non-current (long-term) liabilities(Reading 32)

Exercise Problems:

1. A company with no interest-bearing debt enters into a finance lease on the first day on the reporting year. The lease requires a year-end payment of $175,000 for 10 years. In the second year of the lease, the company reported the EBIT of $450,000. Assuming a 7% imputed interest rate on the lease, the firm’s interest coverage ratio in the second year is closest to:

A. 4.3X

B. 5.2X

C. 5.6X

Ans: C.

The present value of the lease payment with an anunual payment of $175,000 (PMT) at the end of the year over the 10 year period (N), discounted at 7% (1/Y), is $1,229,127 (solve for PV).

Interest during the second year of the lease is $1,140,166 * 0.07= $79,812.

2. An analyst is assessing a company that entered into a take-or-pay contract during the year and also has significant number of operating leases. Which of the following statement is the least accurate?

A. The company’s financial statements must be adjusted before the analyst compares this company to other companies in its industry.

B. Despite the off-balance sheet nature of take-or-pay contracts and operating leases, an attempt to determine the actual financial position of the company can be garnered from the footnotes.

C. The take-or-pay contracts and operating leases mean that this company has much higher business risk than similar companies that do not use off-balance sheet financing techniques.

Ans. C.

The existence of take-or-pay contracts and operating leases does not necessarily increase the business risk of a company when compared to companies that do not use off-balance seet financing techniques, although the existence of the obligations must be considered when analyzing business risk.

A is incorrect. When companies make use of off-balance sheet financing techniques, the financial statements must be adjusted before the company’s financing position and operating results can be analyzed and compared to other companies.

C is incorrect. It is not difficult to determine the true financial position of companies that use off-balance sheet financing techniques because both IFRS and U.S.GAAP require extensive footnote disclosures regarding off-balance sheet financing. The information in the disclosures can be used to adjust the financial statements for the off-balance sheet items.

3. A company leased equipment under a seven-year finance lease requiring year-end payments of $20,541. The present value of the lease liability is approximately $100,000 based on a 10% discount rate. The interest portion of the first payment is closest to:

A. $10,000.

B. $13,340.

C. $14,200.

Ans: A.

First year interest expense will be:

1st year interest expense= $100,00 *0.10= $10,000.

4. The most likely impact on a lessee’s financial statements from reporting a lease as a finance lease rather than as an operating lease will be:

A. Unchanged total lease expense over the lease term.

B. Lower operating cash flows during the life of the finance lease.

C. Lower operating profit (margin) in the early years of the finance lease.

Ans. A.

Although the annual lease expense in any given year is different between an operating and a finance lease, over the life of the lease (lease term) both methods will result in the same total lease expense.

B is incorrect. Under a finance lease, only the interest payments are outflows from operating activities, while the principal payments are outflows from financing activities. All operating lease payments are outflows from operating activities, resulting in lower operating cash flows during the lease term if the lease is an operating lease.

C is incorrect. Operating profit margins are higher (rather than lower) during the entire term of a finance lease because only the related depreciation expense, rather than the entire lease payment is included in operating expenses. However, the interest portion of the payment is reflected in pretax earnings and net profit margins, both of which will be lower in the early years of a fiancé lease as the combined deprecation and interest expense will be in excess of the lease payment.

5. Backhoe Partners (BP) sells each of its backhoes for $175,000 with an expected economic life of 10 years. The company also leases them directly to construction companies with good credit. If Construction Group (CG) leases the equipment from BP, the relevant interest rate is 10% and the lease payments will be $4,000 per month for four years. CG has purchased equipment in the past by financing through Prime Finance. Assuming that CG decides to lease the equipment, BP should treat the lease as a(n):

A. Direct financing lease.

B. Operating lease.

C. Sales-type lease.

And. C.

The lease must be capitalized since the present value of the lease payment is greater than 90% of the fair value of the asset:

 $4,000 PMT, 10%/12 i (1/Y), 4*12 n (N), (CPT) PV = $157,713

$157,713/$175,000 =90.12%

A. The lease would not direct financing lease because BP manufactures the equipment and leases it to third parties; BP is obviously a manufacturer or dealer.

B. Since BP manufactures the equipment for sale, the lease would be a sales-type lease.

6. When a bondholder converts a convertible bond, the effects on the corporation’s subsequent financial statements will include a:

A. An increase in tax expense and an increase to the debt-to-equity ratio.

B. An increase in tax expense and a decrease to the debt-to-equity ratio.

C. A decrease in tax expense and an increase to the debt-to-equity ratio.

Ans: B.

Since interest is tax deductible, it will decrease tax expense while the bonds are outstanding. When the debt is converted to equity, the reduced interest deduction will increase tax expense. When the debt is converted to equity, the numerator of the debt-to-equity ratio will be reduced and the denominator will be increased. The debt-to-equity ratio will be reduced as a result.

7. A company is considering issuing $10,000,000 of long-term debt with a 6% coupon rate or the same amount of convertible debt with a 5% coupon rate. Both will be issued at par and have the same maturity. Which statement below best describes the impact on the firm’s debt ratio?

