Financial Reporting and Analysis【 Reading 25】Sample reported, disposal, following, 2012, net

sabaruch

Duster Corporation’s year-end income statement reported the following:

Operating income		$187,000
Results from discontinued operations:
Loss from segment operations
(net of $1,440 tax effect)	($2,160)
Gain on segment disposal
(net of $8,640 tax effect)	12,960	10,800
Gain on sale of equipment		3,400
Interest expense		12,400
Extraordinary loss
(net of $2,200 tax benefit)		3,300
Income tax expense		71,200

Calculate Duster’s income from continuing operations for the year.

A) $103,500.

B) $106,800.

C) $114,300.

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Income from continuing operations includes all revenues and expenses except discontinued operations and extraordinary items: $187,000 operating income + $3,400 gain on sale of equipment – $12,400 interest expense – $71,200 income tax expense = $106,800.

sabaruch

Galaxy Company recognized a restructuring charge in its year-end income statement. Similar restructuring charges have occurred in the past. In addition, Galaxy recognized an extraordinary loss. Galaxy uses the term “operational earnings” when discussing its financial results. According to Galaxy, “operational earnings” excludes special nonrecurring transactions such as restructuring charges, discontinued operations, and extraordinary items. Should the restructuring charge and extraordinary loss be included or excluded from “operational earnings” for analytical purposes?

A) One is included.

B) Both are included.

C) Both are excluded.

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The restructuring charge does not appear to be nonrecurring; thus, it should be included in “operational earnings.” By definition, an extraordinary loss is unusual in nature and infrequent in occurrence. Therefore, the extraordinary loss should be excluded from “operational earnings.”

sabaruch

Which of the following statements about financial disclosures are correct or incorrect?

Statement #1:	Transitory earnings are usually more important to investors than permanent earnings.
Statement #2:	Pro-forma earnings are usually prepared in accordance with generally accepted accounting principles.

A) Both are incorrect.

B) Only statement #1 is incorrect.

C) Only statement #2 is incorrect.

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Statement #1 is incorrect. Investors are usually more interested in permanent earnings. Statement #2 is incorrect. Pro-forma earnings are not prepared in accordance with generally accepted accounting principles because they may exclude certain transactions. This is why it is important for an analyst to understand the disclosures

sabaruch

As compared to an operating lease, which of the following best describes the impact of a finance lease on earnings before interest and taxes (EBIT) and operating cash flow (OCF) according to U.S. generally accepted accounting principles?

EBIT

OCF

A) Higher Higher

B) Lower Higher

C) Higher Lower

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With an operating lease, rent expense is included in EBIT. In a finance lease, rent expense is replaced by depreciation expense and interest expense. Since EBIT is calculated before interest and taxes, EBIT is higher with a finance lease. In an operating lease, the rent payment is included in operating cash flow. With a finance lease, the rent payment is replaced by principal and interest. Since principal payments are considered financing activities, operating cash flow is higher with a finance lease.

sabaruch

Which of the following statements about operating income and operating cash flow are correct or incorrect?

Statement #1:	If operating income is growing faster than operating cash flow over the long-term, the firm may be recognizing revenue too soon or delaying the recognition of expense.
Statement #2:	Operating cash flow exceeding operating income is sustainable over the long-term.

A) Only one is correct.

B) Both are correct.

C) Both are incorrect.

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Statement #1 is correct. If operating income and operating cash flow are growing at different rates over the long-term, the firm may be engaging in earnings manipulation. Statement #2 is incorrect. Over the long-term, operating cash flow will eventually decline without the support of operating income.

sabaruch

Which of the following statements about operating income and operating cash flow is most accurate?

A) Operating income is more reliable than operating cash flow because of the judgments and estimates involved with accrual accounting.

B) Operating income is confirmed by operating cash flow when the growth rates of the two measures are relatively stable over time.

C) Operating cash flow usually increases faster than operating income when the firm is growing.

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When the growth rates of operating income and operating cash flow are stable over time, operating income is being confirmed by operating cash flow. Operating cash flow is more reliable than operating income. During growth, operating cash flow is usually lower than operating income as the firm uses cash to increase inventories and receivables.

sabaruch

Recently, Galaxy Corporation lowered its allowance for doubtful accounts by reducing bad debt expense from 2 percent of sales to 1 percent of sales. Ignoring taxes, what are the immediate effects on Galaxy’s operating income and operating cash flow?

Operating income

Operating cash flow

A) No effect No effect

B) Higher No effect

C) Higher Lower

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Lower bad debt expense will result in higher operating income. Operating cash flow is not affected until Galaxy actually collects the receivables.

sabaruch

What value is used in the balance sheet when reporting a derivative instrument used in a cash flow hedge and where are the unrealized gains and losses on the derivative instrument reported?

Balance sheet

Unrealized gains and losses

A) Cost Other comprehensive income

B) Fair value Income statement

C) Fair value Other comprehensive income

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A derivative instrument used in a cash flow hedge is reported on the balance sheet at fair value and the unrealized gains and losses are recognized in the other comprehensive income

sabaruch

What value is used in the balance sheet when reporting a derivative instrument used in a cash flow hedge and where are the unrealized gains and losses on the derivative instrument reported?

Balance sheet

Unrealized gains and losses

A) Cost Other comprehensive income

B) Fair value Income statement

C) Fair value Other comprehensive income

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A derivative instrument used in a cash flow hedge is reported on the balance sheet at fair value and the unrealized gains and losses are recognized in the other comprehensive income

soverby

Recently, Firebird Corporation purchased 1,000 shares of GTO Corporation for $50 per share. GTO is a non-dividend paying stock and Firebird expects to sell the investment in the near term. To hedge the investment, Firebird purchases put options and designates the options as a fair value hedge. Ignoring the premium paid for the options, what is the net effect on Firebird’s total assets and net income if GTO declines $5 per share at year-end?

Total assets

Net income

A) No net effect No net effect

B) Decrease No net effect

C) No net effect Decrease

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Total assets do not change. The decrease in the value of the investment is exactly offset by the increase in value of the options. Net income is also unaffected. The unrealized loss on the investment is offset by the unrealized gain on the options.