Deck 3: Analyzing Financing Activities

Question 1

An increase in the pension obligation because of passage of time is referred to as the interest cost.

Answer 1

True

Question 2

Which of the following is not a criterion for defining a lease as a capital lease?

A)Ownership is transferred at the end of the lease agreement.
B)The lease contains an option to purchase the asset at a bargain price.
C)The present value of the lease payments at the beginning of the lease is 75% or more than the value of the asset.
D)The lease term is at least 75% of the economic life of the asset.

Answer 2

C

Question 3

The majority of financing for most companies comes from which of the following sources?

A)Owners and customers
B)Creditors and customers
C)Owners and managers
D)Creditors and owners

Answer 3

D

Question 4

An SPE investor may secure its investment with a guarantee so that the SPE remains unconsolidated.

Question 5

Companies report the funded status of pension plans as a separate line item on the balance sheet.

Question 6

Retail Inc. has both operating and capital leases. Below is a portion of its lease footnote taken from its 2006 financial statements.
$\begin{array}{lrr}&\text { Capital}&\text { Operating }\\\text { MLP (in millions) }\\2007 & \$ 233 & \$ 529 \\2008 & 201 & 567 \\2009 & 199 & 554 \\2010 & 180 & 540 \\2011 & 145 & 528 \\ \underline{\text { Thereafter }} & \underline{1,050} & \underline{5,941} \\ \text { Total MLP } &2,008 & \underline{ \underline{\$ 8,659}}\\\text { Less interest } & \underline{ 680} \\\text { Present value of MLP } & \underline{ \underline{ \$ 1,328 }}\\\text { Current } & 100 \\\text { Long term } & \$ 1,228\end{array}$

a. Obtain a crude estimate of the remaining length of the operating and capital leases.
b. Estimate the interest rate implicit in the capital leases.
c. Compute the present value of the operating leases.

Question 7

Below is part of Harnischfeger's footnote on Postretirement Benefits other than Pensions from its X6 Annual report.
$\begin{array}{lrr} \text {(in thousands)}&\underline{X 6}&\underline{X 5}\\ \text {Accumulated postretirement benefit}\\ \text {obligation (APBO)} &\$ 69,439 &\$ 78,800 \\ \text {Plan assets at fair value}\\\text { APBO in excess of plan assets } & 69,439 & 78,800 \\\text { Unrecognized prior service credit } & 20,653 & 31,433 \\\text { Unrecognized gain } & \underline{7,214} & \underline{7,873} \\\text { Accrued postretirement benefit liability } & \underline{97,306} & \underline{118,106} \\ \text { Less: Current portion } & 18,492 & 16,501\\&\underline{\underline{ \$78,814}}&\underline{\underline{ \$101,605}}\end{array}$


$\begin{array}{lrr}\text { (in thousands) }&\underline{X 6}&\underline{X 5}\\\text { Service cost } & \$ 327 & \$ 502 \\\text { Interest cost on APBO } & 5,623 & 6,475 \\\text { Amortization of prior service (credit) } & (10,780) & (9,417) \\\text { Net amortization and deferral } &\underline{ (2,624)} &\underline{ (225)} \\ \text { Net periodic postretirement benefit cost } &\underline{\underline{ \$(7,454)}} &\underline{\underline{ \$(2,665)}}\end{array}$
a. What amount is Harnischfeger showing as a liability on their balance sheet with respect to postretirement benefits other than pensions at the end of fiscal X6?
b. What amount is Harnischfeger showing as an expense on the income statement for the fiscal year X6?
c. Why is Harnischfeger's accrued postretirement benefit liability greater than the APBO?
d. If Harnischfeger wanted to reduce its APBO how might they do it? Provide three ways.

Question 8

You are considering purchasing a company. You are aware that sometimes liabilities do not always show up on the balance sheet. Give five examples of liabilities that may not be explicitly recognized on the balance sheet, being sure to explain why they are liabilities.