A. The debt ratio would be higher for U.S.GAAP than for IFRS.

B. The debt ratio would be lower for U.S.GAAP than for IFRS.

C. The debt ratio would be the for U.S.GAAP than for IFRS.

Ans: A.

Under U.S.GAAP the entire amount of the issue is recorded as debt while under IFRS the amount of the issue is split into the fair value of the debt and the difference between fair value and issue value is recorded as (option) equity.

8. The following information is available from a company’s 2011 financial statements:

Note 6: Employee costs

Note 17: Retirement benefit obligations

Amounts recognized in the income statement for the year

The pension expense (in thousands) reported in 2011 is closest to:

A. $1,525.

B. $2,217.

C. $2,253.

Ans: C.

The pension expense would be the sum of the expense for the defined contribution plan and the defined benefit plan (retirement benefit obligation): 1,525 + 728 = 2,253.

9. A retail company that leases the majority of its space has:

? total assets of $4,500 million,

? total long-term debt of $2,125 million, and

? average interest rate on debt of 12%.

Note 8 to the 2011 financial statements contains the following information about the company’s future beginning of year lease commitments:

Note 8: Operating leases

After adjustment for the off-balance-sheet financing, the debt-to-total-assets ratio for the company is closest to:

A. 55%.

B. 57%.

C. 65%.

Ans: A.

The present value of the operating leases should be added to both the total debt and the total assets.

The present value of an annuity due of $200 for 5 years at 12% = $807.5.

(N = 5; I = 12; PMT = 200; Mode = Begin)

Adjusted debt to total assets = (2,125 + 807.5) ÷ (4,500 + 807.5) = 55.3%.

10. On 1 January 2009, a company that prepares its financial statements according to IFRS issued bonds with the following features:

? Face value ￡20,000,000

? Term 5 years

? Coupon rate 6% paid annually on December 31

? Market rate at issue 4%

The company did not elect to carry the bonds at fair value. In December 2011 the market rate on similar bonds had increased to 5% and the company decided to buy back (retire) the bonds after the coupon payment on December 31. As a result, the gain on retirement reported on the 2011 statement of income is closest to:

A. ￡340,410.

B. ￡371,882.

C. ￡382,556.

Ans. C.

The market value of debt at retirement can be determined by discounting the future cash flows at the current market rate (5%) using a financial calculator:

FV = 20,000,000; i = 5%; PMT = 1,200,000; N = 2; Compute PV = 20,371,882

The book value after the third interest payment (two payments remaining) can be found either using a financial calculator and the market rate at the time of issue (4%) or an amortization table (shown below).

FV = 20,000,000; i = 4%; PMT = 1,200,000; N = 2; Compute PV = 20,754,438.

The bond’s initial value (required for amortization) can be found using a financial calculator:

FV = 20,000,000; i = 4%; PMT = 1,200,000; N = 5; Compute PV = 21,780,729.

Gain=Book value of debt – Market value

        = 20,754,438 – 20,371,882 =382,556

11. Which of the following is most likely a reason that a lessor can offer attractive lease terms and lower cost financing to a lessee? Because the:

A. Lessor retains the tax benefits of ownership.

B. Lessor avoids reporting the liability on its balance sheet.

C. Lessee is better able to resell the asset at the end of the lease.

Ans: A.

The lessor often retains the tax benefits of ownership of the leased asset, which allows the lessor to pass those savings along to the lessee in the form of lower financing costs or other attractive terms.

B is incorrect. Lessor owns the asset.

C is incorrect. The lessee does not own the asset.

12. On 1 January 2011 the market rate of interest on a company’s bonds is 5% and it issues a bond with the following characteristics:

If the company uses IFRS, its interest expense (in millions) in 2011 is closest to:

A. €1.846.

B. €2.307.

C. €2.386.

Ans: B.

IFRS requires the effective interest method for the amortization of bond discounts/premiums. The bond is issued for 0.9228 × €50 million = €46.140.

Interest expense

= Liability value × Market rate at issuance

= 0.05 × €46.140 = €2.307.

13. Given the following information about a company:

What is the most appropriate conclusion an analyst can make about the solvency of the company? Solvency has:

A. improved because the debt-to-equity ratio decreased.

B. deteriorated because the debt-to-equity ratio increased.

C. improved because the fixed charge coverage ratio increased.

Ans: A.

The debt–equity ratio decreased, thereby improving solvency; the fixed charge ratio remained the same.

14. A company, which prepares its financial statements in accordance with IFRS issues ￡5,000,000 face value ten year bonds on January 1, 2010 when interest rates are 5.50%. The bonds carry a coupon of 6.50%, with interest paid annually on December 31. The carrying value of the bonds as of December 31, 2011 will be closest to:

A. ￡4,695,562.

B. ￡5,301,000.

C. ￡5,316,000.

Ans: C.

The bond proceeds are determined by taking the present value of the coupon stream and terminal payment at the interest rate of 5.5%:

Proceeds

= 5,000,000 x 6.5% x PVA(10y, 5.5%) + 5,000,000 x PV(10y, 5.5%)

= 325,000 x PVA(10y, 5.5%) + 5,000,000 x PV(10y, 5.5%)

= 5,376,881

Where PVA(10y, 5.5%) is the present value interest factor for an annuity of $1 for 10years at 5.5%, and PV(10y, 5.5%) is the present value interest factor for $1 to be received in 10years when rates are 5.5%

Using the effective annual interest (EAI) rate method which is required under IFRS.

