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Financial Statement Analysis
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Reading 29Financial Statement Analysis: An introduction
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Financial Statement Analysis
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1-Which of the following statements about financial statement
analysis and reporting is least accurate?A) Deciding whether to recommend a companys securities toinvestors is a role of financial statement analysis.
B) Financial statement analysis uses financial statement data toform opinions about the companys ability to generate cash flow inthe future.
C) Providing information about changes in a companys financialposition is a role of financial reporting.
D) Financial statement analysis focuses on the way companiesshow their financial performance to investors by preparing andpresenting financial statements.
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Financial Statement Analysis
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Financial reporting refers to the way companies show their financial
performance to investors, creditors, and other interested parties bypreparing and presenting financial statements, including informationabout changes in a companys financial position. The role of financialstatement analysis is to use the information in a companys financialstatements, along with other relevant information, to make economic
decisions, such as whether to invest in the companys securities orrecommend them to other investors. Analysts use financial statementdata to evaluate a companys past performance and current financialposition in order to form opinions about the companys ability to earnprofits and generate cash flow in the future.
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Financial Statement Analysis
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2-Which of the following best describes financial reporting andfinancial statement analysis?
A) Financial reporting is performed by investors, creditors, andother interested parties.
B) Financial reports assess a companys past performance inorder to draw conclusions about the companys ability to generatecash and profits in the future.
C) The objective of financial analysis is to provide informationabout the financial position of an entity that is useful to a wide range
of users.
D) Financial reporting refers to how companies show theirfinancial performance and financial analysis refers to using theinformation to make economic decisions.
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Financial Statement Analysis
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Financial reporting refers to the way companies show their financialperformance to investors, creditors, and other interested parties bypreparing and presenting financial statements. The objective offinancial statements, not analysis, is to provide information about thefinancial position, performance and changes in financial position of
an entity that is useful to a wide range of users in making economicdecisions. The role of financial statement analysis, not reporting, is touse the information in a companys financial statements, along with
other relevant information, to make economic decisions.
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Financial Statement Analysis
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3-Which of the following is least likely to be considered a role offinancial statement analysis?
A) Determining whether to invest in the companys securities.
B) Deciding whether to extend trade credit to the company.
C) To make economic decisions.
D) Assessing the management skill of the companys executives.
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Financial Statement Analysis
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The role of financial statement analysis is to use the information in acompanys financial statements, along with other relevantinformation, to make economic decisions. Examples of suchdecisions include whether to invest in the companys securities orrecommend them to other investors, or whether to extend trade orbank credit to the company. Although the financial statements mightprovide indirect evidence about the management skill of the
companys executives, that is not generally considered the role offinancial statement analysis.
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Financial Statement Analysis
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4-According to the IASB, which of the following least accuratelydescribes financial reporting?
A) provides information about changes in financial position of anentity.
B) is useful to a wide range of users.
C) uses the information in a companys financial statements tomake economic decisions.
D) provides information about the financial performance of an
entity.
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Financial Statement Analysis
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The role of financial reporting is described by the InternationalAccounting Standards Board (IASB) in its Framework for thePreparation and Presentation of Financial Statements: The objective of financial statements is to provide information aboutthe financial position, performance and changes in financial positionof an entity that is useful to a wide range of users in making economicdecisions.Using the information in a companys financial statements to makeeconomic decisions is financial analysis, not financial reporting.
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Financial Statement Analysis
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5-Which of the following statements represents information at aspecific point in time?
A) The income statement.
B) The statement of cash flows.
C) The income statement and the balance sheet.
D) The balance sheet.
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Financial Statement Analysis
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The balance sheet represents information at a specific point in time.
The income statement represents information over a period of time.
The statement of cash flows also represents information over a period
of time.
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Financial Statement Analysis
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6- Which of the following statements regarding footnotes to thefinancial statements is FALSE?
A) Footnotes provide information about assumptions andestimates used by management.
B) Some supplementary schedules are audited whereasfootnotes are not audited.
C) Footnotes may disclose what types of accounting methods arebeing used.
D) Footnotes may contain information regarding contingentlosses.
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Financial Statement Analysis
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Some supplementary schedules are not audited whereas footnotesare audited. The financial statements and footnotes in the annualreport and the SEC 10-k filings are all audited. The other statements
are true.
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Financial Statement Analysis
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7-The Management Discussion and Analysis (MD&A) portion of thefinancial disclosure is required to discuss all of the followingEXCEPT:
A) capital resources and liquidity.