Question 9

Werter Inc. has a defined benefit pension plan. Information related to this plan as of the end of 2006 is as follows:
$\begin{array}{lr}\text { PBO } & \$ 5,350,000 \\\text { ABO } & 4,100,000 \\\text { Plan Assets } & 3,500,000 \\\text { Unamortized Prior Service Cost } & 360,000 \\\text { Unamortized transition asset } & 540,000\\\\\text { Discount rate } & 8 \% \\\text { Compensation rate increase } & 5 \% \\\text { Expected rate of return } & 10 \%\end{array}$
a. Estimate pension expense for 2006 assuming that the pension plan assumptions remain unchanged from 2006, service cost is 10% of beginning of year PBO and that the prior service costs and transition assets are being amortized over 20 years.
b. Calculate the liability to be recorded in the balance sheet at the end of fiscal 2006.

Question 10

Which of the following would be found listed as a liability on a company's balance sheet?

A)Operating lease obligations
B)Projected benefit obligation
C)Purchase commitment obligation
D)Other postretirement employee benefits

Question 11

Pension risk arises to the extent to which plan assets have a different risk profile than the pension obligation.

Question 12

Warden Corp. has a postretirement health benefit plan for its employees. As of December 31, 2006, the accumulated postretirement benefit obligation (APBO) is $250 million and the postretirement health benefit cost for the year was $23 million. The plan assets are $10 million. Warden chose to recognize its unfunded liability immediately. Warden also has a pension plan, which is fully funded.

a. What reasons are there for the minimal funding of the postretirement health benefits plans versus the full funding of the pension plan?

b. In 2006 Warden makes the following changes.

• Increases its expected rate of return on plan assets.
• Increases the expected compensation growth rate.
• Increases its discount rate.

Explain the effect of each of these on

i. economic cost as of the end of 2007.
ii. reported cost for 2007.

Question 13

If a company that leases equipment from another company records these leases as operating leases rather than capital leases, its: I. recorded liabilities will be lower.II. recorded assets will be higher.III. total cash flows will be higher.IV. leverage ratios will be higher.

A)I and III
B)II and IV
C)I only
D)II, III, and IV

Question 14

Which of the following is true concerning bond covenants?

A)Bond covenants are restrictions placed on bondholders to protect rights of equity holders.
B)Violation of a bond covenant requires that a company declares bankruptcy.
C)If a company violates a bond covenant, it means it has failed to make interest or principal repayments on debt in a timely manner.
D)Bond covenants are legal restrictions placed in order to minimize the risk of default on bonds.

Question 15

Following is selected financial information for Universal Skyhook:
$\begin{array}{lr}&\underline{2006}\\\text { Capitalized leases } & \$ 4,100 \\\text { Total assets } & 18,000 \\\text { Total liabilities } & 10,000\\\\\text { Depreciation expense } & 1,000 \\\text { Rent expense } & 2,000 \\\text { Interest expense } & 1,000 \\\text { Net income } & 1,200\\\\\text {Cash flow}&2,000\end{array}$
Skyhook installed a new giant forging machine on January 1, 2006. It was financed as a five-year capitalized lease with year-end payments of $1,002 with an implied 8% interest rate. After the lease period, the scrap value will just about cover the cost to remove the machine. Skyhook had no tax expense in 2006 and uses straight-line depreciation for book and tax purposes.

a. The company is examining financing alternatives for another machine and has received a synthetic lease proposal from a bank. To better understand this structure, the CEO asks you how the above 2006 numbers would have changed had Skyhook used a synthetic lease for the forging machine.
b. How would you interpret your results and what would your recommendation be?
c. Would your recommendation change if Skyhook had a tax rate of 36% and used accelerated depreciation for tax purposes?

Question 16

Which of the following would not be found listed as a liability on a company's balance sheet?

A)Operating lease obligations
B)Capital lease obligations
C)Bonds payable
D)Taxes payable

Question 17

Recording a long-term lease as an operating lease, as opposed to a capital lease, for a lessee will cause the following ratios to be: $\begin{array} { l c c } &\underline{ \text { Debt to equity} } &\underline{ \text { Total asset turnover }} \\\end{array}$
A. $\begin{array} { l c c } & \text { Higher } &\quad\quad\quad\quad \text { Lower } \\\end{array}$
B. $\begin{array} { l c c } & \text { Higher } &\quad\quad\quad\quad \text { Higher } \\\end{array}$
C. $\begin{array} { l c c } & \text { Lower } &\quad\quad\quad\quad \text { Higher } \\\end{array}$
D. $\begin{array} { l c c } & \text { Lower } &\quad\quad\quad\quad \text { Lower }\end{array}$

A)Option A
B)Option B
C)Option C
D)Option D

Question 18

An analyst should treat preferred stock on a firm's balance sheet as debt when calculating leverage ratios if the preferred stock is convertible into common stock.

