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2012 AICPA Newly Released Questions – Business 1 Following are multiple choice questions recently released by the AICPA. These questions were released by the AICPA with letter answers only. Our editorial board has provided the accompanying explanation. Please note that the AICPA generally releases questions that it does NOT intend to use again. These questions and content may or may not be representative of questions you may see on any upcoming exams.

2012 AICPA Business Questions 2

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Page 1: 2012 AICPA Business Questions 2

2012 AICPA Newly Released Questions – Business

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Following are multiple choice questions recently released by the AICPA. These

questions were released by the AICPA with letter answers only. Our editorial board has

provided the accompanying explanation.

Please note that the AICPA generally releases questions that it does NOT intend to use

again. These questions and content may or may not be representative of questions you

may see on any upcoming exams.

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2012 AICPA Newly Released Questions – Business

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1. If a product required a great deal of electricity to produce, and crude oil prices increased, which of the following costs most likely increased?

a. Direct materials. b. Direct labor. c. Prime costs. d. Conversion costs. Solution: Choice "d" is correct. Conversion costs include both direct labor and overhead. Increases in crude oil prices are likely to impact the cost of generating electricity (and, by extension, the rate for electricity). Electricity is significant in manufacture of the product in the fact pattern and would likely increase the overhead costs of the manufacturer.

Choice "a" is incorrect. Electricity is not included in direct materials. Direct material costs would likely not increase.

Choice "b" is incorrect. Electricity is not included in direct labor. Direct labor costs would likely not increase.

Choice "c" is incorrect. Prime costs are the sum of direct materials and direct labor. Electricity is not included in prime costs. Prime costs would likely not increase.

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2. According to the Sarbanes-Oxley Act of 2002, a chief executive officer or chief financial officer who misrepresents the company's finances may be penalized by being:

a. Fined, but not imprisoned. b. Imprisoned, but not fined. c. Removed from the corporate office and fined. d. Fined and imprisoned. Solution: Choice "d" is correct. An individual who knowingly executes or attempts to execute, securities fraud will be fined or imprisoned not more than 25 years or both.

Choice "a" is incorrect. The provisions of the Sarbanes-Oxley Act of 2002 provide for penalties for misrepresentation of company finance that may include both fines and penalties.

Choice "b" is incorrect. The provisions of the Sarbanes-Oxley Act of 2002 provide for penalties for misrepresentation of company finance that may include both penalties and fines.

Choice "c" is incorrect. The provisions of the Sarbanes-Oxley Act of 2002 provide for penalties for misrepresentation of company finance that may include both fines and penalties but do not carry provisions for removal from corporate office.

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3. Which of the following items is one of the eight components of COSO's enterprise risk management framework?

a. Operations. b. Reporting. c. Monitoring. d. Compliance. Solution: Choice "c" is correct. Monitoring is one of the eight components of COSO's enterprise risk management (ERM) framework. The eight components of the ERM framework are summarized as follows in the mnemonic IS EAR AIM:

Internal environment Event identification Activities (control) Setting objectives Assessment of risk Information and communication Risk response Monitoring

Choice "a" is incorrect. Operations are not one of the eight components of the COSO's ERM framework identified by the mnemonic IS EAR AIM as shown above.

Choice "b" is incorrect. Reporting is not one of the eight components of the COSO's ERM framework identified by the mnemonic IS EAR AIM as shown above.

Choice "d" is incorrect. Compliance is not one of the eight components of the COSO's ERM framework identified by the mnemonic IS EAR AIM as shown above.

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4. Based on the following data, what is the gross profit for the company?

Sales $1,000,000 Net purchases of raw materials 600,000 Cost of goods manufactured 800,000 Marketing and administrative expenses 250,000 Indirect manufacturing costs 500,000

Beginning inventory Ending inventory Work in process $500,000 $400,000 Finished goods 100,000 500,000

a. $200,000 b. $400,000 c. $600,000 d. $900,000 Solution: Choice "c" is correct. The gross profit for the company is $600,000 computed as follows:

Sales $1,000,000 Beginning finished goods inventory $100,000 Cost of goods manufactured 800,000 Less: Ending finished goods inventory (500,000) Cost of goods sold 400,000 Gross profit $ 600,000

Note that significant irrelevant information was provided in the problem. Some of the information (e.g., the raw materials purchases, indirect costs and WIP) relate to data used to develop the relevant cost of goods manufactured. Other information (e.g., marketing and administrative expenses) relate to computation of operating income rather than gross profit.

Choices "a", "b", and "d" are incorrect per computations above.

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5. Management of a company has a lack of segregation of duties within the application environment, with programmers having access to development and production. The programmers have the ability to implement application code changes into production without monitoring or a quality assurance function. This is considered a deficiency in which of the following areas?

a. Change control. b. Management override. c. Data integrity. d. Computer operations. Solution: Choice "a" is correct. Programmer access to development and production represents flawed segregation of duties that creates deficiencies for change control. Change control considers the manner in which management monitors and authorizes changes to a variety of information technology matters including software applications programs. Only authorized individuals should be allowed to move changes into production and the function of making the change should be segregated from the function of putting the change into production. Programmers with access to both programming instructions and live data undermine management's control of data and their ability to verify that all changes have been performed in a manner consistent with their instructions.

Choice "b" is incorrect. Management override is a control weakness in which managers ignore or circumvent controls. Programmers are typically not management.

Choice "c" is incorrect. Data integrity requires that information be accurate and complete. The poor segregation of duties associated with programmer access to production may not impact the completeness or even the accuracy of data.

Choice "d" is incorrect. Computer operations would not necessarily be compromised as a result of programmer access to live data. The computer operations would continue to efficiently generate results only with potentially flawed instructions as a result of compromised change control.

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6. The coefficient of determination, r squared, in a multiple regression equation is the:

a. Percentage of variation in the independent variables explained by the variation in the dependent variable.

b. Percentage of variation in the dependent variable explained by the variation in the independent variables.

c. Measure of the proximity of actual data points to the estimated data points. d. Coefficient of the independent variable divided by the standard error of regression coefficient. Solution: Choice "b" is correct. The coefficient of determination (R2) is the proportion of the total variation in the dependent variable (y) explained by the independent variable (x).

