Question 1

2.A.4.e
qual.earn.tb.025_2210
LOS: 2.A.4.e
Lesson Reference: Quality of Earnings
Difficulty: hard
Bloom Code: 5

Which of the following companies would an analyst conclude has relatively low earnings quality?

A A company that increases its net income by reducing spending on employee training
B A company that increases its net income by reducing spending on research and development
C A company that increases its net income by reducing its spending on manufacturing labor

Your Answer

A, B, and C

B and C

A only
Correct

A and B

Rationale
 A, B, and C
This answer is incorrect. Manufacturing labor is not a type of discretionary spending.

Rationale
 B and C
This answer is incorrect. Manufacturing labor is not a type of discretionary spending. In addition,
employee training is a type of discretionary spending.

Rationale
 A only
This answer is incorrect. Research and development is a type of discretionary spending.

Rationale
 A and B
Correct. Earnings quality refers to how useful reported earnings are as a measure of performance.
Higher quality earnings provide more useful information about a company than do lower quality
earnings. When companies make decisions that make reported earnings look better but that do not
actually improve performance, earnings quality suffers. One example is a decision to cut discretionary
spending as this improves current income while hurting future income. Employee training and research
and development are both types of discretionary spending. However, manufacturing labor is not a type
of discretionary spending.
Question 2
2.A.2.o
profit.use.tb.010_2204
LOS: 2.A.2.o
Lesson Reference: Efficiency Ratios – Use of Assets
Difficulty: easy
Bloom Code: 3

The FWJ Company has the following financial information:

Year 1 Year 2
Sales $100,000 $110,000
Net income $10,000 $13,200
Total assets $50,000 $52,000
PPE, Gross $30,000 $35,000
Accumulated Depreciation $10,000 $11,000

What is FWJ’s total asset turnover in Year 2?

Correct

2.16

2.12

2.06

0.26

Rationale
 2.16
Correct. One way to assess an organization’s profitability is to measure how well the organization uses
its assets to generate sales revenue. One such measure is total asset turnover. This measure tells how
much sales revenue is generated by each dollar of average total assets. Higher numbers are generally
preferred as it indicates better use of assets. The formula is “Sales / Average Total Assets.” It is
important to remember that “average total assets” are used in the formula, not total assets for a single
year. This gives a better measure of the total assets in use while the sales are generated than total
assets for one year. In this example, FWJ’s average total assets for Year 2 is $51,000 (average of $50,000
and $52,000). This results in total asset turnover of 2.16 ($110,000 / $51,000).

Rationale
 2.12
This answer is incorrect. Total assets just for Year 2 are not used to calculate total asset turnover.

Rationale
 2.06
This answer is incorrect. Average sales for the two-year period are not used to calculate total asset
turnover.

Rationale
 0.26
This answer is incorrect. Net income is not used to calculate total asset turnover.
Question 3
2.A.2.y
sources.fin.tb.0007_2104
LOS: 2.A.2.y
Lesson Reference: Sources of Financial Information and Their Use in Evaluating a Company’s Financial
Strength
Difficulty: hard
Bloom Code: 6
You have been investing in Ingram Energy for several years. The company is a traditional energy company
that derives most of its energy from coal and oil. During this time period, Ingram’s liquidity and solvency
ratios have been holding steady while its profitability and leverage ratios have been increasing. Recently,
legislation was passed that will require all energy companies to drastically lower emission levels while
simultaneously limiting the amount of energy that may be generated from coal. What action, if any, should
you take at this time?
Do nothing. The company’s ratios are good, and the legislation will have no impact on expected future
returns.
Your Answer

Compare Ingram Energy’s financial ratios to other energy companies, especially those that are generating
solar energy.
Correct

Do further research to see how prepared Ingram Energy is to meet these challenges.

Sell now, Ingram Energy is a high risk.

Rationale
 Do nothing. The company’s ratios are good, and the legislation will have no impact on
expected future returns.
This answer is incorrect. Evaluating a company’s future health requires including relevant nonfinancial
information.

Rationale
 Compare Ingram Energy’s financial ratios to other energy companies, especially those that are
generating solar energy.
This answer is incorrect. While this information may be interesting, it will not address the risk that
Ingram Energy is facing from regulatory changes.

Rationale
 Do further research to see how prepared Ingram Energy is to meet these challenges.
This answer is correct. When evaluating a company’s financial strength, savvy investors will review
ratios as well as incorporate industry issues like changing regulations into their assessment of the
future financial health of that company.

