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Financial Reporting and Analysis 【Reading 25】Sample

Would an increase in the cost of raw materials used in the production of inventory and would an increase in marketing expenses result in lower gross profit?
Increase in
raw materials cost
Increase in
marketing expense
A)
Yes No
B)
No Yes
C)
Yes Yes



Gross profit is equal to sales minus cost of goods sold. Cost of goods sold includes the direct costs of producing a product or service such as raw materials, direct labor, and overhead (fixed costs). Thus, an increase in raw materials costs will result in higher cost of goods sold and lower gross profit. Marketing expenses are considered operating expenses (SG&A), not in cost of goods sold.

Do gains and losses, as well as expenses appear on the income statement?
A)
Only expenses appear on the income statement.
B)
Only gains and losses appear on the income statement.
C)
Both appear on the income statement.



Gains and losses result from, transactions that are not a part of the firm’s normal business operations. Expenses are amounts that are incurred to generate revenue; thus, expenses result from the firm’s ongoing operations. Both are included on the income statement.

TOP

During 2007, Topeka Corporation entered into the following transactions:

Transaction #1 – Interest on a certificate of deposit owned by Topeka was credited to Topeka’s investment account.
Transaction #2 – Topeka sold 10,000 shares of common stock at $30 that had been repurchased by Topeka last year for $20.

Should Topeka recognize the results of these transactions as income on the income statement for the year ended December 31, 2007?
A)
Only one should be recognized.
B)
Neither should be recognized.
C)
Both should be recognized.



Interest earned on the CD is recognized as interest income. The gain on the sale of treasury stock is not reported on the income statement but is relected on the statement of changes in stockholders’ equity and on the balance sheet. The sale proceeds simply increase equity and increase cash.

TOP

In accounting for long-term construction contracts, the percentage-of-completion method is preferable to the completed contract method when:
A)
the contracts are of a relatively short duration (less than one year).
B)
estimates of the costs to complete and the extent of progress toward completion are reasonably dependable.
C)
lack of dependable cost estimates cause forecasts to be doubtful.



In accounting for long-term construction contracts, the percentage-of-completion method is preferable to the completed contract method when estimates of the costs to complete and the extent of progress toward completion are reasonably dependable.

TOP

An airplane manufacturing company routinely builds fighter jets for the U.S. armed forces. It takes fourteen months to build one jet, and the government pays for them in installments over the fourteen-month period. Which revenue recognition method should be used?
A)
Percentage-of-completion method.
B)
Installment sales method.
C)
Completed contract method.



The percentage-of-completion method is appropriate in this case because payment is assured when dealing with the U.S. government, and cost and price estimates are assumed reliable due to the ongoing and routine nature of the contract.

TOP

If a reliable estimate of total costs of the contract does not exist, which of the following revenue recognition methods should be used?
A)
Cost recovery method.
B)
Percentage-of-completion method.
C)
Completed contract method.



The cost recovery method is used when future cash collections are not assured even after receipt of partial payments. Gross profit is not recognized until all of the cost of goods sold is collected.
The percentage-of-completion method is used when ultimate payment is assured and revenue is earned as costs are incurred. Profit is recognized corresponding to the percentage of costs incurred to the total estimated.

TOP

When evaluating the differences between two revenue recognition policies, an analyst should view the policy as more conservative which:
A)
results in less leverage on the balance sheet.
B)
recognizes revenue later.
C)
is more dependent on management estimates.



Recognizing revenue later rather than sooner is considered more conservative. More aggressive (less conservative) revenue recognition can result in less leverage by increasing assets.

TOP

Information about a company’s revenue recognition policies is most likely disclosed in:
A)
the standard auditor’s report.
B)
the financial statement notes.
C)
Management’s Discussion and Analysis.



Revenue recognition policies are disclosed in the footnotes to the financial statements.

TOP

Jerry Krome, CFA, is an equity analyst. The head of research at Krome’s firm composes a memo that contains the following statements:
  • To the extent that management has discretion over the firm’s revenue recognition, an analyst should consider policies that recognize revenue later to be more conservative than policies that recognize revenue sooner.
  • When comparing the performance of companies, an analyst can use the information in the financial statement disclosures to adjust the financial statements for differences in revenue recognition policies.

With regard to the implications of revenue recognition policies for financial analysis, Krome should agree with:
A)
only one of these statements.
B)
both of these statements.
C)
neither of these statements.



Because revenue recognition often relies on judgment and estimates from management, it is not always possible to calculate the appropriate adjustments that would account for the differences between companies’ revenue recognition policies. An analyst should use the policies disclosed in companies’ financial statement footnotes to understand the degree to which their revenue recognition is conservative or aggressive. In general, recognizing revenue sooner is considered aggressive and recognizing revenue later is considered conservative.

TOP

Which revenue recognition method is used when the payment is assured and revenue is earned as costs are incurred?
A)
Percentage-of-completion method.
B)
Installment sales method.
C)
Cost recovery method.



The installment sales method is used when the assurance of payment and estimated bad debts does not exist before cash is collected. Sales revenue and COGS are recognized only when cash is received.
The cost recovery method is used when future cash collections are not assured even after receipt of partial payments. Gross profit is not recognized until all of the cost of goods sold is collected.

TOP

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