12

Debt Financing

Overview

There are three primary ways in which a business can obtain assets. The most important means, in the long run, is through operations. Selling goods or services for more than it costs to make, procure, and/or administer the selling of them is essential for a company’s long-term stability. However, in the short term, especially when a business is new or is planning to expand, other means of financing become necessary. The two other primary ways in which a business can obtain assets is through debt and through equity financing. This chapter focuses on the first of those two, right-hand-side-of-the-balance-sheet financing methods. There are a wide variety of debt financing options available to businesses. The number of options seems to be increasing every day. These liabilities are generally listed on the balance sheet in the order in which they will come due. Items that will usually be paid back in the next month, such as Accounts Payable, are shown first. The last liabilities listed may be items that are not to be paid for ten years or more, such as Bonds Payable. Some “debt” doesn’t even show up on the balance sheet. Off-balance-sheet financing has become a hot topic in recent years—largely in part to abuses and scandals that have taken place with companies like Enron that used such tactics to make their financial position look better than it was. New accounting standards are now requiring additional disclosures when this kind of financing happens and fewer opportunities for off-balance-sheet financing to take place. The issue isn’t going to go away, however, so it is important to understand how off-balance-sheet financing happens, how to discover its existence in the disclosure notes, and how to interpret what it would mean should that “debt” actually show up on the face of the balance sheet. Financial ratios dealing with debt financing need to be examined with care. For instance, a business with no off-balance-sheet financing probably shouldn’t be compared straight across with a company which has billions of dollars of operating leases (not shown on the balance sheet) for which the leased assets will be used for, say, 74 percent of their useful lives by the business leasing the asset.

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Learning Objectives

Refer to the Review of Learning Objectives at the end of the chapter. It is crucial that this section of the chapter is second nature to you before you attempt the homework, a quiz, or exam. This important piece of the chapter serves as your CliffsNotes or “cheat sheet” to the basic concepts and principles that must be mastered. If after reading this section of this chapter you still don’t feel comfortable with all of the Learning Objectives covered, you will need to spend additional time and effort reviewing these concepts that you are struggling with. The following “Tips, Hints, and Things to Remember” are organized according to the Learning Objectives (LOs) in the chapter and should be gone over after reading each of the LOs in the textbook.

Tips, Hints, and Things to Remember

LO1 – Understand the various classification and measurement issues associated with debt. Why? The classification of long-term vs. short-term (current) is very important to many companies—especially those looking for additional debt financing. Companies want to show more long-term than short-term debt. Doing so may help them obtain financing they wouldn’t otherwise be able to obtain and/or achieve the financing at a lower cost (better interest rate). Why is this? A company with fewer obligations coming due in the near future is more likely to be able to pay the interest on new debt. In other words, the risk the creditor is taking on goes down. This lower risk translates into a higher degree of willingness to lend, and possibly at a lower interest rate as well. Many loans have provisions added to them that encourage a business to maintain a relatively low amount of current liabilities. Again, this is to lower the risk the creditor is taking on. For instance, a creditor may be able to demand repayment of a loan before the normal due date if a current ratio drops below a certain threshold.

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LO2 – Account for short-term debt obligations, including those expected to be refinanced, and describe the purpose of lines of credit. How? As mentioned in the previous Why?, businesses frequently do not want to show excessive short-term debt obligations. When large debt obligations are coming due in the next year, a company usually has to show it as current. This can dramatically increase the normal current liabilities for a company and significantly reduce the current ratio as well. The potential way around this dilemma is to refinance the debt so that it isn’t paid off in the current period, refinance the debt so that it is paid off with new long-term debt, or have the due date of the maturing debt extended. Management must intend to refinance the current debt and demonstrate that they have the ability to do so in order to classify the currently maturing debt as non-current. If they are only going to refinance a piece of the maturing debt, then the remaining portion of the debt should still be classified as current. Why? Students frequently list a line of credit as a liability. Think about these two things before falling into that trap:

1. What account would you debit when a line of credit is established to go along with your credit to a liability account? No cash is received by merely setting up a line of credit, so you can’t debit Cash.

2. Would you also list a bank account as an asset if a business merely set up an account with a bank but didn’t put any cash into it? It’s the same thing with a line of credit. There is no liability for a line of credit until the line of credit is used and cash is obtained (with an obligation to pay it back with interest) from the lending institution.

LO3 – Apply present value concepts to the accounting for long-term debts such as mortgages. How? Most long-term debt payments include both a principal and an interest component. The interest portion becomes smaller over time as it is based on the principal which is continually being reduced by payments. To compute the interest piece of a payment, multiply the interest rate by the existing principal amount. The remaining amount paid reduces principal. The reported liability is not the total payments that will be made. Rather, it is the amount that if paid today would completely satisfy the debt. In other words, the principal only is recorded as the debt—not the principal plus the interest.

