Financial Reporting And Analysis 7Th Ed By Revsine – Test Bank A+

Description

True/False

[QUESTION]

1. The discounted cash flow valuation approach expresses current value of a firm as the discounted present value of expected future cash flows.

Answer: True

Learning Objective: 06-01

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Understand

AICPA: FN Measurement

Topic: Discounted cash flow―Approach to valuation

[QUESTION]

1. In applying the free cash flow valuation model, the discount rate used is the weighted-average cost of capital.

Answer: True

Learning Objective: 06-01

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Resource Management

AICPA: FN Measurement

Blooms: Remember

Topic: Discounted cash flow―Free cash flow model

[QUESTION]

1. Accrual accounting produces an earnings number that depicts the effects of economic events on cash flows in the period in which the effects occur and provides an estimate of sustainable long-run future free cash flows.

Answer: True

Learning Objective: 06-02

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Remember

Topic: Earnings―Role in valuation

[QUESTION]

1. In the flows to equity model of valuation, and using simplifying assumptions, the current stock price estimate can be expressed as a capitalization rate (1 × r) multiplied by a perpetuity equal to cash flow after paying debtholders and preferred shareholders.

Answer: False

Feedback: The capitalization rate is (1 ÷ r).

Learning Objective: 06-01

Difficulty: 3 Hard

AACSB: Analytical Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Analyze

Topic: Discounted cash flow―Flows to equity model

[QUESTION]

1. The two most significant explanations for variations in the earnings multiple are risk differences and maturity of the firm.

Answer: False

Learning Objective: 06-04

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Risk Analysis

Blooms: Understand

Topic: Price/Earnings multiples―Variation factors

[QUESTION]

1. The value of the future growth opportunities of a firm can be determined by considering the firm’s potential earnings from reinvesting current earnings in new projects that will eventually earn a rate of return more than the cost of equity capital.

Answer: True

Learning Objective: 06-04

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Resource Management

AICPA: FN Measurement

Blooms: Remember

Topic: Price/Earnings multiples―Variation factors

[QUESTION]

1. Return on assets (ROA) can be used to assess whether a firm is likely to earn a return on reinvested earnings that exceeds its cost of equity capital.

Answer: False

Feedback: Return on common equity (ROCE) can be used for this purpose.

Learning Objective: 06-02

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Resource Management

AICPA: FN Measurement

Blooms: Understand

Topic: Earnings―Abnormal earnings approach

[QUESTION]

1. A component that is unrelated to future free cash flows or future earnings and is not pertinent to assessing current share price is a noise component.

Answer: True

Learning Objective: 06-04

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Resource Management

AICPA: FN Measurement

Blooms: Remember

Topic: Price/Earnings multiples―Variation factors

[QUESTION]

1. The degree of conservatism associated with a firm’s accounting choices will have a direct bearing on the relationships among share price, earnings, and the firm’s equity book value components of the abnormal earnings valuation approach.

Answer: True

Learning Objective: 06-02

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Understand

Topic: Earnings―Abnormal earnings approach

[QUESTION]

1. Much of the information needed for assessing the quality and value-relevance of a company’s reported accounting numbers cannot be found in the company’s Form 10-K.

Answer: False

Learning Objective: 06-05

Difficulty: 3 Hard

AACSB: Analytical Thinking

AICPA: BB Critical Thinking

Blooms: Analyze

Topic: Quality of earnings

[QUESTION]

1. Under the GAAP hierarchy of approaches used in measuring fair value, Level 3 uses quoted prices from active markets for identical assets or liabilities to determine fair value.

Answer: False

Feedback: Level 1 uses quoted prices from active markets for identical assets or liabilities to determine fair value.

Learning Objective: 06-03

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Remember

Topic: Fair value measurements

[QUESTION]

1. Because income from discontinued operations is not likely to be recurring, it would be considered transitory earnings and be valued at a lower multiple than recurring components (such as income from operations).

Answer: True

Learning Objective: 06-04

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Understand

Topic: Price/Earnings multiples―Components of earnings

[QUESTION]

1. If securities markets are rational and efficient in that they fully and correctly include all available information into a company’s stock price, the resulting price will reflect investors’ unbiased expectations about the company’s future earnings and cash flows.

Answer: True

Learning Objective: 06-06

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Resource Management

AICPA: FN Measurement

Blooms: Understand

Topic: Stock returns and earnings surprises

[QUESTION]

1. Lenders form opinions about a firm’s credit risk by comparing current and future debt-service requirements to the estimates of the firm’s current and expected future cash flows.

Answer: True

Learning Objective: 06-07

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Resource Management

AICPA: FN Measurement

Blooms: Understand

Topic: Credit risk assessment―Types of lending

[QUESTION]

1. The starting point for developing comprehensive financial statement forecasts is a detailed understanding of the company, its recent financial performance and its health.

Answer: True

Learning Objective: 06-08

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: FN Measurement

Blooms: Understand

Topic: Appendix B―Forecasts of financial statements

Multiple Choice

[QUESTION]

1. The fundamental valuation approach to business valuation uses basic accounting measures to assess the amount, timing and
2. certainty of a firm’s past operating cash flows or earnings.
3. certainty of a firm’s future non-operating cash flows or earnings.
4. uncertainty of a firm’s future operating cash flows or earnings.
5. uncertainty of a firm’s future non-operating cash flows or earnings.

Answer: c

Learning Objective: 06-01

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

AICPA: FN Measurement

Blooms: Understand

Topic: Basic steps in business valuation

[QUESTION]

1. The steps involved in business valuation are forecasting the future values of a financial attribute that drives a company’s value, determining the risk associated with that forecasted value and determining the
2. future values of the value-relevant attribute.
3. certain future value of earnings.
4. present value of a firm’s earnings.
5. discounted present value of the expected future amounts using a discount rate that reflects the risk or uncertainty.

Answer: d

Learning Objective: 06-01

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Understand

Topic: Basic steps in business valuation

[QUESTION]

1. Cash flow assessment plays a central role in analyzing
2. the credit risk of a company.
3. management’s effectiveness.
4. the future earnings potential of a company.
5. the firm’s investment potential.

Answer: a

Learning Objective: 06-01

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Resource Management

AICPA: FN Risk Analysis

Blooms: Remember

Topic: Basic steps in business valuation

[QUESTION]

1. Valuing an entire company, an operating division of that company or its ownership shares involves three basic steps. These steps include all of the following except:
2. Forecasting future amounts of a value-relevant attribute.
3. Determining the risk or uncertainty associated with the forecasted future amounts.
4. Determining the discounted present value of the expected future amounts using an appropriate discount rate.
5. Determining the dividends the company will pay in the future based on the company’s dividend policy and expected future earnings.

Answer: d

Learning Objective: 06-01

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Remember

Topic: Basic steps in business valuation

[QUESTION]

1. When using the discounted flows to equity valuation model, the market value of common shares depends upon investors’
2. future expectations about the future economic prospects of cash flows before payments to debtholders and preferred shareholders.
3. current expectations about the future economic prospects of cash flows after payments to debtholders and preferred shareholders.
4. future expectations about the current economic prospects of cash flows to both debtholders and preferred shareholders.
5. current expectations about the current economic prospects of cash flows to both debtholders and preferred shareholders.

Answer: b

Learning Objective: 06-01

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Resource Management

AICPA: FN Measurement

Blooms: Understand

Topic: Discounted cash flow―Flows to equity model

[QUESTION]

1. A simplified version of the discounted free cash flow valuation model assumes a zero-growth perpetuity for future cash flows. This assumption is best applied to
2. start-up firms with stable cash flow patterns.
3. growth firms with increasing cash flow patterns.
4. growth firms with stable cash flow patterns.
5. mature firms with stable cash flow patterns.

Answer: d

Learning Objective: 06-01

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Understand

Topic: Discounted cash flow―Free cash flow model

[QUESTION]

1. To apply the discounted free cash flow model, the analyst needs to estimate

a net cash flows from operations for each future period, starting one period from now.

1. free cash flows for each future period, starting one period from now.
2. free cash flows for approximately ten years as the present value of cash flows occurring beyond that point are insignificant.
3. net cash flows from operations for approximately ten years as the present value of cash flows occurring beyond that point are insignificant.

Answer: b

Learning Objective: 06-01

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Understand

Topic: Discounted cash flow―Free cash flow model

[QUESTION]

1. The FASB stresses that the primary objective of financial reporting is to provide information useful to investors and creditors in assessing the amount, timing and uncertainty of future net cash flows. The FASB contends that
2. users pay attention to firms’ accounting earnings because this accrual measure of periodic firm performance improves their ability to forecast future cash flows.
3. information about current cash receipts and payments is the best indicator for this task.
4. users pay attention to managements’ estimates of free cash flows because this information improves their ability to forecast future cash flows.
5. current cash flows outperform current earnings in predicting future cash flows.

Answer: a

Learning Objective: 06-02

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Understand

Topic: Earnings―Role in valuation

[QUESTION]

1. By using accruals and deferrals, accrual accounting
2. produces a cash flow number that reflects only cash earnings.
3. produces information about current cash receipts and payments.
4. enables management to estimate future free cash flows.
5. produces an earnings number that depicts the effects of economic events on cash flows.

Answer: d

Learning Objective: 06-02

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Understand

Topic: Earnings―Role in valuation

[QUESTION]

1. Research indicates that stock returns correlate better with
2. accrual earnings than realized operating cash flows.
3. cash basis earnings than realized operating cash flows.
4. realized operating cash flows than accrual earnings.
5. future operating cash flows than accrual earnings.

Answer: a

Learning Objective: 06-02

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Resource Management

Blooms: Understand

Topic: Earnings―Role in valuation

[QUESTION]

1. The reciprocal of the risk-adjusted equity cost of capital used to discount future earnings is the
2. return on assets.
3. return on common equity.
4. price/earnings ratio.
5. profit margin on sales.

Answer: c

Learning Objective: 06-02

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Resource Management

AICPA: FN Measurement

Blooms: Understand

Topic: Earnings―Role in valuation

[QUESTION]

1. If a company currently earns $5.00 per share, and has a risk-adjusted equity cost of capital of 9%, a share of common stock should theoretically sell for approximately
2. $0.45
3. $5.00
4. $48.00
5. $55.55

Answer: d

Feedback: The earnings multiple is 1 ÷ 0.09 = 11.11. $5.00 x 11.11 = $55.55.

Learning Objective: 06-02

Difficulty: 2 Medium

AACSB: Knowledge Application

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Apply

Topic: Earnings―Role in valuation

[QUESTION]

1. If a company currently earns $6.00 per share and has a risk-adjusted equity cost of capital of 12.5%, a share of common stock should theoretically sell for
2. $0.75
3. $6.00
4. $48.00
5. $75.75

Answer: c

Feedback: The earnings multiple is 1 ÷ 0.125 = 8. $6.00 x 8 = $48.00

Learning Objective: 06-02

Difficulty: 2 Medium

AACSB: Knowledge Application

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Apply

Topic: Earnings―Role in valuation

[QUESTION]

1. If most firms’ price/earnings ratios are between 10 and 15, what is the range of the risk-adjusted interest rate?
2. 6.67% to 10%
3. 6.67% to 15%
4. 10% to 15%
5. 10% to 16.67%

Answer: a

Feedback: P/E = 1 ÷ r; 10 =1 ÷ r; r = 1 ÷ 10; r = 10%. 15 = 1 ÷ r; r = 1 ÷ 15; r = 6.67%

Learning Objective: 06-04

Difficulty: 2 Medium

AACSB: Knowledge Application

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Apply

Topic: Price/Earnings multiples―Variation factors

[QUESTION]

1. Risky firms have a higher risk-adjusted cost of capital. Which one of the following factors would contribute to a risky firm also having a relatively high price/earnings ratio?
2. The firm has a high earnings per share.
3. The firm has a low earnings per share.
4. The firm has strong growth opportunities.
5. The firm has a significant amount of long-term debt.

Answer: c

Learning Objective: 06-04

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Resource Management

AICPA: FN Risk Analysis

Blooms: Understand

Topic: Price/Earnings multiples―Variation factors

[QUESTION]

1. To obtain a better current price, the net present value of future growth opportunities (NPVGO) can be calculated and
2. added to the price per share calculated from the P/E ratio.
3. subtracted from the price per share calculated from the P/E ratio.
4. multiplied by the price per share calculated from the P/E ratio.
5. divided into the price per share calculated from the P/E ratio.

