CHAPTER 4

ACCOUNTING ANALYSIS AND

THE FINANCIAL STATEMENTS
LEARNING OBJECTIVES
1.
2.
3.
4.

Why analysts must know how financial statements are prepared.

The balance sheet, income, and cash flow statements, and the relationship among them.
The recognition criteria and valuation methods used for common balance sheet and income statement items.
How management choices, estimates, and judgment affect the quality of the three primary financial statements.

TRUE/FALSE QUESTIONS
1.

As a part of the second phase of security analysis, the analyst may make adjustments to the financial
statements.
(easy, L.O. 1, Introduction, true)

2.

The security analyst is like an accountant searching for clues in the financial statements by using ratios as
the magnifying glass to solve the case.
(moderate, L.O. 1, Introduction, false)

3.

The accounting equation is different from the balance sheet equation.

(moderate, L.O.2, Section 1, false)

4.

The first tier of the GAAP Hierarchy consists of major pronouncements which are so straightforward they
receive very little due process.
(moderate, L.O. 2, Section 1, false)

5.

The income statement is considered to be more important to investors and creditors than the balance sheet.
(easy, L.O. 2, Section 2, true)

6.

GAAP defines a firms income to be the change in its net assets, excluding stock issuances and dividends.
(moderate, L.O. 2, Section 2, true)

7.

Extraordinary items are gains and losses that are deemed to be both unusual and nonrecurring.
(easy, L.O. 2, Section 2, true)

8.

Conservative accounting methods are those that tend to accelerate recognition of assets and delay
recognition of liabilities.
(moderate, L.O. 2, Section 2, false)

9.

Regarding the statement of cash flows, cash flow from financing includes the items that relate to the
determination of net income
(moderate, L.O. 2, Section 3, false)

10.

Quality issues are less problematic for the cash flow statement than for the income statement or balance
sheet.
(moderate, L.O. 2, Section 3, true)

11.

Current assets are not expected to be converted to cash or used to satisfy a liability within one year.
(easy, L.O. 2, Section 4, false)

12.

Minority interest represents the portion of the book value of net assets of a firms subsidiary that is owned
by shareholders other than the firm.

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(moderate, L.O. 2, Section 4, true)

13.

A joint venture may be accounted for under the equity method when the company is deemed to have
substantial influence over the operations of another company.
(moderate, L.O. 3, Section 4, true)

14.

Preferred stockholders have preference over common stockholders in a bankruptcy and always have voting
rights.
(moderate, L.O. 3, Section 4, false)

15.

Warrants and options give the holder the right to purchase stock from the company at a fixed price,
depending on the stocks market price at the time.
(moderate, L.O. 2, Section 4, false)

MULTIPLE CHOICE QUESTIONS

16.

Management plays an important role in preparing the financial statements. Managements choices affect
financial statements. The effects of such choices is known as:
a. managements priorities
b. management responsibility
c. financial statement materiality
d. financial statement quality
(moderate, L.O. 1, Introduction, d)

17.

In FASB Statement of Financial Accounting Concepts No. 6, probable future economic benefits obtained or
controlled by a particular entity as a result of past transactions or events are called:
a. assets
b. liabilities
c. shareholders equity
d. valuation rules
(moderate, L.O. 2, Section 1, a)

18.

Shareholders equity is described as a residual claim. This can be demonstrated by the following equation:
a. Assets Liabilities Shareholders equity = Net Assets
b. Assets + Shareholders equity = Liabilities
c. Shareholders equity = Assets Liabilities = Net Assets
d. Shareholders equity = Assets Net Assets = Liabilities
(moderate, L.O. 2, Section 1, c)

19.

When recognition criteria or valuation methods are __________, there is __________ opportunity for
managers to influence reported results.
a. selected; moderate
b. selected; significant
c. dictated; significant
d. fact-dependent; little
(moderate, L.O. 3, Section 1, b)

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20.

Within the GAAP Hierarchy, a FASB Concepts Statement falls within:

a. Tier 5
b. Tier 4
c. Tier 2
d. Tier 1
(difficult, L.O. 2, Section 1, a)

21.

An increase in assets that does not arise in the ordinary course of business is known as a:
a. revenue
b. gain
c. expense
d. extraordinary item
(easy, L.O. 2, Section 2, b)

22.

