JUN18L1FRA/C05 R30/31/32/33

Question 1
Company × reports the estimated remaining useful life is 30 years, however a physical inspection of a company's PPE
reveals that the actual remaining useful life is 20 years. This would imply that the reported net income is:
a) Understated.
b) Overstated.
c) Accurate.
If 20 years were used to calculate Company X's depreciation expense, the expense would be higher than that
reported and higher depreciation expense would decrease net income to what was reported.

Question 2
When screening for potential equity investments based on the debt-to-assets ratio as a means to control risk, an
analyst would most likely include a criterion that requires a debt/assets ratio to be:
a) less than 0.5.
b) greater than 0.5.
c) exactly 0.5.
A lower value of debt/assets indicates greater financial strength. Requiring that a company's debt/total assets be
below a certain cutoff point would allow the analyst to screen out highly leveraged and, therefore, potentially financially
weak companies.

Question 3
Tax credits that directly reduce taxes are most likely classified as:
a) Deferred tax assets.
b) Deferred tax liabilities.
c) Permanent differences.
Tax credits that directly reduce taxes are examples of permanent differences.

Question 4
The following disclosures regarding finance and operating leases are made by Magnus Corp. in its notes to the
financial statements for 2010:

Leased Assets
2010 2009
Acquisition Cost ($ Net Book Value ($ Acquisition Cost ($ Net Book Value ($
Millions) Millions) Millions) Millions)
Land and
58 50 65 54
buildings
Machinery 545 224 560 345
Others 90 52 105 56
Total 693 326 730 455

Liabilities from Finance Leases ($ Millions)

2010 2009
Minimum Lease Interest Leasing Minimum Lease Interest Leasing
Payments Portion Liability Payments Portion Liability
Following
45 10 25 54 12 28
Year 1
Following
55 12 30 58 14 31
Year 2
Following
40 8 20 76 22 38
Year 3
Over 3 years 60 16 35 72 18 36
200 46 110 260 66 133

Commitments Due to Operating Lease Contracts ($ Millions)

 Nominal Value of the Future Minimum Payments
December 31, 2010 December 31, 2009
Less than 1 year 395 430
1-3 years 860 775
Over 3 years 790 645
2,045 1,850
The amount of leased assets reported by Magnus Corp. at the end of 2010 is closest to:
a) $693 million.
b) $326 million.
c) $730 million.
This is the total of the 2010 column “Net Book Value” in the “Leased Assets” table.

Question 5
An analyst is reviewing the following information from the financial statements of Company Z.

20X2 20X1
$ Thousands $ Thousands
Net sales 750,000 700,000
Cost of sales 500,000 400,000
Gross margin 250,000 300,000

Based solely on this information, Company Z's differentiation strategy can best be described as:
a) less than stellar.
b) modestly successful.
c) dramatically successful.
The gross profit margin has decreased from 43 percent ($300,000/700,000) to 33 percent ($250,000/750,000)
reflecting an unsuccessful differentiation strategy.

Question 6
Plane Corp. reported the following on its December 31, 2014, balance sheet (amounts are in $):
 Property, Plant and Equipment: 16,000,000
 Patent: 6,000,000
 Inventory: 12,000,000
 Trade Receivables: 20,000,000
 Trade Payables: 24,000,000
 Cash: 8,000,000
For tax purposes, the following information is used:
 Tax base of property, plant and equipment, and patent was $12,000,000 and $4,000,000, respectively.
 Provision for inventory loss due to obsolescence for $2,000,000 is not allowable for tax purposes.
 Impairment loss against receivables of $4,000,000 has been made. This charge will not be allowed in the
current year for tax purposes.
 The tax rate is 30%.
What amount should be recognized as deferred tax expense 2014?
a) $0
b) $2,400,000
c) $3,600,000
The first choice is correct.

Carrying Amount Tax Base DTA DTL

PPE $ 16,000,000 $ 12,000,000 $ 1,200,000
Patent 6,000,000 4,000,000 600,000
Inventory 12,000,000 10,000,000 600,000
Trade Receivables 20,000,000 16,000,000 1,200,000
Net deferred tax expense is $0.

