CIA Part3

Gleim's CIA Test Prep: Part III: Business Analysis and Information Technology (1347 questions)

[Fact Pattern #1] The management and employees of a large household goods moving company decided to adopt total quality management (TQM) and continuous improvement (CI). They believed that, if their company became nationally known as adhering to TQM and CI, one result would be an increase in the company’s profits and market share. [1] Gleim #: 1.1 -- Source: CIA 1195 III-12 (Refers to Fact Pattern #1) The primary reason for adopting TQM was to achieve

A. B. C. D.

Greater customer satisfaction. Reduced delivery time. Reduced delivery charges. Greater employee participation. Answer (A) is correct. TQM is an integrated system that anticipates, meets, and exceeds customers’ needs, wants, and expectations. Answer (B) is incorrect because reduced delivery time is one of many potential activities that need improvement. Answer (C) is incorrect because reduced delivery charges is one of many potential activities that need improvement. Answer (D) is incorrect because increased employee participation is necessary to achieve TQM, but it is not the primary purpose for establishing the program.

[2] Gleim #: 1.2 -- Source: CIA 1195 III-13 (Refers to Fact Pattern #1) Quality is achieved more economically if the company focuses on

A. B. C. D.

Appraisal costs. Prevention costs. Internal failure costs. External failure costs. Answer (A) is incorrect because prevention is ordinarily less costly than the combined costs of appraisal, internal failure, and external failure. Answer (B) is correct. Prevention attempts to avoid defective output. Prevention costs include preventive maintenance, employee training, review of equipment design, and evaluation of suppliers. Prevention is less costly than detection and correction of defective output. Answer (C) is incorrect because prevention is ordinarily less costly than the combined costs of appraisal, internal failure, and external failure. Answer (D) is incorrect because prevention is ordinarily less costly than the combined costs of appraisal, internal failure, and external failure.

[3] Gleim #: 1.3 -- Source: CIA 1195 III-28 A traditional quality control process in manufacturing consists of mass inspection of goods only at the end of a production process. A major deficiency of the traditional control process is that

Copyright 2006 Gleim Publications, Inc. Printed for Pol Mirafuentes

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A. B. C. D.

It is expensive to do the inspections at the end of the process. It is not possible to rework defective items. It is not 100% effective. It does not focus on improving the entire production process. Answer (A) is incorrect because other quality control processes can also be expensive. Answer (B) is incorrect because reworking defective items may be possible although costly. Answer (C) is incorrect because no quality control system will be 100% effective. Answer (D) is correct. The process used to produce the goods is not thoroughly reviewed and evaluated for efficiency and effectiveness. Preventing defects and increasing efficiency by improving the production process raises quality standards and decreases costs.

[4] Gleim #: 1.4 -- Source: CIA 1196 III-24 Under a total quality management (TQM) approach

A. B. C. D.

Measurement occurs throughout the process, and errors are caught and corrected at the source. Quality control is performed by highly trained inspectors at the end of the production process. Upper management assumes the primary responsibility for the quality of the products and services. A large number of suppliers are used in order to obtain the lowest possible prices. Answer (A) is correct. Total quality management emphasizes quality as a basic organizational function. TQM is the continuous pursuit of quality in every aspect of organizational activities. One of the basic tenets of TQM is doing it right the first time. Thus, errors should be caught and corrected at the source. Answer (B) is incorrect because total quality management emphasizes discovering errors throughout the process, not inspection of finished goods. Answer (C) is incorrect because all members of the organization assume responsibility for quality of the products and services. Answer (D) is incorrect because the total quality management philosophy recommends limiting the number of suppliers to create a strong relationship.

[5] Gleim #: 1.5 -- Source: CIA 596 III-29 Which of the following is a characteristic of total quality management (TQM)?

A. B. C. D.

Management by objectives. On-the-job training by other workers. Quality by final inspection. Education and self-improvement. Answer (A) is incorrect because one of the 14 points recommends elimination of numerical quotas. MBO causes aggressive pursuit of numerical quotas. Answer (B) is incorrect because informal learning from coworkers serves to entrench bad work habits. One of the 14 points stresses proper training of everyone. Answer (C) is incorrect because another of the 14 points states that quality by final inspection is unnecessary if quality is built in from the start. Answer (D) is correct. According to management theorist W. Edwards Deming’s well-known 14 points, education and self-improvement are essential. Knowledge is opportunity. Hence, continuous improvement should be everyone’s primary career objective.


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[6] Gleim #: 1.6 -- Source: CIA 596 III-30 In which of the following organizational structures does total quality management (TQM) work best?

A. B. C. D.

Hierarchal. Teams of people from the same specialty. Teams of people from different specialties. Specialists working individually. Answer (A) is incorrect because hierarchal organization stifles TQM. Answer (B) is incorrect because TQM works best with teams of people from different specialties. Answer (C) is correct. TQM advocates replacement of the traditional hierarchal structure with teams of people from different specialties. This change follows from TQM’s emphasis on empowering employees and teamwork. Employees should have proper training, necessary information, and the best tools; be fully engaged in the decision process; and receive fair compensation. If such empowered employees are assembled in teams of individuals with the required skills, TQM theorists believe they will be more effective than people performing their tasks separately in a rigid structure. Answer (D) is incorrect because teamwork is essential for TQM.

[7] Gleim #: 1.7 -- Source: CIA 1196 III-23 The most important component of quality control is

A. B. C. D.

Ensuring goods and services conform to the design specifications. Satisfying upper management. Conforming with ISO-9000 specifications. Determining the appropriate timing of inspections. Answer (A) is correct. The intent of quality control is to ensure that goods and services conform to the design specifications. Whether the focus is on feedforward, feedback, or concurrent control, the emphasis is on ensuring product or service conformity. Answer (B) is incorrect because quality control is geared towards satisfying the customer, not upper management. Answer (C) is incorrect because ensuring the conformance with ISO-9000 specifications is a component of a compliance audit, not quality control. Answer (D) is incorrect because determining the appropriate timing of inspections is only one step towards approaching quality control. Consequently, it is not the primary component of the quality control function.

[8] Gleim #: 1.8 -- Source: CMA 1296 3-22 The cost of scrap, rework, and tooling changes in a product quality cost system is categorized as a(n)

A. B. C. D.

Training cost. External failure cost. Internal failure cost. Prevention cost.


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Answer (A) is incorrect because training costs are prevention costs. Answer (B) is incorrect because the costs of external failure, such as warranty expense, product liability, and customer ill will, arise when problems are discovered after products have been shipped. Answer (C) is correct. Internal failure costs are incurred when detection of defective products occurs before shipment. Examples of internal failure costs are scrap, rework, tooling changes, and downtime. Answer (D) is incorrect because prevention costs are incurred to avoid defective output. Examples include preventive maintenance, employee training, review of equipment design, and evaluation of suppliers. [9] Gleim #: 1.9 -- Source: CMA 1295 3-12 The four categories of costs associated with product quality costs are

A. B. C. D.

External failure, internal failure, prevention, and carrying. External failure, internal failure, prevention, and appraisal. External failure, internal failure, training, and appraisal. Warranty, product liability, training, and appraisal. Answer (A) is incorrect because carrying cost is not one of the elements of quality costs. Answer (B) is correct. The following are the four categories of quality costs: prevention, appraisal, internal failure, and external failure (lost opportunity). Costs of prevention include attempts to avoid defective output, including employee training, review of equipment design, preventive maintenance, and evaluation of suppliers. Appraisal costs include quality control programs, inspection, and testing. Internal failure costs are incurred when detection of defective products occurs before shipment, including scrap, rework, tooling changes, and downtime. External failure costs are incurred after the product has been shipped, including the costs associated with warranties, product liability, and customer ill will. Answer (C) is incorrect because training costs are not a category of quality costs. Answer (D) is incorrect because warranty, product liability, and training are not cost categories identified by SMA 4R.

[10] Gleim #: 1.10 -- Source: CMA 1295 3-14 The cost of statistical quality control in a product quality cost system is categorized as a(n)

A. B. C. D.

Internal failure cost. Training cost. External failure cost. Appraisal cost. Answer (A) is incorrect because internal failure costs arise after poor quality has been found; statistical quality control is designed to detect quality problems. Answer (B) is incorrect because statistical quality control is not a training cost. Answer (C) is incorrect because external failure costs are incurred after the product has been shipped, including the costs associated with warranties, product liability, and customer ill will. Answer (D) is correct. The following are the four categories of quality costs: prevention, appraisal, internal failure, and external failure (lost opportunity). Appraisal costs include quality control programs, inspection, and testing. However, some authorities regard statistical quality and process control as preventive activities because they not only detect faulty work but also allow for adjustment of processes to avoid future defects.


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[11] Gleim #: 1.11 -- Source: CMA 697 3-28 Listed below are selected line items from the cost-of-quality report for Watson Products for last month. Category

Amount

Rework Equipment maintenance Product testing Product repair

$ 725 1,154 786 695

What is Watson’s total prevention and appraisal cost for last month?

A. B. C. D.

$786 $1,154 $1,940 $2,665 Answer (A) is incorrect because $786 is the appraisal cost. Answer (B) is incorrect because $1,154 is the prevention cost. Answer (C) is correct. The costs of prevention and appraisal are conformance costs that serve as financial measures of internal performance. Prevention costs are incurred to prevent defective output. These costs include preventive maintenance, employee training, review of equipment design, and evaluation of suppliers. Appraisal costs are incurred to detect nonconforming output. They embrace such activities as statistical quality control programs, inspection, and testing. The equipment maintenance cost of $1,154 is a prevention cost. The product testing cost of $786 is an appraisal cost. Their sum is $1,940. Answer (D) is incorrect because $2,665 includes rework, an internal failure cost.

[12] Gleim #: 1.12 -- Source: CMA 697 3-27 All of the following are generally included in a cost-of-quality report except

A. B. C. D.

Warranty claims. Design engineering. Supplier evaluations. Lost contribution margin. Answer (A) is incorrect because the costs of warranty claims are readily measurable external failure costs captured by the accounting system. Answer (B) is incorrect because the cost of design engineering is a prevention cost that is usually included in cost-ofquality reports. Answer (C) is incorrect because the cost of supplier evaluations is a prevention cost that is usually included in cost-ofquality reports. Answer (D) is correct. A cost-of-quality report includes most costs related to quality, including the costs of external failure, internal failure, prevention, and appraisal. Lost contribution margins from poor product quality are external failure costs that normally do not appear on a cost-of-quality report because they are opportunity costs. Opportunity costs are not usually recorded by the accounting system, thereby understating the costs of poor quality. Lost contribution margins from reduced sales, market share, and sales prices are external failure costs that are also not usually included in a cost-of-quality report.

[13] Gleim #: 1.13 -- Source: Publisher Conformance is how well a product and its components meet applicable standards. According to the robust quality concept,


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A. B. C. D.

A certain percentage of defective units is acceptable. Units are acceptable if their characteristics lie within an acceptable range of values. The goal is for all units to be within specifications. Every unit should reach a target value. Answer (A) is incorrect because the traditional view of quality treats a certain number of defective units as acceptable. Answer (B) is incorrect because the traditional view of quality deems that a unit is acceptable if it is within a range of specified values. Answer (C) is incorrect because the robust quality concept is an extension of the zero-defects approach. The goal of robust quality is in every case to reach a target value, not merely a range of acceptable values. Answer (D) is correct. Conformance is how well a product and its components meet applicable standards. The traditional view is that conforming products are those with characteristics that lie within an acceptable specified range of values that includes a target value. This view also regarded a certain percentage of defective (nonconforming) units as acceptable. The traditional view was superseded by the zero-defects approach that sought to eliminate all nonconforming output. An extension of this approach is the robust quality concept. Its goal is to reach the target value in every case. The reason is that hidden quality costs occur when output varies from the target even though the units are within specifications.

[14] Gleim #: 1.14 -- Source: Publisher The Plan-Do-Check-Act (PDCA) Cycle is a quality tool devised by W.E. Deming. It is best described as

A. B. C. D.

A “management by fact” approach to continuous improvement. An ongoing evaluation of the practices of best-in-class organizations. The translation of customer requirements into design requirements. The responsibility of every employee, work group, department, or supplier to inspect the work. Answer (A) is correct. PDCA is a “management by fact” or scientific method approach to continuous improvement. PDCA creates a process-centered environment because it involves studying the current process, collecting and analyzing data to identify causes of problems, planning for improvement, and deciding how to measure improvement (Plan). The plan is then implemented on a small scale if possible (Do). The next step is to determine what happened (Check). If the experiment was successful, the plan is fully implemented (Act). The cycle is then repeated using what was learned from the preceding cycle. Answer (B) is incorrect because competitive benchmarking is an ongoing evaluation of the practices of best-in-class organizations. Answer (C) is incorrect because quality deployment is the translation of customer requirements into design requirements. Answer (D) is incorrect because the “quality at the source” concept emphasizes the responsibility of every employee, work group, department, or supplier to inspect the work.

[15] Gleim #: 1.15 -- Source: Publisher Which of the following quality costs are nonconformance costs?

A. B. C. D.

Systems development costs. Costs of inspecting in-process items. Environmental costs. Costs of quality circles.


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Answer (A) is incorrect because systems development costs are prevention (conformance) costs. Answer (B) is incorrect because costs of inspecting in-process items are appraisal (conformance) costs. Answer (C) is correct. Nonconformance costs include internal and external failure costs. External failure costs include environmental costs, e.g., fines for violations of environmental laws and loss of customer goodwill. Answer (D) is incorrect because costs of quality circles are prevention (conformance) costs. [16] Gleim #: 1.16 -- Source: Publisher Quality costing is similar in service and manufacturing organizations. Nevertheless, the differences between these organizations have certain implications for quality management. Thus,

A. Direct labor costs are usually a higher percentage of total costs in manufacturing organizations. B. External failure costs are relatively greater in service organizations. C. Quality improvements resulting in more efficient use of labor time are more likely to be accepted by employees in service organizations. D. Poor service is less likely to result in loss of customers than a faulty product. Answer (A) is incorrect because direct labor costs are usually a higher percentage of total costs in service organizations. Answer (B) is correct. External failure costs arise when problems occur after delivery. They occur because products or services are nonconforming or otherwise do not satisfy customers. External failure costs in service enterprises are even more important than in manufacturing environments. Faulty goods sometimes may be reworked or replaced to a customer’s satisfaction, but poor service tends to result in a loss of customers. Answer (C) is incorrect because service activities are usually more labor intensive than in modern manufacturing environments. Thus, more efficient labor usage is more likely to be viewed as a threat to employee job security in service organizations. Answer (D) is incorrect because the badwill resulting from poor service may be even more likely than a defective product to result in loss of customers. [17] Gleim #: 1.17 -- Source: Publisher An organization has adopted the robust quality approach. According to this view of quality,

A. The minimum point on the total quality cost curve occurs when conformance cost per unit equals nonconformance cost per unit. B. Improving quality requires tradeoffs among categories of quality costs. C. Beyond some point, incurrence of prevention and appraisal costs is not cost beneficial. D. Costs in all categories of quality costs may be reduced while improving quality.


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Answer (A) is incorrect because, according to the robust quality concept, conformance costs do not necessarily have to continue to increase to obtain additional reductions in nonconformance costs. Answer (B) is incorrect because, according to the robust quality concept, conformance costs do not necessarily have to continue to increase to obtain additional reductions in nonconformance costs. Answer (C) is incorrect because, according to the robust quality concept, conformance costs do not necessarily have to continue to increase to obtain additional reductions in nonconformance costs. Answer (D) is correct. The optimal level of quality costs traditionally has been deemed to occur where the conformance cost curve intercepts the nonconformance cost curve, which corresponds to the minimum point on the total cost curve. Thus, beyond some point, incurrence of prevention and appraisal costs is not cost beneficial. However, the modern robust quality view is that this relationship does not always hold. Improving quality and reducing costs in each category may be possible if the most efficient prevention methods are applied. For example, selection of a supplier meeting high quality standards regarding defect rates and delivery times may drive down not only failure costs but also the prevention and appraisal costs incurred when supplier performance was less reliable. Thus, conformance costs do not have to continue to increase to obtain additional reductions in nonconformance costs. [18] Gleim #: 1.18 -- Source: CMA 693 4-28 When evaluating projects, breakeven time is best described as

A. B. C. D.

Annual fixed costs ÷ monthly contribution margin. Project investment ÷ annual net cash inflows. The point at which cumulative cash inflows on a project equal total cash outflows. The point at which discounted cumulative cash inflows on a project equal discounted total cash outflows. Answer (A) is incorrect because it is related to breakeven point, not breakeven time. Answer (B) is incorrect because the payback period equals investment divided by annual undiscounted net cash inflows. Answer (C) is incorrect because the payback period is the period required for total undiscounted cash inflows to equal total undiscounted cash outflows. Answer (D) is correct. Breakeven time evaluates the rapidity of new product development. The usual calculation determines the period beginning with project approval that is required for the discounted cumulative cash inflows to equal the discounted cumulative cash outflows. However, it may also be calculated as the point at which discounted cumulative cash inflows on a project equal discounted total cash outflows. The concept is similar to the payback period, but it is more sophisticated because it incorporates the time value of money. It also differs from the payback method because the period covered begins at the outset of a project, not when the initial cash outflow occurs.

[19] Gleim #: 1.19 -- Source: CIA 594 III-56 Management of a company is attempting to build a reputation as a world-class manufacturer of quality products. Which of the following measures would not be used by the firm to measure quality?

A. B. C. D.

The percentage of shipments returned by customers because of poor quality. The number of parts shipped per day. The number of defective parts per million. The percentage of products passing quality tests the first time.


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Answer (A) is incorrect because the percentage of shipments returned measures quality by the number of defective units. Answer (B) is correct. The number of parts shipped per day would most likely be used as a measure of the effectiveness and efficiency of shipping procedures, not the quality of the product. This measure does not consider how many of the parts are defective. Answer (C) is incorrect because the number of defective parts per million measures quality by the number of defective units. Answer (D) is incorrect because the percentage of products passing quality tests the first time measures quality by the number of nondefective products. [20] Gleim #: 1.20 -- Source: CMA 694 3-16 In year 2, a manufacturing company instituted a total quality management (TQM) program producing the following report: Summary Cost of Quality Report (000s) Year 1

Year 2

% Change

Prevention costs Appraisal costs Internal failure costs External failure costs

$ 200 210 190 1,200

$ 300 315 114 621

+50 +50 –40 –48

Total quality costs

$1,800

$1,350

–25

On the basis of this report, which one of the following statements is most likely true?

A. An increase in conformance costs resulted in a higher quality product and therefore resulted in a decrease in nonconformance costs. B. An increase in inspection costs was solely responsible for the decrease in quality costs. C. Quality costs such as scrap and rework decreased by 48%. D. Quality costs such as returns and repairs under warranty decreased by 40%. Answer (A) is correct. TQM emphasizes the supplier’s relationship with the customer, and recognizes that everyone in a process is at some time a customer or supplier of someone else, either within or outside the organization. The costs of quality include costs of conformance and costs of nonconformance. Costs of conformance include prevention costs and appraisal (inspection) costs. Nonconformance costs are composed of internal failure costs and external failure costs, such as lost opportunity. Conformance costs (prevention and appraisal) increased substantially, whereas the nonconformance costs (internal and external failure) decreased. Hence, the increase in conformance costs resulted in a higher quality product. Answer (B) is incorrect because prevention costs also increased substantially, which could also have led to higher quality products. Answer (C) is incorrect because scrap and rework are internal failure costs, which decreased by 40%. Answer (D) is incorrect because returns and repairs are external failure costs, which decreased by 48%.


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[21] Gleim #: 1.21 -- Source: CIA 1195 III-98 Quality cost indices are often used to measure and analyze the cost of maintaining a given level of quality. One example of a quality cost index, which uses a direct labor base, is computed as

The following quality cost data were collected for May and June:

Prevention costs Appraisal costs Internal failure costs External failure costs Direct labor costs

May

June

$ 4,000 6,000 12,000 14,000 90,000

$ 5,000 5,000 15,000 11,000 100,000

Based upon these cost data, the quality cost index

A. B. C. D.

Decreased 4 points from May to June. Was unchanged from May to June. Increased 10 points from May to June. Decreased 10 points from May to June. Answer (A) is correct. The index for May was 40% [($4,000 + $6,000 + $12,000 + $14,000) ÷ $90,000], and the index for June was 36% [($5,000 + $5,000 + $15,000 + $11,000) ÷ $100,000]. Answer (B) is incorrect because the index decreased. Answer (C) is incorrect because the increase in prevention costs was 10% of the increase in labor costs. Answer (D) is incorrect because the decrease in appraisal costs was 10% of the increase in labor costs.

[Fact Pattern #2]

Wolk Corporation is a highly automated manufacturing firm. The vice president of finance has decided that traditional standards are inappropriate for performance measures in an automated environment. Labor is insignificant in terms of the total cost of production and tends to be fixed, material quality is considered more important than minimizing material cost, and customer satisfaction is the number one priority. As a result, delivery performance measures have been chosen to evaluate performance.

The following information is considered typical of the time involved to complete orders: •

• • •

Wait time: - From order being placed to start of production - From start of production to completion Inspection time Process time Move time

10.0 days 5.0 days 1.5 days 3.0 days 2.5 days

[22] Gleim #: 1.22 -- Source: CMA 693 3-17 (Refers to Fact Pattern #2) What is the manufacturing cycle efficiency for this order?


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A. B. C. D.

25.0%. 13.6%. 37.5%. 69.2%. Answer (A) is correct. Manufacturing cycle efficiency is defined as the quotient of the time required for value-added production divided by total manufacturing lead time. For this order, the total lead time is 12 days (5.0 + 1.5 + 3.0 + 2.5), and the manufacturing cycle efficiency is 25% (3 days of processing ÷ 12). Answer (B) is incorrect because 13.6% includes the 10 days prior to production in the denominator, a period not included in the calculation of manufacturing cycle efficiency. Answer (C) is incorrect because inspection time and move time should be included in the denominator. Answer (D) is incorrect because the calculation involves dividing the 3 days of processing time by the total of 12 days to complete production.

[23] Gleim #: 1.23 -- Source: CMA 693 3-18 (Refers to Fact Pattern #2) What is the delivery cycle time for this order?

A. B. C. D.

7 days. 12 days. 15 days. 22 days. Answer (A) is incorrect because 7 days excludes the wait time. Answer (B) is incorrect because 12 days ignores the 10 days of the waiting period prior to the start of production. Answer (C) is incorrect because 15 days incorporates the wait time but not the production periods. Answer (D) is correct. The delivery cycle time is defined as the entire time from receipt of the order until delivery of the order. This period equals 22 days (10.0 + 5.0 + 1.5 + 3.0 + 2.5)

[24] Gleim #: 1.24 -- Source: Publisher Quality Company produces a component of a machine. The target value for a key dimension of the component is 100 millimeters (mm). The quality loss per unit if the key dimension is measured at precisely the upper or lower specification limit (100 mm ± 1 mm) is estimated to be $10. The following are the measures of a sample of four units: Unit 1 2 3 4

Measurement 99.0 101.0 99.5 100.5

The Quality Company produces 1,000 of the components. Based on the sample, the estimated quality loss is

A. B. C. D.

$625 $6,250 $10,000 $25,000


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Answer (A) is incorrect because $625 equals $.625 times 1,000 units. Answer (B) is correct. The quality loss constant (k) in the Taguchi quality loss function equation is $10 [$10 loss at the specification limit ÷ (1 mm)²]. Accordingly, the quality loss for the sample may be determined as follows:

Unit

Measurement in mm

Actual – Target (x – T)

(x – T)2

k(x – T)2

1 2 3 4

99.0 101.0 99.5 100.5

–1 +1 –.5 +.5

1.00 1.00 .25 .25

$10.00 10.00 2.50 2.50

2.50

$25.00

The average per unit quality loss for the sample is $6.25 ($25 ÷ 4). Consequently, the total estimated loss for 1,000 components is $6,250. Answer (C) is incorrect because $10,000 equals $10 times 1,000 units. Answer (D) is incorrect because $25,000 is based on the total loss for the sample ($25), not the unit average loss ($6.25). [25] Gleim #: 1.25 -- Source: Publisher Which of the following statements regarding benchmarking is false?

A. Benchmarking involves continuously evaluating the practices of best-in-class organization and adapting company processes to incorporate the best of these practices. B. Benchmarking, in practice, usually involves a company’s formation of benchmarking teams. C. Benchmarking is an ongoing process that entails quantitative and qualitative measurement of the difference between the company’s performance of an activity and the performance by the best in the world or the best in the industry. D. The benchmarking organization against which a firm is comparing itself must be a direct competitor. Answer (A) is incorrect because they are true statements about benchmarking. Answer (B) is incorrect because they are true statements about benchmarking. Answer (C) is incorrect because they are true statements about benchmarking. Answer (D) is correct. Benchmarking is an ongoing process that entails quantitative and qualitative measurement of the difference between the company’s performance of an activity and the performance by a best-in-class organization. The benchmarking organization against which a firm is comparing itself need not be a direct competitor. The important consideration is that the benchmarking organization be an outstanding performer in its industry. [26] Gleim #: 1.26 -- Source: CIA 595 III-22 An example of an internal nonfinancial benchmark is

A. B. C. D.

The labor rate of comparably skilled employees at a major competitor’s plant. The average actual cost per pound of a specific product at the company’s most efficient plant. A $50,000 limit on the cost of employee training programs at each of the company’s plants. The percentage of customer orders delivered on time at the company’s most efficient plant.


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Answer (A) is incorrect because the labor rate of a competitor is a financial benchmark. Answer (B) is incorrect because the cost per pound of a product at the company’s most efficient plant is a financial benchmark. Answer (C) is incorrect because the cost of a training program is a financial benchmark. Answer (D) is correct. Benchmarking is a continuous evaluation of the practices of the best organizations in their class and the adaptation of processes to reflect the best of these practices. It requires analysis and measurement of key outputs against those of the best organizations. This procedure also involves identifying the underlying key actions and causes that contribute to the performance difference. The percentage of orders delivered on time at the company’s most efficient plant is an example of an internal nonfinancial benchmark. [27] Gleim #: 1.27 -- Source: Publisher Managerial performance may be measured in many ways. For example, an internal nonfinancial measure is

A. B. C. D.

Market share. Delivery performance. Customer satisfaction. Manufacturing lead time. Answer (A) is incorrect because market share is an external nonfinancial measure. Answer (B) is incorrect because delivery performance is an external nonfinancial measure. Answer (C) is incorrect because customer satisfaction is an external nonfinancial measure. Answer (D) is correct. Feedback regarding managerial performance may take the form of financial and nonfinancial measures that may be internally or externally generated. Moreover, different measures have a long-term or short-term emphasis. Examples of internal nonfinancial measures are product quality, new product development time, and manufacturing lead time (cycle time).

[28] Gleim #: 1.28 -- Source: CIA 597 III-14 Which of the following criteria would be most useful to a sales department manager in evaluating the performance of the manager’s customer-service group?

A. B. C. D.

The customer is always right. Customer complaints should be processed promptly. Employees should maintain a positive attitude when dealing with customers. All customer inquiries should be answered within 7 days of receipt. Answer (A) is incorrect because customer orientation is difficult to quantify. Answer (B) is incorrect because the standard specified is vague. Answer (C) is incorrect because no measure of a positive attitude has been specified for the employee. Answer (D) is correct. A criterion that requires all customer inquiries to be answered within 7 days of receipt permits accurate measurement of performance. The quantitative and specific nature of the appraisal using this standard avoids the vagueness, subjectivity, and personal bias that may afflict other forms of personnel evaluations.

[29] Gleim #: 1.29 -- Source: CIA 597 III-3 Focusing on customers, promoting innovation, learning new philosophies, driving out fear, and providing extensive training are all elements of a major change in organizations. These elements are aimed primarily at


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A. B. C. D.

Copying leading organizations to better compete with them. Focusing on the total quality of products and services. Being efficient and effective at the same time, in order to indirectly affect profits. Managing costs of products and services better, in order to become the low-cost provider. Answer (A) is incorrect because competitive benchmarking is just one tool for implementing TQM. Answer (B) is correct. TQM is a comprehensive approach to quality. It treats the pursuit of quality as a basic organizational function that is as important as production or marketing. TQM is the continuous pursuit of quality in every aspect of organizational activities through a philosophy of doing it right the first time, employee training and empowerment, promotion of teamwork, improvement of processes, and attention to satisfaction of customers, both internal and external. TQM emphasizes the supplier’s relationship with the customer, identifies customer needs, and recognizes that everyone in a process is at some time a customer or supplier of someone else, either within or without the organization. Answer (C) is incorrect because TQM’s primary focus is not profitability. Answer (D) is incorrect because TQM’s primary focus is not cost reduction.

[30] Gleim #: 1.30 -- Source: CIA 597 III-4 Total quality management in a manufacturing environment is best exemplified by

A. B. C. D.

Identifying and reworking production defects before sale. Designing the product to minimize defects. Performing inspections to isolate defects as early as possible. Making machine adjustments periodically to reduce defects. Answer (A) is incorrect because TQM emphasizes prevention, not rework. The approach of TQM is to build in and design in quality, not to “fix it in” or “inspect it in.” Answer (B) is correct. Total quality management emphasizes quality as a basic organizational function. TQM is the continuous pursuit of quality in every aspect of organizational activities. One of the basic tenets of TQM is doing it right the first time. Thus, errors should be caught and corrected at the source, and quality should be built in (designed in) from the start. Answer (C) is incorrect because TQM emphasizes prevention, not inspection. The approach of TQM is to build in and design in quality, not to “fix it in” or “inspect it in.” Answer (D) is incorrect because TQM emphasizes prevention, not adjustment. The approach of TQM is to build in and design in quality, not to “fix it in” or “inspect it in.”

[31] Gleim #: 1.31 -- Source: CIA 597 III-24 One of the main reasons that implementation of a total quality management program works better through the use of teams is

A. B. C. D.

Teams are more efficient and help an organization reduce its staffing. Employee motivation is always higher for team members than for individual contributors. Teams are a natural vehicle for sharing ideas, which leads to process improvement. The use of teams eliminates the need for supervision, thereby allowing a company to reduce staffing.


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Answer (A) is incorrect because teams are often inefficient and costly. Answer (B) is incorrect because high motivation does not directly affect the process improvement that is the key to quality improvement. Answer (C) is correct. TQM promotes teamwork by modifying or eliminating traditional (and rigid) vertical hierarchies and instead forming flexible groups of specialists. Quality circles, cross-functional teams, and self-managed teams are typical formats. Teams are an excellent vehicle for encouraging the sharing of ideas and removing process improvement obstacles. Answer (D) is incorrect because the use of teams with less supervision and reduced staffing may be by-products of TQM, but they are not ultimate objectives. [32] Gleim #: 1.32 -- Source: CIA 1195 III-28 A traditional quality control process in manufacturing consists of mass inspection of goods only at the end of a production process. A major deficiency of the traditional control process is that

A. B. C. D.

It is expensive to do the inspections at the end of the process. It is not possible to rework defective items. It is not 100% effective. It does not focus on improving the entire production process. Answer (A) is incorrect because other quality control processes can also be expensive. Answer (B) is incorrect because reworking defective items may be possible although costly. Answer (C) is incorrect because no quality control system will be 100% effective. Answer (D) is correct. The process used to produce the goods is not thoroughly reviewed and evaluated for efficiency and effectiveness. Preventing defects and increasing efficiency by improving the production process raises quality standards and decreases costs.

[Fact Pattern #3] Listed below are costs of quality that a manufacturing company has incurred throughout its operations. The company plans to prepare a report that classifies these costs into the following four categories: preventive costs, appraisal costs, internal failure costs, and external failure costs.

Cost Items

Amount

Design reviews Finished goods returned due to failure Freight on replacement finished goods Labor inspection during manufacturing Labor inspection of raw materials Manufacturing product-testing labor Manufacturing rework labor and overhead Materials used in warranty repairs Process engineering Product-liability claims Product-testing equipment Repairs to equipment due to breakdowns Scheduled equipment maintenance Scrap material Training of manufacturing workers

$275,000 55,000 27,000 75,000 32,000 63,000 150,000 68,000 180,000 145,000 35,000 22,000 90,000 125,000 156,000


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[33] Gleim #: 1.33 -- Source: CIA 597 III-96 (Refers to Fact Pattern #3) The costs of quality that are incurred in detecting units of product that do not conform to product specifications are referred to as

A. B. C. D.

Preventive costs. Appraisal costs. Internal failure costs. External failure costs. Answer (A) is incorrect because prevention attempts to avoid defective output, e.g., by employee training, review of equipment design, preventive maintenance, and evaluation of suppliers. Answer (B) is correct. The categories of quality costs include conformance costs (prevention and appraisal) and nonconformance costs (internal failure and external failure). Appraisal costs embrace such activities as statistical quality control programs, inspection, and testing. Thus, the cost of detecting nonconforming products is an appraisal cost. Answer (C) is incorrect because internal failure costs are incurred when detection of defective products occurs before shipment, including scrap, rework, tooling changes, and downtime. Answer (D) is incorrect because external failure costs are incurred after shipment, including the costs associated with warranties, product liability, and loss of customer goodwill.

[34] Gleim #: 1.34 -- Source: CIA 597 III-97 (Refers to Fact Pattern #3) The dollar amount of the costs of quality classified as preventive costs for the manufacturing firm would be

A. B. C. D.

$643,000 $701,000 $736,000 $768,000 Answer (A) is incorrect because $643,000 omits scheduled equipment maintenance and includes labor inspection of raw materials (an appraisal cost). Answer (B) is correct. Prevention attempts to avoid defective output, e.g., by employee training, review of equipment design, preventive maintenance, and evaluation of suppliers. Accordingly, the preventive costs equal $701,000 ($275,000 design reviews + $180,000 process engineering + $90,000 scheduled maintenance + $156,000 training). Answer (C) is incorrect because $736,000 includes the cost of product testing equipment (an appraisal cost). Answer (D) is incorrect because $768,000 includes the cost of product testing equipment and labor inspection of raw materials. Both costs are appraisal costs.

[35] Gleim #: 1.35 -- Source: CIA 597 III-23 Which of the following is a key to successful total quality management?

A. B. C. D.

Training quality inspectors. Focusing intensely on the customer. Creating appropriate hierarchies to increase efficiency. Establishing a well-defined quality standard, then focusing on meeting it.


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Answer (A) is incorrect because total quality management (TQM) de-emphasizes specialized quality inspectors. Answer (B) is correct. TQM emphasizes satisfaction of customers, both internal and external. TQM considers the supplier’s relationship with the customer, identifies customer needs, and recognizes that everyone in a process is at some time a customer or supplier of someone else, either within or without the organization. Thus, TQM begins with external customer requirements, identifies internal customer-supplier relationships and requirements, and establishes requirements for external suppliers. Answer (C) is incorrect because centralization often needs to be reduced to implement a TQM process. Answer (D) is incorrect because TQM involves continuous improvement; once a standard is reached, continuous improvement requires its constant reevaluation. [36] Gleim #: 1.36 -- Source: CIA 597 III-20 One of the main reasons total quality management (TQM) can be used as a strategic weapon is that

A. B. C. D.

The cumulative improvement from a company’s TQM efforts cannot readily be copied by competitors. Introducing new products can lure customers away from competitors. Reduced costs associated with better quality can support higher shareholder dividends. TQM provides a comprehensive planning process for a business. Answer (A) is correct. TQM is a comprehensive approach to quality. It treats the pursuit of quality as a basic organizational function that is as important as production or marketing. Because TQM affects every aspect of the organization’s activities, it permeates the organizational culture. Thus, the cumulative effect of TQM’s continuous improvement process can attract and hold customers and cannot be duplicated by competitors. Answer (B) is incorrect because new products can be quickly copied by competitors and therefore do not provide a sustained competitive advantage. Answer (C) is incorrect because TQM does not focus solely on cost reduction. Answer (D) is incorrect because TQM is only one tool of strategic management.

[37] Gleim #: 1.37 -- Source: Publisher Using the balanced scorecard approach, an organization evaluates managerial performance based on

A. B. C. D.

A single ultimate measure of operating results, such as residual income. Multiple financial and nonfinancial measures. Multiple nonfinancial measures only. Multiple financial measures only. Answer (A) is incorrect because the balanced scorecard approach uses multiple measures. Answer (B) is correct. The trend in managerial performance evaluation is the balanced scorecard approach. Multiple measures of performance permit a determination as to whether a manager is achieving certain objectives at the expense of others that may be equally or more important. These measures may be financial or nonfinancial and usually include items in four categories: (1) financial; (2) customer; (3) internal business processes; and (4) learning, growth, and innovation. Answer (C) is incorrect because the balanced scorecard approach includes financial measures. Answer (D) is incorrect because the balanced scorecard approach includes nonfinancial measures.

[38] Gleim #: 1.38 -- Source: Publisher On a balanced scorecard, which of the following is not a customer measure?


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A. B. C. D.

Market share. Economic value added. Service response time. Warranty expense. Answer (A) is incorrect because market share and its trend is a customer measure. Answer (B) is correct. Customer measures include market share and its trend, service response time, delivery performance, warranty returns, expense, complaints, and survey results. Economic value added, or EVA, is a financial measure. Answer (C) is incorrect because service response time is a customer measure. Answer (D) is incorrect because warranty expense is a customer measure.

[39] Gleim #: 1.39 -- Source: CPA, adapted Under the balanced scorecard concept, employee satisfaction and retention are measures used under which of the following perspectives?

A. B. C. D.

Customer. Internal business. Learning and growth. Financial. Answer (A) is incorrect because, for the customer perspective, the CSFs may be customer satisfaction and retention rate, dealer and distributor relationships, marketing and selling performance, prompt delivery, and quality. Answer (B) is incorrect because, for the internal business perspective, the CSFs may be quality, productivity, flexibility of response to changing conditions, operating readiness, and safety. Answer (C) is correct. The balanced scorecard is an accounting report that connects the firm’s critical success factors (CSFs) determined in a strategic analysis to measures of its performance. CSFs are financial and nonfinancial measures. For the learning, growth, and innovation perspective, the CSFs may be development of new products, promptness of their introduction, human resource development, morale, and competence of the workforce. Measures of employee satisfaction, retention, and competence may include R&D personnel qualifications, hours of training, skill set levels attained, personnel turnover, and personnel complaints and survey results. Answer (D) is incorrect because, for the financial perspective, the CSFs may be sales, fair value of the firm’s stock, profits, and liquidity.

[40] Gleim #: 1.40 -- Source: Publisher On a balanced scorecard, which is more of an internal process measure than an external-based measure?

A. B. C. D.

Cycle time. Profitability. Customer satisfaction. Market share. Answer (A) is correct. Cycle time is the manufacturing time to complete an order. Thus, cycle time is strictly related to internal processes. Profitability is a combination of internal and external considerations. Customer satisfaction and market share are related to how customers perceive a product and how competitors react. Answer (B) is incorrect because profitability is a measure that includes external considerations. Answer (C) is incorrect because customer satisfaction is a measure that includes external considerations. Answer (D) is incorrect because market share is a measure that includes external considerations.


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[41] Gleim #: 1.41 -- Source: Publisher According to ISO 9000 standards, which of the following is false in regard to registrars?

A. B. C. D.

Most employees are subject to being audited. Companies may have preliminary audits by registrars. Employees must be able to competently describe their jobs and demonstrate that they are performing properly. Upon satisfactory completion of an on-site visit, a registrar may issue a certificate describing the scope of the registration, which is valid for 3 years. Answer (A) is correct. During an on-site visit, the registrar has the right to audit all employees if he or she decides to do so. Employees must have the ability to explain their jobs and show that they are capable of performing properly. Answer (B) is incorrect because some companies have preliminary audits by registrars to prepare for the official audit. Answer (C) is incorrect because employees must be able to “say what they do” and demonstrate that they “do what they say.” Answer (D) is incorrect because a registrar who is convinced that a quality system conforms to the selected standard issues a certificate describing the scope of the registration. The registration is usually valid for a 3-year period.

[42] Gleim #: 1.42 -- Source: Publisher Which of the following is not true about the advantages of adopting ISO 9000 standards?

A. B. C. D.

Adoption of ISO 9000 standards may allow the company to sell products in foreign markets. ISO registration makes customers more comfortable with the supplier’s products and services. ISO 9000 allows companies to understand who internal customers and users are without sharing private information. ISO registration may help companies discover internal process and quality improvements. Answer (A) is incorrect because many foreign countries are beginning to require adoption of ISO 9000 standards as a prerequisite for a company to sell products or services in that country. Answer (B) is incorrect because many companies view ISO registration as a key to remaining competitive. ISO registration allows customers to be more comfortable with suppliers’ products and services. Answer (C) is correct. Market pressure is usually the main driving force for companies that adopt ISO 9000 standards. However, many of the companies that register uncover internal process and quality improvement as a result. ISO 9000 forces companies to share information, which leads to a better understanding of who internal customers and users are. Answer (D) is incorrect because many companies that implement ISO 9000 standards uncover internal process and quality improvements.

[43] Gleim #: 1.43 -- Source: Publisher Why have many European Union countries not adopted ISO 14000 standards?

A. B. C. D.

Adhering to ISO 14000 standards will not reduce monitoring and inspection by regulatory agencies. Individual European Union countries’ standards are typically more strict than ISO 14000 standards. Regulators are permitted to use voluntary audits as a basis for punitive action. ISO 14000 standards will not make it easier to do business across borders.


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Answer (A) is incorrect because many believe adhering to ISO 14000 standards will reduce monitoring or inspection by regulatory agencies. Answer (B) is correct. Many European countries already have environmental systems in place, and many individual countries’ standards are typically more strict than the ISO 14000 standards. Answer (C) is incorrect because many countries in the European Union have adopted measures similar to the ones in the US to prevent self-incrimination during voluntary ISO audits. Answer (D) is incorrect because ISO 14000 establishes internationally recognized standards that are intended to diminish trade barriers and make it easier to do business across borders. [44] Gleim #: 1.44 -- Source: Publisher Which of the following is not required when ISO 9000 standards are adopted?

A. B. C. D.

Organization of a quality management system. Creation of an internal audit system. Consistent high quality products. On-site inspections by a registrar. Answer (A) is incorrect because one of the most important steps to adhering to ISO 9000 standards is to organize a QMS. A QMS explains the company’s quality control and management’s commitment to quality. Answer (B) is incorrect because internal audits assure that the company is complying with the documented QMS procedures and ISO 9000 standards. Answer (C) is correct. ISO 9000 is a set of generic standards for establishing and maintaining a quality system within a company. The standards provide no basis for judging the quality of the end product. The marketplace will make this determination on its own. The objective of ISO 9000 standards is to ensure consistent quality. Answer (D) is incorrect because a registrar must ensure that the company’s quality control system conforms to the selected standard.

[45] Gleim #: 1.45 -- Source: CIA 1196 III-60 The International Organization for Standardization has developed standards for ring networks that include fault management, configuration management, accounting management, security management, and performance monitoring. Which of the following controls is included in the performance-monitoring standards?

A. B. C. D.

Reporting the failure of network fiber-optic lines. Recording unauthorized access violations. Compiling statistics on the number of times that application software is used. Allocating network costs to system users of the network. Answer (A) is incorrect because the failure of network fiber-optic lines is a fault management control. Answer (B) is incorrect because recording unauthorized access violations is a security management control. Answer (C) is correct. The IOS consists of standards organizations from more than 75 countries. Its performancemonitoring standards pertain to management’s ongoing assessment of the quality of performance over time. Recording software usage is a performance-monitoring control concerned with the extent and efficiency of network software use. Answer (D) is incorrect because allocating network costs to system users of the network is an accounting management control.


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[46] Gleim #: 1.46 -- Source: CIA 593 III-64 What coefficient of correlation results from the following data?

X

Y

1 2 3 4 5

10 8 6 4 2

A. B. C. D.

0 –1 +1 Cannot be determined from the data given. Answer (A) is incorrect because a perfect negative correlation exists. Answer (B) is correct. The coefficient of correlation (in standard notation, r) measures the strength of the linear relationship. The magnitude of r is independent of the scales of measurement of X and Y. Its range is –1.0 to 1.0. A value of –1.0 indicates a perfectly inverse linear relationship between X and Y. A value of zero indicates no linear relationship between X and Y. A value of +1.0 indicates a perfectly direct relationship between X and Y. As X increases by 1, Y consistently decreases by 2. Hence, a perfectly inverse relationship exists, and r must be equal to –1.0. Answer (C) is incorrect because an inverse, not a direct, relationship exists. Answer (D) is incorrect because a linear relationship exists between X and Y.

[47] Gleim #: 1.47 -- Source: CIA 1194 II-46 In regression analysis, which of the following correlation coefficients represents the strongest relationship between the independent and dependent variables?

A. B. C. D.

1.03 –.02 –.89 .75 Answer (A) is incorrect because 1.03 is an impossible value. Answer (B) is incorrect because –.02 is a very weak correlation coefficient. Answer (C) is correct. Because the range of values is between –1.0 and 1.0, –.89 suggests a very strong inverse relationship between the independent and dependent variables. A value of –1.0 signifies a perfect inverse relationship, and a value of 1.0 signifies a perfect direct relationship. Answer (D) is incorrect because .75 is .25 from the maximum value, whereas –.89 is .11 from the minimum value.

[48] Gleim #: 1.48 -- Source: CIA 595 II-46 The internal auditor of a bank has developed a multiple regression model which has been used for a number of years to estimate the amount of interest income from commercial loans. During the current year, the auditor applies the model and discovers that the r2 value has decreased dramatically, but the model otherwise seems to be working okay. Which of the following conclusions are justified by the change?


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A. B. C. D.

Changing to a cross-sectional regression analysis should cause r 2 to increase. Regression analysis is no longer an appropriate technique to estimate interest income. Some new factors, not included in the model, are causing interest income to change. A linear regression analysis would increase the model’s reliability. Answer (A) is incorrect because cross-sectional regression analysis is inappropriate. The auditor is trying to estimate changes in a single account balance over time. Answer (B) is incorrect because regression analysis may still be the most appropriate methodology to estimate interest income, but the auditor should first understand the factors that may be causing r 2 to decrease. The reason may be a systematic error in the account balance. Answer (C) is correct. The coefficient of determination (r 2) is the amount of variation in the dependent variable (interest income) that is explained by the independent variables. In this case, less of the change in interest income is explained by the model. Thus, some other factor must be causing interest income to change. This change merits audit investigation. Answer (D) is incorrect because linear regression models are simpler models, but the auditor should be searching for a systematic error in the account balance or applying a more complex model.

[Fact Pattern #4]

In preparing the annual profit plan for the coming year, Wilkens Company wants to determine the cost behavior pattern of the maintenance costs. Wilkens has decided to use linear regression by employing the equation y = a + bx for maintenance costs. The prior year’s data regarding maintenance hours and costs, and the results of the regression analysis, are given below and in the opposite column. Average cost per hour a b Standard error of a Standard error of b Standard error of the estimate r2

$9.00 684.65 7.2884 49.515 .12126 34.469 .99724

Hours of Activity

Maintenance Costs

480 320 400 300 500 310 320 520 490 470 350 340

$ 4,200 3,000 3,600 2,820 4,350 2,960 3,030 4,470 4,260 4,050 3,300 3,160

Sum

4,800

$43,200

Average

400

$ 3,600

January February March April May June July August September October November December

[49] Gleim #: 1.49 -- Source: CMA 1290 4-27 (Refers to Fact Pattern #4) In the standard regression equation y = a + bx, the letter b is best described as a(n)

A. B. C. D.

Independent variable. Dependent variable. Constant coefficient. Variable coefficient.


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Answer (A) is incorrect because x is the independent variable. Answer (B) is incorrect because the dependent variable is y. Answer (C) is incorrect because the constant coefficient is a. Answer (D) is correct. In the standard regression equation, b represents the variable coefficient. For example, in a cost determination regression, y equals total costs, b is the variable cost per unit, x is the number of units produced, and a is fixed cost. [50] Gleim #: 1.50 -- Source: CMA 1290 4-28 (Refers to Fact Pattern #4) The letter x in the standard regression equation is best described as a(n)

A. B. C. D.

Independent variable. Dependent variable. Constant coefficient. Coefficient of determination. Answer (A) is correct. The letter x in the standard regression equation is the independent variable. For example, in a regression to determine the total cost of production, x equals units produced. Answer (B) is incorrect because the dependent variable is y. Answer (C) is incorrect because the constant coefficient is a. Answer (D) is incorrect because r 2 is the coefficient of determination.

[51] Gleim #: 1.51 -- Source: CMA 1290 4-29 (Refers to Fact Pattern #4) Based upon the data derived from the regression analysis, 420 maintenance hours in a month would mean the maintenance costs (rounded to the nearest dollar) would be budgeted at

A. B. C. D.

$3,780 $3,600 $3,790 $3,746 Answer (A) is incorrect because the budgeted maintenance costs are $3,746. Answer (B) is incorrect because the budgeted maintenance costs are $3,746. Answer (C) is incorrect because the budgeted maintenance costs are $3,746. Answer (D) is correct. Substituting the given data into the regression equation results in a budgeted cost of $3,746 (rounded to the nearest dollar).

y = a + bx y = 684.65 + 7.2884(420) y = $3,746

[52] Gleim #: 1.52 -- Source: CMA 1290 4-30 (Refers to Fact Pattern #4) The percentage of the total variance that can be explained by the regression equation is


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A. B. C. D.

99.724% 69.613% 80.982% 99.862% Answer (A) is correct. The coefficient of determination (r²) measures the percentage of the total variance in cost that can be explained by the regression equation. If the coefficient of determination is .99724, 99.724% of the variance is explained by the regression equation. Thus, the values in the regression equation explain virtually the entire amount of total cost. Answer (B) is incorrect because the percentage of the total variance explained by the regression equation is 99.724%, which corresponds to the coefficient of determination (r²), or .99724. Answer (C) is incorrect because the percentage of the total variance explained by the regression equation is 99.724%, which corresponds to the coefficient of determination (r²), or .99724. Answer (D) is incorrect because the percentage of the total variance explained by the regression equation is 99.724%, which corresponds to the coefficient of determination (r²), or .99724.

[53] Gleim #: 1.53 -- Source: CIA 1195 II-30 A division uses a regression in which monthly advertising expenditures are used to predict monthly product sales (both in millions of dollars). The results show a regression coefficient for the independent variable equal to 0.8. This coefficient value indicates that

A. B. C. D.

The average monthly advertising expenditure in the sample is $800,000. When monthly advertising is at its average level, product sales will be $800,000. On average, every additional dollar of advertising results in $.80 of additional sales. Advertising is not a good predictor of sales because the coefficient is so small. Answer (A) is incorrect because a regression coefficient is unrelated to the means of the variables. Answer (B) is incorrect because, to predict a specific value of sales, the value of the independent variable is multiplied by the coefficient. The product is then added to the y-intercept value. Answer (C) is correct. The regression coefficient represents the change in the dependent variable corresponding to a unit change in the independent variable. Thus, it is the slope of the regression line. Answer (D) is incorrect because the absolute size of the coefficient bears no necessary relationship to the importance of the variable.

[54] Gleim #: 1.54 -- Source: CIA 595 II-47 An internal auditor for a large automotive parts retailer wishes to perform a risk analysis and wants to use an appropriate statistical tool to help identify stores that would be out of line compared to the majority of stores. The most appropriate statistical tool to use is

A. B. C. D.

Linear time series analysis. Cross-sectional regression analysis. Cross tabulations with chi-square analysis of significance. Time series multiple regression analysis to identify changes in individual stores over time.


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Answer (A) is incorrect because linear time series analysis is inapplicable. It is a simple model that compares data for an individual store over time. Answer (B) is correct. Time series data pertain to a given entity over a number of prior time periods. Cross-sectional data, however, pertain to different entities for a given time period or at a given time. Thus, cross-sectional regression analysis is the most appropriate statistical tool because it compares attributes of all stores’ operating statistics at one moment in time. Answer (C) is incorrect because cross tabulations have to be built on a model of expectations. Unless the model is built, the analysis is not useful. Answer (D) is incorrect because the objective is to compare stores at one moment in time. Multiple regression time series analysis compares the performance of an individual store over a period of time. [55] Gleim #: 1.55 -- Source: CIA 1195 III-11 Quality control programs employ many tools for problem definition and analysis. A scatter diagram is one of these tools. The objective of a scatter diagram is to

A. B. C. D.

Display a population of items for analysis. Show frequency distribution in graphic form. Divide a universe of data into homogeneous groups. Show the vital trend and separate trivial items. Answer (A) is correct. The objective of a scatter diagram is to demonstrate correlations. Each observation is represented by a dot on a graph corresponding to a particular value of X (the independent variable) and Y (the dependent variable). Answer (B) is incorrect because the objective of a histogram is to show frequency distribution in graphic form. Answer (C) is incorrect because the objective of stratification is to divide a universe of data into homogeneous groups. Answer (D) is incorrect because regression analysis is used to find trend lines.

[56] Gleim #: 1.56 -- Source: Publisher Violation of which assumption underlying regression analysis is prevalent in time series analysis?

A. B. C. D.

Variance of error term is constant. Error terms are independent. Distribution of error terms is normal. Expected value of error term equals zero. Answer (A) is incorrect because constant variance of the error term is usually met. Answer (B) is correct. Time series analysis is a regression model in which the independent variable is time. In time series analysis, the value of the next time period is frequently dependent on the value of the time period before that. Hence, the error terms are usually correlated or dependent on the prior period; i.e., they are characterized by autocorrelation (serial correlation). Answer (C) is incorrect because normal distribution of the error term is usually met. Answer (D) is incorrect because an expected value of the error term equal to zero is usually met.

[57] Gleim #: 1.57 -- Source: CIA 589 III-50 The moving-average method of forecasting


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A. B. C. D.

Is a cross-sectional forecasting method. Regresses the variable of interest on a related variable to develop a forecast. Derives final forecasts by adjusting the initial forecast based on the smoothing constant. Includes each new observation in the average as it becomes available and discards the oldest observation. Answer (A) is incorrect because cross-sectional regression analysis examines relationships among large amounts of data (e.g., many or different production methods or locations) at a particular moment in time. Answer (B) is incorrect because regression analysis relates the forecast to changes in particular variables. Answer (C) is incorrect because, under exponential smoothing, each forecast equals the sum of the last observation times the smoothing constant, plus the last forecast times one minus the constant. Answer (D) is correct. The simple moving-average method is a smoothing technique that uses the experience of the past N periods (through time period t) to forecast a value for the next period. Thus, the average includes each new observation and discards the oldest observation. The forecast formula for the next period (for time period t+1) is the sum of the last N observations divided by N.

[58] Gleim #: 1.58 -- Source: CIA 594 II-38 As part of a risk analysis, an auditor wishes to forecast the percentage growth in next month’s sales for a particular plant using the past 30 months’ sales results. Significant changes in the organization affecting sales volumes were made within the last 9 months. The most effective analysis technique to use would be

A. B. C. D.

Unweighted moving average. Exponential smoothing. Queuing theory. Linear regression analysis. Answer (A) is incorrect because an unweighted average will not give more importance to more recent data. Answer (B) is correct. Under exponential smoothing, each forecast equals the sum of the last observation times the smoothing constant, plus the last forecast times one minus the constant. Thus, exponential means that greater weight is placed on the most recent data, with the weights of all data falling off exponentially as the data age. This feature is important because of the organizational changes that affected sales volume. Answer (C) is incorrect because queuing theory is used to minimize the cost of waiting lines. Answer (D) is incorrect because linear regression analysis determines the equation for the relationship among variables. It does not give more importance to more recent data.

[59] Gleim #: 1.59 -- Source: CMA 1293 4-24 The average labor cost per unit for the first batch produced by a new process is $120. The cumulative average labor cost after the second batch is $72 per product. Using a batch size of 100 and assuming the learning curve continues, the total labor cost of four batches will be

A. B. C. D.

$4,320 $10,368 $2,592 $17,280


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Answer (A) is incorrect because $4,320 equals the cost of the items in the fourth batch. Answer (B) is incorrect because $10,368 is based on the assumption that the cumulative average unit labor cost is reduced by the learning curve percentage with each batch, not each doubling of output. Answer (C) is incorrect because $2,592 represents the labor cost of 100 units at the unit rate expected after another doubling of production to eight batches. Answer (D) is correct. The learning curve reflects the increased rate at which people perform tasks as they gain experience. The time required to perform a given task becomes progressively shorter. Ordinarily, the curve is expressed in a percentage of reduced time to complete a task for each doubling of cumulative production. One common assumption in a learning curve model is that the cumulative average time (and labor cost) per unit is reduced by a certain percentage each time production doubles. Given a $120 cost per unit for the first 100 units and a $72 cost per unit when cumulative production doubled to 200 units, the learning curve percentage must be 60% ($72 ÷ $120). If production is again doubled to 400 units (four batches), the average unit labor cost should be $43.20 ($72 × 60%). Hence, total labor cost for 400 units is estimated to be $17,280 (400 × $43.20). [Fact Pattern #5]

Moss Point Manufacturing recently completed and sold an order of 50 units that had costs as shown in the next column. The company has now been requested to prepare a bid for 150 units of the same product.

Direct materials Direct labor ($8.50 × 1,000 hours) Variable overhead ($4.00 × 1,000 hours)* Fixed overhead **

$ 1,500 8,500 4,000 1,400 $15,400

* Applied on the basis of direct labor hours ** Applied at the rate of 10% of variable cost

[60] Gleim #: 1.60 -- Source: CMA 1288 5-19 (Refers to Fact Pattern #5) If an 80% learning curve is applicable, Moss Point’s total cost on this order would be estimated at

A. B. C. D.

$26,400 $32,000 $38,000 $41,800


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Answer (A) is correct. Assuming that the cumulative average-time model applies, an 80% learning curve means that the cumulative average time per unit (and labor cost, given a constant labor rate) declines by 20% when unit output doubles in the early stages of production. The first lot size was 50 units, which was produced at a total cost of $15,400 ($1,500 for materials and $13,900 for labor and overhead). Materials costs are strictly variable and should remain proportional to production. The labor ($8,500) and variable overhead ($4,000) costs (labor-related), however, will be affected by the learning curve. The average cost per lot for labor and variable overhead after 100 units have been produced should be 80% of the costs of the first lot of 50 units. Thus, the average labor and variable overhead cost per 50-unit lot will be $10,000 ($12,500 × 80%). If production doubles again (to a total production of 200 units or four lots of 50 each), the cumulative average cost for labor and variable overhead will be $8,000 per lot ($10,000 × 80%). Given four lots of 50 each, at an average cost of $8,000 per lot, the total cost for labor and variable overhead must be $32,000. Adding $6,000 for raw materials ($1,500 per 50-unit lot) gives a total variable cost of $38,000 for 200 units. Fixed overhead is 10% of total variable cost, so total cost is $41,800. The total cost for the last 150 units is $26,400 ($41,800 – $15,400). Answer (B) is incorrect because $32,000 is the total cost for labor and variable overhead for 200 units. Answer (C) is incorrect because $38,000 is the total variable cost for 200 units. Answer (D) is incorrect because $41,800 is the total cost for 200 units. [61] Gleim #: 1.61 -- Source: CMA 1288 5-20 (Refers to Fact Pattern #5) If Moss Point had experienced a 70% learning curve, the bid for the 150 units would

A. B. C. D.

Show a 30% reduction in the total direct labor hours required with no learning curve. Include increased fixed overhead costs. Be 10% lower than the total bid at an 80% learning curve. Include 6.40 direct labor hours per unit at $8.50 per hour. Answer (A) is incorrect because, with no learning curve effect, estimated total hours would be 4,000 instead of 1,960, a change of more than 50%. Answer (B) is incorrect because fixed costs applied per lot would decline because they are based on labor hours, which are declining. Answer (C) is incorrect because, with no learning curve effect, estimated total hours would be 4,000 instead of 1,960, a change of more than 50%. Answer (D) is correct. The sum of the direct labor hours for the initial lot of 50 units was 1,000. A second lot of 50 would reduce the cumulative hours per lot to 700 (70% × 1,000). A doubling to four lots would reduce the cumulative hours per lot to 490 (70% × 700). Thus, for an output of 200 units, the total hours worked would be 1,960 (4 × 490). Subtracting the 1,000 hours required for the first 50 units from the 1,960-hour total gives 960 hours for the last 150 units. Dividing 960 hours by 150 units produces a per-unit time of 6.4 hours.

[62] Gleim #: 1.62 -- Source: CMA 683 5-8 A company is simulating the actions of a government agency in which 50% of the time a recall of a product is required, 40% of the time only notification of the buyer about a potential defect is required, and 10% of the time no action on its part is required. Random numbers of 1 to 100 are being used. An appropriate assignment of random numbers for the recall category would be

A. B. C. D.

1-40 40-90 61-100 11-60


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Answer (A) is incorrect because 1-40 is an appropriate assignment of random numbers for the notification category. Answer (B) is incorrect because 40-90 includes 51 numbers. Answer (C) is incorrect because 61-100 is an appropriate assignment of random numbers for the notification category. Answer (D) is correct. Given a 50% chance of a recall, 50 different numbers should be assigned to that alternative. This answer is the only alternative with 50 numbers (11-60). [63] Gleim #: 1.63 -- Source: CMA 1294 4-29 Quick Response Plumbing (QRP), a wholesale distributor, supplies plumbing contractors and retailers throughout the Northeast on a next-day delivery basis. QRP has a centrally located warehouse to accept receipts of plumbing supplies. The warehouse has a single dock to accept and unload railroad freight cars during the night. It takes 5 hours to unload each freight car. QRP’s prior records indicate that the number of freight cars that arrive in the course of a night range from zero to five or more, with no indicated pattern of arrivals. If more than two freight cars arrive on the same night, some freight must be held until the next day for unloading. QRP wants to estimate the wait time when more than two freight cars arrive in the same night. The appropriate technique to analyze the arrival of freight cars is

A. B. C. D.

Integer programming. Linear programming. Monte Carlo simulation. Regression analysis. Answer (A) is incorrect because integer programming is a variation of linear programming that concerns problems in which some variables are not continuous. Integer programming problems are also known as discrete models because the variables take on discrete, noncontinuous values. Answer (B) is incorrect because linear programming is a technique used to maximize a revenue or profit function, or minimize a cost function, subject to constraints such as limited resources or minimum (or maximum) levels of production time. Answer (C) is correct. The Monte Carlo simulation method is often used to generate the individual values for a random variable. The performance of a quantitative model under uncertainty may be investigated by randomly selecting values for each variable in the model (based on the probability distribution of each variable) and then calculating the value of the solution. If this process is performed many times, the distribution of results from the model will be obtained. Answer (D) is incorrect because regression analysis is used to find an equation for the linear relationships among variables.

[64] Gleim #: 1.64 -- Source: CMA 690 5-21 Through the use of decision models, managers thoroughly analyze many alternatives and decide on the best alternative for the company. Often the actual results achieved from a particular decision are not what was expected when the decision was made. In addition, an alternative that was not selected would have actually been the best decision for the company. The appropriate technique to analyze the alternatives by using expected inputs and altering them before a decision is made is

A. B. C. D.

Expected value analysis. Linear programming. Program Evaluation Review Technique (PERT). Sensitivity analysis.


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Answer (A) is incorrect because expected value analysis is used to determine an anticipated return or cost based upon probabilities of events and their related outcomes. Answer (B) is incorrect because linear programming optimizes a function given certain constraints. Answer (C) is incorrect because PERT is a network technique used to plan and control large projects. Answer (D) is correct. Sensitivity modeling can be used to determine the outcome of a variety of decisions. A trial-and-error method may be adopted, usually in a computer model, to calculate the sensitivity of the solution (variability of outcomes) to changes in a variable. [65] Gleim #: 1.65 -- Source: CIA 1190 III-46 A firm is attempting to estimate the reserves for doubtful accounts. The probabilities of these doubtful accounts follow a transition process over time. They evolve from their starting value to a changed value. As such, the most effective technique to analyze the problem is

A. B. C. D.

Markov chain analysis. Econometric theory. Monte Carlo analysis. Dynamic programming. Answer (A) is correct. A Markov chain is a series of events in which the probability of an event depends on the immediately preceding event. An example is the game of blackjack in which the probability of certain cards being dealt is dependent upon what cards have already been dealt. In the analysis of bad debts, preceding events, such as collections, credit policy changes, and writeoffs, affect the probabilities of future losses. Answer (B) is incorrect because econometrics forecasts the impact of different economic policies and conditions. Answer (C) is incorrect because Monte Carlo analysis is a simulation technique that uses random-number procedures to create values for probabilistic components. Answer (D) is incorrect because dynamic programming is a problem-solving approach that breaks a large mathematical model into a number of smaller, manageable problems.

[66] Gleim #: 1.66 -- Source: CIA 1193 III-67 A company has several departments that conduct technical studies and prepare reports for clients. Recently, there have been long delays in having these reports copied at the company’s centralized copy center because of the dramatic increase in business. Management is considering decentralizing copy services to reduce the turnaround and provide clients with timely reports. An appropriate technique for minimizing turnaround time and the cost of providing copy services is

A. B. C. D.

Queuing theory. Linear programming. Regression analysis. Game theory. Answer (A) is correct. Queuing theory is a group of mathematical models for systems involving waiting lines. In general, a queuing system consists of a waiting line and a service facility (a copy center in this case). The objective is to minimize total costs, including both service and waiting costs (turnaround time), for a given rate of arrivals. Answer (B) is incorrect because linear programming optimizes a given objective function subject to constraints. Answer (C) is incorrect because regression analysis estimates the relation among variables. Answer (D) is incorrect because game theory is an approach to decision making that considers the actions of competitors.


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[67] Gleim #: 1.67 -- Source: CMA 688 5-27 Queuing models are concerned with balancing the cost of waiting in the queue with the

A. B. C. D.

Cost of providing service. Number of customers in the queue. Average waiting time in the queue. Usage rate for the service being rendered. Answer (A) is correct. Queuing (waiting-line) models minimize, for a given rate of arrivals, the sum of (1) the cost of providing service (including facility costs and operating costs) and (2) the cost of idle resources waiting in line. The latter may be a direct cost, if paid employees are waiting, or an opportunity cost in the case of waiting customers. This minimization occurs at the point where the cost of waiting is balanced by the cost of providing service. Answer (B) is incorrect because queuing theory minimizes the sum of the costs of waiting and of providing service. Answer (C) is incorrect because queuing theory minimizes the sum of the costs of waiting and of providing service. Answer (D) is incorrect because queuing theory minimizes the sum of the costs of waiting and of providing service.

[68] Gleim #: 1.68 -- Source: CMA 688 5-28 The operating condition that cannot be identified by using a queuing model is the

A. B. C. D.

Average percentage of time that a service facility is idle. Probability of a specified number of units in the queue. Actual amount of time each unit spends in the queue. Average number of units in the system and the mean length of the queue. Answer (A) is incorrect because the queuing model calculates the average percentage of time that a service facility is idle, the probability of a specified number of units in the queue, and the average number of units in the system and the mean length of the queue. Answer (B) is incorrect because the queuing model calculates the average percentage of time that a service facility is idle, the probability of a specified number of units in the queue, and the average number of units in the system and the mean length of the queue. Answer (C) is correct. Queuing models determine the operating characteristics of a waiting line: the probability that no units are in the system, the average units in the line, the average units in the system, the average time a unit waits, the average time a unit is in the system, the probability that a unit must wait, and the probability of a given number of units in the system. However, the actual time spent in the queue cannot be determined from the model. Answer (D) is incorrect because the queuing model calculates the average percentage of time that a service facility is idle, the probability of a specified number of units in the queue, and the average number of units in the system and the mean length of the queue.

[69] Gleim #: 1.69 -- Source: CIA 586 III-15 A bank has changed from a system in which lines are formed in front of each teller to a one-line, multiple-server system. When a teller is free, the person at the head of the line goes to that teller. Implementing the new system will

A. B. C. D.

Decrease the bank’s wage expenses because the new system uses fewer tellers. Decrease time customers spend in the line. Increase accuracy in teller reconciliations at the end of the day because fewer customers are served by each teller. Improve on-the-job training for tellers because each will perform different duties.


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Answer (A) is incorrect because the number of employees is unlikely to change due to the new system. Answer (B) is correct. When all customers must wait in a single queue, a decrease in waiting time is possible given multiple servers. An added effect is to increase customer satisfaction. Answer (C) is incorrect because, assuming a Poisson process, the number of customers per teller will not change. Answer (D) is incorrect because tellers’ duties will not change, so on-the-job training will not improve. [70] Gleim #: 1.70 -- Source: CIA 1187 III-39 The drive-through service at a fast-food restaurant consists of driving up to place an order, advancing to a window to pay for the order, and then advancing to another window to receive the items ordered. This type of waiting-line system is

A. B. C. D.

Single channel, single phase. Single channel, multiple phase. Multiple channel, single phase. Multiple channel, multiple phase. Answer (A) is incorrect because service by one ticket-seller at a movie theater is an example of a single-channel, singlephase system. Answer (B) is correct. The drive-through represents a single queue (channel). Because this waiting line has three services in series, it may be said to be multiple phase. Another example is the typical factory assembly line. This terminology (channel, phase), however, is not used by all writers on queuing theory. Answer (C) is incorrect because supermarket checkout lines are a common example of multiple single-phase servers servicing multiple lines. Answer (D) is incorrect because an example of a multiple-channel, multiple-phase system is a set of supermarket checkout lines each of which is served in sequence by a cashier and a person who packs grocery bags.

[71] Gleim #: 1.71 -- Source: CIA 584 IV-34 A post office serves customers in a single line at one service window. During peak periods, the rate of arrivals has a Poisson distribution with an average of 100 customers per hour and service times that are exponentially distributed with an average of 60 seconds per customer. From this, one can conclude that the

A. B. C. D.

Queue will expand to infinity. Server will be idle one-sixth of the time. Average rate is 100 customers per hour. Average customer waiting time is 2.5 minutes. Answer (A) is correct. One hundred customers arrive in line per hour and only 60 are serviced per hour. Accordingly, the queue will expand to infinity during peak periods. Answer (B) is incorrect because insufficient information is given to determine overall idle time or average customer waiting time. The question gives only peak period data. Answer (C) is incorrect because peak customer service is only 60 per hour. Answer (D) is incorrect because insufficient information is given to determine overall idle time or average customer waiting time. The question gives only peak period data.


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[Fact Pattern #6]

A bank has two drive-in lanes to serve customers, one attached to the bank itself, the second on an island. One teller serves both stations. The bank is interested in determining the average waiting times of customers and has developed a model based on random numbers. The two key factors are the time between successive car arrivals and the time customers wait in line. Assume that the analysis begins with cars just arriving at both service windows, both requiring 3 minutes of service time. Car 1 is at the attached window and car 2 at the island window. A car will always go to the window attached to the bank unless that window has more cars waiting than the island window. The lone teller will always serve the car that arrived first. If two cars arrive simultaneously, the one at the attached window will be served before the one at the island.

Based on a known probability distribution, the bank assigns random numbers to arrival and service times:

Random #

Time between Arrivals

Random #

1 2, 3 4, 5, 6 7, 8

1 minute 2 minutes 3 minutes 4 minutes

1, 2 3 4, 5, 6 7, 8, 9

Service Time 1 minute 2 minutes 3 minutes 4 minutes

The bank then selects random numbers for the next two cars as Random Numbers Selected: Arrival Car 3 Car 4

#3 #7

Service #7 #8

[72] Gleim #: 1.72 -- Source: CIA 1192 III-98 (Refers to Fact Pattern #6) The arrival time follows which probability distribution?

A. B. C. D.

Binomial. Chi-square. Poisson. Exponential. Answer (A) is incorrect because the binomial distribution is a discrete distribution in which each trial has just two outcomes. Answer (B) is incorrect because the chi-square distribution is a continuous distribution used to measure the fit between actual data and the theoretical distribution. Answer (C) is correct. Queuing models assume that arrivals follow a Poisson process: the events (arrivals) are independent, any number of events must be possible in the interval of time, the probability of an event is proportional to the length of the interval, and the probability of more than one event is negligible if the interval is sufficiently small. If λ is the average number of events in a given interval, k is the number of events, and e is the natural logarithm (2.71828...), the probability of k is

λke-λ f(k) = k! Answer (D) is incorrect because service time has an exponential distribution. This distribution gives the probability of zero events in a given interval, i.e., the probability of a specified time between arrivals. [73] Gleim #: 1.73 -- Source: CIA 1192 III-99 (Refers to Fact Pattern #6) The time that car 3 will have to wait to be serviced (not including its own service time) is


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A. B. C. D.

0-2 minutes. 3 minutes. 4 minutes. 5+ minutes. Answer (A) is incorrect because car 3 must wait for 4 minutes. Answer (B) is incorrect because car 3 must wait for 4 minutes. Answer (C) is correct. Car 1 is at the attached window and will require 3 minutes to service. Car 2 must wait for car 1 to be serviced (3 minutes in the queue + 3 minutes to be serviced = 6 minutes). Car 3 arrived at the attached window 2 minutes after cars 1 and 2. It must wait 1 minute for car 1 to be serviced and 3 minutes for car 2 to be serviced, a waiting time of 4 minutes. Answer (D) is incorrect because car 3 must wait for 4 minutes.

[74] Gleim #: 1.74 -- Source: CIA 1192 III-100 (Refers to Fact Pattern #6) The time that car 4 will have to wait to be serviced (not including its own service time) is

A. B. C. D.

0-2 minutes. 3 minutes. 4 minutes. 5+ minutes. Answer (A) is incorrect because car 4 must wait 4 minutes. Answer (B) is incorrect because car 4 must wait 4 minutes. Answer (C) is correct. Car 4 arrives at the just-vacated island window 4 minutes after car 3. It must wait 4 minutes for car 3 to be serviced. Answer (D) is incorrect because car 4 must wait 4 minutes.

[Fact Pattern #7] An organization has collected data on the complaints made by personal computer users and has categorized the complaints.

(Refer to Figure FIGURE18_12.) [75] Gleim #: 1.75 -- Source: CIA 1195 III-15 (Refers to Fact Pattern #7) Using the information collected, the organization should focus on

A. B. C. D.

The total number of personal computer complaints that occurred. The number of computer complaints associated with diskette problems and new software usage. The number of computer complaints associated with the lack of user knowledge and hardware problems. The cost to alleviate all computer complaints.


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Answer (A) is incorrect because more detailed information is not available. The Pareto diagram does not focus on the total quantity of computer complaints. Answer (B) is incorrect because complaints about diskettes and software are infrequent. Answer (C) is correct. Complaints based on lack of user knowledge and hardware problems are by far the most frequent according to this chart. Consequently, the company should devote its resources primarily to these issues. Answer (D) is incorrect because cost information is not provided. [76] Gleim #: 1.76 -- Source: CIA 1195 III-16 (Refers to Fact Pattern #7) The chart displays

A. B. C. D.

The arithmetic mean of each computer complaint. The relative frequency of each computer complaint. The median of each computer complaint. The absolute frequency of each computer complaint. Answer (A) is incorrect because the chart does not display arithmetic means, relative frequencies, or medians of each type of complaint. Answer (B) is incorrect because the chart does not display arithmetic means, relative frequencies, or medians of each type of complaint. Answer (C) is incorrect because the chart does not display arithmetic means, relative frequencies, or medians of each type of complaint. Answer (D) is correct. This Pareto diagram depicts the frequencies of complaints in absolute terms. It displays the actual number of each type of complaint. The chart does not display arithmetic means, relative frequencies, or medians of each type of complaint.

[77] Gleim #: 1.77 -- Source: CMA 689 5-25 A Gantt chart

A. B. C. D.

Shows the critical path for a project. Is used for determining an optimal product mix. Shows only the activities along the critical path of a network. Does not necessarily show the critical path through a network. Answer (A) is incorrect because the critical path is not shown on a Gantt chart. Answer (B) is incorrect because linear programming is used to determine an optimal product mix. Answer (C) is incorrect because a Gantt chart shows the activities to be completed but not their sequencing. Answer (D) is correct. A Gantt or bar chart is sometimes used in conjunction with PERT or CPM to show the progress of a special project. Time is shown on the horizontal axis, the length of a bar equals the length of an activity, and shading indicates the degree of completion. However, the Gantt chart is not as sophisticated as PERT or CPM in that it does not reflect the relationships among the activities or define a critical path.


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[78] Gleim #: 1.78 -- Source: CIA 586 III-23 As of week 8, the Gantt chart shows that the project is

(Refer to Figure CIA2_08_26.)

A. B. C. D.

Complete. Ahead of schedule. On schedule. Behind schedule. Answer (A) is incorrect because the project is ahead of schedule, but activity D has not yet been started, much less completed. Answer (B) is correct. Assuming that (1) each of the bars represents the expected time necessary to complete an activity and (2) the shaded regions represent the portions completed, activity A has been completed as scheduled and activities B and C are ahead of schedule. Consequently, the project is ahead of schedule. Answer (C) is incorrect because the project is ahead of schedule, but activity D has not yet been started, much less completed. Answer (D) is incorrect because the project is ahead of schedule, but activity D has not yet been started, much less completed.

[79] Gleim #: 1.79 -- Source: CMA 694 4-1 When using PERT (Program Evaluation Review Technique), the expected time for an activity when given an optimistic time (A), a pessimistic time (B), and a most likely time (m) is calculated by which one of the following formulas?

A. B. C. D.

(b – a) ÷ 2 (a + b) ÷ 2 (a + 4m + b) ÷ 6 (4abm) ÷ 6 Answer (A) is incorrect because the most likely time estimate should be included in the formula. Answer (B) is incorrect because the most likely time estimate should be included in the formula. Answer (C) is correct. PERT was developed to aid managers in controlling large, complex projects. PERT analysis includes probabilistic estimates of activity completion times. Three time estimates are made: optimistic, most likely, and pessimistic. The time estimates for an activity are assumed to approximate a beta probability distribution. PERT approximates the mean of the beta distribution by dividing the sum of the optimistic time, the pessimistic time, and four times the most likely time by six. Answer (D) is incorrect because all time estimates are not weighted equally.

[80] Gleim #: 1.80 -- Source: CIA 597 III-98 The process of adding resources to shorten selected activity times on the critical path in project scheduling is called

A. B. C. D.

Crashing. The Delphi technique. Material-requirements planning. A branch-and-bound solution.


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Answer (A) is correct. When making a cost-time trade-off, the first activity to be crashed (have its completion time accelerated) is one on the critical path. To select an activity on another path would not reduce the total time of completion. The activity chosen should have a completion time that can be accelerated at the lowest possible cost per unit of time saved. Answer (B) is incorrect because the Delphi technique is a qualitative forecasting approach. Answer (C) is incorrect because material-requirements planning is an inventory model. Answer (D) is incorrect because a branch-and-bound solution is an integer programming solution. [81] Gleim #: 1.81 -- Source: CMA 1288 5-24 California Building Corporation uses the critical path method to monitor construction jobs. The company is currently 2 weeks behind schedule on Job #181, which is subject to a $10,500-per-week completion penalty. Path A-B-C-F-G-H-I has a normal completion time of 20 weeks, and critical path A-D-E-F-G-H-I has a normal completion time of 22 weeks. The following activities can be crashed:

Activities

Cost to Crash 1 Week

Cost to Crash 2 Weeks

BC DE EF

$ 8,000 10,000 8,800

$15,000 19,600 19,500

California Building desires to reduce the normal completion time of Job #181 and, at the same time, report the highest possible income for the year. California Building should crash

A. B. C. D.

Activity BC 1 week and activity EF 1 week. Activity BC 2 weeks. Activity EF 2 weeks. Activity DE 1 week and activity EF 1 week. Answer (A) is incorrect because BC is not on the critical path. Answer (B) is incorrect because BC is not on the critical path. Answer (C) is incorrect because the cost of crashing EF 2 weeks is $19,500, which is greater than the total cost to crash DE and EF for 1 week each. Answer (D) is correct. Activities that are to be crashed in a CPM problem should be ones that are on the critical (longest) path. Thus, activity BC should not be selected because it is not on the critical path. To finish activity BC 2 weeks early would not reduce the total time to complete the project. Therefore, the only feasible choices are DE and EF on the critical path. The total cost to crash DE and EF for 1 week each is $18,800 ($10,000 + $8,800), which is less than the cost to crash either activity for 2 weeks. Thus, DE and EF should be crashed for 1 week each because the total cost is less than the $21,000 ($10,500 × 2) 2-week delay penalty.

[82] Gleim #: 1.82 -- Source: CMA 688 5-13 In a PERT network, the optimistic time for a particular activity is 9 weeks, and the pessimistic time is 21 weeks. Which one of the following is the best estimate of the standard deviation for the activity?

A. B. C. D.

2 6 9 12


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Answer (A) is correct. PERT analysis includes probabilistic estimates of activity completion times. Three time estimates are made: optimistic, most likely, and pessimistic. The time estimates for an activity are assumed to approximate a beta probability distribution. In contrast to the normal distribution, this distribution has finite endpoints (the optimistic and pessimistic estimates) and is unimodal; that is, it has only one mode (the most likely time). PERT approximates the mean of the beta distribution by dividing the sum of the optimistic time, the pessimistic time, and four times the most likely time (the mode) by six. The standard deviation is approximated by dividing the difference between the pessimistic and optimistic times by six. The basis for the latter approximation is that various probability distributions have tails that lie about plus or minus three standard deviations from the mean. For example, 99.9% of observations in the normal distribution are expected to lie within this range. Accordingly, if the pessimistic and optimistic times are 21 and 9 weeks, respectively, the standard deviation is 2 weeks (12 ÷ 6). Answer (B) is incorrect because 6 is the approximate number of standard deviations between the tails of the normal distribution. Answer (C) is incorrect because 9 weeks is the pessimistic estimate. Answer (D) is incorrect because 12 weeks is the difference between the optimistic and the pessimistic estimates. [83] Gleim #: 1.83 -- Source: CMA 688 5-17 A PERT network has only two activities on its critical path. These activities have standard deviations of 6 and 8, respectively. The standard deviation of the project completion time is

A. B. C. D.

7 10 14 48 Answer (A) is incorrect because 7 is the average standard deviation. Answer (B) is correct. The mean time for the critical path is simply the sum of the means of the activity times. However, the standard deviation equals the square root of the sum of the variances (squares of the standard deviations) of the times for activities on the critical path. The standard deviation of the project completion time (time for the critical path) is therefore the square root of 100 (6 2 + 82), or 10. Answer (C) is incorrect because 14 is the sum of the standard deviations. Answer (D) is incorrect because 48 is the product of the standard deviations.

[Fact Pattern #8] The PERT network diagram and the corresponding activity cost chart for a manufacturing project at Networks, Inc. are presented below. The numbers in the diagram are the expected times (in days) to perform each activity in the project.


Activity

Normal Cost

Crash Time

Crash Cost

AB AC AD BE CE DE BC BD

$3,000 5,000 4,000 6,000 8,000 6,000 2,500 2,000

3.50 days 4.50 4.00 5.00 5.00 6.50 .50 .25

$4,000 5,250 4,750 7,000 9,200 6,750 3,500 2,500


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[84] Gleim #: 1.84 -- Source: CMA 1290 4-7 (Refers to Fact Pattern #8) The expected time of the critical path is

A. B. C. D.

12.0 days. 13.0 days. 11.5 days. 11.0 days. Answer (A) is incorrect because the expected time of the critical path is 13.0 days. Answer (B) is correct. The critical path is the longest path. The longest path in the diagram is A-D-E, which requires 13 days (5.5 + 7.5) based on expected times. Answer (C) is incorrect because the expected time of the critical path is 13.0 days. Answer (D) is incorrect because the expected time of the critical path is 13.0 days.

[85] Gleim #: 1.85 -- Source: CMA 1290 4-8 (Refers to Fact Pattern #8) To keep costs at a minimum and decrease the completion time by 1 1/2 days, Networks, Inc. should crash activity(ies)

A. B. C. D.

AD and AB. DE. AD. AB and CE. Answer (A) is correct. The critical (longest) path is A-D-E, which has an expected time of 13 days (see preceding question). However, to decrease the project’s completion time by 1.5 days, paths A-B-C-E (4.5 + 1.0 + 6.5 = 12 days) and A-B-D-E (4.5 + .5 + 7.5 = 12.5 days) as well as A-D-E must also be shortened. Hence, A-D-E must be reduced by 1.5 days, A-B-C-E by .5 day, and A-B-D-E by 1.0 day. The only way to decrease A-D-E by 1.5 days is to crash activity AD (5.5 expective time – 4.0 crash time = 1.5 days). Crashing DE results in a 1.0-day saving (7.5 – 6.5) only. Crashing AB is the efficient way to reduce both A-B-C-E and A-B-D-E by the desired amount of time because it is part of both paths. The incremental cost of crashing AB is $1,000 ($4,000 crash cost – $3,000 normal cost) to shorten the completion time by 1.0 day (4.5 – 3.5). The alternatives for decreasing both A-B-C-E and A-B-D-E are more costly. Answer (B) is incorrect because crashing activity DE saves only 1.0 day (7.5 – 6.5) on the critical path and does not reduce the time needed for A-B-C-E. Answer (C) is incorrect because crashing AD does not reduce the time necessary to complete A-B-C-E or A-B-D-E. Answer (D) is incorrect because AB and CE are not on the critical path.

[86] Gleim #: 1.86 -- Source: CMA 694 4-3 When making a cost-time trade-off in PERT analysis, the first activity that should be crashed is the activity

A. B. C. D.

With the largest amount of slack. With the lowest unit crash cost. On the critical path with the maximum possible time reduction. On the critical path with the lowest unit crash cost.


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Answer (A) is incorrect because eliminating an activity with slack will not reduce the total time of the project. Answer (B) is incorrect because the activity with the lowest unit crash cost may not be on the critical path. Answer (C) is incorrect because the time reduction should be related to its cost. The maximum time reduction may not be cost effective. Answer (D) is correct. When making a cost-time trade-off, the first activity to be crashed (have its completion time accelerated) is one on the critical path. To select an activity on another path would not reduce the total time of completion. The initial activity chosen should be the one with the completion time that can be accelerated at the lowest possible cost per unit of time saved. [87] Gleim #: 1.87 -- Source: CMA 695 4-12 In PERT, slack is the

A. B. C. D.

Uncertainty associated with time estimates. Difference between the latest starting time and earliest finishing time. Path that has the largest amount of time associated with it. Number of days an activity can be delayed without forcing a delay for the entire project. Answer (A) is incorrect because uncertainty is reflected in the use of probabilistic estimates of completion times. Answer (B) is incorrect because the difference between the latest starting time and earliest finishing time is irrelevant. Answer (C) is incorrect because the path with the largest amount of time associated with it is the critical path. Answer (D) is correct. PERT diagrams are free-form networks showing each activity in a large project as a line between events. The critical path is the longest path in time through the network. That path is critical in that, if any activity on the critical path takes longer than expected, the entire project will be delayed. Paths that are not critical have slack time. Slack is the number of days an activity can be delayed without forcing a delay for the entire project.

[88] Gleim #: 1.88 -- Source: CIA 1196 III-96 The network below describes the interrelationships of several activities necessary to complete a project. The arrows represent the activities. The numbers between the arrows indicate the number of months to complete each activity.

(Refer to Figure CIA3_01_09.) The shortest time to complete the project is

A. B. C. D.

5 months. 6 months. 8 months. 14 months. Answer (A) is incorrect because the project cannot be completed in less than 8 months. Answer (B) is incorrect because the project cannot be completed in less than 8 months. Answer (C) is correct. The longest, or critical, path in the network from node (A) to node (F) is path A-C-D-F. All other paths are shorter than path A-C-D-F, so the activities along those paths can be completed before the activities along path A-C-D-F. Thus, the shortest time to complete the project is 8 months (3 + 3 + 2). Answer (D) is incorrect because no path through the network requires 14 months.


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[89] Gleim #: 1.89 -- Source: CIA 596 III-100 A shortest-route algorithm is used in network models to

A. B. C. D.

Identify bottlenecks in a network and hence identify the longest path. Minimize total travel time from one site to each of the other sites in a transportation system. Maximize throughput in networks with distinct entry (source node) and exit (sink node) points. Identify the set of connecting branches having the shortest combined length. Answer (A) is incorrect because the critical path method (CPM) is intended to identify bottlenecks in a network and hence identify the longest path. Answer (B) is correct. Network models are used to solve managerial problems pertaining to project scheduling, information systems design, and transportation systems design. Networks consisting of nodes and arcs may be created to represent in graphic form problems related to transportation, assignment, and transshipment. The shortest-route, minimal spanning tree, and maximal flow problems are other applications of network models. A shortest-route algorithm minimizes total travel time from one site to each of the other sites in a transportation system. Answer (C) is incorrect because the maximal flow algorithm maximizes throughput in networks with distinct entry (source node) and exit (sink node) points. Examples of applications are highway transportation systems and oil pipelines. Flows are limited by capacities of the arcs (e.g., highways or pipes). Answer (D) is incorrect because the minimal spanning tree algorithm identifies the set of connecting branches having the shortest combined length. A spanning tree is a group of branches (arcs) that connects each node in the network to every other node. An example problem is the determination of the shortest telecommunications linkage among users at remote sites and a central computer.

[90] Gleim #: 1.90 -- Source: CIA 597 III-32 Reengineering is the thorough analysis, fundamental rethinking, and complete redesign of essential business processes. The intended result is a dramatic improvement in service, quality, speed, and cost. An internal auditor’s involvement in reengineering should include all of the following except

A. B. C. D.

Determining whether the process has senior management’s support. Recommending areas for consideration. Developing audit plans for the new system. Directing the implementation of the redesigned process. Answer (A) is incorrect because internal auditors may perform the functions of determining whether the process has senior management’s support, recommending areas for consideration, and developing audit plans for the new system. Answer (B) is incorrect because internal auditors may perform the functions of determining whether the process has senior management’s support, recommending areas for consideration, and developing audit plans for the new system. Answer (C) is incorrect because internal auditors may perform the functions of determining whether the process has senior management’s support, recommending areas for consideration, and developing audit plans for the new system. Answer (D) is correct. Internal auditors should not become directly involved in the implementation of the redesign process. This involvement would impair their independence and objectivity. Staff assignments of internal auditors should be rotated periodically whenever it is practicable to do so.

[91] Gleim #: 1.91 -- Source: CIA 1195 I-66 Monitoring is an important component of internal control. Which of the following is not an example of monitoring?


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A. Management regularly compares divisional performance with budgets for the division. B. Data processing management regularly generates exception reports for unusual transactions or volumes of transactions and follows up with investigation as to causes. C. Data processing management regularly reconciles batch control totals for items processed with batch controls for items submitted. D. Management has asked internal auditing to perform regular audits of the controls over cash processing. Answer (A) is incorrect because budgetary comparison is a typical example of a monitoring control. Answer (B) is incorrect because investigation of exceptions is a monitoring control used by lower-level management to determine when their operations may be out of control. Answer (C) is correct. Monitoring assesses the quality of internal control over time. Management considers whether internal control is properly designed and operating as intended and modifies it to reflect changing conditions. Monitoring may be in the form of separate, periodic evaluations or of ongoing monitoring. Ongoing monitoring occurs as part of routine operations. It includes management and supervisory review, comparisons, reconciliations, and other actions by personnel as part of their regular activities. However, reconciling batch control totals is a processing control. Answer (D) is incorrect because internal auditing is a form of monitoring. It serves to evaluate management’s other controls. [92] Gleim #: 1.92 -- Source: Publisher Tocon Company produces two components: A-1 and A-2. The unit throughput contribution margins for A-1 and A-2 are $150 and $300, respectively. Each component must proceed through two processes: Operation 1 and Operation 2. The capacity of Operation 1 is 180 machine hours, with A-1 and A-2 requiring 1 hour and 3 hours, respectively. Furthermore, Tocon can sell only 45 units of A-1 and 100 units of A-2. However, Tocon is considering expanding Operation 1’s capacity by 90 machine hours at a cost of $80 per hour. Assuming that Operation 2 has sufficient capacity to handle any additional output from Operation 1, Tocon should produce

Units of A-1

Units of A-2

A. B.

180 45

0 100

C. D.

45 0

75 60

Answer (A) is incorrect because Tocon can sell only 45 units of A-1. Answer (B) is incorrect because Tocon can produce only 75 units of A-2 if it produces 45 units of the more profitable A-1. Answer (C) is correct. A-1’s throughput contribution margin per unit of the scarce resource (the internal binding constraint) is $150 ($150 UCM ÷ 1 machining hour). A-2’s throughput contribution margin per unit of the scarce resource is $100 ($300 UCM ÷ 3 machine hours). Consequently, Tocon should produce as much A-1 as it can sell (45 units). If Tocon adds 90 machine hours to increase the capacity of Operation 1 to 270 hours (180 + 90), it cannot produce additional units of A-1 because the external binding constraint has not been relaxed. However, it can produce additional units of A-2. Given that the UCM per machine hour of A-2 is $100 and that the cost is $80 per hour, adding capacity to Operation 1 is profitable. Thus, Tocon should use 45 machine hours to produce 45 units of A-1. The remaining 225 machine hours (270 - 45) should be used to produce 75 units (225 ÷ 3 hours) of A-2. The latter amount is within the external binding constraint. Answer (D) is incorrect because Tocon should produce as much of A-1 as it can sell. [93] Gleim #: 1.93 -- Source: Publisher Which of the following is a short-term approach to managing bottlenecks or binding constraints in production and distribution processes?


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A. B. C. D.

Theory of constraints. Reengineering. Rationalization. Micromotion study. Answer (A) is correct. The theory of constraints (TOC) is a short-term approach to managing bottlenecks (binding constraints) in production and distribution processes. Its basic principle is that short-term profit maximization requires maximizing the contribution margin of the binding constraint (the throughput contribution). Answer (B) is incorrect because reengineering an approach to business process analysis that entails process innovation and core process redesign. Instead of improving existing procedures, it finds new ways of doing things. Answer (C) is incorrect because rationalization is yet another approach to business process analysis. It is the streamlining of procedures to make automation more efficient. Answer (D) is incorrect because a micromotion study is a method used for work management, and it requires videotaping the performance of a job.

[Fact Pattern #9] This information is relevant to a theory of constraints (TOC) analysis. A manufacturer that can sell all of its output produces its sole product using three operations. Each unit sells for $120, and direct materials costing $48 per unit are added at the start of the first operation. Other variable costs are immaterial. The following annual cost and capacity information is available concerning those operations:

Total capacity per year Total output per year Fixed cost of operations (not including direct materials)

Operation 1

Operation 2

Operation 3

200,000 units 150,000 units

150,000 units 150,000 units

180,000 units 150,000 units

$1,200,000

$1,800,000

$2,250,000

[94] Gleim #: 1.94 -- Source: Publisher (Refers to Fact Pattern #9) Assume that additional workers are hired for the bottleneck operation to expedite setups and materials handling. The cost of the additional workers is $50,000 per year. As a result, the annual output of the bottleneck operation will increase by 500 units. The change in operating income attributable to the increase in workers is

A. B. C. D.

$50,000 $36,000 $(14,000) $(20,000) Answer (A) is incorrect because $50,000 is the incremental cost. Answer (B) is incorrect because $36,000 is the incremental throughput contribution. Answer (C) is correct. Operation 2 is the bottleneck because it is functioning at its capacity. The incremental annual throughput contribution (revenues – direct materials costs) from adding workers to Operation 2 is $36,000 [500 units × ($120 unit price – $48 DM per unit)]. Because the cost of the additional workers is $50,000, the change in operating income is $(14,000). Answer (D) is incorrect because $(20,000) is based on the assumption that an additional $12 per unit of fixed costs will be applied.


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[95] Gleim #: 1.95 -- Source: Publisher (Refers to Fact Pattern #9) Assume that X Company offers to perform the Operation 2 function on 1,000 units at a unit price of $40, excluding direct materials cost. Also assume that Y Company offers to perform the Operation 1 function on 1,000 units at a unit price of $7, excluding direct materials cost. Which of these mutually exclusive offers is acceptable?

A. B. C. D.

X but not Y. Y but not X. X or Y. Neither offer should be accepted. Answer (A) is correct. X’s offer should be accepted because its cost is $40,000 (1,000 units × $40), but the increase in throughput contribution is $72,000 [1,000 units × ($120 unit price – $48 DM per unit)]. Hence, the relevant cost of X’s offer is less than the incremental throughput contribution. X’s offer effectively increases the capacity of the bottleneck operation. Y’s offer should be rejected because, even though its $7 unit price is less than the $8 unit operating cost (excluding direct materials) for Operation 1, it will result in the incurrence of additional costs with no increase in throughput contribution, given that Operation 2 is already producing at its 150,000-unit capacity. Answer (B) is incorrect because X’s offer but not Y’s offer is acceptable. Answer (C) is incorrect because X’s offer but not Y’s offer is acceptable. Answer (D) is incorrect because X’s offer but not Y’s offer is acceptable.

[96] Gleim #: 1.96 -- Source: Publisher Which of the following statements is not true regarding ISO 9000 standards?

A. B. C. D.

Compliance with the standards is voluntary. The ISO 9000 standards are revised every 5 years to account for technological and market developments. The objective of ISO 9000 standards is to ensure high quality products and services. ISO 9000 is a set of generic standards for establishing and maintaining a quality system within a company. Answer (A) is incorrect because compliance is voluntary but many companies are adopting the standards for competitive reasons or out of fear that the standards will become a requirement in foreign markets. Answer (B) is incorrect because the ISO rules specify that standards are periodically revised every 5 years in light of technological and market developments. Answer (C) is correct. The objective of ISO 9000 standards is to ensure consistent quality even if the quality is poor. The market will determine the quality of the end result. Answer (D) is incorrect because ISO 9000 standards are generic in nature and only ensure consistent quality in the product being produced.

[97] Gleim #: 1.97 -- Source: Publisher What is the main benefit for most companies who adopt ISO 14000 standards?

A. B. C. D.

Reduced monitoring and inspection by regulatory agencies. Companies are required to adopt ISO 14000 standards to operate in the European Union. The Environmental Protection Agency cannot use voluntary ISO audits as a basis for imposing penalties. Companies learn how well their environmental management system operates relative to those of other companies.


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Answer (A) is incorrect because not all companies are regulated by government agencies. Also, there is no guarantee that compliance with ISO 14000 standards will reduce monitoring and inspection by agencies. Answer (B) is incorrect because ISO 14000 standards are not currently required by the European Union. Answer (C) is incorrect because this is a benefit to some companies but not others. Not all companies are subject to the EPA’s audits. Answer (D) is correct. The main benefit of instituting ISO 14000 standards is internal; companies learn how well their environmental management system operates relative to those of other companies. This is accomplished through the sharing of information required by ISO standards. [98] Gleim #: 1.98 -- Source: Publisher What ensures that a company is complying with the documented Quality Management System procedures and ISO 9000 standards?

A. B. C. D.

The internal audit. The registrar. On-site inspections by an external auditor. Management commitment. Answer (A) is correct. An important requirement of the ISO 9000 standards is the internal audit system. Internal audits assure that the company is complying with the documented QMS procedures and ISO 9000 standards. Answer (B) is incorrect because the registrar evaluates whether the quality control system conforms to the selected standard. Answer (C) is incorrect because the registrar is the external auditor who performs the on-site inspection. The registrar observes the quality control system and evaluates the conformity to the selected standard. Answer (D) is incorrect because the internal audit is responsible for ensuring compliance with the QMS and ISO 9000 standards. However, management commitment plays an important role in determining the amount of resources dedicated to quality.

[99] Gleim #: 1.99 -- Source: CIA 591 III-44 The following data on variables x and y was collected from June to October:

x y

June

July

August

September

October

24 104

31 76

19 124

15 140

22 112

The correlation coefficient between variables x and y is nearest to

A. B. C. D.

1.00 -1.00 0.50 0.00


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Answer (A) is incorrect because a positive correlation coefficient implies that one variable increases (decreases) as the other increases (decreases). The data clearly do not support this conclusion. Answer (B) is correct. A correlation coefficient of -1.00 implies a perfect inverse correlation; that is, the observations fall exactly along a straight line and the value of one variable increases (decreases) as the other decreases (increases). In the example to the left, the equation of the straight line is

y = or x =

200 – 4x 50 – 1y 4

Answer (C) is incorrect because a positive correlation coefficient implies that one variable increases (decreases) as the other increases (decreases). The data clearly do not support this conclusion. Answer (D) is incorrect because a correlation coefficient of zero implies that the two variables are unrelated. The data clearly indicate that the two variables move in opposite directions. [100] Gleim #: 1.100 -- Source: CIA 595 III-97 A company is formulating its plans for the coming year, including the preparation of its cash budget. Historically, 30% of the company’s sales are cash sales. The remaining 70% are credit sales with the following collection pattern. Collections on Account

Percentage

In the month of sale In the month following the sale Uncollectible

40% 58% 2%

Sales for the first five months of the coming year are forecast as follows. January February March April May

$3,500,000 3,800,000 3,600,000 4,000,000 4,200,000

For the month of April, the total cash receipts from sales and collections on account would be

A. B. C. D.

$3,729,968 $3,781,600 $4,025,200 $4,408,000 Answer (A) is incorrect because $3,729,968 results from improperly calculating the collections of April and March credit sales. The 2% uncollectible amount should not be removed from the credit sales before the collection percentage is applied. Answer (B) is correct. The cash receipts for April equal April’s cash sales (30% × $4,000,000 = $1,200,000), 40% of April’s credit sales, and 58% of March’s credit sales. Consequently, total cash receipts equal $3,781,600 [$1,200,000 + (40% × 70% × $4,000,000) + (58% × 70% × $3,600,000)]. Answer (C) is incorrect because $4,025,200 includes the collection of May credit sales rather than March credit sales. Answer (D) is incorrect because $4,408,000 improperly calculates the collections of March credit sales. The calculation treats the entire sales figure for March as credit sales.


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[101] Gleim #: 1.101 -- Source: CIA 597 III-100 The following information and diagram apply to a project:


Activity

Time (days)

Immediate Predecessor

A B C D E

5 3 4 2 6

None None A B C, D

The earliest completion time for the project is

A. B. C. D.

11 days. 14 days. 15 days. 20 days. Answer (A) is incorrect because 11 days is the shortest, not the longest, time to completion. Answer (B) is incorrect because 14 days is not the completion time of a path to completion. Answer (C) is correct. The two paths through the network are ACE (5 + 4 + 6 = 15 days) and BDE (3 + 2 + 6 = 11 days). The critical or longest path is A-C-E. Hence, the earliest completion time is 15 days. Answer (D) is incorrect because 20 days is the sum of all of the activity times.

[102] Gleim #: 1.102 -- Source: CIA 1191 III-33 The data below were gathered on two different machine centers and two products. Product Hours per Unit

Machine Center 1 Machine Center 2 Contribution per unit

A

B

Hours Available

2.5 6 $4

4 3 $5

60 70

Which item below would be part of a linear programming formulation of this problem?

A. B. C. D.

Maximize: Contribution > 4A + 5B. Subject to: A < 0. Subject to: 2.5A + 4B < 60. Subject to: 4A + 5B < 130.


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Answer (A) is incorrect because the objective function is to maximize the total contribution margin (4A + 5B). This amount is not expressed as an inequality. Answer (B) is incorrect because this equation (A < 0) is nonsensical. Answer (C) is correct. The linear programming solution is subject to constraints on the availability of machine hours in both centers. For example, products A and B require 2.5 and 4 hours per unit, respectively, in Machine Center 1, but only 60 hours are available. Hence, the optimal production of A and B to the following constraint: 2.5A + 4B < 60 Answer (D) is incorrect because the hours available in the two machine centers cannot be added together. Also, the left side of the equation states the objective function, not a constraint. [103] Gleim #: 1.103 -- Source: CIA 594 II-40 Various tools are employed to control large scale projects. They include all of the following except:

A. B. C. D.

PERT. CPM. Statistical process control. Gantt charts. Answer (A) is incorrect because PERT breaks down a project into a set of events, arranges the events into a strict priority network, and establishes a completion time for each event. Answer (B) is incorrect because CPM is used to control large scale projects. Essentially a subset of PERT, CPM uses a deterministic rather than a probabilistic estimate of the time required for task completion. Answer (C) is correct. Statistical process (quality) control is not used to control large scale projects. Statistical quality control is a method of determining whether the shipment or production run of units lies within acceptable limits. It is also used to determine whether production processes are out of control. Answer (D) is incorrect because Gantt charts compare scheduled production with actual production. Its control function lies in its ability to identify variations and thus formulate corrective actions.

[104] Gleim #: 1.104 -- Source: CIA 594 III-61 Which of the following terms is not used in project management?

A. B. C. D.

Dummy activity. Latest finish. Optimistic time. Lumpy demand. Answer (A) is incorrect because a dummy activity is one that consumes no time but establishes precedence among activities. It is used specifically in project management. Answer (B) is incorrect because the latest finish is the latest that an activity can finish without causing delay in the completion of the project. Answer (C) is incorrect because optimistic time is the time for completing a project if all goes well. Answer (D) is correct. Project management concerns managing teams assigned to special projects. Lumpy demand refers to periodic demand for a product or service that increases in large, lumpy increments.


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[105] Gleim #: 1.105 -- Source: CIA 592 III-69 Activity scheduling information for the installation of a new computer system is given below.

Activity

Immediate Predecessor

Duration (Days)

A B C D E

A A B, D

4 3 9 6 5

For this project, the critical path is

A. B. C. D.

A-C. B-E. A-D-E. B-D-C. Answer (A) is incorrect because the path length of A-C is 13. Answer (B) is incorrect because the path length of B-E is 8. Answer (C) is correct. The critical path is the longest path because it defines the minimum duration of the project. A-DE (4 + 6 + 5 = 15) is the critical path. Answer (D) is incorrect because B-D-C is not a path. The predecessor of C is A.

[106] Gleim #: 1.106 -- Source: CIA 1191 III-37 In a critical path analysis, if slack time in an activity exists, the activity

A. B. C. D.

Is not essential to the overall project. Is a backup activity to replace a main activity should it fail. Could be delayed without delaying the overall project. Involves essentially no time to complete. Answer (A) is incorrect because an activity with slack may nevertheless be essential to the overall project. Answer (B) is incorrect because it is not a backup activity. Answer (C) is correct. Slack is the free time associated with each activity. In other words, paths that are not critical have slack time. Slack represents unused resources that can be diverted to the critical path. Answer (D) is incorrect because time is involved in a slack activity.

[107] Gleim #: 1.107 -- Source: CIA 1193 III-67 A company has several departments that conduct technical studies and prepare reports for clients. Recently, there have been long delays in having these reports copied at the company’s centralized copy center because of the dramatic increase in business. Management is considering decentralizing copy services to reduce the turnaround and provide clients with timely reports. An appropriate technique for minimizing turnaround time and the cost of providing copy services is


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A. B. C. D.

Queuing theory. Linear programming. Regression analysis. Game theory. Answer (A) is correct. Two basic costs are involved in queuing (waiting-line) models: (1) the cost of providing service (including facility costs and operating costs), and (2) the cost of idle resources waiting in line. The latter may be a direct cost if paid employees are waiting, or an opportunity cost in the case of waiting customers. The objective of queuing theory is to minimize the total cost of the system, including both service and waiting costs, for a given rate of arrivals. This minimization occurs at the point at which cost of waiting is balanced by the cost of providing service. This company wishes to reduce the total of waiting costs (turnaround time) and the cost of copy services. Answer (B) is incorrect because linear programming is a mathematical technique for optimizing a given objective function subject to constraints. Answer (C) is incorrect because regression analysis is a statistical procedure for estimating the relation between variables. Answer (D) is incorrect because game theory is a mathematical approach to decision-making in which each decision-maker takes into account the courses of action of competitors.

[Fact Pattern #10] A bank has two drive-in lanes to serve customers, one attached to the bank itself, the second on an island. One teller serves both stations. The bank is interested in determining the average waiting times of customers and has developed a model based on random numbers. The two key factors are the time between successive car arrivals and the time customers wait in line. Assume that the analysis with cars just arriving at both service windows, both requiring 3 minutes of service time. Car 1 is at the attached window and car 2 at the island window. A car will always go to the window attached to the bank unless that window has more cars waiting than the island window. The lone teller will always serve the car that arrived first. If two cars arrive simultaneously, the one at the attached window will be served before the one at the island. Based on a known probability distribution, the bank assigns random numbers to arrival and service times:

Random # 1 2, 3 4, 5, 6 7, 8

Time between arrivals:

Random #

1 minute 2 minutes 3 minutes 4 minutes

1, 2 3 4, 5, 6 7, 8, 9

Service time 1 minute 2 minutes 3 minutes 4 minutes

The bank then selects random numbers for the next two cars as Random Numbers Selected

Car 3 Car 4

Arrival

Service

#3 #7

#7 #8

[108] Gleim #: 1.108 -- Source: CIA 1192 III-95 (Refers to Fact Pattern #10) The problem just described is best approached by use of which quantitative method?


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A. B. C. D.

Integrated autoregressive-moving average (ARIMA) modeling. Exponential smoothing, multiple parameters. Queuing theory. Linear programming. Answer (A) is incorrect because ARIMA modeling is a times-series technique. Answer (B) is incorrect because exponential smoothing is a time-series model. Answer (C) is correct. Two basic costs are involved in queuing (waiting-line) models, (1) the cost of providing service (including facility costs and operating costs), and (2) the cost of idle resources waiting in line. The latter may be a direct cost if paid employees are waiting, or an opportunity cost in the case of waiting customers. The objective of the queuing theory is to minimize the total cost of the system, including both service and waiting costs, for a given rate of arrivals. This minimization occurs at the point where the cost of waiting is balanced by the cost of providing service. Answer (D) is incorrect because linear programming optimizes outputs given scarce resources.

[109] Gleim #: 1.109 -- Source: CIA 1192 III-96 (Refers to Fact Pattern #10) The technique used in analyzing the problem is best described as

A. B. C. D.

Simulation theory. Integrated autoregressive-moving average (ARIMA) modeling. Linear programming. Differential calculus. Answer (A) is correct. Simulation is a technique for experimenting with logical/mathematical models using a computer. Despite the power of mathematics, many problems cannot be solved by known analytical methods because of the behavior of the variables and the complexity of their interactions. However, the performance of a quantitative model under uncertainty may be investigated by randomly selecting values for each of the variables in the model (based on the probability distribution of each variable) and then calculating the value of the solution. If this process is performed a large number of times, the distribution of results from the model will be obtained. Answer (B) is incorrect because ARIMA modeling is a time-series technique. Answer (C) is incorrect because linear programming optimizes outputs given scarce resources. Answer (D) is incorrect because differential calculus is used to establish optimization points.

[110] Gleim #: 1.110 -- Source: CIA 1192 III-97 (Refers to Fact Pattern #10) The process of making sure that the model measures what it is supposed to measure is called

A. B. C. D.

Statistical inference. Hypothesis testing. Confidence coefficient analysis. Validation.


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Answer (A) is incorrect because statistical inference refers to estimation or hypothesis testing. Answer (B) is incorrect because hypothesis testing relates to the testing of specific null hypotheses. Answer (C) is incorrect because confidence coefficients are an integral part of statistical estimation and hypothesis testing. Answer (D) is correct. Validation is a step in the simulation procedure. Some assurance is needed that the results of the experiment will be realistic. This assurance requires validation of the model -- often using historical data. If the model gives results equivalent to what actually happened, the model is historically valid. There is still some risk, however, that changes could make the model invalid for the future. [111] Gleim #: 1.111 -- Source: CIA 1193 III-71 The marketing department of your company is deciding on the price to charge for a key product. In setting this price, marketing needs to consider the price that a major competitor will charge for a similar product because the competitor’s price will affect the demand for your company’s product. Similarly, in setting its price, the competitor will consider what your company will charge. An appropriate mathematical technique for analyzing such a decision is

A. B. C. D.

Game theory. Probability theory. Linear programming. Sensitivity analysis. Answer (A) is correct. Game (or decision) theory is a mathematical approach to decision making when confronted with an enemy or competitor. Games are classified according to the number of players and the algebraic sum of the payoffs. In a two-person game, if the payoff is given by the loser to the winner, the algebraic sum is zero and the game is called a zero-sum game. If it is possible for both players to profit, however, the game is a positive-sum game. Mathematical models have been developed to select optimal strategies for certain simple games. Answer (B) is incorrect because probability theory is a mathematical technique used to express quantitatively the likelihood of occurrence of an event. Answer (C) is incorrect because linear programming is a mathematical technique for optimizing a given objective subject to certain constraints. Answer (D) is incorrect because sensitivity analysis is a method for studying the effects of changes in one or more variables on the results of a decision model.

[112] Gleim #: 1.112 -- Source: CIA 592 III-64 Because of the large number of factors that could affect the demand for its new product, interactions among these factors, and the probabilities associated with different values of these factors, the marketing department would like to develop a computerized model for projecting demand for this product. By using a random-number procedure to generate values for the different factors, it will be able to estimate the distribution of demand for this new product. This method of estimating the distribution of demand for the new product is called

A. B. C. D.

Monte Carlo simulation. Linear programming. Correlation analysis. Differential analysis.


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Answer (A) is correct. Simulation is a technique in which a probabilistic process is first modeled. The inputs to the model are then varied a large number of times to estimate the distribution of possible outcomes from the model of the variable of interest. Simulations that use a random-number procedure to generate values for the inputs are referred to as Monte Carlo simulations. Answer (B) is incorrect because linear programming is a mathematical technique for maximizing or minimizing a given objective subject to certain constraints. Answer (C) is incorrect because correlation analysis is a statistical procedure for studying the relations among variables. Answer (D) is incorrect because differential analysis is a method used for decision-making that compares differences in costs (and revenues) of two or more possibilities. [113] Gleim #: 1.113 -- Source: CIA 1190 III-41 An account executive has just designed a Monte Carlo model to estimate the costs of a particular type of project. Validating the model could include all except

A. B. C. D.

Checking for errors in the computer programming. Checking that assumed probability distributions are reasonable. Comparing test results with previously validated models. Applying the model. Answer (A) is incorrect because it is part of the validation process. Answer (B) is incorrect because it is part of the validation process. Answer (C) is incorrect because it is part of the validation process. Answer (D) is correct. The Monte Carlo technique is used in a simulation to generate the individual values for a random value. An essential step in the simulation procedure is to validate the mathematical model used. This process involves not only searching for errors but also verifying the assumptions. It also should provide some assurance that the results of the experiment will be realistic. This assurance is often obtained using historical data. If the model gives results equivalent to what actually happened, the model is historically valid. There is still some risk, however, that changes could make the model invalid for the future. The model should not be implemented until this validation process is complete.

[114] Gleim #: 1.114 -- Source: CIA 593 III-65 A large fishing operation has information on the interval, time, and probabilities of shrimp schools staying beneath their fishing boats. In order to use this information to predict when and where to send their boats, which of the following techniques should be used?

A. B. C. D.

Simulation. Least squares. Queuing theory. Exponential smoothing.


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Answer (A) is correct. Simulation (Monte Carlo simulation) is a technique for experimenting with logical/mathematical models using a computer. Despite the power of mathematics, many problems cannot be solved by known analytical methods because of the behavior of the variables and the complexity of their interactions. However, the performance of a quantitative model under uncertainty may be investigated by randomly selecting values for each variable in the model (based on its probability distribution) and then calculating the value of the solution. If this process is performed many times, the distribution of results from the model will be obtained. Answer (B) is incorrect because least squares is a prediction and estimation technique using a single dependent and single or multiple independent variables. Answer (C) is incorrect because queuing theory is a waiting-line technique used to balance desirable service levels against the cost of providing more service. Answer (D) is incorrect because exponential smoothing is a forecasting technique using arbitrary weights. [115] Gleim #: 1.115 -- Source: CIA 594 III-60 Which of the following is not true about simulation models?

A. B. C. D.

They are deterministic in nature. The may involve sampling. They mathematically estimate what actual performance would be. They emulate stochastic systems. Answer (A) is correct. Simulation is a technique for experimenting with logical/mathematical models using a computer. The simulation procedure has five steps: define the objectives, formulate the model, validate the model, design the experiment, and conduct the simulation and evaluate the results. A simulation uses the laws of probability to generate values for random variables. Thus, simulation models are probabilistic, not deterministic. Answer (B) is incorrect because simulation modeling samples the operation of a system. Answer (C) is incorrect because simulation models mathematically estimate what performance would be under various conditions. Answer (D) is incorrect because simulation models are by definition stochastic or probabilistic models.

[116] Gleim #: 1.116 -- Source: CIA 593 III-66 A cost-volume-profit model developed in a dynamic environment determined that the estimated parameters used may vary between limits. Subsequent testing of the model with respect to all possible values of the estimated parameters is termed

A. B. C. D.

A sensitivity analysis. Statistical estimation. Statistical hypothesis testing. A time-series study. Answer (A) is correct. After a problem has been formulated into any mathematical model, it may be subjected to sensitivity analysis. Sensitivity analysis is a method for studying the effects of changes in one or more variables on the results of a decision model. Answer (B) is incorrect because statistical estimation involves the estimation of parameters. Answer (C) is incorrect because statistical hypothesis testing calculates the conditional probability that both the hypothesis is true and the sample results have occurred. Answer (D) is incorrect because a time-series study involves forecasting data over time.


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[117] Gleim #: 1.117 -- Source: CIA 1194 III-58 An investment company is attempting to allocate its available funds between two investment alternatives, stocks and bonds, which differ in terms of expected return and risk. The company would like to minimize its risk while earning an expected return of at least 10% and investing no more than 70% in either of the investment alternatives. An appropriate technique for allocating its funds between stocks and bonds is

A. B. C. D.

Linear programming. Capital budgeting. Differential analysis. Queuing theory. Answer (A) is correct. Linear programming is a mathematical technique for planning resource allocation that optimizes a given objective function that is subject to certain constraints. In this case, the maximum investment is constrained by a 70% limit on either investment choice. Answer (B) is incorrect because capital budgeting is used to analyze and evaluate long-term capital investments. Answer (C) is incorrect because differential analysis is used for decision making when differences in costs (revenues) for two or more options are compared. Answer (D) is incorrect because queuing theory is used to minimize the sum of the costs of waiting lines and servicing waiting lines when items arrive randomly at a service point and are serviced sequentially.

[118] Gleim #: 1.118 -- Source: CIA 1194 III-61 A company is deciding whether to purchase an automated machine to manufacture one of its products. Expected net cash flows from this decision depend on several factors, interactions among those factors, and the probabilities associated with different levels of those factors. The method that the company should use to evaluate the distribution of net cash flows from this decision and changes in net cash flows resulting from changes in levels of various factors is

A. B. C. D.

Simulation and sensitivity analysis. Linear programming. Correlation analysis. Differential analysis. Answer (A) is correct. Simulation is a technique used to describe the behavior of a real-world system over time. This technique usually employs a computer program to perform the simulation computations. Sensitivity analysis examines how outcomes change as the model parameters change. Answer (B) is incorrect because linear programming is a mathematical technique for optimizing a given objective function subject to certain constraints. Answer (C) is incorrect because correlation analysis is a statistical procedure for studying the relation between variables. Answer (D) is incorrect because differential analysis is used for decision making that compares differences in costs (revenues) of two or more options.

[119] Gleim #: 1.119 -- Source: CIA 1196 III-8 In forecasting purchases of inventory for a firm, all of the following are useful except

A. B. C. D.

Knowledge of the behavior of business cycles. Internal allocations of costs to different segments of the firm. Information on the seasonal variations in demand. Econometric modeling.


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Answer (A) is incorrect because, in time series analysis, the cyclical fluctuation in business activity is usually incorporated as an index number in the forecasting model. Answer (B) is correct. Internal allocations of costs relate to costs already incurred, that is, to sunk costs. Sunk costs are not relevant to decision making, for example, to forecasting future purchases. Answer (C) is incorrect because, in time series analysis, the seasonal variation is usually incorporated as an index number in the forecasting model. Answer (D) is incorrect because an econometric model is an application of statistical methods to economic problems. Such a model is used as a forecasting tool. [120] Gleim #: 1.120 -- Source: CMA 689 5-24 The primary difference between PERT and CPM is that

A. B. C. D.

CPM uses probabilities on the activity times and PERT does not. PERT considers activity costs and CPM does not. PERT can assign probabilities to activity times and CPM does not. CPM considers activity costs and PERT does not. Answer (A) is incorrect because CPM specifies the activity times (uses deterministic estimates). Answer (B) is incorrect because CPM but not PERT uses activity costs and considers crash times. Answer (C) is incorrect because a less significant difference between PERT and CPM is that PERT uses probabilistic estimates of completion times. CPM times are deterministic. The 1:4:1 method is typically used in PERT. Under this method, the most optimistic and pessimistic estimates are weighted equally, but the most likely estimate is weighted four times more heavily than the others. Answer (D) is correct. Both PERT and CPM are network analysis techniques. But CPM was developed independently of PERT and is widely used in the construction industry. CPM may be thought of as a subset of PERT. Like PERT, it is a network technique, but, unlike PERT, it uses deterministic time and cost estimates. Its advantages include cost estimates plus the concept of "crash" efforts and costs. Activity times are estimated for normal effort and crash effort. Crash time is the time to complete an activity assuming that all available resources were devoted to the task (overtime, extra crew, etc.). Activity costs are also estimated for normal and crash efforts. These estimates allow the project manager to estimate the costs of completing the project if some of the activities are completed on a crash basis. The network diagram is constructed in the same manner as PERT diagrams. Once the diagram is constructed, the critical paths are found for normal and crash times. More than one critical path may exist for each diagram.

[121] Gleim #: 1.121 -- Source: CMA 689 5-25 A Gantt chart

A. B. C. D.

Shows the critical path for a project. Is used for determining an optimal product mix. Shows only the activities along the critical path of a network. Does not necessarily show the critical path through a network. Answer (A) is incorrect because the critical path is not shown. Answer (B) is incorrect because linear programming is used to determine an optimal product mix. Answer (C) is incorrect because a Gantt chart shows the activities to be completed but not their relationships (sequencing). Answer (D) is correct. A Gantt or bar chart is sometimes used in conjunction with PERT or CPM to show the progress of a special project. Time is shown on the horizontal axis, the length of a bar equals the length of an activity, and shading indicates the degree of completion. However, the Gantt chart is not as sophisticated as PERT or CPM in that it does not reflect the relationships among the activities or define a critical path.


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[122] Gleim #: 1.122 -- Source: CMA 697 4-26 A regression equation

A. B. C. D.

Estimates the dependent variables. Encompasses factors outside the relevant range. Is based on objective and constraint functions. Estimates the independent variable. Answer (A) is correct. Regression analysis is used to find an equation for the linear relationship among variables. The behavior of the dependent variable is explained in terms of one or more independent variables. Regression analysis is often used to estimate a dependent variable (such as cost) given a known independent variable (such as production). Answer (B) is incorrect because regression results are limited to observations within the relevant range. Answer (C) is incorrect because regression analysis does not use constraint functions. Answer (D) is incorrect because the dependent variable is estimated using regression analysis.

[123] Gleim #: 1.123 -- Source: CMA 1285 5-27 The correlation coefficient that indicates the weakest linear association between two variables is

A. B. C. D.

-0.73 -0.11 0.12 0.35 Answer (A) is incorrect because -0.73 signifies a strong negative correlation. Answer (B) is correct. The correlation coefficient can vary from -1 to +1. A -1 relationship indicates a perfect negative correlation, and a +1 relationship indicates a perfect positive correlation. A zero correlation coefficient would indicate no association between the variables. Thus, the correlation coefficient that is nearest to zero would indicate the weakest linear association. Of the options given in the question, the correlation coefficient that is nearest to zero is -0.11. Answer (C) is incorrect because 0.12 is a slightly stronger correlation. Answer (D) is incorrect because 0.35 is a considerably stronger correlation.

[124] Gleim #: 1.124 -- Source: CMA 1289 5-14 Correlation is a term frequently used in conjunction with regression analysis and is measured by the value of the coefficient of correlation, r. The best explanation of the value r is that it

A. B. C. D.

Is always positive. Interprets variances in terms of the independent variable. Ranges in size from negative infinity to positive infinity. Is a measure of the relative relationship between two variables.


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Answer (A) is incorrect because the coefficient is negative if the relationship between the variables is inverse. Answer (B) is incorrect because the coefficient relates the two variables to each other. Answer (C) is incorrect because the size of the coefficient varies between -1.0 and +1.0. Answer (D) is correct. The coefficient of correlation (r) measures the strength of the linear relationship between the dependent and independent variables. The magnitude of r is independent of the scales of measurement of x and y. The coefficient lies between -1.0 and +1.0. A value of zero indicates no linear relationship between the x and y variables. A value of +1.0 indicates a perfectly direct relationship, and a value of -1.0 indicates a perfectly inverse relationship. [125] Gleim #: 1.125 -- Source: CMA 1293 4-25 The four components of time series data are secular trend, cyclical variation, seasonality, and random variation. The seasonality in the data can be removed by

A. B. C. D.

Multiplying the data by a seasonality factor. Ignoring it. Taking the weighted average over four time periods. Subtracting a seasonality factor from the data. Answer (A) is incorrect because adding a seasonality factor to, or subtracting it from, a forecast based on trend analysis is a means of adjusting for seasonality. Answer (B) is incorrect because seasonality factors cannot be ignored; they are reflected in the data and must be considered for a model to be accurate. Answer (C) is correct. Time series analysis relies on past experience. Changes in the value of a variable may have several possible components including secular trends, cyclical variation, seasonality, and random variation. Seasonal variations are common in many businesses. A variety of methods exist for including seasonal variations in a forecasting model, but most methods use a seasonal index. Alternatively, seasonal variations can be removed from data by using a weighted average of several time periods instead of data from individual periods. Answer (D) is incorrect because the seasonality adjustment for a single season’s data may be an increase or a decrease.

[126] Gleim #: 1.126 -- Source: CMA 696 4-20 A widely used approach that managers use to recognize uncertainty about individual items and to obtain an immediate financial estimate of the consequences of possible prediction errors is

A. B. C. D.

Expected value analysis. Learning curve analysis. Sensitivity analysis. Regression analysis. Answer (A) is incorrect because expected value is the probabilistically weighted average of the outcomes of an action. Answer (B) is incorrect because learning curve analysis quantifies how labor costs decline as employees learn their jobs through repetition. Answer (C) is correct. Sensitivity analysis determines how a result varies with changes in a given variable or parameter in a mathematical decision model. For example, in a present value analysis, a manager might first calculate the net present value or internal rate of return assuming that a new asset has a 10-year life. The NPV or IRR can then be recalculated using a 5-year life to determine how sensitive the result is to the change in the assumption. Answer (D) is incorrect because regression, or least squares, analysis determines the average change in the dependent variable given a unit change in one or more independent variables.


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[Fact Pattern #11] An international nonprofit organization finances medical research. The majority of its revenue and support comes from fund-raising activities, investments, and specific grants from an initial sponsoring corporation. The organization has been in operation over 15 years and has a small internal audit department. The organization has just finished a major fundraising drive that raised $500 million for the current fiscal period. The following are selected data from recent financial statements (dollar figures in millions):

Revenue Investments (average balances) Medical research grants made Investment income Administrative expense

Current Year

Past Year

$500 210 418 16 10

$425 185 325 20 8

[127] Gleim #: 1.127 -- Source: CIA 597 I-31 (Refers to Fact Pattern #11) The auditor wishes to determine if the change in investment income during the current year was due to (a) changes in investment strategy, (b) changes in portfolio mix, or (c) other factors. Which of the following analytical review procedures should the auditor use?

A. Simple linear regression that compares investment income changes over the past 5 years to determine the nature of the changes. B. Ratio analysis that compares changes in the investment portfolio on a monthly basis. C. Trend analysis that compares the changes in investment income as a percentage of total assets and of investment assets over the past 5 years. D. Multiple regression analysis that includes independent variables related to the nature of the investment portfolio and market conditions. Answer (A) is incorrect because simple linear regression is based on just one independent variable. Answer (B) is incorrect because ratio analysis measure changes but do not explain them. Answer (C) is incorrect because trend analysis measure changes but do not explain them. Answer (D) is correct. Regression analysis develops an equation to explain the behavior of a dependent variable (for example, investment income) in terms of one or more independent variables (for example, market risk and the risks of particular investments). Multiple regression analysis is the best approach because it allows the auditor to regress the change in investment income on more than one independent variable. [128] Gleim #: 1.128 -- Source: CIA R98 III-35 Which of the following will allow a manufacturer with limited resources to maximize profits?

A. B. C. D.

The Delphi technique. Exponential smoothing. Regression analysis. Linear programming.


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Answer (A) is incorrect because the Delphi technique is an approach in which the manager solicits opinions on a problem from experts, summarizes the opinions, and feeds the summaries back to the experts (without revealing any of the participants to each other). The process is reiterated until the opinions converge on an optimal solution. Answer (B) is incorrect because under exponential smoothing, each forecast equals the sum of the last observation times the smoothing constant, plus the last forecast times one minus the constant. Thus, exponential means that greater weight is placed on the most recent data, with the weights of all data falling off exponentially as the data age. Answer (C) is incorrect because regression analysis is used to fit a linear trend line to a dependent variable based on one or more independent variables. Answer (D) is correct. Linear programming is a technique used to optimize an objective function, that is, to maximize a revenue or profit function or to minimize a cost function, subject to constraints, e.g., limited (scarce) resources or minimum/maximum levels of production, performance, etc. In business, linear programming is used for planning resource allocations. Managers are often faced with problems of selecting the most profitable or least costly way to use available resources. [129] Gleim #: 1.129 -- Source: CIA R98 III-36 Which of the following is not an appropriate time series forecasting technique?

A. B. C. D.

Least squares. Exponential smoothing. The Delphi technique. Moving averages. Answer (A) is incorrect because regression (least squares) analysis extends correlation to find an equation for the linear relationship among variables. The behavior of the dependent variable is explained in terms of one or more independent variables. Thus, regression analysis determines functional relationships among quantitative variables. Answer (B) is incorrect because, under exponential smoothing, each forecast equals the sum of the last observation times the smoothing constant, plus the last forecast times one minus the constant. Thus, exponential means that greater weight is placed on the most recent data, with the weights of all data falling off exponentially as the data age. Answer (C) is correct. The Delphi technique is an approach in which the manager solicits opinions on a problem from experts, summarizes the opinions, and feeds the summaries back to the experts (without revealing any of the participants to each other). The process is reiterated until the opinions converge on an optimal solution. Thus, the Delphi technique is a qualitative, not a quantitative, method. Answer (D) is incorrect because a moving average is the simplest form of smoothing. Each forecast is based on a fixed number of prior observations.

[130] Gleim #: 1.130 -- Source: CIA 1184 III-12 Which of the following observations concerning quality control is more accurate?

A. Process quality control is used when examining the quality of goods or services which already exist. B. Process quality control is used to prevent defects, whereas product quality control is used primarily to identify defects after the fact. C. Product quality control is designed to balance the marketability of higher quality against the cost of attaining higher quality. D. Product quality control is more important than process quality control.


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Answer (A) is incorrect because it describes product (not process) quality control. Answer (B) is correct. Process analysis studies the means of producing a product with a view to lowering costs and increasing efficiency while producing items of appropriate quality. The effect of process analysis is to act as a pre-control to prevent defects. Product quality control involves inspection during production to eliminate defective items. Answer (C) is incorrect because it is applicable to process (not product) quality control. Answer (D) is incorrect because process quality control and product quality control are both important elements in a quality control program. [131] Gleim #: 1.131 -- Source: CIA 594 III-53 Which statement best describes Total Quality Management (TQM)?

A. B. C. D.

TQM emphasizes reducing the cost of inspection. TQM emphasizes participation by all employees in the decision-making process. TQM emphasizes encouraging cross-functional teamwork. TQM emphasizes doing each job right the first time. Answer (A) is incorrect because TQM has a broader emphasis. It focuses on improving quality, reducing cycle time, providing increased customer satisfaction, and achieving the lowest overall business cost. Reducing the cost of inspection helps achieve the lowest overall business cost. Answer (B) is incorrect because this statement describes participative management. Answer (C) is incorrect because TQM has a broader emphasis. It focuses on improving quality, reducing cycle time, providing increased customer satisfaction, and achieving the lowest overall business cost. Encouraging cross-functional teamwork helps achieve the lowest overall business cost. Answer (D) is correct. TQM establishes quality as an organizational objective and views it as a major component of the organization’s service to its customers. It emphasizes employee training and commitment, product/service design and production, and customer service. Ordinarily, the quality of a product or service is as important to customers as cost and timeliness. Superior product quality is not attained merely through more inspection, better statistical quality control, and cross-functional teamwork. Manufacturers must make fundamental changes in the way they produce products and do each job right the first time.

[132] Gleim #: 1.132 -- Source: CIA 1191 III-11 The operations manager of a company notified the treasurer of that organization 60 days in advance that a new, expensive piece of machinery was going to be purchased. This notification allowed the treasurer to make an orderly liquidation of some of the company’s investment portfolio on favorable terms. What type of control was involved?

A. B. C. D.

Feedback. Strategic. Budgetary. Feedforward. Answer (A) is incorrect because feedback controls apply to decision making based on evaluations of past performance. Answer (B) is incorrect because strategic controls are broad-based and affect an organization over a long period. They apply to such long-term variables as quality and R&D. Answer (C) is incorrect because control of budgeted expenditures is not mentioned in the example. Answer (D) is correct. Feedforward control provides for the active anticipation of problems so that they can be avoided or resolved in a timely manner. Another example is the quality control inspection of raw materials and work-in-process to avoid defective finished goods.


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[133] Gleim #: 1.133 -- Source: CIA 592 III-17 As part of a Total Quality Control program, a firm not only inspects finished goods but also monitors product returns and customer complaints. Which type of control best describes these efforts?

A. B. C. D.

Feedback control. Feedforward control. Production control. Inventory control. Answer (A) is correct. A feedback control measures actual performance, something that has already occurred, to ensure that a desired future state is attained. It is used to evaluate the past to improve future performance. Inspecting finished goods, monitoring product returns, and evaluating complaints are post-action controls intended to eliminate deviations in future cycles of the process under control. Answer (B) is incorrect because feedforward controls anticipate problems before they occur. Answer (C) is incorrect because customer complaints are not part of production control. Answer (D) is incorrect because TQC, which is often associated with JIT systems but is applicable to other environments, is a philosophy emphasizing that each member of the organization is a quality control inspector. It deemphasizes the role of separate quality control departments by making each employee responsible for his/her work. Hence, TQC is not limited to inventory control.

[134] Gleim #: 1.134 -- Source: CIA 1191 III-10 To be successful, large companies must develop means to keep the organization focused in the proper direction. Organizational control systems help keep companies focused. These control systems consist of which three basic components?

A. B. C. D.

Budgeting, financial ratio analysis, and cash management. Objectives, standards, and an evaluation-reward system. Role analysis, team building, and survey feedback. Setting goals, empowering employees, and job enrichment. Answer (A) is incorrect because budgeting, financial ratio analysis, and cash management are means of financial control. Answer (B) is correct. An organizational control system must be based on a statement of what is to be achieved and when (objectives). The accomplishment of objectives depends on the establishment of standards that serve as feedforward controls. Adherence to performance standards signifies that an organization is on course to attain its objectives. A well-developed evaluation-reward system that is clearly communicated to employees should motivate them to improved performance. Answer (C) is incorrect because role analysis, team building, and survey feedback are used in developmental efforts to correct organizational deficiencies. Answer (D) is incorrect because goal setting, empowerment, and job enrichment are all motivational strategies.

[135] Gleim #: 1.135 -- Source: CIA 588 III-12 Performance appraisal systems might use any of three different approaches: (1) who did the job, (2) how the job was done, or (3) what was accomplished. Which approach is used by a system that places the focus on how the job was done?

A. B. C. D.

Behavior-oriented. Goal-oriented. Trait-oriented. Employee-oriented.


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Answer (A) is correct. Behavior-oriented performance evaluation rewards the behavior that is desired by management. Behavior control involves examining work processes rather than work output. Answer (B) is incorrect because the goal-oriented approach measures how well the employee attained the objectives or goals set by management. Answer (C) is incorrect because a trait-oriented approach tends to reward what the supervisor thinks of the employee rather than the job the employee did. Answer (D) is incorrect because an employee-oriented approach would focus on who did the job. [136] Gleim #: 1.136 -- Source: CIA 592 III-7 Identify the management technique in which employees assist in setting goals, making decisions, solving problems, and designing and implementing organizational changes.

A. B. C. D.

Total quality control. Job enlargement. Kanban. Participative management. Answer (A) is incorrect because TQC is a quality control program in which everyone sees quality control as his/her job. Answer (B) is incorrect because job enlargement refers to increasing the number of tasks one must perform. Answer (C) is incorrect because kanban is a manual inventory technique used in just-in-time inventory control systems. Answer (D) is correct. According to Marshall Soshkin ["Participative Management is an Ethical Imperative," Organizational Dynamics 12 (Spring 1984): 4-22] employees may participate in goal setting, decision making, problem solving, and designing and implementing change. Subject to various individual (values and attitudes), organizational (e.g., job design and company culture), and environmental (such as technological change and competition) contingencies, workers who participate in the aforementioned ways should experience greater autonomy and find their tasks more meaningful. In turn, this experience should lead to satisfaction, challenge, security, and acceptance and commitment. Ultimate results are innovation and improved performance and productivity.

[137] Gleim #: 1.137 -- Source: Publisher Is PERT analysis a control tool or a planning tool?

Planning

Control

A.

Yes

No

B. C.

Yes No

Yes Yes

D.

No

No

Answer (A) is incorrect because PERT is a control tool as well as a planning tool. Answer (B) is correct. PERT (Program Evaluation Review Technique) is applied in the management of complex projects. It analyzes the project in terms of its component activities and determines their sequencing and timing. Thus, it systematically combines planning with control. Answer (C) is incorrect because PERT is a planning tool. Answer (D) is incorrect because PERT is a planning tool.


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[138] Gleim #: 1.138 -- Source: CIA 1196 III-60 ISO 9000 standards for ring networks include fault management, configuration management, accounting management, security management, and performance monitoring. Which of the following controls is included in the performance-monitoring standards?

A. B. C. D.

Reporting the failure of network fiber-optic lines. Recording unauthorized access violations. Compiling statistics on the number of times that application software is used. Allocating network costs to system users of the network. Answer (A) is incorrect because the failure of network fiber-optic lines is a fault management control. Answer (B) is incorrect because recording unauthorized access violations is a security management control. Answer (C) is correct. The ISO 9000 performance-monitoring standards pertain to management’s ongoing assessment of the quality of performance over time. Recording software usage is a performance-monitoring control concerned with the extent and efficiency of network software use. Answer (D) is incorrect because allocating network costs to system users of the network is an accounting management control.

[139] Gleim #: 1.139 -- Source: CIA 596 III-32 If a company is customer-centered, its customers are defined as

A. B. C. D.

Only people external to the company who have purchased something from the company. Only people internal to the company who directly use its product. Anyone external to the company and those internal who rely on its product to get their job done. Everybody external to the company who is currently doing, or may in the future do, business with the company. Answer (A) is incorrect because customers are internal as well as external. Answer (B) is incorrect because customers are internal as well as external. Answer (C) is correct. One of the tenets of TQM is customer orientation, whether the customer is internal or external. An internal customer is a member of the organization who relies on another member’s work to accomplish his/her task. Answer (D) is incorrect because customers are internal as well as external.

[140] Gleim #: 1.140 -- Source: CIA 596 III-20 Which one of the following is not a characteristic of an innovative manufacturing company?

A. B. C. D.

Emphasis on continuous improvement. Responsiveness to the changing manufacturing environment. Emphasis on existing products. Improved customer satisfaction through product quality.


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Answer (A) is incorrect because continuous improvement is important for achieving and maintaining high levels of performance. Answer (B) is incorrect because more and more manufacturers are automating to achieve high quality, deliver customized products on time, minimize inventory, and increase flexibility. Answer (C) is correct. Innovative companies are customer driven. Because customers demand ever better quality and competitors are attempting to provide that quality, continuous improvement (called kaizen by the Japanese) is essential for such companies. Thus, the flow of innovative products and services must be continuous. Simply emphasizing existing products is not an effective strategy for most organizations. Answer (D) is incorrect because customer satisfaction is the highest priority according to modern management practice. [141] Gleim #: 1.141 -- Source: CIA 594 III-57 Which of the following is an example of an efficiency measure?

A. B. C. D.

The rate of absenteeism. The goal of becoming a leading manufacturer. The number of insurance claims processed per day. The goal of increasing market share. Answer (A) is incorrect because the rate of absenteeism does not compare input and output. Answer (B) is incorrect because the goal of becoming a leading manufacturer concerns effectiveness, not efficiency. Answer (C) is correct. An organizational structure is efficient if it facilitates the accomplishment of organizational objectives with minimum resources and fewest unsought consequences. An efficient organizational structure maximizes output for a given amount of input. Thus, an efficiency measure compares input to output. Insurance claims processed per day relates output (claims processed) to input (a day’s work). Answer (D) is incorrect because the goal of increasing market share concerns effectiveness, not efficiency.

[142] Gleim #: 1.142 -- Source: Publisher Goal congruence is

A. B. C. D.

The desire and the commitment to achieve a specific goal. The sharing of goals by supervisors and subordinates. The extent to which individuals have the authority to make decisions. The extent of the attempt to accomplish a specific goal. Answer (A) is incorrect because motivation is the desire and the commitment to achieve a specific goal. Answer (B) is correct. Goal congruence is agreement on the goals of the organization and/or the segment by both supervisors and subordinates. Performance is assumed to be optimized when there is an understanding that personal and segmental goals be consistent with those of the organization. Answer (C) is incorrect because autonomy is the extent to which individuals have the authority to make decisions. Answer (D) is incorrect because managerial effort is the extent of the attempt to accomplish a specific goal.

[143] Gleim #: 1.143 -- Source: CIA 596 II-1 A company, which has many branch stores, has decided to benchmark one of its stores for the purpose of analyzing the accuracy and reliability of branch store financial reporting. Which one of the following is the most likely measure to be included in a financial benchmark?


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A. B. C. D.

High turnover of employees. High level of employee participation in setting budgets. High amount of bad debt write-offs. High number of suppliers. Answer (A) is incorrect because turnover of employees is not a financial benchmark. Answer (B) is incorrect because employee participation in setting budgets is not a financial benchmark. Answer (C) is correct. A high level of bad debt write-offs could indicate fraud, which would compromise the accuracy and reliability of financial reports. Bad debt write-offs may result from recording fictitious sales. Answer (D) is incorrect because the number of suppliers is not a financial benchmark.

[144] Gleim #: 1.144 -- Source: CIA 596 III-23 Which statement best describes the emphasis of total quality management (TQM)?

A. B. C. D.

Reducing the cost of inspection. Implementing better statistical quality control techniques. Doing each job right the first time. Encouraging cross-functional teamwork. Answer (A) is incorrect because reducing the cost of inspection is a detail of the TQM emphasis. Answer (B) is incorrect because implementing better statistical quality control techniques is a detail of the TQM emphasis. Answer (C) is correct. The basic principles of TQM include doing each job right the first time, being customer oriented, committing the company culture to continuous improvement, and building teamwork and employee empowerment. Answer (D) is incorrect because encouraging cross-functional teamwork is a detail of the TQM emphasis.

[145] Gleim #: 1.145 -- Source: CIA 1196 III-92 Quality cost indices are often used to measure and analyze the cost of maintaining or improving the level of quality. Such indices are computed by dividing the total cost of quality over a given period by some measure of activity during that period (for example, sales dollars). The following cost data are available for a company for the month of March. The company’s quality cost index is calculated using total cost of quality divided by sales dollars. Sales Direct materials cost Direct labor cost Testing and inspection cost Scrap and rework cost Quality planning cost Cost of customer complaints and returns

$400,000 100,000 80,000 6,400 16,800 2,800 4,000

The quality cost index for March is

A. B. C. D.

7.5% 6.5% 22.0% 5.9%


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Answer (A) is correct. The total cost of quality equals the sum of prevention costs (quality planning), appraisal costs (testing and inspection), internal failure costs (scrap and rework), and external failure costs (customer complaints and returns), or $30,000 ($2,800 + $6,400 + $16,800 + $4,000). The quality cost index equals the total costs of quality, divided by sales, times 100%. Thus, the quality cost index for March is 7.5% [($30,000 ÷ $400,000) × 100%]. Answer (B) is incorrect because 6.5% does not include the $4,000 cost of customer complaints. Answer (C) is incorrect because 22.0% equals the sum of direct labor and testing and inspection costs, divided by sales. Answer (D) is incorrect because 5.9% does not include testing and inspection cost in quality costs. [146] Gleim #: 1.146 -- Source: CIA 1196 III-23 The most important component of quality control is

A. B. C. D.

Ensuring goods and services conform to the design specifications. Satisfying upper management. Conforming with ISO-9000 specifications. Determining the appropriate timing of inspections. Answer (A) is correct. The intent of quality control is to ensure that goods and services conform to the design specifications. Whether the focus is on feedforward, feedback, or concurrent control, the emphasis is on ensuring product or service conformity. Answer (B) is incorrect because quality control is geared towards satisfying the customer, not upper management. Answer (C) is incorrect because ensuring the conformance with ISO-9000 specifications is a component of a compliance audit, not quality control. Answer (D) is incorrect because determining the appropriate timing of inspections is only one step towards approaching quality control. Consequently, it is not the primary component of the quality control function.

[147] Gleim #: 1.147 -- Source: CMA 693 3-13 Product-quality-related costs are part of a total quality control program. A product-quality-related cost incurred in detecting individual products that do not conform to specifications is an example of a(n)

A. B. C. D.

Prevention cost. Appraisal cost. External failure cost. Opportunity cost. Answer (A) is incorrect because prevention costs are incurred in an attempt to avoid defective output. Answer (B) is correct. Quality-related costs can be subdivided into four categories: external failure costs, internal failure costs, prevention costs, and appraisal costs. Appraisal costs embrace such activities as statistical quality control programs, inspection, and testing. Thus, the cost of detecting nonconforming individual products is an appraisal cost. Answer (C) is incorrect because external failure costs arise when quality problems occur after shipment. Answer (D) is incorrect because opportunity costs are not specifically associated with product quality. Opportunity cost is the maximum benefit forgone by using a scarce resource for a given purpose; it is the benefit provided by the next best use of that resource.


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[148] Gleim #: 1.148 -- Source: CMA 694 3-16 In 2004, a manufacturer instituted a total quality management (TQM) program producing the following report (in currency units): Summary Cost of Quality Report (000s) 2003

2004

% Change

Prevention costs Appraisal costs Internal failure costs External failure costs

200 210 190 1,200

300 315 114 621

+50 +50 -40 -48

Total quality costs

1,800

1,350

-25

On the basis of this report, which one of the following statements is most likely true?

A. An increase in conformance costs resulted in a higher quality product and therefore resulted in a decrease in nonconformance costs. B. An increase in inspection costs was solely responsible for the decrease in quality costs. C. Quality costs such as scrap and rework decreased by 48%. D. Quality costs such as returns and repairs under warranty decreased by 40%. Answer (A) is correct. TQM emphasizes the supplier’s relationship with the customer and recognizes that everyone in a process is at some time a customer or supplier of someone else, either within or outside the organization. The costs of quality include costs of conformance and costs of nonconformance. Costs of conformance include prevention costs and appraisal (inspection) costs. Nonconformance costs are composed of internal failure costs and external failure costs, such as lost opportunity. Conformance costs (prevention and appraisal) increased substantially, whereas the nonconformance costs (internal and external failure) decreased. Hence, the increase in conformance costs resulted in a higher quality product. Answer (B) is incorrect because prevention costs also increased substantially, which could also have led to higher quality products. Answer (C) is incorrect because scrap and rework are internal failure costs, which decreased by 40%. Answer (D) is incorrect because returns and repairs are external failure costs, which decreased by 48%. [149] Gleim #: 1.149 -- Source: CIA 1184 III-11 Which of the following statements best describes the relationship between planning and controlling?

A. B. C. D.

Planning looks to the future; controlling is concerned with the past. Planning and controlling are completely independent of each other. Planning prevent problems; controlling is initiated by problems which have occurred. Controlling cannot operate effectively without the tools provided by planning.


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Answer (A) is incorrect because a control system looks to the future when it provides for corrective action and review and revision of standards. Answer (B) is incorrect because planning and controlling overlap. Answer (C) is incorrect because comprehensive planning includes creation of controls. Answer (D) is correct. Control is the process of making certain that plans are achieving the desired objectives. A control system operates through establishing standards of performance, measuring actual performance, analysis and comparison of performance with standards, taking corrective action, and reviewing and revising standards. Planning provides needed tools for the control process by establishing standards, e.g., budgets. [150] Gleim #: 1.150 -- Source: CIA 593 III-63 A firm must decide the mix of production of Product X and Product Y. There are only two resources used in the two products, resources A and B. Data related to the two products is given in the following table: Products

Resource A Resource B Unit Profit

X

Y

3 2 $8

7 1 $6

What is the appropriate objective function to maximize profit?

A. B. C. D.

3X + 7Y 2X + Y 8X + 6Y 5X + 8Y Answer (A) is incorrect because 3X + 7Y is a constraint. Answer (B) is incorrect because 2X + Y is a constraint. Answer (C) is correct. The objective function is the function to be optimized. This firm wishes to maximize profits on the sales of two products (X and Y). Based on profits per unit ($8 and $6, respectively), the objective function is 8X + 6Y. Answer (D) is incorrect because 5X + 8Y is the sum of the constraints.

[151] Gleim #: 1.151 -- Source: CIA R98 III-32 An appropriate technique for planning and controlling manufacturing inventories, such as raw materials, components, and subassemblies whose demand depends on the level of production is

A. B. C. D.

Materials requirements planning. Regression analysis. Capital budgeting. Linear programming.


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Answer (A) is correct. Materials requirements planning (MRP) is a system that translates a production schedule into requirements for each component needed to meet the schedule. It is usually implemented in the form of a computer-based information system designed to plan and control raw materials used in production. It assumes that forecasted demand is reasonably accurate and that suppliers can deliver based upon this accurate schedule. MRP is a centralized push-through system; output based on forecasted demand is pushed through to the next department or to inventory. Answer (B) is incorrect because regression analysis is used to fit a linear trend line to a dependent variable based on one or more independent variables. Answer (C) is incorrect because capital budgeting is the process of planning expenditures for long-lived assets. It involves choosing among investment proposals using a ranking procedure. Answer (D) is incorrect because linear programming is a decision model concerned with allocating scarce resources to maximize profit or minimize costs. [152] Gleim #: 1.152 -- Source: IIA, adapted The costs of quality that are incurred in detecting units of product that do not conform to product specifications are referred to as

A. B. C. D.

Prevention costs. Appraisal costs. Rework costs. Failure costs. Answer (A) is incorrect because prevention costs are incurred to prevent the production of products that do not conform to specifications. Answer (B) is correct. Appraisal embraces such activities as statistical quality control programs, inspection, and testing. Appraisal costs are those costs (such as test equipment maintenance and destructive testing) incurred to detect which products do not conform to specifications. Answer (C) is incorrect because rework costs, a type of failure cost, are incurred when a nonconforming product is detected and corrections are made. Answer (D) is incorrect because failure costs are incurred in the repair of nonconforming products.

[153] Gleim #: 1.153 -- Source: IIA, adapted The use of teams in total quality management is important because

A. B. C. D.

Well-managed teams can be highly creative and are able to address complex problems better than individuals can. Teams are quicker to make decisions, thereby helping to reduce cycle time. Employee motivation is higher for team members than for individual contributors. The use of teams eliminates the need for supervision, thereby allowing a company to become leaner and more profitable. Answer (A) is correct. Teams can use the diverse knowledge and skills of all team members. Employee involvement means training and empowering employees to harness their creativity for problem solving. Quality control circles are used to obtain input from employees and to locate the best perspective on problem solving. Answer (B) is incorrect because teams are often inefficient and costly. Answer (C) is incorrect because, although employee motivation may be high in teams, the high motivation does not always translate directly to quality improvement. Answer (D) is incorrect because, although need for supervision may be reduced, it is not eliminated.


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[154] Gleim #: 1.154 -- Source: IIA, adapted Which of the following is a major element of the ISO 9000:2000 quality management system standards?

A. B. C. D.

The principle that improved employee satisfaction will lead to increased productivity. The attitude and actions of the board and management regarding the significance of control within the organization. The assessment of the risk that objectives are not achieved. A requirement for organizations to monitor information on customer satisfaction as a measure of performance. Answer (A) is incorrect because this is not a part of the ISO 9000 standards. ISO argues that following the eight management principles that underlie the ISO 9000 standards will lead to improved employee satisfaction. Answer (B) is incorrect because this is the control environment as defined in the glossary of The IIA’s Standards; there is no direct reference to any such concept in the ISO 9000 standards. Answer (C) is incorrect because the ISO 9000 approach does not take a risk assessment approach; a risk assessment approach is what underlies internal auditing. Answer (D) is correct. ISO 9001:2000, Quality Management Systems – Requirements, is the standard that provides a model for quality assurance programs. Organizations are required to monitor information on customer satisfaction as a measure of performance. This is one of the major changes to the ISO 9000 standards made in the 2000 revision.

[155] Gleim #: 1.155 -- Source: IIA, adapted The sales manager for a builder of custom yachts developed the following conditional table for annual production and sales Demand Probability

10 0.1

20 0.2

Yachts Built 10 20 30 50

30 0.5

50 0.2

Expected Profit 10 0 -10 -30

10 20 10 -10

10 20 30 10

10 20 30 50

According to the table, how many yachts should be built?

A. B. C. D.

10 20 30 50 Answer (A) is incorrect because of the following computation: 0.1($10) + 0.2($10) + 0.5($10) + 0.2($10) = $10. Answer (B) is incorrect because of the following computation: 0.1($0) + 0.2($20) + 0.5($20) + 0.2($20) = $18. Answer (C) is correct. To achieve the maximum expected profit, 30 yachts should be built. For each level of production, multiply the probability of demand by the expected profit. The computation is: 0.1(-$10) + 0.2($10) + 0.5($30) + 0.2($30) = $22. Answer (D) is incorrect because of the following computation: 0.1(-$30) + 0.2(-$10) + 0.5($10) + 0.2($50) = $10.


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[156] Gleim #: 1.156 -- Source: IIA, adapted All of the following are useful for forecasting the needed level of inventory except

A. B. C. D.

Knowledge of the behavior of business cycles. Internal accounting allocations of costs to different segments of the company. Information about seasonal variations in demand. Econometric modeling. Answer (A) is incorrect because knowing the behavior of business cycles can be valuable when forecasting the required purchases of inventory. Answer (B) is correct. Forecasts are the basis for business plans. Models are used in the forecasting process to make decisions that optimize future results. Internal accounting allocations of costs to different segments of the company are arbitrary assignments of already incurred costs that do not have anything to do with forecasting demand. Answer (C) is incorrect because understanding seasonal variations in demand for the product can be valuable when forecasting the required purchases of inventory. Answer (D) is incorrect because using econometric models can be valuable when forecasting the required purchases of inventory.

[157] Gleim #: 1.157 -- Source: IIA, adapted The process of adding resources to shorten selected activity times on the critical path in project scheduling is called

A. B. C. D.

Crashing. The Delphi technique. ABC analysis. A branch-and-bound solution. Answer (A) is correct. Activity times are estimated for normal effort and crash effort. Crashing is the process of adding resources to shorten activity times on the critical path in project scheduling. Answer (B) is incorrect because the Delphi technique is a qualitative forecasting approach. Answer (C) is incorrect because ABC analysis is an inventory model. Answer (D) is incorrect because the branch-and-bound solution is an integer programming solution.

[158] Gleim #: 1.158 -- Source: IIA, adapted Which of the following will allow a manufacturer with limited resources to maximize profits?

A. B. C. D.

The Delphi technique. Exponential smoothing. Regression analysis. Linear programming.


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Answer (A) is incorrect because the Delphi technique is a qualitative forecasting method that obtains forecasts through group consensus. Answer (B) is incorrect because exponential smoothing is a forecasting technique that uses past time series values to arrive at forecasted values. Answer (C) is incorrect because regression analysis is a statistical technique used to develop forecasts based on the relationship between two or more variables. Answer (D) is correct. Linear programming is a mathematical technique for maximizing or minimizing a given objective subject to certain constraints. It is the correct technique to optimize the problem of limited resources. [159] Gleim #: 1.159 -- Source: IIA, adapted A means of limiting production delays caused by equipment breakdown and repair is to

A. B. C. D.

Schedule production based on capacity planning. Plan maintenance activity based on an analysis of equipment repair work orders. Pre-authorize equipment maintenance and overtime pay. Establish a preventive maintenance program for all production equipment. Answer (A) is incorrect because scheduling production based on capacity utilization ignores other important factors such as demands. Answer (B) is incorrect because budgeting maintenance department activities based on previous work orders will not prevent equipment breakdowns and repairs. Answer (C) is incorrect because standing authorizations of work orders and overtime will not address the problem posed. Answer (D) is correct. A preventive maintenance program will reduce equipment breakdowns and repairs.

[160] Gleim #: 1.160 -- Source: IIA, adapted To remove the effect of seasonal variation from a time series, original data should be

A. B. C. D.

Increased by the seasonal factor. Reduced by the seasonal factor. Multiplied by the seasonal factor. Divided by the seasonal factor. Answer (A) is incorrect because the original data should be divided by the seasonal factor, not increased. Answer (B) is incorrect because the original data should be divided by the seasonal factor, not reduced. Answer (C) is incorrect because the original data should be divided by the seasonal factor, not multiplied. Answer (D) is correct. Seasonal variations are common in many businesses. To remove the effect of seasonal variation from a time series, the original data (with the four trends) is divided by the seasonal norm.

[161] Gleim #: 1.161 -- Source: IIA, adapted A balanced scorecard is primarily concerned with

A. B. C. D.

Staff. Structure. Strategy. Systems.


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Answer (A) is incorrect because although a balanced scorecard should be developed with staff in mind, the primary aim is the alignment of performance measures with strategy. Answer (B) is incorrect because structure should be created after the scorecard has been developed to ensure that responsibilities, competencies and measures are appropriate to achieve the agreed-upon strategies. Answer (C) is correct. The scorecard is primarily a tool to assist the organization in describing and clarifying its strategy and then alignment of its performance measures to that strategy. Answer (D) is incorrect because systems are a means to achieving objectives that have been established after the development of the scorecard. [162] Gleim #: 1.162 -- Source: CIA 596 I-20 If a manufacturer has established a limit on the number of defects that are tolerable in the final assembly of its product, which of the following quality control procedures should be employed? I. II. III. IV.

A. B. C. D.

Inspect completed goods for compliance with established tolerances. Review sales returns for defects not detected during the final inspection process. Compare materials and machinery specifications with original product designs. Establish a quality circle that includes management and subordinates to discuss labor efficiency.

I, III, and IV. II and III only. I, II, and III. III and IV only. Answer (A) is incorrect because establishing a quality circle is not a specific quality control procedure, although such discussions may lead to improved procedures. Answer (B) is incorrect because inspection is a necessary procedure. Answer (C) is correct. Quality control procedures may be categorized according to the nature of the costs incurred. An organization incurs appraisal costs to ensure product quality. These costs include the costs of inspection, testing, and statistical quality control programs. An organization also should investigate the causes of sales returns, which represent an external failure cost. Furthermore, the organization should incur certain prevention costs, e.g., by reviewing equipment design and materials requirements. Answer (D) is incorrect because establishing a quality circle is not a specific quality control procedure, although such discussions may lead to improved procedures.


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[Fact Pattern #12]

Candman Company is a wholesale distributor of candy. The company leases space in a public warehouse and is charged according to the square feet occupied. Candman has decided to employ the economic order quantity (EOQ) method to determine the optimum number of cases of candy to order. The company placed 2,400 orders the last year. Data for the high-activity month, the low-activity month, and the year for the purchasing and warehouse operations appear in the next column. The annual charges for the warehouse totaled $12,750 last year. In addition, the annual insurance and property taxes on the candy stored in the warehouse amounted to $1,500 and $2,250, respectively. The average monthly inventory last year was $75,000.

Long-term capital investments are expected to earn 12% after income taxes. Candman is subject to an effective income tax rate of 40%. High-Activity Low-Activity Month Month Annual (160 Orders) (100 Orders) Costs Purchasing Dept. Manager Clerks Supplies Warehouse Supervisor Rcvg. clerks Ship. clerks Totals

$ 1,600 1,750 400

$1,600 1,250 260

$ 23,400 18,000 3,500

1,550 2,200 2,800

1,550 1,700 2,500

18,600 20,500 31,200

$10,300

$8,860

$115,200

[163] Gleim #: 2.1 -- Source: CMA 686 5-29 (Refers to Fact Pattern #12) The incremental cost of placing an order that would be used in the EOQ model is

A. B. C. D.

$48 $35 $24 $19 Answer (A) is incorrect because $48 equals total annual cost divided by total orders from the previous year. Answer (B) is incorrect because $35 equals total annual cost minus the costs associated with the shipping clerks, divided by total orders from the previous year. Answer (C) is incorrect because $24 includes the costs associated with shipping. Answer (D) is correct. The incremental cost of additional orders equals the variable costs incurred in purchasing and receiving inventory (but not costs associated with shipping). Using the high-low method of analysis, these variable costs can be computed by determining the apparent variable costs for the two given levels of activity. For 160 orders, the relevant costs with a variable element include purchasing clerks, $1,750; supplies, $400; and receiving clerks, $2,200. The total is $4,350. For 100 orders, these costs are $1,250, $260, and $1,700, respectively, for a total of $3,210. As the number of orders increased by 60, the costs increased by $1,140. Consequently, the variable or incremental costs per order must have been $19 ($1,140 ÷ 60 orders).

[164] Gleim #: 2.2 -- Source: CMA 686 5-30 (Refers to Fact Pattern #12) The annual carrying cost, stated as a percentage, that would be used in the EOQ model is


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A. B. C. D.

42% 37% 34% 22% Answer (A) is correct. The annual carrying costs are $12,750 for the warehouse, $1,500 for insurance, and $2,250 for property taxes. These costs total $16,500. In addition, the company desires a 12% after-tax return on investments. Because the tax rate is 40%, the 12% after-tax return equals a 20% before-tax return (12% ÷ 60%). A 20% return on the $75,000 average investment in inventory is $15,000. Hence, the total carrying cost is $31,500 ($16,500 + $15,000). This amount is 42% of the $75,000 investment in inventory. Answer (B) is incorrect because 37% does not consider insurance and property taxes. Answer (C) is incorrect because 34% is based on a 12% before-tax return. Answer (D) is incorrect because 22% equals carrying costs other than return on investment divided by average inventory.

[165] Gleim #: 2.3 -- Source: CIA 597 III-91 When the economic order quantity (EOQ) decision model is employed, the are being offset or balanced by the .

List A

List B

A. B.

Ordering costs Purchase costs

Carrying costs Carrying costs

C. D.

Purchase costs Ordering costs

Quality costs Stockout costs

Answer (A) is correct. The objective of the EOQ model is to find an optimal order quantity that balances carrying and ordering costs. Only variable costs should be considered. The EOQ is the point where the ordering cost and carrying cost curves intersect. It corresponds to the minimum point on the total inventory cost curve. Answer (B) is incorrect because purchase costs are not directly incorporated into the EOQ model. Answer (C) is incorrect because neither purchase costs nor quality costs are incorporated into the EOQ model. Answer (D) is incorrect because stockout costs are not directly incorporated into the EOQ model. [166] Gleim #: 2.4 -- Source: CMA 1290 4-9 The calculation of an economic order quantity (EOQ) considers

A. B. C. D.

The purchasing manager’s salary. A corporate charge for advertising expenses. The shipping costs to deliver the product to the customer. Capital costs. Answer (A) is incorrect because the purchasing manager’s salary is a fixed cost. The EOQ model includes variable costs only. Answer (B) is incorrect because advertising is not an ordering or carrying cost. Answer (C) is incorrect because the cost of shipping to customers is a selling expense. Answer (D) is correct. The determination of the economic order quantity balances the variable costs of ordering and carrying inventory. Factors in the equation include the cost of placing an order, unit carrying cost, and annual demand in units. Carrying costs include storage costs, handling costs, insurance, property taxes, obsolescence, and the opportunity cost of investing capital in inventory. Thus, the return on capital that is forgone when it is invested in inventory should be considered.


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[167] Gleim #: 2.5 -- Source: CMA 1294 4-8 A characteristic of the basic economic order quantity (EOQ) model is that it

A. B. C. D.

Is relatively insensitive to error. Should not be used when carrying costs are large in relation to procurement costs. Is used when product demand, lead-time, and ordering costs are uncertain. Should not be used in conjunction with computerized perpetual inventory systems. Answer (A) is correct. The basic EOQ model equals the square root of the quotient of (1) the product of twice the demand times the cost per order, (2) divided by the periodic carrying cost. Hence, the model is relatively insensitive to error. A given percentage error in a value results in a lower percentage change in the EOQ. Answer (B) is incorrect because the EOQ model can be used regardless of the relationship between carrying and holding costs. Answer (C) is incorrect because product demand and ordering costs must be known with some certainty. Answer (D) is incorrect because an EOQ model can be used with any type of system.

[168] Gleim #: 2.6 -- Source: CMA 1294 4-6 Companies that adopt just-in-time purchasing systems often experience

A. B. C. D.

An increase in carrying costs. A reduction in the number of suppliers. A greater need for inspection of goods as the goods arrive. Less need for linkage with a vendor’s computerized order entry system. Answer (A) is incorrect because carrying costs typically decline in JIT companies. Less inventory is on hand. Answer (B) is correct. The objective of JIT is to reduce carrying costs by eliminating inventories and increasing the deliveries made by suppliers. Ideally, shipments of raw materials are received just in time to be incorporated into the manufacturing process. The focus of quality control under JIT is the prevention of quality problems. Quality control is shifted to the supplier. JIT companies typically do not inspect incoming goods; the assumption is that receipts are of perfect quality. Suppliers are limited to those who guarantee perfect quality and prompt delivery. Answer (C) is incorrect because, in a JIT system, materials are delivered directly to the production line ready for insertion in the finished product. Answer (D) is incorrect because the need for communication with the vendor is greater. Orders and deliveries must be made on short notice, sometimes several times a day.

[169] Gleim #: 2.7 -- Source: CIA 597 III-94 A manufacturing company is attempting to implement a just-in-time (JIT) purchase policy system by negotiating with its primary suppliers to accept long-term purchase orders which result in more frequent deliveries of smaller quantities of raw materials. If the JIT purchase policy is successful in reducing the total inventory costs of the manufacturing company, which of the following combinations of cost changes would be most likely to occur?

Cost Category to Increase

Cost Category to Decrease

A. B.

Purchasing costs Purchasing costs

Stockout costs Quality costs

C. D.

Quality costs Stockout costs

Ordering costs Carrying costs


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Answer (A) is incorrect because the supplier may seek a concession on the selling price that will raise purchasing costs, but the manufacturing company’s stockout costs will increase. Answer (B) is incorrect because the cost of quality is not necessarily affected by a JIT system. Answer (C) is incorrect because fewer purchase orders are processed by the manufacturer, so the ordering costs are likely to decrease. However, the cost of quality is not necessarily affected by a JIT system. Answer (D) is correct. The objective of a JIT system is to reduce carrying costs by eliminating inventories and increasing the deliveries made by suppliers. Ideally, shipments are received just in time to be incorporated into the manufacturing process. This system increases the risk of stockout costs because the inventory buffer is reduced or eliminated. [170] Gleim #: 2.8 -- Source: CMA 1288 5-22 Arnold Enterprises uses the EOQ model for inventory control. The company has an annual demand of 50,000 units for part number 191 and has computed an optimal lot size of 6,250 units. Per-unit carrying costs and stockout costs are $13 and $3, respectively. The following data have been gathered in an attempt to determine an appropriate safety stock level: Units Short Because of Excess Demand During the Lead Time Period

Number of Times Short in the Last 40 Reorder Cycles

200 300 400

6 12 6

The annual cost of establishing a 200-unit safety stock is expected to be

A. B. C. D.

$2,600 $4,040 $4,260 $5,200 Answer (A) is incorrect because $2,600 is the annual carrying cost of 200 units of safety stock. Answer (B) is correct. The annual cost consists of the carrying cost of the 200 units of safety stock at $13 each, or $2,600, plus the stockout costs incurred when 200 units are insufficient. The stockout cost per unit is $3. The excess demand has been 100 units (300 – 200) greater than the proposed safety stock 30% of the time (12 ÷ 40). The cost per stockout was $300 ($3 × 100). Demand has exceeded the safety stock by 200 units (400 – 200) 15% of the time (6 ÷ 40). The cost per stockout was $600 ($3 × 200). Given 30% and 15% probabilities of $300 and $600 stockout costs, respectively, the expected stockout cost for a 200-unit safety stock is $180 per inventory cycle [($300 × 30%) + ($600 × 15%)]. Given 8 cycles (50,000 units ÷ 6,250 EOQ), the annual cost of a 200-unit safety stock is therefore $4,040 [$2,600 + (8 × $180)]. Answer (C) is incorrect because $4,260 is the annual cost of establishing a 300-unit safety stock. Answer (D) is incorrect because $5,200 is the annual cost of establishing a 400-unit safety stock.

[Fact Pattern #13] The diagram presented represents the economic order quantity (EOQ) model.



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[171] Gleim #: 2.9 -- Source: CMA 1289 5-16 (Refers to Fact Pattern #13) Which line segment represents the reorder lead time?

A. B. C. D.

AB. AE. AF. BC. Answer (A) is incorrect because AB is the time between receipt of the last order and the placing of the next order. Answer (B) is incorrect because AE is the safety stock. Answer (C) is incorrect because AF represents the quantity of inventory that will be used during the reorder lead time. Answer (D) is correct. The quantity of inventory on hand is represented by the y axis and time by the x axis. The reorder lead time is represented by the line segment BC.

[172] Gleim #: 2.10 -- Source: CMA 1289 5-17 (Refers to Fact Pattern #13) Which line segment identifies the quantity of safety stock maintained?

A. B. C. D.

AB. AE. AC. BC. Answer (A) is incorrect because AB is the time between the receipt of the last order and the placing of the next order. Answer (B) is correct. Quantities of inventory are shown along the y axis. Safety stock is represented by the line AE. Answer (C) is incorrect because AC is the time to consume the EOQ. Answer (D) is incorrect because BC is the reorder lead time.

[173] Gleim #: 2.11 -- Source: CMA 1289 5-18 (Refers to Fact Pattern #13) Which line segment represents the length of time to consume the total quantity of materials ordered?

A. B. C. D.

DE. BC. AC. AE. Answer (A) is incorrect because DE represents the total inventory on hand just after an order has been received. Answer (B) is incorrect because BC is the reorder lead time. Answer (C) is correct. Time is shown along the x axis. The line segment AC depicts the time to consume an entire order (to reduce the inventory to the safety stock). Answer (D) is incorrect because AE is the safety stock.


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[174] Gleim #: 2.12 -- Source: CMA 692 4-23 Each stockout of a product sold by A.W. Inn Co. costs $1,750 per occurrence. The carrying cost per unit of inventory is $5 per year, and the company orders 1,500 units of product 24 times a year at a cost of $100 per order. The probability of a stockout at various levels of safety stock is

Units of Safety Stock

Probability of a Stockout

0 100 200 300 400

.50 .30 .14 .05 .01

The optimal safety stock level for the company is

A. B. C. D.

0 units. 100 units. 300 units. 400 units. Answer (A) is incorrect because a safety stock of 0 units has a total expected cost of $21,000. Answer (B) is incorrect because a safety stock of 100 units has a total expected cost of $13,100. Answer (C) is incorrect because a safety stock of 300 units has a total expected cost of $3,600. Answer (D) is correct. The total expected cost of safety stock equals the sum of the expected annual stockout cost and the expected annual carrying cost. Annual expected stockout cost equals the cost per occurrence ($1,750), times the probability of a stockout per cycle, times the number of cycles (24). Annual expected carrying cost of a safety stock equals the unit carrying cost ($5) times the number of units. Hence, a safety stock of 400 units has the lowest total expected cost.

Units Held 0 100 200 300 400

Carrying Cost $

0 500 1,000 1,500 2,000

Expected Stockout Cost Per Cycle

Expected Stockout Cost for 24 Cycles

Total Expected Cost

$21,000 12,600 5,880 2,100 420

$21,000 13,100 6,880 3,600 2,420

$875.00 525.00 245.00 87.50 17.50

[Fact Pattern #14] The Huron Corporation purchases 60,000 headbands per year. The average purchase lead time is 20 working days. Maximum lead time is 27 working days. The corporation works 240 days per year. [175] Gleim #: 2.13 -- Source: CMA 1293 4-8 (Refers to Fact Pattern #14) Huron Corporation should carry safety stock of


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A. B. C. D.

5,000 units. 6,750 units. 1,750 units. 250 units. Answer (A) is incorrect because 5,000 units represents the quantity expected to be sold during the normal lead time. Answer (B) is incorrect because 6,750 units includes not only the safety stock but also the units expected to be sold during the normal lead time. Answer (C) is correct. Safety stock is defined as the amount of extra stock that is kept to guard against stockouts. It is the inventory level at the reorder point minus the expected usage during the lead time. Daily usage is 250 units (60,000 per year ÷ 240 days). Given a maximum lead time of 27 days and a normal lead time of 20 days, a safety stock for 7 days (27 – 20) should be maintained. Hence, safety stock is 1,750 units (7 × 250 units). Answer (D) is incorrect because 250 units is 1 day’s sales.

