CHAPTER 5

OFF-BALANCE SHEET FINANCING & FINANCIAL ANALYSIS

Difficulty: 2 Correct: D

1. Debt eligible for insubstance defeasance

a) has a floating interest rate.
b) is payable on demand.
c) is convertible into preferred stock.
d) may mature within five years.

Difficulty: 3 Correct: A

2. The pension liability that frequently appears on company balance sheets represents
a) an accounting credit that results from an excess of amounts expensed over
amounts contributed to the pension. fund.
b) the total unfunded portion of the pension liability.
c) the economic obligations under the pension plan.
d) recognition of prior service costs and not current costs.

Difficulty: 2 Correct: D

3. Unfunded pension liabilities

a) affect the company's quality of earnings.
b) represent future demands on the resources of the company.
c) may arise from cost-conscious management cutting funding.
d) All of these answers are correct.

Difficulty: 2 Correct: B

4. The amount recognized as pension expense is

a) totally at the discretion of management.
b) sensitive to interest rate assumptions.
c) independent of changes in the value of pension assets.
d) excluded in the analysis of cash flows.

Difficulty: 2 Correct: A

5. If the solvency of the firm is in question, government regulations hold that the company
is liable for either the unfunded vested amount
a) or 30 percent of stockholders' equity, whichever is less.
b) and non-vested amounts or 30 percent of stockholders' equity, whichever is less.
c) or 30 percent of stockholders' equity, whichever is more.
d) and non-vested amounts or 30 percent of stockholders' equity, whichever is more.
Difficulty: 3 Correct: B

6. The criterion that causes the lease to be capitalized determines the depreciation method.
Which of the following statements is true?
a) If no bargain purchase option exists, then the firm's normal depreciation policies
apply.
b) If the lease transfers ownership, then the firm's normal depreciation policies
apply.
c) If the lease term is equal to or greater than 90 percent of the leased asset's
economic life, then the asset is amortized over the life of the lease contract.
d) All of these answers are correct.

Difficulty: 2 Correct: A

7. Management would rather report leases

a) as operating leases because they are not included on the balance sheet.
b) as capital leases since they will increase the size of the firm's assets.
c) as operating leases because this results in higher cash flow.
d) Both (a) and (c) are correct.

Difficulty: 2 Correct: A

8. Which of the following is characteristic of a financial lease?

a) Must appear on lessee's balance sheet
b) Terms of lease last for less than 50 percent of the asset's useful life
c) Contains provisions for lessor to retain ownership after lease expires
d) All of these answers are correct.

Difficulty: 2 Correct: B

9. An approximation for estimating the present value of operating leases is as follows:

a) (present value of capital leases) x (total minimum capital lease payments) / (total
minimum operating lease payments).
b) (total minimum operating lease payments) / (total minimum capital lease
payments) x (present value of capital leases).
c) (total minimum capital lease payments) / (present value of capital leases) x (total
minimum operating lease payments).
d) None of these answers is correct.
Difficulty: 2 Correct: C

10. Which of the following statements is false? Insubstance defeasance of debt

a) results in lower debt-equity ratios.
b) circumvents dealing with individual bondholders.
c) releases the company from being the primary obligator under the debt instrument.
d) may result in interest costs associated with financing the purchase of government
securities exceeding the interest costs of debt being extinguished.

Difficulty: 2 Correct: C

11. Unconditional commitment arrangements may take the form of take-or-pay contracts or
throughput contracts.
a) A take-or-pay contract is an agreement between a buyer and a seller for the buyer
to pay specified amounts periodically for services, even if the buyer does not use
the service
b) A throughput contract is similar to (a) except that it represents contracts to
acquire products rather than services.
c) A take-or-pay contract is an agreement. between a buyer and a seller for the buyer
to pay specified amounts periodically for products, even if the buyer does not take
the product.
d) None of these answers is correct.

Difficulty: 2 Correct: A

12. An advantage of an operating lease relative to a financial lease from the lessee's
viewpoint is that
a) it transfers risk of obsolescence to the lessor.
b) an operating lease is non-cancelable.
c) an operating lease yields greater tax benefits.
d) Both (a) and (b) are correct.

Difficulty: 2 Correct: C

13. For the lessee, a financing lease arrangement is most comparable to

a) 100 percent equity, financing.
b) 50 percent debt, 50 percent equity financing.
c) 100 percent debt financing.
d) financing at the firm's current debt-equity ratio.
Difficulty: 2 Correct: A

14. Generally accepted accounting principles require that certain lease agreements be
accounted for as purchases. The theoretic basis for this treatment is that a lease of this
type
a) effectively conveys all of the benefits and risks incident to the ownership of
property.
b) is an example of form over substance.
c) provides the use of the leased asset to the lessee for a limited period of time.
d) must be recorded in accordance with the concept of cause and effect.

