Test bank for financial statement analysis and valuation 5th edition by easton mcanally sommers zhan

Test Bank for Financial Statement Analysis and Valuation, 5th Edition, by Easton, McAnally,

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Module 7 Liability Recognition and Nonowner Financing Learning Objectives – Coverage by question True/False

Multiple Choice

Exercises

Problems

Essays

LO1 – Explain accounting for accrued liabilities.

1-4

1-7

1-3

1

1, 2

LO2 – Analyze reporting for short-term debt.

5

8-10

4, 5

2

LO3 – Determine the pricing of long-term debt.

6-9

11-21

6-10

2

3

LO4 – Analyze reporting for long-term debt.

10

13, 22, 23

11-14

3-6

4

LO5 – Explain how the quality of debt is determined

11-14

21, 24-29

15, 16

14-20

6-10

LO6 – Apply time value of money concepts (Appendix 7A)

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5, 6

Financial Statement Analysis & Valuation, 5th Edition

Module 7: Liability Recognition and Nonowner Financing

True/False Topic: Deferred Revenue LO: 1 1. Unearned revenue, an operating liability, arises when a company receives cash before any goods are delivered or services are rendered.

Answer: True

Topic: Accrued Liabilities LO: 1 2. Accrued liabilities are obligations for which there is no external transaction.

Answer: True Rationale: Companies must estimate accrued liabilities such as rent payable because there has been no bill received or no transaction.

Topic: Income Shifting LO: 1 3. If accrued liabilities are overestimated in the current period, the reported income in a following period will be lower than it should be.

Answer: False Rationale: If the accrued liabilities in this period are overestimated, then the current income is lower than it should be. This error will be corrected in a following period, and will artificially inflate income.

Topic: Contingent Liabilities LO: 1 4. Contingent liabilities that are ‘probable’ and can be reasonably estimated are recorded on the balance sheet as a liability and as an expense in the income statement.

Answer: True Rationale: Only ‘probable’ contingent liabilities are estimated and recorded on the balance sheet or the income statement. Anything less than ‘probable’ liabilities (such as ‘reasonably possible’) are referenced in footnotes.

Test Bank, Module 7

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Topic: Reporting of Current Portion of Long-Term Debt LO: 2 5. The principal and interest that will be paid on long-term debt within the next operating cycle are reported on the balance sheet as “current portion of long-term debt.”

Answer: False Rationale: Only the principal portion is classified as “current portion of long-term debt.”

Topic: Premium Bond LO: 3 6. A bond selling for an amount above face value is said to be selling at a discount.

Answer: False Rationale: This bond sells at a premium, not a discount.

Topic: Secondary Market for Bonds LO: 3 7. Unlike stock, once sold, bonds can only be traded in private transactions between arms’ length parties.

Answer: False Rationale: After the bonds are issued, they can trade in the secondary market just like stocks.

Topic: Bond Prices LO: 3 8. Market prices of bonds fluctuate because the company’s obligation (in the form of principal and interest payments) remains fixed.

Answer: True Rationale: Market prices fluctuate similar to stocks. The reasoning behind this is that bonds compete with other investments and become more or less attractive based on the interest rates of competing securities and the financial condition of the borrowing company.

Topic: Cost of Debt LO: 3 9. The coupon rate of a bond typically equals the yield (market) rate.

Answer: False Rationale: The coupon rate and the market rate are nearly always different. The coupon rate is fixed prior to issuance of the bond and normally remains fixed throughout its life. Market rates of interest, on the other hand, fluctuate continually with the supply and demand for bonds in the marketplace, general macroeconomic conditions, and the borrower’s financial condition.

Topic: Gains (Losses) on Bond Repurchase LO: 4 10. The gain (or loss) on the repurchase of a bond carries no economic effects, as the gain (or loss) is exactly offset by the present value of the future cash flow implications of the repurchase.

Answer: True

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Financial Statement Analysis & Valuation, 5th Edition

Topic: Quality of Debt LO: 5 11. The market rate of interest is equal to the risk-free rate plus a credit-rating premium.

Answer: False Rationale: The market rate of interest is usually defined as the yield on U.S. Government borrowings such as treasury bills, notes, and bonds, called the risk-free rate, plus a spread (also called a risk premium).

Topic: Debt Ratings LO: 5 12. Credit ratings are an opinion of a company’s relative default risk.

Answer: True Rationale: The credit rating agencies provide an assessment of their view of the likelihood that a company will default on its debt obligations.

Topic: Quality of Debt LO: 5 13. The market rate of interest is equal to the risk-free rate plus a risk premium.

Answer: True Rationale: The market rate of interest is usually defined as the yield on U.S. Government borrowings such as treasury bills, notes, and bonds, called the risk-free rate, plus a spread (also called a risk premium).

Topic: Credit Ratings and the Cost of Debt LO: 5 14. Higher credit-rated borrowers receive lower interest rates than lower credit-rated borrowers, but the differences are typically not significant.

Answer: False Rationale: Higher credit-rated borrowers receive lower interest rates than lower credit-rated borrowers and the difference is significant. For example, in March 2016, the average 10-year treasury bond yield was 1.89%, while the Aaa corporate bond yield was 3.82% and the average Baa (the lowest investment grade corporate bond) yield was 5.13%.

Test Bank, Module 7

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Multiple Choice Topic: Contingent Liabilities LO: 1 1. Contingent Liabilities must have the following criteria – select all that apply.

A) The obligation is certain to require payment at some point in the future.

B) The obligation will probably require payment at some point in the future.

C) The obligation is estimable.

D) The obligation will possibly require payment at some point in the future.

E) None of the above Answer: B and C Rationale: Contingent liabilities are only included when the amount is probable and estimable. An obligation that is guaranteed at some point in the future is a liability, and one for which the liability is less than reasonably possible does not need to be reported.

Topic: Current Liabilities LO: 1 2. Which of the following does not affect the current liabilities section of the balance sheet?

A) Purchase of inventory on credit B) Wages owing to employees but not yet paid C) Insurance bill to be paid next month D) Sale of goods on credit E) A probable legal obligation, due within 12 months Answer: D Rationale: The sale of goods on credit impacts non-cash assets, specifically accounts receivable; all the other items are liabilities that the company must pay within the next year, hence current liabilities.

Topic: Contingent Liability LO: 1 3. Which one of the following would be considered a contingent liability?

A) A company estimates that it will probably have to pay $75,000 to the EPA for a chemical spill.

B) A company owes $35,000 on inventories purchased on credit.

C) A company has access to a line of credit with a bank in the amount of $120,000.

D) A company believes that it is reasonably possible it will lose a lawsuit and damages could be $100,000.

E) None of the above Answer: A Rationale: For a liability to be a contingent liability, the amount must be estimable and probable.

© Cambridge Business Publishers, 2018 7-5

Financial Statement Analysis & Valuation, 5th Edition

Topic: Reporting of Accruals LO: 1 4. Which of the following would not require the company to record an accrual on the balance sheet?

A) The company owes $43,000 in wages to its employees for the previous two weeks.

B) Interest will be paid when a note payable matures in the following accounting period.

C) Management believes a lawsuit against the company is meritless because they have never had a single complaint about dangerous side effects of their drug in two years.

D) The company knows that they will be fined for pollution as a result of their manufacturing process and can estimate the amount of the obligation.

E) None of the above Answer: C Rationale: Based on management’s belief, the lawsuit at hand can be deemed less than reasonably possible and therefore does not need to be disclosed in the financial statements.

Topic: Current Liability LO: 1 5. Which of the following does not represent a current liability?

A) Accrual of taxes payable B) Short-term loan C) Purchase of inventory on credit D) Bond issue E) None of the above Answer: D Rationale: Bonds are issued to raise capital with repayment of the principal amount on a specified date in the future (more than one year from the point of issue); therefore, bonds are considered longterm liabilities.