15.  Compared to classifying a lease as a financing lease, if a lessee reports the lease as an operating lease it will most likely result in a:

A. lower return on assets.

B. higher debt-to-equity ratio.

C. lower cash from operations.

Ans: C.

The cash from operations is lower if the lease is classified as an operating lease, because the full lease payment is shown as an operating cash outflow. If it were classified as a financing lease, only the portion of the lease payment relating to interest expense reduces the operating cash flow and the portion of the lease payment that reduces the lease liability is classified as a financing cash flow. Therefore, the lessee’s cash from operations tends to be lower under operating leases.

The following two figures summarize the difference between the effects of finance leases and operating leases on the financial statements and ratios of the lessee.

Figure 1: financial statement impact of lease accounting

Figure 2: ratio impact of lease accounting

16. A company issued $2,000,000 of bonds with a 20 year maturity at 96. Seven years later, the company called the bonds at 103 when the unamortized discount was $39,000. The company would most likely report a loss of:

A. $60,000.

B. $99,000.

C. $138,000.

Ans: B.

17. A capital lease requires annual lease payments of $2,000 at the start of each year. Fair value of the leased equipment at inception of the lease is $10,000 and the implicit interest rate is 12 percent. If the present value of the lease payments equals the fair value of the equipment at the inception of the lease, the interest expense (in $) recorded by the lessee in the second year of the lease is closest to:

A. 960.

B. 1,104.

C. 1,200.

Ans: A.

18. Which of the following is most likely a benefit of debt covenants for the borrower?

A. Reduction in the cost of borrowing.

B. Limitations on the company’s ability to pay dividends.

C. Restrictions on how the borrowed money may be invested.

Ans: A.

Debt covenants are restrictions imposed by the lender on the borrower to protect the lender’s position. Debt covenants can reduce default risk and thus reduce borrowing costs.

B is incorrect. This is a disadvantage of using debt covenants for the borrower.

C is incorrect. This is a disadvantage of using debt covenants for the borrower.

19. An analyst makes the appropriate adjustments to the financial statements of retail companies that are lessees using a substantial number of operating leases. Compared to ratios computed from the unadjusted statements, the ones computed from the adjusted statements would most likely be higher for:

A. the debt-equity ratio but not the interest coverage ratio.

B. the interest coverage ratio but not the debt-equity ratio.

C. both the debt-equity ratio and the interest coverage ratio.

Ans: A.

The adjustments to convert operating leases into capital leases would increase the amount of total debt in the debt-equity ratio thus increasing the ratio; the portion of the lease payment estimated to be lease interest expense would lower the interest coverage ratio.

20.A company issued a $50,000 7-year bond for $47,565. The bonds pay 9 percent per annum and the yield-to-maturity at issue was 10 percent. The company uses the effective interest rate method to amortize any discounts or premiums on bonds. After the first year, the yield to maturity on bonds equivalent in risk and maturity to these bonds is 9 percent. The amount of the bond discount amortization ($) recorded in the second year is closest to:

A. 282.

B. 348.

C. 2,178.

Ans: A.

21. On 1 January 2008 a company enters into a lease agreement to lease a piece of machinery as the lessor with the following terms:

Which of the following best describes the classification of the lease on the company’s financial statements for 2008?

A. Operating lease.

B. Sales type lease.

C. Direct financing lease.

Ans: B.

Under U.S.GAAP, lessee must treat a lease as a capital (finance) lease if any of the following criteria are met:

Title to the leased asset is transferred to the lessee at the end of the lease period.

A bargain purchase option permits the lessee to purchase the leased asset for a price that is significantly lower than the fair market value of the asset at some future date.

The lease period is 75% or more of the asset’s economic life.

The present value of the lease payments is 90% or more of the fair value of the leased asset.

Under U.S.GAAP, if any one of the capital (finance) lease criteria for lessees is met, and the collectability of lease payments is reasonably certain, and the lessor has substantially completed performance, the lessor must treat the lease as a capital (finance) lease.

From the lessor’s perspective, a capital lease under U.S.GAAP is treated as tither a sales-type lease or a direct financing lease. If the present value of the lease payments exceeds the carrying value of the assets, the lease is treated as a sales-type lease. If the present value of the lease payments is equal to the carrying value, the lease is treated as a direct financing lease.

It is a sales type lease: the lease period covers more than 75% of its useful life (5/6=83.3%) and the asset is on its books at less than the present value of the lease payments ($199,635) (PMT = $50,000, N=5, i=8%). The firm must have acquired or manufactured the asset if it is recorded at less than the present value of the lease payments.

22. At the beginning of the year, a lessee company enters into a new lease agreement that is correctly classified as a finance lease, with the following terms:

With respect to the effect of the lease on the company’s financial statements in the first year of the lease, which of the following is most accurate? The reduction in the company’s:

A. pretax income is $72,096.

B. cash flow from financing is $56,742.

C. cash flow from operations is $72,096.

Ans: B.