Question 19

Which one of the following statements is false?

A)Short-term obligations may be classified as long-term if the company intends to refinance them on a long-term basis and can demonstrate the ability to do so.
B)Violation of a long-term debt covenant automatically means the company must reclassify the debt as current.
C)Current liabilities are recorded at their maturity value, and not their present value.
D)If a bond is issued at a discount the effective interest rate is greater than the coupon rate.

Question 20

If a company leases equipment to other companies and records these leases as operating leases rather than capital leases, its: I. recorded liabilities will be lower.II. recorded assets will be higher.III. total cash flows will be higher.IV. debt to equity ratios will be lower.

A)I and III
B)II and IV
C)I only
D)II, III, and IV

Question 21

When considering defined benefit pension plans, which of the following will not increase the projected benefit obligation (PBO)?

A)A decrease in the discount rate
B)An increase in estimated compensation growth
C)An increase in expected average length of lives of employees
D)A decrease in the expected rate of return on plan assets

Question 22

Which of the following will give rise to off-balance sheet financing? I. Take-or-pay arrangements
II) Sale of receivables without recourse
III) Through-put agreements
IV) Purchase commitments

A)I, II, III, and IV
B)I, II, and IV
C)II, III, and IV
D)I, III, and IV

Question 23

Reling Company reports the following information as of 12/31/05
$\begin{array}{ll}\text {\( 10 \% \) cumulative preferred stock, par value \( \$ 10 \)}\\\text { and liquidation value \( \$ 11 ; 20,000 \) shares}\\\text { authorized and issued: } 10,000 \text { shares outstanding } & \$ 100,000 \\\text { Common stock - authorized } 50,000 \text { and } 40,000 & \\\text { outstanding; } \$ 1 \text { par value } & \$ 40,000 \\\text { Additional paid-in capital } & \$ 350,000 \\\text { Retained earnings } & \$ 230,000\end{array}$

-The book value per share of common stock is:

A)$12.20.
B)$12.40.
C)$15.25.
D)$15.50.

Question 24

With respect to pension liabilities, which of the following statements is true? I. The projected benefit obligation (PBO) is always greater than or equal to the accumulated benefit obligation (ABO).II. The vested benefit obligation (VBO) is always as least as or as big as the accumulated benefit obligation (ABO).III. If the PBO is greater than the plan assets, the plan is said to be overfunded.IV. If the weighted-average assumed discount rate is increased, the PBO will decrease.

A)I, III, and IV
B)I and III
C)II and IV
D)I and IV

Question 25

Which of the following statements about stock dividends is true?

A)Stock dividends increase the number of shares outstanding.
B)Stock dividends are more valuable than stock splits.
C)Stock dividends are recorded as a reduction in cash.
D)Stock dividends are dividends given in the form of stock from another company.

Question 26

Dylan Corporation issues a zero coupon bond with $100,000 face value, with a 5-year maturity, and the market rate is 7%. Interest on corporate bonds is normally paid semiannually. In the liability section of Dylan's balance sheet, the proceeds from selling the zero-coupon immediately after issuance will be closest to:

A)$70,892.
B)$71,299.
C)$70,000.
D)$100,000.

Question 27

A company's current ratio is 1.5. If the company uses cash to retire notes payable due within one year, would this transaction increase or decrease the current ratio and return on assets ratio?

A)Current ratio: Increase; Return on assets: Increase
B)Current ratio: Increase; Return on assets: Decrease
C)Current ratio: Decrease; Return on assets: Increase
D)Current ratio: Decrease; Return on assets: Decrease

Question 28

Which of the following lease provisions would cause a lease to be classified as an operating lease?

A)The lease contains a bargain purchase option.
B)The collectability of lease payments by the lessor is unpredictable.
C)The term of the lease is more than 75 percent of the estimated economic life of the leased property.
D)The present value of the minimum lease payments equals or exceeds 90 percent of the fair value of the leased property.

