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Chapter 8
Long-term Obligations
TRUE/FALSE (CHAPTER 8)
1. Unlike individuals and businesses, governments cannot seek protection under the Federal
Bankruptcy Code.
2. General obligation debt is the obligation of the government at large and is thereby backed by
the government’s general credit and revenue-raising powers.
3. Revenue debt is secured only by designated revenue streams.
4. When the proceeds of general long-term debt are received by a governmental fund, rather
than reporting a liability on the balance sheet, the inflow of resources is treated as an other
financing source on the operating statement.
5. Per GASB Statement No. 34, governments generally should report their bonds, notes, and
comparable long-term obligations at present value.
6. A government is prohibited from ever recognizing bond anticipation notes (BANs) as long-
term obligations.
7. Tax anticipation notes (TANs) must be reported as current liabilities of the governmental
funds in which the related revenues will be reported, as well as in the government-wide
statements.
8. Governments may enter into operating leases, but may not enter into capital leases.
9. In accounting for operating leases, the rental payments should be recognized as expenditures
in a governmental fund and as expenses in the government-wide statement of activities in the
periods in which they apply.
10. Because they are not obligations of the government at large, revenue bonds are usually not
subject to voter approvals or other forms of voter oversight.
11. Although governments may elect to report conduit debt in their government-wide and
proprietary fund statements, the GASB has ruled that note disclosure is sufficient.
12. Financial analysts look at the ratio of assessed value of property to total market value of
property as a measure of a government’s ability to issue new revenue bonds.
13. Overlapping debt refers to the obligations of property owners within a government’s
boundaries for their proportionate share of the debt of other governments with overlapping
geographic boundaries.
14. A government’s debt margin is the difference between its authorized debt limit and its
outstanding debt.
15. A high bond rating by a recognized agency guarantees the creditworthiness of a government’s
debt.
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MULTIPLE CHOICE (CHAPTER 8)
1. A government that is unable to satisfy claims against it
a) Is prohibited from filing bankruptcy.
b) May seek protection under the Federal Bankruptcy Code, using the same section that is
used by businesses.
c) May seek protection under the Federal Bankruptcy Code, using a special section directed
to governments.
d) Is automatically placed under the jurisdiction of a higher level of government.
2. To seek protection under the Federal Bankruptcy Code, a government must
a) Be unable to provide the level of services it has provided in the recent past.
b) Be unable to pay its debts in the current year.
c) Have budgeted expenditures in excess of revenues.
d) Both (b) and (c).
3. General long-term debt of a government includes
a) All future financial obligations.
b) All future financial obligations that result from past transactions.
c) All future financial obligations that result from past transactions for which the
government has already received a benefit.
d) All future financial obligations that are backed by the government’s general credit and
revenue raising power and that result from past transactions for which the government
has already received a benefit.
4. When the proceeds of long term debt are reported in governmental fund financial statements
a) They are reported only as an increase in liabilities in the funds.
b) They are reported only as revenues in the funds.
c) They are reported only as an other financing source—debt proceeds.
d) They are reported only as an other financing use—debt proceeds.
5. In governmental fund financial statements, the assets acquired under a capital lease would be
reported at
a) The total of all payments required under the lease.
b) The present value of the required lease payments.
c) The undiscounted total of required lease payments.
d) They are not reported in the fund financial statements.
6. In the government-wide financial statements, the assets acquired under a capital lease would
be reported at
a) The total of all payments required under the lease.
b) The present value of the required lease payments.
c) The undiscounted total of required lease payments.
d) They are not reported in the government-wide financial statements.
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7. Salvador County issued $25 million of 5 percent demand bonds for construction of a county
maintenance building. The county has no take-out agreement related to the bonds. It
estimates that 20 percent of the bonds would be demanded (called) by the buyers if interest
rates increased by at least one percentage point. At year-end, rates on comparable debt were
7 percent. How should these demand bonds be reported in the government-wide financial
statements at year-end?
a) $25 million in the long-term liabilities section of the governmental activities column.
b) $5 million in the current liabilities section of the governmental activities column AND
$20 million in the long-term liabilities section of the governmental activities column.
c) $5 million in the governmental activities column AND $20 million would be reported in
the schedule of changes in long-term obligations.
d) $25 million in the current liabilities section of the governmental activities column.
