FRA- CFA L1 queries

Finance Junkie
Posts: 49
Joined: Thu Aug 09, 2012 4:45 pm

FRA- CFA L1 queries

Postby deepakkrkanodia » Mon Feb 25, 2013 8:43 pm

Q1. If any asset is sold at profit in a given year, lets say any machinery is sold at profit of rs 200000, in F/Y 2011-12 then how does it affect financial statements, B/S, P/L and CF.
According to my understanding, if any asset is sold at profit, then its profit i.e. recoverable amount less carrying value of asset will be recorded in P/L in 2011-12 and in 2011-12 B/S, that asset will be removed as it is sold and Cash flow from investing will increase by recoverable amount.
Query: Whether my understanding of sale of asset and its reporting in all Financial statements are correct or incorrect? And the reporting of sale of asset at profit or loss is similar under both IFRS and US GAAP

Q2. If the firm has DTL that results from accelerated depreciation for tax purposes and the firm is expected to grow in the foreseeable future, why does the analysts treat liability as equity at its full value? Why analysts does not treat it as liability at its full value? What exactly we mean from above statement and the difference between both treatments?

Q3. A capital lease requires annual lease payments of $2,000 at the start of each year.
Fair value of the leased equipment at inception of the lease is $10,000 and the implicit interest rate is 12 percent. If the present value of the lease payments equals the fair value of the equipment at the inception of the lease, the interest expense (in $) recorded by the lessee in the second year of the lease is closest to:

A. 960.
B. 1,104.
C. 1,200.

Query: why the answer is A and not B. Plz see my below calculation
Year starting balance interest expense @12% lease payment ending balance
1 10,000 1200 2,000 9200
2 9200 1104

Q4. During the past year, a company’s production facility was operating at 75% of capacity. The firm’s costs were as follows:

$ millions
Fixed production overhead costs 3
Raw materials costs 6
Labor costs 4
Freight-in costs for raw materials 1
Warehousing costs for finished goods 2

The firm ended the year with no remaining work-in-process inventory. The total capitalized inventory cost (in $ millions) for the year is closest to:

A. 13.25.
B. 15.25.
C. 16.00.

Query: answer is A and given below the calculation, but could not understand why 75% utilization capacity is taken for fixed production costs and not for Raw materials and Labor cost because if there is underutilization of capacity, raw material and Labor used will also be used in same utilized capacity, but fixed production costs should not be as they are fixed and must be taken in full.
$ millions
Fixed Production Costs: 75% of capacity: 75% x $3 2.25
Raw materials 6.00
Labor Costs 4.00
Freight In 1.00

Total Capitalized Inventory Cost 13.25

Q5. Which of the following transactions will most likely result in a decrease in a
company’s current ratio? The:

A. recording of a warranty expense.
B. recording of revenue before cash is received.
C. payment of a property insurance policy for the following year.

Query: why the most accurate answer in above is A and not B as both leads to Current ratio to decrease. Warranty expense creates a warranty liability so increase in current liabilities, hence Current ratio to decrease. Recording of revenue before cash is received is Unearned revenue which is also current liability, hence Current ratio to decrease.

Q6. An analyst makes the appropriate adjustments to the financial statements of retail companies that are lessees using a substantial number of operating leases. Compared to ratios computed from the unadjusted statements, the ones computed from the adjusted statements would most likely be higher for:

A. the debt-equity ratio but not the interest coverage ratio.
B. the interest coverage ratio but not the debt-equity ratio.
C. both the debt-equity ratio and the interest coverage ratio.

Query: Here the adjustments are done to convert operating leases to capital lease.
Why Finance lease has higher Debt/ Equity ratio as compared to Operating lease because equal amounts of asset and liabilities are added to finance lease.