[176] Gleim #: 2.14 -- Source: CMA 1293 4-9 (Refers to Fact Pattern #14) Huron Corporation should reorder headbands when the quantity in inventory reaches

A. B. C. D.

5,000 units. 6,750 units. 1,750 units. 5,250 units. Answer (A) is incorrect because 5,000 units does not allow for safety stock. Answer (B) is correct. The reorder point is the quantity on hand when an order is placed. With a 20-day normal lead time, a 7-day safety stock, and usage of 250 units per day, an order should be placed when 27 days of inventory are on hand, a total of 6,750 units (27 × 250). Answer (C) is incorrect because 1,750 units covers only safety stock. Answer (D) is incorrect because 5,250 units includes only 1 day of safety stock.


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[Fact Pattern #15] Ryerson Computer Furniture, Inc. (RCF) manufactures a line of office computer chairs. The annual demand for the chairs is estimated to be 5,000 units. The annual cost to hold one unit in inventory is $10 per year, and the cost to initiate a production run is $1,000. There are no computer chairs on hand, and RCF has scheduled four equal production runs of computer chairs for the coming year, the first of which is to be run immediately. RCF has 250 business days per year, sales occur uniformly throughout the year, and production start-up is within one day. RCF is considering using the following formula for determining the economic order quantity (EOQ):

If:

A = cost to initiate a production run per purchase order D = annual unit demand K = cost of carrying one unit per year

[177] Gleim #: 2.15 -- Source: CMA 694 4-23 (Refers to Fact Pattern #15) The number of production runs per year of computer chairs that would minimize the sum of carrying and setup costs for the coming year is

A. B. C. D.

1 2 4 5

Answer (A) is incorrect because a single production run indicates an EOQ of 5,000 units. The carrying costs of $25,000 [$10 × ($5,000 ÷ 2)] would exceed the $1,000 of setup costs. Answer (B) is incorrect because two production runs correspond to an EOQ of 2,500 units and an average inventory of 1,250 units. The resulting $12,500 of carrying costs would exceed the $2,000 of setup costs. Answer (C) is incorrect because four production runs correspond to an EOQ of 1,250 units and an average inventory of 625 units. The resulting $6,250 of carrying costs would exceed the $4,000 of setup costs. Answer (D) is correct. The EOQ minimizes the sum of carrying and setup costs. The EOQ is the amount at which carrying costs are equal to setup costs. Thus, plugging the data into the EOQ formula results in the following:

Thus, if each lot consists of 1,000 units, five production runs per year are needed to meet the 5,000-unit demand. At this level, setup costs will total $5,000 (5 × $1,000). Carrying costs will also equal $5,000 ($10 per unit carrying cost × average inventory of 500 units). Accordingly, total costs are minimized at $10,000.


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[178] Gleim #: 2.16 -- Source: CMA 694 4-22 (Refers to Fact Pattern #15) If RCF does not maintain a safety stock, the estimated total carrying costs for the computer chairs for the coming year based on their current schedule is

A. B. C. D.

$4,000 $5,000 $6,250 $12,500 Answer (A) is incorrect because the cost of maintaining an average inventory of 625 units is $6,250. Answer (B) is incorrect because $5,000 is based upon an EOQ of 1,000 units and an average inventory of 500 units. Answer (C) is correct. Given four production runs and an annual demand of 5,000 units, each production run must generate 1,250 units. Inventory will total 1,250 units at the completion of each run but will decline to zero just prior to the next run. Thus, the average inventory is 625 units (1,250 ÷ 2), and the total carrying cost is $6,250 ($10 × 625 units). Answer (D) is incorrect because $12,500 is based on the maximum inventory level.

[179] Gleim #: 2.17 -- Source: Publisher An organization must manage its flows of raw materials, components, finished goods, services, or information through intermediaries to ultimate consumers. These flows may occur across the functions in an organization’s

A. B. C. D.

Supply chain. Value chain. Logistic chain. Integrated chain. Answer (A) is incorrect because the supply chain consists of the flows that may occur across the functions in an organization’s value chain or separate organizations. Answer (B) is correct. The supply chain consists of flows from sources of (a) raw materials, (b) components, (c) finished goods, (d) services, or (e) information through intermediaries to ultimate consumers. These flows and the related activities may occur across the functions in an organization’s value chain (R&D, design, production, marketing, distribution, and customer service). These flows and the related activities also may occur across separate organizations. Answer (C) is incorrect because logistics is a branch of military science. It addresses the procurement, maintenance, and transportation of military materials, facilities, and personnel. Answer (D) is incorrect because the phrase “integrated chain” is not a technical term.

[180] Gleim #: 2.18 -- Source: Publisher The bullwhip or whiplash effect on inventories begins when retailers face uncertain demand from consumers caused by randomness in buying habits. It can be avoided by

A. B. C. D.

The need to purchase or manufacture goods in cost-efficient batches. Changes in price that may encourage purchases in anticipation of future increases. Shortages that may lead to rationing by suppliers or manufacturers and hoarding by manufacturers or retailers. Sharing of information and coordination among the organizations in the supply chain.


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Answer (A) is incorrect because the need to purchase or manufacture goods in cost-efficient batches is a cause of the bullwhip or whiplash effect. Answer (B) is incorrect because purchases in anticipation of future price increases cause the bullwhip or whiplash effect. Answer (C) is incorrect because rationing by suppliers or manufacturers and hoarding by manufacturers or retailers cause the bullwhip or whiplash effect. Answer (D) is correct. Sharing information about sales, inventory, pricing, advertising campaigns, and sales forecasts by all functions and organizations in the supply chain moderates demand uncertainty for all parties. The desired results are: (a) minimization of inventories held by suppliers, manufacturers, and retailers; (b) avoidance of stockouts; (c) fewer rush orders; and (d) production as needed by retailers. [181] Gleim #: 2.19 -- Source: Publisher A desired result of the sharing of information by all functions and organizations in the supply chain is

A. B. C. D.

Fewer rush orders. Maximization of inventories held by suppliers, manufacturers, and retailers. Stockouts. Incompatibility of the information systems of the parties. Answer (A) is correct. Sharing information about sales, inventory, pricing, advertising campaigns, and sales forecasts by all functions and organizations in the supply chain moderates demand uncertainty for all parties. The desired results are: (a) minimization of inventories held by suppliers, manufacturers, and retailers; (b) avoidance of stockouts; (c) fewer rush orders; and (d) production as needed by retailers. Answer (B) is incorrect because minimization of inventories held by all parties in the supply chain is a desired result of sharing information. Answer (C) is incorrect because avoidance of stockouts is a desired result of sharing information. Answer (D) is incorrect because incompatibility of the information systems of the parties is a difficulty faced by supplychain management, not a desired result of sharing information.

[182] Gleim #: 2.20 -- Source: Publisher Which of the following are intermediaries between sellers and buyers? I. II. III. IV.

A. B. C. D.

Agent Broker Consignee Consumer

I and II only. I and III only. I, II, and III only. I, II, III, and IV. Answer (A) is incorrect because a consignee is also an intermediary between sellers and buyers. Answer (B) is incorrect because a broker is an intermediary. Answer (C) is correct. A distribution channel is a series of interdependent marketing institutions that facilitate the transfer of a product from producer (seller) to consumer (buyer). Intermediaries include merchant middlemen, agents, brokers, consignees, and facilitating intermediaries. Answer (D) is incorrect because a consumer is a buyer, not an intermediary.


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[183] Gleim #: 2.21 -- Source: Publisher The channel structure in which producers, wholesalers, and retailers act as a unified system is a

A. B. C. D.

Horizontal distribution system. Vertical distribution system. Unilateral distribution system. Multichannel system. Answer (A) is incorrect because, in a horizontal distribution system, two or more companies at one level of the channel work together. Answer (B) is correct. In vertical distribution systems, producers, wholesalers, and retailers act as a unified system. Channel conflict is managed through common ownership, contractual relationships, or administration by one or a few dominant channel members. Horizontal distribution systems consist of two or more companies at one level of the channel working together to exploit new opportunities, such as the introduction of ATMs in supermarkets. The joint nature of horizontal distribution efforts is the tool for managing channel conflict. In a multichannel system, a single firm sets up two or more channels to reach one or more customer segments. Because such a system is managed by a single firm, channel conflicts can be evaluated and managed internally. Answer (C) is incorrect because a unilateral distribution system is not a channel structure. Answer (D) is incorrect because, in a multichannel system, a single firm sets up two or more channels.

[184] Gleim #: 2.22 -- Source: CIA 596 IV-78 Which one of the graphs depicts the demand curve for prestige goods?

A.


B.


C.


D.


Answer (A) is incorrect because this graph describes the familiar, negatively sloped relation between price charged and the resulting demand level for normal goods. Answer (B) is incorrect because the demand curve can be linear or curvilinear. Answer (C) is correct. Over some intermediate range of prices, the reaction to a price increase for prestige goods is an increase, not a decrease, in the quantity demanded. Within this range, the demand curve is upward sloping. The reason is that consumers interpret the higher price to indicate a better or more desirable product. Above some price level, the relation between price and quantity demanded will again become negatively sloped. Answer (D) is incorrect because this demand curve has the same basic shape as the demand curve for prestige goods, but it bends the wrong way. As prices increase, quantity demanded first falls and then rises in this graph.


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[185] Gleim #: 2.23 -- Source: CIA 1194 IV-78 Buyer-based pricing involves

A. B. C. D.

Adding a standard markup to the cost of the product. Determining the price at which the product will earn a target profit. Basing prices on the product’s perceived value. Basing prices on competitors’ prices. Answer (A) is incorrect because adding a standard markup to the cost of the product is cost-plus pricing. Answer (B) is incorrect because determining the price at which the product will earn a target profit is target profit pricing. Answer (C) is correct. Buyer-based pricing involves basing prices on the product’s perceived value rather than on the seller’s cost. Nonprice variables in the marketing mix augment the perceived value. For example, a cup of coffee may have a higher price at an expensive restaurant than at a fast-food outlet. Answer (D) is incorrect because basing prices on competitors’ prices is going-rate pricing.

[186] Gleim #: 2.24 -- Source: CIA 1194 IV-79 Market-skimming pricing strategies could be appropriate when

A. B. C. D.

No buyers want the product at a high price. The costs of producing a small volume are low. Competitors can easily enter the market. The product is of poor quality. Answer (A) is incorrect because, if no buyers want the product at a high price, this marketing strategy is inappropriate. Answer (B) is correct. Market-skimming pricing is used when a new product is introduced at the highest price possible given the benefits of the product. For market skimming to work, the product must appear to be worth its price, the costs of producing a small volume cannot be so high that they eliminate the advantage of charging more, and competitors cannot enter the market and undercut the price. Answer (C) is incorrect because, if competitors can easily enter the market, they can undercut the price. Answer (D) is incorrect because the product quality and image must support a high price.

[187] Gleim #: 2.25 -- Source: CIA 595 IV-74 Which of the following pricing policies involves the selling company setting freight charges to customers at the actual average freight cost?

A. B. C. D.

Freight absorption pricing. Uniform delivered pricing. Zone pricing. FOB-origin pricing.


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Answer (A) is incorrect because, in freight absorption pricing, the selling company absorbs all or part of the actual freight charges. Customers are not charged actual delivery costs. Answer (B) is correct. In uniform delivered pricing, the company charges the same price, inclusive of shipping costs, to all customers regardless of their location. This price is the company’s average actual freight cost. Thus, both nearby and distant customers are charged the same amount. This policy is easy to administer, permits the company to advertise one price nationwide, and facilitates marketing to faraway customers. Answer (C) is incorrect because, in zone pricing, differential freight charges are set for customers on the basis of their location. Customers are not charged actual average freight costs. Answer (D) is incorrect because, in FOB-origin pricing, each customer pays its actual freight costs. [188] Gleim #: 2.26 -- Source: CIA 1195 IV-75 Which of the following price adjustment strategies is designed to stabilize production for the selling firm?

A. B. C. D.

Cash discounts. Quantity discounts. Functional discounts. Seasonal discounts. Answer (A) is incorrect because cash discounts encourage prompt payment. Answer (B) is incorrect because quantity discounts encourage large volume purchases. Answer (C) is incorrect because functional or trade discounts are provided to channel members in return for the performance of certain functions, such as selling, storing, and record keeping. Answer (D) is correct. Seasonal discounts are designed to smooth production by the selling firm. For example, a ski manufacturer offers seasonal discounts to retailers in the spring and summer to encourage early ordering.

[189] Gleim #: 2.27 -- Source: CIA 1195 IV-76 In which product-mix pricing strategy is it appropriate for the seller to accept any price that exceeds the storage and delivery costs for the product?

A. B. C. D.

By-product pricing. Optional-product pricing. Captive-product pricing. Product-bundle pricing. Answer (A) is correct. A by-product is a product of relatively minor importance generated during the production of one or more other products. Its production entails no additional costs. Any amount received above the storage and delivery costs for a by-product allows the seller to reduce the main product’s price to make it more competitive. Answer (B) is incorrect because optional products are offered for sale along with the main product. They are unlikely to have a zero production cost, so the seller must receive a price above their storage and delivery costs. Answer (C) is incorrect because captive products must be used along with the main product, such as film for use with a camera. Sellers often make their profits on the captive products rather than on the main product, which is sold at a low price. The captive products therefore will be priced well above the storage and delivery costs. Answer (D) is incorrect because product bundles are combinations of products sold together at a reduced price, such as season tickets for a theater. Products are bundled to promote the sale of certain items that consumers might not otherwise purchase. The combined price of the bundle must be low enough to encourage consumers to buy the bundle but must recover production costs and provide some profit for the seller, so the price must exceed storage and delivery costs.


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[190] Gleim #: 2.28 -- Source: CMA 1296 4-6 Several surveys point out that most managers use full product costs, including unit fixed costs and unit variable costs, in developing cost-based pricing. Which one of the following is least associated with cost-based pricing?

A. B. C. D.

Price stability. Price justification. Target pricing. Fixed-cost recovery. Answer (A) is incorrect because full-cost pricing promotes price stability. It limits the ability to cut prices. Answer (B) is incorrect because full-cost pricing provides evidence that the company is not violating antitrust laws against predatory pricing. Answer (C) is correct. A target price is the expected market price of a product, given the company’s knowledge of its customers and competitors. Hence, under target pricing, the sales price is known before the product is developed. Subtracting the unit target profit margin determines the long-term unit target cost. If cost-cutting measures do not permit the product to be made at or below the target cost, it will be abandoned. Answer (D) is incorrect because full-cost pricing has the advantage of recovering the full long-term costs of the product. In the long term, all costs are relevant.

[191] Gleim #: 2.29 -- Source: Publisher A U.S. seller’s price in the U.S. market is below an appropriate measure of costs. Moreover, the seller has a reasonable prospect of recovering the resulting loss in the future through higher prices or a greater market share. Accordingly, the seller has engaged in

A. B. C. D.

Collusive pricing. Dumping. Predatory pricing. Price discrimination. Answer (A) is incorrect because collusive pricing involves a conspiracy to set higher prices. Answer (B) is incorrect because dumping is defined under U.S. law as sale by a non-U.S. company in the U.S. market of a product below its market value in the country where it was produced. Such sale is illegal if it threatens material injury to a U.S. industry. Answer (C) is correct. Predatory pricing is intentionally pricing below cost to eliminate competition and reduce supply. Federal statutes and many state laws prohibit the practice. The U.S. Supreme Court has held that pricing is predatory when two conditions are met: (1) the seller’s price is below “an appropriate measure of its costs,” and (2) it has a reasonable prospect of recovering the resulting loss through higher prices or greater market share. Answer (D) is incorrect because price discrimination entails charging different prices to different customers for essentially the same product if the effect is to lessen competition substantially; to tend to create a monopoly; or to injure, destroy, or prevent competition.


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[192] Gleim #: 2.30 -- Source: Publisher Fulford Company applies the target pricing and costing approach. The following information about costs and revenues of Fulford’s product are available for the year just ended:

Unit sales Unit selling price Cost of goods sold Value-chain operating costs excluding production

60,000 $400 $13,200,000 $7,920,000

Fulford plans to increase unit sales to 80,000 by reducing the product’s unit price to $320. If Fulford desires a unit target operating income of 12%, by what amount must it reduce the full cost per unit?

A. B. C. D.

$32.00 $38.40 $70.40 $80.00 Answer (A) is incorrect because $32.00 equals the current full cost per unit minus the new unit target price. Answer (B) is incorrect because $38.40 is the unit target operating income. Answer (C) is correct. Unit target operating income is $38.40 ($320 unit target price × 12%). Hence, the unit target full cost is $281.60 ($320 – $38.40). The current full cost per unit is $352.00 [($13,200,000 CGS + $7,920,000 other value chain operating costs) ÷ 60,000 units sold], so the necessary reduction in the full cost per unit is $70.40 ($352.00 – $281.60). Answer (D) is incorrect because $80.00 equals the change in the unit price.

[193] Gleim #: 2.31 -- Source: Publisher A company’s product has an expected 4-year life cycle from research, development, and design through its withdrawal from the market. Budgeted costs are Upstream costs (R&D, design) Manufacturing costs Downstream costs (marketing, distribution, customer service) After-purchase costs

$2,000,000 3,000,000 1,200,000 1,000,000

The company plans to produce 200,000 units and price the product at 125% of the whole-life unit cost. Thus, the budgeted unit selling price is

A. B. C. D.

$15 $31 $36 $45


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Answer (A) is incorrect because $15 is the budgeted unit manufacturing cost. Answer (B) is incorrect because $31 is the budgeted unit life-cycle cost. Answer (C) is incorrect because $36 is the budgeted unit whole-life cost. Answer (D) is correct. Whole-life costs include after-purchase costs (operating, support, repair, and disposal) incurred by customers as well as life-cycle costs (R&D, design, manufacturing, marketing, distribution, and research). Hence, the budgeted unit whole-life cost is $36 [($2,000,000 + $3,000,000 + $1,200,000 + $1,000,000) ÷ 200,000 units], and the budgeted unit selling price is $45 ($36 × 125%). [194] Gleim #: 2.32 -- Source: IIA, adapted A manufacturing company produces plastic utensils for a particular segment at the lowest possible cost. The company is pursuing a cost

A. B. C. D.

Leadership strategy. Focus strategy. Differentiation strategy. Containment strategy. Answer (A) is incorrect because a cost leader is the lowest cost producer in the industry as a whole. Answer (B) is correct. A cost focus strategy aims at cost leadership in a particular segment, such as a regional market or a specialty product line. The rationale for a focus strategy is that the narrower market can be better served. Answer (C) is incorrect because cost differentiation aims at providing a product at different costs in different market segments. Answer (D) is incorrect because cost containment aims at controlling costs related to a particular product/market but not necessarily producing at the lowest possible cost.

[195] Gleim #: 2.33 -- Source: Publisher A runner-up firm in a market may choose a market-challenger strategy. Which general attack strategy adopted by a market challenger is directed at a gap in customer need fulfillment?

A. B. C. D.

Guerilla warfare. Bypass attack. Frontal attack. Flank attack. Answer (A) is incorrect because guerilla warfare consists of numerous small attacks designed to reduce the strength of the target, e.g., by ad campaigns, carefully chosen price decreases, and lawsuits. Such warfare ordinarily must be followed by a different (and stronger) type of attack if the challenge is to succeed. Answer (B) is incorrect because the bypass attack directs the assault against markets other than those where the competitive target is strong. It may involve diversification of products or geographic markets. It may also entail developing next-generation technology so as to move the competition to an arena where the challenger is in a stronger position. Answer (C) is incorrect because a frontal attack directly pits the firm’s products, prices, promotions, and methods of distribution against the target’s. Answer (D) is correct. A flank attack may be directed at a geographic or segmental weakness of the target (an underserved market) or an unmet need (such as the desire for more healthful fast food). A flank attack succeeds when market segments shift. The result is a gap in need fulfillment that the attacker can convert into a strong position in a profitable segment.

[196] Gleim #: 2.34 -- Source: Publisher The dominant firm in a market pursues a market-leader strategy. This strategy may involve


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A. B. C. D.

Holding the market stable to avoid attracting new competitors. A flank defense to strengthen the firm’s brand. Sending market signals as a mobile defense. Innovations as an offensive strategy. Answer (A) is incorrect because, as the firm most likely to gain, the leader should attempt to increase total demand, for example, by attracting new users, encouraging new uses, and promoting increased use. Answer (B) is incorrect because a position defense strengthens the firm’s brand power. Answer (C) is incorrect because a preemptive defense anticipates an attack, such as by targeting particular competitors before they can launch assaults, flooding the market with products for every segment and niche, or by sending market signals indicating ways in which the leader intends to anticipate attacks. Answer (D) is correct. Constant innovation to improve products and services, control costs, and increase distribution effectiveness is the basis for a good offensive strategy. The leader must continuously improve the value offered to customers.

[197] Gleim #: 2.35 -- Source: IIA, adapted During the growth stage of a product’s life cycle

A. B. C. D.

The quality of products is poor. New product models and features are introduced. There is little difference between competing products. The quality of the products becomes more variable and products are less differentiated. Answer (A) is incorrect because poor product quality is evident during the introduction stage of the product life cycle. Answer (B) is correct. In the growth stage, sales and profits increase rapidly, cost per customer decreases, customers are early adopters, new competitors enter an expanding market, new product models and features are introduced, and promotion spending declines or remains stable. The firm enters new market segments and distribution channels and attempts to build brand loyalty and achieve the maximum share of the market. Thus, prices are set to penetrate the market, distribution channels are extended, and the mass market is targeted through advertising. The strategy is to advance by these means and by achieving economies of productive scale. Answer (C) is incorrect because competitors are most numerous and products become less differentiated during the maturity stage of the product life cycle. In this stage, imitators have entered the market and competitors have learned which technologies and features are successful. Answer (D) is incorrect because the quality of the products becomes more variable and products are less differentiated during the decline stage of the product life cycle.

[198] Gleim #: 2.36 -- Source: IIA, adapted In a product’s life cycle, the first symptom of the decline stage is a decline in the

A. B. C. D.

Firm’s inventory levels. Product’s sales. Product’s production cost. Product’s prices.


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Answer (A) is incorrect because a decline in the firm’s purchases–resulting in a decline in the firm’s inventory levels–is not the first symptom. It will occur only when production declines as a result of a drop in sales. Answer (B) is correct. The sales of most product types and brands eventually decrease permanently. This decline may be slow or rapid. This first symptom of the decline stage of a product’s life cycle triggers such other effects as price cutting, narrowing of the product line, and reduction in promotion budgets. Answer (C) is incorrect because a decline in production costs may be due to many factors, e.g., new plant technology or the increased availability of raw materials. Moreover, production costs may decrease in any stage of a product’s life cycle and not specifically in the decline stage. Answer (D) is incorrect because a change in prices is a marketing decision. It is an action that may be taken in the maturity stage to compete in the market. Moreover, a decrease in the product’s prices is a response to a permanent decline in sales. [199] Gleim #: 2.37 -- Source: IIA, adapted At the introduction stage of an innovative product, the profit growth is normally slow due to

A. B. C. D.

Expensive sales promotion. High competition. A mass market. Available alternatives. Answer (A) is correct. The introduction stage is characterized by slow sales growth and lack of profits because of the high expenses of promotion and selective distribution to generate awareness of the product and encourage customers to try it. Thus, the per-customer cost is high. Competitors are few, basic versions of the product are produced, and higherincome customers (innovators) are usually targeted. Cost-plus prices are charged. They may initially be high to permit cost recovery when unit sales are low. The strategy is to infiltrate the market, plan for financing to cope with losses, build supplier relations, increase production and marketing efforts, and plan for competition. Answer (B) is incorrect because, during the introduction stage, little competition exists. Competitors tend not to enter the market until they have greater assurance of profits. Answer (C) is incorrect because no mass market is available during the introduction stage. Answer (D) is incorrect because, by definition, not many alternatives are available during the introduction stage of an innovative product.

[200] Gleim #: 2.38 -- Source: IIA, adapted While auditing a marketing department, the internal auditor discovered that the product life cycle model was used to structure the marketing mix. Under such a philosophy, the price charged on a consistent basis for a specific product would probably be lowest during which life cycle stage?

A. B. C. D.

Introduction stage. Growth stage. Maturity stage. Decline stage.


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Answer (A) is incorrect because, during the introduction stage, pre-unit costs of production are high and little competition exists. Hence, prices are at their highest. Answer (B) is incorrect because, during the growth stage, prices will be lower than during the introduction stage, but not as low as during the maturity stage. In the growth stage, costs are dropping and competitors are being added, but costs are not at their minimum and competitors are not at their maximum. Answer (C) is correct. During the maturity stage, competition is at its greatest and costs are at their lowest. Moreover, firms are engaged in competitive price-cutting measures, resulting in some of the lowest prices seen during a product’s life cycle. Answer (D) is incorrect because, during the decline stage, price-cutting predominates as firms struggle to maintain sales volume in the face of a permanent decrease in demand. However, late in the decline stage, there are few competitors, so prices can be raised. In addition, pre-unit costs are on the rise because volume is declining, resulting in higher prices. [201] Gleim #: 2.39 -- Source: IIA, adapted While auditing a marketing department, the internal auditor discovered that the product life cycle model was used to structure the marketing mix. Under such a philosophy, the opportunity for cost reductions would be greatest in which stage of the life cycle?

A. B. C. D.

Introduction stage. Growth stage. Maturity stage. Decline stage. Answer (A) is incorrect because production volume is low during the introduction stage. Although costs are also high during this period, low volume reduces the opportunities for cost reductions. Answer (B) is correct. During the growth stage, the opportunity for cost reductions is at its maximum because production volume is increasing at a high rate. Thus, fixed costs are being spread over more units of production, and the benefits of the learning curve are being realized. Answer (C) is incorrect because production volume changes little during the maturity stage. The result is less opportunity for cost reductions. Answer (D) is incorrect because costs per unit typically rise during the decline stage as production volume declines.

[202] Gleim #: 2.40 -- Source: IIA, adapted While auditing a marketing department, the internal auditor discovered that the product life cycle model was used to structure the marketing mix. The manager has asked the auditor for advice about increasing advertising of various products. During which stage of the life cycle would it be appropriate to advertise that the company’s product is the lowest price and best quality of all competitors?

A. B. C. D.

Introduction stage. Growth stage. Maturity stage. Decline stage.


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Answer (A) is incorrect because few competitors exist during the introduction stage, and quality is sometimes poor. Answer (B) is incorrect because buyers are less concerned with price and quality during the growth stage than in the maturity stage. Answer (C) is correct. The maturity stage is the ideal time for advertising lower prices and superior quality because this is the period during a product’s life when competition is greatest. Due to the availability of many alternatives or substitutes, a firm has reasons to set itself apart. Because price and quality are both concerns of customers during the maturity stage, it is ideal for the firm to differentiate its product by advertising low prices and higher quality. Answer (D) is incorrect because few competitors exist during the decline stage. Moreover, prices may rise late in the decline stage for the remaining firms as per-unit costs increase. [203] Gleim #: 2.41 -- Source: Publisher Gray market activity is in essence a form of arbitrage. To prevent this activity by their distributors, multinational firms I. Raise prices charged to lower-cost distributors. II. Police their distributors. III. Change the product.

A. B. C. D.

I only. I and II only. II and III only. I, II, and III. Answer (A) is incorrect because multinational firms also police their distributors and change the product to prevent gray market activity. Answer (B) is incorrect because multinational firms also change the product to prevent gray market activity. Answer (C) is incorrect because multinational firms also raise prices charged to lower-cost distributors to prevent gray market activity. Answer (D) is correct. In a gray market, products imported from one country to another are sold by persons trying to make a profit from the difference in retail prices between the two countries. These activities clearly lower the profits in some markets of the multinational firm that was the initial seller. One response is to monitor the practices of distributors and retaliate if necessary. A second response is to charge higher prices to the low-cost distributors to reduce their incentives to participate in a gray market. A third response is to differentiate products sold in different countries, e.g., by adapting the product or offering distinct service features.

[204] Gleim #: 2.42 -- Source: Publisher A firm buys like-new computer equipment from bankrupt companies and resells it in foreign markets at prices significantly below those charged by competitors. The firm is

A. B. C. D.

Engaged in dumping. Engaged in price discrimination. Operating in a gray market. Operating in a black market.


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Answer (A) is incorrect because dumping is sale below cost or at less than the price charged in the home market. Answer (B) is incorrect because price discrimination involves illegally selling the same products at different prices to different customers. Answer (C) is correct. In a gray market, products imported from one country to another are sold by persons trying to make a profit from the difference in retail prices between the two countries. In essence, the seller firm in this case was exploiting a price difference between markets. Answer (D) is incorrect because black market operations are illegal. [205] Gleim #: 2.43 -- Source: Publisher A firm ships its product to a foreign subsidiary and charges a price that may increase import duties but lower the income taxes paid by the subsidiary. The most likely reason for these effects is that the

A. B. C. D.

Price is an arm’s-length price. Price is a cost-plus price. Transfer price is too low. Transfer price is too high. Answer (A) is incorrect because an arm’s-length price is what a competitor would charge in that market. Answer (B) is incorrect because a cost-plus price does not necessarily trigger higher import duties. Answer (C) is incorrect because, if the transfer price is too low, import duties would be lower and taxes would be higher. Answer (D) is correct. A transfer price is the price charged by one subunit of a firm to another. When the subsidiarybuyer is in a foreign country, the higher the transfer, the higher the potential tariffs. However, the tax levied on a subsequent sale by the subsidiary will be lower because of its higher acquisition cost.

[206] Gleim #: 2.44 -- Source: Publisher A global firm establishes a cost-based price for its product in each country. The most likely negative outcome is that this pricing strategy will

A. B. C. D.

Set too high a price in countries where the firm’s costs are high. Overprice the product in some markets and underprice it in others. Create a gray market. Result in dumping. Answer (A) is correct. A firm may set a cost-based price in each market with a standard markup. In a region or country where costs are high, this strategy may result in prices that are too high to be competitive within the local market. Answer (B) is incorrect because a uniform pricing policy may overprice the product in some markets and underprice it in others. Answer (C) is incorrect because charging what consumers can afford in each country may create a gray market. Answer (D) is incorrect because dumping often entails charging a below-cost price.

[207] Gleim #: 2.45 -- Source: Publisher A firm sells its product in a foreign market for a much higher price than in its home market. The reason is most likely


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A. B. C. D.

Price elasticity of demand. Dumping. Gray market activity. Price escalation. Answer (A) is incorrect because price elasticity of demand is the relationship of total revenue to a change in price. If demand is price elastic, a price increase results in lower revenue. Answer (B) is incorrect because dumping is sale at a price below cost or below the price in the home country. Answer (C) is incorrect because In a gray market, products imported from one country to another are sold by persons trying to make a profit from the difference in retail prices between the two countries. Answer (D) is correct. Price escalation is caused by an accumulation of additional costs, e.g., currency fluctuations; transportation expenses; profits earned by importers, wholesalers, and retailers; and import duties.

[208] Gleim #: 2.46 -- Source: CMA 696 1-20 The protected group under the Age Discrimination in Employment Act of 1967, as amended, is defined as anyone in which age group?

A. B. C. D.

35 through 60. 40 through 75. 40 and older. 45 and older. Answer (A) is incorrect because the act provides protection for individuals who are aged 40 and older. Answer (B) is incorrect because the act provides protection for individuals who are aged 40 and older. Answer (C) is correct. The Age Discrimination in Employment Act is designed to protect individuals aged 40 and older from employment discrimination. The act has been amended to eliminate the mandatory retirement age. However, certain managerial employees are not protected by this amendment. Answer (D) is incorrect because the act provides protection for individuals who are aged 40 and older.

[209] Gleim #: 2.47 -- Source: Publisher Evaluating performance is not done to

A. B. C. D.

Determine the amount of nondiscriminatory benefits that each employee deserves. Assess the available human resources of the firm. Motivate the employees. Determine which employees deserve salary increases. Answer (A) is correct. There are many reasons for evaluating performance. Evaluations reinforce accomplishments, help in assessing employee strengths and weaknesses, provide motivation, assist in employee development, permit the organization to assess its human resource needs, and serve as a basis for wage increases. Nondiscriminatory benefits are given to everyone in the organization in equal amounts regardless of title, pay, or achievement of objectives. Answer (B) is incorrect because it is a purpose of a performance evaluation. Answer (C) is incorrect because it is a purpose of a performance evaluation. Answer (D) is incorrect because it is a purpose of a performance evaluation.


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[210] Gleim #: 2.48 -- Source: Publisher When a manager generalizes from the evaluation of one or a few traits to the employee’s total performance, (s)he has made

A. B. C. D.

A judgmental evaluation. An evaluation subject to the halo effect. A projection. An objective evaluation. Answer (A) is incorrect because a judgmental evaluation is based on nonverifiable, subjective criteria. Answer (B) is correct. 1. The halo effect occurs when the appraiser judges one or a few employee traits and carries over this judgment to the evaluation of the employee’s other traits. 2. The converse of the halo effect is the horn effect. It occurs when the manager allows one negative trait to influence the evaluation of other traits. Answer (C) is incorrect because projection is the process of attributing one’s own traits to another person. Answer (D) is incorrect because an objective evaluation uses verifiable, often quantitative criteria.

[211] Gleim #: 2.49 -- Source: CIA 596 II-33 A manager discovers by chance that a newly hired employee has strong beliefs that are very different from the manager’s and from those of most of the other employees. The manager’s best course of action would be to

A. B. C. D.

Facilitate the reassignment of the new hire as quickly as possible before this situation becomes disruptive. Ask the rest of the team for their reaction and act according to the group consensus. Take no action unless the new hire’s behavior is likely to cause harm to the organization. Try to counsel the new hire into more reasonable beliefs. Answer (A) is incorrect because personal beliefs alone are not an appropriate basis for managerial action. Answer (B) is incorrect because personal beliefs alone are not an appropriate basis for managerial action. Answer (C) is correct. The only legitimate grounds on which the supervisor may take action is the employee’s behavior. Personal beliefs, such as those on religious and political matters, cannot be the basis of personnel actions. Discrimination on the basis of personal beliefs could expose the organization to legal action. Answer (D) is incorrect because personal beliefs alone are not an appropriate basis for managerial action.

[212] Gleim #: 2.50 -- Source: Publisher A company allows each of its departments to develop its own system for evaluating performance. Linda Ward, the personnel director, should communicate appraisal information to a new employee by

A. B. C. D.

Presenting anything that is pertinent to the listener’s situation. Providing an overview of all systems within the company. Describing how her own performance is evaluated. Discussing each department’s evaluation system in detail.


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Answer (A) is correct. The personnel director should tailor the discussion to the listener by describing how the employee’s department evaluates performance and what is expected of him/her. The director should also obtain feedback from the employee to determine if everything is clearly understood. Answer (B) is incorrect because discussing information that is irrelevant to the new employee’s appraisal information would confuse the new employee. Answer (C) is incorrect because discussing information that is irrelevant to the new employee’s appraisal information would confuse the new employee. Answer (D) is incorrect because discussing information that is irrelevant to the new employee’s appraisal information would confuse the new employee. [213] Gleim #: 2.51 -- Source: Publisher A disadvantage of separating performance evaluations from wage-increase decisions is that

A. B. C. D.

Not enough emphasis is placed on short-run performance. Financial rewards may lose their motivational effect. Employees may not be motivated by good appraisals. The employee’s performance evaluation does not consider the financial status of the company overall. Answer (A) is incorrect because an advantage of separating appraisals from wage increases is that more emphasis is placed on long-term objectives and goals. Answer (B) is incorrect because this separation does not deprive money of its motivational power, but it does emphasize other rewards, such as feelings of achievement and the recognition of superiors. Answer (C) is correct. The employee may not be motivated immediately by a good appraisal because of the delay in receipt of any monetary reward. The evaluation may also not be taken as seriously by the employee if compensation is not correlated with performance. Answer (D) is incorrect because an advantage of separating performance evaluations from wage-increase decisions is that the employee’s good performance can be separated from the overall company’s bad financial performance.

[214] Gleim #: 2.52 -- Source: Publisher A company that wishes to improve its rate of retention of its experienced employees might

A. B. C. D.

Abolish its hire-from-within policy. Improve its fringe benefit package. Initiate job simplification programs. Set a mandatory retirement age. Answer (A) is incorrect because reduced opportunity for advancement may motivate employees to find jobs elsewhere. Answer (B) is correct. Fringe benefits (e.g., pensions and profit-sharing plans) may be contingent on duration of employment. Accordingly, they motivate employees to remain with the company. Answer (C) is incorrect because job simplification may result in boredom, lessened job satisfaction, and a higher turnover rate. Answer (D) is incorrect because abolition of a mandatory retirement age would be more appropriate.

[215] Gleim #: 2.53 -- Source: Publisher A company that formerly paid certain management employees on a salary plus commission basis decided to compensate a test group solely with commissions. Performance of these employees declined. The most likely explanation for this result is that


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A. B. C. D.

The employee received special attention. Compensation was a motivational factor. Compensation was not a hygiene factor. Increased concerns about security made the employees risk averse. Answer (A) is incorrect because the famous Hawthorne studies suggest that the employees’ knowledge of their special status would improve their output. Answer (B) is incorrect because Herzberg defines a motivational factor as one whose absence will not diminish performance but whose presence will be a motivator. Answer (C) is incorrect because a performance decline followed a reduction in the security of compensation; hence, money was probably a hygiene (maintenance) factor according to Herzberg’s two-factor theory of motivation. Answer (D) is correct. A straight salary with commissions rewarded increased efforts while providing greater security and a reduction in anxiety. Satisfaction of the need for security may have permitted the employees to adopt promising and profitable but more risky strategies. Since people concerned about security needs tend to be risk averse, the change in compensation method probably caused the performance decline.

[216] Gleim #: 2.54 -- Source: CIA 1195 III-22 The human resource department of an organization observed that accounting staff turnover was unusually high. Exit interviews indicated that the accounting department work schedule was highly restrictive for accountants who had young children. To improve the retention of skilled employees in the accounting department, the best solution would be to

A. B. C. D.

Implement a program of job rotation within the accounting department. Promote job enlargement for the positions experiencing the greatest turnover. Provide job sharing and flextime opportunities for accounting department employees. Enrich the jobs of accounting department employees. Answer (A) is incorrect because job rotation would not adequately address the scheduling issue. Answer (B) is incorrect because job enlargement would not adequately address the scheduling issue. Answer (C) is correct. Job sharing and flextime allow employees to adjust their work schedules and hours to better achieve personal objectives. These programs can increase worker loyalty and motivation. Answer (D) is incorrect because job enrichment would not adequately address the scheduling issue.

[217] Gleim #: 2.55 -- Source: Publisher The factor that would not contribute to retention of experienced employees would be

A. B. C. D.

Initiation of job enrichment programs. Adherence to federal regulations regarding sex discrimination in paying and promoting workers. Paying new employees more than older ones. Adoption of flextime rules.


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Answer (A) is incorrect because a more intrinsically satisfying job will improve the retention rate. Answer (B) is incorrect because employees subject to discrimination may be strongly motivated to find other jobs. Answer (C) is correct. When old employees discover that newcomers are being hired at higher salaries, the group hired first will be unhappy, feeling that their greater experience should warrant greater reward. In the short run, the newcomers will be satisfied. But it is possible that next year’s newcomers will be hired at still higher salaries, contributing to the overall dissatisfaction. Thus, such a policy will provide incentives for experienced workers to leave the company. Answer (D) is incorrect because greater freedom in determining his/her hours may enable a worker to remain with the company when other responsibilities (e.g., child care) might have compelled him/her to leave. [218] Gleim #: 2.56 -- Source: Publisher The value of retaining employees is determined by

A. B. C. D.

Human asset accounting. Financial accounting. Cost accounting. Human resource planning. Answer (A) is correct. Human resource or human asset accounting attempts to measure the value, and the changes in value, of the organization’s investment in human assets. Although this “asset” is enormously valuable (sometimes estimated at two or three times the annual payroll), it is not shown in balance sheets or accounted for in earnings statements. One experimental measurement approach is a sort of “present value” of human resources. Another is a “cost” approach, with dollar investments (training, customer goodwill, etc.) offset by reductions (e.g., retirement). Answer (B) is incorrect because this traditional accounting method does not value the organization’s human assets. Answer (C) is incorrect because this traditional accounting method does not value the organization’s human assets. Answer (D) is incorrect because it merely audits the skills of the current employees and forecasts needs.

[219] Gleim #: 2.57 -- Source: Publisher An employee with a good background and years of experience earns a salary at the top of his/her range. Under the company’s compensation program, the employee must earn a promotion in order to increase his/her salary above the usual annual increase. Which of the following is most likely to be an effect on his/her behavior?

A. B. C. D.

The employee may refuse new duties or tasks. The employee may become less productive. The employee may not be motivated to improve performance. The employee may seek a position with another company. Answer (A) is incorrect because this behavior would undermine the employee’s chance for a promotion. Answer (B) is incorrect because this behavior would undermine the employee’s chance for a promotion. Answer (C) is incorrect because this behavior would undermine the employee’s chance for a promotion. Answer (D) is correct. When an employee can earn a desired salary increase only through a promotion, (s)he is likely to be motivated to perform better. If this does not result in a promotion, (s)he will probably look for another job.

[220] Gleim #: 2.58 -- Source: Publisher A company’s compensation program does not allow for salary increases based on above-average performance after an employee reaches the top of a position’s salary range. It also pays some employees higher salaries because of their educational qualifications. This company could improve the program by


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A. B. C. D.

Allowing each manager to set up his/her own system of salary increases. Providing only monetary compensation. Developing a system that equates years of experience with education. Decreasing the annual percentage increase in each salary range. Answer (A) is incorrect because the company should administer a uniform system of salary increases. Answer (B) is incorrect because the company could improve its system if it provided other compensation, such as assisting with an employee’s tuition or recognizing an employee who has given many years of service. Answer (C) is correct. A company with a compensation program that stops rewarding above-average performance at the top of each salary range and rewards education with higher compensation could improve the system in several ways. These include starting a bonus program for above-average performance, refusing to hire a person at the top of a salary range unless (s)he will be promoted quickly, and equating experience and education so that employees are treated fairly. Answer (D) is incorrect because the company would please all employees by increasing this percentage.

[221] Gleim #: 2.59 -- Source: Publisher Which of the following methods of employee evaluation is best used in a situation where employees are heavily involved in teamwork?

A. B. C. D.

360-degree performance appraisal. Attribution method. Critical incident technique. Behaviorally anchored rating scales (BARS). Answer (A) is correct. The 360-degree performance appraisal is a model for employee assessment in the age of teamwork. It is based on giving workers feedback from peers, customers, supervisors, and those who work for the employee. Feedback is typically provided anonymously and is usually subjective. Answer (B) is incorrect because this is a nonsense term. Answer (C) is incorrect because the critical incident technique is based on having a list of critical aspects of a job against which to compare the employee’s performance; it would usually not be effective in a team situation. Answer (D) is incorrect because BARS is based on specific job-related behaviors.

[222] Gleim #: 2.60 -- Source: Publisher If a supervisor fails to give an employee a negative evaluation because of fear of damaging a good working relationship, this is known as the

A. B. C. D.

Leniency error. Recency effect. Halo effect. Contrast error.


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Answer (A) is correct. A leniency error is when a manager fails to give a negative evaluation because of fear of damaging a good working relationship with an employee. Answer (B) is incorrect because the recency effect means that the employee’s most recent behavior overshadows overall performance. Answer (C) is incorrect because the halo effect means the manager’s judgment on one positive trait affects the rating on other traits. Answer (D) is incorrect because a contrast error is the tendency to rate people relative to other people, without consideration of performance standards. [223] Gleim #: 2.61 -- Source: CIA 591 III-11 During an audit of the personnel function, it was noted that numerous questions were asked of potential hirees. Which of the following questions would normally be appropriate when interviewing an inexperienced person applying for an entry-level internal auditing position?

A. B. C. D.

How have you kept up your internal auditing education? What kind of reports have you written in previous jobs? What are your career goals? What is your marital status? Answer (A) is incorrect because the inexperienced applicant may have just finished his/her education. Thus, continuing education may not be relevant. Answer (B) is incorrect because the applicant is inexperienced and thus may not have written reports in previous jobs. Answer (C) is correct. Sawyer’s Internal Auditing (IIA, 1988. p. 791) suggests the following questions for inexperienced candidates:

What is your concept of internal auditing? How did you hear about it? Why do you think you’d like it? What kinds of assignments would you like best? What are your outside interests? What are your personal goals? Answer (D) is incorrect because federal law prohibits asking about marital status. [224] Gleim #: 2.62 -- Source: CIA 1192 III-10 When faced with the problem of filling a newly created or recently vacated executive position, organizations must decide whether to promote from within or to hire an outsider. One of the disadvantages of promoting from within is that

A. B. C. D.

Internal promotions can have negative motivational effect on the employees of the firm. Internal promotions are more expensive to the organization than hiring an outsider. It is difficult to identify proven performers among internal candidates. Hiring an insider leads to the possibility of social inbreeding within the firm.


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Answer (A) is incorrect because internal promotions usually lead to increased motivation among employees. Answer (B) is incorrect because internal promotions are less expensive. The firm can avoid the expenses associated with an executive search and certain training costs. Answer (C) is incorrect because it is more difficult to identify proven performers from among outside candidates than internal candidates. Answer (D) is correct. Hiring an internal candidate can lead to social inbreeding. Many firms look to external candidates for certain jobs because they bring a fresh perspective to the organization’s problems and may have more up-to-date training or education. [225] Gleim #: 2.63 -- Source: CIA 597 IV-80 The airlines have been leaders in the use of technology. Customers can make reservations either with an airline or through a travel agency. In this situation, a travel agency is classified as which type of distribution channel?

A. B. C. D.

An intermediary. A jobber. A distributor. A facilitating agent. Answer (A) is correct. Marketing intermediaries assist companies in promoting, selling, and distributing their goods and services to ultimate consumers. For example, travel agents access an airline’s computerized reservation system and make reservations for their customers without ever taking title to the ticket. Answer (B) is incorrect because jobbers buy from manufacturers, then resell the products. Answer (C) is incorrect because distributors, or wholesalers, usually have selective or exclusive distribution rights. Answer (D) is incorrect because facilitating agents assist in functions other than buying, selling, or transferring title.

[226] Gleim #: 2.64 -- Source: CIA 595 III-32 Just-in-time (JIT) inventory systems have been adopted by large manufacturers to minimize the carrying costs of inventories. Identify the primary vulnerability of JIT systems.

A. B. C. D.

Computer resources. Materials supply contracts. Work stoppages. Implementation time. Answer (A) is incorrect because JIT systems can require significant computer resources, but they can also be maintained manually. Answer (B) is incorrect because contracts may have to be renegotiated with strict delivery and quality specifications, but these changes usually occur over extended periods. Answer (C) is correct. JIT minimizes inventory by relying on coordination with suppliers to provide deliveries when they are needed for production. Consequently, work stoppages at suppliers or transportation disruptions can cause almost immediate work stoppages at the manufacturer plant. Answer (D) is incorrect because JIT can be implemented over an extended period or a shorter time frame depending on the manufacturer’s immediate needs.


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[227] Gleim #: 2.65 -- Source: CIA 596 III-98 A company manufactures banana hooks for retail sale. The bill of material for this item and the parts inventory for each material required are as follows: Bill of Materials Raw Material

Quantity Required

Wooden neck Wooden base Swag hook Wood screws Foot pads

1 1 1 2 4

On Hand 0 0 300 400 1,000

An incoming order calls for delivery of 2,000 banana hooks in 2 weeks. The company has 200 finished banana hooks in current inventory. If no safety stocks are required for inventory, what are the company’s net requirements for swag hooks and screws needed to fill this order?

Swag Hooks

Wood Screws

A.

1,500

1,400

B. C.

1,500 1,700

3,200 3,600

D.

1,800

3,600

Answer (A) is incorrect because 1,400 wood screws assumes that one wood screw is used per banana hook. Answer (B) is correct. The company needs 1,800 banana hooks (2,000 – 200) and therefore 1,800 swag hooks (1 × 1,800) and 3,600 wood screws (2 × 1,800). Given that 300 swag hooks and 400 wood screws are on hand, the company must obtain 1,500 swag hooks (1,800 – 300) and 3,200 wood screws (3,600 – 400). Answer (C) is incorrect because 1,700 swag hooks and 3,600 wood screws would be needed if no banana hooks were in current inventory. Answer (D) is incorrect because 1,800 swag hooks would be needed if no swag hooks were in current inventory. Also, 3,600 wood screws would be needed if no banana hooks were in current inventory. [228] Gleim #: 2.66 -- Source: CIA 594 III-66 The purpose of the economic order quantity model is to:

A. B. C. D.

Minimize the safety stock. Minimize the sum of the order costs and the holding costs. Minimize the inventory quantities. Minimize the sum of the demand costs and the backlog costs. Answer (A) is incorrect because the basic EOQ model does not include safety stock. Answer (B) is correct. The purpose of the EOQ model is to minimize the sum of inventory order costs and holding costs. The EOQ equals the square root of: twice the annual demand multiplied by the variable cost per order, divided by the unit periodic holding cost. Answer (C) is incorrect because, in the EOQ model, costs, not quantities, are to be minimized. Answer (D) is incorrect because quantity demanded is a variable in the model, but order costs, not demand costs, are relevant. Backlogs are customer orders that cannot be filled immediately because of stockouts. Backlog costs are not quantified in the model.


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[229] Gleim #: 2.67 -- Source: CIA 593 III-70 Which of the following is used in determining the economic order quantity (EOQ)?

A. B. C. D.

Regression analysis. Calculus. Markov process. Queuing theory. Answer (A) is incorrect because regression analysis is used to fit a linear trend line to a dependent variable based on one or more independent variables. Answer (B) is correct. The primary business application of differential calculus is to identify the maxima or minima of curvilinear functions. In business and economics, these are the points of revenue or profit maximization (maxima) or cost minimization (minima). The EOQ results from differentiating the total cost with regard to order quantity. Answer (C) is incorrect because Markov process models are used to study the evolution of certain systems over repeated trials. Answer (D) is incorrect because queuing theory is a waiting-line technique used to balance desirable service levels against the cost of providing more service.

[230] Gleim #: 2.68 -- Source: CIA 590 III-45 The EOQ (economic order quantity) model calculates the cost-minimizing quantity of a product to order, based on a constant annual demand, carrying costs per unit per annum, and cost per order. For example, the EOQ is approximately 447 units if the annual demand is 10,000 units, carrying costs are 1 currency unit per item per annum, and the cost of placing an order is $10. What will the EOQ be if the demand falls to 5,000 units per annum and the carrying and ordering costs remain at $1 and $10, respectively?

A. B. C. D.

316 447 483 500 Answer (A) is correct. The EOQ formula is

If: D is the demand, or number of units used per year. A is the cost of placing one order. K is the cost of carrying one item for 1 year.

Answer (B) is incorrect because 447 is the EOQ when demand is 10,000 units per year. Answer (C) is incorrect because 483 results when annual demand is 11,664 units. Answer (D) is incorrect because 500 results when annual demand is 12,500 units.


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[231] Gleim #: 2.69 -- Source: CIA 1190 III-42 A company stocks, maintains, and distributes inventory. The company decides to add to the safety stock and expedite delivery for several product lines on a trial basis. For the selected product lines the company will experience

A. B. C. D.

An increase in some costs but no change in the service level. A change in the service level. An increase in ordering, carrying, and delivery costs. A decrease in ordering, carrying, and delivery costs. Answer (A) is incorrect because service will improve. Answer (B) is correct. Safety stocks are amounts held in excess of forecasted demand to avoid the losses associated with stockouts. Holding safety stocks improves the level of service to customers at the expense of increased holding costs. Answer (C) is incorrect because ordering costs will not increase. The fixed costs of the ordering department will be unaffected. Also, the department’s variable costs should not change because the EOQ will be the same. However, in the first year, an additional order may be necessary to increase the safety stock. Answer (D) is incorrect because delivery will increase under the new expedited delivery policy. Moreover, increasing the safety stock increases carrying costs.

[232] Gleim #: 2.70 -- Source: CIA 1193 IV-26 Which of the following inventory items would be the most frequently reviewed in an ABC inventory control system?

A. B. C. D.

Expensive, frequently used, high stock-out cost items with short lead times. Expensive, frequently used, low stock-out cost items with long lead times. Inexpensive, frequently used, high stock-out cost items with long lead times. Expensive, frequently used, high stock-out cost items with long lead times. Answer (A) is incorrect because long, not short, lead times prompt a more frequent review. Answer (B) is incorrect because high, not low, stockout costs prompt a more frequent review. Answer (C) is incorrect because expensive, not inexpensive, items prompt a more frequent review. Answer (D) is correct. The ABC system is a method for controlling inventories that divides inventory items into three groups:

Group A -- high-dollar value items, which account for a small portion (perhaps 10%) of the total inventory usage Group B --

medium-dollar value items, which may account for about 20% of the total inventory items

Group C --

low-dollar value items, which account for the remaining 70% of sales or usage

The ABC system permits the proper degree of managerial control to be identified and exercised over each group. Group A items are reviewed on a regular basis. Group B items may not have to be reviewed as often as group A items, but more often than group C items. For group C, extensive use of models and records is not cost effective. It is cheaper to order large quantities infrequently. The ABC method therefore reduces the safety-stock investment because high-value items are frequently monitored and medium-value items are monitored more often than inexpensive items. Frequent review can prevent stockouts and decrease inventory levels, and the cost of such review is minimized if it is limited to high- or medium-value items.


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[233] Gleim #: 2.71 -- Source: CIA 1193 IV-25 The company uses a planning system that focuses first on the amount and timing of finished goods demanded and then determines the derived demand for raw material, components, and subassemblies at each of the prior stages of production. This system is referred to as

A. B. C. D.

Economic order quantity. Materials requirements planning. Linear programming. Just-in-time purchasing. Answer (A) is incorrect because the economic order quantity is a decision model that focuses on the trade-off between carrying and ordering costs. Answer (B) is correct. Materials requirements planning (MRP) is usually a computer-based information system designed to plan and control raw materials used in a production setting. It assumes that estimated demand for materials is reasonably accurate and that suppliers can deliver based upon this accurate schedule. It is crucial that delivery delays be avoided because, under MRP, production delays are almost unavoidable if the materials are not on hand. An MRP system uses a parts list, often called a bill of materials, and lead times for each type of material to obtain materials just as they are needed for planned production. Answer (C) is incorrect because linear programming is a decision model concerned with allocating scarce resources to maximize profit or minimize costs. Answer (D) is incorrect because just-in-time purchasing involves the purchase of goods such that delivery immediately precedes demand or use.

[234] Gleim #: 2.72 -- Source: CIA 592 III-62 An inventory planning method that minimizes inventories by arranging to have raw materials and subcomponents arrive immediately preceding their use is called

A. B. C. D.

A safety stock planning system. An economic order quantity model. A just-in-time inventory system. A master budgeting system. Answer (A) is incorrect because safety stock is the inventory maintained in order to reduce the number of stockouts resulting from higher-than-expected demand during lead time. Answer (B) is incorrect because the economic order quantity is the order quantity that minimizes total inventory costs. Answer (C) is correct. JIT is a manufacturing philosophy popularized by the Japanese that combines purchasing, production, and inventory control. As with MRP, minimization of inventory is a goal; however, JIT also encompasses changes in the production process itself. An emphasis on quality and a “pull” of materials related to demand are key differences between JIT and MRP. The factory is organized so as to bring materials and tools close to the point of use rather than keeping them in storage areas. A key element of the JIT system is reduction or elimination of waste of materials, labor, factory space, and machine usage. Minimizing inventory is the key to reducing waste. When a part is needed on the production line, it arrives just in time, not before. Daily deliveries from suppliers are the ultimate objective, and some Japanese users have been able to get twice-daily deliveries. Answer (D) is incorrect because the master budget is the detailed financial plan for the next period.

[235] Gleim #: 2.73 -- Source: CIA 595 III-98 One of the elements included in the economic order quantity (EOQ) formula is


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A. B. C. D.

Safety stock. Yearly demand. Selling price of item. Lead time for delivery. Answer (A) is incorrect because the safety stock is not included in the basic EOQ formula. Answer (B) is correct. The basic EOQ formula is used to minimize the total of inventory carrying and ordering costs. The basic EOQ equals the square root of a fraction consisting of a numerator equal to the product of twice the unit periodic demand and the variable cost per order and a denominator equal to the unit periodic carrying cost. Answer (C) is incorrect because the selling price of the item is not included in the basic EOQ formula. Answer (D) is incorrect because the lead time for delivery is not included in the basic EOQ formula.

[Fact Pattern #16] Using an EOQ analysis (assuming a constant demand), it is determined that the optimal order quantity is 2,500. The company desires a safety stock of 500 units. A five-day lead time is needed for delivery. Annual inventory holding costs equal 25% of the average inventory level. It costs the company $4 per unit to buy the product, which it sells for $8. It costs the company $150 to place a detailed order, and the monthly demand for the product is 4,000 units. [236] Gleim #: 2.74 -- Source: CIA 595 III-99 (Refers to Fact Pattern #16) Annual inventory holding costs equal

A. B. C. D.

$750 $1,250 $1,750 $2,250 Answer (A) is incorrect because $750 results from subtracting instead of adding the cost of holding safety stock. Answer (B) is incorrect because $1,250 ignores safety stock. Answer (C) is correct. Given that demand is constant and the EOQ is 2,500 units, the average inventory level without regard to safety stock is 1,250 units (2,500 ÷ 2). Adding safety stock results in an average level of 1,750 units (1,250 + 500). Given also that annual holding costs are 25% of average inventory and that unit cost is $4, total annual holding cost is $1,750 [(1,750 units × $4) × 25%]. Answer (D) is incorrect because $2,250 results from double counting the cost of holding safety stock.

[237] Gleim #: 2.75 -- Source: CIA 595 III-100 (Refers to Fact Pattern #16) Total inventory ordering costs per year equal

A. B. C. D.

$1,250 $2,400 $2,880 $3,600


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Answer (A) is incorrect because $1,250 equals the annual holding cost of the average inventory excluding safety stock. Answer (B) is incorrect because $2,400 assumes an EOQ of 3,000 units. Answer (C) is correct. Total annual demand is 48,000 units (4,000 per month × 12). Hence, total annual ordering costs equal $2,880 [$150 cost per order × (48,000 units ÷ 2,500 EOQ)]. Answer (D) is incorrect because $3,600 assumes an EOQ of 2,000 units. [238] Gleim #: 2.76 -- Source: CIA 1195 III-66 An organization sells a product for which demand is uncertain. Management would like to ensure that there is sufficient inventory on hand during periods of high demand so that it does not lose sales (and customers). To do so, the organization should

A. B. C. D.

Keep a safety stock. Use a just-in-time inventory system. Employ a materials requirements planning system. Keep a master production schedule. Answer (A) is correct. Safety stock is inventory maintained to reduce the number of stockouts resulting from higherthan-expected demand during lead time. Maintaining a safety stock avoids the costs of stockouts, e.g., lost sales and customer dissatisfaction. Answer (B) is incorrect because a just-in-time inventory system involves the purchase of materials and production of components immediately preceding their use. Answer (C) is incorrect because materials requirements planning is a system for scheduling production and controlling the level of inventory for components with dependent demand. Answer (D) is incorrect because a master production schedule is a statement of the timing and amounts of individual items to be produced.

[239] Gleim #: 2.77 -- Source: CIA 1195 III-97 The economic order quantity is the size of the order that minimizes total inventory costs which include ordering and holding costs. It can be calculated using the formula

If: Q = order size in units, D = annual demand in units, p = cost per purchase order, s = carrying cost per year for one unit of inventory. If the annual demand decreases by 36% the optimal order size will

A. B. C. D.

Decrease by 20%. Increase by 20%. Increase by 6%. Decrease by 6%.


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Answer (A) is correct. If D decreases by 36%, that is, from 100% to 64%, the EOQ will decrease by 20%.

Answer (B) is incorrect because the new EOQ decreases to 80% of its former value. Answer (C) is incorrect because 6% is the square root of 36%. Answer (D) is incorrect because 6% is the square root of 36%. [240] Gleim #: 2.78 -- Source: CIA 1196 III-95 The economic order quantity, Q, is the size of the order that minimizes total inventory costs. These costs, which are composed of ordering and holding costs, can be computed using the following expression:

If: TC Q D F p s

= = = = = =

total inventory costs size of each order annual demand in units fixed costs of ordering variable cost of placing one order holding cost per year for one unit of inventory

The following inventory information is available for an organization (costs stated in currency units): Annual demand (D) Variable cost of placing one order (p) Holding cost per unit (s) Economic order quantity (Q) Fixed cost of ordering

20,000 units CU100 CU1 2,000 units CU0

If the organization decides to order 4,000 units at a time rather than 2,000 units, by how much will its total inventory costs change?

A. B. C. D.

CU500 increase. CU1,000 increase. CU1,000 decrease. CU900 increase.

Answer (A) is correct. When the order size is 2,000 units, the variable inventory costs are CU2,000 {[(2,000 units × CU1) ÷ 2] + [(20,000 units ÷ 2,000 units) × CU100]}. When the order size is 4,000 units, the variable inventory costs are CU2,500 {[(4,000 units × CU1) ÷ 2] + [(20,000 units ÷ 4,000 units) × CU100]}. The increase in inventory costs is CU500 (CU2,500 – CU2,000). Answer (B) is incorrect because a CU1,000 increase omits the change in the number of orders. Answer (C) is incorrect because increasing the order size increases total costs. The EOQ is 2,000 units. Answer (D) is incorrect because a CU900 increase results from an order size of 5,000 units.


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[241] Gleim #: 2.79 -- Source: Publisher Which of the following is the method of adding a standard markup to the cost of the product?

A. B. C. D.

Penetration pricing. Going-rate pricing. Cost-based pricing. Price skimming. Answer (A) is incorrect because penetration pricing is a new product pricing method in which an introductory price is set relatively low to attract as many customers as possible. Answer (B) is incorrect because going-rate pricing is a method of pricing based largely on competitors’ prices. Answer (C) is correct. Cost-based pricing is a pricing method in which a standard markup or target profit is added to the cost of the product in determining the product’s sales price. Answer (D) is incorrect because price skimming sets the introductory price relatively high to attract buyers who are not concerned with price.

[242] Gleim #: 2.80 -- Source: Publisher Which of the following is not a component of physical distribution?

A. B. C. D.

Transportation. Pricing. Location of retail outlets. Warehousing. Answer (A) is incorrect because a physical distribution system includes transportation. Answer (B) is correct. Physical distribution (market logistics) involves planning, implementing, and controlling the movement of materials and final goods to meet customer needs while earning a profit. Physical distribution systems coordinate suppliers, purchasing agents, marketers, channels, and customers. They include warehousing, transportation, and retail outlets. Answer (C) is incorrect because a physical distribution system includes the location of retail outlets. Answer (D) is incorrect because a physical distribution system includes warehousing.

[243] Gleim #: 2.81 -- Source: Publisher Physical distribution is the moving of finished products to

A. B. C. D.

Retail outlets. Shipping point. Consumers. Warehouses. Answer (A) is incorrect because physical distribution is the efficient movement of finished products to consumers. Answer (B) is incorrect because physical distribution is the efficient movement of finished products to consumers. Answer (C) is correct. Physical distribution is the efficient management of supply chains. It controls value-added flows from suppliers to consumers. Answer (D) is incorrect because physical distribution is the efficient movement of finished products to consumers.


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[244] Gleim #: 2.82 -- Source: Publisher Intensive distribution is most likely to be used for

A. B. C. D.

Shopping goods. Specialty goods. Convenience goods. Unsought goods. Answer (A) is incorrect because shopping goods are usually sold through selective distribution. Answer (B) is incorrect because specialty goods are usually sold through selective or exclusive distribution. Answer (C) is correct. Convenience goods are consumer goods and services that are usually low-priced and widely available. Consumers buy them often and with a minimum of comparison and effort. Examples are soap and newspapers. Producers of convenience goods ordinarily use intensive distribution to sell their products through a large number of retail or wholesale units. Answer (D) is incorrect because unsought goods, e.g., life insurance, are often marketed through personal selling.

[245] Gleim #: 2.83 -- Source: CMA 691 4-4 A decrease in inventory order costs will

A. B. C. D.

Decrease the economic order quantity. Increase the reorder point. Increase the economic order quantity. Decrease the holding cost percentage. Answer (A) is correct. A decrease in inventory ordering costs should decrease the economic order quantity. The effect is that more orders can be made (of smaller quantities) without increasing costs. Accordingly, in the EOQ model, ordering cost is a numerator value. Answer (B) is incorrect because the reorder point is based on lead time, not the EOQ model. Answer (C) is incorrect because the EOQ does not increase when inventory order costs decrease. Answer (D) is incorrect because the holding cost percentage will always be identical to the ordering cost percentage in accordance with the fundamental calculus underlying the EOQ model.

[246] Gleim #: 2.84 -- Source: CMA 1294 4-7 Which one of the following items is not directly reflected in the basic economic order quantity (EOQ) model?

A. B. C. D.

Interest on invested capital. Inventory obsolescence. Public warehouse rental charges. Quantity discounts lost on inventory purchases. Answer (A) is incorrect because interest on invested capital is considered in the basic EOQ model. Answer (B) is incorrect because inventory obsolescence is considered in the basic EOQ model. Answer (C) is incorrect because public warehouse rental charges is considered in the basic EOQ model. Answer (D) is correct. The basic EOQ model minimizes the sum of ordering (or setup) and carrying costs. Included in the formula are annual demand, ordering (or setup) costs, and carrying costs. Carrying costs include warehousing costs, insurance, spoilage, obsolescence, and interest on invested capital. The cost of the inventory itself and any quantity discounts lost on inventory purchases are not components of the EOQ model.


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[247] Gleim #: 2.85 -- Source: CMA 1286 5-10 In production management, product breakdown into component parts and lead times for procuring these parts is necessary for

A. B. C. D.

A critical path method (CPM) system. A materials requirements planning (MRP) system. An economic order quantity (EOQ) system. An ABC system. Answer (A) is incorrect because a CPM system is a project management and scheduling technique that determines the longest time path from the first to the last event for a project. Answer (B) is correct. Materials requirements planning (MRP) is usually considered a computer-based information system designed to plan and control raw materials used in a production setting. It assumes that estimated demand for materials is reasonably accurate and that suppliers can deliver based upon this accurate schedule. It is crucial that delivery delays be avoided because, under MRP, production delays are almost unavoidable if the materials are not on hand. An MRP system uses a parts list, often called a bill of materials, and lead times for each type of material to obtain materials just as they are needed for planned production. Answer (C) is incorrect because the EOQ model does not adjust for the dependent demand for the components of an inventory item. Answer (D) is incorrect because the main purpose of the ABC system is to increase control over items accounting for the most profit.

[248] Gleim #: 2.86 -- Source: CMA 1286 5-11 The inventory model that follows the concept that 80% of the value of an inventory is in 20% of the inventory items is the

A. B. C. D.

ABC system. Economic order quantity (EOQ) model. Just-in-time inventory system. Materials requirements planning (MRP) system. Answer (A) is correct. The ABC method of inventory control requires management to exert greatest control over the A classification items, which usually include a relatively small percentage of total items but a high percentage of the dollar volume. This method is analogous to the 80/20 rule, which says, for instance, that 20% of the customers account for 80% of the profit. Answer (B) is incorrect because the EOQ model is intended to minimize the sum of holding and ordering costs. Answer (C) is incorrect because a just-in-time system attempts to reduce holding costs by scheduling deliveries of materials as closely as possible to when they are needed in production. Answer (D) is incorrect because an MRP system recognizes that the demand for one inventory item creates a dependent demand for the components of that item.

[249] Gleim #: 2.87 -- Source: CMA 688 5-22 When a specified level of safety stock is carried for an item in inventory, the average inventory level for that item

A. B. C. D.

Decreases by the amount of the safety stock. Is one-half the level of the safety stock. Increases by one-half the amount of the safety stock. Increases by the amount of the safety stock.


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Answer (A) is incorrect because the average inventory level increases by the amount of the safety stock. Answer (B) is incorrect because the average inventory level increases by the amount of the safety stock. Answer (C) is incorrect because the average inventory level increases by the amount of the safety stock. Answer (D) is correct. If there is no safety stock, the average level of inventory will be one-half of the economic order quantity. For example, if the EOQ is 500, the basic model predicts that the average inventory level will be 250. The company will have 500 units immediately after a purchase and zero immediately before the receipt of the next purchase (replenishment is assumed to be instantaneous). However, safety stock increases the average inventory level by the amount of the safety stock. The modified EOQ model assumes that safety stock will never be used. Thus, if a safety stock of 100 is carried by the company in the example, the average inventory level will increase to 350. Inventory will be 600 units immediately upon receipt of a purchase and 100 units immediately before the receipt of the next purchase. [250] Gleim #: 2.88 -- Source: CIA 597 IV-78 A distribution channel moves goods from producers to customers. Suppose a channel has four producers, each serving the same four customers, and no middlemen. If a distributor is introduced, the number of contacts (among producers, customers, and the distributor) in the channel will

A. B. C. D.

Be unaffected. Decrease from 8 to 4. Increase from 8 to 16. Decrease from 16 to 8. Answer (A) is incorrect because the introduction of a distributor will affect the number of contacts in the marketing channel. Answer (B) is incorrect because the number of contacts declined from 16 to 8. Answer (C) is incorrect because the number of contacts decreased. Answer (D) is correct. The number of contacts without a distributor is 16 (four producers × four customers). The number with a distributor is 8 (four producers + four customers). Thus, the effort required of producers and consumers is reduced by the distributor, thereby increasing marketing efficiency.

[251] Gleim #: 2.89 -- Source: CIA R98 III-32 An appropriate technique for planning and controlling manufacturing inventories, such as raw materials, components, and subassemblies whose demand depends on the level of production is

A. B. C. D.

Materials requirements planning. Regression analysis. Capital budgeting. Linear programming. Answer (A) is correct. Materials requirements planning (MRP) is a system that translates a production schedule into requirements for each component needed to meet the schedule. It is usually implemented in the form of a computerbased information system designed to plan and control raw materials used in production. It assumes that forecasted demand is reasonably accurate and that suppliers can deliver based upon this accurate schedule. MRP is a centralized push-through system; output based on forecasted demand is pushed through to the next department or to inventory. Answer (B) is incorrect because regression analysis is used to fit a linear trend line to a dependent variable based on one or more independent variables. Answer (C) is incorrect because capital budgeting is the process of planning expenditures for long-lived assets. It involves choosing among investment proposals using a ranking procedure. Answer (D) is incorrect because linear programming is a decision model concerned with allocating scarce resources to maximize profit or minimize costs.


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[252] Gleim #: 2.90 -- Source: CIA 1194 IV-79 Price skimming involves

A. B. C. D.

Setting a low introductory price. Setting a high introductory price. Setting different freight charges for customers in different zones. Using markups tied closely to the price paid for a product. Answer (A) is incorrect because it refers to penetration pricing. Answer (B) is correct. Price skimming is used when a new product is introduced at the highest price possible given the benefits of the product. For market skimming to work, the product must appear to be worth its price, the costs of producing a small volume cannot be so high that they eliminate the advantage of charging more, and competitors cannot enter the market and undercut the price. Answer (C) is incorrect because it refers to zone pricing. Answer (D) is incorrect because it relates to pricing by intermediaries.

[253] Gleim #: 2.91 -- Source: CIA 1195 IV-75 Which of the following price adjustment strategies is designed to smooth production for the selling firm?

A. B. C. D.

Cash discounts. Quantity discounts. Functional discounts. Seasonal discounts. Answer (A) is incorrect because cash discounts encourage prompt payment. Answer (B) is incorrect because quantity discounts encourage large volume purchases. Answer (C) is incorrect because functional or trade discounts are provided to channel members in return for the performance of certain functions, such as selling, storing, and record keeping. Answer (D) is correct. Seasonal discounts are designed to smooth production by the selling firm. For example, a ski manufacturer offers seasonal discounts to retailers in the spring and summer to encourage early ordering.

[254] Gleim #: 2.92 -- Source: Publisher A seller that does which of the following is engaged in uniform delivered pricing?

A. B. C. D.

Charges each customer its actual freight costs. Charges the same price, inclusive of shipping, to all customers regardless of location. Absorbs all of the actual freight charges. Sets differential freight charges for customers on the basis of their location. Answer (A) is incorrect because it refers to FOB-origin pricing. Answer (B) is correct. A seller that uses uniform delivered pricing charges the same price, inclusive of shipping, to all customers regardless of their location. Answer (C) is incorrect because it refers to freight-absorption pricing. Answer (D) is incorrect because it refers to zone pricing.


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[255] Gleim #: 2.93 -- Source: Publisher Jabberwock Corporation’s corporate headquarters is in Carroll City. Jabberwock also has six distribution centers, one in Carroll City and the others located throughout North America. Jabberwock sets freight costs based on the distance of the destination city from Carroll City. What is this pricing method?

A. B. C. D.

Basing-point pricing. Zone pricing. FOB-origin pricing. Cost-plus pricing. Answer (A) is correct. Basing-point pricing charges each customer the freight costs incurred from a specified city to the destination, regardless of the actual point of origin of the shipment. Answer (B) is incorrect because zone pricing sets differential freight charges for customers on the basis of their location. Answer (C) is incorrect because FOB-origin pricing charges each customer its actual freight costs. Answer (D) is incorrect because cost-plus pricing is not a geographical pricing method.

[256] Gleim #: 2.94 -- Source: Publisher Manx Co. produces and sells two products. Product A costs $10 per unit and Product B costs $5 per unit. The As are selling very well, but sales of B are low. In order to increase sales of B, Manx has begun setting a price of $13 for one of each. This pricing method is

A. B. C. D.

Product-bundle pricing. By-product pricing. Value pricing. Collusive pricing. Answer (A) is correct. Product-bundle pricing entails selling combinations of products at a price lower than the combined prices of the individual items. This strategy promotes sales of items consumers might not otherwise buy. Answer (B) is incorrect because it refers to the practice of accepting prices at any amount in excess of storing and delivering the by-products. Answer (C) is incorrect because it refers to the practice of redesigning products to improve quality without raising prices, or offering the same quality at lower prices. Answer (D) is incorrect because collusive pricing occurs when companies conspire to restrict output and set artificially high prices.

[257] Gleim #: 2.95 -- Source: Publisher Selling below cost in other countries is called

A. B. C. D.

Predatory pricing. Price discrimination. Dumping. Collusive pricing.


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Answer (A) is incorrect because it is pricing products below cost. It may be done both domestically and in other countries. Answer (B) is incorrect because price discrimination is charging different prices to different customers. Answer (C) is correct. Dumping, which refers to selling below cost in other countries, is an inappropriate pricing tactic that may trigger retaliatory tariffs and other sanctions. Answer (D) is incorrect because collusive pricing occurs when companies conspire to restrict output and set artificially high prices. [258] Gleim #: 2.96 -- Source: Publisher All of the following are objectives of pricing except

A. B. C. D.

Image oriented objectives. Profit maximization. Stabilization. Production maximization. Answer (A) is incorrect because it is a pricing objective. Answer (B) is incorrect because it is a pricing objective. Answer (C) is incorrect because it is a pricing objective. Answer (D) is correct. Pricing objectives include 1. 2. 3. 4.

profit maximization, which assumes that all firms select the price that results in the highest profit target margin maximization, which is stated as a percentage ratio of profits to sales volume-oriented objectives, which refers to setting prices to meet target sales volumes or market shares image oriented objectives, which refers to setting prices to enhance the consumer’s perception of the firm’s merchandise mix 5. stabilization objectives, which refers to setting prices to maintain a stable relationship between the firm’s prices and the industry leader’s prices Price setting is not a factor in maximizing production. [259] Gleim #: 2.97 -- Source: Publisher Monolith Company, which produces Hal computers, uses a target pricing and costing approach. The following is Monolith’s costs and revenues for the year just ended: Number of computers sold Sales price per computer Cost of goods sold Operating costs excluding production

10,000 $1,500 $8,000,000 $5,500,000

Monolith plans to increase sales of computers to 15,000 in the next year by reducing the unit price to $1,250. If Monolith wishes to achieve a unit target operating income of 10%, by what amount must it reduce the full cost per unit?

A. B. C. D.

$100 $125 $225 $250


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Answer (A) is incorrect because it equals the current full cost per unit minus the new unit target price. Answer (B) is incorrect because it is the unit target operating income. Answer (C) is correct. Unit target operating income is $125 (10% × $1,250 target price). Thus, the unit target full cost is $1,125 ($1,250 – $125). The current full cost per unit is $1,350 [($8,000,000 cost of goods sold + $5,500,000 operating costs excluding production) ÷ 10,000 units sold], so the necessary reduction in full cost per unit is $225 ($1,350 – $1,125). Answer (D) is incorrect because it is the change in unit price. [260] Gleim #: 2.98 -- Source: CIA 1194 IV-78 Market-based pricing involves

A. B. C. D.

Adding a standard markup to the cost of the product. Determining the price at which the product will earn a target profit. Basing prices on the product’s perceived value. Basing prices on competitors’ prices. Answer (A) is incorrect because adding a standard markup to the cost of the product is cost-plus pricing. Answer (B) is incorrect because determining the price at which the product will earn a target profit is target-profit pricing. Answer (C) is correct. Market-based pricing involves basing prices on the product’s perceived value rather than on the seller’s cost. Nonprice variables in the marketing mix augment the perceived value. For example, a cup of coffee may have a higher price at an expensive restaurant than at a fast food outlet. Answer (D) is incorrect because basing prices on competitors’ prices is going-rate pricing.

[261] Gleim #: 2.99 -- Source: CMA 1296 4-6 Several surveys point out that most managers use full product costs, including unit fixed costs and unit variable costs, in developing cost-based pricing. Which one of the following is least associated with cost-based pricing?

A. B. C. D.

Price stability. Price justification. Target pricing. Fixed-cost recovery. Answer (A) is incorrect because full-cost pricing promotes price stability. It limits the ability to cut prices. Answer (B) is incorrect because full-cost pricing provides evidence that the company is not violating antitrust laws against predatory pricing. Answer (C) is correct. A target price is the expected market price of a product, given the company’s knowledge of its customers and competitors. Hence, under target pricing, the sales price is known before the product is developed. Subtracting the unit target profit margin determines the long-term unit target cost. If cost-cutting measures do not permit the product to be made at or below the target cost, the product will be abandoned. Answer (D) is incorrect because full-cost pricing has the advantage of recovering the full long-term costs of the product. In the long term, all costs are relevant.

[262] Gleim #: 2.100 -- Source: Publisher Value engineering is


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A. B. C. D.

A policy of seeking continuous improvement in all phases of company activities. A method of determining prices based on a cost determination. An element of a marketing mix strategy. A systematic approach to assessing all aspects of cost buildup for a product. Answer (A) is incorrect because it refers to Kaizen. Answer (B) is incorrect because it refers to cost-plus pricing. Answer (C) is incorrect because value added engineering is not directly related to marketing mix strategies. Answer (D) is correct. Value engineering is a means of reaching targeted cost levels. It is a systematic approach to assessing all aspects of the value chain cost buildup for a product: R&D, design of products, design of processes, production, marketing, distribution, and customer service. The purpose is to minimize costs without sacrificing customer satisfaction.

[263] Gleim #: 2.101 -- Source: Publisher Sunshine Co. is a producer of citrus flavored dessert products. Its most popular product is its key lime pies, which are made with many fine ingredients, including egg yolks. Sunshine also sells the egg whites that are left over from its production process. These egg whites are sold at any price that is greater than the cost of storing and delivering them. The pricing of the egg whites is

A. B. C. D.

By-product pricing. Captive-product pricing. Product-bundle pricing. Value pricing. Answer (A) is correct. By-product pricing usually sets prices at any amount in excess of storing and delivering byproducts. Such prices allow the seller to reduce the costs and therefore the prices of the main products. Answer (B) is incorrect because captive-product pricing involves products that must be used with a main product. Answer (C) is incorrect because product-bundle pricing entails selling combinations of products at a price lower than the combined prices of individual items. Answer (D) is incorrect because value pricing entails redesigning products to improve quality without raising prices or offering the same quality at lower prices.

[264] Gleim #: 2.102 -- Source: Publisher Which of the following is a definition of predatory pricing?

A. B. C. D.

Pricing products below cost to destroy competitors. Pricing products at different prices for different customers. Conspiring to restrict output and set artificially high prices. Selling below cost in other countries. Answer (A) is correct. Predatory pricing is the practice of pricing products below cost to destroy competitors. The U.S. Supreme Court has held that a price is predatory if it is below an appropriate measure of costs and the seller has a reasonable prospect of recovering its losses in the future through higher prices or greater market share. Answer (B) is incorrect because it refers to price discrimination. Answer (C) is incorrect because it refers to collusive pricing. Answer (D) is incorrect because it refers to dumping.


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[265] Gleim #: 2.103 -- Source: Publisher Prices vary directly with capacity usage under

A. B. C. D.

Collusive pricing. Peak-load pricing. Market-based pricing. Cost-based pricing. Answer (A) is incorrect because it refers to the illegal practice of conspiring to restrict output and set artificially high prices. Answer (B) is correct. Under peak-load pricing, prices vary directly with capacity usage. Thus, when idle capacity is available, that is, when demand falls, the price of a product or service tends to be higher given a peak-load pricing approach. Answer (C) is incorrect because it involves basing prices on the product’s perceived value. Answer (D) is incorrect because it involves making a cost determination and setting a price that will recover costs and provide a return on investment.

[266] Gleim #: 2.104 -- Source: Publisher Which of the following is a false statement about cost-based pricing?

A. B. C. D.

A cost-based price should cover costs and provide the desired return on investment. A commonly used cost-plus pricing formula is to add a markup percentage to the total cost. Variable costs may not be used as the basis for costs. A cost-plus price equals the cost plus a markup. Answer (A) is incorrect because it is a true statement about cost-based pricing. Answer (B) is incorrect because it is a true statement about cost-based pricing. Answer (C) is correct. Cost-based pricing begins with a cost determination followed by setting a price that will recover the value chain costs and provide the desired return on investment. A cost-plus price equals the cost plus a markup. Cost may be defined in many ways. Most companies use either absorption manufacturing cost or total cost when calculating the price. Variable costs may be used as the basis for cost, but then fixed costs must be covered by the markup. Answer (D) is incorrect because it is a true statement about cost-based pricing.

[267] Gleim #: 2.105 -- Source: Publisher A company uses a target pricing and costing approach. The following is its costs and revenues for the current year:

Units sold Sales price per unit Cost of goods sold Operating costs excluding production

100,000 $10 $515,000 $335,000

The company intends to increase unit sales to 120,000 in the next year by reducing the unit price to $8. If the company is to achieve a unit target operating income of 15%, by what amount must it reduce the full cost per unit?


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A. B. C. D.

$0.50 $1.20 $1.50 $1.70 Answer (A) is incorrect because it equals the current full cost per unit minus the new unit target price. Answer (B) is incorrect because it is the unit target operating income. Answer (C) is incorrect because it is the change in unit price. Answer (D) is correct. Unit target operating income is $1.20 (15% × $8 target price). Thus, the unit target full cost is $6.80 ($8 – $1.20). The current full cost per unit is $8.50 [$515,000 cost of goods sold + $335,000 operating costs excluding production) ÷ 100,00 units sold], so the necessary reduction in full cost per unit is $1.70 ($8.50 – $6.80).

[268] Gleim #: 2.106 -- Source: Publisher A situation in which companies conspire to restrict output and set artificially high prices is known as:

A. B. C. D.

Collusive pricing. Predatory pricing. Price discrimination. Market-based pricing. Answer (A) is correct. Collusive pricing is illegal. It involves two or more competitors conspiring to restrict output and charge artificially high prices. Answer (B) is incorrect because predatory pricing occurs when a company sells products below cost to destroy competitors. Answer (C) is incorrect because price discrimination occurs when different prices are charged to different customers. Answer (D) is incorrect because market-based pricing bases prices on a product’s perceived value rather than on cost.

[269] Gleim #: 2.107 -- Source: CIA 595 IV-74 Which of the following pricing policies involves the selling company setting freight charges to customers at the actual average freight cost?

A. B. C. D.

Freight absorption pricing. Uniform delivered pricing. Zone pricing. FOB-origin pricing. Answer (A) is incorrect because, in freight absorption pricing, the selling company absorbs all or part of the actual freight charges. Customers are not charged actual delivery costs. Answer (B) is correct. In uniform delivered pricing, the company charges the same price, inclusive of shipping costs, to all customers regardless of their location. This price is the company’s average actual freight cost. Thus, both nearby and distant customers are charged the same amount. This policy is easy to administer, permits the company to advertise one price nationwide, and facilitates marketing to faraway customers. Answer (C) is incorrect because, in zone pricing, differential freight charges are set for customers on the basis of their location. Customers are not charged actual average freight costs. Answer (D) is incorrect because, in FOB-origin pricing, each customer pays its actual freight costs.


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[270] Gleim #: 2.108 -- Source: Publisher Setting the introductory price of a new product relatively high is

A. B. C. D.

Market-based pricing. Price skimming. Penetration pricing. Pricing by intermediaries. Answer (A) is incorrect because the price is based on buyer perceptions in market-based pricing, rather than simply being set at a high price. Answer (B) is correct. Price skimming is the practice of setting an introductory price relatively high to attract buyers who are not concerned about price and to recover research and development costs rather quickly. The opposite approach is to use penetration pricing, which involves setting a relatively low price to gain deep market penetration quickly. Answer (C) is incorrect because penetration pricing sets a relatively low price to gain deep market penetration quickly. Answer (D) is incorrect because pricing by intermediaries does not describe the setting of a high introductory price.

[271] Gleim #: 2.109 -- Source: Publisher Washboard Inc. charges customers the shipping costs incurred from Detroit to the destination regardless of the shipping point of origin. What is this pricing method commonly called?

A. B. C. D.

Discriminatory pricing. Zone pricing. Basing-point pricing. FOB-origin pricing. Answer (A) is incorrect because it is not discriminatory to charge everyone the same from the same point. Answer (B) is incorrect because zone pricing differs by region of the country to which a shipment is made. Answer (C) is correct. Basing-point pricing charges each customer the freight costs incurred from a specified city to the destination regardless of the actual point of origin of the shipment. Answer (D) is incorrect because FOB-origin pricing charges each customer its actual freight costs.

[272] Gleim #: 2.110 -- Source: Publisher A pricing strategy that sells combinations of products at a price lower than the combined prices of the individual items is

A. B. C. D.

Predatory pricing. Going-rate pricing. Product-bundle pricing. Captive-product pricing. Answer (A) is incorrect because predatory prices are prices set below cost to destroy competitors. Answer (B) is incorrect because this means charging the going rate in the market. Answer (C) is correct. Product-bundle pricing is a strategy to promote items consumers might not otherwise buy by selling combinations of products at a price lower than the prices of the individual items combined. Answer (D) is incorrect because captive-product pricing involves charging a low price for a main product (such as a razor), while razor blades are sold at a high markup. Once a person has a razor, he has to buy blades.


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[273] Gleim #: 2.111 -- Source: Publisher Which of the following statements is true with respect to value engineering? I. Value engineering is a means of reaching targeted cost levels. II. Value engineering is the Japanese concept that emphasizes continuous improvement in all phases of company activities through numerous minor changes. III. Value engineering requires distinguishing between cost incurrence and locked-in costs, with an emphasis on controlling costs at the design stage.

A. B. C. D.

Items I and II only. Items I and III only. Items II and III only. Items I, II, and III. Answer (A) is incorrect because the Japanese concept of continuous improvement is known as “Kaizen.” Answer (B) is correct. Value engineering is a means of reaching targeted cost levels. Value engineering requires distinguishing between cost incurrence and locked-in costs, with emphasis on controlling costs at the design stage. It is not Japanese. Answer (C) is incorrect because the Japanese concept of continuous improvement is known as “Kaizen.” Answer (D) is incorrect because the Japanese concept of continuous improvement is known as “Kaizen.”

[274] Gleim #: 2.112 -- Source: CIA 1195 IV-76 In which product-mix pricing strategy is it appropriate for the seller to accept any price that exceeds the storage and delivery costs for the product?

A. B. C. D.

By-product pricing. Optional-product pricing. Captive-product pricing. Product-bundle pricing. Answer (A) is correct. A by-product is a product of relatively minor importance generated during the production of one or more other products. Its production entails no additional costs. Any amount received above the storage and delivery costs for a by-product allows the seller to reduce the main product’s price to make it more competitive. Answer (B) is incorrect because optional products are offered for sale along with the main product. They are unlikely to have a zero production cost, so the seller must receive a price above their storage and delivery costs. Answer (C) is incorrect because captive products must be used along with the main product, such as film for use with a camera. Sellers often make their profits on the captive products rather than on the main product, which is sold at a low price. The captive products therefore will be priced well above the storage and delivery costs. Answer (D) is incorrect because product bundles are combinations of products sold together at a reduced price, such as season tickets for a theater. Products are bundled to promote the sale of certain items that consumers might not otherwise purchase. The combined price of the bundle must be low enough to encourage consumers to buy the bundle but must recover production costs and provide some profit for the seller, so the price must exceed storage and delivery costs.

[275] Gleim #: 2.113 -- Source: Publisher If a U.S. manufacturer’s price in the U.S. market is below an appropriate measure of costs and the seller has a reasonable prospect of recovering the resulting loss in the future through higher prices or a greater market share, the seller has engaged in


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A. B. C. D.

Collusive pricing. Dumping. Predatory pricing. Price discrimination. Answer (A) is incorrect because collusive pricing involves a conspiracy to set higher prices. Answer (B) is incorrect because dumping is defined under U.S. law as sale by a non-U.S. company in the U.S. market of a product below its market value in the country where it was produced. Such sale is illegal if it threatens material injury to a U.S. industry. Answer (C) is correct. Predatory pricing is intentionally pricing below cost to eliminate competition and reduce supply. Federal statutes and many state laws prohibit the practice. The U.S. Supreme Court has held that pricing is predatory when two conditions are met: (1) the seller’s price is below “an appropriate measure of its costs,” and (2) it has a reasonable prospect of recovering the resulting loss through higher prices or greater market share. Answer (D) is incorrect because price discrimination entails charging different prices to different customers for essentially the same product if the effect is to lessen competition substantially; to tend to create a monopoly; or to injure, destroy, or prevent competition.

[276] Gleim #: 2.114 -- Source: Publisher Flesher Furniture Company applies a target pricing and costing approach. The following information about costs and revenues of Flesher’s product are available for the year just ended: Unit sales Unit selling price Cost of goods sold Value-chain operating costs excluding production

60,000 $400 $13,200,000 $7,920,000

Flesher plans to increase unit sales to 80,000 by reducing the product’s unit price to $320. If Flesher desires a unit target operating income of 12%, by what amount must it reduce the full cost per unit?

A. B. C. D.

$32.00 $38.40 $70.40 $80.00 Answer (A) is incorrect because $32.00 equals the current full cost per unit minus the new unit target price. Answer (B) is incorrect because because $38.40 is the unit target operating income. Answer (C) is correct. Unit target operating income is $38.40 (12% × $320 unit target price). Hence, the unit target full cost is $281.60 ($320 – $38.40). The current full cost per unit is $352.00 [($13,200,000 CGS + $7,920,000 other value chain operating costs) ÷ 60,000 units sold], so the necessary reduction in the full cost per unit is $70.40 ($352.00 – $281.60). Answer (D) is incorrect because $80.00 equals the change in the unit price.


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[277] Gleim #: 2.115 -- Source: Publisher Labrador Hardware Co. has implemented the following discount policies: Customers may trade in older models of tools when buying the latest models. Customers purchasing with cash receive a 10% discount. Credit customers who pay their balances in full within 30 days receive a 5% discount. Customers who purchase supplies such as nails in bulk receive discounted prices. Labrador uses all of the following discount methods except

A. B. C. D.

Cash discounts. Quantity discounts. Allowances. Trade discounts. Answer (A) is incorrect because it is a discount offered by Labrador. Answer (B) is incorrect because it is a discount offered by Labrador. Answer (C) is incorrect because it is a discount offered by Labrador. Answer (D) is correct. Cash discounts encourage prompt payment, improve cash flows, and avoid bad debts. Quantity discounts encourage large volume purchases. Trade (functional) discounts are offered to other members of the marketing channel for performing certain services, such as selling. Seasonal discounts are offered for sales out of season. They help smooth production. Allowances such as trade-ins reduce list prices.

[278] Gleim #: 2.116 -- Source: Publisher Questions about which of the following can legally be asked in recruiting interviews?

A. B. C. D.

Age. Number of children. Kind of military discharge. Criminal record (but only for security clearance purposes). Answer (A) is incorrect because age may not be asked in a recruiting interview. Answer (B) is incorrect because number of children may not be asked in a recruiting interview. Answer (C) is incorrect because the kind of military discharge cannot be asked in a recruiting interview. Answer (D) is correct. In a recruiting interview, one may not ask about the applicant’s marital status, number of children, height and weight, criminal record (except for the purpose of giving a security clearance), kind of military discharge, or age.

[279] Gleim #: 2.117 -- Source: Publisher The halo effect may diminish the accuracy of the evaluation of employees. Which of the following is an example?

A. B. C. D.

A manager rates some employees as very good and some as very poor. A manager’s judgment of one positive trait affects his/her rating of other traits. The most recent behavior overshadows overall performance. All personnel who work together are rated within the same narrow range.


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Answer (A) is incorrect because this is not an example of the halo effect. Answer (B) is correct. The halo effect diminishes the accuracy of an evaluation when a manager’s judgment on one positive trait affects the rating of other traits. Answer (C) is incorrect because the recency effect is when the most recent behavior overshadows overall performance. Answer (D) is incorrect because the central tendency effect is when all personnel who work together are rated within the same narrow range. [280] Gleim #: 2.118 -- Source: Publisher Which of the following is not a characteristic of an effective evaluation system?

A. B. C. D.

Relevant. Significant. Unbiased. Highly structured. Answer (A) is incorrect because the evaluation system should be relevant. Answer (B) is incorrect because the evaluation system should be significant. Answer (C) is incorrect because the evaluation system should be unbiased. Answer (D) is correct. The system should be relevant, unbiased, significant, and practical. The evaluation system should be as objective, easy to use, clearly understood, and efficient as possible, but it is not necessary that it be highly structured.

[281] Gleim #: 2.119 -- Source: IIA, adapted An advantage of using bar codes rather than other means of identification of parts used by a manufacturer is that

A. B. C. D.

The movement of all parts is controlled. The movement of parts is easily and quickly recorded. Vendors can use the same part numbers. Vendors use the same identification methods. Answer (A) is incorrect because the movement of parts can escape being recorded with any identification method. Answer (B) is correct. A reason to use bar codes rather than other means of identification is to record the movement of parts with minimal labor costs. Answer (C) is incorrect because each vendor has its own part-numbering scheme, which is unlikely to correspond to the buyer’s scheme. Answer (D) is incorrect because each vendor has its own identification method, although vendors in the same industry often cooperate to minimize the number of bar-code systems that they use.

[282] Gleim #: 2.120 -- Source: IIA, adapted An appropriate technique for planning and controlling manufacturing inventories, such as raw materials, components, and subassemblies, whose demand depends on the level of production is

A. B. C. D.

Materials requirements planning. Regression analysis. Capital budgeting. Linear programming.


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Answer (A) is correct. Materials requirements planning (MRP) is an integrated computer-based system designed to plan an control dependent-demand manufacturing inventories. It assumes the forecasted demand for materials is typically dependent upon some other factor, which can be programmed into the computer. Answer (B) is incorrect because regression analysis is a statistical procedure for estimating the relation between variables. Answer (C) is incorrect because capital budgeting is used for analyzing and evaluating long-term capital investments. Answer (D) is incorrect because linear programming is a mathematical technique for maximizing or minimizing a given objective subject to certain constraints. [283] Gleim #: 2.121 -- Source: IIA, adapted If a just-in-time purchasing policy is successful in reducing the total inventory costs of a manufacturing company, which of the following combinations of cost changes would be most likely to occur?

A. B. C. D.

An increase in purchasing costs and a decrease in stockout costs. An increase in purchasing costs and a decrease in quality costs. An increase in quality costs and a decrease in ordering costs. An increase in stockout costs and a decrease in carrying costs. Answer (A) is incorrect because the supplier may ask for a concession in its selling price, which would raise the manufacturer’s purchasing costs. However, the manufacturing company will be receiving fewer materials at any point in time, increasing the likelihood of stockout and thereby resulting in an increase in stockout costs. Answer (B) is incorrect because the supplier may ask for a concession in its selling price, which would raise the manufacturer’s purchasing costs. However, the cost of quality would not necessarily be affected by the just-in-time purchasing system. Answer (C) is incorrect because with fewer purchase orders being processed by the manufacturer, the ordering costs are likely to decrease. However, the cost of quality would not necessarily be affected by the just-in-time purchasing system. Answer (D) is correct. In this situation, the company will be receiving fewer materials at any point in time, increasing the likelihood of stockout and thereby resulting in an increase in a reduction in the carrying cost. At the same time, the average inventory will be less, resulting in a reduction in the carrying cost.

[284] Gleim #: 2.122 -- Source: IIA, adapted In an economic order quantity (EOQ) model, both the costs per order and the holding costs are estimates. If those estimates are varied to determine how much the changes affect the optimal EOQ, such an analysis would be called a

A. B. C. D.

Forecasting model. Sensitivity analysis. Critical path method analysis. Decision analysis. Answer (A) is incorrect because forecasting models involve projecting data over time or developing regression models when time series data are not available. Answer (B) is correct. An economic order quantity (EOQ) sensitivity analysis involves varying the holding costs per unit and/or the order costs to determine how much the changes affect the optimal EOQ. Answer (C) is incorrect because critical path method involves project scheduling. Answer (D) is incorrect because decision analysis involves selecting the best option from alternatives.

[285] Gleim #: 2.123 -- Source: IIA, adapted When film is sold for use with a camera, this is an example of which of the following product mix pricing strategies?


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A. B. C. D.

By-product pricing. Optional product pricing. Captive product pricing. Product bundle pricing. Answer (A) is incorrect because there are no additional costs incurred other than storage and delivery for the development of this product. Therefore, the manufacturer will make a profit on any price over the cost of storage and delivery. Answer (B) is incorrect because optional products are those offered for sale along with the main product. They are unlikely to have zero production cost so the seller must receive a price above the storage and delivery costs for such products. Answer (C) is correct. Captive products are those that must be used along with the main product. Sellers often make their money on the captive products, rather than on the main product that is sold at a low price. The captive products will therefore be priced well above the storage and delivery costs. Answer (D) is incorrect because product bundles are combinations of products sold together at a reduced price, such as season tickets for a theater. Products are bundled in order to promote the sale of certain items that consumers might not otherwise purchase. The combined price of the bundle must be low enough to encourage consumers to buy the bundle, but must recover production costs and provide some profit for the seller. The price must exceed storage and delivery costs.

[286] Gleim #: 2.124 -- Source: IIA, adapted A competitive marketing strategy in which a firm specializes in serving customers overlooked or ignored by major competitors is called a

A. B. C. D.

Market leader strategy. Market challenger strategy. Market follower strategy. Market niche strategy. Answer (A) is incorrect because market leader strategies are employed by the major competitors that dominate a market. Answer (B) is incorrect because market challenger strategies are followed by runner-up companies that aggressively attack competitors to get more market share. Answer (C) is incorrect because market follower strategies are used by runner-up companies that follow competitor’s product offers, pricing, and market programs. Answer (D) is correct. Specializing in serving customers overlooked or ignored by major competitors is a market niche strategy. This strategy specializes along market, customer, product, or marketing mix lines.

[287] Gleim #: 2.125 -- Source: IIA, adapted Which of the following hiring procedures provides the most control over the accuracy of information submitted on an employment application?

A. Applicants are required to submit unofficial copies of their transcripts along with the application as verification of their educational credentials. B. The hiring organization calls the last place of employment for each finalist to verify the employment length and position held. C. Letters of recommendation which attest to the applicant’s character must be mailed directly to the hiring organization rather than being submitted by the applicant. D. Applicants are required to sign that the information on the applicant is true and correct as a confirmation of the truth of the information in the application.


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Answer (A) is incorrect because the applicant is providing the transcript, leading to a loss of independence. In addition, the transcript is unofficial, making it very easy to change the information and send a photocopy of the altered transcript. Answer (B) is correct. Calling the last place of employment for candidates to verify information represents an independent verification of employment since the hiring organization is performing the verification process. Answer (C) is incorrect because there is nothing to prevent the applicants from writing the letters themselves, putting fraudulent return address information on the letters, and mailing them. Answer (D) is incorrect because if an applicant is going to lie about information, there is no reason to believe that the applicant will not sign the applicant’s own name to the fraudulent information. This is not an independent verification. [288] Gleim #: 2.126 -- Source: CIA 590 IV-51 With regard to inventory management, an increase in the frequency of ordering will normally

A. B. C. D.

Reduce the total ordering costs. Have no impact on total ordering costs. Reduce total carrying costs. Have no impact on total carrying costs. Answer (A) is incorrect because total ordering costs will increase. Answer (B) is incorrect because total ordering costs will increase. Answer (C) is correct. Inventory carrying costs can sometimes be transferred to suppliers. If a seller has good enough control of demand schedules to know exactly when goods are needed, orders can be placed so that goods arrive no earlier than when actually needed. This practice relies on a supplier who is willing to take the responsibility for storing the needed inventory and shipping it to arrive on time. Suppliers are more willing to provide this type of service when they have many competitors. Answer (D) is incorrect because total carrying costs are reduced.

[289] Gleim #: 2.127 -- Source: CIA 594 IV-37 An entity sells 1,500 units of a particular item each year and orders the items in equal quantities of 500 units at a price of 5 per unit. No safety stocks are held. If the entity has a cost of capital of 12%, its annual cost of carrying inventory is

A. B. C. D.

150 180 300 900 Answer (A) is correct. The annual cost of carrying inventory equals the average inventory level times the cost per unit of inventory times the cost of capital. The average inventory level is the order quantity divided by 2. Thus, the annual cost of carrying inventory is 150 [(500 ÷ 2) × 5 × .12]. Answer (B) is incorrect because 180 is obtained by using the total annual quantity rather than the average inventory level and by not multiplying by the unit price. Answer (C) is incorrect because 300 is obtained by using the order size rather than the average inventory level. Answer (D) is incorrect because 900 is based on the total annual quantity rather than the average inventory level.

[290] Gleim #: 2.128 -- Source: CIA 596 I-4 A perpetual inventory system uses a minimum quantity on hand to initiate purchase ordering procedures for restocking. In reviewing the appropriateness of the minimum quantity level established by the stores department, the internal auditor is least likely to consider


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A. B. C. D.

Stockout costs, including lost customers. Seasonal variations in forecasting inventory demand. Optimal order sizes determined by the economic order quantities model. Available storage space and potential obsolescence. Answer (A) is incorrect because stockout costs are directly affected by the quantity on hand. Answer (B) is incorrect because seasonal variations in demand directly affect the minimum quantity available. Answer (C) is correct. The basic economic order quantity (EOQ) model is based on the following variables: demand, variable cost per purchase order, and variable unit carrying cost. Thus, minimum stocking levels do not affect the EOQ. Answer (D) is incorrect because storage space and potential obsolescence directly affect stocking levels.

[291] Gleim #: 3.1 -- Source: CIA 597 IV-1 The measurement basis most often used to report a long-term payable representing a commitment to pay money at a determinable future date is

A. B. C. D.

Historical cost. Current cost. Net realizable value. Present value of future cash flows. Answer (A) is incorrect because historical cost is used to measure property, plant, and equipment and most inventories. Answer (B) is incorrect because some inventories are measured at current (replacement) cost. Answer (C) is incorrect because short-term receivables and some inventories are reported at net realizable value. Answer (D) is correct. The measurement basis most commonly adopted by entities in preparing their financial statements is historical cost. However, it is usually combined with other measurement bases (attributes). The attribute used to measure a long-term receivable or payable is the present or discounted value of its future cash flows.

[292] Gleim #: 3.2 -- Source: CIA 593 IV-25 In December year 1, catalogs were printed for use in a special promotion in January year 2. The catalogs were delivered by the printer on December 13, year 1, with an invoice for 70,000 attached. Payment was made in January year 2. The 70,000 should be reported as a deferred cost at the December 31, year 1 balance sheet date because of the

A. B. C. D.

Matching principle. Revenue recognition principle. Reliability principle. Cost principle. Answer (A) is correct. Matching is the simultaneous or combined recognition of revenues and expenses resulting directly and jointly from the same transactions or other events. Expenses should be associated with the revenues that they help to create. Because the catalogs are still on hand at the balance sheet date, they will not contribute to an inflow of economic benefits until the next period. Hence, the cost should be deferred and matched with the revenues of the following period. Answer (B) is incorrect because the revenue recognition principle determines the period in which revenue is recognized. Answer (C) is incorrect because reliable information is free of error and bias and is representationally faithful. Answer (D) is incorrect because the cost principle states that cost is the usual basis for recording most assets and liabilities.


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[293] Gleim #: 3.3 -- Source: CIA 1192 IV-37 Because of inexact estimates of the service life and the residual value of a plant asset, a fully depreciated asset was sold in the current year at a material gain. This gain most likely should be reported

A. B. C. D.

In the other revenues and gains section of the current income statement. As part of sales revenue on the current income statement. In the extraordinary item section of the current income statement. As an adjustment to prior periods’ depreciation on the statement of changes in equity. Answer (A) is correct. Income includes revenue and gains. Their essential nature is the same, and they are not treated as separate financial statement elements. Revenues occur in the course of ordinary activities. Gains may or may not occur in the course of ordinary activities. For example, gains may occur from the sale of noncurrent assets. Thus, the gain on the sale of a plant asset is not an operating item and should be classified in an income statement with separate operating and nonoperating sections in the other revenues and gains section. Answer (B) is incorrect because the asset sold was not stock in trade. Answer (C) is incorrect because extraordinary items are not reported in the financial statements or notes. Answer (D) is incorrect because the transaction is not the correction of an error in the financial statements of a prior period.

[294] Gleim #: 3.4 -- Source: CIA 595 IV-29 Assume that employees confessed to a 500,000 inventory theft but are not able to make restitution. How should this material fraud be shown in the company’s financial statements?

A. Classified as a loss and shown as a separate line item in the income statement. B. Initially classified as an accounts receivable because the employees are responsible for the goods. Because they cannot pay, the loss would be recognized as a write-off of accounts receivable. C. Included in cost of goods sold because the goods are not on hand, losses on inventory shrinkage are ordinary, and it would cause the least amount of attention. D. Recorded directly to retained earnings because it is not an income-producing item. Answer (A) is correct. Expenses include losses. Their essential nature is the same, and they are not treated as separate financial statement elements. Losses may or may not occur in the course of ordinary activities. For example, they may result from nonreciprocal transactions (e.g., theft), reciprocal transactions (e.g., a sale of plant assets), or from holding assets or liabilities. Losses are typically displayed separately. Answer (B) is incorrect because no restitution will be made. Thus, recording the item as a receivable, then writing it off, is not consistent with the substance of the event. Answer (C) is incorrect because, although some inventory shrinkage is expected in the normal course of processing, fraud is abnormal. Hence, the item should be recorded as a loss. Answer (D) is incorrect because losses are included in the determination of net profit or loss. [295] Gleim #: 3.5 -- Source: CIA 591 IV-44 The assets of a liquidating entity should be shown on the balance sheet at their

A. B. C. D.

Undepreciated historical cost. Fair market value. Realizable value. Current cost.


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Answer (A) is incorrect because a going concern should report assets at their undepreciated historical cost. When liquidation appears imminent, historical cost is inappropriate for balance sheet reporting. Answer (B) is incorrect because an entity facing liquidation is expected to dispose of its assets in a “forced” or “distressed” sale and is unlikely to realize the fair value amount. The net realizable value of the assets is the appropriate amount for reporting purposes. Answer (C) is correct. When liquidation is imminent, and the going concern assumption is no longer valid, the most appropriate valuation method for assets is realizable value, which is the amount of cash currently obtainable by sale in an orderly disposal. Answer (D) is incorrect because current cost is only appropriate when the going concern assumption is applicable and the effects of changing prices are to be measured and reported in the financial statements. [296] Gleim #: 3.6 -- Source: CIA 1190 IV-27 An objective of financial reporting is

A. B. C. D.

Providing information useful to investors, creditors, donors, and other users for decision making. Assessing the adequacy of internal control. Evaluating management results compared with standards. Providing information on compliance with established procedures. Answer (A) is correct. The objectives of financial reporting are concerned with the underlying goals and purposes of accounting. They are to provide information that (1) is useful to those making investment and credit decisions, assuming that those individuals have a reasonable understanding of business and economic activities; (2) is helpful to current and potential investors and creditors and other users in assessing the amount, timing, and uncertainty of future cash flows; and (3) discloses economic resources, claims to those resources, and the changes therein. Answer (B) is incorrect because assessing the adequacy of internal control is a function of internal auditing, not financial reporting. Answer (C) is incorrect because evaluating management results compared with standards is a function of internal auditing, not financial reporting. Answer (D) is incorrect because providing information on compliance with established procedures is a function of internal auditing, not financial reporting.

[297] Gleim #: 3.7 -- Source: CIA 592 IV-29 An entity with total assets of 100,000,000 and net profit of 9,000,000 purchases staplers with an estimated life of 10 years for 1,000. In connection with the purchase, the company debits miscellaneous expense. This scenario is most closely associated with which of the following concepts or principles?

A. B. C. D.

Materiality and going concern. Relevance and neutrality. Reliability and comparability. Materiality and the balance between cost and benefit.


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Answer (A) is incorrect because the going-concern principle relates to circumstances in which there is doubt as to the viability of the enterprise. Answer (B) is incorrect because relevance and reliability are two of the principal qualitative characteristics of information in financial statements. Information is relevant if it permits users to predict the outcome of future events or confirm or correct their prior expectations. Reliability provides assurance that the information is reasonably free from error and bias and represents what it purports to represent. Thus, reliable information must be neutral, that is, free from error and bias. Answer (C) is incorrect because comparability is a principal qualitative characteristic. Financial statements must be comparable for the same entity over time and also among different entities. Information is relevant if it permits users to predict the outcome of future events or confirm or correct their prior expectations. Answer (D) is correct. In principle, wasting assets should be capitalized and depreciated. However, the effect on the financial statements of expensing rather than capitalizing and depreciating the staplers is clearly not material given that they cost 1,000 and the enterprise has total assets of 100,000,000. The choice of treatment is not likely to influence the decisions of financial statement users. The balance between benefit and cost is a pervasive constraint, not a qualitative characteristic. The benefits should exceed the cost of information. Specifically, the cost of producing the information about depreciation expense over 10 years for the staplers probably is higher than the benefits of the information for decision making. Thus, the expedient procedure of expensing the 1,000 should be followed. [298] Gleim #: 3.8 -- Source: CIA 1191 IV-29 To comply with the matching principle, the cost of labor services of an employee who participates in the manufacturing of a product normally should be charged to the income statement in the period in which the

A. B. C. D.

Work is performed. Employee is paid. Product is completed. Product is sold. Answer (A) is incorrect because direct labor cost is a product (inventoriable) cost that is normally not recognized until sale. Answer (B) is incorrect because direct labor cost is a product (inventoriable) cost that is normally not recognized until sale. Answer (C) is incorrect because direct labor cost is a product (inventoriable) cost that is normally not recognized until sale. Answer (D) is correct. Recognition of expenses occurs concurrently with recognition of increases in liabilities or decreases in assets. Expenses are recognized if the costs are directly associated with the earning of particular income items. This process is often called matching. Matching is simultaneous or combined recognition of the revenues and expenses that result directly and jointly from the same transactions or other events. This direct relationship is exemplified by the sale of a product. This transaction results in revenue (sales revenue) for receipt of cash or a receivable, the recognition of an expense (cost of sales) for the sacrifice of the product to a customer, and a decrease in inventory. The direct labor cost of manufacturing the product is absorbed by the finished goods inventory and is not recognized until sale.

[299] Gleim #: 3.9 -- Source: CIA 1192 IV-38 In recording transactions, which of the following best describes the relation between expenses and losses?

A. B. C. D.

Losses are extraordinary charges to income, whereas expenses are ordinary charges to income. Losses are material items, whereas expenses are immaterial items. Losses are expenses that may or may not arise in the course of ordinary activities. Expenses can always be prevented, whereas losses can never be prevented.


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Answer (A) is incorrect because not all losses are extraordinary items. They are not reported in the financial statements or notes. Answer (B) is incorrect because losses may be immaterial, and most expenses are material. Answer (C) is correct. Expenses are defined as “decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.” Expenses include losses. Thus, losses are not treated as separate elements. Expenses include items arising in the course of ordinary activities. Losses meet the definition of expenses but may or may not occur in the course of ordinary activities. For example, losses may result from the sale of noncurrent assets or from natural disasters. Answer (D) is incorrect because some expenses cannot be prevented, or at least not in the short run. Some losses can be prevented. [300] Gleim #: 3.10 -- Source: CIA 597 IV-12 A service enterprise keeps its accounting records on a cash basis. During the recent year, the enterprise collected $600,000 from customers. The following information is also available:

Accounts receivable Unearned revenue

Beginning of Year

End of Year

$120,000 0

$180,000 15,000

What was the amount of service revenue for the year on an accrual basis?

A. B. C. D.

$525,000 $555,000 $645,000 $675,000 Answer (A) is incorrect because $525,000 deducts rather than adds the $60,000 increase in receivables. Answer (B) is incorrect because $555,000 deducts the increase in receivables and adds the increase in unearned revenue. Answer (C) is correct. The amount of service revenue for the year on an accrual basis equals $645,000 ($600,000 cash collected – $15,000 unearned revenue + $60,000 increase in accounts receivable). Answer (D) is incorrect because $675,000 adds the $15,000 increase in unearned revenue.

[301] Gleim #: 3.11 -- Source: CIA 1195 IV-3 The correct order of the following steps of the accounting cycle is

A. B. C. D.

Posting, closing, adjusting, reversing. Posting, adjusting, closing, reversing. Posting, reversing, adjusting, closing. Adjusting, posting, closing, reversing.


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Answer (A) is incorrect because adjusting entries are made prior to closing. Answer (B) is correct. The order of the steps in the accounting cycle is identification and measurement of transactions and other events required to be recognized, journalization, posting from the journals to the ledgers, the development of a trial balance, adjustments to produce an adjusted trial balance, statement presentation, closing, taking a postclosing trial balance (optional), and making reversing entries (optional). Answer (C) is incorrect because reversing entries are made after adjustments and closing entries. Answer (D) is incorrect because posting is done prior to adjusting. [302] Gleim #: 3.12 -- Source: CIA 596 IV-5 An entity has made all necessary adjusting entries and is now closing its accounts for the period. Dividends of 30,000 were declared and distributed during the year. The entry to close the dividends account would be

A. Retained earnings Dividends B. Dividends Retained earnings C. Income summary Dividends D. Dividends Income summary

30,000 30,000 30,000 30,000 30,000 30,000 30,000 30,000

Answer (A) is correct. Assuming an account entitled “dividends” or “dividends declared” is debited when dividends payable is credited on the declaration date, it must be closed at the end of the period. The balance in this account is closed directly to retained earnings. The effect of declaring and paying dividends is to reduce retained earnings, so the entry is a debit to retained earnings and a credit to dividends. Answer (B) is incorrect because the closing entry should credit dividends and debit retained earnings. Answer (C) is incorrect because dividends is closed directly to retained earnings. Answer (D) is incorrect because dividends is closed directly to retained earnings by a credit. [Fact Pattern #17]

An enterprise is in the equipment rental business. Part of its unadjusted trial balance at December 31 is as follows: Cash Prepaid insurance Property, plant, and equipment Accumulated depreciation Accounts payable Share capital Retained earnings Rental revenue Salaries and wages expense Utilities expense

17,400 3,600 180,000 32,000 12,000 60,000 38,000 171,000 80,000 14,000

On October 1, 20X4, the enterprise paid 18,000 to renew its only insurance policy for a 3-year period beginning on that date. This transaction has not been recorded. Salaries and wages of 1,700 have been incurred but not paid as of December 31, 20X4. At December 31, 20X4, the balance per bank statement was 12,000. Outstanding checks amounted to 6,900. Interest of 40 was credited to the enterprise’s account by the bank during December, but has not yet been entered on the books.


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[303] Gleim #: 3.13 -- Source: CIA 597 IV-4 (Refers to Fact Pattern #17) What amounts should be reported for prepaid insurance and insurance expense in the annual financial statements prepared at December 31?

Prepaid Insurance

Insurance Expense

A. B.

16,500 16,500

1,500 5,100

C. D.

18,000 20,100

3,600 1,500

Answer (A) is incorrect because the existing balance in the prepaid insurance account should be expensed. Answer (B) is correct. The insurance policy in effect at the beginning of the year expired and was renewed during the year. Hence, the entire 3,600 beginning balance in the prepaid insurance account should be expensed. The amount of the prepayment on the new policy to be expensed is 1,500 [3 months elapsed × (18,000 ÷ 36-month duration of the policy)]. The debit balance in prepaid insurance at year-end is therefore 16,500 (18,000 – 1,500), and total insurance expense is 5,100 (3,600 + 1,500). Answer (C) is incorrect because insurance expense should be recognized for the last 3 months of the year. Answer (D) is incorrect because prepaid insurance should be credited and insurance expense debited for 3,600. [304] Gleim #: 3.14 -- Source: CIA 597 IV-5 (Refers to Fact Pattern #17) The required adjusting entry at December 31 related to salaries and wages is

A. Salaries & wages expense Income summary B. Salaries & wages payable Salaries & wages expense C. Salaries & wages expense Salaries & wages payable D. Income summary Salaries & wages payable

1,700 1,700 1,700 1,700 1,700 1,700 1,700 1,700

Answer (A) is incorrect because the income summary account is used for closing entries, not adjusting entries. Answer (B) is incorrect because the entry shown is a reversing entry that could be made at the beginning of the subsequent period. Answer (C) is correct. An expense incurred but not yet paid is an accrued expense. The adjusting entry to record an accrued expense of 1,700 for unpaid salaries and wages is to debit an expense account and credit a liability account. Answer (D) is incorrect because the debit should be to an expense account. [305] Gleim #: 3.15 -- Source: CIA 597 IV-6 (Refers to Fact Pattern #17) The journal entry required to close the utilities expense account is


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A. Utilities expense Income summary B. Income summary Utilities expense C. Rental revenue Utilities expense D. Utilities expense Retained earnings

14,000 14,000 14,000 14,000 14,000 14,000 14,000 14,000

Answer (A) is incorrect because an expense account should be credited in a closing entry, and the income summary account should be debited. Answer (B) is correct. All income statement account balances are closed either to a summary account (such as income summary or revenue and expense summary) or to retained earnings. The normal balance of an expense account is a debit; therefore, an expense account is credited in a closing entry. Answer (C) is incorrect because an expense account should not be closed to a revenue account. Such offsetting is not good practice. Answer (D) is incorrect because an expense account should be credited in a closing entry. [306] Gleim #: 3.16 -- Source: CIA 1195 IV-4 Which of the following statements is the best description of reversing entries?

A. B. C. D.

The recording of reversing entries is a mandatory step in the accounting cycle. Reversing entries are made at the end of the next accounting period, after recording regular transactions of the period. Reversing entries are identical to the adjusting entries made in the previous period. Reversing entries are the exact opposite of the adjustments made in the previous period. Answer (A) is incorrect because reversing entries are optional. Answer (B) is incorrect because reversing entries are made at the beginning of the next accounting period. Answer (C) is incorrect because reversing entries are the exact opposite of the adjustments made in the previous period. Answer (D) is correct. Reversing entries are made at the beginning of a period to reverse the effects of adjusting entries made at the end of the preceding period. They are optional entries made for the sake of convenience in recording the transactions of the period. In order for reversing entries to reverse the prior adjustments, they must be the exact opposite of the adjustments made in the previous period.

[307] Gleim #: 3.17 -- Source: CIA 1195 IV-27 The practice of recording advance payments from customers as a liability is an example of applying the

A. B. C. D.

Going concern assumption. Monetary unit assumption. Historical cost principle. Revenue recognition principle.


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Answer (A) is incorrect because the going concern assumption is that the business will have an indefinite life. Answer (B) is incorrect because the monetary unit assumption is that money is the common denominator by which economic activity is conducted and that the monetary unit provides an appropriate basis for accounting measurement and analysis. Answer (C) is incorrect because the historical cost principle reflects the practice that many assets and liabilities are accounted for and reported on the basis of acquisition price. Answer (D) is correct. Recognition of revenue occurs when the flow of future economic benefits to the enterprise is probable and such benefits are reliably measurable. Recording advance payments as a liability reflects a determination that the receipt of future economic benefits is not sufficiently certain to merit revenue recognition, given that the enterprise has not yet performed its obligations. [308] Gleim #: 3.18 -- Source: CIA 1194 IV-24 An entity sells a durable good to a customer on January 1, 20X3, and the customer is automatically given a 1-year warranty. The customer also buys an extended warranty package, extending the coverage for an additional 2 years to the end of 20X5. At the time of the original sale, the company expects warranty costs to be incurred evenly over the life of the warranty contracts. The customer has only one warranty claim during the 3-year period, and the claim occurs during 20X4. The company will recognize income from the sale of the extended warranty

A. B. C. D.

On January 1, 20X3. In years 20X4 and 20X5. At the time of the claim in 20X4. December 31, 20X5, when the warranty expires. Answer (A) is incorrect because the recognition of income from the sale of the extended warranty is deferred until the extended warranty period begins. Answer (B) is correct. Because warranty costs are expected to be incurred evenly over the life of the warranty contracts, the income should be recognized on the straight-line basis over the life of the extended warranty contract. Answer (C) is incorrect because the income should be recognized evenly over the life of the contract. It is not related to the timing of the claims. Answer (D) is incorrect because income is recognized over the life of the warranty, not at expiration.

[309] Gleim #: 3.19 -- Source: CIA 596 IV-4 An entity had cash receipts from sales of 175,000 during 20X4, of which 30,000 was unearned at the end of 20X4. At the end of 20X3, the company had 40,000 of unearned revenue, all of which was earned in 20X4. The company’s sales revenue for 20X4 would be

A. B. C. D.

145,000 165,000 175,000 185,000 Answer (A) is incorrect because 145,000 equals 20X4 revenue from 20X4 sales. Answer (B) is incorrect because 165,000 adds, rather than subtracts, the 20X4 unearned revenue and subtracts, rather than adds, the 20X3 receipts for which revenue was earned in 20X4. Answer (C) is incorrect because 175,000 equals the cash receipts for 20X4. Answer (D) is correct. The sales revenue earned in 20X4 equals 20X4 cash receipts, minus any receipts in 20X4 for which the revenue has not yet been earned, plus the revenue earned from cash receipts in 20X3, or 185,000 (175,000 – 30,000 + 40,000).


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[310] Gleim #: 3.20 -- Source: CIA 590 IV-26 ABC operates a catering service that specializes in business luncheons for large corporations. ABC requires customers to place their orders 2 weeks in advance of the scheduled events. ABC bills its customers on the tenth day of the month following the date of service and requires that payment be made within 30 days of the billing date. Conceptually, ABC should recognize revenue from its catering services at the date when a

A. B. C. D.

Customer places an order. Luncheon is served. Billing is mailed. Customer’s payment is received. Answer (A) is incorrect because the certainty and measurability criteria are not met when the customer places an order. Answer (B) is correct. Income, which includes revenue and gains, should not be recognized until an increase in future economic benefits related to an increase in an asset or a decrease in a liability is sufficiently certain and can be measured reliably. The most common time at which these two conditions are met is when the product or merchandise is delivered or services are rendered to customers. Thus, the entity has substantially accomplished what it must do to be entitled to future economic benefits when it serves the luncheon. It should then accrue a receivable and revenue. Answer (C) is incorrect because the date for billing is a matter of administrative procedure and convenience. The revenue should be recognized at the date the service was performed. Answer (D) is incorrect because the revenue should be recognized at the point of performance of the service. To wait until the receivable is collected is to ignore the accrual basis of accounting, which is identified in the Framework for the Preparation and Presentation of Financial Statements as an underlying assumption of financial accounting.

[311] Gleim #: 3.21 -- Source: CIA 595 IV-11 If sales are accounted for using the installment method, which of the following is(are) only recognized in proportion to the cash collected on the sales during the period?

A. B. C. D.

Sales. Sales and cost of sales. Sales and cost of sales and selling expenses. Sales and cost of sales and administrative expenses. Answer (A) is incorrect because sales and cost of sales are recognized in proportion to cash collections. Answer (B) is correct. Under the installment method, the gross profit on sales (sales – cost of sales) is not recognized until cash is collected. The proportion of cash collected on the sales during the accounting period determines the proportion of the gross profit on those sales that is recognized during the period. Hence, both sales and cost of sales are deferred. Answer (C) is incorrect because only the gross profit is deferred on sales for which cash has not yet been collected. Answer (D) is incorrect because only the gross profit is deferred on sales for which cash has not yet been collected.

[312] Gleim #: 3.22 -- Source: CIA 597 IV-10 Using the cost-recovery method of revenue recognition, profit on an installment sale is recognized

A. B. C. D.

On the date of the installment sale. In proportion to the cash collections. After cash collections equal to the cost of goods sold have been received. On the date the final cash collection is received.


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Answer (A) is incorrect because the accrual basis recognizes revenue on the date of the installment sale. Answer (B) is incorrect because the installment basis recognizes revenue in proportion to the cash collections. Answer (C) is correct. Under the cost-recovery method, no revenue is recognized until cash payments by the buyer exceed the seller’s cost of the merchandise sold. This method is appropriate when collection of the revenue is very uncertain. Answer (D) is incorrect because, after the cash collections equal the cost of sales, revenue is to be recognized for any further collections. [313] Gleim #: 3.23 -- Source: CIA 1190 IV-28 On February 1, year 1 a computer software firm agrees to program a software package. Twelve payments of 10,000 on the first of each month are to be made, with the first payment March 1, year 1. The software is accepted by the client June 1, year 2. How much year 1 revenue should be recognized?

A. B. C. D.

0 100,000 110,000 120,000 Answer (A) is correct. Recognition of an element of financial statements (e.g., income, which includes revenue and gains) requires that two criteria be met. It must be probable that any future economic benefit associated with the item will flow to or from the entity, and the cost or value of the item must be measurable with reliability. The usual procedures for income recognition, e.g., that income be earned, reflect these criteria. Thus, income is recognized when an increase in future economic benefits is associated with an increase in an asset or a decrease in a liability. However, the entity has not substantially completed what it must do to be entitled to the benefits represented by the advance payment, and the receipt of future economic benefits is not sufficiently certain to merit income recognition. Accordingly, a liability should be recognized because the entity has a current obligation arising from a past event that will require an outflow of economic benefits, that is, to deliver the software or to refund the customer’s money. Thus, a liability for 100,000 and revenue of 0 should be recognized for year 1. NOTE: This analysis assumes that the sale of the software is a sale either of goods or of services for which the appropriate conditions have not been met. Under IAS 18, Revenue Recognition, revenue is recognized for a sale of goods when the entity has transferred the significant risks and rewards of ownership, the entity has neither continuing managerial involvement to an extent associated with ownership nor effective control over the goods, the amount can be reliably measured, it is probable that the economic benefits will flow to the entity, and transaction costs can be reliably measured. For a sale of services, revenue is recognized when revenue can be reliably measured, it is probable that the economic benefits will flow to the entity, the stage of completion can be reliably measured, and the costs incurred and the costs to complete can be reliably measured. Answer (B) is incorrect because income, which includes revenue and gains, should not be recognized until an increase in future economic benefits related to an increase in an asset or a decrease in a liability is sufficiently certain and can be measured reliably. Answer (C) is incorrect because income, which includes revenue and gains, should not be recognized until an increase in future economic benefits related to an increase in an asset or a decrease in a liability is sufficiently certain and can be measured reliably. Answer (D) is incorrect because income, which includes revenue and gains, should not be recognized until an increase in future economic benefits related to an increase in an asset or a decrease in a liability is sufficiently certain and can be measured reliably.

[314] Gleim #: 3.24 -- Source: CIA 1193 IV-28 A building contractor has a fixed-price contract to construct a large building. It is estimated that the building will take 2 years to complete. Progress billings will be sent to the customer at quarterly intervals. Which of the following describes the preferable point for revenue recognition for this contract if the outcome of the contract can be estimated reliably?


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A. B. C. D.

After the contract is signed. As progress is made toward completion of the contract. As cash is received. When the contract is completed. Answer (A) is incorrect because revenue is not recognized until progress has been made toward completion. Answer (B) is correct. Under the percentage-of-completion method, revenues and expenses are recognized based on the stage of completion at the balance sheet date if the outcome of the contract can be estimated reliably. For a fixed-price contract, the outcome can be estimated reliably if (1) total revenue can be measured reliably, (2) it is probable that the economic benefits of the contract will flow to the enterprise, (3) contract costs to complete and stage of completion can be measured reliably, and (4) contract costs can be clearly identified and measured reliably so that actual and estimated costs can be compared. Answer (C) is incorrect because the cash basis is inappropriate. An accrual method, that is, the percentage-of-completion method, should be used. Answer (D) is incorrect because the completed-contract method is not a permissible method.

[315] Gleim #: 3.25 -- Source: CIA 590 IV-32 The major distinction between the multiple-step and single-step income statement formats is the separation of

A. B. C. D.

Operating and nonoperating data. Income tax expense and administrative expenses. Cost of goods sold expense and administrative expenses. The effect on income taxes of extraordinary items and the effect on income taxes of profit or loss from ordinary activities. Answer (A) is correct. The IASs do not require a particular income statement format, although, at a minimum, certain line items must be presented. The single-step income statement provides one grouping for income items and one for expense items. The “single step” is the one subtraction necessary to arrive at net profit or loss. The multiple-step income statement matches operating income and expenses separately from nonoperating items. Answer (B) is incorrect because both formats separate income tax expense and administrative expenses. Answer (C) is incorrect because both formats separate cost of goods sold expense and administrative expenses. Answer (D) is incorrect because intraperiod income tax allocation procedures must be applied to both formats. Extraordinary items are not reported.

[316] Gleim #: 3.26 -- Source: CIA 1196 IV-5 At January 1, year 1, a sole proprietorship’s assets totaled 210,000, and its liabilities amounted to 120,000. During year 1, owner investments amounted to 72,000, and owner withdrawals totaled 75,000. At December 31, year 1, assets totaled 270,000, and liabilities amounted to 171,000. The amount of net profit for year 1 was

A. B. C. D.

0 6,000 9,000 12,000


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Answer (A) is incorrect because the enterprise did have a net profit. Answer (B) is incorrect because 6,000 mistakenly deducts the 72,000 and adds the 75,000. Answer (C) is incorrect because 9,000 is the difference between beginning and ending equity without taking into consideration the capital transactions with, and distributions to, the owner. Answer (D) is correct. Net profit or loss may be derived using the basic accounting equation (assets = liabilities + equity). Equity at 1/1/year 1 was 90,000 (210,000 of assets – 120,000 of liabilities). Equity at 12/31/year 1 was 99,000 (270,000 – 171,000). Because owner transactions decreased net assets by 3,000 (72,000 investment – 75,000 withdrawals), net profit must have been 12,000 [99,000 – (90,000 – 3,000)]. [317] Gleim #: 3.27 -- Source: CIA 596 IV-44 An entity has a 50% gross margin, general and administrative expenses of 50, interest expense of 20, and net profit of 10 for the year just ended. If the corporate tax rate is 50%, the level of sales for the year just ended was

A. B. C. D.

90 135 150 180 Answer (A) is incorrect because 90 is the gross margin. Answer (B) is incorrect because 135 is 150% of the gross margin. Answer (C) is incorrect because 150 assumes profit before tax equals 50% of net profit. Answer (D) is correct. Net profit equals sales minus cost of sales, G&A expenses, interest, and tax. Given a 50% tax rate, profit before tax must have been 20 [10 net profit ÷ (1.0 – .5 tax rate)]. Accordingly, profit before interest and tax must have been 40 (20 profit before tax + 20 interest), and the gross margin (sales – cost of sales) must have been 90 (40 profit before interest and tax + 50 G&A expenses). If the gross margin is 50% of sales, sales equals 180 (90 gross margin ÷ .5).

[318] Gleim #: 3.28 -- Source: CIA 1193 IV-33 Which combination below explains the impact of credit card interest incurred and paid during the period on (1) equity on the balance sheet and (2) the statement of cash flows?

(1)

(2) Reflected on

Effect on Equity on Balance Sheet

Statement of Cash Flows as a(n)

A. B.

Decrease Decrease

Investing outflow Operating or financing outflow

C.

No effect

D.

No effect

Financing or investing outflow Operating outflow


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Answer (A) is incorrect because interest payments are classified as an operating or financing outflow on the statement of cash flows. Answer (B) is correct. Interest incurred is classified as interest expense on the income statement, which in turn reduces equity on the balance sheet by reducing retained earnings. According to IAS 7, cash payments for interest made by an enterprise that is not a financial institution may be classified on the statement of cash flows as an outflow of cash from operating or financing activities. Answer (C) is incorrect because credit card interest charges reduce equity. Answer (D) is incorrect because credit card interest charges reduce equity. [319] Gleim #: 3.29 -- Source: CIA 1192 IV-32 A reader of a statement of cash flows wishes to analyze the major classes of gross cash receipts and gross cash payments from operating activities. Which methods of reporting cash flows from operating activities will supply that information?

A. B. C. D.

Both the direct and indirect methods. Only the direct method. Only the indirect method. Neither method. Answer (A) is incorrect because only the direct method supplies information about major classes of gross cash receipts and payments related to operating activities. Answer (B) is correct. The statement of cash flows may report cash flows from operating activities in either an indirect or a direct format. The direct format reports the major classes of operating cash receipts and cash payments as gross amounts. The indirect presentation adjusts net profit or loss to the same amount of net cash from operating activities that would be determined in accordance with the direct method. To arrive at this amount, the indirect method adjusts net profit or loss for the effects of noncash transactions, deferrals or accruals of past or future operating cash flows, and income or expense related to financing or investing activities. Answer (C) is incorrect because the direct method, rather than the indirect method, supplies information about major classes of gross cash receipts and payments related to operating activities. Answer (D) is incorrect because the direct method reports major classes of gross cash receipts and payments from operating activities.

[320] Gleim #: 3.30 -- Source: CIA 1195 IV-34 In the statement of cash flows, the payment of cash dividends appears in the activities section as a of cash.

List A

List B

A.

Operating or investing

Source

B. C.

Operating or financing Investing or financing

Use Use

D.

Investing

Source

Answer (A) is incorrect because payment of cash dividends is a use of cash for an operating or financing activity. Answer (B) is correct. According to IAS 7, dividends paid may be treated as a cash outflow from financing activities because they are a cost of obtaining resources from owners. However, they may also be treated as operating items to help determine the enterprise’s ability to pay dividends from operating cash flows. Answer (C) is incorrect because payment of cash dividends is a use of cash for an operating or financing activity. Answer (D) is incorrect because payment of cash dividends is a use of cash for an operating or financing activity.


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[321] Gleim #: 3.31 -- Source: CIA 596 IV-10 The comparative balance sheet for an enterprise that had net profit of 150,000 for the year ended December 31, 20X4, and paid 125,000 of dividends during 20X4 is as follows: 12/31/X4

12/31/X3

Cash Accounts receivable

150,000 200,000

180,000 220,000

Total assets

350,000

400,000

Payables Share capital Retained earnings

80,000 130,000 140,000

160,000 125,000 115,000

Total

350,000

400,000

If dividends paid are treated as a cost of obtaining financial resources, the amount of net cash from operating activities during 20X4 was

A. B. C. D.

70,000 90,000 150,000 210,000 Answer (A) is incorrect because 70,000 fails to add to net profit the reduction in accounts receivable. Answer (B) is correct. Net profit is adjusted to determine the net cash from operations. The payment of cash dividends is regarded as a cash flow from a financing activity. Hence, it is not a reconciling item. However, the decrease in accounts receivable (220,000 – 200,000 = 20,000) during the period represents a cash inflow (collections of pre-20X4 receivables) not reflected in 20X4 net profit. Moreover, the decrease in payables (160,000 – 80,000 = 80,000) indicates a cash outflow (payment of pre-20X4 liabilities) that also is not reflected in 20X4 net income. Accordingly, net cash from operations was 90,000 (150,000 + 20,000 – 80,000). Answer (C) is incorrect because 150,000 is net profit. Answer (D) is incorrect because 210,000 subtracts the reduction in receivables and adds the reduction in payables.


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[Fact Pattern #18] Balance sheets on December 31, year 1 and December 31, year 2 are presented below:

Dec. 31, year 1 Assets: Cash Accounts receivable Allowance for uncollectible accounts Inventory Property, plant, and equipment Accumulated depreciation Total Assets

Dec. 31, year 2

50,000 95,000

60,000 89,000

(4,000) 120,000

(3,000) 140,000

295,000

340,000

(102,000)

(119,000)

454,000

507,000

Liabilities and Equity: Trade accounts payable Interest payable Bonds payable Unamortized bond discount Equity

62,000 8,000 200,000 (15,000) 199,000

49,000 11,000 200,000 (10,000) 257,000

Total Liabilities and Equity

454,000

507,000

Additional information for year 1: 1. Cash payments to suppliers of merchandise were 180,000. 2. Sales revenue was 338,000. 3. 3,000 of accounts receivable was written off. 4. Equipment was acquired for 65,000. 5. Depreciation expense was 30,000. 6. Interest expense was 20,000.

[322] Gleim #: 3.32 -- Source: CIA 1196 IV-13 (Refers to Fact Pattern #18) Cost of goods sold in year 2 was

A. B. C. D.

147,000 160,000 167,000 180,000 Answer (A) is correct. Cost of goods sold equals beginning inventory, plus purchases, minus ending inventory. To determine cost of goods sold, purchases must be calculated. Purchases equal 167,000 (49,000 ending accounts payable + 180,000 payments to suppliers – 62,000 beginning accounts payable). Thus, cost of goods sold equals 147,000 (120,000 beginning inventory + 167,000 purchases – 140,000 ending inventory). Answer (B) is incorrect because 160,000 results from assuming that 180,000 of cash payments to suppliers equaled purchases. Answer (C) is incorrect because 167,000 equals purchases. Answer (D) is incorrect because 180,000 is the amount of cash payments to suppliers.

[323] Gleim #: 3.33 -- Source: CIA 1196 IV-14 (Refers to Fact Pattern #18) Cash collections from customers in year 2 were

A. B. C. D.

341,000 338,000 344,000 335,000


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Answer (A) is correct. Cash collections from customers equals beginning accounts receivable, plus sales revenue, minus accounts written off, minus ending accounts receivable. In year 2, cash collections from customers were 341,000 (95,000 + 338,000 – 3,000 – 89,000). Answer (B) is incorrect because 338,000 is the sales revenue for the year. Answer (C) is incorrect because 344,000 includes the 3,000 of accounts written off. Answer (D) is incorrect because 335,000 is sales revenue minus accounts written off. [324] Gleim #: 3.34 -- Source: CIA 1196 IV-15 (Refers to Fact Pattern #18) The carrying amount (cost minus accumulated depreciation) of property, plant, and equipment disposed of in year 2 was

A. B. C. D.

7,000 17,000 20,000 32,000 Answer (A) is correct. The cost of PPE disposed of is 20,000 (295,000 beginning PPE + 65,000 acquisitions – 340,000 ending PPE). The accumulated depreciation is 13,000 (102,000 beginning accumulated depreciation + 30,000 depreciation expense – 119,000 ending accumulated depreciation). Thus, the carrying amount of PPE disposed of is 7,000 (20,000 cost of PPE – 13,000 accumulated depreciation). Answer (B) is incorrect because 17,000 is the difference between ending and beginning accumulated depreciation. Answer (C) is incorrect because 20,000 is the cost of the PPE disposed. Answer (D) is incorrect because 32,000 results from using the change in the PPE account without acquisitions minus the accumulated depreciation.

[325] Gleim #: 3.35 -- Source: CIA 1196 IV-16 (Refers to Fact Pattern #18) Cash interest payments in year 2 were

A. B. C. D.

8,000 12,000 20,000 25,000 Answer (A) is incorrect because 8,000 is the beginning interest payable. Answer (B) is correct. The interest payable credited in year 1 was 15,000 (20,000 interest expense – 5,000 amortized bond discount). Thus, the cash interest payment was 12,000 (8,000 beginning interest payable + 15,000 interest payable credited in year 1 – 11,000 ending interest payable). Answer (C) is incorrect because 20,000 is the interest expense for year 1. Answer (D) is incorrect because 25,000 is the interest expense plus the amortized discount.

[326] Gleim #: 3.36 -- Source: CIA 595 IV-2 In the determination of cost of goods sold, must be cash payments for goods along with other adjustments.


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List A

List B

A.

An increase in accounts payable

Added to

B.

Added to

C.

A decrease in accounts payable An increase in inventory

D.

A decrease in inventory

Subtracted from

Added to

Answer (A) is correct. To convert from the cash basis (cash payments) to the accrual basis (cost of goods sold), an increase in accounts payable must be added to cash payments for goods to determine net purchases. Net purchases is then adjusted for the change in inventory to determine cost of goods sold. Answer (B) is incorrect because a decrease in accounts payable must be subtracted from, not added to, cash payments. Answer (C) is incorrect because an increase in inventory must be subtracted from, not added to, cash payments to calculate cost of goods sold. Answer (D) is incorrect because a decrease in inventory must be added to, not subtracted from, cash payments to calculate cost of goods sold. [327] Gleim #: 3.37 -- Source: CIA 1196 IV-1 A corporation reported salaries expense of 190,000 for December of the current year. The following data are from its records:

Prepaid salaries Salaries payable

Dec. 31

Nov. 30

46,000 170,000

40,000 140,000

The amount of cash payments for salaries during December of the current year was

A. B. C. D.

154,000 166,000 214,000 226,000 Answer (A) is incorrect because 154,000 subtracts the 6,000 increase in prepaid salaries instead of adding it. Answer (B) is correct. An increase in prepaid salaries indicates that salaries expense is less than the cash paid for salaries. An increase in salaries payable indicates that salaries expense is more than the cash paid for salaries. Thus, the amount of cash payments for salaries was 166,000 (190,000 salaries expense + 6,000 increase in prepaid salaries – 30,000 increase in salaries payable). Answer (C) is incorrect because 214,000 subtracts the increase in prepaid salaries instead of adding it and adds the 30,000 increase in salaries payable instead of subtracting it. Answer (D) is incorrect because 226,000 adds the 30,000 increase in salaries payable instead of subtracting it.

[328] Gleim #: 3.38 -- Source: CIA 593 IV-44 In reconciling net profit on an accrual basis to net cash from operating activities, what adjustment is needed to net profit because of (1) an increase during the period in prepaid expenses and (2) the periodic amortization of premium on bonds payable?


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(1) Increase in

(2) Amortization of Premium

Prepaid Expenses

on Bonds Payable

A.

Add

Add

B. C.

Add Deduct

Deduct Add

D.

Deduct

Deduct

Answer (A) is incorrect because the increase in prepaid expenses requires a deduction from net profit in the reconciliation. Answer (B) is incorrect because the increase in prepaid expenses requires a deduction from net profit in the reconciliation. Answer (C) is incorrect because amortization of premium on bonds payable requires a deduction from net profit in the reconciliation. Answer (D) is correct. An increase in prepaid expenses indicates that cash outlays for expenses exceeded the related expense incurred; thus, net profit exceeded net cash from operating activities, and a deduction is needed in the reconciliation. Also, the amortization of premium on bonds payable causes a reduction of interest expense but does not increase cash; therefore, net profit exceeds net cash from operating activities, and a deduction is needed in the reconciliation. [329] Gleim #: 3.39 -- Source: CIA 1193 IV-34 An entity has publicly announced a detailed, formal plan to dispose in its entirety of a component of the entity that represents a separate major line of business that is distinct operationally and financially. Which of the following is the proper treatment of the disclosures that should be made after the announcement?

A. B. C. D.

As part of continuing operations. As a discontinued operation. As an extraordinary item. As a prior-period item. Answer (A) is incorrect because the component is to be terminated (discontinued). Answer (B) is correct. A separate major line of business or geographical operating area that is distinct for operational and reporting purposes is a component of an entity. Thus, its disposal qualifies to be reported. Answer (C) is incorrect because extraordinary items are not reported in the financial statements or notes. They are not clearly distinct from ordinary activities. Answer (D) is incorrect because disclosures begin with the current period, i.e., when the criteria for classification of the DO as held for sale are met.

[330] Gleim #: 3.40 -- Source: CIA 591 IV-38 Which of the following is a unique reporting problem associated with the determination of the results of operations for an interim period?

A. Advertising and similar costs expensed in one interim period may benefit other interim periods in the same annual period. B. Cost of goods sold for an interim period reflects only the amount of product cost applicable to sales revenue recognized in the interim period. C. Depreciation for an interim period represents an estimate. D. An extraordinary loss occurring in the second quarter must be prorated over the last three interim periods of the year.


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Answer (A) is correct. Costs and expenses other than product costs should be either charged to income in interim periods as incurred or allocated among interim periods based upon the benefits received. Accordingly, costs such as advertising should be deferred in an interim period if the benefits extend beyond that period; otherwise, they should be expensed as incurred. But such a determination is difficult, and deferral raises the additional issue of how the deferred costs should be allocated among quarters. Thus, many entities expense the costs as incurred even though they may benefit other interim periods in the same annual period. Answer (B) is incorrect because the only product costs appropriate to expense in an interim period are the ones related to the revenue transactions recognized in the same interim period. Answer (C) is incorrect because the annual depreciation amount is an estimate. The depreciation amount for an interim period is simply a pro rata amount of the annual estimate. Answer (D) is incorrect because extraordinary items are not reported in interim or annual statements. [331] Gleim #: 3.41 -- Source: CIA 1188 IV-33 The following data were extracted from the financial statements of a company for the year ended December 31. Net profit Depreciation expense Amortization of intangibles Decrease in accounts receivable Increase in inventories Increase in accounts payable Increase in plant assets Increase in share capital Decrease in short-term notes payable

70,000 14,000 1,000 2,000 9,000 4,000 47,000 31,000 55,000

There were no disposals of plant assets during the year. Based on the information above, a statement of cash flows will report a net increase in cash of

A. B. C. D.

11,000 17,000 54,000 69,000 Answer (A) is correct. Depreciation and amortization are noncash expenses and are added to net profit. A decrease in receivables indicates that cash collections exceed sales on an accrual basis, so it is added to net profit. To account for the difference between cost of goods sold (a deduction from net profit) and cash paid to suppliers, a two-step adjustment of net profit is necessary. The difference between CGS and purchases is the change in inventory. The difference between purchases and the amount paid to suppliers is the change in accounts payable. Accordingly, the conversion of CGS to cash paid to suppliers requires deducting the inventory increase and adding the accounts payable increase. An increase in plant assets indicates an acquisition of plant assets, causing a decrease in cash, so it is deducted. An increase in share capital represents a cash inflow and is added to net profit. A decrease in short-term notes payable is deducted from net profit because it reflects a cash outflow. Thus, cash increased by 11,000 (70,000 net profit + 14,000 + 1,000 + 2,000 – 9,000 + 4,000 – 47,000 + 31,000 – 55,000). Answer (B) is incorrect because 17,000 results from subtracting the amortization and the decrease in receivables and adding the increase in inventories. Answer (C) is incorrect because 54,000 results from adjusting net profit for the increase in plant assets and the increase in share capital only. Answer (D) is incorrect because 69,000 results from failing to make the adjustments for receivables, inventories, notes payable, and accounts payable.


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[332] Gleim #: 3.42 -- Source: CIA 1192 IV-26 A newly acquired plant asset is to be depreciated over its useful life. The rationale for this process is the

A. B. C. D.

Economic entity assumption. Monetary unit assumption. Materiality assumption. Going concern assumption. Answer (A) is incorrect because the economic entity assumption provides that economic activity can be identified with a particular unit of accountability. Answer (B) is incorrect because the monetary unit assumption provides that all transactions and events can be measured in terms of a common denominator, for instance, the euro. Answer (C) is incorrect because the materiality assumption simply implies that items of insignificant value may be expensed rather than capitalized and depreciated or amortized. The difference in treatment is not large enough to influence users if the item is not material. Answer (D) is correct. A basic feature of financial accounting is that the entity is assumed to be a going concern in the absence of evidence to the contrary. The going concern concept is based on the empirical observation that many entities have an indefinite life. The reporting entity is assumed to have a life long enough to fulfill its objectives and commitments and therefore to depreciate wasting assets over their useful lives.

[333] Gleim #: 3.43 -- Source: CIA 590 IV-35 Assuming all of the following involve material amounts, which is most likely to be classified as an extraordinary item in the income statement?

A. B. C. D.

A loss because of an expropriation of assets by a foreign government. A loss because of adjustments of accruals on long-term contracts. A gain because of the disposal of assets associated with a discontinuing operation of a business. None of the above. Answer (A) is incorrect because no items described as extraordinary are not presented on the face of the income statement or in the notes. Answer (B) is incorrect because no items described as extraordinary are not presented on the face of the income statement or in the notes. Answer (C) is incorrect because no items described as extraordinary are not presented on the face of the income statement or in the notes. Answer (D) is correct. According to IAS 1, “An entity shall not present any items of income and expense as extraordinary items, either on the face of the income statement or in the notes.”

[334] Gleim #: 3.44 -- Source: CIA 1191 IV-42 An extraordinary gain occurs in the second fiscal quarter. How should the gain be accounted for?

A. B. C. D.

Recognized in full in the second quarter. Recognized equally over the second, third, and fourth quarters. Recognized only in the annual financial statements. Recognized equally in each quarter, by restating the first quarter.


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Answer (A) is correct. Gains and losses similar to those that would not be deferred at year-end should not be deferred to later interim periods of the same year. Hence, the extraordinary gain should not be prorated. However, no items of income or expense are presented as extraordinary on the income statement or in the notes. Answer (B) is incorrect because the gain should be recognized in full in the second quarter. Answer (C) is incorrect because the gain should be recognized in full in the second quarter. Answer (D) is incorrect because the gain should be recognized in full in the second quarter. [335] Gleim #: 3.45 -- Source: CIA 1191 IV-34 An entity offers its customers credit terms of a 2% discount if paid within 10 days, or the full balance is due within 30 days (2/10, n/30). If some customers take advantage of the cash discount and others do not, which of the following accounts will appear on the income statement if the net method of recording receivables is employed?

Sales Discounts Sales Discounts

Forfeited

A.

Yes

Yes

B. C.

Yes No

No No

D.

No

Yes

Answer (A) is incorrect because the net method requires a sales discount forfeited but not a sales discount account. Answer (B) is incorrect because the net method requires a sales discount forfeited but not a sales discount account. Answer (C) is incorrect because the net method requires a sales discount forfeited. Answer (D) is correct. The gross method accounts for receivables at their face amount. If a discount is taken, a sales discount is recorded and classified as an offset to sales in the income statement to yield net sales. The net method records receivables net of the applicable discount. If the payment is not received during the discount period, an interest revenue account, such as sales discounts forfeited, is credited at the end of the discount period or when the payment is received. Accordingly, the application of the net method requires a sales discount forfeited but not a sales discount account. [336] Gleim #: 3.46 -- Source: CIA 1193 IV-41 An internal auditor is deriving cash flow data based on an incomplete set of facts. Bad debt expense was 2,000. Additional data for this period follows: Net sales Accounts receivable beginning balance Allowance for bad debts beginning balance Accounts receivable written off Increase in net accounts receivable (after subtraction of allowance for bad debts)

100,000 5,000 (500) 1,000 30,000

How much cash was collected this period?

A. B. C. D.

67,000 68,500 68,000 70,000


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Answer (A) is incorrect because 67,000 results from subtracting the write-offs and the bad debt expense from the sum of net income and beginning net accounts receivable. Answer (B) is incorrect because 68,500 assumes a zero balance in the beginning allowance account and deducts bad debt expense from the sum of net profit and beginning net accounts receivable. Answer (C) is incorrect because 68,000 deducts bad debt expense from the sum of net profit and beginning net accounts receivable. Answer (D) is correct. The cash collected equals net sales adjusted for the change in net accounts receivable (gross A/R – allowance for bad debts). An increase in net accounts receivable implies that cash collected was less than net sales. Hence, cash collected was 70,000 (100,000 – 30,000 increase in net A/R). Write-offs (debit the allowance, credit A/R) do not affect the computation of cash collected because the allowance and gross accounts receivable are reduced by the same amount. Moreover, recognition of bad debt expense (debit bad debt expense, credit the allowance) is not included in this calculation because it is already reflected in the net accounts receivable balance. [337] Gleim #: 3.47 -- Source: CIA 1196 IV-33 An analysis of an entity’s 150,000 accounts receivable at year-end resulted in a 5,000 ending balance for its allowance for uncollectible accounts and a bad debt expense of 2,000. During the past year, recoveries on bad debts previously written off were correctly recorded at 500. If the beginning balance in the allowance for uncollectible accounts was 4,700, what was the amount of accounts receivable written off as uncollectible during the year?

A. B. C. D.

1,200 1,800 2,200 2,800 Answer (A) is incorrect because 1,200 results from subtracting the recoveries instead of adding them. Answer (B) is incorrect because 1,800 results from subtracting bad debt expense from the allowance account. Answer (C) is correct. Under the allowance method, uncollectible accounts are written off by a debit to the allowance account and a credit to accounts receivable. The 500 of recovered bad debts is accounted for by a debit to accounts receivable and a credit to the allowance account. The 2,000 bad debt expense is also credited to the allowance account. The amount of accounts receivable written off as uncollectible is 2,200 [5,000 ending allowance – (4,700 beginning allowance + 500 recoveries + 2,000 bad debt expense)]. Answer (D) is incorrect because 2,800 results from subtracting the recoveries and bad debt expense from the allowance account.

[Fact Pattern #19] An entity sells goods on an installment basis. The table below includes information about the level of installment sales, the cost of the goods sold on installment, and the cash receipts on installment sales for 20X3 through 20X5. All cash receipt amounts shown are net of any interest charges.

20X3 Installment sales Cost of installment sales Cash receipts on 20X3 sales Cash receipts on 20X4 sales Cash receipts on 20X5 sales

20X4

20X5

10,000 5,000 20,000 6,000 4,000 10,000 2,000 4,000 1,000

4,000 2,000 4,000


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[338] Gleim #: 3.48 -- Source: CIA 596 IV-1 (Refers to Fact Pattern #19) The rate of gross profit on 20X4 installment sales is

A. B. C. D.

20% 40% 50% 80% Answer (A) is correct. The rate of gross profit on 20X4 installment sales is 20% [(5,000 of 20X4 installment sales – 4,000 cost of 20X4 installment sales) ÷ 5,000 of 20X4 installment sales]. Answer (B) is incorrect because 40% is the gross profit on 20X3 installment sales. Answer (C) is incorrect because 50% is the gross profit on 20X5 installment sales. Answer (D) is incorrect because 80% is the ratio of the cost of 20X4 installment sales to 20X4 installment sales.

[339] Gleim #: 3.49 -- Source: CIA 596 IV-2 (Refers to Fact Pattern #19) The amount of gross profit to be recognized in 20X3 on 20X3 installment sales is

A. B. C. D.

800 2,000 3,200 4,000 Answer (A) is correct. In 20X3, cash receipts were 2,000 from 20X3 installment sales. The gross profit realized is the gross profit on the portion of sales for which payment has been received. This amount equals the 20X3 gross profit percentage multiplied by the cash receipts, or 800 {[(10,000 – 6,000) ÷ 10,000] × 2,000}. Answer (B) is incorrect because 2,000 is the amount of cash receipts during 20X3 on 20X3 installment sales. Answer (C) is incorrect because 3,200 is the amount of the total gross profit on 20X3 installment sales that is deferred to future periods. Answer (D) is incorrect because 4,000 is the total gross profit on 20X3 installment sales.

[340] Gleim #: 3.50 -- Source: CIA 596 IV-3 (Refers to Fact Pattern #19) The gross profit amount from 20X5 sales to be deferred to future years would be

A. B. C. D.

2,000 3,000 8,000 10,000 Answer (A) is incorrect because 2,000 is the realized gross profit on 20X5 sales. Answer (B) is incorrect because 3,000 equals total receipts for 20X4 and 20X5 on 20X4 sales. Answer (C) is correct. The total gross profit on 20X5 sales is 10,000 (20,000 sales – 10,000 cost), and the amount realized is 2,000 {[(20,000 – 10,000) ÷ 20,000] × 4,000 of 20X5 cash receipts}. Accordingly, the amount deferred is 8,000 (10,000 – 2,000). Answer (D) is incorrect because 10,000 is the total gross profit on 20X5 sales.


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[341] Gleim #: 3.51 -- Source: CIA 1196 IV-42 At the end of September, an entity has outstanding accounts receivable of 350 on third-quarter credit sales, composed as follows:

Month

Credit Sales

Still Outstanding at the End of September

July August September

600 900 500

100 170 80

The percentage of receivables in the 31-to-60-day age group at the end of September is

A. B. C. D.

22.86% 28.57% 48.57% 71.43% Answer (A) is incorrect because 22.86% is the proportion of receivables in the 0-to-30-day age group at the end of September. Answer (B) is incorrect because 28.57% is the proportion of receivables in the 61-to-90-day age group at the end of September. Answer (C) is correct. Receivables from August sales still outstanding at the end of September are in the 31-to-60-day age group. This group represents 48.57% of total receivables [170 ÷ (100 + 170 + 80)]. Answer (D) is incorrect because 71.43% is the proportion of outstanding receivables that are from 0 to 60 days old at the end of September.

[342] Gleim #: 3.52 -- Source: CIA 595 IV-12 An entity sells inventory for 80,000 that had an inventory cost of 40,000. The terms of the sale involve payments receivable of 10,000 in the first year, 45,000 in the second year, and 25,000 in the third year. The buyer of the inventory is a new firm with no credit history. If the cost-recovery method of revenue recognition is used, the amount of gross profit to be recognized in the second year is

A. B. C. D.

0 5,000 15,000 45,000 Answer (A) is incorrect because, under the cost-recovery method, profit is recognized in the second year when cash payments by the buyer exceed the seller’s cost of merchandise. Answer (B) is incorrect because 5,000 is the profit to be recognized without consideration of the payment received in the first year. Answer (C) is correct. The profit recognized in the second year equals the cumulative payments received minus the seller’s cost, or 15,000 [(10,000 + 45,000) – 40,000]. Answer (D) is incorrect because 45,000 is the payment received in the second year.

[343] Gleim #: 3.53 -- Source: CIA 1195 IV-15 When a right of return exists, an entity may recognize revenue from a sale of goods at the time of sale only if


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A. B. C. D.

The amount of future returns can be reliably estimated. The seller retains the risks and rewards of ownership. The buyer resells the goods. The seller believes returns will not be material. Answer (A) is correct. One condition for recognition of revenue from the sale of goods is the transfer of the significant risks and rewards of ownership. Retention of significant risk may occur when, for example, the buyer may rescind the purchase for a reason stipulated in the contract, and the buyer is uncertain about the probability of return. However, if the entity can reliably estimate future returns and recognizes a liability for returns based on experience and other pertinent information, revenue may be recognized at the time of sale if the other conditions for revenue recognition are also met. Answer (B) is incorrect because the risks and rewards of ownership must be transferred. Answer (C) is incorrect because this contingency is an example of retention of significant risk. Answer (D) is incorrect because returns may be material if they can be reliably estimated.

[344] Gleim #: 3.54 -- Source: CMA 1287 3-26 If receivables transferred with recourse qualify for derecognition, the proceeds from the transfer are

A. B. C. D.

Accounted for as a collateralized borrowing. Recorded at fair value for the assets obtained and liabilities incurred. Recorded at the historical cost of the assets obtained. Reduced by the fair value of the recourse obligation. Answer (A) is incorrect because the proceeds of the sale are reduced by the fair value of the recourse obligation. Answer (B) is incorrect because the proceeds of the sale are reduced by the fair value of the recourse obligation. Answer (C) is incorrect because the proceeds of the sale are reduced by the fair value of the recourse obligation. Answer (D) is correct. The entity derecognizes financial assets if it has transferred substantially all of the risks and rewards of ownership. Derecognition also is appropriate when the entity neither has transferred nor retained substantially all the risks and rewards of ownership, providing the entity does not have control. After derecognition, periodic profit or loss will include the difference between the carrying amount transferred and the proceeds, plus or minus any prior adjustment reflecting the fair value of the asset that had been reported in equity. If a new financial asset is created or a new financial liability is assumed, the calculation is adjusted for the fair value of the asset or liability. Thus, the proceeds of the sale are reduced by the fair value of the recourse obligation (a new financial liability). When the transfer does not meet these criteria, the transfer is accounted for as a collateralized borrowing.

[345] Gleim #: 3.55 -- Source: Publisher A transferor entity most likely should continue to recognize a transferred financial asset if

A. B. C. D.

The transferor may reacquire the asset, and the asset is readily obtainable in the market. The transferee may sell the full fair value of the asset. The transferor has an option to reacquire the asset, and the reacquisition price is fair value. The transferor is entitled and obligated to repurchase the asset, and the transferee receives a lender’s return.


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Answer (A) is incorrect because a financial asset should be derecognized despite the transferor’s right to reacquire it if the asset is readily obtainable in the market. Answer (B) is incorrect because, when the transferee has the ability unilaterally to sell the entire asset to an unrelated third party without transfer restrictions, the transferor lacks control. Answer (C) is incorrect because a financial asset should be derecognized despite the transferor’s option to reacquire it at fair value at the date of reacquisition. Answer (D) is correct. An entity derecognizes a financial asset if it has transferred substantially all of the risks and rewards of ownership. Derecognition also is appropriate when the entity neither has transferred nor retained substantially all the risks and rewards of ownership, providing the entity does not have control. A transferor does not derecognize the financial asset if it is entitled and obligated to repurchase or redeem the asset, and the terms of this transaction in effect allow the transferee to obtain a lender’s return on the assets it receives in exchange for the transferred financial asset. [346] Gleim #: 3.56 -- Source: Publisher Derivatives that are not hedging instruments are always classified in which category of financial instruments?

A. B. C. D.

Financial assets or liabilities held for trading. Held-to-maturity investments. Loans and receivables. Available-for-sale financial assets. Answer (A) is correct. Financial assets or liabilities at fair value through profit or loss include those held for trading. Regardless of intent, a financial asset is held for trading if it is included in a portfolio with a recent pattern of short-term profit taking. Derivatives also are deemed to be held for trading unless they are designated and effective as hedging instruments. Answer (B) is incorrect because held-to-maturity investments have fixed or determinable payments and a fixed maturity. Moreover, the entity must have a positive intent and ability to hold such investments to maturity. Answer (C) is incorrect because loans and receivables are not derivatives. Answer (D) is incorrect because available-for-sale financial assets are nonderivatives. They do not fall within one of the other classifications.

[347] Gleim #: 3.57 -- Source: Publisher Subsequent to their initial recognition, which financial assets with quoted market prices in an active market are measured at fair value?

Loans and Receivables

Availablefor-Sale Financial Assets

Financial Assets Held for Trading

Yes

Yes

Yes

No

B. C.

Yes No

Yes No

No Yes

No Yes

D.

No

No

No

Yes

Held-toMaturity Investments A.


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Answer (A) is incorrect because available-for-sale and held-for-trading financial assets are measured at fair value unless they do not have quoted market prices in an active market and their fair values cannot be reliably measured. Answer (B) is incorrect because available-for-sale and held-for-trading financial assets are measured at fair value unless they do not have quoted market prices in an active market and their fair values cannot be reliably measured. Answer (C) is correct. Subsequent measurement of financial assets is normally at fair value. Thus, derivative, available-forsale, and held-for-trading financial assets are measured at fair value. Loans and receivables and held-to-maturity investments are measured at amortized cost using the effective interest rate method. Unquoted equity instruments whose fair value is not reliably measurable are reported at cost. Answer (D) is incorrect because available-for-sale and held-for-trading financial assets are measured at fair value unless they do not have quoted market prices in an active market and their fair values cannot be reliably measured. [348] Gleim #: 3.58 -- Source: Publisher Assuming an available-for-sale financial asset that is not part of a hedge is remeasured to fair value at the balance sheet, the gain or loss not arising from foreign exchange transactions or impairment

A. B. C. D.

Must be recognized in profit or loss. Must be recognized directly in equity. May be recognized in profit or loss or directly in equity. Must be recognized in profit or loss if the result is a loss and directly in equity if the result is a gain. Answer (A) is incorrect because a gain or loss on a financial asset or liability classified as at fair value through profit or loss is recognized in profit or loss. Answer (B) is correct. A gain or loss on an available-for-sale financial asset that is not part of a hedge is recognized directly in equity through the statement of changes in equity except for impairment losses and foreign exchange gains and losses. The accumulated remeasurement gain or loss is included in profit or loss when the asset is derecognized. Answer (C) is incorrect because a gain or loss on an available-for-sale financial asset is normally recorded directly in equity. Answer (D) is incorrect because a gain or loss on an available-for-sale financial asset is normally recorded directly in equity.

[349] Gleim #: 3.59 -- Source: CIA 597 IV-15 A retail entity maintains a markup of 25% based on cost. The entity has the following information for the current year: Purchases of merchandise Freight-in on purchases Sales Ending inventory

690,000 25,000 900,000 80,000

Beginning inventory was

A. B. C. D.

40,000 85,000 110,000 265,000


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Answer (A) is incorrect because 40,000 is based on a 25% markup on sales. Answer (B) is correct. Cost of goods sold equals beginning inventory, plus purchases (including freight-in), minus ending inventory. Given that sales reflect 125% of cost, cost of goods sold must equal 720,000 (900,000 sales ÷ 1.25). Consequently, the beginning inventory must have been 85,000 (720,000 CGS + 80,000 EI – 690,000 purchases – 25,000 freight-in). Answer (C) is incorrect because 110,000 omits the freight-in from the computation of cost of goods available for sale. Answer (D) is incorrect because 265,000 uses the sales figure for cost of goods sold. [350] Gleim #: 3.60 -- Source: CIA 597 IV-16 Which inventory pricing method generally approximates current cost for each of the following?

Ending

Cost of

Inventory

Goods Sold

A.

FIFO

FIFO

B. C.

LIFO FIFO

FIFO LIFO

D.

LIFO

LIFO

Answer (A) is incorrect because LIFO approximates current cost of goods sold. Answer (B) is incorrect because FIFO approximates current cost for ending inventory, and LIFO approximates current cost of goods sold. Answer (C) is correct. FIFO assigns the most recent purchase prices to ending inventory and the earliest purchase prices to cost of goods sold. LIFO uses the earliest acquisition costs to price the ending inventory. It is not permitted by the IFRSs. Thus, FIFO approximates current cost for ending inventory, and LIFO approximates current cost of goods sold. Answer (D) is incorrect because FIFO approximates current cost for ending inventory. [351] Gleim #: 3.61 -- Source: CIA 596 IV-11 The cost of materials has risen steadily over the year. Which of the following methods of estimating the ending balance of the materials inventory account will result in the highest net profit, assuming all other variables remain constant?

A. B. C. D.

Last-in, first-out (LIFO). First-in, first-out (FIFO). Weighted average. Specific identification. Answer (A) is incorrect because LIFO yields the lowest net profit. It is not permitted by the IFRSs. Answer (B) is correct. Net profit will be higher when cost of goods sold is lower, other factors held constant. Cost of goods sold equals beginning inventory, plus purchases, minus ending inventory. Accordingly, cost of goods sold will be lowest when the ending inventory is highest. Ending inventory is highest under FIFO because the older, less expensive items are deemed to have been sold, leaving the more expensive items in the ending inventory. Answer (C) is incorrect because weighted average averages inventory, so it results in a lower net profit than FIFO. Answer (D) is incorrect because, under specific identification, the newest (most expensive) items are not necessarily in the ending inventory. The result is a higher cost of goods sold and lower net profit than under FIFO.


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[352] Gleim #: 3.62 -- Source: CIA 1193 IV-31 A physical inventory count showed an entity had inventory costing 1,000,000 on hand at December 31, 20X3. Excluded from this amount were the following: Goods costing 82,000, shipped to a customer free on board (FOB) shipping point on December 28, 20X3. They were expected to be received by the customer on January 4, 20X4. Goods costing 122,000, shipped to a customer free on board (FOB) destination December 30, 20X3. They were expected to be received by the customer on January 5, 20X4. Compute the correct ending inventory to be reported on the shipper’s balance sheet at December 31, 20X3.

A. B. C. D.

1,000,000 1,082,000 1,122,000 1,204,000 Answer (A) is incorrect because 1,000,000 excludes the goods shipped FOB destination. Answer (B) is incorrect because 1,082,000 excludes the goods shipped FOB destination and fails to exclude the goods shipped FOB shipping point. Answer (C) is correct. The goods shipped FOB shipping point should be counted in the buyer’s, not the seller’s, inventory because title and risk of loss pass at the time and place of shipment. These goods were properly excluded from ending inventory. The goods shipped FOB destination were improperly excluded from the seller’s ending inventory. The title and risk of loss did not pass until the time and place where the goods reached their destination and were duly tendered. Thus, the correct ending inventory is 1,122,000 (1,000,000 beginning balance + 122,000 goods shipped FOB destination). Answer (D) is incorrect because 1,204,000 includes the goods shipped FOB shipping point.

[353] Gleim #: 3.63 -- Source: CIA 1191 IV-31 When a perpetual inventory system is used and a difference exists between the perpetual inventory amount balance and the physical inventory count, a separate entry is needed to adjust the perpetual inventory amount. Which of the following demonstrates that adjusting entry?

A. Inventory over and short Inventory B. Extraordinary loss due to write-down of inventory Inventory C. Extraordinary loss due to write-down of inventory Allowance for inventory shortages D. Cost of goods sold Retained earnings appropriated for shortages Answer (A) is correct. The entry to record a write-down is a debit to inventory over and short and a credit to inventory. This amount is reported as an adjustment of cost of goods sold or as an other expense on the income statement. Answer (B) is incorrect because a difference between a physical count and a perpetual inventory balance is common. Reasons include normal and expected shrinkage, breakage, shoplifting, and faulty record keeping. Thus, it is not an extraordinary item. Answer (C) is incorrect because a difference between a physical count and a perpetual inventory balance is common. Reasons include normal and expected shrinkage, breakage, shoplifting, and faulty record keeping. Thus, it is not an extraordinary item. Answer (D) is incorrect because, although the debit to cost of goods sold is acceptable, the credit should be to inventory. Also, any appropriation of retained earnings would also have to involve the unappropriated retained earnings account.


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[Fact Pattern #20] Illustrated below is a perpetual inventory card for the current year.

Date

Units Purchased

Units Sold

January 1

Units Balance 0

January 12

1,000

1,000 @ 2.00

March 15

300

May 5

700

500 @ 2.20

July 8

1,200 500

November 24

700

1,000 @ 1.65

1,700

Additional Information: The entity had no opening inventory. The items sold on March 15 were purchased on January 12. The items sold on July 8 were purchased on May 5. [354] Gleim #: 3.64 -- Source: CIA 596 IV-17 (Refers to Fact Pattern #20) The ending inventory balance under the first-in, first-out (FIFO) method of inventory valuation is

A. B. C. D.

3,050 3,150 3,230 3,430 Answer (A) is incorrect because 3,050 is the ending inventory under the specific identification method. Answer (B) is correct. Under the FIFO method, the 1,700 units of ending inventory are valued at the most recent prices. Ending inventory is assumed to include 1,000 units purchased November 24, 500 units purchased May 5, and 200 units purchased January 12. Hence, the ending inventory is 3,150 [(1,000 × 1.65) + (500 × 2.20) + (200 × 2.00)]. Answer (C) is incorrect because 3,230 is the ending inventory under the weighted-average method. Answer (D) is incorrect because 3,430 is the ending inventory under the LIFO method.

[355] Gleim #: 3.65 -- Source: CIA 596 IV-18 (Refers to Fact Pattern #20) The cost of goods sold under the specific identification method of inventory valuation is

A. B. C. D.

1,320 1,520 1,600 1,700


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Answer (A) is incorrect because 1,320 is the cost of goods sold under the LIFO method. Answer (B) is incorrect because 1,520 is the cost of goods sold under the weighted-average method. Answer (C) is incorrect because 1,600 is the cost of goods sold under the FIFO method. Answer (D) is correct. Of the 800 units sold during the period, the 300 units sold on March 15 were purchased on January 12 at a cost of 2.00 per unit. The remaining 500 units were purchased on May 5 at a cost of 2.20 per unit. The cost of goods sold under the specific identification method is therefore 1,700 [(300 units × 2.00) + (500 units × 2.20)]. [356] Gleim #: 3.66 -- Source: CIA 1192 IV-43 An entity had the following selected per-unit data relating to work-in-process: Selling price Completion costs Historical cost Replacement cost Normal gross profit Selling cost

100 10 91 108 20 5

In comparison with historical cost, what will be the per-unit impact on gross profit of measuring ending inventory?

