Chapter 10 – Financing and business structures
TRUE/FALSE
1. The effect that the collapse of an airline has on the tourist industry is seen to be industry-specific
and therefore a business risk.
2. Working capital is represented by current assets less current liabilities for short-term working
capital, whereas long-term working capital is total assets less total liabilities.
3. Business risk is industry-specific, whereas financial risk is more firm-specific.
4. Financing through creditors can result in opportunity costs where discounts are not taken up by the
entity.
5. Trade credit is widely used as a source of finance but the importance and use of trade credit varies
from industry to industry and within industries.
6. Financing through trade credit requires less security than financing through factoring.
7. A bank overdraft is normally securitised over assets, either as a fixed charge over specific assets or
as a floating charge over all assets; factoring is secured over specific assets being debtors; creditors
generally require no security.
8. Where an overdraft facility has been offered, the bank sees this as a semi-permanent source of
finance, and prefers to see the account consistently overdrawn, as it will receive more fees through
overdraft charges, thus reducing the risk of the finance.
9. The purchase of an asset using loan finance and the leasing of an asset under a finance lease will
both result in ownership of the asset being transferred at the time of acquisition/beginning of lease
and not when all payments have been made.
10. Under a hire-purchase agreement, ownership of the asset remains with the financier until all
payments have been received.
11. A major difference between accounting for an operating lease and a finance lease, in the books of
the lessee, is that a finance lease will create an asset and a liability, whereas an operating lease will
be treated as an expense.
12. AKP enterprises have negotiated a lease for a photocopier. The useful life of the asset is eight
years. The lease is non-cancellable and provides that the term of the lease is over three years with
the present value of the lease payments being 55% of the fair value. Title will not pass at the end of
the lease period. Using the criteria in AASB 117, the lease would definitely constitute a finance
lease.
13. A major discriminator between an operating lease and a finance lease is whether the risks and
rewards of ownership have been substantially transferred to the lessee.
14. Debentures are essentially the same as a long-term loan except that debentures are particular to
limited companies and have a fixed interest rate.
15. An entity that can only raise equity finance through one owner’s contributions and retained profits
is a sole proprietorship.
16. Partnerships may have more ability to raise equity finance than sole proprietorships, as
partnerships tend to have more people to contribute funds, but limited companies have a wider
range of equity options than partnerships.
17. In an entity that is highly geared, the effect of a decrease in profits or an increase in interest rates
will have a greater negative impact on returns to shareholders than it will on an entity that is not so
highly geared.
18. A choice between debt finance and equity finance will result in a trade-off between risk and return.
19. A factoring company is a finance company that specialises in providing a service for the collection
of payments from debtors.
20. The principal sources of revenue for a factoring company are the interest earned on the finance
provided and the fees for managing the collection of debt.
21. The sole source of equity finance for a company is contributed equity.
22. The notion of substance over form may result in certain types of preference shares being classified
as debt not equity.
23. Classifying preference shares as debt not equity, would alter the gearing (leverage) of a company.
24. The mix of debt finance and equity finance for a given entity is known as gearing.
MULTIPLE CHOICE
1. Which of the following terms best describes a firm-specific risk that an entity faces, as opposed to
an industry-specific risk?
A.
Investment risk
B.
Financial risk
C.
Market risk
D.
Business risk
2. Working capital is:
A.
loan capital.
B.
total assets less total liabilities.
C.
current assets less current liabilities.
D.
quick assets less current liabilities.
3. The term ‘working capital’ is used to describe the:
A.
amount of equity (ownership) capital in the firm.
B.
portion of capital actively employed in generating revenues.
C.
amount of debt (borrowed) capital in the firm.
D.
cushion of current assets over current liabilities.
4. Which of the following must be known in order to determine the firm’s total amount of working
capital?
Current assets Current liabilities
A.
Yes Yes
B.
Yes No
C.
No Yes
D.
No No
5. What is the total working capital for the following company?
Cash
$10,000
Debtors
$40,000
Creditors
$30,000
Land
$100,000
Equipment
$70,000
Long-term loan
$40,000
A.
$10,000
B.
$20,000
C.
