Review for the June 2008 Level 1 CFA Exam Study Session 9 Tuesday, February 26, 2008 Assets and Liabilities

Review for the June 2008 Level 1 CFA Exam Study Session 9 Tuesday, February 26, 2008 Assets and Liabilities Kris Clark 404.413.7208 or kjclark@gsu.edu Reading 35: Analysis of Inventories LOS 35a: Compute inventory balances and COGS using LIFO, FIFO, and average cost methods. Beginning inventory + Purchases COGS = Ending Inventory GAAP requires inventory valuation on the basis of lower of cost or market (LCM) regardless of inventory costing method. Three methods for inventory accounting: FIFO, LIFO, and Average Cost (NOTE: be able to answer questions by cranking numbers or conceptually see LO s below!) Baldwin, Inc. uses the last in, first out (LIFO) inventory cost flow assumption. Inventory transactions for beginning inventory and for furniture purchased and sold during 2007 were as follows: Units Unit Cost Total Cost Beginning Inventory 100 $500 $50,000 Purchases March 1, 200 $550 $110,000 2007 Sales March 18, 2007-300 Purchases August 30,2007 300 $600 $180,000 Baldwin, Inc. s balance sheet at December 31, 2007 will show furniture inventory of: A) $160,000. B) $170,000. C) $150,000. D) $180,000. 1

In 2004, Torrence Co. had a beginning inventory of $19,924 and made purchases of $15,923. If the 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 understated by $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 a small 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 the owner leaves for her voice lesson, she hands Webster a photocopy of the inventory data for the current 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 sticky note 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? All else 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 inventory and COGS data provided by LIFO, FIFO, and average cost methods when prices are stable or changing. In periods of changing prices, different inventory costing methods affect the comparability of financial statements between firms. If prices of good do not change, the n the different inventory valuation methods do not affect the financial statements. During periods of changing prices, FIFO will provide the most useful estimate of the 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 best inventory balance on the balance sheet. In a period of rising prices, FIFO gives the best COGS, whereas LIFO gives the best inventory 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 cash flows 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 on COGS and inventory balances and discuss how a company s choice of inventory accounting method affects other financial items such as income, cash flow, and work capital. The LIFO to FIFO conversion. FIFO Inventory = LIFO Inventory + LIFO Reserve COGS 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 current value. COGS LIFO = COGS FIFO + (BI FIFO x inflation rate) NOTE: Inflation rate should not be a general inflation rate for the economy but should be an inflation rate appropriate for the firm or industry. When prices are changing, an analyst should use LIFO-based values for income statement items and ratios, and FIFO-based values for balance sheet items and ratios. In periods of rising prices and stable or increasing inventories: LIFO Higher COGS Lower taxes Lower net income (EBT & EAT) Lower inventory balances Lower working capital Higher cash flows (less taxes paid out) FIFO Lower COGS Higher taxes Higher net income (EBT & EAT) Higher inventory balances Higher working capital Lower cash flows (more taxes paid out) In periods of rising prices and stable or increasing inventories: LIFO Higher COGS Lower taxes Lower net income (EBT & EAT) Lower inventory balances Lower working capital Higher cash flows (less taxes paid out) FIFO Lower COGS Higher taxes Higher net income (EBT & EAT) Higher inventory balances Higher working capital Lower 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 $4,300 What 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 LIFO reserve of $4,000, the estimated value for the inventory on a first in, first out (FIFO) basis would be: A) $13,000. B) $26,000. C) $18,000. D) $24,000. LOS 35d: Compare and contrast the effects of the choice of inventory method on profitability, liquidity, activity, and solvency ratios. Profitability LIFO produces COGS balances that are higher Profitability ratios are lower under LIFO Liquidity FIFO produces inventory figures that are higher Liquidity ratios are higher under FIFO Activity LIFO produces a better estimate of COGS FIFO produces a better estimate of inventory Inventory turnover ratio is always higher when using LIFO Solvency The balance sheet must be adjusted by accounting for the LIFO reserve Solvency ratios will be lower under FIFO 5

