porter sm ch. 10_2pp (1)

Chapter 2: Long-Term Liabilities

10-30Financial accounting solutions manual

chapter 10 Long-term Liabilities10-31

CHAPTER 10

Long-Term Liabilities

OVERVIEW OF EXERCISES, PROBLEMS, AND CASES

Estimated

Time in

Learning OutcomesExercisesMinutesLevel

1.Identify the components of the long-term liability

category of the balance sheet.

2.Define the important characteristics of bonds payable.110Easy

3.Determine the issue price of a bond using compound 215Easy

interest techniques.325Mod

4.Show that you understand the effect on the balance410Mod

sheet of the issuance of bonds.15*15Mod

16*20Mod

17*20Mod

5.Find the amortization of premium or discount 15*15Mod

using the effective interest method.16*20Mod

17*20Mod

6.Find the gain or loss on retirement of bonds.510Mod

610Mod

7.Determine whether or not a lease agreement must be 710Mod

reported as a liability on the balance sheet.810Mod

920Mod

8.Explain the effects that transactions involving long-term 105Easy liabilities have on the statement of cash flows.1120Mod

1210Mod

9.Explain deferred taxes and calculate the deferred tax liability135Easy

(Appendix).1410Easy

*Exercise, problem, or case covers two or more learning outcomes

Level = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)

ProblemsEstimated

andTime in

Learning OutcomesAlternatesMinutesLevel

1.Identify the components of the long-term liability 9*20Mod

category of the balance sheet.

2.Define the important characteristics of bonds payable.

3.Determine the issue price of a bond using compound 115Mod

interest techniques.

4.Show that you understand the effect on the balance8*20Mod

sheet of the issuance of bonds.

5.Find the amortization of premium or discount 225Mod

using the effective interest method.325Mod

8*20Mod


8#20Mod

7.Determine whether or not a lease agreement must be535Diff

reported as a liability on the balance sheet.

8.Explain the effects that transactions involving long-term

liabilities have on the statement of cash flows.

9.Explain deferred taxes and calculate the deferred tax liability615Mod

(Appendix).730Diff

9*20Mod

*Exercise, problem, or case covers two or more learning outcomes

#Alternate problem only


Estimated

Time in

Learning OutcomesCasesMinutesLevel

1.Identify the components of the long-term liability1*40Mod

category of the balance sheet.425Mod

2.Define the important characteristics of bonds payable.

3.Determine the issue price of a bond using compound

interest techniques.

4.Show that you understand the effect on the balance

sheet of the issuance of bonds.

5.Find the amortization of premium or discount

using the effective interest method.


7.Determine whether or not a lease agreement must be1*25Mod

reported as a liability on the balance sheet.630Mod

8.Explain the effects that transactions involving long-term240Mod

liabilities have on the statement of cash flows.3*25Mod

9.Explain deferred taxes and calculate the deferred tax liability3*25Mod

(Appendix).*Exercise, problem, or case covers two or more learning outcomes


questions

1.The issue price of a bond should always be calculated using the market rate of interest. The face rate determines the dollar amount of interest, but the market rate is used to calculate the present value that represents the issue price.

2.The tax advantage for bonds is the fact that interest paid on bonds is an expense that is deductible for tax purposes, whereas dividends paid on stock are not deductible.

3.When bonds are issued at a premium, it is an indication that the face rate is higher than the market rate.

4.By basing each periods interest expense on a decreasing or increasing amount, the amount of interest expense is different each period, but the rate of interest remains the same.

5.Amortization affects interest expense because premium or discount is amortized to the Interest Expense account. Amortization of premium decreases interest expense. Amortization of discount increases interest expense.

6.Amortization of premium decreases the bond carrying value because it decreases the Premium on Bonds Payable account. Since Discount on Bonds Payable is a contra liability account, amortization of discount increases the bond carrying value.

7.Gain or loss on bond redemption will almost always occur when bonds are redeemed or retired before their scheduled due date. The gain or loss is computed as the difference between the bond carrying value at the redemption date and the reacquisition price.

8.Leases are not all accounted for in the same manner because of the variety of provisions that can be found in lease agreements. Some leases are only short-term rental arrangements to use the asset, and others are actually purchases of the asset over a long time period. It may be possible to develop an accounting rule to treat all leases similarly. However, the rule must also be flexible enough to cover the wide variety of financial arrangements that are all called leases.

9.Off-balance-sheet financing refers to transactions whereby a party obtains the use of an asset but is not required to record the related liability on the balance sheet. Firms may favor off-balance-sheet arrangements because they believe there are benefits in not recording an obligation as a liability. Benefits may include the maintenance of borrowing capacity and flexibility in meeting debt/equity or similar requirements in existing loan contracts.

10.An operating lease is not recorded on the balance sheet of the lessee, and the only expense on the income statement is the rental payments. A capital lease is shown as an asset and a liability by the lessee. Expense on the income statement includes interest on the liability and depreciation on the asset.

11.Depreciation should be recorded on leased assets treated as capital leases. Generally, depreciation should be recorded over the time period benefited by the asset, which normally is the term of the lease.

