Chapter 06 - Analyzing Operating Activities

Chapter 06
Analyzing Operating Activities

Multiple Choice Questions

 
 

1. As a general rule, revenue is normally recognized when it is: 

A. measurable and earned.
B. measurable and received.
C. realizable and earned.
D. realizable.

 
2. Which of the following measures of accounting income is typically reported in an income
statement? 
A. Net income
B. Comprehensive income
C. Continuing income
D. All of the above
 
3. According to FASB, initial franchise fees should be recognized as income when: 
A. the franchiser has substantially performed or satisfied all material services and conditions.
B. the franchiser has collected the majority of fee in cash.
C. the franchisee shows the ability to pay the fee.
D. the franchiser bills the franchisee.
 
 
4. Which of the following statements concerning deferred taxes is correct? 
A. Deferred taxes will not be found in asset section of the balance sheet.
B. Deferred taxes arise from permanent differences in GAAP and tax accounting.
C. Deferred taxes will only decrease when a cash payment is made.
D. Deferred taxes arising from the depreciation of a specific asset will ultimately reduce to
zero as the item is depreciated.
 
5. Differences in taxable income and pretax accounting income that will not be offset by
corresponding differences or "turn around" in future periods are called: 
A. timing differences.
B. circular differences.
C. permanent differences.
D. reverse differences.

6-1
Chapter 06 - Analyzing Operating Activities
 6. If a company that normally expenses advertising costs was to capitalize and amortize these
costs over 3 years instead: 
A. after the third year net income would always be higher if it is capitalized.
B. after the third year net income would always be lower if it is capitalized.
C. after the third year net income would be higher (if it is capitalized) only if advertising costs
were increasing.
D. after the third year net income would be lower (if it is capitalized) only if advertising costs
were increasing.
 
7. Compared with companies that expense costs, firms that capitalize costs can be expected to
report: 
A. higher asset levels and lower equity levels.
B. higher asset levels and higher equity levels.
C. lower asset levels and higher equity levels.
D. lower asset levels and lower equity levels.
 
 
8. The capitalization of interest cost during construction: 
A. increases future net income.
B. decreases future depreciation expense.
C. increases net income during construction phase.
D. decreases assets during construction phase.
 

6-2
Chapter 06 - Analyzing Operating Activities

 
 
9. If a company estimates that its expected return on pension plan assets will increase to 9.5%
from 9.0%, this would be considered: 
A. an extraordinary gain.
B. a change in accounting principle.
C. a prior period adjustment.
D. a change in accounting estimate.
 
 
10. Which of the following items is not included in the calculation of net income but is
included in the calculation of comprehensive income? 
A. Unrealized holding gain on available-for-sale marketable securities.
B. Unrealized holding gain on trading marketable securities.
C. Gain from early extinguishments of bonds.
D. Gain arising from sale of available-for-sale marketable securities.
 
11. Which of the following statements is true? Under GAAP, comprehensive income: 
A. may be reported in addition to net income.
B. must be reported in addition to net income.
C. may be reported instead of net income.
D. must be reported instead of net income.
 
12. Which of the following statements is incorrect? Employee stock options 
A. are not recorded as an expense when granted if they are at or out-of-the money under the
intrinsic value method.
B. will not affect the share price of the company when exercised.
C. may reduce agency costs by more closely aligning interests of stockholders and managers.
D. may increase the risk propensity of managers.
 

True / False Questions

 13. Economic income and accounting income are always the same. 

14. The matching principle in accounting prescribes that costs must be recognized in the same
period when the related revenues are recognized. 

15. Revenue from sales where the buyer has the right of return can only be recognized after
the return period has expired. 

16. If two firms are identical except that one firm uses percentage-of-completion accounting
and the other uses completed contract accounting for revenue recognition, the cash flows of
the firms will be identical. 

17. Generally revenue should be recorded when it is probable and reasonably estimable. 

6-3
Chapter 06 - Analyzing Operating Activities
18. Revenues are earned inflows that arise from the company's ongoing business activities. 

19. Gains are earned inflows that arise from the company's ongoing business activities. 
 
20. Comprehensive income is computed by adjusting net income for dirty surplus items. 

21. For item to be considered extraordinary, it should be either unusual in nature or infrequent

in occurrence. 

22. For item to be considered a special item, it should be either unusual in nature or infrequent
in occurrence but not both. 

23. Accounting changes are usually cosmetic and do not yield cash flow consequences. 

24. A long term asset is said to be impaired when its fair value is below its book value. 

25. Under current accounting standards, gains and losses relating to the extinguishment of
debt must be both unusual and infrequent to be classified as an extraordinary item, and debt
refinancing does not typically meet these criteria. 
 
26. One difference between revenues and gains is that gains arise from transactions that are
incidental to the operations of the business. 

27. The capitalization of interest costs during construction increases future net income. 

28. Software costs may be capitalized once a company can show that the product is
technologically feasible. 

29. A company that capitalizes costs, rather than expensing them will have a higher asset
turnover. 

30. If revenue is recognized for financial reporting purposes but deferred for tax purposes this
results in a deferred tax liability. 

31. If an expense is recognized for financial reporting purposes but not allowed as a bona-fide
deduction for tax purposes, this results in a deferred tax asset. 

32. Extraordinary items are defined as those that are both unusual in nature and infrequent in
occurrence. These items are disclosed, net of tax in the income statement. 

33. Accounting errors are considered accounting changes and treated accordingly. 

34. When a company disposes of a segment of its business, it must restate all prior year
financial statements as if it had never owned that segment of the business. 
 

6-4
Chapter 06 - Analyzing Operating Activities
35. A company that capitalizes rather than expenses software development costs, will have a
less volatile net income, all other things equal. 

36. Comprehensive income differs from net income in that it reflects certain unrealized
holding gains and losses foreign currency translation adjustments, and minimum pension
liability adjustments. 
 

37. If a company, operating in an inflationary environment, uses FIFO for tax purposes and
weighted-average for financial reporting purposes, this will result in a deferred tax asset. 
 

38. Deferred taxes arise due to temporary timing differences in recognizing items for tax and
financial reporting purposes. 

39. If a company depreciates an asset at a faster rate for tax purposes than for financial
reporting purposes this will give rise to a deferred tax liability. 
 

40. A deferred tax liability imposes an obligation on the business to pay taxes. 
 

41. Some items appear on a company's income statement but never appear on its tax return. 
 

42. In order to determine permanent income for the year being analyzed, it is necessary to
consider special charges from other years. 
 

43. Timing is one of the few revenue recognition issues that are seldom a concern in financial
analysis. 
 

44. R&D expenses for tangible assets that have alternative future uses qualify as deferred
charges. 
 

45. Employee stock options (ESOs) usually constitute a wealth transfer from current
shareholders to prospective shareholders (employees) and have no effect on total liabilities
and shareholders' equity. 

6-5
Chapter 06 - Analyzing Operating Activities
46. Under long-term performance contracts—such as product warranty contracts and software
maintenance contracts—revenues are often collected in advance and are recognized
proportionally over the entire period of the contract. 
 

47. ESOs often are granted to managers in growth and innovative industries to induce more
risk-taking. 
 

6-6