Choice "a" is incorrect. The independent variable is not explained by the dependent variable. Changes in the independent variable drive the variation in the dependent variable. The coefficient of determination (R2) is the proportion of the total variation in the dependent variable (y) explained by the independent variable (x).

Choice "c" is incorrect. The measure of proximity of actual data points to estimated data points is not the coefficient of determination. The coefficient of determination (R2) is the proportion of the total variation in the dependent variable (y) explained by the independent variable (x).

Choice "d" is incorrect. The coefficient of determination (R2) is the proportion of the total variation in the dependent variable (y) explained by the independent variable (x), not the coefficient of the independent variable divided by the standard error of regression coefficient.

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7. For the current period production levels, XL Molding Co. budgeted 8,500 board feet of production and used 9,000 board feet for actual production. Material cost was budgeted at $2 per foot. The actual cost for the period was $3 per foot. What was XL's material efficiency variance for the period? a. $1,000 favorable. b. $1,000 unfavorable. c. $1,500 favorable. d. $1,500 unfavorable. Solution: Choice "b" is correct. The materials efficiency variance is computed as:

(Actual Quantity Used – Standard Quantity Used) x Standard Price

The fact pattern anticipates that budgeted amounts are the standard quantity allowed. As a result, the variance is computed as follows:

(9,000 board feet – 8,500 board feet) x $2 = $1,000

Since we used more than budget, the variance is unfavorable.

Choice "a" is incorrect. The variance is unfavorable, not favorable, because the company used more board feet than budgeted.

Choice "c" is incorrect. The variance is unfavorable, not favorable. The materials efficiency variance is calculated using the budgeted material cost, not the actual material cost. Actual material cost is used when computing the materials price variance.

Choice "d" is incorrect. The materials efficiency variance is calculated using the budgeted material cost, not the actual material cost. Actual materials cost is used when computing the material price variance.

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8. State College is using cost-volume-profit analysis to determine tuition rates for the upcoming school year. Projected costs for the year are as follows:

Contribution margin per student $1,800 Variable expenses per student 1,000 Total fixed expenses 360,000

Based on these estimates, what is the approximate break-even point in number of students?

a. 129 b. 200 c. 360 d. 450 Solution: Choice "b" is correct. The breakeven point in units is 200. The breakeven point in units is computed by dividing fixed costs by contribution margin per unit. Both figures are given in the problem and are used to compute breakeven point in units (students) as follows:

Fixed costs $360,000 Contribution margin per student ÷ $1,800 Breakeven point in students 200

Choice "a" is incorrect. The breakeven point in students is not fixed costs divided by tuition per student (contribution margin plus variable costs) as suggested by this proposed solution.

Choice "c" is incorrect. The breakeven point in students is not fixed costs divided by variable costs per student as suggested by this proposed solution.

Choice "d" is incorrect. The breakeven point in students is not fixed costs divided by difference between contribution margin and variable costs as suggested by this proposed solution.

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9. Brewster Co. has the following financial information:

Fixed costs $20,000 Variable costs 60% Sales price $50

What amount of sales is required for Brewster to achieve a 15% return on sales?

a. $33,333 b. $50,000 c. $80,000 d. $133,333 Solution: Choice "c" is correct. Sales of $80,000 provide a 15% return on sales. The required sales volume may be computed algebraically as follows assuming sales = "S" as follows:

S – 0.6S – $20,000 = 0.15S S – 0.6S – 0.15S = $20,000 0.25 S = $20,000 S = $20,000 ÷ 0.25 S = $80,000

Choice "a" is incorrect. The required level of sales is not computed as the ratio of fixed costs divided by the variable cost percentage ($20,000 ÷ 60%).

Choice "b" is incorrect. Sales of $50,000 are breakeven computed as fixed costs divided by the contribution margin ratio ($20,000 ÷ 0.4). Breakeven provides no return on sales.

Choice "d" is incorrect. The required level of sales is not computed as the ratio of fixed costs divided by the desired profitability ($20,000 ÷ 15%).

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10. A company forecast first quarter sales of 10,000 units, second quarter sales of 15,000 units, third quarter sales of 12,000 units and fourth quarter sales of 9,000 units at $2 per unit. Past experience has shown that 60% of the sales will be in cash and 40% will be on credit. All credit sales are collected in the following quarter, and none are uncollectible. What amount of cash is forecasted to be collected in the second quarter?

a. $8,000 b. $18,000 c. $26,000 d. $30,000 Solution: Choice "c" is correct. Cash collections for the second quarter are comprised of second quarter cash sales and collections of first quarter credit sales.

Second quarter cash sales 15,000 units x $2.00 x 60% $18,000

Collections of first quarter credit sales 10,000 units x $2.00 x 40% 8,000

Second quarter cash collections $26,000

Choice "a" is incorrect. Total cash collections for the second quarter include collections of first quarter credit sales ($8,000) but also include second quarter cash sales of $18,000 as shown above.

Choice "b" is incorrect. Total cash collections for the second quarter include collections of second quarter sales ($18,000) but also include collection of first quarter credit sales of $8,000 as shown above.

Choice "d" is incorrect. Total sales in the second quarter ($2 x 15,000) do not represent the cash collections for the second quarter as computed above.

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11. A ceramics manufacturer sold cups last year for $7.50 each. Variable costs of manufacturing were $2.25 per unit. The company needed to sell 20,000 cups to break even. Net income was $5,040. This year, the company expects the following changes: sales price per cup to be $9.00; variable manufacturing costs to increase 33.3%; fixed costs to increase 10%; and the income tax rate to remain at 40%. Sales in the coming year are expected to exceed last year's sales by 1,000 units. How many units does the company expect to sell this year?

a. 21,000 b. 21,600 c. 21,960 d. 22,600 Solution: Choice "d" is correct. Current year sales (in units) are expected to be 22,600, 1,000 more than the 21,600 units sold in the current year. The 21,600 units sold last year is derived from computations of last year sales in units based on last year cost structure data as follows (note that current year increases are irrelevant):

Step 1: Calculate last year's contribution margin per unit (CM/unit)

