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# Inventory and depreciation methods for low/high net income

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Aardvark Company and Bear Company both began operations on 1/1/11. The companies had identical balance sheets at 1/1/11, consisting of the following items:
Cash \$80,000
Merchandise Inventory (3,000 units at \$3 each) 9,000
Delivery trucks 75,000
Note payable (10%) 70,000
Common stock 94,000
During 2011, the two companies had identical transactions. All five transactions described below were cash transactions.

Purchase: 3/1/11 (3,400 units at \$6 each) \$20,400
Purchase: 5/1/11 (7,000 units at \$8 each) 56,000
Sales: 8/1/11 (10,000 units at \$15 each) 150,000
Selling expenses paid at various dates 21,000
Administrative expenses paid at various dates 17,000

The note is due with interest on 1/1/12. The delivery trucks have a useful life of five years with a total expected salvage value of \$15,000. Both companies have a 30% income tax rate, and all income taxes for 2011 will be paid in 2012.

Aardvark Company wishes to report as high a net income as possible.
Bear Company wishes to report as low a net income as possible.

Step 1: Aardvark Company wishes to report as high a net income as possible. Prepare a 2011 income statement for Aardvark. Choose the depreciation method and inventory cost flow assumption that will result in the highest net income.

Step 2: Based on the information given and the 2011 income statement prepared in Step 1, prepare a 12/31/11 balance sheet for Aardvark. Use the same depreciation method and inventory cost flow assumption as in Step 1.

Step 3: Bear Company wishes to report as low a net income as possible. Prepare a 2011 income statement for Bear. Choose the depreciation method and inventory cost flow assumption that will result in the lowest net income.

Step 4: Based on the information given and the 2009 income statement prepared in Step 3, prepare a 12/31/11 balance sheet for Bear. Use the same depreciation method and inventory cost flow assumption as in Step 3.

#### Solution Preview

Your tutorial is attached. It explains the strategy needed to achieve ...

#### Solution Summary

Your tutorial is attached in Excel (click in cells to see computations). It explains the strategy needed to achieve the low and high net income desired. It shows the computations of the four methods to achieve these results and then maps out the multi-step income statement needed to reveal how net income end up with these method choices.

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## Financial Accounting: practice exam

1. As a general rule, revenue is normally recognized when it is
A) measurable and earned.
C) realizable and earned.
D) collected (the cash is received).

2. According to accounting standards, initial franchise fees should be recognized as income when:
A) the franchiser has substantially performed or satisfied all material services and conditions.
B) the franchiser has collected the majority of fee in cash.
C) the franchisee shows the ability to pay the fee.
D) the franchiser bills the franchisee.

Use the following to answer questions 3-4:

The following information was extracted from Slurm Corporation's 2009 annual report:

Common stock
Shares outstanding 12/31/08 90 Million
New shares issued 4/1/09 10 Million
Shares outstanding 12/31/09 100 Million
Preferred stock
\$10 par, 10%, convertible into 2 shares of common stock, shares
Outstanding 50 Million
Options
1 Million options, each to purchase one common share at \$50 per
Share

Market price of stock
Average for year \$ 75
Beginning of year \$ 70
End of year \$ 78

Preferred dividends paid
\$ 50,000,000
Net Income for 2009 \$350,000,000

3. Basic earnings per share for 2009 is:
A) \$3.50
B) \$3.16
C) \$3.08
D) \$3.00

4. Using the treasury stock method, the options would result in how many extra shares being recognized in the diluted EPS calculation:
A) 500,000
B) 358,975
C) 333,333
D) 285,714

5. Hulk Company reports the following
2008 2009
Sales \$300,000 \$360,000
Cost of goods sold \$75,000 \$90,000
Based upon this information which of the following is most correct:
A) Cost of goods sold is a permanent cost
B) Cost of goods sold is a economic cost
C) Cost of goods sold is a totally variable cost
D) Cost of goods sold is a period expense

6. Which of the following combinations of accounting practices will lead to the highest reported earnings in an inflationary environment?
Depreciation Method Inventory Method
A) Straight-line LIFO
B) Double-declining balance LIFO
C) Straight-line FIFO
D) Double-declining balance FIFO

Use the following to answer questions 7 and 8:
TMTOMH Company reported in its annual report software refinement expenses of \$12M, \$15M and \$18M for fiscal years 2007, 2008 and 2009, respectively. At the end of fiscal 2009 it had total assets of \$140M. Net income was \$20M for fiscal 2009, and it had a marginal tax rate of 35%.

