FRA Level 2 Question Bank

Inventories: Implications for Financial Statements and Ratios
Test ID: 7440393
Question #1 of 111 Question ID: 461995
In periods of falling prices, which of the following statements is CORRECT? Compared to FIFO, LIFO results in:
ᅞ A) higher inventory balances and lower working capital.

ᅚ B) higher inventory balances and higher working capital.
ᅞ C) lower COGS, lower taxes and higher net income.
Explanation
In periods of falling prices, LIFO results in lower COGS, higher taxes, higher net income, higher inventory balances, higher
working capital, and lower cash flows compared to FIFO.
The Orchard Supply Company uses LIFO inventory valuation. Orchard Supply had a cost of goods sold of $1 million for the period. The
inventory at the beginning of the period was $0.5 million, and the inventory at the end of the period was $0.6 million. Orchard Supply's
LIFO reserve was $0.1 million for the previous year and $0.2 million for the current year. What is Orchard Supply's ending inventory
according to FIFO inventory valuation?
ᅞ A) $0.5 million.
ᅞ B) $0.7 million.
ᅚ C) $0.8 million.
Explanation
FIFO Inventory = $0.6 + 0.2 = $0.8 million.
JME had beginning inventory of $200 and ending inventory of $300. JME had COGS of $800. JME must have purchased inventory
amounting to:
ᅞ A) $1,100.
ᅞ B) $700.
ᅚ C) $900.
Explanation
beginning inv. + purchases - COGS = ending inv.
200 + purchases - 300 = 800

purchases = 900
Units Unit Price

Beginning Inventory 709 $2.00
Purchases 556 $6.00
Sales 959 $13.00
What is gross profit using the FIFO method and LIFO method?
FIFO LIFO
ᅚ A) $9,549 $8,325
ᅞ B) $8,325 $8,862
ᅞ C) $8,862 $9,549
Explanation
FIFO COGS = (709 units)($2/unit) + (959 − 709)($6/unit) = $1,418 + $1,500 = $2,918
Sales = (959 units)($13/unit) = $12,467
Gross profit = Sales − COGS
= 12,467 − 2,918 = $9,549
LIFO COGS = (556 units)($6/unit) + (959 − 556)($2/unit) = $3,336 + $806 = $4,142
Sales = (959 units)($13/unit) = $12,467
Gross profit = Sales − COGS
= 12,467 − 4,142 = $8,325
Tim Rogers is senior equity analyst with White Capital LLP. While analyzing the financial statements of Drako Toys Inc., a toy
manufacturer based in Cleveland, Ohio, Tim concludes that Drako is expected to see above-average sales growth over the
next three years. Which of the following conditions most likely support Tim's conclusion?
ᅞ A) Increase in finished goods inventory and corresponding decline in raw-

materials and work-in-progress inventory over the last two years.
ᅚ B) Increase in raw-materials and work-in-progress inventory and corresponding decline
in finished goods inventory over the last two years.
ᅞ C) Finished goods inventory growing faster than sales in the last two years.
Explanation
An increase in raw materials and/or work-in-process inventory is probably an indication of an expected increase in demand.
Conversely, an increase in finished goods inventory, while raw materials and work-in-process are decreasing, may be an
indication of decreasing demand. Finished goods inventory that is growing faster than sales may be an indication of declining
demand.
An analyst acquires the following information regarding a company:
Units Unit Price

Purchases 785 $5.00
Sales 848 $15.00
SGA Expenses $3,191 per annum
What are the Earnings Before taxes using the Weighted Average Method?
ᅞ A) $5,500.
ᅞ B) $6,200.
ᅚ C) $6,700.
Explanation
EBT = Sales − (COGS + SGA)
COGS = Beginning inventory + Purchases − Ending inventory

Ending inventory in units = 559 + 785 − 848 = 496 units
Average cost = (559 × $1 + $785 × $5) / (559 + 785)
= ($559 + $3,925) / 1,344 = $3.3363
Ending inventory = 496 × $3.3363 = $1,654.81
COGS = $559 + $3,925 − $1,654.81 = $2,829.19
EBT = 12,720 − (2,829.19 + 3,191) = $6,699.81.
The Mountain Bike Supply Company had 500 units in its beginning inventory. Each of these units cost $5. During the period,
Mountain Bike Supply first purchased 400 units at $6 each and then 200 units at $7 each. At the end of the period, Mountain
Bike Supply had 600 units. What is the cost of goods sold and inventory for Mountain Bike Supply if it uses FIFO inventory
valuation?
COGS Inventory
ᅚ A) $2,500 $3,800
ᅞ B) $3,200 $3,100
ᅞ C) $2,500 $3,100
Explanation
Under FIFO:
COGS = 500 @ $5 = $2,500

Inventory = 200 @ $7 + 400 @ $6 = $3,800
Selected information from Jenner, Inc.'s financial statements for the year ended December 31 included the following (in $):
Cash $200,000 Accounts Payable $300,000
Accounts Receivable 300,000 Deferred Tax Liability 600,000
Inventory 1,500,000 Long-term Debt 8,100,000
Property, Plant & Equip. 11,000,000 Common Stock 2,200,000
Total Assets 13,000,000 Retained Earnings 1,800,000
LIFO Reserve at Jan. 1 400,000 Total Liabilities & Equity $13,000,000
LIFO Reserve at Dec. 31 600,000

Net Income
(after 40% tax rate) 800,000
Jenner uses the last in, first out (LIFO) inventory cost flow assumption. If Jenner changed from LIFO to first in, first out (FIFO)
in 2001, return on total equity would:
ᅞ A) decrease from 20.0 to 18.3%.

ᅞ B) increase from 20.0 to 23.0%.
ᅚ C) increase from 20.0 to 21.1%.
Explanation
Return on total equity (net income / total equity) was ($800,000 / ($2,200,000 + $1,800,000) =) 20%. Under FIFO, net income
increases by the increase in the LIFO reserve multiplied by (1 - tax rate). FIFO net income for 2001 was ($800,000 +
($600,000 - $400,000) (1 - 0.40) = ) $920,000. Total equity increases by the amount of accumulated FIFO profits that are
added to retained earnings which is calculated by multiplying the amount of the ending LIFO reserve by (1 - tax rate) for an
increase of (($600,000) × (1 - 0.40) =) $360,000. Total equity is ($2,200,000 + $1,800,000 + $360,000 =) $4,360,000. FIFO
return on total equity is ($920,000 / $4,360,000 =) 21.1%.
Which inventory method will provide the largest net income during periods of falling prices?
ᅚ A) LIFO.
ᅞ B) Weighted average cost.
ᅞ C) FIFO.
Explanation
During periods of falling prices last in, first out (LIFO) provides a higher net income than first in, first out (FIFO) or the average
cost methods because the items most recently purchased are the ones being sold first and these costs are continually falling
increasing net income. Using FIFO during periods of falling prices would cause net income to be lower than LIFO or average
cost methods because the first inventory purchased is the first sold but during periods of falling prices this is the most
expensive inventory causing net income to be lower.
In case of a decline in LIFO reserve, to obtain a better analysis an analyst should:
ᅞ A) adjust the income statement, regardless of the reasons for the decline.
ᅞ B) not make any adjustments.
ᅚ C) adjust the income statement, only if such a decline is due to LIFO liquidation.
Explanation
A decline in LIFO reserve is due to either falling prices or LIFO liquidations. In the case of LIFO liquidation, the income
statement does not reflect the current costs and should be adjusted. In the case of falling prices, the LIFO income statement
amounts are current and do not need adjustment.
Questions #11-16 of 111
Wallace Lumber uses LIFO and had the following note in its last financial statement: "Wallace Lumber showed a LIFO reserve
of $90,000 in 2012 and $86,000 in 2013." Wallace's marginal tax rate is 31%. Assume normal inflationary conditions.
If Wallace's 2013 year-end LIFO inventory balance was $400,000, the firm's inventory based on FIFO would be closest to:
ᅞ A) $400,000.
ᅞ B) $314,000.
ᅚ C) $486,000.
Explanation
INVF = INVL + LIFO reserve
= $400,000 + $86,000
= $486,000
(LOS 17.c)
If Wallace's 2013 LIFO COGS was $70,000, the firm's FIFO COGS would be closest to:
ᅚ A) $74,000.
ᅞ B) $64,000.
ᅞ C) $66,000.
Explanation
COGSF = COGSL − (LIFO reserveE − LIFO reserveB)
= $70,000 − ($86,000 − $90,000)
= $74,000
(LOS 17.c)
If Wallace's 2013 reported net income was $12,000, the firm's FIFO net income would be closest to:
ᅞ A) $14,760.
ᅚ B) $9,240.
ᅞ C) $12,000.
Explanation
NI(F) = NI(L) + (LIFO reserveE − LIFO reserveB)(1 − T)
= $12,000 + ($86,000 − $90,000)(0.69)
= $9,240
(LOS 17.c)
If Wallace Lumber had reported using the FIFO cost flow assumption, the firm's net income would be:
ᅞ A) the same.
ᅞ B) higher.
ᅚ C) lower.
Explanation
In this scenario we have LIFO liquidation, and hence net income (and retained earnings) will be higher under LIFO leading to
a higher equity and lower debt-to-equity ratio. Under FIFO, the benefit of LIFO liquidation would not exist (as evidenced by
lower Net Income under FIFO) and hence debt-to-equity ratio would be higher. (LOS 17.e)
Compared to Wallace's current ratio under LIFO, the firm's current ratio under FIFO is most likely to be:
ᅚ A) higher.
ᅞ B) lower.
ᅞ C) the same.
Explanation
LIFO inventory would be lower by the LIFO reserve, hence FIFO current ratio will be higher than the LIFO current ratio. (LOS
17.e)
An analyst wanting to use Wallace Lumber's profit margin ratio for forecasting purposes, would most likely:
ᅞ A) use the profit margin without adjustment, as LIFO reflects the most-recent
costs.
ᅞ B) use FIFO profit margin instead.
ᅚ C) adjust the computed ratio lower.
Explanation
Under inflationary conditions, Wallace Lumber's decreasing LIFO reserve must be due to a LIFO liquidation, leading to a one-
off boost to reported profits which is not sustainable. An analyst should revise the computed ratio lower. (LOS 17.b)
Assuming inventory levels remain constant during the year and prices have been stable over time, COGS would be:
ᅞ A) higher under the average cost than LIFO or FIFO.

ᅞ B) higher under LIFO than FIFO or average cost.
ᅚ C) the same for both LIFO and FIFO.
Explanation
During stable prices inventory levels are the same for both LIFO and FIFO.
In periods of rising prices and stable or increasing inventory quantities, a company using LIFO rather than FIFO will report cost of goods
sold and cash flows which are, respectively:
COGS Cash Flows
ᅞ A) Lower Lower
ᅚ B) Higher Higher
ᅞ C) Higher Lower
Explanation
In this situation, LIFO results in higher cost of goods sold because it uses the more recent and higher costs than FIFO. LIFO results in
higher cash flows because with lower reported income, income tax will be lower.
Costiuk Ltd. uses the LIFO inventory cost flow assumption. Its inventory balance is $400 at the end of 20X8 and was $350 at
the end of 20X7. A footnote in its financial statements reads: "Inventories would have been $70 higher in 20X8 and $80 higher
in 20X7 using the FIFO cost flow assumption."
Which of the following amounts represents the inventory balance under FIFO at the end of 20X8?
ᅞ A) $410.
ᅞ B) $390.
ᅚ C) $470.
Explanation
The $70 and $80 amounts represent the LIFO reserves which are differences between LIFO inventory and its value under
FIFO.
FIFO inventory (20X8) = LIFO inventory (20X8) + LIFO reserve (20X8)
$400 + $70 = $470
A company's beginning inventory was overstated by $3,000, now ending inventory is understated by $2,000. If purchases
were properly reported, then earnings before taxes will be:
ᅚ A) understated by $5,000.
ᅞ B) overstated by $1,000.
ᅞ C) overstated by $5,000.
Explanation
The key relationship being tested is beginning inventory + purchases - COGS = ending inventory. So, beginning inventory +
purchases - ending inventory = COGS. You could solve the equation as +3000 +0 - -2000 = +5000. However, it is probably
easier to conceptualize by making up numbers that meet the requirements.
Actual (I made these numbers up):

20,000 + 5,000 - 15,000 = 10,000
Reported:
(20,000 + 3,000) + 5,000 - (15,000-2,000) = 15,000
COGS will be overstated by 5,000 so earnings before taxes (EBT) will be understated by 5,000.
The cost flow assumption of LIFO vs. FIFO has several implications while analyzing financial statements, especially when
comparing companies using different methods.
Suppose that we are comparing two firms: Alpha (which uses LIFO) and Beta (which uses FIFO).
In an inflationary scenario, with rising inventory levels, which company is most likely to report a COGS that reflects current
prices?
ᅞ A) Both Alpha and Beta.
ᅚ B) Alpha only.
ᅞ C) Beta only.
Explanation
The LIFO cost flow assumption transfers the most recent purchases to COGS and hence reflects current prices. Alpha, which
uses the LIFO cost flow assumption, would therefore report current prices in their COGS. (LOS 17.a)
In a deflationary scenario, with rising inventory levels, which company is most likely to report a COGS that reflects current
prices?
ᅚ A) Alpha only.
ᅞ B) Both Alpha and Beta.
ᅞ C) Beta only.
Explanation
The LIFO cost flow assumption transfers the most recent purchases to COGS and hence COGS will reflect current prices. This
holds true whether prices are rising or falling. Alpha, which uses the LIFO cost flow assumption, will therefore report current
prices in the firm's COGS. (LOS 17.a)
For this question only, suppose that there is a third company Gamma. Like Alpha, Gamma also uses the LIFO cost flow
assumption. However, unlike Alpha, Gamma's LIFO reserve has been decreasing over the years. In an inflationary scenario,
which company is most likely to report COGS that reflect current prices?
ᅚ A) Alpha.
ᅞ B) Gamma.
ᅞ C) Beta.
Explanation
Both Alpha and Gamma will reflect more-current prices in COGS than Beta does in its COGS. However, since Gamma has a
LIFO liquidation (while Alpha does not), Gamma's COGS includes some older price inventory. Alpha's inventory levels are
increasing and therefore its COGS would reflect the most current prices. (LOS 17.a)
Suppose Beta is considering an inventory write-down. Which group of ratios is most likely to look worse due to such a move?
ᅚ A) Profitability and leverage.
ᅞ B) Inventory turnover and leverage.
ᅞ C) Profitability and inventory turnover.
Explanation
An inventory write-down would lower inventory values and the current period's reported profits. Profitability ratios would suffer.
The turnover ratio would be favorable due to the lower asset (inventory) values. Leverage ratios would also suffer due to lower
equity (via retained earnings). (LOS 17.d)
Which cost-flow assumption is least likely to be associated with inventory writedowns?
ᅞ A) Specific Identification.
ᅚ B) LIFO.
ᅞ C) FIFO.
Explanation
Specific Identification, FIFO and weighted average cost methods are more likely to be associated with inventory write-downs
compared to the LIFO method. LIFO reflects the oldest costs in inventory and in a normal inflationary environment would
already reflect a conservative valuation of inventory. (LOS 17.a, d)
Which of the following is most likely to signal inventory obsolescence? An increase in:
ᅞ A) raw material and work-in-progress inventory.

ᅞ B) raw material inventory only.
ᅚ C) finished goods inventory with falling raw material inventory.
Explanation
An increase in finished goods inventory, along with falling raw material/work-in-progress inventory, is generally an indication of
obsolete inventory. Increases in raw material/work-in-progress may signal expectations of increasing demand for a company's
products. (LOS 17.f)
Given the following data and assuming a periodic inventory system, what is the ending inventory value using the FIFO
method?
Purchases Sales
50 units at $50/unit 25 units at $55/unit

ᅞ A) $3,600.
ᅞ B) $3,200.
ᅚ C) $3,250.
Explanation
Purchased 50 + 60 + 70 = 180 units. Sold 25 + 30 + 45 = 100.
Ending inventory = 180 - 100 = 80 of the last units purchased.
(70 units)($40/unit) + (10 units)($45/unit) = $2,800 + $450 = $3,250.
Which of the following statements concerning a period of rising prices is least accurate?
ᅞ A) The debt-to-equity ratio is greater using the last in, first out (LIFO) inventory
valuation method than using the first in, first out (FIFO) method.
ᅚ B) Inventory turnover is less using the last in, first out (LIFO) inventory valuation method
than using the first in, first out (FIFO) method.
ᅞ C) Gross profit using the last in, first out (LIFO) inventory valuation method is less than
the gross profit using the first in, first out (FIFO) method.
Explanation
LIFO results in lower inventory and higher cost of goods sold (COGS) during a period of rising prices, hence a higher inventory
turnover.
Arlington, Inc. uses the first in, first out (FIFO) inventory cost flow assumption. Beginning inventory and purchases of
refrigerated containers for Arlington were as follows:
Units Unit Cost Total Cost
Beginning Inventory 20 $10,000 $200,000

Purchases, April 10 12,000 120,000
Purchases, July 10 12,500 125,000
Purchases, October 20 15,000 300,000
In November, Arlington sold 35 refrigerated containers to Johnson Company. What is the cost of goods sold assigned to the
35 sold containers?
ᅞ A) $434,583.
ᅚ B) $382,500.
ᅞ C) $485,000.
Explanation
Under FIFO, cost of goods sold is the value of the first units purchased. The 35 units sold consist of the 20 units in beginning
inventory, the 10 units purchased in April, and 5 of the units purchased in July. COGS = $200,000 + $120,000 + (5 × $12,500)
= $382,500.
Assuming high inflation in the short run and lower levels of inflation in the long run, the current ratio of a company using last in,
first out (LIFO) relative to a firm using first in, first out (FIFO), will be:
ᅞ A) higher, and the difference between the two firms' current ratios will decrease as
inflation decreases.
ᅚ B) lower, and the difference between the two firms' current ratios will increase as inflation
decreases.
ᅞ C) lower, and the difference between the two firms' current ratios will decrease as
inflation decreases.
Explanation
The LIFO firm's current ratio will be lower and the difference between the two firms' current ratios will increase as inflation
decreases. For example, assume purchases equal sales so the quantity of inventory is constant. Inventory value under LIFO
will also remain constant as inflation decreases, whereas FIFO inventory value will increase even as the inflation rate
decreases. As long as inflation remains positive, the FIFO inventory value and the difference between LIFO and FIFO
inventory values will increase, as will the difference between the LIFO and FIFO firms' current ratios.
JME purchased 400 units of inventory that cost $4.00 each. Later the firm purchased an additional 500 units that cost $5.00 each. JME
sold 700 units of inventory for $7.00 each. If JME uses a first in, first out (FIFO) cost flow method, the amount of gross profit appearing
on the income statement is:
ᅞ A) $2,400.
ᅚ B) $1,800.
ᅞ C) $3,100.
Explanation
(units sold × sales price) - [(inventory cost × unit cost) + (inventory cost × unit cost)] = sales - COGS = gross profit
(700 × 7.00) - [(400 × 4.00) + (300 × 5.00)] = 1,800
Barber Inc. sells DVD recorders. On October 14, it purchased a large number of recorders at a cost of $90 each. Due to an
oversupply of recorders remaining in the marketplace due to lower than anticipated demand during the Christmas season, the
selling price at December 31 is $80 and the replacement cost is $73. The normal profit margin is 5 percent of the selling price
and the selling costs are $2 per recorder.
Under U.S. GAAP, what is the value of the recorders on December 31?
ᅚ A) $74.
ᅞ B) $73.
ᅞ C) $78.
Explanation
Under U.S. GAAP, market is equal to the replacement cost subject to replacement cost being within a specific range. The
upper bound is net realizable value (NRV), which is equal to selling price ($80) less selling costs ($2) for an NRV of $78. The
lower bound is NRV ($78) less normal profit (5% of selling price = $4) for a net amount of $74. Since replacement cost ($73) is
less than NRV minus normal profit ($74), then market equals NRV minus normal profit ($74). As well, we have to use the lower
of cost ($90) or market ($74) principle so the recorders should be recorded at the lower amount of $74.
The year-end financial statements for a firm using last in first out (LIFO) acounting show an inventory level of $5,000, cost of goods sold
(COGS) of $16,000, and inventory purchases of $14,500. If the LIFO reserve is $4,000 at year-end and was $1,500 at the beginning of the
year, what would the COGS have been using FIFO accounting?
ᅞ A) $18,500.
ᅞ B) $12,000.
ᅚ C) $13,500.
Explanation
COGS from LIFO to FIFO:
COGSF = COGSL − change in LIFO reserve

= COGSL - (LIFO reserveE − LIFO reserveB)
= $16,000 − ($4,000 − $1,500)
= $16,000 − $2,500
= $13,500
LIFO liquidation may result when:
ᅞ A) purchases are more than goods sold.

ᅚ B) purchases are less than goods sold.
ᅞ C) cost of goods sold is less than the available inventory.
Explanation
For LIFO companies, when more goods are sold than are purchased during a period, the goods held in opening inventory are
in included in COGS. This will result in LIFO liquidation.
Given the following data what is the ending inventory value using the LIFO method, assuming a periodic inventory system?
Purchases Sales
ᅞ A) $3,200.
ᅚ B) $3,850.
ᅞ C) $3,250.
Explanation
Purchased 50 + 60 + 70 = 180 units. Sold 25 + 30 + 45 = 100.
Ending inventory = 180 - 100 = 80 of the first units purchased.
(50 units)($50/unit) + (30 units)($45/unit) = $2,500 + $1,350 = $3,850.
Given the following inventory data about a firm:
Beginning inventory 20 units at $50/unit

Purchased 10 units at $45/unit
Sold 60 units at $80/unit
What is the inventory value at the end of the period using LIFO?
ᅚ A) $1,225.
ᅞ B) $1,575.
ᅞ C) $3,450.
Explanation
Ending inventory equals 20 + 10 + 35 + 20 − 60 = 25 of the first units purchased equals:
(20 units)($50/unit) + (5 units)($45/unit) =
$1,000 + $225 = $1,225

During periods of rising prices, which of the following is most likely to occur?
ᅞ A) LIFO COGS < FIFO COGS, therefore LIFO net income < FIFO net income.
ᅞ B) LIFO COGS > FIFO COGS, therefore LIFO net income > FIFO net income.
ᅚ C) LIFO COGS > FIFO COGS, therefore LIFO net income < FIFO net income.
Explanation
Under the assumptions of this question and using LIFO, the most expensive units go to COGS, resulting in lower net income.
During a period of rising prices, the financial statements of a firm using first in, first out (FIFO) reporting, instead of last in, first
out (LIFO) reporting would show:
ᅞ A) lower total assets and higher net income.

ᅞ B) lower total assets and lower net income.
ᅚ C) higher total assets and higher net income.
Explanation
When the FIFO method is used when prices are rising, the cheaper goods in beginning inventory, reflecting earlier purchases,
are assigned to COGS (hence, higher income) and the more expensive units (last purchases) are assigned to ending
inventory (greater current assets). When the LIFO method is used during a period when prices are rising, the more expensive
last purchases are assigned to COGS (hence, lower income) and the cheaper units in beginning inventory and earlier
purchases are assigned to ending inventory.
An analyst gathers the following information about a firm:
Last in, first out (LIFO) inventory = $10,000

Beginning LIFO reserve = $2,500
Ending LIFO reserve = $4,000
LIFO cost of goods sold = $15,000
LIFO net income = $1,500
Tax rate is 40%
To convert the financial statements to a FIFO basis, the amount the analyst should add to the stockholders' equity is closest
to:
ᅞ A) $4,000.
ᅚ B) $2,400.
ᅞ C) $2,800.
Explanation
If the firm had used FIFO inventory cost, tax liability would be higher by (LIFO reserve × tax rate) and retained earnings would
be higher by [LIFO reserve × (1 − tax rate)].
(LIFO reserve)(1 − t) = $4,000(1 − 0.4) = $2,400
Due to declining prices, Steffen Inc. has a LIFO reserve of -$20. Its income tax rate is 35%. If an analyst is converting Steffen's
financial statements to a FIFO basis, which of the following adjustments is most likely required?
ᅚ A) Increase cash by $7.

ᅞ B) Increase shareholders' equity by $13.
ᅞ C) Increase assets by $20.
Explanation
Declining prices (negative LIFO reserve) would result in FIFO inventory being less than LIFO inventory based on the following
equation:
FIFO inventory = LIFO inventory + LIFO reserve
The balance sheet adjustment would decrease assets (inventory) by the $20 LIFO reserve. In addition, the analyst would
increase cash by $7 ($20 LIFO reserve × 35% tax rate). To bring the accounting equation into balance, the analyst would
decrease shareholders' equity by $13 [$20 LIFO reserve × (1 − 35% tax rate)].
A firm uses the last in, first out (LIFO) accounting method and posts $100,000 as ending inventory. Last year's financial
statements show inventory at $110,000. This period's income statement shows costs of goods sold at $90,000 with a LIFO
reserve of $30,000. How much inventory was purchased this period, and what would the ending inventory balance be under
first in, first out (FIFO)?
Ending inventory
Inventory purchases
(FIFO)
ᅞ A) $90,000 $130,000
ᅚ B) $80,000 $130,000
ᅞ C) $80,000 $70,000
Explanation
EI = BI + P - COGS
100 = 110 + P - 90
P = $80,000
In order to convert ending inventory under FIFO to LIFO you have to add the LIFO reserve to the ending inventory under
LIFO.
EIFIFO = $100,000 + $30,000 = $130,000
Given the following information and assuming beginning inventory was zero and a periodic inventory system was used, what is the gross
profit at the end of the period using the FIFO, LIFO, and average cost methods?
Purchases Sales
20 units at $50 15 units at $60

FIFO LIFO Cost Average
ᅞ A) $650 $750 $990
ᅞ B) $677 $650 $677
ᅚ C) $650 $750 $677
Explanation
Sales = (15 * 60) + (35 * 45) + (85 * 35) = 5,450
COGSFIFO = (20 * 50) + (35 * 40) + (80 * 30) = 4,800

GMFIFO: $5,450 − 4,800 = $650
COGSLIFO = (15 * 50) + (35 * 40) + (85 * 30) = 4,700

GMLIFO: $5,450 − $4,700 = $750
COGSAverage = (20 * 50) + (35 * 40) + (85 * 30) = 4,950

4,950*135 / 140 = 4,773.21
GMCost Average: $5,450 − $4,773.21 = $676.79
In general, when analyzing profitability and costs, or when analyzing asset and equity ratios, which of the following should be
used?
Profitability/Cost Ratios Asset/Equity Ratios
ᅞ A) FIFO FIFO
ᅞ B) FIFO LIFO
ᅚ C) LIFO FIFO
Explanation
In general, an analyst should use LIFO when examining profitability or cost ratios and FIFO when examining asset or equity
ratios.
A financial analyst could adjust the current ratio in which a company uses the LIFO inventory valuation method to the FIFO
method by:
ᅞ A) deducting the LIFO reserve from the current asset.

ᅚ B) adding the LIFO reserve to the current assets.
ᅞ C) adding the LIFO reserve to the current liabilities.
Explanation
The LIFO reserve increases the inventory value under FIFO and inventory is included in the numerator in the current ratio.
Which accounting methods are preferable for income statements and balance sheets?
ᅚ A) Last in, first out (LIFO) for income statements and first in, first out (FIFO) for
the balance sheet.
ᅞ B) First in, first out (FIFO) for both income statements and balance sheets.
ᅞ C) Last in, first out (LIFO) for the balance sheet and first in, first out (FIFO) for the
income statement.
Explanation
LIFO allocates the most recent prices to the cost of goods sold and provides a better measure of current income. For balance
sheet purposes, inventories based on FIFO are preferable since these values most closely resemble current cost and
economic value.
In a period of rising prices and stable or increasing inventory quantities, use of the first in, first out (FIFO) inventory cost flow assumption
results in all of the following EXCEPT:
ᅚ A) lower inventory balances than under last in, first out (LIFO).
ᅞ B) higher earnings before taxes than under last in, first out (LIFO).
ᅞ C) higher earnings after taxes than under last in, first out (LIFO).
Explanation
Ending Inventory under FIFO includes more recently purchased higher cost goods than under LIFO. The LIFO inventory consists of older,
cheaper goods. Both before and after tax earnings under FIFO will be higher because less expensive goods are used for the cost of goods
sold (COGS). Working capital, which is equal to current assets - current liabilities will also be higher under FIFO due the higher inventory
balance causing a higher level of current assets.
The Orchard Supply Company uses last in, first out (LIFO) inventory valuation. Orchard Supply had a cost of goods sold
(COGS) of $1 million for the period. The inventory at the beginning of the period was $500,000 and the inventory at the end of
the period was $600,000. Orchard Supply's LIFO reserve was $100,000 at the end of the previous year and $200,000 at the
end of the current year. What is Orchard Supply's COGS according to first in, first out (FIFO) inventory valuation?
ᅞ A) $800,000.
ᅞ B) $1.1 million.
ᅚ C) $900,000.
Explanation
FIFO COGS = LIFO COGS − change in LIFO reserve
FIFO COGS = $1 million − $100,000 = $900,000
The following information has been gathered about a firm:
LIFO inventory = $10,000

Beginning LIFO reserve = $2,500
Ending LIFO reserve = $4,000
LIFO cost of goods sold = $15,000
LIFO net income = $1,500
Tax rate is 40%
What is the FIFO COGS?
ᅞ A) $16,500.
ᅞ B) $19,000.
ᅚ C) $13,500.
Explanation
FIFO COGS = LIFO COGS - change in LIFO reserve
= $15,000 - (4,000 − 2,500) = $13,500
First in, first out (FIFO) inventory equals:

ᅚ A) LIFO inventory + LIFO reserve.
ᅞ B) the change in LIFO reserve − LIFO ending reserve.
ᅞ C) LIFO cost of goods sold − changes in LIFO reserve.
Explanation
To convert LIFO inventory balances to a FIFO basis, simply add the LIFO reserve to the LIFO inventory:
INVF = INVL + LIFO Reserve
A firm's financial statements reflect the following information:
Beginning inventory $3,200,000
Purchase during the year $1,700,000
Ending inventory $2,100,000
Sales $4,800,000
Gross profit margin ????
What was the firm's gross profit margin?
ᅞ A) 0.58.
ᅞ B) 2.29.
ᅚ C) 0.42.
Explanation
First we can determine the COGS by: COGS = beginning inventory + purchases - ending inventory = $2,800,000.
Then, gross profit margin = (sales - COGS) / sales = 0.42.
Which of the following statements regarding inventory methods used during periods of rising prices is least accurate?
ᅞ A) FIFO results in higher taxes than LIFO.

ᅞ B) FIFO results in higher inventory balances than LIFO.
ᅚ C) LIFO results in lower cost of goods sold than FIFO.
Explanation
LIFO results in higher cost of goods sold during periods of rising prices because the last items bought, which are the most
expensive, are the first items sold resulting in a higher cost of goods sold.
Which of the following is least likely to be a result of using last in, first out (LIFO) as the inventory method during periods of
decreasing prices compared to using first in, first out (FIFO)?
ᅞ A) Lower COGS.
ᅞ B) Higher taxes.
ᅚ C) Higher cash flows.
Explanation
Using LIFO during periods of declining prices will result in lower cash flows because net income will be higher than if FIFO is
used leading to more taxes being paid out.
In an inflationary environment, a company's:
ᅚ A) assets will be lower if it uses last in, first out (LIFO) as opposed to FIFO.
ᅞ B) COGS sold will be lower if it uses LIFO as opposed to FIFO.
ᅞ C) net income will be larger if it uses LIFO than if it uses FIFO.
Explanation
In an inflationary period, assets will be lower under LIFO since the last, higher priced items are charged to the income statement.
Which of the following is least likely to happen after a last in, first out (LIFO) liquidation in an environment of rising prices?
ᅞ A) Increase taxable income.

ᅞ B) Increase gross income.
ᅚ C) Increase cost of goods sold (COGS).
Explanation
In a LIFO liquidation, a firm allows inventory to decrease so that it is using lower-cost materials (purchased in the past). This
will lower the COGS and increase income and profit. This is one of the ways that a firm's management can manipulate
earnings.
Which of the following statements is least accurate?

ᅞ A) In a period of rising prices, LIFO gives the best COGS, whereas FIFO gives the
best inventory balance on the balance sheet.
ᅞ B) LIFO produces a tax benefit in a period of rising prices, therefore results in higher
cash flows than FIFO.
ᅚ C) In a period of rising prices, FIFO gives the best COGS, whereas LIFO gives the best
inventory balance on the balance sheet.
Explanation
If prices are rising steadily, FIFO inventory is valued at the more recent purchase prices which are higher and provide a better
estimate of the replacement value of the inventory. LIFO costing will produce a cost of goods sold much closer to replacement
cost which provides a better estimate than using FIFO.
Selected financial data from Krandall, Inc.'s balance sheet for the year ended December 31 was as follows (in $):
Cash $1,100,000 Accounts Payable $400,000
Property, Plant & Eq. 8,000,000 Common Stock 1,000,000
LIFO Reserve at Jan. 1 600,000 Total Liabilities & Equity 11,800,000
Krandall uses the last in, first out (LIFO) inventory cost flow assumption. The tax rate is 40%. If Krandall used first in, first out
(FIFO) instead of LIFO and paid any additional tax due, its assets-to-equity ratio would be closest to:
ᅚ A) 4.06
ᅞ B) 3.73
ᅞ C) 4.18
Explanation
With FIFO instead of LIFO:
Inventory would be higher by $900,000, the amount of the ending LIFO reserve.
Cumulative pretax income would also be higher by $900,000, so taxes paid would be higher by 0.40($900,000) =
$360,000. Therefore cash would be lower by $360,000.
Cumulative retained earnings would be higher by (1 − 0.40)($900,000) = $540,000.
So assets under FIFO would be $11,800,000 + $900,000 - $360,000 = $12,340,000 and equity would be $1,000,000 +
$1,500,000 + $540,000 = $3,040,000. The assets-to-equity ratio would be $12,340,000 / $3,040,000 = 4.06.

During periods of declining prices, which inventory method would result in the highest net income?
ᅚ A) LIFO.
ᅞ B) Average Cost.
ᅞ C) FIFO.
Explanation
When prices are declining and LIFO is used the COGS is smaller than if FIFO is used leading to a larger net income.
A firm ended the last period with inventory of $4.0 million and a last in, first out (LIFO) reserve of $175,000. During the year, it
made purchases of $2.0 million and reported sales of $5.5 million with a gross margin of 0.32. At the end of the year, it
reported a LIFO reserve of $75,000. What is the value of the firm's cost of goods sold (COGS) on a first in, first out (FIFO)
basis?
ᅚ A) $3,840,000.
ᅞ B) $3,740,000.
ᅞ C) $3,640,000.
Explanation
With sales of $5.5 million and a gross margin of 0.32, the COGS (on a LIFO basis) is $3.74 million. In order to convert COGS
to a FIFO basis, we need to subtract the change in LIFO reserve during the year: $3,740,000 − ($75,000 − $175,000) =
$3,840,000.
Using the lower of cost or market principle under U.S. GAAP, if the market value of inventory falls below its historical cost, the
minimum value at which the inventory can be reported in the financial statements is the:
ᅞ A) net realizable value minus selling costs.

ᅞ B) net realizable value.
ᅚ C) market price minus selling costs minus normal profit margin.
Explanation
When inventory is written down to market, the replacement cost of the inventory is its market value, but the "market value"
must fall between net realizable value (NRV) and NRV less normal profit margin. NRV is the market price of the inventory less
selling costs. Therefore the minimum value is the market price minus selling costs minus normal profit margin.
If a company using last in, first out (LIFO) reports an inventory balance of $22,000 and a LIFO reserve of $4,000 (assume a 40% effective
tax rate), the estimated value for the inventory on a first in, first out (FIFO) basis would be:
ᅞ A) $24,400.
ᅚ B) $26,000.
ᅞ C) $18,000.
Explanation
FIFO INV = LIFO INV + LIFO Reserve

X = 22,000 + 4,000
X = 26,000
The effective tax rate is not used in this calculation.
Inventory transaction information for a manufacturing firm is provided chronologically below.
Purchases Sales

Assume that beginning inventory was zero.
Inventory value at the end of the period using the average cost method is closest to:
ᅞ A) $4,680.
ᅚ B) $177.
ᅞ C) $1,540.
Explanation
Average Cost = Cost of Goods Available / Total Units Available
Average Cost = $4,950 / 140 = $35.36
EOP Inventory Value = $35.36 × 5 = $176.79
(LOS 17.a)
Inventory value at the end of the period if using FIFO is closest to:
ᅞ A) $1,200.
ᅞ B) $175.
ᅚ C) $150.
Explanation
(Units purchased minus units sold) times cost = EOP value
(140 - 135) × $30 = $150
(LOS 17.a)
Inventory value at the end of the period if using LIFO, is closest to:
ᅞ A) $1,200.
ᅚ B) $250.
ᅞ C) $2,400.
Explanation
5 × $50 = $250. Under LIFO we assume that the inventory items purchased or manufactured most recently are sold first, so
the items remaining in inventory are assumed to be the oldest items purchased or manufactured. (LOS 17.a)
The change in LIFO reserve during the year is closest to:
ᅞ A) $250.
ᅞ B) $100.
ᅚ C) −$100.
Explanation
LIFO reserve (ending)= INVFIFO − INVLIFO = 150 − 250 = −100. Beginning LIFO reserve = 0 (there is no beginning inventory).
Change in LIFO reserve = −100 − 0 = −100. (LOS 17.b)
For this question only, assume that the tax rate is 30%. The cost of goods sold (COGS) under LIFO is closest to:
ᅞ A) $4,800.
ᅞ B) $4,950.
ᅚ C) $4,700.
Explanation
Number of units sold during the year = 15 + 35 + 85 = 135.

LIGO COGS = (85 × 30) + (35 × 40) + (15 × 50) = 4,700.
(LOS 17.a)
Reversal of previous inventory write-downs may occur under:
ᅞ A) Neither U.S. GAAP nor IFRS.

ᅞ B) U.S. GAAP but not under IFRS.
ᅚ C) IFRS but not under U.S. GAAP.
Explanation
Reversal of previous inventory write-downs may occur under IFRS but is not allowed under U.S. GAAP. (LOS 17.d)
Which of the following statements about inventory accounting is least accurate?
ᅞ A) During periods of rising prices, last in, first out (LIFO) income will be lower than
under first in, first out (FIFO) but cash flows will be higher.
ᅚ B) During periods of rising prices, first in, first out (FIFO) based current ratios will be
smaller than last in, first out (LIFO) based current ratios.
ᅞ C) If a U.S. firm uses last in, first out (LIFO) for tax reporting it must use LIFO for financial
reporting.
Explanation
During periods of rising prices, FIFO based current ratios will be larger than LIFO based current ratios because the more
expensive units (last purchases) are assigned to ending inventory, resulting in greater current assets.
A firm's financial statements reflect the following information:
Beginning inventory $2,900,000
Purchase during the year $1,600,000
Ending inventory ????
Sales $3,900,000
Gross Margin 0.41
What was the firm's ending inventory for this period?
ᅞ A) $1,699,000.
ᅚ B) $2,199,000.
ᅞ C) $2,799,000.
Explanation
First we can determine the cost of goods sold (COGS) by: COGS = sales (1 − gross margin) = $2,301,000.
Then, the ending inventory = beginning inventory + purchases − COGS = $2,199,000.
Given the following data:
Beginning LIFO Reserve $2,300

Cost of Goods Sold (COGS) using LIFO $6,100
COGS using FIFO of $4,300
What is the Ending LIFO reserve?
ᅞ A) $500.
ᅞ B) $2,800.
ᅚ C) $4,100.
Explanation
Ending LIFO Reserve = (LIFO COGS − FIFO COGS) + Beginning LIFO Reserve = (6,100 − 4,300) + 2,300 = $4,100.
During periods of decreasing prices, a firm using a periodic inventory system will report higher gross profit if its inventory cost
assumption is:
ᅚ A) LIFO because during periods of decreasing prices, COGS will be lower,

resulting in a higher gross profit.
ᅞ B) FIFO because during periods of decreasing prices, COGS will be higher, resulting in a
higher gross profit.
ᅞ C) FIFO because during periods of decreasing prices, COGS will be lower, resulting in a
higher gross profit.
Explanation
In periods of falling prices, LIFO results in lower COGS, and therefore higher gross profit than FIFO, because LIFO assumes
the most recently purchased (lower cost) goods are sold first.
If all else holds constant in periods of rising prices and inventory levels:
ᅞ A) FIFO firms have higher debt to equity ratios than LIFO firms do.
ᅚ B) FIFO firms will have greater stockholder's equity than LIFO firms do.
ᅞ C) LIFO firms have higher gross profit margins than FIFO firms do.
Explanation
The FIFO method of inventory accounting assigns the cost of the earliest units acquired to goods transferred out and the cost
of most recent acquisitions to ending inventory. When prices are rising, the cheaper goods in beginning inventory reflecting
earlier purchases are assigned to COGS (hence, higher income and higher shareholder's equity through retained earnings.)
Explanations for other choices:
In periods of rising prices and inventory levels (all else constant):
FIFO firms have lower debt to equity ratios than LIFO firms do because stockholder's equity is higher and debt is constant.
LIFO firms have lower gross profit margins ((Sales-COGS)/Sales) because the more expensive last purchases are
assigned to COGS, lowering the numerator.
During periods of rising prices:
ᅞ A) LIFO Gross Profit Margin > FIFO Gross Profit Margin.

ᅞ B) LIFO Inventory Turnover < FIFO Inventory Turnover.
ᅚ C) LIFO Debt to Equity Ratio > FIFO Debt to Equity Ratio.
Explanation
FIFO inventory, and therefore FIFO assets and equity, will be higher by the LIFO reserve.
The Baker Company uses the last in, first out (LIFO) inventory valuation method and reported its inventory at $200,000 and its
cost of goods sold (COGS) at $500,000. The company's LIFO reserve increased from $5,000 to $30,000 during the year.
What amounts would the company report for ending inventory and cost of goods sold if it were to use the first in, first out
(FIFO) method?
Ending
COGS
Inventory
ᅞ A) $170,000 $525,000
ᅞ B) $230,000 $525,000
ᅚ C) $230,000 $475,000
Explanation
Ending inventory under FIFO is equal to LIFO ending inventory + LIFO reserve
= 200,000 + 30,000 = 230,000
COGS under FIFO equals LIFO COGS − (ending LIFO reserve − beginning LIFO reserve)
= 500,000 − (30,000 − 5,000) = 475,000.
Under last in first out (LIFO) accounting during periods of inflation, when a firm sells a greater quantity of its inventory than it
produces or acquires, the result is:
ᅞ A) lower earnings.
ᅚ B) an understatement of the cost of goods sold (COGS).
ᅞ C) an increase in the LIFO reserve.
Explanation
This is a LIFO liquidation which refers to a declining inventory balance (the units available for sale are declining). In this case
the prices for goods that are being sold are no longer recent prices and can be many years out of date. This would make
COGS appear to be very low and gross and net profits to be artificially high.
When analyzing profitability ratios, which inventory accounting method is preferred?
ᅞ A) First in, first out (FIFO).

ᅚ B) Last in, first out (LIFO).
ᅞ C) Weighted average.
Explanation
Using LIFO cost of goods sold (COGS) gives a more accurate measure of future earnings because the LIFO COGS is more
representative of the current cost of product sold as compared to using FIFO therefore net income will be more accurately
represented.
Which of the following statements regarding inventory accounting methods is most accurate? In periods of:
ᅞ A) rising prices and stable unit purchases, using the FIFO method results in
higher inventory turnover than the LIFO method.
ᅚ B) rising prices and stable unit purchases, using the LIFO method results in a lower
current ratio than the FIFO method.
ᅞ C) declining prices FIFO results in higher net income than LIFO.
Explanation
In periods of rising prices LIFO results in lower current assets because the ending inventory is based on inventory items that
were purchased first at a lower price.
The formula to convert an ending inventory value from the LIFO to the FIFO method is to:
ᅚ A) FIFO inventory = LIFO inventory + LIFO reserve.
ᅞ B) FIFO inventory = LIFO inventory × LIFO reserve.
ᅞ C) FIFO inventory = LIFO inventory − LIFO reserve.
Explanation
The formula to convert an ending inventory value from the LIFO to the FIFO method is to FIFO inventory = LIFO inventory + LIFO
reserve.
Pischke Motors provided you with the following financials:
Beginning LIFO reserve $2,484.

Cost of goods sold (COGS) using LIFO $3,988.
COGS using FIFO $2,004.
What is the ending LIFO reserve?
ᅚ A) $4,468.
ᅞ B) $500.
ᅞ C) $1,984.
Explanation
Ending LIFO reserve = (LIFO COGS − FIFO COGS) + Beginning LIFO reserve
= ($3,988 − $2,004) + $2,484
= $4,468
If a firm has a first in, first out (FIFO) inventory of 9,000 and a last in, first out (LIFO) inventory of 6,500, what is the value of
the LIFO reserve assuming a 40% tax rate?
ᅞ A) $1,000
ᅚ B) $2,500.
ᅞ C) $1,500.
Explanation
LIFO reserve = FIFO inventory − LIFO inventory = 9,000 − 6,500 = 2,500
For balance sheet purposes, inventories based on:

ᅞ A) LIFO are preferable to those based on FIFO, as they more closely reflect the
current costs.
ᅞ B) LIFO are preferable to those based on average cost, as they more closely reflect the
current costs.
ᅚ C) FIFO are preferable to those based on LIFO, as they more closely reflect current
costs.
Explanation
The inventories based on FIFO are preferable to those presented under LIFO or average cost for balance sheet purposes.
Under FIFO, the older inventories are taken out first, and the ending inventory balance consists of the recent purchases and
thus most closely reflect the current (economic) value.
An analyst provided the following information about a company:
Purchases throughout the year $55,000
COGS $60,000
Ending inventory $35,000
The beginning inventory was:
ᅚ A) $40,000.
ᅞ B) $55,000.
ᅞ C) $45,000.
Explanation
COGS of $60,000 + ending inventory of $35,000, less purchases of $55,000.
Selected information from Mendota, Inc.'s financial statements for the year ended December 31 includes the following (in $):
Sales 7,000,000
Cost of Goods Sold 5,000,000
LIFO Reserve on Jan. 1 600,000
LIFO Reserve on Dec. 31 850,000
Mendota uses the last in, first out (LIFO) inventory cost flow assumption. The tax rate is 40%. If Mendota changed from LIFO
to first in, first out (FIFO), its gross profit margin would:
ᅞ A) increase to 40.1%.
ᅞ B) increase to 30.0%.
ᅚ C) increase to 32.1%.
Explanation
Gross profit margin under LIFO ((sales - cost of goods sold) / sales) is (($7,000,000 − $5,000,000) / $7,000,000) = 28.6%.
Under FIFO, cost of goods sold is reduced by the increase in the LIFO reserve, and the resulting FIFO gross profit margin is
(($7,000,000 - ($5,000,000 - ($850,000 - $600,000)) / $7,000,000) = 32.1%. Note that the tax rate only affects income totals
after income tax expense is shown and does not affect the gross profit margin.
Granulated Corp. uses the last in, first out (LIFO) inventory cost flow assumption. Selected information from Granulated's
financial statements for the years ended December 31, 20X3 and 20X4 was as follows (in $):
20X3 20X4
Beginning Inventory 4,375,000 5,525,000
Purchases 10,200,000 11,300,000
Ending Inventory 5,525,000 6,100,000
Beginning LIFO Reserve 825,000 975,000
Ending LIFO Reserve 975,000 1,125,000
If Granulated changed from LIFO to first in, first out (FIFO) for 20X4, Granulated's cost of goods sold (COGS) in 20X4 under
FIFO would be:
ᅞ A) $10,325,000.
ᅞ B) $11,850,000.
ᅚ C) $10,575,000.
Explanation
Granulated's 20X4 LIFO cost of goods sold (beginning inventory plus purchases less ending inventory) was ($5,525,000 +
$11,300,000 − $6,100,000 =) $10,725,000. To convert to FIFO the LIFO cost of goods sold would be reduced by the increase
in the LIFO reserve during 20X4 ($1,125,000 − $975,000 =) $150,000. The FIFO COGS in 2001 was ($10,725,000 −
$150,000 =) $10,575,000.
Given the following inventory data about a firm:
Beginning inventory 20 units at $50/unit

Sold 60 units at $80/unit
What is the inventory value at the end of the period using first in, first out (FIFO)?
ᅞ A) $3,100.
ᅚ B) $1,575.
ᅞ C) $3,475.
Explanation
Ending inventory equals 20 + 10 + 35 + 20 − 60 = 25 of last units purchased in inventory.
(20 units)($65/unit) + (5 units)($55/unit) = $1,300 + $275 = $1,575
Premier Corp.'s year-end last in, first out (LIFO) reserve was $2,500,000 in 2000 and $2,300,000 in 2001. Premier's $200,000 decline in
the LIFO reserve could be explained by each of the following EXCEPT:
ᅞ A) declining inventory prices.
ᅞ B) a LIFO liquidation occurred.
ᅚ C) the LIFO reserve was being amortized.
Explanation
A decline in the LIFO reserve occurs when the increasing prices that created the reserve begin declining or when the inventory is
liquidated (i.e. less units in inventory at the end of the year than at the beginning). LIFO reserves are not amortized.
In a period of rising prices, LIFO liquidation results in:
ᅞ A) lower earnings.
ᅚ B) higher earnings.
ᅞ C) increase in inventory.
Explanation
Since older layers of inventory that are liquidated were purchased at lower prices, the cost of goods sold will be lower and
earnings will be higher.
Assume that Hunter Round Restaurant Supply currently uses the last in, first out (LIFO) method to account for inventory and
that the business environment is one of rising prices and stable or growing inventory balances. In addition, Hunter Round has
an effective tax rate of zero percent due to tax loss carrybacks. All else equal, which of the following statements is least likely
valid? By using LIFO instead of first in, first out (FIFO), Hunter Round has:
ᅞ A) lower net income.
ᅞ B) lower working capital.
ᅚ C) higher cash flows.
Explanation
In the absence of taxes, there is no difference in cash flow between LIFO and FIFO. The other statements are true. For the
examination, memorize the financial impact of rising and falling prices for the two inventory methods.
Selected information from Oldtown, Inc.'s financial statements for the year ended December 31, 2004 included the following (in $):
Cash 1,320,000 Accounts Payable 1,620,000
Accounts Receivable 2,430,000 Deferred Tax Liability 715,000
Property, Plant & Equip. 12,470,000 Common Stock 1,000,000
Total Liabilities & Equity 22,930,000
Sales 15,000,000
Net Income 3,000,000
LIFO Reserve at Jan. 1 1,620,000
LIFO Reserve at Dec. 31 1,620,000
Oldtown uses the last in, first out (LIFO) inventory cost flow assumption. The tax rate was 40%. If Oldtown changed from LIFO to first
in, first out (FIFO) for 2004, net profit margin would:
ᅚ A) remain unchanged at 20.0%.
ᅞ B) decrease from 20.0 to 16.8%.
ᅞ C) decrease from 20.0 to 13.5%.
Explanation
Net profit margin under LIFO (net income / net sales) was ($3,000,000 / $15,000,000 =) 20.0%. Under FIFO, net income does not change
in 2004 because there was no change in the LIFO reserve balance, and no adjustment of net income is made.
Given the following inventory information about the Buckner Company:
Year-end last in, first out (LIFO) inventory of $6,500.

Year-end LIFO reserve of $2,500.
The current year's LIFO cost of goods sold (COGS) is $15,000.
After tax income is $1,600.
The previous year's LIFO reserve was $2,000.
How much higher would the firm's retained earnings be on a first in, first out (FIFO) basis if the firm's tax rate is 40%?
ᅞ A) $2,100.
ᅞ B) $1,800.
ᅚ C) $1,500.
Explanation
Adjustment to retained earnings = LIFO reserve (1 − t) = $2,500(1 − 0.4) = $1,500
The best way to compute an inventory turnover ratio is to use:
ᅞ A) last in, first out (LIFO) for both cost of goods sold (COGS) and average
inventory.
ᅞ B) first in, first out (FIFO) for both cost of goods sold (COGS) and average inventory.
ᅚ C) last in, first out (LIFO) for cost of goods sold (COGS) and first in, first out (FIFO) for
average inventory.
Explanation
Inventory turnover makes no sense at all for firms using LIFO due to the mismatching of costs (the numerator is current while
the denominator is historical). FIFO based inventory is relatively unaffected by price changes and is a good approximation of
actual turnover. In this way, current costs are matched in the numerator and denominator.
M J Inc reported COGS of $80,000 for the year under the LIFO inventory valuation method. M J had a beginning LIFO reserve of $8,000
and an ending LIFO reserve of $11,000. The COGS under the FIFO inventory valuation method is:
ᅞ A) $83,000.
ᅚ B) $77,000.
ᅞ C) $91,000.
Explanation
FIFO COGS is reduced when a LIFO reserve is increased. So, COGS = 80,000 − (11,000 − 8,000) = 77,000.
An analyst notes the following about a company:

Beginning inventory was reported as $5,000.
Costs of goods sold were reported as $8,000.
Ending inventory is $7,000 (the analyst has physically verified this amount).
Which of the following statements is most accurate?
ᅞ A) Purchases must have been $6,000.

ᅞ B) If the analyst discovered that beginning inventory was overstated by $1,000, then cost
of goods sold must have been understated by $1,000.
ᅚ C) If the analyst discovered that beginning inventory was understated by $2,000, then
earnings before taxes must have been overstated by $2,000.
Explanation
If inventory is overstated then COGS must also be overstated or purchases were understated, since you are told that ending
inventory is ok.
The formula to convert cost of goods sold (COGS) from last in, first out (LIFO) to first in, first out (FIFO) is:
ᅞ A) COGS FIFO = COGS LIFO + beginning LIFO reserve.

ᅚ B) COGS FIFO = COGS LIFO - change in the LIFO reserve.
ᅞ C) COGS FIFO = COGS LIFO + change in the LIFO reserve.
Explanation
The formula for converting COGS from LIFO to FIFO is COGSF = COGSL − (LIFO reserveE − LIFO reserveB)
Selected information from Newcomb, Inc.'s financial statements for the year ended December 31, 20X4 included the following
(in $):
Cash 70,000 Accounts Payable 90,000
Inventory 460,000 Long-term Debt 520,000
Property, Plant & Equip. 1,200,000 Common Stock 600,000
Total Assets 1,870,000 Retained Earnings 360,000
Total Liabilities & Equity 1,870,000
Earnings Before Interest and Taxes 280,000
Interest Expense 60,000

Income Tax Expense 75,000
Net Income 145,000
LIFO Reserve at Jan. 1 185,000
If Newcomb had used first in, first out (FIFO) for 20X4 and we assume that average total capital was $1,700,000 for both the
LIFO and FIFO computations, the return on total capital would:
ᅞ A) remain unchanged at 16.5%.