Question 29

Minority interest appears on the balance sheet of some companies. Minority interest:

A)is classified as a liability.
B)is classified as an equity.
C)arises when a company records investments using the equity method.
D)arises when a company owns controlling interest in another company, but less than 100%.

Question 30

The difference between the accumulated benefit obligation (ABO) and the projected benefit obligation (PBO) is:

A)the PBO considers non-vested obligations and the ABO does not.
B)the PBO takes into account the time value of money and the ABO does not.
C)the PBO takes into account future pay increases and the ABO does not.
D)the PBO takes into account mortality rates of employees and the ABO does not.

Question 31

Reling Company reports the following information as of 12/31/05
$\begin{array}{ll}\text {\( 10 \% \) cumulative preferred stock, par value \( \$ 10 \)}\\\text { and liquidation value \( \$ 11 ; 20,000 \) shares}\\\text { authorized and issued: } 10,000 \text { shares outstanding } & \$ 100,000 \\\text { Common stock - authorized } 50,000 \text { and } 40,000 & \\\text { outstanding; } \$ 1 \text { par value } & \$ 40,000 \\\text { Additional paid-in capital } & \$ 350,000 \\\text { Retained earnings } & \$ 230,000\end{array}$

-The book value per share of preferred stock is:

A)$22.
B)$20.
C)$11.
D)$10.

Question 32

Treasury stock is:

A)investments in government securities.
B)retained earnings that have been appropriated to make equity investments.
C)a company's own stock that it has repurchased.
D)assets held for safekeeping in company's vaults.

Question 33

Many of the postretirement health benefit plans offered by companies to their employees are unfunded, while all of their pension plans have some degree of funding. Which of the following statements is false?

A)There is no legal requirement to fund postretirement health benefits, but there are legal requirements covering pension funding.
B)Contributions to pension plans are normally tax deductible, but contributions to postretirement health plans are not tax deductible.
C)Funds contributed to a pension plan can be withdrawn at any time, but funds contributed to a postretirement health plan cannot be withdrawn by law.
D)Taxes do not have to be paid on investment income earned by assets in pension plan, but they do normally have to be paid on postretirement health plans.

Question 34

If a company engages in off-balance sheet financing, generally the effect is: I. to cause assets to be understated.II. to increase leverage ratios.III. to increase cash flows.IV. to cause liabilities to be understated.

A)I, II, III, and IV
B)I, III, and IV
C)I only
D)IV only

Question 35

Which of the following is an example of off-balance sheet financing?

A)Operating leases
B)Capital leases
C)Issuance of convertible bonds
D)Issuance of common stock

Question 36

A lessee must account for a lease as a capital lease if: I. lease transfers ownership to lessee at the end of the lease.II. lease contains option to purchase the asset at the end of the lease at a bargain price.III. lease is longer than 20 years.IV. present value of lease is greater than 10% of lessee's assets.

A)I and II
B)I, II and III
C)I, III and IV
D)I, II and IV

Question 37

One way for a company to increase its book value per share is to:

A)issue long-term debt.
B)retire long-term debt.
C)increase dividend payout ratio.
D)buy back shares at market prices below their book value.

Question 38

Hert Corporation acquired a capital lease that is carried on its books at a present value of $100,000 (discounted at 12%). Its annual rental payment is $15,000. What is the amount of interest expense from this lease? $\begin{array} { l c c } &\underline{ \text { First Year }} & \underline{\text { Second Year }} \\\end{array}$
A. $\begin{array} { l c c } & \$ 12,000 & \$ 10,200 \\\end{array}$
B. $\begin{array} { l c c } & \$ 12,000 & \$ 11,640 \\\end{array}$
C. $\begin{array} { l c c } & \$ 12,000 & \$ 12,350 \\\end{array}$
D. $\begin{array} { l c c } & \$ 15,000 & \$ 15,000\end{array}$

A)Option A
B)Option B
C)Option C
D)Option D

Question 39

An analyst should consider whether a company acquired assets through a capital lease or an operating lease because a company may structure:

A)leases to be treated like capital leases to enhance its leverage ratios.
B)leases to be treated like capital leases to enhance its cash flow.
C)leases to be treated like operating leases to lower its debt to equity ratio.
D)leases to be treated like operating leases to enhance its cash flow.

