Question 1

2.A.2.q
tb.profit.vertical.038_1711
LOS: 2.A.2.q
Lesson Reference: Profitability – Vertical Analysis Revisited and Return Ratios
Difficulty: medium
Bloom Code: 4

A financial analyst is comparing Fremont Computers to its industry. Fremont's return on assets ratios are
presented in the accompanying table.

20X1 20X2 20X3 20X4 20X5

Fremont 12.44 12.4 11.9 12.1 10.8
Industry 10.87 11.08 10.99 10.45 10.12

Over the 5-year period from 20x1 to 20x5,

Correct

Fremont has performed better than the industry average.

Fremont has performed worse than the industry average.

Fremont has improved its profitability over time.

Your Answer

The industry has not increased its total assets over time.

Rationale
 Fremont has performed better than the industry average.
Return on assets (ROA) measures how much income a company generates per dollar in average total
assets. Higher values are generally preferred as it indicates that the firm is using its assets more
efficiently to generate income. Since Fremont's ROA is higher than the industry average every year from
20x1 to 20x5, it is fair to conclude that Fremont performed better than the industry average. Therefore,
this is the correct answer.

Rationale
 Fremont has performed worse than the industry average.
Return on assets (ROA) measures how much income a company generates per dollar in average total
assets. Higher values are generally preferred as it indicates that the firm is using its assets more
efficiently to generate income. Since Fremont's ROA is higher than the industry average every year from
20x1 to 20x5, it is fair to conclude that Fremont performed better than the industry average, not worse.
Therefore, this is an incorrect answer.

Rationale
 Fremont has improved its profitability over time.
Return on assets (ROA) measures how much income a company generates per dollar in average total
assets. Higher values are generally preferred as it indicates that the firm is using its assets more
efficiently to generate income. Since Fremont's ROA decreased between 20x1 and 20x5, it appears that
Fremont has not improved its profitability over time. Therefore, this is an incorrect answer.

Rationale
 The industry has not increased its total assets over time.
Return on assets (ROA) measures how much income a company generates per dollar in average total
assets. Higher values are generally preferred as it indicates that the firm is using its assets more
efficiently to generate income. ROA by itself does not tell anything about the amount of total assets
used over time. Therefore, this is an incorrect answer.
Question 2
2.A.2.o
profit.use.tb.013_2204
LOS: 2.A.2.o
Lesson Reference: Efficiency Ratios – Use of Assets
Difficulty: hard
Bloom Code: 4

The FOA Company has the following financial information:

Year 1 Year 2
Sales $200,000 $240,500
Net income $8,000 $12,000
Total assets $120,000 ?
PPE, Net $66,000 ?

If FOA’s total asset turnover for Year 2 is 1.85, what are its total assets at the end of Year 2?

$118,000

$130,000

$194,000
Correct

$140,000

Rationale
 $118,000
This answer is incorrect. Average sales for the two-year period are not used to calculate total asset
turnover.

Rationale
 $130,000
This answer is incorrect. Total assets just for Year 2 are not used to calculate total asset turnover.

Rationale
 $194,000
This answer is not correct. PPE, Net is not used to calculate total asset turnover.

Rationale
 $140,000
Correct. One way to assess an organization’s profitability is to measure how well the organization uses
its assets to generate sales revenue. One such measure is total asset turnover. This measure tells how
much sales revenue is generated by each dollar of average total assets. Higher numbers are generally
preferred as it indicates better use of assets. The formula is “Sales / Average Total Assets.” It is
important to remember that “average total assets” are used in the formula, not total assets for a single
year. This gives a better measure of the total assets in use while the sales are generated than total
assets for one year. Rearranging the formula results in “Average Total Assets = Sales / Total Asset
Turnover.” This results in Average Total Assets of $130,000 ($240,500 / 1.85). Since Total Assets in Year 1
is $120,000, Total Assets must be $140,000 in Year 2 in order for Average Total Assets to be $130,000.
Question 3
2.A.3.d
sales.rev.tb.004_2104
LOS: 2.A.3.d
Lesson Reference: Sales and Revenues – Important Considerations
Difficulty: medium
Bloom Code: 4