CM/unit = Sales price per unit – Variable cost per unit = $7.50 – $2.25 = $5.25

Step 2: Determine last year's fixed costs using the breakeven formula

Breakeven units = Fixed costs / Contribution margin per unit 20,000 = Fixed costs / $5.25 Fixed costs = 20,000 x $5.25 = $105,000

Step 3: Calculate last year's before-tax profit

Before-tax profit = After-tax profit / (1 – tax rate) Before-tax profit = $5,040/60% = $8,400

Step 4: Calculate units sold last year

Units sold to achieve profit = (Fixed costs + Profit) / Contribution margin per unit Units sold last year = ($105,000 + $8,400)/$5.25 = 21,600

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12. Which of the following statements is correct regarding the difference between the absorption costing and variable costing methods?

a. When production equals sales, absorption costing income is greater than variable costing income. b. When production equals sales, absorption costing income is less than variable costing income. c. When production is greater than sales, absorption costing income is greater than variable costing

income. d. When production is less than sales, absorption costing income is greater than variable costing

income. Solution: Choice "c" is correct. When production is greater than sales, absorption costing income is greater than variable costing income. Production in excess of sales result in increases in inventory that include capitalization of fixed product costs that are immediately expensed under variable costing. Since costs that are used in the determination of net income for variable costing are accounted for in inventory for absorption costing, absorption costing will produce higher net income than variable costing when production is greater than sales.

Choice "a" is incorrect. When production equals sales, there is no change in inventory and absorption costing and variable costing produce identical results.

Choice "b" is incorrect. When production equals sales, there is no change in inventory and absorption costing and variable costing produce identical results.

Choice "d" is incorrect. When production is less than sales, inventory declines and absorption costing produces earnings less than variable costing because fixed product costs included in inventory in prior years are charged to earnings when inventory declines. These "extra" costs were already recognized in prior periods under variable costing. As a result, absorption costing produces lower net income than variable costing when production is less than sales and inventory declines.

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13. Johnson Co., distributor of candles, has reported the following budget assumptions for year 1: No change in candles inventory level; cash disbursement to candle manufacturer, $300,000; target accounts payable ending balance for year 1 is 150% of accounts payable beginning balance; and sales price is set at a markup of 20% of candle purchase price. The candle manufacturer is Johnson's only vendor, and all purchases are made on credit. The accounts payable has a balance of $100,000 at the beginning of year 1. What is the budgeted gross margin for year 1?

a. $60,000 b. $70,000 c. $75,000 d. $87,500 Solution: Choice "b" is correct. The budgeted gross margin is $70,000, 20% of the cost of goods sold of $350,000 computed from the assumptions described in the fact pattern. The steps in the solution are as follows:

Compute/ derive purchases from the accounts payable assumptions

Beginning accounts payable 100,000 Plus: Purchases 350,000 (squeeze) Less: Cash disbursements (300,000) Ending accounts payable 150,000 (150% of beginning balance)

Compute cost of goods sold

Beginning inventory 0 Plus: Purchases 350,000 (computed above) Less: Ending inventory (no change) (0) Cost of goods sold 350,000

Compute gross margin as a percentage of gross margin

Cost of goods sold x gross margin percent = gross margin

$350,000 x 20% = $70,000 gross margin

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14. A static budget contains which of the following amounts?

a. Actual costs for actual output. b. Actual costs for budgeted output. c. Budgeted costs for actual output. d. Budgeted costs for budgeted output. Solution: Choice "d" is correct. A static budget is based on costs at one level of output. Static budgets thus include budgeted costs for budgeted output. They are not based on or adjusted for actual performance.

Choice "a" is incorrect. Actual costs for actual output represent actual activity, not budget.

Choice "b" is incorrect. Actual cost for budgeted output would not be computed as part of static budget.

Choice "c" is incorrect. Budgeted costs for actual output are the basis for flexible budget computations and would not be part of a static budget.

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15. Which of the following types of budgets is the last budget to be produced during the budgeting process?

a. Cash. b. Capital. c. Cost of goods sold. d. Marketing. Solution: Choice "a" is correct. The annual business plan process typically begins with operating budgets that are driven by sales budgets that, in turn, provide the required variables for production, selling and personnel budgets. Financial budgets including pro forma financial statements and cash budgets come at the end of the process and are prepared last. Cash budgets are typically derived from the operating budgets that assume accrual basis assumptions (e.g., credit sales and credit purchases).

Choice "b" is incorrect. Capital budgets would be developed as part of a business's strategic planning process and would precede the development of cash budgets derived from operating budgets.

Choice "c" is incorrect. The annual business plan process is comprised of the development of operating budgets followed by financial budgets. The cost of goods sold budget is an operating budget that is driven by the purchases and sales budgets. The operating budgets precede the financial budgets that include the cash budget.

Choice "d" is incorrect. The annual business plan process is comprised of the development of operating budgets followed by financial budgets. The marketing (selling and administration) budget is an operating budget that precedes the financial budgets that include the cash budget.

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16. The discount rate is determined in advance for which of the following capital budgeting techniques?

a. Payback. b. Accounting rate of return. c. Net present value. d. Internal rate of return. Solution: Choice "c" is correct. The discount or hurdle rate is determined in advance for computations of net present value. Project cash flows are discounted based upon a predetermined rate and compared to the investment in the project to arrive at a positive or negative net present value. Advance determination of management's required return is integral to the development and evaluation of net present value.

Choice "a" is incorrect. The payback method computes the period of time required to recover the cost of an investment and does not require a predetermined discount rate.

Choice "b" is incorrect. The accounting rate of return computes a percentage return based upon accrual basis data and does not require a predetermined discount rate.

Choice "d" is incorrect. The internal rate of return computes a rate of return that produces a net present value of zero and does not require a predetermined rate. The computed internal rate of return is evaluated in relation to management's required rate of return after the computation is done.

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17. An investment in a new product will require an initial outlay of $20,000. The cash inflow from the project will be $4,000 a year for the next six years. The payment will be received at the end of each year. What is the net present value of the investment at 8% using the correct factor from below?