Rationale
 Sell now, Ingram Energy is a high risk.
This answer is incorrect. While the regulatory changes are threatening, if Ingram Energy had the
foresight to strategize alternatives, they may be poised to turn this challenge into potential growth in
the long run.
Question 4
2.A.2.q
tb.profit.vertical.024_1711
LOS: 2.A.2.q
Lesson Reference: Profitability – Vertical Analysis Revisited and Return Ratios
Difficulty: medium
Bloom Code: 3

Harvey Roofing reported the following information:

December 31,
20×7 20×6
5% Cumulative preferred stock, $50 par $100,000 $100,000
Common stock, $10 par 140,000 90,000
Additional paid-in capital 80,000 70,000
Retained earnings (includes current year net income) 240,000 210,000
Net income 60,000

What is their rate of return on common stock equity for 20x7 (in thousands)?

Your Answer

60 ÷ 460
Correct

55 ÷ 415

60 ÷ 415

55 ÷ 460

Rationale
 60 ÷ 460
The rate of return on common equity (ROCE) expresses the amount of net income available to common
shareholders per dollar of average common equity. Higher values are preferred as it indicates that the
company has generated more income for common shareholders per dollar of average common equity.
Net income available to common shareholders is defined as Net Income – Preferred Dividends.
Preferred dividends are subtracted because they are unavailable to common shareholders. The rate of
return on common equity is defined as Net Income Available to Common Shareholders ÷ Average
Common Equity. Harvey's ROCE would be $60 ÷ $460 [($140 + $90 + $80 + $70 + $240 + $210) ÷ 2] if
preferred dividends are not subtracted to get the numerator and ending common equity is used as the
denominator. Therefore, this is an incorrect answer.

Rationale
 55 ÷ 415
The rate of return on common equity (ROCE) expresses the amount of net income available to common
shareholders per dollar of average common equity. Higher values are preferred as it indicates that the
company has generated more income for common shareholders per dollar of average common equity.
Net income available to common shareholders is defined as Net Income – Preferred Dividends.
Preferred dividends are subtracted because they are unavailable to common shareholders. The rate of
return on common equity is defined as Net Income Available to Common Shareholders ÷ Average
Common Equity. Harvey's ROCE is [($60 − $5) ÷ $415 [($140 + $90 + $80 + $70 + $240 + $210) ÷ 2]].
Therefore, this is the correct answer.

Rationale
 60 ÷ 415
The rate of return on common equity (ROCE) expresses the amount of net income available to common
shareholders per dollar of average common equity. Higher values are preferred as it indicates that the
company has generated more income for common shareholders per dollar of average common equity.
Net income available to common shareholders is defined as Net Income – Preferred Dividends.
Preferred dividends are subtracted because they are unavailable to common shareholders. The rate of
return on common equity is defined as Net Income Available to Common Shareholders ÷ Average
Common Equity. Harvey's ROCE would be $60 ÷ $415 [($140 + $100 + $80 + $70 + $240 + $210) ÷ 2] if
preferred dividends are not subtracted to get the numerator. Therefore, this is an incorrect answer.

Rationale
 55 ÷ 460
The rate of return on common equity (ROCE) expresses the amount of net income available to common
shareholders per dollar of average common equity. Higher values are preferred as it indicates that the
company has generated more income for common shareholders per dollar of average common equity.
Net income available to common shareholders is defined as Net Income – Preferred Dividends.
Preferred dividends are subtracted because they are unavailable to common shareholders. The rate of
return on common equity is defined as Net Income Available to Common Shareholders ÷ Average
Common Equity. Harvey's ROCE would be $55 ÷ $460 if ending common equity is used as the
denominator. Therefore, this is an incorrect answer.
Question 5
2.A.2.l
tb.eff.ratios.009_1711
LOS: 2.A.2.l
Lesson Reference: Efficiency Ratios
Difficulty: medium
Bloom Code: 4
How is accounts receivable turnover computed?
By dividing total sales by average net accounts receivable

By dividing cost of goods sold by ending receivables

By dividing net credit sales by average receivables

By dividing net credit sales by ending receivables

Rationale
 By dividing total sales by average net accounts receivable
Accounts receivable turnover is calculated as Net Credit Sales ÷ Average Accounts Receivables. Using
total sales is not correct since total sales includes cash sales. Therefore, this is an incorrect answer.

Rationale
 By dividing cost of goods sold by ending receivables
Accounts receivable turnover is calculated as Net Credit Sales ÷ Average Accounts Receivables. Using
cost of goods sold is not correct since cost of goods sold relates to inventory, not accounts receivable.
Therefore, this is an incorrect answer.