Abbott Industries has compiled the following sales results:

Quarter 1 Quarter 2 Quarter 3 Quarter 4

20X1 $99,000 201,500 47,500 98,700
20X2 147,200 249,900 97,000 146.800
20X3 198,600 287,800 153,0200 197,700

What is a reasonable conclusion about Abbott Industries after analyzing its sales?

Competition in its industry is strong.

Your Answer

Sales prices are increasing, and elasticity of demand is highly elastic.

Correct

While sales are cyclical, the overall sales trend is positive.

Sales prices are decreasing, and elasticity of demand is highly inelastic.

Rationale
 Competition in its industry is strong.
This answer is incorrect. Abbott Industries sales have shown steady increases. This is not consistent
with an industry experiencing strong competition.

Rationale
 Sales prices are increasing, and elasticity of demand is highly elastic.
This answer is incorrect. If demand is highly elastic and sales prices increase, total sales would drop as
customers would buy substitute products.

Rationale
 While sales are cyclical, the overall sales trend is positive.
This answer is correct. Sales revenues are increasing year over year, but the sales appear to be cyclical
as there is a regular drop in sales in the third quarter of each year.

Rationale
 Sales prices are decreasing, and elasticity of demand is highly inelastic.
This answer is incorrect. If demand is highly inelastic, total sales revenues would decrease as prices
decrease because, when demand is inelastic lower prices do not entice customers to purchase more.
Question 4
2.A.4.c
tb.changes.acct.011_1711
LOS: 2.A.4.c
Lesson Reference: Changes in Accounting Treatment
Difficulty: medium
Bloom Code: 3
An employee for Rotan Company is preparing the financial statements. He made a simple calculation error,
but did not catch it before the statements are submitted. What is this an example of?
Changes to financial accounting
Correct

Errors in financial statements

Changes in accounting principle

Changes in reporting entity

Rationale
 Changes to financial accounting
This is an example of an error in financial statements. A change in financial accounting is not an
accounting term. Therefore, this is an incorrect answer.

Rationale
 Errors in financial statements
This is an example of an error in financial statements. Once it is detected, a prior period adjustment
must be made to correct the error. Therefore, this is the correct answer.

Rationale
 Changes in accounting principle
This is an example of an error in financial statements. A change in accounting principle is when a
company changes from one GAAP-approved method to another GAAP-approved method (for example,
changing from average cost inventory to FIFO). Therefore, this is an incorrect answer.

Rationale
 Changes in reporting entity
This is an example of an error in financial statements. A change in reporting entity is when the reporting
company changes composition. One type of composition change is when consolidated statements are
presented in place of statements of individual companies. A second type is when the actual companies
included in the consolidated statements change. Therefore, this is an incorrect answer.
Question 5
2.A.3.d
tb.sales.rev.002_1711
LOS: 2.A.3.d
Lesson Reference: Sales and Revenues – Important Considerations
Difficulty: easy
Bloom Code: 2
Repeat customers who continually purchase the product or service are an example of the principle of
__________.
Elasticity

Trends
Correct

Stability

Source

Rationale
 Elasticity
Elasticity refers to how the customers respond to a change in selling price.

Rationale
 Trends
Trends are developed when sales are analyzed using a horizontal analysis.

Rationale
 Stability
Stability refers to repeat customers who continually purchase the product or service.

Rationale
 Source
Source refers to the product or service from which revenues are generated.
Question 6
2.A.2.p
tb.profit.vertical.013_1711
LOS: 2.A.2.p
Lesson Reference: Profitability – Vertical Analysis Revisited and Return Ratios
Difficulty: medium
Bloom Code: 3

Information from Haas Incorporated's 20x7 income statement is shown in the accompanying chart. Based on
this information, what was Haas’ gross profit rate for 20x7? Round to the nearest hundredth.

