Financial Reporting and Analysis Session 6 - Reading 21

CFA Level 2 - Financial Reporting and Analysis Session 6 - Reading 21 (Practice Questions, Sample Questions) 1. Selected information from Yorktown Corp.’s financial statements for the year ended December 31, 2004 was as follows (in $ millions): Accounts Payable 8 Long-term Debt 9 Common Stock 17 Retained Earnings 23 Total Liabilities & Equity 57 In 2004, Yorktown paid $10 million cash to purchase a franchise. The franchise cost was fully expensed in 2004. If the company had elected to amortize the franchise cost over 5 years instead of expensing it, Yorktown’s total debt ratio (total debt-to-total capital) would (ignore taxes): A) decrease from 0.298 to 0.262. B) increase from 0.474 to 0.551. C) decrease from 0.474 to 0.403. {Explanation: Total capital equals total assets which must equal total liabilities and equity. Yorktown’s total debt ratio was (($8 + $9) / $57 =) 0.298. If the franchise cost were amortized, retained earnings would be increased $8 million ($10 cost less ($10 / 5 =) $2 million of amortization.) The total debt ratio would change to (($8 + $9) / ($57 + $8) =) 0.262.} 2. Which of the following statements regarding the capitalization of an expense is least accurate? A) Capitalizing an expense creates an asset. B) Capitalizing an expense lowers current period net income. C) Capitalized expenses increases equity. {Explanation: Capitalizing expenses reduces current period expenses by the amount capitalized. The amount capitalized is added to assets which increases equity by increasing net income and retained earnings in the current period.} 3. When comparing capitalizing versus expensing costs which of the following statements is most accurate? A) Capitalizing costs creates higher cash flows from operations and lower cash flows from investing. B) Expensing costs creates lower cash flows from operations and lower cash flows from investing. C) Capitalizing costs creates lower cash flows from operations and higher cash flows from investing. {Explanation: Although net cash flows are not affected by the choice of capitalization or expensing, the components of cash flow are affected. Because, a firm that capitalizes classifies the expenditure as investing (not operations), cash flow from operations will be higher for firms that capitalize and investing cash flows will be lower than that of an expensing firm.} 4.Compared with firms that expense costs, firms that capitalize costs can be expected to report: A) higher asset levels and higher equity levels in the early years of the asset's life. B) higher asset levels and lower equity levels in the early years of the asset's life. C) lower asset levels and higher equity levels in the early years of the asset's life. {Explanation: The capitalized cost is recorded as an asset, which is then expensed in the form of depreciation over future years. Spreading the depreciation out over future years causes net income to increase along with retained earnings and equity in the early years of the asset’s life.} 5. 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. {Explanation: The cost of an acquisition of a patent from an outside entity is correct because this cost may be capitalized.} 6. Capitalizing interest costs related to a company’s construction of assets for its own use is required by: A) both IFRS and U.S. GAAP. B) IFRS only. C) U.S. GAAP only. {Explanation: Both U.S. GAAP and IFRS require companies to capitalize the interest that accrues during a the construction of capital assets for their own use.} 7. Which of the following statements regarding finance and operating leases is least accurate? A) For financial reporting of finance and operating leases, no entry is required on the lessee's balance sheet at the inception of the lease. B) During the life of an operating lease, the rent expense equals the lease payment. C) Asset turnover is higher for the lessee with an operating lease than a finance lease. {Explanation: If the lease is an operating lease there is no entry made on the balance sheet for the lessee. For finance leases, the leased asset and liability are recognized on the balance sheet by the amount equal to the present value of the minimum lease payments using as the discount rate the lower of the lessor's implicit rate or the lessee's incremental borrowing rate.} 8. Which of the following statements about leases is least accurate? A) In the first years of a finance lease, the lessee's debt to equity ratio is greater than it would have been if the firm had used an operating lease. B) In the first years of a finance lease, the lessee's current ratio is greater than it would have been had the firm used an operating lease. C) All else equal, when a lease is capitalized the lessee's income will rise over the term of the lease. {Explanation: From the lessee's perspective, if a lease is considered to be a finance lease instead of an operating lease, then the lessee's current liabilities will be greater until the lease has expired. This will result in a lower current ratio (larger denominator). In the early years, the capitalized lease expense (interest plus depreciation) is greater than in the later years because interest expense decreases over time. Less expenses = more income. In the first years of a finance lease the lessee's debt to equity ratio will be greater than if the firm had used an operating lease because in the case of the finance lease, the numerator is comprised of (debt + lease), while the numerator in the case of the operating lease is (debt) only. In addition, the greater capitalized lease expense flows through to decrease shareholder's equity (the denominator).} 9. Which of the following statements regarding the effect of a finance lease on the lessee's statement of cash flows is least accurate? A) The change in the finance lease liability on the balance sheet is a cash flow from financing. B) The interest expense portion of the lease payments reduces cash flow from operations. C) The rental expense serves to reduce the cash flow for financing because it is an investment expense. {Explanation: In finance leases, there is only interest expense and principal repayment. Rental expense is only charged when the lease is an operating lease.