B) results of operations.
C) expected effects of marketplace events.
D) a general business overview based on known trends.
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Financial Statement Analysis
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The MD&A portion of the financial disclosure is required to discussresults of operations, capital resources and liquidity and a generalbusiness overview based on known trends. A discussion of expectedeffects of marketplace events may voluntarily be included by a firm,
but is not required in the MD&A portion.
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Financial Statement Analysis
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8-The standard auditor's report is most likely required to:
A) provide an "unqualified" opinion if material uncertainties exist.
B) provide reasonable assurance that the financial statementscontain no material errors.
C) mention any significant deficiencies in the internal controlstructure.
D) provide reasonable assurance that management is reliable.
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Financial Statement Analysis
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The standard auditor's report contains three parts:1. The financial statements are prepared by management and aretheir responsibility and the auditor has performed an independentreview.2. The audit was conducted using generally accepted auditingstandards, which provides reasonable assurance that there are nomaterial errors in the financial statements.3. The auditor is satisfied the statements were prepared inaccordance with accepted accounting principles, and the principleschosen and estimates are reasonable.
Under U.S. GAAP, the auditor is required to state an opinion on thecompany's internal controls. The auditor may add this opinion as afourth element of the auditor's report or provide it separately.
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Financial Statement Analysis
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9-Which of the following would NOT require an explanatory paragraphadded to the auditors report?
A) Doubt regarding the "going concern" assumption.
B) Uncertainty regarding the valuation or realization of assetsand payment of liabilities.
C) Uncertainty due to litigation.
D) Statements that the financial information was preparedaccording to GAAP.
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Financial Statement Analysis
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The statements that the financial information was prepared accordingto GAAP should be included in the regular part of the auditors' reportand not as an explanatory paragraph. The other information would becontained in explanatory paragraphs added to the auditors report.
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Financial Statement Analysis
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10-Which of the following is an independent auditor least likely to dowith respect to a companys financial statements?
A) Provide an opinion concerning their fairness and reliability.
B) Prepare and accept responsibility for them.
C) Perform an independent review of them.
D) Confirm assets and liabilities contained in them.
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Financial Statement Analysis
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Auditors make an independent review of financial statements, whichare prepared by company management and are managementsresponsibility. It is the responsibility of auditors to confirm the assets,liabilities, and other items included in the statements and then issuean opinion concerning their fairness and reliability.
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Financial Statement Analysis
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11-Which of the following is the best description of the financialstatement analysis framework?
A) Gather data, analyze and interpret the data, determine thecontext, report the conclusions, update the analysis.
B) State the objective and context, gather data, process the data,
analyze and interpret the data, report the conclusions orrecommendations, update the analysis.
C) Process and analyze the data, interpret the context, determinethe objective, report the recommendations.
D) Gather data, analyze and interpret the data, process theconclusions, assess the context, report the recommendations, updatethe analysis.
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Financial Statement Analysis
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The financial statement analysis framework consists of six steps:1. State the objective and context.2. Gather data.3. Process the data.4. Analyze and interpret the data.5. Report the conclusions or recommendations.6. Update the analysis.
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Financial Statement Analysis
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READING 32
UNDERSTANDING THE INCOME STATEMENT
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Financial Statement Analysis
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35- Do gains and losses, and do expenses appear on the incomestatement?
Gains and Losses ExpensesA) Yes Yes
B) Yes No
C) No Yes
D) No No
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Financial Statement Analysis
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Gains and losses result from, transactions that are not a part of thefirms normal business operations. Expenses are amounts that areincurred to generate revenue; thus, expenses result from the firmsongoing operations. Both are included on the income statement.
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Financial Statement Analysis
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36- Would an increase in the cost of raw materials used in the
production of inventory and would an increase in marketing expensesresult in lower gross profit?
Increase in raw materials cost Increase in marketing expense
A) Yes Yes
B) No No
C) No Yes
D) Yes No
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Financial Statement Analysis
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Gross profit is equal to sales minus cost of goods sold. Cost of goodssold includes the direct costs of producing a product or service suchas raw materials, direct labor, and overhead (fixed costs). Thus, anincrease in raw materials costs will result in higher cost of goods soldand lower gross profit. Marketing expenses are considered operatingexpenses (SG&A), not in cost of goods sold.
