Review for the June 2008 CFA Level 1 CFA Exam - CFA Society of ...

In 2004, Torrence Co. had a beginning inventory of $19,924 and made purchases of $15,923. Ifthe ending inventory level was $19,204, what was the Cost of Goods Sold for year 2004?A) $15,923.B) $15,203.C) $720.D) $16,643.A company's beginning inventory was overstated by $3,000, now ending inventory is understatedby $2,000. If purchases were properly reported, then earnings before taxes will be:A) overstated by $5,000.B) understated by $1,000.C) overstated by $1,000.D) understated by $5,000.While attending a local college, music major Anjolie Webster accepts a temporary position with asmall manufacturing firm. Currently, the firm uses LIFO to account for inventory, but the owner is“just curious” about how the financial results would look if the company used FIFO. Before theowner leaves for her voice lesson, she hands Webster a photocopy of the inventory data for thecurrent period (summarized below).• Beginning inventory of 1,000 units at $30 cost.• Ending inventory of 800 units.• Sales of 1,100 units.• Three inventory purchases (listed from earliest purchase to latest purchase): 400 units at$27 each, 300 units at $25 each, and an unreadable number of units at $22 each.(Unfortunately, when the owner copied the original document, she left a yellow stickynote covering some of the inventory information.)• Current assets (less inventory) of $75,000.• Current liabilities of $65,000.Using the information provided, determine which of the following statements is least accurate? Allelse equal, compared to LIFO, using FIFO would result in:A) a lower gross margin.B) a lower ending inventory balance.C) cost of goods sold of $32,700.D) a current ratio of approximately 1.60.2

LOS 35b: Explain the relationship among and the usefulness of inventoryand COGS data provided by LIFO, FIFO, and average cost methods whenprices are stable or changing.In periods of changing prices, different inventory costing methods affect thecomparability of financial statements between firms. If prices of good do notchange, the n the different inventory valuation methods do not affect the financialstatements.During periods of changing prices, FIFO will provide the most useful estimate ofthe inventory value and LIFO will provide the most useful estimate of the COGS.Which of the following statements is least accurate?A)B)In a period of rising prices, LIFO gives the best COGS, whereas FIFO gives the bestinventory balance on the balance sheet.In a period of rising prices, FIFO gives the best COGS, whereas LIFO gives the bestinventory balance on the balance sheet.C) In a period of stable prices, LIFO and FIFO will produce similar account balances.D)LIFO produces a tax benefit in a period of rising prices, therefore results in higher cashflows than FIFO.During inflationary periods, which of the following statements is TRUE?A) LIFO will generate lower earnings, but lower after tax cash flows.B) FIFO will generate higher earnings, but lower after tax cash flows.C) FIFO will generate lower earnings, but lower after tax cash flows.D) LIFO will generate higher earnings, but lower after tax cash flows.LOS 35c: Compare and contrast the effect of the different methods onCOGS and inventory balances and discuss how a company’s choice ofinventory accounting method affects other financial items such as income,cash flow, and work capital.The LIFO to FIFO conversion….FIFO Inventory = LIFO Inventory + LIFO ReserveCOGS FIFO = COGS LIFO – (LIFO reserve ENDING – LIFO reserve BEGINNING )3

The FIFO to LIFO conversion….Not done for inventory since inventory under LIFO is not a reflection of currentvalue.COGS LIFO = COGS FIFO + (BI FIFO x inflation rate)NOTE: Inflation rate should not be a general inflation rate for the economy butshould be an inflation rate appropriate for the firm or industry.When prices are changing, an analyst should use LIFO-based values for incomestatement items and ratios, and FIFO-based values for balance sheet items andratios.In periods of rising prices and stable or increasing inventories:LIFOHigher COGSLower taxesLower net income (EBT & EAT)Lower inventory balancesLower working capitalHigher cash flows (less taxes paid out)FIFOLower COGSHigher taxesHigher net income (EBT & EAT)Higher inventory balancesHigher working capitalLower cash flows (more taxes paid out)In periods of rising prices and stable or increasing inventories:LIFOHigher COGSLower taxesLower net income (EBT & EAT)Lower inventory balancesLower working capitalHigher cash flows (less taxes paid out)FIFOLower COGSHigher taxesHigher net income (EBT & EAT)Higher inventory balancesHigher working capitalLower cash flows (more taxes paid out)Given the following data:• Beginning LIFO Reserve $2,300• Cost of Goods Sold (COGS) using LIFO $6,100• COGS using FIFO of $4,300What is the Ending LIFO reserve?A) $4,100.B) $500.C) $2,300.D) $2,800.4