Present value of $1 to be received after six periods 0.63017 Present value of an ordinary annuity of $1 per period for six periods 4.62288 Present value of an ordinary annuity due of $1 per period for six periods 4.99271 Future value of $1 at the end of six periods 1.58687

a. ($4,875.92) b. ($1,508.48) c. ($29.16) d. $18,084.88 Solution: Choice "b" is correct. The project has a negative net present value of ($1,508.48). Net present value is computed as follows:

Investment ($20,000.00) Cash inflows ($4,000 x 4.62288) 18,491.52 Net present value ($ 1,508.48)

Since cash inflows are received at the end of the year, the analysis uses the present value of an ordinary annuity of $1 per period for six periods.

Choice "a" is incorrect. Computation should be based on discounted cash inflows using an ordinary annuity factor and the amount of the investment.

Choice "c" is incorrect. Since cash inflows are received at the end of the year, the analysis uses the present value of an ordinary annuity of $1 per period for six periods. The annuity due factor would be used if the cash inflows were received at the beginning of each year.

Choice "d" is incorrect. Computation should be based on discounted cash inflows using an ordinary annuity factor and the amount of the investment.

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18. Which of the following phrases defines the internal rate of return on a project?

a. The number of years it takes to recover the investment. b. The discount rate at which the net present value of the project equals zero. c. The discount rate at which the net present value of the project equals one. d. The weighted-average cost of capital used to finance the project. Solution: Choice "b" is correct. Internal rate of return is defined as the discount rate at which the net present value of the project equals zero.

Choice "a" is incorrect. The number of years it takes to recover an investment is the payback period. Internal rate of return is defined as the discount rate at which the net present value of the project equals zero.

Choice "c" is incorrect. Internal rate of return is defined as the discount rate at which the net present value of the project equals zero, not one.

Choice "d" is incorrect. The weighted average cost of capital for financing a project is the financing cost weighted by the relative proportion of each source of funds for financing the total project. Internal rate of return is defined as the discount rate at which the net present value of the project equals zero.

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19. The following information is available on market interest rates:

The risk-free rate of interest 2% Inflation premium 1% Default risk premium 3% Liquidity premium 2% Maturity risk premium 1%

What is the market rate of interest on a one-year U.S. Treasury bill?

a. 3% b. 5% c. 6% d. 7% Solution: Choice "a" is correct. The market rate of interest on a one year U.S. Treasury bill is comprised of the risk free rate of return and an inflation premium. The fact pattern gives this information as follows:

Risk free rate of interest 2% Inflation premium 1% Market rate of interest on one-year T-bill 3%

Choice "b" is incorrect. The market rate of interest on a one year U.S. Treasury bill is 3% based on the fact pattern provided and is comprised of the risk free rate of return and an inflation premium. It does not represent a combination of rates that might include the default, liquidity or maturity premium.

Choice "c" is incorrect. The market rate of interest on a one year U.S. Treasury bill is 3% based on the fact pattern provided and is comprised of the risk free rate of return and an inflation premium. It does not represent a combination of rates that might include the default, liquidity or maturity premium.

Choice "d" is incorrect. The market rate of interest on a one year U.S. Treasury bill is 3% based on the fact pattern provided and is comprised of the risk free rate of return and an inflation premium. It does not represent a combination of rates that might include the default, liquidity or maturity premium.

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20. The following information was taken from the income statement of Hadley Co.:

Beginning inventory 17,000 Purchases 56,000 Ending inventory 13,000

What is Hadley Co.'s inventory turnover?

a. 3 b. 4 c. 5 d. 6 Solution: Choice "b" is correct. Inventory turnover is 4x. The fact pattern requires:

1. Computation of cost of goods sold as follows:

Beginning inventory $17,000 + Purchases 56,000 Less: Ending inventory (13,000) Cost of goods sold $60,000

2. Computation of average inventory

(Beginning inventory + Ending inventory)/2 = Average inventory

(17,000 + 13,000)/2 = 15,000

3. Computation of inventory turnover

Cost of Goods Sold / Average inventory = Inventory Turnover

$60,000 / 15,000 = 4

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21. Management at MDK Corp. is deciding whether to replace a delivery van. A new delivery van costing $40,000 can be purchased to replace the existing delivery van, which cost the company $30,000 and has accumulated depreciation of $20,000. An employee of MDK has offered $12,000 for the old delivery van. Ignoring income taxes, which of the following correctly states relevant costs when making the decision whether to replace the delivery vehicle?

a. Purchase price of new van, disposal price of old van, and gain on sale of old van. b. Purchase price of new van, purchase price of old van, and gain on sale of old van. c. Purchase price of new van, disposal price of old van. d. Purchase price of new van, purchase price of old van, accumulated depreciation of old van, gain on

sale of old van, disposal price of old van. Solution: Choice "c" is correct. Costs are deemed to be relevant if they change as a result of selecting different alternatives. The decision to replace the old van will result in the company paying the purchase price of the new van and receiving the disposal price of the old van. Neither the purchase price of the new van nor the disposal price of the old van will be incurred if the van is not replaced. Ignoring income taxes, the book value of the old van and any potential gain is not relevant.

Choice "a" is incorrect. The gain on the sale of the old van is not relevant absent any consideration of taxation.

Choice "b" is incorrect. Neither the purchase price of the old van (a sunk cost) nor the gain on the sale of the old van (ignoring tax consequences) are relevant to our decision.

Choice "d" is incorrect. Neither the purchase price/accumulated depreciation of the old van (a sunk cost) nor the gain on the sale of the old van (ignoring tax consequences) are relevant to our decision.

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22. The stock of Fargo Co. is selling for $85. The next annual dividend is expected to be $4.25 and is expected to grow at a rate of 7%. The corporate tax rate is 30%. What percentage represents the firm's cost of common equity?

a. 12.0%. b. 8.4%. c. 7.0%. d. 5.0%. Solution: Choice "a" is correct. Under the discounted cash flow (DCF) method, the cost of equity is computed as:

Cost of equity = Expected dividend / Current share price + Growth rate

= $4.25 / $85 + 0.07

= 0.05 + 0.07

= 0.12

Choice "b" is incorrect. The proposed solution is incorrect because the cost of equity is not computed on an after-tax basis. Dividends are not tax deductible.

Choice "c" is incorrect. The growth rate of the stock (7%) does not, by itself, represent the cost of equity capital. The proposed solution excludes the costs of dividends.

