Accounting what the numbers mean 9th edition marshall solutions manual

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Chapter 07 - Accounting for and Presentation of Liabilities

CHAPTER

7

Accounting for and Presentation of Liabilities

CHAPTER OUTLINE: I. Current Liabilities A. Short-term debt 1. Used to finance working capital needs 2. Interest calculation methods (Business in Practice) 3. Interest accrual B. Current maturities of long-term debt C. Accounts payable D. Unearned revenue or deferred credits E. Payroll tax and other withholdings F. Other accrued liabilities II. Noncurrent Liabilities A. Long-term debt 1. Financial leverage illustrated 2. Accounting for bonds payable a. Original issuance b. Recognition of interest expense c. Retirements and conversions 3. Bond discount or premium 4. Bond characteristics, classifications and terminology a. By how interest is paid b. By security c. By how principal is paid B. Deferred tax liabilities 1. An application of the accrual and matching concepts C. Other noncurrent liabilities 1. Pension plan obligations 2. Post-retirement benefits other than pensions 3. Estimated liabilities for lawsuits, warranties, etc.

7-1

Chapter 07 - Accounting for and Presentation of Liabilities

TEACHING/LEARNING OBJECTIVES: Principal: 1. To have the student understand that a principal concern about the liability section of the balance sheet is that liabilities are not understated, because if liabilities are too low, then expenses will probably be too low also, and net income will be overstated.

2. To have the student understand the nature of a bond payable, and to learn why the market value of a bond moves inversely with changes in interest rates.

3. To have the student understand the concept of financial leverage.

Supporting: 4. To have the student understand different interest calculation methods.

5. To reinforce the student's understanding of the accrual and matching concepts.

6. To review cash discount terms and have the student understand the internal control benefits of recording purchases using the net method.

7. To have the student understand the characteristics of a bond.

8. To have the student understand bond premium and discount.

9. To have the student understand the nature of the liability for deferred income taxes, and to be able to relate it to the difference between book and tax depreciation.

TEACHING OBSERVATIONS/ASSIGNMENT SUGGESTIONS: 1. A review of the accrual and matching concepts in the context of liabilities and expenses should help students understand the first principal objective of accounting for liabilities. Exercises 7-3 through 7-6 (and Case 7-29) focus on the issue of accruing expenses so that liabilities are not understated and net income is not overstated. Exercises 7-7 and 7-8, and Problems 7-23 and 7-24, are concerned with the opposite issue--reducing “unearned revenue” liabilities for the revenue that has been earned.

7-2

Chapter 07 - Accounting for and Presentation of Liabilities

TEACHING OBSERVATIONS/ASSIGNMENT SUGGESTIONS: (continued) 2. The discussion of interest calculation methods is an opportunity to apply the present value concept introduced in the Chapter 6 Appendix. See Exercises 7-1 and 7-2.

3. The discussion of the net and gross methods of recording purchases is an opportunity to review transaction analysis, and to integrate that process with the system of internal control, introduced in Chapter 5.

4. Financial leverage should be put into a context that the student understands. For example, students may invest the student loan proceeds not immediately needed for tuition into a savings account. The discussion should reinforce their understanding of both ROI and ROE. 5. The coverage of bonds can be related both to students' future investment opportunities, and to current market interest rates and bond price reactions. Reference to the bond listing in The Wall Street Journal is appropriate and helpful.

6. In our opinion, present value tables should be used to explain bond premium and discount.

Students are frequently confused about whether to use the stated rate or the market interest rate to calculate cash flows and present value--the distinction between these two rates must be emphasized. Exercises 7-9 through 7-14 and Problems 7-25 through 7-28 cover a variety of issues related to bonds.

7. Have students review the liability section of the balance sheet of the annual report that they obtained or were provided, and determine the significance of deferred taxes. A real world example may help them to better understand this item.

8. Cases 7-29 and 7-30 can be used to help students develop an ability to read and understand financial statement data; they also reinforce a lot of terminology introduced in this chapter.

9. Problem 7-24 (optional continuation) provides an opportunity to illustrate the use of present value analysis in a management decision-making context.

7-3

Chapter 07 - Accounting for and Presentation of Liabilities

ASSIGNMENT OVERVIEW: NO. E7.1.

E7.2.

LEARNING OBJECTIVES 2 2

DIFFICULTY & TIME ESTIMATE Easy, 5-8 min.

Med., 7-10 min.

E7.3.

E7.4.

E7.5.

E7.6.

4 5 5 5

Easy, 5-8 min.

Easy, 5-8 min.

Easy, 3-5 min.

Med., 5-8 min.

E7.7.

3

Med., 7-10 min.

E7.8.

E7.9.

E7.10.

E7.11.

3 8 8 8

Easy, 3-5 min.

Med., 7-10 min.

Med., 7-10 min.

Med., 10-12 min.

E7.12.

E7.13.

E7.14.

E7.15.

E7.16.

E7.17.

E7.18.

E7.19.

8 8 8 9 6 4,5,8 4,5,8 1,2,5,8,9

Med., 10-12 min.

Easy, 3-5 min.

Easy, 3-5 min.

Med, 5-8 min.

Med., 5-8 min.

Easy-Med., 5-8 min Easy-Med., 5-8 min Easy-Med., 5-8 min.

OTHER COMMENTS Straight-forward.

Students sometimes have difficulty with the math. Stress that the $8,000 discount represents only 5/12 of the year—not the amount that would be charged for a full year.

Emphasize the matching concept.

Alternative to E7.3.

Straight-forward.

Good in-class demonstration exercise. Emphasize the financial statement effects of the accrual and payment entries.

Emphasize the liability-revenue relationship rather than the specific account titles.

Good in-class demonstration exercise.

Easy way to introduce bonds.

See E7.9. Good homework assignment.

Explain that you still have to “price” the bond with present value analysis; however, the remaining bond term is less.

See E7.11. Good in-class demonstration or homework exercise.

Straight-forward conceptual bonds problem.

See E7.13.

Good theory question.

Review Exhibit 7-2.

Excellent exercise for self-study / review.

See E7.17.

See E7.17.

E7.20.

5,8

Easy-Med., 5-8 min.

See E7.17.

P7.21.

3

Med., 5-8 min.

Straight-forward.

P7.22.

3

P7.23.

P7.24.

4 4

Med.-Hard, 12-15 min.

Easy, 5-8 min.

Med., 10-15 min.

P7.25.

7

Hard, 12-15 min.

P7.26.

P7.27.

P7.28.

C7.29.

C7.30.

7 8 8 1,5,7,8 5,7,8

Hard, 12-15 min.

Med., 10-15 min.

Med., 10-15 min.

Med., 10-12 min.

Hard, 12-15.

Group learning problem. Generates class discussion, and provides an opportunity to reinforce present value concepts.

Straight-forward.

Distinguish clearly between the entries for: 1) accrued payroll (i.e., gross pay to employees), versus 2) accrued payroll taxes (i.e., employer taxes).

Group learning problem. Provided for instructors wishing to delve into bond details. Needs instructor support/clarification.

Group learning problem. See P7.25.