A. B. C. D.

No effect. Reduction of 6. Reduction of 26. Increase of 5. Answer (A) is incorrect because no effect implies that NRV is at least as high as cost. Answer (B) is correct. Inventories are measured at the lower of cost or net realizable value (NRV). NRV equals selling price minus completion and selling costs. Given that historical cost is 91 and NRV is 85 (price of 100 – 10 completion cost – 5 selling cost), the effect on per-unit gross profit is a reduction of 6. This amount is the writedown expensed. Answer (C) is incorrect because a reduction of 26 results from treating normal gross profit as if it were a completion or selling cost. Answer (D) is incorrect because an increase is permissible only to the extent of a prior writedown.

[357] Gleim #: 3.67 -- Source: CIA 1196 IV-22 An entity started in 20X4 with 200 scented candles on hand at a cost of 3.50 each. These candles sell for 7.00 each. The following schedule represents the purchases and sales of candles during 20X4: Transaction Number

Quantity Purchased

Unit Cost

Quantity Sold

1 2 3 4 5 6 7

--250 --200 --350 ---

--3.30 --3.10 --3.00 ---

150 --100 --200 --300

If the entity uses periodic FIFO inventory pricing, the gross profit for 20X4 would be


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A. B. C. D.

2,755 2,805 2,854 2,920 Answer (A) is incorrect because 2,755 equals sales minus purchases. Answer (B) is correct. The FIFO method assumes that the first goods purchased are the first goods sold and that ending inventory consists of the latest purchases. Moreover, whether the inventory system is periodic or perpetual does not affect FIFO valuation. The cost of goods sold is 2,445 {beginning inventory (200 units × 3.50) + purchases [(250 units × 3.30) + (200 units × 3.10) + (350 units × 3.00)] – ending inventory (250 units × 3.00)}. Thus, the gross profit for 20X4 using FIFO is 2,805 [sales (750 units × 7.00) – cost of goods sold of 2,445]. Answer (C) is incorrect because 2,854 uses a weighted-average ending inventory and part of the cost of goods sold calculation. Answer (D) is incorrect because 2,920 uses a periodic LIFO inventory value.

[358] Gleim #: 3.68 -- Source: CIA 1196 IV-9 The following data are available from the records of a department store for the year ended December 31, 20X3:

Merchandise inventory, as of January 1, 20X3 Purchases Markups (net) Markdowns (net) Sales

At cost

At retail

9,000 33,000

13,000 46,000 1,000 4,000 48,000

Using the retail method to approximate valuation at lower of average cost or net realizable value, the department store’s merchandise inventory at December 31, 20X3, is

A. B. C. D.

8,400 8,000 6,000 5,600


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Answer (A) is incorrect because 8,400 neglects to subtract the net markdowns to compute the merchandise inventory at retail at December 31, 20X3. Answer (B) is incorrect because 8,000 is the inventory at retail at December 31, 20X3. Answer (C) is incorrect because 6,000 is computed by including the net markdowns in the cost-to-retail ratio. Answer (D) is correct. The version of the retail method that approximates a lower-of-average-cost-or-NRV valuation includes markups but not markdowns in the cost-to-retail ratio. Thus, the cost of the inventory at December 31, 20X3 is 5,600. Cost

Retail

9,000 33,000

13,000 46,000 1,000

42,000 Sales Markdowns, net

60,000 (48,000) (4,000)

Inventory at retail, December 31, 20X3 Cost-to-retail ratio (42,000 ÷ 60,000)

8,000 × .70

Inventory at cost, December 31, 20X3

5,600

Inventory, January 1, 20X3 Purchases Markups, net

[359] Gleim #: 3.69 -- Source: CIA 595 IV-15 An entity is depreciating an asset with a 5-year useful life. It cost 100,000 and has no residual value. If the method is used, depreciation in the second year will be .

List A

List B

A. B.

Sum-of-years’-digits Sum-of-years’-digits

20,000 40,000

C. D.

200% diminishing-balance 200% diminishing-balance

16,000 24,000

Answer (A) is incorrect because depreciation in year two will be 20,000 under the straight-line method. Answer (B) is incorrect because, under the SYD method, second-year depreciation will be 26,667 [(4 ÷ 15) × 100,000]. Answer (C) is incorrect because 16,000 is based on the 100% diminishing-balance method. Answer (D) is correct. The 200% diminishing-balance method uses twice the straight-line rate. Accordingly, first-year depreciation expense is 40,000 (100,000 × 20% × 2). In the second year, the depreciation base is reduced by the amount of depreciation already taken in the first year. Thus, depreciation expense in year two is 24,000 [(2 × 20%) × (100,000 – 40,000)]. [360] Gleim #: 3.70 -- Source: CIA 595 IV-10 Which of the following is not an appropriate basis for measuring the cost of property, plant, and equipment?


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A. The purchase price, freight costs, and installation costs of a productive asset should be included in the asset’s cost. B. Proceeds obtained in the process of readying land for its intended purpose, such as from the sale of cleared timber, should be recognized immediately as income. C. The costs of improvements to equipment incurred after its acquisition should be added to the asset’s cost if they increase future service potential. D. All costs incurred in the construction of a plant building, from excavation to completion, should be considered as part of the asset’s cost. Answer (A) is incorrect because the purchase price, freight costs, and installation costs of a productive asset are included in the asset’s cost. Answer (B) is correct. Accordingly, items of property, plant, and equipment (PPE) that meet the recognition criterion are initially measured at cost. The cost includes the purchase price (minus trade discounts and rebates, plus purchase taxes) and the directly attributable costs of bringing the assets to working condition for their intended use. Directly attributable costs include site preparation, installation, initial delivery and handling, architect and equipment fees, costs of removing the assets and restoring the site, etc. Accordingly, the cost of land includes the cost of obtaining the land and readying it for its intended uses, but it is inappropriate to recognize the proceeds related to site preparation immediately in profit or loss. They should be treated as reductions in the price of the land. Answer (C) is incorrect because subsequent costs are added to the carrying amount of an item of PPE if it is probable that, as a result, future economic benefits will be received, and the costs are reliably measurable. Answer (D) is incorrect because all costs of construction should be included as a part of the asset’s cost. [361] Gleim #: 3.71 -- Source: CIA 1196 IV-10 A depreciable asset has an estimated 20% residual value. At the end of the asset’s estimated useful life, the accumulated depreciation will equal the original cost of the asset under which of the following depreciation methods?

Diminishing-

Sum-of-the-Years'-

Balance

Digits (SYD)

A.

Yes

Yes

B. C.

Yes No

No Yes

D.

No

No

Answer (A) is incorrect because at the end of the estimated useful life of a depreciable asset, the amount of accumulated depreciation should equal the depreciable cost (original cost – estimated residual value), regardless of the depreciation method used. Answer (B) is incorrect because at the end of the estimated useful life of a depreciable asset, the amount of accumulated depreciation should equal the depreciable cost (original cost – estimated residual value), regardless of the depreciation method used. Answer (C) is incorrect because at the end of the estimated useful life of a depreciable asset, the amount of accumulated depreciation should equal the depreciable cost (original cost – estimated residual value), regardless of the depreciation method used. Answer (D) is correct. At the end of the estimated useful life of a depreciable asset, the amount of accumulated depreciation should equal the depreciable cost (original cost – estimated residual value), regardless of the depreciation method used. Periodic diminishing-balance depreciation is calculated without regard to residual value, but the asset is not depreciated below its residual value. The SYD method uses a depreciable base equal to cost minus residual value.


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[362] Gleim #: 3.72 -- Source: CIA 596 IV-22 An entity donated land to a municipality for a park. The acquisition cost of the land was 75,000, and the market value at the time of the donation was 200,000 as determined by a professional appraisal. If the entity has not chosen to adopt the cost model for measurement of property, plant, and equipment subsequent to initial recognition, the journal entry to record the disposition of the land is

A. Expense Land B. Land Revaluation surplus Revaluation surplus Income Expense Land C. Land Revaluation surplus Expense Land D. Donation expense Land Income

75,000 75,000 125,000 125,000 125,000 125,000 200,000 200,000 125,000 125,000 200,000 200,000 200,000 75,000 125,000

Answer (A) is incorrect because the revaluation of the land must be recognized. Answer (B) is incorrect because the revaluation surplus is not transferred through profit or loss. Answer (C) is correct. An item of PPE is carried at cost minus any accumulated depreciation and impairment losses. Under the allowed alternative treatment, an item of PPE may be carried at a revalued amount equal to fair value at the revaluation date minus any subsequent accumulated depreciation and impairment losses. Land is not depreciated, so it should be carried at its revalued amount. This amount should be determined by a professional appraisal. The revaluation increased the carrying amount and is therefore credited directly to equity as revaluation surplus. Accordingly, the entry is to debit land and credit revaluation surplus for 125,000. The entire surplus may be transferred to retained earnings (but not through profit or loss) when the asset is derecognized. Upon derecognition, the asset should be removed from the balance sheet, and the resulting loss (revalued carrying amount of 200,000 – 0 net disposal proceeds = 200,000) should be included in profit or loss. Answer (D) is incorrect because the revaluation surplus is not transferred through profit or loss. [363] Gleim #: 3.73 -- Source: CIA 1195 IV-22 An entity sells a piece of machinery, for cash, prior to the end of its estimated useful life. The sale price is less than the carrying amount of the asset on the date of sale. The entry that the entity uses to record the sale is


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A. Cash Accumulated depreciation -- machinery Expense-disposal of machinery Machinery B. Cash Accumulated depreciation -- machinery Income-disposal of machinery Machinery C. Cash Expense-disposal of machinery Accumulated depreciation -- machinery Machinery D. Cash Machinery Accumulated depreciation -- machinery Expense-disposal of machinery Answer (A) is correct. The cash account is debited for the amount of the sale proceeds. The machinery account and the related accumulated depreciation account are eliminated by a credit and a debit, respectively. Because the sale price was less than the carrying amount of the asset on the date of sale, a loss on disposal should be recognized in profit or loss. The term “expenses” includes losses. Answer (B) is incorrect because a loss on disposal should be recognized in profit or loss. The term “expenses” includes losses. Answer (C) is incorrect because accumulated depreciation should be debited. Answer (D) is incorrect because an expense and accumulated depreciation should be debited. [364] Gleim #: 3.74 -- Source: CIA 1196 IV-29 If an entity employs the sum-of-the-years’-digits (SYD) method of depreciation for an asset with an estimated useful life of 4 years, the percentage of the total depreciable cost that will be expensed in the third year is

A. B. C. D.

10% 25% 20% 70% Answer (A) is incorrect because 10% is the amount expensed in the last year. Answer (B) is incorrect because 25% is the percentage expensed each year under the straight-line method. Answer (C) is correct. Under the SYD method, the amount of the depreciable cost that is expensed each year is the remaining useful life at the beginning of that year divided by the sum of the years of useful life. For the third year, the portion expensed is 20% [2 ÷ (1 + 2 + 3 + 4)]. Answer (D) is incorrect because 70% is the total amount expensed in the first 2 years.

[365] Gleim #: 3.75 -- Source: CIA 1193 IV-42 In making a cash flow analysis of property, plant, and equipment (PPE), the internal auditor discovered that depreciation expense for the period was 10,000. PPE with a cost of 50,000 and related accumulated depreciation of 30,000 was sold for a gain of 1,000. If the carrying amount of PPE increased by 80,000 during the period, how much PPE was purchased this period?


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A. B. C. D.

91,000 100,000 110,000 119,000 Answer (A) is incorrect because 91,000 ignores the carrying amount of items sold and includes the gain in the computation. Answer (B) is incorrect because 100,000 ignores the depreciation expense for the period. Answer (C) is correct. The carrying amount of the PPE account, net of accumulated depreciation, is increased by the cost of purchases and decreased by the carrying amount of items of PPE sold and depreciation. The net PPE decreased by the carrying amount of items sold, or 20,000 (50,000 cost – 30,000 accumulated depreciation), and by the 10,000 of depreciation. If PPE still increased by 80,000, 110,000 (30,000 total decrease + 80,000 increase) of equipment must have been purchased. Answer (D) is incorrect because 119,000 double counts depreciation expense and deducts the gain.

[366] Gleim #: 3.76 -- Source: CIA 1193 IV-38 A theme park purchased a new, exciting ride and financed it through the manufacturer. The following facts pertain: Purchase price Delivery cost Installation cost Cost of trial-runs Interest charges for first year

800,000 50,000 70,000 40,000 60,000

The straight-line method is to be used. Compute the depreciation on the equipment for the first year assuming an estimated service life of 5 years.

A. B. C. D.

160,000 184,000 192,000 204,000 Answer (A) is incorrect because 160,000 excludes the delivery, installation, and trial-run costs. Answer (B) is incorrect because 184,000 excludes the trial-run cost. Answer (C) is correct. Under the straight-line method, the annual depreciation expense for an asset equals the asset’s amount (cost – residual value) divided by the asset’s estimated useful life. The cost of the asset includes its price and the directly attributable costs of bringing it to working condition for intended use. Thus, the depreciation expense is 192,000 [(800,000 purchase price + 50,000 delivery cost + 70,000 installation cost + 40,000 trial-run cost) ÷ 5-year estimated service life]. Borrowing costs incurred after the asset is prepared for its intended use are expensed even if the allowed alternative treatment of such costs is followed, and the asset otherwise satisfies the criteria for capitalization of such expenses. Answer (D) is incorrect because 204,000 includes the borrowing costs.

[367] Gleim #: 3.77 -- Source: CIA 1196 IV-32 On January 1, 20X0, an entity purchased an abandoned quarry for 1,200,000 to be used as a landfill to service its trash collection contracts with nearby cities for the next 20 years. The entity depletes the quarry using the units-of-production method based on a surveyor’s measurements of volume of the quarry’s pit. This amount was 500,000 cubic yards when purchased and 350,000 cubic yards at year-end 20X4. What is the net amount that should be shown on the entity’s December 31, 20X4, balance sheet for the quarry?


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A. B. C. D.

1,200,000 900,000 840,000 360,000 Answer (A) is incorrect because 1,200,000 is the purchase price of the quarry. Answer (B) is incorrect because 900,000 results from using straight-line depletion. Answer (C) is correct. The units-of-production method allocates cost based on output. The net amount reported as an asset for the quarry using this method is 840,000 [(350,000 cubic yards ÷ 500,000 total cubic yards) × 1,200,000]. Answer (D) is incorrect because 360,000 equals {1,200,000 – [(350,000 ÷ 500,000) × 1,200,000]}. The 350,000 cubic yards is the volume remaining in the quarry’s pit at year-end 20X4, not the volume depleted.

[368] Gleim #: 3.78 -- Source: CIA 592 IV-28 An entity installed an assembly line in 20X0. Four years later, 100,000 was invested to automate the line. The automation increased the market value and productive capacity of the assembly line but did not affect its useful life. Proper accounting for the cost of the automation should be to

A. B. C. D.

Report it as an expense in 20X4. Establish a separate account for the 100,000. Allocate the cost of automation between the asset and accumulated depreciation accounts. Debit the cost to the property, plant, and equipment account. Answer (A) is incorrect because the cost should be capitalized. Answer (B) is incorrect because the same account should be used. Answer (C) is incorrect because allocation is not an accepted procedure. Answer (D) is correct. Subsequent costs are added to the carrying amount of an item of PPE if it is probable that, as a result, future economic benefits will be received, and the costs are reliably measurable. An extended useful life, improved output quantity or quality, and reduced operating costs future economic benefits.

[369] Gleim #: 3.79 -- Source: CIA 1196 IV-18 An entity purchased new equipment on July 1, 20X4, having a list price of 52,500. The entity traded old equipment that was being depreciated using the straight-line method and paid 35,000 in cash. The following information pertains to the old equipment: Cost on January 1, 20X1 Estimated useful life Residual value Fair value on July 1, 20X4

38,900 5 years 2,900 16,000

If the old and new equipment are dissimilar, the entity will record the new equipment at

A. B. C. D.

45,100 48,700 51,000 52,500


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Answer (A) is incorrect because 45,100 equals the carrying amount of the old equipment after being depreciated for 4 years plus the cash paid for the new equipment. Answer (B) is incorrect because 48,700 equals the carrying amount of the old equipment after being depreciated for 3.5 years plus cash paid for the new equipment. Answer (C) is correct. The cost of what is received in an exchange of similar or dissimilar items of PPE is recorded at fair value unless the exchange lacks economic substance or the fair value of what is given or received is not reliably measurable. Hence, the entity will record the new equipment at the fair value of the old asset plus cash paid, or 51,000 (16,000 + 35,000). Answer (D) is incorrect because 52,500 is the list price of the new equipment. [370] Gleim #: 3.80 -- Source: CIA 595 IV-25 Which of the following is not considered to be an intangible asset?

A. B. C. D.

Goods on consignment. Patents. Copyrights. Trademarks. Answer (A) is correct. IAS 38, Intangible Assets, defines an intangible asset as “an identifiable nonmonetary asset without physical substance.” Inventory is a tangible asset. Thus, goods on consignment are not intangible assets. Answer (B) is incorrect because patents are intangible assets. Answer (C) is incorrect because copyrights are intangible assets. Answer (D) is incorrect because trademarks are intangible assets.

[371] Gleim #: 3.81 -- Source: CIA 593 IV-32 The costs of start-up activities, including fees of attorneys, should be

A. B. C. D.

Capitalized, but not amortized, because of the indefinite life of the business. Capitalized and amortized. Capitalized and deferred until liquidation of the business. Expensed when incurred. Answer (A) is incorrect because start-up costs are expensed when incurred. Answer (B) is incorrect because start-up costs are expensed when incurred. Answer (C) is incorrect because start-up costs are expensed when incurred. Answer (D) is correct. Expenditures on start-up activities are expensed when incurred unless they are included in the cost of an item of property, plant, and equipment. They include the costs of establishing a new legal entity, such as legal and secretarial costs; pre-opening costs of an entity’s new business facility; and the pre-operating costs of new operations, products, or processes.

[372] Gleim #: 3.82 -- Source: Publisher A recognized intangible asset is amortized over its useful life

A. B. C. D.

Unless the pattern of consumption of the economic benefits of the asset is not reliably determinable. If that life is determined to be finite. Unless the precise length of that life is not known. If that life is indefinite but not infinite.


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Answer (A) is incorrect because an intangible asset is amortizable if its useful life is finite. If the pattern of consumption of the economic benefits of such an intangible asset is not reliably determinable, the straight-line amortization method is applied. Answer (B) is correct. A recognized intangible asset is amortized over its useful life if that useful life is finite, that is, unless the useful life is determined to be indefinite. The useful life of an intangible asset is indefinite if no foreseeable limit exists on the period over which it will contribute, directly or indirectly, to the reporting entity’s cash flows. Answer (C) is incorrect because, if the precise length of the useful life is not known, an intangible asset with a finite useful life is amortized over the best estimate of its useful life. Answer (D) is incorrect because a recognized intangible asset is not amortized if its useful life is indefinite. [373] Gleim #: 3.83 -- Source: CIA 590 IV-25 The amortization of intangible assets with finite useful lives is justified by the

A. B. C. D.

Economic entity assumption. Going concern assumption. Monetary unit assumption. Historical cost assumption. Answer (A) is incorrect because the economic entity assumption is that every entity’s affairs are separate from those of its owners. Answer (B) is correct. Every business is assumed to be a going concern that will continue operating indefinitely. Thus, liquidation values are not important. If an entity is not a going concern, its intangible assets are reported at liquidation values, not at historical cost net of amortization. Answer (C) is incorrect because the monetary unit assumption provides that all transactions and events can be measured in terms of money. Answer (D) is incorrect because the historical cost principle deems cost to be the most objective and reliable measure.

[374] Gleim #: 3.84 -- Source: CIA 595 IV-71 The restriction that manufacturers should not market a new product that is illegally similar to that of another company’s product is due to which public policy instrument?

A. B. C. D.

Copyright. Minimum standards for product warranties. Anti-merger laws. Patent laws. Answer (A) is incorrect because a copyright provides legal protection for tangible expressions of ideas, e.g., novels, songs, and software. Answer (B) is incorrect because laws establishing minimum warranty standards do not limit the similarity of product offerings. Answer (C) is incorrect because anti-merger laws can affect the ability of one entity to acquire another entity producing similar products if the result will be to lessen competition, but they do not affect the design of new products. Answer (D) is correct. A patent is the exclusive legal right to use or sell an invention, such as a device or process. A patent may be given to any new and useful process, machine, manufacture, or composition of matter, and any infringement of a patent is a basis for a lawsuit. Thus, patent laws require that entities not design new products that are illegally similar to those of other entities that enjoy patent protection.


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[375] Gleim #: 3.85 -- Source: CIA 593 IV-43 MNO purchased all of XYZ’s 100,000 outstanding common shares for 40 per share on August 31. On this date, XYZ’s balance sheet showed total assets of 5,000,000 and total liabilities of 2,000,000. The fair value of XYZ’s identifiable assets on this date was 550,000 greater than their carrying amount. The amount that should be reported on MNO’s consolidated balance sheet on August 31 for goodwill is

A. B. C. D.

0 450,000 550,000 1,000,000 Answer (A) is incorrect because cost in excess of fair value of the identifiable assets and liabilities is reported as goodwill. Answer (B) is correct. Goodwill is recognized as an asset equal to the excess of the cost over the acquirer’s interest in the fair value of the identifiable assets and liabilities acquired. The cost of 4,000,000 (40 × 100,000) is in excess of the 3,550,000 (5,000,000 + 550,000 – 2,000,000) fair value of the identifiable assets and liabilities by 450,000. This excess is goodwill. Answer (C) is incorrect because 550,000 is the excess of fair value over the carrying amount of the identifiable assets and liabilities on the seller’s books. Answer (D) is incorrect because the purchase price of 4,000,000 exceeds the seller’s 3,000,000 carrying amount by 1,000,000.

[376] Gleim #: 3.86 -- Source: Publisher Which of the following is not classified as a development activity?

A. B. C. D.

Evaluation of process alternatives. Construction of a pilot plant. Construction of a preproduction prototype. Design of tools involving new technology. Answer (A) is correct. Evaluation of process alternatives is an activity typically classified as research. Research is “original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding” (IAS 38). Answer (B) is incorrect because construction of a pilot plant is a development activity. Answer (C) is incorrect because construction of a preproduction prototype is a development activity. Answer (D) is incorrect because the design of tools involving new technology is an activity typically classified as development.

[377] Gleim #: 3.87 -- Source: Publisher On January 1, 20X2, Chertco acquired a patent for 500,000 and using the straight-line method began amortizing it properly over its estimated useful life of 10 years. The asset has no residual value. At December 31, 20X5, a significant change in the business climate caused Chertco to assess the recoverability of the carrying amount of the patent. Chertco estimated that the discounted future net cash inflows from the patent would be 325,000 and that its fair value minus cost to sell was 275,000. Accordingly, for the year ended December 31, 20X5, Chertco should recognize an impairment loss of

A. B. C. D.

175,000 50,000 25,000 0


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Answer (A) is incorrect because 175,000 assumes no amortization. Answer (B) is incorrect because 50,000 is the excess of the estimated discounted future net cash inflows over the fair value minus cost to sell. Answer (C) is incorrect because 25,000 is the excess of the carrying amount over the fair value minus cost to sell. Answer (D) is correct. The entity should determine whether the carrying amount exceeds the recoverable amount. The recoverable amount is the greater of fair value minus cost to sell (275,000) or value in use (the present value of expected cash flows from the asset, or 325,000). Thus, Chertco should recognize no impairment loss because the estimated discounted future net cash inflows (325,000) exceed the carrying amount {500,000 – [4 years × (500,000 ÷ 10 years)] = 300,000}. [378] Gleim #: 3.88 -- Source: CIA 593 IV-27 An airline should recognize revenue from airline tickets in the period when

A. B. C. D.

Passenger reservations are booked. Passenger reservations are confirmed. Tickets are issued. Related flights occur. Answer (A) is incorrect because a sufficient degree of certainty that economic benefits will flow to the enterprise does not exist when the reservations are booked or confirmed. Answer (B) is incorrect because a sufficient degree of certainty that economic benefits will flow to the enterprise does not exist when the reservations are booked or confirmed. Answer (C) is incorrect because a sufficient degree of certainty that economic benefits will flow to the enterprise does not exist when the ticket is issued. Answer (D) is correct. Recognition of an element of financial statements (e.g., income, which includes revenue and gains) requires that two criteria be met. It must be probable that any future economic benefit associated with the item will flow to or from the enterprise, and the cost or value of the item must be measurable with reliability. The usual procedures for income recognition, e.g., that income be earned, reflect these criteria. Thus, income is recognized when an increase in future economic benefits is associated with an increase in an asset or a decrease in a liability. The recognition criteria are not met with respect to the collections from sales of airline tickets until the receipt of future economic benefits is sufficiently certain. Such certainty exists when the airline performs the contracted-for service, that is, when the related flights occur. The critical event in the earning process for the airline is the delivery of the service to the customer, which occurs when the related flight takes place.

[379] Gleim #: 3.89 -- Source: CIA 1192 IV-27 A company provides fertilization, insect control, and disease control services for a variety of trees, plants, and shrubs on a contract basis. For 50 per month, the company will visit the subscriber’s premises and apply appropriate mixtures. If the subscriber has any problems between the regularly scheduled application dates, the company’s personnel will promptly make additional service calls to correct the situation. Some subscribers elect to pay for an entire year because the company offers an annual price of 540 if paid in advance. For a subscriber who pays the annual fee in advance, the company should recognize the related revenue

A. B. C. D.

When the cash is collected. Evenly over the year as the services are performed. At the end of the contract year after all of the services have been performed. At the end of the fiscal year.


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Answer (A) is incorrect because a liability is recognized when the cash is collected prior to the rendition of the service. Answer (B) is correct. Income, which includes revenue and gains, should not be recognized until an increase in future economic benefits related to an increase in an asset or a decrease in a liability is sufficiently certain and can be measured reliably. The most common time at which these two conditions are met is when the product or merchandise is delivered or services are rendered to customers. In the situation presented, the performance of the service (monthly spraying) is so significant to creating a sufficient certainty of an increase in future economic benefits that revenue should not be recognized until delivery occurs. Answer (C) is incorrect because revenue from services rendered is recognized when the services have been performed. A portion of the services is performed monthly. Thus, a portion of the related revenue should be recognized monthly rather than waiting until the entire contract year is complete. Answer (D) is incorrect because a portion of the related revenue should be recognized monthly rather than waiting until the entire fiscal year is complete. [Fact Pattern #21] A company had the pre-closing trial balance at December 31 shown. Additional information: The balance of opening inventory was 140,000. The long-term debt pays interest at a rate of 10% per annum, payable every 12 months. The debt was issued on July 1 of the current year and originally had 5 years to maturity. The assets classified as property, plant, and equipment (exclusive of land) have a 10-year estimated useful life and were 1 year old at the start of the current year. Straight-line depreciation is used by the company.

Cash Accounts receivable Inventory Gross property, plant, and equipment Accumulated depreciation Accounts payable Long-term debt Share capital Retained earnings (Jan. 1) Sales revenue Purchases Administrative expenses

80,000 100,000 230,000 600,000 60,000 200,000 1,000,000 2,000,000 500,000 750,000 530,000 200,000

[380] Gleim #: 3.90 -- Source: CIA 594 IV-2 (Refers to Fact Pattern #21) On the year-end financial statements, the company will report cost of goods sold of

A. B. C. D.

440,000 620,000 670,000 900,000


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Answer (A) is correct. Cost of goods sold equals beginning inventory, plus purchases, minus ending inventory. Hence, cost of goods sold is 440,000 (140,000 + 530,000 – 230,000). Answer (B) is incorrect because 620,000 is obtained by reversing the opening and closing inventory figures. Answer (C) is incorrect because 670,000 omits closing inventory from the calculation. Answer (D) is incorrect because 900,000 adds, rather than subtracting, closing inventory. [381] Gleim #: 3.91 -- Source: CIA 594 IV-3 (Refers to Fact Pattern #21) Which is the correct order of the following four steps in the accounting cycle? Step 1 Step 2 Step 3 Step 4

A. B. C. D.

prepare adjusting journal entries take a post-closing trial balance prepare an adjusted trial balance prepare reversing entries

1, 3, 2, 4 4, 1, 3, 2 3, 1, 2, 4 1, 2, 3, 4 Answer (A) is correct. The accounting cycle may be summarized as consisting of nine steps: record the period’s transactions in the appropriate journals, post to the ledger(s) from the journals, prepare an unadjusted trial balance, prepare and post adjusting journal entries, prepare an adjusted trial balance, prepare the financial statements, prepare and post the closing entries, take a post-closing trial balance, and prepare reversing entries (optional). Answer (B) is incorrect because the preparation of reversing entries is the last step in the accounting cycle. Answer (C) is incorrect because the adjusted trial balance is prepared after adjusting entries are made. Answer (D) is incorrect because the post-closing trial balance is prepared after adjusting entries and the adjusted trial balance are completed.

[382] Gleim #: 3.92 -- Source: CIA 591 IV-43 On 1/1/X1, an enterprise acquired a plant asset for 300,000. Using the straight-line method of depreciation over a service life of 10 years with no residual value, the enterprise recorded depreciation of 30,000 for the year ending 12/31/X1. The fair value of the asset at 12/31/X1 is not reliably measurable but is estimated to be 310,000. If the enterprise uses the appropriate treatment for the measurement of property, plant, and equipment subsequent to initial recognition, the balance sheet prepared on 12/31/X1 will

A. B. C. D.

Report the excess of the fair value over the carrying amount as goodwill. Report the excess of the fair value over the carrying amount as part of property, plant, and equipment. Report the excess of the fair value over the carrying amount in equity as revaluation surplus. Not report the excess of the fair value over the carrying amount.


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Answer (A) is incorrect because an excess of fair value over the carrying amount of a plant asset is not reflected in conventional financial statements if the fair value is not reliably measurable. Answer (B) is incorrect because an excess of fair value over the carrying amount of a plant asset is not reflected in conventional financial statements if the fair value is not reliably measurable. Answer (C) is incorrect because an excess of fair value over the carrying amount of a plant asset is not reflected in conventional financial statements if the fair value is not reliably measurable. Answer (D) is correct. An item of property, plant, and equipment may be carried at a revalued amount equal to fair value minus any subsequent accumulated depreciation and impairment losses. An increase in the carrying amount after a revaluation is credited directly to equity as revaluation surplus. However, revaluation is not allowed when the fair value is not reliably measurable. Thus, the measurement of property, plant, and equipment subsequent to initial recognition as an asset is at cost minus any accumulated depreciation and impairment losses. The plant asset should be reported at its carrying amount of 270,000 [300,000 – (300,000 ÷ 10 years)]. [383] Gleim #: 3.93 -- Source: CIA 1192 IV-30 The management of ABC Corporation is analyzing the financial statements of XYZ Corporation because ABC is strongly considering purchasing a block of XYZ ordinary shares that would give ABC significant influence over XYZ. Which financial statement should ABC primarily use to assess the amounts, timing, and certainty of future cash flows of XYZ Company?

A. B. C. D.

Income statement. Statement of changes in equity. Statement of cash flows. Balance sheet. Answer (A) is incorrect because the statement of income is prepared on an accrual basis and is not meant to report cash flows. Answer (B) is incorrect because the statement of changes in equity is prepared on the accrual basis. Answer (C) is correct. A statement of cash flows provides information about the cash receipts and cash payments of an enterprise during a period. This information helps investors, creditors, and other users to assess the enterprise’s ability to generate cash and cash equivalents and the needs of the enterprise to use those cash flows. Historical cash flow data indicate the amount, timing, and certainty of future cash flows. It is also a means of verifying past cash flow assessments and of determining the relationship between profits and net cash flows and the effects of changing prices. Answer (D) is incorrect because the balance sheet reports on financial position at a moment in time.

[384] Gleim #: 3.94 -- Source: CIA 1191 IV-32 In a statement of cash flows (indirect method), depreciation expense should be presented as

A. B. C. D.

An inflow of cash. An outflow of cash. An addition to net profit in converting net profit or loss to net cash flows from operating activities. A deduction from net profit in converting net profit or loss to net cash flows from operating activities.


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Answer (A) is incorrect because depreciation does not involve an inflow or outflow of cash. The purchase and the sale of property, plant, and equipment constitute investing activities, but the process of depreciating such assets is not defined as an investing activity. Depreciation is a noncash operating expense. Answer (B) is incorrect because depreciation is a noncash operating expense. Answer (C) is correct. Net cash flow from (used by) operating activities may be reported indirectly by removing from net profit or loss the effects of (1) deferrals of past operating cash flows, (2) accruals of expected future operating cash flows, (3) income or expense items related to financing and investing cash flows, and (4) noncash transactions. These adjustments include such items as depreciation, amortization of patents, amortization of bond discount and bond premium, gains and losses, changes during the period in trade receivables, changes in inventory, and changes in accounts payable and accrued liabilities. In the reconciliation of net profit or loss to net cash from (used by) operations, depreciation (a noncash expense) is added to net profit or loss. Answer (D) is incorrect because depreciation should be added. [385] Gleim #: 3.95 -- Source: CIA 592 IV-35 A financial statement includes all of the following items: net profit, depreciation, operating activities, and financing activities. What financial statement is this?

A. B. C. D.

Balance sheet. Income statement. Statement of cash flows. Statement of changes in equity. Answer (A) is incorrect because the balance sheet does not include periodic net profit or loss or depreciation expense. Answer (B) is incorrect because the income statement does not have captions for operating and financing activities. Answer (C) is correct. A statement of cash flows is a required financial statement. It provides information about cash receipts and payments by reporting the cash effects of an enterprise’s operating, investing, and financing activities. Related disclosures report the effects of noncash investing and financing activities. If the statement is presented using the indirect method, it will reconcile net profit or loss to net cash from (used in) operating activities. Depreciation, a noncash expense, is included in this presentation. Answer (D) is incorrect because the statement of changes in equity does not include captions for operating and investing activities and depreciation.

[386] Gleim #: 3.96 -- Source: CIA 592 IV-36 An enterprise decided to sell a separate major line of its business. The assets were sold for 100,000 and had a net carrying amount of 70,000. The applicable tax rate was 20%. The result of this transaction may appear on the

A. B. C. D.

Balance sheet as a fundamental error. Income statement as an extraordinary item. Income statement as a single amount for a discontinued operation. Income statement as a change in accounting policy.


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Answer (A) is incorrect because a fundamental error is no longer recognized under IFRSs. Answer (B) is incorrect because extraordinary items are not recognized. Answer (C) is correct. A discontinued operation (DO) is a component of an entity that has been disposed of or meets the criteria for classification as held for sale. It is (1) a separate major line of business or geographical operating area, (2) part of a single plan to dispose of such a line or area, or (3) a subsidiary acquired solely for resale. A component of an entity consists of operations and cash flows that are clearly distinguishable from the rest of the entity for financial reporting as well as operationally. A single amount is disclosed on the face of the income statement equal to the sum of (1) after-tax profit (loss) on DOs and (2) after-tax gain (loss) on (a) remeasurement of noncurrent assets (or disposal groups) classified as held for sale at fair value minus cost to sell or (b) disposal of the assets or disposal groups that constituted the DO. Answer (D) is incorrect because accounting policies guide the preparation and presentation of financial statements. [387] Gleim #: 3.97 -- Source: CIA 1191 IV-40 A company uses the percentage-of-completion method and reports the following:

Construction costs Estimated cost to complete at year-end

Year 1

Year 2

100 300

200 0

The contract price is 1,000. What is the gross profit recognized in year 2?

A. B. C. D.

150 400 550 800 Answer (A) is incorrect because gross profit recognized in year 2 is 550. Answer (B) is incorrect because gross profit recognized in year 2 is 550. Answer (C) is correct. At the end of year 1, total cost was expected to be 400 (100 incurred + 300 estimated cost to complete), and estimated total gross profit was 600 (1,000 price – 400 estimated total cost). Hence, the amount of gross profit recognized in year 1 was 150 [600 × (100 cost incurred ÷ 400 estimated total cost)]. The project was completed in year 2 at an additional cost of 200. Actual gross profit was therefore 700 (1,000 – 300 actual total cost). Gross profit recognized in year 2 is 550 (700 total – 150 recognized in year 1). Answer (D) is incorrect because gross profit recognized in year 2 is 550.

[388] Gleim #: 3.98 -- Source: CIA 594 IV-30 Which of the following is not an appropriate basis for measuring the historical cost of property, plant, and equipment?

A. Delivery and handling costs and installation costs of a productive asset should be included in the asset’s cost. B. The cost should include the purchase price without a deduction for trade discounts. C. The costs of improvements to equipment incurred after its acquisition should be added to the asset’s cost if they provide future economic benefits exceeding the originally assessed standard of performance. D. All costs incurred in the construction of a plant building, from excavation to completion, should be considered as part of the asset’s cost.


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Answer (A) is incorrect because directly attributable costs of bringing the asset to working condition for its intended use are included in its cost. Answer (B) is correct. An asset classified under property, plant, and equipment is measured initially at cost. This amount includes the purchase price and any directly attributable costs of bringing the asset to working condition for its intended use. Directly attributable costs include costs of, for example, site preparation, initial delivery and handling, installation, professional fees (e.g., those of architects and engineers), and dismantling and removing the asset and restoring the site. The purchase price is determined by adding any import fees and nonrefundable purchase taxes and subtracting any trade discounts and rebates. Answer (C) is incorrect because subsequent expenditures should be added to the carrying amount if it is probable that they will result in future economic benefits exceeding the originally assessed standard of performance. Answer (D) is incorrect because the costs of a self-constructed asset are determined in the same way as those of an acquired asset. Hence, all costs of construction of a building are included in its initially recorded cost because they are directly attributable costs of bringing the asset to its working condition for its intended use. [389] Gleim #: 3.99 -- Source: CIA 590 IV-31 DEF is the consignee for 1,000 units of product X for ABC Company. ABC should recognize the revenue from these 1,000 units when

A. B. C. D.

The agreement between DEF and ABC is signed. ABC ships the goods to DEF. DEF receives the goods from ABC. DEF sells the goods and informs ABC of the sale. Answer (A) is incorrect because the revenue recognition criteria for sales of goods are not met in a consignment until the consignee sells the goods to a third party. Answer (B) is incorrect because the revenue recognition criteria for sales of goods are not met in a consignment until the consignee sells the goods to a third party. Answer (C) is incorrect because the revenue recognition criteria for sales of goods are not met in a consignment until the consignee sells the goods to a third party. Answer (D) is correct. Under a consignment arrangement, the consignor ships merchandise to the consignee who acts as agent for the consignor in selling the goods. The goods are in the physical possession of the consignee but remain the property of the consignor and are included in the consignor’s inventory. Revenue and the related cost of goods sold from these consigned goods should only be recognized by the consignor when the merchandise is sold and delivered to the final customer. Accordingly, recognition occurs when notification is received that the consignee has sold the goods. Only then are the recognition criteria for a sale of goods satisfied: the enterprise has transferred the significant risks and rewards of ownership, the enterprise has neither continuing managerial involvement to an extent associated with ownership nor effective control over the goods, the amount can be reliably measured, it is probable that the economic benefits will flow to the enterprise, and transactional costs can be reliably measured.

[390] Gleim #: 3.100 -- Source: CIA 1193 IV-37 ABC Manufacturing Company ships merchandise costing 40,000 on consignment to XYZ Stores. ABC pays 3,000 of freight costs to a transport company, and XYZ pays 2,000 for local advertising costs that are reimbursable from ABC. By the end of the period, three fourths of the consigned merchandise has been sold for 50,000 cash. XYZ notifies ABC of the sales, retains a 10% commission and the paid advertising costs, and remits the cash due ABC. Select the journal entry that appropriately records the notification of sale and the receipt of cash by ABC.


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A. Cash Advertising expense Commission expense Freight expense Revenue from consignment sales B. Cash Advertising expense Commission expense Revenue from consignment sales C. Cash Revenue from consignment sales D. Cash Commission expense Revenue from consignment sales

40,000 2,000 5,000 3,000 50,000 43,000 2,000 5,000 50,000 50,000 50,000 45,000 5,000 50,000

Answer (A) is incorrect because the freight was paid earlier in the period and would have been recorded then by a credit to cash and a debit to inventory. Thus, the freight costs will be included in the determination of net profit when cost of goods sold is recognized. Answer (B) is correct. ABC debits the cash received 43,000 [50,000 sales – 2,000 advertising – (.10 × 50,000) sales commission]. The advertising and commission expenses are debited for 2,000 and 5,000, respectively. Finally, 50,000 of gross revenue is credited. Answer (C) is incorrect because the 10% commission and the advertising costs are ignored in this answer. Answer (D) is incorrect because the reimbursable advertising costs are ignored in this answer. [391] Gleim #: 3.101 -- Source: CIA 592 IV-34 On December 1, year 1, a company using the installment sales method sold goods that cost 1,000 for 1,500. The buyer paid 100 down. Monthly payments start January 1, year 2. Interest accrues at 1% per month on the unpaid balance. To the nearest dollar, the effect on profit for year 1 is

A. B. C. D.

33 increase. 47 increase. 67 increase. 114 increase. Answer (A) is incorrect because 33 is the net profit effect excluding interest revenue of 14 [.01 × (1,500 – 100)]. Answer (B) is correct. The gross profit margin is 33 1/3% [(1,500 – 1,000) ÷ 1,500], so the amount of profit from the 100 down payment recognizable in year 1 is 33 (rounded). Interest accrued on the 1,400 (1,500 – 100) balance for 1 month is 14. Consequently, the effect on profit is 47 (33 + 14). Answer (C) is incorrect because 67 is the cost of goods sold [(1,000 ÷ 1,500) × 100]. Answer (D) is incorrect because 114 {100 + [.01 × (1,500 – 100)]} is the total revenue, not the profit.

[392] Gleim #: 3.102 -- Source: CIA 1189 IV-9 On January 31, 20X3, a company prepaid the 72,000 rental fee for a parking lot it leases. The rental fee covered a 3-year period beginning February 1, 20X3. What is the effect of this transaction on the December 31, 20X3 financial statements for each of the following?


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Current Expenses

Prepaid Expenses

A. B.

0 22,000

72,000 50,000

C. D.

24,000 72,000

48,000 0

Answer (A) is incorrect because the expenses relating to the current year need to be recognized. Answer (B) is correct. The 72,000 rental fee should be recognized as expense evenly over the 36-month duration of the lease. In 20X3, 22,000 should be debited to current expenses (11 months × 72,000 ÷ 36), and 50,000 should be deferred as prepaid expense. Answer (C) is incorrect because 24,000 is the expense recognized for 12 months instead of the 11 months from January 31, 20X3 to December 31, 20X3. Answer (D) is incorrect because only those expenditures related to the current year should be expensed. [393] Gleim #: 3.103 -- Source: CIA 1189 IV-29 A department store sells gift certificates that may be redeemed for merchandise. Each certificate expires 3 years after issuance. The revenue from the gift certificates should be recognized

A. B. C. D.

Evenly over 3 years from the date of issuance. In the period the certificates are sold. In the period the certificates expire. In the period the certificates are redeemed or in the period they expire if they are allowed to lapse. Answer (A) is incorrect because there is no basis for such an allocation. Answer (B) is incorrect because, when the certificates are sold, future economic benefits are neither sufficiently certain nor reliably measurable. The store has not yet performed its obligations created by the sales of gift certificates. Answer (C) is incorrect because revenue is also recognized when certificates are redeemed. Answer (D) is correct. Income, which includes revenue and gains, should not be recognized until an increase in future economic benefits related to an increase in an asset or a decrease in a liability is sufficiently certain and can be measured reliably. These criteria are met when the certificates are redeemed or expire because the liability for redemptions will then decrease and economic benefits will be reliably measurable.

[394] Gleim #: 3.104 -- Source: CIA 1185 IV-20 Which of the following costs is most likely to be expensed immediately rather than recognized as an asset?

A. B. C. D.

Development. Equipment. Goodwill. Research.


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Answer (A) is incorrect because an internally generated intangible asset may arise from the development (but not the research) phase of asset generation. An asset is recognized if the enterprise demonstrates the technical feasibility of completing the asset, the intent to complete and use or sell the asset, the ability to use or sell it, how it will generate probable future economic benefits, the availability of resources to complete development and to use or sell the asset, and the ability to make a reliable measurement of development expenditures for the asset. Answer (B) is incorrect because items of equipment that qualify for asset recognition are initially measured at cost. The depreciable amounts of these assets are then allocated as expense (unless included in the carrying amount of other assets) over their useful lives. Answer (C) is incorrect because goodwill arising from a business combination that meets the definition of an acquisition is recognized as an asset. It is not amortized. However, impairment of goodwill is recognized as a loss. Answer (D) is correct. Research expenditures should be expensed when incurred. No intangible asset resulting from research should be recognized. The enterprise cannot demonstrate at this stage that future economic benefits are probable. [Fact Pattern #22] On January 1, 20X3, a construction company signed a contract with a property management firm involving the construction of a large urban office tower. The total price of constructing the tower was agreed to be 10 million with 2 million being paid on the date of the agreement. Construction began immediately upon the signing of the contract and was expected to take 3 years to complete. The original estimate of total construction costs was 8 million. During the year ended December 31, 20X3, 4 million of construction costs were incurred, and engineering estimates indicated that the office tower was 30% complete at year-end. At year-end, the revised estimate of total construction costs was 8.5 million and the property management firm had been billed a further 4 million, although only 1 million of that amount had been collected by year-end. [395] Gleim #: 3.105 -- Source: CIA 1194 IV-8 (Refers to Fact Pattern #22) If the construction company uses the percentage-of-completion (cost-to-cost basis) method of revenue recognition, in 20X3 the amount of revenue it will recognize on the long-term contract will be

A. B. C. D.

3,000,000 4,705,882 5,000,000 6,000,000 Answer (A) is incorrect because 3,000,000 is based on the engineering estimate of the stage of completion. Answer (B) is correct. Under the cost-to-cost approach to determining the stage of completion of the contract, the stage of completion equals contract costs incurred to date divided by the most recent estimate of total contract costs. Hence, the revenue to be recognized in the first year is 4,705,882 [(4,000,000 ÷ 8,500,000) × 10,000,000]. This amount equals costs incurred plus recognized profit. Answer (C) is incorrect because 5,000,000 is based on the original estimate of contract costs. Answer (D) is incorrect because 6,000,000 is based on the percentage of total revenue billed to date.

[396] Gleim #: 3.106 -- Source: CIA 1194 IV-9 (Refers to Fact Pattern #22) Assume that the construction company recognizes 2 million of revenue for the long-term contract in 20X3. If the company uses the percentage-of-completion method (cost-to-cost basis), the difference between revenue recognized to date and contract billings at the end of 20X3 will be shown on the December 31, 20X3 balance sheet as a of .


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List A

List B

A.

Current asset

1,000,000

B. C.

Current asset Current liability

4,000,000 1,000,000

D.

Current liability

4,000,000

Answer (A) is incorrect because an excess of billings over the sum of costs and recognized profits is a liability, and 1,000,000 is the amount of cash collected. Answer (B) is incorrect because an excess of billings over the sum of costs and recognized profits is a liability. Answer (C) is incorrect because 1,000,000 equals cash collected. Answer (D) is correct. The gross amount due from (to) customers for contract work is an asset (liability). If the amount of costs incurred plus recognized profits minus recognized losses exceeds progress billings, the enterprise presents an asset. If the amount of progress billings exceeds costs incurred plus recognized profits minus recognized losses, the enterprise presents a liability. At the end of 20X3, the company had recognized 2,000,000 of revenue (costs to date + recognized profit) and had submitted billings of 6,000,000. Thus, the excess billings equal 4,000,000. Because the billings exceed revenue recognized, this amount is listed as a current liability. It represents unearned revenue. NOTE: Given a 10 million fixed price and 8.5 million of total costs, the assumption that 2 million of revenue was recognized under the percentage-of-completion method (cost-to-cost basis) necessarily includes the assumption that the stage of completion was 20% (2 million ÷ 10 million), that recognized profit was 300,000 [20% × (10 million – 8.5 million)], and that costs to date were 1.7 million (20% × 8.5 million). [Fact Pattern #23] On January 1, a new landscaping firm acquired a fleet of vehicles, all the necessary tools and equipment, and a parking and storage facility. It began operations immediately. It is now the end of the first year of operations, and the first set of year-end financial statements are being prepared. Several decisions have to be made regarding the appropriate accounting and reporting practices for this company. Relevant information for several of these items is described in the following list of transactions and events: At year-end, the parking and storage facility that was purchased for 150,000 has a fair value of 250,000. The physical flow of inventory is first in, first out, and the cost of materials has risen steadily over the year. To promote sales for the coming year, maintenance contracts were sold in December at very reasonable prices, provided that the customers paid cash. On April 1, the company arranged a 100,000, 10% bank loan. Interest payments of 5,000 are due on October 1 and April 1 of each year during the 5-year term of the loan. During the first year of operations, the company experienced a 5% bad debt rate on credit sales. None of the bad debts are expected to be recovered, given that 5% is the industry average level of bad debts. Total credit sales for the year were 400,000. The year-end balance of accounts receivable, which includes uncollected overdue accounts, is 100,000. Half of the uncollected overdue amounts are estimated to be uncollectible. [397] Gleim #: 3.107 -- Source: CIA 1194 IV-25 (Refers to Fact Pattern #23) The company will recognize revenue from the December sale of the maintenance contracts in the year if it selects basis reporting.


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List A

List B

A.

First

Cash

B. C.

First Second

Accrual Cash

D.

Third

Accrual

Answer (A) is correct. Under the cash basis of accounting, revenue is recognized when the cash is received. Because the customers paid cash for the maintenance contracts in the first year, that is the year in which the revenue should be recognized. Answer (B) is incorrect because, if the accrual basis is used, revenue received for the maintenance contracts is recognized after the first year. The services are provided and the revenue recognition criteria are met after year one. Answer (C) is incorrect because, under cash-basis accounting, the revenue received in the first year is recognized in the first year. Answer (D) is incorrect because accrual-basis accounting recognizes the revenue in year two. Services will be provided in year two. [398] Gleim #: 3.108 -- Source: CIA 1194 IV-26 (Refers to Fact Pattern #23) The company will report a value of for the parking and storage facility if it prepares financial reports consistent with the principle.

List A

List B

A.

150,000

Matching

B. C.

150,000 250,000

Historical cost Going concern

D.

250,000

Revenue recognition

Answer (A) is incorrect because the matching principle requires the recognition of related revenues and expenses in the same accounting period. Answer (B) is correct. An asset classified under property, plant, and equipment is measured initially at cost. This amount includes the purchase price and any directly attributable costs of bringing the asset to working condition for its intended use. Directly attributable costs include costs of, for example, site preparation, initial delivery and handling, installation, professional fees (e.g., those of architects and engineers), and dismantling and removing the asset and restoring the site. The purchase price is determined by adding any import fees and nonrefundable purchase taxes and subtracting any trade discounts and rebates. Answer (C) is incorrect because the going-concern assumption is that the enterprise will continue in existence indefinitely. Answer (D) is incorrect because revenue recognition principles refer to the timing of revenue recognition, not to the valuation basis for property, plant, and equipment. [399] Gleim #: 3.109 -- Source: CIA 1194 IV-27 (Refers to Fact Pattern #23) If the company uses the approach to estimate bad debt expense, the estimated bad debt expense will be .

List A

List B

A. B.

Balance sheet Balance sheet

20,000 100,000

C. D.

Income statement Income statement

20,000 50,000


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Answer (A) is incorrect because the balance sheet approach estimates bad debts as a portion of overdue accounts estimated to be uncollectible. Under this approach, the amount estimated to be uncollectible is 50,000 (100,000 × 50%). Answer (B) is incorrect because the balance sheet approach estimates bad debts as a portion of overdue accounts estimated to be uncollectible. Under this approach, the amount estimated to be uncollectible is 50,000 (100,000 × 50%). Answer (C) is correct. Using the income statement approach, the bad debt expense is determined using a percentage of total credit sales. Thus, bad debt expense is 20,000 (400,000 credit sales × 5% estimated bad debt rate). Answer (D) is incorrect because 50,000 is the estimated bad debt expense using the balance sheet approach. [400] Gleim #: 3.110 -- Source: CIA 1194 IV-28 (Refers to Fact Pattern #23) If the company reports expenses on an accrual basis, interest expense for the first year of operations is

A. B. C. D.

5,000 7,500 10,000 12,500 Answer (A) is incorrect because 5,000 is the interest expense under the cash basis. Answer (B) is correct. The interest expense for the first year equals the 5,000 payment made on October 1 plus the three months’ accrued interest at year-end, or 7,500 (5,000 + 2,500). Answer (C) is incorrect because 10,000 is the interest expense for a full year. Answer (D) is incorrect because 12,500 is equal to 15 months of interest.

[401] Gleim #: 3.111 -- Source: CIA 595 IV-1 To calculate net sales, must be cash receipts from customers.

List A

List B

A.

An increase in accounts receivable

Added to

B. C.

An increase in accounts receivable An increase in accounts payable

Subtracted from Added to

D.

An increase in accounts payable

Subtracted from

Answer (A) is correct. To convert from the cash basis (cash receipts) to the accrual basis (net sales), the increase in net accounts receivable must be added to cash receipts from customers. Answer (B) is incorrect because a decrease in receivables would be subtracted from cash receipts. Answer (C) is incorrect because changes in accounts payable are not included in the calculation of net sales. Answer (D) is incorrect because changes in accounts payable are not included in the calculation of net sales. [402] Gleim #: 3.112 -- Source: CIA 595 IV-3 Which of the following steps in the accounting cycle is completed later than the others?

A. B. C. D.

Adjustments. Journalization. Posting. Identification and measurement of transactions.


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Answer (A) is correct. The order of the steps in the accounting cycle is identification and measurement of transactions and other events required to be recognized, journalization, posting from the journals to the ledgers, the development of a trial balance, adjustments to produce an adjusted trial balance, statement presentation, closing, taking a post-closing trial balance (optional), and making reversing entries (optional). Answer (B) is incorrect because, of the steps listed, journalization occurs second. Answer (C) is incorrect because, of the steps listed, posting occurs third. Answer (D) is incorrect because the identification and measurement of transactions is the first step in the accounting cycle. [403] Gleim #: 3.113 -- Source: CIA 595 IV-4 A company purchased 50,000 worth of office supplies on January 1st and had 15,000 of office supplies still on hand at yearend. If the initial purchase of supplies entry on January 1st was to debit office supplies expense and to credit cash for 50,000, the adjusting entry on December 31 will be

A. Office supplies Office supplies expense B. Office supplies expense Office supplies C. Office supplies Office supplies expense D. Office supplies expense Office supplies

15,000 15,000 15,000 15,000 35,000 35,000 35,000 35,000

Answer (A) is correct. Because the initial entry recorded the entire purchase to a nominal account, the year-end adjusting entry must debit a prepaid asset to reflect the remaining supplies on hand of 15,000. The adjusting entry must also credit (reduce) expenses for the 15,000 of supplies that were not used during the period. Answer (B) is incorrect because the reversing entry is to debit expense and credit a prepaid asset. Answer (C) is incorrect because the appropriate amount is 15,000, not 35,000. Answer (D) is incorrect because the closing entry would have been to debit expense and credit a prepaid asset if the initial entry had been to a real account. [404] Gleim #: 3.114 -- Source: CIA 1196 IV-11 A company began work on a long-term construction contract in year 1. The contract price was 3,000,000. Year-end information related to the contract is as follows:

Estimated total cost Cost incurred Billings Collections

Year 1

Year 2

Year 3

2,000,000 700,000 800,000 600,000

2,000,000 900,000 1,200,000 1,200,000

2,000,000 400,000 1,000,000 1,200,000

If the company uses the percentage-of-completion method of accounting for this contract, the gross profit to be recognized in year 1 is

A. B. C. D.

(100,000) 100,000 200,000 350,000


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Answer (A) is incorrect because (100,000) is the difference between costs incurred and collections. Answer (B) is incorrect because 100,000 is the difference between billings and costs incurred. Answer (C) is incorrect because 200,000 is the difference between billings and collections. Answer (D) is correct. When the outcome of a contract can be reasonably estimated, the percentage-of-completion method recognizes revenue based on the stage of completion of the contract. One typical method for estimating the stage of completion is the calculation of ratio of the contract costs incurred to date to the estimated total costs. The percentage-ofcompletion at year-end on the cost-to-cost basis is 35% (700,000 ÷ 2,000,000). The gross profit for year 1 is the anticipated gross profit on the contract times the completion percentage. Thus, gross profit for year 1 is 350,000 [(3,000,000 – 2,000,000) × 35%]. [405] Gleim #: 3.115 -- Source: CIA 1196 IV-30 A vendor sells specialty inks on consignment to a manufacturer of colored paper at a price of 200 per barrel. Payment is made to the vendor in the month the manufacturer uses the barrels in production. The vendor records revenues when the barrels are shipped and makes no adjusting entries to record unearned revenues until the December 31st closing of the books. At the end of July, the manufacturer had 40 barrels of ink on consignment. During August, the vendor consigned 50 barrels and received payment for 30 barrels. Another 5 barrels were returned to the vendor by the manufacturer for credit. At the end of August, what is the amount of unearned revenue contained in the vendor’s accounts receivable from the manufacturer?

A. B. C. D.

3,000 4,000 11,000 12,000 Answer (A) is incorrect because 3,000 does not include the 40 barrels consigned in July. Answer (B) is incorrect because 4,000 does not include the 40 barrels consigned in July or deduct the 5 barrels returned. Answer (C) is correct. Under a consignment arrangement, the consignor ships merchandise to the consignee who acts as agent for the consignor in selling the goods. The goods are in the physical possession of the consignee but remain the property of the consignor and are included in the consignor’s inventory. Revenue and the related cost of goods sold from these consigned goods should only be recognized by the consignor when the merchandise is sold and delivered to the final customer. Accordingly, recognition occurs when notification is received that the consignee has sold the goods. Only then are the recognition criteria for a sale of goods satisfied: the enterprise has transferred the significant risks and rewards of ownership, the enterprise has neither continuing managerial involvement to an extent associated with ownership nor effective control over the goods, the amount can be reliably measured, it is probable that the economic benefits will flow to the enterprise, and transactional costs can be reliably measured. In this consignment arrangement, 30 barrels have been paid for, so the revenue is recognized for these barrels. The 5 barrels returned are not included in unearned revenue because they constitute a return of consigned goods. Accordingly, the amount of inappropriately recognized revenue is 11,000 [(40 consigned + 50 consigned - 30 paid for - 5 returns) x 200]. Answer (D) is incorrect because 12,000 does not reflect the 5 barrels returned.

[406] Gleim #: 3.116 -- Source: CIA 591 IV-52 A project is expected to result in the following adjustments over the next year: Cash sales increase by 400,000. Expenses (except depreciation) increase by 180,000. Depreciation increases by 80,000. Assume the corporate tax rate is 34%. The total relevant net cash flows during that year are


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A. B. C. D.

92,400 140,000 172,400 220,000 Answer (A) is incorrect because 92,400 equals the increase in after-tax net profit. Answer (B) is incorrect because 140,000 is the increase in pre-tax net profit. Answer (C) is correct. The increase in pre-tax net profit is 140,000 (400,000 cash sales increase – 180,000 nondepreciation expenses increase – 80,000 depreciation). Thus, taxes will increase by 47,600 (34% × 140,000), and the increase in net cash inflows will be 172,400 (400,000 – 180,000 – 47,600). Answer (D) is incorrect because 220,000 equals cash sales minus expenses other than depreciation.

[407] Gleim #: 3.117 -- Source: CIA 590 IV-55 A company had 30 million in total sales last year and expects 40 million in total sales this year. Ten percent of each year’s sales are on credit that will be paid the following year. The company anticipates the following expenses for this year: Depreciation of 5 million. Labor, materials, taxes, and other expenses of 51 million. Assume the company begins this year with a zero cash balance. At the end of this year, the company will have a cash deficit of

A. B. C. D.

8 million. 12 million. 15 million. 17 million. Answer (A) is incorrect because 8 million includes next year’s payments on this year’s sales in the estimation of this year’s cash inflows. Answer (B) is correct. The cash inflows from last year’s credit sales are estimated to be 3,000,000 (10% × 30,000,000). The cash inflows from this year’s sales are expected to be 36,000,000 (90% × 40,000,000), a total cash inflow of 39,000,000 for the current year. Ignoring depreciation, which is a noncash expense, cash outflows are estimated at 51,000,000. Hence, the net cash outflow is anticipated to be 12,000,000 (39,000,000 – 51,000,000). Answer (C) is incorrect because 15 million excludes the 3 million cash inflow that resulted from last year’s credit sales. Answer (D) is incorrect because 17 million includes depreciation when estimating cash outflows.

[408] Gleim #: 3.118 -- Source: CIA 597 IV-32 The management discussion and analysis section of a company’s annual report typically contains

A. B. C. D.

A description of the company’s primary business and segments. A discussion of the company’s operating results. A discussion of the future prospects of the company. All of the answers are correct.


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Answer (A) is incorrect because a description of the company’s primary business and segments, a discussion of the company’s operating results, and a discussion of the future prospects of the company are included. Answer (B) is incorrect because a description of the company’s primary business and segments, a discussion of the company’s operating results, and a discussion of the future prospects of the company are included. Answer (C) is incorrect because a description of the company’s primary business and segments, a discussion of the company’s operating results, and a discussion of the future prospects of the company are included. Answer (D) is correct. The MD&A section addresses capital resources, liquidity, and operating results. Management must also identify trends and discuss significant events and uncertainties. Thus, the MD&A section typically includes a description of the company’s primary business and segments. It reviews the operating results of the company, providing a breakdown of net sales and income by segment. It also contains prospective information on economic trends and market changes, and their potential effects on the company’s future performance. [409] Gleim #: 3.119 -- Source: CIA R98 IV-36 The present value of 100,000 due at the end of eight years, at 10%, is 46,650. What is the approximate value of 100,000 invested for the same length of time and at the same rate?

A. B. C. D.

46,650 100,000 114,360 214,360 Answer (A) is incorrect because 46,650 is the present value of 100,000 discounted at 10% for 8 years. Answer (B) is incorrect because 100,000 is the present value of 214,360 discounted at 10% for 8 years. Answer (C) is incorrect because 114,360 is the interest earned. Answer (D) is correct. The present value of a future amount equals that amount divided by the interest factor for the given discount period and discount rate. The interest factor for the present value of 1 due in 8 years and discounted at 10% is 2.1436 (100,000 ÷ 46,650). Thus, the future value of 100,000 must be 214,360 (2.1436 × 100,000).

[410] Gleim #: 3.120 -- Source: CIA R98 IV-41 A company purchased a new machine on an installment payment plan and is to make equal annual payments beginning one year from the date of purchase. Using an interest rate of 10%, the cost of the machine can be determined by multiplying one payment by the

A. B. C. D.

Future value of one currency unit. Future value of an annuity due of one currency unit. Present value of one currency unit. Present value of an ordinary annuity of one currency unit. Answer (A) is incorrect because the cost at the date of purchase is the present value of an ordinary annuity. Answer (B) is incorrect because the cost at the date of purchase is the present value of an ordinary annuity. Answer (C) is incorrect because the cost at the date of purchase is the present value of an ordinary annuity. Answer (D) is correct. The cost of the machine is the present value of the annuity (the series of equal periodic payments). The annuity is an ordinary annuity because the payments begin one period after the date of purchase. The cost therefore equals the periodic payment times the interest factor for an ordinary annuity of one currency unit for a specified number of equal periodic payments discounted at a given interest rate.


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[411] Gleim #: 3.121 -- Source: Publisher IAS 34, Interim Financial Reporting, provides guidelines for interim reporting stating that enterprises

A. May use estimates based on sales margins for interim inventory valuation although a different method is used for annual reporting. B. Must determine income tax expense by applying progressive tax rates to income on a quarterly basis. C. May prorate extraordinary items over four quarters. D. Need not disclose basic and diluted earnings per share each quarter. Answer (A) is correct. Essentially the same reporting methods should be used for interim and annual financial statements. However, the preparation of interim financial reports ordinarily requires a greater use of estimates. For example, IAS 34 states that complete inventory-taking and valuation may not be required at interim dates. Estimates based on sales margins may suffice. Answer (B) is incorrect because income tax expense is based on the estimated annual effective income tax rate. Answer (C) is incorrect because the same accounting policies should be applied in the interim statements as in the annual statements. Accordingly, an extraordinary item is to be reported in the interim period in which the gain or loss occurred. Answer (D) is incorrect because the same accounting policies should be applied in the interim statements as in the annual statements. Thus, BEPS and DEPS must be reported. [412] Gleim #: 3.122 -- Source: CIA 1193 IV-30 An enterprise that sprays chemicals in residences to eliminate or prevent infestation of insects requires that customers prepay for 3 months’ service at the beginning of each new quarter. Select the term that appropriately describes this situation from the viewpoint of the enterprise.

A. B. C. D.

Unearned income. Earned income. Accrued income. Prepaid expense. Answer (A) is correct. The prepayment does not meet the income recognition criteria because the future inflow of economic benefits is not sufficiently certain given that the enterprise has not done what is required to be entitled to those benefits. Thus, the amount received in advance is considered a liability (unearned income) because it represents an obligation to perform a service in the future arising from a past transaction. Answer (B) is incorrect because the income is not earned. The exterminator has not performed the related services for the customer. Answer (C) is incorrect because accrued income has met the recognition criteria but has not been received. Answer (D) is incorrect because the customer has a prepaid expense (expense paid but not incurred).

[413] Gleim #: 3.123 -- Source: CIA 1196 IV-4 The purpose of an entry that contains a debit to prepaid property taxes and a credit to property tax expense is to recognize a(n)

A. B. C. D.

Prepaid expense. Accrued expense. Prepaid income. Expired cost.


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Answer (A) is correct. An entry debiting prepaid property taxes and crediting property tax expense is needed at the balance sheet date when prepayments are initially recorded in an expense account. This adjusting entry defers expense recognition to the future period in which the property taxes apply. Answer (B) is incorrect because the entry records an asset. Answer (C) is incorrect because the entry records an asset. Answer (D) is incorrect because the entry records an unexpired cost (an asset). [414] Gleim #: 3.124 -- Source: CIA 597 IV-3 What are the effects of an adjusting entry used to accrue revenue from credit sales?

Assets

Liabilities

Equity

A. B.

Decrease Increase

No effect No effect

Decrease Increase

C. D.

No effect No effect

Decrease Increase

Increase Decrease

Answer (A) is incorrect because the accrual of revenue increases assets, increases equity, and has no effect on liabilities. Answer (B) is correct. The journal entry to accrue revenue requires a debit to a receivable account and a credit to a revenue account. Thus, the accrual of revenue increases assets and equity. Answer (C) is incorrect because the accrual of revenue increases assets, increases equity, and has no effect on liabilities. Answer (D) is incorrect because the accrual of revenue increases assets, increases equity, and has no effect on liabilities. [415] Gleim #: 3.125 -- Source: CIA 597 IV-14 A manufacturer receives an advance payment for special-order goods that are to be manufactured and delivered within the next year. The advance payment should be reported in the manufacturer’s current-year balance sheet as a(n)

A. B. C. D.

Current liability. Noncurrent liability. Contra asset amount. Accrued revenue. Answer (A) is correct. Recognition of an element of financial statements (e.g., income, which includes revenue and gains) requires that two criteria be met. It must be probable that any future economic benefit associated with the item will flow to or from the enterprise, and the cost or value of the item must be measurable with reliability. The usual procedures for income recognition, e.g., that income be earned, reflect these criteria. Thus, income is recognized when an increase in future economic benefits is associated with an increase in an asset or a decrease in a liability. However, the enterprise has not substantially completed what it must do to be entitled to the benefits represented by the advance payment, and the receipt of future economic benefits is not sufficiently certain to merit income recognition. Accordingly, a liability should be recognized because the entity has a current obligation arising from a past event that will require an outflow of economic benefits, that is, to deliver goods or to refund the customer’s money. The delivery of goods is to take place within a year of the balance-sheet date; therefore, the obligation is expected to be settled in the normal course of the operating cycle or is due to be settled within 12 months. Answer (B) is incorrect because the obligation is current. Answer (C) is incorrect because a contra account reduces the valuation of the related account. Answer (D) is incorrect because the payment has not met the income recognition criteria.


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[416] Gleim #: 3.126 -- Source: CIA 597 IV-28 An enterprise that owns a new professional basketball team sells season tickets to its team’s games. The season lasts from November through April, with 10 games played each month. In 20X3, the enterprise collected 3 million from season-ticket sales for the 20X3-20X4 season. Its fiscal year-end is December 31. Based on this information, the enterprise should

A. B. C. D.

Report a liability for unearned income of 2 million on its December 31, 20X3 balance sheet. Report a liability for unearned income of 3 million on its December 31, 20X3 balance sheet. Report income of 3 million on its 20X3 income statement. Report income of 1 million on its 20X4 income statement. Answer (A) is correct. The collections represent a liability (unearned income). The income recognition criteria are not met with respect to the season ticket collections until the receipt of future economic benefits is sufficiently certain. Such certainty exists with respect to collections related to the games played as of the balance sheet date. Accordingly, the enterprise should recognize 1 million as income in 20X3 [2 months × (3,000,000 ÷ 6 months)]. The remaining 2 million should be reported as a liability. Answer (B) is incorrect because the liability at the end of 20X3 is 2 million. Answer (C) is incorrect because the enterprise should report income of 1 million in 20X3 and 2 million in 20X4. Answer (D) is incorrect because the enterprise should report income of 1 million in 20X3 and 2 million in 20X4.

[Fact Pattern #24] An enterprise had the pre-closing trial balance at December 31 shown below. Additional information: The balance of opening inventory was 140,000. The long-term debt pays interest at a rate of 10% per annum, payable every 12 months. The debt was issued on July 1 of the current year and originally had 5 years to maturity. The assets classified as property, plant, and equipment have a 10-year estimated useful life and were 1 year old at the start of the current year. Straight-line depreciation is used.

80,000 100,000 230,000 600,000 60,000 200,000 1,000,000 2,000,000 500,000 750,000 530,000 200,000

Cash Accounts receivable Inventory Gross property, plant, and equipment Accumulated depreciation Accounts payable Long-term debt Share capital Retained earnings (Jan. 1) Sales revenue Purchases Administrative expenses [417] Gleim #: 3.127 -- Source: CIA 594 IV-1

(Refers to Fact Pattern #24) The enterprise uses straight-line depreciation for financial reporting purposes, but uses accelerated depreciation for tax purposes. Which of the following account balances would be lower in the financial statements used for tax purposes than it would be in the general purpose financial statements?


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A. B. C. D.

Accumulated depreciation. Cash. Retained earnings. Gross property, plant, and equipment. Answer (A) is incorrect because the balance of accumulated depreciation is higher in the tax-basis financial statements. Answer (B) is incorrect because depreciation expense is a noncash charge. The cash balance is unaffected by the depreciation method used. Answer (C) is correct. Because the tax basis uses an accelerated method, depreciation expense and accumulated depreciation will be greater. Moreover, taxable income will be lower than financial net income. Consequently, tax-basis retained earnings will be less than that in the general purpose financial statements. Answer (D) is incorrect because the historical cost of property, plant, and equipment is recorded in the gross property, plant, and equipment account. This amount is unaffected by depreciation.


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[Fact Pattern #25] An entity’s financial statements for the current year are presented below:

Balance Sheet Cash Accounts receivable Inventory Net fixed assets

100 200 50 600

Total

950

Accounts payable Long-term debt Share capital Retained earnings

140 300 260 250

Total

950

Statement of Income and Retained Earnings Sales Cost of goods sold

3,000 1,600

Gross profit Operations expenses

1,400 970

Operating profit Interest expense

430 30

Profit before tax Income tax

400 200

Net profit Plus Jan. 1 retained earnings Minus dividends

200 150 100

Dec. 31 retained earnings

250

[418] Gleim #: 3.128 -- Source: CIA 594 IV-5 (Refers to Fact Pattern #25) The enterprise will report year-end total assets of

A. B. C. D.

800,000 890,000 950,000 1,010,000


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Answer (A) is incorrect because 800,000 uses the beginning balance of inventory. Answer (B) is correct. The year-end total assets can be determined by summing all of the assets and deducting accumulated depreciation (including the current year’s depreciation). Total accumulated depreciation at the end of the second year is 120,000 [(600,000 ÷ 10 years) × 2 years]. Total assets equal 890,000 (80,000 cash + 100,000 A/R + 230,000 EI + 600,000 gross property, plant, and equipment – 120,000 accumulated depreciation). Answer (C) is incorrect because 950,000 omits second-year depreciation from the calculation. Answer (D) is incorrect because 1,010,000 omits total accumulated depreciation from the calculation. [419] Gleim #: 3.129 -- Source: CIA 594 IV-4 (Refers to Fact Pattern #24) Which adjusting entry should be used at year-end to account for interest expense on the long-term debt?

A. Interest expense Interest payable B. Interest expense Cash C. Interest payable Interest expense D. Interest expense Interest payable

100,000 100,000 50,000 50,000 100,000 100,000 50,000 50,000

Answer (A) is incorrect because the debt has been outstanding for only 6 months, so accrued interest is only 50,000. Answer (B) is incorrect because the debt pays annual interest on July 1, and no cash outlay is required at year-end. Answer (C) is incorrect because accrued interest is 50,000. Also, interest expense is debited and interest payable is credited. Answer (D) is correct. The debt was issued on July 1 and has been outstanding for only 6 months. Interest expense equals the face amount of the debt multiplied by the interest rate and the fraction of the year the debt was outstanding [1,000,000 × 10% × (6 ÷ 12) = 50,000]. Because interest is payable on July 1, 6 months’ interest is accrued and expensed in the current period. The payable is also recognized in the current period. Thus, the adjusting entry should be

50,000

Interest expense Interest payable

50,000

[420] Gleim #: 3.130 -- Source: CIA 594 IV-6 (Refers to Fact Pattern #24) Assume that the enterprise reports cost of goods sold of 200,000 and interest expense of 10,000 for the current period. Also assume a 50% tax rate on corporate earnings. The final closing entry required to ensure that current earnings are incorporated into year-end retained earnings is

A. Income summary Retained earnings B. Retained earnings Income summary C. Income summary Retained earnings D. Retained earnings Income summary

140,000 140,000 280,000 280,000 240,000 240,000 240,000 240,000


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Answer (A) is correct. Current period pretax net income equals 280,000 (750,000 sales – 200,000 CGS – 60,000 depreciation – 10,000 interest – 200,000 administrative expenses). Thus, after-tax net income credited to retained earnings equals 140,000 [(1.0 – .5) × 280,000]. Answer (B) is incorrect because income taxes are omitted and the journal entry is reversed. Answer (C) is incorrect because administrative expenses were omitted. Answer (D) is incorrect because administrative expenses were omitted and the journal entry is reversed. [421] Gleim #: 3.131 -- Source: IIA, adapted The practice of recording advanced payments from customers as liabilities is an application of the

A. B. C. D.

Going concern assumption. Monetary unit assumption. Historic cost principle. Revenue recognition principle. Answer (A) is incorrect because the going concern assumption is that the business will have a long life. This does not relate directly to the practice of recording unearned revenues as liabilities. Answer (B) is incorrect because the monetary unit assumption is that money is the common denominator by which economic activity is conducted, and that the monetary unit provides an appropriate basis for accounting measurement and analysis. It does not relate directly to the practice of recording unearned revenues as liabilities. Answer (C) is incorrect because the historic cost principle is the requirement that most assets and liabilities be accounted for and reported on the basis of acquisition price. It does not relate directly to the practice of recording unearned revenues as liabilities. Answer (D) is correct. Since the amount received in cash has not yet been earned, it is appropriate to record the advance payment as a liability of the company. This is an example of the revenue recognition principle, which states that revenue should not be recognized until it is earned.

[422] Gleim #: 3.132 -- Source: IIA, adapted Which of the following is a product cost for a manufacturing company?

A. B. C. D.

Insurance on the corporate headquarters building. Property taxes on a factory. Depreciation on a salesperson’s vehicle. The salary of a sales manager. Answer (A) is incorrect because insurance on the corporate headquarters building is not a cost of production and is therefore a period cost. Answer (B) is correct. Product costs such as material, labor, and overhead attach to the product and are carried in future periods if the revenue from the product is recognized in subsequent periods. Period costs are expensed immediately because no direct relationship between cost and revenue exists. Answer (C) is incorrect because depreciation on salespersons’ vehicles is not a cost of production and is therefore a period cost. Answer (D) is incorrect because the salary of a sales manager is not a cost of production and is therefore a period cost.

[423] Gleim #: 3.133 -- Source: CIA 597 IV-55 An entity has excess capacity in production-related property, plant, and equipment. If in a given year these assets are being used to only 80% of capacity and the sales level in that year is 2 million, the full capacity sales level is


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A. B. C. D.

1,600,000 2,000,000 2,500,000 10,000,000 Answer (A) is incorrect because 1,600,000 is 80% of the actual sales. Answer (B) is incorrect because 2,000,000 equals the actual sales. Answer (C) is correct. Full capacity sales equals actual sales divided by the percentage of capacity at which PPEs were operated. Thus, full capacity sales equals 2,500,000 (2,000,000 ÷ 80%). Answer (D) is incorrect because 10,000,000 equals actual sales divided by the proportion of unused capacity.

[424] Gleim #: 3.134 -- Source: CIA 1191 IV-14 Actual and projected sales of an entity for September and October are as follows:

September (actual) October (projected)

Cash Sales

Credit Sales

20,000 30,000

50,000 55,000

All credit sales are collected in the month following the month in which the sale is made. The September 30 cash balance is 23,000. Cash disbursements in October are projected to be 94,000. To maintain a minimum cash balance of 15,000 on October 31, the entity will need to borrow

A. B. C. D.

0 6,000 11,000 16,000 Answer (A) is incorrect because the entity will need to borrow 6,000. Answer (B) is correct. This entity will collect 80,000 (50,000 from September credit sales + 30,000 from October cash sales) in October. To reach its targeted cash balance on October 31, it will have to borrow 6,000.

September 30 cash balance Collections Disbursements Ending balance Necessary borrowing Targeted ending balance

23,000 80,000 (94,000)

(14,000) 9,000 6,000 15,000

Answer (C) is incorrect because the entity will need to borrow 6,000. Answer (D) is incorrect because the entity will need to borrow 6,000.


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[425] Gleim #: 3.135 -- Source: CIA 597 IV-34 An entity purchased a machine on January 1, 20X1 for 1,000,000. The machine had an estimated useful life of 9 years and a residual value of 100,000. The company uses straight-line depreciation. On December 31, 20X3, the machine was sold for 535,000. The gain or loss that should be recorded on the disposal of this machine is

A. B. C. D.

35,000 gain. 65,000 loss. 365,000 loss. 465,000 loss. Answer (A) is incorrect because 35,000 gain equals selling price, minus carrying amount, plus residual value. Answer (B) is correct. The accumulated depreciation was 400,000 {[(1,000,000 – 100,000) ÷ 9 years] × 4 years}, so the carrying amount was 600,000 (1,000,000 – 400,000). Thus, the loss was 65,000 (600,000 – 535,000 sales price). Answer (C) is incorrect because 365,000 loss equals cost, minus selling price, minus residual value. Answer (D) is incorrect because 465,000 loss equals cost minus selling price.

[426] Gleim #: 3.136 -- Source: CIA 597 IV-33 An entity purchased a machine for 700,000. The machine was depreciated using the straight-line method and had a residual value of 40,000. The machine was sold on December 31, 20X1. The accumulated depreciation related to the machine was 495,000 on that date. The entity reported a gain on the sale of the machine of 75,000 in its income statement for the fiscal year ending December 31, 20X1. The selling price of the machine was

A. B. C. D.

280,000 240,000 205,000 115,000 Answer (A) is correct. The selling price minus the carrying amount of the machine equals the gain or loss. The carrying amount equals cost minus accumulated depreciation, or 205,000 (700,000 – 495,000). Thus, the selling price was 280,000 (205,000 + 75,000 gain). Answer (B) is incorrect because 240,000 equals carrying amount, plus gain, minus residual value. Answer (C) is incorrect because 205,000 is the carrying amount. Answer (D) is incorrect because 115,000 equals the gain plus the residual value.

[427] Gleim #: 3.137 -- Source: CIA R98 IV-39 A transfer of receivables, with recourse, in exchange for cash should

A. B. C. D.

Not be recorded until all of the receivables have been collected. Be recorded as a sale or a borrowing transaction, depending on the provisions of the transfer agreement. Be recorded as a sale of receivables. Be recorded as a borrowing transaction.


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Answer (A) is incorrect because the transferor must recognize cash and either a sale or a borrowing. Answer (B) is correct. An entity derecognizes a financial asset (or a part thereof) when it loses control of the contractual rights the asset represents. Control is lost when the entity realizes the rights to the benefits of the contract, the rights expire, or the entity surrenders the rights. Moreover, whether loss of control has occurred depends on the positions of both the transferor and the transferee. Control is not lost, for example, if the entity may reacquire the asset (unless it is readily obtainable in the market or the price is fair value) or when the transferor is entitled and obligated to repurchase or redeem at a price giving the transferee a lender’s return. Control ordinarily is lost when the transferee may obtain the benefits of the asset, for example, if the transferee may freely sell or pledge the full fair value of the asset. When the conditions above are met, the transfer of receivables with recourse is accounted for as a sale, with the proceeds of the sale reduced by the fair value of the recourse obligation (a new financial liability). Answer (C) is incorrect because certain conditions must be met before a sale may be recognized. Answer (D) is incorrect because a sale may be recognized if certain conditions are met. [428] Gleim #: 3.138 -- Source: CIA 1190 IV-46 On January 1, year 1, an entity recorded the purchase of an asset correctly at 275,132. A down payment of 200,000 was made with the balance of 100,000 due in 3 years at an imputed annual interest rate of 10%. What is the year 1 interest to record on the payable?

A. B. C. D.

7,513 8,289 10,000 27,513 Answer (A) is correct. The balance outstanding during the year was 75,132 (275,132 – 200,000). At an interest rate of 10%, the entity should accrue 7,513.20 (10% × 75,132) of interest for the year. Answer (B) is incorrect because 8,289 is the balance due in 3 years minus the balance outstanding during the year divided by 3 [(100,000 – 75,132) ÷ 3]. Answer (C) is incorrect because 10,000 equals 10% of the face amount due. Answer (D) is incorrect because 27,513 equals the interest rate times the cost of the asset (275,132 × 10%).

[429] Gleim #: 3.139 -- Source: CIA 589 IV-35 The following facts are presented for an entity that uses the retail inventory method:

Beginning inventory Purchases Sales Ending inventory (per physical count) at retail prices

Cost

Retail

28,000 126,000

40,000 180,000 170,000 45,000

What is the forgone sales revenue from inventory shrinkage?

A. B. C. D.

3,500 5,000 35,000 45,000


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Answer (A) is incorrect because 3,500 is the inventory shrinkage at cost. Answer (B) is correct. The retail inventory method converts ending inventory at retail to cost by applying a cost-retail ratio. The advantage is that a physical inventory can be taken at retail without the necessity of counting individual items at cost. Because this method requires detailed inventory records to be kept at retail, lost sales revenue (at retail) caused by inventory shrinkage can be calculated using the following retail data:

Beginning inventory Purchases

40,000 180,000

Goods available for sale Sales

220,000 (170,000)

Estimated ending inventory Actual ending inventory

50,000 (45,000)

Inventory shrinkage

5,000

Answer (C) is incorrect because 35,000 equals the estimated ending inventory at cost. Answer (D) is incorrect because 45,000 equals the actual ending inventory at retail. [430] Gleim #: 3.140 -- Source: CIA 592 IV-30 An entity purchased 1,000 gross amount of inventory on account with terms of 2% discount if paid within 10 days. The seller was responsible for delivery to the shipping point, with freight of 30 prepaid by the seller. The entity records purchases at the net amount. The journal entry to record payment 8 days after the invoice date is

A. Accounts payable Cash B. Accounts payable Freight-in Cash C. Purchases Freight-in Accounts payable D. Purchases Freight-in Accounts payable

1,010 1,010 980 30 1,010 1,000 30 1,030 980 30 1,010

Answer (A) is correct. Under the net method, the payable is initially credited at the discounted amount. Because the payment was within the discount period and freight was prepaid, the buyer’s remittance to the seller includes the freight cost of 30 and the discounted price of the merchandise [1,000 × (1.0 – .02) = 980], a total of 1,010. Answer (B) is incorrect because freight-in was debited at the invoice date (debit freight-in and purchases, credit accounts payable). Accounts payable needs to be debited for the entire amount (including freight of 30) owed to the seller. Answer (C) is incorrect because this entry would have been made at the invoice date if the gross method had been used. Answer (D) is incorrect because this entry was made at the invoice date. [Fact Pattern #26] An entity with a December 31 year-end purchased 2,000 of inventory on account. The seller was responsible for delivery to the shipping point, with freight of 50 paid at destination by the buyer. The invoice date was December 27, 20X1, and the goods arrived on January 3, 20X2.


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[431] Gleim #: 3.141 -- Source: CIA 592 IV-33 (Refers to Fact Pattern #26) Now assume the terms required the seller to deliver to the destination instead of the shipping point. What is the correct amount of inventory and freight-in relating to this purchase on the 20X3 financial statements?

Inventory

Freight-In

A.

0

0

B. C.

2,050 0

0 50

D.

2,000

50

Answer (A) is correct. Title and risk of loss passed to the buyer at the destination, and the seller incurred the expense of delivery to that point. The goods did not arrive until after year-end, so they should not be included in 20X1 inventory. Freight-in should also not be recorded until 20X2. Answer (B) is incorrect because no inventory should be included in the 20X1 financial statements. Answer (C) is incorrect because freight-in should be recorded in 20X2. Answer (D) is incorrect because no inventory should be included in the 20X1 financial statements, and freight-in should be recorded in 20X2. [432] Gleim #: 3.142 -- Source: CIA 594 IV-18 A merchandising company had the following inventory related transactions in its first year of operations:

Date Jan. 1 March 1 May 1 July 1 Sept. 1 Nov. 1 Dec. 1

Purchases in Units

Sales in Units

10,000 @ 5 6,000 @ 6 3,000 8,000 @ 6.25 12,000 5,000 @ 7 2,000

Balance in Units 10,000 16,000 13,000 21,000 9,000 14,000 12,000

If the company uses the first-in-first-out (FIFO) method of inventory valuation, its ending inventory balance (rounded) will be

A. B. C. D.

62,000 70,759 78,750 84,000 Answer (A) is incorrect because 62,000 is the ending inventory balance under LIFO. Answer (B) is incorrect because 70,759 is the ending inventory balance under the weighted average method. Answer (C) is correct. The first-in-first-out (FIFO) method assumes that the oldest units are used first and the newest units remain in inventory. Because the company has 12,000 units remaining, ending inventory equals 78,750 [(5,000 × 7) + (7,000 × 6.25)]. Answer (D) is incorrect because 84,000 computes all 12,000 units of ending inventory at the most recent purchase price of 7.


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[433] Gleim #: 3.143 -- Source: CIA 597 IV-13 An entity has appropriately used the installment method of accounting since it began operations at the beginning of the current year. The following information pertains to its operations for this year: Installment sales Cost of installment sales Collections on installment sales General and administrative expenses

1,200,000 840,000 480,000 120,000

The amount of gross profit deferred at the end of the current year should be

A. B. C. D.

720,000 288,000 216,000 144,000 Answer (A) is incorrect because 720,000 is the year-end balance of installment accounts receivable. Answer (B) is incorrect because 288,000 applies the gross profit percentage to the sum of cost of sales and general and administrative expenses. Answer (C) is correct. The gross profit on installment sales is 360,000 (1,200,000 installment sales – 840,000 cost of installment sales). Accordingly, the gross profit percentage is 30% (360,000 gross profit ÷ 1,200,000 installment sales), and the amount of gross profit deferred at the end of the current year is 216,000 [30% × (1,200,000 installment sales – 480,000 collections)]. General and administrative expenses have no effect on the computation of realized gross profit or deferred gross profit. They are to be classified as operating expenses on the income statement in the period in which they are incurred. Answer (D) is incorrect because 144,000 treats general and administrative expenses as costs of installment sales.

[434] Gleim #: 3.144 -- Source: CIA 594 IV-17 The cost of materials has risen steadily over the year. The entity uses its newest materials first when removing items from inventory. Which of the following methods of estimating the ending balance of the materials inventory account will result in the highest net profit, all other variables held constant?

A. B. C. D.

Last-in-first-out (LIFO). First-in-first-out (FIFO). Weighted average. Specific identification. Answer (A) is incorrect because the last-in-first-out (LIFO) method assumes that the most recent and costliest units have been removed from inventory. If costs rise steadily during the accounting period, this method will result in the lowest inventory balance, the highest cost of goods sold, and the lowest net profit. LIFO is not permitted. Answer (B) is correct. The first-in-first-out (FIFO) method assumes that the oldest and hence least costly units are used first, and the newest and most costly items remain in inventory. This method will result in the highest inventory balance if costs rise steadily during the accounting period. Accordingly, FIFO results in the lowest cost of goods sold and the highest net profit. Answer (C) is incorrect because the weighted-average cost method averages the costs of all inventory items and results in a lower inventory balance and net profit than does the FIFO method. Answer (D) is incorrect because specific identification charges the actual cost of each unit to cost of goods sold each period, leaving as inventory the actual cost of all items still in inventory. Given that the newest and most costly items are removed from inventory first, the inventory balance and net profit will be lower than that obtained using FIFO estimation.


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[435] Gleim #: 3.145 -- Source: CIA 593 IV-35 An entity uses the retail method of inventory estimation for interim reporting purposes. Management expects some normal shrinkage in the inventory because of theft. What effect will the failure to consider this shrinkage have on the computation of (1) the cost-retail ratio, and (2) the estimated ending inventory at retail?

(1)

(2)

Effect on CostRetail Ratio

Effect on Estimated Ending Inventory at Retail

A. B.

No effect No effect

No effect Overstatement

C. D.

Overstatement Overstatement

Overstatement Understatement

Answer (A) is incorrect because shrinkage has no effect on the ratio but should be deducted in arriving at the estimated ending inventory at retail. Answer (B) is correct. The retail method of inventory estimation applies a cost-retail ratio to the ending inventory at retail to determine ending inventory at cost. The ratio equals goods available at cost divided by goods available at retail. Normal inventory shrinkage is deducted from the retail amount of goods available because the goods are not available. However, abnormal amounts of theft, etc., are deducted in arriving at both the cost and retail amounts. The reason for the difference in treatment is that normal but not abnormal inventory losses are anticipated and included in selling price (retail value). Accordingly, failure to account for normal inventory shrinkage has no effect on the calculation of the cost-retail ratio but overstates ending inventory at retail. Answer (C) is incorrect because shrinkage has no effect on the ratio but should be deducted in arriving at the estimated ending inventory at retail. Answer (D) is incorrect because shrinkage has no effect on the ratio but should be deducted in arriving at the estimated ending inventory at retail. [436] Gleim #: 3.146 -- Source: CIA 1193 IV-29 An entity purchases office equipment for 525,000 on account. Select the appropriate journal entry to record this transaction.

A. Office expense Accounts payable B. Office equipment Accounts payable C. Accounts payable Office expense D. Accounts payable Office equipment

525,000 525,000 525,000 525,000 525,000 525,000 525,000 525,000

Answer (A) is incorrect because the charge should be to an asset account rather than an expense account. Answer (B) is correct. The purchase of office equipment represents the acquisition of an asset. An increase in an asset is recorded by a debit. The purchase on account increases liabilities. An increase in a liability is recorded by a credit. Answer (C) is incorrect because an increase in accounts payable is recorded by a credit. The purchase of equipment results in an asset that is recorded by a debit to an asset account. Answer (D) is incorrect because an increase in a liability is recorded by a credit. An increase in an asset is recorded by a debit.


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[437] Gleim #: 3.147 -- Source: CIA 592 IV-27 An entity acquired an item of property, plant, and equipment with an estimated useful life of 5 years for 15,000 at the beginning of year 1. For financial statement purposes, how would the depreciation expense calculated using the 200% diminishing-balance method compare with that calculated using the sum-of-the-years’-digits method in year 1 and year 2, respectively?

Year 1

Year 2

A. B.

Lower Lower

Lower Higher

C. D.

Higher Higher

Lower Higher

Answer (A) is incorrect because 200% diminishing-balance depreciation is higher in year 1. Answer (B) is incorrect because 200% diminishing-balance depreciation is higher in year 1 and lower in year 2. Answer (C) is correct. 200% diminishing-balance is an accelerated depreciation method that determines periodic depreciation expense by multiplying the carrying amount at the beginning of each period by a constant rate that is equal to twice the straight-line rate of depreciation. Each year the carrying amount of the asset decreases by the depreciation expense recognized. Residual value is ignored in determining the carrying amount except as a floor beneath which the asset may not be depreciated. SYD depreciation multiplies a constant depreciable amount (cost - residual value) by the SYD fraction. The SYD fraction’s numerator is the number of years of remaining useful life (n). The formula to compute the denominator in the SYD method is (n(n+1)) ÷ 2. For a 5-year estimated useful life, the denominator of the fraction is 15 [5(5 + 1) ÷ 2].

200% DB: SYD:

Year 1 Year 2 Year 1 Year 2

= = = =

15,000(.4) = 6,000 9,000(.4) = 3,600 15,000(5 ÷ 15) = 5,000 15,000(4 ÷ 15) = 4,000

Answer (D) is incorrect because 200% diminishing-balance depreciation is lower in year 2. [438] Gleim #: 3.148 -- Source: CIA 1196 IV-36 Which of the following is a noncash item?

A. B. C. D.

Administrative expense. Interest expense. Income tax expense. Depreciation expense. Answer (A) is incorrect because administrative expense is a cash charge. Answer (B) is incorrect because interest expense is a cash charge. Answer (C) is incorrect because income tax expense is a cash charge. Answer (D) is correct. Depreciation expense is a noncash charge. It represents the allocation of the historical cost of assets to the time periods in which they are used to generate revenues.


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[439] Gleim #: 3.149 -- Source: CIA 590 IV-45 An entity purchased the following for 120,000:

Land Building

Seller’s Carrying Amount

Estimated Fair Value

50,000 100,000

60,000 90,000

The land should be recorded at

A. B. C. D.

40,000 48,000 50,000 60,000 Answer (A) is incorrect because 40,000 assumes the purchase price allocation is based on carrying amounts instead of fair values. Answer (B) is correct. An item of PPE is initially measured at its cost. Accordingly, the cost, which equals the 120,000 purchase price, should be allocated between the land and the building based on their respective fair values. The cost of the land should be recorded at 48,000 {120,000 × [60,000 ÷ (60,000 + 90,000)]}. Answer (C) is incorrect because 50,000 is the seller’s carrying amount of the land. Answer (D) is incorrect because 60,000 is the estimated fair value of the land.

[440] Gleim #: 3.150 -- Source: Publisher Whenever an entity must use net realizable value rather than cost to value an inventory item, the inventory account is reduced and the account “expense due to decline of inventory to net realizable value” is increased. The balance of this account is reflected as a separate item on the

A. B. C. D.

Balance sheet as a deduction from inventory. Income statement as an extraordinary loss. Income statement as a deduction from gross profit on sales. Income statement as an operating expense. Answer (A) is incorrect because the write-down is expensed in the period in which the writedown occurs. Answer (B) is incorrect because the loss is ordinary. Answer (C) is correct. If a separate expense account is not used, the ending inventory will be reduced directly and the result will be an increase in cost of goods sold. No separate disclosure of the inventory writedown will appear in the income statement. The effect is to hide the loss in cost of goods sold. If the separate expense account is used, it appears on the income statement as a deduction from gross profit (sales – cost of goods sold). One advantage is that cost of goods sold is not misstated. Answer (D) is incorrect because the writedown is not treated as a selling or administrative expense.


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[441] Gleim #: 3.151 -- Source: CMA 1292 2-5 Aston Company acquired a new machine at a cost of 200,000 and incurred costs of 2,000 to have the machine shipped to its factory. Aston also paid 4,500 to construct and prepare a site for the new machine and 3,500 to install the necessary electrical connections. Aston estimates that the useful life of this new machine will be 5 years and that it will have a residual value of 15,000 at the end of that period. Assuming that Aston acquired the machine on January 1 and will take a full year’s depreciation, the proper amount of depreciation expense to be recorded by Aston if it uses the 200% diminishing-balance method is

A. B. C. D.

74,000 84,000 80,000 80,800 Answer (A) is incorrect because 74,000 assumes that the depreciable amount is the invoice price minus residual value. Answer (B) is correct. Items of property, plant, and equipment (PPE) that meet the recognition criteria are initially measured at cost. The cost includes the purchase price (minus trade discounts and rebates, plus purchase taxes) and the directly attributable costs of bringing the assets to working condition for their intended use. Hence, the depreciable amount is 210,000 (200,000 invoice price + 2,000 delivery expense + 4,500 site preparation + 3,500 electrical work). Under the 200% DB method, residual value is ignored at the beginning. Thus, the full 210,000 will be subject to depreciation. Given a 5-year life, the annual straight-line rate is 20%, and the 200% DB rate will be 40%. Depreciation for the first year is therefore 84,000 (40% × 210,000). Answer (C) is incorrect because the depreciable amount of the machine was 210,000, not the 200,000 invoice price. Answer (D) is incorrect because 80,800 assumes a depreciable amount of 202,000, but the site preparation and electrical costs are part of that cost.

[442] Gleim #: 3.152 -- Source: CMA 683 1-13 An entity often factors its accounts receivable. The finance company requires an 8% reserve and charges a 1.5% commission on the amount of the receivable. The remaining amount to be advanced is further reduced by an annual interest charge of 16%. What proceeds (rounded to the nearest dollar) will the entity receive from the finance company at the time a 110,000 account that is due in 60 days is turned over to the finance company?

A. B. C. D.

81,950 83,630 96,895 99,550 Answer (A) is incorrect because the proceeds would be determined by reducing the 110,000 by 9.5% (8% reserve + 1.5% commission) and then reducing that amount by the interest expense [16% × (60 ÷ 360)]. Answer (B) is incorrect because the proceeds would be determined by reducing the 110,000 by 9.5% (8% reserve + 1.5% commission) and then reducing that amount by the interest expense [16% × (60 ÷ 360)]. Answer (C) is correct. The factor will hold out 8,800 (8% × 110,000) as a reserve against returns and allowances and 1,650 (1.5% × 110,000) as a commission. That leaves 99,550 to be advanced to the seller. However, interest at the rate of 16% annually is also to be withheld. For 60 days that interest would amount to approximately 2,655 (assuming a 360-day year). The proceeds to be given to the seller equal 96,895 (99,550 – 2,655). Answer (D) is incorrect because the proceeds would be determined by reducing the 110,000 by 9.5% (8% reserve + 1.5% commission) and then reducing that amount by the interest expense [16% × (60 ÷ 360)].

[443] Gleim #: 3.153 -- Source: Publisher Under IAS 2, Inventories, all of the following should be disclosed when reporting inventories except


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A. B. C. D.

The use of the lower-of-cost-or-net-realizable-value method, if applicable. The cost formulas used. The carrying amount of inventories in classifications appropriate to the entity. An estimated amount of obsolete inventory included in the total inventory valuation. Answer (A) is incorrect because disclosures should include the accounting policies applied, such as the lower-of-cost-or-NRV method. Answer (B) is incorrect because disclosures should include the cost formulas used. Answer (C) is incorrect because disclosures should include the amounts for classifications of inventory appropriate to the entity. Answer (D) is correct. According to IAS 2, Inventories, disclosures about inventories include, for example, the accounting policies applied in measuring inventories, including the cost formulas used; total carrying amount; carrying amount for each classification appropriate to the entity; carrying amount of items carried at fair value minus costs to sell; amount of any reversal of writedowns recognized as income; reasons for such a reversal; and carrying amount of inventory pledged as security. Thus, the disclosures under IAS 2 include the carrying amount of inventories carried at NRV, not the amount of obsolete inventory.

[444] Gleim #: 3.154 -- Source: Publisher Subsequent measurement of trade receivables is at

A. B. C. D.

Fair value through profit or loss. Cost. Amortized cost. Fair value through equity. Answer (A) is incorrect because initial measurement of financial assets and liabilities is at fair value. Subsequent measurement of assets or liabilities held for trading and of certain other designated items is at fair value through profit or loss. Answer (B) is incorrect because unquoted equity instruments whose fair value is not reliably measurable are reported at cost. Answer (C) is correct. According to IAS 39, subsequent measurement of financial assets (including derivatives that are assets) is at fair value with certain exceptions. Loans and receivables and held-to-maturity investments are measured at amortized cost using the effective interest method. Unquoted equity instruments whose fair value is not reliably measurable are reported at cost. Answer (D) is incorrect because a gain or loss on an available-for-sale financial asset is recognized directly in equity until the asset is derecognized. Available-for-sale financial assets and liabilities are nonderivatives not designated as such or not falling within one of the other categories: (1) items at fair value through profit or loss, (2) held-to-maturity items, or (3) loans and receivables.

[445] Gleim #: 3.155 -- Source: CIA 1194 IV-19 A new machine has an initial cost of 300,000, an estimated useful life of 2,000 hours of use over a 3-year period, and an estimated residual value of 70,000. Usage rates are estimated as 500 hours in the first year, 700 hours in the second year, and 800 hours in the third year. Depreciation expense in year two under the sum-of-the-units method of depreciation will be

A. B. C. D.

57,500 75,000 80,500 105,000


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Answer (A) is incorrect because 57,500 is the depreciation expense for year one. Answer (B) is incorrect because 75,000 is the expense for year one calculated without subtracting the residual value. Answer (C) is correct. Depreciation expense equals cost minus residual value, times the quotient of estimated hours of use in year two divided by the total estimated hours of use. Thus, depreciation expense is 80,500 [(300,000 – 70,000) × (700 hours ÷ 2,000 hours)]. Answer (D) is incorrect because 105,000 results from not subtracting the residual value. [446] Gleim #: 3.156 -- Source: CIA 595 IV-9 What is the journal entry recorded upon the sale of an item of property, plant, and equipment (PPE) that was sold for cash in excess of its carrying amount?

A. No journal entry is required. B. Debit cash Debit accumulated depreciation Debit income on disposal of PPE Credit PPE C. Debit cash Debit PPE Credit accumulated depreciation Credit income on disposal of PPE D. Debit cash Debit accumulated depreciation Credit PPE Credit income on disposal of PPE Answer (A) is incorrect because depreciation must be taken up to the date of disposition and all amounts relating to the retired asset should be eliminated. Answer (B) is incorrect because the gain should be recorded as a credit. Answer (C) is incorrect because the PPE account should be credited, and accumulated depreciation should be debited. Answer (D) is correct. The journal entry to record the sale of an item of PPE for cash in excess of its carrying amount should debit the cash account to record the sale proceeds received. Accumulated depreciation should be eliminated by debiting an amount equal to depreciation accumulated up to the start of the current accounting period plus any depreciation that has accumulated between the start of the current period and the date of disposal. Finally, the PPE account should be credited to eliminate the original cost of the asset. The gain should be recorded as a credit and recognized as income on the income statement. [447] Gleim #: 3.157 -- Source: CIA 595 IV-13 An entity had 1,000 units of opening inventory that cost 10 per unit. On May 1, 1,000 units were purchased at a cost of 11 each, and on September 1 another 1,000 units were purchased at a cost of 12 each. If 2,000 units were sold during the year, the company will report cost of goods sold of if the method of inventory valuation is used.

List A

List B

A.

22,000

LIFO

B. C.

23,000 21,000

Weighted average FIFO

D.

22,000

FIFO


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Answer (A) is incorrect because cost of goods sold is 22,000 under the weighted-average method. Under LIFO, cost of goods sold is 23,000 (12,000 + 11,000). The 2,000 most recently purchased units are presumed to have been sold. Answer (B) is incorrect because the weighted-average unit cost of all items available for sale is 11 [(10,000 + 11,000 + 12,000) ÷ 3,000]. Given that 2,000 units were sold, cost of goods sold is 22,000 (2,000 × 11) under this method. Answer (C) is correct. Under FIFO, the first items purchased are presumed to be the first sold. Given that 3,000 units were available and 2,000 units were sold, FIFO cost of goods sold must have been 21,000 [(1,000 × 10) BI + (1,000 × 11) May 1 purchase]. Answer (D) is incorrect because FIFO cost of goods sold is 21,000. Under the weighted-average method, cost of goods sold is 22,000. [448] Gleim #: 3.158 -- Source: CIA 595 IV-17 An entity sold a depreciable asset in the middle of the fifth year of its estimated 10-year useful life. The original cost of the asset was 100,000, and it was being depreciated on the straight-line basis. If the asset was sold for 80,000, the gain on the sale will be

A. B. C. D.

20,000 25,000 30,000 35,000 Answer (A) is incorrect because 20,000 omits depreciation for the first half of the fifth year. Answer (B) is correct. The gain on the sale is the difference between the sale proceeds and the undepreciated cost of the asset. Depreciation must be taken up to the time of sale. Assuming that residual value is 0, annual depreciation is 10,000 (100,000 ÷ 10 years). Thus, the gain is 25,000 {80,000 – [100,000 – (4.5 years × 10,000)]}. Answer (C) is incorrect because 30,000 results if 5 full years of depreciation are taken. Answer (D) is incorrect because 35,000 results from subtracting accumulated depreciation from the sale proceeds.

[449] Gleim #: 3.159 -- Source: CIA 595 IV-22 Which of the following changes in accounting policies resulting from a significant change in the expected pattern of economic benefit will increase net profit?

A. B. C. D.

A change from FIFO to LIFO inventory valuation when costs are rising. A change from FIFO to weighted-average inventory valuation when costs are falling. A change from accelerated to straight-line depreciation in the later years of the depreciable lives of the assets. A change from straight-line to accelerated depreciation in the early years of the depreciable lives of the assets.


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Answer (A) is incorrect because a change to LIFO is not allowed. Answer (B) is correct. According to IAS 16, Property, Plant, and Equipment , a change in depreciation method resulting from a significant change in the expected pattern of economic benefits is accounted for as a change in estimate, that is, prospectively. In a period of falling costs, FIFO results in higher cost of goods sold than the weighted-average method. FIFO includes the higher, earlier costs in cost of goods sold, whereas the weighted-average method averages the later, lower costs with the higher, earlier costs. Thus, a change from FIFO to weighted-average costing reduces cost of goods sold and increases reported net profit. Answer (C) is incorrect because, in the later years of the depreciable life of an asset, accelerated depreciation results in lower depreciation expense than does the straight-line method. A change to straight line increases depreciation expense and reduces reported net profit. Answer (D) is incorrect because, in the early years of the depreciable life of an asset, straight-line depreciation results in lower depreciation expense than accelerated depreciation. A change to accelerated depreciation increases depreciation expense and reduces reported net profit. [Fact Pattern #27] An entity had the following account balances in the pre-closing trial balance:

Opening inventory Closing inventory Purchases Transportation-in Purchase discounts Purchase allowances Returned purchases

100,000 150,000 400,000 6,000 40,000 15,000 5,000

[450] Gleim #: 3.160 -- Source: CIA 1195 IV-5 (Refers to Fact Pattern #27) The entity had net purchases for the period of

A. B. C. D.

340,000 346,000 370,000 376,000 Answer (A) is incorrect because 340,000 omits transportation-in from the calculation. Answer (B) is correct. Purchase discounts, allowances, and returns are subtractions from purchases because they are reductions of cost. Transportation-in is an addition because it increases cost. Thus, net purchases equals 346,000 (400,000 + 6,000 – 40,000 – 15,000 – 5,000). Answer (C) is incorrect because 370,000 omits transportation-in and adds, rather than subtracts, purchase allowances. Answer (D) is incorrect because 376,000 adds, rather than subtracts, purchase allowances.


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[Fact Pattern #28] An entity has 8,000 units in inventory on January 1, valued at 10 per unit. During the year, the entity sold 25,000 units and purchased inventory as follows:

Date April 1 July 1 October 1

Quantity Purchased

Unit Price

15,000 units 10,000 units 12,500 units

8 9 10

[451] Gleim #: 3.161 -- Source: CIA 1195 IV-18 (Refers to Fact Pattern #28) If the entity uses the weighted-average method of inventory valuation, cost of goods sold for the period will be

A. B. C. D.

186,978 197,000 228,023 235,000 Answer (A) is incorrect because 186,978 is the value of ending inventory under the weighted-average method. Answer (B) is incorrect because 197,000 is the ending inventory under the FIFO method. Answer (C) is correct. Under the weighted-average method, the weighted-average cost per unit is multiplied by the number of units sold to determine the cost of goods sold for the period. The total units available for sale equaled 45,500 (8,000 + 15,000 + 10,000 + 12,500). The total cost of all units available for sale was 415,000 [(8,000 × 10) + (15,000 × 8) + (10,000 × 9) + (12,500 × 10)]. Thus, the weighted-average cost per unit of inventory was 9.1209 (415,000 ÷ 45,500), and cost of goods sold was 228,023 (25,000 × 9.1209). Answer (D) is incorrect because 235,000 is the cost of goods sold under the LIFO method.

[452] Gleim #: 3.162 -- Source: CIA 1196 IV-8 The following information is available for an entity for the quarter ended March 31, of the current year: Merchandise inventory, as of January 1 of the current year Sales Purchases

30,000 200,000 190,000

The gross profit margin is normally 20% of sales. What is the estimated cost of the merchandise inventory at March 31, of the current year?

A. B. C. D.

20,000 40,000 60,000 180,000


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Answer (A) is incorrect because 20,000 is the difference between sales for the period and cost of goods available for sale. Answer (B) is incorrect because 40,000 is the amount of gross profit. Answer (C) is correct. The gross profit margin percentage is given as 20% of sales. Hence, cost of goods sold must have been 160,000 [200,000 sales × (1.0 – .2)]. The estimated cost of the inventory at March 31, 2004 is computed as follows:

Inventory, 1/1 Purchases Cost of goods available for sale, 3/31 Estimated cost of goods sold Estimated inventory at 3/31

30,000 190,000 220,000 (160,000) 60,000

Answer (D) is incorrect because 180,000 results from subtracting the gross profit from cost of goods available for sale. [453] Gleim #: 3.163 -- Source: CIA 596 IV-27 On January 1 of year 1, an entity purchased a piece of equipment for 250,000 that was originally estimated to have a useful life of 10 years with no residual value. Depreciation has been recorded for 3 years on a straight-line basis. On January 1 of year 4, the estimated useful life was revised so that the equipment is considered to have a total life of 20 years. Assume that the depreciation method and the useful life for financial reporting and tax purposes are the same. The depreciation expense in year 4 on this equipment would be

A. B. C. D.

8,750 10,294 12,500 14,706 Answer (A) is incorrect because 8,750 is the result of depreciating the remaining carrying amount over 20 years rather than the remaining 17 years. Answer (B) is correct. In year 4, the carrying amount at the start of the period will be amortized over the revised estimated years of useful life. The depreciation recognized during years 1 through 3 was 75,000 [3 years × (250,000 ÷ 10)]. Thus, the carrying amount at the beginning of year 4 was 175,000, and year four depreciation based on the revised estimated useful life is 10,294 [175,000 ÷ (20 – 3)]. Answer (C) is incorrect because 12,500 results from accounting for the change in estimate retroactively. Answer (D) is incorrect because 14,706 results from depreciating the original carrying amount over the revised estimate of remaining useful life.


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[Fact Pattern #29] An entity had the following opening and closing inventory balances during the current year:

1/1 Finished goods Raw materials Work-in-progress

90,000 105,000 220,000

12/31 260,000 130,000 175,000

The following transactions and events occurred during the current year: 300,000 of raw materials were purchased, of which 20,000 were returned because of defects. 600,000 of direct labor costs were incurred. 750,000 of production overhead costs were incurred.

[454] Gleim #: 3.164 -- Source: CIA 596 IV-14 (Refers to Fact Pattern #29) The cost of goods sold for the current year ended December 31 would be

A. B. C. D.

1,480,000 1,500,000 1,610,000 1,650,000 Answer (A) is correct. Cost of goods sold equals cost of goods produced (CGP) adjusted for the change in finished goods. CGP equals the sum of raw materials used, direct labor costs, and production overhead, adjusted for the change in work-in-progress. Raw materials used equals 255,000 (105,000 BI + 300,000 purchases – 20,000 returns – 130,000 EI). Thus, CGP equals 1,650,000 (255,000 RM + 600,000 DL + 750,000 OH + 220,000 BWIP – 175,000 EWIP), and CGS equals 1,480,000 (1,650,000 CGP + 90,000 BFG – 260,000 EFG). Answer (B) is incorrect because 1,500,000 results from not subtracting purchase returns when calculating raw materials used. Answer (C) is incorrect because 1,610,000 fails to deduct the ending balance of raw materials when calculating raw materials used. Answer (D) is incorrect because 1,650,000 is the cost of goods produced.

[455] Gleim #: 3.165 -- Source: CIA 596 IV-15 (Refers to Fact Pattern #29) Without prejudice to your answer to any other question, assume that cost of goods sold for the current year ended December 31 is 2,000,000. Inventory turnover on total inventory for the entity would be

A. B. C. D.

2.04 times. 3.54 times. 4.08 times. 4.82 times.


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Answer (A) is incorrect because 2.04 times results from adding all inventory balances, opening and closing, to obtain the denominator of the turnover ratio. Answer (B) is incorrect because 3.54 times results from using the year-end inventory balances only. Answer (C) is correct. Inventory turnover is the ratio of cost of goods sold to the average inventory balance. The total average inventory is 490,000 [(90,000 BFG + 105,000 BRM + 220,000 BWIP + 260,000 EFG + 130,000 ERM + 175,000 EWIP) ÷ 2]. Hence, total inventory turnover is 4.08 times (2,000,000 assumed CGS ÷ 490,000 average total inventory). Answer (D) is incorrect because 4.82 times results from using the opening inventory balances only. [456] Gleim #: 3.166 -- Source: CIA 596 IV-16 (Refers to Fact Pattern #29) If the entity’s raw materials inventory as of December 31 of the current year (ending inventory) was miscounted and the true figure was higher than 130,000, one effect on the year-end financial statements would be that

A. B. C. D.

Net profit is overstated. Cost of goods sold is overstated. Working capital is overstated. Cost of goods produced is understated. Answer (A) is incorrect because, if the ending inventory of raw materials is understated, cost of goods sold is overstated, and net income is understated. Answer (B) is correct. If the ending inventory of raw materials is understated, raw materials used is overstated, cost of goods produced is overstated, and cost of goods sold is overstated. Answer (C) is incorrect because working capital is higher when the balances of current assets are higher. If the raw materials inventory balance is understated, working capital will also be understated. Answer (D) is incorrect because, if the ending inventory of raw materials is understated, raw materials used is overstated, and cost of goods produced is overstated.

[457] Gleim #: 3.167 -- Source: CIA 593 IV-42 A plot of land is acquired in exchange for 250,000 cash and a noninterest-bearing note with a face amount of 1,000,000 on January 1 of the current year. The 1,000,000 is payable in installments of 250,000 each, with the first installment due December 31 of the current year. With regard to imputing interest on this note, (1) what market rate should be used to account for interest for the current year and (2) what should be done in future years when there is a change in prevailing interest rates?

(2) Impact of Change in (1)

Prevailing Interest Rates in Future

Market Rate Used to Compute Interest Expense for the current year

Periods on Rate Used to Account for This Note

A. B.

Rate prevailing at January 2 Rate prevailing at January 2

Ignore change in rate Use new market rate

C. D.

Rate prevailing at December 31 Rate prevailing at December 31

Ignore change in rate Use new market rate


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Answer (A) is correct. Determination of the imputed interest rate is made at the time the debt instrument is issued. Subsequent to initial recognition, most financial liabilities are measured at amortized cost using the effective interest method. Exceptions are those (1) classified as at fair value through profit or loss or (2) arising when a transfer of a financial asset does not qualify for derecognition or is accounted for on a continuing involvement basis (IAS 39). Consequently, a change in the prevailing market rate does not affect the measurement of the noninterest-bearing note given for the land. Answer (B) is incorrect because any subsequent changes in prevailing interest rates are ignored. Answer (C) is incorrect because determination of the imputed interest rate is made at the time the debt instrument is issued. Answer (D) is incorrect because determination of the imputed interest rate is made at the time the debt instrument is issued, and any subsequent changes in prevailing interest rates are ignored. [458] Gleim #: 3.168 -- Source: CIA 1193 IV-44 An entity issued a noninterest bearing note payable due in 1 year in exchange for land. The fair value of the land is not reliably determinable. Which of the following statements is true concerning the accounting for the transaction?

A. The land should be recorded at the future value of the note, and interest should be imputed at the prevailing rate on similar notes. B. No interest should be recognized on the note, and the land should be recorded at the present value of the note. C. Interest on the note should be imputed at the prime rate, and the land should be recorded at the discounted value of the note. D. Interest on the note should be imputed at the prevailing rate for similar notes, and the land should be recorded at the present value of the note. Answer (A) is incorrect because the value of the land will be overstated if it is recorded at future value; present value is the proper valuation. Answer (B) is incorrect because interest should be recognized on the note. Answer (C) is incorrect because the proper discount rate is the prevailing rate for similar notes, not necessarily the prime rate. Answer (D) is correct. When a financial liability is initially recognized, the entity should measure it at its cost, that is, the fair value of the consideration received. The fair value ordinarily is determined by reference to the transaction price or other market prices. If these prices are not reliably determinable, the fair value is estimated by discounting the future cash payments at an imputed rate equal to the prevailing market rate for a similar instrument (e.g., similar as to currency, term, and type of rate) of an issuer with a similar credit rating. [459] Gleim #: 3.169 -- Source: IIA, adapted Which must be part of any risk model involving inventory valuation?

A. B. C. D.

Product warranty policies. Vendor pricing policies. Inventory shrinkage expense. Annual sales forecasts. Answer (A) is incorrect because warranties are not a part of inventory valuation. Answer (B) is incorrect because vendor pricing policies have no effect on inventory valuation until goods are purchased. The price at the time of purchase is the only price that matters in inventory valuation, and changes in vendor pricing policies would not necessarily affect valuation. Answer (C) is correct. The amount of inventory loss through shrinkage directly affects inventory valuation. Inventory shrinkage must be considered in risk models involving inventory valuation. Answer (D) is incorrect because sales forecasts do not affect inventory valuation.


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[460] Gleim #: 3.170 -- Source: IIA, adapted On January 1, a company has no opening inventory balance. The following purchases are made during the year:

January 1 April 1 July 1 October 1

Units Purchased

Unit Cost

5,000 5,000 5,000 5,000

$10.00 9.00 8.00 7.50

There are 10,000 units in inventory on December 31. If the company uses the first in, first out (FIFO) method of inventory valuation, the ending inventory balance will be

A. B. C. D.

$77,500 $85,000 $86,250 $95,000 Answer (A) is correct. Under first-in, first-out (FIFO) inventory valuation, the 10,000 units in ending inventory are assumed to have been the most recent items purchased. The cost of the most recent 10,000 units purchased is : (5,000 units × $7.50) + (5,000 units × $8) = $77,500. Answer (B) is incorrect because this solution is the ending inventory balance under the specific identification method if the units remaining in inventory at year end were identified as having been purchased on April 1 and July 1: (5,000 units × $9) + (5,000 units × $8) = $85,000. Answer (C) is incorrect because this solution is the ending inventory balance under the average cost method. The average cost of all items purchased is used to calculate the ending inventory balance. The average cost of items purchased is: [$10 (5,000) + $9 (5,000) + $8 (5,000) + $7.50 (5,000)] ÷ 20,000 = $8.625 per unit so 10,000 units are assigned a value of $86,250. Answer (D) is incorrect because this solution is the ending inventory balance under the last-in, first-out (LIFO) method of inventory valuation. The most recent items purchased are assumed to be sold first, so the items remaining in inventory are assigned the cost of the earliest purchases: (5,000 units × $10) + (5,000 units × $9) = $95,000.


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[Fact Pattern #30] At the end of the accounting period, an entity has the partially completed financial statements shown as follows.

Income Statement: Sales Cost of goods sold Gross profit Administrative expense Depreciation expense Profit before interest and tax Interest expense Profit before tax Tax expense Profit Balance Sheet: Current assets Other assets Total assets Current liabilities Long-term debt Equity Total liabilities and equity Additional Information: Gross profit percentage = 30% Tax rate = 40% Annual interest cost on long-term debt = 10% Return on total assets = 3% Fixed assets originally cost 500,000 and are being depreciated over 10 years on a straight-line basis. Working capital = 2,000,000

40,000

100,000

300,000

1,000,000

[461] Gleim #: 3.171 -- Source: CIA 1195 IV-12 (Refers to Fact Pattern #30) The entity had sales for the period of

A. B. C. D.

891,667 1,100,000 1,188,890 1,466,667 Answer (A) is incorrect because 891,667 uses a gross profit percentage of 40%. Answer (B) is incorrect because 1,100,000 calculates profit before tax as profit divided by the tax rate and also calculates sales as gross profit divided by the tax rate. Answer (C) is correct. Gross profit equals 30% of sales. Thus, dividing gross profit by 30% yields sales. Gross profit equals profit before interest and tax (PBIT) plus administrative expense (given as 40,000) and depreciation (500,000 fixed assets ÷ 10 years = 50,000). Interest equals 10% of the long-term debt, or 100,000 (10% × 1,000,000). Profit before tax equals 166,667 [100,000 profit ÷ (1.0 – 40% tax rate)]. Hence, PBIT must equal 266,667 (166,667 + 100,000), and gross profit must be 356,667 (266,667 PBIT + 40,000 administrative expense + 50,000 depreciation). Sales is therefore 1,118,890 (356,667 gross profit ÷ 30% gross profit rate). Answer (D) is incorrect because 1,466,667 calculates profit before tax as profit divided by the tax rate.


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[462] Gleim #: 3.172 -- Source: CIA 1195 IV-13 (Refers to Fact Pattern #30) The entity has current assets of

A. B. C. D.

1,000,000 3,033,333 3,333,333 3,633,333 Answer (A) is incorrect because 1,000,000 equals working capital minus long-term debt. Answer (B) is correct. Return on total assets (3%) equals profit (100,000) divided by total assets. Consequently, total assets equals 3,333,333 (100,000 ÷ .03). Current assets must therefore equal 3,033,333 (3,333,333 total assets – 300,000 other assets). Answer (C) is incorrect because 3,333,333 is the amount of total assets. Answer (D) is incorrect because 3,633,333 is the sum of total and other assets.

[463] Gleim #: 3.173 -- Source: CMA 1290 1-30 Lawson Ltd. has the opportunity to increase annual sales 100,000 by selling to a new, riskier group of customers. Based on sales, the uncollectible expense is expected to be 15%, and collection costs will be 5%. Manufacturing and selling expenses are 70% of sales, and the effective tax rate is 40%. If Lawson accepts this opportunity, the after-tax profit will increase by

A. B. C. D.

4,000. 6,000. 10,000. 9,000. Answer (A) is incorrect because after-tax profit will increase by 6,000. Answer (B) is correct. Manufacturing and selling costs exclusive of bad debts equal 70% of sales. Hence, the gross profit on the 100,000 increase in sales will be 30,000 (30% × 100,000). Assuming 15,000 of bad debts and 5,000 of collection expense, the increase in pre-tax profit will be 10,000 (30,000 – 20,000). Consequently, after-tax profit will increase by 6,000 [10,000 – (40% × 10,000)]. Answer (C) is incorrect because after-tax profit will increase by 6,000. Answer (D) is incorrect because after-tax profit will increase by 6,000.


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[Fact Pattern #31] An entity has the following income statements: 20X2 Sales Cost of goods sold Gross profit Selling and administrative expense Depreciation expense Profits before interest and taxes Interest expense Profit before taxes Income tax (50%) Profit

20X1

1,500,000 800,000 700,000 62,000 50,000 688,000 100,000 588,000 294,000 294,000

1,400,000 750,000 650,000 60,000 50,000 540,000 100,000 440,000 220,000 220,000

20X2 Year-end

20X1 Year-end

300,000 250,000

200,000 275,000

Selected balance sheet items are as follows:

Accounts receivable Accounts payable Assume a 365-day year in any calculations. [464] Gleim #: 3.174 -- Source: CIA 1196 IV-37 (Refers to Fact Pattern #31) In 20X2, the entity had cash provided by operations of

A. B. C. D.

219,000 244,000 344,000 469,000 Answer (A) is correct. Cash provided by operations equals profit, plus depreciation, minus the increase in accounts receivable, minus the decrease in accounts payable. The cash provided is 219,000 [294,000 + 50,000 – (300,000 – 200,000) – (275,000 – 250,000)]. An increase in receivables is a noncash component of profit. A decrease in accounts payable is added when adjusting cost of goods sold to reflect cash paid to suppliers. Thus, it is subtracted when adjusting profit to arrive at cash provided by operations. Answer (B) is incorrect because 244,000 does not consider the changes in accounts receivable and payable and subtracts depreciation. Answer (C) is incorrect because 344,000 does not consider the changes in accounts receivable and payable. Answer (D) is incorrect because 469,000 adds rather than subtracts the increase in receivables and the decrease in payables.

[465] Gleim #: 3.175 -- Source: CIA 1196 IV-38 (Refers to Fact Pattern #31) Based on the 20X2 year-end balance of accounts receivable and the 20X2 income statement, the company had an average collection period for 20X2 of


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A. B. C. D.

49 days. 52 days. 73 days. 78 days. Answer (A) is incorrect because 49 days uses accounts receivable from 20X1 instead of 20X2. Answer (B) is incorrect because 52 days is the average collection period for 20X1. Answer (C) is correct. The average collection period for 20X2 is 73 days [300,000 accounts receivable ÷ (1,500,000 sales ÷ 365 days)]. Answer (D) is incorrect because 78 days uses 20X1 annual sales.

[466] Gleim #: 3.176 -- Source: Publisher The effective portion of a gain arising from an increase in the fair value of a derivative is included in profit or loss in the period of change if the derivative is appropriately designated and qualifies as a hedge of

A. B. C. D.

A net investment in a foreign entity. The variable cash flows of a forecast transaction. An unrecognized firm commitment. The variable cash flows of a recognized asset. Answer (A) is incorrect because the effective portion of gains and losses on this hedge is reported as a component of equity. Answer (B) is incorrect because the effective portion of gains and losses on these hedges is included in equity. Answer (C) is correct. A fair value hedge includes a hedge of an exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment. Such a hedge minimizes the risk associated with fixed cash flows. Gains and losses arising from changes in fair value of a derivative classified as a fair value hedge are included in the determination of profit or loss in the period of change. They are offset by losses or gains on the hedged item attributable to the risk being hedged. Thus, profit or loss of the period of change is affected only by the net gain or loss attributable to the ineffective portion of the hedge. Answer (D) is incorrect because the effective portion of gains and losses on these hedges is included in equity.

[467] Gleim #: 3.177 -- Source: Publisher Garcia Corporation has entered into a binding agreement with Hernandez Company to purchase 400,000 pounds of Colombian coffee at $2.53 per pound for delivery in 90 days. This contract is accounted for as a

A. B. C. D.

Financial instrument. Firm commitment. Forecast transaction. Fair value hedge. Answer (A) is incorrect because a financial instrument does not involve the delivery of a product. Answer (B) is correct. A firm commitment is an agreement with an unrelated party, binding on both parties and usually legally enforceable, that specifies all significant terms and includes a disincentive for nonperformance. Answer (C) is incorrect because a forecast transaction is a transaction that is expected to occur for which no firm commitment exists. Answer (D) is incorrect because the purchase commitment is an exposure to risk, not a hedge of an exposure to risk.


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[468] Gleim #: 3.178 -- Source: Publisher On October 1, 20X1, Bordeaux, Inc., a calendar-year-end firm, invested in a derivative designed to hedge the risk of changes in fair value of certain assets, currently valued at $1.5 million. The derivative is structured to result in an effective hedge. However, some ineffectiveness may result. On December 31, 20X1, the fair value of the hedged assets has decreased by $350,000; and the fair value of the derivative has increased by $325,000. Bordeaux should recognize a net effect on 20X1 profit or loss of

A. B. C. D.

$0 $25,000 $325,000 $350,000 Answer (A) is incorrect because the effect on profit or loss is equal to the ineffective portion of the hedge. Answer (B) is correct. A hedge of an exposure to changes in the fair value of a recognized asset or liability is classified as a fair value hedge. Gains and losses arising from changes in fair value of a derivative classified as a fair value hedge are included in the determination of profit or loss in the period of change. They are offset by losses or gains on the hedged item attributable to the risk being hedged. Thus, profit or loss of the period of change is affected only by the net gain or loss attributable to the ineffective aspect of the hedge. The ineffective portion is equal to $25,000 ($350,000 – $325,000). Answer (C) is incorrect because the increase in the fair value of the derivative is a gross effect. Answer (D) is incorrect because the decrease in the fair value of the hedged assets is a gross effect.

[469] Gleim #: 4.1 -- Source: CIA 597 IV-21 Which of the following statements is true for a defined contribution postemployment benefit plan?

A. B. C. D.

The employer is required to contribute a certain amount each period based on the plan’s formula. The employer bears the risk of the plan’s investment performance. Postemployment benefits received by employees are defined by the plan’s formula. The employer and employees are required to contribute equal amounts to the fund. Answer (A) is correct. A defined contribution plan provides benefits in exchange for services, provides an account for each participant, and specifies how contributions are to be determined. Postemployment benefits depend only on contributions, returns on investment, and allocated forfeitures of other participants’ benefits. Thus, employees have the benefit of gain and the risk of loss. Answer (B) is incorrect because the employees bear the risk of the plan’s investment performance. Answer (C) is incorrect because, under a defined benefit plan, the postemployment benefits received by employees are defined by the plan’s formula. Answer (D) is incorrect because equal contributions are not required for a defined contribution plan.

[470] Gleim #: 4.2 -- Source: CIA 595 IV-16 The defined postemployment benefit obligation of an entity includes benefit obligations to employees at salary levels.

List A

List B

A. B.

Vested Vested

Current Future

C. D.

Vested and nonvested Vested and nonvested

Current Future


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Answer (A) is incorrect because the defined postemployment benefit includes both vested and nonvested benefits and is calculated at future levels. Answer (B) is incorrect because the defined postemployment benefit includes both vested and nonvested benefits and is calculated at future levels. Answer (C) is incorrect because the defined postemployment benefit includes both vested and nonvested benefits and is calculated at future levels. Answer (D) is correct. The measurement of a postemployment benefit obligation includes estimates of future salary increases, the benefits defined in the plan, the benefits arising from any constructive obligation beyond the terms of the plan, and estimates of future changes in state benefits that affect the level of plan benefits. The possibility that nonvested projected benefits will not vest is a factor in the measurement of the DBO, but it does not affect the existence of the obligation. [471] Gleim #: 4.3 -- Source: CIA 1189 IV-44 An employee’s right to obtain postemployment benefits regardless of whether (s)he remains employed is known as his/her

A. B. C. D.

Past service cost. Defined benefit plan. Vested benefits. Additional minimum liability. Answer (A) is incorrect because past service cost relates to benefits for employee service provided prior to the adoption or amendment of a defined benefit plan. Answer (B) is incorrect because a defined benefit plan provides a defined benefit based on one or more factors, such as level of compensation, years of service, or age. Answer (C) is correct. Vested benefits are those earned postemployment benefits owed to an employee that are not contingent upon the employee’s continued service. Whether benefits have vested affects the measurement of the employer’s defined benefit obligation but not its existence. Moreover, vesting affects the accounting for past service cost. Past service cost is amortized as an expense over the average period until the benefits are vested. Answer (D) is incorrect because, under IAS 19, the employer does not recognize an additional minimum liability.

[472] Gleim #: 4.4 -- Source: Publisher An employer sponsors a defined postemployment benefit plan. If the given amount of the present value of the defined benefit obligation exceeds the given amount of the fair value of plan assets, the defined benefit liability to be recognized in the balance sheet is greatest when the employer has

A. B. C. D.

Net unrecognized actuarial gains and no past service cost. Net unrecognized actuarial losses and no past service cost. Net unrecognized actuarial losses and unrecognized past service cost. No unrecognized actuarial gains or losses and unrecognized past service cost.


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Answer (A) is correct. The amount of the defined benefit liability recognized equals the present value of the defined benefit obligation at the balance sheet date, plus (minus) unrecognized actuarial gains (losses), minus unrecognized past service cost, minus the fair value of plan assets at the balance sheet date. If this amount is negative, it represents an asset. However, the maximum that may be recognized for such an asset is the sum of unrecognized actuarial losses, unrecognized past service cost, and the present value of future refunds from the plan or reductions in future contributions. Moreover, the application of this section should not result in a gain being recognized solely because of an actuarial loss or past service cost in the current period or in a loss being recognized solely because of an actuarial gain in the current period. Thus, if the excess of the DBO over the fair value of plan assets is constant, net unrecognized actuarial gains will increase the liability. Net unrecognized actuarial losses and unrecognized past service cost decrease the liability. Answer (B) is incorrect because net unrecognized actuarial losses decrease the liability. Answer (C) is incorrect because net unrecognized actuarial losses and unrecognized past service cost decrease the liability. Answer (D) is incorrect because net unrecognized actuarial gains increase the liability. [473] Gleim #: 4.5 -- Source: Publisher The following information relates to the activity of the defined postemployment benefit plan of Twain Publishers, Ltd.: Current service cost Expected return on plan assets Interest cost on defined benefit obligation Amortization of net actuarial loss Past service cost

120,000 30,000 40,000 10,000 5,000

Twain’s expense recognized in the income statement is

A. B. C. D.

120,000 135,000 140,000 145,000 Answer (A) is incorrect because 120,000 includes only the current service cost component. Answer (B) is incorrect because 135,000 excludes the amortization of the actuarial loss. Answer (C) is incorrect because 140,000 excludes the past service cost. Answer (D) is correct. Components of the expense are current service cost, interest cost, the expected return on plan assets, past service cost (recognition in full of vested amounts and amortization of nonvested amounts). Current service cost, interest cost, the amortization of actuarial loss, and the past service cost increase the expense. The expected return on plan assets decreases the expense. Current service cost Return on plan assets Interest cost Amortization of actuarial loss Past service cost

120,000 (30,000) 40,000 10,000 5,000

Expense

145,000


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[474] Gleim #: 4.6 -- Source: Publisher At the start of its current fiscal year, Emper Corporation amended its defined postemployment benefit plan, resulting in an increase in the present value of the DBO. The benefits become vested after 6 years of service. Past service cost arising from the plan amendment includes 400,000 of benefits that are already vested and 200,000 of nonvested benefits. If the average period until vesting is 4 years, the minimum past service cost to be recognized in the first year is

A. B. C. D.

50,000 200,000 450,000 600,000 Answer (A) is incorrect because 50,000 is the periodic amortization of nonvested benefits. Answer (B) is incorrect because 200,000 is the amount of the nonvested benefits. Answer (C) is correct. Past service cost is the increase in the present value of the DBO related to prior employee service that arises in the current period from the introduction of, or an amendment to, postemployment benefits. Accordingly, 400,000 should be recognized immediately to reflect the vested benefits and amortization of the nonvested benefits equals 50,000 (200,000 ÷ 4), a total of 450,000. Answer (D) is incorrect because 600,000 includes nonvested benefits not yet required to be amortized.

[475] Gleim #: 4.7 -- Source: Publisher At end of the year, Employer’s defined benefit obligation (DBO) was determined to be 1,500,000, which was 200,000 higher than had been expected. The defined benefit plan’s assets had a fair value of 1,250,000. No other actuarial gains and losses have occurred. If the average remaining working life is 20 years, the minimum required amortization of the unrecognized net actuarial gains and losses in the next year will be

A. B. C. D.

20,000 3,750 2,500 0 Answer (A) is incorrect because 20,000 is the result of using the full 200,000 liability loss without regard to the corridor amount and assumes an amortization period of 10 years instead of 20. Answer (B) is incorrect because 3,750 is the result of using 125,000 (10% × 1,250,000 plan assets) as the corridor amount instead of 150,000. Answer (C) is correct. At a minimum, amortization of the cumulative unrecognized net actuarial gains and losses must be included as income or expense if, as of the close of the prior period, that unrecognized gain or loss exceeds 10% of the greater of the present fair value of the DBO or the fair value of plan assets. At year-end, the present value of the DBO was 200,000 greater than estimated (a 200,000 liability loss). Given that no other gain or loss has occurred, the unrecognized actuarial net loss to be amortized beginning next year is 200,000. The corridor amount is 150,000 (10% of the greater of 1,500,000 present value of the DBO or 1,250,000 fair value of plan assets). The amount outside the corridor is 50,000 (200,000 – 150,000), and the amount to be amortized is therefore 2,500 (50,000 ÷ 20 years of average remaining working life). Answer (D) is incorrect because 50,000 of the liability loss must be amortized over the average remaining working life beginning the year following the loss.

[476] Gleim #: 4.8 -- Source: Publisher For an entity with a defined postemployment benefit plan, the fair value of plan assets at the beginning of the year was 500,000. No unrecognized net cumulative actuarial gain or loss existed. On the last day of the fiscal year, the fair value of plan assets was 620,000. Benefits paid equaled 100,000, and the entity made 120,000 in contributions. The discount rate was 10%, and the expected long-term rate of return on plan assets was 12%. The actual return on plan assets was


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A. B. C. D.

50,000 60,000 75,000 100,000 Answer (A) is incorrect because 50,000 equals 10% of the beginning fair value. Answer (B) is incorrect because 60,000 equals 12% of the beginning fair value. Answer (C) is incorrect because 75,000 is a nonsense number. Answer (D) is correct. The actual return on plan assets is equal to the difference between the fair value of plan assets at the beginning and the end of the year adjusted for contributions and benefits paid. Thus, the actual return is 100,000. FV, end of year Benefits paid Contributions FV, beginning of year

620,000 100,000 (120,000) (500,000)

Actual return

100,000

[477] Gleim #: 4.9 -- Source: Publisher An entity that sponsors a defined benefit postemployment benefit plan has discontinued a segment of its business. As a result, the employees of that segment will not be able to earn additional benefits. On the date of the discontinuance, the present value of the DBO was 10,000,000, the fair value of the plan assets was 8,500,000, the net unrecognized actuarial gain was 500,000, and the unrecognized past service cost was 100,000. The effect of the discontinuance was to reduce the present value of the DBO by 10%. The portions of the unrecognized actuarial gain and past service cost related to the portion of the DBO that was eliminated also equaled 10%. Accordingly, the entity should recognize what net defined benefit liability immediately after the discontinuance?

A. B. C. D.

410,000 860,000 900,000 950,000 Answer (A) is incorrect because 410,000 omits the remaining unrecognized actuarial gain. Answer (B) is correct. A curtailment arises from a reduction in covered employees or amendment of the plan to reduce benefits for future service. A settlement is a transaction that eliminates the DBO for part or all of plan benefits. When a curtailment or settlement occurs, the gain or loss recognized encompasses the change in the present value of the DBO, the change in the fair value of plan assets, and previously unrecognized related actuarial gains and losses and past service cost. Thus, the present value of the DBO after the curtailment was 9,000,000 [10,000,000 – (10% × 10,000,000)]. The fair value of plan assets was given as 8,500,000. The unrecognized actuarial gain was reduced to 450,000. The unrecognized past service cost was reduced to 90,000. Accordingly, the defined benefit liability immediately after the discontinuance was 860,000 (9,000,000 – 8,500,000 + 450,000 – 90,000). Answer (C) is incorrect because 900,000 is 10% of the present value of the remaining DBO. Answer (D) is incorrect because 950,000 omits past service cost from the calculation.

[478] Gleim #: 4.10 -- Source: Publisher IFRS 2, Share-Based Payment, normally requires entities to account for their share-based employee compensation plans in accordance with which of the following methods?


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Fair-ValueBased Method

Intrinsic-ValueBased Method

A. B.

Yes Yes

Yes No

C. D.

No No

Yes No

Answer (A) is incorrect because the intrinsic-value method is allowed only in rare cases. Answer (B) is correct. Entities must account for share-based employee compensation plans in accordance with the fair-valuebased method except in the rare cases in which the fair value of the equity instruments is not reliably measurable at the measurement date (the grant date for transactions with employees and those providing similar services). In these rare cases, IFRS 2 requires entities to account for these plans in accordance with the intrinsic-value-based method. Answer (C) is incorrect because the intrinsic-value method is allowed only in rare cases. Answer (D) is incorrect because the intrinsic-value method is allowed only in rare cases. [479] Gleim #: 4.11 -- Source: Publisher The measurement date in accounting for shares issued to employees in share option plans accounted for in accordance with the fair value method prescribed by IFRS 2 is

A. B. C. D.

The date on which options are granted to specified employees. The earliest date on which both the number of shares to be issued and the option price are known. The date on which the options are exercised by the employees. The date the corporation forgoes alternative use of the shares to be sold under option. Answer (A) is correct. Under the fair-value-based method prescribed by IFRS 2, compensation expense is measured at the grant date. This expense is based on the fair value of the award at that date and recognized over the vesting period, the period over which the vesting conditions are expected to be satisfied. Answer (B) is incorrect because the earliest date on which both the number of shares to be issued and the option price are known, the date on which the options are exercised by employees, and the date the entity forgoes alternative use of the shares to be sold under option may coincide with, but do not define, the measurement date. Answer (C) is incorrect because the earliest date on which both the number of shares to be issued and the option price are known, the date on which the options are exercised by employees, and the date the entity forgoes alternative use of the shares to be sold under option may coincide with, but do not define, the measurement date. Answer (D) is incorrect because the earliest date on which both the number of shares to be issued and the option price are known, the date on which the options are exercised by employees, and the date the entity forgoes alternative use of the shares to be sold under option may coincide with, but do not define, the measurement date.

[480] Gleim #: 4.12 -- Source: CIA 1195 III-58 On January 2, year 1, Kine Co. granted Morgan, its president, share options to buy 1,000 shares of Kine’s $10 par common stock. The options call for a price of 20 per share and are exercisable for 3 years following the grant date. Morgan exercised the options on December 31, year 1. The market price of the shares was 50 on January 2, year 1 and 70 on the following December 31. If the intrinsic value-based method is followed because the fair value of the options is not reliably measurable, by what net amount should equity increase as a result of the grant and exercise of the options?


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A. B. C. D.

20,000 30,000 50,000 70,000 Answer (A) is correct. The measurement date is January 2, year 1. At that date, the intrinsic value of the options is 30,000 [1,000 shares × (50 market price – 20 option price)]. This 30,000 will be recorded as both compensation expense and options outstanding. The net effect on equity is 0. When the options are exercised, the 20,000 (1,000 shares × 20 exercise price) cash received and the 30,000 options outstanding will be allocated to share capital as 10,000 common stock and 40,000 additional paid-in capital. The net effect on equity will be a 20,000 increase. Answer (B) is incorrect because 30,000 is the amount of compensation expense. Answer (C) is incorrect because 50,000 is the increase in the equity without regard to the compensation expense. Answer (D) is incorrect because 70,000 results from calculating the increase in equity using the share price on the exercise date.

[481] Gleim #: 4.13 -- Source: Publisher On January 1, year 1, International Entity entered into an equity-settled share-based payment transaction with its senior executives. This award of 1,000 share options has a four-year vesting period. The market prices of the options and the related shares on the grant date are 20 and 80, respectively. The exercise price is 85. Assuming that the vesting conditions were not met for 100 of the options because of unexpected events in year 4, the entry to debit option expense at

A. B. C. D.

December 31, year 4 is for 5,000. December 31, year 3 is for 4,500. December 31, year 2 is for 5,000. January 1, year 1 is for 20,000. Answer (A) is incorrect because the year 4 expense is 3,000 [20,000 total expected – 15,000 recognized in years 1-3 – (100 × 20) not vested]. Answer (B) is incorrect because no retrospective adjustment is made. The year 3 entry would have been 5,000 based on a then-expected total expense of 20,000. Answer (C) is correct. The fair value of each share option is determined at the measurement date, which is the grant date for transactions with employees and others providing similar services. Thus, the fair value of each share option was set at its market price of 20 on January 1, year 1. The periodic expense varies only with the expected number of equity instruments expected to vest. Because the events causing 100 options not to vest occurred unexpectedly in year 4, the entity presumably expected at each balance sheet date for the first three years of the vesting period that all options would vest. Total expected expense was therefore 20,000, and the proportional expense recognized in each of the first three years was 5,000 [(1,000 options × 20) ÷ 4 years]. Answer (D) is incorrect because 20,000 would have been recognized at January 1, year 1 if the options had vested immediately.

[482] Gleim #: 4.14 -- Source: CIA 1195 IV-28 If a lease agreement transfers substantially all of the risks and rewards of ownership of the asset to the lessee, the asset amount is recognized on the lessee’s records as a(n) asset, and the lease is classified as a lease.


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List A

List B

A.

Tangible

Finance

B. C.

Intangible Tangible

Finance Operating

D.

Intangible

Operating

Answer (A) is correct. When a lease agreement transfers the risks and rewards of ownership of the asset to the lessee, the lease is treated as a finance lease because the transaction is in essence an installment purchase. Accordingly, the lessee records a depreciable asset and a liability. Moreover, IAS 38, Intangible Assets, specifically does not apply to leases that are within the scope of IAS 17, Leases. A finance lease is therefore regarded as a tangible asset. Answer (B) is incorrect because the recorded asset is a tangible asset. Answer (C) is incorrect because, if it transfers substantially all of the risks and rewards of ownership, the lease is a finance lease. Answer (D) is incorrect because, if it transfers substantially all of the risks and rewards of ownership, the lease is a finance lease. [483] Gleim #: 4.15 -- Source: CIA 596 IV-32 Finance and operating leases differ in that the lessor

A. Obtains use of the asset only under a finance lease. B. Is using the lease as a source of financing only under an operating lease. C. Makes rent payments that are actually installment payments constituting a payment of both principal and interest only under a finance lease. D. Finances the transaction through the leased asset only under a finance lease. Answer (A) is incorrect because the lessee obtains use of the asset. Answer (B) is incorrect because the lessee uses the lease as a source of financing under a finance lease, not an operating lease. Answer (C) is incorrect because the lessee makes payments to the lessor. Answer (D) is correct. A lease is a rental or sub-purchase arrangement between a lessor (the owner or seller of the property) and a lessee (the renter or purchaser). The issue in all leases is whether the risks and rewards of ownership have been transferred from the lessor to the lessee; if so, the lease should be accounted for as a sale-purchase, i.e., a finance lease. If the risks and rewards of ownership have not transferred, the lease is a rental arrangement and is called an operating lease. In effect, the lessor provides financing for an installment purchase, and the lessee’s payments include both principal and interest components. [484] Gleim #: 4.16 -- Source: CIA 595 IV-27 Which of the following statements about a finance lease is false?

A. B. C. D.

The lessor capitalizes the net investment in the lease. The lessor records the leased item as an asset. The lessee records depreciation or finance cost allowance on the leased asset. The lease arrangement represents a form of financing.


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Answer (A) is incorrect because, under a finance lease, the lessor recognizes a net receivable equal to the net investment in the lease: gross investment (minimum lease payments from the lessor’s perspective plus unguaranteed residual value) discounted at the interest rate implicit in the lease. Answer (B) is correct. When a transaction meets the criteria of a finance lease, the lessor removes the leased item from the books and records lease payments receivable regardless of whether the lessor is a manufacturer or dealer. The lessee records and depreciates the leased item under a finance lease. Answer (C) is incorrect because the lessee records depreciation on the leased asset under a finance lease. This process is separate from the accounting for the lease obligation. Answer (D) is incorrect because, in essence, the leased asset is being purchased when a lease meets the criteria for capitalization. Hence, the lease agreement represents a form of financing. [485] Gleim #: 4.17 -- Source: CIA 596 IV-31 Which of the following leases ordinarily should be classified as a finance lease by the lessee? Lease A Lease B Lease C Lease D Contains a bargain purchase option?

Yes

No

No

No

Lease term is for the major part of the economic life of the leased asset

No

No

Yes

No

Present value of the minimum lease payments is substantially all of the fair value of the leased asset

No

No

No

Yes

Leased asset usable only by lessor without major modification

No

Yes

Yes

No

A. B. C. D.

Lease A only. Lease B only. Leases A, C, and D. Leases C and D only. Answer (A) is incorrect because Leases C and D are also finance leases. Answer (B) is incorrect because B is the only operating lease in the set. If it were usable by the lessee (not the lessor) without major modification, it would normally be classified as a finance lease. Answer (C) is correct. A lease should be classified as a finance lease by a lessee if it transfers substantially all of the risks and rewards of ownership. A lease is classified at its inception. It normally is classified as a finance lease if, for example, (1) the lease provides for the transfer of ownership of the leased asset by the end of the lease term; (2) the lease contains a bargain purchase option, i.e., the lessee has the option to purchase at a price expected to be sufficiently below the fair value of the exercise date that, at the lease’s inception, exercise is reasonably certain; (3) the lease term is for the major part of the economic life of the leased asset; (4) the present value of the minimum lease payments is at least substantially all of the fair value of the leased asset at the inception of the lease; or (5) the leased asset is such that it can be used only by the lessee without major modification. Lease A is a finance lease because the terms of the lease include a bargain purchase option. Lease C passes the economic life test, and lease D passes the recovery of investment test. Answer (D) is incorrect because Lease A contains a bargain purchase option, so it qualifies as a finance lease.


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[486] Gleim #: 4.18 -- Source: CIA 1191 IV-44 At the inception of a finance lease, how should the lessee account for guaranteed residual value?

A. B. C. D.

As part of minimum lease payments at present value. As part of minimum lease payments at future value. As part of minimum lease payments at future value of an annuity due. As not a part of the lease contract. Answer (A) is correct. The lessee records a finance lease as an asset and a liability at the inception of the lease at the fair value of the leased property (not to exceed the present value of the minimum lease payments). The lessee’s minimum lease payments include required payments (excluding contingent rent and costs for services and taxes to be paid by and reimbursed to the lessor) during the lease term and the amount of a bargain purchase option. If no bargain purchase option exists, the minimum lease payments equal the sum of the minimum payments payable over the lease term and any amounts guaranteed by the lessee or by a party related to the lessee. Answer (B) is incorrect because the guaranteed residual must be discounted to present value. Answer (C) is incorrect because the guaranteed residual value must be discounted to present value. Answer (D) is incorrect because a guaranteed residual value is part of the lease contract.

[487] Gleim #: 4.19 -- Source: CIA 585 IV-22 ABC entities, a manufacturer lessor, leased a machine to XYZ on January 1. The lease meets the criteria for a finance lease. Title to the asset will automatically pass to the lessee at the end of the lease term. Other details are as follows: Lease term Useful life of the asset Cost of the leased asset to the lessor Annual payment payable at the beginning of each year, beginning January 1 Implicit interest rate Present value of an annuity due of 1 discounted for 10 years at 10% Present value of 1 due in 10 years discounted at 10%

10 years 10 years 55,000 10,000 10% 6.7590 .3855

Assuming the fair value of the asset is at least equal to the present value of the minimum lease payments, the journal entry to record the inception of this lease on the lessor’s books at January 1 is


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A.

Leased machine

67,590

Lease liability Cash B.

C.

57,590 10,000

Lease payments receivable

90,000

Cash Cost of sales

10,000 55,000

Inventory Unearned finance

55,000

income--leases Sales

45,000 55,000

Lease payments receivable Cash Finance income

90,000 10,000 32,410

Gross profit on lease Inventory D.

12,590 55,000

Lease payments receivable

90,000

Cash Cost of sales

10,000 55,000

Sales Inventory

67,590 55,000

Unearned finance income--leases

32,410

Answer (A) is incorrect because it is the lessee’s journal entry. Answer (B) is incorrect because the sale should be recorded at the present value of the minimum lease payments, and the unearned finance income should be recorded as the difference between the gross lease payments receivable and the present value of this gross investment. Answer (C) is incorrect because the lease should reflect both cost of goods sold and sales, not the netted gross profit on the lease. Answer (D) is correct. For this finance lease, the manufacturer-lessor should record 1. As gross investment, the minimum lease payments because there is no residual value 2. As net investment, the difference between the gross investment in the lease (a debit to a receivable) and unearned finance income (a credit to a liability) 3. As unearned finance income, the difference between the gross investment and the net investment (gross investment discounted at the interest rate implicit in the lease) 4. As sales revenue, the fair value of the asset or, if lower, the present value of the minimum lease payments computed at the interest rate implicit in the lease 5. As cost of goods sold, the cost of the leased asset Because the first payment is made at the inception of the lease, the payment structure is that of an annuity due. Sales revenue is therefore equal to the 10,000 periodic payment times the present value of an annuity due of 1 discounted for 10 years at 10% (10,000 × 6.7590 = 67,590). Given that cash is paid at the beginning of the year, the initial 10,000 cash debit immediately decreases the gross investment in the lease (lease payments receivable) from 100,000 to 90,000. The cost of the leased asset (55,000) must also be charged to cost of sales and credited to inventory. Finally, at the inception of the lease, unearned finance income equals the difference between the gross investment and the sales price (100,000 – 67,590 = 32,410).


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[488] Gleim #: 4.20 -- Source: J.O. Hall On August 1, Jones leased property to Smith for a 5-year period. The annual 20,000 lease payment is payable at the end of each year. The expected residual value at the end of the lease term is 10,000. Jones’s implicit interest rate is 12%. The cost of the property to Jones was 50,000, which is the fair value at the lease date. The present value of an ordinary annuity of 1 for five periods is 3.605. The present value of 1 at the end of five periods is .567. At the inception of the lease, the recorded gross investment is

A. B. C. D.

110,000 100,000 72,100 90,000 Answer (A) is correct. For a finance lease, the lessor should record the gross investment in the lease at the undiscounted sum of the minimum lease payments (the total of the lessee’s required payments, excluding contingent rent and costs for services and taxes to be paid by and reimbursed to the lessor, and any guaranteed residual value) and any unguaranteed residual value. The gross investment is the same regardless of whether any residual value is guaranteed. The five periodic payments of 20,000 equal 100,000. The expected residual value including guaranteed and unguaranteed portions equals 10,000. The gross investment should be 110,000 (100,000 + 10,000). Answer (B) is incorrect because 100,000 does not include the residual value in the gross investment. Answer (C) is incorrect because the annual lease payments should be recorded at their undiscounted value. Answer (D) is incorrect because the residual value is added to, not subtracted from, the undiscounted lease payments.

[489] Gleim #: 4.21 -- Source: H.F. Bush KW Ltd. leased equipment under a 4-year, noncancelable lease properly classified as a finance lease. The lease does not transfer ownership or contain a bargain purchase option. The equipment had an estimated economic life of 5 years and an estimated residual value of 20,000. Terms of the lease included a guaranteed residual value of 50,000. KW initially recorded the leased equipment at 240,000, and its depreciation policy for owned assets is to use the straight-line method. Thus, the amount of depreciation that should be charged each year is

A. B. C. D.

55,000 47,500 44,000 38,000 Answer (A) is incorrect because the guaranteed residual value, not the estimated residual value, must be subtracted from the amount initially recorded. Answer (B) is correct. Depreciation should be consistent with the accounting policy for owned assets. Absent a reasonable certainty that the lessee will own the asset at the end of the lease term, it should be fully depreciated over the shorter of the useful life or the lease term. The lease does not transfer ownership or contain a bargain purchase option. Accordingly, the period of amortization should be the lease term. In accordance with the straight-line method used by KW for owned assets, the depreciable base for this finance lease is equal to the 240,000 initially recorded minus the 50,000 guaranteed residual value allocated equally over the 4-year lease term. Consequently, annual depreciation expense is 47,500 [(240,000 – 50,000) ÷ 4 years]. Answer (C) is incorrect because the guaranteed residual value, not the estimated residual value, must be subtracted from the initially recorded amount, and the term of the lease, not the estimated economic life, is used as the denominator in the depreciation calculation. Answer (D) is incorrect because the term of the lease, not the estimated economic life, must be used as the denominator in the depreciation calculation.


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[Fact Pattern #32]

On January 1, Plantation Partners is planning to enter as the lessee into the two lease agreements described in the opposite column. Each lease is noncancelable, and Plantation does not receive title to either leased property during or at the end of the lease term. All payments required under these agreements are due on January 1 each year.

Lessor Type of property Yearly rental Lease term Economic life Purchase option Renewal option Fair value at inception of lease Unguaranteed residual value Lessee’s incremental borrowing rate Executory costs paid by Annual executory costs Present value factor at 10% (of an annuity due)

Lease A

Lease B

Oven 15,000 10 years 15 years None None

Computer 4,000 3 years 5 years 3,000 None

125,000 None

10,200 2,000

10% Lessee 800

10% Lessor 500

6.76

2.74

[490] Gleim #: 4.22 -- Source: CMA 1293 2-27 (Refers to Fact Pattern #32) Plantation should treat Lease A as a(n)

A. B. C. D.

Finance lease with an initial asset amount of 101,400. Operating lease, charging 14,200 in rental expense and 800 in executory costs to annual operations. Operating lease, charging the present value of the yearly rental expense to annual operations. Operating lease, charging 15,000 in rental expense and 800 in executory costs to annual operations. Answer (A) is incorrect because Lease A does not qualify as a finance lease. Answer (B) is incorrect because rental expense is 15,000. Answer (C) is incorrect because the actual cash outlay for rent, 15,000, is charged to expense. Answer (D) is correct. Lease A is an operating lease with a 15,000 annual rental expense with annual executory costs (e.g., maintenance, insurance, and taxes) of 800 to be paid by the lessee. An operating lease does not transfer the risks and rewards of ownership to the lessee. Lease A is nothing more than a rental arrangement. Circumstances in which the risks and rewards of ownership are normally deemed to be transferred include the following: the lease transfers title to the lessee, the lease has a bargain purchase option, the lease term is for the major part of the useful life of the leased asset, the present value of the minimum lease payments is at least substantially all of the asset’s fair value, or the asset is usable only by the lessee without major modification.

[491] Gleim #: 4.23 -- Source: CMA 1293 2-28 (Refers to Fact Pattern #32) Plantation should treat Lease B as a(n)


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A. B. C. D.

Finance lease with an initial asset amount of 10,960. Finance lease with an initial asset value of 10,200. Operating lease, charging 3,500 in rental expense and 500 in executory costs to annual operations. Finance lease with an initial asset value of 9,590. Answer (A) is incorrect because the initial asset amount cannot exceed the fair value of the leased asset. Moreover, 10,960 includes the present value of the executory costs. Answer (B) is incorrect because 10,200 is the fair value of the leased asset. Answer (C) is incorrect because the lease meets the criteria of a finance lease. Answer (D) is correct. A finance lease is one in which the risks and rewards of ownership are transferred to the lessee. For accounting purposes, the lessee treats a finance lease as similar to the purchase of an asset capitalized at the fair value of the leased asset or, if lower, the present value of the minimum lease payments. The lessee’s minimum lease payments include the required payments, excluding contingent rent and executory costs (e.g., taxes and insurance), plus any amounts guaranteed by the lessee or a related party. If a bargain purchase option exists, however, minimum lease payments equal the required payments plus the amount of the option. If the present value of the minimum lease payments (calculated without guaranteed amounts or a bargain purchase option) is substantially all of the asset’s fair value, the lease normally is accounted for as a finance lease. Given that the executory costs associated with the lease are to be paid by the lessor, a portion of the lease rental price is for those costs, not for the asset. Consequently, the annual minimum lease payment equals the annual payment minus the executory costs, or 3,500 (4,000 yearly rental – 500). The present value of the minimum lease payments is therefore 9,590 (2.74 × 3,500), which is substantially all of the fair value of the asset. Thus, the lease should be capitalized. The appropriate amount of the initial asset value is the present value of the minimum lease payments calculated above.

[492] Gleim #: 4.24 -- Source: CIA 596 IV-75 Which one of the following statements best describes the asset-liability method of accounting for deferred income taxes?

A. The amount of deferred tax is based on tax rates in effect when temporary differences originate. B. The amount of deferred tax is based on the tax rates expected to be in effect during the periods in which the deferred tax liability is settled or the deferred tax asset is realized. C. The tax effects of temporary differences are not reported separately but are reported as adjustments to the amounts of specific assets and liabilities and the related revenues and expenses. D. The appropriate tax rate to be reported on the income statement is the tax actually levied in that year, meaning no deferred taxes would be reported. Answer (A) is incorrect because this statement describes the deferred method of accounting for deferred income taxes. Answer (B) is correct. A DTA or DTL is measured at the rates expected to apply when it is realized or settled, based on tax laws and rates enacted or substantively enacted as of the balance sheet date. If different rates apply to different taxable profit levels, a DTA or DTL is measured based on the average rates expected to apply in the periods when the TDs are expected to reverse. The tax rate or tax base may vary with the manner of recovery or settlement. For example, one tax rate may apply if an asset is sold immediately and another may apply if it is to be recovered through continued use. Answer (C) is incorrect because this statement describes the net-of-tax method, which recognizes that future taxability and deductibility are important factors in the valuation of individual assets and liabilities. Answer (D) is incorrect because this statement describes the nonallocation or flow-through approach, which does not support the calculation and reporting of deferred income tax. [493] Gleim #: 4.25 -- Source: CMA 696 2-9 Which one of the following temporary differences will result in a deferred tax asset?


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A. Use of the straight-line depreciation method for determining accounting profit and an accelerated method for determining taxable profit (tax loss). B. Installment sale profits accounted for on the accrual basis for determining accounting profit and on a cash basis for determining taxable profit (tax loss). C. Advance rental receipts accounted for on the accrual basis for financial statement purposes and on a cash basis for tax purposes. D. Prepaid expenses accounted for on the accrual basis for determining accounting profit and on a cash basis for determining taxable profit (tax loss). Answer (A) is incorrect because using an accelerated depreciation method for determining taxable profit (tax loss) results in a deferred tax liability. Answer (B) is incorrect because recognizing installment income on the financial statements but not the tax return results in a taxable temporary difference. Answer (C) is correct. A deferred tax asset records the deferred tax consequences attributable to deductible temporary differences and carryforwards. Advance rental receipts accounted for on the accrual basis for determining accounting profit and on a cash basis for determining taxable profit (tax loss) would give rise to a deferred tax asset. The financial statements would show no income and no related tax expense because the rental payments apply to future periods. The tax return, however, would show the rent as income when the cash was received, and a tax would be due in the year of receipt. Because the tax is paid prior to recording accounting profits, it represents an asset that will be recognized as an expense when income is finally recorded. Answer (D) is incorrect because recognizing prepaid expenses earlier on the tax return than on the financial statements (a situation akin to the accelerated depreciation of fixed assets) gives rise to a deferred tax liability. [494] Gleim #: 4.26 -- Source: Publisher At December 31, SCM Ltd., a calendar-year entity, reported the following accounts for which the carrying amount differed from the tax base:

Depreciable assets (net) Deferred rental income

Carrying Amount

Tax Base

150,000 40,000

80,000 0

What taxable and deductible amounts are related to these temporary differences?

Taxable

Deductible

Amounts

Amounts

A. B.

40,000 70,000

70,000 40,000

C. D.

0 110,000

110,000 0


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Answer (A) is incorrect because the taxable amount is 70,000 and the deductible amount is 40,000. Answer (B) is correct. The difference between the carrying amount of an asset or liability and its tax base is a temporary difference (TD). A taxable (deductible) TD results in taxable (deductible) amounts in the future when the carrying amount of the asset or liability is recovered or settled. The tax base is the amount attributed for tax purposes to an asset or liability. The tax base of an asset is the amount deductible against future taxable economic benefits when the asset’s carrying amount is recovered. The tax base of a liability is the portion of the carrying amount that will not be deductible against future taxable economic benefits for tax purposes. The tax base of revenue received in advance (a liability) is the portion of the carrying amount taxable in the future. Thus, the 70,000 temporary difference (150,000 carrying amount – 80,000 tax base) related to the depreciable assets is classified as a taxable amount. When income, such as rental income, is taxable before being recognized in accounting profit, future sacrifices to provide the rental service or refund amounts paid will result in future tax deductible amounts when the liability is settled. Thus, the 40,000 temporary difference (40,000 carrying amount – 0 tax base) related to the deferred rental revenue is classified as a deductible amount. Answer (C) is incorrect because the taxable amount is 70,000 and the deductible amount is 40,000. Answer (D) is incorrect because the taxable amount is 70,000 and the deductible amount is 40,000. [495] Gleim #: 4.27 -- Source: Publisher Which of the following results in a tax base of zero?

A. Trade receivables have a carrying amount of 1,000, and the related revenue has been included in full in the determination of taxable profit. B. A loan receivable has a carrying amount of 1,000, and repayment has no tax effects. C. Unearned interest revenue has a carrying amount of 1,000, and the related interest revenue was included in full in the determination of taxable profit. D. Accrued expenses have a carrying amount of 1,000, and the related expense has been included in full in the determination of taxable profit. Answer (A) is incorrect because the tax base is 1,000. Answer (B) is incorrect because the tax base is 1,000. Answer (C) is correct. The difference between the carrying amount of an asset or liability and its tax base is a temporary difference (TD). A taxable (deductible) TD results in taxable (deductible) amounts in the future when the carrying amount of the asset or liability is recovered or settled. The tax base is the amount attributed for tax purposes to an asset or liability. The tax base of an asset is the amount deductible against future taxable economic benefits when the asset’s carrying amount is recovered. The tax base of a liability is the portion of the carrying amount that will not be deductible against future taxable economic benefits for tax purposes. The tax base of revenue received in advance (a liability) is the portion of the carrying amount taxable in the future. For unearned interest revenue for which the related interest revenue was taxed on a cash basis, the tax base equals zero (1,000 carrying amount – 1,000 not taxable in the future). Answer (D) is incorrect because the tax base is 1,000. [Fact Pattern #33] An entity has purchased an asset with a 10-year useful life. It will use an accelerated depreciation method for determining taxable profit or tax loss. For determining accounting profit, it will use straight-line depreciation. [496] Gleim #: 4.28 -- Source: CIA 1194 IV-69 (Refers to Fact Pattern #33) During the 10-year life of the asset, the entity will report as deferred tax an amount that


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A. B. C. D.

Increases steadily for the 10 years. Is constant. Increases and then decreases. Decreases and then increases. Answer (A) is incorrect because the deferred tax liability will increase and then decrease. Answer (B) is incorrect because the deferred tax liability will increase and then decrease. Answer (C) is correct. The cumulative deferred tax increases, peaks, and then decreases to zero over the life of the asset. In the early years, the asset is depreciated more quickly for tax purposes than for financial reporting purposes. This temporary difference reverses in later years. Hence, in the early years, actual taxes payable will be less than tax expense reported in the financial statements, and a deferred tax liability will be recognized. By the end of the asset’s useful life, cumulative actual taxes paid will equal cumulative reported tax expense, so the deferred tax balance will be zero. Answer (D) is incorrect because the deferred tax liability will increase and then decrease.

[497] Gleim #: 4.29 -- Source: CIA 1194 IV-70 (Refers to Fact Pattern #33) When determining cash flows accruing to the entity, using financial statements prepared for tax purposes will result in

A. B. C. D.

No effect on cash flow amounts. An overstatement of cash flows throughout the economic life of the asset. An understatement of cash flows throughout the economic life of the asset. An overstatement of cash flows in the early years and then an understatement of cash flows in the later years of the economic life of the asset. Answer (A) is correct. Cash flows are not affected by the basis of accounting used to prepare the financial statements. Accordingly, whether the financial statements are prepared based on the tax basis, the cash basis, or accounting principles generally accepted in a given country, cash flows should be the same. For example, the cash inflow or outflow resulting from using an accelerated depreciation method to determine actual tax expense or benefit (the amount paid to or refunded by the taxing authority) is completely unaffected by the depreciation method used in the financial statements. However, if cash flows are derived indirectly by adjusting net profit or loss reported in the financial statements, different adjustments are necessary to arrive at the same cash flow amounts if different bases of accounting are used in the preparation of the financial statements. Answer (B) is incorrect because cash flows are not affected by the method of depreciation used for reporting purposes. Answer (C) is incorrect because cash flows are not affected by the method of depreciation used for reporting purposes. Answer (D) is incorrect because cash flows are not affected by the method of depreciation used for reporting purposes.

[498] Gleim #: 4.30 -- Source: Publisher Based on its current operating levels, Glucose LLC estimates that its annual level of taxable profit in the foreseeable future will be 200,000 annually. Enacted tax rates for the tax jurisdiction in which Glucose operates are 15% for the first 50,000 of taxable profit, 25% for the next 50,000 of taxable profit, and 35% for taxable profit in excess of 100,000. Which tax rate should Glucose use to measure a deferred tax liability or asset?

A. B. C. D.

15% 25% 27.5% 35%


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Answer (A) is incorrect because 15% is the tax rate for the first 50,000 of taxable profit. Answer (B) is incorrect because 25% is the tax rate for taxable profit over 50,000 but less than 100,000. Answer (C) is correct. In measuring a deferred tax liability or asset, the objective is to use the enacted or substantively enacted tax rate(s) expected to apply to taxable profit in the periods in which the deferred tax liability or asset is expected to be settled or realized. If different rates apply to different taxable profit levels, a DTA or DTL is measured based on the average rates expected to apply in the periods when the TDs are expected to reverse. Accordingly, the applicable tax rate is 27.5%.

Taxable Profit 50,000 50,000 100,000 200,000

Tax Rate × × ×

15% 25% 35%

= = =

7,500 12,500 35,000 55,000

55,000 ÷ 200,000 = 27.5% Answer (D) is incorrect because 35% is the tax rate for taxable profit over 100,000. [499] Gleim #: 4.31 -- Source: Publisher When an entity reports deferred tax assets and liabilities, deferred tax expense or income should be disclosed equal to the

A. B. C. D.

Decrease in the deferred tax assets. Sum of the net changes in deferred tax assets and deferred tax liabilities. Increase in the deferred tax liabilities. Amount of the total tax liability. Answer (A) is incorrect because the deferred tax expense or income is equal to the sum of the net changes in the deferred tax assets and deferred tax liabilities. Answer (B) is correct. The deferred tax expense or income disclosed is the sum of the net changes in the deferred tax assets and deferred tax liabilities. This amount is the deferred tax expense or income relating to the origination or reversal of temporary differences. For example, the reduction in a deferred tax asset or an increase in a deferred tax liability increases deferred tax expense. Answer (C) is incorrect because the deferred tax expense or income is equal to the sum of the net changes in the deferred tax assets and deferred tax liabilities. Answer (D) is incorrect because the total tax liability includes both the current and deferred tax expense or income for the year.

[500] Gleim #: 4.32 -- Source: Publisher On December 31, year 1, Health entities reported a 150,000 warranty expense in its income statement. The expense was based on actual warranty costs of 30,000 in year 1 and expected warranty costs of 35,000 in year 2, 40,000 in year 3, and 45,000 in year 4. For tax purposes, warranty costs are not deductible until paid. At December 31, year 1, deferred taxes should be based on a

A. B. C. D.

120,000 deductible temporary difference. 150,000 deductible temporary difference. 120,000 taxable temporary difference. 150,000 taxable temporary difference.


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Answer (A) is correct. At year-end year 1, Health entities should report a 120,000 warranty liability in its balance sheet. The warranty liability is equal to the 150,000 warranty expense minus the 30,000 warranty cost actually incurred in year 1. Because warranty costs are not deductible until paid, the tax base of the warranty liability is 0. The result is a 120,000 temporary difference (120,000 carrying amount – 0 tax base). When the liability is settled through the actual incurrence of warranty costs, the amounts will be deductible. Thus, the temporary difference should be classified as a deductible temporary difference. Answer (B) is incorrect because 150,000 equals the warranty expense, not the payable. Answer (C) is incorrect because warranty costs will result in a deductible amount. Answer (D) is incorrect because the warranty costs will result in a deductible amount, and the 30,000 actual warranty costs is currently deductible. [501] Gleim #: 4.33 -- Source: CIA 597 IV-29 An entity introduced a new product that carries a 2-year warranty against defects. It estimates that warranty costs will be 2% of sales in the year of sale and 3% of sales in the year following the year of sale. Sales in year 1 and year 2 were 5 million and 7 million, respectively. Actual costs of servicing the warranty in year 1 and year 2 were 110,000 and 260,000, respectively. What provision for warranty costs must the entity recognize in year 2?

A. B. C. D.

260,000 290,000 350,000 370,000 Answer (A) is incorrect because 260,000 is the actual cost of servicing the warranty in year 2. Answer (B) is incorrect because 290,000 equals the sum of 2% of year 2 sales and 3% of year 1 sales. Answer (C) is correct. The warranty provision must be matched with revenue in the year of sale. Thus, the provision related to year 2 sales must be recognized in year 2 even if actual expenditures will not occur until year 3. The provision related to year 2 sales equals 350,000 [7,000,000 × (2% for the year of sale + 3% for the year after the year of sale)]. Answer (D) is incorrect because 370,000 equals the actual cost of servicing the warranty in year 1 and year 2.