8. Salvador County issued $25 million of 5 percent demand bonds for construction of a county
maintenance building. Before year-end the county entered into a two-year noncancellable
take-out agreement with a local bank with a 10-year payback period. The county estimates
that 20 percent of the bonds would be demanded (called) by the buyers if interest rates
increased by at least One percentage point. At year-end, rates on comparable debt were 7
percent. How should these demand bonds be reported in the county’s government-wide
financial statements at year-end?
a) $25 million in the long-term liabilities section of the governmental activities column.
b) $5 million in the current liabilities section of the governmental activities column AND
$20 million in the long-term liabilities section of the governmental activities column.
c) $5 million in the governmental activities column AND $20 million would be reported in
the schedule of changes in long-term obligations.
d) $25 million in the current liabilities section of the governmental activities column.
9. Salvador County issued $25 million of 5 percent demand bonds for construction of a county
maintenance building. The county has no take-out agreement related to the debt. It estimates
that 20 percent of the bonds would be demanded (called) by the buyers if interest rates
increased by at least one percentage point. At year-end, rates on comparable debt were 7
percent. How should these demand bonds be reported in the governmental fund financial
statements at year-end?
a) $25 million in the capital projects fund.
b) $5 million in the capital projects fund AND $20 million would be reported in the
schedule of changes in long-term obligations.
c) $20 million in the capital projects fund AND $5 million would be reported in the
schedule of changes in long-term obligations.
d) $25 million in the schedule of changes in long-term obligations.
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10. Voters of Valdez School District, a public school district, approved construction of a new
high school at a cost not to exceed $20 million. The district will finance the construction by
issuing $20 million of 6 percent term bonds payable in 20 years. Because the site had already
been prepared, the school district began construction immediately but the bonds would not be
issued for nearly a year. Shortly before the fiscal year-end, the school district borrowed $5
million from a local bank due in one year with interest at 6.2 percent. The note will be repaid
from bond proceeds. The school district secured a financing agreement with the bank to
convert the debt to a 10-year debt if the school district is unable to sell the bonds by the due
date. At year-end, how should the $5 million note be displayed in the governmental fund
financial statements?
a) Capital projects fund—Notes payable $5 million; Nothing in the schedule of changes in
long-term obligations.
b) Capital projects fund—Notes payable $5 million; $15 million in the schedule of changes
in long-term obligations.
c) Capital projects fund—Encumbrances of $5 million; $15 million in the schedule of
changes in long-term obligations.
d) Nothing in the capital projects fund AND $5 million notes payable in the schedule of
Changes in long-term obligations.
11. Dumas County has a December 31 fiscal year-end. In November, the county borrowed $8
million from a local bank, due in six months at 6 percent interest, to finance general
government operations. The county pledges property tax revenues to secure the loan. At
year-end, how should the county display the bank note in the governmental fund financial
statements?
a) Nothing in the General Fund; Nothing in the schedule of changes in long-term
obligations.
b) General fund—$8 million in other financing sources; Nothing in the schedule of changes
in long-term obligations.
c) General fund—$8 million in other financing sources; $8 million in the schedule of
changes in long-term obligations.
d) General fund—$8 million in notes payable; Nothing in the schedule of changes in long-
term obligations.
12. Governments enter into capital leases rather than conventional buy and borrow arrangements
for which of the following reasons? Capital leases
a) May be an effective means of circumventing debt limitations.
b) Are less expensive overall than buy and borrow arrangements.
c) Reduce the cash outflows related to the asset acquisition.
d) Have less effect on governmental fund balances than buy and borrow arrangements.
13. Olden City entered into a capital lease agreement for several new dump trucks to be used in
general government activities. The city maintains its books and records in a manner that
facilitates the preparation of the fund financial statements. Acquisition of these dump trucks
would require entries in which of the following funds and/or schedules?
a) General fund only.
b) General fund AND schedule of changes in long-term obligations.
c) General fund AND schedule of changes in capital assets.
d) General fund, schedule of Changes in Capital assets AND schedule of changes in long-
term obligations.
