LOS a: Analyze and evaluate the balance sheet for assets and liabilities that are not recorded, and for assets and liabilities for which the amounts shown on the balance sheet differ from their current values.

Q1. Short Haul Airlines reports a commitment to purchase 10 new aircraft at a total cost of $1.2 billion over the next 5 years in its

footnotes. The present value of these purchases is estimated to be $780 million. What are the appropriate balance sheet

adjustments need to adequately reflect the commitment? Increase long-term liabilities and:

A)   long-term assets by $780 million.

B)   decrease equity by $780 million.

C)   long-term assets by $1.2 billion.

Q2. Northern Bottling (NB) currently shows minimum expected operating leases over the next 5 years of $3 million, $2.5 million, $2

million, $2 million, and $1.5 million. The firm’s current financing rate is 6.75% and the rate implicit in the lease contract is 7%.

What adjustments would an analyst make to modify the balance sheet of NB to include this off-balance sheet financing?

Increase long-term:

A)   assets and long-term liabilities by $9.22 million.

B)   assets and long-term liabilities by $9.27 million.

C)   liabilities by $9.27 million and decrease equity by $9.27 million.

Q3. Lucky Strike Mining Corp. (LSMC) reports in a footnote to the financial statements that it is party to a variable interest entity

(VIE) through which it leases heavy equipment. LSMC has chosen not to report a residual value guarantee of $120 million for

the equipment because it is not required to do so under accounting standards. However, the standards will change next year. What is the appropriate analytical treatment of this residual value guarantee?

A)   Ignore the liability because current accounting standards do not require it to be included on the balance sheet. Include it in next year’s balance sheet adjustments.

B)   Increase long-term liabilities by $120 million and decrease equity by $120 million.

C)   Increase long-term liabilities and long-term assets by $120 million.

The UNI Company Balance Sheet

As of December 31, 2002

(in millions)

	2001	2002					2001	2002
Cash	$50	$60				Accounts payable	$100	$150
Accounts receivable	100	110				Long-term debt	400	300
Inventory	200	180				Common Stock	50	50
						Retained earnings	400	500
Fixed assets (gross)	800	900				Total liabilities and equity	$950	$1,000
Accumulated depreciation	200	250
Fixed assets (net)	600	600
Total assets	$950	$1,000
The UNI Company Income Statement
For year ended December 31, 2002
(in millions)
Sales			$1,000
Cost of goods sold (COGS)			600
Depreciation			50
Selling, general, and administrative expenses (SG&A)			160
Interest expense			23
Income before taxes			$167
Tax			67
Net income			$100

Additional information:

• UNI uses the last in first out (LIFO) inventory valuation method. The LIFO reserve is $20 for 2002 and $10 for 2001.
• UNI leases equipment. These leases are classified as operating leases and require annual, end-of-year payments of $10 million for each of the next 5 years.

The COGS using first in, first out (FIFO) inventory valuation is:

A)   $580 million.

B)   $590 million.

C)   $610 million.

LOS a: Analyze and evaluate the balance sheet for assets and liabilities that are not recorded, and for assets and liabilities for which the amounts shown on the balance sheet differ from their current values. fficeffice" />

Q1. Short Haul Airlines reports a commitment to purchase 10 new aircraft at a total cost of $1.2 billion over the next 5 years in its

footnotes. The present value of these purchases is estimated to be $780 million. What are the appropriate balance sheet

adjustments need to adequately reflect the commitment? Increase long-term liabilities and:

A)   long-term assets by $780 million.

B)   decrease equity by $780 million.

C)   long-term assets by $1.2 billion.

Correct answer is A)

Increase long-term liabilities and long-term assets by $780 million. Recall that the balance sheet adjustment is done using present values, not total commitments.

Q2. Northern Bottling (NB) currently shows minimum expected operating leases over the next 5 years of $3 million, $2.5 million, $2

million, $2 million, and $1.5 million. The firm’s current financing rate is 6.75% and the rate implicit in the lease contract is 7%.

What adjustments would an analyst make to modify the balance sheet of NB to include this off-balance sheet financing?

Increase long-term:

A)   assets and long-term liabilities by $9.22 million.

B)   assets and long-term liabilities by $9.27 million.

C)   liabilities by $9.27 million and decrease equity by $9.27 million.

Correct answer is B)

Recall that the interest rate in this present value computation is the lower of the firm’s financing rate or the interest rate that is implicit in the lease.  Therefore, the PV (operating leases) is:

= 3 / (1 + 0.0675) + 2.5 / (1 + 0.0675)² + 2 / (1+ 0.0675)³ + 2 / (1 + 0.0675)⁴ + 1.5 / (1 + 0.0675)⁵

= 9.27 million

The proper adjustment is to increase both long-term assets and liabilities by the same amount.

Q3. Lucky Strike Mining Corp. (LSMC) reports in a footnote to the financial statements that it is party to a variable interest entity

(VIE) through which it leases heavy equipment. LSMC has chosen not to report a residual value guarantee of $120 million for

the equipment because it is not required to do so under accounting standards. However, the standards will change next year. What is the appropriate analytical treatment of this residual value guarantee?

A)   Ignore the liability because current accounting standards do not require it to be included on the balance sheet. Include it in next year’s balance sheet adjustments.

B)   Increase long-term liabilities by $120 million and decrease equity by $120 million.

C)   Increase long-term liabilities and long-term assets by $120 million.

Correct answer is C)

Increase long-term liabilities and long-term assets by $120 million.

The UNI Company Balance Sheet

As of December 31, 2002

(in millions)

	2001	2002					2001	2002
Cash	$50	$60				Accounts payable	$100	$150
Accounts receivable	100	110				Long-term debt	400	300
Inventory	200	180				Common Stock	50	50
						Retained earnings	400	500
Fixed assets (gross)	800	900				Total liabilities and equity	$950	$1,000
Accumulated depreciation	200	250
Fixed assets (net)	600	600
Total assets	$950	$1,000
The UNI Company Income Statement
For year ended December 31, 2002
(in millions)
Sales			$1,000
Cost of goods sold (COGS)			600
Depreciation			50
Selling, general, and administrative expenses (SG&A)			160
Interest expense			23
Income before taxes			$167
Tax			67
Net income			$100

Additional information:

• UNI uses the last in first out (LIFO) inventory valuation method. The LIFO reserve is $20 for 2002 and $10 for 2001.
• UNI leases equipment. These leases are classified as operating leases and require annual, end-of-year payments of $10 million for each of the next 5 years.

The COGS using first in, first out (FIFO) inventory valuation is:

A)   $580 million.

B)   $590 million.

C)   $610 million.

Correct answer is B)

Purchases = $600 + 180 ? 200 = $580 million
Beginning inventory (FIFO) = $200 + 10 = $210 million
Ending inventory (FIFO) = $180 + $20 = $200 million
COGS (FIFO) = $210 + 580 ? 200 = $590 million

Check:

FIFO: $210 + 580 = $590 + 200
LIFO: $200 + 580 = $600 + 180

thx