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.
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.
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.
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.
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
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.
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.
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.
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.
f 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.
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.
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.
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.
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
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.
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.
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).
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.
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.
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.
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.
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.
f 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
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.