Q7. This is regarding Revaluation Model under IFRS. Please see whether below calculation of Revaluation model under IFRS is derived from written statements and given under :

Suppose Revalued fair value of asset is 280000 in F/Y 2011-12and historical cost of asset is 250000, then 30000 is the gain in F/Y 2011-12, but if previous loss is 24000, then in F/Y 2011-12, 24000 will be reported in P/L ( max gain reporting will be previously written loss) and balance 6000 will be shown in B/S as Revaluation Surplus.
Now suppose Fair value becomes 240000, then it means 40000 decline (280000-240000) which will reduce the Revaluation surplus by 6000 (previously reported) and balance 34000 will not be reported as loss in P/L, only 10000 will be reported as loss in P/L because loss will be reported to the extent of fair value<historical cost (240000-250000)

Query: Is the calculation part correct or incorrect? And give calculation if incorrect?

Finance Junkie
Posts: 61
Joined: Fri Aug 03, 2012 11:24 am

FRA- CFA L1 queries

Postby pankaj » Mon Mar 25, 2013 5:27 pm

1. U r Corrent and there is no treatment diference under US GAAP anf IFRS.

2. if firm is expected to grow, it means more investment will be made towards fixed assets and if ths happens, the difference in depreciation method (accelarated depreciation for tax purpose and straight line depreciation for reporting purpose) will creat DTL each time the new investment in assets is made. Thus the old DTL are less likely to be reversed in the future. Therefor, an analyst may conside DTL which is not expected to reverse as eqyity (the underlying idea is that, if the outstanding tax liability is not required to be paid, firm will save cash (otherwise to be paid as Tax) which should go to its owner. Therefor Liability decreases, equity increases and no change in asset. The change in asset is not required because at the time when equity is increasing by the amount of DTL no cash infow or cash outflow is taking place. Initially when DTL was created, at that time assets (cash) had increased by the same amount of DTL.

3. The question has some problem but let me tell you the way how interest expense is calculated when lease payment is to be made at the beginning of the year

PV of Lease Payment = Fair value (in this case) 10000
Mode of Lease payment start of each year
annual lease payments  2000
Interest Rate 12%
Yr Beginning Lease Value(1) Int.Exp(2) Lease Payment(3) Lease Liability (1+2-3)
0 10000 0 2000 8000
1 8000 960 2000 5795.2
3 5795.2 695.424 2000 4490.624
4 4490.624 538.87488 2000 3029.49888
5 3029.49888 363.5398656 2000 1393.038746
6 1393.038746 167.1646495 2000 -439.7966049
At the end of the lease period the Lease liability should be zero (0), but as i said ......question is not properly structured.
But hope you understood the process, here we are considering the opening liability of 8000 because the lease payment is to be made at the beginning of each period. So when the firm as taken the assets worth of 10,000, at the time itself it has paid the first lease payment of 2000, therefore the liability of be only 8000 under such arrangement.

5. Recording of warrant expense decrease net profit of the firm, which decreases the retained earnings, thereby decreasing cash (a current assets). In this case Current ratio decreases. Recording revenue before cash is received increases the net income, which in turn increase the retained earnings, therby increases cash/ BR (a current assets), This will increase current ratio. Payment of a property insurance policy for the following year, will lead to an increases in an current asset (pre-paid expenses)and at the same time will lead to decrease in another current asset which is cash, so inceases and decrease netoff with no change in current assets. Therefore assumong the current liability is constant, the current ratio will not change.

6. When operating lease is converted in finace (capital) lease , the debt and asset will increase in the balance sheet by the same amount and there will be no change in equity (balancing the balance sheet equation: Assets = Liability + equity). Therfore in debt to equity ratio debt (numerator) will increase but equity (denomerator) will remain same, thereby increases the debt to equity ratio. The interest coverage ratio will decrease because as new debt id added to the existing debt, the total debt amount will increase which in turn increases the interest expense, so in interest coverage ratio: EBIT (numerator) remains the same but the denomerator which is interest expense increases which leads to decrease in interest coverage ratio. The take away is the if in a ratio numerator increases (decreases), the respective ratio will increase (decrease) but if denomerator increases(decreases) than the respective ratio decreases (increases).

Hope this helps!!
Give me some time to solve problem no. 4 and 7

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