Accrual Accounting and Performance Measurement
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Accrual Accounting and Performance Measurement

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Which of the following statements accurately reflects the accrual method of accounting?

  • Accrual accounting does not incorporate future cash flows in its reporting.
  • Accrual accounting is solely focused on cash transactions.
  • Accrual accounting principles dictate the timing of recognizing revenue and expenses based on cash flows. (correct)
  • Accrual accounting recognizes revenues and expenses only when cash is received.

    • Over the total life of a firm, cash flows and profits will always be equal at any given time.

    False

    What are the two components captured in the balance sheet according to the accrual method?

    Accrued assets and accrued liabilities

    The accrual method is also known as _____ in Swedish.

    <p>Periodisering</p> Signup and view all the answers

    Match the following terms with their descriptions:

    <p>Accrual accounting = Recognizes revenues when earned, regardless of cash flow Cash flow = Actual cash received or paid during an accounting period Profit measurement = A broader indicator of future cash generation Earnings management = Manipulating financial results to meet certain targets</p> Signup and view all the answers

    What is the minimum percentage of voting rights an owner company must hold to presume significant influence?

    <p>20%</p> Signup and view all the answers

    The equity method is applied when the owner company has no voting rights in the associated company.

    <p>False</p> Signup and view all the answers

    What reflected significant influence in a company relationship?

    <p>Board representation, participation in strategic issues, significant transactions, exchange of personnel or technical information.</p> Signup and view all the answers

    If an owner company pays out dividends, the asset side ______ with respect to the equity method.

    <p>decreases</p> Signup and view all the answers

    Match the following terms with their definitions:

    <p>Significant Influence = Presumed with 20% voting rights Equity Method = Accounting for associated companies Net Profit = Profit after taxes Dividends = Distribution of profits to shareholders</p> Signup and view all the answers

    Which of the following is NOT a characteristic of significant influence?

    <p>Ownership of 50% or more of shares</p> Signup and view all the answers

    What was Alfa Ltd's percentage ownership in Beta Ltd?

    <p>40%</p> Signup and view all the answers

    When Alfa Ltd acquired shares in Beta Ltd, it was reported at fair market value.

    <p>False</p> Signup and view all the answers

    Which of the following statements about the indirect method of cash flow reporting is true?

    <p>It adjusts net profit for transactions without receipts or payments.</p> Signup and view all the answers

    The direct method is consistently reported in cash flow statements under IFRS.

    <p>True</p> Signup and view all the answers

    What financial statement items are affected by dividends paid?

    <p>Retained earnings and cash</p> Signup and view all the answers

    The __________ method shows the relationship between profit and cash flow more clearly.

    <p>indirect</p> Signup and view all the answers

    Match each cash flow statement item with its impact:

    <p>Income taxes paid = Affects cash outflow Dividends paid = Affects retained earnings Changes in working capital = Affects cash flow statement Change in inventories = Manipulates reported cash flow</p> Signup and view all the answers

    What is a common criticism of the indirect method in cash flow reporting?

    <p>It does not reflect actual cash flows.</p> Signup and view all the answers

    The indirect method allows for easy understanding for individuals not trained in accounting.

    <p>False</p> Signup and view all the answers

    What significant deviation is noted in the cash flow statement for large companies using the indirect method?

    <p>73 million</p> Signup and view all the answers

    What is the primary distinction between accounting depreciation and economic depreciation?

    <p>Accounting depreciation allocates costs over time, while economic depreciation preserves cash for reinvestment.</p> Signup and view all the answers

    The straight-line method is the most commonly used depreciation method under IFRS.

    <p>True</p> Signup and view all the answers

    What is the formula for calculating the depreciable amount?

    <p>Acquisition cost minus the residual value</p> Signup and view all the answers

    The period over which an asset is expected to be available for use is referred to as its __________.

    <p>useful life</p> Signup and view all the answers

    Match the following depreciation-related terms with their definitions:

    <p>Depreciation = Allocation of cost for tangible fixed assets Amortization = Allocation of cost for intangible fixed assets Depletion = Allocation of cost for natural resources Residual value = Estimated net realizable value at the end of useful life</p> Signup and view all the answers

    Which inventory valuation method is allowed under US GAAP but not under IFRS?

    <p>LIFO</p> Signup and view all the answers

    The retail inventory method can be used reliably for valuing inventory destroyed in a warehouse fire.

    <p>False</p> Signup and view all the answers

    What is the primary trade-off firms face when deciding to capitalize expenditures?

