CFA Institute CFA Institute Certifications CFA-LEVEL-1 Questions & Answers

• Question 2301:

  Firm A issues convertible bonds to raise capital in the amount of a million dollars. An identical Firm B issues debt with warrants attached to raise the same amount. Which of the following statements is/are true in this situation?

  I. Firm A ignores the convertibility feature completely while recording the bonds.

  II. Firm B's interest expense is higher than that of Firm A.

  III.

  Both the firms recognize the dilutive effects of the debt while calculating EPS.

  A.

  I, II and III

  B.

  II and III

  C.

  I only

  D.

  II only

  Correct Answer: A

  While both convertible bonds and bonds with attached warrants derive significant value from the possibility of conversion to common stock, the accounting treatments for the two are quite different. With convertible bonds, the conversion feature is completely ignored and the bond is recorded as an ordinary bond. On the other hand, the proceeds from a bond-with-warrant issue are divided into two groups: those related to the bond and those related to the warrant. The former is recorded as a liability while the latter is directly added to equity, without any income statement effects. This leads to a bigger amortization of a discount (or a smaller amortization of premium) with a warrant-debt than with a convertible bond. This effect offsets the fact that a higher liability is recognized with a convertible bond. Hence, the interest expense is higher in general when debt-with-warrant is issued.

• Question 2302:

  The promulgation of GAAP is a responsibility that rests with:

  A. The Securities and Exchange Commission (SEC).

  B. The Committee on Accounting Procedures (CAP).

  C. None of these answers.

  D. The American Accounting Association (AAA).

  Correct Answer: A

  The SEC has the primary responsibility for creation of accounting standards in the US. The AAA does issue its own statements about accounting standards and these are quite influential in shaping the official framework. However, its statements are not binding on the industry unless the SEC adopts them.Currently, the SEC has relegated most of the duties of addressing needs for various accounting standards to the Financial Accounting Standards Board (FASB), though it remains the final authority in these matters.

• Question 2303:

  The __________ is the most conservative of the following liquidity ratios.

  A. current ratio

  B. quick ratio

  C. cash ratio

  D. liquid ratio

  Correct Answer: C

  The cash ratio is the most conservative of the 3 liquidity ratios since it considers only cash and marketable securities relative to the current liabilities.

• Question 2304:

  A firm needs to purchase 20 warehouses in various states. To finance the purchases, it issues new shares in a seasoned equity offering. It also issues high coupon bonds on which interest must be paid semiannually. If the firm purchases the warehouses at the beginning of the year, which of the cash flows will be affected in the year-end statements?

  Investing Operating Financing

  I.affected affected affected II.affected affected unaffected III.affected unaffected affected IV.unaffected unaffected unaffected

  A. I.

  B. II.

  C. IV.

  D. III.

  Correct Answer: A

  The purchase of the warehouses affects the investing cash flows. The bonds and equity offering affect the financing cash flows. These transactions do not affect operating cash flow immediately. The interest payments on the issued debt, however, will affect it. In addition, the dividends paid on the new equity will affect financing cash flows.

• Question 2305:

  If a company converted a short-term note payable into a long-term note payable, this transaction would

  A. none of these answers.

  B. increase working capital.

  C. decrease working capital and the current ratio.

  D. increase both working capital and the current ratio.

  E. decrease only working capital.

  Correct Answer: D

  This transaction reduces current liabilities, but does not change current assets and, therefore, increases working capital and increases the current ratio.

• Question 2306:

  The following data have been extracted from the financial statements of a firm for two years, 1985 and 1986:

  1985 1986 Assets 4,376 5,214 Sales 8,312 7,845 Receivables 985 756 Inventory 1,108 1,243 COGS 5,494 4,971

  The inventory turnover ratio and the average inventory processing period for 1986 equal ________.

  A. 4.23 86.31 days

  B. 5.19 70.33 days

  C. 4.87 74.95 days

  D. 5.62 64.95 days

  Correct Answer: A

  One of the properties of the inventory that is of interest is the rate at which it turns over i.e. the average processing time it takes for a given inventory item to be sold. This can be estimated using either net sales (as is the case with receivables) or the cost-of-goods-sold. COGS is preferable since it does not include the profit margins involved in net sales. Therefore, two relevant ratios are: a. Inventory turnover ratio = COGS/average inventory. b. Average inventory processing period = 365/inventory turnover. For 1986, the average inventory equals (1243+1108)/2 = 1,176. Inventory turnover ratio = 4,971/1,176 = 4.23. Average inventory processing period = 365/4.23 = 86.31 days.

• Question 2307:

  Bay Co. purchased a 3-month U.S. Treasury bill. In preparing Bay's statement of cash flows, this purchase would

  A. have no effect.

  B. be treated as an outflow from lending activities.

  C. be treated as an outflow from financing activities.

  D. be treated as an outflow from operating activities.

  E. be treated as an outflow from investing activities.

  Correct Answer: A

  The T-bill is a cash equivalent and has no effect on the statement of cash flows. Cash equivalents are short-term, highly liquid investments that are both readily convertible to known amounts of cash and so near their maturities that they present insignificant risk of changes in value because of the changes in interest rates. They only include investments with original maturities to the holder of 3 months or less.

• Question 2308:

  Which of the following will most affect the valuation of a firm's receivables?

  A. The rate of sales growth

  B. None of these answers

  C. The type of business that a firm is engaged in

  D. The allowance for uncollectible accounts

  E. The seasonality of a company's products

  Correct Answer: D

  The most important factor that will affect the valuation of receivables, of the choices given, is the allowance for uncollectible accounts. This is so, because receivables are reported on the balance sheet as "net realizable value;" i.e., total amount of receivables, less an allowance for uncollectible accounts. If management understates this allowance, the realizable value of accounts receivable will be overstated and the firm's liquidity position will not be as strong as it would appear.

• Question 2309:

  In the full cost method, oil firms:

  A. none of these answers.

  B. are required to expense all oil-drilling costs resulting in dry holes.

  C. must expense drilling costs which result in productive oil wells.

  D. can capitalize all oil-drilling costs.

  Correct Answer: D

  In extractive industries, firms are allowed to use either the full-cost method, in which all search and development costs can be capitalized, or the successful-efforts method, where all such costs are expensed unless they result in revenue- generating assets, in which case, they are capitalized.

• Question 2310:

  When valuing inventories using the lower-of-cost-or market (LCM), which of the following is/are true?

  I. The inventory value cannot exceed the net realizable value.

  II. If the inventory is written down from cost, the value of the inventory cannot fall below the net realizable value.

  III. Inventories can only be written back up to the original cost.

  IV.

  Write-downs are charged directly to retained earnings account.

  A.

  I and III

  B.

  I, II and III

  C.

  II only

  D.

  II and III

  Correct Answer: A

  US GAAP requires that inventory be valued at the lower of cost or market value. This means that if the inventory value falls below the cost (FIFO, LIFO, average cost, etc.) for reasons which include price changes, obsolescence, damage or theft, the loss in value must be recognized immediately. Specifically, the inventory must be "written-down" in value and the loss recognized on the income statement. In the application of this principle, "market value" is defined as current replacement cost, except that this value cannot exceed the net realizable value (NRV) or fall below NRV minus the normal profit margin.