect to the current rate
method? Revenues:

are translated at the average rate while operating expenses are translated at the
A)
current rate.
B) and operating expenses are translated at the average rate.
C) and operating expenses are translated at the current rate.

Explanation

As a general rule for the current rate method, all revenues and operating expenses are
translated using the average rate.

(Module 9.4, LOS 9.e)

Question #124 of 127 Question ID: 1685416

Which of the following statements is least accurate regarding the use of the temporal method
for foreign exchange accounting?

Under the temporal method, the foreign exchange gain or loss is placed on the
A)
balance sheet in the equity section.
All nonmonetary assets and liabilities are translated at the historical rate of
B)
exchange.
C) All monetary assets are translated at the current rate of exchange.

Explanation

Under the temporal method, the foreign exchange gain or loss is placed on the income
statement.
(Module 9.3, LOS 9.e)

Question #125 of 127 Question ID: 1685415

Which of the following statements regarding the translation of a foreign subsidiary into the
reporting currency is most accurate?

If the reporting currency is the functional currency, the temporal method is applied
A)
and exposure is equal to net monetary assets.
A multinational firm with small liability balances generally has minimal foreign
B)
currency exposure on its balance sheet.
If the functional currency is equal to the local currency, exchange gains and losses
C)
on translation will be recognized in the income statement.

Explanation

The choice of functional currency is the determining factor as to which method of foreign
currency translation is utilized. Therefore, when the reporting currency is the functional
currency, the temporal method must be used. The choice of functional currency is largely left
to management's discretion.

(Module 9.3, LOS 9.e)

Question #126 of 127 Question ID: 1685453

Which of the following statements is NOT a characteristic of the current rate method of
accounting for foreign currency translation?

A) Nonmonetary liabilities are translated at the historical rate of exchange.

All asset accounts are translated at the current rate of exchange as of the balance
B)
sheet date.
The common stock account is translated at the rate of exchange that applied when
C)
the equity was issued.

Explanation

Under the current rate method, all liabilities are translated at the current rate of exchange.

(Module 9.4, LOS 9.e)

Question #127 of 127 Question ID: 1685424

Which of the following general statements is CORRECT with respect to the temporal method?
Monetary assets are:

A) translated at the current rate.

B) not translated.
C) translated at the average rate.

Explanation

As a general rule in using the temporal method, monetary assets are translated using the
current rate.

(Module 9.3, LOS 9.e)

Question #1 of 23 Question ID: 1685558

Important attributes that the CAMELS approach to assessing bank soundness does not address
are most likely to include:

A) earnings, liquidity, and sensitivity to market risk.

B) competitive environment, mission, and support by government.
C) management capabilities, asset quality, and capital adequacy.

Question #2 of 23 Question ID: 1685559

When analyzing a bank, important attributes that the CAMELS approach to assessing bank
soundness does not address are most likely to include:

A) corporate culture, exposure to currencies, and segment information.

B) sensitivity to market risk, liquidity, and earnings.
C) capital adequacy, asset quality, management capabilities.

Question #3 of 23 Question ID: 1685557

John Gittens is reviewing his firm's guidance for the application of the CAMELS framework and
notices the following two statements:

"The mission of a banking entity will affect the way its assets and liabilities
Statement 1: are managed, and hence this qualitative impact is usually addressed within
the management capabilities section of the CAMELS approach."

"The corporate culture may lead to excessive risk taking, or even a high level
Statement 2:
of risk aversion, and this aspect is not covered in a typical CAMELS analysis."

Regarding the two statements made by Gittens, statement 1 is most likely:

A) incorrect and statement 2 is most likely incorrect
B) correct and statement 2 is most likely correct
C) incorrect, and statement 2 is most likely correct

Question #4 of 23 Question ID: 1685562

Under the Basel III Regulatory Framework, the Net Stable Funding Ratio (NSFR) is most likely to
be calculated as:

A) available stable funding ÷ required stable funding.

B) highly liquid assets ÷ available stable funding.
C) required stable funding ÷ expected cash outflows.

Question #5 of 23 Question ID: 1685551

When using the fair value hierarchy as defined by IFRS and US GAAP, a financial asset valuation
performed by discounting future cash-flows at a discount rate would most likely be classified as
a:

A) level 1 valuation
B) level 3 valuation
C) level 2 valuation

Question #6 of 23 Question ID: 1685546

Compared to manufacturing or merchandising companies, financial institutions are most likely

to have higher direct exposures to:

A) inflationary risk, business risk, exchange rate risk, and legal risk.
B) market risk, credit risk, liquidity risk, and interest rate risk.
C) operational risk, process risk, political risk, and compliance risk.

Question #7 of 23 Question ID: 1685544

Which of the following statements is least likely correct? Financial institutions differ from other
companies:

A) due to their balance sheet containing assets that are often measured at fair value.
B) due to their activities giving rise to systemic risk.
C) due to their assets being predominantly tangible.

Question #8 of 23 Question ID: 1685560

Gert Fonn, CFA, extracted the following information on the regulatory capital and total assets
for JJK Inc., a U.S. commercial bank he is considering as an investment. Fonn weights cash at
0%, performing loans at 100% and non-performing loans at 150% when calculating risk-
weighted assets, and only considers investing in institutions with a tier 1 capital ratio over 15%.
However, he is concerned that JJK has classified $85m of non-performing loans as performing
loans.

2018 2018

Regulatory Capital $('000) $('000)

Common Equity Tier 1 Capital 80,438 Cash 165,754

Additional Tier 1 Capital 14,294 Performing loans 235,631

Tier 2 Capital 22,395 Non-performing loans 158,654

Using the information in the table, which of the following conclusions is Fonn most likely to
make?

A) JJK’s current tier 1 capital ratio does not meet Fonn’s criteria
JJK’s current tier 1 capital ratio meets Fonn’s criteria, but would not if the $85m of non-
B)
performing loans were reclassified
 JJK’s current tier 1 capital ratio meets Fonn’s criteria even if the $85m of non-
C)
performing loans were reclassified

Question #9 of 23 Question ID: 1685561

The following extract shows data prepared by OWB, a financial institution conducting a review
of its BASEL III compliance from 2016 to 2018. All data has been prepared in accordance with
BASEL III requirements.

2016 2017 2018

$m $m $m

Net Outflows (30 days of stress level cash flows) 70,363 79,454 111,547

Available Stable Funding 337,964 347,945 298,045

Required Stable Funding 327,043 287,953 247,876

High Quality Liquid Assets 82,334 87,677 109,654

Using the data extracted from OWB, which of the following statements is most likely correct?

The liquidity coverage ratio meets the standard BASEL III requirements in each of the
A)
three years
B) The net stable funding ratio was highest in 2017
The number of days of stress level cash flows that OWB can withstand has steadily
C)
increased over the period

Question #10 of 23 Question ID: 1685556

Which of the following factors is least likely to be considered during a CAMELS analysis of a
financial institution?

A) Accuracy of accounting estimates

B) Levels of government support
C) Estimation methods used for the fair value of assets

Question #11 of 23 Question ID: 1685545

Systemic risk in financial services is least likely to:

A) concern the co-movement of an institution’s asset values with the overall market.
B) have consequences for the economy as a whole.
C) be caused by interdependencies in the financial system.

Question #12 of 23 Question ID: 1685555

Which of the following statements about a bank's sources of earnings is most accurate?

A) Service income is the most volatile from year-to-year.

B) Net interest income is the most volatile from year-to-year.
C) Trading income is the most volatile from year-to-year.

Question #13 of 23 Question ID: 1685554

A bank's earnings are considered to be high quality if:

A) They are sustainable.

B) They are adequate.
C) They are both sustainable and adequate.

Question #14 of 23 Question ID: 1685565

When analyzing insurance companies, the combined ratio is most likely to:

A) suggest a soft market when it is low.

B) indicate an underwriting loss when it is higher than 100%.
C) equal net premiums earned divided by total insurance expenses.

Question #15 of 23 Question ID: 1685552

The CAMELS approach to analyzing a bank considers:

A) character, ability to pay, market exposure, efficiency, liabilities, and stability.

B) capital adequacy, asset quality, management, earnings, liquidity, and sensitivity.
C) capacity, appetite for risk, monetary assets, evidence, legislative factors, and structure.

Question #16 of 23 Question ID: 1685563

Which of the following statements regarding Property and Casualty insurance institutions is
most likely correct?

A) The priority in the selection of assets should be liquidity

The suitability of assets held can be analyzed by observing the status of the assets in
B) the fair value hierarchy. A majority of level 3 reported values indicates an appropriate
asset base
Due to the uncertainty of payout timings and levels, the institution will usually invest in
C)
high-risk, longer term assets

Question #17 of 23 Question ID: 1685549

It would be least accurate to state that the Basel Committee:

A) develops international regulatory framework for banks.

 has legal authority to enforce compliance with supervision and accountability
B)
standards.
C) monitors adoption and implementation of standards in member jurisdictions.

Question #18 of 23 Question ID: 1685550

When assessing capital adequacy using risk-weighted assets, cash will most likely:

A) be weighted at 100%.
B) not be included in risk-weighted assets.
C) be weighted over 100%.

Question #19 of 23 Question ID: 1685547

Which of the following is least likely a reason for the establishment of global and regional
regulatory bodies?

A) To increase global opportunities for regulatory arbitrage.

B) To minimize systemic risk.
C) To increase harmonization or regulatory rules.

Question #20 of 23 Question ID: 1685566

Compared to a life and health (L&H) insurance company, it is most likely that a property and
casualty (P&C) insurer's:

A) policies’ final cost will typically be known within a year of an insured event.
B) policies will be longer term.
C) claims will be more predictable.
Question #21 of 23 Question ID: 1685548

Basel III regulation that aims to prevent banks from assuming so much leverage that they are
unable to withstand loan losses is most correctly described as the:

A) minimum capital requirement.

B) minimum liquidity requirement.
C) stable funding requirement.

Question #22 of 23 Question ID: 1685564

Which of the following statements comparing Property and Casualty insurers to Life and Health
insurers is least likely correct?

Property and Casualty insurers typically require a higher equity cushion and hence can
A)
have higher capital requirements
The calculation of Property and Casualty insurers minimum capital requirements is
B)
more likely to factor in exposure to interest rate risk
Life and Health insurers typically face more predictable claims than Property and
C)
Casualty insurers

Question #23 of 23 Question ID: 1685553

The following information is collected for Anniston Bank.

Description 20X3 20X4

Highly liquid assets 1,380 1,390

Average monthly withdrawals 800 770

Expected monthly outflows in a stress scenario 1,200 1,350

As compared to 20X3, the bank's liquidity coverage ratio has:

A) improved.
B) worsened.
C) remained the same.
Question #1 of 23 Question ID: 1685558

Important attributes that the CAMELS approach to assessing bank soundness does not address
are most likely to include:

A) earnings, liquidity, and sensitivity to market risk.

B) competitive environment, mission, and support by government.
C) management capabilities, asset quality, and capital adequacy.

Explanation

In addition to the CAMELS components, important attributes deserving analysts' attention

include government support, the bank's mission, corporate culture and competitive
environment, off-balance-sheet items, segment information, currency exposure, and risk
disclosures. CAMELS itself focuses on a bank's: capital adequacy, asset quality, management
capabilities, earnings sufficiency, liquidity position, and sensitivity to market risk.

(Module 10.5, LOS 10.d)

Question #2 of 23 Question ID: 1685559

When analyzing a bank, important attributes that the CAMELS approach to assessing bank
soundness does not address are most likely to include:

A) corporate culture, exposure to currencies, and segment information.

B) sensitivity to market risk, liquidity, and earnings.
C) capital adequacy, asset quality, management capabilities.

Explanation

In addition to the CAMELS components, important attributes deserving analysts' attention

include government support, the bank's mission, corporate culture and competitive
environment, off-balance-sheet items, segment information, currency exposure, and risk
disclosures. CAMELS itself focuses on a bank's: capital adequacy, asset quality, management
capabilities, earnings sufficiency, liquidity position, and sensitivity to market risk.

(Module 10.5, LOS 10.d)

Question #3 of 23 Question ID: 1685557

John Gittens is reviewing his firm's guidance for the application of the CAMELS framework and
notices the following two statements:

"The mission of a banking entity will affect the way its assets and liabilities
Statement 1: are managed, and hence this qualitative impact is usually addressed within
the management capabilities section of the CAMELS approach."

"The corporate culture may lead to excessive risk taking, or even a high level
Statement 2:
of risk aversion, and this aspect is not covered in a typical CAMELS analysis."

Regarding the two statements made by Gittens, statement 1 is most likely:

A) incorrect and statement 2 is most likely incorrect

B) correct and statement 2 is most likely correct
C) incorrect, and statement 2 is most likely correct

Explanation

Neither the mission nor the corporate culture are addressed in a typical CAMELS analysis,
hence statement 1 is incorrect (stating that the mission is included) but statement 2 is correct
(in stating that the corporate culture is not included).

(Module 10.5, LOS 10.d)

Question #4 of 23 Question ID: 1685562

Under the Basel III Regulatory Framework, the Net Stable Funding Ratio (NSFR) is most likely to
be calculated as:

A) available stable funding ÷ required stable funding.

B) highly liquid assets ÷ available stable funding.
C) required stable funding ÷ expected cash outflows.

Explanation
The Net Stable Funding Ratio (NSFR) is the percentage of a bank's required stable funding
that must be sourced from available stable funding. The numerator (available stable funding)
is a function of the composition and maturity of a bank's funding sources (i.e., capital and
deposits and other liabilities), while the denominator (required stable funding) is a function
of the composition and maturity of a bank's asset base.

(Module 10.5, LOS 10.e)

Question #5 of 23 Question ID: 1685551

When using the fair value hierarchy as defined by IFRS and US GAAP, a financial asset valuation
performed by discounting future cash-flows at a discount rate would most likely be classified as
a:

A) level 1 valuation
B) level 3 valuation
C) level 2 valuation

Explanation

Neither the future cash flows or the discount rate in a PV calculation are directly observable,
hence the valuation is level 3. Level 1 valuations are based on observed quoted prices for
identical assets. Level 2 valuations are observable but are not quoted prices for identical
assets, they may be prices for similar assets.

(Module 10.2, LOS 10.c)

Question #6 of 23 Question ID: 1685546

Compared to manufacturing or merchandising companies, financial institutions are most likely

to have higher direct exposures to:

A) inflationary risk, business risk, exchange rate risk, and legal risk.
B) market risk, credit risk, liquidity risk, and interest rate risk.
C) operational risk, process risk, political risk, and compliance risk.

Explanation
Because the productive assets of financial institutions are primarily financial assets such as
securities and loans, financial institutions are likely to have significant direct exposures to
risks such as credit risk, liquidity risk, market risk, and interest rate risk.

(Module 10.1, LOS 10.a)

Question #7 of 23 Question ID: 1685544

Which of the following statements is least likely correct? Financial institutions differ from other
companies:

A) due to their balance sheet containing assets that are often measured at fair value.
B) due to their activities giving rise to systemic risk.
C) due to their assets being predominantly tangible.

Explanation

Lots of companies have predominantly tangible assets. Financial institutions differ in that
their assets are predominantly financial assets. These are often measured at fair value, and
financial institutions do give rise to systemic risk.

(Module 10.1, LOS 10.a)

Question #8 of 23 Question ID: 1685560

Gert Fonn, CFA, extracted the following information on the regulatory capital and total assets
for JJK Inc., a U.S. commercial bank he is considering as an investment. Fonn weights cash at
0%, performing loans at 100% and non-performing loans at 150% when calculating risk-
weighted assets, and only considers investing in institutions with a tier 1 capital ratio over 15%.
However, he is concerned that JJK has classified $85m of non-performing loans as performing
loans.

2018 2018

Regulatory Capital $('000) $('000)

Common Equity Tier 1 Capital 80,438 Cash 165,754

Additional Tier 1 Capital 14,294 Performing loans 235,631

Tier 2 Capital 22,395 Non-performing loans 158,654

Using the information in the table, which of the following conclusions is Fonn most likely to
make?

A) JJK’s current tier 1 capital ratio does not meet Fonn’s criteria
JJK’s current tier 1 capital ratio meets Fonn’s criteria, but would not if the $85m of
B)
non-performing loans were reclassified
JJK’s current tier 1 capital ratio meets Fonn’s criteria even if the $85m of non-
C)
performing loans were reclassified

Explanation
Common Equity Tier 1 Capital 80,438
Additional Tier 1 Capital 14,294

Tier 1 Capital 94,732

Pre Adjustment
Cash 165,754 0% 0
Performing loans 235,631 100% 235,631
Non-performing loans 158,654 150% 237,981
TotalTotal 473,612 Tier 1 Ratio 94,732
473,612
Post Adjustment
Cash 165,754 0% 0 20.0%
Performing loans 150,631 100% 150,631
Non-performing loans 243,654 150% 365,481
Total 516,112 Tier 1 Ratio 94,732
516,112

18.4%

JJK's tier 1 ratio is 20% pre-adjustment and 18.4% post adjustment, both above 15%.

(Module 10.5, LOS 10.e)

Question #9 of 23 Question ID: 1685561

The following extract shows data prepared by OWB, a financial institution conducting a review
of its BASEL III compliance from 2016 to 2018. All data has been prepared in accordance with
BASEL III requirements.

2016 2017 2018

$m $m $m

Net Outflows (30 days of stress level cash flows) 70,363 79,454 111,547

Available Stable Funding 337,964 347,945 298,045

Required Stable Funding 327,043 287,953 247,876

High Quality Liquid Assets 82,334 87,677 109,654

Using the data extracted from OWB, which of the following statements is most likely correct?

The liquidity coverage ratio meets the standard BASEL III requirements in each of
A)
the three years
B) The net stable funding ratio was highest in 2017
The number of days of stress level cash flows that OWB can withstand has steadily
C)
increased over the period

Explanation
 2016 2017 2018
$m $m $m
Net Outflows 70,363 79,454 111,547
Available Stable Funding 337,964 347,945 298,045
Required Stable Funding 327,043 287,953 247,876
High Quality Liquid Assets 82,334 87,677 109,654

Liquidity Coverage Ratio High Quality Liquid Assets 117% 110% 98%
Net Outflows

Number of days of stress 30 x 1.17 30 x 1.10 30 x 0.98

level volume of cash outflows OWB can withstand 35.1 33.1 29.5

Net Stable Funding Ratio Available Stable Funding 103% 121% 120%
Required Stable Funding

The answer "The net stable funding ratio was highest in 2017" is correct, the net stable
funding ratio was highest in 2017. The number of days of stress level cash flows OWB can
withstand has decreased over the period and is below the BASEL III requirement in 2018.

(Module 10.5, LOS 10.e)

Question #10 of 23 Question ID: 1685556

Which of the following factors is least likely to be considered during a CAMELS analysis of a
financial institution?

A) Accuracy of accounting estimates

B) Levels of government support
C) Estimation methods used for the fair value of assets

Explanation

The level of government support or ownership is not part of the CAMELS process. The
accuracy of accounting estimates and the valuation process used (level 1,2,3) would be
considered within the earnings category.

(Module 10.5, LOS 10.d)

Question #11 of 23 Question ID: 1685545

Systemic risk in financial services is least likely to:

A) concern the co-movement of an institution’s asset values with the overall market.
B) have consequences for the economy as a whole.
C) be caused by interdependencies in the financial system.

Explanation

Systemic risk refers to the risk that impairment in one part of the financial system could
spread throughout other parts of the financial system, and then negatively affect the entire
economy. Note that systemic risk is distinct from systematic (beta) risk.

(Module 10.1, LOS 10.a)

Question #12 of 23 Question ID: 1685555

Which of the following statements about a bank's sources of earnings is most accurate?

A) Service income is the most volatile from year-to-year.

B) Net interest income is the most volatile from year-to-year.
C) Trading income is the most volatile from year-to-year.

