Week 4 Quiz Flashcards
During the year MNR Ltd. entered into a contract to provide monthly consulting services to XYZ Inc. that is expected to last for 12 months. The contract commenced on March 1 and the year-end is October 31. The total value of the contract is $120,000. XYZ paid the full amount on July 11. Which of the following is correct with respect to MNR’s October 31 financial statements?
a) $80,000 recorded as deferred revenue as that is the amount earned.
b) $120,000 recorded as revenue as that was the amount of cash received.
c) $40,000 recorded as deferred revenue as the contract is not complete.
d) $120,000 recorded as deferred revenue as the contract is not complete.
Answer C is correct because the portion unearned should be recorded as deferred from November 1 to February 28 = 4/12 x $120,000 = $40,000.
Which one of the following statements is true?
a) The internal auditor is interested primarily in the internal controls that relate to reliable financial statements.
b) Well-designed internal controls prevent or detect errors, thereby ensuring that financial statements are not materially misstated.
c) Even well-designed internal controls cannot prevent or detect all fraudulent activities.
d) Small entities are unable to segregate duties well enough to implement good internal controls.
Answer C is correct because fraud can be perpetrated as there is always a trade-off between the cost and benefits of internal controls. For example, collusion between employees and third parties, or management and employees can circumvent normal controls. Management override of controls can result in fraudulent financial reporting.
Which of the following would NOT be a consideration in determining materiality for the review of JCS Enterprises?
a) JCS is planning to go public in the next year.
b) The bank has requested audited financial statements.
c) The financial statements and the review engagement report must be completed within three weeks.
d) The current shareholders want to minimize income taxes.
C is correct
On November 1, 20X0, Jane’s Enterprises purchased a one-year insurance policy for $12,000. Jane’s Enterprises debited cash and credited prepaid insurance for $12,000. At the end of the year December 31, 20X0, $2,000 of insurance had expired. The journal entry to properly state all accounts involved on December 31, 20X0, would be:
a) DR Prepaid insurance $22,000, CR Cash $24,000 and DR Insurance expense $2,000
b) DR Prepaid insurance $2,000, CR Insurance expense $2,000
c) DR Cash $2,000, CR Insurance expense $2,000
d) DR Insurance expense $2,000, CR Prepaid insurance $2,000
Answer A is correct because the original entry was backwards and we also have to now record the expired portion of insurance. The expired insurance ($2,000) is a debit. The unadjusted balance of the prepaid is CR $12,000. A DR adjustment of $22,000 is required to arrive at the correct prepaid balance (DR $10,000). Cash was debited $12,000 when it should have been credited $12,000. An adjustment of CR $24,000 is required to arrive at the correct cash balance.
Which of the following assertions does not relate to classes of transactions on the income statement?
a) Occurrence
b) Completeness
c) Accuracy
d) Rights and Obligations
Answer D is correct because rights and obligations is an assertion pertaining to the balance sheet accounts.
Income statement items: EBITDA $2,700,000 Income taxes – 40% 1,080,000 Net income after tax 1,620,000
Included in above are the following:
· Salaries paid to shareholders not active in the business – $250,000
· Dividends paid above usual amounts – $100,000
· Inventory bought at below fair market value from affiliated company – $5,000 less than FMV – of which $4,000 was sold this year
· Capitalization rate – 20%
· Sustaining capital, net of tax shield – $50,000 per year
Using the capitalization of cash flows approach, what would be the estimated maintainable operation cash flow (normalized EBITDA)?
a) $2,943,000
b) $2,946,000
c) $3,046,000
d) $2,454,000
Answer B is correct because this properly adjusts for the extra $250,000 in salaries for inactive shareholders, and the $4,000 less in Cost of Goods sold (2,700,000 + 250,000 – 4,000).
The sole shareholder of HTZ Ltd. is selling her business. Income before taxes for the fiscal year ended December 31, Year 9, was $240,000, a level that is expected to be maintainable into the foreseeable future. Currently, the shareholder’s son is employed by HTZ Ltd. and is earning $80,000 per year. The son’s services can be replaced by hiring a new employee for $45,000 per year. Upon a sale, the son will no longer be involved in the business. HTZ Ltd. also incurs $10,000 per year in administrative costs that are considered to be personal in nature. HTZ Ltd.’s tax rate is 40% and the appropriate earnings multiple is 10. Based on a capitalized earnings approach to business valuation, what is the value of the HTZ Ltd.’s shares?
a)
$1,500,000
b)
$1,710,000
c)
$1,650,000
d)
$2,850,000
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Answer B is correct because of the following calculation:
Income before taxes
$ 240,000
Normalizing adjustments:
Son’s salary
Personal costs
Maintainable earnings
$ 285,000
Taxes (40%)
$ 114,000
After-tax, sustainable income
$ 171,000
Earnings multiple
(10x)
Capitalized earnings/business value
$1,710,000
Note 1 – The son’s salary is not at fair market value. The total salary is $35,000 in excess of its fair value. Because the son will no longer be involved in the business after a sale, the excess salary will be avoidable and therefore should be added back.