12.Deferred Tax is an account that reconciles the differences between the accounting for tax purposes and the accounting for the financial statement prepared for stockholders. If the Deferred Tax account has a credit balance, it represents a liability. If the account has a debit balance, it should be presented as an asset on the balance sheet.

13.A permanent difference affects only book accounting but not tax accounting, or vice versa, tax accounting but not book accounting. Temporary differences affect both book and tax accounting but in different time periods.

14.The amount of tax expense on the income statement does not represent the amount of tax actually paid to the IRS. Tax expense represents the expense computed using the accounting methods adopted for financial statement purposes. It does not reflect the accounting methods actually used for tax accounting purposes.

15.Accounting liabilities are not necessarily legal liabilities. Accounting takes a broader view and considers some items as liabilities that are not legally enforceable claims. Examples include accrued liabilities, some unearned income amounts, and deferred tax.

exercises

LO 2EXERCISE 10-1 RELATIONSHIPS

CashInterestAmort.Carrying

InterestExpenseDisc./Prem.Value

1.

CIII

2.

CDID

LO 3EXERCISE 10-2 ISSUE PRICE

1.a.$500,000

b.$500,000

c.$500,000

2.a.$500,000 8% 1/2 year = $20,000

b.$500,000 8% 1/2 year = $20,000

c.$500,000 8% 1/2 year = $20,000

3.a.$20,00013.590(Table 9-4, n = 20, i = 4%) =$271,800

$500,0000.456(Table 9-2, n = 20, i = 4%) =

228,000

Issue price

$499,800*

*Should equal $500,000; the difference is due to rounding in present value factors.

b.$20,00014.877(Table 9-4, n = 20, i = 3%) =$297,540

$500,0000.554(Table 9-2, n = 20, i = 3%) =

277,000

Issue price

$574,540

c.$20,00012.462(Table 9-4, n = 20, i = 5%) =$249,240

$500,0000.377(Table 9-2, n = 20, i = 5%) =

188,500

Issue price

$437,740LO 3EXERCISE 10-3 ISSUE PRICE

a.$500,0000.621 (n = 5, i = 10%) =$310,500

$40,000*3.791 (n = 5, i = 10%) =

151,640

$462,140

*500 bonds $1,000 par 8% = $40,000.

b.$500,0000.614 (n = 10, i = 5%) =$307,000

$20,000*7.722 (n = 10, i = 5%) =

154,440

$461,440

*500 bonds $1,000 par 8% 6/12 = $20,000.

c.$800,0000.377 (n = 20, i = 5%) =$301,600

$32,000*12.462 (n = 20, i = 5%) =

398,784

$700,384

*800 bonds $1,000 par 8% 6/12 = $32,000.

d.$1,000,0000.231 (n = 30, i = 5%) =$231,000

$60,000*15.372 (n = 30, i = 5%) =

922,320

$1,153,320

*2,000 bonds $500 par 12% 6/12 = $60,000.

LO 4EXERCISE 10-4 IMPACT OF TWO BOND ALTERNATIVES

1.If the company issues bonds with a face rate of 8% when the market rate is 9%, the bonds will be issued at a discount. The real interest cost the company incurs is the market rate of interest of 9%. Thus, the company cannot save money by issuing bonds at a discount.

2.If the company issues bonds with a face rate of 10% when the market rate is 9%, the bonds will be issued at a premium. The company will receive an amount in excess of the par value of the bonds, but that amount is offset by the fact that the company must then pay interest at 10%. The result is that the company incurs a real interest cost of 9%, which is the market rate of interest. Thus, the company does not benefit by issuing bonds at 10%.

LO 6EXERCISE 10-5 REDEMPTION OF BONDS

1.Redemption price:$75,000 1.03=$77,250

Carrying value:$75,000 $1,750=

73,250

$(4,000)loss

2.The gain or loss on bond redemption should be presented on the income statement. In most cases, the gain or loss on bond redemption should not be considered unusual or infrequent and therefore should not be presented in the section of the statement where extraordinary items are presented.

LO 6EXERCISE 10-6 REDEMPTION OF A BOND AT MATURITY

Since the bonds are fully matured, the carrying value equals the face value and there will be no gain or loss on the redemption of the bonds.

The effect on the accounting equation of the redemption of the bonds is as follows:

Balance Sheet

income Statement

Assets=Liabilities+Stockholders Equity+ Revenues Expenses

Cash

(250,000) Bonds Payable (250,000)

LO 7EXERCISE 10-7 LEASED ASSET

1.Payment Table factor ord. annuity = PV min. lease payments

$8,000 6.418 (Table 9-4, n = 10, i = 9%) = $51,344

2.$80,000 is not a correct amount to record because it does not recognize the time value of money. Since the payments will extend over 10 years, the lease must be recorded at the present value of the payments.