Explanation

For a typical bank, major sources of earnings are (1) net interest income, (2) service income,
and (3) trading income. Of these, trading income is the most volatile year-to-year, and, hence,
on a relative basis, banks with proportionally higher net interest income and service income
would have more sustainable earnings.

(Module 10.3, LOS 10.c)

Question #13 of 23 Question ID: 1685554

A bank's earnings are considered to be high quality if:

A) They are sustainable.

B) They are adequate.
C) They are both sustainable and adequate.

Explanation

Earnings are considered high quality if they are adequate (providing a rate of return above
the cost of capital) as well as sustainable.

(Module 10.3, LOS 10.c)

Question #14 of 23 Question ID: 1685565

When analyzing insurance companies, the combined ratio is most likely to:

A) suggest a soft market when it is low.

B) indicate an underwriting loss when it is higher than 100%.
C) equal net premiums earned divided by total insurance expenses.

Explanation

An underwriting loss is indicated by a combined ratio higher than 100% for a single insurance
company. Low prices for premiums leads to a high combined ratio, indicating a soft market.
The combined ratio equals the total insurance expenses divided by the net premiums earned.

(Module 10.6, LOS 10.f)

Question #15 of 23 Question ID: 1685552

The CAMELS approach to analyzing a bank considers:

A) character, ability to pay, market exposure, efficiency, liabilities, and stability.

B) capital adequacy, asset quality, management, earnings, liquidity, and sensitivity.
capacity, appetite for risk, monetary assets, evidence, legislative factors, and
C)
structure.

Explanation

The CAMELS approach to analyzing a bank stands for: capital adequacy, asset quality,
management, earnings, liquidity, and sensitivity.

(Module 10.2, LOS 10.c)

Question #16 of 23 Question ID: 1685563

Which of the following statements regarding Property and Casualty insurance institutions is
most likely correct?

A) The priority in the selection of assets should be liquidity

The suitability of assets held can be analyzed by observing the status of the assets
B) in the fair value hierarchy. A majority of level 3 reported values indicates an
appropriate asset base
Due to the uncertainty of payout timings and levels, the institution will usually
C)
invest in high-risk, longer term assets

Explanation

Due to the uncertain nature of required payouts, liquidity is the key concern. High-risk, long
term assets are therefore not appropriate. Level 1 valuations would suggest liquid assets, as
they are priced using identical trading (and hence liquid) assets.

(Module 10.6, LOS 10.f)

Question #17 of 23 Question ID: 1685549

It would be least accurate to state that the Basel Committee:

A) develops international regulatory framework for banks.

has legal authority to enforce compliance with supervision and accountability
B)
standards.
C) monitors adoption and implementation of standards in member jurisdictions.

Explanation

The Basel Committee develops international regulatory framework for banks, and monitors
adoption and implementation in member jurisdictions. However, the Basel Committee does
not have legal authority (i.e., jurisdiction) to enforce compliance.

(Module 10.1, LOS 10.b)

Question #18 of 23 Question ID: 1685550

When assessing capital adequacy using risk-weighted assets, cash will most likely:

A) be weighted at 100%.
B) not be included in risk-weighted assets.
C) be weighted over 100%.

Explanation

Cash has zero risk and hence is not included in risk-weighted assets (i.e. is weighted at zero).

(Module 10.2, LOS 10.c)

Question #19 of 23 Question ID: 1685547

Which of the following is least likely a reason for the establishment of global and regional
regulatory bodies?

A) To increase global opportunities for regulatory arbitrage.

B) To minimize systemic risk.
C) To increase harmonization or regulatory rules.

Explanation

One aim of establishing global regulatory bodies is to reduce, not increase, opportunities for
regulatory arbitrage (multinational companies exploiting differences in regional regulations
to avoid unfavorable rules).

(Module 10.1, LOS 10.b)

Question #20 of 23 Question ID: 1685566

Compared to a life and health (L&H) insurance company, it is most likely that a property and
casualty (P&C) insurer's:

A) policies’ final cost will typically be known within a year of an insured event.
B) policies will be longer term.
C) claims will be more predictable.

Explanation

P&C insurers' final cost will usually be known within a year of an insured event occurring. P&C
insurers' policies are usually short term, and P&C claims are more variable and "lumpier"
because they stem from unpredictable events such as accidents.

(Module 10.6, LOS 10.f)

Question #21 of 23 Question ID: 1685548

Basel III regulation that aims to prevent banks from assuming so much leverage that they are
unable to withstand loan losses is most correctly described as the:

A) minimum capital requirement.

B) minimum liquidity requirement.
C) stable funding requirement.

Explanation

The minimum capital requirement specifies a ratio of assets to risk-weighted assets to ensure
the balance sheet is robust enough to cope with loan losses. Stable funding requirements
specify the amount of stable funding relative to liquidity needs over a one-year horizon. The
minimum liquidity requirement specifies a minimum level of liquidity to cover a partial loss of
funding sources or outflow due to off balance sheet commitments.

(Module 10.1, LOS 10.b)

Question #22 of 23 Question ID: 1685564

Which of the following statements comparing Property and Casualty insurers to Life and Health
insurers is least likely correct?

Property and Casualty insurers typically require a higher equity cushion and hence
A)
can have higher capital requirements
The calculation of Property and Casualty insurers minimum capital requirements is
B)
more likely to factor in exposure to interest rate risk
 Life and Health insurers typically face more predictable claims than Property and
C)
Casualty insurers

Explanation

Property and Casualty insurers typically face more unpredictable claims and hence have
higher capital requirements.

Life and Health insurers are more likely to sell products with material exposures to interest
rate risk and hence they, not Property and Casualty insurers, are more likely to factor that
risk into capital requirements.

(Module 10.6, LOS 10.f)

Question #23 of 23 Question ID: 1685553

The following information is collected for Anniston Bank.

Description 20X3 20X4

Highly liquid assets 1,380 1,390

Average monthly withdrawals 800 770

Expected monthly outflows in a stress scenario 1,200 1,350

As compared to 20X3, the bank's liquidity coverage ratio has:

A) improved.
B) worsened.
C) remained the same.

Explanation

LCR = Highly liquid assets / expected monthly outflows in a stress scenario

20X3: 1380/1200 = 1.15

20X4: 1390/1350 = 1.03

LCR declined (i.e., worsened) from 20X3 to 20X4.

(Module 10.4, LOS 10.c)

Question #1 of 55 Question ID: 1685589
William Jones, CFA, is analyzing the financial performance of two U.S. competitors in connection
with a potential investment recommendation of their common stocks. He is particularly
concerned about the quality of each company's financial results in 2007–2008 and in
developing projections for 2009 and 2010 fiscal years.

Adams Company has been the largest company in the industry, but Jefferson Inc. has grown
more rapidly in recent years. Adams's net sales in 2004 were 33-1/3% higher than Jefferson's
but were only 18% above Jefferson's in 2008. During 2008, a slowing U.S. economy led to lower
domestic revenue growth for both companies. The 10-k reports showed overall sales growth of
6% for Adams in 2008 compared to 7% for 2007 and 9% in 2006. Jefferson's gross sales rose
almost 12% in 2008 versus 8% in 2007 and 10% in 2006. In the past three years, Jefferson has
expanded its foreign business at a faster pace than Adams. In 2008, Jefferson's growth in
overseas business was particularly impressive. According to the company's 10-k report,
Jefferson offered a sales incentive to overseas customers. For those customers accepting the
special sales discount, Jefferson shipped products to specific warehouses in foreign ports
rather than directly to those customers' facilities.

In his initial review of Adams's and Jefferson's financial statements, Jones was concerned about
the quality of the growth in Jefferson's sales, considerably higher accounts receivables, and the
impact of overall accruals on earnings quality. He noted that Jefferson had instituted an
accounting change in 2008. The economic life for new plant and equipment investments was
determined to be five years longer than for previous investments. For Adams, he noted that the
higher level of inventories at the end of 2008 might be cause for concern in light of a further
slowdown expected in the U.S. economy in 2009.

The accompanying table shows financial data for both companies' Form 10-k reports for 2006–
2008 used by Jones for his analysis. To evaluate sales quality, he focused on trends in sales and
related expenses for both companies as well as cash collections and receivables comparisons.
Inventory trends relative to sales and the number of days' sales outstanding in inventory were
determined for both companies. Expense trends were examined for Adams and Jefferson
relative to sales growth and accrual ratios on a balance sheet and cash flow basis were
developed as overall measures of earnings quality.

Adams Company Jefferson Inc.

($ in thousands) 2006 2007 2008 2006 2007 2008

Gross sales 32,031 34,273 36,330 25,625 27,675 30,900

Sales discounts, returns,
781 836 886 625 675 900
and allowances

Net sales 31,250 33,438 35,444 25,000 27,000 30,000

Cost of goods sold 15,312 16,384 17,367 12,250 13,250 15,500

SG&A expenses 9,028 9,660 10,240 7,222 7,800 8,200

Depreciation expense 625 669 709 500 515 516

Interest expense 400 428 454 360 366 396

Income before taxes 5,835 6,243 6,618 4,668 5,069 5,388

Taxes (tax rate 40%) 2,334 2,497 2,647 2,000 2,028 2,155

Net income 3,501 3,746 3,971 2,668 3,041 3,233

Dividends 3,000 3,180 3,307 2,460 2,760 2,880

Net addition to retained

501 566 664 208 281 353
earnings

Balance Sheet

Cash and equivalents 150 160 170 120 130 120

Short-term marketable
250 325 345 200 217 195
securities

Accounts receivable (net) 15,875 16,758 17,763 12,700 13,000 15,892

Inventories 6,500 6,850 7,800 5,200 5,200 4,500

PP&E (net of depreciation) 8,562 8,991 9,440 6,850 7,057 7,200

Total assets 31,337 33,084 35,518 25,070 25,604 27,907

Accounts payable 7,062 7,880 9,300 6,050 6,100 6,398

Other current liabilities 337 400 450 270 373 1,525

Long-term debt 7,500 7,800 8,100 6,000 6,100 6,600

Common stock 15,000 15,000 15,000 12,000 12,000 12,000

Retained earnings 1,438 2,004 2,668 750 1,031 1,384

Total liabilities and
31,337 33,084 35,518 25,070 25,604 27,907
shareholders equity

% change gross sales 7.0% 6.0% 8.0% 11.7%

% change sales discounts

6.0% 6.0% 8.0% 33.3%
and allowances

% change net sales 7.0% 6.0% 8.0% 11.1%

% change cost of goods

7.0% 6.0% 8.0% 17.0%
sold

% change in SG&A 6.0% 6.0% 8.0% 5.1%

% change in depreciation
6.0% 6.0% 3.0% 0.2%
expense

% change in accounts
6.0% 6.0% 2.0% 22.3%
receivable

% change in inventories 5.0% 13.8% 0.0% (13.5%)

Revenues % cash
1.03 1.03 1.03 1.0 1.0 1.1
collections

Days inventory
155 153 164 144 143 106
outstanding

Balance sheet accrual ratio 3.4% 3.5% 3.9% 2.0% 2.4% 10.1%

Cash flow accrual ratio 3.4% 3.5% 3.8% 2.0% 2.0% 4.3%

Jones also observed that inventory and cost of goods sold comparisons showed:

Jefferson’s inventory increase and large increase in cost of goods sold may be related
A) to the success of the special offer; Adams’s large increase in inventories suggests
possible inventory obsolescence.
Jefferson’s inventory levels may be understated and sales overstated to the extent of
B) product shipments for the special offer; Adams’s inventory increase may reflect
slowing product demand and possible inventory obsolescence.
 Jefferson’s inventory decline suggests possible problems in inventory management to
C) meet the stronger customer demand from the special offer; Adams’s large inventory
increase suggests better inventory management to meet future sales growth.

Question #2 of 55 Question ID: 1685593

Pritesh Deshmukh, CFA is analyzing the financial statements of Baza Restaurants Inc.
Deshmukh wants to use the Beneish model to evaluate the probability of earnings
manipulation.

Deshmukh makes the following statements:

1. Depreciation index of less than 1 would indicate that the company is depreciating assets
at a lower rate than in prior years.
2. Sales growth index of more than 1 indicates revenue inflation.

Which of the statements by Deshmukh are most accurate?

A) Statement 2 only.
B) None of the statements is accurate.
C) Statement 1 only.

Question #3 of 55 Question ID: 1685586

Which of the following statements about operating income and operating cash flow is most
accurate?

Operating income is more reliable than operating cash flow because of the judgments
A)
and estimates involved with accrual accounting.
Operating income is confirmed by operating cash flow when the growth rates of the
B)
two measures are relatively stable over time.
Operating cash flow usually increases faster than operating income when the firm is
C)
growing.
Question #4 of 55 Question ID: 1685575

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) Misclassifying cash flow.

B) Ignoring cash flow.
C) Managing cash flow.

Question #5 of 55 Question ID: 1685617

Samuel Maskin, CFA is evaluating the financial statements of Northern Energy Inc. The following
is an extract from Northern's cash flow statement for the past three years:

20x6 20x5 20x4

Net Income $1,023 $988 $744

Depreciation $187 $145 $128

Restructuring Charges $(108) $(104) $212

Accounts receivable $(172) $(145) $(33)

Inventories $(418) $(202) $(180)

Accounts Payable $38 $37 $33

OCF $550 $719 $904

Which of the following conclusions is least likely for Northern?

A) Northern is stretching payables.
B) Northern may have accelerated revenue recognition.
C) Days sales outstanding is probably increasing.

Question #6 of 55 Question ID: 1685610

Andre Bursh, is analyzing large retailers and has collected the following information on three
companies based on the most recent financial statements:

Allied Stores Beta Mart Cash-N-Carry

Total Earnings (per share) $2.80 $1.33 $0.75

Cash element $1.90 $0.78 $0.25

Accrual element $0.90 $0.55 $0.50

Bursh notes that all three companies have reported stellar earnings this past year. Bursh is
concerned about sustainability of such high earnings. Which company's earnings will revert to
its mean fastest?

A) Allied Stores.
B) Beta Mart.
C) Cash-N-Carry.

Question #7 of 55 Question ID: 1685618

Samuel Maskin, CFA is evaluating the financial statements of Northern Energy Inc. The following
is an extract from Northern's cash flow statement for the past three years:

20x6 20x5 20x4

Net Income $1,023 $988 $744

Depreciation $187 $145 $128

Restructuring Charges $(108) $(104) $212

Accounts receivable $(172) $(145) $(33)

Inventories $(418) $(202) $(180)

Accounts Payable $38 $37 $33

OCF $550 $719 $904

The restructuring charges for Northern has most likely:

Increased reported earnings in 20x6 while reducing reported earnings in 20x4 and
A)
20x5.
Increased reported earnings for 20x4 while reducing reported earnings in 20x5 and
B)
20x6.
Reduced reported earnings in 20x4 while increasing reported earnings in 20x5 and
C)
20x6.

Question #8 of 55 Question ID: 1685572

Which of the following items is least likely to involve the use of subjective measurement
estimates by management?

A) Use of straight-line depreciation method to depreciate tangible assets.

B) Use of FIFO (first in-first out) to cost inventories.
C) Use of criteria to determine treatment as an extraordinary item.
Question #9 of 55 Question ID: 1685576

Joe Carter, CFA, believes Triangle Equipment, a maker of large, specialized industrial
equipment, has overstated the salvage value of its equipment. This would:

A) understate earnings.
B) overstate earnings.
C) overstate liabilities.

Question #10 of 55 Question ID: 1685621

Asma Pharma has made several strategic investments in other pharmaceutical companies. In
each instance, Asma has kept its stake just below 50% so it can account for the investment
using the equity method of consolidation.

Asma's balance sheet quality can be most accurately characterized as:

A) High-quality due to compliance with local GAAP.

B) Low-quality due to bias in measurement.
C) Low-quality due to lack of completeness.

Question #11 of 55 Question ID: 1685608

Sustainable earnings are most likely to be driven by:

A) Cash flow element of earnings.

B) Conservative revenue recognition practices.
C) Accruals element of earnings.

Question #12 of 55 Question ID: 1685611

Pysha Heavy Metals Ltd. supplies specialized metals to the chip fabrication industry. Selected
financial data for Pysha, as well as industry comparables, are shown below:

Pysha selected financial data (£ '000s):

20x7 20x8 20x9

Sales 1,169 1,312 1,414

Accounts receivable 58.45 72.16 98.98

Industry average:

20x7 20x8 20x9

DSO 22.6 22.8 22.4

Receivables turnover 16.2 16.0 16.3

Based on the trend in revenues and receivables, it can be most accurately concluded that:

A) Pysha’s revenues are growing at a faster rate than its receivables.

B) Pysha’s revenues are growing at a slower rate than its receivables.
C) The revenue growth rate divided by receivables growth rate is increasing over time.

Question #13 of 55 Question ID: 1685604

Which of the following statements about financial disclosures are correct or incorrect?

Transitory earnings are usually more important to investors than permanent

Statement #1:
earnings.

Pro-forma earnings are usually prepared in accordance with generally

Statement #2:
accepted accounting principles.

A) Only statement #1 is incorrect.

B) Only statement #2 is incorrect.
C) Both are incorrect.
Question #14 of 55 Question ID: 1685594

Brent Jones, CFA is analyzing the financial statements of Imperial Resorts Inc. Jones wants to
use the Beneish model to evaluate the probability of earnings manipulation.

Jones makes the following statements:

1. Depreciation index of less than 1 would indicate that the company is depreciating assets
at a higher rate than its peers.
2. Increases in Asset quality index indicate that the revenue recognition policies are
conservative.

Regarding the statements by Jones:

A) None of the statements is correct.

B) Only statement 1 is correct.
C) Only statement 2 is correct.

Question #15 of 55 Question ID: 1685603

A manufacturing firm purchases equipment for use in its operations. With regard to recording
the purchase using the cash basis versus the accrual basis of accounting, which of the following
statements is most appropriate?

With the cash basis, revenues and expenses relating to the equipment are generally
A)
recognized in the same period.
With the accrual basis, the cost of the equipment is allocated to the cash flow
B)
statements over the asset’s life.
With the cash basis, revenues and expenses relating to the equipment are generally
C)
recognized in different periods.

Question #16 of 55 Question ID: 1685588

William Jones, CFA, is analyzing the financial performance of two U.S. competitors in connection
with a potential investment recommendation of their common stocks. He is particularly
concerned about the quality of each company's financial results in 2007–2008 and in
developing projections for 2009 and 2010 fiscal years.

Adams Company has been the largest company in the industry, but Jefferson Inc. has grown
more rapidly in recent years. Adams's net sales in 2004 were 33-1/3% higher than Jefferson's
but were only 18% above Jefferson's in 2008. During 2008, a slowing U.S. economy led to lower
domestic revenue growth for both companies. The 10-k reports showed overall sales growth of
6% for Adams in 2008 compared to 7% for 2007 and 9% in 2006. Jefferson's gross sales rose
almost 12% in 2008 versus 8% in 2007 and 10% in 2006. In the past three years, Jefferson has
expanded its foreign business at a faster pace than Adams. In 2008, Jefferson's growth in
overseas business was particularly impressive. According to the company's 10-k report,
Jefferson offered a sales incentive to overseas customers. For those customers accepting the
special sales discount, Jefferson shipped products to specific warehouses in foreign ports
rather than directly to those customers' facilities.

In his initial review of Adams's and Jefferson's financial statements, Jones was concerned about
the quality of the growth in Jefferson's sales, considerably higher accounts receivables, and the
impact of overall accruals on earnings quality. He noted that Jefferson had instituted an
accounting change in 2008. The economic life for new plant and equipment investments was
determined to be five years longer than for previous investments. For Adams, he noted that the
higher level of inventories at the end of 2008 might be cause for concern in light of a further
slowdown expected in the U.S. economy in 2009.