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14. North City enters into a lease agreement that contains a nonappropriation clause. The clause
a) Has been held by courts in 26 states to effectively cancel the lease.
b) Stipulates that the yearly lease payment must be appropriated by the city council each
year.
c) Prohibits the city from replacing leased property with similar property.
d) Permits the city to lease at lower rates than would be possible without the presence of the
clause.
15. Why would a government issue revenue bonds (which generally are issued at a higher rate of
interest than general obligation bonds) even though the government knows that if revenues
from the project are not sufficient to cover principal and interest payments, the government
will use resources from general government activities to fund the principal and interest
payments?
a) Revenue bonds may not require approval of the voters.
b) Revenue bonds may not be considered in legal debt limitations.
c) Revenue bonds may permit the interest costs to be passed on to the users of the services
financed.
d) All of the above.
16. Which of the following funds is most likely to receive the proceeds of revenue bonds?
a) General fund.
b) Capital projects fund.
c) City utility enterprise fund.
d) Highway department special revenue fund.
17. Obligations of property owners within a particular government for their proportionate share
of debts of other governments with whom their government shares boundaries are called
a) Overlapping debt.
b) Conduit debt.
c) Committed debt.
d) Moral obligation debt.
18. Overlapping debt should be reported in which of the following ways?
a) It should be reported in the schedule of changes in long-term obligations.
b) It should be disclosed as a note to the financial statements.
c) It should be reported in a schedule in the statistical section of the annual report.
d) It should not be reported anywhere in the annual report.
19. Obligations issued in the name of a government on behalf of a nongovernmental entity are
called
a) Overlapping debt.
b) Conduit debt.
c) Committed debt.
d) Moral obligation debt.
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20. Pacheco City issued $20 million of bonds at par. The city loaned the proceeds to Sharpe
Cheese Processors to expand the size of its facility, which would allow Sharpe to hire
additional workers. The loan payments from Sharpe to the city are established to match the
principal and interest payments on the bond issue. The bonds are payable exclusively from
the loan repayments by Sharpe. The bonds are secured by the additional plant facilities built
by Sharpe. Where should the city report the bonds in its annual financial report?
a) In the government-wide financial statements.
b) In the notes to the financial statements.
c) In the proprietary fund financial statements.
d) In any of the above ways.
21. Industrial development bonds are issued in the name of a government with the proceeds used
to attract private businesses to a community. Which of the following is a true statement about
industrial development bonds?
a) The proceeds are used by the private corporations and principal and interest payments are
made by the private corporation. The government backs the bonds in the event of default
by the private corporation.
b) The proceeds are used by the private corporations and principal and interest payments are
made by the private corporation. The government does not back the bonds in the event of
default by the private corporation.
c) The proceeds are used by the government to build infrastructure to service private
corporations, with principal and interest payments made by the government out of the
additional tax revenues received from the private corporation.
d) The proceeds are used by the government to build infrastructure to service private
corporations, with principal and interest payments made by the private corporation in lieu
of property taxes.
22. Easterly City has $47 million of debt recorded in its schedule of changes in long-term
obligations, made up of $30 million of general obligation debt, $1 million of compensated
absences payable, $4 million of claims and judgments, and $12 million of obligations under
capital leases. The state limits the amount of general obligation debt that can be issued by a
city to 20 percent of the assessed value of its taxable property. The assessed value of
property in Easterly City is $250 million. The city’s legal debt margin is
a) $ 3 million.
b) $ 20 million.
c) $ 30 million.
d) $50 million.
23. A state created a housing authority to provide financing for low-income housing. The
authority issues bonds and uses the proceeds for that purpose. Currently the authority has
outstanding $200 million in bonds backed by the state’s promise to cover debt service
shortages should they arise. The state constitution specifically limits the state to no more
than $2 million in general obligation debt. How can the state officials defend the $200
million in debt outstanding?
a) The debt is not general obligation debt.
b) The state is only morally obligated for the debt.
c) The debt is the debt of the authority, not the state.
d) All of the above.