ᅞ B) decrease from 16.5 to 12.6%.
ᅚ C) increase from 16.5 to 20.3%.
Explanation
The return on total capital under LIFO (EBIT / average total capital) was $280,000 / $1,700,000 = 16.5%. Under FIFO, EBIT is
increased by the increase in the LIFO reserve during the year. FIFO return on total capital is ($280,000 + ($250,000 −
$185,000)) / $1,700,000 = 20.3%.
In periods of rising prices and stable or increasing inventory quantities, using the LIFO method for inventory accounting
compared to FIFO will have:
ᅞ A) higher COGS, lower income, lower cash flows, and lower inventory.
ᅚ B) higher COGS, lower income, higher cash flows, and lower inventory.
ᅞ C) lower COGS, higher income, identical cash flows, and lower inventory.
Explanation
In periods of rising prices and stable or increasing inventory quantities, the LIFO method - as compared with FIFO - will result
in higher COGS, lower taxes, lower net income, lower inventory balances, lower working capital, and higher cash flows.
Jim Banaji, credit analysts for HEQ, a fixed income fund, is evaluating three bonds. One of the bonds, issue by Prime Inc, a
large printing and packaging company, has six years remaining to maturity and has limited liquidity in the market. While
evaluating the financial statements of Prime, Banaji notices the following:
Excerpts (Financial statements for years 20X9 and 20X8)
($'000) 20X9 20X8
Sales 11300 10800
ROE 12% 11.6%
R&D expense 288 381
Inventory:
Finished goods 492 368
Raw Materials 329 324
Dividends 144 132
Based on the information gathered, which of the following conclusions are most likely?
ᅚ A) Sales are expected to decrease in the future or grow at a slower pace.
ᅞ B) Sales are expected to grow at a more rapid pace in the future.

ᅞ C) Profits are expected to grow at a more rapid pace.
Explanation
Sales are expected to grow at a slower pace (or decrease). This is evidenced by growth in finished goods inventory
accompanied with a stable raw materials inventory (as a proportion of sales).
GR Corporation uses the last-in, first out (LIFO) method of accounting for inventory and $70,000 is reported as cost of goods sold (COGS)
on their income statement. However, if GR had used first-in, first-out (FIFO), the COGS would have been $60,000. If the ending LIFO
reserve (LR) reported in the financial statements is $40,000, the beginning LIFO reserve is:
ᅞ A) $50,000.
ᅚ B) $30,000.
ᅞ C) $20,000.
Explanation
Beginning LR + ΔLR = Ending LR
ΔLR = COGS(LIFO) - COGS(FIFO) = $70,000 - 60,000 = $10,000
Beginning LR = $40,000 - 10,000 = $30,000
Units Unit Price

Purchases 556 $6.00
Sales 959 $13.00
Sales Expenses $2,649 per annum
Ignoring taxes, what is profit using the weighted average method?
ᅞ A) $5,676.00.
ᅞ B) $6,027.56.
ᅚ C) $6,213.98.
Explanation
weighted average cost per unit = (709 units)($2/unit) + (556 units)($6/unit) = $4,754 / 1,265units = $3.7581
weighted average COGS = ($3.7581)(959 units) = $3,604.02
Sales = (959 units)($13/unit) = $12,467
Profit = Sales − COGS − Sales Expenses = 12,467 − 3,604.02 − 2,649 = $6,213.98
While attending a local university, CFA candidate Anjolie Webster accepts a temporary position with a small manufacturing
firm. Currently, the firm uses LIFO to account for inventory, but the owner is "just curious" about how the financial results
would look if the company used FIFO. The owner hands Webster a photocopy of the inventory data for the current period
(summarized below).
Beginning inventory of 1,000 units at $30 cost.

Ending inventory of 800 units.
Sales of 1,100 units.
Three inventory purchases (listed from earliest purchase to latest purchase): 400 units at $27 each, 300 units at $25 each,
and an unreadable number of units at $22 each. (Unfortunately, when the owner copied the original document, he left a
yellow sticky note covering some of the inventory information.)
Current assets (less inventory) of $75,000.
Current liabilities of $65,000.
Using the information provided, determine which of the following statements is least accurate? All else equal, compared to
LIFO, using FIFO would result in:
ᅚ A) a current ratio of approximately 1.60.
ᅞ B) a lower ending inventory balance.
ᅞ C) a lower gross margin.
Explanation
To calculate the current ratio (which includes the ending inventory balance) using FIFO, we first need to determine how many
units were purchased in the third illegible purchase order.
Ending inventory = beginning inventory + units purchased - units sold, so

units purchased = units sold + ending inventory - beginning inventory
= 1,100 + 800 - 1,000 = 900
Third purchase units = 900 - 400 - 300 = 200
FIFO ending inventory = [(300 × 27) + (300 × 25) + (200 × 22)] = $20,000
FIFO current ratio (all else equal) = (75,000 + 20,000) / 65,000 = approximately 1.46
The other choices are correct. Since prices are decreasing, FIFO cost of goods sold is higher (and gross margin is lower) than
LIFO. And, FIFO ending inventory is lower than LIFO ending inventory. No LIFO calculations are necessary.

Which of the following is least likely part of the basic inventory equation?
ᅚ A) Beginning inventory − ending inventory − cost of goods sold = purchases.

ᅞ B) Beginning inventory + purchases = ending inventory + cost of goods sold.
ᅞ C) Purchases − ending inventory + beginning inventory = cost of goods sold.
Explanation
To solve for purchases the basic inventory equation would then be: ending inventory + COGS − beginning inventory =
purchases.
Sweet Milk Inc uses the last in, first out (LIFO) inventory method and had 5,000 units of beginning inventory on January 1,
2002, that was valued at $10.00 a unit. The company purchased 50,000 units at $12 a unit and sold 52,000 units at $15 a unit.
Sweet Milk is considering an additional purchase of 10,000 units at $13 a unit. The company will make the purchase at the end
of December or in the early part of year 2003. Which statement about the effect of the purchase decision on net income is
most accurate?
ᅞ A) Income for year 2002 will not be affected no matter when the inventory is
purchased.
ᅚ B) Postponing the purchase until January will increase income for 2002 by $14,000.
ᅞ C) Making the purchase in December will increase income by $16,000 in year 2002.
Explanation
By postponing the purchase until January, cost of goods sold (COGS) would be $620,000. A purchase in December would
increase COGS to $634,000.
COGS for January purchase = (50,000 × 12) + (2,000 × 10) = 620,000
COGS for December purchase = (10,000 × 13) + (42,000 × 12) = 634,000
Jefferson Corp. decided to change its inventory valuation method from first in, first out (FIFO) to last in, first out (LIFO) in a
period of rising prices. What was the result of the change for the ending inventory and net income?
Ending
Net Income
Inventory
ᅞ A) Increases Increases
ᅞ B) Decreases Increases
ᅚ C) Decreases Decreases
Explanation
LIFO provides the lowest inventory values and the lowest net income under rising prices because the least expensive
purchases are left in inventory and the more expensive purchases flow to cost of goods sold (COGS) which lowers net income.
During inflationary periods, which of the following statements is CORRECT?
ᅞ A) LIFO will generate lower earnings, but lower after tax cash flows.
ᅞ B) LIFO will generate higher earnings, but lower after tax cash flows.
ᅚ C) FIFO will generate higher earnings, but lower after tax cash flows.
Explanation
During inflation, FIFO will generate higher earnings because cost of goods will be lower than if LIFO was used. However, LIFO will
generate higher cash flows since cash outflows for taxes will be lower for LIFO.
Which is the preferred inventory method for purposes of analysis and which is the preferred method for reporting cost of goods sold?
Inventory
COGS
Analysis
ᅚ A) FIFO LIFO
ᅞ B) LIFO FIFO
ᅞ C) LIFO LIFO
Explanation
FIFO is the preferred inventory method for purposes of analysis and LIFO is the preferred method for reporting cost of goods
sold.
During periods of rising prices and stable or growing inventories, the most informative inventory accounting method for income
statement purposes is:
ᅞ A) FIFO because it allocates historical prices to cost of good sold (COGS) and
provides a better measure of current income.
ᅚ B) LIFO because it allocates current prices to cost of good sold (COGS) and provides a
better measure of current income.
ᅞ C) weighted average because it allocates average prices to cost of good sold (COGS)
and provides a better measure of current income.
Explanation
LIFO is the most informative inventory accounting method for income statement purposes in periods of rising prices and stable
or growing inventories. It allocates the most recent purchase prices to COGS, and thus provides a better measure of current
income and future profitability.
In 2004, Torrence Co. had a beginning inventory of $19,924 and made purchases of $15,923. If the ending inventory level
was $19,204, what was the cost of goods sold (COGS) for year 2004?
ᅞ A) $15,923.
ᅚ B) $16,643.
ᅞ C) $15,203.
Explanation
Beginning Inventory + Purchases − Ending Inventory = COGS

$19,924 + $15,923 − $19,204 = $16,643
Moore Ltd. uses the LIFO inventory cost flow assumption. Its cost of goods sold in 20X8 was $800. A footnote in its financial
statements reads: "Using FIFO, inventories would have been $70 higher in 20X8 and $80 higher in 20X7." Moore's COGS if
FIFO inventory costing were used in 20X8 is closest to:
ᅚ A) $810.
ᅞ B) $790.
ᅞ C) $730.
Explanation
The ending LIFO reserve is $70 and the beginning LIFO reserve is $80.
FIFO COGS = LIFO COGS − (ending LIFO reserve − beginning LIFO reserve)
$800 − ($70 − $80) = $810
A firm ended the last period with inventory of $3.0 million and a last in, first out (LIFO) reserve of $40,000. During the year, it
made purchases of $1 million and reported sales of $4 million with a gross margin of 0.58. At the end of the year, it reported a
LIFO reserve of $75,000. What is the value of the firm's ending inventory converted to a first in, first out (FIFO) basis?
ᅞ A) $2,360,000.
ᅚ B) $2,395,000.
ᅞ C) $2,320,000.
Explanation
With sales of $4 million and a gross margin of 0.58, the COGS (on a LIFO basis) is 1.68 million. This would leave an ending
inventory of 3 million + 1 million − 1.68 million = $2.32 million on a LIFO basis. In order to adjust this to FIFO, we would add
the ending LIFO reserve of $75,000 to arrive at $2.395 million.
Which of the following inventory accounting methods must be used for financial reporting purposes if a U.S. firm uses last in, first out
(LIFO) for tax purposes?
ᅞ A) The firm may use any of the above methods.
ᅞ B) FIFO.
ᅚ C) LIFO.
Explanation
If a U.S. firm uses LIFO for tax purposes, it must also use LIFO for financial reporting purposes, according to U.S. tax law.
Brigham Corporation uses the last-in, first-out (LIFO) method of accounting for inventory. For the year 2005, the following is
provided:
Cost of goods sold (COGS): $24,000

Beginning inventory: $6,000
Ending inventory: $7,500
The notes accompanying the financial statements indicate that the LIFO reserve at the beginning of the year was $2,250
and at the end of the year was $6,000
If Brigham had used first-in, first-out (FIFO), the COGS for 2005 would be:
ᅚ A) $20,250.
ᅞ B) $3,750.
ᅞ C) $29,250.
Explanation
FIFO COGS = LIFO COGS − change in LIFO reserve. Therefore, $24,000 − ($6,000 − 2,250) = $20,250.
Given the following data and assuming a periodic inventory system, what is the ending inventory using the average cost
method?
Purchases Sales
40 units at $60/unit 25 units at
$65/unit
30 units at
50 units at $55/unit
$60/unit
40 units at
60 units at $45/unit
$50/unit
ᅞ A) $3,141.
ᅞ B) $2,933.
ᅚ C) $2,878.
Explanation
Average cost per unit purchased:
40 units at $60/per unit = $2,400

Total = 150 units = $7,850
Average cost per unit = $7,850 /150 units = $52.33/unit
Purchased 40 + 50 + 60 = 150 units. Sold 25 + 30 + 40 = 95
Ending inventory = 150 − 95 = 55 units × $52.33/unit = $2,878

Long-lived Assets: Implications for Financial Statements and Ratios
Test ID: 7440403
In industries where there are rapid changes in technology related to production processes, which of the following characteristics will most
likely indicate that a firm has a competitive advantage?
ᅞ A) Low capital expenditures.
ᅞ B) High earnings per share.
ᅚ C) Low average age of equipment.
Explanation
Average age of depreciable assets is useful for two reasons:
1. To assess how competitive the corporation will be going forward (older assets are less efficient).
2. Estimate financing required for major capital expenditures to replace depreciated assets.
While low capital expenditures may result in higher earnings in the short run, in the long run, the company may find itself at a comparative
disadvantage if technological changes are rapidly increasing. EPS is not comparable between companies.
The Mader Corporation leases an asset for five years with lease payments of $10,000 per year. If Mader classifies the lease
as a finance lease, which financial statements are affected at the end of the first year?
ᅞ A) Income statement only.

ᅚ B) Statement of cash flows, income statement, and balance sheet.
ᅞ C) Income statement and balance sheet only.
Explanation
The classification of a lease as a finance lease creates an asset, a debt obligation, financing cash flows (amortization of the
loan), and operating cash flows (interest expense).
Which of the following statements about depreciation is least accurate?
ᅞ A) Return on assets is initially higher using straight-line depreciation than it is using

accelerated depreciation.
ᅞ B) If an asset produces a constant stream of net income over its useful life and is depreciated
using the straight-line method, the rate of return on the asset increases over its life.
ᅚ C) For a firm with increasing capital expenditures, accelerated depreciation methods tend to
increase both net income and stockholders' equity when compared to straight-line
depreciation.
Explanation
For a firm with increasing capital expenditures, accelerated depreciation methods tend to decrease both net income and stockholders'
equity when compared to straight-line depreciation.
Assuming the firm continues to invest in new assets, the following relationships hold. These relationships will eventually reverse if the
firm's capital expenditures decline.
Straight Line Accelerated (DDB & SDY)
Depreciation Expense Lower Higher
Net Income Higher Lower
Assets Higher Lower
Equity Higher Lower
Return on Assets Higher Lower
Return on Equity Higher Lower
An impairment write-down is least likely to decrease a company's:
ᅞ A) future depreciation expense.

ᅚ B) debt-to-equity ratio.
ᅞ C) assets.
Explanation
An impairment write-down reduces equity and has no effect on debt. The debt-to- equity ratio would therefore increase.
Marcel Inc. is a large manufacturing company based in the U.S. but also operating in several European countries. Marcel has
long-lived assets currently in use that are valued on the balance sheet at $600 million. This includes previously recognized
impairment losses of $80 million. The original cost of the assets was $750 million. The fair value of the assets was determined
in a professional appraisal to be $690 million. Assuming that Marcel reports under U.S. GAAP, the new appraisal of the assets'
value most likely results in:
ᅞ A) an $80 million gain on income statement and $10 million gain in other
comprehensive income.
ᅞ B) a $90 million gain in other comprehensive income.
ᅚ C) no change to Marcel's financial statements.
Explanation
Under U.S. GAAP, long-lived assets are reported on the balance sheet at depreciated cost less any impairment losses ($750
million original cost less $70 million accumulated depreciation and less $80 million impairment loss, for a net amount of $600
million). Increases are generally prohibited with the exception of assets held for sale. Since these assets are currently in use,
this exception does not apply. Therefore, Marcel may not revalue the assets upward.
In a sales-type lease, a lessor recognizes a gross profit at the inception of the lease equaling the:
ᅞ A) sale price of the leased asset plus the present value of the minimum lease
payments.
ᅚ B) present value of the minimum lease payments less the cost of the leased asset.
ᅞ C) sale price of the leased asset less the present value of the minimum lease payments.
Explanation
In a sales-type lease, the implicit interest rate is such that the present value of MLP is the selling price of the asset. At the time
of the lease inception, the lessor will recognize a gain equaling the present value of the MLPs, less the cost of the leased
asset.
Which of the following statements that classify a lease as a finance lease under U.S. GAAP is least accurate?
ᅞ A) Title is transferred at the end of the lease period.

ᅚ B) The present value of the lease payments is at least 80% of the fair market value of the
asset.
ᅞ C) A bargain purchase option exists.
Explanation
For a lease to be classified as a finance (capital) lease the present value of the lease payments must be at least 90% of the
fair market value of the asset.
A firm revalues its long-lived assets upward. All other things equal, which of the following financial impacts is least likely to
occur?
ᅚ A) Higher profitability in the periods after revaluation.

ᅞ B) Lower solvency ratios.
ᅞ C) Higher earnings in the revaluation period.
Explanation
Because the asset has now been increased to a higher depreciable base, there will now be higher depreciation expense and
therefore, lower profitability in the periods after revaluation. There could be higher earnings in the revaluation period because
there may be impairment losses that can be reversed on the income statement. Otherwise, there will be an adjustment to
earnings through other comprehensive income. Solvency ratios (i.e. debt to equity) will decrease since the increase in assets
will be balanced by an increase in equity. Higher denominators and unchanged numerators will result in lower solvency ratios.
Capitalized interest costs are typically reported in the cash flow statement as an outflow from:
ᅞ A) operating.
ᅞ B) financing.
ᅚ C) investing.
Explanation
Capitalized interest costs are reported as CFI on the statement of cash flows, as they are treated as part of the cost of the
constructed capital asset.
Under a finance lease (versus an operating lease) which of the lessee's financial ratios will be higher?
ᅞ A) Asset turnover.
ᅞ B) Return on equity.
ᅚ C) Debt/equity.
Explanation
The debt/equity ratio will be higher because the finance lease requires the creation of a long-term liability on the balance
sheet.
Statement of Financial Accounting Standard (SFAS) 86 requires that costs incurred to establish the feasibility of computer
software must be:
ᅞ A) capitalized only after the software is completely developed.

ᅞ B) expensed once the economic feasibility is established.
ᅚ C) viewed like Research & Development (R&D) costs and expensed as incurred.
Explanation
SFAS 86 requires that all the costs incurred in establishing software feasibility be viewed as R&D costs and expensed as
incurred. Once technological feasibility has been established, subsequent costs (for software to be sold or leased to others)
can be capitalized as part of product inventory.
Lakeside Co. recently determined that one of its processing machines has become obsolete after 7 years of use and,
unexpectedly, has no salvage value. The machine was being depreciated over a useful economic life of 10 years. Which of the
following statements is most consistent with this discovery?
ᅞ A) Lakeside Co. will owe back taxes.

ᅞ B) Historically, economic depreciation was overstated in the financial statements.
ᅚ C) Historically, economic depreciation was understated in the financial statements.
Explanation
Historically, economic depreciation was understated. If an asset becomes obsolete and its useful life is less than expected,
accounting methods for depreciation have understated the economic depreciation. In addition, if there is no salvage value
when positive salvage value was expected, the understatement problem is compounded.
Train, Inc.'s cash flow from operations (CFO) in 2004 was $14 million. Train paid $8 million cash to acquire a franchise at the
beginning of 2004 that was expensed in 2004. If Train had elected to amortize the cost of the franchise over eight years, 2004
cash flow from operations (CFO) would have been:
ᅞ A) $21 million.
ᅚ B) $22 million.
ᅞ C) unchanged.
Explanation
If Train decided to amortize the franchise cost, it would be capitalized and none of the cash expended would flow though CFO,
and all of the $8 million would be added back to CFO. Subsequent amortization would be a non-cash expense and would be
added back to NI to arrive at CFO.
Management of the Beef, Etc. corporation has changed certain accounting assumptions in hopes of improving the public
perception of the company's prospects. These accounting assumptions relate primarily to the treatment of capitalized
expenses and long-term leases. Lisa Kelps, CFA, wants to adjust the financial statements to make them more comparable
across years and to similar firms in the same industry.
When comparing a company that expenses with a company that capitalizes the same expense, an analyst can adjust the cash
flow statement of the company that capitalizes by:
ᅚ A) increasing cash flow from investing activities and reducing cash flow from
operations.
ᅞ B) increasing cash flow from investing activities and increasing cash flow from
operations.
ᅞ C) reducing cash flow from investing activities and reducing cash flow from operations.
Explanation
When adjusting cash flow statement, we want to reverse capitalizing of expenses. For that we reduce cash flow from
operations (due to lower net income as expenses are recognized), and reduce cash outflow from investing activities. Reducing
cash outflow is the same as increasing cash flow. (LOS 18.a)
When comparing a company that expenses with a company that capitalizes the same expense, an analyst can adjust the
earnings before tax of the company that capitalizes by:
ᅚ A) subtracting the capitalized expenses and adding back amortization of

capitalized expenses.
ᅞ B) adding the capitalized expenses and adding back amortization of capitalized

expenses.
ᅞ C) subtracting the capitalized expenses and subtracting amortization of capitalized

expenses.
Explanation
When adjusting the earnings before tax, we want to reverse capitalizing of expenses.
For that we use:
Adj. EBT = EBT − Capitalized exp. + Amortization of Capitalized exp.
(LOS 18.a)
When comparing a company that reports a lease as an operating lease with a company that reports that same lease as a
financial lease, the company that reports a lease as an operating lease will most likely:
ᅚ A) report higher profits, higher return measures and higher solvency in earlier
years.
ᅞ B) report lower profits, higher return measures and lower solvency in earlier years.
ᅞ C) report higher profits, lower return measures and lower solvency in earlier years.
Explanation
Companies that report a lease as an operating lease instead of a finance lease will usually have higher profits in early years
due to lower lease expense as compared to sum of depreciation and interest expense under a finance lease. Due to higher
reported profits, return measures (Profit Margin, ROA, ROE etc. will be higher). Also, since operating lease does not recognize
a liability, solvency measures are higher. (LOS 18.f)
When comparing a company that capitalizes interest costs associated with construction of a new factory, with a company that
expenses these costs, the company that capitalizes interest cost is most likely to report a:
ᅞ A) lower interest coverage ratio and lower fixed asset turnover ratio.
ᅚ B) higher interest coverage ratio and lower fixed asset turnover ratio.
ᅞ C) higher interest coverage ratio and higher fixed asset turnover ratio.
Explanation
Companies that capitalize interest cost will report lower interest expense (and higher interest coverage ratio) and higher fixed
assets (lower fixed asset turnover ratio). (LOS 18.a)
Which of the following statements about fixed assets is most accurate?
ᅞ A) Average remaining life can be estimated as average age minus average useful
life.
ᅞ B) Average age can be estimated as sum of average useful life and average remaining
life.
ᅚ C) Average useful life can be estimated as the sum of average age and average
remaining life.
Explanation
Average useful life can be estimated as the sum of average age and average remaining life. (LOS 18.d)
Compared to a company that uses straight line depreciation, a company that uses accelerated depreciation is most likely to
have:
ᅞ A) higher activity ratios and stronger solvency ratios.

ᅞ B) lower activity ratios and weaker solvency ratios.
ᅚ C) higher activity ratios and weaker solvency ratios.
Explanation
Accelerated depreciation will lead to lower reported income and asset values in early years. The lower income will reduce
reported equity (hence weaker solvency ratios) and lower asset values will increase the fixed-asset turnover (activity) ratios.
(LOS 18.d)
A firm using straight-line depreciation reports the following financial information:
Gross investment in fixed assets of $89,167,205.

Accumulated depreciation of $35,341,773.
Annual depreciation expense of $3,885,398.
The approximate age of the fixed assets is:

ᅚ A) 9.10 years.
ᅞ B) 22.95 years.
ᅞ C) 2.52 years.
Explanation
Average age of fixed assets = accumulated depreciation / annual depreciation = $35,341,773 / $3,885,398 = 9.10.
Which of the following is least likely to be a problem with accounting for internally generated intangible assets?
ᅞ A) Costs of developing these assets may not be easily separable.

ᅚ B) The potential benefits are spread over a long time period.
ᅞ C) Determining the economic life.
Explanation
The problems with accounting for internally generated intangible assets are: determination of economic life and separation of
the cost for development.
Income statement information for Quick Corp. for the years ended December 31, 20X0 and 20X1 was as follows (in $ millions):
20X0 20X1
Sales 30,000,000 32,000,000
Cost of Goods Sold (16,000,000) (17,000,000)
Gross Profit 14,000,000 15,000,000

Amortization of (1,500,000) (1,500,000)
Franchise
Other Expenses (7,000,000) (7,000,000)
Net Income 5,500,000 6,500,000
Quick acquired a franchise in 20X0 for $15,000,000 and elected to amortize the cost over 10 years. Ignoring taxes, if Quick
had expensed the franchise cost in 20X0 instead of amortizing it, net income for 20X0 and 20X1 would be:
20X0 20X1
ᅚ A) -$8,000,000 $8,000,000
ᅞ B) -$8,000,000 $6,500,000
ᅞ C) -$9,500,000 $8,000,000
Explanation
If the franchise cost were expensed, amortization would be eliminated and franchise expense would be fully taken in 20X0. 20X0 net
income would be $5,500,000 + 1,500,000 - $15,000,000= -$8,000,000, and 20X1 net income would be $6,500,000 + $1,500,000=
$8,000,000.
Doug Dalby, CFA and Luke Brown, CFA are consulting to the executive board of Housekeeping Enterprises (Housekeeping)
concerning strategic changes to the company's balance sheet.
Housekeeping is considering changing its inventory accounting method to FIFO from LIFO. Dalby briefs the board on the
effect of falling/rising prices and stable or increasing inventory quantities, on cost of goods sold and cash flows, depending on
inventory accounting method.
Housekeeping would like to capitalize various costs it had previously been expensed, but is worried about the change being
refused by its auditors. The board asks Brown which costs are most likely to be capitalized under U.S. GAAP.
If Housekeeping uses last in, first out (LIFO) reports an inventory balance of $44,000 and a LIFO reserve of $8,000 (assume a
40% effective tax rate), the estimated value for the inventory on a first in, first out (FIFO) basis would be closest to:
ᅞ A) $36,000.
ᅞ B) $48,800.
ᅚ C) $52,000.
Explanation
FIFO INV = LIFO INV + LIFO Reserve

X = 44,000 + 8,000
X = 52,000
The effective tax rate is not used in this calculation.
(Study Session 5, LOS 17.b)
In periods of rising prices and stable or increasing inventory quantities, a company using LIFO rather than FIFO will report cost
of goods sold which is:
ᅚ A) higher.
ᅞ B) lower.
ᅞ C) the same.
Explanation
In this situation, LIFO results in higher cost of goods sold because it uses the more recent and higher costs than FIFO. (Study
Session 5, LOS 17.a)
In periods of rising prices and stable or increasing inventory quantities, a company using LIFO rather than FIFO will report
cash flows which are:
ᅞ A) lower.
ᅞ B) the same.
ᅚ C) higher.
Explanation
LIFO results in higher cash flows because with lower reported income, income tax will be lower. (Study Session 5, LOS 17.a)
If Housekeeping changed policy and capitalizes some costs instead of expensing them, the company will:
ᅞ A) have a higher reported income initially, with lower income levels to follow
invariably.
ᅚ B) have a higher reported income as long as capitalized expenditures exceed
depreciation on them.
ᅞ C) have a lower reported income initially, with higher income levels to follow invariably.
Explanation
If management decides to capitalize costs instead of expensing them, it will report higher income as long as such capitalized
expenses exceed the depreciation of such expenses in later periods. (Study Session 5, LOS 18.a)
Compared to capitalizing, expensing these costs will result in:
ᅞ A) lower asset levels and higher equity levels.

ᅚ B) lower asset levels and lower equity levels.
ᅞ C) lower asset levels and lower liability levels.
Explanation
Expensing instead of capitalizing results in lower assets. Since the entire expense is recognized in the current period (whereas
only a portion of the expenditure is amortized when capitalizing), net income (and therefore equity, via retained earnings) is
lower with expensing than with capitalizing. Liabilities are unaffected. (Study Session 5, LOS 18.a)
Under U.S. Generally Accepted Accounting Principles (GAAP), which of the following costs associated with intangible assets is
most likely to be capitalized?
ᅞ A) Research and development costs associated with software development.
ᅞ B) The costs associated with an internally created trademark.

ᅚ C) The cost of an acquisition of a patent from an outside entity.
Explanation
The cost of an acquisition of a patent from an outside entity is correct because this cost may be capitalized. When patents and
copyrights are internally developed, only the legal fees incurred for registration can be capitalized. However, if the patents and
copyrights are purchased from other entities, full acquisition cost can be capitalized. (Study Session 5, LOS 18.a)
Under U.S. generally accepted accounting principles (GAAP), which of the following costs associated with intangible assets is
most likely to be capitalized?
ᅚ A) The cost of an acquisition of a patent from an outside entity.

ᅞ B) The costs associated with an internally created trademark.
ᅞ C) Research and development costs associated with software development.
Explanation
The cost of an acquisition of a patent from an outside entity is correct because this cost may be capitalized.
On the lessee's cash flow statement, the principal portion of a finance lease payment is a:
ᅞ A) operating cash flow.

ᅚ B) financing cash flow.
ᅞ C) investing cash flow.
Explanation
The principal portion of a finance lease payment is a financing cash outflow for the lessee. The interest portion is an operating
cash outflow.
Meyer Investment Advisory and Smith Brothers Investments are operationally identical except that Meyer capitalizes some
costs that Smith expenses. Compared to Smith, Meyer is likely to have:
ᅞ A) higher debt/equity ratio and higher debt/assets ratio.

ᅚ B) higher cash flows from operations and lower cash flow from investing.
ᅞ C) lower profitability (ROA & ROE) in early years and higher in later years.
Explanation
The net cash flow remains the same regardless of which accounting method is used. But components of cash flows change
and cash flows from operations (CFO) will be higher when costs are capitalized and lower when expensed. On the other hand,
cash flows from investing (CFI) will be lower when costs are capitalized and higher when expensed. Compared to firms
expensing costs, firms that capitalize costs will have smaller debt to equity ratios and higher initial ROAs, but lower ROAs in
the future.
For a finance lease, the amount recorded initially by the lessee as a liability will most likely:
ᅚ A) equal the present value of the minimum lease payments at the beginning of the
lease.
ᅞ B) be less than the fair value of the leased asset.
ᅞ C) equal the total of the minimum lease payments.
Explanation
With a finance lease, both an asset and liability are reported on the lessee's balance sheet, with lease payments divided
between interest and principal components. The future payments on principal and interest must be discounted to present
value at the beginning of the lease.
If a lessee enters into a finance lease rather than an operating lease, it can expect to have a:
ᅞ A) higher return on assets.

ᅞ B) lower debt-to-equity ratio.
ᅚ C) higher debt-to-equity ratio.
Explanation
Leasing the asset with an operating lease avoids recognition of the debt on the lessee's balance sheet. Having fewer assets
and liabilities on the balance sheet than would exist if the assets were purchased increases profitability ratios (e.g., return on
assets) and decreases leverage ratios (e.g., debt-to-equity ratio). In the case of a finance lease, the assets are reported on
the balance sheet and are depreciated.
For firms that expense rather than capitalize costs, which of the following statements is least accurate?
ᅞ A) Net cash flows are the same regardless of which method is used.
ᅞ B) Higher debt/equity and debt/assets will occur because of lower asset and equity
levels.
ᅚ C) Lower ROA and ROE will occur because of higher asset and equity levels in the early
years.
Explanation
Firms that expense costs rather than capitalize costs will have lower ROE and lower ROA in early years. This occurs because
of lower profits and not because of higher assets and equity levels. Actually, the assets and equity are lower due to expensing
the costs.
An analyst determined the following information concerning Franklin, Inc.'s stamping machine:
Acquired seven years ago for $22 million

Straight line method used for depreciation
Useful life estimated to be 12 years
Salvage value originally estimated to be $4 million
The stamping machine is expected to generate $1,500,000 per year for five more years and will then be sold for $1,000,000.
Under U.S. GAAP, the stamping machine is:
ᅞ A) impaired because expected salvage value has declined.

ᅚ B) impaired because its carrying value exceeds expected future cash flows.
ᅞ C) not impaired.
Explanation
The carrying value of the stamping machine is its cost less accumulated depreciation. Depreciation taken through 7 years was
($22,000,000 - $4,000,000) / 12 × 7 = $10,500,000, so carrying value is $22,000,000 - $10,500,000 = $11,500,000. Because
the $11,500,000 carrying value is more than expected future cash flows of (5 × $1,500,000) + $1,000,000 = $8,500,000, the
stamping machine is impaired.
Two companies in the same industry are similar in all aspects except that the average age of the depreciable assets for
Company B is 10 times greater than the average age of the depreciable assets for Company A. Which of the following
statements is least likely accurate? Company B will have:
ᅞ A) higher taxes.
ᅞ B) lower depreciation expense.
ᅚ C) a competitive advantage in the future.
Explanation
Company A will most likely have a competitive advantage from using newer equipment on average. Company B's assets are
mostly depreciated. Therefore, depreciation expense will be lower and if all other aspects are similar, the earnings and taxes
for Company B will be higher.
Roger Margotta, the CFO of Brainchild, Inc., is considering several alternative methods of depreciation for long-term assets. With respect
to double-declining method of depreciation, which of the following statements is the most accurate?
ᅞ A) Asset turnover ratio will decrease over the life of the asset.
ᅞ B) Current ratio will increase over the life of the asset.
ᅚ C) Return on Investment will increase over the life of the asset.
Explanation
With the use of any accelerated method of depreciation, the deductions in assets and net income are greatest in the early years. For
DDB, the greatest impact is year 1. After year 1, net income will increase, increasing ROI.
Classifying a lease as an operating lease for a lessee, as opposed to a finance lease, will result in:
Asset Turnover
Current Ratio Debt/Equity Ratio
Ratio
ᅞ A) Higher Lower Lower
ᅞ B) Lower Lower Higher
ᅚ C) Higher Lower Higher
Explanation
For a lessee using operating leases, the current ratio will be higher, the debt/equity ratio will be lower, and the asset turnover
will be higher than they would be with finance leases. With operating leases, assets and liabilities are lower.
An analyst will most likely use the average age of depreciable assets to estimate the company's:
ᅚ A) near-term financing requirements.
ᅞ B) earnings potential.
ᅞ C) cash flows.
Explanation
Average age of depreciable assets is useful for two reasons:
1. To assess how competitive the corporation will be going forward (older assets are less efficient).
2. To estimate financing required for major capital expenditures in the near-term to replace depreciated assets.
Which of the following statements about leasing is least accurate?

ᅞ A) Firms that capitalize their leases will have lower current ratios and higher debt
to equity ratios than firms that structure their leases as operating leases.
ᅚ B) If the lessor is only financing the purchase of an asset, the lease is considered to be a
direct financing lease and gross profits are recognized at the inception of the lease.
ᅞ C) The interest rate implicit in a lease is the discount rate that the lessor used to
determine the lease payments.
Explanation
With a direct financing lease, the lessor recognizes profit as interest revenue over the life of the lease. A sales-type lease
allows the lessor to recognize profits at the lease inception.
Ending gross investment/depreciation expense is used to estimate the average:
ᅞ A) age as a percent of depreciable life.

ᅚ B) depreciable life.
ᅞ C) age.
Explanation
Average depreciable life is approximated by: ending gross investment / depreciation expense
When comparing capitalizing versus expensing costs which of the following statements is most accurate?
ᅚ A) Capitalizing costs creates higher cash flows from operations and lower cash
flows from investing.
ᅞ B) Capitalizing costs creates lower cash flows from operations and higher cash flows
from investing.
ᅞ C) Expensing costs creates lower cash flows from operations and lower cash flows from
investing.
Explanation
Although net cash flows are not affected by the choice of capitalization or expensing, the components of cash flow are
affected. Because, a firm that capitalizes classifies the expenditure as investing (not operations), cash flow from operations will
be higher for firms that capitalize and investing cash flows will be lower than that of an expensing firm.
Compared to an operating lease, a lessee using a finance lease is least likely to have:
ᅞ A) lower net income in the earlier years of the lease.

ᅞ B) a lower current ratio.
ᅚ C) higher cash flow from financing during the lease period.
Explanation
Since a portion of the lease payment is treated as repayment of principal under a finance lease, cash flow from financing will
be lower.
A company is switching from straight-line depreciation to an accelerated method of depreciation. Assuming all other revenue and
expenses are at the same levels for the next period, switching to an accelerated method will most likely increase the company's:
ᅞ A) net income/sales ratio.
ᅚ B) fixed asset turnover ratio.
ᅞ C) total assets on the balance sheet.
Explanation
The use of an accelerated depreciation method will increase depreciation expenses early in the asset's life. The book value of the asset
will be lower. Fixed asset turnover ratio (sales/fixed assets) will increase, because the book value of the fixed assets will be lower.
Compared with firms that expense costs, firms that capitalize costs can be expected to report:
ᅞ A) lower asset levels and higher equity levels in the early years of the asset's life.
ᅞ B) higher asset levels and lower equity levels in the early years of the asset's life.
ᅚ C) higher asset levels and higher equity levels in the early years of the asset's life.
Explanation
The capitalized cost is recorded as an asset, which is then expensed in the form of depreciation over future years. Spreading
the depreciation out over future years causes net income to increase along with retained earnings and equity in the early
years of the asset's life.
Which of the following statements regarding capitalizing versus expensing costs is least accurate?
ᅚ A) Total cash flow is higher with capitalization than expensing.

ᅞ B) Capitalization results in higher profitability initially.
ᅞ C) Cash flow from investing is higher with expensing than with capitalization.
Explanation
Total cash flow is higher with capitalization than expensing is least accurate because total cash flow would be the same under
both methods, not considering tax implications.
In a direct-financing lease, the implicit rate is such that the present value of the minimum lease payments:
ᅚ A) equals the cost of the leased asset.

ᅞ B) is lower than the cost of the leased asset.
ᅞ C) equals the sale price of the leased asset.
Explanation
In a direct-financing lease, the implicit rate is such that the present value of the MLPs equals the cost of the leased asset.
Thus, at lease inception the total assets do not change and no gain is recognized.
Capitalizing interest costs related to a company's construction of assets for its own use is required by:
ᅚ A) both IFRS and U.S. GAAP.

ᅞ B) IFRS only.
ᅞ C) U.S. GAAP only.
Explanation
Both U.S. GAAP and IFRS require companies to capitalize the interest that accrues during a the construction of capital assets
for their own use.
Which of the following statements about leases is least accurate?
ᅞ A) In the first years of a finance lease, the lessee's debt to equity ratio is greater
than it would have been if the firm had used an operating lease.
ᅞ B) All else equal, when a lease is capitalized the lessee's income will rise over the term of
the lease.
ᅚ C) In the first years of a finance lease, the lessee's current ratio is greater than it would
have been had the firm used an operating lease.
Explanation
From the lessee's perspective, if a lease is considered to be a finance lease instead of an operating lease, then the lessee's
current liabilities will be greater until the lease has expired. This will result in a lower current ratio (larger denominator).
In the early years, the capitalized lease expense (interest plus depreciation) is greater than in the later years because interest
expense decreases over time. Less expenses = more income.
In the first years of a finance lease the lessee's debt to equity ratio will be greater than if the firm had used an operating lease
because in the case of the finance lease, the numerator is comprised of (debt + lease), while the numerator in the case of the
operating lease is (debt) only. In addition, the greater capitalized lease expense flows through to decrease shareholder's
equity (the denominator).
A firm that capitalizes rather than expensing costs will have:
ᅞ A) lower profitability in the earlier years.

ᅞ B) lower cash flows from operations.
ᅚ C) lower cash flows from investing.
Explanation
A firm that capitalizes costs classifies them as an investing cash flow rather than an operating cash flow. Investing cash flows
will be lower and cash flow from operations will be higher when costs are capitalized.
Which of the following statements regarding the capitalization of an expense is least accurate?
ᅞ A) Capitalized expenses increases equity.

ᅚ B) Capitalizing an expense lowers current period net income.
ᅞ C) Capitalizing an expense creates an asset.
Explanation
Capitalizing expenses reduces current period expenses by the amount capitalized. The amount capitalized is added to assets
which increases equity by increasing net income and retained earnings in the current period.
Selected information from Yorktown Corp.'s financial statements for the year ended December 31, 2004 was as follows (in $
millions):
Accounts Payable 8
Long-term Debt 9
Common Stock 17
Retained Earnings 23
Total Liabilities & Equity 57

In 2004, Yorktown paid $10 million cash to purchase a franchise. The franchise cost was fully expensed in 2004. If the
company had elected to amortize the franchise cost over 5 years instead of expensing it, Yorktown's debt ratio would (ignoring
taxes):
ᅞ A) increase from 0.158 to 0.184.

ᅞ B) decrease from 0.184 to 0.138.
ᅚ C) decrease from 0.158 to 0.138.
Explanation
The debt ratio is the ratio of total debt (which excludes accounts payable) to total assets. Total assets must equal total
liabilities and equity. Yorktown's total debt ratio was Total debt / Total assets = $9 / $57 = 0.158. If the franchise cost were
amortized, retained earnings would increase by $8 million ($10 cost, less $10/5 = $2 million of amortization.) The debt ratio
would decrease to $9 / ($57 + $8) = 0.138.
Dobkin Company decides to expense costs that it would have otherwise capitalized. Compared to capitalizing, expensing these costs will
result in:
ᅞ A) lower asset levels and lower liability levels.
ᅞ B) lower asset levels and higher equity levels.
ᅚ C) lower asset levels and lower equity levels.
Explanation
Expensing instead of capitalizing results in lower assets. Since the entire expense is recognized in the current period (whereas only a
portion of the expenditure is amortized when capitalizing), net income (and therefore equity, via retained earnings) is lower with expensing
than with capitalizing. Liabilities are unaffected.
The lessee has an incentive to classify a lease as an operating lease, rather than as a finance lease, because an operating
lease:
ᅞ A) has no risk involved because the lessor assumes all risk.

ᅞ B) has payments that are less than a capital lease's payments.
ᅚ C) does not appear on the balance sheet.
Explanation
Having less assets and liabilities on the balance sheet than would exist if the asset were purchased increases profitability
ratios (e.g., return on assets) and decreases leverage ratios (e.g., the debt to equity ratio).

Under U.S. GAAP, which statement is CORRECT?
ᅞ A) Goodwill cannot be recognized and capitalized in a purchase transaction.

ᅞ B) Research and development costs are not expensed.
ᅚ C) Purchased patent and copyright costs are not expensed.
Explanation
Purchased patent and copyright costs are not expensed is correct because these costs are capitalized.
A manufacturing firm reports the following in its financial statements:
Gross plant and equipment: $2,700,000.

Depreciation expense: $235,000.
Accumulated depreciation: $1,850,000.
The average useful life of plant and equipment is closest to:
ᅚ A) 11.5 years.
ᅞ B) 15.4 years.
ᅞ C) 19.4 years.
Explanation
The average useful life = gross investment / depreciation expense
$2,700,000 / $235,000 = 11.49.
(LOS 18.d)
The average age of plant and equipment is closest to:
ᅞ A) 19.4 years.
ᅞ B) 11.5 years.
ᅚ C) 7.9 years.
Explanation
The average age = accumulated depreciation / depreciation expense
$1,850,000 / $235,000 = 7.87
(LOS 18.d)

The average remaining life of plant and equipment is closest to:
ᅚ A) 3.6 years.
ᅞ B) 11.5 years.
ᅞ C) 7.9 years.
Explanation
The average remaining life = average useful life − average age = 11.49 − 7.87 = 3.62 years.
Average remaining life = Net PP&E / annual depreciation = (2,700,000 − 1,850,000) / 235,000 = 3.62. (LOS 18.d)
The impairment loss recognized under U.S. GAAP is most likely equal to the difference between the asset's carrying value
and:
ᅞ A) fair value minus selling cost, subject to a recoverability test.

ᅞ B) value in use, subject to a recoverability test.
ᅚ C) fair value, subject to a recoverability test.
Explanation
U.S. GAAP impairment loss recognition is a 2-step process. Step 1: Recoverability test. Step 2: Loss measurement = carrying
value − fair value or carrying value − PV of future cash flows. (LOS 18.c)
The impairment loss recognized under IFRS is most accurately described as the difference between carrying value and:
ᅞ A) fair value.
ᅞ B) value in use minus selling cost.
ᅚ C) fair value minus selling cost.
Explanation
IFRS impairment measurement = carrying value − (fair value − selling costs) or carrying value − value in use. (LOS 18.c)
Recognition of an impairment loss would improve which of the following ratios?
ᅞ A) Current year net profit margin.

ᅚ B) Future ROE.
ᅞ C) Current year ROA.
Explanation
An impairment loss would reduce the current year's net income but would lead to lower depreciation expense. This would
lower current year net profit margin, ROA and ROE. However future ROE would improve due to lower depreciation expense in
the future. (LOS 18.c)
Under U.S. Generally Accepted Accounting Principles (GAAP), development cost of patents and copyrights can be capitalized:
ᅞ A) when developed internally.

ᅚ B) when purchased from other entities.
ᅞ C) when purchased or developed internally but excluding registration costs.
Explanation
When patents and copyrights are internally developed, only the legal fees incurred for registration can be capitalized.
However, if the patents and copyrights are purchased from other entities, full acquisition cost can be capitalized.
Taking an impairment of long-lived assets will result in:
ᅞ A) increased deferred tax liabilities.

ᅞ B) decreased debt/equity ratio.
ᅚ C) increased future ROA.
Explanation
In future years, less depreciation expense is recognized on the written-down asset resulting in higher net income and return
on assets since ROA = NI/Total Assets. Deferred tax liabilities related to the asset decrease because the impairment cannot
be deducted from taxable income until the asset is sold or disposed of. The debt/equity ratio increases because equity
decreases while debt is unchanged.
Selected information from Ingot Company's financial statements for the year ended December 31, 20X4, was as follows prior
to the consideration of its impaired asset write-down (in $):
Cash 120,000 Short-term Debt 290,000

Accounts Receivable 200,000 Long-term Debt 740,000
Inventory 300,000 Common Stock 800,000
Property Plant & Eq. (net) 1,700,000 Retained Earnings 490,000

2,320,000 2,320,000
Ingot Company's excavation machine is permanently impaired. Its purchase price was $1,600,000 and its accumulated
depreciation was $800,000 through 20X4. The present value of its future cash flows is $500,000.
The write-down of the excavation machine will cause Ingot's total debt ratio (total debt-to-total capital) to:
ᅚ A) increase from 0.44 to 0.51.
ᅞ B) decrease from 0.44 to 0.40.
ᅞ C) increase from 0.44 to 0.48.
Explanation
The write-down of the excavation machine in the amount of ((($1,600,000 − $800,000) − $500,000) =) $300,000 decreases
retained earnings from $490,000 to $190,000. The total debt to total captital ratio increases from (($290,000 + $740,000) /
($290,000 + $740,000 + $800,000 + $490,000) =) 0.44 to (($290,000 + $740,000) / ($290,000 + $740,000 + $800,000 +
$190,000) =) 0.51.
Davis Inc. is a large manufacturing company operating in several European countries. Davis has long-lived assets currently in
use that are valued on the balance sheet at $600 million. This includes previously recognized impairment losses of $80 million.
The original cost of the assets was $750 million. The fair value of the assets was determined by in independent appraisal to be
$690 million. Which of the following entries may Davis record under IFRS?
ᅚ A) $80 million gain on income statement and a $10 million revaluation surplus.
ᅞ B) $90 million gain on income statement.
ᅞ C) $90 million revaluation surplus.
Explanation
Under IFRS, firms may choose to report long-lived assets at fair value. Upward revaluations are permitted and will result in a
gain recognized on the income statement to the extent it reverses a previously recognized loss. Any excess is reported as a
revaluation surplus, a direct adjustment to equity. In this case, the carrying value of the assets is $600 million ($750 million
original cost less $70 million accumulated depreciation and less $80 million impairment loss). The fair value is $690 million. Of
the $90 million excess of fair value over carrying value, $80 million is recognized as a gain on the income statement to reverse
the $80 million impairment loss that was previously recognized. The remaining $10 million is recorded as a revaluation surplus
in shareholders' equity.
Under an operating lease (versus a finance lease) which of the following is higher for the lessee?
ᅚ A) Cash flow from financing.

ᅞ B) Assets.
ᅞ C) Cash flow from operations.
Explanation
The lessee's cash flows from financing will be higher for an operating lease because the payments made for an operating
lease are operating cash outflows, not financing cash outflows. The payments made under a finance lease are split between
interest paid and principal. The latter is charged to cash flow from financing.
Which of the following statements regarding finance and operating leases is least accurate?
ᅚ A) For financial reporting of finance and operating leases, no entry is required on

the lessee's balance sheet at the inception of the lease.
ᅞ B) Asset turnover is higher for the lessee with an operating lease than a finance lease.
ᅞ C) During the life of an operating lease, the rent expense equals the lease payment.
Explanation
If the lease is an operating lease there is no entry made on the balance sheet for the lessee. For finance leases, the leased
asset and liability are recognized on the balance sheet by the amount equal to the present value of the minimum lease
payments using as the discount rate the lower of the lessor's implicit rate or the lessee's incremental borrowing rate.
Under U.S. GAAP, an asset is impaired when:
ᅞ A) accumulated depreciation plus salvage value exceeds acquisition costs.

ᅞ B) the present value of future cash flows exceeds the carrying amount of the asset.
ᅚ C) the firm can no longer fully recover the carrying amount of the asset.
Explanation
An asset is impaired if its future cash flows (undiscounted) are less than its carrying value.
The management of Berger Investments has changed their policy and will capitalize some costs instead of expensing them.
Due to the new policy, Berger will:
ᅞ A) report a smooth income pattern initially, but income variability will increase
over time.
ᅚ B) have smoother reported income over time.

ᅞ C) have lower income variability as it grows, but the variability will increase as the firm
matures.
Explanation
If management decides to capitalize costs instead of expensing them, it will report smoother reported income over time. If the
firm decided to expense costs as incurred, it will have greater variability in reported income. This variability declines as the firm
matures and is lower for larger firms.

Which of the following is least likely one of the criteria under U.S. GAAP for classifying a lease as a finance lease? The:
ᅞ A) term of the lease is 75% or more of the estimated economic life of the leased
property.
ᅞ B) lease contains a bargain purchase option.
ᅚ C) lessor retains ownership of the property at the end of the lease term.
Explanation
If the lease transfers ownership of the property to the lessee at the end of the lease term, the lessee will classify the lease as a
finance lease.
For a given lease payment and term, which of the following is least accurate regarding the effects of the classification of the
lease as a finance lease as compared to an operating lease?
ᅞ A) The lessee's asset turnover will be lower for a finance lease.

ᅚ B) The lessee's current ratio will be higher for a finance lease.
ᅞ C) The lessee's debt-to-equity ratio will be higher for a finance lease.
Explanation
The lessee's current ratio will be lower because the current portion of the finance lease increases current liabilities, hence
reducing the current ratio.
Which of the following statements regarding a direct financing lease is least accurate?
ᅞ A) The lessor recognizes no gross profit at the inception of the lease.

ᅚ B) Interest revenue on the lessor's income statement equals the implicit interest rate
times the lease payment.
ᅞ C) The principal portion of the lease payment is a cash inflow from investing on the
lessor's cash flow statement.
Explanation
Interest revenues are calculated by multiplying the implicit interest rate by net receivables at the beginning of the period.
Compared to a finance lease, an operating lease is most likely to be favored when:

ᅞ A) at the end of the lease, the lessee may be better able to sell the asset than the
lessor.
ᅚ B) the lessee has bond covenants relating to financial policies.
ᅞ C) management compensation is not based on returns on invested capital.
Explanation
If the lessee has bond covenants (e.g., debt-to-equity ratio) relating to its financial policies that it must follow, it is best to have
an operating lease due to the fact that the operating lease will keep the asset off of the balance sheet resulting in less
liabilities.
As part of a major restructuring of business units, General Security (an industrial conglomerate operating solely in the U.S. and
subject to U.S. GAAP) recognizes significant impairment losses. The Investor Relations group is preparing an informational
packet for shareholders, employees, and the media. Which of the following statements is least accurate?
ᅞ A) During the year of the write-downs, retained earnings and deferred taxes will
decrease.
ᅚ B) Write-downs taken on asset values can be reversed in later years if market conditions
improve.
ᅞ C) The write-downs are reported as a component of income from continuing operations.
Explanation
Impairments cannot be restored under U.S. GAAP. Both remaining statements are correct.
Which of the following statements comparing straight-line depreciation methods to alternative depreciation methods is least
accurate? Companies that use:
ᅚ A) accelerated depreciation methods will have lower asset turnover ratios than if
they used straight line depreciation.
ᅞ B) straight-line depreciation methods will have higher book values for the assets on the
balance sheet than companies that use accelerated depreciation.
ᅞ C) accelerated depreciation methods for tax purposes will decrease the amount of taxes
paid in early years.
Explanation
Accelerated depreciation will lead to lower book values and hence a higher asset turnover ratio.