LO 7EXERCISE 10-8 FINANCIAL STATEMENT IMPACT OF A LEASE

1.Payment Table factor ord. annuity = PV min. lease payment

Payment 4.355 (Table 9-4, n = 6, i = 10%) = $13,065

Payment = $13,065/4.355 = $3,000 per year

2.$9,508.65

LeaseInterestReduction ofLease

DatePaymentExpenseObligationObligation

1/01/07

$13,065.00

12/31/07$3,000$1,306.50$1,693.5011,371.50

12/31/083,0001,137.151,862.859,508.65

LO 7EXERCISE 10-9 LEASED ASSETS

1.a.The value of the forklift will not appear on the balance sheet.

b.The lease payments will appear on the income statement as Lease Expense.

2.a.The effect on the accounting equation when the lease is signed is as follows:

Balance Sheet

income Statement


Leased Asset5,001*Lease Liability5,001

*$1,510 3.312 (Table 9-4, n = 4, i = 8%) = $5,001

The leased asset should be reported at the present value of the payments which is $5,001, not at $6,040.

b.The effect on the accounting equation of the first lease payment, on December 31, 2007, is as follows:

Balance Sheet

income Statement


Cash

(1,510) Lease Liability (1,110)

Interest Expense (400)*

*$5,001 8% = $400

c.Depreciation expense = $5,001/4 years = $1,250.

EXERCISE 10-9 (Concluded)

d.Current liabilities:

Lease liability (current portion)$1,199*

*($5,001 $1,110) 8% = $311.

$1,510 $311 = $1,199.

Long-term liabilities:

Lease liability$2,692**

**$5,001 $1,110 $1,199 = $2,692

LO 8EXERCISE 10-10 IMPACT OF TRANSACTIONS INVOLVING BONDS ON STATEMENT OF CASH FLOWS

FProceeds from issuance of bonds payable

OInterest expense

FRedemption of bonds payable at maturity

LO 8EXERCISE 10-11 IMPACT OF TRANSACTIONS INVOLVING CAPITAL LEASES ON STATEMENT OF CASH FLOWS

1.Garnett obtained the equipment by signing a lease; no cash changed hands. As a result, this transaction would be reported as a noncash investing and financing transaction on the statement of cash flows.

2.FReduction of lease obligation (principal portion of lease payment)

OInterest expense

ODepreciation expenseleased assets

LO 8EXERCISE 10-12 IMPACT OF TRANSACTIONS INVOLVING TAX LIABILITIES ON STATEMENT OF CASH FLOWS

O(deduct from net income)Decrease in taxes payable

O(add to net income)Increase in deferred taxes

LO 9EXERCISE 10-13 TEMPORARY AND PERMANENT DIFFERENCES (Appendix)

1.Permanent4.Temporary

2.Permanent5.Temporary

3.Temporary6.Permanent

LO 9EXERCISE 10-14 DEFERRED TAX (Appendix)

Balance of deferred tax account:

2007Tax depreciation =$10,667

Book depreciation=

6,400

Difference=$4,267

Tax rate

0.40

Entry to deferred tax

=$1,707credit

Balance of account

=$1,707credit


Book depreciation=

6,400

Difference=$4,267

Tax rate

0.40


=$1,707credit

Balance of account

=$3,414credit


Book depreciation=

6,400

Difference=$4,266

Tax rate

0.40


=$1,706credit

Balance of account

=$5,120credit

2010Tax depreciation =$0

Book depreciation=

6,400

Difference=$(6,400)

Tax rate

0.40


=$2,560debit

Balance of account

=$2,560credit

2011Tax depreciation=$0

Book depreciation=

6,400

Difference=$(6,400)

Tax rate

0.40


=$2,560debit

Balance of account

=$0MULTI-CONCEPT exercises

LO 4,5EXERCISE 10-15 ISSUANCE OF A BOND AT FACE VALUE

1.$300,000*0.614(Table 9-2, n = 10, i = 5%) =$184,200

$15,000**7.722(Table 9-4, n = 10, i = 5%) =

115,830

Issuance price

$300,030***

*300 $1,000 = $300,000.

**$300,000 10% 1/2 year = $15,000.

***Should equal $300,000; difference due to rounding in present value factors.

2.If the market rate of interest had been higher than 10%, the issue price would have been less than the face value of the bonds. The bonds would have been issued at a discount.

3.The effect on the accounting equation of the payment of interest on July 1, 2007, is as follows:

Balance Sheet

income Statement


Cash

(15,000)

Interest

Expense (15,000)

4.The amount of interest to be accrued on December 31, 2007, is calculated as follows:

$300,000 10% 1/2 year = $15,000.

LO 4,5EXERCISE 10-16 IMPACT OF A DISCOUNT

1.The effect on the accounting equation of the January 1, 2007, sale of bonds is as follows:

Balance Sheet

income Statement


Cash

91,526Bonds Payable100,000

Discount on

Bonds Payable (8,474)

Bonds payable

$100,000

Less: Discount on bonds payable

8,474

$91,526

2.The effect on the accounting equation of the payment of interest on December 31, 2007, is as follows:

Balance Sheet

income Statement


Cash (9,000)* Discount on

Interest

Bonds Payable153

Expense(9,153)**

*$100,000 9% 1 year = $9,000

**$91,526 10% 1 year = $9,153

Bonds payable$100,000


8,321*

$91,679*$8,474 $153 = $8,321

3.The market rate of interest was greater than the interest rate that Berol Corporation is paying. Therefore, the issuance price, discounted at 10%, the market rate, will be less than face value.

