Profitability Analysis and Analytical Issues Paper 9
In financial statement analysis, expressing all financial statement items as a percentage of base-year amounts is called
Answer (A) is correct. Expressing financial statement items as percentages of corresponding base-year figures is a horizontal form of common-size (percentage) analysis that is useful for evaluating trends. The base amount is assigned the value of 100%, and the amounts for other years are denominated in percentages compared to the base year.
On a common-size balance sheet, what would represent 100%?
Answer (B) is correct. On a common-size balance sheet, all amounts are converted to percentages with total assets representing 100%. Of course, if the balance sheet is in balance, the total of liabilities plus stockholders’ equity will also equal 100%
A company has the following summarized income statement:
Sales returns and allowances 10
Cost of goods sold 600
Gross profit 390
Operating expenses 190
Income before taxes 200
Income taxes 70
Net income 130
Which of the following amounts would be converted to 100% on a common-size income statement?
Answer (B) is correct. Net sales represents 100% on a common-size income statement. Thus, sales of $1,000 minus returns and allowances of $10 results in net sales of $990.
In assessing the financial prospects for a firm, financial analysts use various techniques. An example of vertical, common-size analysis is
Answer (D) is correct. Vertical, common-size analysis compares the components within a set of financial statements. A base amount is assigned a value of 100%. For example, total assets on a common-size balance sheet and net sales on a common-size income statement are valued at 100%. Common-size statements permit evaluation of the efficiency of various aspects of operations. An analyst who states that advertising expense is 2% of sales is using vertical, common-size analysis.
Leases should be classified by the lessee as either operating leases or capital leases. Which of the following statements best characterizes operating leases?
Answer (D) is correct. Operating leases are transactions whereby lessees rent the right to use lessor assets without acquiring a substantial portion of the benefits and risks of ownership of those assets.
Careful reading of an annual report will reveal that off-balance-sheet debt includes
Answer (A) is correct. Off-balance-sheet debt includes any type of liability for which the company is responsible but that does not appear on the balance sheet. The most common example is the amount due in future years on operating leases. Under U.S. GAAP, operating leases are not capitalized; instead, only the periodic payments of rent are reported when actually paid. Capital leases (those similar to a purchase) must be capitalized and reported as liabilities.
Which one of the following is not a form of off-balance-sheet financing?
Answer (B) is correct. Off-balance-sheet financing takes four principal forms: investments in unconsolidated subsidiaries, special purpose entities, operating leases, and factoring receivables with recourse.
An investment in trading securities is measured on the statement of financial position at the
Answer (D) is correct. Under U.S. GAAP, trading securities are those held principally for sale in the near term. They are classified as current and consist of debt securities and equity securities with readily determinable fair values. Unrealized holding gains and losses on trading securities are reported in earnings. Hence, these securities are reported at fair value.
An investment in available-for-sale securities is measured on the statement of financial position at the
Answer (C) is correct. Under U.S. GAAP, available-for-sale securities are investments in debt securities that are not classified as held-to-maturity or trading securities and in equity securities with readily determinable fair values that are not classified as trading securities. They are measured at fair value in the balance sheet.
When using fair value accounting it would be to a firm’s benefit to report the liability at fair value when it has
Answer (C) is correct. A firm would want to report a liability at fair value when its fair value is less than its carrying amount. The fair value of this bond ($27,440,000 = $28,000,000 × .98) is less than its carrying amount of $28,000,000. This would decrease the liabilities section of the balance sheet, which a company would prefer to do.