Answer: a

Learning Objective: 06-04

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Understand

Topic: Price/Earnings multiples―Variation factors

[QUESTION]

1. The net present value of future growth opportunities (NPVGO) will contribute to an above average P/E multiple when the additional share value created is
2. positive and the return on new investment is lower than the cost of equity capital.
3. positive and the return on new investment is greater than the cost of equity capital.
4. negative and the return on new investment is lower than the cost of equity capital.
5. negative and the return on new investment is greater than the cost of equity capital.

Answer: b

Learning Objective: 06-04

Difficulty: 2 Medium

AACSB: Analytical Thinking

AICPA: BB Resource Management

Blooms: Analyze

Topic: Price/Earnings multiples―Variation factors

[QUESTION]

1. In general, the growth rate in earnings will depend on the portion of earnings reinvested each period and
2. the earnings retention rate.
3. the rate of return earned on new investment.
4. the firm’s cost of equity capital.
5. the firm’s weighted average cost of capital.

Answer: b

Learning Objective: 06-04

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Resource Management

AICPA: FN Measurement

Blooms: Understand

Topic: Price/Earnings multiples―Variation factors

[QUESTION]

1. A component that is valuation-relevant, but is not expected to persist into the future is a
2. permanent earnings component.
3. transitory earnings component.
4. noise component.
5. quiet component.

Answer: b

Learning Objective: 06-04

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Remember

Topic: Price/Earnings multiples―Components of earnings

[QUESTION]

1. Income from continuing operations, excluding special or nonrecurring items, is generally regarded as
2. permanent earnings.
3. transitory earnings.
4. value-irrelevant earnings.
5. abnormal earnings.

Answer: a

Learning Objective: 06-04

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Remember

Topic: Price/Earnings multiples―Components of earnings

[QUESTION]

1. Income or loss from discontinued operations is regarded as
2. permanent earnings.
3. transitory earnings.
4. value-irrelevant earnings.
5. abnormal earnings.

Answer: b

Learning Objective: 06-04

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Remember

Topic: Price/Earnings multiples―Components of earnings

[QUESTION]

1. An adjustment to income due to a non-recurring item is regarded as
2. permanent earnings.

b transitory earnings.

1. value-irrelevant earnings.
2. abnormal earnings.

Answer: b

Learning Objective: 06-04

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Remember

Topic: Price/Earnings multiples―Components of earnings

Use the following to answer questions 38 – 43:

REFERENCE: Ref. 06_01

	Firm A	Firm B	Firm C
Reported EPS	$12	$15	$18
Analyst’s EPS composition:
Permanent component (bP = 5)	80%	60%	75%
Transitory component (bT = 1)	10%	35%	25%
Value-irrelevant component (b0 = 0)	10%	5%	0%

[QUESTION]

REFER TO: Ref. 06_01

1. The implied share price of Firm A’s stock is
2. $12.00
3. $48.00
4. $49.20
5. $54.40

Answer: c

Feedback:

Permanent	0.80 ´ $12 = $9.60 ´ 5 =	$48.00
Transitory	0.10 ´ $12 = $1.20 ´ 1 =	1.20
Value-irrelevant	0.10 ´ $12 = $1.20 ´ 0 =	0.00
	Implied share price	$49.20

Learning Objective: 06-04

Difficulty: 3 Hard

AACSB: Knowledge Application

AICPA: BB Resource Management

AICPA: FN Measurement

Blooms: Apply

Topic: Price/Earnings multiples―Components of earnings

[QUESTION]

REFER TO: Ref. 06_01

1. The implied share price of Firm B’s stock is
2. $15.00
3. $45.00
4. $50.25
5. $55.25

Answer: c

Feedback:

Permanent	.60 ´ $15 = $9.00 ´ 5 =	$45.00
Transitory	.35 ´ $15 = $5.25 ´ 1 =	5.25
Value-irrelevant	.05 ´ $15 = $0.75 ´ 0 =	0.00
	Implied share price	$50.25

Learning Objective: 06-04

Difficulty: 3 Hard

AACSB: Knowledge Application

AICPA: BB Resource Management

AICPA: FN Measurement

Blooms: Apply

Topic: Price/Earnings multiples―Components of earnings

[QUESTION]

REFER TO: Ref. 06_01

1. The implied share price of Firm C’s stock is
2. $18.00
3. $63.00
4. $72.00
5. $90.00

Answer: c

Feedback:

Permanent	.75 ´ $18 = $13.50 ´ 5 =	$67.50
Transitory	.25 ´ $18 = $ 4.50 ´ 1 =	4.50
Value-irrelevant	.00 ´ $18 = $ 0.00 ´ 0 =	0.00
	Implied share price	$72.00

Learning Objective: 06-04

Difficulty: 3 Hard

AACSB: Knowledge Application

AICPA: BB Resource Management

AICPA: FN Measurement

Blooms: Apply

Topic: Price/Earnings multiples―Components of earnings

[QUESTION]

REFER TO: Ref. 06_01

1. The implied total earnings multiple of Firm A is
2. 1.00.
3. 4.10.
4. 5.00.
5. 10.00

Answer: b

Feedback: Implied earnings multiple = Implied share price ÷ Reported EPS = $49.20 ÷ $12.00 = 4.1

Learning Objective: 06-04

Difficulty: 3 Hard

AACSB: Knowledge Application

AICPA: BB Resource Management

AICPA: FN Measurement

Blooms: Apply

Topic: Price/Earnings multiples―Components of earnings

[QUESTION]

REFER TO: Ref. 06_01

1. The implied total earnings multiple of Firm B is
2. 1.00.
3. 3.00.
4. 3.35.
5. 12.00

Answer: c

Feedback: Implied earnings multiple = Implied share price ÷ Reported EPS = $50.25 ÷ $15.00 = 3.35

Learning Objective: 06-04

Difficulty: 3 Hard

AACSB: Knowledge Application

AICPA: BB Resource Management

AICPA: FN Measurement

Blooms: Apply

Topic: Price/Earnings multiples―Components of earnings

[QUESTION]

REFER TO: Ref. 06_01

1. The implied total earnings multiple of Firm C is
2. 1.00.
3. 3.75.
4. 4.00.
5. 15.00

Answer: c

Feedback: Implied earnings multiple = Implied share price ÷ Reported EPS = $72.00 ÷ $18.00 = 4.00

Learning Objective: 06-04

Difficulty: 3 Hard

AACSB: Knowledge Application

AICPA: BB Resource Management

AICPA: FN Measurement

Blooms: Apply

Topic: Price/Earnings multiples―Components of earnings

[QUESTION]

1. Reported earnings numbers often contain three distinctly different components possibly subject to different earnings capitalization rates. Which of the following is not one of these components?
2. A permanent earnings component.
3. A transitory earnings component.
4. A restructured earnings component.
5. A value-irrelevant earnings component.

Answer: c

Learning Objective: 06-04

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Resource Management

AICPA: FN Measurement

Blooms: Remember

Topic: Price/Earnings multiples―Components of earnings

[QUESTION]

1. Which one of the following is an example of sustainable earnings?
2. Loss from debt retirement.
3. Expenditures for advertising.
4. Earnings from repeat customers.
5. Gain from corporate restructuring.

Answer: c

Learning Objective: 06-05

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Remember

Topic: Quality of earnings

[QUESTION]

1. As transitory components become a more important part of a firm’s reported earnings, the reported earnings
2. become a more reliable indicator of sustainable cash flows.
3. are more quality enhanced.
4. are a more reliable indicator of fundamental value.
5. are a less reliable indicator of sustainable cash flows.

Answer: d

Learning Objective: 06-05

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Understand

Topic: Quality of earnings

[QUESTION]

1. The assessment of earnings quality to calculate an implied share price is best accomplished using which of the following?
2. Single-step financial statement.
3. Multiple-step income statement.
4. Cash flow statement.
5. Single-step income statement, balance sheet, and cash flow statement.

Answer: b

Learning Objective: 06-04

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Understand

Topic: Price/Earnings multiples―Components of earnings

[QUESTION]

1. As transitory or value-irrelevant components become a larger part of a firm’s reported earnings, which of the following effects would you not expect to witness?
2. The quality of those reported earnings is eroded.
3. The firm’s stock price rises in the year such components are reported proportionate to their impact on income.
4. Reported earnings become a less reliable indicator of the company’s long-run sustainable cash flows.
5. Earnings are a less reliable indicator of the firm’s fundamental value.

Answer: b

Learning Objective: 06-05

Difficulty: 2 Medium

AACSB: Analytical Thinking

AICPA: BB Resource Management

Blooms: Analyze

Topic: Quality of earnings

[QUESTION]

1. Under the abnormal earnings approach of equity valuation, investors willingly pay a premium for those firms that
2. earn less than the cost of equity capital.
3. produce negative abnormal earnings.
4. produce positive abnormal earnings.
5. earn an amount equal to the equity cost of capital.

Answer: c

Learning Objective: 06-02

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Resource Management

Blooms: Understand

Topic: Earnings―Abnormal earnings approach

[QUESTION]

1. One popular approach to estimating the equity cost of capital is
2. the asset pricing model (APM).
3. the equity costing model (ECM).
4. the cost of equity pricing model (CEPM).
5. the capital asset pricing model (CAPM).

Answer: d

Learning Objective: 06-01

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Understand

Topic: Discounted cash flow―Free cash flow model

[QUESTION]

51 When calculating forecasted cash flows available to common stockholders (CF) under the flows to equity model,

1. cash interest payments and preferred dividends are added.
2. preferred dividends are added.
3. cash interest payments, debt repayments, and preferred dividends are subtracted.
4. cash interest payments, debt repayments, and preferred dividends are not included.

Answer: c

Learning Objective: 06-01

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Resource Management

AICPA: FN Measurement

Blooms: Understand

Topic: Discounted cash flow―Flows to equity model

[QUESTION]

1. The expected abnormal earnings of a firm that has earnings of $40,000 with a required equity cost of capital of 8% and a beginning book value of $800,000 is
2. $(24,000)
3. $(64,000)
4. $40,000
5. $104,000

Answer: a

Feedback: Abnormal earnings = Earnings – (required equity cost of capital ´ beginning book value) = $40,000 – (0.08 ´ $800,000) = $(24,000)

Learning Objective: 06-02

Difficulty: 2 Medium

AACSB: Knowledge Application

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Apply

Topic: Earnings―Abnormal earnings approach

Use the following to answer questions 53 – 57:

REFERENCE: Ref. 06_02

	Firm A	Firm B	Firm C
Actual earnings	$6,000	$14,000	$18,000
r	10%	8%	12%
BVt-1	$100,000	$150,000	$190,000

[QUESTION]

REFER TO: Ref. 06_02

1. What are the abnormal earnings for Firm A?
2. $(4,000)
3. $(6,000)
4. $4,000
5. $6,000

Answer: a

Feedback: Abnormal earnings = Actual earnings – (equity cost of capital ´ beginning book value) = $6,000 – (0.10 ´ $100,000) = $(4,000)

Learning Objective: 06-02

Difficulty: 2 Medium

AACSB: Knowledge Application

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Apply

Topic: Earnings―Abnormal earnings approach

[QUESTION]

REFER TO: Ref. 06_02

1. What are the abnormal earnings for Firm B?
2. $1,000
3. $2,000
4. $12,000
5. $14,000

Answer: b

Feedback: Abnormal earnings = Actual earnings – (equity cost of capital ´ beginning book value) = $14,000 – (0.08 ´ $150,000) = $2,000

Learning Objective: 06-02

Difficulty: 2 Medium

AACSB: Knowledge Application

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Apply

Topic: Earnings―Abnormal earnings approach

[QUESTION]

REFER TO: Ref. 06_02

1. What are the abnormal earnings for Firm C?
2. $(2,400)
3. $(4,800)
4. $4,800
5. $9,600

Answer: b

Feedback: Abnormal earnings = Actual earnings – (equity cost of capital ´ beginning book value) = $18,000 – (0.12 ´ $190,000) = $(4,800)

Learning Objective: 06-02

Difficulty: 2 Medium

AACSB: Knowledge Application

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Apply

Topic: Earnings―Abnormal earnings approach

[QUESTION]

REFER TO: Ref. 06_02

1. Assume that Firm A can increase earnings $4,000 by cutting costs. Abnormal earnings would be
2. $(1,000)
3. $0
4. $1,000
5. $1,500

Answer: b

Feedback: Abnormal earnings = Expected earnings – (equity cost of capital ´ beginning book value) = ($6,000 + $4,000) – (0.10 ´ $100,000) = $0

Learning Objective: 06-02

Difficulty: 3 Hard

AACSB: Knowledge Application

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Analyze

Topic: Earnings―Abnormal earnings approach

[QUESTION]

REFER TO: Ref. 06_02

1. Assume that at the beginning of the year, Firm B divested itself of $20,000 of unproductive capital and earnings for the year fell by only $3,000. Abnormal earnings are
2. $200
3. $400
4. $600
5. $800

Answer: c

Feedback: Abnormal earnings = Expected earnings – (equity cost of capital ´ beginning book value) = ($14,000 – $3,000) – (0.08 ´ ($150,000 – $20,000)) = $600

Learning Objective: 06-02

Difficulty: 3 Hard

AACSB: Analytical Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Analyze

Topic: Earnings―Abnormal earnings approach

[QUESTION]

1. A company with a return on equity that consistently exceeds the industry average ROCE will generally have shares that sell at a
2. market-to-book ratio equal to the industry average.
3. lower market-to-book ratio than the industry average.
4. higher market-to-book ratio than the industry average.
5. higher market price than its competitors.