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LO4 – Understand the various types of bonds, compute the price of a bond issue, and account for the issuance, interest, and redemption of bonds. How? Bond computations are frequently difficult for students because remembering which interest rate to use and when isn’t necessarily intuitive. It may help to think about what is actually happening rather than try to memorize something that you may forget or get reversed in your head later. Bonds pay a stated rate of interest regardless of what the current market rate is. Therefore, it is the stated rate that is used to compute what the actual payments will be. However, investors are going to purchase the bonds based on the current market rate—not the stated rate. Therefore, the discounting is based on the market rate. If the bonds are paying more than the market rate, the bonds will be attractive to investors and discounting them at the lower market rate will result in bonds going at a premium. Conversely, if the bonds are paying less than the market rate, the bonds won’t be attractive to investors and discounting them at the higher market rate will result in the bonds selling at a discount. This is the case whether the bonds are being sold brand new or on the secondary markets. Do a reasonableness check before performing your calculations. For instance, if a question says that the stated rate for a $100 face value bond is 8 percent and the market rate is only 6 percent, then before ever running the numbers you should notice that these bonds will be attractive to investors. Your answer should be a number greater than $100 for the price an investor is willing to pay for them. If your calculated answer is $100 or less or something well above $100, then you know that you did something wrong in your calculation.

LO5 – Discuss the use of the fair value option for financial assets and liabilities. Why? For a long time, historical cost has been the basis for financial accounting. Now (under SFAS No. 159) companies have the option of reporting some financial assets and liabilities of a certain type using the fair value option and reporting other financial assets and liabilites of the same type using historical cost.

LO6 – Explain various types of off-balance-sheet financing, and understand the reasons for this type of financing. Why? Businesses want a healthy-looking balance sheet. To that end, reducing the debt showing up on a balance sheet can sometimes be achieved through the means mentioned in this learning objective. The most common method is the first one given—using operating leases instead of capitalized leases in the utilization of assets. Chapter 15 will go over the difference and how lease characterization is accomplished.

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LO7 – Analyze a firm’s debt position using ratios. Why? You are an investor and have the chance to invest in two different businesses for the same price. Both businesses make the same amount of money every year and the prospects for the future don’t look any different. Business A has a debt-to-equity ratio of 2.0 and Business B has a debt-to-equity ratio of 1.3. Which company do you invest in and why? That is a trick question. You don’t have enough information to know. What if I told you that your investment was a debt investment? Would it make a difference if your investment was the purchase of stock instead? Debt investors prefer a low debt-to-equity ratio so they should opt for the investment in Business B. Why? A low debt-to-equity ratio means they have less risk. They are more assured of receiving their investment and the interest they earn off of it back. Equity investors, on the other hand, prefer a relatively higher debt-to-equity ratio assuming the businesses are both profitable. The lower the amount of equity in a company that you own equity in means the more earnings your investment is effectively earning. Fewer shares means a higher return on equity and higher earnings per share. If you are buying stock you should opt for the investment in Business A, and hope that Business A continues to be profitable while financing their future operations with debt instead of equity. Financing through equity means that your existing shares become diluted (unless you are buying the new shares). This is the concept of financial leverage.

LO8 – Review the notes to financial statements, and understand the disclosure associated with debt financing.

LO9 – Understand the conditions under which troubled debt restructuring occurs, and be able to account for troubled debt restructuring. The following sections, featuring various multiple choice questions, matching exercises, and problems, along with solutions and approaches to arriving at the solutions, is intended to develop your problem-solving and critical-thinking abilities. While learning through trial and error can be effective for improving your quiz and exam scores, and it can be a more interesting way to study than merely re-reading a chapter, that is only a secondary objective in presenting this information in this format.

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The main goal of the following sections is to get you thinking, “How can I best approach this problem to arrive at the correct solution—even if I don’t know enough at this point to easily arrive at the proper results?” There is not one simple approach that can be applied to all questions to arrive at the right answer. Think of the following approaches as possibilities, as tools that you can place in your problem-solving toolkit—a toolkit that should be consistently added to. Some of the tools have yet to even be created or thought of. Through practice, creative thinking, and an ever-expanding knowledge base, you will be the creator of the additional tools.

Multiple Choice

MC12-1 (LO1) For a liability to exist, a. a past transaction or event must have occurred. b. the exact amount must be known. c. the identity of the party owed must be known. d. an obligation to pay cash in the future must exist. MC12-2 (LO2) Guanajuato Co. has a $50,000, three-year note payable to the Bank of Mexico that matures on May 31, 2011. Guanajuato's management intends to refinance the note for an additional three years and is negotiating a financing agreement with the Bank of Mexico. In order to exclude this note from current liabilities on its December 31, 2010, balance sheet, Guanajuato Co. must a. pay off the note and complete the refinancing before the 2010 financial

statements are issued. b. demonstrate an ability to refinance the obligation before the 2010 financial

statements are issued. c. complete the refinancing before the balance sheet date. d. complete the refinancing before the note's maturity date. MC12-3 (LO3) On July 1, 2010, Quartz Co. issued a five-year note payable with a face amount of $500,000 and an interest rate of 10 percent. The terms of the note require Quartz to make five annual payments of $100,000 plus accrued interest, with the first payment due on June 30, 2011. With respect to this item, the Current Liabilities section of Quartz's December 31, 2010, balance sheet should include a. $25,000. b. $100,000. c. $125,000. d. $150,000.

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MC12-4 (LO4) The effective interest rate on bonds is lower than the stated rate when bonds sell a. at face value. b. above face value. c. below face value. d. at maturity value. MC12-5 (LO4) When interest expense is calculated using the effective-interest amortization method, interest expense (assuming that interest is paid annually and the bonds did not sell at par) always equals the a. actual amount of interest paid. b. book value of the bonds multiplied by the stated interest rate. c. book value of the bonds multiplied by the effective interest rate. d. maturity value of the bonds multiplied by the stated interest rate. MC12-6 (LO6) Which of the following is NOT considered a form of off-balance-sheet financing? a. VIEs b. unconsolidated subsidiaries c. capital leases d. operating leases MC12-7 (LO7) Selected financial data of Armando Corporation for the year ended December 31, 2011, is presented below: Operating income $ 900,000 Interest expense (100,000) Income before income tax $ 800,000 Income tax expense (320,000) Net income $ 480,000 Preferred stock dividends (200,000) Net income available to common stockholders $ 280,000 Common stock dividends were $120,000. The times-interest-earned ratio is a. 2.8 to 1. b. 4.8 to 1. c. 6.0 to 1. d. 9.0 to 1. MC12-8 (LO8) Which of the following items is NOT a required disclosure associated with debt financing? a. the parties holding the debt b. maturity dates c. assets pledged d. interest rates

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MC12-9 (LO9) In which of the following situations will no gain or loss be recognized by the issuer in a troubled debt restructuring? a. total payment under new structure is less than debt carrying value b. total payment under new structure exceeds debt carrying value c. grant of equity interest in full settlement d. transfer of assets in full settlement

Matching

Matching 12-1 (LO1, LO2) Listed below are the terms and associated definitions from the chapter for LO1 and LO2. Match the correct definition letter with each term number. ___ 1. liabilities ___ 2. accounts

payable ___ 3. promissory

note ___ 4. note payable ___ 5. trade notes

payable ___ 6. nontrade

notes payable ___ 7. line of credit

a. a formal written pledge to pay a certain amount of money at a specified future date

b. issued to creditors for the purchase of goods or services c. a formal written promise to pay a sum of money in the

future—generally evidenced by a promissory note d. probable future sacrifices of economic benefits arising

from present obligations of a particular entity to transfer assets, provide services, or deliver equity shares to other entities in the future as a result of past transactions or events

e. amounts due for the purchase of materials by a manufacturing company or for the purchase of merchandise by a wholesaler or retailer

f. a negotiated arrangement with a lender in which the terms are agreed to prior to the need for actual borrowing

g. issued to creditors for purposes other than to purchase goods or services

Matching 12-2 (LO3) Listed below are the terms and associated definitions from the chapter for LO3. Match the correct definition letter with each term number. ___ 1. mortgage ___ 2. loan

(mortgage) amortization

___ 3. secured loan ___ 4. long-term debt ___ 5. municipal debt

a. the process by which payments on a loan are allocated between principal and interest components

b. debt securities issued by state, county, and local governments and their agencies

c. a loan backed by an asset with the asset title pledged to the lender

d. backed by certain assets as collateral e. obligations that are not expected to be paid in cash or

other current assets within one year or the normal operating cycle

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Matching 12-3 (LO4) Listed below are the terms and associated definitions from the chapter for LO4. Match the correct definition letter with each term number. ___ 1. serial bonds ___ 2. secured bonds ___ 3. collateral trust

bond ___ 4. unsecured

(debenture) bonds

___ 5. registered bonds

___ 6. bearer (coupon) bonds

___ 7. zero-interest (deep-discount) bonds

___ 8. junk bonds ___ 9. convertible

bonds ___ 10. commodity-

backed (asset-linked) bonds

___ 11. callable bonds ___ 12. stated

(contract) rate ___ 13. bond premium ___ 14. bond discount ___ 15. market, yield,

or effective interest rate

___ 16. bond issuance costs

___ 17. straight-line method

___ 18. bond financing ___ 19. term bonds ___ 20. face value, par

value, or maturity value

a. bonds whose ownership is determined by possession and for which interest is paid to the holder of an interest coupon

b. bonds that can turn into common stock at the option of the bondholder

c. bonds for which the issuer reserves the right to pay the obligation prior to the maturity date

d. the rate of interest printed on the bond e. the actual rate of interest earned or paid on a bond f. bonds for which no specific collateral has been pledged g. issuing new bonds to replace outstanding bonds either

at maturity or prior to maturity h. high-risk, high-yield bonds issued by companies in a

weak financial condition i. bonds that are sold at significant discounts, providing

the investor with a total interest payoff at maturity j. legal services, printing and engraving, taxes, and

underwriting in connection with the sale of a bond k. bonds that are secured by the stocks and bonds of other

corporations owned by the issuer but held in trust for the benefit of the bondholders

l. the difference between the face value and the sales price when bonds are sold below their face value

m. bonds that mature in a series of installments at future dates

n. bonds that may be redeemed for things such as oil or precious metals

o. an amortization method that provides for recognition of an equal amount of bond premium or discount amortization each period

p. bonds for which the bondholders’ names and addresses are kept on file by the issuing company

q. the difference between the face value and the sales price when bonds are sold above their face value

r. bonds for which assets are pledged to guarantee repayment

s. the amount that will be paid on a bond at the date the bonds come due

t. bonds that mature in one lump sum at a specified future date

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Matching 12-4 (LO6, LO7, LO8, LO9) Listed below are the terms and associated definitions from the chapter for LO6 through LO9. Match the correct definition letter with each term number. ___ 1. off-balance-

sheet financing ___ 2. joint venture ___ 3. debt-to-equity

ratio ___ 4. times interest

earned ___ 5. troubled debt

restructuring

a. an indicator of a company’s ability to meet interest payments; calculated as income before income taxes plus interest expense divided by interest expense for the period

b. measures the relationship between the debt and equity of an entity; calculated as total debt divided by total stockholders’ equity

c. a situation involving a concession by creditors to allow debtors to eliminate or significantly modify debt obligations due to the debtor’s financial difficulties

d. a separate economic entity created when companies join forces with other companies to share the costs and benefits associated with a specifically defined project

e. procedures used by companies to avoid disclosing all of their debt on the balance sheet to make their financial position look stronger

Problems

Problem 12-1 (LO2, LO3) On December 31, 2010, Americana Airlines purchased machinery having a cash selling price of $85,933.74. The company paid $10,000 down and agreed to finance the remainder by making four equal payments each December 31 at the implicit annual interest rate of 12%. The company uses the effective-interest method. 1. Determine the amount of the annual payments to be made under the financing

agreement. 2. Prepare the journal entry to record the acquisition of the machinery on December

31, 2010. 3. Prepare the journal entry on December 31, 2011. 4. Prepare the journal entry on December 31, 2012. 5. Repeat requirements 3 and 4 assuming the company uses the straight-line method

for recognizing interest expense. Problem 12-2 (LO4) On January 1, 2010, Fashion Floors issued ten-year convertible bonds of $1,800,000 at 105. Interest is payable semiannually on June 30 and December 31 at an annual rate of 12 percent. On June 30, 2012, the company retired bonds of $150,000 at 102 plus accrued interest. Straight-line amortization is recorded at the end of the calendar year.

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1. Provide the journal entries required to record the issuance and partial retirement of the bonds.

2. Assuming that each $1,000 bond is convertible into eight shares of Fashion Floors’ $120 par common stock (with market value of $130), provide the journal entries on June 30, 2012, for the two methods that may be used to record a conversion rather than a retirement of $150,000 of bonds.