$50,000
D.
$150,000
6. Which of the following is not an example of short-term finance?
A.
Trade credit
B.
Factoring
C.
Finance lease
D.
Bank overdraft
7. An example of a source of medium-term finance is:
A.
hire purchase.
B.
debentures.
C.
factoring.
D.
equity finance.
8. Which of the following is not a characteristic of a finance lease?
A.
It is generally non-cancellable.
B.
The lessee guarantees that the lessor will receive a specific residual value from the sale of
the asset at the end of the lease term.
C.
It is like a rental agreement.
D.
The lessee has the right to use the leased asset.
9. The major accounting difference between a finance lease and an operating lease is that finance
leases:
A.
involve larger amounts of funds.
B.
are for longer periods of time.
C.
involve the recognition of assets and liabilities.
D.
are cancellable.
10. When a firm leases a resource for most of its useful life and controls the resource as though it had
been purchased, the lease is treated as:
A.
an operating lease.
B.
a finance lease.
C.
a primary lease.
D.
a producing lease.
11. If a lessee enters into a finance lease agreement, it will record:
A.
an asset only.
B.
a liability only.
C.
an asset and a liability.
D.
an expense only.
12. The Shifting Sands Company has negotiated to lease a piece of equipment. The equipment has a
useful life of 10 years. The lease is non-cancellable but there is only a minor penalty if the lessee
returns the equipment before the expiry of the lease. The lease terms provide that the lease is over
five years and the present value of the minimum lease payments is 60% of the fair value of the
asset at the commencement of the lease. Shifting Sands records the lease payments as an expense
in the statement of comprehensive income. Based on this information, which of the following
statements is correct?
A.
Assets and liabilities are understated as the lease should be a finance lease.
B.
Assets and liabilities are not affected as the lease is an operating lease.
C.
The non-cancellable nature of the lease determines that it should be a finance lease.
D.
There is insufficient information to determine whether the lease is a finance or an
operating lease.
13. Raffles Ltd had retained profits of $10,000 on 1 January 20X7 and $30,000 on 31 December 20X7.
If a profit of $60,000 was earned during the year, then the amount declared and/or paid in
dividends during the period would be:
A.
$20,000.
B.
$30,000.
C.
$40,000.
D.
$50,000.
14. FF Ltd declared and paid $150,000 in dividends during 20X7. Closing retained profits at 31/12/X7
was $860,000. What was opening retained profits at 1/1/X7, if FF Ltd made a loss of $180,000 for
the year ended 31/12/X7?
A.
$530,000
B.
$860,000
C.
$890,000
D.
$1,190,000
15. When a holder of preference shares has the right to receive all previously omitted dividends before
ordinary shareholders receive any dividends, the preferred share is known as:
A.
participating preferred.
B.
cumulative preferred.
C.
compensating preferred.
D.
ex post rights preferred.
16. A preference share is preferred because:
A.
it has a higher claim on dividends and assets than ordinary shares.
B.
it is preferred by shareholders as a potentially better investment.
C.
preferred shareholders have more voting rights than ordinary shareholders.
D.
it has a higher claim on assets in liquidation than creditors do.
17. Which of the following statements is incorrect?
A.
Preference shares usually have a fixed dividend and rate higher than ordinary shares in a
situation where a company goes into liquidation.
B.
A redeemable preference share with a fixed redemption date is classified as equity.
C.
A non-redeemable cumulative preference share gives the right to be paid current or
accumulated dividends before ordinary shareholders.
D.
A non-redeemable cumulative preference is normally classified as equity.
18. Which of the following statements is incorrect?
A.
A redeemable preference share that is redeemable by the holder is classified as equity if it
is not probable that redemption will occur.
B.
A redeemable preference share with a fixed redemption date is classified as debt.
C.
Sole proprietorships, partnerships and limited companies can all raise equity finance from
owners’ contributions but only limited companies can issue ordinary shares.
D.
A company distributes profits in the form of dividends, which is a reduction in retained
profits, whereas distributions of profits by partnerships and sole proprietors are reductions
in owners’ equity.
19. What is the amount of equity financing for this partnership?
A.
