andytrader

Which of the following statements that classify a lease as a finance lease under U.S. GAAP is least accurate?

A) Title is transferred at the end of the lease period.

B) The present value of the lease payments is at least 80% of the fair market value of the asset.

C) A bargain purchase option exists.

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For a lease to be classified as a finance (capital) lease the present value of the lease payments must be at least 90% of the fair market value of the asset.

andytrader

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.

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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.

andytrader

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) higher.

B) lower.

C) the same.

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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.

andytrader

A lessee most likely has an incentive to structure a lease as an operating lease rather than a finance lease when it:

A) does not have debt covenants.

B) is very profitable.

C) has a high debt-to-equity ratio.

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A firm with a high debt-to-equity ratio is more likely to use an operating lease instead of a capital lease. Use of an operating lease avoids the recognition of debt on the lessee’s balance sheet and will not increase the debt-to-equity ratio.

andytrader

Compared to a finance lease, an operating lease is most likely to be favored when:

A) management compensation is not based on returns on invested capital.

B) the lessee has bond covenants relating to financial policies.

C) at the end of the lease, the lessee may be better able to sell the asset than the lessor.

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If the lessee has bond covenants (e.g., debt-to-equity ratio) relating to its financial policies that it must follow, it is best to have an operating lease due to the fact that the operating lease will keep the asset off of the balance sheet resulting in less liabilities.

andytrader

The lessee has an incentive to classify a lease as an operating lease, rather than as a finance lease, because an operating lease:

A) has no risk involved because the lessor assumes all risk.

B) has payments that are less than a capital lease's payments.

C) does not appear on the balance sheet.

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Having less assets and liabilities on the balance sheet than would exist if the asset were purchased increases profitability ratios (e.g., return on assets) and decreases leverage ratios (e.g., the debt to equity ratio).

andytrader

As compared to purchasing an asset, which of the following is least likely an incentive to structure a transaction as a finance lease?

A) Risk of obsolescence is reduced because the asset is returned to the lessor.

B) The terms of the lease can be negotiated to better meet each party's needs.

C) The lease enhances the balance sheet by the lease liability.

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Operating leases enhance the balance sheet by excluding the lease liability. With a finance lease, an asset and a liability are reported on the balance sheet just like a purchase made with debt.

andytrader

Which of the following is least likely to be disclosed in the financial statements of a bond issuer?

A) The market rate of interest on the balance sheet date.

B) Collateral pledged as security in the event of default.

C) The amount of debt that matures in each of the next five years.

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The market rate on the balance sheet date is not typically disclosed. The amount of 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.

andytrader

In analyzing disclosures related to the financing liabilities of a company, which of the following disclosures would be least helpful to the analyst?

A) The interest expense for the period as provided on the income statement or in a footnote.

B) The present value of the future bond payments discounted at the coupon rate of the bonds.

C) Filings with the Securities and Exchange Commission (SEC) that disclose all outstanding securities and their features.

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When analyzing disclosures related to financing liabilities, analysts would review the balance sheet and find the present value of the promised future liability payments. These payments would then be discounted at the rate in effect at issuance (i.e., the yield to maturity), not the coupon rate of the bonds.

andytrader

Which of the following provisions would least likely be included in the bond covenants? The borrower must:

A) maintain a debt-to-equity ratio of no less than 2:1.

B) maintain insurance on the collateral that secures the bond.

C) not increase dividends to common shareholders while the bonds are outstanding.

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A lender wants to prohibit the borrower from becoming more leveraged. This can be done by requiring a leverage ratio that is no more than a specified amount. Reducing leverage would be beneficial to the lender by lowering risk.