7. If software refinement had been capitalized each year and amortized over a three-year
period beginning in the year the cost was incurred, total assets at the end of fiscal 2009
would have been:
A) \$185M
B) \$172M
C) \$158M
D) \$157M

8. If software refinement had been capitalized each year and amortized over a three year period beginning in the year the cost was incurred, net income for fiscal 2009 would have been:
A) \$31.7M
B) \$29.75M
C) \$21.95M
D) \$14.95M
9. A firm has net sales of \$6,000, cash expenses (including taxes) of \$2,800, and depreciation of \$1,000. If accounts receivable increased in the period by \$800, cash flows from operations equal
A) \$2,400
B) \$3,200
C) \$3,400
D) \$4,200

10. Which of the following represents an investing activity in the statement of cash flows
A) depreciation of plant assets
B) sale of plant assets at a loss
C) stock dividend
D) purchase of inventory

11. Which of the following is not a financing activity in the statement of cash flows?
A) cash dividend
B) repurchase of common stock
C) payment of interest on debt
D) issuance of new debt

Use the following to answer questions 12-15:

Below is an example of an incorrectly prepared statement of cash flows. The descriptions of the activities are correct.

Cash from operating activities
Net Income \$ 60,000
Depreciation (4,000)
Increase in accounts receivable (2,000)
Increase in deferred tax liability (1,000)
\$ 53,000

Cash from investing activities
Purchase of marketable securities \$(48,000)
Dividends paid 1,500
\$(46,500)

Cash from financing activities
Increase in Short-term debt - trade \$ (500)
Increase in Long-term debt - bonds
Payable
(2,500)
\$ (3,000)
Increase in cash \$ 3,500

12. The correct cash flows from operating activities is:
A) 65,500
B) 63,500
C) 53,500
D) none of the above

13. The correct cash flows from investing activities is:
A) (\$41,000)
B) (\$45,500)
C) (\$48,000)
D) none of the above

14. The correct cash flows from financing activities is:
A) (\$4,500)
B) \$3,000
C) \$1,000
D) none of the above

15. The correct change in cash for the year is:
A) \$4,000
B) \$15,000
C) \$16,500
D) none of the above

16. On a statement of cash flows that uses the indirect approach, calculation of cash flow from operations treats depreciation as an adjustment to reported net income because:
A) depreciation is a direct source of cash
B) depreciation is an outflow of cash to a reserve account for the replacement of assets
C) depreciation reduces net income and involves an outflow of cash
D) depreciation reduces net income but does not involve an outflow of cash

17. Err Company has a major lawsuit against them for unsafe products. It recognizes a huge liability in 2008 of \$300M. The effect of this liability is to decrease stockholders' equity by 50%. In 2009, the effect of recognizing this lawsuit in 2008, all else being equal in 2009, is:
A) Return on net operating assets will increase dramatically
B) Return on net operating assets will decrease dramatically
C) Return on equity will increase dramatically
D) Return on equity will decrease dramatically

18. If Company A has a high profit margin and Company B has a low profit margin, then return on assets
A) should be higher for Company A than Company B.
B) should be lower for Company A than Company B.
C) should be the same for Company A and Company B.
D) cannot be determined based on the information given.

Use the following to answer questions 19-22:
Below is selected information from Tripe Corp:

Year 1 Year 2
Net operating assets /common equity 1.37 1.53
Net operating profit margin 19% 21%
Income tax rate 47% 28%
Revenues/net operating assets 0.81 0.61
EBIT/revenues 38% 32%

19. Return on Net Operating Assets for Year 1 is:
A) 30.8%
B) 16.3%
C) 15.4%
D) 14.5%

20. Return on Common Equity for Year 1 is:
A) 19.0%
B) 19.60%
C) 21.08%
D) 26.03%

21. Which of the following is correct concerning changes at Tripe Corp. from Year 1 to Year 2?
RNOA ROCE
A) Increased Increased
B) Increased Decreased
C) Decreased Decreased
D) Decreased Increased

22. Which of the following statements is correct concerning changes from year 1 to year 2 at Tripe Corp?
A) Despite favorable changes in the tax rate return on net operating assets has decreased
B) Despite favorable changes in net operating asset utilization return on net operating assets has decreased
C) Largely because of favorable changes in tax rates return on net operating assets has increased
D) Largely due to favorable changes in leverage return on net operating assets has increased

23. An increase in net operating income (NOPAT) will cause which of the following?
A) Increase in the return on net operating assets
B) Decrease in the return on net operating assets
C) No change in the return on net operating assets
D) The change in the return on net operating assets is unclear, there is not sufficient information

24. Which of the following ratios best measures the profitability of a company?
A) Return on equity
B) Gross margin
C) Current ratio
D) Net operating asset turnover

Use the following to answer questions 25-27:
SQB Corporation reports sales of \$10M for Year 2, with a gross profit margin of 40%. 20% of SQB's sales are on credit.

