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510 Reading 15 ■ Introduction to Financial Statement Analysis

PRACTICE PROBLEMS
1 Providing information about the performance and financial position of compa-
nies so that users can make economic decisions best describes the role of:
A auditing.
B financial reporting.
C financial statement analysis.
2 Which of the following best describes the role of financial statement analysis?
A To provide information about a company’s performance
B To provide information about a company’s changes in financial position
C To form expectations about a company’s future performance and financial
position
3 The role of financial statement analysis is best described as:
A providing information useful for making investment decisions.
B evaluating a company for the purpose of making economic decisions.
C using financial reports prepared by analysts to make economic decisions.
4 A company’s financial position would best be evaluated using the:
A balance sheet.
B income statement.
C statement of cash flows.
5 A company’s profitability for a period would best be evaluated using the:
A balance sheet.
B income statement.
C statement of cash flows.
6 The financial statement that presents a shareholder’s residual claim on assets is
the:
A balance sheet.
B income statement.
C cash flow statement.
7 A company’s profitability over a period of time is best evaluated using the:
A balance sheet.
B income statement.
C cash flow statement.
8 The income statement is best used to evaluate a company’s:
A financial position.
B sources of cash flow.
C financial results from business activities.
9 Accounting policies, methods, and estimates used in preparing financial state-
ments are most likely to be found in the:
A auditor’s report.
B management commentary.
C notes to the financial statements.

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Practice Problems 511

10 Information about management and director compensation are least likely to be

found in the:
A auditor’s report.
B proxy statement.
C notes to the financial statements.
11 Information about a company’s objectives, strategies, and significant risks are
most likely to be found in the:
A auditor’s report.
B management commentary.
C notes to the financial statements.
12 Which of the following best describes why the notes that accompany the finan-
cial statements are required? The notes:
A permit flexibility in statement preparation.
B standardize financial reporting across companies.
C provide information necessary to understand the financial statements.
13 What type of audit opinion is preferred when analyzing financial statements?
A Qualified.
B Adverse.
C Unqualified.
14 An auditor determines that a company’s financial statements are prepared in
accordance with applicable accounting standards except with respect to inven-
tory reporting. This exception is most likely to result in an audit opinion that is:
A adverse.
B qualified.
C unqualified.
15 An independent audit report is most likely to provide:
A absolute assurance about the accuracy of the financial statements.
B reasonable assurance that the financial statements are fairly presented.
C a qualified opinion with respect to the transparency of the financial
statements.
16 Interim financial reports released by a company are most likely to be:
A monthly.
B unaudited.
C unqualified.
17 Which of the following sources of information used by analysts is found outside
a company’s annual report?
A Auditor’s report
B Peer company analysis
C Management’s discussion and analysis
18 Ratios are an input into which step in the financial statement analysis
framework?
A Process data.
B Collect input data.
C Analyze/interpret the processed data.
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512 Reading 15 ■ Introduction to Financial Statement Analysis

19 Which phase in the financial statement analysis framework is most likely to

involve producing updated reports and recommendations?
A Follow-up
B Analyze/interpret the processed data
C Develop and communicate conclusions and recommendations
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Solutions 513

SOLUTIONS
1 B is correct. This is the role of financial reporting. The role of financial state-
ment analysis is to evaluate the financial reports.
2 C is correct. In general, analysts seek to examine the past and current perfor-
mance and financial position of a company in order to form expectations about
its future performance and financial position.
3 B is correct. The primary role of financial statement analysis is to use financial
reports prepared by companies to evaluate their past, current, and potential
performance and financial position for the purpose of making investment,
credit, and other economic decisions.
4 A is correct. The balance sheet portrays the company’s financial position on a
specified date. The income statement and statement of cash flows present differ-
ent aspects of performance during the period.
5 B is correct. Profitability is the performance aspect measured by the income
statement. The balance sheet portrays the financial position. The statement of
cash flows presents a different aspect of performance.
6 A is correct. Owners’ equity is the owners’ residual interest in (i.e., residual
claim on) the company’s assets after deducting its liabilities, which is informa-
tion presented on the balance sheet.
7 B is correct. A company’s profitability is best evaluated using the income
statement. The income statement presents information on the financial results
of a company’s business activities over a period of time by communicating
how much revenue was generated and the expenses incurred to generate that
revenue.
8 C is correct. A company’s revenues and expenses are presented on the income
statement, which is used to evaluate a company’s financial results (or profit-
ability) from business activities over a period of time. A company’s financial
position is best evaluated by using the balance sheet. A company’s sources of
cash flow are best evaluated using the cash flow statement.
9 C is correct. The notes disclose choices in accounting policies, methods, and
estimates.
10 A is correct. Information about management and director compensation is
not found in the auditor’s report. Disclosure of management compensation is
required in the proxy statement, and some aspects of management compensa-
tion are disclosed in the notes to the financial statements.
11 B is correct. These are components of management commentary.
12 C is correct. The notes provide information that is essential to understanding
the information provided in the primary statements.
13 C is correct. An unqualified opinion is a “clean” opinion and indicates that the
financial statements present the company’s performance and financial position
fairly in accordance with a specified set of accounting standards.
14 B is correct. A qualified audit opinion is one in which there is some scope
limitation or exception to accounting standards. Exceptions are described in
the audit report with additional explanatory paragraphs so that the analyst can
determine the importance of the exception.
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514 Reading 15 ■ Introduction to Financial Statement Analysis