If a company using last in, first out (LIFO) reports an inventory balance of $22,000 and a LIFOreserve of $4,000, the estimated value for the inventory on a first in, first out (FIFO) basis wouldbe:A) $13,000.B) $26,000.C) $18,000.D) $24,000.LOS 35d: Compare and contrast the effects of the choice of inventorymethod on profitability, liquidity, activity, and solvency ratios.Profitability• LIFO produces COGS balances that are higher• Profitability ratios are lower under LIFOLiquidity• FIFO produces inventory figures that are higher• Liquidity ratios are higher under FIFOActivity• LIFO produces a better estimate of COGS• FIFO produces a better estimate of inventory• Inventory turnover ratio is always higher when using LIFOSolvency• The balance sheet must be adjusted by accounting for the LIFO reserve• Solvency ratios will be lower under FIFO5

Selected information from Oldtown, Inc.’s financial statements for the year endedDecember 31, 2004 included the following (in $):Cash 1,320,000 Accounts Payable 1,620,000Accounts Receivable 2,430,000 Deferred Tax Liability 715,000Inventory 6,710,000 Long-term Debt 15,230,000Property, Plant & Equip. 12,470,000 Common Stock 1,000,000Total Assets 22,930,000 Retained Earnings 4,365,000Total Liabilities & Equity 22,930,000Sales 15,000,000Net Income 3,000,000LIFO Reserve at Jan. 1 1,620,000LIFO Reserve at Dec. 31 1,620,000Oldtown uses the last in, first out (LIFO) inventory cost flow assumption. The tax rate was 40percent. If Oldtown changed from LIFO to first in, first out (FIFO) for 2004, net profit marginwould:A) decrease from 20.0 to 13.5 percent.B) decrease from 20.0 to 9.2 percent.C) decrease from 20.0 to 16.8 percent.D) remain unchanged at 20.0 percent.LOS 35e: Indicate the reasons that a LIFO reserve might declineduring agiven period and evaluate the implications of such a decline for financialanalysis.The LIFO reserve will decline if inventory quantity is falling and/or prices arefalling.In periods of falling prices, which of the following statements is TRUE? Compared to FIFO, LIFOresults in:A) higher inventory balances and higher working capital.B) higher inventory balances and lower working capital.C) lower COGS, lower taxes and higher net income.D) higher COGS, lower taxes and higher net income.6

LOS 35f: Ilustrate how inventory are reported in the financial statementsand how the lower of cost or market principles is used and applied.GAAP requires inventory valuation on the basis of lower of cost or market (LCM)regardless of inventory costing method. (Concept of Conservatism)Cost is calculated using the actual purchase prices of the items.Market is the replacement cost which consists of a range of values from “netrealizable value less a normal profit margin” to “net realizable value”.Barber Inc. sells DVD recorders. On October 14, it purchased a large number of recorders at acost of $90 each. Due to an oversupply of recorders remaining in the marketplace due to lowerthan anticipated demand during the Christmas season, the selling price at December 31 is $80and the replacement cost is $73. The normal profit margin is 5 percent of the selling price and theselling costs are $2 per recorder.What should Barber value the recorders at on December 31?A) $74.B) $73.C) $78.D) $80.Reading 36: Long-Lived Assets: CapitalizationLOS 36a: Demonstrate the effects of capitalizing versus expensing on netincome, shareholders’ equity, cash flow from operations, and financialratios.Capitalizing ExpensingIncome Variability Lower HigherProfitability-Early Years(ROA&ROE)Profitability-Later Years(ROA&ROE)HigherLowerLowerHigherTotal Cash Flows Same SameCash Flow from Operations Higher LowerCash Flow from Investing Lower HigherLeverage Ratios (D/E & D/A) Lower Higher7