Answer: c

Learning Objective: 06-02

Difficulty: 2 Medium

AACSB: Analytical Thinking

AICPA: BB Critical Thinking

Blooms: Analyze

Topic: Earnings―Abnormal earnings approach

[QUESTION]

1. Per U.S. GAAP, fair value for accounting purposes is
2. an entry price.
3. an exit price.
4. the market price in a forced sale.
5. always easily determinable.

Answer: b

Learning Objective: 06-03

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms Understand

Topic: Fair value measurements

[QUESTION]

1. Carrying amounts in a GAAP balance sheet are measured using all the following except
2. historical cost.
3. net realizable value.
4. discounted present value.
5. projected ROI.

Answer: d

Learning Objective: 06-03

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: FN Measurement

Blooms: Remember

Topic: Fair value measurements

[QUESTION]

1. In the process of determining fair value, the exit price refers to
2. the amount the firm would receive if it sold a given asset.
3. the amount the firm would pay if it bought an asset of the same type and condition as the one being valued.
4. the sum of the future cash flows expected to be generated by continuing to use the asset.
5. the expected sale price of the stock in a corporate buy-out.

Answer: a

Learning Objective: 06-03

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: FN Measurement

Blooms: Remember

Topic: Fair value measurements

[QUESTION]

1. When determining the fair value of an asset using an exit price approach,
2. fair value is determined by how the company uses the asset.
3. management may choose to reduce the fair value of the asset by the approximate amount of expected transaction costs (i.e., costs to dispose of the asset) if such costs are deemed to be material.
4. transaction costs do not reduce the asset’s fair value.
5. transaction costs reduce the asset’s fair value.

Answer: c

Learning Objective: 06-03

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: FN Measurement

Blooms: Understand

Topic: Fair value measurements

[QUESTION]

1. Prior to the announcement of unexpected bad earnings (a negative earnings surprise), a firm’s stock price will generally exhibit
2. a negative drift downward.
3. no change in stock price.
4. a negative drift downward followed by an immediate upward drift.
5. a positive drift upward.

Answer: a

Learning Objective: 06-06

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Resource Management

Blooms: Understand

Topic: Stock returns and earnings surprises

[QUESTION]

1. An earnings surprise
2. usually precedes a negative drift downward in a firm’s stock price.
3. means that some bias must exist since unbiased means that the market’s earnings expectations will be correct.
4. demonstrates the inherent inefficiency of securities markets.
5. occurs when earnings deviate from investors’ expectations.

Answer: d

Learning Objective: 06-06

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Resource Management

Blooms: Understand

Topic: Stock returns and earnings surprises

[QUESTION]

1. The fact that a firm’s stock price does not change when earnings are announced indicates that
2. per share earnings were the same as the previous quarter.
3. the securities markets are rational and efficient.
4. the information contained in the earnings release was fully anticipated by investors.
5. the earnings deviate from investors’ expectations.

Answer: c

Learning Objective: 06-06

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Resource Management

Blooms: Understand

Topic: Stock returns and earnings surprises

[QUESTION]

1. The interest rate on a revolving loan will usually
2. be below the prime interest rate.
3. be equal to the prime interest rate.
4. remain fixed.
5. float.

Answer: d

Learning Objective: 06-07

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Resource Management

Blooms: Remember

Topic: Credit risk assessment―Types of lending

[QUESTION]

1. Short-term notes sold directly to investors by large, highly rated companies are called
2. commercial paper.
3. secured notes.
4. bonds.
5. debentures.

Answer: a

Learning Objective: 06-07

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Resource Management

Blooms: Remember

Topic: Credit risk assessment―Types of lending

[QUESTION]

1. A bond that is considered unsecured is referred to as a
2. debenture.
3. sinking fund bond.
4. senior bond.
5. callable bond.

Answer: a

Learning Objective: 06-07

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Resource Management

Blooms: Remember

Topic: Credit risk assessment―Types of lending

[QUESTION]

1. A qualitative assessment of the business, its customers and suppliers, and management’s character and capability is known as
2. covenant waivers.
3. due diligence.
4. indenture evaluation.
5. a debenture.

Answer: b

Learning Objective: 06-07

Difficulty:1 Easy

AACSB: Ethics

AICPA: BB Critical Thinking

Blooms: Remember

Topic: Credit risk assessment―Credit ratings―Analysis

[QUESTION]

1. The degree to which cash needs can be satisfied during periods of fiscal stress is known as
2. credit availability.
3. credit worthiness.
4. working capital.
5. financial flexibility.

Answer: d

Learning Objective: 06-07

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Resource Management

Blooms: Remember

Topic: Credit risk assessment―Credit ratings―Analysis

[QUESTION]

1. The two ways to implement the discounted cash flow valuation approach are
2. CAPM and the weighted average cost of capital.
3. the free cash flow model and the flows to equity model.
4. the price/earnings model and the cash flows model.
5. the weighted cash flows model and the capital assets model.

Ans b

Learning Objective: 06-01

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Remember

Topic: Discounted cash flow―Approach to valuation

[QUESTION]

1. The interest rate charged on bank loans must be sufficient to cover all the following except
2. a risk premium when loans are personally guaranteed by the borrower.
3. the lender’s cost of borrowing funds.
4. the costs of administering, monitoring, and servicing the loan.
5. a premium for exposure to default risk.

Ans a

Learning Objective: 06-07

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Resource Management

AICPA: FN: Risk Analysis

Blooms: Understand

Topic: Credit risk assessment―Credit ratings―Analysis

[QUESTION]

1. Financial statement forecasts are
2. one of the required note disclosures found in each company’s annual report.
3. filed annually with the SEC by all public companies.
4. frequently used in determining management compensation.
5. essential ingredients of business valuation and credit risk analysis.

Answer: d

Learning Objective: 06-08

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Remember

Topic: Appendix B―Forecasts of financial statements

[QUESTION]

1. Preparing comprehensive financial statement forecasts involves six steps. Among these steps are all the following except:
2. Forecast sales revenue for each period in the forecast horizon.
3. Forecast depreciation expense and tax expense for each period.
4. Forecast the company’s financial structure and dividend policy for each period.
5. Forecast the market price per share for the company’s common stock for each period.

Answer: d

Learning Objective: 06-08

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Understand

Topic: Appendix B―Forecasts of financial statements

[QUESTION]

1. Which of the following statements is false regarding the global vantage point of fair value measurement?
2. The FASB revised ASC 820-10 to make the U.S. fair value disclosure rules more consistent with IFRS.
3. IFRS 13 “Fair Value Measurement” is not in agreement with U.S. GAAP.
4. ASC Topic 820 provides fair value guidance for companies, investors, and company auditors.
5. The FASB and the IASB worked together on a joint convergence project for fair value measurement and disclosure.

Answer: b

Learning Objective: 06-03

Difficulty: 2 Medium

AACSB: Diversity

AICPA: BB Global

AICPA: FN Measurement

Blooms: Understand

Topic: Fair value measurements

[QUESTION]

1. Common value-relevant attributes for determining the value of a company include all the following except:
2. Fair value of fixed assets.
3. Balance sheet book values.
4. Accounting earnings.
5. Free cash flows.

Answer: a

Learning Objective: 06-01

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Resource Management

AICPA: FN Measurement

Blooms: Remember

Topic: Basic steps in business valuation

[QUESTION]

1. Which of the following statements is false regarding the flows to equity model?
2. The forecasted cash flow stream to be discounted is reduced by flows to preferred shareholders.
3. The flows are reduced by cash interest payments.
4. The flows are increased by debt repayments.
5. The flows calculation begins with free cash flow.

Answer: c

Learning Objective: 06-01

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Resource Management

AICPA: FN Measurement

Blooms: Remember

Topic: Discounted cash flow―Flows to equity model

[QUESTION]

1. Which of the following statements is false regarding the FASB’S view on valuation?
2. The FASB believes that current cash flows are more useful than current accrual accounting earnings in predicting future cash flows.
3. The FASB contends that users pay attention to a firm’s accounting earnings because this measure improves their ability to forecast future cash flows.
4. The FASB believes that a reliable valuation needs to rely on more than an analysis of cash receipts and payments during a certain period.
5. The FASB stresses that the primary objective of financial reporting is to provide useful information to investors and creditors in assessing the amount, timing, and uncertainty of future net cash flows.

Answer: a

Learning Objective: 06-02

Difficulty 2 Medium

AACSB: Reflective Thinking

AICPA: FN Measurement

Blooms: Understand

Topic: Earnings―Role in valuation

[QUESTION]

1. Which of the following statements is false regarding the abnormal earnings approach to valuation?
2. The method uses earnings and equity book value numbers as direct inputs in the valuation process.
3. The method uses the cost of capital as a fundamental economic benchmark.
4. This approach produces results that are generally equivalent to the free cash flow model.
5. This approach is based on the notion that the value of a company is driven primarily by the level of earnings.

Answer: d

Learning Objective: 06-02

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: FN Measurement

Blooms: Understand

Topic: Earnings―Abnormal earnings approach

[QUESTION]

1. Which of the following statements is false regarding credit risk analysis?
2. A comprehensive credit risk analysis involves evaluating and summarizing the various individual risks associated with a loan.
3. Credit risk is not affected by the aggressive application of accounting standards since cash flows are not impacted by financial reporting choices.
4. A simple alternative to credit risk analysis is to rely on credit reports issued by third parties.
5. Certain financial statement ratios are very useful in predicting loan default.

Answer: b

Learning Objective: 06-07

Difficulty: 2 Medium

AACSB: Analytical Thinking

AICPA: BB Resource Management

AICPA: FN Risk Analysis

Blooms: Analyze

Topic: Credit risk assessment―Credit ratings―Analysis

[QUESTION]

1. Which of the following statements is false regarding credit risk analysis?
2. A lender is protected against credit risks by a loan’s covenant provisions since the interest rate is fixed by the Federal Reserve Bank.
3. High-quality financial statements help a credit analyst to see the true performance at a company.
4. Greater default risk is determined to exist when there is significant organizational reliance on a certain individual or customer.
5. An estimate of a firm’s future financial condition is very important to most lending decisions.

Answer: a

Learning Objective: 06-07

Difficulty: 2 Medium

AACSB: Analytical Thinking

AICPA: BB Resource Management

AICPA: FN Risk Analysis

Blooms: Analyze

Topic: Credit risk assessment―Credit ratings―Analysis

[QUESTION]

1. Which of the following statements is false regarding traditional lending products?
2. A term lending agreement has an original maturity of more than one year with maturities ranging from two to five years being the most common.
3. The written agreement between the between the borrowing company and its lenders is referred to as the indenture.
4. A bond that has collateral to protect the bondholder is referred to as a debenture bond.
5. A call provision allows the borrowing company to repurchase part or all the debt at a stated price over a specific period.

