CFA Practice Question

There are 520 practice questions for this study session.

CFA Practice Question

Which of the following would be an effect of capitalizing interest costs?

I. Depreciation is understated.
II. Interest coverage is understated.
III. Cash flows from investing are understated.
IV. Cash flows from operations are understated.
A. I, II and III
B. III only
C. II and IV
Explanation: Depreciation is overstated (interest is included in the cost of the asset), interest coverage is overstated (interest expense is too low), and cash flows from operations are overstated (not enough interest has been deducted). Cash flows from investing are understated, as the interest expense has been included in the cost of the asset.

User Contributed Comments 7

User Comment
eheinzer Interst is part of CFI or CFO? Explanation does not make sense to me!
gjwhite replace CFI with CFO in my comment above.
gjwhite interest is part of CFO. Capitalising interest makes it part of the price for the asset and removes it from CFI, so, CFI is overstated, there is more to depreciate, less interest recognised, so EBIT/(interest expense) is overstated.
elda CFI is understated because the cash paid on fixed assets recorded here would include the interest cost (outflow increases)
danlan 1)More depreciation,
2)Less interest expense(part of interest payment is capitalized)==>Interest coverage is higher
3)Less expense for CFO==>Higher cash flow for CFO
4)More expense for CFI==>Lower cash flower for CFI
StJohnDale CFO - will be higher becasue we are not processing the expense through the income statement which rolls into CFO. Thus CFO will be higher than it should be. If CFI is a net inflow, capitalised interest will reduce this inflow and it will be understated. If CFI is a net outflow, capitalised interest will make the net outflow bigger, still understating the CFI, as actual CFI should be higher. Thus understated.
rjdelong A = L + E

If Capitalize --> A up, L up, IE down
If A up --> Dep up
If IE down --> EBIT/IE up
IE classified as CFO (outflow)
Capitalized interest classified as CFI (outflow)
CFO will increase and CFI will decrease because there is less IE, less of a drag on CFO, instead that drag is placed on the CFI
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