Chapter 06

Analyzing Operating Activities

Multiple Choice Questions

 

1. Which of the following is not a reason for economic income and accounting income to differ? 
A. Transaction basis
B. The monetary assumption
C. Conservatism
D. Earnings management

2. As a general rule, revenue is normally recognized when it is: 

A. measurable and earned.
B. measurable and received.
C. realizable and earned.
D. realizable.

3. Which of the following measures of accounting income is typically reported in an income

statement? 
A. Net income
B. Comprehensive income
C. Continuing income
D. All of the above

4. According to FASB, 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.

 
 Brierton Company enters a contract at the beginning of year 1 to build a new federal courthouse
for a price of $16 million. Brierton estimates that total cost of the project will be $12 million, and
will take four years to complete.

5. If Brierton used percentage-of-completion method to account for this project, what would they
have reported as profit in year 2? 
A. $ 0
B. $ 1.333M
C. $ 1.5M
D. $ 0.667M

6. If Brierton used cash accounting to account for this project, what would they have reported as
profit (loss) in year 2? 
A. $ 0
B. $ 1.333M
C. $ (2M)
D. $ (4M)

 
7. Hurik Company reports the following

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 an economic cost.
C. Cost of goods sold is a totally variable cost.
D. Cost of goods sold is a period expense.

8. Which of the following combinations of accounting practices will lead to the highest reported
earnings in an inflationary environment?

 
A. Choice A
B. Choice B
C. Choice C
D. Choice D

 
9. Which of the following are correct?
I. If a company uses straight-line depreciation for financial reporting purposes, it is very likely
they have a deferred tax liability with respect to its depreciable assets.
II. Straight line depreciation yields an increasing rate of return on book value over the life of
asset.
III. Straight line depreciation results in lower tax payments than accelerated depreciation
methods over the life of an asset.
IV. If a company revises its estimate of the useful life of an asset upwards this will decrease
annual depreciation expense. 
A. I, II, III and IV
B. I, II and IV
C. I, II and III
D. I and IV

10. Which of the following statements concerning deferred taxes is correct? 

A. Deferred taxes will not be found in asset section of the balance sheet.
B. Deferred taxes arise from permanent differences in GAAP and tax accounting.
C. Deferred taxes will only decrease when a cash payment is made.
D. Deferred taxes arising from the depreciation of a specific asset will ultimately reduce to zero
as the item is depreciated.

11. Differences in taxable income and pretax accounting income that will not be offset by
corresponding differences or "turn around" in future periods are called: 
A. timing differences.
B. circular differences.
C. permanent differences.
D. reverse differences.

 
 The following information was extracted from Smurm Corporation's 2006 annual report:

12. Basic earnings per share for 2006 was: 

A. $3.50
B. $3.16
C. $3.08
D. $3.00

13. 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

 
14. Diluted earnings per share for 2006 was: 
A. $3.52
B. $1.77
C. $2.00
D. $2.03

 Tecktroniks Company reported in its annual report software refinement expenses of $12M, 15M
and 18M for fiscal years 2005, 2006 and 2007, respectively. At the end of fiscal 2007, it had total
assets of 140M. Net income was 20M for fiscal 2007, and it had a marginal tax rate of 35%.

15. 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 2007 would have
been: 
A. $185M
B. $172M
C. $158M
D. $157M

16. 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 2007 would have been: 
A. $31.7M
B. $29.75M
C. $21.95M
D. $14.95M

17. If the software refinement had been capitalized and amortized over a three year period
beginning in the year the cost was incurred, but was expensed for tax purposes, the deferred tax
position at the end of fiscal 2005 would have been: 
A. A deferred tax credit of $2.8M
B. A deferred tax credit of $3.5M
C. A deferred tax credit of $5.2M
D. A deferred tax debit of $4M

 
18. If a company that normally expenses advertising costs was to capitalize and amortize these
costs over 3 years instead: 
A. after the third year net income would always be higher if it is capitalized.
B. after the third year net income would always be lower if it is capitalized.
C. after the third year net income would be higher (if it is capitalized) only if advertising costs
were increasing.
D. after the third year net income would be lower (if it is capitalized) only if advertising costs
were increasing.

19. Compared with companies that expense costs, firms that capitalize costs can be expected to
report: 
A. higher asset levels and lower equity levels.
B. higher asset levels and higher equity levels.
C. lower asset levels and higher equity levels.
D. lower asset levels and lower equity levels.