The accompanying table shows financial data for both companies' Form 10-k reports for 2006–
2008 used by Jones for his analysis. To evaluate sales quality, he focused on trends in sales and
related expenses for both companies as well as cash collections and receivables comparisons.
Inventory trends relative to sales and the number of days' sales outstanding in inventory were
determined for both companies. Expense trends were examined for Adams and Jefferson
relative to sales growth and accrual ratios on a balance sheet and cash flow basis were
developed as overall measures of earnings quality.

Adams Company Jefferson Inc.

($ in thousands) 2006 2007 2008 2006 2007 2008

Gross sales 32,031 34,273 36,330 25,625 27,675 30,900

Sales discounts, returns,
781 836 886 625 675 900
and allowances

Net sales 31,250 33,438 35,444 25,000 27,000 30,000

Cost of goods sold 15,312 16,384 17,367 12,250 13,250 15,500

SG&A expenses 9,028 9,660 10,240 7,222 7,800 8,200

Depreciation expense 625 669 709 500 515 516

Interest expense 400 428 454 360 366 396

Income before taxes 5,835 6,243 6,618 4,668 5,069 5,388

Taxes (tax rate 40%) 2,334 2,497 2,647 2,000 2,028 2,155

Net income 3,501 3,746 3,971 2,668 3,041 3,233

Dividends 3,000 3,180 3,307 2,460 2,760 2,880

Net addition to retained

501 566 664 208 281 353
earnings

Balance Sheet

Cash and equivalents 150 160 170 120 130 120

Short-term marketable
250 325 345 200 217 195
securities

Accounts receivable (net) 15,875 16,758 17,763 12,700 13,000 15,892

Inventories 6,500 6,850 7,800 5,200 5,200 4,500

PP&E (net of depreciation) 8,562 8,991 9,440 6,850 7,057 7,200

Total assets 31,337 33,084 35,518 25,070 25,604 27,907

Accounts payable 7,062 7,880 9,300 6,050 6,100 6,398

Other current liabilities 337 400 450 270 373 1,525

Long-term debt 7,500 7,800 8,100 6,000 6,100 6,600

Common stock 15,000 15,000 15,000 12,000 12,000 12,000

Retained earnings 1,438 2,004 2,668 750 1,031 1,384

Total liabilities and
31,337 33,084 35,518 25,070 25,604 27,907
shareholders' equity

% change gross sales 7.0% 6.0% 8.0% 11.7%

% change sales discounts

6.0% 6.0% 8.0% 33.3%
and allowances

% change net sales 7.0% 6.0% 8.0% 11.1%

% change cost of goods

7.0% 6.0% 8.0% 17.0%
sold

% change in SG&A 6.0% 6.0% 8.0% 5.1%

% change in depreciation
6.0% 6.0% 3.0% 0.2%
expense

% change in accounts
6.0% 6.0% 2.0% 22.3%
receivable

% change in inventories 5.0% 13.8% 0.0% (13.5%)

Revenues % cash
1.03 1.03 1.03 1.0 1.0 1.1
collections

Days inventory
155 153 164 144 143 106
outstanding

Balance sheet accrual ratio 3.4% 3.5% 3.9% 2.0% 2.4% 10.1%

Cash flow accrual ratio 3.4% 3.5% 3.8% 2.0% 2.0% 4.3%

Jones observed that comparisons of 2007–2008 trends in sales, accounts receivables, and cash
collections showed:

Jefferson’s sales growth accelerated in 2008 compared to Adams’s, but cash collections
A) declined as indicated by the rise in receivables and the revenue/collections ratio;
Adams’s sales, accounts receivables, and cash collections rose at similar rates in 2008.
Jefferson’s higher increase in sales relative to Adams’s led to improvement in cash
B) collections indicated by the rise in the revenue/collections ratio. There was no change
in Adams’s cash collections in 2008.
 Jefferson’s decline in cash and equivalents in 2008 resulted in lower cash collections
C) despite strong sales growth; Adams’s showed similar growth in cash and equivalents
and accounts receivable relative to sales gains.

Question #17 of 55 Question ID: 1685620

Which of the following is least likely an indicator of biased measurement in assessing balance
sheet quality?

A) Overly high assumed discount rate for pension obligations.

B) Understatement of impairment charges for property, plant, and equipment.
Company’s investment in debt securities of other companies, carried on the books at
C)
market value.

Question #18 of 55 Question ID: 1685614

William Jones, CFA, is analyzing the financial performance of two U.S. competitors in connection
with a potential investment recommendation of their common stocks. He is particularly
concerned about the quality of each company's financial results in 2007–2008 and in
developing projections for 2009 and 2010 fiscal years.

Adams Company has been the largest company in the industry, but Jefferson Inc. has grown
more rapidly in recent years. Adams's net sales in 2004 were 33-1/3% higher than Jefferson's
but were only 18% above Jefferson's in 2008. During 2008, a slowing U.S. economy led to lower
domestic revenue growth for both companies. The 10-k reports showed overall sales growth of
6% for Adams in 2008 compared to 7% for 2007 and 9% in 2006. Jefferson's gross sales rose
almost 12% in 2008 versus 8% in 2007 and 10% in 2006. In the past three years, Jefferson has
expanded its foreign business at a faster pace than Adams. In 2008, Jefferson's growth in
overseas business was particularly impressive. According to the company's 10-k report,
Jefferson offered a sales incentive to overseas customers. For those customers accepting the
special sales discount, Jefferson shipped products to specific warehouses in foreign ports
rather than directly to those customers' facilities.

In his initial review of Adams's and Jefferson's financial statements, Jones was concerned about
the quality of the growth in Jefferson's sales, considerably higher accounts receivables, and the
impact of overall accruals on earnings quality. He noted that Jefferson had instituted an
accounting change in 2008. The economic life for new plant and equipment investments was
determined to be five years longer than for previous investments. For Adams, he noted that the
higher level of inventories at the end of 2008 might be cause for concern in light of a further
slowdown expected in the U.S. economy in 2009.

The accompanying table shows financial data for both companies' Form 10-k reports for 2006–
2008 used by Jones for his analysis. To evaluate sales quality, he focused on trends in sales and
related expenses for both companies as well as cash collections and receivables comparisons.
Inventory trends relative to sales and the number of days' sales outstanding in inventory were
determined for both companies. Expense trends were examined for Adams and Jefferson
relative to sales growth and accrual ratios on a balance sheet and cash flow basis were
developed as overall measures of earnings quality.

Adams Company Jefferson Inc.

($ in thousands) 2006 2007 2008 2006 2007 2008

Gross sales 32,031 34,273 36,330 25,625 27,675 30,900

Sales discounts, returns,
781 836 886 625 675 900
and allowances

Net sales 31,250 33,438 35,444 25,000 27,000 30,000

Cost of goods sold 15,312 16,384 17,367 12,250 13,250 15,500

SG&A expenses 9,028 9,660 10,240 7,222 7,800 8,200

Depreciation expense 625 669 709 500 515 516

Interest expense 400 428 454 360 366 396

Income before taxes 5,835 6,243 6,618 4,668 5,069 5,388

Taxes (tax rate 40%) 2,334 2,497 2,647 2,000 2,028 2,155

Net income 3,501 3,746 3,971 2,668 3,041 3,233

Dividends 3,000 3,180 3,307 2,460 2,760 2,880

Net addition to retained

501 566 664 208 281 353
earnings

Balance Sheet

Cash and equivalents 150 160 170 120 130 120

Short-term marketable
250 325 345 200 217 195
securities

Accounts receivable (net) 15,875 16,758 17,763 12,700 13,000 15,892

Inventories 6,500 6,850 7,800 5,200 5,200 4,500

PP&E (net of depreciation) 8,562 8,991 9,440 6,850 7,057 7,200

Total assets 31,337 33,084 35,518 25,070 25,604 27,907

Accounts payable 7,062 7,880 9,300 6,050 6,100 6,398

Other current liabilities 337 400 450 270 373 1,525

Long-term debt 7,500 7,800 8,100 6,000 6,100 6,600

Common stock 15,000 15,000 15,000 12,000 12,000 12,000

Retained earnings 1,438 2,004 2,668 750 1,031 1,384

Total liabilities and
31,337 33,084 35,518 25,070 25,604 27,907
shareholders equity

% change gross sales 7.0% 6.0% 8.0% 11.7%

% change sales discounts

6.0% 6.0% 8.0% 33.3%
and allowances

% change net sales 7.0% 6.0% 8.0% 11.1%

% change cost of goods

7.0% 6.0% 8.0% 17.0%
sold

% change in SG&A 6.0% 6.0% 8.0% 5.1%

% change in depreciation
6.0% 6.0% 3.0% 0.2%
expense

% change in accounts
6.0% 6.0% 2.0% 22.3%
receivable

% change in inventories 5.0% 13.8% 0.0% (13.5%)

Revenues % cash
1.03 1.03 1.03 1.0 1.0 1.1
collections

Days inventory
155 153 164 144 143 106
outstanding

Balance sheet accrual ratio 3.4% 3.5% 3.9% 2.0% 2.4% 10.1%

Cash flow accrual ratio 3.4% 3.5% 3.8% 2.0% 2.0% 4.3%

Based on the financial results of Adams and Jefferson in 2007 and 2008, the company
demonstrating the lower earnings quality would be:

Adams due to slower revenue growth, higher expense growth compared to Jefferson,
possible inventory obsolescence related to higher 2008 inventories despite slowing
A)
customer demand, and lower balance sheet and cash flow based accrual ratios in 2008
compared to Jefferson.
Jefferson due to sharply higher accruals ratios and less conservative accounting
B) methods indicated by the change in depreciation policies and the impact of changes in
shipment terms on revenue recognition and inventories for the special overseas offer.
 Adams due to lower cash collection measures, possible inventory obsolescence related
to higher 2008 inventories despite slowing customer demand, higher expense growth
C)
compared to Jefferson, and lower balance sheet and cash flow accrual ratios relative to
Jefferson.

Question #19 of 55 Question ID: 1685622

The least valuable source of information about a businesses' risk is:

A) Management discussion and analysis section of the annual report.

B) Auditor’s report.
C) Notes to financial statements.

Question #20 of 55 Question ID: 1685601

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 level of earnings.

B) Higher degree of conservatism of earnings.
C) Higher degree of persistence of earnings.

Question #21 of 55 Question ID: 1685582

With regard to specific measures to analyze in detecting manipulation in the financial reporting
process, which of the following statements is the least accurate?

Negative nonrecurring or non-operating items may be indicative of misclassifying an

A)
operating expense.
 An increasing days’ inventory on hand (DOH) measure may be indicative of obsolete
B)
inventory.
A decreasing days’ sales outstanding (DSO) measure may be an indication of lower
C)
quality revenue.

Question #22 of 55 Question ID: 1685587

High Plains Tubular Company is a leading manufacturer and distributor of quality steel
products used in energy, industrial, and automotive applications worldwide.

The U.S. steel industry has been challenged by competition from foreign producers located
primarily in Asia. All of the U.S. producers are experiencing declining margins as labor costs
continue to increase. In addition, the U.S. steel mills are technologically inferior to the foreign
competitors. Also, the U.S. producers have significant environmental issues that remain
unresolved.

High Plains is not immune from the problems of the industry and is currently in technical
default under its bond covenants. The default is a result of the failure to meet certain coverage
and turnover ratios. Earlier this year, High Plains and its bondholders entered into an
agreement that will allow High Plains time to become compliant with the covenants. If High
Plains is not in compliance by year end, the bondholders can immediately accelerate the
maturity date of the bonds. In this case, High Plains would have no choice but to file
bankruptcy.

High Plains follows U.S. GAAP. For the year ended 2008, High Plains received an unqualified
opinion from its independent auditor. However, the auditor's opinion included an explanatory
paragraph about High Plains' inability to continue as a going concern in the event its bonds
remain in technical default.

At the end of 2008, High Plains' Chief Executive Officer (CEO) and Chief Financial Officer (CFO)
filed the necessary certifications required by the Securities and Exchange Commission (SEC).

To get a better understanding of High Plains' financial situation, it is helpful to review High
Plains' cash flow statement found in Exhibit 1 and selected financial footnotes found in Exhibit
2.

Exhibit 1: Cash Flow Statement

High Plains Tubular Cash Flow Statement

Year ended December 31,

in thousands 2008 2007

Net income $158,177 $121,164

Depreciation expense 34,078 31,295

Deferred taxes 7,697 11,407

Receivables (144,087) (24,852)

Inventory (79,710) (72,777)

Payables 36,107 22,455

Cash flow from operations $12,262 $88,692

Cash flow from investing ($39,884) ($63,953)

Cash flow from financing $82,676 $6,056

Change in cash $55,054 $30,795

Exhibit 2: Selected Financial Footnotes

1. During 2008, High Plains' sales increased 27% over 2007. Its sales growth continues to
significantly exceed the industry average. Sales are recognized when a firm order is
received from the customer, the sales price is fixed and determinable, and collectability
is reasonably assured.
2. The cost of inventories is determined using the last-in, first-out (LIFO) method. Had the
first-in, first-out method been used, inventories would have been $152 million and $143
million higher as of December 31, 2008 and 2007, respectively.
3. Effective January 1, 2008, High Plains changed its depreciation method from the double-
declining balance method to the straight-line method in order to be more comparable
with the accounting practices of other firms within its industry. The change was not
retroactively applied and only affects assets that were acquired on or after January 1,
2008.

4. High Plains made the following discretionary expenditures for maintenance and repair of
plant and equipment and for advertising and marketing:

in millions 2008 2007 2006

Maintenance and repairs $180 $184 $218

Advertising and marketing 94 108 150

5. During the fiscal year ended December 31, 2008, High Plains sold $50 million of its
accounts receivable, with recourse, to an unrelated entity. All of the receivables were still
outstanding at year end.
6. High Plains conducts some of its operations in facilities leased under noncancelable
finance (capital) leases. Certain leases include renewal options with provisions for
increased lease payments during the renewal term.
 7. High Plains' average net operating assets at the end of 2008 and 2007 was $977.89
million and $642.83 million, respectively.

What is the most likely effect of High Plains' revenue recognition policy on net income and
inventory turnover?

A) Net income and inventory turnover are overstated.

B) Only inventory turnover is overstated.
C) Only net income is overstated.

Question #23 of 55 Question ID: 1685591

William Jones, CFA, is analyzing the financial performance of two U.S. competitors in connection
with a potential investment recommendation of their common stocks. He is particularly
concerned about the quality of each company's financial results in 2007– 2008 and in
developing projections for 2009 and 2010 fiscal years.

Adams Company has been the largest company in the industry, but Jefferson Inc. has grown
more rapidly in recent years. Adams's net sales in 2004 were 33-1/3% higher than Jefferson's
but were only 18% above Jefferson's in 2008. During 2008, a slowing U.S. economy led to lower
domestic revenue growth for both companies. The 10-k reports showed overall sales growth of
6% for Adams in 2008 compared to 7% for 2007 and 9% in 2006. Jefferson's gross sales rose
almost 12% in 2008 versus 8% in 2007 and 10% in 2006. In the past three years, Jefferson has
expanded its foreign business at a faster pace than Adams. In 2008, Jefferson's growth in
overseas business was particularly impressive. According to the company's 10-k report,
Jefferson offered a sales incentive to overseas customers. For those customers accepting the
special sales discount, Jefferson shipped products to specific warehouses in foreign ports
rather than directly to those customers' facilities.

In his initial review of Adams's and Jefferson's financial statements, Jones was concerned about
the quality of the growth in Jefferson's sales, considerably higher accounts receivables, and the
impact of overall accruals on earnings quality. He noted that Jefferson had instituted an
accounting change in 2008. The economic life for new plant and equipment investments was
determined to be five years longer than for previous investments. For Adams, he noted that the
higher level of inventories at the end of 2008 might be cause for concern in light of a further
slowdown expected in the U.S. economy in 2009.

The accompanying table shows financial data for both companies' Form 10-k reports for 2006–
2008 used by Jones for his analysis. To evaluate sales quality, he focused on trends in sales and
related expenses for both companies as well as cash collections and receivables comparisons.
Inventory trends relative to sales and the number of days' sales outstanding in inventory were
determined for both companies. Expense trends were examined for Adams and Jefferson
relative to sales growth and accrual ratios on a balance sheet and cash flow basis were
developed as overall measures of earnings quality.

Adams Company Jefferson Inc.

($ in thousands) 2006 2007 2008 2006 2007 2008

Gross sales 32,031 34,273 36,330 25,625 27,675 30,900

Sales discounts, returns,
781 836 886 625 675 900
and allowances

Net sales 31,250 33,438 35,444 25,000 27,000 30,000

Cost of goods sold 15,312 16,384 17,367 12,250 13,250 15,500

SG&A expenses 9,028 9,660 10,240 7,222 7,800 8,200

Depreciation expense 625 669 709 500 515 516

Interest expense 400 428 454 360 366 396

Income before taxes 5,835 6,243 6,618 4,668 5,069 5,388

Taxes (tax rate 40%) 2,334 2,497 2,647 2,000 2,028 2,155

Net income 3,501 3,746 3,971 2,668 3,041 3,233

Dividends 3,000 3,180 3,307 2,460 2,760 2,880

Net addition to retained

501 566 664 208 281 353
earnings

Balance Sheet

Cash and equivalents 150 160 170 120 130 120

Short-term marketable
250 325 345 200 217 195
securities

Accounts receivable (net) 15,875 16,758 17,763 12,700 13,000 15,892

Inventories 6,500 6,850 7,800 5,200 5,200 4,500

PP&E (net of depreciation) 8,562 8,991 9,440 6,850 7,057 7,200

Total assets 31,337 33,084 35,518 25,070 25,604 27,907

Accounts payable 7,062 7,880 9,300 6,050 6,100 6,398

Other current liabilities 337 400 450 270 373 1,525

Long-term debt 7,500 7,800 8,100 6,000 6,100 6,600

Common stock 15,000 15,000 15,000 12,000 12,000 12,000

Retained earnings 1,438 2,004 2,668 750 1,031 1,384

Total liabilities and
31,337 33,084 35,518 25,070 25,604 27,907
shareholders equity

% change gross sales 7.0% 6.0% 8.0% 11.7%

% change sales discounts

6.0% 6.0% 8.0% 33.3%
and allowances

% change net sales 7.0% 6.0% 8.0% 11.1%

% change cost of goods

7.0% 6.0% 8.0% 17.0%
sold

% change in SG&A 6.0% 6.0% 8.0% 5.1%

% change in depreciation
6.0% 6.0% 3.0% 0.2%
expense

% change in accounts
6.0% 6.0% 2.0% 22.3%
receivable

% change in inventories 5.0% 13.8% 0.0% (13.5%)

Revenues % cash
1.03 1.03 1.03 1.0 1.0 1.1
collections

Days inventory
155 153 164 144 143 106
outstanding

Balance sheet accrual ratio 3.4% 3.5% 3.9% 2.0% 2.4% 10.1%

Cash flow accrual ratio 3.4% 3.5% 3.8% 2.0% 2.0% 4.3%

The quality of earnings as measured by balance-sheet-based accruals ratios showed:

both companies’ earnings quality improved due to the increase in the ratio with
A)
Jefferson showing the most improvement.
strong improvement in Jefferson’s earnings quality relative to Adams’s due to the sharp
B)
jump in the ratio in 2008 compared to the much smaller increase for Adams.
decrease in Jefferson’s earnings quality relative to Adams’s due to the sharp jump in
C)
the ratio in 2008 compared to a much smaller increase for Adams.
Question #24 of 55 Question ID: 1685584

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 excluded.
C) Both are included.

Question #25 of 55 Question ID: 1685600

Complete the following sentence. An analyst would apply _________ to the cash component of
income compared to the accrual component when evaluating company performance.

A) the same weighting.