Problem 12-3 (LO4) On March 1, 2011, Alberto’s Bird Company issued $700,000 of 10 percent bonds to yield 8 percent. Interest is payable semiannually on February 28 and August 31. The bonds mature in ten years. Alberto’s Bird Company is a calendar-year corporation. 1. Determine the issue price of the bonds. 2. Prepare an amortization table through the first two interest periods using the

effective-interest method. 3. Prepare the journal entries to record bond-related transactions as of the following

dates: a. March 1, 2011 b. August 31, 2011 c. December 31, 2011 d. February 28, 2012

Solutions, Approaches, and Explanations

MC12-1 Answer: a Approach and explanation: There are three criteria, which must all be met, for a liability to exist: They (1) are based on past transactions or events, (2) involve a future transfer of assets or services, and (3) are an obligation of a particular entity. Liabilities are never based on possible future events. That is why, as mentioned on page 12-3, establishing a line of credit does not result in a liability. A past transaction (obtaining the money the line of credit allows) has not yet happened. Notice that the three criteria do not include amounts (choice b). Liabilities are sometimes based on estimates. For instance, if it is probable that pending litigation will result in an obligation but the amount is not known (because the case isn’t settled yet), then an estimate of the amount of the liability is accrued. Notice that even though the litigation has not been completed, the litigation is based on a past transaction or event, and hence, a liability exists if the negative outcome is probable. If a negative outcome were merely possible or remote, then a liability for such litigation should not be booked.

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Choice c sounds something like our third criteria of “an obligation of a particular entity.” The key difference is that choice c mentions the party owed, not the party to which an obligation exists. Getting back to our litigation example, if a lawsuit against the business looked like it was going to be settled but the recipients weren’t specifically known because it was a class action suit made up of numerous (anonymous to the company) investors, then the company still has a liability. Choice d is perhaps the easiest one to eliminate. Unearned revenue is a common liability that occurs when cash is received before goods are shipped or services are performed. The liability, then, involves future performance of services or delivery of goods—not a payment of cash. MC12-2 Answer: b Approach and explanation: Management must intend to refinance and demonstrate an ability to do so before the financial statements are issued in order to have liabilities that would otherwise be considered current classified as non-current. Demonstration of the ability to do so need not include actual refinancing before the financial statements are issued, so choice a is too conservative. Choice b is incorrect for the same reason. It is even more conservative, pushing the refinancing back an extra month or two in most cases. Choice d can also be too conservative. The note need not be refinanced before the maturity date so long as the intent and ability are in existence at the time of financial statement issuance. The incorrect choices could all be correct were it not for the word “must” in the question. MC12-3 Answer: c Approach and explanation: Amounts payable in the next year that have already been incurred should be included in the Current Liabilities section of Quartz’s balance sheet. As only six months worth of interest has been incurred, half of the total interest ($500,000 × 0.10) that will be payable on June 30, 2011, should show up on the balance sheet. If the question asked how much will be paid on June 30, 2011, then choice d would be correct. MC12-4 Answer: b Approach and explanation: First of all, choices a and d are the same thing. Both can’t be correct so you can safely cross them off. Choices a and d would be correct if the effective interest rate and stated rate were the same as each other.

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So now you are left which choices b and c. Don’t try to memorize that if one is higher than the other the bonds will sell above or below face value. You’ll soon forget and possibly get them flip-flopped in your head anyway. Rather, think about what the interest rates mean and whether these bonds will be attractive to investors based on the stated interest rate relative to the market rate of interest. If the effective interest rate is lower than the stated rate, that means these bonds are paying (because the bonds so state) more than the market (effective) rate and will be attractive to investors. Because they are attractive, investors will be willing to pay more than the face value for them. The fact that they will get less back at maturity than they are paying today is made up for by the fact that they will get more over the years in interest than other, similar bond issues that are paying the market, or effective, rate. If the question were reworded to say, “The effective interest rate on bonds is higher than the stated rate when bonds sell,” then the answer would change to choice c. In that situation, the bonds would be unattractive to investors since they are paying less than the market rate, and the bonds would sell at a discount. MC12-5 Answer: c Approach and explanation: If the bonds sold at par, then choices a, b, and d would have the same meaning. Since these bonds did not sell at par, they are not the same choice. The first thing to remember with respect to bond amortization tables and the calculation of interest expense using the effective-interest method is that the book value of the bonds is the basis for the interest calculation. This isn’t difficult to recall if you study a bond amortization table that uses the effective-interest method. You will note that interest expense changes each period. That would not be the case if the fixed, maturity value was used in the calculation. Therefore, you can cross off choice d. By the same reasoning, if interest expense changes each period under the effective-interest method then choice a can’t be correct either. The actual amount of interest paid is the same each period. So now we are left with choices b and c. Don’t let the fact that two of the choices mention the stated interest rate as the multiplier sway you. The only thing that the stated rate is used for is in the computation of the interest payments. It is not the interest rate used to figure the present value of the bonds, nor is it the rate used to compute the interest expense. Hence, choice c is the correct choice. MC12-6 Answer: c Approach and explanation: VIEs, although more difficult to implement after FASB tightened the rules surrounding Enron and other SPEs, are still a form of off-balance-sheet financing.

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The debt of an unconsolidated subsidiary also doesn’t appear on a balance sheet. The asset associated with that subsidiary will be valued differently than if the subsidiary was consolidated, too. This may not be a big deal for a subsidiary in which less than 1 percent stock ownership exists, but it can be a weighty matter for a subsidiary in which 49 percent, or even 19 percent ownership and no equity method for accounting for the entity, exists. Which brings us to leases…What kind of leases are of the off-balance-sheet variety? The asset and liability to which a capital lease applies does show up on a business’s balance sheet. Therefore, it is an operating lease (especially those that are long term and account for 50–74 percent of an asset’s useful life) that is a form of off-balance-sheet financing. MC12-7 Answer: d Approach and explanation: Don’t let all of the extra figures throw you for a loop. You don’t need to use most of the financial data given. Times interest earned is calculated by adding a company’s income before income taxes and interest expense and then dividing by the interest expense for the period. So the calculation, in this case, is just operating income divided by interest expense. Use the first two numbers given and you can derive the correct answer of 9.0 ($900,000/$100,000). Thinking about it intuitively, “times interest earned” just show how many times the interest expense was earned by the operating income of the business without consideration of interest expense itself. The figure provides a measure of the margin of safety available to creditors. A low number is more worrisome than a high number to a creditor. Equity investors are not very concerned with this ratio. MC12-8 Answer: a Approach and explanation: The parties holding the debt are likely not even known to the business soon after issuance since debt (in the form of bonds, at least) tends to change hands after the initial offering. The other three are all required disclosures. Take a look at the IBM example in the textbook. Real company examples in the textbook should not be skipped over. Frequently, by reviewing them, the concepts stick better than by merely reading a list in a textbook or looking at the original FASB statement. Other required disclosures include: the nature of the liabilities, methods of liquidation, conversion privileges, sinking fund requirements, borrowing restrictions, dividend limitations, and the portion of long-term debt coming due in the current period.

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MC12-9 Answer: b Approach and explanation: When the total payment under the new structure is greater than the prior structure, the restructuring is not considered to be a significant economic transaction. Hence, no gain or loss is recognized in that situation. Choice a will result in a gain to the issuer. Choices c and d will result in a gain or a loss to the issuer depending on the amount of the equity interest or the book value of the assets transferred relative to the debt carrying value. Matching 12-1 1. d 2. e 3. a 4. c 5. b 6. g 7. f Remember that accounting is the “language of business.” Terminology can account for anywhere from 10 to 40 percent of many quizzes and exams. Sometimes answering problems, that aren’t directly testing terminology knowledge, correctly can also be dependent on an accurate understanding of the terms used in the problem. New vocabulary is essential to master when first encountered since the same words will appear (without definitions provided again) in subsequent chapters. Matching 12-2 1. c 2. a 3. d 4. e 5. b

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Matching 12-3 1. m 2. r 3. k 4. f 5. p 6. a 7. i 8. h 9. b 10. n 11. c 12. d 13. q 14. l 15. e 16. j 17. o 18. g 19. t 20. s Matching 12-4 1. e 2. d 3. b 4. a 5. c Problem 12-1 1. The total cash price of the machinery is $85,933.74. The company paid $10,000

down, leaving a balance of $75,933.74 to finance. This amount represents the present value of four payments of unknown amounts discounted at 12%. The problem can be solved by using the following inputs on your financial calculator:

4 = N, 12 = i%, 75,933.74 = PV, 0 = FV, CPT = PMT

or by entering the formula =PMT(0.12,4,-75933.74) into Excel.

Each of the payments are $25,000, which means that the company will be paying $110,000 [($25,000 × 4) + $10,000] in total for the machinery. $24,066.26 ($110,000 – $85,933.74) of those payments represent interest being paid for the financing arrangement.

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2. The journal entry to record the acquisition of the machinery on December 31, 2010, would be:

Machinery 85,933.74 Discount on Notes Payable 24,066.26

Cash 10,000.00Notes Payable 100,000.00

3. The journal entry on December 31, 2011, would be:

Notes Payable 25,000.00 Interest Expense 9,112.05*

Cash 10,000.00Notes Payable 100,000.00

*($100,000.00 – $24,066.24) × 0.12 = $9,112.05 4. The journal entry on December 31, 2012, would be:

Notes Payable 25,000.00 Interest Expense 7,205.50*

Cash 25,000.00Discount on Notes Payable 7,205.50

*($100,000.00 – $25,000.00 – $24,066.24 + $9,112.05) × 0.12 = $7,205.50 5. The journal entries on December 31, 2011, and 2012, would be the same under the

straight-line method as follows:

