67 Questions
Why might it be appropriate to focus on a single borrowing entity instead of the consolidated group?
To avoid distorting inventory turns and gross profit margin in the consolidated statements.
In a scenario where a borrowing entity has difficulty accessing earnings or assets from a foreign subsidiary, why might lenders prefer stand-alone analysis of the domestic borrowing entity?
Due to legal and tax barriers that hinder access to foreign subsidiary earnings and assets.
What are some key reasons why lenders generally prefer GAAP financial statements?
To adhere to historical cost measurement, revenue recognition, and the matching principle.
Which of the following is NOT one of the areas of GAAP that warrant attention when underwriting a customer relationship?
Fair value measurement
Why is it important to focus on a single borrowing entity when different entities within a consolidated group may have legally or pragmatically difficult access to earnings or assets?
To prevent distortion in financial metrics and facilitate assessment of the accessible assets.
What does the concept of conservatism in GAAP refer to?
Choosing the option that is least likely to overstate assets or income.
What is the key factor that makes the liquidation value of an asset difficult to establish and maintain over its life?
All of the above
What is the primary purpose of obtaining multiple appraisals on the same asset?
To evaluate the reliability and accuracy of the appraisal
Which inventory valuation method assumes that the inventory purchased most recently has been sold first?
LIFO (last in, first out)
What is the primary purpose of a LIFO reserve?
To reflect the higher cost of inventory purchases
Which inventory valuation method is generally used for high-value or serialized inventory items?
Specific identification
What is the key factor that determines the reliability of a valuation source for an asset?
The reputation of the valuation source
What is the primary purpose of the lower of cost or market (LCM) inventory valuation method?
To reflect the current market value of the inventory
What is the primary reason for the difficulty in valuing long-term assets such as investments and intangibles?
The volatility in the market for these assets
Which inventory valuation method assumes that the inventory purchased first has been sold?
FIFO
What is the primary purpose of the weighted average cost inventory valuation method?
To value inventory when several batches of unidentifiable product are purchased throughout the year
What must be included in a footnote disclosure about the method of accounting for inventory?
Whether the company has changed its accounting method since the prior year’s statement
How does the use of historical cost impact an analyst's ability?
It clouds an analyst's ability to recognize current values
Why might a company need to obtain appraisals of significant assets and liabilities?
To rectify discrepancies between historical cost and current market value
What impact can the matching principle have on the recognition of cash inflows and outflows?
It obscures the receipt and payment of cash
Why does GAAP permit alternatives to account for some transactions?
To increase the importance of footnote disclosure
What is a potential challenge of comparing financial statements between companies in different industries?
Use of accounting methods specific to certain industries
How do companies that develop software for sale differ from those developing software for internal use in terms of cost treatment?
One capitalizes costs while the other expenses them when incurred
Why should analysts pay attention to the market value of a company's assets?
To understand the reliability of asset valuation
In credit analysis, what is a limitation imposed by historical cost principles?
Prevention of recognizing current asset values accurately
How do contingent liabilities affect footnote disclosures according to GAAP?
They influence the level of detail required in footnotes
When are revenues recognized in accrual accounting?
When goods or services are shipped or delivered
What does the historical cost principle dictate about assets on the balance sheet?
Assets must be recorded at original cost plus accumulated depreciation
Which method of depreciation is generally used for financial statement disclosure?
Straight-line method
In the context of conservatism, how are liabilities and expenses treated?
Liabilities and expenses will not be understated
Which principle requires that the movement of cash may not align with the recognition of revenue or expenses?
Matching principle
Under GAAP, what should preparers of financial statements rely on if a specific accounting treatment is not prescribed?
Materiality
What is the primary consideration in deciding whether to expense or capitalize costs?
Desire to report favorable earnings to owners and creditors
How are revenues recognized according to accrual accounting principles?
When goods or services are shipped or delivered
What is the main purpose of the matching principle in accounting?
To link expenses with related revenues
How does consistency in financial statement preparation contribute to comparability among companies?
By measuring and recording transactions consistently over time
What is the main type of risk associated with cash held by a company?