20. Two growing firms are identical except that one firm capitalizes whereas the other firm
expenses costs for long-lived resources over time. For these two firms, which of the following
statements is generally true?
I. The expensing firm will show a more volatile pattern of reported income than capitalizing
firm.
II. The expensing firm will show a less volatile pattern of return on assets than the capitalizing
firm.
III. The expensing firm will show lower cash flows from operations than the capitalizing firm. 
A. I only
B. II only
C. I and III only
D. II and III only

21. The capitalization of interest cost during construction: 

A. increases future net income.
B. decreases future depreciation expense.
C. increases net income during construction phase.
D. decreases assets during construction phase.

 
22. Windsor Company has net temporary differences between tax and book accounting of $80
million, resulting in a deferred tax liability of $28 million. An increase in the tax rate would have
the following impact on deferred taxes and net income:

 
A. Choice A
B. Choice B
C. Choice C
D. Choice D

23. Exoil recorded an expense and corresponding liability to recognize potential losses relating to
an oil spill in 2006 of $10 million. Its net income for the year was $200 million. It was not able
to take a deduction for tax purposes until later years when it actually paid cash out in relation to
this event. In 2006, with respect to this, Exoil would have: 
A. recognized a deferred tax liability.
B. recognized a tax loss carryforward.
C. recognized a deferred tax asset.
D. recognized a deferred equity loss.

24. Which of the following statements are correct?

I. Tax loss carrybacks result in deferred tax assets.
II. Tax loss carryforwards result in deferred tax assets.
III. The tax valuation account is used to adjust deferred tax liabilities if it is "more likely than
not" that they will not result in increased future taxes. 
A. I only
B. II only
C. III only
D. I and II

 
25. Which of the following will cause the reported effective tax rate to differ from the federal
statutory tax rate?
I. Foreign tax rates that are lower than federal statutory tax rate.
II. Tax-exempt income.
III. Different depreciation methods for tax and financial reporting purposes.
IV. Foreign tax rates that are higher than federal statutory tax rate. 
A. I, II, and IV
B. I, II and III
C. I and II
D. III only

26. If a company changes the useful life of its assets from 10 years to 12 years, this will be
recorded as: 
A. a non-recurring gain.
B. an extraordinary item.
C. a change in accounting principle.
D. None of the above

27. If a company estimates that its expected return on pension plan assets will increase to 9.5%
from 9.0%, this would be considered: 
A. an extraordinary gain.
B. a change in accounting principle.
C. a prior period adjustment.
D. a change in accounting estimate.

28. A company changes its depreciation method from an accelerated system to straight line.
Which of the following would normally be true?
I. The change would be discussed in the auditor's letter.
II. The cumulative effect of the change would appear net of tax on the income statement.
III. The change would appear in cash flow from operations as a cash inflow.
IV. The change would be mentioned in the footnotes. 
A. I, II, III and IV
B. I, II and III
C. II and IV
D. I, II and IV

 
29. Which of the following is true with respect to extraordinary items?
I. Extraordinary items are recorded net of tax in income statement.
II. Extraordinary items, by definition, are probable and unusual in nature.
III. By definition, gains and losses from strikes are always extraordinary.
IV. By definition, gains and losses from sale of plant, property and equipment are never
extraordinary. 
A. I and IV
B. I, III and IV
C. II and IV
D. I, II and III

30. Which of the following would be considered an extraordinary item?

I. Write-down of receivables
II. Gains on disposal of a business segment
III. Loss of inventory resulting from a fire
IV. Loss resulting from a strike 
A. I and IV
B. I, III and IV
C. III only
D. I, II and III

31. Which of the following items is not included in the calculation of net income but is included
in the calculation of comprehensive income? 
A. Unrealized holding gain on available-for-sale marketable securities.
B. Unrealized holding gain on trading marketable securities.
C. Gain from early extinguishments of bonds.
D. Gain arising from sale of available-for-sale marketable securities.

32. Which of the following statements is true? Under GAAP, comprehensive income: 

A. may be reported in addition to net income.
B. must be reported in addition to net income.
C. may be reported instead of net income.
D. must be reported instead of net income.