    <p>Investment versus expenses</p> Signup and view all the answers

    Under stable prices, the _____ inventory method would result in lower cost of goods sold compared to LIFO.

    <p>FIFO</p> Signup and view all the answers

    Match the following inventory methods with their definitions:

    <p>FIFO = First-In-First-Out method LIFO = Last-In-First-Out method Weighted average cost = Average cost method based on total cost and total units Retail inventory method = Method using ratios of cost to price applied to inventory</p> Signup and view all the answers

    Which scenario will most likely lead to the highest reported income when using the FIFO method?

    <p>Rising prices</p> Signup and view all the answers

    Research and Development (R&D) expenditures are always classified as expenses.

    <p>False</p> Signup and view all the answers

    A capitalization decision involves determining whether a purchase is classified as an _____ or an investment.

    <p>expense</p> Signup and view all the answers

    What is the goodwill calculated after the purchase price and net assets are compared?

    <p>196MSEK</p> Signup and view all the answers

    Goodwill is taxed under IFRS regulations.

    <p>False</p> Signup and view all the answers

    What is the purpose of purchase price allocation (PPA)?

    <p>To analyze the acquisition costs and assign values to tangible and intangible assets.</p> Signup and view all the answers

    The initial effects of a merger will reduce __________ and increase __________.

    <p>RoE, D/E</p> Signup and view all the answers

    Match the following terms with their explanations:

    <p>Brand = Expensed according to IFRS regulations Net Assets = Assets minus liabilities Goodwill = Difference between purchase price and net assets Deferred Tax Liability = Arises from temporary differences</p> Signup and view all the answers

    What is the calculated value of Equity when Capital Employed is 70 units?

    <p>35 units</p> Signup and view all the answers

    The Net Debt to Equity Ratio calculated as 100% indicates that Net Debt is half of the Equity.

    <p>False</p> Signup and view all the answers

    What is the Interest Expense calculated based on a Net Debt of 35 units?

    <p>1.75 units</p> Signup and view all the answers

    The calculated ROE is _____%, indicating a return that exceeds the target.

    <p>17.7</p> Signup and view all the answers

    Match the following terms with their respective values:

    <p>Equity = 35 units Net Debt = 35 units Interest Expense = 1.75 units Net Income = 6.2 units</p> Signup and view all the answers

    What is the Earnings Before Taxes (EBT) calculated from EBIT of 9.5 units after deducting Interest Expense?

    <p>7.75 units</p> Signup and view all the answers

    The calculated ROCE of 15% means the ROCE target was achieved.

    <p>True</p> Signup and view all the answers

    What percentage tax rate is applied to calculate the Net Income from EBT?

    <p>20%</p> Signup and view all the answers

    What is the net profit calculated from the given Return on Equity (ROE) of 16% on equity of 6588?

    <p>1044.5</p> Signup and view all the answers

    Dividends increase the equity in a company's balance sheet.

    <p>False</p> Signup and view all the answers

    What is the growth in equity calculated after taking away dividends based on a 9.6% increase?

    <p>7154.7</p> Signup and view all the answers

    The growth in assets is calculated to be __________ based on the change from 10851 to 17886.8.

    <p>7035.7</p> Signup and view all the answers

    Match the following income statement items with their values:

    <p>Sales = 11359 EBIT = 2271.84 EBT = 2074.4 Net Income = 1618</p> Signup and view all the answers

    What is the impact on ROCE of a 1% increase in operating margin?

    <p>Higher in Building than Industry</p> Signup and view all the answers

    Dividends are assumed to be paid in the same year as corresponding profit is earned.

    <p>True</p> Signup and view all the answers

    Calculate the EBIT from sales of 11359 with an operating margin of 20%.

    <p>2271.8</p> Signup and view all the answers

    The formula for calculating dividends based on the given equity growth and net income is: Dividends = __________ - Net Income.

    <p>Reduction in Equity</p> Signup and view all the answers

    Match the following concepts related to financial ratios:

    <p>ROE = Return on Equity EBT = Earnings Before Tax Net Income = Revenue after taxes EBIT = Earnings Before Interest and Tax</p> Signup and view all the answers

    What signifies that an asset is impaired according to IAS 36?

    <p>The carrying amount exceeds the recoverable amount</p> Signup and view all the answers

    Management must test intangible assets for impairment only when there is evidence of impairment.

    <p>False</p> Signup and view all the answers

    What is the definition of a liability?

    <p>A present obligation to transfer an economic resource due to past events.</p> Signup and view all the answers

    For a liability to be classified as a __________, there needs to be a probability of greater than 50% that it will come to fruition.