Currency valuation risk
Which of the following is NOT considered a form of cash in a company's financial statement?
Accounts receivable
What type of financial instruments are often considered cash equivalents by management?
Treasury notes
Which factor plays a vital role in determining the profitability and cash flow of a company?
Accounts receivable quality and liquidity
What is a key parameter used in analyzing a company's cash flow?
Accounts receivable turnover
In the context of accounts receivable, what does an aging list provide information about?
Customers' payment history
Which of the following is NOT a situation where tax laws allow transactions to be measured differently than under accrual or cash accounting?
Capitalizing all expenses related to the purchase of fixed assets
What is the primary reason for analyzing the quality of asset accounts on a company's balance sheet?
To assess the company's ability to generate income and cash flow for repaying debt
Which of the following statements is TRUE regarding tax basis financial statements?
They closely mirror the income and expenses reported on the tax return
What is the primary reason for the difficulty in assessing the true profitability and financial condition of a company from a tax-basis financial statement?
Differences between tax basis and accrual accounting principles
Which of the following factors should be considered when evaluating the quality of an asset account, according to the text?
Restrictions on the use of the asset
Based on the information in the text, which of the following statements is TRUE regarding the classification of assets on the balance sheet?
Assets are arranged from most liquid to least liquid
What is the primary purpose of balance sheet ratio analysis, according to the text?
To analyze the company's capital structure
Which of the following factors should be considered when determining the net realizable value of an asset?
The company's ability to operate without the asset
Which of the following statements is TRUE regarding the classification of liability accounts on the balance sheet?
Liabilities are classified based on their maturity dates
Which of the following statements is TRUE regarding the source, term, and cost of funding assets?
It is important to understand these factors for assessing the company's repayment ability
Which of the following statements about liabilities in the provided text is correct?
Tax liability, including tax payable and tax deferred accounts, is considered.
Which of the following statements about company-prepared financial reports is true?
They can be useful for assessing risk or monitoring financial performance between audits, if prepared consistently with auditor's reports.
Which of the following statements about cash-basis accounting is correct according to the text?
Revenues are recorded when cash is collected, and expenses are recorded when cash is paid.
Which of the following statements about modified cash basis accounting is NOT true?
There is a specific set of rules that all companies using this method must follow.
Which of the following is NOT mentioned in the text as a common modification to cash transactions under the modified cash basis accounting method?
Recognizing accounts receivable on the balance sheet.
What is the purpose of the tax basis accounting approach?
To measure and record the dollar impact of transactions according to allowable income and expense recognition under tax laws.
Which of the following statements about cash-basis financial statements is correct according to the text?
They understate revenues if the company sells on credit.
Which of the following statements about a true cash-basis balance sheet is correct?
It would show cash and equity as its only accounts.
Which of the following statements about company-prepared financial reports is NOT true according to the text?
They are always independently prepared in accordance with GAAP.
Which of the following statements about the modified cash basis accounting method is correct?
It may involve recognizing borrowed funds as liabilities on the balance sheet.
Which of the following inventory valuation methods is based on the assumption that the most recently produced items are sold first?
LIFO (last in, last out)
What is the typical collateral value used for inventory?
40
Which of the following inventory categories is often the most valuable to a lender as collateral in the event of payment default and liquidation?
Finished goods
Which of the following inventory valuation methods is based on the assumption that the oldest units in inventory are sold first?
FIFO (first in, first out)
What type of insurance does the text recommend that companies maintain to ensure sufficient cash flow in the event of a catastrophe?
Business interruption insurance
Study Notes
Historical Cost Assets
- Assets are reflected on the balance sheet at their original cost, plus capitalized additions or improvements, minus accumulated depreciation since acquisition.
- The current market value of assets may differ significantly from their historical cost.
Revenue Recognition and Matching Principle
- Revenues are recognized and recorded when earned, typically when goods or services are shipped or delivered.
- Expenses are matched to the revenues they help generate, regardless of when payment obligations are incurred or fulfilled.
Expense Recognition
- Expenses are recognized and recorded when an asset has been used or a service received, in the generation of a specific revenue stream.