B) a lower weighting.
C) a higher weighting.

Question #26 of 55 Question ID: 1685615

High-quality cash flow is least likely to be characterized by:

Financing cash flows sufficient to cover capital expenditures, dividends and debt
A)
repayments.
B) No significant differences between operating cash flow and reported earnings.
C) Volatility of operating cash flow being lower than that of the firm’s peers.
Question #27 of 55 Question ID: 1685596

Which one of the following choices is least likely to be an indicator of poor-quality earnings?

A) An investigation by the market regulatory authority is initiated.

B) Restatement of previously issued financial statements.
C) Reported earnings handily beat analyst estimates.

Question #28 of 55 Question ID: 1685602

Classification of non-operating income as operating would lead to stated earnings that are
likely to be:

A) non-compliant with GAAP.

B) compliant with GAAP but not sustainable.
C) compliant with GAAP and sustainable.

Question #29 of 55 Question ID: 1685578

Charles Nicholls, chief investment officer of Gertmann Money Management, is reviewing the
year-end financial statements of Zartner Canneries. In those statements he sees a sharp
increase in inventories well above the sales-growth rate, and an increase in the discount rate
for its pension liabilities. To determine whether or not Zartner Canneries is cooking the books,
what should Nicholls do?

A) Check Zartner’s cash-flow statement and review its footnotes.

B) Calculate Zartner’s turnover ratios and review the footnotes of its competitors.
Analyze trends in Zartner’s receivables and consider the changing characteristics of its
C)
work force.
Question #30 of 55 Question ID: 1685592

In the context of the Beneish model to evaluate the probability of earnings manipulation, an
increase in Days Sales Receivable Index is least likely to signify:

A) revenue inflation.
B) a decrease in probability of earnings manipulation.
C) an increase in M-score.

Question #31 of 55 Question ID: 1685581

Duster Corporation's year-end income statement reported the following:

Operating income $187,000

Results from discontinued operations:

Loss from segment operations

(net of $1,440 tax effect) ($2,160)

Gain on segment disposal

(net of $8,640 tax effect) 12,960 10,800

Gain on sale of equipment 3,400

Interest expense 12,400

Extraordinary loss

(net of $2,200 tax benefit) 3,300

Income tax expense 71,200

Calculate Duster's income from continuing operations for the year.

A) $106,800.
B) $103,500.
C) $100,200.
Question #32 of 55 Question ID: 1685567

High results quality is most likely demonstrated by:

A) an adequate level of return that is sustainable.

B) high level of earnings determined conservatively.
C) GAAP compliant financial reports that are decision useful.

Question #33 of 55 Question ID: 1685579

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?

Computer Automobile
division division
earnings earnings

A) Decrease Increase

B) Increase Decrease

C) Decrease Decrease

Question #34 of 55 Question ID: 1685568

To assess the quality of financial reports, which question is least necessary for an analyst to
answer?

A) Do earnings represent an adequate level of return?

B) Are the financial reports decision useful and GAAP compliant?
C) Are reported earnings consistent with the firm’s budget?

Question #35 of 55 Question ID: 1685605

High Plains Tubular Company is a leading manufacturer and distributor of quality steel
products used in energy, industrial, and automotive applications worldwide.

The U.S. steel industry has been challenged by competition from foreign producers located
primarily in Asia. All of the U.S. producers are experiencing declining margins as labor costs
continue to increase. In addition, the U.S. steel mills are technologically inferior to the foreign
competitors. Also, the U.S. producers have significant environmental issues that remain
unresolved.

High Plains is not immune from the problems of the industry and is currently in technical
default under its bond covenants. The default is a result of the failure to meet certain coverage
and turnover ratios. Earlier this year, High Plains and its bondholders entered into an
agreement that will allow High Plains time to become compliant with the covenants. If High
Plains is not in compliance by year end, the bondholders can immediately accelerate the
maturity date of the bonds. In this case, High Plains would have no choice but to file
bankruptcy.

High Plains follows U.S. GAAP. For the year ended 2008, High Plains received an unqualified
opinion from its independent auditor. However, the auditor's opinion included an explanatory
paragraph about High Plains' inability to continue as a going concern in the event its bonds
remain in technical default.

At the end of 2008, High Plains' Chief Executive Officer (CEO) and Chief Financial Officer (CFO)
filed the necessary certifications required by the Securities and Exchange Commission (SEC).

To get a better understanding of High Plains' financial situation, it is helpful to review High
Plains' cash flow statement found in Exhibit 1 and selected financial footnotes found in Exhibit
2.

Exhibit 1: Cash Flow Statement

High Plains Tubular Cash Flow Statement

Year ended December 31,

in thousands 2008 2007

Net income $158,177 $121,164

Depreciation expense 34,078 31,295

Deferred taxes 7,697 11,407

Receivables (144,087) (24,852)

Inventory (79,710) (72,777)

Payables 36,107 22,455

Cash flow from operations $12,262 $88,692

Cash flow from investing ($39,884) ($63,953)

Cash flow from financing $82,676 $6,056

Change in cash $55,054 $30,795

Exhibit 2: Selected Financial Footnotes

1. During 2008, High Plains' sales increased 27% over 2007. Its sales growth continues to
significantly exceed the industry average. Sales are recognized when a firm order is
received from the customer, the sales price is fixed and determinable, and collectability
is reasonably assured.
2. The cost of inventories is determined using the last-in, first-out (LIFO) method. Had the
first-in, first-out method been used, inventories would have been $152 million and $143
million higher as of December 31, 2008 and 2007, respectively.
3. Effective January 1, 2008, High Plains changed its depreciation method from the double-
declining balance method to the straight-line method in order to be more comparable
with the accounting practices of other firms within its industry. The change was not
retroactively applied and only affects assets that were acquired on or after January 1,
2008.

4. High Plains made the following discretionary expenditures for maintenance and repair of
plant and equipment and for advertising and marketing:

in millions 2008 2007 2006

Maintenance and repairs $180 $184 $218

Advertising and marketing 94 108 150

5. During the fiscal year ended December 31, 2008, High Plains sold $50 million of its
accounts receivable, with recourse, to an unrelated entity. All of the receivables were still
outstanding at year end.
6. High Plains conducts some of its operations in facilities leased under noncancelable
finance (capital) leases. Certain leases include renewal options with provisions for
increased lease payments during the renewal term.
 7. High Plains' average net operating assets at the end of 2008 and 2007 was $977.89
million and $642.83 million, respectively.

Which of the following statements about evaluating High Plains' financial reporting quality is
least accurate?

A) Higher Plains may have manipulated earnings due to the risk of default.
B) High Plains’ extreme revenue growth will likely revert back to normal levels over time.
Because of the estimates involved, a higher weighting should be assigned to the
C)
accrual component of High Plains’ earnings as compared to the cash component.

Question #36 of 55 Question ID: 1685609

Mean reversion in earnings means that:

A) Extreme high as well as low levels of earnings will revert to the mean.
B) Extreme low earnings will revert to the mean but extreme high earnings will not.
C) Extreme high earnings will revert to the mean but extreme low earnings will not.

Question #37 of 55 Question ID: 1685570

Aggressive revenue recognition practices are least likely to increase:

A) reported ending inventory

B) reported expenses
C) reported assets

Question #38 of 55 Question ID: 1685590

William Jones, CFA, is analyzing the financial performance of two U.S. competitors in connection
with a potential investment recommendation of their common stocks. He is particularly
concerned about the quality of each company's financial results in 2007–2008 and in
developing projections for 2009 and 2010 fiscal years.

Adams Company has been the largest company in the industry, but Jefferson Inc. has grown
more rapidly in recent years. Adams's net sales in 2004 were 33-1/3% higher than Jefferson's
but were only 18% above Jefferson's in 2008. During 2008, a slowing U.S. economy led to lower
domestic revenue growth for both companies. The 10-k reports showed overall sales growth of
6% for Adams in 2008 compared to 7% for 2007 and 9% in 2006. Jefferson's gross sales rose
almost 12% in 2008 versus 8% in 2007 and 10% in 2006. In the past three years, Jefferson has
expanded its foreign business at a faster pace than Adams. In 2008, Jefferson's growth in
overseas business was particularly impressive. According to the company's 10-k report,
Jefferson offered a sales incentive to overseas customers. For those customers accepting the
special sales discount, Jefferson shipped products to specific warehouses in foreign ports
rather than directly to those customers' facilities.

In his initial review of Adams's and Jefferson's financial statements, Jones was concerned about
the quality of the growth in Jefferson's sales, considerably higher accounts receivables, and the
impact of overall accruals on earnings quality. He noted that Jefferson had instituted an
accounting change in 2008. The economic life for new plant and equipment investments was
determined to be five years longer than for previous investments. For Adams, he noted that the
higher level of inventories at the end of 2008 might be cause for concern in light of a further
slowdown expected in the U.S. economy in 2009.

The accompanying table shows financial data for both companies' Form 10-k reports for 2006–
2008 used by Jones for his analysis. To evaluate sales quality, he focused on trends in sales and
related expenses for both companies as well as cash collections and receivables comparisons.
Inventory trends relative to sales and the number of days' sales outstanding in inventory were
determined for both companies. Expense trends were examined for Adams and Jefferson
relative to sales growth and accrual ratios on a balance sheet and cash flow basis were
developed as overall measures of earnings quality.

Adams Company Jefferson Inc.

($ in thousands) 2006 2007 2008 2006 2007 2008

Gross sales 32,031 34,273 36,330 25,625 27,675 30,900

Sales discounts, returns,
781 836 886 625 675 900
and allowances

Net sales 31,250 33,438 35,444 25,000 27,000 30,000

Cost of goods sold 15,312 16,384 17,367 12,250 13,250 15,500

SG&A expenses 9,028 9,660 10,240 7,222 7,800 8,200

Depreciation expense 625 669 709 500 515 516

Interest expense 400 428 454 360 366 396

Income before taxes 5,835 6,243 6,618 4,668 5,069 5,388

Taxes (tax rate 40%) 2,334 2,497 2,647 2,000 2,028 2,155

Net income 3,501 3,746 3,971 2,668 3,041 3,233

Dividends 3,000 3,180 3,307 2,460 2,760 2,880

Net addition to retained

501 566 664 208 281 353
earnings

Balance Sheet

Cash and equivalents 150 160 170 120 130 120

Short-term marketable
250 325 345 200 217 195
securities

Accounts receivable (net) 15,875 16,758 17,763 12,700 13,000 15,892

Inventories 6,500 6,850 7,800 5,200 5,200 4,500

PP&E (net of depreciation) 8,562 8,991 9,440 6,850 7,057 7,200

Total assets 31,337 33,084 35,518 25,070 25,604 27,907

Accounts payable 7,062 7,880 9,300 6,050 6,100 6,398

Other current liabilities 337 400 450 270 373 1,525

Long-term debt 7,500 7,800 8,100 6,000 6,100 6,600

Common stock 15,000 15,000 15,000 12,000 12,000 12,000

Retained earnings 1,438 2,004 2,668 750 1,031 1,384

Total liabilities and
31,337 33,084 35,518 25,070 25,604 27,907
shareholders equity

% change gross sales 7.0% 6.0% 8.0% 11.7%

% change sales discounts

6.0% 6.0% 8.0% 33.3%
and allowances

% change net sales 7.0% 6.0% 8.0% 11.1%

% change cost of goods

7.0% 6.0% 8.0% 17.0%
sold

% change in SG&A 6.0% 6.0% 8.0% 5.1%

% change in depreciation
6.0% 6.0% 3.0% 0.2%
expense

% change in accounts
6.0% 6.0% 2.0% 22.3%
receivable

% change in inventories 5.0% 13.8% 0.0% (13.5%)

Revenues % cash
1.03 1.03 1.03 1.0 1.0 1.1
collections

Days inventory
155 153 164 144 143 106
outstanding

Balance sheet accrual ratio 3.4% 3.5% 3.9% 2.0% 2.4% 10.1%

Cash flow accrual ratio 3.4% 3.5% 3.8% 2.0% 2.0% 4.3%

Comparisons of expense trends in 2007–2008 showed:

Jefferson’s management appeared to have managed SG&A and depreciation expenses

more effectively than Adams’s; there was a small increase in Jefferson’s depreciation
A)
expense and slower growth in SG&A relative to the company’s previous year and
compared to Adams’s trends.
higher growth of Adams’s SG&A and depreciation expense versus Jefferson’s; the small
change in Jefferson’s depreciation may relate to the change in depreciation lives, while
B)
the slower SG&A growth may reflect expense controls imposed to offset lower gross
profit margins.
 higher growth of Adams’s SG&A and depreciation expense versus Jefferson’s may
C)
indicate more effective expense control by Jefferson in a slowing domestic economy.

Question #39 of 55 Question ID: 1685577

The failure to recognize inventory obsolescence is an example of ___________.

A) Understating expenses.
B) Misclassifying expenses.
C) Delaying expenses.

Question #40 of 55 Question ID: 1685619

Which of the following is least likely an indicator of biased measurement in assessing balance
sheet quality?

A) Understatement of valuation allowance for deferred tax assets.

B) Presence of substantial goodwill on balance sheet.
C) Understatement of inventory impairment charges.

Question #41 of 55 Question ID: 1685571

Errors that affect multiple financial statement elements are most likely to arise from:

A) measurement and timing issues.

B) compound issues.
C) classification issues.
Question #42 of 55 Question ID: 1685599

Complete the following sentence. The cash component of income is ___________ than the accrual
component.

A) the same persistence.

B) less persistent.
C) more persistent.

Question #43 of 55 Question ID: 1685613

William Jones, CFA, is analyzing the financial performance of two U.S. competitors in connection
with a potential investment recommendation of their common stocks. He is particularly
concerned about the quality of each company's financial results in 2007–2008 and in
developing projections for 2009 and 2010 fiscal years.

Adams Company has been the largest company in the industry, but Jefferson Inc. has grown
more rapidly in recent years. Adams's net sales in 2004 were 33-1/3% higher than Jefferson's
but were only 18% above Jefferson's in 2008. During 2008, a slowing U.S. economy led to lower
domestic revenue growth for both companies. The 10-k reports showed overall sales growth of
6% for Adams in 2008 compared to 7% for 2007 and 9% in 2006. Jefferson's gross sales rose
almost 12% in 2008 versus 8% in 2007 and 10% in 2006. In the past three years, Jefferson has
expanded its foreign business at a faster pace than Adams. In 2008, Jefferson's growth in
overseas business was particularly impressive. According to the company's 10-k report,
Jefferson offered a sales incentive to overseas customers. For those customers accepting the
special sales discount, Jefferson shipped products to specific warehouses in foreign ports
rather than directly to those customers' facilities.

In his initial review of Adams's and Jefferson's financial statements, Jones was concerned about
the quality of the growth in Jefferson's sales, considerably higher accounts receivables, and the
impact of overall accruals on earnings quality. He noted that Jefferson had instituted an
accounting change in 2008. The economic life for new plant and equipment investments was
determined to be five years longer than for previous investments. For Adams, he noted that the
higher level of inventories at the end of 2008 might be cause for concern in light of a further
slowdown expected in the U.S. economy in 2009.

The accompanying table shows financial data for both companies' Form 10-k reports for 2006–
2008 used by Jones for his analysis. To evaluate sales quality, he focused on trends in sales and
related expenses for both companies as well as cash collections and receivables comparisons.
Inventory trends relative to sales and the number of days' sales outstanding in inventory were
determined for both companies. Expense trends were examined for Adams and Jefferson
relative to sales growth and accrual ratios on a balance sheet and cash flow basis were
developed as overall measures of earnings quality.

Adams Company Jefferson Inc.

($ in thousands) 2006 2007 2008 2006 2007 2008

Gross sales 32,031 34,273 36,330 25,625 27,675 30,900

Sales discounts, returns,
781 836 886 625 675 900
and allowances

Net sales 31,250 33,438 35,444 25,000 27,000 30,000

Cost of goods sold 15,312 16,384 17,367 12,250 13,250 15,500

SG&A expenses 9,028 9,660 10,240 7,222 7,800 8,200

Depreciation expense 625 669 709 500 515 516

Interest expense 400 428 454 360 366 396

Income before taxes 5,835 6,243 6,618 4,668 5,069 5,388

Taxes (tax rate 40%) 2,334 2,497 2,647 2,000 2,028 2,155

Net income 3,501 3,746 3,971 2,668 3,041 3,233

Dividends 3,000 3,180 3,307 2,460 2,760 2,880

Net addition to retained

501 566 664 208 281 353
earnings

Balance Sheet

Cash and equivalents 150 160 170 120 130 120

Short-term marketable
250 325 345 200 217 195
securities

Accounts receivable (net) 15,875 16,758 17,763 12,700 13,000 15,892

Inventories 6,500 6,850 7,800 5,200 5,200 4,500

PP&E (net of depreciation) 8,562 8,991 9,440 6,850 7,057 7,200

Total assets 31,337 33,084 35,518 25,070 25,604 27,907

Accounts payable 7,062 7,880 9,300 6,050 6,100 6,398

Other current liabilities 337 400 450 270 373 1,525

Long-term debt 7,500 7,800 8,100 6,000 6,100 6,600

Common stock 15,000 15,000 15,000 12,000 12,000 12,000

Retained earnings 1,438 2,004 2,668 750 1,031 1,384

Total liabilities and
31,337 33,084 35,518 25,070 25,604 27,907
shareholders equity

% change gross sales 7.0% 6.0% 8.0% 11.7%

% change sales discounts

6.0% 6.0% 8.0% 33.3%
and allowances

% change net sales 7.0% 6.0% 8.0% 11.1%

% change cost of goods

7.0% 6.0% 8.0% 17.0%
sold

% change in SG&A 6.0% 6.0% 8.0% 5.1%

% change in depreciation
6.0% 6.0% 3.0% 0.2%
expense

% change in accounts
6.0% 6.0% 2.0% 22.3%
receivable

% change in inventories 5.0% 13.8% 0.0% (13.5%)

Revenues % cash
1.03 1.03 1.03 1.0 1.0 1.1
collections

Days inventory
155 153 164 144 143 106
outstanding

Balance sheet accrual ratio 3.4% 3.5% 3.9% 2.0% 2.4% 10.1%

Cash flow accrual ratio 3.4% 3.5% 3.8% 2.0% 2.0% 4.3%

The quality of earnings as measured by cash-flow-based accruals ratios showed:

Jefferson’s 2008 accrual ratio exceeded Adams’s ratio for the first time in the 2006–
A) 2008 period, thus demonstrating significant improvement in earnings quality relative
to Adams’s.
Jefferson’s 2008 accrual ratio exceeded Adams’s ratio for the first time in the 2006–
B) 2008 period, indicating a decline in earnings quality compared to previous years and
lower earnings quality relative to Adams’s in 2008.
Jefferson’s higher accruals ratio in 2008 compared to 2007 and relative to Adams’s in
C)
2008 indicates Jefferson’s higher earnings quality.
Question #44 of 55 Question ID: 1685569

Which of the following choices is most likely a biased accounting choice to overstate
profitability?

A) Classifying non-operating expenses as operating.

B) Channeling gains through OCI and losses through income statement.
C) Lessor use of sales-type finance lease classification.

Question #45 of 55 Question ID: 1685606

Complete the following sentence. When earnings are relatively free of accruals, mean reversion
will occur __________.

A) at the same rate as usual.

B) relatively faster than usual.
C) relatively slower than usual.

Question #46 of 55 Question ID: 1685616

Which of the following is least likely an indicator of high-quality cash flow?

A) OCF adequate to cover capital expenditures, dividends and debt repayments.

B) OCF derived from sustainable sources.
C) Total cash flow that is positive and high.

Question #47 of 55 Question ID: 1685585

Which of the following statements about operating income and operating cash flow are correct
or incorrect?

