Sergei Leenid, CFA, is a long-only fi xed income portfolio manager for the Parliament Funds.He has developed a quantitative model, based on fi nancial statement data, to predict changesin the credit ratings assigned to corporate bond issues. Before applying the model, Leenid fi rstperforms a screening process to exclude bonds that fail to meet certain criteria relative to theircredit rating. Existing holdings that fail to pass the initial screen are individually reviewed forpotential disposition. Bonds that pass the screening process are evaluated using the quantitative model to identify potential rating changes.Leenid is concerned that a pending change in accounting rules could aff ect the results ofthe initial screening process. One current screen excludes bonds when the fi nancial leverage ratio (equity multiplier) exceeds a given level and/or the interest coverage ratio falls below a givenlevel for a given bond rating. For example, any “A” rated bond of a company with a fi nancial leverage ratio exceeding 2.0 or an interest coverage ratio below 6.0 would fail the initialscreening. Th e failing bonds are eliminated from further analysis using the quantitative model.Th e new accounting rule would require substantially all leases to be capitalized on a company’s balance sheets. To test whether the change in accounting rules will aff ect the outputof the screening process, Leenid collects a random sample of “A” rated bonds issued by companies in the retail industry, which he believes will be among the industries most aff ected bythe change.Two of the companies, Silk Road Stores and Colorful Concepts, recently issued bondswith similar terms and interest rates. Leenid decides to thoroughly analyze the potential eff ectsof the change on these two companies and begins by gathering information from their mostrecent annual fi nancial statements (Exhibit 1).After examining lease disclosures, Leenid estimates the average lease term for each companyat 8 years with a fairly consistent lease expense over that time. He believes the leases should becapitalized using 6.5 percent, the rate at which both companies recently issued bonds.EXHIBIT 1 Selected Financial Data for Silk Road Stores and Colorful ConceptsSilk Road Colorful ConceptsRevenue 3,945 7,049EBIT 318 865Interest expense 21 35Income taxes 121 302Net income 176 528Average total assets 2,075 3,844Average total equity 1,156 2,562Lease expense 213 406While examining the balance sheet for Colorful Concepts, Leenid also discovers thatthe company has a 204 ending asset balance (188 beginning) for investments in associates,primarily due to its 20 percent interest in the equity of Exotic Imports. Exotic Imports is a 982 International Financial Statement Analysisspecialty retail chain and in the most recent year reported 1,230 in sales, 105 in net income,and had average total assets of 620.1 . If the accounting rules were to change, Silk Road’s assets would increase by approximately:A . 1,297.B . 1,576.C . 1,704.
Sergei Leenid, CFA, is a long-only fi xed income
He has developed a quantitative model, based on fi nancial statement data, to predict changes
in the credit ratings assigned to corporate bond issues. Before applying the model, Leenid fi rst
performs a screening process to exclude bonds that fail to meet certain criteria relative to their
credit rating. Existing holdings that fail to pass the initial screen are individually reviewed for
potential disposition. Bonds that pass the screening process are evaluated using the quantitative model to identify potential rating changes.
Leenid is concerned that a pending change in accounting rules could aff ect the results of
the initial screening process. One current screen excludes bonds when the fi nancial leverage ratio (equity multiplier) exceeds a given level and/or the interest coverage ratio falls below a given
level for a given bond rating. For example, any “A” rated bond of a company with a fi nancial leverage ratio exceeding 2.0 or an interest coverage ratio below 6.0 would fail the initial
screening. Th e failing bonds are eliminated from further analysis using the quantitative model.
Th e new accounting rule would require substantially all leases to be capitalized on a company’s balance sheets. To test whether the change in accounting rules will aff ect the output
of the screening process, Leenid collects a random sample of “A” rated bonds issued by companies in the retail industry, which he believes will be among the industries most aff ected by
the change.
Two of the companies, Silk Road Stores and Colorful Concepts, recently issued bonds
with similar terms and interest rates. Leenid decides to thoroughly analyze the potential eff ects
of the change on these two companies and begins by gathering information from their most
recent annual fi nancial statements (Exhibit 1).
After examining lease disclosures, Leenid estimates the average lease term for each company
at 8 years with a fairly consistent lease expense over that time. He believes the leases should be
capitalized using 6.5 percent, the rate at which both companies recently issued bonds.
EXHIBIT 1 Selected Financial Data for Silk Road Stores and Colorful Concepts
Silk Road Colorful Concepts
Revenue 3,945 7,049
EBIT 318 865
Interest expense 21 35
Income taxes 121 302
Net income 176 528
Average total assets 2,075 3,844
Average total equity 1,156 2,562
Lease expense 213 406
While examining the
the company has a 204 ending asset balance (188 beginning) for investments in associates,
primarily due to its 20 percent interest in the equity of Exotic Imports. Exotic Imports is a
982 International Financial Statement Analysis
specialty retail chain and in the most recent year reported 1,230 in sales, 105 in net income,
and had average total assets of 620.
1 . If the accounting rules were to change, Silk Road’s assets would increase by approximately:
A . 1,297.
B . 1,576.
C . 1,704.
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