An analyst compares two companies that are identical except that Company X uses finance leases and Company Y uses
operating leases. The analyst would expect Company X's debt-to-equity ratio, relative to Company Y's, to be:
ᅚ A) higher.
ᅞ B) lower.
ᅞ C) the same.
Explanation
Lease capitalization adds both current and noncurrent liabilities to debt, resulting in a corresponding increase in the debt-to-
equity and other leverage ratios. Thus, Company X's (Debt + Lease)/Equity is greater than Company Y's Debt/Equity.
Selected information from Willingham Corp.'s financial statements for the year ended December 31 included the following (in $ millions):
Accounts Payable 12
Long-term Debt 32
Common Stock 10
Retained Earnings 16
Total Liabilities and Equity 70
During the year, Willingham paid $14 million cash to purchase a franchise and fully expensed the franchise cost. If the company had
elected to amortize the franchise cost over 7 years instead of expensing it, Willingham's total asset-to-equity ratio would be closest to:
ᅞ A) 3.15.
ᅚ B) 2.16.
ᅞ C) 1.84.
Explanation
Given that total assets must equal total liabilities and equity, Willingham's total asset-to-equity ratio was 70 / (10 + 16) = 2.69. If the
franchise cost were amortized, retained earnings would be $12 million higher ($14 million cost less 14 / 7 = $2 million of amortization). The
total asset-to-equity ratio would decrease to (70 + 12) / (10 + 16 + 12) = 2.16.
If a lease is treated as a finance lease, as compared to being treated as an operating lease, the effect on the lessee's current
ratio and the debt/equity ratio will be an:
Debt/Equity
Current Ratio
Ratio
ᅞ A) Increase Increase
ᅚ B) Decrease Increase
ᅞ C) Increase Decrease
Explanation
With finance leases the lessee's assets, current liabilities, and long-term liabilities will be greater than if the lease was an
operating lease. With the debt to equity ratio, the liability is in the numerator, which results in an increase in the ratio. With the
current ratio, current liabilities are increased and are in the denominator which results in a decrease in the ratio.
Compared to firms that expense costs, firms that capitalize expenses will have:
ᅞ A) higher leverage ratios.
ᅞ B) lower cash flow from operations.
ᅚ C) lower income variablity.
Explanation
Firms that capitalize expenses have less variability of net income because the capitalized expense becomes an asset that is depreciated
over years instead of all at once which happens when costs are expensed. Capitalizing expenses will result in higher cash flows from
operations because capitalizing an expense becomes an investing cash flow instead of an operating cash flow which occurs when
expenditures are expensed. Firms that capitalize expenses have lower leverage ratios because assets and equity are increased so any
leverage ratio that have assets and equity in the denominator will decrease.
Selected information from the financial statements of Salvo Company for the years ended December 31, 2003 and 2004 is as follows (in $
millions):
2003 2004
Sales $21 $23
Cost of Goods Sold (8) (9)
Gross Profit 13 14
Cost of Franchise (6) 0
Other Expenses (6) (6)
Net Income $1 $8
Cash $4 $5
Accounts Receivable 6 5
Inventory 9 7
Property, Plant & Equip. (net) 12 15
Total Assets $31 $32
Accounts Payable $7 $5
Long-term Debt 10 5
Common Stock 8 8
Retained Earnings 6 14
Total Liabilities and Equity $31 $32
Salvo's return on average total equity for 2004 was ($8 / (($8 + $6) + ($8 + $14)) / 2 =) 44.4%.
If Salvo had amortized the cost of the franchise acquired in 2003 over six years instead of expensing it, Salvo's return on average total
equity for 2004 would have decreased from 44.4% to:
ᅚ A) 31.1%.
ᅞ B) 35.6%.
ᅞ C) 38.9%.
Explanation
If the franchise cost had been amortized over six years beginning in 2003, net income in 2003 would have been $6 million instead of $1
million due to the cost of franchise expense of $6 million being eliminated and replaced by franchise amortization of $1 million. Net
income in 2004 would have been reduced by the franchise amortization to $7 million instead of $8 million. On the equity side, retained
earnings at the end of 2003 would have been $11 million ($5 million higher), and total equity for 2003 would have been ($8 + $11 =) $19
million. Retained earnings for 2004 would be the 2003 retained earnings of $11 million increased by 2004 net income of $7 million for a
total of $18 million, and total equity for 2004 would be ($8 + $18 =) $26 million. If the franchise cost were amortized, return on total equity
for 2004 would be ($7 / ((19 + 26) / 2 =) 31.1%.
Which of the following statements regarding the effect of a finance lease on the lessee's statement of cash flows is least accurate?
ᅞ A) The change in the finance lease liability on the balance sheet is a cash flow from
financing.
ᅞ B) The interest expense portion of the lease payments reduces cash flow from operations.
ᅚ C) The rental expense serves to reduce the cash flow for financing because it is an investment
expense.
Explanation
In finance leases, there is only interest expense and principal repayment. Rental expense is only charged when the lease is an operating
lease.
Which of the following statements about the impact of leases on the financial statements of the lessee is least accurate?
ᅞ A) A finance lease results in higher liabilities compared to an operating lease.
ᅚ B) Cash flow from investing is higher for a finance lease than an operating lease.
ᅞ C) Net income is lower in the early years of a finance lease than an operating lease.
Explanation
Cash flow from investing is not affected by a lease being either a finance or an operating lease. Finance leases reduce cash flow from
operations by only the portion of the lease payment attributed to interest expense. Cash flow from financing is reduced by the rest of the
finance lease payment which is the principal part of the payment.
Intercorporate Investments Test ID: 7440409
Company A acquired a 50% stake in Company T on January 1, 2003 by paying T's shareholders $100,000 in cash. Pre
acquisition balance sheets for the two firms are presented below:
Balance Sheet
Company A Company T
Current assets $400,000 $60,000
Fixed assets 600,000 100,000
Total $1,000,000 $160,000
Current liabilities $50,000 $ 30,000
Common stock 350,000 60,000
Retained earnings 600,000 70,000
Total $1,000,000 $160,000
What are the postacquisition balance sheet values for total assets for Company A under the equity and acquisition methods of
accounting respectively?
✗ A) $1,060,000 and $1,000,000.
✗ B) $1,060,000 and $1,060,000.
✓ C) $1,000,000 and $1,060,000.
Explanation
Using the equity method will result in a decrease of the current asset account to $300,000 because of the cash outflow.
However, a new noncurrent asset called "Investment in Company T" will be added to the balance sheet. This amount will be
$100,000, so the total assets will remain unchanged. Under acquisition, total assets will be $1,060,000 (400,000 + 60,000 +
600,000 + 100,000 100,000).
Questions #27 of 117
James White works in the compliance and reporting department of Linnekt Inc., a large transportation company based on the
west coast of the U.S.A. Linnekt has a small investment division which holds U.S. equities as a source of income. Linnekt's has
no clear investment strategy, holding some stocks long term aiming for capital growth, and some short term with a view to
turning a quick profit.
White is currently putting together a presentation for the investment department to show the impact of different accounting
treatments on the group accounts.
White is considering the securities shown in exhibit 1, all of which are currently held by GLI.
Exhibit 1 Security Information
Security Cost 2005 Value 2006 Value
ABC $80 $75 $85
HIJ $20 $30 $35
XYZ $40 $20 $45
Linnekt holds 100,000 shares of each security. None of the holdings represents more than a 1% ownership in the respective
company. As a result Linnekt has no significant influence over the any of the companies.
In addition to the securities shown in Exhibit 1, Linnekt purchased 40,000 shares in Trackite Inc. on the first day of this period.
White has been tasked with deciding on the correct accounting treatment for this holding.
Trackite is a supplier of materials to several of Linnekt's divisions and the investment was initially made with a view to gaining
significant influence over Trackite's operations through further share purchases. This plan was put hold, however, due to
tough economic conditions during the year.
However, Linnekt intends to hold the shares permanently and may revisit increasing the holding to gain significant influence in
the future.
White's supervisor, Dan Gatuso believes that the treatment of the shares is straightforward and sent White an email with the
following recommendations:
Recommendation 1
As the shares are to be held permanently they should be valued at cost
Recommendation 2
Dividends should be taken to the income statement
Which of the following statements regarding the income statement and balance sheet treatment of securities classified as
heldtomaturity is most accurate? They are carried at:
✓ A) cost on the balance sheet and coupon receipts are considered income.
✗ B) cost on the balance sheet and realized and unrealized gains are taken to the income
statement.
✗ C) fair market value on the balance sheet with unrealized gains and losses excluded from
income and reported as a separate component of shareholders' equity.
Explanation
Accounting standards require a company to classify its securities into categories based upon the company's intent relative to
the eventual disposition of the securities.
One of these categories, heldtomaturity securities, is composed of debt securities which a company has the positive intent
and ability to hold to maturity. These securities are carried at the cost on the balance sheet and coupon receipts are
considered income.
(LOS 19.a)
How many of Gatuso's recommendations are most likely accurate?
✓ A) Recommendation two only
✗ B) Recommendation one only
✗ C) Both recommendations
Explanation
Shares cannot be classified as held to maturity. If they are not held for trading purposes, then they should be shown at fair
value on the balance sheet. Dividend income should be taken to the income statement and unrealized gains and losses to
other comprehensive income.
(LOS 19.b)
availableforsale is most accurate? They are carried at:
✗ A) fair market value on the balance sheet with unrealized gains and losses
reported in income.
✗ B) cost on the balance sheet and coupon receipts are considered income.
✓ C) fair market value on the balance sheet with unrealized gains and losses excluded from
income and reported as a separate component of shareholders' equity.
Explanation
One of these categories, availableforsale securities, may be sold to address the liquidity and other needs of a company. Debt
and equity securities classified as availableforsale are carried at fair market value on the balance sheet with unrealized gains
and losses excluded from income and reported as a separate component of shareholders' equity.
(LOS 19.a)
trading securities is most accurate? They are carried at:
✓ A) fair market value on the balance sheet with unrealized gains and losses
reported in income.
✗ B) fair market value on the balance sheet with unrealized gains and losses excluded from
income and reported as separate component of shareholders' equity.
✗ C) cost on the balance sheet with unrealized gains and losses reported in income.
Explanation
One of these categories, trading securities, is for debt and equity securities acquired for the purpose of selling them in the
near term. These securities are measured at fair market value and are listed as current assets on the balance sheet.
Unrealized and realized gains and losses are reported in income.
(LOS 19.a)
If the securities are classified as trading securities the balance sheet value for the portfolio at yearend 2005 is:
✓ A) $12,500,000 and record an unrealized loss of $1,500,000.
✗ B) $12,500,000 and record no gains or losses.
✗ C) $14,000,000 and record no gains or losses.
Explanation
The original portfolio cost was: $8,000,000 + $2,000,000 + $4,000,000 = $14,000,000
In 2005: $7,500,000 + $3,000,000 + $2,000,000 = $12,500,000
Thus we write the portfolio down by $1,500,000 and take an unrealized loss.
(LOS 19.b)
If the securities are classified as trading securities the balance sheet value for the portfolio at yearend 2006 is:
✗ A) $16,500,000 and record an unrealized gain over the past year of $2,500,000.
✓ B) $16,500,000 and record an unrealized gain over the past year of $4,000,000.
✗ C) $14,000,000 and record an unrealized gain over the past year of $2,500,000.
Explanation
The original portfolio cost was: $8,000,000 + $2,000,000 + $4,000,000 = $14,000,000
In 2005 the value of the portfolio was: $7,500,000 + $3,000,000 + $2,000,000 = $12,500,000
In 2006 the value of the portfolio was: $8,500,000 + $3,500,000 + $4,500,000 = $16,500,000
We write the balance sheet value up to current value and recognize an unrealized gain of $4,000,000.
(LOS 19.b)
A company reports an intercorporate investment using the acquisition method. Which of the following statements is most
accurate?
✗ A) The use of the equity method by a company will generally report the same
results.
✗ B) The use of the acquisition method by a company will generally report the more
favorable results.
✓ C) The use of the acquisition method by a company will generally report the less
favorable results.
Explanation
The equity method will provide more favorable results, while the acquisition method will provide less favorable results.
Which of the following methods of accounting for investments will reflect the highest net income on a company's income
statement?
✓ A) Both methods report the same net income.
✗ B) Acquisition method.
✗ C) Equity method.
Explanation
Both methods will report the same net income.
Under U.S. GAAP rules, where an investor owns 41% of the voting shares of an investee and is able to control the investee,
which of the following methods of accounting is most appropriate to use?
✓ A) Acquistion method.
✗ B) Equity method.
✗ C) Proportionate consolidation method.
Explanation
It is possible to control with less than a 50% ownership interest. In this case, the investment is still considered controlling and
the acquisition method would be most appropriate.
Which of the following statements about variable interest entities (VIE) are correct or incorrect?
Statement #1 One potential benefit of a VIE is a lower cost of capital since the assets and
liabilities of the VIE are isolated in the event the sponsor experiences
financial difficulties.
Statement #2 The organizational form of a VIE must be either a partnership or a joint
venture and it is necessary for the VIE to have separate management and
employees.
✓ A) Only one is correct.
✗ B) Both are correct.
✗ C) Both are incorrect.
Explanation
Statement #1 is a correct statement. A lower cost of capital is a potential benefit of forming a VIE. Statement #2 is an incorrect
statement. The organizational form can be a corporation, partnership, joint venture or trust. It is not necessary for the VIE to
have separate management and employees.
On December 15, 2009, the Zeisler Company faces a financial crisis. Zeisler's industry has gone into recession and net
income has declined to nearly zero. Jeremiah Welch, the company's CFO, is extremely concerned that, when the final figures
for 2009 come in, the poor operating results will throw the firm into violation of its debt covenants, which specify that it must
meet a certain return on assets (ROA) and not exceed a certain debttoasset ratio. A violation of either covenant would trigger
a provision in the lending agreement allowing lenders to put Zeisler's debt back to the firm and likely force Zeisler into
bankruptcy.
With only two weeks before the close of the firm's fiscal year on December 31, there is no way to avoid bankruptcy through
improved operations. Welch calls an emergency meeting with Olivia Dupree, the firm's controller, to come up with a plan of
action to keep Zeisler out of bankruptcy. He explains to Dupree that they need to increase Zeigler's reported ROA and reduce
its reported debttoassets ratio relative to the numbers that would otherwise be reported for 2009.
Dupree suggests that Zeisler's equity investments might be useful in staving off bankruptcy. Zeisler acquired 100,000 shares
of the Market Square Corporation on January 1, 2009, at $25 per share. Market Square paid dividends during 2009 of $1.50
per share and was expected to have earnings for 2009 of $2.50 per share. Zeisler also holds 250,000 shares of General
Nuclear, purchased for $72 per share. General Nuclear has no dividends and is expected to report a loss for 2009. Both
securities are classified on the financial statements as availableforsale.
Dupree added that Zeisler also holds several million dollars of Market Square's debt securities, classified as a heldtomaturity
investment. The holding in Market Square represents a small fraction of Zeisler's total fixedincome investments, all of which
are also classified as heldtomaturity. The investment in Market Square's debt differs significantly from Zeisler's other
investments in fixedincome securities in that Market Square's debt is trading slightly above Zeisler's cost while Zeisler's other
fixedincome investments are all trading significantly below Zeisler's cost because of a general increase in market interest
rates. Welch points out, however, that even if the firm were to sell all its marketable securities, the proceeds would not be
sufficient to pay off the debt and avert bankruptcy.
Dupree left the meeting with Welch for a moment to check the stock market. She found that Market Square was trading at $35
per share and General Nuclear was at $43. This new information gave Dupree an idea.
Dupree suggested to Welch, "We could reclassify our equity investment in Market Square as trading before yearend. That will
help raise our ROA for this year." Welch pointed out that a reclassification of the equity investment from availableforsale to
trading would reduce Zeisler's reported net income because the firm would be required to stop including the dividends it
receives from Market Square in net income.
Welch suggested that, instead of reclassifying Market Square's equity, they sell Market Square's debt. That would reduce
Zeisler's debttoassets ratio because the unrealized gain in the market value of the Market Square debt would be realized
when the security was sold. Dupree added that the firm could also liquidate the General Nuclear investment to raise cash
without affecting the firm's reported ROA for 2009. Welch and Dupree decided to liquidate the two assets to help improve the
firm's financial position.
What is the investment income that Zeisler Company will report for the year 2009 on its investment in Market Square
Corporation shares if it continues to account for the shares as an availableforsale investment?
✓ A) $150,000.
✗ B) $250,000.
✗ C) $200,000.
Explanation
The investment income for availableforsale securities includes dividends, interest, and realized gains. In this case, the
investment income from Market Square Corporation would be the dividends it paid to the number of shares Zeisler owns:
100,000 shares × $1.50 per share = $150,000. (Study Session 6, LOS 19.c)
If Zeisler were to account for the Market Square Corporation shares as trading securities, assuming that the securities do not
change in value between the December 15th meeting and the end of the year, the carrying amount of these shares on
Zeisler's December 31, 2009 balance sheet would be:
✓ A) $3.50 million.
✗ B) $2.50 million.
✗ C) $2.75 million.
Explanation
Trading securities are carried at fair market value:
100,000 shares × $35 per share = $3,500,000. (Study Session 6, LOS 19.c)
If Zeisler reclassified the common stock of General Nuclear as a trading security, what effect would it have on Zeisler's 2009
income statement?
✗ A) Reclassifying the security would have no effect on the income statement
because gains and losses would be recognized in equity.
✓ B) Net income would decline.
✗ C) Net income would increase.
Explanation
Reclassifying a security from availableforsale to trading requires unrealized gains and losses to be recognized in income.
Since Zeisler's investment in General Nuclear has an unrealized loss, net income would be reduced. (Study Session 6, LOS
19.c)
Regarding the statements made by Dupree and Welch about reclassifying Zeisler's equity investment in Market Square to
trading:
✓ A) Welch's statement is incorrect; Dupree's statement is correct.
✗ B) Welch's statement is correct; Dupree's statement is incorrect.
✗ C) Welch's statement is incorrect; Dupree's statement is incorrect.
Explanation
Welch's statement is incorrect because dividends and interest are recognized as income both when the securities are
classified as trading and when they are classified as availableforsale.
Dupree's statement is correct. Reclassifying the securities from availableforsale to trading will significantly raise Zeisler's
nearzero net income by allowing Zeisler to recognize the unrealized gain in income when the security is reclassified. It will
have no material effect on asset value because the shares will be carried at fair market value as trading securities and were
already carried at fair market value (with the net unrealized gain in equity) as availableforsale securities. Even though it may
appear that equity would decline by the amount of the unrealized gain if the securities were reclassified, the unrealized gain
will flow through income in 2009 and thus return to equity. Consequently, reclassifying the equity securities of Market Square
would help increase Zeisler's ROA by raising net income and having little effect on assets. (Study Session 6, LOS 19.c)
If Zeisler were to account for the Market Square Corporation shares using the equity method, assuming that the securities do
not change in value between the December 15th meeting and the end of the year, the carrying amount of these shares on
Zeisler's December 31, 2009 balance sheet would be:
✗ A) $3.50 million.
✓ C) $2.60 million.
Explanation
Under the equity method the market value of the stock is ignored but the proportionate share of the earnings are added to the
original investment and the proportionate share of the dividends are subtracted from the earnings. Hence, we have the original
investment + (earnings − dividends) = total value of the investment.
[(100,000 shares)($25)] + [(100,000 shares)($2.50 earnings − 1.50 dividend)] = $2,600,000. (Study Session 6, LOS 19.c)
Regarding the statements made by Welch about reclassifying Zeisler's debt investment in Market Square to trading, and
Dupree's statement on General Nuclear:
✓ A) Welch's statement is incorrect; Dupree's statement is incorrect.
✗ B) Welch's statement is correct; Dupree's statement is incorrect.
✗ C) Welch's statement is correct; Dupree's statement is correct.
Explanation
Welch's statement is incorrect because accounting standards require a firm that sells a heldtomaturity security before
maturity to carry its remaining heldtomaturity securities at market value instead of cost. Since the Market Square debt is the
only fixedincome investment trading above Zeisler's cost, and it represents only a small part of Zeisler's total fixedincome
portfolio, the net effect of selling the Market Square debt would be to reduce assets (not raise them) because it would require
Zeisler to mark down all its other fixedincome investments. A decline in assets would effectively increase the debt to assets
ratio.
Dupree's statement is also incorrect. The investment in General Nuclear would be carried on the books at fair market value,
with the unrealized loss in equity. Selling the asset and converting it to cash would not materially affect total assets. However,
selling the General Nuclear shares would reduce net income because the realized loss would have to be recognized in
income. Thus, the sale would reduce reported ROA. (Study Session 6, LOS 19.c)
GTH Corporation has just purchased 18% of the common stock of Pittor Corporation, one of their major suppliers, making
GTH the largest single shareholder in Pittor. The primary motivation for the purchase is that managerial problems at Pittor
have resulted in quality control difficulties, thereby affecting the reliability of several critical component parts for GTH products.
At the time of the purchase, GTH management announced they plan to be an active investor and exercise significant influence
on Pittor so the quality problems can be resolved. Given these circumstances, the accounting method used to record the
intercorporate investment will most likely be the:
✗ A) investment in financial assets method.
✗ B) acquisition method.
✓ C) equity method.
Explanation
Normally, due to the less than 20% ownership stake, investment in financial assets accounting would be used to record this
investment. However, percentage ownership rules are guidelines only and the appropriate accounting method is dependant on
the degree of influence the acquirer intends to exert. In this case, GTH has announced their desire to exert significant
influence, hence, the equity method is the appropriate choice.
Which of the following statements is INCORRECT regarding the classification of debt and equity security investments?
✗ A) If equity and debt securities are trading securities, any realized and unrealized gains
and losses are reported in the income statement.
✗ B) Debt heldtomaturity is reported in the balance sheet at amortized cost.
✓ C) If equity and debt securities are availableforsale securities, any realized and unrealized gains
and losses are reported in the income statement.
Explanation
In the case of availableforsale securities, unrealized gains and losses are excluded from the income statement and are reported as a
component of shareholders' equity.
Harter Company recently acquired a 40% stake in Compton Corp. for $40 million in cash by borrowing at 10%. Harter will account for this
acquisition using which of the following methods:
✗ A) Held to maturity debt securities method.
✓ B) Equity method.
✗ C) Acquisition Method.
Explanation
The 40% ownership stake would indicate significant control has been gained over the affiliate company. The equity method would be
used.
On January 9, 2006, Company X paid $2,000,000 for 100,000 shares of stock in Company S. Originally the company intended
on holding the securities for the foreseeable future. As of December 31, the stocks were valued at $2,200,000. In 2006,
Company S had earnings per share of $0.90 and paid dividends per share of $0.20. In late December 2006, the company
decided to place the securities in their active marketable securities portfolio.
What is the impact of this change in status on the value of the assets of Company X?
✗ A) $70,000.
✗ B) $200,000.
✓ C) $0.
Explanation
The stocks were classified as debt and equity securities available for sale, but now they will be classified as debt and equity
trading securities. However, although it will affect net income, the change in status will not impact the reported value of the
assets. According to SFAS 115, securities transferred from availableforsale to trading securities are transferred at fair market
value and unrealized gains or losses would be included in income.
What is the impact of this change in status on the income and the stockholders' equity of Company X?
✗ A) Income and stockholder's equity will rise by $200,000.
✗ B) Stockholders' equity will rise by $200,000, but income will not change.
✓ C) Income will rise by $200,000, but stockholders' equity will not change.
Explanation
The stocks were classified as debt and equity securities available for sale, but now they will be classified as debt and equity
trading securities. The gain would have been reported in the securities valuation account in the equity section and not on the
income statement, but now will be reported as income.
Acme Corporation purchases a 3% interest in Bandy Company to become the single largest shareholder of Bandy. Acme will hold a seat
on the Board of Directors of Bandy. Acme will account for its investment in Bandy using the:
✗ A) acquisition method.
✓ B) equity method.
✗ C) lower of cost or market method.
Explanation
Even though Acme's interest is low at only 3%, they have significant influence by having a seat on Bandy's Board of Directors. As such,
they must use the equity method.
Company X owns 15% of company S and exerts significant influence over the operations of the company. The book value of the
investment on December 31, 2001, is $48,000. In 2002, company S earned $100,000 and paid dividends of $20,000. The value of the
investment account on December 31, 2002, is:
✗ A) $63,000.
✗ B) $48,000.
✓ C) $60,000.
Explanation
Because company X exerts significant influence over company S, the investment will be treated using the equity method, even though
the ownership is less than the 20% guideline. The value of the investment account is equal to the beginning balance plus the
proportionate income of company S minus the dividends received from company S, which equals 48,000 + (0.15 x 100,000) − (0.15 x
20,000) = 60,000.
Accounting standards for passive intercorporate investments include a category of securities that is carried on the company
balance sheet at cost. This category of securities is called debt:
✗ A) and equity securities availableforsale.
✓ B) securities heldtomaturity.
✗ C) and equity trading securities.
Explanation
When debt securities are purchased with both the intent and ability to hold them until they mature, they are recorded on the
balance sheet at cost.
The factors that determine the required accounting methods for intercorporate investments under both U.S. GAAP and IFRS
rules are:
✗ A) degree of influence and whether the acquiring firm has the intent and ability to
hold the securities to maturity.
✗ B) purchase cost compared with book value of the interest purchased.
✓ C) percentage of ownership and/or degree of influence.
Explanation
The factors that determine the required accounting method for intercorporate investments are percentage of ownership and/or
degree of influence over the investee firm. The principal accounting methods are cost, equity, and consolidation under both
U.S. GAAP and IFRS rules.
Rocky Mountain Air Cargo is a privately held commercial aviation company serving the western United States. It publishes
financial statements in accordance with U.S. GAAP and uses a fiscal year that matches the calendar year.
Rocky Mountain was in good financial shape heading into 2003, with assets of $50 million at the beginning of the fiscal year.
That year, it earned $3 million in net income and was easily able to maintain its traditional 50% dividend payout ratio. However,
Rocky Mountain had a very difficult year in 2004, reporting a loss of $800,000. It managed to pay $1 million in dividends, but
the decision to pay dividends in such a weak financial year further undermined the company's fiscal stability.
Flitenight Air Lines, a publiclytraded aviation firm serving the central and Midwestern United States, wanted to expand its
range of service by coordinating its flight schedule with airlines serving different geographic regions of North America. One of
these airlines was Rocky Mountain Air Cargo.
To cement the relationship, Flitenight's CEO, John "Bulldog" Basten, decided to make a significant investment in Rocky
Mountain Air Cargo. He was easily able to convince both boards of the wisdom of the deal, and, in his usual brash style,
personally negotiated the terms with his counterpart at Rocky Mountain, Buck Matthews. Flitenight Air Lines acquired a 20%
stake in Rocky Mountain Air Cargo (with an option to purchase 40% more) for $10 million cash. The deal closed on January 1,
2003 and Flitenight accounted for the investment using the equity method.
Basten was not happy to find that he had invested right at the peak of Rocky Mountain's profitability and wound up with a
moneylosing airline. He had a difficult conversation with Matthews in early 2005, complaining about the impact of the Rocky
Mountain investment on Flitenight's financials. Basten pointed out that he had a loss on his books: the original $10 million
investment in Rocky Mountain was carried at only $9,940,000 on Flitenight's December 31, 2004 balance sheet. Matthews
countered that this was just an accounting entry: on a cash basis, Flitenight had a gain of 5% on its investment over the two
years.
Matthews' insistence that the investment had earned money for Flitenight did not sit well with Basten. Basten decided that
Rocky Mountain was clearly being mismanaged and concluded it was time to gain control of the company.
Basten assured Neil Glenn, the Chairman of Flitenight's board, that he could turn Rocky Mountain around. He promised Glenn
that, in 2005, Rocky Mountain would once again achieve $3 million in earnings and a 50% payout ratio. "With those results,"
Basten promised Glenn, "our asset accounts will value the Rocky Mountain investment at $10,240,000 on our December 31,
2005 balance sheet so we'll show a gain on our original investment." Glenn was skeptical of anyone's ability to turn the airline
around so quickly. Even so, Glenn assured Basten, "If it takes you longer to turn it around, at least we'll have the dividend
income on our 2005 cash flow statements."
Basten notified Matthews and Rocky Mountain's board that Flitenight intended to exercise its option. At the direction of Basten
and Glenn, Flitenight purchased the additional shares for cash and gained control of Rocky Mountain on December 31, 2004.
In 2003, Flitenight would reflect its investment in Rocky Mountain on its income statement by recording:
✗ A) $300,000.
✓ B) $600,000.
✗ C) −$200,000.
Explanation
Under the equity method, Flitenight would record $600,000 (= $3 million × 0.2) on its 2003 income statement as its share of
Rocky Mountain's earnings. The dividends received by Flitenight are already included as part of its share of Rocky Mountain's
net income in the equity method. (Study Session 6, LOS 19.b)
If Flitenight were to account for its Rocky Mountain investment as an investment in financial assets instead of the equity
method, Flitenight's 2004 income statement would reflect its investment in Rocky Mountain by including which of the following?
✗ A) Only a loss of $160,000.
✗ B) Nothing, since the cost of the acquisition is not adjusted until the asset is sold.
✓ C) Only income of $200,000.
Explanation
If Flitenight accounted for its Rocky Mountain investment as an investment in financial assets, in 2004 it would record on its
income statement $200,000 (= $1 million × 0.2) in dividends. That method would not be a permissible choice for Flitenight,
however, since it controls more than 20% of Rocky Mountain. (Study Session 6, LOS 19.b)
Under the acquisition method, minority interest is considered:
✓ A) equity under IFRS and US GAAP.
✗ B) a liability under IFRS and US GAAP.
✗ C) equity under IFRS and a liability under US GAAP.
Explanation
Under the acquisition method, minority interest is now considered equity under IFRS and US GAAP. Prior to SFAS 160
minority interest was considered either a liability or a mezzanine(hybrid) item under US GAAP. (Study Session 6, LOS 19.c)
Regarding Basten's and Matthews' statements about the gain/loss that Flitenight had at the end of 2004 on its investment in
Rocky Mountain, which is most accurate?
✓ A) Basten's statement is correct and Matthews' statement is correct.
✗ B) Basten's statement is incorrect and Matthews' statement is correct.
✗ C) Basten's statement is correct and Matthews' statement is incorrect.
Explanation
If Flitenight accounted for its Rocky Mountain investment using the equity method, the value of the investment as of December
31, 2004, would be:
Flitenight's original $10 million investment + (Flitenight's share of Rocky Mountain's 2003 earnings less dividends Flitenight
received in 2003) + (Flitenight's share of Rocky Mountain's 2004 earnings less dividends Flitenight received in 2004).
Since we know that Flitenight owns 20% of Rocky Mountain and consequently receives 20% of the dividends that Rocky
Mountain pays, we can calculate:
Value of Rocky Mountain on Flitenight's books at the end of 2004 =
$10 million + (0.20 × $3 million in 2003 earnings − 0.20 × $1.5 million in 2003 dividends) + (0.20 × −$800,000
in 2004 earnings − 0.20 × $1 million in 2004 dividends) =
$10 million + ($600,000 − $300,000) + (−$160,000 − $200,000) =
$10,000,000 + $300,000 − $360,000 = $9,940,000
Basten's statement is correct.
On a cash basis, Flitenight spent $10 million to acquire its stake in Rocky Mountain, and received $500,000 (= $300,000 in
2003 dividends + $200,000 in 2004 dividends) in dividends over the two years. $500,000 in cash return on a $10,000,000
cash investment equals 5% over the two years. Matthews' statement is also correct. (Study Session 6, LOS 19.b)
Regarding Basten's and Glenn's statements about the impact of Rocky Mountain on Flitenight's 2005 balance sheet and cash
flow statement, which is most accurate?
✗ A) Basten's statement is incorrect and Glen's statement is correct.
✓ B) Basten's statement is incorrect and Glen's statement is incorrect.
✗ C) Basten's statement is correct and Glen's statement is correct.
Explanation
The equity method of accounting is used when the parent has significant influence over the investee but does not exercise
control. The acquistion method is required when the parent controls, directly or indirectly, more than 50% of the voting stock.
Once Flitenight exercised its option to purchase the additional 40% of Rocky Mountain's stock (for total ownership of 60%) on
December 31, 2004, it could no longer use the equity method and had to switch to the acquistion method. In the acquistion
method, Flitenight's investment in Rocky Mountain is no longer listed as a separate asset on the balance sheet (all of Rocky
Mountain's assets and liabilities are combined with Flitenight's, with the minority interest shown as equity), so Basten's
statement is incorrect. In the acquistion method, parent company cash flows exclude those between parent and investee, so
Glenn's statement is also incorrect. (Study Session 6, LOS 19.b)
Firm A recently leased equipment used in its manufacturing plant. If the leased asset is worth less than $100,000 at the end of
the lease, Firm A will pay the lessor the difference.
Firm B provided debt financing to an unrelated entity. The debt has a provision whereby Firm B cannot be repaid until all other
senior debt is satisfied.
Do Firm A and Firm B have a variable interest?
✓ A) Both have a variable interest.
✗ B) Only one has a variable interest.
✗ C) Neither have a variable interest.
Explanation
A lease residual guarantee and subordinated debt are both examples of variable interests. Firm A will experience a loss if the
leased asset is worth less than $100,000 at the end of the lease. Firm B will experience a loss if the senior debt is not paid in
full.
Maverick Incorporated formed a special purpose entity (SPE) to purchase and lease a 50,000 acre ranch. The SPE financed
95% of the purchase price with debt. The remaining 5% was financed with equity capital received from two separate
independent investors. The lender would not make the loan without Maverick's guarantee. How should Maverick treat the SPE
in its financial statements if Maverick is the lessee?
✗ A) Each equity investor must proportionately consolidate the SPE.
✗ B) No firm must consolidate the SPE.
✓ C) Maverick must consolidate the SPE.
Explanation
The 5% atrisk equity investment is not sufficient to support the activities of the SPE without Maverick's guarantee. Thus, the
SPE is considered a variable interest entity (VIE). Since Maverick is responsible for the guarantee, Maverick is the primary
beneficiary and must consolidate the SPE.
Which of the following statements regarding securities classified as held to maturity is most accurate?
✗ A) Equity securities can be classified as "held to maturity" if the firm's
management has decided to hold the security for more than five years.
✗ B) Equity securities can be classified as "held to maturity" if the security pays a large and
consistent dividend and management has decided to hold the security for more than
five years.
✓ C) Only debt securities can be classified as "held to maturity" securities.
Explanation
Only debt securities, which the firm has the positive intent and ability to hold until final maturity, may be classified as held to
maturity.
Accounting standards for passive intercorporate investments establish different categories of securities with distinct ways of
treating them on the financial statements of the company. Which of the following categories requires realized and unrealized
gains and losses to be reported as income? Debt:
✓ A) and equity trading securities.
✗ B) and equity securities availableforsale.
✗ C) securities heldtocall.
Explanation
Accounting standards for passive intercorporate investments include, debt and equity trading securities, is for securities that,
when acquired, are intended to be resold within a near term time horizon. They are classified as current assets on the balance
sheet, with any realized or unrealized gains and losses reported as income.
Accounting standards for intercorporate investments establish different categories of securities with distinct ways of treating
them on the financial statements of the company. One category requires the securities to be carried at fair value on the
balance sheet with unrealized gains and losses excluded from the income statement. This category of security classification is
called debt:
✗ A) and equity trading securities.
✓ B) and equity securities availableforsale.
✗ C) securities heldtomaturity.
Explanation
If securities are designated as debt and equity securities availableforsale they can be sold to meet the liquidity and other
needs of the company. As such, the securities are to be carried at fair value on the balance sheet with unrealized gains and
losses excluded from the income statement.
Milburne Company purchased 1,000 shares of Marino Co. for $20 per share on January 1. By December 31, shares of Marino
were trading at $15 per share in the open market. Marino Co. has 100,000 shares outstanding with a dividend yield of 2% at
year end. Milburne plans to hold the shares of Marino for nearterm trading purposes. The impact of the Marino holding on the
Milburne income statement is:
✗ A) −$5,300.
✗ B) −$5,000.
✓ C) −$4,700.
Explanation
Since these securities are to be classified as trading securities, both the dividend received and the unrealized loss are posted
to the income statement. The dividend is computed as 0.02 × $15 × 1,000 = $300 whereas the unrealized loss is $5,000 =
($15 $20) × 1,000. The net income statement impact is $300 $5,000 = $4,700.
The Anderson Company acquired 100,000 shares of the Birschbach Company on January 1, 2012, at $25 per share. The market price of a
share of Birschbach stock on December 31, 2012, was $35 per share. During 2012, Birschbach paid dividends of $1.50 per share and had
earnings of $2.50 per share.
The Anderson Company did not buy or sell any additional shares in 2013. The market price of Birschbach stock on December
31, 2013 was $42.50 per share. During 2013 Birschbach paid dividends of $1.75 per share and had earnings of $2.25 per
share.
If the Anderson Company accounts for the Birschbach shares as trading securities, the carrying amount of these shares on Anderson's
balance sheet at the end of 2012 is:
✓ B) $3.5 million.
Explanation
Trading securities are measured at fair market value.
(100,000)($35) = $3,500,000
(LOS 19.a)
If Anderson Company accounts for the Birschbach Company shares as securities availableforsale, the carrying amount of these shares
on Anderson's balance sheet at the end of 2012 is:
✓ A) $3.5 million.
Explanation
Availableforsale securities are measured at fair market value.
(100,000)($35) = $3,500,000
(LOS 19.a)
If Anderson Company accounts for the Birschbach Company shares using the equity method, the carrying amount of these
shares on Anderson's balance sheet at the end of 2012 is closest to:
✓ C) $2.6 million.
Explanation
Under the equity method, market value is ignored. The carrying value of the shares is: the original investment + proportional
share of earnings − dividend received.
[(100,000)($25)] + [(100,000)($2.50 − 1.50)] = $2,600,000
(LOS 19.a)
For the year 2012, the investment income that Anderson Company reports on its investment in Birschbach Company shares, if
Anderson accounts for the shares as an availableforsale investment, is :
✓ A) $150,000.
✗ B) $250,000.
✗ C) $100,000.
Explanation
Under the availableforsale accounting method, unrealized gains and losses are not recognized on the income statement, so
the only impact on the income statement is the dividend received:
(100,000 shares)($1.50 per share) = $150,000
(LOS 19.a)
If the investment in Birschbach Company is treated as heldfortrading securities, transactions that impact the income
statement include:
✓ A) an unrealized gain of $1,000,000 and dividend income of $150,000.
✗ B) earnings of $250,000 and dividend income of $150,000.
✗ C) an unrealized gain of $1,000,000 and earnings of $250,000.
Explanation
Held for trading securities are reported at fair value, with unrealized gains and losses included in income. The income
statement also includes dividends from equity securities that are classified as held for trading. Unrealized gains and losses and
dividends received are both recognized in the income statement, however earnings are not.
(LOS 19.a)
If Anderson Company accounts for the Birschbach Company shares using the equity method, the change in carrying value
from 2012 to 2013 is closest to:
✗ A) +$2,650,000.
✓ B) +$50,000.
✗ C) +$225,000.
Explanation
For the equity method, the ending carrying value on the balance sheet is the beginning carrying value plus a proportion of
earnings minus a proportion of dividends. For the Anderson Company, the change in the carrying value is the difference
between the earnings per share and the dividends per share. Dividends per share in 2013 were $1.75 per share and the
earnings per share were $2.25 per share. 100,000 shares × ($2.25 $1.75) = +$50,000. The actual carrying value on the
balance sheet is $2,600,00 + $225,000 $175,000 = $2,650,000.
(LOS 19.a)
Mustang Corporation formed a special purpose entity (SPE) for purposes of providing research and development. An
unrelated firm absorbs the expected losses of the SPE and the independent shareholders of the SPE receive the expected
residual returns. Is the SPE considered a variable interest entity (VIE) according to FASB Interpretation No. 46(R) and is
consolidation required by Mustang, respectively?
✗ A) No; No.
✓ B) Yes; No.
✗ C) Yes; Yes.
Explanation
Since the shareholders do not absorb the expected losses, the SPE is considered a VIE. The unrelated firm (not Mustang) that
absorbs the losses is the primary beneficiary and must consolidate the VIE.
Under which of the following is a minority interest account most likely to appear on the consolidated balance sheet?
I. The acquisition method.
II. Equity method.
✗ A) II only.
✓ B) I only.
✗ C) Both I and II.
Explanation
Minority interest is included in the parent's company's equity under consolidation method only.
Carter Schmitz, Inc. (Schmitz) purchased 200 shares of Intelismart at $21 a share in June 2006 and intends to actively trade
80 shares in the near future and hold the remaining 120 shares as available for sale securities. Intelismart's closing price was
$26 on December 31, 2006, and Schmitz did not sell any of its shares.
What amount should Schmitz report on this investment under the income statement?
✓ A) $400.
✗ B) $600.
✗ C) $1,000.
Explanation
The unrealized gain on the 120 shares available for sale is $600 (26 21 = 5 × 120 shares). There is also an unrealized gain
of $400 (5 × 80) related to the 80 shares that are trading securities which would be reported on the income statement. For
trading securities, realized and unrealized gains and losses are reported on the income statement. For available for sale
securities, only realized gains and losses are reported on the income statement.
Equity method is:
✗ A) recommended under U.S GAAP for jointly controlled entities, but is not
normally permitted under IFRS.
✓ B) required under IFRS and under U.S. GAAP for jointly controlled entities.
✗ C) recommended under IFRS and U.S. GAAP for jointly controlled entities.
Explanation
Equity method is required under both U.S. GAAP and IFRS for jointly controlled entities.
Which of the following methods of accounting for investments will reflect the highest assets and liabilities on a company's
balance sheet?
✗ A) Both methods result in reporting the same balances for assets and liabilities.
✓ C) Acquisition method.
Explanation
The consolidation method will reflect the highest assets and liabilities. The equity method would reflect the lowest.
Global Life Insurance (GLI) holds a wide range of assets in a range of different portfolios across its various divisions. Some of
these assets are held long term to meet future liabilities, whereas others are held short term to make profits and meet shorter
term liquidity needs.
GLI set up a small portfolio of U.S. equities in one of its smaller divisions last year. GLI's chief investment officer has recently
contacted the accounting department to discuss the correct treatment of the portfolio in the group accounts.
Details of the portfolio's transactions and results for the previous period are shown below in exhibit one.
Exhibit 1 Equity Portfolio Results
2013 Q1 2013 Q2 2013 Q3 2013 Q4
Shares purchased (sold) 1,000 (200) 700 0
Total shares quarter
1,000 800 1,500 1,500
end
Purchase price 50.00 45.00
Sale price 45.00
Quarterend market
52.00 43.00 52.00 60.00
price
Total dividends 500 400 750 750

The chief investment officer's also provides the following extract from the portfolio's investment policy statement:
IPS Extract
1. The portfolio should consist solely of U.S. midcap equities.
2. The number of transactions in the portfolio should be kept to a minimum. Shares should not be purchased on a
speculative basis for short term profits.
3. The anticipated average holding period for securities in the portfolio is 3.5 − 4 years.
4. Securities should only be sold to meet urgent liquidity needs.
Another reporting issue the accounting department is looking at concerns a fixed income portfolio. An overview of the portfolio
is given in exhibit 2:
Exhibit 2 Fixed Income Portfolio
Par Value $25,000,000

Coupon rate 5%

Current Market Value $27,000,000
The portfolio consists of $1000 par value, 5 year bonds issued by RTF Inc. They were purchased on the date of issue 1st
January 2012 for $25,893,577. For the year ending 31st December the bonds were classed as held to maturity.
The chief investment officer believes a more appropriate classification would be available for sale, as he is not convinced the
bonds will be held for the remaining 3 years.
What is the income from the equity portfolio if the securities are classified as trading or availableforsale?
Availablefor
Trading
sale
✗ A) $6,600 $1,400
✓ B) $19,900 $1,400
✗ C) $19,900 $19,900
Explanation
Trading income is calculated as dividends plus all gains and losses (realized and unrealized). Total dividends are 2,400. GLI
realized a loss on the sale of 200 shares at 45.00 per share for a total realized loss of 1,000. GLI has an unrealized gain of
8,000 (800× (6050)) on the shares purchased in Q1 and 10,500 (700× (6045)) the shares purchased in Q3, or total
unrealized gains of 18,500. Therefore, total income under the trading classification is 19,900 (2,400 1,000 + 18,500).
Under the availableforsale classifications income is calculated as dividends plus realized gains and losses. Therefore, total
income is 1,400 (2,400 + (1,000)).
What is the balance sheet carrying value of the securities under each of the classifications at yearend?
Availablefor
Trading
sale
✗ A) $71,500 $71,500
✗ B) $90,000 $71,500
✓ C) $90,000 $90,000
Explanation
Under the trading and availableforsale classifications the balance sheet carrying values are the market values of the shares
or 90,000 = (1,500 × 60).
What is the rate of return (income/yearend carrying value) under each of the three methods?
Availablefor
Trading
sale
✗ A) 23.22% 23.22%
✓ B) 22.11% 1.56%
✗ C) 2.67% 2.67%
Explanation
Trading = 22.11% (19,900/90,000)
Availableforsale = 1.56% (1,400/90,000)
Given the information regarding the equity portfolio in the IPS extract, which of the following treatments for the securities in the
portfolio detailed in exhibit 1 is most likely correct?
✓ A) Available for sale
✗ B) Held to maturity
✗ C) Trading
Explanation
The securities in the portfolio are equities and hence cannot be classed as held to maturity. As the IPS suggests that the
shares are not purchased for resale at a profit, and will be held for several periods and only sold to meet liquidity needs,
available for sale is the most likely classification. (LOS 19.b)
If the fixed income portfolio outlined in exhibit 2 is remains classified as held to maturity, which of the following is closest to the
interest income reported in the income statement for the year ending 31st December 2013?
✗ A) $1,088,000
✓ B) $1,079,000
✗ C) $1,086,000
Explanation
If the bonds are classified as held to maturity they will be accounted for using the amortized cost method. Interest will be
calculated using the yield at the date of purchase.
Yield at date of purchase can be calculated as follows:
10 N, −25,893,577 PV, 625,000 PMT, 25,000,000 FV
CPT I/Y = 2.1%. This is semiannual. The annual yield is 4.2%.
Asset Interest (2.1%) Coupon

6m 25,893,577 543,765 625,000
1yr 25,812,342 542,059 625,000
18m 25,729,401 540,317 625,000
2yr 25,644,718 538,539 625,000
Total interest in 2013 (i.e., year 2) is $540,317 + $538,539 = $1,078,856.
(LOS 19.b)
If the bonds are reclassified as suggested by the chief investment officer, which of the following statements is most likely
correct?
✓ A) The difference between the amortized cost and fair value will be shown in other
comprehensive income
✗ B) The difference between the amortized cost and fair value will be shown in net income
✗ C) The difference between the purchase price and fair value will be shown in other
comprehensive income
Explanation
Under US GAAP, bonds held for maturity will be shown at amortized cost. When reclassified to available for sale, the bond will
be restated at fair value and the difference taken to other comprehensive income. (LOS 19.b)
Which of the following statements about special purpose entities (SPE) are correct or incorrect?
Statement #1: The sponsor usually maintains the decisionmaking power and voting
control over the SPE.
Statement #2: The equity owners of an SPE usually receive a rate of return that is tied to
the performance of the SPE.
✗ A) Both are correct.
✗ B) Only one is correct.
✓ C) Both are incorrect.
Explanation
Both statements are incorrect. The sponsor does not usually have voting control over the SPE; the activities of an SPE are
specifically detailed in governing documents created at the origination of the SPE. The structure of the SPE transfers the risks
and rewards from the equity owners to the variable interest owners. In return, the equity owners usually receive a fixed rate of
return.
The consolidation method results in:
✓ A) same net income as the equity method but different shareholders' equity.
✗ B) same net income and shareholders' equity as the equity method.
✗ C) same equity as the cost method.
Explanation
Consolidation results in the SAME net income and higher equity as compared to the equity method.
Which of the following securities will most likely be characterized as an availableforsale security?
✗ A) Debt securities that a company has a positive intent and ability to hold to
maturity.
✓ B) Debt or equity securities that are carried on the balance sheet at fair market value and
may be sold for liquidity purposes.
✗ C) Equity securities representing 30% ownership in another firm.
Explanation
Debt or equity securities that are carried on the balance sheet at fair market value and may be sold for liquidity purposes are
likely to be considered as availableforsale.
Cosmo Inc. (Cosmo) invests in two portfolios Portfolio 1 and Portfolio 2. Portfolio 1 contains securities with an overall intent to
profit within a month or two. Portfolio 2 contains equity securities with a moderate amount of acquisition and disposition
activity. Which of the following treatments of Cosmo's reporting of the investments in Portfolios 1 and 2, respectively, is most
accurate?
Portfolio 1 Portfolio 2
✗ A) Unrealized amounts reported
Assets reported at cost.
on income statement.
✗ B) Unrealized amounts reported
Assets reported at fair value.
on balance sheet.
✓ C) Unrealized amounts reported
Assets reported at fair value.
on income statement.
Explanation
Portfolio 1 contains heldfortrading securities because it is clear that the securities are acquired with the intent to profit over
the near term. Therefore, the unrealized gains and losses would be reported immediately in the income statement.
Portfolio 2 contains availableforsale securities. There are no debt securities and therefore, it cannot contain heldtomaturity
securities. As well, there is no indication that the securities are acquired with the intent to profit over the near term. By default,
the correct classification would be availableforsale. Therefore, the securities (assets) would be reported at fair value.
Birch Corporation is a large conglomerate based in the U.S. that has grown primarily through acquisition. On the first day of
this reporting year, January 1, 2012, Birch acquired 1,500,000 shares of the common stock of TRQ Inc. TRQ Inc. produces
high quality fabrics for use in the fashion industry. Exhibit 1 shows key numbers from TRQ Inc.'s accounts.
Exhibit 1 TRQ Financial Statement Extracts
TRQ Inc
Income year ending 31 Dec 12 $700,000
Dividend paid $210,000
Number of common shares in issue 6,000,000
Number preferred shares in issue 3,000,000
Total number of shares in issue 9,000,000
Both Birch and TRQ prepare their accounts using US GAAP.
Dan Fitzroy is the CFO of Birch, and is currently preparing with a meeting with the auditors to discuss the correct treatment of
the TRQ investment in Birch's group accounts. Fitzroy is of the opinion that the equity method of accounting should be used
for the following reasons:
1. The proportion of TRQ's common shares owned by Birch suggests that Birch has significant influence over TRQ's
operations
2. The lack of ownership of preferred shares suggests that Birch has no significant influence over TRQ's operations
3. The proportion of TRQ's total shares owned by Birch suggests that Birch has significant influence over TRQ's operations
Fitzroy has to present to the board on the implications of the decision once he has spoken to the auditors. He intends to
discuss the following impacts on the financial statements:
Impact One
If the auditors rule that the TRQ investment should be accounted for as a subsidiary rather than an associate, the group's
liquidity ratios will be unaffected
Impact Two
If the auditors rule that the TRQ investment should be accounted for as a subsidiary rather than an associate, the group's net
profit margin will be lower
Fitzroy also intends to ask the auditors about another potential acquisition that Birch may potentially make this year. The
company under consideration is Tyrobin Inc., a small U.S. based company in the pharmaceutical industry.
Fitzroy has observed the note shown in exhibit two in the company's footnotes for last year. He is unsure how it would be
accounted for in the event of a 100% acquisition of Tyrobin's share capital by Birch.
Exhibit Two Tyrobin Footnote
Note 45 Contingent Liabilities
Tyrobin is involved in various legal proceedings considered typical to its business, including actual or threatened litigation
and/or actual or potential government investigations relating to product liability, infringement of IP rights, the validity of certain
patents and competition laws. All of the claims involve highly complex issues.
Often these issues are subject to substantial uncertainties and, therefore, the probability of a loss, if any, being sustained and
an estimate of the amount of any loss is difficult to ascertain. Consequently, for a majority of these claims, it is not possible to
make a reasonable estimate of the expected financial effect, if any, that will result from ultimate resolution of the proceedings.
Assuming the equity method of accounting is used, what will be the reported investment income for Birch?
✗ A) $60,000.
✓ B) $175,000.
✗ C) $115,000.
Explanation
Under the equity method, dividends are not included as income to the acquirer. ($700,000 × 0.25) = $175,000 will be the
reported investment income for Birch. (LOS 19.a)
Assuming the equity method of accounting is used, what will be the cash flow received by Birch, due to their investment in
TRQ?
✗ A) $227,500.
✗ B) $65,400.
✓ C) $52,500.
Explanation
The cash flow to Birch will be the dividend received ($700,000)(0.30)(0.25) = $52,500. (LOS 19.a)
If the consolidation method is used, how much of TRQ's net income will Birch recognize in the group income statement?
✗ A) $122,500
✓ B) $175,000
✗ C) $700,000
Explanation
Birch would recognize 25% of the net income = $700,000 × 0.25 = $175,000. This would be recognized line by line to include
the full $700,000, then 75% would be removed as belonging to the non controlling interest. (LOS 19.a)
Which of Fitzroy's reasons would most likely support the equity accounting method being appropriate for TRQ?
✗ A) Reason 2
✓ B) Reason 1
✗ C) Reason 3
Explanation
Birch owns 1,500/6,000 = 25% of the common shares of TRQ. This suggests significant influence which would make equity
accounting appropriate. The percentage of preferred shares owned is not relevant. (LOS 19.a)
Which of the impacts Fitzroy intends to present to the board is most likely correct?
✗ A) Neither impact is correct
✓ B) Impact two only
✗ C) Impact one only
Explanation
If TRQ is a subsidiary it will be consolidated on a line by line basis. This will affect liquidity ratios. Revenue will be increased but
net income unaffected by the treatment as in both cases (associate and subsidiary) Birch's share of TRQ's net income will be
included in the income statement. (LOS 19.a)
If Birch were to acquire 100% of the share capital of Tyrobin, how would the issues detailed in exhibit 2 be treated when
accounting for the business acquisition?
✓ A) The contingent liabilities would not be recognized in the balance sheet or
income statement on acquisition
✗ B) The contingent liabilities would be charged immediately as an expense to the group
income statement
✗ C) The contingent liabilities would be measured at their fair value and shown as a liability
in the group accounts
Explanation
As the financial effect of the contingent liabilities cannot be reasonably estimated, under U.S. GAAP they should not be
included. (LOS 19.b)
On December 31, 2008 Company P invests $5,000 in Company S in exchange for 25% of the company. During 2009,
Company S earns $2,000 and pays a dividend of $500. If Company P uses the equity method of accounting, what values will
be reported on the balance sheet and income statement? How much cash will be recognized from the investment?
Balance Sheet Income Statement Cash
✓ A) $5,375 $500 $125
✗ B) $5,500 $0 $0
✗ C) $5,375 $125 $125
Explanation
The carrying value on the balance sheet is $5,375, the income statement will show $500 of income, and the cash recognized
is equal to the dividend of $125.
Using the equity method, for 2008, Company P will:
Recognize $500 ($2000 × 0.25) on its income statement as equity in the net income of Company S.
Increase the investment in the Company S account on the balance sheet to $5,500, reflecting its share of the net assets of
Company S.
Receive $125 in cash dividends from Company S and reduce its investment in Company S by that amount to reflect the
decline in the net assets of Company S due to the dividend payment.
At the end of 2008, the carrying value of Company S on Company P's balance sheet will be ($5,000 original investment + $500
proportional share of Company S earnings $125 dividend received = $5,375).
Which of the following statements about the various classifications of securities held by a firm is least accurate?
✓ A) A firm which invests in the debt securities of another firm cannot classify these
securities as "held to maturity" if they have the positive intent and ability to hold the
securities until final maturity.
✗ B) Trading securities are, by definition, current assets because the firm intends to trade these
securities in the near term.
✗ C) Equity securities of other companies cannot be classified as "held to maturity" under SFAS
115.
Explanation
Under SFAS 115, only debt securities, which the firm has the positive intent and ability to hold until final maturity, may be classified as
held to maturity.
Which of the following statements regarding asset securitizations and special purpose entities (SPEs) is most accurate?
✗ A) When receivables are securitized, the sponsor reports the cash inflow as an
investing activity in the cash flow statement.
✓ B) The SPE usually issues debt to purchase receivables from the sponsor.
✗ C) If the sponsor has no recourse, then the transaction is nothing more than a
collateralized borrowing.
Explanation
SPEs are often created to securitize assets, usually receivables of the sponsor. Typically, the SPE issues debt to purchase the
receivables from the sponsor and the debt is repaid as the receivables are collected.
When the receivables are securitized, the sponsor removes the receivables from the balance sheet and reports the cash
inflow as an operating activity in the cash flow statement. If the sponsor still has recourse, the transaction is nothing more than
a collateralized borrowing.
Which of the following securities would most likely be characterized as a heldtomaturity security?
✓ A) Debt securities.
✗ B) Debt or equity securities.
✗ C) Equity securities.
Explanation
Only debt securities, that a company has a positive intent and ability to hold to maturity, can be characterized as a heldto
maturity security.
When comparing companies that hold equity investments in other corporations, which of the following statements is most
accurate? All else being equal, leverage measures for a firm using consolidation will appear:
✗ A) more favorable than those for a comparable firm using the equity method.
✓ B) more or less favorable depending on the leverage of the investee company.
✗ C) less favorable than those for a comparable firm using the equity method.
Explanation
Under consolidation, the debt of the subsidiary is included in the parent company balance sheet. Parent company's equity is
also increased due to minority interest. The impact on leverage will depend on the leverage employed by the subsidiary.
Fiduciary Investors held two portfolios of marketable equity securities:
$50 million in Portfolio A was accounted for as availableforsale.
$50 million in Portfolio B was accounted for as trading securities.
Assume that Fiduciary reclassified securities ($10 million carrying value, $8 million market value) from Portfolio B into Portfolio
A under U.S. GAAP. If no previous write downs were made, Fiduciary must:
✗ A) charge $2 million to the equity section of its balance sheet.
✗ B) do nothing to its income statement or equity section of its balance sheet.
✓ C) charge $2 million to its income statement.
Explanation
U.S. GAAP allows investment managers some latitude in reclassifying investment assets from "trading" to "availableforsale."
Unrealized gains and losses are recognized on the income statement. IFRS severely restricts reclassification out of the held
fortrading category.
When comparing companies that hold equity investments in other corporations, which of the following statements is most
accurate? All else being equal, return on asset measures for a firm using consolidation will appear:
✓ A) less favorable than those for a comparable firm using the equity method.
✗ B) more favorable than those for a comparable firm using the equity method.
✗ C) same as for a comparable firm using the equity method.
Explanation
All else being equal, return on asset measures for a firm using consolidation will appear less favorable than those for a
comparable firm using the equity method. This is because the choice of accounting method will affect the book value of assets,
while the level of net income remains the same.
Prior to 2007, Company X (reporting under U.S. GAAP) had never made any acquisitions of other companies. However, on
January 2, 2007, it went on a buying spree, purchasing 10% of Company A for $10,000; 30% of Company B for $20,000; 40%
of Company C for $80,000; and 70% of Company D for $168,000.
Below are the balance sheets for the five companies (in thousands) just prior to the purchase.
Company X A B C D
Cash 400 10 20 30 40
Other
1,600 90 180 270 360
assets
Total
2,000 100 200 300 400
assets
Liabilities 300 40 80 120 160
Equity 1,700 60 120 180 240
Total 2,000 100 200 300 400
During 2007, the companies generated the following sales, income, and dividends:
Company X A B C D
Revenue 2,000 100 200 300 400
Net income 200 10 20 30 40
Dividends 4 8 12 16
The company accounts for the acquisitions based on typical ownership proportion guidelines.
After the acquisitions, the other assets reported by Company X will be:
✓ A) $2,070,000.
✗ B) $1,878,000.
✗ C) $1,962,000.
Explanation
Company X will treat the acquisition of Company A as an investment in financial assets, the acquisitions of Companies B and C
using the equity method, and the acquisition of Company D using the acquisition method. The investments in Companies A, B,
and C, will be reported, while Company D's financial statements will be consolidated with Company X. The other asset balance
will be the starting balance plus the investments in Companies A, B, and C, plus the other asset amount for Company D, which
equals 1,600,000 + 10,000 + 20,000 + 80,000 + 360,000 = 2,070,000. (Study Session 6, LOS 19.a)
After the acquisitions, the liabilities reported by company X will be:
✗ A) $480,000.
✓ B) $460,000.
✗ C) $300,000.
Explanation
Liabilities will be equal to the starting balance plus the liability balance for Company D, which equals 300,000 + 160,000 =
460,000. (Study Session 6, LOS 19.a)
After the acquisitions, minority interest reported by Company X will be:
✓ A) $72,000.
✗ B) $168,000.
✗ C) $0.
Explanation
Minority interest will be equal to the proportion not owned of Company D multiplied by the equity of Company D, which is (1 −
0.7) × 240,000 = 72,000. (Study Session 6, LOS 19.a)
Company X will report revenue for 2007 of:
✗ A) $2,000,000.
✗ B) $2,280,000.
✓ C) $2,400,000.
Explanation
Revenues will equal the revenue of Company X and D, which is 2,000,000 + 400,000. (Study Session 6, LOS 19.a)
Company X will report income for 2007 of:
✓ A) $246,400.
✗ B) $247,000.
✗ C) $258,400.
Explanation
Income will equal the income of X, plus 10% of the dividends for A, plus 30% of the income of B, plus 40% of the income of C,
plus the income of D less the minority interest, which is 200,000 + (0.1 × 4,000) + (0.3 × 20,000) + (0.4 × 30,000) + (40,000) −
(0.3 × 40,000) = 246,400. (Study Session 6, LOS 19.a)
The change in the investment account (the account that reflects all nonconsolidated investments in other companies)
between January 3 and December 31 is:
✓ A) $10,800.
✗ B) $27,600.
✗ C) $11,400.
Explanation
The investment account will not change for company A, and there is no investment account for Company D. The investment
account will increase from the proportionate income of Companies B and C, and will decrease from the dividends received
from Companies B and C. The changes will be (0.3 × 20,000) + (0.4 × 30,000) − (0.3 × 8,000) − (0.4 × 12,000) = 10,800.
(Study Session 6, LOS 19.a)
Luna Life Insurance is a publicly traded corporation with total assets in excess of $500 million. Joy Manning, CFA, has served
as Luna's chief investment officer for the past decade. Recent poor performance of Luna investment portfolio has led to the
formation of a special task force to review Luna's investment holdings as well as its operating policies. The task force is
composed of two current Luna board members (who are not employees of Luna) and three independent investment
professionals. Their assignment is to thoroughly review Luna's financial statements for evidence of impropriety or mishandling
of corporate assets. The task force is expected to complete their review within one month and report back to Luna's board of
directors shortly thereafter.
Luna's most recent financial statements reflect approximately $200 million in various equity holdings and $100 million in debt
instruments. A broad classification of the portfolio (in millions of $) as of December 31, 2006 is as follows:
HeldtoMaturity AvailableforSale Trading
Equity $0 $125 $75
Debt $50 $25 $25

