chapter 9

Question 1

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.

Answer 1

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.

Question 2

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.

Answer 2

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.

Question 3

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.

Answer 3

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.

Question 4

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.

Answer 4

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.

Question 5

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

Answer 5

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

Question 6

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.

Answer 6

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

Question 7

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.

Answer 7

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

Question 8

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.

Answer 8

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

Question 9

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.

Answer 9

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

Question 10

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.

Answer 10

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.

Question 11

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.

Answer 11

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.

Question 12

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.

Answer 12

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.

Question 13

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.

Answer 13

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.

Question 14

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.

Answer 14

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

Question 15

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.

Answer 15

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.

Question 16

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.

Answer 16

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.

Question 17

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.

Answer 17

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).

Question 18

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.

Answer 18

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.

Question 19

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.

Answer 19

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.

Question 20

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.

Answer 20

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

Question 21

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.

Answer 21

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.

Question 22

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.

Answer 22

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.

Question 23

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

Answer 23

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

Question 24

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.

Answer 24

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.

Question 25

For the lessee, during the later years of a
finance lease:
A. the debt-to-equity ratio will increase compared
to the initial years.
B. a higher net profit (margin) will be obtained
versus an operating lease.
C. a high asset turnover ratio will be obtained
versus the operating lease.

Answer 25

Ans: B.
In the later years of a finance lease, the net profit (margin) will be
greater than the net profit (margin) reported with an operating lease.
Although rent expense is normally constant throughout the term of an
operating lease, interest expense declines in a finance lease as the
lease obligation is reduced while depreciation expense remains
constant. This leads to lower total expenses in the later years of a
finance lease versus an operating lease and a higher reported net profit
(margin).
A is incorrect. Through the passage of time, the lease obligation with a
finance lease is reduced leading to a lower debt-to-equity ratio
compared to the early years.
C is incorrect. Although the asset turnover ratio rises over time as the
leased asset is depreciated with a finance lease, the asset turnover
remains higher with an operating lease since the leased asset is never
recorded with an operating lease.

Question 26

A company is considering issuing $10,000,000
of long-term debt with a 6% coupon rate or the
same amount of convertible debt with a 5%
coupon rate. Both will be issued at par and have
the same maturity. Which statement below best
describes the impact on the firm’s debt ratio?
A. The debt ratio would be higher for U.S.GAAP
than for IFRS.
B. The debt ratio would be lower for U.S.GAAP
than for IFRS.
C. The debt ratio would be the for U.S.GAAP than
for IFRS.

Answer 26

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

Question 27

When a bondholder converts a convertible
bond, the effects on the corporation’s subsequent
financial statements will include a:
A. An increase in tax expense and an increase to
the debt-to-equity ratio.
B. An increase in tax expense and a decrease to
the debt-to-equity ratio.
C. A decrease in tax expense and an increase to
the debt-to-equity ratio.

Answer 27

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

Question 28

The most likely impact on a lessee’s financial
statements from reporting a lease as a finance
lease rather than as an operating lease will be:
A. Unchanged total lease expense over the lease
term.
B. Lower operating cash flows during the life of
the finance lease.
C. Lower operating profit (margin) in the early
years of the finance lease.

Answer 28

Ans. A.
Although the annual lease expense in any given year is different
between an operating and a finance lease, over the life of the lease
(lease term) both methods will result in the same total lease expense.
B is incorrect. Under a finance lease, only the interest payments are
outflows from operating activities, while the principal payments are
outflows from financing activities. All operating lease payments are
outflows from operating activities, resulting in lower operating cash
flows during the lease term if the lease is an operating lease.
C is incorrect. Operating profit margins are higher (rather than lower)
during the entire term of a finance lease because only the related
depreciation expense, rather than the entire lease payment is included
in operating expenses. However, the interest portion of the payment is
reflected in pretax earnings and net profit margins, both of which will
be lower in the early years of a fiancé lease as the combined
deprecation and interest expense will be in excess of the lease
payment.

Question 29

An analyst is assessing a company that
entered into a take-or-pay contract during the
year and also has significant number of operating
leases. Which of the following statement is the
least accurate?
A. The company’s financial statements must be
adjusted before the analyst compares this
company to other companies in its industry.
B. Despite the off-balance sheet nature of take-
or-pay contracts and operating leases, an attempt
to determine the actual financial position of the
company can be garnered from the footnotes.
C. The take-or-pay contracts and operating leases
mean that this company has much higher
business risk than similar companies that do not
use off-balance sheet financing techniques.

Answer 29

Ans. C.
The existence of take-or-pay contracts and operating leases does not
necessarily increase the business risk of a company when compared to
companies that do not use off-balance seet financing techniques,
although the existence of the obligations must be considered when
analyzing business risk.
A is incorrect. When companies make use of off-balance sheet financing
techniques, the financial statements must be adjusted before the
company’s financing position and operating results can be analyzed and
compared to other companies.
C is incorrect. It is not difficult to determine the true financial position
of companies that use off-balance sheet financing techniques because
both IFRS and U.S.GAAP require extensive footnote disclosures
regarding off-balance sheet financing. The information in the
disclosures can be used to adjust the financial statements for the off-
balance sheet items

Question 30

Which of the following is most likely a reason
that a lessor can offer attractive lease terms and
lower cost financing to a lessee? Because the:
A. Lessor retains the tax benefits of ownership.
B. Lessor avoids reporting the liability on its
balance sheet.
C. Lessee is better able to resell the asset at the
end of the lease

Answer 30

Ans: A.
The lessor often retains the tax benefits of ownership of the leased
asset, which allows the lessor to pass those savings along to the lessee
in the form of lower financing costs or other attractive terms.
B is incorrect. Lessor owns the asset.
C is incorrect. The lessee does not own the asset.

Question 31

Compared to classifying a lease as a
financing lease, if a lessee reports the lease as an
operating lease it will most likely result in a:
A. lower return on assets.
B. higher debt-to-equity ratio.
C. lower cash from operations.

Answer 31

Ans: C.
The cash from operations is lower if the lease is classified as an
operating lease, because the full lease payment is shown as an
operating cash outflow. If it were classified as a financing lease, only
the portion of the lease payment relating to interest expense reduces
the operating cash flow and the portion of the lease payment that
reduces the lease liability is classified as a financing cash flow.
Therefore, the lessee’s cash from operations tends to be lower under
operating leases.
The following two figures summarize the difference between the effects
of finance leases and operating leases on the financial statements and
ratios of the lessee.

Question 32

Which of the following is most likely a benefit
of debt covenants for the borrower?
A. Reduction in the cost of borrowing.
B. Limitations on the company’s ability to pay
dividends.
C. Restrictions on how the borrowed money may
be invested.

Answer 32

Ans: A.
Debt covenants are restrictions imposed by the lender on the borrower
to protect the lender’s position. Debt covenants can reduce default risk
and thus reduce borrowing costs.
B is incorrect. This is a disadvantage of using debt covenants for the
borrower.
C is incorrect. This is a disadvantage of using debt covenants for the
borrower.

Question 33

An analyst makes the appropriate
adjustments to the financial statements of retail
companies that are lessees using a substantial
number of operating leases. Compared to ratios
computed from the unadjusted statements, the
ones computed from the adjusted statements
would most likely be higher for:
A. the debt-equity ratio but not the interest
coverage ratio.
B. the interest coverage ratio but not the debt-
equity ratio.
C. both the debt-equity ratio and the interest
coverage ratio.

Answer 33

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