LO 4,5EXERCISE 10-17 IMPACT OF A PREMIUM

1.The effect on the accounting equation of the sale of bonds on January 1, 2007, is as follows:

Balance Sheet

income Statement


Cash109,862Bonds Payable100,000

Premium on

Bonds Payable9,862

Bonds payable

$100,000

Plus: Premium on bonds payable

9,862

$109,862


Balance Sheet

income Statement


Cash

(9,000)* Premium on

Interest

Bonds Payable (211)

Expense (8,789)**

*$100,000 9% 1 year = $9,000

**$109,862 8% 1 year = $8,789

Bonds payable$100,000


9,651*

$109,651

*$9,862 $211 = $9,651

3.The market rate of 8% is lower than the interest rate Berol is paying. Therefore, investors will be willing to pay more on the basis of the future cash flows discounted at the market rate.

problems

LO 3PROBLEM 10-1 FACTORS THAT AFFECT THE BOND ISSUE PRICE

1.a.The bonds would be issued at par, since the face or coupon rate is equal to the market rate of interest.

b.The bonds would be issued at a discount in this situation because investors would demand a 7% return on their investment. Since the cash flows are fixed, the investment must be decreased to increase the effective interest rate.

2.a.$100,0000.554(Table 9-2, n = 20, i = 3%) = $55,400

$3,000*14.877(Table 9-4, n = 20, i = 3%) =

44,631

Total present value =

$100,031**

*$100,000 6% 6/12 = $3,000

**Should be $100,000; difference due to rounding.

b.$100,0000.508(Table 9-2, n = 10, i = 7%) = $50,800

$6,000*7.024(Table 9-4, n = 10, i = 7%) =

42,144

Total present value =

$92,944

*$100,000 6% = $6,000.

LO 5PROBLEM 10-2 AMORTIZATION OF DISCOUNT

1.

Discount Amortization

Effective Interest Method of Amortization

Col. 1Col. 2Col. 3Col. 4

CashInterestDiscount

InterestExpenseAmortizedCarrying

Date10%12%Col. 2 Col. 1Value

1/01/07$9,275

12/31/07$1,000$1,113$1139,388

12/31/081,0001,1271279,515

12/31/091,0001,1421429,657

12/31/101,0001,1591599,816

12/31/11

1,000

1,184*

18410,000

Totals$5,000$5,725$725

*Amount needed to bring carrying value to face value.

PROBLEM 10-2 (Concluded)

2.Interest expense =$5,725

Cash interest payment =

5,000

Discount amortized = $7253.The effect on the accounting equation of the payment of interest and amortization of discount on December 31, 2009, is as follows:

Balance Sheet

income Statement


Cash (1,000)

Discount on

Interest Expense(1,142)

Bonds Payable142

Bonds payable

$10,000


343

$9,657

LO 5PROBLEM 10-3 AMORTIZATION OF PREMIUM

1.

Premium Amortization



CashInterestPremium



1/01/07$10,803

12/31/07$1,000$864$13610,667

12/31/081,00085314710,520

12/31/091,00084215810,362

12/31/101,00082917110,191

12/31/11

1,000

809*

19110,000

Totals$5,000$4,197$803




5,000

Premium amortized =$803PROBLEM 10-3 (Concluded)

3.The effect on the accounting equation of the payment of interest and the amortization of premium on December 31, 2009, is as follows:

Balance Sheet

income Statement


Cash

(1,000) Premium on

Interest Expense (842)

Bonds Payable (158)

Bonds payable

$10,000


362

$10,362

LO 6PROBLEM 10-4 REDEMPTION OF BONDS

1.Redemption price$200,000 1.01 = $202,000

Carrying value$200,000 + ($4,500 $1,000) =

203,500

Gain on redemption

$1,500

2.Redemption price$200,000 1.03 = $206,000

Carrying value$200,000 + $3,500 =

203,500

Loss on redemption

$2,500


4.Bonds are redeemed early only if it is advantageous to the issuing firm. However, early redemption is usually not favorable to the investor because it usually means the investor can no longer benefit from a favorable interest rate. To compensate the investor for foregone interest, as well as for the costs and inconvenience involved, the call price is normally set at an amount higher than 100.

LO 7PROBLEM 10-5 FINANCIAL STATEMENT IMPACT OF A LEASE

1.


LeaseInterestReduction of

PaymentExpenseObligationLease

Date

8%Col. 1 Col. 2Obligation

1/01/07$113,000

12/31/07$28,300$9,040$19,26093,740

12/31/0828,3007,49920,80172,939

12/31/0928,3005,83522,46550,474

12/31/1028,3004,03824,26226,212

12/31/1128,3002,08826,212*0

*Amount needed to pay off lease obligation.