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24. Debt that is issued by one entity but backed by the promise of another entity to make up any
debt service deficiency is
a) Committed debt.
b) Overlapping debt.
c) Conduit debt.
d) Moral obligation debt.
25. Beaver city entered into a long-term capital lease for some office equipment. The city
maintains its books and records in a manner to facilitate preparation of fund financial
statements. What entry should be made in its general fund to record this event?
a) Debit Expenditures; Credit Other financing sources—leases.
b) Debit Equipment; Credit Other financing sources—leases.
c) Debit Equipment; Credit Leases payable.
d) No entry, because this event had no effect on financial resources.
26. A city’s electric utility enterprise fund made its annual interest payment on its outstanding
$20 million of 6 percent bonds, which were originally issued at a premium. The city
maintains its books and records in a manner that facilitates preparation of fund financial
statements. The entry to record the interest payment would include a credit to cash for the
amount of the interest checks written and debit(s) to
a) Interest expenditure AND bond premium.
b) Interest expense AND bond premium.
c) Interest expenditure only.
d) Interest expense only.
27. Which of the following is likely to be used by a bond rating agency to rate a government’s
general obligation bonds?
a) A review of the basic financial statements.
b) Consideration of economic statistics such as unemployment rates.
c) Consideration of legal debt margin.
d) All of the above.
28. In a bond covenant, a city agreed to create and maintain a $2 million reserve. These funds
can be used
a) Only to make the final year’s interest and principal payments on the bonds.
b) Only to make the interest and principal payments on the bonds in a year in which the city
is unable to make them from other resources.
c) To make either the final year’s interest and principal payments on the bonds or to make
the payments in any year that the city is unable to make them from other resources.
d) By the city as it chooses since the funds legally belong to the city.
29. Bond insurance issued by credit enhancement agencies
a) Assures the holder of the debt that all interest and principal payments will be made.
b) Ensures that the bonds receive the highest possible rating.
c) May seem cost prohibitive to many governments.
d) All of the above.
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30. The work of bond rating agencies is important because
a) They ensure that all principal and interest payments on bonds issued will be made.
b) The rating they assign proves the quality of a particular debt instrument.
c) They affect the debt’s marketability and hence its interest rate.
d) Bonds cannot be issued without them.
31. A major exception to the general rule of expenditure accrual for governmental funds of a
state or local government relates to unmatured
Interest on General Principal of general
Long-term debt Long-term debt
a) Yes No
b) No Yes
c) Yes Yes
d) No No
32. Flora City is accumulating financial resources that are legally restricted to payments of
general long-term debt principal and interest maturing in future years. At year-end,
$7,000,000 has been accumulated for principal payments, and $2,200,000 has been
accumulated for interest payments. These restricted funds should be accounted for in the
General Fund Debt Service Fund
a) $0 $9,200,000
b) $9,200,000 $0
c) $2,200,000 $7,000,000
d) $7,000,000 $0
33. Which of the following is not likely to be a reason why a government might obtain an asset
through an operating lease? The government
a) Does not have enough cash or credit to purchase the asset.
b) Wishes to avoid the risk of owning an asset that has become obsolete and cannot be sold.
c) Believes the total value of assets reported in the schedule of changes in capital assets is
already too high.
d) Needs the asset for only a small part of its useful life.
34. A government is required to report a lease as a capital lease if it meets which of the following
conditions?
a) The lease term is equal to or greater than 75 percent of the estimated economic life of the
leased property.
b) The lease transfers ownership of the property from the lessor to the lessee by the end of
the lease term and/or the lease contains an option for the lessee to purchase the property
at a bargain price.
c) The present value of rental and other minimum lease payments equals or exceeds 90
percent of the fair value of the leased property.
d) Any one of the above conditions meets the requirement.