Notes Payable 25,000.00 Interest Expense 6,016.56*

Cash 25,000.00Discount on Notes Payable 6,016.56

*$24,066.24/4 = $6,016.56

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Problem 12-2 Similar to explanations for journal entry problems from prior chapters, you should fill in what you do know first and then plug the missing piece in. Start with a skeleton entry and work from there. For instance, on the first part of the first requirement, create blank debits for Cash and Discount on Bonds Payable. Then, create blank credits for Bonds Payable and Premium on Bonds Payable. Your skeleton entry should look like the following: Cash Discount on Bonds Payable

Bonds Payable Premium on Bonds Payable

Then, fill in what you know. The credit to Bonds Payable of $1,800,000 is essentially given in the problem. Since they were issued at 105, you can compute how much cash came in and enter your debit to Cash. Finally, since your debit exceeds your credit (and because 105 is greater than 100), you can plug the difference between your entries to the Premium on Bonds Payable account and cross off the Discount on Bonds Payable portion of the skeleton entry to end up with the following: 1. 2010 Jan. 1 Cash 1,890,000a

Bonds Payable 1,800,000 Premium on Bonds Payable 90,000

2012 June 30 Premium on Bonds Payable 375b

Interest Expense 375 30 Bonds Payable 150,000

Premium on Bonds Payable 5,625c

Interest Expense 9,000 Gain on Bond Retirement 2,625 Cash 162,000

a$1,800,000 × 1.05 = $1,890,000 b(6/120 × $150,000)/($1,800,000 × $90,000) = $375 c(90/120 × $150,000)/($1,800,000 × $90,000) = $5,625

Chapter 12 12-19

2. Stock recorded at book value of bonds:

2012 June 30 Premium on Bonds Payable 375

Interest Expense 375

30 Bonds Payable 150,000 Premium on Bonds Payable 5,625 Interest Expense 9,000 Cash 9,000 Common Stock 144,000* Paid-In Capital in Excess of Par 11,625

*$1,200 × $120 = $144,000

Stock recorded at book value of bonds:

2012 June 30 Premium on Bonds Payable 375

Interest Expense 375

30 Bonds Payable 150,000 Premium on Bonds Payable 5,625 Interest Expense 9,000 Loss on Conversion of Bonds 375 Cash 9,000 Common Stock 144,000 Paid-In Capital in Excess of Par 12,000

Problem 12-3 1. 20 = N, 8 / 2 = i%, 700,000 = FV, .10 / 2 x 700,000 = PMT, CPT = PV

or by entering the formula =PV(0.08/2,20,-0.1/2*700000,-700000) into Excel. Selling price of bonds = $795,132.28

Reasonableness check: These bonds are paying more (10%) than the market rate (8%) so they should be attractive to investors and sell at a premium above the face value of $700,000. Since $795,132.28 is greater than $700,000, but not so much greater as to be unreasonable, you know that if your answer isn’t correct it is at least in the ballpark (unlike a solution such as $612,373 or $984,154,980).

12-20 Chapter 12

2. Interest

Date Interest Payment

Amortization Expense

Carrying of Premium Value

3/1/2011 $795,132 8/31/2011 $35,000 $31,805a $3,195 791,937 2/28/2012 35,000 31,677b 3,323 788,614

a$795,132 × 4% = $31,805 b$791,937 × 4% = $31,677

3.

2011 a. Mar. 1 Cash 795,132

Bonds Payable 700,000 Premium on Bonds Payable 95,132

b. Aug. 31 Interest Expense 31,805

Premium on Bonds Payable 3,195 Cash 35,000

c. Dec. 31 Interest Expense 21,118a

Premium on Bonds Payable 2,215b

Interest Payable 23,333c

2012 d. Feb. 28 Interest Payable 23,333

Premium on Bonds Payable 1,108 Interest Expense 10,559 Cash 35,000

a$31,677 × 4/6 = $21,118 b$3,323 × 4/6 = $2,215 c$35,000 × 4/6 = $23,333

Chapter 12 12-21

Glossary

Note that Appendix C in the rear portion of the textbook contains a comprehensive Glossary for all of the terms used in the textbook. That is the place to turn to if you need to look up a word but don’t know which chapter(s) it appeared in. The glossary below is identical with one major exception: It contains only those terms used in Chapter 12. This abbreviated Glossary can prove quite useful when reviewing a chapter, when studying for a quiz for a particular chapter, or when studying for an exam which covers only a few chapters including this one. Use it in those instances instead of wading through the 19 pages of comprehensive glossary in the textbook trying to pick out just those words that were used in this chapter.

accounts payable Amounts due for the purchase of materials by a manufacturing company or merchandise by a wholesaler or retailer.