Selected information from Oldtown, Inc. s financial statements for the year ended December 31, 2004 included the following (in $): Cash 1,320,000 Accounts Payable 1,620,000 Accounts Receivable 2,430,000 Deferred Tax Liability 715,000 Inventory 6,710,000 Long-term Debt 15,230,000 Property, Plant & Equip. 12,470,000 Common Stock 1,000,000 Total Assets 22,930,000 Retained Earnings 4,365,000 Total Liabilities & Equity 22,930,000 Sales 15,000,000 Net Income 3,000,000 LIFO Reserve at Jan. 1 1,620,000 LIFO Reserve at Dec. 31 1,620,000 Oldtown uses the last in, first out (LIFO) inventory cost flow assumption. The tax rate was 40 percent. If Oldtown changed from LIFO to first in, first out (FIFO) for 2004, net profit margin would: 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 a given period and evaluate the implications of such a decline for financial analysis. The LIFO reserve will decline if inventory quantity is falling and/or prices are falling. In periods of falling prices, which of the following statements is TRUE? Compared to FIFO, LIFO results 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 statements and 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 net realizable 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 a cost of $90 each. Due to an oversupply of recorders remaining in the marketplace due to lower than anticipated demand during the Christmas season, the selling price at December 31 is $80 and the replacement cost is $73. The normal profit margin is 5 percent of the selling price and the selling 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: Capitalization LOS 36a: Demonstrate the effects of capitalizing versus expensing on net income, shareholders equity, cash flow from operations, and financial ratios. Capitalizing Expensing Income Variability Lower Higher Profitability-Early Years (ROA&ROE) Profitability-Later Years (ROA&ROE) Higher Lower Lower Higher Total Cash Flows Same Same Cash Flow from Operations Higher Lower Cash Flow from Investing Lower Higher Leverage Ratios (D/E & D/A) Lower Higher 7

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

Under U.S. generally accepted accounting principles (GAAP), which of the following costs associated 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 Impairment LOS 37a: Demonstrate the different depreciation methods and explain how the 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 Line Units of Production or Service Hours Sum of the Year s Digits Double Declining Balance NOTE: Sinking fund depreciation where depreciation expense actually increases each year so that the asset earns the same rate of return each year is prohibited in 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-line The 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 useful life of 5 years and $4,000 salvage value. The amount of depreciation expense recognized in 2006 assuming that JME uses the double declining balance method is: A) $4,000. B) $3,456. C) $5,760. D) $8,000. Straight Line Accelerated Depreciation expense Lower Higher Net income Higher Lower Assets Higher Lower Equity Higher Lower ROA Higher Lower ROE Higher Lower Turnover ratios Lower Higher Cash flow Same Same Roger Margotta, the CFO of Brainchild, Inc., is considering several alternative methods of depreciation for long-term assets. With respect to double-declining method of depreciation, which of 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 decreasing earnings trend. LOS 37b: Demonstrate how modifying the depreciation method, the estimated useful life, and/or the salvage value affect financial statements and ratios. Change in depreciation method is a change in an accounting principles and therefore requires the cumulative effect of the change on past income to be shown net of tax on the income statement. 10

Change in useful life and/or salvage value is a change in accounting estimate and do not require past income to be restated. In 2005, Carpet Company decides to change from the straight-line method of depreciation to the sum of the year s digits method. The following information is available: Pre-2005 2005 Straight Line Depreciation $1,600,000 $400,000 Sum of the Years Digits $2,300,000 $500,000 On its 2005 financial statements, Carpet will report: A) B) C) D) $400,000 depreciation expense in the 2005 income statement and $800,000 separately as a change in accounting principle net of taxes. $1,200,000 depreciation expense in the 2005 income statement and include a footnote of explanation including the tax effect. $500,000 depreciation expense and restate prior period financial statements to reflect the change net of taxes. $500,000 depreciation expense in the 2005 income statement and $700,000 separately as a change in accounting principle net of taxes. LOS 37c: Determine the average age and average depreciable life of a company s assets using the company s fixed asset disclosures. Average Age in Years: accumulated depreciation depreciation expense Relative Age: accumulated depreciation ending gross investment Average Depreciable Life: ending gross investment depreciation expense 11

