Accounting for Decision Makers (C213)

Correct Answer

A. True

Explanation

Lenders assess a borrower's financial stability by reviewing their income, expenses, and credit history. Providing accurate and transparent financial information reduces perceived risk, allowing lenders to offer lower interest rates. When risk is lower, lenders are more confident in timely repayment, leading to more favorable loan terms for borrowers.

Why Other Options Are Wrong

B. False This option is incorrect because lenders determine interest rates based on risk assessment. If a borrower withholds financial information or has an unclear financial history, lenders may charge a higher interest rate to compensate for the increased uncertainty of repayment.

Correct Answer

A. Product quality or service effectiveness

Explanation

Financial analysis primarily focuses on quantitative measures like profitability, liquidity, and leverage, rather than subjective factors like product quality or service effectiveness. While these qualitative aspects affect long-term success, they are not directly measured through financial ratios or cash flow analysis. Financial statement analysis relies more on industry trends, operational diversity, and capital structure to provide meaningful insights.

Why Other Options Are Wrong

B. Industry type - This option is incorrect because the industry type affects which financial metrics are most relevant. For example, leverage and asset turnover are crucial in capital-intensive industries, while profit margins and revenue growth may be more important for service industries.

C. Diversity of business operations - This option is incorrect because companies with diverse business segments require different financial measures. A conglomerate may need segment-specific profitability analysis, while a single-product company may focus more on cost control.

D. Capital structure - This option is incorrect because capital structure significantly impacts financial analysis. Leverage ratios, interest coverage, and debt-to-equity ratios are essential for assessing a company’s financial risk and stability.

Correct Answer

A. Supplementary information required by the Internal Revenue Service

Explanation

The Internal Revenue Service (IRS) focuses on tax reporting, which is separate from financial reporting. While financial statement notes provide essential details for investors, creditors, and regulators, they are not primarily designed to fulfill IRS requirements. The four main types of notes in financial statements include disclosures on accounting policies, additional explanations of financial statement totals, legally required disclosures, and other material information that influences financial decisions.

Why Other Options Are Wrong

B. Additional information about the summary totals found in the financial statements. – This is a key function of financial statement notes. They provide more context on figures reported in financial statements, such as breaking down asset categories or explaining changes in liabilities.

C. Disclosure of important information that is not recognized in the financial statements. – Some events, like pending lawsuits or lease obligations, may not be recorded as transactions but still affect a company's financial position. Notes to financial statements ensure such information is disclosed for transparency.

D. Summary of significant accounting policies. – Companies must disclose the accounting methods they use, such as depreciation methods, revenue recognition policies, and inventory valuation techniques. This allows stakeholders to understand how financial figures are determined.

Correct Answer

B. 77 percent

Explanation

On a common-size income statement, each item is expressed as a percentage of total sales revenue. The percentage for cost of goods sold (COGS) is calculated as:

$\left(\frac{700,000}{915,000}\right)\times 100=76.5\%$

                           ≈77% 

This means that 77% of sales revenue is spent on COGS, leaving the remaining portion for operating expenses and net income.

Why Other Options Are Wrong

A. 49 percent - This option is incorrect because 49% is much lower than the correct value. The calculation clearly shows that the cost of goods sold is a significant portion of sales revenue.

C. 20 percent - This option is incorrect because 20% does not reflect the high proportion of sales revenue allocated to COGS. If COGS were only 20% of sales, the company would have an exceptionally high gross profit margin, which is unlikely given the provided data.

D. 100 percent - This option is incorrect because COGS cannot equal total sales revenue unless there is no gross profit. Since the company has net income, COGS must be less than 100% of revenue.

Correct Answer

B. Debt ratio

Explanation

The debt ratio is calculated using the formula:

$\mathrm{Debt} \mathrm{Ratio}=\frac{\mathrm{Total} \mathrm{Liabilities}}{\mathrm{Total} \mathrm{Assets}}$

This ratio measures the extent to which a company's assets are financed through debt. A higher debt ratio indicates a greater reliance on borrowed funds, which could imply higher financial risk. Companies with a lower debt ratio are generally considered more financially stable.

Why Other Options Are Wrong

A. Return on assets This is incorrect because return on assets (ROA) measures a company's profitability by comparing net income to total assets. It focuses on efficiency rather than the proportion of borrowed funds.

C. Return on sales This is incorrect because return on sales (ROS) measures profitability by comparing net income to revenue. It does not analyze how a company finances its assets.

D. Current ratio This is incorrect because the current ratio measures short-term liquidity by comparing current assets to current liabilities. While it assesses financial health, it does not indicate the proportion of debt financing.

