ExpertMedium1 markMultiple Choice
CPA · Question 17 · Area I: Financial Reporting
A company has a Debt-to-Equity ratio of 1.5. It purchases a machine by signing a 5-year note payable. How does this transaction affect the Debt-to-Equity ratio and the Return on Assets (ROA) immediately?
A company has a Debt-to-Equity ratio of 1.5. It purchases a machine by signing a 5-year note payable. How does this transaction affect the Debt-to-Equity ratio and the Return on Assets (ROA) immediately?
Answer options:
A.
Increase Debt-to-Equity; Decrease ROA
B.
Increase Debt-to-Equity; Increase ROA
C.
Decrease Debt-to-Equity; Decrease ROA
D.
No change to Debt-to-Equity; Decrease ROA
How to approach this question
Analyze the components. D/E = Total Liab / Total Equity. ROA = Net Income / Avg Total Assets. <br/>Transaction: Debit Asset, Credit Liability.
Full Answer
A.Increase Debt-to-Equity; Decrease ROA✓ Correct
1. Debt-to-Equity: Liabilities increase (Note Payable). Equity is unchanged. Ratio increases.<br/>2. Return on Assets: Total Assets increase (Machine). Net Income is unchanged immediately. Since the denominator (Assets) increases, the ratio decreases.
Common mistakes
Confusing the direction of the ratio change when the denominator increases.
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