15 B is correct. The independent audit report provides reasonable assurance that

the financial statements are fairly presented, meaning that there is a high proba-
bility that the audited financial statements are free from material error, fraud, or
illegal acts that have a direct effect on the financial statements.
16 B is correct. Interim reports are typically provided semiannually or quarterly
and present the four basic financial statements and condensed notes. They are
not audited. Unqualified is a type of audit opinion
17 B is correct. When performing financial statement analysis, analysts should
review all company sources of information as well as information from external
sources regarding the economy, the industry, the company, and peer (compara-
ble) companies.
18 C is correct. Ratios are an output of the process data step but are an input into
the analyze/interpret data step.
19 A is correct. The follow-up phase involves gathering information and repeat-
ing the analysis to determine whether it is necessary to update reports and
recommendations.
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Practice Problems 537

PRACTICE PROBLEMS
1 Which of the following is most likely not an objective of financial statements?
A To provide information about the performance of an entity.
B To provide information about the financial position of an entity.
C To provide information about the users of an entity’s financial statements.
2 International financial reporting standards are currently developed by which
entity?
A The IFRS Foundation.
B The International Accounting Standards Board.
C The International Organization of Securities Commissions.
3 US generally accepted accounting principles are currently developed by which
entity?
A The Securities and Exchange Commission.
B The Financial Accounting Standards Board.
C The Public Company Accounting Oversight Board.
4 A core objective of the International Organization of Securities Commissions is
to:
A eliminate systemic risk.
B protect users of financial statements.
C ensure that markets are fair, efficient, and transparent.
5 According to the Conceptual Framework for Financial Reporting, which of the
following is not an enhancing qualitative characteristic of information in finan-
cial statements?
A Accuracy.
B Timeliness.
C Comparability.
6 Which of the following is not a constraint on the financial statements according
to the Conceptual Framework?
A Understandability.
B Benefit versus cost.
C Balancing of qualitative characteristics.
7 The assumption that an entity will continue to operate for the foreseeable future
is called:
A accrual basis.
B comparability.
C going concern.
8 The assumption that the effects of transactions and other events are recognized
when they occur, not when the cash flows occur, is called:
A relevance.
B accrual basis.
C going concern.

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538 Reading 16 ■ Financial Reporting Standards

9 Neutrality of information in the financial statements most closely contributes to

which qualitative characteristic?
A Relevance.
B Understandability.
C Faithful representation.
10 Valuing assets at the amount of cash or equivalents paid or the fair value of
the consideration given to acquire them at the time of acquisition most closely
describes which measurement of financial statement elements?
A Current cost.
B Historical cost.
C Realizable value.
11 The valuation technique under which assets are recorded at the amount that
would be received in an orderly disposal is:
A current cost.
B present value.
C realizable value.
12 Which of the following is not a required financial statement according to IAS
No. 1?
A Statement of financial position.
B Statement of changes in income.
C Statement of comprehensive income.
13 Which of the following elements of financial statements is most closely related
to measurement of performance?
A Assets.
B Expenses.
C Liabilities.
14 Which of the following elements of financial statements is most closely related
to measurement of financial position?
A Equity.
B Income.
C Expenses.
15 Which of the following disclosures regarding new accounting standards pro-
vides the most meaningful information to an analyst?
A The impact of adoption is discussed.
B The standard will have no material impact.
C Management is still evaluating the impact.
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Solutions 539

SOLUTIONS
1 C is correct. Financial statements provide information, including information
about the entity’s financial position, performance, and changes in financial posi-
tion, to users. They do not typically provide information about users.
2 B is correct. The IASB is currently charged with developing International
Financial Reporting Standards.
3 B is correct. The FASB is responsible for the Accounting Standards
Codification™, the single source of nongovernmental authoritative US generally
accepted accounting principles.
4 C is correct. A core objective of IOSCO is to ensure that markets are fair, effi-
cient, and transparent. The other core objectives are to reduce, not eliminate,
systemic risk and to protect investors, not all users of financial statements.
5 A is correct. Accuracy is not an enhancing qualitative characteristic. Faithful
representation, not accuracy, is a fundamental qualitative characteristic.
6 A is correct. Understandability is an enhancing qualitative characteristic of
financial information—not a constraint.
7 C is correct. The Conceptual Framework identifies two important underlying
assumptions of financial statements: accrual basis and going concern. Going
concern is the assumption that the entity will continue to operate for the
foreseeable future. Enterprises with the intent to liquidate or materially curtail
operations would require different information for a fair presentation.
8 B is correct. Accrual basis reflects the effects of transactions and other events
being recognized when they occur, not when the cash flows. These effects are
recorded and reported in the financial statements of the periods to which they
relate.
9 C is correct. The fundamental qualitative characteristic of faithful representa-
tion is contributed to by completeness, neutrality, and freedom from error.
10 B is correct. Historical cost is the consideration paid to acquire an asset.
11 C is correct. The amount that would be received in an orderly disposal is realiz-
able value.
12 B is correct. There is no statement of changes in income. Under IAS No. 1, a
complete set of financial statements includes a statement of financial position, a
statement of comprehensive income, a statement of changes in equity, a state-
ment of cash flows, and notes comprising a summary of significant accounting
policies and other explanatory information.
13 B is correct. The elements of financial statements related to the measure of
performance are income and expenses.
14 A is correct. The elements of financial statements related to the measurement of
financial position are assets, liabilities, and equity.
15 A is correct. A discussion of the impact would be the most meaningful,
although B would also be useful.