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Mid-term Examination with Answers – Mgt. 624

Please complete and send/bring completed exam by February 25 before class. All questions are True/False or multiple-choice. Please make sure to include the rationale for the answer(s) you give – no need to cite a reference – just your reasoning for your answer. You may any source except help from another human being (no loose definitions of human being!) or old exam answers. Have fun and hopefully solidify your learning to date.

1. If a company reports retained earnings of $175.3 million on its balance sheet, it must also report $175.3 million in cash.

Answer: False
Rationale: The accounting equation requires total assets to equal total liabilities plus stockholders’ equity. That does not imply, however, that liability and equity accounts relate directly to specific assets.

2. The income statement reports net income which is defined as the company’s profit after all expenses and dividends have been paid.

Answer: False
Rationale: The statement contains two errors. First, net income does not include any dividends during the period; these are a distribution of profits and not part of its calculation. Second, the income statement is prepared on an accrual basis and thus includes expenses incurred (as opposed to paid).

3. Consider two companies (A and B) with equal profit margins of 15%. Company A has an asset turnover of 1.2 and Company B has an asset turnover of 1.5. If all else is equal, Company B with its’ higher asset turnover, is less profitable because it is expensive to turn assets over.

Answer: False
Rationale: “Profitability” is not clearly defined: it could be “profit margin/return on sales on the one hand or it could be return on assets (e.g., ROA). If the former, the statement is false since it states that the two are equally profitable. If the latter, it is also false since the higher the turnover, the more efficient the company is with its assets and thus, the more profitable. Algebraically, ROA = PM × AT. Company A is less profitable: 15% × 1.2 = 18% whereas Company B’s ROA is 15% × 1.5 = 22.5% so B is more not less profitable.

4. Assets, expenses and dividends increase with debits.

Answer: True
Rationale: Assets increase with debits and equity decreases with debits. Therefore, higher expenses and dividends paid decrease equity so they are debits.

5. Revenues and expenses affect the income statement but not the balance sheet.

Answer: False
Rationale: Revenue and expense recognition change retained earnings on the balance sheet.

6. Accrual accounting recognizes revenues only when cash is received and expenses only when cash is paid.

Answer: False
Rationale: Accrual accounting refers to the recognition of revenue when earned and the matching of expenses when incurred. The recognition of revenues and expenses does not, necessarily, relate to the receipt or payment of cash.

7. Highly leveraged firms have higher RNOA than firms with lower leverage.

Answer: False
Rationale: Financial leverage (ratio of assets to equity) does not affect the RNOA (Net operating profit after taxes/average net operating assets) computation because RNOA is based on operating profit. High financial leverage will increase ROE, however.

8. Repurchasing shares near year end will increase a firm’s return on equity (ROE).

Answer: True
Rationale: Repurchasing shares will decrease equity because treasury stock is a contra-account (it reduces total equity). If the repurchases happen at year end, there are likely no significant profit impacts and thus, the numerator in the ROE ratio will be largely unaffected. Thus, the ratio will increase.

9. If Company A has a higher net operating profit margin (NOPM) than Company B, then Company A’s RNOA will be higher.

Answer: False
Rationale: RNOA depends on NOPM but also depends on operating asset productivity (NOAT). If Company B had a...
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