Choice "d" is incorrect. The dividend rate of the stock (5%) does not, by itself, represent the cost of equity capital. The proposed solution excludes the costs of growth.

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23. A company uses its company-wide cost of capital to evaluate new capital investments. What is the implication of this policy when the company has multiple operating divisions, each having unique risk attributes and capital costs?

a. High-risk divisions will over-invest in new projects and low risk divisions will under-invest in new projects.

b. High-risk divisions will under-invest in high-risk projects. c. Low-risk divisions will over-invest in low-risk projects. d. Low-risk divisions will over-invest in new projects and high risk divisions will under-invest in new

projects. Solution: Choice "a" is correct. A company-wide cost of capital averages risks to arrive at required return for investments. The company-wide cost of capital will be lower than the cost of capital specific to high-risk projects and higher than the cost-of-capital specific to low-risk projects. If a company is comprised of multiple divisions with unique risk characteristics, higher risk divisions will automatically beat the threshold for investments and invest in higher risk projects that beat the company wide average. Meanwhile, their lower risk counterparts will find it hard to achieve the risk return that beats the average (artificially inflated) returns that are driven by higher risk divisions and will under invest in new projects.

Choice "b" is incorrect. A company-wide cost of capital averages risks to arrive at a required return for investments. The company-wide cost of capital will be lower than the cost of capital specific to high-risk projects and higher than the cost-of-capital specific to low-risk projects. If a company is comprised of multiple divisions with unique risk characteristics, higher risk divisions will automatically beat the threshold for investments and invest in higher risk projects that beat the company wide average.

Choice "c" is incorrect. A company-wide cost of capital averages risks to arrive at required return for investments. The company-wide cost of capital will be lower than the cost of capital specific to high-risk projects and higher than the cost-of-capital specific to low-risk projects. If a company is comprised of multiple divisions with unique risk characteristics, lower risk divisions will find it hard to achieve the risk return that beats the average (artificially inflated) returns that are driven by higher risk divisions and thereby under invest in new projects.

Choice "d" is incorrect. A company-wide cost of capital averages risks to arrive at required return for investments. The company-wide cost of capital will be lower than the cost of capital specific to high-risk projects and higher than the cost-of-capital specific to low-risk projects. If a company is comprised of multiple divisions with unique risk characteristics, higher risk divisions will automatically beat the threshold for investments and invest in more, not less, higher risk projects that beat the company wide average. Meanwhile, their lower risk counterparts will find it hard to achieve the risk return that beats the average (artificially inflated) returns that are driven by higher risk divisions and thereby invest less and not more new projects.

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24. A company has cash of $100 million, accounts receivable of $600 million, current assets of $1.2 billion, accounts payable of $400 million, and current liabilities of $900 million. What is its acid-test (quick) ratio?

a. 0.11 b. 0.78 c. 1.75 d. 2.11 Solution: Choice "b" is correct. The acid-test or quick ratio is the ratio of the most liquid assets to current liabilities and provides an even more rigorous test of liquidity than the current ratio. The quick ratio excludes less liquid current assets from the numerator (e.g., prepaid expenses and inventory) and includes only such line items as cash and accounts receivable as provided in the problem. The quick ratio would be computed as follows:

Cash $100 Accounts receivable 600 Quick assets $700 Current liabilities ÷ 900 Quick ratio 0.78

Choice "a" is incorrect. The quick ratio does not limit assets to cash only.

Choice "c" is incorrect. The quick ratio is not the ratio of the most liquid assets to the most current liabilities.

Choice "d" is incorrect. The quick ratio is computed in the manner shown in response "b" above.

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25. Which of the following inventory management techniques focuses on a set of procedures to determine inventory levels for demand-dependent inventory types such as work-in-process and raw materials?

a. Materials requirements planning. b. Cycle counting. c. Safety stock reorder point. d. Economic order quantity. Solution: Choice "a" is correct. Materials requirements planning (MRP) is an inventory management technique that projects and plans inventory levels in order to control the usage of raw materials in the production process. MRP primarily applies to work in process and raw materials.

Choice "b" is incorrect. Cycle counting is an inventory auditing procedure, not an inventory control technique.

Choice "c" is incorrect. Safety stock is a concept applied to both manufacturing and finished goods inventory to ensure that supply requirements are met. Safety stock is not limited to or designed for work in process and raw materials inventory.

Choice "d" is incorrect. Economic order quantity (EOQ) is an inventory model that attempts to minimize both ordering and carrying costs. The objective of the EOQ is to compute the quantity to order, not to comprehensively plan the requirements of production inventories.

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26. Credit Card International developed a management reporting software package that enables members to interactively query a data warehouse and drill down into transaction and trend information via various network set-ups. What type of management reporting system has Credit Card International developed?

a. On-line analytical processing system. b. On-line transaction-processing system. c. On-line executive information system. d. On-line information storage system. Solution: Choice "a" is correct. Online analytical processing allows end users to retrieve data from a system and perform analysis using statistical and graphical tools. A credit card company's system that enables members to interactively query a data warehouse and drill down into transaction and trend information is an online analytical processing system.

Choice "b" is incorrect. On line transaction processing systems would process customer payments or other transactions, not analyze or trend transactions.

Choice "c" is incorrect. On line executive information systems would likely provide strategic level information to company leadership, not analytical data to managers.

Choice "d" is incorrect. On line information storage systems would likely provide information storage services (e.g., lists of charges by month, etc.) for later retrieval by users without the analytical tools anticipated by an online analytical process system.

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27. Which of the following systems assists with non routine decisions, serves strategic levels of the organization, and helps answer questions regarding what a company's competitors are doing, as well as identifies new acquisitions that would protect the company from cyclical business swings?

a. Executive support system. b. Decision support system. c. Transaction processing system. d. Management information system. Solution: Choice "a" is correct. Executive support systems provide senior executives with immediate and easy access to internal and external information to assist the executives in strategic issues such as non routine decisions that may involve analysis of cyclical data, acquisitions and competitor behavior.

Choice "b" is incorrect. Decision support systems (DSS) provide interactive support for managers during decision making. DSS are expert systems that are not specifically designed for the strategic decisions made by executives.

Choice "c" is incorrect. Transaction processing systems are systems that process and record routine daily transactions necessary to conduct business. They do not provide strategic level information support.

