Financial Statements

Question 1

How must the sale of an asset you bought for £5,000 and sold for £6,000 be recorded on the cash flow statement?

Answer 1

It will be £6,000 into CFI. However, the income statement will show this as a gain of £1,000 in the net income figure, so we must remove £1,000 from CFO.

Question 2

What are the components of closing assets on the balance sheet?

Answer 2

Opening assets
+ purchases
- depreciation
- disposals (at NBV)

Question 3

What is free cash flow to the firm, and how do you calculate it?

Answer 3

The cash available to all of the company’s suppliers of debt and equity capital.

Net income + non-cash charges + interest(1 - tax rate) - fixed capital expenditures - working capital expenditures

Or

CFO + interest(1 - tax rate) - fixed capital expenditures

Question 4

What is the difference between free cash flow to the firm and free cash flow to equity?

Answer 4

FCFF is the cash available to the company’s suppliers of debt and equity capital (common and preference shares, bonds, etc.)

FCFE is the cash available to common shareholders ONLY

Question 5

How do you calculate free cash flow to equity (FCFE)?

Answer 5

CFO - fixed capital expenditure - net debt repayment

Or

CFO - fixed capital expenditure + net borrowing

Question 6

How do you calculate cash flow to revenue, and what does it measure?

Answer 6

CFO / Net revenue

Measures cash generated per dollar of revenue

Question 7

How do you calculate cash return on assets, and what does it measure?

Answer 7

CFO / Average total assets

Measures the cash generated from all resources

Question 8

How do you calculate cash return on equity, and what does it measure?

Answer 8

CFO / Average shareholder equity

Measures the cash generated from owner resources

Question 9

How do you calculate cash to income, and what does it measure?

Answer 9

CFO / Operating income

Measures the cash generating ability of operations

Question 10

How do you calculate cash flow per share, and what does it measure?

Answer 10

(CFO - Preferred dividends) / Number of common shares outstanding

Measures operating cash flow on a per share basis

Question 11

How do you calculate interest cover, and what does it measure?

Answer 11

(CFO + Interest paid + Taxes paid) / Interest paid

Measures the company’s ability to meet its interest obligations

(The numerator is a stand in for EBIT)

Question 12

What are the four enhancing qualitative characteristics of useful financial information?

Answer 12

Comparability
Verifiability
Timeliness
Understandability

Question 13

What are the two fundamental qualitative characteristics of useful financial information?

Answer 13

Faithful representation
Relevance

Question 14

What does it mean when an auditor adds a disclaimer of opinion to their report?

Answer 14

The auditor cannot give a fair opinion on a company’s financial statements as they have been prevented from carrying out their function properly due to significant uncertainties, limitations in obtaining evidence, or lack of independence. This can have serious consequences for the company.

Question 15

What does it mean when an auditor adds a qualified opinion to their report?

Answer 15

The auditor finds the financial statements generally accurate, but with some exceptions. This is still generally acceptable to investors, lenders and creditors.

Question 16

What does it mean when an auditor adds an adverse opinion to their report?

Answer 16

The auditor has found that the company’s financial statements are materially misrepresented.

Question 17

What does it mean when an auditor adds an unqualified opinion to their report?

Answer 17

The auditor has found the company’s financial statements to be an accurate and compliant with accounting standards.

Question 18

In which financial statement would you find information about the compensation of directors and management?

Answer 18

The proxy statement.

Question 19

Under US GAAP, how would issues that involve “especially challenging, subjective, or complex auditor judgment” be described?

Answer 19

Critical audit matters

Question 20

What is meant by going concern?

Answer 20

The assumption that a company will continue to operate into the foreseeable future and not go into liquidation.

Question 21

What is the fundamental principle of materiality in financial statements?

Answer 21

Materiality suggests that the financial statements should be free from misstatements and omissions that could influence the decisions of an investor.

Question 22

A company issues 100 shares at £1.50. The shares have a par value of £1.00. What is the increase in share capital?

Answer 22

£100

The additional £50 raised is the share premium.

Question 23

Current assets are those expected to be used up within how much time?

Answer 23

Either one year or within the firm’s operating cycle, whichever is longer.

If it takes the firm 18 months to produce an asset then current assets are those expected to be used up within 18 months.

Question 24

On the balance sheet, a company’s current liabilities are those that they are expected to pay within how long?

Answer 24

One year or one operating cycle, whichever is longer.

Question 25

Under US GAAP, what is the formula for cash flow from financing?

Answer 25

CFF = Issue of stock + Issue of bonds - Dividends paid - Bank overdrafts

Question 26

How do you calculate cost of goods sold (COGS)?