In the footnotes, there is a reference to $10 million of availableforsale securities that were transferred to the heldtomaturity
portfolio last year. The securities were transferred at fair market value, and an unrealized loss of $1 million was included in
that period's income. Several members of the task force believe the transaction deserves further analysis to determine if the
securities' transfer between portfolios was executed in accordance with SFAS 115, "Accounting for Certain Investments in
Debt and Equity Securities" as Manning has represented.
Also, in 2006, Luna transferred $5 million of shares in ABC Corp from the availableforsale portfolio to the trading portfolio. In
association with this transaction, $1 million in unrealized gains were included in the year's income. The task force observes
that after the transfer, there are $2.5 million of ABC Corp remaining in the availableforsale portfolio. Manning has stated that
the firm's desire to reduce exposure to the equity market was the reason for selling only a portion of the position in ABC Corp.
In addition, the group is performing its own analysis on the impact of last year's acquisition of a 20% stake in Instate, a
regional provider of commercial insurance. Instate reported $15 million in earnings for the year ending December 31, 2006,
and paid approximately $1 million in dividends. Manning directed Luna's accountants to record the purchase using the equity
method, and thus has included a proportional share of Instate's net income for the year. The acquisition was effective as of
January 1st of 2006, and operating results for the investment stake in Instate are incorporated into Luna's 2006 financial
statements. The group will perform basic analysis both with and without the operating results of Instate in order to better
evaluate what financial impact the inclusion of Luna's results had on Instate's overall performance.
With regard to the $50 million of debt securities currently classified as heldtomaturity on Luna's financial statements:
✗ A) the cost method of accounting should be used on the income statement while
the market method should be used on the balance sheet.
✗ B) unrealized gains and losses are excluded from income but reported as a separate
component of shareholders' equity.
✓ C) they are carried at their amortized cost and cannot be sold prior to maturity except
under unusual circumstances.
Explanation
When debt securities are classified as heldtomaturity, the company has both the intent and ability to hold them until they
reach their respective maturities. Only under unusual, isolated circumstances can a company liquidate prior to maturity. Note
that only debt securities can be classified as heldtomaturity; equity securities cannot. (Study Session 6, LOS 19.a)
Although the appropriate classification of investments is determined at the purchase date, management can reevaluate the
classifications at the end of each financial period and adjust accordingly. When transferring debt securities from the available
forsale portfolio to heldtomaturity, which of the following rules is most likely in accordance with SFAS 115? Availableforsale
securities transferred to heldtomaturity are transferred at:
✓ A) fair market value, and any unrealized gains or losses remain in equity but are
subsequently amortized over the remaining life of the security.
✗ B) fair market value, and any unrealized gains or losses are included in income in the
period of transfer.
✗ C) their amortized cost, and any unrealized gains or losses remain in equity but are
subsequently amortized over the remaining life of the security.
Explanation
When transferring debt securities between portfolios, availableforsale securities transferred to heldtomaturity are
transferred at fair market value, and any unrealized gains or losses remain in equity but are subsequently amortized over the
remaining life of the security. Note that this only applies to debt securities because equity securities cannot be classified as
heldtomaturity. (Study Session 6, LOS 19.a)
Analysts should be wary of which of the following equity transactions a company may use to manipulate its reported earnings
to reflect a higher net income? A company can move shares that have appreciated in value from:
✓ A) availableforsale to the trading portfolio.
✗ B) heldtomaturity to the trading portfolio.
✗ C) trading to the availableforsale portfolio.
Explanation
Because shares of the same company can be classified as separate investments, a company could move those securities with
unrealized gains to the trading portfolio, and thus recognize the gains, while leaving those securities with unrealized losses in
the availableforsale portfolio. Equity shares cannot be classified as heldtomaturity. (Study Session 6, LOS 19.a)
Which of the following investments would most likely be reported under the equity method?
✗ A) An investment in 80% of the equity of an entity that gives the owner control
over that entity
✓ B) An investment in 5% of the equity of an entity that gives the owner significant influence
over that entity
✗ C) An investment in 40% of the equity of an entity that gives the owner control over that
entity
Explanation
The parentcompany must have significant influence over the management of the affiliate. Control would require the
consolidation method. (Study Session 6, LOS 19.a)
Luna has recorded its investment in Instate utilizing the equity method of accounting for intercorporate investments. According
to FASB, which of the following statements most accurately reflects the impact on an investor's financial statements by using
the equity method?
✗ A) Market values can be compared with the carrying amount for analysis
purposes, but only market values may be used in the financial statements.
✓ B) The investing firm can include a proportionate share of the investee's income in its
earnings, regardless of whether or not there are actual cash flows (i.e. dividends).
✗ C) The investing firm will not make any adjustments to its financial statements to reflect
its proportionate share of the investee's net assets, but will reference the investment
in the footnotes.
Explanation
The proportionate share of the investee's income is included in the parent's income statement. Changes in the market value of
the investee are not reflected in the investing firm's income statement so long as the decline in value is not considered to be
permanent. (Study Session 6, LOS 19.b)
Suppose Luna had accounted for the Instate acquisition using the passive method for investments in financial assets rather
than the equity method of accounting for intercorporate investments. Explain how the different methods would most likely
impact Luna's financial statements? Under the equity method, Luna will report:
✗ A) improved debt coverage than under the passive method for investments in
financial assets.
✓ B) higher interest coverage ratios and return on investment than under the passive
method for investments in financial assets.
✗ C) lower net income than under the passive method for investments in financial assets.
Explanation
In this scenario where the investee reported positive earnings and paid out less than 100% of its earnings as dividends, the
parent will report higher income, thus resulting in higher interest coverage ratios and return on investment. (Study Session 6,
LOS 19.c)
Company X owns 15% of company S and exerts significant influence over the operations of the company. The book value of the
investment on December 31, 2008, is $48,000. In 2009, company S earned $100,000 and paid dividends of $20,000. The impact of the
investment on the income statement of company X is:
✗ A) $12,000.
✗ B) $3,000.
✓ C) $15,000.
Explanation
Because company X exerts significant influence over company S, the investment will be treated using the equity method, even though
the ownership is less than the 20% guideline. The impact on the income statement is the proportionate income of company S, which is
0.15 × 100,000 = 15,000.
Which of the following statements regarding qualifying special purpose entities (QSPE) is most accurate?
✗ A) A QSPE can hold only certain financial and nonfinancial assets.
✓ B) The QSPE has total control of the assets transferred from the sponsor.
✗ C) Under IFRS, the sponsor can avoid consolidating asset securitizations by creating a
QSPE.
Explanation
A QSPE can only hold financial assets (and the assets are usually receivables). As a legally separate, independent entity, the
QSPE has total control of the assets transferred from the sponsor. Previously, under U.S. GAAP, the sponsor could avoid
consolidating asset securitizations by creating a QSPE. QSPEs are no longer permitted under U.S. GAAP or IFRS.
Assume that on the balance sheet date shown below TME Corporation acquires 70% of Abcor, Inc. common stock for $25,000 in cash.
Preacquisition Balance Sheets
December 31, 2001
TME Corp. Abcor, Inc.
Other assets 28,000 15,000
Total assets $108,000 $53,000

Current liabilities $60,000 $32,000
Total liabilities and equity $108,000 $53,000
What will be the postacquisition current ratio, using both the acquistion method and the equity method, respectively, for TME? The
choices below represent Acquisition and Equity, respectively.
✓ A) 1.01, 0.92.
✗ B) 1.04, 1.11.
✗ C) 1.21, 1.02.
Explanation
With the acquisition method: The current assets are ($80,000 + $38,000 $25,000) = $93,000. The current liabilities are ($60,000 +
$32,000) = $92,000. The current ratio is $93,000/$92,000 = 1.01. With the equity method: The current assets are ($80,000 $25,000) =
$55,000. The current liabilities are $60,000. The current ratio is $55,000/$60,000 = 0.92.
Using the acquistion method to account for the acquisition, what will be the postacquisition current assets of TME?
✓ A) $93,000.
✗ B) $118,000.
✗ C) $105,000.
Explanation
Using the acquisition basis of accounting, the postacquisition level of the current assets is the amount of the current assets prior to
acquisition minus the amount of cash used for the acquisition. ($80,000 + 38,000 25,000) = $93,000.
Using the acquistion method to account for the acquisition, which of the following is closest to the postacquisition amount that
will be recorded as the minority interest under US GAAP?
✗ A) $6,300.
✗ B) $21,000.
✓ C) $10,700.
Explanation
Since only 70% of Abcor was purchased by TME there is a minority interest that must be accounted for, equal to the
percentage of Abcor not owned by TME times Abcor's fair value.
Abcor's fair value = 25,000/0.7 = 35,714.29
Under US GAAP, only full goodwill.
Minority interest = 35,714.29 (0.3) = 10, 714.29
Which of the following statements regarding special purpose entities (SPEs) is least accurate?
✓ A) According to U.S. GAAP, a special purpose entity is classified as a variable
interest entity (VIE) if it has atrisk equity that is sufficient to finance its own
activities without additional financial support.
✗ B) Under IFRS, a special purpose entity must be consolidated by the entity which
exercises control over that entity.
✗ C) According to U.S. GAAP, if a SPE is considered a VIE, it must be only consolidated by
the primary beneficiary.
Explanation
Under U.S. GAAP rules, a VIE could include a SPE that has atrisk equity that is insufficient to finance the entity's activities
without additional financial support.
Joseph Haggs, CFA, is an analyst working for Garvess Jones, a large publicly traded investmentbaking firm. Haggs covers
the Internet sector. Recently, one of the more successful companies Haggs covers, Simpson Corporation, made an
aggressive move to acquire another Internet company, Bailey Corporation (BC). BC is a company specializing in graphics and
animation on the World Wide Web and has 1,000,000 shares outstanding. Simpson also holds minimal investments in other
technology companies both public and private. In 1999 Simpson saw an opportunity to substantially increase its share in BC.
Simpson feels that their sophisticated animation can greatly improve Simpson's market share and sees an acquisition as an
opportunity to expand their business. The relevant financial data are in the following tables.
Bailey Corporation
Selected Financial Data, Years Ended December 31
(in Thousands)
Item 1998 1999 2000
Sales $50,000 $60,000 $70,000
Less: cost of goods sold (COGS) 37,000 43,700 47,250
Earnings before interest & taxes (EBIT) 13,000 16,300 22,750
Less: Interest 10,000 13,000 19,000
EBT 3,000 3,300 3,750
Less: Taxes 1,000 1,100 1,250
Net Income $2,000 $2,200 $2,500
Dividends Paid $1,000 $1,200 $1,500
Total Shares Outstanding 1,000,000
Simpson's Purchase Transactions in BC's Stock
Date January 1, 1998 January 1, 1999 January 1, 2000
Number of Shares 10,000 290,000 700,000
Price per Share 10 11 15
Because this is the largest acquisition in Simpson's history, Mr. Haggs' supervisor has asked him to prepare a report for
Garvess Jones' clients detailing the affects of the acquisition on Simpson's financial statements.
Haggs wonders which accounting method Simpson uses to calculate the book value of the BC investment for the year ending December
31, 1999. Which is the correct method?
✗ A) Investment in Financial Assets method.
✓ C) Equity method.
Explanation
When a company owns an influential but noncontrolling interest in another company, commonly 2050%, it must account for it under the
equity method.
✗ A) Acquisition method.
✓ B) Investment in Financial Assets method.
✗ C) Equity method.
Explanation
When a company owns a noninfluential and noncontrolling interest in another company the investment must be carried at cost. Simpson
must carry its BC investment at cost for 1998.
✗ A) Proportional consolidation method.
✓ C) Acquisition method.
Explanation
When a company's interest in another exceeds 50% it is considered to have controlling interest and must consolidate the financial
statements.
Haggs wants to make sure that he assumes the proper accounting method when he does his analysis. The acquisition of BC stock will
lead to Simpson's total net cash flow equaling which of the following for the year ending December 31, 1999?
✗ A) $−3,190,000.
✗ B) $360,000.
✓ C) $−2,830,000.
Explanation
Simpson paid a total of $−3,190,000 (290,000 shares × $11) however, they also received a dividend from BC of $360,000. For 1999 Bailey
Corporation is paying $1.20 in dividends per share (1,200,000 / 1,000,000). As of December 1999, Simpson has purchased 300,000
shares of BC (= 290,000 + 10,000). So dividends received is 300,000 × $1.20 = $360,000. This will make the total cash flow for the year $
−2,830,000.
Trading securities are defined as:
✓ A) debt and equity securities acquired with the intent of selling them in the near
future.
✗ B) equity securities representing 20% to 50% ownership in a public firm.
✗ C) debt and equity securities that are very liquid and easy to sell.
Explanation
Debt and equity securities acquired with the intent of selling them in the near future are likely to be considered trading
securities.
Omricon Capital Associates specializes in making investments in the small cap market sector. In some cases the firm operates
as a supplier of private equity for restructurings. In this instance, the firm views itself as having a value investment focus. In
others, it acts as a venture capital firm. Here, the investment focus is usually growth. Finally, in some cases it simply takes
passive investment positions in publiclytraded firms. The positions in marketable securities are sometimes considered trading
positions, and other times the view is to hold for a longer period until valuation parameters are met or exceeded.
Omricon's chief compliance officer, Raymond "Buzz" Richards has recently become concerned that the firm may not be
correctly following the relevant accounting standards for these investments. To ensure that the rules are being effectively
adhered to, he is seeking advice from the accounting firm of MerzBrokaw and Associates on the matter. Sally Lee is the
MerzBrokaw partner heading up the consulting team assigned to review the situation.
The size of the investments ranges from a few percent of the firm's outstanding equity, to positions of greater than 50%.
Richards says that it has always been his understanding that the percentage of the equity held is the major determinant with
respect to which accounting method applies. Lee reminds him that the firm's intent for its investments also plays a role in
determining how they are accounted for.
Some of the firm's investments have not worked out as planned. Richards has conferred with the firm's portfolio managers
regarding securities being held by the firm that are worth less than when they were acquired, and has presented a list of these
investments to Lee. His concern is what this implies for the accounting for these investments. Lee tells him that the issue here
is whether or not the security can be considered impaired, and that designating a security as impaired implies that the decline
in value is permanent.
Top managers at Omricon have asked Lee to help them evaluate the impact of the choice of accounting method on the firm's
profitability. Some members of the management team are of the belief that the accounting method does not affect financial
measures because these are driven by underlying economic factors. Others believe that these measures can be affected by
the accounting method chosen.
Assuming no significant influence exists, which of the following statements concerning percentage ownership and accounting
method is most accurate?
✗ A) When the ownership is less than 20%, US GAAP requires the investment in
financial assets method, IFRS the equity method.
✗ B) When the ownership is less than 20%, both US GAAP and IFRS require the equity
method.
✓ C) When the ownership is less than 20%, both US GAAP and IFRS require the
investment in financial assets method.
Explanation
When the percentage ownership is less than 20% (with no significant influence over the investee firm), both US GAAP and
IFRS require the investment in financial assets method. (Study Session 6, LOS 19.a)
For instances in which Omricon holds exactly 50% of the outstanding equity of the investee firm's equity (i.e., the investee firm
is a joint venture), which of the following statements is most accurate?
✗ A) IFRS requires that the equity method be used; US GAAP permits a choice
between the equity method and proportional consolidation.
✗ B) IFRS and US GAAP both permit a choice between the equity method and proportional
consolidation.
✓ C) Both US GAAP and IFRS require that the equity method be used.
Explanation
Equity method is required accounting method under both IFRS and U.S. GAAP for joint ventures (Study Session 6, LOS 19.b)
The three classifications for passive investments in securities that trade in secondary markets are:
✗ A) trading securities, marketable securities, heldtomaturity securities.
✓ B) trading securities, availableforsale securities, heldtomaturity securities.
✗ C) marketable securities, availableforsale securities, heldtomaturity securities.
Explanation
The three classifications for passive investments in securities that trade in secondary markets (i.e., marketable securities) are
trading securities, availableforsale securities, and heldtomaturity securities. (Study Session 6, LOS 19.a)
When a passive investment in marketable equity securities is classified as availableforsale:
✗ A) IFRS requires that unrealized gains and losses are reported in comprehensive
income on the balance sheet, while under US GAAP the firm can elect to report
on either the income statement or in comprehensive income on the balance
sheet.
✓ B) US GAAP and IFRS require that unrealized gains and losses are reported as equity in
other comprehensive income on the balance sheet.
✗ C) US GAAP requires that unrealized gains and losses are reported on the income
statement, while under IFRS the firm can elect to report on either the income
statement or in comprehensive income on the balance sheet.
Explanation
When a passive investment in marketable equity securities is classified as availableforsale, US GAAP and IFRS require that
unrealized gains and losses are reported as equity in other comprehensive income on the balance sheet. (Study Session 6,
LOS 19.b)
With respect to Lee's statement concerning securities that are currently worth less than when they were acquired, a security
should be considered impaired when the:
✗ A) decline in value is other than temporary, its value should be written down to
the new fair value, and a loss reported in comprehensive income in equity on
the balance sheet.
✗ B) decline in value is permanent, its value should be written down to the new fair value,
and a loss reported on the income statement.
✓ C) decline in value is other than temporary, its value should be written down to the new
fair value, and a loss reported on the income statement.
Explanation
A security should be considered impaired when the decline in value is "other than temporary". That is to say that it is obviously
not due to a temporary decline in the market. No one knows for sure if any decline in value is permanent, but in most cases it
is obvious that it is not simply a market phenomenon. When this is the case, the asset's value should be written down to the
new fair value, and a loss reported on the income statement. (Study Session 6, LOS 19.a)
Relative to consolidation, using the equity method of accounting for investments results in:
✗ A) ROA being higher and leverage being higher than under consolidation.
✓ B) ROA being higher than under consolidation.
✗ C) ROA being lower and leverage being higher than under consolidation.
Explanation
Since consolidation results in inclusion of investee's assets in the investor's balance sheet, the total assets would be higher
under consolidation as compared to equity method. Net income is same under either methods. ROA would be higher under
equity method as compared to under consolidation. Leverage effects will depend on the debt of the investee company. Under
consolidation, all of investee's debt would be included in investors balance sheet. However, total equity in the consolidated
balance sheet will also be higher due to inclusion of minority interest. (Study Session 6, LOS 19.c)
Sawbuck Corporation recently acquired a 60% stake in Rawboard Inc. for $70 million in newly issued common stock. Given
this information, which of the following methods should be used to account for the acquisition of Rawboard?
✓ A) Acquisition.
✗ B) Proportionate consolidation.
✗ C) The pooling of interest method.
Explanation
When the parent company has at least a 50% ownership stake and control over the subsidiary, the acquisition method is used.
Evergreen Brothers is a large producer of bedding plants and shrubs that are sold to various retail nurseries and home
improvement stores located across the western coast of the United States with approximately $85 million in annual sales.
Evergreen grows its products at two facilities, one in Northern California and the other in the Southern part of the state. Each
production facility currently distributes its products within an approximate 150 mile radius of its location. All aspects of the
shipping and delivery of products have historically been provided by an independent, thirdparty distribution company.
Because of impressive growth in the company's sales over the past several years, management has decided to pursue plans
to bring "inhouse" the distribution of the company's products. They believe that the projected decreased freight costs as well
as the increased efficiencies in more actively managing the distribution of their production should immediately yield increased
profit margins. As an initial step, Evergreen has negotiated the price for ten delivery trucks, which could provide all distribution
capacity needed for the company's Northern production facility for the upcoming season. Current plans are to continue the use
of the independent distribution company for the needs of the firm's Southern facility for at least the next several years.
Under advice from the company's CFO, Evergreen has created a new special purpose entity (SPE), QuickTime, Inc., which will
serve as the entity that will purchase the trucks from the dealer. The purchase will be financed through a combination of debt
and equity, with the dealer lending 75% of the total cost. The loan is collateralized by both the trucks and Evergreen's
guarantee of the debt, as required by the dealer.
Evergreen has arranged for an outside investor to provide the remaining 25% of the upfront costs of the equipment in
exchange for 100% of QuickTime's nonvoting stock. In addition, the outside investor is guaranteed an 8% annual return for the
life of the financing term. At the end of seven years, QuickTime will be liquidated and Evergreen will have the option of
purchasing the equipment for its fair value at that time. The proceeds of the liquidation will be used to repurchase the outside
investor's stock at par value. In the event that the liquidation value is insufficient to buy back the outside investor's stock,
Evergreen has committed to fund the shortfall.
Management has given its tentative approval of the project and the proposed structure. Questions remain, however, as to the
effect of the creation of QuickTime on Evergreen's financial statements. With the relatively recent issuance of FASB
Interpretation No. 46(R), "Consolidation of Variable Interest Entities" (FIN 46(R)), the management of Evergreen has not had
prior experience with the new consolidation requirements for SPEs.
Which of the following statements regarding special purpose entities (SPEs) is least accurate?
✗ A) In general, the equity investors in an SPE can expect to receive a limited rate of
return on their investment in exchange for limited risk exposure.
✓ B) An SPE can be established as one of several legal forms, such as corporations,
partnerships, or trusts, but must establish separate management from that of the
sponsor.
✗ C) An SPE can be formed to isolate specific assets from the sponsor, thus lowering the
cost of capital by protecting the assets of the SPE in the event the sponsor
experiences financial distress.
Explanation
An SPE can take on one of many legal forms, but does not necessarily have to have separate management or employees
from that of the sponsor.
In exchange for providing lowercost financing to an SPE, lenders typically require additional financial support from a sponsor,
which may be in the form of additional collateral or guarantees. In return, the sponsor will typically receive which of the
following risk and return profiles?
✗ A) Prorata share of the actual returns on the project and a predetermined fixed
level of risk on the project.
✓ B) Prorata share of the actual risks and returns on the project.
✗ C) Prorata share of the actual risk and a predetermined fixed rate of return on the
project.
Explanation
By transferring the variability in the risk of a project to a sponsor, a lender can provide a lower cost of financing to the company
that creates the SPE. In return, the sponsor will receive prorata profits or other residual interests in the project.
According to FIN 46(R), if an SPE is to be considered a variable interest entity (VIE), it must meet which of the following
conditions?
✗ A) The SPE must be consolidated by the primary beneficiary, whose status as
primary beneficiary is defined by the level of the firm's percentage of voting
control.
✓ B) The total atrisk equity of the SPE is not sufficient to finance the entity's activities
without additional subordinated financial support.
✗ C) The equity investors in the VIE must bear all of the SPE's risk up to a predetermined
level as outlined in the governing documents.
Explanation
To qualify as a VIE under FIN 46(R), any one of four conditions must be met, one of which is the presence of an insufficient at
risk equity investment.
In order to be considered a VIE under FIN 46(R), an entity must meet certain conditions. Which of the following statements
about QuickTime is most accurate? Under FIN 46(R), QuickTime is:
✗ A) considered a VIE because outside investors share the residual gains and
losses at liquidation with Evergreen.
✓ B) considered a VIE because the outside investor's capital contribution is not sufficient to
finance QuickTime's operations.
✗ C) not considered a VIE because the outside investor does not have any decision making
rights.
Explanation
The outside investor contributed 25% of the necessary capital, but this was not sufficient because the dealer additionally
required Evergreen's guarantee in order to close the deal. This condition satisfies the requirements established by FIN 46(R)
in order to be classified as a VIE.
As outlined in FIN 46(R), the primary beneficiary of a VIE is that entity which meets which of the following conditions?
✗ A) Holds the majority voting control of the VIE and has separate management from
the VIE.
✗ B) Holds the majority voting control of the VIE and shares management with the VIE.
✓ C) Has exposure to the majority of the loss risks or receives the majority of the residual
benefits of the VIE.
Explanation
Unlike past accounting treatments of VIEs where consolidation was based upon voting control, FIN 46(R) recognizes the
primary beneficiary of a VIE as that entity that absorbs the majority of the risks and enjoys the majority of the benefits of the
VIE. The primary beneficiary is required to consolidate the VIE on their financial statements.
Assuming that QuickTime is considered a VIE in accordance with FIN 46(R), which of the following statements regarding the
consolidation of QuickTime on Evergreen's financial statements is most accurate?
✓ A) Evergreen is exposed to the majority of QuickTime's risks and rewards, so
Evergreen must consolidate QuickTime on its financial statements.
✗ B) Because the outside investor holds only nonvoting stock, Evergreen holds the majority
controlling financial interest in QuickTime and must consolidate QuickTime on its
financial statements.
✗ C) The truck dealer is supplying the financing for the majority (75%) of QuickTime's debt,
so Evergreen may not consolidate QuickTime on its financial statements.
Explanation
Before the issuance of FIN 46(R), consolidation was based upon possession of voting control of an entity. FIN 46(R) uses a
risk/reward approach when determining which firm must consolidate the VIE on its financial statements. Since Evergreen is the
sole entity exposed to variability in QuickTime's net income, as well asset value, QuickTime should be consolidated on their
financial statements.
Under IFRS rules, which of the following accounting treatments is most preferred for joint ventures where there is shared
control?
✗ A) Proportionate consolidation method.
✓ C) Equity method.
Explanation
Only equity method is now permitted under both IFRS and U.S. GAAP.
On January 9, 2006, Company X, reporting under U.S. GAAP, purchased $1,000,000 of government bonds and 100,000
shares of stock in Company S for $2,000,000. The company intends on holding the stock for the foreseeable future and
holding the bonds to maturity. As of December 31, the bonds were valued at $900,000, and the stocks were valued at
$2,200,000. The bonds paid $50,000 of interest and the stocks paid $20,000 of dividends. In 2006, Company S had earnings
per share of $0.90. Company X reports under U.S. GAAP.
The marketable securities balance amount shown on the balance sheet is:
✗ A) $3,100,000.
✗ B) $3,000,000.
✓ C) $3,200,000.
Explanation
The bonds are classified as debt securities heldtomaturity and are valued at cost. The stocks are classified as debt and
equity securities available for sale and are valued at market value.
(LOS 19.a)
The impact of the marketable securities on net income is:
✗ A) $140,000.
✓ B) $70,000.
✗ C) $270,000.
Explanation
The bonds are classified as debt securities heldtomaturity, and the income generated from them is $50,000. The stocks are
classified as debt and equity securities available for sale, and although the increased value is reported as an asset, the gain is
reported in the securities valuation account in the equity section and not on the income statement. The effect of the stocks on
income is the $20,000 of dividends.
(LOS 19.a)
In late 2006, Company X decided to reclassify the investments as trading securities. What is the impact of this change in status
on the value of the assets of Company X?
✗ A) $200,000.
✗ B) $70,000.
✓ C) $0.
Explanation
The stocks were classified as available for sale, but now they will be classified as trading securities. However, although it will
affect net income, the change in status will not impact the reported value of the assets. According to SFAS 115, securities
transferred from availableforsale to trading securities are transferred at fair market value and unrealized gains or losses
would be included in income.
(LOS 19.b)
Assuming that the company would report under IFRS 9, the appropriate classification for the investment in government bonds
would be:
✗ A) Amortized cost or Available for Sale only.
✓ B) Amortized cost or Fair value through profit or loss only.
✗ C) Amortized cost or Fair value through OCI only.
Explanation
Under IFRS 9 (new standards), debt securities can be classified at amortized cost (if they meet business model and cash flow
characteristic test) or as fair value through profit or loss.
(LOS 19.a)
Assuming that the company would report under IFRS 9 and that the investments were initially classified as fair value through
profit or loss. The company can reclassify:
✓ A) Debt security only if the business model has changed.
✗ B) Both debt and equity securities into fair value through OCI.
✗ C) Equity security but only into fair value through OCI.
Explanation
Reclassification of equity securities under the new standards is not permitted as the initial designation (FVPL or FVOCI) is
irrevocable. Reclassification of debt securities from amortized cost to FVPL (or vice versa) is permitted only if the business
model has changed.
(LOS 19.a)
In 2010 the company recorded an impairment loss on their investment in government bonds. Two years later, the bonds
recovered. Under U.S. GAAP a reversal of impairment loss:
✓ A) Is not allowed.
✗ B) Is only allowed if the reversal is other than temporary.
✗ C) Not exceeding the original loss is allowed.
Explanation
U.S. GAAP does not allow for reversal of impairment losses on financial assets.
(LOS 19.a)
Under U.S. GAAP rules, where an investor owns a significant number (39%) of the voting shares of an investee but has no
involvement in policy making and no Board of Directors' representation, which of the following investment classifications is
most appropriate to characterize the situation?
✓ A) Investment in financial assets.
✗ B) Investment in associates.
✗ C) Significant influence.
Explanation
Investment in financial assets is the correct classification here because there is no significant influence (i.e. no involvement in
policy marking, no Board of Directors' representation). Although the ownership interest level is significant at 39% (it is between
20% and 50%), the lack of control classifies the investment as an investment in financial assets.
Significant influence is not in investment classification per se. It is a measure of relative degree of influence.
Milburne Company purchased 1,000 shares of Marino Co. for $20 per share on January 1. By December 31, shares of Marino were trading
at $15 per share in the open market. Marino Co. has 100,000 shares outstanding with a dividend yield of 2% at year end. Milburne plans
to hold the shares of Marino for longerterm investment and liquidity purposes. The impact of the Marino holding on the Milburne income
statement is:
✗ A) $4,700.
✓ B) $300.
✗ C) $5,000.
Explanation
These securities are to be classified as available for sale and hence, all unrealized gains and losses are posted to a securities valuation
reserve on the balance sheet. Hence, the only income statement impact is the $300 dividend = 0.02 × $15 × 1,000.
Mashburn Company acquired 25% of the 100,000 outstanding shares of Humm Co. on January 1 for $250,000 in cash. Humm Co. earned
$1 per share and had a dividend payout ratio of 40%. As of December 31, Humm Co. shares were trading in the open market at $12 per
share. Calculate the income statement treatment of the Humm Co. investment as of December 31.
✗ A) $75,000.
✓ B) $25,000.
✗ C) $10,000.
Explanation
Under the equity method, the investor recognizes its prorata share of the affiliate's income on the income statement. Since Mashburn
owns 25,000 shares of Humm and Humm earned $1, the income statement impact of the investment is $25,000.
Employee Compensation: Post-Employment and Share-Based
Test ID: 7440434
When considering the major differences between a defined contribution and a defined benefit pension plan, which of the
following statements is most accurate?
ᅞ A) A company with a defined contribution plan will report on its balance sheet the
net difference between the value of the pension fund assets and the value of
the pension liability.
ᅞ B) Accounting for a defined contribution pension plan is the most complicated because of
the many investment options available to the employees.
ᅚ C) Among the different types of pension plans, accounting for a pay-related defined
benefit plan is the most complicated because of the required actuarial assumptions.
Explanation
Three actuarial assumptions (discount rate, expected increase in employee compensation and the expected return on plan
assets) must be estimated to project the value of the corporation's pension liability today. Subtle changes to any of the three
assumptions can drastically change the estimated liability.
Which of the following statements regarding total periodic pension cost is least accurate?
ᅚ A) It is equal to the change in the funded status for the period.

ᅞ B) It is equal to the sum of all the changes in projected benefit obligation (PBO) for the
period (except for benefits paid) minus the actual return on assets.
ᅞ C) It is a more volatile measure of pension expense than reported pension expense.
Explanation
Total periodic pension cost (the true or economic pension expense) is equal to the change in the funded status for the period
excluding the firm's contributions.
Total periodic pension cost is calculated by eliminating the smoothed amounts from reported pension expense and including
the actual return on assets. The result is a more volatile measure of pension expense.
Peak Productions is a publicly traded company that manufactures consumer electronics products in the U.S. The company has
been in operation nearly fifty years, and has a considerable pension plan liability on its financial statements. Peak has a well-
deserved reputation among analysts of utilizing aggressive accounting practices with regard to its pension plan. Which of the
treatments of the following actuarial assumptions is the best example of aggressive accounting for a pension plan?
ᅚ A) A high discount rate.
ᅞ B) A high calculated projected benefit obligation (PBO).
ᅞ C) A high compensation growth rate.
Explanation
The assumption of a high discount rate will result in a lower pension liability and almost always a lower pension expense. The
more aggressive the actuarial assumptions for a pension plan are, the lower the quality of earnings for the firm.
Fly-By-Night Airlines is a U.S. company planning to change its pension plan so that it can reduce its costs. It is considering
reducing its defined benefit percentage from 10% to 5% of ending salary, retroactive for 10 years. In addition, since the firm is
anticipating substantially reduced salary increases in the future, it is planning to reduce its compensation growth rate
assumption. From a pension accounting perspective, the change in the:
ᅞ A) Benefit percentage is a past service cost that will be amortized into and thus
increase pension expense over the remaining service lives of its employees.
ᅚ B) Compensation growth rate assumption is a change in actuarial assumption that will

reduce the defined benefit obligation and future pension expense.
ᅞ C) Benefit percentage is a change in actuarial assumption that will be recognized in full in

current period pension expense.
Explanation
The change in the compensation growth rate assumption is a change in actuarial assumption that will reduce the defined
benefit obligation and future pension expense, as the effect is amortized into pension expense over time. In this question, the
change is a reduction in both the defined benefit obligation and pension expense.
The change in the contribution percentage is not a change in actuarial assumption but a plan amendment (which would be
reflected as negative past service cost and either amortized under US GAAP or recognized in full under IFRS).
Amortization of negative past service cost (applicable only under US GAAP) would decrease, not increase, pension expense
over the remaining service lives of its employees. (LOS 20.d)
A company reporting under U.S. GAAP reduced the discount rate for its pension obligation from 10% to 8%, reduced the
expected long-term rate of return on the assets in its pension plan from 8% to 6%, and changed its compensation growth rate
assumption from 4% to 5%. What is the most likely impact of these changes on the current year ending defined benefit
obligation and pension expense?
ᅞ A) The reduction in the discount rate will decrease the defined benefit obligation
and will increase reported pension expense.
ᅞ B) The decrease in the long-term rate of return on plan assets will decrease reported
pension expense.
ᅚ C) The decrease in the long-term rate of return will have no impact on the defined benefit
obligation and will increase reported pension expense.
Explanation
The decrease in the expected long-term rate of return on plan assets from 8% to 6% will have no effect on the defined benefit
obligation (after all, it is an obligation and not an asset). The reduction will, however, increase reported pension expense for
current and future periods because the expected return is subtracted while computing pension expense.
The reduction in the discount rate from 10% to 8% will increase (not decrease) the defined benefit obligation and will also
increase reported pension expense because it will increase the current service cost. Additionally, the actuarial gains and
losses resulting from this change (the difference between the defined benefit obligation after the increase and the defined
benefit obligation before the increase) will be amortized into pension expense over time using the corridor approach.
Amortization will start in the period after the change is made.
The decrease in the expected long-term rate of return on its plan assets from 8% to 6% will increase, not decrease, reported
pension expense. Expected return reduces pension expense. (LOS 20.d)
Which of the following statements about stock appreciation rights, performance stock, and phantom stock is most accurate?
ᅞ A) Phantom stock payoffs are based on the performance of the firm's actual
shares.
ᅚ B) Stock appreciation rights never have any dilution effect on the existing shareholders.
ᅞ C) Performance stock cannot be sold by the employee until vesting has occurred.
Explanation
Stock appreciation rights do not cause dilution to the existing shareholders since no shares are actually issued.
Performance stock is a type of stock grant. It is contingent on meeting performance goals such as accounting earnings or
other financial reporting metrics like return on assets or return on equity. Unfortunately, tying performance to accounting
earnings and other metrics may result in manipulation by the employee. With restricted stock, the transferred stock cannot be
sold by the employee until vesting has occurred.
Phantom stock is similar to stock appreciation rights except the payoff is based on the performance of hypothetical stock
instead of the firm's actual shares.
Which of the following statements about cash flow is (are) CORRECT?
Statement #1: The cash effects of decreasing accounts payable turnover are unlimited.
Statement #2: The tax benefits from employee stock options can result in a significant source of investing cash
flow.
Statement #1 Statement #2
ᅚ A) Incorrect Incorrect
ᅞ B) Correct Incorrect
ᅞ C) Incorrect Correct
Explanation
Statement #1 is an incorrect statement. The cash effects of decreasing accounts payable turnover are limited. Suppliers will
eventually stop extending credit because of delayed payments. Statement #2 is an incorrect statement. The tax benefits from
employee stock options can result in a significant source of operating and financing cash flows. Tax benefits do not affect
investing cash flows.
Consider a situation at a firm where the differences in its cash flow and economic pension expense are considered material to
the financial statements. The relevant tax rate is 30%. The expected return on plan assets is $120,000, interest cost is
$85,000, employer's contribution is $215,000, service cost is $450,000, and the actual return on plan assets is $50,000. Based
on the information provided and for analytical purposes only, which of the following statements is most appropriate?
ᅞ A) There is a reclassification of $270,000 from operating cash flow to financing

cash flow.
ᅚ B) There is a reclassification of $189,000 from operating cash flow to financing cash flow.
ᅞ C) There is a reclassification of $140,000 from operating cash flow to financing cash flow.
Explanation
The total periodic pension cost = service cost + interest cost − actual return on plan assets = $450,000 + $85,000 − $50,000 =
$485,000.
Since the differences in cash flow and economic pension expense are considered material, for analysis purposes we should
consider reclassifying the difference from operating activities to financing activities in the cash flow statement.
The employer's contribution was only $215,000. Since the total periodic pension cost exceeds the cash flow, the difference,
net of tax, is treated as a borrowing in the cash flow statement for analytical purposes. Given a tax rate of 30%, $189,000 is
reclassified from operating cash flow to financing cash flow [($485,000 total periodic pension cost − $215,000 employer
contribution) ((1 − 30% tax rate)].
Wonderful Manufacturing has implemented a change in its pension plan, that will increase the future benefits for all of its
current employees. Which of the following is the most likely effect on the company's financial statements of this change in
promised benefits under current U.S. GAAP standards?
ᅞ A) The pension expense for the next reporting period will increase by the
projected increase in pension benefits due to employees.
ᅚ B) The net pension liability will increase immediately by the projected increase in pension
benefits due to employees.
ᅞ C) The firm's prior financial statements will be adjusted to reflect the increase in benefits.
Explanation
A plan amendment will result in an immediate increase in the PBO. Under current U.S. accounting standards, an increase in
PBO will result in an increase in the net pension liability (decrease in funded status).
Which of the following measures is least sensitive to changes in pension plan actuarial assumptions?
ᅚ A) Projected benefit obligation (PBO).

ᅞ B) Total periodic pension cost.
ᅞ C) Balance sheet asset or liability.
Explanation
Total periodic pension cost is a net (smaller) amount and therefore, is generally quite sensitive to relatively minor changes in
actuarial assumptions.
Changing an assumption may have a small effect on the projected benefit obligation (PBO) but may have a much larger effect
on the funded status (which is a net pension amount) which is the balance sheet asset or liability.
Which of the following is NOT an advantage of share based compensation over cash compensation?
ᅚ A) In a share based compensation plan, expense is not recognized, unless the

exercise price is set below the market price.
ᅞ B) Share based compensation does not require a cash outlay.
ᅞ C) Share based compensation serves to align employee interest with the interests of
stockholders.
Explanation
Share based compensation needs to be recognized at fair value under both U.S. GAAP and IFRS. Intrinsic value does not
matter. However, the expense is does not require a cash outlay and serves to align the interests of employees and
stockholders.
Federal Companies reported the following information in the footnotes to its most recent financial statements:
Beginning Projected Benefit Obligation (PBO) $65,000,000

Ending PBO 90,000,000
Service Cost 27,000,000
Interest Cost 3,000,000
Benefits Paid 5,000,000
Actual Return on Plan Assets 7,500,000
Expected Return on Plan Assets 8,500,000
Given the information above, calculate Federal's total periodic pension cost for the year.
ᅞ A) $41,000,000.
ᅞ B) $27,500,000.
ᅚ C) $22,500,000.
Explanation
Total periodic pension cost = service cost + interest cost - actual return on plan assets + plan ammendments
Therefore, $27,000,000 + 3,000,000 - 7,500,000 = $22,500,000
There are no other actuarial assumptions affecting PBO as evidenced by reconciliation of PBO:
Beginning
65
PBO
(+) Service
27
cost
(+) Interest
3
cost
(-) Benefits
(5)
paid
(=) Ending
90
PBO
Tim Gresham, CFO of Alpha Logistics is concerned about changes in the business environment which could lead to Alpha
violating some of the covenants of their outstanding debentures. Specifically Gresham is concerned about leverage and
profitability ratios. Gresham reviews Alpha's most recent financial statements and decides that changing the assumptions for
the company's defined benefit pension plan may provide some relief in the short-run. Alpha reports under U.S. GAAP.
Which of the following changes in the pension plan's assumptions would most likely lead to lower reported leverage and higher
reported profitability?
ᅞ A) Increasing expected return on plan assets.

ᅚ B) Increasing the discount rate.
ᅞ C) Increasing the growth rate in compensation expense.
Explanation
Increasing discount rate leads to lower present values and reduces reported pension liability in the balance sheet and also
reduces pension expense by reducing the service cost component. Increasing expected return on plan assets does reduce
pension expense but does not affect reported assets or liabilities. Increasing the growth rate in compensation expense
increases service cost as well as reported pension liability.
Which of the following statements about the methods of valuing employee stock options is least accurate?
ᅞ A) With either method, the offset to compensation expense recognized is an

increase in paid-in capital.
ᅞ B) With the fair value method, compensation expense is allocated in the income
statement for the period between the grant date and the vesting date.
ᅚ C) With the intrinsic value method, once the options are in-the-money, compensation
expense is recognized on the income statement.
Explanation
With the intrinsic value method, compensation expense is recognized in the income statement only if the market price of the
stock exceeds the exercise price of the option on the date the option was granted (grant date).
Compensation expense is now based on the fair value of the option on the grant date based on the number of options that are
expected to vest. The vesting date is the first date the employee can actually exercise the option. The compensation is
allocated in the income statement over the service period (which is the time between the grant date and the vesting date).
For any compensation expense recognized, the offset is an expense in paid-in capital, which is a stockholders' equity account.
Jason Moore, CFA, is a credit analyst for Everest Bank in New York in the firm's investment banking division. An existing
customer of Everest, Longhorn Partners, which is based in Texas, has approached the bank for a $45 million loan to be used
to acquire a smaller competitor. Moore has been appointed head of the credit team that will review Longhorn's current
business with Everest as well as Longhorn's current operations, in order to assess Longhorn's request.
Overall, Longhorn has achieved consistent profitability over the last decade. The company is appropriately leveraged and
appears to be well-run by its senior management team. However, there are a couple of items in the company's financial
statements that Moore believes may warrant further analysis. He specifically wants to adjust Longhorn's reported operating
profit for comparative analysis with other companies who may not report their entire pension expense as an operating
expense.
For many years, Longhorn has offered to its fulltime employees a traditional defined-benefit pension plan: eligible employees
are promised an annual pension payment of 3% per year of service times their annual salary at retirement. Selected
information regarding the pension plan from Longhorn's most recent financial statement is as follows:
Pension Benefit Obligation (PBO)

$85,475,000
(ending)
Accumulated Benefit Obligation (ABO)
65,250,000
(ending)
Fair value of plan assets (ending) 71,365,000
Fair value of plan assets (beginning) 66,360,000
Operating income 17,185,000
Interest expense 1,285,000
Pension Expense 5,456,000
Contributions 7,200,000
Service cost 4,114,000
Interest cost 5,342,000
Discount rate 6.25%
Additionally, Longhorn has a share-based compensation plan for its senior executives.
The balance sheet asset/liability related to Longhorn's pension plan is closest to:
ᅚ A) a liability of $14,110,000.
ᅞ B) an asset of $6,115,000.
ᅞ C) a liability of $6,115,000.
Explanation
Pension plans are underfunded when the PBO exceeds the fair market value of the plan assets. In this case, the PBO exceeds
the plan assets by $14,110,000 (= $85,475,000 − 71,365,000) and hence a liability will be reported. (Study Session 6, LOS
20.b)
Moore reads in the footnotes to Longhorn's financial statements that the pension plan's PBO increased by $5,000,000 last
year. Of this amount, approximately 50% was attributed to benefits earned by its employees that year. The remaining 50%
was attributed to a change in the pension plan's actuarial assumptions. Which of the following changes to actuarial
assumptions is most likely to cause an increase in PBO? A decrease in the:
ᅚ A) discount rate.
ᅞ B) expected rate of return.
ᅞ C) rate of compensation growth.
Explanation
Decreasing the assumed discount rate used to calculate the present value of the pension obligations will increase the PBO.
(Study Session 6, LOS 20.d)
Compared to the reported net income, if Longhorn had used a higher stock price volatility assumption in valuing stock option
grants to its senior executives, Longhorn's net income would have most likely have been:
ᅚ A) lower.
ᅞ B) higher.
ᅞ C) unchanged.
Explanation
An increase in the assumed stock price volatility would increase the value of the option grants, increase the compensation
expense and lower the reported net income. (Study Session 6, LOS 20.h)
Compared to the reported compensation expense, if Longhorn had used a lower estimated life assumption in valuing stock
option grants to its senior executives, Longhorn's compensation expense would have most likely been:
ᅞ A) unchanged.
ᅚ B) lower.
ᅞ C) higher.
Explanation
Lower estimated life of the options lead to lower values of the option and lower compensation expense. (Study Session 6, LOS
20.h)
Longhorn's adjusted operating profit is closest to:
ᅞ A) $15,843,000
ᅚ B) $18,527,000
ᅞ C) $14,110,000
Explanation
Adjusted operating profit is computed as reported operating profit + reported pension expense − service cost.
=17,185,000 + 5,456,000 − 4,114,000 = $18,527,000
(Study Session 6, LOS 20.f)
Assume for this question only that the actual return on plan assets was $981,200 higher than the expected return of
$5,308,800. The amount of benefits paid to plan participants was closest to:
ᅚ A) $8,485,000.
ᅞ B) $5,192,000.
ᅞ C) $1,285,000.
Explanation
Actual return on plan assets = 5,308,800 + 981,200 = $6,290,000
Beginning Plan assets (given) 66,360,000

(+) Contributions (given) 7,200,000
(+) Actual return on plan assets 6,290,000
(computed)
(−) Benefits paid (plug) 8,485,000
(=) End Plan Assets (given) 71,365,000
Wes Livingston is the founder and CEO of Bigwell Corporation. Livingston is interested in Bigwell being acquired by a larger
competitor and wants to have his company's financial statements appear as attractive as possible to a potential suitor. In order
to decrease the projected benefit obligation (PBO) of the company's pension plan, which of the following changes in actuarial
assumptions could be made?
ᅞ A) Increase the rate of compensation growth.

ᅚ B) Increase the discount rate.
ᅞ C) Decrease the discount rate.
Explanation
Increasing the assumed discount rate of a pension plan will result in lower projected benefit obligation (PBO). Increasing rate
of compensation growth and decreasing discount rate would increase the PBO.
In determining the fair value of employee stock options, which of the following statements is most appropriate?
ᅞ A) A lower risk-free rate will usually increase the estimated fair value.
ᅚ B) A higher than expected dividend yield will decrease the estimated fair value.
ᅞ C) Absent a market-based instrument, U.S. GAAP and IFRS prefer firms to use the
Black-Scholes option-pricing model.
Explanation
Dividends paid out reduce the value of the underlying shares and therefore, reduce the value of the option.
There is no preference of a specific option-pricing model in either IFRS or U.S. GAAP. Acceptable models include the Black-
Scholes model or the binomial model.
A lower risk-free rate will usually decrease the estimated fair value of the option (Refer to Study Session 17). The sensitivity
factor is "Rho" and for call options, there is a positive relationship between the risk-free rate and the estimated fair value of the
option.

The financial statements of Pace Industries issued over the past five years show a progressively increasing net difference
between the value of its pension fund and the projected future pension liability on the balance sheet. Pace most likely offers
which of the following types of pension plans to its employees?
ᅞ A) A defined contribution plan.

ᅚ B) A defined benefit plan.
ᅞ C) A 401(k) plan.
Explanation
A company with a defined benefit plan will fund a portfolio structured to fulfill future pension obligations. The difference
between the current value of the assets and the projected future liability is shown as a net amount on the balance sheet.
Which of the following statements about stock-based compensation are correct or incorrect?
Statement #1: The grant date of a service-based award is the date when the employees'
benefits are fully vested.
Statement #2: When two or more performance conditions must be satisfied, the requisite
service period ends when the first condition is met.
ᅞ A) Only one is correct.

ᅚ B) Both are incorrect.
ᅞ C) Both are correct.
Explanation
The grant date is the date an award is approved by the board of directors or compensation committee. When two or more
performance conditions must be satisfied, the requisite service period does not end until all conditions are met.
The projected benefit obligation (PBO) is defined as the:
ᅞ A) actuarial future value of all post-retirement healthcare benefits earned to date.

ᅚ B) actuarial present value of all future pension benefits earned to date based on
expected future salary increases.
ᅞ C) actuarial present value of all future pension benefits earned to date and based on
current salary levels.
Explanation
The projected benefit obligation (PBO) is defined as the actuarial present value of all future pension benefits earned to date
based on expected future salary increases.
The following information relates to Nazarali Inc. (Nazarali) and its defined-benefit pension plan for the year:
Contributions $3.0 million
Reported pension expense $2.8 million
Total periodic pension cost $3.1 million
Based on the information above, which of the following statements is most accurate?
ᅞ A) There is a reduction in the overall pension obligation of $100,000.

