FIA Financial Statement Interpretation 5 — Questions and Answers
Question 1: A company capitalizes an expenditure rather than expensing it. In the period of capitalization, this decision will:
- Decrease net income and decrease total assets
- Increase net income and increase total assets (Correct answer)
- Increase net income and decrease total assets
- Decrease net income and increase total assets
Correct answer: Increase net income and increase total assets
Capitalizing moves a cost to the balance sheet as an asset, avoiding immediate expense recognition, which boosts current net income while increasing total assets.
Question 2: Which of the following best describes 'earnings quality'?
- The absolute dollar amount of net income
- The degree to which reported earnings reflect sustainable, cash-backed operating performance (Correct answer)
- The ratio of earnings to dividends paid
- The growth rate of revenue year over year
Correct answer: The degree to which reported earnings reflect sustainable, cash-backed operating performance
High earnings quality means that net income is driven by repeatable operations and is well-supported by actual cash flow, not accounting choices.
Question 3: In horizontal analysis, a company's selling expenses grew from $100,000 to $130,000. The percentage change is:
- 13%
- 23%
- 30% (Correct answer)
- 130%
Correct answer: 30%
Horizontal (trend) analysis calculates percentage change as (New – Old) / Old × 100 = ($30,000 / $100,000) × 100 = 30%.
Question 4: An off-balance-sheet arrangement that was once commonly used to keep debt off the balance sheet is:
- A stock repurchase program
- An operating lease under old GAAP standards (Correct answer)
- A stock dividend issuance
- A deferred tax liability
Correct answer: An operating lease under old GAAP standards
Under pre-ASC 842 GAAP, operating leases were not recorded on the balance sheet, allowing companies to use assets without reporting the corresponding liability.
Question 5: If a firm's effective tax rate is significantly lower than the statutory rate, which of the following is the most common explanation?
- The firm had no deferred tax liabilities
- The firm benefited from tax credits, exemptions, or favorable deductions (Correct answer)
- The firm reported a net operating loss carryforward as a liability
- Revenue recognition was accelerated for tax purposes
Correct answer: The firm benefited from tax credits, exemptions, or favorable deductions
Tax credits, accelerated deductions, or income excluded from taxation reduce the effective rate below the statutory corporate rate.
Question 6: Which statement about goodwill under U.S. GAAP is correct?
- Goodwill is amortized over 40 years
- Goodwill is tested for impairment annually and written down if impaired, but not amortized (Correct answer)
- Goodwill is expensed immediately at acquisition
- Goodwill is never recognized on the balance sheet
Correct answer: Goodwill is tested for impairment annually and written down if impaired, but not amortized
Under ASC 350, goodwill is not amortized but must be tested for impairment at least annually; any impairment is recognized as a loss.
Question 7: A firm's operating leverage is high when:
- It has a large proportion of variable costs relative to fixed costs
- Small changes in sales produce large changes in operating income due to high fixed costs (Correct answer)
- Its interest expense is a large proportion of operating income
- It relies heavily on equity financing over debt
Correct answer: Small changes in sales produce large changes in operating income due to high fixed costs
High operating leverage means fixed costs dominate; once those are covered, additional revenue flows largely to operating income, amplifying both gains and losses.
FIA Financial Statement Interpretation 5
A company capitalizes an expenditure rather than expensing it.
In the period of capitalization, this decision will: