Fa4e Sm Ch09

Chapter 9

Reporting and Analyzing Liabilities

Learning Objectives – coverage by questionMini-

ExercisesExercises Problems

Cases and Projects

LO1 – Identify and account for current operating liabilities.

18, 19, 21,

22, 25, 3038 - 40, 49 59 61

LO2 – Describe and account for current nonoperating (financial) liabilities.

21 49 59

LO3 – Explain and illustrate the pricing of long-term nonoperating liabilities.

22, 31, 32,

34 - 37

42, 43,

45 - 48, 5051 - 60 60, 61

LO4 – Analyze and account for financial statement effects of long-term nonoperating liabilities.

23, 24,

26 - 29, 31,

34 - 36

41, 42,

44 - 5051 - 58 60, 61

LO5 – Explain how solvency ratios and debt ratings are determined and how they impact the cost of debt.

23, 30, 32 43 51 60, 61

©Cambridge Business Publishers, 2014

Solutions Manual, Chapter 9 9-1

DISCUSSION QUESTIONSQ9-1. Current liabilities are obligations that require payment within the coming year or

operating cycle, whichever is longer.

Generally, current liabilities are normally settled with use of existing current assets or operating cash flows.

Q9-2. If a company fails to take a cash discount that is offered by a supplier, it is effectively paying a penalty for taking additional time to pay the account payable. Depending on the size of the discount, this penalty (an implicit interest rate) can be quite high.

The net-of-discount method records the inventory at the purchase cost less the discount. If the discount is lost, the extra cost is treated as part of interest expense for the period. This has two benefits: (1) the lost discount is not capitalized as part of the cost of inventory, and (2) the lost discount is highlighted, which is useful information that may be helpful in managing accounts payable.

Q9-3. An accrual is the recognition of an event in the financial statements even though no actual transaction has occurred. Accruals can involve both liabilities (and expenses) and assets (and revenues).

Accruals are vital to the fair presentation of the financial condition of a company as they impact both the recognition of revenue and the matching of expense.

Q9-4. The coupon rate is the rate specified on the face of the bond. It is used to compute the amount of cash interest paid to the bond holder. The market rate is the rate of return expected by investors that purchase the bonds. The market rate determines the market price of the bond. It incorporates expectations about the relative riskiness of the borrower and the rate of inflation. In general, there is an inverse relation between the bond’s market rate and the bond’s market price.

Q9-5. Bonds sold at face (par) value earn an effective interest rate equal to the bonds’ coupon rate. Bonds are sold at a discount when the effective interest rate is higher than the coupon rate. Bonds are sold at a premium when the effective interest rate is lower than the coupon rate.

Q9-6. Bonds are reported at historical cost, that is, the face amount plus (minus) unamortized premium (discount). The market price of the bonds varies inversely with the level of interest rates and fluctuates continuously. Differences between the market price of a bond and its carrying amount represent unrealized gains and losses. These unrealized gains (losses) are not reflected in the financial statements (although they are disclosed in the footnotes). They must be recognized upon repurchase of the bonds, the point at which they become “realized.”

continued next page


9-2 Financial Accounting, 4th Edition

continued

If the bonds are refunded (that is, replaced with new bonds reflecting current market values and interest rates), the gain (or loss) that is recognized in the current period will be offset by correspondingly higher (lower) interest payments in the future. The present value of the future interest payments, along with the present value of the difference between the face amount of the new bond and the former face amount, exactly offset the reported gain (loss).

Q9-7. Debt ratings reflect the relative riskiness of the borrowing company. This riskiness relates to the probability of default (e.g., not repaying the principal and interest when due). Higher (greater quality) debt ratings result in higher market prices for the bonds and a correspondingly lower effective interest rate for the issuer. Lower (lesser quality) debt ratings result in lower market prices for the bonds and a correspondingly higher effective interest rate for the issuer.

Q9-8. Reported gains or losses on bond redemption result from changes in the market price of the bonds and the use of historical cost accounting. Because bonds are typically reported at historical cost, fluctuations in bond prices are not recognized until they are realized when the bonds are redeemed or refunded. If the bonds are refunded (new bonds are issued), the gain or loss is offset by the present value of lower (higher) future interest payments on the new bond issue.

Q9-9. (a) Term loan – a loan that matures on a single, pre-specified date

(b) Bonds payable – the liability account used to record the face value of bonds issued by a company

(c) Serial bonds – bonds that mature in installments rather than on one date

(d) Call provision – the right for the bond issuer to repurchase the debt, before it matures, at a predetermined price.

(e) Convertible bonds – bonds that can be converted into some other asset (typically common stock) at the option of the bondholder

(f) Face value – the predetermined amount (typically $1,000) that must be repaid when a bond matures

(g) Nominal rate – the rate specified on the face of the bond that determines the periodic interest (coupon) payment

(h) Bond discount – the difference between the face value of the bond and the market price when the price is lower than the face value; recorded as a contra-liability

(i) Bond premium – the difference between the market price of a bond and the face value when the market price is higher than the face value; recorded as an adjunct-liability

(j) Amortization of premium or discount – the periodic reduction of the balance in the premium or discount account recorded each time interest expense is accrued; equal to the difference between the accrued interest and the coupon payment (or payable)



Q9-10. The advantages of issuing bonds are (1) the interest payments are limited to the predetermined amount specified on the bond; (2) the interest is tax deductible; (3) bondholders do not have a vote when it comes to electing directors and managing the company; (4) the additional financial leverage created when bonds are issued increases profits in good years. The disadvantages of bonds include (1) bonds must be repaid while common stock is issued with an indefinite life; (2) bondholders can impose restrictive covenants in the loan indenture; (3) the additional financial leverage created when bonds are issued decreases profits in lean years.

Q9-11. $3,000,000 x [.98 + (.09 x 3/12)] = $3,007,500

Q9-12. The contract rate (or stated rate or coupon rate) determines the periodic coupon payment. If this rate is not equal to the rate required by the market, the bond price is adjusted to the present value of the cash payments from the bond discounted at the applicable market rate of interest. If the market rate is higher than the coupon rate, then the periodic coupon payments are insufficient and the bond will be priced lower than the face value (a discount). If the market rate is lower than the coupon rate, then the periodic coupon payments will be higher than required by the market, and the bond will sell for a premium.

Q9-13. When the bonds mature, the book value of the bonds will be equal to the face value. Over the life of the bonds, the change in the book value of the bonds will be equal to face value less the market value at the time that the bonds are issued.

Q9-14. When the effective interest method is used to amortize a bond discount or premium, the effective rate is multiplied by the net balance in bonds payable (bonds payable plus/minus the premium or discount). If the bond is issued at a discount, the balance increases over the life of the bond; the interest expense will increase as the balance increases. If the bond is issued at a premium, the balance decreases over the life of the bond; the interest expense will decrease as the balance decreases.

Q9-15. Bonds payable is presented in the balance sheet net of any discount or plus any premium.

Q9-16. The loss is the difference between the retirement value and the book value of the bond: 101% x $200,000 – $197,600 = $4,400.

Q9-17. Each payment includes both interest on the outstanding balance and repayment of the principal. As each payment is made, the principal balance is reduced. As a consequence, the interest component of the payment is smaller each period.



MINI EXERCISES

M9-18. (15 minutes)

a.11/15 Inventory (+A) 6,076

Accounts payable (+L) 6,076

11/23 Accounts payable (-L) 6,076Cash (-A) 6,076

$6,076 = $6,200 x 0.98.

b.+ Inventory (A) - - Accounts Payable (L) +

11/15 6,076 6,076 11/1511/23 6,076

+ Cash (A) -6,076 11/23

c. [($6,200 - $6,076)/$6,076] x [365/(30-10)] = 37.24%. (With interest compounding, the annual rate of interest r can be solved from (1+r)(20/365)=1.02. The value that solves this relationship is r = 43.5%.)



M9-19. (15 minutes)

a.1/20 Inventory (+A) 12,250

Accounts payable (+L) 12,250

2/15 Accounts payable (-L) 12,250Interest expense, discounts lost (+E, -SE) 250

Cash (-A) 12,500

$12,250 = $12,500 x 0.98.

b.+ Inventory (A) - - Accounts Payable (L) +

1/20 12,250 12,250 1/202/15 12,250

+ Cash (A) - + Interest Expense, Discounts Lost (E) -12,500 2/15 2/15 250

c. [($12,500- $12,250)/$12,250] x [365/(60-15)] = 16.55%. (With interest compounding, the annual rate of interest r can be solved from (1+r)(45/365)=1.02. The value that solves this relationship is r = 17.4%.)

M9-20. (10 minutes)

a. Interest expense (+E,-SE)…………………… 24Interest payable (+L)……………………. 24

b.- Interest Payable (L) + + Interest Expense (E) -

24 a. a. 24

c.Balance Sheet Income Statement

TransactionCash Asset + Noncash

Assets = Liabil-ities + Contrib.

Capital + Earned capital Revenues - Expenses = Net

IncomeAccrued $24 interest onnote payable =

+24Interest Payable

-24Retained Earnings

-+24

Interest Expense

=-24



M9-21. (15 minutes)

a. Accounts Payable, $110,000 (current liability).

b. Not recorded as a liability; an accountable transaction has not yet occurred.

c. Estimated liability for product warranty, $2,200 (current liability).

d. Bonuses Payable, $30,000 (current liability)—computed as $600,000 5%. This liability must be reported since its payment is “probable” and can be “estimated.”

M9-22. (10 minutes)

a. Boston Scientific is offering bonds with a coupon (stated) rate of 4.25% when the market rate (yield) is higher (4.349%). In order to obtain this expected rate of return, the bonds sell at a discount price of 99.476 (99.476% of par).

b. The first bond matures in 2011 while the second matures in 2017. There is, generally, a higher rate (yield) expected for a longer maturity.

M9-23. (10 minutes)

Amount paid to retire bonds ($200,000 x 101%)............................................ $202,000Book value of retired bonds, net of $2,400 unamortized discount................... 197,600 Loss on bond retirement................................................................................ $ 4,400

M9-24. (10 minutes)

a. The $597 million indicates that BMY has bonds maturing that will require payment in the amount of $597 million in 2013.

b. BMY will need to pay off the bonds when they mature. This will result in a cash outflow that must come from operating activities if the bonds cannot be refinanced prior to maturity. However, most of BMY’s long-term debt matures more than 5 years after the financial statement date (December 31, 2011). Thus, BMY’s near-term cash needs for covering long-term debt should not place a significant burden on the company’s operations.



M9-25 (10 minutes)

a. Gain on Bond Retirement: In the other (nonoperating) revenues and expenses section unless it meets the tests for extraordinary treatment (e.g., unusual and infrequent)

b. Discount on Bonds Payable: Deduction from Bonds Payable; thus, a (contra) long-term liability in the balance sheet (e.g., it is netted in the presentation of long-term liabilities).

c. Mortgage Notes Payable: Long-term liability in the balance sheet.

d. Bonds Payable: Long-term liability in the balance sheet.

e. Bond Interest Expense: In other (nonoperating) revenues and expenses section of income statement.

f. Bond Interest Payable: Current liability in the balance sheet.

g. Premium on Bonds Payable: Addition to Bonds Payable; thus, part of a long-term liability in the balance sheet (e.g., it is included in the presentation of long-term liabilities).

h. Loss on Bond Retirement: In the other (nonoperating) revenues and expenses section unless it meets the tests for extraordinary treatment (e.g., unusual and infrequent)

M9-26. (10 minutes)

a. Restrictive loan covenants are typically designed to protect the bond holders against actions by management that they feel would be detrimental to their interests. These covenants might include restrictions against the impairment of liquidity, restrictions on the amount of financial leverage the company can employ, and restrictions on the payment of dividends. In addition, bond holders usually impose various covenants prohibiting the acquisition of other companies or the divestiture of business segments without their consent. All of these covenants, by design, restrict management in its actions.

b. Management, facing imminent violation of one or more of its bond covenants, may be pressured into taking actions in order to avoid default. These may include, for example, foregoing profitable investments, reduction of discretionary spending such as R&D or advertising in order to improve profitability, missing opportunities to take cash discounts and other methods of “leaning on the trade,” or reduction of receivables (via early payment incentives) and inventories (by marketing promotions or delaying restocking) in order to boost cash balances. Actions may also include questionable accounting measures, such as improper recognition of revenues or delayed recognition of expenses.

continued next page



M9-26. concluded

c. When evaluation solvency, analysts should compare a company’s position relative to its restrictive covenants. A company pay appear solvent, but in fact may be in close proximity to a restrictive covenant. Also, analysts should be aware of the potential effect that restrictive covenants can have management decisions (see the answer to requirement b). Restricted assets, such as cash or securities, should not be considered as general assets in an analysis of the firm’s liquidity or solvency because they are not available to management for general corporate uses.

M9-27. (15 minutes)

a.1/1/2008 Cash (+A) ……………………………………..... 432,000

Bonds payable (+L) ………………..…… 400,000Bond premium (+L) ………………..…… 32,000

1/1/2014 Bonds payable (-L) ………………………..….. 400,000Bond premium (-L) ……………………..…….. 27,809

Cash (-A) ………………………………..... 412,000Gain on retirement of bonds (+R, +SE) 15,809

b.+ Cash (A) - - Bonds Payable (L) +

1/1/08 432,000 400,000 1/1/08412,000 1/1/14 1/1/14 400,000

- Gain on Retirement of Bonds (R) + - Bond Premium (L) +15,809 1/1/14 32,000 1/1/08

1/1/14 27,809



Assets = Liabilities + Contrib. Capital + Earned

Capital Revenues - Expenses = Net Income

1/1/08 Issue bonds at a premium.

432,000Cash

=

+400,000Bonds

Payable

+32,000Bonds

Payable, net

- =

1/1/14 Retired bonds issued on 1/1/08.

-412,000Cash

=

-400,000Bonds

Payable

-27,809Bonds

Payable, net

+15,809Retained Earnings

+15,809Gain on

Retirement of Bonds - =

+15,809



M9-28. (15 minutes)

a. 7/1/2007 Cash (+A) ……………………………………. 240,000

Bond discount (+XL, -L) …………….….…. 10,000Bonds payable (+L) ………………….. 250,000

7/1/2014 Bonds payable (-L) ………………………… 250,000Loss on retirement of bonds (+E, -SE) … 9,314

Bond discount (-XL, +L) ……….…… 6,814Cash (-A) ………………………………. 252,500


7/1/07 240,000 250,000 7/1/07252,500 7/1/14 7/1/14 250,000

+ Loss on Retirement of Bonds (E) - + Bond Discount (XL) -7/1/14 9,314 7/1/07 10,000

6,814 7/1/14





7/1/07 Issue bonds at a discount

+240,000Cash

=

+250,000Bonds

Payable

-10,000Bonds

Payable, net

- =

7/1/14 Retired bonds issued on 7/1/03

-252,500Cash

=

-250,000Bonds

Payable

+6,814Bonds

Payable, net

-9,314Retained Earnings

-

+9,314Loss on

retirementof Bonds =

-9,314

M9-29. (10 minutes)

Nissim: $18,000 0.10 40/365 = $197.26

Klein: $14,000 0.09 18/365 = 62.14

Bildersee: $16,000 0.12 12/365 = 63.12$322.52



M9-30. (10 minutes)

a. The Debt-to-Equity ratio (D/E) will likely change, but the direction and amount is difficult to determine from the information given. The increase in outstanding debt by $450 million (-$742.6+$1200.0-$7.4) along with the net share repurchases of $646.9 million ($1163.5-$516.6) and dividend payments of $739.7 million will increase D/E. (The effect of the share repurchases on reported equity is not provided – the $1163.5 million is the market value of the repurchased shares.)Times interest earned will decrease as additional interest cost on new borrowing is added to the denominator. How much of an effect this will have depends on the size of the change in net income.

b. Generally, the higher (lower) the firm's solvency measures, the higher (lower) the firm's debt rating. In financial leverage terms, the higher (lower) the firm's leverage the lower (higher) the firm's debt rating. Increasing the amount of debt while decreasing equity may harm General Mills’ debt ratings.

M9-31. (15 minutes)

a. Selling price of 9% bonds discounted at 8%

Present value of principal repayment ($500,000 0.45639) ....................$228,195Present value of interest payments ($22,500 13.59033) .................... 305,782Selling price of bonds...................................................................................$533,977

b. Selling price of 9% bonds discounted at 10%

Present value of principal repayment ($500,000 0.37689) ....................$188,445Present value of interest payments ($22,500 12.46221) .................... 280,400Selling price of bonds...................................................................................$468,845

M9-32. (15 minutes)

a. Selling price of zero-coupon bonds discounted at 8%:Present value of principal repayment ($500,000 0.45639) $228,195

b. Selling price of zero coupon bonds discounted at 10%:Present value of principal repayment ($500,000 0.37689) $188,445

c. Based on the debt-to-equity ratio, financial leverage would increase from 2.0 [=($3 - $1)/$1] to 2.19 [=($3 - $1 + $0.188)/$1)



M9-33. (15 minutes)

a.1. Inventory (+A) …………………………………. 300

Accounts payable (+L) ………………… 300

2. Accounts receivable (+A) …………………… 420Sales revenue (+R, +SE) …..………….. 420

3. Cost of goods sold (+E, -SE) ………………. 300Inventory (-A) …………………………… 300

4. Accounts payable (-L) ………………………. 300Cash (-A) ………………………………… 300

5. Cash (+A) ……………………………………… 420Accounts receivable (-A) ……………… 300

b.+ Cash (A) - - Accounts Payable (L) +

300 4. 300 1.5. 420 4. 300

+ Accounts Receivable (A) - - Sales Revenue (R) +2. 420 420 2.

420 5.

+ Inventory (A) - + Cost of Goods Sold (E) -1. 300 3. 300

300 3.




Capital + Earned Capital Revenues - Expenses = Net

Income1. Purchase inventory

on account.+300

Inventory =+300

Accounts Payable

- =

2. Sell inventory on credit.

+420Accts Rec =

+420Retained Earnings

+420Sales - =

+420

3. Cost of sales from 2.

-300Inventory =

-300Retained Earnings

-+300

Cost of Goods Sold

=-300

4. Paid cash for inventory purchased in 1.

-300Cash =

-300Accounts Payable

- =

d. Receive cash on receivable from 2.

420Cash

-420Accts Rec = - =



M9-34.(30 minutes)



M9-35. (15 minutes)

a. Gain on bond retirement Reported in the income statement under other (nonoperating) income

b. Discount on bonds payable Contra-liability netted against bonds payable under long-term liabilities in the balance sheet

c. Mortgage notes payable Long-term liability in the balance sheet; the amount due within one year would be reported as a current liability

d. Bonds payable Long-term liability in the balance sheet; the amount due within one year would be reported as a current liability

e. Bond interest expense Nonoperating expense reported in the income statement

f. Bond interest payable A current liability in the balance sheet

g. Premium on bonds payable Adjunct-liability added to bonds payable under long-term liabilities in the balance sheet

M9-36. (15 minutes)

a. 12/31/13 Cash (+A) …………………………………….. 700,000

Mortgage note payable (+L) ………….. 700,000

6/30/14 Interest expense (+E, -SE) ………………….. 42,000Mortgage note payable (-L) …………………. 8,854

Cash (-A) …………………………………. 50,854

12/31/14 Interest expense (+E, -SE) ………………….. 41,469Mortgage note payable (-L) …………………. 9,385

Cash (-A) …………………………………. 50,854

* $41,469 = ($700,000 – $8,854) x 12%/2.

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M9-36. concluded

b.+ Cash (A) - - Mortgage Note Payable (L) +

12/31/13 700,000 700,000 12/31/1350,854 6/30/14 6/30/14 8,85450,854 12/31/14 12/31/14 9,385

+ Interest Expense (E) -6/30/14 42,000

12/31/14 41,469





Income12/31/13 Borrow

$700,000 on a 15-year mortgage note payable.

+700,000Cash

=

+700,000Mortgage

Note Payable

- =

6/30/14 Interest payment on note.

-50,854Cash

=

-8,854Mortgage

Note Payable


-

+42,000Interest Expense

=

-42,000


-50,854Cash

=

-9,385Mortgage

Note Payable


-


=

-41,469

M9-37. (5 minutes)

$900,000 x 0.55839 + (900,000 x 10%/2) x 7.36009 = $833,755.$833,755 / $900,000 = 92.6% of par value.



EXERCISES

E9-38. (15 minutes)

a.Total expected failures from units sold (69,000 0.02).................... 1,380

Average cost per failure................................................................... $50 Total expected future warranty costs................................................ $69,000

Current warranty liability................................................................... $10,000Additional warranty cost liability required.......................................... $ 59,000

The product warranty liability must be increased by $59,000 to cover the expected repair costs, (because the warranty is for a 60-day period, the $10,000 remaining in the liability account represents unused amounts left from prior years’ accruals). Warranty expense of $59,000 must be recorded in the income statement when the liability account is increased.

b. The warranty liability should be equal, at all times, to the expected dollar cost of repairs. Analysis issues relate to whether the warranty liability exists and, if so, is it at the correct amount. Understating (overstating) the accrual overstates (understates) current period income at the expense (benefit) of future income.

c. The debt-to-equity ratio will increase and the operating cash flow to liabilities will decrease. The times-interest earned ratio will not be affected.

E9-39. (10 minutes)

Item Accounting Treatment

a. Neither record nor disclose (neither probable nor reasonably possible)

b. Record a current liability for the note, no liability for interest until incurred

c. Disclose in a footnote (at least reasonably possible)

d. Record warranty liability on balance sheet and recognize expense in income statement (costs are probable and reasonably estimable).



E9-40. (15 minutes)

The company must accrue the $25,000 of wages that have been earned by employees even though these wages will not be paid until the first of next month. The required accounting accrual will:

increase wages payable by $25,000 on the balance sheet

increase wages expense by $25,000 in the income statement

Failure to make this accounting accrual (called adjusting entry) would understate liabilities, understate expenses, overstate income, and overstate stockholders’ equity.

M9-41. (15 minutes)

a. Selling price of bonds: Present value of principal repayment ($300,000 0.30832).................$ 92,496

Present value of interest payments ($16,500 17.29203).......... 285,318 Selling price of bonds $377,814

b. 1/1/14 Cash (+A) …………………………………….. 377,814

Bond premium (+L) …………………… 77,814Bonds payable (+L) ……………...…… 300,000

6/30/14 Interest expense (+E, -SE) ………………… 15,113Bond premium (-L) ……………...………….. 1,387

Cash (-A) ……………………………….. 16,500

12/31/14 Interest expense (+E, -SE) ………………… 15,057Bond premium (-L) …………………………. 1,443

Cash (-A) ……………………………….. 16,500

* $15,057 = ($377,814 – $1,387) x 8%/2.

c.+ Cash (A) - - Bonds Payable (L) +

1/1/14 377,814 300,000 1/1/1016,500 6/30/1016,500 12/31/10

+ Interest Expense (E) - - Bond Premium (L) +77,814 1/1/10

6/30/14 15,113 6/30/14 1,38712/31/14 15,057 12/31/14 1,443

continued next page



M9-41. concluded

d.Balance Sheet Income Statement





+377,814Cash

=

+300,Payable

+77,814Bonds

Payable, net

- =

6/30/14 Interest payment on bonds.

-16,500Cash =

-1,387Bonds

Payable, net


-+15,113Interest

Expense=

-15,113


-16,500Cash =

-1,443Bonds

Payable, net


-+15,057Interest

Expense=

-15,057

E9-42. (10 minutes)

Selling price of bonds

Present value of principal repayment ($900,000 0.44230)...................$398,070 Present value of interest payments ($49,500 9.29498)........................ 460,102 Selling price of bonds..............................................................................$858,172

E9-43. (15minutes)

a.

Warranty expense (+E, -SE) ……………………. 123.0Warranty liability (+L)…………………… 123.0

b.- Accrued Warranty Liability (L) + + Warranty Expense (E) -

60.5 07 bal.08 cost 125.1 123.0 08 exp. 123.0

55.2 08 bal.

c. 2008: $123.0 / $6,086.1 = 2.0% 2007: $118.8 / $6563.2 = 1.8%.

Warranty expense appears to have increased in 2008 as a percentage of sales revenue.



E9-44. (15 minutes)

a.5/1/13 Cash (+A) ………………………………………... 500,000

Bonds payable (+L) ……………………… 500,000

10/31/13 Interest expense (+E, -SE) …………………… 22,5001

Cash (-A) ………………………………….. 22,500

11/1/14 Bonds payable (-L) ……………………………. 300,000Loss on retirement of bonds (+E, -SE) ……. 3,000

Cash (-A) ………………………………….. 303,0002

1 $500,000 x 0.09 x 1/2 = $22,500 interest expense. Because the bonds were sold at par, there is no discount or premium amortization.

2 Cash required to retire $300,000 of bonds at 101 = $300,000 x 1.01 = $303,000. The difference between the cash paid and the carrying amount of the bonds is the gain or loss on the redemption. In this case, the loss is $3,000. This calculation assumes that the interest was paid on 10/31/14, so accrued interest is not recorded.


5/1/13 500,000 500,000 5/1/1322,500 10/31/10

303,000 11/1/11 11/1/14 300,000

+ Interest Expense (E) - + Loss on Retirement of Bonds (E) -10/31/13 22,500 11/1/14 3,000





Income5/1/10 Issue bonds. +500,000

Cash =+500,000

Bonds Payable

- =

10/31/10Interest payment on bonds.

-22,500Cash =


-+22,500Interest Expense

=-22,500

11/1/11 Early retirement of bonds.

-303,000Cash

=

-300,000Bonds

Payable


-

+3,000Loss on

Retirement of Bonds

=

-3,000



E9-45. (25 minutes)

a. Selling price of bonds

Present value of principal repayment ($250,000 0.41552)..............$103,880 Present value of interest payments ($10,000 11.68959)............... 116,896 Selling price of bonds........................................................................$220,776

b.1/1/13 Cash (+A) ………………………………………. 220,776

Bond discount (+XL, -L) ……………………… 29,224Bonds payable (+L) …………………….. 250,000

6/30/13 Interest expense (+E, -SE) …………………… 11,039Bond Discount (-XL, +L) ………….……. 1,039Cash (-A) ………………………………….. 10,000

$11,039 = $220,776 .05.

12/31/13 Interest expense (+E, -SE) …………………. 11,091Bond Discount (-XL, +L) …………….…. 1,091Cash (-A) ………………………………….. 10,000

$11,091 = [$220,776 + $1,039] .05.


1/1/13 220,776 250,000 1/1/1310,000 6/30/1310,000 12/31/13

+ Interest Expense (E) - + Bond Discount (XL) -1/1/13 29,224

6/30/13 11,039 1,039 6/30/1312/31/13 11,091 1,091 12/31/13





1/1/10 Issue bonds at a discount.

+220,776Cash

=

+250,000Bonds

Payable

-29,224Bonds

Payable, net

- =


-10,000Cash =

+1,039Bonds

Payable, net



=-11,039


-10,000Cash =

+1,091Bonds

Payable, net



=-11,091



E9-46. (25 minutes)

a. Selling price of bonds:

Present value of principal repayment ($800,000 0.20829)..............$166,632 Present value of interest payments ($36,000 19.79277)................. 712,540 Selling price of bonds........................................................................$879,172

b.1/1/14 Cash (+A) ………………………………………... 879,172

Bond premium (+L) ……………………… 79,172Bonds payable (+L) ……………………… 800,000

6/30/14 Interest expense (+E,-SE) ……………………. 35,167Bond premium (-L) …………….……………… 833

Cash (-A) ………………………………….. 36,000$35,167 = $879,172 x .04.

12/31/14 Interest expense (+E,-SE) ……………………. 35,134Bond premium (-L) …………….……………… 866

Cash (-A) ………………………………….. 36,000$35,134 = ($879,171 - $833) x .04.


1/1/14 879,172 800,000 1/1/1436,000 6/30/1436,000 12/31/14

+ Interest Expense (E) - - Bond Premium (L) +79,172 1/1/14

6/30/14 35,167 6/30/14 83312/31/14 35,134 12/31/14 866






+879,172Cash

=

+800,000Bonds

Payable

+79,172Bonds

Payable, net

- =


-36,000Cash =

-833Bonds

Payable, net



=-35,167


-36,000Cash =

-866Bonds

Payable, net



=-35,134



E9-47. (20 minutes)

a. There is an inverse relation between interest rates and bond prices (examine the increasing discount rates as the yield increases in present value tables). Since the bonds now trade at a premium and assuming that Deere’s credit ratings have not changed, we can conclude that interest rates have fallen since the bonds were issued.

b. No, once the bond is initially recorded, neither the coupon rate nor the yield used to compute interest expense is changed. Bonds are recorded at historical cost (like most other balance sheet assets and liabilities). As a result, changes in the general level of interest rates have no effect on interest expense (or the interest payment) that is reflected in the financial statements.

c. Because the bonds trade at a premium in the market, Deere would be paying more to retire the bonds than the amount at which they are carried on its balance sheet. This would result in a loss on the repurchase that would lower current profitability.

d. The face amount of the bonds will be paid at maturity. As a result, the market price of the bonds must also equal their face amount ($200 million) at that time.

E9-48. (25 minutes)

a. Selling price of bonds

Present value of principal repayment ($600,000 0.09722)..............$ 58,332 Present value of interest payments ($33,000 15.04630)................. 496,528 Selling price of bonds........................................................................$554,860

b.1/1/13 Cash (+A) ………………………………………….. 554,860

Bond discount (+XL, -L) ………………..……… 45,140Bonds payable (+L) ……………………….. 600,000

6/30/13 Interest expense (+E, -SE) ……………………… 33,292Bond discount (-XL, +L) ……………….…. 292Cash (-A) ……………………………………. 33,000

$33,292 = $554,860 .06.

12/31/13 Interest expense (+E, -SE) ……………………… 33,309Bond discount (-XL, +L) …………….……. 309Cash (-A) ………….…………………………. 33,000

$33,309 = ($554,860 + $292) .06.

continued next page



E9-48. concluded


1/1/13 554,860 600,000 1/1/1333,000 6/30/1333,000 12/31/13


6/30/13 33,292 292 6/30/1312/31/13 33,309 309 12/31/13

d. At December 31, 2013 (after the coupon payment recorded in b) the book value of the bonds would be $554,860 + $292 + $309 = $555,461. The market value would be $600,000 X 1.01 = $606,000. Thus, a fair value adjustment of $50,539 (=$606,000-$555,461) would be recorded as follows:

12/31/13 Loss due to adjustment of bonds to fair value (+E, -SE) 50,539Fair value adjustment (+L) ……………….…. 50,539

e.Coupon payments ($33,000 X 2) …………… $66,000Discount amortization ($292 + $309) ……… 601Total interest expense ……………………….. 66,601Fair value adjustment ………………………... 50,539Total effect on income (deduction) ……….. $117,140

E9-49. (10 minutes)

Current liabilities:Bond interest payable $ 25,000Current maturities of long-term debt:10% bonds payable due 2014, including $15,000 premium 515,000Total current liabilities $540,000

Long-term debt:9% bonds payable due 2015, net of $19,000 discount $581,000Zero coupon bonds payable due 2016 170,5008% bonds payable due 2018 100,000Total long-term debt $851,500



E9-50. (20 minutes)

a.12/31/13 Cash (+A) …………………………………………… 500,000

Mortgage note payable (+L) ………………. 500,000

3/31/14 Interest expense (+E, -SE) ………………………. 10,000Mortgage note payable (-L) ……………………... 8,278

Cash (-A) ……………………………………… 18,278

6/30/14 Interest expense (+E, -SE) ………………………. 9,834Mortgage note payable (-L) ……………………... 8,444

Cash (-A) ……………………………………… 18,278

$9,834 = ($500,000 – $8,278) x 8%/4.

b.+ Cash (A) - - Mortgage Note Payable (L) +

12/31/13 500,000 500,000 12/31/1318,278 3/31/14 3/31/14 8,27818,278 6/30/14 6/30/14 8,444

+ Interest Expense (E) -3/31/14 10,0006/30/14 9,834







+500,000Cash

=

+500,000Mortgage

Note Payable

- =


-18,278Cash

=

-8,278Mortgage

Note Payable


-


=

-10,000


-18,278Cash

=

-8,444Mortgage

Note Payable


-


=

-9,834



PROBLEMS

P9-51. (20 minutes)

a.Hewlett-Packard Dell Inc.

- Accrued Warranty Liability (L) + - Accrued Warranty Liability (L) +2,447 10 bal. 895 10 bal.2,657 11 exp. 1,025 11 exp.

2,653 1,0322,451 11 bal. 888 11 bal.

Hewlwtt-Packard incurred $2,653 million in warranty repair costs and settlements in 2011 while Dell, Inc. incurred costs of $1,032 million.

b. HP’s ratio of warranty expense to sales was 3.1% in 2011 ($2,657/$84,757) down slightly from 3.2% in 2010 ($2,689/$84,799). Dell’s ratio was 2.1% both years ($1,005/$49,906 in 2011 and $1,042/$50,002 in 2010). Dell’s warranty expense is lower relative to sales revenue than that of HP. Possible reasons for this include the following: (1) perhaps Dell products are higher- quality and require fewer repairs than HP products or (2) HP may have a more generous warranty policy than Dell, resulting in more warranty repairs, even if the quality is the same. The decrease in HP’s warranty expense as a percent of sales indicates that either (1) warranty costs have gone down, (2) the company overestimated warranty costs in the past and needed to record smaller than normal accruals in 2011 to correct the overestimation; or (3) HP was building up a “cookie-jar reserve” by increasing its warranty liability in past years.



P9-52. (20 minutes)

a. Cash (+A) ………………………………………….. 518,750Accrued interest payable (+L) …………… 18,750Bonds payable (+L) ……………………….. 500,000

$18,750 = $500,000 x .09 x 5/12

b. Interest expense (+E, -SE)………………………. 3,750Accrued interest payable (-L) ………………….. 18,750

Cash (-A) …………………………………….. 22,500$22,500 = $500,000 x 9%/2

c. Interest expense (+E, -SE) ……………………… 7,500Accrued interest payable (+L) …………… 7,500

$7,500 = $500,000 x 9% x 2/12

d. Fair value adjustment (+XL, -L) ……………….. 5,000Gain from adjustment of bonds to fair value (+R, +SE) ……………………………..

5,000

e. Interest expense (+E, -SE) ……………………… 15,000Accrued interest payable (-L) ………………….. 7,500

Cash (-A) …………………………………….. 22,500

f. Bonds payable (-L) ………………………………. 300,000Loss on retirement of bonds (+E, -SE) ………. 18,000

Cash (-A) …………………………………….. 303,000Fair value adjustment (-XL, +L) … 15,000

continued next page



P9-52. concluded

+ Cash (A) - - Bonds payable (L) +a. 518,750 500,000 a.

22,500 b.22,500 e.

303,000 f. f. 300,000

+ Interest expense (E) - - Accrued Interest Payable (L) +18,750 a.

b. 3,750 b. 18,750c. 7,500 7,500 c.e. 15,000 e. 7,500

+ Loss on Retirement of Bonds (E) -- Fair Value Adjustment (L) + f. 18,000

d. 5,00015,000 f.

- Gain from Fair Value Adjustment +5,000 d.

Balance Sheet Income Statement



capital Revenues - Expenses = Net Income

a. (10/1/13) Issue bonds.

+518,750Cash

=

+500,000Bonds

Payable

+18,750Interest Payable

- =

b. (11/1/13) Interest payment on bonds.

-22,500Cash =

-18,750Interest Payable



=-3,750

c. (12/31/13) Accrued interest on bonds.

=+7,500Interest Payable



=-7,500

d. (12/31/13) Fair value adjustment

-5,000Fair value adjustment

+5,000Retained Earnings

+5,000Gain on FV adjustment

+5,000

e. (5/1/14) Interest payment on bonds.

-22,500Cash =




=-15,000

f. 5/1/18 Early retirement of bonds.

-303,000Cash

=

-300,000Bonds

Payable+15,000

Fair value adjustment


-

+18,000Loss on

Retirement of Bonds

=

-18,000



P9-53. (15 minutes)

a. CVS reports interest expense of $588 million on average debt of $10,035.5 million ([$10,014 million + $10,057 million]/2) for an average rate of 5.9%. Using interest paid ($647 million) instead of interest expense yields 6.5%. See the answer to c below.

b. CVS reports coupon rates of 3.25% to 6.6%. In addition, no rates are reported for capital leases, mortgage notes, commercial paper, or the floating rate notes. So, the average rate seems reasonable given the information disclosed in the long-term debt footnote.

c. Interest paid can differ from interest expense if bonds are sold at a premium or a discount. It can also differ because of capitalized interest. CVS reported capitalized interest of $37 million in 2011. Thus, CVS apparently amortized $22 million in net bond discounts ($647m -$588m -$37m).

P9-54. (25 minutes)

a. 6/1/13 Cash (+A) ……………………………………. 824,000Accrued interest payable (+L) ……. 24,000Bonds payable (+L) ………………… 800,000

$24,000 = $800,000 x .09 x 4/12

b. 9/1/13 Interest expense (+E, -SE) ……………..… 12,000Accrued interest payable (-L) ……………. 24,000

Cash (-A) ……………………………… 36,000$36,000 = $800,000 x 9%/2

c. 12/31/13 Interest expense (+E, -SE) ………………… 24,000Accrued interest payable (+L) ……. 24,000

d. 3/1/14 Interest expense (+E) ……………………… 12,000Accrued interest payable (-L) ……………. 24,000

Cash (-A) ……………………………… 36,000

e. 3/1/14 Bonds payable (-L) ………………………… 200,000Loss on retirement of bonds (+E, -SE) … 2,000

Cash (-A) …………………………….. 202,000

continued next page



P9-54. concluded

+ Cash (A) - - Bonds Payable (L) +a. 824,000 36,000 b. 800,000 a.

36,000 d.202,000 e. e. 200,000

+ Interest Expense (E) - - Accrued Interest Payable (L) +b. 12,000 b. 24,000 24,000 a.c. 24,000 d. 24,000 24,000 c.d. 12,000

+ Loss on Retirement of Bonds (E) -e. 2,000

Balance Sheet Income Statement




Incomea. (7/1/13) Issue

bonds.+824,000

Cash

=

+800,000Bonds

Payable


- =

b. (9/1/13) Interest payment on bonds.

-36,000Cash =




=-12,000

c. (12/31/13) Accrued interest on bonds.

=



-


=

-24,000

d. (3/1/14) Interest payment on bonds.

-36,000Cash =




=-12,000

e. 3/1/14 Early retirement of bonds.

-202,000Cash

=

-200,000Bonds

Payable


-

+2,000Loss on

Retirement of bonds

=

-2,000



P9-55. (20 minutes)

a.

PeriodInterest Expense

Cash Interest

Paid

Discount Amortizatio

nDiscount Balance

Bond Payable Net

0 $41,292 $678,7081 $40,722 $39,600 $1,122 $40,170 $679,8302 $40,790 $39,600 $1,190 $38,980 $681,020

$40,722 = $678,708 x 12%/2.$40,790 = $679,830 x 12%/2.

b.12/31/13 Cash (+A) ………………………………….. 678,708

Bond discount (+XL) ……………………. 41,292Bonds payable (+L) ……………….. 720,000

6/30/14 Interest expense (+E,-SE) ………………. 40,722Bond discount (-XL) ……………….. 1,122Cash (-A) …………………………….. 39,600

12/31/14 Interest expense (+E,-SE) ………………. 40,790Bond discount (-XL) ……………….. 1,190Cash (-A) …………………………….. 39,600


12/31/13 678,708 720,000 12/31/1339,600 6/30/1439,600 12/31/14


6/30/14 40,722 1,122 6/30/1412/31/14 40,790 1,190 12/31/14



Assets = Liabilities + Contrib. Capital + Retained

Earnings Revenues - Expenses = Net Income


+678,708Cash

=

+720,000Bonds

Payable

-41,292Bonds

Payable, net

- =


-39,600Cash =

+1,122Bonds

Payable, net


-+40,722Interest

Expense=

-40,722


-39,600Cash =

+1,190Bonds

Payable, net


-+40,790Interest

Expense=

-40,790



P9-56. (20 minutes)

a.

PeriodInterest Expense

Cash Interest Paid

Discount Amortization

Discount Balance

Bond Payable Net

0 $43,230 $206,7701 $8,271 $7,500 $771 $42,459 $207,5412 $8,302 $7,500 $802 $41,657 $208,343

$8,271= $206,770 x 8%/2.$8,302 = $207,541 x 8%/2.

b.4/30/13 Cash (+A) …………………….……….………..…… 206,770

Bond discount (+XL, -L) …………………………. 43,230Bonds payable (+L) …….…………………… 250,000

10/31/13 Interest expense (+E, -SE) ………………..….….. 8,271Bond discount (-XL, +L) ……………………. 771Cash(-A) ……………………………………….. 7,500

12/31/13 Interest expense (+E, -SE) ………………..….….. 2,767Bond discount (-XL, +L) ……………………. 267Accrued interest payable (+L) …………….. 2,500

4/30/14 Interest expense (+E, -SE) …………………...….. 5,535Accrued interest payable (-L) ………..….………. 2,500

Bond discount (-XL, +L) ……………………. 535Cash(-A) ……………………………………….. 7,500


4/30/13 206,770 250,000 4/30/137,500 10/31/137,500 4/30/14


10/31/13 8,271 771 10/31/1312/31/13 2,767 267 12/31/13

4/30/14 5,535 535 4/30/14

- Accrued Interest Payable (L) +2,500 12/31/13

4/30/14 2,500

continued next page



P9-56. concluded






+206,770Cash

=

+250,000Bonds

Payable

-43,230Bonds

Payable, net

- =


-7,500Cash =

+771Bonds

Payable, net



=-8,271

12/31/13 Accrued interest on bonds.