Difficulty: 2 Correct: A

15. Which of the following disclosures concerning pension plans should be made in a
company's financial statements or their notes?
a) A statement of a company's accounting and funding policies
b) The amount of retirement benefits paid during the year
c) A description of the actuarial assumptions made
d) The amount of unfunded past service costs

Difficulty: 2 Correct: D

16. The past service costs in a pension plan

a) are charged to income in the year of the inception of the pension plan.
b) are funded in the year of the inception of the pension plan.
c) are not included in the determination of either the accumulated benefit obligation
or the projected benefit obligation.
d) represent pension costs assigned to years prior to the inception of the pension
plan.

Difficulty: 3 Correct: B

17. A company has a contributory pension plan for all of its employees. In 19x1, a total. of
$100,000 was withheld from employees' salaries and deposited into a pension fund
administered by a trustee. In addition, the company deposited $200,000 of its own money
into the fund in 19x1. The actuarial cost of the pension plan was $320,000. As a result,
the company, deposited $20,000 of its own money into the fund in January, 19x2. How
much should the provision for pension cost be in the firm's 19x1 income statement:
a) $200,000
b) $220,000
c) $300,000
d) $320,000
Difficulty: 2 Correct: B

18. What is the difference between the terms "past service costs" and "prior service costs"?
a) Past service costs refer to costs applicable to periods prior to a particular date of
actuarial valuation, and prior service costs refer to costs applicable to employee
service prior to the inception of a pension plan.
b) Past service costs refer to costs applicable to employee service prior to the
inception of a pension plan, and prior service costs refer to costs applicable to
periods prior to a particular date of actuarial valuation.
c) There is no difference between the two terms and they can be used
interchangeably.
d) There is a difference between the two terms, but none of the above answers
describe it.

Difficulty: 2 Correct: C

19. When an investor uses the equity method to account for investments in common stock,
cash dividends received by the investor from the investee should be recorded as
a) dividend income.
b) an addition to the investment account.
c) a deduction from the investment account.
d) a deduction from the stockholders' equity account, as dividends to stockholders.

Difficulty: 3 Correct: D

20. In a parent's unconsolidated financial statements, which accounts, other than cash, are
affected when reflecting a subsidiary's earnings and dividends?
a) Dividend revenue, equity in earnings of subsidiary, and retained earnings
b) Dividend revenue and retained earnings
c) Investment in subsidiary, equity in earnings of subsidiary, dividend revenue, and
retained earnings
d) Investment in subsidiary, equity in earnings of subsidiary, and retained earnings

Difficulty: 2 Correct: B

21. Management agrees to rent a tractor. It signs an agreement whereby it will pay $100 a
month for four years, perform repairs, pay property taxes, and insure against losses
arising from accidents. At. the end of four years, it can pay $50 and keep the tractor or
bring it back and rent another one. For accounting purposes, this is an example of a(n)
a) buy/sell agreement.
b) capital lease.
c) operating lease.
d) equipment purchase.
Difficulty: 2 Correct: D

22. Carney Inc., leased an auto from a local company for four years. Carney pays; all the
expenses and maintenance costs, and at the end of the lease it keeps the auto. The lease is
non-cancelable. Carney should treat this as
a) an operating lease, debiting Auto Expense.
b) an operating lease, debiting Auto Asset.
c) a financing lease, debiting Auto Expense.
d) a financing lease, debiting Auto Asset.

Difficulty: 2 Correct: B

23. What two factors can negate the requirement of consolidated financial statements?
a) Control is temporary and economic incompatibility exists among the businesses.
b) Control is temporary and/or control does not reside with the majority owner.
c) Both lack of control and little financial compatibility exist.
d) Both economic and financial incompatibility exist.

Difficulty: 2 Correct: A

24. An operating lease for $1500 per year for 20 years discounted at 10 percent would
a) not appear on the firm's balance sheet.
b) be a liability on the firm's balance sheet
c) be an asset on the firm's balance sheet.
d) be both an asset and a liability on the firm's balance sheet.

Difficulty: 2 Correct: C

25. SFAS 87 accounts for a portion of unfunded defined-benefit pension costs as

a) an expense.
b) a reduction in stockholders' equity.
c) an intangible asset.
d) Does not account for them.

Difficulty: 2 Correct: D

26. Expected post-retirement health benefits payable to employees are

a) accounted for as an indeterminate liability.
b) accounted for as a reduction in stockholders' equity.
c) accounted for as an intangible asset.
d) accounted for in a way similar to pension liabilities.
e) not accounted for until they are realized.
Difficulty: 2 Correct: B

27. Which of the following strategies can be used to avoid capitalizing a lease?
a) Identify the lease agreement as less than 90 percent of the true economic life of
the leased property.
b) Lease property where the lease term begins during the last 25 percent of the
economic life of the leased property.
c) Establish a high incremental borrowing rate so that the present value of minimum
lease payments will be more than 90 percent of the fair value of the leased
property at the inception of the lease.
d) None of the above is correct.

