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8. The following information is available from a company’s 2011 financial statements: Note 6: Employee costs (in thousands) 2011 2010 Wages and salaries $21,000 $18,500 Share-based payment costs 600 425 Defined contribution pension plan 1,525 1,462 Retirement benefit obligations (note 17) 728 620 Other employee costs 3,233 3,080 Total employee costs $27,086 $24,087 Note 17: Retirement benefit obligations Amounts recognized in the income statement for the year (in thousands) 2011 2010 Current service cost $692 $588 Interest cost on pension obligation 80 65 Expected return on plan assets (50) (45) Past service costs recognized in the year 6 12 Total income statement charge $728 $620 The pension expense (in thousands) reported in 2011 is closest to: A. $1,525. B. $2,217. C. $2,253.

Ans: C. The pension expense would be the sum of the expense for the defined contribution plan and the defined benefit plan (retirement benefit obligation): 1,525 + 728 = 2,253.

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7. A company is considering issuing $10,000,000 of long-term debt with a 6% coupon rate or the same amount of convertible debt with a 5% coupon rate. Both will be issued at par and have the same maturity. Which statement below best describes the impact on the firm’s debt ratio? A. The debt ratio would be higher for U.S.GAAP than for IFRS. B. The debt ratio would be lower for U.S.GAAP than for IFRS. C. The debt ratio would be the for U.S.GAAP than for IFRS.

Ans: A. Under U.S.GAAP the entire amount of the issue is recorded as debt while under IFRS the amount of the issue is split into the fair value of the debt and the difference between fair value and issue value is recorded as (option) equity.

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6. When a bondholder converts a convertible bond, the effects on the corporation’s subsequent financial statements will include a: A. An increase in tax expense and an increase to the debt-to-equity ratio. B. An increase in tax expense and a decrease to the debt-to-equity ratio. C. A decrease in tax expense and an increase to the debt-to-equity ratio.

Ans: B. Since interest is tax deductible, it will decrease tax expense while the bonds are outstanding. When the debt is converted to equity, the reduced interest deduction will increase tax expense. When the debt is converted to equity, the numerator of the debt-to-equity ratio will be reduced and the denominator will be increased. The debt-to-equity ratio will be reduced as a result.

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5. Backhoe Partners (BP) sells each of its backhoes for $175,000 with an expected economic life of 10 years. The company also leases them directly to construction companies with good credit. If Construction Group (CG) leases the equipment from BP, the relevant interest rate is 10% and the lease payments will be $4,000 per month for four years. CG has purchased equipment in the past by financing through Prime Finance. Assuming that CG decides to lease the equipment, BP should treat the lease as a(n): A. Direct financing lease. B. Operating lease. C. Sales-type lease.

And. C. The lease must be capitalized since the present value of the lease payment is greater than 90% of the fair value of the asset: $4,000 PMT, 10%/12 i (1/Y), 4*12 n (N), (CPT) PV = $157,713 $157,713/$175,000 =90.12% A. The lease would not direct financing lease because BP manufactures the equipment and leases it to third parties; BP is obviously a manufacturer or dealer. B. Since BP manufactures the equipment for sale, the lease would be a sales-type lease.

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4. The most likely impact on a lessee’s financial statements from reporting a lease as a finance lease rather than as an operating lease will be: A. Unchanged total lease expense over the lease term. B. Lower operating cash flows during the life of the finance lease. C. Lower operating profit (margin) in the early years of the finance lease.

Ans. A. Although the annual lease expense in any given year is different between an operating and a finance lease, over the life of the lease (lease term) both methods will result in the same total lease expense. B is incorrect. Under a finance lease, only the interest payments are outflows from operating activities, while the principal payments are outflows from financing activities. All operating lease payments are outflows from operating activities, resulting in lower operating cash flows during the lease term if the lease is an operating lease. C is incorrect. Operating profit margins are higher (rather than lower) during the entire term of a finance lease because only the related depreciation expense, rather than the entire lease payment is included in operating expenses. However, the interest portion of the payment is reflected in pretax earnings and net profit margins, both of which will be lower in the early years of a fiancé lease as the combined deprecation and interest expense will be in excess of the lease payment.

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3. A company leased equipment under a seven-year finance lease requiring year-end payments of $20,541. The present value of the lease liability is approximately $100,000 based on a 10% discount rate. The interest portion of the first payment is closest to: A. $10,000. B. $13,340. C. $14,200.

Ans: A. First year interest expense will be: 1st year interest expense= $100,00 *0.10= $10,000.

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2. An analyst is assessing a company that entered into a take-or-pay contract during the year and also has significant number of operating leases. Which of the following statement is the least accurate? A. The company’s financial statements must be adjusted before the analyst compares this company to other companies in its industry. B. Despite the off-balance sheet nature of take-or-pay contracts and operating leases, an attempt to determine the actual financial position of the company can be garnered from the footnotes. C. The take-or-pay contracts and operating leases mean that this company has much higher business risk than similar companies that do not use off-balance sheet financing techniques.

Ans. C. The existence of take-or-pay contracts and operating leases does not necessarily increase the business risk of a company when compared to companies that do not use off-balance seet financing techniques, although the existence of the obligations must be considered when analyzing business risk. A is incorrect. When companies make use of off-balance sheet financing techniques, the financial statements must be adjusted before the company’s financing position and operating results can be analyzed and compared to other companies. C is incorrect. It is not difficult to determine the true financial position of companies that use off-balance sheet financing techniques because both IFRS and U.S.GAAP require extensive footnote disclosures regarding off-balance sheet financing. The information in the disclosures can be used to adjust the financial statements for the off-balance sheet items.