Correct Answer

D. It is a government agency

Explanation

The Financial Accounting Standards Board (FASB) is an independent, private organization responsible for developing and maintaining accounting standards in the United States. While it plays a crucial role in establishing generally accepted accounting principles (GAAP), it is not a government agency. Instead, it operates under the Financial Accounting Foundation (FAF), a non-profit organization.

Why Other Options Are Wrong

A. It seeks consistency for its proposed standards – FASB aims to ensure consistency in financial reporting by creating standardized accounting principles. Consistency in financial statements helps investors, creditors, and other users compare financial performance across different companies and industries. Without consistency, financial information would be unreliable and difficult to interpret.

B. It consists of seven full-time members – The FASB is composed of seven full-time board members who are appointed to serve five-year terms, with the possibility of reappointment. These members come from diverse backgrounds in accounting, finance, and business to provide well-rounded expertise. Without full-time commitment, the board would lack the dedication needed to develop and refine accounting standards effectively.

C. It has no legal power to enforce the standards it sets – While FASB establishes GAAP, it does not have direct legal enforcement authority. Instead, compliance with its standards is mandated by regulatory agencies such as the Securities and Exchange Commission (SEC) and other governing bodies. Without enforcement through external agencies, adherence to GAAP would be voluntary and could lead to inconsistencies in financial reporting.

Correct Answer

C. Investing decisions

Explanation

External users, such as investors and creditors, analyze financial statements primarily to assess a company’s profitability, financial stability, and growth potential before making investment decisions. Investors use financial ratios and performance trends to determine whether to buy, hold, or sell stocks. Creditors, on the other hand, evaluate a company’s ability to meet debt obligations before lending funds.

Why Other Options Are Wrong

A. Operating, investing, and financing decisions. – Operating decisions are typically made by internal users, such as management, rather than external users. While external users are concerned with investing and financing, they do not participate in day-to-day operations.

B. Financing decisions. – Financing decisions are more relevant to company executives who determine how to raise funds through debt or equity. External users may assess financing structures, but their primary focus is on investment opportunities rather than managing corporate finances.

D. Operating and financing decisions. – External users are not responsible for operating decisions, as these are handled internally by management. While they may consider financing structures, their main concern is making sound investment choices.

Correct Answer

B. Securities and Exchange Commission (SEC)

Explanation

The Securities and Exchange Commission (SEC) has the legal authority to establish accounting standards for publicly traded companies in the United States. The SEC was created by the Securities Exchange Act of 1934 to regulate securities markets and protect investors. While the SEC often delegates the standard-setting process to the Financial Accounting Standards Board (FASB), it retains the ultimate authority to enforce and modify financial reporting requirements.

Why Other Options Are Wrong

A. Financial Accounting Standards Board (FASB) – While FASB is responsible for developing accounting standards, it does not have the legal authority to enforce them. Instead, it establishes generally accepted accounting principles (GAAP), which the SEC and other regulatory bodies require companies to follow. Without the SEC’s enforcement power, FASB’s standards would not be legally binding on public companies.

C. Internal Revenue Service (IRS) – The IRS overseas tax regulations, not accounting standards. While businesses must report financial information for tax purposes, tax accounting rules differ from financial reporting standards. If the IRS had authority over accounting standards, financial reporting would be influenced primarily by tax collection rather than by providing useful information to investors.

D. American Institute of Certified Public Accountants (AICPA) – The AICPA is a professional organization that provides guidance and ethical standards for certified public accountants (CPAs). It previously played a role in setting accounting standards but no longer has authority in this area. If the AICPA had legal authority, financial reporting standards might lack regulatory oversight and public accountability.

Correct Answer

D. Price-earnings ratio

Explanation

The price-earnings (P/E) ratio compares a company’s market price per share to its earnings per share (EPS). This ratio is significant for investors as it indicates how much they are willing to pay for each dollar of earnings, reflecting market expectations about future growth. Since it involves both financial statement data (earnings) and market value data (stock price), it is the correct answer.

Why Other Options Are Wrong

A. Debt ratio. – The debt ratio measures financial leverage by comparing total debt to total assets. It does not involve any market value figures, making it unrelated to a company’s stock price or market valuation.

B. Return on equity. – Return on equity (ROE) measures profitability by comparing net income to shareholders’ equity. Since it is entirely based on financial statement data, it does not incorporate any market value figures.

C. Return on sales. – Return on sales (ROS) measures operating efficiency by comparing net income to revenue. Like ROE, it only uses financial statement data and does not factor in market valuation.