Correct

43.75%

97.68%

2.32%

12.32%

Rationale
 43.75%
Gross profit is defined as Net Sales – Cost of Goods Sold. Gross profit rate is defined as Gross Profit ÷ Net
Sales. It measures the percentage of sales revenue left after the cost of the inventory is deducted. Haas’
gross profit rate is 43.75% [$24,500 ($56,000 − $31,500) ÷ $56,000]. Therefore, this is the correct answer.

Rationale
 97.68%
Gross profit is defined as Net Sales – Cost of Goods Sold. Gross profit rate is defined as Gross Profit ÷ Net
Sales. It measures the percentage of sales revenue left after the cost of the inventory is deducted. Haas’
total expenses as a percentage of net sales is 97.68% [$54,700 ($31,500 + $17,600 + $5,600) ÷ $56,000].
The question asks about Haas’ gross profit rate, not its total expenses as a percentage of net sales.
Therefore, this is an incorrect answer.

Rationale
 2.32%
Gross profit is defined as Net Sales – Cost of Goods Sold. Gross profit rate is defined as Gross Profit ÷ Net
Sales. It measures the percentage of sales revenue left after the cost of the inventory is deducted. Haas’
return on sales (Net Income ÷ Net Sales) is 2.32% ($1,300 ÷ $56,000). The question asks about Haas’
gross profit rate, not its return on sales. Therefore, this is an incorrect answer.

Rationale
 12.32%
Gross profit is defined as Net Sales – Cost of Goods Sold. Gross profit rate is defined as Gross Profit ÷ Net
Sales. It measures the percentage of sales revenue left after the cost of the inventory is deducted. Haas’
operating income as a percentage of net sales (Net Sales – Cost of Goods Sold – Operating Expenses) is
12.32% [$6,900 ($56,000 − $31,500 − $17,600) ÷ $56,000]. The question asks about Haas’ gross profit
rate, not its operating income as a percentage of net sales. Therefore, this is an incorrect answer.
Question 7
2.A.2.p
tb.profit.vertical.003_1711
LOS: 2.A.2.p
Lesson Reference: Profitability – Vertical Analysis Revisited and Return Ratios
Difficulty: hard
Bloom Code: 5
Daria's Discount Store opened in 20x6 and carried low-cost personal and home items with high turnover and
low markup. In 20x7, Daria's began carrying some higher-cost, better quality items with lower turnover and
higher markup. In 20x8, Daria's discontinued the higher-cost items and returned to only low-cost items. If net
sales and all expenses other than cost of goods sold were equal in all three years, how did Daria's profit
margins change from 20x6 to 20x8?
Your Answer

Daria's profit margins were lowest in 20x7 but were about the same in 20x6 and 20x8.
Correct

Daria's profit margins were highest in 20x7 but were about the same in 20x6 and 20x8.

Daria's profit margins gradually decreased from 20x6 to 20x8.

Daria's profit margins gradually increased from 20x6 to 20x8.

Rationale
 Daria's profit margins were lowest in 20x7 but were about the same in 20x6 and 20x8.
Profit margin is defined as Net Income ÷ Net Sales. It measures what percentage of every dollar of sales
a company earns as income. Since the facts of the question indicate all expenses other than cost of
goods sold were equal in all three years, cost of goods sold is the expense to focus on. A higher markup
means that the “spread” between selling price and the price the company paid for the goods (cost of
goods sold) increases. As the markup increases in 20x7, profit margin will also increase, not decrease.
The profit margin will decrease back toward the 20x6 level in 20x8 as the markup decreases. Therefore,
this is an incorrect answer.