Choice "d" is incorrect. A management information system provides managers and other users with reports that are typically predefined by management and used to make daily business decisions, not strategic decisions.

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28. Review of the audit log is an example of which of the following types of security control?

a. Governance. b. Detective. c. Preventive. d. Corrective. Solution: Choice "b" is correct. Audit logs are detective security controls. They are generally chronological records that provide documentary evidence of the sequence of activities that can be used to detect errors or irregularities.

Choice "a" is incorrect. Audit logs do not represent governance security controls. Governance controls typically involve strategic and organizational controls to enhance security.

Choice "c" is incorrect. Audit logs do not represent preventive security controls. The existence of a log does not prevent errors or irregularities, it provides the record necessary to detect errors or irregularities.

Choice "d" is incorrect. Audit logs do not represent corrective security controls. Corrective security controls represent procedures put in place to correct security weaknesses.

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29. Which of the following statements presents an example of a general control for a computerized system?

a. Limiting entry of sales transactions to only valid credit customers. b. Creating hash totals from Social Security numbers for the weekly payroll. c. Restricting entry of accounts payable transactions to only authorized users. d. Restricting access to the computer center by use of biometric devices. Solution: Choice "d" is correct. Restricting access to the computer center by use of biometric devices represents a general control. General controls are designed to ensure that an organization's control environment is stable and well managed.

Choice "a" is incorrect. Limiting entry of sales transaction to only valid credit customers likely represents an application control (imbedded within the software). Application controls prevent, detect and correct transaction errors and fraud and are application specific.

Choice "b" is incorrect. Creating hash totals from Social Security numbers for the weekly payroll is a processing control. Processing controls include recalculation of batch totals and similar procedures.

Choice "c" is incorrect. Restricting entry of accounts payable to only authorized users represents a user control.

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30. What is the role of the systems analyst in an IT environment?

a. Developing long-range plans and directing application development and computer operations. b. Designing systems, preparing specifications for programmers, and serving as intermediary between

users and programmers. c. Maintaining control over the completeness, accuracy, and distribution of input and output. d. Selecting, implementing, and maintaining system software, including operating systems, network

software, and the data base management system. Solution: Choice "b" is correct. In an IT environment, a systems analyst is generally responsible for designing systems, preparing specifications for programmers, and serving as an intermediary between users and programmers. For internally developed systems, the analyst designs the overall application system but when the system is purchased, the analyst becomes a system integrator that adapts system design to processes.

Choice "a" is incorrect. Development of long-range plans and direction of application development and computer operations is undertaken by the EDP Steering Committee, not the systems analyst.

Choice "c" is incorrect. End users are typically responsible for maintaining control over the completeness, accuracy, and distribution of input and output, not the systems analyst.

Choice "d" is incorrect. System programmers would be involved in the selection of system software and would be responsible for maintaining system software, including operating systems, network software, and the data management system, not the systems analyst.

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31. Which of the following control activities should be taken to reduce the risk of incorrect processing in a newly installed computerized accounting system?

a. Segregation of duties. b. Ensure proper authorization of transactions. c. Adequately safeguard assets. d. Independently verify the transactions. Solution: Choice "d" is correct. The independent verification of transactions that typically occurs using concurrent update controls such as parallel processing of transactions represents one of the most effective methods to reduce the risk of incorrect processing of transactions in a newly installed accounting system.

Choice "a" is incorrect. Although segregation of duties is a foundational control that helps ensure that transactions are not controlled by one individual from beginning to end, the separation of transaction authorization, recordkeeping and asset custodial duties does not reduce the risk of incorrect processing of transactions.

Choice "b" is incorrect. Authorization of transactions is a strong control over the validity or legitimacy of transactions, but does not necessarily reduce the risk of incorrect processing.

Choice "c" is incorrect. Asset safeguarding is an important security measure but does not provide effective reduction of the risk for incorrect processing.

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32. A client would like to implement a management information system that integrates all functional areas within an organization to allow information exchange and collaboration among all parties involved in business operations. Which of the following systems is most effective for this application?

a. A decision support system. b. An executive support system. c. An office automation system. d. An enterprise resource planning system. Solution: Choice "d" is correct. A system that integrates multiple functional areas in business operations is referred to as an enterprise resource planning system.

Choice "a" is incorrect. A decision support system or expert system provides operational support for different business circumstances and does not necessary integrate all functional areas within an organization.

Choice "b" is incorrect. An executive support system provides strategic support for executive decisions but does not necessarily integrate all functional areas within an organization.

Choice "c" is incorrect. An office automation system coordinates back office operations but does not integrate all functional areas within an organization.

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33. The controller of Gray, Inc. has decided to use ratio analysis to analyze business cycles for the past two years in an effort to identify seasonal patterns. Which of the following formulas should be used to compute percentage changes for account balances for year 1 to year 2?

a. (Prior balance - current balance) / current balance. b. (Prior balance - current balance) / prior balance. c. (Current balance - prior balance) / current balance. d. (Current balance - prior balance) / prior balance. Solution: Choice "d" is correct. The percentage change in account balances is most logically constructed as the current balance minus the prior balance divided by the prior balance. (Similar to the CPI computation.)

If account balances were to increase as follows, the percentage change would be computed using the formula proposed by the solution.

Year 2 Year 1 Change Sales $120,000 $100,000 $20,000

(Current balance $120,000 – Prior balance $100,000)/ Prior balance $100,000 = 20%

If account balances were to decrease as follows, the percentage change would be computed (and automatically show a percentage decrease) as follows:

Year 2 Year 1 Change Sales $100,000 $120,000 ($20,000)

(Current balance, $100,000 – Prior balance, $120,000)/ Prior balance, $120,000 = (16.7%)

Choice "a" is incorrect. Computing the amount of the account change as a percentage of the current balance is not the percentage change from period to period.

Choice "b" is incorrect. The proposed formula computes the percentage change backwards, decreases in accounts would be expressed as increases and increases in accounts would be expressed as decreases.

Choice "c" is incorrect. Computing the amount of the account change as a percentage of the current balance is not the percentage change from period to period.