=

+267Bonds

Payable, net+2,500

AccruedInterestPayable


-


=

-2,767


-7,500Cash

=

+535Bonds

Payable, net-2,500

AccruedInterestPayable


-


=

-5,535

P9-57. (20 minutes)

a. Payment x 12.46221 = $500,000; Payment = $500,000/12.46221 = $40,121.

b. 12/31/13 Cash (+A) ………………………………………..…… 500,000

Mortgage note payable (+L) ………………… 500,000

6/30/14 Interest expense (+E, -SE) ………………………… 25,000Mortgage note payable (-L) ………………………. 15,121

Cash (-A) …………………………………..…… 40,121

* $25,000 = $500,000 x 10%/2

12/31/14 Interest expense (+E, -SE) ……………………….… 24,244Mortgage note payable (-L) ……………………….. 15,877

Cash (-A) …………………………………..…… 40,121

$24,244 = ($500,000 – $15,121) x 10%/2.

continued next page



P9-57. concluded

c.+ Cash (A) - - Mortgage Note Payable (L) +

12/31/13 500,000 500,000 12/31/1340,121 6/30/11 6/30/14 15,12140,121 12/31/11 12/31/14 15,877

+ Interest Expense (E) -

6/30/14 25,00012/31/14 24,244







+500,000Cash

=

+500,000Mortgage

Note Payable

- =


-40,121Cash

=

-15,121Mortgage

Note Payable


-


=

-25,000


-40,121Cash

=

-15,877Mortgage

Note Payable


-


=

-24,244

P9-58. (20 minutes)

a. Payment x 16.35143 = $950,000; Payment = $950,000/16.35143 = $58,099.

b.12/31/10 Cash (+A) ………………………………………..…… 950,000

Mortgage note payable (+L) ………………… 950,000

3/31/11 Interest expense (+E, -SE) ………………………… 19,000*Mortgage note payable (-L) ………………………. 39,099

Cash (-A) …………………………………..…… 58,099

* $19,000 = $950,000 x 8%/4

6/30/11 Interest expense (+E, -SE) ………………………… 18,218*Mortgage note payable (-L) ………………………. 39,881

Cash (-A) …………………………………..…… 58,099

* $18,218 = ($950,000 – $39,099) x 8%/4.

continued next page



P9-58. concluded

c.+ Cash (A) - - Mortgage Note Payable (L) +

12/31/13 950,000 950,000 12/31/1358,099 3/31/14 3/31/14 39,09958,099 6/30/14 6/30/14 39,881

+ Interest Expense (E) -

3/31/14 19,0006/30/14 18,218







+950,000Cash

=

+950,000Mortgage

Note Payable

- =

3/31/14 Payment on note.

-58,099Cash

=

-39,099Mortgage

Note Payable


-

+19,000Interest

Expense=

-19,000

6/30/14 Payment on note.

-58,099Cash

=

-39,881Mortgage

Note Payable


-

+18,218Interest

Expense=

-18,218

P9-59. (10 minutes)

a. BP recorded the $9.2 billion estimate as an expense on its 2010 income statements. This increased the company’s liabilities.

b. If BP had prepared its financial statements in accordance with U.S. GAAP, the accrual would most likely have been at the low end of the range -- $6 million, instead of the expected amount (best reliable estimate), or mid-point in the range.



CASES and PROJECTS

C9-60. (30 minutes) a. The difference between interest expense and interest paid can be caused by three

factors: (1) interest capitalized as part of self constructed assets is paid but not part of interest expense; (2) coupon payments differ from interest expense charged on bonds due to amortization of discounts or premiums; (3) interest payments may not coincide with the fiscal period, thus requiring the company to record accrued interest payable.

b. In 2011, Comcast’s debt had a fair value of $45.1 billion while its historical cost was $39.3 billion. Thus, Comcast would report a fair value adjustment as a credit in its balance sheet of $5.8 billion ($45.1 - $39.3). In 2010, the fair value was $34.3 billion and the historical cost was $31.4 billion yielding a credit balance in the fair value adjustment account of $2.9 billion ($34.3 - $31.4). The change in the fair value adjustment from 2010 to 2011 ($2.9 = $5.8 – $2.9) would be recorded as follows:

12/31/11 Loss due to adjustment of bonds to fair value (+E, -SE) 2.9Fair value adjustment (+L) ……………….…. 2.9

c. It is likely that Comcast could get a lower interest rate by replacing its 7% debt with a new debt issue. While this would translate into lower future interest costs, it would have an adverse impact on the 2012 income statement. If interest rates have fallen, the market value of Comcast’s 7% notes would have increased. Thus, Comcast would have to either pay a high price to repurchase the notes or pay a call premium, if the loan agreement allows them to call the notes. Either way, Comcast would record a loss on early retirement of the notes.

d. Debt-to-equity: $110,163 million/$47,655 million = 2.31

Times interest earned: ($8,207 million + $2,505 million)/$2,505 million = 4.28

Creditors are naturally concerned about the risk of default. The debt-to-equity ratio measures the extent to which a company is relying on debt financing and the higher the ratio, the greater chance of default. In addition, the times interest earned ratio measures the company’s ability to pay the interest on the debt.

e. Management may bypass profitable investment projects or cut discretionary expenditures such as R&D or advertising. It may also engage in questionable accounting practices in an attempt to manage the ratios.



C9-61. (20 minutes)

a. The gain results from the difference between the book value of the debt ($3,000,000) and the current redemption (market) value ($1,900,000). The gain would be reported in the income statement under other (nonoperating) income. The source of the gain should be adequately disclosed in the notes.

b. Currently, Foster is paying 8% interest on the $3,000,000 of long-term debt, or $240,000 per year. Under the proposed refinancing, Foster would pay 16%, or $480,000. The refinancing would generate an additional $1,100,000 in cash. However, because interest costs are increasing by $240,000 per year ($480,000 - $240,000), Foster is effectively borrowing the additional $1,100,000 at a rate of almost 22% ($240,000 / $1,100,000). As such, Foster would be paying in the future (in the form of higher interest costs) for a one-time boost in current earnings.

c. The potential ethical conflict exists because Foster’s president is concerned that his job might be dependent on producing short-term earnings. Because of this, he might be tempted to accept this proposal and boost current earnings at the cost of lower earnings in future years. This thinking is misguided because, given adequate disclosure, analysts and investors would be able to identify and discount the source of the earnings boost. The most serious unethical act would be to try to hide (or obfuscate) the bond refinancing with inadequate disclosure.



Fa4e Sm Ch09

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Transcript of Fa4e Sm Ch09