An analyst should adjust income statements and balance sheets to reverse theimpact of capitalized interest.Selected information from the financial statements of Salvo Company for the years endedDecember 31, 2003 and 2004 is as follows (in $ millions):2003 2004Sales $21 $23Cost of Goods Sold (8) (9)Gross Profit 13 14Cost of Franchise (6) 0Other Expenses (6) (6)Net Income $1 $8Cash $4 $5Accounts Receivable 6 5Inventory 9 7Property, Plant & Equip. (net) 12 15Total Assets $31 $32Accounts Payable $7 $5Long-term Debt 10 5Common Stock 8 8Retained Earnings 6 14Total Liabilities and Equity $31 $32Salvo’s return on average total equity for 2004 was ($8 / (($8 + $6) + ($8 + $14)) / 2 =) 44.4percent.If Salvo had amortized the cost of the franchise acquired in 2003 over six years instead ofexpensing it, Salvo’s return on average total equity for 2004 would have decreased from 44.4percent to:A) 38.9 percent.B) 31.1 percent.C) 35.6 percent.D) 25.6 percent.LOS 36b: Determine which intangible assets should be capitalizedaccording to GAAP and international accounting standards.An intangible asset is an asset that has no physical existence and has a highdegree of uncertainty regarding future benefits.8

Under U.S. generally accepted accounting principles (GAAP), which of the following costsassociated with intangible assets is most likely to be capitalized?A) Research and development costs associated with software development.B) The costs associated with an internally created trademark.C) The cost of an acquisition of a patent from an outside entity.D) Advertising expenses.Reading 37: Long-Lived Assets: Depreciation and ImpairmentLOS 37a: Demonstrate the different depreciation methods and explain howthe choice of depreciation method affects a company’s financial statement,ratios, and taxes.Depreciation is the systematic allocation of the asset’s cost over time.Straight LineUnits of Production or Service HoursSum of the Year’s DigitsDouble Declining BalanceNOTE: Sinking fund depreciation where depreciation expense actually increaseseach year so that the asset earns the same rate of return each year is prohibitedin the U.S.This information pertains to equipment owned by Brigade Company.• Cost of equipment $10,000• Estimated residual value $2,000• Estimated useful life 5 years• Depreciation method Straight-lineThe accumulated depreciation at the end of year 3 is:A) $4,800.B) $1,600.C) $3,200.D) $5,200.9

On January 1, 2004, JME purchased a truck that cost $24,000. The truck had an estimated usefullife of 5 years and $4,000 salvage value. The amount of depreciation expense recognized in 2006assuming that JME uses the double declining balance method is:A) $4,000.B) $3,456.C) $5,760.D) $8,000.Straight LineAcceleratedDepreciation expense Lower HigherNet income Higher LowerAssets Higher LowerEquity Higher LowerROA Higher LowerROE Higher LowerTurnover ratios Lower HigherCash flow Same SameRoger Margotta, the CFO of Brainchild, Inc., is considering several alternative methods ofdepreciation for long-term assets. With respect to double-declining method of depreciation, whichof the following statements is the most accurate?A) Current ratio will increase over the life of the asset.B) Return on Investment will increase over the life of the asset.C) Asset turnover ratio will decrease over the life of the asset.D)Depreciation expense will increase over the life of the asset, thus showing a decreasingearnings trend.LOS 37b: Demonstrate how modifying the depreciation method, theestimated useful life, and/or the salvage value affect financial statementsand ratios.Change in depreciation method is a change in an accounting principles andtherefore requires the cumulative effect of the change on past income to beshown net of tax on the income statement.10

