Question #1 of 28 Question ID: 1586145

An analyst finds return-on-equity (ROE) (based on beginning of the year equity) 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?

A) 18.4 and 14.3.

B) 16.0 and 18.0.
C) 17.1 and 16.9.

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

(Module 13.5, LOS 13.e)

Question #2 of 28 Question ID: 1586143

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"?

A) $143.04 million.
B) $147.00 million.
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.

(Module 13.5, LOS 13.e)

Question #3 of 28 Question ID: 1472660

A firm seeking to lower current tax liability may elect to use which method of inventory
valuation during an inflationary period?

A) LIFO.
B) FIFO.
C) Average cost.

Explanation

During an 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.

(Module 13.2, LOS 13.b)

Question #4 of 28 Question ID: 1472655

An analyst is developing a framework for financial statement analysis for his firm. The
primary goal of financial statement analysis is to:

A) justify trading decisions for purposes of the Statement of Code and Standards.
B) document portfolio changes for purposes of the Prudent Investor Rule.
C) facilitate an economic decision.

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.

(Module 13.1, LOS 13.a)

Question #5 of 28 Question ID: 1472658

Express Delivery Inc. (EDI) reported the following year-end data:

Depreciation expense $30 million

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:

A) ROA 5.0% and ROE 18.2%.

B) ROA 5.7% and ROE 19.5%.
C) ROA 5.3% and ROE 20.5%.

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 expense $35.20 million (30 + 5.2)

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

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).

(Module 13.2, LOS 13.b)

Question #6 of 28 Question ID: 1586141

Which of the following statements is CORRECT when inventory prices are falling?

LIFO results in higher COGS, lower earnings, higher taxes, and higher cash
A)
flows.
B) LIFO results in lower COGS, higher earnings, higher taxes, and lower cash flows.
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.

(Module 13.5, LOS 13.e)

SnapPrints and NetPhoto Case Scenario

Josephine Howard, CFA, is an equity analyst for an investment bank. She is preparing
financial reports for two publicly traded digital photography companies, SnapPrints and Net
Photo. Howard just attended a CFA Institute-sponsored conference on detecting quality
issues in financial statements and is eager to apply what she has learned.

SnapPrints provides photo prints and various other photo-related products, including
calendars, T-shirts, and coffee mugs. NetPhoto is SnapPrints' largest competitor. NetPhoto
has been receiving increasing attention from the analyst community due to its high sales
growth rate, although NetPhoto's sales are still less than 50% of SnapPrints' sales.

During the conference, Howard learned about the importance of analyzing accruals to
evaluate earnings quality. Therefore, Howard is going to analyze the accruals for each
company as part of her review. Howard remembers a discussion from the conference about
disaggregating income into its major components to improve earnings forecasts, but she
cannot remember which component (cash or accruals) should receive a higher weighting in
the forecast.

Howard gathered the following data from the income statement and statement of cash flows
for SnapPrints.

Selected SnapPrints Income Statement Items (000s) Year

Ended December 31, 2009

Sales 45,000

Cost of Good Sold (30,000)

Depreciation Expense (3,000)

SG&A Expense (2,000)

Interest Expense (1,500)

Income Tax Expense (3,000)

Net Income 5,500

Cash Flows for SnapPrints (000s) Year Ended December 31,

2009

Cash from Operations 6,500

Cash from Investing (3,500)

Cash from Financing (1,200)

Change in Cash 1,800

Howard collected the following balance sheet data for NetPhoto.

Selected Balance Sheet items for NetPhoto as of December 31, in $Ms

2009 2008 2009 2008

Cash 5,500 4,500 Accounts Payable 4,500 4,300

Accounts Short-term Notes

6,500 5,500 5,800 6,500
Receivable Payable

Inventory 11,500 14,000 Long-Term Debt 28,500 29,750

Fixed Assets, Net 35,000 34,300 Total Liabilities 38,800 40,550

Common Stock 15,000 12,800

Retained Earnings 4,700 4,950

Total Liabilities and

Total Assets 58,500 58,300 58,500 58,300
Equity

Howard has concerns about revenue recognition practices at both firms and has collected
the following data.

2009 2008 2007 2006

SnapPrints

Revenue 45,000 44,000 44,400 38,500

 Cash Collections 43,000 45,000 44,000 37,000

NetPhoto

Revenue 22,000 15,000 11,500 7,500

Cash Collections 11,000 12,000 8,500 7,000

Question #7 - 11 of 28 Question ID: 1586148

The aggregate accruals (in $M's) for SnapPrints and the accrual ratio for NetPhoto are
closest to:

A) 3,700 and −0.51%.