Have students review Exhibit 7-3 before attempting this problem.

Good homework assignment.

Group learning problem. Good homework assignment.

Group learning problem. Real world financial reporting!

7-4

Chapter 07 - Accounting for and Presentation of Liabilities

SOLUTIONS: Matching I 1.

2.

3.

4.

5.

q c a g b

Matching II 6.

7.

8.

9.

10.

k i p n m

6.

7.

8.

9.

10.

e b c d e

1.

2.

3.

4.

5.

i b h o k

6.

7.

8.

9.

10.

m e n j c

Multiple Choice 1.

2.

3.

4.

5.

a e e e c

Multiple Choice Annotations: 1. Interest owed on short-term notes would be an example of an accrued liability, but the Notes Payable itself is recorded when money is borrowed. All of the other answers are examples of amounts that are accrued.

6. Mere negotiations are not enough to justify the recording of a liability because an exchange transaction has not yet taken place. Liabilities are the result of “past transactions or events.”

8. If the market interest rate rises after the bonds are authorized but before they are issued, investors will not be willing to pay the full face amount for the bonds—because they could earn a higher interest rate by investing in the bonds of another similar company.

Thus, the bonds will sell at a discount.

9. Property Taxes Payable would also increase (credit).

7-5

Chapter 07 - Accounting for and Presentation of Liabilities

E7.1. a. Discount basis means interest is paid in advance.

Proceeds = Face amount of note - Interest = $300,000 - ($300,000 * 9% * 6/12) = $300,000 - $13,500 = $286,500

Balance Sheet Income Statement .

Assets = Liabilities + Owners’ Equity  Net income = Revenues - Expenses Cash + 286,500

Notes Payable + 300,000 Discount on Notes Payable - 13,500

(Note: The discount account is a contra liability, so the initial carrying value of the note is equal to the cash proceeds received--which is the approach taken when interest is calculated on a straight basis.)

April 15, 2010 Dr. Cash ...........................................................................................

Dr. Discount on Notes Payable ........................................................

Cr. Notes Payable......................................................................

286,500 13,500 300,000

To record the proceeds of a short-term note payable (discount basis).

b. The note was dated April 15, 2010, so 2.5 months have passed from the time the note was signed until the June 30, 2010 fiscal year-end. Interest = $300,000 * 9% * 2.5/12 = $5,625 c. Current liability = Face amount less discount balance. = $300,000 - ($13,500 - $5,625) = $300,000 - $7,875 = $292,125 E7.2. a. Discount = Principal (Maturity value) – Proceeds = $240,000 - $232,000 = $8,000 Discount rate = Discount / (Principal * Time) = $8,000 / ($240,000 * 5/12) = 8% b. Effective rate = Discount / (Proceeds * Time) = $8,000 / ($232,000 * 5/12) = 8.3%

7-6

Chapter 07 - Accounting for and Presentation of Liabilities

E7.2.

(continued) c.

Balance Sheet Income Statement .

Assets = Liabilities + Owners’ Equity  Net income = Revenues - Expenses 1. On August 1, 2010 to record loan proceeds: Cash + 232,000

Notes Payable + 240,000 Discount on Notes Payable - 8,000

(Note: The discount account is a contra liability, so the initial carrying value of the note is equal to the cash proceeds received.)

2. On September 30, 2010 (and each month-end) to record interest expense: Discount Note Payable (Note: A reduction of the discount + 1,600 increases the carrying value.)

Interest Expense - 1,600

3. On December 31, 2010 to record principal repayment: Cash Notes Payable - 240,000 - 240,000

Journal entries: 1. August 1, 2010 Dr. Cash ...........................................................................................

Dr. Discount on Notes Payable ........................................................

Cr. Notes Payable......................................................................

232,000 8,000 240,000

To record the proceeds of a short-term note payable (discount basis).

2. September 30, 2010 Dr. Interest Expense ($240,000 * 8% * 1/12) ..................................

Cr. Discount on Notes Payable .....................................………

1,600 1,600

To record interest expense and discount amortization for one month.

3. December 31, 2010 Dr. Notes Payable ................................................................………

Cr. Cash.........................................................................………

To record the repayment of a short-term note. The discount is amortized for $1,600 each month, and would be fully amortized at the maturity date.

7-7

240,000 240,000

Chapter 07 - Accounting for and Presentation of Liabilities

E7.3. a.

Balance Sheet Income Statement .

Assets = Liabilities + Owners’ Equity  Net income = Revenues - Expenses Payroll Taxes Payable + 4,800

Payroll Tax Expense - 4,800

3/31/10 Dr. Payroll Tax Expense ..................................................................

Cr. Payroll Taxes Payable .........................................................

4,800 4,800

To accrue payroll taxes for the year.

b. Failure to make the accrual resulted in an understatement of expense and an overstatement of net income. On the 3/31/10 balance sheet, current liabilities are understated and the retained earnings account is overstated. c.

3/31/10

3/31/11 X

X Paid taxes of prior year in April; debited expense for $4,800 this year.

Should have recognized $5,000 expense this year.

Effect on net income for year ended 3/31/11:

Expense is too high by amount applicable to prior year: $4,800 Expense is too low by accrual not made this year: $5,000 Net effect is that expense this year is $200 too low, and profits this year are $200 too high.

Effect on the 3/31/11 balance sheet:

Current liabilities are $5,000 understated and the retained earnings account is $5,000 overstated.

E7.4. a. The amount is estimated based on prior year taxes, or based on the known assessed valuation and expected tax rate. b.

Balance Sheet Income Statement .

Assets = Liabilities + Owners’ Equity  Net income = Revenues - Expenses Real Estate Taxes Payable + 7,200

Real Estate Tax Expense - 7,200

Dr. Real Estate Tax Expense ...........................................................………

Cr. Real Estate Taxes Payable ..............................................................

To accrue real estate taxes for the year.

7-8

7,200 7,200

Chapter 07 - Accounting for and Presentation of Liabilities

E7.4.

(continued) c.

Balance Sheet Income Statement .

Assets = Liabilities + Owners’ Equity  Net income = Revenues - Expenses Real Estate Taxes Payable + 300

Real Estate Tax Expense - 300

Dr. Real Estate Tax Expense ...........................................................………

Cr. Real Estate Taxes Payable ..............................................................

300 300

To adjust the real estate taxes accrual.

d. Current liabilities at 12/31/10 and expenses for 2010 would both be understated by $7,200, or by $7,920 ($7,200 * 1.10) if it is assumed that $7,200 is the amount of prior year taxes.

E7.5. a. Warranty Expense = ($7,200,000 sales * 0.4% estimated warranty expense) = $28,800 b. Estimated Warranty Liability, 1/1/10 balance ...................................……...

Less: Actual warranty costs during 2010 .......................................................

Add: Warranty Expense accrued during 2010 ...................................……...

Estimated Warranty Liability, 12/31/10 balance ...........................................

$70,400 (31,200) 28,800 $68,000

E7.6. a. 2010 estimated warranty expense = $4,600,000 * 0.2% = $9,200 Balance Sheet Income Statement .