- Costs may be capitalized (carried on the balance sheet as an asset) and depreciated or amortized over time.
Accounting Principles
- Conservatism: assets and revenues are not overstated, and liabilities and expenses are not understated.
- Consistency and Comparability: financial statements are prepared in a consistent and comparable manner to facilitate analysis among companies in the same industry.
- Materiality: statement preparers classify and disclose transactions in a way that acknowledges their significance to the company's financial condition.
Limitations of GAAP
- Historical cost accounting can cloud an analyst's ability to recognize current values.
- The use of historical cost and accrual accounting principles can obscure the receipt and payment of cash.
Understanding Market Value of Assets
- The current and future market value of a company's assets is essential to assess repayment ability.
- The reliability of asset valuation stems from the independence and market knowledge of the individual preparing the valuation.
Working Capital Assets
- Inventory valuation methods include FIFO, LIFO, LCM, specific identification, and weighted average cost.
Marketable Securities
- Stated at the lower of cost or market (mark-to-market) and valued based on posted prices on recognized security exchanges.
Fixed Assets
- Valued by certified appraisers based on readily available and comparable market data.
Long-term Assets
- Valuation of operating subsidiaries, intangibles, and investments can be complex and require sophisticated appraisals.
Liabilities
- Carried at face value, but consider adequacy of reserves, accrued liabilities, and tax liability.
Company-Prepared Financial Reports
- May not be prepared in accordance with GAAP, but can be useful in assessing risk or monitoring financial performance.
Cash-Basis and Other Financial Statement Preparation Methods
- Cash-basis accounting measures and records dollar impact of transactions when paid or received, not when they occur.
- Modified cash basis and tax basis accounting methods also exist, with varying degrees of accuracy in measuring profit.### Current Assets
- Current assets are liquidated or used within a company's operation within a year.
- Cash, accounts receivable, and inventory are common current assets that may have different requirements at different times of the year.
Cash and Cash Equivalents
- Cash is the common denominator for all business transactions, regardless of the currency used.
- Cash on hand and cash in banks are the basic forms of cash.
- Cash equivalents, such as CDs, treasury notes, and commercial paper, are used to increase the investment return on cash.
- Risks associated with cash equivalents include:
- Solvency risk of the issuing institution
- Transaction risk of accessing or moving the funds
- Valuation risk translating into liquidity risk
Accounts Receivable (A/R)
- A/R represents funds due to the company from customers.
- Quality and liquidity of A/R are key determinants of a company's profitability and cash flow.
- Risks associated with A/R include:
- Credit policies and terms of sale
- Composition of sales (e.g., by customer, product line, geographic area, or socioeconomic market)
- Valuation of A/R (face value minus discounts, returns, and allowances)
- A/R aging list provides information on customer names, amount owed, and age of the receivable.
- A/R turnover is a key parameter in analyzing a company's cash flow.
Inventory
- Inventory composition includes:
- Raw materials (amount necessary to support production cycle, spoilage, and obsolescence factors)
- Work in process (WIP) (production stage, completion status, and sales order)
- Finished goods (value, obsolescence, style changes, and spoilage risks)
- Inventory valuation methods include:
- FIFO (first in, first out)
- LIFO (last in, last out)
- LCM (lower of cost or market)
- Specific identification
- Weighted average cost
- Collateral value of inventory is typically 40% of its value, but may vary depending on the proportion of finished goods.
- Write-down policy and insurance coverage are important considerations for inventory.
GAAP Concepts
- GAAP financial statements are preferred by lenders because they provide:
- Historical cost measurement of transactions
- Revenue recognition when earned
- Expense recognition matched with revenue
- Conservatism and materiality in financial reporting
- Key areas of GAAP to focus on when underwriting a customer relationship include:
- Historical cost
- Revenue recognition and the matching principle
- Expense recognition
- Conservatism
- Consistency and comparability
- Materiality
- Limitations of GAAP
Learn about the appropriateness of focusing on a single borrowing entity instead of the consolidated group in financial reporting. Understand how certain financial ratios may be distorted in consolidated statements due to varying nature of entities within a group.
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