    <p>provision</p> Signup and view all the answers

    Match the following inventory scenarios with their descriptions:

    <p>FIFO = Higher profits when prices rise LIFO = Higher cost of goods sold leading to lower taxes Write-down = Accounting for lower inventory prices Reversal = Reporting increased inventory values when prices rise</p> Signup and view all the answers

    Which of the following statements about impairment is true?

    <p>Impairment provides a signal that investment in technology may be needed.</p> Signup and view all the answers

    Under IFRS, you can report a write-up of inventory without any specified conditions.

    <p>False</p> Signup and view all the answers

    What is meant by the term 'contingent liabilities'?

    <p>Liabilities with less than 50% probability of occurring.</p> Signup and view all the answers

    The recoverable amount is the higher of an asset's net selling price and its __________.

    <p>value in use</p> Signup and view all the answers

    Match the terms to their definitions:

    <p>Impairment = Decline in the ability to generate future economic benefits Recoverable amount = Higher of net selling price or value in use Indefinite useful life = Assets tested annually for impairment Provision = Greater than 50% probability of obligation</p> Signup and view all the answers

    What is the primary purpose of the cash flow statement?

    <p>To provide information about changes in net assets and cash flows</p> Signup and view all the answers

    Cash equivalents must have a maturity of more than three months from the acquisition date.

    <p>False</p> Signup and view all the answers

    What are the three types of cash flows reported in the cash flow statement?

    <p>Operating, investing, and financing activities</p> Signup and view all the answers

    Investments must be readily convertible to a known amount of cash with an ______ risk of changes in value to qualify as cash equivalents.

    <p>insignificant</p> Signup and view all the answers

    Match the following terms with their definitions:

    <p>Cash equivalents = Short-term investments converted to cash Liquidity = Ability to meet short-term obligations Solvency = Ability to meet long-term obligations Investing activities = Cash flows associated with acquiring and disposing of long-term assets</p> Signup and view all the answers

    Which of the following best describes cash equivalents?

    <p>Investments with a short maturity and low risk of value changes</p> Signup and view all the answers

    Operating activities generate cash flows from the core business operations.

    <p>True</p> Signup and view all the answers

    A statement of cash flows helps evaluate the entity's ______ structure, including liquidity and solvency.

    <p>financial</p> Signup and view all the answers

    According to IAS 7, cash equivalents are held primarily for what purpose?

    <p>Meeting short-term cash commitments</p> Signup and view all the answers

    What is NOT a category of cash flows reported in the cash flow statement?

    <p>Profit activities</p> Signup and view all the answers

    Study Notes

    General Perspective

    • Profit measurement involves using either cash flow or profit as a basis for performance evaluations.
    • The accrual method of accounting determines when revenue and expense consequences of cash flows are recognized.
    • The accrual method captures accrued assets and liabilities arising from differences between recognized profit and actual cash flows.

    Performance Measurement

    • The accrual method aims to align revenue and expense recognition with the periods in which they occur, bridging the gap between cash flows and profits.
    • While cash flow and profit converge over the firm's lifetime, they differ in their timing of recognition.
    • The accrual method's strength lies in its ability to accurately reflect business performance, but its weakness is the potential for earnings management by managers.
    • Accrual accounting serves as a better indicator of future cash flow generation capabilities compared to cash accounting.

    Financial Reporting from a Capital Markets Perspective

    • Financial statements provide valuable information for investors and other stakeholders.
    • Significant influence is established when a company owns at least 20% of another company’s voting rights, allowing for potential influence over the target company’s operations.
    • The equity method is used when accounting for associated companies in consolidated statements, reflecting the ownership company’s share of the associated company's net assets.
    • The equity method increases assets with profits and decreases them with dividend payments, reflecting the value of equity in the associated company.

    Cash Flow Statements

    • The cash flow statement uses the direct or indirect method to report cash flows from operating activities.
    • The direct method reports gross amounts of cash receipts and payments, focusing on the specific items.
    • The indirect method adjusts net profit for non-cash transactions and income/costs related to investing or financing activities.
    • Both methods are used in financial reporting, each offering unique strengths and weaknesses.

    Inventories

    • There are different inventory costing methods, such as FIFO, LIFO, and weighted average cost, used to account for changes in inventory value.
    • These methods can significantly impact the reported cost of goods sold and inventory valuation.
    • The choice of inventory costing method depends on the specific business environment and industry practices.