Assets = Liabilities + Owners’ Equity  Net income = Revenues - Expenses To accrue estimated warranty expense: Estimated Warranty Liability + 9,200

Warranty Expense - 9,200

To record the actual costs of servicing products under warranty.

Cash Estimated Warranty and/or Liability Inventory - 12,700 - 12,700

7-9

Chapter 07 - Accounting for and Presentation of Liabilities

E7.6.

(continued) a. Dr. Warranty Expense ......................................................................

Cr. Estimated Warranty Liability ..............................................

9,200 9,200

To accrue estimated warranty expense for the year.

Dr. Estimated Warranty Liability ....................................................

Cr. Cash or Inventory ................................................................

To record the actual costs of servicing products under warranty .

12,700 12,700

b. At the end of 2010 an adjustment should be made to increase the warranty expense already recognized to the amount of cost incurred, and to accrue additional estimated warranty expense related to other items sold in 2010 that are still under warranty. c. The amount of this adjustment could be determined by an analysis of the experience of 2010 and an analysis of the reasons for the larger than expected warranty claims.

E7.7. a. Keg deposits are a current liability on the balance sheet because they are amounts that are likely to be paid within a year. b.

Balance Sheet Income Statement .

Assets = Liabilities + Owners’ Equity  Net income = Revenues - Expenses Cash - 50

Keg Deposits - 50

Dr. Keg Deposits ..............................................................................

Cr. Cash.........................................................................………

50 50

To record the refund of keg deposits.

c.

The Keg Deposits liability for the 200 kegs (200 * $50 = $10,000) should be eliminated with a debit; an income statement account (such as Keg Deposits Revenue) should be credited.

Balance Sheet Income Statement .

Assets = Liabilities + Owners’ Equity  Net income = Revenues - Expenses To eliminate the liability for unreturned kegs: Keg Deposits - 10,000

Keg Deposits Revenue +10,000

Dr. Keg Deposits ..............................................................................

Cr. Keg Deposits Revenue ........................................................

To eliminate the liability for unreturned kegs.

7-10

10,000 10,000

Chapter 07 - Accounting for and Presentation of Liabilities

E7.7.

(continued) d. The cost of kegs purchased would be capitalized in a noncurrent asset account, and then be depreciated over the kegs' estimated useful life. The net book value of kegs removed from service or lost (as in part c) would be removed from the asset and recorded as an expense (or a loss).

Balance Sheet Income Statement .

Assets = Liabilities + Owners’ Equity  Net income = Revenues - Expenses To record a loss for the net book value of unreturned kegs: - Kegs + Accumulated Depreciation

- Keg Expense (or Unreturned Kegs Loss)

Dr. Keg Expense (or Loss on Unreturned Kegs) ............................

Dr. Accumulated Depreciation ........................................................

Cr. Kegs (or other appropriate asset account) ...........................

xxx xxx xxx

To record a loss for the net book value of unreturned kegs.

E7.8. a.

Balance Sheet Income Statement .

Assets = Liabilities + Owners’ Equity  Net income = Revenues - Expenses Cash + 302,400

Unearned Ticket Revenue + 302,400

Dr. Cash (1,200 tickets @ $ 252)......................................................

Cr. Unearned Ticket Revenue ....................................................

302,400 302,400

To record the cash collection for season ticket sales made in advance.

b.

Balance Sheet Income Statement .

Assets = Liabilities + Owners’ Equity  Net income = Revenues - Expenses Unearned Ticket Revenue - 50,400

Ticket Revenue + 50,400

Dr. Unearned Ticket Revenue (200 tickets @ $252) .......................

Cr. Ticket Revenue ....................................................................

To record revenues earned for presenting an event.

c. The unearned revenues are a current liability.

7-11

50,400 50,400

Chapter 07 - Accounting for and Presentation of Liabilities

E7.9. a. The market interest rate is lower than the stated interest rate, so the bonds will sell for more than their face amount. The lower the discount rate (i.e., market interest rate), the higher the present value of cash flows associated with the bond (for interest payments and principal) becomes. Buyers are willing to pay a premium for the right to receive more interest than they could get in the marketplace for a bond of similar risk and maturity. b.

Balance Sheet Income Statement .

Assets = Liabilities + Owners’ Equity  Net income = Revenues - Expenses Cash +1,080,000

Bonds Payable +1,000,000 Premium on Bonds Payable +80,000

Dr. Cash ........................................................................................... 1,080,000 Cr. Bonds Payable ......................................................................

1,000,000 Cr. Premium on Bonds Payable .....................................………

80,000 To record the issuance of bonds payable at a premium.

c.

| 4/1/10 Bonds issued.

| 6 months

| 9/30/10 End of fiscal year.

Accrued interest payable ($1,000,000 * 11% * 6/12) ....................................

Premium amortization ($80,000 / 20 years * 6/12) ...............………............

Interest expense for 6 months ................................................………............

$55,000 (2,000) $53,000

Balance Sheet Income Statement .

Assets = Liabilities + Owners’ Equity  Net income = Revenues - Expenses Interest Payable +55,000 Premium on Bonds Payable -2,000

Interest Expense -53,000

Dr. Interest Expense ........................................................................

Dr. Premium on Bonds Payable ...............................………............

Cr. Interest Payable ............................................………............

To record the accrual of interest and premium amortization for 6 months.

7-12

53,000 2,000 55,000

Chapter 07 - Accounting for and Presentation of Liabilities

E7.10. a. The market interest rate is higher than the stated interest rate, so the bonds will sell for less than their face amount. The higher the discount rate (i.e., market interest rate), the lower the present value of cash flows associated with the bond (for interest payments and principal) becomes. b.

Balance Sheet Income Statement .

Assets = Liabilities + Owners’ Equity  Net income = Revenues - Expenses Cash Bonds Payable +29,640,000 +30,000,000 Discount on Bonds Payable -360,000

Dr. Cash ............................................................................... 29,640,000 Dr. Discount on Bonds Payable ............................................

360,000 Cr. Bonds Payable ..........................................................

30,000,000

To record the issuance of bonds payable at a discount.

c. Accrued interest payable ($30,000,000 * 9% * 4/12) ....................................

Discount amortization ($360,000 / 10 years * 4/12)..............………............

Interest expense for 4 months ........................………....................................

$900,000 12,000 $912,000

Balance Sheet Income Statement .

Assets = Liabilities + Owners’ Equity  Net income = Revenues - Expenses Effect of interest accrual on financial statements: Discount on Bonds Payable +12,000 Interest Payable +900,000

Dr. Interest Expense ........................................................................

Cr. Interest Payable ...........................................………............

Cr. Discount on Bonds Payable ........................………............

To record the accrual of interest and discount amortization for 4 months.

7-13

Interest Expense -912,000

912,000 900,000 12,000

Chapter 07 - Accounting for and Presentation of Liabilities

E7.11.

The semiannual interest on the bonds = 10% stated rate * $15,000 face amount * 6/12 = $750 The remaining term of the bonds is 12 years, or 24 semiannual periods.