Answer: c

Learning Objective: 06-07

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Resource Management

AICPA: FN Measurement

Blooms: Understand

Topic: Credit risk assessment―Types of lending

[QUESTION]

1. Which of the following statements is false regarding the business valuation process?
2. Credit valuation involves estimating the worth of a company, one of its operating units, or its ownership shares.
3. Business valuation involves estimating the intrinsic value of a company or one of its operating units.
4. Fundamental valuation uses basic accounting measures to assess the amount, timing, and uncertainty of a firm’s future operating cash flows or earnings.
5. Operating cash flow minus cash outlays to replace operating capacity represents free cash flow.

Answer: a

Learning Objective: 06-01

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Resource Management

AICPA: FN Measurement

Blooms: Understand

Topic: Basic steps in business valuation

[QUESTION]

1. Which of the following statements is false regarding the business valuation process?
2. If a company is currently generating a sustainable free cash flow of $10 per share and the discount rate is 10%, the estimated share price is $100.
3. FASB contends that current accrual earnings are a proxy for free cash flow.
4. A simplified version of the discounted free cash flow valuation model assumes a zero-growth perpetuity for future cash flows. This approach is best applied to growth companies with stable cash flow patterns.
5. One popular approach to estimate a firm’s equity cost of capital is the capital asset pricing model.

Answer: c

Learning Objective: 06-01

Learning Objective: 06-02

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Understand

Topic: Basic steps in business valuation

Topic: Discounted cash flow―Free cash flow model

Topic: Earnings―Role in valuation

[QUESTION]

1. Which of the following statements is false regarding the business valuation process?
2. Income or loss from discontinued operations is considered a transitory component of a firm’s earnings.
3. Forecasting future cash flows requires calculations using factors from future value tables.
4. A component of earnings that is unrelated to future free cash flows or future earnings and is not pertinent to assessing current share price is considered a noise component.
5. Firms that earn less than the cost of equity capital produce negative abnormal earnings and generally have a share price below book value.

Answer: b

Learning Objective: 06-01

Learning Objective: 06-02

Learning Objective: 06-04

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Resource Management

AICPA: FN Measurement

Blooms: Understand

Topic: Basic steps in business valuation

Topic: Earnings―Abnormal earnings approach

Topic: Price/Earnings multiples―Variation factors

Essay and Computational Questions

[QUESTION]

1. Briefly define “free cash flows” and describe the key features of the free cash flow model for business valuation.

Answer: Free cash flow is operating cash flow minus cash outlays for operating capacity such as buildings, equipment, and furnishings. A company’s free cash flow consequently represents the amount available to finance planned expansion of operating capacity, reduce debt, pay dividends or repurchase stock. Under the free cash flow model for business valuation, the value of a firm’s stock and debt at a certain time is equal to the sum of the future stream of expected free cash flow discounted back to the present at the firm’s weighted-average cost of capital. In summary, the free cash flow model expresses today’s intrinsic value as a function of investors’ current expectations of the firm’s future economic prospects as measured by its expected future free cash flows.

Learning Objective: 06-01

Difficulty: 3 Hard

AACSB: Communication

AICPA: BB Resource Management

AICPA: FN Measurement

AICPA: BB Critical Thinking

Blooms: Understand

Topic: Discounted cash flow―Free cash flow model

[QUESTION]

1. Describe the general role of accounting numbers in business valuation.

Answer: Business valuation involves estimating the worth of a company, one of its operating units or its ownership shares. Some equity valuation models are based on discounting a firm’s future earnings or free cash flows. In such settings, the role of accounting numbers (i.e., the information disclosed in financial statements) is to aid in the development of forecasts of the firm’s future earnings and cash flows. These forecasts are then discounted at the firm’s risk-adjusted cost of equity capital to arrive at an estimate of the equity’s value. The book value from the balance sheet of the firm is used for the abnormal earnings approach to valuation. Components of the income statement are categorized for calculating an implied share price of the business. Earnings per share is used for calculating an implied earnings multiple to use in assessing earnings quality and comparing one company to another.

Learning Objective: 06-01

Learning Objective: 06-02

Learning Objective: 06-04

Difficulty: 2 Medium

AACSB: Communication

AICPA: FN Measurement

AICPA: BB Critical Thinking

Blooms: Understand

Topic: Basic steps in business valuation

Topic: Discounted cash flow―Approach to valuation

Topic: Earnings―Role in valuation

Topic: Earnings―Abnormal earnings approach

Topic: Price/Earnings multiples―Components of earnings

[QUESTION]

1. P/E ratios are a useful indicator and tool when performing valuation and comparing firms. List three factors that should be considered or adjusted for when comparing P/E ratios among different firms.

Answer: Possible answers include risk differences, growth opportunities, earnings components (valuation irrelevant, permanent, and transitory) as well as differences in accounting policies.

Learning Objective: 06-04

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Risk Analysis

Blooms: Understand

Topic: Price/Earnings multiples―Variation factors

[QUESTION]

1. What is meant by sustainable earnings?

Answer: Sustainable earnings comprise the component of earnings that is valuation-relevant and is expected to persist into the future. The sustainable component of a company’s earnings is represented by recurring income from continuing operations and would fall into the permanent earnings category for valuation. Earnings generated from repeat customers or from a high-quality product that enjoys steady customer demand are examples of drivers behind sustainable earnings.

Learning Objective: 06-04

Learning Objective: 06-05

Difficulty: 2 Medium

AACSB: Communication

AICPA: BB Resource Management

AICPA: FN Measurement

Blooms: Understand

Topic: Price/Earnings multiples―Components of earnings

Topic: Quality of earnings

[QUESTION]

1. Briefly discuss how a firm’s P/E ratio is related to the firm’s choice of accounting methods, estimates, and timing of discretionary expenditures.

Answer: The denominator of the P/E ratio is earnings and so the lower the earnings, the greater the P/E ratio. Firms that use conservative accounting methods and recognize lower net income (i.e., those that tend to recognize expenses sooner rather than later or recognize revenues later rather than sooner) will generally report lower earnings. Conversely, firms that use aggressive accounting methods (i.e., those that tend to recognize expenses later rather than sooner and revenues sooner rather than later) tend to report higher earnings. Thus, choice of accounting methods such as for inventory and for depreciation, and for estimates of uncollectibles, and timing of discretionary expenses and can affect net income and thus the P/E ratio.

Learning Objective: 06-05

Difficulty: 3 Hard

AACSB: Communication

AICPA: BB Resource Management

AICPA: FN Decision-Making

AICPA: BB Critical Thinking

Blooms: Evaluate

Topic: Quality of earnings

[QUESTION]

1. Briefly discuss how a firm’s P/E ratio is related to the present value of growth opportunities available to the firm.

Answer: Price-earnings ratios are positively related to the present value of a firm’s growth opportunities. The market values the firm’s potential earnings from reinvesting current earnings in new projects that will eventually earn a rate of return in excess of the firm’s cost of equity capital. The net present value of growth opportunities (NPVGO) adds a positive increment to the firm’s stock price which results in higher P/E multiples. Consequently, as growth opportunities increase, so do P/E ratios. The firm’s stock value is a function of the present value of earnings from assets in place in addition to the firm’s future growth opportunities. Thus, firms with little or no current earnings may still have very high P/E ratios because they have substantial future growth opportunities. Examples include companies in the biotechnology, computer software and computer hardware industries.

Learning Objective: 06-04

Difficulty: 2 Medium

AACSB: Communication

AICPA: BB Resource Management

AICPA: FN Risk Analysis

Blooms: Understand

Topic: Price/Earnings multiples―Components of earnings

[QUESTION]

1. Recent values of P₀ (current stock price), X₀ (current reported EPS), and r (equity cost of capital) for Alpha Company follow:

P0	X0	r
$23.50	$1.47	0.150

Required:

Compute Alpha’s NPVGO (net present value of future growth opportunities).

Answer: To find the NPVGO for Alpha Company, solve the following equation:

Rearranging terms yields: = $23.50 − ($1.47 ÷ 0.15) = $13.70 NPVGO

Learning Objective: 06-04

Difficulty: 3 Hard

AACSB: Analytical Thinking

AICPA: FN Measurement

AICPA: BB Critical Thinking

Blooms: Analyze

Topic: Price/Earnings multiples―Variation factors

[QUESTION]

1. One measure for determining expected earnings for the current quarter could be considering earnings for the same quarter last year. List some of the disadvantages to using this measure.

Answer: Some disadvantages include: this measure (a) does not consider non-recurring items that were included in previous corresponding period earnings, and (b) does not consider new information and events that occurred after the previous corresponding period.

Learning Objective: 06-04

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: FN Measurement

AICPA: BB Critical Thinking

Blooms: Analyze

Topic: Price/Earnings multiples―Components of earnings

[QUESTION]

1. List some possible techniques that management can use to improve a company’s reported performance in the short run.

Answer: Management can improve reported earnings in the short-term by:

(a.) Changing accounting methods.

(b.) Adjusting expense estimates (e.g., increasing estimated useful lives of fixed assets or reducing bad debt or warranty expense estimates).

(c.) Altering the timing of revenue or expense recognition (i.e., shifting revenues or expenses from one period to the next).

(d.) Initiating business transactions that produce one-time gains or losses; e.g., sell real estate.

(e.) Reducing or eliminating expenditures for advertising, R&D, etc.

Learning Objective: 06-05

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: FN Measurement

AICPA: BB Critical Thinking

Blooms: Understand

Topic: Quality of earnings

[QUESTION]

1. Give at least three examples of low-quality earnings items.

Answer: Examples of low-quality earnings items include:

(a.) One-time gains and losses from asset sales.

(b.) Liberal accounting choices that increase short-term profits.

(c.) Changes in discretionary expenditures for R&D, advertising, and maintenance.

(d.) Illusory profits from LIFO liquidations.

(e.) Changes in accounting estimates.

Feedback: A variety of other examples could be listed here.

Learning Objective: 06-05

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: FN Measurement

AICPA: BB Critical Thinking

Blooms: Understand

Topic: Quality of earnings

[QUESTION]

1. Below is data for calendar 2018 for two companies.

	Company A	Company B
Actual earnings	$79,632	$176,341
BVt-1	$504,000	$943,000
Cost of equity capital	0.167	0.175

Required:

Calculate each firm’s abnormal earnings and indicate which firm was better managed during calendar year 2018.

Answer:

	Company A	Company B
Actual earnings	$79,632	$176,341
BVt-1	504,000	943,000
Cost of equity capital	0.167	0.175
Return on capital	0.158	0.187
Expected earnings	84,168	165,025
Abnormal earnings	$(4,536)	$11,316

Company B created value by generating positive abnormal earnings while Company A eroded value due to negative abnormal earnings. Consequently, Company B was the better managed of the two companies for 2018.

Learning Objective: 06-02

Difficulty: 2 Medium

AACSB: Analytical Thinking

AICPA: FN Measurement

AICPA: BB Critical Thinking

Blooms: Analyze

Blooms: Evaluate

Topic: Earnings―Abnormal earnings approach

[QUESTION]

1. Briefly define “abnormal earnings” and describe the key features of the abnormal earnings approach to valuation.

Answer: Abnormal earnings is the difference between actual earnings for the period

and stockholders’ required dollar return on invested capital for the period. Investors willingly pay a premium only for the stocks of firms that earn more than their cost of equity capital (i.e., firms that earn positive abnormal earnings). Conversely, investors will generally pay less than book value for firms that earn negative abnormal earnings. As described in the text, the abnormal earnings valuation model is: Price of equity at time 0 = Book value of equity at time 0 + Present value of expected abnormal earnings in all future periods. The discount rate that is applied to the future abnormal earnings is the cost of equity capital.

Learning Objective: 06-02

Difficulty: 2 Medium

AACSB: Communication

AICPA: FN Measurement

AICPA: BB Critical Thinking

Blooms: Understand

Topic: Earnings―Abnormal earnings approach

[QUESTION]

1. Why do the stock returns of firms reporting “good news” drift upwards before the earnings announcement date?

Answer: “Good news” firms are those that report earnings better than expected when they actually announce their earnings and these are firms that are performing well during the quarter leading up to the earnings announcement date. One possible reason for the upward drift during the quarter is that accounting earnings announced at the end of the quarter is not the sole source of value-relevant information about the firm. During the quarter, other information will generally become available to indicate that the firm is doing better than previously expected. Consequently, investors can anticipate good earnings from the firm and will tend to buy more of their stock which will lead to an increase in the stock price of the firm. This good performance is then confirmed at the end of the quarter when the firm reports earnings greater than expected at the beginning of the quarter.

