CFA 32: Non-Current Long-term Liabilities

At the time of issue of 4.50% coupon bonds, the effective interest rate was 5.00%. The bonds were most likely issued at: par. a discount. a premium.

B is correct. The effective interest rate is greater than the coupon rate and the bonds will be issued at a discount.

The management of Bank EZ repurchases its own bonds in the open market. They pay €6.5 million for bonds with a face value of €10.0 million and a carrying value of €9.8 million. The bank will most likely report: other comprehensive income of €3.3 million. other comprehensive income of €3.5 million. a gain of €3.3 million on the income statement.

C is correct. A gain of €3.3 million (carrying amount less amount paid) will be reported on the income statement.

Debt covenants are least likely to place restrictions on the issuer's ability to: pay dividends. issue additional debt. issue additional equity.

C is correct. Covenants protect debtholders from excessive risk taking, typically by limiting the issuer's ability to use cash or by limiting the overall levels of debt relative to income and equity. Issuing additional equity would increase the company's ability to meet its obligations, so debtholders would not restrict that ability.

A lessor will record interest income if a lease is classified as: a capital lease. an operating lease. either a capital or an operating lease.

A is correct. A portion of the payments for capital leases, either direct financing or sales-type, is reported as interest income. With an operating lease, all revenue is recorded as rental revenue.

Under US GAAP, a lessor's reported revenues at lease inception will be highest if the lease is classified as: a sales-type lease. an operating lease. a direct financing lease.

A is correct. A sales-type lease treats the lease as a sale of the asset, and revenue is recorded at the time of sale equal to the present value of future lease payments. Under a direct financing lease, only interest income is reported as earned. Under an operating lease, revenue from rent is reported when collected.

Consolidated Enterprises issues €10 million face value, five-year bonds with a coupon rate of 6.5 percent. At the time of issuance, the market interest rate is 6.0 percent. Using the effective interest rate method of amortisation, the carrying value after one year will be closest to: €10.17 million. €10.21 million. €10.28 million.

A is correct. The coupon rate on the bonds is higher than the market rate, which indicates that the bonds will be issued at a premium. Taking the present value of each payment indicates an issue date value of €10,210,618. The interest expense is determined by multiplying the carrying amount at the beginning of the period (€10,210,618) by the market interest rate at the time of issue (6.0 percent) for an interest expense of €612,637. The value after one year will equal the beginning value less the amount of the premium amortised to date, which is the difference between the amount paid (€650,000) and the expense accrued (€612,637) or €37,363. €10,210,618 - €37,363 = €10,173,255 or €10.17 million.

Innovative Inventions, Inc. needs to raise €10 million. If the company chooses to issue zero-coupon bonds, its debt-to-equity ratio will most likely: rise as the maturity date approaches. decline as the maturity date approaches. remain constant throughout the life of the bond.

A is correct. The value of the liability for zero-coupon bonds increases as the discount is amortised over time. Furthermore, the amortised interest will reduce earnings at an increasing rate over time as the value of the liability increases. Higher relative debt and lower relative equity (through retained earnings) will cause the debt-to-equity ratio to increase as the zero-coupon bonds approach maturity.

Oil Exploration LLC paid $45,000 in printing, legal fees, commissions, and other costs associated with its recent bond issue. It is most likely to record these costs on its financial statements as: an asset under US GAAP and reduction of the carrying value of the debt under IFRS. a liability under US GAAP and reduction of the carrying value of the debt under IFRS. a cash outflow from investing activities under both US GAAP and IFRS.

A is correct. Under US GAAP, expenses incurred when issuing bonds are generally recorded as an asset and amortised to the related expense (legal, etc.) over the life of the bonds. Under IFRS, they are included in the measurement of the liability. The related cash flows are financing activities.

Fairmont Golf issued fixed rate debt when interest rates were 6 percent. Rates have since risen to 7 percent. Using only the carrying amount (based on historical cost) reported on the balance sheet to analyze the company's financial position would most likely cause an analyst to: overestimate Fairmont's economic liabilities. underestimate Fairmont's economic liabilities. underestimate Fairmont's interest coverage ratio.

