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Free CFA-Level-II Exam Braindumps (page: 11)

Page 10 of 181
PDF with 715 Questions

Jason Bennett is an analyst for Valley Airlines (Valley), a U.S. firm. Valley owns a stake in Southwest Air Cargo (Southwest), also a U.S. firm. The two firms have had a long-standing relationship. The relationship has become even closer because several of Valley's top executives hold seats on Southwest's Board of Directors.

Valley acquired a 45% ownership stake in Southwest on December 31, 2007. Acquisition of the ownership stake cost $9 million and was paid in cash. Valley's stake in Southwest is such that management can account for the investment using either the equity method or the acquisition method. While Valley's management desires to fairly represent the firm's operating results, they have assigned Bennett to assess the impact of each method on reported financial statements.

Immediately prior to the acquisition. Valley's current asset balance and total equity were $96 million and $80 million, respectively. Southwest's current assets and total equity were $32 million and $16 million, respectively.

While analyzing the use of the equity method versus the acquisition method, Bennett calculates the return on assets (ROA) ratio. He arrives at two conclusions:

Statement 1: Compared to the acquisition method, the equity method results in a higher ROA because of the higher net income under the equity method.
Statement 2: Compared to the acquisition method, the equity method results in a higher ROA because of the smaller level of total assets under the equity method.
In order to get a better picture of Valley's operating condition, Bennett is also considering the use of proportionate consolidation to account for Southwest. He makes the following statements regarding the acquisition method and a proportionate consolidation:
Statement 3: Both methods are widely accepted under the provisions of U.S. GAAP and International Financial Reporting Standards (IFRS).
Statement 4: Both methods report the same level of assets on the parent's balance sheet. Statement 5: Both methods report all of Southwest's liabilities on the parent's balance sheet.

In addition. Valley has always wanted to pursue its goal of vertical integration by expanding its scope of operations to include the manufacturing of airline parts for its own airplanes. Therefore, it established a subsidiary, Mountain Air Parts (Mountain), in Switzerland on January 1,2008.

Switzerland was chosen as the location for economic and geographical diversification reasons. Mountain will operate as a self-contained, independent subsidiary. Local management in Switzerland will make the majority of operating, financing, and investing decisions.

The Swiss franc (CHF) is the official currency in Switzerland. On January 1, 2008, the USD/CHF exchange rate was 0.77. At December 31, 2008, the exchange rate had changed to 0.85 USD/CHF. The average exchange rate in 2008 was 0.80 USD/CHF. In its first year of operations. Mountain paid no dividends and no taxes. Mountain uses the FIFO assumption for its flow of inventory.



For this question only, assume that Mountain is operating in a highly inflationary environment. Which of the following statements is least correct? Mountain's:

  1. nonmonetary assets and nonmonetary liabilities are adjusted for inflation in accordance with U.S. GAAP.
  2. functional currency is the U.S. dollar.
  3. financial statements are adjusted for inflation, and the net purchasing power gain or loss is recognized in the income statement in accordance with IFRS.

Answer(s): A

Explanation:

Under U.S. GAAP, the nonmonetary assets and liabilities of the foreign subsidiary are not restated for inflation. Under IFRS, the subsidiary's financial statements are adjusted for inflation, and the net purchasing power gain or loss is recognized in the income statement. Then, the subsidiary is translated into U.S. dollars using the all-current method. If Mountain operates in a highly inflationary environment, the appropriate method is the temporal method. Under the temporal method, the functional currency is considered to be the-parent's presentation currency. Thus, Mountain's functional currency is the U.S. dollar. (Study Session 6, LOS 23.0



Tobin Yoakam, CFA, is analyzing the financial performance of Konker Industries, a U.S. company which is publicly traded under the ticker KONK. Yoakam is particularly concerned about the quality of Konker's financial statements and its choices of accounting methodologies.

Below is a summary of Konker's financial statements prepared by Yoakam.

Konker has an operating lease for several of its large machining tools. The lease term expires in five years, and the annual lease payments are $2 million. The applicable interest rate on the operating lease is 9%. Yoakam believes that the operating lease should be capitalized and treated as a finance lease. For purposes of adjusting the financial statements, Yoakam believes that the machining tools should be depreciated using straight-line depreciation with a salvage value of $3 million.

At the beginning of 20X8, Konker formed a qualified special purposes entity (QSPE) and sold a portion of its accounts receivables to the QSPE. The total amount of accounts receivables sold to the QSPE was $13.5 million. Yoakam has noted in his research that the Financial Accounting Standards Board (FASB) is considering the elimination of qualified special purposes entities.

Konker has three major operating divisions: Konker Industrial, Konker Defense, and Konker Capital. Yoakam has computed the EBIT margin for each division over the last three years as well as the ratio of the percentage of total capital expenditures to the percentage of total assets for each division.


Since Yoakam is concerned about the quality of Konker's earnings, he decides to analyze the accrual ratios using the balance sheet approach. The table below contains the last three years of accrual ratios for Konker and the industry average.

With respect to the balance sheet accrual ratio, which of the following, other things equal, would most likely lead to an increase in the ratio for a growing company?