    Long-Lived Assets

    • Capitalization is a crucial step when dealing with long-term tangible and intangible assets, determining whether expenditures are classified as investments or expenses.
    • The capitalization process involves trade-offs, particularly when determining whether an expense is for maintenance or an investment.
    • Analyzing differences in firm practices related to capitalization is essential for financial analysts to gain insights into the company’s financial performance.

    Depreciation

    • Depreciation refers to the allocation of the cost of tangible fixed assets to the periods in which the asset is used.
    • Accounting depreciation focuses on allocating costs over the asset's useful life, while economic depreciation emphasizes the reinvestment of a portion of cash flows.
    • Amortization is used for intangible assets and depletion for natural resources, analogous to depreciation procedures.

    Depreciation Methods

    • The straight-line method is the most common depreciation method, allocating the cost of the asset evenly over its useful life.
    • Accelerated depreciation methods are widely used for tax purposes, recognizing higher depreciation expenses in earlier years.
    • The depreciable amount is calculated by subtracting the residual value from the acquisition cost.
    • The useful life of an asset refers to its expected duration or the estimated production units it can generate.

    Impairment of Long-Lived Assets

    • Impairment occurs when the carrying value of an asset cannot be fully recovered due to factors such as market conditions or technology.
    • The impairment process leads to a reduction in the asset's carrying value, reflecting the loss of its economic value.
    • Analysts need to carefully evaluate the reasons for impairment charges to determine if they represent real events or accounting adjustments.

    Capital Employed and Equity

    • Capital Employed = Equity + Net Debt
    • Net Debt = Equity
    • Capital Employed = 2 x Equity
    • Capital Employed = 70 units
    • Equity = 35 units
    • Net Debt = 35 units

    Interest Expense

    • Interest Expense = 0.05 x Net Debt
    • Interest Expense = 1.75 units

    Earnings Before Taxes (EBT)

    • EBT = EBIT - Interest Expense
    • EBT = 9.5 - 1.75 = 7.75 units

    Net Income

    • Net Income = EBT x (1 - Tax rate)
    • Net Income = 7.75 x (1 - 0.20) = 6.2 units

    Return on Equity (ROE)

    • ROE = Net Income / Equity
    • ROE = 6.2 / 35 = 17.7%
    • This is higher than the target of 15%
    • Suggests the equity return is better than expected

    Net Debt to Equity Ratio

    • Net Debt to Equity = Net Debt / Equity
    • Net Debt to Equity = 35 / 35 = 100%
    • This is within the target range of 75% to 125%

    Cash Flow Statement

    • Provides information to evaluate changes in net assets, financial structure, and ability to adapt to changing circumstances
    • Three types of cash flows: operating, investing, and financing

    Cash and Cash Equivalents

    • Held for meeting short-term cash commitments
    • Readily convertible to cash with insignificant risk of value change
    • Maturity of three months or less from date of acquisition

    Impairment Charge

    • Reflects decline in asset's ability to generate future economic benefits
    • May signal need for investment in improved technology
    • Management has some discretion with regard to timing

    Impairment According to IAS 36

    • Asset is impaired when carrying amount exceeds recoverable amount
    • Recoverable amount is the higher of the asset's net selling price and value in use
    • Assessment of impairment is done at the end of each reporting period
    • Intangible assets with indefinite useful life (including goodwill) are tested annually

    Age Structure Analysis

    • Average economic life is the average period an asset is expected to be used
    • Average age is the average age of the assets currently held

    Liabilities

    • A present obligation of the entity to transfer an economic resource
    • Result of past events

    Contingent Liabilities

    • Less than 50% probability of coming to fruition

    Provision

    • Greater than 50% probability of coming to fruition

    Scenario Based Acquisitions (Purchase Analysis)

    • Also called acquisition analysis or purchase price allocation (PPA)
    • Starts with the purchase price and compares to net assets
    • Includes fair value valuations of assets like brands and inventory
    • Removes book value liabilities and deferred tax liability
    • Difference between purchase price and net assets is goodwill
    • Goodwill can only exist in groups, and the group is not the tax base
    • Goodwill is not taxed due to IASB rules

    Fair Value Acquisitions

    • Acquisition may initially reduce ROE, EPS, ROCE, solvency, and increase debt-to-equity ratios

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    Description

    This quiz delves into the intricacies of accrual accounting and its impact on performance evaluation. It discusses the differences between cash flow and profit, and how the accrual method enhances financial reporting by aligning revenue and expense recognition. Test your understanding of profit measurement and the implications of earnings management.

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