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Financial Statement Analysis
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37- CPP Corporation has a contract to build a custom test chamber fora client for $100,000. CPP Corporation uses the percentage-of-completion method for accounting and estimates the total costs forthe project to be equal to $80,000. CPP Corporation has promised tocomplete the project within three years. At year-end the customer haspaid $60,000, equaling the total amount billed for the year, and totalcosts incurred to date are $40,000. On the income statement, netincome for the year-end will be:
A) $10,000.
B) $20,000.
C) $6,667.
D) -$10,000.
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Financial Statement Analysis
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Under the percentage-of-completion method, one-half of the totalrevenue is recognized because one-half of the costs have been
incurred ($40,000 / $80,000). Therefore, revenue will be equal to$50,000, expenses are $40,000, and net income will be $10,000.
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Financial Statement Analysis
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38- According to the installment method of accounting, gross profiton an installment sale is recognized:
A) on the date of sale.
B) on the date the final cash collection is received.
C) in proportion to the cash collection.
D) after cash collections equal to the cost of sales have beenreceived.
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Financial Statement Analysis
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The installment sales method recognizes sales and COGS inproportion to cash collections
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Financial Statement Analysis
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An analyst has gathered the following data pertaining to HegelCompanys construction projects, which began during 2002:
Project 1 Project 2Contract price $420,000 $300,000Costs incurred in 2002 240,000 280,000Estimated costs to complete 120,000 40,000Billed to customers during 2002 150,000 270,000
Received from customers during 2002 90,000 250,00039 -If Hengel used the completed contract method, what amount ofgross profit (loss) would Hengel report in its 2002 income statementfor:
Project 1 Project 2A) ($20,000) $0
B) $0 ($20,000)
C) ($20,000) ($20,000)
D) $0 $0
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Financial Statement Analysis
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No profit is recognized until the completion of the project, howeverlosses are recognized. Project 2 has an expected loss of $20,000.
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Financial Statement Analysis
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40- If Hengel used the percentage-of-completion method, what amountof gross profit (loss) would Hengel report in its 2002 income
statement?
A) $20,000.
B) $(20,000).
C) $22,500.
D) $40,000.
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Financial Statement Analysis
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Under the percentage of completion method, $40,000 of profit isrecognized for project 1. 120,000 + 240,000 = 360,000 total costs;
240,000 / 360,000 60,000 estimated profit = $40,000 profit.Project 2 is running at a $20,000 loss. If the loss can be estimated theloss must be recognized at the time it is estimated. Total revenue forproject 2 = 300,000 contract price 320,000 total costs = -$20,000estimated loss40,000 (project 1) 20,000 (project 2) = $20,000 gross profit in 2002
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Financial Statement Analysis
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41- An analyst has gathered the following data pertaining to HegelCompanys construction projects, which began during 2002:
Project 1 Project 2Contract price $420,000 $300,000Costs incurred in 2002 240,000 280,000Estimated costs to complete 120,000 40,000Billed to customers during 2002 150,000 270,000Received from customers during 2002 90,000 250,000If Hengel used the completed contract method, what amount of grossprofit (loss) would Hengel report in its 2002 income statement for:
Project 1 Project 2A) $0 ($20,000)
B) ($20,000) $0
C) ($20,000) ($20,000)
D) $0 $0
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Financial Statement Analysis
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No profit is recognized until the completion of the project, howeverlosses are recognized. Project 2 has an expected loss of $20,000.
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Financial Statement Analysis
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42-Cash collection is a critical event for income recognition under the:Cost-Recovery Method Installment Method
A) Yes Yes
B) No Yes
C) No No
D) Yes No
|
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Financial Statement Analysis
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Recognition of income depends on cash collected under bothmethods.
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Financial Statement Analysis
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43 -Lee Ann Company collected the following amounts forsubscriptions to the magazine it publishes during the past year:
Date Amount Collected SubscriptionApril 1 $60,000 one yearJuly 1 $30,000 two yearsOctober 1 $36,000 three yearsWhat amount of subscription revenue should Lee Ann Co recognize
for the year?A) $45,000.
B) $55,500.
C) $60,000.
D) $126,000.
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Financial Statement Analysis
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The subscriptions earned is the sum of $45,000 ($60,000 9/12),
$7,500 [($30,000 x 6/24)] and $3,000 ($36,000 x 3/36).
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Financial Statement Analysis
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44-Under the cost recovery method, profit is recognized:
A) as collection occurs.