Question 40

Which of the following statements concerning contingencies is correct? I. Gain contingencies are recorded if they are probable and reasonably estimable.II. Unredeemed frequent flyer mileage is an example of a loss contingency.III. A loss contingency is a form of off-balance sheet financing.IV. Loss contingencies are not recognized unless there is a greater than 95% chance they will be realized.

A)I, II, III, and IV
B)II, III, and IV
C)II and III
D)II only

Question 41

Which of the following is not a component of recognized OPEB cost?

A)Service cost
B)Amortization of prior service costs
C)Interest cost
D)Amortization of prior interest costs

Question 42

Which of the following is reported in the equity section of the balance sheet?

A)Redeemable preferred stock
B)Treasury stock
C)Investment in affiliates
D)Debentures

Question 43

Creditors of a business are more concerned with the future cash flows of a business than the future return on equity.

Question 44

Current liabilities should always be expected to be liquidated within one year.

Question 45

Which of the following is not an actuarial assumption underlying the computation of the pension obligation?

A)Employee turnover
B)Life expectancy
C)Interest rate
D)Service cost

Question 46

On January 1, a company entered into a capital lease resulting in an obligation of $20,000 being recorded on the balance sheet. Estimated economic life of the leased asset is ten years with an expected salvage value of zero at the end of ten years. The company will depreciate this asset on a straight-line basis over its economic life. The lessor's implicit interest was 10 percent. At the end of the first year of the lease, the cash flow from financing activities section of the lessee's statement of cash flows showed a use of cash of $2,200 applicable to the lease. How much did the company pay the lessor in the first year of the lease?

A)$2,000
B)$2,200
C)$4,200
D)$20,000

Question 47

Harms Inc. reported in its 2006 annual report the following information:
$\quad$ $\quad$ $\quad$ $\quad$ $\quad$$\underline{\text { Plan Status: December 31, } 2006}$

$\begin{array} { l r } \text { Accumulated Benefit Obligation (ABO) } & \$ 90 \text { million } \\ \text { Projected Benefit Obligation (PBO) } & 95 \text { million } \\ \text { Plan Assets (at fair value) } & 80 \text { million } \\ \text { Unrecognized transition asset } & 11 \text { million } \\ \text { Unrecognized actuarial losses } & 1 \text { million }\\\\\text { Assumptions: }\\ \text {Discount rate}&8\%\\ \text {Return on assets}&9\%\\ \text {Compensation growth}&5\% \end{array}$


-If Harms had decreased its compensation growth rate to 4.5% in 2006, the effect would have been:

A)an increased ABO.
B)an increased PBO.
C)a decreased ABO.
D)a decreased PBO.

Question 48

Synthetic leases may achieve all of the following benefits to the borrower except:

A)window-dress the balance sheet.
B)increase cash flow.
C)reduce tax expense on the income statement.
D)increase net income.

Question 49

If a company increases its expected return on plan assets this year, the effect would be to: I. increase plan assets.II. decrease PBO.III. decrease pension expense.IV. decrease minimum liability.

A)I, II, and IV
B)I and IV
C)III and IV
D)III only

Question 50

Pension intensity of a company can be measured by expressing the pension plan assets and the pension obligation separately as:

A)a percentage of its total liabilities.
B)a percentage of its total assets.
C)a percentage of its net income.
D)a percentage of its shareholders' equity.

Question 51

Harms Inc. reported in its 2006 annual report the following information:
$\quad$ $\quad$ $\quad$ $\quad$ $\quad$$\underline{\text { Plan Status: December 31, } 2006}$

$\begin{array} { l r } \text { Accumulated Benefit Obligation (ABO) } & \$ 90 \text { million } \\ \text { Projected Benefit Obligation (PBO) } & 95 \text { million } \\ \text { Plan Assets (at fair value) } & 80 \text { million } \\ \text { Unrecognized transition asset } & 11 \text { million } \\ \text { Unrecognized actuarial losses } & 1 \text { million }\\\\\text { Assumptions: }\\ \text {Discount rate}&8\%\\ \text {Return on assets}&9\%\\ \text {Compensation growth}&5\% \end{array}$


-The estimated interest cost for 2007 is:

A)$7.95 million.
B)$7.60 million.
C)$7.36 million.
D)$7.20 million.

