Tricky FSA Questions From CFAI Sample Exams

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minocfa

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1. Is interest coverage ratio higher or lower if we capitalize operating leases?

2. For a manufacturing company, lending money and getting interest on lent money is investing activity. But then, why is the interest received reported in CFO?

3. Why does the percentage of completion method lead to lower liabilities than completed contract method?

Thanks..
 
1- capitalized lease => interest expense increases => ratio is lower

2) interest received is always reported as CFO under GAAP

3) because unearned revenue is recognized earlier



Edited 1 time(s). Last edit at Thursday, June 5, 2008 at 12:26PM by supersharpshooter.
 
1. highter
2. I think it depends on the investment horizon.
3. If you question is based on lower Debt ratio, for percentage of completing result in a higher retained earnings and that leads to a higher denominator.
 
supersharpshooter Wrote:
-------------------------------------------------------
> 1- capitalized lease => interest expense increases
> => ratio is lower
>
> 2) interest received is always reported as CFO
> under GAAP
>
> 3) because unearned revenue is recognized earlier


capitalizing the lease moves interest expense from int expense to the CFI. this means a capitalization will reduce your interest expense and make the coverage ratio higher no?
 
SkipE99 Wrote:
-------------------------------------------------------
> supersharpshooter Wrote:
> --------------------------------------------------
> -----
> > 1- capitalized lease => interest expense
> increases
> > => ratio is lower
> >
> > 2) interest received is always reported as CFO
> > under GAAP
> >
> > 3) because unearned revenue is recognized
> earlier
>
>
> capitalizing the lease moves interest expense from
> int expense to the CFI. this means a
> capitalization will reduce your interest expense
> and make the coverage ratio higher no?

hmm, in the income statement treatment, operating lease only has "rent expense" and capital lease has interest expense + depreciation, so i thought interest coverage will be lower because of the presence of interest expense
 
1. Lower
2. Operating activities are different from CFO
3. Unearned Revenue under completed contract method accrues a liability.



Edited 1 time(s). Last edit at Thursday, June 5, 2008 at 12:40PM by Alexandrov.
 
You are getting confused with capitalising an asset and capital lease.. I agree capital lease with reduce interest coverage ratio. Because of higher int expense and lower profitability in earlier years.



Edited 1 time(s). Last edit at Thursday, June 5, 2008 at 12:37PM by mambovipi.
 
supersharpshooter Wrote:
-------------------------------------------------------
> SkipE99 Wrote:
> --------------------------------------------------
> -----
> > supersharpshooter Wrote:
> >
> --------------------------------------------------
>
> > -----
> > > 1- capitalized lease => interest expense
> > increases
> > > => ratio is lower
> > >
> > > 2) interest received is always reported as
> CFO
> > > under GAAP
> > >
> > > 3) because unearned revenue is recognized
> > earlier
> >
> >
> > capitalizing the lease moves interest expense
> from
> > int expense to the CFI. this means a
> > capitalization will reduce your interest
> expense
> > and make the coverage ratio higher no?
>
> hmm, in the income statement treatment, operating
> lease only has "rent expense" and capital lease
> has interest expense + depreciation, so i thought
> interest coverage will be lower because of the
> presence of interest expense


yeah i think that is right...makes sense....when you capitalize the lease, you are added an interest expense that was not previously there....i was gettin confused.drat
 
int coverage ratio will be LOWER if you capitalize.


in t cov = EBIT/int exp.

if you cap, you boost int exp, thus lower ratio (no effect to EBIT)
 
EBIT is higher with a capital lease

but the ratio is still decreased



Edited 1 time(s). Last edit at Thursday, June 5, 2008 at 02:24PM by supersharpshooter.
 
supersharpshooter,

why is ebit higher? is it because of adding back rent expense ?

And we're obviously assuming that EBIT is higher than int expense to begin with, so an increase in ebit does not offset the increase in int exp, hence the ratio is lower correct?
 
ebit is higher because the only operating expense incurred with a capital lease is the depreciation expense, whereas an operating lease includes the entire lease payment as 'rent expense'

the interest portion of the capital lease is a non-operating component of the income statement and has no effect on EBIT
 
Thank you all for your answers..

Is there any "unearned revenue" under percentage of completion method or does it exist only for completed contract method?
 
minocfa Wrote:
-------------------------------------------------------
> Thank you all for your answers..
>
> Is there any "unearned revenue" under percentage
> of completion method or does it exist only for
> completed contract method?



No, there is no unearned revenue, because revenue is considered earned in proportion to completion (costs).
 
minocfa Wrote:
-------------------------------------------------------
> Thank you all for your answers..
>
> Is there any "unearned revenue" under percentage
> of completion method or does it exist only for
> completed contract method?


I would say it depends on how much it was billed, and how much was received in payment of an issued bill. Theoretically, they should match and a client would theoretically not pay more than it was billed.
 
minocfa Wrote:
-------------------------------------------------------

> 3. Why does the percentage of completion method
> lead to lower liabilities than completed contract
> method?

Under the POC method, we recognize a portion as revenue plus profit on the Income Statement, which increases the net income, thereby increasing the equity and reducing liabilities.. am I right in my thinking??
 
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