The semiannual market interest rate is = 8% * 6/12 = 4% The present value of an interest annuity of $750 for 24 periods at 4% = $750 * 15.2470 = $11,435.25 The present value of the maturity value of $15,000 in 24 periods at 4% = $15,000 * 0.3901 = $5,851.50 The market value of the bonds = PV of interest + PV of maturity value = $11,435.25 + $5,851.50 = $17,286.75 E7.12.

The annual interest on the bonds = 8% stated rate * $63,000 face amount = $5,040 The remaining term of the bonds is 15 years.

The present value of an interest annuity of $5,040 for 15 years at 12% = $5,040 * 6.8109 = $34,326.93 The present value of the maturity value of $63,000 in 15 years at 12% = $63,000 * 0.1827 = $11,510.10 The market value of the bonds = PV of interest + PV of maturity value = $34,326.93 + $11,510.10 = $45,837.03 E7.13. a. Annual interest payment = $40 million * 11% = $4,400,000 b. The bonds were issued at a discount because market interest rates were more than the stated rate when the bonds were issued. The higher the discount rate (i.e., the market interest rate), the lower the present value of cash flows for interest payments and principal (i.e., the lower the bond’s selling price). c. Interest expense will be more than the interest paid because the amortization of bond discount will increase interest expense.

7-14

Chapter 07 - Accounting for and Presentation of Liabilities

E7.14. a. Annual interest payment = $250 million * 9% = $22,500,000 b. The bonds were issued at a premium because market interest rates were less than the stated rate when the bonds were issued. The lower the discount rate (i.e., the market interest rate), the higher the present value of cash flows for interest payments and principal (i.e., the higher the bond’s selling price). c. Interest expense will be less than the interest paid because the amortization of bond premium will decrease interest expense.

E7.15.

The amount of deferred income taxes has risen steadily because the excess of accelerated tax depreciation over straight-line book depreciation on recent asset additions exceeds the excess of book depreciation over tax depreciation for older assets. This occurs because as the company grows over time, asset additions increase and over time the cost of replacement assets rises due to inflation.

E7.16.

ROE will be higher using debt. The difference between the cost of debt of 10% and ROI of 12% results in increased return to the owners without additional owners' investment.

E7.17.

Transaction/ Adjustment a. b. c. d. e. f.

Current Assets

Current Liabilities +867 +170 +1,700

-1,240

-1,240 +1,500

Long-Term Debt

+50

7-15

Net Income -867 -170 -1,700 -50 -1,500

Chapter 07 - Accounting for and Presentation of Liabilities

E7.17.

(continued)

Journal entries: a. Dr. Wages Expense ..............................................................

Cr. Wages Payable .......................................................

867 867

b. Dr. Interest Expense ..............................................................

Cr. Interest Payable ......................................................

170

c. Dr. Interest Expense ($240,000 * 8.5% * 1/12) ...................

Cr. Interest Payable .....................................................

1,700

d. Dr. Interest Expense ............................................................

Cr. Discount on Bonds Payable ...................................

50

e. Dr. Estimated Warranty Liability ........................................

Cr. Cash........................................................................

Cr. Parts Inventory .......................................................

1,240

f. Dr. Sales ..............................................................................

Cr. Unearned Revenues .......................………............

1,500

170

1,700

50

410 830

1,500

E7.18.

Transaction/ Adjustment a. b. c. d. e. f.

Current Assets -768

Current Liabilities -768 +2,400 +2,250

Long-Term Debt

-70 +1,836 +76,000

7-16

+21,000

Net Income -2,400 -2,250 +70 -1,836 -97,000

Chapter 07 - Accounting for and Presentation of Liabilities

E7.18.

(continued)

Journal entries: a. Dr. Wages Payable ...............................................................………

Cr. Cash.........................................................................………

768 768

b. Dr. Real Estate Tax Expense ...................................………............

Cr. Real Estate Taxes Payable ......................................………

2,400

c. Dr. Interest Expense ($360,000 * 7.5% * 1/12) ...............................

Cr. Interest Payable ..................................................................

2,250

d. Dr. Premium on Bonds Payable .......................................................

Cr. Interest Expense ..................................................................

70

e. Dr. Estimated Warranty Expense ($918,000 * 0.2%) ......................

Cr. Estimated Warranty Liability ..............................................

1,836

f. Dr. Income Tax Expense..................................................................

Cr. Income Taxes Payable ........................................................

Cr. Deferred Income Taxes .......................................................

97,000

7-17

2,400

2,250

70

1,836

76,000 21,000

Chapter 07 - Accounting for and Presentation of Liabilities

E7.19.

Transaction/ Current Noncurrent Current Noncurrent Owners' Net Adjustment Assets Assets Liabilities Liabilities Equity Income a.

Income Taxes Deferred Income Tax Payable Income Taxes Expense +500 +200 -700 b.

Cash +4,950

c.

Cash -3,000

d.

Inventory -64

Estimated Warranty Liability -64

e.

Cash +19,400

Notes Payable +20,000 Discount on Notes Payable -600

f.

Bonds Payable +5,000 Discount on Bonds Payable -50 Land +3,000

Current Serial Bonds Maturities Payable of Long-term -35,000 Debt + 35,000

Journal entries: a. Dr. Income Tax Expense..................................................................

Cr. Income Taxes Payable ........................................................

Cr. Deferred Income Taxes ....................................................... b. Dr. Cash ...........................................................................................

Dr. Discount on Bonds Payable .......................................................

Cr. Bonds Payable ....................................................................

7-18

700 500 200 4,950 50 5,000

Chapter 07 - Accounting for and Presentation of Liabilities

E7.19.

(continued)

c. Dr. Land ...........................................................................................

Cr. Cash....................................................................................

3,000

d. Dr. Estimated Warranty Liability ........................................………

Cr. Inventory ............................................................................

64

e. Dr. Cash ($20,000 - ($20,000 * 12% * 3/12)) ...............................

Dr. Discount on Notes Payable ($20,000 * 12% * 3/12) .................

Cr. Notes Payable.....................................................................

19,400 600

f. Dr. Serial Bonds Payable .................................................................

Cr. Current Maturities of Long-Term Debt ..............................

35,000

3,000

64

20,000

35,000

E7.20.

Transaction/ Current Noncurrent Adjustment Assets Assets a.

Truck +32,000

b.

Cash -1,485

c.

Cash +7,140

d.

e.

Current Noncurrent Owners' Net Liabilities Liabilities Equity Income Capital Lease Liability +32,000 Accounts Payable -1,500

Purchases Discounts +15 Bonds Payable +7,000 Premium on Bonds Payable +140

Estimated Warranty Liability -2,500 Cash -3,030

Warranty Expense +2,500

Bonds Payable -3,000

7-19

Loss on Retirement of Bonds -30

Chapter 07 - Accounting for and Presentation of Liabilities

E7.20.

(continued) Transaction/ Current Noncurrent Adjustment Assets Assets f.

Current Noncurrent Owners' Net Liabilities Liabilities Equity Income Estimated Estimated Retiree Liability for Liability for Health Retiree Retiree Care Health Care Health Care Expense +24,000 +310,000 -334,000

Journal entries: a. Dr. Truck ..........................................................................................

