Practice: Topics in Long-Term Liabilities and Equity

Financial Statement Analysis. 11 question(s) in this unit's pool (0 above the exam). Free up to ten a day; the coach picks which ones based on what you have already answered and when each is next due.

Financial Statement AnalysisTopics in Long-Term Liabilities and Equity
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Today's practice

Pick an answer, say how sure you are, then reveal. Every wrong choice gets its own explanation. Questions you have already answered correctly and confidently stay out of the way until they are due for review again.

Question 1Exam level

Under IFRS 16, a lessee signs a 5-year lease for office space. At lease commencement, the lessee will most likely record:

How sure are you?

Correct: B. The correct answer is Both a right-of-use asset and a lease liability.
A. You might confuse the asset recognition with the old finance lease treatment (asset only), forgetting the matching liability. IFRS 16 always pairs the ROU asset with a lease liability. They are recognized simultaneously and measured at the same present value.
C. Students who misread the question may think only the financial obligation side is recorded. IFRS 16 is explicit: both asset and liability are recognized; the ROU asset represents the right to use the underlying asset over the lease term.

Unit: topics-in-long-term-liabilities-and-equity

Question 2Harder

Compared to treating a lease as an operating lease, capitalizing a lease (as a finance lease) will most likely result in:

How sure are you?

Correct: B. The correct answer is Lower net income in early years of the lease.
A. You might incorrectly believe capitalization is always 'better' for profitability; they confuse EBITDA improvement with net income improvement. While EBITDA rises (lease expense moves below EBIT as depreciation + interest), net income in early years is LOWER because the interest component of capitalized leases is front-loaded.
C. Over the entire lease life, total cash outflows are equal. You might extrapolate this to income. Total expense IS equal over the full term, but the question asks about EARLY years specifically. Timing differs: front-loaded under capitalization.

Unit: topics-in-long-term-liabilities-and-equity

Question 3Exam level

A company operating under IFRS 16 enters a lease with a term of 10 months and annual payments of $4,000. The company will most likely:

How sure are you?

Correct: B. The correct answer is Recognize only lease expense on the income statement.
A. Students memorize 'all leases go on balance sheet under IFRS 16' without knowing the two exemptions. IFRS 16 paragraph 5 explicitly exempts short-term leases (<=12 months) from the on-balance-sheet requirement.
C. Footnote-only disclosure was the old operating lease treatment under IAS 17. Under the short-term exemption, the company recognizes a lease EXPENSE (income statement line item), not merely a footnote disclosure.

Unit: topics-in-long-term-liabilities-and-equity

Question 4Exam level

When a company capitalizes its previously off-balance-sheet operating leases, which of the following ratios will most likely INCREASE?

How sure are you?

Correct: B. The correct answer is Debt-to-equity ratio.
A. Students know assets increase, so they think asset turnover (Revenue / Total Assets) stays the same because revenue is unchanged. Asset turnover = Revenue / Average Assets. Revenue is unchanged; total assets INCREASE (ROU asset added). Therefore asset turnover DECREASES, not increases.
C. EBITDA increases (rent expense removed), so candidates assume all profitability metrics improve. ROA = Net Income / Total Assets. Assets increase AND net income decreases (in early years). Both effects push ROA DOWN, not up.

Unit: topics-in-long-term-liabilities-and-equity

Question 5Harder

Under US GAAP ASC 842, which of the following criteria would most likely classify a lessee's lease as a finance lease?

How sure are you?

Correct: B. The correct answer is The lessee obtains ownership of the asset at the end of the lease term.
A. Students know 'major part of useful life' is a criterion but invert it. They think 25% qualifies. The criterion is that the lease term covers the MAJOR PART (75% bright-line guideline under legacy GAAP, still used as reference) of useful life. 25% is far too short to qualify.
C. Students remember 'substantially all' criterion but use a wrong percentage. The bright-line guideline for 'substantially all of fair value' is 90%, not 40%. PV of 40% of fair value would NOT classify the lease as a finance lease.

Unit: topics-in-long-term-liabilities-and-equity

Question 6Harder

A financial analyst is comparing two retailers: Company A (IFRS filer) and Company B (US GAAP filer). Company B reports significant operating leases. To make the two companies comparable, the analyst would most likely:

How sure are you?