[502] Gleim #: 4.34 -- Source: CIA 590 IV-34 On December 31, 2000, XYZ issued 5-year bonds with a face amount of 1 million. The bonds carry a stated interest rate of 10% and were sold at par. Interest is payable annually on December 31. According to the provisions of the bond indenture, XYZ was to make annual deposits into a bond sinking fund (beginning December 31, 2001) to accumulate the funds necessary to retire the bonds at their maturity. On December 31, 2004, all required interest payments and sinking-fund payments due to date had been made on schedule. If the sinking-fund assets are properly classified as noncurrent, how should the balance of bonds payable be classified on the December 31, 2004 balance sheet?

A. B. C. D.

Current liability. Long-term liability. Contra to long-term investments. Deferred credit.


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Answer (A) is correct. A current liability is an obligation that is expected to be settled within the normal operating cycle or is due to be settled within 12 months of the balance sheet date. Any other liability is noncurrent. Some current liabilities are included in the working capital employed in the normal operating cycle, e.g., trade payables and accrued employee operating costs. Current liabilities not settled within the normal operating cycle include the current part of interest-bearing debt, dividends, income taxes, and bank overdrafts. Thus, the bonds payable should be classified as current because they are due to be settled within 12 months. Under the IASs, the classification of the sinking-fund assets is irrelevant to the classification of the bond payable. Answer (B) is incorrect because the bonds should be classified as a current liability. Answer (C) is incorrect because offsetting assets and liabilities is rarely acceptable. Answer (D) is incorrect because the bonds are a liability and should not be put in an ambiguous category such as deferred credits. [503] Gleim #: 4.35 -- Source: CIA 1192 IV-31 On August 1, 2000, an entity issued 5-year bonds with a face amount of 10 million. The bonds carry a stated interest rate of 10% and interest is payable annually on July 31. Which is the appropriate classification of bonds payable and the related accrued interest payable on the December 31, 2004 balance sheet? Classification Table

Classification A Classification B Classification C Classification D

A. B. C. D.

Bonds Payable

Interest Payable

Current liability Current liability Long-term liability Long-term liability

Current liability Long-term liability Current liability Long-term liability

Classification A. Classification B. Classification C. Classification D. Answer (A) is correct. A current liability is an obligation that is expected to be settled within the normal operating cycle or is due to be settled within 12 months of the balance sheet date. Any other liability is noncurrent. Some current liabilities are included in the working capital employed in the normal operation cycle, e.g., trade payables and accrued employee operating costs. Current liabilities not settled within the normal operating cycle include the current part of interest-bearing debt, dividends, income taxes, and bank overdrafts. Given that the bonds payable and interest payable are due within 12 months, they should be classified and current. Answer (B) is incorrect because the interest payable should be classified as a current liability. It is due within a year after the balance sheet date. Answer (C) is incorrect because the balance of bonds payable should be classified as a current liability. The bonds are due within a year after the balance sheet date. Answer (D) is incorrect because both the balance of bonds payable and interest payable should be classified as current liabilities.

[504] Gleim #: 4.36 -- Source: CIA 1193 IV-39 A manufacturer produces a quality product for which it charges a little more than some competing items but gives its consumers a more liberal warranty policy. The product carries a 5-year warranty that covers both labor and materials charges. Which of the following defines the appropriate method of accounting for the warranty?


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A. B. C. D.

Cash basis. Recognition of a provision. Sales warranty. Tax basis. Answer (A) is incorrect because the cash basis calls for recognizing warranty expense as labor and materials are expended to satisfy the warranty. Answer (B) is correct. A provision is a liability of uncertain timing and amount. A liability is a present obligation arising from past events, the settlement of which is expected to result in an outflow of resources embodying economic benefits. Whether a past event results in a present obligation is usually clear. Thus, it is clear from the circumstances that the entity’s sale of goods without warranty is an obligating event that resulted in a present obligation for the issuance of warranty costs. Recognition of provisions is appropriate when the entity has a legal or constructive present obligation resulting from a past event (called an obligating event), it is probable that an outflow of economic benefits will be necessary to settle the obligation, and its amount can be reliably estimated. Assuming that the amount of warranty costs can be reliably estimated (although they are uncertain in timing and amount compared with a trade payable, for example) and that the outflow is probable (in these circumstances, “more likely than not”), the manufacturer’s contractual present obligation should result in recognition of a provision. Answer (C) is incorrect because the sales warranty method is appropriate for situations when a warranty is sold separately from the product. Answer (D) is incorrect because the method of accounting for warranties for tax purposes is the cash basis. The cash basis is unacceptable for accounting purposes because it violates the matching principle.

[505] Gleim #: 4.37 -- Source: CIA 1191 IV-41 At its balance sheet date, an entity reliably estimates that the expected cost of compensated absences resulting from short-term disability will be 100,000. This unused entitlement arose from employee services rendered during the period and is accumulating. How should it be accounted for?

A. B. C. D.

Only a disclosure should be made because recognition does not occur until the absences occur. An expense should be recorded for 100,000. An asset of 100,000 should be recognized. A direct reduction to retained earnings of 100,000 should occur. Answer (A) is incorrect because recognition occurs at the time of the absences if the benefits are not accumulating. Answer (B) is correct. Short-term employee benefits expected to be paid as a result of service rendered during the period ordinarily should be recognized as an expense and a liability (accrued expense). For short-term compensated absences, the timing of recognition depends on whether the benefits accumulate. If the benefits for compensated absences accumulate, the expected cost of short-term compensated absences is recognized when services are rendered that increase the employees’ entitlement to future compensated absences. The obligation is recognized whether it is vesting (the employee is entitled to a cash payment for an unused entitlement upon leaving the entity) or not vesting. The amount should not be discounted. It equals the additional amount expected to be paid as a result of the unused accumulated entitlement at the balance sheet date. Hence, the entity should debit expense and credit liability for 100,000 because the entitlement accumulates and the employees have rendered services during the period that increase their future entitlement. Answer (C) is incorrect because a liability rather than an asset is recognized. Answer (D) is incorrect because the expense is recognized in the income statement.

[506] Gleim #: 4.38 -- Source: CIA 1190 IV-37 A company allows customers to redeem 20 coupons for a toy (cost 3.00). Estimates are that 40% of coupons distributed will result in redemption. Since beginning the promotion this year, 4 million coupons were distributed and 1 million coupons redeemed. The adjusting entry to accrue for unredeemed coupons at year-end is


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A. Premium expense Provision for premiums B. Sales Provision for premiums C. Premium expense Provision for premiums D. Sales Provision for premiums

90,000 90,000 90,000 90,000 1,800,000 1,800,000 1,800,000 1,800,000

Answer (A) is correct. An expense and a provision should be accrued for the coupons still outstanding that are expected to be redeemed. Of the 4 million coupons distributed, 40%, or 1.6 million, are estimated to be redeemable. Of those, 1 million have already been redeemed, and 600,000 more are expected to be redeemed. The promotion requires 20 coupons to receive one toy, so 30,000 (600,000 ÷ 20) more toys will be required. Each toy costs 3.00, creating a provision of 90,000 (30,000 × 3.00). Answer (B) is incorrect because the debit should be to an expense. Answer (C) is incorrect because, although an expense should be accrued, the amount is incorrect. Answer (D) is incorrect because the debit should be to an expense, and the amount is incorrect. [507] Gleim #: 4.39 -- Source: CIA 1192 IV-29 The publisher of a popular magazine offers a special discounted price for a 3-year subscription. At the balance sheet date, the amount that has already been collected but pertains to future periods is best referred to as

A. B. C. D.

Accrued subscriptions revenue (an asset account). Deferred subscriptions revenue (a liability account). Earned subscriptions revenue (a revenue account). Precollected subscriptions receivable (a deferred asset account). Answer (A) is incorrect because an accrued revenue is revenue that has met the recognition criteria but has not been received. Answer (B) is correct. Income, which includes revenue and gains, is recognized in the income statement when an increase in future economic benefits related to an increase in an asset or a decrease in a liability can be reliably measured. Revenue is recognized (reported as revenue) in the period in which the recognition criteria are met; therefore, when it is received in advance, the amount applicable to future periods is deferred. This deferral reflects the uncertainty of the reliable measurement of the future economic benefits. The uncertainty arises because the entity still must satisfy an obligation to perform in the future before it is entitled to the future economic benefits. The amount received in advance is considered a liability because it represents a present obligation arising from a past event. Accordingly, deferred or unearned revenue is an amount that has been received but that has not met the recognition criteria for revenue. Answer (C) is incorrect because the revenue will be recognized in future periods when forthcoming issues of the magazine are published and distributed to the subscribers. Answer (D) is incorrect because there is no such thing as a precollected receivable. Precollected revenue is deferred revenue, which is an amount received that has not met the recognition criteria (classified as a liability). A subscription receivable (an asset) would arise from accrued revenue, which is revenue not yet received.

[508] Gleim #: 4.40 -- Source: CIA 592 IV-38 A cable television entity receives deposits from customers that are refunded when service is terminated. The average customer stays with the entity 8 years. How should these deposits be shown on the financial statements?


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A. B. C. D.

Operating revenue. Other revenue. Share capital. Liability. Answer (A) is incorrect because deposits meet the definition of liabilities, not revenue. Revenue is income that arises in the ordinary activities of the entity. Income is an increase in economic benefits in the form of inflows or enhancements of assets or decreases of liabilities that result in an increase in equity (excluding transactions with owners). Answer (B) is incorrect because deposits meet the definition of liabilities, not revenue. Revenue is income that arises in the ordinary activities of the entity. Income is an increase in economic benefits in the form of inflows or enhancements of assets or decreases of liabilities that result in an increase in equity (excluding transactions with owners). Answer (C) is incorrect because deposits are liabilities, not equity items. The equity of an entity is the residual interest in the assets of an entity that remains after deducting its liabilities. Answer (D) is correct. Liabilities are present obligations arising from past events, the settlement of which is expected to result in an outflow of resources embodying economic benefits. Customers’ deposits must be returned or credited to their accounts. The deposits should therefore be recorded as liabilities.

[509] Gleim #: 4.41 -- Source: CIA 590 IV-28 In performing an audit, you encounter an adjusting journal entry recorded at year-end that contains a debit to rental revenue and a credit to deferred rental revenue. The purpose of this journal entry is to record

A. B. C. D.

An accrued revenue. An unexpired expense. An expired expense. A liability. Answer (A) is incorrect because an accrued revenue has met the recognition criteria but has not yet been received. The journal entry described indicates that collection has been made. Answer (B) is incorrect because the entry concerns a revenue rather than an expense transaction. Answer (C) is incorrect because the entry concerns a revenue rather than an expense transaction. Answer (D) is correct. A deferred revenue is a revenue item that has been received but has not met the recognition criteria. The journal entry described in the question is an adjusting entry to transfer an amount from the revenue account to a liability (deferred revenue) account. The initial collection of cash in advance from the tenant was apparently recorded by a credit to revenue. An adjusting entry is therefore required at year-end to transfer any remaining amount that does not qualify for revenue recognition.

[510] Gleim #: 4.42 -- Source: CIA 597 IV-36 Because of a defect discovered in its seat belts in December 2004, an automobile manufacturer believes it is probable that it will be required to recall its products. The final decision on the recall is expected to be made in March 2005. The cost of the recall is reliably estimated to be 2.5 million. How should this information be reported in the December 31, 2004 financial statements?

A. B. C. D.

As a loss of 2.5 million and a provision of 2.5 million. As an adjustment of the opening balance of retained earnings equal to 2.5 million. As an appropriation of retained earnings of 2.5 million. It should not be disclosed because it has not yet happened.


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Answer (A) is correct. A provision is a liability of uncertain timing or amount. Recognition of provisions is appropriate when the entity has a legal or constructive present obligation resulting from a past event (called an obligating event), it is probable that an outflow of economic benefits will be necessary to settle the obligation, and its amount can be reliably estimated. Consequently, the company must recognize a loss and a liability for 2.5 million. Answer (B) is incorrect because such an adjustment is appropriate for fundamental errors and changes in accounting policies (under the benchmark treatments). Answer (C) is incorrect because an appropriation of retained earnings is permissible although not required, but the entity must still recognize a loss and a provision. Moreover, no part of the appropriation may be transferred to income, and no loss may be charged to an appropriation of retained earnings. Answer (D) is incorrect because, if the loss is probable and can be reliably estimated, it should be recognized by a charge to income. [511] Gleim #: 4.43 -- Source: CIA 1192 IV-45 An entity is subject to warranty claims. A reliable estimate is that between 1 million and 3 million will probably be paid out. No estimate of loss within this range is more likely than any other. The entity should

A. B. C. D.

Make no journal entry at this time. Disclose only a possible loss. Defer a provision of 1 million to 3 million depending on the applicable national accounting standards. Recognize a provision of 1 million to 3 million depending on the applicable national accounting standards. Answer (A) is incorrect because the criteria for recognition of a provision have been met, including a reliable estimate of the range of the obligation. Answer (B) is incorrect because the loss is probable. Answer (C) is incorrect because the loss is not deferred; it is accrued. Answer (D) is correct. A provision is a liability of uncertain timing or amount. Recognition of provisions is appropriate when the entity has a legal or constructive present obligation resulting from a past event (called an obligating event), it is probable that an outflow of economic benefits will be necessary to settle the obligation, and its amount can be reliably estimated. Thus, a provision should be recognized. Moreover, the amount recognized should be the best estimate of the expenditure required to settle the obligation. However, the amount within the reliable estimate of the range of the obligation that will be recognized will vary from country to country.

[512] Gleim #: 4.44 -- Source: CIA 596 IV-25 Which one of the following will usually be accounted for by recognizing a provision?

A. Just prior to the balance sheet date, the board decided to close a division. No implementation steps have been taken. B. As of the balance sheet date, the board was aware that a new law would require the entity to fit smoke filters to its factories within the next year. No such filters have been fitted. C. A law requires an airline to overhaul its aircraft once every 3 years. D. Premiums offered to customers.


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Answer (A) is incorrect because no obligating event has occurred. The entity could avoid the future expenditure by its future actions. Answer (B) is incorrect because no obligating event has occurred. The entity could avoid the future expenditure by its future actions. Answer (C) is incorrect because no obligating event has occurred. The entity could avoid the future expenditure by its future actions. Answer (D) is correct. When premiums are offered to customers, for example, upon redemption of coupons, the entity can usually establish that it has a legal present obligation resulting from a past event and that an outflow of economic benefits is probable. Furthermore, if the entity has prior experience with such offers or information about the experience of similar entities, a reliable estimate of the obligation should be feasible. [513] Gleim #: 4.45 -- Source: CIA 595 IV-20 Which of the following is not a factor, with respect to pending litigation, that must be considered in determining whether a provision should be recognized?

A. B. C. D.

The time period in which the underlying cause of action occurred. The probability of an unfavorable outcome. The ability to make a reliable estimate of the amount of loss. The number of parties involved in the litigation. Answer (A) is incorrect because the time period in which the obligating event occurred is relevant. If it arose after the date of the financial statements, a provision may not be recognized in those statements. Answer (B) is incorrect because a provision is not recognized unless it is probable that an outflow of resources embodying economic benefits will be required to settle a present obligation arising from a past event. Answer (C) is incorrect because a provision is not recognized unless it is probable that an outflow of resources embodying economic benefits will be required to settle a present obligation arising from a past event. Moreover, the amount of the obligation should be capable of reliable estimation. Answer (D) is correct. The number of parties involved in the litigation is irrelevant. For example, the same accounting treatment is applied whether a claim is brought by an individual or in a class action suit.

[514] Gleim #: 4.46 -- Source: CIA 589 IV-33 An entity has been sued for 100 million for producing and selling an unsafe product. Attorneys for the entity cannot reliably predict the outcome of the litigation. In its financial statements, the entity should

A. Make the following journal entry, and disclose the existence of the lawsuit in a footnote. Estimated loss from litigation 100,000,000 Estimated provision for litigation loss 100,000,000 B. Disclose the existence of the lawsuit in a note without making a journal entry. C. Neither make a journal entry nor disclose the lawsuits in a note because bad publicity will hurt the entity. D. Make the following journal entry, and disclose the existence of the lawsuit in a note. Cost of goods sold 100,000,000 Estimated provision for litigation loss

100,000,000


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Answer (A) is incorrect because a journal entry is made when the outflow in settlement is probable and can be reliably estimated. Answer (B) is correct. In the very rare case in which a reliable estimate of an obligation that otherwise qualifies for treatment as a provision cannot be determined, no liability is recognized. Instead, the existing liability is disclosed as a contingent liability (unless the possibility of any outflow in settlement is remote). Answer (C) is incorrect because a disclosure must be made of a contingent liability. Answer (D) is incorrect because a journal entry is made when the outflow in settlement is probable and can be reliably estimated. [515] Gleim #: 4.47 -- Source: Publisher An entity is currently being sued by a customer. A reliable estimate can be made of the costs that would result from a ruling unfavorable to the entity, and the amount involved is material. The entity’s managers, lawyers, and auditors agree that the likelihood of an unfavorable ruling is remote. This contingent liability

A. B. C. D.

Should be disclosed in a note. Should be disclosed as a parenthetical comment in the balance sheet. Need not be disclosed. Should be disclosed by an appropriation of retained earnings. Answer (A) is incorrect because the contingent liability is required to be neither recognized nor disclosed. Answer (B) is incorrect because the contingent liability is required to be neither recognized nor disclosed. Answer (C) is correct. A contingent liability includes a present obligation for which an outflow of resources embodying economic benefits is not probable. A contingent liability is not recognized but is disclosed unless the possibility of the outflow is remote. Answer (D) is incorrect because the contingent liability is required to be neither recognized nor disclosed.

[516] Gleim #: 4.48 -- Source: CIA 597 IV-19 In November of the current year, the vice-president of a local bank reviews the bank’s mortgage portfolio prior to the December 31 year-end. The bank’s largest client has mortgages on buildings in three cities. The client has incurred net losses for the past 3 years and is now experiencing serious cash flow problems. For the past 6 months, no payments have been made on any of the three mortgages. The vice-president reluctantly concludes that it is probable that the full amount of principal and interest will not be collected. What is the impact of this conclusion on the local bank’s current year financial statements?

A. B. C. D.

No accounting or disclosure of a possible loss in value is necessary. Contingency note disclosure of a possible impairment is required. The carrying amount of the mortgages should be reduced, with a charge directly to retained earnings. The carrying amount of the mortgages should be reduced, with a charge to the income statement.


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Answer (A) is incorrect because the carrying amount should be reduced, and the charge should be included in net profit or loss. Answer (B) is incorrect because the carrying amount should be reduced, and the charge should be included in net profit or loss. Answer (C) is incorrect because the carrying amount should be reduced, and the charge should be included in net profit or loss. Answer (D) is correct. A financial asset, such as a lender’s mortgage receivable, is impaired if its carrying amount at the balance sheet date exceeds its estimated recoverable amount. If it is probable that all amounts due on such a held-to-maturity investment (a financial asset carried at amortized cost) cannot be collected, the loss should be included in net profit or loss. The loss equals the difference between the carrying amount and the present value of the expected future cash flows discounted at the original effective interest rate. The carrying amount of the asset should be reduced to its estimated recoverable amount directly or by crediting an allowance account. [517] Gleim #: 4.49 -- Source: CIA 597 IV-30 If bonds are initially sold at a discount and the effective-interest method of amortization is used,

A. B. C. D.

Interest expense in the earlier periods will be less than interest expense in the later periods. Interest expense in the earlier periods will be greater than interest expense in the later periods. Interest expense will equal the cash interest payment each period. Interest expense will be less than the cash interest payment each period. Answer (A) is correct. Interest expense equals the carrying amount of the liability at the beginning of the period times the effective interest rate. The carrying amount of the liability equals the face amount of the bond minus the discount. As the discount is amortized over the life of the bond, the carrying amount increases. Consequently, the interest expense increases over the term of the bond. Answer (B) is incorrect because interest expense will increase over the term of the bonds. Answer (C) is incorrect because interest expense exceeds the cash interest payment when bonds are issued at a discount. The reason is that the effective rate is higher than the nominal rate. The excess of interest expense over the cash payment is the amount of discount amortized each period. Answer (D) is incorrect because interest expense exceeds the cash interest payment when bonds are issued at a discount. The reason is that the effective rate is higher than the nominal rate. The excess of interest expense over the cash payment is the amount of discount amortized each period.

[518] Gleim #: 4.50 -- Source: CIA 595 IV-19 An entity issues 10-year bonds with a face value of 1 million, dated January 1, 2004 and bearing interest at an annual rate of 12% payable semiannually on January 1 and July 1. The full interest amount will be paid each due date. The market rate of interest on bonds of similar risk and maturity, with the same schedule of interest payments, is also 12%. If the bonds are issued on February 1, 2004, the amount the issuing entity receives from the buyers of the bonds on that date is

A. B. C. D.

990,000 1,000,000 1,010,000 1,020,000


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Answer (A) is incorrect because 990,000 is the result if 1 month of accrued interest is deducted from, rather than added to, the amount received. Answer (B) is incorrect because the purchasers must pay for the accrued interest from the last interest date to the issue date. They will receive 6 months’ interest on July 1 despite holding the bonds for 5 months. Answer (C) is correct. The amount the issuing entity receives on 2/1/04 is the face amount of the issue plus 1 month of accrued interest, or 1,010,000 {1,000,000 + [(1,000,000 × 12%) ÷ 12]}. Answer (D) is incorrect because 1,020,000 results from adding 2 months of accrued interest to the face amount. [519] Gleim #: 4.51 -- Source: CIA 1191 IV-39 If bonds payable with a carrying amount equal to par value are refunded by use of a call provision, the call premium of the refunded issue should be

A. B. C. D.

Amortized over the remaining original life of the extinguished issue. Amortized over the life of the new issue. Recognized currently in net profit or loss as an extraordinary item. Recognized currently in net profit or loss. Answer (A) is incorrect because the excess of the reacquisition price over the net carrying amount of the old bonds is recognized in full in net profit or loss for the period. Answer (B) is incorrect because the excess of the reacquisition price over the net carrying amount of the old bonds is recognized in full in net profit or loss for the period. Answer (C) is incorrect because an extraordinary item is income or an expense arising from events or transactions that are clearly distinct from the ordinary activities of the entity and are not expected to recur frequently or regularly. Answer (D) is correct. An entity should remove a financial liability from its balance sheet only when it is extinguished, for example, when the creditor is paid. The difference between the carrying amount and the amount paid should be included in net profit or loss for the period.

[520] Gleim #: 4.52 -- Source: CIA 591 IV-36 At December 31, 20X3, an entity had the following obligations that were expected to be refinanced:

17% note payable 15% note payable

140,000 200,000

The 17% note payable was issued on October 1, 20X2 and matures on July 1, 20X4. The 15% note payable was issued on May 1, 20X2 and matures on May 1, 20X4. On February 1, 20X4, the entire 140,000 balance of the 17% note payable was refinanced by issuance of a long-term debt instrument. On February 7, 20X4, the entity entered into a noncancelable agreement with a lender to refinance the 15% note payable on a long-term basis. The financial statements were authorized to be issued on March 1, 20X4. The total amount of obligations that may be properly excluded from current liabilities on the entity’s December 31, 20X3 balance sheet is

A. B. C. D.

0 140,000 200,000 340,000


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Answer (A) is incorrect because 340,000 may be excluded from current liabilities. Answer (B) is incorrect because the 15% note is also excluded from current liabilities. Answer (C) is incorrect because the 17% note is also excluded from current liabilities. Answer (D) is correct. Some noncurrent, interest-bearing liabilities due to be settled within 12 months should nevertheless continue to be classified as noncurrent if the original term exceeded 12 months, the entity intends to refinance on a long-term basis, and its intent is supported by an agreement to refinance or reschedule payments. This agreement must be consummated before the financial statements are authorized for issue. Thus, 340,000 (140,000 + 200,000) may be excluded from current liabilities. [521] Gleim #: 4.53 -- Source: Publisher An entity most likely may derecognize a financial liability if it

A. B. C. D.

Transfers amounts to a trust to be used to repay the obligation. Exchanges debt instruments with the lender with substantially similar terms. Exchanges debt instruments with the lender with substantially different terms. Transfers amounts in a transaction that meets the requirements of an in-substance defeasance. Answer (A) is incorrect because payment to a third party such as a trust (also known as an in-substance defeasance) does not by itself extinguish the obligation absent a legal release. Answer (B) is incorrect because the terms should be substantially different. Answer (C) is correct. Derecognition of a financial liability (or a part thereof) occurs only by means of extinguishment. This condition is satisfied only when the debtor pays the creditor or is legally released from primary responsibility either by the creditor or through the legal process. An extinguishment and derecognition of the old debt and recognition of new debt occurs when the borrower and lender exchange debt instruments with substantially different terms, that is, when the respective discounted cash flows differ by at least 10%. Answer (D) is incorrect because payment to a third party such as a trust (also known as an in-substance defeasance) does not by itself extinguish the obligation absent a legal release.

[522] Gleim #: 4.54 -- Source: CIA 1192 IV-44 An entity has a 100,000 liability on the books. In 12 months, 110,000 will be due, including 10% interest. The entity negotiates settlement of the debt today by exchanging customer receivables with a carrying amount of 90,000. What is the journal entry today?

A. Liability Receivables Gain B. Liability Receivables Gain C. Liability Receivables Gain D. Liability Receivables Gain

110,000 99,000 11,000 100,000 99,000 1,000 110,000 90,000 20,000 100,000 90,000 10,000


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Answer (A) is incorrect because the liability and receivables should not be increased by the 10% interest rate. Answer (B) is incorrect because the receivables should not be increased by the 10% interest rate. Answer (C) is incorrect because the liability should not be increased by the 10% interest rate. Answer (D) is correct. An entity may derecognize a financial liability when it is extinguished. This condition is met when the debtor discharges the debt by paying the creditor, such as with cash, other financial assets (e.g., receivables), goods, or services. Consequently, the liability should be debited for its 100,000 balance. Receivables with a 90,000 balance are given up, so that account should be credited. The difference is a gain. [523] Gleim #: 4.55 -- Source: CIA 1196 IV-19 How will profit or loss be affected by the amortization of a premium on bonds payable?

A. B. C. D.

Interest expense is decreased, so net profit or loss is increased. Interest expense is increased, so net profit or loss is decreased. Interest income is increased, so net profit or loss is increased. Interest income is decreased, so net profit or loss is decreased. Answer (A) is correct. The entry is to debit interest expense, debit bond premium, and credit cash paid. Thus, the amortization of a premium on bonds payable reduces the interest expense, thereby increasing profit or loss. Answer (B) is incorrect because the amortization of a premium on bonds payable reduces interest expense. Answer (C) is incorrect because interest income is not affected by the amortization of a premium on bonds payable. Answer (D) is incorrect because interest income is not affected by the amortization of a premium on bonds payable.

[524] Gleim #: 4.56 -- Source: Publisher What is the preferred method of handling unamortized discount, unamortized issue costs, and the costs of implementing a conversion of debt into common shares?

A. B. C. D.

Expense them in the period bonds are converted. Amortize them over the remaining life of the issue retired. Amortize them over a period not to exceed 40 years. Charge them to share premium in excess of the par value of the shares issued. Answer (A) is incorrect because this amount is not expensed. In effect, it reduces the amount at which the shares are issued. Answer (B) is incorrect because this amount is not expensed. In effect, it reduces the amount at which the shares are issued. Answer (C) is incorrect because this amount is not expensed. In effect, it reduces the amount at which the shares are issued. Answer (D) is correct. The conversion of debt into common shares is ordinarily based upon the carrying amount of the debt at the time of issuance. Because the carrying amount is based on all related accounts, the debit balances of unamortized bond discount, unamortized issue costs, and conversion costs should be considered reductions in the net carrying amount at the time of conversion. Consequently, these items should be reflected as reductions in the share premium in excess of par account.

[525] Gleim #: 4.57 -- Source: CIA 1186 IV-30 On May 1, 20X4, an entity issued, at 103 plus accrued interest, 500 of its 12%, 1,000 bonds. The bonds are dated January 1, 20X4 and mature on January 1, 20X9. Interest is payable semiannually on January 1 and July 1. The journal entry to record the issuance of the bonds and the receipt of the cash proceeds is


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A. Cash Interest payable Bonds payable Premium on bonds payable B. Cash Bonds payable Premium on bonds payable Interest payable C. Cash Bonds payable Premium on bonds payable Interest payable D. Cash Bonds payable Premium on bonds payable

515,000 20,000 500,000 35,000 525,000 500,000 15,000 10,000 535,000 500,000 15,000 20,000 535,000 500,000 35,000

Answer (A) is incorrect because the bond premium is 15,000 (500,000 × .03), and interest payable should be credited. Answer (B) is incorrect because interest payable should be 20,000 [500,000 × .12 × (4 ÷ 12)]. Answer (C) is correct. The face amount of the 500 bonds is equal to 500,000 (500 × 1,000). The cash proceeds excluding interest from the issuance of the bonds are 515,000 (103% × 500,000). The 15,000 premium is the difference between the cash issuance proceeds and the face amount of the bonds. Because the bonds were issued between interest payment dates, the issuer is also entitled to receive accrued interest for the 4 months between the prior interest date and the issuance date. The accrued interest is 20,000 [500 bonds × 1,000 face value × 12% stated rate × (4 ÷ 12)]. The issuing company will therefore receive 535,000 in cash (515,000 + 20,000). The resulting journal entry includes a 535,000 debit to cash, a 500,000 credit to bonds payable, a 15,000 credit to premium, and a 20,000 credit to either interest payable or interest expense. Answer (D) is incorrect because the premium on bonds payable should not include interest payable. [526] Gleim #: 4.58 -- Source: Publisher Debtor owes Bank on a 10-year, 15% note in the amount of 100,000, plus 30,000 accrued interest. Because of financial difficulty, Debtor has been unable to make annual interest payments for the past 2 years, and the note is due today. Accordingly, Bank legally agreed to restructure Debtor’s debt as follows: The 30,000 of accrued interest was forgiven. Debtor was given 3 more years to pay off the debt at 8% interest. Payments are to be made annually at year-end. The present value of the payments using the prevailing rate for similar instruments of an issuer with a similar credit rating is 84,018. At the date of the restructuring, Debtor properly records

A. B. C. D.

A loss of 30,000. A gain of 30,000. A gain of 45,982. No gain or loss because no extinguishment occurred.


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Answer (A) is incorrect because 30,000 is the difference between the sum of the existing liabilities and the face amount of the note with modified terms. Moreover, a gain should be recognized. Answer (B) is incorrect because 30,000 is the difference between the sum of the existing liabilities and the face amount of the note with modified terms. Moreover, a gain should be recognized. Answer (C) is correct. Derecognition of a financial liability (or a part thereof) occurs only by means of extinguishment. This condition is satisfied only when the debtor pays the creditor or is legally released from primary responsibility either by the creditor or through the legal process. An extinguishment and derecognition of the old debt and recognition of new debt occurs when the borrower and lender exchange debt instruments with substantially different terms, that is, when the respective discounted cash flows differ by at least 10%. A substantial modification of terms is also accounted for as an extinguishment. The difference between the carrying amount (including unamortized costs) of a liability (or part thereof) that has been extinguished or transferred and the amount paid is included in net profit or loss. This transaction qualifies as an extinguishment based on a substantial modification of terms because the discounted cash flow from the old debt (130,000 due immediately) and the new debt (given as 84,018) differ by at least 10%. Hence, the amount included by Debtor in net profit or loss at the date of the restructuring is a 45,982 gain (130,000 – 84,018), that is, the difference between the carrying amount extinguished and the amount paid (the present value of the new debt instrument determined by discounting the cash outflows at the prevailing rate for similar instruments of an issuer with a similar credit rating). The entry is to debit the extinguished liability for accrued interest and principal (130,000), debit discount on note payable (15,982), credit note payable (100,000), and credit gain (45,982). Answer (D) is incorrect because the terms were substantially different. Thus, an extinguishment occurred. [527] Gleim #: 4.59 -- Source: CIA 1185 IV-15 An entity received a 2-year, 190,000 note on January 1, 20X2 in exchange for property it sold. According to the terms of the note, interest of 5% is payable annually on January 1, 20X3 and January 1, 20X4, when the face amount is also due. There was no established exchange price for the property. The prevailing rate of interest for a note of this type was 12% at the beginning of 20X2 and 14% at the beginning of 20X3. What interest rates should be used to calculate the amount of interest income from this transaction for the years ended December 31, 20X2 and 20X3, respectively?

A. B. C. D.

0% and 5%. 5% and 5%. 12% and 12%. 12% and 14%. Answer (A) is incorrect because the market rate of interest at the issuance date should be used to calculate the amount of interest income. Answer (B) is incorrect because the market rate of interest at the issuance date should be used to calculate the amount of interest income. Answer (C) is correct. When the nominal interest rate on a note is not equal to the prevailing market rate for this type of note, the face amount of the note is not equal to its fair value or present value. In this case, the present value of the note should be determined by discounting the 190,000 maturity value and the 9,500 annual interest payments using an appropriately imputed rate of interest. Given that 12% was the prevailing rate of interest for a note of that type at the issuance date, 12% should be used to determine both the fair value and the interest income during the life of the note, regardless of fluctuations in prevailing interest rates. Answer (D) is incorrect because the market rate of interest at the issuance date should be used to calculate the amount of interest income.


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[528] Gleim #: 4.60 -- Source: CIA 597 IV-2 During the year, an entity’s balance sheet accounts increased by the following amounts: Assets Liabilities Common shares Share premium

180,000 50,000 90,000 15,000

Net profit for the year was 42,000. The only other change in retained earnings was for the declaration of cash dividends. The amount of dividends declared was

A. B. C. D.

2,000 17,000 33,000 67,000 Answer (A) is incorrect because 2,000 ignores the 15,000 increase in share premium. Answer (B) is correct. Assets equals liabilities plus equity. Given an increase of 180,000 in assets, the sum of liabilities and equity must also have increased by 180,000. Because liabilities, share capital, and share premium increased by 155,000 (50,000 + 90,000 + 15,000), retained earnings must have increased by 25,000 (180,000 – 155,000). Given net profit of 42,000, dividends declared must have been 17,000 (42,000 – 25,000). Answer (C) is incorrect because 33,000 equals the increase in assets minus the sum of the increases in share capital accounts and net profit. Answer (D) is incorrect because 67,000 equals net profit plus the increase in net assets other than from owner contributions.

[529] Gleim #: 4.61 -- Source: CIA 591 IV-37 At December 31, year 1, an entity had the following equity accounts: Common shares, 10 par, 100,000 shares authorized, 40,000 shares issued and outstanding Share premium from issuance of common shares Retained earnings

640,000 1,000,000

Total equity

2,040,000

400,000

Each of the 40,000 common shares outstanding was issued at a price of 26. On January 2, year 2, 2,000 shares were reacquired for 30 per share. The cost method is used in accounting for these treasury shares. Which of the following correctly describes the effect of the acquisition of the treasury shares?

A. B. C. D.

Common shares is reduced by 20,000. Share premium from issuance of common shares is reduced by 32,000. The retained earnings account balance is reduced by 8,000. Total equity is reduced by 60,000.


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Answer (A) is incorrect because the common shares account balance is not affected when treasury shares are acquired. Answer (B) is incorrect because share premium is not affected when treasury shares are acquired and accounted for by the cost method. Answer (C) is incorrect because retained earnings is not affected by treasury share acquisitions when the cost method is used. Answer (D) is correct. Using the cost method, the journal entry to record the acquisition of the treasury shares includes a debit to treasury shares for 60,000. The balance of the treasury shares account is classified as a contra equity item. Thus, the acquisition of the treasury shares reduces total equity by 60,000 (30 × 2,000 shares = 60,000). [530] Gleim #: 4.62 -- Source: CIA 1188 IV-36 At December 31, year 1, an entity has the following account balances: Common shares (10 par, 50,000 shares issued) 8% preferred shares (50 par, 10,000 shares issued) Share premium on common shares Share premium on preferred shares Retained earnings

500,000 500,000 640,000 20,000 600,000

The preferred shares are cumulative and nonparticipating, and has a call price of 55 per share. The journal entry to record the redemption of all preferred shares on January 2, year 2 pursuant to the call provision is

A. Preferred shares Share premium: preferred Discount on preferred shares Cash B. Preferred shares Share premium: preferred Loss on redemption of preferred shares Cash C. Preferred shares Loss on redemption of preferred shares Retained earnings Cash Share premium: preferred D. Preferred shares Share premium: preferred Retained earnings Cash

500,000 20,000 30,000 550,000 500,000 20,000 30,000 550,000 500,000 50,000 300,000 550,000 300,000 500,000 20,000 30,000 550,000


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Answer (A) is incorrect because the 30,000 excess of cash paid over the carrying amount of the redeemed shares should be debited to retained earnings. Answer (B) is incorrect because the 30,000 excess of cash paid over the carrying amount of the redeemed shares should be debited to retained earnings. Answer (C) is incorrect because the premium on the preferred shares must be debited for only 20,000. Moreover, retained earnings must also be debited for the difference of 30,000. Answer (D) is correct. The exercise of the call provision resulted in the redemption of the 10,000 preferred shares issued and outstanding at the call price of 550,000 (10,000 shares × 55 call price per share). To eliminate the carrying amount of the preferred shares and recognize the cash paid in this transaction, the required journal entry is to debit preferred shares for 500,000, debit share premium: preferred for 20,000, and credit cash for 550,000. The difference of 30,000 (550,000 cash – 520,000 carrying amount of the preferred shares) is charged to retained earnings. No loss is reported because an Interpretation of IAS 32 does not permit the recognition of a gain or loss on transactions involving an entity’s own shares. [531] Gleim #: 4.63 -- Source: Publisher Entity X effects self-insurance against loss from fire by appropriating an amount of retained earnings each year equal to the amount that would otherwise be paid out as fire insurance premiums. The procedure used by entity X is

A. B. C. D.

Prohibited for external reporting purposes. Acceptable provided that fire losses are not charged against the appropriation. Acceptable provided that fire losses are charged against the appropriation. Acceptable if the amount is shown outside the equity section of the balance sheet. Answer (A) is incorrect because an appropriation of retained earnings for self-insurance is permissible. Answer (B) is correct. Accrual of an expense prior to the occurrence of the event for which an entity is self-insured should not be permitted. This rule holds because the fair value of the property diminishes only if the event actually occurs. But an appropriation of retained earnings is acceptable to disclose the self-insurance policy if, when a fire loss occurs, the entry appropriating retained earnings is reversed, and the loss is charged against income of the period of loss and not against retained earnings. Answer (C) is incorrect because fire losses may never be charged against the appropriation of retained earnings. Answer (D) is incorrect because the procedure is acceptable only if the appropriation is shown within the equity section of the balance sheet.

[532] Gleim #: 4.64 -- Source: CIA 580 IV-8 Unlike a share split, a share dividend requires a formal journal entry in the financial accounting records because share

A. B. C. D.

Dividends increase the relative carrying amount of an individual’s share holding. Splits increase the relative carrying amount of an individual’s share holdings. Dividends are payable on the date they are declared. Dividends represent a transfer from retained earnings to share capital.


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Answer (A) is incorrect because share dividends have no effect on total equity or on the carrying amount of an individual shareholder’s investment. Answer (B) is incorrect because share splits have no effect on total equity or on the carrying amount of an individual shareholder’s investment. Answer (C) is incorrect because dividends, whether of shares, cash, or property, are usually payable on a date different from the declaration date. Answer (D) is correct. The purpose of a share dividend is to provide evidence to the shareholders of their interest in accumulated earnings without distribution of cash or other property. Share dividends are typically accounted for by a transfer from retained earnings at fair value. [533] Gleim #: 4.65 -- Source: CMA 695 1-11 Entity UK has 6,000 shares of 5% cumulative, 100 par value preferred shares outstanding and 200,000 common shares outstanding. The board of directors last declared dividends for the year ended May 31, 20X2, and there were no dividends in arrears. For the year ended May 31, 20X4, UK had net profit of 1,750,000. The board of directors is declaring a dividend for common shareholders equivalent to 20% of net profit. The total amount of dividends to be paid by UK at May 31, 20X4 is

A. B. C. D.

350,000 380,000 206,000 410,000 Answer (A) is incorrect because 350,000 is the common shares dividend. Answer (B) is incorrect because 380,000 omits the 30,000 of cumulative dividends for 20X2. Answer (C) is incorrect because 206,000 is based on a flat rate of 1 per share. Answer (D) is correct. If an entity has cumulative preferred shares, all preferred dividends for the current and any unpaid prior years must be paid before any dividends can be paid on common shares. The total preferred dividends that must be paid equal 60,000 (2 years × 5% × 100 par × 6,000 shares), and the common dividend is 350,000 (1,750,000 × 20%), for a total of 410,000.

[534] Gleim #: 4.66 -- Source: Publisher Early in its fiscal year, Starr purchased 1,000 shares of Pack common shares for 54,000. In the same transaction, Starr acquired 2,000 detachable share purchase warrants. Two of the warrants are required to purchase one additional Pack common share. The market price without the warrants was 49 per share. The market price of the warrants was 3.50 per warrant. Starr sold 50% of the warrants several weeks later. If the proceeds received by Starr equaled 4,000, it recognized a realized gain of

A. B. C. D.

3,000 625 500 0 Answer (A) is incorrect because 3,000 is the excess of the fair value of 2,000 rights over the sale price of 1,000 rights. Answer (B) is correct. The recipient of share purchase warrants should allocate the carrying amount of the shares owned between those shares and the rights based on their relative fair values. Thus, the amounts to be allocated to the common shares and warrants are 47,250 ({(49 × 1,000) ÷ [(49 × 1,000) + (3.50 × 2,000)]} × 54,000) and 6,750 (54,000 – 47,250), respectively. The realized gain is therefore 625 [4,000 – (6,750 × 50%)]. Answer (C) is incorrect because 500 equals the excess of the sale price of 1,000 rights over their fair value. Answer (D) is incorrect because Starr should recognize a realized gain for the excess of the price over the carrying amount.


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[Fact Pattern #34] An entity has issued 1,000 common shares with a par value of 10, and its credit balance in retained earnings is 5,000. Two proposals are under consideration. The first is a share split giving each shareholder two new shares for each share formerly held. The second is to declare and distribute a 10% share dividend. [535] Gleim #: 4.67 -- Source: CIA 1194 IV-50 (Refers to Fact Pattern #34) The share split proposal will earnings per share by than will the share dividend proposal.

List A

List B

A. B.

Increase Increase

More Less

C. D.

Decrease Decrease

More Less

Answer (A) is incorrect because the split results in a greater number of shares outstanding and a lower EPS than results from the share dividend. Answer (B) is incorrect because the split results in a greater number of shares outstanding and a lower EPS than results from the share dividend. Answer (C) is correct. The share split will double the number of shares outstanding to 2,000. The 10% share dividend will increase the number of outstanding shares to 1,100. The higher number of shares in the split will result in a lower earnings per share than will result from the share dividend. Answer (D) is incorrect because the split results in a greater number of shares outstanding and a lower EPS than results from the share dividend. [536] Gleim #: 4.68 -- Source: CIA 1194 IV-51 (Refers to Fact Pattern #34) Under the share , the par value per outstanding share will .

List A

List B

A. B.

Dividend Split

Increase Increase

C. D.

Dividend Split

Decrease Decrease

Answer (A) is incorrect because par value per share does not change following a share dividend. Answer (B) is incorrect because par value per share decreases following a share split. Answer (C) is incorrect because par value per share does not change following a share dividend. Answer (D) is correct. A share split results in a lower par value per share because the total number of shares increases but the total par value of outstanding share does not change. [537] Gleim #: 4.69 -- Source: CIA 595 IV-24 Entity A acquires entity B for 1,000,000. At the time of the acquisition, the net fair value of the identifiable assets, liabilities, and contingent liabilities recognized had a carrying amount of 900,000 and a fair value of 800,000. The amount of goodwill entity A will record on the acquisition date is


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A. B. C. D.

0 100,000 200,000 300,000 Answer (A) is incorrect because goodwill must be recorded. Answer (B) is incorrect because 100,000 is the excess of the acquisition cost over the carrying amount. Answer (C) is correct. Goodwill equals the excess of the acquisition cost over the acquirer’s interest in the net fair value of the identifiable assets, liabilities, and contingent liabilities recognized. Consequently, goodwill is 200,000 (1,000,000 – 800,000). Answer (D) is incorrect because 300,000 equals goodwill plus the excess of the carrying amount over fair value.

[538] Gleim #: 4.70 -- Source: CIA 1194 IV-21 A corporation acquires a 30% voting interest in another corporation. In this situation, the long-term investment is generally accounted for on the investor corporation’s books using which of the following reporting methods?

A. B. C. D.

Lower-of-cost-or-market. Cost. Consolidated. Equity. Answer (A) is incorrect because the lower-of-cost-or-market method is not generally used for equity investments. Answer (B) is incorrect because the cost basis is used when the investor cannot exercise significant influence over the investee (it has less than 20% of the voting power of the investee) and market prices are not readily available. Answer (C) is incorrect because consolidated reporting is ordinarily required only when the investor controls the investee. Answer (D) is correct. If an investor can exercise significant influence over an investee, the investment should be accounted for by the equity method. When a corporation owns 20% or more of the voting power of the investee, the ability to exercise significant influence is presumed.


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[539] Gleim #: 4.71 -- Source: CIA 596 IV-30 A conglomerate company acquired 100% of the net assets of a target company for 900 cash. The target company’s balance sheet just prior to the acquisition is presented below. Target Company (as of acquisition date)

Cash Receivables Inventory Property, plant, and equipment (net) Total assets

Current liabilities Share capital Retained earnings Total liabilities and equity

Carrying Amount

Fair Value

100 200 150

100 200 200

600

400

1,050

900

200 200 650

200

1,050

The amount of goodwill to be recorded by the conglomerate company related to its purchase of the target company is

A. B. C. D.

$(200) $50 $200 None of the answers are correct. Answer (A) is incorrect because goodwill is positive, not negative. Answer (B) is incorrect because $50 is based on carrying amounts. Answer (C) is correct. Goodwill is the excess of the cost over the net fair value of the acquired identifiable assets, liabilities, and contingent liabilities recognized. This net fair value equals the sum of cash, receivables, inventory, and PPE, minus liabilities. Hence, the net fair value acquired is $700, and goodwill is $200 ($900 cost – $700). Answer (D) is incorrect because the goodwill recorded is $200.

[540] Gleim #: 4.72 -- Source: CIA 1191 IV-46 Entity X owns 90% of entity Y. Early in the year, X lent Y 1,000,000. No payments have been made on the debt by year-end. Proper accounting at year-end in the consolidated financial statements would

A. B. C. D.

Eliminate 100% of the receivable, the payable, and the related interest. Eliminate 100% of the receivable and the payable but not any related interest. Eliminate 90% of the receivable, the payable, and the related interest. Eliminate 90% of the receivable and the payable but not any related interest.


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Answer (A) is correct. In a consolidated balance sheet, reciprocal balances, such as receivables and payables, between a parent and a consolidated subsidiary should be eliminated in their entirety regardless of the portion of the subsidiary’s shares held by the parent. Thus, all effects of the 1,000,000 loan should be eliminated in the preparation of the year-end consolidated balance sheet. Answer (B) is incorrect because the interest must be eliminated. Answer (C) is incorrect because all aspects of the transaction must be eliminated. Answer (D) is incorrect because all aspects of the transaction must be eliminated. [541] Gleim #: 4.73 -- Source: CIA 593 IV-37 An entity issues bonds payable at a premium. You are analyzing the effects of using the effective interest rate (constant yield) method in accounting for the bonds over their 10-year life. Which of the following trends related to the reported amounts for (1) interest expense and (2) carrying amount of the bonds would you expect to find?

Interest Expense

Carrying Amount

A. B.

Constant amount Increasing amount

Constant amount Decreasing amount

C. D.

Decreasing amount Decreasing amount

Decreasing amount Constant amount

Answer (A) is incorrect because the interest expense is a decreasing amount each period. It is computed by applying a constant rate to a decreasing carrying amount. Answer (B) is incorrect because the interest expense is a decreasing amount each period. It is computed by applying a constant rate to a decreasing carrying amount. Answer (C) is correct. When the effective interest rate method is used, interest expense equals the effective rate (a constant rate) times the carrying amount at the beginning of the period. The carrying amount is the par value plus the balance of the unamortized premium. The difference between interest expense and the nominal interest is the premium amortization for the period. Thus, interest expense is a decreasing amount each period because a constant rate is applied to a decreasing carrying amount. Answer (D) is incorrect because the interest expense is a decreasing amount each period. It is computed by applying a constant rate to a decreasing carrying amount. [542] Gleim #: 4.74 -- Source: CIA 590 IV-41 At December 31 of year 1, an entity had a provision of 40,000 for the “Estimated Liability under Warranties” account. During year 2, the entity sold 1,000 new units under warranties reliably estimated at 100 per unit. The actual parts and labor warranty expenditures for year 2 were 90,000. Warranty expense for year 2 should be

A. B. C. D.

40,000 50,000 90,000 100,000


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Answer (A) is incorrect because 40,000 is the beginning liability balance. Answer (B) is incorrect because 50,000 equals actual expenditures minus the beginning liability. Answer (C) is incorrect because 90,000 equals current-year expenditures. Answer (D) is correct. Recognition of provisions is appropriate when the entity has a legal or constructive present obligation resulting from a past event (called an obligating event), it is probable that an outflow of economic benefits will be necessary to settle the obligation, and its amount can be reliably estimated. Accordingly, a provision should be recognized for warranty expense in the period in which the matching revenue is recorded. Thus, the debit to warranty expense and the credit to provision for warranty expense in year 2 is 100,000 (100 × 1,000 units). [543] Gleim #: 4.75 -- Source: CIA 594 IV-22 Which of the following is required in order for an entity to record a provision?

A. B. C. D.

The exact payee must be known. The exact date payable must be known. It must be reasonably possible that an outflow of resources will be required to settle the obligation. It must be possible to determine a reliable estimate of the amount of the obligation. Answer (A) is incorrect because the exact payee does not have to be known. Answer (B) is incorrect because the exact date payable does not have to be known. Answer (C) is incorrect because the resource outflow must be probable. Answer (D) is correct. A provision is a liability of uncertain timing and amount. Recognition of provisions is appropriate when the entity has a legal or constructive present obligation resulting from a past event (called an obligating event), it is probable that an outflow of economic benefits will be necessary to settle the obligation, and its amount can be reliably estimated.

[544] Gleim #: 4.76 -- Source: CIA 593 IV-33 An entity has the following contingencies at a balance sheet date: I. An obligation for clean-up costs relating to environmental damage may, but probably will not, require an outflow of resources. II. An obligation for decommissioning costs of a nuclear reactor may, but probably will not, require an outflow of resources. III. The entity is jointly and severally liable for an obligation arising from a lawsuit; the likelihood of an outflow of resources is remote. Which of the above items must be disclosed in the notes to the financial statements?

A. B. C. D.

I and II only. II and III only. I and III only. I, II, and III.


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Answer (A) is correct. Recognition of provisions is appropriate when the entity has a legal or constructive present obligation resulting from a past event (called an obligating event), it is probable that an outflow of economic benefits will be necessary to settle the obligation, and its amount can be reliably estimated. Thus, none of the circumstances in the question meet the recognition criteria for a provision. Hence, each is treated as a contingent liability, which requires disclosure unless the possibility of the outflow of resources is remote. Answer (B) is incorrect because items I and II but not III should be disclosed. Answer (C) is incorrect because items I and II but not III should be disclosed. Answer (D) is incorrect because items I and II but not III should be disclosed. [545] Gleim #: 4.77 -- Source: CIA 593 IV-34 An entity had the following account balances at December 31 of year 1: Common shares, 10 par, 100,000 shares authorized, 80,000 shares issued and outstanding Share premium Retained earnings

800,000 400,000 500,000

All shares outstanding were issued in a prior period for 15 per share. On January 5 of year 2, 1,000 shares were purchased for the treasury for 17 per share. These treasury shares were sold on February 6 of year 2, for 18 per share. The effect of the purchase and sale of the 1,000 treasury shares was to

A. B. C. D.

Increase equity by 1,000. Increase equity by 2,000. Increase equity by 3,000. Not change equity. Answer (A) is correct. Using the cost method, the journal entry to record the purchase of the treasury shares is

Treasury shares Cash

17,000 17,000

The journal entry to record the sale is Cash Treasury shares Share premium from treasury shares

18,000 17,000 1,000

Consequently, the net effect is to increase equity by 1,000. Answer (B) is incorrect because the purchase of treasury shares reduces equity by the cost of the shares, and the sale of treasury shares increases equity by the amount received. Answer (C) is incorrect because the purchase of treasury shares reduces equity by the cost of the shares, and the sale of treasury shares increases equity by the amount received. Answer (D) is incorrect because the purchase of treasury shares reduces equity by the cost of the shares, and the sale of treasury shares increases equity by the amount received. [546] Gleim #: 4.78 -- Source: CIA 1186 IV-29 The proper classification of noncurrent, interest-bearing obligations scheduled to mature within 1 year of the balance sheet date but that are expected to be refinanced on a long-term basis should be to


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A. Exclude all such obligations from the current liabilities classification. B. Include in the current liabilities classification only those obligations that have actually been refinanced on a long-term basis after the balance sheet date but before the financial statements are authorized to be issued. C. Exclude from the current liabilities classification those obligations that have been refinanced on a long-term basis after the balance sheet date but before the financial statements are authorized to be issued. D. Exclude from the current liabilities classification those obligations management wishes to exclude because they intended to convert them to long-term obligations. Answer (A) is incorrect because exclusion is only appropriate when the intent to refinance is properly supported. Answer (B) is incorrect because exclusion is proper in these circumstances given that the intent to refinance has been supported. Answer (C) is correct. Some noncurrent, interest-bearing liabilities due to be settled within 12 months should nevertheless continue to be classified as noncurrent if the original term exceeded 12 months, the entity intends to refinance on a long-term basis, and its intent is supported by an agreement to refinance or reschedule payments. This agreement must be consummated before the financial statements are authorized for issue. Answer (D) is incorrect because management’s intent is not sufficient for exclusion. [547] Gleim #: 4.79 -- Source: CMA 688 3-25 In year 1, Voorhees introduced a new line of computer products that carry a 2-year warranty against defects and workmanship. The entity estimates that the total warranty cost will be 10% of sales, with 40% of the expenditures occurring during the first year and 60% during the second year. Sales and actual warranty expenditures for year 1 and year 2 were as follows:

Year

Sales

Actual Warranty Expenditures

1 2

300,000 400,000

12,000 30,000

At the end of year 2, the balance in the estimated accrued warranty liability account will be

A. B. C. D.

24,000 46,000 58,000 28,000 Answer (A) is incorrect because the account balance is found by subtracting the actual expenditures from the total expense. Answer (B) is incorrect because the account balance is found by subtracting the actual expenditures from the total expense. Answer (C) is incorrect because the account balance is found by subtracting the actual expenditures from the total expense. Answer (D) is correct. If the warranty expense is 10% of sales, the total expense for the 2 years is 70,000 (10% × 700,000). Of that 70,000, 12,000 was paid in year 1 and 30,000 in year 2. The 42,000 of payments leaves an unpaid balance of 28,000 (70,000 – 42,000).

[548] Gleim #: 4.80 -- Source: CMA 689 3-11 On March 26, Zepher entities contracted with a consultant for services to be performed during the period from March 26 through April 30 in exchange for 10,000 treasury shares. The exchange took place on April 30. The treasury shares were acquired in January, and recorded at cost when the market price was 25 per share. The market price on March 26 was 21.50 per share. It was 23 per share on April 30. The per share amount recorded for the services should have been


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A. B. C. D.

21.50 22.25 23.00 25.00 Answer (A) is correct. A transaction is typically measured at the fair value of the consideration given up unless the fair value of the consideration received is more clearly evident. No information is given about the value of the services, so the market price of the treasury shares must be used. This price was 21.50 on March 26, the date of the agreement to trade the shares for services. Thus, the services to be received should have been measured on that date based on the price of the shares, or 21.50 per share. Because no gain or loss is recognized on transactions in treasury shares, the entry is to debit services for 21,500 (21.50 × 10,000), debit retained earnings or share premium from treasury share transactions for 3,500 [(25 – 21.50) × 10,000], and credit treasury shares for 25,000 (25 × 10,000). Answer (B) is incorrect because the services should be measured at the fair value on the date of the exchange. Answer (C) is incorrect because the services should be measured at the fair value on the date of the exchange. Answer (D) is incorrect because the services should be measured at the fair value on the date of the exchange.

[549] Gleim #: 4.81 -- Source: CMA 689 3-13 Muncie sold 1,000 treasury shares at 33 per share. The shares had originally been issued at 12 per share and had been repurchased at 27 per share. The par value is 5 per share. The entry to record the reissuance using the cost method should include a credit to

A. B. C. D.

Retained earnings of 6,000. Treasury shares of 28,000. Paid-in capital in excess of par of 28,000. Share premium of 6,000. Answer (A) is incorrect because share premium should be credited when using the cost method, not retained earnings. Answer (B) is incorrect because the repurchase price was 27 per share. Answer (C) is incorrect because share premium should be credited for only 6,000. Answer (D) is correct. Under the cost method, treasury shares are carried at cost. In this case, cost is 27,000 (27 × 1,000 shares). The journal entry to record a sale at 33 per share is

33,000

Cash Treasury shares Share premium

27,000 6,000

[550] Gleim #: 4.82 -- Source: CIA 596 IV-24 The effective-interest method and the straight-line method of amortizing a bond discount differ in that the effective-interest method results in

A. B. C. D.

Higher total interest expense over the term of the bonds. Escalating annual interest expense over the term of the bonds. Shrinking annual interest expense over the term of the bonds. Constant annual interest expense over the term of the bonds.


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Answer (A) is incorrect because the two methods of amortization result in the same total interest expense over the term of the bonds. Answer (B) is correct. Under the effective-interest method, interest expense for each period equals the effective interest rate times the carrying value of the bond issue. As the discount is amortized, the carrying value rises and interest expense increases. Answer (C) is incorrect because annual interest expense would decrease if a premium were being amortized. Answer (D) is incorrect because the straight-line method results in constant annual interest expense. [551] Gleim #: 4.83 -- Source: CIA 596 IV-23 On January 1, an entity issued a 10-year 500,000 bond at 96% of its face amount. The bond bears interest at 12%, payable on January 1 and July 1. The entry to record the issuance of the bond on January 1 is

A. Cash Bonds payable B. Cash Bonds payable C. Cash Discount on bonds payable Bonds payable D. Cash Premium on bonds payable Bonds payable

480,000 480,000 500,000 500,000 480,000 20,000 500,000 500,000 20,000 480,000

Answer (A) is incorrect because the entry to bonds payable is based on the face, or maturity, amount of the bond issued. The difference between the amount received on issuance and the face amount is recorded as a premium or discount on bonds payable. Answer (B) is incorrect because the discount should be recognized. Answer (C) is correct. The entity received 480,000 cash on the issuance of the bond. Its face amount is 500,000, the amount to be paid at maturity. Hence, the credit to bonds payable is 500,000. The 20,000 difference is recorded as a discount on bonds payable (a debit) and is amortized over the life of the issue. Answer (D) is incorrect because the debit to cash is 480,000, a 20,000 discount should be debited, and the credit to bonds payable is 500,000. [552] Gleim #: 4.84 -- Source: CIA 596 IV-21 The unit selling price of a new entity’s product is 10,000. The buyers are provided with a 2-year warranty that is expected to cost the entity 250 per unit in the year of the sale and 750 per unit in the year following the sale. The entity sold 80 units in the first year of operation and 100 units in the second year. Actual payments for warranty claims were 10,000 and 65,000 in years one and two, respectively. The amount charged to warranty expense during the second year of operation is

A. B. C. D.

25,000 65,000 85,000 100,000


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Answer (A) is incorrect because 25,000 is the expected amount of warranty claims for the first year of second-year sales. Answer (B) is incorrect because 65,000 is the actual amount of claims in the second year. Answer (C) is incorrect because 85,000 is the expected amount of warranty claims in the second year. Answer (D) is correct. Under the accrual method, the total estimated warranty costs are charged to operating expense in the year of sale. The total estimated warranty cost per unit is 1,000 (250 + 750). In year two, 100 units were sold, so the warranty expense recognized is 100,000. [553] Gleim #: 4.85 -- Source: CIA 1191 IV-59 Which of the following brings in additional capital to the firm?

A. B. C. D.

Two-for-one share split. Conversion of convertible bonds to common shares. Exercise of warrants. Exercise of options purchased through an option exchange. Answer (A) is incorrect because a share split is merely an accounting action that increases (or occasionally decreases) the number of shares outstanding. It does not generate additional capital. Answer (B) is incorrect because conversion of convertible bonds to common shares simply replaces debt with outstanding common shares. Answer (C) is correct. Warrants are options that permit the holder to buy shares for a stated price. Their exercise results in inflows and the issuance of shares. Answer (D) is incorrect because options purchased and exercised through option exchanges are transactions between individual investors not affecting the entity whose shares are involved.

[554] Gleim #: 4.86 -- Source: CMA 689 1-9 A sound justification for an entity’s repurchase of its own shares (e.g., treasury shares) is to

A. B. C. D.

Lower the debt to equity ratio of the firm. Increase the entity’s total assets. Reduce the idle cash and increase marketable securities. Meet the share availability needs of a potential merger. Answer (A) is incorrect because the purchase of treasury shares increases the debt-to-equity ratio. Equity but not debt is reduced by the acquisition. Answer (B) is incorrect because the purchase of treasury shares decreases assets. Cash is paid out and shareholders’ equity is decreased. Answer (C) is incorrect because treasury shares are recorded as a reduction of equity, not as a marketable security. The theory of this treatment is that an entity cannot own itself. Answer (D) is correct. An entity has many reasons to repurchase its own shares. These include meeting the needs created by potential mergers or pension and profit-sharing plans. Also, management may want to buy out a dissident shareholder. Sometimes, an entity has excess cash and can find no better investment than its own shares. Moreover, management may believe the shares are selling for a low price for no apparent reason. Thus, a purchase may not only be a good investment but may also support the market price of the shares.

[555] Gleim #: 4.87 -- Source: CIA 595 IV-40 Compared with another bond with the same risk and maturity but without a conversion feature, a convertible bond has a


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A. B. C. D.

Higher face amount. Lower face amount. Higher coupon rate. Lower coupon rate. Answer (A) is incorrect because the face amount is not a distinguishing feature of convertible bonds. Answer (B) is incorrect because the face amount is not a distinguishing feature of convertible bonds. Answer (C) is incorrect because convertible bonds have lower, not higher, coupon rates. Answer (D) is correct. Convertible bonds are convertible at the holder’s option into the issuer’s common shares at a specified price. They have a lower coupon rate than nonconvertible bonds because they offer investors a chance for capital gains.

[556] Gleim #: 4.88 -- Source: CMA 692 2-21 A contingent asset is

A. B. C. D.

Recognized when condemnation awards are probable or can be reliably estimated. Recognized when damages to be awarded in a copyright infringement suit are highly probable. Recognized when disclosure in the notes to financial statements only could be misleading. Not recognized under any circumstances. Answer (A) is incorrect because contingent assets are not recognized. Answer (B) is incorrect because contingent assets are not recognized. Answer (C) is incorrect because contingent assets are not recognized. If disclosure would be misleading, the disclosure should not be made. Answer (D) is correct. A contingent asset is a possible asset arising from past events and the existence of which will be confirmed only by uncertain future events not wholly within the entity’s control. An example is a potential recovery on a legal claim with an uncertain outcome. A contingent asset is not recognized but should be disclosed if an inflow of economic benefits is probable. Disclosures include a description of the contingent asset and an estimate of its financial effects. A contingent asset is not recognized because the income may not be realized. However, if realization is virtually certain, the asset is not contingent and may be recognized.

[557] Gleim #: 4.89 -- Source: Publisher On the first day of the current fiscal year, entity XXX issued 1,000 bonds, each of which is convertible into 100 common shares of the issuer. The face amount of each bond is 1,000, the nominal annual interest rate is 7%, and the market annual interest rate for similar nonconvertible debt is 9%. Interest is payable at the end of each year of the bonds’ 5-year term. The present values of 1 for 5 periods at 7% and 9% are .713 and .650, respectively. The present values of an ordinary annuity of 1 for 5 periods at 7% and 9% are 4.100 and 3.890, respectively. The fair value of the bonds’ equity component is not determinable. What is the entry for the initial recognition of the convertible bonds?


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A. Cash Bonds payable B. Cash Bond discount Bonds payable Share capital-equity component of convertible debt C. Cash Bonds payable Share capital-equity component of convertible debt D. Cash Bond discount Bonds payable

1,000,000 1,000,000 1,000,000 77,700 1,000,000

77,700 1,000,000 713,000

287,000 713,000 287,000 1,000,000

Answer (A) is incorrect because the IASs require that the debt and equity components of a compound instrument be separately presented on the issuer’s balance sheet. Answer (B) is correct. The initial total carrying amount of convertible debt or of debt instruments issued with detachable share purchase warrants should be allocated between the debt instruments and the equity feature, and these debt and equity components should be separately accounted for. The total assigned initially to the instrument as a whole equals the fair value of the consideration received. However, the IFRSs do not stipulate a method for making the allocation. One approach is to assign to the less easily measurable component a residual amount after determining the amount of the more readily measurable component. For example, the future payments on the financial liability might be discounted at the market rate for a similar instrument without an equity feature. This amount would then be subtracted from the amount of the compound instrument as a whole to determine the carrying amount of the equity feature. This method is appropriate when the fair value of the equity feature is not determinable. Thus, the present value of the principal repayment discounted at the market rate of 9% is 650,000 (1,000,000 × .650), the present value of the interest payments discounted at 9% is 272,300 [(.07 × 1,000,000) × 3.890], and their total is 922,300. The residual amount assignable to the equity feature is therefore 77,700 [(1,000 par × 1,000 bonds) proceeds – 922,300 assigned to the debt component], which is also the bond discount given that the convertible bonds were issued at par. Answer (C) is incorrect because the cash flows from the bonds should be discounted at the market rate. Answer (D) is incorrect because the proceeds equaled 1,000,000, the cash flows from the bonds should be discounted at the market rate, and the equity feature should be separately presented. [558] Gleim #: 4.90 -- Source: IIA, adapted A company uses straight-line depreciation for financial reporting purposes, but uses accelerated depreciation for tax purposes. Which of the following account balances would be lower in the financial statements used for tax purposes than it would be in the general purpose financial statements?

A. B. C. D.

Accumulated depreciation. Cash. Retained earnings. Gross fixed assets.


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Answer (A) is incorrect because the balance of accumulated depreciation would be higher in the financial statements for tax purposes, since higher depreciation expense would be reported under accelerated depreciation than under straight-line depreciation. Answer (B) is incorrect because depreciation expense is a non-cash charge. The cash balance is unaffected by the depreciation method used. Answer (C) is correct. Under accelerated depreciation, depreciation expense is higher and net income is lower. Retained earnings would therefore be lower for tax-reporting purposes than for general purpose financial reporting based on straightline depreciation. Answer (D) is incorrect because the historic cost of fixed assets is recorded in the gross fixed assets account. The historic cost of the assets is unaffected by the depreciation method used. [559] Gleim #: 4.91 -- Source: IIA, adapted If bonds are sold at a discount and the effective interest method of amortization is used, interest expense will

A. B. C. D.

Increase from one period to another. Remain constant from one period to another. Equal the cash interest payment each period. Be less than the cash interest payment each period. Answer (A) is correct. Interest expense equals the carrying value of the liability at the beginning of the period times the effective interest rate. The carrying value of the liability equals the face value of the of the bond minus the discount. As the discount is amortized over the life of the bond, the carrying value increases. Consequently, the interest expense increases over the life of the bond. Answer (B) is incorrect because interest expense increases from one period to the next, due to an increased carrying value as the discount is amortized over the life of the bond. Answer (C) is incorrect because interest expense exceeds the cash interest payment. The excess is the amount of discount amortized each period. Answer (D) is incorrect because interest expense exceeds the cash interest payment. The excess is the amount of discount amortized each period.

[560] Gleim #: 4.92 -- Source: CIA 1195 IV-24 Changes in accounting estimates are viewed as

A. B. C. D.

Extraordinary items. Errors in reported amounts in prior periods. Catch-up adjustments related to amounts reported in prior periods. Reassessments of current status and future benefits and obligations. Answer (A) is incorrect because items are not classified as extraordinary under IFRSs. Answer (B) is incorrect because changes in accounting estimates are not errors. Answer (C) is incorrect because catch-up adjustments to prior reported amounts are retroactive. Changes in accounting estimates are accounted for prospectively. Answer (D) is correct. A change in accounting estimate adjusts the carrying amount of an asset or liability or the consumption of an asset. It results from reassessing the status and expected benefits and obligations related to assets and liabilities. It is based on new information and is not an error correction.


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[561] Gleim #: 4.93 -- Source: CIA 597 IV-20 On January 1, 20X1, an entity purchased a machine for 10,000. The estimated useful life was 10 years, with no residual value. The entity depreciates its property, plant, and equipment using the straight-line method. On January 1, 20X5, it was estimated that the machine had a remaining useful life of 3 years. Compute the entity’s 20X5 depreciation expense for the machine.

A. B. C. D.

1,000 2,000 3,000 6,000 Answer (A) is incorrect because 1,000 assumes no change in estimate. Answer (B) is correct. The machine’s net carrying amount at January 1, 20X5 is 6,000 (10,000 cost – 4,000 accumulated depreciation for 4 years). A change in accounting estimate is applied prospectively. Thus, depreciation expense is 2,000 per year for the next 3 years. Answer (C) is incorrect because 3,000 assumes a 2-year remaining useful life. Answer (D) is incorrect because 6,000 is the carrying amount at January 1, 2005.

[562] Gleim #: 4.94 -- Source: CIA 597 IV-22 The following financial statement notes are extracts from the audited financial statements of public entities. Which note describes a change in accounting estimate?

A. The entity changed its amortization of capital assets based on a reassessment of the useful lives of the assets. Accordingly, the entity changed its rate of amortization from 5% and 6% to 8% and 10%, for machinery and equipment. B. Prior to 20X5, plant and equipment (other than customer service replacement parts) were depreciated using the diminishing-balance method. Plant and equipment are now depreciated on a straight-line basis. C. During the year, the entity changed a method of accounting pursuant to a change in an International Financial Reporting Standard. D. Effective January 1, 20X5, the entity changed to the LIFO method of inventory valuation. Prior to 20X5, the FIFO method was used. Answer (A) is correct. Accounting estimates, e.g., service lives, residual values, warranty costs, uncollectible accounts, and inventory obsolescence, are a necessary part of preparing financial statements. However, they inevitably change as new events occur and as additional experience and information are obtained. When altered conditions require a change in estimate, it is accounted for prospectively. Thus, a change in the estimate of the service lives of depreciable assets is a change in accounting estimate. Answer (B) is incorrect because a change from diminishing-balance depreciation to straight-line depreciation is a change in accounting policy. Answer (C) is incorrect because changing an accounting method due to a change in an IFRS is a change in accounting policy. Answer (D) is incorrect because LIFO inventory valuation is not permitted under IFRSs. [563] Gleim #: 4.95 -- Source: CIA 596 IV-28 When financial statements are being prepared, which of the following items requires that accountants estimate the effects of future conditions and events?

A. B. C. D.

The purchase price for an acquired building. The price of a marketable security. The amount of recoverable mineral reserves. The physical quantity of inventory.


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Answer (A) is incorrect because the purchase price for an acquired building can be ascertained with certainty. No estimate is required. Answer (B) is incorrect because the price of a marketable security can be calculated with certainty. No estimate is required. Answer (C) is correct. Changes in estimates used in accounting are necessary consequences of periodic presentations of financial statements. Preparing financial statements requires estimating the effects of future events. Examples of items for which estimates are necessary are uncollectible receivables, inventory obsolescence, service lives and residual values of depreciable assets, warranty costs, periods benefited by a deferred cost, and recoverable mineral reserves. Answer (D) is incorrect because the physical quantity of inventory as of the balance sheet date can be measured. Although some estimation of the correct amount may be required, the estimates will not depend on future conditions and events but on current conditions and measurement methods. [564] Gleim #: 4.96 -- Source: CIA 1195 IV-23 In the prior accounting period, an entity incorrectly expensed a newly purchased piece of equipment rather than establishing an asset balance and beginning to depreciate it over the estimated useful life of the item. To correct this material error in the single-period financial statements of the current period, the entity records which entry?

A.

B.

Debit equipment Credit retained earnings Credit accumulated depreciation – equipment Debit retained earnings Debit accumulated depreciation – equipment Credit equipment

C.

D.

Debit equipment Debit retained earnings Credit accumulated depreciation – equipment Debit equipment Debit accumulated depreciation – equipment Credit equipment Answer (A) is correct. To correct the prior-period material error, the entity must, in the single-period statements issued for the current period, adjust the affected opening balances. Hence, the entity must debit equipment for its cost and credit accumulated depreciation for the depreciation expense appropriate for the first year of the estimated useful life. Retained earnings must be credited because the error understated profit or overstated loss in the prior period. Answer (B) is incorrect because this entry is the reverse of the correct entry. Answer (C) is incorrect because retained earnings should be credited. Answer (D) is incorrect because accumulated depreciation and retained earnings should be credited.

[565] Gleim #: 4.97 -- Source: CIA 1188 IV-45 A retrospective voluntary change in an accounting policy in the current period should be accounted for in comparative reports by

A. B. C. D.

An adjustment directly to equity balances for the first period presented and restatement of other comparative amounts. A line item on the current income statement for the cumulative effect of the change. Presentation of pro forma comparative information. Note disclosure only in the current period.


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Answer (A) is correct. A voluntary change in accounting policy is applied retrospectively unless it is impracticable to determine period-specific effects or the cumulative effect. Retrospective application means adjusting the opening balances of equity for the first period presented and restating other comparative amounts. Answer (B) is incorrect because reporting the cumulative effect in current profit or loss is not allowed. Answer (C) is incorrect because retrospective application is required to the extent practicable. Answer (D) is incorrect because retrospective application means adjusting the opening balances of equity for the first period presented and restating other comparative amounts. [566] Gleim #: 4.98 -- Source: CMA 681 3-24 An accounting change requiring retrospective treatment is a change in

A. B. C. D.

The residual value of equipment. Depreciation methods from straight-line to diminishing-balance. An accounting policy inseparable from a change in an accounting estimate. A provision for warranty costs. Answer (A) is incorrect because the residual value of equipment is a change in estimate that is accounted for on a prospective basis (in the future). Answer (B) is correct. A change in depreciation methods is reported as a change in accounting policy. A voluntary change in accounting policy is applied retrospectively unless it is impracticable. Retrospective application means adjusting the opening balances of equity for the first period presented and restating other comparative amounts. Answer (C) is incorrect because, if distinguishing between a change in estimate and a change in accounting policy is difficult, the change is accounted for as a change in estimate and properly disclosed. Answer (D) is incorrect because a provision for warranty costs is a change in estimate that is accounted for on a prospective basis (in the future).

[567] Gleim #: 4.99 -- Source: CIA 595 IV-21 An entity changes its method of accounting for depreciation during the current year because it believes that the result will be reliable and more relevant information. In its financial statements for the year, how should the entity report the adjustment resulting from the change in accounting policy if the practicability criterion is met?

A. B. C. D.

Not disclosed in the financial statements. Reported as an adjustment to beginning retained earnings of the earliest period presented. Disclosed as a separate type of depreciation expense, directly following depreciation expense for the current year. Included in the determination of profit or loss for the current period as a cumulative effect adjustment. Answer (A) is incorrect because changes in accounting policies must be disclosed in the financial statements for the period. Answer (B) is correct. Under IAS 8, Accounting Policies, Changes in Estimates and Accounting Errors , a voluntary change in accounting policy should be applied retrospectively unless any resulting adjustment that relates to prior periods is not reasonably determinable. Thus, if it is not impracticable to apply the new policy retroactively, the policy should be applied to comparative information as far back as practicable. The entity should determine the cumulative effect on the opening and closing balance sheets for the earliest period for which it is practicable to do so. Answer (C) is incorrect because the new policy should be retrospectively applied if practicable. Answer (D) is incorrect because retrospective application is required to the extent practicable.


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[568] Gleim #: 4.100 -- Source: CIA 1196 IV-2 If ending inventory is underestimated due to an error in the physical count of items on hand, the cost of goods sold for the period will be and net earnings will be .

List A

List B

A. B.

Underestimated Underestimated

Underestimated Overestimated

C. D.

Overestimated Overestimated

Underestimated Overestimated

Answer (A) is incorrect because cost of goods sold will be overestimated. Answer (B) is incorrect because cost of goods sold will be overestimated and profit will be underestimated. Answer (C) is correct. Cost of goods sold equals beginning inventory, plus purchases, minus ending inventory. If ending inventory is underestimated, cost of goods sold will be overestimated for the period. If cost of goods sold is overestimated, profit for the period will be underestimated. Answer (D) is incorrect because profit will be underestimated. [569] Gleim #: 4.101 -- Source: CIA 1196 IV-3 The failure to record an accrued expense at year-end will result in which of the following overstatement errors in the financial statements prepared at that date?

Profit

Working Capital

Cash

A. B.

No No

No Yes

Yes No

C. D.

Yes Yes

No Yes

No No

Answer (A) is incorrect because the failure to record an accrued expense will result in an overstatement of profit and an overstatement of working capital and will have no effect on cash. Answer (B) is incorrect because the failure to record an accrued expense will result in an overstatement of profit. Answer (C) is incorrect because the failure to record an accrued expense will result in an overstatement of working capital. Answer (D) is correct. An accrued expense is an expense that has been incurred but not paid. The appropriate adjusting entry to record an accrued expense will increase an expense account and increase a liability account. The failure to record an accrued expense will result in an understatement of expenses leading to an overstatement of profit. The failure to record the increase in a liability account will result in an understatement of current liabilities leading to an overstatement of working capital. There will be no effect on cash. [570] Gleim #: 4.102 -- Source: CIA 1196 IV-31 Which of the following errors is not self-correcting over two accounting periods?

A. B. C. D.

Failure to record accrued wages. Failure to record depreciation. Overstatement of inventory. Failure to record prepaid expenses.


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Answer (A) is incorrect because understatement of accrued wages is a self-correcting error. Future wage expense will be overstated, future cost of goods sold will be overstated, and future expenses will be understated, respectively. Answer (B) is correct. A failure to record depreciation must be corrected because the effects of the error do not automatically reverse in future periods. Expenses are understated in the year of the error, but no corresponding overstatement of expenses occurs in later years. Answer (C) is incorrect because overstatement of inventory and the consequent understatement of cost of goods sold is a selfcorrecting error. Future wage expense will be overstated, future cost of goods sold will be overstated, and future expenses will be understated, respectively. Answer (D) is incorrect because understatement of prepaid expenses (overstatement of expenses) is a self-correcting error. Future wage expense will be overstated, future cost of goods sold will be overstated, and future expenses will be understated, respectively. [571] Gleim #: 4.103 -- Source: CPA 595 F-32 On September 22, 20X2, Yumi Corp. purchased merchandise from an unaffiliated foreign entity for 10,000 units of the foreign entity’s local currency. On that date, the spot rate was .55. Yumi paid the bill in full on March 20, 20X3, when the spot rate was .65. The closing rate was .70 on December 31, 20X2. What amount should Yumi report as a foreign currency transaction loss in its income statement for the year ended December 31, 20X2?

A. B. C. D.

0 500 1,000 1,500 Answer (A) is incorrect because a loss resulted when the spot rate increased. Answer (B) is incorrect because 500 results from using the rates at 12/31/X2 and 3/20/X3. Answer (C) is incorrect because 1,000 results from using the rates at 9/22/X2 and 3/20/X3. Answer (D) is correct. A receivable or payable denominated in a foreign currency is adjusted to its current exchange rate at each balance sheet date. The resulting gain or loss should ordinarily be included in determining profit or loss. It is the difference between the spot rate on the date the transaction originates (or the rate applied in the prior year) and the closing rate. Thus, the 20X2 transaction loss for Yumi Corp. is $1,500 [(0.55 – 0.70) × 10,000 units].

[572] Gleim #: 4.104 -- Source: Publisher A reporting entity consolidates a foreign operation. This operation maintains its books in its functional currency, which is not that of a hyperinflationary economy. How should the amounts in the foreign operation’s financial statements be translated into the presentation currency?

A. B. C. D.

Assets are translated at the exchange rates in effect at the translation dates. All amounts are translated at the closing rate for the most recent balance sheet date. Exchange differences are recognized in equity. Expenses are translated at the closing rate.


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Answer (A) is incorrect because assets and liabilities for each balance sheet presented are translated at the closing rate as of its date. Answer (B) is incorrect because, if the functional currency is that of a hyperinflational economy, translation to a different presentation currency is at the closing rate for the most recent balance sheet for all amounts. Answer (C) is correct. An exchange difference arises when a given amount of one currency is translated into another currency at different exchange rates. Exchange differences are recognized in a separate component of equity when they arise from translation of functional currency amounts into the presentation amounts. Such exchange differences are not recognized in profit or loss because they have little, if any, direct effect on operational cash flows. Answer (D) is incorrect because income and expenses for each income statement presented are translated at the exchange rates at the transaction dates (but an average rate may be used unless rates fluctuate greatly). [573] Gleim #: 4.105 -- Source: Publisher On June 1 of the current year, XYZ Company purchased British pounds for 10,000 foreign currency units (FCUs) for 10,000 euros. It also acquired land for 25,000 euros. At the end of XYZ Company’s fiscal year on December 31, the spot rate for the FCU was $1.20 euros. The land had a value of 27,500 euros. XYZ Company records its nonmonetary items at historical cost. Which of the following is the correct presentation of this transaction on XYZ Company’s balance sheet?

FCUs

Land

A. B.

10,000 10,000

25,000 27,500

C. D.

12,000 12,000

25,000 27,500

Answer (A) is incorrect because the FCUs are reported at the spot rate on the date of the balance sheet. Answer (B) is incorrect because the FCUs are reported at the spot rate on the balance sheet date, and the land is valued at the date of purchase. Answer (C) is correct. At the balance sheet date, monetary items are reported at the closing rate, which is often the spot rate on the balance sheet date. Nonmonetary items measured at historical cost are reported at the rate on the transaction date. Thus, the FCUs are reported at 12,000 (1.20 × 10,000) euros, and the land is reported at 25,000 euros. Answer (D) is incorrect because the land is reported based upon the historical cost on the purchase date. [574] Gleim #: 4.106 -- Source: Publisher Which of the following is true with regard to joint ventures?

A. B. C. D.

The establishment of a separate financial structure is necessary when joint venturers own joint assets. Two venturers are not allowed to transfer assets and liabilities in a given line of business to a jointly controlled entity. When a jointly controlled entity becomes a subsidiary of the venturer, consolidation is required. An investor is a party to the venture who has joint control. Answer (A) is incorrect because jointly controlled assets do not require the establishment of an organization or financial structure separate from the venturers. Answer (B) is incorrect because the venturers may establish a separate entity in which each has an interest and that operates in the same manner as other entities if they choose to have a jointly controlled entity. Answer (C) is correct. A joint venture “is a contractual arrangement whereby two or more parties undertake an economic activity that is subject to joint control.” When a jointly controlled entity becomes a subsidiary of the venturer, consolidation is required. Answer (D) is incorrect because an investor is a party to the venture who lacks joint control.


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[575] Gleim #: 4.107 -- Source: Publisher For the past several years, M.F.S. Company has invested in the common stock of Annabelle Company. M.F.S. currently owns approximately 13% of the total of Annabelle’s outstanding voting common stock. Recently, managements of the two companies have discussed a possible combination of the two entities. If they do decide to combine, the resulting combination should be accounted for as a

A. B. C. D.

Uniting of interests. Purchase. Part purchase, part uniting of interests. Joint venture. Answer (A) is incorrect because the uniting-of-interests method is no longer an acceptable method of accounting for business combinations. Answer (B) is correct. IFRS 3, Business Combinations, requires that all business combinations within its scope be accounted for using the purchase method. Answer (C) is incorrect because accounting for a business combination as part purchase and part uniting of interests is not allowed. Answer (D) is incorrect because a business combination cannot be accounted for as a joint venture. A joint venture requires some form of separate accounting by each venturer.

[576] Gleim #: 4.108 -- Source: CPA 1192 T-33 To effect a business combination initiated on July 1, 20X5, Proper Co. acquired all the outstanding common shares of Scapula Co. for cash equal to the carrying amount of Scapula’s net assets. The carrying amounts of Scapula’s assets and liabilities approximated their fair values, except that the carrying amount of its building was more than fair value. In preparing Proper’s December 31, 20X5 consolidated income statement, what is the effect of recording the assets acquired and liabilities assumed at fair value and should goodwill amortization be recognized?

Depreciation Expense

Goodwill Amortization

A. B.

Lower Higher

Yes Yes

C. D.

Lower Higher

No No

Answer (A) is incorrect because depreciation will decrease, and goodwill will be recognized but not amortized. Answer (B) is incorrect because depreciation will decrease, and goodwill will be recognized but not amortized. Answer (C) is correct. A business combination is accounted for as a purchase regardless of the form of consideration given. Under purchase accounting, assets acquired and liabilities assumed should be recorded at their fair values. The differences between fair values and carrying amounts will affect profit or loss when related expenses are incurred. The effect of recording the building at fair value in the consolidated balance sheet instead of its higher carrying amount on Scapula’s books will be to decrease future depreciation. If the building is to be used, fair value is its current replacement cost for similar capacity unless expected use indicates a lower value to the acquirer. If the building is to be sold, it should be reported at fair value minus cost to sell. The excess of the cost over fair value of the net assets acquired will be recognized as goodwill, but, under IFRS 3, this amount will be tested for impairment but not amortized. Answer (D) is incorrect because depreciation will decrease, and goodwill is not amortized.


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[577] Gleim #: 4.109 -- Source: CPA 593 II-8 Pellew Corp. paid 600,000 for the outstanding common stock of Samos Co. in a business combination initiated and completed in December 2005. At that time, Samos had the following condensed balance sheet: Carrying Amounts Current assets Plant and equipment, net Liabilities Equity

80,000 760,000 400,000 440,000

The fair value of the plant and equipment was 120,000 more than its carrying amount. The fair values and carrying amounts were equal for all other assets and liabilities. What amount of goodwill, related to Samos’s acquisition, should Pellew report in its consolidated balance sheet?

A. B. C. D.

40,000 80,000 120,000 160,000 Answer (A) is correct. A business combination is accounted for as a purchase regardless of the form of the consideration given. Under purchase accounting, assets acquired and liabilities assumed should be recorded at their fair values. Any excess of cost over the fair value of the net assets acquired is recorded as goodwill. After adjusting the net plant and equipment, and given that other items are stated at fair value, the fair value of the net assets acquired is 560,000 [80,000 current assets + (760,000 + 120,000) plant and equipment – 400,000 liabilities]. Hence, goodwill is 40,000 (600,000 cost – 560,000). Answer (B) is incorrect because 80,000 is the amount of current assets. Answer (C) is incorrect because 120,000 is the amount plant and equipment is undervalued. Answer (D) is incorrect because 160,000 is the difference between the 600,000 cost and the 440,000 carrying amount of the net assets.

[578] Gleim #: 4.110 -- Source: CPA 590 T-33 In a business combination, the sum of the amounts assigned by the acquiring entity to assets acquired and liabilities incurred and assumed exceeds the cost of the acquired entity. The excess should be reported as a

A. B. C. D.

Deferred credit. Reduction of the amounts assigned to current assets and a deferred credit for any unallocated portion. Gain immediately in profit or loss. Pro rata reduction of the amounts assigned to all acquired assets and a gain for any unallocated portion. Answer (A) is incorrect because a deferred credit is never recognized for the excess over cost. Answer (B) is incorrect because the allocated portion is reported as a gain, not as a deferred credit, and the values of the assets are not reduced below fair value. Answer (C) is correct. In a business combination, any excess over cost must be recognized immediately in profit or loss as a gain. Before concluding that an excess over cost has arisen, however, IFRS 3 requires the reassessment of the identification and measurement of the acquiree’s assets, liabilities, and cost of the combination. Answer (D) is incorrect because the amounts assigned to certain acquired assets (most financial assets, assets to be disposed of by sale, etc.) are not reduced.


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[579] Gleim #: 4.111 -- Source: CIA 594 IV-15 Suppose that an entity has paid one of its liabilities twice during the year, in error. The effects of this mistake would be

A. B. C. D.

Assets, liabilities, and equity are understated. Assets, net income, and equity are unaffected. Assets and liabilities are understated. Assets and net profit and equity are understated, and liabilities are overstated. Answer (A) is incorrect because the double payment of a liability does not affect expenses of the period so it does not affect net profit and equity. Answer (B) is incorrect because assets will be reduced. Answer (C) is correct. When a liability is paid, an entry debiting accounts payable and crediting cash is made. If an entity erroneously pays a liability twice, the accounts payable and cash accounts will be understated by the amount of the liability. Hence, assets and liabilities will be understated. Answer (D) is incorrect because both assets and liabilities will be understated, whereas net profit and equity will be unaffected.

[580] Gleim #: 4.112 -- Source: CIA 1191 IV-45 The present value of future benefits payable as a result of work done before the introduction of, or amendment to, postemployment benefits is the

A. B. C. D.

Additional minimum liability. Fair value of plan assets. Defined benefit obligation. Past service cost. Answer (A) is incorrect because the IASs provide for no additional minimum liability. Answer (B) is incorrect because plan assets are assets held by a separate legal entity (fund) to be used to settle the employee benefit obligation. Answer (C) is incorrect because the defined benefit obligation (DBO) consists of future amounts required to settle the obligation arising from services provided by employees in the current and prior periods. Answer (D) is correct. Past service cost is the increase in the present value of the DBO related to prior employee service that arises in the current period from the introduction of, or an amendment to, postemployment benefits. Past service cost is expensed on a straight-line basis over the average period until vesting. To the extent it is vested upon introduction of, or amendment to, a plan, past service cost is immediately recognized.

[581] Gleim #: 4.113 -- Source: CIA 593 IV-36 An audit of an entity records for its first year of operations determined that the following errors were made at the balance sheet date: Failed to accrue 50,000 interest expense. Failed to record depreciation expense on office equipment of 80,000. Failed to amortize prepaid rent expense of $100,000. Failed to defer recognition of prepaid advertising expense of 60,000.

The net effect of these errors was to overstate net profit by


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A. B. C. D.

130,000 170,000 230,000 290,000 Answer (A) is incorrect because 130,000 ignores the errors related to prepaid rent and prepaid advertising expense. Answer (B) is correct. The computation is as follows:

Error Failure to accrue interest expense Failure to record depreciation Failure to amortize prepaid rent expense Failure to recognize prepaid advertising Totals

Effect on Expense

Effect on Net Profit

Understate

50,000

Overstate

50,000

Understate

80,000

Overstate

80,000

Understate

100,000

Overstate

100,000

Overstate Understate

60,000 170,000

Understate Overstate

60,000 170,000

Answer (C) is incorrect because 230,000 ignores the error related to prepaid advertising expense. Answer (D) is incorrect because 290,000 treats the error related to prepaid advertising expense as an understatement of expenses. [Fact Pattern #35] An audit of an entity has revealed the following four errors that have occurred but have not been corrected: 1. 2. 3. 4.

Inventory at December 31, 2003: 40,000, understated Inventory at December 31, 2004: 15,000, overstated Depreciation for 2003: 7,000, understated Accrued expenses at December 31, 2004: 10,000, understated

[582] Gleim #: 4.114 -- Source: CIA 591 IV-45 (Refers to Fact Pattern #35) The errors cause the reported net profit for the year ending December 31, 2004 to be

A. B. C. D.

Overstated by 72,000. Overstated by 65,000. Understated by 28,000. Understated by 45,000.


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Answer (A) is incorrect because the net effect of these errors was a 65,000 overstatement. Answer (B) is correct. The effect of the understatement of the 2003 year-end inventory (beginning inventory for 2004) was to overstate 2004 net profit by 40,000. The reason is that beginning inventory is a component of cost of sales. The overstatement of the December 31, 2004 inventory overstated 2004 net income by 15,000 because the amounts in ending inventory are excluded from cost of sales. The understatement of 2003 depreciation expense (a nominal account) has no effect on 2004 net income. Finally, the failure to accrue 10,000 of expenses for 2004 overstated 2004 net income. The net effect of these errors was a 65,000 (40,000 + 15,000 + 0 + 10,000) overstatement. Answer (C) is incorrect because the net effect of these errors was a 65,000 overstatement. Answer (D) is incorrect because the net effect of these errors was a 65,000 overstatement. [583] Gleim #: 4.115 -- Source: CIA 591 IV-46 (Refers to Fact Pattern #35) The errors cause the reported retained earnings at December 31, 2004 to be

A. B. C. D.

Overstated by 65,000. Overstated by 32,000. Overstated by 25,000. Understated by 18,000. Answer (A) is incorrect because the net effect of the errors was a 32,000 overstatement. Answer (B) is correct. The 2003 inventory error reversed in 2004 (excluding tax considerations) and therefore had no effect on reported retained earnings at December 31, 2004. The 15,000 inventory error at year-end 2004 and the failure to accrue 10,000 of expenses for 2004 both overstated retained earnings as well as 2004 net profit. The omission of 7,000 of depreciation overstated 2003 net income and 2003 and 2004 retained earnings. Hence, the net effect of the errors on December 31, 2004 retained earnings was a 32,000 (0 + 15,000 + 7,000 + 10,000) overstatement. Answer (C) is incorrect because the net effect of the errors was a 32,000 overstatement. Answer (D) is incorrect because the net effect of the errors was a 32,000 overstatement.

[584] Gleim #: 4.116 -- Source: CMA 690 3-1 For a finance lease, the gross investment, lease payments receivable, recorded by the lessor is equal to the

A. Present value of the minimum lease payments minus the unguaranteed residual value accruing to the lessor at the end of the lease term. B. Lower of 90% of the present value of the minimum lease payments or the fair value of the leased asset. C. Minimum lease payments plus the unguaranteed residual value accruing to the lessor at the end of the lease term. D. Difference between the present value of the minimum lease payments and the unearned finance income. Answer (A) is incorrect because the gross investment is not adjusted for the time value of money or fair value. Answer (B) is incorrect because the gross investment is not adjusted for the time value of money or fair value. Answer (C) is correct. For a finance lease, the lessor should record as the gross investment in the lease the amount of the minimum lease payments (payments plus either any bargain purchase option or any residual value guaranteed by the lessee, a party related to the lessee, or by a financially capable party unrelated to the lessor or the lessee) plus any amounts of unguaranteed residual value. The net investment in the lease is equal to the gross investment, minus unearned finance income. Answer (D) is incorrect because the gross investment is not adjusted for the time value of money or fair value. [585] Gleim #: 4.117 -- Source: CMA 690 3-2 Initial direct costs incurred by the lessor under a finance lease may be


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A. B. C. D.

Allocated over the economic life of the leased asset. Expensed in the period incurred. Deferred and allocated over the term of the lease in proportion to the recognition of rental income. Subtracted from the gross investment in the lease. Answer (A) is incorrect because initial direct costs of a finance lease may be allocated over the lease term or recognized immediately. Answer (B) is correct. The initial direct costs of entering into a finance lease, e.g., commissions and legal fees, may be recognized immediately or allocated over the lease term. One possibility is to recognize the expense as incurred while also recognizing as income in the same period an equal amount of the unearned finance income. Answer (C) is incorrect because initial direct costs of an operating lease may be deferred and allocated over the term of the lease in proportion to the recognition of rental income. Answer (D) is incorrect because initial direct costs of a finance lease are recognized immediately in income or allocated over the lease term.

[586] Gleim #: 4.118 -- Source: CIA 589 IV-41 A new asset with a fair value of 100,000 and a useful life of 10 years is being leased by an entity (lessee). Which of the situations below will most likely result in classifying the lease on the lessee’s books as a finance lease?

A. B. C. D.

The lease term is 7 years. The lease term is 8 years. The present value of the minimum lease payments is 60,000. The present value of the minimum lease payments is 70,000. Answer (A) is incorrect because a 7-year lease term is less likely to be for the major part of the economic life of the asset than an 8-year lease term. Answer (B) is correct. A lease may be classified as either a finance lease or an operating lease by a lessee. A finance lease transfers substantially all of the risks and rewards of ownership of the asset to the lessee. A lease is classified at its inception. It normally is classified as a financial lease if, for example, 1. The lease provides for the transfer of ownership of the asset by the end of the lease term. 2. The lease contains a bargain purchase option; i.e., the lessee has the option to purchase at a price expected to be sufficiently below the fair value of the exercise date that, at the lease’s inception, exercise is reasonably certain. 3. The lease term is for the major part of the economic life of the asset. 4. The present value of the minimum lease payments is at least substantially all of the fair value of the leased asset at the inception of the lease. 5. The leased assets are such that they can be used only by the lessee without major modification. Thus, a lease term that is 80% (8 ÷ 10) of the economic life of the asset will most likely result in classifying the lease as a finance lease, assuming that 80% is a “major part” of the economic life of the asset. Answer (C) is incorrect because a present value of the minimum lease payments of only 60,000 is not substantially all of the fair value of the leased asset. Answer (D) is incorrect because a present value of the minimum lease payments of only 70,000 is not substantially all of the fair value of the leased asset.

[587] Gleim #: 4.119 -- Source: CMA 1291 2-27 On December 31, 2003, Johnson sold on account and shipped merchandise with a list price of 75,000 to Gibsen. The terms of the sale were n/30, FOB shipping point. The merchandise arrived at Gibsen on January 5, 2004. Because of confusion about the shipping terms, the sale was not recorded until January of 2004 and the merchandise, sold at a markup of 25% of cost, was included in Johnson’s inventory on December 31, 2003. Johnson uses a periodic inventory system. As a result of the above, Johnson’s profit before income taxes for the year ended December 31, 2003 was


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A. B. C. D.

Understated by 15,000. Understated by 75,000. Understated by 18,750. Overstated by 60,000. Answer (A) is correct. The shipping term was FOB shipping point. Hence, title to the goods and risk of loss passed to the buyer on December 31, 2003, and the 75,000 sale should have been recorded on that date. Given a selling price of 75,000 and a markup on cost of 25%, cost must have been 60,000 (75,000 ÷ 1.25), and profit before taxes must have been 15,000 (75,000 – 60,000). Because the sale was unrecorded, the seller’s balance sheet reflected inventory of 60,000 instead of an account receivable of 75,000. Thus, assets were understated by 15,000. Also, profit was understated by 15,000 because of the failure to credit sales for 75,000 and debit cost of goods sold for 60,000. Answer (B) is incorrect because income was understated by 15,000. Answer (C) is incorrect because income was understated by 15,000. Answer (D) is incorrect because income was understated by 15,000.

[588] Gleim #: 4.120 -- Source: CIA 592 IV-52 Finance leases are differentiated from operating leases in that finance leases normally

A. B. C. D.

Provide for maintenance service at no extra cost to the lessee. Are cancelable at any time upon request by the lessee. Have rental payments that are approximately equal to the amortized cost of the leased asset. Are used only by financial institutions. Answer (A) is incorrect because finance leases do not normally provide for maintenance service. Answer (B) is incorrect because finance leases are not normally cancelable. Answer (C) is correct. A lease may be classified as either a finance lease or an operating lease by a lessee. A finance lease transfers substantially all of the risks and rewards of ownership of the asset to the lessee. A lease is classified at its inception. It normally is classified as a finance lease if, for example, 1. The lease provides for the transfer of ownership of the asset by the end of the lease term. 2. The lease contains a bargain purchase option; i.e., the lessee has the option to purchase at a price expected to be sufficiently below the fair value of the exercise date that, at the lease’s inception, exercise is reasonably certain. 3. The lease term is for the major part of the economic life of the asset. 4. The present value of the minimum lease payments is at least substantially all of the fair value of the leased asset at the inception of the lease. 5. The leased assets are such that they can be used only by the lessee without major modification. Thus, the rental payments tend to approximate the cost of the leased property plus a return on the investment. Answer (D) is incorrect because finance leases are used by entities in various industries.

[589] Gleim #: 4.121 -- Source: CMA 1293 2-10 For the past three years, Colbeth entities has failed to accrue unpaid wages earned by workers during the last week of the year. The amounts omitted, which are considered material, were as follows. December 31, 2001 December 31, 2002 December 31, 2003

56,000 51,000 64,000

The entry on December 31, 2003 to correct for these omissions includes a


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A. B. C. D.

Credit to wage expense for 64,000. Debit to wage expense for 51,000. Debit to wage expense for 13,000. Credit to retained earnings for 64,000. Answer (A) is incorrect because 64,000 is the total accrued wages payable, not the amount of the adjustment. Answer (B) is incorrect because 51,000 was the correct wage accrual for 2002. Answer (C) is correct. Failing to record accrued wages is a self-correcting error. Expenses are understated in one year and overstated in the next, resulting in the correction of the error over the 2-year period. The 2001 error overstated 2001 earnings and understated 2002 earnings by 56,000. Consequently, no correction is necessary for the 2001 error. The 2002 error overstated 2002 profit before taxes and understated 2003 profit before taxes by 51,000. The 2003 error overstated 2003 profit before taxes by 64,000. Thus, the net effect in 2003 of the 2002 and 2003 errors is a 13,000 (64,000 – 51,000) overstatement. The correcting entry is to debit expense for 13,000, debit retained earnings for 51,000, and credit wages payable for 64,000. Answer (D) is incorrect because retained earnings should be debited because of the overstatement of 2002 income.

[Fact Pattern #36] During the year ended December 31, 2003, an entity had 500,000 in sales revenue and purchased 150,000 of inventory. The cost of goods sold was 250,000 for the year, and the entity incurred 25,000 of general and administrative expenses. The January 1, 2003 opening balance sheet was as follows:

Cash Accounts receivable Inventory Fixed assets (gross) Accum. depreciation Net fixed assets

120,000 100,000 200,000 600,000 (100,000) 500,000

Total assets

920,000

Accounts payable Long-term debt Common shares Retained earnings

220,000 400,000 100,000 200,000

Total liabilities and equity

920,000

The cost of long-term debt financing is 10% per annum, payable in one installment on December 31 of each year. The entity has a 50% tax rate. The entity has a dividend payout ratio of 25%. The fixed assets were 1-year old at the start of the current year, were originally estimated to have a 6-year useful life, and are being depreciated on the straight-line basis. [590] Gleim #: 4.122 -- Source: CIA 1194 IV-1 (Refers to Fact Pattern #36) The entity has a closing inventory balance of


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A. B. C. D.

100,000 250,000 300,000 350,000 Answer (A) is correct. Ending inventory equals beginning inventory, plus purchases, minus cost of goods sold. Thus, ending inventory is 100,000 (200,000 + 150,000 – 250,000). Answer (B) is incorrect because 250,000 is the cost of goods sold. Answer (C) is incorrect because 300,000 results from adding cost of goods sold to beginning inventory and subtracting purchases. Answer (D) is incorrect because 350,000 equals beginning inventory plus purchases.

[591] Gleim #: 4.123 -- Source: CIA 1194 IV-2 (Refers to Fact Pattern #36) If the entity had purchased a larger amount of inventory during the year, with the additional items being purchased on December 31, 2003, what is the effect on cost of goods sold and on net profit for the year?

Cost of Goods Sold

Net Profit

A. B.

Increase Increase

Decrease Increase

C. D.

Decrease No effect

Increase No effect

Answer (A) is incorrect because cost of goods sold and net profits are unaffected. Answer (B) is incorrect because cost of goods sold and net profits are unaffected. Answer (C) is incorrect because cost of goods sold and net profits are unaffected. Answer (D) is correct. Cost of goods sold equals beginning inventory, plus purchases, minus ending inventory. If a purchase is made on December 31, purchases and ending inventory should increase by the same amount. Thus, cost of goods sold is unaffected. Because cost of goods sold is unaffected, net profit is also unaffected. [592] Gleim #: 4.124 -- Source: CIA 1194 IV-3 (Refers to Fact Pattern #36) The entity will pay dividends for the year of

A. B. C. D.

10,625 21,250 23,125 42,500 Answer (A) is correct. The entity has a dividend payout ratio of 25% of net profit. Profit before taxes is 85,000 [500,000 sales – 250,000 CGS – 25,000 G&A expenses – (10% interest rate × 400,000 LT debt) – (600,000 fixed assets ÷ 6 years)]. Hence, after-tax net profit is 42,500 [(1.0 – .5) × 85,000], and the dividend payout is 10,625 (25% × 42,500). Answer (B) is incorrect because 21,250 uses a 50% dividend payout ratio instead of 25%. Answer (C) is incorrect because 23,125 calculates net profit without subtracting the 100,000 depreciation expense. Answer (D) is incorrect because 42,500 is the after-tax net profit.


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[593] Gleim #: 4.125 -- Source: CIA 1194 IV-6 (Refers to Fact Pattern #36) What would be the effect of a lower tax rate on the ending balance of common shares and on dividends paid for the year?

Ending Balance of Common Shares

Dividends Paid

A.

Increase

Increase

B. C.

Decrease No effect

Decrease Increase

D.

No effect

Decrease

Answer (A) is incorrect because the common shares account is not affected, but dividends will increase. Answer (B) is incorrect because the common shares account is not affected, but dividends will increase. Answer (C) is correct. The balance in the common shares account represents share capital, i.e., capital contributed by owners, not earnings retained in the business. It is not affected by a change in tax rate. Dividends will increase, however, because they are a constant percentage of after-tax earnings. Answer (D) is incorrect because the common shares account is not affected, but dividends will increase. [594] Gleim #: 4.126 -- Source: CIA 1194 IV-22 How are material prior-period errors in financial statements accounted for when comparative statements are issued?

A. B. C. D.

They are included in the determination of net profit or loss for the current period. Prior-period financial statements are adjusted and reissued. They are corrected by restating comparative amounts for years when errors occurred. They are charged or credited directly to the closing balance of current-year retained earnings. Answer (A) is incorrect because errors are excluded from the determination of current period profit or loss. Answer (B) is incorrect because prior-period financial statements need not be reissued. However, if comparative statements are presented, the prior-period statements must be restated if it is practicable to do so. Answer (C) is correct. All material prior-period errors must be corrected retrospectively in the first set of financial statements issued after their discovery. This may be done by restating the comparative amounts for the prior periods when the error occurred. If the error occurred prior to the first period presented, the opening balances for the first period presented are restated. A material error is one that could, individually or collectively, affect the decisions of users of the financial statements. However, comparative information should be restated only if practicable. Answer (D) is incorrect because errors are adjustments of the current year’s opening balance of retained earnings and other relevant balances.

[595] Gleim #: 4.127 -- Source: CIA 1194 IV-40 A change in an accounting estimate is shown on the income statement

A. B. C. D.

Only in the relevant account. In a separate section entitled extraordinary items. In a separate section after continuing operations but before extraordinary items. As a cumulative-effect adjustment.


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Answer (A) is correct. A change in an accounting estimate is accounted for prospectively and is shown on the income statement only in the relevant account. The effect of the change is included in the same income statement classification as the previous estimate. However, prior-period statements and opening balances are not adjusted. Answer (B) is incorrect because changes in an accounting estimate are not extraordinary, that is, clearly distinct from the ordinary activities of the entity. Answer (C) is incorrect because changes in accounting estimates are shown only in the relevant accounts. The effect of the change is included in the same income statement classification as the previous estimate. Answer (D) is incorrect because a change in an accounting estimate is only shown in the relevant account. The effect of the change is included in the same income statement classification as the previous estimate. No cumulative effect of the change is recognized because estimates are accounted for prospectively. [596] Gleim #: 4.128 -- Source: CIA 595 IV-26 An entity has 100 of current assets, 100 of fixed assets, 100 of debt, and 100 of equity. If it then leases a 75 asset in a(n) lease agreement, the debt-to-assets ratio of the entity will be

List A

List B

A. B.

Operating Operating

64% 00%

C. D.

Finance Finance

50% 64%

Answer (A) is incorrect because 64% is the debt-to-assets ratio if the lease is a finance lease. Answer (B) is incorrect because 100% is the debt-to-equity ratio if the lease is an operating lease. Operating leases are treated as rental agreements, and neither the asset nor the obligation for future payments is recorded on the balance sheet. The balance of debt remains at 100, so the debt-to-equity ratio is 100% (100 ÷ 100). Answer (C) is incorrect because 50% is the debt-to-assets ratio if the lease is an operating lease. Answer (D) is correct. If the lease is a finance lease, both the asset and the obligation for future payments are recorded. The entity would have current assets of 100, debt of 175 (100 + 75), fixed assets of 175 (100 + 75), and equity of 100. Hence, the debt-to-assets ratio would be 64% (175 ÷ 275). [597] Gleim #: 4.129 -- Source: CIA 1195 IV-1 If certain goods owned by an entity were not recorded as a purchase and were not counted in ending inventory, in error, then

A. B. C. D.

Cost of goods sold for the period will be understated. Cost of goods sold for the period will be overstated. Profit for the period will be understated. There will be no effect on cost of goods sold or net profit for the period. Answer (A) is incorrect because the errors offset each other, so cost of goods sold is not understated or overstated for the period. Answer (B) is incorrect because the errors offset each other, so cost of goods sold is not understated or overstated for the period. Answer (C) is incorrect because cost of goods sold is unaffected by the error, so profit is also unaffected. Answer (D) is correct. The effects of the errors on cost of goods sold are offsetting. Purchases, which increase cost of goods sold, and ending inventory, which decreases cost of goods sold, are understated by the same amount. Neither cost of goods sold nor profit is affected.


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[598] Gleim #: 4.130 -- Source: CIA 1195 IV-25 Because changes in accounting estimates relate to changes in circumstances in the [List A] period, they should be reported [List B].

List A

List B

A. B.

Current Current

Not at all Prospectively

C. D.

Prior Prior

Retroactively Not at all

Answer (A) is incorrect because changes in accounting estimates should be reported. Answer (B) is correct. Changes in accounting estimates arise as new events occur, as more experience is obtained, or as additional evidence is acquired. A change should be reported in the period in which it occurs, as well as prospectively if future periods are affected. Retroactive reporting is impracticable because it would result in continual adjustments of prior years’ financial statements. Answer (C) is incorrect because changes in accounting estimates arise from changes in current, not prior, circumstances. Answer (D) is incorrect because changes in accounting estimates arise from changes in current, not prior, circumstances. [599] Gleim #: 4.131 -- Source: CIA 1195 IV-26 Under a defined contribution postemployment benefit plan, a(n) [List A] is reported on the balance sheet only if the amount the employer has contributed to the pension trust fund is [List B] the amount required.

List A

List B

A. B.

Asset Asset

Greater than Equal to

C. D.

Liability Liability


Answer (A) is correct. Under a defined contribution plan, the employer recognizes an expense and a liability for the contribution payable in exchange for an employee’s services performed during the period. The amount is determined after subtracting any contribution already made. However, if the contribution made exceeds the amount due, the excess is treated as a prepaid expense. Answer (B) is incorrect because an asset is reported only if the contribution is in excess of the amount required. Answer (C) is incorrect because the employer reports a liability only if the contribution is less than the required amount. Answer (D) is incorrect because the employer reports a liability only if the contribution is less than the required amount. [600] Gleim #: 4.132 -- Source: CIA 589 IV-32 An entity incurred the following costs during its first year of operation. Legal fees in connection with establishing the legal entity Pre-opening costs of the new business Operating losses

100,000 200,000 400,000

During its second and later years, the entity became profitable. It amortizes start-up costs using the straight-line method over a 5-year period. What is the correct amount of amortization expense for start-up costs during the second year of the life of the entity?


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A. B. C. D.

20,000 40,000 60,000 0 Answer (A) is incorrect because current-year start-up costs are expensed as incurred. Answer (B) is incorrect because current-year start-up costs are expensed as incurred. Answer (C) is incorrect because current-year start-up costs are expensed as incurred. Answer (D) is correct. In some circumstances, expenditures may be made to provide future economic benefits, but no intangible asset results that is recognized. Accordingly, such expenditures should be expensed as incurred. Examples include expenditures for start-up costs (start-up activities), such as legal and secretarial costs of establishing a legal entity, pre-opening costs of a new facility or business, or pre-operating costs of commencing new operations or marketing new products. Thus, the entity should have expensed the full amount of the start-up costs in the first year. No amortization expense should be recognized in the second year. Moreover, to correct this error, an adjustment should be made to the opening balance of current year retained earnings and other relevant balances, unless any resulting adjustment relating to prior periods is not practicable.

[601] Gleim #: 4.133 -- Source: Publisher Mill, which began operations on January 1, 20X1, recognizes income from long-term construction contracts under the percentage-of-completion method in its financial statements and under the completed-contract method for tax reporting. Income under each method follows:

Year

CompletedContract

Percentageof-Completion

20X1 20X2 20X3

-400,000 700,000

300,000 600,000 850,000

There are no other temporary differences. If the applicable tax rate is 25%, Mill should report in its balance sheet at December 31, 20X3 a deferred income tax liability of

A. B. C. D.

87,500 125,000 162,500 37,500 Answer (A) is incorrect because 87,500 ignores the difference for 20X1. Answer (B) is incorrect because 125,000 ignores the difference for 20X3. Answer (C) is correct. In its financial statements issued through December 31, 20X3, Mill has reported 1,750,000 (300,000 + 600,000 + 850,000) of income from long-term contracts. In its tax returns for the same period, it has reported 1,100,000 (400,000 + 700,000) of income from the same sources. The result is a taxable temporary difference. Thus, Mill expects to have future taxable amounts of 650,000 and should recognize a deferred tax liability of 162,500 (25% applicable tax rate × 650,000). Answer (D) is incorrect because 37,500 ignores the differences for 20X1 and 20X2.

[602] Gleim #: 4.134 -- Source: Publisher A deferred tax asset is recognized for


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A. Goodwill if its amortization is nondeductible for tax purposes. B. The initial recognition of an asset that is not part of a business combination and does not affect accounting profit or taxable profit at the date of the transaction. C. A deductible temporary difference if the future availability of taxable profit is probable. D. Negative goodwill treated as deferred income. Answer (A) is incorrect because a deferred tax liability (DTL) is recognized for most taxable TDs. However, no DTL is recognized when it arises from goodwill if the amortization of the goodwill is not deductible for tax purposes. The reason is that the recognition of a DTL would increase goodwill. In a business combination that is an acquisition, goodwill equals the excess of the acquisition cost over the acquirer’s interest in the net fair value of the identifiable net assets, liabilities, and contingent liabilities recognized. Answer (B) is incorrect because neither a deferred tax liability nor a deferred tax asset is recognized in these circumstances. Answer (C) is correct. A deferred tax asset is recognized for most deductible TDs and for the carryforward of unused tax losses and credits, but only to the extent it is probable that taxable profit will be available to permit the use of those amounts. Answer (D) is incorrect because no DTA is recognized when it arises from an excess over cost (negative goodwill) treated as deferred income. The reason is that the recognition of a DTA would increase an excess over cost. In a business combination that is an acquisition, an excess over cost equals the excess of the acquirer’s interest in the net fair value of the identifiable assets, liabilitiies, and contingent liabilities recognized over the acquisition cost. [603] Gleim #: 4.135 -- Source: Publisher At the beginning of year 1, Cody Construction began work on a 3-year construction contract. This contract is accounted for by the percentage-of-completion method for financial accounting purposes and the completed-contract method for tax purposes. During year 1, Cody reported 800,000 of income from this contract. However, because of cost overruns incurred in year 2, Cody reported a 500,000 loss from this contract. Cody’s year 2 balance sheet should include a

Deferred

Deferred

Tax Asset

Tax Liability

A.

Yes

Yes

B. C.

Yes No

No No

D.

No

Yes

Answer (A) is incorrect because a taxable temporary difference usually results in a deferred tax liability in the current period. Answer (B) is incorrect because a taxable temporary difference usually results in a deferred tax liability in the current period. Answer (C) is incorrect because a taxable temporary difference usually results in a deferred tax liability in the current period. Answer (D) is correct. A deferred tax liability is recognized for the deferred tax consequences attributable to most taxable temporary differences. A deferred tax asset is recognized for the deferred tax consequences attributable to most deductible temporary differences, but only to the extent it is probable that taxable profit will be available to permit the use of those amounts. At the end of year 2, the cumulative effect of the difference in accounting for financial reporting and tax purposes is a 300,000 (800,000 – 500,000) temporary difference. Because this 300,000 temporary difference will result in future taxable amounts, it is a taxable temporary difference for which a deferred tax liability is recognized.


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[Fact Pattern #37] The following relates to Lally Plc for 20X1 and 20X2.

20X2 Profit before income taxes Interest income included above that was not subject to income taxes

5,000,000 100,000

20X1 4,000,000 100,000

Profit before income taxes in 20X1 included rent income of 80,000 that was not subject to income tax until its receipt in 20X2. Lally was subject to an effective income tax rate of 40% in 20X1 and 20X2. [604] Gleim #: 4.136 -- Source: CMA 686 3-7 (Refers to Fact Pattern #37) The tax expense that would have been reported on Lally’s income statement for the year ended December 31, 20X1 is

A. B. C. D.

1,560,000 1,528,000 1,600,000 1,568,000 Answer (A) is correct. Tax expense (tax income) equals the sum of current tax expense (current tax income) and deferred tax expense (deferred tax income). Current tax expense equals taxes paid or payable, and deferred tax expense equals the change in the entity’s deferred tax assets and liabilities. Because 100,000 of interest income and 80,000 of rental income are not subject to tax in 20X1, taxable profit is 3,820,000, and current tax expense is 1,528,000. Deferred tax expense equals the deferred tax liability (40% × 80,000 = 32,000) at year-end, assuming no deferred tax asset or liability balances existed at the beginning of the year. Hence, tax expense is 1,560,000 (1,528,000 + 32,000). Answer (B) is incorrect because 1,528,000 does not include tax on the rent income. Answer (C) is incorrect because 1,600,000 includes tax on the tax-exempt interest. Answer (D) is incorrect because 1,568,000 includes tax on the tax-exempt interest but does not include tax on the rent income.

[605] Gleim #: 4.137 -- Source: CMA 686 3-9 (Refers to Fact Pattern #37) Lally’s current tax expense for 20X2 was

A. B. C. D.

1,960,000 1,992,000 2,000,000 2,032,000 Answer (A) is incorrect because 1,960,000 does not include the deferred tax liability from the rent. Answer (B) is correct. The 5,000,000 of pre-tax profit is reduced by the 100,000 of interest income not subject to tax. However, the rental income accrued in the previous year is taxable in 20X2. Thus, the profit subject to tax is 4,980,000. Given a 40% rate, the current tax expense is 1,992,000. Answer (C) is incorrect because 2,000,000 includes the tax-exempt interest but does not include the deferred tax liability from the rent. Answer (D) is incorrect because 2,032,000 includes the tax-exempt interest.


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[606] Gleim #: 4.138 -- Source: CMA 686 3-10 (Refers to Fact Pattern #37) The deferred tax asset or liability reported on Lally’s balance sheet on December 31, 20X2 is

A. B. C. D.

40,000 32,000 8,000 0 Answer (A) is incorrect because the non-taxable interest income does not have deferred tax consequences. The rental income created a deferred tax liability in 20X1 that reversed in 20X2. Therefore, no deferred tax amount existed at the end of 20X2. Answer (B) is incorrect because the non-taxable interest income does not have deferred tax consequences. The rental income created a deferred tax liability in 20X1 that reversed in 20X2. Therefore, no deferred tax amount existed at the end of 20X2. Answer (C) is incorrect because the non-taxable interest income does not have deferred tax consequences. The rental income created a deferred tax liability in 20X1 that reversed in 20X2. Therefore, no deferred tax amount existed at the end of 20X2. Answer (D) is correct. The correct answer is 0. Deferred tax assets arise from deductible temporary differences and the carryforward of unused tax losses and credits. Deferred tax liabilities arise from taxable temporary differences. The interest income not subject to tax resulted in neither future taxable nor future deductible amounts and therefore no deferred tax item was recognized for it. The only item resulting in a temporary difference was the rental income. A deferred tax liability would have been created at the end of 20X1. Given that the difference reversed in 20X2, no deferred amount existed at the end of 20X2.

[607] Gleim #: 4.139 -- Source: IIA, adapted Under a defined contribution pension plan, is reported on the balance sheet only if the amount the organization has contributed to the pension trust is the amount required.

List A

List B

A. B.

An asset An asset


C. D.

A liability A liability


Answer (A) is correct. Under a defined contribution plan, the company reports an asset on the balance sheet only if the contribution to the pension trust is greater than the defined, required contribution. Answer (B) is incorrect because an asset is reported only if the contribution is in excess of the required contribution. If the actual contribution is equal to that required, no asset is reported. Answer (C) is incorrect because the company would report a liability on the balance sheet only if the contribution was less than the required amount, not greater than the required amount. Answer (D) is incorrect because the company would not report a liability on the balance sheet if it contributed the required amount to the pension trust. [608] Gleim #: 4.140 -- Source: IIA, adapted If a lease agreement transfers substantially all of the benefits and risks of ownership of the asset to the lessee, the asset value is recognized on the lessee’s books a asset and the lease is lease.


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List A

List B

A.

A tangible

A capital

B. C.

An intangible A tangible

A capital An operating

D.

An intangible

An operating

Answer (A) is correct. Leased assets are recognized as tangible assets. When lease agreements transfer the risks and benefits of ownership of the asset to the lessee, the lessee is referred to as a capital lease since it is essentially a form of financing, or capital, for the lessee. Answer (B) is incorrect because leased assets are not recognized as intangibles. Answer (C) is incorrect because, if substantially all of the risks and benefits of ownership of the asset are transferred to the lessee, then the lease is referred to as a capital lease, not an operating lease. Answer (D) is incorrect because leased assets are not recognized as intangibles. If substantially all of the risks and benefits of ownership of the asset are transferred to the lessee, then the lease is referred to as a capital lease, not an operating lease. [609] Gleim #: 4.141 -- Source: IIA, adapted A U.S. company and a European company purchased the same stock on a European stock exchange and held the stock for one year. If the value of the euro weakened against the U.S. dollar during the period, in comparison with the European company’s return, the U.S. company’s return will be

A. B. C. D.

Lower. Higher. The same. Indeterminate from the information provided. Answer (A) is correct. Because the return to the U.S. company is adversely affected and the return to the European company is unaffected, the return to the U.S. company will definitely be lower than the return to the European company. Answer (B) is incorrect because the return to the U.S. company is adversely affected by the exchange rate movement. Answer (C) is incorrect because the return to the U.S. company is directly affected by the exchange rate movement, while the return to the European company is not. Answer (D) is incorrect because the return to the U.S. company is adversely affected and the return to the European company is unaffected, the return to the U.S. company will definitely be lower than the return to the European company.

[610] Gleim #: 4.142 -- Source: CIA 591 IV-34 When the equity method is used to account for the investment in an associate, the recording of the receipt of a cash distribution from the investee will result in

A. B. C. D.

The recognition of investment income. A reduction in the investment balance. An increase in a liability account. An increase in a special equity account.


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Answer (A) is incorrect because, when the equity method is used, investment income (loss) is recognized for the investee’s share of the profits or losses of the associate. Dividends received from the investee are recorded as a reduction of the investment account. Answer (B) is correct. When the equity method is used, the investment is initially recorded at cost on the entity’s books. The carrying amount is subsequently adjusted to recognize the profits or losses of the associate after the date of acquisition. Dividends received from an associate reduce the carrying amount. Answer (C) is incorrect because the investment account is credited. Answer (D) is incorrect because the investment account is credited. [611] Gleim #: 4.143 -- Source: IIA, adapted Which of the following is an example of a contingent liability?

A. A retail store in a shopping mall pays the lessor a minimum monthly rent plus an agreed-upon percentage of sales. B. A company is refusing to pay the invoice for the annual audit because it seems higher than the amount agreed upon with the public accounting firm’s partner . C. A company accrues income tax payable in its interim financial statements. D. A lessee agrees to reimburse a lessor for a shortfall in the residual value of an asset under lease. Answer (A) is incorrect because there is no uncertainty regarding the amount of rent. Rent expense can be accrued as sales occur. Answer (B) is incorrect because a service was received and the company owes an amount. The amount is not contingent on a future event. The company can accrue the amount that it expected the invoice to show. Answer (C) is incorrect because as of the date of the interim financial statements, the income tax is payable because earnings have occurred. There is no uncertainty regarding the amount or the timing of the payment as of the date of the interim financial statements. Answer (D) is correct. This is a guarantee. The liability is contingent on the lessor’s not receiving the full residual value from a third party. [612] Gleim #: 4.144 -- Source: CIA 595 IV-21 An enterprise changes its method of accounting for depreciation during the current year because it believes that the result will be a more appropriate presentation in the financial statements. In its income statement for the year, how should the enterprise report the adjustment resulting from the change in accounting policy if all relevant amounts are practicably determinable?

A. B. C. D.

Not disclosed in the financial statements. Included in the determination of net profit or loss for the current period. Disclosed as a separate type of depreciation expense, directly following depreciation expense for the current year. Reported as an adjustment to beginning retained earnings for the first period presented. Answer (A) is incorrect because changes in accounting policies must be disclosed in the financial statements for the period. Answer (B) is incorrect because restrospective application is indicated unless it is impracticable. Answer (C) is incorrect because restrospective application is indicated unless it is impracticable. Answer (D) is correct. A change in accounting policy should be applied retrospectively unless it is impracticable to determine period-specific effects or the cumulative effect. Retrospective application means adjusting the opening balances of equity (e.g., retained earnings) for the first period presented and restating other comparative amounts.

[613] Gleim #: 5.1 -- Source: CIA 597 IV-48 Common shareholders with preemptive rights are entitled to


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A. B. C. D.

Vote first at annual meetings. Purchase any additional bonds sold by the firm. Purchase any additional shares sold by the firm. Gain control of the firm in a proxy fight. Answer (A) is incorrect because there is no prescribed order of shareholder voting. Answer (B) is incorrect because preemptive rights concern only equity ownership. Thus, they do not apply to nonconvertible debt. Answer (C) is correct. Preemptive rights protect common shareholders, proportional ownership interests from dilution in value. A secondary purpose is to maintain the shareholders control of the company. Accordingly, the preemptive right, whether granted by statute or by the corporate charter, grants common shareholders the power to acquire on a pro rata basis any additional common shares sold by the firm. Preemptive rights also apply to debt convertible into common shares. Answer (D) is incorrect because a proxy fight is an attempt to gain control of a company by persuading shareholders to grant their voting rights to others.

[614] Gleim #: 5.2 -- Source: CIA 597 IV-49 Participating preferred shareholders are entitled to

A. B. C. D.

Monitor any sinking funds for the purchase and retirement of debt. Vote at all annual meetings. Convert their shares into common shares. Share in the firm’s earnings beyond the stated dividend level. Answer (A) is incorrect because the participation privilege is unrelated to monitoring privileges. Answer (B) is incorrect because preferred shareholders do not have voting rights except in circumstances in which the firm has not paid the preferred share dividends for a specified period. Answer (C) is incorrect because a conversion feature, not a participation feature, allows conversion to common stock. Answer (D) is correct. Participating preferred shareholders are entitled to share in the earnings of the firm. They participate in earnings distributions under set terms and conditions. Hence, after the stated preferred dividend is paid, and common shareholders receive an equal dividend, any remaining dividends are allocated to all shareholders in proportion to the par values of their shares.

[615] Gleim #: 5.3 -- Source: CIA 596 IV-46 Preferred shares are securities with characteristics of both common shares and bonds. Preferred shares have like common shares and like bonds.

List A

List B

A.

A maturity date

A fixed periodic payment

B. C.

No maturity date A maturity date

No fixed periodic payment No fixed periodic payment

D.

No maturity date

A fixed periodic payment


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Answer (A) is incorrect because preferred shares do not have a maturity date. Answer (B) is incorrect because preferred shares have fixed periodic dividend payments. Answer (C) is incorrect because preferred shares do not have a maturity date but do have fixed periodic dividend payments. Answer (D) is correct. Like common shares (but unlike bonds), preferred shares have no maturity date, although certain preferred shares (transient preferred shares) must be redeemed within a short time (e.g., 5 to 10 years). Like bonds (but unlike common shares), preferred shares have a fixed periodic payment. The fixed payment is in the form of a stated dividend in the case of the preferred shares and interest payments in the case of bonds. However, preferred dividends, unlike interest, do not become an obligation unless declared. [616] Gleim #: 5.4 -- Source: CIA 1195 IV-47 Which of the following is usually not a feature of cumulative preferred shares?

A. B. C. D.

Has priority over common shares with regard to earnings. Has priority over common shares with regard to assets. Has voting rights. Has the right to receive dividends in arrears before common share dividends can be paid. Answer (A) is incorrect because preferred shares have priority over common shares with regard to earnings, so dividends must be paid on preferred shares before they can be paid on common shares. Answer (B) is incorrect because preferred shares have priority over common shares with regard to assets. In the event of liquidation, for example, because of bankruptcy, the claims of preferred shareholders must be satisfied in full before the common shareholders receive anything. Answer (C) is correct. Preferred shares do not usually have voting rights. Preferred shareholders are usually given the right to vote for directors only if the company has not paid the preferred dividend for a specified period of time, such as 10 quarters. Such a provision is an incentive for management to pay preferred dividends. Answer (D) is incorrect because cumulative preferred shares have the right to receive any dividends not paid in prior periods before common share dividends are paid.

[617] Gleim #: 5.5 -- Source: CIA 596 IV-57 If a company has outstanding bonds with a sinking fund provision and if interest rates have since the bonds were issued, the company would realize a savings in meeting its sinking fund obligations by .

List A

List B

A.

Increased

Buying back bonds

B.

Remained constant

in the open market Calling in a portion of

C.

Increased

the bonds at face value Calling in a portion of

Decreased

the bonds at face value Buying back bonds in

D.

the open market


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Answer (A) is correct. If interest rates have increased, the prices of outstanding bonds must decrease so that their yields will reach the market rate. Hence, the bonds will be selling at a discount (below face value) in the open market. Retiring a portion of the outstanding bonds by buying them in the open market at the discounted price will be cheaper than calling a portion of the bonds at face value. Answer (B) is incorrect because, if interest rates have remained constant, the bonds will still be selling at face value in the open market. The cost of buying bonds on the open market will be the same as the cost of calling a portion of the bonds at face value. Answer (C) is incorrect because, if interest rates have increased, buying bonds in the open market will be the cheaper strategy. Answer (D) is incorrect because, if interest rates have decreased, the bonds will be selling at a premium in the open market. Retiring a portion of the bonds by purchasing them on the open market will be more costly than calling a portion of the bonds at face value. [618] Gleim #: 5.6 -- Source: CIA 1195 IV-46 Convertible bonds and bonds issued with warrants differ in that

A. Convertible bonds have lower coupon rates than straight bonds, while bonds issued with warrants have higher coupon rates than straight bonds. B. Convertible bonds have higher coupon rates than straight bonds, while bonds issued with warrants have lower coupon rates than straight bonds. C. Convertible bonds remain outstanding after the bondholder exercises the right to become a common shareholder, while bonds that are issued with warrants do not. D. Bonds that are issued with warrants remain outstanding after the bondholder exercises the right to become a common shareholder, while convertible bonds do not. Answer (A) is incorrect because bonds issued with warrants and convertible bonds have lower coupon rates than conventional bonds. Answer (B) is incorrect because bonds issued with warrants and convertible bonds have lower coupon rates than conventional bonds. Answer (C) is incorrect because convertible bonds do not remain outstanding. Answer (D) is correct. Warrants are usually detachable. They are options to purchase equity securities and should be separately accounted for. A capital gain results if the share price rises above the option price. The bonds remain outstanding if the warrants are exercised. Convertible bonds must be surrendered when the conversion privilege is exercised. The equity feature of convertible bonds is not separately accounted for. [619] Gleim #: 5.7 -- Source: CIA 1196 IV-20 Zero-coupon bonds

A. B. C. D.

Sell for a small fraction of their face value because their yield is much lower than the market rate. Increase in value each year as they approach maturity, providing the owner with the total payoff at maturity. Are redeemable in measures of a commodity such as barrels of oil, tons of coal, or ounces of rare metal (e.g., silver). Are high-interest-rate, high-risk, unsecured bonds that have been used extensively to finance leveraged buyouts. Answer (A) is incorrect because deep discount bonds pay interest significantly below the market rate, whereas zerocoupon bonds do not pay interest. Answer (B) is correct. Zero-coupon bonds sell at a deep discount and increase in value each year until maturity. These bonds do not pay interest. Answer (C) is incorrect because commodity-backed bonds are redeemable in measures of a commodity. Answer (D) is incorrect because junk bonds are high-interest-rate, high-risk, unsecured bonds.


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[620] Gleim #: 5.8 -- Source: CIA 595 IV-39 Bondholders are assured of protection against inflation if they hold

A. B. C. D.

Income bonds. Convertible bonds. Mortgage bonds. Indexed bonds. Answer (A) is incorrect because income bonds pay interest to the holder only if the interest is earned. The interest paid is not inflation adjusted. Answer (B) is incorrect because convertible bonds can be redeemed for the common shares of the issuer at the option of the holder. Interest payments are not inflation adjusted. Answer (C) is incorrect because mortgage bonds are secured by fixed assets of the issuer. Thus, they provide greater security to bondholders, but the interest payments are not inflation adjusted. Answer (D) is correct. The interest payments on indexed or purchasing power bonds are based on an inflation index, such as the consumer price index. Thus, interest paid to bondholders rises automatically when the inflation rate rises.

[621] Gleim #: 5.9 -- Source: CIA 1191 IV-50 From the viewpoint of the investor, which of the following securities provides the least risk?

A. B. C. D.

Mortgage bond. Subordinated debenture. Income bond. Debentures. Answer (A) is correct. A mortgage bond is secured with specific fixed assets, usually real property. Thus, under the rights enumerated in the bond indenture, creditors will be able to receive payments from liquidation of the property in case of default. In a bankruptcy proceeding, these amounts are paid before any transfers are made to other creditors, including those preferences. Hence, mortgage bonds are less risky than the others listed. Answer (B) is incorrect because a debenture is long-term debt that is not secured (collateralized) by specific property. Subordinated debentures have a claim on the debtor’s assets that may be satisfied only after senior debt has been paid in full. Debentures of either kind are therefore more risky than mortgage bonds. Answer (C) is incorrect because an income bond pays interest only if the debtor earns it. Such bonds are also more risky than secured debt. Answer (D) is incorrect because unsecured debt is riskier than a mortgage bond.

[622] Gleim #: 5.10 -- Source: CIA 589 IV-49 Which of the following classes of securities are listed in order from lowest risk/opportunity for return to highest risk/opportunity for return?

A. B. C. D.

U.S. Treasury bonds; corporate first mortgage bonds; corporate income bonds; preferred shares. Corporate income bonds; corporate mortgage bonds; convertible preferred shares; subordinated debentures. Common shares; corporate first mortgage bonds; corporate second mortgage bonds; corporate income bonds. Preferred shares; common shares; corporate mortgage bonds; corporate debentures.


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Answer (A) is correct. The general principle is that risk and return are directly correlated. For example, U.S. Treasury securities are backed by the full faith and credit of the U.S. government and are therefore the least risky form of investment listed. However, their return is correspondingly lower. Corporate first mortgage bonds are less risky than income bonds or shares because they are secured by specific property. In the event of default, the bondholders can have the property sold to satisfy their claims. Holders of first mortgages have rights paramount to those of any other parties, such as holders of second mortgages. Income bonds pay interest only in the event the corporation earns income. Thus, holders of income bonds have less risk than shareholders because meeting the condition makes payment of interest mandatory. Preferred shareholders receive dividends only if they are declared, and the directors usually have complete discretion in this matter. Also, shareholders have claims junior to those of debtholders if the enterprise is liquidated. Answer (B) is incorrect because the proper listing is mortgage bonds, subordinated debentures, income bonds, and preferred shares. Debentures are unsecured debt instruments. Their holders have enforceable claims against the issuer even if no income is earned or dividends declared. Answer (C) is incorrect because the proper listing is first mortgage bonds, second mortgage bonds, income bonds, and common shares. The second mortgage bonds are secured, albeit junior, claims. Answer (D) is incorrect because the proper listing is mortgage bonds, debentures, preferred shares, and common shares. Holders of common shares cannot receive dividends unless the holders of preferred shares receive the stipulated periodic percentage return, in addition to any arrearages if the preferred shares are cumulative. [623] Gleim #: 5.11 -- Source: CIA 1195 IV-53 The correct equation for calculating the approximate percentage cost, on an annual basis, of not taking trade discounts is

A.

B.

C.

D.

Answer (A) is correct. The first term of the formula represents the periodic cost of the trade discount, calculated as the cost per unit of trade credit (discount %) divided by the funds made available by not taking the discount (100 – discount %). The second term represents the number of times per year this cost is incurred. The multiple of these terms is the approximate annual percentage cost of not taking the trade discount. A precise formula would incorporate the effects of compounding when calculating the annual cost. Answer (B) is incorrect because the denominator of the first term should represent the funds made available by not taking the discount (100 – discount %). Answer (C) is incorrect because the first term is the reciprocal of the correct term. Answer (D) is incorrect because the second term is the reciprocal of the correct term.


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[624] Gleim #: 5.12 -- Source: CIA 597 IV-51 A company obtaining short-term financing with trade credit will pay a higher percentage financing cost, everything else being equal, when

A. B. C. D.

The discount percentage is lower. The items purchased have a higher price. The items purchased have a lower price. The supplier offers a longer discount period. Answer (A) is incorrect because the lower the discount percentage, the lower the opportunity cost of forgoing the discount and using the trade credit financing. Answer (B) is incorrect because percentage financing cost is unaffected by the purchase price of the items. Answer (C) is incorrect because percentage financing cost is unaffected by the purchase price of the items. Answer (D) is correct. If the discount period is longer, the days of extra credit obtained by forgoing the discount are fewer. Assuming other factors are constant, the result is that the cost of trade credit, that is, the cost of not taking the discount, is greater.

[625] Gleim #: 5.13 -- Source: CIA 1192 IV-54 A company has accounts payable of $5 million with terms of 2% discount within 15 days, net 30 days (2/15 net 30). It can borrow funds from a bank at an annual rate of 12%, or it can wait until the 30th day when it will receive revenues to cover the payment. If it borrows funds on the last day of the discount period in order to obtain the discount, its total cost will be

A. B. C. D.

$51,000 less. $75,500 less. $100,000 less. $24,500 more. Answer (A) is incorrect because $51,000 less is based on a 30-day borrowing period. Answer (B) is correct. The interest cost of borrowing $4,900,000 (98% × $5,000,000) to take advantage of the discount is $24,500 [$4,900,000 × 12% × (15 ÷ 360)], and the total cost will be $4,924,500. The total cost if the discount is not taken will be $5,000,000, a difference of $75,500. Answer (C) is incorrect because $100,000 less does not consider the interest paid. Answer (D) is incorrect because $24,500 more reflects interest paid but ignores the discounted price.

[626] Gleim #: 5.14 -- Source: CIA 1196 IV-52 A short-term bank loan will have a higher effective financing cost if it has which combination of characteristics?

A. B. C. D.

A 10% compensating balance and regular interest. A 10% compensating balance and discount interest. A 20% compensating balance and regular interest. A 20% compensating balance and discount interest.


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Answer (A) is incorrect because lower compensating balances and regular interest are less costly. Answer (B) is incorrect because lower compensating balances and regular interest are less costly. Answer (C) is incorrect because lower compensating balances and regular interest are less costly. Answer (D) is correct. The most costly combination of characteristics is a higher compensating balance and discount interest. The higher the compensating balance, the higher the portion of the loan funds that must be left on deposit with the lender. Hence, the interest paid is charged on a smaller amount of funds available to be used by the borrower, and the effective cost is higher. Also, discount interest is deducted from the loan funds in advance, resulting in a further increase in the effective financing cost. [627] Gleim #: 5.15 -- Source: CIA 596 IV-41 The credit instrument known as a banker’s acceptance

A. Calls for immediate payment upon delivery of the shipping documents to the bank’s customer and acceptance of goods by the bank. B. Involves an invoice being signed by the banker upon receipt of goods, after which both the banker and the seller record the transaction on their respective books. C. Is a time draft payable on a specified date and guaranteed by the bank. D. Is a method of sales financing in which the bank retains title to the goods until the buyer has completed payment. Answer (A) is incorrect because a sight draft calls for immediate payment upon delivery of the shipping documents to, and the acceptance of the draft by, the buyer. Answer (B) is incorrect because an open account is a credit arrangement involving only the signing of an invoice by the buyer. Answer (C) is correct. A time draft (trade acceptance) is a form of commercial draft because it is drawn by a seller on the buyer; that is, it calls for the buyer to pay a specified amount. The draft and the shipping documents related to the goods are then sent to the buyer’s bank, which transmits the draft to the buyer. The buyer accepts the draft by signing it. A time draft, however, is similar to a promissory note because it is payable at a specific time in the future rather than upon acceptance by the buyer, which is characteristic of a sight draft. If a seller is reluctant to ship goods because of concern about the buyer’s ability to pay a time draft, the seller’s bank may, for a fee, guarantee payment. This banker’s acceptance is an assumption of the obligation to pay at the due date. Answer (D) is incorrect because the description is of a conditional sales contract except that the seller, not the bank, retains title to the goods until the buyer has completed payment. [628] Gleim #: 5.16 -- Source: CIA 1191 IV-56 An example of secured short-term financing is

A. B. C. D.

Commercial paper. A warehouse receipt. A revolving credit agreement. Trade credit.


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Answer (A) is incorrect because commercial paper is a type of unsecured, short-term promissory note issued by large firms to other firms, insurance companies, mutual funds, etc. Answer (B) is correct. A document of title is usually issued by a bailee covering goods in the bailee’s possession or care (UCC 1-201). It represents ownership of the goods and is ordinarily needed to obtain the goods from the bailee. The two major types of documents of title are bills of lading (issued by carriers) and warehouse receipts. A warehouse receipt is issued by a person engaged in the business of storing goods for hire. Security for short-term inventory financing can be arranged if the debtor places its inventory under the control of the lender or its agent (e.g., a public warehouse), and the lender holds the warehouse receipts. Answer (C) is incorrect because a revolving credit agreement is a formal line of credit, usually with a bank, that large firms often use. Answer (D) is incorrect because accounts payable, or trade credit, is the most common source of unsecured short-term financing. [629] Gleim #: 5.17 -- Source: CIA 590 IV-50 Factoring is the

A. B. C. D.

Selling of accounts receivable by one company to another. Selling of inventory by one company to another. Conversion of accounts receivable to bad debt on financial statements for accounts that are long overdue. Adjustment of inventories on financial statements for supplies that have become obsolete. Answer (A) is correct. A factor purchases a company’s accounts receivable and assumes the risk of collection. The seller receives money immediately to reinvest in new inventories. The financing cost is usually high: about 2 points or more above prime, plus a fee for collection. Factoring has been traditional in the textile industry for years, and recently companies in many industries have found it an efficient means of operation. A company that uses a factor can eliminate its credit department, accounts receivable staff, and bad debts. These reductions in costs can more than offset the fee charged by the factor, which can often operate more efficiently than its clients because of the specialized nature of its service. Answer (B) is incorrect because factoring is a source of short-term funds through sale of receivables. Answer (C) is incorrect because factoring is a source of short-term funds through sale of receivables. Answer (D) is incorrect because factoring is a source of short-term funds through sale of receivables.

[630] Gleim #: 5.18 -- Source: CMA 1286 1-35 The following forms of short-term borrowing are available to a firm: Floating lien Factoring Revolving credit Chattel mortgages Bankers’ acceptances Lines of credit Commercial paper The forms of short-term borrowing that are unsecured credit are

A. B. C. D.

Floating lien, revolving credit, chattel mortgage, and commercial paper. Factoring, chattel mortgage, bankers’ acceptances, and line of credit. Floating lien, chattel mortgage, bankers’ acceptances, and line of credit. Revolving credit, bankers’ acceptances, line of credit, and commercial paper.


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Answer (A) is incorrect because a chattel mortgage is a loan secured by personal property (movable property such as equipment or livestock). Also, a floating lien is secured by property, such as inventory, the composition of which may be constantly changing. Factoring is a form of financing in which receivables serve as security. Answer (B) is incorrect because a chattel mortgage is a loan secured by personal property (movable property such as equipment or livestock). Also, a floating lien is secured by property, such as inventory, the composition of which may be constantly changing. Factoring is a form of financing in which receivables serve as security. Answer (C) is incorrect because a chattel mortgage is a loan secured by personal property (movable property such as equipment or livestock). Also, a floating lien is secured by property, such as inventory, the composition of which may be constantly changing. Factoring is a form of financing in which receivables serve as security. Answer (D) is correct. An unsecured loan is a loan made by a bank based on credit information about the borrower and the ability of the borrower to repay the obligation. The loan is not secured by collateral, but is made on the signature of the borrower. Unsecured credit is not backed by collateral. Revolving credit, bankers’ acceptances, lines of credit, and commercial paper are all unsecured means of borrowing. A chattel mortgage is a loan secured by personal property (movable property such as equipment or livestock). A floating lien is also secured by property, such as inventory, the composition of which may be constantly changing. Factoring is a form of financing in which receivables serve as security. [631] Gleim #: 5.19 -- Source: CIA 597 IV-42 A company has made the decision to finance next year’s capital projects through debt rather than additional equity. The benchmark cost of capital for these projects should be

A. B. C. D.

The before-tax cost of new-debt financing. The after-tax cost of new-debt financing. The cost of equity financing. The weighted-average cost of capital. Answer (A) is incorrect because the cost of capital is a composite, or weighted average, of all financing sources in their usual proportions. The cost of capital should also be calculated on an after-tax basis. Answer (B) is incorrect because the cost of capital is a composite, or weighted average, of all financing sources in their usual proportions. The cost of capital should also be calculated on an after-tax basis. Answer (C) is incorrect because the cost of capital is a composite, or weighted average, of all financing sources in their usual proportions. The cost of capital should also be calculated on an after-tax basis. Answer (D) is correct. A weighted average of the costs of all financing sources should be used, with the weights determined by the usual financing proportions. The terms of any financing raised at the time of initiating a particular project do not represent the cost of capital for the firm. When a firm achieves its optimal capital structure, the weightedaverage cost of capital is minimized. The cost of capital is a composite, or weighted average, of all financing sources in their usual proportions. The cost of capital should also be calculated on an after-tax basis.

[632] Gleim #: 5.20 -- Source: CIA 597 IV-50 When a company increases its degree of financial leverage (DFL),

A. B. C. D.

The equity beta of the company falls. The systematic risk of the company falls. The systematic risk of the company rises. The standard deviation of returns on the equity of the company rises.


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Answer (A) is incorrect because an increase in the DFL increases the riskiness of the firm’s shares. Thus, beta rises. Beta is a measure of the volatility of a firm’s share price relative to the average share. Answer (B) is incorrect because systematic risk, also known as market risk, is unrelated to the DFL. Systematic risk is not specific to a company. It is the risk associated with a company’s shares that cannot be diversified because it arises from factors that affect all shares. Answer (C) is incorrect because systematic risk, also known as market risk, is unrelated to the DFL. Systematic risk is not specific to a company. It is the risk associated with a company’s shares that cannot be diversified because it arises from factors that affect all shares. Answer (D) is correct. The DFL equals the percentage change in EPS (earnings available to common shareholders) divided by the percentage change in net operating profit. When the DFL rises, fixed interest charges and the riskiness of the firm rise. As a result, the variability of returns will increase. In other words, the standard deviation of returns of the company rises. [633] Gleim #: 5.21 -- Source: CIA 597 IV-52 In its first year of operations, a firm had $50,000 of fixed operating costs. It sold 10,000 units at a $10 unit price and incurred variable costs of $4 per unit. If all prices and costs will be the same in the second year and sales are projected to rise to 25,000 units, what will the degree of operating leverage (the extent to which fixed costs are used in the firm’s operations) be in the second year?

A. B. C. D.

1.25 1.50 2.0 6.0 Answer (A) is incorrect because 1.25 ignores variable costs. Answer (B) is correct. The DOL may be calculated as the contribution margin (sales – variable cost) divided by the excess of the contribution margin over fixed costs. The contribution margin is $150,000 [25,000 units × ($10 unit price – $4 unit variable cost)]. Hence, the DOL in the second year is 1.50 [$150,000 CM ÷ ($150,000 – $50,000 FC)]. Answer (C) is incorrect because 2.0 uses the first-year sales level and ignores variable costs. Answer (D) is incorrect because 6.0 uses the first-year sales level.

[634] Gleim #: 5.22 -- Source: CIA 597 IV-53 If a company has a higher dividend-payout ratio, then, if all else is equal, it will have

A. B. C. D.

A higher marginal cost of capital. A lower marginal cost of capital. A higher investment opportunity schedule. A lower investment opportunity schedule. Answer (A) is correct. The higher the dividend-payout ratio, the sooner retained earnings are exhausted and the company must seek external financing. Assuming the same investments are undertaken, the result is a higher marginal cost of capital because lower-cost capital sources will be used up earlier. Answer (B) is incorrect because the marginal cost of capital is higher. Answer (C) is incorrect because the existence of investment opportunities is unrelated to the dividend payout. Answer (D) is incorrect because the existence of investment opportunities is unrelated to the dividend payout.


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[635] Gleim #: 5.23 -- Source: CIA 1196 IV-49 If two companies, company X and company Y, are alike in all respects except that company X employs more debt financing and less equity financing than company Y does, which of the following statements is true?

A. B. C. D.

Company X has more net earnings variability than company Y. Company X has more operating earnings variability than company Y. Company X has less operating earnings variability than company Y. Company X has less financial leverage than company Y. Answer (A) is correct. Given that company X is more highly leveraged, it has greater fixed financing charges than company Y. Interest payments are fixed financing charges, but common share dividends are not. As a result, company X will be more risky and therefore will have a more volatile net income stream than company Y, if other factors are constant. Answer (B) is incorrect because the level of fixed financing charges does not affect operating income variability. Answer (C) is incorrect because the level of fixed financing charges does not affect operating income variability. Answer (D) is incorrect because company X has greater, not less, financial leverage than company Y. Greater use of debt financing means that a company has greater financial leverage.

[636] Gleim #: 5.24 -- Source: CIA 1196 IV-25 The market value of a firm’s outstanding common shares will be higher, everything else equal, if

A. B. C. D.

Investors have a lower required return on equity. Investors expect lower dividend growth. Investors have longer expected holding periods. Investors have shorter expected holding periods. Answer (A) is correct. The dividend growth model is used to calculate the cost of equity. The simplified formula is

R is the required rate of return, D is the next dividend, P is the share’s price, and G is the growth rate in earnings per share. The equation is also used to determine the share price.

Thus, when investors have a lower required return on equity, the denominator is smaller, which translates into a higher market value. Answer (B) is incorrect because, if investors expect lower dividend growth, the market value of common shares will decrease. Answer (C) is incorrect because the expected holding periods of investors are not related to the market value of the common shares. Answer (D) is incorrect because the expected holding periods of investors are not related to the market value of the common shares. [637] Gleim #: 5.25 -- Source: CIA 593 IV-49 Assume that nominal interest rates just increased substantially but that the expected future dividends for a company over the long run were not affected. As a result of the increase in nominal interest rates, the company’s share price should


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A. B. C. D.

Increase. Decrease. Stay constant. Change, but in no obvious direction. Answer (A) is incorrect because a higher interest rate raises the required return of investors, which results in a lower share price. Answer (B) is correct. The dividend growth model is used to calculate the price of a share.

If:

P0 D1 RS G

= = = =

current price next dividend required rate of return EPS growth rate

Assuming that D1 and G remain constant, an increase in R S resulting from an increase in the nominal interest rate will cause P 0 to decrease. A higher interest rate raises the required return of investors, which results in a lower share price. Answer (C) is incorrect because a higher interest rate raises the required return of investors, which results in a lower share price. Answer (D) is incorrect because a higher interest rate raises the required return of investors, which results in a lower share price. [638] Gleim #: 5.26 -- Source: CIA 594 IV-80 A company has 10,000 outstanding shares with a market value of $25 each. It just paid a $1 per share dividend. Dividends are expected to grow at a constant rate of 10%. If flotation costs are 5% of the selling price, the cost of new equity financing is calculated by the following formula:


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A.

B.

C.

D.

Answer (A) is incorrect because the end-of-period expected dividend and the net proceeds of the issue should be included in calculating the dividend yield. Answer (B) is incorrect because the end-of-period expected dividend should be included in calculating the dividend yield. Answer (C) is incorrect because the net proceeds, not market price, should be included in calculating the dividend yield. Answer (D) is correct. The cost of new equity is calculated by adding the expected dividend yield, based on the net proceeds of the new issue, to the expected dividend growth rate. The expected dividend at the end of the period equals the dividend at time zero times one plus the expected dividend growth rate. Net proceeds received by the firm when issuing one common share equals the market price of a share times one minus the flotation cost percentage. Flotation costs include items such as underwriting fees, printing, and advertising. The calculation of the cost of new equity is as follows:


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[639] Gleim #: 5.27 -- Source: CIA 594 IV-48 The marginal cost of debt for a firm is defined as the interest rate on debt minus the .

List A

List B

A.

New

Firm’s marginal tax rate

B. C.

Outstanding New

Firm’s marginal tax rate Interest rate times the firm’s marginal tax rate

D.

Outstanding

Interest rate times the firm’s marginal tax rate

Answer (A) is incorrect because the marginal cost of debt financing is the interest rate on new debt minus the firm’s marginal tax rate multiplied by the interest rate. Moreover, the marginal or incremental cost of debt to the firm is based on the cost of newly issued debt, not on the cost of outstanding debt. Answer (B) is incorrect because the marginal cost of debt financing is the interest rate on new debt minus the firm’s marginal tax rate multiplied by the interest rate. Moreover, the marginal or incremental cost of debt to the firm is based on the cost of newly issued debt, not on the cost of outstanding debt. Answer (C) is correct. The marginal cost of debt must equal the cost of new debt minus the tax savings. Hence, marginal cost equals the cost of new debt times one minus the marginal tax rate, or Kd(1 – T). This expression equals Kd – KdT. The marginal cost of debt financing is the interest rate on new debt minus the firm’s marginal tax rate multiplied by the interest rate. Moreover, the marginal or incremental cost of debt to the firm is based on the cost of newly issued debt, not on the cost of outstanding debt. Answer (D) is incorrect because the marginal cost of debt financing is the interest rate on new debt minus the firm’s marginal tax rate multiplied by the interest rate. Moreover, the marginal or incremental cost of debt to the firm is based on the cost of newly issued debt, not on the cost of outstanding debt.


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[Fact Pattern #38]

A company has the following three investment projects available: Project

Cost

Internal Rate of Return

A

$ 50 million

14%

B

$ 75 million

12%

C

$125 million

8%

These investment opportunities and financing costs are shown in the graph below:

(Refer to Figure CIA3_6_46.) MCC = Marginal cost of capital IOS = Investment opportunity schedule

The company has a 40% debt and 60% equity capital structure. Each dollar of investment funds will be raised in these proportions (40 cents of debt and 60 cents of equity). The marginal cost of financing increases with the amount of new funds raised, as follows:

Weighted-Average Cost of Capital

Interval

Amount Raised

1

First $ 75 million

6%

2

Next $100 million

10%

3

Over $175 million

12%

[640] Gleim #: 5.28 -- Source: CIA 596 IV-48 (Refers to Fact Pattern #38) The investment opportunity schedule (IOS) shows, in rank order, how much money the company would invest at different rates of return. Such schedules can be drawn only for a set of projects that

A. B. C. D.

Have the same investment cost. Are mutually exclusive. Have the same net present value. Are independent. Answer (A) is incorrect because IOS schedules do not require that all projects have the same investment cost. The steps of the schedule can be of varying lengths. Answer (B) is incorrect because IOS schedules cannot be drawn for mutually exclusive projects. Answer (C) is incorrect because IOS schedules do not require that all projects have the same NPV. The NPV of each project depends on the investment cost and on the present value of the expected cash flows. Both costs and cash flows can vary for projects on an IOS. Answer (D) is correct. An IOS schedule is drawn for a set of independent projects. The decision to be made is whether to accept or reject each project without regard to other investment opportunities. Thus, the cash flows of one independent project are not influenced by those of another. Independence should be distinguished from mutual exclusivity. Projects are mutually exclusive if acceptance of one requires rejection of the other.


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[641] Gleim #: 5.29 -- Source: CIA 596 IV-49 (Refers to Fact Pattern #38) The company should invest in Project(s) and has an optimal capital budget of million dollars.

List A

List B

A.

B only

B. C.

A and B only A and C only

125 175

75

D.

C only

125

Answer (A) is incorrect because both A and B should be undertaken. Answer (B) is correct. The intersection of the IOS and MCC schedules determines the cost of capital and the optimal capital budget. The company should begin with the project having the highest return and continue accepting projects as long as the IRR exceeds the MCC. The highest ranked project is A, with a $50 million cost and a 14% IRR. The MCC is only 6% over this range of financing. The next highest ranked project is B, with a $75 million cost and a 12% IRR. When $125 million has been invested, the marginal cost of the next dollar of capital is 10%, so Project B is also acceptable, bringing the optimal capital budget to $125 million. Project C is not acceptable because it has an 8% return. The MCC is 10% for the first $50 million invested in this project and 12% for the remaining $75 million. Answer (C) is incorrect because A is acceptable, but C is not. Answer (D) is incorrect because C is not acceptable. It offers an IRR less than the marginal cost of financing the project. [642] Gleim #: 5.30 -- Source: CIA 596 IV-50 (Refers to Fact Pattern #38) Without prejudice to your answer to any other question, assume that the optimal capital budget for the company is $150 million. The marginal cost of capital and the appropriate discount rate to use in evaluating investment proposals for this company would be

A. B. C. D.

6% 8% 10% 12% Answer (A) is incorrect because 6% applies only to the first $75 million of new financing. Given that the optimal capital budget exceeds $75 million, 6% cannot be the discount rate. Answer (B) is incorrect because 8% is the IRR of Project C. Answer (C) is correct. The appropriate discount rate (the cost of capital used in capital budgeting) theoretically is determined at the intersection of the IOS and MCC schedules. This intersection is at an MCC of 10% and an optimal capital budget of $125 million. However, if the optimal capital budget is assumed to be $150 million, the company is still in the second interval of the MCC schedule. The marginal cost of financing in this part of the schedule is 10%. Answer (D) is incorrect because at an investment level of $150 million, the MCC is 10%.

[643] Gleim #: 5.31 -- Source: CMA 691 1-9 The most direct way to prepare a cash budget for a manufacturing firm is to include


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A. B. C. D.

Projected sales, credit terms, and net income. Projected net income, depreciation, and goodwill amortization. Projected purchases, percentages of purchases paid, and net income. Projected sales and purchases, percentages of collections, and terms of payments. Answer (A) is incorrect because net income includes noncash elements, e.g., goodwill amortization and depreciation. Answer (B) is incorrect because net income includes noncash elements, e.g., goodwill amortization and depreciation. Answer (C) is incorrect because collection percentages must be considered, and net income includes noncash elements. Answer (D) is correct. The most direct way of preparing a cash budget requires incorporation of sales projections and credit terms, collection percentages, estimated purchases and payment terms, and other cash receipts and disbursements. In other words, preparation of the cash budget requires consideration of both inflows and outflows.

[644] Gleim #: 5.32 -- Source: CMA Sample Q1-6 Cleveland Masks and Costumes, Inc. (CMC) has a majority of its customers located in the states of California and Nevada. Keystone National Bank, a major west coast bank, has agreed to provide a lockbox system to CMC at a fixed fee of $50,000 per year and a variable fee of $0.50 for each payment processed by the bank. On average, CMC receives 50 payments per day, each averaging $20,000. With the lockbox system, the company’s collection float will decrease by 2 days. The annual interest rate on money market securities is 6%. If CMC makes use of the lockbox system, what would be the net benefit to the company? Use 365 days per year.

A. B. C. D.

$59,125 $60,875 $50,000 $120,000 Answer (A) is incorrect because $59,125 is the annual lockbox cost. Answer (B) is correct. If payments are collected 2 days earlier, the company can earn $120,000 ($20,000 × 50 payments per day × 2 days × .06) at a cost of $59,125 [$50,000 + (50 payments × 365 days × $.50)], a gain of $60,875. Answer (C) is incorrect because $50,000 is the annual fixed fee. Answer (D) is incorrect because $120,000 is the annual savings without regard to costs.

[645] Gleim #: 5.33 -- Source: Publisher DLF is a retail mail order firm that currently uses a central collection system that requires all checks to be sent to its Boston headquarters. An average of 6 days is required for mailed checks to be received, 3 days for DLF to process them, and 2 days for the checks to clear through its bank. A proposed lockbox system would reduce the mailing and processing time to 2 days and the check clearing time to 1 day. DLF has an average daily collection of $150,000. If DLF adopts the lockbox system, its average cash balance will increase by

A. B. C. D.

$1,200,000 $750,000 $600,000 $450,000


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Answer (A) is correct. Checks are currently tied up for 11 days (6 for mailing, 3 for processing, and 2 for clearing). If that period were reduced to 3 days, DLF’s cash balance would increase by $1,200,000 (8 days × $150,000 per day). Answer (B) is incorrect because the decrease is 8 days, not 5. Answer (C) is incorrect because $600,000 represents only a 4-day savings. Answer (D) is incorrect because the lockbox system will result in an additional 8 days of savings, not 3. [646] Gleim #: 5.34 -- Source: CMA 694 1-24 Assume that each day a company writes and receives checks totaling $10,000. If it takes 5 days for the checks to clear and be deducted from the company’s account, and only 4 days for the deposits to clear, what is the float?

A. B. C. D.

$10,000 $0 $(10,000) $50,000 Answer (A) is correct. The float period is the time between when a check is written and when it clears the payor’s checking account. Check float results in an interest-free loan to the payor because of the delay between payment by check and its deduction from the bank account. If checks written require one more day to clear than checks received, the net float equals one day’s receipts. The company will have free use of the money for one day. In this case, the amount is $10,000. Answer (B) is incorrect because the company enjoys one day’s net float because its checks clear more slowly than its deposits. Answer (C) is incorrect because the net float is positive. The company can write checks (up to $10,000) even when it has no money because the checks do not clear until a day after deposits clear. Answer (D) is incorrect because the net float represents the difference between when deposits clear and when disbursements clear.

[647] Gleim #: 5.35 -- Source: CMA 696 1-11 A company obtained a short-term bank loan of $250,000 at an annual interest rate of 6%. As a condition of the loan, the company is required to maintain a compensating balance of $50,000 in its checking account. The company’s checking account earns interest at an annual rate of 2%. Ordinarily, the company maintains a balance of $25,000 in its checking account for transaction purposes. What is the effective interest rate of the loan?

A. B. C. D.

6.44% 7.00% 5.80% 6.66% Answer (A) is correct. The $50,000 compensating balance requirement is partially satisfied by the company’s practice of maintaining a $25,000 balance for transaction purposes. Thus, only $25,000 of the loan will not be available for current use, leaving $225,000 of the loan usable. At 6% interest, the $250,000 loan would require an interest payment of $15,000 per year. This is partially offset by the 2% interest earned on the $25,000 incremental balance, or $500. Subtracting the $500 interest earned from the $15,000 of expense results in net interest expense of $14,500 for the use of $225,000 in funds. Dividing $14,500 by $225,000 produces an effective interest rate of 6.44%. Answer (B) is incorrect because 7.00% fails to consider that the $25,000 currently being maintained counts toward the compensating balance requirement. Answer (C) is incorrect because 5.8% fails to consider the compensating balance requirement. Answer (D) is incorrect because 6.66% fails to consider the interest earned on the incremental balance being carried.


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[648] Gleim #: 5.36 -- Source: CMA 691 1-12 Which one of the following is not a characteristic of a negotiable certificate of deposit? Negotiable certificates of deposit

A. B. C. D.

Have a secondary market for investors. Are regulated by the Federal Reserve System. Are usually sold in denominations of a minimum of $100,000. Have yields considerably greater than bankers’ acceptances and commercial paper. Answer (A) is incorrect because negotiable CDs do have a secondary market (i.e., they are negotiable). Answer (B) is incorrect because negotiable CDs are regulated. Answer (C) is incorrect because negotiable CDs are typically issued in a denomination of $100,000. Answer (D) is correct. A certificate of deposit (CD) is a form of savings deposit that cannot be withdrawn before maturity without incurring a high penalty. A negotiable CD can be traded. CDs usually have a fairly high rate of return compared with other savings instruments because they are for fixed, usually long-term periods. However, their yield is less than that of commercial paper and bankers’ acceptances because they are less risky.

[649] Gleim #: 5.37 -- Source: Publisher A firm has daily cash receipts of $300,000. A bank has offered to provide a lockbox service that will reduce the collection time by 3 days. The bank requires a monthly fee of $2,000 for providing this service. If money market rates are expected to average 6% during the year, the additional annual income (loss) of using the lockbox service is

A. B. C. D.

$(24,000) $12,000 $30,000 $54,000 Answer (A) is incorrect because $(24,000) ignores the additional interest revenue from investing the increased funds. Answer (B) is incorrect because $12,000 is based on 2 days of accelerated inflows rather than 3. Answer (C) is correct. Because collections will be accelerated by 3 days at a rate of $300,000 per day, the company will have an additional $900,000 to invest. At a rate of 6%, the interest earned will be $54,000 per year. However, the bank will charge $24,000 (12 months × $2,000 per month) for its services. Thus, the firm will increase its income by $30,000 ($54,000 – $24,000). Answer (D) is incorrect because $54,000 ignores the $24,000 bank service charge.

[650] Gleim #: 5.38 -- Source: CMA 1295 1-12 When managing cash and short-term investments, a corporate treasurer is primarily concerned with

A. B. C. D.

Maximizing rate of return. Minimizing taxes. Investing in Treasury bonds since they have no default risk. Liquidity and safety.


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Answer (A) is incorrect because most companies are not in business to earn high returns on liquid assets (i.e., they are held to facilitate operations). Answer (B) is incorrect because the holding of cash and cash-like assets is not a major factor in controlling taxes. Answer (C) is incorrect because investments in Treasury bonds do not have sufficient liquidity to serve as short-term assets. Answer (D) is correct. Cash and short-term investments are crucial to a firm’s continuing success. Sufficient liquidity must be available to meet payments as they come due. At the same time, liquid assets are subject to significant control risk. Therefore, liquidity and safety are the primary concerns of the treasurer when dealing with highly liquid assets. Cash and short-term investments are held because of their ability to facilitate routine operations of the company. These assets are not held for purposes of achieving investment returns. [651] Gleim #: 5.39 -- Source: CMA 697 1-8 Garo Company, a retail store, is considering foregoing sales discounts in order to delay using its cash. Supplier credit terms are 2/10, net 30. Assuming a 360-day year, what is the annual cost of credit if the cash discount is not taken and Garo pays net 30?

A. B. C. D.

24.0% 24.5% 36.0% 36.7% Answer (A) is incorrect because the length of the extra credit period is 20 days, not 30 days. Answer (B) is incorrect because the length of the extra credit period is 20 days, not 30 days. Answer (C) is incorrect because 36.0% calculates the interest rate based on the full invoice price. Answer (D) is correct. On a $1,000 invoice, the company could save $20 by paying within the discount period. Thus, an immediate payment of $980 would save the company $20, and the interest rate charged for holding $980 an additional 20 days (30 – 10) is 2.04% ($20/$980). Because the number of 20-day periods in a year is 18 (360/20), the annual rate is 36.7% (18 × 2.04%).

[652] Gleim #: 5.40 -- Source: CMA 697 1-14 The sales manager at Ryan Company feels confident that, if the credit policy at Ryan’s were changed, sales would increase and, consequently, the company would utilize excess capacity. The two credit proposals being considered are as follows:

Increase in sales Contribution margin Bad debt percentage Increase in operating profits Desired return on sales

Proposal A

Proposal B

$500,000 20% 5% $75,000 15%

$600,000 20% 5% $90,000 15%

Currently, payment terms are net 30. The proposed payment terms for Proposal A and Proposal B are net 45 and net 90, respectively. An analysis to compare these two proposals for the change in credit policy would include all of the following factors except the

A. B. C. D.

Cost of funds for Ryan. Current bad debt experience. Impact on the current customer base of extending terms to only certain customers. Bank loan covenants on days’ sales outstanding.


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Answer (A) is incorrect because the cost of funds is an obvious element in the analysis of any investment. Answer (B) is correct. All factors should be considered that differ between the two policies. Factors that do not differ, such as the current bad debt experience, are not relevant. Ryan must estimate the expected bad debt losses under each new policy. Answer (C) is incorrect because the impact on the current customer base of extending terms to only certain customers is relevant. The current customers may demand the same terms. Answer (D) is incorrect because existing loan agreements may require Ryan to maintain certain ratios at stated levels. Thus, Ryan’s ability to increase receivables and possible bad debt losses may be limited. [653] Gleim #: 5.41 -- Source: CMA 1295 1-4 The average collection period for a firm measures the number of days

A. B. C. D.

After a typical credit sale is made until the firm receives the payment. For a typical check to “clear” through the banking system. Beyond the end of the credit period before a typical customer payment is received. Before a typical account becomes delinquent. Answer (A) is correct. The average collection period measures the number of days between the date of sale and the date of collection. It should be related to a firm’s credit terms. For example, a firm that allows terms of 2/15, net 30, should have an average collection period of somewhere between 15 and 30 days. Answer (B) is incorrect because it describes the concept of float. Answer (C) is incorrect because the average collection period includes the total time before a payment is received, including the periods both before and after the end of the normal credit period. Answer (D) is incorrect because it describes the normal credit period.

[654] Gleim #: 5.42 -- Source: CMA 1292 1-20 Best Computers believes that its collection costs could be reduced through modification of collection procedures. This action is expected to result in a lengthening of the average collection period from 28 days to 34 days; however, there will be no change in uncollectible accounts. The company’s budgeted credit sales for the coming year are $27,000,000, and short-term interest rates are expected to average 8%. To make the changes in collection procedures cost beneficial, the minimum savings in collection costs (using a 360-day year) for the coming year would have to be

A. B. C. D.

$30,000. $360,000. $180,000. $36,000. Answer (A) is incorrect because $36,000 is the minimum savings required. Answer (B) is incorrect because $36,000 is the minimum savings required. Answer (C) is incorrect because $36,000 is the minimum savings required. Answer (D) is correct. Given sales of $27,000,000, the average amount of daily sales must be $75,000 ($27,000,000 ÷ 360 days). The increased accounts receivable balance is therefore $450,000 (6 days × $75,000). With an additional $450,000 of capital invested in receivables, the company’s interest cost will increase by $36,000 per year (8% × $450,000). Thus, the company must save at least $36,000 per year to justify the change in procedures.


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[655] Gleim #: 5.43 -- Source: CMA 1294 1-22 A firm averages $4,000 in sales per day and is paid, on an average, within 30 days of the sale. After they receive their invoice, 55% of the customers pay by check, while the remaining 45% pay by credit card. Approximately how much would the company show in accounts receivable on its balance sheet on any given date?

A. B. C. D.

$4,000 $120,000 $48,000 $54,000 Answer (A) is incorrect because $4,000 is only one day’s sales. Answer (B) is correct. If sales are $4,000 per day, and customers pay in 30 days, 30 days of sales are outstanding, or $120,000. Whether customers pay by credit card or cash, collection requires 30 days. Answer (C) is incorrect because invoices are outstanding for 30 days, not 12 days. Answer (D) is incorrect because $54,000 is based on the 45% of collections via credit card.

[656] Gleim #: 5.44 -- Source: Publisher A common mistake in valuing the firm to be acquired in a business combination is

A. B. C. D.

Using market values in the valuation. Including incremental cash flows in the valuation. Using the acquiring firm’s discount rate when valuing the incremental cash flows. Including all related transaction costs associated with an acquisition. Answer (A) is incorrect because market values is an essential element of the valuation. Answer (B) is incorrect because incremental cash flow is an essential element of the valuation. Answer (C) is correct. If the net incremental cash flows to the acquiring firm’s shareholders are to be valued, the discount rate used should be the cost of equity capital. Moreover, this rate should reflect the risk associated with the use of funds rather than their source. The rate therefore should not be the cost of capital of the acquiring firm but rather the cost of equity of the combined firm after the combination. This calculation requires a new estimate of beta to be used in the Capital Asset Pricing Model. Answer (D) is incorrect because transaction costs is an essential element of the valuation.

[657] Gleim #: 5.45 -- Source: CIA 590 IV-57 A company has recently purchased some stock of a competitor as part of a long-term plan to acquire the competitor. However, it is somewhat concerned that the market price of this stock could decrease over the short run. The company could hedge against the possible decline in the stock’s market price by

A. B. C. D.

Purchasing a call option on that stock. Purchasing a put option on that stock. Selling a put option on that stock. Obtaining a warrant option on that stock.


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Answer (A) is incorrect because a call option is the right to purchase shares at a given price within a specified period. Answer (B) is correct. A put option is the right to sell stock at a given price within a certain period. If the market price falls, the put option may allow the sale of stock at a price above market, and the profit of the option holder will be the difference between the price stated in the put option and the market price, minus the cost of the option, commissions, and taxes. The company that issues the stock has nothing to do with put (and call) options. Answer (C) is incorrect because selling a put option could force the company to purchase additional stock if the option is exercised. Answer (D) is incorrect because a warrant gives the holder a right to purchase stock from the issuer at a given price (it is usually distributed along with debt). [658] Gleim #: 5.46 -- Source: Publisher If a call option is “out-of-the-money,”

A. B. C. D.

The option has expired. The value of the underlying asset is less than the exercise price. The option no longer exists. The option has become a put option. Answer (A) is incorrect because an out-of-the-money option may not have expired. Answer (B) is correct. When the value of the asset underlying a call option is less than the exercise price of the option, the option is “out-of-money.” Answer (C) is incorrect because the option does exist; it is just not worth exercising. Answer (D) is incorrect because call options do not change into put options.