B) 2,500 and −2.04%.
C) −4,500 and −1.49%.

Explanation
Aggregate accruals using the cash flow method are calculated as net income minus cash
flow from operation minus cash flow from investing activities. For SnapPrints we have:

accrualsCF = NI − CFO − CFI

accrualsCF = 5,500 − 6,500 − (−3,500) = 2,500

In order to calculate the accrual ratio for NetPhoto, the first step is to compute the net
operating assets. Net operating assets are equal to operating assets minus operating
liabilities, where operating assets are total assets minus cash, cash equivalents, and
marketable securities, and operating liabilities are total liabilities minus total debt.

2009 2008
Total Assets 58,500 58,300
Cash −5,500 −4,500
Operating Assets 53,000 53,800

Total Liabilities 38,800 40,550

Short-term Notes Payable −5,800 −6,500
Long-Term Debt −28,500 −29,750
Operating Liabilities 4,500 4,300

Net Operating Assets 48,500 49,500

The accruals ratio for NetPhoto using the balance sheet approach is:
END BEG
(NOA − NOA )
BS
accruals ratio =
END BEG
(NOA + NOA )/2

(48,500 − 49,500)
BS
accruals ratio = = −2.04%
(48,500 + 49,500)/2

(Module 13.5, LOS 13.e)

Question #8 - 11 of 28 Question ID: 1586149

Compared to aggregate accruals, the accrual ratio is especially useful when:

A) comparing across companies.

B) comparing year-over-year accruals.
C) the cash component is large.

Explanation
The accrual ratio presents accruals for the period as a proportion of average net operating
assets. This ratio is especially useful for comparing accruals across companies.

(Module 13.5, LOS 13.e)

Question #9 - 11 of 28 Question ID: 1586150

Based on her calculations of accruals, Howard believes that NetPhoto has a higher accruals
ratio over the recent past compared with SnapPrints. If both companies have recently had
extreme earnings, Howard would most likely conclude that:

A) NetPhoto’s income will revert to its mean more quickly than SnapPrints’.
B) SnapPrints’ income will revert to its mean more quickly than NetPhoto’s.
C) SnapPrints’ income will revert to its mean, but NetPhoto’s income will not.

Explanation

Analysts should be aware that extreme earnings levels will not persist and that earnings
will typically revert to normal levels over time. Additionally, the larger the accruals
component of earnings relative to the cash component, the more rapidly earnings will
revert to their mean. All else equal, if NetPhoto has a higher accruals ratio than
SnapPrints, NetPhoto's earnings should revert to the mean more rapidly.

(Module 13.5, LOS 13.e)

Question #10 - 11 of 28 Question ID: 1586151

Based on the revenue and cash collections data for SnapPrints and NetPhoto, Howard would
most likely conclude that:

A) NetPhoto is accelerating revenue.

B) SnapPrints is misclassifying nonrecurring and nonoperating revenue.
C) SnapPrints is accelerating revenue.

Explanation
Typically, the ratio of revenue to cash collections is relatively stable. If a firm's ratio is
increasing significantly over time (as NetPhoto's is), the firm may be accelerating revenue
recognition through aggressive accounting methods.

Comparative Revenue / Cash Collections by Firm

2009 2008 2007 2006

SnapPrints 105% 98% 101% 104%
NetPhoto 200% 125% 135% 107%

(Module 13.5, LOS 13.e)

Question #11 - 11 of 28 Question ID: 1586152

In reviewing the footnotes to NetPhoto's financial statements, Howard discovers that the
firm has engaged in a LIFO liquidation. The most likely effects on the financial statements
(compared to no LIFO liquidation) are:

A) a decrease in COGS and an increase in the net profit margin.

B) a decrease in inventory turnover and an increase in the gross profit margin.
C) an increase in the gross profit margin and an increase in days of inventory.

Explanation

A LIFO liquidation refers to slowing the purchase of inventory items so that older lower
costs are used to calculate COGS. Compared to following regular purchase policies, this
will reduce COGS, reduce inventory, and artificially increase gross and net margins. Since
the percentage decrease in inventory is likely greater than the percentage decrease in
COGS, the inventory turnover ratio is likely increased, rather than decreased, by a LIFO
liquidation.