It is true that the change in shareholders equity during a year is equal to the change in net assets in that
year. This equation is important because:
a. net income is the change in shareholders equity that is due to distributions of capital
b. net income is the change in shareholders equity that is due to contributions of capital
c. GAAP defines net income implicitly, based on the change in shareholders equity
d. GAAP defines net income explicitly, based on the change in shareholders equity
(difficult, L.O. 2, Section 2, c)

23.

Accounting analysis of the income statement focuses on earnings quality. Different analysts use the term
differently. Most analysts agree that:
a. earnings quality includes nonrecurring items
b. earnings quality is independent of conservative accounting methods
c. a firm has good earnings quality if earnings are free of manipulation
d. conservative accounting methods always result in lower reported, and therefore quality, earnings
(moderate, L.O. 3, Section 2, c)

24.

The income statement summarizes the transactions that led to the firms net income. The income statement
consists of several categories of items. Which category would not provide a helpful clue in forecasting
based on the income statement?
a. revenues
b. expenses
c. a special item
d. a residual claim
(moderate, L.O. 2, Section 2, d)

25.

Special items are generally of a nonrecurring nature. Which item below is not considered a special item?
a. a change in accounting principle
b. a gain from the sale of a manufacturing plant
c. discontinued operations
d. an extraordinary item
(easy, L.O. 2, Section 2, b)

26.

Which item below is not considered an extraordinary item?

a. the September 11, 2001 attack on the World Trade Center in New York
b. a category F5 tornado that destroyed a factory in Colorado
c. an earthquake in Virginia that destroys a local winery
d. a major flood through Las Vegas, Nevada, that ruins a convention center
(moderate, L.O. 2, Section 2, a)

27.

The GAAP statement of cash flows divides cash flow into three categories. The purchase of property, plant,
and equipment is classified as a cash flow from:
a. operations

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b. investing
c. financing
d. In this situation all of the above answers are correct.
(moderate, L.O. 2, Section 3, b)
28.

Which item below is not considered a reconciling item when a GAAP statement of cash flows is prepared
using the indirect method?
a. depreciation
b. a change in inventory
c. a change in current debt
d. net income
(difficult, L.O. 3, Section 2, d)

29.

Cash equivalents are a financial statement example of:

a. depreciable assets
b. current liabilities
c. current assets
d. residual equity
(easy, L.O. 2, Section 4, c)

30.

Almost all filings with the SEC today are made electronically. Such documents are available via the SECs
EDGAR system. A firm must file a report with the SEC whenever there are material events that must be
disclosed to the public. This report is known as the:
a. Form 10-K
b. Form 10-Q
c. Form 8-K
d. Form 8-Q
(moderate, L.O. 2, Section 4, c)

31.

Equity is broken down into one or more classes of stock on a firms balance sheet. Assume that a firm has
both common and preferred stock outstanding. The common equity for the firm is equal to:
a. net assets less preferred stock
b. net assets less common stock
c. the residual claim of the preferred stockholders
d. the basic earnings per share of all classes of common stock
(moderate, L.O. 3, Section 4, a)

32.

Analysts are interested in a firms earnings per share (EPS) because it expresses the firms income in the
same units as its stock price. The numerator found in the basic EPS formula is:
a. net income common stock dividends
b. weighted-average number of shares outstanding + convertible securities outstanding
c. weighted-average number of shares outstanding
d. net income preferred dividends
(difficult, L.O. 3, Section 4, d)

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33.

Many different valuation methods can be used on a balance sheet under GAAP. A balance sheet item that is
generally valued at the lower of cost or market is:
a. a cash equivalent
b. a marketable security
c. accounts receivable
d. inventory
(easy, L.O. 4, Section 4, d)

34.

Investments subject to SFAS No. 115 are divided into several categories. Debt and equity securities that
management plans to sell in the near term are known as:
a. trading securities
b. held-to-maturity securities
c. available-for-sale securities
d. common stock
(moderate, L.O. 3, Section A4.1, a)

35.

Firms invest in another companys stock when they have excess cash available to invest for a period of time
or when they make a strategic investment for the longer term. The accounting treatment for the investment
depends on the degree to which the investor can influence the operations of the investee. If a firm owns
between 20% and 50% of the investee, the presumption is that:
a. the investment is a marketable security
b. there is a controlling equity investment
c. there is a significant influence
d. the investment is not sanctioned by the FASB and it violates GAAP
(moderate, L.O. 3, Section A4.1, c)

36.