Note 2 – The personal administrative costs are discretionary, and are not required to generate the maintainable business income. Therefore, those costs are added back as a normalizing adjustment.
Note 3 – Maintainable earnings must be net of taxes.
Valuations: liquidation value
Fair Value
Tax Value
Balance sheet items:
Fair value of assets at liquidation value $7,400,000 $6,400,000 (tax) Fair value of liabilities 2,000,000 2,000,000 (Tax) Redundant assets in above 100,000 100,000 (Tax)
The applicable tax rate is 40%. The adjusted cost base of the assets is $10,000,000. There are no other sources of income or loss. Using a liquidation approach, what value would you give to the business?
a) $5,400,000
b) $5,000,000
c) $5,200,000
d) $5,300,000
Answer B is correct because the answer correctly adjusts for the tax – correct answer derived as (7,400,000 – 2,000,000) – ((7,400,000 – 6,400,000) x .4)
A target business is not expected to be profitable in the near future and the buyer is only interested in the assets. As such:
a) The most appropriate method of valuation is a transaction or market-based approach.
b) The most appropriate value is determined using an asset-based approach.
c) The most appropriate value is an average of the values determined under the asset and transaction (or market) based approaches.
d) Because the business will not continue to be profitable, it has no value.
Answer B is correct because an asset-based approach is the minimum price for any business and the best value of the assets of an unprofitable business.
Valuations: asset-based Balance sheet items: Fair Value Total assets $ 4,250,000 Total liabilities 2,500,000 Redundant asset value 650,000 Income taxes on asset disposal 50,000 Selling costs on asset disposal 15,000 Income statement items: Maintainable EBITDA $ 2,500,000 Income tax rate 35% Present value of the tax shield on the current assets 160,000 Weighted average cost of capital 15% Sustaining capital, net of tax shield 250,000
What would the adjusted net asset value be for the above company?
a) $1,685,000
b) $1,700,000
c) $1,735,000
d) $1,750,000
Answer A is correct because it properly adjusts the adjusted net asset value for the latent taxes and asset disposal costs ($4,250,000 – 2,500,000 – 50,000 – 15,000)
When considering a sale transaction of a going concern business, what is the minimum value the seller should consider for the business?
a) Discounted cash flow value
b) Liquidation value
c) Capitalized cash flow value
d) Adjusted net asset value
Answer D is correct because this represents the maximum value of the net assets but does not incorporate any additional value for them being used in operations (also known as going concern risk). Thus, this often represents the minimum value a seller should accept for a going concern business.
Which of the following is NOT an example of a redundant asset?
a) Loan to a shareholder
b) Building used for production
c) Vacant lot
d) Temporary investments
Answer B is correct because the building is used for production, assuming that the production in the building is required in the operations of the business
Which of the following is NOT something a purchaser has to consider before finalizing a purchase of a company?
a) Financing the purchase
b) Competitors in the same industry
c) Key personnel committed to staying with the company
d) Continuing association with the company’s current legal counsel
Answer D is correct because the legal counsel used by the company is irrelevant as the purchaser has the freedom to use whoever he chooses.
Which of the following is the most accurate statement regarding the sale and purchase of a business?
a) The purchaser prefers to purchase shares since the $800,000 capital gains exemption can be claimed in the future when the shares are sold.
b) The vendor prefers to sell assets since the vendor may be able to claim the $800,000 capital gains exemption.
c) The purchaser prefers to purchase assets as the UCC values of the assets acquired will be the fair value of the assets and potential problems with liabilities are avoided.
d) The vendor prefers to sell shares to avoid annual tax filing costs on the incorporated company.
Answer C is correct because the purchase of assets adjusts the value to fair value which would reduce the potential future capital gain on subsequent sale. Also, the UCC of the assets purchased can be bumped up to FMV, creating increased CCA claims (and tax savings) in the future. This will be a significant advantage when the FV > book value. If only assets are sold, all liabilities are retained by the seller.
Dave’s Sleep Shop Ltd. has been a client of your firm for the past two years. Dave Ainsworth is the sole shareholder of the business. Dave’s wife Maureen pays all the bills, and deposits the daily cash receipts. Your firm has been engaged to record the transactions from the bank records, prepare financial statements, and prepare the corporate tax return on an annual basis. However, this year Dave’s bank has requested that your firm perform an audit of the financial statements.
Which of the following statements is true?
a) Your firm is free to continue with the current work as well as accepting the audit engagement.
b) Your firm must decline all other work for the client if they accept the audit engagement.
c) Preparation of the financial statements is a “familiarity” threat to independence. Your firm must either decline the audit engagement, or tell Dave that someone else must prepare the year-end financial statements.
d) Preparation of the financial statements is a “self review” threat to independence. Your firm must either establish that the threat is not significant, or document appropriate safeguards to this threat.
Answer D is correct because safeguards are possible, such as having periodic external practice review, rotating the senior personnel or requiring an engagement quality control review. The safeguards adopted to reduce or eliminate the threat should be documented.