(Module 13.5, LOS 13.e)

Question #12 of 28 Question ID: 1472656

An analyst is developing a framework for financial statement analysis for his firm. This
framework is most likely to include:

A) Define the purpose of the analysis, process input data, and follow up.
Determine the allocation of firm fees, interpret processed data, and
B)
communicate conclusions.
 Maintain integrity of capital markets, perform duties to clients and employers,
C)
and avoid conflicts of interest.

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.

(Module 13.1, LOS 13.a)

Question #13 of 28 Question ID: 1586144

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?

A) $6.236 million and $3.724 million.

B) $3.99 million and $2.54 million.
C) $7.1 million and $5.2 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).

(Module 13.5, LOS 13.e)

Question #14 of 28 Question ID: 1586138

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?

A) 60.0%.
B) 55.6%.
C) 61.9%.

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.

(Module 13.5, LOS 13.e)

Question #15 of 28 Question ID: 1472664

If segmental cash flow data has not been reported, we can most appropriately approximate
cash flow as:

A) operating cash flow − cash interest − cash taxes.

B) EBIT + depreciation + amortization.
C) EBIT + non-cash charges + increase in working capital.

Explanation

We are most likely to approximate segment cash flow as EBIT plus depreciation and
amortization. This calculation is necessary because segmental cash flow data is generally
not reported.

(Module 13.2, LOS 13.c)

Question #16 of 28 Question ID: 1472659

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?

A) $1,820,000.00
B) $1,855,000.00
C) $1,980,000.00

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).

(Module 13.2, LOS 13.b)

Question #17 of 28 Question ID: 1472663

In order to compare companies using a common size statement, the various line items in a
company's income statement are most likely to be divided by the company's:

A) net earnings.
B) revenues.
C) total assets.

Explanation

In a common size income statement, all the line items in a company's income statement
are divided by the company's revenues. Common size statements make comparability
across companies much easier. An analyst might use a common size statement to
compare trends in income statement variables (such as gross margins) for a group of
companies.

(Module 13.2, LOS 13.c)

Question #18 of 28 Question ID: 1472653

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:

A) a review of his firm’s framework for analysis of financial statements.

B) analysts adjustments to the financial statements.
C) a DuPont analysis.

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.

(Module 13.1, LOS 13.a)

Question #19 of 28 Question ID: 1472665

Cash generated from operations (CGO) is least appropriately calculated as:

A) EBIT + non-cash charges − increase in working capital.

B) operating cash flow + cash interest paid + cash taxes paid.
C) net income − cash flow from operations − cash flow from investing.

Explanation

The following is an appropriate formula for calculating cash flow based accruals, not
CGO: cash flow based accruals = net income − cash flow from operations − cash flow from
investing.

(Module 13.5, LOS 13.e)

Question #20 of 28 Question ID: 1513732

High Plains Tubular Company is a leading manufacturer and distributor of quality steel
products used in energy, industrial, and automotive applications worldwide.

The U.S. steel industry has been challenged by competition from foreign producers located
primarily in Asia. All of the U.S. producers are experiencing declining margins as labor costs
continue to increase. In addition, the U.S. steel mills are technologically inferior to the
foreign competitors. Also, the U.S. producers have significant environmental issues that
remain unresolved.

High Plains is not immune from the problems of the industry and is currently in technical
default under its bond covenants. The default is a result of the failure to meet certain
coverage and turnover ratios. Earlier this year, High Plains and its bondholders entered into
an agreement that will allow High Plains time to become compliant with the covenants. If
High Plains is not in compliance by year end, the bondholders can immediately accelerate
the maturity date of the bonds. In this case, High Plains would have no choice but to file
bankruptcy.

High Plains follows U.S. GAAP. For the year ended 2008, High Plains received an unqualified
opinion from its independent auditor. However, the auditor's opinion included an
explanatory paragraph about High Plains' inability to continue as a going concern in the
event its bonds remain in technical default.

At the end of 2008, High Plains' Chief Executive Officer (CEO) and Chief Financial Officer
(CFO) filed the necessary certifications required by the Securities and Exchange Commission
(SEC).

To get a better understanding of High Plains' financial situation, it is helpful to review High
Plains' cash flow statement found in Exhibit 1 and selected financial footnotes found in
Exhibit 2.