2.The effect on the accounting equation of the lease transaction on January 1, 2007, is as follows:

Balance Sheet

income Statement


Leased Truck 113,000Lease Liability113,000

3.The effect on the accounting equation of the annual payment and interest expense on December 31, 2008, is as follows:

Balance Sheet

income Statement


Cash

(28,300)Lease Liability(20,801)


The effect on the accounting equation of the depreciation expense for the second year of the lease is as follows:

Balance Sheet

income Statement


Accumulated

Depreciation

Depreciation

Expense

Leased Truck(22,600)*

Leased Truck (22,600)

*$113,000/5 years = $22,600

PROBLEM 10-5 (Concluded)

4.Long-term assets:

Leased truck$113,000

Less: Accumulated depreciation

45,200*

$67,800

*$22,600 2 years = $45,200.

Current liabilities:

Lease liability$22,465


Lease liability$50,474LO 9PROBLEM 10-6 DEFERRED TAX (Appendix)

1.The effect on the accounting equation for income tax expense, deferred tax, and income tax payable for 2007 is as follows:

Balance Sheet

income Statement


Income Tax Payable120

Income Tax

Deferred Tax80

Expense(200)

2.The Deferred Tax account exists to reconcile the difference between the accounting done for tax purposes and that done for reporting to stockholders, also referred to as book purposes. The balance of the Deferred Tax account represents all temporary differences between book and tax accounting reflected at the corporate tax rate. The amount of the temporary differences is entered into the Deferred Tax account when it originates. In theory, the items will be removed from the account when they reverse, and the balance of the account will be reduced at that time.

The current provision for tax of $120 represents the amount paid or payable to the government for 2007 taxes. The deferred portion of $80 represents the increase in the balance of the Deferred Tax account.

The deferred amount of $80 in the note represents the entry to deferred tax during the current year. The amount of $180 in the liability category of the balance sheet represents the year-end balance of the account.

LO 9PROBLEM 10-7 DEFERRED TAX CALCULATIONS (Appendix)

1.2005Income before taxes$210,000

Less: Excess of tax depreciation over

book depreciation ($50,000 $26,667*)

(23,333)

Taxable income$186,667

Tax paid or payable (35%)$65,333

*($88,000 $8,000)/3 years = $26,667.

2006Income before taxes$240,000

Plus: Excess of book depreciation over

tax depreciation ($26,667 $20,000)

6,667






16,667



2.2005Income before taxes$210,000

Income tax expense (35%)$73,500





3.


Income TaxIncome TaxCol. 1 Deferred Tax

YearExpensePayableCol. 2Account

2005$73,500$65,333$8,167$8,167 credit

200684,00086,3332,3335,834 credit

200798,000103,8335,834*0

*Difference due to rounding.

MULTI-CONCEPT PROBLEMS

LO 4,5PROBLEM 10-8 BOND TRANSACTIONS

1.The effect on the accounting equation of the April 1, 2007, issuance of the bonds is as follows:

Balance Sheet

income Statement


Cash

1,000,000 Bonds

Payable 1,000,000

2.The effect on the accounting equation of the October 1, 2007, interest payment is as follows:

Balance Sheet

income Statement


Cash

(60,000)

Interest

Expense (60,000)*

*$1,000,000 ( 12% ( 6/12 = $60,000

3.Additional interest must be recorded on December 31 to accrue interest for the time period of October 1December 31. The interest should be recorded as an expense when it is incurred under the accrual accounting process. The accrual does not affect the amount of interest paid on April 1, 2008. A full semiannual payment of $60,000 should occur on that date.

4.Total cash inflow to Brand

$1,000,000

Total cash outflow:

Interest $60,000 16 payments$960,000

Principal

1,000,000

Total outflow

1,960,000

Difference

$960,000

LO 1,9PROBLEM 10-9 PARTIAL CLASSIFIED BALANCE SHEET FOR WALGREENS

1.The following is the liabilities section of the consolidated balance sheet of Walgreens at August 31, 2004. (All amounts are in millions.)

CurrentTrade accounts payable$2,641.5

LiabilitiesAccrued expenses and other liabilities1,370.5

Income taxes payable

65.9

Total current liabilities$4,077.9

Long-TermDeferred income tax$274.1

LiabilitiesOther noncurrent liabilities

850.4

Total long-term liabilities$1,124.5

2.Computation of debt-to-equity ratios:

2003:$4,539.0/$7,117.8 = 0.64

2004:$5,202.4/$8,139.7 = 0.64

Walgreens debt-to-equity ratio has stayed the same from 2003 to 2004. This means that the company has maintained a stable financing pattern from year to year. Most investors would prefer a decrease rather than an increase in this ratio over time. Debt has fixed repayment terms, and its repayment must include interest. Equity never has to be repaid, and dividend payments are optional. Also, the debt represents a claim on the companys assets. In the event of liquidation, this claim would need to be repaid before any assets are distributed to stockholders. However, overall Walgreens is a very safe company with a low level of debt compared to most other companies.