Question 7
Which of the following is least likely required by debt covenants?
 a) Mandatory dividend payments
b) Maximum levels of leverage
c) Maintenance of pledged collateral
Debt covenants typically put restrictions on dividend payments; they do not require the company to pay out dividends
to shareholders.

Question 8
Which of the following is least likely a benefit of conservative accounting?
a) Given asymmetrical information, conservatism can protect contracting parties with less information and
higher risk.
b) Conservatism reduces the possibility of litigation.
c) Conservatism results in higher financial reporting quality.
Conservatism in accounting standards can impair the relevance of financial statements. When it comes to financial
reporting, the ideal situation would be if financial reporting were unbiased, i.e., neither conservative nor aggressive

Question 9
Bond covenants are used to:
a) Protect investors in the bond.
b) Clarify the relationship between bond holder and the bond issuer.
c) Protect equity investors from bond holders exercising a claim on a firm's assets.
Covenants are to protest creditors'—in this case, the bond holders'—interests by limiting the debtor's activities if it
could weaken the creditors' position.

Question 10
Which of the following provides motivation for a company to prepare low quality financial statements?
a) Weak accounting standards.
b) Ineffective external directors.
c) High earnings expectations from investors.
The first and second choices would provide an opportunity, whereas pressure from investors can provide the
motivation.

Question 11

Alpha Inc. ($ Millions) Beta Inc. ($ Millions)

2010 2009 2010 2009
Short-term borrowings 2,331 3,524 4,681 1,140
Current portion of long-term interest bearing debt 4,250 3,942 215 775
Long-term interest bearing debt 35,675 31,422 1,464 984
Total shareholders’ equity 160,250 151,250 29,625 30,450
Total assets 310,425 270,495 44,655 42,350
EBIT 17,291 35,467 10,425 14,365
Interest expense 1,919 1,729 695 255

Consider the following statements:

Statement 1: Alpha Inc.’s interest coverage ratio has improved over the 2 years.
Statement 2: Beta Inc. is in a better position to cover its interest payments compared to Alpha Inc.
Which of the following is most likely?
a) Only Statement 1 is incorrect.
b) Only Statement 2 is incorrect.
c) Both statements are correct.
Alpha Inc.
Interest coverage ratio for 2009 = EBIT / Interest payments
Interest coverage ratio for 2009 = 35,467 / 1,729 = 20.51
Interest coverage ratio for 2010 = 17,291 / 1,919 = 9.01
Beta Inc.
Interest coverage ratio for 2010 = 10,425 / 695 = 15

Question 12
Prime Books Inc., a renowned publishing company, received in advance interest of $300,000 in 2012. By the year
end, $100,000 of the interest is earned and the remaining balance is deferred. However, the tax authorities recognized
interest on a cash basis at the rate of 30%. A new tax law has been proposed for 2013 that will change the tax rate to
25% for 2013. All of the interest received will be earned by the end of 2013. If the proposed tax law is implemented,
based solely on the information provided, what is the most likely impact on the reported profits for 2013?
a) Increase by $10,000.
b) Decrease by $10,000.
c) Decrease by $15,000.
A decrease in tax rates will reduce the value of both deferred tax liabilities and assets.

Carrying balance of the liability $200,000

Tax base of the liability* 0
Deductible temporary difference $200,000
Deferred tax asset (at 30%) 60,000
Deferred tax asset (at 25%) 50,000
Reduction in deferred tax asset $10,000
The reduction in the deferred tax asset will result in an increase in income tax expense and a decrease in profits for
2013.

Question 13
XYZ Company leases an asset for 4 years. During the term of the lease, XYZ must make a payment of $8,000 each
year for using the asset. The rate implicit in the lease is 7%. XYZ has a bargain purchase option on the asset.
The book value of the lease-related liability at the beginning of Year 3 is closest to:
a) $14,464
b) Zero
c) $7,477

ANNUAL LEASE INTEREST EXPENSE REDUCTION OF LEASE BALANCE

YEARS
PAYMENTS ($) (7%) ($) OBLIGATION ($) ($)
0 - - - 27,097.69
1 8,000 1,896.84 6,103.16 20,994.53
2 8,000 1,469.62 6,530.38 14,464.15
3 8,000 1,012.49 6,987.51 7,476.64
4 8,000 523.36 7,476.64 -

