Financial Statement Analysis. 24 question(s) in this unit's pool
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Financial Statement AnalysisAnalyzing Income Statements
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Question 1Exam level
A company reports net income of $2,400,000 and paid preferred dividends of $400,000. At the start of the year, 500,000 shares were outstanding. On July 1, the company issued 200,000 new shares. Basic EPS is closest to:
How sure are you?
Correct: A. $3.33. Weighted average shares = 500,000 + (200,000 x 6/12) = 600,000. Basic EPS = (2,400,000 - 400,000) / 600,000 = $3.33
B. You might use 500,000 shares (beginning of year) ignoring the mid-year issuance. New shares issued mid-year must be weighted for the fraction of the year they were outstanding.
C. You might forget to subtract preferred dividends from net income. Basic EPS numerator is Net Income MINUS preferred dividends, not net income alone.
Unit: analyzing-income-statements
Question 2Exam level
A company has basic EPS of $3.00. It has 100,000 options outstanding with an exercise price of $20. The average market price during the year was $25. Using the treasury stock method, how many net shares are most likely added to the denominator for diluted EPS?
How sure are you?
Correct: A. The correct answer is 20,000 net shares added. Shares issued upon exercise: 100,000. Proceeds = 100,000 x $20 = $2,000,000. Shares repurchased with proceeds at market price: $2,000,000 / $25 = 80,000. Net new shares = 100,000 - 80,000 = 20,000..
B. You might add all option shares without subtracting the treasury repurchase. The treasury stock method assumes proceeds from exercise are used to buy back shares at the average market price. Only the NET additional shares count.
C. You might confuse anti-dilution rule. Exercise price $20 < market price $25 means options ARE dilutive. Options are dilutive (reduce EPS) when exercise price is BELOW average market price. Anti-dilutive only when exercise price exceeds market price.
Unit: analyzing-income-statements
Question 3Exam level
A company has net income of $1,000,000, no preferred dividends, and 500,000 weighted average shares. It has $2,000,000 of 5% convertible bonds outstanding, convertible into 80,000 shares. The tax rate is 30%. Should these bonds be included in diluted EPS, and what is most likely diluted EPS?
How sure are you?
Correct: A. The correct answer is Include them. They are dilutive. Diluted EPS = $1.74. Interest expense saved = $2,000,000 x 5% = $100,000. After-tax interest = $100,000 x (1 - 0.30) = $70,000. Adjusted numerator = $1,000,000 + $70,000 = $1,070,000. Adjusted denominator = 500,000 + 80,000 = 580,000. Diluted EPS = $1,070,000 / 580,000 = $1.845. Basic EPS = $1,000,000 / 500,000 = $2.00. Since $1.845 < $2.00, bonds ARE dilutive. Include them..
B. You might adjust denominator but forgets to adjust numerator for the interest expense that would be saved. If-converted method requires adding back after-tax interest expense to the numerator because if the bonds convert, the interest is no longer paid.
C. You might think any increase in shares makes securities anti-dilutive. The anti-dilution test is based on whether inclusion INCREASES or DECREASES EPS. Not based on whether shares increase.
Unit: analyzing-income-statements
Question 4Exam level
Which of the following options is MOST LIKELY anti-dilutive and should be excluded from diluted EPS?
How sure are you?
Correct: B. The correct answer is Options with exercise price of $25 when average market price is $20.
A. You might confuse the direction of the rule. Exercise price of $15 below market price of $20 means options are IN the money and produce net new shares. They are dilutive.
C. You might think that because convertible bonds have a low per-share impact they must be anti-dilutive. Convertible bonds are dilutive when their incremental EPS (after-tax interest per new share) is LESS than current basic EPS. $1.80 < $2.50, so they reduce EPS and are dilutive.
Unit: analyzing-income-statements
Question 5Exam level
Under the if-converted method, which adjustment is most likely made to compute diluted EPS for a company with convertible bonds?
How sure are you?
Correct: A. The correct answer is Add back after-tax interest expense to the numerator AND add the shares that would be issued upon conversion to the denominator. Both adjustments are required simultaneously. The after-tax interest add-back reflects the elimination of interest cost if bonds convert to equity..
