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Chapter 13
Knowledge Check – Page XXX
 What is the difference between permanent and transitory earnings?
Permanent earnings are earnings that are expected to be repeated in the future.
Transitory earnings are earnings that are not expected to be repeated in the
future.
 What is meant by the term earnings quality? Give examples of how managers’
accounting choices and operating decisions can affect an entity’s earnings
quality.
Earnings quality refers to the usefulness of current earnings for predicting
future earnings. Earnings quality is high if there is a close relationship
between current and future earnings. Earnings quality is low if the relationship
between current and future earnings is not close. Managers can lower earnings
quality when they manage earnings through their accounting policies,
estimates, and accruals. (There are many examples of this effect—any time
policies are chosen or estimates or accruals made it is possible that earnings
quality is reduced.)
Knowledge Check – Page XXX
 What is gross margin? What is gross margin percentage? What does gross
margin percentage mean?
Gross margin is the difference between sales and cost of sales. From gross
margin an entity must be able to cover all its other costs of operations and
provide profit. Gross margin percentage is gross margin divided by sales. The
gross margin percentage indicates the percentage of each dollar of sales that is
available to cover other costs and return a profit to the entity's owners.
 Distinguish return on assets from return on equity. How is each calculated?
Return on assets is a measure of the performance of the entity that is
independent of how the entity’s assets were financed. Return on equity
measurers the return on the investment made by the common equity investors.
These return measures are calculated as:
Return on assets
=
Net Income + After tax interest expense
Average total assets
Return on equity
=
Net income – preferred dividends
Average common shareholders’ equity
= Net income + interest expense (1 - ta
Average total assets
Knowledge Check – Page XXX
 What is liquidity? Why are creditors very interested in the liquidity of entities
they provide credit to?
Liquidity is an entity’s ability to make payments as they come due. Lenders
and creditors want to assess the liquidity of an entity to ensure that it will be
able to pay amounts owed. If there is concern that the entity will not be able to
meet its obligations, lenders and creditors may not want to provide credit. At
the very least they will attach terms to any credit offered that will reflect the
level of risk associated with the entity.
 Explain the difference between quick ratio and the current ratio. How is each
calculated?
The current ratio provides a measure of the resources an entity has to meet its
short-term obligations. A larger current ratio also indicates greater protection
in the event the entity’s cash flow somehow becomes impaired. The ratio
assumes that inventory, receivables, and other current assets can be converted
to cash on a timely basis.
The quick or acid test ratio is a stricter test of an entity’s ability to meet its
obligations because it excludes less liquid assets such as inventory and
prepaids. The concept behind the quick ratio is that it can take a fairly long
time to convert inventory into cash and prepaids will never be realized in cash.
The current ratio and quick ratio are calculated as follows:
Current ratio
=
Current Assets
Current Liabilities
Quick ratio
=
Quick assets
Current Liabilities