Rationale
 Daria's profit margins were highest in 20x7 but were about the same in 20x6 and 20x8.
Profit margin is defined as Net Income ÷ Net Sales. It measures what percentage of every dollar of sales
a company earns as income. Since the facts of the question indicate all expenses other than cost of
goods sold were equal in all three years, cost of goods sold is the expense to focus on. A higher markup
means that the “spread” between selling price and the price the company paid for the goods (cost of
goods sold) increases. As the markup increases in 20x7, profit margin will also increase. However, profit
margin will decrease back toward the 20x6 level in 20x8 as the markup decreases. Therefore, this is the
correct answer.

Rationale
 Daria's profit margins gradually decreased from 20x6 to 20x8.
Profit margin is defined as Net Income ÷ Net Sales. It measures what percentage of every dollar of sales
a company earns as income. Since the facts of the question indicate all expenses other than cost of
goods sold were equal in all three years, cost of goods sold is the expense to focus on. A higher markup
means that the “spread” between selling price and the price the company paid for the goods (cost of
goods sold) increases. As the markup increases in 20x7, profit margin will also increase. The profit
margin will decrease back toward the 20x6 level in 20x8 as the markup decreases. Therefore, this is an
incorrect answer.

Rationale
 Daria's profit margins gradually increased from 20x6 to 20x8.
Profit margin is defined as Net Income ÷ Net Sales. It measures what percentage of every dollar of sales
a company earns as income. Since the facts of the question indicate all expenses other than cost of
goods sold were equal in all three years, cost of goods sold is the expense to focus on. A higher markup
means that the “spread” between selling price and the price the company paid for the goods (cost of
goods sold) increases. As the markup increases in 20x7, profit margin will also increase. However, the
profit margin will decrease back toward the 20x6 level in 20x8 as the markup decreases. Therefore, this
is an incorrect answer.
Question 8
2.A.2.l
tb.eff.ratios.023_1711
LOS: 2.A.2.l
Lesson Reference: Efficiency Ratios
Difficulty: medium
Bloom Code: 3

Selected financial information for Schultz Industries is listed as follows:

Cost of Goods Sold $425,000

Net Sales Revenue $908,505
Beginning Inventory Balance $44,550
Average Accounts Receivable $62,255
Ending Inventory Balance $38,950

Compute Schultz's inventory turnover.

Correct

10.2 times

14.6 times

21.8 times
Your Answer

10.9 times

Rationale
 10.2 times
Inventory turnover measures the number of times in a period that inventory is sold. Higher turnover is
generally preferred as it means inventory is sold more quickly. It is defined as Cost of Goods Sold ÷
Average Inventory. Schultz's inventory turned over 10.2 times [$425,000 ÷ $41,750 (($44,550 + $38,950) ÷
2)]. Therefore, this is the correct answer.

Rationale
 14.6 times
Inventory turnover measures the number of times in a period that inventory is sold. Higher turnover is
generally preferred as it means inventory is sold more quickly. It is defined as Cost of Goods Sold ÷
Average Inventory. Schultz's inventory turnover would be 14.6 times if net sales revenue is used in the
numerator and average accounts receivable is used in the denominator ($908,505 ÷ $62,255). This is
accounts receivable turnover. However, cost of goods sold and average inventory need to be used since
cost of goods sold and inventory are both measured using the original purchase cost of inventory.
Therefore, this is an incorrect answer.

Rationale
 21.8 times
Inventory turnover measures the number of times in a period that inventory is sold. Higher turnover is
generally preferred as it means inventory is sold more quickly. It is defined as Cost of Goods Sold ÷
Average Inventory. Schultz's inventory turnover would be 21.8 times if net sales revenue is used in the
numerator [$908,505 ÷ $41,750 (($44,550 + $38,950) ÷ 2)]. However, cost of goods sold needs to be used
since cost of goods sold and inventory are both measured using the original purchase cost of inventory.
Therefore, this is an incorrect answer.