amortization An adjustment to interest expense (for either a premium or a discount) to reflect the effective interest being incurred on bonds. This periodic adjustment results in the convergence of the carrying value of a bond to its face value over time.

bearer (coupon) bonds Bonds whose ownership is determined by possession and for which interest is paid to the holder (bearer) of an interest coupon.

bond certificates Certificates of indebtedness issued by a company or government agency guaranteeing payment of a principal amount at a specified future date plus periodic interest; usually issued in denominations of $1,000.

bond discount The difference between the face value and the sales price when bonds are sold below their face value.

bond indenture The contract between the issuing entity and the bondholders specifying the terms, rights, and obligations of the contracting parties.

bond issuance costs Costs incurred by the issuer for legal services, printing and engraving, taxes, and underwriting in connection with the sale of a bond.

bond premium The difference between the face value and the sales price when bonds are sold above their face value.

bond refinancing Issuing new bonds to replace outstanding bonds either at maturity or prior to maturity.

callable bonds Bonds for which the issuer reserves the right to pay the obligation prior to the maturity date.

collateral trust bond Bonds that are secured by the stocks and bonds of other corporations owned by the issuer but held in trust for the benefit of the bondholders.

commodity-backed (asset-linked) bonds Bonds that may be redeemed in terms of commodities, such as oil or precious metals.

convertible bonds Bonds that provide for conversion into common stock at the option of the bondholder.

12-22 Chapter 12

convertible debt securities Securities that have an interest rate lower than the issuer could establish for nonconvertible debt, an initial conversion price higher than the market value of the common stock at the time of issuance, and a call option retained by the issuer.

debenture bonds, or debentures Another name for unsecured bonds which are not protected by the pledge of any specific assets.

debt-to-equity ratio A ratio that measures the relationship between the debt and equity of an entity. The debt-to-equity formula is total debt divided by total stockholders’ equity.

effective-interest method An amortization method that provides for recognition of an equal rate of amortization of bond premium or discount each period; uses a constant interest rate times a changing investment balance.

face value, par value, or maturity value The amount that will be paid on a bond at the maturity date.

hedging Structuring transactions to reduce risk.

joint venture A separate economic entity created when companies join forces with other companies to share the costs and benefits associated with a specifically defined project.

junk bonds High-risk, high-yield bonds issued by companies in a weak financial condition.

liabilities The claims of creditors against an entity’s resources; technically defined by the FASB as “probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.”

line of credit A negotiated arrangement with a lender in which the terms are agreed to prior to the need for actual borrowing.

loan (mortgage) amortization The process by which payments on a loan are allocated between principal and interest components.

long-term debt Obligations that are not expected to be paid in cash or other current assets within one year or the normal operating cycle.

market, yield, or effective interest rate The actual rate of interest earned or paid on a bond.

mortgage A loan backed by an asset with the asset title pledged to the lender.

municipal debt Debt securities issued by state, county, and local governments and their agencies.

nontrade notes payable Notes issued to nontrade creditors for purposes other than to purchase goods or services.

notes payable Formal written promises to pay a sum of money in the future. Notes payable are generally evidenced by a promissory note.

Chapter 12 12-23

off-balance-sheet financing Procedures used by companies to avoid disclosing all of their debt on the balance sheet to make their financial position look stronger.

promissory note A formal written promise to pay a certain amount of money at a specified future date.

registered bonds Bonds for which the bondholders’ names and addresses are kept on file by the issuing company.

secured bonds Bonds for which assets are pledged to guarantee repayment.

secured loan A loan backed by certain assets as collateral.

serial bonds Bonds that mature in a series of installments at future dates.

stated (contract) rate The rate of interest printed on the bond.

straight-line method An amortization method that provides for recognition of an equal amount of bond premium or discount amortization each period.

term bonds Bonds that mature in one lump sum at a specified future date.

times interest earned An indicator of a company’s ability to meet interest payments; calculated as income before income taxes plus interest expense divided by interest expense for the period.

trade notes payable A note issued to trade creditors for the purchase of goods or services.

troubled debt restructuring A situation involving a concession by creditors to allow debtors to eliminate or significantly modify debt obligations due to the debtor’s financial difficulties.

trust indenture A legal agreement specifying how a bond fund should be administered by its trustees.

unsecured (debenture) bonds Bonds for which no specific collateral has been pledged.

Variable interest entity (VIE) A category of unconsolidated subsidiaries, formerly called special-purpose entities.

zero-interest (deep-discount) bonds Bonds that do not bear interest but instead are sold at significant discounts, providing the investor with a total interest payoff at maturity.