The present value of the lease is $360,477.62. (n = 5, I = 12%, PMT = $100,000) 12% of the original PV is $43,257.31 and represents the interest component of the payment in the first year. The difference between the annual payment and the interest is the amortization of the lease obligation included in cash flow from financing. $100,000 – 43,257.31 = $56,742.69.

A is incorrect. Depreciation is $360,477.62 / 5 or $72,095.52 so the total reduction in pretax income would be interest plus depreciation or $115,352.83 (=43,257.31+72,095.52).

C is incorrect. Cash flow from operations would be reduced by the amount of the interest only (43,257.31) because the depreciation would be added back to determine cash flow from operations.

23. At the beginning of the year, a company issues a $1,000 face value, semiannual coupon, bond with an 8 percent coupon rate maturing in 10 years. The annual market rate of interest at issuance was 12 percent. The initial liability recorded for this bond is closest to:

A. $771.

B. $774.

C. $1,000.

Ans: A.

The liability recorded is based on market rates of interest when the bond is issued and not the coupon rate on the bond. The market value of the bond at issuance was $770.60. (FV=1,000, PMT=40, N=20, I=6.0).

24. At the beginning of the year, two companies issued debt with the same market rate, maturity date, and total face value. One company issued coupon-bearing bonds at par and the other company issued zero-coupon bonds. All other factors being equal for

that year, compared with the company that issued par bonds, the company that issued zero-coupon debt will most likely report:

A. higher cash flow from operations but not higher interest expense.

B. both higher cash flow from operations and higher interest expense.

C. neither higher cash flow from operations nor higher interest expense.

Ans: A.

When a company issues a zero-coupon bond, cash flow from operations is overstated over the life of the bond. Interest expense is recorded for income statements purposes, but is added back in the statement of cash flows as a non-cash adjustment to cash flow from operations.

25. A company is considering issuing either a straight coupon bond or a coupon bond with warrants attached. The proceeds from either issue would be the same. If the firm issues the bond with warrants attached instead of the straight coupon bond, which of the following ratios will most likely be lower for the bond with warrants?

A. Return on assets.

B. Debt to equity ratio

C. Interest coverage ratio.

Ans: B.

The portion of the proceeds attributable to the warrants would be classified as equity, thus the portion classified as a liability would be smaller (lower). Therefore the debt-to-equity ratio will be lower, for the bonds with warrants.

A is incorrect. Since interest expense would be lower for a bond with warrants attached, Net Income would be higher and ROA would be higher.

C is incorrect. EBIT would be the same regardless of financing method; the coupon on the bond with warrants attached would be lower if the two issues provided the same proceeds, so the interest coverage (=EBIT/ Interest expense) would be higher for a bond with warrants attached.

26. On 1 January 2012 a company enters into a lease agreement to lease a piece of machinery as the lessor with the following terms:

The total affect on 2012 pre-tax income for the lessor from this lease is closest to:

A. $32,143.

B. $75,000.

C. $82,519.

Ans: C.

This is a sales type lease: the lease period covers more than 75% of its useful life

(6/7=85.7%) and the asset is on its books at less than the present value of the lease payments ($357,490) (PMT = $75,000, N=6, i=7%). The firm must have acquired or manufactured the asset if it is recorded at less than the present value of the lease payments.

The income in the first year will therefore consist of the gross profit on the sale (357,490-300,000)=57,490 plus interest revenue from financing the lease = 25,024(see below)

Total income = 57,490 + 25,024 = 82,514

27.  A company had the following events related to $5 million of 10-year bonds with a coupon rate of 8% payable semi-annually on 30 June and 31 December:

Issued on 1 January 2005, when the market rate of interest was 6%.

Bought back in an open market transaction on 1 January 2011, when the market rate of interest rate was 8%.

Which of the following statements best describes the effect of the bond repurchase on the financial statements for 2011? If the company uses the indirect method of calculating the cash from operations, there will be a:

A. $346,511 gain on the income statement.

B. $743,873 gain on the income statement.

C. $350,984 decrease in the cash from operations.

Ans: C.

The book value of the bonds on 1 January 2011 is equal to the present value of the remaining coupon payments and principal discounted at the market rate at time of issue (3% per period).

Coupon = 0.08 x0.5x5,000,000=200,000; there are 4 years remaining or 8 coupon payments

Book value

= 200,000 PVAnnuity (n=8, i=3%)+5,000,000PV(n=8, i=3%)

=1,403,938+3,947,046

=5,350,984

Using a financial calculator: PMT = 200,000; FV=5,000,000; I=3%; N=8;

Compute PV = 5,350,984,

Because the market interest rate when the bonds are brought back (8%) is equal to the coupon rate, the company can buy back the bonds at par, $5,000,000

Cost of repurchase     $5,000,000

Book value                      5,350,984

Gain on retirement             350,984

On the cash flow statement the gain would be deducted from net income in calculating the cash from operations under the indirect method, and the cash paid to repurchase the bonds would be a cash outflow in the financing section.