Change in useful life and/or salvage value is a change in accounting estimateand do not require past income to be restated.In 2005, Carpet Company decides to change from the straight-line method of depreciation to thesum of the year’s digits method. The following information is available:Pre-2005 2005Straight Line Depreciation $1,600,000 $400,000Sum of the Years Digits $2,300,000 $500,000On its 2005 financial statements, Carpet will report:A)B)C)D)$400,000 depreciation expense in the 2005 income statement and $800,000 separately asa change in accounting principle net of taxes.$1,200,000 depreciation expense in the 2005 income statement and include a footnote ofexplanation including the tax effect.$500,000 depreciation expense and restate prior period financial statements to reflect thechange net of taxes.$500,000 depreciation expense in the 2005 income statement and $700,000 separately asa change in accounting principle net of taxes.LOS 37c: Determine the average age and average depreciable life of acompany’s assets using the company’s fixed asset disclosures.Average Age in Years:accumulated depreciationdepreciation expenseRelative Age:accumulated depreciationending gross investmentAverage Depreciable Life: ending gross investmentdepreciation expense11

Determine the average age as a percent of depreciable life and the average age of the plant andequipment given the following information:• Depreciation expense is $15,000.• Plant and equipment is $250,000.• Accumulated depreciation is $60,000.Average Age (%)Average Age (Years)A) 25% 4B) 24% 6C) 25% 6D) 24% 4LOS 37d: Explain and illustrate the use of impairment charges and theireffect on financial statements and ratios.GAAP require that assets be carried at acquisition cost less accumulateddepreciation AND that carrying amounts be reduced to market value when thereis no longer an expectation that net balance sheet values can be recovered fromfuture operations.Impairments are reported on the income statement pretax (above the line) as acomponent of income from continuing operations. In the U.S. impairmentscannot be restored. However, the IASB allow firms to recognize increases invalue.In testing for impairment, undiscounted future cash flows are used to compare tothe carrying value of the asset. However, once impairment has been detected,the amount of the impairment is estimated using discounted future cash flows.An impairment write-down results in a decrease in all of the following financial statement itemsand ratios EXCEPT:A) assets.B) the debt-to-equity ratio.C) stockholders' equity.D) future depreciation expense.12

LOS 37e: Discuss accounting requirements related to remedyingenvironmental damage caused by operating assets and the relatedfinancial statement and ratio effects.SFAS 143 requires a consistent treatment of the ARO (asset retirementobligation) from obligations related to remedying environmental damage causedby a company.Which of the following statements regarding the financial statement impact of recording liabilitiesresulting from the application of SFAS 143 is TRUE? In accounting periods following an assetacquisition, liability values are:A)B)C)D)accreted in a manner similar to interest for bond amortization. The difference here is that theinterest component falls through time instead of rising.accreted in a manner similar to interest for bond amortization. This accretion is recorded asa gain on the income statement.recorded as an expense on the income statement that is recorded over a period of ten yearsor the life of an asset whichever is less.accreted in a manner similar to interest for bond amortization. The difference here is that theinterest component rises through time instead of falling.Reading 38: Analysis of Income TaxesLOS 38a: Explain the key terms related to income tax accounting and theorigin of deferred tax liabilities and assets.Taxable Income: income subject to tax based on the tax return.Taxes Payable: the tax liability on the balance sheet caused by taxable income.Pretax Income: Income before income tax expense.Income Tax Expense: The expense recognized on the income statement thatincludes taxes payable and deferred income tax expense. NOTE: the incometax expense is composed of taxes payable plus noncash items such as changesin deferred tax assets and liabilities.Income Tax Expense = Taxes Payable + ∆DTL - ∆DTAA deferred tax liability is created when an income or expense item is treateddifferently on financial statements that it is on the company’s tax returns, and thatdifference results in greater tax expense on the financial statements that taxespayable on the tax return. Often occurs when an accelerated method ofdepreciation is used on the tax return and straight line is used for book purposes.13