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PROBLEMS (CHAPTER 8)
1. During the fiscal year ended 6/30/15, the Harriscity engaged in the following transactions.
REQUIRED: Assume that the city maintains its books and records in a manner that
facilitates the preparation of its governmental fund financial statements. Prepare all necessary
journal entries that the city should make for each transaction. Clearly indicate in which fund
the entry is being made. If no entry is required, write “No entry required.”
a) In July 2014, the city issued $30 million in 6% general obligation term bonds to finance
construction of a new building to house city offices. The bonds were issued at a
premium of $300,000.
b) In September 2014, the city transferred $1.5 million from the general fund to cover the
$0.9 million principal and $0.6 million interest payments due that month on debt issued
in previous years.
c) In September 2014, the city paid the principal and interest due from (b).
d) In June 2015, the city transferred $3 million from the general fund to cover the $1.8
million interest payment and the $1.2 million principal payment due in July 2015 on the
bonds issued in (a).
2. Rand city entered into the following transactions during the current year. REQUIRED:
Assume that the city maintains its books and records in a manner that facilitates the
preparation of its fund financial statements. Prepare entries to record the following
transactions. Indicate the fund in which the entry is being made.
a) The city issues $5 million of tax anticipation notes, backed by property taxes that will be
recorded in the general fund.
b) The city issues $2 million of 90-day bond anticipation notes that it expects to roll over
into long-term bonds.
c) The city repays the $5 million in (a) plus $0.125 million in interest.
d) The city successfully issues $20 million in long-term bonds and repays the notes in (b).
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3. Yarrow County engaged in the following debt-related transactions during the year.
REQUIRED: Assume that the county maintains its books and records in a manner that
facilitates the preparation of its government-wide financial statements. Prepare the necessary
journal entries to record these transactions. Clearly indicate if debt is long-term or short-term
(current). If no entry is required, write “No entry required.”
a) The county issued $10 million in 6 percent, 20-year bonds for $10,234,932 to yield 5.8
percent (2.9 percent per semi-annual period) to the investor.
b) The county made the first semi-annual interest payment on the bonds in (a).
c) The county issued $3 million in 6 percent demand bonds for which it did not enter into a
take-out agreement.
d) In anticipation of finally issuing $20 million in bonds that were approved by the voters
several months ago, the county borrowed $20 million from a consortium of national
banks due in six months. The county also entered into a financing agreement with the
consortium to convert the debt to 10-year debt if long-term bonds were not sold
successfully.
e) In anticipation of property tax revenues to be received several months after its fiscal year–
end, the county borrowed $2 million from a local bank payable in nine months.
f) The county leased a new machine for its county highway department in an arrangement
that qualified as a capital lease. The present value of the minimum lease payments is
$250,000, which approximates the fair value of the machine.
4. Mod City is located in Harper County. Mod Valley School District encompasses all of Mod
City and some of Harper County. Property in Mod City is assessed at $400 million; property
in Harper County is assessed at $800 million; property in Mod Valley School District is
assessed at $600 million. The total debt outstanding for Mod City is $30 million; Harper
County is $50 million; Mod Valley School District is $45 million. REQUIRED: For Mod
City, compute (a) the amount of direct debt and (b) the amount of overlapping debt.
5. In August 2014, the voters of Carp City approved construction of a new public library at the
cost of $20 million, to be financed by general obligation bonds. The city put the contracts out
to bid and approved the bid of the lowest bidder. In September 2014, the city began the long
process of issuing the general obligation bonds. However, so that construction could begin
immediately, the city also issued $5 million in bond anticipation notes in September 2014,
maturing in March 2015. In December 2014, one of the city’s major manufacturers
announced that it would be closing its plant in the city, eliminating over half of the jobs
currently available in the city.
REQUIRED:
(a) Prepare journal entries to initially record the issuance of the BANs in the city’s capital
projects fund as well as in its government-wide financial statements.
(b) The city decided to reconsider the scope of the library project in light of the plant closure,
prepare any entries necessary to change the reporting of the BANs assuming that the city
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negotiated a 6-month extension of the initial due date for the BANs and would not issue
any general obligation bonds before issuing its June 30, 2015 financial statements.
6. Midway City engaged in two types of debt transactions in its fiscal year ending December 31,
2014. The city issued its financial statements for 2014 on May 15, 2015.
A. In November 2014, the city issued $4 million in bond anticipation notes (BANs) to
finance construction of a new maintenance facility. The proceeds were placed in a capital
projects fund and the city began construction immediately. Although the city intended to
refinance the BANs with long-term bonds, interest rates were higher than anticipated and
as of May 15, 2015 the city had neither issued the bonds nor entered into an agreement to
do so. How, if at all, should the debt be reported in the capital projects fund and the
government-wide statements? Be specific.