[659] Gleim #: 5.47 -- Source: CIA 1196 IV-58 A call option on a common share is more valuable when there is a lower

A. B. C. D.

Market value of the underlying share. Exercise price on the option. Time to maturity on the option. Variability of market price on the underlying share. Answer (A) is incorrect because a call option is the right to purchase a common share at a set price for a set time period. If the underlying share has a lower market value, the call option is less, not more, valuable. Answer (B) is correct. The lower the exercise price, the more valuable the call option. The exercise price is the price at which the call holder has the right to purchase the underlying share. Answer (C) is incorrect because a call option is less, not more, valuable given less time to maturity. When the option has less time to maturity, the chance that the share price will rise is smaller. Answer (D) is incorrect because a call option is less, not more, valuable if the price of the underlying share is less variable. Less variability means a lower probability of a price increase.

[660] Gleim #: 5.48 -- Source: Publisher The type of option that does not have the backing of stock is called a(n)


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A. B. C. D.

Covered option. Unsecured option. Naked option. Put option. Answer (A) is incorrect because a covered option is one that is written against stock held in the option writer’s portfolio. Answer (B) is incorrect because an unsecured option is a nonsense term. Answer (C) is correct. A naked or uncovered option is a call option that does not have the backing of stock. Thus, the option writer will have to purchase the underlying stock if the call option is exercised. Answer (D) is incorrect because a put option is an option that gives the owner the right to sell the underlying asset for a fixed price.

[661] Gleim #: 5.49 -- Source: Publisher A contractual arrangement that gives the owner the right to buy or sell an asset at a fixed price at any moment in time before or on a specified date is a(n)

A. B. C. D.

European option. Foreign option. Future option. American option. Answer (A) is incorrect because a European option is exercisable only at the expiration date. Answer (B) is incorrect because a foreign option is a nonsense term. Answer (C) is incorrect because although an option can be exercised in the future, it is not called a future option. Answer (D) is correct. An American option is a contractual arrangement that gives the owner the right to buy or sell an asset at a fixed price at any moment in time before or on a specified date.

[662] Gleim #: 5.50 -- Source: Publisher The use of derivatives to either hedge or speculate results in

A. B. C. D.

Increased risk regardless of motive. Decreased risk regardless of motive. Offset risk when hedging and increased risk when speculating. Offset risk when speculating and increased risk when hedging. Answer (A) is incorrect because hedging decreases risk by using offsetting commitments that avoid the impact of adverse price movements. Answer (B) is incorrect because speculation involves the assumption of risk in the hope of gaining from price movements. Answer (C) is correct. Derivatives, including options and futures, are contracts between the parties who contract. Unlike stocks and bonds, they are not claims on business assets. A futures contract is entered into as either a speculation or a hedge. Speculation involves the assumption of risk in the hope of gaining from price movements. Hedging is the process of using offsetting commitments to minimize or avoid the impact of adverse price movements. Answer (D) is incorrect because speculating increases risk while hedging offsets risk.


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[663] Gleim #: 5.51 -- Source: Publisher An automobile company that uses the futures market to set the price of steel to protect a profit against price increases is an example of

A. B. C. D.

A short hedge. A long hedge. Selling futures to protect the company from loss. Selling futures to protect against price declines. Answer (A) is incorrect because a short hedge is a futures contract that is sold to protect against price declines. The automobile company wishes to protect itself against price increases. Answer (B) is correct. A change in prices can be minimized or avoided by hedging. Hedging is the process of using offsetting commitments to minimize or avoid the impact of adverse price movements. The automobile company desires to stabilize the price of steel so that its cost to the company will not rise and cut into profits. Accordingly, the automobile company uses the futures market to create a long hedge, which is a futures contract that is purchased to protect against price increases. Answer (C) is incorrect because the automobile company needs to purchase futures in order to protect itself from loss, not sell futures. Selling futures protects against price declines. Answer (D) is incorrect because it is the definition of a short hedge, which is used for avoiding price declines. The automobile company wants to protect itself against price increases.

[664] Gleim #: 5.52 -- Source: Publisher If a corporation holds a forward contract for the delivery of U.S. Treasury bonds in 6 months and, during those 6 months, interest rates decline, at the end of the 6 months the value of the forward contract will have

A. B. C. D.

Decreased. Increased. Remained constant. Any of the answers may be correct, depending on the extent of the decline in interest rates. Answer (A) is incorrect because the value of the forward contract will increase when interest rates decrease. Answer (B) is correct. Interest rate futures contracts involve risk-free bonds, such as U.S. Treasury bonds. When interest rates decrease over the period of a forward contract, the value of the bonds and the forward contract increase. Answer (C) is incorrect because the value of the forward contract will not remain constant if interest rates decline. Answer (D) is incorrect because any decline in interest rates increases the value of the bonds.

[665] Gleim #: 5.53 -- Source: Publisher Herbert Corporation was a party to the following transactions during November and December 2002. Which of these transactions is most likely to be defined as a derivative?

A. Purchased 1,000 shares of common stock of a public corporation based on the assumption that the stock will increase in value. B. Purchased a term life insurance policy on the company’s chief executive officer to protect the company from the effects of an untimely demise of this officer. C. Agreed to cosign the note of its 100%-owned subsidiary to protect the lender from the possibility that the subsidiary might default on the loan. D. Based on its forecasted need to purchase 300,000 bushels of wheat in 3 months, entered into a 3-month forward contract to purchase 300,000 bushels of wheat to protect itself from changes in wheat prices during the period.


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Answer (A) is incorrect because it involves a net investment equal to the fair value of the stock. Answer (B) is incorrect because insuring the CEO’s life is a transaction based on identifiable events, not underlyings. Answer (C) is incorrect because cosigning a subsidiary’s note is a transaction based on identifiable events, not underlyings. Answer (D) is correct. A derivative is a financial instrument or other contract that (1) has (a) one or more underlyings and (b) one or more notional amounts or payment provisions, or both; (2) requires either no initial net investment or an immaterial net investment; and (3) requires or permits net settlement. An underlying may be a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other variable. A notional amount is a number of currency units, shares, bushels, pounds, or other units specified. Settlement of a derivative is based on the interaction of the notional amount and the underlying. The purchase of the forward contract as a hedge of a forecasted need to purchase wheat meets the criteria above. [666] Gleim #: 5.54 -- Source: Publisher On December 1, 2004, Lombardi Company, a calendar-year-end firm, entered into a derivative contract designed to hedge the risk of cash flows associated with the forecast future sale of 300,000 bushels of wheat. The anticipated sales date is February 1, 2005. The notional amount of the derivative contract is 300,000 bushels, the underlying is the price of the same variety and grade of wheat that Lombardi expects to sell, and the settlement date of the derivative is February 1, 2005. The fair value of the derivative contract on December 31, 2004 increased by $30,000, an amount equal to the decrease in the fair value of the wheat. The fair value of the derivative contract had increased by an additional $25,000 on February 1, 2005, also an amount equal to the decrease in the fair value of the wheat. On February 1, 2005, the wheat was sold and the derivative contract was settled. The gains attributable to the increase in the fair value of the derivative that should be recognized in 2004 and 2005 earnings, respectively, are

2004

2005

A. B.

$30,000 $0

$25,000 $55,000

C. D.

$55,000 $0

$0 $0

Answer (A) is incorrect because given that the hedge was fully effective, the $55,000 gain should be recognized in the period in which the forecasted transaction affects earnings. Answer (B) is correct. A cash flow hedge is a hedge of an exposure to variability in the cash flows of a recognized asset or liability or a forecasted transaction. The accounting treatment of gains and losses arising from changes in fair value of a derivative designated as a cash flow hedge varies for the effective and ineffective portions. The effective portion initially is reported as other comprehensive income. It is reclassified into earnings when the forecasted transaction affects earnings. The ineffective portion is immediately included in earnings. This hedge has no ineffective portion. Given that the sale occurred in 2005, the $30,000 gain in 2004 is recognized as other comprehensive income in 2004. It is reclassified and included in earnings in 2005. Thus, 2005 earnings include the $30,000 reclassified from other comprehensive income and the $25,000 gain attributable to the increase in fair value in 2005. Given that the hedge was fully effective, the $55,000 gain should be recognized in the period in which the forecasted transaction affects earnings. Answer (C) is incorrect because given that the hedge was fully effective, the $55,000 gain should be recognized in the period in which the forecasted transaction affects earnings. Answer (D) is incorrect because given that the hedge was fully effective, the $55,000 gain should be recognized in the period in which the forecasted transaction affects earnings.


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[667] Gleim #: 5.55 -- Source: Publisher At the beginning of period 1, Forecast Corporation enters into a qualifying cash flow hedge of a transaction it expects to occur at the beginning of period 4. Forecast assesses hedge effectiveness by comparing the change in present value (PV) of the expected cash flows associated with the forecasted transaction with all of the hedging derivative’s gain or loss (change in fair value). The change in those cash flows that occurs for any reason has been designated as the hedged risk. The following information about the periodic changes hedging relationship is available:

Period 1 2 3

Change in Fair Value of the Derivative $50,000 47,000 (81,000)

Change in PV of Expected Cash Flows from the Forecasted Transactions $(48,000) (51,000) 80,000

Given that the hedge is effective to the extent it offsets the change in the present value of the expected cash flows on the forecasted transaction, Forecast should

A. B. C. D.

Recognize a loss of $2,000 in earnings for period 1. Report a balance in other comprehensive income (OCI) of $16,000 at the end of period 3. Recognize a gain of $47,000 in earnings for period 2. Record other comprehensive income of $97,000 for period 2. Answer (A) is incorrect because Forecast should recognize earnings for period 1 of $2,000. The increase in fair value of the derivative exceeds the decrease in PV of the cash flows by $2,000. The derivative is adjusted to fair value by a $50,000 debit, OCI is credited for $48,000, and earnings is credited for $2,000. Answer (B) is correct. The effective portion of a cash flow hedge of a forecasted transaction is included in OCI until periods in which the forecasted transaction affects earnings. At the end of period 3, the net change in the hedging derivative’s fair value is $16,000 ($50,000 + $47,000 – $81,000), and the change in the PV of the expected cash flows on the forecasted transaction is $-19,000 ($80,000 – $48,000 – $51,000). Thus, the hedge is effective at the end of period 3 to the extent it offsets $16,000 of the net $19,000 decrease in the cash flows of the forecasted transaction that are expected to occur in period 4. Answer (C) is incorrect because the entry for period 2 is to debit the derivative for $47,000, debit earnings for $2,000, and credit OCI for $49,000 ($50,000 + $47,000 – $48,000 credit in period 1). Answer (D) is incorrect because, at the end of period 2, OCI should have a credit balance of $97,000 (the extent of the hedge’s effectiveness).

[668] Gleim #: 5.56 -- Source: CIA 597 IV-24 An entity has a high fixed-assets turnover ratio. What conclusion can a financial analyst draw from this?

A. B. C. D.

The entity may be overcapitalized. The entity may have a problem with employees converting inventory to personal use. The entity may be undercapitalized. The entity has favorable profitability.


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Answer (A) is incorrect because the ratio may indicate undercapitalization. Answer (B) is incorrect because fluctuations in inventory do not affect fixed-assets turnover. Answer (C) is correct. The fixed-assets turnover ratio equals net sales divided by net fixed assets. A high ratio indicates either that the entity is undercapitalized, that is, it cannot afford to buy enough fixed assets, or that it uses fixed assets efficiently. Answer (D) is incorrect because the fixed-assets turnover ratio is not a profitability indicator. It measures the efficiency of asset management. [669] Gleim #: 5.57 -- Source: CIA 597 IV-31 The times-interest-earned ratio is primarily an indication of

A. B. C. D.

Solvency. Liquidity. Asset management. Profitability. Answer (A) is correct. The times-interest-earned ratio equals net profit before taxes and interest divided by interest. It measures the extent to which operating profit can decline before the entity is unable to meet its annual interest cost. Thus, it is a measure of debt-paying capacity (solvency). Answer (B) is incorrect because liquidity ratios, e.g., the current ratio, indicate the relationship of current assets to current liabilities. Answer (C) is incorrect because asset management ratios indicate how effectively the entity is using its assets. Answer (D) is incorrect because profitability ratios measure operating results.

[670] Gleim #: 5.58 -- Source: CIA 597 IV-27 An entity’s receivables collection period is equal to

A. B. C. D.

The inventory conversion period. The cash conversion cycle. The day’s sales outstanding. The inventory divided by average daily sales. Answer (A) is incorrect because the inventory conversion period (days of inventory) is the average time required to convert materials into finished goods and then to sell them. This process typically occurs before the receivables collection period, and the amount of time in one period does not necessarily bear any relationship to the other. Answer (B) is incorrect because the cash conversion cycle equals the inventory conversion period, plus the receivables collection period, minus the payables deferral period (average time between resource purchases and payment of cash for them). It estimates the time between when the entity makes payments and when it receives cash inflows. Answer (C) is correct. The day’s sales outstanding (days of receivables) may be stated as the accounts receivable balance divided by average credit sales per day or as days in the year divided by the receivables turnover. It is the average time required to convert the entity’s receivables into cash. Thus, it is also called the receivables collection period. Answer (D) is incorrect because the inventory divided by the sales per day is the inventory conversion period (days of inventory).

[671] Gleim #: 5.59 -- Source: CIA 597 IV-35 Which of the following is true about the impact of price inflation on financial ratio analysis?


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A. B. C. D.

Inflation has no impact on financial ratio analysis. Inflation affects financial ratio analysis for one entity over time but not comparative analysis of entities of different ages. Inflation affects financial ratio analysis for one entity over time, as well as comparative analysis of entities of different ages. Inflation affects comparative analysis of entities of different ages but not financial ratio analysis for one entity over time. Answer (A) is incorrect because inflation badly distorts balance sheets, depreciation charges, inventory costs, and profits. Answer (B) is incorrect because inflation affects any financial ratio analysis involving comparisons of prior-period with current-period monetary amounts. Answer (C) is correct. Inflation is the diminution over time of the purchasing power of money. Because balance sheet amounts are expressed in terms of money, historical cost amounts for different periods are measured in units representing different levels of purchasing power. Net profit is also distorted because of inflation’s impact on depreciation expense and inventory costs. Inflation therefore impairs the comparability of financial statement items, whether for the same entity over time or for entities of differing ages. Answer (D) is incorrect because inflation affects any financial ratio analysis involving comparisons of prior-period with current-period monetary amounts.

[672] Gleim #: 5.60 -- Source: CIA 597 IV-37 An investor has been given several financial ratios for an entity but none of the financial reports. Which combination of ratios can be used to derive return on equity?

A. B. C. D.

Market-to-book-value ratio and total-debt-to-total-assets ratio. Price-to-earnings ratio, earnings per share, and net profit margin. Price-to-earnings ratio and return-on-assets ratio. Net profit margin, total assets turnover, and equity multiplier. Answer (A) is incorrect because the market-to-carrying-amount ratio and the total-debt-to-total-assets ratio do not provide any information about net profit available to shareholders. Answer (B) is incorrect because the price-to-earnings ratio, EPS, and the net profit margin do not provide information about the carrying amount of common equity. Answer (C) is incorrect because the price-to-earnings ratio and the return-on-assets ratio do not provide information about the carrying amount of common equity. Answer (D) is correct. The net profit margin equals the net profit available to common shareholders divided by sales, the total assets turnover equals sales divided by total assets, and the product of these two ratios is the return on assets. This result is the basic Du Pont equation. In the extended Du Pont equation, the return on assets is multiplied by the leverage factor, also called the equity multiplier (total assets ÷ common equity at carrying amount). The extended Du Pont equation gives the return on common equity. This result is obtained because the total assets and sales factors cancel in the multiplication of the three ratios.

[673] Gleim #: 5.61 -- Source: CIA 597 IV-38 The following ratios relate to an entity’s financial situation compared with that of its industry:

Return on Assets (ROA) Return on Equity (ROE)

The Company

Industry Average

7.9% 15.2%

9.2% 12.9%

What conclusion could a financial analyst validly draw from these ratios?


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A. B. C. D.

The entity’s product has a high market share, leading to higher profitability. The entity uses more debt than does the average entity in the industry. The entity’s profits are increasing over time. The entity’s shares have a higher market value to carrying amount than does the rest of the industry. Answer (A) is incorrect because the question gave no information about market share. Answer (B) is correct. The use of financial leverage has a multiplier effect on the return on assets. The extended Du Pont formula illustrates this point by showing that the return on equity equals the return on assets times the leverage factor, also called the equity multiplier (total assets ÷ common equity). Thus, greater use of debt increases the equity multiplier and the return on equity. In this example, the equity multiplier is 1.92 (15.2% ROE ÷ 7.9% ROA), and the industry average is 1.40 (12.9% ROE ÷ 9.2% ROA). The higher equity multiplier indicates that the entity uses more debt than the industry average. Answer (C) is incorrect because this comparison is with an industry average, not over time. Answer (D) is incorrect because share valuation is a response to many factors. The higher-than-average return on equity does not mean that the entity has a more favorable market-to-carrying-amount ratio.

[674] Gleim #: 5.62 -- Source: CIA 1196 IV-53 All else being equal, an entity with a higher dividend-payout ratio will have a debt-to-assets ratio and a current ratio.

List A

List B

A. B.

Higher Higher

Higher Lower

C. D.

Lower Lower

Higher Lower

Answer (A) is incorrect because the current ratio will be lower. Answer (B) is correct. An entity with a higher dividend-payout ratio is distributing more of its earnings as dividends to common shareholders. It will have less cash and less total assets than a comparable entity with a lower payout ratio. The debt-to-assets ratio will be higher because total assets are lower, and the current ratio will be lower because cash is lower. Answer (C) is incorrect because the debt-to-assets ratio will be higher and the current ratio will be lower. Answer (D) is incorrect because the debt-to-assets ratio will be higher.


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[675] Gleim #: 5.63 -- Source: CIA 1193 IV-46 The following account balances represent the December 31 balance sheet of an entity. Accounts payable Accounts receivable (net) Accumulated depreciation -- building Accumulated depreciation -- equipment Cash Common shares (10 par value) Deferred income taxes payable (expected to reverse more than one year from now) Equipment Income taxes payable Inventory Land and building Long-term notes payable Financial assets held for trading Notes payable within 1 year Other current liabilities Share premium Prepaid expenses Retained earnings

67,000 115,000 298,500 50,500 27,500 100,000 37,500 136,000 70,000 257,000 752,000 123,000 64,000 54,000 22,500 150,000 27,000 403,500

The quick ratio for this year is

A. B. C. D.

1.42 1.08 0.97 0.82 Answer (A) is incorrect because 1.42 excludes the income taxes payable from the current liabilities. Answer (B) is incorrect because 1.08 includes prepaid expenses in the quick assets and excludes income taxes payable in the current liabilities. Answer (C) is correct. The acid test (quick) ratio equals quick assets (cash, financial assets held for trading, and accounts receivable) divided by current liabilities. Quick assets total 206,500 (27,500 cash + 64,000 financial assets held for trading + 115,000 net accounts receivable). Given current liabilities of 213,500 (67,000 accounts payable + 54,000 current notes payable + 70,000 income taxes payable + 22,500 other current liabilities), the quick ratio is 0.967 (206,500 ÷ 213,500). Answer (D) is incorrect because 0.82 includes deferred income taxes payable in the current liabilities.


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Balance Sheet

Statement of Income and Retained Earnings

Cash Accounts receivable Inventory Net fixed assets Total Accounts payable Long-term debt Share capital Retained earnings

100 200 50 600

Sales Cost of goods sold

3,000 1,600


1,400 970

950


430 30


400 200


200 150 100


250

140 300 260 250

Total

950

[676] Gleim #: 5.64 -- Source: CIA 596 IV-36 (Refers to Fact Pattern #39) The entity has a dividend-payout ratio of

A. B. C. D.

19.6% 28.6% 40.0% 50.0% Answer (A) is incorrect because 19.6% is the ratio of dividends paid to the December 31 carrying amount of common equity. Answer (B) is incorrect because 28.6% is the ratio of dividends paid to the sum of beginning retained earnings and net profit. Answer (C) is incorrect because 40.0% is the ratio of dividends paid to the December 31 retained earnings. Answer (D) is correct. The dividend-payout ratio is the ratio of dividends paid to net profit for the period. Hence, it equals 50.0% (100 dividends ÷ 200 net profit).

[677] Gleim #: 5.65 -- Source: CIA 596 IV-38 (Refers to Fact Pattern #39) The entity has return on assets of

A. B. C. D.

21.1% 39.2% 42.1% 45.3%


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Answer (A) is correct. The return on assets is the ratio of net profit to total assets. It equals 21.1% (200 net profit ÷ 950 total assets). Answer (B) is incorrect because 39.2% is the ratio of net profit to common equity. Answer (C) is incorrect because 42.1% is the ratio of profit before tax to total assets. Answer (D) is incorrect because 45.3% is the ratio of profit before interest and tax to total assets. [678] Gleim #: 5.66 -- Source: CIA 596 IV-40 (Refers to Fact Pattern #39) The entity has a profit margin of

A. B. C. D.

6.67% 13.33% 14.33% 46.67% Answer (A) is correct. The profit margin is the ratio of net profit to sales. It equals 6.67% (200 net profit ÷ 3,000 sales). Answer (B) is incorrect because 13.33% is the ratio of profit before tax to sales. Answer (C) is incorrect because 14.33% is the ratio of profit before interest and taxes to sales. Answer (D) is incorrect because 46.67% is the ratio of gross profit to sales.

[679] Gleim #: 5.67 -- Source: CIA 1195 IV-32 An entity has 100,000 outstanding common shares with a market value of 20 per share. Dividends of 2 per share were paid in the current year, and the entity has a dividend-payout ratio of 40%. The price-to-earnings ratio of the entity is

A. B. C. D.

2.5 4 10 50 Answer (A) is incorrect because 2.5 equals EPS divided by dividends per share. Answer (B) is correct. The P-E ratio equals the share price divided by EPS. If the dividends per share equaled 2 and the dividend-payout ratio was 40%, EPS must have been 5 (2 ÷ .4). Accordingly, the P-E ratio is 4 (20 share price ÷ 5 EPS). Answer (C) is incorrect because 10 equals share price divided by dividends per share. Answer (D) is incorrect because 50 equals price per share divided by the dividend-payout percentage.


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[680] Gleim #: 5.68 -- Source: CIA 1192 IV-52 The following are the January 1 and June 30 balance sheets of an entity: Assets (in millions)

Jan. 1

June 30

Cash Accounts receivable Inventories Fixed assets

3 5 8 10

4 4 10 11

Total assets

26

29

Accounts payable Notes payable Accrued wages Long-term debt Equity

2 4 1 9 10

3 3 2 11 10


26

29

From January 1 to June 30, the net working capital

A. B. C. D.

Decreased by 1 million. Stayed the same. Increased by 1 million. Increased by 2 million. Answer (A) is incorrect because a decrease of 1,000,000 results from omitting inventories. Answer (B) is incorrect because the difference between all assets and all liabilities stayed the same. Answer (C) is correct. Net working capital equals current assets (cash, accounts receivable, inventories for this entity) minus current liabilities (accounts payable, notes payable, accrued wages). From January 1 to June 30, the net working capital increased by 1,000,000 {[(4 + 4 + 10) – (3 + 3 + 2)] – [(3 + 5 + 8) – (2 + 4 + 1)]}. Answer (D) is incorrect because an increase of 2,000,000 results from omitting accrued wages.

[681] Gleim #: 5.69 -- Source: CMA 1296 3-27 Which denominator used in the return on investment (ROI) formula is criticized because it combines the effects of operating decisions made at one organizational level with financing decisions made at another organizational level?

A. B. C. D.

Total assets employed. Equity. Working capital plus other assets. Total assets available.


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Answer (A) is incorrect because it reflects an assumption that the subunit manager does not influence the resource base (denominator of the ROI calculation). Answer (B) is correct. ROI equals income divided by invested capital. The denominator may be defined in various ways, e.g., total assets available, assets employed, working capital plus other assets, and equity. If equity (total assets – total liabilities) is chosen, a portion of long-term liabilities must be allocated to the investment center to determine the manager’s resource base. One problem with this definition of the resource base is that, although it has the advantage of emphasizing return to owners, it reflects decisions at different levels of the entity: short-term liabilities incurred by the responsibility center (operating decisions) and long-term liabilities controlled at the corporate level (long-term financing decisions). Answer (C) is incorrect because working capital plus other assets reflects the assumption that the manager controls short-term credit. However, no corporate-level decision to allocate long-term liabilities to subunits is necessary. Answer (D) is incorrect because it reflects an assumption that the subunit manager does not influence the resource base (denominator of the ROI calculation). [682] Gleim #: 5.70 -- Source: CIA 596 IV-53 A growing entity is assessing current working capital requirements. An average of 58 days is required to convert raw materials into finished goods and to sell them. Then an average of 32 days is required to collect on receivables. If the average time the entity takes to pay for its raw materials is 15 days after they are received, the total cash conversion cycle is

A. B. C. D.

11 days. 41 days. 75 days. 90 days. Answer (A) is incorrect because 11 days results from subtracting the receivables collection period. Answer (B) is incorrect because 41 days results from subtracting the receivables collection period and adding the payables deferral period. Answer (C) is correct. The cash conversion cycle is the length of time between paying for purchases and receiving cash from the sale of finished goods. It equals the inventory conversion period, plus the receivables collection period, minus the payables deferral period, or 75 days (58 days + 32 days – 15 days). Answer (D) is incorrect because 90 days omits the payables deferral period.

[Fact Pattern #40] An entity has a current ratio of 1.4, a quick, or acid test, ratio of 1.2, and the following partial summary balance sheet:

Cash Accounts receivable Inventory Fixed assets Total assets

10 ___ ___ ___ 100

Current liabilities Long-term liabilities Equity Total liabilities and equity

___ 40 30 ___

[683] Gleim #: 5.71 -- Source: CIA 1196 IV-34 (Refers to Fact Pattern #40) The entity has an accounts receivable balance of


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A. B. C. D.

12 26 36 66 Answer (A) is incorrect because 12 equals current assets minus current liabilities. Answer (B) is correct. Total assets equal total liabilities and equity. Hence, if total assets equal 100, total liabilities and equity must equal 100, and current liabilities must equal 30 (100 – 40 – 30). Because the quick ratio equals the quick assets (cash + accounts receivable) divided by current liabilities, the quick assets must equal 36 (30 × 1.2 quick ratio), and the accounts receivable balance is 26 (36 – 10 cash). Answer (C) is incorrect because 36 equals the quick assets. Answer (D) is incorrect because 66 equals the sum of the quick assets and current liabilities.

[684] Gleim #: 5.72 -- Source: CIA 1196 IV-35 (Refers to Fact Pattern #40) The entity has a fixed assets balance of

A. B. C. D.

0 16 58 64 Answer (A) is incorrect because the sum of cash, accounts receivable, and inventory is less than 100. Answer (B) is incorrect because 16 is the result of neglecting to subtract the equity balance when calculating the current liability balance. Answer (C) is correct. Total assets (given as 100) equals the sum of cash (given as 10), accounts receivable (26), inventory, and fixed assets. Inventory can be determined because it is included in current, but not quick, assets, and the current and quick ratios are known. Current assets equal 42 (1.4 current ratio × 30 current liabilities), and the quick assets equal 36 (1.2 quick ratio × 30 current liabilities). Thus, inventory, which is the only difference in this question between current and quick assets, equals 6 (42 – 36). Fixed assets must then equal 58 (100 total assets – 10 cash – 26 accounts receivable – 6 inventory). Answer (D) is incorrect because 64 assumes that inventory is 0.

[685] Gleim #: 5.73 -- Source: Publisher Earnings-per-share data must be reported on the face of the income statement for

Profit or Loss from Continuing Operations

Discontinued Operation

A. B.

Yes Yes

Yes No

C. D.

No No

No Yes


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Answer (A) is incorrect because EPS data must be reported on the face of the income statement for income from continuing operations and net income but not for the effect of an accounting change. Answer (B) is correct. EPS data for profit or loss from continuing operations and profit or loss must be reported on the face of the income statement. EPS data for a discontinued operation may be disclosed on the face of the income statement or in a note. Answer (C) is incorrect because EPS data must be reported on the face of the income statement for income from continuing operations and net income but not for the effect of an accounting change. Answer (D) is incorrect because EPS data must be reported on the face of the income statement for income from continuing operations and net income but not for the effect of an accounting change. [686] Gleim #: 5.74 -- Source: Publisher In computing the loss per share of ordinary shares, cumulative preference dividends not earned should be

A. B. C. D.

Deducted from the loss for the year. Added to the loss for the year. Deducted from income in the year paid. Added to income in the year paid. Answer (A) is incorrect because the effect is to reduce loss per share. Answer (B) is correct. When preference shares are cumulative, the dividend, whether earned or not, is deducted from profit or loss from continuing operations and profit or loss, or added to any loss for the year, in computing earnings or loss. When preference shares are noncumulative, an adjustment is made for dividends declared. If the dividend is cumulative only if earned, no adjustment is necessary except to the extent of available income; that is, the preference dividends accumulate only to the extent of profit or loss. Answer (C) is incorrect because preference dividends are an adjustment when they accumulate. Answer (D) is incorrect because preference dividends are an adjustment when they accumulate.

[687] Gleim #: 5.75 -- Source: CPA 1190 I-52 Snell Co. had 300,000 shares of ordinary shares issued and outstanding at December 31, 2004. No shares were issued during 2005. On January 1, 2005, Snell issued 200,000 shares of nonconvertible preference shares. During 2004, Snell declared and paid 75,000 of cash dividends on the ordinary shares and 60,000 on the preference shares. Profit for the year ended December 31, 2005 was 330,000. What is Snell’s 2003 basic earnings per share?

A. B. C. D.

1.10 0.90 0.85 0.65


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Answer (A) is incorrect because 1.10 assumes no preference dividends were declared. Answer (B) is correct. BEPS is equal to the amount of profit or loss attributable to ordinary equity holders divided by the weighted-average number of ordinary shares outstanding during the year. To calculate the numerator, dividends on cumulative preference shares must be subtracted from profit or loss whether or not the dividends were declared. Earnings per share for 2005 thus amounted to 0.90.

330,000 – 60,000 = 0.90 300,000 Answer (C) is incorrect because 0.85 assumes the ordinary but not the preference dividends were subtracted from the numerator. Answer (D) is incorrect because 0.65 assumes all dividends are subtracted from the numerator. [688] Gleim #: 5.76 -- Source: CMA 1294 2-15 Smith Corporation had profit for the year of 101,504 and a simple capital structure consisting of the following ordinary shares outstanding: Months Outstanding

Number of Shares

January - February March - June July - November December

24,000 29,400 36,000 35,040

Total

124,440

Smith Corporation’s basic earnings per share (rounded to the nearest cent) were

A. B. C. D.

2.90 3.20 3.26 3.45 Answer (A) is incorrect because 2.90 is based on the shares outstanding at year-end. Answer (B) is correct. BEPS equals profit or loss attributable to ordinary equity holders divided by the weightedaverage number of ordinary shares outstanding. The latter is calculated as follows:

24,000 29,400 36,000 35,040

× × × ×

(2 ÷ 12) (4 ÷ 12) (5 ÷ 12) (1 ÷ 12)

= = = =

4,000 9,800 15,000 2,920 31,720

Accordingly, BEPS is 3.20 (101,504 profit ÷ 31,720 shares). Answer (C) is incorrect because 3.26 is based on an unweighted average of the four levels of shares outstanding during the year. Answer (D) is incorrect because 3.45 is based on the shares outstanding March through June.


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[689] Gleim #: 5.77 -- Source: CPA 1186 T-32 In the computation of DEPS, which of the following are potential ordinary shares?

Nonconvertible A.

Preference Shares Yes

Share Options No

B. C.

Yes No

Yes Yes

D.

No

No

Answer (A) is incorrect because nonconvertible instruments do not entitle holders to obtain ordinary shares. However, share call options allow holders to purchase shares under specified conditions. Answer (B) is incorrect because nonconvertible instruments do not entitle holders to obtain ordinary shares. However, share call options allow holders to purchase shares under specified conditions. Answer (C) is correct. Potential ordinary shares are contracts that may entitle holders to obtain ordinary shares. They include options, warrants, convertible preference shares, convertible debt, and contingently issuable shares. Unlike an option, nonconvertible preference shares are never potential ordinary shares. Answer (D) is incorrect because nonconvertible instruments do not entitle holders to obtain ordinary shares. However, share call options allow holders to purchase shares under specified conditions. [690] Gleim #: 5.78 -- Source: CMA 693 2-18 When an entity reports amounts for basic and diluted earnings per share,

A. They should be presented with equal prominence on the face of the income statement. B. They need not be shown on the face of the income statement but must be disclosed in the notes to the financial statements. C. They need to be reported for profit or loss only. D. BEPS should be presented on the face of the income statement. DEPS may be disclosed either on the face of the income statement or in the notes. Answer (A) is correct. A public entity or any entity that discloses EPS must report EPS information on the face of the income statement for both profit or loss from continuing operations and profit or loss. In addition, EPS data for any discontinued operation must be presented on the face of the income statement or in a note. The entity must present BEPS and DEPS with equal prominence. Answer (B) is incorrect because certain EPS amounts must be presented on the face of the income statement. Answer (C) is incorrect because EPS also must be presented for profit or loss from continuing operations and any discontinued operations. Answer (D) is incorrect because BEPS and DEPS are to be presented on the face of the income statement with equal prominence. [691] Gleim #: 5.79 -- Source: CPA 577 T-27 In a diluted earnings-per-share computation, outstanding options issued by the reporting entity are assumed to be exercised. If the exercise price of these options exceeds the average market price, the computation would

A. Fairly present diluted earnings per share on a prospective basis. B. Fairly present the maximum potential dilution of diluted earnings per share on a prospective basis. C. Reflect the excess of the number of shares assumed issued at the average market price over the number of shares assumed issued at the exercise price. D. Be antidilutive.


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Answer (A) is incorrect because, when the exercise price exceeds the average market price, the result is antidilutive. Answer (B) is incorrect because, when the exercise price exceeds the average market price, the result is antidilutive. Answer (C) is incorrect because, if an option is not in the money, it is antidilutive. Answer (D) is correct. Options and warrants (instruments that give the holders the right to purchase ordinary shares of the entity) issued by the reporting entity are assumed to be exercised at the beginning of the period or at time of issuance, if later. The proceeds are assumed to be from an issuance at the average market price for the period. The difference between (1) the shares issued and (2) the shares that would have been issued at the average market price is an issue for no consideration. If the options are in the money (exercise price is less than average market price), they are dilutive because (1) exceeds (2), and the excess will be added to the BEPS denominator. However, when the exercise price exceeds the average market price, the result is antidilutive. [692] Gleim #: 5.80 -- Source: CMA 693 1-3 The trough of a business cycle is generally characterized by

A. B. C. D.

Shortages of essential raw materials and rising costs. Increasing purchasing power and increasing capital investments. Rising costs and an unwillingness to risk new investments. Unused productive capacity and an unwillingness to risk new investments. Answer (A) is incorrect because the trough of a business cycle is characterized by excess resources and a lack of demand-pull inflation; thus, prices are more apt to be stable or decline during the trough. Answer (B) is incorrect because investors are unwilling to risk new investments during the trough. Answer (C) is incorrect because costs ordinarily do not rise during the trough. Answer (D) is correct. There are four phases of a business cycle: trough, recovery, peak, and recession. The trough is marked by low levels of economic activity and underuse of resources. Investors are unwilling to risk new investments in productive capacity.

[693] Gleim #: 5.81 -- Source: CMA 693 1-2 During the recessionary phase of a business cycle,

A. B. C. D.

The purchasing power of money is likely to decline rapidly. The natural rate of unemployment will increase dramatically. Potential national income will exceed actual national income. Actual national income will exceed potential national income. Answer (A) is incorrect because, technically, the purchasing power of money is unrelated to the concept of recession; purchasing power relates to inflation. However, demand-pull inflation is unlikely during a recession. Answer (B) is incorrect because the natural rate of unemployment, which results from the normal workings of the labor market, remains unchanged. Any increase in unemployment will be cyclical, i.e., the amount caused by inadequate aggregate demand. Answer (C) is correct. There are four phases of a business cycle: trough, recovery, peak, and recession. During the recessionary phase of a business cycle, economic activities and employment levels contract and society’s resources are underused. Because of the underuse of resources, potential national income will exceed actual national income. Answer (D) is incorrect because potential income will be greater than actual national income given the existence of idle capacity.


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[694] Gleim #: 5.82 -- Source: CIA 595 IV-55 Which of the following may provide a leading indicator of a future increase in gross domestic product?

A. B. C. D.

A reduction in the money supply. A decrease in the issuance of building permits. An increase in the timeliness of delivery by vendors. An increase in the average hours worked per week of production workers. Answer (A) is incorrect because a falling money supply is associated with falling GDP. Answer (B) is incorrect because a decline in the issuance of building permits signals lower expected building activity and a falling GDP. Answer (C) is incorrect because an increase in the timeliness of delivery by vendors indicates slacking business demand and potentially falling GDP. Answer (D) is correct. An economic indicator is highly correlated with changes in aggregate economic activity. A leading indicator changes prior to a change in the direction of the business cycle. The leading indicators included in the Conference Board’s index are average weekly hours worked by manufacturing workers, unemployment claims, consumer goods orders, stock prices, orders for fixed assets, building permits, timeliness of deliveries, money supply, consumer confidence, and the spread between the yield on 10-year Treasury bonds and the federal funds rate. An increase in weekly hours worked by production workers is favorable for economic growth.

[695] Gleim #: 5.83 -- Source: CIA 597 IV-58 Some economic indicators lead the economy into a recovery or recession, and some lag it. An example of a lag variable is

A. B. C. D.

Chronic unemployment. Orders for consumer and producer goods. Housing starts. Consumer expectations. Answer (A) is correct. Economists use a variety of economic indicators to forecast turns in the business cycle. Economic indicators are variables that in the past have had a high correlation with aggregate economic activity. The best known are the composite indexes calculated by The Conference Board, a private research group with more than 2,700 corporate and other members worldwide. Indicators may lead, lag, or coincide with economic activity. The Conference Board’s lagging indicators include average duration of unemployment in weeks, the change in the index of labor cost per unit of output, the average prime rate charged by banks, the ratio of manufacturing and trade inventories to sales, the commercial and industrial loans outstanding, the ratio of consumer installment credit outstanding to personal income, and the change in the CPI for services. Answer (B) is incorrect because orders for consumer and producer goods are leading indicators. Answer (C) is incorrect because housing starts are leading indicators. Answer (D) is incorrect because consumer expectations are leading indicators.

[696] Gleim #: 5.84 -- Source: Publisher All of the following are stages of the business cycle except

A. B. C. D.

Boom, or peak. Trough. Recovery. Acceleration.


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Answer (A) is incorrect because these are stages in the business cycle. Answer (B) is incorrect because these are stages in the business cycle. Answer (C) is incorrect because these are stages in the business cycle. Answer (D) is correct. A business cycle has four stages: the trough, recovery, peak, and recession. Acceleration is not one of the stages. [697] Gleim #: 5.85 -- Source: IIA, adapted During the growth stage of a product’s life cycle:

A. B. C. D.

The quality of products is poor. New product models and features are introduced. There is little difference between competing products. The quality of the products becomes more variable and products are less differentiated. Answer (A) is incorrect because poor product quality is evident during the introduction stage of the product life cycle. Answer (B) is correct. In the growth stage, sales and profits increase rapidly, cost per customer decreases, customers are early adopters, new competitors enter an expanding market, new product models and features are introduced, and promotion spending declines or remains stable. The firm enters new market segments and distribution channels and attempts to build brand loyalty and achieve the maximum share of the market. Thus, prices are set to penetrate the market, distribution channels are extended, and the mass market is targeted through advertising. The strategy is to advance by these means and by achieving economies of productive scale. Answer (C) is incorrect because competitors are most numerous and products become less differentiated during the maturity stage of the product life cycle. In this stage, imitators have entered the market and competitors have learned which technologies and features are successful. Answer (D) is incorrect because the quality of the products becomes more variable and products are less differentiated during the decline stage of the product life cycle.

[698] Gleim #: 5.86 -- Source: IIA, adapted In a product’s life cycle, the first symptom of the decline stage is a decline in the

A. B. C. D.

Firm’s inventory levels. Product’s sales. Product’s production cost. Product’s prices. Answer (A) is incorrect because a decline in the firm’s purchases, resulting in a decline in the firm’s inventory levels, is not the first symptom. It will occur only when production declines as a result of a drop in sales. Answer (B) is correct. The sales of most product types and brands eventually decrease permanently. This decline may be slow or rapid. This first symptom of the decline stage of a product’s life cycle triggers such other effects as price cutting, narrowing of the product line, and reduction in promotion budgets. Answer (C) is incorrect because a decline in production costs may be due to many factors, e.g., new plant technology or the increased availability of raw materials. Moreover, production costs may decrease in any stage of a product’s life cycle and not specifically in the decline stage. Answer (D) is incorrect because a change in prices is a marketing decision. It is an action that may be taken in the maturity stage to compete in the market. Moreover, a decrease in the product’s prices is a response to a permanent decline in sales.


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[699] Gleim #: 5.87 -- Source: IIA, adapted At the introduction stage of an innovative product, the profit growth is normally slow due to

A. B. C. D.

Expensive sales promotion. High competition. A mass market. Available alternatives. Answer (A) is correct. The introduction stage is characterized by slow sales growth and lack of profits because of the high expenses of promotion and selective distribution to generate awareness of the product and encourage customers to try it. Thus, the per-customer cost is high. Competitors are few, basic versions of the product are produced, and higherincome customers (innovators) are usually targeted. Cost-plus prices are charged. They may initially be high to permit cost recovery when unit sales are low. The strategy is to infiltrate the market, plan for financing to cope with losses, build supplier relations, increase production and marketing efforts, and plan for competition. Answer (B) is incorrect because, during the introduction stage, little competition exists. Competitors tend not to enter the market until they have greater assurance of profits. Answer (C) is incorrect because no mass market is available during the introduction stage. Answer (D) is incorrect because, by definition, not many alternatives are available during the introduction stage of an innovative product.

[700] Gleim #: 5.88 -- Source: IIA, adapted While auditing a marketing department, the internal auditor discovered that the product life cycle model was used to structure the marketing mix. Under such a philosophy, the price charged on a consistent basis for a specific product would probably be lowest during which life cycle stage?

A. B. C. D.

Introduction stage. Growth stage. Maturity stage. Decline stage. Answer (A) is incorrect because, during the introduction stage, per-unit costs of production are high and little competition exists. Hence, prices are at their highest. Answer (B) is incorrect because, during the growth stage, prices will be lower than during the introduction stage, but not as low as during the maturity stage. In the growth stage, costs are dropping and competitors are being added, but costs are not at their minimum and competitors are not at their maximum. Answer (C) is correct. During the maturity stage, competition is at its greatest and costs are at their lowest. Moreover, firms are engaged in competitive price-cutting measures, resulting in some of the lowest prices seen during a product’s life cycle. Answer (D) is incorrect because, during the decline stage, price-cutting predominates as firms struggle to maintain sales volume in the face of a permanent decrease in demand. However, late in the decline stage, there are few competitors, so prices can be raised. In addition, per-unit costs are on the rise because volume is declining, resulting in higher prices.

[701] Gleim #: 5.89 -- Source: IIA, adapted While auditing a marketing department, the internal auditor discovered that the product life cycle model was used to structure the marketing mix. Under such a philosophy, the opportunity for cost reductions would be greatest in which stage of the life cycle?


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A. B. C. D.

Introduction stage. Growth stage. Maturity stage. Decline stage. Answer (A) is incorrect because production volume is low during the introduction stage. Although costs are also high during this period, low volume reduces the opportunities for cost reductions. Answer (B) is correct. During the growth stage, the opportunity for cost reductions is at its maximum because production volume is increasing at a high rate. Thus, fixed costs are being spread over more units of production, and the benefits of the learning curve are being realized. Answer (C) is incorrect because production volume changes little during the maturity stage. The result is less opportunity for cost reductions. Answer (D) is incorrect because costs per unit typically rise during the decline stage as production volume declines.

[702] Gleim #: 5.90 -- Source: IIA, adapted While auditing a marketing department, the internal auditor discovered that the product life cycle model was used to structure the marketing mix. The manager has asked the auditor for advice about increasing advertising of various products. During which stage of the life cycle would it be appropriate to advertise that the company’s product is the lowest price and best quality of all competitors?

A. B. C. D.

Introduction stage. Growth stage. Maturity stage. Decline stage. Answer (A) is incorrect because few competitors exist during the introduction stage, and quality is sometimes poor. Answer (B) is incorrect because buyers are less concerned with price and quality during the growth stage than in the maturity stage. Answer (C) is correct. The maturity stage is the ideal time for advertising lower prices and superior quality because this is the period during a product’s life when competition is greatest. Due to the availability of many substitutes, a firm has reasons to set itself apart. Because price and quality are both concerns of customers during the maturity stage, it is an ideal time for the firm to differentiate its product by advertising low prices and higher quality. Answer (D) is incorrect because few competitors exist during the decline stage. Moreover, prices may rise late in the decline stage for the remaining firms as per-unit costs increase.

[703] Gleim #: 5.91 -- Source: CIA 597 III-20 Faced with 3 years of steadily decreasing profits despite increased sales and a growing economy, which of the following is the healthiest course of action for a chief executive officer to take?

A. Set a turnaround goal of significantly increasing profits within 2 months. Set clear short-term objectives for each operating unit that, together, should produce the turnaround. B. Reduce staff by 10% in every unit. C. Classify all job functions as either (a) adding value in the eyes of the customer (such as production and sales) or (b) not adding value in the eyes of the customer (such as accounting and human resources). Reduce staff in the non-valueadding functions by 20%. D. Implement a plan to encourage innovation at all levels. Use early retirement and reemployment programs to trim staff size.


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Answer (A) is incorrect because this response illustrates two of the characteristics of organizational decline: increased centralization of decision making and lack of long-term planning. The exclusive emphasis on short-term results is likely to be counterproductive. Answer (B) is incorrect because another characteristic of organizational decline is nonprioritized downsizing. By itself, downsizing rarely turns a company around. Answer (C) is incorrect because reducing staff disproportionately in control functions could have disastrous consequences. Answer (D) is correct. Organizational decline has been found to have the following characteristics: greater centralization, lack of long-term planning, reduced innovation, scapegoating, resistance to change, high turnover of competent leaders, low morale, nonprioritized downsizing, and conflict. Reversing these characteristics is the key to reversing organizational decline, for example, by encouraging innovation in all aspects of the organization’s activities and by redeploying personnel. [704] Gleim #: 5.92 -- Source: CIA 1196 IV-51 In which stage of a firm’s development is it most likely to seek and obtain external equity financing in the form of venture capital?

A. B. C. D.

Formation. Rapid growth. Growth to maturity. Maturity and industry decline. Answer (A) is incorrect because, during the formation stage, personal savings, trade credit, and government agencies are the main sources of financing. Prior to demonstrating initial success, a firm is not likely to attract venture capital financing easily. Answer (B) is correct. At the rapid growth stage, if a company is reasonably profitable, it will experience financing needs in excess of funds available either internally or from trade credit or bank credit. Additional debt financing often results in an unreasonable amount of financial leverage at this stage, and public equity financing ordinarily is not yet available. Hence, a rapidly growing firm is most likely to seek and obtain venture capital financing. Answer (C) is incorrect because, in the growth to maturity stage of development, the firm is able to access formal markets for debt and equity. It has a record of success and a better balance between cash inflows and outflows than in the rapid growth stage. Formal capital markets provide financing at lower cost than venture capitalists, so venture capital is not likely to be sought at this stage. Answer (D) is incorrect because the decline phase is characterized by more than adequate cash flows, relative to available investment opportunities, so venture capital is not likely to be sought at this stage of development.

[705] Gleim #: 5.93 -- Source: CIA 1196 IV-45 A company is arranging debt financing for the purchase of a new piece of equipment that has a 5-year expected useful life. Which of the following alternative financing arrangements has the lowest effective annual percentage rate if each has a quoted nominal rate of 9.5%?

A. B. C. D.

A 5-year term loan with interest compounded annually. A 10-year term loan with interest compounded semiannually. A 5-year term loan with interest compounded quarterly. A 10-year term loan with interest compounded monthly.


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Answer (A) is correct. For any given quoted nominal rate, the least frequent compounding is associated with the lowest effective annual percentage cost. Annual compounding is less frequent than semiannual, quarterly, or monthly. The term of the loan is not relevant to the calculation of the effective annual percentage cost of financing. Answer (B) is incorrect because, the more frequent the interest compounding, the more costly the loan. Semiannual, quarterly, and monthly compounding are all more frequent than annual compounding. Answer (C) is incorrect because, the more frequent the interest compounding, the more costly the loan. Semiannual, quarterly, and monthly compounding are all more frequent than annual compounding. Answer (D) is incorrect because, the more frequent the interest compounding, the more costly the loan. Semiannual, quarterly, and monthly compounding are all more frequent than annual compounding. [706] Gleim #: 5.94 -- Source: CIA 1195 IV-65 Which of the following financial instruments can be traded in international money markets?

A. B. C. D.

Mortgages. Preferred shares. U.S. Treasury bills. U.S. Treasury bonds. Answer (A) is incorrect because mortgages are long-term, capital market securities. Answer (B) is incorrect because preferred shares are long-term, capital market securities. Answer (C) is correct. Funds are borrowed or lent for short periods (less than one year) in money markets. Examples of instruments traded in money markets are U.S. Treasury bills, bankers’ acceptances, commercial paper, negotiable certificates of deposit, money market mutual funds, Eurodollar market time deposits, and consumer credit loans. Capital markets trade shares and long-term debt. Answer (D) is incorrect because U.S. Treasury bonds are long-term, capital market securities.

[707] Gleim #: 5.95 -- Source: CMA 689 1-13 Short-term, unsecured promissory notes issued by large firms are known as

A. B. C. D.

Agency securities. Bankers acceptances. Commercial paper. Repurchase agreements. Answer (A) is incorrect because an agency security is issued by a corporation or agency created by a government. Examples are government securities issued by the bodies that finance mortgages, such as the Federal National Mortgage Association (Fannie Mae) in the U.S. Answer (B) is incorrect because bankers’ acceptances are drafts drawn on deposits at a bank. The acceptance by the bank guarantees payment at maturity. They are normally used to finance a specific transaction. Answer (C) is correct. Commercial paper is the term for the short-term (typically less than 9 months), unsecured, large denomination (often over $100,000) promissory notes issued by large, creditworthy companies to other companies and institutional investors. In many instances, the maturity date is only a few days after issuance. Answer (D) is incorrect because a repurchase agreement involves a secured loan to a government securities dealer. It allows the buyer to retain interest income although the seller-dealer can repurchase after a specified time.


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[708] Gleim #: 5.96 -- Source: CIA 1191 IV-58 A firm must select from among several methods of financing arrangements when meeting its capital requirements. To acquire additional growth capital while attempting to maximize earnings per share, a firm should normally

A. Attempt to increase both debt and equity in equal proportions, which preserves a stable capital structure and maintains investor confidence. B. Select debt over equity initially, even though increased debt is accompanied by interest costs and a degree of risk. C. Select equity over debt initially, which minimizes risk and avoids interest costs. D. Discontinue dividends and use current cash flow, which avoids the cost and risk of increased debt and the dilution of EPS through increased equity. Answer (A) is incorrect because EPS is not a function of investor confidence and is not maximized by concurrent proportional increases in both debt and equity. EPS are usually higher if debt is used instead of equity to raise capital, at least initially. Answer (B) is correct. Earnings per share will ordinarily be higher if debt is used to raise capital instead of equity, provided that the firm is not over-leveraged. The reason is that the cost of debt is lower than the cost of equity because interest is tax deductible. However, the prospect of higher EPS is accompanied by greater risk to the firm resulting from required interest costs, creditors’ liens on the firm’s assets, and the possibility of a proportionately lower EPS if sales volume fails to meet projections. Answer (C) is incorrect because equity capital is initially more costly than debt. Answer (D) is incorrect because using only current cash flow to raise capital is usually too conservative an approach for a growth-oriented firm. Management is expected to be willing to take acceptable risks to be competitive and attain an acceptable rate of growth. [709] Gleim #: 5.97 -- Source: CIA 596 IV-51 The marginal cost of capital (MCC) curve for this company rises twice, first when the company has raised $75 million and again when $175 million of new funds has been raised. These increases in the MCC are caused by

A. B. C. D.

Increases in the returns on the additional investments undertaken. Decreases in the returns on the additional investments undertaken. Decreases in the cost of at least one of the financing sources. Increases in the cost of at least one of the financing sources. Answer (A) is incorrect because financing costs do not depend on rates of return on investment. Answer (B) is incorrect because financing costs do not depend on rates of return on investment. Answer (C) is incorrect because as additional funds are raised, an increase in the cost of a source of financing, not a decrease, will result in an increase in the MCC. Answer (D) is correct. The MCC is a weighted average of the costs of the different financing sources. If the cost of any source of financing increases, the MCC curve will rise. The MCC curve is upward sloping because the lowest cost financing sources are assumed to be used first. Thus, as cumulative debt increases, the cost of debt also increases.

[710] Gleim #: 5.98 -- Source: CMA 692 1-26 RLF Corporation had income before taxes of $60,000 for the year. Included in this amount were depreciation of $5,000, a charge of $6,000 for the amortization of bond discounts, and $4,000 for interest expense. The estimated cash flow for the period is


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A. B. C. D.

$60,000. $66,000. $49,000. $71,000. Answer (A) is incorrect because the cash flow for the period is greater than net income given noncash expenses in the form of depreciation and bond discount amortization. Answer (B) is incorrect because $66,000 does not reflect the noncash expense for depreciation. Answer (C) is incorrect because the $5,000 of depreciation and the $6,000 for amortization should be added back to, not subtracted from, income. Answer (D) is correct. To determine cash flow for the period, all noncash expenses should be added back to net income. Adding the $5,000 of depreciation and the $6,000 of discount amortization to the $60,000 of net income produces a cash flow of $71,000.

[711] Gleim #: 5.99 -- Source: CMA 1295 1-8 Shown below is a forecast of sales for Cooper Inc. for the first 4 months of the year (all amounts are in thousands of dollars). January Cash sales Sales on credit

$ 15 100

February

March

April

$ 24 120

$18 90

$14 70

On average, 50% of credit sales are paid for in the month of sale, 30% in the month following the sale, and the remainder is paid 2 months after the month of sale. Assuming there are no bad debts, the expected cash inflow for Cooper in March is

A. B. C. D.

$138,000 $122,000 $119,000 $108,000 Answer (A) is incorrect because $138,000 equals the sum of February credit sales and March cash sales. Answer (B) is incorrect because $122,000 equals 50% of January credit sales, 30% of February credit sales, 20% of March credit sales, and 100% of March cash sales. Answer (C) is correct. Cash inflows for March would consist of 50% of March credit sales (50% × $90 = $45), plus 30% of February credit sales (30% × $120 = $36), plus 20% of January credit sales (20% × $100 = $20), plus cash sales for March of $18. Consequently, total collections equal $119,000. Answer (D) is incorrect because $108,000 is the total sales for March, not the total cash collections for March.

[712] Gleim #: 5.100 -- Source: CMA 696 1-12 A firm has daily cash receipts of $100,000 and collection time of 2 days. A bank has offered to reduce the collection time on the firm’s deposits by 2 days for a monthly fee of $500. If money market rates are expected to average 6% during the year, the net annual benefit (loss) from having this service is

A. B. C. D.

$3,000 $12,000 $0 $6,000


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Answer (A) is incorrect because $3,000 miscalculates the annual service charge. Answer (B) is incorrect because $12,000 fails to deduct the annual service charge from the interest earned. Answer (C) is incorrect because $0 results from figuring the interest earned for only one day, not two. Answer (D) is correct. If collection time is 2 days, and average daily receipts are $100,000, the average cash balance will increase by $200,000 if the bank’s system is adopted. At a 6% interest rate, $200,000 will generate $12,000 of interest revenue annually. The $500 monthly charge by the bank will result in an annual expense of $6,000. Thus, the net annual benefit is $6,000 ($12,000 – $6,000). [713] Gleim #: 5.101 -- Source: CMA 697 1-15 The treasury analyst for Garth Manufacturing has estimated the cash flows for the first half of next year (ignoring any shortterm borrowings) as follows. Cash (millions)

January February March April May June

Inflows

Outflows

$2 2 2 2 4 5

$1 4 5 3 2 3

Garth has a line of credit of up to $4 million on which it pays interest monthly at a rate of 1% of the amount utilized. Garth is expected to have a cash balance of $2 million on January 1 and no amount utilized on its line of credit. Assuming all cash flows occur at the end of the month, approximately how much will Garth pay in interest during the first half of the year?

A. B. C. D.

Zero. $61,000 $80,000 $132,000 Answer (A) is incorrect because interest must be paid monthly when the credit line is used in April, May, and June. Answer (B) is correct. The sum of the beginning balance and inflows exceeds the outflows for the first 2 months. At the end of March, however, Garth must use $2,000,000 of its line of credit ($2,000,000 beginning balance + $6,000,000 inflows – $10,000,000 outflows). Thus, interest for April is $20,000 (1% × $2,000,000). The net cash outflow for April (ignoring short-term borrowings) is $1,000,000 of an additional $1,000,000 of the line of credit. However, the $20,000 of interest for April must also be paid, so the amount of the line of credit used in May is $3,020,000 ($2,000,000 + $1,000,000 + $20,000). Interest for May is therefore $30,200 (1% × $3,020,000). Given the net cash inflow for May of $2,000,000 (again ignoring short-term borrowings) and the borrowing of $30,200 to pay the interest for May, the amount of the line of credit used in June is $1,050,200. Interest in June is $10,502 (1% × $1,050,200), and total interest is $60,702 ($20,000 + $30,200 + $10,502). Consequently, the closest answer is $61,000. Answer (C) is incorrect because the company would repay the credit line at the end of months with a positive cash flow. Answer (D) is incorrect because the company would repay the credit line at the end of months with a positive cash flow.


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[714] Gleim #: 5.102 -- Source: CMA 697 1-20 Kemple is a newly established janitorial firm, and the owner is deciding what type of checking account to open. Kemple is planning to keep a $500 minimum balance in the account for emergencies and plans to write roughly 80 checks per month. The bank charges $10 per month plus a $0.10 per check charge for a standard business checking account with no minimum balance. Kemple also has the option of a premium business checking account that requires a $2,500 minimum balance but has no monthly fees or per check charges. If Kemple’s cost of funds is 10%, which account should Kemple choose?

A. B. C. D.

Standard account, because the savings is $34 per year. Premium account, because the savings is $34 per year. Standard account, because the savings is $16 per year. Premium account, because the savings is $16 per year. Answer (A) is incorrect because the relevant cost of the minimum premium account deposit is based on the $2,000 incremental deposit, not the full $2,500. Answer (B) is incorrect because the savings on the premium account is $16. Answer (C) is incorrect because the savings on the premium account is $16. Answer (D) is correct. The standard account will cost $10 per month plus $8 in check charges ($.10 x 80 checks), for a total of $18 per month or $216 per year. The premium account has no check charges, but it will require the depositor to maintain a balance of $2,000 more than desired. At a 10% cost of capital, the incremental $2,000 minimum deposit will cost $200 per year. Thus, the premium account should be selected because it is cheaper by $16 per year.

[715] Gleim #: 5.103 -- Source: CMA 697 1-13 Newman Products has received proposals from several banks to establish a lockbox system to speed up receipts. Newman receives an average of 700 checks per day averaging $1,800 each, and its cost of short-term funds is 7% per year. Assuming that all proposals will produce equivalent processing results and using a 360-day year, which one of the following proposals is optimal for Newman?

A. B. C. D.

A $0.50 fee per check. A flat fee of $125,000 per year. A fee of 0.03% of the amount collected. A compensating balance of $1,750,000. Answer (A) is incorrect because the annual cost is $126,000. Answer (B) is incorrect because the annual cost is $125,000. Answer (C) is incorrect because the annual cost is $136,080. Answer (D) is correct. Multiplying 700 checks times 360 days results in a total of 252,000 checks per year. Accordingly, under (A), total annual cost is $126,000 ($.50 × 252,000), which is less desirable than the $125,000 flat fee in (B). Given that the annual collections equal $453,600,000 ($1,800 × 700 × 360), (C) is also less desirable because the annual fee would be $136,080 (.03% × $453,600,000). The best option is therefore to maintain a compensating balance of $1,750,000 when the cost of funds is 7%, resulting in a total cost of $122,500 (.07 × $1,750,000).

[716] Gleim #: 5.104 -- Source: Publisher A firm has daily cash receipts of $300,000 and is interested in acquiring a lockbox service in order to reduce collection time. Bank 1’s lockbox service costs $3,000 per month and will reduce collection time by 3 days. Bank 2’s lockbox service costs $5,000 per month and will reduce collection time by 4 days. Bank 3’s lockbox service costs $500 per month and will reduce collection time by 1 day. Bank 4’s lockbox service costs $1,000 per month and will reduce collection time by 2 days. If money market rates are expected to average 6% during the year, and the firm wishes to maximize income, which bank should the firm choose?


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A. B. C. D.

Bank 1. Bank 2. Bank 3. Bank 4. Answer (A) is incorrect because Bank 1 will increase the firm’s income by only $18,000. Answer (B) is incorrect because Bank 2 will increase the firm’s income by only $12,000. Answer (C) is incorrect because Bank 3 will increase the firm’s income by only $12,000. Answer (D) is correct. Because collections made using Bank 4’s lockbox service will be accelerated by 2 days at a rate of $300,000 per day, the firm will have an additional $600,000 to invest. At a rate of 6%, the interest earned will be $36,000 per year. However, the bank will charge $12,000 (12 months × $1,000 per month) for its services. Thus, the firm will gain $24,000 ($36,000 – $12,000).

[717] Gleim #: 5.105 -- Source: Publisher If the average age of inventory is 60 days, the average age of the accounts payable is 30 days, and the average age of accounts receivable is 45 days, the number of days in the cash flow cycle is

A. B. C. D.

135 days. 90 days. 75 days. 105 days. Answer (A) is incorrect because the age of payables should be deducted from the sum of the other items. Answer (B) is incorrect because the payables are not added to the inventory period. They are deducted. Answer (C) is correct. The cash flow cycle begins when the firm pays for merchandise it has purchased and ends when the firm receives cash from the sale of the merchandise. Inventory is held for an average of 60 days prior to sale, but the average age of accounts payable is 30 days. Consequently, the average time between outlay and sale is 30 days. Receivables are collected an average of 45 days after sale, so the length of the cash flow cycle is 75 days (30 + 45). Answer (D) is incorrect because 105 days equals the sum of the inventory cycle and the receivables cycle.

[Fact Pattern #41] CyberAge Outlet, a relatively new store, is a cafe that offers customers the opportunity to browse the Internet or play computer games at their tables while they drink coffee. The customer pays a fee based on the amount of time spent signed on to the computer. The store also sells books, tee-shirts, and computer accessories. CyberAge has been paying all of its bills on the last day of the payment period, thus forfeiting all supplier discounts. Shown below are data on CyberAge’s two major vendors, including average monthly purchases and credit terms.

Vendor

Average Monthly Purchases

Credit Terms

Web Master Softidee

$25,000 50,000

2/10, net 30 5/10, net 90


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[718] Gleim #: 5.106 -- Source: CMA 1296 1-10 (Refers to Fact Pattern #41) Assuming a 360-day year and that CyberAge continues paying on the last day of the credit period, the company’s weightedaverage annual interest rate for trade credit (ignoring the effects of compounding) for these two vendors is

A. B. C. D.

27.0% 25.2% 28.0% 30.2% Answer (A) is incorrect because 27.0% is based on weights of $25,000 and $50,000. Answer (B) is correct. If the company pays Web Master within 10 days, it will save $500 (2% × $25,000). Thus, the company is effectively paying $500 to retain $24,500 ($25,000 – $500) for 20 days (30 – 10). The annualized interest rate on this borrowing is 36.7346% [($500 ÷ $24,500) × (360 days ÷ 20 days)]. Similarly, the company is, in effect, paying Softidee $2,500 (5% × $50,000) to hold $47,500 ($50,000 – $2,500) for 80 days (90 – 10). The annualized rate on this borrowing is 23.6842% [($2,500 ÷ $47,500) × (360 days/80 days)]. The average amount borrowed from Web Master is $16,333.33 [1 month × $24,500 × (20 days ÷ 30 days)], and the average amount borrowed from Softidee is $126,666.67 [3 months × $47,500 × (80 days ÷ 90 days)]. Thus, the weighted average of these two rates based on average borrowings is 25.2% {[36.7346% × $16,333.33) + (23.6842% × $126,666.67)] ÷ ($16,333.33 + $126,666.67)}. This calculation, however, understates the true cost of not taking the discount because it does not consider the effects of compounding. Answer (C) is incorrect because 28.0% is based on weights of $24,500 and $47,500. Answer (D) is incorrect because 30.2% is an unweighted average of the two interest rates.

[719] Gleim #: 5.107 -- Source: CMA 1296 1-11 (Refers to Fact Pattern #41) Should CyberAge use trade credit and continue paying at the end of the credit period?

A. B. C. D.

Yes, if the cost of alternative short-term financing is less. Yes, if the firm’s weighted-average cost of capital is equal to its weighted-average cost of trade credit. No, if the cost of alternative long-term financing is greater. Yes, if the cost of alternative short-term financing is greater.


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Answer (A) is incorrect because the company should continue the current practice unless alternative short-term financing is available at a lower rate. Answer (B) is incorrect because the weighted-average cost of capital is usually a concern in capital budgeting and is not as important in the decision process as the marginal cost of capital. Furthermore, trade credit is just one element in the firm’s financing structure. An optimal mix of financing sources may require that trade credit be obtained at less than the weightedaverage cost of capital. Answer (C) is incorrect because the company should maintain its current practice if the cost of alternative long-term financing is higher. Answer (D) is correct. The company is currently paying an annual rate of 25.2% (as determined below) to obtain trade credit and pay at the end of the credit period. This policy should be continued if trade credit is the only source of financing, or if other sources are available only at a higher rate. The annual rate is determined as follows: If the company pays Web Master within 10 days, it will save $500 (2% × $25,000). Thus, the company is effectively paying $500 to retain $24,500 ($25,000 – $500) for 20 days (30 – 10). The annualized interest rate on this borrowing is 36.7346% [($500 ÷ $24,500) × (360 days ÷ 20 days)]. Similarly, the company is, in effect, paying Softidee $2,500 (5% × $50,000) to hold $47,500 ($50,000 – $2,500) for 80 days (90 – 10). The annualized rate on this borrowing is 23.6842% [($2,500 ÷ $47,500) × (360 days ÷ 80 days)]. The average amount borrowed from Web Master is $16,333.33 [1 month × $24,500 × (20 days ÷ 30 days)], and the average amount borrowed from Softidee is $126,666.67 [3 months × $47,500 × (80 days ÷ 90 days)]. Thus, the weighted average of these two rates based on average borrowings is 25.2% {[36.7346% × $16,333.33) + (23.6842% × $126,666.67)] ÷ ($16,333.33 + $126,666.67)}. [720] Gleim #: 5.108 -- Source: CMA 1294 1-17 Troy Toys is a retailer operating in several cities. The individual store managers deposit daily collections at a local bank in a non-interest bearing checking account. Twice per week, the local bank issues a depository transfer check (DTC) to the central bank at headquarters. The controller of the company is considering using a wire transfer instead. The additional cost of each transfer would be $25; collections would be accelerated by 2 days; and the annual interest rate paid by the central bank is 7.2% (0.02% per day). At what amount of dollars transferred would it be economically feasible to use a wire transfer instead of the DTC? Assume a 360-day year.

A. B. C. D.

It would never be economically feasible. $125,000 or above. Any amount greater than $173. Any amount greater than $62,500. Answer (A) is incorrect because the $25 transfer fee is covered by the interest on $62,500 for 2 days. Answer (B) is incorrect because $125,000 is required if collections are accelerated by only one day. Answer (C) is incorrect because the interest on $173 for 2 days is less than $.07. Answer (D) is correct. Given a $25 fee and an interest rate of 0.02% per day for 2 days, the breakeven amount is $62,500 [$25 transfer fee ÷ (2 × .02% interest rate)]. Thus, the interest earned on a transfer of any amount greater than $62,500 would exceed the $25 fee.

[721] Gleim #: 5.109 -- Source: CMA 1296 1-5 A working capital technique that increases the payable float and therefore delays the outflow of cash is

A. B. C. D.

Concentration banking. A draft. Electronic Data Interchange (EDI). A lockbox system.


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Answer (A) is incorrect because concentration banking, a lockbox system, and the use of a local post office box are techniques used to accelerate cash receipts. Answer (B) is correct. Payment by draft, a three-party instrument in which the drawer orders the drawee to pay money to the payee, is a means of slowing cash outflows. A check is the most common type of draft. Check float arises from the delay between an expenditure and the clearing of the check through the banking system. Answer (C) is incorrect because EDI is the communication of electronic documents directly from a computer in one entity to a computer in another entity. Thus, EDI expedites cash payments. The payee receives the money almost instantaneously. Answer (D) is incorrect because concentration banking, a lockbox system, and the use of a local post office box are techniques used to accelerate cash receipts. [722] Gleim #: 5.110 -- Source: CMA 688 1-13 A compensating balance

A. B. C. D.

Compensates a financial institution for services rendered by providing it with deposits of funds. Is used to compensate for possible losses on a marketable securities portfolio. Is a level of inventory held to compensate for variations in usage rate and lead time. Is the amount of prepaid interest on a loan. Answer (A) is correct. Banks sometimes require a borrower to keep a certain percentage of the face amount of a loan in a noninterest-bearing checking account. This requirement raises the effective rate of interest paid by the borrower. This greater rate compensates a bank for services provided and results in greater profitability for the financial institution. Funds kept as a compensating balance can often be withdrawn if a certain average balance is maintained. Answer (B) is incorrect because, in financial accounting, a valuation allowance is used to reflect losses on marketable securities. Answer (C) is incorrect because safety stock is held for such purposes. Answer (D) is incorrect because interest deducted in advance is discount interest.

[723] Gleim #: 5.111 -- Source: CMA 697 1-19 Hagar Company’s bank requires a compensating balance of 20% on a $100,000 loan. If the stated interest on the loan is 7%, what is the effective cost of the loan?

A. B. C. D.

5.83% 7.00% 8.40% 8.75% Answer (A) is incorrect because the borrower has access to less, not more, than the face amount of the loan. Answer (B) is incorrect because the effective rate is higher than the contract rate as a result of the compensating balance requirement. Answer (C) is incorrect because 8.40% is 120% of the contract rate. Answer (D) is correct. Interest on the loan is $7,000 (7% × $100,000). Given that the borrower has to maintain a 20% compensating balance, only $80,000 [$100,000 – (20% × $100,000)] is available for use. Thus, the company is paying $7,000 for the use of $80,000 in funds at an effective cost of 8.75% ($7,000 ÷ $80,000).


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[724] Gleim #: 5.112 -- Source: CMA 696 1-10 A company uses the following formula in determining its optimal level of cash.

If: b = fixed cost per transaction i = interest rate on marketable securities T = total demand for cash over a period of time

This formula is a modification of the economic order quantity (EOQ) formula used for inventory management. Assume that the fixed cost of selling marketable securities is $10 per transaction and the interest rate on marketable securities is 6% per year. The company estimates that it will make cash payments of $12,000 over a one-month period. What is the average cash balance (rounded to the nearest dollar)?

A. B. C. D.

$1,000 $2,000 $3,464 $6,928 Answer (A) is incorrect because $1,000 results from using 24% in the denominator. Answer (B) is incorrect because $2,000 results from using 6% in the denominator. Answer (C) is correct. The EOQ for inventory is a function of ordering cost per order, inventory demand, and carrying cost. In the cash model, the fixed cost per sale of securities is equivalent to the ordering cost, the demand for cash is similar to the demand for inventory, and the interest rate is effectively the cost of carrying a dollar of cash for the period. Substituting in the formula yields an optimal cash balance of about $6,928. Thus, the average cash balance is $3,464 ($6,928 ÷ 2).

Answer (D) is incorrect because $6,928 is the optimal cash balance. [725] Gleim #: 5.113 -- Source: Publisher Which of the following models is essentially an application to cash management of the inventory economic order quantity (EOQ) formula?

A. B. C. D.

Miller-Orr cash management model. Baumol cash management model. Altman’s Z-Score model. Arbitrage pricing model.


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Answer (A) is incorrect because the Miller-Orr cash management model is not deterministic, but simply provides a range in which marketable securities will not be transacted. Answer (B) is correct. The Baumol cash management model is essentially the inventory EOQ model in that it minimizes the total of fixed trading costs and cash carrying costs. It is a deterministic model in the same way that the EOQ model is deterministic. Answer (C) is incorrect because Altman’s Z-Score is a means of forecasting a firm’s future solvency by adding the weighted amounts of five financial ratios. Answer (D) is incorrect because an arbitrage pricing model is a means of valuing an asset by means of using several risk factors. [726] Gleim #: 5.114 -- Source: CMA 694 1-25 All of the following are alternative marketable securities suitable for investment except

A. B. C. D.

U.S. Treasury bills. Eurodollars. Commercial paper. Convertible bonds. Answer (A) is incorrect because U.S. Treasury bills are short-term marketable securities. Answer (B) is incorrect because Eurodollars are short-term marketable securities. Answer (C) is incorrect because commercial paper is a short-term marketable security. Answer (D) is correct. Marketable securities are near-cash items used primarily for short-term investment. Examples include U.S. Treasury bills, Eurodollars, commercial paper, money-market mutual funds with portfolios of short-term securities, bankers’ acceptances, floating rate preferred stock, and negotiable CDs of U.S. banks. A convertible bond is not a short-term investment because its maturity date is usually more than one year in the future and its price can be influenced substantially by changes in interest rates or by changes in the investee’s stock price.

[727] Gleim #: 5.115 -- Source: CMA 1294 1-16 The term “short-selling” is the

A. B. C. D.

Selling of a security that was purchased by borrowing money from a broker. Selling of a security that is not owned by the seller. Selling of all the shares you own in a company in anticipation that the price will decline dramatically. Betting that a stock will increase by a certain amount within a given period of time. Answer (A) is incorrect because margin trading involves buying securities by borrowing from a broker. Answer (B) is correct. Short-selling is accomplished by borrowing securities from a broker and selling those securities. At a later time, the loan is repaid by buying securities on the open market and returning them to the broker. The seller speculates that the stock’s market price will decline. Answer (C) is incorrect because the investor does not own the shares sold in a short-sale. Answer (D) is incorrect because the short-seller is betting that the stock will decrease in price.

[728] Gleim #: 5.116 -- Source: CMA 1295 1-6 Jackson Distributors sells to retail stores on credit terms of 2/10, net 30. Daily sales average 150 units at a price of $300 each. Assuming that all sales are on credit and 60% of customers take the discount and pay on day 10 while the rest of the customers pay on day 30, the amount of Jackson’s accounts receivable is


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A. B. C. D.

$1,350,000 $990,000 $900,000 $810,000 Answer (A) is incorrect because 60% of the sales will be paid for within the 10-day discount period. Answer (B) is incorrect because $990,000 is based on a sales total of $1,500,000 for 30 days rather than $1,350,000. Answer (C) is incorrect because $900,000 is based on a sales total of $1,500,000 for 30 days rather than $1,350,000. Answer (D) is correct. The firm has daily sales of $45,000 consisting of 150 units at $300 each. For 30 days, sales total $1,350,000. Forty percent of these sales, or $540,000, will be uncollected because customers do not take their discounts. The remaining 60%, or $810,000, will be paid within the discount period. However, by the end of 30 days, only 2/3 of the $810,000 will be collected because the sales from days 21 through 30 are still within the discount period. Therefore, an additional $270,000 ($810,000 – $540,000) will still be uncollected after the 30th day, but will be subject to a discount. In total, the average receivable balance is $810,000, consisting of $540,000 on which no discount will be taken and $270,000 that will be paid within the discount period.

[729] Gleim #: 5.117 -- Source: CMA 1289 1-15 A change in credit policy has caused an increase in sales, an increase in discounts taken, a decrease in the amount of bad debts, and a decrease in the investment in accounts receivable. Based upon this information, the company’s

A. B. C. D.

Average collection period has decreased. Percentage discount offered has decreased. Accounts receivable turnover has decreased. Working capital has increased. Answer (A) is correct. An increase in discounts taken accompanied by declines in receivables balances and doubtful accounts all indicate that collections on the increased sales have been accelerated. Accordingly, the average collection period must have declined. The average collection period is a ratio calculated by dividing the number of days in a year (365) by the receivable turnover. Thus, the higher the turnover, the shorter the average collection period. The turnover increases when either sales (the numerator) increase, or receivables (the denominator) decrease. Accomplishing both higher sales and a lower receivables increases the turnover and results in a shorter collection period. Answer (B) is incorrect because a decrease in the percentage discount offered provides no incentive for early payment. Answer (C) is incorrect because accounts receivable turnover (sales ÷ average receivables) has increased. Answer (D) is incorrect because no information is given relative to working capital elements other than receivables. Both receivables and cash are elements of working capital, so an acceleration of customer payments will have no effect on working capital.

[730] Gleim #: 5.118 -- Source: CMA 1294 1-24 A company plans to tighten its credit policy. The new policy will decrease the average number of days in collection from 75 to 50 days and will reduce the ratio of credit sales to total revenue from 70% to 60%. The company estimates that projected sales will be 5% less if the proposed new credit policy is implemented. If projected sales for the coming year are $50 million, calculate the dollar impact on accounts receivable of this proposed change in credit policy. Assume a 360-day year.

A. B. C. D.

$3,817,445 decrease. $6,500,000 decrease. $3,333,334 decrease. $18,749,778 increase.


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Answer (A) is incorrect because the decrease will be $3,333,334. Answer (B) is incorrect because the decrease will be $3,333,334. Answer (C) is correct. If sales are $50 million, 70% of which are on credit, total credit sales will be $35 million. The receivables turnover equals 4.8 times per year (360 days ÷ 75-day collection period). Receivables turnover equals net credit sales divided by average receivables. Accordingly, average receivables equal $7,291,667 ($35,000,000 ÷ 4.8). Under the new policy, sales will be $47.5 million (95% × $50,000,000), and credit sales will be $28.5 million (60% × $47,500,000). The collection period will be reduced to 50 days, resulting in a turnover of 7.2 times per year (360 ÷ 50). The average receivables balance will therefore be $3,958,333 ($28,500,000 ÷ 7.2), a reduction of $3,333,334 ($7,291,667 – $3,958,333). Answer (D) is incorrect because receivables will decrease. [731] Gleim #: 5.119 -- Source: CMA 696 1-13 A company with $4.8 million in credit sales per year plans to relax its credit standards, projecting that this will increase credit sales by $720,000. The company’s average collection period for new customers is expected to be 75 days, and the payment behavior of the existing customers is not expected to change. Variable costs are 80% of sales. The firm’s opportunity cost is 20% before taxes. Assuming a 360-day year, what is the company’s benefit (loss) on the planned change in credit terms?

A. B. C. D.

$0 $28,800 $144,000 $120,000 Answer (A) is incorrect because the company benefits from the change in credit terms. Answer (B) is incorrect because $28,800 results from multiplying the contribution margin by the 20% interest rate. Answer (C) is incorrect because $144,000 overlooks the costs created by having funds invested in receivables for 75 days. Answer (D) is correct. The incremental sales will produce an increased contribution margin of $144,000 (20% × $720,000). However, that amount must be offset by the cost of funds invested in receivables. The variable costs associated with the incremental sales are $576,000 (80% × $720,000). Given a 75-day credit period, the average investment in receivables equals $120,000 [$576,000 × (75 ÷ 360)]. Accordingly, the cost of the investment in additional receivables is $24,000 (20% opportunity cost × $120,000), and the net benefit of the planned change in credit terms is $120,000 ($144,000 – $24,000).

[732] Gleim #: 5.120 -- Source: CMA 1296 1-18 Which of the following represents a firm’s average gross receivables balance? I. Days’ sales in receivables × accounts receivable turnover. II. Average daily sales × average collection period. III. Net sales/average gross receivables.

A. B. C. D.

I only. I and II only. II only. II and III only.


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Answer (A) is incorrect because Alternative I cannot be correct. Neither of the multiplicands is a dollar figure, so the product could not be the dollar balance of receivables. Answer (B) is incorrect because Alternative I cannot be correct. Neither of the multiplicands is a dollar figure, so the product could not be the dollar balance of receivables. Answer (C) is correct. A firm’s average gross receivables balance can be calculated by multiplying average daily sales by the average collection period (days’ sales outstanding). Alternatively, annual credit sales can be divided by the accountsreceivable turnover (net credit sales/average accounts receivable) to obtain the average balance in receivables. Answer (D) is incorrect because Alternative III cannot be correct. It contains average gross receivables, the amount being calculated. [733] Gleim #: 5.121 -- Source: Publisher The high cost of short-term financing has recently caused a company to reevaluate the terms of credit it extends to its customers. The current policy is 1/10, net 60. If customers can borrow at the prime rate, at what prime rate must the company change its terms of credit in order to avoid an undesirable extension in its collection of receivables?

A. B. C. D.

2% 5% 7% 8% Answer (A) is incorrect because the prime rate must be greater than 7.37% to make the company’s terms preferable to those of a bank. Answer (B) is incorrect because the prime rate must be greater than 7.37% to make the company’s terms preferable to those of a bank. Answer (C) is incorrect because the prime rate must be greater than 7.37% to make the company’s terms preferable to those of a bank. Answer (D) is correct. Terms of 1/10, net 60 mean that a buyer can save 1% of the purchase price by paying 50 days early. In essence, not taking the discount results in the buyer’s borrowing 99% of the invoice price for 50 days at a total interest charge of 1% of the invoice price. Because a year has 7.3 50-day periods (365 ÷ 50), the credit terms 1/10, net 60 yield an effective annualized interest charge of approximately 7.37% [(1% ÷ 99%) × 7.3]. If the prime rate were higher than 7.37%, the buyer would prefer to borrow from the vendor (i.e., not pay within the discount period) rather than from a bank. Consequently, an 8% prime rate could cause the vendor’s receivables to increase.

[734] Gleim #: 5.122 -- Source: Publisher The appropriate discount rate to use in valuing a business combination is the

A. B. C. D.

Combined firm’s cost of debt. Acquiring firm’s weighted average cost of capital. Acquiring firm’s cost of equity. Combined firm’s cost of equity.


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Answer (A) is incorrect because the cost of equity, not the cost of debt, should be the discount rate. Answer (B) is incorrect because the discount rate should be that of the combined firm, not the acquiring firm. Answer (C) is incorrect because the discount rate should be that of the combined firm, not the acquiring firm. Answer (D) is correct. If the net incremental cash flows to the acquiring firm’s shareholders are to be calculated, the discount rate used should be the cost of equity capital. Moreover, this rate should reflect the risk associated with the use of funds rather than their source. The rate therefore should not be the cost of capital of the acquiring firm but rather the cost of equity of the acquired firm after the combination. This calculation requires a new estimate of beta to be used in the Capital Asset Pricing Model. [735] Gleim #: 5.123 -- Source: Publisher Business combinations are accomplished either through a direct acquisition of assets and liabilities by a surviving corporation or by stock investments in one or more companies. A parent-subsidiary relationship always arises from a

A. B. C. D.

Tax-free reorganization. Vertical combination. Horizontal combination. Greater than 50% stock investment in another company. Answer (A) is incorrect because a tax-free reorganization may or may not be a combination, and it may or may not result in a parent-subsidiary relationship. Answer (B) is incorrect because vertical and horizontal combinations may also be accomplished by a merger or a consolidation, in which case the combining entities become one. A vertical combination combines a supplier or a customer firm with the acquirer. A horizontal combination combines two firms in the same line of business. Answer (C) is incorrect because vertical and horizontal combinations may also be accomplished by a merger or a consolidation, in which case the combining entities become one. A vertical combination combines a supplier or a customer firm with the acquirer. A horizontal combination combines two firms in the same line of business. Answer (D) is correct. A parent-subsidiary relationship arises from an effective investment in the stock of another enterprise in excess of 50%. The financial statements for the two companies ordinarily should be presented on a consolidated basis. To the extent the corporation is not wholly-owned, a minority interest is presented.

[736] Gleim #: 5.124 -- Source: CMA 1291 1-13 When a firm finances each asset with a financial instrument of the same approximate maturity as the life of the asset, it is applying

A. B. C. D.

Working capital management. Return maximization. Financial leverage. A hedging approach. Answer (A) is incorrect because working capital management is short-term asset management. Answer (B) is incorrect because return maximization is more aggressive than maturity matching. It entails using the lowest cost forms of financing. Answer (C) is incorrect because financial leverage is the relationship between debt and equity financing. Answer (D) is correct. Maturity matching, or equalizing the life of an asset and the debt instrument used to finance that asset, is a hedging approach. The basic concept is that the company has the entire life of the asset to recover the amount invested before having to pay the lender.


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[737] Gleim #: 5.125 -- Source: Publisher A forward contract involves

A. B. C. D.

A commitment today to purchase a product on a specific future date at a price to be determined some time in the future. A commitment today to purchase a product some time during the current day at its present price. A commitment today to purchase a product on a specific future date at a price determined today. A commitment today to purchase a product only when its price increases above its current exercise price. Answer (A) is incorrect because the price of a future contract is determined on the day of commitment, not some time in the future. Answer (B) is incorrect because performance is deferred in a future contract, and the price of the product is not necessarily its present price. The price can be any price determined on the day of commitment. Answer (C) is correct. A forward contract is an executory contract in which the parties involved agree to the terms of a purchase and a sale, but performance is deferred. Accordingly, a forward contract involves a commitment today to purchase a product on a specific future date at a price determined today. Answer (D) is incorrect because a forward contract is a firm commitment to purchase a product. It is not based on a contingency. Also, a forward contract does not involve an exercise price (exercise price is in an option contract).

[738] Gleim #: 5.126 -- Source: Publisher A firm is planning to issue a callable bond with an 8% coupon rate and 10 years to maturity. A straight bond with a similar rate is priced at $1,000. If the value of the issuer’s call option is estimated to be $50, what is the value of the callable bond?

A. B. C. D.

$1,000 $950 $1,050 $900 Answer (A) is incorrect because the call feature reduces the value of the bond by the value of the call option. Answer (B) is correct. A callable bond is not as valuable to an investor as a straight bond. Thus, the $50 call option is subtracted from the $1,000 value of a straight bond to arrive at a $950 value for the callable bond. Answer (C) is incorrect because the call feature reduces the value of the bond by the value of the call option. Answer (D) is incorrect because the call feature reduces the value of the bond by the value of the call option.

[739] Gleim #: 5.127 -- Source: Publisher How much must the stock be worth at expiration for a call holder to break even if the exercise price is $60 and the call premium was $3?

A. B. C. D.

$57.00 $60.00 $61.50 $63.00 Answer (A) is incorrect because $57 is the result of deducting the call premium from the exercise price. Answer (B) is incorrect because $60 is the result of failing to consider the impact of the call premium. Answer (C) is incorrect because the full call premium must be added to the exercise price. Answer (D) is correct. Because the call premium is $3, the stock price must be at least $63 ($60 exercise price + $3 call premium).


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[Fact Pattern #42] AA Company has purchased one share of QQ Company common stock and one put option. It has also sold one call option. The options are written on one share of QQ Company common stock and have the same maturity date and exercise price. The exercise price ($40) is the same as the share price. Moreover, the options are exercisable only at the expiration date. [740] Gleim #: 5.128 -- Source: Publisher (Refers to Fact Pattern #42) Assume that the value of a share of QQ Company common stock at the expiration date is either $30 or $45. The difference in the net payoff on the portfolio because of a difference in the stock price at the maturity date is

A. B. C. D.

$10.00 $7.50 $5.00 $0 Answer (A) is incorrect because the portfolio has the same value at the maturity date regardless of the price of the stock. Answer (B) is incorrect because the portfolio has the same value at the maturity date regardless of the price of the stock. Answer (C) is incorrect because the portfolio has the same value at the maturity date regardless of the price of the stock. Answer (D) is correct. If the stock price at the maturity date is $30, AA Company will have a share of stock worth $30 and a put option worth $10 ($40 exercise price – $30 stock price). The call option will be worthless. Hence, the net payoff is $40 ($30 + $10). If the stock price at the maturity date is $45, the share of stock will be worth $45, the put will be worthless, and the loss on the call will be $5 ($45 – $40). Thus, the net payoff will be $40 ($45 – $5). Consequently, the difference in the net payoff on the portfolio because of a difference in the stock price at the maturity date is $0 ($40 – $40).

[741] Gleim #: 5.129 -- Source: Publisher (Refers to Fact Pattern #42) Assuming the present value of the exercise price is $36 and the value of the call is $4.50, the value of the put in accordance with the put-call parity theorem is

A. B. C. D.

$4.50 $4.00 $.50 $0 Answer (A) is incorrect because $4.50 is the value of the call. Answer (B) is incorrect because $4.00 is the difference between the exercise price and its present value. Answer (C) is correct. For European options, given market equilibrium for all relevant prices (no arbitrage possibilities), equal exercise prices for the put and the call, and the same expiration date, the put-call parity theorem states that a fixed relationship applies to the market values of the put and call options on a security. For example, a strategy of selling one call option, buying one share of the stock, and buying one put option should result in a risk-free return. The gain (loss) from the stock and the put should equal the gain (loss) on the call. If VS is the value of the stock, VP is the value of the put, VC is the value of the call, and PVE is the present value of the exercise price (the time interval is the time to expiration), the formula for put-call parity may be stated as follows:

Accordingly, the value of the put is $.50 ($36 + $4.50 – $40). Answer (D) is incorrect because the put has a value of $.50.


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[Fact Pattern #43] On November 15, 20X1, Hector Corp., a calendar-year-end U.S. company, signed a legally binding contract to purchase equipment from Diego Corp., a foreign company. The negotiated price is FC1,000,000. The scheduled delivery date is February 15, 20X0. Terms require payment by Hector Corp. upon delivery. The terms also impose a 10% penalty on Diego Corp. if the equipment is not delivered by February 15, 20X2. To hedge its commitment to pay FC1,000,000, Hector entered into a forward-exchange contract on November 15, 20X2 to receive FC1,000,000 on February 15, 20X2 at an exchange rate of FC1.00 = U.S.$0.36. Additional exchange rate information:

Date

Spot Rates

Forward Rates for February 15, 20X2

11/15/X0 12/31/X0 02/15/X1

1 FC = $0.35 U.S. 1 FC = $0.36 U.S. 1 FC = $0.39 U.S.

1 FC = $0.36 U.S. 1 FC = $0.38 U.S. 1 FC = $0.39 U.S.

Quotes obtained from dealers indicate the following incremental changes in the fair values of the forward-exchange contract based on the changes in forward rates discounted on a net-present-value basis:

Date

Gain/(Loss)

11/15/X0 12/31/X0 02/15/X1

$0 $19,600 $10,400

Hector formally documented its objective and strategy for entering into this hedge. Hector also decided to assess hedge effectiveness based on an assessment of the difference between changes in value of the forward-exchange contract and the U.S. dollar equivalent of the firm commitment. Because both changes are based on changes in forward rates, Hector further determined that the hedge is 100% effective. Furthermore, Hector accounts for hedges of the foreign currency risk of a firm commitment as a fair value hedge. [742] Gleim #: 5.130 -- Source: Publisher (Refers to Fact Pattern #43) The contract signed by Hector Corp. to purchase the equipment from Diego Corp. meets the definition of a

Firm

Forecast

Commitment

Transaction

A.

Yes

Yes

B. C.

No Yes

No No

D.

No

Yes

Answer (A) is incorrect because the contract meets the definition of a firm commitment. Thus, it cannot be a forecast transaction. Answer (B) is incorrect because the contract meets the definition of a firm commitment. Thus, it cannot be a forecast transaction. Answer (C) is correct. A firm commitment is a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date(s). A forecast transaction is an uncommitted but anticipated future transaction (IAS 39). Answer (D) is incorrect because the contract meets the definition of a firm commitment. Thus, it cannot be a forecast transaction.


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[743] Gleim #: 5.131 -- Source: Publisher (Refers to Fact Pattern #43) What are the amounts reported for the forward contract receivable and the firm commitment liability at December 31, 20X0 and February 15, 20X1 (prior to the settlement of the contract)?

12/31/X0

02/15/X1

A.

$10,000

$40,000

B. C.

$19,600 $19,600

$30,000 $10,400

D.

$20,000

$30,000

Answer (A) is incorrect because $10,000 and $40,000 reflect the undiscounted changes in the spot rate from 11/15/X0 to 12/31/X0 and from 11/15/X0 to 02/15/X1, respectively. Answer (B) is correct. This hedge is a foreign currency fair value hedge because it hedges a foreign currency exposure of an unrecognized firm commitment. IAS 39 requires recognition of the forward contract receivable as an asset at fair value, with the changes in fair value recognized in profit or loss. IAS 39 requires recognition of the changes in the fair value of the firm commitment that are attributable to the changes in exchange rates. The changes in fair value are recognized in profit or loss and as entries to a liability. Fair values should reflect changes in the forward exchange rates on a net-present-value basis. Thus, the forward contract receivable should be debited and a gain credited for $19,600 at 12/31/X0. A loss should be debited and a firm commitment liability should be credited in the same amount at the same date. At 2/15/X1, a further $10,400 forward contract gain and firm commitment loss should be recorded. Because the changes in value of both the forward-exchange contract and the U.S. dollar equivalent of the firm commitment are based on changes in forward rates, the hedge is completely effective. The changes in fair values ($19,600 and $10,400) of the forward contract receivable (gains) and the firm commitment (losses) offset each other in the income statement. Answer (C) is incorrect because $19,600 and $10,400 reflect the income statement effects. Answer (D) is incorrect because $20,000 and $30,000 reflect the undiscounted changes in the forward rates. [744] Gleim #: 5.132 -- Source: Publisher (Refers to Fact Pattern #43) As a result of this hedging transaction, at what amount should Hector recognize the equipment on February 15, 20X1?

A. B. C. D.

$350,000 $360,000 $390,000 $420,000 Answer (A) is incorrect because $350,000 is the amount that should be recognized if the equipment had been delivered on 11/15/X0. Answer (B) is correct. The equipment should be recorded at $360,000. This amount equals $390,000 (FC1,000,000 x $0.39 spot rate at 2/15/03) minus the $30,000 balance in the firm commitment liability account. The entry is to debit equipment for $360,000, debit the firm commitment liability for $30,000, and credit a payable for $390,000. On the same date, Hector will debit the payable for $390,000, credit the forward contract receivable for $30,000, and credit cash for $360,000. The latter entry reflects settlement of the payable and of the forward contract. Answer (C) is incorrect because $390,000 is the amount that should be recognized if the firm commitment had not been hedged. Answer (D) is incorrect because $420,000 equals $390,000 plus the $30,000 balance in the firm commitment liability account.


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[745] Gleim #: 5.133 -- Source: CIA 1187 IV-66 A measure that describes the risk of an investment project relative to other investments in general is the

A. B. C. D.

Coefficient of variation. Beta coefficient. Standard deviation. Expected return. Answer (A) is incorrect because the coefficient of variation compares risk with expected return (standard deviation ÷ expected return). Answer (B) is correct. The required rate of return on equity capital in the Capital Asset Pricing Model is the risk-free rate, plus the product of the market risk premium times the beta coefficient. The market risk premium is the amount above the risk-free rate that will induce investment in the market. The beta coefficient of an individual share is the correlation between the volatility (price variation) of the stock market and that of the price of the individual share. For example, if an individual share goes up 15% and the market only 10%, beta is 1.5. Answer (C) is incorrect because standard deviation measures dispersion (risk) of project returns. Answer (D) is incorrect because expected return does not describe risk.

[746] Gleim #: 5.134 -- Source: IIA, adapted Which of the following securities is likely to have the least risk?

A. B. C. D.

Income bonds. Debentures. Subordinated debentures. First-mortgage bonds. Answer (A) is incorrect because income bonds only pay interest if interest is earned. Answer (B) is incorrect because debentures are unsecured bonds. Answer (C) is incorrect because subordinated debentures are subordinated to other debt. Answer (D) is correct. First-mortgage bonds are backed by fixed assets.

[747] Gleim #: 5.135 -- Source: IIA, adapted The difference between the required rate of return on a given risky investment and that of a risk-free investment with the same expected return is the

A. B. C. D.

Risk premium. Coefficient of variation. Standard error of measurement. Beta coefficient. Answer (A) is correct. The market risk premium (RM – RF) is the amount above the risk-free rate required to include average investors to enter the market. The risk premium is the portion of expected return attributed to the increased risk. Answer (B) is incorrect because the coefficient of variation represents the standard deviation of an investment’s returns divided by the mean returns. Answer (C) is incorrect because the standard error represents a measure of variability in the investment’s returns. Answer (D) is incorrect because the beta coefficient represents the sensitivity of the investment’s returns to the market returns.


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[748] Gleim #: 5.136 -- Source: IIA, adapted Capital structure decisions involve determining the proportions of financing from

A. B. C. D.

Short-term or long-term debt. Debt or equity. Short-term or long-term assets. Retained earnings or common stock. Answer (A) is incorrect because this answer ignores equity. Answer (B) is correct. The optimal capital structure minimizes the weighted average cost of capital and thereby maximizes the value of the firm’s stock. Both debt and equity are factors in a company’s capital structure. Answer (C) is incorrect because the decision does not directly involve assets. Answer (D) is incorrect because the decision involves equity, but does not focus on the type of equity used.

[749] Gleim #: 5.137 -- Source: IIA, adapted If a high percentage of a firm’s total costs is fixed, the firm’s operating leverage will be

A. B. C. D.

High. Low. Unchanged. Unable to be determined. Answer (A) is correct. In business terminology, a high degree of operating leverage, other things held constant, means that a relatively small change in sales will result in a large change in operating income. Therefore, if a high percentage of a firm’s total cost is fixed, the firm is said to have a high degree of operating leverage. Answer (B) is incorrect because the opposite is true. Answer (C) is incorrect because the firm has a high degree of operating leverage. Answer (D) is incorrect because the firm has a high degree of operating leverage.

[750] Gleim #: 5.138 -- Source: IIA, adapted When comparing two companies, if all else is equal, the company that has a higher dividend payout ratio will have a

A. B. C. D.

Higher marginal cost of capital. Lower debt ratio. Higher investment opportunity schedule. Higher price to earnings ratio. Answer (A) is correct. The higher the dividend payout ratio, the sooner retained earnings are exhausted and the company must seek more costly, outside equity financing. This drives the marginal cost of capital. Answer (B) is incorrect because the debt ratio is computed by dividing total debts by total assets. The dividend payout ratio has no impact on the debt ratio. Answer (C) is incorrect because the investment opportunities available to the company are not determined by the level of dividend payout. Answer (D) is incorrect because the opposite is true. The price to earnings ratio is computed by dividing price per share by earnings per share, so a company with a higher dividend payout ratio would have a lower price to earnings ratio.


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[751] Gleim #: 5.139 -- Source: IIA, adapted Why would a company maintain a compensating cash balance?

A. B. C. D.

To make routine payments and collections. To pay for banking services. To provide a reserve in case of unforeseen fluctuations in cash flows. To take advantage of bargain purchase opportunities that may arise. Answer (A) is incorrect because the cash balance maintained for making routine payments and collections is called the transactions balance. Answer (B) is correct. The compensating cash balance is the money left in a checking account in the bank in order to compensate the bank for services it provides. Answer (C) is incorrect because the cash balance maintained as a reserve for unforeseen cash flow fluctuations is called the precautionary balance. Answer (D) is incorrect because it is the speculative cash balance that is maintained in order to enable the firm to take advantage of any bargain purchase opportunities that may arise.

[752] Gleim #: 5.140 -- Source: IIA, adapted The efficient markets theory implies that securities prices are

A. B. C. D.

Not a good estimate of future cash flows. Fair and a reflection of all publicly available information. Not the best benchmark for corporate financial decisions. Always less than their fair value. Answer (A) is incorrect because securities prices are a good estimate of future cash flows under this theory. Answer (B) is correct. The efficient markets theory proposes that the market is continuously adjusting to new information and acting to correct pricing errors. Answer (C) is incorrect because securities prices are the best benchmark under this theory. Answer (D) is incorrect because securities prices equal their fair value as perceived by investors.

[Fact Pattern #44]

(Refer to Figure CIA3_06_01.) [753] Gleim #: 5.141 -- Source: IIA, adapted (Refers to Fact Pattern #44) If all else is equal, firms with higher profit margins require less additional financing for any sales growth rate. If the profit margin of a company increased, the funds-needed line would shift

A. B. C. D.

Up and become less steep. Up and become more steep. Down and become less steep. Down and become more steep.


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Answer (A) is incorrect because a higher profit margin would reduce the additional financing needed, as stated in the question. The result would be a downward, not an upward, shift in the funds-needed line. Answer (B) is incorrect because a higher profit margin would cause a downward shift with a lower slope. Answer (C) is correct. A higher profit margin would reduce the additional financing needed, shifting the funds needed line down. Answer (D) is incorrect because the line would become less, not more, steep if the firm had a higher profit margin. [754] Gleim #: 5.142 -- Source: IIA, adapted (Refers to Fact Pattern #44) The funds-needed line does not pass through the origin unless the firm has a

A. B. C. D.

One-hundred percent dividend payout policy. Zero percent dividend payout policy. One-hundred percent sales growth rate. Zero percent sales growth rate. Answer (A) is correct. If all earnings are paid out as dividends, then there is no earnings retention. All sales growth must be financed from spontaneous or external sources. Answer (B) is incorrect because the funds-needed line only passes through the origin in the special case where all earnings are paid out as dividends. Answer (C) is incorrect because the funds-needed line is a graph of the relationship between sales growth rates and additional financing needs. It is not drawn for just one point, or one level of sales growth. Answer (D) is incorrect because, while the sales growth rate would be zero at the point where the funds-needed line passed through the origin, funds needed may be non-zero when sales growth is zero.

[755] Gleim #: 5.143 -- Source: IIA, adapted The economic value of a firm will rise following an increase in

A. B. C. D.

Net cash flow. Systematic risk. Unsystematic risk. The discount rate. Answer (A) is correct. Net cash flow represents the numerator in the formula used to derive the value of the firm. Therefore, the economic value of the firm will increase as net cash flow increases. Answer (B) is incorrect because an increase in systematic (or market) risk will increase the overall cost of capital and thereby increase K, the discount rate. As a result, the value of the firm will fall. Answer (C) is incorrect because an increase in unsystematic (or firm-specific) risk is diversifiable and will have no affect on the value of the firm. Answer (D) is incorrect because an increase in the discount rate will reduce the value of the firm.


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[756] Gleim #: 5.144 -- Source: Publisher The basic formula for the Black-Scholes Option Pricing Model essentially reflects the difference between the expected present value of the final stock price and the present value of the exercise price.

A company wishes to price a call option written on a nondividend-paying stock using the Black-Scholes Option Pricing Model. The current stock price is $50, the exercise price is $48, the risk-free interest rate is 5.0%, the option expires in 1 year, and the cumulative probabilities used to calculate the present values of the final stock price and the exercise price are .65 and .58, respectively. If the value of e (-rt) is .9512, the current value of the call option is

A. B. C. D.

$6.02 $4.66 $4.02 $2.00 Answer (A) is correct. C is the current value of a call option with time t in years until expiration, S is the current stock price, N (d i ) is the cumulative probability that a i deviation less than d i will occur in a standardized normal distribution [N (di) is an area to the left of d under the curve for the standard normal distribution], E is the call’s exercise price, e is a constant (approximately 2.7183), and r is the annualized continuous risk-free rate of return. Thus, the value of the call is C = ($50 × .65) – ($48 × .9512 × .58) = $32.50 – ($48 × .9512 × .58) = $32.50 – $26.48 = $6.02 Answer (B) is incorrect because $4.66 results from omitting the term e (-rt) from the equation. Answer (C) is incorrect because $4.02 equals the estimated call price minus the difference between the current stock price and the exercise price. Answer (D) is incorrect because $2.00 is the difference between the current stock price and the exercise price.

[757] Gleim #: 5.145 -- Source: CMA 1291 1-5 The purchase of treasury shares with an entity’s surplus cash

A. B. C. D.

Increases an entity’s financial leverage. Increases an entity’s equity. Increases an entity’s interest coverage ratio. Dilutes an entity’s earnings per share. Answer (A) is correct. A purchase of treasury share involves a decrease in assets (usually cash) and a corresponding decrease in shareholders’ equity. Thus, equity is reduced and the debt-to-equity ratio and financial leverage increase. Answer (B) is incorrect because equity (assets – liabilities) declines. A treasury share purchase is equivalent to a special dividend because assets are paid out to one or more shareholders. Answer (C) is incorrect because a firm’s interest coverage ratio is unaffected. Earnings, interest expense, and taxes will all be the same regardless of the transaction. Answer (D) is incorrect because the purchase of treasury share is antidilutive; the same earnings will be spread over fewer shares. Some firms purchase treasury share for this reason.


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[758] Gleim #: 5.146 -- Source: CIA 1193 IV-36 A service entity’s working capital at the beginning of January was 70,000. The following transactions occurred during January: Performed services on account Purchased supplies on account Consumed supplies Purchased office equipment for cash Paid short-term bank loan Paid salaries Accrued salaries

30,000 5,000 4,000 2,000 6,500 10,000 3,500

What is the amount of working capital at the end of January?

A. B. C. D.

80,500 78,500 50,500 47,500 Answer (A) is correct. Working capital is the excess of total current assets (CA) over total current liabilities (CL). Thus, working capital at the end of January equals 80,500 computed as follows:

Beginning working capital Performed services on account Purchased supplies on account Consumed supplies Purchased office equipment Paid short-term bank loan Paid salaries Accrued salaries Working capital, end of January

70,000 30,000 -0(4,000) (2,000) -0(10,000) (3,500)

CA*

CL*

I I D D D D N

N I N N D N I

80,500

* N = no effect; I = increase; D = decrease Answer (B) is incorrect because 78,500 ignores the consumed supplies, the cash purchase of office equipment, and the accrued salaries. However, it incorrectly considers the supplies purchased on account and the repayment of the shortterm bank loan. Answer (C) is incorrect because 50,500 does not include the services performed on account. Answer (D) is incorrect because 47,500 omits the services performed on account and accrued salaries but includes the repayment of short-term loan. [759] Gleim #: 5.147 -- Source: CIA 593 IV-39 Which of the following financial statement analyses is most useful in determining whether the various expenses of a given entity are higher or lower than industry averages?


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A. B. C. D.

Horizontal. Vertical. Activity ratio. Defensive-interval ratio. Answer (A) is incorrect because a horizontal analysis indicates the proportionate change over a period of time and is useful in trend analysis of an individual entity. Answer (B) is correct. Vertical analysis is the expression of each item on a financial statement in a given period in relation to a base figure. On the income statement, each item is stated as a percentage of sales. Thus, the percentages for the entity in question can be compared with industry norms. Answer (C) is incorrect because activity ratio analysis includes the preparation of turnover ratios such as those for receivables, inventory, and total assets. Answer (D) is incorrect because the defensive-interval ratio is part of a liquidity analysis.

[Fact Pattern #45] An entity reports the following account balances at year-end:

Account

Balance

Long-term debt Cash Net sales Fixed assets (net) Tax expense Inventory Common shares Interest expense Administrative expense Retained earnings Accounts payable Accounts receivable Cost of goods sold Depreciation expense

200,000 50,000 600,000 320,000 67,500 25,000 100,000 20,000 35,000 150,000 65,000 120,000 400,000 10,000

Additional Information: The opening balance of common shares was 100,000. The opening balance of retained earnings was 82,500. The entity had 10,000 common shares outstanding all year. No dividends were paid during the year. [760] Gleim #: 5.148 -- Source: CIA 594 IV-12 (Refers to Fact Pattern #45) For the year just ended, the entity has times-interest-earned of:

A. B. C. D.

3.375 times. 6.75 times. 7.75 times. 9.5 times.


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Answer (A) is incorrect because 3.375 times results from including in the numerator deductions for taxes and interest. Answer (B) is incorrect because 6.75 times results from including in the numerator a deduction for interest. Answer (C) is correct. The TIE ratio is a leverage ratio. It emphasizes the ability to pay interest expense. The ratio equals profit before interest and taxes divided by interest.

Answer (D) is incorrect because 9.5 times results from failing to deduct the administrative expenses from the numerator. [761] Gleim #: 5.149 -- Source: CIA 594 IV-13 (Refers to Fact Pattern #45) At year-end, the entity has a carrying amount per share of

A. B. C. D.

10.00 15.00 21.63 25.00 Answer (A) is incorrect because 10.00 excludes retained earnings from the numerator. Answer (B) is incorrect because 15.00 excludes common shares from the numerator. Answer (C) is incorrect because 21.63 is based on average equity. Answer (D) is correct. Carrying amount per share, based on balance sheet amounts, measures the per share amount that would be received if the entity were liquidated. The ratio is calculated as common equity divided by the number of outstanding shares.

[762] Gleim #: 5.150 -- Source: CIA 594 IV-14 (Refers to Fact Pattern #45) For the year just ended, the entity had a rate of return on equity, rounded to two decimals, of:


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A. B. C. D.

31.21% 58.06% 67.50% 71.68% Answer (A) is correct. Rate of return on equity, a profitability ratio, measures the rate of return on investment. The ratio equals net profit divided by average equity.

Answer (B) is incorrect because 58.06% excludes common shares from the denominator. Answer (C) is incorrect because 67.50% excludes retained earnings from the denominator. Answer (D) is incorrect because 71.68% excludes interest expense and tax expense from the numerator. [Fact Pattern #46] Entity A has 50,000 common shares and 10,000 preferred shares outstanding at the start of the year on January 1. The preferred shares are entitled to a 2 per share annual cash dividend, payable on December 31. The entity had net profit of 150,000 for the year. On April 1, the entity issued 15,000 additional common shares for cash. Entity B is identical to entity A in all respects except that it had 75,000 common shares outstanding for the entire year. [763] Gleim #: 5.151 -- Source: CIA 1195 IV-30 (Refers to Fact Pattern #46) Basic earnings per share for entity B is approximately

A. B. C. D.

1.73 1.87 2.00 2.27 Answer (A) is correct. BEPS equals net profit minus preference dividends, divided by common shares outstanding. Thus, BEPS equals 1.73 {[150,000 – (2 × 10,000 preferred shares)] ÷ 75,000}. Answer (B) is incorrect because 1.87 assumes the preference dividend is 1. Answer (C) is incorrect because 2.00 does not subtract preference dividends from net profit. Answer (D) is incorrect because 2.27 adds the preference dividends to net profit.


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[Fact Pattern #47]

An entity has a current ratio of 1.4, a quick, or acid test, ratio of 1.2, and the following partial summary balance sheet:

Cash Accounts receivable Inventory Fixed assets Total assets

10 Current liabilities Long-term ___ liabilities ___ Equity ___ Total liabilities 100 and equity

___ 40 30 ___

[764] Gleim #: 5.152 -- Source: CIA 594 IV-33 (Refers to Fact Pattern #47) The entity has an accounts receivable balance of

A. B. C. D.

12 26 36 66 Answer (A) is incorrect because 12 equals current assets minus current liabilities. Answer (B) is correct. Total assets equal total liabilities and equity. Hence, if total assets equal 100, total liabilities and equity must equal 100, and current liabilities must equal 30 (100 – 40 – 30). Because the quick ratio equals the quick assets (cash + accounts receivable) divided by current liabilities, the quick assets must equal 36 (30 × 1.2 quick ratio), and the accounts receivable balance is 26 (36 – 10 cash). Answer (C) is incorrect because 36 equals the quick assets. Answer (D) is incorrect because 66 equals the sum of the quick assets and current liabilities.

[765] Gleim #: 5.153 -- Source: CIA 594 IV-34 (Refers to Fact Pattern #47) The entity has a fixed assets balance of

A. B. C. D.

0 16 58 64


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Answer (A) is incorrect because the sum of cash, accounts receivable, and inventory is less than 100. Answer (B) is incorrect because 16 is the result of neglecting to subtract the equity balance when calculating the current liability balance. Answer (C) is correct. Total assets (given as 100) equals the sum of cash (given as 10), accounts receivable (26 as calculated in the preceding question), inventory, and fixed assets. Inventory can be determined because it is included in current, but not quick, assets, and the current and quick ratios are known. Current assets equal 42 (1.4 current ratio × 30 current liabilities), and the quick assets equal 36 (1.2 quick ratio × 30 current liabilities). Thus, inventory, which is the only difference in this question between current and quick assets, equals 6 (42 – 36). Fixed assets must then equal 58 (100 total assets – 10 cash – 26 accounts receivable – 6 inventory). Answer (D) is incorrect because 64 assumes that inventory is 0.


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[Fact Pattern #48]

RST entity’s: Income Stmt. for Yr. Five and Six Year Six

Year Five

Sales (all are credit) Cost of goods sold

285,000 150,000

200,000 120,000

Gross profit S and A exp

135,000 65,000

80,000 36,000

Profit bef. int. & inc. tax Interest expense

70,000 3,000

44,000 3,000

Profit before income tax Income tax expense

67,000 27,000

41,000 16,000

Net profit

40,000

25,000

RST entity’s: Balance Sheets End of Yr. Five and Six Assets

Year Six

Year Five

5,000

4,000

3,000 16,000 30,000

2,000 14,000 20,000

54,000

40,000

11,000 80,000 3,000

11,000 70,000 4,000

148,000

125,000

11,000 1,000

7,000 1,000

Total current liabilities Bonds payable, 10%, due Yr 12

12,000 30,000

8,000 30,000

Total liabilities

42,000

38,000

24,000 82,000

24,000 63,000

106,000

87,000

148,000

125,000

Current assets Cash Financial assets held for trading Accounts receivable (net) Inventory Total current assets Noncurrent assets: Long-term investments PP&E Intangibles Total assets Liabilities and Equity Current liabilities: Accounts payable Accrued payables

Equity: Common shares, 2,400 shares, 10 par Retained earnings Total equity Total liabilities and equity

The market value of RST’s common stock at the end of Year Six was $100.00 per share. [766] Gleim #: 5.154 -- Source: CIA 592 IV-40 (Refers to Fact Pattern #48) RST’s current ratio at the end of Year Six is


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A. B. C. D.

4.5 to 1 2.4 to 1 2.0 to 1 1.5 to 1 Answer (A) is correct. The current ratio equals current assets divided by current liabilities. At the end of Year Six, it was 4.5 (54,000 ÷ 12,000). Answer (B) is incorrect because 2.4 was derived by dividing current liabilities (12,000) by the amount of cash (5,000), which produces no meaningful ratio. Answer (C) is incorrect because 2.0 was derived by dividing the total of cash, financial assets held for trading, and net receivables (the quick assets) by total current liabilities. This computation determines the acid-test or quick ratio [(5,000 + 3,000 + 16,000) ÷ 12,000]. Answer (D) is incorrect because 1.5 [12,000 ÷ (5,000 + 3,000)] was derived by dividing total current liabilities by the sum of cash and financial assets held for trading, which produces no meaningful ratio.

[767] Gleim #: 5.155 -- Source: CIA 592 IV-41 (Refers to Fact Pattern #48) RST’s acid-test (or quick) ratio at the end of Year Six is

A. B. C. D.

2.40 to 1 2.18 to 1 2.00 to 1 1.50 to 1 Answer (A) is incorrect because 2.4 was derived by dividing total current liabilities (12,000) by the amount of cash (5,000), which produces no meaningful ratio. Answer (B) is incorrect because 2.18 was derived by dividing quick assets (5,000 + 3,000 + 16,000) by accounts payable (11,000). The denominator should include all current liabilities other than accounts payable. Answer (C) is correct. Liquidity ratios measure the ability to meet short-term obligations. A commonly used liquidity ratio is the acid-test or quick ratio, which equals the sum of the quick assets (net accounts receivable, financial assets held for trading, and cash) divided by current liabilities. This ratio at the end of Year Six is 2.0 [(5,000 + 3,000 + 16,000) ÷ 12,000]. Answer (D) is incorrect because 1.5 was derived by dividing total current liabilities (12,000) by the sum of cash (5,000) and financial assets held for trading (3,000), which produces no meaningful ratio.

[768] Gleim #: 5.156 -- Source: CIA 592 IV-42 (Refers to Fact Pattern #48) Based on a comparison of RST’s quick ratios in Year Five and Year Six, what is a likely conclusion?

A. B. C. D.

RST has improved its management of long-term investments in Year Six. RST has written off obsolete inventory in Year Six. RST’s ability to meet short-term financing needs has declined since Year Five. RST’s ability to meet short-term financing needs has improved since Year Five.


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Answer (A) is incorrect because the quick ratio compares current assets (minus inventory) with current liabilities; it does not provide a basis for conclusions about long-term investments. Answer (B) is incorrect because the quick ratio compares current assets (minus inventory) with current liabilities; it does not provide a basis for determining the effects or the existence of inventory write-offs. Answer (C) is correct. RST’s quick ratio decreased from 2.5 in Year Five [(4,000 cash + 2,000 financial assets held for trading + 14,000 net A/R) ÷ 8,000] to 2.0 in Year Six [(5,000 + 3,000 + 16,000) ÷ 12,000]. RST has fewer assets that are easily convertible to cash available to meet current liabilities. Thus, its ability to meet short-term financing needs has declined. Answer (D) is incorrect because RST is less liquid. [769] Gleim #: 5.157 -- Source: CIA 592 IV-43 (Refers to Fact Pattern #48) RST’s accounts receivable turnover for Year Six is

A. B. C. D.

19 times. 16 times. 10 times. 6 times. Answer (A) is correct. The accounts receivable turnover equals net credit sales divided by average trade receivables (net). In Year Six, the accounts receivable turned over 19 times {285,000 ÷ [(16,000 ending A/R + 14,000 beginning A/R) ÷ 2]}. Answer (B) is incorrect because 16 times was derived by dividing average sales of Years Five and Six [(285,000 + 200,000) ÷ 2] by average receivables (15,000), which produces no meaningful ratio. Answer (C) is incorrect because 10 times was derived by dividing cost of goods sold (150,000) for Year Six by average accounts receivable (15,000), which produces no meaningful ratio. Answer (D) is incorrect because 6 times is the inventory turnover ratio which equals the cost of goods sold for Year Six (150,000) divided by average inventory (25,000).

[770] Gleim #: 5.158 -- Source: CIA 592 IV-45 (Refers to Fact Pattern #48) Based on a comparison of RST’s times-interest-earned ratios in Year Five and Year Six, what is a likely conclusion?

A. B. C. D.

RST’s long-run solvency has declined. RST’s long-run solvency has improved. RST’s liquidity has improved. RST’s liquidity has declined. Answer (A) is incorrect because long-run solvency has improved. Answer (B) is correct. The times-interest-earned ratio increased from 14.67 times in Year Five (44,000 ÷ 3,000) to 23.33 times in Year Six (70,000 ÷ 3,000). This increase signifies that RST has more profit available to meet the interest payments on its debt, and that long-run solvency has improved. Consequently, creditors will view RST’s obligations as less risky. Answer (C) is incorrect because liquidity is a firm’s short-term solvency, that is, its ability to meet current liabilities with current assets by converting assets to cash. It is not related to the times-interest-earned ratio, which compares profit before interest and taxes with interest expense associated with long-term investments. Answer (D) is incorrect because the times-interest-earned ratio is not a liquidity measure.


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[Fact Pattern #49] An entity’s balance sheet is presented in Table A. The entity has 175,000 common shares outstanding.

The following results of operations for the year ended December 31, 20X1: Sales Cost of goods sold Net operating profit Net profit

15,000,000 11,500,000 1,750,000 1,000,000

Table A -- Balance Sheet, 20X1 (in thousands) Assets Cash Financial assets held for trading Accounts receivable Inventories

450 50 650 1,350

Total current assets Gross plant and equipment Minus: depreciation

7,000 2,000

2,500

Net plant and equipment Goodwill

5,000 500

Total assets

8,000

Liabilities and Equity Accounts payable Notes payable Accrued wages Accrued taxes

250 550 100 200

Total current liabilities

1,100

Long-term debt

3,500

Common shares Share premium Retained earnings

1,000 900 1,500

Total equity

3,400


8,000

[771] Gleim #: 5.159 -- Source: CIA 592 IV-58 (Refers to Fact Pattern #49) Based on the information provided, the return on operating assets is

A. B. C. D.

21.88% 35.00% 23.33% 12.50%


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Answer (A) is incorrect because 21.88% equals net operating profit divided by total assets. Answer (B) is incorrect because 35.00% equals net operating profit divided by net plant and equipment. Answer (C) is correct. Net operating assets equal total assets minus goodwill, or 7,500,000. The return on net operating assets is therefore 23.33% (1,750,000 net operating profit ÷ 7,500,000 net operating assets). Answer (D) is incorrect because 12.50% equals net profit divided by total assets. [Fact Pattern #50]

EXHIBIT A Balance Sheet 20X1 (millions of dollars)

Assets Cash Financial assets held for trading Accounts receivable Inventories Net plant and equipment

300 400 200 400 1,700

Total assets

3,000

Liabilities and Equity Accounts payable Notes payable Accrued wages Accrued taxes Debentures Common shares Retained earnings

300 400 50 150 600 500 1,000


3,000

[772] Gleim #: 5.160 -- Source: CIA 1193 IV-58 (Refers to Fact Pattern #50) Based on the balance sheet shown in EXHIBIT A, the debt ratio is

A. B. C. D.

20% 40% 50% 100% Answer (A) is incorrect because 20% excludes short-term debt. Answer (B) is incorrect because 40% divides long-term debt by total equity. Answer (C) is correct. The debt ratio equals total debt divided by total assets, or .50 [(3,000,000,000 total debt and equity – 500,000,000 common shares – 1,000,000,000 retained earnings) ÷ 3,000,000,000 total assets]. Answer (D) is incorrect because 100% divides total debt by total equity.


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[773] Gleim #: 5.161 -- Source: CIA 1193 IV-59 (Refers to Fact Pattern #50) An entity experienced sales of 5 billion, profit before interest and taxes of 200 million, profit before taxes of 100 million, and net profit of 70 million. Based on this information and the entity’s balance sheet information in Exhibit A, the return on equity (ROE) is

A. B. C. D.

4.67% 6.67% 13.33% 14% Answer (A) is correct. The return on equity equals net profit (70,000,000) divided by equity (500,000,000 common shares + 1,000,000,000 retained earnings). Answer (B) is incorrect because 6.67% uses profit before taxes instead of net profit. Answer (C) is incorrect because 13.33% uses profit before interest and taxes instead of net profit. Answer (D) is incorrect because 14% divides net profit by common shares.

[774] Gleim #: 5.162 -- Source: CIA 590 IV-59 Which of the outcomes represented in the following table would result from an entity’s retirement of debt with excess cash?

Total Assets

Following Period's Interest-

Turnover Ratio

Earned Ratio

A.

Increase

Increase

B. C.

Increase Decrease

Decrease Increase

D.

Decrease

Decrease

Answer (A) is correct. Because total assets will decline without any impact on sales, the total assets turnover ratio (sales ÷ total assets) will increase. In addition, a reduced debt level should cause a reduction in annual interest payments, so the times-interest-earned ratio [(net profit + interest + taxes) ÷ interest] should increase. Answer (B) is incorrect because the times-interest-earned ratio will increase. Answer (C) is incorrect because the total assets turnover ratio will increase. Answer (D) is incorrect because the total assets turnover ratio will increase and the times-interest-earned ratio will increase. [775] Gleim #: 5.163 -- Source: CIA 1188 IV-60 Heilman Plc purchased a new machine for 500,000 by borrowing the required funds from a bank for 180 days. The direct impact of this transaction will be to

A. B. C. D.

Decrease the current ratio and increase the debt ratio. Increase the current ratio and decrease the debt ratio. Increase the current ratio and increase the debt ratio. Decrease the current ratio and decrease the debt ratio.


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Answer (A) is correct. The borrowing of funds for 180 days constitutes short-term borrowing. The new machine is a fixed asset. Current liabilities have increased, and current assets have remained constant. Consequently, the current ratio (current assets ÷ current liabilities) has decreased. Total debt and total assets increased by the same absolute amount, and the debt ratio (total debt ÷ total assets) should have increased, assuming total debt is less than total asset. Answer (B) is incorrect because the current ratio decreased and the debt ratio increased. Answer (C) is incorrect because the current ratio decreased and the debt ratio increased. Answer (D) is incorrect because the current ratio decreased and the debt ratio increased. [776] Gleim #: 5.164 -- Source: CMA 688 1-20 Which one of the following ratios provides the best measure of liquidity?

A. B. C. D.

Sales minus returns to total debt. Total assets minus goodwill to total equity. Current assets minus inventories to current liabilities. Net profit minus dividends to interest expense. Answer (A) is incorrect because it does not refer to expenses that have to be paid out of the sales dollars. Also, the sales revenue available to pay liabilities is indeterminable. Thus, sales minus debt service is not a liquidity measure. Answer (B) is incorrect because fixed assets are included in the numerator of the ratio; hence, this ratio is not a measure of liquidity. Answer (C) is correct. Liquidity is the degree to which assets can be converted to cash in the short run to meet maturing obligations. The usual measures of liquidity are the current ratio and the quick (acid-test) ratio. The quick ratio is the best measure of short-term liquidity because it uses only the most liquid assets (for example, cash, financial assets held for trading, and receivables) in the calculation; inventories are not included because they are two steps away from cash (they have to be sold, and then the receivable has to be collected). Answer (D) is incorrect because it shows only the amount of profit available to pay interest expense and not other obligations. Also, net profit is not a measure of liquidity because it includes items that did not result in an increase of liquid assets.

[777] Gleim #: 5.165 -- Source: CMA 691 1-4 Which group of ratios would be useful in evaluating the effectiveness of working capital management?

A. B. C. D.

Profit margin, acid-test ratio, and return on assets. Acid-test ratio, inventory turnover ratio, and average collection period ratio. Inventory turnover ratio, times interest earned, and debt-to-equity ratio. Acid-test ratio, current ratio, and return on equity. Answer (A) is incorrect because profit margin and return on assets are measures of the management of all assets. Answer (B) is correct. Working capital equals current assets minus current liabilities. The acid-test ratio equals quick assets (current assets – inventory – prepaid expenses) divided by current liabilities. Inventory (a current asset) turnover equals cost of goods sold divided by average inventory. The average collection period (number of days’ sales in accounts receivable, a current asset) equals the number of days in a year divided by the accounts receivable turnover (net credit sales ÷ average receivables). The foregoing are some of the many ratios that can be used to evaluate working capital management. Answer (C) is incorrect because times interest earned and the debt-to-equity ratio are measures of capital structure management. Answer (D) is incorrect because return on equity is a measure of capital structure management.


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[778] Gleim #: 5.166 -- Source: CMA 692 1-27 The following information applies to Brandon entities. Purchases

Sales

160,000 160,000 160,000 140,000 140,000 120,000

100,000 200,000 240,000 300,000 260,000 240,000

January February March April May June

A cash payment equal to 40% of purchases is made at the time of purchase, and 30% is paid in each of the next 2 months. Purchases for the previous November and December were 150,000 per month. Payroll is 10% of sales in the month it occurs, and operating expenses are 20% of the following month’s sales (July sales were 220,000). Interest payments were 20,000 paid quarterly in January and April. Brandon’s cash disbursements for the month of April were

A. B. C. D.

140,000. 152,000. 200,000. 254,000. Answer (A) is incorrect because the disbursements for the month are greater than the purchases for the month. Answer (B) is incorrect because 152,000 excludes operating expenses, payroll, and interest. Answer (C) is incorrect because 200,000 is based on a miscalculation of operating expenses and payroll. Answer (D) is correct. The cash disbursements for the month of April include 40% of April purchases, 30% of March purchases, 30% of February purchases, April payroll (10% of April sales), operating expenses (20% of May sales), and an interest payment of 20,000.

40% × 140,000 30% × 160,000 30% × 160,000 10% × 300,000 20% × 260,000 Interest

= = = = = =

56,000 48,000 48,000 30,000 52,000 20,000

Total disbursements

=

254,000


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[779] Gleim #: 5.167 -- Source: CMA 1288 1-11 An entity earned 10,000 before interest and taxes, has a 36% tax rate, and has the following debt outstanding: First mortgage bond, 9.0% Debenture, 10.2% Subordinated bond, 12.0%

5,000 10,000 6,000

Total long-term debt

21,000

The annual coverage of the entity’s debt is

A. B. C. D.

4.57 times. 2.92 times. 11.85 times. 5.46 times. Answer (A) is correct. The times-interest-earned (interest coverage) ratio is computed by dividing the profit available for paying interest (pretax, pre-interest profit) by the annual interest expense. The first step is to determine the annual interest expense:

First Mortgage Debenture Subordinated

9.0% × 5,000 = 10.2% × 10,000 = 12.0% × 6,000 =

TOTAL EXPENSE

450 1,020 720 2,190

Dividing the pretax, pre-interest profit of 10,000 by the 2,190 of interest expense produces an interest coverage ratio of 4.57. Answer (B) is incorrect because the coverage of the debt is measured by the times-interest-earned ratio, which is found by dividing the pretax, pre-interest profit of 10,000 by the 2,190 of interest expense, yielding 4.57. Answer (C) is incorrect because the coverage of the debt is measured by the times-interest-earned ratio, which is found by dividing the pretax, pre-interest profit of 10,000 by the 2,190 of interest expense, yielding 4.57. Answer (D) is incorrect because the coverage of the debt is measured by the times-interest-earned ratio, which is found by dividing the pretax, pre-interest profit of 10,000 by the 2,190 of interest expense, yielding 4.57. [780] Gleim #: 5.168 -- Source: CMA 1291 1-9 Which one of the following factors will most likely cause an entity to increase its use of debt financing as measured by the debt-to-total-capitalization ratio?

A. B. C. D.

Increased economic uncertainty. An increase in the degree of operating leverage. An increase in the price-earnings ratio. An increase in the income tax rate.


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Answer (A) is incorrect because increased economic uncertainty makes equity financing more desirable. There is no legal mandate to make regular payments to equity holders. Answer (B) is incorrect because increased operating leverage (a greater degree of fixed production costs) increases risk. Hence, debt holders will require higher rates of interest. Higher interest costs will reduce the desirability of debt as a means of financing. Answer (C) is incorrect because an increase in the price-earnings ratio makes equity financing less costly and more desirable. Hence, a given level of earnings will support a higher share price. The cost of equity capital declines when the share price increases. Answer (D) is correct. Debt financing usually has a lower cost than equity financing because interest payments are usually tax deductible. If tax rates rise, debt becomes even more desirable because the tax shield becomes more valuable. The disadvantages of debt include the increase in fixed payments (interest). Thus, in an unstable economy, debt represents a greater risk to a firm than equity financing. [781] Gleim #: 5.169 -- Source: CIA 587 III-42 An analysis of inventory turnover in a store’s clothing department indicated extremely low turnover. Which of the following would most likely increase the turnover rate?

A. B. C. D.

Increase inventories. Increase sales incentives. Increase selling prices. Decrease the frequency of purchases but maintain the same level of inventory. Answer (A) is incorrect because increasing the denominator of the ratio decreases turnover. Answer (B) is correct. Inventory turnover equals cost of sales divided by average inventory. Reducing inventory therefore increases turnover. Sales incentives to improve sales should lower inventory levels. Answer (C) is incorrect because increasing price would probably decrease sales, increase inventory, and decrease turnover. Answer (D) is incorrect because a constant inventory level would not affect the turnover rate.


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[Fact Pattern #51] Presented below are partial year-end financial statement data for entities A and B.

A Cash Accounts receivable Inventories Net fixed assets Accounts payable Long-term debt Common shares Retained earnings

100 unknown unknown 200 100 200 100 150 A

Sales Cost of goods sold Administrative expenses Depreciation expense Interest expense Income tax expense Net profit

600 300 100 100 20 40 40

B 200 100 100 100 50 50 200 100 B 5,800 5,000 500 100 10 95 95

[782] Gleim #: 5.170 -- Source: CIA 595 IV-33 (Refers to Fact Pattern #51) Based on 365 days per year, B has days’ sales outstanding to the nearest full day of

A. B. C. D.

0 days. 3 days. 6 days. 7 days. Answer (A) is incorrect because 0 days equals accounts receivable divided by sales. Answer (B) is incorrect because 3 days is the result if accounts payable is used rather than accounts receivable. Answer (C) is correct. Days’ sales of receivables (days’ sales outstanding) equals the days in the year divided by the receivables turnover ratio (net credit sales ÷ average accounts receivable). Assuming sales are net credit sales and that ending accounts receivable equals average accounts receivable, the turnover ratio is 58 (5,800 ÷ 100), and the days’ sales of receivables equals 6 days (365 ÷ 58) (rounded). Answer (D) is incorrect because 7 days is the result if average cost of goods sold per day is used rather than sales.

[783] Gleim #: 5.171 -- Source: CIA 595 IV-34 (Refers to Fact Pattern #51) A has a times-interest-earned ratio of

A. B. C. D.

Four times. Five times. 10 times. 15 times.


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Answer (A) is incorrect because four times results if profit before tax rather than profit before interest and tax is used in the formula. Answer (B) is correct. The times-interest-earned ratio for A equals profit before interest and tax divided by interest expense. Profit before interest and tax is 100 (40 net profit + 20 interest + 40 tax expense). Hence, interest was earned five times (100 ÷ 20). Answer (C) is incorrect because 10 times results if depreciation expense is not deducted in calculating profit before interest and tax. Answer (D) is incorrect because 15 times results if gross margin is used in the numerator rather than profit before interest and tax. [784] Gleim #: 5.172 -- Source: CIA 595 IV-35 (Refers to Fact Pattern #51) The degree of financial leverage of B, to two decimal places, is

A. B. C. D.

1.03 1.05 1.12 1.25 Answer (A) is incorrect because 1.03 results if depreciation expense is omitted from the calculation of profit before interest and tax. Answer (B) is correct. The degree of financial leverage for B may be calculated as profit before interest and taxes (PBIT), divided by PBIT minus interest. PBIT is 200 (95 net profit + 10 interest + 95 tax expense). Thus, the DFL is 1.05 [200 ÷ (200 – 10)]. Answer (C) is incorrect because 1.12 results if net profit is used instead of PBIT. Answer (D) is incorrect because 1.25 is the degree of financial leverage for A.

[785] Gleim #: 5.173 -- Source: CIA 595 IV-36 (Refers to Fact Pattern #51) If A has 60 common shares outstanding, it has a carrying amount per share of approximately

A. B. C. D.

1.67 2.50 4.17 5.00 Answer (A) is incorrect because 1.67 results if retained earnings is omitted from the numerator. Answer (B) is incorrect because 2.50 results if the amount of common shares is omitted from the numerator. Answer (C) is correct. The carrying amount per share for A equals the sum of common shares and retained earnings, divided by the number of shares, or 4.17 [(100 + 150) ÷ 60]. Answer (D) is incorrect because 5.00 is the carrying amount per share for B.


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[Fact Pattern #52] An entity had the following number of shares outstanding during the year:

Period

Shares Outstanding

January 1 - April 30 May 1 - June 30 July 1 - September 30 October 1 - December 31

60,000 96,000 90,000 70,000

During the year, the entity had net profit of 600,000. It paid 100,000 in preference dividends, declared and paid 250,000 of common share dividends, and paid 50,000 of interest to debt holders. [786] Gleim #: 5.174 -- Source: CIA 595 IV-79 (Refers to Fact Pattern #52) The number of shares the entity had outstanding for the year, for the purpose of computing basic earnings per share (BEPS), is

A. B. C. D.

65,000 70,000 76,000 79,000 Answer (A) is incorrect because 65,000 is the simple average of the shares outstanding on January 1 and December 31. Answer (B) is incorrect because 70,000 is the year-end number of shares outstanding. Answer (C) is correct. The weighted-average number of shares outstanding for the year (76,000 shares) is used in the BEPS calculation.

Dates Outstanding

Shares Outstanding

Fraction of Year

Weighted Shares

January 1 - April 30 May 1 - June 30 July 1 - September 30 October 1 - December 31

60,000 96,000 90,000 70,000

4 ÷ 12 2 ÷ 12 3 ÷ 12 3 ÷ 12

20,000 16,000 22,500 17,500 76,000

Answer (D) is incorrect because 79,000 is the simple average of the shares outstanding at various times during the year. [787] Gleim #: 5.175 -- Source: CIA 1195 IV-35 An entity has total asset turnover of 3.5 times and a total debt to total assets ratio of 70%. If the entity has total debt of 1,000,000, it has a sales level of

A. B. C. D.

5,000,000.00 2,450,000.00 408,163.26 200,000.00


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Answer (A) is correct. If the debt-to-total assets ratio is 70% and debt is 1,000,000, total assets must be 1,428,571.4 (1,000,000 ÷ .7). Given total asset turnover (sales ÷ total assets) of 3.5, sales must be 5,000,000 (3.5 × 1,428,571.4). Answer (B) is incorrect because 2,450,000.00 is obtained if total assets is calculated as total debt multiplied by .7. Answer (C) is incorrect because 408,163.26 results if sales is determined by dividing total assets by 3.5. Answer (D) is incorrect because 200,000.00 is obtained by calculating total assets as total debt multiplied by .7 and sales as total assets divided by 3.5. [788] Gleim #: 5.176 -- Source: CIA 1195 IV-54 All other things held constant, external capital requirements are lower for entities with which one of the following characteristics?

A. B. C. D.

Lower retention ratios. Higher sales growth rates. Lower capital intensity ratios. Lower profit margins. Answer (A) is incorrect because, if earnings retention is low (that is, if dividend payout is high), less internal capital is available, so more external capital is needed. Answer (B) is incorrect because higher sales require more assets and more capital. Answer (C) is correct. The capital intensity ratio is the amount of assets required per dollar of sales. External financial requirements are lower if the capital intensity ratio is low because sales can grow rapidly without much outside capital, other things held constant. Answer (D) is incorrect because entities with lower profit margins have lower retained earnings and therefore require more external capital.

[789] Gleim #: 5.177 -- Source: CIA 1195 IV-52 An entity borrows funds from its bank for a one-year period. The bank charges interest at a nominal rate of 15% per annum, on a discount basis, and requires a 10% compensating balance. The effective annual interest rate on the loan is

A. B. C. D.

16.67% 17.65% 20.00% 25.00% Answer (A) is incorrect because 16.67% does not adjust for the discount interest arrangement. Answer (B) is incorrect because 17.65% does not adjust for the compensating balance requirement. Answer (C) is correct. Discount interest is subtracted before the loan proceeds are paid to the borrower. A compensating balance is an amount that the borrower must keep on deposit with the lender. The effective annual interest rate is increased by both the discount interest arrangement and by the compensating balance requirement. The effective rate equals the nominal rate dividend by one minus the sum of the nominal rate and the compensating balance percentage, or 20% [.15 ÷ (1.0 – .15 – .10)]. Answer (D) is incorrect because 25.00% is the sum of the nominal rate and the compensating balance percentage.

[790] Gleim #: 5.178 -- Source: CIA 1194 IV-12 An entity has 400 of current assets, composed of 200 of cash, 100 of accounts receivable, and 100 of inventory. The entity has 200 of long-term debt, $100 of accounts payable, and 75 of notes payable. The notes payable are due in 6 months. The acidtest ratio, to two decimal places, is


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A. B. C. D.

0.80 1.29 1.71 2.29 Answer (A) is incorrect because 0.80 is based on total liabilities instead of current liabilities. Answer (B) is incorrect because 1.29 uses working capital in the numerator. Answer (C) is correct. The acid-test ratio equals current assets (400) minus inventories (100), divided by current liabilities (100 + 75 = 175), or 1.71. Answer (D) is incorrect because 2.29 is the current ratio.

[791] Gleim #: 5.179 -- Source: CIA 596 IV-34 In calculating diluted earnings per share when an entity has convertible bonds outstanding, the weighted-average number of ordinary shares outstanding must be to adjust for the conversion feature of the bonds, and the net profit attributable to ordinary shareholders must be by the amount of interest expense on the bonds, net of tax.

List A

List B

A. B.

Increased Increased

Increased Decreased

C. D.

Decreased Decreased

Increased Decreased

Answer (A) is correct. The weighted-average number of ordinary shares outstanding must be increased to reflect the shares into which the bonds could be converted. Also, the effect of the bond interest on net profit attributable to ordinary shareholders (net profit after subtracting preference dividends) must be eliminated. In this way, diluted earnings per share is calculated as if the bonds had been converted into common shares as of the start of the year. Answer (B) is incorrect because the net profit attributable to ordinary shareholders must be increased. Answer (C) is incorrect because the weighted-average number of ordinary shares outstanding must be increased, and the net profit attributable to ordinary shareholders must be increased. Answer (D) is incorrect because the weighted-average number of ordinary shares outstanding must be increased, and the net profit attributable to ordinary shareholders must be increased.


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Balance Sheet Cash Accounts receivable Inventory Net fixed assets

100 200 50 600

Total

950

Accounts payable Long-term debt Share capital Retained earnings

140 300 260 250

Total

950

Statement of Income and Retained Earnings Sales Cost of goods sold

3,000 1,600


1,400 970


430 30


400 200


200 150 100


250

[792] Gleim #: 5.180 -- Source: CIA 596 IV-37 (Refers to Fact Pattern #53) The net working capital is

A. B. C. D.

160 210 350 490


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Answer (A) is incorrect because 160 equals net quick assets minus current liabilities. Answer (B) is correct. Net working capital is the difference between current assets and current liabilities. It equals 210 (100 cash + 200 A/R + 50 inventory – 140 A/P). Answer (C) is incorrect because 350 equals current assets. Answer (D) is incorrect because 490 equals current assets plus current liabilities. [793] Gleim #: 5.181 -- Source: IIA, adapted In a two-tier merger offer, shareholders receive a higher amount per share if they

A. B. C. D.

Agree to purchase newly issued bonds in the combined firm. Agree to sell back to the firm any bonds that they currently own. Tender their stock later. Tender their stock earlier. Answer (A) is incorrect because an offer that is “two-tier” involves two different offer prices for the shares acquired. The terms of the share acquisition do not relate to the issuance or repurchase of bonds in the company. Answer (B) is incorrect because an offer that is “two-tier” involves two different offer prices for the shares acquired. The terms of the share acquisition do not relate to the issuance or repurchase of bonds in the company. Answer (C) is incorrect because a two-tier offer is made to entice early action by shareholders so that they will not hold out for a higher price. Answer (D) is correct. In a two-tier merger offer, shareholders are enticed to sell to the bidder early by a higher stock price offer for those who tender their stock early.

[794] Gleim #: 5.182 -- Source: IIA, adapted Which combination of ratios can be used to derive return on equity?

A. B. C. D.

Market value to book value ratio and total debt to total assets ratio. Price to earnings ratio, earnings per share, and net profit margin. Price to earnings ratio and return on assets. Net profit margin, asset turnover, and equity multiplier.


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Answer (A) is incorrect because the market value to book value ratio is the market value of common equity per share derived by dividing the book value of common equity by the average number of shares outstanding. Neither this ratio nor the total debt to total assets ratio provides any information about net income available to shareholders, which is necessary to calculate the return on equity. Answer (B) is incorrect because the price to earnings ratio is the ratio of the stock’s market price divided by earnings per share; the earnings per share is the net income available to shareholders divided by the average number of shares outstanding; and the net profit margin is net profit divided by sales. While all three ratios contain much information about the equity account, none of them provides information about the book value of common equity, which is necessary to calculate the return on equity. Answer (C) is incorrect because the price to earnings ratio is the ratio of the stock’s market price divided by earnings per share, and the return on assets ratio is net income divided by assets. Neither of these two ratios provides information about the book value of common equity, which is necessary to calculate the return on equity. Answer (D) is correct. The simple Du Pont equation combines the following ratios: (Net income available to Shareholders ÷ Sales) × (Sales ÷ Total assets) × (Total assets ÷ Common equity at Book value) = Return on equity. The total assets and sales cancel out in multiplication, leaving net income available to shareholders divided by common equity at book value, which equals return on equity. [795] Gleim #: 5.183 -- Source: IIA, adapted Which of the following is true about the impact of price inflation on financial ratio analysis?

A. Inflation impacts only those ratios computed from balance sheet accounts. B. Inflation impacts financial ratio analysis for one firm over time, but not comparative analysis of firms of different ages. C. Inflation impacts financial ratio analysis for one firm over time, as well as comparative analysis of firms of different ages. D. Inflation impacts comparative analysis of firms of different ages, but not financial ratio analysis for one firm over time. Answer (A) is incorrect because inflation also distorts depreciation charges, inventory costs, and profits. Answer (B) is incorrect because inflation impacts both aspects. Answer (C) is correct. Inflation has considerable impact on financial ratio analysis. This impact distorts both analysis of a single firm over time and comparative analysis of different aged firms. Answer (D) is incorrect because inflation impacts both aspects. [Fact Pattern #54] A company sells 10,000 skateboards a year at $66 each. All sales are on credit, with terms of 3/10, net 30, which means three percent discount if payment is made within 10 days; otherwise full payment is due at the end of 30 days. One half of the customers are expected to take advantage of the discount and pay on day 10. The other half are expected to pay on day 30. Sales are expected to be uniform throughout the year for both types of customers. [796] Gleim #: 5.184 -- Source: CIA 594 IV-35 (Refers to Fact Pattern #54) What is the expected average collection period for the company?

A. B. C. D.

10 days. 15 days. 20 days. 30 days.


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Answer (A) is incorrect because 10 days assumes all customers take the discount. Answer (B) is incorrect because 15 days assumes half of the customers pay on day 30 but ignores the remaining half of the customers who pay on day 10. Answer (C) is correct. The average collection period is the average time it takes to receive payment from customers. because one-half of the customers will pay on day 10 and half will pay on day 30, the average collection period is 20 days [.5(10 days) + .5(30 days)]. Answer (D) is incorrect because 30 days assumes all customers pay on day 30. [797] Gleim #: 5.185 -- Source: CIA 594 IV-36 (Refers to Fact Pattern #54) Assume that the average collection period is 25 days. After the credit policy is well established, what is the expected average accounts receivable balance for the company at any moment in time, assuming a 365-day year?

A. B. C. D.

684.93 1,808.22 27,123.30 45,205.48 Answer (A) is incorrect because 684.93 is based on annual credit sales of 10,000. Answer (B) is incorrect because 1,808.22 equals the credit sales per day. Answer (C) is incorrect because 27,123.30 is based on a 15-day average collection period. Answer (D) is correct. The expected average accounts receivable balance equals the average collection period times the credit sales per day. Thus, the average accounts receivable balance is 45,205.48 {[(10,000 units sold on credit × 66 price) ÷ 365 days] × 25 days}. The foregoing calculation assumes that receivables are recorded at their gross amounts.

[798] Gleim #: 6.1 -- Source: CIA 1192 IV-16 Presented below is a cost-volume-profit chart for a firm. Various reference points are marked on the chart with letters.

(Refer to Figure CIA3_07_05.) The letters CEH on the chart represent the

A. B. C. D.

Total sales. Total expenses. Area of the chart where total sales exceed total expenses. Area of the chart where total expenses exceed total sales. Answer (A) is incorrect because line HEO represents total sales. Answer (B) is incorrect because line CED represents total expenses. Answer (C) is correct. A cost-volume-profit chart contains elements (lines, points, axes) that identify variable cost, fixed cost, the breakeven point, total revenue, profit, and volume in units. When the total sales revenue line rises above the total expense line, a company will have positive net income. Answer (D) is incorrect because the loss area, i.e., the area of the chart where total expenses exceed sales, is represented by the area OED.


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[799] Gleim #: 6.2 -- Source: CIA 1196 III-91 A company manufactures a single product. Estimated cost data regarding this product and other information for the product and the company are as follows: Sales price per unit Total variable production cost per unit Sales commission (on sales) Fixed costs and expenses: Manufacturing overhead General and administrative Effective income tax rate

$40 $22 5% $5,598,720 $3,732,480 40%

The number of units the company must sell in the coming year in order to reach its breakeven point is

A. B. C. D.

388,800 units. 518,400 units. 583,200 units. 972,000 units. Answer (A) is incorrect because 388,800 units results from not subtracting the variable costs per unit from sales price. Answer (B) is incorrect because 518,400 units does not reflect the sales commissions in the total variable costs. Answer (C) is correct. The breakeven point is determined by dividing total fixed costs by the unit contribution margin. The total fixed costs are $9,331,200 ($5,598,720 manufacturing overhead + $3,732,480 general and administrative). The contribution margin is $16.00 ($40 sales price – $22 variable production cost – $2.00 commission). Thus, the breakeven point is 583,200 units ($9,331,200 ÷ $16). Answer (D) is incorrect because 972,000 units includes taxes in the total variable costs, which understates the unit contribution margin.

[800] Gleim #: 6.3 -- Source: CIA 1193 IV-11 A retail company determines its selling price by marking up variable costs 60%. In addition, the company uses frequent selling price markdowns to stimulate sales. If the markdowns average 10%, what is the company’s contribution margin ratio?

A. B. C. D.

27.5% 30.6% 37.5% 41.7% Answer (A) is incorrect because 27.5% omits markdowns from the denominator. Answer (B) is correct. The contribution margin equals revenues minus variable costs. The CMR equals the UCM divided by the selling price. For example, if variable costs average $10 per unit, the average selling price is $16 (1.60 × $10). However, the 10% markdown implies that the actual average selling price is $14.40 (.90 × $16). The CMR is therefore 30.6% [($14.40 – $10.00) ÷ $14.40]. Answer (C) is incorrect because 37.5% ignores markdowns. Answer (D) is incorrect because 41.7% omits markdowns from the numerator.


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[Fact Pattern #55]

A company that sells its single product for $40 per unit uses cost-volume-profit analysis in its planning. The company’s after-tax net income for the past year was $1,188,000 after applying an effective tax rate of 40%. The projected costs for manufacturing and selling its single product in the coming year are listed.

Variable costs per unit: Direct material Direct labor Manufacturing overhead Selling and administrative costs

$ 5.00 4.00 6.00 3.00

Total cost per unit

$18.00

Annual fixed operating costs: Manufacturing overhead Selling and administrative costs

$6,200,000 3,700,000

Total annual fixed cost

$9,900,000

[801] Gleim #: 6.4 -- Source: CIA 596 III-84 (Refers to Fact Pattern #55) The dollar sales volume required in the coming year to earn the same after-tax net profit as the past year is

A. B. C. D.

$20,160,000 $21,600,000 $23,400,000 $26,400,000 Answer (A) is incorrect because $20,160,000 does not adjust after-tax net profit to pretax net profit. Answer (B) is correct. The desired after-tax net profit is $1,188,000 (the past year’s amount). Given a 40% tax rate, the pretax equivalent is $1,980,000 [$1,188,000 ÷ (1.0 – .40)]. Pretax net profit equals dollar sales (unit sales × $40), minus total fixed costs, minus total variable costs (unit sales × unit variable cost). Hence, the contribution margin (sales – variable costs) is equated with the sum of fixed costs and the targeted pretax net profit. Unit sales (S) equal 540,000, and sales dollars equal $21,600,000 ($40 × 540,000 units).

$40S – $9,900,000 – $18 S = $1,980,000 $22S = $11,880,000 S = 540,000 units Answer (C) is incorrect because $23,400,000 results from adjusting after-tax net profit by dividing by the tax rate rather than one minus the tax rate. Answer (D) is incorrect because $26,400,000 results from equating the sum of the desired pretax net profit and total fixed costs with total variable costs instead of the contribution margin. [802] Gleim #: 6.5 -- Source: CIA 596 III-85 (Refers to Fact Pattern #55) The company has learned that a new direct material is available that will increase the quality of its product. The new material will increase the direct material costs by $3 per unit. The company will increase the selling price of the product to $50 per unit and increase its marketing costs by $1,575,000 to advertise the higher-quality product. The number of units the company has to sell in order to earn a 10% before-tax return on sales would be


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A. B. C. D.

337,500 units. 346,875 units. 425,000 units. 478,125 units. Answer (A) is incorrect because 337,500 units results from using the wrong sign for the pretax net profit. Answer (B) is incorrect because 346,875 units results from subtracting, not adding, the incremental marketing costs to determine total fixed costs. Answer (C) is incorrect because 425,000 units fails to adjust for the increase in direct materials costs. Answer (D) is correct. Pretax net profit (10% of dollar sales) equals dollar sales (unit sales × $50), minus total fixed costs (increased by $1,575,000 of marketing costs), minus total variable costs (increased by $3 per unit). Unit sales (S) therefore equal 478,125 units.

.10($50) = $50S – ($9,900,000 + $1,575,000) – ($18 + $3) S $24S = $11,475,000 S = 478,125 units

[Fact Pattern #56] A company manufactures and sells a single product. Planned and actual production in its first year of operation was 100,000 units. Planned and actual costs for that year were as follows:

Variable Fixed

Manufacturing

Nonmanufacturing

$600,000

$500,000

400,000

300,000

The company sold 85,000 units of product at a selling price of $30 per unit. [803] Gleim #: 6.6 -- Source: CIA 595 III-87 (Refers to Fact Pattern #56) Using absorption costing, the company’s operating profit was

A. B. C. D.

$750,000 $900,000 $975,000 $1,020,000


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Answer (A) is incorrect because $750,000 equals absorption costing net profit minus ending inventory ($15,000 units × $10). Answer (B) is correct. Under absorption costing, product costs include fixed and variable manufacturing costs. The unit product cost under absorption costing is $10 [($600,000 + $400,000) ÷ 100,000 units produced]. All nonmanufacturing costs are expensed in the period incurred. Thus, operating profit is $900,000. Revenue (85,000 units × $30) Cost of goods sold (85,000 units × $10) Nonmanufacturing costs ($500,000 + $300,000)

$2,550,000 (850,000)

Operating profit

$ 900,000

(800,000)

Answer (C) is incorrect because $975,000 treats the variable nonmanufacturing costs as manufacturing costs. Answer (D) is incorrect because $1,020,000 assumes that all costs are manufacturing costs. [804] Gleim #: 6.7 -- Source: CIA 595 III-88 (Refers to Fact Pattern #56) Using variable costing, the company’s operating profit was

A. B. C. D.

$750,000 $840,000 $915,000 $975,000 Answer (A) is incorrect because $750,000 equals variable costing net profit minus ending inventory (15,000 units × $6). Answer (B) is correct. Under variable costing, the product cost includes only variable manufacturing costs. All fixed costs are expensed in the period incurred. Unit product cost under variable costing is $6 ($600,000 ÷ 100,000 units produced). Revenue (85,000 units × $30) Variable cost of goods sold (85,000 units × $6) Variable nonmanufacturing costs

$2,550,000

Contribution margin Fixed costs

$1,540,000 (700,000)

Operating profit

$ 840,000

(510,000) (500,000)

Answer (C) is incorrect because $915,000 treats all variable costs as manufacturing costs. Answer (D) is incorrect because $975,000 treats all variable costs and fixed manufacturing costs as product costs.


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[805] Gleim #: 6.8 -- Source: CIA 1190 IV-12 During its first year of operations, a company produced 275,000 units and sold 250,000 units. The following costs were incurred during the year: Variable costs per unit: Direct materials Direct labor Manufacturing overhead Selling and administrative

$15.00 10.00 12.50 2.50

Total fixed costs: Manufacturing overhead Selling and administrative

$2,200,000 1,375,000

The difference between operating profit calculated on the absorption-costing basis and on the variable-costing basis is that absorption-costing operating profit is

A. B. C. D.

$200,000 greater. $220,000 greater. $325,000 greater. $62,500 less. Answer (A) is correct. Absorption-costing operating profit will exceed variable-costing operating income because production exceeds sales, resulting in a deferral of fixed manufacturing overhead in the inventory calculated using the absorption method. The difference of $200,000 is equal to the fixed manufacturing overhead per unit ($2,200,000 ÷ 275,000 = $8.00) times the difference between production and sales (275,000 – 250,000 = 25,000, which is the inventory change in units). Answer (B) is incorrect because units produced, not units sold, should be used as the denominator to calculate the fixed manufacturing cost per unit. Answer (C) is incorrect because fixed selling and administrative costs are not properly inventoriable under absorption costing. Answer (D) is incorrect because variable selling and administrative costs are period costs under both variable- and absorption-cost systems in the determination of operating profit.


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[Fact Pattern #57]

A and B are autonomous divisions of a corporation. They have no beginning or ending inventories, and the number of units produced is equal to the number of units sold. Following is financial information relating to the two divisions.

A Sales

B

$150,000

$400,000

Other revenue

10,000

15,000

Direct materials

30,000

65,000

Direct labor

20,000

40,000

5,000

15,000

Fixed factory overhead

25,000

55,000

Variable S&A expense

15,000

30,000

Fixed S&A expense

35,000

60,000

Central corporate expenses (allocated)

12,000

20,000

Variable factory overhead

[806] Gleim #: 6.9 -- Source: CIA 1193 IV-20 (Refers to Fact Pattern #57) What is the total contribution to corporate profits generated by Division A before allocation of central corporate expenses?

A. B. C. D.

$18,000 $20,000 $30,000 $90,000 Answer (A) is incorrect because $18,000 is the result of deducting the central corporate expenses. Answer (B) is incorrect because $20,000 is the result of excluding other revenue. Answer (C) is correct. Division A’s total contribution to corporate profits includes everything except the central corporate expense allocation. Thus, the total contribution is $30,000 ($150,000 sales + $10,000 other revenue – $30,000 direct materials – $20,000 direct labor – $5,000 variable overhead – $25,000 fixed overhead – $15,000 variable S&A expense – $35,000 fixed S&A expense). Answer (D) is incorrect because $90,000 is the result of failing to deduct the fixed costs.

[807] Gleim #: 6.10 -- Source: CIA 1193 IV-21 (Refers to Fact Pattern #57) What is the contribution margin of Division B?

A. B. C. D.

$150,000 $205,000 $235,000 $265,000


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Answer (A) is incorrect because $150,000 is the result of subtracting fixed costs. Answer (B) is incorrect because $205,000 is the result of subtracting fixed S&A costs. Answer (C) is incorrect because $235,000 is the result of subtracting fixed S&A costs but not variable S&A costs. Answer (D) is correct. The contribution margin equals revenue minus variable costs. Thus, Division B’s contribution margin is $265,000 ($400,000 sales + $15,000 other revenue – $65,000 direct materials – $40,000 direct labor – $15,000 variable overhead – $30,000 variable S&A expense). [808] Gleim #: 6.11 -- Source: CIA 595 III-94 A company allocates overhead to jobs in process using direct labor costs, raw material costs, and machine hours. The overhead application rates for the current year are

100% of direct labor 20% of raw materials $117 per machine hour

A particular production run incurred the following costs:

Direct labor, $8,000 Raw materials, $2,000 A total of 140 machine hours were required for the production run

What is the total cost that would be charged to the production run?

A. B. C. D.

$18,000 $18,400 $24,780 None of the answers are correct. Answer (A) is incorrect because $18,000 includes only $8,000 for overhead (based on 100% of direct labor). Answer (B) is incorrect because $18,400 includes only $8,400 for overhead (based on 100% of direct labor and 20% of raw materials). Answer (C) is incorrect because $24,780 is the overhead applied, not total cost. Answer (D) is correct. The total cost is $34,780. It consists of direct labor ($8,000), raw materials ($2,000), and overhead ($24,780). The overhead applied component of total costs is calculated as follows:

100% × $8,000 of direct labor 20% × $2,000 of raw materials $117 × 140 machine hours

= = =

$ 8,000 400 16,380 $24,780

Accordingly, no answer given is correct.


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[809] Gleim #: 6.12 -- Source: CIA 1184 IV-21 A company manufactures plastic products for the home and restaurant market. The company also does contract work for other customers and uses a job-order costing system. The flexible budget covering next year’s expected range of activity is Direct labor hours

50,000

80,000

110,000

Machine hours

40,000

64,000

88,000

Variable O/H costs Fixed O/H costs

$100,000 $160,000 $220,000 150,000 150,000 150,000

Total O/H costs

$250,000 $310,000 $370,000

A predetermined overhead rate based on direct labor hours is used to apply total overhead. Management has estimated that 100,000 direct labor hours will be used next year. The predetermined overhead rate per direct labor hour to be used to apply total overhead to the individual jobs next year is

A. B. C. D.

$3.36 $3.50 $3.70 $3.88 Answer (A) is incorrect because $3.36 per direct labor hour is based on use of an activity level of 110,000 direct labor hours to determine the fixed overhead rate. Answer (B) is correct. The predetermined overhead rate is calculated by dividing the total fixed overhead by the activity level to arrive at a unit fixed overhead cost that is added to the unit variable overhead cost. The unit variable overhead rate is the same at each activity level. Thus, the predetermined overhead rate is $3.50 [($150,000 FOH ÷ 100,000 hrs.) + ($220,000 VOH ÷ 110,000 hrs.)]. Answer (C) is incorrect because $3.70 is the result of assuming that $220,000 of variable overhead will be incurred for 100,000 (not 110,000) direct labor hours. Answer (D) is incorrect because $3.88 (rounded) results from using an activity level of 80,000 direct labor hours to determine the fixed overhead rate.

[810] Gleim #: 6.13 -- Source: Publisher At the beginning of the year, Smith Inc. budgeted the following: Units

10,000

Sales Minus: Total variable expenses Total fixed expenses

$100,000

Net income

$ 20,000

Factory overhead: Variable Fixed

$ 30,000 10,000

60,000 20,000

There were no beginning inventories. At the end of the year, no work was in process, total factory overhead incurred was $39,500, and underapplied factory overhead was $1,500. Factory overhead was applied on the basis of budgeted unit production. How many units were produced this year?


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A. B. C. D.

10,250 10,000 9,875 9,500 Answer (A) is incorrect because 10,250 would have been produced if overhead had been overapplied by $1,500 [($39,500 + $1,500) ÷ $4]. Answer (B) is incorrect because 10,000 is the result of dividing budgeted, not applied, overhead by the application rate. Answer (C) is incorrect because 9,875 units would have been produced if $39,500 had been the amount of applied overhead. Answer (D) is correct. Given actual overhead of $39,500 and underapplied overhead of $1,500, overhead applied was $38,000 ($39,500 – $1,500). Overhead is applied at the rate of $4 per unit ($40,000 budgeted overhead ÷ 10,000 budgeted units). Accordingly, 9,500 units were produced ($38,000 applied overhead ÷ $4 per unit application rate).

[Fact Pattern #58]

Kimbeth Manufacturing uses a process cost system to manufacture Dust Density Sensors for the mining industry. The following information pertains to operations for the month of May: Units Beginning work-in-process inventory, May 1 Started in production during May Completed production during May Ending work-in-process inventory, May 31

16,000 100,000 92,000 24,000

The beginning inventory was 60% complete for materials and 20% complete for conversion costs. The ending inventory was 90% complete for materials and 40% complete for conversion costs. Costs pertaining to the month of May are as follows: Beginning inventory costs are materials, $54,560; direct labor, $20,320; and factory overhead, $15,240. Costs incurred during May are materials used, $468,000; direct labor, $182,880; and factory overhead, $391,160.

[811] Gleim #: 6.14 -- Source: CMA 695 3-1 (Refers to Fact Pattern #58) Using the first-in, first-out (FIFO) method, the equivalent units of production (EUP) for materials are

A. B. C. D.

97,600 units. 104,000 units. 107,200 units. 108,000 units. Answer (A) is incorrect because 97,600 units omits the 6,400 EUP added to beginning work-in-process. Answer (B) is correct. Under FIFO, EUP are based solely on work performed during the current period. The EUP equals the sum of the work done on the beginning work-in-process inventory, units started and completed in the current period, and the ending work-in-process inventory. Given that beginning work-in-process was 60% complete as to materials, the current period is charged for 6,400 EUP (40% × 16,000 units). Because 92,000 units were completed during the period, 76,000 (92,000 – 16,000 in BWIP) must have been started and completed during the period. They represent 76,000 EUP. Finally, the EUP for ending work-in-process equal 21,600 (90% × 24,000 units). Thus, total EUP for May are 104,000 (6,400 + 76,000 + 21,600). Answer (C) is incorrect because 107,200 units assumes beginning work-in-process was 40% complete. Answer (D) is incorrect because 108,000 units equals the sum of the physical units in beginning work-in-process and the physical units completed.


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[812] Gleim #: 6.15 -- Source: CMA 695 3-2 (Refers to Fact Pattern #58) Using the FIFO method, the equivalent units of production for conversion costs are

A. B. C. D.

85,600 units. 88,800 units. 95,200 units. 98,400 units. Answer (A) is incorrect because 85,600 units omits the work done on beginning work-in-process. Answer (B) is incorrect because 88,800 units omits the work done on ending work-in-process. Answer (C) is incorrect because 95,200 units assumes the beginning work-in-process was 40% complete as to conversion costs. Answer (D) is correct. The beginning inventory was 20% complete as to conversion costs. Hence, 12,800 EUP (80% × 16,000 units) were required for completion. EUP for units started and completed equaled 76,000 [100% × (92,000 completed units – 16,000 units in BWIP)]. The work done on ending work-in-process totaled 9,600 EUP (40% × 24,000 units). Thus, total EUP for May are 98,400 (12,800 + 76,000 + 9,600).

[813] Gleim #: 6.16 -- Source: CMA 695 3-3 (Refers to Fact Pattern #58) Using the FIFO method, the equivalent unit cost of materials for May is

A. B. C. D.

$4.12 $4.50 $4.60 $4.80 Answer (A) is incorrect because $4.12 is based on EUP calculated under the weighted-average method. Answer (B) is correct. Under the FIFO method, EUP for materials equal 104,000 [(16,000 units in BWIP × 40%) + (76,000 units started and completed × 100%) + (24,000 units in EWIP × 90%)]. Consequently, the equivalent unit cost of materials is $4.50 ($468,000 total materials cost in May ÷ 104,000 EUP). Answer (C) is incorrect because $4.60 is the weighted-average cost per equivalent unit. Answer (D) is incorrect because $4.80 omits the 6,400 EUP added to beginning work-in-process.

[814] Gleim #: 6.17 -- Source: CMA 695 3-4 (Refers to Fact Pattern #58) Using the FIFO method, the equivalent unit conversion cost for May is

A. B. C. D.

$5.65 $5.83 $6.00 $6.20


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Answer (A) is incorrect because $5.65 is based on EUP calculated under the weighted-average method. Answer (B) is correct. Under the FIFO method, EUP for conversion costs equal 98,400 [(16,000 units in BWIP × 80%) + (76,000 units started and completed × 100%) + (24,000 units in EWIP × 40%)]. Conversion costs incurred during the current period equal $574,040 ($182,880 DL + $391,160 FOH). Hence, the equivalent unit cost for conversion costs is $5.83 ($574,040 ÷ 98,400). Answer (C) is incorrect because $6.00 is the cost per equivalent unit calculated under the weighted-average method. Answer (D) is incorrect because $6.20 results from combining conversion costs for May with those in beginning work-inprocess and dividing by 98,400 EUP. [815] Gleim #: 6.18 -- Source: CMA 695 3-5 (Refers to Fact Pattern #58) Using the FIFO method, the total cost of units in the ending work-in-process inventory at May 31 is

A. B. C. D.

$153,168 $154,800 $155,328 $156,960 Answer (A) is correct. The FIFO costs per equivalent unit for materials and conversion costs are $4.50 and $5.83, respectively. EUP for materials in ending work-in-process equal 21,600 (90% × 24,000). Thus, total FIFO materials cost is $97,200 (21,600 EUP × $4.50). EUP for conversion costs in ending work-in-process equal 9,600 (40% × 24,000). Total conversion costs are therefore $55,968 (9,600 EUP × $5.83). Consequently, total work-in-process costs are $153,168 ($97,200 + $55,968). Answer (B) is incorrect because $154,800 is based on a FIFO calculation for materials and a weighted-average calculation for conversion costs. Answer (C) is incorrect because $155,328 is based on a weighted-average calculation for materials and a FIFO calculation for conversion costs. Answer (D) is incorrect because $156,960 is the weighted-average cost of ending work-in-process.

[816] Gleim #: 6.19 -- Source: Publisher Operation costing is appropriate for products that are

A. B. C. D.

Unique. Produced in batches or production runs. Homogeneous. Related to food and beverage industries. Answer (A) is incorrect because job-order costing is used for unique products. Answer (B) is correct. Operation costing is used when different groups of products are subject to some but not all of the same processing steps (operations). Every unit passing through a given operation is processed in the same way, and conversion costs are accumulated by operation. Direct materials costs are accumulated by batch. Answer (C) is incorrect because process costing is used for homogeneous products. Answer (D) is incorrect because food and beverage products may be unique or homogeneous, and produced in jobs, lots, or batches.


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[Fact Pattern #59] This information was presented as part of Question 3 on Part 3 of the June 1992 CMA examination, which covered activity-based costing. Alaire Corporation manufactures printed circuit boards. Two of the boards account for the majority of sales. The first, a television (TV) circuit board, is the industry standard. The market for this board is competitive and price-sensitive. Alaire plans to sell 65,000 of the TV boards next year at a price of $150 per unit. The second high-volume item, a personal computer (PC) circuit board, is a new product. Because the PC board has the latest technology, it can be sold at a premium price. Plans include the sale of 40,000 PC boards at $300 per unit. Alaire uses a standard cost system, and the following data apply to the TV and PC boards:

Direct materials Direct labor Machine time

TV Board

PC Board

$80 1.5 hours .5 hours

$140 4 hours 1.5 hours

Variable factory overhead is applied on the basis of direct labor hours. For next year, variable factory overhead is budgeted at $1,120,000, and direct labor hours are estimated at 280,000. The hourly rates for machine time and direct labor are $10 and $14, respectively. Alaire applies a materials handling charge at 10% of materials cost. This charge is not included in variable factory overhead. Total annual materials costs are budgeted at $10,600,000. The following data reflect an activity-based costing analysis:

Budgeted Cost Materials overhead: Procurement Production scheduling Packaging and shipping

$ 400,000 220,000 440,000 $1,060,000

Variable overhead: Machine setup Hazardous waste disposal Quality control General supplies

$ 446,000 48,000 560,000 66,000 $1,120,000

Manufacturing: Machine insertion Manual insertion Wave soldering

$1,200,000 4,000,000 132,000

Cost Driver

Annual Activity for Cost Driver

Number of parts Number of boards Number of boards

4,000,000 parts 110,000 boards 110,000 boards

Number of setups Pounds of waste Number of inspections Number of boards

278,750 setups 16,000 pounds 160,000 inspections 110,000 boards

Number of parts Number of parts Number of boards

3,000,000 parts 1,000,000 parts 110,000 boards

$5,332,000

Required per unit Parts Machine insertions Manual insertions Machine setups Hazardous waste Inspections

TV Board

PC Board

25 24 1 2 .02 lb. 1

55 35 20 3 .35 lb. 2


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[817] Gleim #: 6.20 -- Source: Publisher (Refers to Fact Pattern #59) On the basis of standard costs, the total contribution budgeted for the TV board is

A. B. C. D.

$1,950,000 $2,275,000 $2,340,000 $2,470,000 Answer (A) is correct. As calculated below, the budgeted standard unit cost of a TV board is $120. This amount includes $6 of variable overhead [1.5 DLH × ($1,120,000 total VOH ÷ 280,000 DLH)]. Given a unit price of $150, the unit contribution margin is therefore $30. Total budgeted contribution is $1,950,000 ($30 UCM × 65,000 budgeted units).

Direct materials DM handling (10% × $80) Direct labor (1.5 hr. × $14) Machine time (.5 hr. × $10) Variable overhead (1.5 hr. × $4)

$ 80 8 21 5 6

Budgeted unit cost

$120

Answer (B) is incorrect because $2,275,000 excludes the cost of machine time ($5 × 65,000 units = $325,000). Answer (C) is incorrect because $2,340,000 excludes the variable overhead ($6 × 65,000 units = $390,000). Answer (D) is incorrect because $2,470,000 excludes the direct materials handling cost ($8 × 65,000 units = $520,000). [818] Gleim #: 6.21 -- Source: Publisher (Refers to Fact Pattern #59) On the basis of activity-based costs (ABC), the total contribution budgeted for the TV board is

A. B. C. D.

$1,594,000 $1,950,000 $2,037,100 $2,557,100


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Answer (A) is incorrect because $1,594,000 is the CM for the PC board based on an ABC calculation. Answer (B) is incorrect because $1,950,000 is the CM for the TV board based on a standard-cost calculation. Answer (C) is incorrect because $2,037,100 erroneously includes $8 per board for materials handling ($8 × 65,000 units = $520,000). Answer (D) is correct. As calculated below, the budgeted activity-based unit cost of a TV board is $110.66. Given a unit price of $150, the unit contribution margin is $39.34. Total budgeted contribution is $2,557,100 ($39.34 UCM × 65,000 budgeted units).