B) at time of delivery.
C) after the amount of cost has been collected.
D) at time of sale.
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Financial Statement Analysis
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The cost recovery method is used when the costs to provide goods or
services are not known. Under this method, sales are recognizedwhen cash is received, but no gross profit is recognized until all of thecost of goods sold is collected.
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Financial Statement Analysis
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45-If a reliable estimate of total costs of the contract does not exist,
which of the following revenue recognition methods should be used?A) Completed contract method.
B) Percentage-of-completion method.
C) Installment sales method.
D) Cost recovery method.
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Financial Statement Analysis
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The installment sales method is used when the assurance of paymentand estimated bad debts does not exist before cash is collected. Salesrevenue 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 notrecognized until all of the cost of goods sold is collected.
The percentage-of-completion method is used when ultimate paymentis assured and revenue is earned as costs are incurred. Profit isrecognized corresponding to the percentage of costs incurred to thetotal estimated.
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Financial Statement Analysis
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46-Which revenue recognition method is used when the payment isassured and revenue is earned as costs are incurred?
A) Installment sales method.
B) Completed contract method.
C) Cost recovery method.
D) Percentage-of-completion method.
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Financial Statement Analysis
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The installment sales method is used when the assurance of paymentand estimated bad debts does not exist before cash is collected. Salesrevenue and COGS are recognized only when cash is received.
The completed contract method is used when a reliable estimate ofthe total costs does not exist and the amount of revenue cannot be
determined until the contract is finished. Revenue is recognized onlywhen the contract is completed and the title is transferred.
The cost recovery method is used when future cash collections arenot assured even after receipt of partial payments. Gross profit is not
recognized until all of the cost of goods sold is collected.
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Financial Statement Analysis
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47-As a general rule, revenue is normally recognized when it is:
A) earned.
B) measurable and received.
C) realized and earned.
D) measurable.
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Financial Statement Analysis
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Under the accrual concept, revenue is recognized when the earningsprocess is completed (earned) and ultimate realization (cash receipt)is assured.
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Financial Statement Analysis
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48-Which of the following statements regarding revenue recognition isleast accurate?
A) The completed contract method does not recognize revenueand expenses until the contract is completed and title is transferred.
B) Revenues should be recognized when the earnings process is
complete and payment is assured.C) The installment sales method recognizes revenue andassociated cost of goods sold only when cash is received.
D) The cost recovery method recognizes revenues at the time ofsale.
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Financial Statement Analysis
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The cost recovery method recognizes sales when cash is received,
but no gross profit is recognized until all the cost of goods sold iscollected.
l l
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Financial Statement Analysis
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49- When a reliable estimate of costs exists, ultimate payment isassured, and revenue is earned as costs are incurred, which of the
following revenue recognition methods should be used?
A) Installment sales method.
B) Completed contract method.
C) Percentage-of-completion method.
D) Cost recovery method.
i i l S A l i
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Financial Statement Analysis
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The completed contract method doesnt recognize revenue andexpense until the contract is completed and title is transferred. Allprofit is recognized when the contract is completed. The completedcontract method is used when selling price or cost estimates areunreliable.
The installment sales method recognizes revenue and associated costof goods sold only when cash is received. Gross profit (sales cost ofgoods sold) reflects the proportion of cash received.
The cost recovery method is similar to the installment sales methodbut is more conservative. Sales are recognized when cash is received,but no gross profit is recognized until all of the cost of goods sold iscollected.
Fi i l S A l i
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Financial Statement Analysis
551
50-The Kammel Building Company has a contract to build a buildingfor $100 million. The estimate of the cost of the project is $75 million.
In the first year of the project, Kammel had costs of $30 million.Kammels reported profit for the first year of the contract, using thecompleted contract method, is:
A) $10 million.
B) $15 million.
C) $20 million.
D) $0.
Fi i l S A l i
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Financial Statement Analysis
552
Under the completed contract method, profit is only reported uponcompletion of the contract.
Fi i l St t t A l i
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Financial Statement Analysis
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51- Which of the following statements regarding the methods ofrevenue recognition is most accurate?
A) The completed contract method, in comparison to thepercentage-of-completion method, will generally result in higher netincome.
B) The completed contract method is used when the selling priceor cost estimates are unreliable.
C) The percentage-of-completion method is primarily used incontracts that have short lives.
D) The percentage-of-completion method generally results inlower retained earnings than the completed contract method.