3.Walgreens lenders want to be sure that the company can repay the principal and pay the interest on the loan. They would be interested in Walgreens times interest earned and debt service coverage ratios. Both ratios measure the degree to which a company can make its debt payments out of current cash flows.

alternate problems

LO 3PROBLEM 10-1A FACTORS THAT AFFECT THE BOND ISSUE PRICE

1.a.The bonds would be issued at par, since the face or coupon rate is equal to the market rate of interest.

b.The bonds would be issued at a premium in this situation because investors would bid the price upward on a bond with a 5% return. Since the cash flows are fixed, the investment must be increased to decrease the effective interest rate.

2.a.$500,0000.610(n = 20, i = 2 1/2%) = $305,000

$12,500*15.599(n = 20, i = 2 1/2%) =

194,988

Total

$499,988**

*$500,000 5% 6/12 = $12,500.

**Should be $500,000; difference is due to rounding.

Note: The tables provided with the text do not give values for 2 1/2%. Students must find the values by using a calculator or by interpolating the values in the existing tables.

b.$500,0000.676(n =10, i = 4%) = $338,000

$25,000*8.111(n =10, i = 4%) =

202,775

Total

$540,775

*$500,000 5% = $25,000.

LO 5PROBLEM 10-2A AMORTIZATION OF DISCOUNT

1.

Discount Amortization



CashInterestDiscount



1/01/07$44,011

12/31/07$2,500$3,521$1,02145,032

12/31/082,5003,6031,10346,135

12/31/092,5003,6911,19147,326

12/31/072,5003,7861,28648,612

12/31/11

2,500

3,888*

1,38850,000

Totals$12,500$18,489$5,989




12,500

Discount amortized =$5,989

3.The effect of on the accounting equation of the payment of interest on December 31, 2009, is as follows:

Balance Sheet

income Statement


Cash

(2,500) Discount on


Bonds Payable1,191

Bonds payable

$50,000


2,674

$47,326LO 5PROBLEM 10-3A AMORTIZATION OF PREMIUM

1.

Premium Amortization



CashInterestPremium



1/01/07$52,230

12/31/07$2,500$2,089$41151,819

12/31/082,5002,07342751,392

12/31/092,5002,05644450,948

12/31/102,5002,03846250,486

12/31/11

2,500

2,014*

48650,000

Totals$12,500$10,270$2,230


2.Interest expense = $10,270


12,500

Premium amortized = $2,230


Balance Sheet

income Statement


Cash

(2,500) Premium on


Bonds Payable(444)

Bonds payable

$50,000

Add: Premium on bonds payable

948

$50,948

LO 6PROBLEM 10-4A REDEMPTION OF BONDS

1.Redemption price $100,000 1.01 = $101,000

Carrying value $100,000 + ($5,500 $2,000) =

103,500

Gain on redemption$2,500

2.Redemption price $100,000 1.04 = $104,000

Carrying value $100,000 + $3,500 =

103,500

Loss on redemption$500


4.Bonds are redeemed early only if it is advantageous to the issuing firm. However, early redemption is usually not favorable to the investor because it usually means the investor can no longer benefit from a favorable interest rate. To compensate the investor for foregone interest, as well as for the costs and inconvenience involved, the call price is normally set at an amount higher than 100.

LO 7PROBLEM 10-5A FINANCIAL STATEMENT IMPACT OF A LEASE

1.


LeaseInterestReduction of

PaymentExpenseObligationLease

Date

9%Col. 1 Col. 2Obligation

1/01/07$98,600

12/31/07$21,980$8,874$13,10685,494

12/31/0821,9807,69414,28671,208

12/31/0921,9806,40915,57155,637

12/31/1021,9805,00716,97338,664

12/31/1121,9803,48018,50020,164

12/31/1221,9801,81620,164*0

*Rounded to bring carrying value to zero.

2.The effect on the accounting equation of the lease transaction on January 1, 2007, is as follows:

Balance Sheet

income Statement


Leased Lease Liability 98,600

Machine98,600PROBLEM 10-5A (Concluded)

3.The effect on the accounting equation of the December 31, 2008, annual payment and interest expense is as follows:

Balance Sheet

income Statement


Cash

(21,980)Lease Liability(14,286)


The effect on the accounting equation of the December 31, 2008, depreciation expense is as follows:

Balance Sheet

income Statement


Accumulated

Depreciation

Depreciation

Expense

Leased Machine (16,433)

Leased

Machine (16,433)

4.Long-term assets:

Leased machine$98,600

Less: Accumulated depreciation

32,866*

$65,734

*$16,433 2 years = $32,866.


Lease liabilitycurrent portion$15,571


Lease liability$55,637LO 9PROBLEM 10-6A DEFERRED TAX (Appendix)

1.The effect on the accounting equation of the December 31, 2007, income tax expense, deferred tax, and income tax payable is as follows:

Balance Sheet

income Statement


Income Tax Payable120

Income Tax

Deferred Tax(20)

Expense(100)

2.The Deferred Tax account exists to reconcile the difference between the accounting done for tax purposes and that done for reporting to stockholders, also referred to as book purposes. The balance of the Deferred Tax account represents all temporary differences between book and tax accounting reflected at the corporate tax rate. The amount of the temporary differences is entered into the Deferred Tax account when it originates. In theory, the items will be removed from the account when they reverse and the balance of the account will be reduced at that time.