A deferred tax asset is when the difference results in lower income tax expenseon the financial statements than on the tax return. Warranty expense is a goodexample since warranty expense is accrued for financial reporting purposes butis not deductible on the tax return until actual warranty claims have been paid.Which of the following statements about tax deferrals is FALSE?A) Income tax paid can include payments or refunds for other years.B) Tax deferrals are created due to the difference in financial and tax accounting.C) Taxes payable are determined by pretax income and the tax rate.D) A deferred tax liability is expected to result in future cash outflow.LOS 38b: Demonstrate the liability method of accounting for deferredtaxes.The liability method of accounting for deferred taxes starts from the premise thatdifferences between taxes calculated on the income statement (GAAP) and taxesfrom the income tax return (IRS code) will be reversed at some future date.Regarding the liability method of accounting for deferred taxes, which of the following statementsis FALSE?A) Taxes payable are affected by changes in deferred taxes.B)C)D)Deferred taxes are calculated by multiplying the temporary differences by the current taxrate.Income tax expense = Taxes payable - Change in Deferred tax asset + Change inDeferred tax liability.Changes in the tax rate are recognized in the reported income the year the change isenacted.LOS 38c: Discuss the use of valuation allowances for deferred tax assetsand their implications for financial statement analysis.Deferred tax assets can have a valuation allowance, which is a contra accountagainst deferred tax assets based on the likelihood that these assets will not berealized. For deferred tax assets to be beneficial, the firm must have futuretaxable income. If there is a greater than 50% probability that a portion ofdeferred tax assets will not be realized, the deferred tax asset must be reducedby a valuation allowance. NOTE: We are only talking about deferred tax assets!14

Which of the following situations will most likely require a company to record a valuationallowance on its balance sheet?A)To report depreciation, a firm uses the double-declining balance method for tax purposesand the straight-line method for financial reporting purposes.B) A firm with deferred tax assets expects an increase in the tax rate.C)D)A firm has differences between taxable and pretax income that are never expected toreverse.A firm is unlikely to have future taxable income that would enable it to take advantage ofdeferred tax assets.LOS 38d: Explain the factors that determine whether a company’s deferredtax liabilities should be treated as a liability or as equity for purposes offinancial analysis.If deferred tax liabilities are expected to reverse in the future, then they are bestclassified as liabilities.If deferred tax liabilities are not expected to reverse in the future, they are bestclassified as equity.Which of the following financial ratios is least likely to be affected by classification of deferredtaxes as a liability or equity?A) Return on equity (ROE).B) Debt-to-equity.C) Return on assets (ROA).D) Debt-to-total assets.LOS 38e: Distinguish between temporary and permanent items in pretaxfinancial income and taxable income.Temporary differences are differences in taxable and pretax incomes that willreverse in future years. They result in deferred tax assets or liabilities.Permanent differences are differences in taxable and pretax incomes that will notreverse. They do not result in deferred tax liabilities or assets. Permanentdifferences are reflected in a difference between a firm’s effective tax rate and itsstatutory tax rate.15

LOS 38f: Calculate and interpret income tax expense, income taxespayable, deferred tax assets, and deferred tax liabilities.A dance club purchased new sound equipment for $25,352. It will work for 5 years and has nosalvage value. Their tax rate is 41 percent, and their annual revenues are constant at $14,384.For financial reporting, the straight-line depreciation method is used, but for tax purposesdepreciation is accelerated to 35 percent in years 1 and 2 and 30 percent in Year 3. For purposesof this exercise ignore all expenses other than depreciation.What is the tax payable for year one?A) $779.B) $1,909.C) $2,259.D) $1,626.What is the deferred tax liability as of the end of year one?A) $1,909.B) $1,559.C) $1,129.D) $320.What is the deferred tax liability as of the end of year three?A) $780.B) $1,029.C) $1,909.D) $4,158.LOS 38g: Calculate and interpret the adjustment(s) to the deferred taxaccounts related to a change in the tax rate.All balance sheet deferred tax assets and liabilities are revalued when the taxrate the firm will face in the future changes. If the tax rate increases, theincrease in deferred tax liabilities increases the income tax expense and theincrease in deferred tax assets decreases the income tax expense. If the t axrate decreases, the decrease in deferred tax liabilities decreases income taxexpense, and the decrease in deferred tax assets increases income tax expense.NOTE: The most common occurrence is that deferred tax liabilities exceeddeferred tax assets.16