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34. A hospital is comparing last year's emergency rescue services expenditures to those from 10 years ago. Last year's expenditures were $100,500. Ten years ago, the expenditures were $72,800. The CPI for last year is 168.5 as compared to 121.3 ten years ago. After adjusting for inflation, what percentage change occurred in expenditures for emergency rescue services?

a. 38.0% increase. b. 13.8% increase. c. 0.6% decrease. d. 18.1% decrease. Solution: Choice "c" is correct. The consumer price index (CPI) is a measure of the overall cost of a fixed basket of goods and services purchased by an average household. The inflation rate is calculated as the percentage change in the CPI from one period to the next. By extension, nominal costs can be deflated to price level adjusted amounts by dividing a base year price index by the current year price index. The current fact pattern anticipates the following computation:

Base year – emergency rescue service 72,800 Current year costs times the ratio of base to current year indices:

$100,500 x 121.3/168.5 = 72,348 Difference (decrease) (452)

The percentage change in the expenses is simply the change divided by the base year computed as follows: (452)/ 72,800 = .6% decrease.

Choice "a" is incorrect. The proposed solution does not adjust the costs for inflation.

Choice "b" is incorrect. The proposed solution "inflates" the base year with the CPI index applicable to that year and then compares it to the unadjusted nominal value in the current year. The proposed solution ignores the idea that inflation adjustments are based on the relative change in economic measures.

Choice "d" is incorrect. The proposed solution "inflates" the base year with the CPI index applicable to the current year and then compares it to the unadjusted nominal value in the current year. The proposed solution ignores the idea that inflation adjustments are based on the relative change in economic measures.

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35. If a CPA's client expected a high inflation rate in the future, the CPA would suggest to the client which of the following types of investments?

a. Precious metals. b. Treasury bonds. c. Corporate bonds. d. Common stock. Solution: Choice "a" is correct. Precious metals are a non-monetary asset whose value increases with inflation. Therefore, precious metals would likely serve as a better hedge against inflation than common stock or fixed income securities.

Choice "b" is incorrect. Treasury bonds are fixed in value and will not keep up with the purchasing power losses caused by inflation. Inflation will likely cause interest rates to increase and thereby reduce the value of fixed interest rate securities purchased at the beginning of an inflationary cycle.

Choice "c" is incorrect. Corporate bonds are assets that are fixed in value and will not keep up with the purchasing power losses caused by inflation. Inflation will likely cause interest rates to increase and thereby reduce the value of fixed interest rate securities purchased at the beginning of an inflationary cycle.

Choice "d" is incorrect. The value of common stock generally increases with inflation, but is also impacted by the value of the underlying company and market fluctuations that are impacted by numerous factors other than inflation. The use of equities may represent a long term hedge against inflation but equities would not be as effective as commodities in the short term.

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36. How does inflation distort reported income?

a. Wages are not reflective of current labor rates. b. Sales are not reflective of current product prices. c. Depreciation is not reflective of current fixed-asset replacement costs. d. Interest expense is not reflective of current borrowing rates. Solution: Choice "c" is correct. Depreciation represents a method of reasonable and rational allocation of the historical cost of fixed assets to benefitting accounting periods. Depreciation is a method of allocation, not valuation. Inflation will cause the consumption of non-monetary assets accounted for as depreciation to be undervalued since the total value used as the basis for depreciation is the asset's historical cost, not an inflation adjusted amount.

Choice "a" is incorrect. Wages will typically increase with inflation as workers negotiate higher wages to keep up with inflation and employers increase wages to compensate for purchasing power losses due to inflation as a means of attracting and retaining a talented work force.

Choice "b" is incorrect. Product prices in a free market will increase with inflation. Sales revenue will reflect inflation.

Choice "d" is incorrect. Although long term borrowing rates may be reflective of historical rates, they include an adjustment for anticipated long term inflation and current interest rates will automatically adjust for inflation as lenders change rates to compensate for changes in purchasing power.

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37. In a large public corporation, evaluating internal control procedures should be the responsibility of:

a. Accounting management staff who report to the CFO. b. Internal audit staff who report to the board of directors. c. Operations management staff who report to the chief operations officer. d. Security management staff who report to the chief facilities officer. Solution: Choice "b" is correct. In a large public corporation, evaluating internal control procedures should be the responsibility of an organizationally independent internal audit function that reports to the governing body of the corporation.

Choice "a" is incorrect. Evaluation of the effectiveness of the internal control procedures by accounting management that report to the CFO would likely be subject to bias and lack objectivity since the controls are likely designed and at least partially implemented by that staff. Use of the accounting management that report to the CFO would not be appropriate.

Choice "c" is incorrect. Operations management staff reporting to the chief operations officer would likely lack the depth of knowledge of financial controls that extend beyond operations necessary to evaluate the internal control procedures of a large public corporation. Use of operations management staff would not be appropriate.

Choice "d" is incorrect. Securities management staff reporting to the chief facilities officers would likely lack the expertise necessary to evaluation the internal control procedures in a large public corporation. Use of securities management staff would not be appropriate.

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38. A put is an option that gives its owner the right to do which of the following?

a. Sell a specific security at fixed conditions of price and time. b. Sell a specific security at a fixed price for an indefinite time period. c. Buy a specific security at fixed conditions of price and time. d. Buy a specific security at a fixed price for an indefinite time period. Solution: Choice "a" is correct. A put option gives its owner the right to sell a specific security at fixed conditions of price and time.

Choice "b" is incorrect. A put option specifies time conditions and is not indefinite.

Choice "c" is incorrect. An option to buy is called a call option. A call option gives its owner the right to purchase a specific security at fixed conditions of price and time.

Choice "d" is incorrect. An option to buy is called a call option. A call option specifies time conditions and is not indefinite.

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39. To evaluate its performance, the Blankie Co. is comparing its costs of quality from one year to the next. The relevant costs are as follows:

First Year Second Year Prevention $45,000 $60,000 Appraisal 25,000 35,000 Internal failure 80,000 50,000 External failure 75,000 65,000

Which of the following conclusions can Blankie draw about its quality program?

a. It has been a failure, because conformance costs decreased by $40,000 while nonconformance costs increased by $25,000.

b. It has been a success, because conformance costs decreased by $40,000 and nonconformance costs increased by $25,000.

c. It has been a failure, because conformance costs increased by $25,000 while nonconformance costs decreased by $40,000.

d. It has been a success, because conformance costs increased by $25,000 while nonconformance costs decreased by $40,000.