Direct materials Procurement [($400,000 ÷ 4,000,000 parts) × 25 parts] Scheduling ($220,000 ÷ 110,000 boards) Packaging and shipping ($440,000 ÷ 110,000 boards) Setups [($446,000 ÷ 278,750 setups) × 2 setups] Waste disposal [($48,000 ÷ 16,000 lb.) × .02] Quality control ($560,000 ÷ 160,000 inspections) General supplies ($66,000 ÷ 110,000 boards) Machine insertion [(1,200,000 ÷ 3,000,000 parts) × 24 parts] Manual insertion ($4,000,000 ÷ 1,000,000 parts) Soldering ($132,000 ÷ 110,000 boards)

$ 80.00 2.50 2.00 4.00 3.20 .06 3.50 .60 9.60 4.00 1.20

Budgeted ABC unit cost

$110.66


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[Fact Pattern #60] Believing that its traditional cost system may be providing misleading information, an organization is considering an activity-based costing (ABC) approach. It now employs a full cost system and has been applying its manufacturing overhead on the basis of machine hours. The organization plans on using 50,000 direct labor hours and 30,000 machine hours in the coming year. The following data show the manufacturing overhead that is budgeted.

Budgeted Activity

Activity

Cost Driver

Material handling Setup costs Machining costs Quality control

No. of parts handled No. of setups Machine hours No. of batches

Budgeted Cost

6,000,000 750 30,000 500

$ 720,000 315,000 540,000 225,000

Total manufacturing overhead cost:

$1,800,000

Cost, sales, and production data for one of the organization’s products for the coming year are as follows:

Prime costs: Direct material cost per unit Direct labor cost per unit .05 DLH @ $15.00/DLH

$4.40 .75

Total prime cost

$5.15

Sales and production data: Expected sales Batch size Setups Total parts per finished unit Machine hours required

20,000 units 5,000 units 2 per batch 5 parts 80 MH per batch

[819] Gleim #: 6.22 -- Source: CIA 1195 III-93 (Refers to Fact Pattern #60) If the organization uses the traditional full cost system, the cost per unit for this product for the coming year will be

A. B. C. D.

$5.39 $5.44 $6.11 $6.95 Answer (A) is incorrect because $5.39 assumes that 80 machine hours are required for the total production of 20,000 units. Answer (B) is incorrect because $5.44 is based on the machining overhead rate ($18). Answer (C) is correct. Given that manufacturing overhead is applied on the basis of machine hours, the overhead rate is $60 per hour ($1,800,000 ÷ 30,000) or $.96 per unit [($60 × 80 machine hours per batch) ÷ 5,000 units per batch]. Accordingly, the unit full cost is $6.11 ($5.15 unit price cost + $.96). Answer (D) is incorrect because $6.95 is based on the direct labor hour manufacturing overhead rate.


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[820] Gleim #: 6.23 -- Source: CIA 1195 III-94 (Refers to Fact Pattern #60) If the organization employs an activity-based costing system, the cost per unit for the product described for the coming year will be

A. B. C. D.

$6.00 $6.08 $6.21 $6.30 Answer (A) is incorrect because $6.00 assumes one setup per batch and 80 total machine hours. Answer (B) is incorrect because $6.08 assumes that only 80 machine hours were used. Answer (C) is incorrect because $6.21 assumes one setup per batch. Answer (D) is correct. Materials handling cost per part is $.12 ($720,000 ÷ 6,000,000), cost per setup is $420 ($315,000 ÷ 750), machining cost per hour is $18 ($540,000 ÷ 30,000), and quality cost per batch is $450 ($225,000 ÷ 500). Hence, total manufacturing overhead applied is $22,920 [(5 parts per unit) × 20,000 units × $.12) + (4 batches × 2 setups per batch × $420) + (4 batches × 80 machine hours per batch × $18) + (4 batches × $450)]. The total unit cost is $6.296 [$5.15 prime cost + ($22,920 ÷ 20,000 units) overhead].

[Fact Pattern #61] Fabricating and Finishing are the two production departments of a manufacturing company. Building Operations and Information Services are service departments that provide support to the two production departments as well as to each other. The company employs departmental overhead rates in the two production departments to allocate the service department costs to the production departments. Square footage is used to allocate building operations, and computer time is used to allocate information services. The costs of the service departments and relevant operating data for the departments are as follows:

Building Operations Labor and benefit costs Other traceable costs Total

Information Services

$200,000

$ 300,000

350,000

900,000

$550,000

$1,200,000

5,000

10,000

Square feet occupied Computer time (in hours)

200

Fabricating

Finishing

16,000

24,000

1,200

600

[821] Gleim #: 6.24 -- Source: CIA 596 III-82 (Refers to Fact Pattern #61) If the company employs the direct method to allocate the costs of the service departments, then the amount of Building Operations costs allocated to Fabricating would be

A. B. C. D.

$140,000 $160,000 $176,000 $220,000


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Answer (A) is incorrect because $140,000 is 40% of other traceable costs. Answer (B) is incorrect because $160,000 assumes an allocation base of 55,000 square feet. Answer (C) is incorrect because $176,000 assumes an allocation base of 50,000 square feet. Answer (D) is correct. The direct method does not allocate service costs to other service departments. Hence, the allocation base is the square footage in the two production departments. Fabricating’s share is 40% (16,000 ÷ 40,000) of the total cost incurred by Building Operations, or $220,000 (40% × $550,000). [822] Gleim #: 6.25 -- Source: CIA 596 III-83 (Refers to Fact Pattern #61) If the company employs the step method to allocate the costs of the service departments and if Information Services costs are allocated first, then the total amount of service department costs (information services and building operations) allocated to Finishing would be

A. B. C. D.

$657,000 $681,600 $730,000 $762,000 Answer (A) is incorrect because $657,000 results from allocating Building Operations costs first. Answer (B) is incorrect because $681,600 results from allocating Building Operations costs to Information Services. Answer (C) is incorrect because $730,000 allocates the costs of both service departments according to the direct method rather than the step method. Answer (D) is correct. The step method of service department cost allocation is a sequential (but not a reciprocal) process. These costs are allocated to other service departments as well as to users. The process usually starts with the service department that renders the greatest percentage of its services to other service departments, the department that provides services to the greatest number of other departments, or the department with the greatest costs of services provided to other service departments. If the $1,200,000 of Information Services costs is allocated first, the allocation base is 2,000 computer hours (200 + 1,200 + 600). Thus, $120,000 [(200 ÷ 2,000) × $1,200,000] will be allocated to Building Operations and $360,000 [(600 ÷ 2,000) × $1,200,000] to Finishing. The total of the Building Operations costs to be allocated to production equals $670,000 ($550,000 + $120,000). The allocation base will be 40,000 square feet because no costs are allocated back to Information Services. Accordingly, the total of service costs allocated to Finishing equals $762,000 {$360,000 + [$670,000 × (24,000 ÷ 40,000)]}.

[823] Gleim #: 6.26 -- Source: CIA 1190 IV-8 The step-down method of service department cost allocation often begins with allocation of the costs of the service department that

A. B. C. D.

Provides the greatest percentage of its services to the production departments. Provides the greatest percentage of its services to other service departments. Provides the greatest total output of services. Has the highest total costs among the service departments.


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Answer (A) is incorrect because the step-down method may start with the department that renders the highest percentage of its total services to other service (not production) departments. Answer (B) is correct. The step-down method may start with the department that renders the highest percentage of its total services to other service departments. It then progresses in descending order to the service department rendering the least percentage of its services to the other service departments. An alternative is to begin with the department that renders the highest dollar value of services to other service departments. A third possibility is to begin with the department that renders service to the greatest number of other service departments. Answer (C) is incorrect because beginning with the service department with the greatest output is not customary. Answer (D) is incorrect because beginning with the service department with the highest costs is not customary. [Fact Pattern #62]

Atlas Foods produces three supplemental food products simultaneously through a refining process costing $93,000. The joint products, Alfa and Betters, have a final selling price of $4 per pound and $10 per pound, respectively, after additional processing costs of $2 per pound of each product are incurred after the split-off point. Morefeed, a by-product, is sold at the split-off point for $3 per pound.

Alfa

10,000 pounds of Alfa, a popular but relatively rare grain supplement having a caloric value of 4,400 calories per pound.

Betters

5,000 pounds of Betters, a flavoring material high in carbohydrates with a caloric value of 11,200 calories per pound.

Morefeed

1,000 pounds of Morefeed, used as a cattle feed supplement with a caloric value of 1,000 calories per pound.

[824] Gleim #: 6.27 -- Source: CMA 1293 3-3 (Refers to Fact Pattern #62) Assuming Atlas Foods inventories Morefeed, the by-product, the joint cost to be allocated to Alfa, using the net realizable value method is

A. B. C. D.

$3,000 $30,000 $31,000 $60,000 Answer (A) is incorrect because $3,000 is the value of the by-product. Answer (B) is correct. The NRV at split-off for each of the joint products must be determined. Given that Alfa has a $4 selling price and an additional $2 of processing costs, the value at split-off is $2 per pound. The total value at split-off for 10,000 pounds is $20,000. Betters has a $10 selling price and an additional $2 of processing costs. Thus, the value at split-off is $8 per pound. The total value of 5,000 pounds of Betters is therefore $40,000. The 1,000 pounds of Morefeed has a split-off value of $3 per pound, or $3,000. Assuming that Morefeed (a by-product) is inventoried (recognized in the accounts when produced) and treated as a reduction of joint costs, the allocable joint cost is $90,000 ($93,000 – $3,000). (NOTE: Other methods of accounting for by-products are possible.) The total net realizable value of the main products is $60,000 ($20,000 Alfa + $40,000 Betters). The allocation to Alfa is $30,000 [($20,000 ÷ $60,000) × $90,000]. Answer (C) is incorrect because $31,000 fails to adjust the joint processing cost for the value of the by-product. Answer (D) is incorrect because $60,000 is the amount allocated to Betters.


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[825] Gleim #: 6.28 -- Source: CMA 1293 3-4 (Refers to Fact Pattern #62) Assuming Atlas Foods inventories Morefeed, the by-product, the joint cost to be allocated to Alfa, using the physical quantity method is

A. B. C. D.

$3,000 $30,000 $31,000 $60,000 Answer (A) is incorrect because $3,000 is the value of the by-product. Answer (B) is incorrect because $30,000 is based on the net realizable value method. Answer (C) is incorrect because $31,000 is based on the net realizable value method and fails to adjust the joint processing cost for the value of the by-product. Answer (D) is correct. Joint cost is $93,000, and Morefeed has a split-off value of $3,000. Assuming the latter amount is treated as a reduction in joint cost, the allocable joint cost is $90,000. The total physical quantity (volume) of the two joint products is 15,000 pounds (10,000 Alfa + 5,000 Betters). Hence, $60,000 [(10,000 ÷ 15,000) × $90,000] of the net joint costs should be allocated to Alfa.

[826] Gleim #: 6.29 -- Source: CMA 1293 3-5 (Refers to Fact Pattern #62) Assuming Atlas Foods inventories Morefeed, the by-product, the joint cost to be allocated to Betters using the weighted quantity method based on caloric value per pound is

A. B. C. D.

$39,208 $39,600 $50,400 $52,080 Answer (A) is incorrect because $39,208 is the amount allocated to Alfa if the 1,000,000 calories attributable to Morefeed is included in the computation. Answer (B) is incorrect because $39,600 is the allocation to Alfa. Answer (C) is correct. The net allocable joint cost is $90,000. The caloric value of Alfa is 44,000,000 (4,400 × 10,000 pounds), the caloric value of Betters is 56,000,000 (11,200 × 5,000 pounds), and the total is 100,000,000. Of this total volume, Alfa makes up 44% and Betters 56%. Thus, $50,400 (56% × $90,000) should be allocated to Betters. Answer (D) is incorrect because $52,080 is the allocation to Betters if the joint cost is not adjusted for the value of the by-product.

[827] Gleim #: 6.30 -- Source: CMA 1293 3-6 (Refers to Fact Pattern #62) Assuming Atlas Foods inventories Morefeed, the by-product, the joint cost to be allocated to Alfa using the gross market value method is

A. B. C. D.

$36,000 $40,000 $41,333 $50,000


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Answer (A) is incorrect because $36,000 is based on 40%, not 4/9. Answer (B) is correct. Alfa has a gross sales value of $40,000 ($4 × 10,000 pounds), Betters has a gross sales value of $50,000 ($10 × 5,000 pounds), and Morefeed has a split-off value of $3,000. If the value of Morefeed is inventoried and treated as a reduction in joint cost, the allocable joint cost is $90,000 ($93,000 – $3,000). The total gross sales value of the two main products is $90,000 ($40,000 + $50,000). Of this total value, $40,000 should be allocated to Alfa [($40,000 ÷ $90,000) × $90,000]. Answer (C) is incorrect because $41,333 fails to adjust the joint cost by the value of the by-product. Answer (D) is incorrect because $50,000 is the joint cost allocated to Betters. [Fact Pattern #63]

A company produces a gasoline additive. The standard costs and input for a 600-liter batch of the additive are presented below.

Chemical

Standard Input Quantity in Liters

Standard Cost per Liter

Echol Protex Benz CT-40

200 100 250 50

$.200 .425 .150 .300

Total Cost $ 40.00 42.50 37.50 15.00

600

$135.00

The quantities purchased and used during the current period are shown below. A total of 140 batches were made during the current period.

Quantity PurChemical chased (Liters)

Total Purchase Price

Quantity Used (Liters)

Echol Protex Benz CT-40

25,000 13,000 40,000 7,500

$ 5,365 6,240 5,840 2,220

26,600 12,880 37,800 7,140

Total

85,500

$19,665

84,420

[828] Gleim #: 6.31 -- Source: Publisher (Refers to Fact Pattern #63) What is the materials mix variance for this operation?

A. B. C. D.

$294 favorable. $388.50 favorable. $94.50 unfavorable. $219.50 favorable.


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Answer (A) is incorrect because $294 favorable is the materials quantity variance. Answer (B) is correct. The materials mix variance equals the actual total quantity used times the difference between the budgeted weighted-average standard unit cost for the budgeted mix and the budgeted weighted-average standard unit cost for the actual mix. This variance is favorable if the standard weighted-average cost for the actual mix is less than the standard weighted-average cost for the budgeted mix. The standard mix weighted-average standard unit cost is $.225 per liter ($135 standard total cost ÷ 600 liters). The standard cost of the actual quantity used was $18,606 (see below). Thus, the actual mix weighted-average standard unit cost was $.220398 ($18,606 ÷ 84,420 liters used), and the mix variance was $388.50 favorable [($.220398 – $.225) × 84,420 liters].

$.200 × 26,600 .425 × 12,880 .150 × 37,800 .300 × 7,140

= = = =

$ 5,320.00 5,474.00 5,670.00 2,142.00 $18,606.00

Answer (C) is incorrect because $94.50 unfavorable is the materials yield variance. Answer (D) is incorrect because $219.50 favorable is based on the actual mix of purchases. [829] Gleim #: 6.32 -- Source: Publisher (Refers to Fact Pattern #63) What is the materials yield variance for this operation?

A. B. C. D.

$294.50 favorable. $388.50 favorable. $94.50 unfavorable. $219.50 favorable. Answer (A) is incorrect because $294.50 favorable is the materials quantity variance. Answer (B) is incorrect because $388.50 favorable is the materials mix variance. Answer (C) is correct. The materials yield variance equals the difference between the actual input and the standard input allowed for the actual output, times the budgeted weighted-average standard cost per input unit at the standard mix. The standard input for the actual output was 84,000 liters (140 batches × 600 liters per batch). The standard mix budgeted weighted-average standard unit cost is $.225 per liter ($135 total cost ÷ 600 liters). Thus, the yield variance is $94.50 unfavorable [(84,420 liters used – 84,000 liters allowed) × $.225]. Answer (D) is incorrect because $219.50 favorable is based on the actual mix of purchases.


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[Fact Pattern #64]

Water Control Inc. manufactures water pumps and uses a standard cost system. The standard factory overhead costs per water pump are based on direct labor hours and are as follows: $32 20

Variable overhead (4 hours at $8/hour) Fixed overhead (4 hours at $5*/hour) Total overhead cost per unit

$52

*Based on a capacity of 100,000 direct labor hours per month.

The following additional information is available for the month of November: 22,000 pumps were produced although 25,000 had been scheduled for production. 94,000 direct labor hours were worked at a total cost of $940,000. The standard direct labor rate is $9 per hour. The standard direct labor time per unit is 4 hours. Variable overhead costs were $740,000. Fixed overhead costs were $540,000.

[830] Gleim #: 6.33 -- Source: CMA 1294 3-26 (Refers to Fact Pattern #64) The fixed overhead spending variance for November was

A. B. C. D.

$40,000 unfavorable. $70,000 unfavorable. $460,000 unfavorable. $240,000 unfavorable. Answer (A) is correct. The fixed overhead spending (budget) variance is the difference between actual and budgeted fixed factory overhead. Actual fixed overhead was $540,000. Budgeted fixed overhead was $5 per hour based on a capacity of 100,000 direct labor hours per month, or $500,000. Because these costs are fixed, the budgeted fixed overhead is the same at any level of production. Hence, the variance is $40,000 unfavorable ($540,000 – $500,000). Answer (B) is incorrect because $70,000 unfavorable is the difference between actual fixed overhead and the product of the standard rate and the actual direct labor hours. Answer (C) is incorrect because $460,000 unfavorable is the volume variance. Answer (D) is incorrect because $240,000 unfavorable is the difference between actual variable overhead and budgeted fixed overhead.

[831] Gleim #: 6.34 -- Source: CMA 1294 3-27 (Refers to Fact Pattern #64) The variable overhead spending variance for November was

A. B. C. D.

$60,000 favorable. $12,000 favorable. $48,000 unfavorable. $40,000 unfavorable.


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Answer (A) is incorrect because $60,000 favorable is based on 100,000 hours, not the actual hours of 94,000. Answer (B) is correct. The variable overhead spending variance is the difference between actual variable overhead and the variable overhead based on the standard rate and the actual activity level. Thus, the variable overhead spending variance was $12,000 favorable [$740,000 actual cost – ($8 standard rate × 94,000 actual hours)]. Because actual is less than standard, the variance was favorable. Answer (C) is incorrect because $48,000 unfavorable is the variable overhead efficiency variance. Answer (D) is incorrect because $40,000 unfavorable is the fixed overhead spending variance. [832] Gleim #: 6.35 -- Source: CMA 1294 3-28 (Refers to Fact Pattern #64) The variable overhead efficiency variance for November was

A. B. C. D.

$48,000 unfavorable. $60,000 favorable. $96,000 unfavorable. $200,000 unfavorable. Answer (A) is correct. The variable overhead efficiency variance equals the standard price ($8 an hour) times the difference between the actual hours and the standard hours allowed for the actual output. Thus, the variance is $48,000 {$8 × [94,000 actual hours – (4 standard hours per unit × 22,000 units produced)]}. The variance is unfavorable because actual hours exceeded standard hours. Answer (B) is incorrect because $60,000 favorable is the variable overhead spending variance calculated based on capacity, not actual hours. Answer (C) is incorrect because $96,000 unfavorable is based on the difference between standard hours allowed for the actual output and capacity hours. Answer (D) is incorrect because $200,000 unfavorable is the excess of actual direct labor costs over actual variable overhead costs.

[833] Gleim #: 6.36 -- Source: CIA 592 IV-18 The following is a standard cost variance analysis report on direct labor cost for a division of a manufacturing company:

Job

Actual Hours at Actual Wages

Actual Hours at Standard Wages

Standard Hours at Standard Wages

213

$3,243

$3,700

$3,100

215

$15,345

$15,675

$15,000

217

$6,754

$7,000

$6,600

219

$19,788

$18,755

$19,250

221

$3,370

$3,470

$2,650

$48,500

$48,600

$46,600

Totals

What is the total flexible budget direct labor variance for the division?


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A. B. C. D.

$100 favorable. $1,900 unfavorable. $1,900 favorable. $2,000 unfavorable. Answer (A) is incorrect because the direct labor rate variance is $100 favorable ($48,500 – $48,600). Answer (B) is correct. The total flexible budget direct labor variance equals the difference between total actual direct labor cost and standard direct labor cost allowed for the actual output. It combines the direct labor rate and efficiency variances. For this company, the variance is $1,900 unfavorable ($48,500 actual wages at actual hours – $46,600 standard wages at standard hours). Answer (C) is incorrect because the total labor variance is unfavorable. Answer (D) is incorrect because the direct labor efficiency variance is $2,000 unfavorable.

[834] Gleim #: 6.37 -- Source: CMA 1295 3-9 Individual budget schedules are prepared to develop an annual comprehensive or master budget. The budget schedule that provides the necessary input data for the direct labor budget is the

A. B. C. D.

Sales forecast. Raw materials purchases budget. Schedule of cash receipts and disbursements. Production budget. Answer (A) is incorrect because the sales forecast is insufficient for completion of the direct labor budget. Answer (B) is incorrect because the raw material purchases budget is not needed to prepare a direct labor budget. Answer (C) is incorrect because the schedule of cash receipts and disbursements cannot be prepared until after the direct labor budget has been completed. Answer (D) is correct. A master budget typically begins with the preparation of a sales budget. The next step is to prepare a production budget. Once the production budget has been completed, the next step is to prepare the direct labor, raw material, and overhead budgets. Thus, the production budget provides the input necessary for the completion of the direct labor budget.


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[Fact Pattern #65]

The Raymar Company is preparing its cash budget for the months of April and May. The firm has established a $200,000 line of credit with its bank at a 12% annual rate of interest on which borrowings for cash deficits must be made in $10,000 increments. There is no outstanding balance on the line of credit loan on April 1. Principal repayments are to be made in any month in which there is a surplus of cash. Interest is to be paid monthly. If there are no outstanding balances on the loans, Raymar will invest any cash in excess of its desired end-of-month cash balance in U.S. Treasury bills. Raymar intends to maintain a minimum balance of $100,000 at the end of each month by either borrowing for deficits below the minimum balance or investing any excess cash. Expected monthly collection and disbursement patterns are shown in the columns to the right.

Collections. 50% of the current month’s sales budget and 50% of the previous month’s sales budget. Accounts Payable Disbursements. 75% of the current month’s accounts payable budget and 25% of the previous month’s accounts payable budget. All other disbursements occur in the month in which they are budgeted Budget Information

Sales Accounts payable Payroll Other disbursements

March

April

May

$40,000 30,000 60,000 25,000

$50,000 40,000 70,000 30,000

$100,000 40,000 50,000 10,000

[835] Gleim #: 6.38 -- Source: CMA 1293 3-19 (Refers to Fact Pattern #65) In April, Raymar’s budget will result in

A. B. C. D.

$45,000 in excess cash. A need to borrow $50,000 on its line of credit for the cash deficit. A need to borrow $100,000 on its line of credit for the cash deficit. A need to borrow $90,000 on its line of credit for the cash deficit. Answer (A) is incorrect because $45,000 equals cash receipts. Answer (B) is incorrect because the cash deficit will be $92,500 without borrowing. Answer (C) is correct. Assuming Raymar maintained a $100,000 cash balance at the end of March, the amount to be borrowed or invested in April is the difference between cash receipts and disbursements. April’s cash collections are $45,000 [(50% × $50,000 April sales) + (50% × $40,000 March sales)]. Disbursements for accounts payable are $37,500 [(75% × $40,000 April payables) + (25% × $30,000 March payables)]. In addition to the accounts payable disbursements, payroll and other disbursements will require an additional $100,000. Hence, total disbursements are estimated to be $137,500. The net negative cash flow (amount to be borrowed to reach the required minimum cash balance of $100,000) is $92,500 ($137,500 – $45,000). Because the line of credit must be drawn upon in $10,000 increments, the loan must be for $100,000. Answer (D) is incorrect because a loan of only $90,000 would still leave a negative cash balance of $2,500.

[836] Gleim #: 6.39 -- Source: CMA 1293 3-20 (Refers to Fact Pattern #65) In May, Raymar will be required to

A. B. C. D.

Repay $20,000 principal and pay $1,000 interest. Repay $90,000 principal and pay $100 interest. Pay $900 interest. Borrow an additional $20,000 and pay $1,000 interest.


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Answer (A) is incorrect because no funds are available to repay the loan. May receipts are less than May disbursements. Answer (B) is incorrect because the 1% interest is calculated on a $100,000 loan, not a $90,000 loan. Answer (C) is incorrect because the 1% interest is calculated on a $100,000 loan, not a $90,000 loan. Answer (D) is correct. The company will have to borrow $100,000 in April, which means that interest will have to be paid in May at the rate of 1% per month (12% annual rate). Consequently, interest expense is $1,000 (1% × $100,000). May receipts are $75,000 [(50% × $100,000 May sales) + (50% × $50,000 April sales)]. Disbursements in May are $40,000 [(75% × $40,000 May payables) + (25% × $40,000 April payables)]. In addition to the May accounts payable disbursements, payroll and other disbursements are $60,000, bringing total disbursements to $101,000 ($60,000 + $40,000 + $1,000). Thus, disbursements exceed receipts by $26,000 ($101,000 – $75,000). However, cash has a beginning surplus balance of $7,500 ($100,000 April loan – $92,500 negative cash flow for April). As a result, the company needs to borrow an additional $18,500 to eliminate its cash deficit. Given the requirement that loans be in $10,000 increments, the May loan must be for $20,000. [837] Gleim #: 6.40 -- Source: CMA 1294 3-13 When sales volume is seasonal in nature, certain items in the budget must be coordinated. The three most significant items to coordinate in budgeting seasonal sales volume are

A. B. C. D.

Production volume, finished goods inventory, and sales volume. Direct labor hours, work-in-process inventory, and sales volume. Raw material inventory, direct labor hours, and manufacturing overhead costs. Raw material inventory, work-in-process inventory, and production volume. Answer (A) is correct. The most difficult items to coordinate in any budget, particularly for a seasonal business, are production volume, finished goods inventory, and sales. Budgets usually begin with sales volume and proceed to production volume, but the reverse is sometimes used when production is more of an issue than generation of sales. Inventory levels are also important because sales cannot occur without inventory, and the maintenance of high inventory levels is costly. Answer (B) is incorrect because direct labor hours and work-in-process are only two components of a production budget. Answer (C) is incorrect because sales is usually the most important aspect of any budget. Answer (D) is incorrect because sales is usually the most important aspect of any budget.

[838] Gleim #: 6.41 -- Source: CMA 1292 3-11 Butteco has the following cost components for 100,000 units of product for 1998: Raw materials Direct labor Manufacturing overhead Selling/administrative expense

$200,000 100,000 200,000 150,000

All costs are variable except for $100,000 of manufacturing overhead and $100,000 of selling and administrative expenses. The total costs to produce and sell 110,000 units during 1998 are

A. B. C. D.

$650,000 $715,000 $695,000 $540,000


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Answer (A) is incorrect because $650,000 is the cost at a production level of 100,000 units. Answer (B) is incorrect because $715,000 assumes a variable unit cost of $6.50 with no fixed costs. Answer (C) is correct. Raw materials unit costs are strictly variable at $2 ($200,000 ÷ 100,000 units). Similarly, direct labor has a variable unit cost of $1 ($100,000 ÷ 100,000 units). The $200,000 of manufacturing overhead for 100,000 units is 50%. The variable unit cost is $1. Selling costs are $100,000 fixed and $50,000 variable for production of 100,000 units, and the variable unit selling expense is $.50 ($50,000 ÷ 100,000 units). The total unit variable cost is therefore $4.50 ($2 + $1 + $1 + $.50). Fixed costs are $200,000. At a production level of 110,000 units, variable costs are $495,000 ($4.50 × 110,000 units). Hence, total costs are $695,000 ($495,000 + $200,000). Answer (D) is incorrect because total costs are $695,000 based on a unit variable cost of $4.50 each. [839] Gleim #: 6.42 -- Source: CMA 1292 3-12 Barnes Corporation expected to sell 150,000 board games during the month of November, and the company’s master budget contained the following data related to the sale and production of these games: Revenue Cost of goods sold Direct materials Direct labor Variable overhead

$2,400,000

Contribution Fixed overhead Fixed selling/administration

$ 975,000 250,000 500,000

675,000 300,000 450,000

Operating income

$ 225,000

Actual sales during November were 180,000 games. Using a flexible budget, the company expects the operating income for the month of November to be

A. B. C. D.

$225,000 $270,000 $420,000 $510,000 Answer (A) is incorrect because $225,000 is the net income before the increase in sales. Answer (B) is incorrect because net income was originally $1.50 per game. The $270,000 figure simply extrapolates that amount to sales of 180,000 games. Answer (C) is correct. Revenue of $2,400,000 reflects a unit selling price of $16 ($2,400,000 ÷ 150,000 games). The contribution margin is $975,000, or $6.50 per game ($975,000 ÷ 150,000 games). Thus, unit variable cost is $9.50 ($16 – $6.50). Increasing sales will result in an increased contribution margin of $195,000 (30,000 × $6.50). Assuming no additional fixed costs, net income will increase to $420,000 ($225,000 originally reported + $195,000). Answer (D) is incorrect because $510,000 assumes that variable overhead is fixed. Variable overhead is a $3 component ($450,000 ÷ 150,000 units) of unit variable cost.

[840] Gleim #: 6.43 -- Source: CIA 595 III-20 The major feature of zero-base budgeting (ZBB) is that it


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A. B. C. D.

Takes the previous year’s budgets and adjusts them for inflation. Questions each activity and determines whether it should be maintained as it is, reduced, or eliminated. Assumes all activities are legitimate and worthy of receiving budget increases to cover any increased costs. Focuses on planned capital outlays for property, plant, and equipment. Answer (A) is incorrect because traditional or incremental budgeting takes the previous year’s budgets and adjusts them for inflation. Answer (B) is correct. ZBB is a planning process in which each manager must justify his/her department’s full budget for each period. The purpose is to encourage periodic reexamination of all costs in the hope that some can be reduced or eliminated. Answer (C) is incorrect because traditional or incremental budgeting assumes all activities are legitimate and worthy of receiving budget increases to cover any increased costs. Answer (D) is incorrect because it is a definition of a capital budget.

[Fact Pattern #66] A firm with an 18% cost of capital is considering the following projects (on January 1, 2001):

Project A Project B

January 1, 2001 Cash Outflow (000’s Omitted)

December 31, 2005 Cash Inflow (000’s Omitted)

Project Internal Rate of Return

$3,500 4,000

$7,400 9,950

16% ?

Present Value of $1 Due at the End of “N” Periods N

12%

14%

15%

16%

18%

20%

22%

4 5 6

.6355 .5674 .5066

.5921 .5194 .4556

.5718 .4972 .4323

.5523 .4761 .4104

.5158 .4371 .3704

.4823 .4019 .3349

.4230 .3411 .2751

[841] Gleim #: 6.44 -- Source: CIA 597 IV-40 (Refers to Fact Pattern #66) Using the net-present-value (NPV) method, project A’s net present value is

A. B. C. D.

$316,920 $23,140 $(265,460) $(316,920) Answer (A) is incorrect because $316,920 discounts the cash inflow over a 4-year period. Answer (B) is incorrect because $23,140 assumes a 16% discount rate. Answer (C) is correct. The cash inflow occurs 5 years after the cash outflow, and the NPV method uses the firm’s cost of capital of 18%. The present value of $1 due at the end of 5 years discounted at 18% is .4371. Thus, the NPV of project A is $(265,460) [(.4371 × $7,400,000 cash inflow) – $3,500,000 cash outflow]. Answer (D) is incorrect because $(316,920) discounts the cash inflow over a 4-year period and also subtracts the present value of the cash inflow from the cash outflow.


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[842] Gleim #: 6.45 -- Source: CIA 597 IV-41 (Refers to Fact Pattern #66) Project B’s internal rate of return is closest to

A. B. C. D.

15% 16% 18% 20% Answer (A) is incorrect because 15% results in a positive NPV for project B. Answer (B) is incorrect because 16% is the approximate internal rate of return for project A. Answer (C) is incorrect because 18% is the company’s cost of capital. Answer (D) is correct. The internal rate of return is the discount rate at which the NPV is zero. Consequently, the cash outflow equals the present value of the inflow at the internal rate of return. The present value of $1 factor for project B’s internal rate of return is therefore .4020 ($4,000,000 cash outflow ÷ $9,950,000 cash inflow). This factor is closest to the present value of $1 for 5 periods at 20%.

[843] Gleim #: 6.46 -- Source: CIA 595 IV-37 Everything else being equal, the internal rate of return (IRR) of an investment project will be lower if

A. B. C. D.

The investment cost is lower. Cash inflows are received later in the life of the project. Cash inflows are larger. The project has a shorter payback period. Answer (A) is incorrect because the present value of the cash inflows is inversely related to the discount rate; that is, if the discount rate is higher, the present value of the cash inflows is lower. If the investment cost is lower, a higher discount rate (the IRR) will be required to set the net present value equal to zero. Answer (B) is correct. The IRR is the discount rate at which the net present value is zero. Because the present value of a dollar is higher the sooner it is received, projects with later cash flows will have lower net present values for any given discount rate than will projects with earlier cash flows, if other factors are constant. Hence, projects with later cash flows will have a lower IRR. Answer (C) is incorrect because the larger the cash inflows, the higher the IRR will be. Higher cash inflows have a higher present value at any given discount rate. A higher discount rate will be required to set the net present value equal to zero. Answer (D) is incorrect because projects with shorter payback periods have higher cash inflows early in the life of the project. Projects with earlier cash inflows have higher IRRs.


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[844] Gleim #: 6.47 -- Source: CIA 596 III-80 A manufacturing company’s primary goals include product quality and customer satisfaction. The company sells a product, for which the market demand is strong, for $50 per unit. Due to the capacity constraints in the Production Department, only 300,000 units can be produced per year. The current defect rate is 12% (i.e., of the 300,000 units produced, only 264,000 units are sold and 36,000 units are scrapped). There is no revenue recovery when defective units are scrapped. The full manufacturing cost of a unit is $29.50, including Direct materials Direct labor Fixed manufacturing overhead

$17.50 4.00 8.00

The company’s designers have estimated that the defect rate can be reduced to 2% by using a different direct material. However, this will increase the direct materials cost by $2.50 per unit to $20 per unit. The net benefit of using the new material to manufacture the product will be

A. B. C. D.

$(120,000) $120,000 $750,000 $1,425,000 Answer (A) is incorrect because $(120,000) considers only the production costs of the good units sold. Moreover, it includes fixed overhead, a cost that is not affected by the choice of materials. Answer (B) is incorrect because $120,000 considers only the variable costs of the good units produced. Answer (C) is correct. If a different direct material is used, incremental revenue will be $1,500,000 {[(12% defect rate – 2%) × 300,000 units] × $50}. Incremental cost will be $750,000 ($2.50 × 300,000 units). Thus, the net benefit will be $750,000 ($1,500,000 – $750,000). Answer (D) is incorrect because $1,425,000 includes only the incremental direct materials cost of the increase in the number of good units produced.


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[Fact Pattern #67]

A business needs a computer application that can be either developed internally or purchased. Suitable software from a vendor costs $29,000. Minor modifications and testing can be conducted by the systems staff as part of their regular workload. If the software is developed internally, a systems analyst would be assigned full time, and a contractor would assume the analyst’s responsibilities. The hourly rate for the regular analyst is $25. The hourly rate for the contractor is $22. The contractor would occupy an empty office. The office has 100 square feet, and occupancy cost is $45 per square foot.

Other related data follows. Computer time is charged using predetermined rates. The organization has sufficient excess computer capacity for either software development or modification/testing of the purchased software.

Internal Development

Purchased Software

1,000

N/A

N/A

40

$800

$250

$3,200

N/A

$500

$200

Systems analyst time in hours: Development Modifications and testing Computer charges Additional hardware purchases Incidental supplies

[845] Gleim #: 6.48 -- Source: CIA 1194 III-56 (Refers to Fact Pattern #67) When applying the cost-benefit approach to a decision, the primary criterion is how well management goals will be achieved in relation to costs. Costs include all expected

A. Variable costs for the courses of action but not expected fixed costs because only the expected variable costs are relevant. B. Incremental out-of-pocket costs as well as all expected continuing costs that are common to all the alternative courses of action. C. Future costs that differ among the alternative courses of action plus all qualitative factors that cannot be measured in numerical terms. D. Historical and future costs relative to the courses of action including all qualitative factors that cannot be measured in numerical terms. Answer (A) is incorrect because variable and fixed costs may be relevant or irrelevant. Answer (B) is incorrect because expected incremental out-of-pocket expenses should be considered, but common costs should not. Answer (C) is correct. The analysis of a make-or-buy decision is based on relevant costs. If costs do not vary with the option chosen, they are irrelevant. Moreover, the decision may be based on nonquantitative factors, for example, the desire to maintain a relationship with a vendor or to assume control over development of a product. Answer (D) is incorrect because historical costs are not relevant to cost-benefit analysis because they are sunk costs. [846] Gleim #: 6.49 -- Source: CIA 1194 III-57 (Refers to Fact Pattern #67) Based solely on the cost figures presented, the cost of developing the computer application will be


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A. B. C. D.

$3,500 less than acquiring the purchased software package. $500 less than acquiring the purchased software package. $1,550 more than acquiring the purchased software package. $3,550 more than acquiring the purchased software package. Answer (A) is correct. Development cost equals the cost of the outside contractor plus the costs for hardware and supplies. Computer charges are transfer prices and do not require additional expenditures, given idle capacity. The relevant cost of supplies is $300 ($500 – $200 cost if the software is purchased). The contractor’s use of an otherwise idle office is not relevant. Thus, the relevant cost of development is $25,500 [($22 hourly cost of the contractor × 1,000 hours) + $3,200 hardware purchases + $300 incremental cost of supplies]. This amount is $3,500 less than the $29,000 cost of purchase. A systems analyst’s work on the new software is not relevant. It is part of the regular workload. Answer (B) is incorrect because the contractor is not paid $25 per hour. Answer (C) is incorrect because $550 in computer charges and $4,500 in occupancy charges should not be included. Answer (D) is incorrect because the contractor is not paid $25 per hour, and 40 hours of modification and testing, $550 of the computer charges, and the occupancy costs are irrelevant.

[Fact Pattern #68] The segmented income statement for a retail company with three product lines is presented below:

Total Company

Product Line 1

Product Line 2

Product Line 3

$2,000,000

20,000 $800,000

28,000 $700,000

50,000 $500,000

$ 180,000 240,000 40,000 980,000 280,000 110,000

$ 60,000 96,000 16,000 360,000 84,000 54,000

$ 60,000 84,000 14,000 420,000 140,000 32,000

$ 60,000 60,000 10,000 200,000 56,000 24,000

Total costs & expenses

$1,830,000

$670,000

$750,000

$410,000

Operating income (loss)

$ 170,000

$130,000

$ (50,000)

$ 90,000

Volume (in units) Sales revenue Costs & expenses: Administrative Advertising Commissions Cost of sales Rent Salaries

The company buys the goods in the three product lines directly from manufacturers’ representatives. Each product line is directed by a manager whose salary is included in the administrative expenses. Administrative expenses are allocated to the three product lines equally because the administration is spread evenly among the three product lines. Salaries represent payments to the workers in each product line and therefore are traceable costs of each product line. Advertising promotes the entire company rather than the individual product lines. As a result, the advertising is allocated to the three product lines in proportion to the sales revenue. Commissions are paid to the salespersons in each product line based on 2% of gross sales. Rent represents the cost of the retail store and warehouse under a lease agreement with 5 years remaining. The product lines share the retail and warehouse space, and the rent is allocated to the three product lines based on the square footage occupied by each of the product lines.


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[847] Gleim #: 6.50 -- Source: CIA 1196 III-98 (Refers to Fact Pattern #68) The company has an opportunity to promote one of its product lines by making a one-time $7,000 expenditure. The company can choose only one of the three product lines to promote. The incremental sales revenue that would be realized from this $7,000 promotion expenditure in each of the product lines is estimated as follows: Increase in Sales Revenue Product Line 1 Product Line 2 Product Line 3

$15,000 20,000 14,000

In order to maximize profits, the promotion expenditure should be spent on , resulting in an increase in operating income of .

List A

List B

A. B.

Product Line 2 Product Line 2

$13,000 $ 5,000

C. D.

Product Line 3 Product Line 3

$ 1,400 $ 1,120

Answer (A) is incorrect because Product Line 2 has an increased profit of $600. Answer (B) is incorrect because Product Line 2 has an increased profit of $600. Answer (C) is incorrect because $1,400 omits the commissions from the calculation. Answer (D) is correct. Fixed costs should be ignored. Thus, the increase in sales revenue should be multiplied by the contribution margin ratio for each product line. The incremental promotion cost ($7,000) is subtracted from this amount to determine the marginal benefit of promoting each product line. Hence, Product Line 3 has an increased profit of $1,120. Calculation of Contribution Margin Total Company

Product Line 1

Product Line 2

Product Line 3

Sales revenue

$2,000,000 $800,000 $700,000 $500,000

Variable costs Commissions Cost of sales

$

Total CM CMR

40,000 $ 16,000 $ 14,000 $ 10,000 980,000 360,000 420,000 200,000

$1,020,000 $376,000 $434,000 $210,000 $ 980,000 $424,000 $266,000 $290,000 49%

53%

38%

58%

Revenue CMR

$ 15,000 $ 20,000 $ 14,000 .38 .58 .53

CM Promotion cost

$ 7,950 $ 7,600 $ 8,120 7,000 7,000 7,000

Increased profits

$

950

$

600 $ 1,120


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[848] Gleim #: 6.51 -- Source: CIA 1196 III-99 (Refers to Fact Pattern #68) One company executive has expressed concern about the operating loss that has occurred in Product Line 2 and has suggested that Product Line 2 be discontinued. If Product Line 2 is dropped, the manager of the line would be retained and assigned other duties with the company, but the other employees would not be retained. Management has indicated that the nature of the company’s advertising might change with the elimination of Product Line 2, but the total dollar amount would not change. If Product Line 2 were to be dropped, the operating income of the company would

A. B. C. D.

Increase by $50,000. Decrease by $94,000. Decrease by $234,000. Increase by $416,000. Answer (A) is incorrect because an increase of $50,000 assumes the revenue will be lost and all of its costs will be avoided. Answer (B) is incorrect because a decrease of $94,000 results from treating rent as an avoidable cost. Answer (C) is correct. The operating income will decrease. Product Line 2 income will be lost, but only the traceable costs of commissions, cost of sales, and salaries will be avoided. Accordingly, the decrease will be $234,000 [$700,000 + ($14,000 + 420,000 + 32,000)]. The other shared costs will have to be absorbed by the two remaining product lines. Answer (D) is incorrect because an increase of $416,000 subtracts the costs that will not be avoided if Product Line 2 is dropped from the lost sales revenue.

[849] Gleim #: 6.52 -- Source: CIA 1196 III-100 (Refers to Fact Pattern #68) A customer, operating in an isolated foreign market, has approached the head salesperson for Product Line 1 and offered to purchase 4,000 units of a special-order product over the next 12 months. This product would be sold in the same manner as Product Line 1’s other products except that the customer is hoping for a price break. Product Line 1’s cost to purchase this product (cost of sales) would be $14.70. Product Line 1 has excess capacity, meaning that the rate or amount of the remaining operating costs would not change as a consequence of the purchase and sale of this special-order product. The minimum selling price for this special-order product would be

A. B. C. D.

$15.00 $17.30 $27.50 $30.20 Answer (A) is correct. Product Line 1 needs to cover its variable out-of-pocket costs as a minimum on this specialorder product; therefore, any selling price greater than the variable cost will contribute towards profits. Thus, the minimum selling price of the special-order product is the variable cost divided by 1 minus the commission rate, or $15 [$14.70 ÷ (1.0 – .02)]. Answer (B) is incorrect because $17.30 includes the average cost of salaries (at the new volume level of 24,000 units) as a cost that needs to be covered when determining the minimum selling price. Answer (C) is incorrect because $27.50 is calculated based on a full cost approach. Answer (D) is incorrect because $30.20 adds all costs and expenses (except cost of sales) and divides them by the original volume level of 20,000 units to determine the average operating costs. The new cost of sales is added to the average operating costs to determine the minimum selling price.


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[850] Gleim #: 6.53 -- Source: CIA 593 IV-19 The ABC Company manufactures components for use in producing one of its finished products. When 12,000 units are produced, the full cost per unit is $35, separated as follows: Direct materials Direct labor Variable overhead Fixed overhead

$ 5 15 10 5

The XYZ Company has offered to sell 12,000 components to ABC for $37 each. If ABC accepts the offer, some of the facilities currently being used to manufacture the components can be rented as warehouse space for $40,000. However, $3 of the fixed overhead currently applied to each component would have to be covered by ABC’s other products. What is the differential cost to the ABC Company of purchasing the components from the XYZ Company?

A. B. C. D.

$8,000 $20,000 $24,000 $44,000 Answer (A) is incorrect because $8,000 assumes that $3 of fixed overhead is avoidable. Answer (B) is correct. Differential (incremental) cost is the difference in total cost between two decisions. The relevant costs do not include unavoidable costs, such as the $3 of fixed overhead. It would cost ABC an additional $20,000 to purchase, rather than manufacture, the components. Cost to purchase ($37 × 12,000) Minus rental income

$444,000 (40,000)

Cost to manufacture ($32 × 12,000)

$404,000 $384,000

Cost differential

$ 20,000

Answer (C) is incorrect because $24,000 compares the full cost of manufacturing with cost to purchase. Answer (D) is incorrect because $44,000 ignores the opportunity cost.


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[851] Gleim #: 6.54 -- Source: CIA 592 IV-10 A company manufactures a product that is sold for $37.95. It uses an absorption-cost system. Plant capacity is 750,000 units annually, but normal volume is 500,000 units. Costs at normal volume are given below. Unit Cost Direct materials

Total Cost

$ 9.80

$4,900,000

4.50

2,250,000

12.00

6,000,000

Variable

2.50

1,250,000

Fixed

4.20

2,100,000

$33.00

$16,500,000

Direct labor Manufacturing overhead Selling and administrative:

Total cost

Fixed manufacturing overhead is budgeted at $4.5 million. A customer has offered to purchase 100,000 units at $25.00 each to be packaged in large cartons, not the normal individual containers. It will pick up the units in its own trucks. Thus, variable selling and administrative expenses will decrease by 60%. The company should compare the total revenue to be derived from this order with the total relevant costs of

A. B. C. D.

$1,830,000 $1,880,000 $2,930,000 $3,150,000 Answer (A) is correct. The necessary assumptions are that all fixed costs and the unit variable costs of direct materials, direct labor, and variable manufacturing overhead are not affected by the special order. Hence, the fixed costs are not relevant. The unit costs of direct materials and direct labor are given as $9.80 and $4.50, respectively. The unit variable manufacturing overhead cost is $3.00 [($6,000,000 total manufacturing overhead – $4,500,000 total fixed manufacturing overhead) ÷ 500,000 units normal volume]. The unit variable selling and administrative cost is $1.00 [$2.50 × (1.0 – .6)]. Consequently, the total relevant cost of the special order is $1,830,000 [100,000 units × ($9.80 + $4.50 + $3.00 + $1.00)]. Answer (B) is incorrect because variable manufacturing per unit is determined by using normal volume, not plant capacity, as the denominator level. Answer (C) is incorrect because the total relevant cost of the special order is $1,830,000 [100,000 units × ($9.80 + $4.50 + $3.00 + $1.00)]. Answer (D) is incorrect because fixed selling and administrative expenses of $4.20 per unit should not be included. Furthermore, variable manufacturing of $3 per unit, not total manufacturing overhead of $12 per unit, should be used in the calculation of relevant costs.

[852] Gleim #: 6.55 -- Source: CIA 1195 III-96 A large manufacturing company has several autonomous divisions that sell their products in perfectly competitive external markets as well as internally to the other divisions of the company. Top management expects each of its divisional managers to take actions that will maximize the organization’s goals as well as their own goals. Top management also promotes a sustained level of management effort of all of its divisional managers. Under these circumstances, for products exchanged between divisions, the transfer price that will generally lead to optimal decisions for the manufacturing company would be a transfer price equal to the


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A. B. C. D.

Full cost of the product. Full cost of the product plus a markup. Variable cost of the product plus a markup. Market price of the product. Answer (A) is incorrect because a transfer at full cost means that the selling division will not make a profit. In addition, the selling division may be forgoing profits that could be obtained by selling to outside customers. Thus, full-cost transfer prices can lead to suboptimal decisions. Answer (B) is incorrect because a transfer at full cost plus markup results in no incentive for the selling division to control its costs. Hence, a sustained level of management effort may not be maintained. Answer (C) is incorrect because a transfer at variable cost plus markup has the same weaknesses as full cost plus markup. Answer (D) is correct. A market price transfer price promotes goal congruence and a sustained level of management effort. It is also consistent with divisional autonomy. A market transfer price is most appropriate when the market is competitive, interdivisional dependency is low, and buying in the market involves no marginal costs or benefits.

[853] Gleim #: 6.56 -- Source: CIA 1193 IV-19 The Eastern division sells goods internally to the Western division of the same company. The quoted external price in industry publications from a supplier near Eastern is $200 per ton plus transportation. It costs $20 per ton to transport the goods to Western. Eastern’s actual market cost per ton to buy the direct materials to make the transferred product is $100. Actual per ton direct labor is $50. Other actual costs of storage and handling are $40. The company president selects a $220 transfer price. This is an example of

A. B. C. D.

Market-based transfer pricing. Cost-based transfer pricing. Negotiated transfer pricing. Cost-plus-20% transfer pricing. Answer (A) is correct. A transfer price is the price charged by one segment of an organization for a product or service supplied to another segment of the same organization. The three basic criteria that the transfer pricing system in a decentralized company should satisfy are to (1) provide information allowing central management to evaluate divisions with respect to total company profit and each division’s contribution to profit, (2) stimulate each manager’s efficiency without losing each division’s autonomy, and (3) motivate each divisional manager to achieve his/her own profit goal in a manner contributing to the company’s success. Because the $220 transfer price selected is based on the quoted external price (market), it is an example of market-based transfer pricing. Answer (B) is incorrect because the cost-based price would be $210 ($100 + $50 + $40 + $20). Answer (C) is incorrect because no negotiations took place. Answer (D) is incorrect because cost plus 20% would be $252 ($210 × 1.20).

[854] Gleim #: 6.57 -- Source: CIA 589 IV-16 Division A of a company is currently operating at 50% capacity. It produces a single product and sells all its production to outside customers for $13 per unit. Variable costs are $7 per unit, and fixed costs are $6 per unit at the current production level. Division B, which currently purchases this product from an outside supplier for $12 per unit, would like to purchase the product from Division A. Division A will operate at 80% capacity to meet outside customers’ and Division B’s demand. What is the minimum price that Division A should charge Division B for this product?


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A. B. C. D.

$7.00 per unit. $10.40 per unit. $12.00 per unit. $13.00 per unit. Answer (A) is correct. From the seller’s perspective, the price should reflect at least its incremental cash outflow (outlay cost) plus the contribution from an outside sale (opportunity cost). Because A has idle capacity, the opportunity cost is $0. Thus, the minimum price Division A should charge Division B is $7.00. Answer (B) is incorrect because $7.00 is the minimum that should be charged. Answer (C) is incorrect because Division A should not include any fixed costs in its transfer price because Division A has idle capacity. Answer (D) is incorrect because, since Division A has idle capacity, the minimum transfer price should recover Division A’s variable (outlay) costs.

[855] Gleim #: 6.58 -- Source: CMA 1291 3-10 A segment of an organization is referred to as a service center if it has

A. Responsibility for developing markets and selling the output of the organization. B. Responsibility for combining the raw materials, direct labor, and other factors of production into a final output. C. Authority to make decisions affecting the major determinants of profit including the power to choose its markets and sources of supply. D. Authority to provide specialized support to other units within the organization. Answer (A) is incorrect because a service center has no responsibility for developing markets or selling. Answer (B) is incorrect because a production center is engaged in manufacturing. Answer (C) is incorrect because a profit center can choose its markets and sources of supply. Answer (D) is correct. A service center exists primarily and sometimes solely to provide specialized support to other units within the organization. Service centers are usually operated as cost centers. [856] Gleim #: 6.59 -- Source: CIA 595 III-96 Which of the following techniques would be best for evaluating the management performance of a department that is operated as a cost center?

A. B. C. D.

Return on assets ratio. Return on investment ratio. Payback method. Variance analysis. Answer (A) is incorrect because return on assets cannot be computed for a cost center. The manager is not responsible for revenue (return) or the assets available. Answer (B) is incorrect because return on investments cannot be computed for a cost center. The manager is not responsible for revenue (return) or the assets available. Answer (C) is incorrect because the payback method is a means of evaluating alternative investment proposals. Answer (D) is correct. A cost center is a responsibility center that is responsible for costs only. Of the alternatives given, variance analysis is the only one that can be used in a cost center. Variance analysis involves comparing actual costs with predicted or standard costs.


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[857] Gleim #: 6.60 -- Source: CMA 694 3-24 Decentralized firms can delegate authority and yet retain control and monitor managers’ performance by structuring the organization into responsibility centers. Which one of the following organizational segments is most like an independent business?

A. B. C. D.

Revenue center. Profit center. Cost center. Investment center. Answer (A) is incorrect because a revenue center is responsible only for revenue generation, not for costs or capital investment. Answer (B) is incorrect because a profit center is responsible for revenues and costs but not for invested capital. Answer (C) is incorrect because a cost center is evaluated only on the basis of costs incurred. It is not responsible for revenues or invested capital. Answer (D) is correct. An investment center is the organizational type most like an independent business because it is responsible for its own revenues, costs incurred, and capital invested. The other types of centers do not incorporate all three elements.

[858] Gleim #: 6.61 -- Source: CMA 1291 3-7 Which one of the following items would most likely not be incorporated into the calculation of a division’s investment base when using the residual income approach for performance measurement and evaluation?

A. B. C. D.

Fixed assets employed in division operations. Land being held by the division as a site for a new plant. Division inventories when division management exercises control over the inventory levels. Division accounts payable when division management exercises control over the amount of short-term credit used. Answer (A) is incorrect because fixed operating assets are controlled by the division manager and contribute to profits. Answer (B) is correct. An evaluation of an investment center is based upon the return on the investment base. These assets include plant and equipment, inventories, and receivables. Most likely, however, an asset, such as land, that is being held by the division as a site for a new plant would not be included in the investment base because it is not currently being used in operations. Total assets in use rather than total assets available is preferable when the investment center has been forced to carry idle assets. Answer (C) is incorrect because inventories are operating assets that contribute to profits and are controlled by the division manager. Answer (D) is incorrect because the level of accounts payable is an operating decision that should be considered in the evaluation of the division manager.


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[859] Gleim #: 6.62 -- Source: CMA 697 3-29 Listed below is selected financial information for the Western Division of the Hinzel Company for last year. Amount (thousands)

Account Average working capital General and administrative expenses Net sales Average plant and equipment Cost of goods sold

$ 625 75 4,000 1,775 3,525

If Hinzel treats the Western Division as an investment center for performance measurement purposes, what is the before-tax return on investment (ROI) for last year?

A. B. C. D.

34.78% 22.54% 19.79% 16.67% Answer (A) is incorrect because 34.78% results from subtracting working capital from plant and equipment in calculating the net investment. Answer (B) is incorrect because 22.54% fails to include average working capital in the total for the net investment. Answer (C) is incorrect because 19.79% results from not subtracting general and administrative expenses in the calculation of before-tax profit. Answer (D) is correct. An investment center is responsible for revenues, expenses, and invested capital. Given average plant and equipment of $1,775 and average working capital of $625, the net investment is $2,400. Before-tax profit is $400 ($4,000 sales – $3,525 cost of goods sold – $75 general expenses). If before-tax ROI equals before-tax profit divided by net investment, the answer is 16.67% ($400 ÷ $2,400).

[860] Gleim #: 6.63 -- Source: CMA 697 3-24 Residual income is a better measure for performance evaluation of an investment center manager than return on investment because

A. B. C. D.

The problems associated with measuring the asset base are eliminated. Desirable investment decisions will not be neglected by high-return divisions. Only the gross book value of assets needs to be calculated. The arguments about the implicit cost of interest are eliminated. Answer (A) is incorrect because this method uses the same asset base. Answer (B) is correct. Residual income is the excess of the amount of the ROI over a targeted amount equal to an imputed interest charge on invested capital. The advantage of using residual income rather than percentage ROI is that the former emphasizes maximizing a dollar amount instead of a percentage. Managers of divisions with a high ROI are encouraged to accept projects with returns exceeding the cost of capital even if those projects reduce the department’s ROI. Answer (C) is incorrect because this method uses the same asset base. Answer (D) is incorrect because use of the residual income method requires a knowledge of the cost of capital; thus, arguments about the implicit cost of interest may escalate with use of the residual income method.


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[861] Gleim #: 6.64 -- Source: CMA 697 3-30 James Webb is the general manager of the Industrial Product Division, and his performance is measured using the residual income method. Webb is reviewing the following forecasted information for his division for next year: Amount (thousands)

Category Working capital Revenue Plant and equipment

$ 1,800 30,000 17,200

If the imputed interest charge is 15% and Webb wants to achieve a residual income target of $2,000,000, what will costs have to be in order to achieve the target?

A. B. C. D.

$9,000,000 $10,800,000 $25,150,000 $25,690,000 Answer (A) is incorrect because this level of cost would result in a residual income greater than $2,000,000. Answer (B) is incorrect because this level of cost would result in a residual income greater than $2,000,000. Answer (C) is correct. Residual income is the excess of the amount of the ROI over a targeted amount equal to an imputed interest charge on invested capital. If a manager has $19,000,000 of invested capital ($17,200,000 of plant and equipment + $1,800,000 of working capital), a 15% imputed interest charge equals $2,850,000. Adding $2,000,000 of residual income to the imputed interest results in a target profit of $4,850,000. This profit can be achieved if costs are $25,150,000 ($30,000,000 revenue – $4,850,000 profit). Answer (D) is incorrect because $25,690,000 results from subtracting working capital from plant and equipment in determining invested capital.

[862] Gleim #: 6.65 -- Source: CMA 695 3-20 REB Service Co. is a computer service center. For the month of May, REB had the following operating statistics: Sales Operating income Net profit after taxes Total assets Shareholders’ equity Cost of capital

$450,000 25,000 8,000 500,000 200,000 6%

Based on the above information, which one of the following statements is true? REB has a

A. B. C. D.

Return on investment of 4%. Residual income of $(5,000). Return on investment of 1.6%. Residual income of $(22,000).


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Answer (A) is incorrect because, although the firm’s return on equity investment was 4%, its return on all funds invested was 5% ($25,000 pretax operating income ÷ $500,000). Answer (B) is correct. Return on investment is commonly calculated by dividing pretax income by total assets available. Residual income is the excess of the return on investment over a targeted amount equal to an imputed interest charge on invested capital. The rate used is ordinarily the weighted-average cost of capital. Some companies measure managerial performance in terms of the amount of residual income rather than the percentage return on investment. Because REB has assets of $500,000 and a cost of capital of 6%, it must earn $30,000 on those assets to cover the cost of capital. Given that operating income was only $25,000, it had a negative residual income of $5,000. Answer (C) is incorrect because ROI is commonly based on before-tax income. Answer (D) is incorrect because $(22,000) equals the difference between net profit after taxes and targeted income. [863] Gleim #: 6.66 -- Source: Publisher Many forms of performance feedback are based on accounting information. For example, a divisional manager may be evaluated based on return on investment (income ÷ investment). One step in the process of developing a performance measure based on accounting information is to determine the basis for stating the measure in terms of dollars. Thus, if ROI is the chosen measure, and investment is defined as total assets, comparability issues are most likely to arise when the attribute used to calculate total assets is

A. B. C. D.

Current cost. Current disposal price. Historical cost. Present value. Answer (A) is incorrect because current cost is an attempt to remedy the theoretical deficiencies of historical cost by presenting more accurate balance sheet values. Answer (B) is incorrect because current disposal price is an attempt to remedy the theoretical deficiencies of historical cost by presenting more accurate balance sheet values. Answer (C) is correct. Historical cost creates comparability issues because returns on significantly depreciated assets may be higher than those on newer assets that have been acquired using inflated dollars. Thus, otherwise similarly situated managers may report different operating results. Moreover, managers may be reluctant to replace aging assets. Answer (D) is incorrect because present value is an attempt to remedy the theoretical deficiencies of historical cost by presenting more accurate balance sheet values.

[864] Gleim #: 6.67 -- Source: Publisher An organization’s managerial decision-making model for capital budgeting is based on the net present value of discounted cash flows. The same organization’s managerial performance evaluation model is based on annual divisional return on investment. Which of the following is true?

A. Divisional managers are likely to maximize the measures in the decision-making model. B. Divisional managers are likely to maximize the measures in the performance evaluation model. C. The manager has an incentive to accept a project with a positive net present value that initially has a negative effect on net income. D. The use of models with different criteria promotes goal congruence.


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Answer (A) is incorrect because self-interest provides an incentive to maximize the measures used in performance evaluation. Answer (B) is correct. Effective management control requires performance measurement and feedback. This process affects allocation of resources to organizational subunits. It also affects decisions about managers’ compensation, advancement, and future assignments. Furthermore, evaluating their performance serves to motivate managers to optimize the measures in the performance evaluation model. However, that model may be inconsistent with the organization’s model for managerial decision making. Answer (C) is incorrect because a manager evaluated on the basis of annual ROI has an interest in maximizing short-term net income, not long-term NPV. Answer (D) is incorrect because the models should be synchronized so that the goals of the organization and the manager are congruent. [865] Gleim #: 6.68 -- Source: CIA 593 IV-5 A company employs a process cost system using the first-in, first-out (FIFO) method. The product passes through both Department 1 and Department 2 in order to be completed. Units enter Department 2 upon completion in Department 1. Additional direct materials are added in Department 2 when the units have reached the 25% stage of completion with respect to conversion costs. Conversion costs are added proportionally in Department 2. The production activity in Department 2 for the current month was as follows: Beginning work-in-process inventory (40% complete with respect to conversion costs) Units transferred in from Department 1 Units to account for

95,000

Units completed and transferred to finished goods Ending work-in-process inventory (20% complete with respect to conversion costs) Units accounted for

15,000 80,000

85,000 10,000 95,000

How many equivalent units for direct materials were added in Department 2 for the current month?

A. B. C. D.

70,000 units. 80,000 units. 85,000 units. 95,000 units. Answer (A) is correct. Beginning inventory is 40% complete. Hence, direct materials have already been added. Ending inventory has not reached the 25% stage of completion, so direct materials have not yet been added to these units. Thus, the equivalent units for direct materials calculated on a FIFO basis are equal to the units started and completed in the current period (85,000 units completed – 15,000 units in BWIP = 70,000 units started and completed). Answer (B) is incorrect because 80,000 total units were transferred in from Department 1. Answer (C) is incorrect because 85,000 equals the equivalent units for direct materials calculated on a weightedaverage basis. Answer (D) is incorrect because 95,000 equals the total units to be account for.


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[866] Gleim #: 6.69 -- Source: CIA 1193 IV-3 A large manufacturing company has two service departments and two production departments. Each of the service departments renders services to each other and to the two production departments. Which one of the following methods would most accurately allocate the costs of the service departments to the production departments of this company?

A. B. C. D.

The direct allocation method. The step-down allocation method. The reciprocal allocation method. The sequential allocation method. Answer (A) is incorrect because the direct allocation method ignores any services that are rendered by one service department to another service department. Answer (B) is incorrect because the step-down allocation method allows for limited recognition of services rendered by service departments to other service departments. Answer (C) is correct. The reciprocal method uses simultaneous equations to allocate each service department’s costs. It allocates costs by explicitly including the mutual services rendered among all departments. When service departments render services to each other, the use of the direct method or the step-down method would not be theoretically accurate. Accordingly, in such situations, the reciprocal method would result in the most accurate allocation. Answer (D) is incorrect because the sequential allocation method is another name for the step-down allocation method.

[867] Gleim #: 6.70 -- Source: CIA 592 IV-6 A metal fabricating company uses a job-order cost system. The company expects to have small residual pieces of metal cuttings and shavings from all of its jobs. Although the metal pieces and shavings cannot be reused, they can be sold for scrap. The scrap metal is sold when a ton of scrap has been accumulated. The requisitions and the scrap recovery for aluminum during the current month are as follows. Aluminum requisitions: 100,000 lbs. at $1.50 per lb. Aluminum scrap recovery:

$150,000 800 lbs.

This amount of scrap is within normal allowances for the company’s operations. The market price for scrap aluminum fluctuates greatly and has ranged from $.25 to $.40 per pound during the last 12 months. The accumulated scrap aluminum was sold last month for $.35 per pound. The appropriate accounting treatment for the scrap aluminum recovered during the current month is to

A. Debit direct materials quantity variance for $1,200 (800 lbs. × $1.50 per lb.) and credit work-in-process inventory control for $1,200, with postings to each job from which the scrap metal was recovered. B. Debit scrap inventory for $280 (800 lbs. × $.35 per lb.) and credit factory overhead control for $280. C. For materiality reasons, no entry is made until the scrap metal is sold. At that time, debit cash and credit factory overhead control for the quantity sold at the current market price. D. Debit direct materials quantity variance for $1,200 (800 lbs. × $1.50 per lb.) and credit factory overhead control for $1,200 at the time of recovery, and when the scrap is sold, debit cash and credit direct materials quantity variance for the quantity sold at the current market price.


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Answer (A) is incorrect because a quantity variance is not recorded for scrap that is anticipated. Furthermore, work-in-process inventory is credited only when scrap is unique to a job. Answer (B) is incorrect because an accounting entry is not needed. The amount is not material. Answer (C) is correct. Making a memorandum entry at the time of recovery is appropriate. The value of the scrap is then recognized at the time of sale. The factory overhead control account is credited because scrap is inevitable to the company’s production operations and not attributable to a specific job. This accounting method has the effect of spreading the revenue from scrap sales over all jobs or products. Answer (D) is incorrect because normal scrap is not the basis for recording a variance. [868] Gleim #: 6.71 -- Source: CIA 1193 IV-6 Some units of output failed to pass final inspection at the end of the manufacturing process. The production and inspection supervisors determined that the estimated incremental revenue from reworking the units exceeded the cost of rework. The rework of the defective units was authorized, and the following costs were incurred in reworking the units: Materials requisitioned from stores: Direct materials Miscellaneous supplies Direct labor

$ 5,000 300 14,000

The manufacturing overhead budget includes an allowance for rework. The predetermined manufacturing overhead rate is 150% of direct labor cost. The account(s) to be charged and the appropriate charges for the rework cost would be

A. B. C. D.

Work-in-process inventory control for $19,000. Work-in-process inventory control for $5,000 and factory overhead control for $35,300. Factory overhead control for $19,300. Factory overhead control for $40,300. Answer (A) is incorrect because factory overhead should be charged for direct materials, supplies, direct labor, and applied overhead incurred for rework. Answer (B) is incorrect because factory overhead should be charged for direct materials, supplies, direct labor, and applied overhead incurred for rework. Answer (C) is incorrect because $19,300 excludes the predetermined manufacturing overhead. Answer (D) is correct. The rework charge for direct materials, indirect materials (supplies), direct labor, and overhead applied on the basis of direct labor cost is $40,300 [$5,000 + $300 + $14,000 + (1.5 × $14,000)]. If an allowance for rework is included in a company’s manufacturing overhead budget, rework of defective units is spread over all jobs or batches as part of the predetermined overhead application rate. Hence, the debit is to overhead control.


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[869] Gleim #: 6.72 -- Source: CIA 1192 IV-10 A company uses a joint production process that produces three products at split-off. Joint production costs during May were $340,000. Product data for May were as follows: Product

Tons produced Tons sold Selling price per ton

X

Y

Z

10,000 8,000 $50

2,000 1,700 $125

5,000 4,300 $10

The company uses the net realizable value method for allocating joint costs.

Assume that product Z is treated as a by-product. Product X can be sold at split-off without further processing but products Y and Z have to be processed further before they can be sold. The separable cost of processing product Y (so it can be sold for $165 per ton) is $30,000. The separable cost of product Z is $25,000. Product Z can be sold for $13 per ton after further processing is complete. What amount of the joint cost should be allocated to product Y?

A. B. C. D.

$40,000 $106,250 $112,500 $120,000


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Answer (A) is incorrect because $40,000 is the NRV of by-product Z. Answer (B) is incorrect because $106,250 is the joint cost allocated to Y assuming that X, Y, and Z are joint products and no separable costs need to be incurred. Answer (C) is correct. By-products are joint products that have minor sales value compared with the sales value of the main product(s). To be salable, the by-product may or may not require additional processing beyond the split-off point. Thus, the incurrence of separable costs beyond the split-off point may or may not be required. Practice with regard to recognizing byproducts in the accounts is not uniform. The most cost-effective method for the initial recognition of by-products is to account for their value at the time of sale as a reduction in the joint cost or as a revenue. The alternative is to recognize the net realizable value at the time of production, a method that results in the recording of by-product inventory. Assuming the NRV is recognized as a reduction in the joint cost, the joint cost allocated to Y is determined as follows:

Joint cost to be allocated to X and Y = Joint cost – NRV of by-product Z = $340,000 – [(5,000 tons × $13) – $25,000] = $300,000 NRVX = 10,000 tons × $50 = $500,000 NRVY = (2,000 tons × $165) – $30,000 = $300,000 Joint cost allocated to Y $300,000 × 30,000

= $300,000 + $500,000 = $112,500

Answer (D) is incorrect because $120,000 is the joint cost of Y if X, Y, and Z are joint products, Y has separable costs of $30,000, and Y has a selling price of $165. [870] Gleim #: 6.73 -- Source: CIA 593 IV-4 A new advertising agency serves a wide range of clients including manufacturers, restaurants, service businesses, department stores, and other retail establishments. The accounting system the advertising agency has most likely adopted for its record keeping in accumulating costs is

A. B. C. D.

Job-order costing. Operating costing. Relevant costing. Process costing. Answer (A) is correct. Job-order costing is used by organizations whose products or services are readily identified by individual units or batches. The advertising agency accumulates its costs by client. Job-order costing is the most appropriate system for this type of nonmanufacturing firm. Answer (B) is incorrect because operation costing would most likely be employed by a manufacturer producing goods that have common characteristics plus some individual characteristics. This would not be an appropriate system for an advertising agency with such a diverse client base. Answer (C) is incorrect because relevant costing refers to expected future costs that are considered in decision making. Answer (D) is incorrect because process costing is employed when a company mass produces a homogeneous product in a continuous fashion through a series of production steps.


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[Fact Pattern #69] The standard direct labor cost to produce one pound of output for a company is presented below. Related data regarding the planned and actual production activities for the current month for the company are also given below:

NOTE: DLH = Direct labor hours Direct labor standard: 0.4 DLH @ $12.00 per DLH = $4.80 Planned production Actual production Actual direct labor costs (6,250 DLH)

15,000 pounds 15,500 pounds $75,250

[871] Gleim #: 6.74 -- Source: CIA R98 IV-67 (Refers to Fact Pattern #69) The company’s direct labor rate variance for the current month is

A. B. C. D.

$10 unfavorable. $240 unfavorable. $248 unfavorable. $250 unfavorable. Answer (A) is incorrect because $10 unfavorable equals the difference between the planned and actual DLH times the difference between the standard and actual rates. Answer (B) is incorrect because $240 unfavorable equals the planned DLH times the difference between the standard and actual rates. Answer (C) is incorrect because $248 unfavorable equals the DLH allowed for the actual output times the difference between the standard and actual rates. Answer (D) is correct. The direct labor rate variance equals actual DLH times the difference between the actual and standard direct labor rates, or $250 unfavorable {6,250 actual DLH × [($75,250 actual costs ÷ 6,250 actual DLH) – $12.00 standard rate]}.

[872] Gleim #: 6.75 -- Source: CIA R98 IV-68 (Refers to Fact Pattern #69) The company’s direct labor efficiency variance for the current month is

A. B. C. D.

$600 unfavorable. $602 unfavorable. $2,400 unfavorable. $3,000 unfavorable.


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Answer (A) is correct. The direct labor efficiency variance equals the standard direct labor rate times the difference between the actual DLH and the standard DLH allowed for the actual output, or $600 unfavorable {$12 × [6,250 actual DLH – (.4 DLH × 15,500 pounds actually produced)]}. Answer (B) is incorrect because $602 unfavorable is based on the actual direct labor rate. Answer (C) is incorrect because $2,400 unfavorable equals the standard direct labor rate times the difference between the DLH allowed for the planned output and the DLH allowed for the actual output. Answer (D) is incorrect because $3,000 unfavorable equals the standard direct labor rate times the difference between the DLH allowed for the planned output and the actual DLH. [873] Gleim #: 6.76 -- Source: CIA 593 IV-11 A company has sales of $500,000, variable costs of $300,000 and pretax profit of $150,000. If the company increased the sales price per unit by 10%, reduced fixed costs by 20%, and left variable cost per unit unchanged, what would be the new breakeven point in sales dollars?

A. B. C. D.

$88,000 $100,000 $110,000 $125,000 Answer (A) is correct. The breakeven point in sales dollars is equal to the sum of fixed cost plus any desired pretax profit, divided by contribution margin ratio [(sales – variable costs) ÷ sales]. Fixed cost was $50,000 ($500,000 sales – $300,000 VC – $150,000 pretax profit). Given the increase in sales of 10% and decrease in fixed costs of 20%, the breakeven point in sales is $88,000.

Fixed costs ($50,000 × .8) + Desired pretax profit 0

$40,000 =

Sales [($500,000 × 1.1) – Variable costs $300,000] ÷ Sales ($500,000 × 1.1)

$250,000 ÷ $550,000

Answer (B) is incorrect because $100,000 ignores the 10% sales price increase. Answer (C) is incorrect because $110,000 ignores the 20% decrease in fixed costs. Answer (D) is incorrect because $125,000 ignores the changes in sales price and fixed costs. [874] Gleim #: 6.77 -- Source: CIA R98 IV-66 Which of the following is a product cost for a manufacturing company?

A. B. C. D.

Insurance on the corporate headquarters building. Property taxes on a factory. Depreciation on a salesperson’s automobile. The salary of a sales manager.


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Answer (A) is incorrect because insurance on the corporate headquarters building is a general and administrative expense. Answer (B) is correct. Product (inventoriable) costs are incurred to produce units of output and are deferred to future periods to the extent output is not sold (kept on hand for sale in future periods). They are expensed in the period the product is sold. Hence, product costs are those that can be associated with specific revenues. Examples are direct materials, direct labor, and factory (not general and administrative) overhead. Property taxes on a factory are included in factory (manufacturing) overhead. Answer (C) is incorrect because depreciation on a salesperson’s automobile is a general and administrative expense. Answer (D) is incorrect because the salary of a sales manager is a general and administrative expense. [Fact Pattern #70] A company manufactures and sells a single product. It takes two machine hours to produce one unit. Annual sales are expected to be 75,000 units. Annual production capacity is 200,000 machine hours. Expected selling price is $10 per unit. Cost data for manufacturing and selling the product are as follows:

Variable Costs (per unit) Direct Materials Direct Labor Variable Manufacturing Overhead Variable Selling

$3.00 1.00 0.80 2.00

Fixed Costs (per year) Fixed Manufacturing Overhead Fixed Selling

$90,000 60,000

[875] Gleim #: 6.78 -- Source: CIA 595 III-85 (Refers to Fact Pattern #70) The company receives a special order for 10,000 units at $7.60. Variable selling cost for each of these 10,000 units will be $1.20. This special order will not affect regular sales of 75,000 units. If the company accepts this special order, its profit will

A. B. C. D.

Increase by $8,000. Increase by $16,000. Decrease by $4,000. Decrease by $12,000. Answer (A) is incorrect because an increase of $8,000 assumes unit variable selling cost is $2.00. Answer (B) is correct. If the company accepts the special order, its revenue will increase by $76,000 ($7.60 × 10,000 units). However, its incremental cost will include only the variable costs because fixed manufacturing and selling costs will be unchanged. The increase in cost from accepting the special order is $60,000 [($3.00 + $1.00 + $0.80 + $1.20) × 10,000 units]. Thus, acceptance of the special order will increase profits by $16,000 ($76,000 – $60,000). Answer (C) is incorrect because profit will increase. Answer (D) is incorrect because profit will increase.

[876] Gleim #: 6.79 -- Source: CIA 595 III-86 (Refers to Fact Pattern #70) The company estimates that by reducing its selling price to $9.30 per unit, it can increase sales to 90,000 units annually. Fixed costs per year and unit variable costs will remain unchanged. If the company reduces its selling price to $9.30 per unit, its profit will


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A. B. C. D.

Decrease by $5,000. Decrease by $15,000. Decrease by $45,000. Increase by $15,000. Answer (A) is incorrect because profit will decrease by $15,000. Answer (B) is correct. Because total fixed costs are unaffected, the change in profit is the change in the contribution margin. The contribution margin at the current selling price is $240,000 [($10 – $3 – $1 – $0.80 – $2) × 75,000 units]. The contribution margin at the $9.30 selling price is $225,000 [($9.30 – $3 – $1 – $0.80 – $2) × 90,000 units]. Hence, profit will be reduced by $15,000 ($240,000 – $225,000) if the selling price is lowered to $9.30. Answer (C) is incorrect because profit will decrease by $15,000. Answer (D) is incorrect because profit will decrease by $15,000.

[Fact Pattern #71] The power and maintenance departments of a manufacturing company are service departments that provide support to each other as well as to the organization’s two production departments, plating and assembly. The manufacturing company employs separate departmental manufacturing overhead rates for the two production departments requiring the allocation of the service department costs to the two manufacturing departments. Square footage of area served is used to allocate the maintenance department costs while percentage of power usage is used to allocate the power department costs. Department costs and operating data are as follows:

Service Depts. Costs:

Power

Production Depts.

Maintenance

Plating

Assembly

Labor Overhead

$

60,000 1,440,000

$180,000 540,000

Total Costs

$1,500,000

$720,000

6,000

1,500

6,000

24,000

5% 4%

60% 70%

35% 26%

Operating Data: Square Feet Percent of Usage: Long-run capacity Expected actual use

[877] Gleim #: 6.80 -- Source: CIA 1195 III-85 (Refers to Fact Pattern #71) The allocation method that would provide this manufacturer with the theoretically best allocation of service department costs would be

A. A dual-rate allocation method allocating variable cost on expected actual usage and fixed costs on long-run capacity usage. B. The step-down allocation method. C. The direct allocation method. D. The reciprocal (or linear algebra) allocation method.


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Answer (A) is incorrect because a dual-rate method is a refinement of the direct method permitting the allocation of the variable and fixed costs in separate pools. Although this method is more precise than the direct method, it does not recognize the mutual services rendered among all service departments. Answer (B) is incorrect because the step-down method provides for partial recognition of services rendered by other service departments, but it does not recognize all mutual services. Answer (C) is incorrect because the direct method is not theoretically precise. It does not give any recognition to the services rendered by other service departments. Answer (D) is correct. The reciprocal method is the theoretically most defensible allocation method. It recognizes the mutual services rendered among all service departments. [878] Gleim #: 6.81 -- Source: CIA 1195 III-86 (Refers to Fact Pattern #71) Assume that the manufacturing company employs the step-down allocation method to allocate service department costs. If it allocates the cost of the maintenance department first, then the amount of the maintenance department’s costs that are directly allocated to the plating department would be

A. B. C. D.

$144,000 $120,000 $115,200 $90,000 Answer (A) is incorrect because $144,000 is the allocation based on the direct method. Answer (B) is correct. The allocation base is 36,000 square feet [6,000 + 6,000 + 24,000]. Plating’s share is one-sixth [6,000 ÷ 36,000] of the total cost of maintenance services, or $120,000 ($720,000 ÷ 6). Answer (C) is incorrect because $115,200 is based on the total square footage of the entire plant. Answer (D) is incorrect because $90,000 results from allocating overhead costs only.

[879] Gleim #: 6.82 -- Source: CIA 1196 III-89 In a company, products pass through some or all of the production departments during manufacturing, depending upon the product being manufactured. Direct material and direct labor costs are traced directly to the products as they flow through each production department. Manufacturing overhead is assigned in each department using separate departmental manufacturing overhead rates. The inventory costing method that the manufacturing company is using in this situation is

A. B. C. D.

Absorption costing. Activity-based costing. Backflush costing. Variable costing. Answer (A) is correct. Absorption costing inventories all direct manufacturing costs and both variable and fixed manufacturing overhead (indirect) costs. Answer (B) is incorrect because activity-based costing develops cost pools for activities and then allocates those costs to cost objects based on the drivers of the activities. Answer (C) is incorrect because a backflush costing system applies costs based on output. Answer (D) is incorrect because variable costing excludes fixed manufacturing overhead costs from inventoriable costs and treats them as period costs.


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[880] Gleim #: 6.83 -- Source: CIA 596 IV-43 A company has $450,000 per year of fixed production costs, of which $150,000 are noncash outlays. The variable cost per unit is $15, and the unit selling price is $25. The breakeven volume in sales units for this company would be

A. B. C. D.

18,000 units. 30,000 units. 45,000 units. 60,000 units. Answer (A) is incorrect because 18,000 units results from dividing fixed costs by unit price. Answer (B) is incorrect because 30,000 units equals fixed costs divided by unit variable cost. Answer (C) is correct. The breakeven volume in sales units equals fixed costs divided by the unit contribution margin (unit price – unit variable cost). Hence, the breakeven point is 45,000 units [$450,000 ÷ ($25 – $15)]. Answer (D) is incorrect because 60,000 units is calculated by adding $150,000 to the fixed costs.

[Fact Pattern #72] Data regarding 20X1 operations for an enterprise that had no beginning or ending inventories are as follows:

Sales (150,000 units) Variable costs: Direct materials Direct labor Manufacturing overhead Selling expenses Fixed costs: Manufacturing overhead Administrative expenses Selling expenses Income tax rate

$9,000,000 $1,800,000 720,000 1,080,000 450,000 $ 600,000 567,840 352,800 40%

The enterprise estimates that next year direct materials costs will increase by 10% and direct labor costs will increase by $0.60 per unit to $5.40 per unit. In addition, fixed selling expenses will increase by $29,520. All other costs will be incurred at the same rates or amounts as the current year. [881] Gleim #: 6.84 -- Source: CIA R98 IV-57 (Refers to Fact Pattern #72) The total contribution margin for 20X1 is

A. B. C. D.

$2,970,000 $4,950,000 $5,400,000 $6,030,000 Answer (A) is incorrect because $2,970,000 results from subtracting income tax. Answer (B) is correct. The total contribution margin equals sales minus variable costs, or $4,950,000 ($9,000,000 – $1,800,000 – $720,000 – $1,080,000 – $450,000). Answer (C) is incorrect because $5,400,000 omits variable selling costs from the calculation. Answer (D) is incorrect because $6,030,000 omits variable overhead from the calculation.


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[882] Gleim #: 6.85 -- Source: CIA R98 IV-58 (Refers to Fact Pattern #72) The gross margin for 20X1 is

A. B. C. D.

$3,429,360 $4,232,160 $4,350,000 $4,800,000 Answer (A) is incorrect because $3,429,360 equals pretax operating income (revenue minus total costs). Answer (B) is incorrect because $4,232,160 equals the gross margin minus fixed administrative expenses. Answer (C) is incorrect because $4,350,000 equals the gross margin minus the variable selling expenses. Answer (D) is correct. The gross margin equals revenue minus cost of goods sold (beginning finished goods inventory + cost of goods manufactured – ending finished goods inventory). Cost of goods manufactured equals all manufacturing adjusted for the change in work-in-process. Consequently, the gross margin was $4,800,000 ($9,000,000 – $1,800,000 DM – $720,000 DL – $1,080,000 VOH – $600,000 FOH), given no beginning or ending finished goods or work-inprocess inventories.

[883] Gleim #: 6.86 -- Source: CIA R98 IV-59 (Refers to Fact Pattern #72) The breakeven point in unit sales for 20X1 is

A. B. C. D.

36,495 units. 42,240 units. 46,080 units. 56,320 units. Answer (A) is incorrect because 36,495 units includes fixed manufacturing overhead and excludes variable selling expenses from the UCM calculation. It also excludes fixed selling expenses from the total fixed costs. Answer (B) is incorrect because 42,240 units excludes variable selling expenses from the UCM calculation. Answer (C) is correct. The breakeven point in unit sales equals total fixed costs divided by the unit contribution margin (UCM). Total fixed costs are $1,520,640 ($600,000 + $567,840 + $352,800), and the UCM is $33 [$4,950,000 contribution margin (sales minus variable costs) ÷ 150,000 units sold]. Hence, the breakeven point in unit sales is 46,080 units ($1,520,640 ÷ $33). Answer (D) is incorrect because 56,320 units results from dividing total fixed costs by the total unit variable cost.

[884] Gleim #: 6.87 -- Source: CIA R98 IV-60 (Refers to Fact Pattern #72) What dollar sales volume, to the nearest dollar, would be required in 20X2 to earn the same net income as in 20X1?

A. B. C. D.

$6,938,031 $8,736,000 $9,576,000 $10,374,000


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Answer (A) is incorrect because $6,938,031 includes net income instead of pretax operating income in the calculation. Answer (B) is incorrect because $8,736,000 omits the unit variable selling expense from the calculation of the total unit variable cost. Answer (C) is correct. To earn the same net income in 20X2 as in 20X1, the contribution margin must equal the sum of the 20X1 pretax operating income and the 20X2 fixed costs. The pretax operating income is calculated as $3,429,360 ($9,000,000 – $4,050,000 variable costs – $1,520,640 fixed costs). Fixed costs in 20X2 will be the same as in 20X1 except for an increase of $29,520 in fixed selling expenses, a total of $1,550,160 ($1,520,640 as previously calculated + $29,520). The desired 20X2 sales volume must equal the 20X2 contribution margin of $4,979,520 ($3,429,360 desired pretax operating income + $1,550,160 fixed costs in 20X2) divided by the contribution margin ratio (CMR). The CMR may be determined from the unit price (constant at $9,000,000 ÷ 150,000 units = $60 per unit) and unit variable cost data. Unit direct materials cost in 20X2 will increase by 10% to $13.20 [1.1 × ($1,800,000 ÷ 150,000 units)]. Unit direct labor cost in 20X2 is given as $5.40. Unit variable overhead cost is constant at $7.20 ($1,080,000 ÷ 150,000 units). Unit variable selling expense is constant at $3.00 ($450,000 ÷ 150,000 units). Thus, total unit variable cost is $28.80 ($13.20 + $5.40 + $7.20 + $3.00), and the UCM is $31.20 ($60 unit selling price – $28.80). The CMR is therefore .52 ($31.20 ÷ $60.00), and the desired 20X2 sales volume is $9,576,000 ($4,979,520 CM ÷ .52). Answer (D) is incorrect because $10,374,000 uses the variable cost ratio instead of the CMR. [885] Gleim #: 6.88 -- Source: CIA R98 IV-61 (Refers to Fact Pattern #72) What selling price would the company have to charge for its product in 20X2 to maintain the same contribution margin percentage rate as in 20X1?

A. B. C. D.

$61.80 $64.00 $64.50 $72.00 Answer (A) is incorrect because $61.80 equals the original unit selling price plus the increase in the unit variable costs. Answer (B) is correct. The CMR equals unit contribution margin (UCM) divided by unit selling price. The UCM equals the unit selling price minus unit variable cost. The original unit selling price was $60 ($9,000,000 revenue ÷ 150,000 units), and the original unit variable cost was $27 [($1,800,000 + $720,000 + $1,080,000 + $450,000) ÷ 150,000 units]. The original CMR was therefore .55 [($60 – $27) ÷ $60]. The new unit variable cost was calculated as $28.80. Accordingly, the unit selling price (X) is $64.

(X – $28.80) ÷ X X – $28.80 .45X X X

= = = = =

.55 .55X $28.80 28.8 ÷ .45 $64

Answer (C) is incorrect because $64.50 omits the unit variable selling costs from all calculations. Answer (D) is incorrect because $72.00 omits the unit variable selling costs from the calculation of the original unit variable cost.


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[Fact Pattern #73] A manufacturing company has the following information for its service departments, S1 and S2, and its production departments, P1 and P2.

Overhead cost Service provided by S1 Service provided by S2

S1

S2

P1

$4,000 -25%

$7,200 30% --

$8,000 30% 30%

P2 $10,000 40% 45%

[886] Gleim #: 6.89 -- Source: CIA 591 IV-1 (Refers to Fact Pattern #73) Using the direct method of service department cost allocation, how much is to be allocated from S2 to P2? Round calculations to the nearest dollar.

A. B. C. D.

$3,240 $4,000 $4,320 $5,040 Answer (A) is incorrect because S2’s overhead allocated to P2 is $4,320. Answer (B) is incorrect because S2’s overhead allocated to P2 is $4,320. Answer (C) is correct. Using the direct method, service use by other service departments is ignored. P2 accounted for 60% [45% ÷ (30% + 45%)] of the service provided to production departments by S2. Hence, the amount of S2’s overhead allocated to P2 is $4,320 (60% × $7,200). Answer (D) is incorrect because S2’s overhead allocated to P2 is $4,320.

[887] Gleim #: 6.90 -- Source: CIA 591 IV-2 (Refers to Fact Pattern #73) Using the reciprocal method of service department allocation, how much is the total overhead cost for P1 for the period? Round calculations to the nearest dollar.

A. B. C. D.

$12,560 $12,594 $16,594 $12,605


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Answer (A) is incorrect because P1 had total overhead costs of $12,605. Answer (B) is incorrect because P1 had total overhead costs of $12,605. Answer (C) is incorrect because P1 had total overhead costs of $12,605. Answer (D) is correct. The reciprocal method applies simultaneous equations to allocate each service department’s costs among the departments providing mutual services before reallocation to other users. Thus, P1 had total overhead costs of $12,605 as shown below.

Determine costs: S1 = $4,000 S2 = $7,200 S1 = $4,000 S1 = $6,270 S2 = $7,200 S2 = $9,081

+ .25 S2 + .30 S1 + $1,800 + .075 S1 + .30 ($6,270)

Allocate costs:

Overhead costs Allocate S1 Allocate S2

S1

S2

P1

P2

$4,000 (6,270) 2,270

$7,200 1,881 (9,081)

$8,000 1,881 2,724

$10,000 2,508 4,086

$0

$12,605

$16,594

Balances

$0

[888] Gleim #: 6.91 -- Source: CIA 592 IV-6 A metal fabricating company uses a job-order cost system. The company expects to have small residual pieces of metal cuttings and shavings from all of its jobs. Although the metal pieces and shavings cannot be reused, they can be sold for scrap. The scrap metal is sold when a ton of scrap has been accumulated. The requisitions and the scrap recovery for aluminum during the current month are as follows. Aluminum requisitions: 100,000 lbs. @ $1.50/lb. Aluminum scrap recovery:

$150,000 800 lbs.

This amount of scrap is within normal allowances for the company’s operations. The market price for scrap aluminum fluctuates greatly and has ranged from $.25 to $.40 per pound during the last 12 months. The accumulated scrap aluminum was sold last month for $.35 per pound. The appropriate accounting treatment for the scrap aluminum recovered during the current month is to


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A. Debit direct materials quantity variance for $1,200 (800 lbs. @ $1.50/lb.) and credit work-in-process inventory control for $1,200, with postings to each job from which the scrap metal was recovered. B. Debit scrap inventory for $280 (800 lbs. @ $.35/lb.) and credit factory overhead control for $280. C. For materiality reasons, no entry is made until the scrap metal is sold. At that time, debit cash and credit factory overhead control for the quantity sold at the current market price. D. Debit direct materials quantity variance for $1,200 (800 lbs. @ $1.50/lb.) and credit factory overhead control for $1,200 at the time of recovery, and when the scrap is sold, debit cash and credit direct materials quantity variance for the quantity sold at the current market price. Answer (A) is incorrect because a quantity variance is not recorded for scrap that is anticipated. Furthermore, work-in-process inventory is credited only when scrap is unique to a job. Answer (B) is incorrect because an accounting entry is not needed. The amount is not material. Answer (C) is correct. Making a memorandum entry at the time of recovery is appropriate. The value of the scrap is then recognized at the time of sale. The factory overhead control account is credited because scrap is inevitable to the company’s production operations and not attributable to a specific job. This accounting method has the effect of spreading the revenue from scrap sales over all jobs or products. Answer (D) is incorrect because normal scrap is not the basis for recording a variance. [Fact Pattern #74] A manufacturer has the following direct materials standard for one of its products. Direct materials: 3 pounds @ $1.60/pound = $4.80 The company records all inventory at standard cost. Data for the current period regarding the manufacturer’s budgeted and actual production for the product as well as direct materials purchases and issues to production for manufacture of the product are presented below.

8,000 units 7,500 units

Budgeted production for the period Actual production for the period Direct materials purchases: Pounds purchased Total cost Direct materials issued to production

25,000 pounds $38,750 23,000 pounds

[889] Gleim #: 6.92 -- Source: CIA 1192 IV-20 (Refers to Fact Pattern #74) The direct materials price variance for the current period is

A. B. C. D.

$1,125 favorable. $1,150 favorable. $1,200 favorable. $1,250 favorable.


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Answer (A) is incorrect because $1,125 favorable results from multiplying the standard direct materials that should have been used in production [(3 × 7,500) = 22,500 lbs.] times the difference between standard price and actual price [($1.60 – $1.55) = $.05]. Answer (B) is incorrect because $1,150 favorable results from multiplying the direct materials issued to production (23,000 lbs.) times the difference between standard price and actual price [($1.60 – $1.55) = $.05]. Answer (C) is incorrect because $1,200 favorable results from multiplying the direct materials that should have been used for budgeted production [(3 × 8,000) = 24,000 lbs.] times the difference between standard price and actual price [($1.60 – $1.55) = $.05]. Answer (D) is correct. The materials price variance measures the difference between what was actually paid for the goods purchased and the standard amount allowed for the goods purchased. Thus, it equals the difference between actual price and standard price, multiplied by the actual quantity purchased. This question assumes that price variances are isolated at the time of purchase. If they are isolated when the materials are used, the variance is the difference between standard and actual price, times the amount used (not amount purchased). Accordingly, the direct materials purchase price variance is $1,250 F {[($38,750 TC ÷ 25,000 lbs.) – $1.60 per lb.] × 25,000 lbs.}. The variance is favorable because actual price was less than standard price. [890] Gleim #: 6.93 -- Source: CIA 1192 IV-21 (Refers to Fact Pattern #74) The materials efficiency variance for the current period is

A. B. C. D.

$775 unfavorable. $800 unfavorable. $1,600 favorable. $3,200 favorable. Answer (A) is incorrect because $775 unfavorable results from multiplying the difference between standard quantity [(3 × 7,500) = 22,500] and actual quantity used (23,000) times the actual price ($1.55). Answer (B) is correct. The efficiency (quantity or usage) variance for direct materials equals standard unit price times the difference between actual usage and the standard usage for the actual output. Accordingly, the direct materials efficiency variance is $800 U {[23,000 lbs. issued – (3 lbs. × 7,500 units)] × $1.60}. The variance is unfavorable because actual usage exceeded standard usage. Answer (C) is incorrect because $1,600 favorable results from multiplying the difference between standard quantity that should have been used for budgeted production [(3 × 8,000) = 24,000] and actual quantity used (23,000) times the standard price ($1.60). Answer (D) is incorrect because $3,200 favorable results from multiplying the difference between the actual quantity purchased (25,000) and actual quantity used (23,000) times the standard price ($1.60).

[891] Gleim #: 6.94 -- Source: CIA 593 IV-14 The sales volume variance may be calculated for each product in the sales mix

A. B. C. D.

The difference between actual and master budget sales volume, times actual unit contribution margin. Flexible budget and actual sales volume, times master budget unit contribution margin. Flexible budget and master budget sales volume, times actual budget unit contribution margin. Flexible budget and master budget sales volume, times master budget unit contribution margin.


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Answer (A) is incorrect because budgeted, not actual, UCM is used to calculate this variance. Answer (B) is incorrect because the flexible budget volume is the actual volume, resulting in a zero variance. Answer (C) is incorrect because budgeted, not actual, UCM is used to calculate this variance. Answer (D) is correct. The sales volume variance is the difference between flexible budget (actual volume) and master budget sales quantity, times master budget unit contribution margin (UCM). This amount is calculated for each product in the sales mix, and the results are added to determine the total sales volume variance. This variance may be further divided into quantity and mix variances. [892] Gleim #: 6.95 -- Source: CIA 1194 III-44 A company services office equipment. Some customers bring their equipment to the company’s service shop; other customers prefer to have the company’s service personnel come to their offices to repair their equipment. The most appropriate costing method for the company is

A. B. C. D.

A job-order costing system. An activity-based costing system. A process costing system. An operations costing system. Answer (A) is correct. Job-order costing systems are designed to accumulate costs for tasks or projects that are unique and nonrepetitive. Service organizations are interested in identifying the costs applicable to each customer and/or each service call. Answer (B) is incorrect because activity-based costing systems focus on generating more accurate cost information by identifying the activities that are cost drivers. Answer (C) is incorrect because process costing systems are designed for homogeneous products that are mass produced in continuous production runs. Answer (D) is incorrect because operations costing systems are designed for batches of homogeneous products; operations costing is a hybrid of job-order and process costing.

[Fact Pattern #75] A manufacturing company employs a process cost system. The company’s product passes through both Department 1 and Department 2 in order to be completed. Conversion costs are incurred uniformly throughout the process in Department 2. The direct material is added in Department 2 when conversion is 80% complete. This direct material is a preservative that does not change the volume. Spoiled units are discovered at the final inspection and are recognized then for costing purposes. The physical flow of units for the current month is presented below.

Beginning work-in-process in Department 2 (90% complete with respect to conversion costs) Transferred in from Department 1 Completed and transferred to finished goods Spoiled units – all normal Ending work-in-process in Department 2 (60% complete with respect to conversion costs)

14,000 76,000 80,000 1,500 8,500

[893] Gleim #: 6.96 -- Source: CIA 1195 III-80 (Refers to Fact Pattern #75) If the manufacturing company uses the weighted-average method, the equivalent units for direct materials in Department 2 for the current month would be


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A. B. C. D.

67,500 80,000 81,500 90,000 Answer (A) is incorrect because 67,500 equivalent units of direct materials were added in accordance with the FIFO method. Answer (B) is incorrect because 80,000 units were transferred. Answer (C) is correct. The weighted-average method does not distinguish between work done currently and in the prior period. Given that materials are added when units are 80% complete, that ending work-in-process is 60% complete, and that goods are inspected when they are 100% complete, and assuming that equivalent units are calculated for normal spoilage, the total weighted-average equivalent units for direct materials equals 81,500 (80,000 units transferred + 1,500 normally spoiled units). Answer (D) is incorrect because 90,000 units equals the actual physical flow for the month.

[894] Gleim #: 6.97 -- Source: CIA 1195 III-81 (Refers to Fact Pattern #75) If the manufacturing company uses the FIFO (first-in, first-out) method, the equivalent units for conversion costs in Department 2 for the current month would be

A. B. C. D.

72,500 74,000 85,200 86,600 Answer (A) is incorrect because 72,500 ignores spoilage. Answer (B) is correct. The FIFO method distinguishes between work done in the prior period and work done currently. The total FIFO equivalent units equals the work done currently on beginning work-in-process, plus the work done on ending work-in-process, plus all units started and completed currently. Hence, total FIFO equivalent units equals 74,000 {(10% × 14,000 units in BWIP) + (60% × 8,500 units in EWIP) + [100% × (81,500 spoiled and transferred – 14,000 units in BWIP)]}. Answer (C) is incorrect because 85,200 includes 90% of the beginning work-in-process. Answer (D) is incorrect because 86,600 calculates the equivalent units for conversion costs according to the weightedaverage method.

[895] Gleim #: 6.98 -- Source: CIA 594 III-70 Three commonly employed systems for product costing are termed job order costing, operations costing, and process costing. Match the type of production environment with the costing method used.

Job Order Costing

Operations Costing

Process Costing

A. B.

Auto repair Loan processing

Clothing manufacturer Drug manufacturing

Oil refining Custom printing

C. D.

Custom printing Engineering design

Paint manufacturing Auto assembly

Paper manufacturing Motion picture production


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Answer (A) is correct. Job order costing is appropriate when producing products with individual characteristics and/or when identifiable groupings are possible. Process costing should be used to assign costs to similar products that are mass produced on a continuous basis. Operations costing is a hybrid of job order and process costing systems. It is used by companies that manufacture goods that undergo some similar and some dissimilar processes. Thus, job order costing would be appropriate for auto repair, operations costing for clothing manufacturing, and process costing for oil refining. Answer (B) is incorrect because custom printing would not use process costing. Answer (C) is incorrect because paint manufacturing would not use operations costing. Answer (D) is incorrect because motion picture production would not use process costing. [896] Gleim #: 6.99 -- Source: CIA 1194 III-46 A company produces stereo speakers for automobile manufacturers. The automobile manufacturers emphasize total quality control (TQC) in their production processes and reject approximately 3% of the stereo speakers received as being of unacceptable quality. The company inspects the rejected speakers to determine which ones should be reworked and which ones should be discarded. The discarded speakers are classified as

A. B. C. D.

Waste. Scrap. Spoilage. Rework costs. Answer (A) is incorrect because waste is input material that is either lost in the production process or has no sales value. Answer (B) is incorrect because scrap is input material that has a relatively minor sales value at the end of the production process. Answer (C) is correct. Rejected units that are discarded are classified as spoilage. Spoilage is separated into abnormal or normal spoilage. Normal spoilage is an inherent result of the normal production process. Abnormal spoilage is spoilage that is not expected to occur under normal, efficient operating conditions. Answer (D) is incorrect because rework costs are incurred to make unacceptable units appropriate for sale or use.

[897] Gleim #: 6.100 -- Source: CIA 595 III-93 A corporation manufactures two brands of barbed wire fencing for sale to wholesalers and large ranchers. Which of the following would be the best type of costing system for such a company to use?

A. B. C. D.

EOQ system. Job-order system. Process system. Retail inventory system. Answer (A) is incorrect because an EOQ system is an inventory control tool, not a cost system. Answer (B) is incorrect because a job-order system is used when products are differentiated from one customer to the next. Each job (customer) is a separate cost center. Answer (C) is correct. A process costing system is used when a company mass produces a standardized product on a continuous basis. The production department becomes the cost center. Answer (D) is incorrect because this company is a manufacturer, not a retailer. The retail method converts ending inventory stated at retail to cost.


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[898] Gleim #: 6.101 -- Source: CIA 1189 IV-15 The following data apply to one item sold by a large retailer: Purchase price Variable selling expenses Variable administrative expenses Fixed costs Expected annual sales

$4.95 $2.00 $1.00 $7,500 5,000 units

Using the contribution approach to pricing, which of the following prices is the lowest that can be charged in the short run?

A. B. C. D.

$5.00 $7.00 $8.00 $9.50 Answer (A) is incorrect because $5.00 covers the purchase price ($4.95) but not the variable selling ($2.00) and administrative ($1.00) expenses. Answer (B) is incorrect because $7.00 covers the purchase price and the variable selling expenses ($4.95 + $2.00) but not the variable administrative expenses ($1.00). Answer (C) is correct. In the short run, the fixed costs are sunk costs. They will be incurred whether or not the item is produced. Accordingly, the retailer will suffer no additional loss if the price charged covers the incremental costs, which are the variable costs in this case. The lowest feasible price is the one that provides a zero (but not a negative) contribution margin (revenue – variable costs). Thus, the lowest short-run price is the unit variable cost ($4.95 + $2.00 + $1.00 = $7.95). The lowest price provided in the answer choices that will recover the unit variable cost is $8.00. Answer (D) is incorrect because $9.50 covers the fixed costs of $1.50 ($7,500 ÷ 5,000) and the variable costs.

[Fact Pattern #76] A manufacturing company is considering a new product for the coming year, an electric motor which the company can purchase from a reliable vendor for $21.00 per unit. The alternative is to manufacture the motor internally. The company has excess capacity to manufacture the 30,000 motors needed in the coming year except for manufacturing space and special machinery. The machinery can be leased for $45,000 annually. Finished goods warehouse space adjoining the main manufacturing facility, leased for $39,000 annually, can be converted and used to manufacture the motors. Additional off-site space can be leased at an annual cost of $54,000 to replace the finished goods warehouse. The estimated unit costs for manufacturing the motors internally, exclusive of the leasing costs itemized above, are:

Direct material Direct labor Variable manufacturing overhead Allocated fixed manufacturing overhead

$ 8.00 4.00 3.00 5.00

Total manufacturing cost per unit

$20.00

[899] Gleim #: 6.102 -- Source: CIA 1195 III-68 (Refers to Fact Pattern #76) A cost-benefit analysis would show that the manufacturing company would save


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A. B. C. D.

$54,000 by purchasing the motors from the outside vendor. $69,000 by purchasing the motors from the outside vendor. $81,000 by making the motors internally. $96,000 by making the motors internally. Answer (A) is incorrect because saving $54,000 by purchasing assumes that fixed manufacturing overhead and the current space rental are relevant and that the new space rental is not. Answer (B) is incorrect because saving $69,000 by purchasing assumes that fixed manufacturing overhead is relevant. Answer (C) is correct. The relevant costs of making the motor are direct materials, direct labor, variable manufacturing overhead, rental costs of the special machinery, and rental costs of the new warehouse. The fixed manufacturing overhead and the costs of the current warehouse space are not relevant because they will be incurred regardless of whether the motor is made or bought. Buying the motor will cost $630,000 ($21 × 30,000). Making the motor will cost $549,000 {[($8 DM + $4 DL + $3 VOH) × 30,000] + $54,000 + $45,000}. Hence, making the motor saves $81,000 ($630,000 – $549,000). Answer (D) is incorrect because saving $96,000 by making the motor assumes that the current space rental is relevant and that the new space rental is not.

[900] Gleim #: 6.103 -- Source: CIA 1195 III-69 (Refers to Fact Pattern #76) If the manufacturing company decides to use its excess manufacturing capacity for the motors, the contribution or net benefit that could have been obtained from other alternative uses is referred to as

A. B. C. D.

Residual income. Sunk costs. Separable costs. Opportunity costs. Answer (A) is incorrect because residual income equals net operating income minus an imputed interest charge for the investment base. Answer (B) is incorrect because sunk costs are unavoidable. They cannot be changed regardless of the action taken. Answer (C) is incorrect because separable costs arise after a joint process. They are incurred beyond the split-off point and can be directly associated with individual products. Answer (D) is correct. Opportunity cost is the net benefit that could be obtained from the best alternative use of a resource. Accordingly, it is the benefit forgone by using that resource in a particular way.

[Fact Pattern #77] A company that annually reviews its investment opportunities and selects appropriate capital expenditures for the coming year is presented with two projects, called Project A and Project B. Best estimates indicate that the investment outlay for Project A is $30,000 and for Project B is $1 million. The projects are considered to be equally risky. Project A is expected to generate cash inflows of $40,000 at the end of each year for 2 years. Project B is expected to generate cash inflows of $700,000 at the end of the first year and $500,000 at the end of the second year. The company has a cost of capital of 8%. [901] Gleim #: 6.104 -- Source: CIA 1190 IV-54 (Refers to Fact Pattern #77) If the net present value (NPV) of Project A is known to be higher than the NPV of Project B, it can be concluded that


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A. B. C. D.

The internal rate of return (IRR) of Project A will definitely be higher than the IRR of Project B. The IRR of Project A will definitely be lower than the IRR of Project B. The ranking of IRRs is indeterminate based on the information provided. The payback period for Project A is definitely shorter than the payback period for Project B. Answer (A) is incorrect because the ranking of IRRs is indeterminate. Answer (B) is incorrect because the ranking of IRRs is indeterminate. Answer (C) is correct. The IRR is the discount rate at which the net present value is zero. The NPV is the present value of future cash flows minus the present value of the investment. Because of a possible difference in the scale of the projects and other factors, a higher NPV does not necessarily result in a higher IRR. Answer (D) is incorrect because the ranking for payback periods is indeterminate.

[902] Gleim #: 6.105 -- Source: CIA 594 IV-43 (Refers to Fact Pattern #77) If Projects A and B are mutually exclusive, which of the following statements is true?

A. B. C. D.

The company should undertake Project A only. The company should undertake Project B only. The company should undertake both projects. The company should not undertake either project. Answer (A) is incorrect because the NPV method ranks B over A. Answer (B) is correct. For two mutually exclusive projects, the company should undertake the project with the highest positive net present value. Project B has a higher NPV than Project A. The NPVs of both projects are calculated using the firm’s 8% cost of capital as follows:

$40,000 NPV of Project A

= –$30,000 +

$40,000 + (1.08)2

(1.08) = $41,331

$700,000 NPV of Project B

$500,000 +

= –$1,000,000 + (1.08)

(1.08)2

= $76,816 Answer (C) is incorrect because the projects are mutually exclusive. Answer (D) is incorrect because both projects have positive NPVs and one should be selected. [903] Gleim #: 6.106 -- Source: CIA 594 IV-44 (Refers to Fact Pattern #77) If Projects A and B are independent, which of the following statements is true?


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A. B. C. D.

The company should undertake Project A only. The company should undertake Project B only. The company should undertake both projects. The company should not undertake either project. Answer (A) is incorrect because each project has a positive NPV and both should be undertaken. Answer (B) is incorrect because each project has a positive NPV and both should be undertaken. Answer (C) is correct. Independent projects are those whose cash flows are not affected by the acceptance or nonacceptance of other projects. The company must decide whether to accept or to reject each of the projects. Because both projects have a positive NPV calculated using the firm’s 8% cost of capital, both should be accepted. Answer (D) is incorrect because each project has a positive NPV and both should be undertaken.

[904] Gleim #: 6.107 -- Source: CIA 1192 IV-18 A manufacturer has been approached by a new customer who wants to place a one-time order for a component similar to one that the manufacturer makes for another customer. Existing sales will not be affected by acceptance of this order. The manufacturer has a policy of setting its targeted selling price at 60% over full manufacturing cost. The manufacturing costs and the targeted selling price for the existing product are presented below. Direct materials Direct labor Variable manufacturing overhead (applied at 75% of direct labor cost) Fixed manufacturing overhead (applied at 150% of direct labor cost) Total manufacturing cost Markup (60% of full manufacturing cost) Targeted selling price

$2.30 3.60 2.70 5.40 $14.00 8.40 $22.40

The manufacturer has excess capacity to produce the quantity of the component desired by the new customer. The direct materials used in the component for the new customer would cost the manufacturer $0.25 less than the component currently being made. The variable selling expenses (packaging and shipping) would be the same, or $0.90 per unit. Under these circumstances, the minimum unit price at which the manufacturer would accept the special order is one exceeding

A. B. C. D.

$8.35 $9.25 $14.00 $14.80


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Answer (A) is incorrect because $8.35 does not consider the variable selling expenses. Answer (B) is correct. Because the manufacturer has excess capacity and existing sales will be unaffected, the minimum price the manufacturer should be willing to accept is anything above the total variable cost of the unit ($2.05 + $3.60 + $2.70 + $0.90 = $9.25), an amount that includes the variable manufacturing cost and the variable selling expenses. The fixed costs are not relevant. Answer (C) is incorrect because $14.00 includes the fixed manufacturing overhead, which will be incurred whether the order is accepted or not. Additional fixed manufacturing overhead costs will not be incurred because the manufacturer is below full capacity. The fixed manufacturing overhead is a sunk cost that is not relevant to this decision. Answer (D) is incorrect because $14.80 does not consider that the manufacturer is below full capacity and that the customer is placing a one-time order. Under these circumstances, the manufacturer would not use its targeted selling price formula. [905] Gleim #: 6.108 -- Source: CIA 1194 III-55 The procedure employed in zero-base budgeting is to

A. Budget from the ground up whereby every proposed expenditure for every unit is reviewed as though the budget was being prepared for the very first time. B. Review the prior period’s budget along with actual results for that period and the expectations for the coming period to develop more realistic budget amounts for the coming period. C. Require managers to establish priorities by including a description of what activities or changes would occur if the budget were increased and decreased by a fixed percentage amount. D. Ascertain the outputs that are desired and work backward to determine the amount of inputs that will be required to generate the desired outputs. Answer (A) is correct. Zero-base budgeting treats the budget as if it were being initiated for the first time. Thus, all costs are reexamined each period. Beginning with the smallest budgetary subunits, managers must determine objectives, operations, and costs for all activities. Alternative methods of conducting each activity are considered, different levels of service are evaluated for each activity, means of measuring work and performance are determined, and activities are ranked in order of importance to the organization. Answer (B) is incorrect because reviewing the prior period’s budget, actual results for that period, and the expectations for the coming period is incremental budgeting. Answer (C) is incorrect because requiring managers to establish priorities in the event the budget is increased or decreased by a fixed percentage is priority incremental budgeting. Answer (D) is incorrect because ascertaining desired outputs and necessary inputs is the input-output procedure for budget development. [906] Gleim #: 6.109 -- Source: CMA 695 3-17 Which one of the following is the best characteristic concerning the capital budget? The capital budget is a(n)

A. Plan to ensure that there are sufficient funds available for the operating needs of the company. B. Exercise that sets the long-range goals of the company including the consideration of external influences caused by others in the market. C. Plan that results in the cash requirements during the operating cycle. D. Plan that assesses the long-term needs of the company for plant and equipment purchases.


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Answer (A) is incorrect because capital budgeting involves long-term investment needs, not immediate operating needs. Answer (B) is incorrect because strategic planning establishes long-term goals in the context of relevant factors in the firm’s environment. Answer (C) is incorrect because cash budgeting determines operating cash flows. Capital budgeting evaluates the rate of return on specific investment alternatives. Answer (D) is correct. Capital budgeting is the process of planning expenditures for long-lived assets. It involves choosing among investment proposals using a ranking procedure. Evaluations are based on various measures involving rate of return on investment. [907] Gleim #: 6.110 -- Source: CMA 694 3-7 Zohar’s budget for next year contains the following information: Zohar Units Beginning finished goods inventory Beginning work-in-process in equivalent units Desired ending finished goods inventory Desired ending work-in-process in equivalent units Projected sales for next year

85 10 100 40 1,800

How many equivalent units should Zohar plan to produce next year?

A. B. C. D.

1,800 1,565 1,815 1,845


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Answer (A) is incorrect because 1,800 equals projected unit sales. Answer (B) is incorrect because 1,565 equals units needed for sales minus all inventory amounts. Answer (C) is incorrect because 1,815 equals finished units needed. Answer (D) is correct. The finished units needed equal 1,815:

Needed for sales Needed for ending inventory

1,800 100

Total finished units needed Minus beginning inventory

1,900 85

Finished units needed

1,815

The units to be produced equal 1,845: Finished units needed Needed for ending inventory

1,815 40

Total units in process Minus beginning WIP inventory

1,855 10

Units to be produced

1,845

[908] Gleim #: 6.111 -- Source: CMA 696 3-14 Comparing actual results with a budget based on achieved volume is possible with the use of a

A. B. C. D.

Monthly budget. Master budget. Rolling budget. Flexible budget. Answer (A) is incorrect because comparing results using a monthly budget is no easier than using a budget of any other duration. Answer (B) is incorrect because a master budget is the overall budget. It will not facilitate comparisons unless it is also a flexible budget. Answer (C) is incorrect because a rolling (or continuous) budget is revised on a regular (continuous) basis. It will not facilitate comparisons unless it is also a flexible budget. Answer (D) is correct. A flexible budget is essentially a series of several budgets prepared for many levels of sales or production. At the end of the period, management can compare actual costs or performance with the appropriate budgeted level in the flexible budget. New columns can quickly be made by interpolation or extrapolation, if necessary. A flexible budget is designed to allow adjustment of the budget to the actual level of activity before comparing the budgeted activity with actual results.


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[Fact Pattern #78] A firm with an 18% cost of capital is considering the following projects (on January 1 of year one):

Jan. 1, Year One Cash Outflow (000s Omitted)

Dec. 31, Year Five Cash Inflow (000s Omitted)

Project Internal Rate of Return

$3,500 $4,000

$7,400 $9,950

15% ?

Project A Project B

Present Value of $1 Due at the End of “N” Periods N

12%

14%

15%

16%

18%

20%

22%

4 5 6

.6355 .5674 .5066

.5921 .5194 .4556

.5718 .4972 .4323

.5523 .4761 .4104

.5158 .4371 .3704

.4823 .4019 .3349

.4230 .3411 .2751

[909] Gleim #: 6.112 -- Source: IIA, adapted (Refers to Fact Pattern #78) Using the net present value method, project A’s net present value is

A. B. C. D.

$(316,920) $(265,460) $0 $316,920 Answer (A) is incorrect because this answer discounts the cash inflow at the correct discount rate (18%), but for four years instead of five, and also subtracts the cash inflow from the cash outflow, instead of vice versa. Answer (B) is correct. The cash flow at December 31 of year five is five years from the present cash outflow, and the net present value method uses the firm’s cost of capital of 18%. The present value factor for 18% for five years is .4371, and $7,400,000 multiplied by .4371 equals $3,234,540, which is $265,460 less than the present cash outflow of $3,500,000. Answer (C) is incorrect because this answer cannot be computed using the table values and dollar amounts given. Answer (D) is incorrect because this answer discounts the cash inflow at the correct discount rate (18%), but for four years instead of five.

[910] Gleim #: 6.113 -- Source: IIA, adapted (Refers to Fact Pattern #78) Project B’s internal rate of return is closest to

A. B. C. D.

15 percent. 18 percent. 20 percent. 22 percent.


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Answer (A) is incorrect because twenty percent gives the project an NPV of zero. Answer (B) is incorrect because twenty percent gives the project an NPV of zero. Answer (C) is correct. Twenty percent is the rate of return that equates the cash inflows with the cash outflows. The present value of 20 percent for five years is .4019, which multiplied by $9,950,000 equals $3,998,905. Therefore, the net present value of the project approximates $0 using the 20 percent rate. Answer (D) is incorrect because twenty percent gives the project an NPV of zero. [911] Gleim #: 6.114 -- Source: IIA, adapted A flexible budget is a quantitative expression of a plan that

A. B. C. D.

Is developed for the actual level of output achieved for the budget period. Is comprised of the budgeted income statement and its supporting schedules for a budget period. Focuses on the costs of activities necessary to produce and sell products and services for a budget period. Projects costs on the basis of future improvements in existing practices and procedures during a budget period. Answer (A) is correct. A flexible budget is a series of budgets prepared for many levels of activity. It is designed to allow adjustment of the budget to the actual level of activity before comparing the budgeted activity with actual results. Answer (B) is incorrect because this is the definition of an operating budget. Answer (C) is incorrect because this is the definition of activity-based budgeting. Answer (D) is incorrect because this is the definition of Kaizen budgeting.

[912] Gleim #: 6.115 -- Source: IIA, adapted A domestic company has sales divisions in country X and country Y. The company sells only one product, which costs $20 per unit to produce. There are no trade barriers or tariffs among the three countries. Information specific to each of the three countries is as follows:

Country

Corporate Tax Rate

Before-Tax Selling Price

Quantity Sold

Additional Costs

Home X

50% 60%

$30 $40

1,500 1,000

$10,000 $12,500

Y

40%

$35

2,000

$11,000

When selling items to its sales division(s) in , the company should set the allowable transfer price.

List A

List B

A.

Countries X and Y

Highest

B. C.

Countries X and Y Country X

Lowest Highest

D.

Country Y

Highest


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Answer (A) is incorrect because country X has a higher tax rate than the home country and country Y has a lower tax rate. The transfer pricing incentives will be different for the two sales divisions. Answer (B) is incorrect because country X has a higher tax rate than the home country and country Y has a lower tax rate. The transfer pricing incentives will be different for the two sales divisions. Answer (C) is correct. Country X has a higher tax rate than the home country, so the incentive is to transfer profits out of country X. The sales division in country X will be less profitable if it is charged a high transfer price, hence pay less tax. Answer (D) is incorrect because country Y has a lower tax rate than the home country, so the incentive is to transfer profits into country Y by charging that sales division a low transfer price. [913] Gleim #: 6.116 -- Source: IIA, adapted A master budget

A. B. C. D.

Shows forecasted and actual results. Contains only controllable costs. Can be used to determine manufacturing cost variances. Contains the operating budget. Answer (A) is incorrect because the master budget does not contain actual results. Answer (B) is incorrect because the master budget reflects all applicable expected costs, whether controllable by individual managers or not. Answer (C) is incorrect because the master budget is not structured to allow determination of manufacturing cost variances. This is accomplished using the flexible budget and actual results. Answer (D) is correct. The operating budget sequence is part of the master budget process that begins with the sales budget and culminates in the pro forma income statement.

[914] Gleim #: 6.117 -- Source: IIA, adapted A company produced and sold 100,000 units of a component with a variable cost of $20 per unit. Of the units produced, 1,200 failed the company’s tolerance specifications and were reworked at a cost of $12 per unit. Reworked units were sold as factory seconds at $45 each, and first-quality units were sold at $50 each. If the company had implemented a quality assurance program to ensure that all units produced conformed to specifications, the increase in the company’s contribution margin from this component would have been

A. B. C. D.

$14,400 $20,400 $21,600 $39,600 Answer (A) is incorrect because this answer only takes into account the rework cost and excludes the income that was lost when the units were sold as factory seconds: $12 × 1,200 = 14,400. Answer (B) is correct. Both the cost of rework and the income lost when units were sold as factory seconds rather than first-quality units need to be included in the calculation. The following is the appropriate calculation: [$12 + ($50 – $45)] × 1,200 = 20,400. Answer (C) is incorrect because this answer computes what the contribution margin would have been if the reworked items had been sold as first-quality units: [$50 – ($20 + $12)] × 1,200 = 21,600. Answer (D) is incorrect because this answer incorrectly computes the contribution margin for the reworked units, ignoring the $20 variable costs per unit. ($45 – $12) × 1,200 = 39,600.


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[915] Gleim #: 6.118 -- Source: IIA, adapted A company has excess capacity in production-related fixed assets. If in a given year these fixed assets were being used to only 80 percent of capacity and the sales level in that year was $2,000,000, the full capacity sales level is

A. B. C. D.

$1,600,000 $2,000,000 $2,500,000 $10,000,000 Answer (A) is incorrect because this is 80 percent of the actual sales, calculated as .80 ($2,000,000) = $1,600,000. Answer (B) is incorrect because this is the actual sales. Answer (C) is correct. Full capacity sales can be calculated as follows: Actual sales ÷ percent of capacity at which fixed assets were operated = $2,000,000 ÷ .80 = $2,500,000. Answer (D) is incorrect because this is actual sales divided by the proportion of unused, rather than used, capacity, or $2,000,000 ÷ .2 = $10,000,000.

[Fact Pattern #79] A company harvests, packs, and ships all of its own produce. The company operates three packing lines. A summary of completed inventory costs is as follows:

Packing-line employee salary expense Packing-line supervision salary expense Quality control salary expense Packing crates expense Electricity expense Depreciation expense

$150,000 90,000 30,000 15,000 3,000 66,000

[916] Gleim #: 6.119 -- Source: IIA, adapted (Refers to Fact Pattern #79) Costs for the packing lines would be accumulated in part by

A. B. C. D.

Recording payroll expense by employee job category. Computing depreciation expense. Producing monthly financial statements. Forecasting monthly material shortages. Answer (A) is correct. Cost accumulation is performed by accounting systems that organize data by an appropriate catalog. Actual costs, rather than predicted costs, are accumulated. Answer (B) is incorrect because computing depreciation expense would not organize date into categories. Answer (C) is incorrect because producing financial statements would not organize data into categories. Answer (D) is incorrect because forecasting material shortages would not organize data into categories.

[917] Gleim #: 6.120 -- Source: IIA, adapted (Refers to Fact Pattern #79) At the end of the reporting period, 600,000 units had been packed and shipped. No inventory remained on hand. If the company used process costing, the cost per unit would be


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A. B. C. D.

$0.197 $0.275 $0.315 $0.590 Answer (A) is incorrect because process costing does not allocate costs per packing line. ($150,000 + 90,000 + 30,000 + 15,000 + 3,000 + 66,000 = $354,000 ÷ 600,000 = .59 ÷ 3 = $0.197). Answer (B) is incorrect because process costing includes all costs. ($150,000 + 15,000 = 165,000 ÷ 600,000 = $0.275). Answer (C) is incorrect because process costing includes all costs. ($90,000 + 30,000 + 3,000 + 66,000 = 189,000 ÷ 600,000 = $0.315). Answer (D) is correct. Process costing is used to assign costs to products or services. It is applicable to relatively homogeneous items that are mass produced on a continuous basis. Process costing is the average cost per unit produced, or total cost divided by the number of units. $150,000 + $90,000 + $30,000 + $15,000 + $3,000 + $66,000 = $354,000 ÷ 600,000 = $0.59.

[918] Gleim #: 6.121 -- Source: IIA, adapted Which of the following would be a reasonable basis for allocating the material handling costs to the units produced in an activity-based costing system?

A. B. C. D.

Number of production runs per year. Number of components per completed unit. Amount of time required to produce one unit. Amount of overhead applied to each completed unit. Answer (A) is incorrect because this allocation basis is related to batch costs and not to individual unit costs. Answer (B) is correct. An essential element of activity-based costing (ABC) is driver analysis, which identifies the cause-and-effect relationship between an activity and its consumption of resources and for an activity and the demands made on it by a cost object. There is a direct causal relationship between the number of components in a finished product and the amount of material handling cost incurred Answer (C) is incorrect because this allocation basis is the traditional basis for allocating overhead costs to the units produced when the production process is labor-intensive. Answer (D) is incorrect because this is not an allocation basis but rather the result of the allocation process when determining product costs.

[919] Gleim #: 6.122 -- Source: IIA, adapted Residual income is often preferred over return on investment (ROI) as a performance evaluation because

A. Residual income is a measure over time while ROI represents the results for a single time period. B. Residual income concentrates on maximizing absolute dollars of income rather than a percentage return as with ROI. C. The imputed interest rate used in calculating residual income is more easily derived than the target rate that is compared to the calculated ROI. D. Average investment is employed with residual income while year-end investment is employed with ROI.


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Answer (A) is incorrect because both measures represent the results for a single time period. Answer (B) is correct. Residual income concentrates on earnings in excess of the minimum desired return. With ROI, a segment may reject a project that exceeds the minimum return if the project will decrease the segments overall ROI. For example, a project that earns an ROI of 22%, which is greater than the target rate of 20%, might be rejected if the segment is currently earning 25%, because the project will decrease the segments ROI. This would not occur if performance was measured using residual income. Answer (C) is incorrect because the target rate for ROI is the same as the imputed interest rate used in the residual income calculation. Answer (D) is incorrect because average investment should be employed in both methods. At any rate, the investment base employed for both methods would be the same. [920] Gleim #: 6.123 -- Source: IIA, adapted Which of the following costs are not relevant in a special-order decision?

A. B. C. D.

Incremental costs. Opportunity costs. Outlay costs. Sunk costs. Answer (A) is incorrect because incremental costs are relevant if they occur in the future. Answer (B) is incorrect because opportunity costs (benefits foregone) are relevant if they occur in the future. Answer (C) is incorrect because outlay costs are relevant if they occur in the future. Answer (D) is correct. Sunk costs are always irrelevant because they occurred in the past.

[921] Gleim #: 6.124 -- Source: IIA, adapted Abnormal spoilage is

A. B. C. D.

Not expected to occur when standard costs are used. Not usually controllable by the production supervisor. The result of unrealistic production standards. Not expected to occur under efficient operating conditions. Answer (A) is incorrect because abnormal spoilage is not a function of the costing system; it is a function of the production process. Answer (B) is incorrect because abnormal spoilage may result from any of a variety of conditions or circumstances, which are generally controllable by first-line supervisors. Answer (C) is incorrect because abnormal spoilage may result from any of a variety of conditions or circumstances, which are not necessarily related to standards. Answer (D) is correct. Abnormal spoilage is not expected under efficient operating conditions. It is not an inherent part of the production process. Furthermore, the cost of abnormal waste of materials and labor is expensed as incurred and not included in inventory.

[922] Gleim #: 6.125 -- Source: Publisher The primary variable affecting active participation in and commitment to the budgeting and control system is


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A. B. C. D.

Management efforts to achieve the budget rather than optimize results. Rigid adherence to the budget without recognizing changing conditions. Top management involvement in support of the budget. The opportunity budgeting gives to managers for departmental growth. Answer (A) is incorrect because “managing to a budget” can result in suboptimal achievement. Answer (B) is incorrect because rigid adherence to the budget could prevent a manager from taking an appropriate action and thus miss a profitable opportunity. Answer (C) is correct. Top management involvement in support of the budget/control system is absolutely vital for the continued success of the operation. The attitude of top management will affect the implementation of the budget and control system because lower level management will recognize and reflect top management’s attitude. Answer (D) is incorrect because budgeting is not directly related to departmental growth. A budget should promote overall company strategies, missions, objectives, and policies.

[923] Gleim #: 6.126 -- Source: Publisher The major disadvantage of a budget produced by means of a top-down process is

A. B. C. D.

Impairment of goal congruence. Lack of involvement by upper-level management. Inconsistency with strategic plans. Absence of a significant motivational effect. Answer (A) is correct. Budgets provide a means for coordinating the plans of all organizational subunits. Thus, budgets are a way to promote goal congruence. Although budgets should be consistent with the strategic plans of top management, they should also be based on input from lower-level managers since the latter have detailed knowledge of operating activities. Successful budgets are therefore a compromise. In a top-down process, however, budgets are imposed on subordinates without their participation. This lack of participation may impair the coordination of the goals of subunits with those of the organization (goal congruence) since lower-level managers will tend not to have understanding of and support for the top-down budget. Answer (B) is incorrect because, in a top-down process, upper-level management imposes a budget on those below, so consistency with strategic plans is unlikely to be impaired. Answer (C) is incorrect because, in a top-down process, upper-level management imposes a budget on those below, so consistency with strategic plans is unlikely to be impaired. Answer (D) is incorrect because the motivational effect is likely to be very negative.

[924] Gleim #: 6.127 -- Source: Publisher An advantage of participatory budgeting is that it

A. B. C. D.

Minimizes the cost of developing budgets. Reduces the effect on the budgetary process of employee biases. Yields information known to management but not to employees. Encourages acceptance of the budget by employees.


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Answer (A) is incorrect because disadvantages of participatory budgeting and standard setting include the cost in terms of time and money. Answer (B) is incorrect because the quality of participation is affected by the goals, values, beliefs, and expectations of those involved. Answer (C) is incorrect because an advantage of participatory budgeting is that it yields information known to employees but not to management. Answer (D) is correct. Participatory budgeting (grass-roots budgeting) and standard setting use input from lower-level and middle-level employees. Participation encourages employees to have a sense of ownership of the output of the process. The result is an acceptance of, and commitment to, the goals expressed in the budget. [925] Gleim #: 6.128 -- Source: CMA 1293 3-17 The budgeting process that uses management by objectives and input from the individual manager is an example of the application of

A. B. C. D.

Flexible budgeting. Human resource management. Responsibility accounting. Capital budgeting. Answer (A) is incorrect because flexible budgeting is the process of preparing a series of multiple budgets for varying levels of production or sales. Answer (B) is incorrect because human resource management is the process of managing personnel. Answer (C) is correct. Managerial performance should ideally be evaluated only on the basis of those factors controllable by the manager. Managers may control revenues, costs, or investments in resources. A well-designed responsibility accounting system establishes responsibility centers within the organization. However, controllability is not an absolute basis for establishment of responsibility. More than one manager may be able to influence a cost, and responsibility may be assigned on the basis of knowledge about the incurrence of a cost rather than the ability to control it. Management by objectives (MBO) is a related concept. It is a behavioral, communications-oriented, responsibility approach to employee self-direction. Under MBO, a manager and his/her subordinates agree upon objectives and the means of attaining them. The plans that result are reflected in responsibility accounting and in the budgeting process. Answer (D) is incorrect because capital budgeting is a means of evaluating long-term investments.

[926] Gleim #: 6.129 -- Source: CIA 1190 IV-21 When comparing the residual income of several investment centers, the validity of comparisons may be destroyed by

A. B. C. D.

Peculiarities of each investment center. Differences in the relative amount of income. Consistent use of an imputed interest rate. Common amounts of invested capital for each investment center.


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Answer (A) is correct. Residual income is income of an investment center, minus an imputed interest charge for invested capital. The theory is that earning an income greater than residual income indicates that expansion is desirable. However, comparisons of investment centers based on residual income may be misleading because of differences in products, markets, costs, and local conditions. Answer (B) is incorrect because comparisons are valid if adjustments are made for relative investment bases. Answer (C) is incorrect because use of the same imputed interest rate provides a consistent objective against which each investment can be measured. Answer (D) is incorrect because common amounts of invested capital would eliminate a major factor causing differences in residual income. [927] Gleim #: 6.130 -- Source: CIA 1191 IV-17 The receipt of raw materials used in the manufacture of products and the shipping of finished goods to customers is under the control of the warehouse supervisor. The warehouse supervisor’s time is spent approximately 60% on receiving activities and 40% on shipping activities. Separate staffs for the receiving and shipping operations are employed. The labor-related costs for the warehousing function are as follows: Warehouse supervisor’s salary Receiving clerks’ wages Shipping clerks’ wages Employee benefit costs (30% of wage and salary costs)

$ 40,000 75,000 55,000 51,000 $221,000

The company employs a responsibility accounting system for performance reporting purposes. The costs are classified on the report as period or product costs. The total labor-related costs that would be listed on the responsibility accounting performance report as product costs under the control of the warehouse supervisor for the warehousing function would be

A. B. C. D.

$97,500. $128,700. $130,000. $221,000. Answer (A) is correct. The responsibility accounting report should list only the costs over which the warehousing supervisor exercises control. The supervisor’s salary should therefore be excluded because it is controlled by the warehouse supervisor’s superior. Moreover, only the product costs are to be considered. These exclude the shipping clerks’ wages and fringe benefits because they are period costs (shipping is a selling expense). Thus, the only product cost under the control of the warehouse supervisor is the receiving clerks’ wages ($75,000) and the related fringe benefits (.3 × $75,000 = $22,500), or a total of $97,500. Answer (B) is incorrect because the product costs controlled by the supervisor total $97,500. Answer (C) is incorrect because the product costs controlled by the supervisor total $97,500. Answer (D) is incorrect because the product costs controlled by the supervisor total $97,500.

[928] Gleim #: 6.131 -- Source: CIA 595 III-95 Making segment disclosures is an advantage to a company because it


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A. B. C. D.

Facilitates evaluation of company management by providing data on particular segments. Eliminates the interdependence of segments. Masks the effect of intersegment transfers. Provides competitors with comparative information on the company’s performance. Answer (A) is correct. Segment reporting is an aspect of responsibility accounting. It facilitates evaluation of company management and of the quality of the economic investment in particular segments. Answer (B) is incorrect because interdependence of segments is not affected by reporting methods. Answer (C) is incorrect because masking the effects of intersegment transfers is a disadvantage of segment reporting. Answer (D) is incorrect because providing information to competitors is a disadvantage of segment reporting.

[929] Gleim #: 6.132 -- Source: CIA 1195 III-67 Return on investment (ROI) is a very popular measure employed to evaluate the performance of corporate segments because it incorporates all of the major ingredients of profitability (revenue, cost, investment) into a single measure. Under which one of the following combination of actions regarding a segment’s revenues, costs, and investment would a segment’s ROI always increase?

Revenues

Costs

Investment

A. B.

Increase Decrease

Decrease Decrease

Increase Decrease

C. D.

Increase Increase

Increase Decrease

Increase Decrease

Answer (A) is incorrect because ROI is not certain to increase if investment increases. Answer (B) is incorrect because ROI is not certain to increase if revenue, costs, and investment decrease. Answer (C) is incorrect because ROI is not certain to increase if costs and investment increase. Answer (D) is correct. An increase in revenue and a decrease in costs will increase the ROI numerator. A decrease in investment will decrease the denominator. The ROI must increase in this situation. [930] Gleim #: 6.133 -- Source: CIA 1195 III-79 Residual income is a performance evaluation that is used in conjunction with return on investment (ROI) or instead of ROI. In many cases, residual income is preferred over ROI because

A. Residual income is a measure over time while ROI represents the results for a single time period. B. Residual income concentrates on maximizing absolute dollars of income rather than a percentage return as with ROI. C. The imputed interest rate used in calculating residual income is more easily derived than the target rate that is compared to the calculated ROI. D. Average investment is employed with residual income while year-end investment is employed with ROI. Answer (A) is incorrect because both measures represent the results for a single period. Answer (B) is correct. Residual income equals earnings in excess of a minimum desired return. Thus, it is measured in dollars. If performance is evaluated using ROI, a manager may reject a project that exceeds the minimum return if the project will decrease overall ROI. For example, given a target rate of 20%, a project with an ROI of 22% might be rejected if the current ROI is 25%. Answer (C) is incorrect because the target rate for ROI is the same as the imputed interest rate used in the residual income calculation. Answer (D) is incorrect because the same investment base should be employed in both methods.


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[931] Gleim #: 6.134 -- Source: CMA 1294 3-20 Fairmount Inc. uses an accounting system that charges costs to the manager who has been delegated the authority to make the decisions incurring the costs. For example, if the sales manager accepts a rush order that will result in higher-than-normal manufacturing costs, these additional costs are charged to the sales manager because the authority to accept or decline the rush order was given to the sales manager. This type of accounting system is known as

A. B. C. D.

Responsibility accounting. Functional accounting. Reciprocal allocation. Transfer price accounting. Answer (A) is correct. Responsibility accounting holds managers responsible only for factors under their control. For this purpose, operations are organized into responsibility centers. Costs are classified as controllable and noncontrollable, which implies that some revenues and costs can be changed through effective management. If a manager has authority to incur costs, a responsibility accounting system will charge them to the manager’s responsibility center. Answer (B) is incorrect because functional accounting allocates costs to functions regardless of responsibility. Answer (C) is incorrect because reciprocal allocation is a means of allocating service department costs. Answer (D) is incorrect because transfer price accounting is a means of charging one department for products acquired from another department in the same organization.

[932] Gleim #: 6.135 -- Source: CIA 1194 IV-65 If the government were to increase corporate tax rates, after-tax cost-volume-profit relationships for individual firms would change as follows

A. B. C. D.

Breakeven points would increase. Breakeven points would decrease. There would be no change in the breakeven points. There would be no change whatsoever in cost-volume-profit relationships. Answer (A) is incorrect because a tax rate increase would not affect the breakeven point. At the breakeven point, profits equal zero. Answer (B) is incorrect because a tax rate increase would not affect the breakeven point. At the breakeven point, profits equal zero. Answer (C) is correct. The firm owes no tax if it does not earn a profit. At the breakeven point, there is no profit. Thus, a tax increase would have no effect on a firm’s breakeven point, which is calculated by dividing fixed costs by the contribution margin ratio. The contribution margin equals sales revenues minus total variable costs. Answer (D) is incorrect because the contribution margin per unit will be lower if the corporate tax rate is higher, for all companies operating above the breakeven point.

[933] Gleim #: 7.1 -- Source: CMA 1291 1-22 Federal regulatory agencies do not have power to

A. B. C. D.

Impose agency taxes on private industry. Issue rules and regulations. Investigate violations of statutes and rules. Conduct hearings and decide whether violations have occurred.


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Answer (A) is correct. A federal regulatory agency may regulate some aspect of all industries or may regulate a specific industry in accordance with power delegated by Congress in the enabling legislation. Agency functions include executive, adjudicatory, and rule-making activities. Such agencies, however, may not impose taxes. Answer (B) is incorrect because federal regulatory agencies have the power to issue rules and regulations. Answer (C) is incorrect because federal regulatory agencies have the power to investigate violations of statutes and rules. Answer (D) is incorrect because federal regulatory agencies have the power to conduct hearings and decide whether violations have occurred. [934] Gleim #: 7.2 -- Source: CMA 1289 1-29 The basic purpose of the securities laws of the United States is to regulate the issue of investment securities by

A. Providing a regulatory framework in those states that do not have their own securities laws. B. Requiring disclosure of all relevant facts so that investors can make informed decisions. C. Prohibiting the issuance of securities that the Securities and Exchange Commission determines are not of investment grade. D. Channeling investment funds into uses that are economically most important. Answer (A) is incorrect because federal law applies in all states and supplements state blue-sky (securities) laws. Answer (B) is correct. The basic purpose of the federal securities laws is to provide disclosure of adequate information so that investors can evaluate investments. This is accomplished through complex registration and reporting requirements concerning the issuance and subsequent trading of securities. However, the federal government does not assess the merits of these securities. Answer (C) is incorrect because the SEC does not determine the merits of securities; it evaluates whether sufficient information is provided. Answer (D) is incorrect because the securities laws are not intended to influence the investment of capital in more socially or economically beneficial ways. [935] Gleim #: 7.3 -- Source: CMA 693 1-11 The basic purpose of the Securities Exchange Act of 1934 was to

A. B. C. D.

Regulate outstanding securities. Regulate new issues of securities. Protect investors from investment losses. Ensure the public that stock market crashes like that of 1929 would not occur again. Answer (A) is correct. The 1934 act was designed to regulate securities after initial issuances. Other purposes of the 1934 act were to provide adequate information to investors and to prevent insiders from unfairly using their information. Answer (B) is incorrect because the Securities Act of 1933 was designed to regulate new issues of securities. Answer (C) is incorrect because the objective is not to protect investors from losses, but to provide investors with adequate information upon which to base investment decisions. Answer (D) is incorrect because the objective was to regulate securities and provide investors with adequate information.

[936] Gleim #: 7.4 -- Source: CMA 679 3-22 The SEC’s antifraud Rule 10b-5 prohibits trading on the basis of inside information of a business corporation’s stock by


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A. B. C. D.

Officers and directors. All officers, directors, and shareholders. Officers, directors, and beneficial holders of 10% of the corporation’s stock. Anyone who bases his/her trading activities on the inside information. Answer (A) is incorrect because officers, directors and beneficial holders of 10% of the corporation’s stock may not trade on the basis of inside information. Answer (B) is incorrect because officers, directors and beneficial holders of 10% of the corporation’s stock may not trade on the basis of inside information. Answer (C) is incorrect because officers, directors and beneficial holders of 10% of the corporation’s stock may not trade on the basis of inside information. Answer (D) is correct. Rule 10b-5 is the SEC rule under the Securities Exchange Act of 1934 that prohibits any person from engaging in manipulative or deceptive acts in the purchase or sale of any security. It prohibits trading on the basis of inside information and applies to anyone who has not made a full disclosure of the inside information. It applies not only to officers, directors, shareholders (and beneficial holders), but also to tippees, i.e., those who receive inside information from insiders.

[937] Gleim #: 7.5 -- Source: Publisher SEC Rule 10b-5 was promulgated pursuant to the Securities Exchange Act of 1934. It is intended to prevent fraud in the trading of securities. Rule 10b-5 applies

A. When brokers with no knowledge of the facts make excessive predictions to customers. B. Although no means or instrumentality of interstate commerce, the mails, or any facility of a national securities exchange was used by the defendant. C. Only to the purchase or sale of securities registered under the 1934 act. D. Only when the defendant has knowingly misstated a material fact. Answer (A) is correct. Rule 10b-5 is known as the antifraud provision. It prohibits any device or scheme to defraud in the purchase or sale of securities. This rule has been used against brokers who make high-pressure sales of securities and wild predictions not based on fact. Rule 10b-5 also makes unlawful a false statement of a material fact or omission of a material fact in the sale of securities. It is often used against the issuer and professionals (lawyers and accountants) when documents filed with the SEC contain erroneous information. Answer (B) is incorrect because the rule applies only when interstate commerce, the mails, or a national securities exchange is involved. Answer (C) is incorrect because the rule applies to the purchase or sale of any security (even if not registered under the 1934 act). Answer (D) is incorrect because unlike the common-law tort of fraud, the rule imposes a duty of affirmative disclosure. Omission of a material fact is also a violation. [938] Gleim #: 7.6 -- Source: CPA 587 L-42 Which of the following persons is not an insider of a corporation subject to the Securities Exchange Act of 1934 registration and reporting requirements?

A. The president. B. A member of the board of directors. C. A shareholder who owns 8% of the outstanding common stock and whose spouse owns 4% of the outstanding common stock. D. An owner of 15% of the total face value of the corporation’s outstanding debentures.


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Answer (A) is incorrect because an officer is an insider. Answer (B) is incorrect because a director is an insider. Answer (C) is incorrect because a 12% owner is considered an insider even though 4% of the ownership is beneficial. A shareholder is a beneficial owner if shares are owned by his/her spouse, minor children, a relative with the same residence, or a trust of which (s)he is a beneficiary. Answer (D) is correct. For the purposes of Section 16(b), an insider is an officer, a director, or a beneficial owner of 10% or more of any class of equity securities registered under the 1934 act. The holder of debentures is not an insider because a debenture is a debt security, not an equity security. [939] Gleim #: 7.7 -- Source: Publisher The Foreign Corrupt Practices Act prohibits

A. B. C. D.

Bribes to all foreigners. Small bribes to foreign corporate officers. Bribery only by corporations and their representatives. Bribes to foreign officials to influence official acts. Answer (A) is incorrect because the FCPA bars payments to governmental officials, political parties and their officials, candidates for office, and anyone who is known to be likely to pass along such payments to one of the foregoing. Answer (B) is incorrect because the FCPA bars payments to governmental officials, political parties and their officials, candidates for office, and anyone who is known to be likely to pass along such payments to one of the foregoing. Answer (C) is incorrect because all U.S. firms are subject to the anti-bribery provisions. Answer (D) is correct. The Foreign Corrupt Practices Act (FCPA) prohibits any U.S. firm from making corrupt political payments for the purpose of obtaining or retaining business. The businesses subject to the FCPA include corporations, partnerships, limited partnerships, business trusts, and unincorporated organizations. Violations of the FCPA are federal felonies.

[940] Gleim #: 7.8 -- Source: Publisher Antitrust laws are intended to

A. B. C. D.

Establish set profit percentages for firms in regulated industries. Prohibit firms in the same industry from engaging in joint ventures. Require firms in regulated industries to share any patent rights with other firms in that industry. Ensure a free and competitive market in which consumer demand dictates prices. Answer (A) is incorrect because profit percentages are not set by antitrust laws other than to the extent that price discrimination is prohibited. Answer (B) is incorrect because firms may enter into joint ventures. Answer (C) is incorrect because patents are available to all inventors, regardless of size. Answer (D) is correct. Antitrust laws are designed to promote more efficient allocation of resources, greater choice for consumers, greater business opportunities, fairness in economic behavior, and avoidance of concentrated political power resulting from economic power. Competition results in greater output and lower prices than other market structures.

[941] Gleim #: 7.9 -- Source: Publisher A major result of the Foreign Corrupt Practices Act is that corporations are now required to


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A. B. C. D.

Keep accurate accounting records and maintain adequate internal controls. Permit authorized agencies access to company records. Prepare financial statements in accordance with U.S. and international accounting standards. Produce information to the SEC on foreign commerce and foreign political party information. Answer (A) is correct. The accounting requirements of the FCPA apply to all companies required to register and report under the Securities Exchange Act of 1934. These companies must maintain books, records, and accounts in reasonable detail that accurately and fairly reflect transactions. The FCPA also requires these companies to maintain a system of internal accounting control that provides certain reasonable assurances, including that corporate assets are not used for bribes. If payoffs are made, they must be reflected in the company’s records. Answer (B) is incorrect because authorized agents of the federal government already have access to records of SEC registrants. Answer (C) is incorrect because although some international accounting standards have been promulgated, they are incomplete and have not gained widespread acceptance. Answer (D) is incorrect because there are no requirements for providing periodic reports on foreign commerce or foreign political party affiliations.

[942] Gleim #: 7.10 -- Source: CMA 693 1-27 The impact of successful prosecution for restraint of trade violations of the Sherman Antitrust Act has been less than many proponents hoped for because

A. Only a limited number of criminal prosecutions have ever been filed under Section 1 of the Act. B. Most companies avoid behaviors that might be construed as antitrust violations because of the likelihood of fines and even jail sentences. C. The predominant criterion for criminal prosecution is market share; a company’s intent is inconsequential. D. The courts created in the beginning a “rule of reason” that required determining whether competition was lessened by the company’s behavior. Answer (A) is incorrect because many cases have been filed under the Sherman Act; however, the rule of reason has limited the number of successful prosecutions. Answer (B) is incorrect because numerous companies still engage in anti-competitive conduct. Answer (C) is incorrect because intent is significant; for example, a company that has a monopoly thrust upon it is not in violation. Answer (D) is correct. The Sherman Antitrust Act of 1890 makes illegal every contract, combination, or conspiracy in restraint of trade in interstate or foreign commerce. Successful prosecutions have been few because the courts developed a rule of reason stipulating that only unreasonable restraints of trade are illegal. Thus, courts balance the anti-competitive effects against the pro-competitive effects of a restraint of trade. Unless a restraint is unreasonable by its very nature (a per se violation), the rule of reason applies. [943] Gleim #: 7.11 -- Source: CMA 1295 1-23 Which one of the following examples of corporate behavior would most clearly represent a violation of the Sherman Act?

A. A retailer offers quantity discounts to large institutional buyers. B. The members of a labor union meet and agree not to work for a specific firm unless the starting wage is at least $10 per hour. C. Two firms that are in different, unrelated industries merge. D. Two firms in the same industry agree in a telephone conversation to submit identical bids on a government contract.


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Answer (A) is incorrect because quantity discounts are not prohibited by the Sherman Act. Answer (B) is incorrect because the Sherman Act does not apply to labor unions. Answer (C) is incorrect because the Sherman Act does not prohibit mergers; only those that could lead to restraint of trade are outlawed. Answer (D) is correct. The Sherman Act of 1890 makes illegal every contract, combination, or conspiracy in restraint of trade in interstate or foreign commerce. Some types of arrangements, called per se violations, are considered unreasonable without inquiry. These violations include price fixing, division of markets, group boycotts, and resale price maintenance. Agreeing to submit identical bids on a government contract is a form of price fixing, a per se violation. [944] Gleim #: 7.12 -- Source: CMA 1295 1-24 The Clayton Act, as amended, prohibits all of the following except

A. B. C. D.

Price discrimination by sellers. Interlocking directorates in large competing organizations. Unfair and deceptive business practices, such as misleading advertising. A merger of companies that substantially lessens competition. Answer (A) is incorrect because the Clayton Act prohibits price discrimination by sellers. Answer (B) is incorrect because the Clayton Act prohibits interlocking directorates in large competing organizations. Answer (C) is correct. The Clayton Act of 1914 prohibits (1) mergers that may lessen competition or tend to create a monopoly, (2) sales that prevent the buyer from dealing with the seller’s competitors, (3) tie-in sales (requiring a buyer to take other products in order to buy the first product), (4) price discrimination, and (5) interlocking directorates. The Federal Trade Commission Act addresses unfair and deceptive business practices such as false advertising. Answer (D) is incorrect because the Clayton Act prohibits a merger of companies that substantially lessens competition.

[945] Gleim #: 7.13 -- Source: CMA 687 1-15 Tie-in sales (e.g., the sale of camera and film together) are legal if

A. B. C. D.

The tie-in is necessary to assure product quality. The tying product is patented. Used to facilitate price discrimination. Used by all firms in an industry. Answer (A) is correct. Tie-in sales involve a seller’s requirement that the buyer purchase another distinct product to obtain the first. They are usually prohibited under the Clayton Act of 1914 unless a small company is attempting to enter a market or the tie-in is needed to protect the firm’s goodwill (e.g., by maintaining a certain quality standard). Tiein sales requirements are usually illegal if the seller has enough market power to restrict competition. Answer (B) is incorrect because tie-in sales requirements are usually illegal if the seller has enough market power to restrict competition. Answer (C) is incorrect because tie-in sales requirements are usually illegal if the seller has enough market power to restrict competition. Answer (D) is incorrect because tie-in sales requirements are usually illegal if the seller has enough market power to restrict competition.

[946] Gleim #: 7.14 -- Source: CMA 1295 1-22 Which one of the following transactions would be considered a violation of the Robinson-Patman Act?


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A. The sale of goods of like quality at different prices to two different wholesalers, both of whom are located outside the United States. B. The sale of goods of like quality within the United States at different prices based on cost differences related to the method of delivery. C. The sale of goods of like quality within the United States at different prices to two different wholesalers; all parties are located within the same state. D. The sale of goods of like quality within the United States but across state lines at different prices to two different wholesalers in the same geographic area. Answer (A) is incorrect because the act does not apply to export sales. Answer (B) is incorrect because cost differences related to delivery are a justification for charging different prices. Answer (C) is incorrect because the act applies only to sales in interstate commerce. Answer (D) is correct. The Robinson-Patman Act of 1936, an amendment to the Clayton Act, outlaws price discrimination that would lead to restraint of trade. Both buyer and seller can be found guilty of price discrimination under the provisions of the Robinson-Patman Act. Price differentiation between customers is allowed if there is a difference in costs. For instance, quantity discounts are permitted if it can be shown that larger quantities can be shipped with a cost savings. Charging competing wholesalers different prices for similar goods would be a violation of the act. [947] Gleim #: 7.15 -- Source: CMA 1295 1-30 The two major functions of the Federal Trade Commission are

A. B. C. D.

Antitrust actions and the regulation of foreign trade. Import quality inspections and anti-dumping measures. Antitrust actions and consumer protection. Price discrimination and unfair trade practices. Answer (A) is incorrect because the FTC is not concerned with the regulation of foreign trade. Answer (B) is incorrect because the FTC is not concerned with the regulation of foreign trade. Answer (C) is correct. The FTC Act of 1914 prohibits unfair methods of competition and unfair or deceptive acts in commerce. The basic objectives are to initiate antitrust actions and protect consumers. Answer (D) is incorrect because price discrimination and unfair trade practices are merely elements of the overall mission of the FTC.

[948] Gleim #: 7.16 -- Source: CFM Sample Q2-11 Consumer protection regulations have resulted in all of the following except

A. Food label laws requiring a list of ingredients and nutritional data. B. Product safety laws that establish the liability of producers of unsafe or defective products. C. Federal Trade Commission rules allowing the award of monetary damages to persons injured by false and misleading advertising. D. Truth-in-lending requirements that lenders must identify the total dollars to be paid by the borrower over the term of the loan.


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Answer (A) is incorrect because the Fair Packaging and Labeling Act of 1967 and other legislation concern food labels. Answer (B) is incorrect because product safety is addressed by the Consumer Product Safety Act. Answer (C) is correct. The Fair Packaging and Labeling Act of 1967, the Consumer Product Safety Act of 1972, and the Consumer Credit Protection Act of 1968 (Truth-in-Lending Act) are the statutes that provide for regulation of the matters listed in (a), (b), and (d), respectively. To date, no legislation allows the award of monetary damages to persons injured by false and misleading advertising. However, the Federal Trade Commission Act prohibits unfair or deceptive acts in commerce, including false or misleading advertising. The FTC has the power to issue cease and desist orders. Answer (D) is incorrect because the Consumer Credit Protection Act addresses truth in lending. [949] Gleim #: 7.17 -- Source: CMA 690 1-5 Truth-in-lending is one form of price standardization that, since the adoption of the Consumer Credit Protection Act on July 1, 1969, has been provided by U.S. government regulations. The purpose of this legislation is to

A. B. C. D.

Regulate the amount of interest that may be charged. Allow immediate wage garnishment by creditors. Prohibit the use of usurious interest rates. Disclose the finance charge and the annual percentage rate. Answer (A) is incorrect because the Consumer Credit Protection Act merely requires disclosure. It does not regulate interest rates. Answer (B) is incorrect because the act had nothing to do with wage garnishment. Answer (C) is incorrect because the Consumer Credit Protection Act merely requires disclosure. It does not regulate interest rates. Answer (D) is correct. The Truth-in-Lending Act applies to creditors that extend consumer credit to individual debtors (not organizations) in amounts of $25,000 or less. For a closed-end credit transaction, e.g., the typical car loan, the total finance charge, annual percentage interest rate, amount financed, late charges, security interest held by the creditor, the number and amounts of payments, due dates, and the total amount of payments must be disclosed. Open-end credit transactions, such as those involving credit cards, also have specific, detailed disclosure requirements.

[950] Gleim #: 7.18 -- Source: CMA 1291 1-25 The general approach to regulation by the Consumer Product Safety Commission is to

A. B. C. D.

Levy fines against the producers of unsafe products. Set safety standards for various products. Increase the freedom of consumer choice. Depend upon voluntary action by manufacturers to produce safe products. Answer (A) is incorrect because the CPSC does not levy fines, although it may bring suit for violations, and a court may levy fines as a result. Answer (B) is correct. The Consumer Product Safety Act created the Consumer Product Safety Commission, which promotes voluntary safety standards, develops and enforces mandatory standards, prohibits unsafe products if safety standards will not be sufficient, recalls hazardous products, furnishes information to consumers, and works with state and local governments. Thus, the emphasis of the Commission’s work is the prevention of problems through standard setting, not the punishment of wrongdoers. Answer (C) is incorrect because consumer choice is lessened when the CPSC keeps unsafe products off the market. Answer (D) is incorrect because the requirements of the CPSC are mandatory.


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[951] Gleim #: 7.19 -- Source: CMA 690 1-2 The Consumer Product Safety Commission (CPSC) has been called by its critics “the most powerful regulatory agency in Washington.” The most likely reason for this concern is that the CPSC

A. B. C. D.

Covers all consumer products. May ban the production and sale of a product until it has formulated a standard. Does not permit an industry group to adopt a voluntary standard. May order the recall of products it has determined to be unsafe. Answer (A) is incorrect because the Consumer Product Safety Act of 1972 exempts certain products, e.g., aircraft, motor vehicles, food, drugs, and cosmetics. Answer (B) is incorrect because a ban on a product is appropriate only if specific standards will be ineffective. Answer (C) is incorrect because industry standards are encouraged. Answer (D) is correct. The CPSC promotes voluntary safety standards, develops and enforces mandatory standards, prohibits unsafe products if safety standards will not be sufficient, recalls hazardous products, furnishes information to consumers, and works with state and local governments. Thus, if a product is hazardous and presents an unreasonable risk of injury and safety standards will not adequately protect the public, the CPSC may issue an appropriate order banning the product. If a hazard is deemed to be imminent, it may seek a U.S. District Court’s authorization to seize the product or halt its distribution.

[952] Gleim #: 7.20 -- Source: CMA 1293 1-4 The primary reason for social regulation (Clean Air Act, Water Pollution Control Act, Food and Drug Act, etc.) is that

A. B. C. D.

The free market provides minimal safety and environmental protection. Consumer and environmental groups are politically powerful. Social benefits from such regulations always exceed the costs. Social regulation is more desirable. Answer (A) is correct. Social regulation concerns quality of life issues, e.g., workplace and product safety, environmental degradation, and fair employment practices. The abuses addressed are those that are difficult for market forces to remedy. For example, consumers may purchase products on the basis of price and quality but without regard to the environmental impact of their production, and unsafe working conditions may be tolerated by individuals who have few opportunities for other employment. Answer (B) is incorrect because, although consumer and environmental groups may occasionally exercise some lobbying power, they are typically underfunded and would have little impact on legislatures in the absence of an obvious need for social regulation. Answer (C) is incorrect because there is great difficulty in measuring both the benefits and costs of most social regulation. Answer (D) is incorrect because no regulation is desirable, but some regulation is necessary when market forces are ineffective.

[953] Gleim #: 7.21 -- Source: Publisher Which of the following statements is true with respect to the Clean Water Act (CWA)?

A. Despite the CWA’s prohibitions, it allows persons to discharge pollutants into waters subject to its jurisdiction as long as navigation thereon will not be permanently obstructed. B. The CWA subjects all bodies of water located in the United States, whether flowing or not, to its protection. C. The notion of protecting waters within the jurisdiction of the United States began with the CWA. D. The CWA seeks to restore and maintain the physical and biological integrity of the waters of the United States.


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Answer (A) is incorrect because the CWA broadly prohibits any discharges of pollutants into waters subject to the jurisdiction of the United States by any person, except in compliance with the Act. Under the CWA, impairment of navigation is irrelevant. Answer (B) is incorrect because to be subject to federal jurisdiction and the CWA, the waters in which pollutants are discharged must be so-called "navigable waters," which are defined as waters of the United States (including the territorial waters). This broad definition does not encompass all bodies of water located within the bounds of the United States. Answer (C) is incorrect because the Rivers and Harbors Act of the late 1800s was the first major piece of federal legislation promulgated to protect U.S. waterways. Until the passage of the CWA, the Rivers and Harbors Act was also used to combat pollutive discharges, although its original purpose was to keep waterways clear from obstructions to navigation. Answer (D) is correct. The CWA (1972) substantially amended the Federal Water Pollution Control Act of 1948. It seeks to restore and maintain the physical and biological integrity of the waters of the United States. Its objectives are to render water suitable for recreation and propagation of fish and other wildlife and to eliminate discharges of pollutants. [954] Gleim #: 7.22 -- Source: CMA 693 1-30 Pharmaceutical companies must be in compliance with regulations set forth by the Food and Drug Administration (FDA). The FDA is responsible for all of the following except

A. Allowing extensions to patent lives of pharmaceutical companies in order to recover time lost during the premarket FDA regulatory review. B. Considering benefit-risk trade-offs when evaluating the safety of drugs prior to approval. C. Maintaining purity standards and regulations concerning drug composition and potency. D. Approving drugs that lack substantial evidence that they will have the effects that are represented in advertisements. Answer (A) is incorrect because the FDA can extend patent lives to allow for time lost during the regulatory review. Answer (B) is incorrect because the FDA considers benefit-risk tradeoffs. Answer (C) is incorrect because the FDA maintains purity standards. Answer (D) is correct. The FDA was created by the Federal Food, Drug, and Cosmetics Act of 1938 to help maintain the safety of drugs, food, cosmetics, and medicinal products and devices. It regulates the testing, distribution, and sale of drugs. Upon receiving a new drug application, the FDA conducts hearings and investigates the merits of the drug in a process that may require years. Thus, an application must be supported by substantial evidence that the drug will have the asserted effects. [955] Gleim #: 7.23 -- Source: CMA 1291 1-20 The Environmental Protection Agency (EPA) might control pollution by setting effluent standards for maximum discharge or by constructing a sliding-tax charge based on the amount of effluent emitted. One advantage of the sliding-tax charge is that

A. B. C. D.

It will totally eliminate pollution. There is greater business incentive to discover new methods of controlling pollution. It increases the necessity for the EPA to fully understand pollution control technology. It increases the degree of direct government intervention in the economy. Answer (A) is incorrect because pollution would not be totally eliminated. Some firms might find that a low level of pollution is more cost beneficial than total elimination. Answer (B) is correct. The setting of effluent standards has been criticized as inefficient. Economists prefer a sliding tax based on the amount of effluent emitted. This method is preferable because, as effluent discharge increases, the tax increases, providing an incentive for firms to discover new methods of controlling pollution. Rather than dictating technology, the tax allows firms to seek out the technology that is the most cost effective. Answer (C) is incorrect because the EPA would not be directly involved in technology. Answer (D) is incorrect because the tax would be an indirect method of economic intervention.


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[956] Gleim #: 7.24 -- Source: CMA 695 1-22 If the Federal Reserve Board wanted to implement an expansionary monetary policy, which one of the following actions would the Federal Reserve Board take?

A. B. C. D.

Raise the reserve requirement and the discount rate. Purchase additional U.S. government securities and lower the discount rate. Reduce the reserve requirement and raise the discount rate. Raise the discount rate and sell U.S. government securities. Answer (A) is incorrect because raising the reserve requirement and the discount rate reduces the money supply. Answer (B) is correct. The Federal Reserve affects monetary policy primarily through the purchase and sale of government securities in open-market operations. A purchase of securities is expansionary because it increases bank reserves and the money supply. However, the sale of government securities by the Federal Reserve contracts the money supply by removing resources from the economy. Lowering the legal reserve requirement (the percentage of deposits that a bank must keep on hand) also expands the money supply by increasing the loanable funds held by banks. Similarly, lowering the discount rate (the rate at which member banks may borrow from the Federal Reserve) encourages borrowing and increases the money supply. Answer (C) is incorrect because raising the discount rate reduces the money supply. Answer (D) is incorrect because raising the discount rate and selling U.S. government securities reduce the money supply.

[957] Gleim #: 7.25 -- Source: CMA 694 1-1 The discount rate set by the Federal Reserve System is the

A. B. C. D.

Required percentage of reserves deposited at the central bank. Rate that commercial banks charge for loans to each other. Rate that commercial banks charge for loans to the general public. Rate that the central bank charges for loans to commercial banks. Answer (A) is incorrect because the required percentage of reserves deposited at the central bank is the legal reserve requirement. Answer (B) is incorrect because the discount rate is the amount the Fed charges to member banks, not what banks charge each other. Answer (C) is incorrect because the rate that commercial banks charge for loans to the general public is usually scaled upward from the prime rate, which is the rate charged to the most creditworthy customers. Answer (D) is correct. The discount rate is the interest rate at which member banks may borrow money from the Fed. A lowering of the discount rate encourages borrowing, which increases the money supply. An increase in the discount rate discourages borrowing and correspondingly increases saving, which decreases the money supply.

[958] Gleim #: 7.26 -- Source: CMA 1287 1-25 One of the major consequences of international trade between nations is

A. B. C. D.

Higher prices for consumers. A decreased variety of consumer products. The possibility for total world output to increase. Reduced competition for businesses.


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Answer (A) is incorrect because prices will be lower and greater quantities will be available with international trade. Answer (B) is incorrect because variety will be increased by international trade. Answer (C) is correct. Under the concept of comparative advantage, total world output will be maximized when each nation specializes in the products in which it has the lowest opportunity costs, that is, a comparative advantage. When nations specialize in what they produce most efficiently and then exchange with others, more is produced and consumed than if each nation tries to be self-sufficient. Specialization of labor is beneficial for individuals; the same principle applies to nations. Answer (D) is incorrect because competition will be increased when more producers are in the market. [959] Gleim #: 7.27 -- Source: CMA 1287 1-26 Which one of the following statements concerning international trade and protection is true?

A. B. C. D.

Protection is necessary in order to keep U.S. money in the United States. When two nations trade, one must gain while the other must lose. The United States cannot compete with nations whose labor costs are lower. U.S. imports raise living standards in the United States. Answer (A) is incorrect because U.S. investment abroad has proven to be beneficial. Answer (B) is incorrect because both nations should benefit from international trade. Under the concept of comparative advantage, no country will be worse off through international trade. Answer (C) is incorrect because the U.S. has other advantages not possessed by countries with low labor costs. Answer (D) is correct. Imports can raise the standard of living because more goods are available to consumers. Tariffs, quotas, and other trade restraints are undesirable because free trade will maximize the total benefit to consumers worldwide (under the concept of comparative advantage).

[960] Gleim #: 7.28 -- Source: CMA 688 1-21 The most widely used currency in international business today is the

A. B. C. D.

United States dollar. Euro. Japanese yen. Swiss franc. Answer (A) is correct. The U.S. dollar is the most widely used currency in international markets today. It is considered much more stable than any of the third-world currencies. Thus, many third-world countries rely on the U.S. dollar for foreign trade. Answer (B) is incorrect because the Euro is not as heavily used as the U.S. dollar. Answer (C) is incorrect because the Japanese yen is not as heavily used as the U.S. dollar. Answer (D) is incorrect because the Swiss franc is not as heavily used as the U.S. dollar.

[961] Gleim #: 7.29 -- Source: CMA 1287 1-24 In the modern world economy, balance-of-payments deficits and surpluses can be eliminated

A. B. C. D.

Through the market mechanism of flexible exchange rates. If all nations adopt tight monetary policies. Only if trade between nations is curtailed. When the opportunity costs of production are made the same in all countries.


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Answer (A) is correct. If exchange rates are allowed to fluctuate, the value of a particular currency will be determined in accordance with the supply of and demand for that currency. For example, if U.S. exports to Japan are greater than imports, the dollar will be in great demand; thus, the dollar will be driven up in price relative to the Japanese yen. This increase in price will discourage the Japanese from buying U.S. goods. The decrease in Japanese purchases will then result, in principle, in less demand for the dollar and a movement back toward equilibrium in the export/import ratio. Answer (B) is incorrect because tight money policies would not affect the balance of payments but would reduce economic activity generally. Answer (C) is incorrect because deficits can be overcome by less drastic and counterproductive methods than eliminating trade. Answer (D) is incorrect because demand for particular products is as important as relative costs in creating trade deficits. [Fact Pattern #80] One Unit of Resources Can Produce

Taiwan United States

Soybeans (tons)

Chips (units)

6 12

1,500 1,800

[962] Gleim #: 7.30 -- Source: CMA 1288 1-12 (Refers to Fact Pattern #80) In trade between Taiwan and the United States,

A. B. C. D.

Taiwan has an absolute advantage in producing soybeans. The United States has a comparative advantage in producing soybeans. Taiwan has a comparative advantage in producing soybeans. The United States has a comparative advantage in producing chips. Answer (A) is incorrect because Taiwan does not have an absolute advantage with respect to either product. Answer (B) is correct. Given two countries and two products, each country will always have a comparative advantage with respect to one of the products. Each country may or may not have an absolute advantage. In this case, the U.S. has an absolute advantage with respect to both products because with one unit of resources it can produce more soybeans (12 to 6) and more chips (1,800 to 1,500) than Taiwan. Comparatively, the U.S. has an advantage with respect to soybeans. Comparative advantage is measured by determining which product can be manufactured more cheaply (for the lower opportunity cost) in comparison to the other country. For 1 ton of soybeans, the U.S. opportunity cost is 150 units (1,800 ÷ 12) of chips. The opportunity cost for Taiwan is 250 units (1,500 ÷ 6) of chips. Answer (C) is incorrect because the U.S. has the comparative advantage in the production of soybeans, and Taiwan has the comparative advantage in the production of chips. Taiwan’s opportunity cost for the production of one unit of chips is .004 ton (6 ÷ 1,500) of soybeans. U.S. chip production has an opportunity cost of .0067 ton (12 ÷ 1,800) of soybeans. Answer (D) is incorrect because the U.S. has the comparative advantage in the production of soybeans, and Taiwan has the comparative advantage in the production of chips. Taiwan’s opportunity cost for the production of one unit of chips is .004 ton (6 ÷ 1,500) of soybeans. U.S. chip production has an opportunity cost of .0067 ton (12 ÷ 1,800) of soybeans.

[963] Gleim #: 7.31 -- Source: CMA 1288 1-13 (Refers to Fact Pattern #80) If there were free trade between the two countries, which one of the following statements would be true?


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A. B. C. D.

Only the United States will gain from free trade. The United States would specialize in the production of both chips and soybeans. The United States will export chips to Taiwan. Taiwan will specialize in the production of chips. Answer (A) is incorrect because both countries will benefit from free trade. Specialization results in the optimal total output. Answer (B) is incorrect because the U.S. will specialize in the production of soybeans. Answer (C) is incorrect because Taiwan will produce chips and export them to the U.S. Answer (D) is correct. Countries should specialize in the production and export of products for which they have a comparative advantage. They should import those products for which they do not have a comparative advantage. Thus, Taiwan will specialize in the production of chips, and the U.S. will specialize in the production of soybeans.

[964] Gleim #: 7.32 -- Source: CMA 1288 1-14 (Refers to Fact Pattern #80) Assuming free trade between the United States and Taiwan, the relative prices of soybeans and chips will be

A. B. C. D.

Exactly 1 ton of soybeans for 250 chips. Between 150 to 250 chips for 1 ton of soybeans. Between 1.2 to 2.0 tons of soybeans for 100 chips. Exactly 1 ton of soybeans for 120 chips. Answer (A) is incorrect because 1 ton of soybeans for 250 chips is the opportunity cost for Taiwan. Answer (B) is correct. Taiwan’s opportunity cost for 1 ton of soybeans is 250 units of chips. The U.S.’s opportunity cost for 1 ton of soybeans is 150 units of chips (1800 ÷ 12). Thus, the lowest price that the U.S. should charge is 150 units of chips per ton of soybeans. Moreover, Taiwan should not pay more than 250 units of chips for imported soybeans because they could be made domestically for that price. Therefore, the trading price must be between 150 and 250 units of chips per ton of soybeans if trade is to be advantageous. Answer (C) is incorrect because the lowest price the U.S. should charge is 150 units of chips per ton of soybeans and the maximum price that Taiwan would be willing to pay is 250 units of chips per ton of soybeans. Answer (D) is incorrect because the lowest price that the U.S. would charge is 150 units of chips per ton of soybeans. Additionally, Taiwan would not be willing to pay more than 250 units of chips per ton of soybeans.