An analyst has gathered the following tax information:Year 1 Year 2Pretax Income $60,000 $60,000Taxable Income $50,000 $65,000The current tax rate is 40 percent. Assume the tax rate is reduced to 30 percent and the changeis enacted at the beginning of Year 2.In year 1, what are the taxes payable and what is the deferred tax liability?Taxes PayableDeferred Tax LiabilityA) $20,000 $1,500B) $24,000 $3,000C) $24,000 $1,500D) $20,000 $3,000LOS 38h: Interpret a deferred tax footnote disclosure that reconciles theeffective and statutory tax rates. SFAS 109While evaluating the financial statements of Omega, Inc., the analyst observes that the effectivetax rate is 7% less than the statutory rate. The source of this difference is determined to be a taxholiday on a manufacturing plant located in South Africa. This item is most likely to be:A)sporadic in nature, but the effect is typically neutralized by higher home country taxes on therepatriated profits.B) continuous in nature, so the termination date is not relevant.C)D)sporadic in nature, and the analyst should try to identify the termination date and determineif taxes will be payable at that time.continuous in nature, but the analyst will want to determine if the size of the tax benefit willchange during the foreseeable future.LOS 38i: Analyze disclosures relating to, and the effect of, deferred taxes.LOS 38j: Compare and contrast a company’s deferred tax items andeffective tax rate reconciliation (1) between reporting periods and (2) withthe comparable items reported by other companies.17

An analyst gathered the following information about a company:• Pretax income of $10,000• Taxes payable of $2,500• Deferred taxes of $500• Tax expense of $3,000What is the firm's reported effective tax rate?A) 5%.B) 25%.C) 30%.D) 35%.Reading 39: Analysis of Financing LiabilitiesLOS 39a: Distinguish between operating and trade debt related to operatingactivities and debt generated by financing activities.Current liabilities can be from operating activities (trade debt, wages payable, oradvances from customers) or from financing activities (short-term debt and thecurrent portion of long-term debt). A shift from operating liabilities to financingliabilities signals liquidity problems.Which of the following situations most likely describes a situation with deteriorating creditimplications?A)The ratio of short-term debt to trade payables increases because vendors reduce creditavailable to the firm.B)The ratio of short-term debt to trade payables increases because bank credit is less costlythan the vendors’ credit terms.C) The level of trade payables increases more rapidly than sales.D) There is a significant increase in cash advances from customers.LOS 39b: Determine the effects of debt issuance and amortization of bonddiscounts and premiums on financial statements and financial ratios.Balance Sheet: Bonds are always listed as a liability. Bonds issued at par arecarried at face value. Bonds issued at a premium will be carried at face valueplus the premium on the balance sheet and the premium is amortized to zeroover the life of the bond. Bonds issued at a discount will be carried at face valueless the discount on the balance sheet and the discount is amortized to zero overthe life of the bond.18

Income Statement (interest expense effect): Interest expense is equal to thebook value of the bonds at the beginning of the period multiplied by the marketrate of interest at issuance. For premium bonds, the interest expense will belower than the coupon, and the amortization of the premium will serve to reducethe interest expense that is shown on the income statement. For discount bonds,the interest expense will be higher than the coupon, and the amortization of thediscount will serve to increase the interest expense that is reported on theincome statement.Cash Flow: Cash flow from operations includes a deduction for interest expense.The amortization of bond discount or premium is a noncash charge to income,and therefore excluded from CFO. Since the coupon is higher for premiumbonds, CFO is understated relative to a firm that does not have premium bonds.The opposite is true for discount bonds - the CFO is overstated. Upon issuanceof a bond, CFF is increased by the amount of the proceeds and upon repaymentof the bond, CFF is reduced by the par value.A company issued an annual-pay bond with the following characteristics:Face value $67,831Maturity4 yearsCoupon 7.00%Market interest rates 8.00%What is the present value of the interest payments on the date when the bonds are issued?A) $65,582.B) $49,857.C) $18,992.D) $15,726.What is the unamortized discount on the date when the bonds are issued?A) $2,249.B) $15,729.C) $1,748.D) $499.19