Learning Objective: 06-06

Difficulty: 2 Medium

AACSB: Communication

AICPA: BB Critical Thinking

Blooms: Understand

Topic: Stock returns and earnings surprises

[QUESTION]

1. Briefly define an earnings surprise and explain how the surprise can impact the value of a firm’s equity.

Answer: An earnings surprise occurs when new information is conveyed to investors at the time of a firm’s quarterly or annual earnings announcement. An earnings surprise occurs when a firm’s reported earnings are different from what the market was expecting the firm to report. Investors use earnings surprises to revise their expectations of the firm’s future earnings and cash flow prospects. The stock price change will generally be positive when the earnings surprise is “good news” (i.e., reported earnings exceed what the market had expected). The stock price change will generally be negative when the earnings surprise is “bad news” (i.e., reported earnings are less than what the market had expected).

Learning Objective: 06-06

Difficulty: 2 Medium

AACSB: Communication

AICPA: BB Critical Thinking

Blooms: Understand

Topic: Stock returns and earnings surprises

[QUESTION]

1. The quarterly cash flows from operations for two technology companies are as follows:

	2018					2019
	Q1	Q2	Q3	Q4		Q1
Firm 1	$451.2	$220.8	$703.5	$475.5		$601.2
Firm 2	$165.9	$240.7	$698.8	$(91.8)		$(173.3)

Required:

Explain why Firm 2 has more credit risk than Firm 1.

Answer: The quarterly operating cash flows of both firms fluctuate seasonally, i.e., operating cash flow levels change from quarter to quarter and the changes are not all positive. Seasonal patterns in sales and operating cash flow are common in many industries, and the cash flow volatility produced by seasonal sales is one of the contributors to increased credit risk. In addition, Firm 2’s operating cash flows are lower than those of Firm 1 and are negative in the two most recent quarters. These two features of Firm 2’s operating cash flow make it a greater credit risk than Firm 1.

Learning Objective: 06-07

Difficulty: 3 Hard

AACSB: Analytical Thinking

AICPA: BB Critical Thinking

Blooms: Analyze

Topic: Credit risk assessment―Credit ratings―Analysis

Chap007 The Role of Financial Information in Contracting

True/False

[QUESTION]

1. Contract terms can be designed to eliminate or reduce conflicting incentives that arise in business relationships.

Answer: True

Learning Objective: 07-01

Topic Area: Conflicts of interest―Contract effects

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

Blooms: Understand

[QUESTION]

1. Contracts include financial reporting information and create incentives for earnings management.

Answer: True

Learning Objective: 07-01

Learning Objective: 07-03

Topic Area: Conflicts of interest―Contract effects

Topic Area: Influences on managerial incentives

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Legal

AICPA: FN Measurement

Blooms: Understand

[QUESTION]

1. Debt covenants help guard against conflicts of interest between creditors and bank regulators.

Answer: False

Learning Objective: 07-02

Topic Area: Debt covenants in lending―Purposes

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

Blooms: Understand

[QUESTION]

1. Some debt covenants preserve repayment capacity by preventing mergers and acquisitions unless the debt is first repaid.

Answer: False

Feedback: Preventing mergers and acquisitions is an example of a covenant designed to protect against credit-damaging events.

Learning Objective: 07-02

Topic Area: Debt covenants in lending―Purposes

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

Blooms: Understand

[QUESTION]

1. Negative covenants tend to be less significant than affirmative covenants because they place direct restrictions on the actions lenders can take.

Answer: False

Learning Objective: 07-02

Topic Area: Debt covenants in lending―Types

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Legal

Blooms: Understand

[QUESTION]

1. Managers wishing to avoid loan covenant violations may resort to making accounting changes that increase reported earnings.

Answer: True

Learning Objective: 07-03

Topic Area: Influences on managerial incentives

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Understand

[QUESTION]

1. Potential conflicts of interest between managers and owners can be overcome if compensation packages are tied to improvement in firm value.

Answer: True

Learning Objective: 07-01

Learning Objective: 07-03

Topic Area: Conflicts of interest―Relationships

Topic Area: Influences on managerial incentives

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Resource management

Blooms: Understand

[QUESTION]

1. Most compensation packages involve a base salary, an annual incentive, and a short-term incentive.

Answer: False

Learning Objective: 07-02

Topic Area: Contracts for compensation purposes

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Legal

Blooms: Remember

Feedback: Most compensation packages involve a base salary, an annual (short-term) incentive, and a long-term incentive.

[QUESTION]

1. When restricted stock is granted as executive compensation, the recipient must wait for collecting dividends and exercising voting rights until the restriction period ends.

Answer: False

Learning Objective: 07-02

Topic Area: Contracts for compensation purposes

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Legal

Blooms: Remember

[QUESTION]

1. Research shows that managers sometimes use accounting flexibility to evade contract constraints in order to gain bonus benefits.

Answer: True

Learning Objective: 07-04

Topic Area: Influences on accounting choices

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Resource management

Blooms: Remember

[QUESTION]

1. A factor that can affect managers’ incentives for short-term focus on performance is that a compensation committee oversees incentive plans and can intervene when circumstances warrant modification of the scheduled incentive award.

Answer: True

Learning Objective: 07-02

Learning Objective: 07-03

Topic Area: Contracts for compensation purposes

Topic Area: Influences on managerial incentives

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Legal

AICPA: FN Risk Analysis

Blooms: Remember

[QUESTION]

1. Banks and other financial institutions are required by federal and state regulatory agencies to meet minimum lending requirements.

Answer: False

Learning Objective: 07-02

Topic Area: Regulatory contracts

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Industry

Blooms: Understand

[QUESTION]

1. Under RAP, loan charge-offs decrease bank capital and also reduce bank net income.

Answer: False

Learning Objective: 07-04

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Understand

Topic Area: Regulatory accounting choices―RAP

[QUESTION]

1. Many managers believe that meeting earnings benchmarks helps to build credibility with investors.

Answer: True

Learning Objective: 07-05

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Industry

AICPA: FN Risk Analysis

Blooms: Remember

Topic Area: Wall Street expectations

[QUESTION]

1. A difference of one penny between reported EPS and analysts’ expectations of EPS matters a lot to investors.

Answer: True

Learning Objective: 07-05

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Understand

Topic Area: Wall Street expectations

Multiple Choice

[QUESTION]

1. Loan provisions that are specifically designed to restrict dividend payments to shareholders are called
2. debt covenants.
3. debt obligations.
4. stock covenants.
5. stock agreements.

Answer: a

Learning Objective: 07-02

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Legal

AICPA: FN Risk Analysis

Blooms: Remember

Topic Area: Debt covenants in lending―Purposes

[QUESTION]

1. A lender may be protected from deterioration of the borrower’s creditworthiness if the commercial lending agreement requires the borrower to maintain a
2. specified return on equity.
3. specified earnings per share (EPS).
4. fixed charge ratio above a certain level.
5. fixed charge ratio below a certain level.

Answer: c

Learning Objective: 07-02

Difficulty: Medium

AACSB: Reflective Thinking

AICPA: BB Resource Management

AICPA: FN Risk Analysis

Blooms: Understand

Topic Area: Debt covenants in lending―Types

[QUESTION]

1. A borrower that violates one or more loan covenants but makes all interest and principal payments timely
2. is in payment default.
3. is in trigger default.
4. is in technical default.
5. is not in default.

Answer: c

Learning Objective: 07-02

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Resource Management

Blooms: Remember

Topic Area: Debt covenants in lending―Types

[QUESTION]

1. Which of the following is not a purpose served by debt covenants?
2. Preservation of repayment capacity
3. Protection against credit damaging events
4. Triggers and signals
5. Guarantee of no default by the creditor

Answer: d

Learning Objective: 07-02

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Legal

AICPA: FN Risk Analysis

Blooms: Understand

Topic Area: Debt covenants in lending―Purposes

[QUESTION]

1. When one party to a business relationship can make decisions that benefit him or her but harm another other party in the relationship
2. a lawsuit is automatically filed.
3. a contract arises.
4. a conflict of interest arises.
5. a contingent liability arises.

Answer: c

Learning Objective: 07-01

Difficulty: 1 Easy

AACSB: Ethics

AICPA: BB Critical Thinking

AICPA: FN Decision Making

Blooms: Remember

Topic Area: Conflicts of interest―Relationships

[QUESTION]

1. Potential conflicts of interest permeate
2. few business relationships.
3. only relationships between investors and managers.
4. only relationships between borrowers and lenders.
5. many business relationships.

Answer: d

Learning Objective: 07-01

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Decision Making

Blooms: Understand

Topic Area: Conflicts of interest―Relationships

[QUESTION]

1. Contract terms
2. confer the rights and obligations of the borrower.
3. depend on data in financial statements that are issued before the contract is executed.
4. cannot be designed to eliminate or reduce conflicting incentives.
5. do not use financial accounting numbers to monitor compliance with contract terms.

Answer: a

Learning Objective: 07-01

Learning Objective: 07-02

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Legal

AICPA: FN Risk Analysis

Blooms: Understand

Topic Area: Conflicts of interest―Contract effects

Topic Area: Debt covenants in lending―Purposes

[QUESTION]

1. A typical rate formula for a public utility includes
2. revenue, operating costs, and taxes.
3. operating costs, depreciation, and taxes.
4. advertising, depreciation, and taxes.
5. operating costs, bad debt provisions, and depreciation.

Answer: b

Learning Objective: 07-02

Learning Objective: 07-04

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Remember

Topic Area: Regulatory contracts

Topic Area: Regulatory accounting choices―RAP

[QUESTION]

1. When agents do not act in the best interest of their principals, the cost is borne by which of the following?
2. Only the principal
3. Only the agent
4. Both the principal and agent
5. There is no cost of an agent not acting on behalf of their principal.

Answer: c

Learning Objective: 07-01

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Legal

Blooms: Understand

Topic Area: Conflicts of interest―Relationships

[QUESTION]

1. When conflicts of interest exist, lenders generally take all of the following actions at the creation of a contract except
2. impose higher interest rates to reflect greater default risk.
3. ensure that affirmative covenants are in the contract.
4. accept the risk and set up a reserve for potential future issues.
5. ensure that negative covenants are in the contract.

Answer: c

Learning Objective: 07-01

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical thinking

AICPA: FN Risk Analysis

Blooms: Understand

Topic Area: Conflicts of interest―Contract effects

[QUESTION]

1. A covenant that specifies a required minimum level of net worth and working capital is a/an
2. compliance covenant.
3. financial covenant.
4. implicit covenant.
5. negative covenant.

Answer: b

Learning Objective: 07-02

Difficulty: Easy

AACSB: Reflective Thinking

AICPA: BB Legal

Blooms: Remember

Topic Area: Debt covenants in lending―Types

[QUESTION]

1. Affirmative covenants generally would not include which of the following stipulations?
2. The lender has the right to inspect business assets and business contracts.
3. Limits on the borrower’s total indebtedness.
4. The borrower must maintain insurance on business properties.
5. Specific financial covenants and reporting requirements.

Answer: b

Learning Objective: 07-02

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Legal

Blooms: Remember

Topic Area: Debt covenants in lending―Types

[QUESTION]

1. Many loan agreements have financial covenants that rely on
2. floating GAAP.
3. fixed GAAP.
4. flexible GAAP.
5. regulatory accounting procedures (RAP).

Answer: b

Learning Objective: 07-02

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Legal

AICPA: FN Measurement

Blooms: Remember

Topic Area: Debt covenants in lending―Types

[QUESTION]

1. What purpose is served by including covenants that place strict limits on new borrowing, prohibit stock repurchases and dividends without prior lender approval, or ensure that cash generated both from ongoing operations and from asset sales will not be diverted away from servicing debt?
2. Signal
3. Protection against credit-damaging events
4. Preservation of repayment capital
5. Trigger

Answer: c

Learning Objective: 07-02

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

Blooms: Understand

Topic Area: Debt covenants in lending―Purposes

[QUESTION]

1. Which of the following is not an example of a negative covenant provision?
2. Limits on capital expenditures.
3. Limits on the borrower’s total indebtedness
4. Limits the use of the loan to an agreed-upon purpose
5. Restricts the payment of cash dividends

Answer: c

Learning Objective: 07-02

Difficulty: Medium

AACSB: Reflective Thinking

AICPA: BB Legal

Blooms: Understand

Topic Area: Debt covenants in lending―Types

[QUESTION]

1. Based on a comprehensive survey of U.S. companies, the most common financial performance measure used in annual and long-term incentive plans for senior executives is
2. return on equity.
3. economic value added.
4. return on capital.
5. net income or revenues.