ᅚ B) There is a source of borrowing of $100,000.
ᅞ C) There is a reduction in the overall pension obligation of $200,000.
Explanation
The total periodic pension cost represents the true cost of the pension. The reported pension expense is irrelevant in this
case.
Since the true pension expense ($3.1 million) exceeds the contributions ($3.0 million), the $100,000 difference can be viewed
as a source of borrowing. Alternatively, if the firm's contributions exceed the true pension expense, the difference can be
viewed as a reduction in the overall pension obligation, similar to an excess principal payment on a loan.
Which of the following statements regarding pension accounting under U.S. GAAP standards and/or under International
Financial Reporting Standards (IFRS) is most accurate?
ᅚ A) Under IFRS, the funded status (difference in the PBO and the plan assets) is
now reported on the balance sheet.
ᅞ B) Under IFRS and U.S. GAAP, the calculation of pension expense is the same.
ᅞ C) Under U.S. GAAP, firms are required to provide a reconciliation of the funded status
and the reported net pension asset or liability.
Explanation
The calculation of reported pension expense differs between U.S. GAAP and IFRS. Under U.S. GAAP and under IFRS, the net
pension asset or liability reported on the balance sheet is equal to the funded status, without adjustment for unrecognized
items.
Since balance sheet asset/liability under U.S. GAAP and IFRS reflects funded status, no reconciliation is necessary in the
footnotes.
Jon Horton, CFA, is the Chief Financial Officer (CFO) for Springtown Corporation, a manufacturer of windows for residential
and commercial applications. As part of an ongoing diversification strategy, Springtown Corp. has recently entered into a
preliminary agreement to purchase all of the assets of Prime Doors, a manufacturer and distributor of doors to the same
residential and commercial market in which Springtown sells its windows. Horton is head of the due diligence team that will
fully evaluate Prime Doors' financial statements prior to the proposed acquisition.p>
Prime Doors has been in operation for thirty years, and currently has approximately 800 employees at two operating facilities.
Horton observes in the notes to the financial statements that Prime Doors has a defined benefit pension plan, for which all
employees are eligible. Employees are vested at the rate of 20% per year of employment, and are fully vested upon
completion of five years of employment. Springtown does not offer a pension plan to its employees, but encourages
employees to contribute to Individual Retirement Accounts (IRAs) and offers a 401(k) program.
Horton wants to fully evaluate the financial implications of Springtown's assumption of Prime Doors' pension assets and the
associated future liabilities and expenses. Like most companies, the pension plan for Springtown's employees is not fully
funded, but Horton wants to review all assumptions used by Springtown's accountants in the valuation of the plan's current
liabilities. The most current information regarding the pension plans is as follows:
Select Pension Plan Information for Prime Doors (as of 12/31/05)

Projected benefit obligation (PBO) $15,500,000
Accumulated benefit obligation (ABO) $13,750,000
Market value of plan assets $11,875,000
Horton notices a paragraph in the pension plan footnotes that the original pension plan was amended last year, effectively
increasing the level of benefits to be paid to employees with more than ten years of service. However, he is not able to detect
what effect, if any, this change in projected benefits has had on Prime Doors' financial statements or is expected to have in the
future.
Horton is aware that a commonly used method can be used to adjust the income statement and provide a better measure of
Prime Doors' economic pension cost than reported pension expense. He is not quite sure which components of the financial
statements are utilized to derive an adjusted pension expense, but intends to investigate what analysis he can perform to gain
more insight into the company's position with regards to its pension plan.
When accounting for pension liabilities in the U.S., a company must make fundamental assumptions to estimate the future
liability and expense for each employee. How are the following assumptions required to be treated in the pension footnotes?
Required disclosure Not required to be disclosed
ᅞ A) Rate of compensation
Discount rate
growth
ᅞ B) Discount rate Expected return on plan assets
ᅚ C) Rate of compensation growth Expected length of employment
Explanation
A company must disclose the discount rate, the expected return on plan assets, and the rate of compensation growth. The
expected length of employment is not a required disclosure.
What effect will an increased discount rate and increased expected rate of return have on a company's projected benefit
obligation (PBO) and accumulated benefit obligation (ABO) as reflected in the financial statements?
ᅚ A) Both will decrease.
ᅞ B) Both will increase.
ᅞ C) Only one will increase.
Explanation
The use of a higher discount rate will decrease a company's PBO and ABO because it will result in a lower present value of
future pension liability. The expected rate of return has no impact on pension obligations.
According to U.S. GAAP, companies must account for pension assets and the associated pension obligation in their financial
statements. These could be reported in two ways. Method 1 is to report the values of the pension fund assets and liability
separately on the balance sheet. Method 2 is to report a net amount for the difference between the value of the fund assets
and the fund liabilities. Which of the following statements most accurately describes the requirements of U.S. GAAP?
ᅞ A) Companies are required to use Method 1.

ᅚ B) Companies are required to use Method 2.
ᅞ C) Companies may choose to use either method.
Explanation
GAAP requires that companies use the "net" method, which decreases a firm's total assets and total liability. Netting also
affects certain financial ratios, such as return on assets and leverage ratios.
Prime Doors has recorded a net pension liability of $1.5 million on its balance sheet. According to current U.S. accounting
standards, Prime Doors is required to:
ᅞ A) immediately recognize $2,125,000 as additional pension expense in its income

statement.
ᅚ B) record $2,125,000 as additional pension liability on its balance sheet.

ᅞ C) record $375,000 as additional pension expense on its balance sheet.
Explanation
According to current U.S. accounting standards, the funded status must be reported on the balance sheet. The plan is
underfunded by $3,625,000 ($11,875,000 Plan assets − $15,500,000 PBO). Since Prime Doors is reporting a liability of
$1,500,000, an additional liability of $2,125,000 ($3,625,000 required liability − $1,500,000 reported liability) must be reported.
Which of the following statements regarding the treatment of pension plan amendments under U.S. GAAP standards is most
accurate? A plan amendment results in:
ᅞ A) an immediate increase in pension expense equal to the amount of the

amendment.
ᅞ B) the disclosure in the pension plan footnotes of the nature of the amendment and the
projected future financial impact.
ᅚ C) an unrecognized prior service cost that is amortized over the expected remaining
service life of the affected employees.
Explanation
The amendment affects the funded status on the balance sheet immediately. In the income statement, the amendment is
amortized as a component of pension expense over the remaining service life of the affected employees.
Pension expense as reported by a firm is routinely adjusted by analysts to derive a more accurate measure of a firm's true
economic pension cost. Economic pension expense is calculated as:
ᅞ A) reported pension cost - actual return on plan assets.

ᅚ B) Contribution - ( Ending funded status - beginning funded status)
ᅞ C) reported pension expense - service cost + interest cost.
Explanation
Economic pension expense is calculated without reflecting the amortized items normally included in pension expense and
using "actual" instead of "expected" return on assets. It can be also computed as Change in funded status excluding
contributions.
The Board of Directors of Prime Bank has asked management to make changes in the accounting of its pension plan
obligations in order to decrease the reported service cost. Management determines that there are two changes in actuarial
assumptions that will result in a lower service cost. Which of the following pairs of changes in actuarial assumptions will best
achieve the desired effect? Prime Bank can either:
ᅞ A) decrease the rate of compensation growth or increase the expected rate of

return.
ᅚ B) increase the discount rate or decrease the rate of compensation growth.

ᅞ C) decrease the discount rate or increase the expected rate of return.
Explanation
An increase in the discount rate will result in lower service cost. Using a lower rate of compensation growth will yield lower
future pension benefits owed, and thus a lower service cost. The expected return has no impact on service cost.
Which of the following statements regarding the projected benefit obligation (PBO) and the value of the pension plan assets is
most accurate?
ᅚ A) If the PBO and the plan assets are the same, then nothing needs to be reported
on the balance sheet.
ᅞ B) The fair value of plan assets is increased by the amount of the expected return on
assets.
ᅞ C) Plan amendments during the year generally result in a decrease of the PBO at the
end of the year.
Explanation
Neither the PBO nor the plan assets are separately reported on the balance sheet. The funded status is the difference in the
PBO and the plan assets. If the PBO exceeds the plan assets, the difference is reported as a liability. If the plan assets exceed
the PBO, the difference is reported as an asset. If the amounts are the same, then neither a liability nor asset needs to be
reported.
Plan amendments (i.e. additional benefits provided that increase the amount of the employer's obligation to plan participants)
generally result in an increase of the PBO.
The fair value of plan assets at the beginning of the period is increased by the actual return on plan assets as well as any
employer contributions. It is reduced by the amount of benefits paid.
Paul Roberts, CPA, is a partner in Roberts & Smith, an accounting firm that is located in Chicago. The firm has recently been
retained by Midwest Manufacturing, a major producer of heavy machinery and tractor parts in the U.S. Midwest has been in
operation since 1965, and currently has approximately 700 full-time employees. The company had its initial public offering in
1986. The company has hired Roberts's firm to ensure that the accounting for Midwest's employee pension plan is fully in
compliance U.S. GAAP standards.
Selected year-end pension plan information for Midwest Manufacturing
2006 2007
PBO $21 million $23 million
Discount Rate 6.0% 7.5%
Rate of Compensation Increase 4.0% 4.0%
Benefits paid $0.8m $1m
Interest cost $1.6m
Service cost $3m
Roberts will educate Midwest's accounting department on pension plan accounting that would be relevant to their situation.
In accordance with U.S. GAAP, distinguish which of the following events are classified as "actual" events and which ones are
"smoothed" events.
Actual Smoothed
ᅞ A) service cost interest cost
ᅞ B) interest cost total periodic pension cost

ᅚ C) expected return on plan
service cost
assets
Explanation
Service cost and interest cost are considered to be actual events. Expected return on plan assets, amortization of
unrecognized prior service costs, and amortization and deferral of actuarial gains and losses are classified as smoothed
events. Together, these five components are used to calculate a plan's reported pension expense or income on the income
statement. Total periodic pension cost is actual cost (not smoothed) of the plan - but not reflected fully in the reported pension
expense. (Study Session 6, LOS 20.c)
Based on the information provided, the impact of change in discount rate in 2007 (as compared to 2006) is closest to:
ᅚ A) a decrease in PBO of $1.6 million.

ᅞ B) a decrease in PBO of $2 million.
ᅞ C) a decrease in PBO of $2.6 million.
Explanation
A higher discount rate will result in lower PBO. Reconciliation of opening and closing PBO shows:
Beginning PBO $21 million Given
(+) Interest cost 1.6 Given
(+) Service cost 3.0 Given
(-) Benefits paid (1.0) Given
(-) Actuarial Changes (1.6) PLUG
(=) Ending PBO $23 million Given
Changes due to actuarial assumptions = −$1.6m

As of January 1st , 2007, the fair value of plan assets was $19 million. Which three components are necessary to calculate the
fair value of the plan assets at the end of the year?
ᅞ A) expected return on plan assets, employer and participant contributions, and

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

ᅞ C) service cost, interest cost, and benefits paid.
Explanation
Companies are required to disclose a reconciliation of the beginning and ending balances of the fair value of plan assets,
which can be calculated as follows:
Fair value of plan assets at the beginning of the year

+ Actual return on assets
+ Employer contributions
− Benefits paid
= Fair value of plan assets at the end of the year
A major change in U.S. GAAP pension accounting standards, effective as of December 2006, resulted in public companies
now being required to report which of the following?
ᅞ A) The expected return on plan assets.

ᅚ B) The funded status of the plan.
ᅞ C) The pension liability adjusted for unrecognized items.
Explanation
The current standard requires companies to report the funded status of the plan, which is the difference between the PBO and
the fair value of plan assets. (Study Session 6, LOS 20.b)
As of December 31st , 2007, the fair value of plan assets was $21 million. For this question only, assume that the sum of the
unrecognized prior service cost and the unrecognized actuarial losses equals $1.5 million. Calculate the amount attributable to
Midwest's pension plan as of December 31st , 2007 that must be reported on the balance sheet under U.S. GAAP.
ᅞ B) −$500,000.
ᅚ C) −$2.0 million.
Explanation
The funded status is the difference between the PBO and the fair value of plan assets as of the reporting date. For Midwest's
plan, $21,000,000 − 23,000,000 = −$2,000,000. PBO figure is already given - and it includes all unrecognized items (and
hence need not be adjusted).
Which of the following statements regarding the U.S. GAAP pension accounting standards is most accurate?
ᅞ A) For most companies, the pension liability will increase while financial leverage
may increase or decrease as a result of applying the standard.
ᅞ B) The changes in GAAP now cause U.S. standards to be consistent with the
International Financial Reporting Standards (IFRS) for pension plans.
ᅚ C) The balance sheet will now reflect the true economic position of the pension plan, but
the income statement will not necessarily reflect a true measure of economic pension
expense.
Explanation
Because deferred and unrecognized items are required to be reported on the balance sheet but not the income statement, the
balance sheet will reflect the true economic position of the pension plan, but the income statement will not necessarily reflect a
true measure of economic pension expense. U.S. GAAP and IFRS still differ with respect to reporting pension expense.
(Study Session 6, LOS 20.b, c)
Under current U.S. GAAP, the assets and liabilities of a defined benefit pension plan are:
ᅞ A) off balance sheet items which are shown only in the footnotes.
ᅞ B) reported in the appropriate section of the balance sheet, with pension obligations
shown under liabilities and plan assets shown under assets.
ᅚ C) netted against each other, and only the net asset or liability amount is reported on the
company's balance sheet.
Explanation
Under current U.S. GAAP, companies are required to report only the net asset or liability amount. They cannot show assets
and liabilities separately. Although some smoothing details are still disclosed in the footnotes, all major components of pension
assets and liabilities are now required to be shown on the balance sheet.
Financial analysts can use select data from a company's financial statements to derive total periodic pension cost in order to
better reflect the company's true economic pension cost. Which of the following formulas will most accurately calculate a
company's true pension expense?
ᅞ A) Service cost + interest cost - actual return on plan assets - benefits paid.
ᅞ B) Beginning fair value of plan assets + service cost + interest cost - ending fair value of
plan assets.
ᅚ C) Service cost + interest cost + plan amendments - actual return on plan assets.
Explanation
The total periodic pension cost, (absent any information on changes in actuarial assumptions) is calculated without reflecting
the amortization of unrecognized items and other smoothing mechanisms included in reported pension expense, and in
addition uses the plan's actual return on assets, rather than the plan's expected return.
An analyst views the assumptions made by a company reporting under U.S. GAAP regarding its pension liabilities as
unrealistic, and thinks the discount rate and expected rate of return should both be increased. The most likely effect of
increasing the discount rate and expected rate of return on the pension benefit obligation (PBO) is:
Expected rate of
Discount rate
return
ᅞ A) Increase Decrease
ᅞ B) No effect Decrease
ᅚ C) Decrease No effect
Explanation
The PBO will decrease because a higher discount rate will cause the present value of the future obligations to decline. There
will be no effect from changing the expected rate of return because expected return relates to the pension expense, not to the
size of the obligation.
Which of the following statements regarding pension accounting is most accurate?
ᅚ A) Changes in the projected benefit obligation (PBO) and plan assets fully and
immediately affect the balance sheet.
ᅞ B) A reconciliation between the funded status and the net pension asset (liability)
reported on the balance is required.
ᅞ C) Changes in actuarial assumptions and past service costs fully and immediately affect
the income statement.
Explanation
Changes in the projected benefit obligation (PBO) and plan assets immediately affect the funded status (difference in PBO and
plan assets) and the full amount of the changes is reflected on the balance sheet when the change occurs.
Changes in actuarial assumptions and past service costs are recognized in the income statement over time thereby smoothing
pension expense.
Since the funded status is equal to the net pension asset (liability) reported on the balance sheet under no reconciliation is
required.
The actuarial present value of all future pension benefits earned to date, based on expected future salary increases, is called
the:
ᅞ A) total projected pension cost.

ᅚ B) projected benefit obligation (PBO).
ᅞ C) pension liability.
Explanation
The PBO is the actuarial present value (at an assumed discount rate) of all future pension benefits earned to date, based on
expected future salary increases. It measures the value of the obligation, assuming the firm is a going concern and that the
employees will continue to work for the firm until they retire. Pension cost is periodic and not total projected. Pension liability is
the net amount of PBO and fair value of plan assets.
(Study Session 6, 20.b)
Roberto Perez, CFA, is the Chief Financial Officer for Home Stores, Inc., a large home improvement retailer with stores
located across the United States. Home Stores is preparing for a secondary stock offering to secure the necessary capital to
pursue an aggressive expansion campaign. Perez has received a directive from his boss to make every legitimate effort to
present Home Stores' upcoming financial statements in the best possible light. Perez determines that certain assumptions in
the pension plan can be changed to fulfill this request. Which of the following pension plan assumptions can be changed by a
firm to manipulate its reported results?
Change Result
ᅚ A) decreased rate of
decreased service cost
compensation growth
ᅞ B) increased expected rate of

decreased service cost
return
ᅞ C) decreased discount rate increased expected return
Explanation
The rate of compensation growth is the expected average annual increase in employee compensation. If the rate of growth is
lowered, reported results will be improved due to a decrease in service cost. A decrease in service cost will result in lower
pension expense.
In order to decrease the projected benefit obligation (PBO) of a pension plan, which of the following changes in pension
assumptions can be made to yield the desired result?
ᅞ A) Increase the expected rate of return.

ᅞ B) Decrease the discount rate.
ᅚ C) Decrease the rate of compensation growth.
Explanation
A decrease in the rate of compensation growth will lower future pension payments and in turn, lower the PBO.
Jason Johnson, CFA, is a principal of a large private equity firm in New York. One of the associates in his firm has identified a
potential investment opportunity for the firm: Gasline, Inc. is a major producer of carbon steel pipe used in the transportation of
natural gas in the Southwestern United States.
Of particular concern to Johnson is Gasline's numerous, complicated transactions related to the company's various stock-
based compensation plans and its defined benefit pension plan.
For example, the CEO of Gasline was awarded a stock option package at the beginning of 2013, which could ultimately have a
significant impact on the company's future earnings. Details of the CEO's stock option grant are outlined below
CEO Options (grant date January 1, 2013)

Strike price $37.00
Current market price $35.00
Number of options 100,000

Option period 4 years
Vesting period 25% per

year
For the valuation of the CEO's stock options granted on January 1, 2013, Gasline estimated a fair value of $100,000 by using
Monte Carlo simulation. In accordance with SFAS No. 123(R), which of the following statements is most accurate? Gasline's
accounting treatment of the options is:
ᅞ A) not in compliance because the fair value must be established by using the
Black-Scholes option pricing model.
ᅞ B) in compliance because the firm can elect to use either the intrinsic value model or the
fair value model in the valuation of stock option plans.
ᅚ C) in compliance because a Monte Carlo simulation is an acceptable method of valuing
options in the absence of a market-based instrument.
Explanation
Under SFAS No. 123(R), firms are required to use the fair value method of valuing stock option plans. In the absence of a
market-based instrument, firms may select and use an option-pricing model such as the Black-Scholes, the binomial model or
Monte Carlo. (LOS 20.h)
Assume that the CEO of Gasline exercises $25,000 of his options on December 31, 2013, and the market price of the stock on
that date is $39.50. Calculate the total compensation expense for the year ending 2013 that Gasline should recognize in
association with the CEO option grant.
ᅞ A) $100,000.
ᅚ B) $25,000.
ᅞ C) $62,500.
Explanation
Under the fair value method, as required by SFAS No. 123(R), Gasline will recognize compensation expense over the 4 year
vesting period. For the year ending 2013, Gasline will recognize $25,000 (= $100,000 / 4 years) in compensation expense.
Compensation expense is not affected when options are exercised. (LOS 20.h)
Which of the following actions by the management is least likely to reduce the reported option expense?
ᅞ A) Assuming a lower risk-free rate.

ᅞ B) Assuming a lower stock price volatility.
ᅚ C) Assuming a low dividend yield on the stock
Explanation
Low dividend yield would increase option value (and option expense). Lower risk-free rate and lower volatility assumptions
would reduce option value and option expense. (LOS 20.h)
If management increases the assumed discount rate, the least likely effect is that the:
ᅚ A) plan assets will increase.

ᅞ B) pension expense reported in P&L will decrease.
ᅞ C) funded status will improve.
Explanation
Increasing the discount rate would reduce PBO and not change the plan assets, improving the funded status. Reported
pension expense would also decrease in most cases. (LOS 20.d)
Regarding Gasline's defined benefit pension plan: if management increases the expected return on plan assets, the most
likely effect is that the:
ᅞ A) funded status would improve.

ᅞ B) total periodic pension cost would decrease.
ᅚ C) pension expense reported in P&L would decrease.
Explanation
Increasing the expected return on plan assets would not affect PBO or plan assets and hence would not affect the funded
status. It would however reduce reported pension expense. Total periodic pension cost is based on actual return on plan
assets and hence would not be affected. (LOS 20.d)
For this question only, assume that Gasline reports under IFRS. If changes in actuarial assumptions affecting the PBO lead to
an actuarial gain, the most likely effect is that the:
ᅞ A) pension expense reported in P&L would decrease.

ᅚ B) total periodic pension cost would decrease.
ᅞ C) plan assets would increase.
Explanation
Changes in actuarial assumptions do not affect plan assets. The funded status would change only due to changes in PBO due
to change in actuarial assumptions. Total periodic pension cost would decrease due to actuarial gains. Actuarial gains would
be considered remeasurement gains and would be reflected OCI (and not income statement). Under US GAAP if the gains
meet the requirements of amortization under corridor approach, the future reported pension expense would be lower. (LOS
20.d)
Multinational Operations Test ID: 7440447
Which of the following statements describing the choice of the functional currency is least accurate? The functional currency
should be the same as the parent's reporting currency if the subsidiary is:
ᅞ A) highly integrated with the parent where the local currency, prices, and some
costs are controlled or restricted.
ᅚ B) mostly independent from the parent.
ᅞ C) highly integrated with the parent where the local currency, prices, and some costs are
not controlled or restricted.
Explanation
The preferred functional currency for subsidiaries that are mostly independent of the parent is the local currency. For highly
integrated subsidiaries (regardless of local conditions), or for subsidiaries operating in high-inflation environments, the parent's
reporting currency should be used as the functional currency.
Which of the following statements regarding the translation of a foreign subsidiary into the reporting currency is most
accurate?
ᅚ A) If the reporting currency is the functional currency, the temporal method is

applied and exposure is equal to net monetary assets.
ᅞ B) A multinational firm with small liability balances generally has minimal foreign currency
exposure on its balance sheet.
ᅞ C) If the functional currency is equal to the local currency, exchange gains and losses on
translation will be recognized in the income statement.
Explanation
The choice of functional currency is the determining factor as to which method of foreign currency translation is utilized.
Therefore, when the reporting currency is the functional currency, the temporal method must be used. The choice of functional
currency is largely left to management's discretion.
Inᅞa hyperinflationary
A) $1,771 and $2,361.
economy, translation under the current rate method will most likely result in relatively:
ᅚ B) $1,845 and $2,401.
ᅚ A) low balance sheet values for long term liabilities.
ᅞ C) $1,845 and $2,361.
ᅞ B) high balance sheet values for long term assets.
ᅞ C) high translation gains.

Explanation
The basis for using the current rate method is when Functional Currency is NOT the same as Parent's Presentation (reporting) Currency.
Explanation
The basis for using the temporal method is when Functional Currency = Parent's Presentation Currency.
In a hyperinflationary economy, translation under the current rate method will most likely result in relatively low balance sheet
values forUSD
Since the assets and
is the liabilities.
functional Translation
currency, losses
use the will also
temporal occur.
method. Under the temporal method, inventory is remeasured using the
historical rate. However, our best guess of the historical rate under the weighted average inventory cost-flow assumption is the average
rate through the period. Hence, A/R = $0.615 × 3,000 = $1,845 and Inventory = $0.6002 × 4,000 = $2,401.
Under the temporal method, the inventory and cost of goods sold (COGS) accounts are both nonmonetary accounts. Which of the
following statements is least accurate regarding these accounts?
Each of the following items is considered a monetary asset or liability account under the temporal method for foreign currency translation
ᅞ A) The Inventory account is remeasured using the historical rate under both LIFO and
EXCEPT:
FIFO.
ᅞ
ᅞ A) accounts
B) If payable. for inventory using first in, first out (FIFO), then a more recent rate will be
the firm accounts
ᅚ B) applied to the inventory account.
inventory.
ᅚ
ᅞ C) long-term
If the firm debt.
accounts for inventory using last in, first out (LIFO), then the beginning-of-period
rate is used to remeasure COGS.
Explanation
Explanation
The monetary asset and liability accounts under the temporal method are cash, accounts receivable, accounts payable, and
long-term
Under LIFO,debt.
the last goods purchased are the first goods out to COGS. Hence, although technically the historical rate is used to
remeasure COGS, a more recent rate is typically more appropriate for COGS under LIFO.

Which of the following statements regarding the foreign currency translation under US GAAP is least accurate? The functional currency is
the:
A company is exposed to foreign exchange risk due the impact of changes in currency values on a:
ᅞ A) parent firm's home currency if the foreign subsidiary operates in a country with high
ᅞ A) company's assets only.
inflation.
ᅞ B) company's assets and liabilities only.
ᅚ B) parent firm's home currency for self-contained independent foreign subsidiaries.
ᅚ C) company's assets, liabilities and future sales.
ᅞ C) subsidiary's local currency for self-contained, independent foreign subsidiaries.
Explanation
Explanation
Foreign exchange risks include the impact of changes in currency values on assets and liabilities of a business, as well as on
future sales.
This statement is incorrect, both remaining statements are correct regarding rules that govern the determination of the functional currency
Questions
of subsidiaries. #6-11 of 154
Hise Home Supply is a large, profitable home improvement retailer located in the United Kingdom. Hise has recently been
acquiring niche retailers with popular brand names in certain segments of the home improvement market. One of these
retailers was Wilson Tile and Stone, a U.S. business that derived a large part of its sales from the UK.
The management team for Hise now makes all operating, financing, and investment decisions. Brian Heltzel, a financial
Which of the following currency translation methods is most appropriate in a hyperinflationary economy under US GAAP? The:
analyst for Hise, is responsible for translating Wilson's financial statements from U.S. dollars to the reporting currency. Hise
ᅞ A) current/non-current
conducts its business and issues financial
method statements
since current in and
assets British poundsare
liabilities (£).translated
Extracts at
from
thethe financial statements of Wilson
are shown below
current in exhibitrate.
exchange one.
ᅞ B) current
Exhibit One - Wilson Financial
rate method Statement
since the translationExtracts
gain or loss is shown on the income statement.
ᅚ C) temporal method because all non-monetary accounts are translated at the historical rate.
Wilson Tile and Stone - December 31, 2007 and 2008 Balance Sheets
Explanation
2007 2008
The temporal rate method is most appropriate because the value of non-monetary assets and liabilities is translated at the
Cash $1,200 $1,400
historical rate. Under IFRS, the firm restates the financials using an inflation index, and then translates using the current rate
Accounts receivable
method. 6,500 9,900
Inventory 10,400 12,400
Question #45 of 154
Fixed assets 40,000 40,000 Question ID: 476593
TheAccumulated depreciation
Precision Screen 10,000 the Acer
Printers (PSP) Company has a foreign subsidiary, 15,000
Tool & Die Company, located in the country
Net fixed
of Rolivia. Theassets $30,000
currency of Rolivia is the Chad. The balance sheet $25,000
and income statement of Acer Tool & Die Company for the
year-ended December 31, 2005, is shown below. The balance sheet has been restated using the U.S. dollar as the functional
currency.
TOTAL ASSETS $48,100 $48,700
Acer Tool & Die Company Balance Sheet
Accounts payable
As of December 31, 2005 $5,000 $6,000
Current portion of LT debt 1,500 1,500
Long term debt 25,000 23,500
Total liabilities $31,500 $31,000

Chad Exchange Rate U.S. $
Total equity $16,600 $17,700
(millions) (Chad/US$) (millions)
Cash 20 0.25 $80
TOTAL LIABILITIES and EQUITY $48,100 $48,700
Accounts receivable 30 0.25 120
Inventory 100 0.3125 320
Wilson
Fixed Tile(net)
assets and Stone - 2008
500 Income Statement
0.3333 1,500
Total assets 650 $2,020
Accounts payable 50 0.25 $200
Revenue $75,000
Capital stock 380 0.3333 1,140
Cost of goods
Retained sold
earnings 220 (60,000) -- 680
Total
Gross liabilities
marginand equity 650 $15,000 $2,020
Other expenses (2,300)

Acer Tool & Die Company Income Statement
Depreciation expense (5,000)
For year ending December 31, 2005
Net Income
(Amounts in millions of Chad)$7,700
Revenues 1,000
Wilson uses the
Cost of sales FIFO method for inventory accounting.
700
Depreciation
Applicable expense
exchange rates are as follows: 50
Selling expense 30
December 31, 2007: £1.00 = $1.60
Translation gain (or loss)
Net
December
income 31, 2008: £1.00 = $1.80 220
Average for 2008 = £1.00 = $1.70
AcerHistorical rate for that
has determined fixedthe
assets, inventory,
exchange and equity:
rate exposure at £1.00 = $1.50 of 2005 is −260 Chad.
the beginning
Heltzel is also using

The exchange rate atsome information
the beginning of that
2005has
wasbeen provided
0.3333 by theThe
Chad/US$. accounts department
exchange of Wilson.
rate at the end of He made
2005 was the
0.25notes
shown below
Chad/US$. in exhibit
The average two from
rate for an e mail
2005 the accounts
is 0.3125 department
Chad/US$. sent.
Beginning inventory is 90 Chad. Acer Tool & Die uses FIFO
inventory valuation and depreciates fixed assets using the straight-line method. Assume that retained earnings at year end
Exhibit Two - Accounting Department Notes
2004 were zero, the historical exchange rate for depreciation is 0.333, and no dividends were paid during 2005.
2008 income before remeasurement
What is Acer Tool & Die's cost of sales in U.S.£4,138
dollars using the temporal method?
gain/loss
Dividends paid during the year £2,250
ᅚ A) $2,222.
Opening retained earnings £5,150
ᅞ B) retained
Ending $2,240. earnings £7,323
ᅞ C) has
Hertzel $2,242.
also discussed the future of Wilson's role in the group with board members from both Wilson and Hise. These
discussions have raised two specific concerns as outline below.
Explanation
Concern One
Purchases = COGS − Beginning inventory + ending inventory = 710 Chad
Heltzel is concerned about the method used to perform the translation. He is of the opinion that in the future Wilson may
become much more independent
Chad and begin to function
Conversion US$ autonomously. To get an idea of the potential accounting impact, he
intends to recalculate
Beginning inventory Wilson's
90 translated
0.3333numbers this year based on the subsidiary being fully autonomous.
$270
Purchases
Concern Two 710 0.3125 2,272
Ending inventory 100 0.3125 320
Wilson's board have warned Heltzel that they are likely to engage in transactions next year which will lead to significant
COGS 700 $2,222
deferred revenue balances remaining on the balance sheet at the year end.

As Heltzel is translating the balance sheet and income statement, which of the following are closest to the values Heltzel
Scud Co. is for
determines a Swiss subsidiary
revenues of the U.S.
and accounts firm Patriot,
payable Inc. On December 31, 2012 the $/SF exchange rate was 0.77. (Each
for 2008?
Swiss Franc buys 77 cents) and is the historical rate applicable for fixed assets and common stock. One year later the Swiss
Accounts
Franc had appreciated to 0.85 $/SF. Scud Co. pays no dividends. The average exchange rate for the year was 0.80 $/SF.
Revenues
Payable
Scud pays no taxes. Assume that inventory is accounted for using the last in, first out (LIFO) inventory assumption and was
bought and sold evenly throughout the year.
ᅚ A) £44,118 £3,333
Scud Co. Int'l
ᅞ B) £44,118 £3,529
Balance Sheet (in SF thousands)
Dec. 31, 2012 Dec. 31, 2013
ᅞ C) £41,667 £3,333
Cash & accounts receivables (A/R) 400 600
Inventory 500 500
Explanation
Net Fixed Assets 700 600
Total
Since theAssets 1,600
British pound is the functional currency, 1,700 should be used. Under both the current rate and
the temporal method
Accounts
temporal payable
methods, (A/P) are translated at the
revenues 100 200 value Heltzel will calculate for revenues is $75,000 /
average rate. The
Long-term
$1.70 debt
= £44,118. 200 100
Common Stock 1,300 1,300
Also, under both the temporal and current rate methods, monetary assets and liabilities are calculated using the current
exchange rate. The value Heltzel will calculate for accounts payable will be $6,000 / $1.80 = £3,333.
Total Liabilities 1,600 1,700
(LOS 21.d) Income Statement (in SF thousands)
December 31, 2013
In SF
Sales assumes the numbers in exhibit two are correct,
If Wilson 7,000
the remeasurement gain/loss for 2008 will be closest to:
Cost of Goods Sold (COGS) (6,800)
ᅞ Depreciation
A) £1,012. (100)
ᅞ Translation
B) -£77. Gain/Loss --
ᅚNet
C) Income
£285. 100
Assume that the functional currency is the U.S. dollar when answering the following questions.
Explanation
Net income = ending retained earnings − beginning retained earnings + dividends paid.
Net income = 7323 − 5150 + 2250 = £4423.
The level of long-term debt on the 2013 balance sheet is closest to:
Remeasurement gain = net income − net income before remeasurement gain = 4423 − 4138 = £285.
ᅞ A) $80.
(LOS 21.e)
ᅚ B) $85.
ᅞ C) $77.
Explanation
After remeasurement, what will be the impact on Wilson's quick ratio and accounts receivable turnover ratios respectively for
2008?
The current rate method is used when the Functional Currency is NOT the same as the Parent's Presentation (reporting)
Currency. The temporal Accounts
method isReceivable
used when the Functional Currency = the Parent's Presentation Currency.
Quick Ratio
Turnover
Since the U.S. dollar is the functional currency and the reporting currency, the temporal method should be used to remeasure
the Swiss Franc into U.S. dollars. With the temporal method, monetary assets like cash and monetary liabilities are
ᅚ A) No change
remeasured Increase
at the current exchange rate. Long term debt is considered a monetary asset, thus the current rate should be
used: 100SF × 0.85$/SF = $85.
ᅞ B) Increase Increase
(LOS 21.e)
ᅞ C) No change Decrease

Explanation
After remeasurement, depreciation will be closest to:
The quick ratio takes (cash + accounts receivable) / (current liabilities). Since all of these items are monetary assets and
liabilities,
ᅚ A) $77. they are all remeasured at the current exchange rate, resulting in no change to the ratio.
ᅞ B)
The $85. receivable turnover ratio is calculated as (sales / accounts receivable). Note that the local currency (the U.S.
accounts
dollar)
ᅞ C)is$80.
depreciating (it takes more $ to buy a pound). Since sales is remeasured at the average rate and accounts
receivable is remeasured at the current rate, the depreciating currency means that the remeasured denominator will be
Explanation
smaller than the remeasured numerator, resulting in a larger ratio.
(LOS 21.f)related to assets translated at historical exchange rate, (e.g., cost of goods sold; depreciation; amortization) are
Expenses
translated at historical rates under the temporal method. Thus under the temporal method we should use the historical rate to
remeasure depreciation:
Question #9 of 154100SF × 0.77$/SF = $77. Question ID: 462441
(LOS
If 21.e)
Heltzel recalculates the translation assuming the change in management as discussed in concern one, Wilson's gross profit
margin will be:
ᅚ A) Higher under the new management method Heltzel predicts and total asset
The value of common
turnover stock on the 2013 balance sheet should be closest to:
higher
ᅞ B) Lower under the new management method Heltzel predicts and total asset turnover
ᅚ A) $1,000.
lower
ᅞ B) $1,100.
ᅞ C) Higher under the new management method Heltzel predicts and total asset turnover
ᅞ C) $1,050.
lower
Explanation
Explanation
Common stock is translated using the historical rate under both the temporal method and the current rate method: 1300SF ×
If Wilson becomes independent, then the current rate method would be used rather than the temporal method.
0.77$/SF = $1001.
Wilson's gross profit margin (gross profit / sales) will be lower under the temporal method. Sales under both methods are
(LOS 21.e)
converted at the average rate, while COGS is converted at the historical rate under the temporal method (note FIFO inventory
accounting). Since the local currency (the U.S. dollar) is depreciating, COGS will be higher under temporal method, resulting in
Question
a lower gross#49 of 154 Question ID: 462325
profit and a lower gross profit margin under the temporal method, and hence higher under the current rate
method.
For Scud Co. under the temporal method, the monetary exposures and the foreign currency movements resulted in a:
Wilson's total asset turnover ratio (sales / total assets) will be higher under the current rate method. Non-monetary assets are
ᅞ A) cumulative
converted translation
at the historical adjustment
rate using gainmethod
the temporal on the and
balance sheet rate
the current . under the current rate method. The
depreciating local currency
ᅞ B) remeasurement lossmeans
on thethat total statement.
income assets will be lower under the current rate method. The lower denominator will
lead to aremeasurement
ᅚ C) higher total asset turnover
gain on the ratio
incomeunder the current rate method
statement.
(LOS 21.f)
Explanation
Question
The #10 exposure
net monetary of 154 is the value of Cash & accounts receivables (A/R) minus Accounts payable (A/P) Question
and Long-term
ID: 462442
debt. This is Sf.600,000 - (Sf.200,000 +Sf.100,000) = Sf.300,000. As the Swiss franc appreciates from 0.77 $/SF to 0.85 $/SF,
Which of the following treatments is most likely correct regarding the items outlined in concern two?
there is a remeasurement gain that is recorded as part of net income on the income statement.
ᅚ A) The balance should be

Exposure translated
Foreign Currencyat the historic rate as it is a non-monetary
item
Temporal method: Appreciating Depreciating
ᅞ B) The balance
Net monetary assets should be translated at Loss
Gain the closing rate as it is a monetary item
ᅞ monetary
Net C) The balance should be
liabilities translated at Gain
Loss the historic rate as it is a monetary item
(LOS 21.e)
Explanation
Question
Deferred #50 isofa 154
revenue non-monetary liability and should be translated at the historic rate. Question ID: 462326
(LOS 21.d)
If the functional currency is the Swiss franc and the retained earnings for Scud Co. as of 12/31/2013 is $80,000, the exchange
rate exposure is a:
ᅚ A)ofcumulative
Which translation
the following statementsadjustment gain
regarding the of $109,000.
treatment of subsidiaries in a hyper-inflationary environment under U.S. GAAP
isᅞmost
B) likely
remeasurement
correct? gain of $51,000.
ᅞ C) cumulative translation adjustment loss of $80,000.
ᅞ A) The subsidiary should be translated using the temporal method regardless of
the level of autonomy, and non-monetary items restated for the effect of local
Explanation
inflation
If ᅚ
theB)
functional currency
The subsidiary is thebe
should Swiss franc then
translated thethe
using current ratemethod
temporal methodregardless
is applied to
of calculate
the level the currency exposure. This will
result in of
a cumulative translation
autonomy, and then noadjustment (CTA). Retained
further restatement earnings are $80,000 and the total asset is valued at
is required
$1,445,000, so based on the current rate method, the CTA = $1,445,000 - $170,000 - $85,000 - $1,001,000 - $80,000 =
ᅞ C) The subsidiary should be translated using the current rate method regardless of the
+$109,000. The current rate method adjusts the equity account to balance the assets to the total of liabilities and equity.
level of autonomy, and non-monetary items restated for the effect of local inflation
Scud Co
Explanation
Balance Sheet 2013 (SF) Rate($/SF) 2013 ($)
CashGAAP
U.S. & accounts receivables
requires the use of(A/R)
the temporal 600
method. 0.85 510
Inventory
(LOS 21.g) 500 0.85 425
Net Fixed Assets 600 0.85 510
Total Assets 1,700 1,445

Accounts payable (A/P) 200 0.85 170
Giant Company is a U.S. firm that produces parts for nuclear reactors. Giant Company has a subsidiary, Grande, Inc., that
Long-term debt 100 0.85 85
operates in Mexico and is responsible for designing and manufacturing connection fittings that are vital for the proper
Common Stock 1,300 0.77 1,001
operation of its parent company's reactors.
Retained Earnings 100 80 Given
CTAGiant Company considers the U.S. dollar to be the functional
109currency of Grande, Inc.
Plug figure
Grande,
Total Inc.,
Liabilities began operations January
& Equity 1, 2001.
1,700 1,445
Common
(LOS 21.d) Stock and Fixed Assets were acquired January 1, 2000.
Inventory is accounted for under the last in, first out (LIFO) cost flow assumption, and was purchased evenly through the
year.
The inventory in the January 1, 2001, Balance Sheet was acquired on January 1, 2001.
If Scud Co.'s functional currency is the Euro, then to adjust the currency exposure to the parent's currency, the US$, start with
the:Exchange Rates January 1, 2000 $0.14/M peso
were:
ᅞ A) Euro and use the current1,
January rate method$0.12/M
2001 to convert
pesoto the local currency, the
Swiss franc; then use the temporal method to convert to the presentation
June 30, 2001 $0.11/M peso (this is the 2001 average
currency, the US$.
rate)
ᅚ B) Swiss franc and use the temporal method to convert to the functional currency, the
December
Euro; then use the 31,
current rate to convertpeso
method $0.10/M to the presentation currency, the
US$. 2001
ᅞ C) Swiss franc and use the current rate method to convert to the functional currency, the
Euro; then use the temporal method to convert to the presentation currency, the US$.
Grande, Inc.
Explanation Balance Sheet (in M Pesos)
Jan. 1, 2001 Dec. 31,

Because the functional currency is neither the local currency nor the presentation currency, there will be two steps to the
2001
conversion. The functional currency is the intermediate step as local currency is converted to the functional currency, and then
to the presentation currency:
Cash Sf → → US$.
5,000,000 The conversion from local currency to a functional currency uses the temporal
20,000,000
method; the conversion from functional currency to a presentation currency uses the current rate method.
Accounts 20,000,000 35,000,000
Translation: Remeasurement Current Rate &
Receivable
Current Rate Method Temporal Method Temporal Methods
Inventory 15,000,000 15,000,000
Fixed Assets
Presentation (net) Presentation
Currency 70,000,000Currency
60,000,000
Presentation Currency
Accounts Payable 10,000,000 10,000,000

=
Long Term
Functional Debt
Currency 40,000,000
Functional 35,000,000
Currency Functional Currency
Common Stock 80,000,000 80,000,000

=
Retained 5,000,000
Earnings
Local Currency Local Currency Local Currency
(LOS 21.d) 2001 Income Statement
(in M Pesos)
Sales 60,000,000
Question #52 of 154
Cost of Goods (45,000,000) Question ID: 462459
Sold
Under U.S. GAAP, the temporal method is preferred to the current rate method in hyperinflationary economies because the
temporal method:
Depreciation (10,000,000)
ᅞ Net
A) Income
is easier to perform under hyperinflation.
5,000,000
ᅞ B) provides better conversions of subsidiary revenues.
ᅚ C) results in non-monetary asset values that are a better proxy for the economic values
Question #12assets.
of those of 154 Question ID: 462382
Giant Company should use the following method to reflect the results of Grande, Inc., in its financial statements:
Explanation
ᅞ A) the temporal method followed by the current rate method.
The temporal method results in non-monetary asset values that are a better proxy for the economic values of those assets
ᅞ B)
than theobtained
those current rate method.
under the current rate method. Both methods convert revenues and SG&A at the average rate so there
ᅚ C)bethe
could no temporal method.when considering these measures.
clear preference
Explanation
The basis for using the current rate method is when Functional Currency is NOT the same as Parent's Presentation (reporting)
Currency. The basis for using the temporal method is when Functional Currency = Parent's Presentation Currency.
Which of the following asset or liability values is likely to be the most understated in a hyperinflationary economy if translation
The temporal
occurs method
under the is used
current when the functional currency is the parent's currency. (Study Session 6, LOS 21.d)
rate method?
ᅞ A) Dividends payable.
ᅚ B) A plant purchased several years ago.
The CostAccounts
ᅞ C) of Goodsreceivable.
Sold for Grande, Inc., for the year ended December 31, 2001, expressed in U.S. dollars is:
ᅚ A) $4,950,000.
Explanation
ᅞ B) $5,400,000.
The accounts receivable and dividends payable will each have book values that are closer to their market values than a plant
ᅞ C) $5,250,000.
purchased many years ago.
Explanation
Both the beginning and ending inventory under LIFO cost flow assumptions are translated at the $0.12 rate as of the date the
Question #54was
original inventory of 154
acquired, January 1, 2001. Because beginning and ending inventories expressed in Mexican pesos
Question are
ID: 462395
equal, the purchases for the year will equal the Cost of Goods Sold, which is remeasured at the average cost of acquiring the
Where does the currency translation gain or loss appear in the financial statements under the temporal method and the
goods during the year: $0.11. (45,000,000 × $0.11) = $4,950,000. The average rate is the best estimate of the historical rate
current rate method?
because the inventory that was sold was purchased evenly through the year. (Study Session 6, LOS 21.d)
Current rate
Temporal method
Question #14 of 154 method Question ID: 472485
Which of the following statements regarding the current rate method is the most accurate?
ᅞ A) Income
Balance sheet
ᅞ A) This method is notstatement
typically used when the subsidiary is relatively independent
of the parent.
ᅞ B) Balance sheet Balance sheet
ᅞ B) Income statements items are translated at the current exchange rate.
ᅚ C) Income statement Balance sheet
ᅚ C) Translation gains and losses are reported in equity.
Explanation
Currency
Under thetranslation
current rate
gain
method,
or losstranslation
appears ongains
the income
and losses
statement
are reported
under in
the
equity
temporal
in themethod
CTA account.
and theThis
balance
method
sheet
is typically
under
used
the current
when the
ratesubsidiary
method. is relatively independent of the parent. Revenues and expenses are translated at the average rate.
(Study Session 6, LOS 21.d)
Question #55
#15 of 154 Question ID: 462385
462372
The translation
Global gain Corp.
International or loss(GIC)
from has
the activities of Grande,GIC
three subsidiaries: Inc., shouldwhose
Europe be reported in:
local currency is the euro and whose functional
currency is the euro; GIC China whose local currency is the yuan and whose functional currency is the Hong Kong dollar; and
ᅚ A) the income statement.
GIC Bahamas whose local currency is the Bahamian dollar and whose functional currency is the U.S. dollar. GIC's reporting
ᅞ B) the statement of cash flows.
currency is the U.S. dollar. Which conversion methods should be used by GIC for each of its subsidiaries?
ᅞ C) the statement of shareholder's equity.
ᅚ A) GIC Europe's data should be translated under the current rate method; GIC
China's data should be remeasured under the temporal method into Hong Kong
Explanation
dollars, and then translated under the current rate method into U.S. dollars; and
Under the temporal method, translation gains and losses are included in the income statement. (Study Session 6, LOS 21.e)
GIC Bahamas' data should be remeasured under the temporal method into U.S.
dollars.
Question #16 of 154
ᅞ B) GIC Europe's data should be remeasured under the temporal method; GIC China's
Question ID: 462386
data
Revenues forshould be remeasured under the temporal method into Hong Kong dollars, and
2001 translated into U.S. dollars amount to:
then translated under the current rate method into U.S. dollars; and GIC Bahamas'
ᅞ A) data
$6,000,000.
should be translated under the current rate method into U.S. dollars.
ᅞ C) $7,800,000.
ᅞ B) The financial data for all three subsidiaries should be remeasured under the temporal
method.
ᅚ C) $6,600,000.
Explanation
The basis
Under the for using the
temporal current
method, rate method
revenues is when Functional
are translated Currency
at the average rate is NOT the
during thereporting
same as period.
Parent's Presentation (reporting)
60,000,000 × 0.11 = $6,600,000
GIC Europe's
(Study Sessiondata should
6, LOS be translated under the current rate method; GIC China's data should be remeasured under the
21.e)
temporal method into Hong Kong dollars, and then translated under the current rate method into U.S. dollars; and GIC
Bahamas'
Question data
#17should be remeasured under the temporal method into U.S. dollars.
of 154 Question ID: 462387
As a result of making the appropriate currency adjustments to the financial statements, Grande Inc.'s December 31, 2001
quick ratio will be:
ᅞ A) higher.
Which
ᅞ B)oflower.
the following statements is most accurate concerning foreign currency translation?
ᅚ A) unchanged.
ᅞ C) In the case of an appreciating currency, the fixed asset turnover will be lower under the
temporal method, as compared to the current rate method.
Explanation
ᅚ B) The receivables turnover ratio is identical under both the temporal method and the current rate
Since the functional currency is the reporting currency, the temporal method must be used. Since it is taking fewer dollars to
method.
buy a peso, the peso is depreciating.
ᅞ C) In the case in which a firm uses first in, first out (FIFO) inventory valuation, if the local
currency depreciates the cost of good sold under the temporal method is less than the cost of
The quick ratio is a liquidity ratio that does not include inventory. The quick ratio is calculated as [(cash + accounts receivable)
goods sold using the current rate method.
/ accounts payable]. Since monetary assets and liabilities are translated at the current rate, the quick ratio will be unchanged.
(Study Session 6, LOS 21.e)
Explanation
The receivables turnover (sales / receivables) is unaffected because both methods translate sales at the average rate and accounts
receivable at the current rate.
When using FIFO and the temporal method we assume that the appropriate rates to use for cost of goods sold (COGS) are the older
Dell
historical rates.has
Air Lines Therecently
average acquired Australian
rate is used for COGSPuddle Jumpers,
under the Inc.,method.
current rate a smallIfairline located
the local in Sydney.
currency The COGS
depreciates, Australian
woulddollar
be
has been
higher chosen
under by Dellmethod.
the temporal as the functional currency for APJ. The Balance Sheet of APJ is given below as of Dec. 31, 2004 in
Australian dollars.
With an appreciating currency the fixed asset turnover ratio (sales / fixed assets) will be higher using the temporal method because the
temporal method uses the historical rateLiabilities
Assets for fixed assets
and whereas
Equity the current rate method uses the current rate. They both use the same
average rate for sales.
Cash 200 A/P 180
A/R 240 Common Stock 720
Maintenance
Question #57 of 154 180 Question ID: 462353
Supplies
Which of the
Fixed following general 280
Assets statements is most accurate with respect to the temporal method? Nonmonetary assets are translated at:
ᅞ A) the current rate. Total Liab &

Total Assets 900 900
Equity
ᅚ B) historical rates at the time of the transaction.
ᅞ C) the average rate during the year.

APJ's income statement for the year ending Dec. 31, 2005 is expressed in Australian dollars as:
Explanation
Sales 3,500
As a general rule in using the temporal method, nonmonetary assets are translated using the historical rate at the time of the
Total Costs 2,900
transaction.
Net Income 600
The Australian dollar has steadily depreciated against the U.S. dollar. At Dec. 31, 2004, the exchange rate was 2 Australian
Questions
dollars = $1 but#58-63 of 2005,
at Dec. 31, 154 the exchange rate had deteriorated to 3 Australian dollars = $1.
Walter Jameson, ® , is an analyst for Continental Corp., a global investment bank. Jameson has been assigned coverage
The Dec. 31, 2005CFA
Balance Sheet for APJ is given in Australian dollars as follows:
of Wasson Brothers (WB), a large U.S. based conglomerate with many subsidiaries in both the U.S. and abroad. Jameson has
completedAssets Liabilities
his review of the firm's and Equity
U.S. operations, but his research report is due at the end of the week and he has yet to
assess
Cashthe impact of 441
Wasson's foreign subsidiaries on
A/P his earnings model.
210
OneA/R 330 foreign

of WB's wholly-owned Common Stock Kasamatsu
subsidiaries, 720 Industries, is based in Japan and manufactures a hugely
successful line of trading cards, toys, and other related products. All of Kasamatsu's operations and sales take place in Japan,
Retained
andSupplies 291
the corresponding transactions are denominated600
in Japanese yen. Additionally, Kasamatsu's books and records are all
Earnings
maintained in yen. WB reports its earnings in U.S. dollars. The history of the exchange rate between the dollar and the yen
overFixed
the last two years is presented in the following table. Figures are presented in yen/$.
468
Assets
Yen/Dollar Exchange Rate
Total Liab. &
Total Assets
December 31,1,530
2002 1,530
150
Equity
December 31, 2001 130
2002 Average 140

2001 Average 120
On APJ's 2005 income statement, the level of net income in U.S. dollars would be:
Exchange rate on date that 2002
ᅞ A)dividends
$300. were declared (payable to 145
ᅚ Wasson
B) $240.Brothers)
ᅞ C) $200.
Exchange rate on date of stock
100
issue and acquisition of fixed assets
Explanation
Kasamatsu Industries Financial Data (12/31/02)
Currency. The basis for using the temporal method Yen Exchange
is when Functional U.S.=Dollars
Currency Parent's Presentation Currency.
Since the Australian dollar is both the local and(in thousands)

the Rate use(in
functional currency, thethousands)
current rate method. The items in the income
statement
Sales are translated at the average exchange700,000
rate. The average rate is (2 + 3) / 2 = 2.5 Australian dollars = $1. (Study
Session 6, LOS 21.e)
COGS 280,000
Depreciation
Question #19 of 154 126,000 Question ID: 462453
SG & 2005
On APJ's A balance sheet, the level of common77,000
stock (not including retained earnings) in U.S. dollars would be:

ᅞ A) $288.
ᅚ Net Income
B) $360. 119,000
ᅞ 2001
C) $240.
Retained Earnings 0
Dividends
Explanation 58,000
2002 Retained Earnings 61,000

Since the Australian dollar is the local and the functional currency, use the current rate method.
Current Assets 50,000
In the balance sheet, all accounts are translated at the current exchange rate, except for the common stock account, which is
translated at the historical rate.
Fixed Assets 486,000
Current
Common Liabilities
Stock (720 / 2) = 360 46,000
Long
(Study Term6,Debt
Session LOS 21.e) 254,000
Capital Stock 175,000

Accumulated Translation Adjustment
On APJ's 2005 balance sheet, the level of retained earnings in U.S. dollars would be:
ᅞ A) $300.
Question
ᅚ B) $240.#58 of 154 Question ID: 462407
ᅞ C) $200.
The first step in Jameson's analysis is to compute Kasamatsu's impact on WB's net income. What is Kasamatsu's impact on
WB's net income (in thousands dollars)?
Explanation
ᅞ A) $821.
Since there is no mention of dividends being paid, the retained earnings will equal net income (RE = NI − Div). The items in the
ᅚ B) $850.
income statement are translated at the average exchange rate under SFAS 52. The average rate is (2 + 3) / 2 = 2.5 Australian
ᅞ C) =$793.
dollars $1.
Income Statement (in $)

Explanation
Sales (3,500 / 2.5) $1,400
Costs (2,900 / 2.5) $1,160
Net Income $240
Because Kasamatsu is a wholly owned subsidiary of WB, all of its net income will be included in WB's. Kasamatsu's local
(Study Session
currency is also6, LOS
the 21.e) currency, so the current rate method should be used to translate the financial statements into
functional
U.S. dollars. The appropriate exchange rate to use would be the average exchange rate for 2002, and no adjustment needs to
Question #21dividend.
be made for the of 154The calculation is: Question ID: 462455
119,000
On APJ's / 140
2005 = 850sheet, the foreign currency translation adjustment in U.S. dollars would be:
balance
ᅞ A) −$220.
Therefore, WB will report an additional $850,000 of net income as a result of their subsidiary's operating results. Both
ᅚ B) −$160.
remaining answers use incorrect exchange rates. (Study Session 6, LOS 21.f)
ᅞ C) −$280.