Topic: Accounting for Warranties LO: 1 6. EZ Wheels Corporation manufactures kick scooters. The company offers a one-year warranty on all scooters. During 2017, the company recorded net sales of $1,900 million. Historically, about 4% of all sales are returned under warranty and the cost of repairing and or replacing goods under warranty is about 30% of retail value. Assume that at the start of the year EZ Wheels’ balance sheet included an accrued warranty liability of $16.3 million and at the end of the year, the accrued warranty liability balance was $12.4 million.

What was EZ Wheels Corporation’s warranty expense for 2017?

A) 12.4 million B) 22.8 million C) 76.0 million D) 26.7 million E) None of the above Answer: B Rationale: $1,900 million x 4% x 30% = 22.8 million

Test Bank, Module 7

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Topic: Accounting for Warranties LO: 1 7. EZ Wheels Corporation manufactures kick scooters. The company offers a one-year warranty on all scooters. During 2017, the company recorded net sales of $1,900 million. Historically, about 4% of all sales are returned under warranty and the cost of repairing and or replacing goods under warranty is about 30% of retail value. Assume that at the start of the year EZ Wheels’ balance sheet included an accrued warranty liability of $16.3 million and at the end of the year, the accrued warranty liability balance was $12.4 million.

How much did EZ Wheels pay during the year to repair and/or replace scooters under warranty?

A) 12.4 million B) 22.8 million C) 76.0 million D) 26.7 million E) None of the above Answer: D Rationale: Total cash paid out is $16.3 million + $22.8 million* - $12.4 million = $26.7 million. *$1,900 million x 4% x 30% = 22.8 million (warranty expense)

Topic: Interest Accrual (Numerical calculations required) LO: 2 8. Chang, Inc. issued a 120-day note in the amount of $360,000 on 12/16/17 with an annual rate of 5%.

What amount of interest has accrued as of 12/31/17?

A) $ 750.00 B) $ 725.81 C) $ 739.73 D) $6,000.00 E) $5,917.81 Answer: C Rationale: $360,000 × 5% × 15 / 365 days = $739.73

Topic: Interest Accrual (Numerical calculations required) LO: 2 9. Chang, Inc. issued a 3-month note in the amount of $360,000 on 12/01/17 with an annual rate of 5%.

What amount of interest has accrued as of 12/31/17?

A) $4,438 B) $1,500 C) $ 950 D) $4,500 E) $1,479 Answer: B Rationale: $360,000 × 5% × 1 / 12 months = $1,500

© Cambridge Business Publishers, 2018 7-7

Financial Statement Analysis & Valuation, 5th Edition

Topic: Accounting for Short-Term Debt (Numerical calculations required) LO: 2 10. On January 1, Bloomingdale, Inc. borrows $92,000 from First Estate Bank. The loan is due in one year along with 4% interest. The company is preparing its quarterly report for March 31. Which of the following best describes the necessary accrual for interest expense?

A) $ 920 increase liabilities, increase expenses B) $3,680 decrease liabilities, decrease cash C) $3 680 increase expenses, decrease cash D) $3,680 increase liabilities, decrease expenses E) $ 920 decrease liabilities, decrease cash Answer: A Rationale: The quarterly interest charge is calculated by multiplying the loan amount ($92,000) by the interest rate (4%) and then by the portion of the year outstanding (3/12), or $920 accrued interest.

The company needs to reflect the outstanding interest owed (accrued interest) by increasing liabilities and increasing interest expense.

Topic: Periodic Interest Payments (Numerical calculations required) LO: 3 11. Hudson Corp. sells $300,000 of bonds to private investors. The bonds have a 7% coupon rate and interest is paid semiannually. The bonds were sold to yield 10%.

What periodic interest payment does Hudson make to its investors?

A) $18,000 B) $20,000 C) $ 9,000 D) $10,500 E) None of the above Answer: D Rationale: Coupon rates are used to compute the dollar amount in interest payments paid to the bondholder semiannually. Hudson pays $300,000 × 7% × ½ year = $10,500.

Topic: Periodic Interest Payment (Numerical calculations required) LO: 3 12. Pinto Corp. sells $300,000 of bonds to private investors. The bonds have a 4% coupon rate and interest is paid semiannually. The bonds were sold to yield 5%.

What periodic interest payment does Pinto make to its investors?

A) $6,000 B) $5,000 C) $2,500 D) $3,000 E) None of the above Answer: A Rationale: Coupon rates are used to compute the dollar amount in interest payments paid to the bondholder semiannually. Pinto pays $300,000 × 4% × ½ year = $6,000.

Test Bank, Module 7

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Topic: Understanding Bonds LO: 3, 4 13. Which one of the following is not correct?

A) For debt issued at par: interest expense reported on the income statement equals the cash paid for interest.

B) For bond repurchases: Gain (loss) on bond repurchase = Cash paid to repurchase – Net book value of bonds.

C) For debt issued at a discount: interest expense reported on the income statement equals cash interest payment less amortization of the discount.

D) For debt issued at a premium, interest expense reported on the income statement equals cash interest payment less amortization of the premium.

E) None of the above Answer: C Rationale: For debt issued at a discount, interest expense reported on the income statement is cash interest paid plus amortization of the discount.

Topic: Bond Pricing (Numerical calculations required) LO: 3, 6 14. Reed Corp. sells $500,000 of bonds to private investors. The bonds are due in five years, have a 6% coupon rate, and interest is paid semiannually. The bonds were sold to yield 4%.

What proceeds does Reed receive from the investors?

A) $544,913 B) $474,345 C) $526,948 D) $499,999 E) None of the above Answer: A Rationale: Using a financial calculator or Excel the present value of the bonds = $544,913 Calculator N = 10 I/Yr = 2 PMT = -15,000 FV = -500,000

Excel Rate = 2% Nper = 10 Pmt = -15,000 FV = -500,000 Type = 0

© Cambridge Business Publishers, 2018 7-9

Financial Statement Analysis & Valuation, 5th Edition

Topic: Bond Pricing (Numerical calculations required) LO: 3, 6 15. Reed Corp. sells $700,000 of bonds to private investors. The bonds are due in five years, have a 4% coupon rate and interest is paid semiannually. The bonds were sold to yield 6%.

What proceeds does Reed receive from the investors?

A) $600,000 B) $574,409 C) $640,289 D) $523,227 E) None of the above Answer: C Rationale: Using a financial calculator or Excel the present value of the bonds = $640,289.

Calculator N = 10 I/Yr = 3 PMT = -14,000 FV = -700,000

Excel Rate = 3% Nper = 10 Pmt = -14,000 FV = -700,000 Type = 0

Topic: Effective Rate (Numerical calculations required) LO: 3, 6 16. Sykora Corp. sells $450,000 of bonds to private investors. The bonds are due in 5 years, have a 6% coupon rate and interest is paid semiannually. Sykora received $490,222 for the bonds at issuance.

The effective rate on these bonds is: A) 6% B) 9% C) 4% D) 10% E) None of the above Answer: C Rationale: Using a financial calculator or Excel, the semi-annual effective interest rate on the bonds equals 2%, resulting in an annual effective rate of 4%.

Calculator N = 10 PV = 490,222 PMT = -13,500 FV = -450,000

Test Bank, Module 7

Excel Nper = 10 Pmt = -13,500 PV = 490,222 FV = -450,000 Type = 0

© Cambridge Business Publishers, 2018 7-10

Topic: Bond Pricing (Numerical calculations required) LO: 3, 6 17. Heller Company issues $950,000 of 12% bonds that pay interest semiannually and mature in 10 years.

What is the bonds’ issue price assuming that the bonds’ market interest rate is 10% per year?

A) $ 950,000 B) $1,068,391 C) $ 626,485 D) $1,111,758 E) None of the above Answer: B Rationale: Using a financial calculator or Excel the present value of the bonds = $1,068,391 Calculator N = 20 I/Yr = 5 PMT = -57,000 FV = -950,000

Excel Rate = 5% Nper = 20 Pmt = -57,000 FV = -950,000 Type = 0

Topic: Bond Pricing (Numerical calculations required)

LO: 3, 6 18. Heller Company issues $950,000 of 10% bonds that pay interest semiannually and mature in 10 years.