} 10. Which of the following statements about leasing is least accurate? A) Firms that capitalize their leases will have lower current ratios and higher debt to equity ratios than firms that structure their leases as operating leases. B) The interest rate implicit in a lease is the discount rate that the lessor used to determine the lease payments. C) If the lessor is only financing the purchase of an asset, the lease is considered to be a direct financing lease and gross profits are recognized at the inception of the lease. {Explanation: With a direct financing lease, the lessor recognizes profit as interest revenue over the life of the lease. A sales-type lease allows the lessor to recognize profits at the lease inception.} 11. Which of the following statements regarding a direct financing lease is least accurate? A) The principal portion of the lease payment is a cash inflow from investing on the lessor's cash flow statement. B) The lessor recognizes no gross profit at the inception of the lease. C) Interest revenue on the lessor's income statement equals the implicit interest rate times the lease payment. {Explanation: Interest revenues are calculated by multiplying the implicit interest rate by net receivables at the beginning of the period.} 12. If a lessee enters into a finance lease rather than an operating lease, it can expect to have a: A) higher debt-to-equity ratio. B) higher return on assets. C) lower debt-to-equity ratio. {Explanation: Leasing the asset with an operating lease avoids recognition of the debt on the lessee’s balance sheet. Having fewer assets and liabilities on the balance sheet than would exist if the assets were purchased increases profitability ratios (e.g., return on assets) and decreases leverage ratios (e.g., debt-to-equity ratio). In the case of a finance lease, the assets are reported on the balance sheet and are depreciated.} 13. For a given lease payment and term, which of the following is least accurate regarding the effects of the classification of the lease as a finance lease as compared to an operating lease? A) The lessee's asset turnover will be lower for a finance lease. B) The lessee's current ratio will be higher for a finance lease. C) The lessee's debt-to-equity ratio will be higher for a finance lease. {Explanation: The lessee's current ratio will be lower because the current portion of the finance lease increases current liabilities, hence reducing the current ratio.} 14. If a lease is treated as a finance lease, as compared to being treated as an operating lease, the effect on the lessee's current ratio and the debt/equity ratio will be an: Current Ratio Debt/Equity Ratio A) Decrease Increase B) Increase Increase C) Increase Decrease {Explanation: With finance leases the lessee's assets, current liabilities, and long-term liabilities will be greater than if the lease was an operating lease. With the debt to equity ratio, the liability is in the numerator, which results in an increase in the ratio. With the current ratio, current liabilities are increased and are in the denominator which results in a decrease in the ratio.} 15. On the lessee's cash flow statement, the principal portion of a finance lease payment is a: A) operating cash flow. B) investing cash flow. C) financing cash flow. {Explanation: The principal portion of a finance lease payment is a financing cash outflow for the lessee. The interest portion is an operating cash outflow.} 16. Under an operating lease (versus a finance lease) which of the following is higher for the lessee? A) Cash flow from financing. B) Cash flow from operations. C) Assets. {Explanation: The lessee's cash flows from financing will be higher for an operating lease because the payments made for an operating lease are operating cash outflows, not financing cash outflows. The payments made under a finance lease are split between interest paid and principal. The latter is charged to cash flow from financing.} 17. Compared to an operating lease, a lessee using a finance lease is least likely to have: A) higher cash flow from financing during the lease period. B) a lower current ratio. C) lower net income in the earlier years of the lease. {Explanation: Since a portion of the lease payment is treated as repayment of principal under a finance lease, cash flow from financing will be lower.} 18. Classifying a lease as an operating lease for a lessee, as opposed to a finance lease, will result in: Current Ratio Debt/Equity Ratio Asset Turnover Ratio A) Higher Lower Lower B) Higher Lower Higher C) Lower Lower Higher {Explanation: For a lessee using operating leases, the current ratio will be higher, the debt/equity ratio will be lower, and the asset turnover will be higher than they would be with finance leases. With operating leases, assets and liabilities are lower.} 19. An analyst compares two companies that are identical except that Company X uses finance leases and Company Y uses operating leases. The analyst would expect Company X’s debt-to-equity ratio, relative to Company Y’s, to be: A) lower. B) higher. C) the same. {Explanation: Lease capitalization adds both current and noncurrent liabilities to debt, resulting in a corresponding increase in the debt-to-equity and other leverage ratios. Thus, Company X’s (Debt + Lease)/Equity is greater than Company Y’s Debt/Equity.} 20. In a direct-financing lease, the implicit rate is such that the present value of the minimum lease payments: A) equals the cost of the leased asset. B) equals the sale price of the leased asset. C) is lower than the cost of the leased asset. {Explanation: In a direct-financing lease, the implicit rate is such that the present value of the MLPs equals the cost of the leased asset. Thus, at lease inception the total assets do not change and no gain is recognized.}