LO 9PROBLEM 10-7A DEFERRED TAX CALCULATIONS (Appendix)

1.Year 1Income before taxes$120,000

Less: Tax-exempt income(5,000)

Less: Excess of tax depreciation over book

depreciation ($30,000 $20,000)

(10,000)


Taxes paid or payable (40%)$42,000

Year 2Income before taxes$120,000




0


Taxes paid or payable (40%)$46,000

Year 3Income before taxes$120,000




10,000


Taxes paid or payable (40%)$50,000PROBLEM 10-7A (Concluded)

2.The Deferred Tax account for Years 13 would contain the following information:

Year 1 entry:Tax expense greater than

tax payable $10,000 40%= $4,000 credit

Year 1 balance

= $4,000 credit, a liability

Year 2 entry:

= 0

Year 2 balance

= $4,000 credit, a liability

Year 3 entry:Tax payable greater than

tax expense $10,000 40%= $4,000 debit

Year 3 balance

= 0

The account would not appear on the balance sheet at the end of Year 3.

ALTERNATE MULTI-CONCEPT PROBLEMS

LO 4,6PROBLEM 10-8A FINANCIAL STATEMENT IMPACT OF A BOND

1.The effect on the accounting equation of the July 1, 2007, issuance of the bonds is as follows:

Balance Sheet

income Statement


Cash 916,200 Bonds

Payable 1,000,000

Discount on

Bonds Payable (83,800)

$50,000* ( 8.384 (Table 9-4, n = 12, i = 6%) = $419,200

$1,000,000 ( 0.497 (Table 9-2, n = 12, i = 6%) =

497,000

$916,200*$1,000,000 ( 10% ( 6/12 = $50,000

PROBLEM 10-8A (Concluded)

2.The effect on the accounting equation of the December 31, 2007, accrual of interest is as follows:

Balance Sheet

income Statement


Interest Payable 50,000

Interest

Discount on

Expense (54,972)*

Bonds Payable 4,972**

*$916,200 ( 6% = $54,972

**Discount amortized = $54,972 $50,000 = $4,972

3.The effect on the accounting equation of the January 1, 2008, interest payment is as follows:

Balance Sheet

income Statement


Cash

(50,000)Interest

Payable (50,000)

4.On the maturity date, July 1, 2013, the balance in Discount on Bonds Payable will have been reduced to zero. The only remaining amount to be paid is the principal on the bond as shown in the Bonds Payable account, $1,000,000.

LO 1,9PROBLEM 10-9A PARTIAL CLASSIFIED BALANCE SHEET FOR BOEING

1.The following is the liabilities section of the consolidated balance sheet of Boeing Inc. at December 31, 2004. (All amounts are in millions.)

Liabilities


Accounts payable and other liabilities$14,869

Income tax payable522

Short-term debt and current portion of long-term debt1,321

Advances in excess of related costs

4,123

Total current liabilities$20,835

Long-term debt$10,879

Accrued retiree healthcare5,959

Deferred income taxes1,090

Deferred lease income745

PROBLEM 10-9A (Concluded)

2.Computation of debt-to-equity ratios:

2003

$44,847/$8,139 = 5.51 to 1

2004

($20,835 + $10,879 + $5,959 + $1,090 + $745)/$11,286 = $39,508/$11,286 = 3.50 to 1

Boeings debt-to-equity ratio has decreased somewhat during 2004. This means that Boeing has less debt for each dollar of equity: $5.51 of debt per $1 of equity in 2003 compared with $3.50 of debt per $1 of equity in 2004. Most investors would prefer a decrease rather than an increase in this ratio. Debt has fixed repayment terms, and its repayment must include interest. Equity never has to be repaid, and dividend payments are optional. Also, the debt represents a claim on the companys assets. In the event of liquidation, this claim would need to be repaid before any assets are distributed to stockholders. Overall, the debt-to-equity ratio is fairly high and indicates the company has a high level of debt.

3.Boeings lenders want to be sure that the company can repay the principal and pay the interest on the loan. They would be interested in Boeings times interest earned and debt service coverage ratios. Both ratios measure the degree to which a company can make its debt payments out of current cash flows.

DECISION CASES

READING AND INTERPRETING FINANCIAL STATEMENTS

LO 1,7DECISION CASE 10-1 EVALUATING THE LIABILITIES OF FOOT LOCKER

1. Foot Locker has the following long-term liabilities:

Long-term debt and obligations under capital leasesdecreased from 2004 to 2005

Other Liabilitiesdecreased from 2004 to 2005

2.Debt-to-equity ratio for 2004: $1,407/$1,830 = 0.77

Debt-to-equity ratio for 2005: $1,285/$2,027 = 0.64

Times interest earned for 2004: $427/$15 = 28.47 times

Times interest earned for 2005: $416/$10 = 41.60 times

The company made improvements in its capital structure from 2004 to 2005. The debt-to-equity ratio decreased markedly, indicating the company has less debt and more equity. The times interest earned ratio increased from 2004 to 2005, indicating the company has a greater ability to make its interest payments on its existing debt. The company has low levels of debt so the times interest earned ratio is quite good in both years.