What is the unamortized discount at the end of the first year?A) $1,209.B) $538.C) $1,750.D) $2,247.LOS 39c: Analyze the effect on financial statements and financial ratios ofissuing zero-coupon debt.Zero-coupon debt is debt issued with no periodic payments of interest andprincipal is paid back with one lump sum payment upon maturity; therefore, theirannual interest expense is implied. This severely overstates cash flow fromoperations.Which of the following statements regarding zero-coupon bonds is TRUE?A) A company should initially record zero-coupon bonds at their discounted present value.B) Interest expense is a combination of operating and financing cash flows.C)The interest expense in each period is found by applying the discount rate to the book valueof debt at the end of the period.D) The discount rate used to value the bond is the average current bond market interest rate.LOS 39d: Classify a debt security with equity features as a debt or equitysecurity and demonstrate the effect of issuing debt with equity features onthe financial statements and ratios.Convertible Bonds – GAAP requires that convertible bonds are recorded on thebalance sheet as if there were no conversion feature. For analysis, comparestock price to conversion price. If stock price is significantly higher thanconversion price, treat as an equity for calculating debt ratios. If the stock priceis significantly lower than the conversion price, treat like debtBonds with Warrants - When bonds are issued with warrants attached, theproceeds are allocated between the two components. The bond portion isrecognized as a liability and the warrants are recognized as equity.20

Jones Inc. has a capital structure consisting of $8 million of liabilities and $10 million of equity.Included in liabilities is $1.2 million worth of exchangeable bonds. Immediately afterwards, Jonesissues $0.7 million of redeemable preferred shares for cash proceeds and also calls its entiregroup of exchangeable bonds, netting a gain of $0.3 million on the bonds.Which of the following amounts is Jones’ revised debt to total capital ratio upon completion of thetwo new transactions?A) 0.458.B) 0.728.C) 0.845.D) 0.421.LOS 39e: Describe the disclosures relating to financing liabilities, anddiscuss the advantages/disadvantages to the company of selecting a givenfinancing instrument.Which of the following statements regarding commodity-linked bonds is least accurate?A) Commodity-linked bonds effectively convert interest expense from a fixed to a variable cost.B)C)D)Commodity-linked bonds are typically issued as part of a hedging strategy by firms that usethe commodity extensively in production.A higher commodity price increases the payments to bondholders but that is offset by thefact that there is more cash available to pay interest expense.For a commodity producer, issuing commodity-linked bonds will result in more stable timesinterest-earnedand cash-interest coverage ratios, compared to issuing conventional debt.LOS 39f: Determine the effects of changing interest rates on the marketvalue of debt and on financial statements and ratios.Under GAAP, balance sheet values for outstanding debt must be based on themarket rate on the date of issuance. Changes in market interest rates lead tochanges in the market values of debt. These gains and losses are not reflectedin the financial statements. For purposes of analysis, market value may be moreappropriate than book values.SFAS 107 requires disclosures about the fair value of outstanding debt based onyear-end or quarter-end prices.21

An increase in interest rates is most likely to benefit:A) firms with better credit ratings.B) firms that issued debt at a lower cost than current rates.C) firms with more equity than debt.D) firms with no debt.LOS 39g: Calculate and describe the accounting treatment of, andeconomic gains and losses resulting from, the various methods of retiringdebt prior to its maturity.When the payment to retire the debt prior to its maturity is greater than or lessthan its book value, a gain or loss is recorded. Unless the debt retirement is anextraordinary item, the gains and losses recorded affect income from continuingoperations. Analysts should back these gains and losses out of operatingearnings since there is no economic gain on the transaction.Retiring non-callable debt by funding a trust that will be used to meet the interest and principalpayments on the debt is called:A) defeasance.B) effective retirement.C) trust retirement.D) de facto termination.LOS 39h: Analyze the implications of debt covenants for creditors and theissuing company.Which of the following statements regarding bond covenants is least accurate?A) Bond covenants are typically disclosed in the footnotes to the financial statements.B) Bond covenants are important in valuing a firm’s credit risk.C) Bond covenants are important in valuing a firm’s equity including its growth prospects.D) All bond covenants are accounting-based, and affect a firm’s choice of accounting policies.22