Answer 26

COGS = Opening inventory + Purchases - Closing inventory

Question 27

What would be the effect of misstating closing inventory as higher than it actually is on the balance sheet and the income statement (assuming indirect accounting method)?

Answer 27

Balance sheet: Assets are overstated Income statement: COGS are understated, and therefore profit is overstated

Question 28

What are the assumptions of first-in first-out (FIFO) inventory valuation?

Answer 28

Oldest goods are sold first. Cost of sales (COGS) reflects the oldest prices, and are therefore relatively understated. Ending inventory is based on current prices.

Question 29

What are the assumptions of last-in first-out (LIFO) inventory valuation? And when is it allowed to be used?

Answer 29

Newest goods are sold first. Cost of sales (COGS) reflects the newest prices, and are therefore relatively overstated. Ending inventory is based on oldest prices. LIFO is only permitted under US GAAP.

Question 30

Which, if any, of these figures will differ from each other under FIFO, LIFO and weighted average inventory valuation methods? Opening inventory, purchases, closing inventory.

Answer 30

Only closing inventory. Opening inventory is taken from the previous year’s balance sheet, and purchases are recorded as they happen so we don’t need to calculate them.

Question 31

What is the LIFO reserve?

Answer 31

The difference between LIFO and FIFO

Question 32

In periods of inventory liquidation (no purchases), which valuation method will have a higher profitability of FIFO and LIFO?

Answer 32

LIFO Given that the remaining inventory is worth less under LIFO, the COGS will be lower, meaning profit will be higher.

Question 33

Under IFRS, what measure of closing inventory is used, cost (using FIFO or weighted average) or net realisable value?

Answer 33

Whichever one is lower

Question 34

What adjustments to the financial statements are needed when an inventory write down is required? (e.g. when sudden reputational damage reduces the NRV of your inventory)

Answer 34

If NVR is now less than the cost of the inventory on the balance sheet, it must be reduced. Since closing inventory is now worth less, COGS increases, which decreases profits. This must be reflected in the income statement.

Question 35

Can impairments of inventory value be reversed?

Answer 35

Under IFRS: Yes Under US GAAP: No

Question 36

How do you calculate inventory turnover and what does it measure?

Answer 36

Inventory turnover = COGS / Average inventory Measures how many times inventory turns over in a year

Question 37

How do you calculate days of inventory on hand?

Answer 37

(Ending inventory / COGS) * 365

Question 38

How are research and development costs recorded under US GAAP and IFRS?

Answer 38

Under US GAAP: Both are expensed Under IFRS: Research costs are expensed but development costs (when the research results in something viable) are capitalised

Question 39

In a period where development costs are rising faster than amortisation, how will the income statement be affected under US GAAP and IFRS? Assume that development costs are permanently ongoing.

Answer 39

Under US GAAP the development costs will be expensed and income will be lower. Under IFRS the development costs will be capitalised and will spread out over a number of years, resulting in a higher net income.

Question 40

When one company acquires another and pays more than the fair value of the assets of the other company, what is this premium recorded as?

Answer 40

Purchased goodwill

Question 41

True or false, expensing development costs will result in a lower net income in the year the cost occurs than if the cost was capitalised, but higher net income in subsequent years?

Answer 41

Trick question While this is almost always true, the assumption for development costs is that they are ongoing and will likely increase over time, meaning that expensing cost will always result in a lower net income

Question 42

What development costs are allowed to be capitalised under US GAAP, and at what point is the transition from research cost to development cost made?

Answer 42

Software development costs. Transition from research cost to development cost is made once feasibility and economic viability have been established.

Question 43

When is a reversal of impairment allowed under US GAAP?

Answer 43

Only on long-lived assets that are being held for sale

Question 44

Under what circumstances is a reversal of impairment of a revaluation of goodwill allowed?

Answer 44

It is never allowed

Question 45

Under what circumstances is a reversal of impairment of a revaluation of goodwill allowed?

Answer 45

It is never allowed

Question 46

What is the current ratio?

Answer 46

Current assets / Current liabilities

Question 47

What is the quick ratio?

Answer 47

(Current assets - Inventory) / Current liabilities

Question 48

In lessor accounting, why would you recognise a higher net income at inception for leasing the same asset under a sales-type financing lease than a direct financing lease?

Answer 48

A sales-type lease is for lessors who produced the leased asset. We can assume that the value of the lease will be greater than the value of the asset. Therefore, when we replace the asset on the balance sheet with the receivable value of the lease, the receivable will be greater than the asset value. To balance this, we treat the difference as if the asset was sold. The profit goes onto the income statement, and is then added back to the balance sheet as retained earnings.