Rationale
 By dividing net credit sales by average receivables
Accounts receivable turnover is calculated as Net Credit Sales ÷ Average Accounts Receivables.
Therefore, this is the correct answer.

Rationale
 By dividing net credit sales by ending receivables
Accounts receivable turnover is calculated as Net Credit Sales ÷ Average Accounts Receivables. Using
ending receivables is not correct since the ending balance does not reflect the entire year like the
average receivables balance does. Therefore, this is an incorrect answer.
Question 6
2.A.1.c
cma11.p2.t1.me.0025_0820
LOS: 2.A.1.c
Lesson Reference: Horizontal Financial Statement Analysis
Difficulty: medium
Bloom Code: 4

Assume the following sales data for a company:

2018: $980,000
2017: 875,000
2016: 700,000

If 2016 is the base year, what is the percentage increase in sales from 2016 to 2017?

  140%

  125%

  40%

  25%

Rationale
 This Answer is Incorrect
This answer is incorrect. 2018 sales are 140% of 2016 sales. ($980,000 ÷ $700,000 = 140%)

Rationale
 This Answer is Incorrect
This answer is incorrect. 2017 sales are 125% of 2016 sales ($875,000 ÷ $700,000 = 125%), which is
different from a 125% increase in sales between 2016 and 2017.

Rationale
 This Answer is Incorrect
This answer is incorrect. The percentage increase in sales from 2016 to 2018 is 40%.

Rationale
 This Answer is Incorrect
This answer is correct. The percentage increase in sales from 2016 to 2017 is 25%. ($875,000 - $700,000)
÷ $700,000 = 25%. 
Question 7
2.A.2.s
tb.profit.market.004_1711
LOS: 2.A.2.s
Lesson Reference: Profitability – Market Value Ratios
Difficulty: medium
Bloom Code: 3

Payne Industries reported the following information in its 20x6 and 20x7 financial statements.

The book value per share for Payne Industries at 12/31/x7 is

$10.92.

$9.94.
Correct

$11.00.

$8.89.

Rationale
 $10.92.
Book value per share measures the book value (from the balance sheet) per share of common equity. It
does not include preferred equity. It is defined as Common Equity ÷ Common Shares Outstanding.
Payne's book value per share would be $10.92 if the preferred dividends are subtracted when
calculating the numerator ($1,965,000 ÷ 180,000). This is not correct since preferred dividends do not
reduce common equity. Therefore, this is an incorrect answer.

Rationale
 $9.94.
Book value per share measures the book value (from the balance sheet) per share of common equity. It
does not include preferred equity. It is defined as Common Equity ÷ Common Shares Outstanding.
Payne's book value per share would be $9.94 if the average common equity for 20x7 is used as the
numerator ($1,790,000 ÷ 180,000). Since book value per share is measured as of a particular day, the
common equity used is as of that particular day. Therefore, this is an incorrect answer.

Rationale
 $11.00.
Book value per share measures the book value (from the balance sheet) per share of common equity. It
does not include preferred equity. It is defined as Common Equity ÷ Common Shares Outstanding.
Payne's book value per share as of 12/31/x7 is $11.00 ($1,980,000 ÷ 180,000). Therefore, this is the
correct answer.

Rationale
 $8.89.
Book value per share measures the book value (from the balance sheet) per share of common equity. It
does not include preferred equity. It is defined as Common Equity ÷ Common Shares Outstanding.
Payne's book value per share as of 12/31/x6 is $8.89 ($1,600,000 ÷ 180,000). However, the question asks
for book value per share as of 12/31/x7. Therefore, this is an incorrect answer.
Question 8
2.A.2.y
sources.fin.tb.0005_2104
LOS: 2.A.2.y
Lesson Reference: Sources of Financial Information and Their Use in Evaluating a Company’s Financial
Strength
Difficulty: medium
Bloom Code: 3
You heard a rumor that Herringbone Corp. may be having trouble paying its bills. As a smart investor, you
plan to check the company’s financial results, calculate some ratios, and evaluate the veracity of this rumor.
What types of ratios would be most helpful in your analysis?
Profitability and leverage ratios

Solvency and profitability ratios

Leverage and solvency ratios

Solvency and liquidity ratios

Rationale
 Profitability and leverage ratios
This answer is incorrect. While current profitability and reliance on fixed costs and/or debt can be
helpful in calculating a company’s financial health, they are not the best ratios for figuring out if the
company really is having trouble paying its bills at this time.