28. At the beginning of the year, a company issued a $1,000 face value bond. Interest on that bond is paid semiannually, the annual coupon rate on the bond is 9%, and the bond matures in ten years. The market rate of the interest at the time the bond was issued was 10% on an annual basis. The amount of the initial liability recorded for this bond was closest to:

A. $938.

B. $961.

C. 1,065.

Ans: A.

The liability and interest expense recorded are both based on market rates of interest when the bond was issued, not the coupon rate on the bond. The market value of the bond at issuance was $937.68. (FV=1000, PMT=45, N=20, i=5.0).

29. Bond Features, Inc. (“BFI”) has bonds outstanding with a $900,00 par value. The BFI bonds pay a 4.5% coupon, mature in three years, and have  net book value of $785,000. The bonds are convertible into 20,000 shares of common stock, with a $1 par value. The current market value of the common shares is $62.50. Under U.S.GAAP, the amount that will be recorded as additional paid-in capital if the bonds are immediately converted is closest to:

A. $115,000.

B. $765,000.

C. $1,250,000.

Ans: B.

Under U.S.GAAP, bond proceeds are reclassified from debt to equity when the bond is converted into common stock. The amount recorded in additional paid-in capital is the balance of the bond liability after crediting the outstanding bond discount and the common stock issued at par. No gain or loss is recorded from the conversion.

Bond discount = net book value – bond par value

                        = $785,000 - $900,000= $115,000

Common stock = # shares on conversion x par value

                          =20,000 x $1= $20,000

Additional paid-in capital

= bond par value – (bond discount + common stock)

= $900,000 – (115,000 +20,000)

=$765,000

30. A company receiving leased equipment would prefer a finance lease to an operating lease when it:

A. wishes to show a higher cash flow from operations.

B. desires a lower debt-to-equity ratio.

C. has a low marginal tax rate.

Ans: A.

Under an operating lease, the entire lease payment is reported as operating cash outflow. A finance lease allocates the outflow between both operating ad financing cash outflows, with only the interest portion of the lease payment treated as an operating cash outflow.

B is incorrect. A company’s leverage ratios will be higher under a finance lease arrangement. The finance lease method creates a lease obligation liability. An operating lease is preferred if a firm wants to keep debt off of its balance sheet.

C is incorrect. Companies with higher marginal tax rates prefer finance leases, as expenses are higher in the early period of the lease. A low marginal tax rate does not result in a finance lease preference.

31. Which of the following statement most accurately reflects the effective interest method of amortizing bond premium and discount?

A. using the effective interest method results in a different interest expense each period.

B. The coupon interest rate is the market interest rate at the time the debt was issued.

C. A bond sells at a premium when the market interest rate exceeds the coupon rate.

Ans: A.

The effective interest method requires multiplying the yield-to-maturity of the bond by the net book value. The net book value approaches par value as the bond nears maturity. Periodic interest expense increase (decreases) as the bond’s book value increase (decreases).

B is incorrect. The coupon interest rate for a bond may be higher or lower than the market interest rate at the date of issuance. Higher coupon rates than market rates indicate a premium to par value, and lower coupon rates than market rates indicate a discount from par value.

C is incorrect. A bond sells at a premium when the market interest rate is less than the coupon t\rate. If the market rate exceeds the coupon rate, the bond will sell at a discount.

32. Madison Inc. is planning a bond issue. They are considering issuing either a straight coupon bond or a coupon bond with warrants attached. The proceeds from either issue would be the same. What will be the effect on their interest expense and balance sheet liability if they issue the bonds with warrants as compared to the straight bonds? For the bonds with warrants the:

Ans: A.

The portion of the proceeds attributable to the warrants would be classified as equity, thus the portion classified as a liability would be smaller (lower). The lower balance sheet value would lead to a lower interest expense when it is calculated. The interest expense is based on the liability at the beginning of the period, not the coupon payment.

33. Compared to an operating lease, all other things being equal, over the term of a finance lease,

A. The interest coverage ratio will decrease.

B. The return on assets ratio will decrease.

C. The asset turnover ratio will increase.

Ans: C.

Lease capitalization will increase asset balances resulting in a lower asset turnover (net sales / average total assets). As the leased asset is depreciated and the asset balance becomes smaller, the ratio will increase. The lower the asset balance is (or becomes), the higher the asset turnover ratio will be.

A is incorrect. The interest coverage ratio increases over the lease term of a finance lease as the interest on the lease liability declines as the principal is paid down. On the other hand, the interest coverage ratio will be higher at all times with an operating lease as there is no interest.

B is incorrect. With a finance lease, the return on assets will increase as the earnings increase due to the lower interest expense on the lease liability and the declining asset base resulting from depreciation. Consequently, later in the lease term, higher earnings will be returns to lower asset levels and the asset turnover ratio will increase, not decrease.

34. Bao Inc. issued its Class H series bonds at $10,400 on 1/1/x3. Class H bonds have a 10% coupon paid semi-annually and a face value of $10,000, maturing in two years. Using the effective interest method, calculate the amount of interest expense associated with the Class H bonds reported by Bao for the period ending 12/31/x3.

A. $405.

B. $808.

C. $1,000.

Ans: B.