What is the bonds’ issue price assuming that the bonds’ market interest rate is 14% per year?

A) $ 748,714 B) $ 950,000 C) $ 751,788 D) $1,273,515 E) None of the above Answer: A Rationale: Using a financial calculator or Excel the present value of the bonds = $748,714 Calculator N = 20 I/Yr = 7 PMT = -47,500 FV = -950,000

Excel Rate = 7% Nper = 20 Pmt = -47,500 FV = -950,000

© Cambridge Business Publishers, 2018 7-11

Financial Statement Analysis & Valuation, 5th Edition

Topic: Accounting for Bonds (Numerical calculations required) LO: 3, 6 19. InterTech Corporation needed financing to build a new manufacturing plant. On June 30th, 2017, InterTech issued $4,350,000 of 8-year bonds with a 6% coupon rate (payments due on December 31st and June 30th). The effective interest rate was 8%.

What amount in interest expense did InterTech record for the December 31, 2017 payment?

A) $153,725 B) $130,500 C) $156,625 D) $174,000 E) None of the above Answer: A Rationale: Using a financial calculator or Excel, the present value of the bond = $3,843,125 12/31 Interest expense = $3,843,125 × 0.04 = $153,725.

Calculator N = 16 I/Yr = 4 PMT = -130,500 FV = -4,350,000 PV = 3,843,125.14

Excel Rate = 4% Nper = 16 Pmt = -130,500 FV = -4,350,000 Type = 0 PV = 3,843,125.14

Topic: Accounting for Bonds (Numerical calculations required) LO: 3, 6 20. InterTech Corporation needed financing to build a new manufacturing plant. On June 30th, 2017, InterTech issued $4,350,000 of 8-year bonds with a 6% coupon rate (payments due on December 31st and June 30th). The effective interest rate was 8%.

What amount in interest expense did InterTech record for the June 30, 2018 payment?

A) $130,500 B) $154,654 C) $174,000 D) $157,671 E) None of the above Answer: B Rationale: Using a financial calculator or Excel, the present value of the bond = $3,843,125 12/31 Interest expense = $3,843,125 × 0.04 = $153,725 06/30 Interest expense = ($3,843,125 + $23,225*) × 0.04 = $154,654 *Discount amortization = $153,725 - $130,500

Calculator N = 16 I/Yr = 4 PMT = -130,500 FV = -4,350,000 PV = 3,843,125.14

Test Bank, Module 7

Excel Rate = 4% Nper = 16 Pmt = -130,500 FV = -4,350,000 Type = 0 PV = 3,843,125.14

© Cambridge Business Publishers, 2018 7-12

Topic: Bond Pricing (Numerical calculations required) LO: 3, 5 21. Assume that in January 2017, Vivendi announced a €1.2 billion bond issuance. The bonds have a coupon rate of 6.75% payable semiannually. Assume the bonds have been assigned credit ratings of BBB (stable outlook) by Standard and Poor’s, Baa2 (stable outlook) by Moody’s, and BBB (stable outlook) by Fitch.

Which of the following is not true?

A) The yield on these bonds would have been lower if Standard and Poor’s, Moody’s, and Fitch had assigned higher credit ratings.

B) The periodic interest payment will be €40.50 million.

C) The coupon rate on these bonds would have been higher if Standard and Poor’s, Moody’s, and Fitch had assigned lower credit ratings.

D) The periodic interest expense will depend on the bond’s yield.

E) None of the above Answer: C Rationale: Credit ratings affect the bond’s yield but not the coupon payments determined by the issuer.

Topic: Calculating Gain or Loss on Bond Redemption LO: 4 22. Butler, Inc. paid $75,000 to retire a note with a face value of $83,000. The note was issued with an 8% coupon rate paid semiannually. The note was three years from maturity and had a net book value of $68,200.

What is the net gain or loss on the redemption of the note?

A) $6,800 loss B) $8,000 gain C) $8,000 loss D) $6,800 gain E) None of the above Answer: D Rationale: $75,000 paid – $68,200 book value = $6,800 net gain on redemption

Topic: Calculating Book Value of Bonds Redeemed LO: 4 23. Washington Inc. issued $705,000 of 6%, 20-year bonds at 98 on January 1, 2009. Through January 1, 2017, Washington amortized $8,200 of the bond discount. On January 1, 2017, Washington Inc. retired the bonds at 102 (after making the interest payment on that date).

What is the gain or loss that Washington Inc. would report for the retirement of this bond?

A) $20,000 gain B) $14,100 loss C) $20,000 loss D) $14,100 gain E) None of the above Answer: C Rationale: Net book value = ($705,000 × 0.98) + $8,200 = $699,100 Gain (loss) = $699,100 – ($705,000 × 1.02) = $(20,000)

© Cambridge Business Publishers, 2018 7-13

Financial Statement Analysis & Valuation, 5th Edition

Topic: Credit Analysis LO: 5 24. Credit analysis concerns which of the following?

A) The price of a company’s stock B) The ability of a company to consistently pay dividends C) The probability a company will make timely payments D) An assessment of a company’s credit-granting policies E) None of the above Answer: C Rationale: The probability a company will make timely payments, that is, the potential risk of default.

Bond investors are primarily concerned with a company’s ability to make interest and principal payments per the bond agreement.

Topic: Credit Ratings LO: 5 25. Which of the following corporate debt ratings are ordered in terms of decreasing market interest rate?

A) AAA, A, BB, C B) A, AAA, BB, C C) BB, C, A, AAA D) C, BB, A, AAA E) None of the above Answer: D Rationale: As debt quality moves from AAA to C, the market interest rate required increases. So, the required rate decreases from C to AAA.

Topic: Credit Analysis LO: 5 26. Which of the following business factors does not play a role in determining a company’s credit rating?

A) Industry characteristics B) Capital structure C) Management D) Profitability E) None of the above Answer: E Rationale: Industry characteristics, capital structure, management, and profitability all play a role in determining a company’s credit rating.

Topic: Credit Analysis LO: 5 27. What is the risk premium for a company that has a yield rate of 6.24% when the risk-free rate is 4.88%?

A) 4.88% B) 1.36% C) 6.24% D) 11.12% E) None of the above Answer: B Rationale: The risk premium can be found by subtracting the risk-free rate from the yield rate: (6.24% – 4.88% = 1.36%).

Test Bank, Module 7

© Cambridge Business Publishers, 2018 7-14

Topic: Credit Analysis LO: 5 28. In general, how do credit analysts determine the risk-free rate?

A) The average corporate yield B) The yield on U.S. Government borrowings C) The rate defined by the largest U.S. banks D) The weighted-average corporate yield based on the preceding four quarters E) None of the above Answer: B Rationale: The risk-free rate is the yield on U.S. Government borrowings such as treasury bills, notes, and bonds.

Topic: Credit Analysis LO: 5 29. Which of the following does Moody’s not consider in deriving the credit rating of a company?

A) Profitability ratios B) Loan covenants C) Solvency ratios D) Collateral E) None of the above Answer: E Rationale: Moody’s considers many factors in deriving a credit rating, including profitability ratios, covenants, solvency ratios, and collateral.

© Cambridge Business Publishers, 2018 7-15

Financial Statement Analysis & Valuation, 5th Edition

Exercises Topic: Transaction Analysis LO: 1 1. For each item below, identify the amount (if any) that would be reported as a liability on Nike, Inc.’s fiscal year-end balance sheet at May 31, 2017. a. Nike, Inc. agreed to purchase materials for its new line of running shoes in June 2017. b. Nike, Inc. signed a 60-day 8% note for $105,000 on May 12, 2017 to finance its seasonal working capital needs. Principal and interest are due on July 11, 2017. c. Nike, Inc. owes $180,000 at year-end for inventory purchases. d. Nike, Inc. received a $250,000 deposit from Foot Locker for an order on the new line of running shoes that will be ready for shipment in September 2017.