Fi i l St t t A l i
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Financial Statement Analysis
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The completed contract method compared to the percentage-of-completion method will result in lower net income since revenue isrecognized later. Hence, retained earnings will also be lower than thepercentage-of-completion method.
Fi i l St t t A l i
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Financial Statement Analysis
555
52- When the cost of goods and services used are recognized as anexpense in the same period that its generated revenue is recognized,
which of the following principle(s) is/are being described?
A) The matching principle for revenue and expense recognition.
B) The accrual and expense recognition principles.
C) The depreciation and accrual principles.
D) The matching and accrual principles.
Financial Statement Analysis
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Financial Statement Analysis
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The accrual concept states that revenue is recognized when theearnings process is completed and cash receipt is assured.
Financial Statement Analysis
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Financial Statement Analysis
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53- Extraordinary items are:
A) reported above the line.
B) unusual or infrequent.
C) unusual and infrequent.
D) reported on the balance sheet.
Financial Statement Analysis
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Financial Statement Analysis
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54- Which of the following is least likely reported net of tax on theincome statement under U.S. GAAP?
A) Income from discontinued operations.
B) Extraordinary items.
C) Interest expense.
D) Uninsured losses from natural disasters.
Financial Statement Analysis
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Financial Statement Analysis
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Interest expense would be considered an expense that is incurred
from continuing operations and, therefore, is listed prior tosubtracting the income tax expense on the income statement. Incomefrom discontinued operations and extraordinary items are included onthe income statement after the net income from continuing operationsis reported and after the income tax expense from continuingoperations is reported. Therefore, these latter accounts are reportednet of tax.
Financial Statement Analysis
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Financial Statement Analysis
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55- All the following items are reported net of taxes below net incomefrom continuing operations on the income statement EXCEPT:
A) extraordinary items.
B) income from discontinued operations.
C) expropriations by foreign governments.
D) unusual or infrequent items.
Financial Statement Analysis
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Financial Statement Analysis
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Unusual or infrequent items appear as a component of net incomefrom continuing operations and are reported "above the line."
Extraordinary items, such as expropriations, are unusual andinfrequent and appear "below the line."
Financial Statement Analysis
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Financial Statement Analysis
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56- Zichron, Inc., had the following equity accounts on December 31:Common stock: 20,000 sharesPreferred stock A: 10,000 shares convertible into common on a 2 for1 basis, dividend of $40,000 was declared during the yearPreferred stock B: 10,000 shares, convertible to common on a 4 for 1basis, dividend of $5,000 was declared during the yearThe company reported net income of $120,000 and paid a $20,000
dividend to its common shareholders.What are the basic earnings per share reported for the year?
A) $2.75.
B) $3.75.C) $1.36.
D) $2.00.
Financial Statement Analysis
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Financial Statement Analysis
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($120,000 40,000 5,000) / 20,000 shares = $3.75.
Financial Statement Analysis
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Financial Statement Analysis
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57-What are the diluted earnings per share reported for the year?
A) $3.00.
B) $1.50.
C) $1.33.
D) $2.00.
Financial Statement Analysis
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Financial Statement Analysis
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($120,000) / (20,000 + 20,000 + 40,000) = $1.50.
Financial Statement Analysis
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Financial Statement Analysis
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58- A firm has a weighted average number of 20,000 common sharesselling at an average of $10 throughout the year and 11,000, 10percent, $100 par value preferred shares. If the firm earns $210,000after taxes, what is its Basic EPS?
A) $7.50 / share.
B) $10.00 / share.
C) $10.50 / share.
D) $5.00 / share.
Financial Statement Analysis
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Financial Statement Analysis
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(210,000 - 110,000)/20,000 = $5 share
Financial Statement Analysis
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Financial Statement Analysis
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59- For a firm with a simple capital structure, all of the following arenecessary to measure basic earnings per share (EPS) EXCEPT:
A) dividends paid to preferred shareholders.
B) number of shares outstanding at the beginning of the year.
C) the timing and number of shares issued or repurchased duringthe year.
D) dividends paid to common shareholders.
Financial Statement Analysis
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Financial Statement Analysis
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Basic EPS = earnings available to common shareholders divided bythe weighted average number of common shares outstanding.
Earnings available to common shareholders equals net income -preferred dividends. The weighted number of common sharesoutstanding equals the number of shares outstanding during the yearweighted by the proportion of the year they were outstanding.