The periodic payment is $500 or one-half of the 10% annual coupon. The yield-to-maturity is solved for, using a financial calculator, as 3.90% semi-annually (see below). At the end of the first reporting period (Year 1), the total interest expense is $807.52 (=$405.60 + 401.92).

Periodic coupon payment

= semi-annual payment x coupon rate x face value

=0.5 x 10.0% x $10,000

= $500

Semi-annual yield-to-maturity:

N=4; PV= -$10,400; PMT =$500; FV = $10,000

Compute 1/Y = 3.90 semi-annual effective interest rate

Interest expense

= NBV of bond at end of previous period x effect interest rate

NBV t= NBV t-1 + interest expense – coupon

Interest expense = 405.60 + 401.92 = 807.52

35. A retail company that leases the majority of its space has total assets of $4,500 million and total long-term debt of $2,125 million bearing an average interest rate of 10%.

Note 8: Operating leases

After adjustment for the off-balance-sheet financing, the debt-to-total-assets ratio for the company is closest to:

A. 58%.

B. 62%.

C. 72%.

Ans: A.

The present value of the operating leases should be added to both the total debt and the total assets. To estimate the present value it is appropriate to estimate the number of years of lease payments reflected in the 2016 and thereagter figure. Based on the constant expense shown in the first 5 years, there are 9 (1,260/140) more payment for total of 14 payments.

Adjusted debt to total assets

= (2,125+1,134)/(4,500+1,134)=57.8%

36. Matrix pricing is a process in which a bond’s yield-to-maturity is determined from bonds currently available in the market that have similar attributes as the bond being considered.

Matrix pricing is most similar to the :

A. Debt-rating approach only.

B. Yield-to-maturity approach.

C. Yield-to-maturity approach and Debt-rating approach.

Ans: A.

Matrix pricing (as describe) is an example of the debt-rating approach only.

37. The following information is available from a company’s 2012 financial statements:

Note 6: employee costs.

Note 17: retirement benefit obligations

Amounts recognized in the income statement for the year

The pension expense (thousands) reported in 2012 is closest to:

A.    $1,525.

B.     $2,217.

C.     $2,253.

Ans: C.

The pension expense would be the sum of the expense for the defined contribution plan and the defined benefit plan (retirement benefit obligation):

1,525+728=2,253.

38. Bao Capital issued bonds in 2006 that mature in 2016. The measurement basis used for the bonds on the 2008 balance sheet will be:

A. market value.

B. historical cost.

C. amortized cost.

Ans: C.

Bonds payable issued by a company are financial liabilities that are measured at amortized cost.

39.  If market interest rates have changed materially since a firm issued a bond, and the firm does not use the fair value reporting option, how is the change in the market value of the firm’s debt most likely to be reported in the firm’s financial statements?

A. The gain or loss in market value must be calculated and disclosed in the footnotes to the financial statements.

B. Net income and equity are unaffected, but the change is disclosed by the firm’s management.

C. Net income is unaffected, but the change in market value is recorded in other comprehensive income.

Ans: B.

Material changes in the firm’s cost of debt capital should be included in the Management Discussion and Analysis section of the financial statements. If the firm does not use fair value reporting of debt obligations, net income and shareholders’ equity are not affected by changes in the market value of the firm’s debt, and disclosing its gain or loss in market value is not required.

40. A firm that reports its lease of a conveyer system as an operating lease must disclose:

A. only the annual lease payment.

B. minimum lease payments for each of the next five years and the sum of lease payments more than five years in the future.

C. minimum lease payments for each of the next ten years and the sum of lease payments more than ten years in the future.

Ans: B.

Whether a lease is an operating or finance (capital) lease, both U.S.GAAP and IFRS require disclosure of the minimum lease payments for each of the next five years and the sum of minimum lease payments more than five years in the future.

41. A dealer of large earth movers that leases the machinery to its customers is most likely to treat the leases as:

A. operating leases, and account for inventory using LIFO.

B. sales-type leases, and account for inventory using specific identification.

C. direct financing leases, and account for inventory using weighted average cost.

Ans: B.

Lessors that are dealers or manufacturers of the leased assets typically recognize sales revenue at the inception of a lease and thus account for their leases as sales-type capital (finance) leases. Dealers of high-value items that can be distinguished one from another, such as large earth movers, typically use specific identification to account for inventory.

42. Which of the following statements regarding the financial statement reporting of leases is most accurate?

A. Under an operating lease, the lease treats the entire lease payment as a cash outflow from operations.

B. The lessee’s current ratio is the same whether a lease is treated as an operating or finance lease.

C. At the inception of a direct financing lease, the lessor recognizes gross profit.

Ans: A.

With an operating lease, the entire lease payment is recorded as rent expense and classified as an operating cash outflow. A finance lease results in a lower current ratio than an operating lease because the current portion of the principal repayment component will be added to current liabilities. The lessor does not recognize any profit at the inception of a direct financing lease.

43. In accounting for a defined benefit pension plan, the amount reported as “prior service cost” refers to the:

A. total value of benefits already paid to retirees who are still receiving pension payments.

B. present value of the pension benefits due to employees based on their employment up to the date of the statement.

C. present value of the increase in future pension benefits from a change in the terms of the pension plan.

Ans: C.