Question 14
Which of the following statements is most likely regarding accounting for discount bonds?
a) The book value of the liability decreases each year over the term of the bonds.
b) Interest expense recognized exceeds the coupon payment each year over the term of the bonds.
c) The excess of interest expense over the coupon payment serves to reduce the liability balance each year.
For bonds issued at a discount:
 Interest expense exceeds the coupon payment due to discount amortization.
 The book value of the liability increases each year and the shortfall of the coupon payment compared to
interest expense serves to increase the liability balance each year.

Question 15
A decrease in the valuation allowance most likely results in a(n):
a) Increase in total assets.
b) Decrease in shareholders’ equity.
c) Increase in income tax expense.
A decrease in the valuation allowance implies that the company’s DTA (assets) are increasing. An increase in DTA
reduces ITE and increases retained earnings (equity).

Question 16
Which of the following statements is most likely an indication that excessive pressure exists on management to meet
third parties' requirements or expectations?
a) A marginal ability to meet debt repayments or covenants.
 b) Significant operations located across international borders.
c) A complex organizational structure with unusual legal entities.
A marginal ability to meet debt repayments or covenants, if known, will likely result in some adverse actions by the
holder of the debt as he or she tries to secure the investment.

Question 17
When a company issues bonds at a discount, it can be safely assumed that the market interest rate, as compared to
the coupon rate, is:
a) greater.
b) lower.
c) the same.
If the market interest rate is greater than the coupon rate, the bond will be issued at a discount. Since the coupon rate
on offer is less than the compensation required by market participants, the bond will sell for less than its face value.

Question 18
Which of the following types of companies are likely to have the most stable operating profit margins?
a) Start-up companies.
b) Mature, diversified companies.
c) Companies with high fixed costs.
High fixed costs will lead to greater volatility in operating margins. New or single-product companies also have less
stable margins. Mature, well-diversified companies will tend to have more stable margins.

Question 19
A company included an expense in its financial statements which is not recognized as an expense for tax purposes.
This leads to the reporting of:
a) A deferred tax asset.
b) A deferred tax liability.
c) Neither a deferred tax asset nor a deferred tax liability.
Permanent differences in tax treatment do not give rise to deferred tax items since they will not reverse in the future.

Question 20
Angela Co. owns an industrial ice cream maker and has decided to depreciate it using the double-declining-balance
method. However, the units-of-production method better reflects the pattern by which the asset is used up. What
describes this manner of financial reporting?
a) Using an acceptable accounting principle that does not reflect its economic substance
b) Using conservative but unrealistic assumptions and estimates
c) Misinterpreting the intent of an accounting principle
The first choice is correct. Although not fully reflective of the economic substance of the activity, the accounting
principle Angela Co. has decided to use, the double declining balance, is an accepted by accounting standards.

Question 21
The following statements about financing accounts payable are false, except:
a) Total operating cash flow remains unchanged as a result of raw material purchases on credit.
b) Some firms find it timely to balance out the lowered operating cash inflows of certain activities by incurring
operating cash outflows.
c) Financing arrangements with a related party, more often than not a financial institution, can be utilizing in
order to delayed cash outflows intended for the repayment of suppliers.
The first choice is correct. The decrease of operating cash flow from an increased inventory is completely offset by the
increase of operating cash flow from an increased accounts payable account.

Question 22
Megan Inc. agreed to lease out a 400-square-meter condominium unit to Pao Inc. The deal was agreed upon on
January 1, 2017, wherein part of the terms state that Megan Inc. will retain ownership of the property and Pao Inc. is
not entitled to a bargain purchase option. It will cost Pao $100,000 a year, paid every December 31, to rent the condo.
Eleven percent is the incremental borrowing rate of the lessee, and 10% is the implicit rate known to both parties. Pao
also shelled out $20,000 in initial direct costs in order to negotiate and secure the agreement. With the noncancelable
lease agreement lasting 10 years and the estimated useful life being 12 years, what amount should be capitalized by
Pao Inc. as the value of the leased property on the date the deal was agreed upon?
a) $614,460
b) $634,460
 c) $608,920
The first choice is incorrect. Check whether the lease term is at least 75% of the estimated useful life. If it is, then it
qualifies to be recognized as a finance lease. To solve for the cost, use the following equation:
([Annual lease payments] × [PVAF for 10 periods at 10%]) + [Initial direct costs] = Cost of lease
(100,000 × 6.1446) + 20,000 = 634,460