Determine the average age as a percent of depreciable life and the average age of the plant and equipment 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% 4 B) 24% 6 C) 25% 6 D) 24% 4 LOS 37d: Explain and illustrate the use of impairment charges and their effect on financial statements and ratios. GAAP require that assets be carried at acquisition cost less accumulated depreciation AND that carrying amounts be reduced to market value when there is no longer an expectation that net balance sheet values can be recovered from future operations. Impairments are reported on the income statement pretax (above the line) as a component of income from continuing operations. In the U.S. impairments cannot be restored. However, the IASB allow firms to recognize increases in value. In testing for impairment, undiscounted future cash flows are used to compare to the 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 items and 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 remedying environmental damage caused by operating assets and the related financial statement and ratio effects. SFAS 143 requires a consistent treatment of the ARO (asset retirement obligation) from obligations related to remedying environmental damage caused by a company. Which of the following statements regarding the financial statement impact of recording liabilities resulting from the application of SFAS 143 is TRUE? In accounting periods following an asset acquisition, liability values are: A) B) C) D) accreted in a manner similar to interest for bond amortization. The difference here is that the interest component falls through time instead of rising. accreted in a manner similar to interest for bond amortization. This accretion is recorded as a gain on the income statement. recorded as an expense on the income statement that is recorded over a period of ten years or the life of an asset whichever is less. accreted in a manner similar to interest for bond amortization. The difference here is that the interest component rises through time instead of falling. Reading 38: Analysis of Income Taxes LOS 38a: Explain the key terms related to income tax accounting and the origin 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 that includes taxes payable and deferred income tax expense. NOTE: the income tax expense is composed of taxes payable plus noncash items such as changes in deferred tax assets and liabilities. Income Tax Expense = Taxes Payable + DTL - DTA A deferred tax liability is created when an income or expense item is treated differently on financial statements that it is on the company s tax returns, and that difference results in greater tax expense on the financial statements that taxes payable on the tax return. Often occurs when an accelerated method of depreciation 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 expense on the financial statements than on the tax return. Warranty expense is a good example since warranty expense is accrued for financial reporting purposes but is 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 deferred taxes. The liability method of accounting for deferred taxes starts from the premise that differences between taxes calculated on the income statement (GAAP) and taxes from 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 statements is 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 tax rate. Income tax expense = Taxes payable - Change in Deferred tax asset + Change in Deferred tax liability. Changes in the tax rate are recognized in the reported income the year the change is enacted. LOS 38c: Discuss the use of valuation allowances for deferred tax assets and their implications for financial statement analysis. Deferred tax assets can have a valuation allowance, which is a contra account against deferred tax assets based on the likelihood that these assets will not be realized. For deferred tax assets to be beneficial, the firm must have future taxable income. If there is a greater than 50% probability that a portion of deferred tax assets will not be realized, the deferred tax asset must be reduced by 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 valuation allowance on its balance sheet? A) To report depreciation, a firm uses the double-declining balance method for tax purposes and 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 to reverse. A firm is unlikely to have future taxable income that would enable it to take advantage of deferred tax assets. LOS 38d: Explain the factors that determine whether a company s deferred tax liabilities should be treated as a liability or as equity for purposes of financial analysis. If deferred tax liabilities are expected to reverse in the future, then they are best classified as liabilities. If deferred tax liabilities are not expected to reverse in the future, they are best classified as equity. Which of the following financial ratios is least likely to be affected by classification of deferred taxes 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 pretax financial income and taxable income. Temporary differences are differences in taxable and pretax incomes that will reverse in future years. They result in deferred tax assets or liabilities. Permanent differences are differences in taxable and pretax incomes that will not reverse. They do not result in deferred tax liabilities or assets. Permanent differences are reflected in a difference between a firm s effective tax rate and its statutory tax rate. 15

LOS 38f: Calculate and interpret income tax expense, income taxes payable, 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 no salvage 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 purposes depreciation is accelerated to 35 percent in years 1 and 2 and 30 percent in Year 3. For purposes of 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 tax accounts related to a change in the tax rate. All balance sheet deferred tax assets and liabilities are revalued when the tax rate the firm will face in the future changes. If the tax rate increases, the increase in deferred tax liabilities increases the income tax expense and the increase in deferred tax assets decreases the income tax expense. If the t ax rate decreases, the decrease in deferred tax liabilities decreases income tax expense, and the decrease in deferred tax assets increases income tax expense. NOTE: The most common occurrence is that deferred tax liabilities exceed deferred tax assets. 16

An analyst has gathered the following tax information: Year 1 Year 2 Pretax Income $60,000 $60,000 Taxable Income $50,000 $65,000 The current tax rate is 40 percent. Assume the tax rate is reduced to 30 percent and the change is enacted at the beginning of Year 2. In year 1, what are the taxes payable and what is the deferred tax liability? Taxes Payable Deferred Tax Liability A) $20,000 $1,500 B) $24,000 $3,000 C) $24,000 $1,500 D) $20,000 $3,000 LOS 38h: Interpret a deferred tax footnote disclosure that reconciles the effective and statutory tax rates. SFAS 109 While evaluating the financial statements of Omega, Inc., the analyst observes that the effective tax rate is 7% less than the statutory rate. The source of this difference is determined to be a tax holiday 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 the repatriated 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 determine if taxes will be payable at that time. continuous in nature, but the analyst will want to determine if the size of the tax benefit will change 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 and effective tax rate reconciliation (1) between reporting periods and (2) with the 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 $3,000 What is the firm's reported effective tax rate? A) 5%. B) 25%. C) 30%. D) 35%. Reading 39: Analysis of Financing Liabilities LOS 39a: Distinguish between operating and trade debt related to operating activities and debt generated by financing activities. Current liabilities can be from operating activities (trade debt, wages payable, or advances from customers) or from financing activities (short-term debt and the current portion of long-term debt). A shift from operating liabilities to financing liabilities signals liquidity problems. Which of the following situations most likely describes a situation with deteriorating credit implications? A) The ratio of short-term debt to trade payables increases because vendors reduce credit available to the firm. B) The ratio of short-term debt to trade payables increases because bank credit is less costly than 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 bond discounts and premiums on financial statements and financial ratios. Balance Sheet: Bonds are always listed as a liability. Bonds issued at par are carried at face value. Bonds issued at a premium will be carried at face value plus the premium on the balance sheet and the premium is amortized to zero over the life of the bond. Bonds issued at a discount will be carried at face value less the discount on the balance sheet and the discount is amortized to zero over the life of the bond. 18