Answer: a. Not recorded as a liability, the transaction is happening next month. b. $105,000 is recorded as a note payable, current nonoperating liability. $437.26* is recorded as interest payable, a current nonoperating liability. *$105,000 x 0.08 x 19/365

c.

$180,000 is recorded in accounts payable (current operating liability) on the balance sheet.

d. $250,000 is recorded as deferred revenue, an accrued liability (current operating liability) on the balance sheet.

Topic: Transaction Analysis—Accounts Payable LO: 1 2. Electronics Incorporated (EI) purchased 120 computers from its supplier on credit at a cost of $500 per computer. The computers were purchased to be held for sale to customers. By the end of the month, EI had sold all 120 computers for $800 each. The store received payment for these computers but waited until the end of the month to settle its account payable with the supplier.

Use the financial statement effects template below to record these transactions.

Balance Sheet Transaction

Cash Asset

+

Noncash Assets

=

Liabil ities

+

Income Statement Contrib. + Capital

Earned Capital

Revenues

–

ExpenNet = ses Income

Purchase computers

=

–

=

Sell computers

=

–

=

Record cost of goods sold

=

–

=

Pay for computers

=

–

=

Test Bank, Module 7

© Cambridge Business Publishers, 2018 7-16

Answer: Balance Sheet Transaction

Cash Asset

Purchase computers

Sell computers

Noncash Assets

=

Liabil+ ities

+60,000 (INV)

=

+60,000 (AP)

+96,000

Record cost of goods sold Pay for computers

+

-60,000 (INV) -60,000

Income Statement Contrib. + Capital

Earned Capital

Revenues

–

ExpenNet = ses Income

–

=

=

+96,000 (Retained Earnings)

+96,000 – (Sales)

=

-60,000 (Retained Earnings)

–

+60,000 = (COGS)

–

=

=

-60,000 (AP)

= +96,000

-60,000

Topic: Accounting for Warranties LO: 1 3. EZ Wheels Corporation manufactures kick scooters. The company offers a one-year warranty on all scooters. During 2017, the company recorded net sales of $2,800 million. Historically, about 3% of all sales are returned under warranty and the cost of repairing and or replacing goods under warranty is about 30% of retail value. Assume that at the start of the year EZ Wheels’ balance sheet included an accrued warranty liability of $15.4 million and at the end of the year, the accrued warranty liability balance was $11.5 million. a. How should EZ Wheels account for warranty claims? b. Calculate EZ Wheels’ warranty expense for 2017. c. How much did EZ Wheels pay during the year to repair and or replace scooters under warranty?

Answer: a. EZ Wheels should record the expected cost of warranties in the same period that sales revenue is recognized. The amount is recorded as a warranty expense in the income statement and as a liability on the balance sheet. The warranty liability should reflect the estimated cost that the company expects to incur as a result of warranty claims and can be estimated based on past experience. b. Warranty expense for 2017 = $2,800 million × 3% × 30% = $25.2 million. c.

During the year, the accrued warranty liability decreased. This means that EZ Wheels paid out more to replace or repair warrantied goods than the expense the company recorded. Total cash paid out is $15.4 million + $25.2 million - $11.5 million = $29.1 million.

© Cambridge Business Publishers, 2018 7-17

Financial Statement Analysis & Valuation, 5th Edition

Topic: Interest Accrual LO: 2 4. On July 1, 2017, Leahy Corporation took out a short-term loan of $45,000 to be repaid in one year.

The annual interest rate is 4% with no interest payments due until the loan is repaid. How much interest should Leahy accrue by year-end December 31, 2017? How should it be recorded in the financial statements?

Answer: Interest expense = $45,000 × 4% × (6/12) = $900 The $900 should be recorded as an increase in current liabilities (interest payable) and an increase in expenses (interest expense) on the income statement.

Topic: Accrued Interest LO: 2 5. Compute the accrued interest as of December 31, 2017, on each of the following notes payable:

a. b. c.

Date of Note 11/20/17 12/19/17 10/29/17

Principal $36,000 $105,000 $72,000

Coupon Rate 8% 12% 15%

Term 60 days 30 days 90 days

Answer: a. $36,000 × 0.08 × 41 days / 365 days = $323.51 b. $105,000 × 0.12 × 12 days / 365 days = $414.25 c.

$72,000 × 0.15 × 63 days / 365 days = $1,864.11

Topic: Accounting for Bonds LO: 3, 6 6. InterTech Corporation needed financing to build a new manufacturing plant. On June 30th, 2017, InterTech issued $3,450,000 of 8-year bonds with a 6% coupon rate (payments due on December 31st and June 30th). The effective interest rate was 8%.

Use the financial statement effects template below to record the bond issue and InterTech’s first two interest payments.

Balance Sheet Transaction

Cash Asset

+

Noncash Assets

=

Liabil+ ities

Income Statement Contrib. + Capital

Earned Capital

Revenues

–

Expenses

=

Bond issue

=

–

=

Interest 12/31

=

–

=

Interest 6/30

=

–

=

Test Bank, Module 7

Net Income

© Cambridge Business Publishers, 2018 7-18

Answer: Balance Sheet =

Liabilities

+3,047,996

=

+3,047,996 (LTD)

Interest 12/31

-$103,500

=

+18,420 (LTD)

Interest 6/30

-$103,500

=

+19,157 (LTD)

Transaction

Cash Asset +

Bond issue

Noncash Assets

Income Statement +

Contrib. + Capital

Earned Capital

Revenues

-121,920 (Retained Earnings) -122,657 (Retained Earnings)

–

Expen -ses

=

Net Income

–

=

–

+121,920 = (IE)

-121,920

–

+122,657 = (IE)

-122,657

(Note: Answers are rounded to the nearest whole number.)

Bond issue price: Using a financial calculator or Excel, the present value of the bond = $3,047,996 Calculator N = 16 I/Yr = 4 PMT = -103,500 FV = -3,450,000

Excel Rate = 4% Nper = 16 Pmt = -103,500 FV = -3,450,000 Type = 0

Interest Cash payment = $3,450,000 × 0.03 = $103,500 12/31 Interest expense = $3,047,996 × 0.04 = $121,920. Bond net book value increases by the difference of $18,420.

6/30 Interest expense = ($3,047,996 + $18,420) × 0.04 = $122,657. Bond net book value increases by the difference of $19,157.

Topic: Accounting for Bonds LO: 3, 6 7. On December 31st, 2017, Daniels Sportsplex opened for business. The company borrowed $18,000,000 at 8% and signed a 10 year note that is to be repaid in 19 equal semiannual payments of $975,000 on June 30th and December 31st, with a balloon payment at maturity. Use the financial statement effects template below to record the issuance of the note and the payments of the first four installments.

Balance Sheet Transaction

Cash Asset

+

Noncash Assets

1) 2)

=

Liabil+ ities

Income Statement Contrib. + Capital

Earned Capital

Revenues

–

Expenses

=

=

–

=

=

–

=

=

–

=

Net Income

3) 4) 5)

© Cambridge Business Publishers, 2018 7-19

Financial Statement Analysis & Valuation, 5th Edition

Answer: Balance Sheet Transaction

Cash Asset

1)

2)

3)

4)

5)

(1) (2) (3) (4) (5)

=

Liabilities

+18 mill

=

+18 mill.

(LTD)

-975,000

=

-255,000 (LTD)

-720,000 (Retained earnings)

=

-265,200 (LTD)

-709,800 (Retained earnings)

+709,800 IE(3)

-709,800

=

-275,808 (LTD)

-699,192 (Retained earnings)

+699,192 IE(4)

-699,192

=

-286,840 (LTD)

-688,160 (Retained earnings)

-975,000

-975,000

-975,000

+

Noncash Assets

Income Statement

+

Contrib. + Capital

Earned Capital

Revenues

–

Expen -ses

–

–

–

=

Net Income

= +720,000 IE(2)

+688,160 IE(5)

=

=

-720,000

-688,160

Received $18 million cash from loan proceeds and recorded the $18 million liability.