Reading #40: Leases and Off-Balance Sheet DebtLOS 40a: Discuss the incentives for leasing assets instead of purchasingthem, and the incentives for reporting leases as operating leases ratherthan capital leases.Penguin Company is planning to lease a $5 million machine to produce goods for eventual sale.Penguin is able to structure the lease so as to classify it as either an operating or a capital lease.The advantages to Penguin of classifying this lease as an operating lease include all of thefollowing EXCEPT:The present value of the lease payments for Lease ABC is equal to 75 percent of the fair value ofthe asset, and the lease contains a bargain purchase option. Lease XYZ does not contain abargain purchase option, but the lease term is equal to 80 percent of the estimated economic lifeof the property. How should these leases be classified in the financial statements of the lessee?A) Both leases should be classified as operating leases.B) Lease ABC should be a capital lease, but Lease XYZ should be an operating lease.C) Both leases should be classified as capital leases.D) Lease ABC should be an operating lease, but Lease XYZ should be a capital lease.A)the lease is not reported as debt on Penguin's balance sheet, so leverage ratios are notincreased.B) the lease is not reported as an asset, so profitability ratios are not reduced.C) no disclosures of payments due under the lease are required.D) depreciation is not recorded.LOS 40b: Contrast the effects of capital and operating leases on thefinancial statements and ratios of lessees and lessors.Statements: Capital lease Operating leaseAssets Higher LowerLiabilities Higher LowerNet income (in the early yrs) Lower HigherCFO Higher LowerCFF Lower HigherTotal cash flow Same Same23

Ratios: Capital lease Operating leaseCurrent ratio (CA/CL) Lower HigherAsset turnover (Sales/TA) Lower HigherROA (EAT/TA) Lower HigherROE (EAT/E) Lower HigherDebt to Equity (D/E) Higher LowerOn December 31, Sandy Company enters into an 8-year lease for a printing press. The economiclife of the press is 10 years. Lease payments of $1,000,000 annually are due on December 31,beginning one year after lease signing. The interest rate implicit in the lease is 7%. SandyCompany’s incremental borrowing rate is 6%. Before entering into this lease, the balance sheetfor Sandy Company was as follows (in $):Cash 100,000 Accounts Payable 200,000Accounts Receivable 300,000 Long-term Debt 1,700,000Inventory 1,500,000 Common Stock 600,000Property, Plant & Equip. 5,200,000 Retained Earnings 4,600,000Total Assets 7,100,000 Total Liab. & Equity 7,100,000After executing this lease, Sandy Company’s long-term debt-to-equity ratio will:A) increase to 1.559.B) increase to 1.227.C) increase to 1.521.D) remain unchanged.LOS 40c: Describe the types of off-balance sheet financing and analyzetheir effects on selected financial ratios.Although the most common type of off-balance sheet financing, operating leasesare not the only type.Which of the following best describes a take-or-pay contract? In a take-or-pay contract:A)the purchasing firm commits to buying up to a maximum quantity of an input over aspecified time period.B) input prices are fixed over the life of the contract.C) input prices are based on market prices over the life of the contract.D)the purchasing firm commits to buying a minimum quantity of an input over a specified timeperiod.24

LOS 40d: Distinguish between sales-type leases and direct financingleases and explain their effects on the financial statements of the lessors.A lessor will most likely record a lease as a sales-type lease when:A) it is a dealer or seller of the leased equipment and the lease is a capital lease.B) it is a dealer or seller of the leased equipment.C) it is a dealer or seller of the leased equipment, and the lease is an operating lease.D) the lease is an operating lease.25