Explanation
Jameson
Since the now computes
Australian dollarthe
is adjustment to WB's
both the local financial
and the datacurrency,
functional due to Kasamatsu's payment
use the current of dividends. What is the U.S.
rate method.
dollar amount of this adjustment (in thousands)?
When using the current rate method, all assets and liabilities are translated at the current rate. Total assets = 1530/3 = 510
and A) $446. payable = 210/3 = 70. The common stock is translated at the historical rate on the date of purchase = 720/2 =
ᅞ accounts
360.
ᅚ B) $400. retained earnings = 0, so ending retained earnings = translated net income = 240. The cumulative translation
Beginning
adjustment is the plug figure that makes the balance sheet balance = 510 − 70 − 360 − 240 = −160. (Study Session 6, LOS
ᅞ C) $414.
21.e)
Explanation
WB receives a cash dividend from their subsidiary. This dividend must be translated at the prevailing exchange rate on the
Which one
date the of the following
dividend is a(145/$).
is declared condition under /which
$58,000 145 =the temporal
400. method should
Both remaining beuse
answers used to account
incorrect for foreign
exchange rates.currency
(Study
translations?
Session 6, LOS 21.f)
ᅞ A) The Australian dollar is chosen as the functional currency.

ᅞ B) The cumulative Australian inflation rate over the last three years would have to be less
than 100%.
The carrying value of Kasamatsu's total assets on December 31, 2002, using the current rate method of accounting for
translations
ᅚ C) APJ is:
would have to be a mere operational extension of Dell's main operations.
ᅚ A) $3,573.
Explanation
ᅞ B) $3,240.
The conditions necessary for implementation of the temporal method are:
ᅞ C) $2,938.
1. APJ would have to be a mere operational extension of Dell's main operations. If the operations of the subsidiary are well
Explanation
integrated with the parent's then the parent's currency (in this case, the U.S. dollar) would be the functional currency.
2. The cumulative Australian inflation rate over the last 3 years would have to exceed 100%. (Hyperinflation)
Under the current rate method, all balance sheet accounts, with the exception of equity, are translated at the current rate. At
the current
(Study rate 6,
Session of LOS
150 under
21.d) the current rate method, the amount is: (486,000 + 50,000) / 150 = $3,573. (Study Session 6,
LOS 21.f)

Which one of the following statements correctly describes the effect on Dell's financial statements if the U.S. dollar had been
The yenas
chosen has
thedepreciated against the dollar in the last year. If the exchange rate in 2001 was in effect during 2002, under the
functional currency?
current rate method the reported cost of goods sold would have been:
ᅞ A) The current rate method would apply.
ᅞ A) lower by $333.
ᅞ B) The translation adjustment would appear as a line item on Dell's balance sheet.
ᅞ B) higher by $287.
ᅚ C) The translation adjustment would appear as a line item on Dell's income statement.
ᅚ C) higher by $333.
Explanation
Explanation
If the U.S. dollar had been chosen as the functional currency, then the provisions of the temporal method would apply. Under
Under the current
the temporal ratethe
method, method, COGS
translation is translated
adjustment at the
would average
appear as arate
line in effect
item duringincome
on Dell's the reporting period.
statement andUsing
not asthe
anaverage
exchangeofrate
element during
equity. 2002,
Hence, COGS is
earnings calculated
may becomeas 280,000
more / 140
volatile as a= result.
$2,000.(Study
UsingSession
the average rate
6, LOS in effect during 2001
21.d)
results in COGS of $2,333 (280,000 / 120), or $333 higher. (Study Session 6, LOS 21.f)

Jameson has prepared a report assessing the impact of the currency translation on Kasamatsu's financial ratios. The details
Which
of of the are
his report following measures is unaffected by the choice between translation under the current rate method and
as follows:
remeasurement under the temporal method?
Quick ratio: higher
Total asset turnover: higher
ᅞ A) Cost of goods sold.
ᅞ B)
With Equity.
respect to the direction of changes for the ratios, Jameson is:
ᅚ C) Tax expense.
ᅞ A) incorrect with respect to the quick ratio, and incorrect with respect to the total
asset turnover ratio.
Explanation
ᅞ B) correct with respect to the quick ratio, but incorrect with respect to the total asset
Taxes are converted
turnover ratio.at the same rate (average rate) under both methods. Equity under the temporal method is a mixed rate
whereas under the current rate method it is at the current rate. COGS under the temporal method is at the historical rate and
ᅚ C) incorrect with respect to the quick ratio, but correct with respect to the total asset
under the current rate method it is at the average rate.
turnover ratio.
Explanation
Questions #25-30
For the quick ratio, both of 154assets (with the exception of inventory) and current liabilities will be translated at the current
current
rate. The ratio will be unchanged, so Jameson is incorrect with respect to this one.
Giant Company is a U.S. Company with a subsidiary, Grande, Inc., that operates in Mexico. Giant Company uses either the
temporal or the current rate method of foreign currency translation for its subsidiaries.
For the total asset turnover ratio, sales will be translated at the average rate, while assets will be translated at the current rate.
Since the currency
Grande, is depreciating,
Inc., began operationsthe rate used
January to translate sales will be higher than the rate used to translate assets,
1, 2012.
resulting
Commonin a higher totalFixed
Stock and assetAssets
turnover ratio.
were Jameson
acquired is correct
January with respect to the direction of change for this one. (Study
1, 2011.
Session 6, LOS
Inventory 21.e)
is accounted for under the last in, first out (LIFO) cost flow assumption, with a slow rate of turnover.
The beginning U.S. dollar value of Giant's retained earnings was $2,600,000.
Question #63 inofthe
The inventory 154
January 1, 2012, Balance Sheet was acquired on January 1, 2012. Question ID: 462412
Exchange Rates were:

Having converted all of January 1, 2011
Kasamatsu's $0.14/peso
accounts using the current rate methods, Jameson is curious to compare the difference
January 1, 2012 $0.12/peso
between the temporal and current rate methods on balance sheet accounts. The difference in translated fixed assets and long
$0.11/peso
term debt respectively if Jameson were to use (thismethod
the temporal is the 2012 average
rather than the current rate method is:
June 30, 2012
rate)
Long-Term
Fixed Assets December 31, 2012 $0.10/peso
Debt
Grande, Inc.
ᅞ A) $1620 $121 Balance Sheet (in M Pesos)
Jan. 1, 2012 Dec. 31, 2012
ᅞ B) $0 $0
Cash 5,000,000 20,000,000
ᅚ C) $1620 $0
Accounts Receivable (A/R) 20,000,000 35,000,000
Inventory 15,000,000 15,000,000
Explanation
Fixed Assets (net) 90,000,000 60,000,000
Fixed assets Payable
Accounts under the temporal method, 10,000,000
(A/P) are reported at historical translation rates. 486,000 / 100 = $4,860. Under current
10,000,000
rate, fixedTerm
Long assets are translated at the current
Debt rate (486,00035,000,000
40,000,000 / 150) = $3,240, a difference of $1,620.
Common Stock 80,000,000 80,000,000
Even though it is a balance sheet account, under the temporal method, long term debt is considered a monetary liability and is
Retained Earnings 5,000,000
translated at the current rate. Under the current rate method, long-term debt is also translated at the current rate, so the
2012 Income Statement
difference between the two methods is $0. (Study Session 6, LOS 21.e)
(in Pesos)
Sales 60,000,000
Cost of Goods Sold (COGS) (45,000,000)
Depreciation
Question #64 of 154 (10,000,000) Question ID: 462310
Net Income 5,000,000
A U.S. firm owns a foreign subsidiary in France. In 2002, sales were EUR 1,000,000 and the USD/EUR exchange rate was
1.0620. In
Assume 2003,
that sales
Giant were EUR
Company 1,100,000
considers and the peso
the Mexican exchange
to berate
bothwas
the 1.1417. What isand
local currency thethe
impact of the currency
functional change inofthe value
Grande,
of the USD on the parent company's translated sales?
Inc.
ᅚ A) Sales will increase by 7.5%.

Question
ᅞ B) Sales#25 of 154by 18.25%.
will increase Question ID: 462315
Toᅞ reflect
C) Sales will decrease
the results by 7.5%.
of Grande, Inc., in its financial statements, it would be most appropriate for Giant Company to use the:
ᅞ A) temporal method.
Explanation
ᅞ B) current rate method followed by the temporal method.
The increase in sales due to the appreciating EUR is measured as 7.5% [= (1.1417 / 1.0620) − 1]. Sales for the subsidiary
ᅚ C) current rate method.
rose 10% [= (1,100,000 / 1,000,000) - 1] in the local currency (EUR). After translation the parent firm will report sales of USD
1,062,000 (= EUR 1,000,000 × 1.0620) for 2002 and USD 1,255,870 (= EUR 1,100,000 × 1.1417) for 2003.
Explanation
Growth measured from the parent's perspective suggests sales rose 18.25% [= (1,255,870 / 1,062,000) − 1], but this includes
The currentrate
the growth rateinmethod is used when
sales measured thelocal
in the Functional Currency
currency and the is NOT
rate the same as in
of appreciation thethe
Parent's
foreignPresentation
currency, or (reporting)
(1.10 × 1.075) −
Currency.
1 = 0.1825.The
Thetemporal
questionmethod is used
only asks when
for the the of
impact Functional Currency
the change = the of
in the value Parent's Presentation Currency.
the USD.
The current rate method is used when the local currency and functional currency are the same.
(LOS 21.d)
Question
The U.S. dollar#26 of 154
has been Question ID: 462316
depreciating relative to the local currency over the past year. The use of the current rate method to translate a
foreign subsidiary's financial statements to U.S. dollars will most likely have which of the following effects on the operating profit margin
The Net Income of Grande, Inc., expressed in U.S. dollars for the year ended December 31, 2012, is closest to:
(EBIT/S) relative to what the ratio would have been without the effects of translation?
ᅞ A) $500,000.
ᅞ A) The ratio will rise.
ᅞ B) $250,000.
ᅚ B) There will be no affect on the ratio.
ᅚ C) $550,000.
ᅞ C) The ratio will fall.
Explanation
Explanation
Using the current rate method, the income statement is translated using the average rate for all income statement accounts:
Under
Sales the current−rate
− COGS method, the
Depreciation = average rate is(60,000,000
Net Income. applied to all×income
$0.11)statement accounts.
− (45,000,000 Hence,
× $0.11) − since the average
(10,000,000 rate is=applied
× $0.11) to
$550,000.
both numerator and denominator of the equation and the ratio will not change.
(LOS 21.e)

What is the change in exposure for Grande, Inc., for the year ended December 31, 2012?
Sopgate is a manufacturer of branded fast moving consumer goods having business operations in 28 countries (in each
ᅞ A) +$85,000,000 pesos.
country, Sopgate has a wholly owned local subsidiary for production and/or distribution). Following information is available
ᅚ B) +$5,000,000 pesos.
from Sopgate's annual report:
ᅞ C) +$35,000,000 pesos.
Revenue Growth Growth in pre-tax profits
Region Tax rate
Explanation (USD)* (USD)*
Latin America 5% 4% 25%

Exposure under the current rate method is simply equal to equity.
North America 3% 3% 35%
Beginning exposure = 80,000,000 pesos
Europe 2% −1% 45%
Ending exposure = 85,000,000 pesos
Asia pacific 4% 6% 20%
Change in rate
*Growth exposure = 85,000,000
indicates pesos −rate
expected growth 80,000,000 pesosfive
over the next = +5,000,000
years. pesos
Sopgate's
(LOS 21.e)effective tax rate is most likely expected to:
ᅞ A) remain unchanged.
ᅞ B) increase.
The translation gain or loss from the activities of Grande, Inc., should be reported in the:
ᅚ C) decrease.
ᅞ A) income statement.
ᅞ B) statement of cash flows.
Explanation
ᅚ C) equity accounts.
Sopgate's profits are expected to grow at a faster rate for lower tax rate regions as compared to higher tax regions. Hence the
effective tax rate can be expected to decrease.
Explanation
Under the current rate method, translation gains or losses are accumulated on the balance sheet in the equity section.
(LOS 21.f) #67 of 154

Question Question ID: 462365
Which of the following general statements is CORRECT with respect to the temporal method? Monetary assets are:
ᅚ A) translated at the current rate.

Compared to the current ratio before translation, the current ratio after translation is most likely to be:
ᅞ B) not translated.
C) higher.
ᅞ A) translated at the average rate.
ᅚ B) the same.
Explanation
ᅞ C) lower.
As a general rule in using the temporal method, monetary assets are translated using the current rate.
Explanation
Translation of the local currency means the current rate method is applied. The current ratio is current assets divided by
current liabilities. The current assets and the current liabilities are both translated at the current rate. This leads to the ratio
remaining the same in terms of both the local currency and the presentation currency.
Which of the following statements regarding foreign currency translation are least accurate? Under the:
(LOS 21.f)
ᅞ A) temporal method, sales are remeasured using the average rate.
Question #30
ᅚ B) current rate of 154 the foreign currency translation gain or loss appears on the parent firm's
method, Question ID: 462320
income statement.
The cumulative translation adjustment (CTA) for 2012 is closest to:
ᅞ C) temporal method, COGS and depreciation are remeasured using the historical rate.
ᅚ A) a loss of $3,250,000.
Explanation
ᅞ B) a loss of $550,000.
Under
ᅞ C)the current
a gain rate method, the foreign currency translation gain or loss appears on the parent firm's balance sheet in the
of $1,900,000.
equity accounts.
Explanation
The Mexican peso is depreciating and there is a net asset; this will result in a CTA loss.
Question #69 of 154 Rate Question ID: 462393

Balance Sheet 2012 (MXN) 2013 (USD)
(USD/MXN)
Which of the following ratios is affected by translation under the current rate method?
Cash 20,000,000 0.1000 $2,000,000
ᅞ A) Debt/Assets ratio.
A/R 35,000,000 0.1000 $3,500,000
Inventory
ᅞ B) Net profit margin. 15,000,000 0.1000 $1,500,000
Current assetsasset turnover ratio.70,000,000
ᅚ C) Fixed $7,000,000
Net Fixed Assets 60,000,000 0.1000 $6,000,000
Total Assets
Explanation 130,000,000 $13,000,000
Recall that all pure income statements and balance sheet ratios are unaffected by translation under the current rate method.
Accounts payable (A/P) 10,000,000 0.1000 $1,000,000
The fixed asset turnover ratio is not a pure ratio; it consists of an income statement measure (sales, translated at the average
Long-term debt 35,000,000 0.1000 3,500,000
rate) and a balance sheet measure (fixed assets, translated at the current rate).
Common Stock 80,000,000 0.1400 $11,200,000
Retained Earnings 5,000,000 from I/S $550,000
CTA ($3,250,000)
Total equities#70
Question of 154 85,000,000 $8,500,000 Question ID: 462301
Total Liabilities and
130,000,000 $13,000,000
equity of the following statements regarding the functional currency is least accurate? The functional currency:
Which
ᅞ A) is the currency of the primary economic environment in which the foreign

Income Statement 2012
subsidiary generates and expends cash.
Sales 60,000,000 0.1100 $6,600,000
ᅚ B) is remeasured into the reporting currency under the temporal method.
Cost
ᅞ C)of goods sold
is determined −45,000,000
by management. 0.1100 ($4,950,000)
Depreciation −10,000,000 0.1100 ($1,100,000)
Net income
Explanation 5,000,000 $550,000
(LOS 21.d)
The local currency

Question #31 ofis remeasured
154 into the functional currency under the temporal method. The functional currency is
Question ID: 462352
translated into the reporting currency using the current rate method.
Which of the following situations does NOT require the use of the temporal method? The:
ᅚ A) local currency is the functional currency.
ᅞ B) functional
Questions #71-76
currencyof
is 154
some currency other that the local currency or the U.S. dollar.
ᅞ C) foreign subsidiary is operating in a highly inflationary economy.

Wasson Brothers (WB) is a large U.S. based conglomerate with many subsidiaries in both the U.S. and abroad. One of WB's wholly-
owned foreign subsidiaries, Kasamatsu Industries, is based in Japan. Kasamatsu manufactures a hugely successful line of trading cards,
Explanation
toys, and related products. All of Kasamatsu's operations and sales take place in Japan, and the corresponding transactions are
The basis for in
denominated using the current
Japanese yen. rate method is
Additionally, when Functional
Kasamatsu's booksCurrency is NOT
and records are the same as Parent's
all maintained in yen. Presentation
WB reports its(reporting)
earnings Currency.
in U.S.
The basis
dollars. forhistory
The using the temporal
of the method
exchange rate is when Functional
between Currency
the dollar and = Parent's
the yen over the Presentation
last two yearsCurrency.
is presented in the following table. Figures
are presented in yen/$.
The temporal method is not required in the situation when the local currency is the functional currency.
Yen/Dollar Exchange Rate
December 31, 2013 150
December 31, 2012 130

2013 Average 140

Organic growth in sales is most accurately defined as growth in sales excluding the effects of:
2012 Average 120
ᅚ A) acquisitions/divestitures and currency value fluctuations.

Exchange rate on date that 2013 dividends
ᅞ B) currency value fluctuations. 145
were declared by Kasmatsu
ᅞ C) acquisitions/divestitures only.
Exchange rate on date of stock issue and
100
acquisition of fixed assets.
Explanation
Organic growthisinan
Shelly Jameson sales is defined
analyst as growth in sales
with Henderson-Wells, excludingbanking
an investment the effects of New
firm in acquisitions/
York, anddivestitures and currency
is the chief analyst coveringeffects.
WB. She
believes that the enormous success of the trading cards has contributed greatly to WB's bottom line. However, Jameson believes that
this effect may be misstated in the company's financial statements because of the recent volatility in exchange rates. Many analysts at
other investment banking firms have been raising their ratings on WB because of the recent earnings growth. Jameson, however, wants to
be absolutely certain that these results are accurate and fully attributable to Kasamatsu's hot new product and not a result of an exchange
rate fluctuation.
Which The following
of the following are the
statements financial
is least statements
accurate of Kasamatsu,
regarding stated
accounting for in thousands
foreign of yen.
currency translations? The:
ᅚ Financial
A) currentStatements for Year
rate method Ending
applies the December 31, 2013rate to all balance sheet accounts.
current exchange
ᅞ B) current rate method applies the

(in thousands average exchange rate to all income statement accounts.
of yen)
ᅞ C) temporal method
Statement uses the
of Income andhistorical
Retainedexchange
Earnings rate to translate non-monetary assets and
liabilities into the currency of the country of the parent company.
Explanation
Sales 700,000
The current rate method applies the current exchange rate to all balance sheet accounts except for common stock, which is
translated at a historical rate.
Expenses
Cost of Goods Sold (COGS) 280,000
Depreciation 126,000
SG&A#34
Question of 154 77,000 Question ID: 462413
Total Expenses 483,000
Which example least accurately describes pure balance sheet and income statement ratios?
Earnings Before Taxes (EBT) 217,000

ᅞ A) The current ratio is a pure balance sheet ratio.
ᅞ B) When multiplying both the numerator and denominator by the current exchange rate, the
Net Income 119,000
current rate is cancelled.
Retained Earnings: December 31, 2012 250,000
ᅚ C) All pure balance sheet ratios are affected by the all-current translation method.
369,000
Dividends 58,000
Explanation
Retained Earnings: December 31, 2013 * 311,000
All pure balance sheet ratios are unaffected by the all-current translation method.
* Retained earnings on 12/31/2013 were US $2million
Balance Sheet
Assets
Wasson Brothers (WB) is a large U.S. based conglomerate with many subsidiaries in both the U.S. and abroad. One of WB's
Cash and receivables 60,000
wholly-owned foreign subsidiaries, Kasamatsu Industries, is based in Japan and manufactures a hugely successful line of
Inventory 180,000
trading cards, toys, and other related products. All of Kasamatsu's operations and sales take place in Japan, and the
Land 200,000
corresponding transactions are denominated in Japanese yen. Additionally, Kasamatsu's books and records are all maintained
Fixed assets 346,000
in yen. WB reports its earnings in U.S. dollars. The history of the exchange rate between the dollar and the yen over the last
Total assets 786,000
two years is presented in the following table. Figures are presented in Yen/dollars.
LiabilitiesYen
and stockholders' equity
/ Dollar Exchange Rate
Liabilities 300,000
December 31, 2005 150
Capital stock 175,000
December 31, 2004 130
Retained earnings 311,000
Total liabilities and stockholders' equity 786,000
2005 Average 140
2004 Average 120

Exchange rate on date that 2005
Jameson wouldwere
dividends like to examine
paid WB's group accounts.
to Wasson 145 What is the most appropriate exchange rate (yen/$) to use in translating
Kasamatsu's reported dividends into U.S. dollars?
Brothers
Exchange rate on date of stock
ᅞ A) 140.
issue 100
ᅚ B) 145.
ᅞ and acquisition of fixed assets
C) 150.
Ashley Jameson is an analyst with Henderson-Wells, an investment banking firm in New York, and is the chief analyst covering
Explanation
Dividends
WB. She believes
are translated
that theatenormous
the exchange
success
rate of
that
theexisted
tradingon
cards
the dividend
has contributed
declaration
greatly
date.
to WB's bottom line. However, she
believes that this effect may be misstated in the company's financial statements because of the recent volatility in exchange
(LOS 21.e)
rates. Many analysts at other major investment banking firms have been raising their ratings on WB because of the recent
earnings growth. Jameson, however, wants to be absolutely certain that these results are accurate and fully attributable to
Kasamatsu's hot new product and not a result of an exchange rate fluctuation. The following are the financial statements of
Kasamatsu, stated to
If Jameson wishes in thousands
convert anyofofyen.
the figures on Kasamatsu's Income Statement from yen to dollars, she should most
appropriately use which of the following exchange rates (yen/$)?
Financial Statements for Year Ending December
31, 2005
ᅚ A) 140.
(in thousands of yen)
ᅞ B) 150.
Statement of Income and Retained Earnings
ᅞ C) 145.
Sales
Explanation 700,000
Under the current rate method, all of the components on the income statement would be translated at the exchange rate that
Expenses
was in effect ongoods
Cost of the day that(COGS)
sold the corresponding transaction
280,000 took place. For example, all sales that occurred on March 15,
2013, would be translated at the exchange rate that
Depreciation prevailed on that date. Likewise, if a large portion of inventory was
126,000
purchased on October 27, 2013, then the appropriate
SG&A portion of cost of goods sold would be calculated using the exchange
77,000
rate from October 27, 2013. This however, is not especially
Total Expenses 483,000 practical, especially for a very large company with many
transactions. The common practice is to use the average exchange rate for the accounting year, in this case 140 JPY/USD.
Earnings before taxes (EBT) 217,000
(LOS 21.d)
Net Income 119,000
Question #73 of 154
Retained Earnings: December 31, 2004 250,000 Question ID: 462345
369,000
Jameson has finally completed translating all the necessary figures into dollars and now wants to compute by how much WB's reported
Dividends 58,000
sales in dollars will change due to Kasamatsu's sales. Which of the following is closest to the amount of sales that WB will report as a
Retained Earnings: December 31,
result of Kasamatsu's operations (in thousands of dollars)?
311,000
2005*
ᅞ A) $4,667.
*Retained earnings on 12/31/2005 were US $2 million
ᅞ B) $4,828.
Balance Sheet
ᅚ C) $5,000.
Explanation
The current rate method is used when the Functional Currency is NOT the same as the Parent's Presentation (reporting) Currency. The
basis for using the temporal method is when the Functional Currency = the Parent's Presentation Currency.
Assets
Because sales as a financial item is on the income statement, the 2013 average exchange rate of 140 JPY/USD must be used to
Cash and receivables 60,000
calculate sales in the reporting currency. Kasamatsu's sales were JPY 700,000. The calculation is:
Inventory 180,000
Land
700,000¥ 200,000
Fixed=assets
$5,000 346,000
140¥/$
Total assets 786,000
WBLiabilities
will report and
$5,000 of sales as aequity
stockholder's result of Kasamatsu's operations.
Liabilities 300,000
(LOS 21.c)
Capital stock 175,000
Retained earnings 311,000
QuestionTotal
#74liabilities
of 154and stockholder's Question ID: 462346
equity
The U.S. dollar 786,000on WB's financial statements (in thousands of dollars) is closest to?
impact of Kasamatsu's total selling expenses
ᅞ A) $4,150.
ᅚ B) $3,450.
ᅞ C) $3,220.
Before Jameson can perform any financial statement analysis she needs to determine which method WB uses to translate
Kasamatsu's earnings into U.S. dollars (USD). Which of the following is the most appropriate method to use?
Explanation
ᅞ A)
Total First
selling the temporal
expenses include method, followed
cost of goods by the current
sold, depreciation, rate method.
and SG&A. Kasamatsu reported a total of JPY 483,000 in selling
expenses.
ᅞ B) The Since these are
temporal all income statement items, they must all be translated at the average 2013 exchange rate of 140 JPY/USD.
method.
Therefore,
ᅚ C) The thecurrent
calculation
rateis:method.
483,000¥
Explanation = 3,450
140 ¥/$
The other answers use inappropriate exchange rates.
Under21.d)
(LOS US GAAP the current method must be used to translate the yen financial statements into USD, the reporting currency.
Had Kasamatsu been operating in a highly inflationary environment or had the local and functional currency not been the
same, then WB
Question would
#75 be required to use the temporal method.
of 154 Question ID: 462347
Before Jameson can perform any financial statement analysis, she wants to determine which method WB uses to translate
Kasamatsu's earnings into U.S. dollars (USD). Which of the following is the most accurate translation method and reasoning?
Jameson
WB shouldmust also determine
translate howearnings
Kasamatsu's the fluctuation in the yen vs. the dollar has affected Kasamatsu's earnings in the reporting
using the:
currency. Which of the following best describes the effect of changes in the yen/dollar rate has had on earnings in the
reporting currency?
ᅞ A) current rateEarnings
method have:
because the local currency is the USD.
ᅞ B) temporal method because the local currency differs from the functional currency.
ᅚ A) decreased because the yen is depreciating versus the USD.
ᅚ C) current rate method because the functional currency is the yen.
ᅞ B) increased because the yen is appreciating versus the USD.
ᅞ C) increased because the yen is depreciating versus the USD.
Explanation
The current rate method is used when the functional currency is NOT the same as parent's presentation (reporting) currency.
Explanation
The temporal method is used when Functional Currency = Parent's Presentation Currency.
Examination of the history of the exchange rate shows that both the year-end and average exchange rates are lower in 2005
UnderinUS
than GAAP
2004 theincurrent
(lower rate
that the yenmethod must be vs.
has weakened usedthetoUSD).
translate Kasamatsu's
Therefore, yen financial
Kasamatsu statements
has to earn more yen
intothan
USD,it the
did in the
reporting
previous year
currency.
for WB
Had
to be
Kasamatsu
able to report
been the
operating
same dollar
in a highly
amountinflationary
of net income.
environment or hadthat
This means thethe
local and
true functional
economic
currency not been
performance the same,isthen
of Kasamatsu WB would
understated when viewed as
be required to ause
component of WB's
the temporal net income.
method.
(LOS 21.d)
#76 of 154
Question #37 462348
Question ID: 462405
Jameson
The alsoCompany,
Herlitzka wants toadetermine how thefirm,
U.S. multinational fluctuation in the
has a 100% yeninvs.
stake the dollar
a Swiss has affected
subsidiary. Kasamatsu's
The Swiss franc (SF) earnings in the
has been determined to
reporting currency.
be the functional WhichAllofthe
currency. thecommon
following most
stock of accurately describes
the subsidiary the at
was issued effect of changes
the beginning in the
of the yearyen/dollar rate has uses
and the subsidiary had on
the
earnings in thecost-flow
FIFO inventory reporting currency?In
assumption. Earnings
addition,have:
the value of the SF is as follows:
Beginning of year $0.5902

ᅞ A) increased because the yen is depreciating versus the USD.
Average throughout the year $0.6002
ᅚ B) decreased because the yen is depreciating versus the USD.
End of year $0.6150
ᅞ C) increased because the yen is appreciating versus the USD.
Explanation
The SF-based balance sheet and income statement data for the Swiss subsidiary are as follows:
Examination of the history of

Accounts receivable the exchange rate shows that the yen has weakened vs. the USD. Therefore, Kasamatsu has to
= 3,000
earn more yen than it did in= the
Inventory previous year for WB to be able to report the same dollar amount of net income. This means
4,000
thatFixed
the true economic performance
assets = 12,000 of Kasamatsu is understated when viewed as a component of WB's net income.
Accounts payable = 2,000
(LOS 21.e)
Long-term debt = 5,000
Common stock = 10,000
Retained earnings = 2,000
Question
Net income#77 of 154= 2,000 Question ID: 462461
The nation of Deadoa is experiencing hyperinflation. A subsidiary of a multinational operating in Deadoa will notice changes in
The translated value of common stock and long-term debt respectively are:
its purchasing power and in its financial results as reported on its parent company's financial statements. Which of the
following best describes the situation for a subsidiary operating in Deadoa? Purchasing power will:
ᅞ A) $5,902 and $3,001.
ᅞ
ᅞ A) quicklyand
B) $6,150 deteriorate
$3,075. and the local currency will be rapidly appreciating against
the presentation currency.
ᅚ C) $5,902 and $3,075.
ᅚ B) quickly deteriorate and the local currency will be rapidly depreciating against the
presentation currency.
Explanation
ᅞ C) dramatically appreciate and the local currency will be rapidly appreciating against the
presentation currency.
Explanation
Since the SF is the functional currency, use the current rate method. Common stock is translated at the historical rate which is the rate
that applied when the transaction was made or $0.5902 and long-term debt is translated at the current rate of $0.615. 10,000 × 0.5902 =
Purchasing power and Deadoa currency will depreciate.
$5,902 for common stock and 5000 × 0.6150 = $3,075 for long term debt.

Which of the following statements regarding the effects of translation on financial statement items/ratios is most accurate?
Which of the following subsidiary ratios will be affected by the translation adjustment under the current rate method?
ᅞ A) Leverage
Net profit is
margin.
higher under the current rate method as compared to under the
ᅚ B) local
Returncurrency.
on equity.
ᅚ C)
ᅞ B) Depreciation
Gross margin.in the reporting currency under the current rate method is higher than
under the temporal method if the local currency has appreciated.
Explanation
ᅞ C) Fixed assets are realtively overstated under the temporal method compared to the
local currency if the local currency has appreciated.
The translation adjustment will affect the book value of equity and therefore the return on equity ratio. The other ratios are
pure ratios (both component of the ratio come from the income statement) and are not affected by translation.
Explanation
Fixed assets are relatively understated under the temporal method if the local currency appreciates as they are translated at
the weaker historic rate.The leverage ratio will be unaltered under the current rate method as it is a pure balance sheet ratio
Question #39 of 154
and hence all translated at the current rate.
Question ID: 462312
A Canadian firm owns a foreign subsidiary in the U.S. In 2002, sales were USD1,000,000 and the USD/CAD exchange rate
was 0.6329. In 2003, sales were also USD1,000,000 but the exchange rate was 0.7484. What is the impact of the change in
the value of the CAD on the parent company's translated sales? Sales will:
ᅞ A) increase by 18%.
Which of the following ratios is unaffected by the choice between the current rate method and the temporal method?
ᅞ B) decrease by 18%.
ᅞ A) Accounts payable turnover.
ᅚ C) decline by 15%.
ᅚ B) Quick ratio.
ᅞ C) Current ratio.
Explanation
While sales were flat at USD 1,000,000 in local currency terms, after translation the parent firm would report sales of CAD
Explanation
1,336,184 for 2003 (= USD 1,000,000 / 0.7484) versus sales of CAD 1,580,028 for 2002 (= USD 1,000,000 / 0.6329). The
All of the components of the quick ratio (cash and cash equivalents, accounts receivable, and accounts payable) are
15% sales decline reported by the Canadian firm (CAD 1,336,184 versus CAD 1,580,028) is a flow effect. Even though there
converted at the same rate under both methods so the ratio is unaffected by the method. The current ratio is the same as the
was no sales growth in the subsidiary, the parent firm still shows a 15% decrease in revenues from the subsidiary due solely to
quick ratio except it also contains inventory which is translated at the historical rate with the temporal method and at the
exchange rate effects. Note that because the subsidiary sales are constant the total exchange rate effect can be measured as
current rate with the current rate method. Accounts payable turnover is purchases/accounts payable. Purchases is an
(0.6329 / 0.7484) − 1 = −0.15.
inventory item (like COGS) that may not use the same rate under the temporal method and the current rate method.

The U.S. dollar has been depreciating relative to the local currency over the past year. The use of the current rate method to translate a
The U.S. Deter Company operates a subsidiary in the UK, and the functional currency is the British pound. The subsidiary's
foreign subsidiary's financial statements to U.S. dollars will most likely have which of the following effects on return on equity (ROE)
2001 income statement shows £500 of net income and a £50 dividend that was paid on December 31, when the exchange
relative to what the ratio would have been without the effects of translation?
rate was $1.50 per pound. The current exchange rate is $1.65 per pound, and the average rate is $1.58 per pound. What is
the
ᅚ change
A) ROEinwill
retained earnings
most likely for the period in U.S. dollars under U.S. GAAP?
decline.
ᅞ
ᅚ B)
A) ROE
$715.will most likely rise.
ᅞ
ᅞ C)
B) The impact of the depreciation of the US dollar on ROE is indeterminate.
$750.
ᅞ C) $725.
Explanation
Explanation
ROE = Net Income / Equity. Under the current rate method, the equity accounts as a whole are translated at the current rate whereas net
income
The is translated
basis for usingatthe
thecurrent
averagerate
rate. Since the
method dollar Functional
is when is depreciating, each foreign
Currency is NOT currency unitas
the same is buying more
Parent's dollars in the
Presentation (reporting)
denominatorThe
Currency. relative
basistofor
theusing
numerator of the equation.
the temporal method Hence, the Functional
is when denominatorCurrency
is increasing and the Presentation
= Parent's entire ratio falls.
Currency.
Since the functional currency is the local currency, use the current rate method. The net income is translated at the average
rate, and dividends are translated at the rate that applied when they were paid. Hence: 1.58(£500) − 1.50(£50) = $715.
The Herlitzka Company, a U.S. multinational firm, has a 100 percent stake in a Swiss subsidiary. The U.S. dollar (USD) has been
determined to be the functional currency. All the common stock of the subsidiary was issued at the beginning of the year and the
subsidiary uses the weighted-average inventory cost-flow assumption. In addition, the value of the SF is as follows:
Which of the following statements is NOT a characteristic of the current rate method of accounting for foreign currency translation?
ᅞ Average
A) All throughout the year
asset accounts $0.6002 at the current rate of exchange as of the balance sheet
are translated
End of year
date. $0.6150
ᅞ B) The common stock account is translated at the rate of exchange that applied when the equity
was issued.
ᅚAccounts
C) Nonmonetary
receivableliabilities are translated at the historical rate of exchange.
= 3,000
Inventory = 4,000
Explanation
Fixed assets = 12,000
Under the current rate method, all liabilities are translated at the current rate of exchange.
Question #82 of 154
Retained earnings = 2,000 Question ID: 462391
Net income = 2,000

Portinta Inc, a U.S. based pharmaceutical company, has a UK based subsidiary, Medaze plc. The U.S. dollar has been
appreciating relative to GBP over the past year. Using the current-rate method to translate a foreign subsidiary's financial
The remeasured value of accounts receivable and inventory respectively are closest to:
statements to U.S. dollars will most likely have which of the following effects on the long-term debt to equity ratio relative to
what the ratio would have been without the effects of translation?
ᅞ A) The ratio will be lower.
ᅞ B) The ratio will be higher.

ᅚ C) The ratio will be the same.
Explanation
Under the current rate method, both LTD and equity are translated at the current rate of exchange. Hence, since the same
rate is applied in both the numerator and denominator, the ratio will not change.
Note: When equity is broken out into separate accounts, common stock is taken at the historical rate. When taken as a whole,
equity should be translated at the current rate. In this case we are not given any information on the common stock amount, so
we translate equity at the current rate.
Hann Company is a U.S. multinational firm with operations in several foreign countries. Hann has a 100 percent stake in a French
subsidiary. The foreign subsidiary's local currency has appreciated against the U.S. dollar over the latest financial statement reporting
period. In addition, the French firm accounts for inventories using the FIFO inventory cost-flow assumption. The net profit margin as
computed under the current rate method would most likely be:
ᅞ A) lower than the same ratio computed under the temporal method.
ᅚ B) either higher or lower than the same ratio computed under the temporal method.
ᅞ C) higher than the same ratio computed under the temporal method.
Explanation
The foreign currency gain or loss appears on the income statement under the temporal method. Hence, to make any
determinations regarding the movements of this ratio, we need more information regarding the net monetary asset or liability
position as of both the beginning and ending balance sheet date.
Which of the following statements is least accurate regarding the use of the temporal method for foreign exchange accounting?
ᅚ A) Under the temporal method, the foreign exchange gain or loss is placed on the balance
sheet in the equity section.
ᅞ B) All nonmonetary assets and liabilities are translated at the historical rate of exchange.
ᅞ C) All monetary assets are translated at the current rate of exchange.
Explanation
Under the temporal method, the foreign exchange gain or loss is placed on the income statement.
Which of the following statements concerning the translation of a subsidiary's financial statement and the subsidiary's ratios is least
accurate?
ᅞ A) The subsidiary's ratios in the local currency will differ from ratios calculated after
translation.
ᅞ B) The statement of cash flows is not affected by the choice of translation.
ᅚ C) Ratios calculated under the current rate method will not differ from those calculated under the
temporal method.
Explanation
Ratios calculated under the current rate method will differ from those calculated under the temporal method.
A German company (reporting currency = Euro) owns a foreign subsidiary in the U.S. If the results below are reported in local
currency (USD), after translation what is the effect of the change in the exchange rate on revenues? Round to the nearest
dollar and/or percent.
$ per 1 Euro avg.

Year Sales Exchange Rate
2001 $10,000 0.9
2002 $10,000 0.8
ᅚ A) The company shows a 12.5% growth in revenues in 2002.
ᅞ B) There is no change is revenue growth between 2001 and 2002.
ᅞ C) The company shows a 0.1% decline in revenues in 2002.
Explanation
While sales were flat in terms of local currency, after translation the reported revenue increased 12.5%. 10,000/0.9 = 11,111; 10,000/0.8 =
12,500; 12,500/11,111 = 12.5% increase due to exchange rate effects.
Which of the following statements regarding the functional currency under US GAAP is least accurate?
ᅞ A) If a firm operates in a country or environment which is subject to cumulative inflation of
100% or more over a three year period, that firm will use the parent's currency as the
functional currency.
ᅞ B) Self-contained, independent subsidiaries whose operations are primarily located in the local
market will use the local currency as the functional currency.
ᅚ C) The functional currency is defined as the primary currency of the economic environment in
which the parent firm operates.
Explanation
The functional currency is defined as the primary currency of the economic environment in which the foreign subsidiary operates.
Gortal Inc, a U.S.company has a wholly owned subsidiary, Fortina GmBh, based in Germany. The U.S. dollar has been appreciating
relative to the Euro over the past year. The use of the temporal method to translate a foreign subsidiary's financial statements to U.S.
dollars will most likely have which of the following effects on the fixed-asset turnover ratio (S/FA) relative to what the ratio would have
been without the effects of translation assuming no new fixed assets were purchased throughout the year?
ᅚ A) The ratio will be lower.
ᅞ B) The ratio will be higher.
ᅞ C) There will be no effect on the ratio.
Explanation
Since the dollar has appreciated, the local currency has depreciated, so each foreign currency unit bought more dollars in the past relative
to the present. Fixed assets are remeasured at the historical rate and sales are remeasured at the average rate under the temporal
method. Since the historical rate is buying more dollars relative to the average rate, the denominator is staying the same whereas the
numerator is getting smaller. Thus, the ratio is lower.
Assume that Scud Co. is a Swiss subsidiary of the U.S. firm Patriot, Inc. On December 31, 2007 the $/SF exchange rate was 0.77. (Each
Swiss Franc buys 77 cents.) Assume that this is the historical rate, except as noted below. One year later the Swiss Franc had
appreciated to 0.85 $/SF. Scud Co. pays no dividends. The average exchange rate for the year was 0.80 $/SF. Scud pays no taxes.
Assume that inventory is accounted for using the LIFO inventory assumption, was bought and sold evenly throughout the year, and that
COGS is translated at the average rate for the year.
Scud Co. Int'l
Dec. 31, 2007 Dec. 31, 2008

Cash & A/R 400 600
Inventory 500 500
Net Fixed Assets 700 600

A/P 100 200
Long-term debt 200 100

Common Stock 1,300 1,300

Total Liabilities 1,600 1,700
Income Statement (in SF thousands)

December 31, 2008
In SF
Sales 7,000
COGS (6,800)
Depreciation (100)
Remeasurement Gain/Loss --
Net Income 100
Assume that the functional currency is the U.S. dollar when answering the following questions.
The level of cash on the 2008 remeasured balance sheet would be:
ᅞ A) $480.
ᅚ B) $510.
ᅞ C) $462.
Explanation
Since the U.S. dollar is the functional currency and the reporting currency, the temporal method should be used to remeasure the Swiss
Franc into U.S. dollars. With the temporal method monetary assets like cash and monetary liabilities are remeasured at the current
exchange rate. 600SF × 0.85$/SF = $510. (Study Session 6, LOS 21.e)
The level of net fixed assets on the remeasured 2008 balance sheet would be:
ᅚ A) $462.
ᅞ B) $480.
ᅞ C) $510.
Explanation
Net fixed assets are considered non-monetary assets. For non-monetary assets, the temporal method uses the historical rate: 600SF ×
0.77$/SF = $462. (Study Session 6, LOS 21.e)
Which of the following ratios may be larger in the presentation currency versus the local currency when translated under the current rate
method?
ᅞ A) Net profit margin.
ᅚ B) Return on assets.
ᅞ C) Current ratio.
Explanation
All pure income statement and balance sheet ratios are unaffected by the application of the current rate method. What we mean by "pure"
is that the components of the ratio all come from the balance sheet, or the components of the ratio all come from the income statement.
Return on assets is a "mixed ratio" because assets come from the balance sheet and are translated at the current rate and net income is
translated at the average rate. Unless the exchange rate doesn't change during the year, the two inputs will be translated at different rates,
and the local currency value of the ratio will change when translated into the reporting currency. The other ratios will always be the same
using the current rate method. (Study Session 6, LOS 21.e)
The level of retained earnings on the remeasured 2008 balance sheet would be:
ᅚ A) $101.
ᅞ B) $85.
ᅞ C) $305.
Explanation
To get this value, we need to finish remeasuring our balance sheet at the appropriate rates. The retained earnings figure will be what
makes the balance sheet balance.
Scud Co. Int'l

Dec. 31, 2008 Remeasured $
Cash & A/R 600 × 0.85 = 510
Inventory 500 × 0.77 = 385
Net Fixed Assets 600 × 0.77 = 462
A/P 200 × 0.85 = 170
Long-term debt 100 × 0.85 = 85
Common Stock 1,300 × 0.77 = 1001
Total Liabilities and Owner's Equity 1,700 1,357

The level of sales on the remeasured income statement would be:
ᅞ A) $5,390.
ᅚ B) $5,600.
ᅞ C) $5,950.
Explanation
Revenues and SG&A use the average exchange rate with both the temporal and current rate methods.
7000SF × 0.80$/SF = $5600
The translation gain or loss on the income statement would be:
ᅞ A) $25.
ᅞ B) $0.
ᅚ C) $18.
Explanation
We need to complete our remeasurement of the income statement. Since beginning retained earnings for the year were zero, we know
that net income on the remeasured income must be equal to ending retained earnings. The remeasurement gain or loss is the plug figure
that causes this to be the case.
Income Statement (in SF thousands)

December 31, 2008
Sales 7,000 × 0.80 = $5,600
COGS (6,800) × 0.80 = $5,440
Depreciation 100 × 0.77 = = $77
Income before remeasurement

= $83
gain/loss
Remeasurement gain = Plug = $18
Net Income $101
Which of the following general statements is most accurate with respect to the current rate method? Revenues:
ᅞ A) and operating expenses are translated at the current rate.
ᅞ B) are translated at the average rate while operating expenses are translated at the current rate.
ᅚ C) and operating expenses are translated at the average rate.
Explanation
As a general rule for the current rate method, all revenues and operating expenses are translated using the average rate.
Hann Company is a U.S. multinational firm with operations in several foreign countries. Hann has a 100% stake in a French subsidiary.
The foreign subsidiary's local currency has appreciated against the U.S. dollar over the latest financial statement reporting period. In
addition, the French firm accounts for inventories using the first in, first out (FIFO) inventory cost-flow assumption. The gross profit
margin as computed under the current rate method would most likely be:
ᅞ A) higher than the gross profit margin as computed under the temporal method.
ᅞ B) equal to the gross profit margin as computed under the temporal method.
ᅚ C) lower than the gross profit margin as computed under the temporal method.
Explanation
The average rate is used to convert sales under both the temporal method and the current rate method. Hence, the only difference
between the two computations is on cost of goods sold (COGS). Since the firm uses FIFO, older materials are flowing into COGS and an
older exchange rate applies. Since in the past the foreign currency bought fewer dollars, the gross profit under the temporal method will be
higher than that of the current rate method.It may help to 'think' that with the current rate method, you use the average rate for COGS,
which makes COGS higher because the currency has appreciated.
Dave Iverson, CFA, is analyzing the recently released financial statement of Global Corp., a large multinational manufacturing company
with production facilities across Europe and Southeast Asia. The company's choice of functional currency is not disclosed, but Iverson
does notice that Global Corp. does not have any cumulative translation adjustments (CTA) on its balance sheet. Which of the following
statements is most accurate based upon Iverson's observation?
ᅞ A) The temporal method of foreign currency translation is used for at least some of its
subsidiaries.
ᅞ B) The current rate method of foreign currency translation is used exclusively.
ᅚ C) The temporal method of foreign currency translation is used exclusively.
Explanation
The choice of functional currency is the determining factor as to which method of foreign currency translation is utilized. If no CTA
appears on the balance sheet, then the parent currency must be the functional currency for all of the company's subsidiaries and only the
temporal method is used.
A U.S. company has a subsidiary based in Malaysia, which has the following income statement for 2006 and balance sheets for 2005 and
2006 (in million Ringgit).
Sales 1,000
Cost of goods sold 600
Depreciation 80
Operating expenses 120
Earnings before 200

taxes
Taxes 60
Net income 140
Dividends 20
2005 2006
Cash 50 60
Accounts receivables 100 110
Inventories 100 110

Other current assets 100 110
Gross PP&E 700 800
Less accumulated 70 150

depreciation
Net PP&E 630 650
Other fixed assets 20 40
Total assets 1,000 1,080
Account payable 70 80
Current portion of LTD 100 100
Notes payable 100 150

Other current liabilities 30 30
Long-term debt 300 200
Common stock 100 100
Paid in capital 50 50
Retained earnings 250 370
The value of the Ringgit at various times over the past two years is as follows:
January 1, 2005 $0.37
April 1, 2005 $0.38

December 31, 2005 $0.40
June 30, 2006 $0.47
December 31, 2006 $0.50
Average for 2005 $0.39
Average for 2006 $0.45
The common stock and long-term debt were originally issued in January of 2005. The fixed assets and first inventory purchases were
made in April of 2005. Additional fixed asset purchases were made in June 2006. Inventory is measured using the FIFO method. It can be
assumed that all of the ending inventory was acquired in June when the last major purchase was made. The operations of the subsidiary
are independent from the operations of the U.S. parent. Inflation over the past three years has averaged 15% per year.
The amount of 2006 cost of goods sold in USD is:

(Note: if needed, use $0.40 as the rate to convert 2005 ending inventory)
ᅞ A) $300,000,000.
ᅚ B) $270,000,000.
ᅞ C) $262,800,000.
Explanation
Because the operations are independent from the parent, the current rate method will be used. Cost of goods sold should be accounted for
at the average rate for the past year. The amount of cost of goods sold is 0.45 × 600,000,000 = $270,000,000. (Study Session 6, LOS
21.e)
The value of December 31, 2006, gross property, plant, and equipment reported in USD is:
ᅚ A) $400,000,000.
ᅞ B) $304,000,000.
ᅞ C) $313,000,000.
Explanation
Because the operations are independent from the parent, the current rate method will be used. Fixed assets should be accounted for at
the current rate. The value is 0.5 × 800,000,000 = $400,000,000. (Study Session 6, LOS 21.e)
The amount of 2006 depreciation expense in USD is:
ᅞ A) $30,400,000.
ᅞ B) $40,000,000.
ᅚ C) $36,000,000.
Explanation
Because the operations are independent from the parent, the current rate method will be used. Depreciation should be accounted for at the
average rate for the past year. The amount of depreciation is 0.45 × 80,000,000 = $36,000,000. (Study Session 6, LOS 21.e)
The value of December 31, 2006, inventory reported in USD is:
ᅚ A) $55,000,000.
ᅞ B) $49,500,000.
ᅞ C) $51,700,000.
Explanation
Because the operations are independent from the parent, the current rate method will be used. Inventory should be accounted for at the
current rate. The value is 0.50 × 110,000,000 = $55,000,000. (Study Session 6, LOS 21.e)
The value of all financing debt (notes payable, current portion of long-term debt, and long-term debt) on December 31, 2006, reported in
USD is:
ᅞ A) $202,500,000.
ᅚ B) $225,000,000.
ᅞ C) $171,000,000.
Explanation
Because the operations are independent from the parent, the current rate method will be used. All debt is considered a monetary liability
and should be accounted for at the current rate. The value is 0.50 × 450,000,000 = $225,000,000. (Study Session 6, LOS 21.e)
The combined value of the common stock and paid in capital on December 31, 2006, reported in USD is:
ᅞ A) $75,000,000.
ᅚ B) $55,500,000.
ᅞ C) $63,000,000.
Explanation
Because the operations are independent from the parent, the current rate method will be used. Common stock should be accounted for at
the historical rate-the rate in effect when it was issued. The value is 0.37 × 150,000,000 = $55,500,000. (Study Session 6, LOS 21.e)

Della Air Lines has recently acquired Australian Puddle Jumpers, Inc. (APJ), a small airline located in Sydney. The Australian dollar has
been chosen by Della as the functional currency for APJ. The balance sheet of APJ is given below as of Dec. 31, 2011 in U.S. dollars.
Assets Liabilities and Equity

Cash $100 Accounts Payable (A/P) $90
Accounts Receivable (A/R) 120 Common Stock 360
Maintenance Supplies 90
Fixed Assets 140
Total Assets $450 Total Liabilities & Equity $450
APJ's income statement for the year ending Dec. 31, 2012 is expressed in Australian dollars as:
Sales 3,500
Total Costs 2,900
Net Income 600
The Australian dollar has steadily depreciated against the U.S. dollar. At Dec. 31, 2011, the exchange rate was 2.5 Australian dollars = $1
but at Dec. 31, 2012, the exchange rate had deteriorated to 3 Australian dollars = $1.
The Dec. 31, 2012 Balance Sheet for APJ is given in Australian dollars as follows:

Cash 441 A/P 210
A/R 330 Common Stock 720
Supplies 291 Retained Earnings 600
Fixed Assets 468
Total Assets 1,530 Total Liabilities & Equity 1,530
On APJ's 2012 income statement, the level of sales in U.S. dollars would be closest to:
ᅚ A) $1,272.
ᅞ B) $1,377.
ᅞ C) $1,985.
Explanation
Since the Australian dollar is the functional currency, use the current rate method. The items in the income statement are translated at the
average exchange rate. The average rate is (2.5 + 3) / 2 = 2.75 Australian dollars per = US$.
Sales (3,500 / 2.75) $1,272
Costs (2,900 / 2.75) $1,055
Net Income $217

(LOS 21.d)
On APJ's 2012 income statement, the level of net income in U.S. dollars would be closest to:
ᅚ A) $217.
ᅞ B) $242.
ᅞ C) $229.
Explanation
Since we are using the current rate method, the items in the income statement are translated at the average exchange rate. The average
rate is (2.5 + 3) / 2 = 2.75 Australian dollars per $1.
Sales (3,500 / 2.75) $1,272
Costs (2,900 / 2.75) $1,055
Net Income $217
(LOS 21.d)
On APJ's 2012 balance sheet, the level of accounts receivable is U.S. dollars would be closest to:
ᅞ A) $132.
ᅞ B) $330.
ᅚ C) $110.
Explanation
Since we are using the current rate method, all balance sheet accounts are translated at the current exchange rate, except for the
common stock account, which is translated at the historical rate.
A/R: (330 / 3) = 110
(LOS 21.d)
For APJ, the conversion to US$ is most likely to result in:
ᅚ A) cumulative translation adjustment loss
ᅞ B) cumulative translation adjustment gain.
ᅞ C) remeasurement gain.
Explanation
APJ shows a net asset:

Total assets A$1,530 / (3.00 A$/US$) = US$510
Total liabilities A$210 / (3.00 A$/US$) = US$70
Net asset = US$440
Because the functional currency is the local currency, the current rate method is used. When we have a net asset balance sheet
exposure, a weakening foreign currency will result in a negative translation adjustment. AJP's net asset position will result in a cumulative
transaction adjustment loss as the foreign currency, the A$, is depreciating.
Exposure Foreign Currency

Current rate method: Appreciating Depreciating
Net assets Gain Loss
Net liabilities Loss Gain
(LOS 21.d)
If the functional currency is the reporting currency, the exposure and the foreign currency movements are most likely to result in a:
ᅞ A) remeasurement gain.
ᅞ B) cumulative translation adjustment loss.
ᅚ C) remeasurement loss.
Explanation
APJ has a net monetary asset exposure:
Total monetary assets: Cash + A/R and Maintenance supplies A$1,062 / (3.00 A$/US$) = US$354
Total monetary liabilities: A$210 / (3.00 A$/US$) = US$70
Net monetary asset = US$284
Because the functional currency is the reporting currency, the temporal method is used and this means there is remeasurement - a loss
as the foreign currency, the A$, is depreciating.