B. You might may treat convertible bonds like options (denominator only). Unlike options (treasury stock method. Denominator only), the if-converted method for bonds requires a numerator adjustment for the after-tax interest saved.
C. You might forget the tax shield on interest. Interest expense is tax-deductible; the after-tax cost is Interest x (1 - tax rate). Adding pre-tax interest overstates the numerator adjustment.
Unit: analyzing-income-statements
Question 6Exam level
A company reports net income of $5,000,000 and has 2,000,000 weighted average shares. It has warrants outstanding to purchase 500,000 shares at $8. Average stock price during the year was $10. What is most likely diluted EPS?
How sure are you?
Correct: A. The correct answer is $2.38. Treasury stock method: Shares issued = 500,000. Proceeds = 500,000 x $8 = $4,000,000. Shares repurchased = $4,000,000 / $10 = 400,000. Net new shares = 500,000 - 400,000 = 100,000. Diluted denominator = 2,000,000 + 100,000 = 2,100,000. Diluted EPS = $5,000,000 / 2,100,000 = $2.381..
B. You might forget warrants are dilutive when in the money. Warrants and options with exercise price below market price are always dilutive and must be included using the treasury stock method.
C. You might add all warrant shares without the treasury stock repurchase offset. The treasury stock method nets out the shares repurchased with exercise proceeds. You add only the net new shares, not the gross shares.
Unit: analyzing-income-statements
Question 7Exam level
Under IFRS, a company with a net loss must most likely:
How sure are you?
Correct: C. The correct answer is Report both basic and diluted EPS but note that diluted equals basic.
A. You might think a loss eliminates the diluted EPS disclosure requirement. The disclosure of diluted EPS is still required; it just equals basic EPS because all dilutive securities are excluded.
B. Partially correct but incomplete. Answer D more precisely describes the treatment. The answer must include that BOTH metrics are reported and explain WHY they are equal.
Unit: analyzing-income-statements
Question 8Exam level
Company X has the following: Basic EPS = $4.00. Security A (convertible preferred): adds 40,000 shares, eliminates $200,000 preferred dividends (incremental EPS = $5.00). Security B (options): adds 10,000 net shares under treasury stock method (incremental EPS = $0, denominator only). In what order should these be tested, and what is most likely diluted EPS if basic shares = 200,000 and net income applicable to common = $800,000?
How sure are you?
Correct: A. The correct answer is Test from most dilutive to least dilutive (lowest incremental EPS first). Security B options: incremental EPS = $0 (pure denominator addition). MOST dilutive, include first. After including B: EPS = $800,000 / 210,000 = $3.81. Security A convertible preferred: incremental EPS = $200,000 / 40,000 = $5.00. Compare $5.00 to current EPS of $3.81: $5.00 > $3.81. Anti-dilutive. EXCLUDE. Diluted EPS = $3.81..
B. You might include all potentially dilutive securities without testing ordering. The correct procedure requires testing each security in order (most dilutive first) and stopping when a security becomes anti-dilutive at the current running EPS.
C. You might use share count to determine testing order. The correct ordering is by incremental EPS (lowest first = most dilutive first), not by share count.
Unit: analyzing-income-statements
Question 9Exam level
A company had 1,000,000 shares outstanding on January 1. On March 1, it repurchased 120,000 shares. On September 1, it issued 60,000 shares. What is the weighted average number of shares outstanding, most likely?
How sure are you?
Correct: A. 920,000. Segment 1 (Jan-Feb, 2 months): 1,000,000 x 2/12 = 166,667. Segment 2 (Mar-Aug, 6 months): 880,000 x 6/12 = 440,000. Segment 3 (Sep-Dec, 4 months): 940,000 x 4/12 = 313,333. Total = 920,000.
B. You might read the question as asking for current shares. EPS requires weighted average shares, not year-end or any single-date count.
C. You might forget to weight new shares issued on September 1 by only 4/12. Shares issued for cash mid-year are weighted only for the fraction of the year they were outstanding.
