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41. 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.

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42. 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.

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43. 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.

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44. 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.

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45. 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.

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46. 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).

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47. Bao Capital issed a 5-year, $50 million face, 6% semiannual bond when market interest rates were 7%. The market yield of the bonds was 8% at the beginning of the next year. What is the initial balance sheet liability, and what is the interest expense that the company should report for the first half of the second year of the bond’s life (the third semiannual period)” Initial liability Int. exp. first half of year 2 A $47,920,849 $1,689,853 B $47,920,849 $1,750,000 C $50,000,000 $1,500,000

Ans: A. This is a discount bond since the market interest rate at issuance exceeds the coupon rate. The initial liability is equal to the proceeds received when the bond was issued. We can find this amount from the following calculation: FV=50,000,000; N=10; I=3.5; PMT=1,500,000;CPT→PV=$47,920,848.67. Change N to 8 and calculate PV to get liability value at the beginning of the second year of the bond’s life, 48,281,511. Interest expense for the next semiannual period is 48,281,511(0.035)=$1,689,853. The subsequent change in the market rate has no effect on the amortization of the discount.

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		Ans: A. This is a discount bond since the market interest rate at issuance exceeds the coupon rate. The initial liability is equal to the proceeds received when the bond was issued. We can find this amount from the following calculation: FV=50,000,000; N=10; I=3.5; PMT=1,500,000;CPT→PV=$47,920,848.67. Change N to 8 and calculate PV to get liability value at the beginning of the second year of the bond’s life, 48,281,511. Interest expense for the next semiannual period is 48,281,511(0.035)=$1,689,853. The subsequent change in the market rate has no effect on the amortization of the discount.
48. 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. Reference: Question 15.

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49. Bao Capital issues a 4-year semiannual-pay bond with a face value of $10 million and a coupon rate of 10%. The market interest rate is 11% when the bond is issued. The balance sheet liability at the end of the first semiannual period is closest to: A. $9,650,700. B. $9,683,250. C. $9,715,850.

Ans: C. The initial liability is the amount received from the creditor, not the par value of the bond. N=8, I/Y=11/2=5.5MT=500,000;FV=10,000,000; CPT→PV=$9,683,272. The interest expense if the effective interest rate (the market rate at the time of issue) times the balance sheet liability. $9,683,272x0.055=$532,580. The value of the liability will change over time and is a function of the initial liability, the interest expense and the actual cash payment. In this case, it increases by the difference between the interest expenses and the actual cash payment: $532,580-500,000=$32,580 $32,580+9,683,272=$9,715,852. Tip: Knowing that the liability will increase is enough to select choice C without performing this last calculation. Entering N=7 and solving for PV also produces $9,715,852.

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50. 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.