Temporal method: Appreciating Depreciating
Net monetary assets Gain Loss
Net monetary liabilities Loss Gain

(LOS 21.d)
The cumulative translation adjustment (CTA) is closest to:
ᅞ A) a gain of US$440.
ᅞ B) a loss of US$135.
ᅚ C) a loss of US$65.
Explanation
Australian Puddle Jumpers

Balance Sheet 2012 (A$) Rate (A$/US$) 2012 (US$)
Cash 441 3.00 $147
A/R 330 3.00 $110
Maintenance Supplies 291 3.00 $97
Current assets 1062 $354
Net Fixed Assets 468 3.00 $156
Total Assets 1,530 $510
Accounts payable (A/P) 210 3.00 $70

Common Stock 720 2.50 $288
Retained Earnings 600 from I/S $217
CTA ($65)
Total equities 1,320 $440
Total Liabilities and equity 1,530 $510
Income Statment 2012

Sales 3,500 2.75 $1,272
Total costs −2,900 2.75 $(1,055)
Net income $217
(LOS 21.f)
Under the current rate method, common stock is translated by using the:
ᅞ A) present value of weighted average rate.
ᅞ B) exchange rate as of the balance sheet date.
ᅚ C) rate that existed when the equity was issued.
Explanation
The historical rate is used.
At what exchange rate are revenues and accounts receivable translated under the current rate method?
Revenues Accounts receivable
ᅞ A) Average rate Historical rate
ᅚ B) Average rate Current rate
ᅞ C) Current rate Current rate
Explanation
Under the current rate method, revenues are translated at the average rate; accounts receivable are translated at the current rate.
An important distinction between the temporal method and the current rate method is that:
ᅚ A) the current rate method results in an adjustment to the equity account on the balance
sheet. The temporal method results in a gain or loss appearing on the income
statement.
ᅞ B) monetary assets and liabilities are remeasured (temporal method) at historical rates but
translated (current rate method) at current rates.
ᅞ C) depreciation and cost of goods sold (COGS) are a function of the current rate under translation
(current rate method), but a function of the average rate under remeasurement (temporal
method).
Explanation
The current rate method results in an adjustment to the equity account on the balance sheet. The temporal method results in a gain or
loss appearing on the income statement. Depreciation and COGS are a function of the average rate under the current rate method, but a
function of the historical rate under the temporal method. Monetary assets and liabilities are use the current rates under both methods.
Geocorp is a global corporation with operations in North America, Asia, and Europe. Its primary business is marketing industrial
machinery for the construction industry. Geocorp has regional headquarters located in New York, Tokyo, and Paris. All North American
and U.S operations report to its regional and world headquarters located in New York, while all Asian operations report to Tokyo, and all
European operations report to Paris.
The following information is relevant to Geocorp's subsidiaries:
Geocorp has a Canadian subsidiary that reports its results in Canadian dollars (CAD). The CAD is the functional currency.
All domestic U.S. operations report their results in U.S. dollars (USD).
All world-wide operations are reported in USD.
Geocorp's Asian operations report their results in Japanese yen (JPY). The JPY is the functional currency.
Geocorp has a Chinese subsidiary that reports its results in Chinese yuan renminbi (CNY). The USD is the functional currency.
Geocorp's European headquarters (in Paris) operations report their results in euros (EUR). The EUR is the functional currency.
Geocorp has a British subsidiary that reports its results in British pounds (GBP). The USD is the functional currency.
The following table is a summary of selected financial results from Geocorp's foreign operations:
All values are in millions CAD JPY CNY GBP EUR
Revenues 50 5,000 250 150 700
Cost of goods sold (COGS) 20 2,700 110 100 480
Gross profit 30 2,300 140 50 220
Selling, general & administrative (SGA) expenses 18 1,000 52 29 200

EBIT 12 1,300 88 21 10
Cash 35 4,200 130 102 400
Accounts receivable 12 1,400 55 45 170
Inventory 20 3,900 135 123 300
Fixed assets 62 7,680 188 370 450
Accounts payable 27 3,300 76 68 350
Long-term debt 70 8,450 290 320 550
Common stock 10 2,000 150 50 350
The following exchange rates apply (USD per foreign currency unit):
Currency Historical Rate Average Rate December 31, 2002
CAD USD 0.7013 USD 0.6803 USD 0.6592
JPY USD 0.0094 USD 0.0088 USD 0.0082
CNY USD 0.1010 USD 0.1109 USD 0.1208
EUR USD 0.9801 USD 1.0318 USD 1.0834
GBP USD 1.4803 USD 1.5506 USD 1.6209
With respect to the Canadian subsidiary, what method should be used to value its revenues, what is the appropriate exchange rate, and
what is the translated value (in USD)?
ᅞ A) Current method, current rate, USD 33.0 million.
ᅞ B) Temporal method, average rate, USD 34.0 million.
ᅚ C) Current method, average rate, USD 34.0 million.
Explanation
Self-contained, independent subsidiaries reporting their results in the local currency that is also the functional currency use the current
method. Revenues under the current method are translated using the average rate. Hence, 50 × 0.6803 = USD 34.0 million. (Study
With respect to the Japanese subsidiary, what method should be used to value its accounts receivable, what is the appropriate exchange
rate, and what is the translated value (in USD)?
ᅞ A) Temporal method, current rate, USD 11.5 million.

ᅞ B) Current method, average rate, USD 12.3 million.
ᅚ C) Current method, current rate, USD 11.5 million.
Explanation
method. Assets under the current method are translated using the current rate. Hence, 1400 × 0.0082 = USD 11.5 million. (Study Session
6, LOS 21.e)
With respect to the European HQ subsidiary, what method should be used to value its SG&A expenses, what is the appropriate exchange
rate, and what is the translated value (USD)?
ᅚ A) Current method, average rate, USD 206.4 million.
ᅞ B) Current method, current rate, USD 216.7 million.
ᅞ C) Temporal method, average rate, USD 206.4 million.
Explanation
method. Expenses under the current method are translated using the average rate. Hence, 200 × 1.0318 = USD 206.4 million. (Study
With respect to the British subsidiary, what method should be used to value its fixed assets, what is the appropriate exchange rate, and
what is the translated value (USD)?
ᅚ A) Temporal method, historical rate, USD 547.7 million.
ᅞ C) Current method, historical rate, USD 547.7 million.
Explanation
Self-contained, independent subsidiaries reporting their results in the local currency that is NOT the functional currency use the temporal
method. Fixed assets under the temporal method are translated using the historical rate. Hence, 370 × 1.4803 = USD 547.7 million.
With respect to the Chinese subsidiary, what method should be used to value its long term debt, what is the appropriate exchange rate,
and what is the translated value (in USD)?
ᅞ A) Temporal method, historical rate, USD 29.3 million.
ᅚ C) Temporal method, current rate, USD 35.0 million.
Explanation
Self-contained, independent subsidiaries reporting their results in the local currency that is NOT the functional currency use the temporal
method. Long-term debt under the temporal method is considered a monetary liability and is translated using the current rate. Hence, 290
× 0.1208 = USD 35.0 million. (Study Session 6, LOS 21.e)
Which of the following statements is most accurate with respect to accounting for inventory and cost of goods sold (COGS) using last-in
first out (LIFO) under the temporal method?
ᅞ A) Inventory is translated at the current rate while COGS is translated at historical rates.
ᅚ B) Inventory is translated at historical rates, and COGS is translated at historical rates.
ᅞ C) Inventory is translated at historical rates, and COGS is translated at the current rate.
Explanation
If using LIFO, units sold during the year are the ones purchased during the year. Under the temporal method, COGS and inventory would
be translated at historical rates. (Study Session 6, LOS 21.d)
In reality, what best describes the real value of non-monetary assets and liabilities in a hyperinflationary environment?
ᅞ A) All non-monetary accounts are re-measured at the current rate.
ᅚ B) Typically not affected because their local currency-denominated values increase to offset the
impact of inflation.
ᅞ C) Typically not affected because their local currency-denominated values decrease to offset the
impact of inflation.
Explanation
Typically not affected because their local currency-denominated values increase to offset the impact of inflation (i.e., real estate values
typically rise with inflation).
Which of the following general statements is CORRECT with respect to the temporal method? Revenues and operating expenses
(excluding COGS) are translated at the:
ᅞ A) historical rate.
ᅚ B) average rate.
ᅞ C) current rate.
Explanation
As a general rule for the temporal method, all revenues and operating expenses (excluding COGS) are translated using the average rate.

South Seas Inc, a subsidiary of Seven Seas Inc., reported its most recent performance in its local currency (LC) which is the functional
currency. The reporting currency of Seven Seas is the U.S. dollar (USD). South Seas also paid a dividend of 16,000LC at year end, at
which time the exchange rate was 2.00 LC/USD. Last year, Seven Seas reported balance sheet retained earnings of 90,000 USD for its
South Seas subsidiary.
Rates LC/US$
Current rate 2.00
Average rate 2.20
Historical rate 2.50

Historical rate for COGS 2.30
Historical rate for depreciation 2.10
Historical rate for ending inventory 2.30
Historical rate for fixed assets 2.10
LC
Revenues 520,000
Cost of Goods Sold (COGS) 225,000

SG&A 100,000
Depreciation 80,000
Income Taxes 46,000
Net Income 69,000
The balance sheet for South Seas is given below.
LC
Cash 25,000
Accounts Receivable 30,000
Inventory 35,000
Net Fixed Assets 500,000
Total Assets 590,000
Accounts Payable 20,000

Long term debt 100,000
Common Stock 250,000
Retained Earnings 220,000
Total Liabilities & Equity 590,000
What is the amount of income Seven Seas should report from its South Seas subsidiary?
ᅞ A) 34,500 USD.
ᅚ B) 31,400 USD.
ᅞ C) 27,600 USD.
Explanation
The current rate method is used when the Functional Currency is NOT the same as the Parent's Presentation (reporting) Currency. The
temporal method is used when the Functional Currency = the Parent's Presentation Currency.
LC Conversion USD
average
Revenues 520,000 /2.20 236,364 rate
average
COGS 225,000 /2.20 102,273 rate
average
SG&A 100,000 /2.20 45,455 rate
average
Depreciation 80,000 /2.20 36,364 rate
Income average
Taxes 46,000 /2.20 20,909 rate
Net Income 69,000 31,364
(LOS 21.d)
The amount of retained earnings that Seven Seas will report on its balance sheet for its South Seas subsidiary is closest to:
ᅚ A) 113,364 USD.
ᅞ B) 121,364 USD.
ᅞ C) 129,364 USD.
Explanation
Dividends are translated at the rate 2LC/USD. Therefore, the 16,000 LC dividend is equivalent to 16,000LC / 2 = 8,000 USD. Net income
less dividends equals the current period retained earnings of 31,364 USD − 8,000 USD = 23,364 USD). The balance sheet retained
earnings is the sum of last year's retained earnings and the current period's retained earnings, or 90,000 + 23,364 = 113,364 USD.
(LOS 21.e)
The currency translation adjustment that results from the translation of South Sea's data is closest to?
ᅞ A) zero because there is no currency translation adjustment under the current rate method.
ᅚ B) 21,600 USD.
ᅞ C) −3,300 USD.
Explanation
LC Conversion USD
Cash 25,000 /2.00 12,500 current rate
Accounts Receivable 30,000 /2.00 15,000 current rate
Inventory 35,000 /2.00 17,500 current rate
Net Fixed Assets 500,000 /2.00 250,000 current rate
Total Assets 590,000 295,000
Accounts Payable 20,000 /2.00 10,000 current rate
Long Term Debt 100,000 /2.00 50,000 current rate
Common Stock 250,000 /2.50 100,000 historical rate
answer from part

Retained Earnings 220,000 113,364 2
Translation
Adjustment 21,636 plug
Total Liabilities &

Equity 590,000 295,000
(LOS 21.e)
If the temporal method is used, the retaining earnings is closest to:
ᅞ A) 21,600 USD.
ᅚ B) 120,800 USD.
ᅞ C) 90,000 USD.
Explanation
The retained earnings value is the plug figure. The value of total assets is $280,813. Subtracting the accounts payable, long-term debt,
and common stock from the total assets leaves $120,813.
LC Conversion USD
Cash 25,000 /2.00 12,500 current rate
Accounts Receivable 30,000 /2.00 15,000 current rate
Inventory 35,000 /2.30 15,217 historical rate for inventory
Net Fixed Assets 500,000 /2.10 238,095 historical rate for fixed assets
Total Assets 590,000 280,813
Accounts Payable 20,000 /2.00 10,000 current rate

Long Term Debt 100,000 /2.00 50,000 current rate
Common Stock 250,000 /2.50 100,000 historical rate
Retained Earnings 220,000 120,813 280,813 − 10,000 − 50,000 − 100,000
Total Liabilities & Equity 590,000 280,813
(LOS 12.f)
If the functional currency is the US$ then the net income before a remeasurement is closest to:
ᅚ A) 34,100 USD.
ᅞ B) 4,700 USD.
ᅞ C) 8,000 USD.
Explanation
Adjust the income statement by the appropriate rates. For COGS and depreciation, historical rates were given. Average rate is used for all
others.
LC Conversion USD
Revenues 520,000 /2.20 236,364 average rate
historical rate for
COGS 225,000 /2.30 97,826
COGs
SG&A 100,000 /2.20 45,455 average rate
historical rate for
Depreciation 80,000 /2.10 39,095
depreciation
Income Taxes 46,000 /2.20 20,909 average rate
Net Income before
69,000 34,079
remeasurement
(LOS 21.d)
If the functional currency had been to the US$, the currency exposure would have resulted in a:
ᅚ A) remeasurement loss.
ᅞ B) cumulative translation gain.
ᅞ C) remeasurement gain.
Explanation
When the functional currency is the reporting or presentation currency, the temporal method is applied to calculate the remeasurement.
The foreign currency LC has appreciated from 2.50 LC/$ to 2.00 LC/$. There is a net monetary liabilities as the value of the cash and
accounts receivables (LC 25,000 + LC 30,000 = LC 55,000) are less than the value of accounts payable and long-term debt (LC 20,000 +
LC 100,000 = LC 120,000). The foreign currency appreciation along with a net monetary asset liability exposure will result in a
remeasurement loss.

Temporal Method: Appreciating Depreciating
Net monetary assets Gain Loss
Net monetary liabilities Loss Gain
(LOS 21.d)
The local currency is:
ᅞ A) the preferred functional currency for subsidiaries that are highly integrated with the
parent.
ᅚ B) the same as the functional currency under the current rate method.
ᅞ C) translated into the functional currency under the current rate method.
Explanation
The local currency is best described as the currency of the country in which the foreign subsidiary is located. If a subsidiary is highly
integrated with its parent or operating in a high-inflation environment, the functional currency is the parent's currency. Local currencies are
remeasured under the temporal method.
The Schuldes Company had the following reported assets in euros at historical cost for the period ending December 31, 2005.
Cash 134
Accounts receivable 270
Inventory 404
Net fixed assets 1347
Total assets 2155
The exchange rate per was $0.8734 on January 1, 2005 and $0.9896 on December 31, 2005. The average exchange rate for the year 2005
was $0.8925. The total assets of Schuldes using the current rate method are:
ᅞ A) $2,178.
ᅚ B) $2,133.
ᅞ C) $1,923.
Explanation
With the current rate method all balance sheet items except common stock use the current exchange rate to translate the functional
currency into the reporting currency.
2155 × $0.9896 = $2,133.

Neptune Corporation (Neptune) is a U.S. company located in Detroit, Michigan. Neptune supplies exhaust emission systems to
manufacturers of passenger cars and light duty trucks. In January 2006, Neptune formed a wholly owned subsidiary, Continental Systems
GmbH (Continental), to supply automotive manufacturers located throughout Europe. Continental is located in Stuttgart, Germany.
Continental's most recent financial statements, denominated in euros, are provided in Exhibit 1.
Exhibit 1: Continental Systems GmbH
Income statement
Year ended December 31
(in thousands) 2008
Sales revenue 76,000
Cost of goods sold (48,000)
Administrative expense (4,000)
Depreciation expense (6,000)
Interest expense (4,800)
Tax expense (5,760)
Net income 7,440
Balance sheet
As of December 31
(in thousands)
Assets 2008 2007
Cash 8,800 8,000
Accounts receivable 44,000 42,000
Inventory 16,800 16,000
Fixed assets, at cost 97,200 88,000
Accumulated depreciation (42,000) (36,000)
Total assets 124,800 118,000
Neptune has net monetary assets and reports its consolidated financial statements in U.S. dollars. The euro has been consistently
appreciating against the dollar.
Continental accounts for its inventory using the first-in, first-out (FIFO) cost flow assumption. Fixed assets consist of machinery, tools,
and equipment. All of the fixed assets were acquired at the beginning of 2006.
All of Neptune's U.S. employees are covered by a defined benefit pension plan. The plan is noncontributory and the benefits are based on
years of service and employee earnings. Both ABO and PBO currently exceed the fair value of pension plan assets.
Which of the following components of the projected benefit obligation is most likely to increase every year as a direct result of the
employee working another year for the company?
ᅞ A) Benefits paid.
ᅚ B) Current service cost.
ᅞ C) Interest cost.
Explanation
The current service cost is the present value of new benefits earned by the employee working another year. Current service cost
increases the PBO. Note that the interest cost increases every year regardless of whether the employee works another year or not.
(Study Session 6, LOS 21.c)
Which of the following are the most likely impacts on gross profit margin and net profit margin, assuming the temporal method is used to
remeasure Continental's financial statements?
ᅞ A) Only gross profit margin will be higher.
ᅞ B) Only net profit margin will be higher.
ᅚ C) Both will be higher.
Explanation
Under the temporal method, sales are remeasured at the average rate, and cost of goods sold is remeasured at the historical rate. Since
the euro is appreciating relative to the dollar, sales will be higher when stated in dollars. Because cost of goods sold is remeasured at the
historical rate, it does not reflect the appreciating euro. Therefore, appreciating sales, without a corresponding increase in cost of goods
sold, will result in higher gross profit margin.
Under the temporal method, exposure is defined as the firm's net monetary asset or net monetary liability position. Continental is holding
net monetary assets (monetary assets exceed monetary liabilities), and the position is increasing. Holding net monetary assets when the
euro is appreciating will result in the recognition of a gain in the income statement. The gain results in higher net income and, thus, higher
net profit margin. (Study Session 7, LOS 22.c)
Which of the following are the most likely impacts on the operating profit margin and the long-term debt-to-equity ratio, assuming the
current rate method is used to translate Continental's financial statements?
ᅞ A) Long-term debt-to-equity ratio will be higher.
ᅞ B) Operating profit margin will be higher.
ᅚ C) Neither ratio will change.
Explanation
Under the current rate method, all revenues and all expenses are translated at the average rate. Consequently, the subtotals (gross profit,
operating profit, and net profit) are translated at the average rate. Translating the numerator (operating profit) and the denominator (sales)
at the same rate will have no impact on the ratio.
Under the current rate method, all assets and all liabilities are translated at the current rate. In order for the balance sheet equation to
balance, total shareholders' equity must also be translated at the current rate. Translating the numerator (long-term debt) and the
denominator (shareholders' equity) at the same rate will have no impact on the ratio. (Study Session 7, LOS 22.c)

When stated in U.S. dollars, would Continental most likely report a higher fixed asset turnover ratio and a higher quick ratio under the
temporal method, as compared to the current rate method?
ᅞ A) Only the quick ratio will be higher under the temporal method.
ᅞ B) Both ratios will be higher under the temporal method.
ᅚ C) Only fixed asset turnover will be higher under the temporal method.
Explanation
Continental would report a higher fixed asset turnover ratio (sales/fixed assets) under the temporal method because sales are translated at
the same rate under both methods (the average rate), but fixed assets would be translated at the lower historical rate (because the euro is
appreciating) under the temporal method. Therefore, the ratio will be higher.
Continental would not report a higher quick ratio under the temporal method. Actually, the quick ratio would be the same under both
methods. Continental's quick assets include cash and accounts receivable. Quick assets and current liabilities are converted at the
current rate under both methods. (Study Session 7, LOS 22.c)
Which of the following statements about the temporal method and the current rate method is least accurate?
ᅞ A) Net income is generally more volatile under the temporal method than under the current
rate method.
ᅚ B) Subsidiaries whose operations are well integrated with the parent will generally use the current
rate method.
ᅞ C) Subsidiaries that operate in highly inflationary environments will generally use the temporal
method under U.S. GAAP.
Explanation
Subsidiaries whose operations are well integrated with the parent will generally use the parent's currency as the functional currency.
Remeasurement from the local currency to the functional currency is done with the temporal method. (Study Session 7, LOS 22.c)
If Neptune was to increase the discount rate used in calculating the pension obligations, which of the following would be most correct,
concerning its net income and the funded status of the pension plan?
ᅚ A) Higher net income, with a higher funded status.
ᅞ B) Higher net income, with a lower funded status.
ᅞ C) Lower net income, with a higher funded status.
Explanation
Service cost, a component of pension expense, is a present value calculation. Consequently, an increase in the discount rate will lower
the service cost. A lower service cost will result in lower pension expense. Lower pension expense will result in higher net income.
The funded status is equal to the difference in the fair value of the plan assets and PBO. Since service cost is also a component of PBO,
an increase in the discount rate will result in a lower PBO. A lower PBO will result in a higher funded status (more funded). (Study Session
6, LOS 21.c)
Deborah Ortiz, CFA®, is the director of Global Research for F.E. Horton & Co. Ortiz recently hired two junior analysts, Tina Hirauye and
Dominique Wilkins to assist in the financial statement analysis of global conglomerates. Hirauye and Wilkins are both Level II candidates
in the CFA® Program, so Ortiz thought they would be the ideal people to work on a project dealing with consolidating the results of foreign
operating units in the financial statements of the global parent.
Before starting on the project, Ortiz has a meeting with Hirayue and Wilkins to discuss the use of different currencies in a company's
operations. At the meeting, Hirayue states that when analyzing multinational firms, there cannot be a difference between local and
functional currencies. Wilkins disagrees with her and states that there can be a difference between local and functional currencies, but
only if the parent of the subsidiary operates in a hyperinflationary environment. After another 30 minutes of discussion, Ortiz concludes
the meeting by telling them to make sure they understand the different accounting rules for remeasurement and translation, under SFAS
52.
Hirauye and Wilkins are given projects involving three different firms:
Molsan Industries is a Canadian multinational firm with a subsidiary in Japan. The subsidiary has operations in both Japan and
Singapore.
Tylo Corporation is a multinational firm based in France. Tylo does business on a global basis, but prepares and issues consolidated
financial statements in U.S. dollars. Tylo has a subsidiary that does business in the United Kingdom. The majority of the cash that
the subsidiary generates and expends is denominated in British Pounds (GBP).
Neslarone is based in Switzerland and generates the majority of its cash in Swiss Francs (CHF). The firm issues and prepares its
consolidated financial statements in U.S. dollars.
Hirauye and Wilkins spend the morning reviewing the details of their assignment and decide to take a break for lunch at a restaurant
across the street from F.E. Horton & Co.'s headquarters. They agree that they have a challenging task and both are nervous about turning
in their consolidated financial statements to Ortiz on the following day. At the restaurant, the two junior analysts run into two F.E. Horton
senior analysts, Brad Windbigler and Elizabeth Alvarez, and the four of them decide to eat lunch together. Windbigler and Alvarez recently
found out that they both passed Level III of the CFA® Exam, and, upon hearing about the task assigned by Ortiz, they are eager to help
their two junior colleagues. Windbigler states that the current exchange rate is defined as the exchange rate between functional and
reporting currencies at the balance sheet date, excluding all of a firm's hedging activities. Alvarez also tries to offer assistance by stating
that the correct exchange rate to use for monetary assets and liabilities when applying the temporal method is the average rate. When
lunch is over, Hirauye and Wilkins thank their colleagues for their advice and go back to work to finish their assignment.
Regarding the statements made at the meeting:
ᅞ A) Hirauye's statement is incorrect; Wilkins' statement is correct.
ᅚ B) Hirauye's statement is incorrect; Wilkins' statement is incorrect.
ᅞ C) Hirauye's statement is correct; Wilkins' statement is correct.
Explanation
Hirauye and Wilkins both make incorrect statements regarding local and functional currencies. A foreign subsidiary may have a local
currency but designate another currency as its functional currency. The functional currency is defined as the currency of the primary
environment in which the subsidiary generates and expends cash, but the choice of the functional currency is ultimately a function of
management's judgment. Wilkins is also incorrect because the rate of inflation does not necessarily have an impact on designated
currencies. (Study Session 6, LOS 21.a)
Hirauye is working on consolidating the financial statements of Molsan Industries' Japanese subsidiary. Under SFAS 52, regarding
Foreign Currency Translation, if:
ᅞ A) more than half of the subsidiary's revenue is from Japanese sources, then the results of
the Singapore operation are translated into Japanese yen and then translated into
Canadian dollars.
ᅚ B) management determines that the subsidiary's functional currency is the Japanese yen, the
results of the Singapore operation are first remeasured into Japanese yen and then translated
into Canadian dollars.
ᅞ C) management determines that the subsidiary's functional currency is the Singapore dollar, then
the results of the Singapore operation are remeasured into Canadian dollars.
Explanation
The functional currency is determined by management. Financial data are remeasured into the functional currency chosen by
management and then translated into the reporting currency. (Study Session 6, LOS 21.a)
Wilkins has been tasked with analyzing Tylo Corporation, and is trying to distinguish between the various currencies employed in Tylo's
operations. Concerning the UK subsidiary's functional and reporting currencies the:
ᅞ A) parent firm (Tylo) is headquartered in France, therefore the functional currency is the
Euro, and the reporting currency is the U.S. dollar.
ᅚ B) functional currency is the British Pound; reporting currency is the U.S. dollar.
ᅞ C) functional currency and reporting currency are the U.S. dollar.
Explanation
The functional currency is defined as the currency of the primary economic environment in which the subsidiary generates and expends
cash. Although the functional currency can be chosen by management, because we are told that Tylo's UK subsidiary generates and
expends cash in British Pounds, the British Pound is the best choice for the functional currency. The reporting currency is the currency in
which the parent firm prepares final consolidated statements, which in this case is the U.S. dollar. (Study Session 6, LOS 21.a)
Ortiz had told the junior analysts to make sure they understand the different accounting rules under SFAS 52. When referring to foreign
exchange rates, the difference between remeasurement and translation is that remeasurement:
ᅞ A) and translation refer to the same process of translating the functional currency into the
reporting currency.
ᅚ B) refers to the conversion of local currency into the functional currency; translation is the
conversion of the functional currency into the reporting currency.
ᅞ C) is used to describe historical exchange rates while translation is used for current rates.
Explanation
Translation is between functional and reporting currency. Remeasurement occurs between local and functional currencies. (Study Session
6, LOS 21.a)
Regarding the statements made at lunch:
ᅞ A) Windbigler's statement is correct; Alvarez's statement is correct.
ᅞ B) Windbigler's statement is incorrect; Alvarez's statement is incorrect.
ᅚ C) Windbigler's statement is correct; Alvarez's statement is incorrect.
Explanation
Windbigler's statement is correct. The current rate is defined as the market rate in effect at the balance sheet date. Hedging activities do
not affect the rate, but affect the gain or loss from changes in exchange rates. Alvarez's statement is incorrect. The correct exchange rate
to use for monetary assets and liabilities when applying the temporal method is the current rate. (Study Session 6, LOS 21.c)
Wilkins and Hirauye are working on constructing the consolidated statements for Neslarone. They know that after they convert from Swiss
Francs (CHF) to U.S. dollars (USD), they will be left with a foreign currency adjustment that needs to be included on the financial
statements. To convert from CHF to USD, the analysts should use the:
ᅞ A) temporal method and they should record the foreign currency adjustment on the
income statement.
ᅞ B) current rate method and they should record the foreign currency adjustment on the income
statement.
ᅚ C) current rate method and they should record the foreign currency adjustment on the balance
sheet.
Explanation
Neslarone is based in Switzerland and generates the majority of its cash in CHF, meaning the local and functional currencies are both
CHF. The firm issues financial reports in USD, so the dollar is the reporting currency. The process of converting from the functional
currency to the reporting currency is translation and the correct method to use is the current rate method. When using the current rate
method, the foreign currency adjustment is recorded in the equity section of the balance sheet. (Study Session 6, LOS 21.d)
Edmonton Oilfield Supply has made an equipment sale in Venezuela in the amount of VEF 15,000,000. On the day of the sale, the
exchange rate is 1.7519 VEF per 1 Canadian dollar. 90 days later, when the Venezuelan firm pays for the equipment, the exchange rate is
1.6326. As a result of the change in the exchange rate, Edmonton will recognize a:
ᅞ A) loss of $1,789,500.
ᅞ B) gain of $1,096,104.
ᅚ C) gain of $625,666.
Explanation
On the day of the sale, Edmonton will record an account receivable of 15m/1.7519 = $8,562,133. When the payment is received and
converted to CAD, the realized amount will be 15m/1.6326 = $9,187,799. As a result of the appreciating VEF, Edmonton will realize a gain
of $9,187,799 − 8,562,133 = CAD 625,666.
The Herlitzka Company, a U.S. multinational firm, has a 100% stake in a Swiss subsidiary. The Swiss franc (SF) has been determined to
be the functional currency. All the common stock of the subsidiary was issued at the beginning of the year and the subsidiary uses the
FIFO inventory cost-flow assumption. In addition, the value of the SF is as follows:
End of year $0.6150
Accounts receivable = 3,000
Inventory = 4,000
Net income = 2,000
The translated value of accounts receivable and inventory respectively are:
ᅚ A) $1,845 and $2,460.
ᅞ B) $1,845 and $2,401.
ᅞ C) $1,801 and $2,401.
Explanation
Since the SF is the functional currency, then the current rate method is employed to translate the SF amounts into USD. Hence, A/R =
0.615 × 3,000 = $1,845 and 0.615 × 4,000 = $2,460.
(Assume U.S. GAAP for this question.) For a subsidiary in a hyperinflationary economy, the functional currency should be the:
ᅚ A) Parent's currency.
ᅞ B) Local currency.
ᅞ C) Subsidiary's operating currency.
Explanation
The functional currency should be the parent's currency. Under IFRS, the firm would restate the financials for inflation, and then translate
under the current rate method.
The Herlitzka Company, a U.S. multinational firm, has a 100% stake in a Swiss subsidiary. The U.S. dollar (USD) has been determined to
be the functional currency. All the common stock of the subsidiary was issued at the beginning of the year and the subsidiary uses the
weighted-average inventory cost-flow assumption. In addition, the value of the SF is as follows:

End of year $0.6150
Accounts receivable = 3,000

Inventory = 4,000
Net income = 2,000
The total value of net monetary assets is equal to:
ᅚ A) -4,000 SF.
ᅞ B) 12,000 SF.
ᅞ C) 3,000 SF.
Explanation
Monetary assets and liabilities include cash, A/R, A/P and Long-term debt. Hence, net monetary assets is equal to 3,000 − (2,000 +
5,000) = -4,000 SF.
A hyperinflationary economy is typically defined as one that has:
ᅞ A) cumulative inflation that exceeds 100% over a twelve-year period.
ᅞ B) an inflation rate that exceeds 10% per year for three consecutive years.
ᅚ C) cumulative inflation that exceeds 100% over a three-year period.
Explanation
The typical definition is that cumulative inflation exceeds 100% over a three-year period.
Which translation method should be used under a hyperinflationary economy when using U.S. GAAP?
ᅞ A) All-current, because dividends are translated at the rate that applied when they were
issued.
ᅚ B) Temporal, because all non-monetary accounts are re-measured at the historical rate.
ᅞ C) Monetary/non-monetary, because all monetary accounts are translated at the historical rate.
Explanation
The temporal method is more appropriate because all non-monetary accounts are remeasured at the historical rate. Under IFRS, the
financials would be restated for inflation, and then translated under the current rate method.
Sycamore Systems sold $5 million worth of software on December 1, 20X1 to a Japanese company with payment denominated in
Japanese yen to be received in two months. Sycamore's year end is 31st December. Payment was received on 31 Jan 20X2.
Exchange rates (1 USD)
1 Dec 20X1 95
31 Dec 20X1 90
31 Jan 20X2 35
The amount of transaction gain/loss recorded by Sycamore on its income statement for the year ending 31 Dec 20X1 is closest to:
ᅞ A) loss of $300,000.
ᅚ B) gain of $280,000.
ᅞ C) gain of $580,000.
Explanation
Sale amount = $5 million × 95 = 475 million yen. Accounts receivable on sale date = $5 million.
Accounts receivable at year-end = 475 million yen/90 = $5.28 million
The appreciation of the yen resulted in a gain of $280,000 on the balance sheet date and would be recognized in the income statement.

Navratov Corp. is a designer and manufacturer of high end sporting goods. The majority of the firm's business comes from Olympic
athletes from Russia and the United States. On January 1, 2003, Navratov was purchased by a U.S. competitor, Evert Industries.
Because Evert's business focuses on professional athletes in North America and Asia, Evert's management feels the acquisition of
Navratov is a natural extension of their business and that buying the Russian firm should generate economies of scale.
Peter Capriati is an analyst for Evert and has been assigned the task of integrating Navratov's financial statements into Evert's. Capriati
knows that Evert's management pays a great deal of attention to making sure the firm's financial ratios are above the industry average.
Because Navratov's sales are split evenly between the U.S. and Russia, management has given him the flexibility to designate the either
the Ruble (Navratov's local currency) or the U.S. dollar (Evert's reporting currency) as Navratov's functional currency. As a result of
choosing the functional currency, Capriati will use either the temporal or current rate method to convert Navratov's financial statements,
depending on which method will have the most favorable impact on Evert's financial ratios.
Selected financial data for Navratov Corp is shown below:
Navratov Corporation
Income Statement (in Russian Rubles)
12 months ended December 31, 2003
Revenue 7,400,000
Cost of Goods Sold (COGS) (5,200,000)
Depreciation (1,200,000)
Taxes (250,000)
Net Income 750,000
Balance Sheet (in Russian Rubles)
December 31, 2002
Cash 500,000 Accounts Payable 3,450,000
Accounts Receivable 2,500,000 Long Term Debt 5,000,000
Inventory 3,700,000 Common Stock 3,500,000
Net Fixed Assets 6,000,000 Retained Earnings 750,000
Total Assets 12,700,000 Total Liabilities and Equity 12,700,000
Balance Sheet (in Russian Rubles)
December 31, 2003
Cash 1,000,000 Accounts Payable 2,000,000
Accounts Receivable 2,500,000 Long Term Debt 5,000,000

Inventory 3,700,000 Common Stock 3,500,000
Net Fixed Assets 4,800,000 Retained Earnings 1,500,000
Total Assets 12,000,000 Total Liabilities and Equity 12,000,000
Navratov Corp. did not pay dividends in 2003.

The common stock was acquired on January 1, 2002.
January 1, 2003 retained earnings in USD is $300,000.
Depreciation is being taken on a straight-line basis over ten years for equipment which was acquired on January 1, 2002, at a cost of
12,000,000 rubles.
Navratov uses FIFO inventory accounting and goods were sold evenly throughout the year. The average rate applicable to inventory
and COGS is $0.37 / ruble.
Exchange rates:
January 1, 2002, $0.40 / ruble

January 1, 2003, $0.40 / ruble
June 30, 2003, $0.37 / ruble (avg. rate)
December 31, 2003, $0.33 / ruble
Which of the following statements about the temporal method and the current rate method is least accurate?
ᅚ A) Subsidiaries whose operations are well integrated with the parent will generally use the
current rate method.
ᅞ B) Subsidiaries that operate in highly inflationary environments will generally use the temporal
method under U.S. GAAP.
ᅞ C) Net income is generally more volatile under the temporal method than under the current rate
method.
Explanation
Subsidiaries whose operations are well integrated with the parent will generally use the parent's currency as the functional currency.
Remeasurement from the local currency to the functional currency is done with the temporal method. (Study Session 6, LOS 21.d)
If Capriati uses the current rate method to translate Navratov's income statement, the net profit margin will be:
ᅞ A) 11.7%.
ᅞ B) 8.6%.
ᅚ C) 10.1%.
Explanation
The net profit margin is a pure income statement ratio, meaning it will be unaffected by the application of the current rate method. The
calculation is shown below:
Under the current rate method, all income statement accounts will be translated at the average rate.
Revenue 7,400,000 $0.37 $2,738,000
Cost of Goods Sold (5,200,000) $0.37 (1,924,000)

(COGS)
Depreciation (1,200,000) $0.37 (444,000)
Taxes (250,000) $0.37 (92,500)
Net Income 750,000 $0.37 $277,500
Note that under the current rate method, since all income statement accounts are translated at the same average rate, you do not have to
translate the income statement to get the correct answer. (750,000 / 7,400,000) = 10.1%. (Study Session 6, LOS 21.e)
What is the difference in the translated receivables turnover ratio for Navratov Corp. between the temporal and current rate methods? The
receivables turnover rate is:
ᅚ A) the same under both methods.
ᅞ B) lower under the current rate method by 0.30x.
ᅞ C) higher under the current rate method by 0.36x.
Explanation
The receivables turnover ratio is calculated as (sales / receivables). Under the both the current rate and temporal methods, sales are
translated at the average rate, while receivables are translated at the current rate. Since both the sales and receivables components are
translated at the same rate, there will be no difference in the ratios between the two methods. (Study Session 6, LOS 21.e)
What is the difference in the total asset turnover ratio for Navratov Corp. between the temporal and current rate methods? The total asset
turnover ratio is:
ᅞ A) lower under the current rate method.
ᅞ B) the same under both methods.
ᅚ C) higher under the current rate method.
Explanation
The total asset turnover ratio = (sales / total assets)
We can see from the exchange rates that the Russian ruble is depreciating (it takes fewer dollars to buy a ruble). With a depreciating local
currency, sales are going to be the same under either method, since sales are translated at the average rate. Assets on the other hand
will be higher under the temporal method, and lower under the current rate method. This is because all assets are translated at the current
rate under the current rate method (which has the lower exchange rate), and at different rates under the temporal method (which is has
fixed assets converted at the higher historical rate). With the same numerator and lower denominator, the current rate method will lead to
the higher total asset turnover ratio. (Study Session 6, LOS 21.e)

Given the observed appreciation or depreciation of the ruble versus the U.S. dollar, which of the following statements regarding Navratov's
leverage ratios under the temporal method compared to the current rate method is most accurate? The temporal method will lead to a:
ᅚ A) lower debt-to-equity ratio and a lower debt-to-capital ratio.
ᅞ B) higher debt-to-equity ratio and a higher debt-to-capital ratio.
ᅞ C) higher debt-to-equity ratio and a lower debt-to-capital ratio.
Explanation
Since it is taking fewer dollars to buy a ruble, the exchange rate is depreciating.
Both the debt-to-equity and debt-to-capital ratios will be lower under the temporal method versus the current rate method if a foreign
currency is depreciating. Under both methods, long term debt and accounts payable are both translated at the current exchange rate, so
those are the same.
Equity under the temporal method is effectively translated at a mixed rate under the temporal method, and the current rate under the
current rate method. Since the currency is depreciating, the equity value will be higher under the mixed rate scenario. With the same debt
and higher equity, the temporal method will lead to a lower debt-to-equity ratio than the current rate method.
Assets under the temporal method are also effectively translated at a mixed rate under the temporal method, and the current rate under
the current rate method. Since the currency is depreciating, the asset value will be higher under the mixed rate scenario. With the same
debt and higher assets, the temporal method will lead to a lower debt-to-capital ratio than the current rate method. (Study Session 6, LOS
21.e)
Capriati has completed his research and has summarized his findings in a report for Evert's management. Which of the statements made
in Capriati's report is least accurate?
ᅞ A) The statement of cash flows for Navratov Corp should be the same under both the
temporal and current rate methods of translation.
ᅞ B) A depreciating foreign currency will have a smaller impact on Evert's consolidated financial
statements than an appreciating foreign currency.
ᅚ C) Evert would prefer the temporal method for reporting its gross profit margin if the Russian
Ruble was depreciating.
Explanation
If the ruble was depreciating, Evert would report a higher gross profit margin under the current rate method. Under both the temporal and
current rate methods, revenues are translated at an average rate, while COGS are translated at a historical rate under the temporal
method and an average rate under the current rate method. A depreciating currency means that COGS would be higher under the temporal
method, resulting in a lower gross profit margin. The other statements are true - an appreciating foreign currency tends to have the largest
impact on the parent company's financials and the statement of cash flows should theoretically be the same under both methods but flow
effects from changing rates will have an impact on reporting currency methods. (Study Session 6, LOS 21.d)
The Precision Screen Printers (PSP) Company has a foreign subsidiary, the Acer Tool & Die Company, located in the country of Rolivia.
The currency of Rolivia is the Chad. The balance sheet and income statement of Acer Tool & Die Company for the year-ended December
31, 2002, is shown below. The balance sheet has been restated using the U.S. dollar as the functional currency.
Acer Tool & Die Company Balance Sheet
As of December 31, 2002
Chad Exchange Rate U.S. $

(millions) (Chad/US$) (millions)
Cash 20 0.25 $80
Accounts receivable 30 0.25 120
Inventory 100 0.3125 320

Fixed assets (net) 500 0.3333 1,500
Total assets 650 $2,020
Accounts payable 50 0.25 $200

Capital stock 380 0.3333 1,140
Retained earnings 220 -- 680
Total liabilities and equity 650 $2,020
Acer Tool & Die Company Income Statement

For year ending December 31, 2002
(Amounts in millions of Chad)
Revenues 1,000
Cost of sales 700
Depreciation expense 50
Selling expense 30
Net income 220
The exchange rate at the beginning of 2002 was 0.3333 Chad/US$. The exchange rate at the end of 2002 was 0.25 Chad/US$. The
average rate for 2002 is 0.3125 Chad/US$. Beginning inventory is 90 Chad. Acer Tool & Die uses FIFO inventory valuation and
depreciates fixed assets using the straight-line method.
Using the current rate method for the Acer Tool & Die Company, what is the value of total assets after translation?
ᅞ A) $1,950.
ᅚ B) $2,600.
ᅞ C) $2,020.
Explanation
With the current rate method, all balance sheet items except for common stock are translated at the current rate. Total assets = 650 /
0.25 = $2,600.
Financial Reporting and Analysis: Quality of Financial Reports and
Financial Statement Analysis
Test ID: 7440516
Holdall Corporation recently reclassified many of their assets such that the average useful life of their depreciable assets was reduced.
Which of the following is the most likely result from this change on net income and inventory turnover? (Assume everything else remains
constant.) Net income will:
ᅞ A) decrease and inventory turnover will rise.
ᅞ B) increase and inventory turnover will not change.
ᅚ C) decrease and inventory turnover may or may not change.
Explanation
Depreciation expense increases as the depreciable life of an asset decreases. Thus, net income will decline. Depreciation will only affect
inventory turnover if depreciation has been allocated to individual inventory items; when and why this happens is outside the scope of the
Level II curriculum.
A firm seeking to lower current tax liability may elect to use which method of inventory valuation during an inflationary period?
ᅚ A) LIFO.
ᅞ B) FIFO.
ᅞ C) Average cost.
Explanation
During a inflationary period, using LIFO would increase COGS, since the most recent (highest cost) inventory would be sold.
Therefore, earnings and taxes would be lowest under LIFO.
Jeremy Jennings is explaining the concept of earnings quality to his new colleagues. Which of the following measures is most
indicative of a higher quality of earnings when attempting to forecast future earnings?
ᅞ A) Higher level of earnings.

ᅞ B) Higher degree of conservatism of earnings.
ᅚ C) Higher degree of persistence of earnings.
Explanation
The term earnings quality usually refers to the persistence and sustainability of a firm's earnings; that is, more persistent and
sustainable earnings are considered higher quality.
Measuring earnings quality based on conservative earnings is an inferior measure when attempting to forecast future earnings
because most accruals will self-correct over time. For example, the lower earnings that result from accelerated depreciation
will increase in the later years of the asset's life. Focusing on accruals and deferrals is a more effective way of measuring
earnings quality.
A higher level of earnings has no impact on increasing the quality of earnings since the former may be derived largely from
earnings manipulation on the part of management.
With regard to specific measures to analyze in detecting manipulation in the financial reporting process, which of the following
statements is the least accurate?
ᅚ A) A decreasing days' sales outstanding (DSO) measure may be an indication of

lower quality revenue.
ᅞ B) Negative nonrecurring or non-operating items may be indicative of misclassifying an

operating expense.
ᅞ C) An increasing days' inventory on hand (DOH) measure may be indicative of obsolete
inventory.
Explanation
Days' sales outstanding (DSO) measures the number of days it takes to convert receivables into cash and is calculated by
dividing the number of days in the period by the accounts receivable turnover ratio. An increasing DSO (decreasing
receivables turnover) may be an indication of lower quality revenue; that is, the longer it takes to collect from customers, the
more likely the receivables will turn into bad debt.
Days' inventory on hand (DOH) is equal to the number of days in the period divided by inventory turnover ratio and it
measures the number of days it takes to sell inventory. An increasing DOH may be indicative of obsolete inventory.
Analysts should compare changes in the core operating margin over time and look for negative nonrecurring (e.g.,
restructuring charges, asset impairments, and write-downs) or non-operating items that occurred when the ratio increased.
This may be the result of misclassifying an operating expense.
Due to a change in accounting standards, TRK Construction's QSPE must now be consolidated. The QSPE has purchased,
TRK's accounts receivables and had financed those with notes payables. Assume that TRK's current ratio before consolidation
is 1.10. Consolidation will most likely result in which of the following:
ᅞ A) an increase in the current ratio.

ᅞ B) no change in the current ratio.
ᅚ C) a decrease in the current ratio.
Explanation
The correct treatment for consolidation of the QSPE would be an increase in current assets (accounts receivable) and in
current liabilities (notes payable) by the same amount. If the current ratio is greater than one, consolidation would decrease
the current ratio.
The following information pertains to Morley Inc. (Morley) and Crowell Inc. (Crowell) for 2007 and 2008:
Accrual 2008 2007

Ratio
Morley 16.1% 14.7%
Crowell 6.9% 8.5%
Based on the information provided, which of the following conclusions about the two companies is most appropriate?
ᅚ A) Crowell's earnings quality is higher than Morley's.

ᅞ B) Morley's earnings quality is higher than Crowell's.
ᅞ C) Crowell's earnings quality is deteriorating compared to Morley's.
Explanation
Crowell's earnings quality is higher because its accrual ratio is lower in both years. Furthermore, Crowell's earnings quality is
also improving (due to the decrease in its accrual ratio) while Morley's is deteriorating (due to the increase in its accrual ratio).
Aggressive revenue recognition practices are least likely to increase:
ᅞ A) reported expenses
ᅞ B) reported assets
ᅚ C) reported ending inventory
Explanation
Aggressive revenue recognition practices would increase accounts receivable, revenues, expenses, income and stockholder's
equity. Ending inventory would decline but by less than the increase in accounts receivable resulting in increase in total assets.
Early recognition of revenues also accelerates recognition of expenses (COGS).
Samuel Maskin, CFA is evaluating the financial statements of Northern Energy Inc. The following is an extract from Northern's
cash flow statement for the past three years:
20x6 20x5 20x4

Net Income $1,023 $988 $744
Depreciation $187 $145 $128
Restructuring Charges $(108) $(104) $212
Accounts receivable $(172) $(145) $(33)
Inventories $(418) $(202) $(180)
Accounts Payable $38 $37 $33
OCF $550 $719 $904
The restructuring charges for Northern has most likely:
ᅚ A) Reduced reported earnings in 20x4 while increasing reported earnings in 20x5

and 20x6.
ᅞ B) Increased reported earnings for 20x4 while reducing reported earnings in 20x5 and
20x6.
ᅞ C) Increased reported earnings in 20x6 while reducing reported earnings in 20x4 and
20x5.
Explanation
Restructuring charges contribute positively to 20x4 cash flow indicating that it was a non-cash charge against that year's
income. In the following two years, there is a reversal of that charge leading to an artificial increase in reported earnings for
20x5 and 20x6.
Star Chemical Inc. (SCI) reported the following year-end data:
Depreciation expense $25 million
Net income $35 million
Dividends $10 million
Total assets $250

million
Shareholder's equity $195

million
Effective tax rate 35 percent
SCI also reported that it changed from an accelerated depreciation method to straight line depreciation. The change resulted
in a decrease in depreciation expense of $5 million. Management felt that the change "would not have a material effect on
financial performance measures." Ignoring deferred taxes, what are the return on assets (ROA) and return on equity (ROE)
measures under the old depreciation methods?
ᅚ A) ROA is 12.96% and ROE is 16.56%.

ᅞ B) ROA is 13.30% and ROE is 17.05%.
ᅞ C) ROA is 13.50% and ROE is 17.51%.
Explanation
The change in depreciation methods results in net income increasing by $3.25 million ($5 million × (1-0.35)) and total assets
increasing by $5 million. Without the change in depreciation methods SCI would have reported:
Depreciation $30 million ($25 + $5)
expense
Net income $31.75 million ($35 - $3.25)
Total assets $245 million ($250 - $5)
Shareholder's $191.75 ($195 − $3.25)

equity million
Note that assets would have been lower by $5 million due to the accelerated depreciation and equity would be lower by $3.25
million ($5 × (1 − 0.35)) due to lower retained earnings. In order to balance the $5 million reduction in assets, equity will fall by
$3.25 million and tax liabilities will fall by $1.75 million. Therefore, ROA would have been 12.96% ($31.75 / $245) and ROE
would have been 16.56% ($31.75 / $191.75).
Joe Carter, CFA, believes Triangle Equipment, a maker of large, specialized industrial equipment, has overstated the salvage
value of its equipment. This would:
ᅞ A) overstate liabilities.
ᅚ B) overstate earnings.
ᅞ C) understate earnings.
Explanation
Overstating the salvage value reduces depreciation expense, which in turn increases earnings.
An analyst finds return-on-equity (ROE) a good measure of management performance and wants to compare two firms: Firm
A and Firm B. Firm A reports net income of $3.2 million and has a ROE of 18. Firm B reports income of $16 million and has an
ROE of 16.
A review of the notes to the financial statements for Firm A, shows that the earnings include a loss from smelting operations of
$400,000 and that the firm has exited this business. In addition, the firm sold the smelting equipment and had a gain on the
sale of $300,000.
A similar review of the notes for Firm B discloses that the $16 million in net income includes $2.6 million gain on the sale of no
longer needed office property. Assume that the tax rate for both firms is 36%, and that the notes describe pre-tax amounts.
Which of the following is closest to the "normalized" ROE for Firm A and for Firm B, respectively?
ᅞ A) 16.0 and 18.0.

ᅞ B) 17.1 and 16.9.
ᅚ C) 18.4 and 14.3.
Explanation
The ROE for Firm A is adjusted for the $400,000 loss on discontinued operations and the $300,000 non-recurring gain. The
ROE for Firm B is adjusted to remove the effects of the $2.6 million one-time gain.
The first step in this problem is to solve for equity using ROE. Then, "normalize" net income by adjusting for discontinued
operations and non-recurring items. Then, solve for "normalized" ROE.
Firm A:
18% = 3,200,000 / EquityA
EquityA = 17,777,778 (rounding)
Normalized Net IncomeA = 3,200,000 + (1 - 0.36)(400,000 - 300,000)
Normalized ROEA = 3,264,000 / 17,777,778 = 18.360%
Firm B:
16% = 16,000,000 / EquityB
EquityB = 100,000,000
Normalized Net IncomeB = 16,000,000 + (1 - 0.36)(-2,600,000)
Normalized ROEB = 14,336,000 / 100,000,000 = 14.336%
18.360 and 14.336 are closest to 18.4 and 14.3
Inventories are listed on the balance sheet at $600,000, retained earnings are $1.9 Million. In the notes to financial
statements, you find a LIFO reserve of $125,000. Also, the probability of a LIFO liquidation is high. Assuming a tax rate of
36%, what will be the adjusted value of retained earnings?
ᅞ A) $1,855,000.
ᅚ B) $1,980,000.
ᅞ C) $1,820,000.
Explanation
The highly probably LIFO liquidation suggests net income, income tax expense, and equity will rise. The analyst can make this
adjustment now for forecasting purposes. The adjustment to retained earnings will be: $125,000 × (1 − 0.36).
Which of the following is least likely an indicator of high-quality cash flow?
ᅚ A) Total cash flow that is positive and high.

ᅞ B) OCF adequate to cover capital expenditures, dividends and debt repayments.
ᅞ C) OCF derived from sustainable sources.
Explanation
High-quality cash flow focuses on positive, adequate and sustainable operating cash flow. Firms with high borrowings could
have high total cash flow but such cash flows would not be sustainable (nor considered high-quality).
Costiuk Inc. (Costiuk) saw a large increase in its net operating assets (NOA) over the year. During the year, it also reported a
number of nonoperating revenues and deferred revenues. Which of the following statements regarding Costiuk's increase in
NOA and the most likely item to self-correct is most accurate?
Most likely item to self-

Increase in NOA
correct
ᅞ A) suggests lower earning

nonoperating revenues
quality
ᅚ B) suggests lower earning quality deferred revenues
ᅞ C) suggests higher earning quality nonoperating revenues
Explanation
Deferrals and accruals are most likely to self-correct.
The large increase in net operating assets is indicative of a high accruals ratio as demonstrated by the following equation:
AccrualsBS = NOAEND − NOABEG
In interpreting the ratio, the higher the ratio, the lower the earnings quality.
Nonrecurring and nonoperating revenues do not typically self-correct like deferrals and accruals, thereby providing a greater
manipulation benefit to the firm.
Analyst Jane Kilgore is worried that some of Maxwell Research's accrual accounting practices will lead to excessive operating
earnings recognition in the near-term. Examples of Kilgore's concerns include the following:
Accelerated revenue recognition of service agreements.

Classification of recurring revenue as nonrecurring revenue.
Understated inventory obsolescence.
Which of Kilgore's concerns is least likely to overstate current operating earnings?
ᅞ A) Understated inventory obsolescence.
ᅚ B) Classification of recurring revenue as nonrecurring revenue.

ᅞ C) Accelerated revenue recognition of service agreements.
Explanation
Classification of recurring revenue as nonrecurring revenue will understate current operating earnings. The other two items act
to overstate revenue and understate expenses.
A firm has booked as a sale, the transfer of $100 million in short-term accounts receivable to Public Finance Co., subject to
recourse. The notes to the financial statements disclose that as of the end of the fiscal year, $80 million remained uncollected.
In order to reflect this on the balance sheet, which of the following adjustments must be made?
ᅞ A) Decrease retained earnings and increase accounts receivable.

ᅚ B) Increase accounts receivable and increase current liabilities.
ᅞ C) Decrease cash and increase accounts receivable.
Explanation
Since the accounts receivable were sold with recourse, the risk on uncollected accounts remains with the company.
De Freitas Inc. (De Freitas) is a conglomerate. Its computer division was very profitable in the current year because it
launched a successful new lightweight laptop computer. Prices in the automobile division have been rising over the years but it
is engaged in a LIFO liquidation in the current year. Which of the following best describes the effect on the long-run earnings
of the computer division and the automobile division compared to the most recent year?
Computer division Automobile division

earnings earnings
ᅞ A) Decrease Increase
ᅚ B) Decrease Decrease
ᅞ C) Increase Decrease
Explanation
When examining earnings, analysts should be aware that earnings at extreme levels tend to revert back to normal levels over
time. This phenomenon is known as mean reversion. For example, capital is attracted to successful projects (i.e. the new
laptop) thereby increasing competition and decreasing earnings in the long-run.
A LIFO liquidation involves selling more goods than are replaced. Thus, the automobile division penetrated the older, lower
cost layers of inventory thereby increasing profit. This higher profitability is not sustainable, however, because the firm will
eventually run out of lower priced inventory. In the long-run, the earnings will decrease (to normal levels).
An analyst is developing a framework for financial statement analysis for his firm. The primary goal of financial statement
analysis is to:
ᅚ A) facilitate an economic decision.
ᅞ B) justify trading decisions for purposes of the Statement of Code and Standards.
ᅞ C) document portfolio changes for purposes of the Prudent Investor Rule.
Explanation
The primary goal of financial statement analysis is to facilitate an economic decision. For example, the firm may use financial
analysis to decide whether to recommend a stock to its clients. Documentation and justification of trading decisions may be
aided by financial statement analysis, but these are not the primary purposes.
To assess the quality of financial reports, which question is least necessary for an analyst to answer?
ᅚ A) Are reported earnings consistent with the firm's budget?