Financial Statement Analysis
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y
570
60- The standard equation for computing basic earnings per share(EPS) is:
A) [Sales - Cost of Goods Sold] / Number of Preferred SharesOutstanding.
B) [Net Income - Common Dividends] / Weighted Average
Number of Common Shares Outstanding.C) [Net Income Preferred Dividends]/Weighted Average Numberof Common Shares Outstanding.
D) Total Assets Total Liabilities + Stockholders Equity.
Financial Statement Analysis
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y
571
The basic EPS calculation does not consider the effects of anydilutive securities in the computation.Basic EPS = [Net Income Preferred Dividends]/Weighted AverageNumber of Common Shares Outstanding.
Financial Statement Analysis
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y
572
61- A complex capital structure would typically contain:
A) bank notes.B) callable bonds.
C) convertible bonds.
D) variable rate notes.
Financial Statement Analysis
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y
573
A complex capital structure is one that contains securities that havethe potential to dilute a firms earnings per share. For example,
convertible bonds, convertible preferred stock, options, and warrantshave the potential to dilute earnings per share upon conversion orexercise.
Financial Statement Analysis
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y
574
62- Which type of a capital structure contains no dilutive securities?
A) Complex.B) Functional.
C) Basic.
D) Simple.
Financial Statement Analysis
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y
575
A complex capital structure contains potentially dilutive securitiessuch as options, warrants, or convertible securities. There is no basic
capital structure but there are basic earnings per share which doesNOT consider the effects of any dilutive securities in the computationof EPS.
Financial Statement Analysis
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576
63- The following information pertains the QRK Company: One million shares of common stock outstanding at thebeginning of 2005. 200,000 shares issued on the last day of March. 500,000 shares issued on the last day of June. 800,000 shares issued on the last day of September.What is the number of shares that should be used to compute 2005
earnings per share for the QRK Company?
A) 2.5 million.
B) 1.9 million.
C) 1.6 million.
D) 1.5 million.
Financial Statement Analysis
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The weighted average number of common shares outstanding is thenumber of shares outstanding during the year weighted by the portion
of the year they were outstanding. For the QRK Company, theweighted number of shares outstanding is the original one millionshares plus 150,000 shares for the end-of-March issue (= 200,000 *9/12), plus 250,000 shares for the end-of-June issue (= 500,000 * 6/12),plus 200,000 shares for the end-of-September issue (= 800,000 * 3/12),or 1.6 million shares.
Financial Statement Analysis
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578
A Diluted EPS Calcu lat ion Using the i f -Conv er ted Metho dfor Preferred Stock .
For the year ended 31 December 2006, Bright-Warm UtilityCompany had net income of $ 1,750,000. The companyhad an average of 500,000 shares of common stock
outstanding, 20,000 shares of convertible preferred, andno other potentially dilutive securities. Each share ofpreferred pays a dividend of $10 per share, and each isconvertible into five shares of the companys commonstock.
Calculate the companys basic and diluted EPS.
Financial Statement Analysis
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Solution
If the 20,000 shares of convertible preferred had eachconverted into 5 shares of the companys common stock,the company would have had an additional 100,000 shares
of common stock (5 shares of common for each of the20,000 shares of preferred). If the conversion had takenplace, the company would not have paid preferreddividends of $200,000 ($10 per share for each of the 20,000shares of preferred).
Financial Statement Analysis
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Basic EPS Diluted EPS
Net income $ 1,750,000 $1,750,000Preferred Dividend 200,000 0
Numerator $ 1,550,000 $1,750,000
Weighted average numberof shares outstanding 500,000 500,000If converted 0 100,000
Denominator 500,000 600,000
EPS 3.10 2.92
Financial Statement Analysis
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581
A Diluted EPS Calcu lat ion Using the i f Con ver ted Metho dfor Con ver t ib le Debt
Oppnox Company reported net income of $ 750 000 for theyear ended 31 December 2005. The company had an
average of 690 000 shares of common stock outstanding.In addition the company has only one potentially dilutivesecurity: $ 50 000 of 6% convertible bonds, convertibleinto a total of 10 000 shares. Assuming a tax rate of 30percent, calculate Oppnoxs basic and diluted EPS.
Financial Statement Analysis
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Solution
If the convertible debt had been converted, the debtsecurities would no longer be outstanding; instead, anadditional 10 000 shares of common stock would beoutstanding. Also, if such a conversion had taken place,the company would not have paid interest on theconvertible debt of $ 3 000, equivalent 3 000 (1 0.30) = 2100 on an after tax basis.