1. Capital projects fund
2. Government-wide statements
B. In October 2014, the city issued $1 million of industrial development bonds to finance
the construction of a new fast-food restaurant. The city will construct the facility and
lease it to a restaurant chain. The lease satisfies the criteria for a capital lease. The lease
payments will be exactly equal to the debt service on the bonds. The bonds are payable
exclusively from the lease payments. In the event the restaurant chain defaults on its
lease payments, the bondholders have a claim only against the restaurant chain and the
leased property, not against the city. In its December 31, 2014 government-wide
statement of net position, the city did not report the debt as a liability. Assuming that the
amount involved is material, would you as an auditor issue an unqualified opinion on the
financial statements? Explain and justify your response.
7. Clavel County leases an office building with a remaining economic life of 20 years. The fair
market value of the building is $6 million. Annual lease payments are agreed at $523,107,
based on a 6 percent interest rate. The lease meets the conditions for a capital lease.
1. Record the lease and the first year’s interest payment
(a) In a governmental fund
(b) In the government-wide statements
2. Should the office building be depreciated? If so, how and where should depreciation be
recorded?
3. Suppose the lease did not meet the conditions for a capital lease. How and where should
the lease be recorded? Should the office building be depreciated? If so, how and where
should depreciation be reported?
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ESSAYS (CHAPTER 8)
1. Identify and define “conduit debt.” What are the current reporting standards for conduit debt
issued by governments? Do you agree or disagree with the use of conduit debt by
governments? Justify your answer. Do you agree or disagree with the current reporting
standards related to conduit debt? Why?
2. Generally accepted accounting principles require governments to report many assets to be
reported at market value. However, few liabilities are reported at market value. Present
arguments for and against reporting liabilities at market value.
3. Why is information about long-term debt important to financial statement users?
4. What is the distinction between general obligation debt and revenue bond debt? Why might a
government issue revenue bond debt instead of general obligation debt?
5. Terry City is considering issuing $50 million in debt to finance construction of a new sewer
system. REQUIRED: Compare the possible financial effects of the city’s decision to finance
the new system with
(a) General obligation debt
(b) State-issued sewer revolving bond fund debt, which carries the moral obligation of the
state in addition to being a primary obligation of the city through its loan payments to the
state
(c) The city’s own sewer revenue bonds, or
(d) General obligation debt insured by a company specializing in municipal bond insurance.
6. What is “overlapping debt” and why is it important to financial analysts and others who use
government financial statements?
7. Flora City financed the construction of sidewalks in a newly annexed subdivision by issuing
$50 million in special assessment debt. The debt is to be serviced entirely by assessments
against the subdivision’s property owners. The government does not have any obligation for
the debt and has not guaranteed it. Nevertheless, when the property owners in a nearby
subdivision were unable to pay their required assessments, the city, fearful of damaging its
own credit rating, serviced the debt using its own resources. Should the city report the $50
million in special assessment debt in its government-wide statement of net position? Explain,
citing specific GASB provisions.
8. On December 31, 2014 Morse City issued $50 million of 8 percent, 20-year, demand bonds
that give bondholders the opportunity to “put” (i.e. sell) the securities back to the issuer at
face value, beginning on January 1, 2018. On December 31, 2017, prevailing interest rates
on comparable bonds were 6.7 percent. Should the city report the bonds as a liability on its
December 31, 2017 governmental fund financial statements? Explain, indicating any
additional information you would need to make a determination.
9. In November 2014, the Frost City issued $3 million in 6 percent TANs, payable in April
2015. In what fund or fund type should the city report the TANs on its December 31, 2014
financial statements? Explain, indicating any additional information you would need.
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ANSWERS TO TRUE/FALSE (CHAPTER 8)
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ANSWERS TO MULTIPLE CHOICE (CHAPTER 8)
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ANSWERS TO PROBLEMS (CHAPTER 8)
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ANSWERS TO ESSAYS (CHAPTER 8)
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