A contingent liability, or contingency, is a potential liability that may have been incurred as a result of a
past transaction or event. A contingency that is __________ and __________ must be recognized.
a. remote; reasonably estimable
b. probable; reasonably estimable
c. reasonably possible; reasonably estimable
d. probable; not reasonably estimable
(moderate, L.O. 4, Section A4.2, b)

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ESSAYS
37.

Discuss the statement, Generally accepted accounting principles are not a single set of rules.
Suggested solution:
Generally accepted accounting principles (GAAP) can be thought of as a hierarchy of rules that have been
established by several different regulatory bodies. This hierarchy has been officially recognized in the
AICPA Statement of Auditing Standards (SAS) No. 69. This statement makes all accounting standards
mandatory if they do not contradict a standard at a higher level.
The GAAP Hierarchy consists of five tiers according to SAS No. 69. Tier 1 consists of major
pronouncements such as Statements of Financial Accounting Standards, which receive a great deal of due
process. Due process here involves issuing proposals in various stages of development and receiving
feedback from the public via letter and public hearings. FASB Technical Bulletins, and AICPA Statements
of Position and Industry Audit and Accounting Guides comprise Tier 2. Tier 3 includes AICPA Practice
Bulletins and consensus positions of the FASB Emerging Issues Task Force (EITF). Tier 4 has AICPA
Accounting Interpretations and prevalent industry practices that are widely recognized. Tier 5 is made up of
various accounting literature such as FASB Concepts Statements, AICPA Issue Papers and Technical
Practice Aids, accounting textbooks, handbooks, and articles.
(moderate, L.O. 4, Section 1)

38.

Explain the concepts of recognition criteria and valuation rules in accounting standards.
Suggested solution:
Accounting standards include both recognition criteria and valuation rules. Recognition criteria are rules
for determining what items are shown on financial statements, such as assets and liabilities on the balance
sheet. Valuation rules determine the amounts at which assets and liabilities are to be reported. Without such
rules, accounting standards would be highly arbitrary and unreliable.
In applying such rules, managers have some degree of flexibility and discretion. GAAP dictates in some
cases what can and cannot be done. In other cases, the facts and circumstances give management some
latitude in preparing the firms financial statements. Three guidelines can be established that help clarify
how recognition criteria and valuation rules are applied by management. The general guidelines are:
If the recognition criteria or valuation method determined is dictated, there is little opportunity
for management to influence results.
If the recognition criteria or valuation method determined is fact-dependent, there is a
moderate opportunity for management to influence results.
If the recognition criteria or valuation method determined is selected, there is significant
opportunity for management to influence results.
These guidelines form a continuum from one extreme to the other. This model has important implications
for securities analysts, since they must comprehend what the accounting rules are, how they are applied,
and what latitude management has and its impact on the preparation of the financial statements. Analysts
must also recognize the meaning of dictated accounting standards and how a given valuation method
impacts financial statement analysis. Experience and knowledge are two essential skill sets for the analyst
in this area.
(moderate, L.O. 3, Section 1)

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39.

Comment on how gains and losses are different than revenues and expenses.
Suggested solution:
Revenues are increases in net assets resulting from selling goods or providing services in the normal course
of business. Expenses are decreases in net assets resulting from activities that are related to preparing a
product for sale or delivering services in the normal course of business. The key phrase here is normal
course of business, which indicates that such transactions will recur frequently and are to be expected in
the operation of the business.
Gains are similar to revenues because they also represent increases in net assets. Losses are similar to
expenses because they represent decreases in net assets. Gains and losses can be very different from cash
revenues and cash expenses because gains and losses do not increase or decrease cash. The key difference
between revenues and expenses and gains and losses is that gains or losses do not arise in the ordinary
course of business. From the standpoint of the regular operating activities of the business, gains and losses
will occur infrequently. It should be remembered that gains and losses are not extraordinary items in and of
themselves unless they arise as a result of an unusual and nonrecurring event of a large magnitude, such as
earthquakes, floods, tornadoes, hurricanes, or some other disaster.
(moderate, L.O. 2, Section 2)

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