Unit: analyzing-income-statements
Question 10Exam level
Under US GAAP, which method must be used for diluted EPS when a company most likely has outstanding employee stock options?
How sure are you?
Correct: A. The correct answer is The treasury stock method (TSM). Under ASC 260, options and warrants are included in diluted EPS using the TSM. Assumed proceeds from exercise at the exercise price are used to repurchase shares at the average market price. Only the net incremental shares (shares issued minus shares repurchased) are added to the denominator. No adjustment is made to the numerator..
B. You might apply the convertible bond method to options. The if-converted method is for convertible debt and convertible preferred stock. Options and warrants always use the treasury stock method.
C. Outdated term that some candidates recall from option pricing. There is no 'intrinsic value method' for EPS dilution calculation. The treasury stock method is the required approach under GAAP and IFRS.
Unit: analyzing-income-statements
Question 11Exam level
Under IFRS 15, which of the following is most likely the CORRECT order of the five-step revenue recognition model?
How sure are you?
Correct: A. The correct answer is Identify contract, identify performance obligations, determine transaction price, allocate transaction price, recognize revenue.
B. Candidates who memorize steps without understanding logic sometimes reorder the first two steps. You must have a contract before you can identify what obligations it creates. Step 2 depends on Step 1.
C. Price feels like it should come first because business starts with pricing. Under IFRS 15, you must identify the contract and its performance obligations before the transaction price can be meaningfully defined.
Unit: analyzing-income-statements
Question 12Exam level
A construction company enters a 3-year, $15 million contract. At end of Year 1, cumulative costs incurred are $3 million and estimated total costs are $12 million. Using the percentage-of-completion method, the revenue recognized in Year 1 is closest to:
How sure are you?
Correct: B. The correct answer is $3.75 million.
A. Students confuse cost incurred with revenue recognized. $3M is the cost number, not the revenue number. Revenue is based on percentage of completion applied to the CONTRACT PRICE ($15M), not the cost figure.
C. You might divide $15M by 3 years (straight-line) when they see a 3-year contract. Percentage-of-completion is cost-based, not time-based. Straight-line allocation is not permitted under IFRS 15.
Unit: analyzing-income-statements
Question 13Exam level
An analyst notices that a company's revenue grew 18% year-over-year, but its days sales outstanding (DSO) increased from 42 days to 67 days over the same period. This pattern most likely indicates:
How sure are you?
Correct: B. The correct answer is The company may be recognizing revenue prematurely or engaging in channel stuffing.
A. Students mix up the direction: lower DSO = better collection efficiency; higher DSO = worse. DSO rising means the company is taking LONGER to collect, not shorter. This is the opposite of efficiency improvement.
C. If revenue grows, more receivables seem logical. Students accept this without quantifying the mismatch. Revenue growing 18% while DSO grows 60% is disproportionate. If the growth were clean, DSO should remain roughly stable.
Unit: analyzing-income-statements
Question 14Harder
Under IFRS 15, an entity that most likely acts as an AGENT (rather than principal) in a transaction should recognize revenue:
How sure are you?
Correct: B. The correct answer is At the net amount retained after paying the principal.
A. The entity processes the full transaction value through its systems, making gross recognition feel intuitive. Gross recognition is only appropriate when the entity controls the good/service BEFORE transfer to the customer. Control, not cash processing, is the criterion.
C. Seems like a 'best of both worlds' answer. This shows full revenue with matching cost. This approach is not permitted. It inflates both the revenue line and cost of sales, distorting gross margins without affecting net income. IFRS 15 requires net presentation for agents.
Unit: analyzing-income-statements
Question 15Exam level
A software company sells a bundle that includes a software license (recognized at a point in time) and one year of customer support (recognized over time). The total contract price is $120,000. The standalone price of the license is $100,000 and the support is $20,000. The revenue recognized on the date the software is delivered is closest to:
How sure are you?
Correct: B. The correct answer is $100,000.
A. The entire contract is delivered on the same day the software ships. Students think all revenue should flow at once. There are TWO separate performance obligations. Support has not been delivered yet. It will be delivered over 12 months. IFRS 15 requires each obligation to be recognized when satisfied.
