Reading 25: non-current (long-term) liabilities

Question 1

According to U.S. GAAP, the coupon payment on a bond is reported as:
an operating cash outflow.
a financing cash outflow.
part operating cash outflow and part financing cash outflow.

Answer 1

The actual coupon payment on a bond is reported as operating cash outflow under U.S. GAAP. (Module 25.1, LOS 25.a)

Question 2

Using the effective interest rate method, the reported interest expense of a bond issued at a premium will:
decrease over the term of the bond.
increase over the term of the bond.
remain unchanged over the term of the bond.

Answer 2

Interest expense is based on the book value of the bond. As the premium is amortized, the book value of the bond decreases until it reaches face value. (Module 25.2, LOS 25.b)

Question 3

A firm issues a $10 million bond with a 6% coupon rate, 4-year maturity, and annual interest payments when market interest rates are 7%.

The bond can be classified as a:
discount bond.
par bond.
premium bond.

Answer 3

This bond is issued at a discount since the coupon rate < market rate. (Module 25.1, LOS 25.a)

Question 4

A firm issues a $10 million bond with a 6% coupon rate, 4-year maturity, and annual interest payments when market interest rates are 7%.

The annual coupon payments will each be:
$600,000.
$676,290.
$700,000.

Answer 4

Coupon payment = (coupon rate × face value of bond) = 6% × $10,000,000 = $600,000. (Module 25.1, LOS 25.b)

Question 5

A firm issues a $10 million bond with a 6% coupon rate, 4-year maturity, and annual interest payments when market interest rates are 7%.

Total of all cash payments to the bondholders is:
$12,400,000.
$12,738,721.
$12,800,000.

Answer 5

Four coupon payments and the face value = ($600,000 × 4) + $10,000,000 = $12,400,000. (Module 25.1, LOS 25.b

Question 6

A firm issues a $10 million bond with a 6% coupon rate, 4-year maturity, and annual interest payments when market interest rates are 7%.

The initial book value of the bonds is:
$9,400,000.
$9,661,279.
$10,000,000.

Answer 6

The present value of a 4-year annuity of $600,000 plus a 4-year lump sum of $10 million, all valued at a discount rate of 7%, equals $9,661,279. Choice C can be eliminated because the bond was issued at a discount. (Module 25.2, LOS 25.b)

Question 7

A firm issues a $10 million bond with a 6% coupon rate, 4-year maturity, and annual interest payments when market interest rates are 7%.

For the first period the interest expense is:
$600,000.
$676,290.
$700,000.

Answer 7

Market interest rate × book value = 7% × $9,661,279 = $676,290. (Module 25.2, LOS 25.b

Question 8

A firm issues a $10 million bond with a 6% coupon rate, 4-year maturity, and annual interest payments when market interest rates are 7%.

If the market rate changes to 8% and the bonds are carried at amortized cost, the book value of the bonds at the end of the first year will be:
$9,484,581.
$9,661,279.
$9,737,568.

Answer 8

The new book value = beginning book value + interest expense – coupon payment = $9,661,279 + $676,290 – $600,000 = $9,737,569. The interest expense was calculated in question 7. Alternatively, changing N from 4 to 3 and calculating the PV will yield the same result. The change in market rates will not affect amortized costs. (Module 25.2, LOS 25.b)

Question 9

A firm issues a $10 million bond with a 6% coupon rate, 4-year maturity, and annual interest payments when market interest rates are 7%.

The total interest expense reported by the issuer over the life of the bond will be:
$2,400,000.
$2,738,721.
$2,800,000.

Answer 9

Coupon payments + discount interest = coupon payments + (face value – issue value) = $2,400,000 + ($10,000,000 – $9,661,279) = $2,738,721. (Module 25.2, LOS 25.b)

Question 10

A firm has bonds with a $10.0 million face value outstanding. The book value of the bond liability is $10.2 million when the firm redeems the bonds for face value. Redeeming the bonds will result in:
a loss on the income statement and a financing cash outflow.
a gain on the income statement and a financing cash outflow.
a loss on the income statement and an operating cash outflow.

Answer 10

The cash paid to redeem the bonds is a CFF outflow. Because the redemption price is less than the book value of the liability, the firm will recognize a gain. (LOS 25.c)

Question 11

The purpose of debt covenants is best described as:
limiting issuance costs.
preventing technical default.
protecting the interests of creditors.

Answer 11

Debt covenants exist to protect the interests of creditors. A bond is considered to be in “technical” default if the borrower violates the bond’s covenants. (LOS 25.d)

Question 12

Which of the following is least likely to be disclosed in the financial statements of a bond issuer?
The amount of debt that matures in each of the next five years.
Collateral pledged as security in the event of default.
The market rate of interest on the balance sheet date.

Answer 12

The market rate on the balance sheet date is not typically disclosed. The amount of debt principal scheduled to be repaid over the next five years and collateral pledged (if any) are generally included in the footnotes to the financial statements. (LOS 25.e)

Question 13

Compared to purchasing a long-lived asset using debt financing, leasing the asset most likely:
is more costly to the lessee.
requires a greater initial cash outflow from the lessee.
allows the lessee to avoid the risk of obsolescence.

Answer 13

Avoiding the risk of obsolescence is one of the advantages of leasing assets instead of purchasing them. At the end of a lease, the lessee often returns the leased asset to the lessor, and therefore does not bear the risk of an unexpected decline in the asset’s end-of-lease value. The interest rate implicit in a lease contract may be less than the interest rate on a loan to purchase the asset. The terms of a lease may not require all the covenants typically included in loan agreements or bond indentures. (LOS 25.f)

Question 14

During the life of a long-term lease under IFRS, the lessee recognizes:
interest expense only.
amortization expense and interest expense.
neither amortization expense nor interest expense.

Answer 14

At lease inception, the lessee records a right-of-use asset and a lease liability, both equal to the present value of the lease payments. In each period over the life of the lease, the lessee recognizes interest expense for the interest portion of the lease payments and amortization expense on the right-of-use asset. (LOS 25.g)

Question 15

For the lessor, cash flows from a lease are classified as:
operating.
investing.
financing.

Answer 15

Cash flows from a lease are operating cash inflows for the lessor. (LOS 25.h)

Question 16

A net pension asset or liability can be associated with:
defined benefit pension plans only.
defined contribution pension plans only.
either defined benefit or defined contribution pension plans.

Answer 16

Defined benefit pension plans can be overfunded and result in a net pension asset, or they can be underfunded and result in a net pension liability. Defined contribution plans do not result in balance sheet assets or liabilities because they are neither owned by the sponsoring firm or obligations of the sponsoring firm. (LOS 25.i)

Question 17

At the end of last year, Maui Corporation’s assets and liabilities were as follows:

total assets: 98000
accrued liabilities: 5000
short-term debt: 12000
bonds payable: 39000

Maui’s debt-to-equity ratio is closest to:

1.2.
1.3.
1.4.

Answer 17

Because A – L = E, shareholders’ equity is 98,500 assets – 5,000 accrued liabilities – 12,000 short-term debt – 39,000 bonds payable = $42,500. Thus, debt-to-equity is (12,000 short-term debt + 39,000 bonds payable) / 42,500 equity = 1.2. Only interest-bearing liabilities are considered debt. Accrued liabilities are not interest bearing. (LOS 25.j)