If operating income is growing faster than operating cash flow over the long-
Statement #1: term, the firm may be recognizing revenue too soon or delaying the
recognition of expense.

Operating cash flow exceeding operating income is sustainable over the

Statement #2:
long-term.

A) Both are incorrect.

B) Only one is correct.
C) Both are correct.

Question #48 of 55 Question ID: 1685607

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) Normal earnings should not be expected to continue indefinitely.
C) High earnings should not be expected to continue indefinitely.

Question #49 of 55 Question ID: 1685595

Classification shifting is least likely to result in a higher:

A) reported net income.

B) equity value derived when earnings forecasts are based on operating earnings.
C) firm value derived when cash flow forecasts are based on core earnings.
Question #50 of 55 Question ID: 1685583

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) The declining LIFO reserve.
C) Equity investment earnings not reflected on the cash-flow statement.

Question #51 of 55 Question ID: 1685598

Consider the following statements:

Compared to the cash basis of accounting, the accrual basis of accounting

Statement 1:
provides more timely information about future cash flows.

Compared to the cash basis of accounting, the accrual basis requires more
Statement 2:
use of discretion than the cash basis.

Are these statements CORRECT?

No, because it is actually the cash basis of accounting that results in more difficulty in
A)
properly assigning revenues and expenses to the appropriate periods.
No, because it is actually the cash basis of accounting that provides more timely and
B)
relevant information to users about future cash flows.
C) Yes.
Question #52 of 55 Question ID: 1685580

Analyst Jane Kilgore is worried that some of Maxwell Research's accrual accounting practices
will lead to excessive operating earnings recognition in the near-term. Examples of Kilgore's
concerns include the following:

Accelerated revenue recognition of service agreements.

Classification of recurring revenue as nonrecurring revenue.
Understated inventory obsolescence.

Which of Kilgore's concerns is least likely to overstate current operating earnings?

A) Understated inventory obsolescence.

B) Classification of recurring revenue as nonrecurring revenue.
C) Accelerated revenue recognition of service agreements.

Question #53 of 55 Question ID: 1685597

Hartford Manufacturing Case Scenario

Sally Wellington, CFA, analyzes the financial statements of Hartford Manufacturing, a company
located in the United States that uses U.S. GAAP. Wellington determines that Hartford's most
significant assets are its inventory and long-term assets. Wellington is interested in the financial
statement and ratio impact of the accounting methods used by Hartford to account for these
assets, especially when compared to the methods used by Hartford's competitors. She gathers
the following information to aid in her analysis:

Exhibit 1

Selected Financial Information (US$ millions)

Year Ended December 31, 20X1

Select Balance Sheet Information

Inventory 16,253

Property, plant and equipment, gross 34,221

Accumulated depreciation (12,835)

Property, plant and equipment, net 21,836

Total assets 60,038

Total liabilities 40,736

Total equity 19,302

Income Statement Information

Revenues 32,396

Cost of goods sold 18,885

Lease expense 590

Other expense 5,911

Depreciation expense 2,336

EBIT 4,674

Interest expense 1,522

Income tax expense (30%) 946

 Net income 2,206

Based on her knowledge of Hartford's competitors and her review of Hartford's financial
statement disclosures and Management's Discussion and Analysis (MD&A), Wellington notes
the following:

Hartford accounts for its inventory using the LIFO method. All of Hartford's competitors
use the FIFO method.
As a result of technological advancements, the cost to produce Hartford's inventory has
fallen each year for the last five years. Hartford's LIFO reserve was (–)$2,603 in 20X0 and
(–)$3,183 in 20X1.
Hartford recorded a $520 fixed-asset impairment loss on its December 31, 20X0 income
statement. Wellington concluded that this impairment loss increased Hartford's fixed-
asset turnover ratio in 20X0, and Hartford's return on assets and net profit margin in
20X1.
In 20X1 Hartford changed its depreciation method from the straight-line method to the
double-declining balance method and increased the useful lives and salvage values of its
fixed assets.
The majority of Hartford's lease agreements are accounted for as operating leases.
Hartford's largest competitors account for the majority of their leases as capital (finance)
leases.

Wellington knows that the Financial Accounting Standards Board (FASB) and International
Accounting Standards Board (IASB) have proposed a change in lease accounting that would
require the capitalization of all leases, including leases currently classified as operating leases.
Using a discount rate of 8% and an average remaining lease term of five years, Wellington
determines that the present value of Hartford's operating leases was $2,630 on December 31,
20X1.

Which of the following characteristics of Hartford's long-term asset accounting is least likely to
be considered a quality of financial reporting problem by Wellington?

A) The change from straight-line to double-declining balance depreciation.

B) The increase in the useful lives and salvage values of Hartford's fixed assets.
C) The classification of the majority of Hartford's leases as operating leases.
Question #54 of 55 Question ID: 1685574

Which of the following statements about cash flow is (are) CORRECT?

Statement #1: The cash effects of decreasing accounts payable turnover are unlimited.

The tax benefits from employee stock options can result in a significant
Statement #2:
source of investing cash flow.

Statement #1 Statement #2

A) Incorrect Correct

B) Incorrect Incorrect

C) Correct Incorrect

Question #55 of 55 Question ID: 1685573

Marcel Schulte is analyzing various retailing firms. Which of the following items is least
indicative of a potential problem with revenue recognition and earnings quality?

A) Implementing a “bill and hold” arrangement.

B) Disproportionate revenues in the last quarter of the calendar year.
C) Use of barter transactions.
Question #1 of 55 Question ID: 1685589
William Jones, CFA, is analyzing the financial performance of two U.S. competitors in connection
with a potential investment recommendation of their common stocks. He is particularly
concerned about the quality of each company's financial results in 2007–2008 and in
developing projections for 2009 and 2010 fiscal years.

Adams Company has been the largest company in the industry, but Jefferson Inc. has grown
more rapidly in recent years. Adams's net sales in 2004 were 33-1/3% higher than Jefferson's
but were only 18% above Jefferson's in 2008. During 2008, a slowing U.S. economy led to lower
domestic revenue growth for both companies. The 10-k reports showed overall sales growth of
6% for Adams in 2008 compared to 7% for 2007 and 9% in 2006. Jefferson's gross sales rose
almost 12% in 2008 versus 8% in 2007 and 10% in 2006. In the past three years, Jefferson has
expanded its foreign business at a faster pace than Adams. In 2008, Jefferson's growth in
overseas business was particularly impressive. According to the company's 10-k report,
Jefferson offered a sales incentive to overseas customers. For those customers accepting the
special sales discount, Jefferson shipped products to specific warehouses in foreign ports
rather than directly to those customers' facilities.

In his initial review of Adams's and Jefferson's financial statements, Jones was concerned about
the quality of the growth in Jefferson's sales, considerably higher accounts receivables, and the
impact of overall accruals on earnings quality. He noted that Jefferson had instituted an
accounting change in 2008. The economic life for new plant and equipment investments was
determined to be five years longer than for previous investments. For Adams, he noted that the
higher level of inventories at the end of 2008 might be cause for concern in light of a further
slowdown expected in the U.S. economy in 2009.

The accompanying table shows financial data for both companies' Form 10-k reports for 2006–
2008 used by Jones for his analysis. To evaluate sales quality, he focused on trends in sales and
related expenses for both companies as well as cash collections and receivables comparisons.
Inventory trends relative to sales and the number of days' sales outstanding in inventory were
determined for both companies. Expense trends were examined for Adams and Jefferson
relative to sales growth and accrual ratios on a balance sheet and cash flow basis were
developed as overall measures of earnings quality.

Adams Company Jefferson Inc.

($ in thousands) 2006 2007 2008 2006 2007 2008

Gross sales 32,031 34,273 36,330 25,625 27,675 30,900

Sales discounts, returns,
781 836 886 625 675 900
and allowances

Net sales 31,250 33,438 35,444 25,000 27,000 30,000

Cost of goods sold 15,312 16,384 17,367 12,250 13,250 15,500

SG&A expenses 9,028 9,660 10,240 7,222 7,800 8,200

Depreciation expense 625 669 709 500 515 516

Interest expense 400 428 454 360 366 396

Income before taxes 5,835 6,243 6,618 4,668 5,069 5,388

Taxes (tax rate 40%) 2,334 2,497 2,647 2,000 2,028 2,155

Net income 3,501 3,746 3,971 2,668 3,041 3,233

Dividends 3,000 3,180 3,307 2,460 2,760 2,880

Net addition to retained

501 566 664 208 281 353
earnings

Balance Sheet

Cash and equivalents 150 160 170 120 130 120

Short-term marketable
250 325 345 200 217 195
securities

Accounts receivable (net) 15,875 16,758 17,763 12,700 13,000 15,892

Inventories 6,500 6,850 7,800 5,200 5,200 4,500

PP&E (net of depreciation) 8,562 8,991 9,440 6,850 7,057 7,200

Total assets 31,337 33,084 35,518 25,070 25,604 27,907

Accounts payable 7,062 7,880 9,300 6,050 6,100 6,398

Other current liabilities 337 400 450 270 373 1,525

Long-term debt 7,500 7,800 8,100 6,000 6,100 6,600

Common stock 15,000 15,000 15,000 12,000 12,000 12,000

Retained earnings 1,438 2,004 2,668 750 1,031 1,384

Total liabilities and
31,337 33,084 35,518 25,070 25,604 27,907
shareholders equity

% change gross sales 7.0% 6.0% 8.0% 11.7%

% change sales discounts

6.0% 6.0% 8.0% 33.3%
and allowances

% change net sales 7.0% 6.0% 8.0% 11.1%

% change cost of goods

7.0% 6.0% 8.0% 17.0%
sold

% change in SG&A 6.0% 6.0% 8.0% 5.1%

% change in depreciation
6.0% 6.0% 3.0% 0.2%
expense

% change in accounts
6.0% 6.0% 2.0% 22.3%
receivable

% change in inventories 5.0% 13.8% 0.0% (13.5%)

Revenues % cash
1.03 1.03 1.03 1.0 1.0 1.1
collections

Days inventory
155 153 164 144 143 106
outstanding

Balance sheet accrual ratio 3.4% 3.5% 3.9% 2.0% 2.4% 10.1%

Cash flow accrual ratio 3.4% 3.5% 3.8% 2.0% 2.0% 4.3%

Jones also observed that inventory and cost of goods sold comparisons showed:

Jefferson’s inventory increase and large increase in cost of goods sold may be
A) related to the success of the special offer; Adams’s large increase in inventories
suggests possible inventory obsolescence.
Jefferson’s inventory levels may be understated and sales overstated to the extent
B) of product shipments for the special offer; Adams’s inventory increase may reflect
slowing product demand and possible inventory obsolescence.
 Jefferson’s inventory decline suggests possible problems in inventory management
to meet the stronger customer demand from the special offer; Adams’s large
C)
inventory increase suggests better inventory management to meet future sales
growth.

Explanation

Jefferson's revenue and inventory levels may be distorted by revenue recognition for new
business from the special offer. Although the customers agreed to delay delivery of the
products, recognition of these sales prior to customer delivery lowers the quality of these
sales and understates inventory. Inventory is understated if the sale is not totally complete.

(Module 11.1, LOS 11.b)

Question #2 of 55 Question ID: 1685593

Pritesh Deshmukh, CFA is analyzing the financial statements of Baza Restaurants Inc.
Deshmukh wants to use the Beneish model to evaluate the probability of earnings
manipulation.

Deshmukh makes the following statements:

1. Depreciation index of less than 1 would indicate that the company is depreciating assets
at a lower rate than in prior years.
2. Sales growth index of more than 1 indicates revenue inflation.

Which of the statements by Deshmukh are most accurate?

A) Statement 2 only.
B) None of the statements is accurate.
C) Statement 1 only.

Explanation

Statement 1 is incorrect. Depreciation index of less than 1 indicates that the company is
depreciating assets at a higher rate than in prior years. Statement 2 is incorrect. Sales growth
index of more than 1 simply implies that the growth in sales is positive. While not a measure
of manipulation by itself, growth companies tend to find themselves under pressure to
manipulate earnings to meet ongoing expectations.

(Module 11.2, LOS 11.d)

Question #3 of 55 Question ID: 1685586

Which of the following statements about operating income and operating cash flow is most
accurate?

Operating income is more reliable than operating cash flow because of the
A)
judgments and estimates involved with accrual accounting.
Operating income is confirmed by operating cash flow when the growth rates of
B)
the two measures are relatively stable over time.
Operating cash flow usually increases faster than operating income when the firm
C)
is growing.

Explanation

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 than
operating income as the firm uses cash to increase inventories and receivables.

(Module 11.1, LOS 11.b)

Question #4 of 55 Question ID: 1685575

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) Misclassifying cash flow.

B) Ignoring cash flow.
C) Managing cash flow.

Explanation
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.
(Module 11.1, LOS 11.b)

Question #5 of 55 Question ID: 1685617

Samuel Maskin, CFA is evaluating the financial statements of Northern Energy Inc. The following
is an extract from Northern's cash flow statement for the past three years:

20x6 20x5 20x4

Net Income $1,023 $988 $744

Depreciation $187 $145 $128

Restructuring Charges $(108) $(104) $212

Accounts receivable $(172) $(145) $(33)

Inventories $(418) $(202) $(180)

Accounts Payable $38 $37 $33

OCF $550 $719 $904

Which of the following conclusions is least likely for Northern?

A) Northern is stretching payables.

B) Northern may have accelerated revenue recognition.
C) Days sales outstanding is probably increasing.

Explanation
We are not provided with income statement data such as revenues and COGS and hence
have to make inferences from the information provided. Accounts payable seem to be stable
and decreasing as a percentage of net income making the conclusion of stretching payables
least likely. Revenue acceleration can be concluded based on large increase in inventory in
20x6 (possibly reflecting returns from customers) combined with increases in accounts
receivable over time. Increases in accounts receivable (relative to earnings) also would
indicate that days sales outstanding would most likely be increasing.

(Module 11.4, LOS 11.i)

Question #6 of 55 Question ID: 1685610

Andre Bursh, is analyzing large retailers and has collected the following information on three
companies based on the most recent financial statements:

Allied Stores Beta Mart Cash-N-Carry

Total Earnings (per share) $2.80 $1.33 $0.75

Cash element $1.90 $0.78 $0.25

Accrual element $0.90 $0.55 $0.50

Bursh notes that all three companies have reported stellar earnings this past year. Bursh is
concerned about sustainability of such high earnings. Which company's earnings will revert to
its mean fastest?

A) Allied Stores.
B) Beta Mart.
C) Cash-N-Carry.

Explanation

Cash-N-Carry's earnings is comprised of large proportion of accruals (0.50/0.75 or 67%).

Allied's accruals comprise (0.90/2.80) 32% of earnings and Beta's accruals comprise 41% of
earnings.

(Module 11.3, LOS 11.g)

Question #7 of 55 Question ID: 1685618

Samuel Maskin, CFA is evaluating the financial statements of Northern Energy Inc. The following
is an extract from Northern's cash flow statement for the past three years:

20x6 20x5 20x4

Net Income $1,023 $988 $744

Depreciation $187 $145 $128

Restructuring Charges $(108) $(104) $212

Accounts receivable $(172) $(145) $(33)

Inventories $(418) $(202) $(180)

Accounts Payable $38 $37 $33

OCF $550 $719 $904

The restructuring charges for Northern has most likely:

Increased reported earnings in 20x6 while reducing reported earnings in 20x4 and
A)
20x5.
Increased reported earnings for 20x4 while reducing reported earnings in 20x5
B)
and 20x6.
Reduced reported earnings in 20x4 while increasing reported earnings in 20x5 and
C)
20x6.

Explanation

Restructuring charges contribute positively to 20x4 cash flow indicating that it was a non-cash
charge against that year's income. In the following two years, there is a reversal of that
charge leading to an artificial increase in reported earnings for 20x5 and 20x6.

(Module 11.4, LOS 11.i)

Question #8 of 55 Question ID: 1685572

Which of the following items is least likely to involve the use of subjective measurement
estimates by management?

A) Use of straight-line depreciation method to depreciate tangible assets.

B) Use of FIFO (first in-first out) to cost inventories.
C) Use of criteria to determine treatment as an extraordinary item.

Explanation

The use of criteria to determine treatment as an extraordinary item (i.e. Is the item within
management's discretion? Is the event likely to recur in the foreseeable future?) does not
involve numerical and subjective estimates per se. It is more a test of qualitative factors to
determine the proper classification. Contrast this to FIFO, which is clearly a numerical
estimate since an alternative of using LIFO (last in-first out) is possible and this will result in a
different reported amount than FIFO. The same argument can be made for the use of the
straight-line method since an alternative of using the declining-balance method is possible to
depreciate tangible assets.

(Module 11.1, LOS 11.b)

Question #9 of 55 Question ID: 1685576

Joe Carter, CFA, believes Triangle Equipment, a maker of large, specialized industrial
equipment, has overstated the salvage value of its equipment. This would:

A) understate earnings.
B) overstate earnings.
C) overstate liabilities.

Explanation

Overstating the salvage value reduces depreciation expense, which in turn increases
earnings.

(Module 11.1, LOS 11.b)

Question #10 of 55 Question ID: 1685621

Asma Pharma has made several strategic investments in other pharmaceutical companies. In
each instance, Asma has kept its stake just below 50% so it can account for the investment
using the equity method of consolidation.

Asma's balance sheet quality can be most accurately characterized as:

A) High-quality due to compliance with local GAAP.

B) Low-quality due to bias in measurement.
C) Low-quality due to lack of completeness.

Explanation

One-line consolidation under the equity method obscures the components of balance sheet
and artificially boosts certain profitability ratios (e.g., return on assets or profit margin). This
reduces the completeness and quality of the firm's balance sheet. Compliance with GAAP is a
necessary but not sufficient condition for evaluating quality of financial statements. Equity
method of accounting does not by itself lead to measurement bias.

(Module 11.5, LOS 11.k)

Question #11 of 55 Question ID: 1685608

Sustainable earnings are most likely to be driven by:

A) Cash flow element of earnings.

B) Conservative revenue recognition practices.
C) Accruals element of earnings.

Explanation

Sustainable and persistent earnings are driven by cash flow element of earnings. The stability
and accuracy of earnings forecasts can be reduced by estimation process that generates the
accruals component of earnings. Conservative and aggressive revenue recognition practices
both would result in reversion in earnings (and hence lowers the sustainability of earnings).

(Module 11.3, LOS 11.g)

Question #12 of 55 Question ID: 1685611

Pysha Heavy Metals Ltd. supplies specialized metals to the chip fabrication industry. Selected
financial data for Pysha, as well as industry comparables, are shown below:

Pysha selected financial data (£ '000s):

20x7 20x8 20x9

Sales 1,169 1,312 1,414

Accounts receivable 58.45 72.16 98.98

Industry average:

20x7 20x8 20x9

DSO 22.6 22.8 22.4

Receivables turnover 16.2 16.0 16.3

Based on the trend in revenues and receivables, it can be most accurately concluded that:

A) Pysha’s revenues are growing at a faster rate than its receivables.

B) Pysha’s revenues are growing at a slower rate than its receivables.
C) The revenue growth rate divided by receivables growth rate is increasing over time.

Explanation

Pysha's revenue growth rate is lagging the receivables growth rate.

20x7 20x8 20x9

Revenue growth - 12.23% 7.77%
Receivable growth - 23.46% 37.17%
Ratio 52.15% 20.92%

(Module 11.3, LOS 11.h)

Question #13 of 55 Question ID: 1685604

Which of the following statements about financial disclosures are correct or incorrect?

Transitory earnings are usually more important to investors than permanent

Statement #1:
earnings.

Pro-forma earnings are usually prepared in accordance with generally

Statement #2:
accepted accounting principles.

A) Only statement #1 is incorrect.

B) Only statement #2 is incorrect.
C) Both are incorrect.

Explanation

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.