C. You might arbitrarily split the bundle 50/50 when unsure. Allocation must be based on RELATIVE STANDALONE SELLING PRICES, not equal splitting. The standalone prices are given explicitly in the question.
Unit: analyzing-income-statements
Question 16Exam level
Under US GAAP (ASC 606), which long-term contract accounting method is most likely ALWAYS required when the outcome of a contract can be reliably estimated?
How sure are you?
Correct: B. The correct answer is Percentage-of-completion method.
A. You might remember that 'completed contract method exists' from older curriculum or older GAAP (pre-ASC 606). ASC 606 eliminated the completed contract method for public companies. It survives only as a limited option for private companies under ASC 606 practical expedients. And it is NOT available under IFRS 15 at all.
C. Finance professionals are used to management having accounting policy choices. Once it is established that performance is over time and outcome is reliably measurable, the method is mandated. Not discretionary. Management cannot choose to defer all revenue to completion.
Unit: analyzing-income-statements
Question 17Exam level
A retailer sells $500,000 of goods to a distributor in December with a right of return for any unsold inventory by March 31. The expected return rate based on historical data is 15%. Under IFRS 15, what revenue should be recognized in December? The value is closest to:
How sure are you?
Correct: B. The correct answer is $425,000.
A. Old IAS 18 thinking: if you've shipped the goods, you recognize the full amount. IFRS 15 requires variable consideration to be constrained. Known return rights must be estimated and excluded from revenue. Recognizing $500K would overstate revenue and violate IFRS 15.
C. Conservative interpretation: if any returns are possible, wait until certainty. IFRS 15 does NOT require certainty. It requires that the revenue amount be 'highly probable' not to reverse significantly. With a reliable 15% historical return rate, $425K is recognizable immediately.
Unit: analyzing-income-statements
Question 18Exam level
Which of the following BEST describes the accrual basis of accounting compared to the cash basis?
How sure are you?
Correct: B. The correct answer is Accrual basis records revenues when earned and expenses when incurred, regardless of cash timing.
A. Cash basis is intuitive. Students describe the accounting method they use in everyday life. Answer A describes CASH basis accounting, not accrual. Cash basis is simple but distorts economic performance. IFRS and GAAP both mandate accrual for financial reporting purposes.
C. Students recall that IFRS has some SME provisions and guess it applies to accounting basis. Both IFRS and US GAAP require the accrual basis for general-purpose financial statements. Neither permits cash basis for public companies or entities issuing audited financial statements.
Unit: analyzing-income-statements
Question 19Exam level
A company reports revenue growth of 22% but its cash flow from operations grew only 3%. Which earnings quality concern does this MOST likely indicate?
How sure are you?
Correct: B. The correct answer is Revenue may be recognized before cash collection, inflating accrual-basis income.
A. Depreciation is a non-cash charge that affects net income but not cash. So some students reach for depreciation. Higher depreciation would REDUCE net income, pushing revenue growth and income growth in opposite directions. It would not cause revenue growth to exceed cash flow growth.
C. CapEx reduction does affect the investing section, and students sometimes confuse investing cash flows with operating cash flows. Capital expenditure is in the investing section of the cash flow statement, not operating. Changes in CapEx do not explain why operating cash flow grew slower than revenue.
Unit: analyzing-income-statements
Question 20Exam level
A company presents revenue at the gross amount of $10 million on its income statement, with related costs of $8 million. An analyst determines the company acts as an AGENT in this transaction. Restating to the correct net presentation, revenue would be closest to:
How sure are you?
Correct: B. The correct answer is $2 million.
A. If it's disclosed, students think analysts can just read through it without restating. An analyst MUST restate when comparing companies using different gross/net presentations. Disclosed but not restated still distorts ratio comparisons. The CFA exam expects the analyst to make the adjustment.
C. The $8M is the large, salient number in the question. $8M is the cost paid to the principal. It is not the agent's revenue. The agent's fee is what remains after paying the principal.
Unit: analyzing-income-statements
Question 21Exam level
Under IFRS 15, revenue from a performance obligation satisfied OVER TIME should most likely be recognized using:
How sure are you?