 
33. Which of the following statements is incorrect? Employee stock options 
A. are not recorded as an expense when granted if they are at or out-of-the money under the
intrinsic value method.
B. will not affect the share price of the company when exercised.
C. may reduce agency costs by more closely aligning interests of stockholders and managers.
D. may increase the risk propensity of managers.

 A company's net income is $100,000, and its weighted-average shares outstanding are 20,000.
During the year, the company issues 5,000 ESOs at an exercise price of $20.

34. What will be the basic EPS if average stock price during the year is $35 and treasury shares
that can be purchased are 1000? 
A. $3
B. $6
C. $5
D. $4.17

35. What will be the basic EPS if average stock price during the year is $15 and treasury shares
that can be purchased are 6000? 
A. $3
B. $6
C. $5
D. $4.17

36. What will be the diluted EPS if average stock price during the year is $15 and treasury shares
that can be purchased are 6000? 
A. $3
B. $5
C. $6
D. $4.17

 
37. What will be the diluted EPS if average stock price during the year is $35 and treasury shares
that can be purchased are 1000? 
A. $3
B. $5
C. $6
D. $4.17

38. Which of the following is not an extraordinary item?

I. Loss on abandonment of property
II. Gain on disposal of a business segment
III. Effect of a strike against a key supplier
IV. Write-down of deferred research and development costs 
A. I and III
B. II and IV
C. I, II and III
D. I, II, III and IV

39. Which of the following overall accounting concepts has a number of exceptions under
GAAP? 
A. Historical cost
B. Transaction basis
C. Conservatism
D. Accrual accounting

40. When comparing expensing or capitalizing (with straight-line depreciation) software, return

on assets 
A. will decrease over time using capitalization.
B. will increase over time using capitalization.
C. will be constant using expensing.
D. will initially be higher under expensing.

 
41. The intrinsic value approach ignores two types of costs: 
A. Interest cost and opportunity cost
B. Opportunity cost and exercise cost
C. Interest cost and option cost
D. Carrying cost and interest cost

 
 

True / False Questions

 

42. Economic income and accounting income are always the same. 

FALSE

43. The matching principle in accounting prescribes that costs must be recognized in the same
period when the related revenues are recognized. 
TRUE

44. Revenue from sales where the buyer has the right of return can only be recognized after the
return period has expired. 
FALSE

45. If two firms are identical except that one firm uses percentage-of-completion accounting and
the other uses completed contract accounting for revenue recognition, the cash flows of the firms
will be identical. 
TRUE

46. Generally revenue should be recorded when it is probable and reasonably estimable. 

FALSE

47. Revenues are earned inflows that arise from the company's ongoing business activities. 
TRUE

 
48. Gains are earned inflows that arise from the company's ongoing business activities. 
FALSE

49. Comprehensive income is computed by adjusting net income for dirty surplus items. 
TRUE

50. For item to be considered extraordinary, it should be either unusual in nature or infrequent in

occurrence. 
FALSE

51. For item to be considered a special item, it should be either unusual in nature or infrequent in
occurrence but not both. 
TRUE

52. Accounting changes are usually cosmetic and do not yield cash flow consequences. 
TRUE

53. A long term asset is said to be impaired when its fair value is below its book value. 
TRUE

54. Under current accounting standards, gains and losses relating to the extinguishment of debt
must be both unusual and infrequent to be classified as an extraordinary item, and debt
refinancing does not typically meet these criteria. 
TRUE

55. One difference between revenues and gains is that gains arise from transactions that are
incidental to the operations of the business. 
TRUE

 
56. Smythe Corporation is in the real estate development business. If they sell a piece of land for
$50,000 that they had previously purchased for $45,000, they should record a loss of $5,000. 
FALSE

57. For companies in an expansion phase, capitalizing interest may result in higher earnings over
an extended period of time as the amount of interest amortization will not catch up with the
amount of interest capitalized in the current period. 
TRUE

58. The capitalization of interest costs during construction increases future net income. 
FALSE

59. Software costs may be capitalized once a company can show that the product is
technologically feasible. 
TRUE

60. A company that capitalizes costs, rather than expensing them will have a higher asset
turnover. 
FALSE

61. If revenue is recognized for financial reporting purposes but deferred for tax purposes this
results in a deferred tax liability. 
TRUE

62. If an expense is recognized for financial reporting purposes but not allowed as a bona-fide
deduction for tax purposes, this results in a deferred tax asset. 
FALSE

