CFA Practice Question

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CFA Practice Question

The capitalization of interest distorts all of the following except ______.

A. interest coverage ratio
B. cash flows from operations
C. net income
D. change in cash during period
Correct Answer: D

Because interest is capitalized, interest expense is understated, which would distort the interest coverage ratio. Cash flows from operations would be understated because part of the interest is included in the cash flows from investing activities. Net income would be too high, because not all of the interest is included in calculating income.

User Contributed Comments 12

User Comment
xweibabson what about the tax effect?
Gina The capitalization of interest affects reported income but not taxable income (IRS). Therefore, the company would still need to pay the same amount of tax, and the change in cash remains the same.
amamed213 Can someone explain more ?
clarelau It affects taxable income. Capitalization results in higher earnings in earlier period. It has tax benefit in later period, but not in earlier period. However, the net change remains the same trough the whole period.
johntan1979 I believe the explanation in the answer by AnalystNotes about CFO is wrong. It should be overstated, not understated. Interest expense reduces CFO, so if part of that interest goes under CFI, then CFO is overstated.
CHUCKYT Analyst notes is stating that interest expense is understated, not CFO. That one got me too Johntan1979. The answer is correct.
philjoe Actual cash taxes paid has NOTHING to do with this. This is for book taxes. Cash taxes is based on tax law... when book tax and cash tax differ, a deferred tax asset or liability is created. I think that is in a future section though.
birdperson i agree with johntan1979 (per usual)
daverco It should't distort the interest coverage ratio, should it? It is supposed to be calculated based on total interest payments, whether capitalized or expensed (see also the next question).
SRI2010 daverco.. it distorts the interest coverage ratio as the interest costs are low. smaller denominator. better coverage. As far as the next question is concerned, it refers to the fact that, as an analyst, you should be cognizant of the interest costs involved, regardless of its classification. interest coverage here refers to the Financial Reporting whereas in the next question, it is about Financial Analysis.
babycdq Johntan1979, the notes is correct. CFO is overstated. Using indirect method to prepare the cash flow statement, everything start from NI. Capitalize the interest will make NI highter. The interest expenses are recorded in cash expenses for interest payable in CFI statement. The capitalized interest make CFI lower(understate), and make CFO higher(overstate).
babycdq Opps...pleases disregard my first sentence in the last comments...
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