  1. Extending the time the firm takes to pay its suppliers.
  2. A significant build-up of cash,
  3. A build-up of inventory.

Answer(s): C

Explanation:

The balance sheet accrual ratio is the year-ovcr-year increase in net operating assets divided by average net operating assets. An increase in payables (a liability) will tend to decrease (reduce the change in) net operating assets, while an increase in inventory will tend to increase (increase the change in) net operating assets. Cash is not an operating asset and does not affect the ratio. (Study Session 7, LOS 26.e)



Tobin Yoakam, CFA, is analyzing the financial performance of Konker Industries, a U.S. company which is publicly traded under the ticker KONK. Yoakam is particularly concerned about the quality of Konker's financial statements and its choices of accounting methodologies.

Below is a summary of Konker's financial statements prepared by Yoakam.


Konker has an operating lease for several of its large machining tools. The lease term expires in five years, and the annual lease payments are $2 million. The applicable interest rate on the operating lease is 9%. Yoakam believes that the operating lease should be capitalized and treated as a finance lease. For purposes of adjusting the financial statements, Yoakam believes that the machining tools should be depreciated using straight-line depreciation with a salvage value of $3 million.

At the beginning of 20X8, Konker formed a qualified special purposes entity (QSPE) and sold a portion of its accounts receivables to the QSPE. The total amount of accounts receivables sold to the QSPE was $13.5 million. Yoakam has noted in his research that the Financial Accounting Standards Board (FASB) is considering the elimination of qualified special purposes entities.

Konker has three major operating divisions: Konker Industrial, Konker Defense, and Konker Capital. Yoakam has computed the EBIT margin for each division over the last three years as well as the ratio of the percentage of total capital expenditures to the percentage of total assets for each division.

Since Yoakam is concerned about the quality of Konker's earnings, he decides to analyze the accrual ratios using the balance sheet approach. The table below contains the last three years of accrual ratios for Konker and the industry average.


If Yoakam capitalizes Konker's operating lease in his analysis, the Konker's adjusted interest coverage ratio for 20X8 would be closest to:

  1. 7.12.
  2. 8.56.
  3. 15.69.

Answer(s): B

Explanation:

The unadjusted interest coverage ratio is calculated as follows:


To adjust the interest coverage ratio for the operating lease, we need to take EBIT and add back the lease/rental expense (the lease payment amount) and subtract an estimate of depreciation for the machinery. Then, we need to add the appropriate interest expense for the operating lease to the overall interest expense.
To compute the interest expense and depreciation for the operating lease, we must first calculate the present value of the operating lease as follows:

Depreciation and interest expense are then calculated as: depreciation =
interest expense =

The adjusted interest coverage ratio is:

interest coverage (adjusted) =
interest coverage (adjusted) =

(Study Session 7, LOS 26.c)



Tobin Yoakam, CFA, is analyzing the financial performance of Konker Industries, a U.S. company which is publicly traded under the ticker KONK. Yoakam is particularly concerned about the quality of Konker's financial statements and its choices of accounting methodologies.
Below is a summary of Konker's financial statements prepared by Yoakam.


Konker has an operating lease for several of its large machining tools. The lease term expires in five years, and the annual lease payments are $2 million. The applicable interest rate on the operating lease is 9%. Yoakam believes that the operating lease should be capitalized and treated as a finance lease. For purposes of adjusting the financial statements, Yoakam believes that the machining tools should be depreciated using straight-line depreciation with a salvage value of $3 million.

At the beginning of 20X8, Konker formed a qualified special purposes entity (QSPE) and sold a portion of its accounts receivables to the QSPE. The total amount of accounts receivables sold to the QSPE was $13.5 million. Yoakam has noted in his research that the Financial Accounting Standards Board (FASB) is considering the elimination of qualified special purposes entities.

Konker has three major operating divisions: Konker Industrial, Konker Defense, and Konker Capital. Yoakam has computed the EBIT margin for each division over the last three years as well as the ratio of the percentage of total capital expenditures to the percentage of total assets for each division.


Since Yoakam is concerned about the quality of Konker's earnings, he decides to analyze the accrual ratios using the balance sheet approach. The table below contains the last three years of accrual ratios for Konker and the industry average.


An analyst is considering the effects of income reported under the equity method on certain financial ratios. For a firm that reports equity income as non-operating income (not included in EBIT), removing equity income from the financial statements would most likely result in:

  1. an increase in the tax burden term in the extended Du Pont decomposition of ROE.
  2. an increase in the asset turnover ratio.
  3. a decrease in the interest coverage ratio.

Answer(s): B

Explanation:

Removing the effects of the income reported under the equity method involves removing the income and the equity asset reported on the balance sheet. The decrease in total assets will increase the asset turnover ratio. The tax burden term is net income divided by earnings before tax so that the decrease in net income from removing the equity income will decrease the term (an apparently greater reduction in ROE due to taxes). Neither interest expense nor operating earnings (EBIT) are affected by the appropriate adjustments, so the interest coverage ratio is unaffected. (Study Session 7, LOS 26.b)






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