LO 8DECISION CASE 10-2 READING FINISH LINES AND FOOT LOCKERS STATEMENT OF CASH FLOWS

1.The major source of cash in the financing activities category for Foot Locker was the issuance of common stock. The major source for Finish Line was also the issuance of common stock.

2.A negative amount related to debt in the cash flow statement indicates that Foot Locker used cash to pay off or redeem debt during the year. The major use of cash in the financing activities category for Foot Locker was the payment of dividends. The major use of cash in the financing activities category for Finish Line was the purchase of treasury stock.

3.Finish Line did not use any cash to retire or redeem debt during the year.

LO 8,9DECISION CASE 10-3 READING PEPSICOS STATEMENT OF CASH FLOWS

1.Proceeds from debt is a positive amount on the cash flows statement because it indicates that the company has incurred a loan and received cash. Payment of debt is a negative amount because it indicates that the company has used cash to repay a loan or other form of debt.

2.When interest rates decline, companies often pay off loans that carry interest at a rate that is higher than the current rate. It makes good economic sense to pay off loans that have a high rate of interest because money borrowed at the current rate of interest will be less than the rate on debt that was incurred previously.

3.When a company has a Deferred Income Tax account, an increase in the account should be presented as a negative on the cash flows statement because it indicates that the amount of taxes actually paid was more than the amount reflected in the net income amount presented in the Operating Activities section of the balance sheet.

Changes in the Deferred Income Tax account should be presented in the Operating Activities section of the cash flows statement because it is related to operating activities and affects the net income amount.

MAKING FINANCIAL DECISIONS

LO 1DECISION CASE 10-4 MAKING A LOAN DECISION

1.The banks policy is that a 2-to-1 ratio of assets to debt must be maintained. The note in Molitors annual report indicates that generally accepted accounting principles do not require the item to be recorded. This is an example of an off-balance-sheet financial arrangement. A strict interpretation of the policy and the accounting principle does not require the item to be recorded, and the ratio is $660,000/$300,000 = 2.2. If the amount is included, the ratio is $860,000/$500,000 = 1.7.

2.The bank should adopt a more flexible policy to consider those financing techniques that are off-balance-sheet. However, it is very difficult to develop a policy that accommodates the wide variety of financial arrangements that fall into this category. Some are, in substance, liabilities and should be considered as such. Others are not liabilities and are more appropriately excluded from the banks policy.

LO 6 DECISION CASE 10-5 BOND REDEMPTION DECISION

TO:Controller

FROM:Student Name

RE:Retirement of Outstanding Bonds

The outstanding bonds have increased in value because they pay 10% in a market that requires only a 4% return. The holders of these instruments would sell them for $148,710 ($100,000 0.676) + ($100,000 10% 8.111). The company is required to pay this amount for the bonds in order to purchase them from the bondholders. If the company issues bonds at 4%, the new issuance will yield the company $100,000. The company would be required to use $48,710 of working capital to reissue the bonds at the lower rate. The benefit to the company is that in the future 10 years, the company is required to pay only $4,000 each year rather than $10,000 in annual interest. Discounting the savings of $6,000 per year yields a net benefit to the company of $48,710 ($6,000 8.111 rounded). I recommend that the company retire the outstanding bonds and reissue the bonds at the lower rate in order to reduce future cash outflow.

It should be noted that if the company had issued the original bonds with a call price of less than 148.71, the company would be able to call the bonds at lower than market.

ACCOUNTING AND ETHICS: WHAT WOULD YOU DO?

LO 7DECISION CASE 10-6 DETERMINATION OF ASSET LIFE

1.The purpose of the case is to illustrate the judgment necessary in recording leases. Even though criteria exist that govern lease accounting, significant judgment is necessary in the application of the criteria. If Jen believes that the first source of information is valid, she should record the lease as a capital lease. If the trade publication is more valid, she should record the lease as an operating lease. Jen should gather additional information and consult other experts or opinions in forming her decision. However, in the final analysis, she must make an informed decision that represents her best professional judgment.

2.In this case, either judgment can be supported provided that it represents Jens best professional judgment using all available information. If, however, Jen decides the issue because Hales does not want the lease recorded as a capital lease, then probably she is acting unethically. Accounting decisions should be based on the substance of the transaction and should not be based on a desire to achieve a certain objective, such as a desire to hide information or a desire to please ones boss.

REAL WORLD PRACTICE 10.1

Long-Term Debt decreased, while Deferred Income Taxes and Other Liabilities increased.

REAL WORLD PRACTICE 10.2

Debt to equity ratio for 2004: $189,048/$385,971 = 0.49

Debt to equity ratio for 2005: $199,274 /$428,542 = 0.47

The ratio decreased slightly, indicating an improved level of solvency for the company. Overall, the companys level of debt is fairly low.

10-1

porter sm ch. 10_2pp (1)

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