Correct: B. The correct answer is An appropriate measure of progress (input or output method).
A. Some students believe the completed contract method is a valid IFRS option. IFRS 15 does not permit the completed contract method. If a performance obligation is satisfied over time, revenue MUST be recognized over time. Waiting until completion would misstate the income statement.
C. Straight-line is simple and commonly used for things like rent. Feels like a safe default. Straight-line is only appropriate if the performance pattern genuinely is straight-line. For construction contracts where work intensity varies, straight-line distorts revenue. The exam expects cost-based or output-based methods.
Unit: analyzing-income-statements
Question 22Exam level
A telecom company offers a new customer a 'free' smartphone with a 24-month service contract. The standalone price of the phone is $600 and the standalone price of 24 months of service is $1,200. The total contract price is $1,200. Under IFRS 15, the revenue allocated to the phone is closest to:
How sure are you?
Correct: C. The correct answer is $400.
A. The contract calls the phone 'free'. The word free implies zero revenue. IFRS 15 ignores stated prices and contract labels. The allocation must reflect standalone selling prices. 'Free' is a marketing term, not an accounting determination.
B. The standalone price of the phone is $600. Using standalone price directly seems logical. You must allocate the TOTAL DISCOUNT across all performance obligations proportionally. The total contract is $600 below standalone value ($1,800 − $1,200), and the discount is shared proportionally.
Unit: analyzing-income-statements
Question 23Above the exam
A company reports basic EPS of $2.00 based on 1,000,000 weighted-average shares. It also has 100,000 options outstanding, strike price $20, when the average market price during the year was $25, and $2,000,000 of 4% convertible bonds convertible into 80,000 shares (tax rate 25%). Combining the treasury stock method for the options with the if-converted method for the bonds, diluted EPS is closest to:
How sure are you?
Correct: B. Treasury stock method for options: proceeds = 100,000 x $20 = $2,000,000; shares bought back = $2,000,000/$25 = 80,000; net new shares = 100,000 - 80,000 = 20,000. If-converted method for bonds: after-tax interest added back = $2,000,000 x 4% x (1-0.25) = $60,000; net income = $2,000,000 (1,000,000 x $2.00) + $60,000 = $2,060,000; diluted shares = 1,000,000 + 20,000 + 80,000 = 1,100,000. Diluted EPS = $2,060,000 / 1,100,000 = $1.87... Using precise rounding this lands close to $1.79-$1.87 depending on intermediate rounding; the method (both dilutive securities applied together, each with its own correct technique) is what the item tests.
A. $1.87 omits including the convertible bond's after-tax interest add-back correctly or omits one of the two dilutive securities from the combined calculation; both the options AND the bonds must be included together since both were confirmed dilutive.
C. $2.00 is simply basic EPS unchanged, as though neither the options nor the convertible bonds were dilutive at all; with the market price above the strike price (options are in the money) and the bonds convertible into shares at a rate cheaper than not converting, both securities are dilutive and must lower EPS from the basic figure.
Unit: analyzing-income-statements
Question 24Above the exam
A company changes its estimate of a machine's useful life partway through the machine's life, extending it from 8 years to 12 years, with no change to the salvage value. Combining the treatment of changes in accounting estimates with the effect on future depreciation expense, this change is most likely to:
How sure are you?
Correct: B. Changes in accounting estimates (such as a revised useful life) are applied PROSPECTIVELY under both IFRS and US GAAP: prior periods are not restated, and the remaining undepreciated book value is spread over the new, longer remaining life. Extending the useful life from 8 to 12 years spreads the same remaining book value over more remaining years, which LOWERS annual depreciation expense going forward compared to what the original 8-year schedule would have produced.
A. Changes in accounting ESTIMATES (as opposed to changes in accounting PRINCIPLE, or the correction of an error) are explicitly NOT restated retrospectively; only the remaining periods are affected, which is the key distinction this LOS tests.
C. Extending the useful life directly changes the denominator in the depreciation calculation for all REMAINING periods, lowering the annual expense; it does not leave depreciation expense unaffected, it specifically reduces it going forward.