Difficulty: 2 Correct: A

28. When the residual value of leased property is guaranteed by a third party, the
a) residual value is not included in the definition of minimum lease payments.
b) residual value is included in the definition of minimum lease payments.
c) lease automatically becomes a capital (i.e., financial) lease.
d) lease automatically qualifies as an operating lease.

Difficulty: 2 Correct: C

29. To circumvent treating the sale of receivables as a loan,

a) control of the future economic benefits of the receivable is transferred to the
buyer.
b) cost of the seller's obligations under the recourse provisions is subject to
reasonable estimation.
c) Both (a) and (b) are correct.
d) Neither (a) nor (b) is correct.

Difficulty: 2 Correct: D

30. In a typical R&D limited partnership structure

a) the corporation is a limited partner and pays royalties to the partnership and
receives legal right to technology developed.
b) any successfully developed technology is leased to the developing contractor,
who pays royalties to the limited partnership.
c) the sponsoring corporation receives royalties from the limited partnership.
d) the corporation (which is usually the general partner) leases successfully
developed technology from the limited partnership and pays royalties to the
limited partnership.
Difficulty: 2 Correct: D

31. Notes to the annual report show an accumulated benefit obligation (ABO) of $1700 and a
projected benefit obligation (PBO) of $2100. Pension plan assets have a value of $2000.
According to SFAS 87, how much will be debited to the intangible asset account?
a) $100
b) $400
c) $300
$ $0

Difficulty: 3 Correct: D

32. In analyzing a firm's annual report you notice that the accumulated benefit obligation for
the company's pension plan is $1700; the projected benefit obligation is $2200; plan
assets are $1650; and the accrued pension expense is $75. According to SFAS 87, how
much is the unfunded liability for this year?
a) $50
b) $550
c) $75
d) $0

Difficulty: 2 Correct: B

33. The notes to the annual report indicate capital lease costs for each of the next five years
and thereafter as a lump sum to be as follows: $15, $16, $14, $14, $12, $200. The total
amount of interest included in these payments is $100. The report also indicates operating
lease payments for the next five years and thereafter as a lump sum as follows: $50, $52,
$55, $60, $60, $300. Given this information, what is the amount that should be used to
capitalize the operating leases?
a) $277
b) $364
c) $130
d) Not enough information is provided.

Difficulty: 2 Correct: D

34. Assume that you do not know the lessor's discount rate and you want to use the net
present value approach to estimate the capitalized value of the operating leases. What rate
should be used to discount the lease payments?
a) The firm's weighted average cost of capital.
b) The firm's cost of equity.
c) The before-tax cost of debt to the firm.
d) The after-tax cost of debt to the firm.
Difficulty: 2 Correct: D

35. Management, has decided to defease $8 million of debt currently carried on the balance
sheet. The debt carries a coupon rate of 5 percent and has eight years until maturity. The
yield on comparable AAA bonds is 10 percent. How much must be segregated with a
trustee?
a) $5,870,000
b) $3,736,000
c) $2,134,000
d) Not enough information is provided.

Difficulty: 3 Correct: C

36. Management finds that it can defease $10 million of 5 percent fixed coupon debt by
placing $6.802 million in an irrevocable trust. The debt still has seven years until
maturity. How much is the discount rate?
a) 5 percent
b) 6.8 percent
c) 12 percent
d) Not enough information is provided.

Difficulty: 2 Correct: C

37. Management: is able to place $6.9 million with a trustee to defease $11 million of debt.
The debt carries a coupon rate of 6 percent, which results in annual interest payments of
$660,000 each year. The corporate tax rate is 34 percent. How much is the gain that will
be recorded when the debt is defeased?
a) $660,000
b) $660,000 times the years left to maturity
c) $4.1 million
d) $2.706 million

Difficulty: 2 Correct: D

38. Off-balance sheet financing arises in an interest rate swap because

a) the principal amount of the debt is removed from the balance :sheet.
b) management has no idea of its liability.
c) the debt is placed in an irrevocable trust.
d) higher interest payments may be incurred that are not reflected on the balance
sheet.
Difficulty: 2 Correct: D

39. A pension put option

a) pertains to a defined-contribution pension plan.
b) means that the pension manager can exercise tradable options to provide
downside protection to the pension assets.
c) is a security traded on an option exchange.
d) None of these answers is correct.

Difficulty: 2 Correct: B

40. A company has a 100 percent owned subsidiary that it can account for by using the equity
method. It started the subsidiary last January 1 with. an investment of $1 million. At the
end of last year the subsidiary had earned a $250,000 profit but did not pay any dividend.
When the books for the subsidiary were closed at the end of the second year, it was
learned that the subsidiary had a loss of $100,000. The subsidiary also paid a dividend of
$25,000. How much is the parent's investment in the subsidiary?
a) It is impossible to tell.
b) $1.125 million
c) $1 million
d) $1.15 million