(Module 11.2, LOS 11.f)

Question #14 of 55 Question ID: 1685594

Brent Jones, CFA is analyzing the financial statements of Imperial Resorts Inc. Jones wants to
use the Beneish model to evaluate the probability of earnings manipulation.

Jones makes the following statements:

1. Depreciation index of less than 1 would indicate that the company is depreciating assets
at a higher rate than its peers.
2. Increases in Asset quality index indicate that the revenue recognition policies are
conservative.

Regarding the statements by Jones:

A) None of the statements is correct.

B) Only statement 1 is correct.
C) Only statement 2 is correct.

Explanation
Statement 1 is incorrect. Depreciation index less than 1 indicates that the company is
depreciating assets at a higher rate than in prior years (and not relative to its peers).
Statement 2 is incorrect. Asset quality index is used as an indicator of excessive capitalization
of expenses.

(Module 11.2, LOS 11.d)

Question #15 of 55 Question ID: 1685603

A manufacturing firm purchases equipment for use in its operations. With regard to recording
the purchase using the cash basis versus the accrual basis of accounting, which of the following
statements is most appropriate?

With the cash basis, revenues and expenses relating to the equipment are
A)
generally recognized in the same period.
With the accrual basis, the cost of the equipment is allocated to the cash flow
B)
statements over the asset’s life.
With the cash basis, revenues and expenses relating to the equipment are
C)
generally recognized in different periods.

Explanation

With the cash basis of accounting, revenues are recognized when cash is collected and
expenses are recognized when cash is paid. Therefore, the cash flows may occur in different
periods than when the revenues are actually earned or when the expenses are actually
incurred. For example, the purchase of equipment used in a firm's manufacturing operation
may result in an immediate cash outflow but the equipment generates revenues over its
useful life. In this case, the revenues and expense are reported in different periods.

With the accrual basis of accounting, revenues are recognized when earned and expenses are
recognized when incurred, regardless of the timing of the cash flows. With the equipment
purchase, the cost of the equipment will be allocated to the income statement (not cash flow
statement) over the asset's life and at the same time, matched with the revenues generated.

(Module 11.2, LOS 11.f)

Question #16 of 55 Question ID: 1685588

William Jones, CFA, is analyzing the financial performance of two U.S. competitors in connection
with a potential investment recommendation of their common stocks. He is particularly
concerned about the quality of each company's financial results in 2007–2008 and in
developing projections for 2009 and 2010 fiscal years.

Adams Company has been the largest company in the industry, but Jefferson Inc. has grown
more rapidly in recent years. Adams's net sales in 2004 were 33-1/3% higher than Jefferson's
but were only 18% above Jefferson's in 2008. During 2008, a slowing U.S. economy led to lower
domestic revenue growth for both companies. The 10-k reports showed overall sales growth of
6% for Adams in 2008 compared to 7% for 2007 and 9% in 2006. Jefferson's gross sales rose
almost 12% in 2008 versus 8% in 2007 and 10% in 2006. In the past three years, Jefferson has
expanded its foreign business at a faster pace than Adams. In 2008, Jefferson's growth in
overseas business was particularly impressive. According to the company's 10-k report,
Jefferson offered a sales incentive to overseas customers. For those customers accepting the
special sales discount, Jefferson shipped products to specific warehouses in foreign ports
rather than directly to those customers' facilities.

In his initial review of Adams's and Jefferson's financial statements, Jones was concerned about
the quality of the growth in Jefferson's sales, considerably higher accounts receivables, and the
impact of overall accruals on earnings quality. He noted that Jefferson had instituted an
accounting change in 2008. The economic life for new plant and equipment investments was
determined to be five years longer than for previous investments. For Adams, he noted that the
higher level of inventories at the end of 2008 might be cause for concern in light of a further
slowdown expected in the U.S. economy in 2009.

The accompanying table shows financial data for both companies' Form 10-k reports for 2006–
2008 used by Jones for his analysis. To evaluate sales quality, he focused on trends in sales and
related expenses for both companies as well as cash collections and receivables comparisons.
Inventory trends relative to sales and the number of days' sales outstanding in inventory were
determined for both companies. Expense trends were examined for Adams and Jefferson
relative to sales growth and accrual ratios on a balance sheet and cash flow basis were
developed as overall measures of earnings quality.

Adams Company Jefferson Inc.

($ in thousands) 2006 2007 2008 2006 2007 2008

Gross sales 32,031 34,273 36,330 25,625 27,675 30,900

Sales discounts, returns,
781 836 886 625 675 900
and allowances

Net sales 31,250 33,438 35,444 25,000 27,000 30,000

Cost of goods sold 15,312 16,384 17,367 12,250 13,250 15,500

SG&A expenses 9,028 9,660 10,240 7,222 7,800 8,200

Depreciation expense 625 669 709 500 515 516

Interest expense 400 428 454 360 366 396

Income before taxes 5,835 6,243 6,618 4,668 5,069 5,388

Taxes (tax rate 40%) 2,334 2,497 2,647 2,000 2,028 2,155

Net income 3,501 3,746 3,971 2,668 3,041 3,233

Dividends 3,000 3,180 3,307 2,460 2,760 2,880

Net addition to retained

501 566 664 208 281 353
earnings

Balance Sheet

Cash and equivalents 150 160 170 120 130 120

Short-term marketable
250 325 345 200 217 195
securities

Accounts receivable (net) 15,875 16,758 17,763 12,700 13,000 15,892

Inventories 6,500 6,850 7,800 5,200 5,200 4,500

PP&E (net of depreciation) 8,562 8,991 9,440 6,850 7,057 7,200

Total assets 31,337 33,084 35,518 25,070 25,604 27,907

Accounts payable 7,062 7,880 9,300 6,050 6,100 6,398

Other current liabilities 337 400 450 270 373 1,525

Long-term debt 7,500 7,800 8,100 6,000 6,100 6,600

Common stock 15,000 15,000 15,000 12,000 12,000 12,000

Retained earnings 1,438 2,004 2,668 750 1,031 1,384

Total liabilities and
31,337 33,084 35,518 25,070 25,604 27,907
shareholders' equity

% change gross sales 7.0% 6.0% 8.0% 11.7%

% change sales discounts

6.0% 6.0% 8.0% 33.3%
and allowances

% change net sales 7.0% 6.0% 8.0% 11.1%

% change cost of goods

7.0% 6.0% 8.0% 17.0%
sold

% change in SG&A 6.0% 6.0% 8.0% 5.1%

% change in depreciation
6.0% 6.0% 3.0% 0.2%
expense

% change in accounts
6.0% 6.0% 2.0% 22.3%
receivable

% change in inventories 5.0% 13.8% 0.0% (13.5%)

Revenues % cash
1.03 1.03 1.03 1.0 1.0 1.1
collections

Days inventory
155 153 164 144 143 106
outstanding

Balance sheet accrual ratio 3.4% 3.5% 3.9% 2.0% 2.4% 10.1%

Cash flow accrual ratio 3.4% 3.5% 3.8% 2.0% 2.0% 4.3%

Jones observed that comparisons of 2007–2008 trends in sales, accounts receivables, and cash
collections showed:

Jefferson’s sales growth accelerated in 2008 compared to Adams’s, but cash

collections declined as indicated by the rise in receivables and the
A)
revenue/collections ratio; Adams’s sales, accounts receivables, and cash collections
rose at similar rates in 2008.
Jefferson’s higher increase in sales relative to Adams’s led to improvement in cash
B) collections indicated by the rise in the revenue/collections ratio. There was no
change in Adams’s cash collections in 2008.
 Jefferson’s decline in cash and equivalents in 2008 resulted in lower cash
C) collections despite strong sales growth; Adams’s showed similar growth in cash
and equivalents and accounts receivable relative to sales gains.

Explanation

The increase in Jefferson's revenues relative to cash collections along with the large increase
in accounts receivable indicates declining cash collections in 2008 compared to its experience
in 2007 and relative to Adams's, which showed consistency in both years.

(Module 11.1, LOS 11.b)

Question #17 of 55 Question ID: 1685620

Which of the following is least likely an indicator of biased measurement in assessing balance
sheet quality?

A) Overly high assumed discount rate for pension obligations.

B) Understatement of impairment charges for property, plant, and equipment.
Company’s investment in debt securities of other companies, carried on the books
C)
at market value.

Explanation

Carrying investments in debt (or equity) securities at market value enhances balance sheet
quality and does not introduce a bias in the estimate. Understatement of impairment charges
on PP&E overstates value of PP&E. High discount rate reduces the value of PBO and hence
improves the funded position reflected on the balance sheet.

(Module 11.5, LOS 11.j)

Question #18 of 55 Question ID: 1685614

William Jones, CFA, is analyzing the financial performance of two U.S. competitors in connection
with a potential investment recommendation of their common stocks. He is particularly
concerned about the quality of each company's financial results in 2007–2008 and in
developing projections for 2009 and 2010 fiscal years.

Adams Company has been the largest company in the industry, but Jefferson Inc. has grown
more rapidly in recent years. Adams's net sales in 2004 were 33-1/3% higher than Jefferson's
but were only 18% above Jefferson's in 2008. During 2008, a slowing U.S. economy led to lower
domestic revenue growth for both companies. The 10-k reports showed overall sales growth of
6% for Adams in 2008 compared to 7% for 2007 and 9% in 2006. Jefferson's gross sales rose
almost 12% in 2008 versus 8% in 2007 and 10% in 2006. In the past three years, Jefferson has
expanded its foreign business at a faster pace than Adams. In 2008, Jefferson's growth in
overseas business was particularly impressive. According to the company's 10-k report,
Jefferson offered a sales incentive to overseas customers. For those customers accepting the
special sales discount, Jefferson shipped products to specific warehouses in foreign ports
rather than directly to those customers' facilities.

In his initial review of Adams's and Jefferson's financial statements, Jones was concerned about
the quality of the growth in Jefferson's sales, considerably higher accounts receivables, and the
impact of overall accruals on earnings quality. He noted that Jefferson had instituted an
accounting change in 2008. The economic life for new plant and equipment investments was
determined to be five years longer than for previous investments. For Adams, he noted that the
higher level of inventories at the end of 2008 might be cause for concern in light of a further
slowdown expected in the U.S. economy in 2009.

The accompanying table shows financial data for both companies' Form 10-k reports for 2006–
2008 used by Jones for his analysis. To evaluate sales quality, he focused on trends in sales and
related expenses for both companies as well as cash collections and receivables comparisons.
Inventory trends relative to sales and the number of days' sales outstanding in inventory were
determined for both companies. Expense trends were examined for Adams and Jefferson
relative to sales growth and accrual ratios on a balance sheet and cash flow basis were
developed as overall measures of earnings quality.

Adams Company Jefferson Inc.

($ in thousands) 2006 2007 2008 2006 2007 2008

Gross sales 32,031 34,273 36,330 25,625 27,675 30,900

Sales discounts, returns,
781 836 886 625 675 900
and allowances

Net sales 31,250 33,438 35,444 25,000 27,000 30,000

Cost of goods sold 15,312 16,384 17,367 12,250 13,250 15,500

SG&A expenses 9,028 9,660 10,240 7,222 7,800 8,200

Depreciation expense 625 669 709 500 515 516

Interest expense 400 428 454 360 366 396

Income before taxes 5,835 6,243 6,618 4,668 5,069 5,388

Taxes (tax rate 40%) 2,334 2,497 2,647 2,000 2,028 2,155

Net income 3,501 3,746 3,971 2,668 3,041 3,233

Dividends 3,000 3,180 3,307 2,460 2,760 2,880

Net addition to retained

501 566 664 208 281 353
earnings

Balance Sheet

Cash and equivalents 150 160 170 120 130 120

Short-term marketable
250 325 345 200 217 195
securities

Accounts receivable (net) 15,875 16,758 17,763 12,700 13,000 15,892

Inventories 6,500 6,850 7,800 5,200 5,200 4,500

PP&E (net of depreciation) 8,562 8,991 9,440 6,850 7,057 7,200

Total assets 31,337 33,084 35,518 25,070 25,604 27,907

Accounts payable 7,062 7,880 9,300 6,050 6,100 6,398

Other current liabilities 337 400 450 270 373 1,525

Long-term debt 7,500 7,800 8,100 6,000 6,100 6,600

Common stock 15,000 15,000 15,000 12,000 12,000 12,000

Retained earnings 1,438 2,004 2,668 750 1,031 1,384

Total liabilities and
31,337 33,084 35,518 25,070 25,604 27,907
shareholders equity

% change gross sales 7.0% 6.0% 8.0% 11.7%

% change sales discounts

6.0% 6.0% 8.0% 33.3%
and allowances

% change net sales 7.0% 6.0% 8.0% 11.1%

% change cost of goods

7.0% 6.0% 8.0% 17.0%
sold

% change in SG&A 6.0% 6.0% 8.0% 5.1%

% change in depreciation
6.0% 6.0% 3.0% 0.2%
expense

% change in accounts
6.0% 6.0% 2.0% 22.3%
receivable

% change in inventories 5.0% 13.8% 0.0% (13.5%)

Revenues % cash
1.03 1.03 1.03 1.0 1.0 1.1
collections

Days inventory
155 153 164 144 143 106
outstanding

Balance sheet accrual ratio 3.4% 3.5% 3.9% 2.0% 2.4% 10.1%

Cash flow accrual ratio 3.4% 3.5% 3.8% 2.0% 2.0% 4.3%

Based on the financial results of Adams and Jefferson in 2007 and 2008, the company
demonstrating the lower earnings quality would be:

Adams due to slower revenue growth, higher expense growth compared to

Jefferson, possible inventory obsolescence related to higher 2008 inventories
A)
despite slowing customer demand, and lower balance sheet and cash flow based
accrual ratios in 2008 compared to Jefferson.
Jefferson due to sharply higher accruals ratios and less conservative accounting
methods indicated by the change in depreciation policies and the impact of
B)
changes in shipment terms on revenue recognition and inventories for the special
overseas offer.
 Adams due to lower cash collection measures, possible inventory obsolescence
related to higher 2008 inventories despite slowing customer demand, higher
C)
expense growth compared to Jefferson, and lower balance sheet and cash flow
accrual ratios relative to Jefferson.

Explanation

According to the simple measures of earnings quality, balance sheet, and cash flow accruals
ratios, Jefferson's earnings quality in 2008 was lower than its 2007 levels and relative to
Adams's. The more aggressive accounting treatment for the overseas special offer lowered
the quality of revenues and may have understated inventories if some of these customers did
not take delivery of the shipments. Jefferson also instituted a more liberal policy toward
depreciable lives versus Adams, another indicator of lower earnings quality.

(Module 11.3, LOS 11.h)

Question #19 of 55 Question ID: 1685622

The least valuable source of information about a businesses' risk is:

A) Management discussion and analysis section of the annual report.

B) Auditor’s report.
C) Notes to financial statements.

Explanation

Because an audit report provides only historical information, such a report's usefulness as an
information source is limited. Companies are required to make certain risk related
disclosures in the notes to financial statements. Both GAAP and IFRS require companies to
disclose risks related to pension benefits, contingent obligations and financial instruments.
Ideally, companies should include principal risks that are unique to the business (as opposed
to risks faced by most businesses) in their MD&A.

(Module 11.5, LOS 11.m)

Question #20 of 55 Question ID: 1685601

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 level of earnings.
B) Higher degree of conservatism of earnings.
C) Higher degree of persistence of earnings.

Explanation

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.

(Module 11.2, LOS 11.f)

Question #21 of 55 Question ID: 1685582

With regard to specific measures to analyze in detecting manipulation in the financial reporting
process, which of the following statements is the least accurate?

Negative nonrecurring or non-operating items may be indicative of misclassifying

A)
an operating expense.
An increasing days’ inventory on hand (DOH) measure may be indicative of
B)
obsolete inventory.
A decreasing days’ sales outstanding (DSO) measure may be an indication of lower
C)
quality revenue.

Explanation
Days' sales outstanding (DSO) measures the number of days it takes to convert receivables
into cash and is calculated by dividing the number of days in the period by the accounts
receivable turnover ratio. An increasing DSO (decreasing receivables turnover) may be an
indication of lower quality revenue; that is, the longer it takes to collect from customers, the
more likely the receivables will turn into bad debt.

Days' inventory on hand (DOH) is equal to the number of days in the period divided by
inventory turnover ratio and it measures the number of days it takes to sell inventory. An
increasing DOH may be indicative of obsolete inventory.

Analysts should compare changes in the core operating margin over time and look for
negative nonrecurring (e.g., restructuring charges, asset impairments, and write-downs) or
non-operating items that occurred when the ratio increased. This may be the result of
misclassifying an operating expense.

(Module 11.1, LOS 11.b)

Question #22 of 55 Question ID: 1685587

High Plains Tubular Company is a leading manufacturer and distributor of quality steel
products used in energy, industrial, and automotive applications worldwide.

The U.S. steel industry has been challenged by competition from foreign producers located
primarily in Asia. All of the U.S. producers are experiencing declining margins as labor costs
continue to increase. In addition, the U.S. steel mills are technologically inferior to the foreign
competitors. Also, the U.S. producers have significant environmental issues that remain
unresolved.

High Plains is not immune from the problems of the industry and is currently in technical
default under its bond covenants. The default is a result of the failure to meet certain coverage
and turnover ratios. Earlier this year, High Plains and its bondholders entered into an
agreement that will allow High Plains time to become compliant with the covenants. If High
Plains is not in compliance by year end, the bondholders can immediately accelerate the
maturity date of the bonds. In this case, High Plains would have no choice but to file
bankruptcy.

High Plains follows U.S. GAAP. For the year ended 2008, High Plains received an unqualified
opinion from its independent auditor. However, the auditor's opinion included an explanatory
paragraph about High Plains' inability to continue as a going concern in the event its bonds
remain in technical default.

At the end of 2008, High Plains' Chief Executive Officer (CEO) and Chief Financial Officer (CFO)
filed the necessary certifications required by the Securities and Exchange Commission (SEC).

To get a better understanding of High Plains' financial situation, it is helpful to review High
Plains' cash flow statement found in Exhibit 1 and selected financial footnotes found in Exhibit
2.

Exhibit 1: Cash Flow Statement

High Plains Tubular Cash Flow Statement

Year ended December 31,

in thousands 2008 2007

Net income $158,177 $121,164

Depreciation expense 34,078 31,295

Deferred taxes 7,697 11,407

Receivables (144,087) (24,852)

Inventory (79,710) (72,777)

Payables 36,107 22,455

Cash flow from operations $12,262 $88,692

Cash flow from investing ($39,884) ($63,953)

Cash flow from financing $82,676 $6,056

Change in cash $55,054 $30,795

Exhibit 2: Selected Financial Footnotes

1. During 2008, High Plains' sales increased 27% over 2007. Its sales growth continues to
significantly exceed the industry average. Sales are recognized when a firm order is
received from the customer, the sales price is fixed and determinable, and collectability
is reasonably assured.
2. The cost of inventories is determined using the last-in, first-out (LIFO) method. Had the
first-in, first-out method been used, inventories would have been $152 million and $143
million higher as of December 31, 2008 and 2007, respectively.
3. Effective January 1, 2008, High Plains changed its depreciation method from the double-
declining balance method to the straight-line method in order to be more comparable
with the accounting practices of other firms within its industry. The change was not
retroactively applied and only affects assets that were acquired on or after January 1,
2008.

4. High Plains made the following discretionary expenditures for maintenance and repair of
plant and equipment and for advertising and marketing:

in millions 2008 2007 2006

Maintenance and repairs $180 $184 $218

Advertising and marketing 94 108 150

5. During the fiscal year ended December 31, 2008, High Plains sold $50 million of its
accounts receivable, with recourse, to an unrelated entity. All of the receivables were still
outstanding at year end.
6. High Plains conducts some of its operations in facilities leased under noncancelable
finance (capital) leases. Certain leases include renewal options with provisions for
increased lease payments during the renewal term.
 7. High Plains' average net operating assets at the end of 2008 and 2007 was $977.89
million and $642.83 million, respectively.