Cr. Capital Lease Liability ........................................................

32,000 32,000

b. Dr. Accounts Payable.......................................................................

Cr. Cash.........................................................................………

Cr. Purchase Discounts .................................................………

1,500

c. Dr. Cash ...........................................................................................

Cr. Bonds Payable ....................................................................

Cr. Premium on Bonds Payable ...............................................

7,140

d. Dr. Estimated Warranty Liability ....................................................

Cr. Warranty Expense ..................................................………

2,500

e. Dr. Bonds Payable ...............................................................………

Dr. Loss on Retirement of Bonds ........................................………

Cr. Cash.........................................................................………

3,000 30

f. Dr. Estimated Health Care Expense.....................................………

Cr. Estimated Liability for Retiree Health Care--Current ......

Cr. Estimated Liability for Retiree Health Care--Noncurrent

334,000

7-20

1,485 15

7,000 140 2,500

3,030

24,000 310,000

Chapter 07 - Accounting for and Presentation of Liabilities

P7.21. a.

Balance Sheet Income Statement .

Assets = Liabilities + Owners’ Equity  Net income = Revenues - Expenses November 1, 2010: Cash Unearned +25,200 Rent Revenue +25,200 Each month-end: Unearned Rent Revenue -4,200

Rent Revenue +4,200

November 1, 2010 1. Dr. Cash ..........................................................................………

Cr. Unearned Rent Revenue ....................................………

25,200 25,200

To record the receipt a six-month advance rent payment.

Each month-end: 2. Dr. Unearned Rent Revenue ...........................................……...

Cr. Rent Revenue .................................................................

4,200 4,200

To record a reduction in the liability account for rent earned each month.

b. At December 31, 2010, two months of rent has been earned, and four months remains to be earned. So 4/6 of the original receipt of $25,200, or $16,800 is unearned rent and will be shown on the December 31 balance sheet as a current liability. c. At a rate of $4,200 per month, the receipt of an 18-month rent prepayment would have been for $75,600. The unearned amount at December 31, 2010, is $67,200 ($4,200 per month for the next 16 months). Only $50,400 ($4,200 * 12 months) of this amount is a current liability, because of the one-year time frame for current liabilities. Thus, $16,800 ($4,200 * 4 months) of the unearned amount is a noncurrent liability.

7-21

Chapter 07 - Accounting for and Presentation of Liabilities

P7.22. a.

Balance Sheet Income Statement .

Assets = Liabilities + Owners’ Equity  Net income = Revenues - Expenses 1. To record the cash collection of subscription fees received in advance: Cash Unearned +10,000 Subscription Revenue +10,000 2. To record subscription revenue earned from delivering magazines: Unearned Subscription Revenue -500

Subscription Revenue +500

1. Dr. Cash ($50 * 200 subscriptions) ..........................………............

Cr. Unearned Subscription Revenue ............………............

10,000 10,000

To record the cash collection of subscription fees received in advance.

2. Dr. Unearned Subscription Revenue ..........................................

Cr. Subscription Revenue ($50 * 120 subscribers * 1/12)… .......

500 500

To record subscription revenue earned from delivering magazines.

b. Revenue earned during September ($50 * 120 subscribers * 1/12) ...........

Revenue earned from October-December ($50 * 200 subscribers * 3/12) Total subscription revenue earned during 2011 .................................

$ 500 2,500 $3,000

c. Solution approach: Assuming that the “profile” of lifetime subscribers for Evans Ltd. will be similar to that of current subscribers, an average lifetime membership will last for 40 years. The present value of a lifetime subscription, discounted at 12% for 40 years = ($50 per year revenues foregone * 8.2438) = $412.19 Analysis of results: Based on calculation above, it would be profitable for Evans Ltd. to sell lifetime subscriptions for $600 because the fee received would be $187.81 greater than the present value of an average lifetime membership achieved otherwise.

Note to instructor: These results would obviously be interest rate sensitive. If the 12% average interest rate seems high, it may be appropriate for the accountants at Evans Ltd. to test some other interest rates such as 10% and 8%. At 10%, the present value of the lifetime subscription would be $488.96 ($50 * 9.7791); at 8% the present value would be $596.23 ($50 * 11.9246). Thus, if long-term interest rates were expected to be less than 8%, the price of the lifetime subscription would need to be increased accordingly.

7-22

Chapter 07 - Accounting for and Presentation of Liabilities

P7.22.

(continued)

d. Points for discussion: Other factors to consider include the following: • ... Would the lifetime subscription offer attract younger customers, such that the average age of a life-time subscriber would become less than the current average age of 38? Yes, but even under the assumption that the average age drops to 28, the present value of the additional 10 years of annual subscription fees would be minimal. PV for 50 years, discounted at 12% = $50 * 8.3045 = $415.23, so the PV of the additional 10 years of revenues foregone would be $3.04 (less than the cost of breakfast)! This provides an excellent opportunity to have the students look again at the present value factors in Tables 6-4 and 6-5 for far-distant cash flows.

•

Is the use of the company’s average interest rate for long-term debt the appropriate rate to use in the present value analysis? Yes, because the money made available from the receipt of lifetime subscription fees can be used for investment in inventories, plant and equipment, etc., and will be “repaid” on a long-term basis as newsletters are delivered. The company would otherwise have to borrow funds to finance its long-term asset growth objectives, and since the present value of the subscription “repayments” is less than the $600 fee, the ROI earned on the “borrowed” funds exceeds the “interest” cost being paid on the “loan” from subscribers.

•

What would be the impact, in present value terms, of changes in the interest rate assumption? Even if 12% represents an appropriate measure of the firm’s current interest cost on long-term debt, is it reflective of the firm’s long-term interest cost?

Actually, the answer shouldn’t matter--in terms of the firm’s payment obligation-because the lifetime subscription offer is essentially the same transaction as a bond issuance. That is, the firm can lock into a fixed “interest” rate that is substantially lower than 12% (see above discussion). However, if interest rates were to fall substantially, say to 6% (and were expected to stay that low), then it would no longer be profitable to offer a lifetime option for $600.00. PV at 6% for 40 years = $50 * 15.0463 = $752.32. In these circumstances, Evans, Ltd. should either increase the cost of a lifetime membership (to say, $800 since it’s nice round number) or choose not to offer a lifetime membership.

7-23

Chapter 07 - Accounting for and Presentation of Liabilities

P7.22. d.

(continued) •

What impact would the lifetime offer have on current subscribers? Several management issues would need to be addressed, including the possibility of offering a “grandfather” clause to present subscribers such that a portion of their past subscription fees could be counted toward the $600 fee. (This is another present value problem.)

P7.23. a. Gross Pay - Total Deductions = Net Pay Gross Pay = (Net Pay + Total Deductions) = ($58,360 + $21,640) = $80,000 FICA Tax Withholdings = (Total Deductions - all other deductions) = ($21,640 - $13,760 - $1,120 - $640) = $6,120 FICA Tax Withholdings / Gross Pay = withholding percentage $6,120 / $80,000 = 7.65% b.