ᅞ B) Do earnings represent an adequate level of return?
ᅞ C) Are the financial reports decision useful and GAAP compliant?
Explanation
Quality of financial reports is assessed by answering two questions: Whether the financial reports are decision useful and
GAAP compliant and whether the results quality is high (i.e., earnings provide adequate return on capital and are sustainable).
Express Delivery Inc. (EDI) reported the following year-end data:
Depreciation $30 million

expense
Net income $30 million
Total assets $535 million
Shareholder's equity $150 million
Effective tax rate 35 percent
Last year EDI purchased a fleet of delivery vehicles for $140 million. For the first year, straight-line depreciation was used
assuming a depreciable life of 7 years with no salvage value. However, at year-end EDI's management determined that
assumptions of a useful life of 5 years with a salvage value of 10 percent of the original value were more appropriate. How
would the return on assets (ROA) and return on equity (ROE) for last year change due to the change in depreciation
assumptions? ROA and ROE would be closest to:
ᅞ A) ROA 5.7% and ROE 19.5%.

ᅞ B) ROA 5.3% and ROE 20.5%.
ᅚ C) ROA 5.0% and ROE 18.2%.
Explanation
The reported ROA and ROE are 5.6% (30/535) and 20.0% (30/150) respectively. Under the new depreciation assumptions,
depreciation expense would be (140-14)/5 = 25.2 million. Under the original assumptions depreciation of the fleet was 20
million. Therefore depreciation increases by 5.2 million. With the change in depreciation methods EDI would have reported:
Depreciation $35.20 million (30 + 5.2)

expense
Net income $26.62 million (30 − (5.2 × (1-
0.35)))
Total assets $529.80 (535 − 5.2 )
million
Shareholder's $146.62 (150 − 3.38)

equity million
Note that assets would have been lower by $5.2 million due to the new depreciation assumptions and shareholder's equity by
$3.38 million (5.2 × (1 − 0.35)) due to lower retained earnings. Tax liabilities would have fallen by $1.82 million to balance the
$5.2 million reduction in assets. Therefore, ROA would have been 5.0% (26.62 / 529.80) and ROE would have been 18.16%
(26.62 / 146.62).
Consider the following statements:
Statement Compared to the cash basis of accounting, the accrual basis of accounting provides more
1: timely information about future cash flows.
Statement Compared to the cash basis of accounting, the accrual basis requires more use of
2: discretion than the cash basis.
Are these statements CORRECT?
ᅚ A) Yes.
ᅞ B) No, because it is actually the cash basis of accounting that provides more timely and
relevant information to users about future cash flows.
ᅞ C) No, because it is actually the cash basis of accounting that results in more difficulty in
properly assigning revenues and expenses to the appropriate periods.
Explanation
Users of financial information seek timely information about future cash flows. The accrual basis of accounting provides this
information at the earliest appearance of objective evidence. Thus, accrual accounting provides more timely and relevant
information to users. The cash basis is more concerned with recording cash flows for transactions that have already occurred.
Accrual accounting (not cash-based accounting) necessitates the use of discretion because of the many estimates and
judgments involved with assigning revenue and expense to the appropriate periods.
Junior analyst Xander Marshall sends an e-mail to his boss, Janet Jacobs, CFA, suggesting that Peterson Novelties is
manipulating its results to artificially inflate profits. He cites four reasons for his conclusion:
The LIFO reserve is declining.

Earnings are much higher in the September quarter than in other quarters.
Many nonoperating and nonrecurring gains are being recorded as revenue.
Much of Peterson's earnings come from equity investments not reflected on the cash-flow statement.
Jacobs is less concerned about Peterson's earnings than Marshall is, though she does resolve to check out one of his
concerns. Which of Marshall's observations best supports his conclusion?
ᅚ A) Equity investment earnings not reflected on the cash-flow statement.

ᅞ B) The declining LIFO reserve.
ᅞ C) Nonoperating and nonrecurring gains recorded as revenue.
Explanation
On its own, a declining LIFO reserve is not a sign of fraud. Peterson Novelties could have simply moved a lot of inventory and
disclosed the LIFO liquidation in its footnotes. When unusual gains are recorded as revenue they will artificially boost sales
growth. Each of the above issues are potential danger signs, but can also be easily explained in a manner beyond reproach.
However, earnings from equity investments that do not generate cash flow are of very low quality and warrant further
examination.
Complete the following sentence. The cash component of income is ___________ than the accrual component.
ᅞ A) the same persistence.

ᅚ B) more persistent.
ᅞ C) less persistent.
Explanation
The accrual component of income (accruals) is less persistent than the cash component. By persistent we mean the income is
sustainable; that is, a dollar of earnings today implies a dollar of earnings in future periods. Lower persistency is partially due
to the estimates involved with accrual accounting.
Endrun Company reported net income of $4.7 million in 1999, and $4.3 million in 2000. In reviewing the annual report an
analyst notices that the Endrun took a charge of $2.4 million in 1999 for the costs of relocating its main office, and in 2000
booked a gain of $900,000 on the sale of its previous office building. What would "normalized earnings" be for 1999 and 2000
if we assume a tax rate of 36% for both years?
ᅞ A) $7.1 million and $5.2 million.

ᅞ B) $3.99 million and $2.54 million.
ᅚ C) $6.236 million and $3.724 million.
Explanation
You will increase 1999 earnings by the tax-adjusted value of the 2.4 million one-time charge (2.4 × (1 - 0.36) = +1.536), and
you would decrease Y2000 earnings by the tax-adjusted amount of the $0.9 million one-time gain (0.9 × (1 - 0.36) = -0.576).
George Edwards is a senior analyst with The Edge Group, an independent equity research firm specializing in micro cap
companies that have recently had an initial public offering, or are likely to go public within the next three years. Over the
current market cycle, small company stocks have been the leading performers in the equity market, and micro cap money
managers have had huge cash inflows due to their funds' strong performance. With an excess amount of cash and few good
investment opportunities due to the high valuations in the marketplace, fund managers have turned to independent research
firms like The Edge Group to help them discover new investment ideas.
With a large number of mutual fund managers asking them for research reports, business at The Edge Group is booming. To
help handle the large amount of business, Edwards has hired two new junior analysts, Paul Kelley and Rachael Schmidt. Both
Kelley and Schmidt have degrees in finance, and came highly recommended to Edwards.
In Kelley and Schmidt's orientation meeting, Edwards told them that what has made The Edge Group successful in delivering
quality research to its clients is its willingness to dig into company financial statements and not take the accounting numbers at
face value. Every item in the financial statements should be scrutinized and adjusted if necessary. Edwards tells the new
analysts that if there is one lesson they should learn, it is that "there is a difference between accounting reality and economic
reality."
For their first assignment, Edwards has asked the new analysts to put together a draft of a research report on Landesign, an
architecture firm specializing in landscape design for municipalities, residential developments, and wealthy individuals. The
firm also sells various kinds of stone and plastic products which are used in landscaping applications. Edwards tells the new
analysts that he will help put together the report, but he would like them to do a majority of the legwork.
Since it was founded seven years ago, Landesign has grown at an annual rate exceeding 20%. Much of the growth comes
from Landesign's acquisitions of regional competitors. Edwards points out to the analysts that Landesign used purchase
method accounting. Kelley, looking to impress Edwards with his knowledge, tells him that when one company acquires
another, assets of both companies are restated to fair market value, and that higher depreciation can lead to lower quality
earnings. Not wanting to be outdone, Schmidt adds that liquidity measures such as the quick ratio and the cash ratio should
improve as Landesign makes acquisitions.
Kelley decides to review Landesign's 2004 financial statements and make notes about significant accounting practices being
used. His notes are shown in the exhibit below:
Exhibit 1: Kelley's Notes on Landesign's Accounting Practices

The firm uses First In, First Out (FIFO) accounting. As a side note, the current inflation rate has remained relatively
constant at an annual rate of 3%.
Equipment and office furniture are depreciated based on the 200% declining balance method.
Fixed assets (equipment) are generally assigned short useful life estimates.
The expected return on defined benefit pension plan assets is 2 to 3 percentage points below the long-term rate of
return for similar assets.
Landesign reports deferred taxes of $350,000 for 2004, compared with $300,000 and $280,000 in deferred taxes for
2003 and 2002, respectively.
Schmidt notices that the footnotes to Landesign's financial statements include a reference to an agreement to receive a
minimum amount of stone used to construct landscape walls from a supplier. Under the terms of the agreement, Landesign
will pay for the stone whether it is used in the current accounting period or not. The agreement allows Landesign to pay a price
that is significantly less than the current market price for similar quality stone.
A second footnote indicates that Landesign has an eight-year rental commitment for a greenhouse used to grow plants and
store mulch that Landesign uses in the landscaping process. On the financial statements, $55,000 in rent expense for the
greenhouse is listed on the income statement. The footnote also states that the $55,000 rental expense payment was agreed
upon with Fred's Nursery, the owner of the greenhouse, based upon an interest rate of 7%.
A third footnote indicates that Landesign has sold its accounts receivable to Dais Enterprises for 95% of their original value of
$130,000. The footnote indicates that Landesign retains the risk of noncollection of the receivables.
The final footnote on the page indicates that Landesign has a revolving line of credit at which it can borrow funds in the future
at an interest rate of 6%.
After going through the information, Kelley and Schmidt discuss their findings and start to work on their report for Edwards.
Which of the following items noted in Kelley's Notes on Landesign's Accounting Practices would least likely be considered
indicators of high earnings quality. Landesign's use of:
ᅞ A) the 200% declining balance method of depreciation on its furniture and

equipment.
ᅚ B) FIFO accounting in a mildly inflationary economy.
ᅞ C) short useful life estimates for fixed assets.
Explanation
High earnings quality is established by a clear and conservative approach to stating earnings. Even though inflation is
relatively mild, FIFO accounting will result in lower cost of goods sold (COGS), and higher net income. This is more aggressive
than the use of Last In, First Out (LIFO) method. Short useful lives for fixed assets, use of accelerated depreciation, and using
a conservative estimate for returns on pension assets will all tend to increase expenses and are examples of conservative
accounting practices.
Which of the following adjustments should Schmidt make to Landesign's financial statements to account for the greenhouse
that Landesign uses to grow plants and store mulch?
ᅚ A) Increase both liabilities and assets by $341,500.

ᅞ B) Increase both liabilities and assets by $328,400.
ᅞ C) Increase liabilities and decrease equity by $440,000.
Explanation
The rental agreement for the greenhouse is an operating lease and essentially represents off-balance sheet financing. To
adjust Landesign's balance sheet for the operating lease, Schmidt needs to capitalize the lease by increasing both liabilities
and assets by the present value of the lease payments. The interest rate used in the present value computation is the lower of
the firm's financing rate or the rate implicit in the lease. We are told that the rental payments of $55,000 are based on an
interest rate of 7%. However, we are told in another footnote that Landesign expects to be able to borrow funds in the future at
a rate of 6%. We therefore use the lower firm financing rate of 6% in our computation. The present value of the lease
payments is: N = 8; I/Y = 6%; PMT = -55,000; FV = 0; CPT PV = $341,539.
Samson Therapeutics records all leases as operating leases. Compared to recording capital leases, this results in lower:
ᅞ A) inventory.
ᅞ B) expenses.
ᅚ C) leverage.
Explanation
Finance (capital) leases are recorded on the balance sheet, and by recording all leases as operating leases, the company can
reduce its leverage. Lease accounting has no effect on inventory. "Expenses" is not the best answer as operating leases will
result in higher expenses in the later years relative to the finance (capital) lease.
Millennium Airlines Corp. (MAC) reported the following year-end data:
Rent expense $24 million
Depreciation expense $17 million
EBIT $88 million
Interest expense $22 million
Total assets $500 million
Long-term debt $150 million
Capital lease obligations $100 million
Total equity $250 million
MAC also reported that the present value of its operating leases at the beginning of the year was $128 million at 10% interest
rate. The term on the leases was 8 years. Ignoring taxes, what are the effects on the leverage (liabilities / total capital) and
times interest earned if an analyst chooses to capitalize the leases using a straight-line depreciation (zero salvage, life = lease
term) assumption? Leverage measures:
ᅞ A) increase to 65% from 50% and times interest earned decreases to 1.78 times
from 4 times.
ᅞ B) remain unchanged and times interest earned decreases to 1.78 times from 4 times.
ᅚ C) increase to 60% from 50% and times interest earned decreases to 2.76 times from 4
times.
Explanation
Using the reported data the leverage measure is 0.50 ((150 + 100) / (150 + 100 + 250)) and times interest earned is 4 times
(88 / 22). Following the capitalization of the operating leases the balance sheet values are:
Total assets $612 million (500 assets + 128 leases - 16 depreciation

on leases)
Value of operating leases $116.80 million(Ending Lease liability = 128 Beg lia + 12.8
Int - 24 Rent payment)
Long-term debt $150 million unchanged
Capital lease obligations $100 million unchanged
Total equity $245.2 million (250 + 24 rent payment − 16 dep − 12.8
interest)
Therefore, the leverage measure is 0.60 ((116.80 + 150 + 100) / (116.8 + 150 + 100 + 245.2)).
The income statement is affected in the following way:
reported EBIT 88
+ rent expense 24
= EBIT excluding cost of operating leases 112
- depreciation of operating leases 16 ($128 million/8 years)
= adjusted EBIT 96
Interest expense will increase by $12.8 million ($128 million × 0.10) to $34.8 million. Therefore times interest earned
decreases to 2.76 times (96 / 34.8). Recall that when capitalizing operating leases interest expense is calculated as the
present value of the lease obligations multiplied by implied interest rate.
Fero Inc. (Fero) is a successful computer consulting services firm that has an established policy of investing its excess cash in
short-term, virtually riskless, and highly liquid money market securities. However, it has recently deviated from this policy by
investing in commercial paper and medium-cap domestic equities. As well, Fero entered into a $1.0 million lease with
Pasquale Inc. (Pasquale) for some specialized computer equipment on December 28, 2008 that will be shipped at the very
start of its next fiscal period on January 1, 2009. In exchange for the lease, Fero agrees to provide consulting services to
Pasquale. Which of the following activities is one in which Fero is least likely involved?
ᅞ A) Misclassifying cash flow.

ᅞ B) Ignoring cash flow.
ᅚ C) Managing cash flow.
Explanation
Fero is ignoring cash flow, most likely misclassifying cash flow, but there is no evidence that Fero is managing cash flow. Firms
can misrepresent their cash generating ability by misclassifying investing activities as operating activities and vice versa. For
example, under U.S. GAAP, the cash flow statement reconciles the changes in cash and cash equivalents. Cash equivalents
include short-term, highly liquid investments. Some firms park cash in longer-term investments such as marketable debt and
equity securities. Typically, the acquisition and disposal cash flows from these longer-term investments are reported as
investing activities in the cash flow statement.
Noncash investing and financing activities are not reported in the cash flow statement since they do not result in an inflow or
outflow of cash. For example, a capital lease is both an investing and financing decision in that the transaction is the
equivalent of borrowing the purchase price. However, since no cash is involved, the transaction is not reported (it is ignored)
on the cash flow statement throughout the life of the lease.
Holding everything else constant, the existence of which of the following items will most likely result in direct cash inflows or
outflows for a firm in the future?
ᅞ A) Deferred expenses.
ᅞ B) Unearned revenue.
ᅚ C) Accrued expenses.
Explanation
Accrued expenses are expenses that have been incurred but not yet paid. For example, a firm may recognize wage expense
in one period but actually pay the wages in a later period. In this case, when the expense is recognized in the income
statement, a liability is increased on the balance sheet (i.e., wages payable). When the wages are paid, the liabilities decrease
as does the firm's cash (cash outflow occurs in the future).
Unearned (deferred) revenue occurs when payment is received in advance of providing goods or services. Unearned revenue
is reported as a liability on the balance sheet. Once the revenue is earned, the liability decreases. For example, a magazine
subscription is usually paid in advance. When received, the publisher increases its cash and records a liability for its obligation
to deliver (cash inflow occurs now). Once delivery occurs, revenue is recognized and the liability decreases.
Deferred expenses are costs that will benefit future periods. These costs usually involve noncurrent assets and prepaid
assets. For example, a tenant must usually pay his rent in advance. The result is a decrease in the tenant's cash and an
increase in a prepaid asset (cash outflow occurs now). Once the rent expires, expense is recognized and the asset decreases.
Hatfield Industries is a large manufacturing conglomerate based in the United States with annual sales in excess of $300
million. Its shares are traded on the New York Stock Exchange, and have a market capitalization of nearly $750 million.
Hatfield is currently under investigation by the Securities and Exchange Commission (SEC) for accounting irregularities and
possible legal violations in the presentation of the company's financial statements. A due diligence team from the SEC has
been sent to Hatfield's corporate headquarters in Philadelphia for a complete audit in order to further assess the situation.
Several unique circumstances at Hatfield are discovered by the SEC due diligence team during the course of the investigation:
Management has been involved in ongoing negotiations with the local labor union, of which approximately 40% of its full-
time labor force are members. Labor officials are seeking increased wages and pension benefits, both of which Hatfield's
management states is not possible at this time due to decreased profitability and a tight cash flow situation. Labor officials
have accused Hatfield's management of manipulating the company's financial statements in order to have a reason to not
grant any concessions during the course of negotiations.
All new equipment obtained over the past several years has been established on Hatfield's books as operating leases,
although past acquisitions of similar equipment was nearly always classified as capital leases. Financial statements of
industry peers indicate that capital leases for this type of equipment are the norm. The SEC wants Hatfield's management
to provide justification for this apparent deviation from "normal" accounting practices.
Inventory on Hatfield's books has been steadily increasing for the past few years in comparison to sales growth.
Management credits improved operating efficiencies in its production methods that have contributed to boosts in overall
production. The SEC is seeking evidence that Hatfield somehow may have manipulated its inventory accounts.
The SEC due diligence team is not necessarily searching for evidence of fraud, but possible manipulation of accounting
standards for the purpose of misleading shareholders and other interested parties. Initial review of Hatfield's financial
statements indicates that at a minimum, certain practices have resulted in low quality earnings.
Labor officials believe that the management of Hatfield is attempting to understate its net income in order to avoid making any
concessions in the labor negotiations. Which of the following actions is least likely to be employed by management in an
attempt to avoid making concessions to the union?
ᅞ A) Recognizing revenue at the time of delivery rather than when payment is

received.
ᅚ B) Lengthening the life of depreciable assets in order to lower the depreciation expense.
ᅞ C) Lowering the discount rate used in the valuation of the company's pension obligations.
Explanation
It is unlikely that management would lengthen the life of depreciable assets in order to extract concessions from the union, as
lengthening the depreciable life of an asset would boost earnings results. (Study Session 7, LOS 23.d)
Hatfield has begun recording all new equipment leases on its books as operating leases, a change from its consistent past use
of capital leases. What is the most likely motivation behind Hatfield's change in accounting methodology? Hatfield is attempting
to:
ᅚ A) improve its leverage ratios and reduce its perceived leverage.

ᅞ B) increase its operating margins relative to industry peers.
ᅞ C) reduce its cost of goods sold and increase it profitability.
Explanation
Off balance-sheet financing through the use of operating leases is acceptable when used appropriately. However, companies
can use them too aggressively in order to reduce their perceived leverage. A comparison among industry peers and their
practices may indicate improper use of accounting methods. (Study Session 7, LOS 23.d)
The SEC due diligence team is searching for the reason behind Hatfield's inventory build-up relative to its sales growth. One
way to identify a deliberate manipulation of financial results by Hatfield is to search for:
ᅞ A) receivables that are growing faster than sales.

ᅚ B) a decline in inventory turnover.
ᅞ C) a delay in the recognition of expenses.
Explanation
A warning sign of accounting manipulation is abnormal inventory growth as compared to sales growth. By overstating
inventory, the cost of goods sold is lower, leading to higher profitability. (Study Session 7, LOS 23.f)
Which of the following findings is most likely to be an indicator of potential revenue quality issues?
ᅚ A) Large increases in trade receivables.

ᅞ B) Reduction in volatility of the ratio of revenue to cash collection.
ᅞ C) Lessor use of the operating lease classification.
Explanation
Revenue quality issues may be indicated by large increases in accounts receivable or large decreases in unearned revenue,
an increase in the volatility of the ratio of revenue to cash collections, and by lessor use of capital leases (Study Session 7,
LOS 23.f)
The accruals ratio can most accurately be computed as the:
ᅞ A) change in net operating assets divided by 2.

ᅚ B) change in net operating assets divided by average net operating assets.
ᅞ C) cash flow from operating activities minus cash flow from investing activities.
Explanation
Accruals ratio can be computed as change in net operating assets divided by average net operating assets. (Study Session 7,
LOS 23.e)
Which of the following is least likely to be an indicator of improper accounting to boost operating performance?
ᅞ A) Classification of ordinary expenses as nonrecurring.

ᅞ B) Deferral of expenses by capitalizing.
ᅚ C) Decreases in core operating margin accompanied by spikes in negative special items.
Explanation
Classification of ordinary expenses as nonrecurring and deferral of expenses via capitalization would improve reported
operating margins as would increases in core operating margin accompanied by spikes in negative special items. (LOS 23.f)
An investor relations spokesperson for the Square Door Corporation was quoted as saying that Square Door shares were a
bargain, selling at a price-to-earnings (P/E) ratio of 12, relative to the S&P 500 average P/E of 15.3. The financial statements
reported net earnings of $126 million, or $4.00 per share. The notes to the financial statements included a statement that
income for the year included a $31.5 million (after-tax) gain from the reclassification of certain assets from its investment
portfolio to its trading portfolio. What would be the normalized P/E?
ᅞ A) 15.
ᅚ B) 16.
ᅞ C) 13.
Explanation
Since the P/E ratio was 12 and EPS was $4, the price of the stock was $48 (12 × 4). After removing the nonrecurring gain,
earnings will be $94.5 million (126 − 31.5). We know the number of shares is 31.5 million (126 Million ÷ 4). So the new EPS
number is 3 (94.5 million ÷ 31.5 million) and new P/E ratio is 16 (48 ÷ 3).
Complete the following sentence. When earnings are relatively free of accruals, mean reversion will occur __________.
ᅞ A) at the same rate as usual.

ᅞ B) relatively faster than usual.
ᅚ C) relatively slower than usual.
Explanation
Earnings consist of cash flow and accruals and there is an inverse relationship between accruals and cash flow. When
earnings are relatively free of accruals, mean reversion will occur at a slower rate. The opposite is true when earnings are
largely comprised of accruals.
Pysha Heavy Metals Ltd. supplies specialized metals to the chip fabrication industry. Selected financial data for Pysha, as well
as industry comparables, are shown below:
Pysha selected financial data (£ '000s):
20x7 20x8 20x9

Sales 1,169 1,312 1,414
Accounts receivable 58.45 72.16 98.98
Industry average:
20x7 20x8 20x9

DSO 22.6 22.8 22.4
Receivables turnover 16.2 16.0 16.3
Based on the trend in revenues and receivables, it can be most accurately concluded that:
ᅞ A) Pysha's revenues are growing at a faster rate than its receivables.

ᅚ B) Pysha's revenues are growing at a slower rate than its receivables
ᅞ C) The revenue growth rate divided by receivables growth rate is increasing over time.
Explanation
Pysha's revenue growth rate is lagging the receivables growth rate.
20x7 20x8 20x9

Revenue growth - 12.23% 7.77%
Receivable growth - 23.46% 37.17%
Ratio 52.15% 20.92%
Assume that inventory costs are increasing in line with an overall inflation rate of 3 percent. If a firm reports inventory using the
last in, first out (LIFO) method, which of the following is most accurate?
ᅚ A) Lower profits and lower taxes are reported because new inventory is flowing
out to COGS.
ᅞ B) The less expensive inventory is flowing out to COGS.

ᅞ C) LIFO reserve measures the accumulation of taxes paid.
Explanation
LIFO firm reports lower profits and lower taxes because all of the new, mores expensive inventory is flowing out to COGS thus,
LIFO reserve measures the accumulation of taxes not paid and profits not recognized.
Coastal Drilling Corp (CDC) reported the following year-end data:
EBIT $23
million
EBT $20
million
Effective tax rate 40

percent
CDC reported in the footnotes to its financial statements that it had increased the expected return on pension plan assets
assumption which resulted in an increase of EBIT of $2 million. Analyst Wanda Brunner, CFA, thinks this change in
assumptions is unfounded and removes the $2 million increase in EBIT. Which of the following is closest to the tax burden
ratio after adjustment?
ᅞ A) 55.6%.
ᅞ B) 61.9%.
ᅚ C) 60.0%.
Explanation
Tax burden = NI/EBT or 1 - the effective tax rate. The increase in the return on pension plan assets assumption increased
EBIT, EBT, Income Taxes, and Net Income from what it would have been. Removing $2 million from the reported numbers will
reduce EBIT, EBT, Income Taxes, and Net Income. However, the tax burden ratio will still be 1 - the effective tax rate.
Lucky Strike Mining Corp. (LSMC) reports in a footnote to the financial statements that it is party to a variable interest entity
(VIE) through which it leases heavy equipment. LSMC has chosen not to report a residual value guarantee of $120 million for
the equipment because it is not required to do so under accounting standards. However, the standards will change next year.
What is the appropriate analytical treatment of this residual value guarantee?
ᅞ A) Ignore the liability because current accounting standards do not require it to

be included on the balance sheet. Include it in next year's balance sheet
adjustments.
ᅞ B) Increase long-term liabilities by $120 million and decrease equity by $120 million.
ᅚ C) Increase long-term liabilities and long-term assets by $120 million.
Explanation
Increase long-term liabilities and long-term assets by $120 million.
Charger Corporation offers extended payment terms to its customers. In order to finance its accounts receivable, Charger is
considering two alternatives. The first alternative is to borrow against the receivables. The second alternative is to securitize
the receivables through a special purpose entity. Which alternative would result in lower operating cash flow and lower
financing cash flow?
Lower operating cash Lower financing cash

flow flow
ᅞ A) Securitize Securitize
ᅞ B) Securitize Borrow
ᅚ C) Borrow Securitize
Explanation
The cash received from borrowing would be reported as a financing inflow. The cash received from securitizing the
receivables would be reported as an operating inflow. So, borrowing would result in lower operating cash flow and higher
financing cash flow. Securitizing would result in lower financing cash flow and higher operating cash flow.
Wanda Brunner, CFA, is analyzing Straight Elements, Inc., (SE). SE is a discount manufacturer of parts and supplies for the
railroad industry. She has followed her firm's suggested financial analysis framework, and has assembled output from
processing data. When applying the financial analysis framework, which of the following is the best example of output from
processing data?
ᅞ A) Audited financial statements.

ᅚ B) Common-size financial statements.
ᅞ C) A written list of questions to be answered by the analysis.
Explanation
Common-size financial statements are created in the data processing step of the framework for financial analysis. Audited
financial statements would be obtained during the "collect input" phase of the financial analysis framework. Creating a written
list of questions to be answered by the analysis is part of the "define the purpose" phase of the financial analysis framework.
ABC Tie Company reports income for the year 2009 as $450,000. The notes to its financial statements state that the firm uses
the last in, first out (LIFO) convention to value its inventories, and that had it used first in, first out (FIFO) instead, inventories
would have been $62,000 greater for the year 2008 and $78,000 greater for the year 2009. If earnings were restated using
FIFO to determine the cost of goods sold (COGS), what would the net income be for the year 2009? Assume a tax rate of
36%. Net income would have been:
ᅞ A) $439,760.
ᅞ B) $455,760.
ᅚ C) $460,240.
Explanation
The reduction in COGS would result in an increase in net income (62,000 − 78,000) × (1 − 0.36).
The failure to recognize inventory obsolescence is an example of ___________.
ᅞ A) Misclassifying expenses.
ᅚ B) Understating expenses.
ᅞ C) Delaying expenses.
Explanation
Inventory must be tested for obsolescence using the lower-of-cost-or-market method. Obsolete inventory must be written
down (expensed) in the income statement which results in lower earnings. Thus, failure to recognize obsolescence
understates expenses and overstates earnings.
Delaying expenses involves deferring recognition to a future period. Delaying expense is the result of capitalizing a cost
instead of immediately recognizing the cost in the income statement. This is not the same as failing to recognize inventory
obsolescence.
Investors typically focus more on operating income than nonrecurring and non-operating income. Thus, firms may have an
incentive to increase operating income by misclassifying an operating expense as a nonrecurring or non-operating item.
Therefore, failure to recognize obsolescence is not an example of misclassification.
An analyst is analyzing TRK Construction (TRK) for possible recommendation to his firm's clients. He wants to use TRK's
financial statements to answer such questions as "Is TRK suitable for firm clients?", "Is TRK priced properly relative to peers?",
"What is TRK's earnings quality?" The analyst is most likely to begin with:
ᅞ A) a DuPont analysis.
ᅚ B) a review of his firm's framework for analysis of financial statements.
ᅞ C) analysts adjustments to the financial statements.
Explanation
Analysis of financial statements should be performed in the context of an overall framework for the analysis of financial
statements. Specific adjustments or analysis of specific ratios is a secondary concern.
Which of the following statements is CORRECT when inventory prices are falling?
ᅞ A) LIFO results in higher COGS, lower earnings, higher taxes, and higher cash
flows.
ᅚ B) LIFO results in lower COGS, higher earnings, higher taxes, and lower cash flows.
ᅞ C) LIFO results in lower COGS, lower earnings, lower taxes, and higher cash flows.
Explanation
Remember, prices are falling. Under LIFO, the most recent purchases flow to COGS. So, LIFO results in lower COGS, higher
earnings, higher taxes, and lower cash flows.
Samuel Maskin, CFA is evaluating the financial statements of Northern Energy Inc. The following is an extract from Northern's
cash flow statement for the past three years:
20x6 20x5 20x4

Net Income $1,023 $988 $744
Depreciation $187 $145 $128
Restructuring Charges $(108) $(104) $212
Accounts receivable $(172) $(145) $(33)
Inventories $(418) $(202) $(180)
Accounts Payable $38 $37 $33
OCF $550 $719 $904
Which of the following conclusions is least likely for Northern?
ᅞ A) Days sales outstanding is probably increasing.
ᅚ B) Northern is stretching payables.
ᅞ C) Northern may have accelerated revenue recognition.
Explanation
We are not provided with income statement data such as revenues and COGS and hence have to make inferences from the
information provided. Accounts payable seem to be stable and decreasing as a percentage of net income making the
conclusion of stretching payables least likely. Revenue acceleration can be concluded based on large increase in inventory in
20x6 (possibly reflecting returns from customers) combined with increases in accounts receivable over time. Increases in
accounts receivable (relative to earnings) also would indicate that days sales outstanding would most likely be increasing.
A firm has reported net income of $136 million, but the notes to financial statements includes a statement that the results
"include a $27 million charge for non-insured earthquake damage" and a "gain on the sale of certain assets during
restructuring of $16 million." If we assume that both of these items are given on a pre-tax basis and the effective tax rate is
36%, what would be the "normal income"?
ᅚ B) $143.04 million.
ᅞ C) $94.08 million.
Explanation
To normalize earnings you would increase it by the non-recurring charge of $27 million and decrease it by the non-recurring
gain, both tax adjusted.
$136 + (27 - 16)(1 - 0.36) = $143.04.
Adjustments for off-balance-sheet items include all but which of the following?
ᅚ A) Using the equity method in place of the proportionate consolidation to reflect the
investment in affiliates.
ᅞ B) Capitalizing operating leases, including this amount as an asset and a liability.
ᅞ C) Estimating the probable obligation for contingent liabilities.
Explanation
The correct statement is that proportionate consolidation should be used in place of the equity method.

In measuring earnings quality, which of the following statements is most appropriate?
ᅞ A) Accruals can be measured as net income less cash flows from operations
(CFO) less cash flows from financing (CFF).
ᅞ B) The higher the accruals ratio, the higher the earnings quality.
ᅚ C) Accruals can be measured as the change in net operating assets (NOA) over a period
of time.
Explanation
Using the balance sheet, we can measure accruals as the change in net operating assets (NOA) over a period of time. NOA is
the difference in operating assets and operating liabilities. Operating assets are equal to total assets minus cash, equivalents
to cash, and marketable securities. Operating liabilities are equal to total liabilities minus total debt (both short-term and long-
term). In summary, the formula for balance sheet based aggregate accruals is:
AccrualsBS = NOAEND − NOABEG
We can also derive the aggregate accruals by subtracting cash flow from operating activities (CFO) and cash flow from
investing activities (CFI) from reported earnings as follows:
AccrualsCF = NI − CFO − CFI
The lower the accruals ratio, the higher the earnings quality.
Which of the following choices is most likely a biased accounting choice to overstate profitability?
ᅚ A) Lessor use of finance lease classification.

ᅞ B) Classifying non-operating expenses as operating.
ᅞ C) Channeling gains through OCI and losses through income statement.
Explanation
Lessor use of finance lease classification results in Lessor recognizing the gross profit at inception of the lease and is a
mechanism to overstate profitability. Classifying non-operating expenses as operating and channeling gains through OCI and
losses through income statement would understate profitability.
Frank Brill, CFA, is concerned that Moses Aviation is overstating its profits. The best indicator of such action would be Moses
Aviation's:
ᅚ A) recognition of revenue from barter transactions.

ᅞ B) sales-growth rate of nearly twice the industry average.
ᅞ C) rising inventory.
Explanation
While an unusually high sales-growth rate may indicate fraud, it could also indicate good management. It's a yellow flag, but
not the best indicator of accounting shenanigans. Rising inventory is also a dual signal. It could be meant to overstate profits,
or it could simply reflect an actual buildup of inventory in response to market forces or corporate operations. However,
companies should not recognize revenue from barter transactions. The additional revenue is likely to improperly boost profits.
Complete the following sentence. An analyst would apply _________ to the cash component of income compared to the
accrual component when evaluating company performance.
ᅞ A) the same weighting.

ᅚ B) a higher weighting.
ᅞ C) a lower weighting.
Explanation
Since the cash component has more sustainability in the future than the accrual component, an analyst would apply a higher
weighting to the cash component of income than the accrual component when evaluating company performance.
Mean reversion in earnings means that:
ᅞ A) Extreme high earnings will revert to the mean but extreme low earnings will not.
ᅞ B) Extreme low earnings will revert to the mean but extreme high earnings will not.
ᅚ C) Extreme high as well as low levels of earnings will revert to the mean.
Explanation
Mean reversion in earnings means that extreme high or low earnings are not sustainable and will mean revert.
Classification of non-operating income as operating would lead to stated earnings that are likely to be:
ᅞ A) non-compliant with GAAP.

ᅚ B) compliant with GAAP but not sustainable.
ᅞ C) compliant with GAAP and sustainable.
Explanation
Non-operating income is less likely to recur and hence the earnings that include such misclassified non-operating income
would be considered non-sustainable. The misclassification need not always be GAAP non-compliant.
Which one of the following choices is least likely to be an indicator of poor-quality earnings?
ᅚ A) Reported earnings handily beat analyst estimates.

ᅞ B) An investigation by the market regulatory authority is initiated.
ᅞ C) Restatement of previously issued financial statements.
Explanation
Enforcement actions by regulatory authorities and restatements of previously issued financial statements are two (external)
indicators of poor-quality earnings. Earnings that meet or narrowly beat analyst estimates are considered to be suspect for
poor quality. Handily beating analyst estimates is not considered to be an indicator of poor-quality earnings.
Northern Bottling (NB) currently shows minimum expected operating lease payments over the next 5 years of $3 million, $2.5
million, $2 million, $2 million, and $1.5 million. The firm's footnotes show a present value of future capital lease payments of
$10.55m discounted at a rate of 6.75%. What adjustments would an analyst make to modify the balance sheet of NB to include
this off-balance sheet financing? Increase long-term:
ᅚ A) assets and long-term liabilities by $9.27 million.

ᅞ B) liabilities by $9.27 million and decrease equity by $9.27 million.
ᅞ C) assets and long-term liabilities by $9.22 million.
Explanation
The operating lease should be capitalized at the rate used to calculate the PV of futurecapital lease payments in the
footnotes. Therefore, the PV (operating leases) is:
= 3 / (1 + 0.0675) + 2.5 / (1 + 0.0675)2 + 2 / (1+ 0.0675)3 + 2 / (1 + 0.0675)4 + 1.5 / (1 + 0.0675)5

= 9.27 million
The proper adjustment is to increase both long-term assets and liabilities by the same amount.
Asma Pharma has made several strategic investments in other pharmaceutical companies. In each instance, Asma has kept
its stake just below 50% so it can account for the investment using the equity method of consolidation.
Asma's balance sheet quality can be most accurately characterized as:
ᅚ A) Low-quality due to lack of completeness.
ᅞ B) Low-quality due to bias in measurement.

ᅞ C) High-quality due to compliance with local GAAP.
Explanation
One-line consolidation under the equity method obscures the components of balance sheet and artificially boosts certain
profitability ratios (e.g., return on assets or profit margin). This reduces the completeness and quality of the firm's balance
sheet. Compliance with GAAP is a necessary but not sufficient condition for evaluating quality of financial statements. Equity
method of accounting does not by itself lead to measurement bias.
High-quality cash flow is least likely to be characterized by:
ᅞ A) Volatility of operating cash flow being lower than that of the firm's peers.
ᅞ B) No significant differences between operating cash flow and reported earnings.
ᅚ C) Financing cash flows sufficient to cover capital expenditures, dividends and debt
repayments.
Explanation
High-quality cash flow is characterized by positive OCF that is derived from sustainable sources and is adequate to cover
capital expenditures, dividends, and debt repayments. Furthermore, high-quality OCF is characterized by lower volatility than
that of the firm's peers. Significant differences between OCF and earnings, or differences that widen over time, can be an
indicator of earnings manipulation.
Brent Jones, CFA is analyzing the financial statements of Imperial Resorts Inc. Jones wants to use the Beneish model to
evaluate the probability of earnings manipulation.
Jones makes the following statements:
1. Depreciation index of less than 1 would indicate that the company is depreciating assets at a higher rate than its peers.
2. Increases in Asset quality index indicate that the revenue recognition policies are conservative.
Regarding the statements by Jones:
ᅞ A) Only statement 1 is correct.

ᅚ B) None of the statements is correct.
ᅞ C) Only statement 2 is correct.
Explanation
Statement 1 is incorrect. Depreciation index less than 1 indicates that the company is depreciating assets at a higher rate than
in prior years (and not relative to its peers). Statement 2 is incorrect. Asset quality index is used as an indicator of excessive
capitalization of expenses.
Which of the following statements regarding adjustments an analyst may make before analyzing a set of financial statements
is least accurate?
ᅞ A) Income statement items that may require adjustment include accounting

changes, one-time charges and restructuring charges.
ᅚ B) The income statement should be adjusted to reflect the liability for purchases
committed to under a take-or-pay contract.
ᅞ C) Cash flow from operations may be affected by the exclusion of off-balance sheet
obligations.
Explanation
The liability for goods under take or pay contracts would be shown on the balance sheet (not income statement). Off-balance
sheet obligations such as operating lease would affect Cash flow from operations (as opposed to treatment under capital
lease).
Pysha Heavy Metals Ltd. supplies specialized metals to the chip fabrication industry. Selected financial data for Pysha, as well
as industry comparables, are shown below:
Pysha selected financial data (£ '000s):
20x7 20x8 20x9

Sales 1,169 1,312 1,414
Accounts receivable 58.45 72.16 98.98
Industry average:
20x7 20x8 20x9

DSO 22.6 22.8 22.4
Receivables turnover 16.2 16.0 16.3
Relative to industry average, for 20x9, Pysha's DSO and Receivables turnover are most likely:
DSO Receivables turnover
ᅞ A) Higher higher
ᅞ B) Lower higher
ᅚ C) Higher lower
Explanation
Pysha's DSO and receivables turnover is calculated as follows:
DSO 18.25 20.08 25.55

receviables turnover 20.00 18.18 14.29
For 20x9, industry DSO and receivables turnover are given as 22.4 and 16.3 respectively. Hence Pysha's DSO is higher and
receivable turnover is lower than industry average.
In the context of the Beneish model to evaluate the probability of earnings manipulation, an increase in Days Sales Receivable
Index is least likely to signify:
ᅞ A) an increase in M-score.
ᅚ B) a decrease in probability of earnings manipulation.
ᅞ C) revenue inflation.
Explanation
An increase in Days Sales Receivable Index indicates revenue inflation and increases the M-score, thereby increasing the
probability of earnings manipulation.
Pritesh Deshmukh, CFA is analyzing the financial statements of Baza Restaurants Inc. Deshmukh wants to use the Beneish
model to evaluate the probability of earnings manipulation.
Deshmukh makes the following statements:
1. Depreciation index of less than 1 would indicate that the company is depreciating assets at a lower rate than in prior years.
2. Sales growth index of more than 1 indicates revenue inflation.
Which of the statements by Deshmukh are most accurate?
ᅞ A) Statement 1 only.
ᅚ B) None of the statements is accurate.
ᅞ C) Statement 2 only.
Explanation
Statement 1 is incorrect. Depreciation index of less than 1 indicates that the company is depreciating assets at a higher rate
than in prior years. Statement 2 is incorrect. Sales growth index of more than 1 simply implies that the growth in sales is
positive. While not a measure of manipulation by itself, growth companies tend to find themselves under pressure to
manipulate earnings to meet ongoing expectations.
A manufacturing firm purchases equipment for use in its operations. With regard to recording the purchase using the cash
basis versus the accrual basis of accounting, which of the following statements is most appropriate?
ᅞ A) With the accrual basis, the cost of the equipment is allocated to the cash flow
statements over the asset's life.
ᅚ B) With the cash basis, revenues and expenses relating to the equipment are generally
recognized in different periods.
ᅞ C) With the cash basis, revenues and expenses relating to the equipment are generally
recognized in the same period.
Explanation
With the cash basis of accounting, revenues are recognized when cash is collected and expenses are recognized when cash
is paid. Therefore, the cash flows may occur in different periods than when the revenues are actually earned or when the
expenses are actually incurred. For example, the purchase of equipment used in a firm's manufacturing operation may result
in an immediate cash outflow but the equipment generates revenues over its useful life. In this case, the revenues and
expense are reported in different periods.
With the accrual basis of accounting, revenues are recognized when earned and expenses are recognized when incurred,
regardless of the timing of the cash flows. With the equipment purchase, the cost of the equipment will be allocated to the
income statement (not cash flow statement) over the asset's life and at the same time, matched with the revenues generated.
Which of the following items is least likely to involve the use of subjective measurement estimates by management?
ᅚ A) Use of criteria to determine treatment as an extraordinary item.

ᅞ B) Use of straight-line depreciation method to depreciate tangible assets.
ᅞ C) Use of FIFO (first in-first out) to cost inventories.
Explanation
The use of criteria to determine treatment as an extraordinary item (i.e. Is the item within management's discretion? Is the
event likely to recur in the foreseeable future?) does not involve numerical and subjective estimates per se. It is more a test of
qualitative factors to determine the proper classification. Contrast this to FIFO, which is clearly a numerical estimate since an
alternative of using LIFO (last in-first out) is possible and this will result in a different reported amount than FIFO. The same
argument can be made for the use of the straight-line method since an alternative of using the declining-balance method is
possible to depreciate tangible assets.
MKF Consolidated reports $500 million in goodwill on its balance sheet. The market consensus indicates that the value of
MKF's intangible assets is $300 million. How should an analyst adjust MKF's balance sheet? Reduce goodwill and:
ᅞ A) equity by $500 million while increasing liabilities by $300 million.

ᅚ B) equity by $200 million.
ᅞ C) increase liabilities by $200 million.
Explanation
If goodwill has no economic value apart from the firm, it should be eliminated from the balance sheet. If the value of the
intangibles can be reliably estimated they can be substituted for accounting goodwill.
Which of the following is least likely an indicator of biased measurement in assessing balance sheet quality?
ᅞ A) Understatement of inventory impairment charges.
ᅞ B) Understatement of valuation allowance for deferred tax assets.
ᅚ C) Presence of substantial goodwill on balance sheet.
Explanation
Presence of substantial goodwill does not inherently make it biased measurement. Only if the value of goodwill is unjustified
(based on market values of the investments), would the measurement be considered biased. Understatement of inventory
impairment charges overstates value of inventory. Similarly understatement of valuation allowance for deferred tax assets
overstates the value of deferred tax assets.
Alex Fisher, CFA, is examining the phenomenon of mean reversion on the earnings of several firms. Which of the following
statements regarding mean reversion is least accurate?
ᅞ A) High earnings should not be expected to continue indefinitely.

ᅚ B) Normal earnings should not be expected to continue indefinitely.
ᅞ C) Low earnings should not be expected to continue indefinitely.
Explanation
When examining net income, analysts should be aware that earnings at extreme levels tend to revert back to normal levels
over time. This phenomenon is known as mean reversion. As a result of mean reversion, analysts must understand that
extreme earnings (high or low) should not be expected to continue indefinitely.
Andre Bursh, is analyzing large retailers and has collected the following information on three companies based on the most
recent financial statements:
Allied StoresBeta MartCash-N-Carry

Total Earnings
$2.80 $1.33 $0.75
(per share)
Cash element $1.90 $0.78 $0.25
Accrual
$0.90 $0.55 $0.50
element
Bursh notes that all three companies have reported stellar earnings this past year. Bursh is concerned about sustainability of
such high earnings. Which company's earnings will revert to its mean fastest?
ᅞ A) Beta Mart.
ᅚ B) Cash-N-Carry.
ᅞ C) Allied Stores.
Explanation
Cash-N-Carry's earnings is comprised of large proportion of accruals (0.50/0.75 or 67%). Allied's accruals comprise
(0.90/1.90) 47% of earnings and Beta's accruals comprise 41% of earnings.
Marcel Schulte is analyzing various retailing firms. Which of the following items is least indicative of a potential problem with
revenue recognition and earnings quality?
ᅞ A) Use of barter transactions.

ᅚ B) Disproportionate revenues in the last quarter of the calendar year.
ᅞ C) Implementing a "bill and hold" arrangement.
Explanation
Disproportionate revenues in the last quarter may be an indication of aggressive revenue recognition to meet analyst forecasts
but it is much more likely if the firm is a non-seasonal one. A retailing firm presumably has a disproportionate amount of sales
during the busy Christmas season in the last quarter of the calendar year so this point alone would not be indicative of a
potential problem.
In a barter transaction, two parties exchange goods or services. The main issue is whether: (a) a sale transaction has actually
occurred in substance; (b) it is not a "sham" transaction; and (c) the transaction amount is overstated.
Bill and hold occurs when the retailer (seller) invoices the customer but does not ship the goods until a later date. Alternatively,
the seller may ship the goods to a location other than the customer's. In either case, the seller may be recognizing revenue
prematurely.
Classification shifting is least likely to result in a higher:
ᅞ A) firm value derived when cash flow forecasts are based on core earnings.
ᅞ B) equity value derived when earnings forecasts are based on operating earnings.
ᅚ C) reported net income.
Explanation
Classification shifting results in inflation of core or recurring earnings while keeping the total reported income same. This is
used to mislead analysts into using a higher number as a basis for generating forecasts of future earnings and cash flows.
Such erroneous forecasts would then result in inflated equity and firm valuation.
Charles Nicholls, chief investment officer of Gertmann Money Management, is reviewing the year-end financial statements of
Zartner Canneries. In those statements he sees a sharp increase in inventories well above the sales-growth rate, and an
increase in the discount rate for its pension liabilities. To determine whether or not Zartner Canneries is cooking the books,
what should Nicholls do?
ᅞ A) Check Zartner's cash-flow statement and review its footnotes.

ᅞ B) Analyze trends in Zartner's receivables and consider the changing characteristics of
its work force.
ᅚ C) Calculate Zartner's turnover ratios and review the footnotes of its competitors.
Explanation
To assess the meaning of the inventory increase, look for declines in industry turnover. And if Zartner changes its pension
assumptions, Nicholls should see how those new assumptions compare to those found in the footnotes of financial statements
from other companies in the same industry.
An analyst is developing a framework for financial statement analysis for his firm. This framework is most likely to include:
ᅞ A) Determine the allocation of firm fees, interpret processed data, and

communicate conclusions.
ᅞ B) Maintain integrity of capital markets, perform duties to clients and employers, and
avoid conflicts of interest.
ᅚ C) Define the purpose of the analysis, process input data, and follow up.
Explanation
Proper analysis framework should include:
1. Define the purpose of the analysis.

2. Collect input data.
3. Process input data.
4. Interpret processed data.
5. Develop and communicate conclusions.
6. Follow up.
What does the LIFO reserve measure?
ᅚ A) The accumulated difference between the reported inventory balance and the
cost of that inventory if first in, first out (FIFO) had been used.
ᅞ B) The overstatement relative to the current cost of inventory.

ᅞ C) The results of older inventory flowing to cost of goods sold (COGS).
Explanation
The LIFO reserve measures the accumulated difference between the reported inventory balance and the cost of that inventory
if FIFO had been used.

An analyst is analyzing a discount manufacturer of parts and supplies. She has followed her firm's suggested financial analysis
framework and has communicated with company suppliers, customers, and competitors. This is an input that occurs while:
ᅞ A) processing data.
ᅚ B) collecting data.
ᅞ C) establishing the objective of the analysis.
Explanation
Communication with management, suppliers, customers, and competitors is an input during the data collection step.
Processing data is the third phase of the financial analysis framework. Establishing the objective of the analysis is part of the
"define the purpose" phase of the financial analysis framework.
Errors that affect multiple financial statement elements are most likely to arise from:
ᅞ A) compound issues.
ᅞ B) classification issues.
ᅚ C) measurement and timing issues.
Explanation
Measurement and timing issues typically affect multiple financial statement elements while classification issues typically affects
categorization of a specific element in a financial statement.
Which of the following measures is least affected by the use of estimates in the financial statement preparation process?
ᅞ A) Net income.
ᅚ B) Cash flow.
ᅞ C) Net equity.
Explanation
Net income is easily manipulated because of accrual accounting and the many estimates involved. On the other hand, cash
flow is unaffected by estimates. However, firms can still manipulate the cash flow statement by misclassifying cash flows,
ignoring cash flows, and managing cash flows.
As a result of its relationship to the income statement, net equity (which is generally an accumulation of earnings and losses
less dividend payments to shareholders) is directly affected by the estimates used to determine the level of earnings.
High results quality is most likely demonstrated by:

ᅞ A) GAAP compliant financial reports that are decision useful.
ᅚ B) an adequate level of return that is sustainable.
ᅞ C) high level of earnings determined conservatively.
Explanation
High results quality occurs if the level of earnings provides an adequate level of return and that the earnings are sustainable.
Sustainable earnings are most likely to be driven by:
ᅞ A) Accruals element of earnings.

ᅞ B) Conservative revenue recognition practices.
ᅚ C) Cash flow element of earnings.
Explanation
Sustainable and persistent earnings are driven by cash flow element of earnings. The stability and accuracy of earnings
forecasts can be reduced by estimation process that generates the accruals component of earnings. Conservative and
aggressive revenue recognition practices both would result in reversion in earnings (and hence lowers the sustainability of
earnings).
The least valuable source of information about a businesses' risk is:
ᅞ A) Notes to financial statements.

ᅞ B) Management discussion and analysis section of the annual report.
ᅚ C) Auditor's report.
Explanation
Because an audit report provides only historical information, such a report's usefulness as an information source is limited.
Companies are required to make certain risk related disclosures in the notes to financial statements. Both GAAP and IFRS
require companies to disclose risks related to pension benefits, contingent obligations and financial instruments. Ideally,
companies should include principal risks that are unique to the business (as opposed to risks faced by most businesses) in
their MD&A.
Which of the following is least likely an indicator of biased measurement in assessing balance sheet quality?
ᅞ A) Understatement of impairment charges for property, plan and equipment.

ᅚ B) Company's investment in debt securities of other companies, carried on the books at
market value.
ᅞ C) Overly high assumed discount rate for pension obligations.
Explanation
Carrying investments in debt (or equity) securities at market value enhances balance sheet quality and does not introduce a
bias in the estimate. Understatement of impairment charges on PP&E overstates value of PP&E. High discount rate reduces
the value of PBO and hence improves the funded position reflected on the balance sheet.

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Inventories: Implications for Financial Statements and Ratios

Test ID: 7440393

Question #1 of 111 Question ID: 461995

ᅞ A) higher inventory balances and lower working capital.

Question #2 of 111 Question ID: 462031

FIFO Inventory = $0.6 + 0.2 = $0.8 million.

Question #3 of 111 Question ID: 461977

beginning inv. + purchases - COGS = ending inv.

200 + purchases - 300 = 800

Question #4 of 111 Question ID: 467386

Units Unit Price

FIFO COGS = (709 units)($2/unit) + (959 − 709)($6/unit) = $1,418 + $1,500 = $2,918

Sales = (959 units)($13/unit) = $12,467

Gross profit = Sales − COGS

= 12,467 − 2,918 = $9,549

LIFO COGS = (556 units)($6/unit) + (959 − 556)($2/unit) = $3,336 + $806 = $4,142

Sales = (959 units)($13/unit) = $12,467

Gross profit = Sales − COGS

= 12,467 − 4,142 = $8,325

Question #5 of 111 Question ID: 462062

ᅞ A) Increase in finished goods inventory and corresponding decline in raw-

Question #6 of 111 Question ID: 461992

An analyst acquires the following information regarding a company:

Units Unit Price

Beginning Inventory 559 $1.00

EBT = Sales − (COGS + SGA)

COGS = Beginning inventory + Purchases − Ending inventory

COGS = $559 + $3,925 − $1,654.81 = $2,829.19

EBT = 12,720 − (2,829.19 + 3,191) = $6,699.81.

Question #7 of 111 Question ID: 461985

COGS = 500 @ $5 = $2,500

Question #8 of 111 Question ID: 462023

LIFO Reserve at Jan. 1 400,000 Total Liabilities & Equity $13,000,000

LIFO Reserve at Dec. 31 600,000

ᅞ A) decrease from 20.0 to 18.3%.

Question #9 of 111 Question ID: 461997

Question #10 of 111 Question ID: 462004

In case of a decline in LIFO reserve, to obtain a better analysis an analyst should:

Questions #11-16 of 111

Question #11 of 111 Question ID: 462056

INVF = INVL + LIFO reserve

Question #12 of 111 Question ID: 462057

COGSF = COGSL − (LIFO reserveE − LIFO reserveB)

= $70,000 − ($86,000 − $90,000)

Question #13 of 111 Question ID: 462058

NI(F) = NI(L) + (LIFO reserveE − LIFO reserveB)(1 − T)

= $12,000 + ($86,000 − $90,000)(0.69)

Question #14 of 111 Question ID: 479057

Question #15 of 111 Question ID: 462060

Question #16 of 111 Question ID: 462061

Question #17 of 111 Question ID: 414467

ᅞ A) higher under the average cost than LIFO or FIFO.

Question #18 of 111 Question ID: 462044

COGS Cash Flows

FIFO inventory (20X8) = LIFO inventory (20X8) + LIFO reserve (20X8)

$400 + $70 = $470

Question #20 of 111 Question ID: 462001

Actual (I made these numbers up):

Questions #21-26 of 111

Question #21 of 111 Question ID: 462036

ᅞ A) Both Alpha and Beta.

Question #22 of 111 Question ID: 462037

Question #23 of 111 Question ID: 462038

Question #24 of 111 Question ID: 462039