Rationale
 10.9 times
Inventory turnover measures the number of times in a period that inventory is sold. Higher turnover is
generally preferred as it means inventory is sold more quickly. It is defined as Cost of Goods Sold ÷
Average Inventory. Schultz's inventory turnover would be 10.9 times if ending inventory is used in the
denominator ($425,000 ÷ $38,950). However, average inventory needs to be used. Therefore, this is an
incorrect answer.
Question 9
2.A.1.b
tb.horiz.financial.003_1711
LOS: 2.A.1.b
Lesson Reference: Horizontal Financial Statement Analysis
Difficulty: medium
Bloom Code: 4

An analysis of financial statements of Gill Corporation revealed the following information for its liabilities
over the past four years.

Based on horizontal analysis, what is the percentage for accounts payable for Year 2 and by what percentage
did it decrease over Year 1?

77.52% and 22.48%

Correct

88.53% and 11.47%

112.95% and 12.95%

11.47% and 88.53%

Rationale
 77.52% and 22.48%
In horizontal analysis, each figure is expressed as a percentage of the Year 1 figure. 77.52% ($3,660 ÷
$4,134) and 22.48% (($3,660 – $4,134) ÷ $4,134) are the Year 2 figures and decrease over Year 1 for long-
term liabilities, not accounts payable. Therefore, this is an incorrect answer.

Rationale
 88.53% and 11.47%
In horizontal analysis, each figure is expressed as a percentage of the Year 1 figure. The accounts
payable in Year 2 is 88.53% ($3,660 ÷ $4,134). By definition, the Year 1 value is 100%, so the Year 2 value
represents a decrease of 11.47% (88.53% – 100%). Therefore, this is the correct answer.

Rationale
 112.95% and 12.95%
In horizontal analysis, each figure is expressed as a percentage of the Year 1 figure. 112.95% is the figure
if Year 2 is used as the base, not Year 1 ($4,134 ÷ $3,660). 12.95% would be the increase from 100% to
112.95%. Therefore, this is an incorrect answer.

Rationale
 11.47% and 88.53%
In horizontal analysis, each figure is expressed as a percentage of the Year 1 figure. The accounts
payable in Year 2 is 88.53% ($3,660 ÷ $4,134). By definition, the Year 1 value is 100%, so the Year 2 value
represents a decrease of 11.47% (88.53% – 100%). This choice has the responses reversed. Therefore,
this is an incorrect answer.
Question 10
2.A.2.p
tb.profit.vertical.008_1711
LOS: 2.A.2.p
Lesson Reference: Profitability – Vertical Analysis Revisited and Return Ratios
Difficulty: medium
Bloom Code: 3
Last month, Shiloh Shoes had net sales of $40,000. If the firm's cost of goods sold was $28,000, then
Correct

Shiloh's gross profit on sales was $12,000.

Shiloh's gross profit on sales was $68,000.

Shiloh's net income was $12,000.

Shiloh's net income was $68,000.

Rationale
 Shiloh's gross profit on sales was $12,000.
Gross profit is defined as Net Sales – Cost of Goods Sold. Shiloh's gross profit is $12,000 ($40,000 −
$28,000). Therefore, this is the correct answer.

Rationale
 Shiloh's gross profit on sales was $68,000.
Gross profit is defined as Net Sales – Cost of Goods Sold. Shiloh's gross profit would be $68,000 ($40,000
+ $28,000) if cost of goods sold is added to revenue. This is not the correct formula. Therefore, this is an
incorrect answer.

Rationale
 Shiloh's net income was $12,000.
Net income is the difference between net sales and all expenses. Since the only expense listed is cost of
goods sold, it is not possible to calculate net income. Therefore, this is an incorrect answer.

Rationale
 Shiloh's net income was $68,000.
Net income is the difference between net sales and all expenses. Since the only expense listed is cost of
goods sold, it is not possible to calculate net income. Therefore, this is an incorrect answer.