Question 52

Investing in equity is considered to be more risky than investing in bonds.

Question 53

A company will record a contingent gain if the gain is probable and reasonably estimable.

Question 54

The net deferrals are included in the balance sheet as part of:

A)assets.
B)current liabilities.
C)shareholders' equity.
D)long-term liabilities.

Question 55

Harms Inc. reported in its 2006 annual report the following information:
$\quad$ $\quad$ $\quad$ $\quad$ $\quad$$\underline{\text { Plan Status: December 31, } 2006}$

$\begin{array} { l r } \text { Accumulated Benefit Obligation (ABO) } & \$ 90 \text { million } \\ \text { Projected Benefit Obligation (PBO) } & 95 \text { million } \\ \text { Plan Assets (at fair value) } & 80 \text { million } \\ \text { Unrecognized transition asset } & 11 \text { million } \\ \text { Unrecognized actuarial losses } & 1 \text { million }\\\\\text { Assumptions: }\\ \text {Discount rate}&8\%\\ \text {Return on assets}&9\%\\ \text {Compensation growth}&5\% \end{array}$


-Funded status at the end of 2006 was:

A)$15 million.
B)$12 million.
C)$10 million.
D)$0 million.

Question 56

A company issues a $100,000, 9% bond and receives $99,000 (ignoring transaction costs). This implies that the effective interest rate is less than 9%.

Question 57

A plan is said to be underfunded, if:

A)the pension obligation is more than the asset value.
B)the pension obligation is less than the asset value.
C)the pension obligation is equal to the asset value.
D)None of the above

Question 58

Evaluating risk of long-term creditors (e.g. bondholders) involves more detail than evaluating the risk of equity holders.

Question 59

Stockholders are the residual claimants of a company.

Question 60

Which of the following is not a component of pension expense?

A)Service cost
B)Interest cost
C)Actual return on plan assets
D)Expected return on plan assets

Question 61

One reason many companies do not fund their postretirement obligations other than pensions is because they are not required to do so by law.

Question 62

For a company to report a contingent loss it should be either probable or reasonably estimable.

Question 63

With a defined contribution plan the risk of pension fund performance rests with the employees/retirees of the company, while with a defined benefit plan this risk rests with the company.

Question 64

If a company increases its expected rate of compensation increase for the purposes of calculating its pension obligations, the accumulated benefit obligation and the projected benefit obligation will both increase.

Question 65

Pension accounting for defined benefit plans requires that retroactive adjustments to the plan (prior service costs) be recognized immediately in full in the pension expense.

Question 66

Funding of pension plans is required by GAAP.

Question 67

Companies must report the economic pension cost in their financial statements.

Question 68

A convertible bond is an equity investment, which is convertible into bonds at the option of the owner of the convertible bond.

Question 69

Many postretirement benefits other than pensions are not funded, in part because they are not required to be funded by law, unlike pension plans.

Question 70

A decrease in the growth rate of the future compensation will cause an increase in pension cost.

Question 71

If a company increases the amount of debt it has, all other things being equal, the risk to the shareholders increases.

Question 72

If a company issues new stock, this will always decrease book value per share.

Question 73

A company which leases a piece of machinery (the lessee) will record it as a sales-type lease if the lessor makes a profit on the lease.

Question 74

If the lease term is 75% or more of the economic life of the asset, the lease needs to be classified as a capital lease.

Question 75

If a company increases its discount rate for the purposes of calculating its pension obligations, the accumulated benefit obligation and the projected benefit obligation will both decrease.

Question 76

Actuarial gain or loss is the change in PBO that occurs when one or more actuarial assumptions are revised in estimating PBO.

Question 77

Three elements of pension expense for defined benefit plans are: service cost, interest cost, and actual return on plan assets.

Question 78

The par value of common stock represents the price at which a company offered its stock to investors when it made its initial public offering.

Question 79

Operating leases can inflate both return on investment and asset turnover ratios.

Question 80

When analyzing postretirement benefits, one should evaluate the actuarial assumptions and their effects on the financial statements.