Answer: d

Learning Objective: 07-03

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Industry

AICPA: FN Measurement

Blooms: Remember

Topic Area: Influences on managerial incentives

[QUESTION]

1. Which of the following situations does not lead to default of a loan contract?
2. Impairment of capital
3. Failure to abide by a covenant
4. Paying interest and principal when due
5. Failure to pay other debts when due

Answer: c

Learning Objective: 07-02

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Risk Analysis

AICPA: BB Legal

Blooms: Understand

Topic Area: Debt covenants in lending―Purposes

[QUESTION]

1. Debt covenants benefit
2. lenders.
3. borrowers.
4. both lenders and borrowers.
5. neither borrowers nor lenders, but are required by the SEC as a condition of issuing debt securities.

Answer: c

Learning Objective: 07-02

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Legal

Blooms: Remember

Topic Area: Debt covenants in lending―Purposes

[QUESTION]

1. Which one of the following is not a broad function served by debt covenants?
2. Debt covenants usually preclude the borrower from being a merger target.
3. Debt covenants serve as both signals and triggers, thereby assuring a steady flow of information from borrower to lender.
4. Debt covenants are designed to preserve the borrower’s repayment capacity.
5. Debt covenants offer the lender some protection against credit-damaging events affecting the borrower.

Answer: a

Learning Objective: 07-02

Difficulty: 3 Hard

AACSB: Reflective Thinking

AICPA: FN Risk Analysis

AICPA: BB Legal

Blooms: Understand

Topic Area: Debt covenants in lending―Purposes

[QUESTION]

1. A financial covenant would stipulate all of the following except
2. financial statements must be prepared in accordance with GAAP.
3. specific levels of performance to be met.
4. which accounting methods are to be used.
5. conditions that must be met.

Answer: c

Learning Objective: 07-02

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Legal

Blooms: Understand

Topic Area: Debt covenants in lending―Types

[QUESTION]

1. In the event of a default, lenders may do all of the following except
2. modify the contract terms.
3. take immediate full control of the creditor.
4. initiate bankruptcy proceedings.
5. seize the collateral.

Answer: b

Learning Objective: 07-02

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Legal

AICPA: BB Industry

Blooms: Understand

Topic Area: Debt covenants in lending―Purposes

[QUESTION]

1. In using financial statements to monitor compliance with debt covenants
2. mandatory changes in accounting principles can be ignored in all cases.
3. many loan agreements have financial covenants that rely on the accounting rules in place when the loan is first granted.
4. the lender is in default if not enforcing the borrower’s compliance with the most recent accounting principles.
5. the lender must renegotiate the covenants if a new accounting principle harms the borrower’s compliance.

Answer: b

Learning Objective: 07-02

Difficulty: 3 Hard

AACSB: Reflective Thinking

AICPA: BB Legal

AICPA: FN Measurement

Blooms: Understand

Topic Area: Debt covenants in lending―Purposes

[QUESTION]

1. A lender’s requirement for a borrower to maintain a certain level of fixed charge coverage
2. directly enhances the borrower’s ability to pay dividends.
3. indirectly enhances the borrower’s ability to pay dividends.
4. directly limits the borrower’s ability to pay dividends.
5. indirectly limits the borrower’s ability to pay dividends.

Answer: d

Learning Objective: 07-02

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Resource Management

AICPA: FN Risk Analysis

Blooms: Understand

Topic Area: Debt covenants in lending―Purposes

[QUESTION]

1. Covenants that place direct restrictions on managerial decisions are called
2. affirmative restrictions.
3. affirmative covenants.
4. negative restrictions.
5. negative covenants.

Answer: d

Learning Objective: 07-02

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Legal

Blooms: Understand

Topic Area: Debt covenants in lending―Types

[QUESTION]

1. Which one of the following is an example of a negative covenant?
2. Compliance with laws.
3. Maintenance of insurance.
4. Limit on capital expenditures.
5. Rights of inspection.

Answer: c

Learning Objective: 07-02

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Legal

Blooms: Understand

Topic Area: Debt covenants in lending―Types

[QUESTION]

1. Which of the following is not an example of an affirmative covenant?
2. Allowing the lender to inspect business assets and business contracts.
3. Limiting new business ventures.
4. Complying with laws.
5. Providing periodic, audited financial statements.

Answer: b

Learning Objective: 07-02

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Legal

Blooms: Remember

Topic Area: Debt covenants in lending―Types

[QUESTION]

1. A requirement that a company maintain a fixed-charge coverage ratio
2. cannot limit the company’s ability to pay dividends.
3. is an example of a negative covenant.
4. is an example of an affirmative covenant.
5. cannot limit the company’s ability to spend replacement capital.

Answer: c

Learning Objective: 07-02

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Legal

Blooms: Understand

Topic Area: Debt covenants in lending―Types

[QUESTION]

1. The section of a loan agreement that describes circumstances in which the creditor obtains additional rights is called the
2. events of compliance section.
3. certificate of compliance section.
4. events of termination section.
5. events of default section.

Answer: d

Learning Objective: 07-02

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Legal

Blooms: Remember

Topic Area: Debt covenants in lending―Types

[QUESTION]

1. The failure of a company to pay other debts, such as payables or other loans, when due is called
2. routine default.
3. non-default.
4. cross default.
5. compliance default.

Answer: c

Learning Objective: 07-02

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Legal

Blooms: Remember

Topic Area: Debt covenants in lending―Types

[QUESTION]
45. Which statement below best describes a technical default?

1. The borrower violates one or more loan covenants but has made all interest and principal payments.
2. The borrower has not violated any covenants but has missed both an interest and principal payment.
3. The borrower violates one or more loan covenants but has made all principal payments.
4. The borrower violates one or more loan covenants but has made all interest payments.

Answer: a

Learning Objective: 07-02

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Legal

Blooms: Remember

Topic Area: Debt covenants in lending―Types

[QUESTION]

1. According to the SEC, any breach of a loan covenant that existed at the balance sheet date that has not subsequently been cured should
2. be recorded as an adjustment to the financial statements.
3. be disclosed in the notes to the financial statements.
4. be disclosed in the audit report.
5. not be disclosed.

Answer: b

Learning Objective: 07-02

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Remember

Topic Area: Debt covenants in lending―Types

[QUESTION]

1. When a debt covenant is violated, the related debt must be classified as current if it is
2. probable that the borrower will not be able to cure the default within the next twelve months.
3. probable that the borrower will not be able to cure the default within the next fifteen months.
4. probable that the borrower will be able to cure the default in the next twelve months.
5. probable that the borrower will be able to cure the default in the next fifteen months.

Answer: a

Learning Objective: 07-02

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Remember

Topic Area: Debt covenants in lending―Types

[QUESTION]

1. Company A’s interest ratio has fallen below the level required by its lender. The lender may not take which action?
2. Gain representation on the company’s board of directors.
3. Replace the CEO of the company.
4. Demand repayment of the loan.
5. Veto payment of a dividend.

Answer: b

Learning Objective: 07-02

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Legal

Blooms: Understand

Topic Area: Debt covenants in lending―Purposes

[QUESTION]

1. Which accounting choice would not be used to reduce the likelihood of a technical default?
2. Bad debt provisions.
3. When to sell assets.
4. Inventory valuation method.
5. Management compensation plans.

Answer: d

Learning Objective: 07-02

Learning Objective: 07-04

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Risk Analysis

Blooms: Understand

Topic Area: Debt covenants in lending―Purposes

Topic Area: Influences on accounting choices

[QUESTION]

1. When a borrower is unable to make a scheduled interest payment, the type of default that occurs is a
2. technical default.
3. covenant default.
4. payment default.
5. transitory default.

Answer: c

Learning Objective: 07-02

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Legal

Blooms: Remember

Topic Area: Debt covenants in lending―Types

[QUESTION]

1. A study examining how incentives arising out of debt contracts affect managers’ accounting choices found that the most common violations of accounting-based covenants occurred with
2. net worth and working capital restrictions.
3. mergers and acquisitions restrictions.
4. leveraged buyout restrictions.
5. debt restructures.

Answer: a

Learning Objective: 07-04

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Industry

Blooms: Remember

Topic Area: Influences on accounting choices

[QUESTION]

1. Discretionary accounting accruals are
2. cash financial statement adjustments, which accrue revenue or expenses.
3. noncash financial statement adjustments, which accrue revenue or expenses.
4. cash financial statement adjustments, which accrue only revenue.
5. noncash financial statement adjustments, which accrue only expenses.

Answer: b

Learning Objective: 07-04

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Remember

Topic Area: Influences on accounting choices

[QUESTION]

1. A study of discretionary accounting accruals found that abnormal accruals in the year prior to reporting covenant violations
2. significantly decreased the company’s current ratio but significantly increased the company’s reported earnings.
3. significantly decreased the company’s net worth.
4. significantly increased reported earnings and increased working capital.
5. significantly increased reported earnings and decreased working capital.

Answer: c

Learning Objective: 07-04

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Resource Management

AICPA: FN Measurement

Blooms: Understand

Topic Area: Influences on accounting choices

[QUESTION]

1. Studies seem to suggest that management tends to make accounting changes and/or manipulate discretionary accruals to
2. enhance technical defaults.
3. eliminate debt covenants.
4. violate debt covenants.
5. avoid violation of debt covenants.

Answer: d

Learning Objective: 07-04

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Resource Management

AICPA: FN Risk Analysis

Blooms: Remember

Topic Area: Influences on accounting choices

[QUESTION]

1. Potential conflicts of interest between shareholders and managers may be overcome if managers are given incentives which cause them to behave as if they were
2. creditors.
3. owners.
4. debtors.
5. vendors.

Answer: b

Learning Objective: 07-03

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Risk Analysis

Blooms: Remember

Topic Area: Influences on managerial incentives

[QUESTION]

1. Firms must provide detailed disclosure of three broad executive pay categories. Which of the following is not one of these categories?
2. Retirement and other postemployment compensation
3. Costs incurred by the corporation for executive travel, entertainment, and other “expense account” items
4. Compensation for the last fiscal year and the two preceding years
5. Holdings of equity-related interests that relate to compensation

Answer: b

Learning Objective: 07-02

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Legal

AICPA: FN Measurement

Blooms: Understand

Topic Area: Contracts for compensation purposes

[QUESTION]

1. Information about a company’s executive compensation practices can be found in a company’s
2. annual report.
3. form 10-K.
4. proxy statement.
5. form 10-Q.

Answer: c

Learning Objective: 07-02

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Legal

AICPA: FN Measurement

Blooms: Remember

Topic Area: Contracts for compensation purposes

[QUESTION]

1. A decrease in market-wide interest rates will result in a/an
2. increase in the cost of equity capital.
3. decrease in the cost of equity capital.
4. increase in the cost of debt.
5. decrease in the demand for fixed-rate bond investments.

Answer: b

Learning Objective: 07-03

Difficulty: 2 Medium

AACSB: Analytical Thinking

AICPA: BB Resource Management

AICPA: FN Risk analysis

Blooms: Analyze

Topic Area: Influences on managerial incentives

[QUESTION]

1. Compensation incentives that motivate and reward executives for three to seven years of growth and prosperity are called
2. base salaries.
3. short-term incentives.
4. long-term incentives.
5. executive compensation packages.

Answer: c

Learning Objective: 07-03

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Resource management

Blooms: Remember

Topic Area: Influences on managerial incentives

[QUESTION]

1. Which of the following is not an accurate statement regarding the compensation committee?
2. It selects the performance metrics used.
3. It may adjust a calculated award up or down at its discretion.
4. It is comprised of both internal and external directors.
5. It selects the annual or multiyear performance goals.

Answer: c

Learning Objective: 07-03

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: BB Resource management

Blooms: Understand

Topic Area: Influences on managerial incentives

[QUESTION]

1. Stock options
2. have value only if the market price of the stock declines.
3. have value only if the market price of the stock rises.
4. are taxed at ordinary rates.
5. do not qualify for favorable tax treatment.