 
63. Extraordinary items are defined as those that are both unusual in nature and infrequent in
occurrence. These items are disclosed, net of tax in the income statement. 
TRUE

64. Accounting errors are considered accounting changes and treated accordingly. 

FALSE

65. When a company disposes of a segment of its business, it must restate all prior year financial
statements as if it had never owned that segment of the business. 
FALSE

66. A company that capitalizes rather than expenses software development costs, will have a less
volatile net income, all other things equal. 
TRUE

67. Comprehensive income differs from net income in that it reflects certain unrealized holding
gains and losses foreign currency translation adjustments, and minimum pension liability
adjustments. 
TRUE

68. If a company, operating in an inflationary environment, uses FIFO for tax purposes and
weighted-average for financial reporting purposes, this will result in a deferred tax asset. 
TRUE

69. Deferred taxes arise due to temporary timing differences in recognizing items for tax and
financial reporting purposes. 
TRUE

 
70. If a company depreciates an asset at a faster rate for tax purposes than for financial reporting
purposes this will give rise to a deferred tax liability. 
TRUE

71. A deferred tax liability imposes an obligation on the business to pay taxes. 
FALSE

72. Some items appear on a company's income statement but never appear on its tax return. 
TRUE

73. In order to determine permanent income for the year being analyzed, it is necessary to
consider special charges from other years. 
TRUE

74. Timing is one of the few revenue recognition issues that are seldom a concern in financial
analysis. 
FALSE

75. R&D expenses for tangible assets that have alternative future uses qualify as deferred
charges. 
TRUE

76. Employee stock options (ESOs) usually constitute a wealth transfer from current
shareholders to prospective shareholders (employees) and have no effect on total liabilities and
shareholders' equity. 
TRUE

 
77. Under long-term performance contracts—such as product warranty contracts and software
maintenance contracts—revenues are often collected in advance and are recognized
proportionally over the entire period of the contract. 
TRUE

78. ESOs often are granted to managers in growth and innovative industries to induce more risk-
taking. 
TRUE

 
 

Essay Questions
 
79. Problem One: Revenue Recognition from Long-Term Contract
Housing Construction Company (HCC) has agreed to build a housing project for the city of New
York. On January 1st, 2006 the company and the city agreed on the following terms, the
construction should take no more than 3 years, HCC would be paid a total of $150 million for the
project; the $150 million would be paid: 3 payments of $50 million each at the end of year 2006,
2007 and 2008. HCC expects contractions costs to be $50 million in year 2006, $50 million in
year 2007, and $10 million in year 2008.
a. If HCC uses the completed contract method, what revenues and expenses would HCC
recognize in year 2006, 2007, and 2008?
b. If HCC uses the percentage of completion method, what revenues and expenses would HCC
recognize in year 2006, 2007, and 2008?
c. Show the balance on the construction-in-process account at the end of 2006, 2007, and 2008
(prior to the completion of the project) using both the completed contract and the percentage of
completion methods? 

Problem One: Revenue Recognition from Long-Term Contract

a. Year 1 and Year 2: no revenues and expenses for the observatory project.
Year 3: $150M – $110M = $40M.
b. Year Revenue Expense Income
2006 (45.45%) x $150M =$68.18M $50M (45.45%) $ 18.18M
2007 (45.45%) x $150M =$68.18M $50M (45.45%) $ 18.18M
2008 ( 9.10%) x $150M =$13.64M $10M ( 9.10%) $ 3.64M
$150M $110M $ 40M
c. Year Completed Contract Method Percentage of Completion Method
1 $50M $68.18M
2 $50M + $50M = $100M $68.18M + 68.18M = $136.36M
3 100M + $50M = $150M $136.36M + $13.64M = $150M

 
80. Problem Two: Earnings per Share
The following information was obtained from Cyber Corporation's annual report.

a. Compute weighted-average number of common shares outstanding for the year.

b. Compute basic EPS.
c. Compute diluted EPS. 
Problem Two: Earnings per Share
a. Compute weighted-average number of common shares outstanding for the year.

Weighted average: 8,400,000 ¸ 12 = 700,000 shares

Compute basic EPS.

Basic Earnings per Share

Compute diluted EPS.

Preferred Shares—if converted

Options: Assumed exercised