$30,000
B.
$25,000
C.
$45,000
D.
$20,000
20. What is the amount of debt financing for this partnership?
A.
$5000
B.
$45,000
C.
$20,000
D.
$15,000
21. When a company obtains financial resources from owners, it is termed:
A.
debt.
B.
operating.
C.
equity.
D.
risk-free.
22. The following amounts of capital were obtained to start operations of Yuppie Manufacturing at the
beginning of 20X8:
Owners’ contribution of cash
$80,000
Owners’ contribution of machinery & equipment
46,000
Loan from the owner
18,000
$144,000
What is the amount of equity financing for this firm?
A.
$18,000
B.
$62,000
C.
$98,000
D.
$126,000
23. Deep Lake Lodging Company was established at the beginning of 20X7 with the following capital:
Partners’ cash contributions
$46,000
Cash obtained from a group of creditors
30,000
Loan obtained from the local bank
10,000
Total
$86,000
What is the amount of equity financing for this firm?
A.
$10,000
B.
$40,000
C.
$46,000
D.
$76,000
24. Which of the following provide resources to an organisation in exchange for future returns?
Owners Creditors
A.
No Yes
B.
No No
C.
Yes Yes
D.
Yes No
25. Which type of shares has a higher claim on dividends and assets than ordinary shares?
A.
Voting
B.
Preference
C.
Senior
D.
Favoured
26. Which of the following represent capital that has been earned by the profitable operation of a
company?
Paid-in capital Retained profits
A.
Yes Yes
B.
Yes No
C.
No Yes
D.
No No
27. Retained profits can best be described as:
A.
cash receipts minus expenses after adjustments.
B.
net profit minus expenses after adjustments.
C.
undistributed profits.
D.
net profit minus cash disbursements after adjustments.
28. The term ‘retained profits’:
A.
is representative of the cash that the corporation has available to pay dividends as of the
balance sheet date.
B.
is found among the assets on the balance sheet of any profitable corporation.
C.
refers to an item whose value is always as large as, or larger than, that of cash on the
balance sheet.
D.
refers to an account balance found on the balance sheet of a corporation that has paid
dividends of lesser amount than profits since the beginning of the corporation.
29. Wilmington Fisheries had a Retained Profits account balance on 1 January 20X2 of $12,000.
During 20X2, the firm had net profit of $7200 and paid a $3600 cash dividend. What is the 31
December 20X2 Retained Profits balance?
A.
$12,200
B.
$15,600
C.
$19,600
D.
$21,200
30. Dividends on ordinary shares are:
A.
expensed when paid.
B.
expensed when incurred.
C.
expensed at year end.
D.
a reduction of retained profits.
31. Blue Nose Cold Storage Company was incorporated on 1 January 20X5. Since then, the following
shares have been issued:
Preference shares, 5%, $25
8000 shares
Ordinary shares, $20
10,000 shares
On 31 December 20X7, the company declared and paid a total of $50,000 in dividends. This was
the first dividend declared by the firm. That is, until this date no dividends had been declared or
paid during the first two years of operations. If the preference shares are cumulative, what is the
most that will be available out of the $50,000 dividend for payment to the ordinary shareholders?
A.
$20,000
B.
$30,000
C.
$40,000
D.
$50,000
32. Identify the correct statement below.
A.
Bank overdrafts are classified as long-term loans in Australia.
B.
Commitments are disclosed on the statement of comprehensive income because they affect
net profit but not cash flow.
C.
Finance leases are accounted for as if the leased items had been purchased.
D.
The expense associated with operating leases is reported on the cash flow statement under
the category of investing activities.
33. A shareholder makes an investment in a company. The net effect of this contribution is an increase
in:
A.
share capital only.
B.
both assets and share capital.
C.
both assets and liabilities.
D.
both liabilities and share capital.
34. Davis Computer Company has total liabilities of $50,000, total assets of $280,000 and paid-up
capital of $120,000. What is the amount of retained earnings and/or reserves?
A.
$20,000
B.
$110,000
C.
$140,000
D.
$160,000
35. The sources of equity finance for a company are:
A.
contributed equity.