Solution: Choice "d" is correct. The Blankie company would conclude that its quality program has been a success because its conformance costs (preventative measures) increased less than its nonconformance costs (error corrections) decreased. The investment in preventative measures has efficiently reduced the time and costs invested in error correction.

Appraisal and prevention costs are conformance costs while internal and external failure costs are nonconformance costs.

Choice "a" is incorrect. The proposed solution inaccurately identifies the listed costs as either conformance or nonconformance. Appraisal and prevention costs are conformance costs while internal and external failure costs are nonconformance costs. Note that a decrease in conformance costs and an increase in nonconformance costs would indicate a failed program.

Choice "b" is incorrect. The proposed solution inaccurately identifies the listed costs as either conformance or non conformance. Appraisal and prevention costs are conformance costs while internal and external failure costs are nonconformance costs. In addition, the conclusions about the relationships between costs is incorrect. A decrease in conformance costs and an increase in nonconformance costs would indicate a failed program.

Choice "c" is incorrect. An increase in conformance costs and a decrease in non conformance costs indicates success, not failure of a quality program. Management would be more concerned if nonconformance costs were increasing.

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40. A company has several long-term floating-rate bonds outstanding. The company's cash flows have stabilized, and the company is considering hedging interest rate risk. Which of the following derivative instruments is recommended for this purpose?

a. Structured short-term note. b. Forward contract on a commodity. c. Futures contract on a stock. d. Swap agreement. Solution: Choice "d" is correct. An interest rate swap agreement would be effective in hedging the risk associated with interest rate fluctuations. A swap agreement is a private agreement between two parties, generally assisted by an intermediary, to exchange future cash payments. In this case, the company would most likely enter into an interest rate swap in which it would pay another party a fixed rate of interest in exchange for receipt of payments of a floating rate of interest. The company would then use the floating interest payments received to pay the interest on its floating-rate bonds. In this way, the company would use the swap agreement to convert its interest payments from floating-rate to fixed-rate.

Choice "a" is incorrect. A structured short term note would not be effective in hedging the interest rate risks associated with long term floating rate bonds. Long term rates will fluctuate based on the expectations associated with the long term bond market. Short term rates at a point in time are based on different assumptions by investors and lenders.

Choice "b" is incorrect. Forward contracts on commodities have a lower likelihood of effectively hedging interest rate risk than an interest rate swap. The financial markets that impact interest rates are more directly connected to interest rates than commodities.

Choice "c" is incorrect. Futures contracts on equities have a lower likelihood of effectively hedging interest rate risk than an interest rate swap. The financial markets that impact interest rates are more directly connected to interest rates than equities.

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AICPA Newly Released BEC Simulations Task 246_01

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Official response:

To : Management team

Re: Advantages and risks of the proposed pension plan

The challenges of an aging workforce to both our company's institutional knowledge base as well as our financial stability require careful planning. The proposal by our human resources director that we adopt a defined benefit plan that pays out based on the highest ten year's of earnings has both advantages and risks.

Clearly the advantage of a defined benefit plan is the loyalty it will encourage for our aging work force. Individuals over 40 will likely stay with us if there is a retirement benefit that accrues with each passing year. A plan of this type gives our work force the incentive to stay for the foreseeable future, preserving their institutional knowledge.

The financial risks of the plan, however, are significant. Rewarding workers with a pension pay out based on their highest 10 years of compensation as they approach their highest earning years and also near retirement will create significant liabilities that could damage our balance sheet and earnings, as well as create cash flow issues. The costs of a pension plan are far less for younger employees whose tenure is questionable, earnings are lower and time horizons (for investment earnings on contributions) are longer.

A number of alternatves exist that could make this plan less risky financially or could even replace this plan altogether. The proposed plan excludes bonuses from the pension benefit base. Our compensation could become more heavily weighted toward bonuses to reduce the ultimate defined benefit liability. In addition, our plan could include a deferred compensation program or 401(k) plan that might allow either voluntary or automatic deferral of the bonus. The plan would serve to involve the employee in their own retirement, demonstrate the company's ongoing commitment to the post employment welfare of employees, reduce cost and the company's financial risk.

Pension plans are excellent vehicles to promote employee loyalty and maintain a stable work force. They also present significant financial risks. I look forward to discussing the benefits, risks and potential opportunities of the proposed plan with each of you soon.

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Task 250_01

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To : CFO

Subject: Voluntary Section 404 compliance

I am delighted to hear of you are considering voluntary compliance with Section 404 of the Sarbanes-Oxley Act.

As you likely know, the Act requires a comprehensive self assessment of your entity’s internal control over financial reporting, representations by management regarding the effectiveness of controls, and attestation by an independent public accountant regarding the fairness of your assessment. All of these requirements have benefits to you.

The comprehensive review of internal control over financial reporting has a number of benefits because it requires executives and managers to consider the effectiveness of multiple dimensions of internal control. We recommend that your company undertake a comprehensive review of internal control using an established criteria, such as the Committee of Sponsoring Organizations (COSO) Internal Control Framework. Using the COSO framework, your company will be able to evaluate your control environment as well as evaluate risk assessment techniques, information and communication procedures, monitoring procedures and existing control procedures at the transaction, account and financial statement levels. The review will highlight any existing weaknesses in your internal controls and will also promote an entity wide understanding of controls.

In addition, management's assertion regarding the effectiveness of internal control is beneficial because it communicates, in a very visible way, management’s commitment to strong internal controls.

The engagement of an auditor to provide an opinion regarding management's assertion will not only provide confirmation of management's assertion, but will also provide you with a critique of your internal controls. The extra set of eyes provides a useful fresh perspective. Ultimately, if you decide to go public, a major hurdle of public filing, compliance with Sarbanes-Oxley requirements, will have already been addressed.

There are many advantages to voluntarily complying with Sarbanes-Oxley requirements, including the self discovery of your own evaluation, the communication of management's commitment and the review by outside parties. We are delighted that you are giving this serious consideration.

If we can do anything to help in this ongoing effort, please do not hesitate to call.