Income Statement (interest expense effect): Interest expense is equal to the book value of the bonds at the beginning of the period multiplied by the market rate of interest at issuance. For premium bonds, the interest expense will be lower than the coupon, and the amortization of the premium will serve to reduce the 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 the discount will serve to increase the interest expense that is reported on the income 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 premium bonds, 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 issuance of a bond, CFF is increased by the amount of the proceeds and upon repayment of the bond, CFF is reduced by the par value. A company issued an annual-pay bond with the following characteristics: Face value $67,831 Maturity 4 years Coupon 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 of issuing zero-coupon debt. Zero-coupon debt is debt issued with no periodic payments of interest and principal is paid back with one lump sum payment upon maturity; therefore, their annual interest expense is implied. This severely overstates cash flow from operations. 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 value of 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 equity security and demonstrate the effect of issuing debt with equity features on the financial statements and ratios. Convertible Bonds GAAP requires that convertible bonds are recorded on the balance sheet as if there were no conversion feature. For analysis, compare stock price to conversion price. If stock price is significantly higher than conversion price, treat as an equity for calculating debt ratios. If the stock price is significantly lower than the conversion price, treat like debt Bonds with Warrants - When bonds are issued with warrants attached, the proceeds are allocated between the two components. The bond portion is recognized 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, Jones issues $0.7 million of redeemable preferred shares for cash proceeds and also calls its entire group 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 the two new transactions? A) 0.458. B) 0.728. C) 0.845. D) 0.421. LOS 39e: Describe the disclosures relating to financing liabilities, and discuss the advantages/disadvantages to the company of selecting a given financing 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 use the commodity extensively in production. A higher commodity price increases the payments to bondholders but that is offset by the fact that there is more cash available to pay interest expense. For a commodity producer, issuing commodity-linked bonds will result in more stable timesinterest-earned and cash-interest coverage ratios, compared to issuing conventional debt. LOS 39f: Determine the effects of changing interest rates on the market value of debt and on financial statements and ratios. Under GAAP, balance sheet values for outstanding debt must be based on the market rate on the date of issuance. Changes in market interest rates lead to changes in the market values of debt. These gains and losses are not reflected in the financial statements. For purposes of analysis, market value may be more appropriate than book values. SFAS 107 requires disclosures about the fair value of outstanding debt based on year-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, and economic gains and losses resulting from, the various methods of retiring debt prior to its maturity. When the payment to retire the debt prior to its maturity is greater than or less than its book value, a gain or loss is recorded. Unless the debt retirement is an extraordinary item, the gains and losses recorded affect income from continuing operations. Analysts should back these gains and losses out of operating earnings 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 principal payments 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 the issuing 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 Debt LOS 40a: Discuss the incentives for leasing assets instead of purchasing them, and the incentives for reporting leases as operating leases rather than 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 the following EXCEPT: The present value of the lease payments for Lease ABC is equal to 75 percent of the fair value of the asset, and the lease contains a bargain purchase option. Lease XYZ does not contain a bargain purchase option, but the lease term is equal to 80 percent of the estimated economic life of 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 not increased. 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 the financial statements and ratios of lessees and lessors. Statements: Capital lease Operating lease Assets Higher Lower Liabilities Higher Lower Net income (in the early yrs) Lower Higher CFO Higher Lower CFF Lower Higher Total cash flow Same Same 23

Ratios: Capital lease Operating lease Current ratio (CA/CL) Lower Higher Asset turnover (Sales/TA) Lower Higher ROA (EAT/TA) Lower Higher ROE (EAT/E) Lower Higher Debt to Equity (D/E) Higher Lower On December 31, Sandy Company enters into an 8-year lease for a printing press. The economic life 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%. Sandy Company s incremental borrowing rate is 6%. Before entering into this lease, the balance sheet for Sandy Company was as follows (in $): Cash 100,000 Accounts Payable 200,000 Accounts Receivable 300,000 Long-term Debt 1,700,000 Inventory 1,500,000 Common Stock 600,000 Property, Plant & Equip. 5,200,000 Retained Earnings 4,600,000 Total Assets 7,100,000 Total Liab. & Equity 7,100,000 After 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 analyze their effects on selected financial ratios. Although the most common type of off-balance sheet financing, operating leases are 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 a specified 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 time period. 24

LOS 40d: Distinguish between sales-type leases and direct financing leases 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