What is the most likely effect of High Plains' revenue recognition policy on net income and
inventory turnover?

A) Net income and inventory turnover are overstated.

B) Only inventory turnover is overstated.
C) Only net income is overstated.

Explanation

Revenue should be recognized when earned and payment is assured. High Plains is
recognizing revenue as orders are received. Since High Plains still has an obligation to deliver
the goods, revenue is not yet earned. By recognizing revenue too soon, net income is
overstated and ending inventory is understated. Understated ending inventory would result
in an overstated inventory turnover ratio.

(Module 11.1, LOS 11.b)

Question #23 of 55 Question ID: 1685591

William Jones, CFA, is analyzing the financial performance of two U.S. competitors in connection
with a potential investment recommendation of their common stocks. He is particularly
concerned about the quality of each company's financial results in 2007– 2008 and in
developing projections for 2009 and 2010 fiscal years.

Adams Company has been the largest company in the industry, but Jefferson Inc. has grown
more rapidly in recent years. Adams's net sales in 2004 were 33-1/3% higher than Jefferson's
but were only 18% above Jefferson's in 2008. During 2008, a slowing U.S. economy led to lower
domestic revenue growth for both companies. The 10-k reports showed overall sales growth of
6% for Adams in 2008 compared to 7% for 2007 and 9% in 2006. Jefferson's gross sales rose
almost 12% in 2008 versus 8% in 2007 and 10% in 2006. In the past three years, Jefferson has
expanded its foreign business at a faster pace than Adams. In 2008, Jefferson's growth in
overseas business was particularly impressive. According to the company's 10-k report,
Jefferson offered a sales incentive to overseas customers. For those customers accepting the
special sales discount, Jefferson shipped products to specific warehouses in foreign ports
rather than directly to those customers' facilities.

In his initial review of Adams's and Jefferson's financial statements, Jones was concerned about
the quality of the growth in Jefferson's sales, considerably higher accounts receivables, and the
impact of overall accruals on earnings quality. He noted that Jefferson had instituted an
accounting change in 2008. The economic life for new plant and equipment investments was
determined to be five years longer than for previous investments. For Adams, he noted that the
higher level of inventories at the end of 2008 might be cause for concern in light of a further
slowdown expected in the U.S. economy in 2009.

The accompanying table shows financial data for both companies' Form 10-k reports for 2006–
2008 used by Jones for his analysis. To evaluate sales quality, he focused on trends in sales and
related expenses for both companies as well as cash collections and receivables comparisons.
Inventory trends relative to sales and the number of days' sales outstanding in inventory were
determined for both companies. Expense trends were examined for Adams and Jefferson
relative to sales growth and accrual ratios on a balance sheet and cash flow basis were
developed as overall measures of earnings quality.

Adams Company Jefferson Inc.

($ in thousands) 2006 2007 2008 2006 2007 2008

Gross sales 32,031 34,273 36,330 25,625 27,675 30,900

Sales discounts, returns,
781 836 886 625 675 900
and allowances

Net sales 31,250 33,438 35,444 25,000 27,000 30,000

Cost of goods sold 15,312 16,384 17,367 12,250 13,250 15,500

SG&A expenses 9,028 9,660 10,240 7,222 7,800 8,200

Depreciation expense 625 669 709 500 515 516

Interest expense 400 428 454 360 366 396

Income before taxes 5,835 6,243 6,618 4,668 5,069 5,388

Taxes (tax rate 40%) 2,334 2,497 2,647 2,000 2,028 2,155

Net income 3,501 3,746 3,971 2,668 3,041 3,233

Dividends 3,000 3,180 3,307 2,460 2,760 2,880

Net addition to retained

501 566 664 208 281 353
earnings

Balance Sheet

Cash and equivalents 150 160 170 120 130 120

Short-term marketable
250 325 345 200 217 195
securities

Accounts receivable (net) 15,875 16,758 17,763 12,700 13,000 15,892

Inventories 6,500 6,850 7,800 5,200 5,200 4,500

PP&E (net of depreciation) 8,562 8,991 9,440 6,850 7,057 7,200

Total assets 31,337 33,084 35,518 25,070 25,604 27,907

Accounts payable 7,062 7,880 9,300 6,050 6,100 6,398

Other current liabilities 337 400 450 270 373 1,525

Long-term debt 7,500 7,800 8,100 6,000 6,100 6,600

Common stock 15,000 15,000 15,000 12,000 12,000 12,000

Retained earnings 1,438 2,004 2,668 750 1,031 1,384

Total liabilities and
31,337 33,084 35,518 25,070 25,604 27,907
shareholders equity

% change gross sales 7.0% 6.0% 8.0% 11.7%

% change sales discounts

6.0% 6.0% 8.0% 33.3%
and allowances

% change net sales 7.0% 6.0% 8.0% 11.1%

% change cost of goods

7.0% 6.0% 8.0% 17.0%
sold

% change in SG&A 6.0% 6.0% 8.0% 5.1%

% change in depreciation
6.0% 6.0% 3.0% 0.2%
expense

% change in accounts
6.0% 6.0% 2.0% 22.3%
receivable

% change in inventories 5.0% 13.8% 0.0% (13.5%)

Revenues % cash
1.03 1.03 1.03 1.0 1.0 1.1
collections

Days inventory
155 153 164 144 143 106
outstanding

Balance sheet accrual ratio 3.4% 3.5% 3.9% 2.0% 2.4% 10.1%

Cash flow accrual ratio 3.4% 3.5% 3.8% 2.0% 2.0% 4.3%

The quality of earnings as measured by balance-sheet-based accruals ratios showed:

both companies’ earnings quality improved due to the increase in the ratio with
A)
Jefferson showing the most improvement.
strong improvement in Jefferson’s earnings quality relative to Adams’s due to the
B)
sharp jump in the ratio in 2008 compared to the much smaller increase for Adams.
decrease in Jefferson’s earnings quality relative to Adams’s due to the sharp jump
C)
in the ratio in 2008 compared to a much smaller increase for Adams.

Explanation
The lower the ratio, the higher will be the earnings quality. Jefferson's ratio rose sharply in
2008 compared to the previous years and was substantially above Adams's. Thus, Jefferson's
earnings quality is lower.

(Module 11.1, LOS 11.b)

Question #24 of 55 Question ID: 1685584

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 excluded.
C) Both are included.

Explanation

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."

(Module 11.1, LOS 11.b)

Question #25 of 55 Question ID: 1685600

Complete the following sentence. An analyst would apply _________ to the cash component of
income compared to the accrual component when evaluating company performance.

A) the same weighting.

B) a lower weighting.
C) a higher weighting.
Explanation

Since the cash component has more sustainability in the future than the accrual component,
an analyst would apply a higher weighting to the cash component of income than the accrual
component when evaluating company performance.

(Module 11.2, LOS 11.f)

Question #26 of 55 Question ID: 1685615

High-quality cash flow is least likely to be characterized by:

Financing cash flows sufficient to cover capital expenditures, dividends and debt
A)
repayments.
B) No significant differences between operating cash flow and reported earnings.
C) Volatility of operating cash flow being lower than that of the firm’s peers.

Explanation

High-quality cash flow is characterized by positive OCF that is derived from sustainable
sources and is adequate to cover capital expenditures, dividends, and debt repayments.
Furthermore, high-quality OCF is characterized by lower volatility than that of the firm's
peers. Significant differences between OCF and earnings, or differences that widen over time,
can be an indicator of earnings manipulation.

(Module 11.4, LOS 11.l)

Question #27 of 55 Question ID: 1685596

Which one of the following choices is least likely to be an indicator of poor-quality earnings?

A) An investigation by the market regulatory authority is initiated.

B) Restatement of previously issued financial statements.
C) Reported earnings handily beat analyst estimates.

Explanation
Enforcement actions by regulatory authorities and restatements of previously issued financial
statements are two (external) indicators of poor-quality earnings. Earnings that meet or
narrowly beat analyst estimates are considered to be suspect for poor quality. Handily
beating analyst estimates is not considered to be an indicator of poor-quality earnings.

(Module 11.2, LOS 11.e)

Question #28 of 55 Question ID: 1685602

Classification of non-operating income as operating would lead to stated earnings that are
likely to be:

A) non-compliant with GAAP.

B) compliant with GAAP but not sustainable.
C) compliant with GAAP and sustainable.

Explanation

Non-operating income is less likely to recur and hence the earnings that include such
misclassified non-operating income would be considered non-sustainable. The
misclassification need not always be GAAP non-compliant.

(Module 11.2, LOS 11.f)

Question #29 of 55 Question ID: 1685578

Charles Nicholls, chief investment officer of Gertmann Money Management, is reviewing the
year-end financial statements of Zartner Canneries. In those statements he sees a sharp
increase in inventories well above the sales-growth rate, and an increase in the discount rate
for its pension liabilities. To determine whether or not Zartner Canneries is cooking the books,
what should Nicholls do?

A) Check Zartner’s cash-flow statement and review its footnotes.

B) Calculate Zartner’s turnover ratios and review the footnotes of its competitors.
Analyze trends in Zartner’s receivables and consider the changing characteristics of
C)
its work force.

Explanation
To assess the meaning of the inventory increase, look for declines in inventory turnover. And
if Zartner changes its pension assumptions, Nicholls should see how those new assumptions
compare to those found in the footnotes of financial statements from other companies in the
same industry.

(Module 11.1, LOS 11.b)

Question #30 of 55 Question ID: 1685592

In the context of the Beneish model to evaluate the probability of earnings manipulation, an
increase in Days Sales Receivable Index is least likely to signify:

A) revenue inflation.
B) a decrease in probability of earnings manipulation.
C) an increase in M-score.

Explanation

An increase in Days Sales Receivable Index indicates revenue inflation and increases the M-
score, thereby increasing the probability of earnings manipulation.

(Module 11.2, LOS 11.c)

Question #31 of 55 Question ID: 1685581

Duster Corporation's year-end income statement reported the following:

Operating income $187,000

Results from discontinued operations:

Loss from segment operations

(net of $1,440 tax effect) ($2,160)

Gain on segment disposal

(net of $8,640 tax effect) 12,960 10,800

Gain on sale of equipment 3,400

Interest expense 12,400

Extraordinary loss

(net of $2,200 tax benefit) 3,300

Income tax expense 71,200

Calculate Duster's income from continuing operations for the year.

A) $106,800.
B) $103,500.
C) $100,200.

Explanation

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.

(Module 11.1, LOS 11.b)

Question #32 of 55 Question ID: 1685567

High results quality is most likely demonstrated by:

A) an adequate level of return that is sustainable.

B) high level of earnings determined conservatively.
C) GAAP compliant financial reports that are decision useful.

Explanation

High results quality occurs if the level of earnings provides an adequate level of return and
that the earnings are sustainable.

(Module 11.1, LOS 11.a)

Question #33 of 55 Question ID: 1685579

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?

Computer Automobile
division division
earnings earnings

A) Decrease Increase

B) Increase Decrease

C) Decrease Decrease

Explanation

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 penetrated the older, lower cost layers of inventory thereby increasing profit. This
higher profitability is not sustainable, however, because the firm will eventually run out of
lower priced inventory. In the long-run, the earnings will decrease (to normal levels).

(Module 11.1, LOS 11.b)

Question #34 of 55 Question ID: 1685568

To assess the quality of financial reports, which question is least necessary for an analyst to
answer?

A) Do earnings represent an adequate level of return?

B) Are the financial reports decision useful and GAAP compliant?
C) Are reported earnings consistent with the firm’s budget?

Explanation

Quality of financial reports is assessed by answering two questions: Whether the financial
reports are decision useful and GAAP compliant and whether the results quality is high (i.e.,
earnings provide adequate return on capital and are sustainable).

(Module 11.1, LOS 11.a)

Question #35 of 55 Question ID: 1685605

High Plains Tubular Company is a leading manufacturer and distributor of quality steel
products used in energy, industrial, and automotive applications worldwide.

The U.S. steel industry has been challenged by competition from foreign producers located
primarily in Asia. All of the U.S. producers are experiencing declining margins as labor costs
continue to increase. In addition, the U.S. steel mills are technologically inferior to the foreign
competitors. Also, the U.S. producers have significant environmental issues that remain
unresolved.

High Plains is not immune from the problems of the industry and is currently in technical
default under its bond covenants. The default is a result of the failure to meet certain coverage
and turnover ratios. Earlier this year, High Plains and its bondholders entered into an
agreement that will allow High Plains time to become compliant with the covenants. If High
Plains is not in compliance by year end, the bondholders can immediately accelerate the
maturity date of the bonds. In this case, High Plains would have no choice but to file
bankruptcy.

High Plains follows U.S. GAAP. For the year ended 2008, High Plains received an unqualified
opinion from its independent auditor. However, the auditor's opinion included an explanatory
paragraph about High Plains' inability to continue as a going concern in the event its bonds
remain in technical default.

At the end of 2008, High Plains' Chief Executive Officer (CEO) and Chief Financial Officer (CFO)
filed the necessary certifications required by the Securities and Exchange Commission (SEC).

To get a better understanding of High Plains' financial situation, it is helpful to review High
Plains' cash flow statement found in Exhibit 1 and selected financial footnotes found in Exhibit
2.

Exhibit 1: Cash Flow Statement

High Plains Tubular Cash Flow Statement

Year ended December 31,

in thousands 2008 2007

Net income $158,177 $121,164

Depreciation expense 34,078 31,295

Deferred taxes 7,697 11,407

Receivables (144,087) (24,852)

Inventory (79,710) (72,777)

Payables 36,107 22,455

Cash flow from operations $12,262 $88,692

Cash flow from investing ($39,884) ($63,953)

Cash flow from financing $82,676 $6,056

Change in cash $55,054 $30,795

Exhibit 2: Selected Financial Footnotes

1. During 2008, High Plains' sales increased 27% over 2007. Its sales growth continues to
significantly exceed the industry average. Sales are recognized when a firm order is
received from the customer, the sales price is fixed and determinable, and collectability
is reasonably assured.
2. The cost of inventories is determined using the last-in, first-out (LIFO) method. Had the
first-in, first-out method been used, inventories would have been $152 million and $143
million higher as of December 31, 2008 and 2007, respectively.
3. Effective January 1, 2008, High Plains changed its depreciation method from the double-
declining balance method to the straight-line method in order to be more comparable
with the accounting practices of other firms within its industry. The change was not
retroactively applied and only affects assets that were acquired on or after January 1,
2008.

4. High Plains made the following discretionary expenditures for maintenance and repair of
plant and equipment and for advertising and marketing:

in millions 2008 2007 2006

Maintenance and repairs $180 $184 $218

Advertising and marketing 94 108 150

5. During the fiscal year ended December 31, 2008, High Plains sold $50 million of its
accounts receivable, with recourse, to an unrelated entity. All of the receivables were still
outstanding at year end.
6. High Plains conducts some of its operations in facilities leased under noncancelable
finance (capital) leases. Certain leases include renewal options with provisions for
increased lease payments during the renewal term.
 7. High Plains' average net operating assets at the end of 2008 and 2007 was $977.89
million and $642.83 million, respectively.

Which of the following statements about evaluating High Plains' financial reporting quality is
least accurate?

A) Higher Plains may have manipulated earnings due to the risk of default.
High Plains’ extreme revenue growth will likely revert back to normal levels over
B)
time.
Because of the estimates involved, a higher weighting should be assigned to the
C)
accrual component of High Plains’ earnings as compared to the cash component.

Explanation

It appears that High Plains manipulated its earnings upward in 2008 to avoid default under its
bond covenants. However, the higher earnings are lower quality as measured by the cash
flow accrual ratio. Because of the estimates involved, a lower weighting should be assigned to
the accrual component of High Plains' earnings. Extreme earnings (including revenues) tend
to revert to normal levels over time (mean reversion).

(Module 11.2, LOS 11.f)

Question #36 of 55 Question ID: 1685609

Mean reversion in earnings means that:

A) Extreme high as well as low levels of earnings will revert to the mean.
B) Extreme low earnings will revert to the mean but extreme high earnings will not.
C) Extreme high earnings will revert to the mean but extreme low earnings will not.

Explanation

Mean reversion in earnings means that extreme high or low earnings are not sustainable and
will mean revert.

(Module 11.3, LOS 11.g)

Question #37 of 55 Question ID: 1685570

Aggressive revenue recognition practices are least likely to increase:

A) reported ending inventory

B) reported expenses
C) reported assets

Explanation

Aggressive revenue recognition practices would increase accounts receivable, revenues,

expenses, income and stockholder's equity. Ending inventory would decline but by less than
the increase in accounts receivable resulting in increase in total assets. Early recognition of
revenues also accelerates recognition of expenses (COGS).

(Module 11.1, LOS 11.b)

Question #38 of 55 Question ID: 1685590

William Jones, CFA, is analyzing the financial performance of two U.S. competitors in connection
with a potential investment recommendation of their common stocks. He is particularly
concerned about the quality of each company's financial results in 2007–2008 and in
developing projections for 2009 and 2010 fiscal years.

Adams Company has been the largest company in the industry, but Jefferson Inc. has grown
more rapidly in recent years. Adams's net sales in 2004 were 33-1/3% higher than Jefferson's
but were only 18% above Jefferson's in 2008. During 2008, a slowing U.S. economy led to lower
domestic revenue growth for both companies. The 10-k reports showed overall sales growth of
6% for Adams in 2008 compared to 7% for 2007 and 9% in 2006. Jefferson's gross sales rose
almost 12% in 2008 versus 8% in 2007 and 10% in 2006. In the past three years, Jefferson has
expanded its foreign business at a faster pace than Adams. In 2008, Jefferson's growth in
overseas business was particularly impressive. According to the company's 10-k report,
Jefferson offered a sales incentive to overseas customers. For those customers accepting the
special sales discount, Jefferson shipped products to specific warehouses in foreign ports
rather than directly to those customers' facilities.

In his initial review of Adams's and Jefferson's financial statements, Jones was concerned about
the quality of the growth in Jefferson's sales, considerably higher accounts receivables, and the
impact of overall accruals on earnings quality. He noted that Jefferson had instituted an
accounting change in 2008. The economic life for new plant and equipment investments was
determined to be five years longer than for previous investments. For Adams, he noted that the
higher level of inventories at the end of 2008 might be cause for concern in light of a further
slowdown expected in the U.S. economy in 2009.

The accompanying table shows financial data for both companies' Form 10-k reports for 2006–
2008 used by Jones for his analysis. To evaluate sales quality, he focused on trends in sales and
related expenses for both companies as well as cash collections and receivables comparisons.
Inventory trends relative to sales and the number of days' sales outstanding in inventory were
determined for both companies. Expense trends were examined for Adams and Jefferson
relative to sales growth and accrual ratios on a balance sheet and cash flow basis were
developed as overall measures of earnings quality.

Adams Company Jefferson Inc.