[965] Gleim #: 7.33 -- Source: CMA 1287 1-28 If the value of the U.S. dollar in foreign currency markets changes from $1 = .95 euros to $1 = .90 euros,

A. B. C. D.

The euro has depreciated against the dollar. Products imported from Europe to the U.S. will become more expensive. U.S. tourists in Europe will find their dollars will buy more European products. U.S. exports to Europe should decrease. Answer (A) is incorrect because the euro has appreciated (increased in value) relative to the dollar. Answer (B) is correct. The dollar has declined in value relative to the euro. If an American had previously wished to purchase a European product that was priced at 10 euros, the price would have been about $10.53. After the dollar’s decline in value, the price of the item has increased to about $11.11. Hence, imports from Europe should decrease and exports increase. Answer (C) is incorrect because dollars will buy fewer European products. Answer (D) is incorrect because U.S. exports should increase.


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[966] Gleim #: 7.34 -- Source: CMA 1286 1-19 An overvalued foreign currency exchange rate

A. B. C. D.

Represents a tax on exports and a subsidy to imports. Represents a subsidy to exports and a tax on imports. Has an effect on capital flows but no effect on trade flows. Has no effect on capital flows but does affect trade flows. Answer (A) is correct. An overvalued exchange rate is a tax on exports because they will be overvalued in terms of the foreign currency. For example, if the true value of $1 is 5 foreign currency units (FCUs) but the exchange rate is $1 to 6 FCUs, the cost of goods priced in dollars will include a 20% tax for holders of FCUs. It is also a subsidy to imports because the overly high exchange rate causes the price of foreign goods and services to be undervalued. In the same example, $1 will buy 6 FCUs’ worth of imports instead of 5, a 20% subsidy. Answer (B) is incorrect because devaluation taxes imports and subsidizes exports. Answer (C) is incorrect because both will be affected. Answer (D) is incorrect because both will be affected.

[967] Gleim #: 7.35 -- Source: CMA 688 1-22 Exchange rates are determined by

A. B. C. D.

Each industrial country’s government. The International Monetary Fund. Supply and demand in the foreign currency market. Exporters and importers of manufactured goods. Answer (A) is incorrect because governments have only temporary influence, if any, on the setting of exchange rates. Answer (B) is incorrect because the International Monetary Fund has only temporary influence, if any, on the setting of exchange rates. Answer (C) is correct. Although currencies can be supported by various means for short periods, the primary determinant of exchange rates is the supply of and demand for the various currencies. Under current international agreements, exchange rates are allowed to “float.” During periods of extreme fluctuations, however, governments and control banks may intervene to maintain stability in the market. Answer (D) is incorrect because exporters and importers have only temporary influence, if any, on the setting of exchange rates.

[968] Gleim #: 7.36 -- Source: CIA 1195 IV-67 Two countries have flexible exchange rate systems and an active trading relationship. If incomes in country 1, everything else being equal, then the currency of country 1 will tend to relative to the currency of country 2.

List A

List B

A. B.

Rise Fall

Remain constant Depreciate

C. D.

Rise Remain constant

Depreciate Appreciate


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Answer (A) is incorrect because, if incomes in country 1 rise, the result will be a tendency for it to devalue relative to the currency of country 2. Answer (B) is incorrect because, if incomes in country 1 fall, consumers in country 1 will reduce their imports. The resulting decrease in the supply of currency 1 will result in a tendency for it to appreciate relative to the currency of country 2. Answer (C) is correct. If incomes in country 1 rise, consumers in country 1 will increase their imports from country 2. The resulting increase in the supply of currency 1 will result in a tendency for it to depreciate relative to the currency of country 2. Answer (D) is incorrect because, if incomes in country 1 remain constant, the currency of country 1 will not tend to appreciate or depreciate relative to the currency of country 2. [969] Gleim #: 7.37 -- Source: CMA 1285 1-33 The purchasing-power parity exchange rate

A. B. C. D.

Is a fixed (pegged) exchange rate. Is always equal to the market exchange rate. Results in an undervalued currency of countries that are net importers. Holds constant the relative price levels in two countries when measured in a common currency. Answer (A) is incorrect because purchasing-power parity is achieved through floating exchange rates. Answer (B) is incorrect because the purchasing-power parity exchange rate is a long-run measure, but the market rate may reflect short-term or medium-term conditions. Answer (C) is incorrect because purchasing-power parity does not affect the valuation of currency. Answer (D) is correct. The purchasing-power parity theorem states that, in the long run, the real price of a good in country A will equal the price of the same good in country B when the prices are expressed in a common currency and converted at the current exchange rate (adjustments for tariffs, taxes, or transportation cost may need to be made).

[970] Gleim #: 7.38 -- Source: CMA 1287 1-30 If the U.S. dollar declines in value relative to the currencies of many of the U.S. trading partners, the likely result is that

A. B. C. D.

Foreign currencies will depreciate against the dollar. The U.S. balance of payments deficit will become worse. U.S. exports will tend to increase. U.S. imports will tend to increase. Answer (A) is incorrect because the dollar has depreciated against foreign currencies. Answer (B) is incorrect because the U.S. trade balance of payments should improve. Answer (C) is correct. The decline in the value of the dollar reduces the prices of U.S. goods to foreigners and should increase exports. Also, foreign goods will be higher priced (in dollars) and imports from foreign countries should decrease, thus helping the U.S. balance of payments. Answer (D) is incorrect because U.S. imports will decline. Foreign goods will be higher priced than before.

[971] Gleim #: 7.39 -- Source: CMA 694 1-4 If the central bank of a country raises interest rates sharply, the country’s currency will likely


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A. B. C. D.

Increase in relative value. Remain unchanged in value. Decrease in relative value. Decrease sharply in value at first and then return to its initial value. Answer (A) is correct. Exchange rates fluctuate depending upon the demand for each country’s currency. If a country raises its interest rates, its currency will appreciate. The demand for investment at the higher interest rates will shift the demand curve for the currency to the right. The reverse holds true for a decrease in interest rates. Answer (B) is incorrect because the currency should increase in relative value when interest rates in the country rise sharply. More investors will want to earn the higher rates of interest. Answer (C) is incorrect because the currency should increase in relative value when interest rates in the country rise sharply. More investors will want to earn the higher rates of interest. Answer (D) is incorrect because the currency should increase in relative value when interest rates in the country rise sharply. More investors will want to earn the higher rates of interest.

[972] Gleim #: 7.40 -- Source: CMA 695 1-24 Assuming exchange rates are allowed to fluctuate freely, which one of the following factors would likely cause a nation’s currency to appreciate on the foreign exchange market?

A. B. C. D.

A relatively rapid rate of growth in income that stimulates imports. A high rate of inflation relative to other countries. A slower rate of growth in income than in other countries, which causes imports to lag behind exports. Domestic real interest rates that are lower than real interest rates abroad. Answer (A) is incorrect because an increase in imports drives down the value of the nation’s currency. Answer (B) is incorrect because a high rate of inflation devalues a nation’s currency. Answer (C) is correct. Assuming that exchange rates are allowed to fluctuate freely, a nation’s currency will appreciate if the demand for it is constant or increasing while supply is decreasing. For example, if the nation decreases its imports relative to exports, less of its currency will be used to buy foreign currencies for import transactions and more of its currency will be demanded for export transactions. Thus, the supply of the nation’s currency available in foreign currency markets decreases. If the demand for the currency increases or does not change, the result is an increase in (appreciation of) the value of the currency. Answer (D) is incorrect because lower interest rates relative to those in other countries discourage foreign investment, decreases demand for the nation’s currency, and reduces its value.

[973] Gleim #: 7.41 -- Source: CIA 1196 IV-74 Assuming that the real rate of interest is the same in both countries, if country A has a higher nominal interest rate than country B, the currency of country A will likely be selling at a

A. B. C. D.

Forward discount relative to the currency of country B. Forward premium relative to the currency of country B. Spot discount relative to the currency of country B. Spot premium relative to the currency of country B.


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Answer (A) is correct. If the real rates of interest are equal, the country with the higher nominal interest rate is expected to experience a higher rate of inflation. A higher rate of inflation is associated with a devaluing currency, so the currency of the country with the higher nominal interest rate will likely be selling at a forward discount. Answer (B) is incorrect because the currency of country A will be selling at a forward discount. Answer (C) is incorrect because the spot relationship between the two currencies cannot be determined from the information given. Answer (D) is incorrect because the spot relationship between the two currencies cannot be determined from the information given. [974] Gleim #: 7.42 -- Source: CMA 1286 1-18 If the annual U.S. inflation rate is expected to be 5% while foreign currency unit (FCU) is expected to depreciate against the U.S. dollar by 10%, an Italian firm importing from its U.S. parent can expect its FCU costs for these imports to

A. B. C. D.

Decrease by about 10%. Decrease by about 5%. Increase by about 5%. Increase by about 16.6%. Answer (A) is incorrect because the combined effect of U.S. inflation and the decline in value of the FCU would cause the FCU costs for U.S. imports to increase. Answer (B) is incorrect because the combined effect of U.S. inflation and the decline in value of the FCU would cause the FCU costs for U.S. imports to increase. Answer (C) is incorrect because 5% is the difference between the currency depreciation and the inflation rate. Answer (D) is correct. Assuming the original exchange rate is $1 to 2,000 FCUs and that U.S. inflation is 5%, the cost in FCUs to purchase what once cost $1 will now be 2,100 FCUs (2,000 × 1.05). However, if the FCU also depreciates by 10%, that is, if the FCU is expected to be worth 90% of its current value against the dollar, the exchange rate before inflation will be $1 to 2,222 (2,000 ÷ .9) FCUs. At this rate, 2,333 FCUs (2,222 × 1.05) will be required to purchase $1.05. FCU costs will thus increase by over 16.6% (333 ÷ 2,000).

[975] Gleim #: 7.43 -- Source: CIA 1196 IV-73 If the exchange rate has changed from 1 U.S. dollar to 5 foreign currency units (FCUs) to a rate of 1 U.S. dollar to 5.5 FCUs,

A. B. C. D.

The U.S. dollar has appreciated by 10%. The U.S. dollar has depreciated by 10%. The FCU has appreciated by 20%. The FCU has depreciated by 20%. Answer (A) is correct. If the exchange rate changes from $1 to 5 FCUs to $1 to 5.5 FCUs, the U.S. dollar has appreciated by 10% [(5.5 – 5) ÷ 5]. Answer (B) is incorrect because the U.S. dollar has appreciated in value. It will now purchase more FCUs. Answer (C) is incorrect because the FCU is depreciating, not appreciating. Answer (D) is incorrect because the FCU has depreciated by 9.09%.

[976] Gleim #: 7.44 -- Source: CMA 1285 1-34 An American importer of English clothing has contracted to pay an amount fixed in British pounds three months from now. If the importer worries that the U.S. dollar may depreciate sharply against the British pound in the interim, it would be well advised to


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A. B. C. D.

Buy pounds in the forward exchange market. Sell pounds in the forward exchange market. Buy dollars in the futures market. Sell dollars in the futures market. Answer (A) is correct. The American importer should buy pounds now. If the dollar depreciates against the pound in the next 90 days, the gain on the forward exchange contract would offset the loss from having to pay more dollars to satisfy the liability. Answer (B) is incorrect because selling pounds would compound the risk of loss for someone who has incurred a liability. However, it would be an appropriate hedge of a receivable denominated in pounds. Answer (C) is incorrect because the importer needs pounds, not dollars. Answer (D) is incorrect because, although buying pounds might be equivalent to selling dollars for pounds, this is not the best answer. This choice does not state what is received for the dollars.

[977] Gleim #: 7.45 -- Source: CMA 1288 1-18 Consider a world consisting of only two countries, Canada and Ruritania. The Canadian currency is the Canadian dollar, and the Ruritanian currency is the RCU. Inflation in Canada in 1 year was 5%, and in Ruritania 10%. Which one of the following statements about the Canadian exchange rate (rounded) during that year will be true?

A. B. C. D.

Inflation has no effect on the exchange rates. The Canadian dollar will appreciate by 5%. The Canadian dollar will depreciate by 5%. The Canadian dollar will depreciate by 15%. Answer (A) is incorrect because inflation affects exchange rates by diminishing a currency’s purchasing power. Answer (B) is correct. Because Ruritania has experienced the greater inflation, its currency should depreciate in relation to Canada’s. For example, if Canada trades 100 units of a product to Ruritania for a preinflation unit price of $100 (the domestic price in Canada), and Ruritania pays with 10,000 units of a product that sells domestically for a unit price of 10,000 preinflation RCUs, the exchange rate without regard to inflation is 100 RCUs per $1 (10,000 RCUs ÷ $100). Allowing for the inflation, the 100 units of the Canadian product would sell for $105. The 10,000 units of the Ruritanian product would sell for 11,000 RCUs. Thus, the new exchange rate will be 104.76 RCUs per $1 (11,000 RCUs ÷ $105), and the price of the Canadian dollar will increase by 4.76% (rounded to 5%). Answer (C) is incorrect because the Canadian currency will appreciate relative to Ruritania’s. Canadian inflation was lower. Answer (D) is incorrect because the Canadian currency will appreciate relative to Ruritania’s. Canadian inflation was lower.

[978] Gleim #: 7.46 -- Source: CMA 1288 1-17 Caroline Brown, the product manager for a U.S. computer manufacturer, is being asked to quote prices of desktop computers to be used in Kuwait. The Kuwaiti government wants the price in British pounds, for delivery next year. Brown knows that the general price level in the United States will increase by 3%. Her banker forecasts that the British pound will depreciate about 5% this year with respect to the U.S. dollar. If Brown is able to quote £700 for immediate delivery, the price that should be quoted for delivery to Kuwait next year is about

A. B. C. D.

£737 £721 £759 £700


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Answer (A) is incorrect because £737 results from considering only the effect of the 5% decline in the pound. Answer (B) is incorrect because £721 results from considering only the effect of the 3% U.S. inflation rate. Answer (C) is correct. Two factors are to be considered: (1) the 3% U.S. inflation rate and (2) the 5% decline in the pound versus the dollar. Assuming that the original exchange rate was $1.20 to £1, £700 was equivalent to $840. Given 5% depreciation of the pound, the new exchange rate is $1.14 to £1 ($1.20 × .95). After U.S. inflation of 3% ($840 × 1.03 = $865.20), the new price is about £759 ($865.20 ÷ $1.14). Accordingly, the price has increased by about 8.4% [(£759 – £700) ÷ £700]. Answer (D) is incorrect because the effects of both the 3% U.S. inflation rate and the 5% decline in the pound must be considered. [979] Gleim #: 7.47 -- Source: CIA 1196 IV-64 A company has a foreign-currency-denominated trade payable, due in 60 days. To eliminate the foreign currency exchange-rate risk associated with the payable, the company could

A. B. C. D.

Sell foreign currency forward today. Wait 60 days and pay the invoice by purchasing foreign currency in the spot market at that time. Buy foreign currency forward today. Borrow foreign currency today, convert it to domestic currency on the spot market, and invest the funds in a domestic bank deposit until the invoice payment date. Answer (A) is incorrect because a forward market sale of foreign currency is appropriate to hedge a receivable denominated in a foreign currency. Answer (B) is incorrect because waiting to buy the currency in 60 days does not eliminate the risk of an adverse exchange-rate movement. Answer (C) is correct. The company can arrange to purchase the foreign currency today rather than in 60 days by buying the currency in the forward market. This hedging transaction will eliminate the exchange-rate risk associated with the trade payable. Answer (D) is incorrect because this strategy would be comparable to a future sale of the foreign currency at a rate known today, which would not provide the currency needed to pay the invoice. However, the opposite strategy would be an effective money market hedge. If the company converted domestic currency to foreign currency in the spot market today and invested in a foreign bank deposit or treasury bill, it could then use the proceeds from the foreign investment to pay the invoice in 60 days.

[980] Gleim #: 7.48 -- Source: Publisher The Bretton Woods Agreement of 1944

A. B. C. D.

Established the gold standard. Pegged the dollar to gold and other currencies to the dollar. Established a system of managed floating exchange rates. Established floating exchange rates. Answer (A) is incorrect because the world began operating on a gold standard is 1870. In 1944, the system was changed to a modified gold standard. Answer (B) is correct. The Bretton Woods Agreement abolished the gold standard that had existed since 1870 in favor of a modified gold standard. Under the modified gold standard, the U.S. dollar was pegged to gold, and other currencies were then pegged to the dollar. Answer (C) is incorrect because managing floating exchange rates were not adopted until the Jamaica Agreement of 1976. Answer (D) is incorrect because floating exchange rates did not occur until 1971.


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[981] Gleim #: 7.49 -- Source: Publisher The cost of capital for foreign investment projects is higher because of all of the following factors except

A. B. C. D.

Exchange-rate risk. Political risk arising from possible expropriation. Laws requiring specific forms of financing. Trigger pricing. Answer (A) is incorrect because they are all causes of higher costs of capital in foreign projects. Answer (B) is incorrect because they are all causes of higher costs of capital in foreign projects. Answer (C) is incorrect because they are all causes of higher costs of capital in foreign projects. Answer (D) is correct. The cost of capital is typically higher for foreign projects for a variety of reasons, including exchange-rate risk, political risk, and limitations on sources of financing that often require a certain percentage of domestic ownership. Trigger pricing is not a cause. Trigger pricing is a means of managing exchange-rate risk by supplying foreign funds at an indexed price, but with an option to convert to a futures-based fixed price when a specified basis differential exists between the two prices.

[982] Gleim #: 7.50 -- Source: CMA 688 1-30 What is the role of gold in the current international monetary system?

A. B. C. D.

Gold is quoted in United States dollars only. All of the major currencies of the world, except the United States dollar, have a fixed value in terms of gold. Gold is like any other asset whose value depends upon supply and demand. Gold is the reserve asset of the International Monetary Fund. Answer (A) is incorrect because, although most exchanges quote the price of gold in U.S. dollars, the dollar’s value is not linked to that of gold. Answer (B) is incorrect because floating exchange rates have existed since about 1973. Tying currency values to a gold standard, in effect, fixes exchange rates. Answer (C) is correct. Gold has no special role in the modern international monetary system. The present system is based upon managed floating currency exchange rates. Consequently, gold is treated as a commodity, the price of which depends upon supply and demand. Answer (D) is incorrect because the only reserves of the IMF are international currencies.

[983] Gleim #: 7.51 -- Source: CIA 594 IV-64 Which of the following is a tariff?

A. B. C. D.

Licensing requirements. Consumption taxes on imported goods. Unreasonable standards pertaining to product quality and safety. Domestic content rules.


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Answer (A) is incorrect because licensing requirements limit exports, e.g., of militarily sensitive technology. Answer (B) is correct. Tariffs are excise taxes on imported goods imposed either to generate revenue or protect domestic producers. Thus, consumption taxes on imported goods are tariffs. Answer (C) is incorrect because unreasonable standards pertaining to product quality and safety are nontariff trade barriers. Answer (D) is incorrect because domestic content rules require that a portion of an imported good be made in the importing country. [984] Gleim #: 7.52 -- Source: CIA 594 IV-65 Which of the following is a direct effect of imposing a protective tariff on an imported product?

A. B. C. D.

Lower domestic prices on the imported item. Lower domestic consumption of the item. Reduced domestic production of the item. Higher sales revenues for foreign producers of the item. Answer (A) is incorrect because a protective tariff can only increase the domestic price of the imported item. Answer (B) is correct. A protective tariff adds to the purchase price of imported goods. If an imported good’s sales price is higher than a comparable, less expensive domestic good, consumers will purchase the domestic good. Thus, the direct effect of imposing a protective tariff on an imported good is lower domestic consumption. Answer (C) is incorrect because, as the imported item’s domestic price increases, demand for domestic goods will increase. Thus, domestic production will increase, not decrease. Answer (D) is incorrect because, as the imported item’s domestic price increases, demand for the item decreases. Lower sales revenues will result.

[985] Gleim #: 7.53 -- Source: CIA 1195 IV-68 A direct effect of imposing a protective tariff on an item for which there are both foreign and domestic producers is that domestic producers will sell of the item while domestic consumers consume of the item.

List A

List B

A.

More

More

B. C.

More Less

Less More

D.

Less

Less

Answer (A) is incorrect because domestic producers will sell more, and domestic consumers will consume less, as a result of the imposition of a protective tariff. Answer (B) is correct. Domestic producers are not subject to the tariff and will therefore have a price advantage over their foreign competitors. However, absent such competition, the domestic price of the item will be higher. Domestic producers will sell more at a higher price, and domestic consumers will consume less following the price increase. Answer (C) is incorrect because domestic producers will sell more, and domestic consumers will consume less, as a result of the imposition of a protective tariff. Answer (D) is incorrect because domestic producers will sell more, and domestic consumers will consume less, as a result of the imposition of a protective tariff. [986] Gleim #: 7.54 -- Source: CMA 1287 1-27 One consequence of the imposition of tariffs or quotas on imported products is


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A. B. C. D.

Lower prices for domestic products that compete with affected imports. Domestic industry opposition to protection from imports. Additional consumption of the affected imported products. Higher prices for the affected imported products. Answer (A) is incorrect because trade restricts full inflation since incentives to charge lower prices for domestic products are removed. Answer (B) is incorrect because domestic industries support protection from imports to reduce competition. Answer (C) is incorrect because consumption is reduced owing to higher prices and reduced supply. Answer (D) is correct. Tariffs lead to higher prices on imported products. Similarly, the imposition of quotas leads to higher prices through an artificial limitation on supply.

[987] Gleim #: 7.55 -- Source: CMA 695 1-23 Which one of the following groups would be the primary beneficiary of a tariff?

A. B. C. D.

Domestic producers of export goods. Domestic producers of goods protected by the tariff. Domestic consumers of goods protected by the tariff. Foreign producers of goods protected by the tariff. Answer (A) is incorrect because domestic producers of export goods are not benefitted. Indeed, they may be harmed by retaliatory tariffs. Answer (B) is correct. Despite the advantages of free trade, nations often levy tariffs to discourage the importation of certain products. A tariff is a tax on imports intended to protect a domestic producer from foreign competition. For instance, a tariff on imported autos benefits U.S. auto manufacturers because it is an additional cost imposed on U.S. consumers of such products. The disadvantages of the tariff are that it may protect an inefficient domestic producer and increase prices paid by domestic consumers. Answer (C) is incorrect because domestic consumers must pay higher prices for imported goods. Answer (D) is incorrect because the foreign producers will be forced to bear an additional cost.

[988] Gleim #: 7.56 -- Source: CIA 1196 IV-78 The graph depicts the domestic supply of and demand for a product that is also sold in the domestic market by foreign producers. The domestic producers are protected by a tariff of the amount P t minus Pw. P t is the domestic price including the tariff, and Pw is the world price for the product. The effect of the tariff is to

(Refer to Figure FIGURE01_03_01_Q.)

A. B. C. D.

Reduce the domestic price from OP w to OP t . Reduce foreign sales in the domestic market from ac to bc. Increase domestic production from Ob to Oc. Increase domestic production from Oa to Ob.


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Answer (A) is incorrect because the inclusion of the tariff increases the domestic price. Answer (B) is incorrect because foreign sales in the domestic market decline from ad to bc. Answer (C) is incorrect because domestic production increases from Oa to Ob. Answer (D) is correct. Without the tariff, domestic production is determined by the intersection of the P w line with the domestic supply curve at the quantity Oa. Domestic production increases from Oa to Ob as a result of the introduction of the tariff. Supply intersects the P t line at a higher price and at a greater domestic quantity, Ob. [989] Gleim #: 7.57 -- Source: CMA 1285 1-28 The creation of a regional economic bloc of trading nations such as the European Union (EU)

A. B. C. D.

Discourages foreign investment by nonmember multinational companies. Encourages trade between the member nations and nonmember nations. Requires the adoption of a common monetary unit. Discriminates economically against nonmember nations. Answer (A) is incorrect because foreign investment may be welcomed under the appropriate conditions. Answer (B) is incorrect because the EU provides incentives to trade with other members, not nonmembers. Answer (C) is incorrect because currencies are not affected by bloc membership. Answer (D) is correct. A trading bloc provides trading incentives to member nations and discriminates against nonmember nations. For example, the European Union calls for abolition of internal tariffs and import quotas, free movement of capital and labor within the market, and implementation of common policies for the member nations. However, the EU also imposed a common system of tariffs on goods of nonmember nations.

[990] Gleim #: 7.58 -- Source: Publisher Import restrictions for purposes of creating domestic employment

A. B. C. D.

Are likely to increase the number of export jobs. May lead to lower prices for consumers. May lead to lower taxes. May lead to retaliation by other countries. Answer (A) is incorrect because export jobs may decline due to retaliation by other countries. Answer (B) is incorrect because consumers will have to pay higher prices for the protected domestic goods and may have to pay higher prices for foreign goods as well. Answer (C) is incorrect because consumers will have to pay higher taxes. Prices for government purchases of protected goods will be higher. Answer (D) is correct. Protectionism in the form of import restrictions can lead to a variety of economic and social costs, including higher prices to consumers for both domestic and imported goods, higher taxes, and retaliation by other countries.

[991] Gleim #: 7.59 -- Source: CIA 595 IV-64 Which of the following measures create the most restrictive barrier to exporting to a country?

A. B. C. D.

Tariffs. Quotas. Embargoes. Exchange controls.


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Answer (A) is incorrect because a tariff is a tax levied by a foreign government against certain imported products. A firm exporting to that country must accept lower profits, absorbing the tariff, or increase selling prices in the foreign country to compensate. The tariff reduces profitability or competitiveness in the foreign market but does not exclude the firm from exporting to that country. Answer (B) is incorrect because a quota is a limit on the amount of goods that an importing country will accept in certain product categories. The effect of a quota is to restrict the quantity the firm can export to that country but not to exclude the firm from selling in that market. The effect on revenues and profitability depends on market conditions in that country. Answer (C) is correct. An embargo is a total ban on some kinds of imports. It is an extreme form of the import quota. Embargoes have the effect of totally excluding the exporting firm from selling in that country and are the most restrictive type of import/export law. Answer (D) is incorrect because exchange controls limit the amount of foreign exchange that can be transacted or the exchange rate against other currencies. These controls limit the ability of a firm selling in the country to repatriate its export earnings but do not exclude the firm from selling in that market. [992] Gleim #: 7.60 -- Source: Publisher Which of the following is an economic rationale for government intervention in trade?

A. B. C. D.

Maintaining spheres of influence. Protecting infant industries. Preserving national identity. Dealing with friendly countries. Answer (A) is incorrect because these are not economic rationales for government intervention in trade. Answer (B) is correct. The infant-industry argument contends that protective tariffs are needed to allow new domestic industries to become established. Once such industries reach a maturity stage in their life cycles, the tariffs can supposedly be removed. Answer (C) is incorrect because these are not economic rationales for government intervention in trade. Answer (D) is incorrect because these are not economic rationales for government intervention in trade.

[993] Gleim #: 7.61 -- Source: Publisher An importer in Cuba must apply to a Cuban government agency to obtain Mexican pesos to pay for an item it is importing from Mexico. This limitation is an example of which nontariff barrier to trade?

A. B. C. D.

An import license. Countertrade. Voluntary export restraint. Foreign-exchange control. Answer (A) is incorrect because the currency must be obtained, not the right to make an import. Answer (B) is incorrect because countertrade is not a nontariff barrier, although it can sometimes be used to counter exchange controls. Countertrade is simply a barter arrangement. Answer (C) is incorrect because the requirement to obtain currency is not a voluntary restraint. Answer (D) is correct. Exchange controls limit foreign currency transactions and set exchange rates. The purpose is to limit the ability of a firm to pay domestic currency to foreigners.


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[994] Gleim #: 7.62 -- Source: Publisher Government subsidies of the domestic production of military weapons is an example of what rationale for government intervention in trade?

A. B. C. D.

Infant industry concept. Maintenance of essential industries. Maintenance of extension of spheres of influence. Protecting the national identity. Answer (A) is incorrect because nothing indicates that weapons production is an infant industry. Answer (B) is correct. Providing subsidies to military weapons manufacturers is an example of the essential-industry argument. The government protects essential domestic industries during peacetime so that a country is not dependent on foreign sources of supply during war. Answer (C) is incorrect because production of military weapons is an essential industry. Answer (D) is incorrect because protecting weapons manufacturers has nothing to do with protecting the national identity.

[995] Gleim #: 7.63 -- Source: Publisher Which of the following organizations was established by industrialized nations to lend money to underdeveloped and developing countries?

A. B. C. D.

OPEC. NAFTA. The World Bank. The International Monetary Fund. Answer (A) is incorrect because OPEC is an international oil cartel that controls oil production and prices. Answer (B) is incorrect because NAFTA is a free-trade agreement among the USA, Canada, and Mexico. Answer (C) is correct. The World Bank was created to provide credit for development purposes to underdeveloped and developing countries. Answer (D) is incorrect because the IMF manages a pool of currency from which participating countries can draw during short-term balance-of-payments difficulties.

[996] Gleim #: 7.64 -- Source: Publisher Which of the following statements is true with respect to international transfer pricing by a U.S. firm?

A. Transfer prices charged to foreign subsidiaries must be the same as those charged to domestic subsidiaries. B. The existence of tariffs in the foreign country may necessitate a higher transfer price be charged a foreign subsidiary. C. Limitations on taking profits out of a foreign country can be avoided by charging the foreign subsidiary a higher transfer price. D. The transfer price must consider the Internal Revenue Code limitation that the amount of taxable income that can be claimed by a foreign subsidiary can be no more than 25% of the total (parent plus subsidiary) taxable income.


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Answer (A) is incorrect because transfer prices charged to foreign subsidiaries are often quite different from those charged domestic subsidiaries. Answer (B) is incorrect because the existence of tariffs in the foreign country would necessitate that a lower transfer price be charged to avoid a high tariff. Answer (C) is correct. Transfer pricing is an important aspect of the tax calculation for multinational corporations that transfer inventories between branches in different countries. Transfer prices charged to foreign subsidiaries may differ substantially from those charged to domestic subsidiaries for a variety of reasons. Limitations on taking profits out of a foreign country can be avoided by charging the foreign subsidiary a higher transfer price so that little or no profit exists to be repatriated. Answer (D) is incorrect because the tax laws limit the profit of foreign subsidiaries to 50% of the total. [997] Gleim #: 7.65 -- Source: CMA 687 1-21 The World Trade Organization

A. B. C. D.

Introduced fixed exchange rates among the United States, Canada, and members of the European Union. Created the International Monetary Fund. Encourages reductions in trade barriers between countries. Introduced exchange rates that adjust in response to changes in trade deficits and surpluses. Answer (A) is incorrect because the WTO is a worldwide agreement concerning trade barriers, not exchange rates. Today, moreover, exchange rates are not pegged (fixed) but are allowed to float. Answer (B) is incorrect because the IMF was founded in 1944 to stabilize exchange rates. Answer (C) is correct. International trade agreements provide regulatory authority for businesses in international trade. The WTO, which was established on January 1, 1995, is the product of the Uruguay Round of international trade negotiations. It is a permanent body with a secretariat based in Geneva, Switzerland. The WTO Agreement is a permanent set of commitments by more than 120 nations designed to prohibit trade discrimination among member nations and between imported and domestic products. Answer (D) is incorrect because the WTO is a worldwide agreement concerning trade barriers, not exchange rates.

[998] Gleim #: 7.66 -- Source: CIA 596 IV-74 An individual had taxable income of $23,000 per year and paid $8,000 in income tax. The individual’s taxable income then increased to $30,000 per year resulting in a $10,000 income tax liability. The personal tax system being applied to this individual is

A. B. C. D.

Progressive. Regressive. Marginal. Proportional. Answer (A) is incorrect because, under a progressive tax system, both the amount of tax and the percentage of income paid in tax (the average tax rate) rise as income increases. In the case described, the individual pays a higher amount of tax but a lower percentage of income in tax. Answer (B) is correct. The average tax rate of the individual has decreased from 34.8% ($8,000 ÷ $23,000) to 33.3% ($10,000 ÷ $30,000). Under a regressive tax system, the average tax rate falls as income rises, although the amount of tax paid may rise. Answer (C) is incorrect because marginal is not a type of tax system but a type of tax rate. The marginal tax rate is the tax rate paid on incremental income. Answer (D) is incorrect because, under a proportional income tax system, the average tax rate is the same for all levels of income. The average tax rate of this individual falls as income rises.


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[999] Gleim #: 7.67 -- Source: CIA 1195 IV-70 In most countries taxes tend to be with respect to income.

List A

List B

A.

General sales

Proportional

B. C.

Property Personal income

Regressive Proportional

D.

Personal income

Regressive

Answer (A) is incorrect because general sales taxes tend to be regressive. The lower the taxpayer’s income, the higher the proportion that is usually paid in sales taxes, which are collected at a flat rate per dollar. Low-income taxpayers are unable to save as high a portion of their income as high-income taxpayers. Thus, the latter are less exposed to general sales taxes because they avoid the tax on the amount saved. Answer (B) is correct. Property taxes tend to be regressive. Taxpayers with lower incomes must pay a higher portion of their incomes for necessities, such as housing. Answer (C) is incorrect because personal income taxes tend to be progressive. Higher tax rates are charged on higher incomes. Answer (D) is incorrect because personal income taxes tend to be progressive. Higher tax rates are charged on higher incomes. [1000] Gleim #: 7.68 -- Source: CIA 595 IV-70 In a personal tax system, an individual’s marginal tax rate is normally the average tax rate.

List A

List B

A.

Progressive

Greater than

B. C.

Progressive Regressive

Equal to Equal to

D.

Regressive

Greater than

Answer (A) is correct. The marginal tax rate is the tax applicable to the last unit of income, whereas the average tax rate is the total tax paid divided by taxable income. In a progressive tax system, higher incomes attract higher tax rates, so the marginal tax rate paid on the last unit of income exceeds the average tax rate. Answer (B) is incorrect because, in a progressive tax system, the tax rate varies with the level of income, so the marginal and average tax rates differ. Answer (C) is incorrect because, in a regressive tax system, the tax rate varies with the level of income, so the marginal and average tax rates differ. Answer (D) is incorrect because, in a regressive tax system, the marginal tax rate is less than, not greater than, the average tax rate. [1001] Gleim #: 7.69 -- Source: CIA 596 IV-77 A value-added tax is collected on the basis of

A. The difference between the value of a firm’s sales and the value of its purchases from other domestic firms. B. The difference between the selling price of a real estate property and the amount the firm originally paid for the property. C. The value of a firm’s sales to related companies. D. The profit earned on a firm’s sales.


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Answer (A) is correct. A value-added tax (VAT) is collected on the basis of the value created by the firm. This tax is measured by the difference between the value of the firm’s sales and the value of its purchases. A VAT is in effect a retail sales tax. Because a consumer can avoid the tax by not purchasing, a VAT encourages saving and discourages consumption. Answer (B) is incorrect because the difference between the selling price of a real estate property and the amount the firm originally paid for the property is a capital gain. Answer (C) is incorrect because the value of a firm’s sales to related companies is the internal transfer price. Answer (D) is incorrect because the profit earned on a firm’s sales is subject to the income tax. [1002] Gleim #: 7.70 -- Source: CIA 1195 IV-69 In order to index a progressive tax system to inflation, the government must

A. B. C. D.

Adjust only tax deductions and exemptions. Adjust only tax brackets. Adjust deductions, exemptions, and tax brackets. Ensure that nominal tax receipts grow more slowly than inflation. Answer (A) is incorrect because, if only deductions and exemptions are indexed, real taxes will still increase with inflation as taxpayers experience bracket creep. Answer (B) is incorrect because, if only tax brackets are adjusted, deductions and exemptions will have less real value. Real taxes will rise. Answer (C) is correct. If tax brackets are not adjusted for inflation, increases in nominal but not real income may push taxpayers into tax brackets with higher (progressive) rates. Additionally, deductions and exemptions must be indexed so that the real incidence of taxation is not increased by inflation. Increases in nominal but not real income will result in higher real taxable income if deductions and exemptions have not been adjusted for inflation. Answer (D) is incorrect because indexing does not result in nominal tax receipts growing more slowly than the rate of inflation. Rather, indexing maintains the same real rate of taxation by ensuring that nominal tax receipts keep pace with inflation.

[1003] Gleim #: 7.71 -- Source: CIA 1196 IV-76 A company purchases $150,000 of inputs from other firms and incurs $500,000 of labor costs in manufacturing its products. It also incurs $100,000 of interest expense. The company sells all of its output for $2.5 million. Rather than paying income tax, the company must pay a 25% value-added tax. How much tax will be due for this year’s activities?

A. B. C. D.

$437,500 $462,500 $587,500 $625,000 Answer (A) is incorrect because $437,500 is 25% of the earnings before tax. Answer (B) is incorrect because $462,500 deducts labor costs as well as purchased inputs. Answer (C) is correct. The value added is the difference between the value of the output and the value of the purchased inputs. Value-added tax payable equals the value-added tax rate times value added, or $587,500 [.25 × ($2,500,000 – $150,000)]. Answer (D) is incorrect because $625,000 is the value-added tax rate multiplied by the output of the firm.


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[1004] Gleim #: 7.72 -- Source: CIA 594 IV-70 Which of the following designations refers to taxes that will not necessarily take a larger absolute amount of income as income rises?

A. B. C. D.

Progressive. Proportional. Regressive. Regenerative. Answer (A) is incorrect because progressive taxes, for which the average tax rate rises as income rises, take both a larger percentage of income and a larger absolute amount of income as income rises. Answer (B) is incorrect because proportional taxes, for which the average tax rate is constant for all income levels, always take a larger absolute amount of income as income rises. Answer (C) is correct. Regressive taxes are those for which the average tax rate falls as income rises. They take a smaller percentage of income as income rises, so they will not necessarily take a larger absolute amount of income as income rises. Answer (D) is incorrect because regenerative is not a term used to designate types of taxes.

[1005] Gleim #: 7.73 -- Source: CIA 594 IV-71 A taxpayer who earns $50,000 during the year and pays a 15% tax rate on the first $30,000 of income and a 30% tax rate on all earnings over $30,000 has a(n)

A. B. C. D.

Marginal tax rate of 15%. Marginal tax rate of 21%. Average tax rate of 21%. Average tax rate of 22.5%. Answer (A) is incorrect because the marginal tax rate is 30%. The marginal tax rate equals the highest rate paid. Answer (B) is incorrect because the marginal tax rate is 30%. The marginal tax rate equals the highest rate paid. Answer (C) is correct. The average tax rate is calculated using the weighted-average method. The weight assigned to each rate is determined by the proportion of taxable income subject to it. The average tax rate is 21% [.15 × ($30,000 ÷ $50,000) + .30 × ($20,000 ÷ $50,000)]. Answer (D) is incorrect because 22.5% is a simple numerical average.

[1006] Gleim #: 7.74 -- Source: CIA 597 IV-59 The two main variables that contribute to increases in real gross domestic product (GDP) derived from labor inputs are labor productivity and

A. B. C. D.

The potential labor force. The inflation rate. Quality of output. Total worker hours.


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Answer (A) is incorrect because the potential labor force is not a factor in the calculation. Rather, real GDP is determined by actual inputs and their productivity. Answer (B) is incorrect because real GDP is adjusted for inflation. Answer (C) is incorrect because national income accounting does not address the quality of output. Answer (D) is correct. Real GDP increases when resource inputs and their productivity increase. Thus, to the extent that real GDP depends on labor inputs, real GDP equals total worker hours (labor input) times labor productivity (real output per worker per hour). [1007] Gleim #: 7.75 -- Source: CIA 596 IV-68 If the government of a country uses its foreign currency reserves to its own currency in the foreign currency market, the effect is to domestic aggregate demand.

List A

List B

A. B.

Purchase Purchase

Not affect Decrease

C. D.

Sell Sell

Not affect Decrease

Answer (A) is incorrect because, if a government increases the demand for its own currency, the currency will appreciate. This action will alter the trade balance and the level of aggregate demand. Answer (B) is correct. Aggregate demand is the amount of real domestic output that domestic consumers, foreign buyers, governments, and businesses will want to purchase at each price level. One factor that changes aggregate demand is net export spending. Exchange rates are among the determinants of net export spending. When a government intervenes in the foreign currency market to purchase its own currency, it causes an appreciation of that currency. One result is that the trade balance will be affected. Exports will fall as domestic goods become more costly from the perspective of foreign consumers. Imports will rise as foreign goods become less costly for domestic consumers. Consequently, net exports will decline and domestic aggregate demand will also decline. Answer (C) is incorrect because a sale of the currency by the domestic government will cause the currency to depreciate. This action will alter the trade balance and the level of aggregate demand. Answer (D) is incorrect because, if the government intervenes and causes a depreciation of the domestic currency, exports will rise and imports will fall. Net exports will therefore rise if the currency appreciates, so aggregate demand will increase. [1008] Gleim #: 7.76 -- Source: CIA 595 IV-57 The sale of final goods is the gross domestic product, and the sale of intermediate goods is the gross domestic product.

List A

List B

A. B.

Included in Included in

Included in Excluded from

C. D.

Excluded from Excluded from

Included in Excluded from

Answer (A) is incorrect because the sale of final goods is included in GDP, and the sale of intermediate goods is excluded. Answer (B) is correct. The sale of final goods is included in, and the sale of intermediate goods is excluded from, GDP. The purpose of this treatment is to avoid double counting. The value of final goods already includes any intermediate transactions involved in their production. Answer (C) is incorrect because the sale of final goods is included in GDP, and the sale of intermediate goods is excluded. Answer (D) is incorrect because the sale of final goods is included in GDP, and the sale of intermediate goods is


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[1009] Gleim #: 7.77 -- Source: CIA 596 IV-60 Under the income approach, gross domestic product (GDP) is measured as

A. Depreciation charges and indirect business taxes + Wages + Rents + Interest + Profits adjusted for net income earned abroad. B. Wages + Rents + Interest + Profits. C. Depreciation charges and indirect business taxes + Wages + Rents – Interest + Profits. D. Wages + Rents + Interest – Profits adjusted for net income earned abroad . Answer (A) is correct. GDP is the total value of goods and services produced within the boundaries of a country. It may be measured using an expenditures approach or an income approach. Under the income approach, GDP equals all income derived from the production of the year’s output, with an adjustment for net income earned abroad (a positive or negative amount in theory). Two types of nonincome charges or allocations must be added to incomes (wages, rents, interest, and profits). Depreciation reflects the consumption of fixed capital during the period. It is the part of the year’s receipts that must be allocated to replace the machinery, plant, etc., used up in the production of GDP. Indirect business taxes, such as sales, excise, and property taxes, are treated by businesses as a cost of production and form part of the total price of goods and services. Thus, they are not paid as wages, rents, interest, and profits. Accordingly, GDP may be measured as the sum of consumption of fixed capital, indirect business taxes, wages, rents, interest, and profits (proprietors’ income, corporate taxes, dividends, and undistributed corporate profits), with an adjustment for net income earned abroad. Answer (B) is incorrect because nonincome charges and the adjustment for net income earned abroad must also be included in the calculation. Answer (C) is incorrect because interest income is added, not subtracted. Also, the adjustment for net income earned abroad must be considered. Answer (D) is incorrect because profits are added, not subtracted. Also, nonincome charges must be included in the calculation. [1010] Gleim #: 7.78 -- Source: CIA 1196 IV-59 Net domestic product is composed of the total market value of

A. B. C. D.

All final goods and services produced in the economy in 1 year. All goods and services produced in the economy in 1 year. All final goods and services produced in the economy in 1 year minus the capital consumption allowance. All goods and services produced in the economy in 1 year minus the capital consumption allowance. Answer (A) is incorrect because net domestic product is calculated net of the capital consumption allowance. Answer (B) is incorrect because net domestic product includes only final goods. The inclusion of intermediate goods would involve double counting. Also, net domestic product is calculated net of the capital consumption allowance. Answer (C) is correct. Net domestic product is the market value of all final goods and services produced within the boundaries of a country within 1 year minus the capital consumption allowance. Answer (D) is incorrect because net domestic product does not include intermediate goods.

[1011] Gleim #: 7.79 -- Source: CMA 1293 1-25 In relation to the balance of trade, all international transactions involving the purchase or sale of physical products between domestic and foreign countries are reflected in


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A. B. C. D.

The balance of the capital account. Official reserves held by the central banks. The official financing account. The trade balance in the current account. Answer (A) is incorrect because the capital account includes capital movements only; the direction of capital movements is influenced by the prevailing interest rates in each nation. Answer (B) is incorrect because official reserves are assets held by central banks and are not necessarily related to current transactions. Answer (C) is incorrect because this is a nonsense answer. Answer (D) is correct. The balance of payments represents all international payments made by one nation to another, including those for imports, exports, investments, unilateral transfers such as pensions and gifts, and capital movements. The principal accounts are the current account and the capital account. The current account includes a net trade balance in goods, net investment receipts or payments, net receipts or payments for services, and the balance of unilateral transfers.

[1012] Gleim #: 7.80 -- Source: CMA 1288 1-19 When analyzing a country’s balance of payments accounts, the

A. B. C. D.

“Current account” refers only to merchandise exports and imports. “Current account” and “trade balance” are the same. “Capital account” refers to the transactions related to the international movement of financial capital. Country will be in financial jeopardy unless each component in the balance of payments accounts balances at the end of the year. Answer (A) is incorrect because the current account includes exports and imports of services as well as goods. Answer (B) is incorrect because the trade balance concerns goods only. Answer (C) is correct. The balance of payments accounts include all international payments made by one nation to another, including capital movements, imports, exports, and unilateral transfers. The net of exports and imports is the current account balance. The current account balance does not include capital transactions. The capital account reflects movements of financial capital (investments). Answer (D) is incorrect because the various components are never in balance. In reality, the important consideration is the total, and that is more of a long-run than an annual problem.

[1013] Gleim #: 7.81 -- Source: CMA 691 1-18 Which one of the following items represents a credit in the U.S. balance of payment accounts?

A. B. C. D.

U.S. imports of crude oil. Expenditures of American tourists abroad. Earnings belonging to foreign businesses that have U.S. plants. Loans to Americans by foreigners.


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Answer (A) is incorrect because imports are debited. Answer (B) is incorrect because expenditures of American tourists abroad are treated as imports and are therefore debited. Answer (C) is incorrect because earnings of foreigners represent outflows of foreign exchange and are debited. Answer (D) is correct. Basically, exports of goods and services are credited to the U.S. balance of payments accounts and imports are debited. Similarly, capital movements may be debited or credited. For example, transfers of capital from foreigners to Americans, such as loans, are credits in the accounts. In effect, these loans constitute exports of debt instruments and increase the supply of foreign exchange available for the U.S. [1014] Gleim #: 7.82 -- Source: CMA 1288 1-21 The following transactions were noted for an economy whose currency is denominated in pesetas (Pta). Amount in Pesetas Imports of goods Exports of goods Domestic long-term investment in foreign countries Investment by foreigners in the country Interest payments on foreign loans Gifts received from abroad

20,300 15,760 6,300 1,400 3,700 1,240

When calculating the balance of trade for this economy, the

A. B. C. D.

Current account has a surplus of Pta 7,000. Capital account has a surplus of Pta 4,000. Capital account has a deficit of Pta 7,700. Current account has a deficit of Pta 7,000. Answer (A) is incorrect because the current account has a deficit, not a surplus, of Pta 7,000. Answer (B) is incorrect because investment by foreigners should be deducted from, not added to, domestic investment in foreign countries. Furthermore, interest payments on foreign loans affect the current, not the capital account, and the capital account has a trade deficit, not a surplus. Answer (C) is incorrect because investment by foreigners should be deducted from, not added to, domestic investment in foreign countries. Answer (D) is correct. The balance of trade is the balance of imports and exports of goods. The current account also considers trade in services (none for this economy), unilateral transfers (e.g., gifts), and investment receipts and payments. It does not include capital transactions. Thus, investments by foreigners in the domestic economy and investments made in foreign countries will not be included in the current account. These transactions will be reflected in the capital account. The capital account will therefore have a deficit of 4,900 (6,300 – 1,400) pesetas, since investment in foreign countries is greater than investment by foreigners. The current account will have a deficit of 7,000 pesetas (15,760 – 20,300 + 1,240 – 3,700).

[1015] Gleim #: 7.83 -- Source: CMA 1285 1-30 The dominant reason countries devalue their currencies is to

A. B. C. D.

Improve the balance of payments. Discourage exports without having to impose controls. Curb inflation by increasing imports. Slow what is regarded as too rapid an accumulation of international reserves.


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Answer (A) is correct. Currency devaluations result in a change in the balance of payments. A devaluation means that other currencies will buy more of the devaluing nation’s currency, and the prices of goods denominated in the devalued currency are therefore cheaper. A devaluation usually results in an increase in exports, a decrease in imports (caused by higher relative input prices), and an improved balance of trade. Answer (B) is incorrect because a devaluation will encourage exports. Answer (C) is incorrect because a devaluation will discourage imports and may encourage domestic inflation. Foreign goods will be more expensive. Answer (D) is incorrect because devaluation most likely occurs when a country is losing its reserves. [1016] Gleim #: 7.84 -- Source: CIA 596 IV-69 If a country has a freely floating exchange rate system and is experiencing an appreciation in the external value of its currency, it has

A. B. C. D.

A current account deficit and a capital account surplus. A current account surplus and a capital account deficit. Shrinking official reserves. No balance of payments surplus or deficit after short-run exchange-rate adjustments are complete. Answer (A) is incorrect because the total balance of payments surplus or deficit, which is the sum of the current and capital account balances, is what determines changes in official reserves and pressures for exchange rates to change. Answer (B) is incorrect because the total balance of payments surplus or deficit, which is the sum of the current and capital account balances, is what determines changes in official reserves and pressures for exchange rates to change. Answer (C) is incorrect because, given an appreciation of the currency, the short-run effects are likely to be a balance of payments surplus and growing official reserves. Answer (D) is correct. In a freely floating exchange-rate system, exchange rates automatically adjust so as to eliminate balance of payments surpluses or deficits. For example, if U.S. demand for country X’s currency increases, the result is a U.S. deficit at the existing exchange rate because demand now exceeds the supply of X’s currency at that rate. However, the system of floating exchange rates allows the change in the relative strength of the currencies to be reflected in their exchange rate. The appreciation of X’s currency against the U.S. dollar, that is, the increase in the amount of U.S. dollars exchangeable for a unit of X’s currency, makes U.S. products cheaper to buyers in country X. Furthermore, X’s products are more expensive to U.S. buyers. Consequently, U.S. imports will fall, U.S. exports will rise, and the balance of payments deficit will decrease.

[1017] Gleim #: 7.85 -- Source: CIA 592 II-13 Which of the following statements describes an internal control questionnaire? It

A. B. C. D.

Provides detailed evidence regarding the substance of the control system. Takes less of the engagement client’s time to complete than other control evaluation devices. Requires that the internal auditor be in attendance to properly administer it. Provides indirect evidence that might need corroboration.


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Answer (A) is incorrect because questionnaires usually provide for yes/no responses and therefore provide less detailed evidence than some other procedures. Answer (B) is incorrect because questionnaires tend to be lengthy, and their completion is time-consuming. Answer (C) is incorrect because an auditor need not be present. Answer (D) is correct. An internal control questionnaire consists of a series of questions about the controls designed to prevent or detect errors or irregularities. Answers to the questions help the internal auditor to identify specific internal control policies and procedures relevant to specific assertions and to design tests of controls to evaluate the effectiveness of their design and operation. The questionnaire provides a framework to assure that specific concerns are not overlooked, but it is not a sufficient means of understanding the entire system. Thus, the evidence obtained is indirect and requires corroboration by means of observation, interviews, flowcharting, examination of documents, etc. [1018] Gleim #: 7.86 -- Source: Publisher Hearsay

A. B. C. D.

Could not consist of evidence of statements made in a court. Is evidence of statements made verbally or nonverbally. Is admissible but not discoverable. Is discoverable but not admissible. Answer (A) is incorrect because hearsay might involve a statement made in a courtroom at an unrelated trial or hearing. Answer (B) is correct. Hearsay is a statement other than one made by the declarant while testifying at the trial or hearing, offered in evidence to prove the truth of the matter asserted. The statement alluded to may be a verbal or a nonverbal statement. It might include body language or written statements. Answer (C) is incorrect because anything which is admissible is also discoverable under the rules of discovery. Answer (D) is incorrect because hearsay is discoverable only if it relates to the subject matter of the pending litigation and is not privileged. Hearsay may be admissible if one of the numerous exceptions to the hearsay rule is applicable.

[1019] Gleim #: 7.87 -- Source: CIA 592 II-25 During interviews with the inventory management personnel, an internal auditor learned that salespersons often order inventory for stock without receiving the approval of the vice president of sales. Also, detail testing showed that there are no written approvals on purchase orders for replacement parts. The detail testing is a good example of

A. B. C. D.

Indirect evidence. Circumstantial evidence. Corroborative evidence. Subjective evidence. Answer (A) is incorrect because detail testing provides direct evidence that the approvals were not received. Indirect evidence establishes immediately collateral facts from which the main fact may be inferred. Answer (B) is incorrect because circumstantial evidence tends to prove a fact by proving other events or circumstances that afford a basis for a reasonable inference of the occurrence of the fact. Thus, it is also indirect evidence. Answer (C) is correct. Corroborative evidence is evidence from a different source that supplements and confirms other evidence. For example, oral testimony that a certain procedure was not performed may be corroborated by the absence of documentation. Answer (D) is incorrect because subjective evidence is opinion-oriented and is not dependable for reaching engagement conclusions. No subjective evidence is present in this situation.


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[1020] Gleim #: 7.88 -- Source: CIA 1188 I-28 A contract dispute has arisen between an organization and a major supplier. To resolve the dispute, the most competent evidence is

A. B. C. D.

Oral testimony of contracting parties. The original contract. Actions by parties to the contract. A letter from the supplier’s attorney. Answer (A) is incorrect because, if the original writing is available, oral testimony cannot contradict the content of the writing. Answer (B) is correct. The best (primary) evidence is the most persuasive evidence. Reliability and the best evidence rule are closely related. The best evidence rule is ordinarily applied only to documentary evidence, especially to proof of the content of a writing. If the original writing is available, the best evidence rule prohibits a party from proving the content of a writing through oral testimony. Therefore, the original writing is the most competent evidence. Answer (C) is incorrect because the contract itself is the best evidence. Answer (D) is incorrect because the contract itself is the best evidence.

[1021] Gleim #: 7.89 -- Source: CIA 1182 I-7 Much of the internal auditor’s work involves accumulation of engagement information. A duplicate of a contract rather than the original is an example of what kind of evidence?

A. B. C. D.

Secondary. Circumstantial. Hearsay. Opinion. Answer (A) is correct. Secondary evidence according to the legal view is acceptable if primary evidence (the strongest evidence, e.g., original documents) has been destroyed or is not reasonably procurable. Secondary evidence must be a proper representation of primary evidence, e.g., copies of a contract. Answer (B) is incorrect because circumstantial evidence inferentially establishes one fact by proving another collateral fact. Answer (C) is incorrect because hearsay is an out-of-court statement offered in evidence to prove the truth of the matter asserted. Answer (D) is incorrect because, except for testimony by experts, witnesses may normally testify as to facts only.

[1022] Gleim #: 7.90 -- Source: Publisher Which of the following is not a required element of a contract?

A. B. C. D.

Legality. Consideration. Legal capacity. A writing.


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Answer (A) is incorrect because legality is a required element of a contract. Answer (B) is incorrect because consideration is a required element of a contract. Answer (C) is incorrect because legal capacity is a required element of a contract. Answer (D) is correct. The four essential elements of a contract are an agreement (offer and acceptance), consideration, legal capacity of the parties to contract, and a legal objective or purpose. A writing is not required to enter into a contract. However, some contracts are not enforceable unless a writing evidences the contract. [1023] Gleim #: 7.91 -- Source: Publisher The necessary elements of a contract include

A. B. C. D.

Some form of writing, equal consideration, and legal capacity. Formal execution, definite terms, and a valid offer and acceptance. Offer and acceptance, consideration, legal capacity, and mutual assent. Bilateral promises, legal capacity, and legality of purpose. Answer (A) is incorrect because an oral contract is usually enforceable. Consideration must be legally sufficient and must be bargained for but need not have equal market value. Answer (B) is incorrect because most contracts are informal (simple), and if a term is missing, it can be implied by the court, with the exception of a quantity term. Answer (C) is correct. Contracts require each of the following: 1. Offer and acceptance 2. Mutual assent (meeting of the minds) 3. Consideration (bargained-for exchange) 4. Legality (legal purpose) 5. Capacity of parties (legal ability) Answer (D) is incorrect because promises can be unilateral or divisible.

[1024] Gleim #: 7.92 -- Source: Publisher Consideration consists of

A. B. C. D.

Something with monetary value. Each party’s receiving an actual benefit only. Two promises. Legal sufficiency and bargained-for exchange. Answer (A) is incorrect because a promise satisfies the element of legal sufficiency. Monetary value is relatively unimportant. Answer (B) is incorrect because consideration is an exchange of legal benefit that may not have actual benefit. Answer (C) is incorrect because contracts can be unilateral, which involves only one promise. Answer (D) is correct. Consideration must be legally sufficient and intended as a bargained-for exchange. A promisee has provided legally sufficient consideration if (s)he incurs a legal detriment or if the promisor receives a legal benefit. An essential aspect of consideration is that it be bargained for, and given in exchange for, the consideration provided by the other party. That is, consideration is mutual.


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[1025] Gleim #: 7.93 -- Source: Publisher Lamar became homeless at a very young age and was taken in by Aunt and Uncle. Many years later, Lamar became a detective in the city police department. When Aunt disappeared and was not heard from for a month, the case was assigned to Lamar. Uncle also came to Lamar and asked him to promise to find Aunt in return for the years of support. Lamar agreed to Uncle’s request. Which of the following is true?

A. B. C. D.

Lamar’s contractual duty to find Aunt is based on past consideration. Lamar has no contractual duty to find Aunt. If Uncle had also promised Lamar $1,000 for finding Aunt, he would be liable when Lamar found her. Lamar will be liable for breach of contract if he does not find Aunt. Answer (A) is incorrect because past consideration does not satisfy the consideration requirement for the formation of a contract. Answer (B) is correct. Lamar has a preexisting legal duty to find Aunt. Consideration does not exist if an existing duty was imposed by law or a person is already under a contractual agreement to render a specified performance. Lamar will suffer no new legal detriment by finding Aunt; thus, no contractual obligation exists. Answer (C) is incorrect because Lamar has a preexisting legal duty to find Aunt. Answer (D) is incorrect because Lamar has not made a valid contract with Uncle.

[1026] Gleim #: 7.94 -- Source: E. Rahm Which of the following creates a valid contract between the parties?

A. A reward was posted for the capture of Tom Jones. Maypole Burden, the county sheriff, captured Jones and claimed the reward. B. Slim Polestone promised to give Mabel Abbot a wedding present. C. Anxious Father promised to pay Albert Niceguy $4,000 to take his daughter to the annual Mulestone Dance. Albert agreed. D. Festival Fanny was drowning in her hot tub. Her boyfriend pulled her out. After the rescue, Festival’s husband promised to pay her boyfriend $4 for rescuing his wife. Answer (A) is incorrect because the sheriff had a preexisting legal duty to capture the criminal. Answer (B) is incorrect because a promise to make a gift is not enforceable. It lacks the bargain element. Answer (C) is correct. A valid contract exists because Anxious Father offered to pay Albert $4,000 for taking his daughter to the dance. This is a unilateral contract supported by the consideration of $4,000. Albert will be entitled to the $4,000 after he takes the daughter to the dance. Answer (D) is incorrect because past consideration is not consideration. [1027] Gleim #: 7.95 -- Source: Publisher Which of the following is a true statement about the legality requirement for a contract?

A. B. C. D.

Only agreements to commit a crime or a tort or to violate a statute fail to meet the legality requirement. All contracts in restraint of trade are considered illegal. The illegality that invalidates the contract must be in the consideration for the promise. The general rule is that neither party may be permitted to enforce an illegal agreement.


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Answer (A) is incorrect because agreements that violate public policy lack legality. Answer (B) is incorrect because the rule of reason is applied in antitrust cases to allow certain contracts to restrain competition. Answer (C) is incorrect because lack of legality in formation or performance renders a contract void. Answer (D) is correct. Legal purpose is requisite to enforceability of a contract. An agreement that cannot be performed without violating a statute is void, as are agreements that violate public policy. The state, not a private citizen, prosecutes violations of criminal statutes. The interest protected is that of society. [1028] Gleim #: 7.96 -- Source: CMA 684 1-20 A tight monetary policy is frequently cited as an important policy instrument for fighting inflation. Keynesian economists believe that one of the possible undesirable side effects of such a policy is

A. B. C. D.

Reduced business investment due to higher interest rates. Reduced business investment due to lower interest rates. Increased business investment due to decreased government spending. Increased business investment because of reduced confidence in business. Answer (A) is correct. A tight monetary policy means that little money is available for borrowing. When supply is reduced, the price increases. Thus, interest rates are increased when the money supply contracts. Because of high interest rates, the cost of investment is increased and investment is discouraged. Answer (B) is incorrect because lower interest rates would lead to higher business investment. Answer (C) is incorrect because increased business investment is a desirable effect. Answer (D) is incorrect because increased business investment is a desirable effect.

[1029] Gleim #: 7.97 -- Source: Publisher Assuming the price level increases by 50%, the value of money decreases

A. B. C. D.

10% 33.33% 50% 55% Answer (A) is incorrect because money declines in value by 33.33%. Answer (B) is correct. If the price level increases 50%, an item that used to cost $1.00 will increase to $1.50. A person with $1.50 could have previously purchased 1.5 units of product. After the price level increases, that person can buy only 1 unit, or a decline of .5 units. Thus, the value of money declines by 33.33% (.5 ÷ 1.5). Answer (C) is incorrect because 50% is the increase in price level, which is calculated using a different base from the one used to calculate the decline in monetary value. Answer (D) is incorrect because money declines in value by 33.33%.

[1030] Gleim #: 7.98 -- Source: Publisher A tax is regressive if


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A. B. C. D.

Individuals with higher incomes pay a higher percentage of their income in tax. The burden for payment falls disproportionately on lower-income persons. Individuals pay a constant percentage in taxes, regardless of income level. Individuals with lower incomes pay a lower percentage of their income in tax. Answer (A) is incorrect because a progressive tax is a tax in which individuals with higher (lower) incomes pay a higher (lower) percentage of their income in tax. For example, income taxes are progressive. Answer (B) is correct. With a regressive tax, the percentage paid in taxes decreases as income increases. For example, excise taxes and payroll taxes are both regressive taxes. An excise tax is regressive because its burden falls disproportionally on lower-income persons. As personal income increases, the percentage of income paid declines because an excise tax is a flat amount per quantity of the good or service purchased. Answer (C) is incorrect because a proportional tax is a tax in which the individual pays a constant percentage in taxes, regardless of income level. A sales tax is a proportional tax. Answer (D) is incorrect because a progressive tax is a tax in which individuals with higher (lower) incomes pay a higher (lower) percentage of their income in tax. For example, income taxes are progressive.

[1031] Gleim #: 7.99 -- Source: CMA 676 1-34 Which of the following economic policies does not tend to correct a balance of payments deficit in the U.S.?

A. B. C. D.

Increase productivity in the manufacturing of U.S. exports. More effective use of monetary and fiscal policies to reduce inflation. A redistribution of economic aid and mutual defense burdens toward western European countries. Increase value of U.S. currency in relation to foreign currencies. Answer (A) is incorrect because increasing productivity will lower the price of U.S. exports which will increase the amount of exports demanded, and thus reduce the balance of payments deficit. Answer (B) is incorrect because as the rate of inflation slows down, prices charged to overseas buyers are reduced, which will increase exports (and reduce the balance of payments deficit). Answer (C) is incorrect because if more money were given to countries the U.S. trades with, they would buy more U.S. exports, thus correcting a balance of payments deficit. Answer (D) is correct. A balance of payments deficit exists when the fixed or managed exchange rate is too high. “Too high” is when the fixed price is higher than the equilibrium price would be if market forces were at work. To correct a balance of payments deficit, the price of dollars must decrease or other means must be undertaken to raise the real value to the fixed level. If the value of U.S. currency is increased, the deficit will grow.

[1032] Gleim #: 7.100 -- Source: CMA 680 1-17 The value of the U.S. dollar in relation to other foreign currencies is

A. B. C. D.

Determined directly by the price of gold because the value of the U.S. dollar is tied to the price of gold. Set by the U.S. government in consultation with other foreign governments. Set along with the value of other currencies held by the International Monetary Fund. Determined by the forces of supply and demand on the foreign exchange markets.


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Answer (A) is incorrect because the value of the dollar is not formally tied to gold. While there may be a long-term relationship between gold and the value of the dollar, there are often inverse (or random) short-term fluctuations. Answer (B) is incorrect because an exchange rate set by the government is called a fixed exchange rate. The old international monetary system which used fixed exchange rates collapsed because of its inefficient handling of currency prices. Answer (C) is incorrect because the International Monetary Fund has little effect on the valuation of currencies. Answer (D) is correct. Exchange rates are determined by the forces of supply and demand on the exchange markets. Often other forces try to intervene in this process of exchange rate determination, but these reflect only short-run policies. An example of this type of policy would be government or central bank intervention in the international money markets. [1033] Gleim #: 7.101 -- Source: CMA 680 1-20 When the U.S. dollar is expected to rise in value against foreign currencies, a U.S. company with foreign currency denominated receivables and payables should

A. B. C. D.

Slow down collections and speed up payments. Slow down collections and slow down payments. Speed up collections and speed up payments. Speed up collections and slow down payments. Answer (A) is incorrect because this would raise the real cost to the company. Answer (B) is incorrect because this would not maximize the amount of U.S. dollars the company will have. Answer (C) is incorrect because this would not maximize the amount of U.S. dollars the company will have. Answer (D) is correct. The proper action would be to increase collections and decrease payments. Collections should be made quickly and converted into dollars to sustain the increase in their value as the dollar appreciates. Decreasing payments would be profitable because, as the company exchanges dollars for foreign currency at a later date, it will receive more of the foreign currency, thus lowering its real cost.

[1034] Gleim #: 7.102 -- Source: CMA 1281 1-16 In most recent years, the U.S. balance of payments has registered a deficit. This balance of payments deficit is a measure of the excess of

A. B. C. D.

Exports over imports. Imports over exports. Imports, private capital outflows, grants, and remittances over exports and private capital inflows. Goods imports over services imports. Answer (A) is incorrect because it excludes capital inflows and outflows, grants, and remittances. Answer (B) is incorrect because it excludes capital inflows and outflows, grants, and remittances. Answer (C) is correct. The balance of payments is defined as the excess of imports, private capital outflows, grants, and remittances over exports and private capital inflows. When there is a surplus in the balance of payments, more domestic goods may have been sold abroad than were imported, and/or foreigners may have invested more capital in the domestic country than domestic citizens invested abroad. For this reason, a surplus is considered a favorable balance of payments. Just the opposite is true for a deficit in the balance of payments. Answer (D) is incorrect because it excludes exports completely.

[1035] Gleim #: 7.103 -- Source: CMA 682 1-12 Of the following transactions, the one that results in a debit entry in the U.S. balance of payments account is the


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A. B. C. D.

Receipt of dividends by an American corporation from its German subsidiary. Buying of IBM shares by a Kuwaiti investor. U.S. export of military equipment to Saudi Arabia. Expenditure of a U.S. resident vacationing in France. Answer (A) is incorrect because receipt of dividends by an American corporation from its German subsidiary increases the demand for U.S. currency. Answer (B) is incorrect because buying of IBM shares by a Kuwaiti investor represents an increase in demand for U.S. assets by foreigners. Answer (C) is incorrect because U.S. export of military equipment to Saudi Arabia reflects an increase in U.S. goods and services demanded by foreigners. Answer (D) is correct. Because debits represent unfavorable items, expenditures by U.S. residents vacationing abroad require debits. Buying French goods and services means using dollars to acquire francs, thus increasing the demand for French currency.

[1036] Gleim #: 7.104 -- Source: CMA 682 1-13 Which one of the following transactions results in a credit entry in the U.S. balance of payments account?

A. B. C. D.

A New York bank’s payment of $5,000 in interest to foreigners. A U.S. subsidiary’s remittance of a dividend of $1 million to its parent company in Germany. A U.S. exporter’s purchase of marine insurance from a British insurance company. An Iowa farmer’s export of grain to Turkey. Answer (A) is incorrect because a New York bank’s payment of $5,000 in interest to foreigners reflects an increase in demand for foreign currency by Americans. Answer (B) is incorrect because a U.S. subsidiary’s remittance of a dividend of $1 million to its parent company in Germany is a private capital outflow and would appear as a debit in the balance of payments account. Answer (C) is incorrect because a U.S. exporter’s purchase of marine insurance from a British insurance company represents imports by the U.S. of insurance services. Answer (D) is correct. Exports help a country’s balance of payments and are therefore considered a credit in the U.S. balance of payments account. Thus, the Iowa farmer’s export of grain to Turkey is recorded as a credit.

[1037] Gleim #: 7.105 -- Source: CMA 1282 1-12 One may characterize the current international monetary system developed by the industrialized countries as a

A. B. C. D.

Clean float. Freely floating exchange rates are determined solely by the forces of demand and supply. Managed or dirty float. Central banks intervene in the foreign exchange market to influence the exchange rates. Stable-rate system. Gold-based system. Answer (A) is incorrect because a clean float system does not exist owing to central bank intervention. Answer (B) is correct. Today’s international monetary system usually permits exchange rates to float freely. However, central banks occasionally intervene to avoid large fluctuations. Accordingly, the system is called a managed or dirty float system. Answer (C) is incorrect because as a result of the floating exchange rate system, rates are not stable. Answer (D) is incorrect because the gold-based system was abandoned in 1973.


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[1038] Gleim #: 7.106 -- Source: CMA 1282 1-13 An overvalued currency may be considered a

A. B. C. D.

Tax on exports and a subsidy to imports. Tax on imports and a subsidy to exports. Tax on both exports and imports. Subsidy to both exports and imports. Answer (A) is correct. If a currency is overvalued relative to a foreign currency, it will purchase more of that currency, thereby encouraging imports of foreign goods. Similarly, exports are discouraged because the foreign currency will purchase less of the overvalued currency. Therefore, an overvalued currency operates as a tax on exports and a subsidy to imports. Answer (B) is incorrect because the effect of an undervalued currency is a tax on exports and a subsidy to imports. Answer (C) is incorrect because overvaluation does not operate as a tax on imports. Answer (D) is incorrect because overvaluation does not operate as a subsidy to exports.

[1039] Gleim #: 7.107 -- Source: CMA 1285 1-31 The U.S. balance of trade is decreased by

A. B. C. D.

Foreign investments in the United States. U.S. investments in foreign countries. U.S. exports. U.S. imports. Answer (A) is incorrect because foreign investments in the United States is a factor in the balance of payments but not trade. Answer (B) is incorrect because U.S. investments in foreign countries is a factor in the balance of payments but not trade. Answer (C) is incorrect because exports increase the balance of trade. Answer (D) is correct. The balance of payments embraces all payments made by one nation to another, including capital movements. The balance of trade is the difference between imports and exports of goods and services over a given period. In T-account form, exports are credits and imports debits. Assuming that a credit balance reflects a positive balance of trade, imports will decrease a positive balance while exports will increase it.

[1040] Gleim #: 7.108 -- Source: CMA 1285 1-35 The basic objective of the International Monetary Fund is to

A. B. C. D.

Promote multilateral tariff reductions among nations. Provide long-term loans to member countries that want to improve their infrastructure. Provide a means of financing food imports so that more domestic resources can be shifted to industrialization. Provide short-term loans to member nations experiencing temporary balance of payments difficulties. Answer (A) is incorrect because the World Trade Organization (WTO) is an attempt by the signatory nations to reduce tariffs and import quotas. Answer (B) is incorrect because the World Bank provides credits for development purposes. Answer (C) is incorrect because the U.S. Food for Peace program permits other countries to purchase U.S. farm products with other currencies. Answer (D) is correct. The resources of the IMF consist of a pool of currency from which short-term loans can be made to member nations who are experiencing temporary balance of payments problems. Special drawing rights (SDRs) have also been created on the books of IMF to serve as an additional reserve for member nations to use in settling accounts.


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[1041] Gleim #: 7.109 -- Source: CMA 686 1-23 The economic reasoning dictating that each nation specialize in the production of goods that it produces relatively more efficiently than other nations and import those goods that are produced relatively more efficiently by other nations is called the doctrine of

A. B. C. D.

Efficient trade. Diminishing returns. Relative competition. Comparative advantage. Answer (A) is incorrect because efficient trade is not meaningful in this context. Answer (B) is incorrect because diminishing returns is not meaningful in this context. Answer (C) is incorrect because relative competition is not meaningful in this context. Answer (D) is correct. The doctrine of comparative advantage relates to comparative costs within one country. It holds that a country should produce those products in which it has a comparative advantage, not necessarily those products in which it has an absolute advantage. The doctrine suggests that a country should produce those products for which the greatest efficiencies are attainable even if it could also produce other goods more efficiently than another nation. In the long run, importing a product in which a country has an absolute advantage but not a comparative advantage will result in an overall increase in global production.

[1042] Gleim #: 7.110 -- Source: CMA 1286 1-16 The balance of trade is the

A. B. C. D.

Same as the balance of the current account. Balance on the capital account. Balance on all international transactions. Balance on the goods transactions in the current account. Answer (A) is incorrect because the balance in the current account contains financial balances, but the balance of trade is concerned only with the balance of transactions in goods and services. Answer (B) is incorrect because the capital account records net capital movements, not the balance of trade. Answer (C) is incorrect because the balance of all international transactions includes items that are not goods or services, such as net capital movements, government transactions, and remittances. Answer (D) is correct. The balance of payments embraces all payments made by one nation to another, including capital movements. The balance of trade is the difference between imports and exports of goods and services over a given period. In T-account form, exports are credits and imports debits. Assuming that a credit balance reflects a positive balance of trade, imports will decrease a positive balance while exports will increase it.

[Fact Pattern #81] Suppose that 2 worker-hours are required to produce a clock radio in Japan, while 3 are required to do the same in Germany. In addition, 4 worker-hours are required to produce a television in Japan, while 5 are required to do the same in Germany. [1043] Gleim #: 7.111 -- Source: CMA 1286 1-21 (Refers to Fact Pattern #81) Under conditions appropriate for free trade, both Japan and Germany would be better off if


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A. Japan produces only televisions while Germany produces only clock radios and both use trade to meet the needs for the item not produced locally. B. Japan produces only clock radios while Germany produces only televisions and both use trade to meet the needs of the item not produced locally. C. Both produce some of each item and use trade to meet additional needs of a product. D. Both Japan and Germany produce both products for internal use only with no need for international trade. Answer (A) is incorrect because Japan and Germany should specialize in producing the product which they have a comparative advantage. Answer (B) is correct. Japan has a comparative advantage in radio production because its cost of producing radios is a smaller fraction of its cost of producing TV sets (2/4 = .5) than is true for Germany (its fraction is 3/5 = .6). Germany has a comparative advantage with regard to TV set production because its costs of producing TV sets (5/3 = 1.67) is a smaller fraction of its cost of producing radios than is true for Japan (its fraction is 4/2 = 2). Under the theory of comparative advantage, Japan should manufacture radios, Germany should make TV sets, and both should trade for what they do not produce. Answer (C) is incorrect because Japan and Germany should specialize in producing the product which they have a comparative advantage. Answer (D) is incorrect because Japan and Germany should specialize in producing the product which they have a comparative advantage. [1044] Gleim #: 7.112 -- Source: CMA 1293 1-27 The economic term used to describe the situation in which each nation specializes in the production of goods that it produces relatively more efficiently than other nations and imports those goods that are produced relatively more efficiently by other nations is called

A. B. C. D.

Balance of trade. Diminishing returns. Relative competition. Comparative advantage. Answer (A) is incorrect because the balance of trade is the difference between imports and exports of goods. Answer (B) is incorrect because beyond some level of output, returns diminish as more and more units of an input are added to the production process. Answer (C) is incorrect because relative competition is not a term relevant to international economics. Answer (D) is correct. The relevant concept is comparative advantage, which compares the costs of inputs within a single country. In contrast, the concept of absolute advantage compares the costs of inputs between countries. It is possible that a country might have an absolute advantage with respect to every product, but comparative advantage is different from absolute advantage. A particular nation can have a comparative advantage even though it does not have an absolute advantage. For example, assume that Country A can produce Item X for $100 and Item Y for $200 and that Country B can produce Item X for $50 and Item Y for $150. B has an absolute advantage in the production of both products; however, B has a comparative advantage in producing Item X (50 ÷ 100, or 50% of the A cost, compared with 150 ÷ 200, or 75% of the A cost for Item Y). A has a comparative advantage in producing Item Y (200 ÷ 150, or 133% of the B cost, versus 100 ÷ 50, or 200% for Item X). A nation will benefit by exporting goods in which it has a comparative advantage and importing goods in which it does not have a comparative advantage. Total output will be maximized when each nation specializes in the products in which it has the greatest comparative advantage or the least comparative disadvantage.

[1045] Gleim #: 7.113 -- Source: CIA 1193 IV-68 Which of the following provides the best justification for reducing trade barriers among nations?


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A. B. C. D.

The military self-sufficiency argument. Diversification for stability argument. The infant industry argument. Increased total world output argument. Answer (A) is incorrect because military self-sufficiency is an argument for increasing trade barriers. Answer (B) is incorrect because diversification for stability is an argument for increasing trade barriers by promoting industrial diversification and less dependence on other nations for certain products. Answer (C) is incorrect because protection of infant industries is an argument for increasing trade barriers for the purpose of allowing new domestic industries to establish themselves. Answer (D) is correct. The general effect of free trade would be to maximize world output because resources in each country would be deployed most efficiently according to the principle of comparative advantage. Comparative advantage means that a country can produce a greater output of certain goods for a given level of input than other goods. Thus, that country should specialize in and export the goods it can produce most efficiently. Total world output will increase in these circumstances.

[1046] Gleim #: 7.114 -- Source: CIA 1190 IV-58 A U.S. company and a German company purchased the same stock on the German stock exchange and held the stock for 1 year. The value of the euro weakened against the dollar over this period. Comparing the returns of the two companies, the United States company’s return will be

A. B. C. D.

Lower. Higher. The same. Higher in the short-run but lower in the long-run. Answer (A) is correct. The returns on the stock are presumably paid in euros. Hence, the change in the value of the euro relative to the dollar does not affect the German company’s return. However, the weakening of the euro reduces the number of dollars it will buy, and the U.S. company’s return in dollars is correspondingly reduced. Answer (B) is incorrect because the return to the U.S. company is adversely affected by the exchange rate movement. Answer (C) is incorrect because the return to the U.S. company is adversely affected by the exchange rate movement. Answer (D) is incorrect because the return to the U.S. company was directly and adversely affected by the exchange rate movement in the short-run, but the return to the German company was not.

[1047] Gleim #: 7.115 -- Source: CMA 694 1-5 All of the following are true about international trade except that

A. The gains from international trade depend on specialization with comparative advantage. B. Absolute advantage without comparative advantage does not result in gains from international trade. C. Absolute advantage is defined as the ability of one nation to produce a product at a relatively lower opportunity cost than another nation. D. If there is reciprocal absolute advantage between two countries, specialization will make it possible to produce more of each product.


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Answer (A) is incorrect because world output will be maximized if each country specializes in those products in which they have a comparative advantage. Answer (B) is incorrect because comparative advantage, not absolute advantage, determines the products in which a country should specialize. Answer (C) is correct. The concept of comparative advantage compares costs within a single country. It is the ability of one nation to produce a product at a relatively lower opportunity cost (benefits forgone) than another nation. Absolute advantage compares the costs of inputs between countries. One country might have an absolute advantage with respect to every product. However, total output will be maximized when each nation specializes in the products in which it has the lowest opportunity costs, that is, a comparative advantage. Answer (D) is incorrect because given a reciprocal absolute advantage, a corresponding comparative advantage will exist. [1048] Gleim #: 7.116 -- Source: CIA 597 IV-76 General sales taxes tend to be regressive with respect to income because

A. B. C. D.

A larger portion of a lower income person’s income is subject to the tax. A smaller portion of a lower income person’s income is subject to the tax. The tax rate is higher for person with lower income. The tax claims an increasing amount of income as income rises. Answer (A) is correct. A sales tax is regressive with respect to income even though the rate is the same regardless of the buyer’s income. The reason is that a greater percentage of a low-income individual’s income is exposed to the tax. A higher-income individual should be able to save more and therefore shield a greater percentage of his/her income from the tax. Answer (B) is incorrect because a larger portion of a lower-income person’s income is subject to the tax. Answer (C) is incorrect because the general sales tax rate is uniform for all taxpayers. Answer (D) is incorrect because, if the tax claims an increasing amount of income as income rises, it is progressive, not regressive.

[1049] Gleim #: 7.117 -- Source: Publisher Under a value-added taxing system

A. B. C. D.

Businesses must pay a tax only if they make a profit. The consumer ultimately bears the incidence of the tax through higher prices. Consumer savings are discouraged. The amount of value added is the difference between a firm’s sales and its cost of goods sold. Answer (A) is incorrect because businesses must pay a value-added tax regardless of whether they make a profit. Answer (B) is correct. A value-added tax is based on consumption. The tax is levied on the value added to goods by each business unit in the production and distribution chain. It is the consumer who ultimately bears the incidence of the tax because businesses subject to the tax will raise prices to offset the operating cost of the tax. Answer (C) is incorrect because a value-added tax encourages savings. This tax is paid only on consumption, not savings. Answer (D) is incorrect because the amount of value added is the difference between a firm’s sales and its purchases.

[1050] Gleim #: 7.118 -- Source: CIA 594 IV-57 The gross domestic product (GDP) does not measure:


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A. B. C. D.

National economic performance. Market-oriented activity. Improvements in product quality. The size of national output. Answer (A) is incorrect because GDP does measure national economic performance. GDP can be measured as the total of all output in the economy or total income. Answer (B) is incorrect because GDP does measure market-oriented activity. GDP can be measured as the total of all output in the economy or total income. Answer (C) is correct. GDP is the total market value of all final goods and services produced within the boundaries of the U.S. in one year, without regard to ownership of the means of production. It is a monetary measure of quantitative data, not qualitative characteristics. Thus, improvements in product quality are not measured by GDP. Answer (D) is incorrect because GDP does measure the size of national output. GDP can be measured as the total of all output in the economy or total income.

[1051] Gleim #: 7.119 -- Source: CIA 1193 IV-64 The Gross Domestic Product (GDP) will fall following an increase in

A. B. C. D.

Consumption expenditures. Imports. Exports. Inflation. Answer (A) is incorrect because an increase in consumption expenditures increases GDP. Answer (B) is correct. By definition, GDP determined using the expenditures approach equals the sum of consumption, investment, government purchases of goods and services, and net exports (exports – imports). Thus, a rise in imports will cause a fall in net exports and GDP. Answer (C) is incorrect because an increase in exports increases GDP. Answer (D) is incorrect because an increase in inflation increases GDP.

[1052] Gleim #: 7.120 -- Source: CIA 1194 IV-59 Under the “output” approach, gross domestic product (GDP) is measured as

A. B. C. D.

Non-income charges or allocations + wages + rents + interest. Non-income charges or allocations + wages + rents + interest + profits. Consumption expenditures + investment + government purchases + interest. Consumption expenditures + investment + government purchases + expenditures by foreigners.


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Answer (A) is incorrect because the income or allocations approach adds the money income from production of the year’s output. This approach to GDP measurement adds nonincome charges or allocations, wages, rents, interest, and profits. From this amount, net American income earned abroad is subtracted. Answer (B) is incorrect because the income or allocations approach adds the money income from production of the year’s output. This approach to GDP measurement adds nonincome charges or allocations, wages, rents, interest, and profits. From this amount, net American income earned abroad is subtracted. Answer (C) is incorrect because the output approach does not include interest, but includes expenditures by foreigners. Answer (D) is correct. GDP is the total value of all goods and services produced in the U.S., regardless of the ownership of the means of production. GDP can be measured using an income or output (expenditures) approach. The output approach measures the amount spent to purchase the year’s total output. Using this approach, GDP is calculated by adding consumption expenditures by households, investment expenditures by businesses, government purchases of goods and services, and expenditures by foreigners. [1053] Gleim #: 7.121 -- Source: CIA 1195 IV-57 In the output or “expenditures” approach to measuring a country’s Gross Domestic Product, which of the following calculations is used?

A. B. C. D.

Consumption + Investment + Government Purchases + Expenditures by Foreigners. Consumption + Investment + Government Purchases – Expenditures by Foreigners. Consumption + Investment – Government Purchases – Expenditures by Foreigners. Consumption – Investment – Government Purchases – Expenditures by Foreigners. Answer (A) is correct. GDP can be calculated using an income approach or an expenditures approach because what is spent on a product or service is income to those who contributed resources to its production and marketing. Thus, the amount spent to purchase the GDP is identical with the income derived from its production and sale. Under the output or expenditures approach, GDP equals the sum of consumption expenditures by households, investment by business, government purchases of goods and services, and expenditures by foreigners (net exports). Answer (B) is incorrect because consumption, investment, government purchases, and expenditures by foreigners (net exports) are added to determine GDP. Answer (C) is incorrect because consumption, investment, government purchases, and expenditures by foreigners (net exports) are added to determine GDP. Answer (D) is incorrect because consumption, investment, government purchases, and expenditures by foreigners (net exports) are added to determine GDP.

[1054] Gleim #: 7.122 -- Source: Publisher Which of the following does the internal auditor not have to review as thoroughly in a lump-sum contract?

A. B. C. D.

Progressive payments. Adjustments to labor costs. Work completed in accordance with the contract. Incentives associated with the contract.


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Answer (A) is incorrect because the internal auditor should ensure that the contractor is receiving payment in order to meet expenses and complete the contract. Answer (B) is incorrect because adjustments to labor cost may change the profitability of the contract and are of great importance to the internal auditor. Answer (C) is correct. The internal auditor usually has little to evaluate when the work is performed in accordance with the contract. Further, the internal auditor may lack the technical expertise to know if the contract is being completed according to the terms. Answer (D) is incorrect because incentives such as a bonus for early completion effect the overall profitability of the contract and are frequently reviewed by the internal auditor. [1055] Gleim #: 7.123 -- Source: CIA 1194 IV 71 A nation has a progressive tax structure with income tax brackets that are not indexed to inflation. An individual taxpayer experiences an income increase just equal to the general inflation rate and moves into a higher tax bracket. The individual taxpayer will then experience nominal taxes payable and real taxes payable.

List A

List B

A. B.

Increasing Increasing

Increasing Decreasing

C. D.

Decreasing Decreasing

Increasing Decreasing

Answer (A) is correct. Because the taxpayer’s income increase is equal to the general inflation rate, no real increase in income has occurred. However, some or all of the increase is subject to a higher tax rate. Accordingly, the taxpayer will experience an increase in both nominal taxes payable and in real taxes payable. Answer (B) is incorrect because real taxes payable and nominal taxes payable will increase. Answer (C) is incorrect because real taxes payable and nominal taxes payable will increase. Answer (D) is incorrect because real taxes payable and nominal taxes payable will increase. [1056] Gleim #: 7.124 -- Source: CIA 1194 IV 72 A value-added tax is collected on the basis of

A. B. C. D.

The difference between the value of a firm’s sales and the value of its purchases from other domestic firms. The difference between the selling price of a real estate property and the amount the firm originally paid for it. The value of a firm’s sales to related companies. The profit earned on a firm’s sales. Answer (A) is correct. A value-added tax is similar to a retail sales tax on consumer goods. It is applied to the difference between the value of a firm’s sales and the value of its purchases from other firms, that is, to the value added to the input. In effect, a value-added tax is a national tax that penalizes consumption. Answer (B) is incorrect because the difference between the selling price of a real estate property and the amount the firm originally paid for it is taxed as capital gain. Answer (C) is incorrect because the value of a firm’s sales to related companies is the internal transfer price. Answer (D) is incorrect because the profit earned on a firm’s sales is subject to income tax.

[1057] Gleim #: 7.125 -- Source: CIA 595 IV 66 An enterprise in a 40% tax bracket needs of operating income to pay 1 of interest and of pretax income to pay 1 of dividends.


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List A

List B

A.

.60

.60

B. C.

1.00 1.00

1.00 1.67

D.

1.67

1.00

Answer (A) is incorrect because at least 1.00 of operating income will be needed to pay 1.00 of either interest or dividends. Answer (B) is incorrect because 1.67 of pretax income is required to pay 1.00 of dividends. Answer (C) is correct. Interest is deductible from operating income to obtain taxable income but dividends are not. Thus, only 1.00 of pretax income is needed to pay 1.00 of interest, but 1.67 of pretax income [1.00 ÷ (1.0 – .4)] is needed to pay 1.00 of dividends if the enterprise is in a 40% tax bracket. Answer (D) is incorrect because 1.00 of operating income is needed to pay 1.00 of interest, and 1.67 of pretax income is needed to pay 1.00 of dividends. [1058] Gleim #: 7.126 -- Source: CIA 595 IV 68 An enterprise produces a good in country A and sells some of its output in country B. Selling prices are identical in the two countries. The corporate tax rates are 40% in country A and 20% in country B. Assuming that the enterprise does not increase or decrease production, it should sales in country B and set as a transfer price as possible, in order to minimize global taxes.

List A

List B

A.

Maximize

High

B. C.

Maximize Minimize

Low High

D.

Minimize

Low

Answer (A) is incorrect because, if selling prices are identical, the tax-minimizing strategy involves maximizing sales in country B. However, to report the highest possible profits in the lower tax country, input costs must be minimized. The transfer price paid to the production facility in country A must therefore be set as low as possible. Answer (B) is correct. The tax-minimizing strategy is to minimize taxable income where tax rates are high and to maximize taxable income where tax rates are low. Consequently, the company should sell more in country B but set a low transfer price. This dual strategy minimizes sales and profits in country A, minimizes cost of sales in country B, and maximizes sales and profits in country B. Answer (C) is incorrect because a strategy of minimizing sales in country B and maximizing reported cost of goods sold in country B would result in the lowest reported profit in the lower tax country, thereby maximizing taxes paid. Answer (D) is incorrect because the tax-minimizing strategy involves maximizing sales revenue in the lower tax country, not minimizing it. [1059] Gleim #: 7.127 -- Source: CIA 595 IV-69 Value-added taxes are levied on

A. B. C. D.

Interest income received by individual owners of publicly traded bonds. Dividend income received by corporations owning shares of other corporations. The value of a firm’s assets. The difference between a firm’s sales and its purchases from other firms.


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Answer (A) is incorrect because value-added taxes are not levied on personal interest income. Answer (B) is incorrect because value-added taxes are not levied on corporate dividend income. Answer (C) is incorrect because value-added taxes are not levied on the value of a firm’s assets. Answer (D) is correct. A value-added tax is levied on the value a firm adds to a good or service. This amount is measured as the difference between the value of a firm’s sales and the value of its purchases from other firms. A value-added tax is therefore similar to a retail sales tax. It is equivalent to a national sales tax on consumer goods. By penalizing consumption, it encourages saving and investment. [1060] Gleim #: 7.128 -- Source: CIA 1195 IV 71 An increase in excise taxes will generate tax revenue if it is levied on products for which demand is elastic.

List A

List B

A. B.

More More

More Less

C. D.

Negative Less

Less Less

Answer (A) is incorrect because price elasticity of demand is inversely correlated with the revenue effects of an increase in excise taxes. Answer (B) is correct. A higher excise tax increases the selling price of the product. This price increase will have a less negative effect on sales volume for products with less elastic demand. Examples of products with low elasticity of demand include gasoline, tobacco, and alcohol. The tax revenue generated by an increase in excise taxes is therefore higher if the tax is levied on products with less elastic demand. Answer (C) is incorrect because price elasticity of demand is inversely correlated with the revenue effects of an increase in excise taxes. Answer (D) is incorrect because price elasticity of demand is inversely correlated with the revenue effects of an increase in excise taxes. [1061] Gleim #: 7.129 -- Source: IIA, adapted Which of the following is a tool of monetary policy that a nation’s central bank could use to stabilize the economy during an inflationary period?

A. B. C. D.

Selling government securities. Lowering bank reserve requirements. Lowering bank discount rates. Encouraging higher tax rates. Answer (A) is correct. Selling government securities is contractional because it takes money out of circulation. Answer (B) is incorrect because lower reserve requirements would fuel the economy because banks could lend more money. Answer (C) is incorrect because lower discount rates would fuel the economy because borrowing would be encouraged. Answer (D) is incorrect because this is fiscal policy, not monetary policy.

[1062] Gleim #: 7.130 -- Source: IIA, adapted If a country uses trade quotas to overcome chronic trade deficits, the most likely outcome would be that


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A. B. C. D.

Unemployment and productivity rates will rise. Unemployment rates will rise and productivity rates will decline. Unemployment rates will decline and productivity rates will rise. Unemployment and productivity rates will decline. Answer (A) is incorrect because unemployment and productivity rates will decline. Answer (B) is incorrect because jobs in the home country are saved, lowering unemployment. Answer (C) is incorrect because productivity rates decline due to the protection of inefficient industry. Answer (D) is correct. With trade quotas, home jobs will be saved; hence, unemployment will decline. Since jobs will be saved for inefficient industries (less efficient than foreign competitors), productivity rates will decline because they will not be specializing in those goods with which they have a comparative advantage.

[1063] Gleim #: 7.131 -- Source: IIA, adapted Which of the following correctly describes the introduction of a government tax credit on investments?

A. B. C. D.

Corporate investments will have higher net present values, all else equal, than without the tax credit. Tax credits on investments are designed to restrain inflation. Tax credits on investments increase investment costs, and all else equal, reduce the level of corporate investment. Tax credits on investments are taxes that are typically levied on individual projects rather than on groups of projects. Answer (A) is correct. An investment tax credit is an incentive because it directly reduces future tax payments. Thus, corporate investments will have higher net present values, all else equal, than without tax credits. Answer (B) is incorrect because tax credits reduce the corporate tax bill. With more profits available for dividends, inflation will not be restrained. Answer (C) is incorrect because, if other factors are held constant, future net cash inflows from an investment are increased by tax credits. Hence, tax credits make investment more attractive. Answer (D) is incorrect because investment tax credits are not taxes levied on projects.

[1064] Gleim #: 7.132 -- Source: IIA, adapted Revenue tariffs are designed to

A. B. C. D.

Develop new export opportunities. Provide the government with tax revenues. Restrict the amount of a commodity that can be imported in a given period. Encourage foreign companies to limit the amount of their exports to a particular country. Answer (A) is incorrect because export opportunities apply to domestic products. Answer (B) is correct. Revenue tariffs are usually applied to products that are not produced domestically. Their purpose is to provide the government with tax revenue. Answer (C) is incorrect because import quotas are designed to restrict the amount of a commodity that can be imported in a period of time. Answer (D) is incorrect because voluntary export restrictions, which have the same effect as import quotas, encourage foreign firms to limit their exports to a particular country.


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[1065] Gleim #: 7.133 -- Source: IIA, adapted A company would like to contract for janitorial services for one year with four option years. The specifications require the potential contractor to perform certain cleaning services at specified intervals. Which of the following is the best contract type for this requirement?

A. B. C. D.

Cost-reimbursable. Indefinite delivery. Fixed-price. Time-and-materials. Answer (A) is incorrect because cost-reimbursable contracts are used when the requirements are complex and costs cannot be easily identified and estimated. Answer (B) is incorrect because indefinite delivery contracts are used only when the supplies and/or service of future deliveries are not known at the time of contract award. Answer (C) is correct. Fixed-price contracts are used when the requirements are well-defined, uncertainties can be identified and costs estimated, and there is adequate competition. Answer (D) is incorrect because time-and-materials contracts are used when it is not possible at the time of placing the contract to estimate accurately the duration of the work.

[1066] Gleim #: 7.134 -- Source: IIA, adapted Which of the following refers to taxes that do not necessarily take a larger absolute share of an increase in income?

A. B. C. D.

Progressive. Proportional. Regressive. Flat. Answer (A) is incorrect because progressive taxes, for which the average tax rate rises as income rises, take both a larger percentage of income and a larger absolute amount of income as income rises. Answer (B) is incorrect because proportional taxes, for which the average tax rate is constant for all income levels, always take a larger absolute amount of income as income rises. Answer (C) is correct. Regressive taxes are those for which the average tax rate falls as income rises. They take a smaller percentage of income as income rises, so they will not necessarily take a larger absolute amount of income as income rises. Answer (D) is incorrect because a flat tax would have the same percentage tax rate regardless of income and would therefore take a larger absolute amount of income as income rises.

[1067] Gleim #: 7.135 -- Source: IIA, adapted Temporary and permanent differences between taxable income and pre-tax financial income differ in that

A. B. C. D.

Temporary differences do not give rise to future taxable or deductible amounts. Only permanent differences have deferred tax consequences. Only temporary differences have deferred tax consequences. Temporary differences include items that enter into pre-tax financial income but never into taxable income.


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Answer (A) is incorrect because it is temporary differences that result in taxable or deductible amounts in some future year(s), when the reported amounts of assets are recovered and the reported amounts of liabilities are settled. Answer (B) is incorrect because temporary differences have deferred tax consequences while the permanent differences do not. Permanent differences affect only the period in which they occur. Answer (C) is correct. Permanent differences have no deferred tax consequences because they affect only the period in which they occur. Permanent differences include (1) items that enter into pre-tax financial income but never into taxable income and (2) items that enter into taxable income but never into pre-tax financial income. In contrast, temporary differences result in taxable or deductible amounts in some future year(s), when the reported amount of assets are recovered and the reported amount of liabilities are settled. Temporary differences therefore do have deferred tax consequences while permanent differences do not. Answer (D) is incorrect because permanent differences, not temporary differences, include items that enter into pre-tax financial income but never into taxable income. [1068] Gleim #: 7.136 -- Source: IIA, adapted A value-added tax is collected on the basis of

A. B. C. D.

The difference between the value of a company’s sales and the value of its purchases from other domestic companies. The difference between the selling price of real property and the price the company originally paid for the property. The value of a company’s sales to related companies. The profit earned on a company’s sales. Answer (A) is correct. A value-added tax is collected on the basis of the value created by the firm. This is measured as the difference between the value of its outputs and its inputs. Answer (B) is incorrect because this is a description of how to calculate capital gains tax. Answer (C) is incorrect because this is a description of an internal transfer price. Answer (D) is incorrect because this is a description of how to calculate income tax.

[1069] Gleim #: 8.1 -- Source: CIA 1189 I-24 Which of the following statements accurately describes the impact that automation has on the controls normally present in a manual system?

A. Transaction trails are more extensive in a computer-based system than in a manual system because there is always a one-for-one correspondence between data entry and output. B. Responsibility for custody of information assets is more concentrated in user departments in a computer-based system than it is in a manual system. C. Controls must be more explicit in a computer-based system because many processing points that present opportunities for human judgment in a manual system are eliminated. D. The quality of documentation becomes less critical in a computer-based system than it is in a manual system because data records are stored in machine-readable files. Answer (A) is incorrect because the “paper trail” is less extensive in an information system. Combining processing and controls within the system reduces documentary evidence. Answer (B) is incorrect because information assets are more likely to be under the control of the information system function. Answer (C) is correct. Using a computer does not change the basic concepts and objectives of control. However, the use of computers may modify the control techniques used. The processing of transactions may be combined with control activities previously performed separately, or control function may be combined within the information system activity. Answer (D) is incorrect because documentation is more important in an information system. Information is more likely to be stored in machine-readable form than in hard copy.


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[1070] Gleim #: 8.2 -- Source: Publisher The two broad groupings of information systems control activities are general controls and application controls. General controls include controls

A. B. C. D.

Relating to the correction and resubmission of faulty data. For developing, modifying, and maintaining computer programs. Designed to assure that only authorized users receive output from processing. Designed to ensure that all data submitted for processing have been properly authorized. Answer (A) is incorrect because control over report distribution (output), correction of input errors, and authorization of input are application controls. Answer (B) is correct. General controls are policies and procedures that relate to many information systems application and support the effective functioning of application controls by helping to ensure the continued proper operation of information systems. General controls include controls over (1) data center and network operations, (2) systems software acquisition and maintenance, (3) access security, and (4) application systems acquisition, development, and maintenance (AU 319). Control over report distribution (output), correction of input errors, and authorization of input are application controls. Answer (C) is incorrect because control over report distribution (output), correction of input errors, and authorization of input are application controls. Answer (D) is incorrect because control over report distribution (output), correction of input errors, and authorization of input are application controls.

[1071] Gleim #: 8.3 -- Source: CIA 590 I-20 The practice of maintaining a test program library separate from the production program library is an example of

A. B. C. D.

An organizational control. Physical security. An input control. A concurrency control. Answer (A) is correct. This separation is an organizational control. Organizational controls concern the proper segregation of duties and responsibilities within the information systems department. Although proper segregation is desirable, functions that would be considered incompatible if performed by a single individual in a manual activity are often performed through the use of an information systems program or series of programs. Thus, compensating controls may be necessary, such as library controls, effective supervisions, and rotation of personnel. Segregating test programs makes concealment of unauthorized changes in production programs more difficult. Answer (B) is incorrect because physical security (e.g., climate control and restrictions on physical access) is another aspect of organizational control. Answer (C) is incorrect because input controls validate the completeness, accuracy, and appropriateness of input. Answer (D) is incorrect because concurrency controls manage situations in which two or more programs attempt to use a file or database at the same time.

[1072] Gleim #: 8.4 -- Source: CIA 596 III-75 In traditional information systems, computer operators are generally responsible for backing up software and data files on a regular basis. In distributed or cooperative systems, ensuring that adequate backups are taken is the responsibility of


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A. B. C. D.

User management. Systems programmers. Data entry clerks. Tape librarians. Answer (A) is correct. In distributed or cooperative systems, the responsibility for ensuring that adequate backups are taken is the responsibility of user management. The systems are under the control of users, not a central information processing department. Answer (B) is incorrect because distributed environments have no systems programmers comparable to those at central sites for traditional systems. Answer (C) is incorrect because distributed environments may not have data entry clerks. Users typically perform their own data entry. Answer (D) is incorrect because, in distributed environments, there are no tape librarians.

[1073] Gleim #: 8.5 -- Source: CIA 1196 III-55 An organization’s computer help-desk function is usually a responsibility of the

A. B. C. D.

Applications development unit. Systems programming unit. Computer operations unit. User departments. Answer (A) is incorrect because applications development is responsible for developing systems, not providing help to end-users. Answer (B) is incorrect because the responsibility of systems programming is to implement and maintain system-level software such as operating systems, access control software, and database systems software. Answer (C) is correct. Help desks are usually a responsibility of computer operations because of the operational nature of their functions. A help desk logs reported problems, resolves minor problems, and forwards more difficult problems to the appropriate information systems resources, such as a technical support unit or vendor assistance. Answer (D) is incorrect because user departments usually lack the expertise to solve computer problems.

[1074] Gleim #: 8.6 -- Source: CIA1195 I-32 Most large-scale computer systems maintain at least three program libraries: production library (for running programs); source code library (maintains original source coding); and test library (for programs which are being changed). Which of the following statements is correct regarding the implementation of sound controls over computer program libraries?

A. B. C. D.

Only programmers should have access to the production library. Users should have access to the test library to determine whether all changes are properly made. Only the program librarian should be allowed to make changes to the production library. The computer operator should have access to both the production library and the source code library to assist in diagnosing computer crashes.


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Answer (A) is incorrect because effective control requires that programmers not be able to make undetected, unrecorded changes in data or programs. Thus, programmers should not have access to the production library. Answer (B) is incorrect because programmers should be responsible for making program changes, and users should be responsible for testing the changes. Hence, users should not have access to the test library. Accountability for changes would be diminished. Moreover, users may lack the competence to make appropriate changes. Answer (C) is correct. The program librarian is accountable for, and has custody of, the programs in the production library. Answer (D) is incorrect because, if the operator has access to both program libraries, (s)he may be able to make unauthorized and undetected changes to the computer programs. [1075] Gleim #: 8.7 -- Source: CIA 597 III-46 Which of the following would not be appropriate to consider in the physical design of a data center?

A. B. C. D.

Evaluation of potential risks from railroad lines and highways. Use of biometric access systems. Design of authorization tables for operating system access. Inclusion of an uninterruptible power supply system and surge protection. Answer (A) is incorrect because external risks should be evaluated to determine the center’s location. Answer (B) is incorrect because biometric access systems control physical access to the data center. These devices identify such unique physical qualities as fingerprints, voice patterns, and retinal patterns. Answer (C) is correct. Authorization tables for operating system access address logical controls, not physical controls. Answer (D) is incorrect because power supply systems and surge protection are included in data center design. Thus, two separate power lines, line conditioning equipment, and backup battery power or a generator are typical elements in the design.

[1076] Gleim #: 8.8 -- Source: CIA 1193 III-20 What type of information system uses communications capabilities to make needed data and computing capability available to end users at separate locations?

A. B. C. D.

Distributed processing system. Time-sharing system. Online processing system. Personal computing system. Answer (A) is correct. The advent of less expensive and smaller computers has permitted the development of a different alternative to centralization or decentralization. In a distributed data processing system, the organization’s processing needs are examined in their totality. The decision is not whether an application should be done centrally or locally but, rather, which parts of the application are better performed by smaller local computers and which parts are better performed at some other, possibly centralized, site. In essence, the best distribution of processing tasks within application areas is sought. The key distinction between decentralized and distributed systems is the interconnection among the nodes (sites) in the network. Answer (B) is incorrect because time-sharing systems are terminal-oriented systems that are connected to a central processing site. Answer (C) is incorrect because an online processing system operates under direct control of the CPU. Answer (D) is incorrect because a personal computing system is a microcomputer resource dedicated to a single user, usually in a stand-alone configuration.


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[1077] Gleim #: 8.9 -- Source: CIA 1196 III-51 Even though an organization is committed to using its mainframe for its manufacturing plant operations, it has been looking for ways to downsize other applications. The purpose of downsizing is to

A. B. C. D.

Improve reliability. Improve security. Reduce complexity. Decrease costs. Answer (A) is incorrect because client-server technology used in downsizing is less reliable. Answer (B) is incorrect because security is usually better on a mainframe. Answer (C) is incorrect because downsizing applications often increases their complexity. The data files become fragmented across multiple systems. Answer (D) is correct. The purpose of downsizing is to reduce costs of applications by abandoning larger, more expensive systems in favor of smaller, less expensive systems that are more versatile. However, downsized applications are less reliable than their mainframe predecessors because they are new and have not been used extensively. Typically, downsized client-server implementations lack the monitoring and control features that permit recovery from minor processing interruptions.

[1078] Gleim #: 8.10 -- Source: CMA 695 4-13 In distributed data processing, a ring network

A. Has all computers linked to a host computer, and each linked computer routes all data through the host computer. B. Links all communication channels to form a loop, and each link passes communications through its neighbor to the appropriate location. C. Attaches all channel messages along one common line with communication to the appropriate location via direct access. D. Organizes itself along hierarchical lines of communication usually to a central host computer. Answer (A) is incorrect because a star network routes all data through the host computer. Answer (B) is correct. In a distributed system, an organization’s processing needs are examined in their totality. The decision is not whether an application should be done centrally or locally, but rather which parts are better performed by small local computers as intelligent terminals, and which parts are better performed at some other, possibly centralized, site. The key distinction between decentralized and distributed systems is the interconnection among the nodes in the network. A ring network links all communication channels to form a loop and each link passes communications through its neighbor to the appropriate location. Answer (C) is incorrect because a bus network attaches all channel messages along one common line with communication to the appropriate location via direct access. Answer (D) is incorrect because a tree configuration is organized along hierarchical lines to a host computer. [1079] Gleim #: 8.11 -- Source: D. Payne Regardless of the language in which an application program is written, its execution by a computer requires that primary memory contain

A. B. C. D.

A utility program. An operating system. Compiler. Assembly.


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Answer (A) is incorrect because utility programs are application programs that are usually attached to larger programs. They perform various activities, such as sorting data, merging files, converting data from one medium to another, and printing. Answer (B) is correct. An operating system (e.g., UNIX or Windows) is required in all computerized systems to oversee the elements of the CPU and the interaction of the hardware components. Answer (C) is incorrect because a compiler converts (compiles) a program written in a source language, such as FORTRAN, into machine language. Answer (D) is incorrect because an assembler translates an assembly language program into machine language. Assembly language uses mnemonic codes for each machine language instruction. [1080] Gleim #: 8.12 -- Source: CPA 1185 A-52 What type of computer processing system is characterized by data that are assembled from more than one location and records that are updated immediately?

A. B. C. D.

Personal computer systems. Data compression systems. Batch processing systems. Online, real-time systems. Answer (A) is incorrect because access from multiple locations is more typical of larger computer systems than of personal computer systems. Answer (B) is incorrect because data compression systems encode data to take up less storage space. Answer (C) is incorrect because batching of transactions requires assembly of data at one place and a delay in updating. Answer (D) is correct. Real-time processing involves processing an input record and receiving the output soon enough to affect a current decision-making process. In a real-time system, the user interacts with the system to control an ongoing activity. Online indicates that the decision maker is in direct communication with the computer. Online, realtime systems usually permit access to the main computer from multiple remote terminals.

[1081] Gleim #: 8.13 -- Source: CPA 1194 A-37 Misstatements in a batch computer system caused by incorrect programs or data may not be detected immediately because

A. B. C. D.

Errors in some transactions may cause rejection of other transactions in the batch. The identification of errors in input data typically is not part of the program. There are time delays in processing transactions in a batch system. The processing of transactions in a batch system is not uniform. Answer (A) is incorrect because the transactions within the batch are typically not contingent upon one another. Answer (B) is incorrect because edit checks can be incorporated into batch processing environments. However, the edit checks are used to test the transactions in batches. Answer (C) is correct. Transactions in a batch computer system are grouped together, or batched, prior to processing. Batches may be processed either daily, weekly, or even monthly. Thus, considerable time may elapse between the initiation of the transaction and the discovery of an error. Answer (D) is incorrect because a batch of transactions is typically processed uniformly.

[1082] Gleim #: 8.14 -- Source: CPA 594 A-16 Which of the following statements most likely represents a disadvantage for an entity that keeps data files on a server rather than on a manual system?


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A. B. C. D.

Attention is focused on the accuracy of the programming process rather than errors in individual transactions. It is usually easier for unauthorized persons to access and alter the files. Random error associated with processing similar transactions in different ways is usually greater. It is usually more difficult to compare recorded accountability with the physical count of assets. Answer (A) is incorrect because the focus on programming is an advantage of using a server. A software program allows transactions to be processed uniformly. Answer (B) is correct. In a manual system, one individual is usually assigned responsibility for maintaining and safeguarding the records. However, in a server environment, the data files may be subject to change by others without documentation or an indication of who made the changes. Answer (C) is incorrect because it describes a disadvantage of a manual system. Answer (D) is incorrect because the method of maintaining the files is independent of the ability to compare this information in the file with the physical count of assets.

[1083] Gleim #: 8.15 -- Source: Publisher Computers containing more than one central processing unit (CPU) are increasingly common. This feature enables a computer to execute multiple instructions from multiple programs simultaneously. This process is

A. B. C. D.

Time sharing. Multitasking. Multiprocessing. Batch processing. Answer (A) is incorrect because in time sharing, the CPU spends a fixed amount of time on each program. Answer (B) is incorrect because multitasking is multiprogramming on a single-user operating system. It is the process of having multiple programs active at a given time, although the CPU is executing instructions from only one program at a time. Answer (C) is correct. Multiprocessing greatly increases system efficiency by executing multiple programs on the same computer at the same time. In systems with only one CPU, although multiple programs may be active simultaneously, program instructions can only be executed for one of these programs at a time. Answer (D) is incorrect because batch processing entails execution of a list of instructions from beginning to end without interruption.

[1084] Gleim #: 8.16 -- Source: Publisher Which of the following statements about personal computers, midrange computers, and mainframe computers is true?

A. B. C. D.

Personal computers usually cost more than midrange computers but less than mainframes. Because of the increased use of personal computers, there will be little need for mainframes in the near future. Midrange computers must be programmed directly in machine language while mainframes use higher-level language. The cost per transaction to process on each type of computer has decreased in recent years.


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Answer (A) is incorrect because personal computers may cost less than $1,000. Relative to personal computers, midrange computers are more costly, more powerful, have more memory, and are able to interface with more peripheral equipment. Mainframes are large computers with many peripheral devices and large memories. There is virtually no upper limit on the cost of a mainframe. Answer (B) is incorrect because, although personal computers have become extremely popular, e.g., for word processing, databases, other business-related activities, and Internet use, large mainframes are still necessary for simulations and processing not possible on other smaller computers. Midrange computers fill the gap between personal and mainframe computers, and a relatively strong demand also exists for these types of processors, particularly for servers used in networks. Answer (C) is incorrect because all three computers ordinarily may be programmed in higher-level languages. Answer (D) is correct. Advances in technology have resulted in less expensive computers and increased computing power. The cost to process transactions on all kinds of computers has therefore decreased. [1085] Gleim #: 8.17 -- Source: CIA 1196 III-76 In the accounting department of a large organization, the most likely use of a CD-ROM would be to

A. B. C. D.

Create permanent audit trails of EDI transactions. Store images of documents received in the department. Record the front and back of checks returned from the bank. Provide a way to look up accounting standards and guidelines. Answer (A) is incorrect because creating permanent audit trails of EDI transaction sequences is likely to be accomplished with write once, read many times (WORM) devices. Answer (B) is incorrect because maintaining images of documents with graphical components is likely to be done with redundant arrays of inexpensive disks (RAID). This technology is a magnetic medium that provides a primary storage method for imaging systems. Answer (C) is incorrect because recording the front and back of checks in banking applications is likely to be done with a microform such as microfilm. Answer (D) is correct. CD-ROM (compact disk, read-only memory) is a fixed optical medium appropriate for storage of very large quantities of unchanging information. Researching standards is the best use of CD-ROM technology for an accounting department because the data are static enough for periodic updates to remain sufficiently current. CD-ROMs commonly use indexing and searching facilities that make reference works usable. However, the use of CD-ROMs will decline as the prices of erasable optical disks become more attractive.

[1086] Gleim #: 8.18 -- Source: CIA 594 III-21 Internal auditors often encounter different personal computer platforms in separate operating divisions or geographic locations. Which of the following statements is true? I. Most data and programs from one personal computer platform are transferable to another environment only through translation and emulation programs. II. Neither data nor programs are transferable when the hardware is not identical. III. Neither data nor programs are transferable when the operating systems are not identical. IV. Most data and many programs are transferable among environments through shareware programs.

A. B. C. D.

I. I, IV. III. II, III.


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Answer (A) is correct. An emulator is a hardware device that permits one system to imitate another, that is, to use the same data and programs and obtain the same results as the other system. A translator is a program that translates from one programming language into another. Answer (B) is incorrect because shareware does not transfer data. Shareware is a program that can be freely copied and tested before purchase. If the party obtaining the shareware continues to use it, there is an obligation to send payment to the author. Shareware typically is found on bulletin boards and online information systems. Answer (C) is incorrect because there are facilities to transfer data and programs between disparate operating systems. Answer (D) is incorrect because there are facilities to transfer data and programs between some environments. [1087] Gleim #: 8.19 -- Source: CIA 597 III-67 Response time on a local area network (LAN) was so slow that programmers working on applications kept their code on their own workstations rather than on the server. As a result, daily backups of the server did not contain the current source code. The best approach to detect deteriorating response time is

A. B. C. D.

Parallel testing. Integrated test facility. Performance monitoring. Program code comparison software. Answer (A) is incorrect because parallel testing is an approach to implementing a new system. Answer (B) is incorrect because an ITF is an audit tool that uses a fictitious entity against which data transactions are processed. Answer (C) is correct. Performance monitoring is the systematic measurement and evaluation of operating results such as transaction rates, response times, and incidence of error conditions. Performance monitoring will reveal trends in capacity usage so that capacity can be upgraded before response deteriorates to the point that users behave in unintended or undesirable ways. Answer (D) is incorrect because program code comparison software is used to detect unauthorized changes in programs.

[1088] Gleim #: 8.20 -- Source: CIA 597 III-75 A manufacturer is considering using bar-code identification for recording information on parts used by the manufacturer. A reason to use bar codes rather than other means of identification is to ensure that

A. B. C. D.

The movement of all parts is recorded. The movement of parts is easily and quickly recorded. Vendors use the same part numbers. Vendors use the same identification methods. Answer (A) is incorrect because any identification method may fail to record the movement of some parts. Answer (B) is correct. Bar-code scanning is a form of optical character recognition. Bar codes are a series of bars of different widths that represent critical information about the item. They can be read and the information can be instantly recorded using a scanner. Thus, bar coding records the movement of parts with minimal labor costs. Answer (C) is incorrect because each vendor has its own part-numbering scheme. Answer (D) is incorrect because each vendor has its own identification method, although vendors in the same industry often cooperate to minimize the number of bar-code systems they use.


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[1089] Gleim #: 8.21 -- Source: CIA 597 III-79 A manufacturer of complex electronic equipment such as oscilloscopes and microscopes has been shipping its products with thick paper manuals but wants to reduce the cost of producing and shipping this documentation. Of the following, the best medium for the manufacturer to use to accomplish this result is

A. B. C. D.

Write once/read many (WORM). Digital audiotape (DAT). Compact disk/read-only memory (CD-ROM). Computer output to microfilm (COM). Answer (A) is incorrect because WORM is an optical storage technique often used as an archival medium. Answer (B) is incorrect because DAT is primarily used as a backup medium in imaging systems and as a master for CDROM. Answer (C) is correct. CD-ROM is cheaper to produce and ship than the existing paper, yet it permits large volumes of text and images to be reproduced. Users of the electronic equipment are likely to have access to CD-ROM readers on PCs for using such documentation. Answer (D) is incorrect because COM is used for frequent access to archived documents, such as canceled checks in banking applications.

[1090] Gleim #: 8.22 -- Source: CMA 1287 5-4 The process of monitoring, evaluating, and modifying a system as needed is referred to as systems

A. B. C. D.

Analysis. Feasibility study. Maintenance. Implementation. Answer (A) is incorrect because systems analysis is the process of determining user problems and needs, surveying the organization’s present system, and analyzing the facts. Answer (B) is incorrect because a feasibility study determines whether a proposed system is technically, operationally, and economically feasible. Answer (C) is correct. Systems maintenance must be undertaken by systems analysts and applications programmers continually throughout the life of a system. Maintenance is the redesign of the system and programs to meet new needs or to correct design flaws. These changes should be part of a regular program of preventive maintenance. Answer (D) is incorrect because implementation involves training and educating users, testing, conversion, and followup.

[1091] Gleim #: 8.23 -- Source: CISA Effective internal control for application development should provide for which of the following? I. II. III. IV.

A. B. C. D.

A project steering committee to initiate and oversee the system A technical systems programmer to evaluate systems software Feasibility studies to evaluate existing systems The establishment of standards for systems design and programming

I and III. I, II, and IV. I, III, and IV. II, III, and IV.


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Answer (A) is incorrect because standards must be established. Answer (B) is incorrect because a technical systems programmer has a role in the development and modification of the operating system but not necessarily in applications development. The technical support in this area would be provided by systems analysts rather than programmers. Answer (C) is correct. Effective systems development requires participation by top management. This can be achieved through a steering committee composed of higher-level representatives of system users. The committee approves or recommends projects and reviews their progress. Studies of the economic, operational, and technical feasibility of new applications necessarily entail evaluations of existing systems. Another necessary control is the establishment of standards for system design and programming. Standards represent user and system requirements determined during systems analysis. Answer (D) is incorrect because a technical systems programmer has a role in the development and modification of the operating system but not necessarily in applications development. [1092] Gleim #: 8.24 -- Source: CIA 592 I-29 Which of the following should be emphasized before designing any system elements in a top-down approach to new systems development?

A. B. C. D.

Types of processing systems being used by competitors. Computer equipment to be used by the system. Information needs of managers for planning and control. Controls in place over the current system. Answer (A) is incorrect because the needs of the organization should be the overriding factor in systems development. Answer (B) is incorrect because the equipment selection should be a function of the processing needs, not vice versa. Answer (C) is correct. The top-down method begins with analysis of broad organizational goals, objectives, and policies as a basis for the design process. This step requires an understanding of the entity’s environment and significant activities. The next step is to determine the decisions made by managers and the information required to make them. The necessary reports, databases, inputs, processing methods, and equipment specifications can then be defined. The weakness of the top-down approach is that it tends to concentrate on managers’ information needs at the expense of the design of efficient transaction processing at the operational level. Answer (D) is incorrect because functional controls should be designed for the new system.

[1093] Gleim #: 8.25 -- Source: CIA 1195 III-65 A benefit of using computer-aided software engineering (CASE) technology is that it can ensure that

A. B. C. D.

No obsolete data fields occur in files. Users become committed to new systems. All programs are optimized for efficiency. Data integrity rules are applied consistently.


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Answer (A) is incorrect because obsolete data fields must be recognized by developers or users. Once recognized, obsolete data fields can be treated consistently in CASE procedures. Answer (B) is incorrect because using CASE will not ensure user commitment to new systems if they are poorly designed or otherwise do not meet users’ needs. Answer (C) is incorrect because, although it has the potential to accelerate system development, CASE cannot ensure that all programs are optimized for efficiency. In fact, some CASE-developed modules may need to be optimized by hand to achieve acceptable performance. Answer (D) is correct. CASE is an automated technology (at least in part) for developing and maintaining software and managing projects. A benefit of using CASE technology is that it can ensure that data integrity rules, including those for validation and access, are applied consistently across all files. [1094] Gleim #: 8.26 -- Source: CIA 592 III-38 CASE (computer-aided software engineering) is the use of the computer to aid in the development of computer-based information systems. Which of the following could not be automatically generated with CASE tools and techniques?

A. B. C. D.

Information requirements determination. Program logic design. Computer program code. Program documentation. Answer (A) is correct. CASE applies the computer to software design and development. It maintains on the computer a library of standard program modules and all of the system documentation, e.g., data flow diagrams, data dictionaries, and pseudocode (structured English); permits development of executable input and output screens; and generates program code in at least skeletal form. Thus, CASE facilitates the creation, organization, and maintenance of documentation and permits some automation of the coding process. However, information requirements must be determined prior to using CASE. Answer (B) is incorrect because CASE may generate program logic design. Answer (C) is incorrect because CASE may generate computer program code. Answer (D) is incorrect because CASE may generate program documentation.

[1095] Gleim #: 8.27 -- Source: CIA 597 III-71 Object technology is likely to become more important in companies’ strategic use of information systems because of its potential to

A. B. C. D.

Permit quicker and more reliable development of systems. Maintain programs written in procedural languages. Minimize data integrity violations in hierarchical databases. Streamline the traditional “waterfall” systems development methodology. Answer (A) is correct. An object-oriented approach is intended to produce reusable code. Because code segments can be reused in other programs, the time and cost of writing software should be reduced. Answer (B) is incorrect because object technology has the potential to support faster maintenance of programs written in object-oriented, but not procedural, languages. Answer (C) is incorrect because object technology is being applied to relational, but not hierarchical, databases. Answer (D) is incorrect because object technology is typically implemented in a prototyping environment.


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[1096] Gleim #: 8.28 -- Source: CIA 597 III-72 User acceptance testing is more important in an object-oriented development process than in a traditional environment because of the implications of the

A. B. C. D.

Absence of traditional design documents. Lack of a tracking system for changes. Potential for continuous monitoring. Inheritance of properties in hierarchies. Answer (A) is incorrect because, instead of traditional design documents, items such as the business model, narratives of process functions, iterative development screens, computer processes and reports, and product descriptions guides are produced in object-oriented development. Answer (B) is incorrect because, in general, object-oriented development systems include tracking systems for changes made in objects and hierarchies. Answer (C) is incorrect because object-oriented systems are usually developed in client-server environments, so the potential exists for continuous monitoring of system use. However, continuous monitoring typically occurs during system operation, not during development. Answer (D) is correct. In object-oriented development, all objects in a class inherit the properties of higher classes in the hierarchy. Thus, changes in one object may affect many other objects, and the extent and effects of errors significantly increase. Testing one object provides no assurance that the objects are properly coordinated. Accordingly, user acceptance testing to verify correct functioning of the whole system becomes more important.

[1097] Gleim #: 8.29 -- Source: CIA 596 III-70 A systems development approach used to quickly produce a model of user interfaces, user interactions with the system, and process logic is called

A. B. C. D.

Neural networking. Prototyping. Reengineering. Application generation. Answer (A) is incorrect because neural networking involves hardware or software that imitates the processing activities of the human brain. Answer (B) is correct. Prototyping produces the first model(s) of a new system. This technique usually employs a software tool for quick development of a model of the user interface (such as by report or screen), interaction of users with the system (for example, a menu-screen approach or data entry), and processing logic (the executable module). Prototyping stimulates user participation because the model allows quick exploration of concepts and development of solutions with quick results. Answer (C) is incorrect because reengineering salvages reusable components of existing systems and restructures them to develop new systems or to improve the old systems. Answer (D) is incorrect because an application generator is software that can be used to develop an application simply by describing its requirements to the computer rather than by writing a procedural program.

[1098] Gleim #: 8.30 -- Source: CISA An MIS manager has only enough resources to install either a new payroll system or a new data security system, but not both. Which of the following actions is most appropriate?


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A. B. C. D.

Giving priority to the security system. Leaving the decision to the MIS manager. Increasing MIS staff output in order for both systems to be installed. Having the information systems steering committee set the priority. Answer (A) is incorrect because not enough information is given to conclude that priority should be given to the security system. Answer (B) is incorrect because the MIS manager should not be the only decision maker. Answer (C) is incorrect because the question indicates that development of both systems is not possible. Answer (D) is correct. The needs assessment and cost-benefit analysis should be conducted by those responsible for making the decision. In this case, the information systems steering committee is the appropriate decision maker.

[1099] Gleim #: 8.31 -- Source: CIA 1193 I-26 Which of the following is the most appropriate activity for an internal auditor to perform during a review of systems development activity?

A. Serve on the MIS steering committee that determines what new systems are to be developed. B. Review the methodology used to monitor and control the system development function. C. Recommend specific automated procedures to be incorporated into new systems that will provide reasonable assurance that all data submitted to an application are converted to machine-readable form. D. Recommend specific operational procedures that will ensure that all data submitted for processing are converted to machine-readable form. Answer (A) is incorrect because service on a management decision-making committee is an operating responsibility and would impair audit objectivity. Answer (B) is correct. Auditor objectivity is not impaired when (s)he recommends standards of control for systems or reviews procedures before implementation. However, drafting procedures for systems and designing, installing, and operating systems are not audit functions. Thus, reviewing the methodology used by an organization is an appropriate activity that enables the internal auditor to determine whether (s)he can rely on the systems development activity to design and implement appropriate automated controls within applications. Answer (C) is incorrect because making recommendations for automated procedures is an operating responsibility. Answer (D) is incorrect because recommending operational procedures is an operating responsibility. [1100] Gleim #: 8.32 -- Source: CIA 1189 II-29 The purpose of input controls is to ensure the

A. B. C. D.

Authorization of access to data files. Authorization of access to program files. Completeness, accuracy, and validity of updating. Completeness, accuracy, and validity of input. Answer (A) is incorrect because access controls authorize access to data files. Answer (B) is incorrect because access controls authorize access to program files. Answer (C) is incorrect because processing controls ensure the completeness, accuracy, and validity of updating. Answer (D) is correct. Input controls provide reasonable assurance that data received for computer processing have been properly authorized and are in a form suitable for processing, i.e., complete, accurate, and valid. Input controls also relate to rejection, correction, and resubmission of data that were initially incorrect.


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[1101] Gleim #: 8.33 -- Source: CIA 1193 I-29 A mail-order retailer of low-cost novelty items is receiving an increasing number of complaints from customers about the wrong merchandise being shipped. The order code for items has the format wwxxyyzz. The major category is ww, xx is the minor category, yy identifies the item, and zz identifies the catalog. In many cases, the wrong merchandise was sent because adjacent characters in the order code had been transposed. The best control for decreasing the number of orders with the wrong merchandise is to

A. B. C. D.

Require customers to specify the name for each item they order. Add check-digits to the order codes and verify them for each order. Separate the parts of the order code with hyphens to make the characters easier to read. Use a master file reference for all order codes to verify the existence of items. Answer (A) is incorrect because having customers specify the name for each item they order would let the company correct erroneous order codes once they had been detected, but would not, in general, detect erroneous codes. Answer (B) is correct. Self-checking digits may be used to detect incorrect codes. The digit is generated by applying an algorithm to the code. During the input process, the check digit is recomputed by applying the same algorithm to the code actually entered. Answer (C) is incorrect because separating the parts of the order code with hyphens would make the characters easier to read, but would not cure the problem of transposed characters. Answer (D) is incorrect because using a master file reference for all order codes would verify the existence of items, but would not detect erroneous order codes in which transposed characters in an order code match other items.

[1102] Gleim #: 8.34 -- Source: CIA 597 I-19 Which of the following computerized control procedures would be most effective in ensuring that data uploaded from personal computers to a mainframe are complete and that no additional data are added?

A. B. C. D.

Self-checking digits to ensure that only authorized part numbers are added to the database. Batch control totals, including control totals and hash totals. Passwords that effectively limit access to only those authorized to upload the data to the mainframe computer. Field-level edit controls that test each field for alphanumerical integrity. Answer (A) is incorrect because self-checking digits detect inaccurate identification numbers. They are an effective control to ensure that the appropriate part has been identified. However, the control objective is to ensure that data transfer is complete. Answer (B) is correct. Batch control totals for the data transferred can be reconciled with the batch control totals in the existing file. This comparison provides information on the completion of the data transfer. Batch totals may include record counts, totals of certain critical amounts, or hash totals. A hash total is a control total without a defined meaning, such as the total of employee numbers or invoice numbers, that is used to verify the completeness of data. Thus, the hash total for the employee listing by the personnel department could be compared with the total generated during the payroll run. Answer (C) is incorrect because passwords help ensure that only authorized personnel make the transfer, not that data transfer is complete. Answer (D) is incorrect because field checks are effective input controls, but they do not ensure completeness of data transfer.

[1103] Gleim #: 8.35 -- Source: CIA 596 I-58 When assessing application controls, which one of the following input controls or edit checks is most likely to be used to detect a data input error in the customer account number field?


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A. B. C. D.

Limit check. Validity check. Control total. Hash total. Answer (A) is incorrect because reasonableness, limit, and range checks are based upon known limits for given information. For example, the hours worked per week is not likely to be greater than 45. Answer (B) is correct. Validity checks are tests of identification numbers or transaction codes for validity by comparison with items already known to be correct or authorized. For example, Social Security numbers on payroll input records can be compared with Social Security numbers authorized by the personnel department. Answer (C) is incorrect because a record count is a control total of the number of records processed during the operation of a program. Financial totals summarize dollar amounts in an information field in a group of records. Answer (D) is incorrect because a hash total is the number obtained from totaling the same field value for each transaction in a batch. The total has no meaning or value other than as a comparison with another hash total.

[1104] Gleim #: 8.36 -- Source: CIA 1192 II-31 Payroll master file updates are sent from a remote terminal to a mainframe program on a real-time system. A control that works to ensure accuracy of the transmission is a(n)

A. B. C. D.

Echo check. Protection ring. Hash total. Integrated test facility. Answer (A) is correct. An echo check is a hardware control that provides for a peripheral device to return (echo) a signal sent by the CPU. For example, the CPU sends a signal to the printer, and the printer, just prior to printing, sends a signal back to the CPU verifying that the proper print position has been activated. Answer (B) is incorrect because a protection ring prevents accidental writing on a tape file. A real-time system would not use tape files. Answer (C) is incorrect because hash totals are used to control data sent to a batch system, not a real-time system. Answer (D) is incorrect because integrated test facilities are useful in testing real-time systems but cannot be used to ensure completeness of data transmissions.

[1105] Gleim #: 8.37 -- Source: CIA 590 II-20 Detecting errors in real memory is a function of

A. B. C. D.

Memory protection. Parity checking. Validity checking. Range checking.


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Answer (A) is incorrect because memory protection prohibits programs from accessing memory outside their designated ranges. Answer (B) is correct. A parity check adds the bits in a character or message and checks the sum to determine if it is odd or even, depending on whether the computer has odd or even parity. This check verifies that all data have been transferred without loss. For example, if the computer has even parity, a bit will be added to a binary coded character or message that contains an odd number of bits. No bit is added if a character or message in binary form has an even number of bits. Answer (C) is incorrect because for hardware, validity checking verifies that a machine-level instruction is a valid instruction; for applications, validity checking verifies that transaction data are complete, authorized, and reasonable. Answer (D) is incorrect because range checking verifies that input data values are within pre-determined ranges. [1106] Gleim #: 8.38 -- Source: CMA 680 5-15 Omen Company is a manufacturer of men’s shirts. It distributes weekly sales reports to each sales manager. The quantity 2R5 appeared in the quantity sold column for one of the items on the weekly sales report for one of the sales managers. The most likely explanation for what has occurred is that

A. B. C. D.

The output quantity has been stated in hexadecimal numbers. The computer has malfunctioned during execution. The printer has malfunctioned and the “R” should have been a decimal point. The program did not contain a data checking routine for input data. Answer (A) is incorrect because R is not a hexadecimal character. Hexadecimal characters are 0-9 and A-F representing 0 to 15 in decimal. Answer (B) is incorrect because the probability of a computer malfunction’s resulting in the printing of an R is slight. Answer (C) is incorrect because 2.5 would not be appropriate for a quantity of shirts sold. Answer (D) is correct. The probable explanation for reporting a quantity using a character other than a digit is that the data were incorrectly encoded and the computer program did not perform a field check, which would have detected the error. A field check tests whether a field consists of the proper characters, whether alphabetic, numeric, special, or combinations thereof.

[1107] Gleim #: 8.39 -- Source: CMA 687 5-5 The online data entry control called preformatting is

A. A program initiated prior to regular input to discover errors in data before entry so that the errors can be corrected. B. A check to determine if all data items for a transaction have been entered by the terminal operator. C. A series of requests for required input data that requires an acceptable response to each request before a subsequent request is made. D. The display of a document with blanks for data items to be entered by the terminal operator. Answer (A) is incorrect because an edit routine is a program initiated prior to regular input to discover errors in data before entry so that the errors can be corrected. Answer (B) is incorrect because a completeness check tests whether all data items for a transaction have been entered by the terminal operator. Answer (C) is incorrect because the dialogue approach is another screen prompting method for data entry. It is most appropriate when information is received orally, e.g., by phone. Answer (D) is correct. To avoid data entry errors in online systems, a preformatted screen approach may be used. It is a screen prompting approach that involves the display on a monitor of a set of boxes for entry of specified data items. The format may even be in the form of a copy of a transaction document. This technique is best suited to conversion of data from a source document.


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[1108] Gleim #: 8.40 -- Source: CIA 595 I-27 A catalog company has been experiencing an increasing incidence of problems in which the wrong products have been shipped to the customer. Most of the customer orders come in over the telephone, and an operator enters the data into the order system immediately. Which of the following control procedures, if properly implemented, would address the problem? I. Have the computer automatically assign a sequential order number to each customer order. II. Implement a self-checking digit algorithm for each product number and request entries by product number. III. Request entries by product number, have the computer program identify the product and price, and require the operator to orally verify the product description with the customer.

A. B. C. D.

II only. I, II, and III. II and III. I and II. Answer (A) is incorrect because oral verification also would address the problem. Answer (B) is incorrect because assigning a sequential number to the customer’s order helps build an audit trail but does not address the product identification issue. Answer (C) is correct. A self-checking digit detects incorrect codes. The digit is generated by applying an algorithm to the code. During input, the digit is recomputed by applying the algorithm to the code actually entered. Oral verification also addresses the problem of incorrectly identifying the product number. Assigning a sequential number to the customer’s order helps build an audit trail but does not address the product identification issue. Answer (D) is incorrect because assigning a sequential number to the customer’s order helps build an audit trail but does not address the product identification issue.

[1109] Gleim #: 8.41 -- Source: CIA 596 I-57 Which one of the following input controls or edit checks would catch certain types of errors within the payment amount field of a transaction?

A. B. C. D.

Record count. Echo check. Check digit. Limit check. Answer (A) is incorrect because a record count determines the number of documents entered into a process. Answer (B) is incorrect because an echo check tests the reliability of computer hardware. For example, the CPU sends a signal to a printer that is echoed just prior to printing. The signal verifies that the proper print position has been activated. Answer (C) is incorrect because a self-checking number is generated by applying an algorithm to an identification number. Answer (D) is correct. A limit, reasonableness, or range test determines whether an amount is within a predetermined limit for given information. It can only detect certain errors (i.e., those that exceed the acceptable limit).

[1110] Gleim #: 8.42 -- Source: CIA 582 IV-12 The key verification process associated with keying computer records for input to a computer system is


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A. B. C. D.

Effectively used to detect the erroneous recording of data on source documents. Inexpensive and therefore widely used. Used to detect errors introduced by the keying process. Ordinarily used with a computer program written to check the data. Answer (A) is incorrect because key verification does not detect errors in the source documents. Answer (B) is incorrect because, although widely used, key verification effectively doubles the work and is expensive. Answer (C) is correct. Key verification is a procedure to determine if the keying process was performed properly. Information from source documents is rekeyed on a special keyboard by another operator and compared with that previously recorded. Answer (D) is incorrect because key verification is a manual process.

[1111] Gleim #: 8.43 -- Source: CIA 597 III-37 Output controls ensure that the results of computer processing are accurate, complete, and properly distributed. Which of the following is not a typical output control?

A. Reviewing the computer processing logs to determine that all of the correct computer jobs executed properly. B. Matching input data with information on master files and placing unmatched items in a suspense file. C. Periodically reconciling output reports to make sure that totals, formats, and critical details are correct and agree with input. D. Maintaining formal procedures and documentation specifying authorized recipients of output reports, checks, or other critical documents. Answer (A) is incorrect because reviewing the computer processing logs is an output control. Answer (B) is correct. Output controls often include comparing output totals with input and processing totals; reviewing computer logs; auditing output reports to ensure that totals, formats, and details are accurate and reconcilable; and specifying authorized recipients by formal means. The data control group also performs important output control functions. Matching the input data with information held on master or suspense files is a processing control, not an output control. It ensures that data are complete and accurate during updating. Answer (C) is incorrect because periodically reconciling output reports is an output control. Answer (D) is incorrect because maintaining formal procedures and documentation specifying authorized recipients is an output control. [1112] Gleim #: 8.44 -- Source: CIA 1195 III-36 The marketing department’s proposal was finally accepted, and the marketing employees attended a class in using the mainframe report writer. Soon, the marketing analysts found that it was easier to download the data and manipulate it on their own microcomputers than to perform all the data manipulation with the mainframe report writer directly. One analyst became highly skilled at downloading and wrote downloading command sequences for the other employees. When the analyst left the company for a better job, the department had problems making modifications to these command sequences. The department’s problems are most likely due to inadequate

A. B. C. D.

Documentation. Data backup. Program testing. Anti-virus software.


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Answer (A) is correct. One risk of end-user computing is that documentation may be poor and that important knowledge may be limited to one person. The command sequences should have been documented so that other analysts could use and modify them readily. Answer (B) is incorrect because the inability of other analysts to understand the command sequences is not a function of inadequate data backup procedures. Answer (C) is incorrect because the inability of other analysts to understand the command sequences is not a function of inadequate testing. Answer (D) is incorrect because the inability of other analysts to understand the command sequences is not a function of inadequate use of anti-virus software. [1113] Gleim #: 8.45 -- Source: CIA 1195 III-34 After using the mainframe report writer for several months, the marketing analysts gained confidence in using it, but the marketing department manager became concerned. Whenever analysts revised reports they had written earlier, the coding errors kept reappearing in their command sequences. The manager was sure that all the analysts knew what the errors were and how to avoid them. The most likely cause of the reappearance of the same coding errors is inadequate

A. B. C. D.

Backups. Change control. Access control. Testing. Answer (A) is incorrect because inadequate backups are not the cause of reuse of erroneous code. Answer (B) is correct. Change control manages changes in information system resources and procedures. It includes a formal change request procedure; assessments of change requests on technical and business grounds; scheduling changes; testing, installing, and monitoring changes; and reporting the status of recorded changes. The analysts were reusing erroneous code that should have been but was not corrected. Answer (C) is incorrect because inadequate access control is not the cause of reuse of erroneous code. Answer (D) is incorrect because inadequate testing is not the cause of reuse of erroneous code.

[1114] Gleim #: 8.46 -- Source: CIA 593 III-46 A control for ensuring that the source code and the executable code for a program match is

A. B. C. D.

Verifying that the program move request is authorized. Requiring program, system, and parallel testing of the code. Authorizing programmer access to test libraries only. Recompiling source code into the production load library. Answer (A) is incorrect because verifying that the program move request is authorized ensures that a change was authorized, not that the source and executable code match. Answer (B) is incorrect because requiring program, system, and parallel testing of the code ensures that the code meets test specifications, not that the source and executable code match. Answer (C) is incorrect because authorizing programmer access to test libraries only ensures that programmers do not have access to production libraries, not that the source and executable code match. Answer (D) is correct. Recompiling source code into the production load library ensures that the source and executable codes match because the executable code is created from the source code.


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[1115] Gleim #: 8.47 -- Source: CIA 1196 III-36 Traditional information systems development procedures that ensure proper consideration of controls may not be followed by users developing end-user computing (EUC) applications. Which of the following is a prevalent risk in the development of EUC applications?

A. Management decision making may be impaired due to diminished responsiveness to management’s requests for computerized information. B. Management may be less capable of reacting quickly to competitive pressures due to increased application development time. C. Management may place the same degree of reliance on reports produced by EUC applications as it does on reports produced under traditional systems development procedures. D. Management may incur increased application development and maintenance costs for EUC systems, compared with traditional (mainframe) systems. Answer (A) is incorrect because EUC systems typically increase flexibility and responsiveness to management’s information requests. Such systems are more easily modified. Answer (B) is incorrect because EUC systems typically reduce application development cycle time. Answer (C) is correct. End-user developed applications may not be subject to an independent outside review by systems analysts and are not created in the context of a formal development methodology. These applications may lack appropriate standards, controls, quality assurance procedures, and documentation. A risk of end-user applications is that management may rely on them as much as traditional applications. Answer (D) is incorrect because EUC systems typically result in reduced application development and maintenance costs. [1116] Gleim #: 8.48 -- Source: CIA 1196 III-37 Traditional information systems development and operational procedures typically involve four functional areas. The systems analysis function focuses on identifying and designing systems to satisfy organizational requirements. The programming function is responsible for the design, coding, testing, and debugging of computer programs necessary to implement the systems designed by the analysis function. The computer operations function is responsible for data preparation, program/job execution, and system maintenance. The user function provides the input and receives the output of the system. Which of these four functions is often poorly implemented or improperly omitted in the development of a new end-user computing (EUC) application?

A. B. C. D.

Systems analysis function. Programming function. Computer operations function. User function. Answer (A) is correct. Systems analysis is one step that is not absolutely required in the development of a system. The desire to produce a system quickly may result in this step being eliminated or poorly implemented. A system is often produced and then analyzed to see if it will satisfy the needs of the organization. In an EUC application, the systems analysis is often incomplete or omitted. Answer (B) is incorrect because, without programming, there would be no system. Answer (C) is incorrect because, without computer operations, the system would not be able to do anything. Answer (D) is incorrect because, without users, there would be no need for the system.

[1117] Gleim #: 8.49 -- Source: CIA 1194 I-37 Responsibility for the control of end-user computing exists at the organizational, departmental, and individual user level. Which of the following should be a direct responsibility of the individual users?


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A. B. C. D.

Acquisition of hardware and software. Taking equipment inventories. Strategic planning of end-user computing. Physical security of equipment. Answer (A) is incorrect because the acquisition of hardware and software is an organizational- and departmental-level responsibility. Answer (B) is incorrect because taking equipment inventories is an organizational-level responsibility. Answer (C) is incorrect because strategic planning is an organizational- and departmental-level responsibility. Answer (D) is correct. End-user computing involves user-created or -acquired systems that are maintained and operated outside of traditional information systems controls. In this environment, an individual user is ordinarily responsible for the physical security of the equipment (s)he uses.

[1118] Gleim #: 8.50 -- Source: CIA 586 II-39 Which of the following represents a limitation on the use of generalized audit software (GAS)?

A. B. C. D.

It requires lengthy detailed instructions in order to accomplish specific tasks. It has limited application without significant modification. It requires significant programming knowledge to be used effectively. It can only be used on hardware with compatible operating systems. Answer (A) is incorrect because the use of GAS is normally more efficient. Less time is required to write instructions to accomplish a function than to manually select and examine items. Answer (B) is incorrect because the program is generalized, i.e., designed to be used on a variety of systems without significant modifications. Answer (C) is incorrect because an advantage is that GAS requires minimal knowledge of computer technology. Answer (D) is correct. Diversity of programming languages, computers, systems designs, and differing data structures makes generalized audit software impossible to apply in certain situations.

[1119] Gleim #: 8.51 -- Source: Publisher Specialized audit software

A. B. C. D.

Is written to interface with many different client systems. May be written while its purposes and users are being defined. Requires the auditor to have less computer expertise than generalized audit software. May be written in a procedure-oriented language.


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Answer (A) is incorrect because generalized audit software is written to interface with many different client systems. Answer (B) is incorrect because the purposes and users of this software must be defined before it is written. Answer (C) is incorrect because generalized audit software purchased “off the shelf” requires less computer expertise than specialized software created by the auditor. Answer (D) is correct. Specialized audit software is written in a procedure- or problem-oriented language to fulfill a specific set of audit tasks. The purposes and users of the software are well defined before the software is written. Auditors develop specialized audit software for the following reasons: 1. Unavailability of alternative software 2. Functional limitations of alternative software 3. Efficiency considerations 4. Increased understanding of systems 5. Opportunity for easy implementation 6. Increased auditor independence and prestige [1120] Gleim #: 8.52 -- Source: CPA 1188 A-57 The two requirements crucial to achieving audit efficiency and effectiveness with a personal computer are selecting

A. The appropriate audit tasks for personal computer applications and the appropriate software to perform the selected audit tasks. B. The appropriate software to perform the selected audit tasks and data that can be accessed by the auditor’s personal computer. C. Company data that can be accessed by the auditor’s personal computer and the appropriate audit tasks for personal computer applications. D. The appropriate sample of company data to test with the auditor’s personal computer and the appropriate software to perform the selected audit tasks. Answer (A) is correct. The question relates to using the computer as an audit tool. To use a personal computer for this purpose effectively and efficiently, the auditor must have the appropriate hardware and software. Answer (B) is incorrect because access to data does not relate directly to the efficient and effective use of a personal computer. Answer (C) is incorrect because access to data does not relate directly to the efficient and effective use of a personal computer. Answer (D) is incorrect because the selection of the appropriate sample size does not apply when using software applications because the entire population can be tested. [1121] Gleim #: 8.53 -- Source: CPA 593 A-40 An auditor is least likely to use computer software to

A. B. C. D.

Construct parallel simulations. Access client data files. Prepare spreadsheets. Assess computer control risk. Answer (A) is incorrect because parallel simulation involves using an auditor’s program to reproduce the logic of management’s program. Answer (B) is incorrect because computer software makes accessing company files much faster and easier. Answer (C) is incorrect because many audit spreadsheet programs are available. Answer (D) is correct. The auditor is required to evaluate the adequacy and effectiveness of the system of internal control and to assess risk to plan the audit. This assessment is a matter of professional judgment that cannot be accomplished with a computer.


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[1122] Gleim #: 8.54 -- Source: CIA 586 I-34 When an auditor performs tests on a computerized inventory file containing over 20,000 line items, that auditor can maintain independence and perform most efficiently by

A. B. C. D.

Asking the console operator to print every item that cost more than $100. Using a generalized audit software package. Obtaining a printout of the entire file and then selecting each nth item. Using the systems department’s programmer to write an extraction program. Answer (A) is incorrect because independence is jeopardized when an operator is involved in the process. Answer (B) is correct. Independence can be preserved when the auditor acquires general audit software (GAS) from an external source rather than relying on auditee-developed audit software. Also, efficiency is enhanced to the extent GAS can be used (as compared to manual auditing or writing special audit programs). Answer (C) is incorrect because printing out the entire file is both unnecessary and inefficient. Answer (D) is incorrect because overreliance on an auditee’s programmer impairs independence.

[1123] Gleim #: 8.55 -- Source: Publisher Which of the following cannot be performed by an auditor using computer-assisted audit techniques (CAATs) software?

A. B. C. D.

Identifying missing check numbers. Extracting data files containing only a two-digit year date field and changing it to hold four digits. Matching identical product information in separate data files. Aging accounts receivable. Answer (A) is incorrect because identifying gaps is a function of major CAATs software packages. Answer (B) is correct. CAATs software has the ability to extract data files containing specified criteria, such as the size of a data field, but it does not enable the auditor to change the format of this information within management’s computer system. However, the auditor can specify the format of data fields in CAATs software-produced reports. Answer (C) is incorrect because merging files is a function of major CAATs software packages. Answer (D) is incorrect because aging is a function of major CAATs software packages.

[1124] Gleim #: 8.56 -- Source: Publisher Which of the following is not true about audit use of the Internet?

A. B. C. D.

It is a useful research tool for gathering audit-related information. It provides a secure medium to transmit confidential information. Electronic communication is the major use of the Internet by internal auditors. An electronic record of a user’s web browsing activities is created. Answer (A) is incorrect because the Internet is a useful audit tool for gathering and disseminating audit-related information. Answer (B) is correct. Users transmitting sensitive information across the Internet must understand the threats that arise that could compromise the confidentiality of the data. Security measures, such as encryption technology, need to be taken to ensure that the information is viewed only by those authorized to view it. Answer (C) is incorrect because the major use of the Internet by internal auditors is electronic communication. Answer (D) is incorrect because web browsing leaves an electronic record of the user’s search path.


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[1125] Gleim #: 8.57 -- Source: CIA 1196 III-61 A company has a very large, widely dispersed internal auditing department. Management wants to implement a computerized system to facilitate communications among auditors. The specifications require that each auditor have the ability to send, file, and answer messages at his/her convenience. Transmission of messages must be quick and the preparation of messages must not be costly. Which type of system would best meet these specifications?

A. B. C. D.

Utility program. Electronic bulletin board system (BBS). Electronic mail system. Private branch exchange (PBX). Answer (A) is incorrect because utility programs are provided by manufacturers of equipment to perform routine processing tasks. Answer (B) is incorrect because an electronic bulletin board system is a centralized information source and message switching system and therefore does not provide a repository to store messages for each auditor. Answer (C) is correct. Electronic mail permits transfer, receipt, and storage of messages within or between computer systems. The “mail” consists of electronically transmitted messages. A user’s “mailbox” is the storage area allocated for messages. The advantages of electronic mail are high-speed transmission, reduction of message preparation costs, and the possibility of sending or reading messages at a convenient time. Answer (D) is incorrect because a PBX is a telecommunications system that routes calls to particular extensions within an organization.

[1126] Gleim #: 8.58 -- Source: CIA 1193 II-23 Image processing can be used to convert paper documents into electronic images. Which of the following concepts distinguishes the retention of computerized audit documents from the traditional hard copy form?

A. Analyses, conclusions, and recommendations are filed on electronic media and are therefore subject to computer system controls and security procedures. B. Evidential support for all findings is copied and provided to local management during the closing conference and to each person receiving the final report. C. Computerized data files can be used in computer audit procedures. D. Audit programs can be standardized to eliminate the need for a preliminary survey at each location. Answer (A) is correct. The only difference between the computerized and hard copy form is how the working papers are stored. Electronic working papers are saved on either disks or hard drive, whereas hard copies are stored in a file cabinet. Unlike computerized working papers, hard copies are not subject to computer controls and security procedures. Answer (B) is incorrect because evidential support is retained and provided on the basis of the nature of the finding and not the media used for storing working papers. Answer (C) is incorrect because this capability is not an exclusive function of computerized working papers. Answer (D) is incorrect because, though the nature of the preliminary survey may change in some cases, the requirement for this phase of the audit is not eliminated by computerized working papers. [1127] Gleim #: 8.59 -- Source: CIA 591 II-33 Which new issues, associated with rapidly advancing computer technology, create new risk exposures for organizations?


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A. B. C. D.

Changes in organizational reporting requirements and controls over computer abuse. Controls over library tape procedures. Complexity of operating systems and controls over privacy of data. Changes in organizational behavior. Answer (A) is incorrect because changes in organizational reporting requirements are not new issues related to advancing computer technology. Answer (B) is incorrect because controls over library tape procedures have not been materially changed by advancing computer technology. Answer (C) is correct. Advancing computer technology presents more complex audit environments. With the advent of systems that permit remote access, the risk that unauthorized parties may obtain or tamper with important information is increased. Answer (D) is incorrect because changes in organizational behavior are not directly associated with auditor responsibilities in advancing technology.

[1128] Gleim #: 8.60 -- Source: CIA 1196 III-67 Which of the following is an important senior management responsibility with regard to information systems security?

A. B. C. D.

Assessing exposures. Assigning access privileges. Identifying ownership of data. Training employees in security matters. Answer (A) is correct. Senior management is responsible for risk assessment, including identification of risks and consideration of their significance, the likelihood of their occurrence, and how they should be managed. Senior management is also responsible for establishing organizational policies regarding computer security and implementing a compliance structure. Thus, senior management should assess the risks to the integrity, confidentiality, and availability of information systems data and resources. Answer (B) is incorrect because assignment of access privileges is the responsibility of security management. Answer (C) is incorrect because determining ownership of data is the responsibility of security management. In this context, ownership of data or resources mean responsibility for ultimate use or disposition. Answer (D) is incorrect because training employees in security matters is the responsibility of security management.

[1129] Gleim #: 8.61 -- Source: Publisher Which of the following is a true statement with regard to technology challenges outlined by The IIA in eSAC?

A. B. C. D.

Privacy is recognized internationally as a fundamental human right. Gains in computer processing and speed have outstripped software development and use. Open systems are subject to less risk than closed private systems. Technology has helped system boundaries to remain relatively discrete.


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Answer (A) is correct. According to eSAC, one of the key technology challenges is privacy. Privacy is recognized internationally as a fundamental human right. The globalization of business through the Internet has resulted in legislation to protect personal information, but the requirements of different nations vary. Answer (B) is incorrect because the use and development of software has outstripped the gains in computer processing and speed. Answer (C) is incorrect because open systems are subject to more risk than closed, private systems. Answer (D) is incorrect because, with the advancement of technology, system boundaries are becoming indistinct as interactions with suppliers, customers, partners, and associates increases. [1130] Gleim #: 8.62 -- Source: Publisher According to eSAC, all of the following are responses to technology challenges except

A. B. C. D.

Risk assessment. Internal control. Change minimization. E-assurance services. Answer (A) is incorrect because risk assessment is a proper response to technology challenges. Answer (B) is incorrect because internal control is a proper response to technology challenges. Answer (C) is correct. A series of responses to technology challenges is outlined by eSAC. These responses include risk assessment of e-commerce, internal control objectives, and e-assurance services. While businesses must respond to technology challenges, the response does not necessarily require the minimization of changes. Answer (D) is incorrect because e-assurance services is a proper response to technology challenges.

[1131] Gleim #: 8.63 -- Source: Publisher According to eSAC, accountability is

A. B. C. D.

Usually an issue with regard to trade secrets and other intellectual property. The control attribute that identifies the source of a transaction. The restriction of access to processing and storage devices. Most often applicable to personal information about employees and customers. Answer (A) is incorrect because confidentiality is usually an issue with regard to trade secrets and other intellectual property. Answer (B) is correct. Accountability is the control attribute that identifies the source of a transaction. It specifies employees’ roles, actions, and responsibilities. Thus, the person who caused a transaction is identifiable. Fundamental concepts of accountability are data ownership, identification, and authentication. Answer (C) is incorrect because physical security is the restriction of access to processing and storage devices. Answer (D) is incorrect because privacy is the attribute most often applicable to personal information about employees and customers.

[1132] Gleim #: 8.64 -- Source: Publisher COBIT is


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A. B. C. D.

A set of guidelines to assist in implementing adequate controls over IT processes. A set of risks and responses to technology challenges. The update of the previous Systems Auditability and Control reports. Published by the Committee of Sponsoring Organizations. Answer (A) is correct. COBIT (Control Objectives for Information and related Technology) is an IT control framework copyrighted by the Information Systems Audit and Control Foundation (ISACF). COBIT is a set of guidelines to assist management and business process owners in implementing adequate controls over IT processes and resources. It is designed to be an IT governance tool that facilitates understanding and managing the risks and benefits associated with information and related IT. Answer (B) is incorrect because it refers to the eSAC model. Answer (C) is incorrect because Electronic Systems Assurance and Control (eSAC) is the update of the previous Systems Auditability and Control. Answer (D) is incorrect because COBIT is copyrighted by ISACF. The Committee of Sponsoring Organizations published COSO.

[1133] Gleim #: 8.65 -- Source: Publisher COBIT is targeted at all of the following except

A. B. C. D.

Management. Users. Shareholders. Auditors. Answer (A) is incorrect because management is a distinct audience of COBIT. Answer (B) is incorrect because users are a distinct audience of COBIT. Answer (C) is correct. COBIT is targeted at three distinct audiences: management, users, and auditors. Management must balance risks and control costs in the volatile IT environment. Users need assurance about the security of, and controls over, internal or third-party IT services. Auditors must be able to support their opinions conveyed to management and others about the state of internal control. Because shareholders are not directly involved with IT services used in the day-to-day management of an organization, they are not a targeted audience of COBIT. Answer (D) is incorrect because auditors are a distinct audience of COBIT.

[1134] Gleim #: 8.66 -- Source: CIA 1193 I-24 Your firm has recently converted its purchasing cycle from a manual process to an online computer system. Which of the following is a probable result associated with conversion to the new automatic system?

A. B. C. D.

Processing errors are increased. The firm’s risk exposures are reduced. Processing time is increased. Traditional duties are less segregated.


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Answer (A) is incorrect because a computer system decreases processing errors. Answer (B) is incorrect because the conversion to a new system does not reduce the number of risk exposures. Answer (C) is incorrect because processing time is decreased. Answer (D) is correct. In a manual system with appropriate internal control, separate individuals are responsible for authorizing transactions, recording transactions, and custody of assets. These checks and balances prevent fraud and detect inaccurate or incomplete transactions. In a computer environment, however, this segregation of duties is not always feasible. For example, a computer may print checks, record disbursements, and generate information for reconciling the account balance. [1135] Gleim #: 8.67 -- Source: CPA 586 A-58 A small client recently put its cash disbursements system on a server. About which of the following internal control features would an auditor most likely be concerned?

A. Programming of the applications are in BASIC, although COBOL is the dominant, standard language for business processing. B. The server is operated by employees who have cash custody responsibilities. C. Only one employee has the password to gain access to the cash disbursement system. D. There are restrictions on the amount of data that can be stored and on the length of time that data can be stored. Answer (A) is incorrect because the choice of language would have little effect on internal control. Answer (B) is correct. Segregation of duties is a basic category of control activities (AU 319). Functions are incompatible if a person is in a position both to perpetrate and conceal fraud or errors. Hence, the duties of authorizing transactions, recording transactions, and custody of assets should be assigned to different people. Those employees that operate the server may be able to override the controls to change records to conceal a theft of cash. Answer (C) is incorrect because the limitation on access would be considered a strength. Answer (D) is incorrect because restrictions on the amount of data that can be stored and on the length of time that data can be stored do not constitute a control weakness. [1136] Gleim #: 8.68 -- Source: CPA 1195 A-14 Which of the following controls most likely could prevent computer personnel from modifying programs to bypass programmed controls?

A. B. C. D.

Periodic management review of computer utilization reports and systems documentation. Segregation of duties within computer for computer programming and computer operations. Participation of user department personnel in designing and approving new systems. Physical security of computer facilities in limiting access to computer equipment. Answer (A) is incorrect because, although periodic management review is appropriate, reports and systems documentation will not prevent or detect unauthorized modifications. Answer (B) is correct. Programmers and analysts can modify programs, data files, and controls. Thus, they should have no access to programs used to process transactions. Segregation of programming and operations is a control necessary to prevent unauthorized modifications of programs. Answer (C) is incorrect because user participation relates to new systems, not modification of existing systems. Answer (D) is incorrect because programmers may have access through data communications. Thus, physical security is not sufficient to prevent unauthorized modifications.


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[1137] Gleim #: 8.69 -- Source: CPA 586 A-1 Matthews Corp. has changed from a system of recording time worked on clock cards to a computerized payroll system in which employees record time in and out with magnetic cards. The computer system automatically updates all payroll records. Because of this change

A. B. C. D.

A generalized computer audit program must be used. Part of the audit trail is altered. The potential for payroll-related fraud is diminished. Transactions must be processed in batches. Answer (A) is incorrect because use of generalized audit software is only one of many ways of auditing through a computer. Answer (B) is correct. In a manual payroll system, a paper trail of documents is created to provide audit evidence that controls over each step in processing are in place and functioning. One element of a computer system that differentiates it from a manual system is that a transaction trail useful for auditing purposes might exist only for a brief time or only in computer-readable form. Answer (C) is incorrect because conversion to a computer system may actually increase the chance of fraud by eliminating segregation of incompatible functions and other controls. Answer (D) is incorrect because automatic updating indicates that processing is not in batch mode.

[1138] Gleim #: 8.70 -- Source: Publisher Operating controls include all of the following except

A. B. C. D.

Halt and error controls. Batch controls. Library security and use of proper file labels. Duplicate files and backup procedures. Answer (A) is incorrect because halt and error condition controls include explicit instructions that should appear in run manuals for handling halts and error messages for programs. Answer (B) is correct. A batch total is the sum of information that results from adding a field from each record in a batch or group. It provides for control over the movement or processing of the batch and is considered an application control. Answer (C) is incorrect because library security controls include the organization and operation of a library to preclude misplacement or theft of tapes, programs, and other file media. In addition, internal and external labels should be used so that the proper files are processed. Answer (D) is incorrect because operating controls also include provisions for backup and reconstruction of files if data are lost as a result of processing errors or catastrophes.

[1139] Gleim #: 8.71 -- Source: CIA 1189 II-25 Which of the following terms best describes the type of control practice evidenced by a segregation of duties between computer programmers and computer operators?

A. B. C. D.

Systems development control. Hardware control. Applications control. Organizational control.


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Answer (A) is incorrect because systems development controls concern systems analysis, design, and implementation. Answer (B) is incorrect because hardware controls are incorporated into the equipment. Answer (C) is incorrect because applications controls pertain to specific programs. They include input, processing, and output controls. Answer (D) is correct. Organizational control concerns the proper segregation of duties and responsibilities within the information systems department. For example, programmers should not have access to the equipment, and operators should not have programming ability. Although proper segregation is desirable, functions that would be considered incompatible if performed by a single individual in a manual activity are often performed through the use of an information systems program or series of programs. Therefore, compensating controls may be necessary, such as library controls, effective supervision, and rotation of personnel. [1140] Gleim #: 8.72 -- Source: CIA 595 III-74 When a new application is being created for widespread use in a large organization, the principal liaison between the information systems (IS) department and the rest of an organization is normally a(n)

A. B. C. D.

End user. Application programmer. Maintenance programmer. Systems analyst. Answer (A) is incorrect because the end user never acts as a liaison between the IS department and the rest of the organization. Answer (B) is incorrect because programmers design, write, test, and document the specific programs developed by systems analysts. It is not their responsibility to act as a liaison between the IS department and the rest of the organization. Answer (C) is incorrect because programmers design, write, test, and document the specific programs developed by systems analysts. It is not their responsibility to act as a liaison between the IS department and the rest of the organization. Answer (D) is correct. Systems analysts are specifically qualified to analyze and design computer information systems. They survey the existing system, analyze the organization’s information requirements, and design new systems to meet those needs. Systems analysts communicate with the entire organization and act as a liaison between the organization and the IS department.

[1141] Gleim #: 8.73 -- Source: CIA 588 II-31 Which of the following represents an internal control weakness in a computer-based system?

A. B. C. D.

Computer programmers write and revise programs designed by analysts. The data control group is solely responsible for distributing reports and other output. The computer librarian maintains custody and record keeping for computer application programs. Computer operators have access to operator instructions and the authority to change programs. Answer (A) is incorrect because writing and revising computer programs are appropriate functions for programmers. Answer (B) is incorrect because distributing computer reports is an appropriate function of the control group. Answer (C) is incorrect because maintaining custody and related record keeping for computer programs is appropriate for a computer librarian. Answer (D) is correct. Computer operators need access to operator instructions. Otherwise, they could not perform their duties. Operators, however, should not have the authority to change computer programs.

[1142] Gleim #: 8.74 -- Source: CPA 585 A-26 For control purposes, which of the following should be organizationally segregated from the computer operations function?


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A. B. C. D.

Data conversion. Surveillance of screen display messages. Systems development. Minor maintenance according to a schedule. Answer (A) is incorrect because data conversion may be assigned to computer operations. Answer (B) is incorrect because surveillance of screen display messages may be assigned to computer operations. Answer (C) is correct. Systems analysts are specifically qualified to analyze and design computer information systems. They survey the existing system, analyze the organization’s information requirements, and design new systems to meet those needs. These design specifications will guide the preparation of specific programs by computer programmers. The console operator should not be assigned programming duties, much less responsibility for systems design, and thus not have the opportunity to make changes in programs and systems as (s)he operates the equipment. Answer (D) is incorrect because minor maintenance according to a schedule may be assigned to computer operations.

[1143] Gleim #: 8.75 -- Source: CMA 695 4-22 In the organization of the information systems function, the most important separation of duties is

A. B. C. D.

Not allowing the data librarian to assist in data processing operations. Assuring that those responsible for programming the system do not have access to data processing operations. Having a separate information officer at the top level of the organization outside of the accounting function. Using different programming personnel to maintain utility programs from those who maintain the application programs. Answer (A) is incorrect because librarians maintain control over documentation, programs, and data files; they should have no access to equipment, but they can assist in data processing operations. Answer (B) is correct. Separation of duties is a general control that is vital in a computerized environment. Some separation of duties common in noncomputerized environments may not be feasible in a computer environment. However, certain tasks should not be combined. Systems analysts and programmers should be separate from computer operators. Both programmers and analysts may be able to modify programs, files, and controls, and should therefore have no access to those programs nor to computer equipment. Operators should not be assigned programming duties or responsibility for systems design, and should have no opportunity to make changes in programs and systems. Answer (C) is incorrect because a separate information officer outside of the accounting function would not be as critical a separation of duties as that between programmers and processors. Answer (D) is incorrect because programmers usually handle all types of programs.

[1144] Gleim #: 8.76 -- Source: CMA 1290 4-24 Information processing made possible by a network of computers dispersed throughout an organization is called

A. B. C. D.

Online processing. Interactive processing. Time sharing. Distributed data processing.


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Answer (A) is incorrect because online processing is a method of processing data that permits both immediate posting (updating) and inquiry of master files as transactions occur. Answer (B) is incorrect because interactive processing is a method of processing data immediately upon input. Answer (C) is incorrect because time sharing is the processing of a program by the CPU until an input or output operation is required. In time sharing, the CPU spends a fixed amount of time on each program. Answer (D) is correct. Distributed processing is characterized by a merger of computer and telecommunications technology. Distributed systems permit not only remote access to a computer but also the performance of local processing at local sites. The result is greater flexibility in systems design and the possibility of an optimal distribution of processing tasks. [1145] Gleim #: 8.77 -- Source: CMA 691 4-26 The concept of timeliness of data availability is most relevant to

A. B. C. D.

Payroll systems. Manual systems. Computerized systems. Online systems. Answer (A) is incorrect because timeliness is not necessarily an element of this type of system. Answer (B) is incorrect because timeliness is not necessarily an element of this type of system. Answer (C) is incorrect because timeliness is not necessarily an element of this type of system. Answer (D) is correct. An online processing system is in direct communication with the computer, giving it the capability to handle transactions as they are entered. An online system permits both immediate posting (updating) and inquiry of master files as transactions occur. In an online system, data are immediately available to users upon entry.

[1146] Gleim #: 8.78 -- Source: CMA 692 4-1 Batch processing

A. B. C. D.

Is not used by most businesses because it reduces the audit trail. Allows users to inquire about groups of information contained in the system. Accumulates transaction records into groups for processing against the master file on a delayed basis. Can only be performed on a centralized basis. Answer (A) is incorrect because batch processing provides as much of an audit trail as any computerized operation. Answer (B) is incorrect because batch processing refers to the input of data, not inquiry. Answer (C) is correct. Batch processing is the accumulation and grouping of transactions for processing on a delayed basis. The batch approach is suitable for applications that can be processed against the master file at intervals and involve large volumes of similar items, such as payroll, sales, inventory, and billing. Answer (D) is incorrect because batch processing can also be performed on a decentralized basis.

[1147] Gleim #: 8.79 -- Source: CMA 1290 4-23 An interactive system environment is best characterized by

A. B. C. D.

Data files with records arranged sequentially. The processing of groups of data at regular intervals. Sorting the transaction file before processing. The processing of data immediately on input.


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Answer (A) is incorrect because an interactive system requires direct-access files. Answer (B) is incorrect because an interactive system permits immediate, online processing of single transactions. Answer (C) is incorrect because the transaction file need not be sorted before processing. Answer (D) is correct. In an interactive (inquiry) system, users employ interactive terminals to converse directly with the system. The system is characterized by online entry and processing, direct access, and timesharing. [1148] Gleim #: 8.80 -- Source: CPA 1185 A-52 What type of computer system is characterized by data that are assembled from more than one location and records that are updated immediately?

A. B. C. D.

Personal computer systems. Midrange computer systems. Batch processing systems. Online, real-time systems. Answer (A) is incorrect because, although personal computer systems may be part of a local area network (LAN), they need not be. Answer (B) is incorrect because, although midrange computer systems may be part of a local area network (LAN), they need not be. Answer (C) is incorrect because batching of transactions requires assembly of data at one place and a delay in updating. Answer (D) is correct. Real-time processing involves processing an input record and receiving the output soon enough to affect a current decision-making process. In a real-time system, the user interacts with the system to control an ongoing activity. Online indicates that the decision maker is in direct communication with the computer. Online, realtime systems usually permit access to the server from multiple remote terminals.

[1149] Gleim #: 8.81 -- Source: CIA 589 III-24 If a workstation contains a processor, monitor, printer, storage, and communications capabilities, it is said to be a(n)

A. B. C. D.

Dumb workstation. Intelligent workstation. Noninteractive workstation. Desktop publishing workstation. Answer (A) is incorrect because a dumb workstation usually lacks data processing capacity. Answer (B) is correct. The workstation is usually said to be intelligent if it has data processing capacity, and stored programs can be modified. Such a workstation usually includes a personal computer, an output device, disk storage, and communications links. Intelligent workstations are often connected in a local area network and can therefore communicate with each other. Thus, they are not mere stand-alone personal computers. Answer (C) is incorrect because a noninteractive workstation does not permit the user to direct system activities. Answer (D) is incorrect because desktop publishing is the capability to produce high-quality printing using specialized software.

[1150] Gleim #: 8.82 -- Source: CIA 1191 III-31 A major disadvantage of the life cycle approach to system development is that it is not well-suited for projects that are


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A. B. C. D.

Structured. Large. Complex. Unstructured. Answer (A) is incorrect because the life cycle approach is better suited for structured projects. Answer (B) is incorrect because the life cycle approach is better suited for large projects. Answer (C) is incorrect because the life cycle approach is better suited for complex projects. Answer (D) is correct. The life cycle approach is best employed when systems are large and highly structured, users understand the tasks to be performed by the information system, and the developers have directly applicable experience in designing similar systems. In the life cycle process, each stage of development is highly structured, and requirements are clearly defined. However, when the task is unstructured, prototyping may be the better approach. Prototyping (an experimental assurance process) is costly and time-consuming and thus is not currently the most common approach. It entails developing and putting into operation successively more refined versions of the system until sufficient information is obtained to produce satisfactory design.

[1151] Gleim #: 8.83 -- Source: CIA 1192 III-39 An insurance firm that follows the systems development life cycle concept for all major information system projects is preparing to start a feasibility study for a proposed underwriting system. Some of the primary factors the feasibility study should include are

A. B. C. D.

Possible vendors for the system and their reputation for quality. Exposure to computer viruses and other intrusions. Methods of implementation such as parallel or cut-over. Technology and related costs. Answer (A) is incorrect because possible vendors for the system and their reputation for quality would be determined after the feasibility study. Answer (B) is incorrect because exposure to computer viruses and other intrusions is part of the information requirements phase. Answer (C) is incorrect because methods of implementation such as parallel or cut-over would be determined during the implementation and operations stage. Answer (D) is correct. The feasibility study should consider the activity to be automated, the needs of the user, the type of equipment required, the cost, and the potential benefit to the specific area and the company in general. Thus, technical feasibility and cost are determined during this stage.

[1152] Gleim #: 8.84 -- Source: CIA 1192 III-87 Compared with prototyping, life cycle methodologies are appropriate for problems involving

A. B. C. D.

High user understanding of tasks and large project size. Low user understanding of tasks and small project size. Low user understanding of tasks and uncertainty of requirements. Uncertainty of requirements and large project size.