Balance Sheet Income Statement .

Assets = Liabilities + Owners’ Equity  Net income = Revenues - Expenses Wages Payable +58,360 Withholding Liabilities (accounts as shown in the entry) +6,120 +13,760 +1,120 +640

Dr. Wages Expense .................................................………............

Cr. Wages Payable (or Accrued Payroll) ..................................

Cr. FICA Taxes Withheld .........................................................

Cr. Income Taxes Withheld ......................................................

Cr. Medical Insurance Contributions ........................................

Cr. Union Dues ....................................………........................

To record accrued payroll.

7-24

Wages Expense -80,000

80,000 58,360 6,120 13,760 1,120 640

Chapter 07 - Accounting for and Presentation of Liabilities

P7.24. a. FICA Tax Withholdings (employees portion) = Gross Pay * 7.65% = $53,000 * 7.65% = $4,054.50 Employee Contributions to Pension Plans = (Total Deductions - all other deductions) = $14,088 - $4.054.50 - $7,680 - $960 = $1,393.50 Net Pay = Gross Pay - Total Deductions = $53,000 - $14,088 = $38,912 Balance Sheet Income Statement .

Assets = Liabilities + Owners’ Equity  Net income = Revenues - Expenses Wages Payable +38,912 Withholding Liabilities (accounts as described below) +4,054.50 +7,680 +960 +1,393.50

Wages Expense -53,000

Dr. Wages Expense .....................................………........................ 53,000.00 Cr. Wages Payable (or Accrued Payroll) .................................

38,912.00 Cr. FICA Taxes Withheld (employees’ share) ………............

4,054.50 Cr. Income Taxes Withheld .....................................................

7,680.00 Cr. Group Hospitalization Insurance .......................................

960.00 Cr. Employee Contributions to Pension Plan ..........................

1,393.50 To record accrued payroll.

b. The employer’s payroll taxes consist of the following: FICA tax withholdings ($53,000 * 7.65%) ........................................

Federal unemployment compensation taxes ($7,500 * 0.8%) ...........

State unemployment compensation taxes ($7,500 * 5.4%) ...............

Total employer payroll taxes .............................................................

7-25

$4,054.50 60.00 405.00 $4,519.50

Chapter 07 - Accounting for and Presentation of Liabilities

P7.24. b.

(continued) Balance Sheet Income Statement .

Assets = Liabilities + Owners’ Equity  Net income = Revenues - Expenses Payroll Taxes Payable (or other descriptions) +4,519.50

Payroll Tax Expense -4,519.50

Dr. Payroll Tax Expense .................................................................

Cr. Payroll Taxes Payable (or Accrued Payroll Taxes)……….

4,519.50 4,519.50

To record accrued payroll taxes.

Alternative entry: The credits in the above entry are often broken down in the chart of accounts based on the nature of the employer’s payroll tax obligations, such as: Dr. Payroll Tax Expense .................................................................

Cr. FICA Taxes Withheld (employer’s share) ..………............

Cr. Federal Unemployment Taxes Withheld ............................

Cr. State Unemployment Taxes Withheld ................................

4,519.50 4,054.50 60.00 405.00

To record accrued payroll taxes.

P7.25. a. Because the exchange ratio is five shares of common stock to one bond, bondholders would be interested in converting the bonds to common stock if the market price per share of common stock was at least 20% (or more) of the market price per bond. For example, when the bonds were issued on January 1, 2002 at their $1,000 face amount, the market rate of interest and the stated rate were both 12%, and the market price per bond was $1,000. At that time, bondholders would not have been willing to convert their bonds unless the common stock was trading at price of $200 per share or more. b. Solution approach: Upon exercise of the conversion feature, the bonds have been retired and thus the Bonds Payable account must be reduced by the carrying value of $1,000 per bond retired (there was no discount or premium). Common stock has been issued for $215 per share and should be recorded in the usual way. The difference is a loss on the early retirement of bonds of $75 per bond retired (or $15 per share of common stock issued) because the company gave more in exchange for the bonds ($215 per share * 5 shares equals $1,075) than the carrying value of the bonds ($1,000 per bond).

7-26

Chapter 07 - Accounting for and Presentation of Liabilities

P7.25.

(continued) Balance Sheet Income Statement .

Assets = Liabilities + Owners’ Equity  Net income = Revenues - Expenses Bonds Payable -400,000

Common Stock +20,000 Additional Paid-In Capital +410,000

Dr. Bonds Payable (400 bonds * $1,000 per bond) ......................

Dr. Loss on Early Retirement of Bonds ................................

Cr. Common Stock (400 bonds * 5 shares * $10 par) .………

Cr. Additional Paid-In Capital (400 * 5 * $205 per share) ....

Loss on Early Retirement of Bonds -30,000

400,000 30,000 20,000 410,000

To record the conversion of bonds to common stock at a loss.

P7.26. a. Management of Riley Co. would be interested in calling the bonds if interest rates dropped enough so that the cost of a new borrowing to pay off the old bonds at a 2% call premium would be less than the cost of continuing to pay the 15% stated interest rate on the old bonds. b. Solution approach: The amount paid to bondholders = ($40,000,000 face amount * 102%) = $40,800,000. The bond discount was $1,000,000 ($40,000,000 face amount$39,000,000 proceeds), and the bonds have been outstanding for 13 years, so $650,000 (13/20 * $1,000,000) of the discount would have been amortized by December 31, 2010.

Thus, the unamortized bond discount = $350,000. The loss on retirement of bonds =($40,800,000 amount paid - $39,650,000 carrying value of bonds) = $1,150,000. b.

Balance Sheet Income Statement .

Assets = Liabilities + Owners’ Equity  Net income = Revenues - Expenses Cash Bonds -40,800,000 Payable -40,000,000 Discount on Bonds Payable +350,000

Loss on Early Retirement of Bonds -1,150,000

Dr. Bonds Payable .......................................………............ 40,000,000 Dr. Loss on Early Retirement of Bonds ..............................

1,150,000 Cr. Cash.............................................................………

40,800,000 Cr. Discount on Bonds Payable (unamortized balance) 350,000 To record the early retirement of bonds by exercise of the call feature.

7-27

Chapter 07 - Accounting for and Presentation of Liabilities

P7.27. a. The semiannual interest payments on the bonds = 14% stated rate * $3,000,000 face amount * 6/12 = $210,000 The term of the bonds is 10 years, or 20 semiannual periods.

The semiannual market interest rate is = 12% * 6/12 = 6% The present value of an annuity of $210,000 for 20 periods at 6% = $210,000 * 11.4699 = $2,408,679 The present value of the maturity value of $3,000,000 in 20 periods at 6% = $3,000,000 * 0.3118 = $935,400 The proceeds (issue price) of the bonds = PV of interest + PV of maturity value = $2,408,679 + $935,400 = $3,344,079 b. The semiannual discount amortization, straight-line basis = $50,000 / 20 periods = $2,500 Balance Sheet Income Statement .

Assets = Liabilities + Owners’ Equity  Net income = Revenues - Expenses Cash -210,000

Discount on Bonds Payable +2,500

Interest Expense -212,500

Dr. Interest Expense .............................................................