To calculate diluted EPS using the if converted method for
convertible debt, the amount of net income available tocommon shareholders is increased by $ 2 100. Also theweighted average number of shares in the denominatorincrease by 10 000 shares
Financial Statement Analysis
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Solution
EPS Diluted EPSNet income 750 000 750 000After tax cost of interest 2 100
Numerator 750 000 752 100
Weighted average numberof shares outstanding 690 000 690 000
If converted 0 10 000
Denominator 690 000 700 000
EPS 1.09 1.07
Financial Statement Analysis
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A Diluted EPS Calcu lat ion Using the Treasu ry Sto ckMethod for Opt ion s .
Hihotech Company reported net income of $2.3 million forthe year ended 30 June 2005 and had an average of 800
000 common shares outstanding. The company hasoutstanding 30 000 options with an exercise price of $35and no other potentially dilutive securities. Over the year,the companys market price has averaged $55 per share.Calculated the companys basic and diluted EPS.
Financial Statement Analysis
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Solution:
Using the treasury stock method, we first calculate thatthe company would have received $ 1 050 ($35 for each ofthe 30 000 options exercised) if all the options had beenexercised. The options would no longer be outstanding,
instead 30 000 new shares of common stock would beoutstanding. Under the treasury stock method we reducethe number of new shares by the number of shares thatcould have been purchased with the cash received uponexercise of the options. At an average market price of $55per share, the $1 050 000 proceeds from option exercisecould have purchased 19 091 shares of treasury stock.Therefore, the net new shares issued would have been10,909 (calculated as 30,000 minus 19, 091). No change is
made to the numerator.
Financial Statement Analysis
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Solution
EPS Diluted EPSNet income 2,300,000 2,300,000Numerator 2,300,000 2,300,000Weighted average numberof shares outstanding 800,000 800,000
If converted 0 10,909
Denominator 800,000 810,909EPS 2.88 2.84
Financial Statement Analysis
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587
An An t id i lu t ive Secur i ty.
For the year ended 31 December 2006, Dim-Cool UtilityCompany had net income of $1,750,000. The company had
an average of 500,000 shares of common stockoutstanding, 20,000 shares of convertible preferred, andno other potencially dilutive securities. Each share ofpreferred pays a dividend of $10 per share, and each isconvertible into three shares of the companys commonstock. What was the companys basic and diluted EPS.
Financial Statement Analysis
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An Antidilutive Security.
Basic EPS. Diluted EPS.Net income $1,750,000 $1,750,000Preferred Dividend 200,000 0
Numerator $1,550,000 $1,750,000
Weighted average numberof shares outstanding 500,000 500,000If converted 0 60,000
EPS $3.10 $3.13
Exceeds basic EPS; security is antidilutive and therefore,not included
Financial Statement Analysis
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64- The following data pertains to the Sapphire Company:Net income equals $15,000
5,000 shares of common stock issued on January 1st10% stock dividend issued on June 1st1,000 shares of common stock were repurchased onJuly 1st1,000 shares of 10%, $100 par preferred stock eachconvertible into 8 shares of common wereoutstanding the whole year
What is the companys diluted earnings per share(EPS)?
A)$1.00. B)$2.50. C)$1.15. D)$1.20 .
B)
$2.50.
C)
$1.15.
D)
$1.20
.
B)
$2.50.
C)
$1.15.
D)
$1.20
.
Financial Statement Analysis
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Number of average common shares:1/1 5,500 shares issued (includes 10% stock dividend on 6/1) 12 = 66,0007/1 1,000 shares repurchased 6 months = -6,000= 60,00060,000 shares / 12 months = 5,000 average sharesPreferred dividends = ($10)(1,000) = $10,000Number of shares from the conversion of the preferred shares = (1,000preferred shares)(8 shares of common/share of preferred) = 8,000 common
Diluted EPS = [$15,000(NI) $10,000(pfd) + $10,000(pfd)] / 5000(commonshares) + 8000(shares from the conv. pfd. shares) = $15,000 / 13,000 shares =$1.15/shareThis number needs to be compared to basic EPS to see if the preferredshares are antidilutive.Basic EPS = [$15,000(NI) $10,000(preferred dividends)] / 5,000 shares =
$5,000 / 5,000 shares = $1/shareSince the EPS after the conversion of the preferred shares is greater thanbefore the conversion the preferred shares are antidilutive and they shouldnot be treated as common in computing diluted EPS. Therefore diluted EPS isthe same as basic EPS or $1/share.