Year 1 Year 2
Accounts receivable \$ 150,000 \$ 170,000
Inventory 900,000 1,000,000
Accounts payable 1,100,000 1,200,000

25. Accounts receivable days outstanding at the end of Year 2 is (use year-end receivable balance):
A) 30.6 days
B) 28.8 days
C) 27.0 days
D) 6.1 days

26. Accounts payable days outstanding at the end of Year 2 is (use average accounts payable for the year):
A) 57.0 days
B) 69.0 days
C) 72.0 days
D) 43.2 days
27. Days in inventory at the end of Year 2 is (use year-end inventory amount):
A) 60.0 days
B) 69.0 days
C) 66.0 days
D) 54.0 days

28. Which of the following industries would you expect to have the longest operating cycle?
A) Fast Food Industry
B) Aerospace Industry
C) Discount retail store industry
D) Utility industry

29. Which of the following industries would you expect to have the highest inventory turnover?
A) restaurant
B) car dealer
C) jewelry store
D) department store

30. If a company issues a 1% stock dividend what is the effect on the following ratios, all other things being equal?

Total Debt/Equity Times Interest Earned Financial Leverage Ratio
A) Increase Increase Increase
B) Increase No effect Increase
C) Increase No effect No effect
D) No effect No effect No effect

31. When calculating debt to equity ratio:
A) Convertible bonds should be treated as debt
B) Convertible bonds should be excluded from debt but not included in equity
C) Convertible bonds should be treated as equity
D) Half the convertible bonds should be treated as debt, and the other half as equity

32. Venture Corporations total assets are 3 times greater than total equity; total equity is 50% of total liabilities. The total debt to total assets ratio is
A) .67
B) .75
C) .87
D) undeterminable with the information given.

33. You are analyzing a stock. You expect that earnings will grow quickly relative to their current level, but the expected return on common stockholders' equity is low. What levels of the price earnings ratio (P/E) and price to book value ratio (P/BV) would you expect to see (relative to industry average)?

P/E Ratio P/BV Ratio
A) Low Low
B) Low High
C) High High
D) High Low

34. AQTHF Inc. is unsuccessfully trading on the equity. Which of the following statements best reflects this?
A) Their bonds payable after-tax interest rate is 7%; their ROI is 5%.
B) Their market capitalization decreased by 3%.
C) Stock dividends were issued this year.
D) Net income was down 18% compared to last year.

35. Which of the following statements is most correct?
A) If two companies have the same ROE and the same risk they must have the same residual income (abnormal earnings) for the year
B) If two companies have the same net book value and the same residual income this year, then their stock prices must be the same
C) If two companies have the same ROE and the same stock price their earnings must be the same for the year
D) If two companies have the same ROE, net book value, and cost of capital then their residual income must be the same for the year

36. When examining quarterly results of a company in a seasonal business it is useful
A) to compare to the preceding quarter
B) to match the company's results against economic statistics
C) to compare to the same period in the prior year
D) to analyze using a percentage income statement

37. Which of the following is not included the definition of earnings persistence?
A) Stability of the earnings
B) Magnitude of the earnings
C) Predictability of the earnings
D) The earnings' trend

38. Which of the following is not a factor in producing earnings forecasts?
A) Estimating the level of earnings
B) Separation of recurring and nonrecurring components
C) Recognizing potential earnings management
D) Recognizing potential income smoothing

Use the following to answer questions 39-40:

Yi Corporation has no preferred stock and reports the following:

2009
Earnings per share \$1.80
Dividends per share \$0.72
Book Value per share-end of year \$8.62

39. If price-to-book value at the end of 2009 equals 1.00, and return on beginning of year equity is expected to remain constant, then cost of equity (to nearest percent) equals:
A) 15%
B) 21%
C) 24%
D) Not determinable

40. If Yi Corporation had preferred stock outstanding then the earnings per share amount of \$1.80 would be
A) unchanged.
B) cannot be determined.
C) greater than \$1.80.
D) less than \$1.80.

41. Interim financial reports are less _________ than annual financial reports.
A) relevant
B) consistent
C) timely
D) reliable

42. Which of the following statements concerning interim financial reports is incorrect?
A) Accrual accounting is used for revenue and expense recognition
B) Extraordinary items are reported in annual but not interim financial reports
C) LIFO liquidation is not reported for interim purposes, unless decline in inventory is expected to be permanent
D) Income taxes are accrued using effective tax rate expected for the annual period

Use the following to answer questions 43-45:

Below is information for year ended 12/31/09 for Company A and Company B.

Company A Company B
Operating Inc. before \$ 1000 \$ 1000
Taxes and Interest
Interest Expense 400 0
Total assets - 12/31/09 10,000 10,000
Total debt 5,000 0
Equity 5,000 10,000
Tax Rate 40% 40%

43. Return on total assets for Company A and B for 2009 are (use NOPAT):

Company A Company B
A) 6% 6%
B) 8.4% 6%
C) 10% 10%
D) 14% 10%

44. ROE for Company A and B for 2009 are:

Company A Company B
A) 2.0% 2.0%
B) 3.6% 4.0%
C) 7.2% 6.0%
D) 8.6% 10%

45. Times interest earned ratio for Company A is:
A) 2.5
B) 2.6
C) 4.0
D) 4.2

46. The effects of leveraging are magnified in
A) good years.