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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