Cr. Cash.........................................................................

Cr. Discount on Bonds Payable ...................................

To record the semiannual cash payment and amortization of discount.

7-28

212,500 210,000 2,500

Chapter 07 - Accounting for and Presentation of Liabilities

P7.27.

(continued)

c. Discount on bonds payable is amortized with a credit, and thus increases interest expense.

Under the straight-line basis, the amount of discount amortization is the same each period. Under the compound (or effective) interest method, the amount of discount amortization increases each period. Thus, interest expense under the compound method will be lower in the early years of the bond’s life and higher in the later years, as compared to interest expense under the straight-line method of amortization.

Rationale of compound interest method: Interest expense under the compound interest method is calculated by multiplying the carrying value of the bond (face amount minus the unamortized discount) by the market rate of interest. This amount is then compared to the cash payment required (the face amount multiplied by the stated rate). Any difference between interest expense and the required cash payment represents the amortization of discount for the period. Because the carrying value of the bond increases over the life of the bond as discount is amortized, the amount of discount amortization also increases each period, causing interest expense to be higher each period. Thus, as compared to the straight-line basis, interest expense under the compound method will be lower in the first year.

P7.28. a. The semiannual interest payments on the bonds = 14% stated rate * $60,000,000 face amount * 6/12 = $4,200,000 The term of the bonds is 20 years, or 40 semiannual periods.

The semiannual market interest rate is = 16% * 6/12 = 8% The present value of an annuity of $4,200,000 for 40 periods at 8% = $4,200,000 * 11.9246 = $50,083,320 The present value of the maturity value of $60,000,000 in 40 periods at 8% = $60,000,000 * 0.0460 = $2,760,000 The proceeds (issue price) of the bonds = PV of interest + PV of maturity value = $50,083,320 + $2,760,000 = $52,843,320

7-29

Chapter 07 - Accounting for and Presentation of Liabilities

P7.28.

(continued)

b. The semiannual premium amortization, straight-line basis = $2,000,000 / 40 periods = $50,000 Balance Sheet Income Statement .

Assets = Liabilities + Owners’ Equity  Net income = Revenues - Expenses Cash -4,200,000

Premium on Bonds Payable -50,000

Interest Expense -4,150,000

Dr. Interest Expense .............................................................

Dr. Premium on Bonds Payable ...........................................

Cr. Cash.........................................................................

4,150,000 50,000 4,200,000

To record the semiannual cash payment and amortization of premium.

c. Premium on bonds payable is amortized with a debit, and thus decreases interest expense.

Under the straight-line basis, the amount of premium amortization is the same each period. Under the compound (or effective) interest method, the amount of premium amortization increases each period. Thus, interest expense under the compound method will be higher in the early years of the bond’s life and lower in the later years, as compared to interest expense under the straight-line method of amortization.

Rationale of compound interest method: Interest expense under the compound interest method is calculated by multiplying the carrying value of the bond (face amount plus the unamortized premium) by the market rate of interest. This amount is then compared to the cash payment required (the face amount multiplied by the stated rate). Any difference between interest expense and the required cash payment represents the amortization of premium for the period. Because the carrying value of the bond decreases over the life of the bond as premium is amortized, the amount of premium amortization increases each period, causing interest expense to be lower each period. Compared to the straight-line basis, interest expense under the compound method will be higher in the first year. d. There is usually a time lag of several weeks from the point that the stated rate of interest has been established (as part of the bond indenture) and the date that the bonds are sold (issuance date). However, because this time lag tends to be relatively short, the market interest rate usually does not change significantly before the bonds are issued.

7-30

Chapter 07 - Accounting for and Presentation of Liabilities

C7.29. a. The average-for-the-year interest rate = (7% + 8%) / 2 = 7.5% The average liability balance = ($190,000 + $250,000) / 2 = $220,000 Balance Sheet Income Statement .

Assets = Liabilities + Owners’ Equity  Net income = Revenues - Expenses Interest Payable +16,500

Interes t Expense -16,500

Dr. Interest Expense ($220,000 * 7.5%) ......………........................

Cr. Interest Payable ...........................................………............

16,500 16,500

To accrue interest on working capital loans for the year.

b. No. The “current maturities of long-term debt” is related to the “serial bonds due in equal annual installments.” The current maturities owed at the end of 2010 would have been paid at some point during 2011 (at the date specified in the serial bond indenture). At the end of 2011, an entry would have been made to reclassify the 2012 installment of the long-term serial bond as a current liability. Thus, the “current maturities” account would have decreased and then increased by equal amounts during the year. c. Solution approach: What happens to the market value of the firm’s bonds outstanding when there is a decline in interest rates for bonds of similar risk? The bonds pay a higher than market-rate of interest, so their price will increase. That is, investors are willing to pay more for bonds offering a higher than market interest rate because such an investment will increase their ROI. Since the bonds are a liability to Corless Co. (the issuer), it is likely that the call feature will be exercised so that bonds with a lower interest rate can be issued in the near future. It would not be to the bondholders’ advantage to exercise the conversion feature at this point.

Points for discussion: What other factors should Corless Co. consider before deciding to call the bonds? 1) cost of the call premium, and 2) cost of registration and issuance of a new bond issue; both factors should be considered relative to the remaining term of the outstanding bonds. Note that interest rate expectations are not terribly relevant because the new bond issue will have a fixed interest rate (at or near 7%), and if interest rates continue to drop, the call feature can be exercised on the new bonds as well.

7-31

Chapter 07 - Accounting for and Presentation of Liabilities

C7.29.

(continued)

d. The market value would be more than the book value of $400,000 because the price of the bonds would increase, as described in item c. This is bad news to Corless Co. because it is paying a higher than market interest rate.

Points for discussion: Why doesn’t the firm adjust the book value of its liability for the change in market value caused by interest rate movements? That is, why not record the unrealized gain or loss each year as a year-end adjusting entry so that the Bonds Payable account will be marked to market? 1) This would violate the historical cost principle-bonds are initially recorded at their market value at the time of issuance, and the initial amount of discount or premium is amortized over the life of the bond issue (much like the depreciation of the historical cost of long-term assets). Accounting for liabilities should be consistent with the accounting for long-term assets. 2) The going concern concept suggests that, in the end, the bonds will be appropriately valued--the book value will be equal to the face amount at the maturity date, and this is the amount of cash the issuer must ultimately pay to satisfy its obligation. So why keep adjusting the “value” of the Bonds Payable liability up and down if the market adjustments are not going to be realized by the firm. This provides a good opportunity to discuss/reinforce alternative valuation approaches for liabilities (and assets) with emphasis on the historical cost/market value debate. e. The following adjusting entry was made at year-end to reclassify the 2012 installment of the serial bond as a current liability: Balance Sheet Income Statement .

Assets = Liabilities + Owners’ Equity  Net income = Revenues - Expenses Serial Bonds Payable -80,000 Current Maturities of Long-Term Debt +80,000

Dr. Serial Bonds Payable .................………....................................

Cr. Current Maturities of Long-Term Debt ..............................