0.04 × $18,000,000 = $720,000 interest expense. The difference between the installment cash payment and the interest expense is the repayment of principal.

0.04 × ($18,000,000 - $255,000) = $709,800 interest expense. The difference between the installment cash payment and the interest expense is the repayment of principal.

0.04 × ($18,000,000 - $255,000 - $265,200) = $699,192 interest expense. The difference between the installment cash payment and the interest expense is the repayment of principal.

0.04 × ($18,000,000 - $255,000 - $265,200 - $275,808) = $688,160 interest expense. The difference between the installment cash payment and the interest expense is the repayment of principal.

Topic: Bond Pricing LO: 3, 6 8. Walter Company issues $750,000 of 12% bonds that pay interest semiannually and mature in 10 years. Compute the bonds’ issue price assuming that the bonds’ market interest rate is: a. 10% per year compounded semiannually b. 14% per year compounded semiannually Answer: a. Using a financial calculator or Excel the present value of the bonds = $843,467 Calculator N = 20 I/Yr = 5 PMT = -45,000 FV = -750,000

Excel Rate = 5% Nper = 20 Pmt = -45,000 FV = -750,000 Type = 0

b. Using a financial calculator or Excel the present value of the bonds = $670,545 Calculator N = 20 I/Yr = 7 PMT = -45,000 FV = -750,000

Test Bank, Module 7

Excel Rate = 7% Nper = 20 Pmt = -45,000 FV = -750,000 Type = 0

© Cambridge Business Publishers, 2018 7-20

Topic: Bond Pricing LO: 3, 6 9. Hamilton Company issues $5,250,000 in 7% bonds due in five years with semiannual interest payments. How much should Hamilton expect to receive if the market return for similar bonds is 8%?

Answer: Using a financial calculator or Excel the present value of the bonds = $5,037,089 Calculator N = 10 I/Yr = 4 PMT = -183,750 FV = -5,250,000

Excel Rate = 4% Nper = 10 Pmt = -183,750 FV = -5,250,000 Type = 0

Topic: Bond Pricing LO: 3, 6 10. Cambridge Corporation issued $1,200,000 of 7% bonds that mature in five years. Compute the bond issue price assuming that the market rate for similar bonds is: a. 8% per year compounded annually (and interest is paid annually) b. 10% per year compounded semi-annually (and interest is paid semi-annually) Answer: a. Using a financial calculator or Excel the present value of the bonds = $1,152,087 Calculator N=5 I/Yr = 8 PMT = -84,000 FV = -1,200,000

Excel Rate = 8% Nper = 5 Pmt = -84,000 FV = -1,200,000 Type = 0

b. Using a financial calculator or Excel the present value of the bonds = $1,061,009 Calculator N = 10 I/Yr = 5 PMT = -42,000 FV = -1,200,000

Excel Rate = 5% Nper = 10 Pmt = -42,000 FV = -1,200,000 Type = 0

Topic: Calculating Gain or Loss on Bond Redemption LO: 4 11. Manfred Company retired $500,000 of 5% bonds payable at 96 on June 30, 2017, two years before the bonds matured. The bond book value on June 30, 2017 is $475,000, and bond interest is paid up to the date of retirement.

What is the gain/loss on the retirement of these bonds?

Answer: Amount to retire bonds = $500,000 × 0.96 = $480,000 Bond book value = $475,000 Loss on bond retirement = $480,000 - $475,000 = $5,000 © Cambridge Business Publishers, 2018 7-21

Financial Statement Analysis & Valuation, 5th Edition

Topic: Calculating Gain or Loss on Bond Redemption LO: 4 12. Mahoney, Inc. paid $66,000 to retire a note with a face value of $75,000. The note was issued with an 8% coupon rate paid semiannually. If the note was three years from maturity and had a net book value of $59,200, what is the net gain or loss on the redemption of this note?

Answer: $66,000 paid – $59,200 book value = $6,800 net loss on redemption

Topic: Calculating Gain or Loss on Bond Redemption LO: 4 13. On June 30th, one year before maturity, Bava Industries retired $495,000 of 8% bonds at a cost of 96. The bond’s had a net book value on June 30th of $457,500. Bond interest is presently paid up to the date of retirement.

What is the gain or loss on the retirement of these bonds?

Answer: Gain (loss) on bond repurchase = Net book value of bonds - Repurchase payment Gain (loss) = $457,500 – (96% of the bond face value) = $457,500 – $475,200 = $(17,700) Loss = $17,700

Topic: Calculating Book Value of Bonds Redeemed LO: 4 14. Washington Inc. issued $675,000 of 6%, 20-year bonds at 98 on January 1, 2009. Through January 1, 2017, Washington amortized $7,500 of the bond discount. On January 1, 2017, Washington Inc. retired the bonds at 103 (after making the interest payment on that date).

Calculate the net book value of the bond on January 1, 2017 and the gain or loss that Washington Inc. would report for this retirement.

Answer: Net book value = Bond proceeds at issuance + discount amortization.

Net book value = ($675,000 × 0.98) + $7,500 = $669,000 Gain (loss) = Net book value – Cash to retire bonds.

Gain (loss) = $669,000 – ($675,000 × 1.03) = $(26,250). Washington must report a loss of $26,250 on the bond retirement.

Topic: Understanding Credit Ratings and Financial Ratios LO: 5 15. The table below shows financial ratios that Moody’s uses to assess risk for corporate debt. For each ratio, indicate whether financial risk increases or decreases when the ratio is higher.

Ratio EBITA/Average assets EBITA/Interest expense Operating margin FFO/Debt Debt/EBITA CAPEX/Depreciation expense Revenue volatility

Test Bank, Module 7

Increases / Decreases

© Cambridge Business Publishers, 2018 7-22

Answer: Ratio EBITA/Average assets EBITA/Interest expense Operating margin FFO/Debt Debt/EBITA CAPEX/Depreciation expense Revenue volatility

Increases / Decreases Decreases Decreases Decreases Decreases Increases Decreases Increases

Topic: Understanding Credit Ratings and Financial Ratios LO: 5 16. Weiss Corporation’s 2017 financial statements yield the following financial ratios.

Operating margin Debt/EBITDA FFO/Debt

13.8% 1.5 21.9%

EBITA/Interest expense CAPEX/Depreciation expense Revenue volatility

6.9 1.2 10.8

Using the partial listing of ratios utilized by Moody’s Investors Services along with the median averages for the various ratings, estimate the credit rating that Moody’s might assign to Weiss Corporation.

