*** Level I
Question 1: The balance sheet for The Jones Company at the
beginning of 1998 reports an accounts receivable balance of
$600,000 and at the end of the year reports a balance of
$1,000,000. The company reported credit sales during 1998 of
$18,000,000. What is the company's collection period equal to for
1998? (Assume a 360 day year)
a) 18 days
b) 16 days
c) 12 days
d) 20 days
Question 2: According to the FASB conceptual framework, which of
the following situations violates the concept of reliability?
a) Financial statements include property with a carrying amount
increased to management's estimate of market value.
b) None of these answers.
c) Financial statements are issued 9 months late.
d) Management reports to stockholders regularly refer to new
projects undertaken, but that financial statements never report
project results.
e) Data on segments having the same expected risks and growth
rates are reported to analysts estimating future profits.
Question 3: Preferred and common stock differ in that
a) none of these answers.
b) preferred stock dividends are deductible as an expense for tax
purposes, while common stock dividends are not.
c) common stock dividends are a fixed amount, while preferred
stock dividends are not.
d) failure to pay dividends on common stock will not force the
firm into bankruptcy, while failure to pay dividends on preferred
stock will force the firm into bankruptcy.
e) preferred stock has a higher priority than common stock with
regard to earnings and assets in the event of bankruptcy.
Question 4: When reporting contingencies
a) none of these answers.
b) disclosure of a loss contingency must include a dollar
estimate of the loss.
c) disclosure of a loss contingency is to be made if there is a
remote possibility that the loss has been incurred.
d) guarantees of others' indebtedness are reported as a loss
contingency only if the loss is considered imminent or highly
probable.
e) a loss that is probable but not estimable must be disclosed
with a notation that the amount of the loss cannot be estimated.
Answer 1: b
Rationale & Reference:
The collection period is equal to the average accounts receivable
balance during the year divided by the daily credit sales. The
average accounts receivable balance is $800,000 divided by credit
sales of $50,000. This gives an average of 16 days.
Bernstein & Wild, p. 30
Answer 2: a
Rationale & Reference:
Reliability has 3 primary qualities: verifiability, neutrality
and representational faithfulness. Neutrality is violated here as
information should not be prepared or reported to obtain a
predetermined result, and should be free from bias.
Bernstein & Wild, pp. 78-79
Answer 3: e
Rationale & Reference:
In the event of bankruptcy, the claims of preferred shareholders
must be satisfied before common shareholders receive anything.
The interests of common shareholders are secondary to those of
other claimants.
Bernstein & Wild, pp. 130-131
Answer 4: e
Rationale & Reference:
Contingent losses should be accrued if both probable and
reasonably estimable. In this case, the contingent loss is not
estimable and, therefore should only be disclosed in the notes
since it is probable.
Bernstein & Wild, pp. 120-121
*** Level II
Question:
Define industry life cycle.
Answer:
One of the most important factors in determining stock prices is
the growth rate of dividends and earnings. When the dividend
growth and the rate of discount is applied to those shares, the
value can be determined.
The success of firms in establishing good growth records depends
to a great extent on the growth opportunities in their industry.
These industry growth opportunities depend, in turn, on the point
at which the industry as a whole is located in the industry life
cycle.
The industry life cycle refers to a regular pattern of growth,
maturity, and decay experienced by many industries. Industry-wide
sales begin at a zero level as the new industry is created, pass
through a growth stage, into a phase of maturity, followed by an
inevitable decline.
Creation of a new industry is generally brought about by the
introduction of some product that is generally the result of some
technological leap. Often in this stage, there is only one firm
in the industry or at least one firm that is totally dominant, as
with Xerox (copy machines) or Apple (personal computers).
After the creation stage and initial acceptance of a new
industry, new competitors enter. The competitive industry
structure changes from a monopoly to an oligopoly. The newcomers
must be very aggressive in defining their own market niche and in
differentiating their products from those of the industry founder
and leader.
After an initial growth phase, the industry matures. This
maturation is characterized by slowly growing sales and a
movement within the industry to a highly competitive environment
where price tends to become a major competitive weapon.
As industries begin to decline, profit margins are reduced and
the emphasis turns to production efficiencies, with price
competition continuing to be a major threat to profits. For
declining industries, it is not inevitable that they disappear,
it is fairly certain that these industries will not be future
growth industries.
All other factors being equal, investors should prefer growth
industries because these industries will be the ones that
generate growing dividends. However, growing industries are often
the most risky as well, so the rate of discount applied by the
market to those growing dividends will tend to be larger. The
investor needs to interpret growth prospects of industries
relative to the risks and find the best investments for the risks
she or he is willing to absorb.
Kolb, pp. 361-362
*** Level III
Question:
Learning Outcome Statement:
Illustrate the potential problems with the design or
implementation of engineered investment strategies.
Answer:
Potential problems with engineered investment strategies:
1. Insufficient Rationale: The existence of this problem suggest
that there is not a sufficient rationale governing why strategies
have worked in the past and why they should work in the future.
2. Blind Assumptions: An example of a blind assumption is that a
high return on equity is always "good."
3. Data Mining: Since everyone scrutinizes the same data, purely
accidental relationships will be discovered. The publication of
several papers on the same anomaly confirms that the anomaly
existed in the past; there is no guarantee that it will exist in
the future. Good financial research starts with a rationale for
why an investment strategy should work, it does not contain the
bias that certain factors are always "good" or always "bad".
4. Quality of Data: Computer based historical data frequently
suffers from problems of inaccuracy, omissions, and survivor
basis.
5. Look-ahead Bias: In its most rudimentary form, this involves
using data that are not yet available.
6. Multiple Factors: Returns associated with certain factors,
such as size, can be misleading unless studied in a multiple
factor context. The combination of highly correlated factors
neither increases returns nor lowers risk and therefore is not
advantageous. Sometimes unimportant individual factors, however,
become important when combined with other variables.
7. Past versus Future: Although it is never certain that the
future will be like the past, strategies which failed in the past
should not be repeated.
8. Statistical Assumptions and Techniques: Researchers often
assume the normality of investment returns. Without this
assumption, statistical tools such as least squares regression
may lead to very misleading answers. Researchers make two common
mistakes:
a. They apply statistical tests that assume normal data (when
historical prices are not normally distributed).
b. They generate historical prices synthetically by assuming that
the prices are generated by a log-normal generating process (when
it is known that they do not conform to this distribution).
9. Linear Models: Researchers may be misled if they apply linear
models to a nonlinear world. Both the capital asset pricing model
and the arbitrage pricing theory are based on linear models. This
is a point of great concern for future research.
10. Laboratory to Real World: It is a giant step to move from a
model that produces significant statistical results to developing
and implementing real-world trading strategies that actually
capture those significant excess returns.
11. Market Impact: It is difficult to estimate in advance the
impact of one's own presence in the market. Reasonable
assumptions as to one's impact on the market must be included as
part of the analysis of any quantitative strategy.
12. Reference or Normal Portfolios: A normal or reference
portfolio against which to measure performance of an engineered
strategy must be selected. Until a legitimate reference portfolio
is constructed, we cannot say that we are deriving value from any
strategy.
13. Measurement of Skill: A problem with investment strategy is
the time it takes to prove that a manager has skill. The
techniques for parsing out skill, and what some consultants are
doing in the performance measurement, are extremely important.
Hagin, pp. 17-19
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