($ in thousands) 2006 2007 2008 2006 2007 2008

Gross sales 32,031 34,273 36,330 25,625 27,675 30,900

Sales discounts, returns,
781 836 886 625 675 900
and allowances

Net sales 31,250 33,438 35,444 25,000 27,000 30,000

Cost of goods sold 15,312 16,384 17,367 12,250 13,250 15,500

SG&A expenses 9,028 9,660 10,240 7,222 7,800 8,200

Depreciation expense 625 669 709 500 515 516

Interest expense 400 428 454 360 366 396

Income before taxes 5,835 6,243 6,618 4,668 5,069 5,388

Taxes (tax rate 40%) 2,334 2,497 2,647 2,000 2,028 2,155

Net income 3,501 3,746 3,971 2,668 3,041 3,233

Dividends 3,000 3,180 3,307 2,460 2,760 2,880

Net addition to retained

501 566 664 208 281 353
earnings

Balance Sheet

Cash and equivalents 150 160 170 120 130 120

Short-term marketable
250 325 345 200 217 195
securities

Accounts receivable (net) 15,875 16,758 17,763 12,700 13,000 15,892

Inventories 6,500 6,850 7,800 5,200 5,200 4,500

PP&E (net of depreciation) 8,562 8,991 9,440 6,850 7,057 7,200

Total assets 31,337 33,084 35,518 25,070 25,604 27,907

Accounts payable 7,062 7,880 9,300 6,050 6,100 6,398

Other current liabilities 337 400 450 270 373 1,525

Long-term debt 7,500 7,800 8,100 6,000 6,100 6,600

Common stock 15,000 15,000 15,000 12,000 12,000 12,000

Retained earnings 1,438 2,004 2,668 750 1,031 1,384

Total liabilities and
31,337 33,084 35,518 25,070 25,604 27,907
shareholders equity

% change gross sales 7.0% 6.0% 8.0% 11.7%

% change sales discounts

6.0% 6.0% 8.0% 33.3%
and allowances

% change net sales 7.0% 6.0% 8.0% 11.1%

% change cost of goods

7.0% 6.0% 8.0% 17.0%
sold

% change in SG&A 6.0% 6.0% 8.0% 5.1%

% change in depreciation
6.0% 6.0% 3.0% 0.2%
expense

% change in accounts
6.0% 6.0% 2.0% 22.3%
receivable

% change in inventories 5.0% 13.8% 0.0% (13.5%)

Revenues % cash
1.03 1.03 1.03 1.0 1.0 1.1
collections

Days inventory
155 153 164 144 143 106
outstanding

Balance sheet accrual ratio 3.4% 3.5% 3.9% 2.0% 2.4% 10.1%

Cash flow accrual ratio 3.4% 3.5% 3.8% 2.0% 2.0% 4.3%

Comparisons of expense trends in 2007–2008 showed:

Jefferson’s management appeared to have managed SG&A and depreciation

expenses more effectively than Adams’s; there was a small increase in Jefferson’s
A)
depreciation expense and slower growth in SG&A relative to the company’s
previous year and compared to Adams’s trends.
higher growth of Adams’s SG&A and depreciation expense versus Jefferson’s; the
small change in Jefferson’s depreciation may relate to the change in depreciation
B)
lives, while the slower SG&A growth may reflect expense controls imposed to
offset lower gross profit margins.
 higher growth of Adams’s SG&A and depreciation expense versus Jefferson’s may
C) indicate more effective expense control by Jefferson in a slowing domestic
economy.

Explanation

The more favorable trends in Jefferson's expenses may reflect more aggressive depreciation
accounting and controls imposed on discretionary expenses to offset declining gross profit
margins.

(Module 11.1, LOS 11.b)

Question #39 of 55 Question ID: 1685577

The failure to recognize inventory obsolescence is an example of ___________.

A) Understating expenses.
B) Misclassifying expenses.
C) Delaying expenses.

Explanation

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.

(Module 11.1, LOS 11.b)

Question #40 of 55 Question ID: 1685619

Which of the following is least likely an indicator of biased measurement in assessing balance
sheet quality?

A) Understatement of valuation allowance for deferred tax assets.

B) Presence of substantial goodwill on balance sheet.
C) Understatement of inventory impairment charges.

Explanation

Presence of substantial goodwill does not inherently make it biased measurement. Only if the
value of goodwill is unjustified (based on market values of the investments), would the
measurement be considered biased. Understatement of inventory impairment charges
overstates value of inventory. Similarly understatement of valuation allowance for deferred
tax assets overstates the value of deferred tax assets.

(Module 11.5, LOS 11.j)

Question #41 of 55 Question ID: 1685571

Errors that affect multiple financial statement elements are most likely to arise from:

A) measurement and timing issues.

B) compound issues.
C) classification issues.

Explanation

Measurement and timing issues typically affect multiple financial statement elements while
classification issues typically affects categorization of a specific element in a financial
statement.

(Module 11.1, LOS 11.b)

Question #42 of 55 Question ID: 1685599

Complete the following sentence. The cash component of income is ___________ than the accrual
component.

A) the same persistence.

B) less persistent.
C) more persistent.

Explanation

The accrual component of income (accruals) is less persistent than the cash component. By
persistent we mean the income is sustainable; that is, a dollar of earnings today implies a
dollar of earnings in future periods. Lower persistency is partially due to the estimates
involved with accrual accounting.

(Module 11.2, LOS 11.f)

Question #43 of 55 Question ID: 1685613

William Jones, CFA, is analyzing the financial performance of two U.S. competitors in connection
with a potential investment recommendation of their common stocks. He is particularly
concerned about the quality of each company's financial results in 2007–2008 and in
developing projections for 2009 and 2010 fiscal years.

Adams Company has been the largest company in the industry, but Jefferson Inc. has grown
more rapidly in recent years. Adams's net sales in 2004 were 33-1/3% higher than Jefferson's
but were only 18% above Jefferson's in 2008. During 2008, a slowing U.S. economy led to lower
domestic revenue growth for both companies. The 10-k reports showed overall sales growth of
6% for Adams in 2008 compared to 7% for 2007 and 9% in 2006. Jefferson's gross sales rose
almost 12% in 2008 versus 8% in 2007 and 10% in 2006. In the past three years, Jefferson has
expanded its foreign business at a faster pace than Adams. In 2008, Jefferson's growth in
overseas business was particularly impressive. According to the company's 10-k report,
Jefferson offered a sales incentive to overseas customers. For those customers accepting the
special sales discount, Jefferson shipped products to specific warehouses in foreign ports
rather than directly to those customers' facilities.

In his initial review of Adams's and Jefferson's financial statements, Jones was concerned about
the quality of the growth in Jefferson's sales, considerably higher accounts receivables, and the
impact of overall accruals on earnings quality. He noted that Jefferson had instituted an
accounting change in 2008. The economic life for new plant and equipment investments was
determined to be five years longer than for previous investments. For Adams, he noted that the
higher level of inventories at the end of 2008 might be cause for concern in light of a further
slowdown expected in the U.S. economy in 2009.

The accompanying table shows financial data for both companies' Form 10-k reports for 2006–
2008 used by Jones for his analysis. To evaluate sales quality, he focused on trends in sales and
related expenses for both companies as well as cash collections and receivables comparisons.
Inventory trends relative to sales and the number of days' sales outstanding in inventory were
determined for both companies. Expense trends were examined for Adams and Jefferson
relative to sales growth and accrual ratios on a balance sheet and cash flow basis were
developed as overall measures of earnings quality.

Adams Company Jefferson Inc.

($ in thousands) 2006 2007 2008 2006 2007 2008

Gross sales 32,031 34,273 36,330 25,625 27,675 30,900

Sales discounts, returns,
781 836 886 625 675 900
and allowances

Net sales 31,250 33,438 35,444 25,000 27,000 30,000

Cost of goods sold 15,312 16,384 17,367 12,250 13,250 15,500

SG&A expenses 9,028 9,660 10,240 7,222 7,800 8,200

Depreciation expense 625 669 709 500 515 516

Interest expense 400 428 454 360 366 396

Income before taxes 5,835 6,243 6,618 4,668 5,069 5,388

Taxes (tax rate 40%) 2,334 2,497 2,647 2,000 2,028 2,155

Net income 3,501 3,746 3,971 2,668 3,041 3,233

Dividends 3,000 3,180 3,307 2,460 2,760 2,880

Net addition to retained

501 566 664 208 281 353
earnings

Balance Sheet

Cash and equivalents 150 160 170 120 130 120

Short-term marketable
250 325 345 200 217 195
securities

Accounts receivable (net) 15,875 16,758 17,763 12,700 13,000 15,892

Inventories 6,500 6,850 7,800 5,200 5,200 4,500

PP&E (net of depreciation) 8,562 8,991 9,440 6,850 7,057 7,200

Total assets 31,337 33,084 35,518 25,070 25,604 27,907

Accounts payable 7,062 7,880 9,300 6,050 6,100 6,398

Other current liabilities 337 400 450 270 373 1,525

Long-term debt 7,500 7,800 8,100 6,000 6,100 6,600

Common stock 15,000 15,000 15,000 12,000 12,000 12,000

Retained earnings 1,438 2,004 2,668 750 1,031 1,384

Total liabilities and
31,337 33,084 35,518 25,070 25,604 27,907
shareholders equity

% change gross sales 7.0% 6.0% 8.0% 11.7%

% change sales discounts

6.0% 6.0% 8.0% 33.3%
and allowances

% change net sales 7.0% 6.0% 8.0% 11.1%

% change cost of goods

7.0% 6.0% 8.0% 17.0%
sold

% change in SG&A 6.0% 6.0% 8.0% 5.1%

% change in depreciation
6.0% 6.0% 3.0% 0.2%
expense

% change in accounts
6.0% 6.0% 2.0% 22.3%
receivable

% change in inventories 5.0% 13.8% 0.0% (13.5%)

Revenues % cash
1.03 1.03 1.03 1.0 1.0 1.1
collections

Days inventory
155 153 164 144 143 106
outstanding

Balance sheet accrual ratio 3.4% 3.5% 3.9% 2.0% 2.4% 10.1%

Cash flow accrual ratio 3.4% 3.5% 3.8% 2.0% 2.0% 4.3%

The quality of earnings as measured by cash-flow-based accruals ratios showed:

Jefferson’s 2008 accrual ratio exceeded Adams’s ratio for the first time in the 2006–
A) 2008 period, thus demonstrating significant improvement in earnings quality
relative to Adams’s.
Jefferson’s 2008 accrual ratio exceeded Adams’s ratio for the first time in the 2006–
B) 2008 period, indicating a decline in earnings quality compared to previous years
and lower earnings quality relative to Adams’s in 2008.
Jefferson’s higher accruals ratio in 2008 compared to 2007 and relative to Adams’s
C)
in 2008 indicates Jefferson’s higher earnings quality.
Explanation

The lower the ratio, the higher will be the earnings quality. Jefferson's ratio rose sharply in
2008 and exceeded Adams's ratio for the first time in the three years. Thus, Jefferson's
earnings quality is lower.

(Module 11.3, LOS 11.h)

Question #44 of 55 Question ID: 1685569

Which of the following choices is most likely a biased accounting choice to overstate
profitability?

A) Classifying non-operating expenses as operating.

B) Channeling gains through OCI and losses through income statement.
C) Lessor use of sales-type finance lease classification.

Explanation

Lessor use of sales-type finance lease classification results in Lessor recognizing the gross
profit at inception of the lease and is a mechanism to overstate profitability. Classifying non-
operating expenses as operating and channeling gains through OCI and losses through
income statement would understate profitability.

(Module 11.1, LOS 11.b)

Question #45 of 55 Question ID: 1685606

Complete the following sentence. When earnings are relatively free of accruals, mean reversion
will occur __________.

A) at the same rate as usual.

B) relatively faster than usual.
C) relatively slower than usual.

Explanation
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.

(Module 11.3, LOS 11.g)

Question #46 of 55 Question ID: 1685616

Which of the following is least likely an indicator of high-quality cash flow?

A) OCF adequate to cover capital expenditures, dividends and debt repayments.

B) OCF derived from sustainable sources.
C) Total cash flow that is positive and high.

Explanation

High-quality cash flow focuses on positive, adequate and sustainable operating cash flow.
Firms with high borrowings could have high total cash flow but such cash flows would not be
sustainable (nor considered high-quality).

(Module 11.4, LOS 11.l)

Question #47 of 55 Question ID: 1685585

Which of the following statements about operating income and operating cash flow are correct
or incorrect?

If operating income is growing faster than operating cash flow over the long-
Statement #1: term, the firm may be recognizing revenue too soon or delaying the
recognition of expense.

Operating cash flow exceeding operating income is sustainable over the

Statement #2:
long-term.

A) Both are incorrect.

B) Only one is correct.
C) Both are correct.
Explanation

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.

(Module 11.1, LOS 11.b)

Question #48 of 55 Question ID: 1685607

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) Normal earnings should not be expected to continue indefinitely.
C) High earnings should not be expected to continue indefinitely.

Explanation

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.

(Module 11.3, LOS 11.g)

Question #49 of 55 Question ID: 1685595

Classification shifting is least likely to result in a higher:

A) reported net income.

B) equity value derived when earnings forecasts are based on operating earnings.
C) firm value derived when cash flow forecasts are based on core earnings.

Explanation
Classification shifting results in inflation of core or recurring earnings while keeping the total
reported income same. This is used to mislead analysts into using a higher number as a basis
for generating forecasts of future earnings and cash flows. Such erroneous forecasts would
then result in inflated equity and firm valuation.

(Module 11.2, LOS 11.e)

Question #50 of 55 Question ID: 1685583

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) The declining LIFO reserve.
C) Equity investment earnings not reflected on the cash-flow statement.

Explanation

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.

(Module 11.1, LOS 11.b)

Question #51 of 55 Question ID: 1685598

Consider the following statements:

Compared to the cash basis of accounting, the accrual basis of accounting

Statement 1:
provides more timely information about future cash flows.

Compared to the cash basis of accounting, the accrual basis requires more
Statement 2:
use of discretion than the cash basis.

Are these statements CORRECT?

No, because it is actually the cash basis of accounting that results in more difficulty
A)
in properly assigning revenues and expenses to the appropriate periods.
No, because it is actually the cash basis of accounting that provides more timely
B)
and relevant information to users about future cash flows.
C) Yes.

Explanation

Users of financial information seek timely information about future cash flows. The accrual
basis of accounting provides this information at the earliest appearance of objective
evidence. Thus, accrual accounting provides more timely and relevant information to users.
The cash basis is more concerned with recording cash flows for transactions that have
already occurred.

Accrual accounting (not cash-based accounting) necessitates the use of discretion because of
the many estimates and judgments involved with assigning revenue and expense to the
appropriate periods.

(Module 11.2, LOS 11.f)

Question #52 of 55 Question ID: 1685580

Analyst Jane Kilgore is worried that some of Maxwell Research's accrual accounting practices
will lead to excessive operating earnings recognition in the near-term. Examples of Kilgore's
concerns include the following:

Accelerated revenue recognition of service agreements.

Classification of recurring revenue as nonrecurring revenue.
Understated inventory obsolescence.

Which of Kilgore's concerns is least likely to overstate current operating earnings?

A) Understated inventory obsolescence.
B) Classification of recurring revenue as nonrecurring revenue.
C) Accelerated revenue recognition of service agreements.

Explanation

Classification of recurring revenue as nonrecurring revenue will understate current operating

earnings. The other two items act to overstate revenue and understate expenses.

(Module 11.1, LOS 11.b)

Question #53 of 55 Question ID: 1685597

Hartford Manufacturing Case Scenario

Sally Wellington, CFA, analyzes the financial statements of Hartford Manufacturing, a company
located in the United States that uses U.S. GAAP. Wellington determines that Hartford's most
significant assets are its inventory and long-term assets. Wellington is interested in the financial
statement and ratio impact of the accounting methods used by Hartford to account for these
assets, especially when compared to the methods used by Hartford's competitors. She gathers
the following information to aid in her analysis:

Exhibit 1

Selected Financial Information (US$ millions)

Year Ended December 31, 20X1

Select Balance Sheet Information

Inventory 16,253

Property, plant and equipment, gross 34,221

Accumulated depreciation (12,835)

Property, plant and equipment, net 21,836

Total assets 60,038

Total liabilities 40,736

Total equity 19,302

Income Statement Information

Revenues 32,396

Cost of goods sold 18,885

Lease expense 590

Other expense 5,911

Depreciation expense 2,336

EBIT 4,674

Interest expense 1,522

Income tax expense (30%) 946

 Net income 2,206

Based on her knowledge of Hartford's competitors and her review of Hartford's financial
statement disclosures and Management's Discussion and Analysis (MD&A), Wellington notes
the following:

Hartford accounts for its inventory using the LIFO method. All of Hartford's competitors
use the FIFO method.
As a result of technological advancements, the cost to produce Hartford's inventory has
fallen each year for the last five years. Hartford's LIFO reserve was (–)$2,603 in 20X0 and
(–)$3,183 in 20X1.
Hartford recorded a $520 fixed-asset impairment loss on its December 31, 20X0 income
statement. Wellington concluded that this impairment loss increased Hartford's fixed-
asset turnover ratio in 20X0, and Hartford's return on assets and net profit margin in
20X1.
In 20X1 Hartford changed its depreciation method from the straight-line method to the
double-declining balance method and increased the useful lives and salvage values of its
fixed assets.
The majority of Hartford's lease agreements are accounted for as operating leases.
Hartford's largest competitors account for the majority of their leases as capital (finance)
leases.

Wellington knows that the Financial Accounting Standards Board (FASB) and International
Accounting Standards Board (IASB) have proposed a change in lease accounting that would
require the capitalization of all leases, including leases currently classified as operating leases.
Using a discount rate of 8% and an average remaining lease term of five years, Wellington
determines that the present value of Hartford's operating leases was $2,630 on December 31,
20X1.

Which of the following characteristics of Hartford's long-term asset accounting is least likely to
be considered a quality of financial reporting problem by Wellington?

A) The change from straight-line to double-declining balance depreciation.

B) The increase in the useful lives and salvage values of Hartford's fixed assets.
C) The classification of the majority of Hartford's leases as operating leases.

Explanation
Double-declining balance (DDB) depreciation is a more conservative method of depreciation
than straight-line because more depreciation expense is reported in the early years under
DDB. Therefore, Wellington is not likely to consider Hartford's change from straight-line to
double-declining balance depreciation to be a quality of financial reporting problem.

Operating leases are a form of off-balance sheet financing that result in an understatement
of an entity's liabilities. Wellington will likely consider Hartford's extensive use of operating
leases to be a quality of financial reporting problem, especially given that Hartford's largest
competitors account for the majority of their leases as capital (finance) leases.

The increase in the useful lives and salvage values of Hartford's fixed assets is likely to be
considered a quality of financial reporting problem by Wellington because longer useful lives
and higher salvage values decrease (understate) depreciation expense. An effort to reduce
expense could be a sign that the firm is trying to hide other problems, such as deteriorating
core profitability.

(Module 11.2, LOS 11.e)

Question #54 of 55 Question ID: 1685574

Which of the following statements about cash flow is (are) CORRECT?

Statement #1: The cash effects of decreasing accounts payable turnover are unlimited.

The tax benefits from employee stock options can result in a significant
Statement #2:
source of investing cash flow.

Statement #1 Statement #2

A) Incorrect Correct

B) Incorrect Incorrect

C) Correct Incorrect

Explanation

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.

(Module 11.1, LOS 11.b)

Question #55 of 55 Question ID: 1685573

Marcel Schulte is analyzing various retailing firms. Which of the following items is least
indicative of a potential problem with revenue recognition and earnings quality?

A) Implementing a “bill and hold” arrangement.

B) Disproportionate revenues in the last quarter of the calendar year.
C) Use of barter transactions.

Explanation

Disproportionate revenues in the last quarter may be an indication of aggressive revenue

recognition to meet analyst forecasts but it is much more likely if the firm is a non-seasonal
one. A retailing firm presumably has a disproportionate amount of sales during the busy
Christmas season in the last quarter of the calendar year so this point alone would not be
indicative of a potential problem.

In a barter transaction, two parties exchange goods or services. The main issue is whether: (a)
a sale transaction has actually occurred in substance; (b) it is not a "sham" transaction; and
(c) the transaction amount is overstated.

Bill and hold occurs when the retailer (seller) invoices the customer but does not ship the
goods until a later date. Alternatively, the seller may ship the goods to a location other than
the customer's. In either case, the seller may be recognizing revenue prematurely.

(Module 11.1, LOS 11.b)