EBITA/ Avg AT

EBITA Margin

EBITA/ Int. Exp

Oper Margin

FFO/ Debt

Aaa

16.0%

22.8%

35.7

19.0%

86.3%

0.9

1.6

8.6

Aa

14.3%

21.4%

21.1

19.2%

62.7%

1.3

1.3

6.5

A

13.6%

19.4%

13.4

16.8%

46.1%

1.6

1.3

10.4

Baa

10.3%

15.1%

7.2

14.0%

31.0%

2.5

1.2

11.0

Ba

8.6%

12.2%

3.8

10.9%

22.4%

3.4

1.2

15.4

B

6.7%

9.7%

1.7

8.1%

13.6%

5.1

1.1

17.4

Caa-C

5.6%

5.9%

0.8

5.4%

3.4%

7.7

0.9

11.7

Answer: Financial Ratio Operating margin Debt/EBITDA FFO/Debt EBITA/Interest expense CAPEX/Depreciation expense Revenue volatility Overall rating

© Cambridge Business Publishers, 2018 7-23

Result 13.8% 1.5 21.9% 6.9 1.2 10.8

Debt/ CAPEX/ EBITDA Dep Exp

Rev Vol

Rating Baa A Ba Baa Baa-Ba A-Baa Baa

Financial Statement Analysis & Valuation, 5th Edition

Problems Topic: Interpreting Contingency Footnote LO: 1 1. Merck & Co. included the following footnote in its 2016 Form 10-K: Environmental Matters The Company believes that there are no compliance issues associated with applicable environmental laws and regulations that would have a material adverse effect on the Company. The Company is also remediating environmental contamination resulting from past industrial activity at certain of its sites. Expenditures for remediation and environmental liabilities were $11 million in 2016, and are estimated at $44 million in the aggregate for the years 2017 through 2021. These amounts do not consider potential recoveries from other parties. The Company has taken an active role in identifying and accruing for these costs and in management’s opinion, the liabilities for all environmental matters that are probable and reasonably estimable have been accrued and totaled $83 million and $109 million at December 31, 2016 and 2015, respectively. These liabilities are undiscounted, do not consider potential recoveries from other parties and will be paid out over the periods of remediation for the applicable sites, which are expected to occur primarily over the next 15 years. Although it is not possible to predict with certainty the outcome of these matters, or the ultimate costs of remediation, management does not believe that any reasonably possible expenditures that may be incurred in excess of the liabilities accrued should exceed $64 million in the aggregate. Management also does not believe that these expenditures should result in a material adverse effect on the Company’s financial position, results of operations, liquidity, or capital resources for any year.

Required: a. How does Merck account for environmental liabilities that are probable and reasonably estimable? At December 31, 2016, how much were these liabilities? b. How does Merck account for environmental liabilities that are reasonably possible? At December 31, 2016, how much were these liabilities? c. The footnote mentions $83 million and $44 million as estimated future expenditures. Explain what each of these amounts represents and why they differ. d. Use the financial statement effects template below, to record Merck’s 2016 remediation and environmental expenditures, assuming that the liability had already been accrued on Merck’s books.

Balance Sheet Transaction 2016 remediation and environmental expenditures

Test Bank, Module 7

Cash Asset

+

Noncash = Assets

=

Liabil+ ities

Income Statement Contrib. + Capital

Earned Capital

Revenues

–

ExpenNet = ses Income

–

=

© Cambridge Business Publishers, 2018 7-24

Answer: a. Merck accrues a liability for environmental liabilities that the company’s management team believes are probable and reasonably estimable. This is current GAAP. At December 31, 2016, Merck had accrued on its balance sheet, $83 million for such liabilities. b. Merck does not accrue a liability for environmental costs that are reasonably possible. Instead, Merck discloses these potential future payments in a footnote. At December 31, 2016, these liabilities amounted to an additional $64 million. c.

The $83 million is the total accrual on Merck’s balance sheet at year end. The $44 million is the amount that Merck anticipates paying out in the coming five years (2017 to 2021). The difference of $39 million will be paid in 2022 and later.

d.

Balance Sheet Transaction

Cash Asset

2016 remediation and environmental expenditures

-11 million

+

Noncash = Assets

Liabilities

=

-11 million (Accrued liabilities)

+

Income Statement Contrib. + Capital

Earned Capital

Revenues

–

ExpenNet = ses Income

–

=

Topic: Interpreting Long-Term Debt Footnote LO: 2, 3 2. Following is a footnote for Abbott Laboratories 2016 annual report (in millions): The following is a summary of long-term debt at December 31: 2016 5.125% Notes, due 2019 2.35% Notes, due 2019 4.125% Notes, due 2020 2.00% Notes, due 2020 2.90% Notes, due 2021 2.55% Notes, due 2022 3.40% Notes, due 2023 2.95% Notes, due 2025 3.75% Notes, due 2026 4.75% Notes, due 2036 6.15% Notes, due 2037 6.0% Notes, due 2039 5.3% Notes, due 2040 4.90% Notes, due 2046 Unamortized debt issuance costs Other, including fair value adjustments relating to interest rate hedge contracts designated as fair value hedges Total, net of current maturities Current maturities of long-term debt Total carrying amount

$

$

2015 947 $ 2,850 597 750 2,850 750 1,500 1,000 3,000 1,650 547 515 694 3,250 (117)

947 — 597 750 — 750 — 1,000 — — 547 515 694 — (21)

(102) 20,681 3 20,684 $

92 5,871 3 5,874

Continued next page

© Cambridge Business Publishers, 2018 7-25

Financial Statement Analysis & Valuation, 5th Edition

In November 2016, Abbott issued $15.1 billion of medium and long-term debt to primarily fund the cash portion of the acquisition of St. Jude Medical. Abbott issued $2.85 billion of 2.35% Senior Notes due November 22, 2019; $2.85 billion of 2.90% Senior Notes due November 30, 2021; $1.50 billion of 3.40% Senior Notes due November 30, 2023; $3.00 billion of 3.75% Senior Notes due November 30, 2026; $1.65 billion of 4.75% Senior Notes due November 30, 2036; and $3.25 billion of 4.90% Senior Notes due November 30, 2046. In November 2016, Abbott also entered into interest rate swap contracts totaling $3.0 billion related to the new debt, which have the effect of changing Abbott's obligation from a fixed interest rate to a variable interest rate obligation on the related debt instruments.

Principal payments required on long-term debt outstanding at December 31, 2016 are $3 million in 2017, $2 million in 2018, $3.8 billion in 2019, $1.3 billion in 2020, $2.9 billion in 2021 and $12.9 billion in 2022 and thereafter.

At December 31, 2016, Abbott's long-term debt rating was A+ by Standard & Poor's Corporation and A2 by Moody's Investors Service. In conjunction with the completion of the St. Jude Medical acquisition on January 4, 2017, the ratings were adjusted to BBB by Standard & Poor's Corporation and Baa3 by Moody's Investors Service. Abbott has readily available financial resources, including unused lines of credit of $5.0 billion which expire in 2019 and that support commercial paper borrowing arrangements. Abbott's weighted-average interest rate on shortterm borrowings was 0.6% at December 31, 2016 and 0.2% at December 31, 2015 and 2014.

Required: a. What proportion of long-term debt will Abbott Labs repay in 2017? b. How much does the company owe under the line of credit at year end? Why does Abbott Labs discuss this in its debt footnote? c. How did the acquisition of St. Jude Medical impact Abbott Labs’ default risk?

Answer: a. Abbott Labs will repay 0.0145% of its long-term debt in 2017 ($3 / $20,684 = 0.000145). b. Abbott Labs does not owe anything under the line of credit at year end. The $5 billion line of credit ensures that the company has easy access to significant amounts of cash if the need arises. This reduces liquidity risk to investors and creditors, which could reduce Abbott Labs’ cost of capital. c.

Prior to the acquisition of St. Jude Medical, Abbott’s corporate debt was rated A+ and A2 by Standard & Poor’s and Moody’s Investors Services as of December 31, 2016. In November 2016, Abbott issued $15.1 million in debt to fund the cash portion of the acquisition of St. Jude Medical. As a result, Abbott’s total 2016 long-term debt balance increased by 3.5 times its 2015 year-end balance. After the acquisition was complete, S&P and Moody’s downgraded Abbott’s corporate debt to BBB and Baa3, respectively. The credit rating agencies determined that Abbott’s default risk had increased with the acquisition of St. Jude’s Medical and with the substantial increase in long-term debt.

Test Bank, Module 7

© Cambridge Business Publishers, 2018 7-26

Topic: Interpreting Total Liabilities Footnote LO: 4 3. The Progressive Corporation (a property and casualty insurance company) reported the following in its 2016 annual report: (in millions) Unearned premiums Loss and loss adjustment expense reserves Net deferred income taxes Dividends payable Accounts payable, accrued expenses and other liabilities Debt* Total liabilities

2016 $7,468.3 11,368.0 111.3 395.4 2,495.5 3,148.2 $24,986.7

2015 $6,621.8 10,039.0 109.3 519.2 2,067.8 2,707.9 $22,065.0

*For purposes of this exercise, assume the entire debt amount is long-term.