Prior service costs arise when changes in the terms of a defined benefit pension plan increase the future benefit due employees based on their prior employment with the company.

44. Under U.S.GAAP, which of the following statements about the financial statement effects of issuing bonds is least accurate?

A. Issuance of debt has no effect on cash flow from operations.

B. Periodic interest payments decrease cash flow from operations by the amount of interest paid.

C. Payment of debt at maturity decreases cash flow from operations by the face value of the debt.

Ans: C.

Issuing debt results in a cash inflow from financing. Payment of debt at maturity has no effect on cash flow from operations but decreases cash flow from financing by the face value of the debt.

45. Bao Company has a defined benefit plan for its employees. Which of the following changes in assumptions would most likely decrease its reported pension expense? An increase in the expected:

A. retirement age.

B. return on plan assets.

C. growth rate of salaries.

Ans: B.

Reported pension expense for a defined benefit plan equals the plan’s costs (the sum of service cost, prior services cost, interest cost, and actuarial gains or losses) minus the expected earnings on the plan’s investments. The expected earnings are based on the expected return on plan assets. An increase in the expected return would increase the plan’s expected earnings and decrease pension expense. Increases in the assumed retirement age or rate of salary growth would result in actuarial losses and increase pension expense.

46. From the lessee’s perspective, compared to an operating lease, a finance lease results in:

A. higher asset turnover.

B. a higher debt-to-equity ratio.

C. lower operating cash flow.

Ans: B.

Operating leases are not recognized as liabilities and therefore the debt-to-equity ratio will be lower than a similar finance lease. Capitalizing a lease will increase the asset base and decrease asset turnover. Lease capitalization decreases the operating cash outflow and therefore increases operating cash flows (all else equal).

47. Bao Capital issed a 5-year, $50 million face, 6% semiannual bond when market interest rates were 7%. The market yield of the bonds was 8% at the beginning of the next year. What is the initial balance sheet liability, and what is the interest expense that the company should report for the first half of the second year of the bond’s life (the third semiannual period)”

Ans: A.

This is a discount bond since the market interest rate at issuance exceeds the coupon rate. The initial liability is equal to the proceeds received when the bond was issued. We can find this amount from the following calculation:

FV=50,000,000; N=10; I=3.5; PMT=1,500,000;CPT→PV=$47,920,848.67.

Change N to 8 and calculate PV to get liability value at the beginning of the second year of the bond’s life, 48,281,511. Interest expense for the next semiannual period is 48,281,511(0.035)=$1,689,853.

The subsequent change in the market rate has no effect on the amortization of the discount.

48. In general, as compared to companies with operating leases, companies with finance leases report:

A. lower working capital and asset turnover.

B. higher debt to equity and return on equity ratios (in the early years).

C. higher expenses in the early years and over the life of the lease.

Ans: A.

Working capital equals current assets minus current liabilities and is lower under a finance lease because the current portion of the finance lease increases current liabilities. Total asset turnover is lower because total assets are higher under a finance lease.

B is incorrect. Companies with finance leases report higher debt-to-equity ratios because liabilities increase and equity is unchanged at lease inception and lower in the early years of the lease. Return on equity is lower with a finance lease because the numerator, net income, is decreased proportionally more than the denominator, equity, from the greater expense of a fiancé lease in its early years.

C is incorrect. Over the life of the lease, the expenses are equal.

Reference: Question 15.

49. Bao Capital issues a 4-year semiannual-pay bond with a face value of $10 million and a coupon rate of 10%. The market interest rate is 11% when the bond is issued. The balance sheet liability at the end of the first semiannual period is closest to:

A. $9,650,700.

B. $9,683,250.

C. $9,715,850.

Ans: C.

The initial liability is the amount received from the creditor, not the par value of the bond.

N=8, I/Y=11/2=5.5;PMT=500,000;FV=10,000,000;

CPT→PV=$9,683,272.

The interest expense if the effective interest rate (the market rate at the time of issue) times the balance sheet liability.

$9,683,272x0.055=$532,580.

The value of the liability will change over time and is a function of the initial liability, the interest expense and the actual cash payment. In this case, it increases by the difference between the interest expenses and the actual cash payment:

$532,580-500,000=$32,580

$32,580+9,683,272=$9,715,852.

Tip: Knowing that the liability will increase is enough to select choice C without performing this last calculation. Entering N=7 and solving for PV also produces $9,715,852.

50. Debt covenants to protect bondholders are least likely to:

A. restrict the issuance of new debt.

B. require sinking fund redemptions.

C. prohibit bond repurchases at a premium to par.

Ans: C.

Covenants protect bondholders from actions the firm may take that would decrease credit quality and reduce the value of the bondholders’ claims to firm assets and earnings. Examples of covenants include restrictions on dividend payments and stock repurchases, mergers and acquisitions, sale, leaseback, and disposal of certain assets; issuance of new debt, and repayment patterns (e.g., sinking fund agreements and priority of claims). Repurchases of bonds in the market do not negatively affect the interests of bondholders.