Financial Statement Analysis
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591
65- Assume that the exercise price of an option is $11, andthe average market price of the stock is $16. Assuming1,039 options are outstanding during the entire year, whatis the number of shares to be added to the denominator ofthe Diluted EPS?
A)289.
B)1,039.
C)714.D)325.
Financial Statement Analysis
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(1,039 options)($11) = $11,429
$11,429/$16 per share=714 shares
1039-714 = 325 shares
or [(16-11)/16]1,039 =325.
Financial Statement Analysis
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593
66- Assume that the exercise price of an option is $10, and
the average market price of the stock is $13. Assuming999 options are outstanding during the entire year, what isthe number of shares to be added to the denominator ofthe diluted earnings per share (EPS)?
A)231.
B)999.
C)768.
D)206.
Financial Statement Analysis
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(999)(10) = 9,990
9,990 / 13 = 768
999 768 = 231
or(13 10) / 13
0.23(999)= 231
Financial Statement Analysis
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595
67- The Gaffe Company had net income of $1,500,000.Gaffe paid preferred dividends of $5 on each of the100,000 preferred shares. Each preferred share isconvertible into 20 common shares. There are 1 millionGaffe common shares outstanding. In addition to thecommon and preferred stock, Gaffe has $25 million of 4%
bonds outstanding. If Gaffe's tax rate is 40%, what is it'sdiluted earnings per share?
A)$0.33.
B)$0.50.
C)$1.00.
D)$1.50.
Financial Statement Analysis
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Basic EPS (1 500 000 500 000) / 500 000
= 1
Diluted EPS. 1 500 000 / ( 2 000 000 + 1 000 000)
= 0.5
Financial Statement Analysis
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597
68- The Widget Company had net income of $1 million forthe period. There were 1 million shares of weighted
common stock outstanding for the entire period. If thereare 100,000 options outstanding with an exercise price of$40, what is the diluted earnings per share for Widgetcommon stock if the average price per share over theperiod was $50?
A)$0.99.
B)$1.00.
C)$0.98.
D)$1.01.
Financial Statement Analysis
http://www.schweser.com/online_program/test_engine/browse_question.php?question_id=2929&node_id=47409&operation=next&node_sort_order=http://www.schweser.com/online_program/test_engine/browse_question.php?question_id=2929&node_id=47409&operation=next&node_sort_order=8/12/2019 Entendiendo El Estado de Resultado
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Use the Treasury stock methodProceeds = 100,000 ($40) = $4,000,000Shares assumed purchased with proceeds=$4,000,000/$50 = 80,000 sharesPotential dilution = 100,000 80,000 = 20,000 shares
OR
(50 - 40) / 50 = 0.20
0.20 * 100000
=20 000
Basic EPS = $1/shareDiluted EPS = $1,000,000 / 1,020,000 = $0.98/share
Financial Statement Analysis
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69- An analyst has gathered the following informationabout Zany Corp.Net income of $200,000 for the year ended December 31,2004.During 2004, 50,000 common shares were outstanding.Zany has 10,000 shares of 7%, $50 par convertible
preferred stock outstanding, each convertible into twoshares of common.5,000 warrants are outstanding with an exercise price of$24. Each warrant is convertible into one common share.The average market price per common share during 2004was $20.Calculate Zany's basic and diluted earnings per share(EPS) for 2004.Basic EPSDiluted EPSA)$3.30 $2.00 B)$4.00 $2.86 C)$4.00 $2.00D)$3.30$2.86
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Basic EPS = (net income preferred dividends) / numberof common shares = (200,000 35,000) / 50,000 = $3.30 pershare
The preferred shares are converted into 20,000 commonshares, the firm does not pay preferred dividends. DilutedEPS = 200,000 / (50,000 + 20,000) = $2.86 per share. Thewarrants are out of the money at a stock price of $20.
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Basic EPS = (net income preferred dividends) / numberof common shares = (200,000 35,000) / 50,000 = $3.30 pershare
The preferred shares are converted into 20,000 commonshares, the firm does not pay preferred dividends. DilutedEPS = 200,000 / (50,000 + 20,000) = $2.86 per share. Thewarrants are out of the money at a stock price of $20.
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