Required: a. Explain in layman’s terms the liabilities labeled “Unearned premiums” and “Loss reserves.” b. What percentage of Progressive’s total liabilities relates to current operating liabilities for 2016?

Do you believe that this number is higher than most companies or lower? Why? c. Which current liability reported by Progressive is the least reliably measured – that is, the most subjective? Explain.

Answer: a. Unearned premiums are cash premiums received from customers for future insurance coverage.

These premiums cover the future and thus Progressive has not earned them yet – they represent a liability until time passes and the premiums are earnings.

Loss reserves are anticipated payments for claims made under current insurance policies. These future payments are liabilities now because they arise from insurance coverage during the current and past years. As the company recognizes premiums as revenue, the company estimates how many claims will arise from current insurance policies and accrues the eventual (estimated) payments. This is evidence of the matching principle. b. ($7,468.3 + $11,368.0 + $111.3 + $2,495.5) / $24,986.7 million = 85.8% This is higher than most companies. It arises from unearned premiums and loss reserves due to the nature of the insurance industry. c.

The loss reserve is the anticipated future payments and is the most subjective current liability on Progressive’s balance sheet. To estimate the reserve, Progressive must estimate the number of claims that will be made, the amount that will be ultimately paid out, and the timing of such future payments. Such estimates are very difficult to audit.

Unearned premiums are more reliable (less subjective) because cash prepayments can be verified and insurance policy terms are easy to confirm and the unearned premium calculation is straight forward.

Accounts payable are more reliably measured because they are typically recorded when bills received or shipping documents arrive with goods. Accrued expenses are more subjective than accounts payable but likely less subjective than loss reserves.

© Cambridge Business Publishers, 2018 7-27

Financial Statement Analysis & Valuation, 5th Edition

Topic: Interpreting Long-Term Debt Footnote LO: 4 4. Progressive Corporation (a property and casualty insurance company) reported the following in its 2016 annual report: 2016

2015

(millions)

Carrying Value

Fair Value

Carrying Value

3.75% Senior Notes due 2021 (issued: $500.0, August 2011)

$ 498.4

$528.8

$498.1

$528.7

2.45% Senior Notes due 2027 (issued: $500.0, August 2016)

495.8

464.6

0

0

6 5/8% Senior Notes due 2029 (issued: $300.0, March 1999)

295.9

380.1

295.7

376.0

6.25% Senior Notes due 2032 (issued: $400.0, November 2002)

395.2

499.0

395.0

490.6

4.35% Senior Notes due 2044 (issued: $350.0, April 2014)

346.4

362.3

346.4

352.8

3.70% Senior Notes due 2045 (issued: $400.0, January 2015) 6.70% Fixed-to-Floating Rate Junior Subordinated Debentures due 2067 (issued: $1,000.0, June 2007; outstanding: $594.6 and $614.4)

395.1

372.5

395.0

362.0

594.1

581.2

612.8

612.8

Other debt instruments

127.3

127.3

164.9

164.9

$3,148.2

$ 3,315.8

$ 2,707.9

$2,887.8

Total

$

Fair Value

During 2016, we renewed the unsecured, discretionary line of credit (the "Line of Credit") with PNC Bank, National Association (PNC) in the maximum principal amount of $100 million. The prior line of credit, entered into in March 2015, had expired. The Line of Credit is on substantially the same terms and conditions as the prior line of credit. Subject to the terms and conditions of the Line of Credit documents, advances under the Line of Credit (if any) will bear interest at a variable rate equal to the higher of PNC's Prime Rate or the sum of the Federal Funds Open Rate plus 50 basis points. Each advance must be repaid on the 30th day after the advance or, if earlier, on April 30, 2017, the expiration date of the Line of Credit. Prepayments are permitted without penalty. All advances under the Line of Credit are subject to PNC's discretion. We had no borrowings under the Line of Credit or the prior line of credit in 2016 or 2015.

Aggregate principal payments on debt outstanding at December 31, 2016, is as follows: (in millions) Year 2017 2018 2019 2020 2021 Thereafter Total

Payments $25.0 25.0 11.3 0.8 500.0 2,609.8 $3,171.9

Continued next page

Test Bank, Module 7

© Cambridge Business Publishers, 2018 7-28

Required: a. What amount does Progressive report for long-term debt on its balance sheet? b. Why is there a difference between the fair value and the carrying value of Progressive’s long-term debt? c. Were the 3.75% notes originally issued at par, at a discount or at a premium? How do you know? d. What is the amount of the unamortized discount on the 6.25% notes as of December 31, 2016? e. What cash interest payment did Progressive make for the 6 5/8 notes in 2016? What interest expense did Progressive record for these notes during 2016? Assume for this question that Progressive pays interest annually. f.

If Progressive were to repurchase all of its bonds on January 1, 2017, how would the income statement be affected?

g. How much does the company owe under the line of credit with PNC Bank at year end? Why does Progressive discuss this in its debt footnote? h. What does the footnote reveal about timing of debt due in 2017 and thereafter?

Answer: a. Progressive reports the carrying value (net book value) of long-term debt on its balance sheet. As of December 31, 2016 this was $3,148.2 million. b. Carrying value and fair value differ because the prevailing market rates of interest are lower than the notes’ coupon (stated) interest rate. Thus, the fair value of the notes is more than their net book value. c.

The 3.75% notes were originally issued at a discount because the carrying value increased in 2016 to 498.4 from 498.1 as the discount amortization is added to the carrying value and the carrying value is less than the face value of 500 million.

d. The unamortized discount on the 6.25% notes as of December 31, 2016 is $4.8 million ($400 million – $395.2 million). e. Progressive paid cash interest of $19.875 million for the 6 5/8% notes ($300 million × 6 5/8 %).

The interest expense for these notes was $20.075 million. Interest expense on a bond issued at a discount = cash interest paid + amortization of bond discount. During the year, the bond’s carrying value increased by $0.2 million, (from $295.7 million to $295.9 million). Therefore, interest expense = $19.875 million + $0.2 million = $20.075 million. f.

Because the market value of Progressive’s notes is more than its book value, Progressive will have to report this difference as a loss on the income statement when it repurchases the bonds.

g. Progressive does not owe anything under the line of credit at year end. The $100 million line of credit ensures that the company has easy access to significant amounts of cash if the need arises. This reduces liquidity risk to investors and creditors, which could reduce Progressive’s cost of capital. h. The footnote reveals that there is $25.0 million of long-term debt due in 2017, $25 million due in 2018, $11.3 million due in 2019, $0.8 million due in 2020, and $500 million due in 2021. $2,609.8 million of long-term debt is due sometime after 2021.

© Cambridge Business Publishers, 2018 7-29

Financial Statement Analysis & Valuation, 5th Edition

Topic: Preparing Bond Amortization Table LO: 4 5. Gold Enterprises recently issued $40 million of 12% coupon bonds, payable semiannually, which mature in 10 years. The bonds were sold for $37,796,299 to yield a 13% annual rate.

Use the table below to show the amortization of the discount, interest expense, and the carrying amount of the bonds from issuance till the end of Period 4.