51. Nan Chen works for a firm that offers a benefit plan that guarantees her an annual payment in retirement equal to her average salary over her last 3 years of full-time employment multiplied by 3% for each of her years of full-time employment, as long as she has reached age 62. The most appropriate term for Nan’s retirement plan is a:

A. salary-based plan.

B. defined benefit plan.

C. years-of-service plan.

Ans: B.

A plan where the company guarantees a specific benefit amount upon retirement is referred to as a defined benefit plan.

52. Which of the following statements about the treatment of leases on the lessor’s financial statements is least accurate?

A. If the present value of the payments on a finance lease is greater than the carrying value of the asset, the lease is a sales-type lease on the books of the lessor.

B. In a direct financing lease, the lessor recognizes gross profit at the lease inception, while in a sales-type lease it does not.

C. To be a finance lease for the lessor, collectability must be reasonably certain and the lessor must have substantially completed performance.

Ans: B.

When the PV of the lease payments is greater than the carrying value of an asset, the lessor records an immediate gross profit on sale equal to the excess of the PV over the carrying value, and the lease is termed a sales-type lease, not a direct financing lease.

53. Compared to an operating lease, a capital lease will have what effects on operating income (earnings before interest and taxes) and net income in the first year?

A. Both will be lower.

B. Both will be higher.

C. One will be lower and one will be higher.

Ans: C.

With an operating lease, the entire lease payment (rent expense) is subtracted from operating income. With a capital lease, only depreciation is subtracted from operating income, so operating income is higher with a ca[ital lease. Net income in the first year is lower with a capital lease because the sum of depreciation (operating expense) and interest (non-operating expense) is greater than the lease payment.

54. If the balance sheets of a firm reporting under U.S.GAAP and a firm reporting under IFRS show equal pension liabilities, it is most likely that:

A. both firms’ defined contribution plans are underfunded.

B. the funded status of the U.S.GAAP firm’s pension is equal to its pension liability.

C. the IFRS firm’s pension is underfunded by a greater amount than the U.S.GAAP firm’s pension.

Ans: B.

Under U.S.GAAP, the asset or liability reported on the balance sheet for a defined benefit pension plan reflects the funded status of the plan. Under IFRS, the balance sheet asset or liability does not include prior service costs or actuarial gains and losses. The net effect of these differences on funded status can be positive or negative. Defined contribution plans do not represent future obligations of the firm and, therefore, do not appear on the balance sheet.

55. A company issues $10 million in 8% annual-pay, 5-year bonds, when the market rate is 8.25%. the initial balance sheet liability and liability one year from the date of issue are closest to:

Ans: A.

PMT = 800,000; FV = 10,000,000; N = 5; I/Y = 8.25;

CPT → PV = $9,900,837

Interest expense = 9,900,836.51 x 0.0825 = $816,819.01

Year-end adjustment = 816,819.01 – 800,000 = $16,819.01

Year-end debt = $9,900,836.51 + $16,819.01 = $9,917,655.52

Note: sine this is a discount bond, we know the initial liability will be less than the face value, so we really didn’t have to do any calculations to answer this question.

56. Which of the following is correct regarding the impact of convertible bonds on a company’s financial statements and ratios:

A. The issuance of convertible bonds by a company results in a decrease in both its debt-to-equity and its interest coverage ratios.

B. The conversion of convertible bonds into common equity results in an increase in the company’s debt-to-equity ratio and an increase in the interest coverage ratio.

C. When there is a conversion of convertible debt into common equity, even if the market price exceeds the conversion price, no gain or loss may be reported on the financial statements.

Ans: C.

The conversion of convertible debt into common equity uses the additional paid-in capital account as a balancing account. No gain or loss is recorded when convertible bonds are converted into common equity.

A is incorrect. The issuance of convertible bonds by a company results in a increased, not decreased, debt-to-equity ratio (convertible bonds are debt until they are converted) and a decreased interest coverage ratio due to the higher interest associated with the increased debt.

B is incorrect. The conversion of convertible bonds into common equity results in lower debt and higher equity balances, as well as lower interest expense in the future due to the reduced debt. The reduced debt and increased equity result in a lower debt-to-equity ratio. The decrease in interest expense results in an increased interest coverage ratio.

57. For the lessee, during the later years of a finance lease:

A. the debt-to-equity ratio will increase compared to the initial years.

B. a higher net profit (margin) will be obtained versus an operating lease.

C. a high asset turnover ratio will be obtained versus the operating lease.

Ans: B.

In the later years of a finance lease, the net profit (margin) will be greater than the net profit (margin) reported with an operating lease. Although rent expense is normally constant throughout the term of an operating lease, interest expense declines in a finance lease as the lease obligation is reduced while depreciation expense remains constant. This leads to lower total expenses in the later years of a finance lease versus an operating lease and a higher reported net profit (margin).

A is incorrect. Through the passage of time, the lease obligation with a finance lease is reduced leading to a lower debt-to-equity ratio compared to the early years.

C is incorrect. Although the asset turnover ratio rises over time as the leased asset is depreciated with a finance lease, the asset turnover remains higher with an operating lease since the leased asset is never recorded with an operating lease.