Answer: b

Learning Objective: 07-03

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Resource management

Blooms: Remember

Topic Area: Influences on managerial incentives

[QUESTION]

1. An award of stock that is not transferable or subject to forfeiture for a period of years is called
2. phantom stock.
3. treasury stock.
4. restricted stock.
5. preferred stock.

Answer: c

Learning Objective: 07-03

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Resource management

Blooms: Remember

Topic Area: Influences on managerial incentives

[QUESTION]

1. Most executive compensation plans link bonus awards to one or more
2. non-accounting based performance measures.
3. accounting-based performance measures.
4. marketing-based performance measures.
5. management-based performance measures.

Answer: b

Learning Objective: 07-02

Learning Objective: 07-03

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Resource management

Blooms: Understand

Topic Area: Contracts for compensation purposes

Topic Area: Influences on managerial incentives

[QUESTION]

1. The widespread use of accounting-based incentives for executive compensation is controversial for which one of the following reasons?
2. earnings growth does not automatically increase shareholder value.
3. accounting-based incentive plans can encourage managers to adopt a long-term business focus.
4. executives cannot use their discretion over the accounting policies.
5. managers do not have accounting flexibility.

Answer: a

Learning Objective: 07-03

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical thinking

AICPA: FN Risk Analysis

Blooms: Understand

Topic Area: Influences on managerial incentives

[QUESTION]

1. Several studies show that incoming CEOs have an incentive to
2. increase earnings in the year of the executive change as well as in years subsequent to the change.
3. decrease earnings in the year of executive change and increase earnings in the next year.
4. decrease earnings for a few years after taking over to establish a low “bonus baseline.”
5. take actions that will make his/her predecessor look incompetent thus validating the board’s decision to change CEOs.

Answer: b

Learning Objective: 07-03

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Resource management

AICPA: FN Risk Analysis

Blooms: Remember

Topic Area: Influences on managerial incentives

[QUESTION]

1. Which statement best describes stock options?
2. Stock options are not an expense on the company’s profit and loss statement.
3. Stock options obligate the holder to purchase shares at a stated price.
4. Stock options give the holder the right to purchase shares at a stated price.
5. Stock options have been replaced by restricted stock.

Answer: c

Learning Objective: 07-03

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: FN Resource Management

Blooms: Remember

Topic Area: Influences on managerial incentives

[QUESTION]

1. Managers believe it is important to meet earnings benchmarks. When a number of executives were asked—within the parameters of GAAP—which choices your company might make to hit an earnings target, the most popular choice was to
2. decrease discretionary spending.
3. alter accrual assumptions (such as allowances).
4. postpone taking an accounting charge.
5. draw down on reserves previously set aside.

Answer: a

Learning Objective: 07-05

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Resource Management

AICPA: FN Risk Analysis

Blooms: Remember

Topic Area: Wall Street expectations

[QUESTION]

1. A clawback provision in an employment contract
2. requires managers to become more conservative in their business decision-making.
3. requires managers to respond to compensation committee requests for information .
4. requires managers to return bonuses received in the event of a financial statement restatement. d. requires managers to refrain from making discretionary accruals.

Answer: c

Learning Objective: 07-04

Difficulty: 2 Medium

AACSB: Ethics

AICPA: BB Legal

AICPA: FN Risk Analysis

Blooms: Understand

Topic Area: Influences on accounting choices

[QUESTION]

1. With respect to executive pay, which of the following is not correct?
2. The proportion of pay “at risk” falls off steeply for executives on lower rungs of the corporate ladder.
3. Top executive bonus opportuni­ties have a maximum payout of 200%.
4. Most executive compensation packages involve a base salary, an annual incentive, and a long-term incentive.
5. Long-term incentives are designed to counterbalance the inherently short-term orientation of other incentives.

Answer: b

Learning Objective: 07-03

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Resource Management

Blooms: Understand

Topic Area: Influences on managerial incentives

[QUESTION]

1. Research has shown that research and development expenditures during the years immediately prior to a CEO’s retirement tend to
2. increase by a large amount.
3. increase by a small amount.
4. decline.
5. show no change.

Answer: c

Learning Objective: 07-04

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Risk Analysis

Blooms: Remember

Topic Area: Influences on accounting choices

[QUESTION]

1. Compensation plans should
2. not link incentive plans to financial performance.
3. not be based on long-term business goals.
4. align shareholders’ incentives with the objectives of managers.
5. align managers’ incentives with the objectives of shareholders.

Answer: d

Learning Objective: 07-02

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Resource management

Blooms: Remember

Topic Area: Contracts for compensation purposes

[QUESTION]

1. Long-term incentive components of executive compensation plans should include stock options
2. to enhance the short-term focus of executives.
3. to mitigate the short-term focus of executives.
4. to mitigate the long-term focus of executives.
5. to encourage better performance by low-level staff.

Answer: b

Learning Objective: 07-02

Learning Objective: 07-03

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Resource management

AICPA: FN Risk Analysis

Blooms: Understand

Topic Area: Contracts for compensation purposes

Topic Area: Influences on managerial incentives

[QUESTION]

1. With respect to executive compensation, which statement is not valid?
2. Compensation packages are designed to minimize conflicts of interest.
3. Stock returns are the best way to align managers’ and owners’ interests since management’s actions control the share price in both the short and long term.
4. Executive compensation components are generally linked to stock returns and/or financial performance measures.
5. Use of accounting earnings should not be used due to its reliance on valuations that involve subjectivity and judgments.

Answer: b

Learning Objective: 07-03

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Resource Management

Blooms: Understand

Topic Area: Influences on managerial incentives

[QUESTION]

1. A compensation committee should be comprised of
2. the CEO and the CFO of the company.
3. the CEO of the company and the outside attorney.
4. members of the Board of Directors who are also officers of the company.
5. members of the Board of Directors who are outside (non-management) directors.

Answer: d

Learning Objective: 07-02

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Legal

Blooms: Remember

Topic Area: Contracts for compensation purposes

[QUESTION]

1. Regulatory accounting principles are important to those outside the regulatory agencies because
2. GAAP may allow reporting for assets and liabilities consistent with the way in which regulators establish rates.
3. GAAP does not allow reporting for assets and liabilities consistent with the way in which regulators establish rates.
4. regulatory accounting principles are not compatible with GAAP.
5. the SEC requires them.

Answer: a

Learning Objective: 07-02

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Industry

AICPA: FN Measurement

Blooms: Understand

Topic Area: Regulatory contracts

[QUESTION]

1. Banks that fail to comply with regulations, including the failure to maintain an adequate capital adequacy ratio, face
2. higher costs.
3. lower costs.
4. mergers and expansion of services.
5. incarceration of officers.

Answer: a

Learning Objective: 07-02

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Industry

AICPA: FN Risk Analysis

Blooms: Remember

Topic Area: Regulatory contracts

[QUESTION]

1. The use of a bank manager’s discretion in the timing and amount of loan loss provisions and loan charge-offs can falsely understate the losses and
2. decrease net income.
3. decrease bank obligations.
4. improve the bank’s debt adequacy ratio.
5. improve the bank’s capital adequacy ratio.

Answer: d

Learning Objective: 07-04

Difficulty: 2 Medium

AACSB: Analytical Thinking

AICPA: BB Industry

AICPA: FN Risk Analysis

Blooms: Analyze

Topic Area: Regulatory accounting choices―RAP

[QUESTION]

1. In the banking industry, the ratio of investor capital/gross assets, as defined by RAP, is the
2. capital asset ratio.
3. capital adequacy ratio.
4. gross asset ratio.
5. indirect capital ratio.

Answer: b

Learning Objective: 07-04

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Industry

AICPA: FN Risk analysis

Blooms: Remember

Topic Area: Regulatory accounting choices―RAP

[QUESTION]

1. A bank’s estimated bad debt expense associated with its loan receivables is the
2. loan loss provision.
3. loan charge-offs.
4. allowance for loans.
5. accumulated loan loss.

Answer: a

Learning Objective: 07-04

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Industry

AICPA: FN Measurement

Blooms: Remember

Topic Area: Regulatory accounting choices―RAP

[QUESTION]

1. In the utilities industry, rate formulas are established to allow the utilities to set total allowed revenues to recover
2. only the administrative costs of operations.
3. only the operating costs associated with operations.
4. all operating costs, depreciation, taxes, and a fair return on invested capital.
5. all operating costs other than depreciation and taxes, and a fair return on invested capital.

Answer: c

Learning Objective: 07-04

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Industry

Blooms: Understand

Topic Area: Regulatory accounting choices―RAP

[QUESTION]

1. In the utilities industry, image advertising and customer safety advertising are
2. both paid for by customers.
3. both paid for by shareholders.
4. both treated as operating expenses under RAP.
5. both treated as operating expenses under GAAP.

Answer: d

Learning Objective: 07-04

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Industry

AICPA: FN Measurement

Blooms: Remember

Topic Area: Regulatory accounting choices―RAP

[QUESTION]

1. Rate regulation provides incentives for public utility managers to
2. artificially decrease the asset base.
3. artificially increase the asset base.
4. artificially decrease operating expenses.
5. artificially decrease taxes.

Answer: b

Learning Objective: 07-04

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Industry

AICPA: FN Measurement

Blooms: Understand

Topic Area: Regulatory accounting choices―RAP

[QUESTION]

1. IRS regulations govern the
2. computation of net income for GAAP.
3. computation of net income for tax purposes.
4. computation of gross profit for GAAP.
5. computation of net income for the SEC.

Answer: b

Learning Objective: 07-04

Difficulty: 1 Easy

AACSB: Reflective Thinking

AICPA: BB Legal

AICPA: FN Measurement

Blooms: Remember

Topic Area: Regulatory accounting choices―RAP

[QUESTION]

1. Regulatory Accounting Principles (RAP) can be used
2. to set the prices customers may be charged.
3. as a basis for supervisory action.
4. as a source of statistical information.
5. to determine the amount of dividend to be paid.

Answer: d

Learning Objective: 07-04

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Industry

Blooms: Understand

Topic Area: Regulatory accounting choices―RAP

[QUESTION]

1. Which of the following does not properly represent the relation of tax and GAAP accounting?
2. Companies using FIFO for financial statements prefer FIFO for tax purposes because FIFO results in a lower taxable income.
3. GAAP and tax depreciation expense will rarely be equal.
4. If LIFO is used for inventory valuation for taxes, LIFO must also be used for GAAP financial reporting.
5. The accounting methods used for tax are permitted to differ from GAAP rules.

Answer: a

Learning Objective: 07-04

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Industry

AICPA: FN Measurement

Blooms: Understand

Topic Area: Regulatory accounting choices―RAP

[QUESTION]

1. Which of the following statements does not reflect the provisions of ASU 2016-01 related to fair value measurement?
2. It requires minority-passive equity investments (generally less than 20% ownership) to be measured at fair value with changes in fair value recognized in net income, unless there is no readily determinable fair value.
3. It simplifies the impairment assessment of equity investments that do not have readily determin­able fair values.
4. It requires an entity applying the fair value option to its own liabilities to recognize in net income the change in fair value attributable to the entity’s creditworthiness.
5. It requires an entity applying the fair value option to its own liabilities to recognize in other comprehensive income (not net income) the change in fair value attributable to the entity’s creditworthiness.

Answer: c

Learning Objective: 07-04

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Remember

Topic Area: Influences on accounting choices

[QUESTION]

1. Which of the following did not contribute to the 2008 financial meltdown?
2. the packaging/bundling of traditional mortgages to be sold as investments.
3. the speculative bubble related to housing demand drove up prices which proved to be unsustainable.
4. an increase in traditional 30 year mortgages.
5. the issuance of high-risk/subprime mortgage loans.

Answer: c

Learning Objective: 07-04

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

AICPA: FN Risk Analysis

Blooms: Understand

Topic Area: Influences on accounting choices

[QUESTION]

1. Banking regulators have a powerful weapon to encourage compliance with minimum capital guidelines as they can compel a noncomplying bank to do any or all of the following except
2. require the bank to increase the number of outside directors on its board.
3. require the bank to submit a plan describing how and when its capital will be increased.
4. subject the bank to more frequent examinations by the regulator.
5. deny a request to merge, open new branches, or expand services.

Answer: a

Learning Objective: 07-02

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Industry

Blooms: Understand

Topic Area: Regulatory contracts

[QUESTION]

1. The prevalence of stock options in executive pay packages
2. eliminates managers’ incentives to engage in short-term earnings management.
3. is frowned upon by the SEC.
4. may actually contribute to, rather than moderate, managers’ short-term focus.
5. has been widely cited as the main cause of the financial system meltdown that occurred in 2008.