B.
retained profits.
C.
general reserves.
D.
all of the above.
36. Where preference shares are redeemable at the discretion of the issuer, and shareholders have not
been advised of the company’s intention to redeem the shares:
A.
meet the definition of a liability.
B.
represent debt.
C.
are recognised as equity.
D.
are recognised as a financial liability.
SHORT ANSWER
1. Describe the nature and importance of working capital to a business entity.
2. Describe the nature of trade credit, factoring and bank overdrafts as sources of short-term finance.
3. Describe the nature and major sources of equity finance.
4. Distinguish between an operating lease and a finance lease and describe how the separate classes
of lease are accounted for in the books of the lessee.
5. Explain the concept of leverage. Why is this concept important for management?
6. Why do companies manage their working capital?
PROBLEM
1. On 1 January 20X3, the Harglo Construction Company leased a bulldozer from ASIS Sales
Corporation. The lease meets the criteria for classification as a finance (capital) lease and requires
Harglo to make annual payments of $30,000 at the end of each of the next 10 years with the first
payment due on 31 December 20X3. The present value of the lease payments is $200,000 based on
an interest rate of 8%.
How would the lessee record:
(a)
The inception of the lease on 1 January 1 20X3?
(b)
The first lease payment on 31 December 20X3?
(c)
Depreciation on the bulldozer for 20X3, assuming the straight-line method is used
over the life of the lease, and zero residual value?
$200,000 to record acquisition of bulldozer under lease from AIS Sales Corporation.
bulldozer.
amortisation on leased bulldozer.
2. On 1 March 20X3, the Red Dour Inn Company purchased a motel for $1,000,000, paying 25% in
cash and financing the remainder with a 20-year, 12% mortgage that requires monthly payments of
$8258.14.
How would the Red Dour Inn record:
(a)
The acquisition of the building on 1 March 20X3?
(b)
The first mortgage payment on 1 April 20X3?
(c)
The second mortgage payment on 1 May 20X3?
$250,000 cash payment and a 20-year, 12% mortgage.
monthly mortgage payment.
$8258.14 to record monthly mortgage payment.
CASE
1. The following is an excerpt from a 2002 press release by the US corporation, Pacific Gas and
Electric (PG&E).
Accounting for PG&E NEG Synthetic Leases
The Corporation announced on Feb. 21 that it was initiating a thorough review of the
accounting treatment of several synthetic leases used to finance power plant
development at the PG&E NEG (National Energy Group). The review confirmed that
payments to the independent equity owners during construction reduced the investor’s
equity below the minimum requirement to maintain these leases off balance sheet. As a
result, the Corporation’s statements now include these financings on balance sheet. The
change in accounting treatment resulted in no restatement of prior year earnings, a less
than $1 million impact on earnings for the fourth quarter 2001, an increase in total
assets and liabilities of $118 million in 1999, $861 million in 2000, and $1.058 billion in
2001.
Additional information
Synthetic leases involve the use of a special purpose entity (SPE) who holds title to the asset(s) (in
this instance, power plants) and raises the debt to finance the assets. The assets are then leased to a
single lessee – here, PG&E. The accounting objective of synthetic leases is to finance the
acquisition of an asset and at the same time keep the corresponding debt off the balance sheet of
the acquiring company. The SPE typically leases the property to the lessee at rates below those of a
traditional lease. Prior to 31 January 2003, the presumption in favour of consolidating an SPE
could be avoided if the following two conditions were met:
(i)
there was an minimum acceptable outside equity investment in the SPE. The SEC
determined, minimum acceptable outside equity investment was 3% of total capital;
and
(ii)
the independent owner had control over the SPE. Control was defined as a majority
voting interest.
The independent equity owner in the case of PG&E was an independent third-party lessor.
Required:
Discuss the accounting and ethical issues involved in the case.
broadly, the accounting issues concern the strategy of keeping debt off balance sheet,
and the consequences of doing so for the various stakeholders involved.
might ensue from existing debt contracts in the event that the debt was brought on
With respect to the issue of consolidation, the practice was within USGAAP at the
time, subject to the consolidation conditions being met.