A is correct. When interest rates rise, bonds decline in value. Thus, the carrying amount of the bonds being carried on the balance sheet is higher than the market value. The company could repurchase the bonds for less than the carrying amount, so the economic liabilities are overestimated. Because the bonds are issued at a fixed rate, there is no effect on interest coverage.

Compared to using a finance lease, a lessee that makes use of an operating lease will most likely report higher: debt. rent expense. cash flow from operating activity.

B is correct. An operating lease is not recorded on the balance sheet (debt is lower), and lease payments are entirely categorised as rent (interest expense is lower.) Because the rent expense is an operating outflow but principal repayments are financing cash flows, the operating lease will result in lower cash flow from operating activity.

On 1 January 2010, Elegant Fragrances Company issues £1,000,000 face value, five-year bonds with annual interest payments of £55,000 to be paid each 31 December. The market interest rate is 6.0 percent. Using the effective interest rate method of amortisation, Elegant Fragrances is most likely to record: an interest expense of £55,000 on its 2010 income statement. a liability of £982,674 on the 31 December 2010 balance sheet. a £58,736 cash outflow from operating activity on the 2010 statement of cash flows.

B is correct. The bonds will be issued at a discount because the market interest rate is higher than the stated rate. Discounting the future payments to their present value indicates that at the time of issue, the company will record £978,938 as both a liability and a cash inflow from financing activities. Interest expense in 2010 is £58,736 (£978,938 times 6.0 percent). During the year, the company will pay cash of £55,000 related to the interest payment, but interest expense on the income statement will also reflect £3,736 related to amortisation of the initial discount (£58,736 interest expense less the £55,000 interest payment). Thus, the value of the liability at 31 December 2010 will reflect the initial value (£978,938) plus the amortised discount (£3,736), for a total of £982,674. The cash outflow of £55,000 may be presented as either an operating or financing activity under IFRS.

A company issues €1 million of bonds at face value. When the bonds are issued, the company will record a: cash inflow from investing activities. cash inflow from financing activities. cash inflow from operating activities.

B is correct. The company receives €1 million in cash from investors at the time the bonds are issued, which is recorded as a financing activity.

Penben Corporation has a defined benefit pension plan. At 31 December, its pension obligation is €10 million and pension assets are €9 million. Under either IFRS or US GAAP, the reporting on the balance sheet would be closest to which of the following? €10 million is shown as a liability, and €9 million appears as an asset. €1 million is shown as a net pension obligation. Pension assets and obligations are not required to be shown on the balance sheet but only disclosed in footnotes.

B is correct. The company will report a net pension obligation of €1 million equal to the pension obligation (€10 million) less the plan assets (€9 million).

Which of the following is most likely a lessee's disclosure about operating leases? Lease liabilities. Future obligations by maturity. Net carrying amounts of leased assets.

B is correct. The lessee will disclose the future obligation by maturity of its operating leases. The future obligations by maturity, leased assets, and lease liabilities will all be shown for finance leases.

For a lessor, the leased asset appears on the balance sheet and continues to be depreciated when the lease is classified as: a sales-type lease. an operating lease. a financing lease.

B is correct. When a lease is classified as an operating lease, the underlying asset remains on the lessor's balance sheet. The lessor will record a depreciation expense that reduces the asset's value over time.

Cavalier Copper Mines has $840 million in total liabilities and $520 million in shareholders' equity. It discloses operating lease commitments over the next five years with a present value of $100 million. If the lease commitments are treated as debt, the debt-to-total-capital ratio is closest to: 0.58. 0.62. 0.64.

C is correct. The current debt-to-total-capital ratio is $840/($840+$520) = 0.62. To adjust for the lease commitments, an analyst should add $100 to both the numerator and denominator: $940/($940+$520) = 0.64.