To reclassify the 2012 installment of the serial bond as a current liability.

7-32

80,000 80,000

Chapter 07 - Accounting for and Presentation of Liabilities

C7.30.

Note to Instructors: This case was originally based on the 1999 annual report of Home Depot, Inc. The long-term debt note disclosures in more recent years have become less interesting from an accounting perspective (i.e., Home Depot no longer reports commercial paper, installment notes, or an unsecured bank loan, for instance. Thus, to preserve the case, we changed the name to a fictional company). a. The notes were converted into shares at a price of $15.3611, which means that approximately 71.80 million shares would have been issued in exchange for the notes ($1,103,000,000 / $15.3611). Note: Home and Office City’s footnote disclosures indicate that 72 million shares were actually issued—perhaps shares were also given in lieu of some accrued interest. b. 1. Below face: No, this is not possible.

2. Above face: Yes, this is possible.

3. Equal to face: Yes, this is possible.

Discussion: The bonds are redeemable at “a redemption price… equal to the greater of (1) 100% of the principal amount of the Senior Notes to be redeemed, or (2)…” This statement indicates that the minimum amount to be paid by Home and Office City is equal to the principal amount of the notes (i.e., face value). Thus, the notes cannot be redeemed at a discount—no matter what the “present value” of the remaining principal and interest payments is.

If, however, the market value of the notes is greater than their principal (i.e., face) value, then Home and Office City (at its option) may redeem the notes at a premium. The language quoted in point (2) describes the market value of the notes as the “sum of the present values of the remaining scheduled payments of principal and interest to maturity.”

If the market value is equal to the face value, then the notes may be redeemed at face value.

Home and Office City would most likely be prompted to redeem the notes if interest rates were expected to fall significantly below 6.5% such that the company would be able to reissue debt at a fixed interest rate of less than 6.5%.

7-33

Chapter 07 - Accounting for and Presentation of Liabilities

C7.30.

(continued)

c. This statement means that Home and Office City has arranged to have “ready access” to $800 million of additional borrowings. As of December 31, 2011, no commercial paper debt was outstanding, which means that the company has not drawn down on this line of credit. Should the company need to do so, the terms and conditions of the debt (i.e., restrictive covenants) are unlikely to make a significant difference in terms of the company’s ability to pay its other debts (i.e., liquidity). Likewise, borrowing on this line of credit is unlikely to have a significant impact on the company’s ability to access funds through other financing sources (i.e., capital resources)—which means that borrowing on the line of credit is not likely to influence the company’s creditworthiness (i.e., debt ratings). d. You might want to know, for instance: 1. What amounts are scheduled to mature in which years; 2. What the implicit interest rate (or a range of implicit interest rates) is on the capital lease obligations; and 3. What underlying assets these borrowings relate to. e. Most installment notes are non-interest bearing on their face. Yet, if you were to add up the total of the amounts to be repaid in future years, this undiscounted sum would greatly exceed the amount initially borrowed. Thus, the interest rate charged on the loan is implicit (rather than explicit, as when it’s stated in the lending documents). The implicit interest rate must be that rate which makes the loan proceeds at the time of borrowing equal to the sum of the discounted values of all future loan repayments. As you can imagine, computers help! f. Any of a number of explanations are possible, including: 1. Lenders are inclined to require security interests.

2. Unsecured loans are more expensive to borrowers (in the form of higher interest rates).

3. Most of Home and Office City’s long-term borrowing needs relate to the construction of new stores, which provides a ready-made form of security interest.

4. Unsecured loans tend to be of relatively short duration (usually 2-4 years), which may not coincide with the borrower’s cash needs.

7-34

Chapter 07 - Accounting for and Presentation of Liabilities

C7.30.

(continued)

g. Most of Home and Office City’s long-term debt has near-term maturities. The $500 million of 6.5% senior notes are due on September 15, 2015; the $15 million of unsecured bank loans are due in August 2013; the capital lease obligations and installment notes fall due over longer periods (through 2038 and 2029, respectively), but perhaps some of these amounts will mature in the next five years as well.

7-35

Chapter 07 - Accounting for and Presentation of Liabilities

TAKE-HOME QUIZ--CHAPTER 7

Name __

_________________

1. This question relates to the following presentation in the balance sheets of Asriel, Inc. at December 31, 2011 and 2010: Current liabilities: Accounts payable ..........................................................................

Accrued wages payable.................................................................

Accrued property taxes payable ....................................................

Accrued interest payable ...............................................................

12/31/11 $ 18,400 3,800 2,200 1,800

12/31/10 $ 16,750 4,430 2,000 0

a. If wages expense during 2011 totaled $137,600, how much cash was paid for wages?

b. If property taxes paid during 2010 totaled $27,350, how much property tax expense was accrued during 2011?

c. If the interest payable at 12/31/11 had not been accrued at that date, by how much and in what direction (too high or too low) would net income for 2011 have been misstated?

d. Why are expenses accrued?

7-36

Chapter 07 - Accounting for and Presentation of Liabilities

TAKE-HOME QUIZ--CHAPTER 7 (continued) 2. On January 1, 2011, Simon, Inc. issued $500,000 of 9%, 10-year bonds at 101. Interest is payable every June 30 and December 31. Premium is amortized on a straight-line basis. a. Was the market interest rate on January 1, 2011 equal to, more than, or less than the stated interest rate of the bonds? Explain your answer.

b. How much interest will be paid on these bonds during 2011?

c. How much interest expense will Simon, Inc. report in its 2011 income statement with respect to these bonds?

3. a. The deferred income tax liability arises because book income is greater than taxable income.

What is the principal item that causes book and taxable income to be different for most companies?

b. What concept is being applied when income taxes that won't be payable for several years are recognized in the current period's financial statements?

7-37

Chapter 07 - Accounting for and Presentation of Liabilities

TAKE-HOME QUIZ KEY—CHAPTER 7 1. a. Analyze the wages payable account: Beginning balance of wages payable ................................................................

Add: Accrual of wages expense for period ........................................................

Total credits to wages payable account .............................................................

Less: Ending balance of wages payable account ...................................………

Debit to wages payable for wages paid during year .......................................... b. Analyze the property taxes payable account: Beginning balance of property taxes payable ....................................................

Less: Property taxes paid during period.............................................................

Net debit to property taxes payable account ......................................................

Add: Ending balance of property tax payable account ......................................

Credit to property tax payable for tax expense accrued during the year ...........

$

4,430 137,600 $142,030 (3,800) $138,230

$

2,000 (27,350) $ 25,350 2,200 $ 27,550

c. Net income would have been $1,800 too high. d. To match revenues and expenses, thus making the financial statements more accurate.

2. a. Less than, because the bonds were issued at a premium. b. $500,000 * 9% = $45,000 c. Interest paid ....................................................................................................... $45,000 Less premium amortization ($5,000 / 10 years) ..............................................

(500) Interest expense for year ................................................................................... $44,500 3. a. Depreciation expense. Accelerated depreciation is claimed for income tax purposes and straight-line depreciation is used for book purposes. b. Matching of revenues and expenses.

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