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Answer (A) is correct. The life cycle approach is best employed when systems are large and highly structured, users understand the tasks to be performed by the information system, and the developers have directly applicable experience in designing similar systems. In the life cycle process, each stage of development is highly structured, and requirements are clearly defined. Answer (B) is incorrect because the lower the user understanding of tasks and the smaller the project size, the less appropriate life cycle methodologies are for the problem. Answer (C) is incorrect because the lower the user understanding of tasks and the more uncertain the requirements, the less appropriate life cycle methodologies are for the problem. Answer (D) is incorrect because the more uncertain the requirements, the less appropriate life cycle methodologies are for the problem. [1153] Gleim #: 8.85 -- Source: CIA 1191 III-29 To be more responsive to its customers, a bank wants a system that will permit account representatives to consolidate information about all the accounts belonging to individual customers. Bank management is willing to experiment with different approaches because the requirements are evolving rapidly. The best development approach for this system is

A. B. C. D.

Prototyping. System development life cycle model. Structured analysis and design technique. Hierarchy-input-process-output. Answer (A) is correct. Prototyping (an experimental assurance process) is costly and time-consuming and thus is not currently the most common approach. It entails developing and putting into operation successively more refined versions of the system until sufficient information is obtained to produce satisfactory design. Prototyping is the best approach in these circumstances because the requirements are difficult to specify in advance and are likely to change significantly during development. Answer (B) is incorrect because the system development life cycle model is appropriate for highly structured operational applications whose requirements can be defined in advance. Thus, it is not suitable for the bank’s application. Answer (C) is incorrect because structured analysis and design technique is a specific application of the system development life cycle model. Answer (D) is incorrect because hierarchy-input-process-output is a specific application of the system development life cycle model.

[1154] Gleim #: 8.86 -- Source: CIA 593 III-47 A bank was considering its first use of computer-aided software engineering (CASE) to develop an inquiry system for account representatives to access consolidated profiles of customers’ accounts. A benefit of using CASE in this situation is that

A. B. C. D.

No new software development tools would be needed. No training of programmers would be required. Management of the development process would be improved. The need for testing would be reduced.


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Answer (A) is incorrect because the first time CASE is used, the bank will have to acquire all the CASE development software. Answer (B) is incorrect because the first time CASE is used, the bank will have to train programmers in its uses. Answer (C) is correct. CASE applies computers to software design and development. It permits creation and maintenance of systems documentation on the computer and the automation of a part of the programming effort. Using CASE would improve management of the development process because the CASE software maintains the links between the different components, provides built-in project management tools, and supplies automated testing aids. Answer (D) is incorrect because using CASE does not reduce the need for testing to verify that program code matches specifications. However, the testing itself is more manageable because of automated testing aids provided by CASE. [1155] Gleim #: 8.87 -- Source: CIA 1192 III-90 Advantages of life cycle methodologies are

A. B. C. D.

Lower overall development costs when requirements change frequently. Ability to give users a functioning system quickly. Reduced application development time to achieve a functioning system. Enhanced management and control of the development process. Answer (A) is incorrect because overall development costs are higher when requirements change frequently in a life cycle methodology. Answer (B) is incorrect because life cycle methodologies are unable to give users a functioning system quickly. Answer (C) is incorrect because life cycle methodologies require lengthy application development time to achieve a functioning system. Answer (D) is correct. The systems development life cycle approach is the most common methodology applied to the development of large, highly structured application systems. The life cycle approach is based on the idea that an information system has a finite life span that is limited by the changing needs of the organization. This cycle is analytically divisible into stages. A new system life cycle begins when the inadequacy of the current system leads to a decision to develop a new or improved system. This method is a structured process for controlling the creative activity required to devise, develop, and implement an information system. The process is described in varying terms by different writers, but the nature and sequence of the steps are essentially the same. Life cycle methodologies provide enhanced management and control of the development process because they provide structure for a creative process by dividing it into manageable steps and specifying what must be produced in each phase.

[1156] Gleim #: 8.88 -- Source: CISA Application control objectives do not normally include assurance that

A. B. C. D.

Authorized transactions are completely processed once and only once. Transaction data are complete and accurate. Review and approval procedures for new systems are set by policy and adhered to. Processing results are received by the intended user.


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Answer (A) is incorrect because an objective of application controls is that authorized transactions are completely processed once and only once. Answer (B) is incorrect because an objective of application controls is that transaction data is complete and accurate. Answer (C) is correct. Application controls provide reasonable assurance that the recording, processing, and reporting of data are properly performed. Review and approval procedures for new systems are among the general controls known as system software acquisition and maintenance controls. Answer (D) is incorrect because an objective of application controls is that processing results are received by the intended user. [1157] Gleim #: 8.89 -- Source: CMA 693 4-6 Data processed by a computer system are usually transferred to some form of output medium for storage. However, the presence of computerized output does not, in and of itself, assure the output’s accuracy, completeness, or authenticity. For this assurance, various controls are needed. The major types of controls for this area include

A. B. C. D.

Transaction controls, general controls, and printout controls. Activity listings, echo checks, and pre-numbered forms. Tape and disk output controls and printed output controls. Input controls, tape and disk output controls, and printed output controls. Answer (A) is incorrect because transaction controls and general controls do not ensure the completeness and authenticity of the output. Answer (B) is incorrect because activity listings and prenumbered forms do not ensure control of the output in a system, and output controls are needed to ensure the accuracy of the output. Answer (C) is incorrect because input controls are needed to ensure the completeness and authenticity of the output. Answer (D) is correct. Input controls provide reasonable assurance that data received for processing have been properly authorized, converted into machine-sensible form, and identified, and that data have not been lost, suppressed, added, duplicated, or otherwise improperly changed. Output controls provide assurance that the processing result (such as reports, tape and disk, magnetic files, invoices, or printed output) is accurate and that only authorized personnel receive the output.

[1158] Gleim #: 8.90 -- Source: CIA 579 II-5 Which of the following should the auditor recommend as the most economical point at which to correct input errors in an online system?

A. B. C. D.

Input data are balanced with computer-produced control totals. Entry of data into each field of a record is completed. Output data are balanced with computer-produced control totals and delivered to the user. Entry of data into each record is completed. Answer (A) is incorrect because the most economical point is the earliest time after data has been entered into the system. Answer (B) is correct. The most economical point at which to correct input errors is at the earliest time after the data has been entered into the system. The earliest point is the entry of data into each field of a record. Errors can easily be rectified because the proper information is already available. Answer (C) is incorrect because the most economical point is the earliest time after data has been entered into the system. Answer (D) is incorrect because the most economical point is the earliest time after data has been entered into the system.


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[1159] Gleim #: 8.91 -- Source: CPA 1192 A-20 If a control total were to be computed on each of the following data items, which would best be identified as a hash total for a payroll computer application?

A. B. C. D.

Hours worked. Total debits and total credits. Net pay. Department numbers. Answer (A) is incorrect because hours worked is an example of a financial (amount) total. Answer (B) is incorrect because total debits and total credits is a financial total. Answer (C) is incorrect because net pay is a financial total. Answer (D) is correct. The three types of control totals are record counts, financial (amount) totals, and hash totals. Record counts establish the number of source documents and reconcile it to the number of output records. Financial (amount) totals compute dollar or amount totals from source documents (e.g., the total dollar amount of invoices processed) and reconcile them with the output records. Hash totals add numbers on input documents that are not normally added (e.g., department numbers for payroll processing) and reconcile them with output records.

[1160] Gleim #: 8.92 -- Source: CPA AUD R98-4 An entity has the following invoices in a batch: Invoice Number

Product

Quantity

Unit Price

201 202 203 204

F10 G15 H20 K35

150 200 250 300

$ 5.00 $10.00 $25.00 $30.00

Which of the following most likely represents a hash total?

A. B. C. D.

FGHK80 4 204 810 Answer (A) is incorrect because a hash total is ordinarily the sum of a numeric field. Answer (B) is incorrect because 4 is a record count. Answer (C) is incorrect because 204 is an invoice number. Answer (D) is correct. Input controls in batch computer systems are used to determine that no data are lost or added to the batch. Depending on the sophistication of a particular system, control may be accomplished by using record counts, batch totals, or hash totals. The hash total is a control total without a defined meaning, such as the total of employee numbers or invoice numbers, that is used to verify the completeness of data. The hash total of the invoice numbers is 810.

[1161] Gleim #: 8.93 -- Source: CIA 1190 III-23 In an order-entry system, in which manually-prepared source documents are entered online for immediate processing, which of the following is an example of an appropriate input-output control?


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A. B. C. D.

Password authorization procedure. Check-digit validation procedure. Hash total verification. Backup and recovery procedures. Answer (A) is incorrect because password authorization is a general control over access to the system or parts of it. Answer (B) is correct. Self-checking digits may be used to detect incorrect identification numbers. The digit is generated by applying an algorithm to the ID number. During the input process, the check digit is recomputed by applying the same algorithm to the code actually entered. Answer (C) is incorrect because hash totals (otherwise meaningless control totals, e.g., of identification numbers) are appropriate for batch processing. Answer (D) is incorrect because backup and recovery procedures are general controls.

[1162] Gleim #: 8.94 -- Source: CPA AUD R98-5 A customer intended to order 100 units of product Z96014, but incorrectly ordered nonexistent product Z96015. Which of the following controls most likely would detect this error?

A. B. C. D.

Check digit verification. Record count. Hash total. Redundant data check. Answer (A) is correct. Check digit verification is used to identify incorrect identification numbers. The digit is generated by applying an algorithm to the ID number. During input, the check digit is recomputed by applying the same algorithm to the entered ID number. Answer (B) is incorrect because a record count is a control total of the number of transactions in a batch. Answer (C) is incorrect because a hash total is a control total that is the sum of a field without a defined meaning. Answer (D) is incorrect because a redundant data check searches for duplicate information in a database.

[1163] Gleim #: 8.95 -- Source: CIA 1195 III-63 A validation check used to determine if a quantity ordered field contains only numbers is an example of a(n)

A. B. C. D.

Input control. Audit trail control. Processing control. Data security control. Answer (A) is correct. A validation check at data entry verifying that a quantity field contains only numbers is an example of a programmatic means of ensuring the accuracy of an input value. Thus, it is an input control. Answer (B) is incorrect because the purpose of an audit trail control is to ensure that a chronological record of all relevant events in a system has been recorded. Answer (C) is incorrect because a processing control ensures that data are complete and accurate during updating. Answer (D) is incorrect because a data security control ensure that only authorized individuals are permitted to access and use a system.


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[1164] Gleim #: 8.96 -- Source: CIA 1187 I-30 An accounts payable program posted a payable to a vendor not included in the online vendor master file. A control that would prevent this error is a

A. B. C. D.

Validity check. Range check. Reasonableness test. Parity check. Answer (A) is correct. Validity checks are tests of identification numbers or transaction codes for validity by comparison with items already known to be correct or authorized. For example, Social Security numbers on payroll input records can be compared with Social Security numbers authorized by the personnel department. Answer (B) is incorrect because a range check is based on known limits for given information. Answer (C) is incorrect because a reasonableness test is based on known limits for given information. Answer (D) is incorrect because a parity check adds the bits in a character or message and checks the sum to determine if it is odd or even, depending on whether the computer has odd or even parity.

[1165] Gleim #: 8.97 -- Source: CMA 687 5-4 Which one of the following input validation routines is not likely to be appropriate in a real-time operation?

A. B. C. D.

Sign check. Reasonableness check. Sequence check. Redundant data check. Answer (A) is incorrect because sign checks test data for the appropriate arithmetic sign. For instance, hours worked in a payroll should always be a positive number. Answer (B) is incorrect because reasonableness tests verify that amounts fall within predetermined limits. Answer (C) is correct. The program controls listed prescreen or edit data prior to processing, but the sequence check is most likely to be used only in batch processing. A sequence check tests to determine that records are in proper order. For example, a payroll input file can be sorted into Social Security number order. A sequence check can then be performed to verify record order. This control would not apply in a real-time operation because records are not processed sequentially. Answer (D) is incorrect because a redundancy check requires sending additional data items to serve as a check on the other transmitted data; for example, part of a customer name can be matched against the name associated with the transmitted customer number.

[1166] Gleim #: 8.98 -- Source: CMA 1287 5-16 An employee in the receiving department keyed in a shipment from a remote terminal and inadvertently omitted the purchase order number. The best systems control to detect this error is

A. B. C. D.

Completeness test. Sequence check. Reasonableness test. Compatibility test.


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Answer (A) is correct. A completeness test checks that all data elements are entered before processing. An interactive system can be programmed to notify the user to enter the number before accepting the receiving report. Answer (B) is incorrect because a sequence check tests for the ordering, not omission, of records. Answer (C) is incorrect because a limit or reasonableness test checks the values of data items against established limits. Answer (D) is incorrect because a compatibility test (field check) determines whether characters are appropriate to a field. [1167] Gleim #: 8.99 -- Source: CIA 1193 II-25 To ensure the completeness of update in an online system, separate totals are accumulated for all transactions processed throughout the day. The computer then agrees these totals to the total of items accepted for processing. This is an example of

A. B. C. D.

Run-to-run controls. Computer matching. Computer sequence check. One-for-one checking. Answer (A) is correct. During each program run in a series, the computer accumulates the totals of transactions that have been processed. The run-to-run check reconciles them with the totals forwarded from the previous program run. Run-to-run totals thus ensure completeness of update. Answer (B) is incorrect because computer matching compares transaction data with referenced fields or records. Answer (C) is incorrect because computer sequence checks identify changes or breaks in a numerical sequence. Answer (D) is incorrect because one-for-one checking usually requires manual comparisons of input data elements with processing results.

[1168] Gleim #: 8.100 -- Source: CIA 1189 II-31 Reconciling input with processing control totals to ensure that all transactions have been processed is an example of

A. B. C. D.

An input control. A processing control. An output control. An access control. Answer (A) is incorrect because input controls are designed to provide reasonable assurance that data received for processing have been properly authorized and are in a suitable form. Input controls also include those that relate to rejection, correction, and resubmission of data that were initially incorrect. Answer (B) is incorrect because processing controls provide reasonable assurance that all transactions are processed as authorized, no authorized transactions are omitted, and no unauthorized transactions are added. Answer (C) is correct. Application controls include input, processing, and output controls. Output controls are designed to assure the accuracy of processing results and that only authorized personnel receive the output. For example, comparing the control total of input documents with the total documents processed is an output control. Answer (D) is incorrect because access controls prevent unauthorized and improper use of data and programs.

[1169] Gleim #: 8.101 -- Source: CMA 685 5-14 Program documentation is a control designed primarily to ensure that


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A. B. C. D.

Programmers have access to the tape library or information on disk files. Programs do not make mathematical errors. Programs are kept up to date and perform as intended. No one has made use of the computer hardware for personal reasons. Answer (A) is incorrect because programmers should not have access to operational materials. Answer (B) is incorrect because editing routines check for arithmetic errors prior to processing, and debugging should uncover errors in programs. Answer (C) is correct. Complete, up-to-date documentation of all programs and associated operating procedures is necessary for efficient operation of a computer installation. Maintenance of programs is important to provide for continuity and consistency of data processing services to users. Program documentation (the program run manual) consists of problem statements, systems flowcharts, operating instructions, record layouts, program flowcharts, program listings, test data, and approval and change sheets. Answer (D) is incorrect because documentation cannot ensure computer security.

[1170] Gleim #: 8.102 -- Source: CIA 593 II-27 The accountant who prepared a spreadsheet model for workload forecasting left the company, and the accountant’s successor was unable to understand how to use the spreadsheet. The best control for preventing such situations from occurring is to ensure that

A. B. C. D.

Use of end-user computing resources is monitored. End-user computing efforts are consistent with strategic plans. Documentation standards exist and are followed. Adequate backups are made for spreadsheet models. Answer (A) is incorrect because monitoring concerns controlling the use of resources. Answer (B) is incorrect because consistency with strategic plans concern evaluation of the system. Answer (C) is correct. The accountant’s successor could not use the forecasting model because of inadequate documentation. By requiring that documentation standards exist and are followed, the company will enable new employees to understand internally developed programs when the developer leaves the organization. Answer (D) is incorrect because maintaining adequate backups for spreadsheet models is necessary, but lack of adequate backup is not the reason the accountant’s successor could not use the forecasting model.

[1171] Gleim #: 8.103 -- Source: CIA 596 III-36 Change control typically includes procedures for separate libraries for production programs and for test versions of programs. The reason for this practice is to

A. B. C. D.

Promote efficiency of system development. Segregate incompatible duties. Facilitate user input on proposed changes. Permit unrestricted access to programs.


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Answer (A) is incorrect because production and test programs can be separated only if a specific procedure exists for placing programs in production libraries. Thus, maintaining the separation requires its own procedure, which may decrease development efficiency. Answer (B) is correct. Separating production and test versions of programs facilitates restricting access to production programs to the individuals, such as computer operators, who need access. The effect is to separate the incompatible functions of operators and programmers. Answer (C) is incorrect because separating production and test versions of programs is independent of facilitating user input on proposed changes. Answer (D) is incorrect because separating production and test versions of programs restricts access to programs. [1172] Gleim #: 8.104 -- Source: CIA 1196 III-49 A company often revises its production processes. The changes may entail revisions to processing programs. Ensuring that changes have a minimal impact on processing and result in minimal risk to the system is a function of

A. B. C. D.

Security administration. Change control. Problem tracking. Problem-escalation procedures. Answer (A) is incorrect because security administration is concerned with access to data. Answer (B) is correct. Change control is the process of authorizing, developing, testing, and installing coded changes so as to minimize the impact on processing and the risk to the system. Answer (C) is incorrect because problem tracking is concerned with collecting data to be analyzed for corrective action. Answer (D) is incorrect because problem escalation-procedures are a means of categorizing problems so that the least skilled person can address them.

[1173] Gleim #: 8.105 -- Source: CIA 597 III-49 Minimizing the likelihood of unauthorized editing of production programs, job control language, and operating system software can best be accomplished by

A. B. C. D.

Database access reviews. Compliance reviews. Good change-control procedures. Effective network security software. Answer (A) is incorrect because database reviews determine whether users have gained access to database areas for which they have no authorization or whether they are employing programs that provide them with unauthorized privileges to view or change information. Answer (B) is incorrect because compliance reviews determine whether an organization has complied with applicable internal and external procedures and regulations. Answer (C) is correct. Program change control includes (1) maintaining records of change authorizations, code changes, and test results; (2) adhering to a systems development methodology (including documentation); (3) authorizing changeovers of subsidiary and headquarters’ interfaces; and (4) restricting access to authorized source and executable codes. Answer (D) is incorrect because network security audits review the physical and logical controls over the network.

[1174] Gleim #: 8.106 -- Source: CIA 591 I-36 Rejection of unauthorized modifications to application systems could be accomplished through the use of


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A. B. C. D.

Programmed checks. Batch controls. Implementation controls. One-for-one checking. Answer (A) is incorrect because programmed checks determine the potential accuracy of input data (e.g., a range check). Answer (B) is incorrect because batch control is used to ensure the completeness and accuracy of input and updating. Answer (C) is correct. General controls include organizational controls, such as a policy (an implementation control) that requires new programs and changes in programs (after adequate testing) to be formally approved before being put into operation (implemented). This policy is reflected in the maintenance of approval and change sheets with appropriate authorizations. Answer (D) is incorrect because one-for-one checking is a technique used to check individual documents for accuracy and completeness of data input or update.

[1175] Gleim #: 8.107 -- Source: CIA 596 III-61 Which of the following risks is more likely to be encountered in an end-user computing (EUC) environment as compared with a mainframe computer system?

A. B. C. D.

Inability to afford adequate uninterruptible power supply systems. User input screens without a graphical user interface (GUI). Applications that are difficult to integrate with other information systems. Lack of adequate utility programs. Answer (A) is incorrect because inability to afford adequate uninterruptible power supply systems is a risk in all computing environments. Answer (B) is incorrect because lack of a GUI is a risk in all computing environments. Answer (C) is correct. The risk of allowing end users to develop their own applications is decentralization of control. End-user developed applications may not be subject to an independent outside review by systems analysts and are not created in the context of a formal development methodology. These applications may lack appropriate standards, controls, and quality assurance procedures. Moreover, when end users create their own applications and files, private information systems may proliferate in which data are largely uncontrolled. These systems may contain the same information, but end-user applications may update and define the data in different ways. Thus, determining the location of data and ensuring data consistency become more difficult because the applications are difficult to integrate. Answer (D) is incorrect because lack of adequate utility programs is a risk in all computing environments.

[1176] Gleim #: 8.108 -- Source: CIA 1194 I-37 Responsibility for the control of end-user computing exists at the organizational, departmental, and individual user level. Which of the following should be a direct responsibility of the individual users?

A. B. C. D.

Acquisition of hardware and software. Taking equipment inventories. Strategic planning of end-user computing. Physical security of equipment.


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Answer (A) is incorrect because the acquisition of hardware and software is an organizational- and departmental-level responsibility. Answer (B) is incorrect because taking equipment inventories is an organizational-level responsibility. Answer (C) is incorrect because strategic planning is an organizational- and departmental-level responsibility. Answer (D) is correct. End-user computing involves user-created or -acquired systems that are maintained and operated outside of traditional information systems controls. In this environment, an individual user is ordinarily responsible for the physical security of the equipment (s)he uses. [1177] Gleim #: 8.109 -- Source: CIA 595 III-40 Which of the following security controls might prevent unauthorized access to sensitive data via an unattended workstation directly connected to a mainframe?

A. B. C. D.

Use of a screen saver. Use of passwords to identify users. Encryption of data files. Automatic log-off of inactive users. Answer (A) is incorrect because a screen saver is software used to prevent the burning of an image onto the monitor’s screen. Answer (B) is incorrect because the unattended workstation has likely already had the required password provided to gain access. Answer (C) is incorrect because data is only encrypted when stored in a file. While the data or file is being modified by a user, the data is not encrypted. Thus, an unattended workstation would leave data susceptible to unauthorized access. Answer (D) is correct. Automatic log-off of inactive users is a utility that disconnects a workstation from the mainframe or server after a certain amount of time. Once the workstation has been disconnected, the user must log back into the system.

[1178] Gleim #: 8.110 -- Source: CIA 595 III-69 In general, mainframe computer production programs and data are adequately protected against unauthorized access. Certain utility software may, however, have privileged access to software and data. To compensate for the risk of unauthorized use of privileged software, information systems (IS) management can

A. B. C. D.

Prevent privileged software from being installed on the mainframe. Restrict privileged access to test versions of applications. Limit the use of privileged software. Keep sensitive programs and data on an isolated machine. Answer (A) is incorrect because privileged software may be needed on the mainframe to modify programs and data. Answer (B) is incorrect because privileged access may be necessary to modify the final versions of applications. Answer (C) is correct. Since certain utility software may have privileged access to software and data stored on the mainframe, management must control the use of this utility software. Management should limit the use of this software to only those individuals with appropriate authority. Answer (D) is incorrect because authorized users must access sensitive programs and data through their workstations that are connected to the mainframe.

[1179] Gleim #: 8.111 -- Source: CIA 1194 III-32 The primary purpose of a controller is to


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A. B. C. D.

Compensate for the differences in the rates of flow of data from input/output devices to the central processing unit (CPU). Compensate for the differences in the lengths of records in a file. Compensate for the differences in the execution time in various program instructions. Compensate for the differences in the volume of data that can be transmitted between communication devices. Answer (A) is correct. Controllers are hardware units designed to operate (control) specific input or output units, e.g., terminals and printers. These devices eliminate the need for the CPU to operate such devices. The term “buffers and channels” is also sometimes used to describe devices that link the CPU with input/output devices and storage units. Controllers may hold large blocks of logical records to compensate for the differences in the rates of flow of data between input/output devices and the central processing unit. Answer (B) is incorrect because compensating for the differences in the lengths of records in a file is achieved by setting aside space in the file control block for the longest record that will be encountered. Answer (C) is incorrect because there is no compensating for the differences in the execution time in various program instructions. Answer (D) is incorrect because multiplexors and concentrators compensate for the differences in the volume of data that can be transmitted between communication devices.

[1180] Gleim #: 8.112 -- Source: CIA 1191 III-32 Which of the following measures would indicate the computational power of a microprocessor?

A. B. C. D.

Capacity of the hard disk. Main memory storage capacity. Number of bits processed per second. Read only memory. Answer (A) is incorrect because capacity of the hard disk is a measure of memory. Answer (B) is incorrect because main memory storage capacity is a measure of memory. Answer (C) is correct. Processing speed is commonly calculated in terms of arithmetic-logic operations performed per second. This method is a function of the main processing chip’s cycle speed stated in gigahertz. Answer (D) is incorrect because read only memory is main memory that ordinarily cannot be modified by the user. It is not a performance measure.

[1181] Gleim #: 8.113 -- Source: CIA 590 III-28 Which of the following computer hardware devices allows for an immediate update of merchandise inventory in a retail environment?

A. B. C. D.

Inventory control terminal. Monitor. Video display terminal. Point-of-sale terminal.


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Answer (A) is incorrect because it is not meaningful in this context. Answer (B) is incorrect because a monitor is a video display device that is the most common device used for human-computer interaction. Answer (C) is incorrect because a video display terminal is a video display device that is the most common device used for human-computer interaction. Answer (D) is correct. Point-of-sale terminals capture data by optical scanning or by keying. The data are then transmitted to a CPU. The system permits collection of sales data, updating and ordering of inventory, pricing at the point of sale, and checking of customer credit cards. [1182] Gleim #: 8.114 -- Source: CIA R98 III-60 What technology is needed in order to convert a paper document into a computer file?

A. B. C. D.

Optical character recognition. Electronic data interchange. Bar-code scanning. Joining and projecting. Answer (A) is correct. Optical character recognition (OCR) hardware scans special marks (e.g., bar codes), characters, or other codes and converts them into digital format. Answer (B) is incorrect because EDI is the communication of electronic documents directly from a computer in one entity to a computer in another entity, for example, to order goods from a supplier or to transfer funds. Answer (C) is incorrect because bar-code scanning is just one form of OCR. Answer (D) is incorrect because joining and projecting are basic operations in a relational database.

[1183] Gleim #: 8.115 -- Source: CMA 1294 4-11 A characteristic of a personal computer system that displays more than one program on the screen at the same time, places each program is in its own area of the screen, but permits only one program to be active, is

A. B. C. D.

Windowing. Distributed processing. Context switching. File extension. Answer (A) is correct. A graphical user interface is part of an operating system with which users may interact. It uses graphic icons to represent activities, programs, and files. The computer mouse is used to make selections. Windows is a graphical user interface shell initially developed by Microsoft to run in conjunction with DOS. Newer operating systems also have this feature. Thus, windowing is the characteristic that allows a computer to display more than one program on the screen at the same time. Each program has its own section of the screen, but only one program is active. Answer (B) is incorrect because distributed processing is a means of assigning computer processing to various segments of a business, with some aspects centralized and some decentralized. Answer (C) is incorrect because context switching does not relate to the various segments on a computer screen. Answer (D) is incorrect because a file extension is a means of extending a logical collection of records.

[1184] Gleim #: 8.116 -- Source: IIA, adapted Which of the following is not a typical output control?


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A. B. C. D.

Reviewing the computer processing logs to determine that all of the correct computer jobs executed properly. Matching input data with information on master files and placing unmatched items in a suspense file. Periodically reconciling output reports to make sure that totals, formats, and critical details are correct and agree with input. Maintaining formal procedures and documentation specifying authorized recipients of output reports, checks, or other critical documents. Answer (A) is incorrect because review of the computer processing logs is an output control to ensure that data are accurate and complete. Answer (B) is correct. Matching the input data with information held on master or suspense files is a processing control, not an output control, to ensure that data are complete and accurate during updating. Answer (C) is incorrect because periodic reconciliation of output reports is an output control to ensure that data are accurate and complete. Answer (D) is incorrect because maintaining formal procedures and documentation specifying authorized recipients is an output control to ensure proper distribution.

[1185] Gleim #: 8.117 -- Source: IIA, adapted Which implemented control would best assist in meeting the control objective that a system have the capability to hold users accountable for functions performed?

A. B. C. D.

Programmed cutoff. Redundant hardware. Activity logging. Transaction error logging. Answer (A) is incorrect because programmed cutoff controls mitigate the risk of recording transactions in the wrong period. Answer (B) is incorrect because redundant hardware is a control over hardware malfunction. Answer (C) is correct. Activity logging provides an audit trail of user activity. Answer (D) is incorrect because transaction error logging controls transactions rather than user terminal activity.

[1186] Gleim #: 8.118 -- Source: IIA, adapted Image processing systems have the potential to reduce the volume of paper circulated throughout an organization. To reduce the likelihood of users relying on the wrong images, management should ensure that appropriate controls exist to maintain the

A. B. C. D.

Legibility of image data. Accessibility of image data. Integrity of index data. Initial sequence of index data. Answer (A) is incorrect because legibility of image data is important to its use, but is independent of using the wrong image. Answer (B) is incorrect because accuracy of image data is important to its use, but is independent of using the wrong image. Answer (C) is correct. Data integrity is a protectibility objective. If index data for image processing systems are corrupted, users will likely be relying on the wrong images. Answer (D) is incorrect because maintaining the initial sequence of index data may not be possible as the image data is modified and images are added/dropped.


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[1187] Gleim #: 8.119 -- Source: IIA, adapted Both users and management approve the initial proposal, design specifications, conversion plan, and testing plan of an information system. This is an example of

A. B. C. D.

Implementation controls. Hardware controls. Computer operations controls. Data security controls. Answer (A) is correct. Implementation controls occur in the systems development process at various points to ensure that implementation is properly controlled and managed. Answer (B) is incorrect because hardware controls ensure that computer hardware is physically secure and check for equipment malfunction. Answer (C) is incorrect because computer operations controls apply to the work of the computer department and help ensure that programmed procedures are consistently and correctly applied to the storage and processing of data. Answer (D) is incorrect because data security controls ensure that data files on either disk or tape are not subject to unauthorized access, change, or destruction.

[1188] Gleim #: 8.120 -- Source: IIA, adapted A total interruption of processing throughout a distributed information technology system can be minimized through the use of

A. B. C. D.

Exception reporting. Fail-soft protection. Backup and recovery. Data file security. Answer (A) is incorrect because exception reporting can be used to control correctness and timeliness of updates but cannot minimize the impact of an interruption. Answer (B) is correct. An advantage of distributed processing is fail-soft protection, that is, the ability to continue processing at all sites except a nonfunctioning one. Answer (C) is incorrect because backup procedures are intended to prevent the recovery process from introducing any erroneous changes into the system after computer failure. Answer (D) is incorrect because data file security is intended to prevent unauthorized changes to data files.

[1189] Gleim #: 8.121 -- Source: IIA, adapted To avoid invalid data input, a bank added an extra number at the end of each account number and subjected the new number to an algorithm. This technique is known as

A. B. C. D.

Sequence check. A check digit. Cross-footing. Field check.


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Answer (A) is incorrect because sequence checks determine that records are in the proper order. Answer (B) is correct. Self-checking digits may be used to detect incorrect identification numbers. A check digit is an extra reference number that follows an identification code and bears a mathematical relationship to the other digits. The extra digit is input with the data. The identification code can be subjected to an algorithm and compared to the check digit. Answer (C) is incorrect because cross-footing compares an amount to the sum of its components. Answer (D) is incorrect because field checks are tests of the characters in a field to verify that they are of an appropriate type for that field (i.e., alphabetic versus numeric). [1190] Gleim #: 8.122 -- Source: IIA, adapted What technique could be used to prevent the input of alphabetic characters into an all numeric identification number?

A. B. C. D.

A sequence check. A check digit. A record count. A format check. Answer (A) is incorrect because a sequence check determines that records are in proper order. Answer (B) is incorrect because a check digit is used to detect an incorrect ID number. Answer (C) is incorrect because a record count is a control total of the number of records processed during the operation of a program. Answer (D) is correct. With a format check, the computer checks the characteristics of the character content, length, or sign of the individual data fields. Field checks, sign checks and range checks are examples of format checks.

[1191] Gleim #: 8.123 -- Source: IIA, adapted A manufacturer of complex electronic equipment such as oscilloscopes and microscopes has been shipping its products with thick paper manuals but wants to reduce the cost of producing and shipping this documentation. Of the following, the best medium for the manufacturer to use to accomplish this is

A. B. C. D.

Write-once-read-many. Digital audio tape. Compact disc/read-only memory. Computer-output-to-microform. Answer (A) is incorrect because write-once-read-many (WORM) is an optical storage technique often used as an archival medium. Answer (B) is incorrect because digital audiotape (DAT) is primarily used as a backup medium in imaging systems and as a master for CD-ROM. Answer (C) is correct. Compact-disc/read-only memory (CD-ROM) would be cheaper to produce and ship than the existing paper yet permit large volumes of text and images to be reproduced. Users of the electronic equipment are likely to have access to CD-ROM readers on personal computers so that they could use the documentation on CDROM. Answer (D) is incorrect because computer-output-to-microform (COM) is used for frequent access to archived documents such as canceled checks in banking applications.

[1192] Gleim #: 8.124 -- Source: IIA, adapted In a large organization, the biggest risk in not having an adequately staffed information center help desk is


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A. B. C. D.

Increased difficulty in performing application audits. Inadequate documentation for application systems. Increased likelihood of use of unauthorized program code. Persistent errors in user interaction with systems. Answer (A) is incorrect because application audits should be about the same dificulty with or without an adequately staffed help desk. Answer (B) is incorrect because preparation of documentation is a development function, not a help desk function. Answer (C) is incorrect because the likelihood of use of unauthorized program code is a function of change control, not of a help desk. Answer (D) is correct. The biggest risk in not having an adequately staffed help desk is that users will unknowingly persist in making errors in their interaction with the information systems.

[1193] Gleim #: 8.125 -- Source: IIA, adapted What technology is needed in order to convert a paper document into a computer file?

A. B. C. D.

Optical character recognition. Electronic data interchange. Bar-code scanning. Shareware. Answer (A) is correct. Optical character recognition (OCR) software converts images of paper documents, as read by a scanning device, into text document computer files. Answer (B) is incorrect because EDI is the electronic communication between computers of two entities. Answer (C) is incorrect because bar code scanning uses technology to read bar codes. Answer (D) is incorrect because shareware is software made available for a fee.

[1194] Gleim #: 8.126 -- Source: IIA, adapted Which of the following would not be appropriate to consider in the physical design of a data center?

A. B. C. D.

Evaluation of potential risks from railroad lines and highways. Use of biometric access systems. Design of authorization tables for operating system access. Inclusion of an uninterruptible power supply system and surge protection. Answer (A) is incorrect because external risks should be evaluated to determine the center’s location. Answer (B) is incorrect because biometric access systems control physical access to the data center. Answer (C) is correct. Authorization tables for operating system access address logical controls, not physical controls. Answer (D) is incorrect because power supply systems and surge protection are included in data center design.

[1195] Gleim #: 8.127 -- Source: IIA, adapted Inefficient usage of excess computer equipment can be controlled by


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A. B. C. D.

Contingency planning. System feasibility studies. Capacity planning. Exception reporting. Answer (A) is incorrect because contingency planning refers to the arrangements for alternative processing facilities in the event of equipment failure. Answer (B) is incorrect because the feasibility study is one of the phases in the systems development life cycle. Answer (C) is correct. The plan should include goals and objectives, an inventory of current capacity, and a forecast of future needs. Answer (D) is incorrect because exception reports are meant to highlight problems and bring them to the attention of management.

[1196] Gleim #: 8.128 -- Source: IIA, adapted An electronics company has decided to implement a new system through the use of rapid application development techniques. Which of the following would be included in the development of the new system?

A. B. C. D.

Deferring the need for system documentation until the final modules are completed. Removing project management responsibilities from the development teams. Creating the system module by module until completed. Using object development techniques to minimize the use of previous code. Answer (A) is incorrect because system documentation is not eliminated or deferred by using rapid application development. Answer (B) is incorrect because project management involves development teams. Answer (C) is correct. The new system would be developed module by module until completed. Answer (D) is incorrect because object development might not be of use; if it were, it would increase usage of previous code.

[1197] Gleim #: 8.129 -- Source: IIA, adapted A bank is developing a computer system to help evaluate loan applications. The information systems (IS) staff interview the bank’s mortgage underwriters to extract their knowledge and decision processes for input into the computer system. The completed system should be able to process information the same as do the underwriters and make final recommendations regarding loan decisions. This approach is called

A. B. C. D.

An expert system. A neural network. An intelligent agent. Fuzzy logic.


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Answer (A) is correct. An expert system is a knowledge-intensive computer program that captures the expertise of a human in limited domains of knowledge. Answer (B) is incorrect because a neural network is software that attempts to emulate the processing patterns of the biological brain. Answer (C) is incorrect because intelligent agents are software programs that use a built-in or learned knowledge base to carry out specific, repetitive, and predictable tasks for an individual user, business process, or software application. On the Internet, an intelligent agent is generally a program that gathers information or performs some other service without the user’s immediate presence and on some regular schedule. Answer (D) is incorrect because fuzzy logic is rule-based artificial intelligence that tolerates imprecision by using non-specific terms called membership functions to solve problems. [1198] Gleim #: 8.130 -- Source: IIA, adapted User acceptance testing is more important in an object-oriented development process than in a traditional environment because of the implications of the

A. B. C. D.

Absence of design documentation. Lack of a tracking system for changes. Potential for continuous monitoring. Inheritance of properties in hierarchies. Answer (A) is incorrect because, instead of traditional design documents, items such as the business model, narratives of process functions, iterative development screens, computer processes and reports, and product descriptions guides are produced in object-oriented development, but the existence of specific documents does not affect the importance of user acceptance testing. Answer (B) is incorrect because, in general, object-oriented development systems do include tracking systems for changes made to objects and hierarchies. Answer (C) is incorrect because object-oriented systems are usually developed in client/server environments, there is the potential for continuous monitoring of system use, but continuous monitoring typically occurs during system operation, not during development. Answer (D) is correct. User acceptance testing is more important in object-oriented development because of the fact that all objects in a class inherit the properties of the hierarchy, which means that changes to one object may affect other objects, which increases the importance of user acceptance testing to verify correct functioning of the whole system.

[1199] Gleim #: 8.131 -- Source: IIA, adapted Which of the following actions would best address a concern that data uploaded from a desktop computer may be erroneous?

A. The mainframe computer should be backed up on a regular basis. B. Two persons should be present at the desktop computer when it is uploading data. C. The mainframe computer should subject the data to the same edits and validation routines that online data entry would require. D. Users should be required to review a random sample of processed data.


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Answer (A) is incorrect because this practice is a wise control, but it does not address the issue of the integrity of uploaded data. Backups cannot prevent or detect data-upload problems, but can only help correct data errors that a poor upload caused. Answer (B) is incorrect because this control may be somewhat helpful in preventing fraud in data uploads, but it is of little use in preventing errors. Answer (C) is correct. The same edits and validation routines used for online data entry should be applied to data uploaded from a desktop computer. This could help prevent data errors. Answer (D) is incorrect because this control is detective in nature, but the error could have already caused erroneous reports and management decisions. Having users try to find errors in uploaded data would be costly. [1200] Gleim #: 8.132 -- Source: IIA, adapted Preventing someone with sufficient technical skill from circumventing security procedures and making changes to production programs is best accomplished by

A. B. C. D.

Reviewing reports of jobs completed. Comparing production programs with independently controlled copies. Running test data periodically. Providing suitable segregation of duties. Answer (A) is incorrect because the reviews of jobs processed will disclose access, but will not prevent it. Answer (B) is incorrect because comparison of production programs and controlled copies will disclose changes, but will not prevent them. Answer (C) is incorrect because periodic running of test data will detect changes, but will not prevent them. Answer (D) is correct. When duties are separated, users cannot obtain a detailed knowledge of programs and computer operators cannot gain unsupervised access to production programs.

[1201] Gleim #: 8.133 -- Source: IIA, adapted Which of the following access setups is appropriate in a computer environment?

Update Access for Production Data

Update Access for Production Programs

Users

Application Programmers

Users

Application Programmers

Have?

Have?

Have?

Have?

A. B.

Yes Yes

No No

No No

No Yes

C. D.

No No

Yes Yes

Yes Yes

No Yes

Answer (A) is correct. The appropriate setup for access in the computer environment is for users to have update access for production data. Users need to update data through applications programs, but have have no need to change production programs. Answer (B) is incorrect because application programmers should not be able to change production programs. They should submit changes to the change control unit. Answer (C) is incorrect because application programmers should never have update access to production data. Users have no need to change production programs. Answer (D) is incorrect because application programmers should not be able to change production programs. They should submit changes to the change control unit. Application programmers should never have update access to production data.


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[1202] Gleim #: 8.134 -- Source: CIA 596 III-73 Use of unlicensed software in an organization I. Increases the risk of introducing viruses into the organization II. Is not a serious exposure if only low-cost software is involved III. Can be detected by software checking routines that run from a network server

A. B. C. D.

I only. I and II only. I, II, and III. I and III only. Answer (A) is incorrect because use of unlicensed software increases the risk of viral infection, and its use can be detected by software checking routines. Moreover, the cost of the software is not relevant. Any software may contain a virus. Answer (B) is incorrect because use of unlicensed software increases the risk of viral infection, and its use can be detected by software checking routines. Moreover, the cost of the software is not relevant. Any software may contain a virus. Answer (C) is incorrect because use of unlicensed software increases the risk of viral infection, and its use can be detected by software checking routines. Moreover, the cost of the software is not relevant. Any software may contain a virus. Answer (D) is correct. Antivirus measures should include strict adherence to software acquisition policies. Unlicensed software is less likely to have come from reputable vendors and to have been carefully tested. Special software is available to test software in use to determine whether it has authorized.

[1203] Gleim #: 8.135 -- Source: IIA, adapted Unauthorized alteration of online records can be prevented by employing

A. B. C. D.

Key verification. Computer sequence checks. Computer matching. Database access controls. Answer (A) is incorrect because key verification ensures the accuracy of selected fields by requiring a different individual to re-key them. Answer (B) is incorrect because sequence checks are used to ensure the completeness of input or update data by checking the use of pre-assigned document serial numbers. Answer (C) is incorrect because computer matching entails checking selected fields of input data with information held in a suspense or master file. Answer (D) is correct. Users can gain access to databases from terminals only through established recognition and authorization procedures; thus, unauthorized access is prevented.

[1204] Gleim #: 8.136 -- Source: $SOURCE Computer program libraries should be kept secure by

A. B. C. D.

Installing a logging system for program access. Monitoring physical access to program library media. Restricting physical and logical access. Denying remote access via terminals.


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Answer (A) is incorrect because installing a logging system for program access would permit detection of unauthorized access but not prevent it. Answer (B) is incorrect because monitoring physical access to program library media would control only unauthorized physical access. Answer (C) is correct. An important operating control is to establish a library to preclude misplacement, misues, or theft of data files, programs and documentation. A librarian should perform this custodianship function and be appropriately accountable. Restricting physical and logical access secures programs from unauthorized use, whether in person or remotely via terminals. Answer (D) is incorrect because denying all remote access via terminals would likely be inefficient and would not secure program libraries against physical access. [1205] Gleim #: 9.1 -- Source: Publisher Which of the following issues would be of most concern to an auditor relating to an organization’s Internet security policy?

A. B. C. D.

Auditor documentation. System efficiency. Data integrity. Rejected and suspense item controls. Answer (A) is incorrect because auditor documentation is not as crucial as data integrity. Answer (B) is incorrect because efficiency does not affect the basis for critical auditor decisions using information provided by the system. Answer (C) is correct. Controls are intended to ensure the integrity, confidentiality, and availability of information. An auditor relies on the integrity of the system’s data and programs in making critical decisions throughout the audit process. Answer (D) is incorrect because rejected and suspense item controls represent a portion of the techniques used to ensure data integrity.

[1206] Gleim #: 9.2 -- Source: CIA 1195 I-31 Management’s enthusiasm for computer security seems to vary with changes in the environment, particularly the occurrence of other computer disasters. Which of the following concepts should be addressed when making a comprehensive recommendation regarding the costs and benefits of computer security? I. Potential loss if security is not implemented II. Probability of occurrences III. Cost and effectiveness of the implementation and operation of computer security

A. B. C. D.

I only. I and II only. III only. I, II, and III.


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Answer (A) is incorrect because potential loss, the probability thereof, and the cost and effectiveness of security measures are important elements of the analysis. Answer (B) is incorrect because potential loss, the probability thereof, and the cost and effectiveness of security measures are important elements of the analysis. Answer (C) is incorrect because potential loss, the probability thereof, and the cost and effectiveness of security measures are important elements of the analysis. Answer (D) is correct. Potential loss is the amount of dollar damages associated with a security problem or loss of assets. Potential loss times the probability of occurrence is an estimate (expected value) of the exposure associated with lack of security. It represents a potential benefit associated with the implementation of security measures. To perform a cost-benefit analysis, the costs should be considered. Thus, all three items need to be addressed. [1207] Gleim #: 9.3 -- Source: CIA 1195 I-28 As organizations become more computer integrated, management is becoming increasingly concerned with the quality of access controls to the computer system. Which of the following provides the most accountability?

Option I Restrict access by:

Option II

Option III

Option IV

Individuals

Groups

Individuals

Departments

Identify computer data at:

Field level

Workstation

Workstation

Individual record level

Restrict access:

Need to know

Right to know

Normal processing by employee type

Items identified as processed by department

Identify users by:

Password

Password

Key access to workstation, or password on workstation

Departmental password

Limit ability to:

Delete, add, or modify data

Add or delete files

Add, delete, or modify data stored at workstation

Add, delete, or modify data normally processed by department

A. B. C. D.

Option I. Option II. Option III. Option IV.


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Answer (A) is correct. Access should be limited to those whose activities necessitate access to the computer system. Moreover, the degree of access allowed should be consistent with an individual’s responsibilities. Restricting access to particular individuals rather than groups or departments clearly establishes specific accountability. Not everyone in a group will need access or the same degree of access. Thus, passwords assigned to individuals should be required for identification of users by the system. Furthermore, data should be restricted at the field level, not the workstation level. It may be possible to limit access to a workstation, but most workstations are connected to larger mainframe or network databases. Thus, the security at the workstation level only would be insufficient. Answer (B) is incorrect because access should be restricted to particular individuals on a need-to-know basis, data should be restricted at the field level, and use should be limited to necessary functions performed by the accountable individual. Answer (C) is incorrect because access should be restricted to particular individuals on a need-to-know basis, data should be restricted at the field level, and use should be limited to necessary functions performed by the accountable individual. Answer (D) is incorrect because access should be restricted to particular individuals on a need-to-know basis, data should be restricted at the field level, and use should be limited to necessary functions performed by the accountable individual. [1208] Gleim #: 9.4 -- Source: CIA 592 III-27 An equipment manufacturer maintains dial-up ports into its order-entry system for the convenience of its customers worldwide so they may order parts as they need them. The manufacturer promises 48-hour delivery anywhere in the world for 95% of these parts orders. Because of the cost and sensitive nature of certain electronic parts, the manufacturer needs to maintain secure access to its order-entry system. The best technique for monitoring the security of access is

A. B. C. D.

Integrated test facility for the order-entry system. Tracing of transactions through the order-entry system. Transaction selection of order-entry transactions. Logging of unsuccessful access attempts. Answer (A) is incorrect because use of an integrated test facility (ITF) is a technique by which an auditor selects transactions and processing functions and applies the transactions to a fictitious entity during a normal processing cycle along with regular transactions. This technique cannot determine whether the data themselves are legitimate. Answer (B) is incorrect because tracing follows the path of a transaction during processing but is inadequate to determine whether a transaction is legitimate. Answer (C) is incorrect because transaction selection uses an independent computer program to monitor and select transactions for internal audit review. Like tracing, it fails to determine whether a transaction is legitimate. It would be an appropriate technique to apply to transactions suspected to be illegitimate. Answer (D) is correct. An access log should be used to record all attempts to use the system. The date and time, codes used, mode of access, and data involved are recorded. The system should monitor unsuccessful attempts because repeated attempts could suggest that someone is trying random or patterned character sequences in order to identify a password.

[1209] Gleim #: 9.5 -- Source: CIA 593 II-23 Data access security related to applications may be enforced through all the following except

A. B. C. D.

User identification and authentication functions incorporated in the application. Utility software functions. User identification and authentication functions in access control software. Security functions provided by a database management system.


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Answer (A) is incorrect because, although there is a migration of control of this type away from applications to other software, the large bulk of these controls still reside in application software. Answer (B) is correct. Utility programs perform routine functions (e.g., sorting and copying), are available to all users, and are promptly available for many different applications. Utility programs are one of the more serious weaknesses in data access security because some can bypass normal access controls. Answer (C) is incorrect because access control software has as one of its primary objectives improving data access security for all data on the system. Answer (D) is incorrect because most database management systems provide for improved data access security while they are running. [1210] Gleim #: 9.6 -- Source: CIA 1195 I-36 Most organizations are concerned about the potential compromise of passwords. Which of the following procedures would be the most effective in controlling against a perpetrator obtaining someone else’s password?

A. Allow only the users to change their passwords and encourage them to change passwords frequently. B. Implement a computer program that tests to see that the password is not easily guessed. C. Implement the use of “see-through” authentication techniques whereby the user uses a card to generate a password and verifies both the key and the generated password to the system. D. Limit password authorization to time of day and location. Answer (A) is incorrect because users often choose passwords that are easily guessed. Answer (B) is incorrect because a program to test passwords is useful but less effective than see-through authentication. Answer (C) is correct. See-through authentication techniques, such as the one described, require the user to have two of the three important elements to authenticate oneself to the system, i.e., a possession (the card used to generate the password), knowledge (the new password), or a personal characteristic (e.g., fingerprints). Answer (D) is incorrect because limiting access to times and locations is helpful in certain environments but not when the system allows dial-up access. [1211] Gleim #: 9.7 -- Source: J. Brooks Which of the following is a control that will prevent accessing the accounts receivable files from a hardwired terminal located in a manufacturing department?

A. B. C. D.

An echo check. A device authorization table. Providing only dial-up terminals. Using data encryption. Answer (A) is incorrect because an echo check relates to the accuracy of signals sent from or to a terminal. Answer (B) is correct. A device authorization table restricts file access to those physical devices that logically need access. Because it is illogical for anyone to access the accounts receivable file from a manufacturing terminal, the device authorization table will deny access even when a valid password is used. Answer (C) is incorrect because dial-up terminals provide less security than hardwired terminals. Any terminal may dial into the communications port using public telephones. Answer (D) is incorrect because, although data encryption (transmitting data in code form) might make the data unusable, it would not prevent access.


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[1212] Gleim #: 9.8 -- Source: CIA 1195 III-32 The primary objective of security software is to

A. B. C. D.

Control access to information system resources. Restrict access to prevent installation of unauthorized utility software. Detect the presence of viruses. Monitor the separation of duties within applications. Answer (A) is correct. The objective of security software is to control access to information system resources, such as program libraries, data files, and proprietary software. Security software identifies and authenticates users, controls access to information, and records and investigates security related events and data. Answer (B) is incorrect because security software will control the use of utilities, not their installation. Answer (C) is incorrect because antivirus software detects the presence of viruses. Answer (D) is incorrect because security software may be a tool to establish, but does not monitor, separation of duties.

[1213] Gleim #: 9.9 -- Source: CIA 597 I-5 A controller became aware that a competitor appeared to have access to the company’s pricing information. The internal auditor determined that the leak of information was occurring during the electronic transmission of data from branch offices to the head office. Which of the following controls would be most effective in preventing the leak of information?

A. B. C. D.

Asynchronous transmission. Encryption. Use of fiber-optic transmission lines. Use of passwords. Answer (A) is incorrect because asynchronous transmission is a method of data transmission, not a means of safeguarding data. It is used for slow, irregular transmissions, such as from a keyboard terminal. Each character is marked by a start and stop code. Answer (B) is correct. Encryption software uses a fixed algorithm to manipulate plain text and an encryption key (a set of random data bits used as a starting point for application of the algorithm) to introduce variation. Although data may be accessed by tapping into the transmission line, the encryption key is necessary to understand the data being sent. Answer (C) is incorrect because, although fiber-optic transmission lines are difficult to tap, their use will not prevent theft of unencrypted data by someone who has access to them. Answer (D) is incorrect because use of passwords will control access at the sending location and the head-office computer. However, passwords will not prevent someone from tapping the transmission line.

[1214] Gleim #: 9.10 -- Source: CIA 1196 III-78 The use of message encryption software

A. B. C. D.

Guarantees the secrecy of data. Requires manual distribution of keys. Increases system overhead. Reduces the need for periodic password changes.


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Answer (A) is incorrect because no encryption approach absolutely guarantees the secrecy of data. Answer (B) is incorrect because keys may also be distributed electronically via secure key transporters. Answer (C) is correct. Encryption software uses a fixed algorithm to manipulate plain text and an encryption key (a set of random data bits used as a starting point for application of the algorithm) to introduce variation. The machine instructions necessary to encrypt and decrypt data constitute system overhead. As a result, processing speed may be slowed. Answer (D) is incorrect because periodic password changes are needed. Passwords are the typical means of validating users’ access to unencrypted data. [1215] Gleim #: 9.11 -- Source: CIA 1190 I-34 All administrative and professional staff in a corporate legal department prepare documents on terminals connected to a host LAN file server. The best control over unauthorized access to sensitive documents in the system is

A. B. C. D.

Required entry of passwords for access to the system. Physical security for all disks containing document files. Periodic server backup and storage in a secure area. Required entry of passwords for access to individual documents. Answer (A) is incorrect because password security for access to the system permits all departmental employees access to all documents in the system. Answer (B) is incorrect because this system uses no floppy disks. Answer (C) is incorrect because periodic server backup and storage in a secure area is a good security/backup procedure, but it would not prevent access to sensitive documents online. Answer (D) is correct. Different passwords may be required to access the system, to read certain files, and to perform certain other functions. Required entry of passwords for access to individual documents is the best single control over unauthorized access to sensitive documents.

[1216] Gleim #: 9.12 -- Source: CIA 1196 III-62 An auditor has just completed a physical security audit of a data center. Because the center engages in top-secret defense contract work, the auditor has chosen to recommend biometric authentication for workers entering the building. The recommendation might include devices that verify all of the following except

A. B. C. D.

Fingerprints. Retina patterns. Speech patterns. Password patterns. Answer (A) is incorrect because authentication using fingerprints is a biometric measure. Answer (B) is incorrect because authentication using retina patterns is a biometric measure. Answer (C) is incorrect because authentication using speech patterns is a biometric measure. Answer (D) is correct. Biometric technologies are automated methods of establishing an individual’s identity using physiological or behavioral traits. These characteristics include fingerprints, retina patterns, hand geometry, signature dynamics, speech, and keystroke dynamics.

[1217] Gleim #: 9.13 -- Source: Publisher An Internet firewall is designed to provide adequate protection against which of the following?


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A. B. C. D.

A computer virus. Unauthenticated logins from outside users. Insider leaking of confidential information. A Trojan horse application. Answer (A) is incorrect because a firewall cannot adequately protect a system against computer viruses. Answer (B) is correct. A firewall is a device that separates two networks and prevents passage of specific types of network traffic while maintaining a connection between the networks. Generally, an Internet firewall is designed to protect a system from unauthenticated logins from outside users, although it may provide several other features as well. Answer (C) is incorrect because industrial spies need not leak information through the firewall. A telephone or floppy disk are much more common means of sharing confidential information. Answer (D) is incorrect because a firewall cannot adequately protect against a Trojan horse (a program, such as a game, that appears friendly but that actually contains applications destructive to the computer system) or any other program that can be executed in the system by an internal user.

[1218] Gleim #: 9.14 -- Source: CIA 1195 III-37 An organization installed antivirus software on all its personal computers. The software was designed to prevent initial infections, stop replication attempts, detect infections after their occurrence, mark affected system components, and remove viruses from infected components. The major risk in relying on antivirus software is that antivirus software may

A. B. C. D.

Not detect certain viruses. Make software installation overly complex. Interfere with system operations. Consume too many system resources. Answer (A) is correct. Antivirus software designed to identify and remove known viruses is sometimes known as a vaccine. A vaccine works only for known viruses and may not be completely effective for variants of those viruses. Answer (B) is incorrect because having antivirus software is unlikely to make software installation overly complex. Answer (C) is incorrect because antivirus software need not interfere with system operations. Its execution can be scheduled in advance so as not to interfere with running programs. Answer (D) is incorrect because antivirus software can be set to execute at times when it would not consume too many system resources, e.g., at startup.

[1219] Gleim #: 9.15 -- Source: CIA 1193 I-32 Each day, after all processing is finished, a bank performs a backup of its online deposit files and retains it for 7 days. Copies of each day’s transaction files are not retained. This approach is

A. B. C. D.

Valid, in that having a week’s worth of backups permits recovery even if one backup is unreadable. Risky, in that restoring from the most recent backup file would omit subsequent transactions. Valid, in that it minimizes the complexity of backup/recovery procedures if the online file has to be restored. Risky, in that no checkpoint/restart information is kept with the backup files.


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Answer (A) is incorrect because the practice of not retaining daily transaction data is unsound in that the bank loses a day’s transactions for each backup that is unreadable. Answer (B) is correct. At appropriate intervals, the disk files should be copied on magnetic tape so that restart procedures can begin at those points if data are lost or destroyed. However, not retaining each day’s transaction files is risky because information processed since the last backup file was created will be lost. Answer (C) is incorrect because the practice of not retaining daily transaction data certainly minimizes complexity but at the expense of losing transaction data if the online file must be restored from the backup. Answer (D) is incorrect because checkpoint/restart information is not needed. The backups are created after all processing is finished for the day. [1220] Gleim #: 9.16 -- Source: CIA 589 II-25 A company updates its accounts receivable master file weekly and retains the master files and corresponding update transactions for the most recent 2-week period. The purpose of this practice is to

A. B. C. D.

Verify run-to-run control totals for receivables. Match internal labels to avoid writing on the wrong volume. Permit reconstruction of the master file if needed. Validate groups of update transactions for each version. Answer (A) is incorrect because comparison of batch totals is a control over the completeness of processing, not a recovery procedure. Answer (B) is incorrect because internal labels may avoid destruction of data but do not aid in recovery. Answer (C) is correct. The grandfather-father-son approach normally employs magnetic tapes to furnish backup in a batch processing system. The procedure involves creation and retention of three generations of master files so that lost or destroyed data may be regenerated from the remaining master files and transaction data. In this case, a master file (the grandfather) and the first week’s transactions are used to generate a second master file (the father). This file and the second week’s transactions are the basis for the current master file (the son). Online systems employ rollback and recovery procedures; i.e., the master file is periodically dumped onto a storage medium. Reconstruction is then possible using the backup copy and the transactions log. Answer (D) is incorrect because validation may avoid destruction of data but does not aid in recovery.

[1221] Gleim #: 9.17 -- Source: CIA 596 III-39 Good planning will help an organization restore computer operations after a processing outage. Good recovery planning should ensure that

A. B. C. D.

Backup/restart procedures have been built into job streams and programs. Change control procedures cannot be bypassed by operating personnel. Planned changes in equipment capacities are compatible with projected workloads. Service level agreements with owners of applications are documented.


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Answer (A) is correct. The disaster plan should embrace data center recovery, critical application recovery, and network recovery. It should be updated and current with regard to recent test results and new applications, equipment, and network configurations. The plan should also ensure that backup facilities are still able to process critical applications and that end-user responsibility is established. Another essential component of a disaster recovery plan is that backup/restart procedures have been anticipated and provided for in the application systems. Answer (B) is incorrect because whether change control procedures can be bypassed is not usually a consideration in disaster recovery planning. Answer (C) is incorrect because planned rather than actual changes in equipment capacities are not relevant in disaster recovery planning. Answer (D) is incorrect because ensuring that service level agreements with owners of critical applications are adequate is not a function of disaster recovery planning. [1222] Gleim #: 9.18 -- Source: CIA 593 I-42 Contingency plans for information systems should include appropriate backup agreements. Which of the following arrangements would be considered too vendor-dependent when vital operations require almost immediate availability of computer resources?

A. B. C. D.

A “hot site” arrangement. A “cold site” arrangement. A “cold and hot site” combination arrangement. Using excess capacity at another data center within the organization. Answer (A) is incorrect because a “hot site” has all needed assets in place and is not vendor-dependent. Answer (B) is correct. Organizations should maintain contingency plans for operations in the case of a disaster. These plans usually include off-site storage of important backup data and an arrangement for the continuation of operations at another location. A “cold site” has all needed assets in place except the needed computer equipment and is vendordependent for timely delivery of equipment. Answer (C) is incorrect because a “cold and hot site” combination allows the “hot site” to be used until the “cold site” is prepared and is thus not too vendor-dependent. Answer (D) is incorrect because excess capacity would ensure that needed assets are available and would not be vendor-dependent.

[1223] Gleim #: 9.19 -- Source: CISA, adapted Advantages of using fiber optic cable are that I. II. III. IV.

A. B. C. D.

The signal is attenuated. Data are transmitted rapidly. It is small and flexible. It is unaffected by electrical interference.

I and III. I and IV. I, II, and III. II, III, and IV.


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Answer (A) is incorrect because attenuation of the signal is not an advantage of using fiber optics. Answer (B) is incorrect because attenuation of the signal is not an advantage of using fiber optics. Answer (C) is incorrect because attenuation of the signal is not an advantage of using fiber optics. Answer (D) is correct. A fiber optic cable uses light impulses that travel through clear flexible tubing half the size of a human hair. Fiber optic cables are not subject to electrical interference and are highly reliable. They provide for extremely flexible and fast data transmission. The signal remains strong across long distances; i.e., it does not tend to weaken (attenuate). [1224] Gleim #: 9.20 -- Source: CIA 592 III-37 When two devices in a data communications system are communicating, there must be agreement as to how both data and control information are to be packaged and interpreted. Which of the following terms is commonly used to describe this type of agreement?

A. B. C. D.

Asynchronous communication. Synchronous communication. Communication channel. Communication protocol. Answer (A) is incorrect because asynchronous communication is a mode of transmission. Communication is in disjointed segments, typically character by character, preceded by a start code and ended by a stop code. Answer (B) is incorrect because synchronous communication is a mode of transmission in which a continuous stream of blocks of characters result in faster communications. Answer (C) is incorrect because a communication channel is a transmission link between devices in a network. The term is also used for a small processor that controls input-output devices. Answer (D) is correct. A protocol is a set of formal rules or conventions governing communication between a sending and a receiving device. It prescribes the manner by which data are transmitted between these communications devices. In essence, a protocol is the envelope within which each message is transmitted throughout a data communications network.

[1225] Gleim #: 9.21 -- Source: CIA 1195 III-58 A real estate brokerage firm is moving into a building that is already equipped with extensive telephone wiring. The firm is considering the installation of a digital private branch exchange (PBX) to connect computers and other office devices such as copying machines, printers, and facsimile machines. A limitation of using a PBX-based system for this network is that

A. B. C. D.

The firm would be dependent on others for system maintenance. The system cannot easily handle large volumes of data. Coaxial cabling would have to be installed throughout the building. Relocating devices in the office would be difficult and expensive. Answer (A) is incorrect because the company would be responsible for all maintenance of the equipment, although it could contract for service. Answer (B) is correct. A PBX has the advantage of using existing telephone lines and therefore not needing special wiring. Moreover, equipment can be moved without necessitating rewiring. However, because PBX-based systems use telephone wiring (most often copper wire), they cannot easily handle large volumes of data. Answer (C) is incorrect because PBXs use telephone wiring. LANs typically require their own coaxial cabling. Answer (D) is incorrect because PBX-based systems do not require rewiring when devices are moved.


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[1226] Gleim #: 9.22 -- Source: CIA 1195 III-40 Large organizations often have their own telecommunications networks for transmitting and receiving voice, data, and images. Very small organizations, however, are unlikely to be able to make the investment required for their own networks and are more likely to use

A. B. C. D.

Public switched lines. Fast-packet switches. Standard electronic mail systems. A WAN. Answer (A) is correct. Companies can use public switched lines (phone lines) on a per-transmission basis. This option is the most cost-effective way for low-volume users to conduct telecommunications. Answer (B) is incorrect because fast-packet switches receive transmissions from various devices, break the data into packets, and route them over a network to their destination. They are typically installed by telecommunication utility companies and other large companies that have their own networks. Answer (C) is incorrect because electronic mail systems do not allow for voice transmissions. Answer (D) is incorrect because large organizations would use a wide area network.

[1227] Gleim #: 9.23 -- Source: CIA 1196 III-72 Using a telecommunications provider affects in-house networks. To prepare for changes resulting from enhanced external network services, management should

A. Optimize in-house networks to avoid bottlenecks that would limit the benefits offered by the telecommunications provider. B. Plan for rapid implementation of new capabilities in anticipation of ready acceptance of the new technology. C. Downsize the company’s disaster recovery plan to recognize the increasing role of the telecommunications provider. D. Enhance the in-house network management to minimize dependence on the telecommunications provider for network management. Answer (A) is correct. To prepare the company for changes resulting from the enhanced external network services, management should take appropriate action. A number of bottlenecks may limit the benefits that can be derived from the external network. For example, conversion from analog to digital technology is necessary to achieve rapid improvements in bandwidth and speed and to improve access to telecommunications services. Furthermore, applications, systems software, and communications protocols must be able to process information in a format and in a manner acceptable to end users. Communications security also has heightened importance as greater amounts of data are transmitted from remote sites. Answer (B) is incorrect because resistance to change, inflexible organizational structures, and skepticism about the technology should be expected and must be successfully managed if the company is to reap the benefits. Answer (C) is incorrect because a company’s disaster recovery plan should be enhanced to ensure the reliability of the network. Answer (D) is incorrect because network management may now be primarily a function, yet it will become more of a partnership arrangement with the communications carrier. [1228] Gleim #: 9.24 -- Source: CMA 695 4-19 A local area network (LAN) is best described as a(n)

A. Computer system that connects computers of all sizes, workstations, terminals, and other devices within a limited proximity. B. System to allow computer users to meet and share ideas and information. C. Electronic library containing millions of items of data that can be reviewed, retrieved, and analyzed. D. Method to offer specialized software, hardware, and data-handling techniques that improve effectiveness and reduce costs.


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Answer (A) is correct. A LAN is a local distributed computer system, often housed within a single building. Computers, communication devices, and other equipment are linked by cable. Special software facilitates efficient data communication among the hardware devices. Answer (B) is incorrect because a LAN is more than a system to allow computer users to share information; it is an interconnection of a computer system. Answer (C) is incorrect because a LAN is not a library. Answer (D) is incorrect because a LAN does not require specialized hardware. [1229] Gleim #: 9.25 -- Source: Publisher Which of the following statements about voice communications is true?

A. B. C. D.

Modern voice recognition input devices have large vocabularies and short training periods. A voice output device converts speech into digital data. Cell phones and PCS services use the same frequency radio waves. Pagers can alert users to the receipt of messages, but cannot transmit text. Answer (A) is correct. Voice recognition input devices provide an alternative to keyboard input. These systems compare the speaker’s voice patterns with prerecorded patterns. Advanced systems now have large vocabularies and shorter training periods. They allow for dictation and are not limited to simple commands. Answer (B) is incorrect because a voice output device converts digital data into speech using prerecorded sounds. Answer (C) is incorrect because PCS services use lower-power, higher-frequency radio waves than cell phones. Answer (D) is incorrect because newer pager systems permit transmission of text messages.

[1230] Gleim #: 9.26 -- Source: CIA 1196 III-56 The Internet consists of a series of networks that include

A. B. C. D.

Gateways to allow personal computers to connect to mainframe computers. Bridges to direct messages through the optimum data path. Repeaters to physically connect separate local area networks (LANs). Routers to strengthen data signals between distant computers. Answer (A) is correct. The Internet facilitates information transfer between computers. Gateways are hardware or software products that allow translation between two different protocol families. For example, a gateway can be used to exchange messages between different e-mail systems. Answer (B) is incorrect because routers are used to determine the best path for data. Answer (C) is incorrect because bridges connect LANs. Answer (D) is incorrect because repeaters strengthen signals.

[1231] Gleim #: 9.27 -- Source: Publisher Which of the following is true concerning HTML?

A. B. C. D.

The acronym stands for HyperText Material Listing. The language is among the most difficult to learn. The language is independent of hardware and software. HTML is the only language that can be used for Internet documents.


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Answer (A) is incorrect because HTML is the acronym for HyperText Markup Language. Answer (B) is incorrect because the language is relatively easy to learn. Almost anyone can learn and use HTML, not just computer programmers. Answer (C) is correct. HTML is the most popular language for authoring Web pages. It is hardware and software independent, which means that it can be read by several different applications and on many different kinds of computer operating systems. HTML uses tags to mark information for proper display on Web pages. Answer (D) is incorrect because a number of other languages can be used for Internet transmissions, including JAVA and XML. [1232] Gleim #: 9.28 -- Source: CIA 592 III-28 Of the following, the greatest advantage of a database (server) architecture is

A. B. C. D.

Data redundancy can be reduced. Conversion to a database system is inexpensive and can be accomplished quickly. Multiple occurrences of data items are useful for consistency checking. Backup and recovery procedures are minimized. Answer (A) is correct. Data organized in files and used by the organization’s various applications programs are collectively known as a database. In a database system, storage structures are created that render the applications programs independent of the physical or logical arrangement of the data. Each data item has a standard definition, name, and format, and related items are linked by a system of pointers. The programs therefore need only to specify data items by name, not by location. A database management system handles retrieval and storage. Because separate files for different applications programs are unnecessary, data redundancy can be substantially reduced. Answer (B) is incorrect because conversion to a database is often costly and time consuming. Answer (C) is incorrect because a traditional flat-file system, not a database, has multiple occurrences of data items. Answer (D) is incorrect because, given the absence of data redundancy and the quick propagation of data errors throughout applications, backup and recovery procedures are just as critical in a database as in a flat-file system.

[1233] Gleim #: 9.29 -- Source: CIA 1186 III-33 In an inventory system on a database management system (DBMS), one stored record contains part number, part name, part color, and part weight. These individual items are called

A. B. C. D.

Fields. Stored files. Bytes. Occurrences. Answer (A) is correct. A record is a collection of related data items (fields). A field (data item) is a group of characters representing one unit of information. Answer (B) is incorrect because a file is a group or set of related records ordered to facilitate processing. Answer (C) is incorrect because a byte is a group of bits (binary digits). It represents one character. Answer (D) is incorrect because occurrences is not a meaningful term in this context.

[1234] Gleim #: 9.30 -- Source: CIA 1188 III-36 An internal auditor encounters a batch-processed payroll in which each record contains the same type of data elements, in the same order, with each data element needing the same number of storage spaces. Which file structure would most appropriately be used to support this set of records?


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A. B. C. D.

Single flat file structure. Hierarchical structure. Network structure. Relational structure. Answer (A) is correct. In a single flat file structure, all attributes and field lengths in a record are identical to those in the other records. The structure is typically a table or spreadsheet with records for rows and attributes for columns. Answer (B) is incorrect because a hierarchical or tree structure is used to express relationships in which one attribute or item is related to many others in layers of subordinate records. Answer (C) is incorrect because a network structure expresses complex relationships in which many attributes are related to many others. Answer (D) is incorrect because a relational structure is not unlike the flat structure but is far more sophisticated. It gives the system the ability to handle many data relationships that were not anticipated by the designers. It uses a series of tables in which each table defines a relationship.

[1235] Gleim #: 9.31 -- Source: CIA 592 III-32 An inventory clerk, using a computer terminal, views the following on screen: part number, part description, quantity on-hand, quantity on-order, order quantity and reorder point for a particular inventory item. Collectively, these data make up a

A. B. C. D.

Field. File. Database. Record. Answer (A) is incorrect because field refers to a single data item. Answer (B) is incorrect because file refers to multiple records. Answer (C) is incorrect because database refers to multiple files. Answer (D) is correct. A record is a collection of related data items (fields). A field (data item) is a group of characters representing one unit of information. The part number, part description, etc., are represented by fields.

[1236] Gleim #: 9.32 -- Source: CPA AUD R98-3 An entity has the following invoices in a batch:

Invoice Number

Product

Quantity

Unit Price

201 202 203 204

F10 G15 H20 K35

150 200 250 300

$ 5.00 $10.00 $25.00 $30.00

Which of the following numbers represents the record count?


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A. B. C. D.

1 4 810 900 Answer (A) is incorrect because 1 is the number of batches. Answer (B) is correct. Input controls in batch computer systems are used to determine that no data are lost or added to the batch. Depending on the sophistication of a particular system, control may be accomplished by using record counts, batch totals, or hash totals. A record count establishes the number of source documents and reconciles it to the number of output records. The total number of invoices processed is an example of a record count. In this case, the record count is 4. Answer (C) is incorrect because 810 is a hash total of the invoice numbers. Answer (D) is incorrect because 900 is the total quantity of items.

[1237] Gleim #: 9.33 -- Source: CIA 593 III-57 Which of the following is the elementary unit of data storage used to represent individual attributes of an entity?

A. B. C. D.

Database. Data field. File. Record. Answer (A) is incorrect because a database is an organized collection of files. Answer (B) is correct. A data item (or field) is a group of characters. It is used to represent individual attributes of an entity, such as an employee’s address. A field is an item in a record. Answer (C) is incorrect because a file is a collection of records. Answer (D) is incorrect because a record is a collection of data items.

[1238] Gleim #: 9.34 -- Source: CIA 594 III-17 A file-oriented approach to data storage requires a primary record key for each file. Which of the following is a primary record key?

A. B. C. D.

The vendor number in an accounts payable master file. The vendor number in a closed purchase order transaction file. The vendor number in an open purchase order master file. All of the answers are correct. Answer (A) is correct. The primary record key uniquely identifies each record in a file. Because there is only one record for each vendor in an accounts payable master file, the vendor number would be the appropriate key. Answer (B) is incorrect because purchase order files can have multiple purchase orders made out to the same vendor. The primary key in purchase order files would be the purchase order number because it is the only unique identifier for the record. Answer (C) is incorrect because purchase order files can have multiple purchase orders made out to the same vendor. The primary key in purchase order files would be the purchase order number because it is the only unique identifier for the record. Answer (D) is incorrect because not all of the answer choices are correct.


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[1239] Gleim #: 9.35 -- Source: CIA 1194 III-29 When required to read customer data, the operating system finds the primary key value in a file whose records contain key values and their corresponding physical addresses. In this situation, the most likely file organization for customer data is

A. B. C. D.

A direct-access file. An indexed sequential file. A sequential file. A text file. Answer (A) is incorrect because a direct-access file has no index file. Answer (B) is correct. If records are stored sequentially on a direct-access storage device, the records can be accessed directly using the indexed-sequential-access method. An index of key fields is maintained that lists the physical location of the record corresponding to each key field. Answer (C) is incorrect because a sequential file has no index file. Answer (D) is incorrect because a text file would probably not be used in this situation.

[1240] Gleim #: 9.36 -- Source: CIA 1188 III-31 A business has decided to use magnetic disks to store accounts receivable information. What data file concepts should be used to provide the ability to answer customer inquiries as they are received?

A. B. C. D.

Sequential storage and chains. Sequential storage and indexes. Record keys, indexes, and pointers. Inverted file structure, indexes, and internal labels. Answer (A) is incorrect because the ability to respond immediately to customers requires direct access. Answer (B) is incorrect because the ability to respond immediately to customers requires direct access. Answer (C) is correct. A record key is an attribute that uniquely identifies or distinguishes each record from the others. An index is a table listing storage locations for attributes, often including those other than the unique record key attribute. A pointer is a data item that indicates the physical address of the next logically related record. Answer (D) is incorrect because internal labels are used to indicate various things to the computer, such as the contents of various types of data storage media, the beginning of each file (with identification information), and the end of each file. However, they do not provide information for locating specific records in a file. An inverted file structure (inverted list) is an index based on a secondary key, for example, years of experience rather than an employee number (the primary key).

[1241] Gleim #: 9.37 -- Source: CIA 595 III-75 Auditors making database queries often need to combine several tables to get the information they want. One approach to combining tables is known as

A. B. C. D.

Extraction. Joining. Sorting. Summarization.


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Answer (A) is incorrect because extraction selects data containing specified criteria from a data file; it does not combine tables. Answer (B) is correct. In CAAT software packages, joining is the combining of data files based on a common data element. For example, if rows in a table containing information about specified parts have been selected, the result can be joined with a table that contains information about suppliers. The join operation may combine the two tables using the supplier number (assuming both tables contained this element) to provide information about the suppliers of particular parts. Answer (C) is incorrect because sorting allows the auditor to organize data by any data field, not combine tables. Answer (D) is incorrect because summarization reports on the information contained in several tables but does not combine the tables. [1242] Gleim #: 9.38 -- Source: CIA 597 III-50 Users making database queries often need to combine several tables to get the information they want. One approach to combining tables is

A. B. C. D.

Joining. Merging. Projecting. Pointing. Answer (A) is correct. Joining is the combining of two or more relational tables based on a common data element. For example, if a supplier table contains information about suppliers and a parts table contains information about parts, the two tables can be joined using the supplier number (assuming both tables contain this attribute) to give information about the supplier of particular parts. Answer (B) is incorrect because the three basic operations in a relational database are selecting, joining, and projecting. Answer (C) is incorrect because projecting is the basic operation in a relational database that results in a subset consisting of columns (fields) in a table. This operation creates a new table containing only the required information. Answer (D) is incorrect because a pointer is a data element attached to a record that gives the address of another record.

[1243] Gleim #: 9.39 -- Source: CIA 596 III-65 All of the following are methods for distributing a relational database across multiple servers except

A. B. C. D.

Snapshot (making a copy of the database for distribution). Replication (creating and maintaining replica copies at multiple locations). Normalization (separating the database into logical tables for easier user processing). Fragmentation (separating the database into parts and distributing where they are needed).


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Answer (A) is incorrect because the snapshot technique makes duplicates to be stored at multiple locations. Answer (B) is incorrect because the replication technique makes duplicates to be stored at multiple locations. Changes are periodically copied and sent to each location. If a database is small, storing multiple copies may be cheaper than retrieving records from a central site. Answer (C) is correct. A distributed database is stored in two or more physical sites. The two basic methods of distributing a database are partitioning and replication. However, normalization is a process of database design, not distribution. Normalization is the term for determining how groups of data items in a relational structure are arranged in records in a database. This process relies on “normal forms,” that is, conceptual definitions of data records and specified design rules. Normalization is intended to prevent inconsistent updating of data items. It is a process of breaking down a complex data structure by creating smaller, more efficient relations, thereby minimizing or eliminating the repeating groups in each relation. Answer (D) is incorrect because fragmentation or partitioning stores specific records where they are most needed. For example, a financial institution may store a particular customer’s data at the branch where (s)he usually transacts his/her business. If the customer executes a transaction at another branch, the pertinent data is retrieved via communications lines. [1244] Gleim #: 9.40 -- Source: CIA 1196 III-75 In a database system, locking of data helps preserve data integrity by permitting transactions to have control of all the data needed to complete the transactions. However, implementing a locking procedure could lead to

A. B. C. D.

Inconsistent processing. Rollback failures. Unrecoverable transactions. Deadly embraces (retrieval contention). Answer (A) is incorrect because inconsistent processing occurs when a transaction has different effects depending on when it is processed. Data locking ensures consistent processing. Answer (B) is incorrect because rollback failure is the inability of the software to undo the effects of a transaction that could not be run to completion. A rollback failure is not caused by data locking. However, data locking may lead to situations in which rollback is required. Answer (C) is incorrect because unrecoverable transactions are not a typical symptom of locking procedures. Answer (D) is correct. In a distributed processing system, the data and resources a transaction may update or use should be held in their current status until the transaction is complete. A deadly embrace occurs when two transactions need the same resource at the same time. If the system does not have a method to cope with the problem efficiently, response time worsens or the system eventually fails. The system should have an algorithm for undoing the effects of one transaction and releasing the resources it controls so that the other transaction can run to completion.

[1245] Gleim #: 9.41 -- Source: CMA 695 4-20 One advantage of a database management system (DBMS) is

A. That each organizational unit takes responsibility and control for its own data. B. The cost of the data processing department decreases as users are now responsible for establishing their own data handling techniques. C. A decreased vulnerability as the database management system has numerous security controls to prevent disasters. D. The independence of the data from the application programs, which allows the programs to be developed for the user’s specific needs without concern for data capture problems.


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Answer (A) is incorrect because each organizational unit develops programs to make use of elements of a broad database. Answer (B) is incorrect because data handling techniques are still the responsibility of the data processing department; it is the use of the data that is departmentalized. Answer (C) is incorrect because the DBMS is no safer than any other database system. Answer (D) is correct. A fundamental characteristic of databases is that applications are independent of the database structure; when writing programs or designing applications to use the database, only the name of the desired item is necessary. Programs can be developed for the user’s specific needs without concern for data capture problems. Reference can be made to the items using the data manipulation language, after which the DBMS takes care of locating and retrieving the desired items. The physical or logical structure of the database can be completely altered without having to change any of the programs using the data items; only the schema requires alteration. [1246] Gleim #: 9.42 -- Source: CISA, adapted Which of the following is a false statement about a database management system application environment?

A. B. C. D.

Data are used concurrently by multiple users. Data are shared by passing files between programs or systems. The physical structure of the data is independent of user needs. Data definition is independent of any one program. Answer (A) is incorrect because the advantage of a DBMS is that data can be used concurrently by multiple users. Answer (B) is correct. In this kind of system, applications use the same database. There is no need to pass files between applications. Answer (C) is incorrect because, when a DBMS is used, the physical structure of the data is independent of user needs. Answer (D) is incorrect because, when a DBMS is used, the data are defined independently of the needs of any one program.

[1247] Gleim #: 9.43 -- Source: CIA 588 II-29 Which of the following should not be the responsibility of a database administrator?

A. B. C. D.

Design the content and organization of the database. Develop applications to access the database. Protect the database and its software. Monitor and improve the efficiency of the database. Answer (A) is incorrect because designing the content and organization of the database is a responsibility of the database administrator. Answer (B) is correct. The database administrator (DBA) is the person who has overall responsibility for developing and maintaining the database. One primary responsibility is for designing the content of the database. Another responsibility of the DBA is to protect and control the database. A third responsibility is to monitor and improve the efficiency of the database. The responsibility of developing applications to access the database belongs to systems analysts and programmers. Answer (C) is incorrect because protecting the database and its software is a responsibility of the database administrator. Answer (D) is incorrect because monitoring and improving the efficiency of the database is a responsibility of the database administrator.

[1248] Gleim #: 9.44 -- Source: Publisher The responsibilities of a data administrator (DA) include monitoring


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A. B. C. D.

The database industry. The performance of the database. Database security. Backup of the system. Answer (A) is correct. The DA handles administrative issues that arise regarding the database. The DA acts as an advocate by suggesting new applications and standards. One of the DA’s responsibilities is to monitor the database industry for new developments. In contrast, the database administrator (DBA) deals with the technical aspects of the database. Answer (B) is incorrect because it is an example of the database administrator’s responsibilities. Answer (C) is incorrect because it is an example of the database administrator’s responsibilities. Answer (D) is incorrect because it is an example of the database administrator’s responsibilities.

[1249] Gleim #: 9.45 -- Source: CIA 589 III-39 To trace data through several application programs, an auditor needs to know what programs use the data, which files contain the data, and which printed reports display the data. If data exist only in a database system, the auditor could probably find all of this information in a

A. B. C. D.

Data dictionary. Database schema. Data encryptor. Decision table. Answer (A) is correct. The data dictionary is a file (possibly manual but usually computerized) in which the records relate to specified data items. It contains definitions of data items, the list of programs used to process them, and the reports in which data are found. Only certain persons or entities are permitted to retrieve data or to modify data items. Accordingly, these access limitations are also found in the data dictionary. Answer (B) is incorrect because the schema describes the structure of the database. Answer (C) is incorrect because an encryptor encodes data. Answer (D) is incorrect because a decision table is a type of logic diagram that presents in matrix form the decision points and related actions reflected in a computer program.

[1250] Gleim #: 9.46 -- Source: CIA 594 I-32 Passwords for personal computer software programs are designed to prevent

A. B. C. D.

Inaccurate processing of data. Unauthorized access to the computer. Incomplete updating of data files. Unauthorized use of the software. Answer (A) is incorrect because passwords concern authorization, not accuracy of data. Answer (B) is incorrect because passwords do not prevent physical access to the computer. Answer (C) is incorrect because passwords concern authorization, not completeness of data. Answer (D) is correct. The use of passwords is an effective control in an online system to prevent unauthorized access to computer files. Lists of authorized users are maintained in the computer. The entry of passwords or ID numbers; a prearranged act of personal questions; and use of badges, magnetic cards, or optically scanned cards may be combined to avoid unauthorized access.


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[1251] Gleim #: 9.47 -- Source: CIA 595 III-37 Which of the following is an objective of logical security controls for information systems?

A. B. C. D.

To ensure complete and accurate recording of data. To ensure complete and accurate processing of data. To restrict access to specific data and resources. To provide an audit trail of the results of processing. Answer (A) is incorrect because it is not an objective of logical security control. Answer (B) is incorrect because it is not an objective of logical security control. Answer (C) is correct. The primary objective of security controls for information systems is to restrict access to data and resources (both hardware and software) to only authorized individuals. Answer (D) is incorrect because it is not an objective of logical security control.

[1252] Gleim #: 9.48 -- Source: Publisher Which of the following is the most effective user account management control in preventing the unauthorized use of a computer system?

A. Management enforces an aggressive password policy that requires passwords to be 10 characters long, to be nonreusable, and to be changed weekly. B. An account manager is responsible for authorizing and issuing new accounts. C. The passwords and usernames of failed log-in attempts are logged and documented in order to cite attempted infiltration of the system. D. Employees are required to renew their accounts semiannually. Answer (A) is incorrect because, although passwords should be changed periodically, changing a long, non-reusable password weekly encourages employees to write each new password down in order to remember it, a practice not considered conducive to the control structure. Answer (B) is incorrect because the duties of authorization and control over assets should be separated. Answer (C) is incorrect because, although failed log-in attempts should be logged, it is considered bad practice to record the password of failed log-in attempts. Employees often mistype their passwords, and therefore access to the log by an infiltrator could facilitate breaking into a user’s account. Answer (D) is correct. Management’s network security policy should include measures to ensure that old and unused accounts are removed promptly. If employees’ accounts expire semiannually, reasonable assurance is provided that accounts in use by unauthorized employees do not exist. [1253] Gleim #: 9.49 -- Source: Publisher Assigning passwords to computer users is a control to prevent unauthorized access. Because a password does not conclusively identify a specific individual, it must be safeguarded from theft. A method used to protect passwords is to

A. B. C. D.

Require that they be displayed on computer screens but not printed on hard copy output. Set maximum character lengths. Require a maximum retention period. Eliminate all records of old passwords.


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Answer (A) is incorrect because a password should not be displayed. Answer (B) is incorrect because a minimum length requirement is more likely. Answer (C) is correct. Security measures include changing passwords frequently, that is, establishing a relatively short maximum retention period; not displaying or printing passwords; setting minimum lengths; prohibiting the use of certain words, character strings, or names; mandating a minimum retention period, so users cannot promptly change passwords back to their old and convenient values; and retaining old passwords to prevent their use. Answer (D) is incorrect because retention of old passwords prevents their reuse. [1254] Gleim #: 9.50 -- Source: CIA 1196 III-59 An insurance firm uses a wide area network (WAN) to allow agents away from the home office to obtain current rates and client information and to submit approved claims using notebook computers and dial-in modems. In this situation, which of the following methods would provide the best data security?

A. B. C. D.

Dedicated phone lines. Call-back features. Frequent changes of user IDs and passwords. End-to-end data encryption. Answer (A) is incorrect because dedicated phone lines are not available to agents in the field. Answer (B) is incorrect because call-back features are used to authenticate the user but do not otherwise protect the transmitted data. Answer (C) is incorrect because frequent changes of user IDs and passwords are used to authenticate the user but do not otherwise protect the transmitted data. Answer (D) is correct. Encryption of data is a security procedure in which a program encodes data prior to transmission and another program decodes the data after transmission. Encoding is important when confidential data that can be electronically monitored are transmitted between geographically separated locations.

[1255] Gleim #: 9.51 -- Source: CIA 595 III-45 A control feature designed to negate the use of utility programs to read files that contain all authorized access user codes for the network is

A. B. C. D.

Internally encrypted passwords. A password hierarchy. Logon passwords. A peer-to-peer network. Answer (A) is correct. Utility programs can be used to gain access to almost any file. However, gaining access to a file of passwords would be useless if those passwords were encrypted prior to placing them in the file. Answer (B) is incorrect because the utility program could gain access to all passwords in the file, regardless of the hierarchy. Answer (C) is incorrect because if the user has access to utility programs, (s)he already has access (is logged on) to the system. Answer (D) is incorrect because a peer-to-peer network relates to connectivity of similar networks.

[1256] Gleim #: 9.52 -- Source: CISA The telecommunication control of dial-up/disconnect/dial-back can be circumvented by using


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A. B. C. D.

Dedicated line technology. Automatic call forwarding. Encryption algorithms. High baud rate lines. Answer (A) is incorrect because dedicated line technology strengthens controls, not circumvents them. Answer (B) is correct. Automatic call forwarding can circumvent the control if the authorized user has this telephone service and the computer callback is forwarded to an unauthorized user. Answer (C) is incorrect because encryption algorithms strengthen controls, not circumvent them. Answer (D) is incorrect because the speed of the lines does not directly contribute to the strength or weakness of telecommunication controls.

[1257] Gleim #: 9.53 -- Source: CIA 1194 I-27 An auditor reviewed access security over the company’s various computer applications. The auditor found that security consisted of access controls programmed into each application. The best recommendation for management in the situation is

A. B. C. D.

Eliminate the built-in access controls. Consider the use of access control software. Consider the use of utility software. Expand the use of the built-in access controls to new applications. Answer (A) is incorrect because the built-in access controls should be retained until replaced with a more comprehensive and cost-effective system. Answer (B) is correct. Access control software provides comprehensive and coordinated security. It permits authorized users to gain access only for purposes of performing their assigned duties and restricts employees from performing incompatible functions. A comprehensive system is more cost-effective than programming access controls into each application. Answer (C) is incorrect because utility software does not usually perform security functions. Answer (D) is incorrect because a comprehensive system is more cost-effective than programming access controls into each application.

[1258] Gleim #: 9.54 -- Source: CIA 1194 I-28 The best source of evidence to determine if ex-employees continue to have access to a company’s automated databases is

A. B. C. D.

Discussing the password removal process with the database administrator. Reviewing computer logs of access attempts. Reconciling current payroll lists with database access lists. Reviewing access control software to determine whether the most current version is implemented. Answer (A) is incorrect because discussing the password removal process does not determine whether ex-employees are still using or are able to use their passwords to access the databases. Answer (B) is incorrect because the computer logs should be compared with current payroll lists. Answer (C) is correct. To determine if ex-employees are accessing the company’s automated database, the auditor should obtain the log showing database accesses. This log should be compared with current payroll lists to see if anyone not on the payroll is still accessing or is able to access the databases. Answer (D) is incorrect because reviewing the access control software does not indicate whether ex-employees can access or are accessing the databases.


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[1259] Gleim #: 9.55 -- Source: Publisher A client installed the most sophisticated controls using biometric attributes of employees to govern access to their computer system. This technology most likely replaced which of the following controls?

A. B. C. D.

Use of security specialists. Reasonableness tests. Passwords. Virus protection software. Answer (A) is incorrect because biometric technologies do not eliminate the need for specialists who evaluate and monitor security needs. Answer (B) is incorrect because checking to see if information is reasonable is related to input controls, not access controls. Answer (C) is correct. The purpose of passwords is to prevent access by unauthorized users just as the more sophisticated control of employee biometric attributes. The use of passwords is an effective control in an online system to prevent unauthorized access to computer systems. However, biometric technologies are more sophisticated and difficult to compromise. Answer (D) is incorrect because virus protection software prevents damage to data in a system, not access to a system.

[1260] Gleim #: 9.56 -- Source: CPA AUD R02-20 Which of the following passwords would be most difficult to crack?

A. B. C. D.

O?Ca!FlSi language 12 HOUSE 24 pass56word Answer (A) is correct. To be effective, passwords should consist of random letters, symbols, and numbers and should not contain words or phrases. Accordingly, computer system users should avoid employing words for or in their passwords. Answer (B) is incorrect because words should not be used for or in passwords. Answer (C) is incorrect because words should not be used for or in passwords. Answer (D) is incorrect because words should not be used for or in passwords.

[1261] Gleim #: 9.57 -- Source: CIA 1190 III-33 A company has a dial-up facility allowing the employees to gain access to the computer when they are not on the premises. The most effective way to prevent unauthorized access to the computer is to use

A. B. C. D.

Call-back. Modem. Echo check. Console log.


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Answer (A) is correct. The call-back technique prevents unauthorized access to the computer in a dial-up environment. The call-back technique is a two-step control. First, the connection is broken after the caller has identified him/herself and given the call number allowing reconnection. The system then checks for authorization. If it is verified, the computer is reconnected. Answer (B) is incorrect because the modem (modulator/demodulator) is a device that allows a connection between a computer and a terminal to be made from a remote location through the use of telephone lines. Answer (C) is incorrect because the echo check is a control used to verify that information sent is identical to the information received. The information sent is echoed back by the recipient to the sender. If the message received by the sender is not identical to what was sent, the transmission is attempted again. Answer (D) is incorrect because the console log has nothing to do with controlling access to the computer. The log lists all operating system activity, maintains an equipment use record, and identifies operator-initiated actions. [1262] Gleim #: 9.58 -- Source: CPA AUD R02-9 Which of the following is an encryption feature that can be used to authenticate the originator of a document and ensure that the message is intact and has not been tampered with?

A. B. C. D.

Heuristic terminal. Perimeter switch. Default settings. Digital signatures. Answer (A) is incorrect because the term "Heuristic terminal" is not meaningful in this context. Answer (B) is incorrect because the term "Perimeter switch" is not meaningful in this context. Answer (C) is incorrect because, in a computer program, a default setting is a value that a parameter will automatically assume unless specifically overridden. Answer (D) is correct. Businesses and others require that documents sent over the Internet be authentic. To authenticate a document, a company or other user may transmit a complete plaintext document along with an encrypted portion of the same document or another standard text that serves as a digital signature. If the plaintext document is tampered with, the two will not match.

[1263] Gleim #: 9.59 -- Source: CIA 1196 III-77 The encryption technique that requires two keys, a public key that is available to anyone for encrypting messages and a private key that is known only to the recipient for decrypting messages, is

A. B. C. D.

Rivest, Shamir, and Adelman (RSA). Data encryption standard (DES). Modulator-demodulator. A cypher lock. Answer (A) is correct. RSA is an encryption standard licensed to hardware and software vendors. Public-key encryption requires management of fewer keys for a given client-server environment than does private-key encryption. However, compared with DES, RSA entails more complex computations and therefore has a higher processing overhead. RSA requires two keys: The public key for encrypting messages is widely known, but the private key for decrypting messages is kept secret by the recipient. Answer (B) is incorrect because DES is a shared private-key method developed by the U.S. government. It encrypts data into 64-bit blocks using a 56-bit key. DES requires only a single key for each pair of parties that want to send each other encrypted messages. DES is being replaced by AES, Advanced Encryption Standard, as the method of choice by the U.S. government. Answer (C) is incorrect because a modem is used for telecommunications. Answer (D) is incorrect because a cypher lock is a physical device.


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[1264] Gleim #: 9.60 -- Source: Publisher A client communicates sensitive data across the Internet. Which of the following controls would be most effective in preventing the use of the information if it were intercepted by an unauthorized party?

A. B. C. D.

A firewall. An access log. Passwords. Encryption. Answer (A) is incorrect because a firewall tries to prevent access from specific types of traffic to an internal network. After someone has obtained information from the site, a firewall cannot prevent its use. Answer (B) is incorrect because an access log only records attempted usage of a system. Answer (C) is incorrect because passwords prevent unauthorized users from accessing the system. If information has already been obtained, a password cannot prevent its use. Answer (D) is correct. Encryption technology converts data into a code. Encoding data before transmission over communications lines makes it more difficult for someone with access to the transmission to understand or modify its contents.

[1265] Gleim #: 9.61 -- Source: CISA To ensure privacy in a public key encryption system, knowledge of which of the following keys would be required to decode the received message? I. Private II. Public

A. B. C. D.

I. II. Both I and II. Neither I nor II. Answer (A) is correct. In a public key system, the public key is used to encrypt the message prior to transmission, whereas the private key is needed to decrypt (decode) the message. Answer (B) is incorrect because the private key, not the public key, is needed to decrypt (decode) the message. Answer (C) is incorrect because the public key is not needed. Answer (D) is incorrect because the private key is needed to decrypt (decode) the message.

[1266] Gleim #: 9.62 -- Source: CIA 593 II-23 Data access security related to applications may be enforced through all the following except

A. B. C. D.

User identification and authentication functions incorporated in the application. Utility software functions. User identification and authentication functions in access control software. Security functions provided by a database management system.


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Answer (A) is incorrect because, although the trend is for this type of control function to be performed by other software, most such controls still reside in application software. Answer (B) is correct. Utility programs perform routine functions (e.g., sorting and copying), are available to all users, and are promptly available for many different applications. Utility programs can actually be a serious weakness in data access security because some can bypass normal access controls. Answer (C) is incorrect because access control software has as one of its primary objectives improving data access security for all data on the system. Answer (D) is incorrect because most database management systems provide for improved data access security while they are running. [1267] Gleim #: 9.63 -- Source: CIA 596 III-44 The duties properly assigned to an information security officer could include all of the following except

A. B. C. D.

Developing an information security policy for the organization. Maintaining and updating the list of user passwords. Commenting on security controls in new applications. Monitoring and investigating unsuccessful access attempts. Answer (A) is incorrect because developing an information security policy for the organization is an appropriate duty of the information security officer. Answer (B) is correct. The information security officer should not know user passwords. They are normally stored on a computer in encrypted format, and users change them directly. Answer (C) is incorrect because commenting on security controls in new applications is an appropriate duty of the information security officer. Answer (D) is incorrect because monitoring and investigating unsuccessful access attempts is an appropriate duty of the information security officer.

[1268] Gleim #: 9.64 -- Source: CMA 693 4-10 Online access controls are critical for the successful operation of today’s computer systems. To assist in maintaining control over such access, many systems use tests that are maintained through an internal access control matrix that consists of

A. Authorized user code numbers, passwords, lists of all files and programs, and a record of the type of access each user is entitled to have to each file and program. B. Authorized user code numbers and passwords. C. A list of controls in the online system and a list of those individuals authorized to change and adjust these controls along with a complete list of files in the system. D. A completeness test, closed loop verification, and a compatibility test. Answer (A) is correct. The list or tables of authorized users or devices are sometimes called access control matrices; however, they are more commonly referred to as device authorization tables. A device authorization table restricts file access to those physical devices that logically need access. A device authorization table can contain such items as authorized user code numbers, passwords, lists of all files and programs, and a record of the type of access each user is entitled to have to each file and program. Answer (B) is incorrect because it is not a complete list of the contents of an access control matrix. Answer (C) is incorrect because it is not information stored in an access control matrix. Answer (D) is incorrect because it is not a list of items stored in an access control matrix.


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[1269] Gleim #: 9.65 -- Source: CMA 687 5-6 A checkpoint/restart procedure is primarily designed to recover from

A. B. C. D.

Programming errors. Data input errors. Computer operator errors. Hardware failures. Answer (A) is incorrect because it is not an error that a checkpoint/restart procedure is primarily designed to recover from. Answer (B) is incorrect because it is not an error that a checkpoint/restart procedure is primarily designed to recover from. Answer (C) is incorrect because it is not an error that a checkpoint/restart procedure is primarily designed to recover from. Answer (D) is correct. Checkpoint/restart procedures involve capturing all the values of data and program indicators at specified points and storing these values in another file. If processing is interrupted, it can be resumed at the last checkpoint rather than at the beginning of the run.

[1270] Gleim #: 9.66 -- Source: CPA AUD R02-6 Which of the following procedures would an entity most likely include in its disaster recovery plan?

A. B. C. D.

Convert all data from EDI format to an internal company format. Maintain a Trojan horse program to prevent illicit activity. Develop an auxiliary power supply to provide uninterrupted electricity. Store duplicate copies of files in a location away from the computer center. Answer (A) is incorrect because converting all data from EDI format to an internal company format would reduce the ability to process transactions with outside companies. Answer (B) is incorrect because a Trojan horse program is a computer program that appears to be legitimate but performs some illicit activity when it is run. Answer (C) is incorrect because the use of an uninterruptible power supply assures continued processing rather than recovery from a disaster. Answer (D) is correct. Off-site storage of duplicate copies of critical files protects them from a fire or other disaster at the computing facility. The procedure is part of an overall disaster recovery plan.

[Fact Pattern #82] An automobile and personal property insurer has decentralized its information processing to the extent that headquarters has less processing capacity than any of its regional processing centers. These centers are responsible for initiating policies, communicating with policyholders, and adjusting claims. The company uses leased lines from a national telecommunications company. Initially, the company thought there would be little need for interregion communication, but that has not been the case. The company underestimated the number of customers that would move between regions and the number of customers with claims arising from accidents outside their regions. The company has a regional center in an earthquake-prone area and is planning how to continue processing if that center, or any other single center, were unable to perform its processing. [1271] Gleim #: 9.67 -- Source: CIA 595 III-71 (Refers to Fact Pattern #82) The company has considered several alternatives for replacing the hardware required for a regional center’s processing. An advantage of using a third-party cold site is that


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A. B. C. D.

Personnel employed at the site would be familiar with company operations. Travel expenses would be minimized for company personnel. No additional equipment would be required at the regional centers. The replacement site could be up and running in a few hours. Answer (A) is incorrect because personnel employed at the site are not related to the company, and would therefore not be familiar with company operations. Answer (B) is incorrect because depending on the location of the cold site, traveling expenses could increase dramatically. Answer (C) is correct. A cold site backup facility is a shell facility where the user can quickly install computer equipment and resume operations in the event of a disaster. The facility has all of the needed assets in place except the needed computer equipment and is vendor-dependent for timely delivery of equipment. Accordingly, an advantage of using a third-party cold site is the elimination of the need for additional equipment. Answer (D) is incorrect because it is not an advantage of using a third-party cold site; a few hours of downtime could be very costly to the organization.

[1272] Gleim #: 9.68 -- Source: CIA 595 III-72 (Refers to Fact Pattern #82) Unfortunately, the company has not revised its contingency plan since the time when its data processing was mostly centralized at headquarters. The existing plan is likely to be out of date because of

A. B. C. D.

Changes in equipment, data, and software. Inadequate processing capability at headquarters. Lack of arrangements for a backup site for headquarters. Personnel turnover at regional centers. Answer (A) is correct. When a company decentralizes its information processing, many changes in equipment, data, and software occur as a result of the different processing methods. Since the company has not revised its contingency plan since the time processing was centralized, the plan is most likely out of date as a result of the changes in equipment, data, and software. Answer (B) is incorrect because it is not a reason that would cause a contingency plan to be out of date. Answer (C) is incorrect because it is not a reason that would cause a contingency plan to be out of date. Answer (D) is incorrect because it is not a reason that would cause a contingency plan to be out of date.

[1273] Gleim #: 9.69 -- Source: CIA 595 III-73 (Refers to Fact Pattern #82) The company considered mirroring the data stored at each regional center at another center. A disadvantage of such an arrangement is

A. B. C. D.

Lack of awareness at headquarters of the state of processing. Increased cost and complexity of network traffic. Interference of the mirrored data with original source data. Confusion on the part of insurance agents about where customer data are stored.


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Answer (A) is incorrect because headquarters could monitor the network on a real-time basis and have complete awareness of the state of processing. Answer (B) is correct. If data stored at one regional center is to mirror the data stored at another center, the most efficient method to ensure each center has the most current data is to transfer data across a network. Consequently, the cost of network traffic would increase dramatically. The complexity of the network would also increase as the network would need to provide a great deal of security when transferring data. Answer (C) is incorrect because adequate controls will ensure that the mirrored data will not affect the source data. Answer (D) is incorrect because the location of the data is not relevant to the insurance agents. The agents will retrieve customer data through the network. [1274] Gleim #: 9.70 -- Source: CPA AUD R98-6 A client is concerned that a power outage or disaster could impair the computer hardware’s ability to function as designed. The client desires off-site backup hardware facilities that are fully configured and ready to operate within several hours. The client most likely should consider a

A. B. C. D.

Cold site. Cool site. Warm site. Hot site. Answer (A) is incorrect because a cold site is a shell facility suitable for quick installation of computer equipment. Installing computer equipment would take more time in a cold site than in a hot site. Answer (B) is incorrect because it is a fabricated term that does not describe actual facilities. Answer (C) is incorrect because it is a fabricated term that does not describe actual facilities. Answer (D) is correct. A hot site is a service bureau that is a fully operational processing facility and is promptly available in the case of a power outage or disaster.

[1275] Gleim #: 9.71 -- Source: Publisher If High Tech Corporation’s disaster recovery plan requires fast recovery with little or no downtime, which of the following backup sites should it choose?

A. B. C. D.

Hot site. Warm site. Cold site. Quick site. Answer (A) is correct. A company uses a hot site backup when fast recovery is critical. The hot site includes all software, hardware, and other equipment necessary for a company to carry out operations. Hot sites are expensive to maintain and may be shared with other organizations with similar needs. Answer (B) is incorrect because a warm site provides an intermediate level of backup and causes more downtime than a hot site. Answer (C) is incorrect because a cold site is a shell facility suitable for quick installation of computer equipment. Disaster recovery would take more time in a cold site than a hot site. Answer (D) is incorrect because there is no backup site called a quick site.

[1276] Gleim #: 9.72 -- Source: CIA 1190 III-17 The system requiring the most extensive backup and recovery procedures is


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A. B. C. D.

A batch system for payroll processing. A database system for online order entry. A file-oriented system for billing clients. An indexed sequential access method file system for fixed asset accounting. Answer (A) is incorrect because it does not require extensive backup and recovery procedures. Answer (B) is correct. Database systems require a more elaborate backup procedure than other systems. A database system for online entry would require almost continuous backup if data loss is to be minimized as transactions are processed on a continuous basis, and without tangible source documentation. Backup procedures that could be employed for online order entry include dual logging and rollback and recovery. Answer (C) is incorrect because it does not require extensive backup and recovery procedures. Answer (D) is incorrect because it does not require extensive backup and recovery procedures.

[1277] Gleim #: 9.73 -- Source: CISA Authentication is the process by which the

A. B. C. D.

System verifies that the user is entitled to enter the transaction requested. System verifies the identity of the user. User identifies him/herself to the system. User indicates to the system that the transaction was processed correctly. Answer (A) is incorrect because authentication involves verifying the identity of the user. This process does not necessarily confirm the functions the user is authorized to perform. Answer (B) is correct. Identification is the process of uniquely distinguishing one user from all others. Authentication is the process of determining that individuals are who they say they are. For example, a password may identify but not authenticate its user if it is known by more than one individual. Answer (C) is incorrect because user identification to the system does not imply that the system has verified the identity of the user. Answer (D) is incorrect because this procedure is an application control for accuracy of the transaction.

[1278] Gleim #: 9.74 -- Source: IIA, adapted Which of the following would provide the least security for sensitive data stored on a notebook computer?

A. B. C. D.

Encrypting data files on the notebook computer. Using password protection for the screen-saver program on the notebook computer. Using a notebook computer with a removable hard disk drive. Locking the notebook computer in a case when not in use. Answer (A) is incorrect because data encryption provides adequate security for notebook computers. Answer (B) is correct. Password protection for a screen-saver program can be easily bypassed. Answer (C) is incorrect because removable hard drives would provide adequate security. Answer (D) is incorrect because security is promoted by physically locking the notebook computer in a case.

[1279] Gleim #: 9.75 -- Source: IIA, adapted Which of the following would be of greatest concern to an auditor reviewing a policy regarding the sale of a company’s used personal computers to outside parties?


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A. B. C. D.

Whether deleted files on the hard disk drive have been completely erased. Whether the computer has viruses. Whether all software on the computer is properly licensed. Whether there is terminal emulation software on the computer. Answer (A) is correct. While most delete programs erase file pointers, they do not remove the underlying data. The company must use special utilities that fully erase the data. This is important because of the potential for confidential data on the microcomputers. Answer (B) is incorrect because this could create a liability for the company if a virus destroyed the purchasing party’s data or programs. However, the purchasing party should use anti-virus software to detect and eliminate any viruses. This concern, while important, is not as serious as the one in the answer choice which states: “Whether deleted files on the hard disk drive have been completely erased.” Answer (C) is incorrect because the purchasing party has a responsibility to insure that all their software is properly licensed. If the company represented that all the software was properly licensed, this could create a liability. However, this liability is not as serious as the implication from the answer choice which states: “Whether deleted files on the hard disk drive have been completely erased.” Answer (D) is incorrect because terminal emulation software is widely available.

[1280] Gleim #: 9.76 -- Source: IIA, adapted The best evidence that contingency planning is effective is to have

A. B. C. D.

No processing interruptions during the past year. Comprehensive documentation of the plan. Signoff on the plan by the internal audit activity. Successful testing of the plan. Answer (A) is incorrect because the absence of processing interruptions indicates nothing about the interruptions that might occur in the future, especially those that are not under the organization’s control. Answer (B) is incorrect because a contingency plan may have comprehensive documentation, but until the plan is tested, an organization has no indication of its effectiveness. Answer (C) is incorrect because audit signoff is one indicator of plan quality, but until the plan is tested, an organization has no indication of its effectiveness. Answer (D) is correct. The only way to know whether contingency planning has been effective is to test the plan, by simulating an interruption or by conducting a paper test with a walk-through of recovery procedures.

[1281] Gleim #: 9.77 -- Source: IIA, adapted A password is an example of

A. B. C. D.

A physical control. An edit control. A digital control. An access control.


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Answer (A) is incorrect because physical controls limit access to an area and do not include passwords. Answer (B) is incorrect because edit controls test the validity of data. Answer (C) is incorrect because digital controls are examples of physical controls. Answer (D) is correct. Passwords are a form of access controls since they limit access to computer systems and the information stored in them. [1282] Gleim #: 9.78 -- Source: IIA, adapted To reduce security exposure when transmitting proprietary data over communication lines, a company should use

A. B. C. D.

Asynchronous modems. Authentication techniques. Call-back procedures. Cryptographic devices. Answer (A) is incorrect because asynchronous modems handle data streams from peripheral devices to a central processor. Answer (B) is incorrect because authentication techniques confirm that valid users have access to the system. Answer (C) is incorrect because call-back procedures are used to ensure incoming calls are from authorized locations. Answer (D) is correct. Encryption involves using a fixed algorithm to manipulate plain text. The information is sent in its manipulated form and the receiver translates the information back into plain text. Cryptographic devices protect data in transmission over communication lines.

[1283] Gleim #: 9.79 -- Source: IIA, adapted A device used to connect dissimilar networks is a

A. B. C. D.

Gateway. Bridge. Router. Wiring concentrator. Answer (A) is correct. A gateway, often implemented via software, translates between two or more different protocol families and makes connections between dissimilar networks possible. Answer (B) is incorrect because a bridge joins network segments so that they appear to be one physical segment. Answer (C) is incorrect because a router connects two or more network segments, such that the segments maintain their separate logical identities. Answer (D) is incorrect because a wiring concentrator accepts twisted-pair cabling from each of several personal computers in the same local area network (LAN).

[1284] Gleim #: 9.80 -- Source: IIA, adapted What language interface would a database administrator use to establish the structure of database tables?

A. B. C. D.

Data definition language. Data control language. Data manipulation language. Data query language.


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Answer (A) is correct. The schema is a description of the overall logical structure of the database using data-definition language (DDL), which is the connection between the logical and physical structure of the database. DDL is used to define, or determine, the database. Answer (B) is incorrect because data control language (DCL) is used to specify privileges and security rules. Answer (C) is incorrect because data manipulation language (DML) provides programmers with a facility to update the database. Answer (D) is incorrect because data query language (DQL) is used for ad hoc queries. [1285] Gleim #: 9.81 -- Source: IIA, adapted Query facilities for a database system would most likely include all of the following except

A. B. C. D.

Graphical output capability. Data dictionary access. A data validity checker. A query-by-example interface. Answer (A) is incorrect because most query tools include the capability of presenting the results of queries graphically. Answer (B) is incorrect because query tools include data dictionary access because that is how they know what table attributes to present to users. Answer (C) is correct. The least likely feature of a query tool would be a data validity checker because the database system has already enforced any validity constraints at the time the data were inserted in the database. Any further data validity checking would be a function of a user application program rather than a query. Answer (D) is incorrect because query tools typically have query-by-example interface.

[1286] Gleim #: 10.1 -- Source: Publisher All of the following are potential security issues for e-commerce except:

A. B. C. D.

Correct identification of transacting parties. Proliferation of computer viruses. Determining who may rightfully make transaction decisions. Verification of payment data. Answer (A) is incorrect because authentication is a security issue related to e-commerce. Answer (B) is correct. E-commerce is the purchase and sale of goods and services by electronic means. E-commerce may occur via online transactions on public networks, electronic data interchange (EDI), and e-mail. Security for ecommerce issues include the correct identification of transacting parties (authentication), determining who may rightfully make decisions (authorization), and verification of payment data. While proliferation of computer viruses is a general security issue with regard to information systems, it is not a specific risk associated with e-commerce. Answer (C) is incorrect because authorization is a security issue related to e-commerce. Answer (D) is incorrect because verification of payment data is a security issue related to e-commerce.

[1287] Gleim #: 10.2 -- Source: CIA 594 III-26 Companies now can use electronic transfers to conduct regular business transactions. Which of the following terms best describes a system in which an agreement is made between two or more parties to electronically transfer purchase orders, sales orders, invoices, and/or other financial documents?


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A. B. C. D.

Electronic mail (e-mail). Electronic funds transfer (EFT). Electronic data interchange (EDI). Electronic data processing (EDP). Answer (A) is incorrect because e-mail can send text or document files, but the term encompasses a wide range of transfers. EDI specifically applies to the system described in the question. Answer (B) is incorrect because electronic funds transfer (EFT) refers to the transfer of money. Answer (C) is correct. Electronic data interchange is the electronic transfer of documents between businesses. EDI was developed to enhance just-in-time (JIT) inventory management. Advantages include speed, reduction of clerical errors, and elimination of repetitive clerical tasks and their costs. Answer (D) is incorrect because electronic data processing (EDP) is a generic term for computerized processing of transaction data within organizations.

[1288] Gleim #: 10.3 -- Source: CPA AUD R99-9 Which of the following is usually a benefit of transmitting transactions in an electronic data interchange (EDI) environment?

A. B. C. D.

A compressed business cycle with lower year-end receivables balances. A reduced need to test computer controls related to sales and collections transactions. An increased opportunity to apply statistical sampling techniques to account balances. No need to rely on third-party service providers to ensure security. Answer (A) is correct. EDI transactions are typically transmitted and processed in real time. Thus, EDI compresses the business cycle by eliminating delays. The time required to receive and process an order, ship goods, and receive payment is greatly reduced compared with that of a typical manual system. Accordingly, more rapid receipt of payment minimizes receivables and improves cash flow. Answer (B) is incorrect because use of a sophisticated processing system would increase the need to test computer controls. Answer (C) is incorrect because computer technology allows all transactions to be tested rather than just a sample. Answer (D) is incorrect because EDI often uses a VAN (value-added network) as a third-party service provider, and reliance on controls provided by the VAN may be critical.

[1289] Gleim #: 10.4 -- Source: CIA 593 III-38 The emergence of electronic data interchange (EDI) as standard operating practice increases the risk of

A. B. C. D.

Unauthorized third-party access to systems. Systematic programming errors. Inadequate knowledge bases. Unsuccessful system use. Answer (A) is correct. EDI is the communication of electronic documents directly from a computer in one entity to a computer in another entity. EDI for business documents between unrelated parties has the potential to increase the risk of unauthorized third-party access to systems because more outsiders will have access to internal systems. Answer (B) is incorrect because systematic programming errors are the result of misspecification of requirements or lack of correspondence between specifications and programs. Answer (C) is incorrect because inadequate knowledge bases are a function of lack of care in building them. Answer (D) is incorrect because a benefit of EDI is to improve the efficiency and effectiveness of system use.


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[Fact Pattern #83] A multinational company has an agreement with a value-added network (VAN) that provides the encoding and communications transfer for the company’s electronic data interchange (EDI) and electronic funds transfer (EFT) transactions. Before transfer of data to the VAN, the company performs online preprocessing of the transactions. The internal auditor is responsible for assessing preprocessing controls. In addition, the agreement between the company and the VAN states that the internal auditor is allowed to examine and report on the controls in place at the VAN on an annual basis. The contract specifies that access to the VAN can occur on a surprise basis during the second or third quarter of the company’s fiscal year. This period was chosen so it would not interfere with processing during the VAN’s peak transaction periods. This provision was not reviewed with internal auditing. The annual audit plan approved by the board of directors specifies that a full audit would be done during the current year. [1290] Gleim #: 10.5 -- Source: CIA 596 I-53 (Refers to Fact Pattern #83) Which one of the following would not be included as a reason for the company to use EFT with the EDI system?

A. B. C. D.

To take advantage of the time lag associated with negotiable instruments. To allow the company to negotiate discounts with EDI vendors based upon prompt payment. To improve its cash management program. To reduce input time and input errors. Answer (A) is correct. The float period is the time lag between transmittal of a regular check (a negotiable instrument) and its clearance through regular banking channels. Float is eliminated by EFT. Answer (B) is incorrect because payment schedules may be based on the time required to process invoices, prepare checks, and transmit checks. Using EFT, payment is instantaneous, and payment schedules can be based on other criteria, e.g., discounts for prompt payment. Answer (C) is incorrect because EFT allows for more effective control of payments and transfers among accounts. Answer (D) is incorrect because integration of EDI and EFT eliminates manual input of transaction data, a process that introduces errors into the accounting system.

[1291] Gleim #: 10.6 -- Source: CIA 596 I-54 (Refers to Fact Pattern #83) Which one of the following is least likely to be recommended by the auditor when an EDI-EFT system is being designed?

A. B. C. D.

The identity of the individual approving an electronic document should be stored as a data field. Disaster recovery plans should be established. Data security procedures should be written to prevent changes to data by unauthorized individuals. Remote access to electronic data should be denied. Answer (A) is incorrect because approval information is needed to provide an audit trail. Answer (B) is incorrect because disaster recovery plans are needed to ensure that the company can continue to function if the system crashes. Answer (C) is incorrect because individuals should not be able to update data without proper identification and authentication. Answer (D) is correct. One of the benefits of an EDI-EFT system is that it can provide remote access at any time from any place if telecommunications links are available. However, appropriate controls should prevent unauthorized access.

[1292] Gleim #: 10.7 -- Source: CIA 596 III-64 Which of the following risks is not greater in an electronic funds transfer (EFT) environment than in a manual system using paper transactions?


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A. B. C. D.

Unauthorized access and activity. Duplicate transaction processing. Higher cost per transaction. Inadequate backup and recovery capabilities. Answer (A) is incorrect because unauthorized access and activity is a risk specific to EFT. Answer (B) is incorrect because inaccurate transaction processing (including duplication) is a risk specific to EFT. Answer (C) is correct. EFT is a service provided by financial institutions worldwide that is based on EDI technology. EFT transaction costs are lower than for manual systems because documents and human intervention are eliminated from the transactions process. Answer (D) is incorrect because inadequate backup and recovery capabilities is a risk specific to EFT.

[1293] Gleim #: 10.8 -- Source: CPA AUD R99-14 Which of the following are essential elements of the audit trail in an electronic data interchange (EDI) system?

A. B. C. D.

Network and sender/recipient acknowledgments. Message directories and header segments. Contingency and disaster recovery plans. Trading partner security and mailbox codes. Answer (A) is correct. An audit trail allows for the tracing of a transaction from initiation to conclusion. Network and sender/recipient acknowledgments relate to the transaction flow and provide for the tracking of transactions. Answer (B) is incorrect because message directories and header segments provide information controlling the message, such as originating and destination stations, message type and priority level, which are part of the message and not the audit trail. Answer (C) is incorrect because, although contingency and disaster recovery plans are important controls, they do not relate to the audit trail. Answer (D) is incorrect because, although maintaining control over security and mailbox codes is an important control, it does not relate to the audit trail.

[1294] Gleim #: 10.9 -- Source: Publisher Which of the following is a false statement about XBRL?

A. B. C. D.

XBRL is freely licensed. XBRL facilitates the automatic exchange of information. XBRL is used primarily in the U.S. XBRL is designed to work with a variety of software applications. Answer (A) is incorrect because the AICPA-led consortium that developed XBRL has promoted the application as a freely licensed product. Answer (B) is incorrect because XBRL will facilitate the exchange of information, for example, for reporting to the SEC. Answer (C) is correct. XBRL stands for eXtensible Business Reporting Language. It is being developed for business and accounting applications. It is an XML-based application used to create, exchange, and analyze financial reporting information and is being developed for worldwide use. Answer (D) is incorrect because XBRL will allow exchange of data across many platforms and will soon be integrated into accounting software applications and products.


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[1295] Gleim #: 10.10 -- Source: CPA AUD R99-11 Which of the following statements is true concerning internal control in an electronic data interchange (EDI) system?

A. B. C. D.

Preventive controls generally are more important than detective controls in EDI systems. Control objectives for EDI systems generally are different from the objectives for other information systems. Internal controls in EDI systems rarely permit control risk to be assessed at below the maximum. Internal controls related to the segregation of duties generally are the most important controls in EDI systems. Answer (A) is correct. In general, preventive controls are more important than detective controls because the benefits typically outweigh the costs. In electronic processing, once a transaction is accepted, there is often little opportunity to apply detective controls. Thus, it is important to prevent errors or frauds before they happen. Answer (B) is incorrect because the basic control objectives are the same regardless of the nature of the processing: to ensure the integrity of the information and to safeguard the assets. Answer (C) is incorrect because, to gather sufficient evidence in a sophisticated computer system, it is often necessary to rely on the controls. Control risk may be assessed at below the maximum if relevant controls are identified and tested and if the resulting evidential matter provides the degree of assurance necessary to support the assessed level of control risk. Answer (D) is incorrect because the level of segregation of duties achieved in a manual system is usually not feasible in a computer system.

[1296] Gleim #: 10.11 -- Source: CIA 1193 III-43 A control that a company can use to detect forged EDI messages is to

A. B. C. D.

Acknowledge all messages initiated externally with confirming messages. Permit only authorized employees to have access to transmission facilities. Delay action on orders until a second order is received for the same goods. Write all incoming messages to a write-once/read-many device for archiving. Answer (A) is correct. If the company acknowledges messages initiated externally, the alleged sender will have the opportunity to recognize that it had not sent the message and will then be able to notify the company of the potential forgery. Then corrective action can be taken by the company. Answer (B) is incorrect because permitting only authorized employees to have access to transmission facilities controls for unauthorized access to the facilities but would not detect forged EDI messages. Answer (C) is incorrect because delaying action on orders until a second order is received for the same goods defeats the purpose of using EDI, namely, rapid communication followed by rapid response. Answer (D) is incorrect because writing all incoming messages to a write-once/read-many device is a good practice, but it will not detect forgeries.

[1297] Gleim #: 10.12 -- Source: Publisher Which of the following statements about SET (Secured Electronic Transaction) is false?

A. B. C. D.

SET is a trademarked protocol that provides individualized security standards. SET is based on a hierarchy of certificate authorities. SET authenticates users with digital certificates and digital signatures. SET is supported through an organization called SETCo.


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Answer (A) is correct. SET (Secured Electronic Transaction) is a trademarked protocol that provides a common security standards, especially with regard to Internet card purchases. It is supported by Visa and MasterCard through an organization called SETCo. SET encrypts the details of payment transactions at all times so as to ensure privacy and data integrity. It also ensures that the identities of buyers and sellers are authenticated using digital signatures and digital certificates. SET is based on a hierarchy of certificate authorities that parallels financial relationships outside cyberspace. Answer (B) is incorrect because SET is based in a hierarchy of certificate authorities that parallels financial relationships outside cyberspace. Answer (C) is incorrect because SET authenticates sellers and buyers using digital signatures and certificates. Answer (D) is incorrect because SET is supported by Visa and Mastercard through an organization called SETCo. [1298] Gleim #: 10.13 -- Source: CIA 591 I-40 Inefficient use of excess computer equipment can be controlled by

A. B. C. D.

Contingency planning. System feasibility studies. Capacity planning. Exception reporting. Answer (A) is incorrect because contingency planning concerns the arrangements for alternative processing facilities in the event of equipment failure. Answer (B) is incorrect because a feasibility study is one of the phases in the systems development life cycle. Answer (C) is correct. Planning is as important for the information systems function as for any other part of the organization. The master plan for this function should be consistent with the strategic plan for the organization and include goals and objectives, an inventory of current capacity, and a forecast of future needs. The plan is the basis for determining hardware needs. Answer (D) is incorrect because exception reports are meant to list errata and bring them to the attention of management.

[1299] Gleim #: 10.14 -- Source: CIA 593 III-42 The best plan for responding to quickly changing information requirements is to foster

A. B. C. D.

Greater online access to information systems. Competitive pressures for enhanced functions in systems. Closer linkage between organizational strategy and information. More widespread use of automated controls. Answer (A) is incorrect because greater online access may or may not be helpful, depending on the user organization’s needs. Answer (B) is incorrect because marketplace creates competitive pressures for enhanced functions in systems. Answer (C) is correct. An important management challenge is to integrate the planning, design, and implementation of complex application systems with the strategy of the organization, which will permit the best possible response to quickly changing information requirements. Answer (D) is incorrect because more pervasive use of automated controls may be independent of responding quickly to changing information requirements.

[1300] Gleim #: 10.15 -- Source: Publisher An enterprise resource planning (ERP) system integrates the organization’s computerized subsystems and may also provide links to external parties. An advantage of ERP is that


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A. B. C. D.

The reengineering needed for its implementation should improve business processes. Customizing the software to suit the unique needs of the organization will facilitate upgrades. It can be installed by organizations of all sizes. The comprehensiveness of the system reduces resistance to change. Answer (A) is correct. The benefits of ERP may significantly derive from the business process reengineering that is needed for its implementation. Using ERP software that reflects the best practices forces the linked subunits in the organization not only to redesign and improve their processes but also to conform to one standard. Answer (B) is incorrect because the disadvantages of ERP are its extent and complexity, which make customization of the software difficult and costly. Answer (C) is incorrect because ERP software is costly and complex. It is usually installed only by the largest enterprises. Answer (D) is incorrect because implementing an ERP system is likely to encounter significant resistance because of its comprehensiveness.

[1301] Gleim #: 10.16 -- Source: Publisher A manufacturing resource planning (MRP II) system

A. B. C. D.

Performs the same back-office functions for a manufacturer as an ERP system. Uses a master production schedule. Lacks the forecasting and budgeting capabilities typical of an ERP system. Performs the same front-office functions for a manufacturer as an ERP system. Answer (A) is incorrect because an MRP II system does not integrate all the subsystems internal to the organization (back-office functions), such as human resources and customer service. Answer (B) is correct. Manufacturing resource planning (MRP II) continued the evolution begun with MRP I. It is a closed-loop manufacturing system that integrates all facets of manufacturing, including production, sales, inventories, schedules, and cash flows. The same system is used for accounting and finance functions, which use the same transactions and numbers. MRP II uses an MPS (master production schedule), a statement of the anticipated manufacturing schedule for selected items for selected periods. MRP also uses the MPS. Thus, MRP is a component of an MRP II system. Answer (C) is incorrect because MRP II includes forecasting and planning capacities for generating cash and other budgets. Answer (D) is incorrect because MRP, MRP II, and traditional ERP do not provide for front-office functions, that is, connections with customers, suppliers, owners, creditors, and strategic allies.

[1302] Gleim #: 10.17 -- Source: Publisher In a traditional ERP system, the receipt of a customer order may result in I. II. III. IV.

A. B. C. D.

Customer tracking of the order’s progress Automatic replenishment of inventory by a supplier Hiring or reassigning of employees Automatic adjustment of output schedules

I, II, and IV only. I and III only. III and IV only. I, II, III, and IV.


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Answer (A) is incorrect because ERP II but not traditional ERP is capable of customer tracking of the order’s progress and automatic replenishment of inventory by a supplier. Answer (B) is incorrect because ERP II but not traditional ERP is capable of customer tracking of the order’s progress and automatic replenishment of inventory by a supplier. Answer (C) is correct. The traditional ERP system is one in which subsystems share data and coordinate their activities. Thus, if marketing receives an order, it can quickly verify that inventory is sufficient to notify shipping to process the order. Otherwise, production is notified to manufacture more of the product, with a consequent automatic adjustment of output schedules. If materials are inadequate for this purpose, the system will issue a purchase order. If more labor is needed, human resources will be instructed to reassign or hire employees. However, the subsystems in a traditional ERP system are internal to the organization. Hence, they are often called back-office functions. The information produced is principally (but not exclusively) intended for internal use by the organization’s managers. The current generation of ERP software (ERP II) has added front-office functions. Consequently, ERP II but not traditional ERP is capable of customer tracking of the order’s progress and automatic replenishment of inventory by a supplier. Answer (D) is incorrect because ERP II but not traditional ERP is capable of customer tracking of the order’s progress and automatic replenishment of inventory by a supplier. [1303] Gleim #: 10.18 -- Source: Publisher What are the possible characteristics of a client-server configuration in a current ERP system? I. Thin clients, local area network, single server II. Fat clients, wide area network, multiple servers III. Fat clients, connection via Internet, and single server

A. B. C. D.

I, II, and III. II and III only. II only. I only. Answer (A) is correct. Current ERP systems have a client-server configuration with, possibly, scores or hundreds of client (user) computers. Clients may be thin or fat. So-called thin clients have little processing ability, but fat clients may have substantial processing power. The system may have multiple servers to run applications and contain databases. The network architecture may be in the form of a local area network (LAN) or wide area network (WAN), or users may connect with the server(s) via the Internet. An ERP system may use almost any of the available operating systems and database management systems. Answer (B) is incorrect because an ERP system also may have thin clients connected via a LAN. Answer (C) is incorrect because an ERP system also may have thin clients connected via a LAN or the Internet with one server. Answer (D) is incorrect because an ERP system also may have fat clients connected via a WAN or the Internet to multiple servers.

[1304] Gleim #: 10.19 -- Source: Publisher A principal advantage of an ERP system is

A. B. C. D.

Program-data dependence. Data redundancy. Separate data updating for different functions. Centralization of data.


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Answer (A) is incorrect because an ERP system uses a central database and a database management system. A fundamental characteristic of a database is that applications are independent of the physical structure of the database. Writing programs or designing applications to use the database requires only the names of desired data items, not their locations. Answer (B) is incorrect because an ERP system eliminates data redundancy. Answer (C) is incorrect because an ERP system is characterized by one-time data updating for all organizational functions. Answer (D) is correct. An advantage of an ERP system is the elimination of data redundancy through the use of a central database. In principle, information about an item of data is stored once, and all functions have access to it. Thus, when the item (such as a price) is updated, the change is effectively made for all functions. The result is reliability (data integrity). [1305] Gleim #: 10.20 -- Source: Publisher The current generation of ERP software (ERP II) has added such front-office functions as

A. B. C. D.

Inventory control. Human resources. Purchasing. Customer service. Answer (A) is incorrect because inventory control is a back-office function. Answer (B) is incorrect because human resources is a back-office function. Answer (C) is incorrect because purchasing is a back-office function. Answer (D) is correct. The current generation of ERP software (ERP II) has added front-office functions. Customer relationship management applications in ERP II extend to customer service, finance-related matters, sales, and database creation and maintenance. Integrated data are helpful in better understanding customer needs, such as product preference or location of retail outlets. Thus, the organization may be able to optimize its sales forecasts, product line, and inventory levels.

[1306] Gleim #: 10.21 -- Source: Publisher The current generation of ERP software (ERP II) may include an advanced planning and scheduling system that

A. B. C. D.

Determines the location of retail outlets. Connects the organization with other members of a joint venture. Controls the flow of a manufacturer’s materials and components through the supply chain. Permits tracking of orders by customers. Answer (A) is incorrect because customer relationship management applications in ERP II extend to customer service, finance-related matters, sales, and database creation and maintenance. Integrated data are helpful in better understanding customer needs, such as product preference or location of retail outlets. Answer (B) is incorrect because partner relationship management applications connect the organization not only with such partners as customers and suppliers but also with owners, creditors, and strategic allies (for example, other members of a joint venture). Answer (C) is correct. An advanced planning and scheduling system may be an element of a supply chain management application for a manufacturer. It controls the flow of materials and components within the chain. Schedules are created given projected costs, lead times, and inventories. Answer (D) is incorrect because an advanced planning scheduling system is used by a manufacturer to control flows through the supply chain. Other software permits customers to obtain information about order availability.

[1307] Gleim #: 10.22 -- Source: CPA AUD R02-5 Which of the following is a computer program that appears to be legitimate but performs some illicit activity when it is run?


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A. B. C. D.

Hoax virus. Web crawler. Trojan horse. Killer application. Answer (A) is incorrect because a hoax virus is a false notice about the existence of a computer virus. It is usually disseminated through use of distribution lists and is sent by e-mail or via an internal network. Answer (B) is incorrect because a web crawler (a spider or bot) is a computer program created to access and read information on websites. The results are included as entries in the index of a search engine. Answer (C) is correct. A Trojan horse is a computer program that appears friendly, for example, a game, but that actually contains an application destructive to the computer system. Answer (D) is incorrect because a killer application is one that is so useful that it may justify widespread adoption of a new technology.

[1308] Gleim #: 10.23 -- Source: CIA 591 III-24 The best preventive measure against a computer virus is to

A. B. C. D.

Compare software in use with authorized versions of the software. Execute virus exterminator programs periodically on the system. Allow only authorized software from known sources to be used on the system. Prepare and test a plan for recovering from the incidence of a virus. Answer (A) is incorrect because comparing software with authorized versions is a detective control used to determine whether only authorized versions of the software are being used on the system. Answer (B) is incorrect because executing virus exterminator programs is a corrective control against a computer virus. Answer (C) is correct. Preventive controls are designed to prevent errors before they occur. Detective and corrective controls attempt to identify and correct errors. Preventive controls are usually more cost beneficial than detective or corrective controls. Allowing only authorized software from known sources to be used on the system is a preventive measure. The authorized software from known sources is expected to be free of viruses. Answer (D) is incorrect because preparing and testing a plan for virus recovery is a corrective control against a computer virus.

[1309] Gleim #: 10.24 -- Source: CIA 595 III-67 Managers at a consumer products company purchased personal computer software from only recognized vendors, and prohibited employees from installing nonauthorized software on their personal computers. To minimize the likelihood of computer viruses infecting any of its systems, the company should also

A. B. C. D.

Restore infected systems with authorized versions. Recompile infected programs from source code backups. Institute program change control procedures. Test all new software on a stand-alone personal computer.


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Answer (A) is incorrect because, if viruses infect a system, the company should restore the system with authorized software, but this procedure does not minimize the likelihood of initial infection. Answer (B) is incorrect because, if viruses infect programs that the company created, it should recompile the programs from source code backups, but this procedure does not minimize the likelihood of initial infection. Answer (C) is incorrect because instituting program change control procedures is good practice but does not minimize the likelihood of the system’s being infected initially. Answer (D) is correct. Software from recognized sources should be tested in quarantine (for example, in a test/development machine or a stand-alone personal computer) because even vendor-supplied software may be infected with viruses. The software should be run with a vaccine program and tested for the existence of logic bombs, etc. [1310] Gleim #: 10.25 -- Source: CIA 1196 III-40 Which of the following is an indication that a computer virus is present?

A. B. C. D.

Frequent power surges that harm computer equipment. Unexplainable losses of or changes to data. Inadequate backup, recovery, and contingency plans. Numerous copyright violations due to unauthorized use of purchased software. Answer (A) is incorrect because power surges are caused by hardware or power supply problems. Answer (B) is correct. The effects of computer viruses range from harmless messages to complete destruction of all data within the system. A symptom of a virus would be the unexplained loss of or change to data. Answer (C) is incorrect because inadequate back-up, recovery, and contingency plans are operating policy weaknesses. Answer (D) is incorrect because copyright violations represent policy or compliance problems.

[1311] Gleim #: 10.26 -- Source: CIA 1196 III-41 Which of the following operating procedures increases an organization’s exposure to computer viruses?

A. B. C. D.

Encryption of data files. Frequent backup of files. Downloading public-domain software from websites. Installing original copies of purchased software on hard disk drives. Answer (A) is incorrect because viruses are spread through the distribution of contaminated programs. Answer (B) is incorrect because backing up files does not increase the chances of a virus entering the computer system. Answer (C) is correct. Viruses are spread through shared data. Downloading public-domain software carries a risk that contaminated data may enter the computer. Answer (D) is incorrect because original copies of purchased software on hard disk drives should be free of viruses.

[1312] Gleim #: 10.27 -- Source: CIA 1195 III-37 An organization installed antivirus software on all its personal computers. The software was designed to prevent initial infections, stop replication attempts, detect infections after their occurrence, mark affected system components, and remove viruses from infected components. The major risk in relying on antivirus software is that antivirus software may


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A. B. C. D.

Not detect certain viruses. Make software installation overly complex. Interfere with system operations. Consume too many system resources. Answer (A) is correct. Antivirus software designed to identify and remove known viruses is sometimes known as a vaccine. A vaccine works only for known viruses and may not be effective for variants of those viruses or new viruses. Answer (B) is incorrect because having antivirus software is unlikely to make software installation overly complex. Answer (C) is incorrect because antivirus software need not interfere with system operations. Its execution can be scheduled in advance so as not to interfere with running programs. Answer (D) is incorrect because antivirus software can be set to execute at times when it would not consume too many system resources, e.g., at startup.

[1313] Gleim #: 10.28 -- Source: CIA 594 III-29 What is the best course of action to take if a program takes longer than usual to load or execute?

A. B. C. D.

Test the system by running a different application program. Reboot the system. Run antivirus software. Back up the hard disk files to floppies. Answer (A) is incorrect because running a different program as a test may cause the virus to spread and do additional damage. Answer (B) is incorrect because rebooting the system may cause the virus to spread and do additional damage. Answer (C) is correct. The described condition is a symptom of a virus. Many viruses will spread and cause additional damage. Use of an appropriate antivirus program may identify and even eliminate a viral infection. Ways to minimize computer virus risk in a networked system include restricted access, regularly updated passwords, periodic testing of systems with virus detection software, and the use of anti-virus software on all shareware prior to introducing it into the network. Answer (D) is incorrect because backing up hard disk files may cause the virus to spread and do additional damage.

[1314] Gleim #: 10.29 -- Source: CIA 1190 III-19 Six months after a disgruntled systems programmer was fired and passwords disabled, the company’s mainframe computer was brought to a halt when it suddenly erased all of its own files and software. The most likely way the programmer accomplished this was by

A. B. C. D.

Returning to the computer center after 6 months. Planting a computer virus through the use of telephone access. Having an accomplice in the computer center. Implanting a virus in the operating system and executing it via a back door. Answer (A) is incorrect because the programmer would most likely be denied access to the center. Answer (B) is incorrect because the programmer would not know the necessary passwords. Answer (C) is incorrect because collusion is less likely than individual wrongdoing. Answer (D) is correct. Viruses are a form of computer sabotage. They are programs hidden within other programs that have the capacity to duplicate themselves and infect other systems. Sharing of storage media or participation in computer networks creates exposure to viruses. Viruses may result in actions ranging from harmless pranks to erasure of files and programs. A back door is a shortcut created in an operating system that permits a programmer simple access to the system.


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[1315] Gleim #: 10.30 -- Source: CIA 1195 III-61 Because of competitive pressures to be more responsive to their customers, some organizations have connected their internal personal computer networks through a host computer to outside networks. A risk of this practice is that

A. B. C. D.

Viruses may gain entry to one or more company systems. Uploaded files may not be properly edited and validated. Data downloaded to the personal computers may not be sufficiently timely. Software maintenance on the personal computers may become more costly. Answer (A) is correct. Viruses are harmful programs that disrupt memory and processing functions and may destroy data. They spread from network to network, from infected diskettes, or from infected machines. Hence, connecting all networked personal computers through a host computer to outside networks increases the exposure of all of a company’s computers to viruses. Answer (B) is incorrect because whether uploaded files are properly edited and validated is independent of whether external links to other networks exist. Answer (C) is incorrect because whether data downloaded to the personal computers is sufficiently timely is independent of whether external links to other networks exist. Answer (D) is incorrect because whether software maintenance on the personal computers becomes more costly is independent of whether external links to other networks exist.

[1316] Gleim #: 10.31 -- Source: Publisher Attacks on computer networks may take many forms. Which of the following uses the computers of innocent parties infected with Trojan horse programs?

A. B. C. D.

A distributed denial-of-service attack. A man-in-the-middle attack. A brute-force attack. A password-cracking attack. Answer (A) is correct. A denial-of-service (DOS) attack is an attempt to overload a system (e.g., a network or Web server) with false messages so that it cannot function (a system crash). A distributed DOS attack comes from multiple sources, for example, the machines of innocent parties infected by Trojan horses. When activated, these programs send messages to the target and leave the connection open. A DOS may establish as many network connections as possible to exclude other users, overload primary memory, or corrupt file systems. Answer (B) is incorrect because a man-in-the-middle attack takes advantage of network packet sniffing and routing and transport protocols to access packets flowing through a network. Answer (C) is incorrect because a brute-force attack uses password cracking software to try large numbers of letter and number combinations to access a network. Answer (D) is incorrect because password-cracking software is used to access a network by using a large number of letter and number combinations.

[1317] Gleim #: 10.32 -- Source: Publisher Spoofing is one type of online activity used to launch malicious attacks. Spoofing is

A. B. C. D.

Trying large numbers of letter and number combinations to access a network. Eavesdropping on information sent by a user to the host computer of a website. Accessing packets flowing through a network. Identity misrepresentation in cyberspace.


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Answer (A) is incorrect because a brute-force attack uses password cracking software to try large numbers of letter and number combinations to access a network. Answer (B) is incorrect because sniffing is use of software to eavesdrop on information sent by a user to the host computer of a website. Answer (C) is incorrect because a man-in-the-middle attack takes advantage of network packet sniffing and routing and transport protocols to access packets flowing through a network. Answer (D) is correct. Passwords, user account numbers, and other information may be stolen using techniques such as Trojan horses, IP spoofing, and packet sniffers. Spoofing is identity misrepresentation in cyberspace, for example, by using a false website to obtain information about visitors. [1318] Gleim #: 10.33 -- Source: Publisher An organization’s computer system should have an intrusion detection system (IDS) if it has external connections. An IDS

A. B. C. D.

Must monitor every call on the system as it occurs. May examine only packets with certain signatures. Uses only knowledge-based detection. Uses only behavior-based detection. Answer (A) is incorrect because a host IDS provides maximum protection only when the software is installed on each computer. It may operate in the following ways: The aggressive response is to monitor every call on the operating system and application as it occurs. A less effective method of preventing attacks is analysis of access log files. A host IDS may also identify questionable processes and verify the security of system files. Answer (B) is correct. A network IDS works by using sensors to examine packets traveling on the network. Each sensor monitors only the segment of the network to which it is attached. A packet is examined if it matches a signature. String signatures (certain strings of text) are potential signs of attack. Port signatures alert the IDS that a point subject to frequent intrusion attempts may be under attack. A header signature is a suspicious combination in a packet header. Answer (C) is incorrect because an IDS is not limited to knowledge-based detection. Knowledge-based detection is based on information about the system’s weaknesses and searches for intrusions that take advantage of them. Answer (D) is incorrect because an IDS is not limited to behavior-based detection. Behavior-based detection presumes that an attack will cause an observable anomaly. Actual and normal system behavior (a model of expected operations) are compared. A discrepancy results in an alert.

[1319] Gleim #: 10.34 -- Source: CPA AUD R99-8 Which of the following is usually a benefit of using electronic funds transfer (EFT) for international cash transactions?

A. B. C. D.

Improvement of the audit trail for cash receipts and disbursements. Creation of self-monitoring access controls. Reduction of the frequency of data entry errors. Off-site storage of source documents for cash transactions. Answer (A) is incorrect because the audit trail is typically less apparent in an electronic environment than in a manual environment. Answer (B) is incorrect because a key control is management’s establishment and monitoring of access controls. Answer (C) is correct. The processing and transmission of electronic transactions, such as EFTs, virtually eliminates human interaction. This process not only helps eliminate errors but also allows for the rapid detection and recovery from errors when they do occur. Answer (D) is incorrect because source documents are often eliminated in EFT transactions.


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[1320] Gleim #: 10.35 -- Source: CIA 596 III-57 Which of the following is likely to be a benefit of electronic data interchange (EDI)?

A. B. C. D.

Increased transmission speed of actual documents. Improved business relationships with trading partners. Decreased liability related to protection of proprietary business data. Decreased requirements for backup and contingency planning. Answer (A) is incorrect because EDI transmits document data, not the actual document. Answer (B) is correct. Electronic data interchange is the electronic transfer of documents between businesses. EDI was developed to enhance just-in-time (JIT) inventory management. Advantages include speed, reduction of clerical errors, and elimination of repetitive clerical tasks and their costs. Improved business relationships result because of the mutual benefits conferred by EDI. Accordingly, some organizations require EDI. Answer (C) is incorrect because liability for protection of a trading partner's proprietary business data is a major risk that must be addressed by the control structure. Answer (D) is incorrect because backup and contingency planning requirements are not diminished by use of EDI technology. Materials purchased from non-EDI vendors are delivered to the receiving dock and recorded manually on receiving reports. Copies of these reports are given to the purchasing and accounts payable departments. The internal audit department is scheduled to complete a full audit of the purchasing and accounts payable cycle before the end of the year. However, there are severe time pressures because other matters delayed the start of the audit.

[1321] Gleim #: 10.36 -- Source: CIA 1192 III-30 Which of the following is an accepted example of electronic data interchange?

A. B. C. D.

Request for an airline reservation by a travel agent. Withdrawal of cash from an automated teller by a bank's customer. Transfer of summary data from a local area network to a centralized mainframe. Placement of order entry transactions from a customer to its supplier. Answer (A) is incorrect because a request for an airline reservation requires an online, real-time reservations system. Answer (B) is incorrect because withdrawal of cash from an automated teller is accomplished via online transactions to copies of master files. Answer (C) is incorrect because the transfer of summary data to headquarters may be accomplished with point-to-point communications, known as distributed computing. Answer (D) is correct. EDI is the communication of electronic documents directly from a computer in one entity to a computer in another entity. Placement of order entry transactions from a customer to its supplier is an accepted use of EDI between trading partners.

[1322] Gleim #: 10.37 -- Source: CIA 596 I-55 An internal auditor was performing an operational audit of the purchasing and accounts payable system. The audit objective was to identify changes in processes that would improve efficiency and effectiveness. Which of the following statements support the auditor's recommendation that electronic data interchange (EDI) be implemented within a company? I. II. III. IV.

There is a small number of transactions. There is a time-sensitive just-in-time purchase environment. There is a large volume of custom purchases. There are multiple transactions with the same vendor.


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A. B. C. D.

I only. II and IV only. I and III. II, III, and IV. Answer (A) is incorrect because a large volume of repetitive purchases from the same vendors suggests that EDI should be implemented. Answer (B) is correct. EDI is advantageous in a JIT environment because it provides the capacity for instantaneous ordering. Moreover, a JIT environment already is characterized by the close vendor-purchaser cooperation required by an EDI system. Another reason for implementing an EDI system is that the purchaser has a large volume of transactions with the same vendor(s). Otherwise, EDI may not be cost efficient. Answer (C) is incorrect because a large volume of repetitive purchases from the same vendors suggests that EDI should be implemented. Answer (D) is incorrect because a large volume of custom purchases is inappropriate for EDI. The absence of standardization imposes unacceptable costs.

[1323] Gleim #: 10.38 -- Source: CIA 596 I-47 The auditor determined that the risks associated with the EDI purchases were less than the risks associated with the purchases made through the traditional system. Which one of the following factors best supports this prioritization of risks?

A. B. C. D.

There are three vendors connected through EDI. About half of the materials are purchased through EDI. The internal auditors were involved with systems development and testing of the EDI software. The external auditor did not examine EDI purchase controls during the annual financial audit. Answer (A) is incorrect because the number of vendors does not indicate the size of the purchases. Answer (B) is incorrect because the amount of purchases is equally divided between the EDI and non-EDI systems and does not provide a basis for prioritizing risks. Answer (C) is correct. Sound controls mitigate the risks associated with EDI. The question states that the internal auditing department's prior involvement consisted of assessing and testing the EDI system. This review found no significant problems. Accordingly, the risk of the EDI system is decreased. Answer (D) is incorrect because failure to examine EDI purchase controls increases risk.

[1324] Gleim #: 10.39 -- Source: CIA 596 III-59 In a review of an EDI application using a third-party service provider, the auditor should I. II. III. IV.

A. B. C. D.

Ensure encryption keys meet ISO standards Determine whether an independent review of the service provider’s operation has been conducted Verify that only public-switched data networks are used by the service provider Verify that the service provider’s contracts include necessary clauses, such as the right to audit

I and II. I and IV. II and III. II and IV.


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Answer (A) is incorrect because using a third-party service provider does not require encryption. Answer (B) is incorrect because using a third-party service provider does not require encryption. Answer (C) is incorrect because use of public-switched data networks is not a requirement of EDI. Answer (D) is correct. An auditor should review trading partner agreements and contracts with third-party service providers. These documents should contain necessary clauses and appropriately limit liabilities. Moreover, legal counsel should have reviewed the agreements or contracts. An auditor should also determine whether the third-party service provider’s operations and controls have been independently reviewed (e.g., by public accountants). [1325] Gleim #: 10.40 -- Source: CIA 593 III-31 Which of the following represents the greatest exposure to the integrity of electronic funds transfer data transmitted from a remote terminal?

A. B. C. D.

Poor physical access controls over the data center. Network viruses. Poor system documentation. Leased telephone circuits. Answer (A) is incorrect because poor physical access controls represent a secondary exposure for compromise of remote data communications lines. Answer (B) is incorrect because network viruses represent a secondary exposure for compromise of remote data communications lines. Answer (C) is incorrect because poor system documentation represent a secondary exposure for compromise of remote data communications lines. Answer (D) is correct. Leased telephone circuits represent a direct exposure to the risk of breached data integrity. They use public lines that can be easily identified and tapped.

[1326] Gleim #: 10.41 -- Source: CIA 1196 III-63 Which of the following is a risk that is higher when an electronic funds transfer (EFT) system is used?

A. B. C. D.

Improper change control procedures. Unauthorized access and activity. Insufficient online edit checks. Inadequate backups and disaster recovery procedures. Answer (A) is incorrect because improper change control procedures is a risk common to all information technology environments. This risk is not higher than for other systems. Answer (B) is correct. Unauthorized access to money transfer activities or data is an inherent and unique risk of EFT systems. An unauthorized person may attempt to read, alter, or delete information in data files or to enter authorized fund transfers. Hence, in the financial services industry, protection of confidential customer transactions is especially important. Moreover, unauthorized transfers subject a financial institution to a direct risk of serious loss. Answer (C) is incorrect because insufficient online edit checks is a risk common to all information technology environments. This risk is not higher than for other systems. Answer (D) is incorrect because inadequate backups and disaster recovery procedures is a risk common to all information technology environments. This risk is not higher than for other systems.


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[1327] Gleim #: 10.42 -- Source: CIA 1193 III-47 Regardless of whether a company develops, buys, leases, or pays for the use of the software for EDI transmissions, internal audit should be responsible for evaluating whether the software

A. B. C. D.

Was developed in a controlled environment. Is backed up adequately to permit recovery. Was acquired with adequate review by legal counsel. Meets business objectives. Answer (A) is incorrect because determining whether the software was developed in a controlled environment is feasible only if the company develops it. Answer (B) is incorrect because, if the company developed and maintained its own software, internal audit would be responsible for evaluating that the software is backed up adequately to permit recovery in the event of a system failure. Answer (C) is incorrect because, if the company purchased, leased, or paid for the use of the software, internal audit would be responsible for evaluating that the software was acquired with legal counsel review of contract terms. Answer (D) is correct. An EDI application should meet business objectives and satisfy user and control requirements. The internal auditors should consider the organization's important EDI applications because they represent significant risk exposures and control problems. This role is within the scope of work of the internal auditors, who are charged with examining and evaluating internal control and the quality of performance in carrying out assigned responsibilities.

[1328] Gleim #: 10.43 -- Source: CIA 597 III-52 A company using EDI made it a practice to track the functional acknowledgments from trading partners and to issue warning messages if acknowledgments did not occur within a reasonable length of time. What risk was the company attempting to address by this practice?

A. B. C. D.

Transactions that have not originated from a legitimate trading partner may be inserted into the EDI network. Transmission of EDI transactions to trading partners may sometimes fail. There may be disagreement between the parties as to whether the EDI transactions form a legal contract. EDI data may not be accurately and completely processed by the EDI software. Answer (A) is incorrect because unauthorized access to the EDI system should be prevented by procedures that ensure the effective use of passwords, and data integrity and privacy should be maintained through the use of encryption and authentication measures. Answer (B) is correct. Tracking of customers’ functional acknowledgments, when required, will help to ensure successful transmission of EDI transactions. Some possible controls include the provision of end-to-end acknowledgments, particularly when multiple, interconnected networks are involved, and maintenance of a tickler file of outstanding functional acknowledgments, with issuance of warnings for those that are overdue. Answer (C) is incorrect because contractual issues should be resolved by the company and its trading partners before EDI is implemented. Answer (D) is incorrect because the risk that EDI data may not be completely and accurately processed is minimized by system-based controls, not by acknowledgments from trading partners.

[1329] Gleim #: 10.44 -- Source: CIA 591 III-50 An audit of the electronic data interchange (EDI) area of a banking group revealed the facts listed below. Which one indicates the need for improved internal control?


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A. B. C. D.

Employees may only access the computer system via an ID and an encrypted password. The system employs message sequencing as a way to monitor data transmissions. Certain types of transactions may only be made at specific terminals. Branch office employees may access the mainframe with a single call via modem. Answer (A) is incorrect because employee access to the computer system via an ID and an encrypted password is considered acceptable. Encrypted passwords further decrease the likelihood of unauthorized access. Answer (B) is incorrect because message sequencing detects unauthorized access by numbering each message and incrementing each message by one more than the last one sent. This procedure will detect a gap or duplicate. Answer (C) is incorrect because allowing certain types of transactions (such as payroll transactions) to be made only at specific terminals minimizes the likelihood of unauthorized access. Answer (D) is correct. The system should employ automatic dial-back to prevent intrusion by unauthorized parties. This procedure accepts an incoming modem call, disconnects, and automatically dials back a prearranged number to establish a permanent connection for data transfer or inquiry.

[1330] Gleim #: 10.45 -- Source: CIA 596 I-46 Before authorizing payment of an EDI invoice, the computer automatically compares the invoice with the purchase order and receiving report data. When the system was being developed, the auditor reviewed the payment authorization program and made recommendations. Which one of the following was most likely recommended by the auditor for the situation in which the quantity invoiced is greater than the quantity received?

A. B. C. D.

Prepare an exception report. Pay the amount billed and adjust the inventory for the difference. Return the invoice to the vendor. Authorize payment of the full invoice, but maintain an open purchase order record for the missing goods. Answer (A) is correct. An exception report (error listing) should be issued so that company personnel can investigate the discrepancy, determine its cause, and take appropriate corrective action. Answer (B) is incorrect because the company should not pay for goods not received. Answer (C) is incorrect because the company should first determine the cause of the discrepancy. Answer (D) is incorrect because the company should not pay for goods not received.

[1331] Gleim #: 10.46 -- Source: CIA 593 III-59 Consider the following computer applications: (a) (b)

At a catalog sales firm, as phone orders are entered into their computer, both inventory and credit are immediately checked. A manufacturer's computer sends the coming week's production schedule and parts orders to a supplier's computer.

Which statement below is true for these applications?

A. B. C. D.

Both applications are examples of electronic data interchange (EDI). Both applications are examples of online real-time processing (OLRT). The first application is an example of EDI and the second an example of OLRT. The first application is an example of OLRT and the second an example of EDI.


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Answer (A) is incorrect because catalog phone orders do not involve EDI. They are not computer to computer. Answer (B) is incorrect because the ordering of parts by computer is not OLRT. Processing does not occur. Answer (C) is incorrect because the catalog phone orders are OLRT, and the ordering of parts by computer is EDI. Answer (D) is correct. The catalog sales firm is using an online processing system known as an online, real-time system (OLRT). OLRT systems handle transactions as they are entered, processing the input and providing output soon enough to affect a current decision making process, e.g., inventory and credit status of phone call orders. The sending of upcoming production schedules and parts orders by and manufacturer's computer to a supplier's computer is an example of electronic data interchange (EDI). EDI is the communication of electronic documents directly from one entity's computer to another's computer. [1332] Gleim #: 10.47 -- Source: CIA 1193 III-51 If implementing EDI with suppliers permitted more frequent orders and more frequent communication about them, a company could be more effective by using EDI to

A. B. C. D.

Reduce costs by reducing raw materials inventory. Ensure that it always maintained a 25-day buffer stock. Track materials through production to completed orders. Schedule production to reduce the number of setups required. Answer (A) is correct. A well-managed company seeks to minimize the sum of the costs of holding and ordering inventory. An EDI system reduces the costs of ordering, thereby permitting the company to order more frequently. More frequent ordering reduces inventory and the associated holding costs. Answer (B) is incorrect because the company would not need to ensure that it maintained a 25-day buffer stock if it can order more frequently. Answer (C) is incorrect because tracking materials through production is not an EDI, which is the intercompany exchange of business information. Answer (D) is incorrect because scheduling production is not an application of EDI.

[1333] Gleim #: 10.48 -- Source: CIA 1196 I-11 Two major retail companies, both publicly traded and operating in the same geographic area, have recently merged. The companies are approximately the same size and have audit departments. Company A has little EDI experience. Company B has invested heavily in information technology and has EDI connections with its major vendors. Which of the following is the least important risk factor when considering the ability to integrate the two companies’ computer systems?

A. B. C. D.

The number of programmers and systems analysts employed by each company. The extent of EDI connections with vendors. The compatibility of existing operating systems and database structures. The size of company databases and the number of database servers used. Answer (A) is correct. The number of systems personnel employed may reflect differences in operating philosophy (outsourcing vs. in-house development of applications). However, the number of personnel in each company is a less serious concern than the compatibility of hardware and software. Answer (B) is incorrect because Company A has little EDI experience. Hence, the greater the number of vendors that must be connected with Company A, the greater the risk exposure. Answer (C) is incorrect because the difficulty and expense of conversion will be increased if the computer systems have significant compatibility problems. Answer (D) is incorrect because the greater the complexity of the systems to be integrated, the greater the risk exposure.


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[1334] Gleim #: 10.49 -- Source: CIA 1193 III-49 After implementing EDI with suppliers, a company discovered a dramatic increase in the prices it paid the single supplier of some special materials for its primary product line. After consulting with the supplier, the company determined that the supplier had assumed the risk of not having inventory and raised its prices accordingly since the company was the only buyer for the special materials. The best approach for managing inventory in this situation is for the company to

A. B. C. D.

Give the supplier more information about expected use of the materials. Demand that the supplier reduce the prices of the materials. Find another supplier to replace the one charging higher prices. Change its product line so the special materials are no longer needed. Answer (A) is correct. If the company gives the supplier more information about use of the materials, the supplier may be able to plan its production more effectively. It could then reduce its inventory of the materials and its inventory costs, thus permitting it to charge a lower price. Answer (B) is incorrect because the company could demand that the supplier reduce the price of the materials, but the supplier could then decline to supply them. Answer (C) is incorrect because other suppliers may also charge a high price. Answer (D) is incorrect because if the special materials are needed in the primary product line, it is unlikely that the company would discontinue it before investigating alternatives, e.g., working with the supplier to help the supplier manage its inventory.

[1335] Gleim #: 10.50 -- Source: CIA 597 III-51 Electronic data interchange (EDI) offers significant benefits to organizations, but it is not without certain major obstacles. Successful EDI implementation begins with which of the following?

A. B. C. D.

Mapping the work processes and flows that support the organization’s goals. Purchasing new hardware for the EDI system. Selecting reliable vendors for translation and communication software. Standardizing transaction formats and data. Answer (A) is correct. Marked benefits arise when EDI is tied to strategic efforts that alter, not mirror, previous practices. Applying EDI to an inefficient process results in continuing to do things the wrong way, only faster. Hence, the initial phase of EDI implementation includes understanding the organization’s mission and an analysis of its activities as part of an integrated solution to the organization’s needs. Answer (B) is incorrect because the prerequisite for EDI success is an understanding of the mission of the business and the processes and flows that support its goals, followed by cooperation with external partners. Purchasing new hardware is a subsequent step. Answer (C) is incorrect because, before applying EDI technology to the business, EDI must be viewed as part of an overall integrated solution to organizational requirements. Answer (D) is incorrect because EDI is not a solution by itself. Instead of considering how to transmit and receive transactions, a company must first analyze the entire process.

[1336] Gleim #: 10.51 -- Source: CIA 1193 III-46 The best approach for minimizing the likelihood of software incompatibilities leading to unintelligible messages is for a company and its customers to


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A. B. C. D.

Acquire their software from the same software vendor. Agree to synchronize their updating of EDI-related software. Agree to use the same software in the same ways indefinitely. Each write their own version of the EDI-related software. Answer (A) is incorrect because the company and its customers may obtain their EDI-related software from the same vendor but still have software incompatibility problems if they do not synchronize their installation of updated versions. Answer (B) is correct. EDI entails the exchange of common business data converted into standard message formats. Thus, two crucial requirements are that the participants agree on transaction formats and that translation software be developed to convert messages into a form understandable by other companies. Thus, if one company changes its software, its trading partners must also do so. Answer (C) is incorrect because, as business requirements change, it may not be possible to use the same software in the same ways indefinitely. Answer (D) is incorrect because, even if the company and its customers each write their own versions, synchronization problems will arise from updates.

[1337] Gleim #: 10.52 -- Source: CIA 1193 III-45 Before sending or receiving EDI messages, a company should

A. B. C. D.

Execute a trading partner agreement with each of its customers and suppliers. Reduce inventory levels in anticipation of receiving shipments. Demand that all its suppliers implement EDI capabilities. Evaluate the effectiveness of its use of EDI transmissions. Answer (A) is correct. Before sending or receiving EDI messages, a company should execute a trading partner agreement with its customers and suppliers. All parties should understand their responsibilities, the messages each will initiate, how they will interpret messages, the means of authenticating and verifying the completeness and accuracy of messages, the moment when the contract between the parties is effective, the required level of security, etc. Answer (B) is incorrect because the company may intend to reduce inventory levels, but that intention is unrelated to the timing of its first EDI messages. Answer (C) is incorrect because the company may want to demand or encourage all its customers and suppliers to implement EDI capabilities, but that request is independent of sending and receiving messages. Answer (D) is incorrect because it is not possible to evaluate the effectiveness of EDI transmissions until after they occur.

[1338] Gleim #: 10.53 -- Source: CIA 1193 IV-25 The company uses a planning system that focuses first on the amount and timing of finished goods demanded and then determines the derived demand for raw materials, components, and subassemblies at each of the prior stages of production. This system is referred to as

A. B. C. D.

Economic order quantity. Materials requirements planning. Linear programming. Just-in-time purchasing.


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Answer (A) is incorrect because the EOQ model focuses on the trade-off between carrying and ordering costs. Answer (B) is correct. Materials requirements planning (MRP) is a system that translates a production schedule into requirements for each component needed to meet the schedule. It is usually implemented in the form of a computer-based information system designed to plan and control raw materials used in production. It assumes that forecasted demand is reasonably accurate and that suppliers can deliver based upon this accurate schedule. MRP is a centralized push-through system; output based on forecasted demand is pushed through to the next department or to inventory. Answer (C) is incorrect because linear programming is a decision model concerned with allocating scarce resources to maximize profit or minimize costs. Answer (D) is incorrect because JIT is a decentralized demand-pull system. It is driven by actual demand. [1339] Gleim #: 10.54 -- Source: Publisher Enterprise resource planning (ERP) software packages, such as SAP R/3 and Oracle, are all-inclusive systems that attempt to provide entity-wide information. ERP systems provide advantages to the auditor because they

A. B. C. D.

Have proven difficult for some firms to install. Typically require firms to reduce the division of duties and responsibilities found in traditional systems. Typically have built-in transaction logs and ability to produce a variety of diagnostic reports. Have been installed by smaller firms so, to date, few auditors have encountered them. Answer (A) is incorrect because the difficulty of installing ERP systems is a disadvantage to the auditor. Answer (B) is incorrect because ERP systems often require the client to depart from the traditional functional division of duties such as accounting, finance, and marketing. The result is increased audit risk. Answer (C) is correct. ERP systems have a variety of controls and report generation functions that allow the auditor to abstract and monitor data collected and processed. Some ERP systems have built-in audit functions. Answer (D) is incorrect because ERP systems are very costly and therefore have been implemented only by large organizations. However, the trend is for more and more organizations to install these systems.

[1340] Gleim #: 10.55 -- Source: CIA 593 II-20 Which of the following is the best program for the protection of a company’s vital information resources from computer viruses?

A. B. C. D.

Stringent corporate hiring policies for staff working with computerized functions. Existence of a software program for virus prevention. Prudent management policies and procedures instituted in conjunction with technological safeguards. Physical protection devices in use for hardware, software, and library facilities. Answer (A) is incorrect because hiring policies can provide assurance of qualified personnel for operation of the system, but they cannot prevent introduction of viruses from bulletin boards or from outside sources. Answer (B) is incorrect because software programs can identify and neutralize known viruses but may not recognize and properly neutralize new strains of a computer virus. Answer (C) is correct. Acceptably safe computing can be achieved by carefully crafted policies and procedures used in conjunction with antivirus and access control software. Answer (D) is incorrect because physical protection devices can reduce access but cannot prevent introduction of viruses by errant employees or from outside sources.


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[1341] Gleim #: 10.56 -- Source: IIA, adapted Which of the following is a malicious program, the purpose of which is to reproduce itself throughout the network and produce a denial of service attack by excessively utilizing system resources?

A. B. C. D.

Logic bomb. Virus. Worm. Trojan horse. Answer (A) is incorrect because a logic bomb is a mechanism for releasing a system attack of some kind, which is triggered when a particular condition (for example, a certain date or system operation) occurs. Answer (B) is incorrect because a virus is a code fragment (not an independent program) that reproduces by attaching to another program. Answer (C) is correct. A worm is an independent program that reproduces by copying itself from one system to another over a network and consumes computer and network resources. Answer (D) is incorrect because a Trojan horse is an independent program that appears to perform a useful function, but hides another unauthorized program inside it.

[1342] Gleim #: 10.57 -- Source: IIA, adapted Which of the following statements are correct regarding electronic mail security? I. II.

III.

A. B. C. D.

Electronic mail can be no more secure than the computer system on which it operates. Confidential electronic mail messages should be stored on the mail server as electronic mail for the same length of time as similar paperbased documents. In larger organizations, there may be several electronic mail administraters and locations with varying levels of security.

I only. I and II only. I and III only. II and III only. Answer (A) is incorrect because statement III is also correct. Answer (B) is incorrect because statement II is not correct, but statement III is correct. Answer (C) is correct. A confidential mail message should not be retained on the server once the user has downloaded it to a personal computer. The security of electronic mail is limited to the capability of the computer system on which it operates. Several electronic mail administrators and locations with varying levels of security exists in larger organizations. Answer (D) is incorrect because statment II is not correct, but statement I is correct.

[1343] Gleim #: 10.58 -- Source: IIA, adapted The most difficult aspect of using Internet resources is


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A. B. C. D.

Making a physical connection. Locating the best information source. Obtaining the equipment required. Getting authorization for access. Answer (A) is incorrect because there is no limitation on the number access ports. Answer (B) is correct. The most difficult aspect of using Internet resources is locating the best information given the large number of information sources. Answer (C) is incorrect because the only equipment required for accessing Internet resources is a computer, a modem, a telephone or other access line, and basic communication software. Answer (D) is incorrect because organizations routinely provide Internet access to their employees, and individuals can obtain access through individual subscription to commercial service providers.

[1344] Gleim #: 11.1 -- Source: Publisher IFRS 2, Share-Based Payment, normally requires entities to account for their share-based employee compensation plans in accordance with which of the following methods?

Fair-Value-

Intrinsic-Value-

Based Method

Based Method

A.

Yes

Yes

B. C.

Yes No

No Yes

D.

No

No

Answer (A) is incorrect because the intrinsic-value method is allowed only in rare cases. Answer (B) is correct. Entities must account for share-based employee compensation plans in accordance with the fairvalue-based method except in the rare cases in which the fair value of the equity instruments is not reliably measurable at the measurement date (the grant date for transactions with employees and those providing similar services). In these rare cases, IFRS 2 requires entities to account for these plans in accordance with the intrinsic-value-based method. Answer (C) is incorrect because the intrinsic-value method is allowed only in rare cases. Answer (D) is incorrect because the intrinsic-value method is allowed only in rare cases. [1345] Gleim #: 11.2 -- Source: Publisher The measurement date in accounting for shares issued to employees in share option plans accounted for in accordance with the fair value method prescribed by IFRS 2 is

A. B. C. D.

The date on which options are granted to specified employees. The earliest date on which both the number of shares to be issued and the option price are known. The date on which the options are exercised by the employees. The date the corporation forgoes alternative use of the shares to be sold under option.


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Answer (A) is correct. Under the fair-value-based method prescribed by IFRS 2, compensation expense is measured at the grant date. This expense is based on the fair value of the award at that date and recognized over the vesting period, the period over which the vesting conditions are expected to be satisfied. Answer (B) is incorrect because the earliest date on which both the number of shares to be issued and the option price are known, the date on which the options are exercised by employees, and the date the entity forgoes alternative use of the shares to be sold under option may coincide with, but do not define, the measurement date. Answer (C) is incorrect because the earliest date on which both the number of shares to be issued and the option price are known, the date on which the options are exercised by employees, and the date the entity forgoes alternative use of the shares to be sold under option may coincide with, but do not define, the measurement date. Answer (D) is incorrect because the earliest date on which both the number of shares to be issued and the option price are known, the date on which the options are exercised by employees, and the date the entity forgoes alternative use of the shares to be sold under option may coincide with, but do not define, the measurement date. [1346] Gleim #: 11.3 -- Source: CIA 1195 III-58 On January 2, year 1, Kine Co. granted Morgan, its president, share options to buy 1,000 shares of Kine’s $10 par common stock. The options call for a price of 20 per share and are exercisable for 3 years following the grant date. Morgan exercised the options on December 31, year 1. The market price of the shares was 50 on January 2, year 1 and 70 on the following December 31. If the intrinsic value-based method is followed because the fair value of the options is not reliably measurable, by what net amount should equity increase as a result of the grant and exercise of the options?

A. B. C. D.

20,000 30,000 50,000 70,000 Answer (A) is correct. The measurement date is January 2, year 1. At that date, the intrinsic value of the options is 30,000 [1,000 shares × (50 market price – 20 option price)]. This 30,000 will be recorded as both compensation expense and options outstanding. The net effect on equity is 0. When the options are exercised, the 20,000 (1,000 shares × 20 exercise price) cash received and the 30,000 options outstanding will be allocated to share capital as 10,000 common stock and 40,000 additional paid-in capital. The net effect on equity will be a 20,000 increase. Answer (B) is incorrect because 30,000 is the amount of compensation expense. Answer (C) is incorrect because 50,000 is the increase in the equity without regard to the compensation expense. Answer (D) is incorrect because 70,000 results from calculating the increase in equity using the share price on the exercise date.

[1347] Gleim #: 11.4 -- Source: Publisher On January 1, year 1, International Entity entered into an equity-settled share-based payment transaction with its senior executives. This award of 1,000 share options has a four-year vesting period. The market prices of the options and the related shares on the grant date are 20 and 80, respectively. The exercise price is 85. Assuming that the vesting conditions were not met for 100 of the options because of unexpected events in year 4, the entry to debit option expense at

A. B. C. D.

December 31, year 4 is for 5,000. December 31, year 3 is for 4,500. December 31, year 2 is for 5,000. January 1, year 1 is for 20,000.


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Answer (A) is incorrect because the year 4 expense is 3,000 [20,000 total expected – 15,000 recognized in years 1-3 – (100 × 20) not vested]. Answer (B) is incorrect because no retrospective adjustment is made. The year 3 entry would have been 5,000 based on a then-expected total expense of 20,000. Answer (C) is correct. The fair value of each share option is determined at the measurement date, which is the grant date for transactions with employees and others providing similar services. Thus, the fair value of each share option was set at its market price of 20 on January 1, year 1. The periodic expense varies only with the expected number of equity instruments expected to vest. Because the events causing 100 options not to vest occurred unexpectedly in year 4, the entity presumably expected at each balance sheet date for the first three years of the vesting period that all options would vest. Total expected expense was therefore 20,000, and the proportional expense recognized in each of the first three years was 5,000 [(1,000 options × 20) ÷ 4 years]. Answer (D) is incorrect because 20,000 would have been recognized at January 1, year 1 if the options had vested immediately.


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CIA Part3

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