Exhibit 1: Cash Flow Statement

High Plains Tubular Cash Flow Statement

Year ended December 31,

in thousands 2008 2007

Net income $158,177 $121,164

Depreciation expense 34,078 31,295

Deferred taxes 7,697 11,407

Receivables (144,087) (24,852)

Inventory (79,710) (72,777)

 Payables 36,107 22,455

Cash flow from operations $12,262 $88,692

Cash flow from investing ($39,884) ($63,953)

Cash flow from financing $82,676 $6,056

Change in cash $55,054 $30,795

Exhibit 2: Selected Financial Footnotes

1. During 2008, High Plains' sales increased 27% over 2007. Its sales growth continues to
significantly exceed the industry average. Sales are recognized when a firm order is
received from the customer, the sales price is fixed and determinable, and
collectability is reasonably assured.
2. The cost of inventories is determined using the last-in, first-out (LIFO) method. Had
the first-in, first-out method been used, inventories would have been $152 million and
$143 million higher as of December 31, 2008 and 2007, respectively.
3. Effective January 1, 2008, High Plains changed its depreciation method from the
double-declining balance method to the straight-line method in order to be more
comparable with the accounting practices of other firms within its industry. The
change was not retroactively applied and only affects assets that were acquired on or
after January 1, 2008.

4. High Plains made the following discretionary expenditures for maintenance and
repair of plant and equipment and for advertising and marketing:

in millions 2008 2007 2006

Maintenance and repairs $180 $184 $218

Advertising and marketing 94 108 150

5. During the fiscal year ended December 31, 2008, High Plains sold $50 million of its
accounts receivable, with recourse, to an unrelated entity. All of the receivables were
still outstanding at year end.
6. High Plains conducts some of its operations in facilities leased under noncancelable
finance (capital) leases. Certain leases include renewal options with provisions for
increased lease payments during the renewal term.
7. High Plains' average net operating assets at the end of 2008 and 2007 was $977.89
million and $642.83 million, respectively.

As compared to the year ended 2007, High Plains' cash flow accrual ratio for the year ended
2008 is:
A) higher.
B) the same.
C) lower.

Explanation

The cash flow accrual ratio increased during 2008 from 15% to 19%.

in thousands 2008 2007

Net income $158,177 $121,164
− Cash from operations 12,262 88,692
− Cash from investing (39,884) (63,953)
= Accruals $185,799 $96,425
÷ Net operating assets $977,890 $642,830
= Cash flow accrual ratio 19% 15%

(Module 13.5, LOS 13.e)

Question #21 of 28 Question ID: 1472657

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:

A) processing data.
B) collecting data.
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.

(Module 13.1, LOS 13.a)

Question #22 of 28 Question ID: 1472662

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?

A) ROA is 12.96% and ROE is 16.56%.

B) ROA is 13.30% and ROE is 17.05%.
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 expense $30 million ($25 + $5)

Net income $31.75 million ($35 – $3.25)
Total assets $245 million ($250 – $5)
Shareholder's equity $191.75 million ($195 − $3.25)

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).

(Module 13.2, LOS 13.b)

Question #23 of 28 Question ID: 1586146

Recently, Galaxy Corporation lowered its allowance for doubtful accounts by reducing bad
debt expense from 2 percent of sales to 1 percent of sales. Ignoring taxes, what are the
immediate effects on Galaxy's operating income and operating cash flow?

Operating Operating cash

income flow

A) Lower Lower

B) No effect Higher

C) Higher No effect

Explanation

Lower bad debt expense will result in higher operating income. Operating cash flow is not
affected until Galaxy actually collects the receivables.

(Module 13.5, LOS 13.e)

Question #24 of 28 Question ID: 1472654

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?

A) Common-size financial statements.

B) A written list of questions to be answered by the analysis.
C) Audited financial statements.

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.

(Module 13.1, LOS 13.a)

Question #25 of 28 Question ID: 1472661

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:

A) decrease and inventory turnover may or may not change.

B) increase and inventory turnover will not change.
C) decrease and inventory turnover will rise.

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.

(Module 13.2, LOS 13.b)

Question #26 of 28 Question ID: 1586139

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:

A) $455,760.
B) $460,240.
C) $439,760.

Explanation

The reduction in COGS would result in an increase in net income (62,000 − 78,000) × (1 −
0.36).

(Module 13.5, LOS 13.e)

Question #27 of 28 Question ID: 1586142

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:

A) increase liabilities by $200 million.

B) equity by $200 million.
C) equity by $500 million while increasing liabilities by $300 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.

(Module 13.5, LOS 13.e)

Question #28 of 28 Question ID: 1586140

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?

A) 13.
B) 16.
C) 15.

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).

(Module 13.5, LOS 13.e)