Rationale
 Solvency and profitability ratios
This answer is incorrect. While current profitability and long-term ability to pay bills can be helpful in
calculating a company’s financial health, they are not the best ratios for figuring out if the company
really is having trouble paying its bills at this time.

Rationale
 Leverage and solvency ratios
This answer is incorrect. While a company’s reliance on fixed cost and/or debt and their long-term
ability to pay bills can be helpful in calculating a company’s financial health, they are not the best ratios
for figuring out if the company really is having trouble paying its bills at this time.

Rationale
 Solvency and liquidity ratios
This answer is correct. Liquidity ratios help investors to evaluate the ability of the company to pay
short-term liabilities as they come due. Solvency ratios assess the ability of the company to pay all
liabilities, including long-term liabilities, as they come due. Both of these ratios should help to reveal if
Herringbone Corp. is actually having trouble paying its bills and whether this is likely to be a short-term
or long-term issue for the company.
Question 9
2.A.2.w
limit.ratio.tb.019_2210
LOS: 2.A.2.w
Lesson Reference: Limitations of Ratio Analysis
Difficulty: hard
Bloom Code: 5
Which of the following factors is least important when comparing the profit margins (return on sales) of two
companies?
Correct

The outsourcing approach of each company

The average age of each company’s products

The accounting estimates used

The strategy each company pursues

Rationale
 The outsourcing approach of each company
Correct. Ratio analysis is a powerful tool for assessing company performance. However, there are some
potential problems with ratio analysis. It is important to compare a company’s ratios to a competitor’s
ratios to provide perspective to the figures. The comparison company should have similar product
offerings. It is also important that the two companies use similar accounting estimates as different
estimates can result in different accounting numbers. It is generally not a problem if the companies
take different approaches to outsourcing certain activities or services (for example, production or
maintenance) as the cost paid to purchase these activities and services is likely to be similar to the cost
paid to provide them internally. This means the profit margins will not be significantly impacted by the
outsourcing approach used.

Rationale
 The average age of each company’s products
This answer is incorrect. Since more established products may have different profit margins than newer
products, comparing profit margins of two companies with products having significantly different
average ages may give misleading results.

Rationale
 The accounting estimates used
This answer is incorrect. Since using different accounting estimates is likely to cause differences in
figures such as depreciation expense and bad debt expense, comparing profit margins of two
companies using significantly different estimates may give misleading results.

Rationale
 The strategy each company pursues
This answer is incorrect. Since different strategies may result in different expected profit margins, (for
example, a company pursuing a cost leadership strategy will tend to have a lower profit margin than a
company pursuing a product differentiation strategy), comparing profit margins of two companies
pursuing different strategies may give misleading results.
Question 10
2.A.4.c
changes.acct.tb.020_2204
LOS: 2.A.4.c
Lesson Reference: Changes in Accounting Treatment
Difficulty: medium
Bloom Code: 4
Which of the following actions would not be taken if a company changes from LIFO to FIFO to account for its
inventory?
Correct

Record the cumulative impact on net income of the change in the current year’s income.
Your Answer

Adjust prior-period financial statements as if FIFO had always been used.

Recalculate financial ratios.

Adjust the earliest retained earnings presented.

Rationale
 Record the cumulative impact on net income of the change in the current year’s income.
Correct. When a company changes from one GAAP approved method to another GAAP approved
method, it uses the retrospective method to account for the change. Changing from LIFO to FIFO
qualifies as a change in accounting method. Under the retrospective method, prior statements are
adjusted to look “as if” the new method had always been used. This means that financial ratios will
need to be recalculated. To account for the impact of the change on net income for years not
presented, the beginning retained earnings balance for the first year presented is adjusted. There is no
impact on the current year’s net income.

Rationale
 Adjust prior-period financial statements as if FIFO had always been used.
This answer is incorrect. Changing from LIFO to FIFO qualifies as a change in accounting method. As
such, the retrospective method is used to account for the change. The retrospective method requires
that prior statements be adjusted to look “as if” the new method had always been used.

Rationale
 Recalculate financial ratios.
This answer is incorrect. Changing from LIFO to FIFO qualifies as a change in accounting method. As
such, the retrospective method is used to account for the change. Because past financial statements
change under the retrospective method, financial ratios need to be recalculated.

Rationale
 Adjust the earliest retained earnings presented.
This answer is incorrect. Changing from LIFO to FIFO qualifies as a change in accounting method. As
such, the retrospective method is used to account for the change. The retrospective method requires
that the cumulative effect on net income of the change be accounted for by adjusting the retained
earnings balance of the earliest period presented.