Answer: c

Learning Objective: 07-02

Learning Objective: 07-03

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Resource management

AICPA: FN Risk Analysis

Blooms: Understand

Topic Area: Contracts for compensation purposes

Topic Area: Influences on managerial incentives

[QUESTION]

1. Managers cater to Wall Street (i.e., try to meet earnings benchmarks) for which of the following reasons?
2. To build credibility with the capital market
3. To maintain or increase the firm’s stock price
4. To build the external reputation of management
5. All of these are reasons managers cite for meeting earnings benchmarks.

Answer: d

Learning Objective: 07-05

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Industry

AICPA: FN Risk Analysis

Blooms: Understand

Topic Area: Wall Street expectations

[QUESTION]

1. When faced with falling short of a desired earnings target, financial executives reportedly might consider any of the following actions except
2. prematurely taking an accounting charge.
3. providing incentives for customers to buy more product this quarter.
4. decreasing discretionary spending.
5. delaying the start of a new project.

Answer: a

Learning Objective: 07-05

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: FN Risk Analysis

Blooms: Understand

Topic Area: Wall Street expectations

[QUESTION]

1. Which of the following does not represent the impact of changes in EPS on the stock price?
2. Small differences in reported EPS to expected EPS will not affect the stock price.
3. Penny differences in EPS matter a lot to investors.
4. Management makes accounting choices to get to an EPS number rather than EPS being a random result around analyst’s expectations.
5. It is better to be $.01 over EPS target than at or $.01 below the target.

Answer: a

Learning Objective: 07-05

Difficulty: 2 Medium

AACSB: Reflective Thinking

AICPA: BB Critical Thinking

Blooms: Understand

Topic Area: Wall Street expectations

[QUESTION]

1. Which of the following is an accounting strategy most likely used by management to meet EPS guidance?
2. postpone taking an accounting charge.
3. draw down accounting reserves.
4. delay R&D expense to the next quarter or year.
5. alter assumptions such as those relating to the allowance for doubtful accounts.

Answer: c

Learning Objective: 07-05

Difficulty: 2 Medium

AACSB: Ethics

AICPA: BB Critical Thinking

AICPA: FN Measurement

Blooms: Understand

Topic Area: Wall Street expectations

Essay and Computational Questions

[QUESTION]

1. Explain the difference between affirmative and negative debt covenants and provide two examples of each.

Answer: Affirmative covenants describe actions that the borrower must take while negative covenants describe actions that the borrower may be limited in, or restricted from, taking. Examples of affirmative covenants include: using the loan for the agreed-upon purpose (i.e., not substituting a more risky investment in place of the original investment the loan was sought for); having the company’s financial statements audited by an independent accounting firm; providing those statements to the lender on a timely basis, complying with all laws and regulations (e.g., environmental regulations); allowing the lender to inspect the borrower’s financial records or physical assets; and maintaining insurance on assets and key employees. Examples of negative covenants include: limits on total debt, capital expenditures, loans and advances to affiliated companies, cash dividends, share repurchases, mergers, and asset sales while the loan is outstanding.

Learning Objective: 07-02

Difficulty: 2 Medium

AACSB: Communication

AICPA: BB Legal

Blooms: Understand

Topic Area: Debt covenants in lending―Types

[QUESTION]

1. Why do loan agreements often contain covenants tied to accounting numbers? Are there any disadvantages to this common practice?

Answer: Accounting uses a set of generally accepted principles to measure a wide array of business activity. It is hard to conceive of some action that management might take that does not directly, or indirectly, affect accounting numbers. Thus, accounting numbers are a convenient way to monitor management’s actions or measure their success at running the company. Because the financial statements are audited by independent accounting firms, lenders can be assured that the reported numbers are relatively free from error and material misstatements. In addition, the borrower (company) must produce financial statements anyway, so there is no added out-of-pocket cost to using these same statements as a basis for loan agreements. There are, however, some disadvantages to using accounting numbers in loan covenants. Even though the financial statements are audited, management still has some discretion over the reported amounts and note disclosures. Opportunistic reporting can never be completely ruled out. Examples include voluntary accounting method changes and changes in accounting estimates. Another potentially negative factor to consider is that accounting-based loan covenants can be influenced by mandatory accounting changes imposed by the FASB or other regulatory group. Lenders may feel that such changes detract from the ability of accounting numbers to accurately portray changes in a borrower’s credit risk. Also, mandatory accounting changes may cause borrowers to be in technical violation of debt covenants even though there has been no real change in underlying default risk.

Learning Objective: 07-02

Difficulty: 2 Medium

AACSB: Communication

AICPA: BB Critical Thinking

Blooms: Understand

Topic Area: Debt covenants in lending―Purposes

[QUESTION]

1. On October 31, 2018, Sterling Construction Company entered into a credit agreement with Comerica Bank. The following appeared among the agreement’s financial covenants: “Commencing with the fiscal quarter ending December 31, 2018, maintain as of the end of each fiscal quarter a Fixed Charge Coverage Ratio of not less than 1.25 to 1.00.” The credit agreement also contained a “definitions” section where this item was listed: “ ‘Fixed Charge Coverage Ratio’ shall mean as of any date of determination a ratio the numerator of which is EBITDA for the Applicable Measuring Period, minus cash taxes and cash tax distributions with respect to such period and the denominator of which is the sum of Current Maturities of Long Term Debt plus interest paid during the trailing twelve month period, plus twenty-five percent (25%) of the daily average total non-amortizing debt during the trailing twelve month period.”

Required:

1. What is a minimum fixed charge coverage ratio and what purpose does it serve in the company’s loan agreements?
2. Why is it necessary for the loan agreement to precisely define “Fixed Charge Coverage Ratio?”

Answer: a. The Fixed Charge Coverage Ratio is a ratio that indicates a firm’s ability to satisfy fixed financing expenses or other fixed charges. Creditors desire such provisions in loan covenants because their interests are protected when the borrower maintains this ratio above some acceptable minimum level.

1. A quick Google search for the term turned up the definitions below, neither of which is the same as the one appearing in the Sterling credit agreement or the TCBY example illustrated in the text. Thus, to avoid misunderstandings or violation of (intended) covenant terms, it is important to carefully define all ratios and other financial measures used in loan agreements that may be subject to interpretation, etc.

The Fixed Charge Coverage Ratio is “the ratio of (Earnings before interest, depreciation and amortization minus unfunded capital expenditures and distributions) divided by total debt service (annual principal and interest payments). Notice that lease payments are sometimes included in the calculations.”

The Fixed Charge Coverage Ratio is “the ratio of (net earnings before taxes plus interest charges paid plus long-term lease payments) to (interest charges paid plus long-term lease payments).”

Learning Objective: 07-02

Difficulty: 2 Medium

AACSB: Communication

AICPA: BB Legal

AICPA: FN Measurement

Blooms: Understand

Topic Area: Debt covenants in lending―Purposes

[QUESTION]

1. Sam Jones is the president of Apollo Finance, a payday lender. The company’s proxy statement contains the following description of Mr. Jones’ pay package.

Mr. Jones is eligible for an annual incentive bonus equal to 1% of Net Income of the company and is eligible for an additional bonus based upon annual increases in EPS only after earnings exceed 15% over the prior year. The additional bonus is determined as follows:

EPS Growth	Additional Bonus
EPS increases up to 14.9%	$0
EPS increases of 15.0% to 24.9%	2% of the earnings increase from the prior year
EPS increases of 25.0% to 34.9%	3% of the earnings increase from the prior year
EPS increases above 35.0%	4% of the earnings increase from the prior year

Assume no change in the number of shares of outstanding stock during the year.

Required:

1. Suppose that Apollo Finance had $75 million of Net Income for the year. How much of a bonus would Mr. Jones receive if the EPS increase for the year was 12%?
2. Suppose that Apollo Finance had $75 million of Net Income for the year. How much of a bonus would Mr. Jones receive if the EPS increase for the year was 28%?

Answer: a. According to the bonus formula, Mr. Jones would receive a bonus of $750,000 if the company reports net income of $75 million and the EPS increase is 12 percent.

Basic bonus = 1% of $75 million = $750,000

Additional bonus = zero

1. According to the bonus formula, Mr. Jones would receive a bonus of $1,242,188 if the company reports net after-tax earnings of $75 million and the EPS increase is 28 percent.

Basic bonus = 1% of $75 million = $750,000

Additional bonus = 3% of $16,406,250 = $492,188

Since the company has not issued or repurchased stock during the year, a 28% increase in EPS must also mean that net income increased 28%. In other words, $75 million = (1 + .28) × earnings last year. So, earnings last year must equal $75 million ÷ (1.28) or $58,593,750. The increase in net income would then be $16,406,250 = ($75 million − $58,593,750).

Learning Objective: 07-03

Difficulty: 2 Medium

AACSB: Analytical Thinking

AACSB: Knowledge Application

AICPA: FN Measurement

Blooms: Apply

Blooms: Analyze

Topic Area: Influences on managerial incentives

[QUESTION]

1. Duke Power & Light just spent $10 million to repair one of its electrical grid substations that was heavily damaged by a lightning strike. The loss was not insured.

Required:

Why would a utility ask the public service commission for approval to treat the $10 million as an asset for rate-making purposes rather than as an allowed expense?

Answer: After studying the effect of this request on the utility’s revenues (using the typical rate formula presented in the text and reproduced below) it should become apparent that this request may not be in the utility’s best interests. Whether it is or not depends in large part upon when, and how frequently, utility rates are revised.

Allowed revenue = Operating costs + Depreciation + Taxes + (ROA × Asset base).

If the repair is treated as an operating cost, Duke can recover the entire $10 million in the current year and again every year thereafter until the rates are revised. Thus, if rates are to be revised in the current year, but not again for a few years, Duke is better off to expense the repair. On the other hand, if the repair is expensed in the current year and rates are not revised until some year in the future, the $10 million will never be recovered from the utility’s customers. If the repair is added to the asset base, some of the amount of the repair will be reflected in increased depreciation charges and the asset base will be increased thus increasing the allowable return on assets. Both of these effects will raise revenue, and for a number of years in the future. However, the amount of this revenue increase will not be as great as the increase that occurs if the costs are expensed—although the increase may be more enduring, and time value of money needs to be considered as well due to the extended cost recovery period.

Learning Objective: 07-04

Difficulty: 3 Hard

AACSB: Communication

AICPA: BB Industry

Blooms: Evaluate

Topic Area: Regulatory accounting choices―RAP

[QUESTION]

1. Define the term “minimum capital requirements” and explain why banks and insurance companies are required by regulators to maintain such capital minimums.

Answer: Minimum capital is defined by regulatory accounting principles and refers to the minimum required amount of investor capital the institution must maintain. Banks and insurance companies are required to maintain minimum levels of investor capital for two reasons. First, it provides a cushion to ensure that funds are available to pay depositors and beneficiaries. Second, investors who are also managers will make less risky business decisions when some of their own money is at risk.

Learning Objective: 07-02

Difficulty: 2 Medium

AACSB: Communication

AICPA: BB Industry

AICPA: FN Risk analysis

Blooms: Understand

Topic Area: Regulatory contracts

[QUESTION]

1. Firms may meet earnings benchmarks via operational excellence or by taking real actions to maintain accounting appearances. Explain why the latter approach may be detrimental to a firm’s stockholders.

Answer: Many of the actions management can take to maintain accounting appearances result in a sacrifice of long-term firm value. For example, management may choose to decrease discretionary spending (e.g. R&D, advertising, or maintenance) to lower expenses in the current period. However, these decreases probably have long-term adverse effects. Lowered levels of R&D may result in fewer new products coming to market in future years. Reduced advertising erodes brand awareness and future sales. Deferred maintenance expenditures can lead to premature, and costly, equipment failures. Or take the case where management engages in channel stuffing. Sales that might normally occur in the future are shifted into the present, but at the cost of whatever incentives management provided to get the customers’ orders sooner rather than later.

Learning Objective: 07-05

Difficulty: 3 Hard

AACSB: Communication

AACSB: Analytical Thinking

AICPA: BB Critical Thinking

Blooms: Analyze

Topic Area: Wall Street expectations