Correct: A. The correct answer is Add the present value of Company B's future operating lease payments to both assets and liabilities.
B. You might think removing IFRS assets normalizes to US GAAP. This is backwards. The direction of adjustment is always to ADD the off-balance-sheet items to make comparisons. Removing on-balance-sheet items would make analysis worse.
C. Both IFRS 16 and ASC 842 both put leases on balance sheet, so candidates think they are equivalent. While both standards require balance sheet recognition, the income statement treatment differs significantly: IFRS 16 shows depreciation + interest for all leases; ASC 842 shows single straight-line lease expense for operating leases.

Unit: topics-in-long-term-liabilities-and-equity

Question 7Harder

After a company adopts IFRS 16 and capitalizes formerly off-balance-sheet operating leases, its operating cash flow will most likely:

How sure are you?

Correct: B. The correct answer is Increase.
A. Capitalization adds depreciation expense, which students confuse with additional cash outflows. Depreciation is a non-cash charge. It has no impact on cash flow. The CASH paid is the same total; it is only RECLASSIFIED between operating and financing.
C. Total cash paid over the lease life is unchanged, so candidates think the cash flow statement is unaffected. The total cash is unchanged but the CLASSIFICATION changes. Principal repayment moves from operating to financing. This mechanically increases operating cash flow.

Unit: topics-in-long-term-liabilities-and-equity

Question 8Exam level

Under IFRS 16, the interest expense recognized on a lease liability in Year 2 of a 5-year lease will most likely be:

How sure are you?

Correct: B. The correct answer is Lower than in Year 1.
A. Students confuse with bonds where coupon is fixed. They expect interest to be constant. Unlike bonds where the face value is repaid at maturity, lease liabilities amortize with each payment. The outstanding balance drops annually, so interest (which is a percentage of that balance) also drops.
C. If the payment is equal each year, students assume interest must also be equal. Equal total payments does NOT mean equal interest. The interest component decreases and the principal component increases each year. Exactly like a mortgage amortization.

Unit: topics-in-long-term-liabilities-and-equity

Question 9Exam level

A company has annual lease payments of $100,000 for a 10-year lease. The discount rate is 5%. Under IFRS 16, the initial lease liability recognized is closest to:

How sure are you?

Correct: A. The correct answer is $772,000.
B. Students sum up total undiscounted cash payments: 10 years x $100,000 = $1,000,000 and record that as the liability. IFRS 16 para 26 requires the lease liability to be measured at the PRESENT VALUE of remaining lease payments, discounted at the rate implicit in the lease (or incremental borrowing rate).
C. Students roughly halve the undiscounted total, vaguely accounting for time value. Time value of money must be calculated precisely using the annuity formula, not estimated. $500,000 would only be correct at an unrealistically high discount rate.

Unit: topics-in-long-term-liabilities-and-equity

Question 10Harder

A retail company with significant store leases adopts IFRS 16. Relative to the prior year's financial statements (prepared under IAS 17 with operating leases off-balance-sheet), which of the following ratios will most likely be LOWER in the adoption year?

How sure are you?

Correct: C. The correct answer is Return on equity.
A. Capitalization adds depreciation to operating expenses. You might think EBITDA margin falls. EBITDA = Earnings Before Interest, Taxes, Depreciation AND Amortization. Depreciation of ROU asset is ADDED BACK in EBITDA calculation. Rent expense (formerly in operating costs) moves below the EBITDA line. Net effect: EBITDA RISES.
B. Students may confuse the direction. They know leverage changes but pick the wrong direction. D/E RISES when leases are capitalized because the lease liability is added to debt. Total debt increases; equity is unchanged (or slightly reduced). The ratio goes UP, not down.

Unit: topics-in-long-term-liabilities-and-equity

Question 11Exam level

Under IFRS 16, which of the following assets would most likely qualify for the low-value asset exemption?

How sure are you?

Correct: B. The correct answer is A single laptop computer worth $1,200 when new.
A. Each truck is individually worth $4,500 (below $5,000), so students think the fleet qualifies. While each truck individually is below $5,000, a fleet of delivery trucks used in operations is NOT typically considered 'low-value'. The IASB examples cite tablets, personal computers, small items of office furniture, and telephones. Trucks are high-dependency operating assets.
C. No one would confuse an $80M aircraft. This is a distractor to confirm the concept. $80 million far exceeds any low-value threshold. Airlines must capitalize aircraft leases under IFRS 16, which dramatically changed airline balance sheets at adoption.

Unit: topics-in-long-term-liabilities-and-equity