Question 23
Expensing research costs is an example of which type of accounting method?
a) Unbiased.
b) Aggressive.
c) Conservative.
As the future benefit of research is uncertain, it is usually expensed; however, this is conservative in assuming
research will not benefit future earnings of the company.

Question 24
The following relates to the bond issued by Vow Inc.:
 Principal: $100 million
 Coupon rate: 8%, semiannual payment
 Maturity: 10 years
 Market rate: 10%
The above transactions causes financing cash flows to increase by:
a) $87,537,790
b) $87,710,866
c) $113,590,326
The first choice is correct. The increase in financing cash flows is equal to the cash proceeds upon issuance net of
issuance costs. The cash proceeds is equal to the present value of cash flows, which is 87,537,790.

Question 25
Permanent difference do not arise from:
a) Officer's life insurance.
b) Research and development costs.
c) Municipal bond interest.
The first choice is incorrect. Officer's life insurance is generally tax-exempt, resulting in a permanent difference.

Question 26

First year sales $200,000

Annual sales growth 30%
COGS as a percentage of sales 30%
Operating expenses as a percentage of sales 45%
Tax rate 35%
Noncash working capital as a percentage of sales 60%
Annual investment in fixed capital as a percentage of sales 8%
Beginning noncash working capital $140,000
Beginning cash $15,000
Change in cash in Year 3 is closest to:
a) −$31,966
b) $24,590
c) −$18,915
 Years 1 2 3 4 5
Sales (30% rise every year) 200,000 260,000 338,000 439,400 571,220
Cost of goods sold (30% of sales) 60,000 78,000 101,400 131,820 171,366
Operating expenses (45% of sales) 90,000 117,000 152,100 197,730 257,049
Pre-tax income 50,000 65,000 84,500 109,850 142,805
Taxes (35% of pre-tax income) 17,500 22,750 29,575 38,447.50 49,981.75
Net income 32,500 42,250 54,925 71,402.50 92,823.25
Net income 32,500 42,250 54,925 71,402.50 92,823.25
Less: Investment in working capital −20,000 36,000 46,800 60,840 79,092
Less: Investment in fixed capital 16,000 20,800 27,040 35,152 45,697.60
Change in cash 36,500 −14,550 -18,915 −24,589.5 −31,966.4
Beginning cash 15,000 51,500 36,950 18,035 −6,554.5
Ending cash 51,500 36,950 18,035 −6,554.5 −38,520.9
Cash 51,500 36,950 18,035 −6,554.5 −38,520.9
Noncash working capital (60% of sales) 120,000 156,000 202,800 263,640 342,732
Current assets 171,500 192,950 220,835 257,085.5 304,211.5

Question 27
XYZ Company leases an asset for 4 years. During the term of the lease, XYZ must make a payment of $8,000 each
year for using the asset. The rate implicit in the lease is 7%. XYZ has a bargain purchase option on the asset.
The increase in liabilities upon inception of the lease is closest to:
a) Zero
b) $27,098
c) $32,000
XYZ must classify the lease as a finance lease because it holds a bargain purchase option on the asset. The present
value of lease payments is recognized as a liability at the inception of the lease for a finance lease.
PMT = −$8,000: N = 4; I/Y = 7; CPT PV; PV = $27,097.69

Question 28
Under US GAAP, unrealized gains on which type of marketable securities are recorded in the income statement?
a) Held-for-trading securities only.
b) Available-for-sale securities only.
c) Held-for-trading securities and available-for-sale securities only.
Available-for-sale securities are recorded at market value, but any unrealized gains flow straight through to
shareholders' equity. Only unrealized gains on held-for-trading securities are recorded in the income statement. Under
IFRS, exchange rate gains and losses on available-for-sale debt securities are recognized in the income statement.