Interest Expense

Cash Interest Paid

Discount Amortization

Discount Balance

Bond Payable, net

0 1 2 3 4 Answer: Interest Expense

Cash Interest Paid

Discount Amortization

Discount Balance 2,203,701

Bond Payable, net 37,796,299

1

2,456,759

2,400,000

56,759

2,146,942

37,853,058

2

2,460,449

2,400,000

60,449

2,086,493

37,913,507

3

2,464,378

2,400,000

64,378

2,022,115

37,977,885

4

2,468,563

2,400,000

68,563

1,953,552

38,046,448

0

Test Bank, Module 7

© Cambridge Business Publishers, 2018 7-30

Topic: Interpreting Long-Term Debt Footnote LO: 4 6. Following is the debt footnote from the Lowe’s 2017 form 10-K: 12 Months Ended February 03, 2017 Debt Category (In millions)

Weighted-Average Interest Rate at February 3, 2017

February 3, January 29, 2017 2016

Secured debt: Mortgage notes due through fiscal 2027 1

5.44%

$

7

$

7

Unsecured debt: Notes due through fiscal 2021

2.87%

3,567

3,990

Notes due fiscal 2022-2026

3.07%

3,783

2,443

Notes due fiscal 2027-2031

6.76%

814

813

Notes due fiscal 2032-2036

5.64%

941

941

Notes due fiscal 2037-2041 2

5.94%

1,585

1,585

Notes due fiscal 2042-2046 Capitalized lease obligations due through fiscal 2037

4.26%

3,631

2,301

861

526

15,189

12,606

(795)

(1,061)

$ 14,394

$ 11,545

Total long-term debt Less current maturities Long-term debt, excluding current maturities

1 Real properties with an aggregate book value of $28 million were pledged as collateral at February 3, 2017, for secured debt.

2 Amount includes $100 million of notes issued in 1997 that may be put at the option of the holder on the 20th anniversary of the issue at par value. None of these notes are currently puttable.

Required: a. What is the amount of debt on Lowe’s balance sheet as of February 3, 2017? b. What proportion of Lowe’s long-term debt is due before February 2, 2018? c. How much of Lowe’s assets were pledged as collateral as of February 3, 2017? d. What effect, if any, does Lowe’s collateral have on its credit risk and interest costs? e. Assume that the notes due fiscal 2042-2046 outstanding at the beginning of the year were 4.26% notes issued to yield 4.4%. At the beginning of the year, these notes had an unamortized discount of $132 million. What cash interest payment did Lowe’s make for these notes, assuming interest is paid annually? What interest expense did Lowe’s record for these notes during the current year?

Answer: a. Total debt at February 3, 2017 was $15,189 million. b. Current portion is $795 million which is 5.23% of total debt outstanding ($795 / $15,189). c.

$28 million of assets were pledged as collateral.

d. To the extent debt is secured, the debt holder is in a preferred position relative to other creditors.

The interest costs should be less to reflect the reduced credit risk. e. Interest expense = Net book value of debt × effective interest rate = $2,301 million × 0.044 = $101.2 million.

Cash paid for interest = Face value of debt × coupon rate = ($2,301 million + $132 million) × 0.0426 = $103.6 million. © Cambridge Business Publishers, 2018 7-31

Financial Statement Analysis & Valuation, 5th Edition

Essay Questions Topic: Understanding Accruals and Earnings Management LO: 1 1. Progressive Corp. (a property and casualty insurance company) reported “Loss and loss adjustment expense reserves” (an operating liability) of $11,368.0 million its 2016 Form 10-K. What is the allowance for loan and lease losses? How could Progressive‘s managers use the reserve to manage income? Provide a numerical example of the income statement effect of this sort of earnings management.

Answer: The allowance relates to anticipated payments for future insurance claims. This is a liability now because the future claims arise from insurance coverage during the current and prior years. Because loss reserves are the anticipated future payments, the number on the balance sheet is very subjective. To estimate the reserve, Progressive must estimate the number of claims that will be made, the amount that will be ultimately paid out, and the timing of such future payments. Such estimates are very difficult to audit. This makes it easy for Progressive’s managers to manipulate the reserve number.

If managers want to increase current period income they could underestimate the reserve. This would boost net income because the loss expense would be lower. Then in the next period, the losses would be more than the accrual and next period earnings would decrease. For example, if managers deliberately underestimated the reserve by $90 million (accruing $11,278 million instead of $11,368.0 million) then 2016 income before tax would be higher by $90 million and 2017 or other future years’ income before tax would be lower by that amount.

Topic: Contingent Liabilities LO: 1 2. What are the requirements for determining the financial reporting of a contingent liability? Why would a company want to keep its contingent liability as low as possible? How could a company manipulate contingent liability to its advantage?

Answer: A contingent liability is an uncertain accrual. The obligation must be “probable” and the amount “estimable” in order to require reporting on the face of the financial statements.

A company would like to keep its contingent liability as low as possible as it appears on the balance sheet of a company as a liability. If the accruals are underestimated, it means that the income and retained earnings are overestimated.

As a company can determine the amount of its contingent liability and whether it’s “probable” or “reasonably possible”, it could choose to aggressively recognize these as part of a “big bath” to relieve future periods of expense or provide a cookie jar if the expenses are overestimated.

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Topic: Effective Cost of Debt LO: 3 3. What determines the effective cost of debt?

Answer: The effective cost of debt is determined by the price at which a bond is issued. If a bond is issued at par, its effective cost of debt is the cash interest paid. However in many cases debt is either issued at a discount or a premium. The effective cost of debt is always equal to the market rate of interest, regardless of the debt’s coupon rate. It is the amount that is reported on the issuer’s income statement as interest expense, and it is usually different from cash interest paid.

Topic: Gains (Loss) on Repurchase of Debt LO: 4 4. What is the difference between the reported gain (loss) on debt repurchase and the economic gain (loss) on the repurchase? How should such gains / losses be analyzed? Why are current values not reflected on a company’s balance sheet?

Answer: GAAP recognizes a gain (loss) on debt repurchase as the carrying amount of the debt less the repurchase price. The gain or loss on repurchase is exactly offset by the present value of the future cash flow implications of the repurchase and as a result, there is no economic gain (loss).

Gains (losses) are nonoperating and transitory and, consequently, will not be repeated in future income statements. For analysis purposes, they have no economic substance.

Current values for debt issues are not reflected on the balance sheet, and hence the income statement, due to the presumption that debt will not be retired prior to maturity and, at maturity, its market value will equal the face amount that will be repaid.

Topic: Ratios Indicating Default Risk LO: 5 5. What are some ratios used by Moody’s to measure default risk? What are some other relevant (nonratio) factors used to determine debt ratings?

Answer: Investors use a number of critical ratios when determining the different classes of risk, including: •

EBITA / Average Assets

•

EBITA margin = (EBITA / Net Revenue)

•

EBITA/ Interest expense

•

Operating margin = (Operating profit / Net revenue)

•

FFO + Interest expense / Interest expense

•

FFO / Debt

•

RCF / Net debt = (FFO – Preferred Dividends – Common Dividends – Minority Dividends) / (Short-Term Debt + Long-Term Debt)

•

Debt / EBITDA

•

Debt / Book capitalization = (Short-term debt + Long-term debt) / (Short-term debt + Longterm debt + Deferred taxes + Minority interest + Book equity)

•

CAPEX / Depreciation expense = (Capital expenditures / Depreciation expense)

•

Revenue volatility = Standard deviation of trailing five years of net revenue growth Continued next page

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Financial Statement Analysis & Valuation, 5th Edition

Test Bank for Financial Statement Analysis and Valuation, 5th Edition, by Easton, McAnally,

Other aspects that are considered in debt ratings are: •

Collateral – security provided on debt; the extent the debt is secured impacts on the position a debtholder has regarding repayments of debt

•

Covenants – restrictions enforced by debtholders on a company

•

Options – ability of debtholder to convert debt to stock or the allowance of a company to repurchase the debt prior to maturity.

Topic: Bond Default LO: 5 6. Define bond default. What are some potential ramifications if a company defaults on its debt?

Answer: Default is the nonpayment of interest and principal of the bond. If a company defaults on its debt, bondholders may force the company into bankruptcy and require asset liquidation to settle debt obligations. Default often leaves the bondholder with a loss. The analysis of the risk of nonpayment is the work that goes into pricing bonds. S&P uses financial ratios related to a company’s liquidity, profitability, and solvency to determine a company’s ability to pay its debt.

Test Bank, Module 7

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